Edgar Filing: HERITAGE FINANCIAL CORP /WA/

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Non-accelerated filer

Smaller reporting company

Form 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

For the quarterly period ended June 30, 2011

¨	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.

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 July 19, 2011 there were 15,651,703 common shares outstanding, with no par value, of the registrant.

HERITAGE FINANCIAL CORPORATION

FORM 10-Q

INDEX

FORWARD LOOKING STATEMENT


		Page
PART I.	Financial Information

Item 1.	Condensed Consolidated Financial Statements (Unaudited):		4

	Condensed Consolidated Statements of Financial Condition as of June 30, 2011 and December 31, 2010		4

	Condensed Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2011 and 2010		5

	Condensed Consolidated Statements of Stockholders’ Equity for the Six Months Ended June 30, 2011 and Comprehensive Income (Loss) for the Three and Six Months Ended June 30, 2011 and 2010		6

	Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 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		35

Item 3.	Quantitative and Qualitative Disclosures About Market Risk		44

Item 4.	Controls and Procedures		45

PART II.	Other Information

Item 1.	Legal Proceedings		45

Item 1A.	Risk Factors		45

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		45

Item 3.	Defaults Upon Senior Securities		45

Item 4.	[Removed and reserved]		45

Item 5.	Other Information		45

Item 6.	Exhibits		46

	Signatures		47

	Certifications

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.

ITEM 1.

HERITAGE FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Dollars in thousands, except for per share amounts)

(Unaudited)


	June 30, 2011			December 31, 2010
Assets
Cash on hand and in banks	$	31,069		$	37,179
Interest earning deposits		86,323			129,822
Federal funds sold		—			1,990
Investment securities available for sale		147,864			125,175
Investment securities held to maturity (market value of $13,898 and $14,290)		13,175			13,768
Loans held for sale		673			764
Originated loans receivable		782,497			742,019
Less: Allowance for loan losses		(22,011	)		(22,062	)

Originated loans receivable, net		760,486			719,957
Purchased covered loans receivable, net of allowance for loan losses of ($2,516 and $0)		117,604			128,715
Purchased non-covered loans receivable, net of allowance for loan losses of ($791 and $0)		103,473			131,049

Total loans receivable, net		981,563			979,721
FDIC indemnification asset		14,485			16,071
Other real estate owned		1,911			3,030
Premises and equipment, at cost, net		22,456			21,750
Federal Home Loan Bank stock, at cost		5,594			5,594
Accrued interest receivable		5,069			4,626
Prepaid expenses and other assets		10,103			8,974
Deferred income taxes, net		3,711			4,255
Intangible assets, net		1,727			1,953
Goodwill		13,012			13,012

Total assets	$	1,338,735		$	1,367,684

Liabilities and Stockholders’ Equity
Deposits	$	1,107,720		$	1,136,276
Securities sold under agreement to repurchase		17,272			19,027
Accrued expenses and other liabilities		8,092			10,102

Total liabilities		1,133,084			1,165,405
Stockholders’ equity:
Common stock, no par, 50,000,000 shares authorized; 15,649,383 and 15,568,471 shares outstanding at June 30, 2011 and December 31, 2010, respectively		128,825			128,436
Unearned compensation – ESOP and other		(138	)		(182	)
Retained earnings		75,628			73,648
Accumulated other comprehensive income , net		1,336			377

Total stockholders’ equity		205,651			202,279

Total liabilities and stockholders’ equity	$	1,338,735		$	1,367,684

See Notes to Condensed Consolidated Financial Statements.

HERITAGE FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Dollars in thousands, except for per share amounts)

(Unaudited)


	Three Months Ended June 30,						Six Months Ended June 30,
	2011			2010			2011			2010
INTEREST INCOME:
Interest and fees on loans	$	18,829		$	11,903		$	35,401		$	23,873
Taxable interest on investment securities		768			675			1,431			1,420
Nontaxable interest on investment securities		199			78			378			151
Interest on federal funds sold and interest bearing deposits		61			60			141			120

Total interest income		19,857			12,716			37,351			25,564
INTEREST EXPENSE:
Deposits		1,682			1,929			3,557			4,092
Other borrowings		20			21			42			41

Total interest expense		1,702			1,950			3,599			4,133

Net interest income		18,155			10,766			33,752			21,431
Provision for loan losses		1,995			3,150			4,590			6,900
Provision for loan losses on purchased loans		1,529			—			3,307			—

Net interest income after provision for loan losses		14,631			7,616			25,855			14,531
NON-INTEREST INCOME:
Gains on sales of loans, net		35			35			186			101
Service charges on deposits		1,278			1,082			2,516			2,107
Merchant Visa income		731			795			1,430			1,510
Change in FDIC indemnification asset		(1,712	)		—			(912	)		—
Other income		521			224			1,111			483

Total non-interest income		853			2,136			4,331			4,201
NON-INTEREST EXPENSE:
Impairment loss on investment securities		19			68			64			263
Less: Portion recorded as other comprehensive income		—			(13	)		(20	)		(18	)

Impairment loss on investment securities, net		19			55			44			245
Salaries and employee benefits		7,075			4,200			13,712			8,215
Occupancy and equipment		1,719			990			3,565			2,018
Data processing		636			416			1,458			835
Marketing		379			423			694			634
Merchant Visa		602			660			1,171			1,257
Professional services		413			338			1,047			625
State and local taxes		369			156			725			373
Federal deposit insurance premium		432			347			889			701
Other real estate owned		48			28			565			(38	)
Other expense		1,483			861			2,957			1,593

Total non-interest expense		13,175			8,474			26,827			16,458

Income before income taxes		2,309			1,278			3,359			2,274
Income tax expense		624			423			909			723

Net income	$	1,685		$	855		$	2,450		$	1,551

Dividends accrued and discount accreted on preferred shares		—			332			—			663
Net income applicable to common shareholders	$	1,685		$	523		$	2,450		$	888

Earnings per share:
Basic	$	0.11		$	0.05		$	0.16		$	0.08
Diluted	$	0.11		$	0.05		$	0.16		$	0.08
Dividends declared per common share:	$	0.03		$	—		$	0.03		$	—

See Notes to Condensed Consolidated Financial Statements.

HERITAGE FINANCIAL CORPORATION

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

JUNE 30, 2011 AND COMPREHENSIVE INCOME FOR THE THREE AND SIX MONTHS ENDED

JUNE 30, 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			—			—			—			—			—
Restricted stock awards canceled		(2	)		—			—			—			—			—
Stock option compensation expense		—			95			—			—			—			95
Exercise of stock options (including tax benefits from nonqualified stock options)		—			1			—			—			—			1
Share based payment and earned ESOP		4			441			44			—			—			485
Tax provision associated with share based payment and unallocated ESOP		—			(148	)		—			—			—			(148	)
Net income		—			—			—			2,450			—			2,450
Change in fair value of securities available for sale, net of reclassification adjustments		—			—			—			—			908			908
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		—			—			—			—			64			64
Cash dividends declared on common stock		—			—			—			(470	)		—			(470	)

Balance at June 30, 2011		15,649		$	128,825		$	(138	)	$	75,628		$	1,336		$	205,651


	Three Months Ended June 30,					Six Months Ended June 30,
Comprehensive Income	2011		2010			2011			2010
Net income	$	1,685	$	855		$	2,450		$	1,551
Change in fair value of securities available for sale, net of tax of $178, $216, $174 and $378		902		402			894			701
Reclassification adjustment of net gain from sale of available for sale securities included in income, net of tax of $7, $0, $8 and $0		13		—			14			—
Other-than-temporary impairment on securities held-to-maturity, net of tax of $0, $(5), $(7) and $(6)		—		(8	)		(13	)		(12	)
Accretion of other-than-temporary impairment in securities held-to-maturity, net of tax of $15, $21, $35 and $75		28		38			64			139

Comprehensive income	$	2,628	$	1,287		$	3,409		$	2,379

See Notes to Condensed Consolidated Financial Statements.

HERITAGE FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

For the six months ended June 30, 2011 and 2010

(Dollars in thousands)

(Unaudited)


	Six Months Ended June 30,
	2011			2010
Cash flows from operating activities:
Net income	$	2,450		$	1,551
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		531			736
Deferred loan fees, net of amortization		301			(54	)
Provision for loan losses		7,897			6,900
Net change in accrued interest receivable, prepaid expenses and other assets, accrued expenses and other liabilities		(2,141	)		(1,390	)
Recognition of compensation related to ESOP shares and share based payment		485			240
Stock option compensation expense		95			114
Tax provision realized from stock options exercised, share based payment and dividends on unallocated ESOP shares		147			5
Amortization of intangible assets		226			39
Deferred income tax		332			15
(Gain) loss on sale of investment securities		(23	)		4
Impairment loss on investment securities		44			245
Origination of loans held for sale		(6,259	)		(4,195	)
Gain on sale of loans		(186	)		(101	)
Proceeds from sale of loans		6,536			5,121
Valuation adjustment on other real estate owned		595			—
Loss (gain) on sale of other real estate owned		53			(93	)
Loss on sale of premises and equipment		1			—

Net cash provided by operating activities		11,084			9,137

Cash flows from investing activities:
Loans originated, net of principal payments		(11,377	)		1,884
Maturities of investment securities available for sale		11,843			8,551
Maturities of investment securities held to maturity		976			1,229
Purchase of investment securities available for sale		(33,559	)		(8,372	)
Purchase of investment securities held to maturity		(271	)		(1,826	)
Purchase of premises and equipment		(1,587	)		(769	)
Proceeds from sales of other real estate owned		1,808			1,647
Proceeds from sales of premises and equipment		—			209
Proceeds from sales of securities available for sale		412			—

Net cash (used in) provided by investing activities		(31,755	)		2,553

Cash flows from financing activities:
Net decrease in deposits		(28,556	)		(11,098	)
Preferred stock cash dividends paid		—			(600	)
Common stock cash dividends paid		(470	)		—
Net (decrease) increase in securities sold under agreement to repurchase		(1,755	)		4,912
Proceeds from exercise of stock options		—			201
Tax provision realized from stock options exercised, share based payment and dividends on unallocated ESOP shares		(147	)		(5	)

Net cash used in financing activities		(30,928	)		(6,590	)

Net (decrease) increase in cash and cash equivalents		(51,599	)		5,100

Cash and cash equivalents at beginning of period		168,991			107,231

Cash and cash equivalents at end of period	$	117,392		$	112,331

Supplemental disclosures of cash flow information:
Cash paid for interest	$	3,692		$	4,143
Cash paid for income taxes		3,089			1,283
Loans transferred to other real estate owned	$	1,337		$	2,440

See Notes to Condensed Consolidated Financial Statements.

HERITAGE FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Three and Six Months Ended June 30, 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”) 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-seven 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 and six months ended June 30, 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

ASU 2011-02, A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring, provides an update for factors to be considered when evaluating whether a restructuring constitutes a troubled debt restructuring. ASU 2011-02 provides that 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. In addition, the amendments to Topic 310 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 troubled debt restructuring. The amendments in this Update are effective for the first interim or annual period beginning on or after June 15, 2011 (third quarter of 2011), and will be applied retrospectively to the beginning of the year. The Company is currently assessing the potential impact of adopting this guidance.

FASB ASU 2011-03, Reconsideration of Effective Control for Repurchase Agreements, was issued April 2011 addressing the accounting for repurchase agreements and other agreements that both entitle and obligate a transferor to repurchase or redeem financial assets before their maturity. The amendments remove from the assessment of effective control (1) the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee, and (2) the collateral maintenance implementation guidance related to that criterion. The provisions of this Update are effective for the first interim or annual period beginning on or after December 15, 2011, and should be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date. Management does not expect the adoption of the Update to have a material effect on the Company’s financial statements at the date of adoption.

FASB ASU 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs, was issued May 2011 as a result of the FASB and International Accounting Standards Board’s (IASB) goal to develop common requirements for measuring fair value and for disclosing information about fair value measurements in accordance with U.S. generally accepted accounting principles and International Financial Reporting Standards. The provisions of this Update are effective during the interim or annual periods beginning after December 15, 2011, and are to be applied prospectively. Management does not expect the adoption of the Update to have a material effect on the Company’s financial statements at the date of adoption.

FASB ASU 2011-05, Presentation of Comprehensive Income, was issued June 2011 requiring that all nonowner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. This Update also requires that reclassification adjustments for items that are reclassified from other comprehensive income to net income be presented on the face of the financial statements. The provisions of this Update are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011, and are to be applied retrospectively. Early adoption is permitted. Management does not expect the adoption of the Update to have a material effect on the Company’s financial statements at the date of adoption.

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.

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.

During the quarter ended June 30, 2011, certain loans were 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.

Originated loans receivable at June 30, 2011 and December 31, 2010 consisted of the following portfolio segments and classes:


	June 30, 2011			December 31, 2010
	(In thousands)
Commercial business:
Commercial and industrial	$	272,313		$	233,875
Owner-occupied commercial real estate		156,615			159,445
Non-owner occupied commercial real estate		219,154			221,718

Total commercial business		648,082			615,038
One-to-four family residential		38,704			38,850
Real estate construction and land development:
One-to-four family residential		23,845			28,989
Five or more family residential and commercial properties		42,043			28,411

Total real estate construction and land development		65,888			57,400
Consumer		31,447			32,054

Gross originated loans receivable		784,121			743,342
Deferred loan fees		(1,624	)		(1,323	)

Total originated loans receivable	$	782,497		$	742,019

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 SFAS 91 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 $10.3 million and $6.0 million as of June 30, 2011 and December 31, 2010, respectively.

The recorded investment of purchased covered loans receivable at June 30, 2011 and December 31, 2010 consisted of the following portfolio segments and classes:


	June 30, 2011			December 31, 2010
	(In thousands)
Commercial business:
Commercial and industrial	$	45,223		$	47,046
Owner-occupied commercial real estate		39,959			45,219
Non-owner occupied commercial real estate		17,009			17,576

Total commercial business		102,191			109,841
One-to-four family residential		5,138			6,224
Real estate construction and land development:
One-to-four family residential		5,943			5,876
Five or more family residential and commercial properties		—			—

Total real estate construction and land development		5,943			5,876
Consumer		6,848			6,774

Total purchased loans receivable		120,120			128,715
Allowance for loan losses		(2,516	)		—

Purchased loans receivable, net	$	117,604		$	128,715

The June 30, 2011 and December 31, 2010 gross recorded investment balance of impaired purchased covered loans accounted for under FASB ASC 310-30 was $85.2 million and $90.1 million, respectively. The gross recorded investment balance of other purchased covered loans was $35.0 million and $38.6 million at June 30, 2011 and December 31, 2010, respectively.

The recorded investment of purchased non-covered loans receivable at June 30, 2011 and December 31, 2010 consisted of the following portfolio segments and classes:


	June 30, 2011			December 31, 2010
	(In thousands)
Commercial business:
Commercial and industrial	$	43,880		$	58,938
Owner-occupied commercial real estate		17,623			18,877
Non-owner occupied commercial real estate		14,833			18,435

Total commercial business		76,336			96,250
One-to-four family residential		3,424			4,986
Real estate construction and land development:
One-to-four family residential		3,424			3,816
Five or more family residential and commercial properties		1,332			1,244

Total real estate construction and land development		4,756			5,060
Consumer		19,748			24,753

Total purchased loans receivable		104,264			131,049
Allowance for loan losses		(791	)		—

Purchased loans receivable, net	$	103,473		$	131,049

The June 30, 2011 and December 31, 2010 gross recorded investment balance of impaired purchased non-covered loans accounted for under FASB ASC 310-30 was $66.3 million and $80.2 million, respectively. The recorded investment balance of other purchased non-covered loans was $37.9 million and $50.8 million at June 30, 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 June 30, 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.

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 June 30, 2011 and December 31, 2010.


	June 30, 2011

	Pass		OAEM		Substandard		Doubtful		Total
	(in thousands)
Commercial business:
Commercial and industrial	$	237,758	$	4,043	$	29,980	$	532	$	272,313
Owner-occupied commercial real estate		149,839		2,777		3,999		—		156,615
Non-owner occupied commercial real estate		211,644		2,085		5,425		—		219,154

Total commercial business		599,241		8,905		39,404		532		648,082
One-to-four family residential		38,298		—		406		—		38,704
Real estate construction and land development:
One-to-four family residential		10,338		1,615		11,892		—		23,845
Five or more family residential and commercial properties		28,731		4,813		8,499		—		42,043

Total real estate construction and land development		39,069		6,428		20,391		—		65,888
Consumer		31,213		—		135		99		31,447

Gross originated loans	$	707,821	$	15,333	$	60,336	$	631	$	784,121


	December 31, 2010

	Pass		OAEM		Substandard		Doubtful		Total
	(in thousands)
Commercial business:
Commercial and industrial	$	200,583	$	2,615	$	29,872	$	805	$	233,875
Owner-occupied commercial real estate		154,890		913		3,642		—		159,445
Non-owner occupied commercial real estate		206,177		12,991		2,550		—		221,718

Total commercial business		561,650		16,519		36,064		805		615,038
One-to-four family residential		38,000		—		848		2		38,850
Real estate construction and land development:
One-to-four family residential		9,948		2,317		16,724		—		28,989
Five or more family residential and commercial properties		18,901		793		8,717		—		28,411

Total real estate construction and land development		28,849		3,110		25,441		—		57,400
Consumer		31,877		—		177		—		32,054

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 June 30, 2011 and December 31, 2010 were $47.3 million and $56.1 million, respectively. The balance of potential problem originated loans guaranteed by a governmental agency was $4.8 million and $5.9 million as of June 30, 2011 and December 31, 2010, respectively. This guarantee reduces the Company’s credit exposure.

The following tables present the recorded balance of the other purchased covered and non-covered loans receivable by credit quality indicator as of June 30, 2011 and December 31, 2010.


	June 30, 2011

	Pass		OAEM		Substandard		Doubtful		Total
	(in thousands)
Commercial business:
Commercial and industrial	$	16,881	$	54	$	455	$	—	$	17,390
Owner-occupied commercial real estate		31,343		—		593		—		31,936
Non-owner occupied commercial real estate		6,427		505		998		—		7,930

Total commercial business		54,651		559		2,046		—		57,256
One-to-four family residential		1,622		—		—		—		1,622
Real estate construction and land development:
One-to-four family residential		53		—		—		—		53
Five or more family residential and commercial properties		—		—		—		—		—

Total real estate construction and land development		53		—		—		—		53
Consumer		13,676		—		283		—		13,959

Gross other purchased covered loans	$	70,002	$	559	$	2,329	$	—	$	72,890


	December 31, 2010

	Pass		OAEM		Substandard		Doubtful		Total
	(in thousands)
Commercial business:
Commercial and industrial	$	23,833	$	261	$	40	$	—	$	24,134
Owner-occupied commercial real estate		34,365		—		398		—		34,763
Non-owner occupied commercial real estate		11,186		575		—		—		11,761

Total commercial business		69,384		836		438		—		70,658
One-to-four family residential		1,879		—		—		—		1,879
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		16,795		—		—		—		16,795

Gross other purchased covered loans	$	88,112	$	836	$	438	$	—	$	89,386

Originated nonaccrual loans, segregated by class of loans, were as follows as of June 30, 2011 and December 31, 2010:


	June 30, 2011 (1)		December 31, 2010 (1)
	(In thousands)
Commercial business:
Commercial and industrial	$	9,359	$	8,155
Owner-occupied commercial real estate		760		779
Non-owner occupied commercial real estate		1,447		1,907

Total commercial business		11,566		10,841
Real estate construction and land development:
One-to-four family residential		6,239		10,226
Five or more family residential and commercial properties		5,884		5,416

Total real estate construction and land development		12,123		15,642
Consumer		105		—

Gross originated loans	$	23,794	$	26,483

(1)	$3.7 million and $3.2 million of nonaccrual originated loans were guaranteed by governmental agencies at June 30, 2011 and December 31, 2010, respectively.

There was a recorded investment balance of $283,000 related to nonaccrual consumer loans recorded in the other purchased loan categories as of June 30, 2011. There were no nonaccrual loans recorded in the other purchased loan categories as of December 31, 2010.

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 June 30, 2011 and December 31, 2010 are as follows.


	June 30, 2011

	30-89 Days		90 Days or Greater		Total Past Due		Current		Total		> 90 Days and Still Accruing
	(in thousands)
Commercial business:
Commercial and industrial	$	1,461	$	5,297	$	6,758	$	265,555	$	272,313	$	53
Owner-occupied commercial real estate		128		1,004		1,132		155,483		156,615		372
Non-owner occupied commercial real estate		—		778		778		218,376		219,154		—

Total commercial business		1,589		7,079		8,668		639,414		648,082		425
One-to-four family residential		—		—		—		38,704		38,704		—
Real estate construction and land development:
One-to-four family residential		486		6,239		6,725		17,120		23,845		—
Five or more family residential and commercial properties		—		5,498		5,498		36,545		42,043		—

Total real estate construction and land development		486		11,737		12,223		53,665		65,888		—
Consumer		79		111		190		31,257		31,447		106

Gross originated loans	$	2,154	$	18,927	$	21,081	$	763,040	$	784,121	$	531


	December 31, 2010

	30-89 Days		90 Days or Greater		Total Past Due		Current		Total		> 90 days and still accruing
	(in thousands)
Commercial business:
Commercial and industrial	$	2,585	$	3,562	$	6,147	$	227,728	$	233,875	$	199
Owner-occupied commercial real estate		187		1,373		1,560		157,885		159,445		594
Non-owner occupied commercial real estate		3,396		1,201		4,597		217,121		221,718		—

Total commercial business		6,168		6,136		12,304		602,734		614,038		793
One-to-four family residential		624		47		671		38,179		38,850		47
Real estate construction and land development:
One-to-four family residential		—		2,844		2,844		26,145		28,989		381
Five or more family residential and commercial properties		941		5,416		6,357		22,054		28,411		—

Total real estate construction and land development		941		8,260		9,201		48,199		57,400		381
Consumer		42		—		42		32,012		32,054		—

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

The balances of other purchased past due loans, segregated by class of loans, as of June 30, 2011 and December 31, 2010 are as follows:


	June 30, 2011

	30-89 Days		90 Days or Greater		Total Past Due		Current		Total		> 90 Days and Still Accruing
	(in thousands)
Commercial business:
Commercial and industrial	$	86	$	—	$	86	$	17,304	$	17,390	$	—
Owner-occupied commercial real estate		154		—		154		31,782		31,936		—
Non-owner occupied commercial real estate		—		444		444		7,486		7,930		—

Total commercial business		240		444		684		56,572		57,256		—
One-to-four family residential		—		—		—		1,622		1,622		—
Real estate construction and land development:
One-to-four family residential		—		—		—		53		53		—
Five or more family residential and commercial properties		—		—		—		—		—		—

Total real estate construction and land development		—		—		—		53		53		—
Consumer		232		283		515		13,444		13,959		—

Gross other purchased covered loans	$	472	$	727	$	1,199	$	71,691	$	72,890	$	—


	December 31, 2010

	30-89 Days		90 Days or Greater		Total Past Due		Current		Total		> 90 days and still accruing
	(in thousands)
Commercial business:
Commercial and industrial	$	774	$	—	$	774	$	23,360	$	24,134	$	—
Owner-occupied commercial real estate		9,898		—		9,898		24,865		34,763		—
Non-owner occupied commercial real estate		—		—		—		11,761		11,761		—

Total commercial business		10,672		—		10,672		59,986		70,658		—
One-to-four family residential		103		—		103		1,776		1,879		—
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		81		—		81		16,714		16,795		—

Gross other purchased covered loans	$	10,856	$	—	$	10,856	$	78,530	$	89,386	$	—

Impaired originated loans (including restructured loans) at June 30, 2011 and December 31, 2010 are set forth in the following tables.


	June 30, 2011

	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	$	4,258	$	5,101	$	9,359	$	13,201	$	1,511	$	10,176
Owner-occupied commercial real estate		167		593		760		774		107		741
Non-owner occupied commercial real estate		1,829		—		1,829		1,160		—		1,163

Total commercial business		6,254		5,694		11,948		15,135		1,618		12,080
One-to-four family residential		—		—		—		—		—		—
Real estate construction and land development:
One-to-four family residential		1,057		5,182		6,239		7,578		1,061		6,570
Five or more family residential and commercial properties		4,709		5,988		10,697		13,425		211		10,202

Total real estate construction and land development		5,766		11,170		16,936		21,003		1,272		16,772
Consumer		6		99		105		105		99		52

Gross originated loans	$	12,026	$	16,963	$	28,989	$	36,243	$	2,989	$	28,904


	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 three and six months ended June 30, 2011 and June 30, 2010, 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 June 30, 2011 and December 31, 2010, respectively.

(f) Troubled Debt Restructured Loans

At June 30, 2011, the Company had $10.5 million in originated restructured loans, of which $5.2 million were accruing and $5.3 million were non-accruing and considered impaired. Originated restructured loans consisted of $4.8 million of real estate construction commercial loans, $4.5 million of real estate construction one-to-four family residential loans, $858,000 of commercial and industrial loans and $382,000 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 June 30, 2011 and December 31, 2010 of the purchased impaired loans:


	Cowlitz Bank
	June 30, 2011		December 31, 2010
	(In thousands)
Covered purchased loans:
Commercial business:
Commercial and industrial	$	42,045	$	44,797
Owner-occupied commercial real estate		20,425		23,216
Non-owner occupied commercial real estate		19,434		22,063

Total commercial business		81,904		90,076
One-to-four family residential		4,326		5,122
Real estate construction and land development:
One-to-four family residential		10,525		10,913
Five or more family residential and commercial properties		—		—

Total real estate construction and land development		10,525		10,913
Consumer		4,682		4,839

Gross impaired purchased covered loans		101,437		110,950
Non-covered purchased loans:
Consumer		518		676

Total impaired purchased loans	$	101,955	$	111,626

The total balance of subsequent advances on the purchased impaired covered loans was $10.3 million and $6.0 million as of June 30, 2011 and December 31, 2010, respectively.


	Pierce Commercial Bank
	June 30, 2011		December 31, 2010
	(In thousands)
Non-covered purchased loans:
Commercial business:
Commercial and industrial	$	44,529	$	54,845
Owner-occupied commercial real estate		7,780		7,759
Non-owner occupied commercial real estate		8,703		8,927

Total commercial business		61,012		71,531
One-to-four family residential		3,772		5,178
Real estate construction and land development:
One-to-four family residential		11,184		11,925
Five or more family residential and commercial properties		4,315		4,333

Total real estate construction and land development		15,499		16,258
Consumer		9,787		11,506

Gross impaired purchased non-covered loans	$	90,070	$	104,473

On the 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 for the three and six months ended June 30, 2011:


	Three Months Ended June 30, 2011						Six Months Ended June 30, 2011
	Cowlitz Bank			Pierce Commercial Bank			Cowlitz Bank			Pierce Commercial Bank
	(in thousands)
Balance at the beginning of period	$	25,485		$	10,251		$	20,082		$	10,943
Accretion		(3,370	)		(1,731	)		(5,438	)		(2,856	)
Disposals and other		(462	)		1,219			1,056			1,652
Change in accretable yield		569			6,536			6,522			6,536

Balance at the end of period	$	22,222		$	16,275		$	22,222		$	16,275

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 and six months ended June 30, 2011 and June 30, 2010 are as follows:


	Three Months Ended June 30,						Six Months Ended June 30,
	2011			2010			2011			2010
	(in thousands)
Balance at the beginning of period	$	21,382		$	24,797		$	22,062		$	26,164
Loans charged off		(1,552	)		(1,736	)		(5,546	)		(7,173	)
Recoveries of loans charged off		186			57			905			377
Provision charged to operations		1,995			3,150			4,590			6,900

Balance at the end of period	$	22,011		$	26,268		$	22,011		$	26,268

A summary of the changes in the purchased loans’ allowance for loan losses for the three and six months ended June 30, 2011 are as follows:


	Three Months Ended June 30,				Six Months Ended June 30,
	Purchased Covered		Purchased Non-Covered		Purchased Covered		Purchased Non-Covered
	(in thousands)
Balance at the beginning of period	$	1,512	$	266	$	—	$	—
Provision charged to operations		1,004		525		2,516		791

Balance at the end of period	$	2,516	$	791	$	2,516	$	791

The following table details activity in the allowance for loan losses disaggregated on the basis of the Company’s impairment method for the three and six months ended June 30, 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 for the three month ended June 30, 2011:
Beginning balance	$	10,585		$	2,410	$	2,796	$	407		$	3,726		$	1,817		$	777		$	642		$	23,160
Charge-offs		(1,237	)		—		—		—			(147	)		(153	)		(15	)		—			(1,552	)
Recoveries		77			—		—		—			—			103			6			—			186
Provisions		1,612			283		518		140			686			(71	)		330			26			3,524

Ending balance		11,037			2,693		3,314		547			4,265			1,696			1,098			668			25,318
Allowance for loan losses for the six month ended June 30, 2011:
Beginning balance	$	10,487		$	1,674	$	2,189	$	500		$	4,321		$	1,114		$	846		$	931		$	22,062
Charge-offs		(2,465	)		—		—		(15	)		(2,053	)		(895	)		(118	)		—			(5,546	)
Recoveries		765			—		25		—			—			103			12			—			905
Provisions		2,250			1,019		1,100		62			1,997			1,374			358			(263	)		7,897

Ending balance		11,037			2,693		3,314		547			4,265			1,696			1,098			668			25,318

Period-end amount allocated to::
Originated loans individually evaluated for impairment		1,511			107		—		—			1,061			211			99			—			2,989
Originated loans collectively evaluated for impairment		8,402			1,786		2,673		402			2,878			1,485			728			668			19,022
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		777			584		511		74			326			—			10			—			2,282
Purchased impaired non-covered loans collectively evaluated for impairment		159			—		75		56			—			—			235			—			525

Ending balance	$	11,037		$	2,693	$	3,314	$	547		$	4,265		$	1,696		$	1,098		$	668		$	25,318

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 three and six months ended June 30, 2011, the Company recorded provision for loan losses related to further credit deterioration of the purchased impaired covered loans of $1.0 million and $2.1 million, respectively. The related increase in the FDIC indemnification asset was $89,000 and $1.2 million, respectively. There were no purchased loans classified as impaired, meaning no purchased loan was individually evaluated for impairment in the table above.

The following table details the recorded investment balance of the loan receivables disaggregated on the basis of the Company’s impairment method as of June 30, 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	$	9,359	$	760	$	1,829	$	—	$	6,239	$	10,697	$	105	$	28,989
Originated loans collectively evaluated for impairment		262,954		155,855		217,325		38,704		17,606		31,346		31,342		755,132
Other purchased covered loans collectively evaluated for impairment		10,050		20,801		328		1,479		53		—		2,254		34,965
Other purchased non-covered loans collectively evaluated for impairment		7,340		11,135		7,602		143		—		—		11,705		37,925
Impaired purchased covered loans collectively evaluated for impairment		35,173		19,158		16,681		3,659		5,890		—		4,594		85,155
Impaired purchased non-covered loans collectively evaluated for impairment	$	36,540	$	6,488	$	7,231	$	3,281	$	3,424	$	1,332	$	8,043	$	66,339

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		7,918		1,511		2,189		498		2,657		913		846		931		17,463

Balance of allowance for loan losses at December 31, 2010	$	10,487	$	1,674	$	2,189	$	500	$	4,321	$	1,114	$	846	$	931	$	22,062

The following table details the recorded investment balance of the loan receivables 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		Total
	(in thousands)
Originated loans individually evaluated for impairment	$	8,153	$	779	$	2,301	$	2	$	10,227	$	5,416	$	—	$	26,878
Originated loans collectively evaluated for impairment—originated		225,722		158,666		219,417		38,848		18,762		22,995		32,054		716,464
Non-impaired purchased covered loans collectively evaluated for impairment		11,304		22,856		331		1,475		54		—		2,565		38,585
Non-impaired purchased non-covered loans collectively evaluated for impairment		12,830		11,907		11,430		404		—		—		14,230		50,801
Impaired purchased covered loans collectively evaluated for impairment		35,742		22,363		17,245		4,749		5,822		—		4,209		90,130
Impaired purchased non-covered loans collectively evaluated for impairment	$	46,108	$	6,970	$	7,005	$	4,582	$	3,816	$	1,244	$	10,523	$	80,248

NOTE 4. FDIC Indemnification Asset

Changes in the FDIC indemnification asset during the three and six months ended June 30, 2011 are as follows:


	Three months ended June 30, 2011			Six months ended June 30, 2011
	(in thousands)
Beginning Balance	$	16,869		$	16,071
Cash payments received from the FDIC		(672	)		(674	)
FDIC share of additional estimated losses		89			1,310
Net amortization		(1,801	)		(2,222	)

Balance at June 30, 2011	$	14,485		$	14,485

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 June 30,						Six Months Ended June 30,
	2011			2010			2011			2010
	(Dollars in thousands)
Net income:
Net income	$	1,685		$	855		$	2,450		$	1,551
Dividends accrued and discount accreted on preferred shares		—			(332	)		—			(663	)

Net income applicable to common shareholders		1,685			523			2,450			888
Dividends and undistributed earnings allocated to participating securities		5			—			5			—

Earnings allocated to common shareholders	$	1,680		$	523		$	2,445		$	888
Basic:
Weighted average common shares outstanding		15,648,496			11,096,841			15,624,412			11,084,405
Less: Restricted stock awards		(185,236	)		(85,171	)		(168,686	)		(77,752	)

Total basic weighted average common shares outstanding		15,463,260			11,011,670			15,455,726			11,006,653

Diluted:
Basic weighted average common shares outstanding		15,463,260			11,011,670			15,455,726			11,006,653
Incremental shares from stock options, restricted stock awards and common stock warrant		69,765			50,576			71,498			46,867

Weighted average common shares outstanding		15,533,025			11,062,246			15,527,224			11,053,520

Potential dilutive shares are excluded from the computation of earnings per share if their effect is anti-dilutive. For the three and six months ended June 30, 2011 anti-dilutive shares outstanding related to options and warrants to acquire common stock totaled 483,927 and 522,620, respectively, as the exercise price was in excess of the market value. For the three and six months ended June 30, 2010 anti-dilutive shares outstanding related to options and warrants to acquire common stock totaled 537,031 and 544,706, 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 July 27, 2011, the Company’s Board of Directors declared a dividend of $0.05 per share payable on August 26, 2011, to shareholders of record on August 12, 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 six months ended June 30, 2011 and 2010 were as follows:


	Six Months Ended June 30,
	2011		2010
	(In thousands)
Compensation expense recognized	$	514	$	285
Related tax benefit recognized		151		70

As of June 30, 2011, the total unrecognized compensation expense related to non-vested stock awards was $1.5 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 six months ended June 30, 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 six months ended June 30, 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.


Six months ended	Weighted Average Risk Free Interest Rate			Expected Term in years		Expected Volatility			Expected Dividend Yield			Weighted Average Fair Value
June 30, 2010		2.45	%		6.21		32	%		2.72	%	$	3.84

NOTE 7. Stock Option and Award Activity

The following table summarizes stock option activity for the six months ended June 30, 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		(107,403	)		20.19

Outstanding at June 30, 2011		443,071		$	18.34		3.9	$	156

Exercisable at June 30, 2011		334,314		$	19.84		2.7	$	104

The total intrinsic value of options exercised during the six months ended June 30, 2011 was $0.

The following table summarizes restricted stock award activity for the six months ended June 30, 2011.


	Shares			Weighted- Average Grant Date Fair Value
Outstanding at December 31, 2010		118,304		$	18.28
Granted		78,403			14.85
Vested		(22,149	)		21.84
Forfeited		(1,740	)		16.64

Outstanding at June 30, 2011		172,818		$	16.28

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)
June 30, 2011
U.S. Treasury and U.S. Government agencies	$	40,596	$	359	$	—		$	40,955
Municipal securities		24,999		519		(20	)		25,498
Corporate securities		10,056		152		—			10,208
Mortgage backed securities and collateralized mortgage obligations:
U.S. Government agencies		69,800		1,486		(83	)		71,203

Total	$	145,451	$	2,516	$	(103	)	$	147,864

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)
June 30, 2011
U.S. Treasury and U.S. Government agencies	$	1,827	$	159	$	—		$	1,986
Municipal securities		3,672		157		(2	)		3,827
Mortgage backed securities and collateralized mortgage obligations:
U.S. Government agencies		5,958		296		—			6,254
Private residential collateralized mortgage obligations		1,718		204		(91	)		1,831

Total	$	13,175	$	816	$	(93	)	$	13,898

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 June 30, 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	$	—	$	—	$	—	$	—	$	—	$	—
Municipal securities		4,133		22		—		—		4,133		22
Mortgage backed securities and collateralized mortgage obligations:
U.S. Government agencies		4,577		83		5		—		4,582		83
Private residential collateralized mortgage obligations		271		3		721		88		992		91

Total temporarily impaired securities	$	8,981	$	108	$	726	$	88	$	9,707	$	196

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 June 30, 2011.

The amortized cost and fair value of securities at June 30, 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	$	25,512	$	25,711
Due after one year through three years		28,570		28,950
Due after three years through five years		1,982		1,995
Due after five through ten years		29,378		29,919
Due after ten years		60,009		61,289

Totals	$	145,451	$	147,864


Securities Held to Maturity	Amortized Cost		Fair Value
	(In thousands)
Due in one year or less	$	95	$	95
Due after one year through three years		625		653
Due after three years through five years		1,328		1,415
Due after five years through ten years		3,016		3,