Edgar Filing: HERITAGE FINANCIAL CORP /WA/

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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 September 30, 2012

¨	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 x 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 October 22, 2012 there were 15,162,798 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):

	Condensed Consolidated Statements of Financial Condition as of September 30, 2012 and December 31, 2011		4

	Condensed Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2012 and 2011		5

	Condensed Consolidated Statements of Comprehensive Income for the Three and Nine Months Ended September 30, 2012 and 2011		6

	Condensed Consolidated Statements of Stockholders’ Equity for the Nine Months Ended September 30, 2012		7

	Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2012 and 2011		8

	Notes to Condensed Consolidated Financial Statements		9

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		43

Item 3.	Quantitative and Qualitative Disclosures About Market Risk		53

Item 4.	Controls and Procedures		53

PART II.	Other Information

Item 1.	Legal Proceedings		54

Item 1A.	Risk Factors		54

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		54

Item 3.	Defaults Upon Senior Securities		54

Item 4.	Mine Safety Disclosures		54

Item 5.	Other Information		54

Item 6.	Exhibits		55

	Signatures		56

	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 and concentration 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; risks related to acquiring assets in or entering markets in which we have not previously operated and may not be familiar; fluctuations in the demand for loans, the number of unsold homes and other properties and fluctuations in real estate values in our market areas; results of examinations of us by the Board of Governors of the Federal Reserve System (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, or impose additional requirements and restrictions on us, any of 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 related to Basel III; the impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act and implementing the regulations ; 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 recruit and retain key members of our senior management team and staff; 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, including the proposed acquisition of Northwest Commercial Bank, 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 the remainder of 2012 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)


	September 30, 2012			December 31, 2011
Assets
Cash on hand and in banks	$	34,257		$	30,193
Interest earning deposits		82,648			93,566

Cash and cash equivalents		116,905			123,759
Investment securities available for sale		147,682			144,602
Investment securities held to maturity (fair value of $11,773 and $12,881)		10,833			12,093
Loans held for sale		1,411			1,828
Originated loans receivable		871,959			837,924
Less: Allowance for loan losses		(20,533	)		(22,317	)

Originated loans receivable, net		851,426			815,607
Purchased covered loans receivable, net of allowance for loan losses of ($4,137 and $3,963)		89,005			105,394
Purchased non-covered loans receivable, net of allowance for loan losses of ($4,937 and $4,635)		65,592			83,479

Total loans receivable, net		1,006,023			1,004,480
FDIC indemnification asset		7,480			10,350
Other real estate owned ($260 and $774 covered by FDIC loss share, respectively)		7,285			4,484
Premises and equipment, net		22,886			22,975
Federal Home Loan Bank (“FHLB”) stock, at cost		5,545			5,594
Accrued interest receivable		5,178			5,117
Prepaid expenses and other assets		10,502			8,190
Deferred income taxes, net		10,647			10,988
Other intangible assets, net		1,193			1,513
Goodwill		13,012			13,012

Total assets	$	1,366,582		$	1,368,985

Liabilities and Stockholders’ Equity
Deposits	$	1,133,700		$	1,136,044
Securities sold under agreement to repurchase		22,889			23,091
Accrued expenses and other liabilities		7,749			7,330

Total liabilities		1,164,338			1,166,465
Stockholders’ equity:
Preferred stock, no par value, 2,500,000 shares authorized; no shares issued and outstanding at September 30, 2012 and December 31, 2011		—			—
Common stock, no par value, 50,000,000 shares authorized; 15,162,879 and 15,456,297 shares outstanding at September 30, 2012 and December 31, 2011, respectively		122,275			126,622
Unearned compensation – Employee Stock Ownership Plan (“ESOP”)		(28	)		(94	)
Retained earnings		78,086			74,256
Accumulated other comprehensive income, net		1,911			1,736

Total stockholders’ equity		202,244			202,520

Total liabilities and stockholders’ equity	$	1,366,582		$	1,368,985

See Notes to Condensed Consolidated Financial Statements.

HERITAGE FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(Dollars in thousands, except for per share amounts)

(Unaudited)


	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
INTEREST INCOME:
Interest and fees on loans	$	16,181		$	17,850		$	49,664		$	53,252
Taxable interest on investment securities		525			792			1,781			2,223
Nontaxable interest on investment securities		274			214			797			592
Interest on interest earning deposits		51			65			167			206

Total interest income		17,031			18,921			52,409			56,273
INTEREST EXPENSE:
Deposits		1,061			1,604			3,501			5,161
Other borrowings		15			18			49			61

Total interest expense		1,076			1,622			3,550			5,222

Net interest income		15,955			17,299			48,859			51,051
Provision for loan losses on originated loans		215			395			415			4,985
Provision for loan losses on purchased loans		592			2,821			902			6,128

Net interest income after provision for loan losses		15,148			14,083			47,542			39,938
NON-INTEREST INCOME:
Gains on sales of loans, net		92			58			208			245
Service charges on deposits		933			892			2,748			2,723
Merchant Visa income, net		182			132			534			391
Change in FDIC indemnification asset		(492	)		(1,666	)		(687	)		(2,578	)
Other income		812			823			2,696			2,619

Total non-interest income		1,527			239			5,499			3,400
NON-INTEREST EXPENSE:
Impairment loss on investment securities		14			28			112			93
Less: Portion recorded as other comprehensive loss		(14	)		—			(52	)		(20	)

Impairment loss on investment securities, net		—			28			60			73
Salaries and employee benefits		7,224			6,495			21,709			20,207
Occupancy and equipment		1,880			1,749			5,497			5,314
Data processing		643			553			1,902			2,011
Marketing		435			390			1,207			1,084
Professional services		742			517			1,924			1,564
State and local taxes		295			290			925			1,015
Federal deposit insurance premium		245			384			783			1,272
Other real estate owned, net		35			31			487			596
Other expense		1,004			1,348			3,477			4,305

Total non-interest expense		12,503			11,785			37,971			37,441

Income before income taxes		4,172			2,537			15,070			5,897
Income tax expense		1,309			701			4,843			1,611

Net income	$	2,863		$	1,836		$	10,227		$	4,286

Earnings per common share:
Basic	$	0.19		$	0.12		$	0.67		$	0.27
Diluted	$	0.19		$	0.12		$	0.67		$	0.27
Dividends declared per common share:	$	0.08		$	0.05		$	0.42		$	0.08

See Notes to Condensed Consolidated Financial Statements.

HERITAGE FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Dollars in thousands, except for per share amounts)

(Unaudited)


	Three Months Ended September 30,					Nine Months Ended September 30,
Comprehensive Income	2012			2011		2012			2011
Net income	$	2,863		$	1,836	$	10,227		$	4,286
Change in fair value of securities available for sale, net of tax of $51, $520, $69 and $695		95			400		128			1,294
Reclassification adjustment of net gain from sale of available for sale securities included in income, net of tax of $0, $0, $0 and $(8)		—			—		—			14
Other-than-temporary impairment on securities held to maturity, net of tax of $(5), $0, $(18) and $(7)		(9	)		—		(34	)		(13	)
Accretion of other-than-temporary impairment on securities held to maturity, net of tax of $15, $18, $43 and $53		29			34		81			98

Other comprehensive income	$	115		$	434	$	175		$	1,393

Comprehensive income	$	2,978		$	2,270	$	10,402		$	5,679

See Notes to Condensed Consolidated Financial Statements.

HERITAGE FINANCIAL CORPORATION

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

SEPTEMBER 30, 2012

(Dollars and shares in thousands)

(Unaudited)


	Number of common shares			Common stock			Unearned Compensation- ESOP			Retained earnings			Accumulated other comprehensive income, net		Total stockholders’ equity
Balance at December 31, 2011		15,456		$	126,622		$	(94	)	$	74,256		$	1,736	$	202,520
Restricted stock awards issued, net of forfeitures		87			—			—			—			—		—
Stock option compensation expense		—			83			—			—			—		83
Exercise of stock options (including tax benefits from nonqualified stock options)		5			53			—			—			—		53
Share based payment and earned ESOP		7			829			66			—			—		895
Tax associated with share based payment and unallocated ESOP		—			(34	)		—			—			—		(34	)
Common stock repurchased and retired		(392	)		(5,278	)		—			—			—		(5,278	)
Net income		—			—			—			10,227			—		10,227
Other comprehensive income, net of tax		—			—			—			—			175		175
Cash dividends declared on common stock ($0.42 per share)		—			—			—			(6,397	)		—		(6,397	)

Balance at September 30, 2012		15,163		$	122,275		$	(28	)	$	78,086		$	1,911	$	202,244

See Notes to Condensed Consolidated Financial Statements.

HERITAGE FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

For the nine months ended September 30, 2012 and 2011

(Dollars in thousands)

(Unaudited)


	Nine Months Ended September 30,
	2012			2011
Cash flows from operating activities:
Net income	$	10,227		$	4,286
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		3,027			1,255
Change in net deferred loan fees		56			249
Provision for loan losses		1,317			11,113
Net change in accrued interest receivable, prepaid expenses and other assets and accrued expenses and other liabilities		882			(2,470	)
Recognition of compensation related to ESOP shares and share based payment		895			681
Stock option compensation expense		83			122
Excess tax benefit realized from stock options exercised, share based payment and dividends on unallocated ESOP shares		34			153
Amortization of intangible assets		320			333
Deferred income taxes		247			94
Gain on sale of investment securities		—			(23	)
Impairment loss on investment securities		60			73
Origination of loans held for sale		(15,136	)		(11,331	)
Gains on sales of loans, net		(208	)		(245	)
Proceeds from sale of loans		15,761			11,417
Valuation adjustment on other real estate owned		483			595
Losses on sale of other real estate owned, net		—			75
Losses on sale of premises and equipment, net		2			1

Net cash provided by operating activities		18,050			16,378

Cash flows from investing activities:
Loans originated, net of principal payments		(8,895	)		(19,046	)
Maturities of investment securities available for sale		37,765			21,159
Maturities of investment securities held to maturity		1,424			1,805
Purchases of investment securities available for sale		(42,276	)		(36,144	)
Purchases of investment securities held to maturity		—			(271	)
Purchases of premises and equipment		(1,464	)		(2,414	)
Proceeds from sales of other real estate owned		2,695			2,866
Proceeds from sales of investment securities available for sale		—			412
Proceeds from repurchase of FHLB stock		49			—

Net cash used in investing activities		(10,702	)		(31,633	)

Cash flows from financing activities:
Net (decrease) increase in deposits		(2,344	)		1,169
Common stock cash dividends paid		(6,397	)		(1,253	)
Net decrease in securities sold under agreement to repurchase		(202	)		(257	)
Proceeds from exercise of stock options		53			—
Excess tax benefits realized from stock options exercised, share based payment and dividends on unallocated ESOP shares		(34	)		(153	)
Repurchase of common stock		(5,278	)		(790	)
Repurchase of common stock warrants		—			(450	)

Net cash used in financing activities		(14,202	)		(1,734	)

Net decrease in cash and cash equivalents		(6,854	)		(16,989	)

Cash and cash equivalents at beginning of period		123,759			168,991

Cash and cash equivalents at end of period	$	116,905		$	152,002

Supplemental disclosures of cash flow information:
Cash paid for interest	$	3,608		$	5,334
Cash paid for income taxes		7,848			5,985
Loans transferred to other real estate owned	$	5,979		$	3,096

See Notes to Condensed Consolidated Financial Statements.

HERITAGE FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Three and Nine Months Ended September 30, 2012 and 2011

(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”). The Banks are Washington-chartered commercial banks and their deposits are insured by the FDIC under the Deposit Insurance Fund (“DIF”). Heritage Bank conducts business from its main office in Olympia, Washington and its twenty-six 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 real estate construction and land development loans, one-to-four family residential loans, 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 bank headquartered in Longview, Washington (the “Cowlitz Acquisition”). The Cowlitz Acquisition included nine branches of Cowlitz Bank, including its division Bay Bank, which opened as branches of Heritage Bank as of August 2, 2010. 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 opened as a branch of Heritage Bank as of November 8, 2010. 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 (“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. GAAP for complete financial statements. These condensed consolidated financial statements should be read with our December 31, 2011 audited consolidated financial statements and its accompanying notes included in our Annual Report on Form 10-K (“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 nine months ended September 30, 2012 are not necessarily indicative of the results that may be expected for the year ending December 31, 2012. 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. Estimates related to fair value measurements, the allowance for loan losses, expected cash flows from, and indemnification asset related to, purchased loans, other real estate owned, other-than-temporary impairment of investment securities, goodwill and other intangible assets, stock-based compensation and income taxes are particularly subject to change.

Certain prior period amounts have been reclassified to conform to the current period’s presentation. Reclassifications had no effect on prior period net income or stockholders’ equity.

(c) Significant Accounting Policies

The significant accounting policies used in preparation of our consolidated financial statements are disclosed in our 2011 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, 2011.

(d) Recently Issued Accounting Pronouncements

Financial Accounting Standards Board (“FASB”) Accounting Standards Updates (“ASU”) 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs, was issued in 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. GAAP 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. The adoption of the Update did not have a material effect on the Company’s consolidated financial statements, however, the additional disclosures are included in Note 10.

FASB ASU 2011-05, Presentation of Comprehensive Income, was issued in June 2011 requiring that all non-owner 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. The adoption of the Update did not have a material effect on the Company’s consolidated financial statements at the date of adoption. The Company has presented condensed consolidated statements of comprehensive income for the three and nine months ended September 30, 2012 and 2011 as a separate statement immediately following the condensed consolidated statements of income for the three and nine months ended September 30, 2012 and 2011.

FASB ASU 2011-12, Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05, was issued in December 2011 updating and superseding certain pending paragraphs relating to the presentation on the face of the financial statements the effects of reclassifications out of accumulated other comprehensive income on the components of net income and other comprehensive income. This Update is effective concurrent with ASU 2011-05, Presentation of Comprehensive Income, and did not have a material effect on the Company’s consolidated financial statements at the date of adoption.

FASB ASU 2012-06, Business Combinations (Topic 805): Subsequent Accounting for an Indemnification Asset Recognized at the Acquisition Date as a Result of a Government-Assisted Acquisition of a Financial Institution, was issued in October 2012. The objective of the Update is to address the diversity in practice about how to interpret the terms “on the same basis” and “contractual limitations” when subsequently measuring an indemnification asset. This Update is effective for fiscal years and interim periods beginning on or after December 15, 2012. Early adoption is permitted, and adoption should be applied prospectively to indemnification assets existing as of the date of adoption. This Update will not have a material effect on the Company’s consolidated financial statements at the date of adoption.

NOTE 2. Loans Receivable

The Company originates loans under the normal course of business. These loans are identified as “originated” loans. Disclosures related to the Company’s recorded investment in originated loans receivable generally exclude accrued interest receivable and net deferred loan origination fees and costs due to their insignificance. The Company has also acquired loans through FDIC-assisted transactions. Loans acquired in a business acquisition are designated as “purchased” loans. The Company refers to the purchased loans subject to the shared-loss agreements as “covered” loans, and those loans without a shared-loss agreement are referred to as “non-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 FASB Accounting Standards Codification (“FASB ASC”) 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality. These loans are identified as “purchased 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. These loans are identified as “purchased other” loans.

(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 the commercial and industrial loans carry different risk characteristics than the commercial real estate loans, they are discussed separately below.

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

Commercial real estate. The Company originates commercial real estate loans within its primary market areas. These loans are subject to underwriting standards and processes similar to commercial and industrial loans, in addition to those of real estate loans. These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Commercial real estate involves more risk than other classes 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 Banks’ 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 if the borrower does not repay the loan. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property or an interim loan commitment from the Company until permanent financing is obtained. These loans are closely monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being 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 September 30, 2012 and December 31, 2011 consisted of the following portfolio segments and classes:


	September 30, 2012			December 31, 2011
	(In thousands)
Commercial business:
Commercial and industrial	$	280,513		$	273,590
Owner-occupied commercial real estate		191,798			166,881
Non-owner occupied commercial real estate		256,670			251,049

Total commercial business		728,981			691,520
One-to-four family residential		39,431			37,960
Real estate construction and land development:
One-to-four family residential		25,045			22,369
Five or more family residential and commercial properties		50,442			54,954

Total real estate construction and land development		75,487			77,323
Consumer		29,976			32,981

Gross originated loans receivable		873,875			839,784
Net deferred loan fees		(1,916	)		(1,860	)

Total originated loans receivable	$	871,959		$	837,924

The recorded investment in purchased covered loans receivable at September 30, 2012 and December 31, 2011 consisted of the following portfolio segments and classes:


	September 30, 2012			December 31, 2011
	(In thousands)
Commercial business:
Commercial and industrial	$	29,198		$	38,607
Owner-occupied commercial real estate		35,231			38,067
Non-owner occupied commercial real estate		14,027			15,753

Total commercial business		78,456			92,427
One-to-four family residential		5,042			5,197
Real estate construction and land development:
One-to-four family residential		4,373			5,786
Five or more family residential and commercial properties		—			—

Total real estate construction and land development		4,373			5,786
Consumer		5,271			5,947

Total purchased covered loans receivable		93,142			109,357
Allowance for loan losses		(4,137	)		(3,963	)

Purchased covered loans receivable, net	$	89,005		$	105,394

The September 30, 2012 and December 31, 2011 gross recorded investment balance of purchased impaired covered loans accounted for under FASB ASC 310-30 was $64.0 million and $78.7 million, respectively. The gross recorded investment balance of purchased other covered loans was $29.1 million and $30.7 million at September 30, 2012 and December 31, 2011, respectively. As of September 30, 2012 and December 31, 2011, the recorded investment balance of purchased covered loans which are no longer covered under the FDIC loss-sharing agreements was $3.2 million and $3.8 million, respectively.

Funds advanced on the purchased covered loans subsequent to acquisition are referred to as “subsequent advances” and are included in the purchased covered loan balances as these subsequent advances are covered under the loss-sharing agreements. These subsequent advances are not accounted for under FASB ASC 310-30. The total balance of subsequent advances on the purchased covered loans was $9.4 million and $13.5 million as of September 30, 2012 and December 31, 2011, respectively.

The recorded investment in purchased non-covered loans receivable at September 30, 2012 and December 31, 2011 consisted of the following portfolio segments and classes:


	September 30, 2012			December 31, 2011
	(In thousands)
Commercial business:
Commercial and industrial	$	26,384		$	35,607
Owner-occupied commercial real estate		16,045			17,052
Non-owner occupied commercial real estate		12,484			12,833

Total commercial business		54,913			65,492
One-to-four family residential		3,036			2,743
Real estate construction and land development:
One-to-four family residential		667			1,381
Five or more family residential and commercial properties		949			1,078

Total real estate construction and land development		1,616			2,459
Consumer		10,964			17,420

Total purchased non-covered loans receivable		70,529			88,114
Allowance for loan losses		(4,937	)		(4,635	)

Purchased non-covered loans receivable, net	$	65,592		$	83,479

The September 30, 2012 and December 31, 2011 gross recorded investment balance of purchased impaired non-covered loans accounted for under FASB ASC 310-30 was $43.7 million and $56.1 million, respectively. The recorded investment balance of purchased other non-covered loans was $26.8 million and $32.0 million at September 30, 2012 and December 31, 2011, 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 September 30, 2012 and December 31, 2011, 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 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 is considered “pass grade” and includes loans on management’s “watch list” and is intended to be utilized on a temporary basis for pass grade borrowers where a potentially significant risk-modifying action is anticipated in the near term.

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

Grade 7: This grade includes “Substandard” loans, in accordance with regulatory guidelines, for which the loan has a high risk.

The loan also has well-defined weaknesses which make payment default or principal exposure likely, but not yet certain. The borrower may have shown serious negative trends in financial ratios and performance. Such loans 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 business loans and real estate construction and land development loans are established at the origination of the loan. One-to-four family residential loans and consumer loans (“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 known to management. Credit improvements are evidenced by known facts regarding the borrower or the collateral property.

The loan grades relate to the likelihood of losses in that the higher the grade, the greater the loss potential. Loans with a pass grade may have some inherent losses in the portfolios, but to a lesser extent than the other loan grades. These pass graded loans may also 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 September 30, 2012 and December 31, 2011.


	September 30, 2012
	Pass		OAEM		Substandard		Doubtful		Total
	(In thousands)
Commercial business:
Commercial and industrial	$	254,046	$	3,665	$	21,733	$	1,069	$	280,513
Owner-occupied commercial real estate		185,948		1,943		3,907		—		191,798
Non-owner occupied commercial real estate		246,948		4,064		5,289		369		256,670

Total commercial business		686,942		9,672		30,929		1,438		728,981
One-to-four family residential		38,005		699		323		404		39,431
Real estate construction and land development:
One-to-four family residential		15,515		1,815		7,715		—		25,045
Five or more family residential and commercial properties		45,826		—		4,616		—		50,442

Total real estate construction and land development		61,341		1,815		12,331		—		75,487
Consumer		29,889		—		87		—		29,976

Gross originated loans	$	816,177	$	12,186	$	43,670	$	1,842	$	873,875


	December 31, 2011
	Pass		OAEM		Substandard		Doubtful		Total
	(In thousands)
Commercial business:
Commercial and industrial	$	247,503	$	2,770	$	22,887	$	430	$	273,590
Owner-occupied commercial real estate		162,536		1,225		3,120		—		166,881
Non-owner occupied commercial real estate		240,096		2,063		8,890		—		251,049

Total commercial business		650,135		6,058		34,897		430		691,520
One-to-four family residential		36,997		431		532		—		37,960
Real estate construction and land development:
One-to-four family residential		10,725		2,828		8,816		—		22,369
Five or more family residential and commercial properties		42,541		—		12,413		—		54,954

Total real estate construction and land development		53,266		2,828		21,229		—		77,323
Consumer		32,629		—		346		6		32,981

Gross originated loans	$	773,027	$	9,317	$	57,004	$	436	$	839,784

The tables above include $30.9 million and $37.1 million of impaired loans as of September 30, 2012 and December 31, 2011, respectively, as detailed in the impaired loans section below. These impaired loans have been individually reviewed for potential losses and have specific valuation allowance, as necessary. The tables above also include potential problem loans. 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 September 30, 2012 and December 31, 2011 were $29.4 million and $29.7 million, respectively. The balance of potential problem originated loans guaranteed by a governmental agency was $3.1 million and $2.8 million as of September 30, 2012 and December 31, 2011, respectively. This guarantee reduces the Company’s credit exposure.

The following tables present the recorded balance of the purchased other covered and non-covered loans receivable by credit quality indicator as of September 30, 2012 and December 31, 2011.


	September 30, 2012
	Pass		OAEM		Substandard		Doubtful		Total
	(In thousands)
Commercial business:
Commercial and industrial	$	12,470	$	83	$	494	$	—	$	13,047
Owner-occupied commercial real estate		25,630		2,414		339		—		28,383
Non-owner occupied commercial real estate		4,470		487		977		—		5,934

Total commercial business		42,570		2,984		1,810		—		47,364
One-to-four family residential		924		468		—		—		1,392
Real estate construction and land development:
One-to-four family residential		47		—		—		—		47
Five or more family residential and commercial properties		—		—		—		—		—

Total real estate construction and land development		47		—		—		—		47
Consumer		6,860		3		172		31		7,066

Gross purchased other loans	$	50,401	$	3,455	$	1,982	$	31	$	55,869


	December 31, 2011
	Pass		OAEM		Substandard		Doubtful		Total
	(In thousands)
Commercial business:
Commercial and industrial	$	11,781	$	125	$	780	$	—	$	12,686
Owner-occupied commercial real estate		29,791		—		587		—		30,378
Non-owner occupied commercial real estate		4,427		1,046		441		—		5,914

Total commercial business		45,999		1,171		1,808		—		48,978
One-to-four family residential		1,529		—		42		—		1,571
Real estate construction and land development:
One-to-four family residential		50		—		—		—		50
Five or more family residential and commercial properties		—		—		—		—		—

Total real estate construction and land development		50		—		—		—		50
Consumer		11,435		—		674		—		12,109

Gross purchased other loans	$	59,013	$	1,171	$	2,524	$	—	$	62,708

(d) Nonaccrual loans

Originated nonaccrual loans, segregated by segments and classes of loans, were as follows as of September 30, 2012 and December 31, 2011:


	September 30, 2012(1)		December 31, 2011(1)
	(In thousands)
Commercial business:
Commercial and industrial	$	5,937	$	6,946
Owner-occupied commercial real estate		856		399
Non-owner occupied commercial real estate		369		921

Total commercial business		7,162		8,266
One-to-four family residential		425		—
Real estate construction and land development:
One-to-four family residential		3,392		5,150
Five or more family residential and commercial properties		4,616		9,797

Total real estate construction and land development		8,008		14,947
Consumer		87		125

Gross originated nonaccrual loans	$	15,682	$	23,338

(1)	$2.0 million and $1.8 million of nonaccrual originated loans were guaranteed by governmental agencies at September 30, 2012 and December 31, 2011, respectively.

The recorded investment balance of purchased other nonaccrual loans, segregated by segments and classes of loans, were as follows as of September 30, 2012 and December 31, 2011:


	September 30, 2012		December 31, 2011
	(In thousands)
Commercial business:
Commercial and industrial	$	254	$	—
Owner-occupied commercial real estate		142		—
Non-owner occupied commercial real estate		437		—

Total commercial business		833		—
Consumer		38		497

Gross purchased other nonaccrual loans	$	871	$	497

(e) Past due loans

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 segments and classes of loans, as of September 30, 2012 and December 31, 2011 were as follows:


	September 30, 2012
	30-89 Days		90 Days or Greater		Total Past Due		Current		Total		90 Days or More and Still Accruing
	(In thousands)
Commercial business:
Commercial and industrial	$	1,509	$	3,680	$	5,189	$	275,324	$	280,513	$	500
Owner-occupied commercial real estate		251		283		534		191,264		191,798		—
Non-owner occupied commercial real estate		—		369		369		256,301		256,670		—

Total commercial business		1,760		4,332		6,092		722,889		728,981		500
One-to-four family residential		390		404		794		38,637		39,431		—
Real estate construction and land development:
One-to-four family residential		377		3,392		3,769		21,276		25,045		—
Five or more family residential and commercial properties		—		4,271		4,271		46,171		50,442		—

Total real estate construction and land development		377		7,663		8,040		67,447		75,487		—
Consumer		50		47		97		29,879		29,976		—

Gross originated loans	$	2,577	$	12,446	$	15,023	$	858,852	$	873,875	$	500


	December 31, 2011
	30-89 Days		90 Days or Greater		Total Past Due		Current		Total		90 Days or More and Still Accruing
	(In thousands)
Commercial business:
Commercial and industrial	$	3,716	$	4,769	$	8,485	$	265,105	$	273,590	$	921
Owner-occupied commercial real estate		1,903		398		2,301		164,580		166,881		—
Non-owner occupied commercial real estate		369		—		369		250,680		251,049		—

Total commercial business		5,988		5,167		11,155		680,365		691,520		921
One-to-four family residential		1,251		404		1,655		36,305		37,960		404
Real estate construction and land development:
One-to-four family residential		582		5,150		5,732		16,637		22,369		—
Five or more family residential and commercial properties		369		9,428		9,797		45,157		54,954		—

Total real estate construction and land development		951		14,578		15,529		61,794		77,323		—
Consumer		465		60		525		32,456		32,981		3

Gross originated loans	$	8,655	$	20,209	$	28,864	$	810,920	$	839,784	$	1,328

The balances of purchased other past due loans, segregated by segments and classes of loans, as of September 30, 2012 and December 31, 2011 are as follows:


	September 30, 2012
	30-89 Days		90 Days or Greater		Total Past Due		Current		Total		90 Days or More and Still Accruing
	(In thousands)
Commercial business:
Commercial and industrial	$	—	$	—	$	—	$	13,047	$	13,047	$	—
Owner-occupied commercial real estate		—		—		—		28,383		28,383		—
Non-owner occupied commercial real estate		—		557		557		5,377		5,934		120

Total commercial business		—		557		557		46,807		47,364		120
One-to-four family residential		150		—		150		1,242		1,392		—
Real estate construction and land development:
One-to-four family residential		—		—		—		47		47		—
Five or more family residential and commercial properties		—		—		—		—		—		—

Total real estate construction and land development		—		—		—		47		47		—
Consumer		409		31		440		6,626		7,066		—

Gross purchased other loans	$	559	$	588	$	1,147	$	54,722	$	55,869	$	120


	December 31, 2011
	30-89 Days		90 Days or Greater		Total Past Due		Current		Total		90 Days or More and Still Accruing
	(In thousands)
Commercial business:
Commercial and industrial	$	243	$	15	$	258	$	12,428	$	12,686	$	15
Owner-occupied commercial real estate		151		—		151		30,227		30,378		—
Non-owner occupied commercial real estate		441		—		441		5,473		5,914		—

Total commercial business		835		15		850		48,128		48,978		15
One-to-four family residential		42		—		42		1,529		1,571		—
Real estate construction and land development:
One-to-four family residential		—		—		—		50		50		—
Five or more family residential and commercial properties		—		—		—		—		—		—

Total real estate construction and land development		—		—		—		50		50		—
Consumer		757		490		1,247		10,862		12,109		—

Gross purchased other loans	$	1,634	$	505	$	2,139	$	60,569	$	62,708	$	15

(f) Impaired loans

Impaired originated loans (including restructured loans) at September 30, 2012 and December 31, 2011 are set forth in the following tables.


	September 30, 2012
	Recorded Investment With No Specific Valuation Allowance		Recorded Investment With Specific Valuation Allowance		Total Recorded Investment		Unpaid Contractual Principal Balance		Related Specific Valuation Allowance
	(In thousands)
Commercial business:
Commercial and industrial	$	8,289	$	3,858	$	12,147	$	13,209	$	1,071
Owner-occupied commercial real estate		417		1,886		2,303		3,878		591
Non-owner occupied commercial real estate		2,952		4,252		7,204		7,204		1,411

Total commercial business		11,658		9,996		21,654		24,291		3,073
One-to-four family residential		424		425		849		1,767		91
Real estate construction and land development:
One-to-four family residential		701		3,053		3,754		4,926		860
Five or more family residential and commercial properties		—		4,616		4,616		4,685		997

Total real estate construction and land development		701		7,669		8,370		9,611		1,857
Consumer		47		40		87		127		40

Gross impaired originated loans	$	12,830	$	18,130	$	30,960	$	35,796	$	5,061


	December 31, 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
	(In thousands)
Commercial business:
Commercial and industrial	$	4,532	$	6,139	$	10,671	$	10,586	$	1,488
Owner-occupied commercial real estate		603		1,368		1,971		2,271		107
Non-owner occupied commercial real estate		3,915		4,314		8,229		9,980		764

Total commercial business		9,050		11,821		20,871		22,837		2,359
One-to-four family residential		—		835		835		1,046		187
Real estate construction and land development:
One-to-four family residential		748		4,765		5,513		6,813		1,436
Five or more family residential and commercial properties		963		8,835		9,798		14,219		530

Total real estate construction and land development		1,711		13,600		15,311		21,032		1,966
Consumer		120		6		126		159		6

Gross impaired originated loans	$	10,881	$	26,262	$	37,143	$	45,074	$	4,518

The Company had governmental guarantees of $2.0 million and $1.8 million related to the impaired originated loan balances at September 30, 2012 and December 31, 2011, respectively.

The average recorded investment of impaired originated loans (including restructured loans) for the three and nine months ended September 30, 2012 and September 30, 2011 are set forth in the following tables.


	Three Months Ended September 30,				Nine Months Ended September 30,
	2012		2011		2012		2011
	(In thousands)
Commercial business:
Commercial and industrial	$	12,162	$	10,051	$	11,628	$	9,828
Owner-occupied commercial real estate		1,675		1,766		2,057		1,096
Non-owner occupied commercial real estate		7,222		1,814		7,561		1,843

Total commercial business		21,059		13,631		21,246		12,767
One-to-four family residential		1,014		418		1,004		209
Real estate construction and land development:
One-to-four family residential		4,080		6,111		4,620		7,337
Five or more family residential and commercial properties		4,629		10,685		5,929		9,123

Total real estate construction and land development		8,709		16,796		10,549		16,460
Consumer		118		158		148		79

Gross impaired originated loans	$	30,900	$	31,003	$	32,947	$	29,515

Impaired purchased other loans (including restructured loans) at September 30, 2012 and December 31, 2011 are set forth in the following tables.


	September 30, 2012
	Recorded Investment With No Specific Valuation Allowance		Recorded Investment With Specific Valuation Allowance		Total Recorded Investment		Unpaid Contractual Principal Balance		Related Specific Valuation Allowance
	(In thousands)
Commercial business:
Commercial and industrial	$	17	$	—	$	17	$	17	$	—
Owner-occupied commercial real estate		—		—		—		—		—
Non-owner occupied commercial real estate		—		540		540		526		21

Total commercial business		17		540		557		543		21
One-to-four family residential		—		468		468		438		46
Consumer		—		7		7		9		3

Gross impaired purchased other loans	$	17	$	1,015	$	1,032	$	990	$	70


	December 31, 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
	(In thousands)
Consumer	$	—	$	9	$	9	$	9	$	5

Gross impaired purchased other loans	$	—	$	9	$	9	$	9	$	5

The average recorded investment of impaired purchased other loans (including restructured loans) for the three and nine months ended September 30, 2012 and September 30, 2011 are set forth in the following tables.


	Three Months Ended September 30,				Nine Months Ended September 30,
	2012		2011		2012		2011
	(In thousands)
Commercial business:
Commercial and industrial	$	18	$	—	$	18	$	—
Owner-occupied commercial real estate		—		—		—		—
Non-owner occupied commercial real estate		534		—		356		—

Total commercial business		552		—		374		—
One-to-four family residential		234		—		156		—
Consumer		7		—		7		—

Gross impaired purchased other loans	$	793	$	—	$	537	$	—

For the three and nine months ended September 30, 2012 and September 30, 2011 no interest income was recognized subsequent to a loan’s classification as impaired.

(g) Troubled Debt Restructured Loans

A troubled debt restructured loan (“TDR”) is a restructuring in which the Banks, for economic or legal reasons related to a borrower’s financial difficulties, grants a concession to the borrower that it would not otherwise consider. TDRs are considered impaired and are separately measured for impairment under ASC 310-10-35, whether on accrual or nonaccrual status. At September 30, 2012 and December 31, 2011, the balance of originated accruing TDRs was $15.3 million and $13.8 million, respectively. The related allowance for loan losses on the originated accruing TDRs was $2.3 million and $1.4 million as of September 30, 2012 and December 31, 2011, respectively. At September 30, 2012, originated non-accruing TDRs were $10.0 million and had a related allowance for loan losses of $2.0 million. At December 31, 2011, originated non-accruing TDRs of $11.7 million had a related allowance for loan losses of $1.8 million. At September 30, 2012 and December 31, 2011, the balance of purchased other TDRs was $1.0 million and $9,000, respectively. Substantially all of the purchased other TDRs were accruing at September 30, 2012 and December 31, 2011. The related allowance for loan losses on the purchased other TDRs was $70,000 and $5,000 as of September 30, 2012 and December 31, 2011, respectively.

Originated loans that were modified as TDRs during the three and nine months ended September 30, 2012 and September 30, 2011 are set forth in the following tables:


	Three Months Ended September 30,
	2012				2011
	Number of Contracts		Outstanding Principal Balance (1)		Number of Contracts		Outstanding Principal Balance (1)
	(Dollars in thousands)
Commercial business:
Commercial and industrial		7	$	1,315		6	$	1,191
Owner-occupied commercial real estate		2		1,052		—		—

Total commercial business		9		2,367		6		1,191

Total originated TDRs		9	$	2,367		6	$	1,191


	Nine Months Ended September 30,
	2012				2011
	Number of Contracts (2)		Outstanding Principal Balance (1)(2)		Number of Contracts (2)		Outstanding Principal Balance (1)(2)
	(Dollars in thousands)
Commercial business:
Commercial and industrial		23	$	4,524		18	$	5,669
Owner-occupied commercial real estate		3		1,247		2		1,585
Non-owner occupied commercial real estate		—		—		1		669

Total commercial business		26		5,771		21		7,923
One-to-four family residential		—		—		2		842
Real estate construction and land development:
One-to-four family residential		1		180		2		364
Five or more family residential and commercial properties		—		—		2		4,813

Total real estate construction and land development		1		180		4		5,177

Total originated TDRs		27	$	5,951		27	$	13,942

(1)

Includes subsequent payments after modifications and reflects the balance as of September 30, 2012 and September 30, 2011, respectively. The Banks’ initial recorded investments in the loans did not change as a result of the modifications as the Banks did not forgive any principal or interest balance as part of the modifications.

(2)	Number of contracts and outstanding principal balance represents loans which have balances as of September 30, 2012 and September 30, 2011 as certain loans may have been paid-down or charged-off during the three months ended September 30, 2012 and September 30, 2011.

Of the nine loans modified during the three months ended September 30, 2012, five loans with outstanding principal balance of $1.2 million were previously reported as TDRs as of June 30, 2012. Of the 27 loans modified during the nine months ended September 30, 2012, 18 loans with outstanding principal balance of $3.6 million were previously reported as TDRs as of December 31, 2011. No loans modified during the three months ended September 30, 2011 were previously reported as TDRs. One loan modified during the nine months ended September 30, 2011 with outstanding principal balance of $400,000 was previously reported as TDRs as of December 31, 2010. These previously reported TDRs were granted additional extensions during the three and nine months ended September 30, 2012, requiring that the loans again be reported as modified during the period. The Banks typically grant shorter extension periods to continually monitor the troubled credits despite the fact that the extended date might not be the date the Banks expect the cash flow. The Company does not consider these modifications a subsequent default of a TDR as new loan terms, specifically maturity dates, were granted. The potential losses related to these loans would have been considered in the period the loan was first reported as a TDR and adjusted, as necessary, in the current periods based on more recent information.

Purchased other loans that were modified as TDRs during the three and nine months ended September 30, 2012 are set forth in the following table:


	Three Months Ended September 30, 2012				Nine Months Ended September 30, 2012
	Number of Contracts		Outstanding Principal Balance (1)		Number of Contracts		Outstanding Principal Balance (1)
			(Dollars in thousands)
Commercial business:
Commercial and industrial		—	$	—		1	$	17
Non-owner occupied commercial real estate		—		—		1		540

Total commercial business		—		—		2		557

One-to-four family residential		1		468		1		468

Total purchased other TDRs		1	$	468		3	$	1,025

(1)

There were no purchased other TDRs modified during the three or nine months ended September 30, 2011.

The majority of the Banks’ TDRs are a result of granting extensions to troubled credits which have already been adversely classified. We grant such extensions to reassess the borrower’s financial status and develop a plan for repayment. Certain modifications with extensions also include interest rate reductions, which is the second most prevalent concession. Certain TDRs were additionally re-amortized over a longer period of time. These modifications would all be considered a concession for a borrower that could not obtain similar financing terms from another source other than from the Banks.

The financial effects of each modification will vary based on the specific restructure. For the majority of the Banks’ TDRs, the loans were interest-only with a balloon payment at maturity. If the interest rate is not adjusted and the terms are consistent with market, the Banks might not experience any loss associated with the restructure. If, however, the restructure involves forbearance agreements or interest rate modifications, the Banks might not collect all the principal and interest based on the original contractual terms. The Banks estimate the necessary allowance for loan losses on TDRs using the same guidance as other impaired loans.

There were no originated or purchased other TDRs that had been modified within the previous twelve months ended September 30, 2012 that subsequently defaulted during the three and nine months ended September 30, 2012. One commercial and industrial loan with outstanding principal balance of $600,000 defaulted during the three and nine months ended September 30, 2011. The default was due to the borrower’s failure to pay the loan’s principal and interest at the extended maturity date. The Banks determined that no allowance was necessary for this loan as it has sufficient collateral that is in the process of liquidation. There were no purchased other TDRs that had been modified within the previous twelve months ended September 30, 2011 that subsequently defaulted within the three and nine months ended September 30, 2011.

(h) Impaired Purchased Loans

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

The following tables reflect the outstanding principal balance at September 30, 2012 and December 31, 2011 of the purchased impaired loans:


	Cowlitz Bank
	September 30, 2012		December 31, 2011
	(In thousands)
Purchased covered loans:
Commercial business:
Commercial and industrial	$	27,090	$	36,267
Owner-occupied commercial real estate		17,548		19,601
Non-owner occupied commercial real estate		13,223		16,212

Total commercial business		57,861		72,080
One-to-four family residential		4,290		4,371
Real estate construction and land development:
One-to-four family residential		6,152		8,524
Five or more family residential and commercial properties		—		—

Total real estate construction and land development		6,152		8,524
Consumer		3,308		3,917

Gross purchased impaired covered loans		71,611		88,892
Purchased non-covered loans:
Consumer		322		435

Total purchased impaired loans	$	71,933	$	89,327

The total balance of subsequent advances on the purchased impaired covered loans was $7.0 million as of September 30, 2012 and $10.5 million as of December 31, 2011. Heritage Bank has the option to modify certain purchased covered loans which may terminate the FDIC loss-share coverage on those modified loans. As of September 30, 2012 and December 31, 2011, the recorded investment balance of purchased impaired covered loans which are no longer covered under the FDIC loss-sharing agreements was $1.6 million and $2.0 million, respectively. Heritage Bank continues to report these loans in the covered portfolio as they are in a pool and they continue to be accounted for under FASB ASC 310-30. The FDIC indemnification asset has been properly adjusted to reflect the change in the loan status.


	Pierce Commercial Bank
	September 30, 2012		December 31, 2011
	(In thousands)
Purchased non-covered loans:
Commercial business:
Commercial and industrial	$	23,369	$	34,352
Owner-occupied commercial real estate		6,811		7,043
Non-owner occupied commercial real estate		8,331		8,624

Total commercial business		38,511		50,019
One-to-four family residential		3,323		3,506
Real estate construction and land development:
One-to-four family residential		3,882		7,244
Five or more family residential and commercial properties		1,161		3,797

Total real estate construction and land development		5,043		11,041
Consumer		4,674		6,205

Gross purchased impaired non-covered loans	$	51,551	$	70,771

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 purchased impaired loans for the three and nine months ended September 30, 2012 and September 30, 2011:


	Three Months Ended September 30, 2012						Nine Months Ended September 30, 2012
	Cowlitz Bank			Pierce Commercial Bank			Cowlitz Bank			Pierce Commercial Bank
				(In thousands)
Balance at the beginning of period	$	16,564		$	11,815		$	19,912		$	14,638
Accretion		(1,514	)		(1,578	)		(5,173	)		(4,734	)
Disposals and other		(535	)		(1,175	)		(921	)		(1,919	)
Change in accretable yield		882			873			1,579			1,950

Balance at the end of period	$	15,397		$	9,935		$	15,397		$	9,935


	Three Months Ended September 30, 2011						Nine Months Ended September 30, 2011
	Cowlitz Bank			Pierce Commercial Bank			Cowlitz Bank			Pierce Commercial Bank
	(In thousands)
Balance at the beginning of period	$	22,222		$	16,275		$	20,082		$	10,943
Accretion		(1,992	)		(1,828	)		(7,430	)		(4,684	)
Disposals and other		(562	)		(1,138	)		494			514
Change in accretable yield		2,052			1,843			8,574			8,379

Balance at the end of period	$	21,720		$	15,152		$	21,720		$	15,152

NOTE 3. Allowance for Loan Losses

The allowance for loan losses is maintained at a level deemed appropriate by management to adequately provide for probable incurred losses from 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 nine months ended September 30, 2012 and September 30, 2011 are as follows:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
	(In thousands)
Balance at the beginning of period	$	20,843		$	22,011		$	22,317		$	22,062
Loans charged off		(588	)		(43	)		(3,883	)		(5,589	)
Recoveries of loans charged off		63			24			1,684			929
Provision charged to operations		215			395			415			4,985

Balance at the end of period	$	20,533		$	22,387		$	20,533		$	22,387

A summary of the changes in the purchased loans’ allowance for loan losses for the three and nine months ended September 30, 2012 and September 30, 2011 are as follows:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
	(In thousands)
Balance at the beginning of period	$	8,640		$	3,307		$	8,598		$	—
Loans charged off		(158	)		(80	)		(426	)		(80	)
Provision charged to operations		592			2,821			902			6,128

Balance at the end of period	$	9,074		$	6,048		$	9,074		$	6,048

The following table details activity in the allowance for loan losses disaggregated on the basis of the Company’s impairment method as of and for the three and nine months ended September 30, 2012:


	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 properties			Consumer			Unallocated			Total
	(In thousands)
Allowance for loan losses for the three months ended September 30, 2012:
June 30, 2012	$	10,733		$	3,493		$	4,432		$	1,148		$	3,820		$	3,352		$	1,577		$	928		$	29,483
Charge-offs		(323	)		(40	)		—			(94	)		—			—			(289	)		—			(746	)
Recoveries		57			—			—			—			—			—			6			—			63
Provisions		(6	)		585			806			137			(374	)		(553	)		357			(145	)		807

September 30, 2012	$	10,461		$	4,038		$	5,238		$	1,191		$	3,446		$	2,799		$	1,651		$	783		$	29,607

Allowance for loan losses for the nine months ended September 30, 2012:
December 31, 2011	$	11,805		$	2,979		$	4,394		$	794		$	4,823		$	3,800		$	1,410		$	910		$	30,915
Charge-offs		(1,223	)		(1,040	)		(292	)		(212	)		(475	)		(445	)		(622	)		—			(4,309	)
Recoveries		1,514			8			11			—			125			—			26			—			1,684
Provisions		(1,635	)		2,091			1,125			609			(1,027	)		(556	)		837			(127	)		1,317

September 30, 2012	$	10,461		$	4,038		$	5,238		$	1,191		$	3,446		$	2,799		$	1,651		$	783		$	29,607

Allowance for loan losses as of September 30, 2012 allocated to:
Originated loans individually evaluated for impairment	$	1,071		$	591		$	1,411		$	91		$	860		$	997		$	40		$	—		$	5,061
Originated loans collectively evaluated for impairment		5,667			2,065			2,431			582			1,624			1,684			636			783			15,472
Purchased other covered loans individually evaluated for impairment		—			—			—			46			—			—			3			—			49
Purchased other covered loans collectively evaluated for impairment		42			29			—			21			—			—			34			—			126
Purchased other non-covered loans individually evaluated for impairment		—			—			21			—			—			—			—			—			21
Purchased other non-covered loans collectively evaluated for impairment		85			52			13			16			—			—			88			—			254
Purchased impaired covered loans collectively evaluated for impairment		1,095			919			964			200			617			—			167			—			3,962
Purchased impaired non-covered loans collectively evaluated for impairment		2,501			382			398			235			345			118			683			—			4,662

September 30, 2012	$	10,461		$	4,038		$	5,238		$	1,191		$	3,446		$	2,799		$	1,651		$	783		$	29,607

The purchased loans acquired in the Cowlitz and Pierce 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.

The following table details the recorded investment balance of the loan receivables disaggregated on the basis of the Company’s impairment method as of September 30, 2012:


	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 properties		Consumer		Total
	(In thousands)
Originated loans individually evaluated for impairment	$	12,147	$	2,303	$	7,204	$	849	$	3,754	$	4,616	$	87	$	30,960
Originated loans collectively evaluated for impairment		268,366		189,495		249,466		38,582		21,291		45,826		29,889		842,915
Purchased other covered loans individually evaluated for impairment		17		—		—		468		—		—		7		492
Purchased other covered loans collectively evaluated for impairment		6,653		18,515		543		862		47		—		1,976		28,596
Purchased other non-covered loans individually evaluated for impairment		—		—		540		—		—		—		—		540
Purchased other non-covered loans collectively evaluated for impairment		6,377		9,868		4,851		62		—		—		5,083		26,241
Purchased impaired covered loans collectively evaluated for impairment		22,528		16,716		13,484		3,712		4,326		—		3,288		64,054
Purchased impaired non-covered loans collectively evaluated for impairment		20,007		6,177		7,093		2,974		667		949		5,881		43,748

Total gross loans receivable as of September 30, 2012	$	336,095	$	243,074	$	283,181	$	47,509	$	30,085	$	51,391	$	46,211	$	1,037,546

The following table details the balance in the allowance for loan losses disaggregated on the basis of the Company’s impairment method for the three and nine months ended September 30, 2011 and as of December 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 properties			Consumer			Unallocated			Total
	(In thousands)
Allowance for loan losses for the three months ended September 30, 2011:
June 30, 2011	$	11,037		$	2,693	$	3,314	$	547		$	4,265		$	1,696		$	1,098		$	668		$	25,318
Charge-offs		(80	)		—		—		—			—			—			(43	)		—			(123	)
Recoveries		16			—		—		—			—			—			8			—			24
Provisions		1,337			151		875		225			(245	)		438			336			99			3,216

September 30, 2011	$	12,310		$	2,844	$	4,189	$	772		$	4,020		$	2,134		$	1,399		$	767		$	28,435

Allowance for loan losses for the nine months ended September 30, 2011:
December 31, 2010	$	10,487		$	1,674	$	2,189	$	500		$	4,321		$	1,114		$	846		$	931		$	22,062
Charge-offs		(2,545	)		—		—		(15	)		(2,053	)		(895	)		(161	)		—			(5,669	)
Recoveries		781			—		25		—			—			103			20			—			929
Provisions		3,587			1,170		1,975		287			1,752			1,812			694			(164	)		11,113

September 30, 2011	$	12,310		$	2,844	$	4,189	$	772		$	4,020		$	2,134		$	1,399		$	767		$	28,435

Allowance for loan losses as of December 31, 2011 allocated to:
Originated loans individually evaluated for impairment	$

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