Annual Report
Table of Contents

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 


FORM 10-K

 

x Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the fiscal year ended December 31, 2005

 

¨ Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

Commission File No. 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)
  (IRS Employer
Identification No.)

201 Fifth Avenue SW, Olympia, Washington 98501

(Address of principal executive offices, including zip code)

Registrant’s telephone number, including area code: (360) 943-1500

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, no par value per share

(Title of class)

 


Indicate by check mark if the registrant is a well-seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨  No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨  No  x

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x  No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer  ¨   Accelerated filer  x   Non-accelerated filer  ¨

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

The aggregate market value of the voting stock held by non-affiliates of the registrant was $104,687,829 and was based upon the last sales price as quoted on the NASDAQ Stock Market for June 30, 2005.

The Registrant had 6,326,772 shares of common stock outstanding as of February 10, 2006.

DOCUMENTS TO BE INCORPORATED BY REFERENCE

Portions of the Registrant’s definitive Proxy Statement expected to be dated March 23, 2006 for the 2006 Annual Meeting of Stockholders will be incorporated by reference into Part III of this Form 10-K.

 



Table of Contents

HERITAGE FINANCIAL CORPORATION

FORM 10-K

December 31, 2005

TABLE OF CONTENTS

 

          Page
   PART I   

ITEM 1.

  

BUSINESS

   3
  

LENDING ACTIVITIES

   3
  

INVESTMENT ACTIVITIES

   10
  

DEPOSIT ACTIVITIES AND OTHER SOURCES OF FUNDS

   12
  

SUPERVISION AND REGULATION

   14
  

COMPETITION

   18

ITEM 1A.

  

RISK FACTORS

   18

ITEM 1B.

  

UNRESOLVED STAFF COMMENTS

   20

ITEM 2.

  

PROPERTIES

   20

ITEM 3.

  

LEGAL PROCEEDINGS

   20

ITEM 4.

  

SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

   20
   PART II   

ITEM 5.

  

MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

   21

ITEM 6.

  

SELECTED FINANCIAL DATA

   22

ITEM 7.

  

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

   23

ITEM 7A.

  

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

   30

ITEM 8.

  

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

   30

ITEM 9.

  

CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES

   30

ITEM 9A.

  

CONTROLS AND PROCEDURES

   31

ITEM 9B.

  

OTHER INFORMATION

   33
   PART III   

ITEM 10.

  

DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

   34

ITEM 11.

  

EXECUTIVE COMPENSATION

   34

ITEM 12.

  

SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

   34

ITEM 13.

  

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

   34

ITEM 14.

  

PRINCIPAL ACCOUNTING FEES AND SERVICES

   34
   PART IV   

ITEM 15.

  

EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

   35

 

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Table of Contents

PART I

 

ITEM 1. BUSINESS

General

Heritage Financial Corporation is a bank holding company incorporated in the State of Washington in August 1997. We were organized for the purpose of acquiring all of the capital stock of Heritage Savings Bank upon our reorganization from a mutual holding company form of organization to a stock holding company form of organization (“Conversion”).

We are primarily engaged in the business of planning, directing and coordinating the business activities of our wholly owned subsidiaries: Heritage Bank and Central Valley Bank. Heritage Bank is a Washington state-chartered commercial bank whose deposits are insured by the Federal Deposit Insurance Corporation (“FDIC”) under the Savings Association Insurance Fund (“SAIF”) and the Bank Insurance Fund (“BIF”). During 2004, Heritage Bank changed its charter from a savings bank to a commercial bank. Heritage Bank conducts business from its main office in Olympia, Washington and its twelve branch offices located in Thurston, Pierce, and Mason Counties. Central Valley Bank is a Washington state-chartered bank whose deposits are insured by the FDIC under the BIF. During 2005, Central Valley Bank changed its charter from a nationally-chartered commercial bank to a state-chartered commercial bank. Central Valley Bank conducts business from its main office in Toppenish, Washington, and its five branch offices located in Yakima and Kittitas Counties.

Our business consists primarily of lending and deposit relationships with small businesses including agribusiness and their owners in our market area, attracting deposits from the general public and originating for sale or investment purposes first mortgage loans on residential properties located in western and central Washington State. We also make residential construction, income property, and consumer loans.

Market Areas

We offer financial services to meet the needs of the communities we serve through our community-oriented financial institutions. Headquartered in Olympia, Thurston County, Washington, we conduct business through Heritage Bank and Central Valley Bank. Heritage Bank has thirteen full service offices, with seven in Pierce County, five in Thurston County, and one in Mason County. Heritage Bank has mortgage origination offices in Thurston County, Mason County and Pierce County, which all operate within banking offices. The mortgage loan operations are performed in one office located in Thurston County. Central Valley Bank operates six full service offices, with five in Yakima County and one in Kittitas County.

Lending Activities

General.    Our lending activities are conducted through Heritage Bank and Central Valley Bank. We offer commercial, real estate, income property, agricultural, and consumer loans. Our focus is on commercial lending with commercial loans increasing in the recent year to $359.8 million, or 55.2% of total loans, as of December 31, 2005 from $336.2 million, or 56.1% of total loans, as of December 31, 2004. We continue to provide real estate mortgages, both single and multifamily residential and commercial. Real estate mortgages increased to $217.9 million, or 33.4% of total loans, at December 31, 2005, from $211.9 million, or 35.3% of total loans, at December 31, 2004.

Our overall lending operations are guided by loan policies, which are reviewed and approved annually by our board of directors. These policies outline the basic policies and procedures by which lending operations are conducted. The policies address the types of loans, underwriting and collateral requirements, terms, interest rate and yield considerations, compliance with laws and regulations, and compliance with internal lending limits. We supplement our own supervision of the loan underwriting and approval process with periodic loan audits by experienced external loan specialists who review credit quality, loan documentation, and compliance with laws and regulations.

 

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The following table provides information about our loan portfolio by type of loan for the dates indicated. These balances are prior to deduction for the allowance for loan losses.

 

    At December 31,  
    2005     2004     2003     2002     2001  
    Balance     % of
Total
    Balance     % of
Total
    Balance     % of
Total
    Balance     % of
Total
    Balance     % of
Total
 
    (Dollars in thousands)  

Commercial

  $ 359,808     55.16 %   $ 336,227     56.06 %   $ 266,252     51.06 %   $ 243,872     51.86 %   $ 263,063     52.75 %

Real Estate Mortgages

                   

One-four family residential(1)

    53,098     8.14       58,903     9.82       57,377     11.00       72,846     15.49       91,189     18.28  

Five or more family residential and commercial properties

    164,788     25.26       152,958     25.50       149,728     28.72       114,750     24.40       107,450     21.55  
                                                                     

Total real estate mortgages

    217,886     33.40       211,861     35.32       207,105     39.72       187,596     39.89       198,639     39.83  

Real estate construction

                   

One-four family residential

    42,245     6.48       23,266     3.88       19,881     3.81       29,201     6.21       32,494     6.51  

Five or more family residential and commercial properties

    21,355     3.27       17,121     2.85       19,570     3.75       3,169     0.67       83     0.02  
                                                                     

Total real estate construction(2)

    63,600     9.75       40,387     6.73       39,451     7.56       32,370     6.88       32,577     6.53  

Consumer

    12,855     1.97       13,045     2.18       10,043     1.93       7,616     1.62       5,794     1.16  
                                                                     

Gross loans

    654,149     100.28 %     601,520     100.29 %     522,851     100.27 %     471,454     100.25 %     500,073     100.27 %

Less deferred loan fees and other

    (1,852 )   (0.28 )     (1,759 )   (0.29 )     (1,438 )   (0.27 )     (1,190 )   (0.25 )     (1,368 )   (0.27 )
                                                                     

Total loans receivable and loans held for sale

  $ 652,297     100.00 %   $ 599,761     100.00 %   $ 521,413     100.00 %   $ 470,264     100.00 %   $ 498,705     100.00 %
                                                                     

(1) Includes loans held for sale of $263, $381, $1,018, $8,113, and $6,275 as of December 31, 2005, 2004, 2003, 2002 and 2001, respectively.
(2) Balances are net of undisbursed loan proceeds.

The following table presents at December 31, 2005 (i) the aggregate maturities of loans in the named categories of our loan portfolio and (ii) the aggregate amounts of fixed rate and variable or adjustable rate loans in the named categories that mature after one year.

 

     Maturing
    

Within

1 year

   1-5 years   

After

5 years

   Total
     (Dollars in thousands)

Commercial

   $ 130,336    $ 93,262    $ 136,210    $ 359,808

Real estate construction

     49,983      13,545      72      63,600
                           

Total

   $ 180,319    $ 106,807    $ 136,282    $ 423,408
                           

Fixed rate loans

      $ 46,369    $ 43,774    $ 90,143

Variable or adjustable rate loans

        60,438      92,509      152,947
                       

Total

      $ 106,807    $ 136,283    $ 243,090
                       

Real Estate Lending

Single-Family Residential Real Estate Lending.    The majority of our one to four family residential loans are secured by single-family residences located in our primary market areas. Our underwriting standards require that single-family portfolio loans generally are owner-occupied and do not exceed 80% (90% with private mortgage insurance) of the current appraised value or cost, whichever is lower, of the underlying collateral. Terms typically range from 15 to 30 years. We offer both fixed rate mortgages and adjustable rate mortgages (“ARMs”) with repricing based on a Treasury Bill or other index. However, our ability to generate volume in ARMs is largely a function of consumer preference and the interest rate environment. Under our current policy we do not originate ARMs with discounted initial interest rates (i.e., “teasers”). We generally sell all government

 

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guaranteed mortgages, both fixed rate and adjustable rate. Management determines to what extent we will retain or sell other ARMs and other fixed rate mortgages in their strategy to control our interest rate sensitivity position. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Asset/Liability Management”.

Multifamily and Commercial Real Estate Lending.    We originate, on a selective basis, multifamily and commercial real estate loans in our primary market areas. Commercial real estate loans are made for small shopping centers, warehouses, and professional offices. Cash flow coverage to debt servicing requirements is generally 1.2 times or more. Our underwriting standards generally require that the loan-to-value ratio for multifamily and commercial real estate loans not exceed 80% of appraised value or cost, whichever is lower.

Multifamily and commercial real estate mortgage lending affords our banks an opportunity to receive interest at rates higher than those generally available from single-family residential lending. However, loans secured by such properties usually are greater in amount, more difficult to evaluate and monitor and, therefore, involve a greater degree of risk than single-family residential mortgage loans. Because payments on loans secured by multifamily and commercial real estate properties are often dependent on the successful operation and management of the properties, repayment of these loans may be affected by adverse conditions in the real estate market or the economy. We seek to minimize these risks by strictly scrutinizing the financial condition of the borrower, the quality of the collateral, and the management of the property securing the loan. We also generally obtain personal guarantees from financially capable borrowers based on a review of personal financial statements.

Construction Loans.    We originate single-family residential construction loans for the construction of custom homes (where the home buyer is the borrower) and provide financing to builders for the construction of pre-sold homes and speculative residential construction (i.e. built before a buyer is identified). We lend to builders who have demonstrated a favorable record of performance and profitable operations and who are building in markets that management understands and is comfortable with existing economic conditions. We further endeavor to limit our construction lending risk through adherence to strict underwriting procedures. Loans to one builder are generally limited on a case-by-case basis with unsold home limits based on builder strengths. Our underwriting standards require that the loan-to-value ratio for pre-sold homes and speculative residential construction generally not exceed 80% of appraised value or builder’s cost, whichever is less. Speculative construction and land development loans are short term in nature and priced with a variable rate of interest using the prime rate as the index. We generally require builders to have some tangible form of equity in each construction project. Also, we require prompt and thorough documentation of all draw requests and we inspect the project prior to paying any draw requests from builders.

Construction lending affords us the opportunity to achieve higher interest rates and fees with shorter terms to maturity than does our single-family permanent mortgage lending. However, construction lending is considered to involve a higher degree of risk than single-family permanent mortgage lending because of the inherent difficulty in estimating both a property’s value at completion of the project and the estimated costs of the project. As a result, these loans are generally more difficult to evaluate and monitor. If the estimate of construction cost proves to be inaccurate, we may be required to advance funds beyond the amount originally committed to permit completion of the project. If the estimate of value upon completion proves to be inaccurate, we may be confronted with a project whose value is insufficient to ensure full repayment. Projects may also be jeopardized by disagreements between buyers and builders, and the failure of builders to pay subcontractors. Loans to builders to construct homes for which no purchaser has been identified carry more risk because the liquidation of the loan depends on the builder’s ability to sell the property.

Commercial Business Lending

We offer commercial loans to sole proprietorships, partnerships, and corporations with an emphasis on real estate related industries and businesses in agricultural, health care, legal, and other professions. The types of commercial loans offered are business lines of credit secured primarily by real estate, accounts receivable and

 

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inventory financing, business term loans secured by real estate for either working capital or lot acquisition, Small Business Administration (“SBA”) loans, and unsecured business loans.

Commercial business lending generally involves greater risk than residential mortgage lending and these risks differ from those associated with residential and commercial real estate lending. Commercial real estate lending is considered to be collateral based lending with loan amounts based on predetermined loan to collateral values, where liquidation of the underlying real estate collateral is viewed as the primary source of repayment if the borrower defaults. Although our commercial business loans are often collateralized by real estate, the decision to grant a commercial business loan depends primarily on the creditworthiness and cash flow of the borrower (and any guarantors), while liquidation of collateral is a secondary source of repayment.

As of December 31, 2005, we had $359.8 million, or 55.2% of our total loans receivable, in commercial loans. The average loan size is approximately $330,000 with loans generally in amounts of $1,000,000 or less.

Origination and Sales of Loans

We originate real estate and other loans with the majority of the residential mortgage volumes generated from our mortgage loan origination offices. Walk-in customers and referrals from real estate brokers are important sources of loan originations.

Consistent with our asset/liability management strategy, we sell a majority of our fixed rate and ARM residential mortgage loans to the secondary market. Commitments to sell mortgage loans generally are made during the period between the taking of the loan application and the closing of the mortgage loan. The timing for making these sale commitments is dependent upon the timing of the borrower’s election to lock-in the mortgage interest rate and fees prior to loan closing. Most of these sale commitments are made on a “best efforts” basis whereby we are only obligated to sell the mortgage if the mortgage loan is approved and closed. As a result, management believes that market risk is minimal. In addition, we have mortgage loan production which is brokered to other lenders prior to funding.

When we sell mortgage loans, we typically sell the servicing of the loans (i.e., collection of principal and interest payments). However, we serviced $0.7 million, $0.9 million, and $2.0 million in mortgage loans for others as of December 31, 2005, 2004, and 2003, respectively. We received fee income for servicing activities on mortgage loans of $4,000, $10,000, and $14,000 for the years ended December 31, 2005, 2004, and 2003, respectively.

The following table presents summary information concerning our origination and sale of residential mortgage loans and the gains achieved on such activities.

 

     Years ended December 31,
     2005    2004    2003    2002    2001
     (Dollars in thousands)

Residential mortgage loans:

              

Originated

   $ 25,097    $ 52,188    $ 125,438    $ 91,614    $ 103,634

Sold

     13,632      35,822      105,790      74,318      97,807

Gains on sales of loans, net

   $ 277    $ 640    $ 1,907    $ 1,404    $ 1,669

Commitments and Contingent Liabilities

In the ordinary course of business, we enter into various types of transactions that include commitments to extend credit that are not included in our consolidated financial statements. We apply the same credit standards to these commitments as we use in all our lending activities and have included these commitments in our lending risk evaluations. Our exposure to credit loss under commitments to extend credit is represented by the amount of these commitments. At December 31, 2005, we had outstanding commitments to extend credit, including letters of credit, in the amount of $152.5 million.

 

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Delinquencies and Nonperforming Assets

Delinquency Procedures.    We send a borrower a delinquency notice 15 days after the due date when the borrower fails to make a required payment on a loan. If the delinquency is not brought current, additional delinquency notices are mailed at 30 and 45 days for commercial loans. Additional written and oral contacts are made with the borrower between 60 and 90 days after the due date.

If a real estate loan payment is past due for 45 days or more, the collection manager may perform a review of the condition of the property if suspect. We may negotiate and accept a repayment program with the borrower, accept a voluntary deed in lieu of foreclosure or, when considered necessary, begin foreclosure proceedings. If foreclosed on, real property is sold at a public sale and we bid on the property to protect our interest. A decision as to whether and when to begin foreclosure proceedings is based on such factors as the amount of the outstanding loan in relation to the value of the property securing the original indebtedness, the extent of the delinquency, and the borrower’s ability and willingness to cooperate in resolving the delinquency.

Real estate acquired by us is classified as real estate owned until it is sold. When property is acquired, it is recorded at the lower of cost or estimated fair value at the date of acquisition, not to exceed net realizable value, and any resulting write-down is charged to the allowance for loan losses. Upon acquisition, all costs incurred in maintaining the property are expensed. Costs relating to the development and improvement of the property, however, are capitalized to the extent of the property’s net realizable value.

We consider loans as an in-substance foreclosure if the borrower has little or no equity in the property based upon its estimated fair value, repayment can be expected only from operation or sale of the collateral, the borrower has effectively abandoned control of the collateral, or it is doubtful the borrower will be able to repay the loan in the foreseeable future because of the borrower’s current financial status. In-substance foreclosures are accounted for as if the properties were held as “real estate owned”.

Delinquencies in the commercial business loan portfolio are handled on a case-by-case basis. Generally, notices are sent and personal contact is made with the borrower when the loan is 15 days past due. Loan officers are responsible for collecting loans they originate or which are assigned to them. Depending on the nature of the loan and the type of collateral securing the loan, we may negotiate and accept a modified payment program or take other actions as circumstances warrant.

Classification of Assets.    Federal regulations require that our banks periodically evaluate the risk inherent in their loan portfolio. In addition, the Division of Banks of the Washington State Department of Financial Institutions (“Division”) and the FDIC have authority to identify problem assets and, if appropriate, require them to be classified by risk. There are three classifications for problem assets: Substandard, Doubtful, and Loss. Substandard assets have one or more defined weaknesses and are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected. Doubtful assets have the weaknesses of Substandard assets, with the additional characteristics that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions, and values questionable. There is a high possibility of loss in assets classified as Doubtful. An asset classified as Loss is considered uncollectible and of such little value that continuance as an asset of the institution is not warranted. If an asset or a portion of the asset is classified as Loss, the institution must charge off this amount. We also have assets we classify as Watch and “other assets especially mentioned” (OAEM). Assets classified as watch are performing assets but have elements of risk that require more monitoring than other performing assets. Assets classified as OAEM are assets that continue to perform but have shown deterioration in credit quality and require close monitoring.

 

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Nonperforming Assets.    Nonperforming assets consist of nonaccrual loans, restructured loans, and real estate owned. The following table provides information about our nonaccrual loans, restructured loans, and real estate owned for the indicated dates.

 

     At December 31,  
     2005     2004     2003     2002     2001  
     (Dollars in thousands)  

Nonaccrual loans

   $ 836     $ 319     $ 297     $ 1,987     $ 1,962  

Real estate and other assets owned

     371       —         389       296       1,053  
                                        

Total nonperforming assets

   $ 1,207     $ 319     $ 686     $ 2,283     $ 3,015  
                                        

Accruing loans past due 90 days or more

   $ —       $ —       $ 19     $ 19     $ 306  

Potential problem loans

   $ 9,882     $ 12,184     $ 10,502     $ 11,261     $ 4,631  

Allowance for loan losses

   $ 8,496     $ 8,295     $ 7,748     $ 6,874     $ 5,751  

Nonperforming loans to loans

     0.13 %     0.05 %     0.06 %     0.42 %     0.39 %

Allowance for loan losses to loans

     1.30 %     1.38 %     1.49 %     1.46 %     1.15 %

Allowance for loan losses to nonperforming loans

     1,016.27 %     2,603.60 %     2,611.97 %     346.05 %     293.12 %

Nonperforming assets to total assets

     0.16 %     0.05 %     0.11 %     0.38 %     0.49 %

Nonaccrual Loans.    Our financial statements are prepared on the accrual basis of accounting, including the recognition of interest income on our loan portfolio, unless a loan is placed on nonaccrual. Loans are considered to be impaired and are placed on nonaccrual when there are serious doubts about the collectibility of principal or interest. Our policy is to place a loan on nonaccrual when the loan becomes past due for 90 days or more, is less than fully collateralized, and is not in the process of collection. Amounts received on nonaccrual loans generally are applied first to principal and then to interest only after all principal has been collected.

Potential Problem Loans.    Potential problem loans are those loans that are currently accruing interest, but which are considered possible credit problems because financial information of the borrowers causes us concerns as to their ability to comply with the present repayment program and could result in placing the loan on nonaccrual. As of December 31, 2005, potential problem loans decreased by $2.3 million to $9.9 million from $12.2 million at December 31, 2004.

Analysis of Allowance for Loan Losses

Management maintains an allowance for loan losses to absorb estimated credit losses associated with the loan portfolio, including all binding commitments to lend. We determine an adequate allowance through our ongoing quarterly loan quality assessments.

We assess the estimated credit losses inherent in our non-classified loan portfolio by considering a number of elements including:

• Risk rating of the credit portfolio;

• Levels and trends in delinquencies and nonaccruals;

• Trends in loan demand and structure including terms and interest rates;

• National and local economic trends;

• Specific industry conditions such as commercial and residential construction;

• Concentrations of credits in specific industries;

• Bank regulatory examination results and our own credit examinations; and

• Recent loss experience in the portfolio.

 

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We calculate an adequate allowance for the non-classified portion of our loan portfolio based on an appropriate percentage risk factor that is calculated based on the above-noted elements and trends. We may add specific provisions for each classified loan after a careful analysis of that loan’s credit and collateral factors. Our analysis of an adequate allowance combines the provisions made for both our non-classified loans and the specific provisions made for each classified loan.

While we believe we use the best information available to determine the allowance for loan losses, net income could be significantly affected if circumstances differ substantially from the assumptions used in determining the allowance, unforeseen market conditions arise or if we are directed to make adjustments to the allowance for loan losses by our regulators.

The following table provides information regarding changes in our allowance for loan losses for the indicated periods:

 

     Years Ended December 31,  
     2005     2004     2003     2002     2001  
     (Dollars in thousands)  

Total loans outstanding at end of period(1)

   $ 652,297     $ 599,761     $ 521,413     $ 470,264     $ 498,705  
                                        

Average loans outstanding during period

   $ 613,655     $ 549,445     $ 481,404     $ 472,785     $ 494,379  
                                        

Allowance balance at beginning of period

   $ 8,295     $ 7,748     $ 6,874     $ 5,751     $ 5,063  

Provision for loan losses

     810       645       1,125       1,835       1,193  

Charge-offs:

          

Real estate(2)

     —         (41 )     (138 )     (69 )     (407 )

Commercial

     (630 )     (55 )     (102 )     (657 )     (88 )

Agriculture

     —         (10 )     —         —         —    

Consumer

     (61 )     (3 )     (19 )     (7 )     (12 )
                                        

Total charge-offs

     (691 )     (109 )     (259 )     (733 )     (507 )
                                        

Recoveries:

          

Real estate(2)

     7       8       3       1       1  

Commercial

     55       —         4       20       —    

Agriculture

     10       3       —         —         —    

Consumer

     10       —         1       —         1  
                                        

Total recoveries

     82       11       8       21       2  
                                        

Net (charge-offs) recoveries

     (609 )     (98 )     (251 )     (712 )     (505 )
                                        

Allowance balance at end of period

   $ 8,496     $ 8,295     $ 7,748     $ 6,874     $ 5,751  
                                        

Ratio of net (charge-offs) recoveries during period to average loans outstanding

     (0.10 )%     (0.02 )%     (0.05 )%     (0.15 )%     (0.10 )%
                                        

(1) Includes loans held for sale
(2) During the periods shown, the charge-offs and recoveries shown under the Real Estate category relate to real estate mortgages and in some periods real estate construction loans were included in this category.

 

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The following table shows the allocation of the allowance for loan losses for the indicated periods. The allocation is based upon an evaluation of defined loan problems, historical loan loss ratios, and industry wide and other factors that affect loan losses in the categories shown below:

 

    At December 31,  
    2005     2004     2003     2002     2001  
    Amount   % of
Total
Loans
(1)
    Amount   % of
Total
Loans
(1)
    Amount   % of
Total
Loans
(1)
    Amount   % of
Total
Loans
(1)
    Amount   % of
Total
Loans
(1)
 
    (Dollars in thousands)  

Commercial

  $ 6,117   55.0 %   $ 5,971   55.9 %   $ 5,578   51.0 %   $ 4,949   51.8 %   $ 4,141   52.7 %

Real Estate Mortgage

                   

One-four family residential

    335   8.1 %     327   9.8 %     305   11.0 %     271   15.4 %     227   18.1 %

Five or more family residential and
commercial
properties

    1,435   25.2 %     1,402   25.4 %     1,310   28.7 %     1,162   24.4 %     972   21.5 %

Real Estate Construction:

                   

One-four family residential

    460   6.4 %     449   3.9 %     419   3.7 %     370   6.2 %     310   6.5 %

Five or more family residential and
commercial
properties

    34   3.3 %     34   2.8 %     31   3.8 %     28   0.6 %     23   —    

Consumer

    115   2.0 %     112   2.2 %     105   1.8 %     94   1.6 %     78   1.2 %
                                                           

Total loans

  $ 8,496   100.0 %   $ 8,295   100.0 %   $ 7,748   100.0 %   $ 6,874   100.0 %   $ 5,751   100.0 %
                                                           

(1) Represents the total of all outstanding loans in each category as a percent of total loans outstanding.

Investment Activities

At December 31, 2005, our investment securities portfolio totaled $45.8 million, which consisted of $41.9 million of securities available for sale and $4.0 million of securities held to maturity. This compares with a total portfolio of $47.4 million at December 31, 2004, which was comprised of $45.9 million of securities available for sale and $1.5 million of securities held to maturity. The composition of the two investment portfolios by type of security, at each respective date, is presented in financial statement Notes 4 and 5.

Our investment policy is established by the board of directors and monitored by the Audit and Finance Committee of the Board of Directors. It is designed primarily to provide and maintain liquidity, generate a favorable return on investments without incurring undue interest rate and credit risk, and compliments our bank’s lending activities. The policy dictates the criteria for classifying securities as either available for sale or held to maturity. The policy permits investment in various types of liquid assets permissible under applicable regulations, which include U.S. Treasury obligations, U.S. Government agency obligations, some certificates of deposit of insured banks, mortgage backed and mortgage related securities, some corporate notes, municipal bonds, and federal funds. Investment in non-investment grade bonds, structured notes, and stripped mortgage backed securities are not permitted under the policy.

 

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The following table provides information regarding our investment securities available for sale at December 31, 2005.

 

     Book
Value
   Fair
Value
   Weighted
Average
Yield(1)
 
     (Dollars in thousands)  

Obligations of US Government agencies

        

Due within one year

   $ 4,214    $ 4,182    2.99 %

Due after 1 year but within 5 years

     14,381      14,026    3.82  

Due after 5 years but within 10 years

     1,202      1,208    5.60  
                
     19,797      19,416   
                

Mortgage backed securities

        

Due within one year

     11,003      10,727    3.82  

Due after 1 year but within 5 years

     374      369    3.87  

Due after 5 years but within 10 years

     23      23    5.75  

Due after 10 years

     1,898      1,902    4.85  
                
     13,298      13,021   
                

Collateralized mortgage obligations

        

Due after 1 year but within 5 years

     142      140    4.57  

Due after 5 years but within 10 years

     1,602      1,536    2.97  

Due after 10 years

     8,066      7,743    4.10  
                
     9,810      9,419   
                

Total all investments available for sale

   $ 42,905    $ 41,856   
                

The following table provides information regarding our investment securities held to maturity at December 31, 2005.

 

     Book
Value
   Fair
Value
   Weighted
Average
Yield(1)
 
     (Dollars in thousands)  

Obligations of US Government agencies

        

Due after 1 year but within 5 years

   $ 500    $ 488    4.44 %

Due after 5 years

     480      480    5.15  
                
     980      968   
                

Municipal bonds

        

Due within one year

     225      228    6.72  

Due after 1 year but within 5 years

     340      347    6.45  

Due after 5 years but within 10 years

     950      950    5.46  
                
     1,515      1,525   
                

Mortgage backed securities

        

Due within one year

     27      27    5.79  

Due after 1 year but within 5 years

     16      16    8.45  

Due after 5 years

     1,428      1,426    5.32  
                
     1,471      1,469   
                

Total all investments held to maturity

   $ 3,966    $ 3,962   
                

(1) Taxable equivalent weighted average yield.

 

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We held $3.1 million of FHLB stock at December 31, 2005. The stock has no contractual maturity and amounts in excess of the required minimum for FHLB membership may be redeemed at par. At December 31, 2005, we were required to maintain an investment in the stock of the FHLB of Seattle of at least $2.4 million.

Deposit Activities and Other Sources of Funds

General.    Our primary sources of funds are deposits, loan repayments and borrowings. Scheduled loan repayments are a relatively stable source of funds, while deposits and unscheduled loan prepayments, which are influenced significantly by general interest rate levels, interest rates available on other investments, competition, economic conditions, and other factors are not. Our deposit balances increased by $49.2 million in 2005 over the prior year, with certificates of deposit accounts increasing as a percentage of total deposits. Although, we continue to increase our non-interest and low interest bearing account balances we had larger increases in certificate of deposits as loan growth in the second half of the year accelerated. Customer deposits remain an important source of funding, but these balances have been influenced in the past by adverse market conditions in the industry and may be affected by future developments such as interest rate fluctuations and new competitive pressures. Borrowings may be used on a short-term basis to compensate for reductions in other sources of funds (such as deposit inflows at less than projected levels). Borrowings may also be used on a longer-term basis to support expanded lending activities and match the maturity of repricing intervals of assets.

Deposit Activities.    We offer a variety of deposit accounts designed to attract both short-term and long-term deposits. These accounts include certificates of deposit (“CDs”), regular savings accounts, money market accounts, checking and negotiable order of withdrawal (“NOW”) accounts, and individual retirement accounts (“IRAs”). These accounts generally earn interest at rates established by management based on competitive market factors and management’s desire to increase or decrease certain types or maturities of deposits. At December 31, 2005, we had no brokered deposits. The more significant deposit accounts are described below.

Certificates of Deposit.    We offer several types of CDs with maturities ranging from one to five years, which require a minimum deposit of $100. In addition, we offer a CD that has a maturity of three to eleven months and a minimum deposit of $2,500, and permits additional deposits at the initial rate throughout the CD term. At Heritage Bank, interest is compounded daily and credited quarterly or at maturity. At Central Valley Bank, interest is accrued daily and compounded quarterly or at maturity. Finally, negotiable CDs are offered in amounts of $100,000 or more for terms of 30 days to 12 months. The negotiable CDs pay simple interest credited at maturity.

Regular Savings Accounts.    We offer savings accounts that allow for unlimited deposits and withdrawals, provided that a $100 minimum balance is maintained. At Heritage Bank, interest is compounded daily and credited quarterly. At Central Valley Bank, interest is accrued daily and compounded quarterly.

Money Market Accounts.    Money market accounts pay a variable interest rate that is tiered depending on the balance maintained in the account. Minimum opening balances vary. At Heritage Bank, interest is compounded daily and paid monthly. At Central Valley Bank, interest is accrued daily and compounded monthly.

Checking and NOW Accounts.    Checking and NOW accounts are non-interest and interest bearing, and may be charged service fees based on activity and balances. NOW accounts pay interest, but require a higher minimum balance to avoid service charges.

Individual Retirement Accounts.    IRAs permit annual contributions regulated by law and pay interest at fixed rates. Maturities are available from one to five years. At Heritage Bank, interest is compounded daily and credited quarterly. At Central Valley Bank, interest is accrued daily and compounded quarterly.

 

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Sources of Funds

Deposit Activities.    The following table provides the average balances outstanding and the weighted average interest rates for each major category of deposits for the years ended December 31:

 

     2005     2004     2003  
     Average
Balance
   Average
Rate
Paid
    Average
Balance
   Average
Rate
Paid
    Average
Balance
   Average
Rate
Paid
 
     (Dollars in Thousands)  

Interest bearing demand and money market accounts

   $ 170,399    1.08 %   $ 165,486    0.73 %   $ 154,420    0.82 %

Savings

     96,425    1.03       104,271    1.00       97,352    1.17  

Certificates of deposit

     264,078    2.94       222,279    2.01       202,141    2.36  
                                       

Total interest bearing deposits

     530,902    2.00       492,036    1.37       453,913    1.58  

Demand and other noninterest bearing deposits

     85,732    —         76,994    —         63,890    —    
                                       

Total deposits

   $ 616,634    1.73 %   $ 569,030    1.18 %   $ 517,803    1.38 %
                                       

The following table provides the change in the balances of deposits during the year and the impact of credited interest on those deposits for the years ended December 31:

 

     2005     2004     2003  
     (Dollars in thousands)  

Net increase in deposits

   $ 49,226     $ 45,446     $ 24,716  

Less: Interest credited

     (10,164 )     (6,458 )     (7,166 )
                        

Net increase before interest credited.

   $ 39,062     $ 38,988     $ 17,550  
                        

The following table shows the amount and maturity of certificates of deposits of $100,000 or more as of December 31, 2005:

 

     (Dollars in
thousands)

Remaining maturity:

  

Three months or less

   $ 72,229

Over three months through six months

     15,753

Over six months through twelve months

     43,084

Over twelve months

     15,252
      

Total

   $ 146,318
      

Borrowings.    Deposits are the primary source of funds for our lending and investment activities, and our general business purposes. We rely upon advances from the Federal Home Loan Bank of Seattle (“FHLB”) to supplement our supply of lendable funds and meet deposit withdrawal requirements. The FHLB of Seattle serves as one of our secondary sources of liquidity. Advances from the FHLB of Seattle are typically secured by our first mortgage loans and stock issued by the FHLB, which is owned by us. Our subsidiary banks also have lines to purchase federal funds up to $29.8 million. In addition, Heritage Bank maintains a $5.0 million line to support letters of credit. We also maintain a line of credit of $5.0 million with Key Bank to supplement any cash needs not covered by dividends from the banks or earnings from investments. At December 31, 2005, our banks maintained credit facilities with the FHLB of Seattle for $133.4 million with an outstanding balance of $39.9 million.

The FHLB functions as a central reserve bank providing credit for member financial institutions. As members, we are required to own capital stock in the FHLB and are authorized to apply for advances on the security of such stock and certain of our mortgage loans and other assets (principally securities which are

 

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obligations of, or guaranteed by, the United States) provided certain standards related to creditworthiness have been met. Advances are made pursuant to several different programs. Each credit program has its own interest rate and range of maturities. Depending on the program, limitations on the amount of advances are based either on a fixed percentage of an institution’s net worth or on the FHLB’s assessment of the institution’s creditworthiness. Under its current credit policies, the FHLB of Seattle limits advances to 20% of assets for Heritage Bank and 10% of assets for Central Valley Bank.

The following table is a summary of FHLB advances for the years ended December 31:

 

     2005     2004     2003  
     (Dollars in thousands)  

Balance at period end

   $ 39,900     $ 40,900     $ 31,100  

Average balance during the period

     28,269       30,352       7,241  

Maximum amount outstanding at any month end

     48,800       48,900       31,100  

Average interest rate:

      

During the period

     3.29 %     1.49 %     1.21 %

At period end

     4.33 %     2.35 %     1.10 %

We maintain a line of credit with Key Bank for short-term corporate funding needs. The following table is a summary of usage on the Key Bank line of credit for the years ended December 31:

 

     2005    2004     2003  
     (Dollars in thousands)  

Balance at period end

   $ —      $ —       $ —    

Average balance during the period

     —        554       730  

Maximum amount outstanding at any month end

     —        2,194       4,127  

Average interest rate:

       

During the period

     —        4.38 %     4.10 %

At period end

     —        —         —    

There were no fed funds purchased for the years ended December 31, 2005, 2004 and 2003.

Supervision and Regulation

We are subject to extensive federal and Washington state legislation, regulation, and supervision. These laws and regulations are primarily intended to protect depositors, the FDIC and shareholders. The laws and regulations affecting banks and bank holding companies have changed significantly over recent years, and it is reasonable to expect that similar changes will continue in the future. Any change in applicable laws, regulations, or regulatory policies may have a material effect on our business, operations, and prospects. We cannot predict the nature or the extent of the effects on our business and earnings that any fiscal or monetary policies or new federal or state legislation may have in the future.

The following information is qualified in its entirety by reference to the particular statutory and regulatory provisions described.

Heritage Financial.    We are subject to regulation as a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended, and are supervised by the Federal Reserve. The Federal Reserve has the authority to order bank holding companies to cease and desist from unsound practices and violations of conditions imposed on it. The Federal Reserve is also empowered to assess civil money penalties against companies and individuals who violate the Bank Holding Company Act or orders or regulations thereunder in amounts up to $1.0 million per day. The Federal Reserve may order termination of non-banking activities by non-banking subsidiaries of bank holding companies, or divestiture of ownership and control of a

 

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non-banking subsidiary by a bank holding company. Some violations may also result in criminal penalties. The FDIC is authorized to exercise comparable authority under the Federal Deposit Insurance Act and other statutes for state nonmember banks such as Heritage Bank and Central Valley Bank.

The Federal Reserve has a policy that a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe or unsound manner. In addition, the Federal Reserve provides that bank holding companies should serve as a source of strength to its subsidiary banks by being prepared to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity, and should maintain the financial flexibility and capital raising capacity to obtain additional resources for assisting its subsidiary banks. A bank holding company’s failure to meet its obligation to serve as a source of strength to its subsidiary banks will generally be considered by the Federal Reserve to be an unsafe and unsound banking practice or a violation of the Federal Reserve’s regulations or both. The Federal Deposit Insurance Act requires an undercapitalized institution to send to the Federal Reserve a capital restoration plan with a guaranty by each company having control of the bank’s compliance with the plan.

We are required to file annual and periodic reports with the Federal Reserve and provide additional information as the Federal Reserve may require. The Federal Reserve may examine us, and any of our subsidiaries, and charge us for the cost of the examination.

We, and any subsidiaries which we may control, are considered “affiliates” within the meaning of the Federal Reserve Act, and transactions between our bank subsidiaries and affiliates are subject to numerous restrictions. With some exceptions, we, and our subsidiaries are prohibited from tying the provision of various services, such as extensions of credit, to other services offered by us, or our affiliates.

Bank regulations require bank holding companies and banks to maintain a minimum “leverage” ratio of core capital to adjusted quarterly average total assets of at least 3%. In addition, banking regulators have adopted risk-based capital guidelines under which risk percentages are assigned to various categories of assets and off-balance sheet items to calculate a risk-adjusted capital ratio. Tier I capital generally consists of common stockholders’ equity (which does not include unrealized gains and losses on securities), less goodwill and certain identifiable intangible assets. Tier II capital includes Tier I capital plus the allowance for loan losses and subordinated debt, both subject to some limitations. Regulatory risk-based capital guidelines require Tier I capital of 4% of risk-adjusted assets and minimum total capital ratio (combined Tier I and Tier II) of 8% of risk-adjusted assets.

Subsidiaries.    Heritage Bank and Central Valley Bank are Washington state-chartered commercial banks, the deposits of which are insured by the FDIC. Heritage Bank and Central Valley Bank are subject to regulation by the FDIC and the Division of Banks of the Washington Department of Financial Institutions (“Division”). Although Heritage Bank and Central Valley Bank are not members of the Federal Reserve System, the Federal Reserve has supervisory authority over us and our subsidiary banks.

Among other things, applicable federal and state statutes and regulations which govern a bank’s operations relate to minimum capital requirements, required reserves against deposits, investments, loans, legal lending limits, mergers and consolidation, borrowings, issuance of securities, payment of dividends, establishment of branches, and other aspects of its operations. The Division and the FDIC also have authority to prohibit banks under their supervision from engaging in what they consider to be unsafe and unsound practices.

The banks are required to file periodic reports with the FDIC and the Division, and are subject to periodic examinations and evaluations by those regulatory authorities. Based upon these evaluations, the regulators may revalue the assets of an institution and require that it establish specific reserves to compensate for the differences between the regulator-determined value and the book value of such assets. These examinations must be conducted every 12 months, except that well-capitalized banks may be examined every 18 months. The FDIC and the Division may each accept the results of an examination by the other in lieu of conducting an independent examination.

 

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As subsidiaries of a bank holding company, our banks are subject to various restrictions in their dealings with us and other companies that may become affiliated with us.

Dividends paid by our subsidiaries provide substantially all of our cash flow. Applicable federal and Washington state regulations restrict capital distributions by our banks, including dividends. Such restrictions are tied to the institution’s capital levels after giving effect to such distributions. The FDIC has established the qualifications necessary for a “well-capitalized” bank, which affects FDIC risk-based insurance premium rates. To qualify as “well-capitalized”, banks must have a Tier I risk-adjusted capital ratio of at least 6%, a total risk-adjusted capital ratio of at least 10%, and a leverage ratio of at least 5%. Both Heritage Bank and Central Valley Bank were “well-capitalized” at December 31, 2005.

Federal laws generally bar institutions, which are not well capitalized, from accepting brokered deposits. The FDIC has issued rules, which prohibit under-capitalized institutions from soliciting or accepting brokered deposits. Adequately capitalized institutions are allowed to solicit brokered deposits, but only to accept them if a waiver is obtained from the FDIC.

Deposit Insurance.    Heritage Bank’s deposit accounts are insured by the FDIC under the SAIF and the BIF to the maximum extent permitted by law. Central Valley Bank is insured by the FDIC under the BIF to the maximum extent permitted by law. Each bank pays deposit insurance premiums to the FDIC based on a risk-based assessment system established by the FDIC for all member institutions. Under applicable regulations, institutions are assigned to one of three capital groups that are based solely on the level of an institution’s capital (“well capitalized”, “adequately capitalized” or “undercapitalized”), which are defined in the same manner as the regulations establishing the prompt corrective action system under the FDIC as described above. The matrix so created results in nine assessment risk classifications.

Pursuant to recent changes in federal law, the FDIC imposed a special assessment on each depository institution with SAIF-assessable deposits, which resulted in the SAIF achieving its designated reserve ratio. In addition, the FDIC reduced the assessment schedule for SAIF members, effective January 1, 1997, to a range of 0% to 0.27%, with most institutions, including Heritage Bank, paying 0%. This assessment schedule is the same as that for the BIF, which reached its designated reserve ratio in 1995. In addition, since January 1, 1997, SAIF members are charged an assessment of approximately 0.06% of SAIF-assessable deposits for the purpose of paying interest on the bonds issued by the Financing Corporation in the 1980’s to help fund the thrift industry cleanup. BIF-assessable deposits will be charged an assessment to help pay interest on the bonds at a rate of approximately 0.013% until the earlier of December 31, 1999 or the date upon which the last savings association ceases to exist, after which time the assessment will be the same for all insured deposits.

Other Regulatory Developments.    Congress has enacted significant federal banking legislation in recent years. The following summarizes some of the recent significant federal banking legislation.

Financial Services Reform Legislation.    On November 12, 1999, the Gramm-Leach-Bliley Act (“GLBA”) was enacted into law. The GLBA removes various barriers imposed by the Glass-Steagall Act of 1933, specifically those prohibiting banks and bank holding companies from engaging in the securities and insurance business. The GLBA also expands the bank holding company act framework to permit bank holding companies with subsidiary banks meeting certain capital and management requirements to elect to become a “financial holding company”.

Beginning March 2000, financial holding companies may engage in a full range of financial activities, including not only banking, insurance, and securities activities, but also merchant banking and additional activities determined to be “financial in nature” or “complementary” to an activity that is financial in nature. The GLBA also provides that the list of permissible financial activities will be expanded as necessary for a financial holding company to keep abreast of competitive and technological changes.

 

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The GLBA also expands the activities in which insured state banks may engage. Under the GLBA, insured state banks are given the ability to engage in financial activities through a subsidiary, as long as the bank and its bank affiliates meet and comply with certain requirements. First, the state bank and each of its bank affiliates must be “well capitalized”. Second, the bank must comply with certain capital deduction and financial statement requirements provided under the GLBA. Third, the bank must comply with certain financial and operational safeguards provided under the GLBA. Fourth, the bank must comply with the limits imposed by the GLBA on transactions with affiliates.

USA Patriot Act.    On October 26, 2001, President George W. Bush signed into law the USA Patriot Act (“Patriot Act”). Title III of the Patriot Act concerns money laundering provisions that may affect many community banks. These provisions include:

 

    The Secretary of the Treasury is authorized to impose special measures, such as recordkeeping or reporting, on domestic financial institutions that are a primary concern;

 

    Financial institutions with private or correspondent accounts with non-U.S. citizens must establish policies and procedures to detect money laundering through those accounts;

 

    Financial institutions are barred from maintaining correspondent accounts for foreign shell banks (that is a bank that does not have a physical presence in any country);

 

    The Secretary of the Treasury is required to prescribe regulations to further encourage cooperation among financial institutions, regulators, and law enforcement agencies and officials to share information about terrorist acts and money laundering activities;

 

    The Secretary of the Treasury is required to issue regulations to establish minimum procedures for financial institutions to use in verifying customer identity during the account-opening process;

 

    Depository institutions are permitted to provide information to other institutions concerning the possible involvement in potentially unlawful activity by a current or former employee;

 

    The Secretary of the Treasury is required to establish a secure website to receive suspicious activity reports and currency transaction reports, and provide institutions with alerts and other information regarding suspicious activity that warrant immediate attention; and

 

    The federal bank regulators are required to consider the anti-money laundering record of each depository institution in evaluating applications under the Bank Merger Act.

Sarbanes-Oxley Act.    On July 30, 2002, President George W. Bush signed into law the Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act implements a broad range of corporate governance and accounting measures for public companies designed to promote honesty and transparency in corporate America and better protect investors from the type of corporate wrongdoing that occurred in Enron, WorldCom, and similar companies. The Sarbanes-Oxley Act’s principal legislation includes:

 

    The creation of an independent accounting oversight board;

 

    Auditor independence provisions that restrict non-audit services accountants may provide to their audit clients;

 

    Additional corporate governance and responsibility measures, including the requirement that the chief executive officer and the chief financial officer certify financial statements and the expansion of powers of audit committees;

 

    Expanded disclosure requirements, including accelerated reporting of stock transactions by insiders;

 

    Mandatory disclosure by analysts of potential conflicts of interest; and

 

    A range of enhanced penalties for fraud and other violations.

 

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Website Access to Company Reports

We post publicly available reports required to be filed with the SEC on our website, www.HF-WA.com, as soon as reasonably practicable after filing such reports with the SEC. The required reports are available free of charge through our website. We have also adopted a Code of Ethics applicable to all officers, directors, and employees, which is posted on our website.

Executive Officers

We have adopted a code of ethics that applies to our principal executive officer, principal financial officer, controller and assistant controller. We have posted the text of our code of ethics at www.HF-WA.com in the section titled Investor Information: Corporate Governance. Any waivers of the code of the ethics will be publicly disclosed to shareholders.

Audit Committee of the Board of Directors

The audit committee of our board of directors retains our independent auditors, reviews and approves the scope and results of the audits with the auditors and management, monitors the adequacy of our system of internal controls and reviews the annual report, auditors’ fees and non-audit services to be provided by the independent auditors. The members of our audit committee are Daryl D. Jensen, chair of the committee, Philip S. Weigand, Brian Charneski, Jeffrey Lyon, Peter Fleutsch and John Clees, all of whom are considered “independent” as defined by the SEC. Our board of directors has determined that Mr. Jensen meets the definition of an audit committee financial expert, as determined by the requirements of the SEC.

Competition

We compete for loans and deposits with other commercial banks, credit unions, mortgage bankers, and other institutions in the scope and type of services offered, interest rates paid on deposits, pricing of loans, and number and locations of branches, among other things. Many of our competitors have substantially greater resources than we do. Particularly in times of high or rising interest rates, we also face significant competition for investors’ funds from short-term money market securities and other corporate and government securities.

We compete for loans principally through the range and quality of the services we provide, interest rates and loan fees, and the locations of our banks’ branches. We actively solicit deposit-related clients and compete for deposits by offering depositors a variety of savings accounts, checking accounts, cash management and other services.

Employees

We have 211 full-time equivalent employees. We experienced an increase of 15 full-time equivalents during 2005 due to staff increases in the mortgage and lending departments. We believe that employees play a vital role in the success of a service company. Employees are provided with a variety of benefits such as medical, vision, dental and life insurance, a generous retirement plan, and paid vacations and sick leave. None of our employees are covered by a collective bargaining agreement.

ITEM 1A.    RISK FACTORS

The following are certain risks that management believes are specific to our business. This should not be viewed as an all inclusive list or in any particular order.

Future loan losses may exceed our allowance for loan losses

We are subject to credit risk, which is the risk of losing principal or interest due to borrowers’ failure to repay loans in accordance with their terms. A downturn in the economy or the real estate market in our market

 

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areas or a rapid change in interest rates could have a negative effect on collateral values and borrowers’ ability to repay. This deterioration in economic conditions could result in losses to the Company in excess of loan loss allowances. To the extent loans are not paid timely by borrowers, the loans are placed on non-accrual, thereby reducing interest income. To the extent loan charge-offs exceed our financial models, increased amounts charged to the provision for loan losses would reduce income.

Rapidly changing interest rate environments could reduce our net interest margin, net interest income, fee income and net income

Interest and fees on loans and securities, net of interest paid on deposits and borrowings, are a large part of our net income. Interest rates are key drivers of our net interest margin and subject to many factors beyond the control of management. As interest rates change, net interest income is affected. Rapid increases in interest rates in the future could result in interest expense increasing faster than interest income because of mismatches in financial instrument maturities. Further, substantially higher interest rates generally reduce loan demand and may result in slower loan growth. Decreases or increases in interest rates could have a negative effect on the spreads between the interest rates earned on assets and the rates of interest paid on liabilities, and therefore decrease net interest income. See “Quantitative and Qualitative Disclosures about Market Risk.”

Slower than anticipated growth in new branches and new product and service offerings could result in reduced net income

We have placed a strategic emphasis on expanding our branch network and product offerings. Executing this strategy carries risks of slower than anticipated growth both in new branches and new products. New branches and products require a significant investment of both financial and personnel resources. Lower than expected loan and deposit growth in new investments can decrease anticipated revenues and net income generated by those investments, and opening new branches and introducing new products could result in more additional expenses than anticipated and divert resources from current core operations.

The financial services industry is very competitive

We face competition in attracting and retaining deposits, making loans, and providing other financial services throughout our market area. Our competitors include other community banks, larger banking institutions, and a wide range of other financial institutions such as credit unions, government-sponsored enterprises, mutual fund companies, insurance companies and other non-bank businesses. Many of these competitors have substantially greater resources than us.

Decreased volumes and lower gains on sales and brokering of mortgage loans sold could adversely impact net income

We originate and sell mortgage loans as well as broker mortgage loans. Changes in interest rates affect demand for our loan products and the revenue realized on the sale of loans. A decrease in the volume of loans sold/brokered can decrease our revenues and net income.

We may fail to complete or fail to realize anticipated benefits from our proposed acquisition of Western Washington Bancorp.

On January 24, 2006, we entered into a definitive agreement pursuant to which we agreed to acquire Western Washington Bancorp by means of a merger of Western Washington Bancorp and Heritage Financial Corporation in which outstanding shares of Western Washington Bancorp common stock will be exchanged for cash and common shares of the Company. As part of the merger, Western Washington Bancorp’s banking subsidiary, Washington State Bank, N.A., will be merged with and into Heritage Bank. Completion of the merger is subject to satisfaction of various conditions set forth in the merger agreement, including regulatory and Western Washington Bancorp shareholder approvals, and therefore may or may not be completed. In addition,

 

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the combined bank may fail to realize some or all of the anticipated cost savings and other benefits of the transaction and integration issues could cause higher than anticipated expenses and lower benefits from the merger than currently anticipated.

Inability to hire or retain certain key professionals, management and staff could adversely affect our revenues and net income.

We rely on key personnel to manage and operate our business, including major revenue generating functions such as our loan and deposit portfolios. The loss of key staff may adversely affect our ability to maintain and manage these portfolios effectively, which could negatively effect our revenues. In addition, loss of key personnel could result in increased recruiting and hiring expenses, which could cause a decrease in our net income.

ITEM 1B.    UNRESOLVED STAFF COMMENTS

There are no unresolved staff comments from the Securities and Exchange Commission.

 

ITEM 2. PROPERTIES

Our executive offices and the main office of Heritage Bank are located in approximately 22,000 square feet of the headquarters building and adjacent office space which are owned by Heritage Bank and located in downtown Olympia. At December 31, 2005, Heritage Bank had six offices located in Tacoma and surrounding areas of Pierce County (all but one of which are owned), five offices located in Thurston County (all of which are owned with one office located on leased land), and one office in Shelton, Mason County (which is owned). Central Valley Bank had six offices, five located in Yakima County and one in Kittitas County (all of which are owned with two on leased land).

 

ITEM 3. LEGAL PROCEEDINGS

We, and our banks, are not a party to any material pending legal proceedings other than ordinary routine litigation incidental to the business of the Bank.

 

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

No matters were submitted to a vote of security holders in the fourth quarter of 2005.

 

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PART II

 

ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Our common stock is traded on the NASDAQ National Market System® under the symbol HFWA. At December 31, 2005, we had approximately 1,300 stockholders of record (not including the number of persons or entities holding stock in nominee or street name through various brokerage firms) and 6,255,921 outstanding shares of common stock. The last reported sales price on February 10, 2006 was $24.60 per share. The following table provides bid information per share of our common stock as reported on the NASDAQ National Market System® for the indicated quarters.

 

     2005 Quarter ended:
     March 31    June 30    September 30    December 31

High

   $ 21.43    $ 21.57    $ 24.20    $ 25.02

Low

   $ 19.91    $ 20.22    $ 20.49    $ 22.00
     2004 Quarter ended:
     March 31    June 30    September 30    December 31

High

   $ 21.09    $ 20.35    $ 20.19    $ 21.42

Low

   $ 19.29    $ 17.30    $ 17.52    $ 18.73

Since our stock offering in January 1998, we have declared quarterly cash dividends. The two most recent fiscal years quarterly cash dividends are listed below:

 

Declared

   Cash
Dividend
per share
  

Record Date

 

Paid

March 18, 2004

   $ 0.148    April 15, 2004   April 29, 2004

June 17, 2004

   $ 0.152    July 15, 2004   July 29, 2004

September 23, 2004

   $ 0.157    October 15, 2004   October 29, 2004

December 21, 2004

   $ 0.162    January 14, 2005   January 28, 2005

March 24, 2005

   $ 0.167    April 15, 2005   April 28, 2005

June 21, 2005

   $ 0.171    July 15, 2005   July 29, 2005

September 15, 2005

   $ 0.185    October 17, 2005   October 28, 2005

December 15, 2005

   $ 0.190    January 16, 2006   January 30, 2006

In addition to the cash dividends, on September 15, 2005, the board of directors of the Company declared a 5% stock dividend to shareholders of record on September 30, 2005 and distributed October 14, 2005. The stock dividend distributed an additional share of common stock for every 20 shares held on the record date. Cash was paid for any fractional shares. All share and per share amounts have been properly restated to reflect the stock dividend.

Dividends to shareholders depend primarily upon the receipt of dividends from our subsidiary banks. The FDIC and the Division have the authority under their supervisory powers to prohibit the payment of dividends by Heritage Bank and Central Valley Bank to us. For a period of ten years after the conversion from mutual to stock ownership, Heritage Bank may not, without prior approval of the Division, declare or pay a cash dividend in excess of one-half of the greater of the Bank’s net income for the current fiscal year or the average of the Bank’s net income for the current fiscal year and the retained earnings of the two prior fiscal years. In addition, Heritage Bank may not declare or pay a cash dividend on its common stock if the effect of the dividend would be to reduce the Bank’s net worth below the amount required for the liquidation account. Other than the specific restrictions mentioned above, current regulations allow us, and our subsidiary banks to pay dividends on our common stock if our or our banks’ regulatory capital would not be reduced below the statutory capital requirements set by the Federal Reserve and the FDIC.

 

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The Company has had various stock repurchase programs since March 1999. In August 2004, the Board of Directors approved a new stock repurchase plan, allowing the Company to repurchase up to 5% of the then outstanding shares, or approximately 309,750 shares over a period of eighteen months. This marked the Company’s eighth stock repurchase plan. On January 25, 2006, the Board of Directors authorized an eighteen month extension to this program. During the quarter ended December 31, 2005, the Company repurchased 105 shares at an average price of $22.18. In total, the Company has repurchased 87,067 shares at an average price of $20.77 under this plan.

The following table sets forth information about the Company’s purchases of its outstanding common stock during the quarter ended December 31, 2005.

 

Period

   Total Number
of Shares
Purchased
   Average
Price Paid
Per Share
   Total Number of
Shares Purchased as
Part of Publicly
Announced Plans or
Programs
   Maximum Number of
Shares that May Yet Be
Purchased Under the
Plans or Programs

December 1, 2005 – December 31, 2005

   105    $ 22.18    5,935,033    222,683

 

ITEM 6. SELECTED FINANCIAL DATA

 

    For the years ended December 31,  
    2005     2004     2003     2002     2001  
    (Dollars in thousands, except per share data)  

Operations Data:

         

Net interest income

  $ 33,881     $ 31,727     $ 29,817     $ 30,203     $ 26,632  

Provision for loan losses

    810       645       1,125       1,835       1,193  

Noninterest income

    6,630       6,498       7,164       6,181       5,925  

Noninterest expense

    24,183       23,270       22,223       20,254       20,624  

Federal income tax expense

    5,042       4,725       4,729       4,871       3,778  

Net income

    10,476       9,585       8,904       9,424       6,962  

Earnings per share

         

Basic

    1.69       1.53       1.31       1.25       0.83  

Diluted

    1.65       1.49       1.26       1.21       0.82  

Dividend payout ratio(1)

    42.0 %     40.4 %     41.6 %     37.4 %     46.9 %

Performance Ratios:

         

Net interest spread

    4.75 %     4.91 %     5.14 %     5.17 %     4.33 %

Net interest margin(2)

    5.08 %     5.13 %     5.40 %     5.53 %     4.98 %

Efficiency ratio(3)

    59.69 %     60.88 %     60.09 %     55.67 %     63.35 %

Return on average assets

    1.46 %     1.44 %     1.49 %     1.58 %     1.19 %

Return on average equity

    16.13 %     15.80 %     13.03 %     12.18 %     8.52 %
    At December 31,  
    2005     2004     2003     2002     2001  

Balance Sheet Data:

         

Total assets

  $ 751,152     $ 697,267     $ 640,920     $ 594,587     $ 609,643  

Loans receivable, net

    643,538       591,085       512,647       455,277       486,679  

Loans held for sale

    263       381       1,018       8,113       6,275  

Deposits

    636,504       587,278       541,832       517,116       515,080  

Federal Home Loan Bank advances

    39,900       40,900       31,100       —         8,000  

Stockholders’ equity

    66,120       60,944       62,232       72,397       78,528  

Book value per share

  $ 10.57     $ 9.76     $ 9.57     $ 10.13     $ 9.92  

Equity to assets ratio

    8.80 %     8.74 %     9.71 %     12.18 %     12.88 %

Asset Quality Ratios:

         

Nonperforming loans to loans

    0.13 %     0.05 %     0.06 %     0.42 %     0.39 %

Allowance for loan losses to loans

    1.30 %     1.38 %     1.49 %     1.46 %     1.15 %

Allowance for loan losses to nonperforming loans

    1,016.27 %     2,603.60 %     2,611.97 %     346.05 %     293.12 %

Nonperforming assets to total assets

    0.16 %     0.05 %     0.11 %     0.38 %     0.49 %

Other Data:

         

Number of banking offices

    18       18       18       18       18  

Number of full-time equivalent employees

    211       196       206       195       198  

(1) Dividend payout ratio is declared dividends per share (excluding stock dividends) divided by basic earnings per share.
(2) Net interest margin is net interest income divided by average interest earning assets.
(3) The efficiency ratio is recurring noninterest expense divided by the sum of net interest income and noninterest income.

 

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion is intended to assist in understanding the financial condition and results of operations of the Company. The information contained in this section should be read with the December 31, 2005 audited consolidated financial statements and notes to those financial statements included in this Form 10-K.

Statements concerning future performance, developments or events, expectations for growth and market forecasts, and any other guidance on future periods, constitute forward-looking statements and are subject to a number of risks and uncertainties, which might cause actual results to differ materially from stated expectations. Specific factors include, but are not limited to, the effect of interest rate changes, risks associated with acquisition of other banks and opening new branches, the ability to control costs and expenses, and general economic conditions. Additional information on these and other factors, which could affect our financial results are included in our filings with the Securities and Exchange Commission.

Critical Accounting Policies

The Company’s consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. Companies may apply certain critical accounting policies requiring management to make subjective or complex judgments, often as a result of the need to estimate the effect of matters that are inherently uncertain.

The Company considers its most critical accounting estimate to be the allowance for loan losses. The allowance for loan losses is established through a provision for loan losses charged against earnings. The balance of the allowance for loan losses is maintained at the amount management believes will be adequate to absorb known and inherent losses in the loan portfolio at the balance sheet date. The allowance for loan losses is determined by applying estimated loss factors to the credit exposure from outstanding loans. Estimated loss factors are based on subjective measurements including management’s assessment of the internal risk classifications, historical loss experience, changes in the nature of the loan portfolio, industry concentrations and the impact of current local, regional and national economic factors on the quality of the loan portfolio. Changes in these estimates and assumptions are reasonably possible and may have a material impact on the Company’s consolidated financial statements, results of operation or liquidity.

For additional information regarding the allowance for loan losses, its relation to the provision for loans losses, risk related to asset quality and lending activity, see Part I, Item 1 as well as the Management’s Discussion and Analysis of Financial Condition and Results of Operation—Provision for Loan Losses.

Overview

Heritage Financial Corporation is a bank holding company which primarily engages in the business activities of our wholly owned subsidiaries: Heritage Bank and Central Valley Bank. We provide financial services to our local communities with an ongoing strategic focus in expanding our commercial banking relationships, market expansion and a continual focus on asset quality. During the period from 2001 through 2005 our total assets have grown $141.5 million, or 23.2%, with net loans growing $156.9 million during the period. Our emphasis in growing our commercial loan portfolio resulted in an increase in commercial loans of $96.7 million, or 36.8%, since 2001. Overall loan increases have benefited from our emphasis in growing our lending in the Pierce county market.

Deposits increased $121.4 million, or 23.6%, for the period from 2001 through 2005 with an increase in the percentage of non-interest and low interest bearing demand deposits to total deposits. From 2001 to 2005, non-interest demand deposits and NOW accounts increased aggregately from 23.5% of total deposits to 29.0% of total deposits. Our deposit increases are due to our focus on growing our customer base as well as investors

 

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continuing to prefer deposit accounts over the stock market. As a whole, while our customers continue to prefer short term deposit products, we are seeing some extension out to two years in certificates. In turn, equity has declined by $12.4 million since December 31, 2001 primarily as a result of our stock repurchase programs. Since 1999, we have repurchased 5,935,033 shares totaling $72.1 million. During the period from 2001 through 2005, our annual net income has increased by 50.5% or $3.5 million. The result of these trends have provided our company with an increase in return on average equity from 8.52% for the year ended December 31, 2001 to 16.13% for year ended December 31, 2005. We exceeded our previous five year strategic goal (a 15.00% return on average equity by the year ended December 31, 2005) one year early during the year ended December 31, 2004.

Our profitability depends primarily on our net interest income, which is the difference between the income we receive on our loan and investment portfolios, and our cost of funds, which consists of interest paid on deposits and borrowed funds. Like most financial institutions, our interest income and cost of funds are affected significantly by general economic conditions, particularly changes in market interest rates and government policies.

Changes in net interest income result from changes in volume, net interest spread, and net interest margin. Volume refers to the average dollar amounts of interest earning assets and interest bearing liabilities. Net interest spread refers to the difference between the average yield on interest earning assets and the average cost of interest bearing liabilities. Net interest margin refers to net interest income divided by average interest earning assets and is influenced by the level and relative mix of interest earning assets and interest bearing and non-interest bearing liabilities.

The following table provides relevant net interest income information for selected time periods. The average loan balances presented in the table are net of allowances for loan losses. Nonaccrual loans have been included in the tables as loans carrying a zero yield. Yields on tax-exempt securities and loans have not been stated on a tax-equivalent basis.

 

    Years Ended December 31,  
    2005     2004     2003  
    Average
Balance
  Interest
Earned/
Paid
  Average
Rate
    Average
Balance
  Interest
Earned/
Paid
  Average
Rate
    Average
Balance
  Interest
Earned/
Paid
  Average
Rate
 
    (Dollars in thousands)  

Interest Earning Assets:

                 

Loans

  $ 613,655   $ 43,605   7.11 %   $ 549,444   $ 36,938   6.72 %   $ 481,577   $ 35,059   7.28 %

Taxable securities

    43,659     1,568   3.59       47,670     1,610   3.38       47,187     1,649   3.49  

Nontaxable securities

    4,117     149   3.62       3,779     141   3.74       3,160     123   3.90  

Interest earning deposits

    2,899     90   3.09       14,945     177   1.18       17,539     188   1.07  

Federal Home Loan Bank stock

    3,089     16   0.50       3,002     78   2.61       2,898     132   4.58  
                                                     

Total interest earning assets

  $ 667,419   $ 45,428   6.81 %   $ 618,840   $ 38,944   6.29 %   $ 552,361   $ 37,151   6.73 %

Noninterest earning assets

    48,430         46,478         45,948    
                             

Total assets

  $ 715,849       $ 665,318       $ 598,309    
                             

Interest Bearing Liabilities:

                 

Certificates of deposit

  $ 264,078   $ 7,755   2.94 %   $ 222,279   $ 4,477   2.01 %   $ 202,133   $ 4,767   2.36 %

Savings accounts

    96,425     993   1.03       104,271     1,094   1.05       97,358     1,139   1.17  

Interest bearing demand and money market accounts

    170,399     1,846   1.08       165,486     1,153   0.70       154,439     1,273   0.82  
                                                     

Total interest bearing deposits

    530,902     10,594   2.00       492,036     6,724   1.37       453,930     7,179   1.58  

FHLB advances and other borrowings

    28,544     953   3.34       30,909     493   1.60       8,043     155   1.93  
                                                     

Total interest bearing liabilities

  $ 559,446   $ 11,547   2.06 %   $ 522,945   $ 7,217   1.38 %   $ 461,973   $ 7,334   1.59 %

Demand and other noninterest bearing deposits

    85,732         76,994         63,909    

Other noninterest bearing liabilities

    5,732         4,708         4,116    

Stockholders’ equity

    64,939         60,671         68,311    
                             

Total liabilities and stockholders’ equity

  $ 715,849       $ 665,318       $ 598,309    
                             

Net interest income

    $ 33,881       $ 31,727       $ 29,817  

Net interest spread

      4.75 %       4.91 %       5.14 %

Net interest margin

      5.08 %       5.13 %       5.40 %

Average interest earning assets to average interest bearing liabilities

      119.30 %       118.34 %       119.57 %

 

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The following table provides the amount of change in our net interest income attributable to changes in volume and changes in interest rates. Changes attributable to the combined effect of volume and interest rates have been allocated proportionately for changes due to volume and interest rates.

 

    Years Ended December 31,  
    2005 Compared to 2004
Increase (Decrease) Due to
    2004 Compared to 2003
Increase (Decrease) Due to
 
    Volume     Rate     Total     Volume     Rate     Total  
    (Dollars in thousands)  

Interest Earning Assets:

           

Loans

  $ 4,316     $ 2,351     $ 6,667     $ 4,941     $ (3,062 )   $ 1,879  

Taxable securities

    (135 )     94       (41 )     17       (56 )     (39 )

Nontaxable securities

    13       (5 )     8       24       (6 )     18  

Interest earning deposits

    (142 )     55       (87 )     (28 )     17       (11 )

Federal Home Loan Bank stock

    2       (65 )     (63 )     5       (59 )     (54 )
                                               

Interest income

  $ 4,054     $ 2,430     $ 6,484     $ 4,959     $ (3,166 )   $ 1,793  
                                               

Interest bearing liabilities:

           

Certificates of deposit

  $ 842     $ 2,436     $ 3,278     $ 475     $ (765 )   $ (290 )

Savings accounts

    (82 )     (19 )     (101 )     81       (126 )     (45 )

Interest bearing demand and money market accounts

    34       659       693       91       (211 )     (120 )
                                               

Total interest bearing deposits

    794       3,076       3,870       647       (1,102 )     (455 )

FHLB advances and other borrowings

    (38 )     498       460       440       (102 )     338  
                                               

Interest expense

  $ 756     $ 3,574     $ 4,330     $ 1,087     $ (1,204 )   $ (117 )
                                               

Results of Operations for the Years Ended December 31, 2005 and 2004

Net Income.    Our net income was $10.5 million or $1.65 per diluted share for the year ended December 31, 2005 compared to $9.6 million or $1.49 per diluted share for the previous year. The 9.3% increase in actual net income was primarily the result of increased loan growth while maintaining a strong net interest margin. 2004 included a fourth quarter after tax gain of $144,000 on the sale of stock held in HCB Bancorp, Inc. Excluding the gain on the sale of HCB Bancorp stock, 2004 net income would have been $9.4 million for an increase this year of 11.0% in actual net income and 12.1% in diluted earnings per share. The net interest margin declined a modest 5 basis points with average earning assets increasing $48.6 million for the year at $667.4 million compared to the previous year’s average of $618.8 million.

Net Interest Income.    Net interest income increased $2.2 million to $33.9 million for the year ended December 31, 2005 compared with the previous year of $31.7 million. The increase in net interest income resulted primarily from strong loan growth and maintenance of the net interest margin above 5.0%.

Net interest income as a percentage of average earning assets (net interest margin) for the year ended December 31, 2005 decreased to 5.08% from 5.13% for the previous year. Our net interest spread for the year ended December 31, 2005 decreased to 4.75% from 4.91% for the prior year. The average rate of interest earning assets increased to 6.81% for the year ended December 31, 2005 from 6.29% for the same period last year while the average cost of funds increased to 2.06% for the year ended December 31, 2005 from 1.38% for the same period last year. Overall, our net interest margin is strong at 5.08% in comparison to the median for West Coast publicly traded commercial banks of 4.88% as reported by D.A. Davidson and Companies for the period ending September 30, 2005.

Provision for Loan Losses.    During the year ended December 31, 2005, we provided $810,000 through operations compared to $645,000 for the year ended December 31, 2004. This increase is necessary due to growth in outstanding loans to maintain our allowance at an adequate level. For the year ended December 31, 2005,

 

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we experienced net charge-offs of $609,000 up from $98,000 for the year ended December 31, 2004. The provision and corresponding net charge-offs decreased our allowance for loan losses as a percentage of total loans to 1.30% at December 31, 2005 from 1.38% at the end of 2004. Our asset quality has remained solid as demonstrated by the nonperforming assets to total assets ratio of 0.16% at December 31, 2005 even though up from a very low 0.05% at December 31, 2004.

We consider the allowance for loan losses at December 31, 2005 to adequately cover loan losses based on our assessment of various factors affecting the loan portfolio, including the level of problem loans, business conditions, estimated collateral values, loss experience including those related to our courtesy overdraft programs, and credit concentrations. See the previous discussion on the allowance for loan losses in Item 1 for further information about these factors.

Noninterest Income.    Total noninterest income increased $132,000, or 2.0%, for the year ended December 31, 2005 compared with the prior year. Gain on loan sales decreased $363,000, or 56.7%, over the prior year. Mortgage loans sold during 2005 were $13.6 million versus $35.8 million sold during 2004, a decrease of 62.0%. Merchant visa income increased $348,000, or 18.2%, due to increased business volumes. Service charges on deposits also increased by $263,000 due to our focus on growing our deposit relationships.

Noninterest Expense.    Total noninterest expense increased $913,000, or 3.9%, for the year ended 2005 compared to the 2004 period. Salaries and employee benefits increased by $396,000 primarily due to an increase in full-time equivalent employees. Merchant Visa expenses increased by $261,000, or 17.4%. The increase was in line with the increase in business volumes as well as Merchant Visa income. Other operating expenses increased by $256,000, or 2.7%, primarily due to the increases in occupancy costs.

Results of Operations for the Years Ended December 31, 2004 and 2003

Net Income.    Our net income was $9.6 million or $1.49 per diluted share for the year ended December 31, 2004 compared to $8.9 million or $1.26 per diluted share for the previous year. The 7.6% increase in net income was a result of increased loan growth, maintaining a strong net interest margin and a decline in the loan loss provision by $480,000. The net interest margin declined 27 basis points with average earning assets increasing $66.5 million, ending the year at $618.8 million compared to the previous year-end of $552.3 million. During 2004, there was a one-time gain on sale of an investment available for sale (HCB Bancorp shares) pre-tax of $218,000 and after-tax of $144,000. Excluding the gain on sale of the HCB Bancorp shares, net income would have been $9.4 million or $1.47 per diluted share.

Net Interest Income.    Net interest income increased $1.9 million to $31.7 million for the year ended December 31, 2004 compared with the previous year of $29.8 million. The increase in net interest income resulted primarily from strong loan growth and our continuation of the net interest margin above 5.0%.

Net interest income as a percentage of average earning assets (net interest margin) for the year ended December 31, 2004 decreased to 5.13% from 5.40% for the previous year. Our net interest spread for the year ended December 31, 2004 decreased to 4.91% from 5.14% for the prior year. This corresponded with the decrease in the average rate of interest earning assets to 6.29% for the year ended December 31, 2004 from 6.73% for the previous year as well as the decrease in the average cost of funds to 1.38% (only a 21 basis point decline) for the year ended December 31, 2004 from 1.59% for the previous year. Overall, our net interest margin was very strong at 5.13% in comparison to the median for West Coast publicly traded commercial banks of 4.65% as reported by D.A. Davidson and Companies for the period ending September 30, 2004.

Provision for Loan Losses.    During the year ended December 31, 2004, we provided $645,000 through operations to maintain our allowance at an adequate level compared to $1.1 million for the year ended December 31, 2003. For the year ended December 31, 2004, we experienced net charge-offs of $98,000 versus net charge-offs of $251,000 for the year ended December 31, 2003. The provision and corresponding net charge-offs decreased our allowance for loan losses as a percentage of total loans to 1.38% at December 31, 2004 from

 

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1.49% at the end of 2003. Our asset quality remained solid as demonstrated by the nonperforming assets to total assets ratio of 0.05% at December 31, 2004 compared to 0.11% at December 31, 2003.

We consider the allowance for loan losses at December 31, 2004 to adequately cover loan losses based on our assessment of various factors affecting the loan portfolio, including the level of problem loans, business conditions, estimated collateral values, loss experience, and credit concentrations. See the previous discussion on the allowance for loan losses in Item 1 for further information about these factors.

Noninterest Income.    Total noninterest income decreased $666,000, or 9.3%, for the year ended December 31, 2004 compared with the prior year. Mortgage banking income decreased $1.3 million, or 66.4%, over the prior year. Mortgage loans sold during 2004 were $35.8 million versus $105.8 million sold during 2003, a decrease of 66.2%. Merchant visa income increased $327,000, or 20.6%, due to increased business volumes. Service charges on deposits also increased by $135,000 due to our focus on growing our deposit relationships.

Noninterest Expense.    Total noninterest expense increased $1.1 million, or 4.7%, for the year ended 2004 compared to the 2003 period. Salaries and employee benefits increased by $574,000 primarily due to the unfavorable impact of lower deferred salary contra expense associated with decreased residential loan volumes. Although we experienced a decline in full time equivalent employees of 10 year over year related to our decreased mortgage department staff, we also experienced increases in health benefit costs. Merchant Visa expenses increased by $205,000, or 15.8%. The increase was in line with the increase in business volumes as well as Merchant Visa income. Other operating expenses increased by $215,000, or 6.3%, due to the increases in accounting and professional services related to the implementation of Sarbanes-Oxley Section 404—Internal Controls over Financial Reporting as well as various expenses associated with Central Valley Bank converting to a new service provider—Bisys.

Liquidity and Capital Resources

Our primary sources of funds are deposits, loan repayments, loan sales, interest earned on and proceeds from investment securities, and advances from the FHLB of Seattle. These funds, together with retained earnings, equity and other borrowed funds, are used to make loans, acquire investment securities and other assets, and fund continuing operations. While maturities and scheduled amortization of loans are a predictable source of funds, deposit flows and prepayments are greatly influenced by the level of interest rates, economic conditions, and competition.

We must maintain an adequate level of liquidity to ensure the availability of sufficient funds to fund loan originations and deposit withdrawals, satisfy other financial commitments, and fund operations. We generally maintain sufficient cash and short-term investments to meet short-term liquidity needs. At December 31, 2005, cash and cash equivalents totaled $25.0 million, or 3.3% of total assets. At December 31, 2005, our banks maintained a credit facility with the FHLB of Seattle for $133.4 million of which we borrowed $39.9 million as of December 31, 2005. In addition, we maintain a credit facility with KeyBank of $5.0 million as well as another $5.0 million line to support letters of credit. Our subsidiary banks also maintain advance lines to purchase federal funds totaling $29.8 million as of December 31, 2005.

During 2005 total assets grew $53.9 million with net loans increasing by $52.5 million over the prior year-end and deposits increasing $49.2 million over the prior year-end. Borrowings from the FHLB of Seattle decreased by $1.0 million over the prior year-end. Our strategy has been to acquire core deposits (which we define to include all deposits except public funds) from our retail accounts, acquire noninterest bearing demand deposits from our commercial customers, and use available borrowing capacity to fund growth in assets. We anticipate that we will continue to rely on the same sources of funds in the future and use those funds primarily to make loans and purchase investment securities.

We, and our banks, are subject to various regulatory capital requirements. As of December 31, 2005, we, and our banks were classified as “well capitalized” institutions under the criteria established by the Federal

 

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Deposit Insurance Act. Our initial public offering in January of 1998 significantly increased our capital to levels well in excess of regulatory requirements and our internal needs. In 1999, we determined that buying our own shares with some of our excess capital was the best use of this capital and we began to buy back our Company’s outstanding shares. As of December 31, 2005, we have repurchased 5,935,033 shares of our stock representing 52.1% of the total outstanding as of March 31, 1999 at an average price of $12.15 reducing our capital levels by $72.1 million.

Our capital levels will also be modestly impacted by our 401(k) Employee Stock Ownership Plan and Trust (“KSOP”). The Employee Stock Ownership Plan (“ESOP”) purchased 2% of the common stock issued in the January 1998 stock offering and borrowed from the Company to fund the purchase of the Company’s common stock. The loan to the ESOP will be repaid principally from the Bank’s contributions to the ESOP. The Bank’s contributions will be sufficient to service the debt over the 15 year loan term at the interest rate of 8.5%. As the debt is repaid, shares are released, and allocated to plan participants based on the proportion of debt service paid during the year. As shares are released, compensation expense is recorded equal to the then current market price of the shares, our capital is increased, and the shares become outstanding for earnings per share calculations. For the year ended December 31, 2005, the Company has allocated or committed to be released to the ESOP 9,256 earned shares and has 65,574 unearned, restricted shares remaining to be released. The fair value of unearned, restricted shares held by the ESOP trust was $1.58 million at December 31, 2005.

Asset/Liability Management

Our primary financial objective is to achieve long term profitability while controlling our exposure to fluctuations in market interest rates. To accomplish this objective, we have formulated an interest rate risk management policy that attempts to manage the mismatch between asset and liability maturities while maintaining an acceptable interest rate sensitivity position. The principal strategies which we employ to control our interest rate sensitivity are: selling most long term, fixed rate, single-family residential mortgage loan originations; originating commercial loans and residential construction loans at variable interest rates repricing for terms generally one year or less; and offering noninterest bearing demand deposit accounts to businesses and individuals. The longer-term objective is to increase the proportion of noninterest bearing demand deposits, low interest bearing demand deposits, money market accounts, and savings deposits relative to certificates of deposit to reduce our overall cost of funds.

Our asset and liability management strategies have resulted in a positive 0-3 month “gap” of 8.83% and a negative 4-12 month “gap” of 8.92% as of December 31, 2005. These “gaps” measure the difference between the dollar amount of our interest earning assets and interest bearing liabilities that mature or reprice within the designated period (three months and 4-12 months) as a percentage of total interest earning assets, based on certain estimates and assumptions as discussed below. We believe that the implementation of our operating strategies has reduced the potential effects of changes in market interest rates on our results of operations. The positive gap for the 0-3 month period indicates that decreases in market interest rates may adversely affect our results over that period.

 

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The following table provides the estimated maturity or repricing and the resulting interest rate sensitivity gap of our interest earning assets and interest bearing liabilities at December 31, 2005 based upon estimates of expected mortgage prepayment rates and deposit run off rates consistent with national trends. We adjusted mortgage loan maturities for loans held for sale by reflecting these loans in the three-month category, which is consistent with their sale in the secondary mortgage market. The amounts in the table are derived from our internal data. We used certain assumptions in presenting this data so the amounts may not be consistent with other financial information prepared in accordance with generally accepted accounting principles. The amounts in the tables also could be significantly affected by external factors, such as changes in prepayment assumptions, early withdrawal of deposits, and competition.

 

    Estimated Maturity or Repricing Within
    0-3
months
    4-12
months
   

1-5

years

    5-15
years
    More than
15 years
    Total
    (Dollars in thousands)

Interest Earnings Assets:

           

Loans(1)

  $ 216,719     $ 50,215     $ 272,178     $ 87,998     $ 25,187     $ 652,297

Investment securities

    26,038       2,641       4,618       4,573       7,952       45,822

FHLB and Federal Reserve Stock

    3,072       —         —         —         —         3,072

Interest earning deposits

    3,030       —         —         —         —         3,030
                                             

Total interest earning assets

  $ 248,859     $ 52,856     $ 276,796     $ 92,571     $ 33,139     $ 704,221
                                             

Interest Bearing Liabilities:

           

Total interest bearing deposits

  $ 146,750     $ 177,887     $ 223,852     $ —       $ —       $ 548,489

FHLB advances and other borrowings

    39,900       —         —         —         —         39,900
                                             

Total interest bearing liabilities

  $ 186,650     $ 177,887     $ 223,852     $ —       $ —       $ 588,389
                                             

Rate sensitivity gap

  $ 62,209     $ (125,031 )   $ 52,944     $ 92,571     $ 33,139     $ 115,832

Cumulative rate sensitivity gap:

           

Amount

    62,209       (62,822 )     (9,878 )     82,693       115,832    

As a percentage of total interest earning assets

    8.83 %     (8.92 )%     (1.40 )%     11.74 %     16.45 %  
                                         

(1) Includes loans held for sale

Certain shortcomings are inherent in the method of analysis presented in the foregoing table. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates. Also, the interest rates on some types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market interest rates. Additionally, some assets, such as adjustable rate mortgages, have features, which restrict changes in the interest rates of those assets both on a short-term basis and over the lives of such assets. Further, if a change in market interest rates occurs, prepayment, and early withdrawal levels could deviate significantly from those assumed in calculating the tables. Finally, the ability of many borrowers to service their adjustable rate debt may decrease if market interest rates increase substantially.

Impact of Inflation and Changing Prices

Inflation affects our operations by increasing operating costs and indirectly by affecting the operations and cash flow of our customers. Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature. As a result, changes in interest rates generally have a more significant impact on a financial institution’s performance than the effects of general levels of inflation. Although interest rates do not necessarily move in the same direction or the same extent as the prices of goods and services, increases in inflation generally have resulted in increased interest rates.

 

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ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to interest rate risk through our lending and deposit gathering activities. For a discussion of how this exposure is managed and the nature of changes in our interest rate risk profile during the past year, see “Asset/Liability Management” under Management’s Discussion and Analysis of Financial Condition and Results of Operation.

Neither we, nor our banks, maintain a trading account for any class of financial instrument, nor do we, or they, engage in hedging activities or purchase high risk derivative instruments. Moreover, neither we, nor our banks, are subject to foreign currency exchange rate risk or commodity price risk.

The table below provides information about our financial instruments that are sensitive to changes in interest rates as of December 31, 2005. The table presents principal cash flows and related weighted average interest rates by expected maturity dates. The data in this table may not be consistent with the amounts in the preceding table, which represents amounts by the repricing date or maturity date (whichever occurs sooner) adjusted by estimates such as mortgage prepayments and deposit reduction or early withdrawal rates.

 

    By Expected Maturity Date
    Year Ended December 31,
    2006     2007     2008    

2009-

2010

   

After

2010

    Total  

Fair

Value

    (Dollars in thousands)

Investment Securities

             

Amounts maturing:

             

Fixed rate

  $ 4,407     $ 4,762     $ 7,325     $ 3,304     $ 13,508     $ 33,306  

Weighted average interest rate

    2.91 %     3.54 %     3.44 %     3.63 %     4.16 %    

Adjustable Rate

    —         —         —         —         12,516       12,516  

Weighted average interest rate

    —         —         —         —         3.83 %    
                                                   

Totals

    4,407       4,762       7,325       3,304       26,024     $ 45,822   $ 45,818

Loans

             

Amounts maturing:

             

Fixed rate

  $ 40,531     $ 17,438     $ 21,836     $ 28,026     $ 109,646     $ 217,477  

Weighted average interest rate

    6.62 %     6.83 %     6.82 %     6.74 %     6.38 %    

Adjustable rate

    160,251       36,461       16,380       38,591       183,137       434,820  

Weighted average interest rate

    7.97 %     7.54 %     7.05 %     6.65 %     6.51 %    
                                                   

Totals

  $ 200,782     $ 53,899     $ 38,216     $ 66,617     $ 292,783     $ 652,297   $ 642,769

Certificates of Deposit

             

Amounts maturing:

             

Fixed rate

  $ 245,178     $ 29,360     $ 4,225     $ 4,588     $ —       $ 283,351   $ 282,321

Weighted average interest rate

    3.45 %     3.82 %     3.20 %     3.86 %     —        

 

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

For financial statements, see the Index to Consolidated Financial Statements on page F-1.

 

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES

There were no changes in accountants nor disagreements with our accountants on accounting and financial disclosure.

 

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ITEM 9A. CONTROLS AND PROCEDURES

(i) Disclosure Controls and Procedures.

Our disclosure controls and procedures are designed to ensure that information the Company must disclose in its reports filed or submitted under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized, and reported on a timely basis. Our management has evaluated, with the participation and under the supervision of our chief executive officer (“CEO”) and chief financial officer (“CFO”), the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act) as of the end of the period covered by this report. Based on this evaluation, our CEO and CFO have concluded that, as of such date, the Company’s disclosure controls and procedures are effective in ensuring that information relating to the Company, including its consolidated subsidiaries, required to be disclosed in reports that it files under the Exchange Act is (1) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (2) accumulated and communicated to our management, including our CEO and CFO, as appropriate to allow timely decisions regarding required disclosure.

(ii) Internal Control Over Financial Reporting.

(a) Management’s report on internal control over financial reporting.

The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control system is designed to provide reasonable assurance to our management and the board of directors regarding the preparation and fair presentation of published financial statements. Nonetheless, all internal control systems, no matter how well designed, have inherent limitations. Even systems determined to be effective as of a particular date can provide only reasonable assurance with respect to financial statement preparation and presentation and may not eliminate the need for restatements.

The Company’s management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control—Integrated Framework. Based on our assessment, we believe that, as of December 31, 2005, the Company’s internal control over financial reporting is effective based on those criteria.

 

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The Company’s independent registered public accounting firm has audited management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005, as stated in their report following.

(b) Attestation report of the registered public accounting firm.

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

Heritage Financial Corporation:

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting that Heritage Financial Corporation and subsidiaries (the Company) maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

 

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We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated statements of financial condition of Heritage Financial Corporation and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2005, and our report dated March 3, 2006 expressed an unqualified opinion on those consolidated financial statements.

/s/    KPMG LLP

Seattle, Washington

March 3, 2006

(c) Changes in internal control over financial reporting.

There were no significant changes in the Company’s internal control over financial reporting during the Company’s most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

ITEM 9B. OTHER INFORMATION.

None.

 

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PART III

 

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

Information concerning directors of the registrant is incorporated by reference to the section entitled “Election of Directors” of our definitive Proxy Statement expected to be dated March 23, 2006 (“Proxy Statement”) for the annual meeting of shareholders to be held April 27, 2006.

The required information with respect to our executive officers is incorporated by reference to the section entitled “Executive Officers” of the Proxy Statement.

The required information with respect to compliance with Section 16(a) of the Exchange Act is incorporated by reference to the section entitled “Section 16(a) Beneficial Ownership Reporting Compliance” of the Proxy Statement.

 

ITEM 11. EXECUTIVE COMPENSATION

For information concerning executive compensation see “Executive Compensation” of the Proxy Statement, which is incorporated as part of this document by reference. Neither the Report of the Personnel and Compensation Committee nor the Stock Performance Graph, both of which are contained in the Proxy Statement, are incorporated as part of this document by this reference.

 

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The Company measures its employee stock-based compensation arrangements using the provisions outlined in Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, which is an intrinsic value-based method of recognizing compensation costs. The Company has adopted the disclosure-only provisions of SFAS No. 123, Accounting for Stock-based Compensation and we have not yet adopted the latest revisions to SFAS No. 123. Most of the Company’s stock options do not have any intrinsic value at grant date. Therefore, no compensation cost has been recognized for its stock option plan activity. However, during 2005 compensation expense was recognized for restricted stock awards and some incentive stock options. See the consolidated financial statement Notes 1(o) and 14 for further discussion and disclosures on stock options. See the following table for the consolidated activity within stock option plans 1994, 1997, 1998 and 2002 as of December 31, 2005, all of which were approved by stockholders.

 

Number of securities to be issued upon exercise of outstanding options and awards

     674,823

Weighted average exercise price of outstanding options

   $ 16.88

Number of securities remaining available for future issuance

     181,595

For information concerning security ownership of certain beneficial owners and management, see “Stock Ownership” of the Proxy Statement, which is incorporated as part of this document by reference.

 

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

For information concerning certain relationships and related transactions, see “Interest of Management in Certain Transactions” of the Proxy Statement, which is incorporated as part of this document by reference.

 

ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES

For information concerning principal accounting fees and services, see “Relationship with Independent Public Accountants” of the Proxy Statement, which is incorporated as part of this document by reference.

 

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PART IV

 

ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

(a)(1) The consolidated financial statements are contained as listed on the “Index to Consolidated Financial Statements” on page F-1.

(2) All schedules are omitted because they are not required or applicable, or the required information is shown in the consolidated financial statements or notes.

(3) Exhibits

 

Exhibit
No.
    
  3.1     

Articles of Incorporation(1)

  3.2     

Bylaws of the Company(1)

10.1     

1998 Stock Option and Restricted Stock Award Plan(2)

10.5     

Form of Severance Agreement entered into between the Company and seven additional executives, effective as of October 1, 1997(1)

10.6     

1997 Stock Option and Restricted Stock Award Plan(3)

10.7     

Employment Agreement between the Company and Michael Broadhead, effective September 28, 1998(4)

10.8     

Employment Agreement between the Company and Brian L. Vance, effective June 1, 2001(5)

10.9     

Employment Agreement between the Company and Donald V. Rhodes, effective June 1, 2001(5)

10.10   

2002 Incentive Stock Option

Plan, Director Nonqualified Stock Option Plan, and Restricted Stock Option

Plan(6)

10.11   

Revised Employment Agreement between the Company and Donald V. Rhodes, effective January 1, 2005(8)

14.0     

Code of Ethics(7)

21.0     

Subsidiaries of the Company

23.0     

Consent of Independent Registered Public Accounting Firm

24.0     

Power of Attorney

31.0     

Certification of Principal Executive Officer and Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.0     

Certification of Principal Executive Officer and Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 
  (1) Incorporated by reference to the Registration Statement on Form S-1 (Reg. No. 333-35573) declared effective on November 12, 1997.

 

  (2) Incorporated by reference to the Registration Statement on Form S-8 (Reg. No. 333-71415).

 

  (3) Incorporated by reference to the Registration Statement on Form S-8 (Reg. No. 333-57513).

 

  (4) Incorporated by reference to the Registration Statement on Form S-4 dated January 20, 1999.

 

  (5) Incorporated by reference to the Annual Report on Form 10-K dated March 20, 2002.

 

  (6) Incorporated by reference to the Registration Statement on Form S-8 (Reg. No. 333-88980; 333-88982; 333-88976).

 

  (7) Incorporated by reference to the Annual Report on Form 10-K dated March 8, 2004.

 

  (8) Incorporated by reference to the Quarterly Report on Form 10Q dated November 2, 2004.

 

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 3rd day of March, 2006.

 

HERITAGE FINANCIAL CORPORATION
(Registrant)
By  

/s/    DONALD V. RHODES        

  Donald V. Rhodes
  Chairman and Chief Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on the 3rd day of March, 2006.

 

Principal Executive Officer:   

/s/    DONALD V. RHODES        

Donald V. Rhodes

  

Chairman and Chief Executive Officer

Principal Financial Officer:   

/s/    EDWARD D. CAMERON        

Edward D. Cameron

  

Senior Vice President and Chief Financial Officer

Remaining Directors:

*Lynn Brunton

*Daryl D. Jensen

*James P. Senna

*Philip S. Weigand

*Brian S. Charneski

*Gary B. Christensen

*Peter N. Fluetsch

*John A. Clees

*Jeffrey S. Lyon

*Brian L. Vance

 

*By  

/s/    DONALD V. RHODES        

  Donald V. Rhodes
  Attorney-in-Fact

 

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005, 2004, and 2003

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

     Page

Report of Independent Registered Public Accounting Firm

   F-2

Consolidated Statements of Financial Condition—December 31, 2005 and December 31, 2004

   F-3

Consolidated Statements of Income—Years ended December 31, 2005, 2004, and 2003

   F-4

Consolidated Statements of Stockholders’ Equity and Comprehensive Income—Years ended December 31, 2005, 2004, and 2003

   F-5

Consolidated Statements of Cash Flows—Years ended December 31, 2005, 2004, and 2003

   F-6

Notes to Consolidated Financial Statements

   F-7

 

F-1


Table of Contents

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

Heritage Financial Corporation:

We have audited the accompanying consolidated statements of financial condition of Heritage Financial Corporation and subsidiaries (the Company) as of December 31, 2005 and 2004, and the related consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2005. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Heritage Financial Corporation and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Heritage Financial Corporation and subsidiaries’ internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 3, 2006 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.

/s/ KPMG LLP

Seattle, Washington

March 3, 2006

 

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Table of Contents

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

December 31, 2005 and 2004

(Dollars in thousands)

 

     2005     2004  
A S S E T S     

Cash on hand and in banks

   $ 24,972     $ 16,570  

Interest earning deposits

     3,030       2,769  

Federal funds sold

     —         6,000  

Investment securities available for sale

     41,856       45,891  

Investment securities held to maturity

     3,966       1,460  

Loans held for sale

     263       381  

Loans receivable

     652,034       599,380  

Less: Allowance for loan losses

     (8,496 )     (8,295 )
                

Loans receivable, net

     643,538       591,085  

Real estate owned

     371       —    

Premises and equipment, at cost, net

     15,801       16,883  

Federal Home Loan Bank and Federal Reserve stock, at cost

     3,072       3,038  

Accrued interest receivable

     3,566       2,946  

Prepaid expenses and other assets

     2,811       2,803  

Deferred Federal income taxes, net

     1,266       801  

Goodwill, net

     6,640       6,640  
                
   $ 751,152     $ 697,267  
                
L I A B I L I T I E S  A N D  S T O C K H O L D E R S’  E Q U I T Y     

Deposits

   $ 636,504     $ 587,278  

Advances from Federal Home Loan Bank

     39,900       40,900  

Accrued expenses and other liabilities

     8,628       8,145  
                
     685,032       636,323  
                

Stockholders’ equity:

    

Common stock, no par, 15,000,000 shares authorized; 6,255,921 and 5,946,990 shares outstanding at December 31, 2005 and 2004, respectively

     17,606       11,883  

Unearned compensation—ESOP and restricted stock award

     (1,151 )     (1,379 )

Retained earnings, substantially restricted

     50,347       50,657  

Accumulated other comprehensive income (loss), net

     (682 )     (217 )
                

Total stockholders’ equity

     66,120       60,944  

Commitments and Contingencies

     —         —    
                
   $ 751,152     $ 697,267  
                

See accompanying notes to consolidated financial statements.

 

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Table of Contents

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

For the years ended December 31, 2005, 2004 and 2003

(Dollars in thousands, except per share amounts)

 

    2005   2004   2003

Interest income:

     

Interest and fees on loans

  $ 43,605   $ 36,938   $ 35,059

Taxable interest on investment securities

    1,568     1,610     1,649

Nontaxable interest on investment securities

    149     141     123

Interest on federal funds sold and interest earning deposits

    90     177     188

Dividends on Federal Home Loan Bank stock

    16     78     132
                 

Total interest income

    45,428     38,944     37,151
                 

Interest expense:

     

Deposits

    10,594     6,724     7,179

Other borrowings

    953     493     155
                 

Total interest expense

    11,547     7,217     7,334
                 

Net interest income

    33,881     31,727     29,817

Provision for loan losses

    810     645     1,125
                 

Net interest income after provision for loan losses

    33,071     31,082     28,692
                 

Noninterest income:

     

Gains on sales of loans, net

    277     640     1,907

Service charges on deposits

    2,819     2,556     2,421

Rental income

    309     294     268

Merchant visa income

    2,263     1,915     1,588

Other income

    962     1,093     980
                 

Total noninterest income

    6,630     6,498     7,164
                 

Noninterest expense:

     

Salaries and employee benefits

    12,618     12,222     11,648

Occupancy and equipment

    3,906     3,746     3,759

Data processing

    1,204     1,252     1,212

Marketing

    494     423     415

Office supplies and printing

    410     383     377

Merchant visa

    1,763     1,502     1,297

Professional Services

    662     645     485

State and Local Taxes

    699     641     602

Other

    2,427     2,456     2,428
                 

Total noninterest expense

    24,183     23,270     22,223
                 

Income before Federal income tax expense

    15,518     14,310     13,633

Federal income tax expense

    5,042     4,725     4,729
                 

Net income

  $ 10,476   $ 9,585   $ 8,904
                 

Basic earnings per common share

  $ 1.69   $ 1.53   $ 1.31

Basic weighted average shares outstanding

    6,189,497     6,248,418     6,819,060

Diluted earnings per common share

  $ 1.65   $ 1.49   $ 1.26

Diluted weighted average shares outstanding

    6,363,002     6,429,532     7,071,736

See accompanying notes to consolidated financial statements.

 

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Table of Contents

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME

For the years ended December 31, 2005, 2004 and 2003

(Dollars and shares in thousands)

 

    Number of
common
shares
    Common
stock
    Unearned
compensation—
ESOP and
Restricted Stock
Awards
    Retained
earnings
    Accumulated
other
comprehensive
income (loss), net
   

Total

stock-

holders’
equity

 

Balance at December 31, 2002

  6,809     $ 33,587     $ (1,208 )   $ 39,672     $ 346     $ 72,397  

Restricted stock awards granted

  1       22       (22 )     —         —         —    

Earned ESOP, incentive stock options and restricted stock shares

  9       155       143       —         —         298  

Exercise of stock options

  147       1,172       —         —         —         1,172  

Stock repurchased

  (773 )     (16,506 )     —         —         —         (16,506 )

Net income

  —         —         —         8,904       —         8,904  

Change in fair value of securities available for sale, net of taxes

  —         —         —         —         (306 )     (306 )

Cash dividends declared ($.54/share cumulative)

  —         —         —         (3,727 )     —         (3,727 )
                                             

Balance at December 31, 2003

  6,193     $ 18,430     $ (1,087 )   $ 44,849     $ 40     $ 62,232  

Restricted stock awards granted

  25       598       (598 )     —         —         —    

Earned ESOP, incentive stock options and restricted stock shares

  9       93       306       —         —         399  

Exercise of stock options

  123       1,069       —         —         —         1,069  

Stock repurchased

  (403 )     (8,307 )     —         —         —         (8,307 )

Net income

  —         —         —         9,585       —         9,585  

Change fair value of securities available for sale, net of taxes

  —         —         —         —         (257 )     (257 )

Cash dividends declared ($.62/share cumulative)

  —         —         —         (3,777 )     —         (3,777 )
                                             

Balance at December 31, 2004

  5,947     $ 11,883     $ (1,379 )   $ 50,657     $ (217 )   $ 60,944  

Restricted stock awards granted

  2       61       (61 )     —         —         —    

Earned ESOP, incentive stock options and restricted stock shares

  9       113       289       —         —         402  

Exercise of stock options

  71       839       —         —         —         839  

Stock repurchased

  (73 )     (1,606 )     —         —         —         (1,606 )

Net income

  —         —         —         10,476       —         10,476  

Change in fair value of securities available for sale, net of taxes

  —         —         —         —         (465 )     (465 )

5% stock dividend

  300       6,316       —         (6,316 )     —         —    

Cash dividends declared ($.71/share cumulative)

  —         —         —         (4,470 )     —         (4,470 )
                                             

Balance at December 31, 2005

  6,256     $ 17,606     $ (1,151 )   $ 50,347     $ (682 )   $ 66,120  
                                             

 

Comprehensive Income

   2005     2004     2003  

Net income

   $ 10,476     $ 9,585     $ 8,904  

Change in fair value of securities available for sale, net of tax of ($248), ($132), and ($154)

     (465 )     (257 )     (306 )
                        

Comprehensive income

   $ 10,011     $ 9,328     $ 8,598  
                        

See accompanying notes to consolidated financial statements.

 

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Table of Contents

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

For the years ended December 31, 2005, 2004 and 2003

(Dollars in thousands)

 

    2005     2004     2003  

Cash flows from operating activities:

     

Net income

  $ 10,476     $ 9,585     $ 8,904  

Adjustments to reconcile net income to net cash provided by operating activities:

     

Depreciation and amortization

    1,770       1,708       1,863  

Deferred loan fees, net of amortization

    93       324       254  

Provision for loan losses

    810       645       1,125  

Federal Home Loan Bank stock dividends

    (16 )     (79 )     (124 )

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

    (212 )     2,705       302  

Recognition of compensation related to ESOP, incentive stock options and restricted stock shares

    402       399       298  

Gain on sale of investment securities available for sale

    —         (218 )     —    

Gain on sale of premises and equipment

    (8 )     (7 )     (2 )

Gain on sale of other real estate owned

    (7 )     (73 )     (1 )

Net decrease in loans held for sale

    118       637       7,095  

Deferred Federal income tax benefit

    (207 )     (254 )     (580 )

Purchase of Federal Home Loan Bank and Federal Reserve Bank stock

    (109 )     —         —    

Proceeds from sale of Federal Home Loan Bank and Federal Reserve Bank stock

    91       3       16  
                       

Net cash provided by operating activities

    13,201       15,375       19,150  
                       

Cash flows from investing activities:

     

Loans (originated) paid down, net of principal payments and loan sales

    (53,903 )     (79,309 )     (58,498 )

Proceeds from other real estate owned

    183       571       645  

Maturities of investment securities available for sale

    6,781       26,829       52,325  

Sales of investment securities available for sale

    —         243       —    

Maturities of investment securities held to maturity

    638       691       670  

Purchase of investment securities available for sale

    (3,421 )     (17,643 )     (59,975 )

Purchase of investment securities held to maturity

    (3,146 )     —         —    

Purchase of premises and equipment

    (738 )     (1,158 )     (1,305 )

Proceeds from premises and equipment

    13       11       22  
                       

Net cash used in investing activities

    (53,593 )     (69,765 )     (66,116 )
                       

Cash flows from financing activities:

     

Net increase in deposits

    49,226       45,446       24,716  

Net increase (decrease) in FHLB advances

    (1,000 )     9,800       31,100  

Cash dividends paid

    (4,291 )     (3,744 )     (3,731 )

Exercise of stock options

    726       1,008       970  

Repurchase of common stock

    (1,606 )     (8,307 )     (16,506 )
                       

Net cash provided by financing activities

    43,055       44,203       36,549  
                       

Net increase (decrease) in cash and cash equivalents

    2,663       (10,187 )     (10,417 )

Cash and cash equivalents at beginning of year

    25,339       35,526       45,943  
                       

Cash and cash equivalents at end of year

  $ 28,002     $ 25,339     $ 35,526  
                       

Supplemental disclosures of cash flow information:

     

Cash payments for:

     

Interest expense

  $ 11,217     $ 6,902     $ 7,312  

Federal income taxes

    5,126       4,583       5,104  

Supplemental disclosure of noncash investing and financing activities:

     

Loans transferred to real estate owned

  $ 547     $ 39     $ 515  

Net charge offs

    609       98       251  

Stock dividend

    6,316       —         —    

Tax benefit from nonqualified stock options

    113       61       202  

See accompanying notes to consolidated financial statements.

 

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Table of Contents

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share amounts)

 

(1) Summary of Significant Accounting Policies

(a) Description of Business

Heritage Financial Corporation (the Company) is a bank holding company 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 subsidiaries: Heritage Bank and Central Valley Bank. Heritage Bank is a Washington-chartered commercial bank whose deposits are insured by the Federal Deposit Insurance Corporation (FDIC) under the Savings Association Insurance Fund (SAIF) and the Bank Insurance Fund (BIF). Heritage Bank conducts business from its main office in Olympia, Washington and its twelve branch offices located in Thurston, Pierce and Mason Counties. Central Valley Bank is a Washington-chartered commercial bank whose deposits are insured by the Federal Deposit Insurance Corporation (FDIC) under the Bank Insurance Fund (BIF). Central Valley Bank conducts business from its main office in Toppenish, Washington, and its five branch offices located in Yakima and Kittitas Counties.

The Company’s business consists primarily of lending and deposit relationships with small businesses including agribusiness and their owners in its market area, attracting deposits from the general public and originating for sale or investment purposes first mortgage loans on residential properties located in western and central Washington. The Company also makes residential construction loans, income property loans and consumer loans.

(b) Basis of Presentation

The accounting and reporting policies of the Company and its subsidiaries conform to accounting principles generally accepted in the United States of America. In preparing the consolidated financial statements, management makes estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of financial statements and the reported amounts of income and expense during the reporting periods. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses. Actual results could differ from these estimates.

The accompanying consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany balances and transactions among the Company and its subsidiaries have been eliminated in consolidation.

Certain amounts in the consolidated financial statements for prior years have been reclassified to conform to the current consolidated financial statement presentation.

(c) Cash and Cash Equivalents

For purposes of reporting cash flows, cash and cash equivalents includes cash on hand and in banks, interest bearing deposits, and federal funds sold.

The Company is required to maintain an average reserve balance with the Federal Reserve Bank in the form of cash. For the years ended December 31, 2005 and 2004 the Company maintained adequate levels of cash to meet the Federal Reserve Bank requirement.

 

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Table of Contents

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

 

(d) Investment Securities

The Company identifies investments as held to maturity or available for sale at the time of acquisition. Securities are classified as held to maturity when the Company has the ability and positive intent to hold them to maturity. Securities classified as available for sale are available for future liquidity requirements and may be sold prior to maturity.

Investment securities held to maturity are recorded at cost, adjusted for amortization of premiums or accretion of discounts using the interest method. Securities available for sale are carried at fair value. Unrealized gains and losses on securities available for sale are excluded from earnings and are reported in other comprehensive income. Realized gains and losses on sale are computed on the specific identification method.

A decline in the market value of any available for sale or held to maturity security below cost that is deemed to be other than temporary results in a reduction in carrying amount to fair value, a charge to earnings and an establishment of a new cost basis for the security. Unrealized investment securities losses are evaluated at least quarterly on pools of securities with similar attributes to determine whether such declines in value should be considered “other than temporary” and therefore be subject to immediate loss recognition in income. Although these evaluations involve significant judgment, an unrealized loss in the fair value of a debt security is generally deemed to be temporary when the fair value of the security is below the carrying value primarily due to changes in interest rates, there has not been significant deterioration in the financial condition of the issuer, and the Company has the intent and ability to hold the security for a sufficient time to recover the carrying value. An unrealized loss in the value of an equity security is generally considered temporary when the fair value of the security is below the carrying value primarily due to current market conditions and not deterioration in the financial condition of the issuer, and the Company has the intent and ability to hold the security for a sufficient time to recover the carrying value. Other factors that may be considered in determining whether a decline in the value of either a debt or an equity security is “other than temporary” include ratings by recognized rating agencies; actions of commercial banks or other lenders relative to the continued extension of credit facilities to the issuer of the security; the financial condition, capital strength and near-term prospects of the issuer and recommendations of investment advisors or market analysts.

(e) Loans Receivable and Loans Held for Sale

Loans are generally recorded at their outstanding principal balance adjusted for charge-offs, the allowance for loan losses and deferred fees or any costs on originated loans. Interest on loans is calculated using the simple interest method based on the daily balance of the principal amount outstanding and is credited to income as earned.

The accrual of interest on mortgage and commercial loans is discontinued at the time the loan is 90 days delinquent unless the credit is well secured and in the process of collection. Credit card loans and other personal loans are typically charged-off no later than 180 days past due. In all cases, loans are placed on non-accrual or charged-off at an earlier date if collection of principal or interest is doubtful.

All interest accrued but not collected on loans that are placed on non-accrual or charged-off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured.

 

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Table of Contents

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

 

Discounts and premiums on purchased loans are amortized using the effective interest method over the remaining contractual lives, adjusted for actual prepayments. Mortgage loans held for sale are carried at the lower of amortized cost or market value determined on an aggregate basis. Any loan that management determines will not be held to maturity is classified as held for sale at the time of origination, purchase or securitization, or when such decision is made. Unrealized losses on such loans are included in income.

(f) Loan Fees

Loan origination fees and certain direct origination costs are deferred and amortized as an adjustment of the yields of the loans over their contractual lives, adjusted for prepayment of the loans, using the effective interest method. In the event loans are sold, the deferred net loan origination fees or costs are recognized as a component of the gains or losses on the sales of loans.

(g) Allowance for Loan Losses

The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, historical loss considerations, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. The evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available.

While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowance for loan losses. Such agencies may require the Bank to make adjustments to the allowance based on their judgments about information available to them at the time of their examinations.

(h) Impaired Loans

A loan is considered impaired when, based on current information and events, it is probable the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrowers, including length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amounts of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.

 

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Table of Contents

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

 

Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential loans for impairment purposes.

(i) Mortgage Banking Operations

The Company sells mortgage loans primarily on a servicing released basis and recognizes a cash gain or loss. A cash gain or loss is recognized to the extent that the sales proceeds of the mortgage loans sold exceed or are less than the net book value at the time of sale. Income from mortgage loans brokered to other lenders is recognized into income on date of loan closing.

Commitments to sell mortgage loans are made primarily during the period between the taking of the loan application and the closing of the mortgage loan. The timing of making these sale commitments is dependent upon the timing of the borrower’s election to lock-in the mortgage interest rate and fees prior to loan closing. Most of these sale commitments are made on a best-efforts basis whereby the Bank is only obligated to sell the mortgage if the mortgage loan is approved and closed by the Bank. As a result, management believes that market risk is minimal.

Loan servicing income is recorded when earned. Loan servicing costs are charged to expense as incurred.

(j) Real Estate and Other Assets Owned

Real estate and other assets acquired by the Company in satisfaction of debt are held for sale and recorded at fair value at time of foreclosure and are carried at the lower of the new cost basis or fair value less estimated costs to sell.

(k) Premises and Equipment

Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of the assets or the lease period, whichever is shorter. The estimated useful lives used to compute depreciation and amortization for buildings and building improvements is 15 to 39 years; and for furniture, fixtures and equipment is 3 to 7 years. The Company reviews buildings, leasehold improvements and equipment for impairment whenever events or changes in the circumstances indicate that the undiscounted cash flows for the property are less than its carrying value. If identified, an impairment loss is recognized through a charge to earnings based on the fair value of the property.

(l) Goodwill

Goodwill represents the costs in excess of net assets acquired arising from the purchase of North Pacific Bank and was being amortized on a straight-line basis over 15 years. Accumulated amortization of goodwill amounted to $2,020 as of December 31, 2001. Effective January 1, 2002, goodwill is no longer being amortized. Instead, goodwill is reviewed for impairment and written down and charged to income during the periods in which the recorded value is more than its implied value. The Company evaluates any potential impairment of goodwill on an annual basis at the Heritage Bank level. The Company has evaluated the impairment of goodwill each year ended since December 31, 2002 and concluded there is no goodwill impairment.

(m) Federal Income Taxes

The Company files a consolidated federal income tax return. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are

 

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Table of Contents

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

 

measured using enacted tax rates expected to apply to taxable income in the periods in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rate is recognized in income in the period that includes the enactment date.

(n) Employee Stock Ownership Plan

The Company sponsors an Employee Stock Ownership Plan (ESOP). The ESOP purchased 2% of the common stock issued in the January 1998 stock offering and borrowed from the Company in order to fund the purchase of the Company’s common stock. The loan to the ESOP will be repaid principally from the Bank’s contributions to the ESOP. The Bank’s contributions will be sufficient to service the debt over the 15 year loan term at the interest rate of 8.5%. As the debt is repaid, shares are released and allocated to plan participants based on the proportion of debt service paid during the year. As shares are released, compensation expense is recorded equal to the then current market price of the shares and the shares become outstanding for earnings per share calculations. Cash dividends on allocated shares are recorded as a reduction of retained earnings and paid or distributed directly to participants’ accounts. Cash dividends on unallocated shares are recorded as a reduction of debt and accrued interest.

(o) Stock Based Compensation

The Company measures its employee stock-based compensation arrangements using the provisions outlined in Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, which is an intrinsic value-based method of recognizing compensation costs. The Company has adopted the disclosure-only provisions of SFAS No. 123, Accounting for Stock-based Compensation. As most of the Company’s stock options have no intrinsic value at grant date, compensation cost generally has not been recognized for its stock option plan activity. However, compensation expense was recognized during 2005, 2004 and 2003 resulting from restricted stock awards and certain incentive stock options.

If the Company had elected to recognize compensation cost on the fair value at the grant dates for awards under its plans, consistent with the method prescribed by SFAS No. 123, net income and earnings per share would have been changed to the pro forma amounts for the years ended December 31:

 

    2005     2004     2003  

Net income:

     

As reported

  $ 10,476     $ 9,585     $ 8,904  

Plus compensation costs recognized under ABP No. 25, net of taxes

    135       143       67  

Less SFAS No. 123 compensation costs, net of taxes

    (392 )     (325 )     (103 )
                       

Pro forma

  $ 10,219     $ 9,403     $ 8,868  
                       

Basic earnings per share:

     

As reported

  $ 1.69     $ 1.53     $ 1.31  

Plus compensation costs recognized under ABP No. 25, net of taxes

    0.02       0.02       0.01  

Less SFAS No. 123 compensation costs, net of taxes

    (0.06 )     (0.05 )     (0.2 )
                       

Pro forma

  $ 1.65     $ 1.50     $ 1.30  
                       

Diluted earnings per share:

     

As reported

  $ 1.65     $ 1.49     $ 1.26  

Plus compensation costs recognized under ABP No. 25, net of taxes

    0.02       0.02       0.01  

Less SFAS No. 123 compensation costs, net of taxes

    (0.06 )     (0.05 )     (0.03 )
                       

Pro forma

  $ 1.61     $ 1.46     $ 1.24  
                       

 

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Table of Contents

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

 

The compensation expense included in the pro forma net income is not likely to be representative of the effect on reported net income for future years because options vest over several years and additional awards generally are made each year.

The fair value of options granted during the years ended December 31, 2005, 2004 and 2003 is estimated on the date of grant using the Black-Scholes options pricing model. The following assumptions were used to calculate the fair value of the options granted:

 

Grant period ended

   Risk
Free
Interest
Rate
    Expected Life
(in years)
   Expected
Volatility
    Expected
Dividend
Yield
    Weighted
Average
Fair Value

December 31, 2005

   3.91 %   6    20 %   4.32 %   $ 2.87

December 31, 2004

   2.99 %   6    20 %   4.31 %   $ 2.45

December 31, 2003

   3.52 %   6    24 %   3.88 %   $ 3.56

(p) Recently Issued Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board (FASB) issued a revision of Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation (SFAS No. 123(R)). This Statement supersedes Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and its related implementation guidance. This Statement establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments. This Statement focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. This Statement does not change the accounting guidance for share-based payment transactions with parties other than employees provided in Statement 123 as originally issued and Emerging Issues Task Force (EITF) Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.” This Statement does not address the accounting for employee share ownership plans, which are subject to AICPA SOP No. 93-6, Employers’ Accounting for Employee Stock Ownership Plans. This Statement is effective for the Company beginning January 1, 2006. The Company is in the process of analyzing the complex provisions of the Statement and the impact the Statement will have on its results of operations. The adoption of this statement is not expected to have a material impact on the Company’s financial position or results of operations, although compensation expense will increase and net income will decrease as a result of adoption of this statement.

 

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Table of Contents

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

 

(2) Loans Receivable and Loans Held for Sale

Loans receivable and loans held for sale at December 31, 2005 and 2004 consist of the following:

 

     2005      2004  

Commercial loans

   $ 359,808      $ 336,227  

Real estate mortgages:

     

One to four family residential

     53,098        58,903  

Five or more family residential and commercial real estate

     164,788        152,958  
                 

Total real estate mortgage

     217,886        211,861  

Real estate construction:

     

One to four family residential

     42,245        23,266  

Five or more family residential and commercial real estate

     21,355        17,121  
                 

Total real estate construction

     63,600        40,387  

Consumer

     12,855        13,045  
                 

Subtotal

     654,149        601,520  

Deferred loan fees and other

     (1,852 )      (1,759 )
                 

Total loans receivable and loans held for sale

   $ 652,297      $ 599,761  
                 

As of December 31, 2005 and 2004, the Company had loans to persons serving as Directors and Executive Officers, and entities related to such individuals, aggregating $15,620 and $16,033, respectively. All loans were made on essentially the same terms and conditions as comparable transactions with other persons, and did not involve more than the normal risk of collectibility. The Company did not have any borrowings from Directors or Executive Officers at December 31, 2005.

Potential problem loans as of December 31, 2005 were $9,882, down from $12,184 at December 31, 2004. Potential problem loans are those loans that are currently accruing interest, but which are considered possible credit problems because financial information of the borrowers causes us concerns as to their ability to comply with the present repayment program and could result in placing the loan on nonaccrual.

Accrued interest on loans receivable amounted to $3,322 and $2,721 as of December 31, 2005 and 2004, respectively. The Company had $836 and $319 of impaired loans, which were nonaccruing as of December 31, 2005 and 2004, respectively. The annual average balance of impaired loans for the years ended December 31, 2005 and 2004 were $658 and $433, respectively. The allowance for loan losses related to impaired loans at December 31, 2005 and 2004 totaled $125 and $52, respectively. There was no interest recognized on impaired loans for the year ended December 31, 2005. Interest recognized on impaired loans for the years ended December 31, 2004 and 2003 totaled $23 and $162, respectively.

Details of certain mortgage banking activities at December 31, 2005 and 2004 are as follows:

 

     2005    2004

Loans held for sale at lower of cost or market

   $ 263    $ 381

Loans serviced for others

     658      899

Total loans sold

     13,632      35,822

Commitments to sell mortgage loans

     563      695

Commitments to fund mortgage loans (at interest rates approximating market rates)

     

Fixed rate

     92      2,656

Variable or adjustable rate

     —        189

 

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Table of Contents

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

 

Servicing fee income from mortgage loans serviced for others amounted to $4, $10 and $14 for the years ended December 31, 2005, 2004 and 2003, respectively.

As of December 31, 2005, the Company had commitments of $76,966 in other commercial lines of credit, $67,930 in real estate commitments (both construction and lines of credit), and $7,556 in other commitments (including consumer credit lines and letters of credit).

 

(3) Allowance for Loan Losses

Activity in the allowance for loan losses is summarized as follows for the years ended December 31:

 

     2005      2004      2003  

Balance at beginning of period

   $ 8,295      $ 7,748      $ 6,874  

Provision

     810        645        1,125  

Recoveries

     82        11        8  

Charge offs

     (691 )      (109 )      (259 )
                          

Balance at end of period

   $ 8,496      $ 8,295      $ 7,748  
                          

The allocation of the allowance for loan losses is summarized as follows for the years ended December 31:

 

    2005     2004     2003  
    Amount   % of
Total
Loans
(1)
    Amount   % of
Total
Loans
(1)
    Amount   % of
Total
Loans
(1)
 
    (Dollars in thousands)  

Commercial

  $ 6,117   55.0 %   $ 5,971   55.9 %   $ 5,578   51.0 %

Real Estate Mortgage

           

One-four family residential

    335   8.1 %     327   9.8 %     305   11.0 %

Five or more family residential and commercial properties

    1,435   25.2 %     1,402   25.4 %     1,310   28.7 %

Real Estate Construction:

           

One-four family residential

    460   6.4 %     449   3.9 %     419   3.7 %

Five or more family residential and commercial properties

    34   3.3 %     34   2.8 %     31   3.8 %

Consumer

    115   2.0 %     112   2.2 %     105   1.8 %
                                   

Total loans

  $ 8,496   100.0 %   $ 8,295   100.0 %   $ 7,748   100.0 %
                                   

(1) Represents the total of all outstanding loans in each category as a percent of total loans outstanding.

 

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Table of Contents

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

 

(4) Investment Securities Available For Sale

The amortized cost and fair values of investment securities available for sale at the dates indicated are as follows:

 

    

Amortized

cost

   Gross
unrealized
gains
   Gross
unrealized
losses
    Fair
value

December 31, 2005

          

U.S. Government agencies

   $ 19,797    $ 12    $ (393 )   $ 19,416

Mortgage backed and related securities:

          

Collateralized mortgage obligations and mortgage backed securities

     12,105      22      (414 )     11,713

Other related securities

     11,003      —        (276 )     10,727
                            

Totals

   $ 42,905    $ 34    $ (1,083 )   $ 41,856
                            

December 31, 2004

          

U.S. Government agencies

   $ 20,795    $ 60    $ (200 )   $ 20,655

Mortgage backed and related securities:

          

Collateralized mortgage obligations and mortgage backed securities

     14,421      76      (132 )     14,365

Other related securities

     11,003      —        (132 )     10,871
                            

Totals

   $ 46,219    $ 136    $ (464 )   $ 45,891
                            

Investments with unrealized losses as of December 31, 2005 are as follows:

 

     Less than 12 months   

12 months or

longer

   Total
     Fair
Value
   Unrealized
Losses
   Fair
Value
   Unrealized
Losses
   Fair
Value
   Unrealized
Losses

U.S. Government and its agencies

   $ 2,900    $ 32    $ 15,870    $ 375    $ 18,770    $ 407

Mortgage backed and related securities

     5,268      126      17,594      583      22,862      709
                                         

Total temporarily impaired securities

   $ 8,168    $ 158    $ 33,464    $ 958    $ 41,632    $ 1,116
                                         

Because the declines in fair value were due to changes in market interest rates, not in estimated cash flows, and because we have the intent and ability to retain our investment in the issuer for a period of time to allow for any anticipated recovery in market value, no other-than-temporary impairment has been recorded.

 

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Table of Contents

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

 

The amortized cost and fair value of securities available for sale, by contractual maturity, at December 31, 2005 are shown below:

 

     Amortized
cost
   Fair
value

Due in one year or less

   $ 15,217    $ 14,909

Due after one year through three years

     12,138      11,817

Due after three through five years

     2,759      2,718

Due after five years through ten years

     2,827      2,767

Due after ten years

     9,964      9,645
             

Totals

   $ 42,905    $ 41,856
             

There were no sales of investment securities available for sale during the year ended December 31, 2005. During the year ended December 31, 2004 there were sales of investment securities (HCB Bancorp shares) available for sale resulting in a $218 gain.

Accrued interest on investment securities available for sale amounted to $211 and $210 as of December 31, 2005 and 2004, respectively.

At December 31, 2005 and 2004, investment securities available for sale with fair values of $13,043 and $13,795, respectively, were pledged to secure public deposits and for other purposes as required or permitted by law.

We had no securities classified as trading at December 31, 2005 or 2004.

 

(5) Investment Securities Held to Maturity

The amortized cost and fair values of investment securities held to maturity are as follows:

 

     Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
    Fair
value

December 31, 2005

          

U.S. Government agencies

   $ 980    $ —      $ (12 )   $ 968

Mortgage backed securities:

          

FNMA certificates

     17      1      —         18

FHLMC certificates

     515      2      (9 )     508

GNMA certificates

     939      14      (10 )     943

Municipal bonds

     1,515      12      (2 )     1,525
                            
   $ 3,966    $ 29    $ (33 )   $ 3,962
                            

December 31, 2004

          

Mortgage backed securities:

          

FNMA certificates

   $ 30    $ 1    $ —       $ 31

FHLMC certificates

     130      7      —         137

GNMA certificates

     275      29      —         304

Municipal bonds

     1,025      39      —         1,064
                            
   $ 1,460    $ 76    $ —       $ 1,536
                            

 

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Table of Contents

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

 

The amortized cost and fair value of investment securities held to maturity, by contractual maturity, at December 31, 2005 are shown below:

 

     Amortized
cost
   Fair
value

Due in one year or less

   $ 225    $ 228

Due after one year through three years

     270      276

Due after three years through five years

     585      576

Due after five years

     2,886      2,882
             

Totals

   $ 3,966    $ 3,962
             

There were no sales of investment securities held to maturity during the years ended December 31, 2005, 2004 and 2003.

Accrued interest on investment securities held to maturity amounted to $22 and $9 as of December 31, 2005 and 2004, respectively.

At December 31, 2005 and 2004, investment securities held to maturity with amortized cost values of $1,412 and $1,391, respectively, were pledged to secure public deposits and for other purposes as required or permitted by law.

 

(6) Premises and Equipment

A summary of premises and equipment at December 31, 2005 and 2004 follows:

 

     2005    2004

Land

   $ 4,527    $ 4,527

Buildings and building improvements

     18,182      18,049

Furniture, fixtures and equipment

     12,020      11,576
             
     34,729      34,152

Less accumulated depreciation

     18,928      17,269
             
   $ 15,801    $ 16,883
             

Total depreciation expense on premises and equipment was $1,815, $1,708 and $1,863 for the years ended December 31, 2005, 2004 and 2003, respectively.

 

(7) Deposits

Deposits consist of the following at December 31,:

 

     2005      2004  
     Amount    Percent      Amount    Percent  

Non interest demand deposits

   $ 88,015    13.8 %    $ 82,076    14.0 %

NOW accounts

     96,538    15.2        90,570    15.4  

Money market accounts

     80,451    12.6        79,017    13.5  

Savings accounts

     88,149    13.9        99,941    17.0  

Certificate of deposit accounts

     283,351    44.5        235,674    40.1  
                           
   $ 636,504   <