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~~

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

For the quarterly period ended March 31, ~~2017~~2018 or

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



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

For the transition period from __________ to __________

Commission File Number 000-29480

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 ý No ¨

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

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



	Large accelerated filer	¨		~~Accelerated filer~~	x
~~Non-accelerated filer~~	¨		~~Smaller reporting company~~	¨
~~Emerging Growth Company~~	¨ ý		Accelerated filer ¨
	Non-accelerated filer ¨ (Do not check if a smaller reporting company)		Smaller reporting company ¨
			Emerging growth company ¨

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨

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

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 ~~27, 2017~~26, 2018 there were ~~29,942,142~~34,018,280 shares of the registrant's common stock, no par value per share, outstanding.

Table of Contents

HERITAGE FINANCIAL CORPORATION

FORM 10-Q

~~INDEX~~

March 31, ~~2017~~2018

TABLE OF CONTENTS



				Page
FORWARD LOOKING STATEMENTS

~~Part~~PART I.	FINANCIAL INFORMATION			4
~~Item~~ITEM 1.	FINANCIAL STATEMENTS			4
		~~Condensed Consolidated Statements of Financial Condition as of March~~CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION AS OF MARCH 31, 2018 AND DECEMBER 31, 2017 ~~and December 31, 2016~~		4
		~~Condensed Consolidated Statements of Income for the Three Months Ended March~~CONDENSED CONSOLIDATED STATEMENTS OF INCOME FOR THE THREE MONTHS ENDED MARCH 31, 2018 AND 2017 ~~and 2016~~		5
		~~Condensed Consolidated Statements of Comprehensive Income for the Three Months Ended March~~CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME FOR THE THREE MONTHS ENDED MARCH 31, 2018 AND 2017 ~~and 2016~~		6
		~~Condensed Consolidated Statements of Stockholders’ Equity for the Three Months Ended March~~CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY FOR THE THREE MONTHS ENDED MARCH 31, 2018 AND 2017 ~~and 2016~~		7
		~~Condensed Consolidated Statements of Cash Flows for the Three Months Ended March~~CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE THREE MONTHS ENDED MARCH 31, 2018 AND 2017 ~~and 2016~~		8
		~~Notes to Condensed Consolidated Financial Statements~~NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS		10
~~Item~~		NOTE 1.	DESCRIPTION OF BUSINESS, BASIS OF PRESENTATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS	10
		NOTE 2.	BUSINESS COMBINATION	14
		NOTE 3.	INVESTMENT SECURITIES	16
		NOTE 4.	LOANS RECEIVABLE	19
		NOTE 5.	ALLOWANCE FOR LOAN LOSSES	30
		NOTE 6.	OTHER REAL ESTATE OWNED	33
		NOTE 7.	GOODWILL AND OTHER INTANGIBLE ASSETS	33
		NOTE 8.	JUNIOR SUBORDINATED DEBENTURES	34
		NOTE 9.	REPURCHASE AGREEMENTS	35
		NOTE 10.	OTHER BORROWINGS	35
		NOTE 11.	DERIVATIVE FINANCIAL INSTRUMENTS	36
		NOTE 12.	STOCKHOLDERS’ EQUITY	37
		NOTE 13.	ACCUMULATED OTHER COMPREHENSIVE (LOSS) INCOME	38
		NOTE 14.	FAIR VALUE MEASUREMENTS	38
		NOTE 15.	STOCK-BASED COMPENSATION	43
		NOTE 16.	CASH REQUIREMENT	46
ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS			4246
~~Item~~ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK			5964
~~Item~~ITEM 4.	CONTROLS AND PROCEDURES			5964

Part II.	OTHER INFORMATION			5964
~~Item~~ITEM 1.	LEGAL PROCEEDINGS			5964
~~Item~~ITEM 1A.	RISK FACTORS			5964
~~Item~~ITEM 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS			6065
~~Item~~ITEM 3.	DEFAULTS UPON SENIOR SECURITIES			6065
~~Item~~ITEM 4.	MINE SAFETY DISCLOSURES			6065
~~Item~~ITEM 5.	OTHER INFORMATION			6065
~~Item~~ITEM 6.	EXHIBITS			6166
	SIGNATURES			6366
	~~CERTIFICATIONS~~

Table of Contents

FORWARD LOOKING STATEMENTS:

~~“Safe Harbor” statement under the Private Securities Litigation Reform Act of 1995:~~ This Quarterly Report on Form 10-Q ("Form 10-Q") ~~contains~~may contain forward-looking statements ~~that~~within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements often include the words “believes,” “expects,” “anticipates,” “estimates,” “forecasts,” “intends,” “plans,” “targets,” “potentially,” “probably,” “projects,” “outlook” or similar expressions or future or conditional verbs such as “may,” “will,” “should,” “would” and “could.” These forward-looking statements are subject to known and unknown risks, uncertainties and ~~uncertainties,~~other factors that could cause actual results to differ materially from the results anticipated, including: our ability to successfully integrate any assets, liabilities, customers, systems, and management personnel from our recent merger with Puget Sound Bancorp, Inc., or our pending merger with Premier Commercial Bancorp, ("Premier Merger"), into our operations and our ability to realize related revenue synergies and cost savings within expected time frames or at all, and any goodwill charges related thereto and costs or difficulties relating to integration matters, including but not limited ~~to:~~to customer and employee retention, which might be greater than expected; the proposed Premier Merger may not close when expected or at all because required regulatory, shareholder or other approvals and conditions to closing are not received or satisfied on a timely basis or at all or adverse regulatory conditions may be imposed in connection with governmental approvals of the merger; 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 effected by deterioration in the housing and commercial real estate markets, which may lead to increased losses and nonperforming assets in our loan portfolio, and may result in our allowance for loan losses no longer being adequate to cover actual losses, and require us to increase our allowance for loan losses; changes in general economic conditions, either nationally or in our market areas; changes in the levels of general interest rates, and the relative differences between short and long term interest rates, deposit interest rates, our net interest margin and funding sources; risks related to acquiring assets in or entering markets in which we have not previously operated and may not be familiar; fluctuations in the demand for loans, the number of unsold homes and other properties and fluctuations in real estate values in our market areas; results of examinations of us by the ~~Board of Governors of the Federal Reserve System and of our~~ bank ~~subsidiary by the Federal Deposit Insurance Corporation ("FDIC"), the Washington State Department of Financial Institutions, Division of Banks or other regulatory authorities,~~regulators, including the possibility that any such regulatory authority may, among other things, initiate an enforcement action against the Company or our bank subsidiary which could require us to increase our allowance for loan losses, write-down assets, change our regulatory capital position, affect our ability to borrow funds or maintain or increase deposits, or impose additional requirements on us, any of which could affect our ability to continue our growth through mergers, acquisitions or similar transactions and adversely affect our liquidity and earnings; legislative or regulatory ~~changes;~~changes that adversely affect our business including but not limited to, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and implementing regulations, changes in regulatory policies and principles, or the interpretation of regulatory capital or other rules as a result of Basel III; our ability to control operating costs and expenses; increases in premiums for deposit insurance; the use of estimates in determining fair value of certain of our assets, which estimates may prove to be incorrect and result in significant declines in valuation; difficulties in reducing risk associated with the loans on our Condensed Consolidated Statements of Financial Condition; staffing fluctuations in response to product demand or the implementation of corporate strategies that affect our workforce and potential associated charges; ~~failure~~disruptions, security breaches, or ~~security breach~~other adverse events, failures or interruptions in, or attacks on, our information technology systems or on the third-party vendors who perform several of ~~computer systems on which we depend;~~our critical processing functions; our ability to retain key members of our senior management team; costs and effects of litigation, including settlements and judgments; our ability to implement our growth strategies; our ability to successfully integrate any assets, liabilities, customers, systems, and management personnel we may acquire into our operations and our ability to realize related revenue synergies and cost savings within expected time frames or at all, and any goodwill charges related thereto and costs or difficulties relating to integration matters, including but not limited to customer and employee retention, which might be greater than expected; increased competitive pressures among financial service companies; changes in consumer spending, borrowing and savings habits; the availability of resources to address changes in laws, rules, or regulations or to respond to regulatory actions; adverse changes in the securities markets; inability of key third-party providers to perform their obligations to us; changes in accounting policies and practices, as may be adopted by the financial institution regulatory agencies or the Financial Accounting Standards Board ("FASB"), including additional guidance and interpretation on accounting issues and details of the implementation of new accounting methods; and other economic, competitive, governmental, regulatory, and technological factors affecting our operations, pricing, products and services and other risks detailed from time to time in our filings with the Securities and Exchange Commission including our Annual Report on Form 10-K for the year ended December 31, ~~2016.~~2017.

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 future periods 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 results 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.

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (Unaudited)

~~(Unaudited)~~(In thousands, except shares)


	March 31, 2017			December 31, 2016
	(Dollars in thousands)						March 31, 2018			December 31, 2017
ASSETS
Cash on hand and in banks	$	74,659		$	77,117		$	86,608		$	78,293
Interest earning deposits	29,713			26,628			43,701			24,722
Cash and cash equivalents	104,372			103,745			130,309			103,015
Investment securities available for sale, at fair value	783,021			794,645			821,567			810,530
Loans held for sale	9,889			11,662			2,669			2,288
Loans receivable, net	2,663,704			2,640,749			3,281,915			2,849,071
Allowance for loan losses	(31,594		)	(31,083		)	(33,261		)	(32,086		)
Total loans receivable, net	2,632,110			2,609,666			3,248,654			2,816,985
Other real estate owned	786			754			—			—
Premises and equipment, net	61,062			63,911			62,147			60,325
Federal Home Loan Bank stock, at cost	7,317			7,564			6,824			8,347
Bank owned life insurance	70,741			70,355			81,700			75,091
Accrued interest receivable	11,237			10,925			13,602			12,244
Prepaid expenses and other assets	78,999			79,351			104,666			99,328
Other intangible assets, net	7,050			7,374			16,563			6,088
Goodwill	119,029			119,029			187,549			119,029
Total assets	$	3,885,613		$	3,878,981		$	4,676,250		$	4,113,270
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits	$	3,243,415		$	3,229,648		$	3,904,741		$	3,393,060
Federal Home Loan Bank advances	66,750			79,600			30,700			92,500
Junior subordinated debentures	19,790			19,717			20,083			20,009
Securities sold under agreement to repurchase	21,440			22,104			26,100			31,821
Accrued expenses and other liabilities	45,022			46,149			59,918			67,575
Total liabilities	3,396,417			3,397,218			4,041,542			3,604,965
Stockholders’ equity:
Preferred stock, no par value, 2,500,000 shares authorized; no shares issued and outstanding at March 31, 2017 and December 31, 2016	—			—
Common stock, no par value, 50,000,000 shares authorized; 29,942,142 and 29,954,931 shares issued and outstanding at March 31, 2017 and December 31, 2016, respectively	359,298			359,060
Preferred stock, no par value, 2,500,000 shares authorized; no shares issued and outstanding at March 31, 2018 and December 31, 2017							—			—
Common stock, no par value, 50,000,000 shares authorized; 34,018,280 and 29,927,746 shares issued and outstanding at March 31, 2018 and December 31, 2017, respectively							490,566			360,590
Retained earnings	131,031			125,309			153,101			149,013
Accumulated other comprehensive income, net	(1,133		)	(2,606		)
Accumulated other comprehensive loss, net							(8,959		)	(1,298		)
Total stockholders’ equity	489,196			481,763			634,708			508,305
Total liabilities and stockholders’ equity	$	3,885,613		$	3,878,981		$	4,676,250		$	4,113,270

See accompanying Notes to Condensed Consolidated Financial Statements.

Table of Contents

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

(In thousands, except per share amounts)

Three Months Ended March 31,
2017 2016
(Dollars in thousands, except per share amounts)
INTEREST INCOME
Interest and fees on loans $ 30,485
$ 30,177
Taxable interest on investment securities 3,049
2,796
Nontaxable interest on investment securities 1,268
1,171
Interest and dividends on other interest earning assets 61
91
Total interest income 34,863
34,235
INTEREST EXPENSE
Deposits 1,266
1,254
Junior subordinated debentures 238
210
Other borrowings 213
11
Total interest expense 1,717
1,475
Net interest income 33,146
32,760
Provision for loan losses 867
1,139
Net interest income after provision for loan losses 32,279
31,621
NONINTEREST INCOME
Service charges and other fees 4,213
3,356
Gain on sale of investment securities, net —
560
Gain on sale of loans, net 1,195
729
Interest rate swap fees 133
136
Other income 1,808
2,209
Total noninterest income 7,349
6,990
NONINTEREST EXPENSE
Compensation and employee benefits 16,024
15,121
Occupancy and equipment 3,810
3,836
Data processing 1,915
1,792
Marketing 807
728
Professional services 1,009
845
State and local taxes 549
607
Federal deposit insurance premium 300
492
Other real estate owned, net 31
411
Amortization of intangible assets 324
335
Other expense 2,454
2,202
Total noninterest expense 27,223
26,369
Income before income taxes 12,405
12,242
Income tax expense 3,089
3,151
Net income $ 9,316
$ 9,091
Basic earnings per common share $ 0.31
$ 0.30
Diluted earnings per common share $ 0.31
$ 0.30
Dividends declared per common share $ 0.12
$ 0.11



	Three Months Ended March 31,
	2018		2017
INTEREST INCOME
Interest and fees on loans	$	38,159	$	30,485
Taxable interest on investment securities	3,529		3,049
Nontaxable interest on investment securities	1,341		1,268
Interest and dividends on other interest earning assets	299		61
Total interest income	43,328		34,863
INTEREST EXPENSE
Deposits	1,960		1,266
Junior subordinated debentures	283		238
Other borrowings	167		213
Total interest expense	2,410		1,717
Net interest income	40,918		33,146
Provision for loan losses	1,152		867
Net interest income after provision for loan losses	39,766		32,279
NONINTEREST INCOME
Service charges and other fees	4,543		4,213
Gain on sale of investment securities, net	35		—
Gain on sale of loans, net	874		1,195
Interest rate swap fees	51		133
Other income	1,964		1,808
Total noninterest income	7,467		7,349
NONINTEREST EXPENSE
Compensation and employee benefits	21,367		16,024
Occupancy and equipment	4,627		3,810
Data processing	2,605		1,915
Marketing	808		807
Professional services	2,837		1,009
State and local taxes	688		549
Federal deposit insurance premium	355		300
Other real estate owned, net	—		31
Amortization of intangible assets	795		324
Other expense	2,665		2,454
Total noninterest expense	36,747		27,223
Income before income taxes	10,486		12,405
Income tax expense	1,399		3,089
Net income	$	9,087	$	9,316
Basic earnings per common share	$	0.27	$	0.31
Diluted earnings per common share	$	0.27	$	0.31
Dividends declared per common share	$	0.15	$	0.12

See accompanying Notes to Condensed Consolidated Financial Statements.

Table of Contents

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)

~~(Unaudited)~~(In thousands)

Three Months Ended March 31,
2017 2016
(Dollars in thousands)
Net income $ 9,316
$ 9,091
Change in fair value of investment securities available for sale, net of tax of $794 and $3,285, respectively 1,473
6,075
Reclassification adjustment for net gain from sale of investment securities available for sale included in income, net of tax of $0 and $(196), respectively —
(364 )
Other comprehensive income 1,473
5,711
Comprehensive income $ 10,789
$ 14,802



	Three Months Ended March 31,
	2018			2017
Net income	$	9,087		$	9,316
Change in fair value of investment securities available for sale, net of tax of $(2,008) and $794, respectively	(7,516		)	1,473
Reclassification adjustment for net gain from sale of investment securities available for sale included in income, net of tax of $(8) and $0, respectively	(27		)	—
Other comprehensive income (loss)	(7,543		)	1,473
Comprehensive income	$	1,544		$	10,789

See accompanying Notes to Condensed Consolidated Financial Statements.

Table of Contents

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Unaudited)

~~(Unaudited)~~(In thousands, except per share amounts)


	Number of common shares		Common stock			Retained earnings			Accumulated other comprehensive income, net			Total stock- holders’ equity
	(Dollars in thousands, except per share amounts)
Balance at December 31, 2015	29,975		$	359,451		$	107,960		$	2,559		$	469,970
Restricted and unrestricted stock awards granted, net of forfeitures	98		—			—			—			—
Exercise of stock options (including excess tax benefits from nonqualified stock options)	10		142			—			—			142
Restricted stock compensation expense	—		445			—			—			445
Net excess tax benefits from vesting of restricted stock	—		23			—			—			23
Common stock repurchased	(111	)	(1,903		)	—			—			(1,903		)
Net income	—		—			9,091			—			9,091
Other comprehensive income, net of tax	—		—			—			5,711			5,711
Cash dividends declared on common stock ($0.11 per share)	—		—			(3,298		)	—			(3,298		)
Balance at March 31, 2016	29,972		$	358,158		$	113,753		$	8,270		$	480,181
															Number of common shares		Common stock			Retained earnings			Accumulated other comprehensive income (loss), net			Total stock- holders’ equity
Balance at December 31, 2016	29,955		$	359,060		$	125,309		$	(2,606	)	$	481,763		29,955		$	359,060		$	125,309		$	(2,606	)	$	481,763
Restricted stock awards forfeited	(5	)	—			—			—			—			(5	)	—			—			—			—
Exercise of stock options	8		109			—			—			109			8		109			—			—			109
Restricted stock compensation expense	—		510			—			—			510
Stock-based compensation expense															—		510			—			—			510
Common stock repurchased	(16	)	(381		)	—			—			(381		)	(16	)	(381		)	—			—			(381		)
Net income	—		—			9,316			—			9,316			—		—			9,316			—			9,316
Other comprehensive income, net of tax	—		—			—			1,473			1,473			—		—			—			1,473			1,473
Cash dividends declared on common stock ($0.12 per share)	—		—			(3,594		)	—			(3,594		)	—		—			(3,594		)	—			(3,594		)
Balance at March 31, 2017	29,942		$	359,298		$	131,031		$	(1,133	)	$	489,196		29,942		$	359,298		$	131,031		$	(1,133	)	$	489,196

Balance at December 31, 2017															29,928		$	360,590		$	149,013		$	(1,298	)	$	508,305
Restricted stock units vested															22		—			—			—			—
Exercise of stock options															1		21			—			—			21
Stock-based compensation expense															—		623			—			—			623
Common stock repurchased															(45	)	(1,438		)	—			—			(1,438		)
Net income															—		—			9,087			—			9,087
Other comprehensive loss, net of tax															—		—			—			(7,543		)	(7,543		)
Common stock issued in business combination															4,112		130,770			—			—			130,770
Cash dividends declared on common stock ($0.15 per share)															—		—			(5,117		)	—			(5,117		)
ASU 2016-01 implementation															—		—			118			(118		)	—
Balance at March 31, 2018															34,018		$	490,566		$	153,101		$	(8,959	)	$	634,708

See accompanying Notes to Condensed Consolidated Financial Statements.

Table of Contents

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

~~(Unaudited)~~(In thousands)


	Three Months Ended March 31,
	2017			2016			Three Months Ended March 31,
	(Dollars in thousands)						2018			2017
Cash flows from operating activities:
Net income	$	9,316		$	9,091		$	9,087		$	9,316
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	2,808			3,313			2,631			2,808
Changes in net deferred loan costs, net of amortization	(338		)	(377		)	9			(338		)
Provision for loan losses	867			1,139			1,152			867
Net change in accrued interest receivable, prepaid expenses and other assets, accrued expenses and other liabilities	802			(881		)	(4,191		)	802
Restricted stock compensation expense	510			445
Net excess tax benefit from exercise of stock options and vesting of restricted stock	—			(23		)
Stock-based compensation expense							623			510
Amortization of intangible assets	324			335			795			324
Gain on sale of investment securities, net	—			(560		)
Origination of loans held for sale	(27,209		)	(23,186		)	(20,380		)	(27,209		)
Gain on sale of loans, net	(1,195		)	(729		)
Proceeds from sale of loans	35,956			24,561			20,651			35,956
Earnings on bank owned life insurance	(375		)	(362		)	(335		)	(375		)
Valuation adjustment on other real estate owned	—			312
Gain on sale of other real estate owned, net	—			(10		)
Gain on sale of loans, net							(874		)	(1,195		)
Gain on sale of investment securities, net							(35		)	—
Loss on sale or write-off of furniture, equipment and leasehold improvements	3			—			6			3
Net cash provided by operating activities	21,469			13,068			9,139			21,469
Cash flows from investing activities:
Loans originated, net of principal payments	(28,784		)	(58,599		)	(46,959		)	(33,249		)
Maturities of other interest earning deposits	—			1,248
Maturities, calls and payments of investment securities available for sale	20,094			23,047			24,443			20,094
Purchase of investment securities available for sale	(7,932		)	(76,580		)	(69,352		)	(7,932		)
Purchase of premises and equipment	(847		)	(290		)	(2,146		)	(847		)
Proceeds from sales of other real estate owned	—			543
Proceeds from sales of other loans							2,813			4,465
Proceeds from sales of investment securities available for sale	—			50,440			103,032			—
Proceeds from redemption of FHLB stock	7,682			—
Purchases of FHLB stock	(7,435		)	(232		)
Investment in low-income housing tax credit partnership	(7		)	—
Net cash used in investing activities	(17,229		)	(60,423		)
Proceeds from redemption of Federal Home Loan Bank stock							10,130			7,682
Purchases of Federal Home Loan Bank stock							(7,984		)	(7,435		)
Capital contribution to low-income housing tax credit partnership							(7,696		)	(7		)
Net cash received from acquisitions							80,133			—
Net cash provided by (used in) investing activities							86,414			(17,229		)
Cash flows from financing activities:
Net increase in deposits	13,767			22,642			5,796			13,767
FHLB advances	184,600			—
Repayments of FHLB advances	(197,450		)	—
Federal Home Loan Bank advances							191,450			184,600
Repayments of Federal Home Loan Bank advances							(253,250		)	(197,450		)
Common stock cash dividends paid	(3,594		)	(3,298		)	(5,117		)	(3,594		)
Net decrease in securities sold under agreement to repurchase	(664		)	(2,872		)	(5,721		)	(664		)
Proceeds from exercise of stock options	109			142			21			109
Net excess tax benefit from exercise of stock options and vesting of restricted stock	—			23
Repurchase of common stock	(381		)	(1,903		)	(1,438		)	(381		)
Net cash (used in) provided by financing activities	(3,613		)	14,734
Net cash used in financing activities							(68,259		)	(3,613		)

Table of Contents


	Three Months Ended March 31,					Three Months Ended March 31,
	2017		2016			2018			2017
	(Dollars in thousands)
Net increase (decrease) in cash and cash equivalents	627		(32,621		)
Net increase in cash and cash equivalents						27,294			627
Cash and cash equivalents at beginning of period	103,745		126,640			103,015			103,745
Cash and cash equivalents at end of period	$	104,372	$	94,019		$	130,309		$	104,372

Supplemental disclosures of cash flow information:
Cash paid for interest	$	1,775	$	1,483		$	2,398		$	1,775
Cash paid for income taxes	—		—			—			—

Supplemental non-cash disclosures of cash flow information:
Transfers of loans receivable to other real estate owned	$	32	$	652		$	—		$	32
Transfers of loans receivable to loans held for sale	5,779		—			—			5,779
Transfers of premises and equipment, net to prepaid expenses and other assets for properties held for sale	2,687		—			—			2,687
Business Combination:
Common stock issued for business combinations						130,770			—
Assets acquired (liabilities assumed) in acquisitions:
Investment securities available for sale						80,353			—
Loans receivable						388,462			—
Premises and equipment						732			—
Federal Home Loan Bank stock						623			—
Accrued interest receivable						1,448			—
Bank owned life insurance						6,264			—
Prepaid expenses and other assets						1,354			—
Other intangible assets						11,270			—
Deposits						(505,885		)	—
Accrued expenses and other liabilities						(2,504		)	—

See accompanying Notes to Condensed Consolidated Financial Statements.

Table of Contents

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)


(1)	Description of Business, Basis of Presentation, Significant Accounting Policies and Recently Issued Accounting Pronouncements

(a) Description of Business

Heritage Financial Corporation ("Heritage" or the “Company”) is a bank holding company that was incorporated in the State of Washington in August 1997. The Company is primarily engaged in the business of planning, directing and coordinating the business activities of its wholly-owned subsidiary, Heritage Bank (the “Bank”). The Bank is a Washington-chartered commercial bank and its deposits are insured by the ~~FDIC.~~Federal Deposit Insurance Corporation ("FDIC"). The Bank is headquartered in Olympia, Washington and conducts business from its 5960 branch offices located throughout Washington State and the greater Portland, Oregon area. The Bank’s business consists primarily of commercial lending and deposit relationships with small businesses and their owners in its market areas and attracting deposits from the general public. The Bank also makes real estate construction and land development loans, ~~and~~ consumer loans and originates first mortgage loans on residential properties primarily located in its market areas.

~~The~~On January 16, 2018, the Company ~~has expanded its footprint through mergers and acquisitions. The largest~~completed the acquisition of ~~these transactions was~~Puget Sound Bancorp, Inc. (“Puget Sound”), the ~~strategic merger~~holding company for Puget Sound Bank, both of Bellevue, Washington (“Puget Sound Merger”). See Note (2), Business Combination for additional information on the merger.

On March 8, 2018, the Company entered into a definitive agreement (the "Agreement") with ~~Washington Banking Company (“Washington Banking”~~Premier Commercial Bancorp, of Hillsboro, Oregon ("Premier Commercial") ~~and its wholly owned subsidiary bank, Whidbey Island Bank ("Whidbey"). Effective May 1, 2014, Washington Banking~~, pursuant to which Premier Commercial will be merged with and into Heritage, and ~~Whidbey~~immediately thereafter Premier Commercial's bank subsidiary, Premier Community Bank, will be merged with and into Heritage Bank (the "Premier Merger"). Premier Commercial Bank has six branch locations. Under the terms of the Agreement, Premier Commercial shareholders will receive 0.4863 shares of Heritage common stock for each share of Premier Commercial common stock. Based on the closing price of Heritage common stock of $31.10 on March 8, 2018, the consideration value per share of Premier Commercial was $15.12, or approximately $88.6 million in aggregate, including the value of the outstanding shares of Premier Commercial restricted stock. The value of the merger consideration will fluctuate until closing based on the value of Heritage's stock price. At December 31, 2017, Premier Commercial had total assets of $400.5 million, total loans of $339.3 million and ~~this~~total deposits of $330.6 million.

The transaction is ~~referred~~subject to ~~herein as~~customary closing conditions, including the ~~"Washington Banking Merger".~~receipt of regulatory approvals and approval of the Agreement by the shareholders of Premier Commercial, and is expected to be completed in the third quarter of 2018. In the event the Agreement is terminated under certain specified circumstances in connection with ~~the Washington Banking Merger,~~a competing transaction, Premier Commercial will be required to pay Heritage ~~also acquired as~~ a ~~subsidiary the Washington Banking Master Trust, a Delaware statutory business trust ('Trust"). Pursuant to the merger agreement, Heritage assumed the performance and observance~~termination fee of $3.45 million in cash. All of the ~~covenants~~directors and executive officers of Premier Commercial have agreed to ~~be performed by Washington Banking under an indenture relating to $25.0 million~~vote their shares of Premier Commercial common stock in ~~trust preferred securities issued in 2007 and the due and punctual payment~~favor of approval of the ~~principal of and premium and interest on such trust preferred securities. For additional information, see Note (8) Junior Subordinated Debentures.~~Agreement.

(b) Basis of Presentation

The accompanying unaudited Condensed Consolidated Financial Statements have been prepared in accordance with the accounting principles generally accepted in the United States (“U.S. GAAP”) for interim financial information and 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. It is recommended that these unaudited Condensed Consolidated Financial Statements and accompanying Notes be read with the audited Consolidated Financial Statements and the accompanying Notes included in the Company's Annual Report on Form 10-K for the year ended December 31, ~~2016~~2017 (“~~2016~~2017 Annual Form 10-K”). In management's 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, ~~2017~~2018 are not necessarily indicative of the results that may be expected for the year ending December 31, ~~2017.~~2018. In preparing the unaudited Condensed Consolidated Financial Statements, management is required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures. Management believes that the judgments, estimates and assumptions used in the preparation of the financial statements are appropriate based on the facts and circumstances at the time. Actual results, however, could differ significantly from those estimates.

Table of Contents

The significant accounting policies used in preparation of the Company's Condensed Consolidated Financial Statements are disclosed in the ~~2016~~2017 Annual Form 10-K. There have not been any material changes in the Company's significant accounting policies from those contained in the ~~2016~~2017 Annual Form 10-K, except for the ~~issuance~~accounting policy relating to revenue from contracts with customers adopted January 1, 2018 as discussed below.

Revenue from Contracts with Customers

Accounting Standards Codification Topic 606, Revenue from Contracts with Customers, (“ASC 606”) as amended was adopted by the Company on January 1, 2018. ASC 606 applies to all contracts with customers to provide goods or services in the ordinary course of ~~restricted stock units, including grants subject~~business, except for contracts that are specifically excluded from its scope. The Company's revenues are primarily composed of interest income on financial instruments, such as loans and investment securities, which are excluded from the scope of ASC 606. Descriptions of our revenue-generating activities that are within the scope ASC 606, which are presented in Service Charges and Other Fees and Other Income on the Company’s Condensed Consolidated Statement of Income, are as follows:

Service Charges on Deposit Accounts: The Company earns fees from its deposit customers from a variety of deposit products and services. Non-transaction based fees such as account maintenance fees and monthly statement fees are considered to ~~performance-based~~be provided to the customer under a day-to-day contract with ongoing renewals. Revenues for these non-transaction fees are earned over the course of a month, representing the period over which the Company satisfies the performance obligation. Transaction-based fees such as non-sufficient fund charges, stop payment charges and ~~market-based vesting conditions, during~~wire fees are recognized at the ~~quarter ended March 31, 2017.~~time the transaction is executed as the contract duration does not extend beyond the service performed.

~~Stock-Based Compensation~~

~~Compensation cost is~~Wealth Management and Trust Services. The Company earns fees from contracts with customers for fiduciary and brokerage activities. Revenues are generally recognized ~~for stock options, restricted stock awards,~~on a monthly basis and ~~restricted stock units issued to employees and directors,~~are generally based on the fair value of these awards at the date of grant. The fair value of stock options granted would be estimated on the date of grant using the Black-Scholes-Merton option pricing model. The market pricea percentage of the ~~Company’s common stock at the date of grant is used~~customer’s assets under management or based on investment or insurance solutions that are implemented for the ~~restricted stock awards~~customer.

Merchant Processing Services and ~~restricted stock units. Compensation cost is~~Debit and Credit Card Fees: The Company earns fees from cardholder transactions conducted through third party payment network providers which consist of (i) interchange fees earned from the payment network as a debit card issuer, (ii) referral fee income, and (iii) ongoing merchant fees earned for referring customers to the payment processing provider. These fees are recognized ~~over~~when the ~~requisite service period, generally defined as the vesting period,~~transaction occurs, but may settle on a ~~straight-line~~daily or monthly basis.

~~Table of Contents~~

Certain restricted stock unit grants are subject to performance-based vesting as well as other approved vesting conditions and cliff vest based on those conditions. Compensation expense is recognized over the service period to the extent restricted stock units are expected to vest. The fair value of these restricted stock unit grants subject to market-based performance criteria is estimated as of the grant date using a Monte Carlo simulation pricing model.

(d) Recently Issued Accounting Pronouncements

FASB ~~Accounting Standards Update ("ASU" or "Update")~~ASU 2014-09, Revenue from Contracts with Customers, was issued in May 2014. Under this Accounting Standard Update ~~FASB~~("ASU" or "Update"), the Financial Accounting Standards Board ("FASB") created a new Topic 606 which is in response to a joint initiative of FASB and the International Accounting Standards Board to clarify the principles for recognizing revenue and to develop a common revenue standard for U.S. GAAP and international financial reporting standards that would:

Remove inconsistencies and weaknesses in revenue requirements.

Provide a more robust framework for addressing revenue issues.

Improve comparability of revenue recognition practices across entities, industries, jurisdictions and capital markets.

Provide more useful information to users of financial statements through improved disclosure requirements.

Simplify the preparation of financial statements by reducing the number of requirements to which an entity must refer.

The original effective date for this Update was deferred in FASB ASU 2015-14, and the Update was adopted on January 1, 2018 as described below.

FASB ASU 2015-14, Revenue from Contracts with Customers (Topic 606), was issued in August 2015 and defers the effective date of the above-mentioned FASB ASU 2014-09 for certain entities. Public business entities, certain not-for-profit entities and certain employee benefit plans should apply the guidance in Update 2014-09 to annual reporting periods beginning after December 15, 2017, including interim reporting periods within that reporting period. Earlier application is ~~now~~ permitted, but only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. The Company ~~expects to adopt~~adopted the revenue recognition guidance on

Table of Contents

January 1, 2018 using the modified retrospective approach. A significant amount of the Company’s revenues are derived from ~~net~~ interest income on financial assets, ~~and liabilities,~~ which are excluded from the scope of the amended guidance. With respect to noninterest income and related disclosures, the Company ~~is in its preliminary stages of identifying~~has identified and ~~evaluating~~evaluated the revenue streams and underlying revenue contracts within the scope of the guidance. The Company ~~is expecting to begin developing processes and procedures during 2017 to ensure it is fully compliant with these amendments. To date, the Company has~~did not ~~yet identified~~identify any significant changes in the timing of revenue recognition when considering the amended accounting ~~guidance; however,~~guidance. The adoption of the ~~Company’s implementation efforts are ongoing and such assessments may~~Update did not have a material impact on the Company's Condensed Consolidated Financial Statements, but the adoption did change ~~prior to the January 1, 2018 implementation date.~~certain disclosure requirements included in Significant Accounting Policies above.

FASB ASU 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities (Subtopic 825-10), was issued in January 2016, to enhance the reporting model for financial instruments to provide users of financial statements with more decision-useful information. This Update contains several provisions, including but not limited to 1)(1) requiring equity investments, with certain exceptions, to be measured at fair value with changes in fair value recognized in net income; 2)(2) simplifying the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment; 3)(3) eliminating the requirement to disclose the method(s) and significant assumptions used to estimate fair value; and 4)(4) requiring separate presentation of financial assets and liabilities by measurement category and form of financial asset on the balance sheet or the accompanying notes to the financial statements. The Update also changes certain financial statement disclosure requirements, including requiring disclosures of the fair value of financial instruments be made on the basis of exit price. The Update iswas effective for public entities for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company ~~is currently evaluating~~adopted this Update effective January 1, 2018 using the ~~impact~~cumulative catch-up transition method. This change resulted in a cumulative adjustment from accumulated other comprehensive loss, net to retained earnings for the unrealized gain related to the Company's equity security. The Company's processes and procedures utilized to estimate the fair value of loans receivable and certificate of deposit accounts for disclosure requirements were additionally changed due to adoption of this Update. Previously, the Company valued these items using an entry price notion. This ASU emphasized that these instruments be measured using the ~~Update will have on~~exit price notion; accordingly, the Company refined its calculation as part of adopting this standard. Prior period information has not been updated to conform with the new guidance. See the Condensed Consolidated ~~Financial Statements.~~Statements of Stockholders' Equity and Note (14) Fair Value Measurements.

FASB ASU 2016-02, Leases (Topic 842), was originally issued in February 2016, to increase transparency and comparability of leases among organizations and to disclose key information about leasing arrangements. The Update sets out the principles for the recognition, measurement, presentation and disclosure of leases for both lessees and lessors. The Update requires lessees to apply a dual approach, classifying leases as either a finance or operating lease. This classification will determine whether the lease expense is recognized based on an effective interest method or on a straight-line basis over the term of the lease. A lessee is also required to record a right-of-use asset and a lease liability for all leases with a term greater than 12 months regardless of their classification. All cash payments will be classified within operating activities in the statement of cash flows. In transition, lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. The Update is effective for public entities for fiscal years beginning after December 15, 2018, including

~~Table of Contents~~

interim periods within those fiscal years. The Company anticipates adopting the Update on January 1, 2019. Upon adoption of the guidance, the Company expects to report increased assets and increased liabilities on its Condensed Consolidated Statements of Financial Condition as a result of recognizing right-of-use assets and lease liabilities related to certain banking offices and certain equipment under noncancelable operating lease agreements, which currently are not reflected in its Condensed Consolidated Statements of Financial Condition. During 2017, management developed its methodology to estimate the right-of use assets and lease liabilities. The Company ~~is anticipating~~anticipates electing an exclusion accounting policy ~~to not recognize~~for lease assets and lease liabilities for leases with a term of twelve months or less. The Company was committed to ~~$14.7~~$13.9 million of minimum lease payments under noncancelable operating lease agreements at ~~December~~March 31, ~~2016.~~2018. The Company does not expect the adoption of this amendment will have a significant impact to its Condensed Consolidated Financial Statements.

FASB ASU 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations, was issued in March 2016 and it clarifies the implementation guidance of the above-mentioned FASB ASU 2014-09 as it relates to principal versus agent considerations. The Update addresses identifying the unit of account and nature of the goods or services as well as applying the control principle and interactions with the control principle. The amendments to the Update do not change the core principle of the guidance. The effective date, transition requirements and impact on the Company's Condensed Consolidated Financial Statements for this Update are the same as those described in FASB ASU 2015-14 above.

FASB ASU ~~2016-09~~, ~~Stock Compensation (Topic 718)~~, issued in March 2016, is intended to simplify several aspects of the accounting for share-based payment award transactions. For public business entities, the guidance is effective for annual periods after December 15, 2016, including interim periods within those annual periods with early adoption permitted. Certain amendments will be applied using a modified retrospective transition method by means of a cumulative-effect adjustment to equity as of the beginning of the period in which the guidance is adopted. Other amendments will be applied retroactively (such as presentation of employee taxes paid on the statement of cash flows) or prospectively (such as recognition of excess tax benefits on the income statement). The Company adopted this standard during this quarter ended March 31, 2017 with an effective date of January 1, 2017. The Company made an accounting policy election to account for forfeitures as they occur and this change resulted in a cumulative adjustment that was immaterial to all periods presented. Changes to the statement of cash flows have been applied prospectively beginning in this quarter ended March 31, 2017 and we recorded an excess tax benefit of $138,000 in our current quarter income tax provision expense. Adoption of all other changes did not have a material impact on the Condensed Consolidated Financial Statements.

~~FASB ASU~~ 2016-10, Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing, was issued in April 2016 which clarifies the implementation guidance of the above-mentioned FASB ASU 2014-09 as it relates to identifying performance obligations and licensing. The effective date, transition

Table of Contents

requirements and impact on the Company's Condensed Consolidated Financial Statements for this Update are the same as those described in FASB ASU 2015-14 above.

FASB ASU 2016-12, Revenue from Contracts with Customers (Topic 606): Narrow-scope Improvements and Practical Expedients, was issued in May 2016. The amendments in this Update do not change the core principle of the guidance in Topic 606. Rather, the amendments in this Update affect only the narrow aspects of Topic 606. The effective date, transition requirements and impact on the Company's Condensed Consolidated Financial Statements for this Update are the same as those described in FASB ASU 2015-14 above.

FASB ASU 2016-13, Financial Instruments: Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, was issued in June 2016. Commonly referred to as the current expected credit loss model ("CECL"), this Update requires financial assets measured at amortized cost basis to be presented at the net amount expected to be collected. The allowance for credit losses is a valuation account that is deducted from the amortized cost basis of the financial asset to present the net carrying value at the amount expected to be collected on the financial asset. The measurement of expected credit losses is based on relevant information about past events including historical experience, current conditions and reasonable and supportable forecasts that affect the collectibility of the reported amount. The amendment affects loans, debt securities, trade receivables, net investments in leases, off-balance-sheet credit exposures, reinsurance receivables and any other financial asset not excluded from the scope that have the contractual right to receive cash. The Update replaces the incurred loss impairment methodology, which generally only considered past events and current conditions, with a methodology that reflects the expected credit losses and required consideration of a broader range of reasonable and supportable information to estimate all expected credit losses. The Update additionally addresses purchased assets and introduces the purchased financial asset with a more-than-insignificant amount of credit deterioration since origination ("PCD"). The accounting for these PCD assets is similar to the existing accounting guidance of FASB ~~Accounting Standards Codification ("ASC")~~ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality, for ~~purchased credit impaired ("PCI")~~PCI assets, except the subsequent improvements in estimated cash flows will be immediately recognized into income, similar to the immediate

~~Table of Contents~~

recognition of subsequent deteriorations in cash flows. Current guidance only allows for the prospective recognition of these cash flow improvements. Because the terminology has been changed to a "more-than-insignificant" amount of credit deterioration, the presumption is that more assets might qualify for this accounting under the Update than those under current guidance. For public business entities, the Update is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years with early adoption permitted for fiscal years after December 15, 2018. An entity will apply the Update through a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is adopted. A prospective transition approach is required for debt securities. An entity that has previously applied the guidance of FASB ASC 310-30 will prospectively apply the guidance in this Update for PCD assets. A prospective transition approach should be used for PCD assets where upon adoption, the amortized cost basis should be adjusted to reflect the addition of the allowance for credit losses. The Company is anticipating adopting the Update on January 1, 2020. Upon adoption, the Company expects a change in the processes, internal controls and procedures to calculate the allowance for loan losses, including changes in assumptions and estimates to consider expected credit losses over the life of the loan versus the current accounting practice that utilizes the incurred loss model. The new guidance may result in an increase in the allowance for loan losses which will also reflect the new requirement to include the nonaccretable principal differences on PCI loans; however, the Company is still in the process of determining the magnitude of the increase and its impact on the Condensed Consolidated Financial Statements. In addition, the current accounting policy and procedures for other-than-temporary impairment on investment securities available for sale will be replaced with an allowance approach. ~~The Company is expecting to begin~~During 2017, the Company's management created a CECL steering committee which has begun developing and implementing processes and procedures to ensure it is fully compliant with the amendments at the adoption date. To date, the CECL steering committee has selected a vendor to assist the Company in the adoption and has begun the implementation discovery sessions.

FASB ASU 2016-15, Statement of Cash Flows (Topic ~~213)~~230): Classification of Certain Cash Receipts and Cash Payments, was issued in August 2016. The Update addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice. For public business entities, the guidance iswas effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal ~~years. Early adoption is permitted~~years, and must be applied using a retrospective transitional method to each period presented. The Company ~~has evaluated the new guidance and does not anticipate that its adoption of~~adopted this Update on January 1, ~~2018 will~~2018. The adoption did not have a significant impact on its Condensed Consolidated Financial ~~Statements.~~

~~FASB ASU 2017-03~~, ~~Accounting Changes~~Statements as cash proceeds received from the settlement of bank-owned life insurance policies and ~~Error Corrections (Topic 250)~~cash payment for premiums on bank-owned life insurance policies were previously classified as cash inflows and ~~Investments—Equity Method and Joint Ventures (Topic 323)~~: Amendments to SEC Paragraphs Pursuant to Staff Announcements at the September 22, 2016 and November 17, 2016 EITF Meetings (SEC Update), was issued in January 2017. The SEC staff view is that a registrant should evaluate ASC updates that have not yet been adopted to determine the appropriate financial disclosures about the potential material effects of the updates on the financial statements when adopted. If a registrant does not know or cannot reasonably estimate the impact of an update, then in addition to making a statement to that effect, the registrant should consider additional qualitative financial statement disclosures to assist the reader in assessing the significance of the impact. The staff expects the additional qualitative disclosures to include a description of the effect of the accounting policies expected to be applied compared to current accounting policies. Also, the registrant should describe the status of its process to implement the new standards and the significant implementation matters yet to be addressed. The amendments specifically addressed recent ASC amendments to Topic 326, Financial Instruments - Credit Losses; Topic 842, Leases; and Topic 606, Revenueoutflows, respectively, from ~~Contracts with Customers; although, the amendments apply to any subsequent amendments to guidance~~investing activities in the ~~ASC. The Company adopted the amendments in this Update during the fourth quarter~~Condensed Consolidated Statements of ~~2016 and appropriate disclosures have been included in this Note for each recently issued accounting standard.~~Cash Flows.

FASB ASU 2017-04, Goodwill (Topic 350), was issued in January 2017 and eliminates Step 2 from the goodwill impairment test. Under the amendments, an entity should perform its goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An entity should recognize an impairment charge for the amount by

Table of Contents

which the carrying amount exceeds the reporting unit’s fair value. The loss recognized, however, should not exceed the total amount of goodwill allocated to that reporting unit. Additionally, an entity should consider income tax effects from any tax deductible goodwill on the carrying amount of the reporting unit when measuring the goodwill impairment loss, if applicable. The Update is effective for annual periods or any interim goodwill impairment tests beginning after December 15, 2019 using a prospective transition method and early adoption is permitted. The Company does not expect the Update will have a material impact on its Condensed Consolidated Financial Statements.

FASB ASU 2017-08, Receivables—Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities was issued in March 2017 and changes the accounting for certain purchased callable debt securities held at a premium to shorten the amortization period for the premium to the earliest call date rather than to the maturity date. Accounting for purchased callable debt securities held at a discount does not change. The discount would continue to amortize to the maturity date. The Update is effective for reporting periods beginning after December 15, 2018, with early adoption permitted. The Company adopted this Update in January 2018. The adoption did not have a material impact on its Condensed Consolidated Financial Statements as the Company had been accounting for premiums as prescribed under this guidance.

FASB ASU 2017-09, Compensation—Stock Compensation (Topic 718): Scope of Modification Accounting was issued in May 2017 to provide clarity as to when to apply modification accounting when there is a change in the terms or conditions of a share-based payment award. According to this Update, an entity should account for the effects of a modification unless the fair value, vesting conditions and balance sheet classification of the award is the same after the modification as compared to the original award prior to the modification. The Update was effective for reporting periods beginning after December 15, 2017. The Company adopted the Update on January 1, 2018. The adoption did not have a material impact on its Condensed Consolidated Financial Statements because we did not modify any share-based payment award during the first quarter ended March 31, 2018. We will apply this Update prospectively for any subsequent modifications of share-based payment awards.

FASB ASU 2018-02, Income Statement — Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income was issued to address the income tax accounting treatment of the stranded tax effects within other comprehensive income due to the prohibition of backward tracing due to an income tax rate change that was initially recorded in other comprehensive income. This issue came about from the enactment of the Tax Cuts and Jobs Act on December 22, 2017 ("Tax Cuts and Jobs Act") that changed the Company’s income tax rate from 35% to 21%. The Update changed current accounting whereby an entity may elect to reclassify the stranded tax effect from accumulated other comprehensive income to retained earnings. The Update is effective for periods beginning after December 15, 2018 although early adoption is permitted. The Company early adopted ASU 2018-02 effective December 31, 2017 and elected a portfolio policy to reclassify the stranded tax effects of the change in the federal corporate tax rate of the net unrealized gains on our available-for-sale investment securities from accumulated other comprehensive loss, net to retained earnings.

FASB ASU 2018-05, Income Taxes (Topic 740): Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin No. 118 was issued to provide guidance on the income tax accounting implications of the Tax Cuts and Jobs Act, and allows for entities to report provisional amounts for specific income tax effects of the Tax Cuts and Jobs Act for which the accounting under ASC Topic 740 was not yet complete but a reasonable estimate could be determined. A measurement period of one-year is allowed to complete the accounting effects under ASC Topic 740 and revise any previous estimates reported. Any provisional amounts or subsequent adjustments included in an entity’s financial statements during the measurement period should be included in income from continuing operations as an adjustment to tax expense in the reporting period the amounts are determined. The Company adopted this Update with the provisional adjustments as reported in the Consolidated Financial Statements on Form 10-K as of December 31, 2017. As of March 31, 2018, the Company did not incur any adjustments to the provisional recognition.


(2)	~~Investment Securities~~Business Combination

On July 26, 2017, the Company, along with the Bank, and Puget Sound Bancorp, Inc. and its wholly owned subsidiary bank, Puget Sound Bank, jointly announced the signing of a definitive agreement. The ~~Company’s investment policy is designed primarily to provide and maintain liquidity, generate a favorable return~~Puget Sound Merger was effective on ~~assets without incurring undue interest rate and credit risk, and complement the Bank’s lending activities.~~January 16, 2018. As of ~~March 31, 2017,~~the acquisition date, Puget Sound merged into Heritage and Puget Sound Bank merged into Heritage Bank. The primary reason for the merger was to create depth in the Company's geographic footprint consistent with its ongoing growth strategy, focused heavily on metro markets, and to achieve operational scale and realize efficiencies of a larger combined organization.

Pursuant to the terms to the Puget Sound Merger, all outstanding Puget Sound restricted stock awards became immediately vested prior to the ~~Bank's securities were classified as available~~merger. Puget Sound shareholders received 1.1688 shares of Heritage common stock per share of Puget Sound stock. Heritage issued an aggregate of 4,112,258 shares of its common stock at the closing date price of $31.80 for ~~sale.~~total fair value of common shares issued of $130.8 million and paid cash of $3,000 for fractional

1314

Table of Contents

shares in the transaction for total consideration paid of $130.8 million. Fair value includes 26,741 shares which were forfeited by the Puget Sound stockholders to pay applicable taxes, totaling fair value of $851,000.

The Puget Sound Merger resulted in $68.5 million of goodwill. This goodwill is not deductible for tax purposes.

The Puget Sound Merger constitutes a business acquisition as defined by FASB ASC 805, Business Combinations. FASB ASC 805 establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired and the liabilities assumed. Heritage was considered the acquirer in this transaction. Accordingly, the preliminary estimates of fair values of the Puget Sound assets, including the identifiable intangible assets, and the assumed liabilities in the Puget Sound Merger were measured and recorded as of January 16, 2018. Fair values on the acquisition date are preliminary and represent management’s best estimates based on available information and facts and circumstances in existence on the acquisition date. Fair values are subject to refinement for up to one year after the closing date of the acquisition as additional information regarding the closing date fair values becomes available. The Company expects to finalize the purchase price allocation by the second quarter of 2018 when the valuation of tax-related matters is complete.

The preliminary fair value estimates of the assets acquired and liabilities assumed in the Puget Sound Merger were as follows:



	Puget Sound Merger
	(In thousands)
Assets
Cash and cash equivalents	$	25,889
Interest earning deposits	54,247
Investment securities available for sale	80,353
Loans receivable	388,462
Premises and equipment, net	732
Federal Home Loan Bank stock, at cost	623
Bank owned life insurance	6,264
Accrued interest receivable	1,448
Prepaid expenses and other assets	1,354
Other intangible assets	11,270
Total assets acquired	$	570,642
Liabilities
Deposits	$	505,885
Accrued expenses and other liabilities	2,504
Total liabilities acquired	$	508,389

Fair value of net assets acquired	$	62,253

Table of Contents

A summary of the net assets purchased and the preliminary estimated fair value adjustments and resulting goodwill recognized from the Puget Sound Merger are presented in the following tables. Goodwill represents the excess of the consideration transferred over the estimated fair value of the net assets acquired and liabilities assumed.



	Puget Sound Merger
	(In thousands)
Cost basis of net assets on merger date	$	54,405
Consideration transferred	(130,773		)
Fair value adjustments:
Investment securities	(348		)
Total loans receivable, net	1,400
Premises and equipment	(121		)
Other intangible assets	9,207
Prepaid expenses and other assets	(2,282		)
Deposits	(62		)
Accrued expenses and other liabilities	54
Goodwill recognized from the Puget Sound Merger	$	(68,520	)

The operating results of the Company for the three months ended March 31, 2018 include the operating results produced by the net assets acquired in the Puget Sound Merger since the January 16, 2018 merger date. The Company has considered the requirement of FASB ASC 805 related to the contribution of the Puget Sound Merger to the Company’s results of operations. The table below presents only the significant results for the acquired business since the January 16, 2018 merger date:



	Three Months Ended⁽¹⁾
	(In thousands)
Interest income: Interest and fees on loans⁽²⁾	$	4,518
Interest income: Interest and fees on investments ⁽³⁾	59
Interest income: Other interest earning assets	88
Interest expense	(144		)
Provision for loan losses for loans	(200		)
Noninterest income	148
Noninterest expense ⁽⁴⁾	(5,580		)
Net effect, pre-tax	$	(1,111	)

⁽¹⁾ The Puget Sound Merger was completed on January 16, 2018.

⁽²⁾ Includes the accretion of the discount on the purchased loans of $479,000.

⁽³⁾ All securities were sold with trade date of January 16, 2018 and settlement dates on or before February 14, 2018.

⁽⁴⁾ Excludes certain compensation and employee benefits for management as it is impracticable to determine due to the integration of the operations for this merger. Also includes certain merger-related costs incurred by the Company.

The Company also considered the pro forma requirements of FASB ASC 805 and deemed it not necessary to provide pro forma financial statements as required under the standard as the Puget Sound Merger is not material to the Company. The Company believes that the historical Puget Sound operating results are not considered of enough significance to be meaningful to the Company’s results of operations.

During the three months ended March 31, 2018, the Company incurred acquisition-related costs (including costs associated with the Premier Merger) of approximately $4.7 million.


(3)	Investment Securities

As a result of the adoption of ASU 2016-01 on January 1, 2018, equity investments (except for investments accounted for under the equity method of accounting) are now measured at fair value, with changes in fair value

Table of Contents

recognized in earnings. These investments were previously measured at fair value, with changes in fair value recognized in AOCI. Accordingly, these securities are no longer classified as available-for-sale and their presentation is not comparable to the presentation as of December 31, 2017. See Note (1) Description of Business, Basis of Presentation, Significant Accounting Policies and Recent Issued Accounting Policies, as well as Equity Securities section discussed below.

Available for sale investment securities

(a) Securities by Type and Maturity

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


	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value		Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(In thousands)									(In thousands)
March 31, 2017
March 31, 2018
U.S. Treasury and U.S. Government-sponsored agencies	$	1,561	$	4	$	—		$	1,565	$	23,448	$	43	$	(102	)	$	23,389
Municipal securities	239,218		3,161		(1,875		)	240,504		203,771		1,747		(1,226		)	204,292
Mortgage backed securities and collateralized mortgage obligations⁽¹⁾:
Mortgage-backed securities and collateralized mortgage obligations⁽¹⁾:
Residential	294,094		1,239		(2,228		)	293,105		307,655		365		(6,743		)	301,277
Commercial	207,242		564		(3,112		)	204,694		250,489		222		(6,351		)	244,360
Collateralized loan obligations	10,186		10		(14		)	10,182		3,266		5		—			3,271
Corporate obligations	17,603		219		(2		)	17,820		16,589		131		(91		)	16,629
Other securities	14,844		307		—			15,151
Other asset-backed securities										27,670		679		—			28,349
Total	$	784,748	$	5,504	$	(7,231	)	$	783,021	$	832,888	$	3,192	$	(14,513	)	$	821,567

December 31, 2016
December 31, 2017
U.S. Treasury and U.S. Government-sponsored agencies	$	1,563	$	6	$	—		$	1,569	$	13,460	$	6	$	(24	)	$	13,442
Municipal securities	237,305		2,427		(2,476		)	237,256		247,358		3,720		(1,063		)	250,015
Mortgage backed securities and collateralized mortgage obligations⁽¹⁾:
Mortgage-backed securities and collateralized mortgage obligations⁽¹⁾:
Residential	310,391		985		(2,200		)	309,176		282,724		422		(2,935		)	280,211
Commercial	211,259		599		(3,540		)	208,318		219,696		444		(3,061		)	217,079
Collateralized loan obligations	10,505		4		(31		)	10,478		4,561		19		—			4,580
Corporate obligations	16,611		104		(9		)	16,706		16,594		220		(44		)	16,770
Other securities(2)	11,005		156		(19		)	11,142		27,781		652		—			28,433
Total	$	798,639	$	4,281	$	(8,275	)	$	794,645	$	812,174	$	5,483	$	(7,127	)	$	810,530


⁽¹⁾	Issued and guaranteed by U.S. Government-sponsored agencies.


⁽²⁾	Primarily asset-backed securities.

There were no securities classified as trading or held to maturity at March 31, ~~2017~~2018 or December 31, ~~2016~~2017.

The amortized cost and fair value of investment securities available for sale at March 31, ~~2017~~2018, 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.

Amortized Cost Fair Value
(In thousands)
Due in one year or less $ 7,479
$ 7,528
Due after one year through five years 128,268
129,246
Due after five years through ten years 256,597
255,550
Due after ten years 392,359
390,585
Investment securities with no stated maturities 45
112
Total $ 784,748
$ 783,021

1417

Table of Contents



	Amortized Cost		Fair Value
	(In thousands)
Due in one year or less	$	8,166	$	8,205
Due after one year through five years	129,062		128,330
Due after five years through ten years	240,584		235,726
Due after ten years	455,076		449,306
Total	$	832,888	$	821,567

(b) Unrealized Losses and Other-Than-Temporary Impairments

The following table shows the gross unrealized losses and fair value of the Company's investment securities available for sale that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that the individual securities have been in continuous unrealized loss positions as of March 31, ~~2017~~2018 and December 31, ~~2016~~2017 ~~were as follows:~~:


	Less than 12 Months					12 Months or Longer					Total					Less than 12 Months					12 Months or Longer					Total
	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
	(In thousands)															(In thousands)
March 31, 2017
March 31, 2018
U.S. Treasury and U.S. Government-sponsored agencies	$	—	$	—		$	—	$	—		$	—	$	—		$	7,353	$	(102	)	$	—	$	—		$	7,353	$	(102	)
Municipal securities	71,800		(1,875		)	—		—			71,800		(1,875		)	63,636		(607		)	16,842		(619		)	80,478		(1,226		)
Mortgage backed securities and collateralized mortgage obligations⁽¹⁾:
Mortgage-backed securities and collateralized mortgage obligations⁽¹⁾:
Residential	169,599		(2,160		)	10,138		(68		)	179,737		(2,228		)	181,058		(3,509		)	70,098		(3,234		)	251,156		(6,743		)
Commercial	149,530		(2,989		)	10,908		(123		)	160,438		(3,112		)	127,395		(2,698		)	87,284		(3,653		)	214,679		(6,351		)
Collateralized loan obligations	—		—			2,987		(14		)	2,987		(14		)
Corporate obligations	1,006		(2		)	—		—			1,006		(2		)	9,483		(91		)	—		—			9,483		(91		)
Other Securities	—		—			—		—			—		—
Total	$	391,935	$	(7,026	)	$	24,033	$	(205	)	$	415,968	$	(7,231	)	$	388,925	$	(7,007	)	$	174,224	$	(7,506	)	$	563,149	$	(14,513	)

December 31, 2016
December 31, 2017
U.S. Treasury and U.S. Government-sponsored agencies	$	—	$	—		$	—	$	—		$	—	$	—		$	11,436	$	(24	)	$	—	$	—		$	11,436	$	(24	)
Municipal securities	90,188		(2,476		)	—		—			90,188		(2,476		)	$	39,298	$	(384	)	$	26,509	$	(679	)	$	65,807	$	(1,063	)
Mortgage backed securities and collateralized mortgage obligations⁽¹⁾:
Mortgage-backed securities and collateralized mortgage obligations⁽¹⁾:
Residential	181,562		(2,148		)	10,854		(52		)	192,416		(2,200		)	175,847		(1,296		)	66,380		(1,639		)	242,227		(2,935		)
Commercial	157,055		(3,446		)	12,597		(94		)	169,652		(3,540		)	75,121		(700		)	90,822		(2,361		)	165,943		(3,061		)
Collateralized loan obligations	2,976		(1		)	2,969		(30		)	5,945		(31		)
Corporate obligations	4,032		(9		)	—		—			4,032		(9		)	3,472		(44		)	—		—			3,472		(44		)
Other Securities	6,998		(19		)	—		—			6,998		(19		)
Total	$	442,811	$	(8,099	)	$	26,420	$	(176	)	$	469,231	$	(8,275	)	$	305,174	$	(2,448	)	$	183,711	$	(4,679	)	$	488,885	$	(7,127	)

⁽¹⁾ Issued and guaranteed by U.S. Government-sponsored agencies.

The Company has evaluated these investment securities available for sale as of March 31, ~~2017~~2018 and December 31, ~~2016~~2017 and has determined that the decline in their value is ~~temporary.~~not other-than-temporary. The unrealized losses are primarily due to increases in market interest ~~rates and larger spreads in the market for mortgage-related products.~~rates. The fair value of these securities is expected to recover as the securities approach their maturity ~~date and/or as the pricing spreads narrow on mortgage-related securities.~~date. None of the underlying issuers of the municipal securities and corporate obligations had credit ratings that were below investment grade levels at March 31, ~~2017~~2018 or December 31, ~~2016.~~2017. The Company has the ability and intent to hold the investments until recovery of the securities' amortized cost, which may be the maturity date of the securities.

~~For the three months ended March 31, 2017 and 2016, there were no investment securities determined to be other-than-temporarily impaired.~~

1518

Table of Contents

For the three months ended March 31, 2018 and 2017, there were no other-than-temporary charges recorded to net income.

The following table presents the gross realized gains and losses on the sale of securities available for sale for the three months ended March 31, 2018 and 2017.



	Three Months Ended March 31,
	2018			2017
	(In thousands)
Gross realized gains	$	104		$	—
Gross realized losses	(69		)	—
Net realized gains	$	35		$	—

(d) Pledged Securities

The following table summarizes the amortized cost and fair value of investment securities available for sale that are pledged as collateral for the following obligations at March 31, ~~2017~~2018 and December 31, ~~2016~~2017:


	March 31, 2017				December 31, 2016				March 31, 2018				December 31, 2017
	Amortized Cost		Fair Value		Amortized Cost		Fair Value		Amortized Cost		Fair Value		Amortized Cost		Fair Value
	(In thousands)								(In thousands)
Washington and Oregon state to secure public deposits	$	209,043	$	209,980	$	214,834	$	215,247	$	202,048	$	199,605	$	206,377	$	206,425
Repurchase agreements	28,573		28,430		29,481		29,294		46,979		45,864		48,750		48,237
Other securities pledged	3,545		3,553		3,557		3,546		17,300		17,096		12,484		12,498
Total	$	241,161	$	241,963	$	247,872	$	248,087	$	266,327	$	262,565	$	267,611	$	267,160

Equity Securities

The Company holds an equity security with a readily determinable fair value of $162,000 and $146,000 as of March 31, 2018 and December 31, 2017, respectively. As a result of the adoption of ASU 2016-01, this security is no longer classified as available for sale and has been reclassified to prepaid expenses and other assets on the Company's Condensed Consolidated Statements of Financial Condition as of March 31, 2018. As such, its presentation is not comparable to the presentation as of December 31, 2017. The Company recorded the unrealized gain on the equity security through an adjustment to accumulated other comprehensive loss,net and retained earnings in the Condensed Consolidated Statement of Stockholders' Equity during the three months ended March 31, 2018.


~~(3)~~(4)	Loans Receivable

The Company originates loans in the ordinary course of business and has also acquired loans through FDIC-assisted and open bank transactions. Disclosures related to the Company's recorded investment in loans receivable generally exclude accrued interest receivable and net deferred ~~loan origination~~ fees ~~and~~or costs because they are insignificant.

Loans acquired in a business combination ~~may be~~are further classified as “purchased” loans. Loans purchased with evidence of credit deterioration since origination for which it is probable that not all contractually required payments will be collected are accounted for under FASB ~~ASC310-30,~~ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality. These loans are identified as ~~PCI~~"PCI" loans. Loans purchased that are not accounted for under FASB ASC 310-30 are accounted for under FASB ASC 310-20, Receivables—Nonrefundable Fees and Other Costs, and are referred to as "non-PCI" loans.

Table of Contents

(a) Loan Origination/Risk Management

The Company categorizes loans in one of the four segments of the total loan portfolio: commercial business, one-to-four family residential, real estate construction and land development and consumer. Within these segments are classes of loans for 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~~criticized loans. The Company also conducts internal loan reviews and validates the credit risk assessment on a periodic basis and presents the results of these reviews to management. The loan review process complements and reinforces the risk identification and assessment decisions made by loan officers and credit personnel, as well as the Company’s policies and procedures.

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

Commercial Business:

There are three significant classes of loans in the commercial business portfolio segment: commercial and industrial, ~~loans,~~ owner-occupied commercial real estate and non-owner occupied commercial real estate. The owner and non-owner occupied commercial real estate classes are both considered commercial real estate loans. As the commercial and industrial loans carry different risk characteristics than the commercial real estate loans, they are discussed separately below.

Commercial and industrial. Commercial and industrial loans are primarily made based on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, may not be as expected and the collateral securing these loans may fluctuate in value. Most commercial and industrial loans are secured by the assets being financed or other business assets such as accounts receivable or inventory and may include a personal guarantee; however, some short-term loans may be made on an unsecured basis. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers. Commercial and industrial loans carry more risk than other loans because the borrowers’ cash flow is less predictable, and in the event of a default, the amount of loss is potentially greater and more difficult to quantify because the value of the collateral securing these loans may fluctuate, may be uncollectible, or may be obsolete or of limited use, among other things.

Commercial real estate. The Company originates commercial real estate loans primarily 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~~that these loans are viewed primarily as cash flow loans and secondarily as loans secured by real ~~estate.~~estate properties. Commercial real estate ~~involves more risk than other classes of loans in that the~~ lending typically involves

~~Table of Contents~~

higher loan principal amounts and payments on loans, ~~secured by real estate properties are~~and repayment is dependent on successful operation and management of the properties. ~~Repayment~~The value of the real estate securing these loans ~~may~~can be ~~more~~ adversely affected by conditions in the real estate market or the economy. ~~Owner-occupied~~There is little difference in risk between owner-occupied commercial real estate loans ~~are generally of lower credit risk than~~and non-owner occupied commercial real estate ~~loans as the borrowers' businesses are likely dependent on the properties.~~loans.

One-to-Four Family Residential:

The majority of the Company’s one-to-four family residential loans are secured by single-family residences located in its primary market areas. The Company’s underwriting standards require that single-family portfolio loans generally are owner-occupied and do not exceed 80% of the lower of appraised value at origination or cost of the underlying collateral. Terms of maturity typically range from 15 to 30 years. ~~Historically, the~~The Company ~~sold~~sells most of its single-family loans in the secondary market and ~~retained~~retains a smaller portion in its loan portfolio. From the second quarter of 2013 until May 1, 2014, the Company only originated single-family loans for its loan portfolio. As a result of the Washington Banking Merger, since May 1, 2014 the Company has been originating and selling a majority of its single-family mortgages.

Real Estate Construction and Land Development:

The Company originates construction loans for one-to-four family residential and for five or more family residential and commercial properties. The one-to-four family residential construction loans generally include construction of custom homes whereby the home buyer is the borrower. The Company also provides financing to builders for the construction of pre-sold homes and, in selected cases, to builders for the construction of speculative residential property. Substantially all construction loans are short-term in nature and priced with variable rates of interest. Construction lending can involve a higher level of risk than other types of lending because funds are advanced partially based upon the value of the project, which is uncertain prior to the project’s completion. Because of the uncertainties inherent in estimating construction costs as well as the market value of a completed project and the effects of governmental regulation of real property, the Company’s estimates with regard to the total funds required to complete a project and the related loan-to-value ratio may vary from actual results. As a result, construction loans often

Table of Contents

involve the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project and the ability of the borrower to sell or lease the property or refinance the indebtedness. If the Company’s estimate of the value of a project at completion proves to be overstated, it may have inadequate security for repayment of the loan and may incur a loss if the borrower does not repay the loan. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property or an interim loan commitment from the Company until permanent financing is obtained. These loans are closely monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being dependent upon successful completion of the construction project, interest rate changes, government regulation of real property, general economic conditions and the availability of long-term financing.

Consumer:

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

~~As a result of the Washington Banking Merger, the~~The Company ~~is originating~~also originates indirect consumer loans. These loans are for new and used automobile and recreational vehicles that are originated indirectly by selected dealers located in the Company's market areas. The Company has limited its purchase of indirect loans primarily to dealerships that are established and ~~well known~~well-known in their market areas and to applicants that are not classified as sub-prime.

~~Table of Contents~~

Loans receivable at March 31, ~~2017~~2018 and December 31, ~~2016~~2017 consisted of the following portfolio segments and classes:


	March 31, 2017			December 31, 2016			March 31, 2018			December 31, 2017
	(In thousands)						(In thousands)
Commercial business:
Commercial and industrial	$	636,286		$	637,773		$	811,678		$	645,396
Owner-occupied commercial real estate	569,316			558,035			702,356			622,150
Non-owner occupied commercial real estate	874,218			880,880			1,133,394			986,594
Total commercial business	2,079,820			2,076,688			2,647,428			2,254,140
One-to-four family residential	78,509			77,391			89,180			86,997
Real estate construction and land development:
One-to-four family residential	52,134			50,414			73,295			51,985
Five or more family residential and commercial properties	125,784			108,764			98,387			97,499
Total real estate construction and land development	177,918			159,178			171,682			149,484
Consumer	324,767			325,140			370,275			355,091
Gross loans receivable	2,661,014			2,638,397			3,278,565			2,845,712
Net deferred loan costs	2,690			2,352			3,350			3,359
Loans receivable, net	2,663,704			2,640,749			3,281,915			2,849,071
Allowance for loan losses	(31,594		)	(31,083		)	(33,261		)	(32,086		)
Total loans receivable, net	$	2,632,110		$	2,609,666		$	3,248,654		$	2,816,985

(b) Concentrations of Credit

Most of the Company’s lending activity occurs within ~~Washington State, and to a lesser extent Oregon. The Company’s~~its primary market areas which are concentrated along the I-5 corridor from Whatcom County to Clark County in Washington State and Multnomah County in Oregon, as well as other contiguous markets. The ~~Washington Banking Merger allowed the expansion of the Company's market area north of Seattle, Washington to the Canadian border. The~~ majority of the Company’s loan portfolio consists of (in order of balances at March 31, ~~2017)~~2018) non-owner occupied commercial real estate, commercial and industrial and owner-occupied commercial real estate. As of March 31, ~~2017~~2018 and December 31, ~~2016~~2017, there were no concentrations of loans related to any single industry in excess of 10% of the Company’s total loans.

Table of Contents

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 1 to 10. A description of the general characteristics of the risk grades is as follows:

Grades 1 to 5: These grades are considered “pass grade” and include loans with negligible to above average but acceptable risk. These borrowers generally have strong to acceptable capital levels and consistent earnings and debt service capacity. Loans with the higher grades within the “pass” category may include borrowers who are experiencing unusual operating difficulties, but have acceptable payment performance to date. Increased monitoring of financial information and/or collateral may be appropriate. Loans with this grade show no immediate loss exposure.

Grade 6: This grade includes "Watch" loans and is considered a “pass grade”. The grade is intended to be utilized on a temporary basis for pass grade borrowers where a potentially significant risk-modifying action is anticipated in the near term.

Grade 7: This grade includes “Other Assets Especially Mentioned” (“OAEM”) loans in accordance with regulatory guidelines, and is intended to highlight loans with elevated risks. Loans with this grade show signs of deteriorating profits and capital, and the borrower might not be strong enough to sustain a major setback. The borrower is typically higher than normally leveraged, and outside support might

~~Table of Contents~~

be modest and likely illiquid. The loan is at risk of further decline unless active measures are taken to correct the situation.

Grade 8: This grade includes “Substandard” loans in accordance with regulatory guidelines, which the Company has determined have a high credit risk. These loans also have well-defined weaknesses which make payment default or principal exposure likely, but not yet certain. The borrower may have shown serious negative trends in financial ratios and performance. Such loans may be dependent upon collateral liquidation, a secondary source of repayment or an event outside of the normal course of business. Loans with this grade can be placed on accrual or nonaccrual status based on the Company’s accrual policy.

Grade 9: This grade includes “Doubtful” loans in accordance with regulatory guidelines, and the Company has determined these loans to have excessive credit risk. Such loans are placed on nonaccrual status and may be dependent upon collateral having a value that is difficult to determine or upon some near-term event which lacks certainty. Additionally, these loans generally have a specific valuation allowance or have been partially charged-off for the amount considered uncollectible.

Grade 10: This grade includes “Loss” loans in accordance with regulatory guidelines, and the Company has determined these loans have the highest risk of loss. Such loans are charged-off or charged-down when payment is acknowledged to be uncertain or when the timing or value of payments cannot be determined. “Loss” is not intended to imply that the loan or some portion of it will never be paid, nor does it in any way imply that there has been a forgiveness of debt.

Numerical loan grades for loans are established at the origination of the loan. Loan grades are reviewed on a quarterly basis, or more frequently if necessary, by the credit department. The Bank follows the FDIC’s Uniform Retail Credit Classification and Account Management Policy for subsequent classification in the event of payment delinquencies or default. Typically, an individual loan grade will not be changed from the prior period unless there is a specific indication of credit deterioration or improvement. Credit deterioration is evidenced by delinquency, direct communications with the borrower, or other borrower information that becomes known to management. Credit improvements are evidenced by known facts regarding the borrower or the collateral property.

The loan grades relate to the likelihood of losses in that the higher the grade, the greater the loss potential. Loans with a pass grade may have some estimated inherent losses, but to a lesser extent than the other loan grades. The OAEM loan grade is transitory in that the Company is waiting on additional information to determine the likelihood and extent of the potential loss. The likelihood of loss for OAEM graded loans, however, is greater than Watch graded loans because there has been measurable credit deterioration. Loans with a Substandard grade are generally loans for which the Company has individually analyzed for potential impairment. For Doubtful and Loss graded loans, the Company is almost certain of the losses, and the outstanding principal balances are generally charged-off to the realizable value.

1922

Table of Contents

The following tables present the balance of the loans receivable by credit quality indicator as of March 31, ~~2017~~2018 and December 31, ~~2016~~2017.


	March 31, 2017										March 31, 2018
	Pass		OAEM		Substandard		Doubtful		Total		Pass		OAEM		Substandard		Doubtful/Loss		Total
	(In thousands)										(In thousands)
Commercial business:
Commercial and industrial	$	599,279	$	9,882	$	27,125	$	—	$	636,286	$	754,720	$	25,050	$	31,908	$	—	$	811,678
Owner-occupied commercial real estate	544,317		5,259		19,740		—		569,316		663,770		19,988		18,598		—		702,356
Non-owner occupied commercial real estate	841,332		14,470		18,416		—		874,218		1,106,904		10,415		16,075		—		1,133,394
Total commercial business	1,984,928		29,611		65,281		—		2,079,820		2,525,394		55,453		66,581		—		2,647,428
One-to-four family residential	77,155		—		1,354		—		78,509		87,962		—		1,218		—		89,180
Real estate construction and land development:
One-to-four family residential	46,866		497		4,771		—		52,134		71,735		275		1,285		—		73,295
Five or more family residential and commercial properties	122,769		1,140		1,875		—		125,784		98,328		59		—		—		98,387
Total real estate construction and land development	169,635		1,637		6,646		—		177,918		170,063		334		1,285		—		171,682
Consumer	319,596		—		5,171		—		324,767		365,577		—		4,172		526		370,275
Gross loans receivable	$	2,551,314	$	31,248	$	78,452	$	—	$	2,661,014	$	3,148,996	$	55,787	$	73,256	$	526	$	3,278,565


	December 31, 2016										December 31, 2017
	Pass		OAEM		Substandard		Doubtful		Total		Pass		OAEM		Substandard		Doubtful/Loss		Total
	(In thousands)										(In thousands)
Commercial business:
Commercial and industrial	$	601,273	$	5,048	$	31,452	$	—	$	637,773	$	597,697	$	19,536	$	28,163	$	—	$	645,396
Owner-occupied commercial real estate	532,585		4,437		21,013		—		558,035		595,455		12,668		14,027		—		622,150
Non-owner occupied commercial real estate	841,383		14,573		24,924		—		880,880		955,450		10,494		20,650		—		986,594
Total commercial business	1,975,241		24,058		77,389		—		2,076,688		2,148,602		42,698		62,840		—		2,254,140
One-to-four family residential	76,020		—		1,371		—		77,391		85,762		—		1,235		—		86,997
Real estate construction and land development:
One-to-four family residential	44,752		500		5,162		—		50,414		49,925		537		1,523		—		51,985
Five or more family residential and commercial properties	105,723		1,150		1,891		—		108,764		96,404		707		388		—		97,499
Total real estate construction and land development	150,475		1,650		7,053		—		159,178		146,329		1,244		1,911		—		149,484
Consumer	320,140		—		5,000		—		325,140		349,590		—		4,976		525		355,091
Gross loans receivable	$	2,521,876	$	25,708	$	90,813	$	—	$	2,638,397	$	2,730,283	$	43,942	$	70,962	$	525	$	2,845,712

Potential problem loans are loans classified as OAEM or worse that are currently accruing interest and are not considered impaired, but which management is monitoring because the financial information of the borrower causes concern as to their ability to meet their loan repayment terms. Potential problem loans may include PCI loans as these loans continue to accrete loan discounts established at acquisition based on the guidance of FASB ASC 310-30. Potential problem loans as of March 31, ~~2017~~2018 and December 31, ~~2016~~2017 were ~~$82.8~~$93.3 million and ~~$87.8~~$83.5 million, ~~respectively. The balance of potential problem loans guaranteed by a governmental agency, which guarantee reduces the Company's credit exposure, was $1.4 million and $1.1 million as of~~ ~~March 31, 2017~~ ~~and~~ ~~December 31, 2016~~, respectively.

2023

Table of Contents

(d) Nonaccrual Loans

Nonaccrual loans, segregated by segments and classes of loans, were as follows as of March 31, ~~2017~~2018 and December 31, ~~2016~~2017:

March 31, 2017 December 31, 2016
(In thousands)
Commercial business:
Commercial and industrial $ 3,378
$ 3,531
Owner-occupied commercial real estate 3,856
3,728
Non-owner occupied commercial real estate 1,297
1,321
Total commercial business 8,531
8,580
One-to-four family residential 90
94
Real estate construction and land development:
One-to-four family residential 2,008
2,008
Five or more family residential and commercial properties —
—
Total real estate construction and land development 2,008
2,008
Consumer 248
227
Nonaccrual loans $ 10,877
$ 10,909

~~The Company had $1.7 million and $2.8 million of nonaccrual loans guaranteed by governmental agencies at March 31, 2017 and December 31, 2016, respectively.~~



	March 31, 2018		December 31, 2017
	(In thousands)
Commercial business:
Commercial and industrial	$	7,627	$	3,110
Owner-occupied commercial real estate	4,544		4,090
Non-owner occupied commercial real estate	2,185		1,898
Total commercial business	14,356		9,098
One-to-four family residential	80		81
Real estate construction and land development:
One-to-four family residential	1,147		1,247
Consumer	145		277
Nonaccrual loans	$	15,728	$	10,703

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

(e) Past due loans

The Company performs an aging analysis of past due loans using the categories of 30-89 days past due and 90 or more days past due. This policy is consistent with regulatory reporting requirements.

The balances of past due loans, segregated by segments and classes of loans, as of March 31, ~~2017~~2018 and December 31, ~~2016~~2017 were as follows:


	March 31, 2017										March 31, 2018
	30-89 Days		90 Days or Greater		Total Past Due		Current		Total		30-89 Days		90 Days or Greater		Total Past Due		Current		Total
	(In thousands)										(In thousands)
Commercial business:
Commercial and industrial	$	1,536	$	1,758	$	3,294	$	632,992	$	636,286	$	16,944	$	1,449	$	18,393	$	793,285	$	811,678
Owner-occupied commercial real estate	674		1,788		2,462		566,854		569,316		1,310		989		2,299		700,057		702,356
Non-owner occupied commercial real estate	3,435		—		3,435		870,783		874,218		931		3,282		4,213		1,129,181		1,133,394
Total commercial business	5,645		3,546		9,191		2,070,629		2,079,820		19,185		5,720		24,905		2,622,523		2,647,428
One-to-four family residential	468		—		468		78,041		78,509		535		—		535		88,645		89,180
Real estate construction and land development:
One-to-four family residential	830		865		1,695		50,439		52,134		—		1,147		1,147		72,148		73,295
Five or more family residential and commercial properties	—		—		—		125,784		125,784		408		—		408		97,979		98,387
Total real estate construction and land development	830		865		1,695		176,223		177,918		408		1,147		1,555		170,127		171,682
Consumer	2,406		567		2,973		321,794		324,767		1,896		—		1,896		368,379		370,275
Gross loans receivable	$	9,349	$	4,978	$	14,327	$	2,646,687	$	2,661,014	$	22,024	$	6,867	$	28,891	$	3,249,674	$	3,278,565

2124

Table of Contents


	December 31, 2016										December 31, 2017
	30-89 Days		90 Days or Greater		Total Past Due		Current		Total		30-89 Days		90 Days or Greater		Total Past Due		Current		Total
	(In thousands)										(In thousands)
Commercial business:
Commercial and industrial	$	2,687	$	1,733	$	4,420	$	633,353	$	637,773	$	2,993	$	1,172	$	4,165	$	641,231	$	645,396
Owner-occupied commercial real estate	1,807		2,915		4,722		553,313		558,035		1,277		1,225		2,502		619,648		622,150
Non-owner occupied commercial real estate	733		—		733		880,147		880,880		870		3,314		4,184		982,410		986,594
Total commercial business	5,227		4,648		9,875		2,066,813		2,076,688		5,140		5,711		10,851		2,243,289		2,254,140
One-to-four family residential	523		—		523		76,868		77,391		513		—		513		86,484		86,997
Real estate construction and land development:
One-to-four family residential	90		2,008		2,098		48,316		50,414		84		1,331		1,415		50,570		51,985
Five or more family residential and commercial properties	—		377		377		108,387		108,764		40		—		40		97,459		97,499
Total real estate construction and land development	90		2,385		2,475		156,703		159,178		124		1,331		1,455		148,029		149,484
Consumer	2,292		105		2,397		322,743		325,140		1,939		687		2,626		352,465		355,091
Gross loans receivable	$	8,132	$	7,138	$	15,270	$	2,623,127	$	2,638,397	$	7,716	$	7,729	$	15,445	$	2,830,267	$	2,845,712

There were no loans 90 days or more past due that were still accruing interest as of March 31, ~~2017~~2018 or December 31, ~~2016,~~2017, excluding PCI loans.

(f) Impaired loans

Impaired loans include nonaccrual loans and performing troubled debt restructured ("TDR") loans. The balances of impaired loans as of March 31, ~~2017~~2018 and December 31, ~~2016~~2017 are set forth in the following tables.


	March 31, 2017										March 31, 2018
	Recorded Investment With No Specific Valuation Allowance		Recorded Investment With Specific Valuation Allowance		Total Recorded Investment		Unpaid Contractual Principal Balance		Related Specific Valuation Allowance		Recorded Investment With No Specific Valuation Allowance		Recorded Investment With Specific Valuation Allowance		Total Recorded Investment		Unpaid Contractual Principal Balance		Related Specific Valuation Allowance
	(In thousands)										(In thousands)
Commercial business:
Commercial and industrial	$	1,580	$	8,463	$	10,043	$	10,923	$	1,204	$	5,135	$	11,390	$	16,525	$	17,191	$	1,769
Owner-occupied commercial real estate	1,097		3,797		4,894		5,115		747		936		12,165		13,101		13,386		1,727
Non-owner occupied commercial real estate	4,852		6,545		11,397		11,488		922		4,692		5,776		10,468		10,630		811
Total commercial business	7,529		18,805		26,334		27,526		2,873		10,763		29,331		40,094		41,207		4,307
One-to-four family residential	—		314		314		319		98		—		295		295		305		93
Real estate construction and land development:
One-to-four family residential	2,736		—		2,736		3,421		—		838		309		1,147		1,892		2
Five or more family residential and commercial properties	—		1,071		1,071		1,071		66
Total real estate construction and land development	2,736		1,071		3,807		4,492		66		838		309		1,147		1,892		2
Consumer	48		262		310		328		62		—		379		379		450		73
Total	$	10,313	$	20,452	$	30,765	$	32,665	$	3,099	$	11,601	$	30,314	$	41,915	$	43,854	$	4,475

2225

Table of Contents

December 31, 2016

Recorded
Investment With
No Specific
Valuation
Allowance

Recorded
Investment With
Specific
Valuation
Allowance

Total
Recorded
Investment

Unpaid
Contractual
Principal
Balance

Related
Specific
Valuation
Allowance
(In thousands)
Commercial business:
Commercial and industrial $ 1,739
$ 10,636
$ 12,375
$ 13,249
$ 1,199
Owner-occupied commercial real estate 1,150
3,574
4,724
5,107
511
Non-owner occupied commercial real estate 4,905
6,413
11,318
11,386
797
Total commercial business 7,794
20,623
28,417
29,742
2,507
One-to-four family residential —
321
321
325
97
Real estate construction and land development:
One-to-four family residential 2,243
828
3,071
3,755
6
Five or more family residential and commercial properties —
1,079
1,079
1,079
60
Total real estate construction and land development 2,243
1,907
4,150
4,834
66
Consumer 48
262
310
325
64
Total $ 10,085
$ 23,113
$ 33,198
$ 35,226
$ 2,734

~~The Company had governmental guarantees of $2.4 million and $3.5 million related to the impaired loan balances at~~ ~~March 31, 2017~~ ~~and~~ ~~December 31, 2016, respectively.~~



	December 31, 2017
	Recorded Investment With No Specific Valuation Allowance		Recorded Investment With Specific Valuation Allowance		Total Recorded Investment		Unpaid Contractual Principal Balance		Related Specific Valuation Allowance
	(In thousands)
Commercial business:
Commercial and industrial	$	2,127	$	9,872	$	11,999	$	12,489	$	1,326
Owner-occupied commercial real estate	2,452		4,356		6,808		7,054		621
Non-owner occupied commercial real estate	4,722		11,297		16,019		16,172		1,222
Total commercial business	9,301		25,525		34,826		35,715		3,169
One-to-four family residential	—		299		299		308		93
Real estate construction and land development:
One-to-four family residential	938		309		1,247		2,200		2
Five or more family residential and commercial properties	—		645		645		645		37
Total real estate construction and land development	938		954		1,892		2,845		39
Consumer	160		282		442		466		54
Total	$	10,399	$	27,060	$	37,459	$	39,334	$	3,355

The average recorded investment of impaired loans for the three months ended March 31, ~~2017~~2018 and ~~2016~~2017 are set forth in the following table.


	Three Months Ended March 31,				Three Months Ended March 31,
	2017		2016		2018		2017
	(In thousands)				(In thousands)
Commercial business:
Commercial and industrial	$	9,834	$	9,706	$	14,261	$	9,834
Owner-occupied commercial real estate	4,017		4,761		12,841		4,017
Non-owner occupied commercial real estate	11,265		11,179		10,358		11,265
Total commercial business	25,116		25,646		37,460		25,116
One-to-four family residential	317		273		297		317
Real estate construction and land development:
One-to-four family residential	2,904		3,550		1,197		2,904
Five or more family residential and commercial properties	1,075		1,980		322		1,075
Total real estate construction and land development	3,979		5,530		1,519		3,979
Consumer	289		573		411		289
Total	$	29,701	$	32,022	$	39,687	$	29,701

For the three months ended March 31, ~~2017~~2018 and ~~2016,~~2017, no interest income was recognized subsequent to a loan’s classification as nonaccrual. For the three months ended March 31, ~~2017~~2018 and ~~2016,~~2017, the Bank recorded ~~$365,000~~$326,000 and ~~$178,000,~~$365,000, respectively, of interest income related to performing TDR loans.

2326

Table of Contents

(g) Troubled Debt Restructured Loans

A TDR loan is a restructuring in which the Bank, for economic or legal reasons related to a borrower’s financial difficulties, grants a concession to the borrower that it would not otherwise consider. ~~TDRs~~TDR loans are considered impaired and are separately measured for impairment under FASB ASC 310-10-35, whether on accrual ("performing") or nonaccrual ("nonperforming") status. The Company has more stringent definitions of concessions and impairment measures for PCI loans as these loans have known credit deterioration and are generally accreting income at a lower discounted rate as compared to the contractual note rate based on the guidance of FASB ASC 310-30.

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

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

The recorded investment balance and related allowance for loan losses of performing and nonaccrual TDR loans as of March 31, ~~2017~~2018 and December 31, ~~2016~~2017 were as follows:


	March 31, 2017				December 31, 2016				March 31, 2018				December 31, 2017
	Performing TDRs		Nonaccrual TDRs		Performing TDRs		Nonaccrual TDRs		Performing TDRs		Nonaccrual TDRs		Performing TDRs		Nonaccrual TDRs
	(In thousands)								(In thousands)
TDR loans	$	19,888	$	6,302	$	22,288	$	6,900	$	26,187	$	8,214	$	26,757	$	5,193
Allowance for loan losses on TDR loans	2,104		417		1,965		437		2,613		336		2,635		379

The unfunded commitment to borrowers related to ~~TDRs~~TDR loans was ~~$482,000~~$517,000 and ~~$249,000~~$1.2 million at March 31, ~~2017~~2018 and December 31, ~~2016~~2017, respectively.

~~Loans that were modified as TDRs during the three months ended March 31, 2017 and 2016 are set forth in the following tables:~~

Three Months Ended March 31,
2017 2016

Number of
Contracts
(1)
Outstanding
Principal Balance
(1)(2)
Number of
Contracts
(1)

Outstanding
Principal Balance
(1)(2)
(Dollars in thousands)
Commercial business:
Commercial and industrial 8
$ 3,245
9
$ 1,918
Owner-occupied commercial real estate 1
56
—
—
Non-owner occupied commercial real estate 1
184
1
1,118
Total commercial business 10
3,485
10
3,036
Real estate construction and land development:
One-to-four family residential 2
1,143
5
2,390
Total real estate construction and land development 2
1,143
5
2,390
Consumer 1
9
3
41
Total TDR loans 13
$ 4,637
18
$ 5,467

2427

Table of Contents

Loans that were modified as TDR loans during the three months ended March 31, 2018 and 2017 are set forth in the following table:



	Three Months Ended March 31,
	2018			2017
	Number of Contracts (1)	Outstanding Principal Balance (1)(2)		Number of Contracts (1)	Outstanding Principal Balance (1)(2)
	(Dollars in thousands)
Commercial business:
Commercial and industrial	9	$	4,323	8	$	3,245
Owner-occupied commercial real estate	—	—		1	56
Non-owner occupied commercial real estate	1	2,201		1	184
Total commercial business	10	6,524		10	3,485
Real estate construction and land development:
One-to-four family residential	—	—		2	1,143
Total real estate construction and land development	—	—		2	1,143
Consumer	3	78		1	9
Total loans modified as TDR loans	13	$	6,602	13	$	4,637


⁽¹⁾	Number of contracts and outstanding principal balance represent loans which have balances as of period end as certain loans may have been paid-down or charged-off during the three months ended March 31, ~~2017~~2018 and ~~2016.~~2017.

⁽²⁾

Includes subsequent payments after modifications and reflects the balance as of period end. As the Bank did not forgive any principal or interest balance as part of the loan modification, the Bank’s recorded investment in each loan at the date of modification (pre-modification) did not change as a result of the modification (post-modification)., except when the modification was the initial advance on a one-to-four family residential real estate construction and land development loan under a master guidance line. There were no advances on these types of loans during the three months ended March 31, 2018 and 2017.

Of the 13 loans modified during the three months ended March 31, 2017, eight loans with a total outstanding principal balance of $2.7 million had no prior modifications. Of the 18 loans modified during the three months ended March 31, 2016, eight loans with a total outstanding principal balance of $1.5 million had no prior modifications. The remainingCertain loans included in the table above ~~for the three months ended March 31, 2017 and 2016 were~~may have been previously reported as ~~TDRs.~~TDR loans. The Bank typically grants shorter extension periods to continually monitor these ~~TDRs~~TDR loans despite the fact that the extended date might not be the date the Bank expects sufficient cash flow from these borrowers. The ~~Company~~Bank does not consider these modifications a subsequent default of a TDR as new loan terms, specifically new maturity dates, were granted. The potential losses related to these loans would have been considered in the period the loan was first reported as a TDR loan and are adjusted, as necessary, in the current period based on more recent information. The related specific valuation allowance at March 31, ~~2017~~2018 was ~~$459,000~~$195,000 for loans that were modified as ~~TDRs~~TDR loans during the three months ended March 31, ~~2017.~~2018.

~~There was one commercial and industrial loan~~

Table of $234,000 at March 31, 2017 that was modified during the previous twelve months that subsequently defaulted during the three months ended March 31, 2017 because the borrower was 90 days delinquent on his scheduled payment. There were no loansContents

Loans that were modified during the previous twelve months that subsequently defaulted during the three months ended March 31, ~~2016.~~2018 and 2017 are set forth in the following table:



	Three Months Ended March 31,
	2018			2017
	Number of Contracts	Outstanding Principal Balance		Number of Contracts	Outstanding Principal Balance
	(Dollars in thousands)
Commercial business:
Commercial and industrial	1	$	283	1	$	234
Non-owner occupied commercial real estate	1	75		—	—
Total commercial business	2	358		1	234
Real estate construction and land development:
One-to-four family residential	2	838		—	—
Total	4	$	1,196	1	$	234

During the three months ended March 31, 2018, the four loans defaulted because they were past their modified maturity dates, and the borrowers have not subsequently repaid the credits. The Bank has chosen not to extend the maturities on these loans. The Bank had no specific valuation allowance at March 31, 2018 related to the credits which defaulted during the three months ended March 31, 2018.

The one commercial and industrial loan that was modified during the previous twelve months subsequently defaulted during the three months ended March 31, 2017 because the borrower was more than 90 days delinquent on his scheduled loan payments.

(h) Purchased Credit Impaired Loans

The Company acquired certain loans and designated them, as appropriate, as PCI loans, which are accounted for under FASB ASC ~~310-30,~~310-30. No loans acquired in the ~~Washington Banking~~Puget Sound Merger on May 1, 2014 and in previously completed acquisitions, including the FDIC-assisted acquisitions of Cowlitz Bank ("Cowlitz") and Pierce Commercial Bank ("Pierce") on July 30, 2010 and November 8, 2010, respectively, and the acquisitions of Northwest Commercial Bank ("NCB") oneffective January ~~9, 2013 and Valley Community Bancshares, Inc. ("Valley") on July 15, 2013.~~16, 2018 were considered PCI.

The following table reflects the outstanding principal balance and recorded investment of the PCI loans at March 31, ~~2017~~2018 and December 31, ~~2016:~~2017:


	March 31, 2017				December 31, 2016				March 31, 2018				December 31, 2017
	Outstanding Principal		Recorded Investment		Outstanding Principal		Recorded Investment		Outstanding Principal		Recorded Investment		Outstanding Principal		Recorded Investment
	(In thousands)								(In thousands)
Commercial business:
Commercial and industrial	$	12,318	$	8,427	$	13,067	$	9,317	$	8,269	$	2,091	$	8,818	$	2,912
Owner-occupied commercial real estate	17,088		15,506		17,639		15,973		10,392		9,840		12,230		11,515
Non-owner occupied commercial real estate	18,652		17,214		25,037		23,360		11,855		11,088		14,295		13,342
Total commercial business	48,058		41,147		55,743		48,650		30,516		23,019		35,343		27,769
One-to-four family residential	4,699		4,498		5,120		4,905		3,891		5,039		4,120		5,255
Real estate construction and land development:
One-to-four family residential	2,880		2,069		2,958		2,123		275		—		841		89
Five or more family residential and commercial properties	2,589		2,470		2,614		2,488		1,820		1,552		2,361		2,035
Total real estate construction and land development	5,469		4,539		5,572		4,611		2,095		1,552		3,202		2,124
Consumer	4,544		5,595		5,296		6,282		3,324		4,861		3,974		5,455
Gross PCI loans	$	62,770	$	55,779	$	71,731	$	64,448	$	39,826	$	34,471	$	46,639	$	40,603

2529

Table of Contents

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

The following table summarizes the accretable yield on the PCI loans for the three months ended March 31, ~~2017~~2018 and ~~2016.~~2017.


	Three Months Ended March 31,						Three Months Ended March 31,
	2017			2016			2018			2017
	(In thousands)						(In thousands)
Balance at the beginning of the period	$	13,860		$	17,592		$	11,224		$	13,860
Accretion	(994		)	(1,417		)	(781		)	(994		)
Disposal and other	(490		)	(1,609		)	(1,698		)	(490		)
Change in accretable yield	756			1,710			2,524			756
Balance at the end of the period	$	13,132		$	16,276		$	11,269		$	13,132


~~(4)~~(5)	Allowance for Loan Losses

The allowance for loan losses is maintained at a level deemed appropriate by management to provide for probable incurred credit losses in the loan portfolio. The following tables detail the activity in the allowance for loan losses disaggregated by segment and class for the three months ended March 31, ~~2017:~~2018:


	Balance at Beginning of Period		Charge-offs			Recoveries		Provision for Loan Losses			Balance at End of Period		Balance at Beginning of Period		Charge-offs			Recoveries		Provision for Loan Losses			Balance at End of Period
	(In thousands)												(In thousands)
Three Months Ended March 31, 2017
Three Months Ended March 31, 2018
Commercial business:
Commercial and industrial	$	10,968	$	(295	)	$	223	$	(805	)	$	10,091	$	9,910	$	(81	)	$	499	$	(385	)	$	9,943
Owner-occupied commercial real estate	3,661		(7		)	149		413			4,216		3,992		—			2		1,046			5,040
Non-owner occupied commercial real estate	7,753		—			—		(152		)	7,601		8,097		—			—		(508		)	7,589
Total commercial business	22,382		(302		)	372		(544		)	21,908		21,999		(81		)	501		153			22,572
One-to-four family residential	1,015		—			—		37			1,052		1,056		—			—		27			1,083
Real estate construction and land development:
One-to-four family residential	797		—			10		(16		)	791		862		—			—		79			941
Five or more family residential and commercial properties	1,359		—			—		187			1,546		1,190		—			—		(75		)	1,115
Total real estate construction and land development	2,156		—			10		171			2,337		2,052		—			—		4			2,056
Consumer	5,024		(543		)	107		607			5,195		6,081		(485		)	88		370			6,054
Unallocated	506		—			—		596			1,102		898		—			—		598			1,496
Total	$	31,083	$	(845	)	$	489	$	867		$	31,594	$	32,086	$	(566	)	$	589	$	1,152		$	33,261

2630

Table of Contents

The following table details the allowance for loan losses disaggregated on the basis of the Company's impairment method as of March 31, ~~2017.~~2018.


	Loans Individually Evaluated for Impairment		Loans Collectively Evaluated for Impairment		PCI Loans		Total Allowance for Loan Losses		Loans Individually Evaluated for Impairment		Loans Collectively Evaluated for Impairment		PCI Loans		Total Allowance for Loan Losses
	(In thousands)								(In thousands)
Commercial business:
Commercial and industrial	$	1,204	$	7,236	$	1,651	$	10,091	$	1,769	$	7,251	$	923	$	9,943
Owner-occupied commercial real estate	747		2,190		1,279		4,216		1,727		2,513		800		5,040
Non-owner occupied commercial real estate	922		4,956		1,723		7,601		811		5,837		941		7,589
Total commercial business	2,873		14,382		4,653		21,908		4,307		15,601		2,664		22,572
One-to-four family residential	98		690		264		1,052		93		832		158		1,083
Real estate construction and land development:
One-to-four family residential	—		543		248		791		2		714		225		941
Five or more family residential and commercial properties	66		1,355		125		1,546		—		1,028		87		1,115
Total real estate construction and land development	66		1,898		373		2,337		2		1,742		312		2,056
Consumer	62		4,126		1,007		5,195		73		5,304		677		6,054
Unallocated	—		1,102		—		1,102		—		1,496		—		1,496
Total	$	3,099	$	22,198	$	6,297	$	31,594	$	4,475	$	24,975	$	3,811	$	33,261

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, ~~2017:~~2018:


	Loans Individually Evaluated for Impairment		Loans Collectively Evaluated for Impairment		PCI Loans		Total Gross Loans Receivable		Loans Individually Evaluated for Impairment		Loans Collectively Evaluated for Impairment		PCI Loans		Total Gross Loans Receivable
	(In thousands)								(In thousands)
Commercial business:
Commercial and industrial	$	10,043	$	617,816	$	8,427	$	636,286	$	16,525	$	793,062	$	2,091	$	811,678
Owner-occupied commercial real estate	4,894		548,916		15,506		569,316		13,101		679,415		9,840		702,356
Non-owner occupied commercial real estate	11,397		845,607		17,214		874,218		10,468		1,111,838		11,088		1,133,394
Total commercial business	26,334		2,012,339		41,147		2,079,820		40,094		2,584,315		23,019		2,647,428
One-to-four family residential	314		73,697		4,498		78,509		295		83,846		5,039		89,180
Real estate construction and land development:
One-to-four family residential	2,736		47,329		2,069		52,134		1,147		72,148		—		73,295
Five or more family residential and commercial properties	1,071		122,243		2,470		125,784		—		96,835		1,552		98,387
Total real estate construction and land development	3,807		169,572		4,539		177,918		1,147		168,983		1,552		171,682
Consumer	310		318,862		5,595		324,767		379		365,035		4,861		370,275
Total	$	30,765	$	2,574,470	$	55,779	$	2,661,014	$	41,915	$	3,202,179	$	34,471	$	3,278,565

2731

Table of Contents

The following tables detail activity in the allowance for loan losses disaggregated by segment and class for the three months ended March 31, ~~2016.~~2017.


	Balance at Beginning of Period		Charge-offs			Recoveries		Provision for Loan Losses			Balance at End of Period		Balance at Beginning of Period		Charge-offs			Recoveries		Provision for Loan Losses			Balance at End of Period
	(In thousands)												(In thousands)
Three Months Ended March 31, 2016
Three Months Ended March 31, 2017
Commercial business:
Commercial and industrial	$	9,972	$	(1,178	)	$	274	$	762		$	9,830	$	10,968	$	(295	)	$	223	$	(805	)	$	10,091
Owner-occupied commercial real estate	4,370		(52		)	—		(33		)	4,285		3,661		(7		)	149		413			4,216
Non-owner occupied commercial real estate	7,722		—			—		(358		)	7,364		7,753		—			—		(152		)	7,601
Total commercial business	22,064		(1,230		)	274		371			21,479		22,382		(302		)	372		(544		)	21,908
One-to-four family residential	1,157		—			1		(71		)	1,087		1,015		—			—		37			1,052
Real estate construction and land development:
One-to-four family residential	1,058		(100		)	83		(237		)	804		797		—			10		(16		)	791
Five or more family residential and commercial properties	813		(53		)	—		307			1,067		1,359		—			—		187			1,546
Total real estate construction and land development	1,871		(153		)	83		70			1,871		2,156		—			10		171			2,337
Consumer	4,309		(338		)	145		640			4,756		5,024		(543		)	107		607			5,195
Unallocated	345		—			—		129			474		506		—			—		596			1,102
Total	$	29,746	$	(1,721	)	$	503	$	1,139		$	29,667	$	31,083	$	(845	)	$	489	$	867		$	31,594

The following table details the allowance for loan losses disaggregated on the basis of the Company's impairment method as of December 31, ~~2016.~~2017.


	Loans Individually Evaluated for Impairment		Loans Collectively Evaluated for Impairment		PCI Loans		Total Allowance for Loan Losses		Loans Individually Evaluated for Impairment		Loans Collectively Evaluated for Impairment		PCI Loans		Total Allowance for Loan Losses
	(In thousands)								(In thousands)
Commercial business:
Commercial and industrial	$	1,199	$	8,048	$	1,721	$	10,968	$	1,326	$	7,558	$	1,026	$	9,910
Owner-occupied commercial real estate	511		1,834		1,316		3,661		621		2,557		814		3,992
Non-owner occupied commercial real estate	797		5,142		1,814		7,753		1,222		5,919		956		8,097
Total commercial business	2,507		15,024		4,851		22,382		3,169		16,034		2,796		21,999
One-to-four family residential	97		643		275		1,015		93		798		165		1,056
Real estate construction and land development:
One-to-four family residential	6		538		253		797		2		635		225		862
Five or more family residential and commercial properties	60		1,168		131		1,359		37		1,064		89		1,190
Total real estate construction and land development	66		1,706		384		2,156		39		1,699		314		2,052
Consumer	64		3,912		1,048		5,024		54		5,303		724		6,081
Unallocated	—		506		—		506		—		898		—		898
Total	$	2,734	$	21,791	$	6,558	$	31,083	$	3,355	$	24,732	$	3,999	$	32,086

2832

Table of Contents

The following table details the recorded investment balance of the loan receivables disaggregated on the basis of the Company’s impairment method as of December 31, ~~2016:~~2017:


	Loans Individually Evaluated for Impairment		Loans Collectively Evaluated for Impairment		PCI Loans		Total Gross Loans Receivable		Loans Individually Evaluated for Impairment		Loans Collectively Evaluated for Impairment		PCI Loans		Total Gross Loans Receivable
	(In thousands)								(In thousands)
Commercial business:
Commercial and industrial	$	12,375	$	616,081	$	9,317	$	637,773	$	11,999	$	630,485	$	2,912	$	645,396
Owner-occupied commercial real estate	4,724		537,338		15,973		558,035		6,808		603,827		11,515		622,150
Non-owner occupied commercial real estate	11,318		846,202		23,360		880,880		16,019		957,233		13,342		986,594
Total commercial business	28,417		1,999,621		48,650		2,076,688		34,826		2,191,545		27,769		2,254,140
One-to-four family residential	321		72,165		4,905		77,391		299		81,443		5,255		86,997
Real estate construction and land development:
One-to-four family residential	3,071		45,220		2,123		50,414		1,247		50,649		89		51,985
Five or more family residential and commercial properties	1,079		105,197		2,488		108,764		645		94,819		2,035		97,499
Total real estate construction and land development	4,150		150,417		4,611		159,178		1,892		145,468		2,124		149,484
Consumer	310		318,548		6,282		325,140		442		349,194		5,455		355,091
Total	$	33,198	$	2,540,751	$	64,448	$	2,638,397	$	37,459	$	2,767,650	$	40,603	$	2,845,712


~~(5)~~(6)	Other Real Estate Owned

There was no other real estate owned at March 31, 2018 or December 31, 2017 and no activity during the three months ended March 31, 2018. Changes in other real estate owned during the three months ended March 31, 2017 ~~and 2016~~ were as follows:


	Three Months Ended March 31,					Three Months Ended March 31,
	2017		2016			2017
	(In thousands)					(In thousands)
Balance at the beginning of the period	$	754	$	2,019		$	754
Additions	32		652			32
Proceeds from dispositions	—		(543		)
Gain (loss) on sales, net	—		10
Valuation adjustment	—		(312		)
Balance at the end of the period	$	786	$	1,826		$	786

At March 31, ~~2017, the carrying amount of other real estate owned that was the result of foreclosure and obtaining physical possession of residential real estate properties was $555,000. At March 31, 2017,~~2018, the recorded investment of consumer mortgage loans secured by residential real estate properties (included in the one-to-four family residential ~~loan class~~loans in Note ~~(3)~~(4) Loans Receivable) for which formal foreclosure proceedings were in process was ~~$944,000.~~$80,000.


~~(6)~~	~~Goodwill and Other Intangible Assets~~

(7)Goodwill and Other Intangible Assets

(a) Goodwill

The Company’s goodwill represents the excess of the purchase price over the fair value of net assets acquired in the recent Puget Sound Merger on January 16, 2018 and the historical acquisitions of Washington Banking ~~Merger~~Company on May 1, ~~2014, and the acquisitions of~~2014; Valley Community Bancshares on July 15, ~~2013,~~2013; Western Washington Bancorp in 2006 and North Pacific Bank in 1998. The Company’s goodwill is assigned to the Bank and is evaluated for impairment at the Bank level (reporting unit).

~~There were no additions to goodwill during the three months ended March 31, 2017 and 2016.~~

2933

Table of Contents

The following table presents the change in goodwill for the periods indicated:



	Three Months Ended March 31,
	2018		2017
	(In thousands)
Balance at the beginning of the period	$	119,029	$	119,029
Additions as a result of acquisitions⁽¹⁾	68,520		—
Impairment	—		—
Balance at the end of the period	$	187,549	$	119,029

~~At March 31,~~⁽¹⁾ See Note (2) Business Combination

The Company performed its annual goodwill impairment test during the fourth quarter of 2017 ~~the Company’s step-one~~and determined based on its Step 1 analysis ~~concluded~~ that the ~~reporting unit’s~~ fair value ~~was greater than its~~of the reporting unit exceeded the carrying value, ~~and therefore no~~such that the Company's goodwill ~~impairment charges were required,~~was not considered impaired. Changes in the economic environment, operations of the reporting unit or recorded, for the three months ended March 31, 2017. Similarly, no goodwill impairment charges were required, or recorded, for the three months ended March 31, 2016. Even though there was no goodwill impairment at ~~March 31, 2017~~,other adverse events ~~may impact the recoverability of goodwill and~~ could result in a future impairment ~~charge~~charges which could have a material impact on the Company’s operating results.

b)(b) Other Intangible Assets

The other intangible assets represent the core deposit intangible ("CDI") acquired in business combinations. The useful life of the CDI related to the acquisitions of Puget Sound Bancorp, Washington Banking ~~Merger, the acquisitions of~~Company, Valley ~~NCB~~Community Bancshares, and ~~Cowlitz~~Northwest Commercial Bank were estimated to be ten, ten, ~~five~~ten, and ~~nine~~five years, respectively.

The following table presents the change in ~~the~~ other intangible assets for the periods indicated:

Three Months Ended March 31,
2017 2016
(In thousands)
Balance at the beginning of the period $ 7,374
$ 8,789
Less: Amortization 324
335
Balance at the end of the period $ 7,050
$ 8,454


~~(7)~~	~~Other Borrowings~~

~~(a) Federal Home Loan Bank Advances~~

The Federal Home Loan Bank ("FHLB") of Des Moines functions as a member-owned cooperative providing credit for member financial institutions. Advances are made pursuant to several different programs. Each credit program has its own interest rate and range of maturities. Limitations on the amount of advances are based on a percentage of the Bank's assets or on the FHLB’s assessment of the institution’s creditworthiness. At March 31, 2017, the Bank maintained a credit facility with the FHLB of Des Moines for $623.9 million and had $66.8 million of short-term FHLB advances outstanding. At December 31, 2016 there were $79.6 million of FHLB advances outstanding.

~~The following table sets forth the details of FHLB advances during the three months ended March 31, 2017 and 2016:~~

Three Months Ended March 31,
2017 2016
(Dollars in thousands)
Average balance during the period $ 101,130
$ —
Maximum month-end balance during the period $ 126,300
$ —
Weighted average rate during the period 0.81 % — %

Advances from the FHLB are collateralized by a blanket pledge on FHLB stock owned by the Bank, deposits at the FHLB, certain one-to-four single family residential loans or other assets, principally investment securities which are obligations of or guaranteed by the United States or other assets. In accordance with the pledge agreement, the Company must maintain unencumbered collateral in an amount equal to varying percentages ranging from 100% to 160% of outstanding advances depending on the type of collateral.

~~(b) Federal Funds Purchased~~

The Bank maintains advance lines with Wells Fargo Bank, US Bank, The Independent Bankers Bank, and Pacific Coast Bankers’ Bank to purchase federal funds of up to $90.0 million as of March 31, 2017. The lines generally mature annually or are reviewed annually. As of March 31, 2017 and December 31, 2016, there were no federal funds purchased.

~~(c) Credit facilities~~

~~Table of Contents~~

The Bank maintains a credit facility with the Federal Reserve Bank of San Francisco for $41.1 million as of March 31, 2017, on which there were no borrowings outstanding as of March 31, 2017 or December 31, 2016. Any advances on the credit facility would have to be first secured by the Bank's investment securities or loans receivable.



	Three Months Ended March 31,
	2018			2017
	(In thousands)
Balance at the beginning of the period	$	6,088		$	7,374
Additions as a result of acquisitions	11,270			—
Amortization	(795		)	(324		)
Balance at the end of the period	$	16,563		$	7,050


(8)	Junior Subordinated Debentures

As part of the acquisition of Washington Banking ~~Merger,~~Company on May 1, 2014, the Company assumed trust preferred securities and junior subordinated debentures with a total fair value of $18.9 million at the ~~May 1, 2014~~ merger date.

Washington Banking Master Trust, a Delaware statutory business trust, was a wholly-owned subsidiary of the Washington Banking Company created for the exclusive purposes of issuing and selling capital securities and utilizing sale proceeds to acquire junior subordinated ~~debt~~debentures issued by the Washington ~~Banking.~~Banking Company. During 2007, the Trust issued $25.0 million of trust preferred securities with a 30-year maturity, callable after the fifth year by the Washington Banking. The trust preferred securities have a quarterly adjustable rate based upon the three-month London Interbank Offered Rate (“LIBOR”) plus 1.56%. On the ~~Washington Banking Merger~~merger date, ~~of May 1, 2014,~~ the Company acquired the Trust, which retained the Washington Banking Master Trust name, and assumed the performance and observance of the covenants under the indenture related to the trust preferred securities.

The adjustable rate of the trust preferred securities at March 31, ~~2017~~2018 was ~~2.71%~~3.88%. The weighted average rate of the junior subordinated debentures ~~was 4.89%~~were as follows for the ~~three months ended March 31, 2017, respectively, and 4.34% for the three months ended March 31, 2016, respectively.~~ indicated periods:



	Three Months Ended March 31,
	2018		2017
Weighted average rate ⁽¹⁾	5.73	%	4.89	%

⁽¹⁾The weighted average rate includes the accretion of the discount established at the merger date which is amortized over the life of the trust preferred securities.

Table of Contents

The junior subordinated debentures are the sole assets of the Trust and payments under the junior subordinated debentures are the sole revenues of the Trust. At March 31, ~~2017~~2018 and December 31, ~~2016,~~2017, the balance of the junior subordinated debentures, net of unaccreted discount, was ~~$19.8~~$20.1 million and ~~$19.7~~$20.0 million, respectively. All of the common securities of the Trust are owned by the Company. Heritage has fully and unconditionally guaranteed the capital securities along with all obligations of the Trust under the trust agreements. For financial reporting purposes, the Company's investment in the Master Trust is accounted for under the equity method and is included in prepaid expenses and other assets on the Company's Condensed Consolidated Statements of Financial Condition. The junior subordinated debentures issued and guaranteed by the Company and held by the Master Trust are reflected as liabilities on the Company's Condensed Consolidated Statements of Financial Condition.


(9)	Repurchase Agreements

The Company utilizes repurchase agreements with one-day maturities as a supplement to funding sources. Repurchase agreements are secured by pledged investment securities available for sale. Under the repurchase agreements, the Company is required to maintain an aggregate market value of securities pledged greater than the balance of the repurchase agreements. The Company is required to pledge additional securities to cover any declines below the balance of the repurchase agreements. The balance of the Company's repurchase agreement obligations by class of collateral pledged as of March 31, 2017 were residential mortgage backed securities and collateralized mortgage obligations of $10.1 million and commercial mortgage backed securities and collateralized mortgage obligations of $11.3 million. The balance of the Company's repurchase agreement obligations by class of collateral pledged as of December 31, 2016, were residential mortgage backed securities and collateralized mortgage obligations of $5.2 million, commercial mortgage backed securities and collateralized mortgage obligations of $14.0 million and U.S. Government-sponsored agencies of $2.9 million. For additional information on the total value of investment securities pledged for repurchase agreements see Note ~~(2)~~(3) Investment Securities.

The following table presents the Company's repurchase agreement obligations by class of collateral pledged:



	March 31, 2018		December 31, 2017
	(In thousands)
Mortgage-backed securities and collateralized mortgage obligations⁽¹⁾:
Residential	$	11,424	$	11,239
Commercial	14,676		20,582
Total repurchase agreements	$	26,100	$	31,821

⁽¹⁾ Issued and guaranteed by U.S. Government-sponsored agencies.


(10)	Other Borrowings

(a) FHLB

The Federal Home Loan Bank ("FHLB") of Des Moines functions as a member-owned cooperative providing credit for member financial institutions. Advances are made pursuant to several different programs. Each credit program has its own interest rate and range of maturities. Limitations on the amount of advances are based on a percentage of the Bank's assets or on the FHLB’s assessment of the institution’s creditworthiness. At March 31, 2018, the Bank maintained a credit facility with the FHLB of Des Moines for $913.0 million and had short-term FHLB advances outstanding of $30.7 million with maturity dates within 30 days. At December 31, 2017 there were FHLB advances outstanding of $92.5 million.

The following table sets forth the details of FHLB advances during the three months ended March 31, 2018 and 2017:



	Three Months Ended March 31,
	2018			2017
	(In thousands)
FHLB Advances:
Average balance during the period	$	35,733		$	101,130
Maximum month-end balance during the period	$	37,200		$	126,300
Weighted average rate during the period	1.70		%	0.81		%

Advances from the FHLB are collateralized by a blanket pledge on FHLB stock owned by the Bank, deposits at the FHLB, certain one-to-four single family residential loans or other assets, investment securities which are obligations of or guaranteed by the United States or other assets. In accordance with the pledge agreement, the Company must maintain unencumbered collateral in an amount equal to varying percentages ranging from 100% to 160% of outstanding advances depending on the type of collateral.

Table of Contents

(b) Federal Funds Purchased

The Bank maintains advance lines with Wells Fargo Bank, US Bank, The Independent Bankers Bank ("TIB") and Pacific Coast Bankers’ Bank to purchase federal funds of up to $90.0 million as of March 31, 2018. The lines generally mature annually or are reviewed annually. As of March 31, 2018 and December 31, 2017, there were no federal funds purchased.

The Bank maintains a credit facility with the Federal Reserve Bank of San Francisco ("Federal Reserve Bank") for $81.4 million as of March 31, 2018, of which there were no borrowings outstanding as of March 31, 2018 or December 31, 2017. Any advances on the credit facility would have to be first secured by the Bank's investment securities or loans receivable.


(11)	Derivative Financial Instruments

The Company has entered into certain interest rate swap contracts that are not designated as hedging instruments. The purpose of these derivative contracts is primarily to provide commercial business loan customers the ability to convert their loans from variable to fixed interest rates. Upon the origination of a derivative contract with a customer, the Company simultaneously enters into an offsetting derivative contract with a third party in order to offset its exposure on the variable and fixed rate components of the customer agreement. The Company recognizes immediate income based upon the difference in the bid/ask spread of the underlying transactions with its customers and the third ~~party.~~party, which is recorded in interest rate swap fees on the Condensed Consolidated Statements of Income. Because the Company acts only as an intermediary for its customer, subsequent changes in the fair value of the underlying derivative contracts offset each other and do not significantly impact the Company’s results of operations.

The notional amounts and estimated fair values of interest rate derivative contracts outstanding at March 31, ~~2017~~2018 and December 31, ~~2016~~2017 are presented in the following table.

~~Table of Contents~~


	March 31, 2017					December 31, 2016					March 31, 2018					December 31, 2017
	Notional Amounts		Estimated Fair Value			Notional Amounts		Estimated Fair Value			Notional Amounts		Estimated Fair Value			Notional Amounts		Estimated Fair Value
	(In thousands)										(In thousands)
Non-hedging interest rate derivatives
Interest rate swaps with customer ⁽¹⁾	$	108,483	$	1,242		$	102,709	$	1,099		$	148,238	$	(4,553	)	$	146,537	$	(882	)
Interest rate swap with third party ⁽¹⁾	108,483		(1,242		)	102,709		(1,099		)	148,238		4,553			146,537		882

⁽¹⁾The estimated fair value of the derivative included in prepaid and other assets on the Condensed Consolidated Statements of Financial Condition was ~~$2.9~~$4.8 million and ~~$2.8~~$3.4 million as of March 31, ~~2017~~2018 and December 31, ~~2016,~~2017, respectively. The estimated fair value of the derivative included in accrued expenses and other liabilities on the Condensed Consolidated Statements of Financial Condition was ~~$2.9~~$4.8 million and ~~$2.8~~$3.4 million as of March 31, ~~2017~~2018 and December 31, ~~2016,~~2017, respectively.

Table of Contents


~~(11)~~(12)	Stockholders’ Equity

(a) Earnings Per Common Share

The following table illustrates the reconciliation of weighted average shares used for earnings per common share computations for the three months ended March 31, ~~2017~~2018 and ~~2016:~~2017:


	Three Months Ended March 31,						Three Months Ended March 31,
	2017			2016			2018			2017
	(Dollars in thousands)						(Dollars in thousands)
Net income:
Net income	$	9,316		$	9,091		$	9,087		$	9,316
Less: Dividends and undistributed earnings allocated to participating securities	(78		)	(98		)	(51		)	(78		)
Net income allocated to common shareholders	$	9,238		$	8,993		$	9,036		$	9,238
Basic:
Weighted average common shares outstanding	29,952,074			29,965,250			33,332,645			29,952,074
Less: Restricted stock awards	(248,170		)	(293,382		)	(127,099		)	(248,170		)
Total basic weighted average common shares outstanding	29,703,904			29,671,868			33,205,546			29,703,904
Diluted:
Basic weighted average common shares outstanding	29,703,904			29,671,868			33,205,546			29,703,904
Effect of potentially dilutive common shares ⁽¹⁾	49,085			14,245			142,556			49,085
Total diluted weighted average common shares outstanding	29,752,989			29,686,113			33,348,102			29,752,989


⁽¹⁾	Represents the effect of the assumed exercise of stock options and vesting of restricted stock units.

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, 2018 and 2017, there were no anti-dilutive shares outstanding related to options to acquire common stock. ~~For~~Anti-dilution occurs when the ~~three months ended March 31, 2016, anti-dilutive shares outstanding related to options to acquire common stock totaled 1,747 as the assumed proceeds from~~ exercise price ~~tax benefits and future~~of a stock option or the unrecognized compensation ~~were in excess~~cost per share of a restricted stock award exceeds the market price of the ~~market value.~~Company’s stock.

(b) Dividends

The timing and amount of cash dividends paid on the Company's common stock depends on the Company’s earnings, capital requirements, financial condition and other relevant factors. Dividends on common stock from the Company depend substantially upon receipt of dividends from the Bank, which is the Company’s predominant source of income.

~~Table of Contents~~

The following table summarizes the dividend activity for the three months ended March 31, ~~2017~~2018 and calendar year ~~2016.~~2017.



Declared	Cash Dividend per Share	Record Date	Paid Date
January ~~27, 2016~~	~~$0.11~~	~~February 10, 2016~~	~~February 24, 2016~~
~~April 20, 2016~~	~~$0.12~~	~~May 5, 2016~~	~~May 19, 2016~~
~~July 20, 2016~~	~~$0.12~~	~~August 4, 2016~~	~~August 18, 2016~~
~~October 26, 2016~~	~~$0.12~~	~~November 8, 2016~~	~~November 22, 2016~~
~~October 26, 2016~~	~~$0.25~~	~~November 8, 2016~~	~~November 22, 2016~~	*
~~January~~ 25, 2017	$0.12	February 9, 2017	February 23, 2017
April 25, 2017	$0.13	May 10, 2017	May 24, 2017
July 25, 2017	$0.13	August 10, 2017	August 24, 2017
October 25, 2017	$0.13	November 8, 2017	November 22, 2017
October 25, 2017	$0.10	November 8, 2017	November 22, 2017	*
January 24, 2018	$0.15	February 7, 2018	February 21, 2018

* Denotes a special dividend.

The FDIC and the Washington State Department of Financial Institutions, Division of Banks have the authority under their supervisory powers to prohibit the payment of dividends by the Bank to the Company. Additionally, current guidance from the Board of Governors of the Federal Reserve System ("Federal ~~Reserve Board"~~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 the Bank to pay dividends on their common stock if the Company’s or the Bank’s regulatory capital would not be reduced below the statutory capital requirements set by the Federal Reserve ~~Board~~ and the FDIC.

Table of Contents

The Company has had various stock repurchase programs since March 1999. On October 23, 2014, the Company's Board of Directors authorized the repurchase of up to 5% of the Company's outstanding common shares, or approximately 1,513,000 shares, under the eleventh stock repurchase plan. The number, timing and price of shares repurchased will depend on business and market conditions and other factors, including opportunities to deploy the Company's capital.

~~The following table provides total~~Since the inception of the eleventh plan, the Company has repurchased 579,996 shares ~~and~~at an average share prices of $16.67. No shares were repurchased under ~~the~~this plan ~~for the periods indicated:~~

Three Months Ended March 31,
2017 2016
Plan Total⁽¹⁾
Eleventh Plan
Repurchased shares —
100,000
579,996
Stock repurchase average share price $ —
$ 17.05
$ 16.76

~~(1) Represents shares repurchased and average price per share paid~~ during the ~~duration of the plan.~~three months ended March 31, 2018 and 2017.

In addition to the stock repurchases ~~disclosed in the table above,~~under a plan, the Company ~~repurchased~~repurchases shares to pay withholding taxes on the vesting of restricted ~~stock.~~ stock awards and units. The following table provides total repurchased shares for the periods indicated:



	Three Months Ended March 31,
	2018		2017
Repurchased shares to pay withholding taxes ⁽¹⁾	45,426		15,891
Stock repurchase to pay withholding taxes average share price	$	31.66	$	23.95

⁽¹⁾During the three months ended March 31, ~~2017 and 2016,~~2018, 26,741 of the ~~Company~~shares repurchased ~~15,891 and 11,255~~related to the withholding taxes due on the accelerated vesting of the restricted stock units of Puget Sound which were converted to Heritage common stock shares with an average share price of $31.80 under the terms of the merger. See Note (2) Business Combination.

(d) Issuance of Common Stock

The Puget Sound Merger was effective on January 16, 2018. In conjunction with the merger was the issuance of 4,112,258 shares of the Company's common stock at ~~an average~~the merger date share price ~~per share~~ of ~~$23.95 and $17.62 to pay withholding taxes on the vesting~~$31.80 for a fair value of ~~restricted stock that vested during the respective periods.~~$130.8 million.


~~(12)~~	~~Accumulated Other Comprehensive Income~~

~~The changes in accumulated other comprehensive income (loss) (“AOCI”) by component, during the three months ended March 31, 2017 and 2016 are as follows:~~

Three Months Ended March 31, 2017 ⁽¹⁾
(In thousands)
Balance of AOCI at the beginning of period $ (2,606 )
Other comprehensive income before reclassification 1,473
Balance of AOCI at the end of period $ (1,133 )


~~(1)~~	~~All amounts are due to the changes in fair value of available for sale securities and are net of tax.~~

~~Table of Contents~~

Three Months Ended
March 31, 2016 ⁽¹⁾
(In thousands)
Balance of AOCI at the beginning of period $ 2,559
Other comprehensive income before reclassification 6,075
Amounts reclassified from AOCI for gain on sale of investment securities available for sale included in net income (364 )
Net current period other comprehensive income 5,711
Balance of AOCI at the end of period $ 8,270


~~(1)~~	~~All amounts are due to the changes in fair value of available for sale securities and are net of tax.~~


(13)	~~Stock-Based Compensation~~Accumulated Other Comprehensive (Loss) Income

~~Stock options generally vest ratably over three years and expire five years after they become exercisable or vest ratably over four years and expire ten years from date~~The changes in accumulated other comprehensive (loss) income (“AOCI”), all of grant. Restricted stock awards issued generally have a four-year cliff vesting or four-year ratable vesting schedule. Restricted stock units vest ratably over three years. Performance restricted stock units issued generally have a three-year cliff vesting schedule. Additionally, performance restricted stock unit grants may be subjectwhich are due to performance-based vesting as well as other approved vesting conditions. The Company issues new shares of common stock to satisfy share option exercises, restricted stock awards and restricted stock units.

~~Under the Company's stock-based compensation plans, 1,077,470 shares remain~~ available for ~~future issuance as~~sale securities and are net of ~~March 31, 2017.~~

~~(a) Stock Option Awards~~

~~For the three months ended March 31, 2017 and 2016, the Company did not recognize any compensation expense or related~~ tax, benefit related to stock options as all of the compensation expense related to the outstanding stock options had been previously recognized. The intrinsic value and cash proceeds from options exercised during the three months ended March 31, 2018 and 2017 ~~was $98,000 and $109,000, respectively. The intrinsic value and cash proceeds from options exercised during the three months ended March 31, 2016 was~~ ~~$38,000~~ ~~and~~ ~~$142,000, respectively.~~

~~The following table summarizes the stock option activity for the three months ended March 31, 2017 and 2016:~~are as follows:

Shares Weighted-Average Exercise Price
Weighted-Average
Remaining
Contractual
Term (In years)

Aggregate
Intrinsic
Value (In
thousands)
Outstanding at December 31, 2015 79,408
$ 14.19

Exercised (10,190 ) 13.90

Forfeited or expired (4,000 ) 17.07

Outstanding at March 31, 2016 65,218
$ 14.06
2.85 $ 229

Outstanding at December 31, 2016 37,495
$ 13.77

Exercised (8,372 ) 13.03

Forfeited or expired (550 ) 11.35

Outstanding, vested and expected to vest and exercisable at March 31, 2017 28,573
$ 14.03
2.81 $ 306

~~Table of Contents~~

~~(b) Restricted and Unrestricted Stock Awards~~

For the three months ended March 31, 2017, the Company recognized compensation expense related to restricted stock awards of $445,000 and a related tax benefit of $156,000. For the three months ended March 31, 2016, the Company recognized compensation expense related to restricted stock awards of $445,000 and a related tax benefit of $156,000. As of ~~March 31, 2017~~, the total unrecognized compensation expense related to non-vested restricted stock awards was $2.6 million and the related weighted average period over which the compensation expense is expected to be recognized is approximately 1.86 years. The vesting date fair value of the restricted stock awards that vested during the three months ended March 31, 2017 and 2016 was $1.3 million and $646,000, respectively.

~~The following table summarizes the restricted and unrestricted stock award activity for the three months ended March 31, 2017 and 2016:~~

Shares Weighted-Average Grant Date Fair Value
Nonvested at December 31, 2015 264,521
$ 15.92
Granted 99,373
17.51
Vested (36,651 ) 15.52
Forfeited (1,681 ) 16.16
Nonvested at March 31, 2016 325,562
$ 16.45

Nonvested at December 31, 2016 261,296
16.80
Granted —
—
Vested (52,201 ) 16.60
Forfeited (5,270 ) 16.78
Nonvested at March 31, 2017 203,825
$ 16.85

~~(b) Restricted and Unrestricted Stock Units~~

For the three months ended March 31, 2017, the Company recognized compensation expense related to restricted stock units of $65,000. As of March 31, 2017, the total unrecognized compensation expense related to non-vested restricted stock units was $1.97 million and the related weighted average period over which the compensation expense is expected to be recognized is approximately 2.96 years.

~~The following table summarizes the restricted and unrestricted stock unit activity for the three months ended March 31, 2017:~~

Shares Weighted-Average Grant Date Fair Value
Nonvested at December 31, 2016 —
$ —
Granted 80,735
25.23
Vested —
—
Forfeited —
—
Nonvested at March 31, 2017 80,735
$ 25.23



	Three Months Ended
	2018			2017
	(In thousands)
Balance of AOCI at the beginning of period	$	(1,298	)	$	(2,606	)
Other comprehensive (loss) income before reclassification	(7,516		)	1,473
Amounts reclassified from AOCI for gain on sale of investment securities included in net income	(27		)	—
Net current period other comprehensive (loss) income	(7,543		)	1,473
ASU 2016-01 implementation	(118		)	—
Balance of AOCI at the end of period	$	(8,959	)	$	(1,133	)


(14)	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.

3538

Table of Contents

Level 2: Valuations for assets and liabilities traded in less active dealer or broker markets, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or valuations using methodologies with observable inputs.

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

(a) Recurring and Nonrecurring Basis

The Company used the following methods and significant assumptions to measure the fair value of certain assets on a recurring and nonrecurring basis:

Investment Securities Available for Sale:

The fair values of all investment securities are based upon the assumptions that market participants would use in pricing the security. If available, fair values of 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). For investment securities where quoted prices or market prices of similar securities are not available, fair values are calculated by using observable and unobservable inputs such as discounted cash flows or other market indicators (Level 3). Security valuations are obtained from third party pricing services for comparable assets or liabilities.

Impaired Loans:

At the time a loan is considered impaired, its impairment is measured based on either the present value of expected future cash flows discounted at the loan’s effective interest rate, the observable market price, or the fair market value of the collateral (less costs to sell) if the loan is collateral-dependent. Impaired loans for which impairment is measured using the discounted cash flow approach are not considered to be measured at fair value because the loan’s effective interest rate is generally not a fair value input, and for the purposes of fair value disclosures, the fair value of these loans are measured commensurate with non-impaired loans. If the Company utilizes the fair market value of the collateral method, the fair value used to measure impairment 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 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 based on 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~~and impairment and is 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 independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in Level 3 classification of the inputs for determining fair value.

Appraisals for both collateral-dependent impaired loans and other real estate owned are performed by certified general appraisers for commercial properties or certified residential appraisers for residential properties whose qualifications and licenses have been reviewed and verified by the Company. Once received, the Company reviews the assumptions and approaches utilized in the appraisal as well as the resulting fair value in comparison with independent data sources such as recent market data or industry-wide statistics. On a quarterly basis, the Company compares the actual selling price of collateral that has been liquidated to the most recent appraised value to determine what additional adjustment should be made to the appraisal value to arrive at fair value.

3639

Table of Contents

Derivative Financial Instruments:

The Company obtains ~~broker/~~broker or dealer quotes to value its interest rate derivative contracts, which use valuation models using observable market data as of the measurement date (Level 2).

The following tables summarize the balances of assets and liabilities measured at fair value on a recurring basis as of March 31, ~~2017~~2018 and December 31, ~~2016~~2017.


	March 31, 2017								March 31, 2018
	Total		Level 1		Level 2		Level 3		Total		Level 1		Level 2		Level 3
	(In thousands)								(In thousands)
Assets
Investment securities available for sale:
U.S. Treasury and U.S. Government-sponsored agencies	$	1,565	$	—	$	1,565	$	—	$	23,389	$	—	$	23,389	$	—
Municipal securities	240,504		—		240,504		—		204,292		—		204,292		—
Mortgage backed securities and collateralized mortgage obligations:
Mortgage-backed securities and collateralized mortgage obligations:
Residential	293,105		—		293,105		—		301,277		—		301,277		—
Commercial	204,694		—		204,694		—		244,360		—		244,360		—
Collateralized loan obligations	10,182		—		10,182		—		3,271		—		3,271		—
Corporate obligations	17,820		—		17,820		—		16,629		—		16,629		—
Other securities	15,151		112		15,039		—
Other asset-backed securities									28,349		—		28,349		—
Total investment securities available for sale	$	783,021	$	112	$	782,909	$	—	821,567		—		821,567		—
Derivative assets - interest rate swaps	$	2,932	$	—	$	2,932	$	—	4,793		—		4,793		—
Liabilities
Derivative liabilities - interest rate swaps	$	2,932	$	—	$	2,932	$	—	$	4,793	$	—	$	4,793	$	—


	December 31, 2016								December 31, 2017
	Total		Level 1		Level 2		Level 3		Total		Level 1		Level 2		Level 3
	(In thousands)								(In thousands)
Assets
Investment securities available for sale:
U.S. Treasury and U.S. Government-sponsored agencies	$	1,569	$	—	$	1,569	$	—	$	13,442	$	—	$	13,442	$	—
Municipal securities	237,256		—		237,256		—		250,015		—		250,015		—
Mortgage backed securities and collateralized mortgage obligations:
Mortgage-backed securities and collateralized mortgage obligations:
Residential	309,176		—		309,176		—		280,211		—		280,211		—
Commercial	208,318		—		208,318		—		217,079		—		217,079		—
Collateralized loan obligations	10,478		—		10,478		—		4,580		—		4,580		—
Corporate obligations	16,706		—		16,706		—		16,770		—		16,770		—
Other securities	11,142		123		11,019		—		28,433		146		28,287		—
Total investment securities available for sale	$	794,645	$	123	$	794,522	$	—	810,530		146		810,384		—
Derivative assets - interest rate swaps	$	2,804	$	—	$	2,804	$	—	3,418		—		3,418		—
Liabilities
Derivative liabilities - interest rate swaps	$	2,804	$	—	$	2,804	$	—	$	3,418	$	—	$	3,418	$	—

There were no transfers between Level 1 and Level 2 during the three months ended March 31, ~~2017~~2018 and ~~2016.~~2017.

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.

3740

Table of Contents

The tables below represent assets measured at fair value on a nonrecurring basis at March 31, ~~2017~~2018 and December 31, ~~2016~~2017 and the net losses ~~(gains)~~ recorded in earnings during three months ended March 31, ~~2017~~2018 and ~~2016.~~2017.

Basis⁽¹⁾
Fair Value at March 31, 2017
Total Level 1 Level 2 Level 3
Net Losses (Gains)
Recorded in
Earnings
During
the Three Months Ended March 31, 2017
(In thousands)
Impaired loans:
Commercial business:
Commercial and industrial $ 172
$ 164
$ —
$ —
$ 164
$ 7
Owner-occupied commercial real estate 182
182
—
—
182
5
Total commercial business 354
346
—
—
346
12
Real estate construction and land development:
One-to-four family residential —
—
—
—
—
—
Total real estate construction and land development —
—
—
—
—
—
Consumer 18
16
—
—
16
(3 )
Total impaired loans and assets measured at fair value on nonrecurring basis $ 372
$ 362
$ —
$ —
$ 362
$ 9


⁽¹⁾	~~Basis represents the unpaid principal balance of impaired loans.~~

Basis⁽¹⁾
Fair Value at December 31, 2016
Total Level 1 Level 2 Level 3
Net Losses
(Gains)
Recorded in
Earnings
During
the Three Months Ended March 31, 2016
(In thousands)
Impaired loans:
Commercial business:
Commercial and industrial $ 205
$ 200
$ —
$ —
$ 200
$ —
Owner-occupied commercial real estate 780
603
—
—
603
(25 )
Total commercial business 985
803
—
—
803
(25 )
Real estate construction and land development:
One-to-four family residential 828
822
—
—
822
(6 )
Total real estate construction and land development 828
822
—
—
822
(6 )
Consumer 16
9
—
—
9
—
Total assets measured at fair value on a nonrecurring basis $ 1,829
$ 1,634
$ —
$ —
$ 1,634
$ (31 )



	Basis⁽¹⁾		Fair Value at March 31, 2018
	Basis⁽¹⁾		Total		Level 1		Level 2		Level 3		Net Losses (Gains) Recorded in Earnings During the Three Months Ended March 31, 2018
	(In thousands)
Impaired loans:
Real estate construction and land development:
One-to-four family residential	$	976	$	307	$	—	$	—	$	307	$	—
Total assets measured at fair value on a nonrecurring basis	$	976	$	307	$	—	$	—	$	307	$	—


⁽¹⁾	Basis represents the unpaid principal balance of impaired loans.



	Basis⁽¹⁾		Fair Value at December 31, 2017
	Basis⁽¹⁾		Total		Level 1		Level 2		Level 3		Net Losses Recorded in Earnings During the Three Months Ended March 31, 2017
	(In thousands)
Impaired loans:
Real estate construction and land development:
One-to-four family residential	$	976	$	307	$	—	$	—	$	307	$	—
Total assets measured at fair value on a nonrecurring basis	$	976	$	307	$	—	$	—	$	307	$	—

~~Table of Contents~~


⁽¹⁾	Basis represents the unpaid principal balance of impaired loans.

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 March 31, ~~2017~~2018 and December 31, ~~2016~~2017.

March 31, 2017

Fair
Value

Valuation
Technique(s)
Unobservable Input(s)
Range of Inputs; Weighted
Average
(Dollars in thousands)
Impaired loans $ 362
Market approach Adjustment for differences between the comparable sales
N/A ⁽¹⁾



	March 31, 2018
	Fair Value		Valuation Technique(s)	Unobservable Input(s)	Range of Inputs; Weighted Average
	(Dollars in thousands)
Impaired loans	$	307	Market approach	Adjustment for differences between the comparable sales	(91.5%) - (14.4)%; (44.0%)


⁽¹⁾	~~Quantitative disclosures are not provided for collateral-dependent impaired loans because there were no adjustments made to the appraisal or stated values during the current period.~~

December 31, 2016

Fair
Value

Valuation
Technique(s)
Unobservable Input(s)
Range of Inputs; Weighted
Average
(Dollars in thousands)
Impaired loans $ 1,634
Market approach Adjustment for differences between the comparable sales (23.8%) - 63.9%; 20.4%



	December 31, 2017
	Fair Value		Valuation Technique(s)	Unobservable Input(s)	Range of Inputs; Weighted Average
	(Dollars in thousands)
Impaired loans	$	307	Market approach	Adjustment for differences between the comparable sales	(91.5%) - (14.4%); (44.0%)

(b) Fair Value of Financial Instruments

Because broadly traded markets do not exist for most of the Company’s financial instruments, the fair value calculations attempt to incorporate the effect of current market conditions at a specific time. These determinations are subjective in nature, involve uncertainties and matters of significant judgment and do not include tax ramifications;

Table of Contents

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.

~~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, 2017										March 31, 2018
	Carrying Value		Fair Value		Fair Value Measurements Using:						Carrying Value		Fair Value		Fair Value Measurements Using:
					Level 1		Level 2		Level 3						Level 1		Level 2		Level 3
	(In thousands)										(In thousands)
Financial Assets:
Cash and cash equivalents	$	104,372	$	104,372	$	104,372	$	—	$	—	$	130,309	$	130,309	$	130,309	$	—	$	—
Investment securities available for sale	783,021		783,021		112		782,909		—		821,567		821,567		—		821,567		—
Federal Home Loan Bank stock	7,317		N/A		N/A		N/A		N/A		6,824		N/A		N/A		N/A		N/A
Loans held for sale	9,889		13,000		—		13,000		—		2,669		2,763		—		2,763		—
Total loans receivable, net	2,632,110		2,696,733		—		—		2,696,733		3,248,654		3,240,722		—		—		3,240,722
Accrued interest receivable	11,237		11,237		2		3,760		7,475		13,602		13,602		3		3,698		9,901
Derivative assets - interest rate swaps	2,932		2,932		—		2,932		—		4,793		4,793		—		4,793		—
Equity security											162		162		162		—		—
Financial Liabilities:
Noninterest deposits, NOW accounts, money market accounts and savings accounts	$	2,899,308	$	2,899,308	$	2,899,308	$	—	$	—
Noninterest deposits, interest bearing demand deposits, money market accounts and savings accounts											3,482,365		3,482,365		3,482,365		—		—
Certificate of deposit accounts	344,107		343,960		—		343,960		—		422,376		425,324		—		425,324		—
Federal Home Loan Bank advances	$	66,750	$	66,750	$	—	$	66,750	$	—	30,700		30,700		—		30,700		—
Securities sold under agreement to repurchase	$	21,440	$	21,440	$	21,440	$	—	$	—	26,100		26,100		26,100		—		—
Junior subordinated debentures	19,790		15,000		—		—		15,000		20,083		19,500		—		—		19,500
Accrued interest payable	157		157		44		82		31		174		174		42		87		45
Derivative liabilities - interest rate swaps	2,932		2,932		—		2,932		—		4,793		4,793		—		4,793		—

4042

Table of Contents


	December 31, 2016										December 31, 2017
	Carrying Value		Fair Value		Fair Value Measurements Using:						Carrying Value		Fair Value		Fair Value Measurements Using:
					Level 1		Level 2		Level 3						Level 1		Level 2		Level 3
	(In thousands)										(In thousands)
Financial Assets:
Cash and cash equivalents	$	103,745	$	103,745	$	103,745	$	—	$	—	$	103,015	$	103,015	$	103,015	$	—	$	—
Investment securities available for sale	794,645		794,645		123		794,522		—		810,530		810,530		146		810,384		—
Federal Home Loan Bank stock	7,564		N/A		N/A		N/A		N/A		8,347		N/A		N/A		N/A		N/A
Loans held for sale	11,662		11,988		—		11,988		—		2,288		2,364		—		2,364		—
Loans receivable, net of allowance for loan losses	2,609,666		2,675,811		—		—		2,675,811		2,816,985		2,810,401		—		—		2,810,401
Accrued interest receivable	10,925		10,925		3		3,472		7,450		12,244		12,244		23		3,772		8,449
Derivative assets - interest rate swaps	2,804		2,804		—		2,804		—		3,418		3,418		—		3,418		—
Financial Liabilities:
Noninterest deposits, NOW accounts, money market accounts and savings accounts	$	2,872,247	$	2,872,247	$	2,872,247	$	—	$	—
Noninterest deposits, interest bearing demand deposits, money market accounts and savings accounts											$	2,994,662	$	2,994,662	$	2,994,662	$	—	$	—
Certificate of deposit accounts	357,401		357,536		—		357,536		—		398,398		397,039		—		397,039		—
Federal Home Loan Bank advances	79,600		79,600		—		79,600		—		92,500		92,500		—		92,500		—
Securities sold under agreement to repurchase	22,104		22,104		22,104		—		—		31,821		31,821		31,821		—		—
Junior subordinated debentures	19,717		15,000		—		—		15,000		20,009		18,500		—		—		18,500
Accrued interest payable	215		215		44		142		29		162		162		45		79		38
Derivative liabilities - interest rate swaps	2,804		2,804		—		2,804		—		3,418		3,418		—		3,418		—


(15)	Stock-Based Compensation

On July 24, 2014, the Company's shareholders approved the Heritage Financial Corporation 2014 Omnibus Equity Plan (the "Plan") that provides for the issuance of 1,500,000 shares of the Company's common stock in the form of stock options, stock appreciation rights, stock awards (which includes restricted stock units, restricted stock, performance units, performance shares or bonus shares) and cash incentive awards. The ~~methods~~Company issues new shares of common stock to satisfy share option exercises and ~~assumptions, not previously presented, used to estimate fair value are described as follows:~~restricted stock awards. As of March 31, 2018, shares that remain available for future issuance under the Company's stock-based compensation plans was 970,132.

~~Cash and Cash Equivalents:~~

~~The fair value of financial instruments that are short-term or reprice frequently and that have little or no risk are considered to have a fair value equal to carrying value (Level 1).~~(a) Stock Option Awards

~~Federal Home Loan Bank~~ Stock:

~~FHLB~~ options generally vest ratably over three years and expire five years after they become exercisable or vest ratably over four years and expire ten years from date of grant. For the three months ended March 31, 2018 and 2017, the Company did not recognize any compensation expense or related tax benefit related to stock ~~is not publicly traded; thus, it is not practicable to determine~~options as all of the ~~fair value of FHLB stock due to restrictions placed on its transferability.~~

~~Loans Held for Sale~~:

~~The fair value of loans held for sale is estimated based upon binding contracts or quotes from third party investors for similar loans. (Level 2).~~

~~Loans Receivable~~:

~~Except for certain impaired loans discussed previously, fair value is based on discounted cash flows using current market rates applied~~compensation expense related to the ~~estimated life (Level 3). While these methodologies are permitted under U.S. GAAP, they are not based on~~outstanding stock options had been previously recognized. The intrinsic value and cash proceeds from options exercised during the ~~exit price concept of~~three months ended March 31, 2018 was $24,000 and $21,000, respectively. The intrinsic value and cash proceeds from options exercised during the ~~fair value required under FASB ASC 820-10,~~three months ended March 31, 2017 was ~~Fair Value Measurements~~$98,000 and ~~Disclosures~~$109,000, ~~and generally produce a higher value.~~respectively.

~~Accrued Interest Receivable/Payable~~:

The fair value of accrued interest receivable/payable balances are determined using inputs and fair value measurements commensurate with the asset or liability from which the accrued interest is generated. The carrying amounts of accrued interest approximate fair value (Level 1, Level 2 and Level 3).

4143

Table of Contents

The following table summarizes the stock option activity for the three ended March 31, 2018 and 2017:



	Shares		Weighted-Average Exercise Price		Weighted-Average Remaining Contractual Term (In years)	Aggregate Intrinsic Value (In thousands)
Outstanding at December 31, 2016	37,495		$	13.77
Exercised	(8,372	)	13.03
Forfeited or expired	(550	)	11.35
Outstanding, vested and expected to vest and exercisable at March 31, 2017	28,573		$	14.03	2.81	$	306

Outstanding at December 31, 2017	23,231		$	14.21
Exercised	(1,428	)	14.77
Forfeited or expired	(831	)	14.77
Outstanding, vested and expected to vest and exercisable at March 31, 2018	20,972		$	14.15	1.96	$	345

(b) Restricted Stock Awards

~~Deposits~~Restricted stock awards granted generally have a four-year cliff vesting or four-year ratable vesting schedule. For the three months ended March 31, 2018, the Company recognized compensation expense related to restricted stock awards of $283,000 and a related tax benefit of $60,000. For the three months ended March 31, 2017, the Company recognized compensation expense related to restricted stock awards of $445,000 and a related tax benefit of $156,000. As of :March 31, 2018

~~For deposits with no contractual maturity,~~, the total unrecognized compensation expense related to non-vested restricted stock awards was $1.2 million and the related weighted average period over which the compensation expense is expected to be recognized is approximately 1.31 years. The vesting date fair value of the restricted stock awards that vested during the three ended March 31, 2018 and 2017 was $1.3 million for both periods.

The following table summarizes the restricted stock award activity for the three ended March 31, 2018 and 2017:



	Shares		Weighted-Average Grant Date Fair Value
Nonvested at December 31, 2016	261,296		$	16.80
Granted	—		—
Vested	(52,201	)	16.60
Forfeited	(5,270	)	16.78
Nonvested at March 31, 2017	203,825		$	16.85

Nonvested at December 31, 2017	137,399		$	17.00
Granted	—		—
Vested	(42,137	)	16.92
Forfeited	—		—
Nonvested at March 31, 2018	95,262		$	17.04

During 2017, the Company began issuing performance-based stock-settled restricted stock unit awards ("PRSU") and stock-settled restricted stock unit awards ("RSU"), collectively called "units". Restricted stock units granted vest ratably over three years. Performance restricted stock units granted generally have a three-year cliff vesting schedule. Additionally, performance restricted stock unit grants may be subject to performance-based vesting as well as other approved vesting conditions. The number of shares of actually delivered pursuant to the PRSUs depends on the performance of the Company's Total Shareholder Return and Return on Average Assets over the performance period in relation to the performance of the common stock of a predetermined peer group. The conditions

Table of Contents

of the grants allow for an actual payout ranging between no payout and 150% of target. The payout level is ~~assumed~~calculated based on actual performance achieved during the performance period compared to ~~equal the carrying value (Level 1).~~a defined peer group. The fair value of ~~fixed maturity deposits~~such PRSUs was determined using a Monte Carlo simulation and will be recognized over the subsequent three years. The Monte-Carlo simulation model uses the same input assumptions as the Black-Scholes model; however, it also further incorporates into the fair value determination the possibility that the market condition may not be satisfied. Compensation costs related to these awards are recognized regardless of whether the market condition is satisfied, provided that the requisite service has been provided.

Expected volatilities in the model were estimated using a historical period consistent with the performance period of approximately three years. The risk-free interest rate was based on ~~discounted cash flows using~~ the ~~difference between~~United States Treasury rate for a term commensurate with the ~~deposit rate and~~expected life of the ~~rates offered by~~grant. The Company used the ~~Company for deposits of similar remaining maturities (Level 2).~~

~~Federal Home Loan Bank advances~~:

~~The~~following assumptions to estimate the fair value of ~~FHLB advances~~PRSUs granted during the periods indicated:



	Three Months Ended March 31,
	2018		2017
Shares issued	5,550		6,089
Expected Term in Years	2.84		2.85
Weighted-Average Risk Free Interest Rate	2.39	%	1.40	%
Expected Dividend Yield	—	%	—	%
Weighted-Average Fair Value	27.69		24.39
Correlation coefficient	ABA NASDAQ Community Bank Index		ABA NASDAQ Community Bank Index
Range of peer company volatilities	18.99% - 51.42%		17.8% - 63.1%
Range of peer company correlation coefficients	28.16% - 94.29%		8.24% - 89.79%
Heritage volatility	22.3	%	21.8	%
Heritage correlation coefficient	76.44	%	75.93	%

For the three months ended March 31, 2018, the Company recognized compensation expense related to the units of $340,000, and a related tax benefit of $72,000. For the three months ended March 31, 2017, the Company recognized compensation expense related the units of $65,000. As of March 31, 2018, the total unrecognized compensation expense related to non-vested units was $4.3 million and the related weighted average period over which the compensation expense is ~~estimated based on discounting the future cash flows using the market rate currently offered (Level 2).~~

~~Securities Sold Under Agreement~~expected to ~~Repurchase~~:

Securities sold under agreement to repurchase are short-term in nature and they reprice 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 abe recognized is approximately 2.83 years. The vesting date fair value ~~equal to carrying value (Level 1).~~

~~Junior Subordinated Debentures:~~of the units that vested during the three months ended March 31, 2018 was $711,000. There were no units that vested during the three months ended March 31, 2017.

The ~~fair value is estimated using discounted cash flow analysis based on current rates~~following table summarizes the unit activity for ~~similar types of debt, which many be unobservable, and considering recent trading activity of similar instruments in markets which can be inactive (Level 3).~~the three months ended March 31, 2018:

~~Off-Balance Sheet Financial Instruments~~:

The majority of our commitments to extend credit, standby letters of credit and commitments to sell mortgage loans carry current market interest rates if converted to loans. As such, no premium or discount was ascribed to these commitments (Level 1). They are excluded from the preceding tables.



	Shares		Weighted-Average Grant Date Fair Value
Nonvested at December 31, 2016	—		$	—
Granted	80,735		25.23
Vested	—		—
Forfeited	—		—
Nonvested at March 31, 2017	80,735		$	25.23

Nonvested at December 31, 2017	90,544		$	25.31
Granted	102,939		29.79
Vested	(22,274	)	25.30
Forfeited	(262	)	25.35
Nonvested at March 31, 2018	170,947		$	28.01

Table of Contents


~~(15)~~(16)	~~Commitments and Contingencies~~Cash Requirement

~~In June 2016,~~Beginning on January 16, 2018, the Company received preliminary findings from the Washington State Department of Revenue ("DOR") regarding its business and occupation ("B&O") tax audit on the B&O tax returns of Whidbey Island Bank for the years 2010-2014. The state B&O tax is a gross receipts tax and is calculated on the gross income from activities. It is measured on the value of products, gross proceeds of sale, or gross income of the business. A substantial portion of the preliminary findings relatedwas required to the receipt of FDIC shared-loss payments from the FDIC to Washington Banking Company in connection with its acquisitions of City Bank in April 2010 and North County Bank in September 2010. In their preliminary findings, the DOR is considering those payments as taxable for B&O tax purposes. The total amount of this preliminary finding, along with calculated back interest, is approximately $1.6 million. Management is in discussionsmaintain an average reserve balance with the DOR as to whether these payments should be taxable for B&O tax purposes. Given the uncertainty of the outcome of these discussions, management's estimates of the Company's ultimate liability, if any, involve significant judgment and are based on currently available information and an assessment of the validity of facts and calculations assumed by the DOR. Management does not believe a material loss is probable at this time and there are significant factual and legal issues to be resolved. Management believes that it is reasonably possible that future changes to the Company's estimates of loss and the ultimate amount paid for resolution of this B&O audit could impact the Company's results of operations in future periods. AnyFederal Reserve Bank or maintain such ~~losses would be reported as a noninterest expense~~reserve balance in the ~~Company's Consolidated Statement~~form of ~~Income.~~cash. The required reserve balance at March 31, 2018 was $25.0 million, and was met by holding cash and maintained an average balance with the Federal Reserve Bank. The Company did not have a cash requirement reserve at December 31, 2017.


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, ~~2017.~~2018. The information contained in this section should be read with the unaudited Condensed Consolidated Financial Statements and the accompanying Notes included herein, and the December 31, ~~2016~~2017 audited Consolidated Financial Statements and the accompanying Notes included in our Annual Report on Form 10-K for the year ended December 31, ~~2016.~~2017.

~~Table of Contents~~

Overview

Heritage Financial Corporation is a bank holding company which primarily engages in the business activities of our wholly-owned financial institution subsidiary, Heritage Bank. We provide financial services to our local communities with an ongoing strategic focus on our commercial banking relationships, market expansion and asset quality. At March 31, ~~2017,~~2018, we had total assets of ~~$3.89~~$4.68 billion and total stockholders’ equity of ~~$489.2~~$634.7 million. The Company’s business activities generally are limited to passive investment activities and oversight of its investment in the Bank. Accordingly, the information set forth in this report relates primarily to the Bank’s operations.

Our business consists primarily of commercial lending and deposit relationships with small businesses and their owners in our market areas and attracting deposits from the general public. We also make real estate construction and land development loans and consumer loans. ~~The Bank also originates~~We additionally originate for sale or for investment purposes one-to-four family residential loans on residential properties located primarily in our markets.

Our core profitability depends primarily on our net interest income. 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 investment securities, and interest expense, which is the amount we pay on our interest bearing liabilities, consisting primarily of deposits. 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. Like most financial institutions, our net interest income is affected significantly by general and local economic conditions, particularly changes in market interest rates, and by governmental policies and actions of regulatory agencies. Net interest income is additionally affected by changes on the volume and mix of interest earning assets, interest earned on these assets, the volume and mix of interest bearing liabilities and interest paid on these liabilities.

Our net income is affected by many factors, including the provision for loan losses. 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~~we believe is appropriate to provide for probable incurred credit losses in ~~its~~our loan portfolio.

Net income is also affected by noninterest income and noninterest expense. Noninterest income primarily consists of service charges and other fees, gain on sale of loans (net) and other income. Noninterest expense consists primarily of compensation and employee benefits, occupancy and equipment, and data ~~processing, professional services and other expenses.~~processing. Compensation 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, and consist primarily of lease payments, ~~taxes,~~ depreciation charges, maintenance, and costs of utilities. Data processing consists primarily of processing and network services related to the Bank’s core operating system, including account processing systems, electronic payments processing of products and services, and internet and mobile banking channels.

Results of operations may also be affected significantly by general and local economic and competitive conditions, governmental policies and actions of regulatory authorities. Other income and other expenses are also impacted by growth of operations and growth in the number of loan and deposit accounts through 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 and other fees, as well as other expenses such as data processing services, supplies, postage, telecommunications and other miscellaneous expenses.

Table of Contents

Earnings Summary

Net income was $9.1 million, or $0.27 per diluted common share, for the three months ended March 31, 2018 compared to $9.3 million, or $0.31 per diluted common share, for the three months ended March 31, ~~2017 compared to $9.1 million,~~2017. Net income decreased $229,000, or ~~$0.30 per diluted common share,~~2.5%, for the three months ended March 31, ~~2016. The $225,000, or 2.5% increase in net income for the three months ended March 31, 2017~~2018 compared to the three months ended March 31, ~~2016 was~~2017 primarily ~~the result~~due to an increase in noninterest expense of ~~a $386,000,~~$9.5 million, or ~~1.2%~~35.0%, partially offset by an increase in net interest income ~~primarily~~of $7.8 million, or 23.4%.

Net interest income as a ~~result~~percentage of ~~an increase in~~ average interest earning assets ~~partially offset by a decrease in the yield on average~~(net interest ~~earning assets. The net interest margin decreased 15~~margin) increased 23 basis points to ~~3.89%~~4.12% for the three months ended March 31, ~~2017~~2018 compared to ~~4.04%~~3.89% for the same period in ~~2016.~~2017. The increase in net interest margin was primarily due to an increase in average total loan receivable, net balances, and increases in loan yields and investment yields.

The efficiency ratio consists of noninterest expense divided by the sum of net interest income before provision for loan losses plus noninterest income. The Company’s efficiency ratio ~~increased to 67.2%~~was 75.95% for the three months ended March 31, ~~2017 from 66.3%~~2018 compared to 67.23% for the three months ended March 31, ~~2016.~~2017. The ~~increase~~change in the efficiency ratio ~~for the three months ended March 31, 2017 compared to the three months ended March 31, 2016 is~~was primarily attributable to anthe increase ~~of $854,000~~ in noninterest ~~expense.~~

expense as a result of the Puget Sound Merger and certain acquisition costs.

Net Interest Income

~~Table of Contents~~

One of the Company's key sources of earnings is net interest income. There are several factors that affect net interest income including, but not limited to, the volume, pricing, mix and maturity of interest earning assets and interest bearing liabilities; the volume of noninterest bearing deposits and other liabilities and stockholders' equity; the volume of noninterest earning assets; market interest rate fluctuations; and asset quality.

Net interest income increased ~~$386,000,~~$7.8 million, or ~~1.2%~~23.4%, to ~~$33.1~~$40.9 million for the three months ended March 31, ~~2017~~2018 compared to ~~$32.8~~$33.1 million for the same period in ~~2016.~~2017. The increase in net interest income was primarily due to increases in average interest earning assets primarily as a result of the Puget Sound Merger and, to a lesser extent, organic growth. Net interest income also increased due to increases in yields on interest earning assets as a result of a higher yield curve in the current market. The following table provides relevant net interest income information for the dates indicated.

Table of Contents


	Three Months Ended March 31,												Three Months Ended March 31,
	2017						2016						2018						2017
	Average Balance		Interest Earned/ Paid		Average Yield/ Rate ⁽¹⁾		Average Balance		Interest Earned/ Paid		Average Yield/ Rate ⁽¹⁾		Average Balance		Interest Earned/ Paid		Average Yield/ Rate ⁽¹⁾		Average Balance		Interest Earned/ Paid		Average Yield/ Rate ⁽¹⁾
	(Dollars in thousands)												(Dollars in thousands)
Interest Earning Assets:
Total loans receivable, net ^{(2) (3)}	$	2,631,816	$	30,485	4.70	%	$	2,391,749	$	30,177	5.07	%	$	3,150,869	$	38,159	4.91	%	$	2,631,816	$	30,485	4.70	%
Taxable securities	567,318		3,049		2.18		592,715		2,796		1.90		599,015		3,529		2.39		567,318		3,049		2.18
Nontaxable securities ⁽³⁾	222,266		1,268		2.31		217,106		1,171		2.17		223,631		1,341		2.43		222,266		1,268		2.31
Other interest earning assets	31,721		61		0.78		60,831		91		0.60		52,123		299		2.33		31,721		61		0.78
Total interest earning assets	3,453,121		34,863		4.09	%	3,262,401		34,235		4.22	%	4,025,638		43,328		4.37	%	3,453,121		34,863		4.09	%
Noninterest earning assets	426,777						379,385						527,947						426,777
Total assets	$	3,879,898					$	3,641,786					$	4,553,585					$	3,879,898
Interest Bearing Liabilities:
Certificates of deposit	$	351,300	$	416	0.48	%	$	413,110	$	524	0.51	%	$	423,569	$	760	0.73	%	$	351,300	$	416	0.48	%
Savings accounts	506,159		264		0.21		462,345		161		0.14		506,158		416		0.33		506,159		264		0.21
Interest bearing demand and money market accounts	1,483,168		586		0.16		1,442,244		569		0.16		1,745,795		784		0.18		1,483,168		586		0.16
Total interest bearing deposits	2,340,627		1,266		0.22		2,317,699		1,254		0.22		2,675,522		1,960		0.30		2,340,627		1,266		0.22
FHLB advances and other borrowings	101,130		203		0.81		—		—		—		35,733		150		1.70		101,130		203		0.81
Securities sold under agreement to repurchase	19,019		10		0.21		22,086		11		0.21		30,265		17		0.23		19,019		10		0.21
Junior subordinated debentures	19,750		238		4.89		19,450		210		4.34		20,035		283		5.73		19,750		238		4.89
Total interest bearing liabilities	2,480,526		1,717		0.28	%	2,359,235		1,475		0.25	%	2,761,555		2,410		0.35	%	2,480,526		1,717		0.28	%
Demand and other noninterest bearing deposits	866,469						776,786						1,113,286						866,469
Other noninterest bearing liabilities	47,213						29,252						63,770						47,213
Stockholders’ equity	485,690						476,513						614,974						485,690
Total liabilities and stockholders’ equity	$	3,879,898					$	3,641,786					$	4,553,585					$	3,879,898
Net interest income			$	33,146					$	32,760					$	40,918					$	33,146
Net interest spread					3.81	%					3.97	%					4.02	%					3.81	%
Net interest margin					3.89	%					4.04	%					4.12	%					3.89	%
Average interest earning assets to average interest bearing liabilities					139.21	%					138.28	%					145.77	%					139.21	%


⁽¹⁾	Annualized


⁽²⁾	The average loan balances presented in the table are net of allowances for loan losses. Nonaccrual loans have been included in the table as loans carrying a zero yield.

⁽³⁾~~Yields on tax-exempt securities and loans have not been stated on a tax-equivalent basis.~~


⁽³⁾	Yields on tax-exempt securities and loans have not been stated on a tax-equivalent basis.

Interest Income

Total interest income increased ~~$628,000,~~$8.5 million, or ~~1.8%~~24.3%, to ~~$34.9~~$43.3 million for the three months ended March 31, ~~2017~~2018 compared to ~~$34.2~~$34.9 million for the same period in ~~2016.~~2017. The balance of average interest earning assets increased ~~$190.7~~$572.5 million, or ~~5.8%~~16.6%, to $4.03 billion for the three months ended March 31, 2018 from $3.45 billion for the three months ended March 31, 2017 ~~from $3.26 billion for the three months ended March 31, 2016~~ and the yield on total interest earning assets ~~decreased 13~~increased 28 basis points to 4.37% for the three months ended March 31, 2018 compared to 4.09% for the three months ended March 31, ~~2017 compared to 4.22% for the three months ended March 31, 2016.~~2017.

Interest income from interest and fees on loans increased ~~$308,000,~~$7.7 million, or ~~1.0%~~25.2%, to ~~$30.5~~$38.2 million for the three months ended March 31, ~~2017~~2018 from ~~$30.2~~$30.5 million for the same period in ~~2016.~~2017 primarily due to an increase in average loans receivable of $519.1 million, or 19.7%, as a result of loan growth which was substantially due to the Puget Sound Merger. The loan yield increased 21 basis points to 4.91% for the three months ended March 31, 2018 from 4.70% for the three months ended March 31, 2017. The increase in loan yield was ~~the~~due to a combination of higher contractual note rates as a result of ~~a $240.1~~the increasing interest rate environment, higher loan yields from the loans acquired in the Puget Sound Merger as compared to legacy Heritage loans, and an increase in incremental accretion on purchased loans substantially due from loans acquired in the Puget Sound Merger.

4448

Table of Contents

million, or 10.0%, increase in average loans receivable as a result of loan growth for the same period, offset partially by 37 basis points decrease in the yield on loans to 4.70% for the three months ended March 31, 2017 from 5.07% for the three months ended March 31, 2016. The decrease in yield was due primarily to a decrease in the contractual note rates in the loan portfolio and a decrease in incremental accretion income.

The following table presents the loan yield and effects of the incremental accretion on purchased loans for the three months ended March 31, ~~2017~~2018 and ~~2016:~~2017:


	Three Months Ended March 31,						Three Months Ended March 31,
	2017			2016			2018			2017
	(Dollars in thousands)						(Dollars in thousands)
Loan yield, excluding incremental accretion on purchased loans ⁽¹⁾	4.52		%	4.77		%	4.70		%	4.52		%
Impact on loan yield from incremental accretion on purchased loans ⁽¹⁾	0.18		%	0.30		%	0.21		%	0.18		%
Loan yield	4.70		%	5.07		%	4.91		%	4.70		%

Incremental accretion on purchased loans ⁽¹⁾	$	1,170		$	1,779		$	1,632		$	1,170

⁽¹⁾

As of the dates of the completion of each of the merger and acquisition transactions, purchased loans were recorded at their estimated fair value, including our estimate of future expected cash flows until the ultimate resolution of these credits. The difference between the contractual loan balance and the fair value represents the purchased discount. The purchased discount is modified quarterly as a result of cash flow re-estimation. The incremental accretion income represents the amount of income recorded on the purchased loans in excess of the contractual stated interest rate in the individual loan notes.

Incremental accretion income was ~~$1.2~~$1.6 million and ~~$1.8~~$1.2 million for the three months ended March 31, ~~2017~~2018 and ~~2016,~~2017, respectively. The ~~decrease~~increase in the incremental accretion was primarily ~~a result~~due to the accretion of ~~a decrease~~the loans acquired in the ~~prepayments of purchased loans, primarily loans from the Washington Banking~~Puget Sound Merger totaling approximately $479,000 during the three months ended March 31, ~~2017 compared~~2018. The Company does not anticipate this same accretion yield for Puget Sound Merger in future periods as nearly $316,000 of the accretion was a result of unanticipated pay-offs of three significant loans during the three months ended March 31, 2018. The incremental accretion and the impact to loan yield will change during any quarter based on the ~~same period in 2016, and a continued decline in~~volume of prepayments, but is expected to decrease over time as the balance of the purchased ~~loan balances.~~loans continues to decrease.

Total interest income increased primarily due to the increase in interest and fees on loans discussed above and secondarily due to a ~~$350,000,~~$553,000, or ~~8.8%~~12.8%, increase in interest income on investment securities to ~~$4.3~~$4.9 million during the three months ended March 31, ~~2017~~2018 from ~~$4.0~~$4.3 million for the three months ended March 31, ~~2016 as~~2017. The increase in income on investment securities was a result of an increase in investment yields, primarily reflecting the effect of the rise in interest rates on our adjustable rate investment securities, and an increase in the average balance of investment securities for the three months ended March 31, ~~2017~~2018 compared to the same period in ~~2016, offset partially by a decrease~~2017. Yields on taxable securities increased 21 basis points to 2.39% for the three months ended March 31, 2018 from 2.18% for the same period in 2017. Yields on nontaxable securities increased 12 basis points to 2.43% for the ~~average balance of investment securities.~~three months ended March 31, 2018 from 2.31% for the same period in 2017. The average balance of investment securities ~~decreased $20.2~~increased $33.1 million, or ~~2.5%~~4.2%, to $822.6 million during the three months ended March 31, 2018 from $789.6 million during the three months ended March 31, 2017 from $809.8 million during the three months ended March 31, 2016. Yields on taxable securities increased 28 basis points to 2.18% for the three months ended March 31, 2017 from 1.90% for the same period in 2016. Yields on nontaxable securities increased 14 basis points to 2.31% for the three months ended March 31, 2017 from 2.17% for the same period in 2016.2017. The Company has actively managed its investment securities portfolio to ~~mitigate declining loan yields.~~improve performance in an increasing rate environment.

Average other interest earning assets ~~decreased $29.1~~increased $20.4 million, or ~~47.9%~~64.3%, to $52.1 million for the three months ended March 31, 2018 compared to $31.7 million for the three months ended March 31, ~~2017~~2017. The increase was due to a combination of an increase in interest earning deposits, as the Bank held more funds in interest earning accounts at the Federal Reserve Bank compared to ~~$60.8~~the same period in 2017, substantially due to the Puget Sound Merger, and an increase in the yields reflecting the risk in interest rates.

Interest Expense

Total interest expense increased $693,000, or 40.4%, to $2.4 million for the three months ended March 31, ~~2016. The decrease was due primarily to a decrease in interest earning deposits as the Bank utilized these assets to fund its loan growth.~~

~~Interest Expense~~

~~Total interest expense increased $242,000, or 16.4%, to $1.7 million for the three months ended March 31, 2017~~2018 compared to ~~$1.5~~$1.7 million for the same period in ~~2016.~~2017. The average cost of interest bearing liabilities increased ~~three~~seven basis points to 0.35% for the three months ended March 31, 2018 from 0.28% for the three months ended March 31, 2017 ~~from 0.25%~~as a result of the rise in market rates. Total average interest bearing liabilities increased $281.0 million, or 11.3%, to $2.76 billion for the three months ended March 31, ~~2016. Total average interest bearing liabilities increased by $121.3 million, or 5.1%, to~~2018 from $2.48 billion for the three months ended March 31, 2017 ~~from $2.36 billion~~substantially due to the Puget Sound Merger.

The average cost of interest bearing deposits increased eight basis points to 0.30% for the three months ended March 31, ~~2016.~~

2018 from 0.22% for the same period in 2017 primarily as a result of the increase in market rates. The ~~cost~~average balance of interest bearing ~~deposits was 0.22% basis points for both the three months ended March 31, 2017~~demand and ~~2016. Total average interest bearing~~money market deposits increased ~~$22.9~~$262.6 million, or ~~1.0%~~17.7%, ~~to $2.34 billion~~ for the three months ended March 31, ~~2017 from $2.32~~2018 to $1.75 billion ~~for the three months ended~~at March 31, ~~2016.~~

~~The average balance of certificates of deposits decreased $61.8 million, or 15.0%, to $351.3 million for the three months ended March~~2018 from $1.48 billion at December 31, 2017 ~~from $413.1 million for~~primarily as a result of the ~~same period in 2016.~~Puget Sound Merger. The cost of certificates of deposits ~~decreased three~~increased 25 basis points to 0.48% for the three months ended March 31, 2017 from 0.51% for the same period in 2015. Based on the change in the average balance and cost of the certificates of deposit, the interest expense on certificates of deposit decreased $108,000, or 20.6%, to $416,000 for the three months ended March 31, 2017 from $524,000 for the same period in 2016.0.73%

4549

Table of Contents

~~The decrease in interest expense on certificates of deposits was offset partially by a $103,000, or 64.0%, increase in interest expense on savings accounts to $264,000 during~~for the three months ended March 31, ~~2017~~2018 from ~~$161,000~~0.48% for the same period in ~~2016~~2017 primarily as a result of the rise in interest rates.

Interest expense on FHLB advances and other borrowings decreased $53,000, or 26.1%, to $150,000 for the three months ended March 31, 2018 from $203,000 for the same period in 2017 due to ~~the combination of~~ a ~~$43.8 million, or 9.5%, increase~~decrease in the average balance, partially offset by an increase in rates. The average balance for FHLB advances and other borrowings decreased $65.4 million, or 64.7%, to ~~$506.2~~$35.7 million for the three months ended March 31, ~~2017~~2018 from ~~$462.3~~$101.1 million for the same period in ~~2016~~2017, as a result of pay downs from using cash and ~~an increase~~cash proceeds from the sale of ~~seven basis points~~investment securities acquired in the ~~cost of savings accounts to 0.21% for the three months ended March 31, 2017 from 0.14% for the same period in 2016.~~Puget Sound Merger.

The average rate of the junior subordinated debentures, including the effects of accretion of the discount established as of the date of the merger with Washington Banking Company, for the three months ended March 31, ~~2017~~2018 was ~~4.89%~~5.73%, an increase of 5584 basis points from ~~4.34%~~4.89% for the same period in ~~2016.~~2017. The rate increase on the junior subordinated debentures was due to an increase in the three-month LIBOR rate to ~~1.15%~~2.32% at March 31, ~~2017~~2018 from ~~0.63%~~1.15% on March 31, ~~2016.~~2017.

Net Interest Margin

Net interest ~~income as a percentage of average interest earning assets (net interest margin)~~margin increased 23 basis points for the three months ended March 31, ~~2017 decreased 15 basis points~~2018 to ~~3.89%~~4.12% from ~~4.04%~~3.89% for the same period in ~~2016.~~2017 primarily due to the above mentioned increase in net interest income. The net interest spread increased 21 basis points for the three months ended March 31, ~~2017 decreased 16 basis points~~2018 to ~~3.81%~~4.02% from ~~3.97%~~3.81% for the same period in ~~2016. The decrease was~~2017 primarily due to the ~~above mentioned decrease~~increase in yields on total interest earning ~~assets and incremental accretion on purchased loans.~~assets.

Net interest margin is impacted by the incremental accretion on purchased loans. The following table presents the net interest margin and effects of the incremental accretion on purchased loans for the three months ended March 31, ~~2017~~2018 and ~~2016:~~2017:


	Three Months Ended March 31,				Three Months Ended March 31,
	2017		2016		2018		2017
Net interest margin, excluding incremental accretion on purchased loans ⁽¹⁾	3.75	%	3.82	%	3.96	%	3.75	%
Impact on net interest margin from incremental accretion on purchased loans ⁽¹⁾	0.14		0.22		0.16		0.14
Net interest margin	3.89	%	4.04	%	4.12	%	3.89	%

⁽¹⁾

Provision for Loan Losses

The Bank has established a comprehensive methodology for determining its allowance for loan losses. The allowance for loan losses is increased by provisions for loan losses charged to expense, and is reduced by loans charged-off, net of loan recoveries or a recovery of previous provision. The amount of the provision expense recognized during the three months ended March 31, ~~2017~~2018 and ~~2016~~2017 was calculated in accordance with the Bank's methodology. For additional information, see the section entitled "Analysis of Allowance for Loan Losses" below.

The provision for loan losses is dependent on the Bank’s ability to manage asset quality and control the level of net charge-offs through prudent underwriting standards. In addition, a decline in general economic conditions could increase future provisions for loan losses and have a material effect on the Company’s net income.

The provision for loan losses ~~decreased $272,000,~~increased $285,000, or ~~23.9%~~32.9%, to ~~$867,000 for the three months ended March 31, 2017 from $1.1~~$1.2 million for the three months ended March 31, ~~2016.~~2018 from $867,000for the three months ended March 31, 2017. The ~~decrease~~increase in the provision for loan losses for the three months ended March 31, ~~2017~~2018 from the same period in ~~2016~~2017 was primarily the result of ~~a change~~changes in ~~the~~our asset quality, volume and mix of loans, ~~as well as changes in~~ certain environmental and historical loss factors and ~~improvements in certain historical loss factors.~~as a result of the impact of loan growth. Based on a thorough review of the loan portfolio, the Bank determined that the provision for loan losses for the three months ended March 31, ~~2017~~2018 was appropriate as it was calculated in accordance with the Bank's methodology for determining the allowance for loan losses.

4650

Table of Contents

Noninterest Income

Total noninterest income increased ~~$359,000,~~$118,000, or ~~5.1%~~1.6%, to ~~$7.3~~$7.5 million for the three months ended March 31, ~~2017~~2018 compared to ~~$7.0~~$7.3 million for the same period in ~~2016.~~2017. The following table presents the change in the key components of noninterest income for the periods noted.


	Three Months Ended March 31,									Three Months Ended March 31,
	2017		2016		Change			Percentage Change		2018		2017		Change			Percentage Change
	(Dollars in thousands)									(Dollars in thousands)
Service charges and other fees	$	4,213	$	3,356	$	857		25.5	%	$	4,543	$	4,213	$	330		7.8	%
Gain on sale of investment securities, net	—		560		(560		)	(100.0	)	35		—		35			100.0
Gain on sale of loans, net	1,195		729		466			63.9		874		1,195		(321		)	(26.9	)
Interest rate swap fees	133		136		(3		)	(2.2	)	51		133		(82		)	(61.7	)
Other income	1,808		2,209		(401		)	(18.2	)	1,964		1,808		156			8.6
Total noninterest income	$	7,349	$	6,990	$	359		5.1	%	$	7,467	$	7,349	$	118		1.6	%

Service charges and other fees increased ~~$857,000,~~$330,000, or ~~25.5%~~7.8% to ~~$4.2~~$4.5 million for the three months ended March 31, ~~2017~~2018 compared to ~~$3.4~~$4.2 million for the same period in ~~2016,~~2017, due primarily to ~~increased~~an increase in deposit balances and changes in fee structures on deposit ~~accounts.~~accounts, including a consumer deposit account consolidation process completed at the end of 2016 and a business deposit consolidation process completed during second quarter 2017. Secondarily, service charges and other fees increased as a result of the Puget Sound Merger.

~~Gain~~The increase in noninterest income was offset by a decrease in gain on the sale of loans, net ~~increased $466,000,~~of $321,000, or ~~63.9%~~26.9%, to ~~$1.2 million~~$874,000 for the three months ended March 31, ~~2017~~2018 compared to ~~$729,000~~$1.2 million the same period in ~~2016,~~2017, due primarily to ~~an increase~~a decrease in mortgage banking activities. Proceeds from sale of loans ~~increased $11.4~~decreased $15.3 million, or ~~46.4%,~~42.6% to ~~$36.0~~$20.7 million for the three months ended March 31, ~~2017~~2018 from ~~$24.6~~$35.7 million for the same period in 2017. The detail of gain on sale of loans, net is included in the following schedule.



	Three Months Ended March 31,
	2018		2017		Change			Percentage Change
	(Dollars in thousands)
Gain on sale of mortgage loans, net	$	652	$	909	$	(257	)	(28.3	)%
Gain on sale of guaranteed portion of SBA loans, net	222		286		(64		)	(22.4	)
Gain on sale of loans, net	$	874	$	1,195	$	(321	)	(26.9	)%

Table of Contents

Noninterest Expense

Noninterest expense increased $9.5 million, or 35.0%, to $36.7 million during the three months ended March 31, 2018 compared to $27.2 million for the three months ended March 31, 2016. The gain on sale of the government guaranteed portion of certain Small Business Administration ("SBA") loans for the three months ended March 31, 2017 and 2016 was $286,000 and $131,000, respectively.

The increase in noninterest income was partially offset by a decrease in gain on sale of investment securities, net, due to no investment sales for the three months ended March 31, 2017 compared to $50.1 million of investment sales, which yielded $560,000 in gain for the three months ended March 31, 2016.

Other income decreased $401,000, or 18.2%, to $1.8 million for three months ended March 31, 2017 from $2.2 million for three months ended March 31, 2016 due primarily to a decrease in recoveries on deficiency notes obtained in mergers and acquisitions.

~~Noninterest Expense~~

~~Noninterest expense decreased $854,000, or 3.2%, to $27.2 million during the three months ended March 31, 2017 compared to $26.4 million for the three months ended March 31, 2016.~~2017. The following table presents changes in the key components of noninterest expense for the periods noted.

~~Table of Contents~~


	Three Months Ended March 31,									Three Months Ended March 31,
	2017		2016		Change			Percentage Change		2018		2017		Change			Percentage Change
	(Dollars in thousands)									(Dollars in thousands)
Compensation and employee benefits	$	16,024	$	15,121	$	903		6.0	%	$	21,367	$	16,024	$	5,343		33.3	%
Occupancy and equipment	3,810		3,836		(26		)	(0.7	)	4,627		3,810		817			21.4
Data processing	1,915		1,792		123			6.9		2,605		1,915		690			36.0
Marketing	807		728		79			10.9		808		807		1			0.1
Professional services	1,009		845		164			19.4		2,837		1,009		1,828			181.2
State and local taxes	549		607		(58		)	(9.6	)	688		549		139			25.3
Federal deposit insurance premium	300		492		(192		)	(39.0	)	355		300		55			18.3
Other real estate owned, net	31		411		(380		)	(92.5	)	—		31		(31		)	(100.0	)
Amortization of intangible assets	324		335		(11		)	(3.3	)	795		324		471			145.4
Other expense	2,454		2,202		252			11.4		2,665		2,454		211			8.6
Total noninterest expense	$	27,223	$	26,369	$	854		3.2	%	$	36,747	$	27,223	$	9,524		35.0	%

Compensation and employee benefits increased ~~$903,000,~~$5.3 million, or ~~6.0%~~33.3%, to $21.4 million during the three months ended March 31, 2018 from $16.0 million during the three months ended March 31, ~~2017 from $15.1 million during the three months ended March 31, 2016.~~2017. The increase in the three months ended March 31, ~~2017~~2018 compared to 2017 was primarily as a result of additional employees and acquisition-related payments from Puget Sound Merger of approximately $2.7 million. The average full time equivalent increased to 796 for the three months ended March 31, 2018 compared to 761 for the same period in ~~2016 was primarily due~~2017.

Professional services increased $1.8 million, or 181.2%, to ~~staffing increases and standard salary increases.~~

~~Federal Deposit Insurance premium decreased $192,000, or 39.0% to $300,000~~$2.8 million during the three months ended March 31, ~~2017~~2018 from ~~$492,000~~$1.0 million during the three months ended March 31, ~~2016.~~2017. The ~~decrease was a result of the FDIC's new assessment rate schedule effective for the third quarter of 2016 due to the~~ increase in the ~~Deposit Insurance Fund Reserve. Effective July 1, 2016,~~three months ended March 31, 2018 compared to 2017 was primarily due to costs of approximately $1.6 million incurred for the ~~range of initial base assessment rates for all insured institutions was reduced based on current reserve levels.~~

~~Other real estate owned, net decreased $380,000, or 92.5%, to $31,000~~Puget Sound Merger and the proposed Premier Merger during the three months ended March 31, ~~2017 compared~~2018.

Occupancy and equipment increased $817,000, or 21.4%, to ~~$411,000~~$4.6 million during the three months ended March 31, ~~2016. The decrease was due to no valuation adjustments~~2018 from $3.8 million during ~~the quarter ended March 31, 2017 compared to $312,000 for three months ended March 31, 2016.~~

~~Other expense increased $252,000, or 11.4%, to $2.5 million for~~ the three months ended March 31, ~~2017 from $2.2 million for the same period in 2016.~~2017. The increase in the three months ended March 31, 2018 compared to 2017 was ~~primarily~~substantially related to on-going costs associated with the Puget Sound Merger.

Data processing increased $690,000, or 36.0%, to $2.6 million during the three months ended March 31, 2018 from $1.9 million during the three months ended March 31, 2017. The increase in the three months ended March 31, 2018 compared to 2017 was substantially due to acquisition related expenses of $352,000 recognized during the three months ended March 31, 2018 as well as additional operations associated with the Puget Sound Merger.

Amortization of intangible assets increased $471,000, or 145.4%, to $795,000 during the three months ended March 31, 2018 from $324,000 during the three months ended March 31, 2017. The increase in the three months ended March 31, 2018 compared to 2017 was a result of ~~an increase~~the amortization of the core deposit intangible recorded in ~~VISA card related expenses.~~the Puget Sound Merger of $513,000 during the three months ended March 31, 2018.

The ratio of noninterest expense to average assets (annualized) was 3.27% for the three months ended March 31, 2018 compared to 2.85% for the three months ended March 31, ~~2017, compared~~2017. The increase was primarily a result of acquisition costs totaling $4.7 million during the three months ended March 31, 2018.

Income Tax Expense

Income tax expense decreased $1.7 million, or 54.7%, to ~~2.91%~~$1.4 million for the three months ended March 31, ~~2016. The decrease was primarily a result of an increase in assets and cost efficiencies gained through efforts by the Company to manage noninterest expenses.~~

~~Income Tax Expense~~

~~Income tax expense decreased by $62,000, or 2.0%, to~~2018 from $3.1 million for the three months ended March 31, 2017. The decrease in the income tax expense during the three months ended March 31, 2018 was primarily due to the impact of the Tax Cuts and Jobs Actenacted in December 2017, which lowered the corporate income tax rate to 21% from ~~$3.2 million~~35%.

Table of Contents

The effective tax rate was 13.3% for the three months ended March 31, ~~2016. The effective tax rate was 24.9% for the three months ended March 31, 2017~~2018 compared to ~~25.7%~~24.9% for the same period in ~~2016.~~2017. The decrease in the effective tax rate during the three months ended March 31, ~~2017~~2018 compared to the same period in ~~2016~~2017 was due primarily to the ~~implementation of ASU 2016-09 whereby we recorded an excess tax benefit of $138,000 in our current quarter's income tax provision expense.~~Tax Cuts and Jobs Act.

Financial Condition Overview

Total assets increased $6.6 million, or 0.2%, to $3.89 billion as of March 31, 2017 compared to $3.88 billion as of December 31, 2016. Total loans receivable, net, increased $22.4 million, or 0.9%, to $2.63 billion at March 31, 2017 compared to $2.61 billion at December 31, 2016. Loans were primarily funded through an increase in deposits. Deposits increased by $13.8 million, or 0.4%, to $3.24 billion as of March 31, 2017 compared to $3.23 billion as of December 31, 2016.

~~Table of Contents~~

Investment securities available for sale decreased $11.6 million, or 1.5%, to $783.0 million at March 31, 2017 from $794.6 million at December 31, 2016. The decrease was due primarily to principal payments, maturities and calls, offset partially by investment purchases.

Premises and equipment, net decreased $2.8 million, or 4.5%, to $61.1 million at March 31, 2017 from $63.9 million at December 31, 2016. The increase was primarily due to the transfer of land and office building assets to prepaid expenses and other assets as a result of management's decision to hold these assets for sale due to planned branch consolidations.

Total non-maturity deposits increased to 89.4% of total deposits at March 31, 2017 from 88.9% at December 31, 2016 and certificates of deposits decreased to 10.6% of total deposits at March 31, 2017 from 11.1% at December 31, 2016.

Federal Home Loan Bank advances decreased $12.9 million, or 16.1%, to $66.8 million as of March 31, 2017 from $79.6 million as of December 31, 2016. The decrease was primarily funded by the increase in total deposits.

Total stockholders’ equity increased by $7.4 million, or 1.5%, to $489.2 million as of March 31, 2017 from $481.8 million at December 31, 2016. The increase during the three months ended March 31, 2017 was due primarily to net income of $9.3 million and a $1.5 million decrease in accumulated other comprehensive loss, net of tax, offset partially by cash dividends declared of $3.6 million. The Company’s equity position remains strong at 12.6% of total assets as of March 31, 2017 and 12.4% as of December 31, 2016.

~~Table of Contents~~

The table below provides a comparison of the changes in the Company's financial condition from December 31, ~~2016~~2017 to March 31, ~~2017.~~2018, and the results of the Puget Sound Merger effective January 16, 2018:


	March 31, 2017			December 31, 2016			Change between March 31, 2017 and December 31, 2016			Percent Change		March 31, 2018			December 31, 2017			Change			Percentage Change		Fair Value of Puget Sound at Merger Date
	(Dollars in thousands)											(Dollars in thousands)
Assets
Cash and cash equivalents	$	104,372		$	103,745		$	627		0.6	%	$	130,309		$	103,015		$	27,294		26.5	%	$	80,136
Investment securities	783,021			794,645			(11,624		)	(1.5	)
Investment securities available for sale, at fair value												821,567			810,530			11,037			1.4		80,353
Loans held for sale	9,889			11,662			(1,773		)	(15.2	)	2,669			2,288			381			16.7		—
Total loans receivable, net	2,632,110			2,609,666			22,444			0.9		3,248,654			2,816,985			431,669			15.3		388,462
Other real estate owned	786			754			32			4.2		—			—			—			—		—
Premises and equipment, net	61,062			63,911			(2,849		)	(4.5	)	62,147			60,325			1,822			3.0		732
Federal Home Loan Bank stock, at cost	7,317			7,564			(247		)	(3.3	)	6,824			8,347			(1,523		)	(18.2	)	623
Bank owned life insurance	70,741			70,355			386			0.5		81,700			75,091			6,609			8.8		6,264
Accrued interest receivable	11,237			10,925			312			2.9		13,602			12,244			1,358			11.1		1,448
Prepaid expenses and other assets	78,999			79,351			(352		)	(0.4	)	104,666			99,328			5,338			5.4		1,354
Other intangible assets, net	7,050			7,374			(324		)	(4.4	)	16,563			6,088			10,475			172.1		11,270
Goodwill	119,029			119,029			—			—		187,549			119,029			68,520			57.6		68,520
Total assets	$	3,885,613		$	3,878,981		$	6,632		0.2	%	$	4,676,250		$	4,113,270		$	562,980		13.7	%	$	639,162

Liabilities
Deposits	$	3,243,415		$	3,229,648		$	13,767		0.4		$	3,904,741		$	3,393,060		$	511,681		15.1	%	$	505,885
Federal Home Loan Bank advances	66,750			79,600			(12,850		)	(16.1	)	30,700			92,500			(61,800		)	(66.8	)	—
Junior subordinated debentures	19,790			19,717			73			0.4		20,083			20,009			74			0.4		—
Securities sold under agreement to repurchase	21,440			22,104			(664		)	(3.0	)	26,100			31,821			(5,721		)	(18.0	)	—
Accrued expenses and other liabilities	45,022			46,149			(1,127		)	(2.4	)	59,918			67,575			(7,657		)	(11.3	)	2,504
Total liabilities	3,396,417			3,397,218			(801		)	—		4,041,542			3,604,965			436,577			12.1		508,389
Stockholders' equity
Common stock	359,298			359,060			238			0.1		490,566			360,590			129,976			36.0		130,773
Retained earnings	131,031			125,309			5,722			4.6		153,101			149,013			4,088			2.7		—
Accumulated other comprehensive income, net	(1,133		)	(2,606		)	1,473			(56.5	)
Accumulated other comprehensive loss, net												(8,959		)	(1,298		)	(7,661		)	590.2		—
Total stockholders' equity	489,196			481,763			7,433			1.5		634,708			508,305			126,403			24.9		130,773
Total liabilities and stockholders' equity	$	3,885,613		$	3,878,981		$	6,632		0.2	%	$	4,676,250		$	4,113,270		$	562,980		13.7	%	$	639,162

Total assets increased $563.0 million, or 13.7%, to $4.68 billion as of March 31, 2018 compared to $4.11 billion as of December 31, 2017. The Puget Sound Merger resulted in an increase of total assets, including goodwill, of $639.0 million at merger date. The Company utilized cash acquired from the Puget Sound Merger to pay down FHLB advances during the three months ended March 31, 2018.

5053

Table of Contents

~~Lending Activities~~

~~As indicated in the table below,~~Total loans receivable, net, ~~was $2.66 billion at March 31, 2017, an increase of $23.0~~excluding Puget Sound Merger increased $43.2 million, or ~~0.9%, from $2.64 billion at December 31, 2016. The increase in loans receivable for~~6.2% annualized, during the three months ended March 31, 2018.

Investment securities increased $11.0 million, or 1.4%, to $821.6 million at March 31, 2018 from $810.5 million at December 31, 2017 ~~was due~~ primarily ~~to increases in real estate construction and land development loans~~as a result of ~~$18.7 million and in owner occupied commercial real estate loans of $11.3 million,~~investment purchases, offset partially by ~~decreases~~maturities, calls and payments of investment securities. The investment securities acquired in the Puget Sound Merger were sold shortly after the merger.

Deposits, excluding Puget Sound Merger, increased $5.8 million, or 0.7% annualized, during the three months ended March 31, 2018. Total non-maturity deposits increased to 89.2% of total deposits at March 31, 2018 from 88.3% at December 31, 2017 and certificates of deposits decreased to 10.8% of total deposits at March 31, 2018 from 11.7% at December 31, 2017.

Federal Home Loan Bank advances decreased $61.8 million, or 66.8%, to $30.7 million as of March 31, 2018 from $92.5 million as of December 31, 2017. The decrease was due to the pay down of FHLB advances using cash acquired in the Puget Sound Merger and proceeds from the sale of the investments acquired in the Puget Sound Merger.

Total stockholders’ equity increased $126.4 million, or 24.9%, to $634.7 million as of March 31, 2018 from $508.3 million at December 31, 2017. The Company’s equity position was 13.6% of total assets as of March 31, 2018 and 12.4% as of December 31, 2017. Changes in stockholders' equity during the three months ended March 31, 2018 were as follows (in thousands):



	Three Months Ended
	March 31, 2018
Balance, beginning of period	$	508,305
Common stock issued in the Puget Sound Merger	130,770
Net income	9,087
Dividends paid	(5,117		)
Accumulated other comprehensive loss	(7,543		)
Other	(794		)
Balance, end of period	$	634,708

Lending Activities

The Bank is a full service commercial bank, which originates a wide variety of loans with a focus on commercial business loans. Total loans receivable, net of allowance for loan losses, increased $431.7 million, or 15.3%, to $3.25 billion at March 31, 2018 from $2.82 billion at December 31, 2017. The increase in loans receivable was primarily in commercial and industrial loans which increased $166.3 million, or 25.8%, to $811.7 million during the three months ended March 31, 2018, in non-owner occupied commercial real estate loans which increased $146.8 million, or 14.9%, to $1.13 billion and in owner-occupied commercial real estate loans which increased $80.2 million, or 12.9%, to $702.4 million during the same period.

Table of ~~$6.7 million.~~Contents

The following table provides information about our loan portfolio by type of loan at the dates indicated. These balances are prior to deduction for the allowance for loan losses.


	March 31, 2017				December 31, 2016				March 31, 2018				December 31, 2017
	Balance		% of Total		Balance		% of Total		Balance		% of Total ⁽³⁾		Balance		% of Total ⁽³⁾
	(Dollars in thousands)								(Dollars in thousands)
Commercial business:
Commercial and industrial	$	636,286	23.9	%	$	637,773	24.2	%	$	811,678	24.7	%	$	645,396	22.7	%
Owner-occupied commercial real estate	569,316		21.4		558,035		21.1		702,356		21.4		622,150		21.8
Non-owner occupied commercial real estate	874,218		32.8		880,880		33.4		1,133,394		34.6		986,594		34.6
Total commercial business	2,079,820		78.1		2,076,688		78.7		2,647,428		80.7		2,254,140		79.1
One-to-four family residential(1)	78,509		2.9		77,391		2.9		89,180		2.7		86,997		3.1
Real estate construction and land development:
One-to-four family residential	52,134		2.0		50,414		1.9		73,295		2.2		51,985		1.8
Five or more family residential and commercial properties	125,784		4.7		108,764		4.1		98,387		3.0		97,499		3.4
Total real estate construction and land development(2)	177,918		6.7		159,178		6.0		171,682		5.2		149,484		5.2
Consumer	324,767		12.2		325,140		12.3		370,275		11.3		355,091		12.5
Gross loans receivable	2,661,014		99.9		2,638,397		99.9		3,278,565		99.9		2,845,712		99.9
Deferred loan costs, net	2,690		0.1		2,352		0.1
Net deferred loan costs									3,350		0.1		3,359		0.1
Loans receivable, net	$	2,663,704	100.0	%	$	2,640,749	100.0	%	$	3,281,915	100.0	%	$	2,849,071	100.0	%

⁽¹⁾ Excludes loans held for sale of $2.7 million, and $2.3 million as of March 31, 2018 and December 31, 2017.

⁽²⁾ Balances do not include undisbursed loan commitments.

⁽³⁾ Percent of loans receivable, net.

5155

Table of Contents

Nonperforming Assets and Credit Quality Metrics

The following table ~~describes~~provides information about our ~~nonperforming assets~~nonaccrual loans, other real estate owned and ~~other credit quality metrics at~~performing TDR loans for the ~~dates indicated:~~indicated dates.


	March 31, 2017			December 31, 2016			March 31, 2018			December 31, 2017
	(Dollars in thousands)						(Dollars in thousands)
Nonaccrual loans:
Commercial business	$	8,531		$	8,580		$	14,356		$	9,098
One-to-four family residential	90			94			80			81
Real estate construction and land development	2,008			2,008			1,147			1,247
Consumer	248			227			145			277
Total nonaccrual loans ~~(2)~~(1)	10,877			10,909			15,728			10,703
Other real estate owned	786			754			—			—
Total nonperforming assets	$	11,663		$	11,663		$	15,728		$	10,703

Allowance for loan losses	$	31,594		$	31,083		$	33,261		$	32,086
Nonperforming loans to loans receivable, net							0.48		%	0.38		%
Allowance for loan losses to loans receivable, net	1.19		%	1.18		%	1.01		%	1.13		%
Allowance for loan losses to nonperforming loans	290.47		%	284.93		%	211.48		%	299.79		%
Nonperforming loans to total loans receivable, net	0.41		%	0.41		%
Nonperforming assets to total assets	0.30		%	0.30		%	0.34		%	0.26		%

Performing TDR loans:
Commercial business	$	17,803		$	19,837		$	25,737		$	25,729
One-to-four family residential	224			227			215			218
Real estate construction and land development	1,798			2,141			—			645
Consumer	63			83			235			165
Total performing TDR loans ~~(3)~~	$	19,888		$	22,288		$	26,187		$	26,757
Accruing loans past due 90 days or more ~~(4)~~	$	—		$	—		$	—		$	—
Potential problem loans ~~(5)~~	82,825			87,762			93,253			83,543


⁽¹⁾	At March 31, ~~2017~~2018 and December 31, ~~2016, $6.3~~2017, $8.2 million and ~~$6.9~~$5.2 million of ~~nonperforming~~nonaccrual loans ~~respectively,~~ were considered TDR ~~loans.~~


⁽²⁾	~~At March 31, 2017 and December 31, 2016, $1.7 million and $2.8 million of nonperforming~~ loans, ~~respectively, were guaranteed by government agencies.~~


⁽³⁾	~~At March 31, 2017 and December 31, 2016, $668,000 and $682,000 of performing TDR loans, respectively, were guaranteed by government agencies.~~


⁽⁴⁾	~~There were no accruing loans past due 90 days or more that were guaranteed by government agencies at March 31, 2017 or December 31, 2016.~~


⁽⁵⁾	~~At March 31, 2017 and December 31, 2016, $1.4 million and $1.1 million of potential problem loans, respectively, were guaranteed by government agencies.~~respectively.

~~At both~~Nonperforming Assets. Nonperforming assets consist of nonaccrual loans and other real estate owned. Nonperforming assets increased $5.0 million to $15.7 million, or 0.34% of total assets at March 31, ~~2017 and~~2018 from $10.7 million, or 0.26% of total assets, at December 31, ~~2016, nonperforming assets totaled $11.7 million, or 0.30% of total assets. For~~2017 due to the ~~three months ended March 31, 2017, the change~~increase in nonaccrual loans discussed below. There was ~~primarily due to $2.1 million in additions to nonaccrual loans, offset partially by $1.8 million of net principal reductions and $157,000 of charge-offs. The~~no other real estate owned ~~balance increased to $786,000~~at March 31, ~~2017~~2018 or December 31, 2017.

Nonaccrual Loans. Nonaccrual loans increased $5.0 million to $15.7 million, or 0.48% of loans receivable, net, at March 31, 2018 from ~~$754,000~~$10.7 million, or 0.38% of loans receivable, net, at December 31, ~~2016~~2017. The increase was due primarily to one agricultural loan relationship in the amount of $3.1 million that was classified as ~~a result of~~nonaccrual during the ~~addition of one property.~~

~~Performing TDR loans were $19.9 million and $22.3 million as of March 31, 2017 and December 31, 2016, respectively. The $2.4 million, or 10.8%, decrease in performing TDR loans for the three months~~period ended March 31, 2017 was primarily the result of $4.9 million of net principal payments and $11,000 of loans charged off, partially offset by $2.5 million of loans restructured during the period. At both March 31, 2017 and December 31, 2016,2018. As this credit relationship is well-secured, the Company ~~had recorded $2.1 million in~~did not record a related allowance for loan ~~losses on~~losses. The increase in the ~~performing TDR loans.~~

~~Potential problem~~nonaccrual loans aswas also due to two commercial credit relationships with an outstanding balance of $1.9 million at March 31, ~~2017 and December 31, 2016 were $82.8~~2018 of which approximately $1.0 million ~~and $87.8 million, respectively. Potential problem loans are those loans that are currently accruing interest and are not considered~~is guaranteed by the Small Business Administration.

5256

Table of Contents

~~impaired, but which we are monitoring because~~The following table reflects the financial information of the borrower causes concerns as to their ability to meet their loan repayment terms. Loans that are past due 90 days or more and still accruing interest are both well secured andchanges in ~~the process of collection. The $4.9 million, or 5.6%, decrease in potential problem~~nonaccrual loans was primarily the result of $4.4 million of net principal payments, $5.8 million of loans transferred to held for sale, $2.7 million of loans transferred to impaired status and $355,000 of loan charge-offs, partially offset by the addition of loans graded as potential problem loans of $9.2 million during the three months ended March 31, 2018 (in thousands):



	Three Months Ended
	March 31, 2018
Nonaccrual loans
Balance, beginning of period	$	10,703
Addition of previously classified pass graded loans	4,066
Addition of previously classified potential problem loans	2,324
Net principal payments	(1,365		)
Balance, end of period	$	15,728

At March 31, 2018, nonaccrual loans of $7.6 million had related allowance for loan losses of $1.9 million and nonaccrual loans of $8.2 million had no related allowance for loan losses. At December 31, 2017 nonaccrual loans of $3.2 million had related allowance for loan losses of $720,000 and nonaccrual loans of $7.5 million had no allowance for loan losses.

At March 31, 2018, nonperforming TDR loans, included in the nonaccrual loan table above, were $8.2 million and had a related allowance for loan losses of $336,000. At December 31, 2017, nonperforming TDR loans were $5.2 million had a related allowance for loan losses of $379,000.

Troubled Debt Restructured Loans. TDR loans are considered impaired and are separately measured for impairment whether on accrual or nonaccrual status. The performing TDR loans are not considered nonperforming assets as they continue to accrue interest despite being considered impaired due to the restructured status. Performing TDR loans decreased $570,000, or 2.1%, to $26.2 million at March 31, 2018 from $26.8 million at December 31, 2017.

The following table reflects the changes in performing TDR loans during the three months ended March 31, 2018 (in thousands):



	Three Months Ended
	March 31, 2018
Performing TDR loans
Balance, beginning of period	$	26,757
Addition of previously classified potential problem loans	79
Net principal payments	(649		)
Balance, end of period	$	26,187

The related allowance for loan losses on performing TDR loans was $2.6 million as of both March 31, 2018 and December 31, 2017.

Potential Problem Loans. Potential problem loans increased $9.7 million, or 11.6%, to $93.3 million at March 31, 2018 from $83.5 million at December 31, 2017. The increase was due primarily to the addition of potential problem loans acquired in the Puget Sound Merger of $6.1 million at March 31, 2018.

Table of Contents

The following table reflects the changes in potential problem loans during the three months ended March 31, 2018 (in thousands):



	Three Months Ended
	March 31, 2018
Potential problem loans
Balance, beginning of period	$	83,543
Addition of previously classified pass graded loans	25,126
Upgrades to pass graded loan status	(3,636		)
Transfers of loan to nonaccrual or troubled debt restructured status	(2,403		)
Charge-offs	(145		)
Net principal payments	(9,232		)
Balance, end of period	$	93,253

Analysis of Allowance for Loan Losses

~~Management maintains an~~The allowance for loan losses ~~(“ALL”)~~is established through a provision for loan losses charged against earnings. The balance of the allowance for loan losses is maintained at the amount management believes will be appropriate to ~~provide for estimated~~absorb probable incurred credit losses in the loan portfolio at the balance sheet date. The ~~adequacy of~~allowance for loan losses is determined by applying estimated loss factors to the ~~ALL is monitored through our ongoing quarterly loan quality assessments.~~credit exposure from outstanding loans.

We assess the estimated credit losses inherent in our loan portfolio by considering a number of elements including:

•~~Historical~~historical loss experience in the loan portfolio;

•~~Balance of potential problem loans in the loan portfolio;~~

•~~Impact~~impact of environmental factors, including:

▪~~Levels of and trends in delinquencies and impaired loans;~~

▪~~Levels of and trends in charge-offs and recoveries;~~

▪~~Trends in volume and terms of loans;~~

▪~~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;~~

▪~~Other external factors such as competition, legal, and regulatory;~~

▪~~Effects of changes in credit concentrations; and~~

▪~~Other factors~~


◦	levels of and trends in delinquencies, classified and impaired loans;


◦	levels of and trends in charge-offs and recoveries;


◦	trends in volume and terms of loans;


◦	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;


◦	other external factors such as competition, legal and regulatory;


◦	effects of changes in credit concentrations; and


◦	other factors

We calculate an appropriate ~~ALL~~allowance for loan losses for the loans in our loan portfolio ~~except PCI loans,~~ 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,~~TDR loans, after a careful analysis of each loan’s credit and collateral factors. Our analysis of an appropriate ~~ALL~~allowance for loan losses combines the provisions made for our non-impaired loans and the specific provisions made for each impaired loan.

The allowance for loan losses on loans designated as non-PCI loans is similar to the methodology described above except that for non-PCI loans, the remaining unaccreted discounts resulting from the fair value adjustments recorded at the time the loans were purchased are additionally factored into the allowance methodology.

For the PCI loans, the acquisition date fair value incorporated our estimate of future expected cash flows until the ultimate resolution of these credits. To the extent actual or projected cash flows are less than previously estimated, additional provisions for loan losses on the PCI loan portfolio will be recognized immediately into earnings. To the extent actual or projected cash flows are more than previously estimated, the increase in cash flows is recognized immediately as a recapture of provision for loan losses up to the previously recognized provision for that loan or pool of loans, if any, and then prospectively recognized in interest income as a yield adjustment.

While we believe we use the best information available to determine the allowance for loan losses, our results of operations could be significantly affected if circumstances differ substantially from the assumptions used in determining the allowance. A decline in national and local 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

Table of Contents

by bank regulators, as part of their routine examination process, which may result in the establishment of additional allowance for loan losses based upon their judgment of information available to them at the time of their examination.

The following table provides information regarding changes in our allowance for loan losses at and for the three months ended March 31, 2018 and 2017:



	Three Months Ended March 31,
	2018			2017
	(Dollars in thousands)
Allowance for loan losses on loans at the beginning of the period	$	32,086		$	31,083
Provision for loan losses	1,152			867
Charge-offs:
Commercial business	(81		)	(302		)
Consumer	(485		)	(543		)
Total charge-offs	(566		)	(845		)
Recoveries:
Commercial business	501			372
Real estate construction and land development	—			10
Consumer	88			107
Total recoveries	589			489
Net recoveries (charge-offs)	23			(356		)
Allowance for loan losses at the end of the period	$	33,261		$	31,594

Allowance for loan losses to loans receivable, net	1.01		%	1.19		%
Net (recoveries) charge-offs on loans to average loans, annualized	—		%	0.05		%

Loans receivable, net at the end of the period ⁽¹⁾	$	3,281,915		$	2,663,704
Average loans receivable during the period ⁽¹⁾	3,150,869			2,631,816

⁽¹⁾ Excludes loans held for sale.

The allowance for loan losses increased to $33.3 million at March 31, 2018 from $32.1 millionat December 31, 2017. The increase was primarily the result of provision for loan losses of $1.2 million recognized during the three months ended March 31, 2018. The allowance for loan losses to loans receivable, net, decreased to 1.01% at March 31, 2018 from 1.13% at December 31, 2017 primarily as a result of an increase in loans from the Puget Sound Merger with no related allowance for loan losses.

The Company recorded net recoveries during the three months ended March 31, 2018 due primarily to a recovery on a commercial and industrial loan of $324,000, offset partially by charge-offs on a large volume of small dollar consumer loans. The Company recorded net charge-offs on average loans, annualized, of 0.05% for the three months ended March 31, 2017 which were also primarily due to the large volumes of small dollar consumer loans.

As of March 31, 2018, the Bank identified $15.7 million of nonperforming loans and $26.2 million of performing TDR loans for a total of $41.9 million of impaired loans. Of these impaired loans, $11.6 million had no allowances for loan losses as their estimated collateral value or discounted expected cash flow is equal to or exceeds their carrying costs. The remaining $30.3 million of impaired loans had related allowances for loan losses totaling $4.5 million. As of December 31, 2017, the Bank identified $10.7 million of nonperforming loans and $26.8 million of performing TDR loans for a total of $37.5 million of impaired loans. Of these impaired loans, $10.4 million had no allowances for loan losses. The remaining $27.1 million of impaired loans had related allowances for loan losses totaling $3.4 million.

5359

Table of Contents

The following table ~~provides information regarding changes in our~~outlines the allowance for loan losses ~~as of~~ and ~~for the three months ended March 31, 2017 and 2016:~~

Three Months Ended March 31,
2017 2016
(Dollars in thousands)
Loans receivable, net at the end of the period $ 2,663,704
$ 2,459,148
Average loans receivable during the period $ 2,631,816
$ 2,391,749

Allowance for loan losses on loans at the beginning of the period $ 31,083
$ 29,746
Provision for loan losses 867
1,139
Charge-offs:
Commercial business (302 ) (1,230 )
Real estate construction and land development —
(153 )
Consumer (543 ) (338 )
Total charge-offs (845 ) (1,721 )
Recoveries:
Commercial business 372
274
One-to-four family residential —
1
Real estate construction and land development 10
83
Consumer 107
145
Total recoveries 489
503
Net recoveries (charge-offs) (356 ) (1,218 )
Allowance for loan losses at the end of the period $ 31,594
$ 29,667

Allowance for loan losses to loans receivable, net 1.19 % 1.21 %
Ratio of net charge-offs to average loans receivable (annualized) 0.05 % 0.20 %

~~The allowance for~~related loan ~~losses was $31.6 million at March 31, 2017 and $31.1 million~~at December 31, 2016, which was the result of net charge-offs of $356,000 and provision for loan losses of $867,000 recorded during the three months ended March 31, 2017. Of the $356,000 of net charge-offs, $128,000 related to the closure of a PCI loan pool during the first quarter of 2017. The allowance for loan losses to loans receivable, net, ratio increased slightly to 1.19% at March 31, 2017 from 1.18% at December 31, 2016.

The Bank recorded two significant commercial and industrial loan charge-offs during the three months ended March 31, 2016 totaling $1.1 million. As a result of these prior period charge-offs, the ratio of net charge-offs to average loans receivable decreased to 0.05% for the three months ended March 31, 2017 compared to net charge-offs of 0.20% for the three months ended March 31, 2016.

At both March 31, 2017 and December 31, 2016, nonperforming loans were $10.9 million or 0.41% of loans receivable, net. The allowance for loan losses to nonperforming loans was 290.47% at March 31, 2017 and 284.93% at December 31, 2016. As of March 31, 2017, the Bank identified $30.8 million of impaired loans, of which $10.3 million had no specific valuation allowance as their estimated collateral value or discounted estimated cash flow was equal to or exceeds their carrying value. The remaining $20.5 million of impairedbalances on loans at March 31, ~~2017 had related specific valuation allowances totaling $3.1 million. Impaired loans totaled $33.2 million at~~2018 and December 31, ~~2016, of which $10.1 million had no specific valuation allowance and $23.1 million had $2.7 million of specific valuation allowance.~~2017:



	March 31, 2018			December 31, 2017
	(Dollars in thousands)
General Valuation Allowance:
Allowance for loan losses	$	24,975		$	24,732
Gross loans, excluding PCI and impaired loans	$	3,202,179		$	2,767,650
Percentage	0.78		%	0.89		%

PCI Allowance:
Allowance for loan losses	$	3,811		$	3,999
Gross PCI loans	$	34,471		$	40,603
Percentage	11.06		%	9.85		%

Specific Valuation Allowance:
Allowance for loan losses	$	4,475		$	3,355
Gross impaired loans	$	41,915		$	37,459
Percentage	10.68		%	8.96		%

Total Allowance for Loan Losses:
Allowance for loan losses	$	33,261		$	32,086
Gross loans receivable	$	3,278,565		$	2,845,712
Percentage	1.01		%	1.13		%

Based on the Bank's established comprehensive methodology, management deemed the allowance for loan losses of ~~$31.6~~$33.3 million at March 31, ~~2017 (1.19%~~2018 (1.01% of loans receivable, net and ~~290.47%~~211.48% of nonperforming loans) appropriate to provide for probable incurred credit losses based on an evaluation of known and inherent risks in the loan portfolio at that date. This compares to an allowance for loan losses at December 31, ~~2016~~2017 of ~~$31.1~~$32.1 million ~~(1.18%~~(1.13% of loans receivable, net and ~~284.93%~~299.79% of nonperforming loans). At the applicable acquisition or merger dates, no allowance for loan losses was established on purchased loans as the loans were accounted for at their fair value and a discount was established for the ~~loans.~~loans in accordance with U.S. GAAP. At March 31, ~~2017~~2018 and December 31, ~~2016,~~2017, the remaining fair value discount for these purchased loans was ~~$12.6~~$12.7 million and ~~$13.5~~$10.1 million, respectively.

~~Table~~While we believe we use the best information available to determine the allowance for loan losses, our results of ~~Contents~~

~~The following table outlines~~operations could be significantly affected if circumstances differ substantially from the assumptions used in determining the allowance. A decline in national and local economic conditions, or other factors, could result in a material increase in the allowance for loan losses and ~~related loan balances at March 31, 2017~~may adversely affect the Company’s financial condition and ~~December 31, 2016:~~

March 31, 2017 December 31, 2016
(Dollars in thousands)
General Valuation Allowance:
Allowance for loan losses $ 22,198
$ 21,791
Gross loans, excluding PCI and impaired loans $ 2,574,470
$ 2,540,751
Percentage 0.86 % 0.86 %

PCI Allowance:
Allowance for loan losses $ 6,297
$ 6,558
Gross PCI loans $ 55,779
$ 64,448
Percentage 11.29 % 10.18 %

Specific Valuation Allowance:
Allowance for loan losses $ 3,099
$ 2,734
Gross impaired loans $ 30,765
$ 33,198
Percentage 10.07 % 8.24 %

Total Allowance for Loan Losses:
Allowance for loan losses $ 31,594
$ 31,083
Gross loans receivable $ 2,661,014
$ 2,638,397
Percentage 1.19 % 1.18 %

~~While~~results of operations. In addition, the ~~Bank believes it has established its existing allowances~~determination of the amount of the allowance for loan losses ~~in accordance with U.S. GAAP, there can be no assurance that~~is subject to review by bank regulators, as part of their routine examination process, which may result in ~~reviewing~~ the ~~Bank’s loan portfolio, will not request the Bank to increase significantly its~~establishment of additional allowance for loan ~~losses. In addition, because~~losses based upon their judgment of information available to them at the time of their examination. 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.

~~Based on management’s assessment of loan quality~~

Deposits and ~~current economic conditions, the Company believes that its allowance for loan losses was appropriate~~Other Borrowings

Total deposits increased $511.7 million, or 15.1%, to ~~absorb the probable incurred losses and inherent risks of loss in the loan portfolio~~$3.90 billion at March 31, ~~2017.~~

2018 from $3.39 billion at December 31, 2017 due primarily to the deposits acquired in the Puget Sound Merger of $505.9 million at merger date. Non-maturity deposits as a percentage of total deposits increased to 89.2% at March 31, 2018 from 88.3% at December 31, 2017 primarily as a result of the mix of deposits acquired from Puget Sound Merger, which had non-maturity deposits as a percentage of total deposits of 93.6% at merger date. Based on the change in the mix and

5560

Table of Contents

~~Deposits and Other Borrowings~~

~~As indicated in the table below, total deposits were $3.24 billion at March 31, 2017, an increase of $13.8 million, or 0.4%, from $3.23 billion at December 31, 2016.~~

March 31, 2017 December 31, 2016
Balance % of Total Balance % of Total
(Dollars in thousands)
Noninterest bearing demand deposits $ 880,998
27.2 % $ 882,091
27.3 %
NOW accounts 989,693
30.5
963,821
29.8
Money market accounts 519,491
16.0
523,875
16.2
Savings accounts 509,126
15.7
502,460
15.6
Total non-maturity deposits 2,899,308
89.4
2,872,247
88.9
Certificates of deposit 344,107
10.6
357,401
11.1
Total deposits $ 3,243,415
100.0 % $ 3,229,648
100.0 %

The increase in deposits was the result of customer activities. Non-maturity deposits (total deposits less certificates of deposit) increased $27.1 million, or 0.9%, to $2.90 billion at March 31, 2017 from $2.87 billion at December 31, 2016 and certificate of deposit accounts have decreased $13.3 million, or 3.7%, to $344.1 million at March 31, 2017 from $357.4 million at December 31, 2016. Based on the change in the mix and volume of deposits, the percentage of certificates of deposit to total deposits decreased to ~~10.6%~~10.8% at March 31, ~~2017~~2018 from ~~11.1%~~11.7% at December 31, ~~2016.~~2017.

The following table summarizes the Company's deposits as of March 31, 2018 and December 31, 2017:



	March 31, 2018				December 31, 2017
	Balance		% of Total		Balance		% of Total		Change		% Change
	(Dollars in thousands)
Noninterest demand deposits	$	1,178,202	30.2	%	$	944,791	27.8	%	$	233,411	24.7	%
Interest bearing demand deposits	1,099,855		28.2		1,051,752		31.1		48,103		4.6
Money market accounts	692,931		17.7		499,618		14.7		193,313		38.7
Savings accounts	511,377		13.1		498,501		14.7		12,876		2.6
Total non-maturity deposits	3,482,365		89.2		2,994,662		88.3		487,703		16.3
Certificate of deposit accounts	422,376		10.8		398,398		11.7		23,978		6.0
Total deposits	$	3,904,741	100.0	%	$	3,393,060	100.0	%	$	511,681	15.1

Borrowings may 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 Bank is utilizing securities sold under agreement to repurchase as a supplement to its funding sources. Our repurchase agreements are secured by available for sale investment securities. At March 31, ~~2017,~~2018, the Bank had securities sold under agreement to repurchase of ~~$21.4~~$26.1 million, a decrease of ~~$664,000,~~$5.7 million, or ~~3.0%~~18.0%, from ~~$22.1~~$31.8 million at December 31, ~~2016.~~2017. The decrease was the result of customer activity during the period.

The Company also has junior subordinated debentures with a par value of $25.0 million which pay quarterly interest based on three-month LIBOR plus 1.56%. The debentures mature in 2037. The balance of the junior subordinated debentures was $20.1 million at March 31, ~~2017 was $19.8 million,~~2018, which reflects the fair value of the junior subordinated debentures established during the ~~merger with~~ Washington Banking Merger, adjusted for the accretion of discount from purchase accounting fair value adjustment.

At March 31, ~~2017,~~2018, the Bank maintained credit facilities with the FHLB of Des Moines for ~~$623.9~~$913.0 million and credit facilities with the Federal Reserve Bank ~~of San Francisco~~ for ~~$41.1~~$81.4 million. The Company had ~~$66.8 million of~~ FHLB advances outstanding of $30.7 million and $92.5 million at March 31, ~~2017~~2018 and ~~$79.6 million outstanding at~~ December 31, ~~2016.~~2017, respectively. The average cost of the FHLB advances during the three months ended March 31, 2018 and 2017 was 1.70% and 0.81%., respectively. The Bank also maintains lines of credit with four correspondent banks to purchase federal funds totaling $90.0 million as of March 31, ~~2017.~~2018. There were no federal funds purchased as of March 31, ~~2017.~~

We are required to 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, 2017, cash and cash equivalents totaled $104.4 million,2018 or 2.7% of total assets. The fair value of investment securities available for sale totaled $783.0 million at March 31, 2017 of which $242.0 million were pledged to secure public deposits or borrowing arrangements. The fair value of investment securities available for sale that were not pledged to secure public deposits or borrowing arrangements totaled $541.0 million, or 13.9%, of total assets at MarchDecember 31, 2017. ~~The fair value of investment securities available for sale with maturities of one year or less were $7.5 million, or 0.19%, of total assets at March 31, 2017.~~

Liquidity and Cash Flows

Our primary sources of funds are customer and local government deposits, loan principal and interest payments, loan sales and interest earned on and proceeds from sales and maturities of investment securities. These

~~Table of Contents~~

funds, together with retained earnings, equity and other borrowed funds, are used to make loans, acquire investment securities and other assets, and fund continuing operations. While maturities and scheduled amortization of loans are a predictable source of funds, deposit flows and loan prepayments are greatly influenced by the level of interest rates, economic conditions and competition.

Heritage Bank: The principal objective of the Bank’s liquidity management program is to maintain the ability to meet day-to-day cash flow requirements of its customers who either wish to withdraw funds or to draw upon credit facilities to meet their cash needs. The Bank monitors the sources and uses of funds on a daily basis to maintain an acceptable liquidity position. In addition to liquidity from core deposits and the repayment and maturities of loans, the Bank can utilize established credit facilities and lines with correspondent banks or sale of investment securities.

Heritage Financial Corporation: The Company is a separate legal entity from the Bank and must provide for its own liquidity. Substantially all of the Company’s revenues are obtained from dividends declared and paid by the Bank. There are statutory and regulatory provisions that could limit the ability of the Bank to pay dividends to the Company. However, management believes that such restrictions will not have an adverse impact on the ability of the Company to meets its ongoing cash obligations. At March 31, ~~2017,~~2018, the Company (on an unconsolidated basis) had cash and cash equivalents of $11.7 million.

Table of Contents

We are required to 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, 2018, cash and cash equivalents totaled $130.3 million, or 2.8% of total assets. The fair value of investment securities available for sale totaled $821.6 million at March 31, 2018, of which $262.6 million were pledged to secure public deposits or borrowing arrangements. The fair value of investment securities available for sale that were not pledged totaled $559.0 million, or 12.0%, of total assets at March 31, 2018. The fair value of investment securities available for sale with ~~no stated~~ maturities of ~~$11.0 million.~~one year or less were $8.2 million, or 0.2%, of total assets at March 31, 2018.

Consolidated Cash Flows: As disclosed in the Condensed Consolidated Statements of Cash Flows, net cash provided by operating activities was ~~$21.5~~$9.1 million for the three months ended March 31, ~~2017,~~2018, and primarily consisted of ~~proceeds from sale of loans held for sale of $36.0 million,~~ net income of ~~$9.3 million, depreciation and amortization of $2.8 million and provision for loan losses of $867,000, partially offset by originations for loans held for sale of $27.2~~$9.1 million. During the three months ended March 31, ~~2017,~~2018, net cash ~~used in~~provided by investing activities was ~~$17.2~~$86.4 million, which consisted primarily of net ~~loan originations of $28.8 million~~proceeds from purchase and ~~purchases~~sale of investment securities available for sale of ~~$7.9~~$58.1 million and net cash received from acquisitions of $80.1 million, offset partially by ~~maturities~~net loan originations of ~~investment securities available for sale of $20.1~~$47.0 million. Net cash used in financing activities was ~~$3.6~~$68.3 million for the three months ended March 31, ~~2017,~~2018, and primarily consisted of anet FHLB repayments of $61.8 million, offset partially by net increase in deposits of ~~$13.8~~$5.8 million and FHLB advances of $184.6 million, offset partially by repayments of FHLB advances of $197.5 million, a $3.6 million payment of cash dividends on common stock and $381,000 of repurchases of common stock.during the period.

Capital and Capital Requirements

Stockholders’ equity at March 31, ~~2017~~2018 was ~~$489.2~~$634.7 million compared ~~with $481.8~~to $508.3 million at December 31, ~~2016. During~~2017. The changes to stockholders' equity during the three months ended March 31, 2017, the Company realized net income of $9.3 million, declared and paid cash dividends of $3.6 million, recorded other comprehensive income of $1.5 million, recorded stock-based compensation expense related to restricted stock, net of tax effect, totaling $510,000, recorded $109,000 related to the exercise of stock options, net of tax effect, and repurchased common stock for $381,000.

Pursuant to minimum capital requirements of the FDIC effective on January 1, 2015, all FDIC-insured financial institutions, including Heritage Bank, are required to maintain a minimum common equity Tier 1 risk-based capital to risk-weighted assets ratio of 4.5%, a minimum Tier 1 leverage ratio to average assets of 4.0% and minimum risk-based capital ratios of Tier 1 capital to risk-weighted assets and total capital to risk-weighted assets of 6.0% and 8.0%, respectively.

~~As of March 31, 2017 and December 31, 2016, the most recent regulatory notifications categorized Heritage Bank~~2018 is as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Bank’s categories. The following table provides our capital requirements and actual results.

~~Table of Contents~~

follows:

Minimum Requirements Well-Capitalized Requirements Actual
(Dollars in thousands)
As of March 31, 2017:
The Company consolidated
Common equity Tier 1 capital to risk-weighted assets $ 142,668
4.5 % N/A
N/A $ 367,572
11.6 %
Tier 1 leverage capital to average assets 150,419
4.0
N/A
N/A 387,324
10.3
Tier 1 capital to risk-weighted assets 190,224
6.0
N/A
N/A 387,324
12.2
Total capital to risk-weighted assets 253,632
8.0
N/A
N/A 419,155
13.2
Heritage Bank
Common equity Tier 1 capital to risk-weighted assets 142,508
4.5
205,845
6.5 374,212
11.8
Tier 1 leverage capital to average assets 150,305
4.0
187,881
5.0 374,212
10.0
Tier 1 capital to risk-weighted assets 190,011
6.0
253,348
8.0 374,212
11.8
Total capital to risk-weighted assets 253,348
8.0
316,685
10.0 405,976
12.8

As of December 31, 2016:
The Company consolidated
Common equity Tier 1 capital to risk-weighted assets $ 142,688
4.5 % N/A
N/A $ 362,350
11.4 %
Tier 1 leverage capital to average assets 148,144
4.0
N/A
N/A 381,989
10.3
Tier 1 capital to risk-weighted assets 190,250
6.0
N/A
N/A 381,989
12.0
Total capital to risk-weighted assets 253,667
8.0
N/A
N/A 413,320
13.0
Heritage Bank
Common equity Tier 1 capital to risk-weighted assets 142,573
4.5
205,938
6.5 369,915
11.7
Tier 1 leverage capital to average assets 148,024
4.0
185,030
5.0 369,915
10.0
Tier 1 capital to risk-weighted assets 190,097
6.0
253,462
8.0 369,915
11.7
Total capital to risk-weighted assets 253,462
8.0
316,828
10.0 401,168
12.7



	Three Months Ended
	March 31, 2018
Balance, beginning of period	$	508,305
Common stock issued in the Puget Sound Merger	130,770
Net income	9,087
Dividends paid	(5,117		)
Accumulated other comprehensive loss	(7,543		)
Other	(794		)
Balance, end of period	$	634,708

Although new capital requirements were effective on January 1, 2015, certain provisions of the new rule will be phased-in from the effective date through 2019, including, among others, a new capital conservation buffer requirement, which requires financial institutions to maintain a common equity capital ratio more than 2.5% above the required minimum levels in order to avoid limitations on capital distributions, including dividend payments, and certain discretionary bonus payments based on percentages of eligible retained income that could be utilized for such actions. The new capital conservation buffer requirement began to be phased-in on January 1, 2016 at 0.625% of risk-weighted assets, and will continue to increase by 0.625% on each subsequent January 1, until it reaches 2.5% on January 1, 2019. At March 31, 2017, the capital conservation buffer was 5.22% and 4.82% for the Company ~~and the Bank, respectively.~~

~~Quarterly, the Company reviews the potential payment of~~has historically paid cash dividends to its common shareholders. ~~The timing and amount~~Payments of future cash dividends, ~~paid~~if any, will be at the discretion of our board of directors after taking into account various factors, including our business, operating results and financial condition, capital requirements, current and anticipated cash needs, plans for expansion, any legal or contractual limitation on our ~~common stock depends on the Company’s earnings, capital requirements, financial condition~~ability to pay dividends and other relevant factors. Dividends on common stock from the Company depend substantially upon receipt of dividends from the Bank, which is the Company’s predominant source of income. On April 25, ~~2017,~~2018, the Company’s Board of Directors declared a regular dividend of ~~$0.13~~$0.15 per common share payable on May 24, ~~2017~~2018 to shareholders of record on May 10, ~~2017.~~2018.

The Company is a bank holding company under the supervision of the Federal Reserve Bank. Bank holding companies are subject to capital adequacy requirements of the Federal Reserve under the Bank Holding Company Act of 1956, as amended, and the regulations of the Federal Reserve. Heritage Bank is a federally insured institution and thereby is subject to the capital requirements established by the FDIC. The Federal Reserve capital requirements generally parallel the FDIC requirements. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company’s consolidated financial statements and operations. Management believes as of March 31, 2018, the Company and the Bank meet all capital adequacy requirements to which they are subject.

As of March 31, 2018 and December 31, 2017, the most recent regulatory notifications categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Bank's categories.

5862

Table of Contents



	Minimum Requirements				Well-Capitalized Requirements				Actual
	(Dollars in thousands)
As of March 31, 2018:
The Company consolidated
Common equity Tier 1 capital to risk-weighted assets	$	176,158	4.5	%	N/A		N/A		$	442,817	11.3	%
Tier 1 leverage capital to average assets	178,471		4.0		N/A		N/A		462,900		10.4
Tier 1 capital to risk-weighted assets	234,878		6.0		N/A		N/A		462,900		11.8
Total capital to risk-weighted assets	313,170		8.0		N/A		N/A		496,557		12.7
Heritage Bank
Common equity Tier 1 capital to risk-weighted assets	175,986		4.5		$	254,203	6.5	%	446,596		11.4
Tier 1 leverage capital to average assets	178,346		4.0		222,933		5.0		446,596		10.0
Tier 1 capital to risk-weighted assets	234,649		6.0		312,865		8.0		446,596		11.4
Total capital to risk-weighted assets	312,865		8.0		391,081		10.0		480,136		12.3

As of December 31, 2017:
The Company consolidated
Common equity Tier 1 capital to risk-weighted assets	$	154,522	4.5	%	N/A		N/A		$	386,689	11.3	%
Tier 1 leverage capital to average assets	159,494		4.0		N/A		N/A		406,687		10.2
Tier 1 capital to risk-weighted assets	206,029		6.0		N/A		N/A		406,687		11.8
Total capital to risk-weighted assets	274,706		8.0		N/A		N/A		439,044		12.8
Heritage Bank
Common equity Tier 1 capital to risk-weighted assets	154,400		4.5		$	223,023	6.5	%	391,092		11.4
Tier 1 leverage capital to average assets	159,300		4.0		199,125		5.0		391,092		9.8
Tier 1 capital to risk-weighted assets	205,867		6.0		274,490		8.0		391,092		11.4
Total capital to risk-weighted assets	274,490		8.0		343,112		10.0		423,348		12.3

Effective January 1, 2015 (with some changes transitioned into full effectiveness over two to four years), the Company became subject to new capital adequacy requirements approved by the Federal Reserve and the FDIC that implement the revised standards of the Basel Committee on Banking Supervision, commonly called Basel III, and address relevant provisions of the Dodd-Frank Act.

Under the new capital requirements both the Company and the Bank are required to have a common equity Tier 1 capital ratio of 4.5%. In addition, both the Company and the Bank are required to have a Tier 1 leverage ratio of 4.0%, a Tier 1 risk-based ratio of 6.0% and a total risk-based ratio of 8.0%. Both the Company and the Bank are required to establish a “conservation buffer”, consisting of common equity Tier 1 capital of more than 2.5% above the minimum risk-based capital ratios. The capital conservation buffer is designed to ensure that banks build up capital buffers outside periods of stress which can be drawn down as losses are incurred. An institution that does not meet the conservation buffer will be subject to restrictions on certain activities including payment of dividends, stock repurchases and discretionary bonuses to executive officers. The conservation buffer is being phased in beginning in 2016 and will take full effect on January 1, 2019. Certain calculations under the rules will also have phase-in periods. The capital conservation buffer requirement began to be phased-in on January 1, 2016 when more than 0.625% of risk-weighted assets was required, and increases by 0.625% on each subsequent January 1, until it is fully phased-in on January 1, 2019. At March 31, 2018, the capital conservation buffer was 4.69% and 4.28% for the Company and the Bank, respectively.

Table of Contents

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to interest rate risk through our lending and deposit gathering activities. 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 December 31, ~~2016.~~2017.

~~We do not~~Neither we, nor the Bank, maintain a trading account for any class of financial instrument, nor do we, or the Bank, engage in hedging activities or purchase ~~high-risk~~high risk derivative instruments. Moreover, neither we, ~~have no material~~nor the Bank, are subject to 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, ~~2017~~2018 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, ~~2017,~~2018, that have materially affected, or are 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

~~Heritage~~We, and ~~Heritage~~our Bank, are not a party to any material pending legal proceedings other than ordinary routine litigation incidental to the business of the Bank.

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, ~~2016.~~2017.

5964

Table of Contents

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

(a) Not applicable.

(b) Not applicable.

Three Months Ended March 31,
2017 2016 Plan Total (1)
Eleventh Plan
Repurchased shares —
100,000
579,996
Stock repurchase average share price $ —
$ 17.05
$ 16.76

~~(1) Represents shares repurchased and average price per share paid~~ during the ~~duration of each plan.~~three months ended March 31, 2018 and 2017.



	Three Months Ended March 31,
	2018		2017
Repurchased shares to pay withholding taxes ⁽¹⁾	45,426		15,891
Stock repurchase to pay withholding taxes average share price	$	31.66	$	23.95

⁽¹⁾During the three months ended March 31, ~~2017,~~2018, 26,741 of the ~~Company~~shares repurchased ~~15,891 shares~~related to the withholding taxes due on the accelerated vesting of the restricted stock units of Puget Sound which were converted to Heritage common stock atshares with an average share price ~~per share~~ of ~~$23.95 to pay withholding taxes on~~$31.80 under the ~~vesting~~terms of ~~restricted stock that vested during~~ the respective periods. During the three months ended March 31, 2016, the Company repurchased 11,255 shares of common stock at an average price per share of $17.62 to pay withholding taxes on the vesting of restricted stock that vested during the respective periods.merger.

The following table sets forth information about the Company’s purchases of its outstanding common stock during the quarter ended March 31, ~~2017.~~2018.

Period
Total Number
of Shares
Purchased(1)

Average Price
Paid Per
Share(1)

Total Number of Shares Purchased as
Part of Publicly
Announced Plans or Programs

Maximum Number
of Shares that May
Yet Be Purchased
Under the Plans or
Programs
January 1, 2017— January 31, 2017 —
$ —
7,893,389
935,034
February 1, 2017— February 28, 2017 —
—
7,893,389
935,034
March 1, 2017— March 31, 2017 15,891
23.95
7,893,389
935,034
Total 15,891
$ 23.95
7,893,389
935,034



Period	Total Number of Shares Purchased⁽¹⁾	Average Price Paid Per Share⁽¹⁾		Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs ⁽²⁾	Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs
January 1, 2018— January 31, 2018	26,741	$	31.80	7,893,389	935,034
February 1, 2018— February 28, 2018	—	—		7,893,389	935,034
March 1, 2018— March 31, 2018	18,685	31.42		7,893,389	935,034
Total	45,426	$	31.66


~~(1)~~	Of the common shares repurchased by the Company between July 1, 2016 and March 31, 2017, 15,891 shares of restricted stock represented the cancellation of stock to pay withholding taxes at a weighted average price per share of $23.95.

⁽¹⁾ All of the common shares repurchased by the Company between January 1, 2018 and March 31, 2018 represented the cancellation of stock to pay withholding taxes on vested restricted stock awards or units.

⁽²⁾ Represents cumulative life-to-date shares repurchased.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable

ITEM 5. OTHER INFORMATION

None

6065

Table of Contents

ITEM 6. EXHIBITS



~~Exhibit No.~~			~~Description of Exhibit~~
~~2.1~~			~~Purchase and Assumption Agreement for Cowlitz Acquisition (1)~~

~~2.2~~			~~Purchase and Assumption Agreement for Pierce Acquisition (2)~~

~~2.3~~			~~Definitive Agreement for Valley Acquisition (3)~~

~~2.4~~			~~Agreement and Plan of Merger with Washington Banking Company (4)~~

~~3.1~~			~~Articles of Incorporation (5)~~

~~3.2~~			~~Amended and Restated Bylaws of the Company (6)~~

~~10.1~~			~~1998 Stock Option and Restricted Stock Award Plan (7)~~

~~10.2~~			~~1997 Stock Option and Restricted Stock Award Plan (8)~~

~~10.3~~			~~2002 Incentive Stock Option Plan, Director Nonqualified Stock Option Plan, and Restricted Stock Option Plan (9)~~

~~10.4~~			~~2006 Incentive Stock Option Plan, Director Nonqualified Stock Option Plan, and Restricted Stock Option Plan (10)~~

~~10.5~~			~~Annual Incentive Compensation Plan (11)~~

~~10.6~~			~~2010 Omnibus Equity Plan (12)~~

~~10.7~~			~~2014 Omnibus Equity Plan (13)~~

~~10.8~~			~~Form of Nonqualified Stock Option Award Agreement under the Heritage Financial Corporation 2014 Omnibus Equity Plan (14)~~

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

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

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

~~10.12~~			~~Form of Cash Incentive Award Agreement under the Heritage Financial Corporation 2014 Omnibus Equity Plan (14)~~

~~10.13~~			~~Form of Incentive Stock Option Award Agreement under the Heritage Financial Corporation 2014 Omnibus Equity Plan (14)~~

~~10.14~~			~~Deferred Compensation Plan and Participation Agreements by and between Heritage and each of Brian L. Vance, Jeffrey J. Deuel and Donald J. Hinson (15)~~

~~10.15~~			~~Employment Agreements by and between Heritage and each of Brian L. Vance, Jeffrey J. Deuel and Donald J. Hinson (15)~~

~~10.16~~			~~Employment Agreement and Deferred Compensation Participation Agreement by and between Heritage and David A. Spurling (16)~~

~~10.17~~			~~Employment Agreement by and between Heritage and Bryan McDonald (17)~~

~~10.18~~			~~Deferred Compensation Plan and Participation Agreement by and between Heritage and Bryan D. McDonald (18)~~

~~10.19~~			~~Form of Split Dollar Agreements, dated August 3, 2015, by and between Heritage and Brian L. Vance, Jeffrey J. Deuel, Donald J. Hinson, Bryan D. McDonald and David A. Spurling (19)~~

~~10.20~~			~~Deferred Compensation Plan and Participation Agreement by and between Heritage and David A. Spurling (20)~~

11			~~Statement regarding computation of earnings per share (21)~~

~~Table of Contents~~




~~31.1~~			~~Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (11)~~

~~31.2~~			~~Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (11)~~

~~32.1~~			~~Certification of Principal Executive Officer and Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (11)~~

~~101~~			The following materials from Heritage Financial Corporation’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2017, formatted in Extensible Business Reporting Language (“XBRL”): (i) Unaudited Condensed Consolidated Statements of Financial Condition, (ii) Unaudited Condensed Consolidated Statements of Income; (iii) Unaudited Condensed Consolidated Statements of Comprehensive Income, (iv) Unaudited Condensed Consolidated Statements of Stockholders' Equity; (v) Unaudited Condensed Consolidated Statements of Cash Flows, and (vi) Unaudited Notes to Condensed Consolidated Financial Statements



		Incorporated by Reference
Exhibit No.	Description of Exhibit	Form	Exhibit	Filing Date/Period End Date

2.5	Agreement and Plan of Merger with Puget Sound Bancorp, Inc	8-K	2.1	7/27/2017

2.6	Agreement and Plan of Merger with Premier Commercial Bancorp, Inc	8-K	2.1	3/9/2018

31.1	Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 ⁽¹⁾

31.2	Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 ⁽¹⁾

32.1	Certification of Principal Executive Officer and Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 ⁽¹⁾

101.INS	XBRL Instance Document ⁽¹⁾

101.SCH	XBRL Taxonomy Extension Schema Document ⁽¹⁾

101.CAL	XBRL Taxonomy Extension Calculation Linkbase Document ⁽¹⁾

101.DEF	XBRL Taxonomy Extension Definition Linkbase Document ⁽¹⁾

101.LAB	XBRL Taxonomy Extension Label Linkbase Document ⁽¹⁾

101.PRE	XBRL Taxonomy Extension Presentation Linkbase Document ⁽¹⁾


~~(1)~~	~~Incorporated by reference to the Current Report on Form 8-K dated July 30, 2010.~~


~~(2)~~	~~Incorporated by reference to the Current Report on Form 8-K dated November 5, 2010.~~


~~(3)~~	~~Incorporated by reference to the Current Report on Form 8-K dated March 11, 2013.~~


~~(4)~~	~~Incorporated by reference to the Current Report on Form 8-K dated October 23, 2013.~~


~~(5)~~	Incorporated by reference to the Registration Statement on Form S-1 (Reg. No. 333-35573) declared effective on November 12, 1997; as amended, said Amendment being incorporated by reference to the Amendment to the Articles of Incorporation of Heritage Financial Corporation filed with the Current Report on Form 8-K dated November 25, 2008.


~~(6)~~	~~Incorporated by reference to the Current Report on Form 8-K dated April 30, 2014 and October 3, 2016.~~


~~(7)~~	~~Incorporated by reference to the Registration Statement on Form S-8 (Reg. No. 333-71415).~~


~~(8)~~	~~Incorporated by reference to the Registration Statement on Form S-8 (Reg. No. 333-57513).~~


~~(9)~~	~~Incorporated by reference to the Registration Statements on Form S-8 (Reg. No. 333-88980; 333-88982; 333-88976).~~


~~(10)~~	~~Incorporated by reference to the Registration Statements on Form S-8 (Reg. No. 333-134473; 333-134474; 333-134475).~~


~~(11)~~	~~Filed herewith.~~


~~(12)~~	~~Incorporated by reference to the Registration Statement on Form S-8 (Reg. No. 33-167146).~~


~~(13)~~	Incorporated by reference to Heritage Financial Corporation's definitive proxy statement dated June 11, 2014; as amended, said Amendment being incorporated by reference to the Current Report on Form 8-K dated February 1, 2017.


~~(14)~~	~~Incorporated by reference to the Current Report on Form 10-Q dated August 6, 2014 and on Form 8-K dated February 1, 2017.~~


~~(15)~~	~~Incorporated by reference to the Current Report on Form 8-K dated September 7, 2012 and December 22, 2016.~~


~~(16)~~	~~Incorporated by reference to the Current Report on Form 8-K dated January 6, 2014 and December 22, 2016.~~


~~(17)~~	~~Incorporated by reference to the Registration Statement on Form S-4 (Reg. No. 333-192985).~~


~~(18)~~	~~Incorporated by reference to the Annual Report on Form 10-K dated March 10, 2015 and Form 8-K dated December 22, 2016.~~


~~(19)~~	~~Incorporated by reference to the Current Report on Form 10-Q updated August 6, 2015.~~


~~(20)~~	~~Incorporated by reference to the Current Report on Form 8-K dated December 22, 2015 and Form 8-K dated December 22, 2016.~~


~~(21)~~	~~Reference is made to Note (17)—Stockholders' Equity in the Notes to Consolidated Financial Statements under Part II. Item 8. herein.~~

⁽¹⁾ Filed herewith.

~~Table of Contents~~

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 ~~2, 2017~~10, 2018		/S/ BRIAN L. VANCE
		Brian L. Vance
		President and Chief Executive Officer
		~~(Duly Authorized Officer)~~

Date:
May ~~2, 2017~~10, 2018		/S/ DONALD J. HINSON
		Donald J. Hinson
		Executive Vice President and Chief Financial Officer
		~~(Principal Financial and Accounting Officer)~~

6366

~~Table of Contents~~

~~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, 2017 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 Unaudited Notes to Condensed Consolidated Financial Statements.



	Three Months Ended March 31, 2017 ⁽¹⁾
	(In thousands)
Balance of AOCI at the beginning of period	$	(2,606	)
Other comprehensive income before reclassification	1,473
Balance of AOCI at the end of period	$	(1,133	)



	Three Months Ended March 31, 2016 ⁽¹⁾
	(In thousands)
Balance of AOCI at the beginning of period	$	2,559
Other comprehensive income before reclassification	6,075
Amounts reclassified from AOCI for gain on sale of investment securities available for sale included in net income	(364		)
Net current period other comprehensive income	5,711
Balance of AOCI at the end of period	$	8,270



	Shares		Weighted-Average Grant Date Fair Value
Nonvested at December 31, 2015	264,521		$	15.92
Granted	99,373		17.51
Vested	(36,651	)	15.52
Forfeited	(1,681	)	16.16
Nonvested at March 31, 2016	325,562		$	16.45

Nonvested at December 31, 2016	261,296		16.80
Granted	—		—
Vested	(52,201	)	16.60
Forfeited	(5,270	)	16.78
Nonvested at March 31, 2017	203,825		$	16.85



	Basis⁽¹⁾		Fair Value at March 31, 2017
	Basis⁽¹⁾		Total		Level 1		Level 2		Level 3		Net Losses (Gains) Recorded in Earnings During the Three Months Ended March 31, 2017
	(In thousands)
Impaired loans:
Commercial business:
Commercial and industrial	$	172	$	164	$	—	$	—	$	164	$	7
Owner-occupied commercial real estate	182		182		—		—		182		5
Total commercial business	354		346		—		—		346		12
Real estate construction and land development:
One-to-four family residential	—		—		—		—		—		—
Total real estate construction and land development	—		—		—		—		—		—
Consumer	18		16		—		—		16		(3		)
Total impaired loans and assets measured at fair value on nonrecurring basis	$	372	$	362	$	—	$	—	$	362	$	9



	Basis⁽¹⁾		Fair Value at December 31, 2016
	Basis⁽¹⁾		Total		Level 1		Level 2		Level 3		Net Losses (Gains) Recorded in Earnings During the Three Months Ended March 31, 2016
	(In thousands)
Impaired loans:
Commercial business:
Commercial and industrial	$	205	$	200	$	—	$	—	$	200	$	—
Owner-occupied commercial real estate	780		603		—		—		603		(25		)
Total commercial business	985		803		—		—		803		(25		)
Real estate construction and land development:
One-to-four family residential	828		822		—		—		822		(6		)
Total real estate construction and land development	828		822		—		—		822		(6		)
Consumer	16		9		—		—		9		—
Total assets measured at fair value on a nonrecurring basis	$	1,829	$	1,634	$	—	$	—	$	1,634	$	(31	)



Period	Total Number of Shares Purchased(1)	Average Price Paid Per Share(1)		Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs	Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs
January 1, 2017— January 31, 2017	—	$	—	7,893,389	935,034
February 1, 2017— February 28, 2017	—	—		7,893,389	935,034
March 1, 2017— March 31, 2017	15,891	23.95		7,893,389	935,034
Total	15,891	$	23.95	7,893,389	935,034