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HERITAGE FINANCIAL CORP /WA/ - Quarter Report: 2012 March (Form 10-Q)

Quarterly Report on Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

 

 

 

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

For the quarterly period ended March 31, 2012 March 31, 2012

OR

 

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

Commission File Number 0-29480

 

 

HERITAGE FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

 

 

 

Washington   91-1857900

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

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

(360) 943-1500

(Registrant’s telephone number, including area code)

 

 

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

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

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

 

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

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

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

As of April 13, 2012 there were 15,475,757 common shares outstanding, with no par value, of the registrant.

 

 

 


Table of Contents

HERITAGE FINANCIAL CORPORATION

FORM 10-Q

INDEX

FORWARD LOOKING STATEMENT

 

          Page  

PART I.

  

Financial Information

  

Item 1.

  

Condensed Consolidated Financial Statements (Unaudited):

  
  

Condensed Consolidated Statements of Financial Condition as of March 31, 2012 and December 31, 2011

     4   
  

Condensed Consolidated Statements of Income for the Three Months Ended March 31, 2012 and 2011

     5   
  

Condensed Consolidated Statements of Comprehensive Income for the Three Months Ended March 31, 2012 and 2011

     6   
  

Condensed Consolidated Statements of Stockholders’ Equity for the Three Months Ended March 31, 2012

     6   
  

Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2012 and 2011

     7   
  

Notes to Condensed Consolidated Financial Statements

     8   

Item 2.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     40   

Item 3.

  

Quantitative and Qualitative Disclosures About Market Risk

     48   

Item 4.

  

Controls and Procedures

     48   

PART II.

  

Other Information

  

Item 1.

  

Legal Proceedings

     48   

Item 1A.

  

Risk Factors

     48   

Item 2.

  

Unregistered Sales of Equity Securities and Use of Proceeds

     49   

Item 3.

  

Defaults Upon Senior Securities

     49   

Item 4.

  

Mine Safety Disclosures

     49   

Item 5.

  

Other Information

     49   

Item 6.

  

Exhibits

     50   
  

Signatures

     51   
  

Certifications

  

 

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Forward Looking Statements

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

The Company cautions readers not to place undue reliance on any forward-looking statements. Moreover, you should treat these statements as speaking only as of the date they are made and based only on information then actually known to the Company. The Company does not undertake and specifically disclaims any obligation to revise any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements. These risks could cause our actual results for 2012 and beyond to differ materially from those expressed in any forward-looking statements by, or on behalf of, us, and could negatively affect the Company’s operating and stock price performance.

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

 

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ITEM 1. HERITAGE FINANCIAL CORPORATION

HERITAGE FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Dollars in thousands, except for per share amounts)

(Unaudited)

 

     March 31,
2012
    December 31,
2011
 
Assets     

Cash on hand and in banks

   $ 28,900      $ 30,193   

Interest earning deposits

     110,857        93,566   
  

 

 

   

 

 

 

Cash and cash equivalents

     139,757        123,759   

Investment securities available for sale

     143,186        144,602   

Investment securities held to maturity (fair value of $12,552 and $12,881)

     11,787        12,093   

Loans held for sale

     1,118        1,828   

Originated loans receivable

     837,346        837,924   

Less: Allowance for loan losses

     (22,563     (22,317
  

 

 

   

 

 

 

Originated loans receivable, net

     814,783        815,607   

Purchased covered loans receivable, net of allowance for loan losses of ($4,111 and $3,963)

     100,498        105,394   

Purchased non-covered loans receivable, net of allowance for loan losses of ($4,121 and $4,635)

     75,606        83,479   
  

 

 

   

 

 

 

Total loans receivable, net

     990,887        1,004,480   

FDIC indemnification asset

     8,921        10,350   

Other real estate owned ($705 and $774 covered by FDIC loss share, respectively)

     8,349        4,484   

Premises and equipment, net

     22,968        22,975   

Federal Home Loan Bank stock, at cost

     5,594        5,594   

Accrued interest receivable

     4,776        5,117   

Prepaid expenses and other assets

     11,986        8,190   

Deferred income taxes, net

     11,117        10,988   

Intangible assets, net

     1,406        1,513   

Goodwill

     13,012        13,012   
  

 

 

   

 

 

 

Total assets

   $ 1,374,864      $ 1,368,985   
  

 

 

   

 

 

 
Liabilities and Stockholders’ Equity     

Deposits

   $ 1,139,537      $ 1,136,044   

Securities sold under agreement to repurchase

     20,786        23,091   

Accrued expenses and other liabilities

     8,879        7,330   
  

 

 

   

 

 

 

Total liabilities

     1,169,202        1,166,465   

Stockholders’ equity:

    

Preferred stock, no par value, 2,500,000 shares authorized; no shares issued and outstanding at March 31, 2012 and December 31, 2011

     —          —     

Common stock, no par, 50,000,000 shares authorized; 15,476,460 and 15,456,297 shares outstanding at March 31, 2012 and December 31, 2011, respectively

     126,799        126,622   

Unearned compensation – Employee Stock Ownership Plan (“ESOP”)

     (71     (94

Retained earnings

     77,499        74,256   

Accumulated other comprehensive income , net

     1,435        1,736   
  

 

 

   

 

 

 

Total stockholders’ equity

     205,662        202,520   
  

 

 

   

 

 

 

Total liabilities and stockholders’ equity

   $ 1,374,864      $ 1,368,985   
  

 

 

   

 

 

 

See Notes to Condensed Consolidated Financial Statements.

 

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HERITAGE FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(Dollars in thousands, except for per share amounts)

(Unaudited)

 

     Three Months Ended
March 31,
 
     2012     2011  

INTEREST INCOME:

    

Interest and fees on loans

   $ 17,018      $ 16,572   

Taxable interest on investment securities

     652        663   

Nontaxable interest on investment securities

     256        179   

Interest on interest earning deposits

     63        79   
  

 

 

   

 

 

 

Total interest income

     17,989        17,493   

INTEREST EXPENSE:

    

Deposits

     1,277        1,875   

Other borrowings

     18        22   
  

 

 

   

 

 

 

Total interest expense

     1,295        1,897   
  

 

 

   

 

 

 

Net interest income

     16,694        15,596   

Provision for loan losses on originated loans

     —          2,595   

Provision for loan losses on purchased loans

     (109     1,778   
  

 

 

   

 

 

 

Net interest income after provision for loan losses

     16,803        11,223   

NON-INTEREST INCOME:

    

Gains on sales of loans, net

     63        151   

Service charges on deposits

     1,305        1,238   

Merchant Visa income, net

     170        130   

Change in FDIC indemnification asset

     (176     800   

Other income

     546        590   
  

 

 

   

 

 

 

Total non-interest income

     1,908        2,909   

NON-INTEREST EXPENSE:

    

Impairment loss on investment securities

     36        46   

Less: Portion recorded as other comprehensive loss

     —          (20
  

 

 

   

 

 

 

Impairment loss on investment securities, net

     36        26   

Salaries and employee benefits

     7,198        6,637   

Occupancy and equipment

     1,785        1,846   

Data processing

     591        823   

Marketing

     403        315   

Professional services

     554        633   

State and local taxes

     310        356   

Federal deposit insurance premium

     275        456   

Other real estate owned, net

     256        517   

Other expense

     1,190        1,474   
  

 

 

   

 

 

 

Total non-interest expense

     12,598        13,083   
  

 

 

   

 

 

 

Income before income taxes

     6,113        1,049   

Income tax expense

     1,943        285   
  

 

 

   

 

 

 

Net income

   $ 4,170      $ 764   
  

 

 

   

 

 

 

Earnings per common share:

    

Basic

   $ 0.27      $ 0.05   

Diluted

   $ 0.27      $ 0.05   

Dividends declared per common share:

   $ 0.06      $ —     

See Notes to Condensed Consolidated Financial Statements.

 

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HERITAGE FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Dollars in thousands, except for per share amounts)

(Unaudited)

 

     Three Months Ended
March 31,
 

Comprehensive Income

       2012             2011      

Net income

   $ 4,170      $ 764   

Change in fair value of securities available for sale, net of tax of $(176) and $(4)

     (327     (7

Other-than-temporary impairment on securities held to maturity, net of tax of $0 and $(7)

     —          (13

Accretion of other-than-temporary impairment on securities held to maturity, net of tax of $14 and $20

     26        36   
  

 

 

   

 

 

 

Other comprehensive (loss) income

     (301     16   
  

 

 

   

 

 

 

Comprehensive income

   $ 3,869      $ 780   
  

 

 

   

 

 

 

See Notes to Condensed Consolidated Financial Statements.

HERITAGE FINANCIAL CORPORATION

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

MARCH 31, 2012

(Dollars and shares in thousands)

(Unaudited)

 

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

Balance at December 31, 2011

     15,456      $ 126,622      $ (94   $ 74,256      $ 1,736      $ 202,520   

Restricted stock awards issued

     28        —          —          —          —          —     

Restricted stock awards canceled

     (1     —          —          —          —          —     

Stock option compensation expense

     —          42        —          —          —          42   

Share based payment and earned ESOP

     2        203        23        —          —          226   

Tax benefit associated with share based payment and unallocated ESOP

     —          46        —          —          —          46   

Common stock repurchased

     (9     (114     —          —          —          (114

Net income

     —          —          —          4,170        —          4,170   

Other comprehensive loss, net of tax

     —          —          —          —          (301     (301

Cash dividends declared on common stock

     —          —          —          (927     —          (927
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at March 31, 2012

     15,476      $ 126,799      $ (71   $ 77,499      $ 1,435      $ 205,662   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

See Notes to Condensed Consolidated Financial Statements.

 

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HERITAGE FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

For the three months ended March 31, 2012 and 2011

(Dollars in thousands)

(Unaudited)

 

     Three Months Ended
March 31,
 
     2012     2011  

Cash flows from operating activities:

    

Net income

   $ 4,170      $ 764   

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

    

Depreciation and amortization

     878        322   

Change in net deferred loan (costs) fees

     (55     18   

Provision for loan losses

     (109     4,373   

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

     (431     (3,636

Recognition of compensation related to ESOP shares and share based payment

     226        221   

Stock option compensation expense

     42        52   

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

     (46     (1

Amortization of intangible assets

     107        113   

Deferred income taxes

     34        —     

Impairment loss on investment securities

     36        26   

Origination of loans held for sale

     (3,260     (3,230

Gains on sales of loans, net

     (63     (151

Proceeds from sale of loans

     4,033        3,667   

Valuation adjustment on other real estate owned

     331        361   

Losses on sale of other real estate owned, net

     12        13   

Losses on sale of premises and equipment, net

     1        —     
  

 

 

   

 

 

 

Net cash provided by operating activities

     5,906        2,912   
  

 

 

   

 

 

 

Cash flows from investing activities:

    

Principal payments on loans, net of loans originated

     9,448        8,873   

Maturities of investment securities available for sale

     10,803        5,562   

Maturities of investment securities held to maturity

     389        570   

Purchases of investment securities available for sale

     (10,344     (14,361

Purchases of investment securities held to maturity

     —          (271

Purchases of premises and equipment

     (498     (1,060

Proceeds from sales of other real estate owned

     101        475   
  

 

 

   

 

 

 

Net cash provided by (used in) investing activities

     9,899        (212
  

 

 

   

 

 

 

Cash flows from financing activities:

    

Net increase (decrease) in deposits

     3,493        (36,556

Common stock cash dividends paid

     (927     —     

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

     (2,305     5,784   

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

     46        1   

Repurchase of common stock

     (114     —     
  

 

 

   

 

 

 

Net cash provided by (used in) financing activities

     193        (30,771
  

 

 

   

 

 

 

Net increase (decrease) in cash and cash equivalents

     15,998        (28,071
  

 

 

   

 

 

 

Cash and cash equivalents at beginning of period

     123,759        168,991   
  

 

 

   

 

 

 

Cash and cash equivalents at end of period

   $ 139,757      $ 140,920   
  

 

 

   

 

 

 

Supplemental disclosures of cash flow information:

    

Cash paid for interest

   $ 1,337      $ 1,957   

Cash paid for income taxes

     650        1,143   

Loans transferred to other real estate owned

   $ 4,309      $ 1,337   

See Notes to Condensed Consolidated Financial Statements.

 

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HERITAGE FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Three Months Ended March 31, 2012 and 2011

(Unaudited)

NOTE 1. Description of Business and Basis of Presentation

(a) Description of Business

Heritage Financial Corporation (the “Company”) is a bank holding company incorporated in the State of Washington in August 1997. The Company is primarily engaged in the business of planning, directing and coordinating the business activities of its wholly owned subsidiaries: Heritage Bank and Central Valley Bank (the “Banks”). The Banks are Washington-chartered commercial banks and their deposits are insured by the FDIC under the Deposit Insurance Fund (“DIF”). Heritage Bank conducts business from its main office in Olympia, Washington and its twenty-six branch offices located in western Washington and the greater Portland, Oregon area. Central Valley Bank conducts business from its main office in Toppenish, Washington and its five branch offices located in Yakima and Kittitas counties of Washington State.

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

Effective July 30, 2010, Heritage Bank entered into a definitive agreement with the FDIC, pursuant to which Heritage Bank acquired certain assets and assumed certain liabilities of Cowlitz Bank, a Washington state-chartered bank headquartered in Longview, Washington (the “Cowlitz Acquisition”). The Cowlitz Acquisition included nine branches of Cowlitz Bank, including its division Bay Bank, which opened as branches of Heritage Bank as of August 2, 2010. It also included the Trust Services Division of Cowlitz Bank. Effective November 5, 2010, Heritage Bank entered into a definitive agreement with the FDIC, pursuant to which Heritage Bank acquired certain assets and assumed certain liabilities of Pierce Commercial Bank, a Washington state-chartered bank headquartered in Tacoma, Washington (the “Pierce Commercial Acquisition”). The Pierce Commercial Acquisition included one branch, which opened as a branch of Heritage Bank as of November 8, 2010. The Cowlitz Acquisition and the Pierce Commercial Acquisition are collectively referred to as the “Cowlitz and Pierce Acquisitions.”

(b) Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with Generally Accepted Accounting Principles (“GAAP”), for interim financial information, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. These condensed consolidated financial statements should be read with our December 31, 2011 audited consolidated financial statements and its accompanying notes included in our Annual Report on Form 10-K (“Form 10-K”). In our opinion, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2012 are not necessarily indicative of the results that may be expected for the year ending December 31, 2012. In preparing the condensed consolidated financial statements, we are required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses. Actual results could differ from those estimates. Estimates related to fair value measurements, the allowance for loan losses, expected cash flows from and indemnification asset related to purchased loans, other real estate owned, other than temporary impairment of investment securities, goodwill and other intangible assets, stock-based compensation and income taxes are particularly subject to change.

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

(c) Significant Accounting Policies

The significant accounting policies used in preparation of our consolidated financial statements are disclosed in our 2011 Annual Form 10-K. There have not been any material changes in our significant accounting policies compared to those contained in our Form 10-K disclosure for the year ended December 31, 2011.

(d) Recently Issued Accounting Pronouncements

Financial Accounting Standards Board (“FASB”) Accounting Standards Updates (“ASU”) 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs, was issued in May 2011 as a result of the FASB and International Accounting Standards Board’s (IASB) goal to develop common requirements for measuring fair value and for disclosing information about fair value measurements in accordance with U.S. GAAP and International Financial Reporting

 

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Standards. The provisions of this Update are effective during the interim or annual periods beginning after December 15, 2011, and are to be applied prospectively. The adoption of the Update did not have a material effect on the Company’s consolidated financial statements, but the additional disclosures are included in Note 10.

FASB ASU 2011-05, Presentation of Comprehensive Income, was issued in June 2011 requiring that all non-owner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. This Update also requires that reclassification adjustments for items that are reclassified from other comprehensive income to net income be presented on the face of the financial statements. The provisions of this Update are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011, and are to be applied retrospectively. Early adoption is permitted. The adoption of the Update did not have a material effect on the Company’s consolidated financial statements at the date of adoption. The Company has presented condensed consolidated statements of comprehensive income for the three months ended March 31, 2012 and 2011 as a separate statement immediately following the condensed consolidated statements of income for the three months ended March 31, 2012 and 2011.

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

NOTE 2. Loans Receivable

The Company originates loans under the normal course of business. These loans are identified as “originated” loans. Disclosures related to the Company’s recorded investment in originated loans receivable generally exclude accrued interest receivable and deferred loan origination fees and costs due to their insignificance. The Company has also acquired loans through FDIC-assisted transactions. Loans acquired in a business acquisition are designated as “purchased” loans. The Bank refers to the purchased loans subject to the shared-loss agreements as “covered” loans, and those loans without a shared-loss agreement are referred to as “non-covered” loan. Loans purchased with evidence of credit deterioration since origination for which it is probable that all contractually required payments will not be collected are accounted for under FASB Accounting Standards Codification (“FASB ASC”) 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality. These loans are identified as “purchased impaired” loans. Loans purchased that are not accounted for under FASB ASC 310-30 are accounted for under FASB ASC 310-20, Receivables—Nonrefundable fees and Other Costs. These loans are identified as “purchased other” loans.

(a) Loan Origination/Risk Management

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

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

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

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

 

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

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

Real Estate Construction and Land Development: The Company originates construction loans for one-to-four family residential and for five or more residential properties and commercial properties. The one-to-four family residential construction loans generally include construction of custom homes whereby the home buyer is the borrower. The Company also provides financing to builders for the construction of pre-sold homes and, in selected cases, to builders for the construction of speculative residential property. Substantially all construction loans are short-term in nature and priced with a variable rate of interest. Construction lending can involve a higher level of risk than other types of lending because funds are advanced partially based upon the value of the project, which is uncertain prior to the project’s completion. Because of the uncertainties inherent in estimating construction costs as well as the market value of a completed project and the effects of governmental regulation of real property, the Company’s estimates with regards to the total funds required to complete a project and the related loan-to-value ratio may vary from actual results. As a result, construction loans often involve the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project and the ability of the borrower to sell or lease the property or refinance the indebtedness. If the Company’s estimate of the value of a project at completion proves to be overstated, it may have inadequate security for repayment of the loan and may incur a loss in the event the borrower does not repay the loan. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property or an interim loan commitment from the Company until permanent financing is obtained. These loans are closely monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being sensitive to interest rate changes, governmental regulation of real property, general economic conditions and the availability of long-term financing.

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

Originated loans receivable at March 31, 2012 and December 31, 2011 consisted of the following portfolio segments and classes:

 

     March 31, 2012     December 31, 2011  
     (In thousands)  

Commercial business:

    

Commercial and industrial

   $ 271,976      $ 273,590   

Owner-occupied commercial real estate

     176,637        166,881   

Non-owner occupied commercial real estate

     249,202        251,049   
  

 

 

   

 

 

 

Total commercial business

     697,815        691,520   

One-to-four family residential

     37,911        37,960   

Real estate construction and land development:

    

One-to-four family residential

     23,483        22,369   

Five or more family residential and commercial properties

     48,122        54,954   
  

 

 

   

 

 

 

Total real estate construction and land development

     71,605        77,323   

Consumer

     31,820        32,981   
  

 

 

   

 

 

 

Gross originated loans receivable

     839,151        839,784   

Net deferred loan fees

     (1,805     (1,860
  

 

 

   

 

 

 

Total originated loans receivable

   $ 837,346      $ 837,924   
  

 

 

   

 

 

 

 

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

 

     March 31, 2012     December 31, 2011  
     (In thousands)  

Commercial business:

    

Commercial and industrial

   $ 37,187      $ 38,607   

Owner-occupied commercial real estate

     37,516        38,067   

Non-owner occupied commercial real estate

     13,587        15,753   
  

 

 

   

 

 

 

Total commercial business

     88,290        92,427   

One-to-four family residential

     5,124        5,197   

Real estate construction and land development:

    

One-to-four family residential

     5,432        5,786   

Five or more family residential and commercial properties

     —          —     
  

 

 

   

 

 

 

Total real estate construction and land development

     5,432        5,786   

Consumer

     5,763        5,947   
  

 

 

   

 

 

 

Total purchased covered loans receivable

     104,609        109,357   

Allowance for loan losses

     (4,111     (3,963
  

 

 

   

 

 

 

Purchased covered loans receivable, net

   $ 100,498      $ 105,394   
  

 

 

   

 

 

 

The March 31, 2012 and December 31, 2011 gross recorded investment balance of purchased impaired covered loans accounted for under FASB ASC 310-30 was $74.0 million and $78.7 million, respectively. The gross recorded investment balance of purchased other covered loans was $30.6 million and $30.7 million at March 31, 2012 and December 31, 2011, respectively. As of March 31, 2012 and December 31, 2011, the recorded investment balance of purchased covered loans which are no longer covered under the FDIC loss-sharing agreements was $3.6 million and $3.8 million, respectively.

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

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

 

     March 31, 2012     December 31, 2011  
     (In thousands)  

Commercial business:

    

Commercial and industrial

   $ 30,949      $ 35,607   

Owner-occupied commercial real estate

     17,112        17,052   

Non-owner occupied commercial real estate

     12,732        12,833   
  

 

 

   

 

 

 

Total commercial business

     60,793        65,492   

One-to-four family residential

     3,117        2,743   

Real estate construction and land development:

    

One-to-four family residential

     1,118        1,381   

Five or more family residential and commercial properties

     1,209       1,078   
  

 

 

   

 

 

 

Total real estate construction and land development

     2,327        2,459   

Consumer

     13,490        17,420   
  

 

 

   

 

 

 

Total purchased non-covered loans receivable

     79,727        88,114   

Allowance for loan losses

     (4,121     (4,635
  

 

 

   

 

 

 

Purchased non-covered loans receivable, net

   $ 75,606      $ 83,479   
  

 

 

   

 

 

 

 

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The March 31, 2012 and December 31, 2011 gross recorded investment balance of impaired purchased non-covered loans accounted for under FASB ASC 310-30 was $49.2 million and $56.1 million, respectively. The recorded investment balance of other purchased non-covered loans was $30.5 million and $32.0 million at March 31, 2012 and December 31, 2011, respectively.

(b) Concentrations of Credit

Most of the Company’s lending activity occurs within the State of Washington, and to a lesser extent the State of Oregon. The primary market areas include Thurston, Pierce, King, Mason, Cowlitz and Clark counties in Washington and Multnomah county in Oregon, as well as other markets. The majority of the Company’s loan portfolio consists of commercial and industrial, non-owner occupied commercial real estate, and owner occupied commercial real estate. As of March 31, 2012 and December 31, 2011, there were no concentrations of loans related to any single industry in excess of 10% of total loans.

(c) Credit Quality Indicators

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

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

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

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

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

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

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

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

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

 

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The following tables present the balance of the originated loans receivable by credit quality indicator as of March 31, 2012 and December 31, 2011.

 

     March 31, 2012  
     Pass      OAEM      Substandard      Doubtful      Total  
     (In thousands)  

Commercial business:

              

Commercial and industrial

   $ 246,372       $ 3,904       $ 20,414       $ 1,286       $ 271,976   

Owner-occupied commercial real estate

     170,670         1,787         4,180         —           176,637   

Non-owner occupied commercial real estate

     237,613         2,969         8,620         —           249,202   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total commercial business

     654,655         8,660         33,214         1,286         697,815   

One-to-four family residential

     36,558         —           445         908         37,911   

Real estate construction and land development:

              

One-to-four family residential

     12,014         2,914         8,555         —           23,483   

Five or more family residential and commercial properties

     40,844         —           7,278         —           48,122   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total real estate construction and land development

     52,858         2,914         15,833         —           71,605   

Consumer

     31,501         100         74         145         31,820   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Gross originated loans

   $ 775,572       $ 11,674       $ 49,566       $ 2,339       $ 839,151   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
     December 31, 2011  
     Pass      OAEM      Substandard      Doubtful      Total  
     (In thousands)  

Commercial business:

              

Commercial and industrial

   $ 247,503       $ 2,770       $ 22,887       $ 430       $ 273,590   

Owner-occupied commercial real estate

     162,536         1,225         3,120         —           166,881   

Non-owner occupied commercial real estate

     240,096         2,063         8,890         —           251,049   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total commercial business

     650,135         6,058         34,897         430         691,520   

One-to-four family residential

     36,997         431         532         —           37,960   

Real estate construction and land development:

              

One-to-four family residential

     10,725         2,828         8,816         —           22,369   

Five or more family residential and commercial properties

     42,541         —           12,413         —           54,954   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total real estate construction and land development

     53,266         2,828         21,229         —           77,323   

Consumer

     32,629         —           346         6         32,981   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Gross originated loans

   $ 773,027       $ 9,317       $ 57,004       $ 436       $ 839,784   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

The tables above include impaired loan balances. Potential problem loans are those loans that are currently accruing interest and are not considered impaired, but which management is monitoring because the financial information of the borrower causes concern as to their ability to meet their loan repayment terms. Potential problem originated loans as of March 31, 2012 and December 31, 2011 were $31.3 million and $29.7 million, respectively. The balance of potential problem originated loans guaranteed by a governmental agency was $2.6 million and $2.8 million as of March 31, 2012 and December 31, 2011, respectively. This guarantee reduces the Company’s credit exposure.

 

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

 

     March 31, 2012  
     Pass      OAEM      Substandard      Doubtful      Total  
     (In thousands)  

Commercial business:

              

Commercial and industrial

   $ 13,570       $ 101       $ 755       $ —         $ 14,426   

Owner-occupied commercial real estate

     29,593         150        586         —           30,329   

Non-owner occupied commercial real estate

     4,364         1,040         437         —           5,841   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total commercial business

     47,527         1,291         1,778         —           50,596   

One-to-four family residential

     1,462         —           —           —           1,462   

Real estate construction and land development:

              

One-to-four family residential

     49         —           —           —           49   

Five or more family residential and commercial properties

     —           —           —           —           —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total real estate construction and land development

     49         —           —           —           49   

Consumer

     8,401         —           199        386        8,986   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Gross purchased other loans

   $ 57,439       $ 1,291       $ 1,977       $ 386      $ 61,093   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

     December 31, 2011  
     Pass      OAEM      Substandard      Doubtful      Total  
     (In thousands)  

Commercial business:

              

Commercial and industrial

   $ 11,781       $ 125       $ 780       $ —         $ 12,686   

Owner-occupied commercial real estate

     29,791         —           587         —           30,378   

Non-owner occupied commercial real estate

     4,427         1,046         441         —           5,914   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total commercial business

     45,999         1,171         1,808         —           48,978   

One-to-four family residential

     1,529         —           42         —           1,571   

Real estate construction and land development:

              

One-to-four family residential

     50         —           —           —           50   

Five or more family residential and commercial properties

     —           —           —           —           —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total real estate construction and land development

     50         —           —           —           50   

Consumer

     11,435         —           674        —           12,109   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Gross purchased other loans

   $ 59,013       $ 1,171       $ 2,524       $ —         $ 62,708   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

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

 

     March  31,
2012(1)
     December  31,
2011(1)
 
     (In thousands)  

Commercial business:

     

Commercial and industrial

   $ 7,005       $ 6,946   

Owner-occupied commercial real estate

     778         399   

Non-owner occupied commercial real estate

     292         921   
  

 

 

    

 

 

 

Total commercial business

     8,075         8,266   

One-to-four family residential

     1,226         —     

Real estate construction and land development:

     

One-to-four family residential

     4,043         5,150   

Five or more family residential and commercial properties

     4,663         9,797   
  

 

 

    

 

 

 

Total real estate construction and land development

     8,706         14,947   

Consumer

     191         125   
  

 

 

    

 

 

 

Gross originated nonaccrual loans

   $ 18,198       $ 23,338   
  

 

 

    

 

 

 

 

(1) $2.4 million and $1.8 million of nonaccrual originated loans were guaranteed by governmental agencies at March 31, 2012 and December 31, 2011, respectively.

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

 

     March  31,
2012
     December  31,
2011
 
     (In thousands)  

Commercial business:

     

Commercial and industrial

   $ 272       $ —     

Owner-occupied commercial real estate

     —           —     

Non-owner occupied commercial real estate

     437         —     
  

 

 

    

 

 

 

Total commercial business

     709         —     

Consumer

     393         497   
  

 

 

    

 

 

 

Gross purchased other nonaccrual loans

   $ 1,102       $ 497   
  

 

 

    

 

 

 

The Company performs aging analysis of past due loans using the categories of 30-89 days past due and 90 or more days past due. This policy is consistent with regulatory reporting requirements. The balances of originated past due loans, segregated by segments and classes of loans, as of March 31, 2012 and December 31, 2011 were as follows:

 

     March 31, 2012  
     30-89 Days      90 Days or
Greater
     Total Past Due      Current      Total      90 Days or More
and Still
Accruing
 
     (In thousands)  

Commercial business:

                 

Commercial and industrial

   $ 2,618       $ 3,644       $ 6,262       $ 265,714       $ 271,976       $ 75   

Owner-occupied commercial real estate

     119         435         554         176,083         176,637         160   

Non-owner occupied commercial real estate

     920        —           920         248,282         249,202         —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total commercial business

     3,657         4,079         7,736         690,079         697,815         235   

One-to-four family residential

     664         908         1,572         36,339         37,911         —     

Real estate construction and land development:

                 

One-to-four family residential

     89        4,043         4,132         19,351         23,483         —     

Five or more family residential and commercial properties

     —           4,301         4,301         43,821         48,122         —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total real estate construction and land development

     89         8,344         8,433         63,172         71,605         —     

Consumer

     40         191         231         31,589         31,820         —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Gross originated loans

   $ 4,450       $ 13,522       $ 17,972       $ 821,179       $ 839,151       $ 235   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

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Table of Contents
     December 31, 2011  
     30-89 Days      90 Days or
Greater
     Total Past Due      Current      Total      90 Days or More
and Still
Accruing
 
     (In thousands)  

Commercial business:

                 

Commercial and industrial

   $ 3,716       $ 4,769       $ 8,485       $ 265,105       $ 273,590       $ 921   

Owner-occupied commercial real estate

     1,903         398         2,301         164,580         166,881         —     

Non-owner occupied commercial real estate

     369        —           369         250,680         251,049         —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total commercial business

     5,988         5,167         11,155         680,365         691,520         921   

One-to-four family residential

     1,251         404         1,655         36,305         37,960         404   

Real estate construction and land development:

                 

One-to-four family residential

     582        5,150         5,732         16,637         22,369         —     

Five or more family residential and commercial properties

     369         9,428         9,797         45,157         54,954         —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total real estate construction and land development

     951         14,578         15,529         61,794         77,323         —     

Consumer

     465         60         525         32,456         32,981         3  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Gross originated loans

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

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

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Table of Contents

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

 

     March 31, 2012  
     30-89 Days      90 Days or
Greater
     Total Past Due      Current      Total      90 Days or More
and Still
Accruing
 
     (In thousands)  

Commercial business:

                 

Commercial and industrial

   $ —         $ —         $ —         $ 14,426       $ 14,426       $ —     

Owner-occupied commercial real estate

     150         —           150         30,179         30,329         —     

Non-owner occupied commercial real estate

     437         —           437         5,404         5,841         —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total commercial business

     587         —           587         50,009         50,596         —     

One-to-four family residential

     —           —           —           1,462         1,462         —     

Real estate construction and land development:

                 

One-to-four family residential

     —           —           —           49         49         —     

Five or more family residential and commercial properties

     —           —           —           —           —           —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total real estate construction and land development

     —           —           —           49         49         —     

Consumer

     412         386        798         8,188         8,986         —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Gross purchased other loans

   $ 999       $ 386      $ 1,385       $ 59,708       $ 61,093       $ —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

     December 31, 2011  
     30-89 Days      90 Days or
Greater
     Total Past Due      Current      Total      90 Days or More
and Still
Accruing
 
     (In thousands)  

Commercial business:

                 

Commercial and industrial

   $ 243       $ 15      $ 258       $ 12,428       $ 12,686       $ 15   

Owner-occupied commercial real estate

     151         —           151         30,227         30,378         —     

Non-owner occupied commercial real estate

     441         —           441         5,473         5,914         —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total commercial business

     835         15        850         48,128         48,978         15   

One-to-four family residential

     42         —           42        1,529         1,571         —     

Real estate construction and land development:

                 

One-to-four family residential

     —           —           —           50         50         —     

Five or more family residential and commercial properties

     —           —           —           —           —           —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total real estate construction and land development

     —           —           —           50         50         —     

Consumer

     757         490        1,247         10,862         12,109         —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Gross purchased other loans

   $ 1,634       $ 505      $ 2,139       $ 60,569       $ 62,708       $ 15   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

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Table of Contents

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

 

     March 31, 2012  
     Recorded
Investment With
No Specific
Valuation
Allowance
     Recorded
Investment With
Specific
Valuation
Allowance
     Total
Recorded
Investment
     Unpaid
Contractual
Principal
Balance
     Related
Specific
Valuation
Allowance
     Average
Recorded
Investment
 
     (In thousands)  

Commercial business:

                 

Commercial and industrial

   $ 5,060       $ 6,347       $ 11,407       $ 13,930       $ 2,035       $ 11,774   

Owner-occupied commercial real estate

     597         1,918         2,515         1,953         464         1,951   

Non-owner occupied commercial real estate

     3,269         4,301         7,570         7,570         751        7,585   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total commercial business

     8,926         12,566         21,492         23,453         3,250         21,310   

One-to-four family residential

     —           1,654         1,654         833         274         834   

Real estate construction and land development:

                 

One-to-four family residential

     1,098         3,706         4,804         5,693         1,115         4,604   

Five or more family residential and commercial properties

     —           4,663         4,663         4,721         774         4,904   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total real estate construction and land development

     1,098         8,369         9,467         10,414         1,889         9,508   

Consumer

     49         142         191         49        32         49   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Gross originated loans

   $ 10,073       $ 22,731       $ 32,804       $ 34,749       $ 5,445       $ 31,701   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

     December 31, 2011  
     Recorded
Investment With
No Specific
Valuation
Allowance
     Recorded
Investment With
Specific
Valuation
Allowance
     Total
Recorded
Investment
     Unpaid
Contractual
Principal
Balance
     Related
Specific
Valuation
Allowance
     Average
Recorded
Investment
 
     (In thousands)  

Commercial business:

                 

Commercial and industrial

   $ 4,532       $ 6,139       $ 10,671       $ 10,586       $ 1,488       $ 11,218   

Owner-occupied commercial real estate

     603         1,368         1,971         2,271         107         1,860   

Non-owner occupied commercial real estate

     3,915         4,314         8,229         9,980         764        5,014   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total commercial business

     9,050         11,821         20,871         22,837         2,359         18,092   

One-to-four family residential

     —           835         835         1,046         187         837   

Real estate construction and land development:

                 

One-to-four family residential

     748         4,765         5,513         6,813         1,436         5,748   

Five or more family residential and commercial properties

     963         8,835         9,798         14,219         530         10,236   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total real estate construction and land development

     1,711         13,600         15,311         21,032         1,966         15,984   

Consumer

     120         6         126         159        6         168   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Gross originated loans

   $ 10,881       $ 26,262       $ 37,143       $ 45,074       $ 4,518       $ 35,081   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

The Company had governmental guarantees of $2.4 million and $1.8 million related to the impaired originated loan balances at March 31, 2012 and December 31, 2011, respectively.

The Company had $28,000 and $9,000 of purchased other impaired loans as of March 31, 2012 and December 31, 2011, respectively. The recorded investment balances for the purchased other impaired consumer loan was $9,000 with a specific valuation allowance of $5,000 as of March 31, 2012 and December 31, 2011. The recorded investment balance for the commercial and industrial loan was $19,000 with no related specific valuation allowance as of March 31, 2012. The commercial and industrial loan was not impaired as of December 31, 2011. The unpaid contractual balances of the purchased other impaired loans and the average recorded investment were equal to the recorded investment balances for both period ends.

 

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Table of Contents

For the three months ended March 31, 2012 and March 31, 2011 no interest income was recognized subsequent to a loan’s classification as impaired.

(f) Troubled Debt Restructured Loans

A troubled debt restructured loan (“TDR”) is a restructuring in which the Banks, for economic or legal reasons related to a borrower’s financial difficulties, grants a concession to the borrower that it would not otherwise consider. TDRs are considered impaired and are separately measured for impairment under ASC 310-10-35, whether on accrual or nonaccrual status. At March 31, 2012 and December 31, 2011, the balance of originated accruing TDRs was $14.6 million and $13.8 million, respectively. The related allowance for loan losses on the originated accruing TDRs was $1.7 million and $1.4 million as of March 31, 2012 and December 31, 2011, respectively. At March 31, 2012, originated non-accruing TDRs were $10.7 million and had a related allowance for loan losses of $2.1 million. At December 31, 2011, originated non-accruing TDRs of $11.7 million had a related allowance for loan losses of $1.8 million.

Originated troubled debt restructured loans that were modified during the three-months ended March 31, 2012 and March 31, 2011 are set forth in the following table:

 

     March 31,  
     2012      2011  
     Number of
Contracts
     Outstanding
Principal Balance
     Number of
Contracts
     Outstanding
Principal Balance
 

Commercial business:

           

Commercial and industrial

     6       $ 1,441         5       $ 917   

Owner-occupied commercial real estate

     1         199         1         206   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total commercial business

     7         1,640         6         1,123   

Real estate construction and land development:

           

One-to-four family residential

     3         578         2         364   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total real estate construction and land development

     3         578         2         364   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total originated TDRs

     10       $ 2,218         8       $ 1,487   
  

 

 

    

 

 

    

 

 

    

 

 

 

The Banks’ recorded investment in the loans shown in the table above did not change as a result of the modifications as the Banks did not forgive any principal or interest balance as part of the modification.

Heritage Bank also recorded a TDR for a non-performing purchased other covered loan during the three-months ended March 31, 2012. The recorded investment balance of this commercial and industrial loan was $19,000, with no related allowance for loan loss at March 31, 2012. There were no purchased other loans modified during the three-months ended March 31, 2011.

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

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

 

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Table of Contents

The balance of TDRs modified during the twelve-months ended March 31, 2012 and March 31, 2011 that subsequently defaulted within the three-months ended March 31, 2012 and March 31, 2011 after the restructure date were as follows:

 

     March 31,  
     2012      2011  
     Number of
Contracts
     Outstanding
Principal Balance
     Number of
Contracts
     Outstanding
Principal Balance
 
     (In thousands)  

Commercial business:

           

Commercial and industrial

     3       $ 360         —         $ —     
  

 

 

    

 

 

    

 

 

    

 

 

 

Total commercial business

     3         360         —           —     
  

 

 

    

 

 

    

 

 

    

 

 

 

Total originated TDRs

     3       $ 360         —         $ —     
  

 

 

    

 

 

    

 

 

    

 

 

 

Of the restructured loans as of March 31, 2012 in the table above, the defaults of the three commercial and industrial loans were the results of granting additional extensions on the credits after they had been classified as TDRs. The Banks typically grant shorter extension periods to continually monitor the troubled credits despite the fact that the extended date might not be the date we expect the cash flow. The Banks have considered these subsequent defaults in our allowance for loan loss calculations. At March 31, 2012, the allowance for loan losses related to the defaulted loans was $23,000. There were no subsequent defaults during the three-months ended March 31, 2011.

(g) Impaired Purchased Loans

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

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

 

     Cowlitz Bank  
     March 31,
2012
     December 31,
2011
 
     (In thousands)  

Purchased covered loans:

     

Commercial business:

     

Commercial and industrial

   $ 34,526       $ 36,267   

Owner-occupied commercial real estate

     19,128         19,601   

Non-owner occupied commercial real estate

     13,972         16,212   
  

 

 

    

 

 

 

Total commercial business

     67,626         72,080   

One-to-four family residential

     4,345         4,371   

Real estate construction and land development:

     

One-to-four family residential

     7,569         8,524   

Five or more family residential and commercial properties

     —           —     
  

 

 

    

 

 

 

Total real estate construction and land development

     7,569         8,524   

Consumer

     3,633         3,917   
  

 

 

    

 

 

 

Gross purchased impaired covered loans

     83,173         88,892   

Purchased non-covered loans:

     

Consumer

     407         435   
  

 

 

    

 

 

 

Total purchased impaired loans

   $ 83,580       $ 89,327   
  

 

 

    

 

 

 

The total balance of subsequent advances on the purchased impaired covered loans was $10.5 million as of March 31, 2012 and December 31, 2011. Heritage Bank has the option to modify certain purchased covered loans which may terminate the FDIC loss-share coverage on those modified loans. As of March 31, 2012 and December 31, 2011, the recorded investment balance of purchased impaired covered loans which are no longer covered under the FDIC loss-sharing agreements was $1.5 million and $2.0 million, respectively. Heritage Bank continues to report these loans in the covered portfolio as they are in a pool and they continue to be accounted for under FASB ASC 310-30. The FDIC indemnification asset has been properly adjusted to reflect the change in the loan status.

 

20


Table of Contents
     Pierce Commercial Bank  
     March 31, 2012      December 31, 2011  
     (In thousands)  

Purchased non-covered loans:

     

Commercial business:

     

Commercial and industrial

   $ 27,771       $ 34,352   

Owner-occupied commercial real estate

     6,985         7,043   

Non-owner occupied commercial real estate

     8,546         8,624   
  

 

 

    

 

 

 

Total commercial business

     43,302         50,019   

One-to-four family residential

     3,426         3,506   

Real estate construction and land development:

     

One-to-four family residential

     6,564         7,244   

Five or more family residential and commercial properties

     1,855         3,797   
  

 

 

    

 

 

 

Total real estate construction and land development

     8,419         11,041   

Consumer

     5,568         6,205   
  

 

 

    

 

 

 

Gross purchased impaired non-covered loans

   $ 60,715       $ 70,771   
  

 

 

    

 

 

 

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

The following table summarizes the accretable yield on the Cowlitz Bank and Pierce Commercial Bank purchased impaired loans for the three months ended March 31, 2012 and 2011:

 

     Three Months Ended
March 31, 2012
 
     Cowlitz Bank     Pierce
Commercial
Bank
 
     (In thousands)  

Balance at the beginning of period

   $ 19,912      $ 14,638   

Accretion

     (1,916     (1,571

Disposals and other

     (239     (519

Change in accretable yield

     67        —     
  

 

 

   

 

 

 

Balance at the end of period

   $ 17,824      $ 12,548   
  

 

 

   

 

 

 

 

     Three Months Ended
March 31, 2011
 
     Cowlitz Bank     Pierce
Commercial
Bank
 
     (In thousands)  

Balance at the beginning of period

   $ 20,082      $ 10,943   

Accretion

     (2,068     (1,125

Disposals and other

     1,518        433   

Change in accretable yield

     5,953        —     
  

 

 

   

 

 

 

Balance at the end of period

   $ 25,485      $ 10,251   
  

 

 

   

 

 

 

 

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Table of Contents

NOTE 3. Allowance for Loan Losses

The allowance for loan losses is maintained at a level deemed appropriate by management to adequately provide for known and inherent risks in the loan portfolio. A summary of the changes in the originated loans’ allowance for loan losses for the three months ended March 31, 2012 and March 31, 2011 are as follows:

 

     Three Months Ended
March 31,
 
     (In thousands)  
     2012     2011  

Balance at the beginning of period

   $ 22,317      $ 22,062   

Loans charged off

     (1,334     (3,994

Recoveries of loans previously charged off

     1,580        719   

Provision charged to operations

     —          2,595   
  

 

 

   

 

 

 

Balance at the end of period

   $ 22,563      $ 21,382   
  

 

 

   

 

 

 

A summary of the changes in the purchased loans’ allowance for loan losses for the three months ended March 31, 2012 and March 31, 2011 are as follows:

 

     Three Months Ended March 31,  
     2012     2011  
     (In thousands)     (In thousands)  
     Purchased
Covered
    Purchased
Non-Covered
    Purchased
Covered
     Purchased
Non-Covered
 

Balance at the beginning of period

   $ 3,963      $ 4,635      $ —         $ —     

Loans charged off

     (33     (224     —           —     

Provision charged to operations

     181        (290     1,512         266   
  

 

 

   

 

 

   

 

 

    

 

 

 

Balance at the end of period

   $ 4,111      $ 4,121      $ 1,512       $ 266   
  

 

 

   

 

 

   

 

 

    

 

 

 

 

22


Table of Contents

The following table details activity in the allowance for loan losses disaggregated on the basis of the Company’s impairment method as of and for the three months ended March 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 three months ended March 31, 2012:

                     

December 31, 2011

   $ 11,805      $ 2,979       $ 4,394       $ 794      $ 4,823      $ 3,800      $ 1,410      $ 910       $ 30,915   

Charge-offs

     (489     —           —           (42     (371     (445     (244     —           (1,591

Recoveries

     1,428        —           11        —          125        —          16        —           1,580   

Provisions

     (1,049     689         19         105        (538     322        278        65         (109
  

 

 

   

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

March 31, 2012

   $ 11,695      $ 3,668       $ 4,424       $ 857      $ 4,039      $ 3,677      $ 1,460      $ 975       $ 30,795   
  

 

 

   

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

Allowance for loan losses as of March 31, 2012 allocated to:

                     

Originated loans individually evaluated for impairment

   $ 2,035      $ 464       $ 751      $ 274      $ 1,115      $ 774      $ 32      $ —         $ 5,445   

Originated loans collectively evaluated for impairment

     6,276        1,814         2,352        224        2,039        2,821        617        975        17,118   

Purchased other covered loans individually evaluated for impairment

     —          —           —           —          —          —          5       —           5   

Purchased other covered loans collectively evaluated for impairment

     48        69         —           21       —          —          7        —           145   

Purchased other non-covered loans collectively evaluated for impairment

     85        52         34        16       —          —          63       —           250   

Purchased impaired covered loans collectively evaluated for impairment

     1,136        964         962         123        638        —          138        —           3,961   

Purchased impaired non-covered loans collectively evaluated for impairment

     2,115        305         325         199        247        82        598        —           3,871   
  

 

 

   

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

March 31, 2012

   $ 11,695      $ 3,668       $ 4,424       $ 857      $ 4,039      $ 3,677      $ 1,460      $ 975       $ 30,795   
  

 

 

   

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

The purchased loans acquired in the Cowlitz and Pierce Acquisitions are subject to the Company’s internal and external credit review. If and when credit deterioration occurs subsequent to the acquisition dates, a provision for loan losses will be charged to earnings for the full amount without regard to the FDIC loss-sharing agreement for the covered loan balances. The portion of the estimated loss reimbursable from the FDIC is recorded in noninterest income and increases the FDIC indemnification asset.

 

23


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 March 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      Total  
     (In thousands)  

Originated loans individually evaluated for impairment

   $ 11,407       $ 2,515       $ 7,570       $ 1,654       $ 4,804       $ 4,663       $ 191      $ 32,804   

Originated loans collectively evaluated for impairment

     260,569         174,122         241,632         36,257         18,679         43,459         31,629         806,347   

Purchased other covered loans individually evaluated for impairment

     19         —           —           —           —           —           9         28   

Purchased other covered loans collectively evaluated for impairment

     7,360         19,428         316         1,400         49         —           2,041         30,594   

Purchased other non-covered loans collectively evaluated for impairment

     7,047         10,901         5,525         62         —           —           6,936         30,471   

Purchased impaired covered loans collectively evaluated for impairment

     29,808         18,088         13,271         3,724         5,383         —           3,713         73,987   

Purchased impaired non-covered loans collectively evaluated for impairment

     23,902         6,211         7,207         3,055         1,118         1,209         6,554         49,256   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total gross loans receivable as of March 31, 2012

   $ 340,112       $ 231,265       $ 275,521       $ 46,152       $ 30,033       $ 49,331       $ 51,073       $ 1,023,487   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

24


Table of Contents

The following table details the balance in the allowance for loan losses disaggregated on the basis of the Company’s impairment method for the three-months ended March 31, 2011 and as of December 31, 2011:

 

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

properties
    Consumer     Unallocated     Total  
     (In thousands)  

Allowance for loan losses for the three months ended March 31, 2011:

                    

December 31, 2010

   $ 10,487      $ 1,674       $ 2,189       $ 500      $ 4,321      $ 1,114      $ 846      $ 931      $ 22,062   

Charge-offs

     (1,228     —           —           (15     (1,906     (742     (103     —          (3,994

Recoveries

     688        —           25        —          —          —          6        —          719   

Provisions

     638        736         582         (78     1,311        1,445        28        (289     4,373   
  

 

 

   

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

March 31, 2011

   $ 10,585      $ 2,410       $ 2,796       $ 407      $ 3,726      $ 1,817      $ 1,410      $ 642      $ 23,160   
  

 

 

   

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Allowance for loan losses as of December 31, 2011 allocated to:

                    

Originated loans individually evaluated for impairment

   $ 1,488      $ 107       $ 764      $ 187      $ 1,436      $ 530      $ 6      $ —        $ 4,518   

Originated loans collectively evaluated for impairment

     6,519        1,690         2,320        229        2,427        3,163        541        910       17,799   

Purchased other covered loans individually evaluated for impairment

     —          —           —           —          —          —          5       —          5   

Purchased other covered loans collectively evaluated for impairment

     48        69         —           21       —          —          32        —          170   

Purchased other non-covered loans collectively evaluated for impairment

     85        52         34        11       —          —          43       —          225   

Purchased impaired covered loans collectively evaluated for impairment

     1,282        712         900         123        645        —          126        —          3,788   

Purchased impaired non-covered loans collectively evaluated for impairment

     2,383        349         376         223        315        107        657        —          4,410   
  

 

 

   

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

December 31, 2011

   $ 11,805      $ 2,979       $ 4,394       $ 794      $ 4,823      $ 3,800      $ 1,410      $ 910      $ 30,915   
  

 

 

   

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

25


Table of Contents

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

 

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

Originated loans individually evaluated for impairment

   $ 10,671       $ 1,971       $ 8,229       $ 835       $ 5,513       $ 9,798       $ 126      $ 37,143   

Originated loans collectively evaluated for impairment

     262,919         164,910         242,820         37,125         16,856         45,156         32,855         802,641   

Purchased other covered loans individually evaluated for impairment

     —           —           —           —           —           —           9         9   

Purchased other covered loans collectively evaluated for impairment

     7,317         19,567         320         1,467         50         —           1,947         30,668   

Purchased other non-covered loans collectively evaluated for impairment

     5,369         10,811         5,594         104         —           —           10,153         32,031   

Purchased impaired covered loans collectively evaluated for impairment

     31,290         18,500         15,433         3,730         5,736         —           3,991         78,680   

Purchased impaired non-covered loans collectively evaluated for impairment

     30,238         6,241         7,239         2,639         1,381         1,078         7,267         56,083   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total gross loans receivable as of December 31, 2011

   $ 347,804       $ 222,000       $ 279,635       $ 45,900       $ 29,536       $ 56,032       $ 56,348       $ 1,037,255   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

NOTE 4. FDIC Indemnification Asset

Changes in the FDIC indemnification asset during the three months ended March 31, 2012 and March 31, 2011 are as follows:

 

     Three Months Ended March 31,  
     2012     2011  
     (In thousands)  

Beginning Balance

   $ 10,350      $ 16,071   

Cash payments received from the FDIC

     (1,253     (2

FDIC share of additional estimated losses

     341        1,221   

Net amortization

     (517     (421
  

 

 

   

 

 

 

Balance at March 31, 2012

   $ 8,921      $ 16,869   
  

 

 

   

 

 

 

 

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Table of Contents

NOTE 5. Stockholders’ Equity

(a) Earnings Per Share

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

 

     Three Months Ended
March 31,
 
     2012     2011  
     (Dollars in thousands)  

Net income:

    

Net income

   $ 4,170      $ 764   

Dividends and undistributed earnings allocated to participating securities

     (57     (10
  

 

 

   

 

 

 

Net income allocated to common shareholders

   $ 4,113      $ 754   
  

 

 

   

 

 

 

Basic:

    

Weighted average common shares outstanding

     15,465,510        15,448,109   

Less: Restricted stock awards

     (170,821     (151,952
  

 

 

   

 

 

 

Total basic weighted average common shares outstanding

     15,294,689        15,296,157   
  

 

 

   

 

 

 

Diluted:

    

Basic weighted average common shares outstanding

     15,294,689        15,296,157   

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

     73,343       75,945  
  

 

 

   

 

 

 

Total diluted weighted average common shares outstanding

     15,368,032        15,372,102   
  

 

 

   

 

 

 

Potential dilutive shares are excluded from the computation of earnings per share if their effect is anti-dilutive. For the three months ended March 31, 2012 and March 31, 2011 anti-dilutive shares outstanding related to options and warrants to acquire common stock totaled 305,660 and 561,743, respectively, as the exercise price was in excess of the market value.

(b) Dividends

Common Stock: The timing and amount of cash dividends paid on our common stock depends on the Company’s earnings, capital requirements, financial condition and other relevant factors. Dividends on common stock from the Company depend substantially upon receipt of dividends from the Banks, which are the Company’s predominant sources of income. On February 1, 2012, the Company’s Board of Directors declared a dividend of $0.06 per share payable on February 24, 2012 to shareholders of record on February 10, 2012. Additionally, on April 26, 2012, the Company’s Board of Directors declared a dividend of $0.08 per share payable on May 24, 2012, to shareholders of record on May 10, 2012.

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

(c) Preferred Stock and Warrants

On November 21, 2008, the Company completed a sale to the U.S. Department of the Treasury (“Treasury”) of 24,000 shares of the Company’s Fixed Rate Cumulative Perpetual Preferred Stock, Series A (“preferred shares”), for an aggregate purchase price of $24.0 million in cash, with a related warrant to purchase 276,074 shares of the Company’s common stock. On December 22, 2010, the Company redeemed the 24,000 preferred shares. The Company paid the Treasury a total of $24.1 million, consisting of $24.0 million of principal and $123,000 of accrued and unpaid dividends.

Under the terms of the warrants, because the Company’s September 2009 offering of common stock, described below, was a “qualified equity offering” resulting in aggregate gross proceeds of at least $24.0 million, the number of shares of the Company’s common stock underlying the warrant was reduced by 50% to 138,037 shares. On August 17, 2011, the Company repurchased the warrant from the Treasury for $450,000. The warrant repurchase, together with the Company’s earlier redemption of the entire amount of the preferred shares issued to the Treasury, represents full repayment of all TARP obligations and cancellation of all equity interests in the Company held by the Treasury.

 

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Table of Contents

NOTE 6. Stock-Based Compensation

(a) Stock Options

The company measures the fair value of each stock option grant at the date of the grant, using the Black-Scholes-Merton option pricing model. There were no options granted during the three months ended March 31, 2012 and 2011.

For the three months ended March 31, 2012 the Company recognized compensation expense related to stock options of $42,000 and a related tax benefit of $1,000. For the three months ended March 31, 2011 the Company recognized compensation expense related to stock options of $51,000 and a related tax benefit of $3,000. As of March 31, 2012, the total unrecognized compensation expense related to non-vested stock options was $148,000 and the related weighted average period over which it is expected to be recognized is approximately 2.0 years.

The following table summarizes stock option activity for the three months ended March 31, 2012.

 

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

Outstanding at December 31, 2011

     417,123      $ 18.33         

Granted

     —        $ —           

Exercised

     —        $ —           

Forfeited or expired

     (66,745   $ 20.24         
  

 

 

         

Outstanding at March 31, 2012

     350,378      $ 17.97         3.7 years       $ 204   
  

 

 

   

 

 

    

 

 

    

 

 

 

Expected to vest at March 31, 2012

     348,040      $ 17.97         3.7 years       $ 204   
  

 

 

   

 

 

    

 

 

    

 

 

 

Exercisable at March 31, 2012

     284,407      $ 18.71         2.8 years       $ 204   
  

 

 

   

 

 

    

 

 

    

 

 

 

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

 

     Shares     Weighted-
Average

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

Outstanding at December 31, 2010

     550,524      $ 18.70         

Granted

     —        $ —           

Exercised

     (50   $ 11.35         

Forfeited or expired

     (104,972   $ 20.26         
  

 

 

         

Outstanding at March 31, 2011

     445,502      $ 18.34         4.1 years       $ 279   
  

 

 

   

 

 

    

 

 

    

 

 

 

Expected to vest at March 31, 2011

     438,424      $ 18.40         4.1 years       $ 278   
  

 

 

   

 

 

    

 

 

    

 

 

 

Exercisable at March 31, 2011

     314,071      $ 20.18         2.5 years       $ 186   
  

 

 

   

 

 

    

 

 

    

 

 

 

(b) Restricted Stock Awards

For the three months ended March 31, 2012 the Company recognized compensation expense related to restricted stock awards of $195,000 and a related tax benefit of $68,000. For the three months ended March 31, 2011 the Company recognized compensation expense related to restricted stock awards of $188,000 and a related tax benefit of $66,000. As of March 31, 2012, the total unrecognized compensation expense related to non-vested restricted stock awards was $1.6 million and the related weighted average period over which it is expected to be recognized is approximately 2.2 years.

 

28


Table of Contents

The following table summarizes restricted stock award activity for the three months ended March 31, 2012.

 

     Shares     Weighted-
Average
Grant
Date Fair
Value
 

Nonvested at December 31, 2011

     164,880      $ 16.29   

Granted

     28,390      $ 14.08   

Vested

     (19,574   $ 14.83   

Forfeited

     (1,541   $ 18.19   
  

 

 

   

Nonvested at March 31, 2012

     172,155      $ 16.08   
  

 

 

   

 

 

 

The grant date fair value of restricted stock awards vested during the period ending March 31, 2012 was $290,000.

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

 

     Shares      Weighted-
Average
Grant
Date Fair
Value
 

Nonvested at December 31, 2010

     118,379       $ 18.29   

Granted

     78,403       $ 14.85   

Vested

     —         $ —     

Forfeited

     —         $ —     
  

 

 

    

Nonvested at March 31, 2011

     196,785       $ 16.08   
  

 

 

    

 

 

 

 

29


Table of Contents

NOTE 7. Investment Securities

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

 

Securities Available for Sale

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

March 31, 2012

          

U.S. Treasury and U.S. Government-sponsored agencies

   $ 27,554       $ 164       $ —        $ 27,718   

Municipal securities

     34,620         1,214         (61     35,773   

Corporate securities

     7,006         46         —          7,052   

Mortgage backed securities and collateralized mortgage obligations-residential:

          

U.S. Government-sponsored agencies

     71,270         1,486         (113     72,643   
  

 

 

    

 

 

    

 

 

   

 

 

 

Total

   $ 140,450       $ 2,910       $ (174   $ 143,186   
  

 

 

    

 

 

    

 

 

   

 

 

 

December 31, 2011

          

U.S. Treasury and U.S. Government-sponsored agencies

   $ 31,069       $ 238       $ —        $ 31,307   

Municipal securities

     31,847         1,578         (2     33,423   

Corporate securities

     8,016         81         —          8,097   

Mortgage backed securities and collateralized mortgage obligations-residential:

          

U.S. Government-sponsored agencies

     70,431         1,541         (197     71,775   
  

 

 

    

 

 

    

 

 

   

 

 

 

Total

   $ 141,363       $ 3,438       $ (199   $ 144,602   
  

 

 

    

 

 

    

 

 

   

 

 

 

Securities Held to Maturity

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

March 31, 2012

          

U.S. Treasury and U.S. Government-sponsored agencies

   $ 1,786       $ 229       $ —        $ 2,015   

Municipal securities

     3,561         204         —          3,765   

Mortgage backed securities and collateralized mortgage obligations-residential:

          

U.S. Government-sponsored agencies

     5,169         331         —          5,500   

Private residential collateralized mortgage obligations

     1,271         109         (108     1,272   
  

 

 

    

 

 

    

 

 

   

 

 

 

Total

   $ 11,787       $ 873       $ (108   $ 12,552   
  

 

 

    

 

 

    

 

 

   

 

 

 

December 31, 2011

          

U.S. Treasury and U.S. Government-sponsored agencies

   $ 1,799       $ 280       $ —        $ 2,079   

Municipal securities

     3,566         237         —          3,803   

Mortgage backed securities and collateralized mortgage obligations-residential:

          

U.S. Government-sponsored agencies

     5,412         331         —          5,743   

Private residential collateralized mortgage obligations

     1,316         102         (162     1,256   
  

 

 

    

 

 

    

 

 

   

 

 

 

Total

   $ 12,093       $ 950       $ (162   $ 12,881   
  

 

 

    

 

 

    

 

 

   

 

 

 

Available for sale investments with unrealized losses as of March 31, 2012, were as follows:

 

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

Municipal securities

   $ 2,866       $ 61       $ —         $ —         $ 2,866       $ 61   

Mortgage backed securities and collateralized mortgage obligations-residential:

                 

U.S. Government-sponsored agencies

     14,085         105         37         8        14,122         113   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total temporarily impaired securities

   $ 16,951       $ 166       $ 37       $ 8       $ 16,988       $ 174   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

30


Table of Contents

Held to maturity investments with unrealized losses as of March 31, 2012, were as follows:

 

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

Mortgage backed securities and collateralized mortgage obligations-residential:

                 

Private residential collateralized mortgage obligations

   $ 94       $ 7       $ 552       $ 101       $ 646       $ 108   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total temporarily impaired securities

   $ 94       $ 7       $ 552       $ 101       $ 646       $ 108   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Available for sale investments with unrealized losses as of December 31, 2011, were as follows:

 

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

Municipal securities

   $ 652       $ 2       $ —         $ —        $ 652       $ 2   

Mortgage backed securities and collateralized mortgage obligations-residential:

                 

U.S. Government-sponsored agencies

     17,211         188         36         9        17,247         197   

Private residential collateralized mortgage obligations

                 
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total temporarily impaired securities

   $ 17,863       $ 190       $ 36       $ 9       $ 17,899       $ 199   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Held to maturity investments with unrealized losses as of December 31, 2011, were as follows:

 

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

Mortgage backed securities and collateralized mortgage obligations-residential:

                 

Private residential collateralized mortgage obligations

   $ 134       $ 14       $ 533       $ 148       $ 667       $ 162   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total temporarily impaired securities

   $ 134       $ 14       $ 533       $ 148       $ 667       $ 162   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

The Company has evaluated these securities and has determined that, other than the three securities discussed on the following page, the decline in their value is temporary. The unrealized losses are primarily due to unusually large spreads in the market for mortgage-related products. The fair value of the mortgage backed securities and the collateralized mortgage obligations is expected to recover as the securities approach their maturity date and/or as the pricing spreads narrow on mortgage-related securities. The Company has the ability and intent to hold the investments until recovery of the market value.

 

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The amortized cost and fair value of securities at March 31, 2012, by contractual maturity, are set forth below. Actual maturities may differ from contractual maturities because certain borrowers have the right to call or prepay obligations with or without call or prepayment penalties.

 

Securities Available for Sale

   Amortized
Cost
     Fair
Value
 
     (In thousands)  

Due in one year or less

   $ 30,385       $ 30,602   

Due after one year through three years

     6,502         6,545   

Due after three years through five years

     2,749         2,851   

Due after five through ten years

     35,567         36,644   

Due after ten years

     65,248         66,544   
  

 

 

    

 

 

 

Totals

   $ 140,451       $  143,186   
  

 

 

    

 

 

 

Securities Held to Maturity

   Amortized
Cost
     Fair
Value
 
     (In thousands)  

Due in one year or less

   $ 402       $ 411   

Due after one year through three years

     793         839   

Due after three years through five years

     997         1,059   

Due after five years through ten years

     2,712         3,015   

Due after ten years

     6,883         7,228   
  

 

 

    

 

 

 

Totals

   $ 11,787       $ 12,552   
  

 

 

    

 

 

 

For the private residential collateralized mortgage obligations we estimated expected future cash flows of the securities by estimating the expected future cash flows of the underlying collateral and applying those collateral cash flows, together with any credit enhancements such as subordination interests owned by third parties, to the security. The expected future cash flows of the underlying collateral are determined using the remaining contractual cash flows adjusted for future expected credit losses (which considers current delinquencies and nonperforming assets, future expected default rates and collateral value by vintage and geographic region) and prepayments. The expected cash flows of the security are then discounted at the interest rate used to recognize interest income on the security to arrive at a present value amount. For the three months ended March 31, 2012, three private residential collateralized mortgage obligations were determined to be other-than-temporarily impaired. The Company recording no impairments on private residential collateralized mortgage obligations through other comprehensive income (loss), as the entire impairment of $36,000 was due to credit losses which were recognized through earnings. The average prepayment rate and discount interest rate used in the valuations of the present value were 6.0% and 6.7%, respectively.

The following table summarizes activity related to the amount of other-than-temporary impairments on held to maturity securities during the three months ended March 31, 2012:

 

     Life-to-Date
Gross  Other-

Than-
Temporary

Impairments
     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   

Additions:

        

Initial impairments

     —           —           —     

Subsequent impairments

     36         —           36   
  

 

 

    

 

 

    

 

 

 

March 31, 2012

   $ 2,471       $ 1,100       $ 1,371   
  

 

 

    

 

 

    

 

 

 

 

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Details of private residential collateralized mortgage obligation securities received in 2008 from the redemption-in-kind of the AMF Ultra Short Mortgage Fund (“Fund”) as of March 31, 2012 were as follows:

 

                                                     Current Ratings  

Type and Year of Issuance

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

Alt-A

   $ 881       $ 276       $ 233       $ (43   $ 73       $ —         $ 648         1     —          —          2     97

Prime

     1,788         995         1,039         44        326         36         723         4     3     6     3     84
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

            

Totals

   $ 2,669       $ 1,271       $ 1,272       $ 1      $ 399       $ 36       $ 1,371         4     3     5     2     86
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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

 

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NOTE 8. Federal Home Loan Bank Stock

The Banks are required to maintain an investment in the stock of the Federal Home Loan Bank (“FHLB”) of Seattle in an amount equal to the greater of $500,000 or 0.50% of residential mortgage loans and pass-through securities or an advance requirement to be confirmed on the date of the advance and 5.0% of the outstanding balance of mortgage loans sold to the FHLB of Seattle. At March 31, 2012 and December 31, 2011, the Company was required to maintain an investment in the stock of FHLB of Seattle of at least $1.2 million. At March 31, 2012 and December 31, 2011, the Company had an investment in FHLB stock carried at a cost basis (par value) of $5.6 million.

The Company evaluated its investment in FHLB of Seattle stock for other-than-temporary impairment, consistent with its accounting policy. Based on the Company’s evaluation of the underlying investment, including the long-term nature of the investment, the liquidity position of the FHLB of Seattle, the actions being taken by the FHLB of Seattle to address its regulatory situation and the Company’s intent and ability to hold the investment for a period of time sufficient to recover the par value, the Company did not recognize an other-than-temporary impairment loss on its FHLB of Seattle stock. Even though the Company did not recognize an other-than-temporary impairment loss on its FHLB of Seattle stock during the three months ended March 31, 2012 or 2011, further deterioration in the FHLB of Seattle’s financial position may result in future impairment losses.

NOTE 9. Goodwill

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

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

During 2011, ASU 2011-08 Intangibles – Goodwill and Other (Topic 350) was issued. Under the Update, 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. 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 Update was effective for yearends beginning after December 15, 2011 but early adoption was permitted. The Company adopted the Update for the quarter ended December 31, 2011.

Based on the results of the annual impairment test it was determined that no goodwill impairment charges were required for the year ended December 31, 2011. The Company’s next annual impairment test will be conducted during the quarter ending December 31, 2012. For the quarter ended March 31, 2012, the Company determined no triggering events had occurred and, therefore, did not conduct an interim impairment test of goodwill. Even though there was no goodwill impairment at March 31, 2012, declines in the value of the Company’s stock price or additional adverse changes in the operating environment of the financial services industry may result in a future impairment charge.

 

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NOTE 10. 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 or quoted prices in markets that are not active.

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

The Company used the following methods and significant assumptions to estimate fair value:

Investment Securities Available for Sale and Held to Maturity: The fair value of all investment securities are based upon the assumptions market participants would use in pricing the security. If available, investment securities are determined by quoted market prices (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. 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, it is valued at the lower of cost or fair value. Impaired loans carried at fair value generally receive specific allocations of the allowance for loan losses. For collateral dependent loans, 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 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 (Level 3).

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 overall 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.

The following table summarizes the balances of assets and liabilities measured at fair value on a recurring basis at March 31, 2012.

 

     Total      Level 1      Level 2      Level 3  
     (In thousands)  

Investment Securities Available for Sale:

           

U.S. Treasury and U.S. Government-sponsored agencies

   $ 27,718       $ —         $ 27,718       $ —     

Municipal securities

     35,773         —           35,773         —     

Corporate securities

     7,052         —           7,052         —     

Mortgage backed securities and collateralized mortgage obligations - residential:

           

U.S Government-sponsored agencies

     72,643         —           72,643         —     
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 143,186       $ —         $ 143,186       $ —     
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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There were no transfers between Level 1 and Level 2 during the three months ending March 31, 2012.

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

 

     Total      Level 1      Level 2      Level 3  
     (In thousands)  

Investment Securities Available for Sale:

           

U.S. Treasury and U.S. Government-sponsored agencies

   $ 31,307       $ —         $ 31,307       $ —     

Municipal securities

     33,423         —           33,423         —     

Corporate securities

     8,097         —           8,097         —     

Mortgage backed securities and collateralized mortgage obligations – residential

           

U.S Government-sponsored agencies

     71,775         —           71,775         —     
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 144,602       $ —         $ 144,602       $ —     
  

 

 

    

 

 

    

 

 

    

 

 

 

There were no transfers between Level 1 and Level 2 during the year ended December 31, 2011.

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. For assets measured at fair value on a nonrecurring basis during the three months ended March 31, 2012 and year ended December 31, 2011 that were still held in the balance sheet at the end of such periods, the following tables provide the level of valuation assumptions used to determine each adjustment and the carrying value of the related assets at the dates indicated.

 

     Fair Value at March 31, 2012      Three Months
Ended
March 31,
2012
 
     Total      Level 1      Level 2      Level 3      Total Losses, net  
     (In thousands)  

Impaired originated loans:

              

Commercial business

   $ 9,315       $ —         $ —         $ 9,315       $ 1,156   

One-to-four family residential

     1,380         —           —           1,380         258   

Real estate construction and land development

     3,889         —           —           3,889         77   

Consumer

     110         —           —           110         371   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total impaired originated loans(1)

     14,694         —           —           14,694         1,862   

Investment securities held to maturity(2):

              

Mortgage back securities and collateralized mortgage obligations - residential:

              

Private residential collateralized mortgage obligations

     16         —           16         —           36   

Other real estate owned(3)

     1,727         —           —           1,727         193   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 16,437       $ —         $ 16      $ 16,421       $ 2,091   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) Impaired originated loans that are measured for impairment using the fair value of the collateral for collateral dependent loans, had a principal balance of $32.8 million, with a valuation allowance of $5.4 million at March 31, 2012, resulting in an additional provision for loan losses of $1.8 million for the three months ended March 31, 2012.
(2) Investment securities held to maturity with a carrying amount of $52,000 were written down to their fair value of $16,000 resulting in an impairment charge of $36,000 to non-interest expense for the three months ended March 31, 2012.

 

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(3) Other real estate owned measured at fair value less costs to sell, had a net carrying amount of $8.6 million, which is made up of the outstanding balance of $8.3 million, net a noncovered valuation allowance of $292,000 at March 31, 2012, resulting in a charge off of $193,000 for the three months ended March 31, 2012.
(4) Noncovered

 

     Fair Value at December 31, 2011      Year
Ended
December 31,
2011
 
     Total      Level 1      Level 2      Level 3      Total Losses, net  
     (In thousands)  

Impaired originated loans:

              

Commercial business

   $ 9,397       $ —         $ —         $ 9,397       $ 1,551   

One-to-four family residential

     648         —           —           648         187   

Real estate construction and land development

     8,682         —           —           8,682         626   

Consumer

     —           —           —           —           6   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total impaired originated loans(1)

     18,727         —           —           18,727         2,370   

Investment securities held to maturity(2):

              

Mortgage back securities and collateralized mortgage obligations - residential:

              

Private residential collateralized mortgage obligations

     106         —           106         —           118   

Other real estate owned(3)

     494         —           —           494         99   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 19,327       $ —         $ 106      $ 19,221       $ 2,587   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) Impaired originated loans that are measured for impairment using the fair value of the collateral for collateral dependent loans, had a principal balance of $37.1 million, with a valuation allowance of $4.5 million at December 31, 2011, resulting in an additional provision for loan losses of $2.4 million for the year ended December 31, 2011.
(2) Investment securities held to maturity with a carrying amount of $204,000 were written down to their fair value of $106,000 resulting in an impairment charge of $98,000 to noninterest expense for the year ended December 31, 2011.
(3) Other real estate owned measured at fair value less costs to sell, had a net carrying amount of $4.6 million, which is made up of the outstanding balance of $4.5 million, net a noncovered valuation allowance of $99,000 at December 31, 2011, resulting in a charge off of $99,000 for the year ended December 31, 2011.

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 the date indicated.

 

     March 31, 2012
     Fair Value      Valuation
Technique(s)
     Unobservable Input(s)    Range (Weighted Average)
     (Dollars in thousands)

Impaired loans

   $ 32,804         Market approach       Adjustment for differences between
the comparable sales
   0.0% -100.0% (14.0%)

Other real estate owned

   $ 8,349         Market approach       Adjustment for differences between
the comparable sales
   0.0%-35.7 (4.1%)

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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Table of Contents

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

 

     March 31, 2012  
     Carrying
Value
     Fair Value Measurements Using:  
        Tota1      Level 1      Level 2      Level 3  
     (In thousands)  

Financial Assets:

              

Cash on hand and in banks

   $ 28,900       $ 28,900      $ 28,900       $ —         $ —     

Interest earning deposits

     110,857         110,857        110,857         —           —     

Investment securities available for sale

     143,186         143,186        —           143,186         —     

Investment securities held to maturity

     11,787         12,552        —           12,552         —     

FHLB stock

     5,594         N/A        N/A         —           —     

Loans held for sale

     1,118         1,118        —           —           1,118   

Loans receivable, net of allowance

     990,887         1,008,046        —           —           1,008,046   

Accrued interest receivable

     4,776         4,776        12         923         3,841   

Financial Liabilities:

              

Deposits:

              

Non-interest deposits, NOW accounts, money market accounts, savings accounts

     825,133         825,133        825,133         —           —     

Certificate of deposit accounts

     314,404         316,132        —           —           316,132   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total Deposits

   $ 1,139,537       $ 1,141,265       $ 825,133       $ —         $ 316,132   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Securities sold under agreement to repurchase

   $ 20,786       $ 20,786      $ 20,786       $ —         $ —     

Accrued interest payable

   $ 140       $ 140      $ 24       $ —         $ 116   

 

     December 31, 2011  
     Carrying
Value
     Fair
Value
 
     (In thousands)  

Financial Assets:

     

Cash on hand and in banks

   $ 30,193       $ 30,193   

Interest earning deposits

     93,566         93,566   

Investment securities available for sale

     144,602         144,602   

Investment securities held to maturity

     12,093         12,881   

FHLB stock

     5,594         N/A   

Loans held for sale

     1,828         1,828   

Loans receivable, net of allowance

     1,004,480         1,027,495   

Accrued interest receivable

     5,117         5,117   

Financial Liabilities:

     

Deposits:

     

Non-interest deposits, NOW accounts, money market accounts, savings accounts

     806,440         806,440   

Certificate of deposit accounts

     329,604         331,618   
  

 

 

    

 

 

 

Total deposits

   $ 1,136,044       $ 1,138,058   
  

 

 

    

 

 

 

Securities sold under agreement to repurchase

   $ 23,091       $ 23,091   

Accrued interest payable

   $ 180       $ 180   

 

 

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Table of Contents

The methods and assumptions, not previously presented, used to estimate fair value are described as follows:

Cash on Hand and in Banks and Interest Earning Deposits: The fair value of financial instruments that are short-term or reprice frequently and accrued interest receivable and payable that have little or no risk are considered to have a fair value equal to carrying value (Level 1).

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 (Level 1).

Loans Receivable and Loans Held for Sale: 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 produces a higher value.

Accrued Interest Receivable/Payable: The carrying amounts of accrued interest approximate fair value (Level 1, Level 2, and Level 3).

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 3).

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).

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).

 

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Table of Contents
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion is intended to assist in understanding the financial condition and results of the Company as of and for the three months ended March 31, 2012. The information contained in this section should be read with the unaudited condensed consolidated financial statements and its accompanying notes, and the December 31, 2011 audited consolidated financial statements and its accompanying notes included in our Annual Report on Form 10-K for the year ended December 31, 2011.

Overview

Heritage Financial Corporation is a bank holding company, which primarily engages in the business activities of our wholly owned subsidiaries: Heritage Bank and Central Valley Bank (collectively, the “Banks”). We provide financial services to our local communities with an ongoing strategic focus in expanding our commercial lending relationships, market area and a continual focus on asset quality. At March 31, 2012, we had total assets of $1.37 billion and total stockholders’ equity of $205.7 million. The Company’s business activities generally are limited to passive investment activities and oversight of its investment in the Banks. Accordingly, the information set forth in this report relates primarily to the Banks’ operations.

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, one-to-four family residential loans, and consumer loans and originate for sale or investment purposes first mortgage loans on residential properties located in western and central Washington State and the greater Portland, Oregon area.

Our core profitability depends primarily on our net interest income after provision for loan losses. Net interest income is the difference between interest income, which is the income that we earn on interest-earning assets, comprised primarily of loans and investments, and interest expense, the amount we pay on our interest-bearing liabilities, which are primarily deposits and borrowings. The results of our operations may also be affected by local and general economic conditions. Changes in levels of interest rates affect our net interest income. Management strives to match the repricing characteristics of the interest earning assets and interest bearing liabilities to protect net interest income from changes in market interest rates and changes in the shape of the yield curve.

The provision for loan losses is dependent on changes in the loan portfolio and management’s assessment of the collectability of the loan portfolio as well as prevailing economic and market conditions. The allowance for loan losses reflects the amount that the Company believes is appropriate to cover probable incurred credit losses in its loan portfolio. Additionally, net income is affected by non-interest income and non-interest expenses. For the three months ended March 31, 2012, non-interest income consisted of gain on the sale of loans, service charges on deposits, merchant Visa income (net), change in the FDIC indemnification asset and other operating income. Non-interest expenses consist primarily of salaries and employee benefits, occupancy and equipment, data processing, professional services and other expenses. Salaries and employee benefits consist primarily of the salaries and wages paid to our employees, payroll taxes, expenses for retirement and other employee benefits. Occupancy and equipment expenses, which are the fixed and variable costs of buildings and equipment, consist primarily of lease payments, taxes, depreciation charges, maintenance and costs of utilities.

Results of operations may also be affected significantly by general and local economic and competitive conditions, changes in market interest rates, governmental policies and actions of regulatory authorities.

Net interest income is affected by changes in the volume and mix of interest earning assets, interest earned on those assets, the volume and mix of interest bearing liabilities and interest paid on interest bearing liabilities. Other income and other expenses are impacted by growth of operations and growth in the number of loan and deposit accounts through both acquisitions and core banking business growth. Growth in operations affects other expenses primarily as a result of additional employees, branch facilities and marketing expense. Growth in the number of loan and deposit accounts affects other income, including service charges as well as other expenses such as data processing services, supplies, postage, telecommunications and other miscellaneous expenses.

Earnings Summary

Net income available to shareholders was $0.27 per diluted common share for the three months ended March 31, 2012 compared to $0.05 per diluted common share for the three months ended March 31, 2011. Net income for the three months ended March 31, 2012 was $4.2 million compared to net income of $764,000 for the same period in 2011. The increase was primarily the result of a $1.1 million increase in net interest income, a $4.5 million decrease in the provision for loan losses, and a $485,000 decrease in non-interest expense partially offset by a $1.0 million decrease in non-interest income. Partially as a result of the decrease in non-interest expense, the Company’s efficiency ratio decreased to 67.7% for the three months ended March 31, 2012 from 70.7% for the three months ended March 31, 2011. The efficiency ratio consists of non-interest expense divided by the sum of net interest income before provision for loan losses plus non-interest income.

 

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Net Interest Income

Net interest income increased $1.1 million, or 7.0%, to $16.7 million for the three months ended March 31, 2012, compared with $15.6 million in the same period in 2011. The increase in net interest income for the three months ended March 31, 2012 was primarily a result of an increase in interest earning assets and an increase in the net interest margin. Net interest income as a percentage of average earning assets (net interest margin) for the three months ended March 31, 2012, increased 27 basis points to 5.35% from 5.08% for the same period in 2011. The increase in net interest margin for the three months ended March 31, 2012 was primarily due to decreased interest bearing deposit rates. The net interest spread for the three months ended March 31, 2012 increased to 5.20% from 4.88% for the same period in 2011.

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

 

     For the Three Months Ended March 31,  
     2012     2011  
     Average
Balance
     Interest
Earned/
Paid
     Average
Yield/Rate(1)
    Average
Balance
     Interest
Earned/
Paid
     Average
Yield/Rate(1)
 
     (Dollars in thousands)  

Interest Earning Assets:

                

Loans

   $ 996,305       $ 17,018         6.87   $ 972,884       $ 16,572         6.91

Taxable securities

     121,108         652         2.16        124,355         663         2.16

Nontaxable securities

     34,779         256         2.96        21,123         179         3.43

Interest earning deposits and Federal funds sold

     96,324         63         0.26        121,707         79         0.26

FHLB stock

     5,594         —           —          5,594         —           —     
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

 

Total interest earning assets

   $ 1,254,110       $ 17,989         5.77      $ 1,245,663       $ 17,493         5.70

Non-interest earning assets

     101,698              106,789         
  

 

 

         

 

 

       

Total assets

   $ 1,355,808            $ 1,352,452         
  

 

 

         

 

 

       

Interest Bearing Liabilities:

                

Certificates of deposit

   $ 322,686       $ 882         1.10      $ 376,281       $ 1,225         1.32

Savings accounts

     109,129         59         0.22        103,804         116         0.45

Interest bearing demand and money market accounts

     465,627         336         0.29        442,341         534         0.49
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

 

Total interest bearing deposits

     897,442         1,277         0.57        922,426         1,875         0.82

Securities sold under agreement to repurchase

     19,697         18         0.37        20,500         22         0.43
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

 

Total interest bearing liabilities

   $ 917,139       $ 1,295         0.57   $ 942,926       $ 1,897         0.82
     

 

 

         

 

 

    

Demand and other non-interest bearing deposits

     227,970              195,834         

Other non-interest bearing liabilities

     5,822              9,437         

Stockholders’ equity

     204,877              204,255         
  

 

 

         

 

 

       

Total liabilities and stockholders’ equity

   $ 1,355,808            $ 1,352,452         
  

 

 

         

 

 

       

Net interest income

      $ 16,694            $ 15,596      
     

 

 

         

 

 

    

Net interest spread

           5.20           4.88

Net interest margin

           5.35           5.08

Average interest earning assets to average interest bearing liabilities

           136.74           132.11

 

(1) Annualized

Total interest income increased $496,000, or 2.8%, to $18.0 million for the three months ended March 31, 2012, from $17.5 million for the three months ended March 31, 2011. The increases in interest income for the three months ended March 31, 2012 was primarily due to higher yields on interest earning assets and also as a result of the increase in average interest earning assets. The balance of average interest earning assets (including nonaccrual loans) increased $8.4 million, or 0.7%, to $1.254 billion for the three months ended March 31, 2012, from $1.246 billion for the three months ended March 31, 2011. The increase in average interest earning assets for the three months ended March 31, 2012 was primarily due to increases in originated loans. The yield on total interest earning assets increased seven basis points from 5.70% for the three months ended March 31, 2011 to 5.77% for the three months ended March 31, 2012. The increase in the yield on interest earning assets for the three months ended March 31, 2012 reflects the decrease in lower yielding average interest earning deposits and the increase in higher yielding average loans. The effect of discount accretion on loan yields for the three months ended March 31, 2012 and March 31, 2011 was approximately 62 basis points and 41 basis points, respectively. For the three months ended March 31, 2012 and March 31, 2011, originated nonaccruing loans reduced the yield earned on loans by approximately 10 basis points and 12 basis points, respectively. Originated nonaccrual loans totaled $18.2 million at March 31, 2012 as compared to $24.0 million at March 31, 2011.

 

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Total interest expense decreased by $602,000, or 31.7%, to $1.3 million for the three months ended March 31, 2012 from $1.9 million for the three months ended March 31, 2011. The decrease in interest expense was attributable to lower average rates paid on interest bearing liabilities and lower average balances of interest bearing liabilities. The average rate paid on interest bearing liabilities decreased to 0.57% for the three months ended March 31, 2012 from 0.82% for the three months ended March 31, 2011. Total average interest bearing liabilities decreased by $25.8 million, or 2.7%, to $917.1 million for the three months ended March 31, 2012 from $942.9 million for the three months ended March 31, 2012. The decreases in average interest bearing liabilities were due primarily to certificate of deposit runoff mostly related to the Cowlitz and Pierce Acquisitions. Deposit interest expense decreased $598,000, or 31.9%, to $1.3 million for the three months ended March 31, 2012 compared to $1.9 million for the same quarter last year. The decrease in deposit interest expense for the three months ended March 31, 2012 is primarily a result of a 25 basis point decrease in the average cost of interest-bearing deposits, reflecting the relatively low interest rate environment.

Provision for Loan Losses

The provision for loan losses decreased $4.5 million, or 102.5%, to $(109,000) for the three months ended March 31, 2012 from $4.4 million for the three months ended March 31, 2011.

There was no provision for loan losses on originated loans for the three months ended March 31, 2012 compared to a provision for loan losses on originated loans of $2.6 million for the three months ended March 31, 2011. The Banks had net recoveries of $246,000 for the three months ended March 31, 2012 compared to net charge-offs of $3.3 million for the three months ended March 31, 2011. The ratio of net charge-offs (recoveries) to average total originated loans outstanding was (0.03)% for the three months ended March 31, 2012 and 0.43% for the three months ended March 31, 2011.

The provision for loan losses on purchased loans for the three months ended March 31, 2012 totaled $(109,000) compared to $1.8 million for the three months ended March 31, 2011. The reduction in provision expense was due substantially to increases in the estimated cash flows in certain pools of acquired loans whereas there were decreases in such cash flows estimates in prior periods. As of the acquisition dates, purchased loans were recorded at their estimated fair value, incorporating our estimate of future expected cash flows until the ultimate resolution of these credits. To the extent actual or projected cash flow 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 (if a provision had previously been recognized for that pool of loans) or prospectively recognized in interest income as a yield adjustment (if a provision had not previously been recognized for that pool of loans).

The Banks have established comprehensive methodologies for determining the allowance for loan losses. On a quarterly basis the Banks perform an analysis taking into consideration pertinent factors underlying the credit 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. The allowance for loan losses on originated loans increased slightly by $246,000 to $22.6 million at March 31, 2012 from $22.3 million at December 31, 2011. As of March 31, 2012, the Banks identified $32.8 million of impaired loans, including $14.6 million of performing restructured loans. Of those impaired loans, $10.1 million have no allowances for credit losses as their estimated collateral value is equal to or exceeds their carrying costs. The remaining $22.7 million have related allowances for credit losses totaling $5.4 million.

Based on the comprehensive methodology, management deemed the allowance for loan losses on originated loans of $22.6 million at March 31, 2012 (2.69% of total originated loans and 143.11% of nonperforming originated loans, net of amounts guaranteed by governmental agencies) appropriate to provide for probable incurred losses based on an evaluation of known and inherent risks in the loan portfolio at that date. While the Banks believe they have established their existing allowances for loan losses in accordance with GAAP, there can be no assurance that regulators, in reviewing the Banks’ loan portfolios, will not request the Banks to increase significantly their 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 credit 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.

Non-interest Income

Total non-interest income decreased $1.0 million, or 34.4%, to $1.9 million for the three months ended March 31, 2012 compared to $2.9 million for the same period in 2011. The decrease for the three months ended March 31, 2012 was due substantially to the effects of a reduction of $1.0 million in the amount of change in the FDIC indemnification asset from $0.8 million for three months ended March 31, 2011 to $(0.2) for the three months ended March 31, 2012.

 

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Non-interest Expense

Non-interest expense decreased $485,000, or 3.7%, to $12.6 million during the quarter ended March 31, 2012 compared to $13.1 million for the quarter ended March 31, 2011. The decrease for the three months ended March 31, 2012 compared to the same period in the prior year was to the result of the following: Decreased data processing expense of $232,000; decreased FDIC insurance premium expense of $181,000; decreased net other real estate owned costs of $261,000; decreased loan expense (included within “other expense”) of $173,000; and was partially offset by a $561,000 increase in salaries and benefits expense.

The efficiency ratio for the quarter ended March 31, 2012 was 67.7% compared to 70.7% for the same period in the prior year. While growth strategies are being executed, the Company expects to incur higher expenses as evidenced by the current efficiency ratio. Expenses are expected to be more in line with revenue when these growth strategies begin producing long term results. The efficiency ratio consists of non-interest expense divided by the sum of net interest income before provision for loan losses plus non-interest income.

Income Tax Expense

The provision for income taxes increased by $1.7 million to $1.9 million for the three months ended March 31, 2012 from $285,000 for the three months ended March 31, 2011. The Company’s effective tax rate was 31.8% for the three months ended March 31, 2012 compared to 27.2% for the same period in 2011. The increase in the Company’s effective tax rate for the three months ended March 31, 2012 is due substantially to an increase in taxable income for the three months ended March 31, 2012 as compared to the same period in 2011, which caused nontaxable interest income on municipal securities to represent a smaller percentage of income before income taxes.

Financial Condition Data

Total assets increased slightly by $5.9 million, or 0.4%, to $1.37 billion as of March 31, 2012 from $1.37 billion as of December 31, 2011 due primarily to an increase in interest earning deposits and primarily offset by a decrease in net loans. For the same period, net loans, which exclude loans held for sale but are net of the allowance for loan losses, decreased $13.6 million, or 1.4%, to $990.9 million as of March 31, 2012 from $1.00 billion at December 31, 2011 due substantially to decreases in purchased loans. Deposits increased slightly by $3.5 million, or 0.3%, to $1.14 billion as of March 31, 2012 compared to December 31, 2011. Securities sold under agreement to repurchase decreased $2.3 million, or 10.0%, to $20.8 million as of March 31, 2012 from $23.1 million as of December 31, 2011 primarily due to decreases in customer balances.

Total stockholders’ equity increased by $3.1 million, or 1.6%, to $205.7 million as of March 31, 2012 from $202.5 million at December 31, 2011 as a result of net income of $4.2 million and stock compensation and earned ESOP in the amount of $314,000 partially offset by a common stock cash dividend of $927,000, common stock repurchased of $114,000 and other comprehensive loss of $301,000. The Company’s capital position remains strong at 15.0% of total assets as of March 31, 2012, an increase from 14.8% at December 31, 2011.

Lending Activities

As indicated in the table below, total loans receivable (not including loans held for sale) decreased $13.7 million to $1.02 billion at March 31, 2012 from $1.04 billion at December 31, 2011. Total originated loans (not including loans held for sale) decreased $578,000, or 0.07%, to $837.3 million at March 31, 2012 from $837.9 million at December 31, 2011.

 

     At
March 31,
2012
    % of
Total
    At
December 31,
2011
    % of
Total
 
     (Dollars in thousands)  

Originated Loans:

        

Commercial business:

        

Commercial and industrial

   $ 271,976        32.4   $ 273,590        32.6

Owner-occupied commercial real estate

     176,637        21.1        166,881        19.9   

Non-owner occupied commercial real estate

     249,202        29.8        251,049        30.0   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total commercial business

     697,815        83.3        691,520        82.5   

One-to-four family residential mortgages

     37,911        4.5        37,960        4.5   

Real estate construction and land development:

        

One-to-four family residential

     23,483        2.8        22,369        2.7   

Multifamily residential and commercial properties

     48,122        5.8        54,954        6.6   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total real estate construction and land development

     71,605        8.6        77,323        9.3   

Consumer

     31,820        3.8        32,981        3.9   
  

 

 

   

 

 

   

 

 

   

 

 

 

Gross originated loans receivable

     839,151        100.2        839,784        100.2   

Less: deferred loan fees

     (1,805     (0.2     (1,860     (0.2
  

 

 

   

 

 

   

 

 

   

 

 

 

Total originated loans

     837,346        100.0 %     837,924        100.0 %
  

 

 

   

 

 

   

 

 

   

 

 

 

Purchased covered loans

     104,609          109,357     

Purchased non-covered loans

     79,727          88,114     
  

 

 

     

 

 

   

Total loans receivable, net of deferred loan fees

   $ 1,021,682        $ 1,035,395     
  

 

 

     

 

 

   

 

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Nonperforming Assets

The following table describes our nonperforming assets for the dates indicated.

 

     At
March 31,
2012
    At
December 31,
2011
 
     (Dollars in thousands)  

Nonaccrual originated loans:

    

Commercial business

   $ 8,075      $ 8,266   

One-to-four family residential

     1,226        —     

Real estate construction and land development

     8,706        14,947   

Consumer

     191        125   
  

 

 

   

 

 

 

Total nonaccrual originated loans (1)(2)

     18,198        23,338   
  

 

 

   

 

 

 

Other noncovered real estate owned

     7,644        3,710   
  

 

 

   

 

 

 

Total nonperforming originated assets

   $ 25,842      $ 27,048   
  

 

 

   

 

 

 

Restructured originated performing loans:

    

Commercial business

   $ 13,417      $ 12,606   

One-to-four family residential

     429        835   

Real estate construction and land development

     760        364   
  

 

 

   

 

 

 

Total restructured originated performing loans(3)

   $ 14,606      $ 13,805   

Accruing originated loans past due 90 days or more(4)

     235        1,328   

Potential problem originated loans(5)

     31,274        29,742   

Allowance for loan losses on originated loans

     22,563        22,317   

Nonperforming originated loans to total originated loans(6)

     1.88     2.57

Allowance for loan losses to total originated loans

     2.69     2.66

Allowance for loan losses to nonperforming originated loans(6)

     143.11     103.52

Nonperforming originated assets to total originated assets(6)

     1.95     2.14

 

(1) $10.7 million and $11.7 million of nonaccrual originated loans were considered troubled debt restructurings at March 31, 2012 and December 31, 2011, respectively.
(2) $2.4 million and $1.8 million of nonaccrual originated loans were guaranteed by government agencies at March 31, 2012 and December 31 2011, respectively.
(3) $461,000 and $592,000 of restructured originated performing loans were guaranteed by government agencies at March 31, 2012 and December 31, 2011, respectively.
(4) There were no accruing originated loans past due 90 days or more that were guaranteed by government agencies at March 31, 2012 and there were $6,000 of accruing originated loans past due 90 days or more guaranteed by government agencies at December 31, 2011.
(5) $2.6 million and $2.8 million of potential problem originated loans were guaranteed by government agencies at March 31, 2012 and December 31, 2011, respectively.
(6) Excludes portions guaranteed by government agencies.

Nonperforming originated assets decreased to $25.8 million, or 1.88% of total originated assets, at March 31, 2012 from $27.0 million, or 2.57% of total originated assets, at December 31, 2011 due to a decrease in nonperforming originated loans which was partially offset by an increase in other real estate owned. During the three months ended March 31, 2012, there were $1.3 million in charge-offs of which $489,000 related to nonperforming commercial loans and $816,000 related to nonperforming construction loans. In addition, nonperforming loan balances totaling $4.3 million were transferred to other real estate owned during the three months ended March 31, 2012. Restructured originated performing loans as of March 31, 2012 and December 31, 2011 were $14.6 million and $13.8 million, respectively. Potential problem originated loans as of March 31, 2012 and December 31, 2011 were $31.3 million and $29.7 million, respectively. 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.

 

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Table of Contents

Analysis of Allowance for Loan Losses

Management maintains an allowance for loan losses (“ALL”) to provide for estimated 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 classes 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 non-classified and classified performing 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-classified loans, classified 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 further 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.

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

 

     Three Months Ended March 31,  
     2012     2011  
     (Dollars in thousands)  

Originated loans receivable outstanding at end of period

   $ 837,346      $ 753,190   

Average originated loans receivable during period

     851,266        760,193   

Allowance for loan losses at beginning of period

     22,317        22,062   

Provision for loan losses on originated loans

     —          2,595   

Charge-offs:

    

Commercial business

     (489     (1,227

One-to-four family residential

     —          (15

Real estate construction and land development

     (816     (2,648

Consumer

     (29     (104
  

 

 

   

 

 

 

Total charge-offs

     (1,334     (3,994
  

 

 

   

 

 

 

Recoveries:

    

Commercial business

     1,439        713   

Real estate construction and land development

     125        —     

Consumer

     16        6   
  

 

 

   

 

 

 

Total recoveries

     1,580        719   
  

 

 

   

 

 

 

Net recoveries (charge-offs)

     246        (3,275
  

 

 

   

 

 

 

Allowance for loan losses at end of period

   $ 22,563      $ 21,382   
  

 

 

   

 

 

 

Allowance for loan losses to total originated loans receivable

     2.69     2.84

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

     0.03     (0.43 )% 

 

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Table of Contents

The allowance for loan losses for originated loans at March 31, 2012 increased $246,000 to $22.6 million from $22.3 million at December 31, 2011. The increase was due to net recoveries received during the three months ended March 31, 2012. Nonperforming originated loans to total originated loans decreased to 1.88% at March 31, 2012 from 2.57% at December 31, 2011 and the allowance for loan losses to nonperforming originated loans was 143.11% at March 31, 2012 and 103.52% at December 31, 2011. Potential problem originated loans increased $1.5 million to $31.3 million at March 31, 2012 from $29.7 million at December 31, 2011. Based on management’s assessment of loan quality and current economic conditions, the Company believes that its allowance for loan losses was appropriate to absorb the probable incurred losses and inherent risks of loss in the loan portfolio at March 31, 2012.

Liquidity and Capital Resources

Our primary sources of funds are customer deposits, loan principal and interest payments, loan sales, interest earned on and proceeds from sales and maturities of investment securities, and advances from the FHLB of Seattle. These funds, together with retained earnings, equity and other borrowed funds, are used to make loans, acquire investment securities and other assets, and fund continuing operations. While maturities and scheduled amortization of loans are predictable sources of funds, deposit flows and prepayments are greatly influenced by the level of interest rates, economic conditions, and competition. In addition to customer deposits, management may utilize the use of brokered deposits on an as-needed basis.

As indicated in the table below, total deposits increased slightly and were $1.1 billion at March 31, 2012 and December 31, 2011.

 

     March 31,
2012
     % of
Total
    December 31,
2011
     % of
Total
 
     (Dollars in thousands)  

Non-interest demand deposits

   $ 234,705         20.6   $ 230,993         20.4

NOW accounts

     300,314         26.3        304,818         26.8   

Money market accounts

     173,903         15.3        166,913         14.7   

Savings accounts

     116,211         10.2        103,716         9.1   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total non-maturity deposits

     825,133         72.4        806,440         71.0   

Certificate of deposit accounts

     314,404         27.6        329,604         29.0   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total deposits

   $ 1,139,537         100.0   $ 1,136,044         100.0
  

 

 

    

 

 

   

 

 

    

 

 

 

Since December 31, 2011, non-maturity deposits (total deposits less certificate of deposit accounts) have increased $18.7 million to $825.1 million and certificate of deposit accounts have decreased $15.2 million to $314.4 million. As a result, the percentage of certificate of deposit accounts to total deposits decreased to 27.6% at March 31, 2012 from 29.0% at December 31, 2011.

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. The Banks are utilizing securities sold under agreement to repurchase as a supplement to our funding sources. Our repurchase agreements are secured by available for sale investment securities. At March 31, 2012, the Banks had securities sold under agreement to repurchase totaling $20.8 million, a decrease of $2.3 million from $23.1 million at December 31, 2011.

We must maintain an adequate level of liquidity to ensure the availability of sufficient funds to fund loan originations and deposit withdrawals, satisfy other financial commitments, and fund operations. We generally maintain sufficient cash and short-term investments to meet short-term liquidity needs. At March 31, 2012, cash and cash equivalents totaled $139.8 million, or 10.2% of total assets, and the fair value of investment securities classified as either available for sale or held to maturity with maturities of one year or less amounted to $31.0 million, or 2.3% of total assets. At March 31, 2012, the Banks maintained an uncommitted credit facility with the FHLB of Seattle for $161.0 million and an uncommitted credit facility with the Federal Reserve Bank of San Francisco for

 

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$70.1 million. The Banks also maintain advance lines with Zions Bank, US Bank and Pacific Coast Bankers’ Bank to purchase federal funds totaling $42.8 million as of March 31, 2012. There were no borrowings outstanding other than repurchase agreements as of March 31, 2012.

Stockholders’ equity at March 31, 2012 was $205.7 million compared with $202.5 million at December 31, 2011. During the three months ended March 31, 2012, the Company realized net income of $4.2 million, recorded $(301,000) in other comprehensive income, recorded stock option compensation and earned ESOP and restricted stock shares totaling $314,000, paid common stock dividends of $927,000 and repurchased $114,000 of common stock.

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 and Central Valley Bank are federally insured institutions and thereby 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 financial statements and operations. Management believes the Company and Banks meet all capital adequacy requirement to which they are subject.

Pursuant to minimum capital requirements of the FDIC, Heritage Bank and Central Valley Bank are required to maintain a leverage ratio (Tier 1 capital to average assets ratio) of 3% and risk-based capital ratios of Tier 1 capital and total capital (to total risk-weighted assets) of 4% and 8%, respectively. As of March 31, 2012 and December 31, 2011, the most recent regulatory notifications categorized Heritage Bank and Central Valley 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 Banks’ categories.

 

     Minimum
Requirements
    Well-
Capitalized
Requirements
     Actual  
     $      %     $      %      $      %  
     (Dollars in thousands)  

As of March 31, 2012:

                

The Company consolidated

                

Tier 1 leverage capital to average assets

   $ 40,242         3.0   $ 67,070         N/A       $ 189,804         14.1

Tier 1 capital to risk-weighted assets

     38,081         4.0        57,122         N/A         189,804         19.9   

Total capital to risk-weighted assets

     76,162         8.0        95,203         N/A         201,938         21.2   

Heritage Bank

                

Tier 1 leverage capital to average assets

     35,263         3.0        58,771         5.0         150,479         12.8   

Tier 1 capital to risk-weighted assets

     33,221         4.0        49,831         6.0         150,479         18.2   

Total capital to risk-weighted assets

     66,441         8.0        83,052         10.0         161,074         19.4   

Central Valley Bank

                

Tier 1 leverage capital to average assets

     4,962         3.0        8,269         5.0         17,241         10.4   

Tier 1 capital to risk-weighted assets

     4,830         4.0        7,245         6.0         17,241         14.3   

Total capital to risk-weighted assets

     9,660         8.0        12,075         10.0         18,770         15.5   

As of December 31, 2011:

                

The Company consolidated

                

Tier 1 leverage capital to average assets

   $ 40,431         3.0   $ 67,384         N/A       $ 186,253         13.8

Tier 1 capital to risk-weighted assets

     39,231         4.0        58,846         N/A         186,253         19.0   

Total capital to risk-weighted assets

     78,461         8.0        98,077         N/A         198,743         20.3   

Heritage Bank

                

Tier 1 leverage capital to average assets

     35,443         3.0        59,071         5.0         148,423         12.6   

Tier 1 capital to risk-weighted assets

     34,601         4.0        51,901         6.0         148,423         17.2   

Total capital to risk-weighted assets

     69,201         8.0        86,501         10.0         159,447         18.4   

Central Valley Bank

                

Tier 1 leverage capital to average assets

     4,975         3.0        8,291         5.0         16,754         10.1   

Tier 1 capital to risk-weighted assets

     4,608         4.0        6,912         6.0         16,754         14.5   

Total capital to risk-weighted assets

     9,216         8.0        11,521         10.0         18,214         15.8   

Quarterly, the Company reviews the potential payment of cash dividends to its 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 Banks,

 

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which are the Company’s predominant sources of income. On February 1, 2012, the Company’s Board of Directors declared a dividend of $0.06 per share payable on February 24, 2012 to shareholders of record on February 10, 2012. Additionally, on April 26, 2012, the Company’s Board of Directors declared a dividend of $0.08 per share payable on May 24, 2012, to shareholders of record on May 10, 2012.

 

ITEM 3. Quantitative and Qualitative Disclosures About Market Risk

Our results of operations are highly dependent upon our ability to manage interest rate risk. We consider interest rate risk to be a significant market risk that could have a material effect on our financial condition and results of operations. Interest rate risk is measured and assessed on a quarterly basis. In our opinion, there has not been a material change in our interest rate risk exposure since the information disclosed in our annual report on Form 10-K for the year-ended at December 31, 2011.

We do not maintain a trading account for any class of financial instrument nor do we engage in hedging activities or purchase high-risk derivative instruments. Moreover, we have no material foreign currency exchange rate risk or commodity price risk.

 

ITEM 4. Controls and Procedures

(a) Evaluation of Disclosure Controls and Procedures

An evaluation of the Company’s disclosure controls and procedure (as defined in Section 13a-15(e) or 15d-15(e) of the Securities Exchange Act of 1934 (the “Act”)) was carried out under the supervision and with the participation of the Company’s Chief Executive Officer, Chief Financial Officer and the Company’s Disclosure Committee as of the end of the period covered by this quarterly report. In designing and evaluating the Company’s disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure controls and procedures, management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Based on their evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures as of March 31, 2012 are effective in ensuring that the information required to be disclosed by the Company in the reports it files or submits under the Act is (i) accumulated and communicated to the Company’s management (including the Chief Executive Officer and Chief Financial Officer) in a timely manner, and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

(b) Changes in Internal Control Over Financial Reporting

There have been no changes in the Company’s internal control over financial reporting (as defined in Rule 13a-15(f) of the Act) that occurred during the quarter ended March 31, 2012, that have materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. The Company does not expect that its internal control over financial reporting will prevent all error and all fraud. A control procedure, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control procedure are met. Because of the inherent limitations in all control procedures, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any control procedure also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control procedure, misstatements due to error or fraud may occur and not be detected.

PART II. OTHER INFORMATION

 

Item 1. Legal Proceedings

The Company is a party to certain legal proceedings incidental to its business. Management believes that the outcome of such currently pending proceedings, in the aggregate, will not have a material effect on our consolidated financial condition or results of operations.

 

Item 1A. Risk Factors

There have been no material changes to the risk factors set forth in Part I. Item 1A of the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.

 

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

The Company has had various stock repurchase programs since March 1999. In August 2011, the Board of Directors approved a new stock repurchase plan, allowing the Company to repurchase up to 5% of the then outstanding shares, or approximately 782,000 shares over a period of twelve months. This marked the Company’s ninth stock repurchase plan. During the quarter ended March 31, 2012, the Company repurchased 9,000 shares at an average price of $12.67 per share under this plan. In total, the Company has repurchased 210,205 shares at an average price of $11.68 per share under this plan.

The following table sets forth information about the Company’s purchases of its outstanding common stock during the quarter ended March 31, 2012.

 

Period

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

January 1, 2012 – January 31, 2012

     —         $ —           6,218,821         580,795   

February 1, 2012 – February 29, 2012

     —         $ —           6,218,821         580,795   

March 1, 2012 – March 31, 2012

     9,000       $ 12.67         6,227,821         571,795   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

     9,000       $ 12.67         6,227,821         571,795   

 

Item 3. Defaults Upon Senior Securities

None

 

Item 4. Mine Safety Disclosures

Not applicable

 

Item 5. Other Information

None

 

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Item 6. Exhibits

 

Exhibit

No.

    
  3.1    Articles of Incorporation(1)
  3.2    Bylaws of the Company(2)
  4.2    Warrant for purchase(3)
10.1    1998 Stock Option and Restricted Stock Award Plan(4)
10.2    1997 Stock Option and Restricted Stock Award Plan(5)
10.3    2002 Incentive Stock Option Plan, Director Nonqualified Stock Option Plan, and Restricted Stock Option Plan(6)
10.4    2006 Incentive Stock Option Plan, Director Nonqualified Stock Option Plan, and Restricted Stock Option Plan(7)
10.5    Employment Agreement between the Company and Brian L. Vance, effective December 3, 2010 as amended and restated in February 2007(8)
10.6    Employment Agreement between Central Valley Bank and D. Michael Broadhead, effective December 3, 2010(8)
10.7    Letter of Understanding between Heritage Financial Corporation and Donald V. Rhodes dated August 18, 2009(9)
10.8    Annual Incentive Compensation Plan(12)
10.9    2010 Omnibus Equity Plan(11)
14.0    Code of Ethics and Conduct Policy(10)
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
32.1    Certification of Principal Financial Officer and Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101    The following financial information from Heritage Financial Corporation’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2012 is formatted in XBRL: (i) the Unaudited Condensed Consolidated Statements of Financial Condition, (ii) the Unaudited Condensed Consolidated Statements of Income, (iii) the Unaudited Condensed Consolidated Statements of Comprehensive Income (iv) the Unaudited Condensed Consolidated Statements of Stockholders’ Equity, (v) the Unaudited Condensed Consolidated Statements of Cash Flows, and (vi) the Notes to Unaudited Condensed Consolidated Financial Statements, tagged as blocks of text(13)

 

(1) Incorporated by reference to the Registration Statement on Form S-1 (Reg. No. 333-35573) declared effective on November 12, 1997; as amended, said Amendments being incorporated by reference to the Amendment to the Articles of Incorporation of Heritage Financial Corporation filed with the Current Reports on Form 8-K dated November 25, 2008 and May 14, 2010.
(2) Incorporated by reference to the Current Report on Form 8-K dated November 29, 2007.
(3) Incorporated by reference to the Current Report on Form 8-K dated November 25, 2008.
(4) Incorporated by reference to the Registration Statement on Form S-8 (Reg. No. 333-71415).
(5) Incorporated by reference to the Registration Statement on Form S-8 (Reg. No. 333-57513).
(6) Incorporated by reference to the Registration Statements on Form S-8 (Reg. No. 333-88980; 333-88982; 333-88976).
(7) Incorporated by reference to the Registration Statements on Form S-8 (Reg. No. 333-134473; 333-134474; 333-134475).
(8) Incorporated by reference to the Current Report on Form 8-K dated December 3, 2010.
(9) Incorporated by reference to the Current Report on Form 8-K dated August 20, 2009.
(10) 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.
(11) Incorporated by reference to the Registration Statement on Form S-8 (Reg. No. 33-167146).
(12) Incorporated by reference to the Yearly Report on Form 10-K dated March 2, 2010.
(13) Submitted electronically herewith

 

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SIGNATURES

Pursuant to the requirements 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.

 

    HERITAGE FINANCIAL CORPORATION

Date: May 1, 2012

 

/S/    BRIAN L. VANCE

  Brian L. Vance
 

President and Chief Executive Officer

(Duly Authorized Officer)

 

/s/    DONALD J. HINSON

  Donald J. Hinson
 

Senior Vice President and Chief Financial Officer

(Principal Financial and Accounting Officer)

 

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EXHIBIT INDEX

 

Exhibit

No.

  

Description of Exhibit

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
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 financial information from Heritage Financial Corporation’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2012 is formatted in XBRL: (i) the Unaudited Condensed Consolidated Statements of Financial Condition, (ii) the Unaudited Condensed Consolidated Statements of Income, (iii) the Unaudited Condensed Consolidated Statements Comprehensive Income, (iv) the Unaudited Condensed Consolidated Statements of Stockholders’ Equity, (v) the Unaudited Condensed Consolidated Statements of Cash Flows, and (vi) the Notes to Unaudited Condensed Consolidated Financial Statements, tagged as blocks of text

 

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