Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

 

 

 

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

For the quarterly period ended March 31, 2011

OR

 

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

Commission File Number 0-29480

 

 

HERITAGE FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

 

 

 

Washington   91-1857900

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

201 Fifth Avenue SW, Olympia, WA   98501
(Address of principal executive offices)   (Zip Code)

(360) 943-1500

(Registrant’s telephone number, including area code)

 

 

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 whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

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

 

Large accelerated filer   ¨    Accelerated filer   x
Non-accelerated filer   ¨    Smaller reporting company   ¨

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

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

As of May 4, 2011 there were 15,648,809 common shares outstanding, with no par value, of the registrant.

 

 

 


Table of Contents

HERITAGE FINANCIAL CORPORATION

FORM 10-Q

INDEX

FORWARD LOOKING STATEMENT

 

          Page  
PART I.    Financial Information   
Item 1.    Condensed Consolidated Financial Statements (Unaudited):   
   Condensed Consolidated Statements of Financial Condition as of March 31, 2011 and December 31, 2010      4   
   Condensed Consolidated Statements of Operations for the Three Months Ended March 31, 2011 and 2010      5   
  

Condensed Consolidated Statements of Stockholders’ Equity for the Three Months Ended March 31, 2011 and Comprehensive Income (Loss) for the Three Months Ended March 31, 2011 and 2010

     6   
   Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2011 and 2010      7   
   Notes to Condensed Consolidated Financial Statements      8   
Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations      34   
Item 3.    Quantitative and Qualitative Disclosures About Market Risk      42   
Item 4.    Controls and Procedures      42   
PART II.    Other Information   
Item 1.    Legal Proceedings      42   
Item 1A.    Risk Factors      42   
Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds      42   
Item 3.    Defaults Upon Senior Securities      42   
Item 4.    [Removed and reserved]      43   
Item 5.    Other Information      43   
Item 6.    Exhibits      44   
   Signatures      45   
   Certifications   

 

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Forward Looking Statements

“Safe Harbor” statement under the Private Securities Litigation Reform Act of 1995: This Form 10-Q contains forward-looking statements that are subject to risks and uncertainties, including, but not limited to: the credit risks of lending activities, including changes in the level and trend of loan delinquencies and write-offs and changes in our allowance for loan losses and provision for loan losses that may be impacted by deterioration in the housing and commercial real estate markets; changes in general economic conditions, either nationally or in our market areas; changes in the levels of general interest rates, and the relative differences between short and long term interest rates, deposit interest rates, our net interest margin and funding sources; fluctuations in the demand for loans, the number of unsold homes and other properties and fluctuations in real estate values in our market areas; results of examinations of us by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”) and of our bank subsidiaries by the Federal Deposit Insurance Corporation (the “FDIC”), the Washington State Department of Financial Institutions, Division of Banks (the “Washington DFI”) or other regulatory authorities, including the possibility that any such regulatory authority may, among other things, require us to increase our reserve for loan losses, write-down assets, change our regulatory capital position or affect our ability to borrow funds or maintain or increase deposits, which could adversely affect our liquidity and earnings; legislative or regulatory changes that adversely affect our business including changes in regulatory policies and principles, including the interpretation of regulatory capital or other rules including changes from the Dodd-Frank Wall Street Reform and Consumer Protection Act and regulations that have been or will be promulgated thereunder; our ability to control operating costs and expenses; the use of estimates in determining fair value of certain of our assets, which estimates may prove to be incorrect and result in significant declines in valuation; difficulties in reducing risk associated with the loans on our balance sheet; staffing fluctuations in response to product demand or the implementation of corporate strategies that affect our workforce and potential associated charges; computer systems on which we depend could fail or experience a security breach; our ability to retain key members of our senior management team; costs and effects of litigation, including settlements and judgments; our ability to implement our expansion strategy; our ability to successfully integrate any assets, liabilities, customers, systems, and management personnel we have acquired including the Cowlitz Bank and Pierce Commercial Bank transactions or may in the future acquire into our operations and our ability to realize related revenue synergies and cost savings within expected time frames and any goodwill charges related thereto; risks relating to acquiring assets or entering markets in which we have not previously operated and may not be familiar; changes in consumer spending, borrowing and savings habits; the availability of resources to address changes in laws, rules, or regulations or to respond to regulatory actions; adverse changes in the securities markets; inability of key third-party providers to perform their obligations to us; changes in accounting policies and practices, as may be adopted by the financial institution regulatory agencies or the Financial Accounting Standards Board, including additional guidance and interpretation on accounting issues and details of the implementation of new accounting methods; other economic, competitive, governmental, regulatory, and technological factors affecting our operations, pricing, products and services; and other risks detailed from time to time in our filings with the Securities and Exchange Commission.

The Company cautions readers not to place undue reliance on any forward-looking statements. Moreover, you should treat these statements as speaking only as of the date they are made and based only on information then actually known to the Company. The Company does not undertake and specifically disclaims any obligation to revise any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements. These risks could cause our actual results for 2011 and beyond to differ materially from those expressed in any forward-looking statements by, or on behalf of, us, and could negatively affect the Company’s operating and stock price performance.

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

 

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ITEM 1. HERITAGE FINANCIAL CORPORATION

HERITAGE FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Dollars in thousands, except for per share amounts)

(Unaudited)

 

     March 31,
2011
    December 31,
2010
 
Assets     

Cash on hand and in banks

   $ 26,156      $ 37,179   

Interest earning deposits

     114,764        129,822   

Federal funds sold

     —          1,990   

Investment securities available for sale

     134,023        125,175   

Investment securities held to maturity (market value of $14,085 and $14,290)

     13,494        13,768   

Loans held for sale

     478        764   

Originated loans receivable

     753,190        742,019   

Less: Allowance for loan losses

     (21,382     (22,062
                

Originated loans receivable, net

     731,808        719,957   

Purchased covered loans receivable, net of allowance for loan losses of ($1,512 and $0)

     123,452        128,715   

Purchased non-covered loans receivable, net of allowance for loan losses of ($266 and $0)

     109,860        131,049   
                

Total loans receivable, net

     965,120        979,721   

FDIC indemnification asset

     16,869        16,071   

Other real estate owned

     3,518        3,030   

Premises and equipment, at cost, net

     22,413        21,750   

Federal Home Loan Bank stock, at cost

     5,594        5,594   

Accrued interest receivable

     5,011        4,626   

Prepaid expenses and other assets

     8,467        8,974   

Deferred income taxes, net

     4,246        4,255   

Intangible assets, net

     1,840        1,953   

Goodwill

     13,012        13,012   
                

Total assets

   $ 1,335,005      $ 1,367,684   
                
Liabilities and Stockholders’ Equity     

Deposits

   $ 1,099,720      $ 1,136,276   

Securities sold under agreement to repurchase

     24,811        19,027   

Accrued expenses and other liabilities

     7,141        10,102   
                

Total liabilities

     1,131,672        1,165,405   

Stockholders’ equity:

    

Common stock, no par, 50,000,000 shares authorized; 15,648,809 and 15,568,471 shares outstanding at March 31, 2011 and December 31, 2010, respectively

     128,688        128,436   

Unearned compensation – ESOP and other

     (160     (182

Retained earnings

     74,412        73,648   

Accumulated other comprehensive income , net

     393        377   
                

Total stockholders’ equity

     203,333        202,279   
                

Total liabilities and stockholders’ equity

   $ 1,335,005      $ 1,367,684   
                

See Notes to Condensed Consolidated Financial Statements.

 

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HERITAGE FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Dollars in thousands, except for per share amounts)

(Unaudited)

 

     Three Months Ended
March 31,
 
     2011     2010  

INTEREST INCOME:

    

Interest and fees on loans

   $ 16,572      $ 11,970   

Taxable interest on investment securities

     663        745   

Nontaxable interest on investment securities

     179        73   

Interest on federal funds sold and interest bearing deposits

     79        60   
                

Total interest income

     17,493        12,848   

INTEREST EXPENSE:

    

Deposits

     1,875        2,163   

Other borrowings

     22        20   
                

Total interest expense

     1,897        2,183   
                

Net interest income

     15,596        10,665   

Provision for loan losses

     2,595        3,750   

Provision for loan losses on purchased loans

     1,778        —     
                

Net interest income after provision for loan losses

     11,223        6,915   

NON-INTEREST INCOME:

    

Gains on sales of loans, net

     151        66   

Service charges on deposits

     1,238        1,025   

Merchant Visa income

     699        715   

FDIC loss sharing income, net

     800        —     

Other income

     590        350   
                

Total non-interest income

     3,478        2,156   

NON-INTEREST EXPENSE:

    

Impairment loss on investment securities

     46        195   

Less: Portion recorded as other comprehensive income

     (20     (5
                

Impairment loss on investment securities, net

     26        190   

Salaries and employee benefits

     6,637        4,015   

Occupancy and equipment

     1,846        1,027   

Data processing

     823        420   

Marketing

     315        211   

Merchant Visa

     569        597   

Professional services

     633        286   

State and local taxes

     356        217   

Federal deposit insurance premium

     456        354   

Other real estate owned

     517        26   

Other expense

     1,474        732   
                

Total non-interest expense

     13,652        8,075   
                

Income before income taxes

     1,049        996   

Income tax expense

     285        300   
                

Net income

   $ 764      $ 696   
                

Dividends accrued and discount accreted on preferred shares

     —          331   

Net income applicable to common shareholders

   $ 764      $ 365   
                

Earnings per common share:

    

Basic

   $ 0.05      $ 0.03   

Diluted

   $ 0.05      $ 0.03   

Dividends declared per common share:

   $ —        $ —     

See Notes to Condensed Consolidated Financial Statements.

 

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HERITAGE FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY FOR THE THREE MONTHS ENDED

MARCH 31, 2011 AND COMPREHENSIVE INCOME FOR THE THREE MONTHS ENDED

MARCH 31, 2011 AND 2010

(Dollars and shares in thousands)

(Unaudited)

 

     Number
of
common
shares
     Common
stock
     Unearned
Compensation-
ESOP and
other
    Retained
earnings
     Accumulated
other
comprehensive
income, net
    Total
stockholders’
equity
 

Balance at December 31, 2010

     15,568       $ 128,436       $ (182   $ 73,648       $ 377      $ 202,279   

Restricted stock awards issued

     79         —           —          —           —          —     

Stock option compensation expense

     —           52         —          —           —          52   

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

     —           1         —          —           —          1   

Share based payment and earned ESOP

     2         199         22        —           —          221   

Net income

     —           —           —          764         —          764   

Change in fair value of securities available for sale, net of reclassification adjustments

     —           —           —          —           (7     (7

Other-than-temporary impairment on securities held to maturity, net of tax

     —           —           —          —           (13     (13

Accretion of other-than-temporary impairment on securities held to maturity, net of tax

     —           —           —          —           36        36   
                                                   

Balance at March 31, 2011

     15,649       $ 128,688       $ (160   $ 74,412       $ 393      $ 203,333   
                                                   

 

     Three Months Ended
March 31,
 

Comprehensive Income

   2011     2010  

Net income

   $ 764      $ 696   

Change in fair value of securities available for sale, net of tax of $(4) and $161

     (7     299   

Other-than-temporary impairment on securities held-to-maturity, net of tax of $(7) and $(2)

     (13     (3

Accretion of other-than-temporary impairment in securities held-to-maturity, net of tax of $20 and $54

     36        101   
                

Comprehensive income

   $ 780      $ 1,093   
                

See Notes to Condensed Consolidated Financial Statements.

 

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HERITAGE FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

For the three months ended March 31, 2011 and 2010

(Dollars in thousands)

(Unaudited)

 

     Three Months Ended
March 31,
 
     2011     2010  

Cash flows from operating activities:

    

Net income

   $ 764      $ 696   

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

    

Depreciation and amortization

     322        404   

Deferred loan fees, net of amortization

     18        (46

Provision for loan losses

     4,373        3,750   

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

     (3,636     (102

Recognition of compensation related to ESOP shares and share based payment

     221        101   

Stock option compensation expense

     52        41   

Tax provision realized from stock options exercised, share based payment and dividends on unallocated ESOP shares

     (1     4   

Amortization of intangible assets

     113        20   

Deferred income tax

     —          15   

Impairment loss on investment securities

     26        190   

Origination of loans held for sale

     (3,230     (3,373

Gain on sale of loans

     (151     (66

Proceeds from sale of loans

     3,667        3,630   

Valuation adjustment on other real estate owned

     361        —     

Loss (gain) on sale of other real estate owned

     13        (93
                

Net cash provided by operating activities

     2,912        5,171   
                

Cash flows from investing activities:

    

Loans originated, net of principal payments

     8,873        8,230   

Maturities of investment securities available for sale

     5,562        3,719   

Maturities of investment securities held to maturity

     570        616   

Purchase of investment securities available for sale

     (14,361     (7,976

Purchase of investment securities held to maturity

     (271     (492

Purchase of premises and equipment

     (1,060     (453

Proceeds from sales of other real estate owned

     475        797   
                

Net cash (used in) provided by investing activities

     (212     4,441   
                

Cash flows from financing activities:

    

Net decrease in deposits

     (36,556     (4,232

Preferred stock cash dividends paid

     —          (300

Net increase (decrease) in securities sold under agreement to repurchase

     5,784        (186

Proceeds from exercise of stock options

     —          201   

Tax provision realized from stock options exercised, share based payment and dividends on unallocated ESOP shares

     1        (4
                

Net cash used in financing activities

     (30,771     (4,521
                

Net (decrease) increase in cash and cash equivalents

     (28,071     5,091   
                

Cash and cash equivalents at beginning of period

     168,991        107,231   
                

Cash and cash equivalents at end of period

   $ 140,920      $ 112,322   
                

Supplemental disclosures of cash flow information:

    

Cash paid for interest

   $ 1,957      $ 2,193   

Cash paid for income taxes

     1,143        150   

Loans transferred to other real estate owned

   $ 1,337      $ 1,590   

See Notes to Condensed Consolidated Financial Statements.

 

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HERITAGE FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Three Months Ended March 31, 2011 and 2010

(Unaudited)

NOTE 1. Description of Business and Basis of Presentation

(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 (the “Banks”). is the Banks are Washington-chartered commercial banks and their deposits are insured by the Federal Deposit Insurance Corporation (“FDIC”) under the Deposit Insurance Fund (“DIF”). Heritage Bank conducts business from its main office in Olympia, Washington and its twenty-five branch offices located in western Washington and the greater Portland, Oregon area. Central Valley Bank conducts business from its main office in Toppenish, Washington and its five branch offices located in Yakima and Kittitas counties of Washington State.

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

Effective July 30, 2010, Heritage Bank entered into a definitive agreement with the FDIC, pursuant to which Heritage Bank acquired certain assets and assumed certain liabilities of Cowlitz Bank, a Washington state-chartered commercial bank headquartered in Longview, Washington (the “Cowlitz Acquisition”). The Cowlitz Acquisition included nine branches of Cowlitz Bank, including its division Bay Bank, which became branches of Heritage Bank. It also included the Trust Services Division of Cowlitz Bank. Effective November 5, 2010, Heritage Bank entered into a definitive agreement with the FDIC, pursuant to which Heritage Bank acquired certain assets and assumed certain liabilities of Pierce Commercial Bank, a Washington state-chartered bank headquartered in Tacoma, Washington (the “Pierce Commercial Acquisition”). The Pierce Commercial Acquisition included one branch, which became a branch of Heritage Bank. The Cowlitz Acquisition and the Pierce Commercial Acquisition are collectively referred to as the “Cowlitz and Pierce Acquisitions”.

(b) Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with Generally Accepted Accounting Principles, or GAAP, for interim financial information, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Accordingly, they do not include all of the information and footnotes required by U.S. Generally Accepted Accounting Principles for complete financial statements. These condensed consolidated financial statements should be read with our December 31, 2010 audited consolidated financial statements and its accompanying notes included in our Annual Report on Form 10-K (“2010 Form 10-K”). In our opinion, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2011 are not necessarily indicative of the results that may be expected for the year ending December 31, 2011. In preparing the condensed consolidated financial statements, we are required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses. Actual results could differ from those estimates.

Certain prior year amounts have been reclassified to conform to the current year’s presentation.

(c) Significant Accounting Policies

The significant accounting policies used in preparation of our consolidated financial statements are disclosed in our 2010 Annual Form 10-K. There have not been any material changes in our significant accounting policies compared to those contained in our Form 10-K disclosure for the year ended December 31, 2010.

(d) Recently Issued Accounting Pronouncements

FASB ASU 2011-02, Receivables (Topic 310): A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring provides additional guidance to clarify when a loan modification or restructuring is considered a troubled debt restructuring (TDR) in order to address current diversity in practice and lead to more consistent application of U.S. GAAP for debt restructurings. In evaluating whether a restructuring constitutes a troubled debt restructuring, a creditor must separately conclude that both of the following exist: (1) the restructuring constitutes a concession, and (2) the debtor is experiencing financial difficulties. The amendments to Topic 310 clarify the guidance regarding the evaluation of both considerations above. Additionally, the amendments clarify that a creditor is precluded from using the effective interest rate test in the debtor’s guidance on restructuring of payables (paragraph 470-60-55-10) when evaluating whether a restructuring constitutes a TDR. This amendment is effective is July 1,

 

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2011. Early adoption is permitted. Retrospective application to the beginning of the annual period of adoption for modifications occurring on or after the beginning of the annual adoption period is required. As a result of applying these amendments, the Company may identify receivables that are newly considered to be impaired. For purposes of measuring impairment of those receivables, an entity should apply the amendments prospectively for the first interim or annual period beginning on or after June 15, 2011.

FASB ASU No. 2011-01, Receivables (Topic 310): Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20, was issued in January 2011. ASU 2011-01 temporarily delays the effective date of the disclosures about troubled debt restructurings in Update 2010-20 for public entities. The delay is intended to allow the FASB time to complete its deliberations on what constitutes a troubled debt restructuring. The effective date of the new disclosures about troubled debt restructurings and the guidance for determining what constitutes a troubled debt restructuring will then be coordinated. Currently, that guidance is anticipated to be effective for interim and annual periods ending after June 15, 2011.

FASB ASU No. 2010-06, Fair Value Measurements and Disclosures (Topic 820)—Improving Disclosures About Fair Value Measurements requires expanded disclosures related to fair value measurements including (i) the amounts of significant transfers of assets or liabilities between Levels 1 and 2 of the fair value hierarchy and the reasons for the transfers, (ii) the reasons for transfers of assets or liabilities in or out of Level 3 of the fair value hierarchy, with significant transfers disclosed separately, (iii) the policy for determining when transfers between levels of the fair value hierarchy are recognized and (iv) for recurring fair value measurements of assets and liabilities in Level 3 of the fair value hierarchy, a gross presentation of information about purchases, sales, issuances and settlements. ASU 2010-06 further clarifies that (i) fair value measurement disclosures should be provided for each class of assets and liabilities (rather than major category), which would generally be a subset of assets or liabilities within a line item in the statement of financial position and (ii) companies should provide disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements for each class of assets and liabilities included in Levels 2 and 3 of the fair value hierarchy. The disclosures related to the gross presentation of purchases, sales, issuances and settlements of assets and liabilities included in Level 3 of the fair value hierarchy are required for the Company beginning January 1, 2011. The remaining disclosure requirements and clarifications made by ASU 2010-06 became effective for the Company on January 1, 2010. See Note 11 “Fair Value of Measurements”.

NOTE 2. Loans Receivable

(a) Loan Origination/Risk Management

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

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

Commercial Business

There are three significant classes of loans in the commercial portfolio segment, including commercial and industrial loans, owner-occupied commercial real estate, and non-owner occupied commercial real estate. The owner and non-owner occupied commercial real estate are both considered commercial real estate loans. As each of the classes carries different risk characteristics, management will discuss them separately.

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

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

 

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One-to-Four Family Residential

The majority of the Company’s one-to four-family residential loans are secured by single-family residences located in its primary market areas. The Company’s underwriting standards require that single-family portfolio loans generally are owner-occupied and do not exceed 80% of the lower of appraised value at origination or cost, of the underlying collateral. Terms typically range from 15 to 30 years. The Company generally sells most single-family loans in the secondary market. Management determines to what extent the Company will retain or sell these loans and other fixed rate mortgages in order to control the Bank’s interest rate sensitivity position, growth and liquidity.

Real Estate Construction and Land Development

The Company originates construction loans for one-to-four family residential and for five or more residential properties and commercial properties. The one-to-four family residential construction loans generally include construction of custom homes whereby the home buyer is the borrower. The Company also provides financing to builders for the construction of pre-sold homes and, in selected cases, to builders for the construction of speculative residential property. Substantially all construction loans are short-term in nature and priced with a variable rate of interest. Construction lending can involve a higher level of risk than other types of lending because funds are advanced partially based upon the value of the project, which is uncertain prior to the project’s completion. Because of the uncertainties inherent in estimating construction costs as well as the market value of a completed project and the effects of governmental regulation of real property, the Company’s estimates with regards to the total funds required to complete a project and the related loan-to-value ratio may vary from actual results. As a result, construction loans often involve the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project and the ability of the borrower to sell or lease the property or refinance the indebtedness. If the Company’s estimate of the value of a project at completion proves to be overstated, it may have inadequate security for repayment of the loan and may incur a loss. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property or an interim loan commitment from the Company until permanent financing is obtained. These loans are closely monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being sensitive to interest rate changes, governmental regulation of real property, general economic conditions and the availability of long-term financing.

Consumer

The Company originates consumer loans and lines of credit that are both secured and unsecured. The underwriting process is developed to ensure a qualifying primary and secondary source of repayment. Underwriting standards for home equity loans are heavily influenced by statutory requirements, which include, but are not limited to, a maximum loan-to-value percentage of 80%, collection remedies, the number of such loans a borrower can have at one time and documentation requirements. To monitor and manage consumer loan risk, policies and procedures are developed and modified, as needed. The majority of the consumer loans are relatively small amounts spread across many individual borrowers which minimizes the credit risk. Additionally, trend reports are reviewed by management on a regular basis.

Originated loans receivable at March 31, 2011 and December 31, 2010 consisted of the following portfolio segments and classes:

 

     March 31, 2011     December 31, 2010  
     (In thousands)  

Commercial business:

    

Commercial and industrial

   $ 255,055      $ 232,857   

Owner-occupied commercial real estate

     158,206        159,444   

Non-owner occupied commercial real estate

     213,938        221,739   
                

Total commercial business

     627,199        614,040   

One-to-four family residential

     44,686        47,505   

Real estate construction and land development:

    

One-to-four family residential

     26,927        29,377   

Five or more family residential and commercial properties

     32,980        28,588   
                

Total real estate construction and land development

     59,907        57,965   

Consumer

     22,739        23,832   
                

Gross originated loans receivable

     754,531        743,342   

Deferred loan fees

     (1,341     (1,323
                

Total originated loans receivable

   $ 753,190      $ 742,019   
                

 

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Loans acquired in a business acquisition are designated as “purchased” loans. Purchased loans subject to loss-sharing agreements with the FDIC are identified as “covered” loans. Loans purchased with evidence of credit deterioration since origination for which it is probable that all contractually required payments will not be collected are accounted for under Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“FASB ASC”) 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality, formerly AICPA SOP 03-3 Accounting for Certain Loans or Debt Securities Acquired in a Transfer. These loans are identified as “impaired” loans. Loans purchased that are not accounted for under FASB ASC 310-30 are accounted for under FASB ASC 310-20, Receivables—Nonrefundable fees and Other Costs, formerly SFAS91 Nonrefundable fees and Other Costs. These loans are identified as “other” loans. Funds advanced on the covered loans subsequent to acquisition, identified as “subsequent advances,” are included in the purchased covered loan balances as these subsequent advances are covered under the loss-sharing agreements. The subsequent advances for loans accounted for under FASB ASC 310-30 are reported with the balances of the purchased impaired covered loans despite the fact that the subsequent advances are not accounted for under FASB ASC 310-30. The total balance of subsequent advances on the purchased impaired covered loans was $7.2 million and $6.0 million as of March 31, 2011 and December 31, 2010, respectively.

The recorded investment of purchased covered loans receivable at March 31, 2011 and December 31, 2010 consisted of the following portfolio segments and classes:

 

     March 31, 2011     December 31, 2010  
     (In thousands)  

Commercial business:

    

Commercial and industrial

   $ 45,396      $ 47,048   

Owner-occupied commercial real estate

     43,827        45,220   

Non-owner occupied commercial real estate

     17,027        17,575   
                

Total commercial business

     106,250        109,843   

One-to-four family residential

     9,604        10,022   

Real estate construction and land development:

    

One-to-four family residential

     5,734        5,875   

Five or more family residential and commercial properties

     —          —     
                

Total real estate construction and land development

     5,734        5,875   

Consumer

     3,376        2,975   
                

Total purchased loans receivable

     124,964        128,715   

Allowance for loan losses

     (1,512     —     
                

Purchased loans receivable, net

   $ 123,452      $ 128,715   
                

The March 31, 2011 and December 31, 2010 gross recorded investment balance of impaired purchased covered loans accounted for under FASB ASC 310-30 was $86.8 million and $90.1 million, respectively. The gross recorded investment balance of other purchased covered loans was $38.2 million and $38.6 million at March 31, 2011 and December 31, 2010, respectively.

The recorded investment of purchased non-covered loans receivable at March 31, 2011 and December 31, 2010 consisted of the following portfolio segments and classes:

 

     March 31, 2011     December 31, 2010  
     (In thousands)  

Commercial business:

    

Commercial and industrial

   $ 56,739      $ 69,049   

Owner-occupied commercial real estate

     17,948        18,840   

Non-owner occupied commercial real estate

     15,343        18,970   
                

Total commercial business

     90,030        106,859   

One-to-four family residential

     10,641        12,209   

Real estate construction and land development:

    

One-to-four family residential

     3,833        3,816   

Five or more family residential and commercial properties

     1,241       1,244   
                

Total real estate construction and land development

     5,074        5,060   

Consumer

     4,381        6,921   
                

Total purchased loans receivable

     110,126        131,049   

Allowance for loan losses

     (266     —     
                

Purchased loans receivable, net

   $ 109,860      $ 131,049   

 

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During the quarter ended March 31, 2011, the purchased non-covered loans were added to the Heritage Bank’s loan servicing system. At that time, it was determined that certain loans should be reclassified to better represent the class of loan based on the Bank’s methodology. Therefore, the December 31, 2010 loan balances have been re-classified since being reported in the Annual Report on Form 10-K.

The March 31, 2011 and December 31, 2010 gross recorded investment balance of impaired purchased non-covered loans accounted for under FASB ASC 310-30 was $69.7 million and $80.2 million, respectively. The recorded investment balance of other purchased non-covered loans was $40.4 million and $50.8 million at March 31, 2011 and December 31, 2010, respectively.

(b) Concentrations of Credit

Most of the Company’s lending activity occurs within the State of Washington, and to a lesser extent the State of Oregon. The primary market areas include Thurston, Pierce, King, Mason, Cowlitz and Clark counties in Washington and Multnomah County in Oregon, as well as other markets. The majority of the Company’s loan portfolio consists of commercial and industrial, non-owner occupied commercial real estate, and owner occupied commercial real estate. As of March 31, 2011 and December 31, 2010, there were no concentrations of loans related to any single industry in excess of 10% of total loans.

(c) Credit Quality Indicators

As part of the on-going monitoring of the credit quality of the Company’s loan portfolio, management tracks certain credit quality indicators including trends related to (i) the risk grade of the loans, (ii) the level of classified loans, (iii) net charge-offs, (iv) nonperforming loans, and (v) the general economic conditions of the United States of America, and specifically the states of Washington and Oregon. The Company utilizes a risk grading matrix to assign a risk grade to each of its loans. Loans are graded on a scale of 0 to 9, and a “W”. A description of the general characteristics of the nine risk grades is as follows:

 

   

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

 

   

Grade “W”—This grade includes loans on management’s “watch list” and is intended to be utilized on a temporary basis for pass grade borrowers where a significant risk-modifying action is anticipated in the near term.

 

   

Grade 6—This grade is for “Other Assets Especially Mentioned” (OAEM) in accordance with regulatory guidelines, and is intended to highlight loans with elevated risks. Loans with this grade show signs of deteriorating profits and capital, and the borrower might not be strong enough to sustain a major setback. The borrower is typically higher than normally leveraged, and outside support might be modest and likely illiquid. The loan is at risk of further decline unless active measures are taken to correct the situation.

 

   

Grade 7—This grade includes “Substandard” loans, in accordance with regulatory guidelines, for which the loan has a high risk. The loan also has defined weaknesses which make payment default or principal exposure likely, but not yet certain. The borrower may have shown serious negative trends in financial ratios and performance. Such loans are apt to be dependent upon collateral liquidation, a secondary source of repayment or an event outside of the normal course of business. Loans with this grade can be accrual or nonaccrual status based on the Company’s accrual policy.

 

   

Grade 8—This grade includes “Doubtful” loans in accordance with regulatory guidelines, and the Company has determined these loans to have excessive risk. Such loans are placed on nonaccrual status and may be dependent upon collateral having a value that is difficult to determine or upon some near-term event which lacks certainty. Additionally, these loans generally have a specific valuation allowance.

 

   

Grade 9—This grade includes “Loss” loans in accordance with regulatory guidelines. These loans are determined to have the highest risk of loss. Such loans are charged-off or charged-down when payment is acknowledged to be uncertain or when the timing or value of payments cannot be determined. “Loss” is not intended to imply that the loan or some portion of it will never be paid, nor does it in any way imply that there has been a forgiveness of debt.

 

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Loan grades for all commercial loans are established at the origination of the loan. Non-commercial loans are not graded as a 0 to 9 at origination date as these loans are determined to be “pass graded” loans. These non-commercial loans may subsequently require a 0-9 risk grade if the credit department has evaluated the credit and determined it necessary to classify the loan. Loan grades are reviewed on a quarterly basis, or more frequently if necessary, by the credit department. Typically, an individual loan grade will not be changed from the prior period unless there is a specific indication of credit deterioration or improvement. Credit deterioration is evidenced by delinquency, direct communications with the borrower, or other borrower information that becomes public. Credit improvements are evidenced by known facts regarding the borrower or the collateral property.

The loan grades relate to the likelihood of losses in that the higher the grade, the greater the loss potential. Loans with a pass grade are believed to have some inherent losses in the portfolios, but at a lesser extent than the other loan grades. These pass graded loans might have a zero percent loss based on historical experience and current market trends. The OAEM loan grade is transitory in that the Company is waiting on additional information to determine the likelihood and extent of the potential loss. However, the likelihood of loss is greater than Watch grade because there has been measurable credit deterioration. Loans with a substandard grade are generally loans for which the Company has individually analyzed for potential impairment. For Doubtful and Loss graded loans, the Company is almost certain of the losses, and the unpaid principal balances are generally charged-off.

The following tables present the balance of the originated loans receivable by credit quality indicator as of March 31, 2011 and December 31, 2010.

 

     March 31, 2011  
     Pass      OAEM      Substandard      Doubtful      Total  
     (in thousands)  

Commercial business:

              

Commercial and industrial

   $ 222,154       $ 3,471       $ 28,640       $ 790       $ 255,055   

Owner-occupied commercial real estate

     152,815         1,921         3,470         —           158,206   

Non-owner occupied commercial real estate

     202,995         6,164         4,779         —           213,938   
                                            

Total commercial business

     577,964         11,556         36,889         790         627,199   

One-to-four family residential

     44,230         —           456         —           44,686   

Real estate construction and land development:

              

One-to-four family residential

     11,040         2,009         13,878         —           26,927   

Five or more family residential and commercial properties

     19,270         —           13,710         —           32,980   
                                            

Total real estate construction and land development

     30,310         2,009         27,588         —           59,907   

Consumer

     22,593         —           146         —           22,739   
                                            

Gross originated loans

   $ 675,097       $ 13,565       $ 65,079       $ 790       $ 754,531   
                                            
     December 31, 2010  
     Pass      OAEM      Substandard      Doubtful      Total  
     (in thousands)  

Commercial business:

              

Commercial and industrial

   $ 199,566       $ 2,615       $ 29,871       $ 805       $ 232,857   

Owner-occupied commercial real estate

     154,910         913         3,621         —           159,444   

Non-owner occupied commercial real estate

     206,178         12,991         2,570         —           221,739   
                                            

Total commercial business

     560,654         16,519         36,062         805         614,040   

One-to-four family residential

     46,653         —           850         2         47,505   

Real estate construction and land development:

              

One-to-four family residential

     10,287         2,317         16,773         —           29,377   

Five or more family residential and commercial properties

     19,078         793         8,717         —           28,588   
                                            

Total real estate construction and land development

     29,365         3,110         25,490         —           57,965   

Consumer

     23,704         —           128         —           23,832   
                                            

Gross originated loans

   $ 660,376       $ 19,629       $ 62,530       $ 807       $ 743,342   
                                            

The tables above include impaired loan balances. Potential problem loans are those loans that are currently accruing interest and are not considered impaired, but which management is monitoring because the financial information of the borrower causes concern as to their ability to meet their loan repayment terms. Potential problem originated loans as of March 31, 2011 and December 31, 2010 were $50.1 million and $56.1 million, respectively. The balance of potential problem originated loans guaranteed by a governmental agency was $4.2 million and $5.9 million as of March 31, 2011 and December 31, 2010, respectively. This guarantee reduces the Company’s credit exposure.

 

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The following tables present the recorded balance of the other purchased loans receivable by credit quality indicator as of March 31, 2011 and December 31, 2010.

 

     March 31, 2011  
     Pass      OAEM      Substandard      Doubtful      Total  
     (in thousands)  

Commercial business:

              

Commercial and industrial

   $ 28,869       $ 23       $ 359       $ —         $ 29,251   

Owner-occupied commercial real estate

     33,854         —           595         —           34,449   

Non-owner occupied commercial real estate

     7,368         508         555        —           8,431   
                                            

Total commercial business

     70,091         531         1,509         —           72,131   

One-to-four family residential

     2,341         —           —           —           2,341   

Real estate construction and land development:

              

One-to-four family residential

     54         —           —           —           54   

Five or more family residential and commercial properties

     —           —           —           —           —     
                                            

Total real estate construction and land development

     54         —           —           —           54   

Consumer

     4,043         —           —           —           4,043   
                                            

Gross other purchased covered loans

   $ 76,529       $ 531       $ 1,509       $ —         $ 78,569   
                                            
     December 31, 2010  
     Pass      OAEM      Substandard      Doubtful      Total  
     (in thousands)  

Commercial business:

              

Commercial and industrial

   $ 20,065       $ 117       $ 40       $ —         $ 20,222   

Owner-occupied commercial real estate

     34,844         —           398         —           35,242   

Non-owner occupied commercial real estate

     11,987         575         —           —           12,562   
                                            

Total commercial business

     66,896         692         438         —           68,026   

One-to-four family residential

     3,665         —           —           —           3,665   

Real estate construction and land development:

              

One-to-four family residential

     54         —           —           —           54   

Five or more family residential and commercial properties

     152         —           —           —           152   
                                            

Total real estate construction and land development

     206         —           —           —           206   

Consumer

     17,345         144         —           —           17,489   
                                            

Gross other purchased covered loans

   $ 88,112       $ 836       $ 438       $ —         $ 89,386   
                                            

 

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Originated nonaccrual loans, segregated by class of loans, were as follows as of March 31, 2011 and December 31, 2010:

 

     March 31,
2011(1)
     December 31,
2010(1)
 
     (In thousands)  

Commercial business:

     

Commercial and industrial

   $ 10,681       $ 9,934   

Owner-occupied commercial real estate

     723         129   

Non-owner occupied commercial real estate

     778         778   
                 

Total commercial business

     12,182         10,841   

Real estate construction and land development:

     

One-to-four family residential

     6,900         10,226   

Five or more family residential and commercial properties

     4,877         5,416   
                 

Total real estate construction and land development

     11,777         15,642   

Consumer

     —           —     
                 

Gross originated loans

   $ 23,959       $ 26,483   
                 

 

(1) $3.7 million and $3.2 million of nonaccrual originated loans were guaranteed by governmental agencies at March 31, 2011 and December 31, 2010, respectively.

There were no nonaccrual loans recorded in the other purchased covered and non-covered loans as of March 31, 2011 and December 31, 2010, respectively.

The Company performs aging analysis of past due loans using the categories of 30-89 days past due and 90 or more days past due. This policy is consistent with regulatory reporting requirements. The balances of originated past due loans, segregated by class of loans, as of March 31, 2011 and December 31, 2010 are as follows.

 

     March 31, 2011  
     30-89 Days      Greater Than
90 Days
     Total Past Due      Current      Total      > 90 Days and Still
Accruing
 
     (in thousands)         

Commercial business:

                 

Commercial and industrial

   $ 2,996       $ 5,684       $ 8,680       $ 246,375       $ 255,055       $ 15   

Owner-occupied commercial real estate

     1,824         851         2,675         155,531         158,206         128   

Non-owner occupied commercial real estate

     —           778         778         213,160         213,938         —     
                                                     

Total commercial business

     4,820         7,313         12,133         615,066         627,199         143   

One-to-four family residential

     844         47         891         43,795         44,686         47   

Real estate construction and land development:

                 

One-to-four family residential

     —           6,901         6,901         20,026         26,927         —     

Five or more family residential and commercial properties

     793         4,876         5,669         27,311         32,980         —     
                                                     

Total real estate construction and land development

     793         11,777         12,570         47,337         59,907         —     

Consumer

     235         —           235         22,504         22,739         —     
                                                     

Gross originated loans

   $ 6,692       $ 19,137       $ 25,829       $ 728,702       $ 754,531       $ 190   
                                                     

 

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     December 31, 2010  
     30-89 Days      Greater Than
90 Days
     Total Past Due      Current      Total      > 90 days and still
accruing
 
     (in thousands)         

Commercial business:

                 

Commercial and industrial

   $ 2,585       $ 3,561       $ 6,146       $ 226,711       $ 232,857       $ 199   

Owner-occupied commercial real estate

     187         1,372         1,559         157,885         159,444         594   

Non-owner occupied commercial real estate

     3,396         1,201         4,597         217,142         221,739         —     
                                                     

Total commercial business

     6,168         6,134         12,302         601,738         614,040         793   

One-to-four family residential

     624         49         673         46,832         47,505         47   

Real estate construction and land development:

                 

One-to-four family residential

     —           2,844         2,844         26,533         29,377         —     

Five or more family residential and commercial properties

     941         5,416         6,357         22,231         28,588         381   
                                                     

Total real estate construction and land development

     941         8,260         9,201         48,764         57,965         381   

Consumer

     42         —           42         23,790         23,832         —     
                                                     

Gross originated loans

   $ 7,775       $ 14,443       $ 22,218       $ 721,124       $ 743,342       $ 1,221   
                                                     

 

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The balances of other purchased past due loans, segregated by class of loans, as of March 31, 2011 and December 31, 2010 are as follows:

 

     March 31, 2011  
     30-89 Days      Greater Than
90 Days
     Total Past Due      Current      Total      > 90 Days and Still
Accruing
 
     (in thousands)         

Commercial business:

                 

Commercial and industrial

   $ 95       $ —         $ 95       $ 29,156       $ 29,251       $ —     

Owner-occupied commercial real estate

     155         —           155         34,294         34,449         —     

Non-owner occupied commercial real estate

     445        —           445        7,986         8,431         —     
                                                     

Total commercial business

     695         —           695         71,436         72,131         —     

One-to-four family residential

     131        —           131        2,210         2,341         —     

Real estate construction and land development:

                 

One-to-four family residential

     —           —           —           54         54         —     

Five or more family residential and commercial properties

     —           —           —           —           —           —     
                                                     

Total real estate construction and land development

     —           —           —           54         54         —     

Consumer

     65         —           65         3,978         4,043         —     
                                                     

Gross other purchased covered loans

   $ 891       $ —         $ 891       $ 77,678       $ 78,569       $ —     
                                                     
     December 31, 2010  
     30-89 Days      Greater Than
90 Days
     Total Past Due      Current      Total      > 90 days and still
accruing
 
     (in thousands)         

Commercial business:

                 

Commercial and industrial

   $ 774       $ —         $ 774       $ 19,448       $ 20,222       $ —     

Owner-occupied commercial real estate

     9,898         —           9,898         25,344         35,242         —     

Non-owner occupied commercial real estate

     —           —           —           12,562         12,562         —     
                                                     

Total commercial business

     10,672         —           10,672         57,354         68,026         —     

One-to-four family residential

     —           —           —           3,665         3,665         —     

Real estate construction and land development:

                 

One-to-four family residential

     —           —           —           54         54         —     

Five or more family residential and commercial properties

     —           —           —           152         152         —     
                                                     

Total real estate construction and land development

     —           —           —           206         206         —     

Consumer

     184         —           184         17,305         17,489         —     
                                                     

Gross other purchased covered loans

   $ 10,856       $ —         $ 10,856       $ 78,530       $ 89,386       $ —     
                                                     

Impaired originated loans at March 31, 2011 and December 31, 2010 are set forth in the following tables.

 

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Table of Contents
     March 31, 2010  
     Recorded
Investment With
No Specific
Valuation
Allowance
     Recorded
Investment With
Specific
Valuation
Allowance
     Total
Recorded
Investment
     Unpaid
Contractual
Principal
Balance
     Related
Specific
Valuation
Allowance
     Average
Recorded
Investment
 
     (in thousands)  

Commercial business:

                 

Commercial and industrial

   $ 5,876       $ 4,805       $ 10,681       $ 10,719       $ 1,719       $ 10,306   

Owner-occupied commercial real estate

     129         593         722         734         123         426   

Non-owner occupied commercial real estate

     1,167         —           1,167         1,172         —           1,169   
                                                     

Total commercial business

     7,172         5,398         12,570         12,625         1,842         11,901   

One-to-four family residential

     —           —           —           —           —           —     

Real estate construction and land development:

                 

One-to-four family residential

     5,988         913         6,901         8,239         323         8,564   

Five or more family residential and commercial properties

     3,734        5,973         9,707         12,426         308         7,561   
                                                     

Total real estate construction and land development

     9,722         6,886         16,608         20,665         631         16,125   

Consumer

     —           —           —           —           —           —     
                                                     

Gross originated loans

   $ 16,894       $ 12,284       $ 29,178       $ 33,290       $ 2,473       $ 28,026   
                                                     
     December 31, 2010  
     Recorded
Investment With
No Specific
Valuation
Allowance
     Recorded
Investment With
Specific
Valuation
Allowance
     Total
Recorded
Investment
     Unpaid
Contractual
Principal
Balance
     Related
Specific
Valuation
Allowance
     Average
Recorded
Investment
 
     (in thousands)  

Commercial business:

                 

Commercial and industrial

   $ 2,462       $ 5,691       $ 8,153       $ 9,261       $ 2,569       $ 8,909   

Owner-occupied commercial real estate

     129         650         779         822         163         771   

Non-owner occupied commercial real estate

     2,301         —           2,301         3,972         —           2,175   
                                                     

Total commercial business

     4,892         6,341         11,233         14,055         2,732         11,855   

One-to-four family residential

     —           2         2         2         2         2   

Real estate construction and land development:

                 

One-to-four family residential

     1,804         8,423         10,227         10,183         1,664         11,228   

Five or more family residential and commercial properties

     —           5,416         5,416         6,453         201         5,697   
                                                     

Total real estate construction and land development

     1,804         13,839         15,643         16,636         1,865         16,925   

Consumer

     —           —           —           —           —           —     
                                                     

Gross originated loans

   $ 6,696       $ 20,182       $ 26,878       $ 30,693       $ 4,599       $ 28,782   
                                                     

For the quarter ended March 31, 2011, no interest income was recognized subsequent to a loan’s classification as impaired. For the year ended December 31, 2010, $13,000 of interest income was recognized on impaired loans.

The Company had governmental guarantees of $3.7 million and $3.2 million related to the impaired originated loan balances at March 31, 2011 and December 31, 2010, respectively.

 

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Table of Contents

(f) Troubled Debt Restructured Loans

At March 31, 2011, the Company had $11.0 million in originated restructured loans, of which $5.4 million were accruing and $5.6 million were non-accruing and considered impaired. The majority of originated restructured loans were real estate construction commercial loans, in the amount of $5.0 million, followed by $4.7 million of real estate construction one-to-four family residential loans, $868,000 of commercial and industrial loans and $389,000 of non-owner occupied commercial properties. At December 31, 2010, the Company had $9.1 million in originated restructured loans, of which $394,000 were accruing and $8.7 million were non-accruing and considered impaired. The majority of originated restructured loans were real estate construction one-to-four family residential loans in the amount of $7.8 million, followed by commercial and industrial loans of $900,000 and non-owner occupied commercial properties of $400,000.

(g) Impaired Purchased Loans

As indicated above, the Company purchased impaired loans from the Cowlitz and Pierce Commercial Acquisitions which are accounted for under FASB ASC 310-30.

The following tables reflect the outstanding balance at March 31, 2011 and December 31, 2010 of the purchased impaired loans:

 

     Cowlitz Bank  
     March 31,
2011
     December 31,
2010
 
     (In thousands)  

Covered purchased loans:

     

Commercial business:

     

Commercial and industrial

   $ 43,112       $ 38,636   

Owner-occupied commercial real estate

     23,006         24,575   

Non-owner occupied commercial real estate

     19,548         20,771   
                 

Total commercial business

     85,666         83,982   

One-to-four family residential

     9,201         9,612   

Real estate construction and land development:

     

One-to-four family residential

     10,569         10,858   

Five or more family residential and commercial properties

     —           —     
                 

Total real estate construction and land development

     10,569         10,858   

Consumer

     485         495   
                 

Gross impaired purchased covered loans

     105,921         104,947   

Non-covered purchased loans:

     

Consumer

     632         676   
                 

Total impaired purchased loans

     106,553         105,623   
                 

 

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Table of Contents
     Pierce Commercial Bank  
     March 31, 2011      December 31, 2010  
     (In thousands)  

Non-covered purchased loans:

     

Commercial business:

     

Commercial and industrial

   $ 47,771       $ 55,556   

Owner-occupied commercial real estate

     7,652         7,722   

Non-owner occupied commercial real estate

     8,738         8,926   
                 

Total commercial business

     64,161         72,214   

One-to-four family residential

     11,315         12,140   

Real estate construction and land development:

     

One-to-four family residential

     11,843         11,925   

Five or more family residential and commercial properties

     4,323         4,332   
                 

Total real estate construction and land development

     16,166         16,257   

Consumer

     3,455         3,862   
                 

Gross impaired purchased non-covered loans

     95,097         104,473   
                 

On acquisition date, the amount by which the undiscounted expected cash flows of the purchased impaired loans exceed the estimate fair value of the loan is the “accretable yield”. The accretable yield is then measured at each financial reporting date and represents the difference between the remaining undiscounted expected cash flows and the current carrying value of the purchased impaired loan.

The following table summarizes the accretable yield on the Cowlitz Bank and Pierce Commercial Bank impaired purchased loans as of December 31, 2010 and the changes therein through March 31, 2011.

 

     Cowlitz Bank     Pierce
Commercial
Bank
 
     (In thousands)  

Accretable yield at December 31, 2010

   $ 20,082      $ 10,943   

Accretion

     (2,068     (1,125

Disposals and other

     1,518        433   

Increase in accretable yield

     5,953        —     
                

Accretable yield at March 31, 2011

   $ 25,485      $ 10,251   
                

NOTE 3. Allowance for Loan Losses

The allowance for loan losses is maintained at a level deemed appropriate by management to adequately provide for known and inherent risks in the loan portfolio. A summary of the changes in the originated loans’ allowance for loan losses for the three months ended March 31, 2011 and March 31, 2010 are as follows:

 

     Three months ended  
     March 31, 2011     March 31, 2010  
     (In thousands)  

Balance at the beginning of period

   $ 22,062      $ 26,164   

Loans charged off

     (3,994     (5,437

Recoveries of loans charged off

     719        320   

Provision charged to operations

     2,595        3,750   
                

Balance at the end of period

   $ 21,382      $ 24,797   
                

 

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Table of Contents

A summary of the changes in the purchased loans’ allowance for loan losses for the three months ended March 31, 2011 are as follows:

 

     Purchased
Covered
     Purchased
Non-Covered
 
     (In thousands)  

Balance at the beginning of period

   $ —         $ —     

Provision charged to operations

     1,512         266   
                 

Balance at the end of period

   $ 1,512       $ 266   
                 

 

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Table of Contents

The following table details the balance in the allowance for loan losses disaggregated on the basis of the Company’s impairment method for the year ended December 31, 2010:

 

    Commercial
and
industrial
    Owner-
occupied
commercial
real estate
    Non-owner
occupied
commercial
real estate
    One-to-four
family
residential
    Real estate
construction
and land
development:
one-to-four
family
residential
    Real estate
construction
and land
development:
five or more
family
residential
and
commercial
real estate
    Consumer     Unallocated     Total  
    (in thousands)  

Allowance for loan losses allocated to:

                 

Originated loans individually evaluated for impairment

    2,569        163        —          2        1,664        201        —          —          4,599   

Originated loans collectively evaluated for impairment

    7,897        1,510        2,190        797        2,653        931        554        931        17,463   
                                                                       

Balance of allowance for loan losses at December 31, 2010

  $ 10,466      $ 1,673      $ 2,190      $ 799      $ 4,317      $ 1,132      $ 554      $ 931      $ 22,062   
                                                                       

 

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Table of Contents

The following table details activity in the allowance for loan losses disaggregated on the basis of the Company’s impairment method for the quarter ended March 31, 2011:

 

    Commercial
and
industrial
    Owner-
occupied
commercial
real estate
    Non-owner
occupied
commercial
real estate
    One-to-four
family
residential
    Real estate
construction
and land
development:
one-to-four
family
residential
    Real estate
construction
and land
development:
five or more
family
residential
and
commercial
real estate
    Consumer     Unallocated     Total  
    (in thousands)  

Allowance for loan losses:

                 

Beginning balance

  $ 10,466      $ 1,673      $ 2,190      $ 799      $ 4,317      $ 1,132      $ 554      $ 931      $ 22,062   

Charge-offs

    (1,230     —          —          (96     (1,905     (742     (21     —          (3,994

Recoveries

    688        —          25       —          —          —          6        —          719   

Provisions

    675        738        581        (40     1,348        1,427        (67     (289     4,373   
                                                                       

Ending balance

    10,599        2,411        2,796        663        3,760        1,817        472        642        23,160   

Period-end amount allocated to::

                 

Originated loans individually evaluated for impairment

    1,719        123        —          —          323        308        —          —          2,473   

Originated loans collectively evaluated for impairment

    7,881        1,644        2,741       648       3,398        1,509        446       642       18,909   

Purchased other covered loans collectively evaluated for impairment

    67        141        2        9       —          —          15       —          234   

Purchased other non-covered loans collectively evaluated for impairment

    121        75        53       6       —          —          11       —          266   

Purchased impaired covered loans collectively evaluated for impairment

    811        428        —          —          39        —          —          —          1,278   

Purchased impaired non-covered loans collectively evaluated for impairment

    —          —          —          —          —          —          —          —          —     
                                                                       

Ending balance

  $ 10,599      $ 2,411      $ 2,796      $ 663      $ 3,760      $ 1,817      $ 472      $ 642      $ 23,160   
                                                                       

The purchased loans acquired in the Cowlitz and Pierce Commercial Acquisitions are subject to the Company’s internal and external credit review. If and when credit deterioration occurs subsequent to the acquisition dates, a provision for loan losses will be charged to earnings for the full amount without regard to the FDIC loss-sharing agreement for the covered loan balances. The portion of the estimated loss reimbursable from the FDIC is recorded in noninterest income and increases the FDIC Indemnification Asset. During the quarter ended March 31, 2011, the Company recorded a $1.3 million provision for loan losses related to further credit deterioration of the purchased impaired covered loans. The related increase in the FDIC indemnification asset was $1.1 million. There were no purchased loans classified as impaired, meaning no purchased loan was individually evaluated for impairment in the table above.

 

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Table of Contents

The following table details the recorded investment balance of the loan receivables disaggregated on the basis of the Company’s impairment method for the month ended March 31, 2011:

 

     Commercial
and
industrial
     Owner-
occupied
commercial
real estate
     Non-owner
occupied
commercial
real estate
     One-to-four
family
residential
     Real estate
construction
and land
development:
one-to-four
family
residential
     Real estate
construction
and land
development:
five or more
family
residential
and
commercial
real estate
     Consumer      Total  
     (in thousands)  

Originated loans individually evaluated for impairment

   $ 10,681       $ 722       $ 1,167       $ —         $ 6901       $ 9,707       $ —         $ 29,178   

Originated loans collectively evaluated for impairment

     244,374         157,484         212,771         44,686         20,026         23,273         22,739         725,353   

Other purchased covered loans collectively evaluated for impairment

     10,889         22,980         332         1,487         54         —           2,427         38,169   

Other purchased non-covered loans collectively evaluated for impairment

     18,362         11,469         8,099         854         —           —           1,616         40,400   

Impaired purchased covered loans collectively evaluated for impairment

     34,507         20,847         16,695         8,117         5,680         —           949         86,795   

Impaired purchased non-covered loans collectively evaluated for impairment

   $ 38,377       $ 6,479       $ 7,244       $ 9,787       $ 3,833       $ 1,241       $ 2,765       $ 69,726   

NOTE 4. FDIC Indemnification Asset

Changes in the FDIC indemnification asset during the three months ended March 31, 2011 are as follows:

 

     (in thousands)  

December 31, 2010

   $ 16,071   

Cash payments received from the FDIC

     (2

FDIC share of additional estimated losses

     1,221   

Net amortization

     (421
        

Balance at March 31, 2011

   $ 16,869   
        

 

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Table of Contents

NOTE 5. Stockholders’ Equity

(a) Earnings Per Common Share

The following table illustrates the reconciliation of weighted average shares used for earnings per common share computations for the noted periods:

 

     Three Months Ended
March 31,
 
     2011     2010  
     (Dollars in thousands)  

Net income:

    

Net income

   $ 764      $ 696   

Dividends accrued and discount accreted on preferred shares

     —          (331
                

Net income applicable to common shareholders

     764        365   

Dividends and undistributed earnings allocated to participating securities

     —          —     
                

Earnings allocated to common shareholders

   $ 764      $ 365   

Basic:

    

Weighted average common shares outstanding

     15,448,109        11,069,076   

Less: Restricted stock awards

     (151,952     (68,079
                

Total basic weighted average common shares outstanding

     15,296,157        11,000,997   
                

Diluted:

    

Basic weighted average common shares outstanding

     15,296,157        11,000,997   

Incremental shares from stock options, restricted stock awards and common stock warrant

     75,945       42,449   
                

Weighted average common shares outstanding

     15,372,102        11,043,446   
                

Potential dilutive shares are excluded from the computation of earnings per share if their effect is anti-dilutive. For the three months ended March 31, 2011 and March 31, 2010 anti-dilutive shares outstanding related to options and warrants to acquire common stock totaled 561,743 and 550,802, respectively, as the exercise price was in excess of the market value.

(b) Dividends

Common Stock. The timing and amount of cash dividends paid on our common stock depends on the Company’s earnings, capital requirements, financial condition and other relevant factors. Dividends on common stock from the Company depend substantially upon receipt of dividends from the Banks, which are the Company’s predominant sources of income. On May 3, 2011, the Company’s Board of Directors declared a dividend of $0.03 per share payable on May 27, 2011, to shareholders of record on May 13, 2011.

The FDIC and the DFI have the authority under their supervisory powers to prohibit the payment of dividends by Heritage Bank and Central Valley Bank to the Company. Additionally, current guidance from the Federal Reserve provides, among other things, that dividends per share on the Company’s common stock generally should not exceed earnings per share, measured over the previous four fiscal quarters. Current regulations allow the Company and its subsidiary banks to pay dividends on their common stock if the Company’s or Banks’ regulatory capital would not be reduced below the statutory capital requirements set by the Federal Reserve and the FDIC.

NOTE 6. Share Based Payment

Total stock-based compensation expense (excluding ESOP expense) for the three months ended March 31, 2011 and 2010 were as follows:

 

     Three Months Ended
March 31,
 
     2011      2010  
     (In thousands)  

Compensation expense recognized

   $ 240       $ 109   

Related tax benefit recognized

     69         28   

As of March 31, 2011, the total unrecognized compensation expense related to non-vested stock awards was $2.0 million and the related weighted average period over which it is expected to be recognized is approximately 2.8 years.

The fair value of options granted during the three months ended March 31, 2010 was estimated on the date of grant using the Black-Scholes option pricing model based on the assumptions noted in the following table (there were no options granted during the three months ended March 31, 2011.) The expected term of share options was derived from historical data and represents the period of time that share options granted are expected to be outstanding. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant. Expected volatility is based on historical volatility of Company shares. Expected dividend yield is based on dividends expected to be paid during the expected term of the share options.

 

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Table of Contents

Three months ended

   Weighted
Average
Risk Free
Interest Rate
    Expected
Term in
years
     Expected
Volatility
    Expected
Dividend
Yield
    Weighted
Average Fair
Value
 

March 31, 2010

     2.33     5.00         35     2.31   $ 4.03   

NOTE 7. Stock Option and Award Activity

The following table summarizes stock option activity for the three months ended March 31, 2011.

 

     Shares     Weighted-
Average
Exercise
Price
     Weighted-
Average
Remaining
Contractual
Term
     Aggregate
Intrinsic
Value (In
thousands)
 

Outstanding at December 31, 2010

     550,524      $ 18.70         

Granted

     —          —           

Exercised

     (50     11.35         

Forfeited or expired

     (104,972     20.26         
                      

Outstanding at March 31, 2011

     445,502      $ 18.34         4.1       $ 279   
                                  

Exercisable at March 31, 2011

     314,071      $ 20.18         2.5       $ 186   
                                  

The total intrinsic value of options exercised during the three months ended March 31, 2011 was $0.

The following table summarizes restricted stock award activity for the three months ended March 31, 2011.

 

     Shares      Weighted-
Average
Grant
Date Fair
Value
 

Outstanding at December 31, 2010

     118,379       $ 18.29   

Granted

     78,403         14.85   

Vested

     —           —     

Forfeited

     —           —     
                 

Outstanding at March 31, 2011

     196,782       $ 16.92   
                 

 

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Table of Contents

NOTE 8. Investment Securities

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

 

Securities Available for Sale

   Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
    Fair
Value
 
     (In thousands)  

March 31, 2011

          

U.S. Treasury and U.S. Government agencies

   $ 42,110       $ 330       $ (54   $ 42,386   

Municipal securities

     21,431         203         (146     21,488   

Corporate securities

     10,076         168         —          10,244   

Mortgage backed securities and collateralized mortgage obligations:

          

U.S. Government agencies

     59,094         1,008         (197     59,905   
                                  

Total

   $ 132,711       $ 1,709       $ (397   $ 134,023   
                                  

December 31, 2010

          

U.S. Treasury and U.S. Government agencies

   $ 41,124       $ 367       $ (62   $ 41,429   

Municipal securities

     20,237         169         (193     20,213   

Corporate securities

     10,097         182         (3     10,276   

Mortgage backed securities and collateralized mortgage obligations:

          

U.S. Government agencies

     52,394         1,034         (171     53,257   
                                  

Total

   $ 123,852       $ 1,752       $ (429   $ 125,175   
                                  

Securities Held to Maturity

   Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
    Fair
Value
 
     (In thousands)  

March 31, 2011

          

U.S. Treasury and U.S. Government agencies

   $ 1,840       $ 84       $ —        $ 1,924   

Municipal securities

     3,677         101         (9     3,769   

Mortgage backed securities and collateralized mortgage obligations:

          

U.S. Government agencies

     6,192         203         —          6,395   

Private residential collateralized mortgage obligations

     1,785         282         (70     1,997   
                                  

Total

   $ 13,494       $ 670       $ (79   $ 14,085   
                                  

December 31, 2010

          

U.S. Treasury and U.S. Government agencies

   $ 1,858       $ 93       $ —        $ 1,951   

Municipal securities

     3,410         100         19       3,491   

Mortgage backed securities and collateralized mortgage obligations:

          

U.S. Government agencies

     6,592         208         —          6,800   

Private residential collateralized mortgage obligations

     1,908         250         (110     2,048   
                                  

Total

   $ 13,768       $ 651       $ (129   $ 14,290   
                                  

Available for sale and held to maturity investments with unrealized losses as of March 31, 2011, were as follows:

 

     Less than 12 Months      12 Months or
Longer
     Total  
     Fair
Value
     Unrealized
Losses
     Fair
Value
     Unrealized
Losses
     Fair
Value
     Unrealized
Losses
 
     (In thousands)  

U.S. Treasury and U.S. Government agencies

   $ —         $ —         $ 10,581       $ 54       $ 10,581       $ 54  

Municipal securities

     793         22         8,808         133         9,602         155   

Mortgage backed securities and collateralized mortgage obligations:

                 

U.S. Government agencies

     5,499         170         6,048         27         11,548         197   

Private residential collateralized mortgage obligations

     422         4         744         66         1,167         70   
                                                     

Total temporarily impaired securities

   $ 6,714       $ 196       $ 26,181       $ 280       $ 32,898       $ 476   

 

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Available for sale and held to maturity investments with unrealized losses as of December 31, 2010, were as follows:

 

     Less than 12 Months      12 Months or
Longer
     Total  
     Fair
Value
     Unrealized
Losses
     Fair
Value
     Unrealized
Losses
     Fair
Value
     Unrealized
Losses
 
     (In thousands)  

U.S. Treasury and U.S. Government agencies

   $ 10,651       $ 62       $ —         $ —         $ 10,651       $ 62   

Municipal securities

     13,575         212         —           —           13,575         212   

Corporate securities

     2,067         3         —           —           2,067         3   

Mortgage backed securities and collateralized mortgage obligations:

                 

U.S. Government agencies

     10,968         171         —           —           10,968         171   

Private residential collateralized mortgage obligations

     681         7         736         103         1,417         110   
                                                     

Total temporarily impaired securities

   $ 37,942       $ 455       $ 736       $ 103       $ 38,678       $ 558   
                                                     

The Company has evaluated these securities and has determined that the decline in their value is temporary. The unrealized losses are primarily due to unusually large pricing spreads in the market for mortgage-related securities. The fair value of the mortgage backed securities and the collateralized mortgage obligations is expected to recover as the securities approach their maturity date and/or as the pricing spreads narrow on mortgage-related securities. Because the Company does not intend to sell these securities nor does the Company consider it more likely than not that it will be required to sell these securities before the recovery of amortized cost basis, which may be maturity, the Company does not consider these investments to be other-than-temporarily impaired at March 31, 2011.

The amortized cost and fair value of securities at March 31, 2011, by contractual maturity, are set forth below. Actual maturities may differ from contractual maturities because certain borrowers have the right to call or prepay obligations with or without call or prepayment penalties.

 

Securities Available for Sale

   Amortized
Cost
     Fair
Value
 
     (In thousands)  

Due in one year or less

   $ 18,749       $ 18,853   

Due after one year through three years

     36,075         36,479   

Due after three years through five years

     2,942         2,945   

Due after five through ten years

     25,044         25,165   

Due after ten years

     49,901         50,581   
                 

Totals

   $ 132,711       $ 134,023   
                 

Securities Held to Maturity

   Amortized
Cost
     Fair
Value
 
     (In thousands)  

Due in one year or less

   $ 95       $ 96   

Due after one year through three years

     626         655   

Due after three years through five years

     1,340         1,410   

Due after five years through ten years

     3,024         3,109   

Due after ten years

     8,409         8,815   
                 

Totals

   $ 13,494       $ 14,085   
                 

For the private residential collateralized mortgage obligations we estimated expected future cash flows of the securities by estimating the expected future cash flows of the underlying collateral and applying those collateral cash flows, together with any credit enhancements such as subordination interests owned by third parties, to the security. The expected future cash flows of the underlying collateral are determined using the remaining contractual cash flows adjusted for future expected credit losses (which considers current delinquencies and nonperforming assets, future expected default rates and collateral value by vintage and geographic region) and prepayments. The expected cash flows of the security are then discounted at the interest rate used to recognize interest income on the security to arrive at a present value amount. For the three months ended March 31, 2011, three private residential collateralized mortgage obligations were determined to be other-than-temporarily impaired resulting in the Company recording $20,000 in impairments on private collateralized mortgage obligations not related to credit losses through other comprehensive income rather than through earnings and $26,000 in impairments related to credit losses through earnings. The average prepayment rate and discount interest rate used in the valuations of the present value were 6.0% and 7.9%, respectively.

 

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The following table summarizes activity related to the amount of other-than-temporary impairments related to credit losses on held to maturity securities during the three months ended March 31, 2011:

 

     Gross Other-
Than-
Temporary
Impairments
     Other-Than-
Temporary
Impairments
Included in
Other
Comprehensive
Loss
     Net Other-
Than-
Temporary
Impairments
Included in
Earnings
 
     (In thousands)  

December 31, 2010

   $ 2,317       $ 1,080       $ 1,237   

Additions:

        

Initial impairments

     7         —           7   

Subsequent impairments

     39         20         19   
                          

March 31, 2011

   $ 2,363       $ 1,100       $ 1,263   
                          

Details of private residential collateralized mortgage obligation securities received in 2008 from the redemption-in-kind of the AMF Ultra Short Mortgage Fund (“Fund”) as of March 31, 2011 were as follows:

 

                                                     Current Ratings  

Type and Year of Issuance

   Par
Value
     Amortized
Cost
     Fair
Value
(2)
     Aggregate
Unrealized
Gain (loss)
     Year-to-date
Change in
Unrealized
Gain (loss)
    Year-to-
date
Impairment
Charge
     Life-to-
date
Impairment
Charge (1)
     AAA     AA     A     BBB     Below
Investment
Grade
 
     (Dollars in thousands)  

Alt-A

     996         260         299         39         (15     19         642         1     —          —          2     97

Prime

     2,555         1,525         1,698         173         (113     7         621         6     4     3     11     76
                                                                                                      

Totals

   $ 3,551       $ 1,785       $ 1,997       $ 212       $ (128   $ 26       $ 1,263         6     4     2     9     79
                                                                                                      

 

(1) Life-to-date impairment charge represents impairment charges recognized in earnings subsequent to redemption of the Fund.
(2) Level three valuation assumptions were used to determine the fair value of the held-to-maturity securities in the Fund.

 

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NOTE 9. Federal Home Loan Bank Stock

The Banks are required to maintain an investment in the stock of the Federal Home Loan Bank (“FHLB”) of Seattle in an amount equal to the greater of $500,000 or 0.50% of residential mortgage loans and pass-through securities or an advance requirement to be confirmed on the date of the advance and 5.0% of the outstanding balance of mortgage loans sold to the FHLB of Seattle. At March 31, 2011 and December 31, 2010, the Company was required to maintain an investment in the stock of FHLB of Seattle of at least $1.5 million and $1.4 million, respectively. At March 31, 2011 and December 31, 2010, the Company had an investment in FHLB stock carried at a cost basis (par value) of $5.6 million.

The Company evaluated its investment in FHLB of Seattle stock for other-than-temporary impairment, consistent with its accounting policy. Based on the Company’s evaluation of the underlying investment, including the long-term nature of the investment, the liquidity position of the FHLB of Seattle, the actions being taken by the FHLB of Seattle to address its regulatory situation and the Company’s intent and ability to hold the investment for a period of time sufficient to recover the par value, the Company did not recognize an other-than-temporary impairment loss on its FHLB of Seattle stock. Even though the Company did not recognize an other-than-temporary impairment loss on its FHLB of Seattle stock during the three months ended March 31, 2011, and March 31, 2010, further deterioration in the FHLB of Seattle’s financial position may result in future impairment losses.

NOTE 10. Goodwill

Goodwill represents the excess of the purchase price over the net assets acquired in the purchases of North Pacific Bank and Western Washington Bancorp. The Company’s goodwill is assigned to Heritage Bank and is evaluated for impairment at the Heritage Bank level (reporting unit). Goodwill is not amortized, but is reviewed for impairment annually and between annual tests if an event occurs or circumstances change that might indicate the Company’s recorded value is more than its implied value. Such indicators may include, among others: a significant adverse change in legal factors or in the general business climate; significant decline in the Company’s stock price and market capitalization; unanticipated competition; and an adverse action or assessment by a regulator. Any adverse changes in these factors could have a significant impact on the recoverability of goodwill and could have a material impact on the Company’s financial statements.

When required, the goodwill impairment test involves a two-step process. The first test for goodwill impairment is done by comparing the reporting unit’s aggregate fair value to its carrying value. Absent other indicators of impairment, if the aggregate fair value exceeds the carrying value, goodwill is not considered impaired and no additional analysis is necessary. If the carrying value of the reporting unit were to exceed the aggregate fair value, a second test would be preformed to measure the amount of impairment loss, if any. To measure any impairment loss the implied fair value would be determined in the same manner as if the reporting unit were being acquired in a business combination. If the implied fair value of goodwill is less than the recorded goodwill an impairment charge would be recorded for the difference.

The Company’s annual impairment test was performed during the quarter ended December 31, 2010, and will be conducted during the quarter ending December 31, 2011. For the quarter ended March 31, 2011, the Company determined no triggering events had occurred and, therefore, did not conduct an interim impairment test of goodwill.

NOTE 11. Fair Value Measurements

Because broadly traded markets do not exist for most of the Company’s financial instruments, the fair value calculations attempt to incorporate the effect of current market conditions at a specific time. These determinations are subjective in nature, involve uncertainties and matters of significant judgment and do not include tax ramifications; therefore, the results cannot be determined with precision, substantiated by comparison to independent markets and may not be realized in an actual sale or immediate settlement of the instruments. There may be inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results. For all of these reasons, the aggregation of the fair value calculations presented herein do not represent, and should not be construed to represent, the underlying value of the Company.

(a) Cash on Hand and in Banks, Interest Earning Deposits and Federal Funds Sold

The fair value of financial instruments that are short-term or reprice frequently and that have little or no risk are considered to have a fair value equal to carrying value.

(b) Investment Securities Available for Sale and Held to Maturity

The fair value of all investment securities are based upon the assumptions market participants would use in pricing the security. Such assumptions include observable and unobservable inputs such as quoted market prices, dealer quotes and discounted cash flows.

 

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(c) Federal Home Loan Bank stock

FHLB of Seattle stock is not publicly traded, however the recorded value of the stock holdings approximates the fair value, as the FHLB is required to pay par value upon re-acquiring this stock.

(d) Loans Receivable and Loans Held for Sale

Fair value is estimated using the Company’s lending rates that would have been offered at March 31, 2011, and December 31, 2010, for loans, which mirror the attributes of the loans with similar rate structures and average maturities. Commercial loans and construction loans, which are variable rate and short-term are reflected with fair values equal to carrying value. Impaired loans are measured on a loan by loan basis by either the present value of expected future discounted cash flows, the loan’s obtainable market price, or the market value (less selling costs) of the collateral if the loan is collateral dependent.

While these methodologies are permitted under U.S. Generally Accepted Accounting Principles or GAAP for this disclosure, the amounts derived are not intended to reflect an exit price of the asset.

(e) Deposits

For deposits with no contractual maturity, the fair value is equal to the carrying value. The fair value of fixed maturity deposits is based on discounted cash flows using the difference between the deposit rate and the rates currently offered by the Company for deposits of similar remaining maturities.

(f) Securities Sold Under Agreement to Repurchase

Securities sold under agreement to repurchase are short-term in nature, repricing on a daily basis. Fair value financial instruments that are short-term or reprice frequently and that have little or no risk are considered to have a fair value equal to carrying value.

(g) Other Financial Instruments

The majority of our commitments to extend credit, standby letters of credit and commitments to sell mortgage loans carry current market interest rates if converted to loans, as such, carrying value is assumed to equal fair value.

The table below presents the carrying value amount of the Company’s financial instruments and their corresponding fair values. This method of estimating fair value does not incorporate the exit-price concept of fair value prescribed by ASC 820-10, Fair Value Measurements and Disclosures, and generally produces a higher fair value.

 

     March 31, 2011      December 31, 2010  
     Carrying
Value
     Fair
Value
     Carrying
Value
     Fair
Value
 
     (In thousands)  
Financial Assets            

Cash on hand and in banks

   $ 26,156       $ 26,156       $ 37,179       $ 37,179   

Interest earning deposits

     114,764         114,764         129,822         129,822   

Federal funds sold

     —           —           1,990         1,990   

Investment securities available for sale

     134,023         134,023         125,175         125,175   

Investment securities held to maturity

     13,494         14,085         13,768         14,290   

Federal Home Loan Bank stock

     5,594         5,594         5,594         5,594   

Loans receivable and loans held for sale, net of allowance

     965,598         972,854         980,485         989,968   
Financial Liabilities            

Deposits:

           

Savings, money market and demand

   $ 740,937       $ 740,937       $ 733,335       $ 733,335   

Time certificates

     358,783         360,195         402,941         404,676   
                                   

Total deposits

   $ 1,099,720       $ 1,101,132       $ 1,136,276       $ 1,138,011   
                                   

Securities sold under agreement to repurchase

   $ 24,811       $ 24,811       $ 19,027       $ 19,027   

We measure certain financial assets and financial liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:

 

   

Level 1 – Valuations for assets and liabilities traded in active exchange markets, or interest in open-end mutual funds that allow the Company to sell its ownership interest back to the fund at net asset value (“NAV”) on a daily basis. Valuations are obtained from readily available pricing sources for market transactions involving identical assets, liabilities, or funds.

 

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Level 2 – Valuations for assets and liabilities traded in less active dealer, or broker markets, such as quoted prices for similar assets or liabilities or quoted prices in markets that are not active. Level 2 includes U.S. Treasury, U.S. government and agency debt securities, and mortgage-backed securities. Valuations are usually obtained from third party pricing services for comparable assets or liabilities.

 

   

Level 3 – Valuations for assets and liabilities that are derived from other valuation methodologies, such as option pricing models, discounted cash flow models and similar techniques, and not based on market exchange, dealer, or broker traded transactions. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities.

The following table summarizes the balances of assets and liabilities measured at fair value on a recurring basis at March 31, 2011.

 

     Total      Level 1      Level 2      Level 3  
     (In thousands)  

Investment Securities Available for Sale:

           

U.S. Treasury and U.S. Government agencies

   $ 42,386       $ —         $ 42,386       $ —     

Municipal securities

     21,488         —           21,488         —     

Corporate securities

     10,244         —           10,244         —     

Mortgage backed securities and collateralized mortgage obligations:

           

U.S Government agencies

     59,905         —           59,905         —     
                                   

Total

   $ 134,023       $ —         $ 134,023       $ —     
                                   

The Company may be required, from time to time, to measure certain assets at fair value on a nonrecurring basis. These adjustments to fair value usually result from application of lower-of-cost-or-market accounting or write-downs of individual assets. For assets measured at fair value on a nonrecurring basis during the three months ended March 31, 2011 and year ended December 31, 2010 that were still held in the balance sheet at the end of such periods, the following tables provide the level of valuation assumptions used to determine each adjustment and the carrying value of the related assets at the dates indicated.

 

     Fair Value at March 31, 2011      Three
Months
Ended
March 31,
2011
 
     Total      Level 1      Level 2      Level 3      Total Losses  
     (In thousands)  

Loans receivable(1)

   $ 6,825       $ —         $ —         $ 6,825       $ 2,551   

Investment securities held to maturity(2):

              

Mortgage back securities and collateralized mortgage obligations:

              

Private residential collateralized mortgage obligations

     123         —           —           123         26   

Other real estate owned(3)

     814         —           —           814         361   
                                            

Total

   $ 7,762       $ —         $ —         $ 7,762       $ 2,938   
                                            

 

(1) As of March 31, 2011, a specific reserve of $2.2 million was recorded on loans receivable identified as impaired. Impairment losses recorded were calculated based on the fair value of the collateral, less the costs to sell. Fair value of the loans’ collateral is determined by an appraisal or independent valuation, which is then adjusted for the cost related to liquidation of the collateral.
(2) Investment securities held to maturity with a carrying amount of $169,000 were written down to their fair value of $123,000 resulting in an impairment charge of $26,000 to non-interest expense for the three months ended March 31, 2011. Impairment losses recorded were determined using cash flow models. We estimated expected future cash flows of the securities by estimating the expected future cash flows of the underlying collateral and applying those collateral cash flows, together with any credit enhancements such as subordination interests owned by third parties, to the security. The expected future cash flows of the underlying collateral are determined using the remaining contractual cash flows adjusted for future expected credit losses (which considers current delinquencies and nonperforming assets, future expected default rates and collateral value by vintage and geographic region) and prepayments. The expected cash flows of the security are then discounted at the interest rate used to recognize interest income on the security to arrive at a present value amount.
(3) Other real estate owned with a carrying amount of $1.2 million were written down to their fair value of $0.8 million when they were transferred to other real estate owned during the three months ended March 31, 2011. The resulting losses, to the extent they impacted the provision for loan losses for the three months ended March 31, 2011, are included in total losses for loans receivable for the three months ended March 31, 2011 shown above.

 

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The following table summarizes the balances of assets and liabilities measured at fair value on a recurring basis at December 31, 2010.

 

     Total      Level 1      Level 2      Level 3  
     (In thousands)  

Investment Securities Available for Sale:

           

U.S. Treasury and U.S. Government agencies

   $ 41,429       $ —         $ 41,429       $ —     

Municipal securities

     20,213         —           20,213         —     

Corporate securities

     10,276         —           10,276         —     

Mortgage backed securities and collateralized mortgage obligations:

           

U.S Government agencies

     53,257         —           53,257         —     
                                   

Total

   $ 125,175       $ —         $ 125,175       $ —     
                                   

The following table summarizes the balances of assets and liabilities measured at fair value on a nonrecurring basis at December 31, 2010, and the total losses resulting from these fair value adjustments for the year ended December 31, 2010.

 

     Fair Value at December 31, 2010      Twelve
Months
Ended
December 31,
2010
 
     Total      Level 1      Level 2      Level 3      Total Losses  
     (In thousands)  

Loans receivable(1)

   $ 13,486       $ —         $ —         $ 13,486       $ 6,118   

Investment securities held to maturity(2):

              

Mortgage back securities and collateralized mortgage obligations:

              

Private residential collateralized mortgage obligations

     96         —           —           96         298   

Other real estate owned(3)

     3,030         —           —           3,030         264   
                                            

Total

   $ 16,612       $ —         $ —