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, 2018 or

¨~~September 30, 2017~~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 ~~November 1, 2017~~April 26, 2018 there were ~~29,929,106~~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, 2018

~~September 30, 2017~~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 September 30,~~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 and Nine Months Ended September 30,~~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 and Nine Months Ended September 30,~~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 Nine Months Ended September 30,~~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 Nine Months Ended September 30,~~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			4746
~~Item~~ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK			6864
~~Item~~ITEM 4.	CONTROLS AND PROCEDURES			6864

Part II.	OTHER INFORMATION			6864
~~Item~~ITEM 1.	LEGAL PROCEEDINGS			6864
~~Item~~ITEM 1A.	RISK FACTORS			6864
~~Item~~ITEM 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS			6965
~~Item~~ITEM 3.	DEFAULTS UPON SENIOR SECURITIES			6965
~~Item~~ITEM 4.	MINE SAFETY DISCLOSURES			6965
~~Item~~ITEM 5.	OTHER INFORMATION			6965
~~Item~~ITEM 6.	EXHIBITS			7066
	SIGNATURES			7066

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, ~~and~~ uncertainties ~~including, but not limited to: the expected revenues, cost savings, synergies~~ and other ~~benefits~~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 ~~pending~~recent merger with Puget Sound Bancorp, Inc., or our pending merger with Premier Commercial Bancorp, ("~~Puget Sound"~~Premier Merger") ~~might not be realized~~, into our operations and our ability to realize related revenue synergies and cost savings within ~~the~~ expected time frames or at all, and any goodwill charges related thereto and costs or difficulties relating to integration matters, including but not limited to customer and employee retention, which might be greater than expected; the proposed ~~Puget Sound merger~~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; 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)


	September 30, 2017			December 31, 2016
	(Dollars in thousands)						March 31, 2018			December 31, 2017
ASSETS
Cash on hand and in banks	$	82,905		$	77,117		$	86,608		$	78,293
Interest earning deposits	28,353			26,628			43,701			24,722
Cash and cash equivalents	111,258			103,745			130,309			103,015
Investment securities available for sale, at fair value	800,060			794,645			821,567			810,530
Loans held for sale	5,368			11,662			2,669			2,288
Loans receivable, net	2,797,513			2,640,749			3,281,915			2,849,071
Allowance for loan losses	(31,400		)	(31,083		)	(33,261		)	(32,086		)
Total loans receivable, net	2,766,113			2,609,666			3,248,654			2,816,985
Other real estate owned	523			754			—			—
Premises and equipment, net	60,457			63,911			62,147			60,325
Federal Home Loan Bank stock, at cost	9,343			7,564			6,824			8,347
Bank owned life insurance	71,474			70,355			81,700			75,091
Accrued interest receivable	12,295			10,925			13,602			12,244
Prepaid expenses and other assets	87,728			79,351			104,666			99,328
Other intangible assets, net	6,408			7,374			16,563			6,088
Goodwill	119,029			119,029			187,549			119,029
Total assets	$	4,050,056		$	3,878,981		$	4,676,250		$	4,113,270
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits	$	3,320,818		$	3,229,648		$	3,904,741		$	3,393,060
Federal Home Loan Bank advances	117,400			79,600			30,700			92,500
Junior subordinated debentures	19,936			19,717			20,083			20,009
Securities sold under agreement to repurchase	28,668			22,104			26,100			31,821
Accrued expenses and other liabilities	55,626			46,149			59,918			67,575
Total liabilities	3,542,448			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 September 30, 2017 and December 31, 2016	—			—
Common stock, no par value, 50,000,000 shares authorized; 29,929,106 and 29,954,931 shares issued and outstanding at September 30, 2017 and December 31, 2016, respectively	360,113			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	145,677			125,309			153,101			149,013
Accumulated other comprehensive income (loss), net	1,818			(2,606		)
Accumulated other comprehensive loss, net							(8,959		)	(1,298		)
Total stockholders’ equity	507,608			481,763			634,708			508,305
Total liabilities and stockholders’ equity	$	4,050,056		$	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 September 30, Nine Months Ended September 30,
2017 2016 2017 2016
(Dollars in thousands, except per share amounts)
INTEREST INCOME
Interest and fees on loans $ 32,595
$ 30,915
$ 94,580
$ 91,595
Taxable interest on investment securities 3,117
2,888
9,307
8,522
Nontaxable interest on investment securities 1,354
1,235
3,926
3,599
Interest and dividends on other interest earning assets 258
76
461
225
Total interest income 37,324
35,114
108,274
103,941
INTEREST EXPENSE
Deposits 1,628
1,269
4,301
3,765
Junior subordinated debentures 261
221
748
647
Other borrowings 444
18
908
78
Total interest expense 2,333
1,508
5,957
4,490
Net interest income 34,991
33,606
102,317
99,451
Provision for loan losses 884
1,495
2,882
3,754
Net interest income after provision for loan losses 34,107
32,111
99,435
95,697
NONINTEREST INCOME
Service charges and other fees 4,769
3,630
13,408
10,462
Gain on sale of investment securities, net 44
345
161
1,106
Gain on sale of loans, net 1,229
3,435
6,562
5,406
Interest rate swap fees 328
742
743
1,105
Other income 2,024
1,715
5,532
5,354
Total noninterest income 8,394
9,867
26,406
23,433
NONINTEREST EXPENSE
Compensation and employee benefits 15,823
15,633
48,119
45,652
Occupancy and equipment 3,979
3,926
11,607
11,873
Data processing 2,090
1,943
6,007
5,564
Marketing 933
745
2,545
2,254
Professional services 1,453
830
3,515
2,508
State and local taxes 640
820
1,828
2,031
Federal deposit insurance premium 433
296
1,090
1,316
Other real estate owned, net (88 ) (142 ) (36 ) 330
Amortization of intangible assets 319
359
966
1,057
Other expense 2,373
2,408
7,346
7,079
Total noninterest expense 27,955
26,818
82,987
79,664
Income before income taxes 14,546
15,160
42,854
39,466
Income tax expense 3,922
4,121
11,086
10,441
Net income $ 10,624
$ 11,039
$ 31,768
$ 29,025
Basic earnings per common share $ 0.35
$ 0.37
$ 1.06
$ 0.97
Diluted earnings per common share $ 0.35
$ 0.37
$ 1.06
$ 0.97
Dividends declared per common share $ 0.13
$ 0.12
$ 0.38
$ 0.35



	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 September 30,						Nine Months Ended September 30,
	2017			2016			2017			2016			Three Months Ended March 31,
	(Dollars in thousands)												2018			2017
Net income	$	10,624		$	11,039		$	31,768		$	29,025		$	9,087		$	9,316
Change in fair value of investment securities available for sale, net of tax of $157, $(570), $2,442 and $4,983, respectively	289			(1,055		)	4,528			9,223
Reclassification adjustment for net gain from sale of investment securities available for sale included in income, net of tax of $(16), $(121), $(57) and $(388), respectively	(28		)	(224		)	(104		)	(718		)
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)	261			(1,279		)	4,424			8,505			(7,543		)	1,473
Comprehensive income	$	10,885		$	9,760		$	36,192		$	37,530		$	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 (loss), 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 stock awards granted, net of forfeitures	111		—			—			—			—
Exercise of stock options (including excess tax benefits from nonqualified stock options)	28		421			—			—			421
Stock-based compensation expense	—		1,367			—			—			1,367
Net excess tax benefits from vesting of restricted stock	—		99			—			—			99
Common stock repurchased	(167	)	(2,887		)	—			—			(2,887		)
Net income	—		—			29,025			—			29,025
Other comprehensive income, net of tax	—		—			—			8,505			8,505
Cash dividends declared on common stock ($0.35 per share)	—		—			(10,488		)	—			(10,488		)
Balance at September 30, 2016	29,947		$	358,451		$	126,497		$	11,064		$	496,012
															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	(10	)	—			—			—			—			(5	)	—			—			—			—
Exercise of stock options	12		159			—			—			159			8		109			—			—			109
Stock-based compensation expense	—		1,568			—			—			1,568			—		510			—			—			510
Common stock repurchased	(28	)	(674		)	—			—			(674		)	(16	)	(381		)	—			—			(381		)
Net income	—		—			31,768			—			31,768			—		—			9,316			—			9,316
Other comprehensive income, net of tax	—		—			—			4,424			4,424			—		—			—			1,473			1,473
Cash dividends declared on common stock ($0.38 per share)	—		—			(11,400		)	—			(11,400		)
Balance at September 30, 2017	29,929		$	360,113		$	145,677		$	1,818		$	507,608
Cash dividends declared on common stock ($0.12 per share)															—		—			(3,594		)	—			(3,594		)
Balance at March 31, 2017															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.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

~~(Unaudited)~~(In thousands)


	Nine Months Ended September 30,
	2017			2016			Three Months Ended March 31,
	(Dollars in thousands)						2018			2017
Cash flows from operating activities:
Net income	$	31,768		$	29,025		$	9,087		$	9,316
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	8,117			9,543			2,631			2,808
Changes in net deferred loan costs, net of amortization	(656		)	(971		)	9			(338		)
Provision for loan losses	2,882			3,754			1,152			867
Net change in accrued interest receivable, prepaid expenses and other assets, accrued expenses and other liabilities	8,315			(193		)	(4,191		)	802
Stock-based compensation expense	1,568			1,367			623			510
Net excess tax benefit from exercise of stock options and vesting of restricted stock	—			(119		)
Amortization of intangible assets	966			1,057			795			324
Origination of loans held for sale	(82,767		)	(99,513		)	(20,380		)	(27,209		)
Proceeds from sale of loans	91,576			101,574			20,651			35,956
Earnings on bank owned life insurance	(1,108		)	(1,086		)	(335		)	(375		)
Valuation adjustment on other real estate owned	—			383
Gain on sale of loans, net	(6,562		)	(5,406		)	(874		)	(1,195		)
Gain on sale of investment securities, net	(161		)	(1,106		)	(35		)	—
Gain on sale of assets held for sale	(53		)	—
Gain on sale of other real estate owned, net	(111		)	(173		)
Loss on sale or write-off of furniture, equipment and leasehold improvements	12			107			6			3
Net cash provided by operating activities	53,786			38,243			9,139			21,469
Cash flows from investing activities:
Loans originated, net of principal payments	(178,800		)	(190,798		)	(46,959		)	(33,249		)
Maturities of other interest earning deposits	—			1,248
Maturities, calls and payments of investment securities available for sale	75,800			94,328			24,443			20,094
Purchase of investment securities available for sale	(101,017		)	(188,164		)	(69,352		)	(7,932		)
Purchase of premises and equipment	(2,221		)	(5,128		)	(2,146		)	(847		)
Proceeds from sales of other loans	24,142			12,931			2,813			4,465
Proceeds from sales of other real estate owned	374			2,486
Proceeds from sales of investment securities available for sale	21,850			94,380			103,032			—
Proceeds from sale of assets held for sale	265			—
Proceeds from redemption of Federal Home Loan Bank stock	21,788			15,416			10,130			7,682
Purchases of Federal Home Loan Bank stock	(23,567		)	(16,356		)	(7,984		)	(7,435		)
Proceeds from sale of premises and equipment	—			659
Purchase of bank owned life insurance	—			(8,000		)
Capital contribution to low-income housing tax credit partnership	(8,506		)	(3,315		)	(7,696		)	(7		)
Net cash used in investing activities	(169,892		)	(190,313		)
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							5,796			13,767
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							(5,117		)	(3,594		)
Net decrease in securities sold under agreement to repurchase							(5,721		)	(664		)
Proceeds from exercise of stock options							21			109
Repurchase of common stock							(1,438		)	(381		)
Net cash used in financing activities							(68,259		)	(3,613		)

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Nine Months Ended September 30,
2017 2016
(Dollars in thousands)
Cash flows from financing activities:
Net increase in deposits 91,170
134,134
Federal Home Loan Bank advances 582,500
403,100
Repayments of Federal Home Loan Bank advances (544,700 ) (385,400 )
Common stock cash dividends paid (11,400 ) (10,488 )
Net increase (decrease) in securities sold under agreement to repurchase 6,564
(789 )
Proceeds from exercise of stock options 159
401
Net excess tax benefit from exercise of stock options and vesting of restricted stock —
119
Repurchase of common stock (674 ) (2,887 )
Net cash provided by financing activities 123,619
138,190
Net increase (decrease) in cash and cash equivalents 7,513
(13,880 )
Cash and cash equivalents at beginning of period 103,745
126,640
Cash and cash equivalents at end of period $ 111,258
$ 112,760

Supplemental disclosures of cash flow information:
Cash paid for interest $ 6,024
$ 4,533
Cash paid for income taxes 1,500
9,000

Supplemental non-cash disclosures of cash flow information:
Transfers of loans receivable to other real estate owned $ 32
$ 677
Transfers of premises and equipment, net to prepaid expenses and other assets for properties held for sale 2,687
—
Investment in low income housing tax credit partnership and related funding commitment 14,267
19,663



	Three Months Ended March 31,
	2018			2017
Net increase in cash and cash equivalents	27,294			627
Cash and cash equivalents at beginning of period	103,015			103,745
Cash and cash equivalents at end of period	$	130,309		$	104,372

Supplemental disclosures of cash flow information:
Cash paid for interest	$	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
Transfers of loans receivable to loans held for sale	—			5,779
Transfers of premises and equipment, net to prepaid expenses and other assets for properties held for sale	—			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.

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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, consumer loans and originates first mortgage loans on residential properties primarily located in its market areas.

On ~~July 26, 2017,~~January 16, 2018, the Company ~~announced~~completed the ~~execution~~acquisition of ~~a definitive agreement to purchase~~ Puget Sound Bancorp, Inc.~~, ("~~ (“Puget ~~Sound"~~Sound”), the holding company offor Puget Sound Bank, ~~a business bank headquartered in downtown~~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 ~~one~~Premier Commercial Bancorp, of Hillsboro, Oregon ("Premier Commercial"), pursuant to which Premier Commercial will be merged with and into Heritage, and 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 ~~location and $567.2~~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 ~~total assets, $366.6 million in total loans receivables, net and $505.1 million in total deposits as~~aggregate, including the value of ~~June 30, 2017. Upon consummation~~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 total deposits of $330.6 million.

The transaction is subject to customary closing conditions, including the receipt of regulatory approvals and approval of the Agreement by the shareholders of ~~Puget Sound~~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 a competing transaction, Premier Commercial will ~~own approximately 13.5%~~be required to pay Heritage a termination fee of $3.45 million in cash. All of the ~~combined company~~directors and ~~Puget Sound will be merged into Heritage Bank. For additional information regarding~~executive officers of Premier Commercial have agreed to vote their shares of Premier Commercial common stock in favor of approval of the ~~proposed transaction, see Note (16), Definitive~~ 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 ~~and nine~~ months ended ~~September 30, 2017~~March 31, 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.

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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 accounting ~~policies for stock-based compensation~~policy relating to ~~the issuance of restricted stock units, including grants subject to performance-based and market-based vesting conditions,~~revenue from contracts with customers adopted January 1, ~~2017~~2018 as discussed below.

~~Stock-Based Compensation~~Revenue from Contracts with Customers

Compensation cost is recognized for stock options, restricted stock awards and restricted stock units issued to employees and directors, based on the fair value of these awards at the date of grant. Compensation cost is recognized over the requisite service period, generally defined as the vesting period, on a straight-line basis. Compensation cost for restricted stock units with market-based vesting is recognized over the service period to the extent the restricted stock units are expected to vest. With the adoption of FASB Accounting Standards ~~Update ("ASU" or "Update"~~Codification Topic 606, Revenue from Contracts with Customers, (“ASC 606”) ~~2016-09~~as amended was adopted by the Company on January 1, ~~2017, forfeitures~~2018. ASC 606 applies to all contracts with customers to provide goods or services in the ordinary course of 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 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 wire fees are recognized at the time the transaction is executed as ~~they occur.~~the contract duration does not extend beyond the service performed.

Wealth Management and Trust Services. The ~~market price~~Company earns fees from contracts with customers for fiduciary and brokerage activities. Revenues are generally recognized on a monthly basis and are generally based on a percentage of the ~~Company’s common stock at the date of grant is used to determine the fair value of the restricted stock awards and restricted stock units. The fair value of stock options granted is estimated~~customer’s assets under management or based on investment or insurance solutions that are implemented for the ~~date~~customer.

Merchant Processing Services and Debit and Credit Card Fees: The Company earns fees from cardholder transactions conducted through third party payment network providers which consist of ~~grant using~~(i) interchange fees earned from the ~~Black-Scholes-Merton option pricing model. Certain restricted stock unit grants are subject to performance-based vesting~~payment network as ~~well as other approved vesting conditions~~a debit card issuer, (ii) referral fee income, and

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cliff vest based on those conditions, and the fair value is estimated using a Monte Carlo simulation pricing model. The assumptions used in the Black-Scholes-Merton option pricing model and the Monte Carlo simulation pricing model include the expected term based on the valuation date and the remaining contractual term of the award; the risk-free interest rate based on the U.S. Treasury curve at the valuation date of the award; the expected dividend yield based on expected dividends being payable (iii) ongoing merchant fees earned for referring customers to the ~~holders; and~~payment processing provider. These fees are recognized when the ~~expected stock price volatility over the expected term based~~transaction occurs, but may settle on ~~the historical volatility over the equivalent historical term.~~a daily or monthly basis.

(d) Recently Issued Accounting Pronouncements

FASB 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

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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. ~~To date, the~~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 change prior to~~Update did not have a material impact on the ~~January 1, 2018 implementation date. The Company expects to develop processes and procedures to ensure it is fully compliant with these amendments at~~Company's Condensed Consolidated Financial Statements, but the adoption ~~date.~~did change 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 ~~does not expect~~adopted this Update effective January 1, 2018 using the 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 will have a significant impact on~~Update. Previously, the ~~Company’s statements~~Company valued these items using an entry price notion. This ASU emphasized that these instruments be measured using the exit price notion; accordingly, the Company refined its calculation as part of ~~financial condition or income. Management is in the planning stages of developing processes and procedures~~adopting this standard. Prior period information has not been updated to ~~comply~~conform with the ~~disclosures requirements~~new guidance. See the Condensed Consolidated Statements of ~~this Update, which could impact the disclosures the Company makes related to fair value of its financial instruments.~~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

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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 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 ~~began its evaluation of its leasing contracts and activities. Management is in the initial stages of developing~~developed its methodology to estimate the right-of use assets and lease liabilities. The Company 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 are required to 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 are 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 effective 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 and the Company recorded excess tax benefits in its income tax expense. Adoption of all other changes under this Update 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

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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

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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 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. During 2017, the Company's management created a CECL steering committee which ~~will begin~~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 ~~reviewed proposals from several vendors~~selected a vendor to assist the Company in the ~~adoption.~~adoption and has begun the implementation discovery sessions.

FASB ASU 2016-15, Statement of Cash Flows (Topic 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 FASB 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 FASB 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 ~~FASB 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

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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.

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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 ~~updated~~Update is effective for reporting periods beginning after December 15, 2018, with early adoption permitted. The Company ~~does~~adopted this Update in January 2018. The adoption did not ~~expect the Update will~~ have a material impact on its Condensed Consolidated Financial Statements as the Company had been accounting for premiums as prescribed under this guidance. ~~The Company anticipates early adopting this Update in January 2018.~~

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 iswas effective for reporting periods beginning after December 15, ~~2017, with early adoption permitted.~~2017. The Company ~~does not expect~~adopted the Update ~~will~~on January 1, 2018. The adoption did not have a material impact on its Condensed Consolidated Financial ~~Statements.~~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~~Puget Sound Merger was effective on January 16, 2018. As of the acquisition date, Puget Sound merged into Heritage and Puget Sound Bank merged into Heritage Bank. The primary reason for the merger was to ~~provide~~create depth in the Company's geographic footprint consistent with its ongoing growth strategy, focused heavily on metro markets, and ~~maintain liquidity, generate~~to achieve operational scale and realize efficiencies of a ~~favorable return on assets without incurring undue interest rate~~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 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 total fair value of common shares issued of $130.8 million and ~~credit risk, and complement the Bank’s lending activities.~~paid cash of $3,000 for fractional

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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

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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

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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)
September 30, 2017
March 31, 2018
U.S. Treasury and U.S. Government-sponsored agencies	$	9,464	$	12	$	(73	)	$	9,403	$	23,448	$	43	$	(102	)	$	23,389
Municipal securities	248,420		5,429		(1,043		)	252,806		203,771		1,747		(1,226		)	204,292
Mortgage-backed securities and collateralized mortgage obligations⁽¹⁾:
Residential	275,128		879		(1,646		)	274,361		307,655		365		(6,743		)	301,277
Commercial	214,793		699		(2,209		)	213,283		250,489		222		(6,351		)	244,360
Collateralized loan obligations	6,007		15		—			6,022		3,266		5		—			3,271
Corporate obligations	15,583		247		—			15,830		16,589		131		(91		)	16,629
Other securities	27,850		505		—			28,355
Other asset-backed securities										27,670		679		—			28,349
Total	$	797,245	$	7,786	$	(4,971	)	$	800,060	$	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⁾:
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 ~~September 30, 2017~~March 31, 2018 or December 31, ~~2016~~2017.

The amortized cost and fair value of investment securities available for sale at ~~September 30, 2017~~March 31, 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 $ 6,556
$ 6,595
Due after one year through five years 121,518
122,740
Due after five years through ten years 248,291
248,603
Due after ten years 420,835
421,972
Investment securities with no stated maturities 45
150
Total $ 797,245
$ 800,060

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	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 ~~September 30, 2017~~March 31, 2018 and December 31, ~~2016~~2017:


	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)
September 30, 2017
March 31, 2018
U.S. Treasury and U.S. Government-sponsored agencies	$	6,484	$	(73	)	$	—	$	—		$	6,484	$	(73	)	$	7,353	$	(102	)	$	—	$	—		$	7,353	$	(102	)
Municipal securities	24,415		(362		)	23,629		(681		)	48,044		(1,043		)	63,636		(607		)	16,842		(619		)	80,478		(1,226		)
Mortgage-backed securities and collateralized mortgage obligations⁽¹⁾:
Residential	135,648		(1,111		)	23,937		(535		)	159,585		(1,646		)	181,058		(3,509		)	70,098		(3,234		)	251,156		(6,743		)
Commercial	112,595		(1,478		)	38,099		(731		)	150,694		(2,209		)	127,395		(2,698		)	87,284		(3,653		)	214,679		(6,351		)
Corporate obligations																9,483		(91		)	—		—			9,483		(91		)
Total	$	279,142	$	(3,024	)	$	85,665	$	(1,947	)	$	364,807	$	(4,971	)	$	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⁾:
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 ~~September 30, 2017~~March 31, 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 ~~September 30, 2017~~March 31, 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 and nine months ended September 30, 2017 and 2016, there were no investment securities determined to be other-than-temporarily impaired.~~

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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		$	—

~~(c)~~

(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 ~~September 30, 2017~~March 31, 2018 and December 31, ~~2016~~2017:


	September 30, 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	$	40,997	$	40,772	$	214,834	$	215,247	$	202,048	$	199,605	$	206,377	$	206,425
Repurchase agreements	12,620		12,724		29,481		29,294		46,979		45,864		48,750		48,237
Other securities pledged	201,783		203,482		3,557		3,546		17,300		17,096		12,484		12,498
Total	$	255,400	$	256,978	$	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 fees or costs because they are insignificant.

Loans acquired in a business combination 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 ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality. These loans are identified as "PCI" loans. Loans purchased that are not accounted for under FASB ASC 310-30 are accounted for under FASB ASC 310-20, Receivables—Nonrefundable Fees and Other Costs, and are referred to as "non-PCI" loans.

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(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, 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.

~~Table of Contents~~

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 that these loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate properties. Commercial real estate lending typically involves higher loan principal amounts and payments on loans, and repayment is dependent on successful operation and management of the properties. The value of the real estate securing these loans can be adversely affected by conditions in the real estate market or the economy. There is little difference in risk between owner-occupied commercial real estate loans and non-owner occupied commercial real estate 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. The Company sells most of its single-family loans in the secondary market and retains a smaller portion in its loan portfolio.

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

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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.

The Company 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 in their market areas and to applicants that are not classified as sub-prime.

~~Table of Contents~~

Loans receivable at ~~September 30, 2017~~March 31, 2018 and December 31, ~~2016~~2017 consisted of the following portfolio segments and classes:


	September 30, 2017			December 31, 2016			March 31, 2018			December 31, 2017
	(In thousands)						(In thousands)
Commercial business:
Commercial and industrial	$	665,582		$	637,773		$	811,678		$	645,396
Owner-occupied commercial real estate	602,238			558,035			702,356			622,150
Non-owner occupied commercial real estate	930,188			880,880			1,133,394			986,594
Total commercial business	2,198,008			2,076,688			2,647,428			2,254,140
One-to-four family residential	81,422			77,391			89,180			86,997
Real estate construction and land development:
One-to-four family residential	51,451			50,414			73,295			51,985
Five or more family residential and commercial properties	122,981			108,764			98,387			97,499
Total real estate construction and land development	174,432			159,178			171,682			149,484
Consumer	340,643			325,140			370,275			355,091
Gross loans receivable	2,794,505			2,638,397			3,278,565			2,845,712
Net deferred loan costs	3,008			2,352			3,350			3,359
Loans receivable, net	2,797,513			2,640,749			3,281,915			2,849,071
Allowance for loan losses	(31,400		)	(31,083		)	(33,261		)	(32,086		)
Total loans receivable, net	$	2,766,113		$	2,609,666		$	3,248,654		$	2,816,985

(b) Concentrations of Credit

Most of the Company’s lending activity occurs within 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 majority of the Company’s loan portfolio consists of (in order of balances at ~~September 30, 2017)~~March 31, 2018) non-owner occupied commercial real estate, commercial and industrial and owner-occupied commercial real estate. As of ~~September 30, 2017~~March 31, 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 be modest and likely illiquid. The loan is at risk of further decline unless active measures are taken to correct the situation.

~~Table of Contents~~

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.

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The following tables present the balance of the loans receivable by credit quality indicator as of ~~September 30, 2017~~March 31, 2018 and December 31, ~~2016~~2017.


	September 30, 2017										March 31, 2018
	Pass		OAEM		Substandard		Doubtful/Loss		Total		Pass		OAEM		Substandard		Doubtful/Loss		Total
	(In thousands)										(In thousands)
Commercial business:
Commercial and industrial	$	625,387	$	11,067	$	29,128	$	—	$	665,582	$	754,720	$	25,050	$	31,908	$	—	$	811,678
Owner-occupied commercial real estate	576,313		8,305		17,620		—		602,238		663,770		19,988		18,598		—		702,356
Non-owner occupied commercial real estate	897,677		15,790		16,721		—		930,188		1,106,904		10,415		16,075		—		1,133,394
Total commercial business	2,099,377		35,162		63,469		—		2,198,008		2,525,394		55,453		66,581		—		2,647,428
One-to-four family residential	79,882		—		1,540		—		81,422		87,962		—		1,218		—		89,180
Real estate construction and land development:
One-to-four family residential	48,101		273		3,077		—		51,451		71,735		275		1,285		—		73,295
Five or more family residential and commercial properties	121,854		722		405		—		122,981		98,328		59		—		—		98,387
Total real estate construction and land development	169,955		995		3,482		—		174,432		170,063		334		1,285		—		171,682
Consumer	335,073		—		5,045		525		340,643		365,577		—		4,172		526		370,275
Gross loans receivable	$	2,684,287	$	36,157	$	73,536	$	525	$	2,794,505	$	3,148,996	$	55,787	$	73,256	$	526	$	3,278,565


	December 31, 2016										December 31, 2017
	Pass		OAEM		Substandard		Doubtful/Loss		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 ~~September 30, 2017~~March 31, 2018 and December 31, ~~2016~~2017 were ~~$84.1~~$93.3 million and ~~$87.8~~$83.5 million, respectively. ~~The balance of potential problem loans guaranteed by a governmental agency, which guarantee reduces~~

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~~the Company's credit exposure, was $1.7 million and $1.1 million as of~~ ~~September 30, 2017~~ ~~and~~ ~~December 31, 2016, respectively.~~

(d) Nonaccrual Loans

Nonaccrual loans, segregated by segments and classes of loans, were as follows as of ~~September 30, 2017~~March 31, 2018 and December 31, ~~2016~~2017:

September 30, 2017 December 31, 2016
(In thousands)
Commercial business:
Commercial and industrial $ 4,056
$ 3,531
Owner-occupied commercial real estate 3,720
3,728
Non-owner occupied commercial real estate 1,907
1,321
Total commercial business 9,683
8,580
One-to-four family residential 84
94
Real estate construction and land development:
One-to-four family residential 869
2,008
Consumer 316
227
Nonaccrual loans $ 10,952
$ 10,909

~~The Company had $2.5 million and $2.8 million of nonaccrual loans guaranteed by governmental agencies at September 30, 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 ~~September 30, 2017~~March 31, 2018 and December 31, ~~2016~~2017 were as follows:


	September 30, 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	$	790	$	1,014	$	1,804	$	663,778	$	665,582	$	16,944	$	1,449	$	18,393	$	793,285	$	811,678
Owner-occupied commercial real estate	498		1,270		1,768		600,470		602,238		1,310		989		2,299		700,057		702,356
Non-owner occupied commercial real estate	—		2,085		2,085		928,103		930,188		931		3,282		4,213		1,129,181		1,133,394
Total commercial business	1,288		4,369		5,657		2,192,351		2,198,008		19,185		5,720		24,905		2,622,523		2,647,428
One-to-four family residential	—		—		—		81,422		81,422		535		—		535		88,645		89,180
Real estate construction and land development:
One-to-four family residential	1,038		309		1,347		50,104		51,451		—		1,147		1,147		72,148		73,295
Five or more family residential and commercial properties	366		—		366		122,615		122,981		408		—		408		97,979		98,387
Total real estate construction and land development	1,404		309		1,713		172,719		174,432		408		1,147		1,555		170,127		171,682
Consumer	1,738		657		2,395		338,248		340,643		1,896		—		1,896		368,379		370,275
Gross loans receivable	$	4,430	$	5,335	$	9,765	$	2,784,740	$	2,794,505	$	22,024	$	6,867	$	28,891	$	3,249,674	$	3,278,565

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	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 ~~September 30, 2017~~March 31, 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 ~~September 30, 2017~~March 31, 2018 and December 31, ~~2016~~2017 are set forth in the following tables.


	September 30, 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	$	3,131	$	8,581	$	11,712	$	12,060	$	1,254	$	5,135	$	11,390	$	16,525	$	17,191	$	1,769
Owner-occupied commercial real estate	1,082		4,676		5,758		6,068		767		936		12,165		13,101		13,386		1,727
Non-owner occupied commercial real estate	4,749		6,034		10,783		10,927		895		4,692		5,776		10,468		10,630		811
Total commercial business	8,962		19,291		28,253		29,055		2,916		10,763		29,331		40,094		41,207		4,307
One-to-four family residential	—		304		304		311		96		—		295		295		305		93
Real estate construction and land development:
One-to-four family residential	1,347		—		1,347		2,305		—		838		309		1,147		1,892		2
Five or more family residential and commercial properties	—		658		658		658		39
Total real estate construction and land development	1,347		658		2,005		2,963		39		838		309		1,147		1,892		2
Consumer	160		274		434		457		60		—		379		379		450		73
Total	$	10,469	$	20,527	$	30,996	$	32,786	$	3,111	$	11,601	$	30,314	$	41,915	$	43,854	$	4,475

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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 $3.9 million and $3.5 million related to the impaired loan balances at~~ ~~September 30, 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 ~~and nine~~ months ended ~~September 30,~~March 31, 2018 and 2017 ~~and 2016~~ are set forth in the following table.


	Three Months Ended September 30,				Nine Months Ended September 30,				Three Months Ended March 31,
	2017		2016		2017		2016		2018		2017
	(In thousands)								(In thousands)
Commercial business:
Commercial and industrial	$	11,171	$	9,625	$	11,190	$	9,750	$	14,261	$	9,834
Owner-occupied commercial real estate	5,289		4,553		5,049		4,560		12,841		4,017
Non-owner occupied commercial real estate	11,037		12,107		11,198		12,232		10,358		11,265
Total commercial business	27,497		26,285		27,437		26,542		37,460		25,116
One-to-four family residential	307		265		312		267		297		317
Real estate construction and land development:
One-to-four family residential	2,157		3,177		2,530		3,253		1,197		2,904
Five or more family residential and commercial properties	860		1,619		967		1,746		322		1,075
Total real estate construction and land development	3,017		4,796		3,497		4,999		1,519		3,979
Consumer	346		885		328		907		411		289
Total	$	31,167	$	32,231	$	31,574	$	32,715	$	39,687	$	29,701

For the three ~~and nine~~ months ended ~~September 30,~~March 31, 2018 and 2017, ~~and 2016,~~ no interest income was recognized subsequent to a loan’s classification as nonaccrual. For the three ~~and nine~~ months ended ~~September 30,~~March 31, 2018 and 2017, the Bank recorded ~~$366,000~~$326,000 and ~~$1.0 million,~~$365,000, respectively, of interest income related to performing TDR loans. ~~For the~~

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~~three and nine months ended September 30, 2016, the Bank recorded $156,000 and $501,000, respectively, of interest income related to performing TDR loans.~~

(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 ~~September 30, 2017~~March 31, 2018 and December 31, ~~2016~~2017 were as follows:


	September 30, 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	$	20,044	$	5,903	$	22,288	$	6,900	$	26,187	$	8,214	$	26,757	$	5,193
Allowance for loan losses on TDR loans	2,136		555		1,965		437		2,613		336		2,635		379

The unfunded commitment to borrowers related to ~~TDRs~~TDR loans was ~~$160,000~~$517,000 and ~~$249,000~~$1.2 million at ~~September 30, 2017~~March 31, 2018 and December 31, ~~2016~~2017, respectively.

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Loans that were modified as ~~TDRs~~TDR loans during the three ~~and nine~~ months ended ~~September 30,~~March 31, 2018 and 2017 ~~and 2016~~ are set forth in the following ~~tables:~~table:

Three Months Ended September 30,
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 4
$ 1,353
8
$ 2,324
Owner-occupied commercial real estate 2
1,299
2
576
Non-owner occupied commercial real estate 1
655
1
818
Total commercial business 7
3,307
11
3,718
Real estate construction and land development:
One-to-four family residential —
—
5
2,274
Five or more family residential and commercial properties —
—
1
1,606
Total real estate construction and land development —
—
6
3,880
Consumer 4
52
2
26
Total TDR loans 11
$ 3,359
19
$ 7,624


	Nine Months Ended September 30,						Three Months Ended March 31,
	2017			2016			2018			2017
	Number of Contracts (1)	Outstanding Principal Balance (1)(2)		Number of Contracts (1)	Outstanding Principal Balance (1)(2)		Number of Contracts (1)	Outstanding Principal Balance (1)(2)		Number of Contracts (1)	Outstanding Principal Balance (1)(2)
	(Dollars in thousands)						(Dollars in thousands)
Commercial business:
Commercial and industrial	13	$	5,564	15	$	2,915	9	$	4,323	8	$	3,245
Owner-occupied commercial real estate	3	1,351		2	576		—	—		1	56
Non-owner occupied commercial real estate	2	1,596		1	818		1	2,201		1	184
Total commercial business	18	8,511		18	4,309		10	6,524		10	3,485
Real estate construction and land development:
One-to-four family residential	2	1,038		5	2,274		—	—		2	1,143
Five or more family residential and commercial properties	—	—		1	1,606
Total real estate construction and land development	2	1,038		6	3,880		—	—		2	1,143
Consumer	5	60		6	70		3	78		1	9
Total TDR loans	25	$	9,609	30	$	8,259
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 ~~and nine~~ months ended ~~September 30, 2017~~March 31, 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 11 loans modified during the three months ended September 30, 2017, seven loans with a total outstanding principal balance of $2.1 million had no prior modifications. Of the 25 loans modified during the nine months

~~Table of Contents~~

ended September 30, 2017, 15 loans with a total outstanding principal balance of $5.0 million had no prior modifications. Of the 19 loans modified during the three months ended September 30, 2016, eight loans with a total outstanding principal balance of $1.4 million had no prior modifications. Of the 30 loans modified during the nine months ended September 30, 2016, 15 loans with a total outstanding principal balance of $1.7 million had no prior modifications. The remainingCertain loans included in the table above ~~for the three and nine months ended September 30, 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 ~~September 30, 2017~~March 31, 2018 was ~~$1.1 million~~$195,000 for loans that were modified as ~~TDRs during the nine months ended September 30, 2017.~~

~~There was one commercial and industrial loan totaling $234,000 at September 30, 2017 that was modified during the previous twelve months that subsequently defaulted~~TDR loans during the three ~~and nine~~ months ended ~~September 30, 2017 because the borrower was more than 90 days delinquent on their scheduled loan payments. There were no loans~~March 31, 2018.

Table of Contents

Loans that were modified during the previous twelve months that subsequently defaulted during the three ~~and nine~~ months ended ~~September 30, 2016.~~March 31, 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 ~~September 30, 2017~~March 31, 2018 and December 31, ~~2016:~~2017:


	September 30, 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	$	9,220	$	5,001	$	13,067	$	9,317	$	8,269	$	2,091	$	8,818	$	2,912
Owner-occupied commercial real estate	14,059		12,492		17,639		15,973		10,392		9,840		12,230		11,515
Non-owner occupied commercial real estate	15,026		13,058		25,037		23,360		11,855		11,088		14,295		13,342
Total commercial business	38,305		30,551		55,743		48,650		30,516		23,019		35,343		27,769
One-to-four family residential	4,426		3,983		5,120		4,905		3,891		5,039		4,120		5,255
Real estate construction and land development:
One-to-four family residential	2,928		1,749		2,958		2,123		275		—		841		89
Five or more family residential and commercial properties	2,392		2,284		2,614		2,488		1,820		1,552		2,361		2,035
Total real estate construction and land development	5,320		4,033		5,572		4,611		2,095		1,552		3,202		2,124
Consumer	3,998		5,129		5,296		6,282		3,324		4,861		3,974		5,455
Gross PCI loans	$	52,049	$	43,696	$	71,731	$	64,448	$	39,826	$	34,471	$	46,639	$	40,603

2729

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 ~~and nine~~ months ended ~~September 30, 2017~~March 31, 2018 and ~~2016.~~2017.


	Three Months Ended September 30,						Nine Months Ended September 30,						Three Months Ended March 31,
	2017			2016			2017			2016			2018			2017
	(In thousands)												(In thousands)
Balance at the beginning of the period	$	12,296		$	15,359		$	13,860		$	17,592		$	11,224		$	13,860
Accretion	(796		)	(1,178		)	(2,725		)	(3,900		)	(781		)	(994		)
Disposal and other	(1,287		)	(491		)	(2,430		)	(2,921		)	(1,698		)	(490		)
Change in accretable yield	939			1,214			2,447			4,133			2,524			756
Balance at the end of the period	$	11,152		$	14,904		$	11,152		$	14,904		$	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 ~~and nine~~ months ended ~~September 30, 2017:~~

~~Table of Contents~~

March 31, 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 September 30, 2017
Three Months Ended March 31, 2018
Commercial business:
Commercial and industrial	$	10,651	$	(3	)	$	4	$	(772	)	$	9,880	$	9,910	$	(81	)	$	499	$	(385	)	$	9,943
Owner-occupied commercial real estate	4,154		(1,494		)	4		1,397			4,061		3,992		—			2		1,046			5,040
Non-owner occupied commercial real estate	7,709		—			—		(415		)	7,294		8,097		—			—		(508		)	7,589
Total commercial business	22,514		(1,497		)	8		210			21,235		21,999		(81		)	501		153			22,572
One-to-four family residential	1,073		(15		)	—		(21		)	1,037		1,056		—			—		27			1,083
Real estate construction and land development:
One-to-four family residential	821		(556		)	191		337			793		862		—			—		79			941
Five or more family residential and commercial properties	1,666		—			—		(271		)	1,395		1,190		—			—		(75		)	1,115
Total real estate construction and land development	2,487		(556		)	191		66			2,188		2,052		—			—		4			2,056
Consumer	5,710		(478		)	112		453			5,797		6,081		(485		)	88		370			6,054
Unallocated	967		—			—		176			1,143		898		—			—		598			1,496
Total	$	32,751	$	(2,546	)	$	311	$	884		$	31,400	$	32,086	$	(566	)	$	589	$	1,152		$	33,261

Nine Months Ended September 30, 2017
Commercial business:
Commercial and industrial	$	10,968	$	(361	)	$	679	$	(1,406	)	$	9,880
Owner-occupied commercial real estate	3,661		(1,579		)	155		1,824			4,061
Non-owner occupied commercial real estate	7,753		—			—		(459		)	7,294
Total commercial business	22,382		(1,940		)	834		(41		)	21,235
One-to-four family residential	1,015		(15		)	1		36			1,037
Real estate construction and land development:
One-to-four family residential	797		(556		)	201		351			793
Five or more family residential and commercial properties	1,359		—			—		36			1,395
Total real estate construction and land development	2,156		(556		)	201		387			2,188
Consumer	5,024		(1,419		)	329		1,863			5,797
Unallocated	506		—			—		637			1,143
Total	$	31,083	$	(3,930	)	$	1,365	$	2,882		$	31,400

2930

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The following table details the allowance for loan losses disaggregated on the basis of the Company's impairment method as of ~~September 30, 2017.~~March 31, 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	$	1,254	$	7,589	$	1,037	$	9,880	$	1,769	$	7,251	$	923	$	9,943
Owner-occupied commercial real estate	767		2,434		860		4,061		1,727		2,513		800		5,040
Non-owner occupied commercial real estate	895		5,389		1,010		7,294		811		5,837		941		7,589
Total commercial business	2,916		15,412		2,907		21,235		4,307		15,601		2,664		22,572
One-to-four family residential	96		740		201		1,037		93		832		158		1,083
Real estate construction and land development:
One-to-four family residential	—		568		225		793		2		714		225		941
Five or more family residential and commercial properties	39		1,259		97		1,395		—		1,028		87		1,115
Total real estate construction and land development	39		1,827		322		2,188		2		1,742		312		2,056
Consumer	60		4,991		746		5,797		73		5,304		677		6,054
Unallocated	—		1,143		—		1,143		—		1,496		—		1,496
Total	$	3,111	$	24,113	$	4,176	$	31,400	$	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 ~~September 30, 2017:~~March 31, 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	$	11,712	$	648,869	$	5,001	$	665,582	$	16,525	$	793,062	$	2,091	$	811,678
Owner-occupied commercial real estate	5,758		583,988		12,492		602,238		13,101		679,415		9,840		702,356
Non-owner occupied commercial real estate	10,783		906,347		13,058		930,188		10,468		1,111,838		11,088		1,133,394
Total commercial business	28,253		2,139,204		30,551		2,198,008		40,094		2,584,315		23,019		2,647,428
One-to-four family residential	304		77,135		3,983		81,422		295		83,846		5,039		89,180
Real estate construction and land development:
One-to-four family residential	1,347		48,355		1,749		51,451		1,147		72,148		—		73,295
Five or more family residential and commercial properties	658		120,039		2,284		122,981		—		96,835		1,552		98,387
Total real estate construction and land development	2,005		168,394		4,033		174,432		1,147		168,983		1,552		171,682
Consumer	434		335,080		5,129		340,643		379		365,035		4,861		370,275
Total	$	30,996	$	2,719,813	$	43,696	$	2,794,505	$	41,915	$	3,202,179	$	34,471	$	3,278,565

3031

Table of Contents

The following tables detail activity in the allowance for loan losses disaggregated by segment and class for the three ~~and nine~~ months ended ~~September 30, 2016.~~March 31, 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 September 30, 2016
Three Months Ended March 31, 2017
Commercial business:
Commercial and industrial	$	9,970	$	(240	)	$	993	$	182		$	10,905	$	10,968	$	(295	)	$	223	$	(805	)	$	10,091
Owner-occupied commercial real estate	3,578		(88		)	—		222			3,712		3,661		(7		)	149		413			4,216
Non-owner occupied commercial real estate	6,924		—			—		303			7,227		7,753		—			—		(152		)	7,601
Total commercial business	20,472		(328		)	993		707			21,844		22,382		(302		)	372		(544		)	21,908
One-to-four family residential	950		—			—		26			976		1,015		—			—		37			1,052
Real estate construction and land development:
One-to-four family residential	754		—			—		96			850		797		—			10		(16		)	791
Five or more family residential and commercial properties	1,277		—			—		5			1,282		1,359		—			—		187			1,546
Total real estate construction and land development	2,031		—			—		101			2,132		2,156		—			10		171			2,337
Consumer	4,816		(572		)	197		665			5,106		5,024		(543		)	107		607			5,195
Unallocated	157		—			—		(4		)	153		506		—			—		596			1,102
Total	$	28,426	$	(900	)	$	1,190	$	1,495		$	30,211	$	31,083	$	(845	)	$	489	$	867		$	31,594

Nine Months Ended September 30, 2016
Commercial business:
Commercial and industrial	$	9,972	$	(2,810	)	$	1,352	$	2,391		$	10,905
Owner-occupied commercial real estate	4,370		(538		)	—		(120		)	3,712
Non-owner occupied commercial real estate	7,722		(350		)	—		(145		)	7,227
Total commercial business	22,064		(3,698		)	1,352		2,126			21,844
One-to-four family residential	1,157		—			2		(183		)	976
Real estate construction and land development:
One-to-four family residential	1,058		(100		)	83		(191		)	850
Five or more family residential and commercial properties	813		(54		)	—		523			1,282
Total real estate construction and land development	1,871		(154		)	83		332			2,132
Consumer	4,309		(1,370		)	496		1,671			5,106
Unallocated	345		—			—		(192		)	153
Total	$	29,746	$	(5,222	)	$	1,933	$	3,754		$	30,211

~~Table of Contents~~

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

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

~~Table of Contents~~


~~(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 ~~and nine~~ months ended ~~September 30,~~March 31, 2017 ~~and 2016~~ were as follows:


	Three Months Ended September 30,						Nine Months Ended September 30,						Three Months Ended March 31,
	2017			2016			2017			2016			2017
	(In thousands)												(In thousands)
Balance at the beginning of the period	$	786		$	1,560		$	754		$	2,019		$	754
Additions	—			25			32			677			32
Proceeds from dispositions	(374		)	(1,716		)	(374		)	(2,486		)
Gain on sales, net	111			131			111			173
Valuation adjustment	—			—			—			(383		)
Balance at the end of the period	$	523		$	—		$	523		$	—		$	786

At September 30, 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 $523,000. At September 30, 2017,March 31, 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 ~~$657,000.~~$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~~

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

⁽¹⁾ See Note (2) Business Combination

The Company performed its annual goodwill impairment test during the ~~three and nine months ended September 30,~~fourth quarter of 2017 and ~~2016.~~

~~At September 30, 2017, the Company’s step-one~~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 and nine months ended September 30, 2017. Similarly, no goodwill impairment charges were required, or recorded, for the three and nine months ended September 30, 2016. Even though there was no goodwill impairment at ~~September 30, 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) 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 September 30, Nine Months Ended September 30,
2017 2016 2017 2016
(In thousands)
Balance at the beginning of the period $ 6,727
$ 8,091
$ 7,374
$ 8,789
Less: Amortization 319
359
966
1,057
Balance at the end of the period $ 6,408
$ 7,732
$ 6,408
$ 7,732


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

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

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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 September 30, 2017, the Bank maintained a credit facility with the FHLB of Des Moines for $662.4 million and had short-term FHLB advances outstanding of $117.4 million with maturity dates within 30 days. At December 31, 2016 there were FHLB advances outstanding of $79.6 million.

~~The following table sets forth the details of FHLB advances during the three and nine months ended September 30, 2017 and 2016:~~

Three Months Ended September 30, Nine Months Ended September 30,
2017 2016 2017 2016
(Dollars in thousands)
Average balance during the period $ 111,293
$ 5,618
$ 106,553
$ 11,608
Maximum month-end balance during the period $ 126,200
$ 17,700
$ 137,450
$ 57,300
Weighted average rate during the period 1.53 % 0.57 % 1.09 % 0.54 %

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 September 30, 2017. The lines generally mature annually or are reviewed annually. As of September 30, 2017 and December 31, 2016, there were no federal funds purchased.

~~(c) Credit facilities~~

The Bank maintains a credit facility with the Federal Reserve Bank of San Francisco for $50.6 million as of September 30, 2017, of which there were no borrowings outstanding as of September 30, 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 ~~September 30, 2017~~March 31, 2018 was ~~2.89%~~3.88%. The weighted average rate of the junior subordinated debentures ~~was 5.20% and 5.05%~~were as follows for the ~~three and nine months ended September 30, 2017, respectively, and 4.49% and 4.43% for the three and nine months ended September 30, 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.

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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 ~~September 30, 2017~~March 31, 2018 and December 31, ~~2016,~~2017, the balance of the junior subordinated debentures, net of unaccreted discount, was ~~$19.9~~$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.

~~Table~~ 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 ~~Contents~~

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. 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:


	September 30, 2017		December 31, 2016		March 31, 2018		December 31, 2017
	(In thousands)				(In thousands)
U.S. Treasury and U.S. Government-sponsored agencies	$	—	$	2,944
Mortgage-backed securities and collateralized mortgage obligations⁽¹⁾:
Residential	12,336		5,191		$	11,424	$	11,239
Commercial	16,332		13,969		14,676		20,582
Total repurchase agreements	$	28,668	$	22,104	$	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.

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(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, 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 ~~September 30, 2017~~March 31, 2018 and December 31, ~~2016~~2017 are presented in the following table.


	September 30, 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⁾	$	134,295	$	74		$	102,709	$	(1,099	)	$	148,238	$	(4,553	)	$	146,537	$	(882	)
Interest rate swap with third party ⁽¹⁾	134,295		(74		)	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 ~~$3.3~~$4.8 million and ~~$2.8~~$3.4 million as of ~~September 30, 2017~~March 31, 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 ~~$3.3~~$4.8 million and ~~$2.8~~$3.4 million as of ~~September 30, 2017~~March 31, 2018 and December 31, ~~2016,~~2017, respectively.

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~~(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 ~~and nine~~ months ended ~~September 30, 2017~~March 31, 2018 and ~~2016:~~2017:


	Three Months Ended September 30,						Nine Months Ended September 30,						Three Months Ended March 31,
	2017			2016			2017			2016			2018			2017
	(Dollars in thousands)												(Dollars in thousands)
Net income:
Net income	$	10,624		$	11,039		$	31,768		$	29,025		$	9,087		$	9,316
Less: Dividends and undistributed earnings allocated to participating securities	(64		)	(102		)	(228		)	(280		)	(51		)	(78		)
Net income allocated to common shareholders	$	10,560		$	10,937		$	31,540		$	28,745		$	9,036		$	9,238
Basic:
Weighted average common shares outstanding	29,929,721			29,962,270			29,940,276			29,968,034			33,332,645			29,952,074
Less: Restricted stock awards	(146,425		)	(277,495		)	(192,186		)	(292,832		)	(127,099		)	(248,170		)
Total basic weighted average common shares outstanding	29,783,296			29,684,775			29,748,090			29,675,202			33,205,546			29,703,904
Diluted:
Basic weighted average common shares outstanding	29,783,296			29,684,775			29,748,090			29,675,202			33,205,546			29,703,904
Effect of potentially dilutive common shares ⁽¹⁾	107,414			11,031			86,004			12,543			142,556			49,085
Total diluted weighted average common shares outstanding	29,890,710			29,695,806			29,834,094			29,687,745			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 ~~and nine~~ months ended ~~September 30,~~March 31, 2018 and 2017, ~~and the three months ended September 30, 2016,~~ there were no anti-dilutive shares outstanding related to options to acquire common stock. ~~For~~Anti-dilution occurs when the ~~nine months ended September 30, 2016, anti-dilutive shares outstanding related to options to acquire common stock totaled 580 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.

The following table summarizes the dividend activity for the ~~nine~~three months ended ~~September 30, 2017~~March 31, 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.

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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.

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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 September 30, Nine Months Ended September 30,
2017 2016 2017 2016
Plan Total⁽¹⁾
Eleventh Plan
Repurchased shares —
38,000
—
138,000
579,996
Stock repurchase average share price $ —
$ 17.46
$ —
$ 17.16
$ 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 ~~and nine~~ months ended ~~September 30, 2017,~~March 31, 2018, 26,741 of the ~~Company~~shares repurchased ~~344 and 27,711~~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 ~~$25.80 and $24.61 to pay withholding taxes on the vesting~~$31.80 for a fair value of restricted stock that vested during the respective periods. During the three and nine months ended September 30, 2016, the Company repurchased 5,276 and 29,206 shares of common stock at an average price per share of $18.64 and $17.77 to pay withholding taxes on the vesting of restricted stock that vested during the respective periods.$130.8 million.


~~(12)~~(13)	Accumulated Other Comprehensive (Loss) Income

The changes in accumulated other comprehensive (loss) income ~~(loss)~~ (“AOCI”) ~~by component, during the three and nine months ended September 30, 2017 and 2016 are as follows:~~

Three Months Ended September 30, 2017 ⁽¹⁾

Nine Months Ended September 30, 2017 ⁽¹⁾
(In thousands)
Balance of AOCI at the beginning of period $ 1,557
$ (2,606 )
Other comprehensive income before reclassification 289
4,528
Amounts reclassified from AOCI for gain on sale of investment securities included in net income (28 ) (104 )
Net current period other comprehensive income 261
4,424
Balance of AOCI at the end of period $ 1,818
$ 1,818

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

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tax, during the three months ended March 31, 2018 and 2017 are as follows:

Three Months Ended
September 30, 2016 ⁽¹⁾

Nine Months Ended September 30, 2016 ⁽¹⁾
(In thousands)
Balance of AOCI at the beginning of period $ 12,343
$ 2,559
Other comprehensive income before reclassification (1,055 ) 9,223
Amounts reclassified from AOCI for gain on sale of investment securities available for sale included in net income (224 ) (718 )
Net current period other comprehensive income (1,279 ) 8,505
Balance of AOCI at the end of period $ 11,064
$ 11,064

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



	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	)


~~(13)~~	~~Stock-Based Compensation~~

Stock options generally vest ratably over three years and expire five years after they become exercisable or vest ratably over four years and expire ten years from date of grant. Restricted stock awards issued generally have a 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 subject 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, 1,073,146 shares remain available for future issuance as of September 30, 2017.~~

~~(a) Stock Option Awards~~

For the three and nine months ended September 30, 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 nine months ended September 30, 2017 was $156,000 and $159,000, respectively. The intrinsic value and cash proceeds from options exercised during the nine months ended September 30, 2016 was ~~$99,000~~ ~~and~~ ~~$401,000, respectively.~~

~~The following table summarizes the stock option activity for the nine months ended September 30, 2017 and 2016:~~

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 (27,867 ) 14.37

Forfeited or expired (4,200 ) 16.80

Outstanding at September 30, 2016 47,341
$ 13.85
2.80 $ 194

Outstanding at December 31, 2016 37,495
$ 13.77

Exercised (12,304 ) 12.92

Forfeited or expired (1,308 ) 13.53

Outstanding, vested and expected to vest and exercisable at September 30, 2017 23,883
$ 14.23
2.45 $ 365

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~~(b) Restricted Stock Awards~~

For the three and nine months ended September 30, 2017, the Company recognized compensation expense related to restricted stock awards of $292,000 and $1.1 million, respectively, and a related tax benefit of $102,000 and $384,000, respectively. For the three and nine months ended September 30, 2016, the Company recognized compensation expense related to restricted stock awards of $494,000 and $1.4 million, respectively, and a related tax benefit of $173,000 and $479,000, respectively. As of ~~September 30, 2017~~, the total unrecognized compensation expense related to non-vested restricted stock awards was $1.8 million and the related weighted average period over which the compensation expense is expected to be recognized is approximately 1.78 years. The vesting date fair value of the restricted stock awards that vested during the nine months ended September 30, 2017 and 2016 was $2.7 million and $2.0 million, respectively.

~~The following table summarizes the restricted stock award activity for the nine months ended September 30, 2017 and 2016:~~

Shares Weighted-Average Grant Date Fair Value
Nonvested at December 31, 2015 264,521
$ 15.92
Granted 119,939
17.53
Vested (111,357 ) 15.62
Forfeited (9,216 ) 16.57
Nonvested at September 30, 2016 263,887
$ 16.76

Nonvested at December 31, 2016 261,296
$ 16.80
Granted —
—
Vested (107,202 ) 16.49
Forfeited (10,418 ) 16.80
Nonvested at September 30, 2017 143,676
$ 17.02

~~(c) Restricted Stock Units~~

For the three and nine months ended September 30, 2017, the Company recognized compensation expense related to restricted stock units of $236,000 and $472,000, respectively, and a related tax benefit of $83,000 and $165,000, respectively. As of September 30, 2017, the total unrecognized compensation expense related to non-vested restricted stock units was $1.8 million and the related weighted average period over which the compensation expense is expected to be recognized is approximately 2.26 years.

~~The following table summarizes the restricted stock unit activity for the nine months ended September 30, 2017:~~

Shares Weighted-Average Grant Date Fair Value
Nonvested at December 31, 2016 —
$ —
Granted 92,019
25.29
Vested —
—
Forfeited (1,812 ) 25.35
Nonvested at September 30, 2017 90,207
$ 25.29

~~The following table summarizes the assumptions used in the Monte Carlo model for restricted stock unit grants with market-based conditions during the nine months ended September 30, 2017:~~

Shares Expected Term in Years Weighted-Average Risk Free Interest Rate Expected Volatility Expected Dividend Yield Weighted-Average Fair Value
6,089 2.85 1.40 % 21.8 % — % $ 24.39

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(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.

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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

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qualifications and licenses have been reviewed and verified by the Company. Once received, the Company reviews the assumptions and approaches utilized in the appraisal as well as the resulting fair value in comparison with independent data sources such as recent market data or industry-wide statistics. On a quarterly basis, the Company compares the actual selling price of collateral that has been liquidated to the most recent appraised value to determine what additional adjustment should be made to the appraisal value to arrive at fair value.

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Derivative Financial Instruments:

The Company obtains 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 ~~September 30, 2017~~March 31, 2018 and December 31, ~~2016~~2017.


	September 30, 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	$	9,403	$	—	$	9,403	$	—	$	23,389	$	—	$	23,389	$	—
Municipal securities	252,806		—		252,806		—		204,292		—		204,292		—
Mortgage-backed securities and collateralized mortgage obligations:
Residential	274,361		—		274,361		—		301,277		—		301,277		—
Commercial	213,283		—		213,283		—		244,360		—		244,360		—
Collateralized loan obligations	6,022		—		6,022		—		3,271		—		3,271		—
Corporate obligations	15,830		—		15,830		—		16,629		—		16,629		—
Other securities	28,355		150		28,205		—
Other asset-backed securities									28,349		—		28,349		—
Total investment securities available for sale	800,060		150		799,910		—		821,567		—		821,567		—
Derivative assets - interest rate swaps	3,308		—		3,308		—		4,793		—		4,793		—
Liabilities
Derivative liabilities - interest rate swaps	$	3,308	$	—	$	3,308	$	—	$	4,793	$	—	$	4,793	$	—

December 31, 2016
Total Level 1 Level 2 Level 3
(In thousands)
Assets
Investment securities available for sale:
U.S. Treasury and U.S. Government-sponsored agencies $ 1,569
$ —
$ 1,569
$ —
Municipal securities 237,256
—
237,256
—
Mortgage-backed securities and collateralized mortgage obligations:
Residential 309,176
—
309,176
—
Commercial 208,318
—
208,318
—
Collateralized loan obligations 10,478
—
10,478
—
Corporate obligations 16,706
—
16,706
—
Other securities 11,142
123
11,019
—
Total investment securities available for sale 794,645
123
794,522
—
Derivative assets - interest rate swaps 2,804
—
2,804
—
Liabilities
Derivative liabilities - interest rate swaps $ 2,804
$ —
$ 2,804
$ —

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	December 31, 2017
	Total		Level 1		Level 2		Level 3
	(In thousands)
Assets
Investment securities available for sale:
U.S. Treasury and U.S. Government-sponsored agencies	$	13,442	$	—	$	13,442	$	—
Municipal securities	250,015		—		250,015		—
Mortgage-backed securities and collateralized mortgage obligations:
Residential	280,211		—		280,211		—
Commercial	217,079		—		217,079		—
Collateralized loan obligations	4,580		—		4,580		—
Corporate obligations	16,770		—		16,770		—
Other securities	28,433		146		28,287		—
Total investment securities available for sale	810,530		146		810,384		—
Derivative assets - interest rate swaps	3,418		—		3,418		—
Liabilities
Derivative liabilities - interest rate swaps	$	3,418	$	—	$	3,418	$	—

There were no transfers between Level 1 and Level 2 during the three ~~and nine~~ months ended ~~September 30, 2017~~March 31, 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.

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The tables below represent assets measured at fair value on a nonrecurring basis at ~~September 30, 2017~~March 31, 2018 and December 31, ~~2016~~2017 and the net losses ~~(gains)~~ recorded in earnings during three ~~and nine~~ months ended ~~September 30, 2017~~March 31, 2018 and ~~2016.~~2017.

Basis⁽¹⁾
Fair Value at September 30, 2017
Total Level 1 Level 2 Level 3
Net Losses
Recorded in
Earnings
During
the Three Months Ended September 30, 2017

Net Losses
(Gains)
Recorded in
Earnings
During
the Nine Months Ended
September 30, 2017
(In thousands)
Impaired loans:
Commercial business:
Commercial and industrial $ 172
$ 163
$ —
$ —
$ 163
$ —
$ 7
Owner-occupied commercial real estate 182
179
—
—
179
—
8
Total commercial business 354
342
—
—
342
—
15
Total assets measured at fair value on a nonrecurring basis $ 354
$ 342
$ —
$ —
$ 342
$ —
$ 15


⁽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 September 30, 2016

Net Losses
(Gains)
Recorded in
Earnings
During
the Nine Months Ended September 30, 2016
(In thousands)
Impaired loans:
Commercial business:
Commercial and industrial $ 205
$ 200
$ —
$ —
$ 200
$ 24
$ 25
Owner-occupied commercial real estate 780
603
—
—
603
23
(2 )
Total commercial business 985
803
—
—
803
47
23
Real estate construction and land development:
One-to-four family residential 828
822
—
—
822
(13 ) (26 )
Total real estate construction and land development 828
822
—
—
822
(13 ) (26 )
Consumer 16
9
—
—
9
—
—
Total assets measured at fair value on a nonrecurring basis $ 1,829
$ 1,634
$ —
$ —
$ 1,634
$ 34
$ (3 )



	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	$	—

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⁽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 ~~September 30, 2017~~March 31, 2018 and December 31, ~~2016~~2017.

September 30, 2017

Fair
Value

Valuation
Technique(s)
Unobservable Input(s)
Range of Inputs; Weighted
Average
(Dollars in thousands)
Impaired loans $ 342
Market approach Adjustment for differences between the comparable sales (23.8%) - 23.0%; (2.8%)



	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%)

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;

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therefore, the results cannot be determined with precision, substantiated by comparison to independent markets and may not be realized in an actual sale or immediate settlement of the instruments. There may be inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results. For all of these reasons, the aggregation of the fair value calculations presented herein do not represent, and should not be construed to represent, the underlying value of the Company.

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


	September 30, 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	$	111,258	$	111,258	$	111,258	$	—	$	—	$	130,309	$	130,309	$	130,309	$	—	$	—
Investment securities available for sale	800,060		800,060		150		799,910		—		821,567		821,567		—		821,567		—
Federal Home Loan Bank stock	9,343		N/A		N/A		N/A		N/A		6,824		N/A		N/A		N/A		N/A
Loans held for sale	5,368		5,553		—		5,553		—		2,669		2,763		—		2,763		—
Total loans receivable, net	2,766,113		2,772,338		—		—		2,772,338		3,248,654		3,240,722		—		—		3,240,722
Accrued interest receivable	12,295		12,295		3		3,770		8,522		13,602		13,602		3		3,698		9,901
Derivative assets - interest rate swaps	3,308		3,308		—		3,308		—		4,793		4,793		—		4,793		—
Equity security											162		162		162		—		—
Financial Liabilities:
Noninterest deposits, interest bearing demand deposits, money market accounts and savings accounts	2,925,637		2,925,637		2,925,637		—		—		3,482,365		3,482,365		3,482,365		—		—
Certificate of deposit accounts	395,181		394,164		—		394,164		—		422,376		425,324		—		425,324		—
Federal Home Loan Bank advances	117,400		117,400		—		117,400		—		30,700		30,700		—		30,700		—
Securities sold under agreement to repurchase	28,668		28,668		28,668		—		—		26,100		26,100		26,100		—		—
Junior subordinated debentures	19,936		15,250		—		—		15,250		20,083		19,500		—		—		19,500
Accrued interest payable	148		148		42		73		33		174		174		42		87		45
Derivative liabilities - interest rate swaps	3,308		3,308		—		3,308		—		4,793		4,793		—		4,793		—

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	December 31, 2017
	Carrying Value		Fair Value		Fair Value Measurements Using:
	Carrying Value		Fair Value		Level 1		Level 2		Level 3
	(In thousands)
Financial Assets:
Cash and cash equivalents	$	103,015	$	103,015	$	103,015	$	—	$	—
Investment securities available for sale	810,530		810,530		146		810,384		—
Federal Home Loan Bank stock	8,347		N/A		N/A		N/A		N/A
Loans held for sale	2,288		2,364		—		2,364		—
Loans receivable, net of allowance for loan losses	2,816,985		2,810,401		—		—		2,810,401
Accrued interest receivable	12,244		12,244		23		3,772		8,449
Derivative assets - interest rate swaps	3,418		3,418		—		3,418		—
Financial Liabilities:
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	398,398		397,039		—		397,039		—
Federal Home Loan Bank advances	92,500		92,500		—		92,500		—
Securities sold under agreement to repurchase	31,821		31,821		31,821		—		—
Junior subordinated debentures	20,009		18,500		—		—		18,500
Accrued interest payable	162		162		45		79		38
Derivative liabilities - interest rate swaps	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 Company issues new shares of common stock to satisfy share option exercises and 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.

(a) Stock Option Awards

Stock options generally vest ratably over three years and expire five years after they become exercisable or vest ratably over four years and expire ten years from date of grant. 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 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 was $24,000 and $21,000, respectively. The intrinsic value and cash proceeds from options exercised during the three months ended March 31, 2017 was $98,000 and $109,000, respectively.

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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

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, 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

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December 31, 2016
Carrying Value Fair Value Fair Value Measurements Using:
Level 1 Level 2 Level 3
(In thousands)
Financial Assets:
Cash and cash equivalents $ 103,745
$ 103,745
$ 103,745
$ —
$ —
Investment securities available for sale 794,645
794,645
123
794,522
—
Federal Home Loan Bank stock 7,564
N/A
N/A
N/A
N/A
Loans held for sale 11,662
11,988
—
11,988
—
Loans receivable, net of allowance for loan losses 2,609,666
2,675,811
—
—
2,675,811
Accrued interest receivable 10,925
10,925
3
3,472
7,450
Derivative assets - interest rate swaps 2,804
2,804
—
2,804
—
Financial Liabilities:
Noninterest deposits, interest bearing demand deposits, money market accounts and savings accounts $ 2,872,247
$ 2,872,247
$ 2,872,247
$ —
$ —
Certificate of deposit accounts 357,401
357,536
—
357,536
—
Federal Home Loan Bank advances 79,600
79,600
—
79,600
—
Securities sold under agreement to repurchase 22,104
22,104
22,104
—
—
Junior subordinated debentures 19,717
15,000
—
—
15,000
Accrued interest payable 215
215
44
142
29
Derivative liabilities - interest rate swaps 2,804
2,804
—
2,804
—

of the grants allow for an actual payout ranging between no payout and 150% of target. The ~~methods and assumptions, not previously presented, used~~payout level is calculated based on actual performance achieved during the performance period compared to ~~estimate fair value are described as follows:~~

~~Cash and Cash Equivalents:~~

a defined peer group. The fair value of ~~financial instruments that are short-term or reprice frequently~~such PRSUs was determined using a Monte Carlo simulation and ~~that have little or no risk are considered to have a~~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 ~~equal~~determination the possibility that the market condition may not be satisfied. Compensation costs related to ~~carrying value (Level 1).~~these awards are recognized regardless of whether the market condition is satisfied, provided that the requisite service has been provided.

~~Federal Home Loan Bank Stock~~:

~~FHLB stock is not publicly traded; thus, it is not practicable~~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 the United States Treasury rate for a term commensurate with the expected life of the grant. The Company used the following assumptions to ~~determine~~estimate the fair value of ~~FHLB stock due~~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 ~~restrictions placed on its transferability.~~

~~Loans Held for Sale~~:

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 expected to be recognized is approximately 2.83 years. The vesting date 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 to~~ the ~~estimated life (Level 3). While these methodologies are permitted under U.S. GAAP, they are not based on~~units that vested during the ~~exit price concept of~~three months ended March 31, 2018 was $711,000. There were no units that vested during the ~~fair value required under FASB ASC 820-10,~~ ~~Fair Value Measurements and Disclosures, and generally produce a higher value.~~

~~Accrued Interest Receivable/Payable~~:three months ended March 31, 2017.

The ~~fair value of accrued interest receivable/payable balances approximates~~following table summarizes the ~~carrying value. The fair value measurements are commensurate with the asset or liability from which the accrued interest is generated (Level 1, Level 2 and Level 3).~~

~~Table of Contents~~

~~Deposits~~:

For deposits with no contractual maturity, the fair value is assumed to equal the carrying value (Level 1). The fair value of certificate of deposit accounts is based on discounted cash flows using the difference between the deposit rate and the rates offered by the Company for deposits of similar remaining maturities (Level 2).

~~Federal Home Loan Bank advances~~:

~~The fair value of FHLB advances is estimated based on discounting the future cash flows using the market rate currently offered (Level 2).~~

~~Securities Sold Under Agreement 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 a fair value equal to carrying value (Level 1).

~~Junior Subordinated Debentures:~~

~~The fair value is estimated using discounted cash flow analysis based on current rates for similar types of debt, which many be unobservable, and considering recent trading~~unit activity ~~of similar instruments in markets which can be inactive (Level 3).~~

~~Off-Balance Sheet Financial Instruments~~:

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


~~(15)~~	~~Commitments and Contingencies~~

In June 2016, 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 related 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 discussions 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. Any such losses would be reported as a noninterest expense in the Company's Consolidated Statement of Income.three months ended March 31, 2018:


~~(16)~~	~~Definitive Agreement~~

On July 26, 2017 the Company announced the execution of a definitive agreement with Puget Sound under which Heritage will acquire Puget Sound in an all-stock transaction valued at approximately $126.1 million based on the closing price of Heritage common stock of $27.15 on July 26, 2017. Puget Sound is a business bank headquartered in Bellevue, Washington with one branch location. Under the terms of the agreement, Puget Sound shareholders will receive 1.320 shares of Heritage common stock for each share of Puget Sound common stock, subject to potential adjustment. The value of the consideration will fluctuate until closing based on the value of Heritage's stock price and may be adjusted by a cap and collar in certain circumstances. The definitive agreement has been unanimously approved by the boards of directors of both Heritage and Puget Sound. The merger is subject to regulatory approvals, approval by Puget Sound shareholders and certain other customary closing conditions and is expected to close in the first quarter of 2018.



	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

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(16)	Cash Requirement

Beginning on January 16, 2018, the Company was required to maintain an average reserve balance with the Federal Reserve Bank or maintain such reserve balance in the form of 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 ~~and nine~~ months ended ~~September 30, 2017.~~March 31, 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.

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 ~~September 30, 2017,~~March 31, 2018, we had total assets of ~~$4.05~~$4.68 billion and total stockholders’ equity of ~~$507.6~~$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. 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 we believe is appropriate to provide for probable incurred credit losses in 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. 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 are the fixed and variable costs of buildings and equipment, and consist primarily of lease payments, 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.

Table of Contents

Earnings Summary

~~Comparison of quarter ended September 30, 2017 to the comparable quarter in the prior year~~

Net income was ~~$10.6~~$9.1 million, or ~~$0.35~~$0.27 per diluted common share, for the three months ended ~~September 30, 2017~~March 31, 2018 compared to ~~$11.0~~$9.3 million, or ~~$0.37~~$0.31 per diluted common share, for the three months ended ~~September 30, 2016. The $415,000,~~March 31, 2017. Net income decreased $229,000, or ~~3.8% decrease in net income~~2.5%, for the three months ended ~~September 30, 2017~~March 31, 2018 compared to the three months ended ~~September 30, 2016 was~~March 31, 2017 primarily ~~the result of a $1.5 million, or 14.9% decrease in noninterest~~

~~Table of Contents~~

~~income and a $1.1 million, or 4.2%~~due to an increase in noninterest expense of $9.5 million, or 35.0%, partially offset by ~~a $1.4 million, or 4.1%,~~an increase in net interest income ~~and a $611,000,~~of $7.8 million, or ~~40.9%, decrease in provision for loan losses.~~23.4%.

Net interest income as a percentage of average interest earning assets (net interest margin) ~~decreased 10~~increased 23 basis points to ~~3.85%~~4.12% for the three months ended ~~September 30, 2017~~March 31, 2018 compared to ~~3.95%~~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 was ~~64.4%~~75.95% for the three months ended ~~September 30, 2017~~March 31, 2018 compared to ~~61.7%~~67.23% for the three months ended ~~September 30, 2016 and the~~March 31, 2017. The change ~~was attributable to the decrease in noninterest income and the increase in noninterest expense.~~

~~Comparison of nine months ended September 30, 2017 to the comparable period in the prior year~~

Net income was $31.8 million, or $1.06 per diluted common share, for the nine months ended September 30, 2017 compared to $29.0 million, or $0.97 per diluted common share, for the nine months ended September 30, 2016. The $2.7 million, or 9.5% increase in net income for the nine months ended September 30, 2017 compared to the nine months ended September 30, 2016 was primarily the result of a $3.0 million, or 12.7%~~increase in noninterest income and a $2.9 million, or 2.9%, increase in net interest income, partially offset by a $3.3 million, or 4.2% increase in noninterest expense.~~

~~The net interest margin decreased 11 basis points to 3.89% for the nine months ended September 30, 2017 compared to 4.00% for the same period in 2016.~~

~~The Company’s efficiency ratio improved to 64.5% for the nine months ended September 30, 2017 from 64.8% for the nine months ended September 30, 2016. The improvement~~ in the efficiency ratio ~~for the nine months ended September 30, 2017 compared to the nine months ended September 30, 2016~~ was primarily attributable to the ~~increases~~increase in noninterest ~~income~~expense as a result of the Puget Sound Merger and ~~net interest income.~~certain acquisition costs.

Net Interest Income

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.

~~Comparison of quarter ended September 30, 2017 to the comparable quarter in the prior year~~

Net interest income increased ~~$1.4~~$7.8 million, or ~~4.1%~~23.4%, to ~~$35.0~~$40.9 million for the three months ended ~~September 30, 2017~~March 31, 2018 compared to ~~$33.6~~$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.

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	Three Months Ended September 30,												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)}	$	2,737,535	$	32,595	4.72	%	$	2,526,150	$	30,915	4.87	%	$	3,150,869	$	38,159	4.91	%	$	2,631,816	$	30,485	4.70	%
Taxable securities	562,256		3,117		2.20		588,749		2,888		1.95		599,015		3,529		2.39		567,318		3,049		2.18
Nontaxable securities ⁽³⁾	229,683		1,354		2.34		225,994		1,235		2.17		223,631		1,341		2.43		222,266		1,268		2.31
Other interest earning assets	72,643		258		1.41		42,934		76		0.70		52,123		299		2.33		31,721		61		0.78
Total interest earning assets	3,602,117		37,324		4.11	%	3,383,827		35,114		4.13	%	4,025,638		43,328		4.37	%	3,453,121		34,863		4.09	%
Noninterest earning assets	418,100						408,634						527,947						426,777
Total assets	$	4,020,217					$	3,792,461					$	4,553,585					$	3,879,898
Interest Bearing Liabilities:
Certificates of deposit	$	394,345	$	633	0.64	%	$	378,407	$	468	0.49	%	$	423,569	$	760	0.73	%	$	351,300	$	416	0.48	%
Savings accounts	494,990		360		0.29		507,523		214		0.17		506,158		416		0.33		506,159		264		0.21
Interest bearing demand and money market accounts	1,499,335		635		0.17		1,480,220		587		0.16		1,745,795		784		0.18		1,483,168		586		0.16
Total interest bearing deposits	2,388,670		1,628		0.27		2,366,150		1,269		0.21		2,675,522		1,960		0.30		2,340,627		1,266		0.22
FHLB advances and other borrowings	111,293		428		1.53		5,618		8		0.57		35,733		150		1.70		101,130		203		0.81
Securities sold under agreement to repurchase	28,999		16		0.22		18,861		10		0.21		30,265		17		0.23		19,019		10		0.21
Junior subordinated debentures	19,897		261		5.20		19,602		221		4.49		20,035		283		5.73		19,750		238		4.89
Total interest bearing liabilities	2,548,859		2,333		0.36	%	2,410,231		1,508		0.25	%	2,761,555		2,410		0.35	%	2,480,526		1,717		0.28	%
Demand and other noninterest bearing deposits	916,074						844,468						1,113,286						866,469
Other noninterest bearing liabilities	50,022						44,378						63,770						47,213
Stockholders’ equity	505,262						493,384						614,974						485,690
Total liabilities and stockholders’ equity	$	4,020,217					$	3,792,461					$	4,553,585					$	3,879,898
Net interest income			$	34,991					$	33,606					$	40,918					$	33,146
Net interest spread					3.75	%					3.88	%					4.02	%					3.81	%
Net interest margin					3.85	%					3.95	%					4.12	%					3.89	%
Average interest earning assets to average interest bearing liabilities					141.32	%					140.39	%					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.

Interest Income

Total interest income increased ~~$2.2~~$8.5 million, or ~~6.3%~~24.3%, to ~~$37.3~~$43.3 million for the three months ended ~~September 30, 2017~~March 31, 2018 compared to ~~$35.1~~$34.9 million for the same period in ~~2016.~~2017. The balance of average interest earning assets increased ~~$218.3~~$572.5 million, or ~~6.5%~~16.6%, to ~~$3.60~~$4.03 billion for the three months ended ~~September 30, 2017~~March 31, 2018 from ~~$3.38~~$3.45 billion for the three months ended ~~September 30, 2016~~March 31, 2017 and the ~~average~~ yield on total interest earning assets ~~decreased two~~increased 28 basis points to ~~4.11%~~4.37% for the three months ended ~~September 30, 2017~~March 31, 2018 compared to ~~4.13%~~4.09% for the three months ended ~~September 30, 2016.~~March 31, 2017.

Interest income from interest and fees on loans increased ~~$1.7~~$7.7 million, or ~~5.4%~~25.2%, to ~~$32.6~~$38.2 million for the three months ended ~~September 30, 2017~~March 31, 2018 from ~~$30.9~~$30.5 million for the same period in ~~2016~~2017 primarily due to an increase in average loans receivable of ~~$211.4~~$519.1 million, or ~~8.4%~~19.7%, as a result of loan growth ~~offset partially by a 15 basis point decrease in~~which was substantially due to the ~~average~~Puget Sound Merger. The loan yield increased 21 basis points to ~~4.72%~~4.91% for the three months ended ~~September 30, 2017~~March 31, 2018 from ~~4.87%~~4.70% for the three months ended ~~September 30, 2016.~~March 31, 2017. The ~~decrease~~increase in ~~average~~ loan yield was due ~~primarily~~ to a ~~decrease~~combination of higher contractual note rates as a result of 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 ~~income~~ on purchased loans ~~and secondarily to a decrease~~substantially due from loans acquired in ~~contractual note rates.~~the Puget Sound Merger.

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The following table presents the ~~average~~ loan yield and effects of the incremental accretion on purchased loans for the three months ended ~~September 30, 2017~~March 31, 2018 and ~~2016:~~2017:

Three Months Ended September 30,
2017 2016
(Dollars in thousands)
Average loan yield, excluding incremental accretion on purchased loans ⁽¹⁾
4.57 % 4.63 %
Impact on average loan yield from incremental accretion on purchased loans (1) 0.15 % 0.24 %
Average loan yield 4.72 % 4.87 %

Incremental accretion on purchased loans ⁽¹⁾
$ 1,036
$ 1,530



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

Incremental accretion on purchased loans ⁽¹⁾	$	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 ~~$1.0~~$1.6 million and ~~$1.5~~$1.2 million for the three months ended ~~September 30,~~March 31, 2018 and 2017, ~~and 2016,~~ respectively. The ~~decrease~~increase in the incremental accretion was primarily due to the accretion of the loans acquired in the Puget Sound Merger totaling approximately $479,000 during the three months ended March 31, 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 ~~a continued decline in the purchased loan balances and a decrease in the prepayments~~unanticipated pay-offs of ~~purchased~~three significant loans during the three months ended ~~September 30, 2017 compared to the same period in 2016.~~March 31, 2018. The incremental accretion and the impact to loan yield will change during any quarter based on the volume of prepayments, but is expected to ~~continue to~~ decrease over time as the balance of the purchased 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 ~~$348,000,~~$553,000, or ~~8.4%~~12.8%, increase in interest income on investment securities to ~~$4.5~~$4.9 million during the three months ended ~~September 30, 2017~~March 31, 2018 from ~~$4.1~~$4.3 million for the three months ended ~~September 30, 2016.~~March 31, 2017. The increase in income on investment securities was a result of an increase in ~~average~~ 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 ~~September 30, 2017~~March 31, 2018 compared to the same period in ~~2016, offset partially by a decrease in the average balance of investment securities. Average yields~~2017. Yields on taxable securities increased 2521 basis points to ~~2.20%~~2.39% for the three months ended ~~September 30, 2017~~March 31, 2018 from ~~1.95%~~2.18% for the same period in ~~2016. Average yields~~2017. Yields on nontaxable securities increased 1712 basis points to ~~2.34%~~2.43% for the three months ended ~~September 30, 2017~~March 31, 2018 from ~~2.17%~~2.31% for the same period in ~~2016.~~2017. The average balance of investment securities ~~decreased $22.8~~increased $33.1 million, or ~~2.8%~~4.2%, to ~~$791.9~~$822.6 million during the three months ended ~~September 30, 2017~~March 31, 2018 from ~~$814.7~~$789.6 million during the three months ended ~~September 30, 2016.~~March 31, 2017. The Company has actively managed its investment securities portfolio to ~~mitigate declining trends~~improve performance in ~~loan yields.~~an increasing rate environment.

Average other interest earning assets increased ~~$29.7~~$20.4 million, or ~~69.2%~~64.3%, to ~~$72.6~~$52.1 million for the three months ended ~~September 30, 2017~~March 31, 2018 compared to ~~$42.9~~$31.7 million for the three months ended ~~September 30, 2016.~~March 31, 2017. The increase was due ~~primarily~~ 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 ~~of San Francisco~~ compared to the same period in 2017, substantially due to the ~~prior year.~~Puget Sound Merger, and an increase in the yields reflecting the risk in interest rates.

Interest Expense

Total interest expense increased ~~$825,000,~~$693,000, or ~~54.7%~~40.4%, to ~~$2.3~~$2.4 million for the three months ended ~~September 30, 2017~~March 31, 2018 compared to ~~$1.5~~$1.7 million for the same period in ~~2016.~~2017. The average cost of interest bearing liabilities increased 11seven basis points to ~~0.36%~~0.35% for the three months ended ~~September 30, 2017~~March 31, 2018 from ~~0.25%~~0.28% for the three months ended ~~September 30, 2016~~March 31, 2017 as a result of ~~increases~~the rise in market rates. Total average interest bearing liabilities increased ~~by $138.6~~$281.0 million, or ~~5.8%~~11.3%, to ~~$2.55~~$2.76 billion for the three months ended ~~September 30, 2017~~March 31, 2018 from ~~$2.41~~$2.48 billion for the three months ended ~~September 30, 2016.~~March 31, 2017 substantially due to the Puget Sound Merger.

The average cost of interest bearing deposits increased ~~six~~eight basis points to ~~0.27%~~0.30% for the three months ended ~~September 30, 2017~~March 31, 2018 from ~~0.21%~~0.22% for the same period in ~~2016~~2017 primarily as a result of ~~increases in both~~ the ~~average balance and cost of certificates of deposit and an~~ increase in ~~the average cost of savings accounts.~~

Interest expense on certificates of deposit increased $165,000, or 35.3%, to $633,000 during the three months ended September 30, 2017 from $468,000 for the same period in 2016 due to increases in the average balance and the cost of the certificates of deposits accounts.market rates. The average balance of ~~certificates of~~interest bearing demand and money market deposits increased ~~$15.9~~$262.6 million, or ~~4.2%~~17.7%, ~~to $394.3 million,~~ for the three months ended ~~September 30,~~March 31, 2018 to $1.75 billion at March 31, 2018 from $1.48 billion at December 31, 2017 ~~from $378.4 million for~~primarily as a result of the ~~same period in 2016.~~Puget Sound Merger. The cost of certificates of deposits increased 1525 basis points to ~~0.64% for the three months ended September 30, 2017 from 0.49% for the same period in 2016.~~0.73%

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~~Interest expense on savings accounts increased $146,000, or 68.2%, to $360,000 during~~for the three months ended ~~September 30, 2017~~March 31, 2018 from ~~$214,000~~0.48% for the same period in ~~2016 due~~2017 primarily ~~to the 12 basis point increase~~as a result of the ~~cost of the savings accounts to 0.29% for the three months ended September 30, 2017 from 0.17% for the same period~~rise in ~~2016.~~interest rates.

Interest expense on FHLB advances and other borrowings ~~increased $420,000,~~decreased $53,000, or ~~52.5%~~26.1%, to ~~$428,000~~$150,000 for the three months ended ~~September 30,~~March 31, 2018 from ~~$8,000~~$203,000 for the same period in ~~2016~~2017 due to a ~~combination of~~decrease in the average balance, partially offset by an increase in ~~both average balances and cost of funds.~~rates. The average balance for FHLB advances and other borrowings ~~increased $105.7~~decreased $65.4 million, or ~~1,881.0%~~64.7%, to ~~$111.3~~$35.7 million for the three months ended ~~September 30, 2017~~March 31, 2018 from ~~$5.6~~$101.1 million for the same period in ~~2016, due primarily to fund loan growth. The average rate~~2017, as a result of pay downs from using cash and cash proceeds from the ~~FHLB advances for~~sale of investment securities acquired in the three months ended September 30, 2017 was 1.53%, an increase of 96 basis points from 0.57% for the same period in 2016, due primarily to continued increases in short-term borrowing rates over the last year.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 ~~September 30, 2017~~March 31, 2018 was ~~5.20%~~5.73%, an increase of 7184 basis points from ~~4.49%~~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 ~~1.33%~~2.32% at ~~September 30, 2017~~March 31, 2018 from ~~0.85%~~1.15% on ~~September 30, 2016.~~March 31, 2017.

Net Interest Margin

Net interest margin increased 23 basis points for the three months ended ~~September 30, 2017 decreased ten basis points~~March 31, 2018 to ~~3.85%~~4.12% from ~~3.95%~~3.89% for the same period in ~~2016 primarily due to the decline in the incremental accretion on purchased loans, as discussed below. The net interest spread for the three months ended September 30,~~ 2017 ~~decreased 13 basis points to 3.75% from 3.88% for the same period in 2016. The decrease was~~ primarily due to the above mentioned ~~increases~~increase in net interest income. The net interest spread increased 21 basis points for the ~~cost of funds of~~three months ended March 31, 2018 to 4.02% from 3.81% for the same period in 2017 primarily due to the increase in yields on total interest ~~bearing liabilities.~~earning 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 ~~September 30, 2017~~March 31, 2018 and ~~2016:~~2017:

Three Months Ended September 30,
2017 2016
Net interest margin, excluding incremental accretion on purchased loans ⁽¹⁾
3.74 % 3.77 %
Impact on net interest margin from incremental accretion on purchased loans ⁽¹⁾
0.11
0.18
Net interest margin 3.85 % 3.95 %

⁽¹⁾

~~Comparison of nine months ended September 30, 2017 to the comparable period in the prior year~~

Net interest income increased $2.9 million, or 2.9%, to $102.3 million for the nine months ended September 30, 2017 compared to $99.5 million for the same period in 2016. The following table provides relevant net interest income information for the dates indicated.

~~Table of Contents~~

Nine Months Ended September 30,
2017 2016

Average
Balance

Interest
Earned/
Paid

Average
Yield/
Rate (1)

Average
Balance

Interest
Earned/
Paid
Average
Yield/
Rate (1)
(Dollars in thousands)
Interest Earning Assets:
Total loans receivable, net (2) (3) $ 2,676,153
$ 94,580
4.73 % $ 2,461,856
$ 91,595
4.97 %
Taxable securities 565,528
9,307
2.20
594,301
8,522
1.92
Nontaxable securities (3) 225,583
3,926
2.33
220,038
3,599
2.18
Other interest earning assets 51,049
461
1.21
47,829
225
0.63
Total interest earning assets 3,518,313
108,274
4.11 % 3,324,024
103,941
4.18 %
Noninterest earning assets 418,837
391,342

Total assets $ 3,937,150
$ 3,715,366

Interest Bearing Liabilities:
Certificates of deposit $ 369,724
$ 1,527
0.55 % $ 397,070
$ 1,496
0.50 %
Savings accounts 499,353
940
0.25
478,762
540
0.15
Interest bearing demand and money market accounts 1,489,149
1,834
0.16
1,457,399
1,729
0.16
Total interest bearing deposits 2,358,226
4,301
0.24
2,333,231
3,765
0.22
FHLB advances and other borrowings 106,556
870
1.09
11,608
47
0.54
Securities sold under agreement to repurchase 23,660
38
0.21
20,031
31
0.21
Junior subordinated debentures 19,823
748
5.05
19,527
647
4.43
Total interest bearing liabilities 2,508,265
5,957
0.32 % 2,384,397
4,490
0.25 %
Demand and other noninterest bearing deposits 885,467
811,043

Other noninterest bearing liabilities 47,283
35,266

Stockholders’ equity 496,135
484,660

Total liabilities and stockholders’ equity $ 3,937,150
$ 3,715,366

Net interest income $ 102,317
$ 99,451

Net interest spread 3.79 % 3.93 %
Net interest margin 3.89 % 4.00 %
Average interest earning assets to average interest bearing liabilities 140.27 % 139.41 %


⁽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.~~

~~Interest Income~~

Total interest income increased $4.3 million, or 4.2%, to $108.3 million for the nine months ended September 30, 2017 compared to $103.9 million for the same period in 2016. The balance of average interest earning assets increased $194.3 million, or 5.8%, to $3.52 billion for the nine months ended September 30, 2017 from $3.32 billion for the nine months ended September 30, 2016 and the yield on total interest earning assets decreased seven basis points to 4.11% for the nine months ended September 30, 2017 compared to 4.18% for the nine months ended September 30, 2016.

Interest income from interest and fees on loans increased $3.0 million, or 3.3%, to $94.6 million for the nine months ended September 30, 2017 from $91.6 million for the same period in 2016 due primarily to an increase in average loans receivable, offset partially by a decrease in average loan yields. Average loans receivable increased $214.3 million, or 8.7%, to $2.68 billion for the nine months ended September 30, 2017 compared to $2.46 billion for the nine months ended September 30, 2016. Average loan yields decreased 24 basis points to 4.73% for the nine months ended September 30, 2017 from 4.97% for the nine months ended September 30, 2016 due mostly to a decrease in incremental accretion income.

~~Table of Contents~~

~~The following table presents the average loan yield and effects of the incremental accretion on purchased loans for the nine months ended September 30, 2017 and 2016:~~

Nine Months Ended September 30,
2017 2016
(Dollars in thousands)
Average loan yield, excluding incremental accretion on purchased loans ⁽¹⁾
4.55 % 4.66 %
Impact on average loan yield from incremental accretion on purchased loans (1) 0.18 % 0.31 %
Average loan yield 4.73 % 4.97 %

Incremental accretion on purchased loans ⁽¹⁾
$ 3,687
$ 5,669

⁽¹⁾

Incremental accretion income was $3.7 million and $5.7 million for the nine months ended September 30, 2017 and 2016, respectively. The decrease in the incremental accretion was primarily a result of a continued decline in the purchased loan balances and a decrease in the prepayments of purchased loans during the nine months ended September 30, 2017 compared to the same period in 2016. The incremental accretion is expected to continue to decrease as the balance of the purchased 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 $1.1 million, or 9.2%, increase in interest income on investment securities to $13.2 million during the nine months ended September 30, 2017 from $12.1 million for the nine months ended September 30, 2016. The increase in interest income on investment securities was the result of an increase in average investment yields for the nine months ended September 30, 2017 compared to the same period in 2016, offset partially by a decrease in the average balance of investment securities. Average yields on taxable securities increased 28 basis points to 2.20% for the nine months ended September 30, 2017 from 1.92% for the same period in 2016. Average yields on nontaxable securities increased 15 basis points to 2.33% for the nine months ended September 30, 2017 from 2.18% for the same period in 2016. The average balance of investment securities decreased $23.2 million, or 2.9%, to $791.1 million during the nine months ended September 30, 2017 from $814.3 million during the nine months ended September 30, 2016. The Company has actively managed its investment securities portfolio to mitigate declining, but recently improving, loan yields.

Average other interest earning assets increased $3.2 million, or 6.7%, to $51.0 million for the nine months ended September 30, 2017 compared to $47.8 million for the nine months ended September 30, 2016. The increase was due primarily to an increase in interest earning deposits, as the Bank held more funds in interest earning accounts at the Federal Reserve Bank of San Francisco compared to the same period in 2016.

~~Interest Expense~~

Total interest expense increased $1.5 million, or 32.7%, to $6.0 million for the nine months ended September 30, 2017 compared to $4.5 million for the same period in 2016. The average cost of interest bearing liabilities increased seven basis points to 0.32% for the nine months ended September 30, 2017 from 0.25% for the nine months ended September 30, 2016. Total average interest bearing liabilities increased by $123.9 million, or 5.2%, to $2.51 billion for the nine months ended September 30, 2017 from $2.38 billion for the nine months ended September 30, 2016.

The average cost of interest bearing deposits increased two basis points to 0.24% for the nine months ended September 30, 2017 from 0.22% for the same period in 2016 due primarily to the changes in savings accounts.

Interest expense on savings accounts increased $400,000, or 74.1%, to $940,000 for the nine months ended September 30, 2017 from $540,000 for the same period in 2016 due to increases in both the average balance and cost of the savings accounts. The average balance of savings accounts increased $20.6 million, or 4.3%, to $499.4 million for the nine months ended September 30, 2017 from $478.8 million for the same period in 2016. The cost of savings accounts increased ten basis points to 0.25% for the nine months ended September 30, 2017 from 0.15% for the same period in 2016.

Interest expense of certificates of deposit accounts increased only $31,000, or 2.1%, to $1.5 million for the nine months ended September 30, 2017. The average balance of certificates of deposit decreased $27.3 million, or

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6.9%, to $369.7 million for the nine months ended September 30, 2017 compared to $397.1 million for the nine months ended September 30, 2016 while the cost of certificates of deposits increased to 0.55% for the nine months ended September 30, 2017 from 0.50% for the same period in 2016.

Interest expense on FHLB advances and other borrowings increased $823,000 to $870,000 for the nine months ended September 30, 2017 from $47,000 for the nine months ended September 30, 2016 due to a combination of an increase in average balances and an increase in the cost of funds. The average balance for FHLB advances and other borrowings increased $94.9 million to $106.6 million for the nine months ended September 30, 2017 from $11.6 million for the same period in 2016, due primarily to fund loan growth. The average rate of the FHLB advances and other borrowings for the nine months ended September 30, 2017 was 1.09%, an increase of 55 basis points from 0.54% for the same period in 2016.

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 nine months ended September 30, 2017 was 5.05%, an increase of 62 basis points from 4.43% for the same period in 2016. The rate increase on the debentures was due to an increase in the three-month LIBOR rate to 1.33% at September 30, 2017 from 0.85% on September 30, 2016.

~~Net Interest Margin~~

Net interest margin for the nine months ended September 30, 2017 decreased 11 basis points to 3.89% from 4.00% for the same period in 2016 primarily due to the decline in the incremental accretion on purchased loans, as discussed below. The net interest spread for the nine months ended September 30, 2017 decreased 14 basis points to 3.79% from 3.93% for the same period in 2016. This decrease was primarily due to the above mentioned decrease in average yields on total interest earning assets and increase in the average cost of funds of total interest bearing liabilities.


	Nine Months Ended September 30,				Three Months Ended March 31,
	2017		2016		2018		2017
Net interest margin, excluding incremental accretion on purchased loans ⁽¹⁾	3.75	%	3.77	%	3.96	%	3.75	%
Impact on net interest margin from incremental accretion on purchased loans ⁽¹⁾	0.14		0.23		0.16		0.14
Net interest margin	3.89	%	4.00	%	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, 2018 and 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.

~~Comparison of quarter ended September 30, 2017 to the comparable quarter in the prior year~~

The provision for loan losses ~~decreased $611,000,~~increased $285,000, or ~~40.9%~~32.9%, to ~~$884,000~~$1.2 million for the three months ended ~~September 30, 2017~~March 31, 2018 from ~~$1.5 million~~$867,000 for the three months ended ~~September 30, 2016.~~March 31, 2017. The ~~decrease~~increase in the provision for loan losses for the three months ended ~~September 30, 2017~~March 31, 2018 from the same period in ~~2016~~2017 was primarily the result of ~~a change in the composition of the loan portfolio,~~ changes in ~~certain environmental factors and improvements in certain historical loss factors. Based on a thorough review of the loan portfolio, the Bank determined that the provision for~~

~~Table of Contents~~

~~loan losses for the three months ended September 30, 2017 was appropriate as it was calculated in accordance with the Bank's methodology for determining the allowance for loan losses.~~

~~Comparison of nine months ended September 30, 2017 to the comparable period in the prior year~~

The provision for loan losses decreased $872,000, or 23.2% to $2.9 million for the nine months ended September 30, 2017 from $3.8 million for the nine months ended September 30, 2016. The decrease in the provision for loan losses for the nine months ended September 30, 2017 from the same period in 2016 was primarily the result of a change in theour asset quality, volume and mix of loans, ~~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 ~~nine~~three months ended ~~September 30, 2017~~March 31, 2018 was appropriate as it was calculated in accordance with the Bank's methodology for determining the allowance for loan losses.

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Noninterest Income

~~Comparison of quarter ended September 30, 2017 to the comparable quarter in the prior year~~

Total noninterest income ~~decreased $1.5 million,~~increased $118,000, or ~~14.9%~~1.6%, to ~~$8.4~~$7.5 million for the three months ended ~~September 30, 2017~~March 31, 2018 compared to ~~$9.9~~$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 September 30,									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	$	4,769	$	3,630	$	1,139		31.4	%	$	4,543	$	4,213	$	330		7.8	%
Gain on sale of investment securities, net	44		345		(301		)	(87.2	)	35		—		35			100.0
Gain on sale of loans, net	1,229		3,435		(2,206		)	(64.2	)	874		1,195		(321		)	(26.9	)
Interest rate swap fees	328		742		(414		)	(55.8	)	51		133		(82		)	(61.7	)
Other income	2,024		1,715		309			18.0		1,964		1,808		156			8.6
Total noninterest income	$	8,394	$	9,867	$	(1,473	)	(14.9	)%	$	7,467	$	7,349	$	118		1.6	%

~~Gain on the sale of loans, net decreased $2.2 million,~~Service charges and other fees increased $330,000, or ~~64.2%~~7.8% to ~~$1.2~~$4.5 million for the three months ended ~~September 30, 2017~~March 31, 2018 compared to $3.4 million the same period in 2016, due primarily to a $2.1 million gain on sale of a previously classified purchased credit impaired loan recognized in 2016. The detail of gain on sale of loans, net is included in the following schedule.

Three Months Ended September 30,
2017 2016 Change Percentage Change
(Dollars in thousands)
Mortgage loans $ 875
$ 1,087
$ (212 ) (19.5 )%
SBA loans 354
285
69
24.2
Other loans —
2,063
(2,063 ) (100.0 )
Total gain on sale of loans, net $ 1,229
$ 3,435
$ (2,206 ) (64.2 )%

Interest rate swap fees decreased $414,000, or 55.8% to $328,000 for the three months ended September 30, 2017 compared to $742,000 the same period in 2016, due primarily to a decrease in the number of swaps executed during the three months ended September 30, 2017 compared to the three months ended September 30, 2016.

The decrease in noninterest income was partially offset by an increase in service charges and other fees of $1.1 million, or 31.4% to $4.8 million for the three months ended September 30, 2017 compared to $3.6$4.2 million for the same period in ~~2016,~~2017, due primarily to an increase in deposit balances and changes in fee structures on deposit 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~~2017. Secondarily, service charges and other fees increased as a result of the ~~related changes~~Puget Sound Merger.

The increase in ~~fee structures, as well as increases~~noninterest income was offset by a decrease in ~~deposit balances.~~

~~Table~~gain on the sale of ~~Contents~~

~~Comparison~~loans, net of ~~nine~~$321,000, or 26.9%, to $874,000 for the three months ended ~~September 30, 2017~~March 31, 2018 compared to $1.2 million the ~~comparable~~same period in ~~the prior year~~

~~Total noninterest income increased $3.0~~2017, due primarily to a decrease in mortgage banking activities. Proceeds from sale of loans decreased $15.3 million, or ~~12.7%,~~42.6% to ~~$26.4~~$20.7 million for the ~~nine~~three months ended ~~September 30, 2017 compared to $23.4~~March 31, 2018 from $35.7 million for the same period in ~~2016. The following table presents the change in the key components of noninterest income for the periods noted.~~

Nine Months Ended September 30,
2017 2016 Change Percentage Change
(Dollars in thousands)
Service charges and other fees $ 13,408
$ 10,462
$ 2,946
28.2 %
Gain on sale of investment securities, net 161
1,106
(945 ) (85.4 )
Gain on sale of loans, net 6,562
5,406
1,156
21.4
Interest rate swap fees 743
1,105
(362 ) (32.8 )
Other income 5,532
5,354
178
3.3
Total noninterest income $ 26,406
$ 23,433
$ 2,973
12.7 %

Service charges and other fees increased $2.9 million, or 28.2% to $13.4 million for the nine months ended September 30, 2017 compared to $10.5 million for the same period in 2016, due primarily to a consumer deposit account consolidation process completed at the end of 2016 and a business deposit consolidation process completed during second quarter 2017 and the related changes in fee structures, as well as increases in deposit balances.

Gain on sale of loans, net increased $1.2 million, or 21.4% to $6.6 million for the nine months ended September 30, 2017 compared to $5.4 million for the same period in 2016, due primarily to a $935,000 increase in sale of other loans. During each of the nine months ended September 30, 2017 and 2016, the Bank sold one loan previously classified as purchased credit impaired. In addition, gain on sale of SBA loans increased $272,000 due primarily to an increase in proceeds from sale of SBA loans of $7.8 million, or 90.9%, to $16.4 million for the nine months ended September 30, 2017 compared to $8.6 million for the same period in 2016.2017. The detail of gain on sale of loans, net is included in the following schedule.

Nine Months Ended September 30,
2017 2016 Change Percentage Change
(Dollars in thousands)
Mortgage loans $ 2,515
$ 2,566
$ (51 ) (2.0 )%
SBA loans 1,049
777
272
35.0
Other loans 2,998
2,063
935
45.3
Total gain on sale of loans, net $ 6,562
$ 5,406
$ 1,156
21.4 %

The increase in noninterest income was partially offset by a decrease in gain on sale of investment securities, net of $945,000, or 85.4%, to $161,000 for the nine months ended September 30, 2017 from $1.1 million for the nine months ended September 30, 2016. The decrease was primarily the result of fewer sales as the Bank actively managed its investment portfolio. The proceeds from sale of investment securities was $21.9 million for the nine months ended September 30, 2017 compared to $94.4 million for the same period in 2016.

~~Noninterest Expense~~

~~Comparison of quarter ended September 30, 2017 to the comparable quarter in the prior year~~

Noninterest expense increased $1.1 million, or 4.2%, to $28.0 million during the three months ended September 30, 2017 compared to $26.8 million for the three months ended September 30, 2016. The following table presents changes in the key components of noninterest expense for the periods noted.



	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	)%

5651

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Noninterest Expense

Three Months Ended September 30,
2017 2016 Change Percentage Change
(Dollars in thousands)
Compensation and employee benefits $ 15,823
$ 15,633
$ 190
1.2 %
Occupancy and equipment 3,979
3,926
53
1.3
Data processing 2,090
1,943
147
7.6
Marketing 933
745
188
25.2
Professional services 1,453
830
623
75.1
State and local taxes 640
820
(180 ) (22.0 )
Federal deposit insurance premium 433
296
137
46.3
Other real estate owned, net (88 ) (142 ) 54
(38.0 )
Amortization of intangible assets 319
359
(40 ) (11.1 )
Other expense 2,373
2,408
(35 ) (1.5 )
Total noninterest expense $ 27,955
$ 26,818
$ 1,137
4.2 %

~~Professional services~~Noninterest expense increased ~~$623,000,~~$9.5 million, or ~~75.1%~~35.0%, to ~~$1.5~~$36.7 million during the three months ended ~~September 30, 2017 from $830,000 during the three months ended September 30, 2016. The increase in the three months ended September 30, 2017~~March 31, 2018 compared to the same period in 2016 was primarily due to legal costs incurred for our pending merger with Puget Sound as discussed in Note (16) Definitive Agreement as well as benefit-based consulting fees related to the consumer and business deposit account consolidation processes, which correspondingly generated an increase in service charges and other fees.

~~Compensation and employee benefits increased $190,000, or 1.2%, to $15.8~~$27.2 million during the three months ended September 30, 2017 from $15.6 million during the three months ended September 30, 2016. The increase in the three months ended September 30, 2017 compared to the same period in 2016 was primarily due to senior level staffing increases and standard salary increases.

~~The ratio of noninterest expense to average assets (annualized) was 2.76%~~ for the three months ended September 30, 2017 compared to 2.81% for the three months ended September 30, 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.

~~Comparison of nine months ended September 30, 2017 to the comparable period in the prior year~~

~~Noninterest expense increased $3.3 million, or 4.2%, to $83.0 million during the nine months ended September 30, 2017 compared to $79.7 million for the nine months ended September 30, 2016.~~March 31, 2017. The following table presents changes in the key components of noninterest expense for the periods noted.

Nine Months Ended September 30,
2017 2016 Change Percentage Change
(Dollars in thousands)
Compensation and employee benefits $ 48,119
$ 45,652
$ 2,467
5.4 %
Occupancy and equipment 11,607
11,873
(266 ) (2.2 )
Data processing 6,007
5,564
443
8.0
Marketing 2,545
2,254
291
12.9
Professional services 3,515
2,508
1,007
40.2
State and local taxes 1,828
2,031
(203 ) (10.0 )
Federal deposit insurance premium 1,090
1,316
(226 ) (17.2 )
Other real estate owned, net (36 ) 330
(366 ) (110.9 )
Amortization of intangible assets 966
1,057
(91 ) (8.6 )
Other expense 7,346
7,079
267
3.8
Total noninterest expense $ 82,987
$ 79,664
$ 3,323
4.2 %

~~Table of Contents~~



	Three Months Ended March 31,
	2018		2017		Change			Percentage Change
	(Dollars in thousands)
Compensation and employee benefits	$	21,367	$	16,024	$	5,343		33.3	%
Occupancy and equipment	4,627		3,810		817			21.4
Data processing	2,605		1,915		690			36.0
Marketing	808		807		1			0.1
Professional services	2,837		1,009		1,828			181.2
State and local taxes	688		549		139			25.3
Federal deposit insurance premium	355		300		55			18.3
Other real estate owned, net	—		31		(31		)	(100.0	)
Amortization of intangible assets	795		324		471			145.4
Other expense	2,665		2,454		211			8.6
Total noninterest expense	$	36,747	$	27,223	$	9,524		35.0	%

Compensation and employee benefits increased ~~$2.5~~$5.3 million, or ~~5.4%~~33.3%, to ~~$48.1~~$21.4 million during the ~~nine~~three months ended ~~September 30, 2017~~March 31, 2018 from ~~$45.7~~$16.0 million during the ~~nine~~three months ended ~~September 30, 2016.~~March 31, 2017. The increase in the ~~nine~~three months ended ~~September 30,~~March 31, 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~~2017.

Professional services increased $1.8 million, or 181.2%, to $2.8 million during the three months ended March 31, 2018 from $1.0 million during the three months ended March 31, 2017. The increase in the three months ended March 31, 2018 compared to 2017 was primarily due to ~~senior level staffing increases, including~~costs of approximately $1.6 million incurred for the ~~addition of~~Puget Sound Merger and the ~~new Portland, Oregon lending team members who started in May 2017,~~proposed Premier Merger during the three months ended March 31, 2018.

Occupancy and ~~standard salary increases.~~

~~Professional services~~equipment increased ~~$1.0 million,~~$817,000, or ~~40.2%~~21.4%, to ~~$3.5~~$4.6 million during the ~~nine~~three months ended ~~September 30, 2017~~March 31, 2018 from ~~$2.5~~$3.8 million during the ~~nine~~three months ended ~~September 30, 2016.~~March 31, 2017. The increase in the ~~nine~~three months ended ~~September 30, 2017~~March 31, 2018 compared to ~~the same period in 2016~~2017 was ~~primarily due to due to benefit-based consulting fees~~substantially related to the consumer deposit account consolidation process, which correspondingly generated an increase in service charges and other fees. Professional services also increased as a result of Trust-related expenses based on a renegotiated contract for 2017, which also increased other noninterest income, and legalon-going costs ~~incurred for our pending merger~~associated with the Puget Sound ~~as discussed in Note (16) Definitive Agreement.~~Merger.

Data processing increased ~~$443,000,~~$690,000, or ~~8.0%~~36.0%, to ~~$6.0~~$2.6 million during the ~~nine~~three months ended ~~September 30, 2017~~March 31, 2018 from ~~$5.6~~$1.9 million during the ~~nine~~three months ended ~~September 30, 2016 primarily~~March 31, 2017. The increase in the three months ended March 31, 2018 compared to 2017 was substantially due to ~~higher transactional activity~~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 ~~core operating system and internet banking as~~three months ended March 31, 2018 compared to 2017 was a result of the ~~growth~~amortization of the core deposit intangible recorded in ~~loans and deposits..~~

~~Other real estate owned, net decreased $366,000 or 110.9%, to income~~the Puget Sound Merger of ~~$36,000~~$513,000 during the ~~nine~~three months ended September 30, 2017 compared to expense of $330,000 during the nine months ended September 30, 2016. The income recorded during the nine months ended September 30, 2017 was due to gain on sale of properties of $111,000, offset by maintenance expense of $75,000. For the nine months ended September 30, 2016, the Bank recorded a valuation adjustment of $383,000 and maintenance expense of $120,000, which was offset by the gain on sale of properties of $173,000.March 31, 2018.

The ratio of noninterest expense to average assets (annualized) was ~~2.82%~~3.27% for the ~~nine~~three months ended ~~September 30, 2017,~~March 31, 2018 compared to ~~2.86%~~2.85% for the ~~nine~~three months ended ~~September 30, 2016.~~March 31, 2017. The ~~decrease~~increase was primarily a result of ~~an increase in assets and cost efficiencies gained through efforts by~~acquisition costs totaling $4.7 million during the ~~Company to manage noninterest expenses.~~three months ended March 31, 2018.

Income Tax Expense

~~Comparison of quarter ended September 30, 2017 to the comparable quarter in the prior year~~

Income tax expense decreased ~~by $199,000,~~$1.7 million, or ~~4.8%~~54.7%, to ~~$3.9~~$1.4 million for the three months ended ~~September 30, 2017~~March 31, 2018 from ~~$4.1~~$3.1 million for the three months ended ~~September 30, 2016.~~ 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 35%.

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The effective tax rate was ~~27.0%~~13.3% for the three months ended ~~September 30, 2017~~March 31, 2018 compared to ~~27.2%~~24.9% for the same period in ~~2016.~~2017. The decrease in the effective tax rate during the three months ended ~~September 30, 2017~~March 31, 2018 compared to the same period in 2016 was due primarily to an increase in tax benefits from low income housing tax credits, offset partially by the implementation of FASB ASU 2016-09 requiring the excess tax benefits on option exercises and restricted stock vesting to be recognized in earnings prospectively starting on January 1, 2017.

~~Comparison of nine months ended September 30,~~ 2017 ~~to the comparable period in the prior year~~

Income tax expense increased by $645,000, or 6.2%, to $11.1 million for the nine months ended September 30, 2017 from $10.4 million for the nine months ended September 30, 2016. The effective tax rate was 25.9% for the nine months ended September 30, 2017 compared to 26.5% for the same period in 2016. The decrease in the effective tax rate during the nine months ended September 30, 2017 compared to the same period in 2016 was due primarily to the ~~implementation of FASB ASU 2016-09 requiring the excess tax benefits on option exercises~~Tax Cuts and ~~restricted stock vesting to be recognized in earnings prospectively starting on January 1, 2017.~~Jobs Act.

Financial Condition Overview

Total assets increased $171.1 million, or 4.4%, to $4.05 billion as of September 30, 2017 compared to $3.88 billion as of December 31, 2016. Total loans receivable, net, increased $156.4 million, or 6.0%, to $2.77 billion at September 30, 2017 compared to $2.61 billion at December 31, 2016. Loans were mostly funded through an increase in deposits. Deposits increased by $91.2 million, or 2.8%, to $3.32 billion as of September 30, 2017 compared to $3.23 billion as of December 31, 2016. Total non-maturity deposits decreased to 88.1% of total deposits at September 30, 2017 from 88.9% at December 31, 2016 and certificates of deposits increased to 11.9% of total deposits at ~~September 30, 2017 from 11.1% at December 31, 2016.~~

Prepaid expenses and other assets increased $8.4 million, or 10.6%, to $87.7 million at September 30, 2017 from $79.4 million at December 31, 2016 primarily as a result of the Company's investment in two new low income housing tax credit partnerships totaling $14.3 million. These investments had corresponding obligations recorded in accrued expenses and other liabilities of $14.3 million at September 30, 2017. These obligations will decrease as

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projects in the partnerships are funded. During the nine months ended September 30, 2017 the Company made capital contributions related to other low income housing tax credit partnerships of $8.5 million, partially offsetting the increase in accrued expenses and other liabilities.

Federal Home Loan Bank advances increased $37.8 million, or 47.5%, to $117.4 million as of September 30, 2017 from $79.6 million as of December 31, 2016. The increase in advances was required as a supplement to deposits in order to fund loan growth.

Total stockholders’ equity increased $25.8 million, or 5.4%, to $507.6 million as of September 30, 2017 from $481.8 million at December 31, 2016. The increase during the nine months ended September 30, 2017 was due primarily to net income of $31.8 million and a $4.4 million improvement in accumulated other comprehensive income, net of tax, offset partially by cash dividends declared of $11.4 million. The Company’s equity position was 12.5% of total assets as of September 30, 2017 and 12.4% as of December 31, 2016.

The table below provides a comparison of the changes in the Company's financial condition from December 31, ~~2016~~2017 to ~~September 30, 2017.~~March 31, 2018, and the results of the Puget Sound Merger effective January 16, 2018:


	September 30, 2017		December 31, 2016			Change			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	$	111,258	$	103,745		$	7,513		7.2	%	$	130,309		$	103,015		$	27,294		26.5	%	$	80,136
Investment securities	800,060		794,645			5,415			0.7
Investment securities available for sale, at fair value											821,567			810,530			11,037			1.4		80,353
Loans held for sale	5,368		11,662			(6,294		)	(54.0	)	2,669			2,288			381			16.7		—
Total loans receivable, net	2,766,113		2,609,666			156,447			6.0		3,248,654			2,816,985			431,669			15.3		388,462
Other real estate owned	523		754			(231		)	(30.6	)	—			—			—			—		—
Premises and equipment, net	60,457		63,911			(3,454		)	(5.4	)	62,147			60,325			1,822			3.0		732
Federal Home Loan Bank stock, at cost	9,343		7,564			1,779			23.5		6,824			8,347			(1,523		)	(18.2	)	623
Bank owned life insurance	71,474		70,355			1,119			1.6		81,700			75,091			6,609			8.8		6,264
Accrued interest receivable	12,295		10,925			1,370			12.5		13,602			12,244			1,358			11.1		1,448
Prepaid expenses and other assets	87,728		79,351			8,377			10.6		104,666			99,328			5,338			5.4		1,354
Other intangible assets, net	6,408		7,374			(966		)	(13.1	)	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	$	4,050,056	$	3,878,981		$	171,075		4.4	%	$	4,676,250		$	4,113,270		$	562,980		13.7	%	$	639,162

Liabilities
Deposits	$	3,320,818	$	3,229,648		$	91,170		2.8		$	3,904,741		$	3,393,060		$	511,681		15.1	%	$	505,885
Federal Home Loan Bank advances	117,400		79,600			37,800			47.5		30,700			92,500			(61,800		)	(66.8	)	—
Junior subordinated debentures	19,936		19,717			219			1.1		20,083			20,009			74			0.4		—
Securities sold under agreement to repurchase	28,668		22,104			6,564			29.7		26,100			31,821			(5,721		)	(18.0	)	—
Accrued expenses and other liabilities	55,626		46,149			9,477			20.5		59,918			67,575			(7,657		)	(11.3	)	2,504
Total liabilities	3,542,448		3,397,218			145,230			4.3		4,041,542			3,604,965			436,577			12.1		508,389
Stockholders' equity
Common stock	360,113		359,060			1,053			0.3		490,566			360,590			129,976			36.0		130,773
Retained earnings	145,677		125,309			20,368			16.3		153,101			149,013			4,088			2.7		—
Accumulated other comprehensive income (loss), net	1,818		(2,606		)	4,424			169.8
Accumulated other comprehensive loss, net											(8,959		)	(1,298		)	(7,661		)	590.2		—
Total stockholders' equity	507,608		481,763			25,845			5.4		634,708			508,305			126,403			24.9		130,773
Total liabilities and stockholders' equity	$	4,050,056	$	3,878,981		$	171,075		4.4	%	$	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.

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~~Lending Activities~~

~~As indicated in the table below,~~Total loans receivable, net, excluding Puget Sound Merger increased $43.2 million, or 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 primarily as a result of investment purchases, offset partially by 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 ~~$2.80~~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 ~~September 30, 2017, an increase of $156.8 million, or 5.9%,~~March 31, 2018 from ~~$2.64~~$2.82 billion at December 31, ~~2016.~~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.

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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 nine months ended September 30, 2017 was primarily due to increases in commercial business loans of $121.3 million, consumer loans of $15.5 million and real estate construction and land development loans of $15.3 million.allowance for loan losses.


	September 30, 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	$	665,582	23.8	%	$	637,773	24.2	%	$	811,678	24.7	%	$	645,396	22.7	%
Owner-occupied commercial real estate	602,238		21.5		558,035		21.1		702,356		21.4		622,150		21.8
Non-owner occupied commercial real estate	930,188		33.3		880,880		33.4		1,133,394		34.6		986,594		34.6
Total commercial business	2,198,008		78.6		2,076,688		78.7		2,647,428		80.7		2,254,140		79.1
One-to-four family residential(1)	81,422		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	51,451		1.8		50,414		1.9		73,295		2.2		51,985		1.8
Five or more family residential and commercial properties	122,981		4.4		108,764		4.1		98,387		3.0		97,499		3.4
Total real estate construction and land development(2)	174,432		6.2		159,178		6.0		171,682		5.2		149,484		5.2
Consumer	340,643		12.2		325,140		12.3		370,275		11.3		355,091		12.5
Gross loans receivable	2,794,505		99.9		2,638,397		99.9		3,278,565		99.9		2,845,712		99.9
Deferred loan costs, net	3,008		0.1		2,352		0.1
Net deferred loan costs									3,350		0.1		3,359		0.1
Loans receivable, net	$	2,797,513	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.

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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.


	September 30, 2017			December 31, 2016			March 31, 2018			December 31, 2017
	(Dollars in thousands)						(Dollars in thousands)
Nonaccrual loans:
Commercial business	$	9,683		$	8,580		$	14,356		$	9,098
One-to-four family residential	84			94			80			81
Real estate construction and land development	869			2,008			1,147			1,247
Consumer	316			227			145			277
Total nonaccrual loans ~~(2)~~(1)	10,952			10,909			15,728			10,703
Other real estate owned	523			754			—			—
Total nonperforming assets	$	11,475		$	11,663		$	15,728		$	10,703

Allowance for loan losses	$	31,400		$	31,083		$	33,261		$	32,086
Nonperforming loans to loans receivable, net							0.48		%	0.38		%
Allowance for loan losses to loans receivable, net	1.12		%	1.18		%	1.01		%	1.13		%
Allowance for loan losses to nonperforming loans	286.71		%	284.93		%	211.48		%	299.79		%
Nonperforming loans to loans receivable, net	0.39		%	0.41		%
Nonperforming assets to total assets	0.28		%	0.30		%	0.34		%	0.26		%

Performing TDR loans:
Commercial business	$	18,571		$	19,837		$	25,737		$	25,729
One-to-four family residential	219			227			215			218
Real estate construction and land development	1,136			2,141			—			645
Consumer	118			83			235			165
Total performing TDR loans ~~(3)~~	$	20,044		$	22,288		$	26,187		$	26,757
Accruing loans past due 90 days or more ~~(4)~~	$	—		$	—		$	—		$	—
Potential problem loans ~~(5)~~	84,089			87,762			93,253			83,543


⁽¹⁾	At ~~September 30, 2017~~March 31, 2018 and December 31, ~~2016, $5.9~~2017, $8.2 million and ~~$6.9~~$5.2 million of ~~nonperforming~~nonaccrual loans ~~respectively,~~ were considered TDR ~~loans.~~


⁽²⁾	~~At September 30, 2017 and December 31, 2016, $2.5 million and $2.8 million of nonperforming~~ loans, ~~respectively, were guaranteed by government agencies.~~


⁽³⁾	~~At September 30, 2017 and December 31, 2016, $1.4 million 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 September 30, 2017 or December 31, 2016.~~


⁽⁵⁾	~~At September 30, 2017 and December 31, 2016, $1.7 million and $1.1 million of potential problem loans, respectively, were guaranteed by government agencies.~~respectively.

Nonperforming Assets. Nonperforming assets ~~were $11.5~~consist of nonaccrual loans and other real estate owned. Nonperforming assets increased $5.0 million to $15.7 million, or ~~0.28%~~0.34% of total assets ~~and $11.7~~at March 31, 2018 from $10.7 million, or ~~0.30%~~0.26% of total assets, as of September 30, 2017 and December 31, 2016, respectively. The balance of nonaccrual loans increased $43,000, or 0.4%, to $11.0 million ($2.5 million guaranteed by governmental agencies) at September 30, 2017 from $10.9 million ($2.8 million guaranteed by governmental agencies) at December 31, ~~2016. For the nine months ended September 30,~~ 2017 due to the increase in nonaccrual loans discussed below. There was ~~primarily due to additions to nonaccrual loans of $5.1 million, offset partially by net principal reductions of $4.3 million and charge-offs of $750,000. The~~no other real estate owned ~~balance decreased~~at March 31, 2018 or December 31, 2017.

Nonaccrual Loans. Nonaccrual loans increased $5.0 million to ~~$523,000~~$15.7 million, or 0.48% of loans receivable, net, at ~~September 30, 2017~~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 the sale of two properties.~~

Performing TDR loans were $20.0 million and $22.3 million as of September 30, 2017 and December 31, 2016, respectively. The $2.2 million, or 10.1%, decrease in performing TDR loans for the nine months ended September 30, 2017 was primarily the result of net principal payments of $8.3 million and loans transferred to nonaccrual ~~of $1.1 million, partially offset by troubled loans restructured~~ during the period ended March 31, 2018. As this credit relationship is well-secured, the Company did not record a related allowance for loan losses. The increase in the nonaccrual loans was also due to two commercial credit relationships with an outstanding balance of ~~$7.1 million. At September 30, 2017 and~~$1.9 million at March 31, 2018 of which approximately $1.0 million is guaranteed by the Small Business Administration.

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The following table reflects the changes in nonaccrual loans 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, ~~2016,~~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 ~~Company~~nonaccrual loan table above, were $8.2 million and had ana 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 ~~the~~ performing TDR loans was $2.6 million as of ~~$2.1 million~~both March 31, 2018 and ~~$2.0 million, respectively.~~December 31, 2017.

Potential Problem Loans. Potential problem loans ~~as of September 30, 2017 and~~increased $9.7 million, or 11.6%, to $93.3 million at March 31, 2018 from $83.5 million at December 31, ~~2016 were $84.1 million and $87.8 million, respectively. Potential~~2017. The increase was due primarily to the addition of potential problem loans are those loans that are currently accruing interest and are not considered impaired, but which we are monitoring because the financial information of the borrower causes 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 andacquired in the ~~process~~Puget Sound Merger of ~~collection.~~ $6.1 million at March 31, 2018.

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The ~~$3.7 million, or 4.2%, decrease~~following table reflects the changes in potential problem loans was primarily the result of net principal payments of $18.9 million, loans transferred to held for sale of $5.8 million, loans transferred to nonaccrual status of $4.6 million and loan grade improvements of $4.4 million, partially offset by the addition of loans graded as potential problem loans of $31.4 million during the ~~nine~~three months ended ~~September 30, 2017.~~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;

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


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


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


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


▪◦	~~Effects~~effects of changes in risk selection and underwriting standards, and other changes in lending policies, procedures and practices;


▪◦	~~Experience,~~experience, ability, and depth of lending management and other relevant staff;


▪◦	~~National~~national and local economic trends and conditions;


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


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


▪◦	~~Other~~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

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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.

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The following table ~~provides information regarding changes in our~~outlines the allowance for loan losses ~~as of~~ and ~~for the three~~related loan balances on loans at March 31, 2018 and ~~nine months ended September 30, 2017 and 2016:~~December 31, 2017:

Three Months Ended September 30, Nine Months Ended September 30,
2017 2016 2017 2016
(Dollars in thousands)
Loans receivable, net at the end of the period $ 2,797,513
$ 2,578,977
$ 2,797,513
$ 2,578,977
Average loans receivable during the period 2,737,535
2,526,150
2,676,153
2,461,856

Allowance for loan losses on loans at the beginning of the period $ 32,751
$ 28,426
$ 31,083
$ 29,746
Provision for loan losses 884
1,495
2,882
3,754
Charge-offs:
Commercial business (1,497 ) (328 ) (1,940 ) (3,698 )
One-to-four family residential (15 ) —
(15 ) —
Real estate construction and land development (556 ) —
(556 ) (154 )
Consumer (478 ) (572 ) (1,419 ) (1,370 )
Total charge-offs (2,546 ) (900 ) (3,930 ) (5,222 )
Recoveries:
Commercial business 8
993
834
1,352
One-to-four family residential —
—
1
2
Real estate construction and land development 191
—
201
83
Consumer 112
197
329
496
Total recoveries 311
1,190
1,365
1,933
Net (charge-offs) recoveries (2,235 ) 290
(2,565 ) (3,289 )
Allowance for loan losses at the end of the period $ 31,400
$ 30,211
$ 31,400
$ 30,211

Allowance for loan losses to loans receivable, net 1.12 % 1.17 % 1.12 % 1.17 %
Net charge-offs (recoveries) on loans to average loans, annualized 0.32 % (0.05 )% 0.13 % 0.18 %

~~The allowance for loan losses increased to $31.4 million at September 30, 2017 from $31.1 million~~at December 31, 2016. The increase was the result of provision for loan losses of $2.9 million, partially offset by net charge-offs of $2.6 million recorded during the nine months ended September 30, 2017, which included PCI loan pool charge-offs of $1.7 million. The allowance for loan losses to loans receivable, net, decreased to 1.12% at September 30, 2017 from 1.18% at December 31, 2016.

The ratio of net charge-offs (recoveries) on loans to average loans, annualized deteriorated to net charge-off of 0.32% for the three months ended September 30, 2017 compared to net recoveries of 0.05% for the three months ended September 30, 2016, primarily due to PCI loan pool charge-offs of $1.5 million for the three months ended September 30, 2017. The ratio of net charge-offs (recoveries) on loans to average loans, annualized improved to a net charge-off of 0.13% for the nine months ended September 30, 2017 from 0.18% for the nine months ended September 30, 2016. The improvement of the ratio was due primarily to fewer net charge-offs recorded during the nine months ended September 30, 2017 compared to the same period in 2016 in addition to growth in the loan portfolio.

Nonperforming loans were $11.0 million and $10.9 million at September 30, 2017 and December 31, 2016, respectively, or 0.39% and 0.41% of loans receivable, net, respectively. The allowance for loan losses to nonperforming loans was 286.71% at September 30, 2017 and 284.93% at December 31, 2016. As of September 30, 2017, the Bank identified $31.0 million of impaired loans, of which $10.5 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 impaired loans at September 30, 2017 had related specific valuation allowances totaling $3.1 million. Impaired loans totaled $33.2 million at 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.

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	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 ~~$31.4~~$33.3 million at ~~September 30, 2017~~March 31, 2018 (1.01% of loans receivable, net and 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 million.~~$32.1 million (1.13% of loans receivable, net and 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 ~~September 30, 2017~~March 31, 2018 and December 31, ~~2016,~~2017, the remaining fair value discount for these purchased loans was ~~$11.7~~$12.7 million and ~~$13.5~~$10.1 million, respectively.

~~The following table outlines~~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 ~~related loan balances at September 30, 2017~~may adversely affect the Company’s financial condition and ~~December 31, 2016:~~

September 30, 2017 December 31, 2016
(Dollars in thousands)
General Valuation Allowance:
Allowance for loan losses $ 24,113
$ 21,791
Gross loans, excluding PCI and impaired loans $ 2,719,813
$ 2,540,751
Percentage 0.89 % 0.86 %

PCI Allowance:
Allowance for loan losses $ 4,176
$ 6,558
Gross PCI loans $ 43,696
$ 64,448
Percentage 9.56 % 10.18 %

Specific Valuation Allowance:
Allowance for loan losses $ 3,111
$ 2,734
Gross impaired loans $ 30,996
$ 33,198
Percentage 10.04 % 8.24 %

Total Allowance for Loan Losses:
Allowance for loan losses $ 31,400
$ 31,083
Gross loans receivable $ 2,794,505
$ 2,638,397
Percentage 1.12 % 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.

Deposits and Other Borrowings

Total deposits increased $511.7 million, or 15.1%, to $3.90 billion at March 31, 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 ~~management’s assessment of loan quality and current economic conditions,~~ the ~~Company believes that its allowance for loan losses was appropriate to absorb the probable incurred losses and inherent risks of loss~~change in the ~~loan portfolio at September 30, 2017.~~

mix and

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~~Deposits and Other Borrowings~~

~~As indicated in the table below, total deposits were $3.32 billion at September 30, 2017, an increase of $91.2 million, or 2.8%, from $3.23 billion at December 31, 2016.~~

September 30, 2017 December 31, 2016
Balance % of Total Balance % of Total
(Dollars in thousands)
Noninterest bearing demand deposits $ 916,265
27.6 % $ 882,091
27.3 %
Interest bearing demand deposits 1,031,449
31.0
963,821
29.8
Money market accounts 480,899
14.5
523,875
16.2
Savings accounts 497,024
15.0
502,460
15.6
Total non-maturity deposits 2,925,637
88.1
2,872,247
88.9
Certificates of deposit 395,181
11.9
357,401
11.1
Total deposits $ 3,320,818
100.0 % $ 3,229,648
100.0 %

Non-maturity deposits (total deposits less certificates of deposit) increased $53.4 million, or 1.9%, to $2.93 billion at September 30, 2017 from $2.87 billion at December 31, 2016. Certificate of deposit accounts increased $37.8 million, or 10.6%, to $395.2 million at September 30, 2017 from $357.4 million at December 31, 2016 due primarily to the addition of $44.1 million of brokered certificates of deposit, which were used to supplement deposit growth in the funding of loan growth. Based on the change in the mix and volume of deposits, the percentage of certificates of deposit to total deposits ~~increased~~decreased to ~~11.9%~~10.8% at ~~September 30, 2017~~March 31, 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 ~~September 30, 2017,~~March 31, 2018, the Bank had securities sold under agreement to repurchase of ~~$28.7~~$26.1 million, ~~an increase~~a decrease of ~~$6.6~~$5.7 million, or ~~29.7%~~18.0%, from ~~$22.1~~$31.8 million at December 31, ~~2016.~~2017. The ~~increase~~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 ~~$19.9~~$20.1 million at ~~September 30, 2017,~~March 31, 2018, which reflects the fair value of the junior subordinated debentures established during the Washington Banking Merger, adjusted for the accretion of discount from purchase accounting fair value adjustment.

At ~~September 30, 2017,~~March 31, 2018, the Bank maintained credit facilities with the FHLB of Des Moines for ~~$662.4~~$913.0 million and credit facilities with the Federal Reserve Bank ~~of San Francisco~~ for ~~$50.6~~$81.4 million. The Company had FHLB advances outstanding of ~~$117.4~~$30.7 million and ~~$79.6~~$92.5 million at ~~September 30, 2017~~March 31, 2018 and December 31, ~~2016,~~2017, respectively. The average cost of the FHLB advances during the ~~nine~~three months ended ~~September 30,~~March 31, 2018 and 2017 was ~~1.09%.~~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 ~~September 30, 2017.~~March 31, 2018. There were no federal funds purchased as of ~~September 30, 2017~~March 31, 2018 or December 31, ~~2016.~~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 September 30, 2017, cash and cash equivalents totaled $111.3 million, or 2.7% of total assets. The fair value of investment securities available for sale totaled $800.1 million at September 30, 2017 of which $257.0 million were pledged to secure public deposits or borrowing arrangements. The fair value of investment securities available for sale that were not pledged totaled $543.1 million, or 13.4%, of total assets at September 30, 2017. The fair value of investment securities available for sale with maturities of one year or less were $6.6 million, or 0.2%, of total assets at September 30, 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 funds, together with retained earnings, equity and other borrowed funds, are used to make loans, acquire investment

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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 ~~September 30, 2017,~~March 31, 2018, the Company (on an unconsolidated basis) had cash and cash equivalents of $11.7 million.

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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 ~~$11.6 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 ~~$53.8~~$9.1 million for the ~~nine~~three months ended ~~September 30, 2017,~~March 31, 2018, and primarily consisted of net income of $31.8 million, net proceeds from origination and sale of loans held for sale of $2.2 million and net change in accrued interest receivable, prepaid expenses and other assets, accrued expenses and other liabilities of $8.3$9.1 million. During the ~~nine~~three months ended ~~September 30, 2017,~~March 31, 2018, net cash ~~used in~~provided by investing activities was ~~$169.9~~$86.4 million, which consisted primarily of ~~net loan originations of $178.8 million, investment in low income housing tax credit partnerships of $8.5 million and~~ net proceeds from purchase and sale of investment securities available for sale of ~~$3.4~~$58.1 million and net cash received from acquisitions of $80.1 million, offset partially by net loan originations of $47.0 million. Net cash ~~provided by~~used in financing activities was ~~$123.6~~$68.3 million for the ~~nine~~three months ended ~~September 30, 2017,~~March 31, 2018, and primarily consisted of anet FHLB repayments of $61.8 million, offset partially by net increase in deposits of ~~$91.2 million, net FHLB advances of $37.8 million and a net increase in securities sold under agreements to repurchase of $6.6 million, offset partially by cash dividends on common stock of $11.4~~$5.8 million during the period.

Capital and Capital Requirements

Stockholders’ equity at ~~September 30, 2017~~March 31, 2018 was ~~$507.6~~$634.7 million compared ~~with $481.8~~to $508.3 million at December 31, ~~2016. During~~2017. The changes to stockholders' equity during the ~~nine~~three months ended September 30, 2017, the Company realized net income of $31.8 million, declared cash dividends of $11.4 million, recorded other comprehensive income of $4.4 million, recognized stock-based compensation expense of $1.6 million, and recorded a net decrease to common stock due to common stock repurchases and exercises of stock options, net of tax, of $515,000.

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 September 30, 2017 and December~~March 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 September 30, 2017:
The Company consolidated
Common equity Tier 1 capital to risk-weighted assets $ 151,086
4.5 % N/A
N/A
$ 383,546
11.4 %
Tier 1 leverage capital to average assets 155,761
4.0
N/A
N/A
403,444
10.4
Tier 1 capital to risk-weighted assets 201,448
6.0
N/A
N/A
403,444
12.0
Total capital to risk-weighted assets 268,598
8.0
N/A
N/A
435,119
13.0
Heritage Bank
Common equity Tier 1 capital to risk-weighted assets 150,874
4.5
$ 217,929
6.5 % 388,852
11.6
Tier 1 leverage capital to average assets 155,582
4.0
194,478
5.0
388,852
10.0
Tier 1 capital to risk-weighted assets 201,165
6.0
268,221
8.0
388,852
11.6
Total capital to risk-weighted assets 268,221
8.0
335,276
10.0
420,422
12.5

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 September 30, 2017, the capital conservation buffer was 5.07% and 4.65% for the Company ~~and the Bank, respectively, and the minimum conservation buffer requirement was 1.25%.~~

~~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 ~~October~~April 25, ~~2017,~~2018, the Company’s Board of Directors declared a regular dividend of ~~$0.13 per common share and a special dividend of $0.10~~$0.15 per common share payable on ~~November 22, 2017~~May 24, 2018 to shareholders of record on ~~November 8, 2017.~~May 10, 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.

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	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.

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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 ~~September 30, 2017~~March 31, 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 ~~September 30, 2017,~~March 31, 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.

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

(a) Not applicable.

(b) Not applicable.

Three Months Ended September 30, Nine Months Ended September 30,
2017 2016 2017 2016 Plan Total (1)
Eleventh Plan
Repurchased shares —
38,000
—
138,000
579,996
Stock repurchase average share price $ —
$ 17.46
$ —
$ 17.16
$ 16.76


~~(1)~~	~~Represents shares repurchased and average price per share paid during the duration of the plan.~~



	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 ~~and nine~~ months ended ~~September 30, 2017,~~March 31, 2018, 26,741 of the ~~Company~~shares repurchased ~~344 and 27,711 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 ~~$25.80 and $24.61 to pay withholding taxes on~~$31.80 under the ~~vesting~~terms of ~~restricted stock that vested during~~ the respective periods. During the three and nine months ended September 30, 2016, the Company repurchased 5,276 and 29,206 shares of common stock at an average price per share of $18.64 and $17.77 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 ~~September 30, 2017.~~March 31, 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
July 1, 2017— July 31, 2017 —
$ —
7,893,389
935,034
August 1, 2017— August 31, 2017 —
—
7,893,389
935,034
September 1, 2017— September 30, 2017 344
25.80
7,893,389
935,034
Total 344
$ 25.80
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)~~	~~All of the common shares repurchased by the Company between July 1, 2017 and September 30, 2017 were shares of restricted stock that represented the cancellation of stock to pay withholding taxes.~~

⁽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

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ITEM 6. EXHIBITS

Incorporated by Reference

Exhibit No.

Description of Exhibit

Form

Exhibit

Filing Date/Period End Date

Exhibit No.

Description of Exhibit

Form

Exhibit

Filing Date/Period End Date

2.5

Agreement and Plan of Merger with Puget Sound Bank

8-K

2.1

7/27/17

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

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

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

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

101

The following financial information from Heritage Financial Corporation’s Quarterly Report on Form 10-Q for the quarter ended September 30, 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.

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⁾ Filed herewith.

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:
~~November 9, 2017~~May 10, 2018		/S/ BRIAN L. VANCE
		Brian L. Vance
		President and Chief Executive Officer
		~~(Duly Authorized Officer)~~

Date:
~~November 9, 2017~~May 10, 2018		/S/ DONALD J. HINSON
		Donald J. Hinson
		Executive Vice President and Chief Financial Officer
		~~(Principal Financial and Accounting Officer)~~

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	Three Months Ended September 30, 2017 ⁽¹⁾			Nine Months Ended September 30, 2017 ⁽¹⁾
	(In thousands)
Balance of AOCI at the beginning of period	$	1,557		$	(2,606	)
Other comprehensive income before reclassification	289			4,528
Amounts reclassified from AOCI for gain on sale of investment securities included in net income	(28		)	(104		)
Net current period other comprehensive income	261			4,424
Balance of AOCI at the end of period	$	1,818		$	1,818



	Three Months Ended September 30, 2016 ⁽¹⁾			Nine Months Ended September 30, 2016 ⁽¹⁾
	(In thousands)
Balance of AOCI at the beginning of period	$	12,343		$	2,559
Other comprehensive income before reclassification	(1,055		)	9,223
Amounts reclassified from AOCI for gain on sale of investment securities available for sale included in net income	(224		)	(718		)
Net current period other comprehensive income	(1,279		)	8,505
Balance of AOCI at the end of period	$	11,064		$	11,064



	Shares		Weighted-Average Grant Date Fair Value
Nonvested at December 31, 2015	264,521		$	15.92
Granted	119,939		17.53
Vested	(111,357	)	15.62
Forfeited	(9,216	)	16.57
Nonvested at September 30, 2016	263,887		$	16.76

Nonvested at December 31, 2016	261,296		$	16.80
Granted	—		—
Vested	(107,202	)	16.49
Forfeited	(10,418	)	16.80
Nonvested at September 30, 2017	143,676		$	17.02



	Basis⁽¹⁾		Fair Value at September 30, 2017
	Basis⁽¹⁾		Total		Level 1		Level 2		Level 3		Net Losses Recorded in Earnings During the Three Months Ended September 30, 2017		Net Losses (Gains) Recorded in Earnings During the Nine Months Ended September 30, 2017
	(In thousands)
Impaired loans:
Commercial business:
Commercial and industrial	$	172	$	163	$	—	$	—	$	163	$	—	$	7
Owner-occupied commercial real estate	182		179		—		—		179		—		8
Total commercial business	354		342		—		—		342		—		15
Total assets measured at fair value on a nonrecurring basis	$	354	$	342	$	—	$	—	$	342	$	—	$	15



	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 September 30, 2016			Net Losses (Gains) Recorded in Earnings During the Nine Months Ended September 30, 2016
	(In thousands)
Impaired loans:
Commercial business:
Commercial and industrial	$	205	$	200	$	—	$	—	$	200	$	24		$	25
Owner-occupied commercial real estate	780		603		—		—		603		23			(2		)
Total commercial business	985		803		—		—		803		47			23
Real estate construction and land development:
One-to-four family residential	828		822		—		—		822		(13		)	(26		)
Total real estate construction and land development	828		822		—		—		822		(13		)	(26		)
Consumer	16		9		—		—		9		—			—
Total assets measured at fair value on a nonrecurring basis	$	1,829	$	1,634	$	—	$	—	$	1,634	$	34		$	(3	)



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
July 1, 2017— July 31, 2017	—	$	—	7,893,389	935,034
August 1, 2017— August 31, 2017	—	—		7,893,389	935,034
September 1, 2017— September 30, 2017	344	25.80		7,893,389	935,034
Total	344	$	25.80	7,893,389	935,034