HFWA-2014.12.31 10K
Table of Contents


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
 
 
FORM 10-K
 
 
 
x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2014
OR
¨ 
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission File Number 0-29480 
 
HERITAGE FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter) 
 
 
 
Washington
 
91-1857900
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
 
 
201 Fifth Avenue SW, Olympia, WA
 
98501
(Address of principal executive offices)
 
(Zip Code)
(360) 943-1500
(Registrant’s telephone number, including area code) 
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
  
Name of each exchange on which registered
Common Stock
  
NASDAQ Stock Market LLC
Securities registered pursuant to Section 12(g) of the Act:
None
 Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  ý
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  ý
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ý    No  ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ý    No  ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    ¨
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 the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer  ¨      Accelerated filer  ý      Non-accelerated filer  ¨      Smaller reporting company  ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  ý
The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant as of June 30, 2014, based on the closing price of its common stock on such date, on the NSADAQ Global Select Market, of $16.09 per share, and 29,423,514 shares held by non-affiliates was $473,242,340.
The registrant had 30,257,691 shares of common stock outstanding as of February 25, 2015.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant’s definitive Proxy Statement for the 2015 Annual Meeting of Shareholders will be incorporated by reference into Part III of this Form 10-K.


Table of Contents


HERITAGE FINANCIAL CORPORATION
FORM 10-K
December 31, 2014
TABLE OF CONTENTS
 
 
 
 
 
Page
 
 
ITEM 1.
ITEM 1A.
ITEM 1B.
ITEM 2.
ITEM 3.
ITEM 4.
 
 
 
 
 
 
 
 
ITEM 5.
ITEM 6.
ITEM 7.
ITEM 7A.
ITEM 8.
ITEM 9.
ITEM 9A.
ITEM 9B.
 
 
 
 
 
 
 
 
ITEM 10.
ITEM 11.
ITEM 12.
ITEM 13.
ITEM 14.
 
 
 
 
 
 
 
 
ITEM 15.
 
 
 
 



Table of Contents


PART I

ITEM 1.     BUSINESS
General
Heritage Financial Corporation (the “Company” or "Heritage") is a bank holding company that was incorporated in the State of Washington in August 1997. We were organized for the purpose of acquiring all of the capital stock of Heritage Savings Bank upon our reorganization from a mutual holding company form of organization to a stock holding company form of organization. Effective September 1, 2004, Heritage Savings Bank switched its charter from a state chartered savings bank to a state chartered commercial bank and changed its legal name from Heritage Savings Bank to Heritage Bank (the "Bank"). Effective September 1, 2005, Central Valley Bank (acquired by the Company in March 1999) changed its charter from a nationally chartered commercial bank to a state chartered commercial bank. In 1998, the Company acquired North Pacific Bank. In June 2006, the Company completed the acquisition of Western Washington Bancorp and its wholly owned subsidiary, Washington State Bank, N.A., at which time Washington State Bank, N.A. was merged into Heritage Bank.
Effective July 30, 2010, Heritage Bank entered into a definitive agreement with the Federal Deposit Insurance Corporation (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 opened as branches of Heritage Bank on August 2, 2010. The acquisition also included the Trust Services Division of Cowlitz Bank. In 2013, the Company consolidated three of these branches into existing Heritage Bank branches. 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 commercial bank headquartered in Tacoma, Washington (the “Pierce Acquisition”). The Pierce Acquisition included one branch, which opened as a branch of Heritage Bank on November 8, 2010.
On September 14, 2012, the Company announced that it had entered into a definitive agreement along with Heritage Bank, to acquire Northwest Commercial Bank (“NCB”), a full service commercial bank headquartered in Lakewood, Washington that operated two branch locations in Washington State (the “NCB Acquisition”). The NCB Acquisition was completed on January 9, 2013, at which time NCB was merged with and into Heritage Bank. The Lakewood branch was subsequently consolidated with an existing Heritage Bank branch in 2013. On March 11, 2013, the Company entered into a definitive agreement to acquire Valley Community Bancshares, Inc. ("Valley" or "Valley Community Bancshares") and its wholly-owned subsidiary, Valley Bank, both headquartered in Puyallup, Washington (the “Valley Acquisition”) and its eight branches. The Valley Acquisition was completed on July 15, 2013. Subsequently, four of these branches were consolidated into existing branches as of December 31, 2013. See Note 2 - Business Combinations of the Notes to Consolidated Financial Statements included in "Item 8. Financial Statements and Supplementary Data" for these acquisitions which closed during fiscal year 2013.
On April 8, 2013, the Company announced the proposed merger of its two wholly-owned bank subsidiaries Central Valley Bank and Heritage Bank, with Central Valley Bank merging into Heritage Bank (the "Central Valley Merger"). The common control merger was completed on June 19, 2013. Central Valley Bank now operates as a division of Heritage Bank.
On October 23, 2013, the Company, along with the Bank, and Washington Banking Company (“Washington Banking”) and its wholly owned subsidiary bank, Whidbey Island Bank ("Whidbey"), jointly announced the signing of a merger agreement pursuant to which Heritage and Washington Banking entered into a strategic merger with Washington Banking merging into Heritage (the "Washington Banking Merger"). Washington Banking branches adopted the Heritage Bank name in all markets, with the exception of six branches in Whidbey Island markets which continued to operate using the Whidbey Island Bank name. The Washington Banking Merger was completed on May 1, 2014. For additional information on the Washington Banking Merger, see Note 2 - Business Combinations of the Notes to Consolidated Financial Statements included in "Item 8. Financial Statements and Supplementary Data."
We are primarily engaged in the business of planning, directing, and coordinating the business activities of our wholly owned subsidiary, Heritage Bank. The deposits of the Bank are insured by the FDIC. Heritage Bank is headquartered in Olympia, Washington and conducts business in its sixty-six branch offices located in Washington and the greater Portland, Oregon area.
Our business consists primarily of lending and deposit relationships with small businesses and their owners in our market areas, and attracting deposits from the general public. We also make real estate construction and land development loans and consumer loans. The Bank also originates for sale or investment purposes one-to-four family

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residential loans on residential properties located primarily in western and central Washington State and the greater Portland, Oregon area.
Market Areas
We offer financial services to meet the needs of the communities we serve through our community-oriented financial institutions. Headquartered in Olympia, Thurston County, Washington, we conduct business through Heritage Bank and its sixty-six branch offices located along the I-5 corridor throughout Washington and the greater Portland, Oregon area. We additionally have offices located in eastern Washington, primarily in Yakima county.
Lending Activities
General.    Lending activities are conducted through Heritage Bank. Our focus is on commercial business lending. We also originate consumer loans, real estate construction and land development loans and one-to-four family residential loans. Our loans are originated under policies that are reviewed and approved annually by our Board of Directors. In addition, we have established internal lending guidelines that are updated as needed. These policies and guidelines address underwriting standards, structure and rate considerations, and compliance with laws, regulations and internal lending limits. We conduct post-approval reviews on selected loans and routinely perform internal loan reviews of our loan portfolio to check for credit quality, proper documentation and compliance with laws and regulations.
The Company has also acquired loans through mergers and acquisitions, which are designated as "purchased" loans. Purchased loans which are covered under FDIC shared-loss agreements are identified as "covered", while purchased loans not subject to FDIC shared-loss agreements as well as loans originated by the Company are referred to as "noncovered."
Noncovered commercial and industrial loans, including owner occupied commercial real estate loans, totaled $1.09 billion, or 51.2% of total noncovered loans, as of December 31, 2014, and $617.8 million, or 52.9% of total noncovered loans, as of December 31, 2013 and non-owner occupied commercial real estate loans totaled $616.8 million, or 29.0%, as of December 31, 2014 and $400.0 million, or 34.2% of total noncovered loans, as of December 31, 2013. One-to-four family residential loans totaled $63.5 million, or 3.0% of total noncovered loans, at December 31, 2014, and $43.1 million, or 3.7% of total noncovered loans, at December 31, 2013. Real estate construction and land development loans totaled $108.1 million, or 5.1% of total noncovered loans, at December 31, 2014, and $68.4 million, or 5.9% of total noncovered loans, at December 31, 2013.
Covered loans totaled $126.2 million and $63.8 million at December 31, 2014 and 2013, respectively. The majority of the covered loans are commercial and industrial loans, including owner occupied commercial real estate loans, totaling $78.4 million, or 62.1% of total covered loans, as of December 31, 2014, and $39.1 million, or 61.3% of total covered loans, as of December 31, 2013 and non-owner occupied commercial real estate totaled $26.9 million, or 21.3%, as of December 31, 2014 and $14.6 million, or 22.9% of total noncovered loans, as of December 31, 2013.

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Table of Contents


The following table provides information about our noncovered loan portfolio by type of loan at the dates indicated. These balances are prior to deduction for the allowance for loan losses.
 
December 31,
 
2014
 
2013
 
2012
 
2011
 
2010
 
Balance
 
% of Total
(4)
 
Balance
 
% of Total
(4)
 
Balance
 
% of Total
(4)
 
Balance
 
% of Total
(4)
 
Balance
 
% of Total
(4)
 
(Dollars in thousands)
Noncovered loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial business:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial and industrial(1)
$
1,087,085

 
51.2
%
 
$
617,849

 
52.9
 %
 
$
503,708

 
53.7
 %
 
$
493,130

 
53.3
 %
 
$
470,116

 
53.9
 %
Non-owner occupied commercial real estate
616,757

 
29.0

 
399,979

 
34.2

 
276,854

 
29.5

 
263,882

 
28.5

 
240,174

 
27.5

Total commercial business
1,703,842

 
80.2

 
1,017,828

 
87.1

 
780,562

 
83.2

 
757,012

 
81.8

 
710,290

 
81.4

One-to-four family residential(2)
63,540

 
3.0

 
43,082

 
3.7

 
41,888

 
4.5

 
40,703

 
4.4

 
52,491

 
6.0

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
One-to-four family residential
46,749

 
2.2

 
19,724

 
1.7

 
25,688

 
2.7

 
23,750

 
2.5

 
33,193

 
3.8

Five or more family residential and commercial properties
61,360

 
2.9

 
48,655

 
4.2

 
52,939

 
5.6

 
56,032

 
6.1

 
29,832

 
3.4

Total real estate construction and land development(3)
108,109

 
5.1

 
68,379

 
5.9

 
78,627

 
8.3

 
79,782

 
8.6

 
63,025

 
7.2

Consumer
250,323

 
11.8

 
41,547

 
3.5

 
39,627

 
4.2

 
50,401

 
5.4

 
48,585

 
5.6

Gross noncovered loans
2,125,814

 
100.1

 
1,170,836

 
100.2

 
940,704

 
100.2

 
927,898

 
100.2

 
874,391

 
100.2

Less: deferred loan fees
(937
)
 
(0.1
)
 
(2,670
)
 
(0.2
)
 
(2,096
)
 
(0.2
)
 
(1,860
)
 
(0.2
)
 
(1,323
)
 
(0.2
)
Total noncovered loans
$
2,124,877

 
100.0
%
 
$
1,168,166

 
100.0
 %
 
$
938,608

 
100.0
 %
 
$
926,038

 
100.0
 %
 
$
873,068

 
100.0
 %
(1)
Commercial and industrial loans include owner-occupied commercial real estate loans.
(2)
Excludes loans held for sale of $5.6 million, $1.7 million, $1.8 million and $764,000 as of December 31, 2014, 2012, 2011 and 2010, respectively. There were no loans held for sale at December 31, 2013.
(3)
Balances are net of undisbursed loan proceeds.
(4)
Percent of total noncovered loans.


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The following table provides information about our covered loan portfolio by type of loan at the dates indicated. These balances are the recorded investment balance and are prior to deduction for the allowance for loan losses.
 
December 31,
 
2014
 
2013
 
2012
 
2011
 
2010
 
Balance
 
% of Total
(3)
 
Balance
 
% of Total
(3)
 
Balance
 
% of Total
(3)
 
Balance
 
% of Total
(3)
 
Balance
 
% of Total
(3)
 
(Dollars in thousands)
Covered loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial business:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial and industrial(1)
$
78,354

 
62.1
%
 
$
39,056

 
61.3
%
 
$
60,577

 
68.6
%
 
$
76,674

 
70.1
%
 
92,265

 
71.7
%
Non-owner occupied commercial real estate
26,879

 
21.3

 
14,625

 
22.9

 
13,028

 
14.7

 
15,753

 
14.4

 
17,576

 
13.6

Total commercial business
105,233

 
83.4

 
53,681

 
84.2

 
73,605

 
83.3

 
92,427

 
84.5

 
109,841

 
85.3

One-to-four family residential
5,990

 
4.7

 
4,777

 
7.5

 
5,027

 
5.7

 
5,197

 
4.8

 
6,224

 
4.8

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
One-to-four family residential
2,446

 
2.0

 
1,556

 
2.4

 
4,433

 
5.0

 
5,786

 
5.3

 
5,876

 
4.6

Five or more family residential and commercial properties
3,560

 
2.8

 

 

 

 

 

 

 

 

Total real estate construction and land development(2)
6,006

 
4.8

 
1,556

 
2.4

 
4,433

 
5.0

 
5,786

 
5.3

 
5,876

 
4.6

Consumer
8,971

 
7.1

 
3,740

 
5.9

 
5,265

 
6.0

 
5,947

 
5.4

 
6,774

 
5.3

Gross purchased covered loans
$
126,200

 
100.0
%
 
$
63,754

 
100.0
%
 
$
88,330

 
100.0
%
 
$
109,357

 
100.0
%
 
128,715

 
100.0
%
(1)Commercial and industrial loans include owner-occupied commercial real estate.
(2)Balances are net of undisbursed loan proceeds.
(3)Percent of total covered loans.

The following table presents at December 31, 2014 (i) the aggregate contractual maturities of noncovered loans in the named categories of our noncovered loan portfolio and (ii) the aggregate amounts of fixed rate and variable or adjustable rate loans in the named categories that mature after one year.
 
 
Maturing
 
 
Within
1 year
 
Over 1-5
years
 
After
5 years
 
Total
 
 
(In thousands)
Commercial business
 
$
230,085

 
$
407,886

 
$
1,065,871

 
$
1,703,842

Real estate construction and land development
 
42,411

 
34,692

 
31,006

 
108,109

Total
 
$
272,496

 
$
442,578

 
$
1,096,877

 
$
1,811,951

Fixed rate loans, due after 1 year
 
 
 
$
236,357

 
$
217,816

 
$
454,173

Variable or adjustable rate loans, due after 1 year
 
 
 
206,221

 
879,061

 
1,085,282

Total
 
 
 
$
442,578

 
$
1,096,877

 
$
1,539,455

Commercial Business Lending
We offer different types of commercial business loans, including lines of credit, term equipment financing and term owner-occupied commercial real estate loans. We also originate loans that are guaranteed by the Small Business Administration (“SBA”), for which Heritage Bank is a “preferred lender.” Before extending credit to a business we review and analyze the borrower’s management ability, financial history, including cash flow of the borrower and all guarantors, and the liquidation value of the collateral. Emphasis is placed on having a comprehensive understanding of the borrower’s global cash flow and performing necessary financial due diligence.

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At December 31, 2014 we had $1.70 billion, or 80.2%, of our total noncovered loans receivable in commercial business loans with an average loan size of approximately $306,000, excluding loans with no outstanding balance.
We originate commercial real estate loans within our primary market areas with a preference for loans secured by owner-occupied properties. Our underwriting standards require that commercial real estate loans not exceed 75% of the lower of appraised value at origination or cost of the underlying collateral. Cash flow coverage to debt servicing requirements is generally a minimum of 1.15 times for five or more family residential loans and 1.25 times for commercial real estate loans. Cash flow coverage is calculated using an “underwriting” interest rate that is higher than the note rate.
Commercial real estate loans typically involve a greater degree of risk than one-to-four family residential loans. Payments on loans secured by commercial real estate properties are dependent on successful operation and management of the properties and repayment of these loans may be affected by adverse conditions in the real estate market or the economy. We seek to minimize these risks by determining the financial condition of the borrower, the quality and value of the collateral, and the management of the property securing the loan. We also generally obtain personal guarantees from the owners of the collateral after a thorough review of personal financial statements. In addition, we review our commercial real estate loan portfolio annually for performance of individual loans, and stress-test loans for potential changes in interest rates, occupancy, and collateral values.
See “Item 1A. Risk Factors—Our loan portfolio is concentrated in loans with a higher risk of loss—Repayment of our commercial business loans, consisting of commercial and industrial loans as well as owner-occupied and non-owner occupied commercial real estate loans, is often dependent on the cash flows of the borrower, which may be unpredictable, and the collateral securing these loans may fluctuate in value.” See also “Item 1A. Risk Factors—Our loan portfolio is concentrated in loans with a higher risk of loss—Our non-owner occupied commercial real estate loans, which includes five or more family residential real estate loans, involve higher principal amounts than other loans and repayment of these loans may be dependent on factors outside our control or the control of our borrowers.”
One-to-Four Family Residential Loans, Originations and Sales
The majority of our one-to-four family residential loans are secured by single-family residences located in our primary market areas. Our underwriting standards require that one-to-four family residential 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.
As part of our asset/liability management strategy, we typically sell a significant portion of our one-to-four family residential loans in the secondary market. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Asset/Liability Management.” We discontinued this strategy in the second quarter of 2013 through the second quarter of 2014, and reinstated these operations following the completion of the Washington Banking Merger.
We typically sell the servicing of the sold one-to-four family residential loans, or the collection of principal and interest payments, to other financial institutions. We did not service any of these sold loans for others for the years ended December 31, 2014 or 2013.
The following table presents summary information concerning our origination and sale of our one-to-four family residential loans and the gains from the sale of loans.
 
 
Years Ended December 31,
 
 
2014
 
2013
 
2012
 
2011
 
2010
 
 
(In thousands)
One-to-four family residential loans:
 
 
 
 
 
 
 
 
 
 
Originated (1)
 
$
75,500

 
$
18,867

 
$
35,730

 
$
23,865

 
$
18,605

Sold
 
55,997

 
8,460

 
21,187

 
15,888

 
16,187

Gains on sales of loans, net (2)
 
1,080

 
142

 
295

 
285

 
226

(1)
Includes loans originated for our loan portfolio or for sale in the secondary market.
(2)
Excludes net gains on sales of SBA loans.


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Real Estate Construction and Land Development
We originate one-to-four family residential construction loans for the construction of custom homes (where the home buyer is the borrower). We also provide financing to builders for the construction of pre-sold homes and, in selected cases, to builders for the construction of speculative residential property. Because of the higher risks present in the residential construction industry, our lending to builders is limited to those who have demonstrated a favorable record of performance and who are building in markets that management understands.
We further endeavor to limit our construction lending risk through adherence to strict underwriting guidelines and procedures. Speculative construction loans are short term in nature and have a variable rate of interest. We require builders to have tangible equity in each construction project and have prompt and thorough documentation of all draw requests, and we inspect the project prior to paying any draw requests.
See “Item 1A. Risk Factors—Our loan portfolio is concentrated in loans with a higher risk of loss—Our real estate construction and land development loans are based upon estimates of costs and value associated with the completed project. These estimates may be inaccurate.”
Consumer
We originate consumer loans and lines of credit that are both secured and unsecured. The majority of our consumer loans are for relatively small amounts disbursed among many individual borrowers.
As a result of the Washington Banking Merger, we originate indirect consumer loans. These loans are for new and used automobile and recreational vehicles that are originated indirectly by selected dealers located in our market areas. We have limited our indirect loans purchased primarily to dealerships that are established and well known in their market areas and to applicants that are not classified as sub-prime.
Commitments and Contingent Liabilities
In the ordinary course of business, we enter into various types of transactions that include commitments to extend credit that are not included in our Consolidated Financial Statements. We apply the same credit standards to these commitments as we use in all our lending activities and have included these commitments in our lending risk evaluations. Our exposure to credit loss under commitments to extend credit is represented by the amount of these commitments.
The following table presents outstanding commitments to extend credit, including letters of credit, at the dates indicated:
 
 
December 31, 2014
 
December 31, 2013
 
 
(In thousands)
Commercial business:
 
 
 
 
Commercial and industrial
 
$
288,930

 
$
169,079

Owner-occupied commercial real estate
 
2,648

 
2,812

Non-owner occupied commercial real estate
 
20,240

 
2,405

Total commercial business
 
311,818

 
174,296

One-to-four family residential
 

 
45

Real estate construction and land development:
 
 
 
 
One-to-four family residential
 
24,028

 
12,236

Five or more family residential and commercial properties
 
32,653

 
20,720

Total real estate construction and land development
 
56,681

 
32,956

Consumer
 
122,633

 
27,480

Total outstanding commitments
 
$
491,132

 
$
234,777

Delinquencies and Nonperforming Assets
Delinquency Procedures.    Delinquencies in the commercial business loan portfolio are handled by the assigned loan officer. Loan officers are responsible for collecting loans they originate or which are assigned to them. We send a borrower a delinquency notice 15 days after the due date when the borrower fails to make a required payment on a loan. If the delinquency is not brought current, additional delinquency notices are mailed at 30 and 45 days for commercial loans. Additional written and oral contacts are made with the borrower between 60 and 90 days after the due date.

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If a real estate loan payment is past due for 45 days or more, the collection manager may perform a review of the condition of the property. Depending on the nature of the loan and the type of collateral securing the loan, we may negotiate and accept a modified payment program with the borrower, accept a voluntary deed in lieu of foreclosure or, when considered necessary, begin foreclosure proceedings. If foreclosed on, real property is generally sold at a public sale and we may bid on the property to protect our interest. A decision as to whether and when to begin foreclosure proceedings is based on such factors as the amount of the outstanding loan relative to the value of the property securing the original indebtedness, the extent of the delinquency, and the borrower’s ability and willingness to cooperate in resolving the delinquency.
Real estate acquired by us in partial or full satisfaction of a loan obligation is classified as other real estate owned until it is sold. When property is acquired, it is recorded at the estimated fair value (less costs to sell) at the date of acquisition, not to exceed net realizable value, and any resulting write-down is charged to the allowance for loan losses. Upon acquisition, all costs incurred in maintaining the property are expensed. Costs relating to the development and improvement of the property, however, are capitalized to the extent of the property’s net realizable value. If the estimated realizable value of the other real estate owned property declines after the acquisition date, the adjustment to the value is charged to other real estate owned expense, net.
Classification of Loans.    Federal regulations require that the Bank periodically evaluate the risks inherent in its loan portfolio. In addition, the Division of Banks of the Washington State Department of Financial Institutions (“Division”) and the FDIC have the authority to identify problem loans and, if appropriate, require them to be reclassified. There are three classifications for problem loans: Substandard, Doubtful, and Loss. Substandard loans have one or more defined weaknesses and are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected. Doubtful loans have the weaknesses of Substandard loans, with additional characteristics that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions, and values questionable. There is a high probability of some loss in loans classified as Doubtful. A loan classified as Loss is considered uncollectible and of such little value that continuance as a loan of the institution is not warranted. If a loan or a portion of the loan is classified as Loss, the institution must charge-off this amount. We also have loans we classify as Watch and Other Assets Especially Mentioned (“OAEM”). Loans classified as Watch are performing assets but have elements of risk that require more monitoring than other performing loans. Loans classified as OAEM are assets that continue to perform but have shown deterioration in credit quality and require closer monitoring.
The Bank routinely tests its problem loans for potential impairment. A loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect all amounts due according to the original contractual terms of the loan agreement. Problem loans that may be impaired are identified using the Bank's normal loan review procedures, which include post-approval reviews, monthly reviews by credit administration of criticized loan reports, scheduled internal reviews, underwriting during extensions and renewals and the analysis of information routinely received on a borrower’s financial performance.
Impairment is measured using the present value of expected future cash flows, discounted at the loan’s effective interest rate, unless the loan is collateral dependent, in which case impairment is measured using the fair value of the collateral after deducting appropriate collateral disposition costs. Furthermore, when it is practically expedient, impairment is measured by the fair market price of the loan.
Subsequent to an initial measure of impairment, if there is a significant change in the amount or timing of a loan’s expected future cash flows or a change in the value of collateral or market price of a loan, based on new information received, the impairment is recalculated. However, the net carrying value of a loan never exceeds the recorded investment in the loan.
Nonperforming Assets.    Nonperforming assets consist of nonaccrual loans and other real estate owned. The following table provides information about our noncovered nonaccrual loans and other real estate owned for the indicated dates. We have also included information regarding our troubled-debt restructured performing noncovered loans for the indicated dates, although these are not considered nonperforming assets as they continue to accrue interest despite being considered impaired due to the restructure.
 

9

Table of Contents


 
 
December 31,
 
 
2014
 
2013
 
2012
 
2011
 
2010
 
 
(Dollars in thousands)
Nonaccrual noncovered loans:
 
 
 
 
 
 
 
 
 
 
Commercial business
 
$
4,719

 
$
5,675

 
$
6,068

 
$
8,266

 
$
10,839

One-to-four family residential
 

 
340

 
450

 

 
2

Real estate construction and land development
 
2,652

 
1,045

 
6,420

 
14,947

 
15,642

Consumer
 
139

 
678

 
281

 
615

 

Total nonaccrual noncovered loans(1)(2)
 
7,510

 
7,738

 
13,219

 
23,828

 
26,483

Noncovered other real estate owned
 
2,178

 
4,377

 
5,406

 
3,710

 
3,030

Total nonperforming noncovered assets
 
$
9,688

 
$
12,115

 
$
18,625

 
$
27,538

 
$
29,513

Accruing noncovered loans past due 90 days or more(3)
 
$

 
$
6

 
$
214

 
$
1,328

 
$
1,313

Potential problem noncovered loans(4)
 
117,250

 
52,814

 
29,183

 
31,925

 
53,086

Allowance for loan losses on noncovered loans
 
22,153

 
22,657

 
24,242

 
26,952

 
22,062

Nonperforming noncovered loans to total noncovered loans
 
0.35
%
 
0.66
%
 
1.41
%
 
2.57
%
 
3.03
%
Allowance for loan losses on noncovered loans to total noncovered loans
 
1.04
%
 
1.94
%
 
2.58
%
 
2.91
%
 
2.53
%
Allowance for loan losses on noncovered loans to nonperforming noncovered loans
 
294.98
%
 
292.80
%
 
183.39
%
 
113.11
%
 
83.31
%
Nonperforming noncovered assets to total noncovered assets
 
0.29
%
 
0.76
%
 
1.48
%
 
2.19
%
 
2.38
%
Restructured performing noncovered loans:
 
 
 
 
 
 
 
 
 
 
Commercial business
 
$
14,408

 
$
15,735

 
$
15,227

 
$
12,606

 
$
394

One-to-four family residential
 
245

 
252

 
888

 
835

 

Real estate construction and land development
 
3,927

 
6,043

 
361

 
364

 

Consumer
 
184

 
101

 

 

 

Total restructured performing noncovered loans(5)
 
$
18,764

 
$
22,131

 
$
16,476

 
$
13,805

 
$
394

(1)
At December 31, 2014, 2013, 2012, 2011 and 2010, $4.1 million, $2.6 million, $9.3 million, $11.7 million and $8.7 million of nonaccrual noncovered loans were considered troubled debt restructured loans, respectively.
(2)
At December 31, 2014, 2013, 2012, 2011 and 2010, $1.6 million, $1.7 million, $1.2 million, $1.8 million and $2.3 million of noncovered nonaccrual loans were guaranteed by government agencies, respectively.
(3)
There were no accruing noncovered loans past due 90 days or more that were guaranteed by government agencies at December 31, 2014, 2013, and 2012. There were accruing noncovered loans past due 90 days or more of $6,000 and $92,000 guaranteed by government agencies at December 31, 2011 and 2010, respectively.
(4)
At December 31, 2014, 2013, 2012, 2011 and 2010, $2.0 million, $1.8 million, $2.9 million, $2.8 million and $5.4 million of potential problem noncovered loans were guaranteed by government agencies, respectively.
(5)
At December 31, 2014, 2013, 2012 and 2011, $751,000, $1.2 million, $965,000 and $592,000 of restructured performing noncovered loans were guaranteed by government agencies . There were no restructured performing noncovered loans guaranteed by government agencies at December 31, 2010.
Nonaccrual Loans.    Our Consolidated Financial Statements are prepared on the accrual basis of accounting, including the recognition of interest income on our loan portfolio, unless a loan is placed on nonaccrual status. Loans are considered to be impaired and are placed on nonaccrual status when there are serious doubts about the collectability of principal or interest. Our policy is to place a loan on nonaccrual status when the loan becomes past due for 90 days or more, is less than fully collateralized, and is not in the process of collection. Payments received on nonaccrual loans generally are applied first to principal and then to interest only after all principal has been collected.

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Nonaccrual noncovered loans decreased to $7.5 million, or 0.35% of total noncovered loans, at December 31, 2014 from $7.7 million, or 0.66% of total noncovered loans, at December 31, 2013 due to the loan resolution efforts of our credit department. During the year ended December 31, 2014, approximately $9.6 million in net principal payments were received on nonaccrual noncovered loans and $322,000 of nonaccrual noncovered loans were transferred back to accrual status. We also recorded $1.6 million in net charge-offs of nonaccrual noncovered loans. In addition, $414,000 of nonaccrual noncovered loans were transferred to other real estate owned during the year ended December 31, 2014. The decrease in total nonaccrual noncovered loans at December 31, 2014 was partially offset by $11.7 million in additions to nonperforming noncovered loans, of which $1.4 million were previously restructured performing noncovered loans that were transferred to nonaccrual status.
Nonperforming noncovered assets decreased to $9.7 million, or 0.29% of total noncovered assets, at December 31, 2014 from $12.1 million, or 0.76% of total noncovered assets, at December 31, 2013 due to a decrease in nonperforming noncovered loans discussed above as well as an overall decrease in noncovered other real estate owned. The noncovered other real estate owned decreased to $2.2 million at December 31, 2014 from $4.4 million at December 31, 2013 due to dispositions of $5.6 million, which were offset partially by additions of $3.3 million during the year ended December 31, 2014. Of the $3.3 million of additions, $1.7 million were acquired with the Washington Banking Merger.
Restructured performing noncovered loans as of December 31, 2014 and December 31, 2013 were $18.8 million and $22.1 million, respectively. The $3.4 million decrease in restructured performing noncovered loans during 2014 was primarily due to $7.3 million of net principal reductions and $1.5 million in loans transferred to nonaccrual, offset partially by $3.8 million of loans restructured during the year ended December 31, 2014 and $2.5 million of advances of existing restructured performing noncovered loans. The Bank also recorded $372,000 in charge-offs of restructured performing noncovered loans during the year ended December 31, 2014.
Troubled Debt Restructured Loans.    A troubled debt restructured loan (“TDR”) is a restructuring in which the Bank, for economic or legal reasons related to a borrower’s financial difficulties, grants a concession to a borrower that it would not otherwise consider. The majority of the Bank's 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. The interest rate reductions can be for a period of time or over the remainder of the life of the loan. We may also bifurcate troubled credits into a “good” loan and a “bad” loan, whereas the good loan continues to accrue under the modified terms. We perform bifurcations to limit potential losses. The remainder of the Bank's TDRs are the result of converting revolving lines of credits to amortizing loans, changing amortizing loans to interest-only loans with balloon payments, or re-amortizing the loan over a longer period of time. These modifications would all be considered a concession for a borrower that could not obtain financing outside of the Bank. We do not forgive principal for a majority of our TDRs, but in those situations where principal is forgiven, the entire amount of such principal forgiveness is immediately charged off to the extent not done so prior to the modification. We sometimes delay the timing on the repayment of a portion of principal (principal forbearance) and charge-off the amount of forbearance if that amount is not considered fully collectible. We also consider insignificant delays in payments when determining if a loan should be classified as a TDR.
TDRs are considered impaired and are separately measured for impairment under Financial Accounting Standards Board ("FASB") Accounting Standards Codification (“ASC”) 310-10-35, whether on accrual or nonaccrual status. At December 31, 2014 and December 31, 2013, the balance of performing noncovered TDRs was $18.8 million and $22.1 million, respectively. The related allowance for loan losses on the performing noncovered TDRs was $1.9 million as of December 31, 2014 and $3.0 million as of December 31, 2013. At December 31, 2014, nonperforming noncovered TDRs were $5.0 million and had a related allowance for loan losses of $1.0 million. At December 31, 2013, nonperforming noncovered TDRs of $2.6 million had a related allowance for loan losses of $191,000.
A loan may have the TDR classification removed if (a) the restructured interest rate was greater than or equal to the interest rate of a new loan with comparable risk at the time of the restructure, and (b) the loan is no longer impaired based on the terms of the restructured agreement. The Bank's policy is that the borrower must demonstrate six consecutive monthly payments in accordance with the modified loan terms before it can be reviewed for removal of TDR classification under the second criteria. However, the loan must be reported as a TDR in at least one of the Company’s Annual Reports on Form 10-K. Once a loan has been classified as a TDR, it will continue to be an impaired loan until paid off or charged-off, even if the loan subsequently is no longer a TDR.
Potential Problem Loans.    Potential problem loans are those loans that are currently accruing interest and are not considered impaired, but which we are monitoring because the financial information of the borrower causes us concerns as to their ability to comply with their loan repayment terms. Loans that are past due 90 days or more and still accruing interest are both well-secured and in the process of collection. Potential problem noncovered loans

11

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increased $64.4 million, or 122.0%, to $117.3 million at December 31, 2014 from $52.8 million at December 31, 2013 primarily due to loans acquired in the Washington Banking Merger.
Analysis of Allowance for Loan Losses
Management maintains an allowance for loan losses (“ALL”) to provide for estimated probable credit losses inherent in the loan portfolio. The adequacy of the ALL is monitored through our ongoing quarterly loan quality assessments.
We assess the estimated credit losses inherent in our loan portfolio by considering a number of elements including:
Historical loss experience in a number of homogeneous segments of the loan portfolio;
The impact of environmental factors, including:
Levels of and trends in delinquencies and impaired loans;
Levels and trends in charge-offs and recoveries;
Effects of changes in risk selection and underwriting standards, and other changes in lending policies, procedures and practices;
Experience, ability, and depth of lending management and other relevant staff;
National and local economic trends and conditions;
External factors such as competition, legal, and regulatory requirements; and
Effects of changes in credit concentrations.
We calculate an appropriate ALL for the loans in our loan portfolio by applying historical loss factors for homogeneous classes of the portfolio, adjusted for changes to the above-noted environmental factors. We may record specific provisions for impaired loans, including loans on nonaccrual status and TDRs, after a careful analysis of each loan’s credit and collateral factors. Our analysis of an appropriate ALL combines the provisions made for our non-impaired loans and the specific provisions made for each impaired loan.
While we believe we use the best information available to determine the allowance for loan losses, results of operations could be significantly affected if circumstances differ substantially from the assumptions used in determining the allowance. A decline in local and national economic conditions, or other factors, could result in a material increase in the allowance for loan losses and may adversely affect the Company’s financial condition and results of operations. In addition, the determination of the amount of the allowance for loan losses is subject to review by bank regulators, as part of their routine examination process, which may result in the establishment of additional allowance allocations based upon their judgment of information available to them at the time of their examination.

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Table of Contents


The following table provides information regarding changes in our allowance for loan losses on noncovered loans at and for the indicated periods:
 
 
At or For the Years Ended December 31,
 
 
2014
 
2013
 
2012
 
2011
 
2010
 
 
(Dollars in thousands)
Allowance for loan losses on noncovered loans at beginning of the year
 
$
22,657

 
$
24,242

 
$
26,952

 
$
22,062

 
$
26,164

Provision for loan losses for noncovered loans
 
2,232

 
1,784

 
1,570

 
10,032

 
11,990

Charge-offs:
 
 
 
 
 
 
 
 
 
 
Commercial business
 
(2,305
)
 
(3,295
)
 
(3,726
)
 
(2,972
)
 
(8,106
)
One-to-four family residential
 

 
(52
)
 
(391
)
 
(53
)
 
(169
)
Real estate construction and land development
 
(376
)
 
(565
)
 
(1,280
)
 
(2,513
)
 
(8,344
)
Consumer
 
(962
)
 
(386
)
 
(620
)
 
(648
)
 
(73
)
Total charge-offs on noncovered loans
 
(3,643
)
 
(4,298
)
 
(6,017
)
 
(6,186
)
 
(16,692
)
Recoveries:
 
 
 
 
 
 
 
 
 
 
Commercial business
 
716

 
807

 
1,579

 
821

 
243

One-to-four family residential
 

 

 

 

 
15

Real estate construction and land development
 
50

 
32

 
125

 
201

 
285

Consumer
 
141

 
90

 
33

 
22

 
57

Total recoveries on noncovered loans
 
907

 
929

 
1,737

 
1,044

 
600

Net charge-offs on noncovered loans
 
(2,736
)
 
(3,369
)
 
(4,280
)
 
(5,142
)
 
(16,092
)
Allowance for loan losses on noncovered loans at end of the year
 
$
22,153

 
$
22,657

 
$
24,242

 
$
26,952

 
$
22,062

Noncovered loans outstanding at end of the year(1)(2)
 
$
2,125,814

 
$
1,170,836

 
$
940,704

 
$
927,898

 
$
874,391

Average noncovered loans receivable during the year(2)
 
1,767,821

 
1,052,552

 
897,342

 
862,812

 
745,819

Ratio of net charge-offs on noncovered loans to average noncovered loans receivable
 
(0.15
)%
 
(0.32
)%
 
(0.48
)%
 
(0.60
)%
 
(2.16
)%
(1)
Gross loan balances.
(2)
Excludes loans held for sale.


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Table of Contents


The following table shows the allocation of the allowance for loan losses on noncovered loans at the indicated dates. The allocation is based upon an evaluation of defined loan problems, historical loan loss ratios, and industry wide and other factors that affect loan losses in the categories shown below:
 
December 31,
 
2014
 
2013
 
2012
 
2011
 
2010
 
Allowance
for Loan
Losses
 
% of
Total
(1)
 
Allowance
for Loan
Losses
 
% of
Total
(1)
 
Allowance
for Loan
Losses
 
% of
Total
(1)
 
Allowance
for Loan
Losses
 
% of
Total
(1)
 
Allowance
for Loan
Losses
 
% of
Total
(1)
 
(Dollars in thousands)
Commercial business
$
15,967

 
80.1
%
 
$
18,020

 
86.9
%
 
$
16,044

 
83.0
%
 
$
16,167

 
81.6
%
 
$
14,350

 
82.5
%
One-to-four family residential
812

 
3.0

 
786

 
3.7

 
944

 
4.4

 
650

 
4.4

 
500

 
6.5

Real estate construction
1,954

 
5.1

 
1,884

 
5.8

 
4,801

 
8.4

 
7,978

 
8.6

 
5,435

 
7.8

Consumer
2,604

 
11.8

 
1,366

 
3.6

 
1,583

 
4.2

 
1,247

 
5.4

 
846

 
3.2

Unallocated
816

 

 
601

 

 
870

 

 
910

 

 
931

 

Total allowance for loan losses on noncovered loans (1)
$
22,153

 
100.0
%
 
$
22,657

 
100.0
%
 
$
24,242

 
100.0
%
 
$
26,952

 
100.0
%
 
$
22,062

 
100.0
%
(1)
Represents total noncovered loans outstanding in each category as a percent of gross noncovered loans.

The following table shows the allocation of the allowance for loan losses on covered loans at the indicated dates. The allocation is based upon an evaluation of defined loan problems, historical loan loss ratios, and industry wide and other factors that affect loan losses in the categories shown below:
 
December 31,
 
2014
 
2013
 
2012
 
2011
 
2010 (2)
 
Allowance
for Loan
Losses
 
% of
Total
(1)
 
Allowance
for Loan
Losses
 
% of
Total
(1)
 
Allowance
for Loan
Losses
 
% of
Total
(1)
 
Allowance
for Loan
Losses
 
% of
Total
(1)
 
Allowance
for Loan
Losses
 
% of
Total
(1)
 
(Dollars in thousands)
Commercial business
$
4,219

 
83.4
%
 
$
4,833

 
84.2
%
 
$
3,258

 
83.3
%
 
$
3,011

 
84.5
%
 
$

 
85.3
%
One-to-four family residential
388

 
4.7

 
314

 
7.5

 
277

 
5.7

 
144

 
4.8

 

 
4.8

Real estate construction
804

 
4.8

 
789

 
2.4

 
639

 
5.0

 
645

 
5.3

 

 
4.6

Consumer
165

 
7.1

 
231

 
5.9

 
178

 
6.0

 
163

 
5.4

 

 
5.3

Unallocated

 

 

 

 

 

 

 

 

 

Total allowance for loan losses on covered loans (1)
$
5,576

 
100.0
%
 
$
6,167

 
100.0
%
 
$
4,352

 
100.0
%
 
$
3,963

 
100.0
%
 
$

 
100.0
%
(1)
Represents total covered loans outstanding in each category as a percent of gross covered loans.
(2)
The Company did not have an allowance for loan losses on covered loans at December 31, 2010 as the covered portfolio was acquired in July 2010 and fair value discounts on covered loans established at acquisition date were determined sufficient to absorb known and inherent loan losses at December 31, 2010.



14

Table of Contents


Investment Activities
At December 31, 2014, our investment securities portfolio totaled $778.7 million, which consisted of $742.8 million of securities available for sale and $35.8 million of securities held to maturity. This compares with a total portfolio of $199.3 million at December 31, 2013, which was comprised of $163.1 million of securities available for sale and $36.2 million of securities held to maturity. The increase in our investment securities portfolio in fiscal 2014 is attributable to investment securities acquired in the Washington Banking Merger. The composition of the investment portfolio by type of security, at each respective date, is presented in Note 4 - Investment Securities of the Notes to Consolidated Financial Statements included in "Item 8. Financial Statements and Supplementary Data."
Our investment policy is established by the Board of Directors and monitored by the Audit and Finance Committee of the Board of Directors. It is designed primarily to provide and maintain liquidity, generate a favorable return on investments without incurring undue interest rate and credit risk, and complements the Bank's lending activities. The policy dictates the criteria for classifying securities as either available for sale or held to maturity. The policy permits investment in various types of liquid assets permissible under applicable regulations, which include U.S. Treasury obligations, U.S. Government agency obligations, some certificates of deposit of insured banks, mortgage backed and mortgage related securities, corporate notes, municipal bonds, and federal funds. Investment in non-investment grade bonds and stripped mortgage backed securities are not permitted under the policy.
The following table provides information regarding our investment securities available for sale at the dates indicated.
 
December 31, 2014
 
December 31, 2013
 
December 31, 2012
 
Fair Value
 
% of
Total
Investments
 
Fair Value
 
% of
Total
Investments
 
Fair Value
 
% of
Total
Investments
 
(Dollars in thousands)
U.S. Treasury and U.S. Government-sponsored agencies
$
21,427

 
2.9
%
 
$
6,039

 
3.7
%
 
$
11,035

 
7.7
%
Municipal securities
173,037

 
23.3

 
49,060

 
30.1

 
47,360

 
32.8

Mortgage backed securities and collateralized mortgage obligations-residential:
 
 
 
 
 
 
 
 
 
 
 
U.S. Government-sponsored agencies
542,399

 
73.0

 
108,035

 
66.2

 
85,898

 
59.5

Corporate obligations
4,010

 
0.5

 

 

 

 

Mutual funds and other equities
1,973

 
0.3

 

 

 

 

Total
$
742,846

 
100.0
%
 
$
163,134

 
100.0
%
 
$
144,293

 
100.0
%


15

Table of Contents


The following table provides information regarding our investment securities available for sale, by contractual maturity, at December 31, 2014.
 
Less Than One 
Year
 
Over One to Five 
Years
 
Over Five to Ten 
Years
 
Over Ten Years
 
Fair 
Value
 
Weighted
Average
Yield(1)
 
Fair 
Value
 
Weighted
Average
Yield(1)
 
Fair 
Value
 
Weighted
Average
Yield(1)
 
Fair 
Value
 
Weighted
Average
Yield(1)
 
(Dollars in thousands)
U.S. Treasury and U.S. Government-sponsored agencies
$

 
%
 
$
20,836

 
1.04
%
 
$
591

 
1.95
%
 
$

 
%
Municipal securities
4,171

 
1.93

 
26,360

 
2.50

 
65,805

 
3.26

 
76,701

 
3.76

Mortgage backed securities and collateralized mortgage obligations-residential:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. Government-sponsored agencies

 

 
8,601

 
2.40

 
81,540

 
1.81

 
452,258

 
2.09

Corporate obligations

 

 

 

 
4,010

 
1.15

 

 

Total
$
4,171

 
1.93
%
 
$
55,797

 
1.91
%
 
$
151,946

 
2.42
%
 
$
528,959

 
2.32
%
(1)Taxable equivalent weighted average yield.

The following table provides information regarding our investment securities held to maturity at the dates indicated.
 
 
December 31, 2014
 
December 31, 2013
 
December 31, 2012
 
 
Amortized
Cost
 
% of
Total
Investments
 
Amortized
Cost
 
% of
Total
Investments
 
Amortized
Cost
 
% of
Total
Investments
 
 
(Dollars in thousands)
U.S. Treasury and U.S. Government-sponsored agencies
 
$
1,591

 
4.4
%
 
$
1,687

 
4.7
%
 
$
1,740

 
17.2
%
Municipal securities
 
22,486

 
62.8

 
24,290

 
67.2

 
2,946

 
29.2

Mortgage backed securities and collateralized mortgage obligations-residential:
 
 
 
 
 
 
 
 
 
 
 
 
U.S. Government-sponsored agencies
 
10,866

 
30.4

 
9,129

 
25.2

 
4,245

 
42.0

Private residential collateralized mortgage obligations
 
871

 
2.4

 
1,048

 
2.9

 
1,168

 
11.6

Total
 
$
35,814

 
100.0
%
 
$
36,154

 
100.0
%
 
$
10,099

 
100.0
%


16

Table of Contents


The following table provides information regarding our investment securities held to maturity, by contractual maturity, at December 31, 2014.
 
Less Than One 
Year
 
Over One to Five 
Years
 
Over Five to Ten 
Years
 
Over Ten Years
 
Amortized
Cost
 
Weighted
Average
Yield(1)
 
Amortized
Cost
 
Weighted
Average
Yield(1)
 
Amortized
Cost
 
Weighted
Average
Yield(1)
 
Amortized
Cost
 
Weighted
Average
Yield(1)
 
(Dollars in thousands)
U.S. Treasury and U.S. Government-sponsored agencies
$

 
%
 
$
492

 
3.76
%
 
$
1,099

 
3.91
%
 
$

 
%
Municipal securities
2,895

 
2.53

 
8,826

 
3.05

 
10,557

 
3.88

 
208

 
5.61

Mortgage backed securities and collateralized mortgage obligations-residential:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. Government-sponsored agencies

 

 
508

 
2.56

 
6,902

 
3.25

 
3,456

 
2.88

Private residential collateralized mortgage obligations

 

 

 

 

 

 
871

 
5.95

Total
$
2,895

 
2.53
%
 
$
9,826

 
3.06
%
 
$
18,558

 
3.64
%
 
$
4,535

 
3.59
%
(1)Taxable equivalent weighted average yield.

The Bank is required to maintain an investment in the stock of the Federal Home Loan Bank (“FHLB”) of Seattle in an amount equal to the greater of $500,000 or 0.50% of residential mortgage loans and pass-through securities or an advance requirement to be confirmed on the date of the advance and 5.0% of the outstanding balance of mortgage loans sold to the FHLB of Seattle. At December 31, 2014 the Bank was required to maintain an investment in the stock of FHLB of Seattle of at least $3.3 million and had an investment in FHLB stock carried at a cost basis (par value) of $12.2 million.
Consistent with its accounting policy, the Company evaluated its investment in FHLB of Seattle stock for other-than-temporary impairment. The Company took into consideration that in September 2012, the FHLB of Seattle announced that it had been reclassified as adequately capitalized by its regulator, the Federal Housing Finance Agency(“FHFA”). Further, during the year ended December 31, 2012, the FHFA granted the FHLB of Seattle authority to repurchase up to $25 million of excess capital stock per quarter at par ($100 per share), provided they receive a non-objection for each quarter’s repurchase from the FHFA. The FHLB of Seattle had been repurchasing stock throughout 2013 and 2014. On December 22, 2014 the FHLB of Seattle and the FHLB of Des Moines announced that the FHFA had approved their merger application submitted on October 31, 2014, subject to satisfaction of specific closing conditions set forth in the FHFA approval letter, including the receipt of approvals by members of both FHLBs. The voting process for both FHLBs is anticipated to conclude in late February 2015. The boards of directors of both FHLBs have unanimously approved the proposed merger. The combined FHLB would be headquartered in Des Moines and maintain a regional office in Seattle. The members of the combined organization would have access to an enhanced suite of products and services and benefit from increased economies of scale and greater risk diversification.
Based on the Company’s evaluation of the underlying investment, including the long-term nature of the investment, the liquidity position of the FHLB of Seattle, the proposed FHLB merger and the Company’s intent and ability to hold the investment for a period of time sufficient to recover the par value, the Company did not recognize an other-than-temporary impairment loss on its FHLB of Seattle stock during the years ended December 31, 2014,

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2013 and 2012. Despite improvements in the FHLB of Seattle’s financial condition, any deterioration in the FHLB of Seattle’s financial position may result in future impairment losses.
Deposit Activities and Other Sources of Funds
General.    Our primary sources of funds are deposits, loan repayments and borrowings. Scheduled loan repayments are a relatively stable source of funds, while deposits and unscheduled loan prepayments, which are influenced significantly by general interest rate levels, interest rates available on other investments, competition, economic conditions, and other factors are not. Customer deposits remain an important source of funding, but these balances have been influenced in the past by adverse market conditions in the industry and may be affected by future developments such as interest rate fluctuations and new competitive pressures. In addition to customer deposits, management may utilize brokered deposits on an as-needed basis.
Borrowings may also be used on a short-term basis to compensate for reductions in other sources of funds (such as deposit inflows at less than projected levels). Borrowings may also be used on a longer-term basis to support expanded lending activities and match the maturity of repricing intervals of assets. In addition, the Company utilizes repurchase agreements as a supplement to other funding sources.
During the year ended December 31, 2014, non-maturity deposits (total deposits less certificate of deposit accounts) increased by $1.29 billion, or 118.5%, to $2.38 billion from $1.09 billion at December 31, 2013. The increase was primarily a result of the non-maturity deposits acquired in the Washington Banking Merger. The percentage of non-maturity deposits to total deposits increased to 81.9% at December 31, 2014 compared to 77.9% at December 31, 2013. As a result of this increase, the certificate of deposit accounts to total deposits decreased to 18.1% at December 31, 2014 from 22.1% at December 31, 2013.
Deposit Activities.    We offer a variety of deposit accounts designed to attract both short-term and long-term deposits. These accounts include noninterest demand accounts, negotiable order of withdrawal (“NOW”) accounts, money market accounts, savings accounts and certificates of deposit (“CDs”). These accounts, with the exception of noninterest demand accounts, generally earn interest at rates established by management based on competitive market factors and management’s desire to increase or decrease certain types or maturities of deposits. The major categories of deposit accounts are described below.
Noninterest Demand Deposits.    Noninterest demand deposits are noninterest bearing and may be charged service fees based on activity and balances.
NOW Accounts.    NOW accounts are interest bearing and may be charged service fees based on activity and balances. NOW accounts pay interest, but require a higher minimum balance to avoid service charges.
Money Market Accounts.    Money market accounts pay a variable interest rate that is tiered depending on the balance maintained in the account. Minimum opening balances vary.
Savings Accounts.    We offer savings accounts that allow for unlimited deposits and withdrawals, provided that a $300 minimum balance is maintained.
CDs.    We offer several types of CDs with maturities ranging from three months to five years, which require a minimum deposit of $2,500. Negotiable CDs are offered in amounts of $100,000 or more for terms of 30 days to five years.

The following table provides the balances outstanding for each major category of deposits at the dates indicated:
 
 
December 31, 2014
 
December 31, 2013
 
December 31, 2012
 
 
Amount
 
Percent
 
Amount
 
Percent
 
Amount
 
Percent
 
 
(Dollars in thousands)
Noninterest demand deposits
 
$
709,673

 
24.4
%
 
$
349,902

 
25.0
%
 
$
247,048

 
22.1
%
NOW accounts
 
793,362

 
27.3

 
352,051

 
25.2

 
303,487

 
27.2

Money market accounts
 
520,065

 
17.9

 
232,016

 
16.6

 
157,728

 
14.1

Savings accounts
 
357,834

 
12.3

 
155,790

 
11.1

 
120,781

 
10.8

Total non-maturity deposits
 
2,380,934

 
81.9

 
1,089,759

 
77.9

 
829,044

 
74.2

CDs
 
525,397

 
18.1

 
309,430

 
22.1

 
288,927

 
25.8

Total deposits
 
$
2,906,331

 
100.0
%
 
$
1,399,189

 
100.0
%
 
$
1,117,971

 
100.0
%


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The following table provides the average balances outstanding and the weighted average interest rates for each major category of deposits for the years indicated:
 
 
Years Ended December 31,
 
 
2014
 
2013
 
2012
 
 
Average
Balance
 
Average
Yield/Rate
 
Average
Balance
 
Average
Yield/Rate
 
Average
Balance
 
Average
Yield/Rate
 
 
(Dollars in thousands)
NOW accounts and money market accounts
 
$
1,049,078

 
0.18
%
 
$
541,793

 
0.19
%
 
$
466,268

 
0.27
%
Savings accounts
 
282,150

 
0.09

 
143,412

 
0.11

 
113,119

 
0.18

CDs
 
494,948

 
0.60

 
307,464

 
0.81

 
306,772

 
0.98

Total interest bearing deposits
 
1,826,176

 
0.28

 
992,669

 
0.37

 
886,159

 
0.50

Noninterest demand deposits
 
574,692

 

 
308,582

 

 
237,888

 

Total deposits
 
$
2,400,868

 
0.21
%
 
$
1,301,251

 
0.28
%
 
$
1,124,047

 
0.40
%

The following table shows the amount and maturity of certificates of deposit of $100,000 or more:
 
December 31, 2014
 
(In thousands)
Remaining maturity:
 
Three months or less
$
1,441

Over three months through twelve months
167,863

Over twelve months through three years
79,922

Over three years
17,356

Total
$
266,582

Borrowings.    Deposits are the primary source of funds for our lending and investment activities and our general business purposes. We rely upon advances from the FHLB to supplement our supply of lendable funds and meet deposit withdrawal requirements. The FHLB of Seattle serves as one of our secondary sources of liquidity. Advances from the FHLB of Seattle are typically secured by our first lien one-to-four family residential loans, commercial real estate loans and stock issued by the FHLB, which is owned by us. At December 31, 2014, the Bank maintained an uncommitted credit facility with the FHLB of Seattle of $374.3 million and an uncommitted credit facility with the Federal Reserve Bank of San Francisco of $53.2 million, of which there were no advances or borrowings outstanding. The Bank also maintains advance lines with Zions Bank, Wells Fargo Bank, US Bank and Pacific Coast Bankers’ Bank to purchase federal funds of up to $43.0 million as of December 31, 2014. At December 31, 2014 we had securities sold under agreement to repurchase of $32.2 million which were secured by investment securities available for sale.
The FHLB functions provide credit for member financial institutions. As a member, we are required to own capital stock in the FHLB and are authorized to apply for advances on the security of such stock and certain of our mortgage loans and other assets (principally securities which are obligations of, or guaranteed by, the United States) provided certain standards related to creditworthiness have been met. Advances are made pursuant to several different programs. Each credit program has its own interest rate and range of maturities. Depending on the program, limitations on the amount of advances are based either on a fixed percentage of an institution’s net worth or on the FHLB’s assessment of the institution’s creditworthiness. Under its current credit policies, the FHLB of Seattle limits advances to 20% of the Bank's assets.
There were no FHLB advances or federal funds purchased for the years ended December 31, 2014, 2013 or 2012.
Supervision and Regulation
We are subject to extensive Federal and Washington State legislation, regulation, and supervision. These laws and regulations are primarily intended to protect depositors, the FDIC and shareholders. The laws and regulations affecting banks and bank holding companies have changed significantly particularly in connection with the enactment

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of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”). Among other changes, the Dodd-Frank Act established the Consumer Protection Financial Bureau (“CFPB”) as an independent bureau of the Board of Governors of the Federal Reserve System (“Federal Reserve”). The CFPB assumed responsibility for the implementation of the federal financial consumer protection and fair lending laws and regulations and has authority to impose new requirements. See “—Other Regulatory Developments—The Dodd-Frank Act” herein for a discussion of this legislation. Any change in applicable laws, regulations, or regulatory policies may have a material effect on our business, operations, and prospects. We cannot predict the nature or the extent of the effects on our business and earnings that any fiscal or monetary policies or new Federal or State legislation may have in the future.
The following is a summary discussion of certain laws and regulations applicable to Heritage Financial and Heritage Bank which is qualified in its entirety by reference to the actual laws and regulations.
Heritage Financial.    As a registered bank holding company with the Federal Reserve, we are subject to comprehensive regulation and supervision under the Bank Holding Company Act of 1956, as amended. This regulation and supervision is generally intended to ensure that we limit our activities to those allowed by law and that we operate in a safe and sound manner without endangering the financial health of Heritage Bank. As a bank holding company supervised by the Federal Reserve, we are required to file annual and periodic reports with the Federal Reserve and provide additional information as the Federal Reserve may require. The Federal Reserve may examine us, and any of our subsidiaries, and assess us for the cost of such examination.
The Federal Reserve has extensive enforcement authority over bank holding companies, including the ability to assess civil money penalties and to issue cease and desist or removal orders. The Federal Reserve may also order termination of non-banking activities by non-banking subsidiaries of bank holding companies, or divestiture of ownership and control of a non-banking subsidiary by a bank holding company. Some violations may also result in criminal penalties.
Federal Reserve policy provides that a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe or unsound manner. Federal Reserve policy further provides that in its capacity as a source of strength to its subsidiary banks, a bank holding company should have the ability to provide financial assistance to its subsidiary banks during periods of financial distress. A bank holding company’s failure to meet its obligation to serve as a source of strength to its subsidiary banks is generally considered by the Federal Reserve to be an unsafe and unsound banking practice or a violation of the Federal Reserve’s regulations or both. The Dodd-Frank Act also extends the "source of strength" doctrine and requires the issuance of implementing regulations by the federal banking regulatory agencies.
Under the prompt corrective action provisions of the Federal Deposit Insurance Act ("FDIA"), a bank holding company with an undercapitalized subsidiary bank must guarantee, within limitations, the capital restoration plan that is required to be implemented of its undercapitalized subsidiary bank. If an undercapitalized subsidiary bank fails to file an acceptable capital restoration plan or fails to implement an accepted plan the Federal Reserve may prohibit the bank holding company or its undercapitalized subsidiary bank from, among other restrictions, paying any dividend or making any other form of capital distribution without the prior approval of the Federal Reserve. In addition, the Federal Reserve policy provides that a bank holding company may pay cash dividends only to the extent that the company’s net income for the past year is sufficient to cover both the cash dividend and a rate of earnings retention that is consistent with the company’s capital needs, asset quality and overall financial condition. In addition, under Washington corporate law, companies generally may not pay dividends if after that payment the company would not be able to pay its liabilities as they become due in the usual course of business, or its total assets would be less than its total liabilities.
We, and any subsidiaries which we may control, are considered “affiliates” within the meaning of the Federal Reserve Act, and transactions between our bank subsidiary and affiliates are subject to numerous restrictions. With some exceptions, we and our subsidiaries are prohibited from tying the provision of various products or services, such as extensions of credit, to other products or services offered by us, or our affiliates.
Bank regulations require bank holding companies and banks to maintain a minimum “leverage” ratio of core capital to adjusted quarterly average total assets of at least 4%. In addition, banking regulators have adopted risk-based capital guidelines under which risk percentages are assigned to various categories of assets and off-balance sheet items to calculate a risk-adjusted capital ratio. Tier 1 capital generally consists of common stockholders’ equity (which does not include unrealized gains and losses on investment securities available for sale), less goodwill and certain identifiable intangible assets. Tier 2 capital includes Tier 1 capital plus the allowance for loan losses and subordinated debt, both subject to some limitations. Regulatory risk-based capital guidelines require Tier 1 capital of 4% of risk-adjusted assets and minimum total capital ratio (combined Tier 1 and Tier 2) of 8% of risk-adjusted assets. In July 2013, the Federal Reserve and the FDIC approved a new rule that will substantially amend the regulatory risk-based capital rules to implement the Basel III regulatory capital reforms and changes required by the Dodd-Frank Act.

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For additional information, see “—Capital Adequacy” below.
Subsidiary Bank.    Heritage Bank is a Washington-chartered commercial bank, the deposits of which are insured by the FDIC. Heritage Bank is subject to regulation by the FDIC and the Division.
Applicable Federal and State statutes and regulations which govern a bank’s operations relate to minimum capital requirements, required reserves against deposits, investments, loans, legal lending limits, mergers and consolidation, borrowings, issuance of securities, payment of dividends, establishment of branches, and other aspects of its operations, among other things. The Division and the FDIC also have authority to prohibit banks under their supervision from engaging in what they consider to be unsafe and unsound practices.
The Bank is required to file periodic reports with the FDIC and the Division, and is subject to periodic examinations and evaluations by those regulatory authorities. Based upon these evaluations, the regulators may revalue the assets of an institution and require that it establish specific reserves to compensate for the differences between the determined value and the book value of such assets. These examinations must be conducted every 12 months, except that well-capitalized banks may be examined every 18 months. The FDIC and the Division may each accept the results of an examination by the other in lieu of conducting an independent examination.
Dividends paid by the Bank provide substantially all of our cash flow. Applicable Federal and Washington State regulations restrict capital distributions by our Bank, including dividends. Such restrictions are tied to the institution’s capital levels after giving effect to such distributions. For an additional discussion of restrictions on the payment of dividends, see “Item 5. Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities” herein.
Capital Adequacy.    The Federal Reserve and FDIC have issued substantially similar risk-based and leverage capital guidelines applicable to bank holding companies and banks. In addition, these regulatory agencies may from time to time require that a bank holding company or bank maintain capital above the minimum levels, based on its financial condition or actual or anticipated growth.
The Federal Reserve’s risk-based guidelines for bank holding companies establish a two-tier capital framework. Tier 1 capital generally consists of common stockholders’ equity (which does not include unrealized gains and losses on investment securities available for sale), less goodwill and certain identifiable intangible assets. Tier 2 capital includes Tier 1 capital plus the allowance for loan losses and subordinated debt, both subject to some limitations. The sum of Tier 1 and Tier 2 capital represents qualifying total capital, at least 50% of which must consist of Tier 1 capital.
Risk-based capital ratios are calculated by dividing Tier 1 and total capital by risk-weighted assets. Assets and off-balance sheet exposures are assigned to one of four categories of risk-weights, based primarily on relative credit risk. The minimum Tier 1 risk- based capital ratios under these guidelines at December 31, 2014 were 4% and 8%, respectively. At December 31, 2014, we had consolidated Tier 1 risk-based capital and total risk-based capital of 13.9% and 15.1%, respectively.
The Federal Reserve’s leverage capital guidelines establish a minimum leverage ratio determined by dividing Tier 1 capital by adjusted average total assets. The minimum leverage ratio is 3% for bank holding companies that meet certain specified criteria, including having the highest regulatory rating. All other bank holding companies generally are required to maintain a leverage ratio of at least 4%. At December 31, 2014, we had a consolidated leverage ratio of 10.2%.
In July 2013, the Federal banking regulators approved a final rule to implement the revised capital adequacy standards of the Basel Committee on Banking Supervision, commonly called Basel III, and to address relevant provisions of the Dodd-Frank Act. The final rule includes new risk-based capital and leverage ratios, which are effective January 1, 2015, and revise the definition of what constitutes “capital” for purposes of calculating those ratios. The proposed new minimum capital level requirements applicable to the Company and the Bank will be: (i) a new common equity Tier 1 capital ratio of 4.5%; (ii) a Tier 1 capital ratio of 6% (increased from 4%); (iii) a total capital ratio of 8% (unchanged from current rules); and (iv) a Tier 1 leverage ratio of 4% for all institutions. The rule eliminates the inclusion of certain instruments, such as trust preferred securities, from Tier 1 capital. Instruments issued prior to May 19, 2010 will be grandfathered for companies with consolidated assets of $15 billion or less. The rule also establishes a “capital conservation buffer” of 2.5% above the new regulatory minimum capital requirements, which must consist entirely of common equity Tier 1 capital and would result in the following minimum ratios: (i) a common equity Tier 1 capital ratio of 7.0%, (ii) a Tier 1 capital ratio of 8.5%, and (iii) a total capital ratio of 10.5%. The new capital conservation buffer requirement will be phased in beginning in January 2016 at 0.625% of risk-weighted assets and would increase by that amount each year until fully implemented in January 2019. An institution would be subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses if its capital level falls below the buffer amount. These limitations would establish a maximum percentage of eligible retained income that could be utilized for such actions.

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The FDIC may impose additional restrictions on institutions that are undercapitalized and generally is authorized to reclassify an institution into a lower capital category and impose the restrictions applicable to such category if the institution is engaged in unsafe or unsound practices or is in an unsafe or unsound condition. An institution is deemed “well capitalized” if it has at least a 5.0% Tier 1 capital ratio, a 6.0% Tier 1 risk-based capital ratio and 10.0% total risk-based capital ratio. At December 31, 2014, the Bank’s current capital levels exceed the required capital amounts to be considered “well capitalized” and we believe it also meets the fully-phased in minimum capital requirements, including the related capital conservation buffers, as required by the Basel III capital rules.
For a complete description of the Company’s and the Bank's required and actual capital levels as of December 31, 2014, see Note 23 - Regulatory Capital Requirements of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data.”
Prompt Corrective Action.    Federal statutes establish a supervisory framework based on five capital categories: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. An institution’s category depends upon where its capital levels are in relation to relevant capital measures, which include a risk-based capital measure, a leverage ratio capital measure and certain other factors. The federal banking agencies have adopted regulations that implement this statutory framework. Under these regulations, an institution is treated as well capitalized if its ratio of total capital to risk-weighted assets is 10% or more, its ratio of core capital to risk-weighted assets is 6% or more, its ratio of core capital to adjusted total assets (leverage ratio) is 5% or more, and it is not subject to any federal supervisory order or directive to meet a specific capital level. In order to be adequately capitalized, an institution must have a total risk-based capital ratio of not less than 8%, a core capital to risk-weighted assets ratio of not less than 4%, and a leverage ratio of not less than 4%. An institution that is not well capitalized is subject to certain restrictions on brokered deposits, including restrictions on the rates it can offer on its deposits generally. Any institution which is neither well capitalized nor adequately capitalized is considered undercapitalized.
Undercapitalized institutions are subject to certain prompt corrective action requirements, regulatory controls and restrictions which become more extensive as an institution becomes more severely undercapitalized. Failure by Heritage Bank to comply with applicable capital requirements would, if unremedied, result in progressively more severe restrictions on its activities and lead to enforcement actions, including, but not limited to, the issuance of a capital directive to ensure the maintenance of required capital levels and, ultimately, the appointment of the FDIC as receiver or conservator. Banking regulators will take prompt corrective action with respect to depository institutions that do not meet minimum capital requirements. Additionally, approval of any regulatory application filed for their review may be dependent on compliance with capital requirements.
As of December 31, 2014, the Bank met the requirements to be classified as “well capitalized.” See Note 23 - Regulatory Capital Requirements of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data.”
Federal law generally bars institutions which are not well capitalized from soliciting or accepting brokered deposits bearing interest rates significantly higher than prevailing market rates.
The recently adopted final rule to strengthen regulatory capital standards will adjust the prompt corrective action categories accordingly.
Deposit Insurance and Other FDIC Programs.    The deposits of the Bank are insured up to applicable limits by the Deposit Insurance Fund (“DIF”), which is administered by the FDIC. The FDIC is an independent federal agency that insures the deposits, up to applicable limits, of depository institutions. As insurer of the Bank's deposits, the FDIC has supervisory and enforcement authority over Heritage Bank and this insurance is backed by the full faith and credit of the United States government. As insurer, the FDIC imposes deposit insurance premiums and is authorized to conduct examinations of and to require reporting by institutions insured by the FDIC. It also may prohibit any institution insured by the FDIC from engaging in any activity determined by regulation or order to pose a serious risk to the institution and the DIF. The FDIC also has the authority to initiate enforcement actions and may terminate the deposit insurance if it determines that an institution has engaged in unsafe or unsound practices or is in an unsafe or unsound condition.
The Dodd-Frank Act requires the FDIC’s deposit insurance assessments to be based on assets instead of deposits. The FDIC issued rules under which the assessment base for a bank is equal to its total average consolidated assets less average tangible capital. The FDIC assessment rates range from approximately five basis points to 35 basis points, depending on applicable adjustments for unsecured debt issued by an institution and brokered deposits (and to further adjustment for institutions that hold unsecured debt of other FDIC-insured institutions), until such time as the FDIC’s reserve ratio equals 1.15%. Once the FDIC’s reserve ratio reaches 1.15% and the reserve ratio for the immediately prior assessment period is less than 2.0%, the applicable assessment rates may range from three basis

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points to 30 basis points (subject to adjustments as described above). If the reserve ratio for the prior assessment period is equal to, or greater than 2.0% and less than 2.5%, the assessment rates may range from two basis points to 28 basis points and if the prior assessment period is greater than 2.5%, the assessment rates may range from one basis point to 25 basis points (in each case subject to adjustments as described above). No institution may pay a dividend if it is in default on its federal deposit insurance assessment.
As insurer, the FDIC is authorized to conduct examinations of and to require reporting by FDIC-insured institutions. It also may prohibit any FDIC-insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious threat to the DIF. The FDIC also has the authority to take enforcement actions against banks and savings associations.
Other Regulatory Developments.    Significant federal banking legislation has been enacted in recent years. The following summarizes some of the recent significant federal banking legislation.
The Dodd-Frank Act:    The Dodd-Frank-Act imposes new restrictions and an expanded framework of regulatory oversight for financial institutions, including depository institutions and implements new capital regulations that we will become subject to and that are discussed above under “- Capital Adequacy.”
The federal banking and securities regulators have issued final rules to implement Section 619 of the Dodd-Frank Act (the “Volcker Rule”) pursuant to the Dodd-Frank Act. Generally, subject to a transition period and certain exceptions, the Volcker Rule restricts insured depository institutions and their affiliated companies from engaging in short-term proprietary trading of certain securities, investing in funds with collateral comprised of less than 100% loans that are not registered with the Securities and Exchange Commission (“SEC”) and from engaging in hedging activities that do not hedge a specific identified risk. After the transition period, the Volcker Rule prohibitions and restrictions will apply to banking entities, including the Company, unless an exception applies. We are continuously reviewing our investment portfolio to determine if changes to our investment strategies may be required in order to comply with the various provisions of the Volcker Rule regulations.
In addition, among other changes, the Dodd-Frank Act requires public companies, like us, to (i) provide their shareholders with a non-binding vote (a) at least once every three years on the compensation paid to executive officers and (b) at least once every six years on whether they should have a “say on pay” vote every one, two or three years; (ii) have a separate, non-binding shareholder vote regarding golden parachutes for named executive officers when a shareholder vote takes place on mergers, acquisitions, dispositions or other transactions that would trigger the parachute payments; (iii) provide disclosure in annual proxy materials concerning the relationship between the executive compensation paid and the financial performance of the issuer; and (iv) amend Item 402 of Regulation S-K to require companies to disclose the ratio of the Chief Executive Officer's annual total compensation to the median annual total compensation of all other employees. For certain of these changes, the implementing regulations have not been promulgated, so the full impact of the Dodd-Frank Act on public companies cannot be determined at this time.
Sarbanes-Oxley Act.    As a public company that files periodic reports with the SEC, under the Securities Exchange Act of 1934, Heritage is subject to the Sarbanes-Oxley Act of 2002, which addresses, among other issues, corporate governance, auditing and accounting, executive compensation and enhanced and timely disclosure of corporate information.
The Sarbanes-Oxley Act represents significant federal involvement in matters traditionally left to state regulatory systems, such as the regulation of the accounting profession, and to state corporate law, such as the relationship between a board of directors and management and between a board of directors and its committees. Our policies and procedures have been updated to comply with the requirements of the Sarbanes-Oxley Act.
Website Access to Company Reports
We post publicly available reports required to be filed with the SEC on our website, www.HF-WA.com, as soon as reasonably practicable after filing such reports with the SEC. The required reports are available free of charge through our website.
Code of Ethics
We have adopted a Code of Ethics that applies to our principal executive officer, principal financial officer and controller. We have posted the text of our code of ethics at www.HF-WA.com in the section titled Investor Information: Corporate Governance. Any waivers of the code of ethics will be publicly disclosed to shareholders.
Competition
We compete for loans and deposits with other commercial banks, credit unions, mortgage bankers, and other institutions in the scope and type of services offered, interest rates paid on deposits, pricing of loans, and number and locations of branches, among other things. Many of our competitors have substantially greater resources than we do.

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Particularly in times of high or rising interest rates, we also face significant competition for investors’ funds from short-term money market securities and other corporate and government securities.
We compete for loans principally through the range and quality of the services we provide, interest rates and loan fees, and the locations of our Bank's branches. We actively solicit deposit-related clients and compete for deposits by offering depositors a variety of savings accounts, checking accounts, cash management and other services.
Employees
We had 748 full-time equivalent employees at December 31, 2014. We believe that employees play a vital role in the success of a service company. Employees are provided with a variety of benefits such as medical, vision, dental and life insurance, a retirement plan, and paid vacations and sick leave. None of our employees are covered by a collective bargaining agreement.
Executive Officers
The following table sets forth certain information with respect to the executive officers of the Company at December 31, 2014.
Name
 
Age as of
December 31,
2014
 
Position
 
Has Served the 
Company or Heritage Bank Since
Brian L. Vance
 
60

 
President and Chief Executive Officer of Heritage; Chief Executive Officer of Heritage Bank
 
1996
Jeffrey J. Deuel
 
56

 
Executive Vice President, Heritage; President and Chief Operating Officer of Heritage Bank
 
2010
Donald J. Hinson
 
53

 
Executive Vice President and Chief Financial Officer of Heritage and Heritage Bank
 
2005
David A. Spurling
 
61

 
Executive Vice President and Chief Credit Officer of Heritage and Heritage Bank
 
1999
Bryan McDonald (1)
 
43

 
Executive Vice President and Chief Lending Officer of Heritage Bank
 
2014
(1)
Former executive officer of Washington Banking Company.
The business experience of each executive officer is set forth below.
Brian L. Vance is the President and Chief Executive Officer of Heritage and Chief Executive Officer of Heritage Bank as well as a director of Heritage.  Mr. Vance was appointed President and Chief Executive Officer of Heritage and Heritage Bank in 2006.  In 2003, Mr. Vance was appointed President and Chief Executive Officer of Heritage Bank and in 1998, Mr. Vance was named President and Chief Operating Officer of Heritage Bank. Mr. Vance joined Heritage Bank in 1996 as its Executive Vice President and Chief Credit Officer. Prior to joining Heritage Bank, Mr. Vance was employed for 24 years with West One Bank, a bank with offices in Idaho, Utah, Oregon and Washington. Prior to leaving West One, he was Senior Vice President and Regional Manager of Banking Operations for the south Puget Sound region.
Jeffrey J. Deuel was promoted to President and Chief Operating Officer of Heritage Bank and Executive Vice President of Heritage in September 2012.  In November 2010, Mr. Deuel was named Executive Vice President and Chief Operating Officer of Heritage Bank and Executive Vice President of the Company. Mr. Deuel joined Heritage Bank in February 2010 as Executive Vice President. Mr. Deuel came to the Company with 28 years of banking experience and most recently held the position of Executive Vice President Commercial Operations with JPMorgan Chase, formerly Washington Mutual. Prior to joining Washington Mutual Mr. Deuel was based in Philadelphia where he worked for Bank United, First Union Bank, CoreStates Bank, and First Pennsylvania Bank. During his career Mr. Deuel held a variety of leadership positions in commercial banking including lending, retail and support services, corporate strategies, credit administration, and portfolio management. He earned his Bachelor’s degree at Gettysburg College.
Donald J. Hinson became Executive Vice President and Chief Financial Officer of Heritage and Heritage Bank in September 2012. In 2007, Mr. Hinson was appointed the Senior Vice President and Chief Financial Officer of Heritage and Heritage Bank. Mr. Hinson joined Heritage Bank in 2005 as Vice President and Controller. Prior to that, he served

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in the banking audit practice of local and national accounting firms of Knight, Vale and Gregory and RSM McGladrey from 1994 to 2005. Mr. Hinson holds a Bachelors of Science degree in Accounting from Central Washington University and is a licensed Certified Public Accountant.
David A. Spurling became Executive Vice President and Chief Credit Officer of Heritage and Heritage Bank in January 2014. Prior to that, he was the Senior Vice President and Chief Credit Officer of Heritage Bank beginning in 2007.  Mr. Spurling joined Heritage Bank in 2001 as a commercial lender, followed by a role as a commercial team leader. He began his banking career as a middle market lender at Seafirst Bank, followed by positions as a commercial lender at Bank of America in Small Business Banking and as a regional manager for Bank of America’s government-guaranteed lending division. Mr. Spurling holds a Master’s Degree in Business Administration from the University of Washington and is Credit Risk Certified by the Risk Management Association.
Bryan McDonald became Executive Vice President and Chief Lending Officer of Heritage Bank upon completion of the Washington Banking Merger effective on May 1, 2014. Prior to that, Mr. McDonald was President and Chief Executive Officer of Whidbey Island Bank since January 1, 2012. Mr. McDonald joined Whidbey Island Bank in 2006 as Commercial Banking Manager and he served as Senior Vice President and Chief Operating Officer of Whidbey Island Bank from April 1, 2010 until his promotion to Executive Vice President on August 26, 2010. Mr. McDonald has been serving in the banking industry since 1994, including in regional commercial lending management roles since 1996 for Washington Mutual and Peoples Bank. Mr. McDonald holds a Bachelor's and Master’s Degree in Business Administration from Washington State University.

ITEM 1A.     RISK FACTORS
We assume and manage a certain degree of risk in order to conduct our business strategy. The following provides a discussion of certain risks that management believes are specific to our business. This discussion should not be viewed as an all inclusive list or in any particular order.
Our strategy of pursuing acquisitions and de novo branching exposes us to financial and operational risks that could adversely affect us.
We are pursuing a strategy of supplementing organic growth by acquiring other financial institutions or their businesses that we believe will help us fulfill our strategic objectives and enhance our earnings. There are risks associated with this strategy, however, including the following:
we may be exposed to potential asset quality issues or unknown or contingent liabilities of the banks, businesses, assets and liabilities we acquire. If these issues or liabilities exceed our estimates, our results of operations and financial condition may be materially negatively affected;
prices at which acquisitions can be made fluctuate with market conditions. We have experienced times during which acquisitions could not be made in specific markets at prices we considered acceptable and expect that we may continue to experience this condition in the future;
the acquisition of other entities generally requires integration of systems, procedures and personnel of the acquired entity into our company to make the transaction economically successful. This integration process is complicated and time consuming and can also be disruptive to the customers of the acquired business. If the integration process is not conducted successfully and with minimal effect on the acquired business and its customers, we may not realize the anticipated economic benefits of an acquisition within the expected time frame, and we may lose customers or employees of the acquired business. We may also experience greater than anticipated customer losses even if the integration process is successful. These risks are present in our completed FDIC-assisted transactions involving our assumption of deposits and the acquisition of assets of Cowlitz Bank and Pierce Commercial Bank in July 2010 and November 2010, respectively; and in the completed open-bank acquisitions of NCB and Valley Community Bancshares in January 2013 and July 2013, respectively, and in the merger of Washington Banking Company in May 2014;
to finance an acquisition, we may borrow funds, thereby increasing our leverage and diminishing our liquidity, or raise additional capital, which could dilute the interests of our existing shareholders;
we completed two acquisitions during 2010, two acquisitions during 2013 and one merger in 2014 that enhanced our rate of growth. We may not be able to continue to sustain our past rate of growth or to grow at all in the future;
we expect our net income will increase following our acquisitions, however, we also expect our general and administrative expenses and consequently our efficiency ratios will also increase. Ultimately, we would expect our efficiency ratio to improve; however, if we are not successful in our integration

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process, this may not occur, and our acquisitions or branching activities may not be accretive to earnings in the short or long-term; and
the purchase and assumption agreement and the shared-loss agreements we entered into with the FDIC in connection with the Cowlitz Acquisition and the Pierce Acquisition, have specific, detailed and cumbersome compliance, servicing, notification and reporting requirements. Our failure to comply with the terms of the agreements or to properly service the loans and real estate owned under the requirements of the shared-loss agreements may cause individual loans or large pools of loans to lose eligibility for shared-loss payments from the FDIC. This could result in material losses that are currently not anticipated.
Our business strategy includes significant growth plans, and our financial condition and results of operations could be negatively affected if we are not successful in executing this strategy or if we fail to grow or manage our growth effectively.
We intend to pursue a significant growth strategy for our business. We regularly evaluate potential acquisitions and expansion opportunities. If appropriate opportunities present themselves, we expect to engage in selected acquisitions of financial institutions in the future, including branch acquisitions, or other business growth initiatives or undertakings. There can be no assurance that we will successfully identify appropriate opportunities, that we will be able to negotiate or finance such activities or that such activities, if undertaken, will be successful.
Our growth initiatives may require us to recruit experienced personnel to assist in such initiatives, which will increase our compensation costs. In addition, the failure to identify and retain such personnel would place significant limitations on our ability to successfully execute our growth strategy. To the extent we expand our lending beyond our current market areas, we also could incur additional risk related to those new market areas. We may not be able to expand our market presence in our existing market areas or successfully enter new markets.
If we do not successfully execute our acquisition growth plan, it could adversely affect our business, financial condition, results of operations, reputation and growth prospects. In addition, if we were to conclude that the value of an acquired business had decreased and that the related goodwill had been impaired, that conclusion would result in an impairment of goodwill charge to us, which would adversely affect our results of operations. While we believe we have the executive management resources and internal systems in place to successfully manage our future growth, there can be no assurance that suitable growth opportunities will be available or that we will successfully manage our growth. See “-If the goodwill we have recorded in connection with acquisitions becomes impaired, our earnings and capital could be reduced” and “-Our strategy of pursuing acquisitions and de novo branching exposes us to financial and operational risks that could adversely affect us” for additional risks related to our acquisition strategy.
We operate in a highly regulated environment and may be adversely affected by changes in federal and state laws and regulations.
The financial services industry is extensively regulated. We are subject to extensive examination, supervision and comprehensive regulation by the Federal Reserve and Heritage Bank is subject to examination, supervision and comprehensive regulation by the FDIC and the Division. The Federal Reserve, FDIC and Division govern the activities in which we may engage, primarily for the protection of depositors and the Deposit Insurance Fund. These regulatory authorities have extensive discretion in connection with their supervisory and enforcement activities, including the ability to impose requirements for additional capital, restrictions on operations, the reclassification of assets, and the determination of the adequacy of the allowance for loan losses and level of deposit insurance premiums assessed. In addition, these bank regulators also have the ability to impose additional conditions in the approval of merger and acquisition transactions.
As discussed under “Item 1. Business - Supervision and Regulation - Capital Adequacy” of this Form 10-K, the Dodd-Frank Act has significantly changed the bank regulatory structure and will affect the lending, deposit, investment, trading and operating activities of financial institutions and their holding companies. The Dodd-Frank Act requires various federal agencies to adopt a broad range of new implementing rules and regulations, and to prepare numerous studies and reports for Congress. The federal agencies are given significant discretion in drafting and implementing rules and regulations, and consequently, many of the details and much of the impact of the Dodd-Frank Act may not be known for many months or years. It is difficult at this time to predict when or how any new standards will ultimately be applied to us or what specific impact the Dodd-Frank Act and the yet to be written implementing rules and regulations will have on community banks. However, it is expected that at a minimum they will increase our operating and compliance costs and could increase our noninterest expense.

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We may face increased compliance costs and uncertainty in residential mortgage lending as a result of the adoption of consumer protection regulations by the Consumer Financial Protection Bureau.
The Dodd Frank Act created a new Consumer Financial Protection Bureau (“CFPB”) with broad powers to supervise and enforce consumer protection laws. The CFPB has broad rule-making authority for a wide range of consumer protection laws that apply to all banks and savings institutions, including the authority to prohibit “unfair, deceptive or abusive” acts and practices. The CFPB has issued a rule designed to clarify for lenders how they can avoid monetary damages under the Dodd-Frank Act, which would hold lenders accountable for ensuring a borrower’s ability to repay a mortgage. Loans that meet this “qualified mortgage” definition will be presumed to have complied with the new ability-to-repay standard. Under the CFPB’s rule, a “qualified mortgage” loan must not contain certain specified features, including:
excessive upfront points and fees (those exceeding 3% of the total loan amount, less “bona fide discount points” for prime loans);
interest-only payments;
negative-amortization; and
terms longer than 30 years.
Also, to qualify as a “qualified mortgage,” a borrower’s total debt-to-income ratio may not exceed 43%. Lenders must also verify and document the income and financial resources relied upon to qualify the borrower for the loan and underwrite the loan based on a fully amortizing payment schedule and maximum interest rate during the first five years, taking into account all applicable taxes, insurance and assessments. The CFPB’s rule on qualified mortgages could limit our ability or desire to make certain types of loans or loans to certain borrowers, or could make it more expensive and/or time consuming to make these loans, which could limit our growth or profitability.
Our loan portfolio is concentrated in loans with a higher risk of loss.
Repayment of our commercial business loans, consisting of commercial and industrial loans as well as owner-occupied and non-owner occupied commercial real estate loans, is often dependent on the cash flows of the borrower, which may be unpredictable, and the collateral securing these loans may fluctuate in value.    We offer different types of commercial loans to a variety of businesses with a focus on real estate related industries and businesses in agricultural, healthcare, legal, and other professions. The types of commercial loans offered are business lines of credit, term equipment financing and term real estate loans. We also originate loans that are guaranteed by the Small Business Administration, or SBA, and are a “preferred lender” of the SBA. Commercial business lending involves risks that are different from those associated with real estate lending. Real estate lending is generally considered to be collateral based lending with loan amounts established on predetermined loan to collateral values and liquidation of the underlying real estate collateral being viewed as the primary source of repayment in the event of borrower default. Our commercial business loans are primarily made based on our assessment of the cash flow of the borrower and secondarily on the underlying collateral provided by the borrower. The borrower's cash flow may be unpredictable, and collateral securing these loans may fluctuate in value. Although commercial business loans are often collateralized by equipment, inventory, accounts receivable or other business assets, the liquidation of collateral in the event of default is often an insufficient source of repayment because accounts receivable may be uncollectible and inventories may be obsolete or of limited use, among other things. Accordingly, the repayment of commercial business loans depends primarily on the cash flow and creditworthiness of the borrower and secondarily on the underlying collateral provided by the borrower. In addition, as part of our commercial business lending activities, we originate agricultural loans. Payments on agricultural loans are typically dependent on the profitable operation or management of the related farm property. The success of the farm may be affected by many factors outside the control of the borrower, including adverse weather conditions that prevent the planting of a crop or limit crop yields, declines in market prices for agricultural products and the impact of government regulations. In addition, many farms are dependent on a limited number of key individuals whose injury or death may significantly affect the successful operation of the farm. If the cash flow from a farming operation is diminished, the borrower’s ability to repay the loan may be impaired.
At December 31, 2014, our noncovered commercial business loans (consisting of commercial and industrial loans, owner-occupied commercial real estate loans and non-owner occupied commercial real estate loans) totaled $1.70 billion, or approximately 80.2% of our total noncovered loan portfolio. Approximately $4.7 million, or 0.3%, of our total noncovered commercial business loans were nonperforming at December 31, 2014. The majority of the nonperforming commercial business loans were commercial and industrial loans.
Our non-owner occupied commercial real estate loans, which includes five or more family residential real estate loans, involve higher principal amounts than other loans and repayment of these loans may be dependent on factors outside our control or the control of our borrowers.    We originate commercial and five or more family residential real estate loans for individuals and businesses for various purposes, which are secured by commercial properties.

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These loans typically involve higher principal amounts than other types of loans, and repayment is dependent upon income generated, or expected to be generated, by the property securing the loan in amounts sufficient to cover operating expenses and debt service, which may be adversely affected by changes in the economy or local market conditions. For example, if the cash flow from the borrower’s project is reduced as a result of leases not being obtained or renewed, the borrower’s ability to repay the loan may be impaired.
Commercial and five or more family residential real estate loans also expose us to greater credit risk than loans secured by residential real estate because the collateral securing these loans typically cannot be sold as easily as residential real estate. In addition, many of our commercial and five or more family residential real estate loans are not fully amortizing and contain large balloon payments upon maturity. Such balloon payments may require the borrower to either sell or refinance the underlying property in order to make the payment, which may increase the risk of default or non-payment. If we foreclose on a commercial and five or more family residential real estate loan, our holding period for the collateral typically is longer than for one-to-four family residential loans because there are fewer potential purchasers of the collateral. Additionally, commercial and five or more family residential real estate loans generally have relatively large balances to single borrowers or related groups of borrowers. Accordingly, if we make any errors in judgment in the collectability of our commercial and five or more family residential real estate loans, any resulting charge-offs may be larger on a per loan basis than those incurred with our residential or consumer loan portfolios.
As of December 31, 2014, our non-owner occupied commercial real estate loans totaled $616.8 million, or 29.0% of our total noncovered loan portfolio.
Our real estate construction and land development loans are based upon estimates of costs and value associated with the completed project. These estimates may be inaccurate.    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, our 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 our 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.
As of December 31, 2014, our noncovered real estate construction and land development loans totaled $108.1 million, or 5.1% of our total noncovered loan portfolio. Of these loans, $46.7 million, or 2.2% of our total noncovered loan portfolio, were one-to-four family residential construction related and $61.4 million, or 2.9% of our total noncovered loan portfolio, were five-or-more family residential and commercial property construction related. Approximately $2.7 million, or 2.5%, of our total noncovered construction loans were nonperforming at December 31, 2014.
Our allowance for loan losses may prove to be insufficient to absorb losses in our loan portfolio.
Lending money is a substantial part of our business. Every loan carries a certain risk that it will not be repaid in accordance with its terms or that any underlying collateral will not be sufficient to assure repayment. This risk is affected by, among other things:
cash flow of the borrower and/or the project being financed;
the changes and uncertainties as to the future value of the collateral, in the case of a collateralized loan;
the character and creditworthiness of a particular borrower;
changes in economic and industry conditions; and
the duration of the loan.
We maintain an allowance for loan losses on our loans, which is a reserve established through a provision for loan losses charged against earnings, which we believe is appropriate to absorb known and inherent losses in our loan portfolio. The amount of this allowance is determined by our management through a periodic review and consideration of several factors, including, but not limited to:
our general reserve, based on our historical default and loss experience;
our specific reserve, based on our evaluation of nonperforming loans and their underlying collateral or discounted cash flows; and
current macroeconomic factors and management’s expectation of future events.
The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity and requires us to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Deterioration in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our control, may

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require an increase in the allowance for loan losses. If current conditions in the housing and real estate markets weaken, we expect we will experience increased delinquencies and credit losses. In addition, bank regulatory agencies periodically review our allowance for loan losses and may require an increase in the provision for possible loan losses or the recognition of further loan charge-offs, based on judgments different than those of management. In addition, if charge-offs in future periods exceed the allowance for loan losses we will need additional provisions to increase the allowance for loan losses. Any increases in the allowance for loan losses will result in a decrease in net income and possibly capital, and may have a material adverse effect on our financial condition and results of operations.
If our allowance for loan losses is not adequate, we may be required to make further increases in our provision for loan losses and to charge-off additional loans, which could adversely affect our results of operations and our capital.
For the year ended December 31, 2014 we recorded a total provision for loan losses of $4.6 million compared to $3.7 million for the year ended December 31, 2013. The provision related to the noncovered portfolio was $2.2 million and $1.8 million for the years ended December 31, 2014 and 2013, respectively. Our provision for loan losses on covered loans was $2.4 million and $1.9 million for the years ended December 31, 2014 and 2013, respectively. We recorded net loan charge-offs for noncovered loans of $2.7 million for the year ended December 31, 2014 compared to $3.4 million for the year ended December 31, 2013. The net charge-offs for covered loans was $3.0 million and $73,000 for the years ended December 31, 2014 and 2013, respectively. At December 31, 2014 our total nonperforming noncovered loans were $7.5 million, or 0.35% of total noncovered loans, compared to $7.7 million or 0.66% of total noncovered loans at December 31, 2013. Generally, our nonperforming loans and assets reflect operating difficulties of individual borrowers, which may be the result of current economic conditions. If economic conditions deteriorate, we expect that we could experience significantly higher delinquencies and loan charge-offs. As a result, we may be required to make further increases in our provision for loan losses in the future, which could adversely affect our financial condition and results of operations, perhaps materially.
General economic conditions tend to impact loan segments at varying degrees. Our commercial and industrial loan portfolio, which represented 46.1% of our nonaccrual noncovered loans at December 31, 2014, generally has the largest percentage of nonperforming loans as the borrowers are primarily business owners whose business results are influenced by deteriorating economic conditions. Slower sales and excess inventory in the housing market has been the primary cause of deterioration in our one-to-four family residential construction loans, which represented 35.3% of our nonperforming noncovered loans at December 31, 2014.
The current economic condition in the market areas we serve may adversely impact our earnings and could increase the credit risk associated with our loan portfolio.
Substantially all of our loans are to businesses and individuals in the states of Washington and Oregon, and a decline in the economies of our primary market areas of the Pacific Northwest could have a material adverse effect on our business, financial condition, results of operations and prospects.
Weakness or a deterioration in economic conditions in the market areas we serve could result in the following consequences, any of which could have a materially adverse impact on our business, financial condition and results of operations:
loan delinquencies, problem assets and foreclosures may increase;
we may increase our provision for loan losses;
demand for our products and services may decline possibly resulting in a decrease in our total loans;
collateral for loans made may decline further in value, exposing us to increased risk of loss on existing loans;
the net worth and liquidity of loan guarantors may decline, impairing their ability to honor commitments to us; and
the amount of our deposits may decrease and the composition of our deposits may be adversely affected.
If the goodwill we have recorded in connection with acquisitions becomes impaired, our earnings and capital could be reduced.
Accounting standards require that we account for acquisitions using the purchase method of accounting. Under purchase accounting, if the purchase price of an acquired company exceeds the fair value of its net assets, the excess is carried on the acquirer’s balance sheet as goodwill. In accordance with generally accepted accounting principles, our goodwill is evaluated for impairment on an annual basis or more frequently if events or circumstances indicate that a potential impairment exists. Such evaluation is based on a variety of factors, including the quoted price of our common stock, market prices of common stock of other banking organizations, common stock trading multiples, discounted

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cash flows, and data from comparable acquisitions. At December 31, 2014, we had goodwill with a carrying amount of $119.0 million.
Declines in our stock price or a prolonged weakness in the operating environment of the financial services industry may result in a future impairment charge. Any such impairment charge could have a material adverse affect on our operating results and capital.
Fluctuating interest rates can adversely affect our profitability.
Our profitability is dependent to a large extent upon net interest income, which is the difference (or “spread”) between the interest earned on loans, securities and other interest earning assets and the interest paid on deposits, borrowings, and other interest bearing liabilities. Because of the differences in maturities and repricing characteristics of our interest earning assets and interest bearing liabilities, changes in interest rates do not produce equivalent changes in interest income earned on interest earning assets and interest paid on interest bearing liabilities. Accordingly, fluctuations in interest rates could adversely affect our interest rate spread, and, in turn, our profitability.
Although management believes it has implemented effective asset and liability management strategies to reduce the potential effects of changes in interest rates on our results of operations, any substantial, unexpected or prolonged change in market interest rates could have a material adverse effect on our financial condition and results of operations. Also, our interest rate risk modeling techniques and assumptions likely may not fully predict or capture the impact of actual interest rate changes on our balance sheet.
Historically low interest rates may adversely affect our net interest income and profitability.
During the past several years it has been the policy of the Federal Reserve to maintain interest rates at historically low levels through its targeted federal funds rate and the purchase of mortgage-backed securities. As a result, market rates on the loans we have originated and the yields on securities we have purchased have been at lower levels than available prior to 2008. As a general matter, our interest bearing liabilities reprice or mature more quickly than our interest earning assets, which has been one factor contributing to the increase in our interest rate spread as interest rates decreased. However, our ability to lower our interest expense will be limited at these interest rate levels while the average yield on our interest earning assets may continue to decrease. The Federal Reserve has recently indicated its intention to maintain low interest rates through at least late 2015. Accordingly, our net interest income may be adversely affected and may decrease, which may have an adverse effect on our profitability.
Decreased volumes and lower gains on sales of mortgage loans sold could adversely impact our noninterest income.
We originate and sell one-to-four family residential loans. Our mortgage banking income is a significant portion of our noninterest income. We generate gains on the sale of one-to-four family residential loans pursuant to programs currently offered by Freddie Mac and other secondary market purchasers. Any future changes in their purchase programs, our eligibility to participate in such programs, the criteria for loans to be accepted or laws that significantly affect the activity of such entities could, in turn, materially adversely affect our results of operations. Further, in a rising or higher interest rate environment, our originations of mortgage loans may decrease, resulting in fewer loans that are available to be sold to investors. This would result in a decrease in mortgage banking revenues and a corresponding decrease in noninterest income. In addition, our results of operations are affected by the amount of noninterest expense associated with mortgage banking activities, such as salaries and employee benefits, occupancy, equipment and data processing expense and other operating costs. During periods of reduced loan demand, our results of operations may be adversely affected to the extent that we are unable to reduce expenses commensurate with the decline in loan originations.
The tightening of available liquidity could limit our ability to replace deposits and fund loan demand, which could adversely affect our earnings and capital levels.
A tightening of the credit markets and the inability to obtain adequate funding to replace deposits and fund continued loan growth may negatively affect asset growth and, consequently, our earnings capability and capital levels. In addition to any deposit growth, maturity of investment securities and loan payments, we rely from time to time on advances from the Federal Home Loan Bank of Seattle, or FHLB, and certain other wholesale funding sources to fund loans and replace deposits. In the event of a further downturn in the economy, these additional funding sources could be negatively affected which could limit the funds available to us. Our liquidity position could be significantly constrained if we were unable to access funds from the FHLB or other wholesale funding sources.

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Our growth or future losses may require us to raise additional capital in the future, but that capital may not be available when it is needed or the cost of that capital may be very high; further, the resulting dilution of our equity may adversely affect the market price of our common stock.
We are required by federal and state regulatory authorities to maintain adequate levels of capital to support our operations. At some point we may need to raise additional capital to support continued internal growth and growth through acquisitions. Our ability to raise additional capital, however, will depend on conditions in the capital markets at that time, which are outside our control, and on our financial condition and performance. If we are able to raise capital it may not be on terms that are acceptable to us. If we cannot raise additional capital when needed, our ability to further expand our operations through internal growth and acquisitions could be materially impaired and our financial condition and liquidity could be materially and adversely affected. Accordingly, we cannot make assurances that we will be able to raise additional capital when needed.
We are not restricted from issuing additional common stock or preferred stock, including any securities that are convertible into or exchangeable for, or that represent the right to receive, common stock or preferred stock or any substantially similar securities. The market price of our common stock could decline as a result of sales of a large number of shares of common stock or preferred stock or similar securities in the market or from the perception that such sales could occur.
Our Board of Directors is authorized generally to cause us to issue additional common stock, as well as series of preferred stock, without any action on the part of our shareholders except as may be required under the listing requirements of the NASDAQ Stock Market. In addition, our Board has the power, without shareholder approval, to set the terms of any such series of preferred stock that may be issued, including voting rights, dividend rights and preferences over the common stock with respect to dividends or upon the liquidation, dissolution or winding-up of our business and other terms.
In addition, if we issue preferred stock in the future that has a preference over the common stock with respect to the payment of dividends or upon liquidation, dissolution or winding-up, or if we issue preferred stock with voting rights that dilute the voting power of the common stock, the rights of holders of the common stock or the market price of the common stock could be adversely affected.
We rely heavily on the proper functioning of our technology.
We rely heavily on communications and information systems to conduct our business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan and other systems. While we have policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.
We rely on third-party service providers for much of our communications, information, operating and financial control systems technology. If any of our third-party service providers experience financial, operational or technological difficulties, or if there is any other disruption in our relationships with them, we may be required to locate alternative sources of such services, and we cannot assure that we could negotiate terms that are as favorable to us, or could obtain services with similar functionality, as found in our existing systems, without the need to expend substantial resources, if at all. Any of these circumstances could have an adverse effect on our business.
Changes in accounting standards may affect how we record and report our performance.
Our accounting policies and methods are fundamental to how we record and report our financial condition and results of operations. From time to time there are changes in the financial accounting and reporting standards that govern the preparation of our financial statements. These changes can be difficult to predict and can materially impact how we report and record our financial condition and results of operations. In some cases, we could be required to apply a new or revised standard retroactively, resulting in a retrospective adjustment to prior financial statements.
We are dependent on key personnel and the loss of one or more of those key personnel may materially and adversely affect our prospects.
Competition for qualified employees and personnel in the banking industry is intense and there are a limited number of qualified persons with knowledge of, and experience in, the community banking industry where we conduct our business. The process of recruiting personnel with the combination of skills and attributes required to carry out our strategies is often lengthy. Our success depends to a significant degree upon our ability to attract and retain qualified

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management, loan origination, finance, administrative, marketing and technical personnel and upon the continued contributions of our management and personnel. In particular, our success has been and continues to be highly dependent upon the abilities of key executives, including our President and Chief Executive Officer, Mr. Brian L. Vance, and certain other employees. The loss of key personnel could adversely affect our ability to successfully conduct our business.

ITEM 1B.     UNRESOLVED STAFF COMMENTS
The Company has no unresolved staff comments from the Securities and Exchange Commission ("SEC") as it relates to the Company's financial information as reported on Form 10-K.

ITEM 2.     PROPERTIES
Our executive offices and the main office of Heritage Bank are located in approximately 22,000 square feet of the headquarters building and adjacent office space and main branch office which are owned by Heritage Bank and located in downtown Olympia. The Company's branch network at December 31, 2014 is comprised of 66 branches located throughout Washington and Oregon counties. The number of branches per county, as well as occupancy type, is detailed in the following table.
 
 
 
 
 
 
Occupancy Type
County
 
State
 
Number of Branches
 
Owned
 
Leased
Clark
 
WA
 
2

 
1

 
1

Cowlitz
 
WA
 
2

 
2

 

Island
 
WA
 
7

 
5

 
2

Kittitas
 
WA
 
1

 

 
1

King
 
WA
 
8

 
3

 
5

Mason
 
WA
 
1

 
1

 

Multnomah
 
OR
 
1

 

 
1

Pierce
 
WA
 
13

 
8

 
5

San Juan
 
WA
 
1

 

 
1

Skagit
 
WA
 
4

 
3

 
1

Snohomish
 
WA
 
12

 
6

 
6

Thurston
 
WA
 
5

 
3

 
2

Whatcom
 
WA
 
4

 
3

 
1

Yakima
 
WA
 
5

 
5

 

Total
 
 
 
66

 
40

 
26

One Snohomish County branch, one Thurston County branch and the branch in Kittitas County have land leases, which are not included in the leased section above as the building is owned.
For additional information concerning our premises and equipment and lease obligations, see Notes 10 and 17, respectively, of the Notes to Consolidated Financial Statements included in "Item 8. Financial Statements and Supplementary Data."

ITEM 3.     LEGAL PROCEEDINGS
Heritage and Heritage Bank, are not a party to any material pending legal proceedings other than ordinary routine litigation incidental to the business of the Bank, other than the matter described below.
On April 4, 2014, Washington Banking, its directors and Heritage entered into and documented an agreement in principle among Washington Banking, its directors, Heritage and the plaintiffs for the settlement of the putative shareholder class action lawsuit captioned In Re Washington Banking Company Shareholder Litigation, Lead Case No. 13-2-38689-5 SEA, pending before the Superior Court of the State of Washington in and for King County (the “Action”).  The Action alleges that Washington Banking’s directors breached their fiduciary duties to Washington Banking and its shareholders in connection with the transactions contemplated by the Agreement and Plan of Merger, dated October 23, 2013 (the “Merger Agreement”), under which Washington Banking and Heritage combined their

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organizations in a strategic combination, with Washington Banking merging with and into Heritage. The Action also alleges, among other things, that Heritage aided and abetted the alleged breaches of fiduciary duties by Washington Banking's directors and that the public disclosures concerning the Washington Banking Merger are misleading in various respects.
              On December 15, 2014, the Court entered an order preliminarily approving the settlement of the consolidated litigation and ordering WBCO to provide notice of the proposed settlement to those persons who held WBCO shares during the purported class period. 
On February 27, 2015, the Court held a hearing to consider whether the settlement was fair and reasonable to the class members and, if so, to approve the settlement and to consider plaintiffs’ counsel’s application for an award of attorneys’ fees and costs from Washington Banking.  At the hearing, the Court approved the settlement and entered a Final Judgment and Order of Dismissal With Prejudice awarding plaintiffs’ counsel fees and expenses totaling $450,000 and terminating the litigation.
The settlement of the Action did not affect the Washington Banking Merger consideration paid to Washington Banking’s shareholders in connection with the completion of the Washington Banking Merger on May 1, 2014.  Washington Banking, its directors and Heritage took the position that the Action was without merit and denied any wrongdoing of any kind.  Washington Banking, its directors and Heritage entered into the settlement solely to eliminate the costs, risks, burden, distraction and expense of further litigation and to put the claims that were or could have been asserted to rest.  Nothing in the stipulation of settlement or any public filing, including this Annual Report on Form 10-K, shall be deemed an admission of the legal necessity of filing or the materiality under applicable laws of any of the additional information contained herein or in any public filing associated with the settlement of the Action.

ITEM 4.     MINE SAFETY DISCLOSURES
Not applicable

PART II

ITEM 5.
MARKET FOR THE REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Our common stock is traded on the NASDAQ Global Select Market under the symbol HFWA. At December 31, 2014, we had approximately 1,514 shareholders of record (not including the number of persons or entities holding stock in nominee or street name through various brokerage firms) and 30,259,838 outstanding shares of common stock. This total does not reflect the number of persons or entities who hold stock in nominee or “street” name through various brokerage firms. The last reported sales price on February 25, 2015 was $16.28 per share. The following table provides sales information per share of our common stock as reported on the NASDAQ Global Select Market for the indicated quarters.
 
 
 
2014 Quarter ended,
 
 
March 31
 
June 30
 
September 30
 
December 31
High
 
$
18.48

 
$
17.86

 
$
16.96

 
$
17.97

Low
 
$
16.18

 
$
15.44

 
$
15.59

 
$
15.80

 
For the interim period subsequent to the 2014 fiscal year through the last reported sales price on February 25, 2015, the high and low sales information price per share of our common stock as reported on the NASDAQ Global Selected Market was $17.16 and $15.52, respectively.
 
 
2013 Quarter ended,
 
 
March 31
 
June 30
 
September 30
 
December 31
High
 
$
15.22

 
$
14.65

 
$
16.45

 
$
17.48

Low
 
$
13.84

 
$
13.25

 
$
14.75

 
$
15.01

Quarterly, the Company reviews the potential payment of cash dividends to common shareholders. 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.

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The dividend activities for the years ended December 31, 2014 and 2013 and subsequent through the date of this filing are listed below:
Declared
 
Cash
Dividend per Share        
 
Record Date        
 
Paid        
January 30, 2013
 
$0.08
 
February 8, 2013
 
February 22, 2013
April 24, 2013
 
$0.08
 
May 10, 2013
 
May 24, 2013
July 23, 2013
 
$0.18
 
August 6, 2013
 
August 15, 2013
October 23, 2013
 
$0.08
 
November 5, 2013
 
November 15, 2013
January 29, 2014
 
$0.08
 
February 10, 2014
 
February 24, 2014
March 27, 2014
 
$0.08
 
April 8, 2014
 
April 23, 2014
July 24, 2014
 
$0.09
 
August 7, 2014
 
August 21, 2014
October 23, 2014
 
$0.09
 
November 6, 2014
 
November 20, 2014
November 11, 2014
 
$0.16
 
December 2, 2014
 
December 12, 2014
January 28, 2015
 
$0.10
 
February 10, 2015
 
February 24, 2015
The primary source for dividends paid to our shareholders is dividends paid to us from Heritage Bank. There are regulatory restrictions on the ability of our subsidiary bank to pay dividends. Under federal regulations, the dollar amount of dividends the bank may pay depends upon its capital position and recent net income. Generally, if an institution satisfies its regulatory capital requirements, it may make dividend payments up to the limits prescribed under state law and FDIC regulations. However, an institution that has converted to a stock form of ownership, as Heritage Bank has done, may not declare or pay a dividend on, or repurchase any of, its common stock if the effect thereof would cause the regulatory capital of the institution to be reduced below the amount required for the liquidation account which was established in connection with the mutual stock conversion.
As a bank holding company, our ability to pay dividends is subject to the guidelines of the Federal Reserve regarding capital adequacy and dividends. The Federal Reserve’s policy is that a bank holding company should pay cash dividends only to the extent that its net income for the past year is sufficient to cover both the cash dividends and a rate of earnings retention that is consistent with the holding company’s capital needs, asset quality and overall financial condition, and that it is inappropriate for a bank holding company experiencing serious financial problems to borrow funds to pay dividends. Under Washington law, we are prohibited from paying a dividend if, after making such dividend payment, we would be unable to pay our debts as they become due in the usual course of business, or if our total liabilities, plus the amount that would be needed, in the event we were to be dissolved at the time of the dividend payment, to satisfy preferential rights on dissolution of holders of preferred stock ranking senior in right of payment to the capital stock on which the applicable distribution is to be made exceed our total assets.
The Company has had various stock repurchase programs since March 1999. On October 23, 2014, the Company's Board of Directors authorized the repurchase of up to 5% of the Company's outstanding common shares, or approximately 1,513,000 shares, under the eleventh stock repurchase plan. The number, timing and price of shares repurchased will depend on business and market conditions, and other factors, including opportunities to deploy the Company's capital. On August 30, 2012, the Board of Directors approved the Company’s tenth stock repurchase plan, authorizing the repurchase of up to 5% of the Company’s outstanding shares of common stock, or approximately 757,000 shares. The Company will not repurchase the remaining 52,025 shares available under the tenth plan as the eleventh plan supersedes the tenth stock repurchase program. On August 30, 2011, the Board of Director approved the Company's ninth stock repurchase plan, authorizing the repurchase of up to 5% of the Company's outstanding shares of common stock, or approximately 782,000 shares over a period of twelve months.


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The following table provides total repurchased shares and average share prices under the applicable Plans and years:
 
Years Ended December 31,
 
 
 
2014
 
2013
 
2012
 
Plan Total
Ninth Plan
 
 
 
 
 
 
 
Repurchased shares

 

 
389,627

 
590,832

Stock repurchase average share price
$

 
$

 
$
13.45

 
$
12.83

 
 
 
 
 
 
 
 
Tenth Plan
 
 
 
 
 
 
 
Repurchased shares
108,075

 
544,000

 
52,900

 
704,975

Stock repurchase average share price
$
16.68

 
$
15.88

 
$
13.88

 
$
15.85

 
 
 
 
 
 
 
 
Eleventh Plan
 
 
 
 
 
 
 
Repurchased shares

 

 

 

Stock repurchase average share price
$

 
$

 
$

 
$


During the years ended December 31, 2014, 2013 and 2012, the Company repurchased 48,304, 13,138 and 3,419 shares at an average price of $16.53, $14.29 and $14.08 to pay withholding taxes on the vesting of restricted stock that vested during the years ended December 31, 2014, 2013 and 2012, respectively, which are not considered repurchased as part of the applicable repurchase Plans.
The following table sets forth information about the Company’s purchases of its outstanding common stock during the quarter ended December 31, 2014.
Period
 
Total Number  of
Shares 
Purchased(1)
 
Average Price
Paid Per Share(1)
 
Total Number of  Shares Purchased as 
Part of Publicly
Announced Plans or Programs
 
Maximum Number 
of Shares that May
Yet Be Purchased
Under the Plans or
Programs
October 1, 2014—
    October 30, 2014
 
277

 
$16.79
 
7,313,423

 
1,513,000

November 1, 2014—November 30, 2014
 

 

 
7,313,423

 
1,513,000

December 1, 2014—December 31, 2014
 
2,695

 
16.97
 
7,313,423

 
1,513,000

Total
 
2,972

 
$16.95
 
7,313,423

 
1,513,000

(1)
Common shares repurchased by the Company between October 1, 2014 and December 31, 2014 included solely the cancellation of 2,972 shares of restricted stock to pay withholding taxes at an average price per share of $16.95.
The information regarding the Company’s equity compensation plan is contained under “Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters” of this Form 10-K and is incorporated by reference herein.
Stock Performance Graph
The chart shown below depicts total return to stockholders during the period beginning December 31, 2009 and ending December 31, 2014. Total return includes appreciation or depreciation in market value of the Company’s common stock as well as actual cash and stock dividends paid to common stockholders. Indices shown below, for comparison purposes only, are the Total Return Index for the NASDAQ Stock Market (U.S. Companies), which is a broad nationally recognized index of stock performance by publicly traded companies and the NASDAQ Bank Index, which is an index that contains securities of NASDAQ-listed companies classified according to the Industry Classification Benchmark as banks. The chart assumes that the value of the investment in Heritage’s common stock and each of the three indices was $100 on December 31, 2009, and that all dividends were reinvested in Heritage common stock.

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Years Ended December 31,
Index
 
2009
 
2010
 
2011
 
2012
 
2013
 
2014
Heritage Financial Corporation
 
$
100.00

 
$
101.02

 
$
94.13

 
$
116.47

 
$
139.38

 
$
147.38

NASDAQ Composite
 
100.00

 
118.15

 
117.22

 
138.02

 
193.47

 
222.16

NASDAQ Bank
 
100.00

 
114.16

 
102.17

 
121.26

 
171.86

 
180.31



ITEM 6.     SELECTED FINANCIAL DATA
The following tables set forth certain information concerning our consolidated financial position and results of operations at and for the dates indicated and have been derived from our audited Consolidated Financial Statements. The information below is qualified in its entirety by the detailed information included elsewhere herein and should be read along with “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Item 8. Financial Statements and Supplementary Data.”
 
Matters affecting comparability in the five-year summary detailed below include the Cowlitz and Pierce Acquisitions in 2010, the Valley and NCB Acquisitions in 2013, and the Washington Banking Merger in 2014. See Note 2 - Business Combinations in "Item 8. Financial Statements and Supplementary Data" discussing the fiscal 2014 and 2013 mergers and acquisitions.

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Years Ended December 31,
 
 
2014
 
2013
 
2012
 
2011
 
2010
 
 
(Dollars in thousands, except per share amounts)
Operations Data:
 
 
 
 
 
 
 
 
 
 
Interest income
 
$
121,106

 
71,428

 
$
69,109

 
$
74,120

 
$
59,522

Interest expense
 
5,681

 
3,724

 
4,534

 
6,582

 
8,511

Net interest income
 
115,425

 
67,704

 
64,575

 
67,538

 
51,011

Provision for loan losses
 
4,594

 
3,672

 
2,016

 
14,430

 
11,990

Noninterest income
 
16,467

 
9,651

 
7,272

 
5,746

 
18,779

Noninterest expense
 
99,379

 
59,515

 
50,392

 
49,703

 
38,011

Income tax expense
 
6,905

 
4,593

 
6,178

 
2,633

 
6,435

Net income
 
21,014

 
9,575

 
13,261

 
6,518

 
13,354

Net income applicable to common shareholders
 
21,014

 
9,575

 
13,261

 
6,518

 
11,668

Earnings per common share
 
 
 
 
 
 
 
 
 
 
Basic
 
$
0.82

 
$
0.61

 
$
0.87

 
$
0.42

 
$
1.05

Diluted
 
0.82

 
0.61

 
0.87

 
0.42

 
1.04

Dividend payout ratio to common shareholders(1)
 
60.98
%
 
68.90
%
 
92.00
%
 
90.50
%
 
%
Performance Ratios:
 
 
 
 
 
 
 
 
 
 
Net interest spread(2)
 
4.45
%
 
4.69
%
 
5.03
%
 
5.23
%
 
4.56
%
Net interest margin(3)
 
4.53

 
4.80

 
5.17

 
5.41

 
4.78

Efficiency ratio(4)
 
75.35

 
76.94

 
70.14

 
67.82

 
54.46

Return on average assets
 
0.74

 
0.62

 
0.98

 
0.48

 
1.16

Return on average common equity
 
5.61

 
4.58

 
6.52

 
3.17

 
8.15

(1)
Dividend payout ratio is declared dividends per common share divided by basic earnings per common share.
(2)
Net interest spread is the difference between the average yield on interest earning assets and the average cost of interest bearing liabilities.
(3)
Net interest margin is net interest income divided by average interest earning assets.
(4)
The efficiency ratio is noninterest expense divided by the sum of net interest income and noninterest income.


 

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December 31,
 
 
2014
 
2013
 
2012
 
2011
 
2010
 
 
(Dollars in thousands)
Balance Sheet Data:
 
 
 
 
 
 
 
 
 
 
Total assets
 
$
3,457,750

 
$
1,659,038

 
$
1,345,540

 
$
1,368,985

 
$
1,367,684

Noncovered loans receivable, net
 
2,102,724

 
1,145,509

 
914,366

 
899,086

 
851,006

Covered loans receivable, net
 
120,624

 
57,587

 
83,978

 
105,394

 
128,715

Total loans receivable, net
 
2,223,348

 
1,203,096

 
998,344

 
1,004,480

 
979,721

Investment securities
 
778,660

 
199,288

 
154,392

 
156,695

 
138,943

FDIC indemnification asset
 
1,116

 
4,382

 
7,100

 
10,350

 
16,071

Goodwill and other intangible assets
 
129,918

 
30,980

 
14,098

 
14,525

 
14,965

Deposits
 
2,906,331

 
1,399,189

 
1,117,971

 
1,136,044

 
1,136,276

Junior subordinated debentures
 
19,082

 

 

 

 

Securities sold under agreement to repurchase
 
32,181

 
29,420

 
16,021

 
23,091

 
19,027

Stockholders’ equity
 
454,506

 
215,762

 
198,938

 
202,520

 
202,279

Book value per common share
 
$
15.02

 
$
13.31

 
$
13.16

 
$
13.10

 
$
12.99

Equity to assets ratio
 
13.1
%
 
13.0
%
 
14.8
%
 
14.8
%
 
14.8
%
Capital Ratios:
 
 
 
 
 
 
 
 
 
 
Total risk-based capital ratio
 
15.1
%
 
16.8
%
 
19.9
%
 
20.3
%
 
21.5
%
Tier 1 risk-based capital ratio
 
13.9

 
15.5

 
18.7

 
19.0

 
20.2

Leverage ratio
 
10.2

 
11.3

 
13.6

 
13.8

 
13.9

Asset Quality Ratios:
 
 
 
 
 
 
 
 
 
 
Nonperforming noncovered loans to total noncovered loans (1)
 
0.35
%
 
0.66
%
 
1.41
%
 
2.57
%
 
3.03
%
Allowance for loan losses on noncovered loans to total noncovered loans (1)
 
1.04

 
1.94

 
2.58

 
2.91

 
2.53

Allowance for loan losses on noncovered loans to nonperforming noncovered loans (1)
 
294.98

 
292.80

 
183.39

 
113.11

 
83.31

Nonperforming noncovered assets to total noncovered assets (1)
 
0.29

 
0.76

 
1.48

 
2.19

 
2.38

Other Data:
 
 
 
 
 
 
 
 
 
 
Number of banking offices
 
66

 
35

 
33

 
33

 
31

Number of full-time equivalent employees
 
748

 
373

 
363

 
354

 
321

(1)
Nonperforming noncovered loan balances include portions guaranteed by governmental agencies of $1.6 million, $1.7 million, $1.2 million, $1.8 million and $2.3 million as of December 31, 2014, 2013, 2012, 2011 and 2010, respectively.

ITEM 7.
MANGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion is intended to assist in understanding the financial condition and results of operations of the Company. The information contained in this section should be read with the December 31, 2014 audited Consolidated Financial Statements and Notes to those financial statements included in this Form 10-K.
This Form 10-K may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements often include the words “believes,” “expects,” “anticipates,” “estimates,” “forecasts,” “intends,” “plans,” “targets,” “potentially,” “probably,” “projects,” “outlook” or similar expressions or future or conditional verbs such as “may,” “will,” “should,” “would” and “could.” These forward-looking statements are subject to known and unknown risks, uncertainties and other factors that could cause actual results to differ materially from the results anticipated, including:

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our ability to successfully integrate any assets, liabilities, customers, systems, and management personnel we have acquired, including those from Cowlitz Bank, Pierce Commercial Bank, Northwest Commercial Bank, Valley Community Bancshares and Washington Banking Company, or may in the future acquire, into our operations and our ability to realize related revenue synergies and cost savings within expected time frames or at all, and any goodwill charges related thereto and costs or difficulties relating to integration matters, including but not limited to customer and employee retention, which might be greater than expected;
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, which may lead to increased losses and non-performing assets in our loan portfolio, and may result in our allowance for loan losses not being adequate to cover actual losses, and require us to increase our allowance for loan losses and increase our provision for loan losses;
changes in general economic conditions, either nationally or in our market areas;
changes in the levels of general interest rates, and the relative differences between short and long term interest rates, deposit interest rates, our net interest margin and funding sources;
risks related to acquiring assets in or entering markets in which we have not previously operated and may not be familiar;
fluctuations in the demand for loans, the number of unsold homes and other properties and fluctuations in real estate values in our market areas;
results of examinations of us by the bank regulators, including the possibility that any such regulatory authority may, among other things, require us to increase our allowance 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 but not limited to, the Dodd-Frank Act and implementing regulations, changes in regulatory policies and principles, or the interpretation of regulatory capital or other rules as a result of Basel III;
our ability to control operating costs and expenses;
increases in premiums for deposit insurance;
the use of estimates in determining fair value of certain of our assets, which estimates may prove to be incorrect and result in significant declines in valuation;
difficulties in reducing risk associated with the loans on our consolidated statement of financial condition;
staffing fluctuations in response to product demand or the implementation of corporate strategies that affect our workforce and potential associated charges;
failure or security breach of computer systems on which we depend;
our ability to retain key members of our senior management team;
costs and effects of litigation, including settlements and judgments;
our ability to implement our growth strategies;
increased competitive pressures among financial service companies;
changes in consumer spending, borrowing and savings habits;
the availability of resources to address changes in laws, rules, or regulations or to respond to regulatory actions;
adverse changes in the securities markets;
inability of key third-party providers to perform their obligations to us;
changes in accounting policies and practices, as may be adopted by the financial institution regulatory agencies or the FASB, including additional guidance and interpretation on accounting issues and details of the implementation of new accounting methods; and
other economic, competitive, governmental, regulatory, and technological factors affecting our operations, pricing, products and services and the other risks described elsewhere in this Form 10-K.
Some of these and other factors are discussed in this Form 10-K under the caption “Item 1A. Risk Factors” and elsewhere in this Form 10-K. Such developments could have a material adverse impact on our business, financial position and results of operations.
Any forward-looking statements are based upon management’s beliefs and assumptions at the time they are made. We undertake no obligation to publicly update or revise any forward-looking statements included in this Form 10-K or to update the reasons why actual results could differ from those contained in such statements, whether as a

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result of new information, future events or otherwise. In light of these risks, uncertainties and assumptions, you should not put undue reliance on any forward-looking statements discussed in this Form 10-K.
Critical Accounting Policies
The Company’s Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America. Companies may apply certain critical accounting policies requiring management to make subjective or complex judgments, often as a result of the need to estimate the effect of matters that are inherently uncertain.
The Company considers its most critical accounting estimates to be the allowance for loan losses, estimations of expected cash flows related to purchased credit impaired loans, business combinations, other than temporary impairments in the market value of investments and consideration of potential impairment of goodwill.
Allowance for Loan Losses.    The allowance for loan losses is established through a provision for loan losses charged against earnings. The balance of the allowance for loan losses is maintained at the amount management believes will be appropriate to absorb known and inherent losses in the loan portfolio at the balance sheet date. The allowance for loan losses is determined by applying estimated loss factors to the credit exposure from outstanding loans.
We assess the estimated credit losses inherent in our non-classified and classified loan portfolio by considering a number of elements including:
historical loss experience in the portfolio;
levels of and trends in delinquencies and impaired loans;
levels and trends in charge-offs and recoveries;
effects of changes in risk selection and underwriting standards, and other changes in lending policies, procedures and practices;
experience, ability, and depth of lending management and other relevant staff;
national and local economic trends and conditions;
external factors such as competition, legal, and regulatory; and
effects of changes in credit concentrations.
We calculate an allowance for our loan portfolio based on an appropriate percentage loss factor that is calculated based on the above-noted elements and trends. We may record specific provisions for each impaired loan after a careful analysis of that loan’s credit and collateral factors. Our analysis of an allowance combines the provisions made for our non-impaired loans and the specific provisions made for each impaired loan.
While we believe we use the best information available to determine the allowance for loan losses, our results of operations could be significantly affected if circumstances differ substantially from the assumptions used in determining the allowance. A decline in local and national economic conditions, or other factors, could result in a material increase in the allowance for loan losses and may adversely affect the Company’s financial condition and results of operations. In addition, the determination of the amount of the allowance for loan losses is subject to review by bank regulators, as part of their routine examination process, which may result in the establishment of additional allowance for loan losses based upon their judgment of information available to them at the time of their examination.
For additional information regarding the allowance for loan losses, its relation to the provision for loan losses, risk related to asset quality and lending activity, see “—Results of Operations for the Years Ended December 31, 2014 and 2013—Provision for Loan Losses” below, “Item 1. Business—Analysis of Allowance for Loan Losses” as well as Note 7 - Allowance for Loan Losses of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data.”
Estimated Expected Cash Flows related to Purchased Credit Impaired 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 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. In situations where such loans have similar risk characteristics, loans may be aggregated into pools to estimate cash flows. A pool is accounted for as a single asset with a single interest rate, cumulative loss rate and cash flow expectation.
The cash flows expected over the life of the loan or pool are estimated using an internal cash flow model that projects cash flows and calculates the carrying values of the pools, book yields, effective interest income and impairment, if any, based on pool level events. Assumptions as to default rates, loss severity and prepayment speeds are utilized to calculate the expected cash flows.
Expected cash flows at the acquisition date in excess of the fair value of loans are considered to be accretable yield, which is recognized as interest income over the life of the loan or pool using a level yield method if the timing

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and amounts of the future cash flows of the pool are reasonably estimable. Subsequent to the acquisition date, any increases in cash flow over those expected at purchase date in excess of fair value are recorded as interest income prospectively. Any subsequent decreases in cash flow over those expected at purchase date are recognized by recording an allowance for loan losses. Any disposals of loans, including sales of loans, payments in full or foreclosures result in the removal of the loan from the loan pool at the carrying amount.
Business Combinations.    The Company applies the acquisition method of accounting for business combinations. Under the acquisition method, the acquiring entity in a business combination recognizes all of the identifiable assets acquired and liabilities assumed at their acquisition date fair values. Management utilizes prevailing valuation techniques appropriate for the asset or liability being measured in determining these fair values. Any excess of the purchase price over amounts allocated to assets acquired, including identifiable intangible assets, and liabilities assumed is recorded as goodwill. Where amounts allocated to assets acquired and liabilities assumed is greater than the purchase price, a bargain purchase gain is recognized. Acquisition-related costs are expensed as incurred unless they are directly attributable to the issuance of the Company's common stock in a business combination.
Other-Than-Temporary Impairments in the Market Value of Investments.    Unrealized losses on investment securities available for sale and held to maturity are evaluated at least quarterly to determine whether declines in value should be considered “other than temporary” and therefore be subject to immediate loss recognition in income. Although these evaluations involve significant judgment, an unrealized loss in the fair value of a debt security is generally deemed to be temporary when the fair value of the security is below the carrying value primarily due to changes in interest rates, there has not been significant deterioration in the financial condition of the issuer, and it is not more likely than not that the Company will be required to sell the security before the anticipated recovery of its remaining carrying value. An unrealized loss in the value of an equity security is generally considered temporary when the fair value of the security is below the carrying value primarily due to current market conditions and not deterioration in the financial condition of the issuer and it is not more likely than not that the Company will be required to sell the security before the anticipated recovery of its remaining carrying value. Other factors that may be considered in determining whether a decline in the value of either a debt or an equity security is “other than temporary” include ratings by recognized rating agencies; actions of commercial banks or other lenders relative to the continued extension of credit facilities to the issuer of the security; the financial condition, capital strength and near-term prospects of the issuer and recommendations of investment advisors or market analysts. Therefore, continued deterioration of market conditions could result in additional impairment losses recognized within the investment portfolio.
Goodwill.    Goodwill represents the excess of the purchase price over the net assets acquired in the of merger of Washington Banking Company and the acquisitions of Valley Community Bancshares, Western Washington Bancorp and North Pacific Bank. The Company’s goodwill is assigned to Heritage Bank and is evaluated for impairment at the Heritage Bank level (reporting unit). Goodwill is not amortized, but is reviewed for impairment annually and between annual tests if an event occurs or circumstances change that might indicate the Company’s recorded value is more than its implied value. Such indicators may include, among others: a significant adverse change in legal factors or in the general business climate; significant decline in the Company’s stock price and market capitalization; unanticipated competition; and an adverse action or assessment by a regulator. Any adverse changes in these factors could have a significant impact on the recoverability of goodwill and could have a material impact on the Company’s Consolidated Financial Statements.
When required, the goodwill impairment test involves a two-step process. The first test for goodwill impairment is done by comparing the reporting unit’s aggregate fair value to its carrying value. Absent other indicators of impairment, if the aggregate fair value exceeds the carrying value, goodwill is not considered impaired and no additional analysis is necessary. If the carrying value of the reporting unit were to exceed the aggregate fair value, a second test would be performed to measure the amount of impairment loss, if any. To measure any impairment loss the implied fair value would be determined in the same manner as if the reporting unit were being acquired in a business combination. If the implied fair value of goodwill is less than the recorded goodwill an impairment charge would be recorded for the difference.
During 2011, ASU 2011-08 Intangibles—Goodwill and Other (Topic 350) was issued. Under the ASU, an entity is not required to calculate the fair value of a reporting unit unless the entity determines that it is more likely than not that its fair value is less than its carrying amount. In other words, before the first step of the existing guidance, the entity has the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that the fair value of goodwill is less than carrying value. The qualitative assessment includes adverse events or circumstances identified that could negatively affect the reporting units’ fair value as well as positive and mitigating events. If, after assessing the totality of events or circumstances, an entity determines it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then performing the two-step process is unnecessary. While the Company adopted the ASU in 2011, for the year ended December 31, 2014, the

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Company completed step one of the two-step process and concluded that the reporting unit’s fair value was greater than its carrying value and there was no impairment of goodwill.
Our Strategy
Our primary objective is to be a well-capitalized, profitable community banking organization, with balanced growth while emphasizing lending and deposit relationships with small and medium size businesses along with their owners and the general public. We consider ourselves to be an innovative team providing financial services focusing on the success of our customers. Our stated mission is: “We are committed to being the leading community bank in the Pacific Northwest by continuously improving: Customer Satisfaction, Employee Empowerment, Community Investment and Shareholder Value.” We will seek to achieve our objective through the following strategies:
Expand geographically as opportunities present themselves.    We are committed to continuing the controlled expansion of our franchise through strategic acquisitions designed to increase our market share and enhance franchise value. We believe that consolidation across the community bank landscape will continue to take place and further believe that, with our capital and liquidity positions, our approach to credit management and extensive acquisition experience, we are well positioned to take advantage of acquisitions or other business opportunities in our market areas. In markets where we wish to enter or expand our business, we will also consider opening de novo branches. In the past, we have successfully integrated acquired institutions and opened de novo branches. We will continue to be disciplined and opportunistic as it pertains to future acquisitions and de novo branching focusing on the Pacific Northwest markets we know and understand.
Focus on Asset Quality.    A strong credit culture is a high priority for us. We have a well-developed credit approval structure that has enabled us to maintain a standard of asset quality that we believe is conservative while at the same time maintaining our lending objectives. We will continue to focus on loan types and markets that we know well and where we have a historical record of success. We focus on loan relationships that are well diversified in both size and industry types. With respect to commercial business lending, which is our predominant lending activity, we view ourselves as cash-flow lenders obtaining additional support from realistic collateral values, personal guarantees and secondary sources of repayment. We have a problem loan resolution process that is focused on quick detection and feasible solutions. We seek to maintain strong internal controls and subject our loans to periodic internal loan reviews.
Maintain Strong Balance Sheet.    In addition to our focus on underwriting, we believe that the strength of our balance sheet has allowed us to endure the economic downturn experienced by the Pacific Northwest more successfully than many of our competitors. As of December 31, 2014, the ratio of our allowance for loan losses on noncovered loans to total noncovered loans was 1.04% and the ratio of the allowance for loan losses on noncovered loans to nonperforming noncovered loans was 294.98%. Our liquidity position is also strong, with $121.6 million in cash and cash equivalents as of December 31, 2014. As of December 31, 2014, the regulatory capital ratios of our subsidiary bank was well in excess of the levels required for “well-capitalized” status, and our consolidated total risk-based capital, Tier 1 risk-based capital and leverage capital ratios were 15.1%, 13.9% and 10.2%, respectively.
Deposit Growth.    Our strategic focus is to continuously grow deposits with emphasis on total relationship banking with our business and retail customers. We continue to seek to increase our market share in the communities we serve by providing exceptional customer service, focusing on relationship development with local businesses and strategic branch expansion. Our primary focus is to maintain a high level of non-maturity deposits to internally fund our loan growth with a low reliance on maturity (certificate) deposits. At December 31, 2014, as a percentage of our total deposits, non-maturity deposits were 81.9%. We maintain state-of-the-art technology-based products, including on-line personal financial management, business cash management, and business remote deposit products that enable us to compete effectively with banks of all sizes. Our retail management team is well-seasoned and has strong ties to the communities we serve with a strong focus on relationship building and customer service.
Emphasize business relationships with a focus on commercial lending.    We will continue to provide primarily commercial business, commercial real estate and residential construction loans with an emphasis on owner occupied commercial real estate and commercial business lending, and the deposit balances that accompany these relationships. Our seasoned lending staff has extensive knowledge and can add value through a focused advisory role that we believe strengthens our customer relationships and develops loyalty. We currently have and will seek to maintain a diversified portfolio of lending relationships without concentrations in any industry.
Recruit and retain highly competent personnel to execute our strategies.    Our compensation and staff development programs are aligned with our strategies to grow our loans and core deposits while maintaining our focus on asset quality. Our incentive systems are designed to achieve balanced high quality asset growth while maintaining appropriate mechanisms to reduce or eliminate incentive payments when appropriate. Our equity compensation programs and retirement benefits are designed to build and encourage employee ownership at all levels of the Company

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and we align employee performance objectives with corporate growth strategies and shareholder value. We have a strong corporate culture, which is supported by our commitment to internal development and promotion from within as well as the retention of management and officers in key roles.
Financial Overview
Heritage Financial Corporation is a bank holding company which primarily engages in the business activities of our wholly owned subsidiary, Heritage Bank. We provide financial services to our local communities with an ongoing strategic focus on our commercial banking relationships, market expansion and asset quality.
The Company has focused on expanding business over the past five years. In 2010, the Company completed two FDIC-assisted transactions of Cowlitz Bank in July 2010 and Pierce Commercial Bank in November 2010. In 2013, the Company completed two open-bank acquisitions of Northwest Commercial Bank in January 2013 and Valley Community Bancshares in July 2013. In May 2014, the Company completed the merger with Washington Banking Company. These acquisitions and mergers, together with organic growth of the business, has significantly increased the Company's net assets.
During the period from December 31, 2010 through December 31, 2014 our total assets have increased $2.09 billion, or 152.8%, to $3.46 billion as of December 31, 2014 from $1.37 billion at December 31, 2010. The noncovered loans receivable, net of allowance for loan losses grew $1.25 billion, or 147.1%, to $2.10 billion as of December 31, 2014 from $851.0 million at December 31, 2010. Our emphasis in growing our commercial business loan portfolio, in addition to mergers and acquisitions, resulted in an increase in noncovered commercial business loans of $993.6 million, or 139.9%, since December 31, 2010. Loan increases have benefited from the merger of Washington Banking and the acquisitions of Valley, Northwest Commercial Bank, Pierce Commercial Bank and Cowlitz Bank and our emphasis on increasing our lending in our market areas.
Deposits increased $1.77 billion, or 155.8%, to $2.91 billion at December 31, 2014 from $1.14 billion at December 31, 2010. From December 31, 2010 to December 31, 2014, non-maturity deposits (total deposits less certificate of deposit accounts) increased $1.65 billion, or 224.7% to $2.38 billion at December 31, 2014. As a result, the percentage of certificate of deposit accounts to total deposits decreased to 18.1% at December 31, 2014 from 35.5% at December 31, 2010.
Stockholders’ equity has increased by $252.2 million to $454.5 million at December 31, 2014 from $202.3 million at December 31, 2010 due primarily to a combination of earnings and issuances of common stock, partially offset by the redemption of preferred stock, repurchases of common stock and declaration of cash dividends. Our annual net income increased by 57.4%, or $7.7 million, to $21.0 million for the year ended December 31, 2014 from $13.4 million for the year ended December 31, 2010 due primarily to an increase of $64.4 million in net interest income that exceeded an increase in noninterest expense of $61.4 million, and a decrease in the provision for loan losses of $7.4 million.
Our core profitability depends primarily on our net interest income, which is the difference between the income we receive on our loan and investment portfolios, and our cost of funds, which consists of interest paid on deposits and borrowed funds. Like most financial institutions, our interest income and cost of funds are affected significantly by general economic conditions, particularly changes in market interest rates and government policies.
Changes in net interest income result from changes in volume, net interest spread, and net interest margin. Volume refers to the average dollar amounts of interest earning assets and interest bearing liabilities. Net interest spread refers to the difference between the average yield on interest earning assets and the average cost of interest bearing liabilities. Net interest margin refers to net interest income divided by average interest earning assets and is influenced by the level and relative mix of interest earning assets and interest bearing and noninterest bearing liabilities.
The following table provides relevant net interest income information for selected periods. The average daily loan balances presented in the table are net of allowances for loan losses. Nonaccrual loans have been included in the tables as loans carrying a zero yield. Yields on tax-exempt securities and loans have not been presented on a tax-equivalent basis.


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Years Ended December 31,
 
2014
 
2013
 
2012
 
Average
Balance
 
Interest
Earned/
Paid
 
Average
Yield/
Rate
 
Average
Balance
 
Interest
Earned/
Paid
 
Average
Yield/
Rate
 
Average
Balance
 
Interest
Earned/
Paid
 
Average
Yield/
Rate
 
(Dollars in thousands)
Interest Earning Assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loans, net
$
1,871,696

 
$
110,437

 
5.90
%
 
$
1,124,828

 
$
67,630

 
6.01
%
 
$
996,186

 
$
65,588

 
6.58
%
Taxable securities
383,626

 
7,328

 
1.91

 
117,132

 
1,918

 
1.64

 
118,124

 
2,195

 
1.86

Nontaxable securities
145,113

 
2,886

 
1.99

 
64,018

 
1,539

 
2.40

 
42,272

 
1,097

 
2.60

Other interest earning assets
150,189

 
455

 
0.30

 
104,770

 
341

 
0.33

 
92,324

 
229

 
0.25

Total interest earning assets
2,550,624

 
121,106

 
4.75

 
1,410,748

 
71,428

 
5.06

 
1,248,906

 
69,109

 
5.53

Noninterest earning assets
295,666

 
 
 
 
 
129,324

 
 
 
 
 
105,166

 
 
 
 
Total assets
$
2,846,290

 
 
 
 
 
$
1,540,072

 
 
 
 
 
$
1,354,072

 
 
 
 
Interest Bearing Liabilities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Certificates of deposit
$
494,948

 
$
2,991

 
0.60
%
 
$
307,464

 
$
2,478

 
0.81
%
 
$
306,772

 
$
3,016

 
0.98
%
Savings accounts
282,150

 
252

 
0.09

 
143,412

 
164

 
0.11

 
113,119

 
204

 
0.18

Interest bearing demand and money market accounts
1,049,078

 
1,907

 
0.18

 
541,793

 
1,031

 
0.19

 
466,268

 
1,249

 
0.27

Total interest bearing deposits
1,826,176

 
5,150

 
0.28

 
992,669

 
3,673

 
0.37

 
886,159

 
4,469

 
0.50

Junior subordinated debentures
12,751

 
458

 
3.59

 

 

 

 

 

 

FHLB advances and other borrowings
111

 

 

 

 

 

 

 

 

Securities sold under agreement to repurchase
27,984

 
73

 
0.26

 
19,102

 
51

 
0.27

 
18,314

 
65

 
0.35

Total interest bearing liabilities
1,867,022

 
5,681

 
0.30

 
1,011,771

 
3,724

 
0.37

 
904,473

 
4,534

 
0.50


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Years Ended December 31,
 
2014
 
2013
 
2012
 
Average
Balance
 
Interest
Earned/
Paid
 
Average
Yield/
Rate
 
Average
Balance
 
Interest
Earned/
Paid
 
Average
Yield/
Rate
 
Average
Balance
 
Interest
Earned/
Paid
 
Average
Yield/
Rate
 
(Dollars in thousands)
Demand and other noninterest bearing deposits
574,692

 
 
 
 
 
308,582

 
 
 
 
 
237,888

 
 
 
 
Other noninterest bearing liabilities
29,669

 
 
 
 
 
10,543

 
 
 
 
 
8,310

 
 
 
 
Stockholders’ equity
374,907

 
 
 
 
 
209,176

 
 
 
 
 
203,401

 
 
 
 
Total liabilities and stock-holders’ equity
$
2,846,290

 
 
 
 
 
$
1,540,072

 
 
 
 
 
$
1,354,072

 
 
 
 
Net interest income
 
 
$
115,425

 
 
 
 
 
$
67,704

 
 
 
 
 
$
64,575

 
 
Net interest spread
 
 
 
 
4.45
%
 
 
 
 
 
4.69
%
 
 
 
 
 
5.03
%
Net interest margin
 
 
 
 
4.53
%
 
 
 
 
 
4.80
%
 
 
 
 
 
5.17
%
Average interest earning assets to average interest bearing liabilities
 
 
 
 
136.61
%
 
 
 
 
 
139.43
%
 
 
 
 
 
138.08
%

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The following table provides the amount of change in our net interest income attributable to changes in volume and changes in interest rates. Changes attributable to the combined effect of volume and interest rates have been allocated proportionately for changes due specifically to volume and interest rates.
 
 
Years Ended December 31,
 
 
2014 Compared to 2013
Increase (Decrease) Due to
 
2013 Compared to 2012
Increase (Decrease) Due to
 
 
Volume
 
Rate
 
Total
 
Volume
 
Rate
 
Total
 
 
(In thousands)
Interest Earning Assets:
 
 
 
 
 
 
 
 
 
 
 
 
Loans
 
$
44,068

 
$
(1,261
)
 
$
42,807

 
$
7,735

 
$
(5,693
)
 
$
2,042

Taxable securities
 
5,090

 
320

 
5,410

 
(16
)
 
(261
)
 
(277
)
Nontaxable securities
 
1,613

 
(266
)
 
1,347

 
523

 
(81
)
 
442

Other interest earning assets
 
138

 
(24
)
 
114

 
40

 
72

 
112

Interest income
 
$
50,909

 
$
(1,231
)
 
$
49,678

 
$
8,282

 
$
(5,963
)
 
$
2,319

Interest Bearing Liabilities:
 
 
 
 
 
 
 
 
 
 
 
 
Certificates of deposit
 
$
1,133

 
$
(620
)
 
$
513

 
$
5

 
$
(543
)
 
$
(538
)
Savings accounts
 
124

 
(36
)
 
88

 
35

 
(75
)
 
(40
)
Interest bearing demand and money market accounts
 
922

 
(46
)
 
876

 
144

 
(362
)
 
(218
)
Total interest bearing deposits
 
2,179

 
(702
)
 
1,477

 
184

 
(980
)
 
(796
)
Junior subordinated debentures
 
458

 

 
458

 

 

 

FHLB advances and other borrowings
 

 

 

 

 

 

Securities sold under agreement to repurchase
 
23

 
(1
)
 
22

 
2

 
(16
)
 
(14
)
Interest expense
 
$
2,660

 
$
(703
)
 
$
1,957

 
$
186

 
$
(996
)
 
$
(810
)
Net Interest Income
 
$
48,249

 
$
(528
)
 
$
47,721

 
$
8,096

 
$
(4,967
)
 
$
3,129


Results of Operations for the Years Ended December 31, 2014 and 2013
Earnings Summary.    Net income applicable to common shareholders of $0.82 per diluted common share was recorded for the year ended December 31, 2014 compared to $0.61 per diluted common share for the year ended December 31, 2013. Net income for the year ended December 31, 2014 was $21.0 million compared to net income of $9.6 million for the same period in 2013. The $11.4 million increase was primarily the result of a $49.7 million increase in interest income and a $6.8 million increase in noninterest income, partially offset by a $39.9 million increase in noninterest expense, a $2.3 million increase in income tax expense, a $2.0 million increase in interest expense and a $922,000 increase in the provision for loan losses. The Company’s efficiency ratio decreased to 75.3% for the year ended December 31, 2014 from 76.9% for the year ended December 31, 2013 primarily due to net interest income increases related to the mergers and acquisitions as well as operating efficiencies gained by the Company which did not increase noninterest expenses by the same extent.
Net Interest Income.    Net interest income increased $47.7 million, or 70.5%, to $115.4 million for the year ended December 31, 2014 compared to $67.7 million for the previous year. The increase in net interest income was due primarily to increases in average interest earning assets, substantially attributable to the Washington Banking Merger, and the results of the positive effects of the discount accretion on the acquired loan portfolios for the year ended December 31, 2014. The increase in net interest income was partially offset by the decrease in the net interest margins due primarily to lower contractual loan note rates in the current lending environment. Net interest income as a percentage of average interest earning assets (net interest margin) for the year ended December 31, 2014 decreased 27 basis points to 4.53% from 4.80% for the previous year. Our net interest spread for the year ended December 31, 2014 decreased 24 basis points to 4.45% from 4.69% for the prior year.
Total interest income increased $49.7 million, or 69.5%, to $121.1 million for the year ended December 31, 2014, from $71.4 million for the year ended December 31, 2013. The increase in interest income was due primarily to the effects of the Washington Banking Merger and the positive effects of the accretable discount, offset partially by

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lower yields on interest earning assets. During the year ended December 31, 2014, the Company recorded approximately $10.8 million of discount accretion into interest income that related to the Washington Banking Merger. This income would be in addition to the acquired loans' contractual interest income. The balance of average interest earning assets (including nonaccrual loans) increased $1.14 billion, or 80.8%, to $2.55 billion for the year ended December 31, 2014 from $1.41 billion for the year ended December 31, 2013. The majority of this increase in interest earning assets was a result of the Washington Banking Merger. The Company acquired fair value at the May 1, 2014 merger date of $458.3 million in investment securities, $896.0 million in noncovered loans, $107.1 million in covered loans and $7.1 million of FHLB stock.
The yield on interest earning assets decreased 31 basis points to 4.75% for the year ended December 31, 2014 from 5.06% for the year ended December 31, 2013. The decrease in the yield on interest earning assets for the year ended December 31, 2014 reflects the decreased loan yields due primarily to lower contractual note rates, offset partially by the effects of the overall discount accretion on all the acquired loan portfolios. The effect of discount accretion on net interest margin for the year ended December 31, 2014 and December 31, 2013 is as follows:
 
Years Ended December 31,
 
2014
 
2013
Net interest margin, excluding incremental accretion on purchased loans (1)
3.97
%
 
4.32
%
Impact on net interest margin from incremental accretion on purchased loans (1)
0.56

 
0.48

Net interest margin
4.53
%
 
4.80
%
(1)
The incremental accretion income represents the amount of income recorded on the purchased loans in excess of the contractual stated interest rate in the individual loan notes. This income results from the discount established at the time these loan portfolios were acquired and modified quarterly as a result of cash flow re-estimation.
The yield on interest earning assets was reduced by nonaccruing loans. For both the years ended December 31, 2014 and December 31, 2013, nonaccruing loans reduced the yield on interest earning assets by approximately five basis points. Nonaccrual noncovered loans totaled $7.5 million at December 31, 2014 compared to $7.7 million at December 31, 2013.
Interest income on taxable and nontaxable investment securities increased $6.8 million to $10.2 million for the year ended December 31, 2014 from $3.5 million for the year ended December 31, 2013 due primarily to an increase in the average investment securities as a result of the Washington Banking Merger and an increase in yields on taxable investments securities, offset by lower yields earned on the nontaxable investment securities in 2014 as a result of declining interest rates. The changes in average balances and interest income on other interest earning had minimal impact on net interest margins for the years ended December 31, 2014 and 2013.
Total interest expense increased by $2.0 million, or 52.6%, to $5.7 million for the year ended December 31, 2014 from $3.7 million for the year ended December 31, 2013. The increase in interest expense was due to an increase in the average deposit balance, primarily as a result of the deposits acquired in the Washington Banking Merger which had a fair value at the acquisition date of $1.43 billion. The effects of the increase in the average deposit balance was offset by lower rates paid on interest bearing deposits, reflecting the relatively low interest rate environment. The average rate paid on interest bearing deposits decreased to 0.28% for the year ended December 31, 2014 from 0.37% for the year ended December 31, 2013. The Company also acquired junior subordinated debentures in the Washington Banking Merger with a fair value of $18.9 million at the merger date. The average rate paid on these liabilities during 2014 was 3.59%. Total average interest bearing liabilities increased by $855.3 million, or 84.5%, to $1.87 billion for the year ended December 31, 2014 from $1.01 billion for the year ended December 31, 2013 and the average rate was 0.30% and 0.37%, respectively.
Provision for Loan Losses.    The provision for loan losses increased $922,000, or 25.1%, to $4.6 million for the year ended December 31, 2014 from $3.7 million for the year ended December 31, 2013. The Bank has established a comprehensive methodology for determining the allowance for loan losses and related provision for loan losses on loans. On a quarterly basis, the Bank performs an analysis taking into consideration pertinent factors underlying the quality of the loan portfolio. These factors include changes in the amount and composition of the loan portfolio, historical loss experience for various loan classes, changes in economic conditions, delinquency rates, a detailed analysis of individual loans on nonaccrual status, and other factors to determine the level of the allowance for loan losses and the related provision for loan losses.
The provision for loan losses on noncovered loans increased $448,000, or 25.1%, to $2.2 million for the year ended December 31, 2014 from $1.8 million for the year ended December 31, 2013. The increase in provision expense

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on noncovered loans was due primarily to the resolution of nonperforming loans and the increase in volume of loans, offset partially by an improvement in the economy and a decrease in net charge-offs during the year ended December 31, 2014 compared the prior year.
The Bank had net charge-offs on noncovered loans of $2.7 million for the year ended December 31, 2014 compared to $3.4 million for the year ended December 31, 2013. The ratio of net charge-offs of noncovered to average total noncovered loans outstanding was 0.15% for the year ended December 31, 2014 and 0.32% for the year ended December 31, 2013. Total gross balance of noncovered loans at December 31, 2014 and 2013 were $2.13 billion and $1.17 billion, respectively. The general allowance as a percentage of non-impaired noncovered loans was 0.90% and 1.63% at December 31, 2014 and 2013, respectively. The decrease in the percentage during the noted periods is due to reduction in the historical loss factors, change in the mix of loans, and a general improvement in the credit environment. The general allowance as a percentage of non-impaired noncovered loans also decreased during the year ended December 31, 2014 as a result of the Washington Banking Merger, since the acquired loans were recorded at a net discount at the merger date and, accordingly, no allowance for loan losses was initially recorded for the acquired loans. The remaining discount for these acquired loans at December 31, 2014 was deemed sufficient to absorb known and inherent losses in the loan portfolio thereby reducing the need for an additional general valuation allowance.
The following table outlines the allowance for loan losses and related outstanding loan balances on noncovered loans at December 31, 2014 and 2013:
 
December 31, 2014
 
December 31, 2013
 
(Dollars in thousands)
General Valuation Allowance:
 
 
 
Allowance for loan losses on noncovered loans
$
18,918

 
$
18,618

Gross noncovered loan balance of non-impaired loans
2,099,658

 
1,140,967

Percentage
0.90
%
 
1.63
%
 
 
 
 
Specific Valuation Allowance:
 
 
 
Allowance for loan losses on noncovered loans
$
3,235

 
$
4,039

Gross noncovered loan balance of impaired loans
26,156

 
29,869

Percentage
12.37
%
 
13.52
%
 
 
 
 
Total Allowance for Loan Losses on noncovered loans:
 
 
 
Allowance for loan losses on noncovered loans
$
22,153

 
$
22,657

Gross noncovered loan balance
2,125,814

 
1,170,836

Percentage
1.04
%
 
1.94
%
The allowance for loan losses on noncovered loans decreased by $504,000, or 2.2%, to $22.2 million at December 31, 2014 from $22.7 million at December 31, 2013. As of December 31, 2014, the Bank identified $7.5 million of nonperforming noncovered loans and $18.8 million of performing restructured noncovered loans for a total of $26.2 million of impaired noncovered loans. Of these impaired loans, $6.3 million have no allowances for loan losses as their estimated collateral value or expected cash flow is equal to or exceeds their carrying costs. The remaining $19.9 million have related allowances for loan losses totaling $3.2 million. Based on the comprehensive methodology, management deemed the allowance for loan losses on noncovered loans of $22.2 million at December 31, 2014 (1.04% of total noncovered loans and 294.98% of nonperforming noncovered loans) appropriate to provide for probable incurred losses based on an evaluation of known and inherent risks in the loan portfolio at that date.
The provision for loan losses on covered loans increased $474,000, or 25.1%, to $2.4 million for the year ended December 31, 2014 compared to $1.9 million for the year ended December 31, 2013. The increase in provision for loan losses on covered loans recorded for the year ended December 31, 2014 was primarily a result of loans acquired in the Washington Banking Merger which had $646,000 of provision expense recorded during the year. The provision expense was necessary based on loan events that occurred after the May 1, 2014 merger date which caused the estimated loss on the loan to increase from original expectations. There was also the default of two large borrowers from the Cowlitz Acquisition which caused $915,000 in provision expense during the year ended December 31, 2014. The impact of these events was partially offset by the general improvements in the remaining loans' expected cash flows. The gross balance of the covered loans increased to $126.2 million at December 31, 2014 from $63.8 million at December 31, 2013 as a result of the covered loans acquired in the Washington Banking Merger. The Bank recorded

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net charge-offs on covered loans of $3.0 million for the year ended December 31, 2014 as compared to $73,000 for the year ended December 31, 2013.
The allowance for loan losses on covered loans decreased $591,000, or 9.58% to $5.6 million at December 31, 2014 from $6.2 million at December 31, 2013. The decrease was primarily the result of the resolution of specific covered loans, offset by the general improvements in the expected cash flow of the covered loans.
While the Bank believes it has established its existing allowance for loan losses in accordance with GAAP, there can be no assurance that regulators, in reviewing the Bank's loan portfolios, will not request the Bank to increase significantly its allowance for loan losses. In addition, because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses is appropriate or that increased provisions will not be necessary should the quality of the loans deteriorate. Any material increase in the allowance for loan losses would adversely affect the Company’s financial condition and results of operations. For additional information, see “Item 1. Business—Analysis of Allowance for Loan Losses.”
Noninterest Income.    Total noninterest income increased $6.8 million, or 70.6%, to $16.5 million for the year ended December 31, 2014 compared to $9.7 million for the prior year. The components of the noninterest income and the changes from prior year are as follows:
 
Years Ended December 31,
 
 
 
 
 
2014
 
2013
 
Change 2014 vs. 2013
 
Percentage Change
 
(Dollars in thousands)
Bargain purchase gain on bank acquisition
$

 
$
399

 
$
(399
)
 
100.0
 %
Service charges and other fees
11,143

 
5,936

 
5,207

 
87.7

Merchant Visa income, net
1,076

 
862

 
214

 
24.8

Change in FDIC indemnification asset
(2,543
)
 
(181
)
 
(2,362
)
 
(1,305.0
)
Gain on sale of investment securities, net
287

 

 
287

 
100.0

Gain on sale of loans, net
1,518

 
142

 
1,376

 
969.0

Other income
4,986

 
2,493

 
2,493

 
100.0

Total noninterest income
$
16,467

 
$
9,651

 
$
6,816

 
70.6
 %
The change in FDIC indemnification asset includes amortization of the FDIC indemnification asset and increases/decreases to the FDIC indemnification asset as a result of changes in projected remaining cash flows of the covered loans. The $2.4 million decrease was primarily due to a $2.2 million decrease in the loan (recapture) impairment and a $204,000 increase in amortization expense to $1.5 million for the year ended December 31, 2014 compared to $1.3 million for the year ended December 31, 2013. The Company recorded loan recaptures during the fourth quarter of 2014 due to the revised estimated loss projections given the 2015 expiration date of certain shared-loss agreements. While the Bank believes additional losses may be incurred on the assets, the timing of those losses will not likely occur before the expiration dates. The increase in the amortization expense was primarily due to the overall improvements of the covered loans because less loss is anticipated than prior period estimates. The balance of the indemnification asset at December 31, 2014 was $1.1 million compared to $4.4 million at December 31, 2013.
Service charges and other fees increased $5.2 million, or 87.7%, to $11.1 million for the year ended December 31, 2014 from $5.9 million for the year ended December 31, 2013 primarily as a result of an increase in the deposit accounts acquired in the Washington Banking Merger. See "Item 1. Business - Deposit Activities and Other Sources of Funds" for additional information. Total deposits increased $1.51 billion, or 107.7% to $2.91 billion at December 31, 2014 from $1.40 billion at December 31, 2013.
Gain on sale of loans, net increased $1.4 million, or 969.0%, to $1.5 million for the year ended December 31, 2014 from $142,000 for the year ended December 31, 2013 as a result of the Bank resuming mortgage banking operations. The Bank had ceased mortgage banking operations in the second quarter of 2013 and resumed these operations on the May 1, 2014 effective date of the merger as Washington Banking had a strong operational presence in the mortgage banking operations.
Other income increased $2.5 million, or 100.0%, to $5.0 million for the year ended December 31, 2014 from $2.5 million for the year ended December 31, 2013 partially due to recoveries on legacy Washington Banking loans which were fully charged-off prior to the merger date. The Bank had estimated that there would be no such recoveries for fair value purposes, but the recovery efforts of the credit department has exceeded anticipated results. Other

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income also increased by $390,000 in 2014 as a result of earnings on the BOLI from the $32.5 million of BOLI acquired on May 1, 2014 in the Washington Banking Merger. The increase in other income for 2014 was partially offset by a gain on sale of a bank branch of $596,000 recorded during the year ended December 31, 2013.
The bargain purchase gain on bank acquisition of $399,000 for the year ended December 31, 2013 was the result of the NCB Acquisition in January 2013. See Note - 2 Business Combinations of the Notes to Consolidated Financial Statements in "Item 8. Financial Statements and Supplementary Data" for additional information on the NCB Acquisition.
Noninterest Expense.    Noninterest expense increased $39.9 million or 67.0% to $99.4 million for the year ended December 31, 2014 compared to $59.5 million for the year ended December 31, 2013.
The following table presents the key components of noninterest expense and the changes from prior year:
 
Years Ended December 31,
 
 
 
 
 
2014
 
2013
 
Change 2014 vs. 2013
 
Percentage Change
 
(Dollars in thousands)
Compensation and employee benefits
$
52,634

 
$
31,612

 
$
21,022

 
66.5
%
Occupancy and equipment
13,406

 
9,724

 
3,682

 
37.9

Data processing
9,243

 
4,806

 
4,437

 
92.3

Marketing
2,502

 
1,598

 
904

 
56.6

Professional services
6,185

 
3,936

 
2,249

 
57.1

State and local taxes
1,976

 
1,150

 
826

 
71.8

Impairment loss on investment securities, net
45

 
38

 
7

 
18.4

Federal deposit insurance premium
1,718

 
1,001

 
717

 
71.6

Other real estate owned, net
638

 
309

 
329

 
106.5

Amortization of intangible assets
1,920

 
543

 
1,377

 
253.6

Other expense
9,112

 
4,798

 
4,314

 
89.9

Total noninterest expense
$
99,379

 
$
59,515

 
$
39,864

 
67.0
%
The increase in total noninterest expense for the year ended December 31, 2014 was due primarily to the Washington Banking Merger and additional ongoing operating costs from mergers and acquisitions as well as specific costs identified in the Company Initiatives table below. These initiatives include the NCB and Valley Acquisitions, the merger of Central Valley Bank and the merger of Washington Banking Company, all of which are discussed in Notes 1 and 2 of the Notes to Consolidated Financial Statements in "Item. 8 Financial Statements and Supplementary Data". Additionally, a core system conversion occurred in fourth quarter of 2013 whereby, after 18 years of using FiServ's Total Plus core system, the Company converted to FiServ's DNA platform which provides a variety of efficiencies in all operation areas of the Bank. The consolidation of existing branches also occurred in the fourth quarter of 2013 with the Company consolidating three Heritage branch locations to nearby branches. The table below includes each of the Company's major initiatives as well as the direct costs associated with the initiatives for the years ended December 31, 2014 and 2013. The amounts include identifiable costs paid to third party providers as well as any retention bonuses or severance payment made in conjunction with these initiatives. The amounts do not include costs of additional staffing required to be maintained or utilized during a period of time in order to complete the initiatives.

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Years Ended December 31,
 
 
2014
 
2013
 
 
(In thousands)
Company Initiatives:
 
 
 
 
NCB Acquisition
 
$

 
$
794

CVB Merger
 

 
220

Valley Acquisition
 
443

 
2,118

Core system conversion
 
40

 
842

Consolidation of existing branches
 
11

 
238

Washington Banking Merger
 
9,094

 
890

Total expense
 
$
9,588

 
$
5,102

The following table further segregates the Company initiative costs by financial statement caption.
 
 
Years Ended December 31,
 
 
2014
 
2013
 
 
(In thousands)
Expense Caption:
 
 
 
 
Compensation and employee benefits
 
$
1,522

 
$
475

Occupancy and equipment
 
602

 
1,328

Data processing
 
3,038

 
1,291

Marketing
 
140

 
34

Professional services
 
3,751

 
1,876

Other expense
 
535

 
98

Total expense
 
$
9,588

 
$
5,102

The types of expenses associated with the significant expense categories in the table above are summarized as follows:
Compensation and employee benefits expense consisted substantially of retention bonus and severances packages paid to transition employees.
Occupancy and equipment expense consisted primarily of lease termination costs.
Data processing expense consisted of costs relating to the Company’s core system conversion as well as data conversions of the NCB, Valley Bank and Whidbey Island Bank information to the Heritage core system.
Professional services expense related to fees paid to: (1) financial advisors for the NCB Acquisition, Valley Acquisition and Washington Banking Merger, (2) attorney, accountant and consultant fees related to mergers and acquisitions, and (3) consultant fees relating to the Company's core system conversion.
Other expense increased $4.3 million, or 89.9%, to $9.1 million for the year ended December 31, 2014 from $4.8 million for the year ended December 31, 2013. Other expense includes, but is not limited to, items such as courier services, phone costs, travel expenses, investor relations, and certain employee-related costs such as travel and meals. The increases in other expense are primarily as a result of the Washington Banking Merger and the general increase due to the growth of the Company during the year ended December 31, 2014 which is demonstrated by the increase in total assets to $3.46 billion at December 31, 2014 from $1.66 billion at December 31, 2013.
The efficiency ratio for the year ended December 31, 2014 was 75.3% compared to 76.9% for the same period in the prior year. The efficiency ratio consists of noninterest expense divided by the sum of net interest income before provision for loan losses plus noninterest income. The decrease in the ratio for the year ended December 31, 2014 was primarily related to the increase in net interest income related to mergers and acquisitions as described above which outpaced the increase in the noninterest expense as described above. As cost savings are realized from the Washington Banking Merger, the Company expects the efficiency ratio to continue to decrease.
Income Tax Expense.    The provision for income taxes increased by $2.3 million to an expense of $6.9 million for the year ended December 31, 2014 from an expense of $4.6 million for the year ended December 31, 2013. The Company’s effective income tax rate was 24.7% for the year ended December 31, 2014 compared to 32.4% for the

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same period in 2013. The decrease in the Company’s effective income tax rate from the prior year was primarily due to higher levels of tax-exempt income in 2014, $812,000 in federal tax credits from new market tax credit partnerships and a $728,000 income tax benefit related to the resolution of a tax position previously taken by Washington Banking Company.
Results of Operations for the Years Ended December 31, 2013 and 2012
Earnings Summary.    Net income applicable to common shareholders of $0.61 per diluted common share was recorded for the year ended December 31, 2013 compared to $0.87 per diluted common share for the year ended December 31, 2012. Net income for the year ended December 31, 2013 was $9.6 million compared to net income of $13.3 million for the same period in 2012. The $3.7 million decrease was primarily the result of a $9.1 million increase in noninterest expense and a $1.7 million increase in the provision for loan losses, partially offset by a $2.3 million increase in interest income, a $2.4 million increase in noninterest income, a $1.6 million decrease in income tax expense and a $810,000 decrease in interest expense. The Company’s efficiency ratio increased to 76.9% for the year ended December 31, 2013 from 70.1% for the year ended December 31, 2012 primarily due to increases in the noninterest expense of $4.5 million related to the Company initiatives including the acquisitions and system conversions of Northwest Commercial Bank and Valley Bank, the merger of Central Valley Bank, the core system conversion, the consolidation of existing branches and the Washington Banking Company merger. The details of these expenses are included in the "Noninterest Expense" section below.
Net Interest Income.    Net interest income increased $3.1 million, or 4.8%, to $67.7 million for the year ended December 31, 2013 compared to $64.6 million for the previous year. The increase in net interest income was due primarily to increases in average interest earning assets, substantially attributable to the NCB and Valley Acquisitions, and the results of the positive effects of the discount accretion on the acquired loan portfolios for the year ended December 31, 2013. The increase in net interest income was partially offset by the decrease in the net interest margins due primarily to lower contractual loan note rates in the current lending environment. Net interest income as a percentage of average interest earning assets (net interest margin) for the year ended December 31, 2013 decreased 37 basis points to 4.80% from 5.17% for the previous year. Our net interest spread for the year ended December 31, 2013 decreased to 4.69% from 5.03% for the prior year.
Total interest income increased $2.3 million, or 3.4%, to $71.4 million for the year ended December 31, 2013, from $69.1 million for the year ended December 31, 2012. The increase in interest income was due primarily to the effects of the NCB and Valley Acquisitions and the positive effects of the accretable discount, offset partially by lower yields on interest earning assets. During the year ended December 31, 2013, the Company recorded approximately $2.7 million of discount accretion into interest income that related to the NCB and Valley Acquisitions. This income would be in addition to the acquired loans' contractual interest income. The balance of average interest earning assets (including nonaccrual loans) increased $161.8 million, or 13.0%, to $1.41 billion for the year ended December 31, 2013 from $1.25 billion for the year ended December 31, 2012. The majority of this increase in interest earning assets was a result of the NCB and Valley Acquisitions. The Company acquired combined fair value at respective acquisition dates of $14.9 million in interest earning deposits, $57.1 million in investment securities and $168.6 million in noncovered loans. The Company additionally generated organic growth by increasing the noncovered loan receivable balance by $61.0 million, or 6.5% due to loan originations, net of loan payments.
The yield on interest earning assets decreased 47 basis points to 5.06% for the year ended December 31, 2013 from 5.53% for the year ended December 31, 2012. The decrease in the yield on interest earning assets for the year ended December 31, 2013 reflects the decreased loan yields due primarily to lower contractual note rates as well as the effects of the overall discount accretion on all the acquired loan portfolios. The effect of discount accretion on net interest margin for the year ended December 31, 2013 and December 31, 2012 is as follows:
 
Years Ended 
 December 31,
 
2013
 
2012
Net interest margin, excluding incremental accretion on purchased loans (1)
4.32
%
 
4.67
%
Impact on net interest margin from incremental accretion on purchased loans (1)
0.48

 
0.50

Net interest margin
4.80
%
 
5.17
%
(1)
The incremental accretion income represents the amount of income recorded on the purchased loans in excess of the contractual stated interest rate in the individual loan notes. This income results from the discount established at the time these loan portfolios were acquired and modified quarterly as a result of cash flow re-estimation.

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Yield on interest earning assets was additionally reduced by nonaccruing loans. For the years ended December 31, 2013 and December 31, 2012, noncovered nonaccruing loans reduced the yield on interest earning assets by approximately five basis points and seven basis points, respectively. Nonaccrual noncovered loans totaled $7.7 million at December 31, 2013 compared to $13.2 million at December 31, 2012.
Interest income on taxable and nontaxable investment securities increased $165,000 to $3.5 million for the year ended December 31, 2013 from $3.3 million for the year ended December 31, 2012 due primarily to an increase in the average investment securities as a result of the NCB and Valley Acquisitions offset by lower yields earned on the investment securities in 2013 as a result of declining interest rates. The changes in average balances and interest income on other interest earning deposits had minimal impact on net interest margins for the years ended December 31, 2013 and 2012.
Total interest expense decreased by $810,000, or 17.9%, to $3.7 million for the year ended December 31, 2013 from $4.5 million for the year ended December 31, 2012. The decrease in interest expense was due to lower rates paid on interest bearing liabilities, reflecting the relatively low interest rate environment. The average rate paid on interest bearing liabilities decreased to 0.37% for the year ended December 31, 2013 from 0.50% for the year ended December 31, 2012. Total average interest bearing liabilities increased by $107.3 million, or 11.9%, to $1.01 billion for the year ended December 31, 2013 from $904.5 million for the year ended December 31, 2012. The increase in average interest bearing liabilities was due primarily to the NCB and Valley Acquisitions which had a combined fair value at the acquisitions dates of $267.5 million, offset by deposit run-off anticipated from the acquisitions and consolidation of existing bank branches.
Provision for Loan Losses.    The total provision for loan losses increased $1.7 million, or 82.1%, to $3.7 million for the year ended December 31, 2013 from $2.0 million for the year ended December 31, 2012. The Bank has established a comprehensive methodology for determining the allowance for loan losses and related provision for loan losses on loans. On a quarterly basis, the Bank performs an analysis taking into consideration pertinent factors underlying the quality of the loan portfolio. These factors include changes in the amount and composition of the loan portfolio, historical loss experience for various loan classes, changes in economic conditions, delinquency rates, a detailed analysis of individual loans on nonaccrual status, and other factors to determine the level of the allowance for loan losses and the related provision for loan losses.
The provision for loan losses on noncovered loans increased $214,000, or 13.6%, to $1.8 million for the year ended December 31, 2013 from $1.6 million for the year ended December 31, 2012. The increase in provision expense on noncovered loans was due primarily to the default of a few acquired borrowing relationships, offset partially by improvements in the environmental factors as well as lower net charge-offs on noncovered loans which decreased to $3.4 million during the year ended December 31, 2013 compared to $4.3 million during the year ended December 31, 2012. The ratio of net charge-offs for noncovered loan to average total noncovered loans outstanding was 0.32% for the year ended December 31, 2013 and 0.48% for the year ended December 31, 2012. Total noncovered loans at December 31, 2013 and 2012 were $1.17 billion and $940.7 million, respectively. The general allowance as a percentage of non-impaired loans was 1.63% and 2.11% at December 31, 2013 and 2012, respectively. The decrease in the percentage during the noted periods is due to reduction in the historical loss factors, change in the mix of loans, and a general improvement in the credit environment.

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The following table outlines the allowance for loan losses and related outstanding loan balances on noncovered loans at December 31, 2013 and 2012:
 
December 31, 2013
 
December 31, 2012
 
(Dollars in thousands)
General Valuation Allowance:
 
 
 
Allowance for loan losses on noncovered loans
$
18,618

 
$
19,558

Gross noncovered loan balance of non-impaired loans
1,140,967

 
927,485

Percentage
1.63
%
 
2.11
%
 
 
 
 
Specific Valuation Allowance:
 
 
 
Allowance for loan losses on noncovered loans
$
4,039

 
$
4,684

Gross noncovered loan balance of impaired loans
29,869

 
13,219

Percentage
13.52
%
 
35.43
%
 
 
 
 
Total Allowance for Loan Losses on noncovered loans:
 
 
 
Allowance for loan losses on noncovered loans
$
22,657

 
$
24,242

Gross noncovered loan balance
1,170,836

 
940,704

Percentage
1.94
%
 
2.58
%
The allowance for loan losses on noncovered loans decreased by $1.6 million, or 6.5%, to $22.7 million at December 31, 2013 from $24.2 million at December 31, 2012. As of December 31, 2013, the Bank identified $7.7 million of nonperforming noncovered loans and $22.1 million of performing restructured noncovered loans for a total of $29.9 million of impaired noncovered loans. Of these impaired loans, $17.4 million have no allowances for loan losses as their estimated collateral value or expected cash flow is equal to or exceeds their carrying costs. The remaining $12.4 million have related allowances for loan losses totaling $4.0 million. Based on the comprehensive methodology, management deemed the allowance for loan losses on noncovered loans of $22.7 million at December 31, 2013 (1.94% of total noncovered loans and 292.8% of nonperforming noncovered loans) appropriate to provide for probable incurred losses based on an evaluation of known and inherent risks in the loan portfolio at that date.
The provision for loan losses on covered loans increased $1.4 million, or 323.3%, to $1.9 million for the year ended December 31, 2013 compared to $446,000 for the year ended December 31, 2012. The provision for loan losses on covered loans recorded for the year ended December 31, 2013 was a result of several specific loan events. The Bank resolved one significant covered loan which generated approximately $585,000 in provision expense. The Bank also experienced significant collateral deficiencies on two borrowers which added an additional $1.6 million in provision expense. The impact of these events was partially offset by the general improvements in the remaining loans' expected cash flows which reduced the provision expense during the year ended December 31, 2013. The Bank recorded net charge-offs of $73,000 for the covered loans for the year ended December 31, 2013 as compared to $57,000 for the year ended December 31, 2012.
The allowance for loan losses on covered loans increased $1.8 million, or 41.7% to $6.2 million at December 31, 2013 from $4.4 million at December 31, 2012. The increase was primarily the result of the specific covered loans described above, offset by the general improvements in the expected cash flow of the covered loans.
Noninterest Income.    Total noninterest income increased $2.4 million, or 32.7%, to $9.7 million for the year ended December 31, 2013 compared to $7.3 million for the prior year.

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The components of the noninterest income and the changes from prior year are as follows:
 
Years Ended December 31,
 
 
 
 
 
2013
 
2012
 
Change 2013 vs. 2012
 
Percentage Change
 
(Dollars in thousands)
Bargain purchase gain on bank acquisition
$
399

 
$

 
$
399

 
100.0
 %
Service charges and other fees
5,936

 
5,516

 
420

 
7.6

Merchant Visa income, net
862

 
685

 
177

 
25.8

Change in FDIC indemnification asset
(181
)
 
(1,033
)
 
852

 
82.5

Gain on sale of loans
142

 
295

 
(153
)
 
(51.9
)
Other income
2,493

 
1,809

 
684

 
37.8

Total noninterest income
$
9,651

 
$
7,272

 
$
2,379

 
32.7
 %
The change in FDIC indemnification asset includes amortization of the FDIC indemnification asset and increases to the FDIC indemnification asset as a result of decreases in projected remaining cash flows of the purchased covered loans. The increase in this income was primarily due to the $609,000 decrease in amortization expense of $1.3 million for the year ended December 31, 2013 compared to $1.9 million for the year ended December 31, 2012. The decrease in the amortization expense was primarily due to the declining indemnification asset balance. The balance of the indemnification asset at December 31, 2013 was $4.4 million compared to $7.1 million at December 31, 2012. The change in FDIC indemnification asset also increased due to an increase in the loan impairment, which was an increase of income of $1.1 million for the year ended December 31, 2013 compared to $843,000 in the prior year. Under the symmetrical accounting for acquired covered loans, an increase in the provision for loan losses for covered loans will generally have a related increase in the loan impairment. The provision for loan losses on covered loans was $1.9 million for the year ended December 31, 2013 compared to $446,000 for the year ended December 31, 2012.
Other income increased $684,000, or 37.8%, to $2.5 million for the year ended December 31, 2013 from $1.8 million for the year ended December 31, 2012 primarily due to the gain on sale of a bank branch of $596,000. The $420,000 increase in service charges and other fees to $5.9 million for the year ended December 31, 2013 compared to $5.5 million for the prior year was primarily the result of increased deposits and an expanded customer base. Deposits at December 31, 2013 increased to $1.40 billion at December 31, 2013 from $1.12 billion at December 31, 2012 primarily as a result of the NCB and Valley Acquisitions. The bargain purchase gain on bank acquisition of $399,000 for the year ended December 31, 2013 was the result of the NCB Acquisition in January 2013. See Note 2 - Business Combinations of the Notes to Consolidated Financial Statements in "Item 8. Financial Statements and Supplementary Data" for additional information on the NCB and Valley Acquisitions.
Noninterest Expense.    Noninterest expense increased $9.1 million or 18.1% to $59.5 million for the year ended December 31, 2013 compared to $50.4 million for the year ended December 31, 2012.

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The following table presents the key components of noninterest expense and the change from prior year:
 
Years Ended December 31,
 
 
 
 
 
2013
 
2012
 
Change 2013 vs. 2012
 
Percentage Change
 
(Dollars in thousands)
Compensation and employee benefits
$
31,612

 
$
29,020

 
$
2,592

 
8.9
 %
Occupancy and equipment
9,724

 
7,365

 
2,359

 
32.0

Data processing
4,806

 
2,555

 
2,251

 
88.1

Marketing
1,598

 
1,517

 
81

 
5.3

Professional services
3,936

 
2,543

 
1,393

 
54.8

State and local taxes
1,150

 
1,226

 
(76
)
 
(6.2
)
Impairment loss on investment securities, net
38

 
78

 
(40
)
 
(51.3
)
Federal deposit insurance premium
1,001

 
1,002

 
(1
)
 
(0.1
)
Other real estate owned, net
309

 
316

 
(7
)
 
(2.2
)
Amortization of intangible assets
543

 
427

 
116

 
27.2

Other expense
4,798

 
4,343

 
455

 
10.5

Total noninterest expense
$
59,515

 
$
50,392

 
$
9,123

 
18.1
 %
The increase in total noninterest expense for the year ended December 31, 2013 was due primarily to increased expenses related to 2013 Company initiatives. The table below includes each of the Company's major initiatives as well as the direct costs associated with the initiatives for the years ended December 31, 2013 and 2012. The amounts include identifiable costs paid to third party providers as well as any retention bonuses or severance payment made in conjunction with these initiatives. The amounts do not include costs of additional staffing required to be maintained or utilized during a period of time in order to complete the initiatives.
 
 
Years Ended December 31,
 
 
2013
 
2012
 
 
(In thousands)
Company Initiatives:
 
 
 
 
NCB Acquisition
 
$
794

 
$
616

CVB Merger
 
220

 

Valley Acquisition
 
2,118

 

Core system conversion
 
842

 

Consolidation of existing branches
 
238

 

Washington Banking Merger
 
890

 

Total expense
 
$
5,102

 
$
616


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The following table further segregates the Company initiative costs by financial statement caption.
 
 
Years Ended December 31,
 
 
2013
 
2012
 
 
(In thousands)
Expense Caption:
 
 
 
 
Compensation and employee benefits
 
$
475

 
$

Occupancy and equipment
 
1,328

 

Data processing
 
1,291

 

Marketing
 
34

 

Professional services
 
1,876

 
610

Other expense
 
98

 
6

Total expense
 
$
5,102

 
$
616

Other expense includes, but is not limited to, items such as courier services, travel expenses, investor relations, and certain employee-related costs such as travel and meals. The increase in other expense for the year ended December 31, 2013 as compared to the year ended December 31, 2012 was partly due to the investor relations expense increase of $115,000 as a result of the NCB and Valley Acquisitions as well as the Washington Banking Merger. The remaining increases in other expense were the result of general increases due to the growth of the Company during the year ended December 31, 2013 which is demonstrated by the increase in total assets to $1.66 billion at December 31, 2013 from $1.35 billion at December 31, 2012 .
The efficiency ratio for the year ended December 31, 2013 was 76.9% compared to 70.1% for the same period in the prior year. The efficiency ratio consists of noninterest expense divided by the sum of net interest income before provision for loan losses plus noninterest income. The increase in the ratio for the year ended December 31, 2013 was primarily related to the increase in noninterest expense as described above. While growth strategies are being executed, the Company expects to incur higher noninterest expenses as evidenced by the current increasing efficiency ratio. Noninterest expenses are expected to be more in line with income when these growth strategies begin producing long term results.
Income Tax Expense.    The provision for income taxes decreased by $1.6 million to an expense of $4.6 million for the year ended December 31, 2013 from an expense of $6.2 million for the year ended December 31, 2012. The Company’s effective income tax rate was 32.4% for the year ended December 31, 2013 compared to 31.8% for the same period in 2012. The increase in the Company’s effective income tax rate from the prior year was primarily due to increased non-deductible acquisition expenses.
Liquidity and Capital Resources
Our primary sources of funds are customer and local government deposits, loan principal and interest payments, loan sales, interest earned on and proceeds from sales and maturities of investment securities. These funds, together with retained earnings, equity and other borrowed funds, are used to make loans, acquire investment securities and other assets, and fund continuing operations. While maturities and scheduled amortization of loans are a predictable source of funds, deposit flows and loan prepayments are greatly influenced by the level of interest rates, economic conditions, and competition.
We must maintain an adequate level of liquidity to ensure the availability of sufficient funds to fund loan originations and deposit withdrawals, satisfy other financial commitments, and fund operations. We generally maintain sufficient cash and investments to meet short-term liquidity needs. At December 31, 2014, cash and cash equivalents totaled $121.6 million, or 3.5% of total assets. Other interest earning deposits totaled $10.1 million at December 31, 2014. These assets are easily converted to liquidity. Investment securities available for sale totaled $742.8 million at December 31, 2014, of which $183.5 million were pledged to secure public deposits or borrowing arrangements. Management considers unpledged investment securities available for sale to be a viable source of liquidity. The fair value of investment securities available for sale that were not pledged to secure public deposits or borrowing arrangements totaled $559.3 million, or 16.2% of total assets at December 31, 2014. The fair value of investment securities available for sale with maturities of one year or less amounted to $4.2 million, or 0.1% of total assets. At December 31, 2014, the Bank maintained credit facilities with the FHLB of Seattle for $374.3 million and credit facilities with the Federal Reserve Bank of San Francisco for $53.2 million, of which there were no borrowings outstanding as of December 31, 2014. The Bank also maintains advance lines with Zions Bank, Wells Fargo Bank, US Bank and

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Pacific Coast Bankers’ Bank to purchase federal funds totaling $43.0 million as of December 31, 2014. As of December 31, 2014, there were no overnight federal funds purchased.
During 2014 total assets increased $1.80 billion, or 108.4%, to $3.46 billion at December 31, 2014 from $1.66 billion at December 31, 2013. The increase was primarily due to the assets acquired in the Washington Banking Merger. The components of the change in assets and the fair value of assets acquired at the May 1, 2014 merger date are included in the following table:
 
December 31, 2014
 
December 31, 2013
 
Change 2014 vs. 2013
 
Fair Value of Washington Banking at Merger Date
 
(Dollars in thousands)
Cash and cash equivalents
$
121,636

 
$
130,400

 
$
(8,764
)
 
$
74,947

Other interest earning deposits
10,126

 
15,662

 
(5,536
)
 

Investment securities available for sale
742,846

 
163,134

 
579,712

 
458,312

Investment securities held to maturity
35,814

 
36,154

 
(340
)
 

Loans held for sale
5,582

 

 
5,582

 
3,923

Noncovered loans receivable, net of allowance for loan losses
2,102,724

 
1,145,509

 
957,215

 
895,978

Covered loans receivable, net of allowance for loan losses
120,624

 
57,587

 
63,037

 
107,050

FDIC indemnification asset
1,116

 
4,382

 
(3,266
)
 
7,174

Other real estate owned
3,355

 
4,559

 
(1,204
)
 
7,121

Premises and equipment, net
64,938

 
34,348

 
30,590

 
31,776

FHLB stock, at cost
12,188

 
5,741

 
6,447

 
7,064

Bank owned life insurance
35,176

 
2,193

 
32,983

 
32,519

Accrued interest receivable
9,836

 
5,462

 
4,374

 
4,943

Prepaid expenses and other assets
61,871

 
22,927

 
38,944

 
14,852

Other intangible assets, net
10,889

 
1,615

 
9,274

 
11,194

Goodwill
119,029

 
29,365

 
89,664

 
89,664

Total assets
$
3,457,750

 
$
1,659,038

 
$
1,798,712

 
$
1,746,517

Our strategy has been to acquire core deposits (which we define to include all deposits except public funds, brokered CDs and other wholesale deposits) from our retail accounts, acquire noninterest bearing demand deposits from our commercial customers and use our available borrowing capacity to fund growth in assets. We anticipate that we will continue to rely on the same sources of funds in the future and use those funds primarily to make loans and purchase investment securities.
Stockholders’ equity was $454.5 million at December 31, 2014 and $215.8 million at December 31, 2013. During the year ended December 31, 2014, we issued 14.0 million shares of common stock valued at $226.2 million related to the Washington Banking Merger, net of $489,000 of stock issuance costs, realized net income of $21.0 million, paid common stock dividends of $12.9 million, recorded $4.7 million in net unrealized gains on investment securities available for sale, net of tax, repurchased $2.6 million in common stock, recorded stock option and restricted stock compensation expense, net of tax, totaling $1.5 million and realized the effects of exercising stock options totaling $921,000.
The Company and the Bank are subject to various regulatory capital requirements as prescribed by the Federal Reserve and by the FDIC, respectively. As of December 31, 2014, the Company and the Bank were classified as “well capitalized” institutions under the criteria established by these banking regulators.
Quarterly, the Company reviews the potential payment of cash dividends to common shareholders. 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 Bank, which is the Company’s predominant sources of income. On January 28, 2015, the Company’s Board of Directors declared a dividend of $0.10 per share payable on February 24, 2015 to shareholders of record on February 10, 2015.


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Contractual Obligations
The following table provides the amounts due under specified contractual obligations for the periods indicated as of December 31, 2014:
 
 
December 31, 2014
 
 
Up to
1 year
 
Over 1-3
years
 
Over 3-5
years
 
More
than
5 years
 
Other (1)
 
Total
 
 
(In thousands)
Contractual payments by period:
 
 
 
 
 
 
 
 
 
 
 
 
Deposits
 
$
347,895

 
$
143,103

 
$
33,770

 
$
629

 
$
2,380,934

 
$
2,906,331

Operating leases
 
3,307

 
5,725

 
3,780

 
3,723

 

 
16,535

Total contractual obligations
 
$
351,202

 
$
148,828

 
$
37,550

 
$
4,352

 
$
2,380,934

 
$
2,922,866

(1)
Represents interest bearing and noninterest bearing checking, money market and checking accounts which can generally be withdrawn on demand and thereby have an undefined maturity.

Asset/Liability Management
Our primary financial objective is to achieve long-term profitability while controlling our exposure to fluctuations in market interest rates. To accomplish this objective, we have formulated an interest rate risk management policy that attempts to manage the mismatch between asset and liability maturities while maintaining an acceptable interest rate sensitivity position. The principal strategies which we employ to control our interest rate sensitivity are: originating certain commercial business loans and real estate construction and land development loans at variable interest rates repricing for terms generally one year or less; and offering noninterest bearing demand deposit accounts to businesses and individuals. The longer-term objective is to increase the proportion of noninterest bearing demand deposits, low-rate interest bearing demand deposits, money market accounts, and savings deposits relative to certificates of deposit to reduce our overall cost of funds.
Our asset and liability management strategies have resulted in a negative 0-3 month “gap” of 21.8% and a negative 4-12 month “gap” of 3.4% as of December 31, 2014. These “gaps” measure the difference between the dollar amount of our interest earning assets and interest bearing liabilities that mature or reprice within the designated period (three months and 4-12 months) as a percentage of total interest earning assets, based on certain estimates and assumptions as discussed below. We believe that the implementation of our operating strategies has reduced the potential effects of changes in market interest rates on our results of operations. The negative gap for the 0-3 month period indicates that decreases in market interest rates may favorably affect our results over that period.
The following table provides the estimated maturity or repricing and the resulting interest rate sensitivity gap of our interest earning assets and interest bearing liabilities at December 31, 2014. We used certain assumptions in presenting this data so the amounts may not be consistent with other financial information prepared in accordance with generally accepted accounting principles. The amounts in the tables also could be significantly affected by external factors, such as changes in prepayment assumptions, early withdrawal of deposits and competition.

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December 31, 2014
 
 
Estimated Maturity or Repricing Within
 
 
0-3
months
 
Over 3
months-12
months
 
1-5
years
 
Over 5
years -15
years
 
Over
15 years
 
Total
 
 
(Dollars in thousands)
Interest Earnings Assets:
 
 
 
 
 
 
 
 
 
 
 
 
Loans Receivable (1)
 
$
1,077,856

 
$
87,449

 
$
919,891

 
$
165,551

 
$
1,267

 
$
2,252,014

Investment securities (2)
 
34,000

 
27,075

 
136,295

 
384,953

 
196,337

 
778,660

FHLB stock
 
12,188

 

 

 

 

 
12,188

Interest earning deposits
 
47,608

 

 

 

 

 
47,608

Other interest earning deposits
 
818

 
6,572

 
2,736

 

 

 
10,126

Total interest earning assets
 
$
1,172,470

 
$
121,096

 
$
1,058,922

 
$
550,504

 
$
197,604

 
$
3,100,596

 
 
 
 
 
 
 
 
 
 
 
 
 
Percentage of interest earning assets
 
37.8
 %
 
3.9
 %
 
34.2
%
 
17.7
%
 
6.4
%
 
100.0
%
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest Bearing Liabilities:
 
 
 
 
 
 
 
 
 
 
 
 
Total interest bearing deposits(3)
 
$
1,797,371

 
$
225,216

 
$
173,442

 
$
629

 
$

 
$
2,196,658

Junior subordinated debentures
 
19,082

 

 

 

 

 
19,082

Securities sold under agreement to repurchase
 
32,181

 

 

 

 

 
32,181

Total interest bearing liabilities
 
$
1,848,634

 
$
225,216

 
$
173,442

 
$
629

 
$

 
$
2,247,921

 
 
 
 
 
 
 
 
 
 
 
 
 
Interest bearing liabilities, as a percentage of total interest earning assets
 
59.6
 %
 
7.3
 %
 
5.6
%
 
%
 
%
 
72.5
%
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest rate sensitivity gap
 
$
(676,164
)
 
$
(104,120
)
 
$
885,480

 
$
549,875

 
$
197,604

 
$
852,675

Interest rate sensitivity gap, as a percentage of total interest earning assets
 
(21.8
)%
 
(3.4
)%
 
28.6
%
 
17.7
%
 
6.4
%
 
27.5
%
Cumulative interest rate sensitivity gap
 
$
(676,164
)
 
$
(780,284
)
 
$
105,196

 
$
655,071

 
$
852,675

 
 
Cumulative interest rate sensitivity gap, as a percentage of total interest earning assets
 
(21.8
)%
 
(25.2
)%
 
3.4
%
 
21.1
%
 
27.5
%
 
 
(1)
Excludes deferred loan fees and allowance for loan losses.
(2)
Interest earning investment securities with no stated maturity date are included in 0-3 months as prices may adjust immediately.
(3)
Adjustable-rate liabilities are included in the period in which interest rates are next scheduled to adjust rather than in the period they are due to mature. Although regular savings, demand, NOW, and money market deposit accounts are subject to immediate withdrawal, based on historical experience management considers a substantial amount of such accounts to be core deposits having significantly longer maturities.
Certain shortcomings are inherent in the method of analysis presented in the foregoing table. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates. Also, the interest rates on some types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market interest rates. Additionally, some assets, such as adjustable rate mortgages, have features, which restrict changes in the interest rates of those assets both on a short-term basis and over the lives of such assets. Further, if a change in market interest rates occurs, prepayment and early withdrawal levels could deviate significantly from those assumed in calculating the tables. Finally, the ability of many borrowers to service their adjustable rate debt may decrease if market interest rates increase substantially.

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

ITEM 7A.     QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to interest rate risk through our lending and deposit gathering activities. For a discussion of how this exposure is managed and the nature of changes in our interest rate risk profile during the past year, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation—Asset/Liability Management.”
Neither we, nor the Bank, maintain a trading account for any class of financial instrument, nor do we, or the Bank, engage in hedging activities or purchase high risk derivative instruments. Moreover, neither we, nor the Bank, are subject to foreign currency exchange rate risk or commodity price risk.
The table below provides information about our financial instruments that are sensitive to changes in interest rates as of December 31, 2014. The table presents principal cash flows and related weighted average interest rates by expected maturity dates. The expected maturity is the contractual maturity or earlier call date of the instrument. The data in this table may not be consistent with the amounts in the preceding table, which represents amounts by the repricing date or maturity date, whichever occurs sooner.

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By Expected Maturity Date
 
 
Year Ended December 31,
 
 
0-3
months
 
Over 3
months-
12
months
 
1-5
years
 
Over 5
years -15
years
 
Over
15 years
 
Total
 
Fair Value
 
 
(Dollars in thousands)
Investment Securities(1)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Amounts maturing:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Fixed rate
 
$

 
$
7,066

 
$
65,612

 
$
404,540

 
$
221,315

 
$
698,533

 
 
Weighted average interest rate
 
%
 
2.2
%
 
2.1
%
 
2.6
%
 
2.4
%
 
2.5
%
 
 
Adjustable rate
 
$

 
$

 
$
10

 
$
12,322

 
$
65,822

 
$
78,154

 
 
Weighted average interest rate
 
%
 
%
 
2.3
%
 
1.1
%
 
1.4
%
 
1.4
%
 
 
Total
 
$

 
$
7,066

 
$
65,622

 
$
416,862

 
$
287,137

 
$
776,687

 
$
777,747

Loans(2)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Amounts maturing:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Fixed rate
 
$
42,727

 
$
51,655

 
$
313,953

 
$
295,738

 
$
79,421

 
$
783,494

 
 
Weighted average interest rate
 
4.8
%
 
5.4
%
 
5.0
%
 
4.5
%
 
4.9
%
 
4.8
%
 
 
Adjustable rate
 
$
96,471

 
$
142,042

 
$
244,540

 
$
817,321

 
$
168,146

 
$
1,468,520

 
 
Weighted average interest rate
 
5.3
%
 
5.1
%
 
4.6
%
 
4.7
%
 
4.2
%
 
4.7
%
 
 
Total
 
$
139,198

 
$
193,697

 
$
558,493

 
$
1,113,059

 
$
247,567

 
$
2,252,014

 
$
2,279,081

Certificates of Deposit
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Amounts maturing:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Fixed rate
 
$
1,693

 
$
346,202

 
$
176,873

 
$
629

 
$

 
$
525,397

 
$
525,768

Weighted average interest rate
 
0.3
%
 
0.7
%
 
0.9
%
 
0.3
%
 
%
 
0.7
%
 
 
Junior Subordinated Debentures
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Amounts maturing:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Adjustable rate
 
$

 
$

 
$

 
$

 
$
19,082

 
$
19,082

 
$
19,082

Weighted average interest rate (3)
 
%
 
%
 
%
 
%
 
3.6
%
 
3.6
%
 
 
(1)
Balances represent carrying value, and excludes investment securities with no stated maturity.
(2)
Excludes deferred loan fees and allowance for loan losses.
(3)
The contractual interest rate of the junior subordinated debentures was 1.82% at December 31, 2014. The weighted average interest rate includes the effects of the discount accretion for the Washington Banking Merger purchase accounting adjustment.


ITEM 8.        FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
For financial statements, see the Index to Consolidated Financial Statements on page F-1.

ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None 

ITEM 9A.     CONTROLS AND PROCEDURES
Disclosure Controls and Procedures.
Our disclosure controls and procedures are designed to ensure that information the Company must disclose in its reports filed or submitted under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized, and reported on a timely basis. Our management has evaluated, with the participation and under the supervision of our chief executive officer (“CEO”) and chief financial officer (“CFO”), the

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effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act) as of the end of the period covered by this report. Based on this evaluation, our CEO and CFO have concluded that, as of such date, the Company’s disclosure controls and procedures are effective in ensuring that information relating to the Company, including its consolidated subsidiaries, required to be disclosed in reports that it files under the Exchange Act is (1) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (2) accumulated and communicated to our management, including our CEO and CFO, as appropriate to allow timely decisions regarding required disclosure.
Internal Control Over Financial Reporting.
(a) Management’s report on internal control over financial reporting.
The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control system is designed to provide reasonable assurance to our management and the board of directors regarding the preparation and fair presentation of published financial statements. Nonetheless, all internal control systems, no matter how well designed, have inherent limitations. Even systems determined to be effective as of a particular date can provide only reasonable assurance with respect to financial statement preparation and presentation and may not eliminate the need for restatements.
The Company’s management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2014. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in the 1992 Internal Control—Integrated Framework. Based on our assessment, we believe that, as of December 31, 2014, the Company’s internal control over financial reporting is effective based on these criteria.
As permitted, the Company excluded the operations of Washington Banking Company, acquired during 2014, from the scope of management’s report on internal control over financial reporting.
Crowe Horwath LLP, an independent registered public accounting firm, has audited the effectiveness of our internal control over financial reporting as of December 31, 2014, and their report is included in “Item 8. Financial Statements and Supplementary Data.”
(b) Attestation report of the registered public accounting firm.
See “Item 8. Financial Statements and Supplementary Data.”
(c) Changes in internal control over financial reporting.
There were no significant changes in the Company’s internal control over financial reporting during the Company’s most recent fiscal year that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

ITEM 9B.        OTHER INFORMATION
None


PART III

ITEM 10.     DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Information concerning directors of the registrant is incorporated by reference to the section entitled “Proposal 1 - Election of Directors” of our definitive proxy statement for the annual meeting of shareholders to be held on May 6, 2015 (“Proxy Statement”).
For information regarding the executive officers of the Company, see “Item 1. Business—Executive Officers.”
The required information with respect to compliance with Section 16(a) of the Exchange Act is incorporated by reference to the section entitled “Security Ownership of Certain Beneficial Owners and Management” of the Proxy Statement.
The Company has adopted a written Code of Ethics that applies to our directors, officers and employees. The Code of Ethics can be accessed electronically by visiting the Company’s website at www.hf-wa.com.
The Audit and Finance Committee of our Board of Directors retains our independent auditors, reviews and approves the scope and results of the audits with the auditors and management, monitors the adequacy of our system of internal controls and reviews the annual report, auditors’ fees and non-audit services to be provided by the

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independent auditors. The members of our Audit Committee are Deborah J. Gavin, chair of the committee, Brian S. Charneski, John A. Clees, Mark D. Crawford and Gragg E. Miller, all of whom are considered “independent” as defined by the SEC. Our Board of Directors has determined that Mrs. Gavin meets the definition of an audit committee financial expert, as determined by the requirements of the SEC.

ITEM 11.     EXECUTIVE COMPENSATION
Information concerning executive and director compensation and certain matters regarding participation in the Company’s Compensation Committee required by this item is incorporated by reference to the headings “Executive Compensation”, “Directors’ Compensation,” and “Report of the Compensation Committee” of the Proxy Statement.

ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The following table summarizes the consolidated activity within the Company’s stock option plans as of December 31, 2014, all of which were approved by shareholders.
 
Plan Category
 
Number of
securities
to be issued
upon exercise of outstanding
options and
awards
 
Weighted-
average
exercise
price of
outstanding
options
 
Number of
securities
remaining
available for
future issuance
under equity
compensation
plans
Equity compensation plans, all of which are approved by security holders
 
395,076

 
$
14.56

 
1,384,105

Information concerning security ownership of certain beneficial owners and management is incorporated by reference to the section entitled “Security Ownership of Certain Beneficial Owners and Management” of the Proxy Statement.

ITEM 13.
CERTAIN RELATIONSHIP AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
Information concerning certain relationships and related transactions is incorporated by reference to the sections entitled “Meetings and Committees of the Board of Directors" and "Corporate Governance” of the Proxy Statement.
Our common stock is listed on the NASDAQ Global Select Market. In accordance with NASDAQ requirements, at least a majority of our directors must be independent directors. The Board of Directors has determined that twelve of our fourteen directors are independent. Directors Altom, Charneski, Christensen, Crawford, Clees, Ellwanger, Gavin, Lyon, Miller, Pickering, Severns, and Watson are all independent.  Only Brian L. Vance, who serves as President and Chief Executive Officer of Heritage Financial Corporation and Chief Executive Officer of Heritage Bank, and David H. Brown, former Chief Executive Officer of Valley Community Bancshares, Inc. and Valley Bank, were not independent.

ITEM 14.     PRINCIPAL ACCOUNTING FEES AND SERVICES
Information concerning principal accounting fees and services is incorporated by reference to the section entitled “Proposal 3—Ratification of the Appointment of Independent Registered Public Accounting Firm” in the Proxy Statement.

PART IV

ITEM 15.     EXHIBITS, FINANCIAL STATEMENT SCHEDULES
(a)(1) Financial Statements: The Consolidated Financial Statements are contained as listed on the “Index to Consolidated Financial Statements” on page F-1.
(2) Financial Statements Schedules: All schedules are omitted because they are not required or applicable, or the required information is shown in the Consolidated Financial Statements or Notes.
(3) Exhibits: Included in schedule below.
 

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Exhibit No.
 
Description of Exhibit
2.1

 
Purchase and Assumption Agreement for Cowlitz Acquisition (1)
 
 
 
2.2

 
Purchase and Assumption Agreement for Pierce Acquisition (2)
 
 
 
2.3

 
Definitive Agreement for Valley Acquisition (3)
 
 
 
2.4

 
Agreement and Plan of Merger with Washington Banking Company (4)
 
 
 
3.1

  
Articles of Incorporation (5)
 
 
3.2

  
Amended and Restated Bylaws of the Company (6)
 
 
10.1

  
1998 Stock Option and Restricted Stock Award Plan (7)
 
 
10.2

  
1997 Stock Option and Restricted Stock Award Plan (8)
 
 
10.3

  
2002 Incentive Stock Option Plan, Director Nonqualified Stock Option Plan, and Restricted Stock Option Plan (9)
 
 
10.4

  
2006 Incentive Stock Option Plan, Director Nonqualified Stock Option Plan, and Restricted Stock Option Plan (10)
 
 
 
10.5

  
Annual Incentive Compensation Plan (11)
 
 
10.6

  
2010 Omnibus Equity Plan (12)
 
 
 
10.7

 
2014 Omnibus Equity Plan (13)
 
 
 
10.8

 
Form of Nonqualified Stock Option Award Agreement under the Heritage Financial Corporation 2014 Omnibus Equity Plan (14)
 
 
 
10.9

 
Form of Restricted Stock Award Agreement under the Heritage Financial Corporation 2014 Omnibus Equity Plan (14)
 
 
10.10

 
Form of Restricted Stock Unit Award Agreement under the Heritage Financial Corporation 2014 Omnibus Equity Plan (14)
 
 
 
10.11

  
Deferred Compensation Plan and Participation Agreements by and between Heritage and each of Brian L. Vance, Jeffrey J. Deuel and Donald J. Hinson (15)
 
 
10.12

  
Employment Agreements by and between Heritage and each of Brian L. Vance, Jeffrey J. Deuel and Donald J. Hinson (15)
 
 
10.13

  
Employment Agreement and Deferred Compensation Participation Agreement by and between Heritage and David A. Spurling (16)
 
 
10.14

  
Employment Agreement by and between Heritage and Bryan McDonald (17)
 
 
 
10.15

  
Employment Agreements by and between Heritage and Edward Eng (17)
 
 
 
10.16

  
Deferred Compensation Plan and Participation Agreement by and between Heritage and Bryan D. McDonald (20)
 
 
 
11

  
Statement regarding computation of earnings per share (18)
 
 
14.0

  
Code of Ethics and Conduct Policy (19)
 
 
 
21.0

 
Subsidiaries of the Company (20)
 
 
 
23.0

 
Consent of Independent Registered Public Accounting Firm (20)
 
 
 
24.0

 
Power of Attorney (20)
 
 
 
31.1

  
Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
 
31.2

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

65

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32.1

  
Certification of Principal Executive Officer and Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 
101

  
The following materials from Heritage Financial Corporation’s Annual Report on Form 10-K for the year ended December 31, 2014, formatted in Extensible Business Reporting Language (“XBRL”): (i) Consolidated Statements of Financial Condition, (ii) Consolidated Statements of Income; (iii) Consolidated Statements of Comprehensive Income, (iv) Consolidated Statements of Stockholders' Equity; (v) Consolidated Statements of Cash Flows, and (vi) Notes to Consolidated Financial Statements (21)

 
(1)
Incorporated by reference to the Current Report on Form 8-K dated July 30, 2010.
(2)
Incorporated by reference to the Current Report on Form 8-K dated November 5, 2010.
(3)
Incorporated by reference to the Current Report on Form 8-K dated March 11, 2013.
(4)
Incorporated by reference to the Current Report on Form 8-K dated October 23, 2013.
(5)
Incorporated by reference to the Registration Statement on Form S-1 (Reg. No. 333-35573) declared effective on November 12, 1997; as amended, said Amendment being incorporated by reference to the Amendment to the Articles of Incorporation of Heritage Financial Corporation filed with the Current Report on Form 8-K dated November 25, 2008.
(6)
Incorporated by reference to the Current Report on Form 8-K dated April 30, 2014.
(7)
Incorporated by reference to the Registration Statement on Form S-8 (Reg. No. 333-71415).
(8)
Incorporated by reference to the Registration Statement on Form S-8 (Reg. No. 333-57513).
(9)
Incorporated by reference to the Registration Statements on Form S-8 (Reg. No. 333-88980; 333-88982; 333-88976).
(10)
Incorporated by reference to the Registration Statements on Form S-8 (Reg. No. 333-134473; 333-134474; 333-134475).
(11)
Incorporated by reference to the Annual Report on Form 10-K dated March 2, 2010.
(12)
Incorporated by reference to the Registration Statement on Form S-8 (Reg. No. 33-167146).
(13)
Incorporated by reference to Heritage Financial Corporation's definitive proxy statement dated June 11, 2014.
(14)
Incorporated by reference to the Current Report on Form 10-Q dated August 6, 2014.
(15)
Incorporated by reference to the Current Report on Form 8-K dated September 7, 2012.
(16)
Incorporated by reference to the Current Report on Form 8-K dated January 6, 2014.
(17)
Incorporated by reference to the Registration Statement on Form S-4 (Reg. No. 333-192985).
(18)
Reference is made to Note 18—Stockholders' Equity in the Notes to Consolidated Financial Statements under Part II Item 8 herein.
(19)
Registrant elects to satisfy Regulation S-K §229.406(c) by posting its Code of Ethics on its website at www.HF-WA.com in the section titled Investor Information: Corporate Governance.
(20)
Filed herewith.
(21)
Pursuant to Rule 406T of Regulation S-T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933 or Section 18 of the Securities Exchange Act of 1934, as amended, and otherwise not subject to liability under those sections.

SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on March 10, 2015.

 
 
HERITAGE FINANCIAL CORPORATION
 
 
(Registrant)
 
 
 
 
 
/S/    BRIAN L. VANCE        
 
 
Brian L. Vance
 
 
President and Chief Executive Officer
    

66

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Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on March 10, 2015.

 
 
 
 
 
 
 
 
 
 
 
Principal Executive Officer:
 
 
 
/S/    BRIAN L. VANCE        
 
 
 
Brian L. Vance
 
 
 
President and Chief Executive Officer
 
 
 
 
 
 
 
 
 
 
 
Principal Financial Officer:
 
 
 
/S/    DONALD J. HINSON        
 
 
 
Donald J. Hinson
 
 
 
Executive Vice President and Chief Financial Officer
 
 
 
 
 
 
 
 
 
 
 
 
 
Remaining Directors*:
 
 
 
David H. Brown
 
 
 
Brian S. Charneski
 
 
 
John A. Clees
 
 
 
Gary B. Christiansen
 
 
 
Mark D. Crawford
 
 
 
Kimberly T. Ellwanger
 
 
 
Deborah J. Gavin
 
 
 
Jeffrey S. Lyon
 
 
 
Gragg E. Miller
 
 
 
Anthony B. Pickering
 
 
 
Robert T. Severns
 
 
 
Ann Watson
 
 
 
 
 
 
 
* Brian L. Vance, pursuant to a power of attorney that is being filed with the Annual Report on Form 10-K, has signed this report as attorney in fact for the following directors who constitute a majority of the Board.
 
 
 
 
 
 
 
 
*By
 
 
 
/S/    BRIAN L. VANCE        
 
 
 
Brian L. Vance
 
 
 
Attorney-in-Fact
 
 
 
March 10, 2015



67

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2014, 2013 and 2012
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
 
 
Page
 
 
 
 
 
 
 
 
 
 
 
 


F-1

Table of Contents


Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders
Heritage Financial Corporation and subsidiaries
Olympia, Washington
We have audited the accompanying consolidated statements of financial condition of Heritage Financial Corporation and subsidiaries (the “Company”) as of December 31, 2014 and 2013, and the related consolidated statements of income, comprehensive income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2014. We also have audited the Company’s internal control over financial reporting as of December 31, 2014, based on criteria established in the 1992 Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on these financial statements and an opinion on the Company’s internal control over financial reporting based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
As permitted, the Company has excluded the operations of Washington Banking Company acquired during 2014, which is described in Note 2, Business Combinations, of the Company's consolidated financial statements, from the scope of management’s report on internal control over financial reporting. As such, it has also been excluded from the scope of our audit of internal control over financial reporting.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Heritage Financial Corporation and subsidiaries as of December 31, 2014 and 2013, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2014 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2014, based on criteria established in the 1992 Internal Control – Integrated Framework issued by COSO.

/s/ Crowe Horwath LLP
San Francisco, California
March 10, 2015

F-2

Table of Contents


HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
December 31, 2014 and 2013
(Dollars in thousands)
 
December 31, 2014
 
December 31, 2013
ASSETS
 
 
 
Cash on hand and in banks
$
74,028


$
40,162

Interest earning deposits
47,608


90,238

Cash and cash equivalents
121,636


130,400

Other interest earning deposits
10,126


15,662

Investment securities available for sale, at fair value
742,846


163,134

Investment securities held to maturity (fair value of $36,874 and $36,340, respectively)
35,814


36,154

Loans held for sale
5,582

 

Noncovered loans receivable, net
2,124,877

 
1,168,166

Allowance for loan losses on noncovered loans
(22,153
)
 
(22,657
)
Noncovered loans receivable, net of allowance for loan losses
2,102,724

 
1,145,509

Covered loans receivable, net
126,200

 
63,754

Allowance for loan losses on covered loans
(5,576
)
 
(6,167
)
Covered loans receivable, net of allowance for loan losses
120,624

 
57,587

Total loans receivable, net
2,223,348

 
1,203,096

FDIC indemnification asset
1,116


4,382

Other real estate owned ($1,177 and $182 covered by FDIC shared-loss agreements, respectively)
3,355


4,559

Premises and equipment, net
64,938


34,348

Federal Home Loan Bank stock, at cost
12,188


5,741

Bank owned life insurance
35,176

 
2,193

Accrued interest receivable
9,836


5,462

Prepaid expenses and other assets
61,871


22,927

Other intangible assets, net
10,889


1,615

Goodwill
119,029


29,365

Total assets
$
3,457,750


$
1,659,038

LIABILITIES AND STOCKHOLDERS' EQUITY
 
 
 
Deposits
$
2,906,331

 
$
1,399,189

Junior subordinated debentures
19,082

 

Securities sold under agreement to repurchase
32,181

 
29,420

Accrued expenses and other liabilities
45,650

 
14,667

Total liabilities
3,003,244

 
1,443,276

Stockholders’ equity:
 
 
 
Preferred stock, no par value, 2,500,000 shares authorized; no shares issued and outstanding at December 31, 2014 and 2013

 

Common stock, no par value, 50,000,000 shares authorized; 30,259,838 and 16,210,747 shares issued and outstanding at December 31, 2014 and 2013, respectively
364,741

 
138,659

Retained earnings
86,387

 
78,265

Accumulated other comprehensive income (loss), net
3,378

 
(1,162
)
Total stockholders’ equity
454,506

 
215,762

Total liabilities and stockholders’ equity
$
3,457,750

 
$
1,659,038

See accompanying Notes to Consolidated Financial Statements.

F-3

Table of Contents


HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
For the Years Ended December 31, 2014, 2013 and 2012
(Dollars in thousands, except per share amounts)

 
 
Years Ended December 31,
 
 
2014
 
2013
 
2012
INTEREST INCOME:
 
 
 
 
 
 
Interest and fees on loans
 
$
110,437

 
$
67,630

 
$
65,588

Taxable interest on investment securities
 
7,328

 
1,918

 
2,195

Nontaxable interest on investment securities
 
2,886

 
1,539

 
1,097

Interest and dividends on other interest earning assets
 
455

 
341

 
229

Total interest income
 
121,106

 
71,428

 
69,109

INTEREST EXPENSE:
 
 
 
 
 
 
Deposits
 
5,150

 
3,673

 
4,469

Junior subordinated debentures
 
458

 

 

Other borrowings
 
73

 
51

 
65

Total interest expense
 
5,681

 
3,724

 
4,534

Net interest income
 
115,425

 
67,704

 
64,575

Provision for loan losses on noncovered loans
 
2,232

 
1,784

 
1,570

Provision for loan losses on covered loans
 
2,362

 
1,888

 
446

Total provision for loan losses
 
4,594

 
3,672

 
2,016

Net interest income after provision for loan losses
 
110,831

 
64,032

 
62,559

NONINTEREST INCOME:
 
 
 
 
 
 
Bargain purchase gain on bank acquisition
 

 
399

 

Service charges and other fees
 
11,143

 
5,936

 
5,516

Merchant Visa income, net
 
1,076

 
862

 
685

Change in FDIC indemnification asset
 
(2,543
)
 
(181
)
 
(1,033
)
Gain on sale of investment securities, net
 
287

 

 

Gain on sale of loans, net
 
1,518

 
142

 
295

Other income
 
4,986

 
2,493

 
1,809

Total noninterest income
 
16,467

 
9,651

 
7,272

NONINTEREST EXPENSE:
 
 
 
 
 
 
Compensation and employee benefits
 
52,634

 
31,612

 
29,020

Occupancy and equipment
 
13,406

 
9,724

 
7,365

Data processing
 
9,243

 
4,806

 
2,555

Marketing
 
2,502

 
1,598

 
1,517

Professional services
 
6,185

 
3,936

 
2,543

State and local taxes
 
1,976

 
1,150

 
1,226

Impairment loss on investment securities, net
 
45

 
38

 
78

Federal deposit insurance premium
 
1,718

 
1,001

 
1,002

Other real estate owned, net
 
638

 
309

 
316

Amortization of intangible assets
 
1,920

 
543

 
427

Other expense
 
9,112

 
4,798

 
4,343

Total noninterest expense
 
99,379

 
59,515

 
50,392

Income before income taxes
 
27,919

 
14,168

 
19,439

Income tax expense
 
6,905

 
4,593

 
6,178

Net income
 
$
21,014

 
$
9,575

 
$
13,261

Basic earnings per common share
 
$
0.82

 
$
0.61

 
$
0.87

Diluted earnings per common share
 
0.82

 
0.61

 
0.87

Dividends declared per common share
 
0.50

 
0.42

 
0.80

See accompanying Notes to Consolidated Financial Statements.


F-4

Table of Contents


HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
For the Years Ended December 31, 2014, 2013 and 2012
(Dollars in thousands)


 
Years Ended December 31,
 
2014
 
2013
 
2012
Net income
$
21,014

 
$
9,575

 
$
13,261

Change in fair value of securities available for sale, net of tax of $2,531, $(1,596) and $(34), respectively
4,676

 
(2,965
)
 
(63
)
Reclassification adjustment of net (gain) loss from sale of available for sale securities included in net income, net of tax of $(101), $0 and $0, respectively
(186
)
 

 

Other-than-temporary impairment on securities held to maturity, net of tax of $0, $0 and $(18), respectively

 

 
(34
)
Accretion of other-than-temporary impairment on securities held to maturity, net of tax of $28, $31 and $57, respectively
50

 
59

 
105

Other comprehensive income (loss)
4,540

 
(2,906
)
 
8

Comprehensive income
$
25,554

 
$
6,669

 
$
13,269

See accompanying Notes to Consolidated Financial Statements.


F-5

Table of Contents


HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
For the Years Ended December 31, 2014, 2013 and 2012
(Dollars in thousands, except per share amounts)

 
Number of
common
shares
 
Common
stock
 
Unearned Compensation ESOP
 
Retained
earnings
 
Accumulated
other
comprehensive
income (loss), net
 
Total
stock-
holders’
equity
Balance at December 31, 2011
15,456

 
$
126,622

 
$
(94
)
 
$
74,256

 
$
1,736

 
$
202,520

Restricted and unrestricted stock awards issued, net of forfeitures
86

 

 

 

 

 

Stock option compensation expense

 
106

 

 

 

 
106

Exercise of stock options (including excess tax benefits from nonqualified stock options)
12

 
129

 

 

 

 
129

Restricted stock compensation expense
10

 
1,091

 
94

 

 

 
1,185

Excess tax benefit from restricted stock

 
(93
)
 

 

 

 
(93
)
Common stock repurchased
(446
)
 
(6,023
)
 

 

 

 
(6,023
)
Net income

 

 

 
13,261

 

 
13,261

Other comprehensive income, net of tax

 

 

 

 
8

 
8

Cash dividends declared on common stock ($0.80 per share)

 

 

 
(12,155
)
 

 
(12,155
)
Balance at December 31, 2012
15,118

 
121,832

 

 
75,362

 
1,744

 
198,938

Restricted and unrestricted stock awards issued, net of forfeitures
100

 

 

 

 

 

Stock option compensation expense

 
71

 

 

 

 
71

Exercise of stock options (including excess tax benefits from nonqualified stock options)
17

 
176

 

 

 

 
176

Restricted stock compensation expense

 
1,223

 

 

 

 
1,223

Excess tax benefit from restricted stock

 
(13
)
 

 

 

 
(13
)
Common stock repurchased
(557
)
 
(8,825
)
 

 

 

 
(8,825
)
Net income

 

 

 
9,575

 

 
9,575

Other comprehensive loss, net of tax

 

 

 

 
(2,906
)
 
(2,906
)
Common stock issued in business combination
1,533

 
24,195

 

 

 

 
24,195

Cash dividends declared on common stock ($0.42 per share)

 

 

 
(6,672
)
 

 
(6,672
)
Balance at December 31, 2013
16,211

 
138,659

 

 
78,265

 
(1,162
)
 
215,762

Restricted and unrestricted stock awards issued, net of forfeitures
121

 

 

 

 

 

Stock option compensation expense

 
20

 

 

 

 
20

Exercise of stock options (including excess tax benefits from nonqualified stock options)
84

 
921

 

 

 

 
921

Restricted stock compensation expense

 
1,395

 

 

 

 
1,395

Tax benefits from restricted stock

 
112

 

 

 

 
112

Common stock repurchased
(156
)
 
(2,601
)
 

 

 

 
(2,601
)
Net income

 

 

 
21,014

 

 
21,014

Other comprehensive income, net of tax

 

 

 

 
4,540

 
4,540

Common stock issued in business combination (1)
14,000

 
226,235

 

 

 

 
226,235

Cash dividends declared on common stock ($0.50 per share)

 

 

 
(12,892
)
 

 
(12,892
)
Balance at December 31, 2014
30,260

 
$
364,741

 
$

 
$
86,387

 
$
3,378

 
$
454,506

(1)
The amount of common stock issued in connection with the merger is net of $489,000 of issuance costs.
See accompanying Notes to Consolidated Financial Statements.

F-6

Table of Contents


HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Years Ended December 31, 2014, 2013 and 2012
(Dollars in thousands)

 
Years Ended December 31,
 
2014
 
2013
 
2012
Cash flows from operating activities:
 
 
 
 
 
Net income
$
21,014

 
$
9,575

 
$
13,261

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
 
Depreciation and amortization
12,882

 
5,411

 
4,290

Changes in net deferred loan fees, net of amortization
(1,733
)
 
574

 
236

Provision for loan losses
4,594

 
3,672

 
2,016

Net change in accrued interest receivable, FDIC indemnification asset, prepaid expenses and other assets, accrued expenses and other liabilities
13,230

 
9,047

 
5,878

Restricted and unrestricted stock compensation expense
1,395

 
1,223

 
1,185

Stock option compensation expense
20

 
71

 
106

Tax benefits and excess tax benefits from restricted stock
(112
)
 
13

 
93

Amortization of intangible assets
1,920

 
543

 
427

Bargain purchase gain on bank acquisition

 
(399
)
 

Gain on sale of investment securities, net
(287
)
 

 

Impairment loss on investment of securities, net
45

 
38

 
78

Origination of loans held for sale
(57,656
)
 
(6,784
)
 
(21,035
)
Gain on sale of loans, net
(1,518
)
 
(142
)
 
(295
)
Proceeds from sale of loans
57,515

 
8,602

 
21,482

Earnings on bank owned life insurance
(455
)
 
(70
)
 
(80
)
Valuation adjustment on other real estate owned

 
371

 
824

Gain on other real estate owned, net
(23
)
 
(264
)
 
(587
)
Loss (gain) on sale or write-off of furniture, equipment and leasehold improvements
505

 
(584
)
 
3

Net cash provided by operating activities
51,336

 
30,897

 
27,882

Cash flows from investing activities:
 
 
 
 

Loans originated, net of principal payments
(21,651
)
 
(43,140
)
 
(2,790
)
Maturities of other interest earning deposits
5,475

 
1,987

 

Maturities of investment securities available for sale
66,876

 
51,443

 
61,751

Maturities of investment securities held to maturity
3,284

 
4,192

 
2,177

Purchase of other interest earning deposits

 

 
(2,232
)
Purchase of investment securities available for sale
(344,146
)
 
(43,627
)
 
(63,903
)
Purchase of investment securities held to maturity
(3,294
)
 
(7,414
)
 

Purchase of premises and equipment
(3,940
)
 
(5,205
)
 
(3,859
)
Proceeds from sales of other real estate owned
9,914

 
6,003

 
5,255

Proceeds from sales of investment securities available for sale
156,994

 

 

Proceeds from redemption of FHLB stock
617

 
208

 
99

Proceeds from sale of premises and equipment
1,170

 
700

 

Investment in new market tax credit partnership
(25,000
)
 

 

Net cash received from acquisitions
32,052

 
18,260

 

Net cash used in investing activities
(121,649
)
 
(16,593
)
 
(3,502
)

F-7

Table of Contents


 
Years Ended December 31,
 
2014
 
2013
 
2012
Cash flows from financing activities:
 
 
 
 
 
Net increase (decrease) in deposits
73,248

 
13,763

 
(18,073
)
Common stock cash dividends paid
(12,892
)
 
(6,672
)
 
(12,155
)
Net increase (decrease) in securities sold under agreement to repurchase
2,761

 
13,399

 
(7,070
)
Proceeds from exercise of stock options
921

 
176

 
129

Excess tax benefits from stock options and restricted and unrestricted stock
112

 
(13
)
 
(93
)
Repurchase of common stock
(2,601
)
 
(8,825
)
 
(6,023
)
Net cash provided by (used in) financing activities
61,549

 
11,828

 
(43,285
)
Net (decrease) increase in cash and cash equivalents
(8,764
)
 
26,132

 
(18,905
)
Cash and cash equivalents at beginning of year
130,400

 
104,268

 
123,173

Cash and cash equivalents at end of year
$
121,636

 
$
130,400

 
$
104,268

 
 
 
 
 
 
Supplemental disclosures of cash flow information:
 
 
 
 
 
Cash paid for interest
$
5,422

 
$
3,678

 
$
4,608

Cash paid for income taxes
15,852

 
3,574

 
10,713

 
 
 
 
 
 
Supplemental non-cash disclosures of cash flow information:
 
 
 
 
 
Transfers of loans receivable to other real estate owned
$
1,566

 
$
2,974

 
$
7,406

Seller-financed sale of other real estate owned

 
250

 
732

Investment in low income housing tax credit partnership and related funding commitment
3,817

 

 

Purchases of investment securities available for sale not settled
1,288

 

 

Common stock issued for business combinations
226,235

 
24,195

 

Stock issuance costs in connection with business combinations
489

 

 

Assets acquired (liabilities assumed) in merger and acquisitions:
 
 
 
 
 
Other interest earning deposits

 
14,869

 

Investment securities available for sale
458,312

 
34,197

 

Investment securities held to maturity

 
22,908

 

Loans held for sale
3,923

 

 

Noncovered loans receivable
895,978

 
168,580

 

Covered loans receivable
107,050

 

 

Other real estate owned
7,121

 
2,279

 

Premises and equipment
31,776

 
6,772

 

Federal Home Loan Bank stock
7,064

 
454

 

FDIC indemnification asset
7,174

 

 

Accrued interest receivable
4,943

 
697

 

Bank owned life insurance
32,519

 

 

Prepaid expenses and other assets
14,852

 
7,135

 

Other intangible assets
11,194

 
1,072

 

Deposits
(1,433,894
)
 
(267,455
)
 

Junior subordinated debentures
(18,937
)
 

 

Accrued expenses and other liabilities
(24,067
)
 
(1,528
)
 

See accompanying Notes to Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Years Ended December 31, 2014, 2013 and 2012


(1)
Description of Business, Basis of Presentation, Significant Accounting Policies and Recently Issued Accounting Pronouncements
(a) Description of Business
Heritage Financial Corporation ("Heritage" or the “Company”) is a bank holding company that was incorporated in the State of Washington in August 1997. The Company is primarily engaged in the business of planning, directing and coordinating the business activities of its wholly-owned bank subsidiary, Heritage Bank (the “Bank”). The Bank is a Washington-chartered commercial bank and its deposits are insured by the FDIC under the Deposit Insurance Fund. The Bank is headquartered in Olympia, Washington and conducts business from its sixty-six branch offices located throughout Washington State and the greater Portland, Oregon area. The Bank’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 Bank also makes real estate construction and land development loans and consumer loans and originates first mortgage loans on residential properties primarily located in its market area which is concentrated along the I-5 corridor from Whatcom County to Clark County in Washington State and Multnomah County in Oregon, as well as other contiguous markets.
The Company has expanded its footprint through mergers and acquisitions. The largest of these transactions was the strategic merger of Washington Banking Company (“Washington Banking”) into the Company and the merger of its wholly owned subsidiary bank, Whidbey Island Bank ("Whidbey") into Heritage Bank. This merger was effective on May 1, 2014 and is referred to as the "Washington Banking Merger". The strategic merger is described in more detail in "Note 2 - Business Combinations." The Washington Banking results since May 1, 2014 are included in this Annual Report on Form 10-K. The Washington Banking Merger has allowed the expansion of the market area north of Seattle, Washington to the Canadian border.
In connection with the Washington Banking Merger, the Company acquired Washington Banking Master Trust (the “Master Trust”), which became a wholly-owned subsidiary of the Company. The Master Trust was formed by Washington Banking in April 2007 for the exclusive purpose of issuing trust preferred securities.

(b) Basis of Presentation
The accounting and reporting policies of the Company and its subsidiaries confirm to U.S. Generally Accepted Accounting Principles (“GAAP”). In preparing the Consolidated Financial Statements management makes estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of income and expenses during the reporting periods. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses, other than temporary impairments in the fair value of investment securities, expected cash flows of purchased loans and related indemnification asset, fair value measurements, stock-based compensation, impairment of goodwill and other intangible assets and income taxes. Actual results could differ from these estimates.
The accompanying Consolidated Financial Statements include the accounts of the Company and its wholly owned subsidiary, the Bank. All significant intercompany balances and transactions among the Company and the Bank have been eliminated in consolidation.
For financial reporting purposes, the Company's investment in the Master Trust is accounted for under the equity method and is included in prepaid expenses and other assets on the Company's Consolidated Statements of Financial Condition. The junior subordinated debentures issued and guaranteed by the Company and held by the Master Trust are reflected as liabilities on the Company's Consolidated Statements of Financial Condition.
Certain prior year amounts have been reclassified to conform to the current year’s presentation. Reclassifications had no effect on the prior year's net income or stockholders’ equity. As a result of the Washington Banking Merger, the Company reclassified its loan portfolio. Total loans receivable are now presented in two categories: noncovered loans receivable and covered loans receivable. A description of the categories is included in the significant accounting policies below. Management made the change to be more comparable to its peers.


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(c) Significant Accounting Policies
Cash and Cash Equivalents
For purposes of reporting cash flows, cash and cash equivalents includes cash on hand and in banks, interest earning deposits with original maturities of 90 days or less, and federal funds sold. Net cash flows are reported for customer loan and deposit transactions, other interest bearing deposits, federal funds sold and repurchase agreements.

Investment Securities
The Company identifies investments as held to maturity or available for sale at the time of acquisition. Securities are classified as held to maturity when the Company has the ability and positive intent to hold them to maturity. Securities classified as available for sale are available for future liquidity requirements and may be sold prior to maturity.
Investment securities held to maturity are recorded at cost, adjusted for amortization of premiums or accretion of discounts using the interest method. Securities available for sale are carried at fair value. Unrealized gains and losses on securities available for sale are generally excluded from earnings and are reported in other comprehensive income (loss), net of related income taxes. Realized gains and losses on sale of investment securities are computed on the specific identification method.
Management evaluates securities for other-than-temporary impairment (“OTTI”) on at least a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. Although these evaluations involve significant judgment, an unrealized loss in the fair value of a debt security is generally deemed to be temporary when the fair value of the security is below the carrying value primarily due to changes in interest rates, there has not been significant deterioration in the financial condition of the issuer, and it is not more likely than not that the Company will be required to, nor does it have the intent to sell the security before the anticipated recovery of its remaining carrying value. If any of these criteria is not met, the impairment is split into two components as follows: 1) OTTI related to credit loss, which must be recognized in the income statement and 2) OTTI related to other factors, which is recognized in other comprehensive income (loss). The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis. If any of these criteria are not met, the entire difference between amortized cost and fair value is recognized as impairment through earnings, and a new cost basis is established for the security. Continued deterioration of market conditions could result in additional impairment losses recognized within the investment portfolio.
Other factors that may be considered in determining whether a decline in the value of either a debt or an equity security is “other than temporary” include ratings by recognized rating agencies; actions of commercial banks or other lenders relative to the continued extension of credit facilities to the issuer of the security; the financial condition, capital strength and near-term prospects of the issuer and recommendations of investment advisors or market analysts.

Loans Held for Sale
Mortgage loans held for sale are carried at the lower of amortized cost or fair value by loan type. Any loan that management does not have the intent and ability to hold for the foreseeable future or until maturity or payoff is classified as held for sale at the time of origination, purchase or securitization, or when such decision is made. Unrealized losses on such loans are included in income.

Loans Receivable and Loan Commitments
Noncovered Loans:
Noncovered loans includes loans originated by the Bank as well as loans acquired in business combinations with no related shared-loss agreements. Loans acquired in a business combination are designated as “purchased” loans. These loans are recorded at their fair value at acquisition date, factoring in credit losses expected to be incurred over the life of the loan. Accordingly, an allowance for loan losses is not carried over or recorded as of the acquisition date.
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 purchased credit impaired ("PCI") loans. In situations where such loans have similar risk characteristics, loans may be aggregated into pools to estimate cash flows. A pool is accounted for as a

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single asset with a single interest rate, cumulative loss rate and cash flow expectation. Expected cash flows at the acquisition date in excess of the fair value of loans are considered to be accretable yield, which is recognized as interest income over the life of the loan or pool using a level yield method if the timing and amount of the future cash flows of the pool is reasonably estimable.
The cash flows expected over the life of the PCI loan or pool are estimated quarterly using an internal cash flow model that projects cash flows and calculates the carrying values of the loans or pools, book yields, effective interest income and impairment, if any, based on loan or pool level events. Assumptions as to default rates, loss severity and prepayment speeds are utilized to calculate the expected cash flows. To the extent actual or projected cash flows are less than previously estimated, additional provisions for loan losses on the purchased loan portfolios will be recognized immediately into earnings. To the extent actual or projected cash flows are more than previously estimated, the increase in cash flows is recognized immediately as a recapture of provision for loan losses up to the amount of any provision previously recognized for that loan or pool, if any, then prospectively recognized in interest income as a yield adjustment. Any disposals of a loan in a pool, including sale of a loan, payment in full or foreclosure results in the removal of the loan from the loan pool at the carrying amount.
Loans accounted for under FASB ASC 310-30 are generally considered accruing and performing loans as the loans accrete interest income over the estimated life of the loan when cash flows are reasonably estimable. Accordingly, PCI loans that are contractually past due are still considered to be accruing and performing loans. If the timing and amount of cash flows is not reasonably estimable, the loans may be classified as nonaccrual loans and interest income may be recognized on a cash basis or all cash payments may be accounted for a as a reduction of the principal amount outstanding.
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 non-PCI loans, and are initially recorded at their fair value, which is estimated using an internal cash flow model and assumptions similar to the FASB ASC 310-30 loans. The difference between the estimated fair value and the unpaid principal balance at acquisition date is recognized as interest income over the life of the loan using an effective interest method for non-revolving credits or a straight-line method, which approximates the effective interest method, for revolving credits. Any unrecognized discount for a loan that is subsequently repaid will be recognized immediately into income.
Loans are generally recorded at the unpaid principal balance, net of premiums, unearned discounts and net deferred loan origination fees and costs. The premiums and unearned discounts may include values determined in purchase accounting. Interest on loans is calculated using the simple interest method based on the daily balance of the principal amount outstanding and is credited to income as earned. Loans are considered past due or delinquent when principal or interest payments are past due 30 days or more. Loans on which the accrual of interest has been discontinued are designated as nonaccrual loans. Delinquent loans may remain on accrual status between 30 days and 89 days past due. The accrual of interest is discontinued at the time the loan is 90 days delinquent unless the credit is well secured and in the process of collection. Loans are placed on nonaccrual at an earlier date if collection of the contractual principal or interest is doubtful. All interest accrued but not collected on loans deemed nonaccrual during the period is reversed against interest income in that period. The interest payments received on nonaccrual loans is accounted for on the cost-recovery method whereby the interest payment is applied to the principal balances. Loans may be returned to accrual status when improvements in credit quality eliminate the doubt as to the full collectability of both interest and principal and a period of sustained performance has occurred. Substantially all loans that are nonaccrual are also impaired. Income recognition on impaired loans conforms to that used on nonaccrual loans.
Loans are charged-off if collection of the contractual principal or interest as scheduled in the loan agreement is doubtful. The Company's policies for placing loans on nonaccrual status, recording payments received on nonaccrual loans, resuming accrual of interest, determining past due or delinquency status and charging off uncollectible loans generally do not differ by loan segments or classes. However, credit card loans and other consumer loans are typically charged-off no later than 180 days past due.
Covered Loans:
Purchased loans subject to FDIC shared-loss agreements are identified as “covered” on the Consolidated Statements of Financial Condition. The covered loans have an additional evaluation separate from noncovered loans as they have shared-loss attributes which may reduce the Bank’s risk of loss. For further information see Note 8, “FDIC Indemnification Asset”. The covered loans include the majority of loans from the Company's acquisition of Cowlitz Bank and certain loans from the Washington Banking Merger, which included loans from Washington Banking's acquisitions of City Bank and North County Bank. The same accounting principles applicable to noncovered loans receivable apply to covered loans receivable, with the added benefit of shared-loss agreements.

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Unfunded Loan Commitments:
Unfunded loan commitments are generally related to the unused portion of the total commitment of a loan or providing credit facilities to clients of the Bank and are not actively traded financial instruments. These unfunded commitments are disclosed as financial instruments with off-balance sheet risk in Notes 17 and 20 in the Notes to Consolidated Financial Statements.

Impaired Loans and Troubled Debt Restructures
Impaired Loans:
A loan is considered impaired when, based on current information and events, it is probable the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrowers, including length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amounts of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis by either the present value of expected future cash flows discounted at the loan’s effective interest rate, or as a practical expedient the loan’s observable market price or the fair value of the collateral (less cost to sell) if the loan is collateral dependent.
Troubled Debt Restructures:
A troubled debt restructured loan (“TDR”) is a restructuring in which the Bank, for economic or legal reasons related to a borrower’s financial difficulties, grants a concession to a borrower that it would not otherwise consider. These concessions may include changes of the interest rate, forbearance of the outstanding principal or accrued interest, extension of the maturity date, delay in the timing of the regular payment, or any other actions intended to minimize potential losses. The Bank does not forgive principal for a majority of its TDRs, but in those situations where principal is forgiven, the entire amount of such principal forgiveness is immediately charged off to the extent not done so prior to the modification. The Bank also considers insignificant delays in payments when determining if a loan should be classified as a TDR.
A loan that has been placed on nonaccrual status that is subsequently restructured will usually remain on nonaccrual status until the borrower is able to demonstrate repayment performance in compliance with the restructured terms for a sustained period, typically for six months. A restructured loan may return to accrual status sooner based on other significant events or mitigating circumstances. A loan that has not been placed on nonaccrual status may be restructured and such loan may remain on accrual status after such restructuring. In these circumstances, the borrower has made payments before the restructuring and is expected to continue to perform after the restructuring. Generally, this type of restructuring involves a reduction in the loan interest rate and/or a change to interest-only payments for a period of time. The restructured loan is considered impaired despite the accrual status and a specific valuation allowance, is any, is calculated in the manner previously described.
A TDR is considered defaulted if, during the 12-month period after the restructure, the loan has not performed in accordance to the restructured terms. Defaults include loans whose payments are 90 days or more past due and loans whose revised maturity date passed and no further modifications will be granted for that borrower.
A loan may subsequently be excluded from the TDR disclosures if: (i) the restructured interest rate was greater than or equal to the interest rate of a new loan with comparable risk at the time of the restructure, and (ii) the loan is no longer impaired based on the terms of the restructured agreement. The Bank's policy is that the borrower must demonstrate a sustained period, typically six consecutive months, of payments in accordance with the modified loan before it can be reviewed for removal from the TDR disclosure under the second criteria. However, the loan must be reported as a TDR in at least one annual report on Form 10-K. Once a loan has been classified as a TDR, it will continue to be disclosed as an impaired loan until paid off or charged-off, even if the loan subsequently is no longer disclosed as a TDR.

Loan Fees and Costs
Loan origination fees and certain direct origination costs are deferred and amortized as an adjustment of the yields of the loans over their contractual lives, adjusted for prepayment of the loans, using the effective interest method or the straight-line method, when the straight-line method approximates the effective interest method. In the event

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loans are sold, the net deferred loan origination fees or costs are recognized as a component of the gains or losses on the sales of loans.

Allowance for Loan Losses
Allowance for Loan Losses on Loans:
The allowance for loan losses is a reserve established through a provision for loan losses charged to expense, which represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans originated by the Bank. The allowance for loan losses on loans designated as non-PCI loans is similar to the methodology described below except that for non-PCI loans, the remaining unaccreted discounts resulting from the fair value adjustments recorded at the time the loans were purchased are additionally factored into the allowance methodology. The allowance for loan losses on PCI loans is described in the “Allowance for Loan Losses on Purchased Credit Impaired Loans” section below.
The allowance, in the judgment of management, is necessary to reserve for estimated loan losses from risks inherent in the loan portfolio. The Company’s allowance for loan losses methodology includes allowance allocations calculated in accordance with FASB ASC 310, Receivables and allowance allocations calculated in accordance with FASB ASC 450, Contingencies. Accordingly, the methodology is based on historical loss experience by type of credit and internal risk grade, specific homogeneous risk pools and specific loss allocations, with adjustments for current events and conditions. The Company’s process for determining the appropriate level of the allowance for loan losses is designed to account for credit deterioration as it occurs. The provision for loan losses reflects loan quality trends, including the levels of and trends related to nonaccrual loans, past due loans, potential problem loans, criticized loans and net charge-offs or recoveries, among other factors. The provision for loan losses also reflects all actions taken on all loans for a particular period. Therefore, the amount of the provision reflects not only the necessary increases in the allowance for loan losses related to newly identified criticized loans, but it also reflects actions taken related to other loans including, among other things, any necessary increases or decreases in specific valuation allowances for impaired loans or loan pools. Losses are charged against the allowance when management believes the uncollectability of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.
The level of the allowance reflects management’s continuing evaluation of known and inherent risks in the loan portfolio. Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management’s judgment, should be charged off.
Loans which management determines are impaired are individually evaluated for impairment, and specific valuation allowances are recorded, if any, on these loans based on the methodology previously described. Loans that are determined not to meet management's definition of impaired are collectively evaluated for impairment based on (i) historical loss factor determined in accordance with FASB ASC 450 based on historical loan loss experience for similar loans with similar characteristics and trends; and (ii) environmental loss factors that reflect the impact of current conditions, as determined in accordance with FASB ASC 450 based on general economic conditions and other qualitative risk factors both internal and external to the Company. The historical loss factors and environmental loss factors are combined and multiplied against the outstanding principal balances of loans in pools of similar loans with similar characteristics.
The Company evaluates specific loans for credit quality indicators and performs regular analysis and evaluation of problem loans. Loans are classified based on an internal credit risk grading process that evaluates, among other things: (i) the obligor’s ability to repay; (ii) the underlying collateral, if any; and (iii) the economic environment and industry in which the borrower operates. This analysis is performed at the loan officer level for all loans. When a loan is performing but has an assigned risk grade other than pass, the loan officer analyzes the loan to determine an appropriate monitoring and collection strategy. When a loan is nonperforming or has been classified as a nonaccrual loan, a member from the special assets department will analyze the loan to determine if it is impaired. If the loan is considered impaired, the special asset department will evaluate the need for a specific valuation allowance on the loan. Specific valuation allowances are determined by analyzing the borrower’s ability to repay amounts owed, collateral deficiencies and economic conditions affecting the borrower’s industry, among other things.
Historical loss factors are calculated based on the historical loss experience and recovery experience of specific classes of loans. The Company calculates historical loss ratios for the classes of loans based on the proportion of actual charge-offs and recoveries experienced to the total loans in the pool for a rolling twelve quarter average.
Environmental loss factors are based on general economic conditions and other qualitative risk factors both internal and external to the Company. In general, such valuation allowances are determined by evaluating, among other things: (i) levels of and trends in delinquencies and impaired loans; (ii) levels and trends in charge-offs and

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recoveries; (iii) effects of changes in risk selection and underwriting standards, and other changes in lending policies, procedures, and practices; (iv) experience, ability, and depth of lending management and other relevant staff; (v) national and local economic trends and conditions; (vi) external factors such as competition, legal, and regulatory and; (vii) effects of changes in credit concentrations. Management evaluates the degree of risk that each one of these components has on the quality of the loan portfolio on a quarterly basis. Each component is determined to be on a scale of risk. The results are then utilized in a matrix to determine an appropriate environmental loss factor for each class of loan. An additional environmental factor is added after the calculated matrix factor if the specific loan is risk graded worse than a rating of "watch".
The allowance for loan losses evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available. While management utilizes its best judgment and information available to recognize losses on loans, future additions to the allowance may be necessary based on declines in local and national economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowance for loan losses. Such agencies may require the Bank to make adjustments to the allowance based on their judgments about information available to them at the time of their examinations. The Company believes the allowance for loan losses is appropriate given all of the above considerations.
Allowance for Loan Losses on Purchased Credit Impaired Loans:
The PCI loans acquired in the Company's mergers and acquisitions are subject to the Company’s internal and external credit review. Under the accounting guidance of FASB ASC 310-30, the allowance for loan losses on PCI loans is measured at each financial reporting period, or measurement date, based on expected cash flows. If and when credit deterioration, or decreases in expected cash flows initially estimated, occurs subsequent to the acquisition date, a provision for loan losses will be charged to earnings as of the measurement date. For the covered PCI loans, a provision for loan losses is charged to earnings for the full amount without regard to the FDIC shared-loss agreement, and the portion of the loss reimbursable from the FDIC is recorded in noninterest income and increases the FDIC indemnification asset.
Allowance for Losses on Unfunded Commitments:
The Bank is also party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit risk in excess of the disbursed amounts recognized in the Consolidated Statements of Financial Condition. The Company has a policy in which it evaluates the risk on a quarterly basis, and provides for an allowance for credit losses, as necessary. The methodology is similar to the allowance for loan losses, and includes an estimate of the probability of drawdown of the loan commitment. Based on its analysis, the Company has recorded an allowance for off-balance sheet financial instruments of $170,000 and $110,000 as of December 31, 2014 and 2013, respectively. This allowance is reported within accrued expenses and other liabilities on the Company's Consolidated Statements of Financial Condition.

Mortgage Banking Operations
Prior to the second quarter of 2013 and subsequent to the second quarter 2014, the Company sells one-to-four family residential loans on a servicing released basis and recognized a cash gain or loss. A cash gain or loss is recognized to the extent that the sales proceeds of the loans sold differ from the net book value at the time of sale. Income from one-to-four family residential loans brokered to other lenders is recognized into income on date of loan closing.
Commitments to sell one-to-four family residential loans are made primarily during the period between the taking of the loan application and the closing of the loan. The timing of making these sale commitments is dependent upon the timing of the borrower’s election to lock-in the mortgage interest rate and fees prior to loan closing. Most of these sale commitments are made on a best-efforts basis whereby the Bank is only obligated to sell the loan if the loan is approved and closed by the Bank. Commitments to fund one-to-four family residential loans (interest rate locks) to be sold into the secondary market and forward commitments for the future delivery of these loans are accounted for as free standing derivatives. Fair values of these mortgage derivatives are estimated based on changes in mortgage interest rates between the date the interest on the loan was locked and the balance sheet date. The Company enters into forward commitments for the future delivery of one-to-four family residential loans when interest rate locks are entered into, in order to hedge the interest rate risk resulting from its commitments to fund the loans. Changes in the fair values of these derivatives are included in other income. The fair value of these derivative instruments was not significant at December 31, 2014. As there were no such commitments at December 31, 2013, there was no associated derivative at that date.

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FDIC Indemnification Asset
The FDIC indemnification asset was measured at estimated fair value at acquisition dates on the same basis as the covered loans, and represents the present value of the estimated losses on covered loans to be reimbursed by the FDIC. The present value was calculated using the shorter of the shared-loss agreement terms or the life of the loan. Under the terms of the FDIC shared-loss agreements, the FDIC absorbs 80% of losses and receives 80% of loss recoveries for the covered loans during the terms of the agreements. Certain shared-loss agreements have loss minimums or tranches which may reduce the shared-loss percentages during the coverage period. The FDIC indemnification asset is reduced as losses are recognized on covered loans and shared-loss payments are received from the FDIC. Since the FDIC indemnification asset was initially recorded at estimated fair value using a discount rate, a portion of the discount is accreted into noninterest income during each reporting period.
The FDIC indemnification asset is evaluated quarterly. Realized losses in excess of prior estimates immediately increase the FDIC indemnification asset by a credit to noninterest income. Conversely, if realized losses are less than prior estimates, the FDIC indemnification asset is reduced by a charge to noninterest income on a prospective basis, and any change in value would be limited to the contractual terms of the shared-loss agreements.

Other Real Estate and Other Assets Owned
Other real estate acquired by the Company in satisfaction of debt is held for sale and recorded at fair value at time of foreclosure. When property is acquired, it is recorded at the estimated fair value (less the costs to sell) at the date of acquisition, not to exceed net realizable value, and any resulting write-down is charged to the allowance for loan losses. After acquisition, all costs incurred in maintaining the property are expensed. Costs relating to the development and improvement of the property, however, are capitalized to the extent of the property’s net realizable value.

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

Bank Owned Life Insurance
The Company has bank owned life insurance (“BOLI”), the majority of which was acquired in the Washington Banking Merger with fair value totaling $32.5 million at May 1, 2014. These policies insure the lives of certain current or former Bank officers or former Whidbey officers, and name the Bank as beneficiary. Noninterest income is generated tax-free (subject to certain limitations) from the increase in the policies' underlying investments made by the insurance company.  The Bank utilizes BOLI to partially offset costs associated with employee compensation and benefit programs with the earnings on the BOLI. The Company records BOLI at the amount that can be realized under the insurance contract at the statement of financial condition date, which is the cash surrender value adjusted for other charges or other amounts due that are probable at settlement.    

Other Intangible Assets
The other intangible assets represents the Core Deposit Intangible (“CDI”) acquired in business combinations. The fair value of the CDI stemming from any given business combination is based on the present value of the expected cost savings attributable to the core deposit funding, relative to an alternative source of funding. The CDI is amortized over an estimated useful life which approximates the existing deposit relationships acquired on an accelerated method. The Company evaluates such identifiable intangibles for impairment when an indication of impairment exists.

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Goodwill
The Company’s goodwill represents the excess of the purchase price over the fair value of net assets acquired in the purchases of Washington Banking Company in 2014, Valley Community Bancshares in 2013, Western Washington Bancorp in 2006 and North Pacific Bank in 1998. The Company’s goodwill is assigned to Heritage Bank and is evaluated for impairment at the Heritage Bank level (reporting unit).
In accordance with Accounting Standards Update ("ASU") 2011-08 Intangibles – Goodwill and Other (Topic 350), an entity is not required to calculate the fair value of a reporting unit unless the entity determines that it is more likely than not that its fair value is less than its carrying amount. In other words, before the first step of the existing guidance, the entity has the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that the fair value of goodwill is less than carrying value. The qualitative assessment includes adverse events or circumstances identified that could negatively affect the reporting units’ fair value as well as positive and mitigating events. Such indicators may include, among others: a significant change in legal factors or in the general business climate; significant change in the Company’s stock price and market capitalization; unanticipated competition; and an action or assessment by a regulator. If, after assessing the totality of events or circumstances, an entity determines it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then performing the two-step process is unnecessary. The entity has the option to bypass the qualitative assessment step for any reporting unit in any period and proceed directly to the first step of the exiting two-step process. The entity can resume performing the qualitative assessment in any subsequent period.
The first step of the goodwill impairment test is performed, when considered necessary, by comparing the reporting unit’s aggregate fair value to its carrying value. Absent other indicators of impairment, if the aggregate fair value exceeds the carrying value, goodwill is not considered impaired and no additional analysis is necessary. If the carrying value of the reporting unit were to exceed the aggregate fair value, a second step would be performed to measure the amount of impairment loss, if any. To measure any impairment loss the implied fair value would be determined in the same manner as if the reporting unit were being acquired in a business combination. If the implied fair value of goodwill is less than the recorded goodwill, an impairment charge would be recorded for the difference.

Income Taxes
The Company and its bank subsidiary file a United States consolidated federal income tax return and an Oregon State income tax return. Income tax expense is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the consolidated financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates applicable to taxable income in the periods in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rate is recognized in income in the period that includes the enactment date. A valuation allowance, if needed, reduces deferred tax assets to the amounts expected to be realized.
A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded.
The Company’s policy is to recognize interest and penalties on unrecognized tax benefits in “income taxes” in the Consolidated Statements of Income as the amounts are generally insignificant each year. 

Employee Stock Ownership Plan
The Company sponsored an Employee Stock Ownership Plan ("ESOP"). The ESOP purchased 2% of the common stock issued in a January 1998 stock offering and borrowed $1.3 million from the Company in order to fund the purchase of the Company’s common stock. The loan to the ESOP was repaid in full as of December 31, 2012. When outstanding, the loan was repaid principally from the Bank's contributions to the ESOP. The Bank's contributions were sufficient to service the debt over the 15-year loan term at the interest rate of 8.5% . As the debt was repaid, shares were released and allocated to plan participants based on the proportion of debt service paid during the year. As shares were released, compensation expense was recorded equal to the then current market price of the shares and the shares became outstanding for earnings per common share calculations. Cash dividends on allocated shares were recorded as a reduction of retained earnings and paid or distributed directly to participants’ accounts. Cash dividends on unallocated shares were recorded as a reduction of debt and accrued interest.

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Stock-Based Compensation
The Company maintains a number of stock-based incentive programs, which are discussed in more detail in Note 21, "Stock-Based Compensation." Compensation cost is recognized for stock options and restricted stock awards issued to employees and directors, based on the fair value of these awards at the date of grant. The Company did not grant stock option awards for the years ended December 31, 2014, 2013 or 2012, other than the options granted in 2014 as part of the Washington Banking Merger. The fair value of stock options granted would be estimated on the date of grant using the Black-Scholes-Merton option pricing model. The market price of the Company’s common stock at the date of grant is used for the restricted stock awards. Compensation cost is recognized over the requisite service period, generally defined as the vesting period, on a straight-line basis.

Deferred Compensation Plans
The Company has adopted a Deferred Compensation Plan and has entered into arrangements with certain executive officers. Under the Plan, participants are permitted to elect to defer compensation and the Company has the discretion to make additional contributions to the Plan on behalf of any participant based on a number of factors. Such discretionary contributions are generally approved by the Compensation Committee of the Company's Board of Directors. The notional account balances of participants under the Plan earn interest on an annual basis. The applicable interest rate is the Moody’s Seasoned Aaa Corporate Bond Yield as of January 1 of each year. Generally, a participant’s account is payable upon the earliest of the participant’s separation from service with the Company, the participant’s death or disability, or a specified date that is elected by the participant in accordance with applicable rules of the Internal Revenue Code. The Company’s obligation to make payments under the Plan is a general obligation of the Company and is to be paid from the Company’s general assets. As such, participants are general unsecured creditors of the Company with respect to their participation under the Plan. The Company records a liability within accrued expenses and other liabilities on the Consolidated Statements of Financial Condition and records compensation expense in a systematic and rationale manner. Since the amounts earned are generally based on the Company’s annual performance, the Company records deferred compensation expense each year for an amount calculated based on that year’s financial performance.

Earnings per Share
Basic earnings per common share is net income available to common stockholders divided by the weighted average number of common shares outstanding during the period. All outstanding unvested share-based payment awards that contain rights to nonforfeitable dividends are considered participating securities for this calculation. Diluted earnings per common share includes the dilutive effect of additional potential common shares issuable under stock options. Earnings and dividends per share are restated for all stock splits and stock dividends through the date of issuance of the financial statements.

Operating Segments
While the Company’s chief decision-makers monitor the revenue streams of the various products and services, operations are managed and financial performance is evaluated on a Company-wide basis. Operating segments are aggregated into one as operating results for all segments are similar. Accordingly, all of the financial service operations are considered by management to be aggregated in one reportable operating segment.

(d) Recently Issued Accounting Pronouncements
FASB ASU 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, A Similar Tax Loss, or a Tax Credit Carryforward Exists, was issued in July 2013. This Update provides that an unrecognized tax benefit, or a portion thereof, be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward, except to the extent that a net operating loss carryforward, a similar tax loss, or a tax credit carryforward is not available at the reporting date to settle any additional income taxes that would result from disallowance of a tax position, or the tax law does not require the entity to use, and the entity does not intend to use, the deferred tax asset for such purpose, then the unrecognized tax benefit should be presented as a liability. This Update was effective for the Company for the year ended December 31, 2014. The adoption of this Update did not have a material impact on the Company's Consolidated Financial Statements.

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FASB ASU 2014-01, Accounting for Investments in Qualified Affordable Housing Projects, was issued in January 2014.  The objective of this Update is to provide guidance on accounting for investments by a reporting entity in flow-through limited liability entities that manage or invest in affordable housing projects that qualify for the low-income housing tax credit. The Update permits reporting entities to make an accounting policy election to account for their investments in qualified affordable housing projects using the proportional amortization method if certain conditions are met. Under the proportional amortization method, an entity amortizes the initial cost of the investment in proportion to the tax credits and other tax benefits received and recognizes the net investment performance in the consolidated statements of income as a component of income tax expense (benefit). The standard will be effective for the Company beginning January 1, 2015; however, early adoption was permitted. The Company adopted the provisions of this Update during the year ended December 31, 2014. The adoption of this Update did not have a material impact on the Company’s Consolidated Financial Statements.
FASB ASU 2014-04, Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure, was issued in January 2014. This Update intends to reduce variations in practice by clarifying when an in-substance repossession or foreclosure occurs, that is, when a creditor should be considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan such that the loan receivable should be derecognized and the real estate property recognized. The Update states that the real estate property should be recognized upon either the creditor obtaining legal title or the borrower conveying all interest through a deed in lieu of foreclosure or similar legal agreement. The Update is effective for interim and annual reporting periods beginning after December 15, 2014. Early adoption is permitted. The Company adopted the amendments in the first quarter of 2014. The adoption did not have an impact on the Company's Consolidated Financial Statements.
FASB ASU 2014-09, Revenue from Contracts with Customers, was issued in May 2014. Under this Update, FASB created a new Topic 606 which is in response to a joint initiative of FASB and the International Accounting Standards Board to clarify the principles for recognizing revenue and to develop a common revenue standard for U.S. GAAP and international financial reporting standards that would:
1.
Remove inconsistencies and weaknesses in revenue requirements.
2.
Provide a more robust framework for addressing revenue issues.
3.
Improve comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets.
4.
Provide more useful information to users of financial statements through improved disclosure requirements.
5.
Simplify the preparation of financial statements by reducing the number of requirements to which an entity must refer.
The Update is effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. Early application is not permitted. The Company is currently evaluating the impact that this Update will have on its Consolidated Financial Statements.
FASB ASU 2014-11, Transfers and Servicing: Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures, was issued in June 2014. This Update aligns the accounting for repurchase-to-maturity transactions and repurchase agreements executed as a repurchase financing with the accounting for other typical repurchase agreements, such as secured borrowings. The guidance eliminates sale accounting and supersedes the guidance under which a transfer of a financial asset and a contemporaneous repurchase financing could be accounted for on a combined basis as a forward agreement. The Update requires new and expanded disclosures that are effective for interim or annual reporting periods beginning after December 15, 2014. Early adoption for a public company is prohibited. The Company does not anticipate the adoption of this Update will have a material impact on its Consolidated Financial Statements.
FASB ASU 2014-14, Receivables - Troubled Debt Restructurings by Creditors: Classification of Certain Government-Guaranteed Mortgage Loans upon Foreclosure, was issued in August 2014 to reduce the diversity of classification of government-guaranteed mortgages upon foreclosure. The Update requires that mortgage loans be derecognized and that a separate other receivable be recognized upon foreclosure if certain conditions are met. The separate other receivable should be measured based on the amount of the loan balance (principal and interest) expected to be recovered from the guarantor. The amendments in this Update are effective for interim and annual periods beginning after December 15, 2014. Early adoption is permitted. The Company adopted the amendment in the third quarter of 2014. The adoption did not have an impact on the Company's Consolidated Financial Statements.

(2)
Business Combinations
During the year ended December 31, 2014, the Company completed the merger of Washington Banking Company, referred to as the "Washington Banking Merger". During the year ended December 31, 2013, the Company

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completed the acquisitions of Northwest Commercial Bank and Valley Community Bancshares, referred to jointly as the "NCB and Valley Acquisitions." During the year ended December 31, 2013, the Company also completed the merger of its wholly-owned bank subsidiary Central Valley Bank with and into Heritage Bank. The merger of Central Valley Bank with an into Heritage Bank was a common control merger which had no accounting impact on the consolidated Company. There were no acquisitions or mergers completed during the year ended December 31, 2012.
Washington Banking Merger
On October 23, 2013, the Company, along with the Bank, and Washington Banking and its wholly owned subsidiary bank, Whidbey, jointly announced the signing of a merger agreement for the Washington Banking Merger. The Washington Banking Merger was effective on May 1, 2014. Pursuant to the terms of the Washington Banking Merger, Washington Banking branches adopted the Heritage Bank name in all markets, with the exception of six branches in the Whidbey Island markets which have continued to operate using the Whidbey Island Bank name. The primary reasons for the merger were to expand the Company's geographic footprint consistent with its ongoing growth strategy and to achieve operational scale and realize efficiencies of a larger combined organization.
Under the terms of the merger agreement, Washington Banking shareholders received 0.89000 shares of Heritage common stock and $2.75 in cash for each share of Washington Banking common stock. The terms of the merger agreement also stipulated immediate vesting of the Washington Banking options and restricted stock awards units. At April 30, 2014, the number of Washington Banking common shares outstanding was 15,587,154. The closing price of Heritage common stock was $16.16 as of April 30, 2014. The total consideration transferred by the Company in conjunction with the Washington Banking Merger was $269.6 million and the total number of Heritage shares of common stock issued were 14,000,178. The Company also incurred $489,000 in capitalized stock issuance costs.
The total consideration transferred in the Washington Banking Merger consisted of the following:
 
 
Washington Banking
 
 
(In thousands)
Consideration transferred
 
 
Cash paid (1)
 
$
42,895

Fair value of common shares issued (2)
 
224,151

Fair value of restricted stock unit awards (3)
 
2,092

Fair value of common stock options
 
481

Total consideration transferred
 
$
269,619

(1)
Includes $3,000 of cash paid due to fractional shares and $27,000 of cash paid from dissenters.
(2)
Total of 13,870,716 shares issued. Excludes 1,686 shares dissented and paid in cash and 165 fractional shares paid in cash.
(3)
Total number of converted shares was 129,462. Fair value includes 26,783 shares which were forfeited by the Washington Banking stockholder to pay applicable taxes, totaling fair value of $433,000.
The transaction qualified as a tax-free reorganization for U.S. federal income tax purposes and Washington Banking shareholders did not recognize any taxable gain or loss in connection with the share exchange and the stock consideration received.
The Washington Banking Merger resulted in $89.7 million of goodwill. This goodwill is not deductible for tax purposes. Subsequent to the goodwill amounts reported in the Form 10-Q for the quarter ended June 30, 2014, the Company recorded adjustments to goodwill totaling $722,000 related to a $489,000 correction of the fair value of consumer loans, a $233,000 correction in the FDIC indemnification asset, a $252,000 correction of the net receivable from the FDIC for losses on covered assets and a $252,000 change in deferred taxes related to correction of tax liabilities. Subsequent to the goodwill amounts reported in the Form 10-Q for the quarter ended September 30, 2014, the Company recorded adjustments to goodwill totaling $118,000 related to a $265,000 correction in the BOLI split-dollar obligation, a $342,000 correction of deferred taxes, and a $489,000 correction in stock issuance costs.
During the years ended December 31, 2014 and 2013, the Company incurred Washington Banking merger-related costs (including system conversion costs) of approximately $9.1 million and $890,000, respectively.
The Company expects to finalize the purchase price allocation by March 31, 2015 when the valuation of acquired noncovered and covered loans, related indemnification asset and deferred taxes is completed.

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Valley Community Bancshares
On March 11, 2013, the Company entered into a definitive agreement to acquire Valley Community Bancshares ("Valley") and its wholly-owned subsidiary, Valley Bank, both headquartered in Puyallup, Washington. The Valley Acquisition was completed on July 15, 2013. Valley operated eight branches prior to acquisition, of which only four were maintained by Heritage Bank. Of the four other branches, three leases were terminated during the fourth quarter of 2013 and one owned branch building was considered held for sale at the time of acquisition.
Pursuant to the terms of the merger agreement, the shareholders of Valley common stock received $19.50 per share in cash and 1.3611 shares of Heritage common stock per Valley share. The merger consideration for Valley consisted of cash and stock, with $22.0 million paid in cash by the Company and 1,533,267 shares of the Company’s common stock being issued with fair value of $24.2 million. The Company also recognized $157,000 in capitalized costs related to the issuance of its securities.
The Valley Acquisition resulted in $16.4 million of goodwill. This goodwill is not deductible for tax purposes.
During the years ended December 31, 2014 and 2013, the Company incurred Valley Acquisition-related costs (including system conversion costs) of approximately $443,000 and $2.1 million, respectively.
Northwest Commercial Bank
On September 14, 2012, the Company and Heritage Bank entered into a definitive agreement to acquire Northwest Commercial Bank ("NCB") headquartered in Lakewood, Washington. NCB was a full service commercial bank that operated two branch locations in Lakewood and Auburn, Washington. Prior to the closing of the transaction, NCB redeemed its outstanding preferred stock of approximately $2.0 million issued to the U.S. Department of Treasury in connection with its participation in the Troubled Asset Relief Program Capital Purchase Plan. The NCB Acquisition was completed on January 9, 2013 with the merger of NCB with and into Heritage Bank. After the NCB Acquisition, the NCB Lakewood branch was consolidated into one of Heritage Bank’s full service banking offices in Lakewood, Washington.
In connection with the NCB Acquisition, the Company paid cash consideration of $3.0 million, or $5.50 per NCB share, to NCB shareholders on January 9, 2013. In addition, pursuant to the merger agreement, the NCB shareholders had the ability to potentially receive an additional cash payment based on an earn-out structure from the sale of a NCB asset included in “other real estate owned.” This contingent payment was factored into the NCB liabilities assumed by Heritage Bank as of the January 9, 2013 acquisition date. This asset was sold by Heritage Bank in June 2013, and the $491,000 of proceeds from the sale were paid to the NCB shareholders in July 2013. The payment of these proceeds did not impact the recorded bargain purchase gain on bank acquisition of $399,000.
During the years ended December 31, 2013 and 2012, the Company incurred NCB Acquisition-related costs (including system conversion costs) of approximately $794,000 and $616,000. There were no NCB Acquisition-related costs incurred during the year ended December 31, 2014.
Business Combination Accounting
The Washington Banking Merger and the NCB and Valley Acquisitions constitute business acquisitions as defined by FASB ASC 805, Business Combinations. FASB ASC 805 establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired and the liabilities assumed.  Heritage was considered the acquirer in the referenced mergers and acquisitions. Accordingly, the preliminary estimates of fair values of the acquired banks' assets, including the identifiable intangible assets, and the assumed liabilities in the merger and acquisitions were measured and recorded as of the respective effective dates of the merger and acquisitions.

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The fair value estimates of the assets acquired and liabilities assumed in the indicated merger and acquisitions were as follows:
 
Washington Banking
 
Valley
 
NCB
 
May 1, 2014
 
July 15, 2013
 
January 9, 2013
 
(In thousands)
Assets
 
 
 
 
 
Cash and cash equivalents
$
74,947

 
$
40,643

 
$
2,712

Other interest earning deposits

 
13,866

 
1,003

Investment securities available for sale
458,312

 
31,444

 
2,753

Investment securities held to maturity

 
22,908

 

Loans held for sale
3,923

 

 

Noncovered loans receivable
895,978

 
117,071

 
51,509

Covered loans receivable
107,050

 

 

FDIC indemnification asset
7,174

 

 

Other real estate owned ($5,122, $0, and $0 covered by FDIC shared-loss agreements, respectively)
7,121

 

 
2,279

Premises and equipment
31,776

 
6,558

 
214

Federal Home Loan Bank stock
7,064

 
366

 
88

Bank owned life insurance
32,519

 

 

Accrued Interest Receivable
4,943

 
465

 
232

Other intangible assets
11,194

 
916

 
156

Prepaid expenses and other assets
14,852

 
3,087

 
4,048

Total assets acquired
1,656,853

 
237,324

 
64,994

Liabilities
 
 
 
 
 
Deposits
1,433,894

 
207,013

 
60,442

Junior subordinated debentures
18,937

 

 

Accrued expenses and other liabilities
24,067

 
342

 
1,186

Total liabilities assumed
1,476,898

 
207,355

 
61,628

Net assets acquired
$
179,955

 
$
29,969

 
$
3,366

A summary of the net assets purchased, the fair value adjustments and resulting goodwill recognized from the Washington Banking Merger and Valley Acquisition and the resulting bargain purchase gain recognized on the NCB Acquisition are presented in the following table. Goodwill on mergers and acquisitions represents the excess of the consideration transferred over the estimated fair value of the net assets acquired and liabilities assumed. A bargain purchase gain on bank acquisition represents the excess of the estimated fair value of the net assets acquired and liabilities assumed over the value of the consideration paid. The bargain purchase gain in the NCB Acquisition was influenced significantly by the net deferred tax asset acquired. NCB had significant net operating losses and as a result of its estimate of whether or not it was more likely than not that the net deferred tax asset would be realized, had recorded a full valuation allowance on the net deferred tax asset. The Company, however, has reviewed the net deferred tax asset and determined it is more likely than not that the net deferred tax asset would be realized by the Company.

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Table of Contents


 
Washington Banking
 
Valley
 
NCB
 
May 1, 2014
 
July 15, 2013
 
January 9, 2013
 
(In thousands)
Cost basis of net assets on merger date
$
181,782

 
$
29,720

 
$
6,113

Less: Consideration transferred
(269,619
)
 
(46,323
)
 
(2,967
)
Fair value adjustments:
 
 
 
 
 
Other interest earning deposits

 
162

 
7

Investment securities

 

 
(2
)
Loans held for sale
86

 

 

Noncovered loans receivable
(12,811
)
 
(3,003
)
 
(3,299
)
Covered loans receivable
6,384

 

 

FDIC indemnification asset
357

 

 

Other real estate owned
387

 

 
(1,301
)
Premises and equipment
(1,540
)
 
1,837

 
(69
)
Other intangible assets
10,216

 
916

 
156

Prepaid expenses and other assets
(6,416
)
 
198

 
2,394

Deposits
(1,737
)
 
(9
)
 
(11
)
Junior subordinated debentures
6,837

 

 

Accrued expenses and other liabilities
(3,590
)
 
149

 
(622
)
(Goodwill) bargain purchase gain recognized
$
(89,664
)
 
$
(16,353
)
 
$
399

    
The operating results of the Company for the years ended December 31, 2014 and 2013 include the operating results produced by the net assets acquired in the merger and acquisitions since the respective effective dates. Disclosure of the amount of revenue and net income (excluding acquisition-related costs) of Washington Banking, Valley and NCB since the effective dates included in the Company's Consolidated Statements of Income is impracticable due to the integration of the operations and accounting for the merger and acquisitions.

The Company also considered the pro forma requirements of FASB ASC 805 and deemed it not necessary to provide pro forma financial statements as required under the standard for the NCB and Valley Acquisitions as they were not material to the Company. The Company believes that the historical NCB and Valley operating results are not considered of enough significance to be meaningful to the Company’s results of operations.
    
The pro forma requirements of FASB ASC 805 were necessary for the Washington Banking Merger. The following table presents certain pro forma information, for illustrative purposes only, for the years ended December 31, 2014 and 2013 as if the Washington Banking Merger had occurred on January 1, 2013. The estimated pro forma information combines the historical results of Washington Banking with the Company's consolidated historical results and includes certain adjustments reflecting the estimated impact of certain fair value adjustments for the respective periods. The pro forma information is not indicative of what would have occurred had the Washington Banking Merger occurred on January 1, 2013. In particular, no adjustments have been made to eliminate the impact of the Washington Banking loans previously accounted for under ASC 310-30 that may have been necessary if these loans had been recorded at fair value at January 1, 2013. The pro forma information also does not consider any changes to the provision for loan losses resulting from recorded loans at fair value. Additionally, Heritage expects to achieve further operating savings and other business synergies, including interest income growth, as a result of the Washington Banking Merger which are not reflected in the pro forma amounts in the following table. As a result, actual amounts will differ from the pro forma information presented.

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Pro Forma for the Year Ended December 31,
 
 
2014
 
2013
 
 
(Dollars In Thousands, except per share amounts)
Net interest income
 
$
144,470

 
$
147,267

Net income
 
35,758

 
30,718

Basic earnings per common share
 
$
1.19

 
$
1.04

Diluted earnings per common share
 
1.18

 
1.04


(3)
Cash and Cash Equivalents
From October 2013 through May 2014, the Company was required to maintain an average reserve balance with the Federal Reserve Bank of San Francisco ("Federal Reserve Bank") or maintain such reserve balance in the form of cash. The Company did not have a cash reserve requirement at December 31, 2014. The required reserve balance at December 31, 2013 was $46.3 million, and was met by holding cash and maintaining an average balance with the Federal Reserve Bank.

(4)
Investment Securities
The Company’s investment policy is designed primarily to provide and maintain liquidity, generate a favorable return on assets without incurring undue interest rate and credit risk, and complement the Bank’s lending activities. Securities are classified as either available for sale or held to maturity when acquired.
(a) Securities by Type and Maturity
The amortized cost, gross unrealized gains, gross unrealized losses and fair values of investment securities available for sale at the dates indicated were as follows:
 
Securities Available for Sale
 
December 31, 2014
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
 
(In thousands)
U.S. Treasury and U.S. Government-sponsored agencies
$
21,414

 
$
44

 
$
(31
)
 
$
21,427

Municipal securities
170,082

 
3,139

 
(184
)
 
173,037

Mortgage backed securities and collateralized mortgage obligations-residential:
 
 
 
 
 
 
 
U.S. Government-sponsored agencies
539,859

 
4,015

 
(1,475
)
 
542,399

Corporate obligations
4,034

 

 
(24
)
 
4,010

Mutual funds and other equities
1,956

 
17

 

 
1,973

Total
$
737,345

 
$
7,215

 
$
(1,714
)
 
$
742,846

 
Securities Available for Sale
 
December 31, 2013
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
 
(In thousands)
U.S. Treasury and U.S. Government-sponsored agencies
$
6,098

 
$
3

 
$
(62
)
 
$
6,039

Municipal securities
49,989

 
806

 
(1,735
)
 
49,060

Mortgage backed securities and collateralized mortgage obligations-residential:
 
 
 
 
 
 
 
U.S. Government-sponsored agencies
108,466

 
898

 
(1,329
)
 
108,035

Total
$
164,553

 
$
1,707

 
$
(3,126
)
 
$
163,134


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The amortized cost, gross unrecognized gains, gross unrecognized losses and fair values of investment securities held to maturity at the dates indicated were as follows:
 
Securities Held to Maturity
 
December 31, 2014
 
Amortized
Cost
 
Gross
Unrecognized
Gains
 
Gross
Unrecognized
Losses
 
Fair
Value
 
(In thousands)
U.S. Treasury and U.S. Government-sponsored agencies
$
1,591

 
$
167

 
$

 
$
1,758

Municipal securities
22,486

 
643

 
(11
)
 
23,118

Mortgage backed securities and collateralized mortgage obligations-residential:
 
 
 
 
 
 
 
U.S. Government-sponsored agencies
10,866

 
364

 
(74
)
 
11,156

Private residential collateralized mortgage obligations
871

 
75

 
(104
)
 
842

Total
$
35,814

 
$
1,249

 
$
(189
)
 
$
36,874

 
Securities Held to Maturity
 
December 31, 2013
 
Amortized
Cost
 
Gross
Unrecognized
Gains
 
Gross
Unrecognized
Losses
 
Fair
Value
 
(In thousands)
U.S. Treasury and U.S. Government-sponsored agencies
$
1,687

 
$
153

 
$

 
$
1,840

Municipal securities
24,290

 
200

 
(184
)
 
24,306

Mortgage backed securities and collateralized mortgage obligations-residential:
 
 
 
 
 
 
 
U.S. Government-sponsored agencies
9,129

 
144

 
(284
)
 
8,989

Private residential collateralized mortgage obligations
1,048

 
185

 
(28
)
 
1,205

Total
$
36,154

 
$
682

 
$
(496
)
 
$
36,340

There were no securities classified as trading at December 31, 2014 or December 31, 2013.
The amortized cost and fair value of securities at December 31, 2014, 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
 
Securities Held to Maturity
 
Amortized
Cost
 
Fair
Value
 
Amortized
Cost
 
Fair Value
 
(In thousands)
Due in one year or less
$
4,148

 
$
4,171

 
$
2,895

 
$
2,912

Due after one year through three years
31,547

 
31,693

 
4,336

 
4,385

Due after three years through five years
23,675

 
24,104

 
5,490

 
5,710

Due after five years through ten years
150,635

 
151,946

 
18,558

 
19,359

Due after ten years
525,384

 
528,959

 
4,535

 
4,508

Investment securities with no stated maturity
1,956

 
1,973

 

 

Total
$
737,345

 
$
742,846

 
$
35,814

 
$
36,874


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Table of Contents


(b) Unrealized Losses and Other-Than-Temporary Impairments
Available for sale investment securities with unrealized losses as of December 31, 2014 and December 31, 2013 were as follows:
 
Securities Available for Sale
 
December 31, 2014
 
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-sponsored agencies
$
3,567

 
$
(31
)
 
$

 
$

 
$
3,567

 
$
(31
)
Municipal securities
25,176

 
(184
)
 

 

 
25,176

 
(184
)
Mortgage backed securities and collateralized mortgage obligations-residential:
 
 
 
 
 
 
 
 
 
 
 
U.S. Government-sponsored agencies
182,970

 
(1,475
)
 

 

 
182,970

 
(1,475
)
Corporate obligations
2,119

 
(24
)
 

 

 
2,119

 
(24
)
Total
$
213,832

 
$
(1,714
)
 
$

 
$

 
$
213,832

 
$
(1,714
)
 
Securities Available for Sale
 
December 31, 2013
 
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-sponsored agencies
$
3,031

 
$
(62
)
 
$

 
$

 
$
3,031

 
$
(62
)
Municipal securities
21,471

 
(1,242
)
 
4,644

 
(493
)
 
26,115

 
(1,735
)
Mortgage backed securities and collateralized mortgage obligations-residential:
 
 
 
 
 
 
 
 
 
 
 
U.S. Government-sponsored agencies
56,327

 
(1,184
)
 
7,758

 
(145
)
 
64,085

 
(1,329
)
Total
$
80,829

 
$
(2,488
)
 
$
12,402

 
$
(638
)
 
$
93,231

 
$
(3,126
)


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Table of Contents


Held to maturity investment securities with unrecognized losses as of December 31, 2014 and December 31, 2013 were as follows:
 
Securities Held to Maturity
 
December 31, 2014
 
Less than 12
Months
 
12 Months or
Longer
 
Total
 
Fair
Value
 
Unrecognized
Losses
 
Fair
Value
 
Unrecognized
Losses
 
Fair
Value
 
Unrecognized
Losses
 
(In thousands)
Municipal securities
$
2,196

 
$
(11
)
 
$

 
$

 
$
2,196

 
$
(11
)
Mortgage backed securities and collateralized mortgage obligations-residential:
 
 
 
 
 
 
 
 
 
 
 
U.S. Government-sponsored agencies
2,553

 
(74
)
 

 

 
2,553

 
(74
)
Private residential collateralized mortgage obligations
558

 
(104
)
 

 

 
558

 
(104
)
Total
$
5,307

 
$
(189
)
 
$

 
$

 
$
5,307

 
$
(189
)

 
Securities Held to Maturity
 
December 31, 2013
 
Less than 12
Months
 
12 Months or
Longer
 
Total
 
Fair
Value
 
Unrecognized
Losses
 
Fair
Value
 
Unrecognized
Losses
 
Fair
Value
 
Unrecognized
Losses
 
(In thousands)
Municipal securities
$
10,967

 
$
(184
)
 
$

 
$

 
$
10,967

 
$
(184
)
Mortgage backed securities and collateralized mortgage obligations-residential:
 
 
 
 
 
 
 
 
 
 
 
U.S. Government-sponsored agencies
4,869

 
(284
)
 

 

 
4,869

 
(284
)
Private residential collateralized mortgage obligations
211

 
(5
)
 
124

 
(23
)
 
335

 
(28
)
Total
$
16,047

 
$
(473
)
 
$
124

 
$
(23
)
 
$
16,171

 
$
(496
)
The Company has evaluated these securities and has determined that, other than certain private residential collateralized mortgage obligations discussed below, the decline in their value is temporary. The unrealized losses are primarily due to increases in market interest rates and larger spreads in the market for mortgage-related products. The fair value of these securities is expected to recover as the securities approach their maturity date and/or as the pricing spreads narrow on mortgage-related securities. The Company has the ability and intent to hold the investments until recovery of the market value which may be the maturity date of the securities.
To analyze the unrealized losses, the Company estimated expected future cash flows of the private residential collateralized mortgage obligations by estimating the expected future cash flows of the underlying collateral and applying those collateral cash flows, together with any credit enhancements such as subordination interests owned by third parties, to the security. The expected future cash flows of the underlying collateral are determined using the remaining contractual cash flows adjusted for future expected credit losses (which considers current delinquencies and nonperforming assets, future expected default rates and collateral value by vintage and geographic region) and prepayments. The expected cash flows of the security are then discounted at the interest rate used to recognize interest income on the security to arrive at a present value amount. The average discount interest rate used in the valuations of the present value as of December 31, 2014 and 2013 was 9.4% and 6.4%, respectively, and the average prepayment rate for each period was 6.0%.

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Table of Contents


For the years ended December 31, 2014 and 2013, there were four and eight, respectively, private residential collateralized mortgage obligations determined to be other-than-temporarily impaired. All unrealized losses for the years ended December 31, 2014 and 2013 were deemed to be credit related, and the Company recorded the impairment in earnings. No impairment for the years ended December 31, 2014 and 2013 was recorded through other comprehensive income (loss). For the year ended December 31, 2012, there were eight private residential collateralized mortgage obligations determined to be other-than-temporarily impaired. A portion of the impairment not related to credit losses was recorded through other comprehensive (loss) income for the year ended December 31, 2012.
The following table summarizes activity for the years ended December 31, 2014, 2013 and 2012 related to the amount of impairments on held to maturity securities:
 
Life-to-Date Gross Other-Than-Temporary Impairments (1)
 
Life-to-Date Other-Than-Temporary Impairments Included in Other Comprehensive Income (Loss)
 
Life-to-Date Net
Other-Than-Temporary Impairments Included in Earnings
 
(In thousands)
December 31, 2011
$
2,435

 
$
1,100

 
$
1,335

Subsequent impairments
130

 
52

 
78

December 31, 2012
2,565

 
1,152

 
1,413

Subsequent impairments
38

 

 
38

December 31, 2013
2,603

 
1,152

 
1,451

Subsequent impairments
45

 

 
45

December 31, 2014
$
2,648

 
$
1,152

 
$
1,496

(1)
Life-to-date gross other-than-temporary impairments disclosed in this table are not reflective of subsequent recoveries, if any.

(c) Pledged Securities
The following table summarizes the amortized cost and fair value of available for sale and held to maturity securities that are pledged as collateral for the following obligations at December 31, 2014 and December 31, 2013:
 
December 31, 2014
 
December 31, 2013
 
Amortized
Cost
 
Fair
Value
 
Amortized
Cost
 
Fair
Value
 
(In thousands)
Washington and Oregon state to secure public deposits
$
150,507

 
$
153,785

 
$
80,386

 
$
80,881

Federal Reserve Bank and FHLB to secure borrowing arrangements
4,430

 
4,460

 

 

Repurchase agreements
43,676

 
44,457

 
34,170

 
33,893

Other securities pledged
14,828

 
14,922

 

 

Total
$
213,441

 
$
217,624

 
$
114,556

 
$
114,774


At December 31, 2014 and 2013, total carrying value of pledged securities was $216.7 million and $114.8 million, respectively.

(5)
Noncovered Loans Receivable
The Company originates loans in the ordinary course of business and has also acquired loans through FDIC-assisted and open bank transactions. Loans that are not covered by FDIC shared-loss agreements are referred to as "noncovered loans." Disclosures related to the Company’s recorded investment in noncovered loans receivable generally exclude accrued interest receivable and net deferred loan origination fees and costs because they are insignificant.

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Table of Contents


Loans acquired in a business combination may be further classified as “purchased” loans. Loans purchased with evidence of credit deterioration since origination for which it is probable that not all contractually required payments will be collected are accounted for under FASB ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality. These loans are identified as “purchased credit impaired” ("PCI") loans. Loans purchased that are not accounted for under FASB ASC 310-30 are accounted for under FASB ASC 310-20, Receivables—Nonrefundable Fees and Other Costs.
(a) Loan Origination/Risk Management
The Company categorizes 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 internal loan reviews and validates the credit risk assessment on a periodic basis and presents the results of these reviews to management. The loan review process complements and reinforces the risk identification and assessment decisions made by loan officers and credit personnel, as well as the Company’s policies and procedures.
A discussion of the risk characteristics of each loan portfolio segment is as follows:
Commercial Business:
There are three significant classes of loans in the commercial portfolio segment: 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 of loans 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. Owner-occupied commercial real estate loans are generally of lower credit risk than non-owner occupied commercial real estate loans as the borrowers' businesses are likely dependent on the properties.
One-to-Four Family Residential:
The majority of the Company’s one-to-four family residential loans are secured by single-family residences located in its primary market areas. The Company’s underwriting standards require that single-family portfolio loans generally are owner-occupied and do not exceed 80% of the lower of appraised value at origination or cost of the underlying collateral. Terms of maturity typically range from 15 to 30 years. Historically, the Company sold most single-family loans in the secondary market and retained a smaller portion in its loan portfolio. From the second quarter of 2013 until May 1, 2014, the Company only originated single-family loans for its loan portfolio. As a result of the Washington Banking Merger, since May 1, 2014 the Company has once again begun originating and selling a majority of its single-family mortgages.
Real Estate Construction and Land Development:
The Company originates construction loans for one-to-four family residential and for five or more family residential and commercial properties. The one-to-four family residential construction loans generally include construction of custom homes whereby the home buyer is the borrower. The Company also provides financing to builders for the construction of pre-sold homes and, in selected cases, to builders for the construction of speculative

F-28

Table of Contents


residential property. Substantially all construction loans are short-term in nature and priced with variable rates of interest. Construction lending can involve a higher level of risk than other types of lending because funds are advanced partially based upon the value of the project, which is uncertain prior to the project’s completion. Because of the uncertainties inherent in estimating construction costs as well as the market value of a completed project and the effects of governmental regulation of real property, the Company’s estimates with regard to the total funds required to complete a project and the related loan-to-value ratio may vary from actual results. As a result, construction loans often involve the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project and the ability of the borrower to sell or lease the property or refinance the indebtedness. If the Company’s estimate of the value of a project at completion proves to be overstated, it may have inadequate security for repayment of the loan and may incur a loss if the borrower does not repay the loan. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property or an interim loan commitment from the Company until permanent financing is obtained. These loans are closely monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being dependent upon successful completion of the construction project, interest rate changes, government regulation of real property, general economic conditions and the availability of long-term financing.
Consumer:
The Company originates consumer loans and lines of credit that are both secured and unsecured. The underwriting process for these loans ensures a qualifying primary and secondary source of repayment. Underwriting standards for home equity loans are significantly influenced by statutory requirements, which include, but are not limited to, a maximum loan-to-value percentage of 80%, collection remedies, the number of such loans a borrower can have at one time and documentation requirements. To monitor and manage consumer loan risk, policies and procedures are developed and modified, as needed. The majority of consumer loans are for relatively small amounts disbursed among many individual borrowers which reduces the credit risk for this type of loan. To further reduce the risk, trend reports are reviewed by management on a regular basis.
As a result of the Washington Banking Merger, the Company is originating indirect consumer loans. These loans are for new and used automobile and recreational vehicles that are originated indirectly by selected dealers located in the Company's market areas. The Company has limited its indirect loans purchased primarily to dealerships that are established and well known in their market areas and to applicants that are not classified as sub-prime.
Noncovered loans receivable at December 31, 2014 and December 31, 2013 consisted of the following portfolio segments and classes:
 
December 31, 2014
 
December 31, 2013
 
(In thousands)
Commercial business:
 
 
 
Commercial and industrial
$
551,343

 
$
336,540

Owner-occupied commercial real estate
535,742

 
281,309

Non-owner occupied commercial real estate
616,757

 
399,979

Total commercial business
1,703,842

 
1,017,828

One-to-four family residential
63,540

 
43,082

Real estate construction and land development:
 
 
 
One-to-four family residential
46,749

 
19,724

Five or more family residential and commercial properties
61,360

 
48,655

Total real estate construction and land development
108,109

 
68,379

Consumer
250,323

 
41,547

Gross noncovered loans receivable
2,125,814

 
1,170,836

Net deferred loan fees
(937
)
 
(2,670
)
Noncovered loans receivable, net
2,124,877

 
1,168,166

Allowance for loan losses
(22,153
)
 
(22,657
)
Noncovered loans receivable, net of allowance for loan losses
$
2,102,724

 
$
1,145,509

(b) Concentrations of Credit
Most of the Company’s lending activity occurs within Washington State, and to a lesser extent Oregon. The Company’s primary market areas have been concentrated along the I-5 corridor from Whatcom County to Clark County in Washington State and Multnomah County in Oregon, as well as other contiguous markets. The Washington Banking

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Table of Contents


Merger has allowed the expansion of the market area north of Seattle, Washington to the Canadian border. The majority of the Company’s loan portfolio consists of (in order of balances at December 31, 2014) non-owner occupied commercial real estate, owner-occupied commercial real estate and commercial and industrial. As of December 31, 2014 and December 31, 2013, there were no concentrations of loans related to any single industry in excess of 10% of the Company’s total loans.
(c) Credit Quality Indicators
As part of the on-going monitoring of the credit quality of the Company’s loan portfolio, management tracks certain credit quality indicators including trends related to (i) the risk grade of the loans, (ii) the level of classified loans, (iii) net charge-offs, (iv) nonperforming loans, and (v) the general economic conditions of the United States of America, and specifically the states of Washington and Oregon. The Company utilizes a risk grading matrix to assign a risk grade to each of its loans. Loans are graded on a scale of 0 to 10. A description of the general characteristics of the risk grades is as follows:
Grades 0 to 5: These grades are considered “pass grade” and include loans with negligible to above average but acceptable risk. These borrowers generally have strong to acceptable capital levels and consistent earnings and debt service capacity. Loans with the higher grades within the “pass” category may include borrowers who are experiencing unusual operating difficulties, but have acceptable payment performance to date. Increased monitoring of financials and/or collateral may be appropriate. Loans with this grade show no immediate loss exposure.
Grade 6: This grade includes "Watch" loans and is considered a “pass grade”. The grade is intended to be utilized on a temporary basis for pass grade borrowers where a potentially significant risk-modifying action is anticipated in the near term.
Grade 7: This grade includes “Other Assets Especially Mentioned” (“OAEM”) loans in accordance with regulatory guidelines, and is intended to highlight loans with elevated risks. Loans with this grade show signs of deteriorating profits and capital, and the borrower might not be strong enough to sustain a major setback. The borrower is typically higher than normally leveraged, and outside support might be modest and likely illiquid. The loan is at risk of further decline unless active measures are taken to correct the situation.
Grade 8: This grade includes “Substandard” loans in accordance with regulatory guidelines, which the Company has determined have a high credit risk. These loans also have well-defined weaknesses which make payment default or principal exposure likely, but not yet certain. The borrower may have shown serious negative trends in financial ratios and performance. Such loans may be dependent upon collateral liquidation, a secondary source of repayment or an event outside of the normal course of business. Loans with this grade can be placed on accrual or nonaccrual status based on the Company’s accrual policy.
Grade 9: This grade includes “Doubtful” loans in accordance with regulatory guidelines, and the Company has determined these loans to have excessive credit risk. Such loans are placed on nonaccrual status and may be dependent upon collateral having a value that is difficult to determine or upon some near-term event which lacks certainty. Additionally, these loans generally have a specific valuation allowance or have been partially charged-off for the amount considered uncollectible.
Grade 10: This grade includes “Loss” loans in accordance with regulatory guidelines, and the Company has determined these loans have the highest risk of loss. Such loans are charged-off or charged-down when payment is acknowledged to be uncertain or when the timing or value of payments cannot be determined. “Loss” is not intended to imply that the loan or some portion of it will never be paid, nor does it in any way imply that there has been a forgiveness of debt.

F-30

Table of Contents


Numerical loan grades for all commercial business loans and real estate construction and land development loans are established at the origination of the loan. Prior to November 2014, one-to-four family residential loans and consumer loans (“non-commercial loans”) were not numerically graded at origination date as these loans were determined to be “pass graded” loans. A numeric grade was assigned to these non-commercial loans if subsequent to origination, the credit department evaluated the credit and determined it necessary to classify the loan. Subsequent to November 2014, the non-commercial loans were designated a loan grade “4” at origination date to reflect a "pass grade". The Bank follows its regulator’s Uniform Retail Credit Classification and Account Management Policy for subsequent classification in the event of payment delinquencies or default. 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 estimated inherent losses, but to a lesser extent than the other loan grades. The OAEM loan grade is transitory in that the Company is waiting on additional information to determine the likelihood and extent of the potential loss. The likelihood of loss for OAEM graded loans, however, is greater than Watch graded loans because there has been measurable credit deterioration. Loans with a Substandard grade are generally loans for which the Company has individually analyzed for potential impairment. For Doubtful and Loss graded loans, the Company is almost certain of the losses, and the unpaid principal balances are generally charged-off to the realizable value.
The following tables present the balance of the noncovered loans receivable by credit quality indicator as of December 31, 2014 and December 31, 2013.
 
December 31, 2014
 
Pass
 
OAEM
 
Substandard
 
Doubtful
 
Total
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
 
 
Commercial and industrial
$
509,483

 
$
14,487

 
$
27,049

 
$
324

 
$
551,343

Owner-occupied commercial real estate
496,234

 
22,946

 
16,562

 

 
535,742

Non-owner occupied commercial real estate
584,262

 
17,643

 
14,852

 

 
616,757

Total commercial business
1,589,979

 
55,076

 
58,463

 
324

 
1,703,842

One-to-four family residential
61,185

 
315

 
2,040

 

 
63,540

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
One-to-four family residential
34,356

 
3,977

 
8,416

 

 
46,749

Five or more family residential and commercial properties
57,025

 

 
4,335

 

 
61,360

Total real estate construction and land development
91,381

 
3,977

 
12,751

 

 
108,109

Consumer
242,836

 

 
7,487

 

 
250,323

Gross noncovered loans
$
1,985,381

 
$
59,368

 
$
80,741

 
$
324

 
$
2,125,814



F-31

Table of Contents


 
December 31, 2013
 
Pass
 
OAEM
 
Substandard
 
Doubtful
 
Total
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
 
 
Commercial and industrial
$
304,959

 
$
9,183

 
$
20,849

 
$
1,549

 
$
336,540

Owner-occupied commercial real estate
269,130

 
3,814

 
8,365

 

 
281,309

Non-owner occupied commercial real estate
381,355

 
9,037

 
8,723

 
864

 
399,979

Total commercial business
955,444

 
22,034

 
37,937

 
2,413

 
1,017,828

One-to-four family residential
40,245

 
269

 
2,568

 

 
43,082

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
One-to-four family residential
11,582

 
4,159

 
3,983

 

 
19,724

Five or more family residential and commercial properties
45,332

 

 
3,323

 

 
48,655

Total real estate construction and land development
56,914

 
4,159

 
7,306

 

 
68,379

Consumer
39,432

 
248

 
1,867

 

 
41,547

Gross noncovered loans
$
1,092,035

 
$
26,710

 
$
49,678

 
$
2,413

 
$
1,170,836


Noncovered potential problem loans are loans classified as OAEM or worse that are currently accruing interest and are not considered impaired, but which management is monitoring because the financial information of the borrower causes concern as to their ability to meet their loan repayment terms. Noncovered potential problem loans also include PCI loans as these loans continue to accrete loan discounts established at acquisition based on the guidance of ASC 310-30. Noncovered potential problem loans as of December 31, 2014 and December 31, 2013 were $117.3 million and $52.8 million, respectively. The balance of noncovered potential problem loans guaranteed by a governmental agency, which guarantees reduce the Company's credit exposure, was $2.0 million and $1.8 million as of December 31, 2014 and December 31, 2013, respectively.
(d) Nonaccrual Loans
Noncovered nonaccrual loans, segregated by segments and classes of loans, were as follows as of December 31, 2014 and December 31, 2013:
 
December 31, 2014
 
December 31, 2013
 
(In thousands)
Commercial business:
 
 
 
Commercial and industrial
$
3,463

 
$
4,648

Owner-occupied commercial real estate
1,163

 
1,024

Non-owner occupied commercial real estate
93

 
3

Total commercial business
4,719

 
5,675

One-to-four family residential

 
340

Real estate construction and land development:
 
 
 
One-to-four family residential
2,652

 
1,045

Total real estate construction and land development
2,652

 
1,045

Consumer
139

 
678

Gross noncovered nonaccrual loans
$
7,510

 
$
7,738

The Company had $1.6 million and $1.7 million of noncovered nonaccrual loans guaranteed by governmental agencies at December 31, 2014 and December 31, 2013, respectively.
Noncovered PCI loans are not included in the nonaccrual table above because these loans are accounted for under ASC 310-30, which provides that accretable yield is calculated based on a loan's expected cash flow even if the loan is not performing under its conventional terms.

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Table of Contents


(e) Past due loans
The Company performs an aging analysis of past due loans using the categories of 30-89 days past due and 90 or more days past due. This policy is consistent with regulatory reporting requirements.
The balances of noncovered past due loans, segregated by segments and classes of loans, as of December 31, 2014 and December 31, 2013 were as follows:
 
December 31, 2014
 
30-89 Days
 
90 Days or
Greater
 
Total Past 
Due
 
Current
 
Total
 
90 Days or More
and  Still
Accruing (1)
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
 
 
 
 
Commercial and industrial
$
2,503

 
$
1,962

 
$
4,465

 
$
546,878

 
$
551,343

 
$

Owner-occupied commercial real estate
1,038

 
100

 
1,138

 
534,604

 
535,742

 

Non-owner occupied commercial real estate
113

 
75

 
188

 
616,569

 
616,757

 

Total commercial business
3,654

 
2,137

 
5,791

 
1,698,051

 
1,703,842

 

One-to-four family residential
200

 

 
200

 
63,340

 
63,540

 

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
 
 
One-to-four family residential
62

 
2,135

 
2,197

 
44,552

 
46,749

 

Five or more family residential and commercial properties

 
376

 
376

 
60,984

 
61,360

 

Total real estate construction and land development
62

 
2,511

 
2,573

 
105,536

 
108,109

 

Consumer
2,413

 
125

 
2,538

 
247,785

 
250,323

 

Gross noncovered loans
$
6,329

 
$
4,773

 
$
11,102

 
$
2,114,712

 
$
2,125,814

 
$

(1)
Excludes PCI loans.

F-33

Table of Contents


 
December 31, 2013
 
30-89 Days
 
90 Days or
Greater
 
Total Past 
Due
 
Current
 
Total
 
90 Days or More
and  Still
Accruing (1)
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
 
 
 
 
Commercial and industrial
$
2,493

 
$
4,379

 
$
6,872

 
$
329,668

 
$
336,540

 
$

Owner-occupied commercial real estate
808

 
849

 
1,657

 
279,652

 
281,309

 

Non-owner occupied commercial real estate
1,161

 
179

 
1,340

 
398,639

 
399,979

 
6

Total commercial business
4,462

 
5,407

 
9,869

 
1,007,959

 
1,017,828

 
6

One-to-four family residential
571

 
509

 
1,080

 
42,002

 
43,082

 

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
 
 
One-to-four family residential
821

 
1,045

 
1,866

 
17,858

 
19,724

 

Five or more family residential and commercial properties
384

 
453

 
837

 
47,818

 
48,655

 

Total real estate construction and land development
1,205

 
1,498

 
2,703

 
65,676

 
68,379

 

Consumer
210

 
13

 
223

 
41,324

 
41,547

 

Gross noncovered loans
$
6,448

 
$
7,427

 
$
13,875

 
$
1,156,961

 
$
1,170,836

 
$
6

(1)
Excludes PCI loans.


(f) Impaired loans

Noncovered impaired loans includes noncovered nonaccrual loans and noncovered performing TDRs. The balance of noncovered impaired loans as of December 31, 2014 and December 31, 2013 are set forth in the following tables.

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Table of Contents


 
December 31, 2014
 
Recorded
Investment With
No Specific
Valuation
Allowance
 
Recorded
Investment With
Specific
Valuation
Allowance
 
Total
Recorded
Investment
 
Unpaid
Contractual
Principal
Balance
 
Related
Specific
Valuation
Allowance
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
 
 
Commercial and industrial
$
1,134

 
$
7,906

 
$
9,040

 
$
9,349

 
$
1,325

Owner-occupied commercial real estate
360

 
2,421

 
2,781

 
2,781

 
684

Non-owner occupied commercial real estate
2,459

 
4,846

 
7,305

 
7,279

 
465

Total commercial business
3,953

 
15,173

 
19,126

 
19,409

 
2,474

One-to-four family residential

 
245

 
245

 
245

 
75

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
One-to-four family residential
2,307

 
2,217

 
4,524

 
4,964

 
396

Five or more family residential and commercial properties

 
2,056

 
2,056

 
2,056

 
234

Total real estate construction and land development
2,307

 
4,273

 
6,580

 
7,020

 
630

Consumer
33

 
172

 
205

 
208

 
56

Gross noncovered loans
$
6,293

 
$
19,863

 
$
26,156

 
$
26,882

 
$
3,235

 
December 31, 2013
 
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
$
6,140

 
$
4,850

 
$
10,990

 
$
13,287

 
$
2,716

Owner-occupied commercial real estate
1,118

 
1,880

 
2,998

 
3,023

 
595

Non-owner occupied commercial real estate
3,300

 
4,123

 
7,423

 
7,412

 
364

Total commercial business
10,558

 
10,853

 
21,411

 
23,722

 
3,675

One-to-four family residential
592

 

 
592

 
619

 

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
One-to-four family residential
3,773

 
911

 
4,684

 
5,426

 
211

Five or more family residential and commercial properties
2,404

 

 
2,404

 
2,404

 

Total real estate construction and land development
6,177

 
911

 
7,088

 
7,830

 
211

Consumer
100

 
678

 
778

 
780

 
153

Gross noncovered loans
$
17,427

 
$
12,442

 
$
29,869

 
$
32,951

 
$
4,039


The Company had governmental guarantees of $2.4 million and $2.9 million related to the noncovered impaired loan balances at December 31, 2014 and December 31, 2013, respectively.
The average recorded investment of noncovered impaired loans for the years ended December 31, 2014, 2013 and 2012 are set forth in the following table.

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Table of Contents


 
Years Ended December 31,
 
2014
 
2013
 
2012
 
(In thousands)
Commercial business:
 
 
 
 
 
Commercial and industrial
$
10,946

 
$
12,628

 
$
11,467

Owner-occupied commercial real estate
3,215

 
2,638

 
2,141

Non-owner occupied commercial real estate
7,744

 
7,897

 
8,174

Total commercial business
21,905

 
23,163

 
21,782

One-to-four family residential
514

 
880

 
977

Real estate construction and land development:
 
 
 
 
 
One-to-four family residential
5,416

 
4,237

 
4,381

Five or more family residential and commercial properties
2,154

 
2,839

 
5,415

Total real estate construction and land development
7,570

 
7,076

 
9,796

Consumer
779

 
254

 
427

Gross noncovered impaired loans
$
30,768

 
$
31,373

 
$
32,982

For the years ended December 31, 2014, 2013 and 2012, no interest income was recognized subsequent to a loan’s classification as nonaccrual. For the years ended December 31, 2014, 2013 and 2012, the Bank recorded $1.2 million, $1.1 million and $1.0 million, respectively, of interest income related to noncovered performing TDR loans.
(g) Troubled Debt Restructured Loans
A troubled debt restructured loan is a restructuring in which the Bank, for economic or legal reasons related to a borrower’s financial difficulties, grants a concession to the borrower that it would not otherwise consider. TDRs are considered impaired and are separately measured for impairment under FASB ASC 310-10-35, whether on accrual ("performing") or nonaccrual ("nonperforming") status.
The majority of the Bank’s noncovered TDRs are a result of granting extensions of maturity on troubled credits which have already been adversely classified. The Bank grants such extensions to reassess the borrower’s financial status and to develop a plan for repayment. 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. The Bank additionally advanced funds to a troubled speculative home builder to complete established projects. These modifications would all be considered a concession for a borrower that could not obtain similar financing terms from another source other than from the Bank.
The financial effects of each modification will vary based on the specific restructure. For the majority of the Bank’s TDRs, the noncovered loans were interest-only with a balloon payment at maturity. If the interest rate is not adjusted and the modified terms are consistent with other similar credits being offered, the Bank may not experience any loss associated with the restructure. If, however, the restructure involves forbearance agreements or interest rate modifications, the Bank may not collect all the principal and interest based on the original contractual terms. The Bank estimates the necessary allowance for loan losses on noncovered TDRs using the same methods used for other noncovered impaired loans.
The recorded investment balance and related allowance for loan losses of noncovered performing and noncovered nonaccrual TDRs as of December 31, 2014 and December 31, 2013 were as follows:
 
December 31, 2014
 
December 31, 2013
 
Performing
TDRs
 
Nonaccrual
TDRs
 
Performing
TDRs
 
Nonaccrual
TDRs
 
(In thousands)
Noncovered TDRs
$
18,764

 
$
5,010

 
$
22,131

 
$
2,634

Allowance for loan losses on noncovered TDRs
1,908

 
1,033

 
2,957

 
191


The unfunded commitment to borrowers related to noncovered TDRs was $1.8 million and $4.5 million at December 31, 2014 and December 31, 2013, respectively.

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Table of Contents


Noncovered loans that were modified as TDRs during the years ended December 31, 2014 and 2013 are set forth in the following table:
 
Years Ended December 31,
 
2014
 
2013
 
Number of
Contracts
(1)
 
Outstanding
Principal Balance
(1)(2)
 
Number of
Contracts
(1)
 
Outstanding
Principal Balance 
(1)(2)
 
(Dollars in thousands)
Commercial business:
 
 
 
 
 
 
 
Commercial and industrial
32

 
$
5,926

 
33

 
$
6,570

Owner-occupied commercial real estate
3

 
1,063

 
5

 
537

Non-owner occupied commercial real estate
3

 
6,548

 
2

 
192

Total commercial business
38

 
13,537

 
40

 
7,299

One-to-four family residential

 

 
1

 
252

Real estate construction and land development:
 
 
 
 
 
 
 
One-to-four family residential
10

 
3,553

 
24

 
3,639

Five or more family residential and commercial properties

 

 
1

 
2,404

Total real estate construction and land development
10

 
3,553

 
25

 
6,043

Consumer
3

 
219

 
3

 
141

Total noncovered TDRs
51

 
$
17,309

 
69

 
$
13,735

(1)
Number of contracts and outstanding principal balance represent loans which have balances as of period end as certain loans may have been paid-down or charged-off during the years ended December 31, 2014 and 2013.
(2)
Includes subsequent payments after modifications and reflects the balance as of period end. As the Bank did not forgive any principal or interest balance as part of the loan modification, the Bank’s recorded investment in each loan at the date of modification (pre-modification) did not change as a result of the modification (post-modification), except when the modification was the initial advance on a one-to-four family residential real estate construction and land development loan under a master guidance line. During the year ended December 31, 2014, the Company's initial advance at the time of modification on these construction loans totaled $45,000, the total commitment amount was $190,000 and the outstanding principal balance at December 31, 2014 was $188,000. During the year ended December 31, 2013, the Company's initial advance at the time of modification on these construction loans totaled $1.1 million, the total commitment amount was $4.3 million and the outstanding principal balance at December 31, 2013 was $2.5 million.
Of the 51 noncovered loans modified during the year ended December 31, 2014, 17 loans with a total outstanding principal balance of $4.7 million had no prior modifications. The remaining noncovered loans included in the tables above for the year ended December 31, 2014 were previously reported as noncovered TDRs. The Bank typically grants shorter extension periods to continually monitor the troubled credits despite the fact that the extended date might not be the date the Bank expects the cash flow. The Company does not consider these modifications a subsequent default of a noncovered 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 noncovered TDR and adjusted, as necessary, in the current periods based on more recent information. The related specific valuation allowance for noncovered loans that were modified as TDRs during the year ended December 31, 2014 was $1.8 million at December 31, 2014.

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Table of Contents


The noncovered loans modified during the previous twelve months ended December 31, 2014 and 2013 that subsequently defaulted during the years ended December 31, 2014 and 2013 are included in the following table:
 
Year Ended December 31, 2014
 
Year Ended December 31, 2013
 
Number of
Contracts
 
Outstanding
Principal Balance
 
Number of
Contracts
 
Outstanding
Principal Balance
 
(Dollars in thousands)
 
 
 
 
Commercial business:
 
 
 
 
 
 
 
Commercial and industrial

 
$

 
3

 
$
918

Non-owner occupied commercial real estate
1

 
75

 

 

Total commercial business
1

 
75

 
3

 
918

Total noncovered loans receivable
1

 
$
75

 
3

 
$
918

The one loan included in the above table defaulted during the year ended December 31, 2014 because it was past its modified maturity date, and the borrower has not repaid the credit. The Bank does not intend to extend the maturity. The three loans which defaulted during the year ended December 31, 2013 defaulted as the loans were greater than 90 days past due at December 31, 2013. At December 31, 2014 and 2013, the Bank had a specific valuation allowance of $4,000 and $63,000, respectively, related to these credits.

(h) Noncovered Purchased Credit Impaired Loans
The Company acquired noncovered PCI loans in the Washington Banking Merger and in previously completed acquisitions which are accounted for under FASB ASC 310-30. These previous acquisitions include the FDIC-assisted acquisitions of Cowlitz Bank ("Cowlitz") and Pierce Commercial Bank ("Pierce") on July 30, 2010 and November 8, 2010, respectively. In addition, the Company completed the acquisitions of NCB on January 9, 2013 and the acquisition of Valley on July 15, 2013.
The following tables reflect the outstanding principal balance and recorded investment at December 31, 2014 and December 31, 2013 of the noncovered PCI loans:
 
December 31, 2014
 
December 31, 2013
 
Outstanding Principal
 
Recorded Investment
 
Outstanding Principal
 
Recorded Investment
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
Commercial and industrial
$
22,144

 
$
18,040

 
$
18,193

 
$
16,779

Owner-occupied commercial real estate
18,165

 
16,208

 
5,510

 
5,119

Non-owner occupied commercial real estate
12,684

 
11,185

 
8,276

 
6,785

Total commercial business
52,993

 
45,433

 
31,979

 
28,683

One-to-four family residential
2,269

 
2,235

 
4,055

 
3,768

Real estate construction and land development:
 
 
 
 
 
 
 
One-to-four family residential
8,456

 
4,223

 
1,967

 
32

Five or more family residential and commercial properties
2,721

 
2,963

 
1,077

 
1,357

Total real estate construction and land development
11,177

 
7,186

 
3,044

 
1,389

Consumer
5,983

 
7,055

 
1,150

 
2,177

Gross noncovered PCI loans
$
72,422

 
$
61,909

 
$
40,228

 
$
36,017

On the acquisition dates, the amount by which the undiscounted expected cash flows of the noncovered PCI loans exceeded the estimated 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 noncovered PCI loans.

F-38

Table of Contents


The following tables summarize the accretable yield on the noncovered PCI loans resulting from the Pierce, NCB, Valley and Washington Banking acquisitions for the years ended December 31, 2014, 2013 and 2012.
 
 
Years Ended December 31,
 
 
2014
 
2013
 
2012
 
(In thousands)
Balance at the beginning of the year
 
$
7,714

 
$
7,352

 
$
14,638

Accretion
 
(4,305
)
 
(4,402
)
 
(6,238
)
Disposal and other
 
(3,263
)
 
(318
)
 
(2,798
)
Change in accretable yield (1)
 
12,426

 
5,082

 
1,750

Balance at the end of the year
 
$
12,572

 
$
7,714

 
$
7,352

(1)
Includes accretable difference at acquisition.

On the May 1, 2014 merger date for the Washington Banking Merger, the contractual cash flows on noncovered PCI loans acquired in the Washington Banking Merger were $75.7 million and the expected cash flows were $59.1 million, resulting in a $16.6 million non-accretable difference. The fair value was estimated at $48.9 million, resulting in a $10.2 million accretable yield which is included in the table above as a change in accretable yield for the year ended December 31, 2014. The contractual cash flows on the noncovered non-PCI loans, excluding credit cards, were $1.12 billion and the expected cash flows were $1.06 billion, resulting in $53.5 million of cash flows not expected to be collected. The fair value of the noncovered non-PCI loans, excluding credit cards, at May 1, 2014 was $841.3 million. The credit cards loans acquired in the Washington Banking Merger totaling $5.8 million at merger date were included in noncovered consumer loans totals. The fair value of the credit cards approximated the carrying values; therefore, there was no cash flows not expected to be collected.
(i) Related Party Loans
In the ordinary course of business, the Company has granted loans to certain directors, executive officers and their affiliates (collectively referred to as “related parties”).
Activity in related party loans for the years ended December 31, 2014, 2013 and 2012 was as follows (in thousands):
 
Balance outstanding at December 31, 2011
$
10,391

Principal additions
8,906

Principal reductions
(7,855
)
Balance outstanding at December 31, 2012
11,442

Principal additions

Elimination of outstanding loan balance due to change in related party status
(3,045
)
Principal reductions
(923
)
Balance outstanding at December 31, 2013
7,474

Principal additions
23

Additional of outstanding loan balance due to change in related party status
1,858

Principal reductions
(191
)
Balance outstanding at December 31, 2014
$
9,164

The Company had $228,000 and $184,000 of unfunded commitments to related parties as of December 31, 2014 and 2013, respectively. The Company did not have any borrowings from related parties at December 31, 2014 or 2013.

(j) Mortgage Banking Activities and SBA Loan Sales
The Bank originates certain one-to-four family residential loans to be sold on the secondary market. These loans were presented as loans held for sale. The Bank ceased these mortgage banking activities in the second quarter of 2013, and resumed activities again in the second quarter of 2014 in connection with the Washington Banking Merger.

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Table of Contents


The Bank does not retain servicing on loans sold in the secondary market. Details of certain mortgage banking activities are as follows:
 
 
Years Ended or As of December 31,
 
 
2014
 
2013
 
 
(In thousands)
Loans held for sale at lower of cost or market
 
$
5,582

 
$

One-to-four family residential loans sold during the year
 
55,997

 
8,460

Commitments to sell mortgage loans
 
10,625

 

Commitments to fund mortgage loans (at interest rates approximating market rates):
 
 
 
 
Fixed rate
 
$
8,467

 
$

Variable or adjustable rate
 
2,158

 


The Company may chose to sell the conditionally guaranteed portion of certain loans guaranteed by the Small Business Administration or the U.S. Department of Agriculture (collectively referred to as "SBA loans") and retain a participating interest in the unguaranteed portion of the loans. These loans are carried at the aggregate cost. SBA loans are sold with servicing retained. Details of certain SBA loan sales activities are as follows:
 
 
December 31, 2014
 
December 31, 2013
 
 
(In thousands)
SBA loans serviced for others with participating interest (1)
 
$
77,233

 
$
26,854

SBA loans serviced for others with no participating interest
 

 

(1)
Represents the gross balance of the loan at year end. The participation owned by the Bank totaled $29.0 million and $9.4 million, respectively, at December 31, 2014 and 2013 and is included in the balance of noncovered loans receivable on the Company's Consolidated Statements of Financial Condition.
There was $260,000, $106,000 and $139,000 of servicing fee income and fees from SBA loans serviced for others for the years ended December 31, 2014, 2013 and 2012. Servicing fee income is reported in other income on the Company's Consolidated Statements of Income.

(6)
Covered Loans Receivable
The Company acquired loans through FDIC-assisted transactions which are covered by FDIC shared-loss agreements. These loans are referred to as "covered loans." Covered loans were acquired in the Cowlitz acquisition in July 2010 and with the Washington Banking Merger in May 2014. Included in the covered loans acquired from Washington Banking were loans Washington Banking had acquired from City Bank in April 2010 and North County Bank in September 2010. As part of the Washington Banking Merger, the shared-loss agreements with these acquisitions were transferred to Heritage Bank.
Loans purchased with evidence of credit deterioration since origination for which it is probable that not all contractually required payments will be collected are accounted for under FASB ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality and are identified as PCI loans. Loans purchased that are not accounted for under FASB ASC 310-30 are accounted for under FASB ASC 310-20, Receivables—Nonrefundable Fees and Other Costs.
Disclosures related to the Company’s recorded investment in covered loans receivable generally exclude accrued interest receivable because it is insignificant.
(a) Risk Management
The Company categorizes covered loans in the same four segments as the noncovered portfolio: commercial business, real estate construction and land development, one-to-four family residential and consumer.     

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Table of Contents


The recorded investment of covered loans receivable at December 31, 2014 and December 31, 2013 consisted of the following portfolio segments and classes:
 
December 31, 2014
 
December 31, 2013
 
(In thousands)
Commercial business:
 
 
 
Commercial and industrial
$
19,110

 
$
14,690

Owner-occupied commercial real estate
59,244

 
24,366

Non-owner occupied commercial real estate
26,879

 
14,625

Total commercial business
105,233

 
53,681

One-to-four family residential
5,990

 
4,777

Real estate construction and land development:
 
 
 
One-to-four family residential
2,446

 
1,556

Five or more family residential and commercial properties
3,560

 

Total real estate construction and land development
6,006

 
1,556

Consumer
8,971

 
3,740

Gross covered loans receivable
126,200

 
63,754

Allowance for loan losses
(5,576
)
 
(6,167
)
Covered loans receivable, net
$
120,624

 
$
57,587

At December 31, 2014 and December 31, 2013, the recorded investment balance of loans which are no longer covered under the FDIC shared-loss agreements, but are included in the covered loan table above as they are included in the loan pool established at the time of acquisition, was $872,000 and $2.6 million, respectively.
(b) Credit Quality Indicators
The following tables present the recorded invested balance of the covered loans receivable by credit quality indicator as of December 31, 2014 and December 31, 2013.
 
December 31, 2014
 
Pass
 
OAEM
 
Substandard
 
Doubtful
 
Total
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
 
 
Commercial and industrial
$
11,297

 
$
131

 
$
5,442

 
$
2,240

 
$
19,110

Owner-occupied commercial real estate
40,357

 
4,957

 
13,583

 
347

 
59,244

Non-owner occupied commercial real estate
9,656

 
40

 
17,183

 

 
26,879

Total commercial business
61,310

 
5,128

 
36,208

 
2,587

 
105,233

One-to-four family residential
5,414

 
425

 
151

 


 
5,990

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
One-to-four family residential
2,178

 

 
268

 

 
2,446

Five or more family residential and commercial properties
1,758

 

 
1,802

 

 
3,560

Total real estate construction and land development
3,936

 

 
2,070

 

 
6,006

Consumer
7,030

 

 
1,941

 

 
8,971

Gross covered loans receivable
$
77,690

 
$
5,553

 
$
40,370

 
$
2,587

 
$
126,200


F-41

Table of Contents


 
December 31, 2013
 
Pass
 
OAEM
 
Substandard
 
Doubtful
 
Total
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
 
 
Commercial and industrial
$
9,516

 
$
3,887

 
$
702

 
$
585

 
$
14,690

Owner-occupied commercial real estate
21,084

 
2,318

 
708

 
256

 
24,366

Non-owner occupied commercial real estate
6,534

 
55

 
4,631

 
3,405

 
14,625

Total commercial business
37,134

 
6,260

 
6,041

 
4,246

 
53,681

One-to-four family residential
3,739

 
882

 
156

 

 
4,777

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
One-to-four family residential
698

 

 
858

 

 
1,556

Five or more family residential and commercial properties

 

 

 

 

Total real estate construction and land development
698

 

 
858

 

 
1,556

Consumer
3,116

 
106

 
518

 

 
3,740

Gross covered loans receivable
$
44,687

 
$
7,248

 
$
7,573

 
$
4,246

 
$
63,754


(c) Nonaccrual Loans
The recorded investment balance of covered nonaccrual loans, segregated by segments and classes of loans, were as follows as of December 31, 2014 and December 31, 2013:
 
December 31, 2014
 
December 31, 2013
 
(In thousands)
Commercial business:
 
 
 
Commercial and industrial
$
2,321

 
$

Owner-occupied commercial real estate
1,132

 

Non-owner-occupied commercial real estate
424

 

Total commercial business
3,877

 

Real estate construction and land development:
 
 
 
One-to-four family residential
179

 

Consumer
6

 
7

Gross covered nonaccrual loans
$
4,062

 
$
7

Covered PCI loans are not included in the nonaccrual table above because the loans are accounted for under ASC 310-30, whereby accretable yield is calculated based on a loan's expected cash flow even if the loan is not performing under its contractual terms.

F-42

Table of Contents


(d) Past Due Loans
The balances of covered past due loans, segregated by segments and classes of loans, as of December 31, 2014 and December 31, 2013 were as follows:
 
December 31, 2014
 
30-89 Days
 
90 Days or
Greater
 
Total Past 
Due
 
Current
 
Total
 
90 Days or More
and  Still
Accruing (1)
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
 
 
 
 
Commercial and industrial
$
2,262

 
$
1,163

 
$
3,425

 
$
15,685

 
$
19,110

 
$

Owner-occupied commercial real estate
645

 
2,680

 
3,325

 
55,919

 
59,244

 

Non-owner occupied commercial real estate
1,713

 
456

 
2,169

 
24,710

 
26,879

 

Total commercial business
4,620

 
4,299

 
8,919

 
96,314

 
105,233

 

One-to-four family residential
112

 

 
112

 
5,878

 
5,990

 

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
 
 
One-to-four family residential
178

 
90

 
268

 
2,178

 
2,446

 

Five or more family residential and commercial properties

 
220

 
220

 
3,340

 
3,560

 

Total real estate construction and land development
178

 
310

 
488

 
5,518

 
6,006

 

Consumer
263

 
727

 
990

 
7,981

 
8,971

 

Gross covered loans receivable
$
5,173

 
$
5,336

 
$
10,509

 
$
115,691

 
$
126,200

 
$

(1)
Excludes covered PCI loans.
 
December 31, 2013
 
30-89 Days
 
90 Days or
Greater
 
Total Past 
Due
 
Current
 
Total
 
90 Days or More
and  Still
Accruing (1)
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
 
 
 
 
Commercial and industrial
$
726

 
$
1,156

 
$
1,882

 
$
12,808

 
$
14,690

 
$

Owner-occupied commercial real estate
28

 
147

 
175

 
24,191

 
24,366

 

Non-owner occupied commercial real estate

 
3,540

 
3,540

 
11,085

 
14,625

 

Total commercial business
754

 
4,843

 
5,597

 
48,084

 
53,681

 

One-to-four family residential
113

 

 
113

 
4,664

 
4,777

 

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
 
 
One-to-four family residential
213

 
644

 
857

 
699

 
1,556

 

Five or more family residential and commercial properties

 

 

 

 

 

Total real estate construction and land development
213

 
644

 
857

 
699

 
1,556

 

Consumer
67

 
78

 
145

 
3,595

 
3,740

 

Gross covered loans receivable
$
1,147

 
$
5,565

 
$
6,712

 
$
57,042

 
$
63,754

 
$

(1)
Excludes covered PCI loans.

F-43

Table of Contents



(e) Impaired Loans
A covered loan, not initially classified as PCI, generally becomes impaired when classified as nonaccrual or when its modification results in a TDR. Covered impaired loans as of December 31, 2014 and December 31, 2013 are set forth in the following tables.
 
December 31, 2014
 
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
$
2,240

 
$
94

 
$
2,334

 
$
3,696

 
$
9

Owner-occupied commercial real estate

 
1,132

 
1,132

 
1,156

 
295

Non-owner occupied commercial real estate

 
424

 
424

 
440

 
66

Total commercial business
2,240

 
1,650

 
3,890

 
5,292

 
370

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

 
179

 
179

 
182

 
51

Total real estate construction and land development

 
179

 
179

 
182

 
51

Consumer

 
6

 
6

 
8

 
2

Gross covered impaired loans
$
2,240

 
$
1,835

 
$
4,075

 
$
5,482

 
$
423


 
December 31, 2013
 
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
$
10

 
$
3,751

 
$
3,761

 
$
3,761

 
$
629

Total commercial business
10

 
3,751

 
3,761

 
3,761

 
629

One-to-four family residential

 
450

 
450

 
423

 
31

Consumer
7

 

 
7

 
8

 

Gross covered impaired loans
$
17

 
$
4,201

 
$
4,218

 
$
4,192

 
$
660


F-44

Table of Contents


The average recorded investment of covered impaired loans for the years ended December 31, 2014 and 2013 are set forth in the following table.
 
 
Years Ended December 31,
 
 
2014
 
2013
 
2012
 
 
(In thousands)
Commercial business:
 
 
 
 
 
 
Commercial and industrial
 
$
3,421

 
$
1,484

 
$
21

Owner-occupied commercial real estate
 
367

 

 

Non-owner occupied commercial real estate
 
171

 

 

Total commercial business
 
3,959

 
1,484

 
21

One-to-four family residential
 
90

 
459

 
187

Real estate construction and land development:
 
 
 
 
 
 
One-to-four family residential
 
36

 

 

Total real estate construction and land development
 
36

 

 

Consumer
 
7

 
20

 
26

Gross covered impaired loans
 
$
4,092

 
$
1,963

 
$
234

For the years ended December 31, 2014, 2013 and 2012, no interest income was recognized subsequent to a covered loan’s classification as nonaccrual. For the years ended December 31, 2014, 2013 and 2012, the Bank recorded $5,000, $16,000 and $7,000, respectively, of interest income related to covered performing TDR loans.

(f) Troubled Debt Restructured Loans
The recorded investment balance and related allowance for loan losses of covered performing and covered nonaccrual TDRs as of December 31, 2014 and December 31, 2013 were as follows:
 
December 31, 2014
 
December 31, 2013
 
Performing
TDRs
 
Nonaccrual
TDRs
 
Performing
TDRs
 
Nonaccrual
TDRs
 
(In thousands)
Covered TDRs
$
10,289

 
$
2,246

 
$
4,211

 
$
7

Allowance for loan losses on covered TDRs
1

 
2

 
660

 

There were no unfunded commitments related to credits classified as covered TDRs at December 31, 2014 and December 31, 2013.

F-45

Table of Contents


Covered loans that were modified as TDRs during the years ended December 31, 2014 and 2013 are set forth in the following table:
 
Years Ended December 31,
 
2014
 
2013
 
Number of
Contracts
(1)
 
Outstanding
Principal Balance
(1)(2)
 
Number of
Contracts
(1)
 
Outstanding
Principal Balance 
(1)(2)
 
(Dollars in thousands)
Commercial business:
 
 
 
 
 
 
 
Commercial and industrial
7

 
$
3,394

 
3

 
$
3,792

Owner-occupied commercial real estate
2

 
1,133

 

 

Non-owner occupied commercial real estate
2

 
7,561

 

 

Total commercial business
11

 
12,088

 
3

 
3,792

One-to-four family residential

 

 

 

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

 

 

 

Five or more family residential and commercial properties
1

 
428

 

 

Total real estate construction and land development
1

 
428

 

 

Consumer

 

 

 

Total covered TDRs
12

 
$
12,516

 
3

 
$
3,792

(1)
Number of contracts and outstanding principal balance represent loans which have balances as of year end as certain loans may have been paid-down or charged-off during the years ended December 31, 2014 and 2013.
(2)
Includes subsequent payments after modifications and reflects the balance as of period end. As the Bank did not forgive any principal or interest balance as part of the loan modification, the Bank’s recorded investment in each loan at the date of modification (pre-modification) did not change as a result of the modification (post-modification).
Of the twelve covered loans modified as TDRs during the year ended December 31, 2014, eleven loans totaling $10.3 million were related to PCI loans acquired in the Washington Banking Merger. There was no allowance for loan losses at December 31, 2014 on these modified loans as the recorded investment was less than the estimated net present value of future cash flows. Four of these modified loans totaling $7.7 million at December 31, 2014 were modified as a result of bankruptcy rulings and the courts dictated the future payment terms. One covered TDR totaling $2.2 million at December 31, 2014 was modified during both the years ended December 31, 2014 and 2013 because the loan's maturity date was extended in each modification. The Bank provided for a shorter maturity date than it expected to receive the cash flows to more closely monitor the borrower. At December 31, 2014, this loan did not have a specific valuation allowance as the loan had been charged-down to the net realizable value during fourth quarter 2014. The other two loans modified as TDRs during the year ended December 31, 2013 also had maturity date extensions. These two loans have outstanding principal balances of $13,000 and specific valuation of $1,000 at December 31, 2014.
There were no covered loans modified during the previous twelve months ended December 31, 2014 and December 31, 2013 that subsequently defaulted during the years ended December 31, 2014 and 2013.

(g) Covered Purchased Credit Impaired Loans
The Company acquired covered loans which the Bank accounts for under FASB ASC 310-30 as they were deemed PCI at the time of acquisition.

F-46

Table of Contents


The following tables reflect the outstanding principal balance and recorded investment at December 31, 2014 and December 31, 2013 of the covered PCI loans:
 
December 31, 2014
 
December 31, 2013
 
Outstanding Principal
 
Recorded Investment
 
Outstanding Principal
 
Recorded Investment
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
Commercial and industrial
$
9,635

 
$
7,134

 
$
10,608

 
$
8,680

Owner-occupied commercial real estate
23,071

 
20,666

 
11,538

 
10,923

Non-owner occupied commercial real estate
20,607

 
20,257

 
10,611

 
12,187

Total commercial business
53,313

 
48,057

 
32,757

 
31,790

One-to-four family residential
3,837

 
3,478

 
3,966

 
3,530

Real estate construction and land development:
 
 
 
 
 
 
 
One-to-four family residential
103

 
1,308

 
1,298

 
1,556

Five or more family residential and commercial properties
2,140

 
1,802

 

 

Total real estate construction and land development
2,243

 
3,110

 
1,298

 
1,556

Consumer
2,945

 
2,717

 
2,022

 
2,000

Gross covered PCI loans
$
62,338

 
$
57,362

 
$
40,043

 
$
38,876

The Bank has the option to modify covered PCI loans; however, modifying the loan may terminate the FDIC shared-loss coverage on those loans. At December 31, 2014 and December 31, 2013, the recorded investment balance of covered PCI loans which are no longer covered under the FDIC shared-loss agreements was $476,000 and $1.7 million, respectively. The 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 adjusted to reflect the change in the loan status.

(h) Accretable Yield
The following table summarizes the accretable yield on the covered PCI loans resulting from the Cowlitz Acquisition and Washington Banking Merger for the years ended December 31, 2014, 2013 and 2012.
 
Years Ended December 31,
 
2014
 
2013
 
2012
 
(In thousands)
Balance at the beginning of the year
$
9,535

 
$
14,286

 
$
19,912

Accretion
(3,749
)
 
(4,210
)
 
(6,679
)
Disposal and other
(1,718
)
 
(4,902
)
 
(1,140
)
Change in accretable yield (1)
4,452

 
4,361

 
2,193

Balance at the end of the year
$
8,520

 
$
9,535

 
$
14,286

(1)
Includes accretable difference at acquisition.
    
On the May 1, 2014 merger date of the Washington Banking Merger, the contractual cash flows on covered PCI loans acquired in the Washington Banking Merger were $75.1 million and the expected cash flows were $52.2 million, resulting in a $22.9 million non-accretable difference. The fair value was estimated at $48.7 million, resulting in a $3.5 million accretable yield which is included in the table above as a change in accretable yield for the year ended December 31, 2014. The contractual cash flows on the covered non-PCI loans were $70.3 million and the expected cash flows were $66.5 million, resulting in $3.8 million of cash flows not expected to be collected. The fair value of the covered non-PCI loans acquired in the Washington Banking Merger at May 1, 2014 was $58.4 million.


F-47

Table of Contents


(7)
Allowance for Loan Losses
The allowance for loan losses is maintained at a level deemed appropriate by management to provide for probable incurred credit losses in the loan portfolio.
A summary of the changes in the noncovered loans’ allowance for loan losses for the years ended December 31, 2014, 2013 and 2012 are as follows:
 
Years Ended December 31,
 
2014
 
2013
 
2012
 
(In thousands)
Balance at the beginning of the year
$
22,657

 
$
24,242

 
$
26,952

Charge-offs
(3,643
)
 
(4,298
)
 
(6,017
)
Recoveries of loans previously charged-off
907

 
929

 
1,737

Provision for loan losses
2,232

 
1,784

 
1,570

Balance at the end of the year
$
22,153

 
$
22,657

 
$
24,242

A summary of the changes in the covered loans’ allowance for loan losses for the years ended December 31, 2014, 2013 and 2012 are as follows:
 
Years Ended December 31,
 
2014
 
2013
 
2012
 
(In thousands)
Balance at the beginning of the year
$
6,167

 
$
4,352

 
$
3,963

Charge-offs
(2,954
)
 
(73
)
 
(57
)
Recoveries of loans previously charged-off
1

 

 

Provision for loan losses
2,362

 
1,888

 
446

Balance at the end of the year
$
5,576

 
$
6,167

 
$
4,352

The covered loans acquired in the Cowlitz Acquisition and Washington Banking Merger (including Washington Banking's prior acquisitions of City Bank and North County Bank and related covered loans) are subject to the Company’s internal 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 of the covered loan balance without regard to the FDIC shared-loss agreements. 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 activity in the allowance for loan losses for the year ended December 31, 2014 and the balance in the allowance for loan losses disaggregated on the basis of the Company’s impairment method as of December 31, 2014:

F-48

Table of Contents


 
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 year ended December 31, 2014:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2013
$
13,478

 
$
4,049

 
$
5,326

 
$
1,100

 
$
1,720

 
$
953

 
$
1,597

 
$
601

 
$
28,824

Charge-offs
(4,504
)
 
(337
)
 
(411
)
 
(31
)
 
(345
)
 

 
(969
)
 

 
(6,597
)
Recoveries
716

 

 

 
7

 
43

 

 
142

 

 
908

Provisions for loan losses
863

 
383

 
623

 
124

 
368

 
19

 
1,999

 
215

 
4,594

December 31, 2014
$
10,553

 
$
4,095

 
$
5,538

 
$
1,200

 
$
1,786

 
$
972

 
$
2,769

 
$
816

 
$
27,729

Allowance for loan losses as of December 31, 2014 allocated to:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Noncovered loans individually evaluated for impairment
$
1,325

 
$
684

 
$
465

 
$
75

 
$
396

 
$
234

 
$
56

 
$

 
$
3,235

Noncovered loans collectively evaluated for impairment
6,449

 
1,629

 
2,541

 
530

 
322

 
650

 
1,931

 
816

 
14,868

Covered loans individually evaluated for impairment
9

 
295

 
66

 

 
51

 

 
2

 

 
423

Covered loans collectively evaluated for impairment
108

 
14

 
6

 
8

 

 

 
12

 

 
148

Noncovered PCI loans collectively evaluated for impairment
2,191

 
330

 
353

 
207

 
264

 
88

 
617

 

 
4,050

Covered PCI loans collectively evaluated for impairment
471

 
1,143

 
2,107

 
380

 
753

 

 
151

 

 
5,005

December 31, 2014
$
10,553

 
$
4,095

 
$
5,538

 
$
1,200

 
$
1,786

 
$
972

 
$
2,769

 
$
816

 
$
27,729


F-49

Table of Contents


The following table details the activity in the allowance for loan losses for the year ended December 31, 2013 and the balance in the allowance for loan losses disaggregated on the basis of the Company’s impairment method as of December 31, 2013:
 
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 year ended December 31, 2013:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

December 31, 2012
$
9,912

 
$
4,021

 
$
5,369

 
$
1,221

 
$
3,131

 
$
2,309

 
$
1,761

 
$
870

 
$
28,594

Charge-offs
(2,826
)
 
(247
)
 

 
(52
)
 
(423
)
 
(142
)
 
(681
)
 

 
(4,371
)
Recoveries
248

 
560

 

 

 

 
32

 
89

 

 
929

Provisions for / (reallocation of) loan losses
6,144

 
(285
)
 
(43
)
 
(69
)
 
(988
)
 
(1,246
)
 
428

 
(269
)
 
3,672

December 31, 2013
$
13,478

 
$
4,049

 
$
5,326

 
$
1,100

 
$
1,720

 
$
953

 
$
1,597

 
$
601

 
$
28,824

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allowance for loan losses as of December 31, 2013 allocated to:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

Noncovered loans individually evaluated for impairment
$
2,716

 
$
595

 
$
364

 
$

 
$
211

 
$

 
$
153

 
$

 
$
4,039

Noncovered loans collectively evaluated for impairment
6,727

 
2,101

 
2,516

 
570

 
429

 
855

 
575

 
601

 
14,374

Covered loans individually evaluated for impairment
629

 

 

 
31

 

 

 

 

 
660

Covered loans collectively evaluated for impairment
18

 
7

 
14

 
13

 

 

 
57

 

 
109

Noncovered PCI loans collectively evaluated for impairment
2,294

 
348

 
359

 
216

 
291

 
98

 
638

 

 
4,244

Covered PCI loans collectively evaluated for impairment
1,094

 
998

 
2,073

 
270

 
789

 

 
174

 

 
5,398

December 31, 2013
$
13,478

 
$
4,049

 
$
5,326

 
$
1,100

 
$
1,720

 
$
953

 
$
1,597

 
$
601

 
$
28,824

The following table details the activity in the allowance for loan losses for the year ended December 31, 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 year ended December 31, 2012:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2011
$
11,805

 
$
2,979

 
$
4,394

 
$
794

 
$
4,823

 
$
3,800

 
$
1,410

 
$
910

 
$
30,915

Charge-offs
(2,292
)
 
(1,142
)
 
(292
)
 
(391
)
 
(835
)
 
(445
)
 
(677
)
 

 
(6,074
)
Recoveries
1,560

 
8

 
11

 

 
125

 

 
33

 

 
1,737

Provisions for / (reallocation of) loan losses
(1,161
)
 
2,176

 
1,256

 
818

 
(982
)
 
(1,046
)
 
995

 
(40
)
 
2,016

December 31, 2012
$
9,912

 
$
4,021

 
$
5,369

 
$
1,221

 
$
3,131

 
$
2,309

 
$
1,761

 
$
870

 
$
28,594


F-50

Table of Contents


The following table details the recorded investment balance of the loan receivables disaggregated on the basis of the Company’s impairment method as of December 31, 2014:
 
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)
Noncovered loans individually evaluated for impairment
$
9,040

 
$
2,781

 
$
7,305

 
$
245

 
$
4,524

 
$
2,056

 
$
205

 
$
26,156

Noncovered loans collectively evaluated for impairment
524,263

 
516,753

 
598,267

 
61,060

 
38,002

 
56,341

 
243,063

 
2,037,749

Covered loans individually evaluated for impairment
2,334

 
1,132

 
424

 

 
179

 

 
6

 
4,075

Covered loans collectively evaluated for impairment
9,642

 
37,446

 
6,198

 
2,512

 
959

 
1,758

 
6,248

 
64,763

Noncovered PCI loans collectively evaluated for impairment
18,040

 
16,208

 
11,185

 
2,235

 
4,223

 
2,963

 
7,055

 
61,909

Covered PCI loans collectively evaluated for impairment
7,134

 
20,666

 
20,257

 
3,478

 
1,308

 
1,802

 
2,717

 
57,362

Total gross loans receivable as of December 31, 2014
$
570,453

 
$
594,986

 
$
643,636

 
$
69,530

 
$
49,195

 
$
64,920

 
$
259,294

 
$
2,252,014

The following table details the recorded investment balance of the loan receivables disaggregated on the basis of the Company’s impairment method as of December 31, 2013:
 
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)
Noncovered loans individually evaluated for impairment
$
10,990

 
$
2,998

 
$
7,423

 
$
592

 
$
4,684

 
$
2,404

 
$
778

 
$
29,869

Noncovered loans collectively evaluated for impairment
308,771

 
273,192

 
385,771

 
38,722

 
15,008

 
44,894

 
38,592

 
1,104,950

Covered loans individually evaluated for impairment
3,761

 

 

 
450

 

 

 
7

 
4,218

Covered loans collectively evaluated for impairment
2,249

 
13,443

 
2,438

 
797

 

 

 
1,733

 
20,660

Noncovered PCI loans collectively evaluated for impairment
16,779

 
5,119

 
6,785

 
3,768

 
32

 
1,357

 
2,177

 
36,017

Covered PCI loans collectively evaluated for impairment
8,680

 
10,923

 
12,187

 
3,530

 
1,556

 

 
2,000

 
38,876

Total gross loans receivable as of December 31, 2013
$
351,230

 
$
305,675

 
$
414,604

 
$
47,859

 
$
21,280

 
$
48,655

 
$
45,287

 
$
1,234,590


(8)
FDIC Indemnification Asset
Changes in the FDIC indemnification asset during the years ended December 31, 2014, 2013 and 2012 were as follows:
 
Years Ended December 31,
 
2014
 
2013
 
2012
 
(In thousands)
Balance at the beginning of the year
$
4,382

 
$
7,100

 
$
10,350

Additions as a result of the Washington Banking Merger
7,174

 

 

Cash payments received or receivable from the FDIC
(7,897
)
 
(2,537
)
 
(2,217
)
Loan (recapture) impairment
(1,072
)
 
1,086

 
843

Net amortization
(1,471
)
 
(1,267
)
 
(1,876
)
Balance at the end of the year
$
1,116

 
$
4,382

 
$
7,100



F-51

Table of Contents


(9)
Other Real Estate Owned
Changes in other real estate owned during the years ended December 31, 2014, 2013 and 2012 were as follows:
 
Years Ended December 31,
 
2014
 
2013
 
2012
 
(In thousands)
Balance at the beginning of the year
$
4,559

 
$
5,666

 
$
4,484

Additions
1,566

 
2,974

 
7,406

Additions from acquisitions
7,121

 
2,279

 

Proceeds from dispositions
(9,914
)
 
(6,253
)
 
(5,987
)
Gain on sales, net
23

 
264

 
587

Valuation adjustment

 
(371
)
 
(824
)
Balance at the end of the year
$
3,355

 
$
4,559

 
$
5,666


At December 31, 2014 and 2013, the balance of other real estate owned that was covered by shared-loss agreements were $1.2 million and $182,000, respectively.
    
(10)        Premises and Equipment

A summary of premises and equipment is as follows:
 
 
December 31, 2014
 
December 31, 2013
 
 
(In thousands)
Land
 
$
22,364

 
$
10,876

Buildings and building improvements
 
52,067

 
33,482

Furniture, fixtures and equipment
 
14,280

 
18,054

Total premises and equipment
 
88,711

 
62,412

Less accumulated depreciation
 
23,773

 
28,064

Premises and equipment, net
 
$
64,938

 
$
34,348

Total depreciation expense on premises and equipment was $3.5 million, $2.3 million and $2.1 million for the years ended December 31, 2014, 2013 and 2012, respectively.

(11)
Goodwill and Other Intangible Assets
(a) Goodwill
The Company’s goodwill represents the excess of the purchase price over the fair value of net assets acquired in the Washington Banking Merger on May 1, 2014, and the acquisitions of Valley Community Bancshares, Inc. on July 15, 2013, Western Washington Bancorp in 2006 and North Pacific Bank in 1998. The Company’s goodwill is assigned to the Bank and is evaluated for impairment at the Bank level (reporting unit).
The Company recorded additions of goodwill of $89.7 million during the year ended December 31, 2014 as a result of the Washington Banking Merger. The Company recorded additions to goodwill of $16.4 million during the year ended December 31, 2013 as a result of the Valley Acquisition. For additional information on the additions to goodwill, see "Note 2. Business Combinations."
At December 31, 2014, the Company’s step-one analysis concluded that the reporting unit’s fair value was greater than its carrying value and therefore no goodwill impairment charges were required for the year ended December 31, 2014. The Company did not record any goodwill impairment charges for the years ended December 31, 2013 and 2012. Even though there was no goodwill impairment at December 31, 2014, adverse events may impact the recoverability of goodwill and could result in a future impairment charge which could have a material impact on the Company’s operating results.

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b) Other Intangible Assets
The other intangible assets represent the core deposit intangible ("CDI") acquired in business combinations. The useful life of the CDI related to the Washington Banking Merger, the acquisitions of Valley, NCB, Pierce, Cowlitz, and Western Washington Bancorp were estimated to be ten, ten, five, four, nine and eight years, respectively.
The following table presents the change in the other intangible assets for the periods indicated:
 
Years Ended 
 December 31,
 
2014
 
2013
 
2012
 
(In thousands)
Balance at the beginning of the year
$
1,615

 
$
1,086

 
$
1,513

Additions as a result of acquisitions
11,194

 
1,072

 

Less: amortization expense
1,920

 
543

 
427

Balance at the end of the year
$
10,889

 
$
1,615

 
$
1,086

The estimated aggregated amortization expense related to these intangible assets for future years is as follows:
 
Years Ending December 31,
 
(In thousands)
2015
$
2,072

2016
1,443

2017
1,285

2018
1,122

2019
1,043

Thereafter
3,924

 
$
10,889


(12)
Deposits
Deposits consisted of the following: 
 
 
December 31, 2014
 
December 31, 2013
 
 
Amount
 
Percent
 
Amount
 
Percent
 
 
(Dollars in thousands)
Noninterest demand deposits
 
$
709,673

 
24.4
%
 
$
349,902

 
25.0
%
NOW accounts
 
793,362

 
27.3

 
352,051

 
25.2

Money market accounts
 
520,065

 
17.9

 
232,016

 
16.6

Savings accounts
 
357,834

 
12.3

 
155,790

 
11.1

Total non-maturity deposits
 
2,380,934

 
81.9

 
1,089,759

 
77.9

Certificate of deposit accounts
 
525,397

 
18.1

 
309,430

 
22.1

Total deposits
 
$
2,906,331

 
100.0
%
 
$
1,399,189

 
100.0
%
Accrued interest payable on deposits was $390,000 and $152,000 as of December 31, 2014 and 2013, respectively and is included in accrued expenses and other liabilities in the Consolidated Statements of Financial Condition.

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Interest expense, by category, is as follows:
 
 
Years Ended December 31,
 
 
2014
 
2013
 
2012
 
 
(In thousands)
NOW accounts
 
$
1,011

 
$
645

 
$
797

Money market accounts
 
896

 
386

 
452

Savings accounts
 
252

 
164

 
204

Certificate of deposit accounts
 
2,991

 
2,478

 
3,016

 
 
$
5,150

 
$
3,673

 
$
4,469

Scheduled maturities of certificates of deposit for future years are as follows:
 
Year Ending December 31,
 
(In thousands)
2015
$
347,895

2016
107,849

2017
35,254

2018
13,887

2019
19,883

Thereafter
629

 
$
525,397

Certificates of deposit issued in denominations equal to or in excess of $250,000 totaled $79.8 million and $55.0 million as of December 31, 2014 and 2013, respectively.

(13)
Junior Subordinated Debentures
As part of the Washington Banking Merger, the Company assumed trust preferred securities and junior subordinated debentures with a total fair value of $18.9 million at May 1, 2014.
Washington Banking Master Trust, a statutory business trust, was a wholly-owned subsidiary of Washington Banking Company created for the exclusive purposes of issuing and selling capital securities and utilizing sale proceeds to acquire junior subordinated debt issued by Washington Banking Company. During 2007, the Master Trust issued $25.0 million of trust preferred securities with a 30-year maturity, callable after the fifth year by Washington Banking Company (now callable by Heritage). The trust preferred securities have a quarterly adjustable rate based upon the three-month London Interbank Offered Rate (“LIBOR”) plus 1.56%. The rate at December 31, 2014 was 1.82%. The weighted average rate of the junior subordinated debentures was 3.59% for the year ended December 31, 2014 and included the accretion of the discount established at the merger date which is amortized over the life of the trust preferred securities.
On the Washington Banking Merger date of May 1, 2014, the Company acquired the Washington Banking Master Trust. The Trust retained the Washington Banking Master Trust name.
The junior subordinated debentures are the sole assets of the Master Trust, and payments under the junior subordinated debentures are the sole revenues of the Trust. All of the common securities of the Master Trust are owned by the Company. Heritage has fully and unconditionally guaranteed the capital securities along with all obligations of the Master Trust under the trust agreements.

(14)
Repurchase Agreements
The Company utilizes repurchase agreements with a one -day maturity as a supplement to funding sources. At December 31, 2014 and 2013 the Company had securities sold under agreement to repurchase of $32.2 million and $29.4 million, respectively. The weighted average interest rates on the utilized repurchased agreements was 0.26% and 0.27% as of December 31, 2014 and 2013, respectively. Repurchase agreements are secured by investment securities available for sale. Upon maturity of the agreements, the pledged investment securities will be returned to the Company.


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(15)
Other Borrowings
(a) FHLB Advances

The Federal Home Loan Bank of Seattle functions as a member-owned cooperative providing credit for member financial institutions. Advances are made pursuant to several different programs. Each credit program has its own interest rate and range of maturities. Depending on the program, limitations on the amount of advances are based either on a fixed percentage of an institution’s net worth or on the FHLB’s assessment of the institution’s creditworthiness. At December 31, 2014, the Bank maintained a credit facility with the FHLB of Seattle for $374.3 million. During the years ended December 31, 2014 and 2013, there were no FHLB borrowing transactions completed other than minimal amounts necessary to test the facilities. At December 31, 2014 and 2013 there were no FHLB advances outstanding.

Advances from the FHLB are collateralized by a blanket pledge on FHLB stock owned by the Bank, deposits at the FHLB and all mortgages or deeds of trust securing such properties. In accordance with the pledge agreement, the Company must maintain unencumbered collateral in an amount equal to varying percentages ranging from 100% to 125% of outstanding advances depending on the type of collateral. At December 31, 2014, the Bank was not required to maintain collateral in order to meet the collateral requirements of the FHLB.

(b) Federal Funds Purchased

The Bank maintains advance lines with Zions Bank, Wells Fargo Bank, US Bank and Pacific Coast Bankers’ Bank to purchase federal funds of up to $43.0 million as of December 31, 2014. The lines generally mature annually or are reviewed annually. As of December 31, 2014 and 2013, there were no federal funds purchased.

(c) Credit facilities

The Bank maintains a credit facility with the Federal Reserve Bank of San Francisco for $53.2 million as of December 31, 2014, of which there were no borrowings outstanding as of December 31, 2014 or 2013. Any advances on the credit facility would have to be first pledged with the Bank's investment securities or loans.


(16)
Employee Benefit Plans
(a) 401(k) Plan
Effective October 1, 1999, the Company combined three retirement plans, a money purchase pension plan, a 401(k) plan, and an employee stock ownership plan ("ESOP") at Heritage Bank, and the 401(k) plan at Central Valley Bank into one plan called the "Heritage Financial Corporation 401(k) Employee Stock Ownership Plan" (the “Plan”). In 2010, the Company amended the Plan to provide certain service credit for vesting and/or contribution purposes to employees of Cowlitz Bank and Pierce Commercial Bank at the time of each acquisition. Effective January 1, 2014, the Plan converted from an ESOP to a profit sharing plan and changed its name to "Heritage Financial Corporation 401(k) Profit Sharing Plan and Trust."
The profit sharing portion of the Plan is a defined contribution retirement plan. Effective January 1, 2014, the Company changed the contribution formula to make all profit sharing and discretionary contributions completely discretionary. For the year ended December 31, 2014, the Company contributed 1.5% of employees' eligible compensation. For the Plan years 2013 and 2012, the Company was required to contribute 2% of the participants’ eligible compensation and it could also provide discretionary profit sharing contributions beyond the required 2% contribution. For the years ended December 31, 2013 and 2012, the Company contributed 3% of employees' eligible compensation. Participants were eligible for profit sharing contributions upon credit of 1,000 hours of service during the plan year, the attainment of 18 years of age, and employment on the last day of the year. It was the Company’s policy to fund plan costs as accrued. Historically, employee vesting in the profit sharing contribution occurred over a period of six years, at which time they became fully vested. All participants employed at May 1, 2014 became 100% vested in all employer contributions. All participants hired after May 1, 2014 are 100% vested in all accounts at all times. Employer profit sharing contributions were $475,000, $600,000 and $631,000 for the years ended December 31, 2014, 2013 and 2012, respectively.
The Plan also includes the Company’s salary savings 401(k) plan for its employees. All persons employed as of July 1, 1984 automatically participate in the plan. All employees hired after that date who are at least 18 years of age may participate in the plan the first of the month following thirty days of service. Employees who participate may contribute a portion of their salary, which is matched by the employer at 50%, not to be greater than 3% of eligible

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compensation, up to certain Internal Revenue Service limits. Employee vesting in employer matching is consistent with the vesting periods discussed in the profit sharing portion above. Employer matching contributions for the years ended December 31, 2014, 2013 and 2012 were $852,000, $497,000 and $444,000, respectively.
The third portion of the Plan was the ESOP. Heritage Bank established the ESOP and related trust for eligible employees effective July 1, 1994, which became active upon the former mutual holding company’s conversion to a stock-based holding company in January 1995. The ESOP provided a contribution to all eligible participants upon completion of one year of service, the attainment of 18 years of age, and employment on the last day of the year. Employee vesting in the ESOP is consistent with the vesting periods discussed in the profit sharing portion above. The ESOP was funded by employer contributions in cash or common stock. During the year ended December 31, 2012, the loan related to the ESOP was paid in full; therefore, there was no ESOP compensation expense for the years ended December 31, 2014 and 2013. ESOP compensation expense was $139,000 for the year ended December 31, 2012. As of December 31, 2014 and 2013, the Company had no allocated or committed shares to be released to the ESOP, and the Company has no unearned, restricted shares remaining to be released as of December 31, 2014.
(b) Employment Agreements
The Company has entered into contracts with certain senior officers that provide benefits under certain conditions following termination without cause, and/or following a change in control of the Company.
(c) Deferred Compensation Plan
During 2012, the Company adopted a Deferred Compensation Plan, which provides its directors and select executive officers with the opportunity to defer current compensation. Under the Plan, participants are permitted to elect to defer compensation and the Company has the discretion to make additional contributions to the Plan on behalf of any participant based on a number of factors. Compensation expense under the Deferred Compensation Plan totaled $343,000, $445,000 and $312,000 for the years ended December 31, 2014, 2013 and 2012, respectively. The Company’s contributions totaled $414,000, $155,000 and $150,000 for the years ended December 31, 2014, 2013 and 2012, respectively.
(d) Split-Dollar Life Insurance Benefit Plan
In conjunction with the Washington Banking Merger, the Company assumed the split-dollar life insurance benefit plan previously maintained by Washington Banking. Life insurance policies are maintained for current officers of the Bank or former Washington Banking officers that are subject to split-dollar life insurance agreements, which continue after the participant's employment and retirement. All participants are fully vested in their split-dollar life insurance benefits. The accrued benefit liability for the split-dollar life insurance agreements represents the present value of the future death benefits payable to the participants' beneficiaries.
The split-dollar life insurance projected benefit obligation is included in accrued expenses and other liabilities on the Company's Consolidated Statements of Financial Condition. As of December 31, 2014, the carrying value of the obligation was $1.2 million. The Company had no obligation at December 31, 2013.

(17)
Commitments and Contingencies
(a) Lease Commitments
The Bank leases premises and equipment under operating leases. Rental expense of leased premises and equipment was $3.4 million, $2.3 million and $1.9 million for the years ended December 31, 2014, 2013 and 2012, respectively, which is included in occupancy and equipment expense.

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The estimated future minimum annual rental commitments under noncancelable leases having an original or remaining term of more than one year are as follows: 
 
Years Ending December 31,
 
(In thousands)
2015
$
3,307

2016
2,984

2017
2,741

2018
2,276

2019
1,504

Thereafter
3,723

 
$
16,535

Certain leases contain renewal options from two to ten years and escalation clauses based on increases in property taxes and other costs.
(b) Commitments to Extend Credit
In the ordinary course of business, the Company may enter into various types of transactions that include commitments to extend credit that are not included in the Consolidated Financial Statements. The Company applies the same credit standards to these commitments as it uses in all its lending activities and has included these commitments in its lending risk evaluations. The Company’s exposure to credit loss under commitments to extend credit is represented by the amount of these commitments.

The following table presents outstanding commitments to extend credit, including letters of credit, at the dates indicated:
 
 
December 31, 2014
 
December 31, 2013
 
 
(In thousands)
Commercial business:
 
 
 
 
Commercial and industrial
 
$
288,930

 
$
169,079

Owner-occupied commercial real estate
 
2,648

 
2,812

Non-owner occupied commercial real estate
 
20,240

 
2,405

Total commercial business
 
311,818

 
174,296

One-to-four family residential
 

 
45

Real estate construction and land development:
 
 
 
 
One-to-four family residential
 
24,028

 
12,236

Five or more family residential and commercial properties
 
32,653

 
20,720

Total real estate construction and land development
 
56,681

 
32,956

Consumer
 
122,633

 
27,480

Total outstanding commitments
 
$
491,132

 
$
234,777

(c) Regulatory and Legal Proceedings
The Company is involved in numerous business transactions, which, in some cases, depend on regulatory determination as to compliance with rules and regulations. Also, the Company has certain litigation and negotiations in progress. All such matters are attributable to activities arising from normal operations, except the matter related to the class action lawsuit mentioned below. In the opinion of management, after review with legal counsel, the eventual outcome of the aforementioned matters, including the class action lawsuit mentioned below, is unlikely to have a materially adverse effect on the Company’s Consolidated Financial Statements or its financial position.
     On April 4, 2014, Washington Banking, its directors and Heritage entered into and documented an agreement in principle among Washington Banking, its directors, Heritage and the plaintiffs for the settlement of the putative shareholder class action lawsuit captioned In Re Washington Banking Company Shareholder Litigation, Lead Case No. 13-2-38689-5 SEA, pending before the Superior Court of the State of Washington in and for King County (the “Action”).  The Action alleges that Washington Banking’s directors breached their fiduciary duties to Washington Banking and its shareholders in connection with the transactions contemplated by the Agreement and Plan of Merger, dated

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October 23, 2013 (the “Merger Agreement”), under which Washington Banking and Heritage combined their organizations in a strategic combination, with Washington Banking merging with and into Heritage. The Action also alleges, among other things, that Heritage aided and abetted the alleged breaches of fiduciary duties by Washington Banking's directors and that the public disclosures concerning the Washington Banking Merger are misleading in various respects.
              On December 15, 2014, the Court entered an order preliminarily approving the settlement of the consolidated litigation and ordering WBCO to provide notice of the proposed settlement to those persons who held WBCO shares during the purported class period. 
On February 27, 2015, the Court held a hearing to consider whether the settlement was fair and reasonable to the class members and, if so, to approve the settlement and to consider plaintiffs’ counsel’s application for an award of attorneys’ fees and costs from Washington Banking.  At the hearing, the Court approved the settlement and entered a Final Judgment and Order of Dismissal With Prejudice awarding plaintiffs’ counsel fees and expenses totaling $450,000 and terminating the litigation.
The settlement of the Action did not affect the Washington Banking Merger consideration paid to Washington Banking’s shareholders in connection with the completion of the Washington Banking Merger on May 1, 2014.  Washington Banking, its directors and Heritage took the position that the Action was without merit and denied any wrongdoing of any kind.  Washington Banking, its directors and Heritage entered into the settlement solely to eliminate the costs, risks, burden, distraction and expense of further litigation and to put the claims that were or could have been asserted to rest.  Nothing in the stipulation of settlement or any public filing, including this Annual Report on Form 10-K, shall be deemed an admission of the legal necessity of filing or the materiality under applicable laws of any of the additional information contained herein or in any public filing associated with the settlement of the Action.

(18)
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 years ended December 31, 2014, 2013 and 2012:
 
Years Ended 
 December 31,
 
2014
 
2013
 
2012
 
(Dollars in thousands)
Net income:
 
 
 
 
 
Net income
$
21,014

 
$
9,575

 
$
13,261

Less: Dividends and undistributed earnings allocated to participating securities
(163
)
 
(118
)
 
(162
)
Net income allocated to common stockholders
$
20,851

 
$
9,457

 
$
13,099

Basic:
 
 
 
 
 
Weighted average common shares outstanding
25,641,229

 
15,667,912

 
15,262,452

Less: Restricted stock awards
(210,690
)
 
(191,677
)
 
(182,303
)
Total basic weighted average common shares outstanding
25,430,539

 
15,476,235

 
15,080,149

Diluted:
 
 
 
 
 
Basic weighted average common shares outstanding
25,430,539

 
15,476,235

 
15,080,149

Incremental shares from stock options
46,750

 
11,480

 
14,640

Total diluted weighted average common shares outstanding
25,477,289

 
15,487,715

 
15,094,789

Potential dilutive shares are excluded from the computation of earnings per share if their effect is anti-dilutive. For the years ended December 31, 2014, 2013 and 2012 anti-dilutive shares outstanding related to options to acquire common stock totaled 20,768, 163,863 and 249,215, respectively, as the assumed proceeds from exercise price, tax benefits and future compensation was in excess of the market value.
(b) Dividends
The timing and amount of cash dividends paid on the Company's common stock depends on the Company’s earnings, capital requirements, financial condition and other relevant factors. Dividends on common stock from the

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Company depend substantially upon receipt of dividends from the Bank, which is the Company’s predominant source of income. The following table summarizes the dividend activity for the years ended December 31, 2014, 2013 and 2012.
Declared
 
Cash Dividend per Share
 
Record Date
 
Paid Date
February 1, 2012

$0.06
 
February 10, 2012
 
February 24, 2012
April 26, 2012

$0.08
 
May 10, 2012
 
May 24, 2012
June 26, 2012

$0.20
 
July 10, 2012
 
July 24, 2012
July 25, 2012

$0.08
 
August 14, 2012
 
August 24, 2012
October 30, 2012

$0.08
 
November 9, 2012
 
November 21, 2012
November 30, 2012

$0.30
 
November 26, 2012
 
December 6, 2012
January 30, 2013
 
$0.08
 
February 8, 2013
 
February 22, 2013
April 24, 2013
 
$0.08
 
May 10, 2013
 
May 24, 2013
July 23, 2013
 
$0.18
 
August 6, 2013
 
August 15, 2013
October 23, 2013

$0.08

November 5, 2013

November 15, 2013
January 29, 2014
 
$0.08
 
February 10, 2014
 
February 24, 2014
March 27, 2014
 
$0.08
 
April 8, 2014
 
April 23, 2014
July 24, 2014
 
$0.09
 
August 7, 2014
 
August 21, 2014
October 23, 2014
 
$0.09
 
November 6, 2014
 
November 20, 2014
November 11, 2014
 
$0.16
 
December 2, 2014
 
December 12, 2014
The FDIC and the Washington State Department of Financial Institutions, Division of Banks have the authority under their supervisory powers to prohibit the payment of dividends by the Bank to the Company. Additionally, current guidance from the Board of Governors of the Federal Reserve System ("Federal Reserve Board") 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 the Bank to pay dividends on their common stock if the Company’s or the Bank’s regulatory capital would not be reduced below the statutory capital requirements set by the Federal Reserve Board and the FDIC.
(c) Stock Repurchase Program
The Company has had various stock repurchase programs since March 1999. On October 23, 2014, the Company's Board of Directors authorized the repurchase of up to 5% of the Company's outstanding common shares, or approximately 1,513,000 shares, under the eleventh stock repurchase plan. The number, timing and price of shares repurchased will depend on business and market conditions, and other factors, including opportunities to deploy the Company's capital. The Company will not repurchase the remaining 52,025 shares available under the tenth plan described below as the eleventh plan supersedes the tenth stock repurchase program.
On August 30, 2012, the Board of Directors approved the Company’s tenth stock repurchase plan, authorizing the repurchase of up to 5% of the Company’s outstanding shares of common stock, or approximately 757,000 shares. On August 30, 2011, the Board of Director approved the Company's ninth stock repurchase plan, authorizing the repurchase of up to 5% of the Company's outstanding shares of common stock, or approximately 782,000 shares over a period of twelve months.


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The following table provides total repurchased shares and average share prices under the applicable Plans and years indicated:
 
Years Ended December 31,
 
 
 
2014
 
2013
 
2012
 
Plan Total
Ninth Plan
 
 
 
 
 
 
 
Repurchased shares

 

 
389,627

 
590,832

Stock repurchase average share price
$

 
$

 
$
13.45

 
$
12.83

 
 
 
 
 
 
 
 
Tenth Plan
 
 
 
 
 
 
 
Repurchased shares
108,075

 
544,000

 
52,900

 
704,975

Stock repurchase average share price
$
16.68

 
$
15.88

 
$
13.88

 
$
15.85

 
 
 
 
 
 
 
 
Eleventh Plan
 
 
 
 
 
 
 
Repurchased shares

 

 

 

Stock repurchase average share price
$

 
$

 
$

 
$


During the years ended December 31, 2014, 2013 and 2012, the Company repurchased 48,304, 13,138 and 3,419 shares at an average price of $16.53, $14.29 and $14.08 to pay withholding taxes on the vesting of restricted stock that vested during the years ended December 31, 2014, 2013 and 2012, respectively, which are not considered repurchased as part of the applicable Plans.
(d) Issuance of Common Stock
The Washington Banking Merger was effective on May 1, 2014. In conjunction with the merger was the issuance of 14,000,178 shares of the Company's common stock at a fair value of $226.2 million. The Valley Acquisition was effective on July 15, 2013. In conjunction with this acquisition was the issuance of 1,533,267 shares of the Company's stock at a fair value of $24.2 million.

(19)
Accumulated Other Comprehensive Income (Loss)
The changes in accumulated other comprehensive income (loss) (“AOCI”) by component, during the years ended December 31, 2014, 2013 and 2012 are as follows:

 
Year ended December 31, 2014
 
Changes in
fair value of
available for sale securities (1)
 
Accretion of other-than-
temporary
impairment on held to maturity
securities (1)
 
Total
 
(In thousands)
Balance of AOCI at the beginning of the year
$
(923
)
 
$
(239
)
 
$
(1,162
)
Other comprehensive income before reclassification
4,676

 
50

 
4,726

Amounts reclassified from AOCI for gain on sale of investment securities available for sale included in net income
(186
)
 

 
(186
)
Net current period other comprehensive income
4,490

 
50

 
4,540

Balance of AOCI at the end of the year
$
3,567

 
$
(189
)
 
$
3,378

(1)
All amounts are net of tax.


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Year ended December 31, 2013
 
Changes in
fair value of
available for sale securities (1)
 
Accretion of other-than-
temporary
impairment on held to maturity
securities (1)
 
Total
 
(In thousands)
Balance of AOCI at the beginning of the year
$
2,042

 
$
(298
)
 
$
1,744

Other comprehensive (loss) income before reclassification
(2,965
)
 
59

 
(2,906
)
Amounts reclassified from AOCI for gain on sale of investment securities available for sale included in net income

 

 

Net current period other comprehensive (loss) income
(2,965
)
 
59

 
(2,906
)
Balance of AOCI at the end of the year
$
(923
)
 
$
(239
)
 
$
(1,162
)
(1)
All amounts are net of tax.

 
Year ended December 31, 2012
 
Changes in
fair value of
available for sale securities (1)
 
Accretion of other-than-
temporary
impairment on held to maturity
securities (1)
 
Other-than-temporary impairments on securities held to maturity (1)
 
Total
 
(In thousands)
Balance of AOCI at the beginning of the year
$
2,105

 
$
(369
)
 
$

 
$
1,736

Other comprehensive (loss) income before reclassification
(63
)
 
105

 
(34
)
 
8

Amounts reclassified from AOCI for gain on sale of investment securities available for sale included in net income

 

 

 

Net current period other comprehensive (loss) income
(63
)
 
105

 
(34
)
 
8

Balance of AOCI at the end of the year
$
2,042

 
$
(264
)
 
$
(34
)
 
$
1,744

(1)
All amounts are net of tax.

(20)
Fair Value Measurements
Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. There are three levels of inputs that may be used to measure fair values:
Level 1: Valuations for assets and liabilities traded in active exchange markets, or interest in open-end mutual funds that allow the Company to sell its ownership interest back to the fund at net asset value on a daily basis. Valuations are obtained from readily available pricing sources for market transactions involving identical assets, liabilities, or funds.
Level 2: Valuations for assets and liabilities traded in less active dealer, or broker markets, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active or valuations using methodologies with observable inputs.
Level 3: Valuations for assets and liabilities that are derived from other valuation methodologies, such as option pricing models, discounted cash flow models and similar techniques using unobservable inputs, and not based on market exchange, dealer, or broker traded transactions. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities.

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(a) Recurring and Nonrecurring Basis
The Company used the following methods and significant assumptions to estimate fair value of certain assets on a recurring and nonrecurring basis:
Investment Securities Available for Sale and Held to Maturity:
The fair values of all investment securities are based upon the assumptions market participants would use in pricing the security. If available, investment securities are determined by quoted market prices which is generally the case for mutual funds and other equities (Level 1). For investment securities where quoted market prices are not available, fair values are calculated based on market prices on similar securities (Level 2). Level 2 includes U.S. Treasury, U.S. government and agency debt securities, municipal securities, corporate securities and mortgage-backed securities and collateralized mortgage obligations-residential. For investment securities where quoted prices or market prices of similar securities are not available, fair values are calculated by using observable and unobservable inputs such as discounted cash flows or other market indicators (Level 3). Security valuations are obtained from third party pricing services for comparable assets or liabilities.
Impaired Loans:
At the time a loan is considered impaired, its impairment is measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, a loan’s observable market price, or fair market value of the collateral if the loan is collateral-dependent. Impaired loans for which impairment is measured using the discounted cash flow approach are not considered to be measured at fair value because the loan’s effective interest rate is not a fair value input, and for the purposes of fair value disclosures, the fair value of these loans are measured commensurate with non-impaired loans. Generally, the Company utilizes the fair market value of the collateral, which is commonly based on recent real estate appraisals, to measure impairment. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. Non-real estate collateral may be valued using an appraisal, net book value per the borrower’s financial statements, or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation, and management’s expertise and knowledge of the client and client’s business (Level 3). Impaired loans are evaluated on a quarterly basis for additional impairment and adjusted accordingly.
Other Real Estate Owned:
Assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. These assets are subsequently accounted for at lower of cost or fair value less estimated costs to sell. Fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in Level 3 classification of the inputs for determining fair value.
Appraisals for both collateral-dependent impaired loans and other real estate owned are performed by certified general appraisers for commercial properties or certified residential appraisers for residential properties whose qualifications and licenses have been reviewed and verified by the Company. Once received, the Company reviews the assumptions and approaches utilized in the appraisal as well as the resulting fair value in comparison with independent data sources such as recent market data or industry-wide statistics. On a quarterly basis, the Company compares the actual selling price of collateral that has been liquidated to the most recent appraised value to determine what additional adjustment should be made to the appraisal value to arrive at fair value.

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The following tables summarize the balances of assets measured at fair value on a recurring basis as of December 31, 2014 and December 31, 2013.
 
December 31, 2014
 
Total
 
Level 1
 
Level 2
 
Level 3
 
(In thousands)
Investment securities available for sale:
 
 
 
 
 
 
 
U.S. Treasury and U.S. Government-sponsored agencies
$
21,427

 
$

 
$
21,427

 
$

Municipal securities
173,037

 

 
173,037

 

Mortgage backed securities and collateralized mortgage obligations—residential:
 
 
 
 
 
 
 
U.S Government-sponsored agencies
542,399

 

 
542,399

 

Corporate obligations
4,010

 

 
4,010

 

Mutual funds and other equities
1,973

 
1,973

 

 

Total
$
742,846

 
$
1,973

 
$
740,873

 
$

 
December 31, 2013
 
Total
 
Level 1
 
Level 2
 
Level 3
 
(In thousands)
Investment securities available for sale:
 
 
 
 
 
 
 
U.S. Treasury and U.S. Government-sponsored agencies
$
6,039

 
$

 
$
6,039

 
$

Municipal securities
49,060

 

 
49,060

 

Mortgage backed securities and collateralized mortgage obligations—residential:
 
 
 
 
 
 
 
U.S Government-sponsored agencies
108,035

 

 
108,035

 

Total
$
163,134

 
$

 
$
163,134

 
$

There were no transfers between Level 1 and Level 2 during the years ended December 31, 2014, 2013 and 2012.
The Company may be required to measure certain financial assets and liabilities at fair value on a nonrecurring basis. These adjustments to fair value usually result from application of lower-of-cost-or-market accounting or write-downs of individual assets.

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The tables below represent assets measured at fair value on a nonrecurring basis at December 31, 2014 and December 31, 2013 and the net losses (gains) recorded in earnings during years ended December 31, 2014 and 2013.
 
Basis (1)
 
Fair Value at December 31, 2014
 
 
 
Total
 
Level 1
 
Level 2
 
Level 3
 
Net Losses
(Gains)
Recorded in
Earnings 
During
the Year Ended December 31, 2014
 
(In thousands)
Noncovered impaired loans:
 
 
 
 
 
 
 
 
 
 
 
Commercial business:
 
 
 
 
 
 
 
 
 
 
 
Commercial and industrial
$
161

 
$
138

 
$

 
$

 
$
138

 
$
23

Total commercial business
161

 
138

 

 

 
138

 
23

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
 
 
One-to-four family residential
2,094

 
1,725

 

 

 
1,725

 
350

Total real estate construction and land development
2,094

 
1,725

 

 

 
1,725

 
350

Consumer
49

 
45

 

 

 
45

 
5

Total noncovered impaired loans
2,304

 
1,908

 

 

 
1,908

 
378

Investment securities held to maturity:
 
 
 
 
 
 
 
 
 
 
 
Mortgage back securities and collateralized mortgage obligations—residential:
 
 
 
 
 
 
 
 
 
 
 
Private residential collateralized mortgage obligations
36

 
11

 

 
11

 

 
45

Total
$
2,340

 
$
1,919

 
$

 
$
11

 
$
1,908

 
$
423

(1)
Basis represents the unpaid principal balance of noncovered impaired loans and amortized cost of investment securities held to maturity.



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Basis (1)
 
Fair Value at December 31, 2013
 
 
 
Total
 
Level 1
 
Level 2
 
Level 3
 
Net Losses
(Gains)
Recorded in
Earnings 
During
the Year Ended December 31, 2013
 
(In thousands)
Noncovered impaired loans:
 
 
 
 
 
 
 
 
 
 
 
Commercial business:
 
 
 
 
 
 
 
 
 
 
 
Commercial and industrial
$
4,850

 
$
2,134

 
$

 
$

 
$
2,134

 
$
1,681

Owner-occupied commercial real estate
1,880

 
1,285

 

 

 
1,285

 
594

Non-owner occupied commercial real estate
4,123

 
3,759

 

 

 
3,759

 
(2,409
)
 Total commercial business
10,853

 
7,178

 

 

 
7,178

 
(134
)
One-to-four family residential

 

 

 

 

 

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
 
 
One-to-four family residential
911

 
700

 

 

 
700

 
211

Total real estate construction and land development
911

 
700

 

 

 
700

 
211

Consumer
678

 
525

 

 

 
525

 
153

Total noncovered impaired loans
12,442

 
8,403

 

 

 
8,403

 
230

Covered impaired loans:
 
 
 
 
 
 
 
 
 
 
 
Commercial business:
 
 
 
 
 
 
 
 
 
 
 
Commercial and industrial
3,751

 
3,122

 

 

 
3,122

 
628

Non-owner occupied commercial real estate

 

 

 

 

 

Total commercial business
3,751

 
3,122

 

 

 
3,122

 
628

One-to-four family residential
450

 
419

 

 

 
419

 
(13
)
Consumer

 

 

 

 

 
(2
)
Total covered impaired loans
4,201

 
3,541

 

 

 
3,541

 
613

Investment securities held to maturity:
 
 
 
 
 
 
 
 
 
 
 
Mortgage back securities and collateralized mortgage obligations – residential:
 
 
 
 
 
 
 
 
 
 
 
Private residential collateralized mortgage obligations
19

 
19

 

 
19

 

 
38

Other real estate owned:
 
 
 
 
 
 
 
 
 
 
 
Commercial properties
1,720

 
1,222

 

 

 
1,222

 
348

Total
$
18,382

 
$
13,185

 
$

 
$
19

 
$
13,166

 
$
1,229

(1)
Basis represents the unpaid principal balance of noncovered impaired and covered impaired loans, amortized cost of investment securities held to maturity, and carrying value at ownership date of other real estate owned.

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The following table presents quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at December 31, 2014 and December 31, 2013.
 
December 31, 2014
 
Fair
Value
 
Valuation
Technique(s)
 
Unobservable Input(s)
 
Range of Inputs; Weighted
Average
 
(Dollars in thousands)
Noncovered impaired loans
$
1,908

 
Market approach
 
Adjustment for differences between the comparable sales
 
(47.5%) - 96.2%; 7.0%
 
December 31, 2013
 
Fair
Value
 
Valuation
Technique(s)
 
Unobservable Input(s)
 
Range of Inputs; Weighted
Average
 
(Dollars in thousands)
Noncovered impaired loans
$
8,403

 
Market approach
 
Adjustment for differences between the comparable sales
 
(27.8%) - 19.1%; (6.6%)
Covered impaired loans
$
3,541

 
Market approach
 
Adjustment for differences between the comparable sales
 
(50.0%) - (25.0%); (35.0%)
Other real estate owned
$
1,222

 
Market approach
 
Adjustment for differences between the comparable sales
 
(60.1)% - 13.6%; (35.2%)

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

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The tables below present the carrying value amount of the Company’s financial instruments and their corresponding estimated fair values at the dates indicated.
 
December 31, 2014
 
Carrying Value

Fair Value

Fair Value Measurements Using:
 

Level 1

Level 2

Level 3
 
(In thousands)
Financial Assets:
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
121,636

 
$
121,636

 
$
121,636

 
$

 
$

Other interest earning deposits
10,126

 
10,145

 

 
10,145

 

Investment securities available for sale
742,846

 
742,846

 
1,973

 
740,873

 

Investment securities held to maturity
35,814

 
36,874

 

 
36,874

 

Federal Home Loan Bank stock
12,188

 
N/A

 
N/A

 
N/A

 
N/A

Loans held for sale
5,582

 
5,710

 

 
5,710

 

Loans receivable, net of allowance for loan losses
2,223,348

 
2,279,081

 

 

 
2,279,081

Accrued interest receivable
9,836

 
9,836

 
3

 
3,009

 
6,824

Financial Liabilities:
 
 
 
 
 
 
 
 
 
Deposits:
 
 
 
 
 
 
 
 
 
Noninterest deposits, NOW accounts, money market accounts and savings accounts
$
2,380,934

 
$
2,380,934

 
$
2,380,934

 
$

 
$

Certificate of deposit accounts
525,397

 
525,768

 

 
525,768

 

Total deposits
$
2,906,331

 
$
2,906,702

 
$
2,380,934

 
$
525,768

 
$

Securities sold under agreement to repurchase
$
32,181

 
$
32,181

 
$
32,181

 
$

 
$

Junior subordinated debentures
19,082

 
19,082

 

 

 
19,082

Accrued interest payable
411

 
411

 
62

 
328

 
21


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December 31, 2013
 
Carrying Value
 
Fair Value
 
Fair Value Measurements Using:
 
 
Level 1
 
Level 2
 
Level 3
 
(In thousands)
Financial Assets:
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
130,400

 
$
130,400

 
$
130,400

 
$

 
$

Other interest earning deposits
15,662

 
15,747

 

 
15,747

 

Investment securities available for sale
163,134

 
163,134

 

 
163,134

 

Investment securities held to maturity
36,154

 
36,340

 

 
36,340

 

Federal Home Loan Bank stock
5,741

 
N/A

 
N/A

 
N/A

 
N/A

Loans receivable, net of allowance
1,203,096

 
1,218,192

 

 

 
1,218,192

Accrued interest receivable
5,462

 
5,462

 
26

 
910

 
4,526

Financial Liabilities:
 
 
 
 
 
 
 
 
 
Deposits:
 
 
 
 
 
 
 
 
 
Noninterest deposits, NOW accounts, money market accounts and savings accounts
$
1,089,759

 
$
1,089,759

 
$
1,089,759

 
$

 
$

Certificate of deposit accounts
309,430

 
311,065

 

 
311,065

 

Total deposits
$
1,399,189

 
$
1,400,824

 
$
1,089,759

 
$
311,065

 
$

Securities sold under agreement to repurchase
$
29,420

 
$
29,420

 
$
29,420

 
$

 
$

Accrued interest payable
152

 
152

 
17

 
135

 

The methods and assumptions, not previously presented, used to estimate fair value are described as follows:
Cash and Cash Equivalents:
The fair value of financial instruments that are short-term or reprice frequently and that have little or no risk are considered to have a fair value equal to carrying value (Level 1).
Other Interest Earning Deposits:
These deposits with other banks have maturities greater than three months. The fair value is calculated based upon market prices for similar deposits (Level 2).
Federal Home Loan Bank ("FHLB") Stock:
FHLB of Seattle stock is not publicly traded, as such, it is not practicable to determine the fair value of FHLB stock due to restrictions placed on its transferability.
Loans Held for Sale:
The fair value of loans held for sale is estimated based upon binding contracts or quotes from third party investors. (Level 2).
Loans Receivable:
Except for impaired loans discussed previously, fair value is based on discounted cash flows using current market rates applied to the estimated life (Level 3). While these methodologies are permitted under U.S. GAAP, they are not based on the exit price concept of the fair value required under ASC 820-10, Fair Value Measurements and Disclosures, and generally produce a higher value.
Accrued Interest Receivable/Payable:
The fair value of accrued interest receivable/payable balances are determined using inputs and fair value measurements commensurate with the asset or liability from which the accrued interest is generated. The carrying amounts of accrued interest approximate fair value (Level 1, Level 2 and Level 3).

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Deposits:
For deposits with no contractual maturity, the fair value is assumed to equal the carrying value (Level 1). The fair value of fixed maturity deposits is based on discounted cash flows using the difference between the deposit rate and the rates offered by the Company for deposits of similar remaining maturities (Level 2).
Securities Sold Under Agreement to Repurchase:
Securities sold under agreement to repurchase are short-term in nature, repricing on a daily basis. Fair value financial instruments that are short-term or reprice frequently and that have little or no risk are considered to have a fair value equal to carrying value (Level 1).
Junior Subordinated Debentures:
The fair value is estimated using discounted cash flow analysis based on current rates for similar types of debt, which many be unobservable, and considering recent trading activity of similar instrument in markets which can be inactive. At December 31, 2014, the fair value approximated the carrying value based on these valuation techniques (Level 3).
Off-Balance Sheet Financial Instruments:
The majority of our commitments to extend credit, standby letters of credit and commitments to sell mortgage loans carry current market interest rates if converted to loans. As such, no premium or discount was ascribed to these commitments (Level 1). They are excluded from the preceding tables.

(21)
Stock-Based Compensation
Stock options generally vest ratably over three years and expire five years after they become exercisable or vest ratably over four years and expire ten years from date of grant. Restricted stock awards issued generally have a five-year cliff vesting or four year ratable vesting schedule. The Company issues new shares of common stock to satisfy share option exercises and restricted stock awards.

On July 24, 2014, the Company's shareholders approved the Heritage Financial Corporation 2014 Omnibus Equity Plan (the "Plan") under which 1,500,000 shares of the Company's common stock may be issued in the form of nonqualified stock option awards, restricted stock awards and restricted stock unit awards.
As of December 31, 2014, 1,384,105 shares remain available for future issuances under the Plan.
(a) Stock Option Awards
For the years ended December 31, 2014, 2013 and 2012 the Company recognized compensation expense related to stock options of $20,000, $71,000 and $106,000, respectively, with related tax benefits of $0, $0 and $1,000, respectively. As of December 31, 2014, all of the compensation expense related to the outstanding stock options had been recognized. The intrinsic value from options exercised during the years ended December 31, 2014, 2013 and 2012 were $459,000, $54,000 and $31,000, respectively. The cash proceeds from options exercised during the years ended December 31, 2014, 2013 and 2012 were $915,000, $200,000, and $129,000, respectively.

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The following tables summarize the stock option activity for the years ended December 31, 2014, 2013 and 2012:
 
Shares
 
Weighted-Average Exercise Price
 
Weighted-Average
Remaining
Contractual
Term (In years)
 
Aggregate
Intrinsic
Value (In
thousands)
Outstanding at December 31, 2011
417,123

 
$
18.33

 
 
 
 
Granted

 

 
 
 
 
Exercised
(11,365
)
 
11.35

 
 
 
 
Forfeited or expired
(105,100
)
 
21.52

 
 
 
 
Outstanding at December 31, 2012
300,658

 
17.48

 
 
 
 
Granted

 

 
 
 
 
Exercised
(16,553
)
 
12.10

 
 
 
 
Forfeited or expired
(89,623
)
 
22.07

 
 
 
 
Outstanding at December 31, 2013
194,482

 
15.82

 
 
 
 
Granted (1)
90,248

 
10.72

 
 
 
 
Exercised
(84,189
)
 
10.86

 
 
 
 
Forfeited or expired
(44,134
)
 
22.76

 
 
 
 
Outstanding at December 31, 2014
156,407

 
$
13.59

 
2.63
 
$
647

Vested and expected to vest at December 31, 2014
156,407

 
$
13.59

 
2.63
 
$
647

Exercisable at December 31, 2014
156,407

 
$
13.59

 
2.63
 
$
647

(1)
Options granted during the year ended December 31, 2014 represent the stock options issued in conjunction with the Washington Banking Merger. See "Note 2. Business Combinations" for additional information. The weighted average exercise price reflects the exchange ratio applied to the original Washington Banking exercise price pursuant to the Merger Agreement.
(b) Restricted and Unrestricted Stock Awards
For the years ended December 31, 2014, 2013 and 2012 the Company recognized compensation expense related to restricted and unrestricted stock awards of $1.4 million, $1.2 million and $1.2 million, respectively, and related tax benefits of $489,000, $428,000 and $415,000, respectively. As of December 31, 2014, the total unrecognized compensation expense related to non-vested restricted and unrestricted stock awards was $2.5 million and the related weighted average period over which it is expected to be recognized is approximately 2.32 years. The vesting date fair value of restricted stock awards that vested during the years ended December 31, 2014, 2013 and 2012 was $1.4 million, $1.2 million and $842,000, respectively.

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The following tables summarize the restricted and unrestricted stock award activity for the years ended December 31, 2014, 2013 and 2012:
 
Shares
 
Weighted-Average Grant Date Fair Value
Nonvested at December 31, 2011
164,880

 
$
16.29

Granted
91,738

 
14.02

Vested
(61,445
)
 
17.41

Forfeited
(5,503
)
 
15.21

Nonvested at December 31, 2012
189,670

 
14.86

Granted
103,195

 
14.31

Vested
(86,819
)
 
15.55

Forfeited
(3,107
)
 
14.89

Nonvested at December 31, 2013
202,939

 
14.29

Granted
130,548

 
16.03

Vested
(85,373
)
 
14.37

Forfeited
(9,445
)
 
14.67

Nonvested at December 31, 2014
238,669

 
$
15.20


(22)
Income Taxes
Income tax expense is substantially due to Federal income taxes as the provision for the state of Oregon income taxes is insignificant. Income tax expense for the years ended December 31, 2014, 2013 and 2012 consisted of the following:
 
 
Years Ended December 31,
 
 
2014
 
2013
 
2012
 
 
(In thousands)
Current tax expense
 
$
9,992

 
$
4,344

 
$
5,916

Deferred tax (benefit) expense
 
(3,087
)
 
326

 
185

(Decrease) increase in valuation allowance
 

 
(77
)
 
77

Income tax expense
 
$
6,905

 
$
4,593

 
$
6,178


A reconciliation of the Company's effective income tax rate with the Federal statutory income tax rate of 35% is as follows:
 
 
Years Ended December 31,
 
 
2014
 
2013
 
2012
 
 
(In thousands)
Income tax expense at Federal statutory rate
 
$
9,772

 
$
4,959

 
$
6,804

Tax-exempt instruments
 
(1,598
)
 
(858
)
 
(649
)
Non-deductible acquisition costs
 
373

 
469

 

Federal tax credits (1)
 
(812
)
 

 

Effects of BOLI
 
(159
)
 
(25
)
 
(28
)
Tax position resolution (2)
 
(728
)
 

 

Valuation allowance
 

 
(77
)
 
77

Other, net
 
57

 
125

 
(26
)
Income tax expense
 
$
6,905

 
$
4,593

 
$
6,178

(1)
Federal tax credits are provided for under the New Market Tax Credit program. A subsidiary of Heritage Bank was awarded an allocation of New Market Tax Credit investments consisting of three tranches totaling $25.0 million. Gross tax credits related to these tranches totaling $9.8 million are available through 2020. The subsidiary

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is required to fund 85 percent of a tranche to claim the entire tax credit, and it has until May 15, 2015 to complete the funding. Tax benefits related to these credits were recognized for financial reporting purposes in the same period that the credits were recognized in the Company's income tax returns. The Company has analyzed the three tranches and believes that it is more likely than not that all tranches will be funded to 85 percent by May 15, 2015. The Company believes that these tax credits will be realized and therefore has reflected the impact of these credits in its estimated annual effective tax rate for 2014.
(2)
Washington Banking Company had recorded a liability for certain tax positions prior to the merger effective date, which the Company assumed as part of the Washington Banking Merger. These tax positions were resolved as of December 31, 2014, resulting in a decrease of the Company's income tax expense for the year ended December 31, 2014.
The following table presents major components of the deferred income tax asset (liability) resulting from differences between financial reporting and tax basis:
 
 
December 31, 2014
 
December 31, 2013
 
 
(In thousands)
Deferred tax assets:
 
 
 
 
Allowance for loan losses
 
$
5,460

 
$
7,003

Accrued compensation
 
1,382

 
821

Stock compensation
 
818

 
524

Capital loss carryforward
 
30

 
95

Unrealized losses charged to earnings on other than temporarily impaired investment securities
 
338

 
622

Net unrealized losses charged to other comprehensive income on securities
 

 
626

Goodwill and other intangible assets
 

 
2,107

Market discount on purchased loans
 
17,949

 
6,767

Foregone interest on nonaccrual loans
 
2,337

 
1,026

Net operating loss carryforward acquired from NCB
 
553

 
588

Difference in amounts reflected in financial statements and income tax basis of certain liabilities assumed in business combinations
 
3,492

 

Other deferred tax assets
 
1,394

 
705

Total deferred tax assets
 
33,753

 
20,884

Deferred tax liabilities:
 
 
 
 
Deferred loan fees, net
 
(1,982
)
 
(867
)
Premises and equipment
 
(1,937
)
 
(1,520
)
FHLB stock
 
(2,768
)
 
(1,039
)
Net unrealized gains charged to other comprehensive income on securities
 
(1,832
)
 

Indemnification asset
 
(392
)
 
(1,539
)
Goodwill and other intangible assets
 
(1,560
)
 

Federal tax credits
 
(439
)
 

Junior subordinated debentures
 
(2,349
)
 

Other deferred tax liabilities
 
(730
)
 
(248
)
Total deferred tax liabilities
 
(13,989
)
 
(5,213
)
Deferred income tax asset, net
 
$
19,764

 
$
15,671

In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. A valuation allowance is required to be recognized for the portion of the deferred tax asset that will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Based upon the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible, management expects to realize the benefits of these deductible differences at December 31, 2014.

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The Company had a net operating loss carryforward of $1.6 million and $1.7 million at December 31, 2014 and 2013, respectively, that will expire in 2033. The Company is limited to the amount of the net operating loss carryforward that it can deduct each year. The Company also had $85,000 and $270,000 of federal capital loss carryforwards as of December 31, 2014 and 2013, respectively, which will expire in 2018. A tax planning strategy has been developed that will enable the Company to deduct all of the net operating loss and capital loss carryforwards prior to their respective expirations. Based on these estimates, management has not recorded a valuation allowance as of December 31, 2014. During the year ended December 31, 2013, management reversed the valuation allowance that was established in the prior year resulting in no valuation allowance at December 31, 2013.
As of December 31, 2014 and December 31, 2013, the Company had an insignificant amount of unrecognized tax benefits, none of which would materially affect its effective tax rate if recognized. The Company does not anticipate that the amount of unrecognized tax benefits will significantly increase or decrease in the next 12 months. The amount of interest and penalties accrued as of December 31, 2014 and 2013 and for the years ended December 31, 2014, 2013 and 2012 were immaterial. 
The Company has qualified under provisions of the Internal Revenue Code to compute income taxes after deductions of additions to the bad debt reserves when it was registered as a Savings Bank. At December 31, 2014, the Company had a taxable temporary difference of approximately $2.8 million that arose before 1988 (base-year amount). In accordance with FASB ASC 740, a deferred tax liability of an estimated $980,000 has not been recognized for the temporary difference. Management does not expect this temporary difference to reverse in the foreseeable future.
The Company and its subsidiary file a United States consolidated federal income tax return and an Oregon State income tax return, and the tax years subject to examination by the Internal Revenue Service are the years ended December 31, 2014, 2013, 2012 and 2011.

(23)
Regulatory Capital Requirements
The Company is a bank holding company under the supervision of the Federal Reserve Bank of San Francisco. Bank holding companies are subject to capital adequacy requirements of the Federal Reserve Board under the Bank Holding Company Act of 1956, as amended, and the regulations of the Federal Reserve Board. Heritage Bank is a federally insured institution and thereby is subject to the capital requirements established by the FDIC. The Federal Reserve Board capital requirements generally parallel the FDIC requirements. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company’s consolidated financial statements and operations. Management believes as of December 31, 2014, the Company and the Bank meet all capital adequacy requirements to which they are subject.
Pursuant to minimum capital requirements of the FDIC, Heritage Bank is required to maintain a leverage ratio (Tier 1 capital to average assets ratio) of 4.0% and risk-based capital ratios of Tier 1 capital and total capital (to total risk-weighted assets) of 4.0% and 8.0%, respectively. As of December 31, 2014 and December 31, 2013, the most recent regulatory notifications categorized Heritage Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Bank's categories.
 

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Minimum
Requirements
 
Well-
Capitalized
Requirements
 
Actual
 
 
$
 
%
 
$
 
%
 
$
 
%
 
 
(Dollars in thousands)
As of December 31, 2014:
 
 
 
 
 
 
 
 
 
 
 
 
The Company consolidated
 
 
 
 
 
 
 
 
 
 
 
 
Tier 1 leverage capital to average assets
 
$
132,881

 
4.0
%
 
N/A

 
N/A
 
$
340,292

 
10.2
%
Tier 1 capital to risk-weighted assets
 
97,620

 
4.0

 
N/A

 
N/A
 
340,292

 
13.9

Total capital to risk-weighted assets
 
195,240

 
8.0

 
N/A

 
N/A
 
368,198

 
15.1

Heritage Bank
 
 
 
 
 
 
 
 
 
 
 
 
Tier 1 leverage capital to average assets
 
132,853

 
4.0

 
166,066

 
5.0
 
332,147

 
10.0

Tier 1 capital to risk-weighted assets
 
97,585

 
4.0

 
146,378

 
6.0
 
332,147

 
13.6

Total capital to risk-weighted assets
 
195,171

 
8.0

 
243,964

 
10.0
 
360,053

 
14.8

As of December 31, 2013:
 
 
 
 
 
 
 
 
 
 
 
 
The Company consolidated
 
 
 
 
 
 
 
 
 
 
 
 
Tier 1 leverage capital to average assets
 
$
65,847

 
4.0
%
 
N/A

 
N/A
 
$
185,951

 
11.3
%
Tier 1 capital to risk-weighted assets
 
47,853

 
4.0

 
N/A

 
N/A
 
185,951

 
15.5

Total capital to risk-weighted assets
 
95,706

 
8.0

 
N/A

 
N/A
 
201,076

 
16.8

Heritage Bank
 
 
 
 
 
 
 
 
 
 
 
 
Tier 1 leverage capital to average assets
 
65,831

 
4.0

 
82,288

 
5.0
 
182,543

 
11.1

Tier 1 capital to risk-weighted assets
 
47,807

 
4.0

 
71,710

 
6.0
 
182,543

 
15.3

Total capital to risk-weighted assets
 
95,613

 
8.0

 
119,517

 
10.0
 
197,656

 
16.5

     In July 2013, the Federal banking regulators approved a final rule to implement the revised capital adequacy standards of the Basel Committee on Banking Supervision, commonly called Basel III, and to address relevant provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act). The final rule strengthens the definition of regulatory capital, increases risk-based capital requirements, makes selected changes to the calculation of risk-weighted assets, and adjusts the prompt corrective action thresholds. Community banking organizations, such as the Company and the Bank, become subject to the new rule on January 1, 2015 and certain provisions of the new rule will be phased in over the period of 2015 through 2019. The final rule:
Permits banking organizations that had less than $15 billion in total consolidated assets as of December 31, 2009, or were mutual holding companies as of May 19, 2010, to include in Tier 1 capital trust preferred securities and cumulative perpetual preferred stock that were issued and included in Tier 1 capital prior to May 19, 2010, subject to a limit of 25% of Tier 1 capital elements, excluding any non-qualifying capital instruments and after all regulatory capital deductions and adjustments have been applied to Tier 1 capital.
Establishes new qualifying criteria for regulatory capital, including new limitations on the inclusion of deferred tax assets and mortgage servicing rights.
Requires a minimum ratio of common equity Tier 1 capital to risk-weighted assets of 4.5%.
Increases the minimum Tier 1 capital to risk-weighted assets ratio requirement from 4% to 6%.
Retains the minimum total capital to risk-weighted assets ratio requirement of 8%.
Establishes a minimum leverage ratio requirement of 4%.
Retains the existing regulatory capital framework for 1-4 family residential mortgage exposures.

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Permits banking organizations that are not subject to the advanced approaches rule, such as the Company and the Bank, to retain, through a one-time election, the existing treatment for most accumulated other comprehensive income, such that unrealized gains and losses on securities available for sale will not affect regulatory capital amounts and ratios.
Implements a new capital conservation buffer requirement for a banking organization to maintain a common equity capital ratio more than 2.5% above the minimum common equity Tier 1 capital, Tier 1 capital and total risk-based capital ratios in order to avoid limitations on capital distributions, including dividend payments, and certain discretionary bonus payments. The capital conservation buffer requirement will be phased in beginning on January 1, 2016 at 0.625% and will be fully phased in at 2.50% by January 1, 2019. A banking organization with a buffer of less than the required amount would be subject to increasingly stringent limitations on such distributions and payments as the buffer approaches zero. The new rule also generally prohibits a banking organization from making such distributions or payments during any quarter if its eligible retained income is negative and its capital conservation buffer ratio was 2.5% or less at the end of the previous quarter. The eligible retained income of a banking organization is defined as its net income for the four calendar quarters preceding the current calendar quarter, based on the organization’s quarterly regulatory reports, net of any distributions and associated tax effects not already reflected in net income.
Increases capital requirements for past-due loans, high volatility commercial real estate exposures, and certain short-term commitments and securitization exposures.
Expands the recognition of collateral and guarantors in determining risk-weighted assets.
Removes references to credit ratings consistent with the Dodd-Frank Act and establishes due diligence requirements for securitization exposures.
The Company’s management is currently evaluating the provisions of the final rule and their expected impact on the Company.

(24)
Heritage Financial Corporation (Parent Company Only)
Following is the condensed financial statements of the Parent Company.

HERITAGE FINANCIAL CORPORATION
(PARENT COMPANY ONLY)
Condensed Statements of Financial Condition
 
 
 
December 31, 2014
 
December 31, 2013
 
 
(In thousands)
ASSETS
 
 
 
 
Cash and interest earning deposits
 
$
8,835

 
$
2,645

Investment in subsidiary bank
 
465,442

 
212,354

Other assets
 
863

 
1,041

 
 
$
475,140

 
$
216,040

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
 
Junior subordinated debentures
 
$
19,082

 
$

Other liabilities
 
1,552

 
278

Total stockholders’ equity
 
454,506

 
215,762

 
 
$
475,140

 
$
216,040



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HERITAGE FINANCIAL CORPORATION
(PARENT COMPANY ONLY)
Condensed Statements of Income
 
 
 
Years Ended December 31,
 
 
2014
 
2013
 
2012
 
 
(In thousands)
Interest income:
 
 
 
 
 
 
Interest earning deposits and other assets
 
$
17

 
$
22

 
$
44

ESOP loan
 

 

 
8

Total interest income
 
17

 
22

 
52

Interest expense:
 
 
 
 
 
 
Junior subordinated debentures
 
458

 

 

Total interest expense
 
458

 

 

Net interest (expense) income
 
(441
)
 
22

 
52

Noninterest income:
 
 
 
 
 
 
Dividends from subsidiary banks
 
66,300

 
26,000

 
14,100

Equity in (excess distributed) undistributed income of subsidiary banks
 
(40,737
)
 
(13,001
)
 
962

Other income
 
3

 

 

Total noninterest income
 
25,566

 
12,999

 
15,062

Noninterest expense:
 
 
 
 
 
 
Professional services
 
2,943

 
1,718

 

Other expense
 
3,109

 
2,905

 
2,766

Total noninterest expense
 
6,052

 
4,623

 
2,766

Income before income taxes
 
19,073

 
8,398

 
12,348

Income tax benefit
 
(1,941
)
 
(1,177
)
 
(913
)
Net income
 
$
21,014

 
$
9,575

 
$
13,261



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HERITAGE FINANCIAL CORPORATION
(PARENT COMPANY ONLY)
Condensed Statements of Cash Flows
 
 
 
Years Ended December 31,
 
 
2014
 
2013
 
2012
 
 
(In thousands)
Cash flows from operating activities:
 
 
 
 
 
 
Net income
 
$
21,014

 
$
9,575

 
$
13,261

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
 
 
Equity in excess distributed (undistributed) income of subsidiary bank
 
40,737

 
13,001

 
(962
)
Tax (benefit) provision realized from stock options exercised, share-based payment and dividends on unallocated ESOP shares
 
(112
)
 
13

 
93

Recognition of compensation related to ESOP shares and share based payment
 
1,395

 
1,223

 
1,185

Stock option compensation expense
 
20

 
71

 
106

Net change in other assets and liabilities
 
811

 
(489
)
 
7

Net cash provided by operating activities
 
63,865

 
23,394

 
13,690

Cash flows from investing activities:
 
 
 
 
 
 
ESOP loan principal repayments
 

 

 
161

Investment in subsidiary
 
(43,215
)
 
(21,666
)
 

Net cash (used in) provided by investing activities
 
(43,215
)
 
(21,666
)
 
161

Cash flows from financing activities:
 
 
 
 
 
 
Common stock cash dividends paid
 
(12,892
)
 
(6,672
)
 
(12,155
)
Proceeds from exercise of stock options
 
921

 
176

 
129

Tax benefit (provision) realized from stock options exercised, share-based payment and dividends on unallocated ESOP shares
 
112

 
(13
)
 
(93
)
Repurchase of common stock
 
(2,601
)
 
(8,825
)
 
(6,023
)
Net cash used in financing activities
 
(14,460
)
 
(15,334
)
 
(18,142
)
Net increase (decrease) in cash and cash equivalents
 
6,190

 
(13,606
)
 
(4,291
)
Cash and cash equivalents at beginning of year
 
2,645

 
16,251

 
20,542

Cash and cash equivalents at end of year
 
$
8,835

 
$
2,645

 
$
16,251



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(25)
Selected Quarterly Financial Data (Unaudited)
Results of operations on a quarterly basis were as follows:
 
 
 
Year Ended December 31, 2014
 
 
First
  Quarter  
 
Second
  Quarter  
 
Third
  Quarter  
 
Fourth
  Quarter  
 
 
(Dollars in thousands, except per share amounts)
Interest income
 
$
17,613

 
$
30,023

 
$
35,031

 
$
38,439

Interest expense
 
872

 
1,426

 
1,724

 
1,659

Net interest income
 
16,741

 
28,597

 
33,307

 
36,780

Provision for loan losses
 
458

 
691

 
594

 
2,851

Net interest income after provision for loan losses
 
16,283

 
27,906

 
32,713

 
33,929

Noninterest income
 
2,307

 
4,780

 
5,483

 
3,897

Noninterest expense
 
14,779

 
26,994

 
28,363

 
29,243

Income before provision for income taxes
 
3,811

 
5,692

 
9,833

 
8,583

Income tax expense
 
1,268

 
1,544

 
2,765

 
1,328

Net income
 
$
2,543

 
$
4,148

 
$
7,068

 
$
7,255

Basic earnings per common share
 
$
0.16

 
$
0.16

 
$
0.23

 
$
0.24

Diluted earnings per common share
 
0.16

 
0.16

 
0.23

 
0.24

Cash dividends declared on common stock
 
0.16

 

 
0.09

 
0.25

 
 
 
Year Ended December 31, 2013
 
 
First
  Quarter  
 
Second
  Quarter  
 
Third
  Quarter  
 
Fourth
  Quarter  
 
 
(Dollars in thousands, except per share amounts)
Interest income
 
$
17,484

 
$
16,859

 
$
18,533

 
$
18,552

Interest expense
 
946

 
919

 
952

 
907

Net interest income
 
16,538

 
15,940

 
17,581

 
17,645

Provision for loan losses
 
858

 
1,308

 
1,078

 
428

Net interest income after provision for loan losses
 
15,680

 
14,632

 
16,503

 
17,217

Noninterest income
 
2,282

 
2,357

 
2,582

 
2,430

Noninterest expense
 
13,719

 
13,007

 
14,285

 
18,504

Income before provision for income taxes
 
4,243

 
3,982

 
4,800

 
1,143

Income tax expense
 
1,358

 
1,292

 
1,510

 
433

Net income
 
$
2,885

 
$
2,690

 
$
3,290

 
$
710

Basic earnings per common share
 
$
0.19

 
$
0.18

 
$
0.20

 
$
0.04

Diluted earnings per common share
 
0.19

 
0.18

 
0.20

 
0.04

Cash dividends declared on common stock
 
0.08

 
0.08

 
0.18

 
0.08



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(26)
Subsequent Event
    
Subsequent to December 31, 2014, the Company sold the legacy Heritage Bank merchant card portfolio. The noninterest income related to this portfolio was recorded in the Company's Consolidated Statements of Income in Merchant Visa income, net. The total consideration of the sale was $2.2 million and will be recognized in noninterest income in the first quarter of 2015. Of this amount, $1.65 million was received by the Company at time of sale and $550,000 is held in escrow and is contingent on the performance of the portfolio in 2015. If certain performance thresholds are met, the payment will range between $440,000 and $550,000. If the thresholds are not met, no contingent payment will be made. The contingent payment is to be paid on or before December 31, 2015. This sale will impact future noninterest income.

F-79