UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

For the quarterly period ended ~~March 31,~~September 30, 2018 or

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

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

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

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

As of ~~April 26,~~October 29, 2018 there were ~~34,018,280~~36,873,123 shares of the registrant's common stock, no par value per share, outstanding.

Table of Contents

HERITAGE FINANCIAL CORPORATION

FORM 10-Q

~~March 31,~~September 30, 2018

TABLE OF CONTENTS



				Page
FORWARD LOOKING STATEMENTS

PART I.	FINANCIAL INFORMATION			4
ITEM 1.	FINANCIAL STATEMENTS			4
		CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION AS OF ~~MARCH 31,~~SEPTEMBER 30, 2018 AND DECEMBER 31, 2017		4
		CONDENSED CONSOLIDATED STATEMENTS OF INCOME FOR THE THREE AND NINE MONTHS ENDED ~~MARCH 31,~~SEPTEMBER 30, 2018 AND 2017		5
		CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME FOR THE THREE AND NINE MONTHS ENDED ~~MARCH 31,~~SEPTEMBER 30, 2018 AND 2017		6
		CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY FOR THE ~~THREE~~NINE MONTHS ENDED ~~MARCH 31,~~SEPTEMBER 30, 2018 AND 2017		7
		CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE ~~THREE~~NINE MONTHS ENDED ~~MARCH 31,~~SEPTEMBER 30, 2018 AND 2017		8
		NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS		10
		NOTE 1.	DESCRIPTION OF BUSINESS, BASIS OF PRESENTATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS	10
		NOTE 2.	BUSINESS ~~COMBINATION~~COMBINATIONS	14
		NOTE 3.	INVESTMENT SECURITIES	1617
		NOTE 4.	LOANS RECEIVABLE	1920
		NOTE 5.	ALLOWANCE FOR LOAN LOSSES	3032
		NOTE 6.	OTHER REAL ESTATE OWNED	3336
		NOTE 7.	GOODWILL AND OTHER INTANGIBLE ASSETS	3336
		NOTE 8.	JUNIOR SUBORDINATED DEBENTURES	3437
		NOTE 9.	REPURCHASE AGREEMENTS	3538
		NOTE 10.	OTHER BORROWINGS	3538
		NOTE 11.	DERIVATIVE FINANCIAL INSTRUMENTS	3639
		NOTE 12.	STOCKHOLDERS’ EQUITY	3740
		NOTE 13.	ACCUMULATED OTHER COMPREHENSIVE (LOSS) INCOME	3842
		NOTE 14.	FAIR VALUE MEASUREMENTS	3842
		NOTE 15.	STOCK-BASED COMPENSATION	4348
		NOTE 16.	CASH REQUIREMENT	4651
ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS			4651
ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK			6476
ITEM 4.	CONTROLS AND PROCEDURES			6476
Part II.	OTHER INFORMATION			6476
ITEM 1.	LEGAL PROCEEDINGS			6476
ITEM 1A.	RISK FACTORS			6477
ITEM 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS			6577
ITEM 3.	DEFAULTS UPON SENIOR SECURITIES			6577
ITEM 4.	MINE SAFETY DISCLOSURES			6577
ITEM 5.	OTHER INFORMATION			6577
ITEM 6.	EXHIBITS			6678
	SIGNATURES			6678

Table of Contents

FORWARD LOOKING STATEMENTS:

This Quarterly Report on Form 10-Q ("Form 10-Q") may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements often include the words “believes,” “expects,” “anticipates,” “estimates,” “forecasts,” “intends,” “plans,” “targets,” “potentially,” “probably,” “projects,” “outlook” or similar expressions or future or conditional verbs such as “may,” “will,” “should,” “would” and “could.” These forward-looking statements are subject to known and unknown risks, uncertainties and other factors that could cause actual results to differ materially from the results anticipated, including: our ability to successfully integrate any assets, liabilities, customers, systems, and management personnel from our recent ~~merger~~mergers with Puget Sound Bancorp, Inc., ~~or our pending merger with~~and Premier Commercial Bancorp, ~~("Premier Merger"),~~ into our operations and our ability to realize related revenue synergies and cost savings within expected time frames or at all, and any goodwill charges related thereto and costs or difficulties relating to integration matters, including but not limited to customer and employee retention, which might be greater than expected; the proposed Premier Merger may not close when expected or at all because required regulatory, shareholder or other approvals and conditions to closing are not received or satisfied on a timely basis or at all or adverse regulatory conditions may be imposed in connection with governmental approvals of the merger; the credit risks of lending activities, including changes in the level and trend of loan delinquencies and write-offs and changes in our allowance for loan losses and provision for loan losses that may be effected by deterioration in the housing and commercial real estate markets, which may lead to increased losses and nonperforming assets in our loan portfolio, and may result in our allowance for loan losses no longer being adequate to cover actual losses, and require us to increase our allowance for loan losses; changes in general economic conditions, either nationally or in our market areas; changes in the levels of general interest rates, and the relative differences between short and long term interest rates, deposit interest rates, our net interest margin and funding sources; risks related to acquiring assets in or entering markets in which we have not previously operated and may not be familiar; fluctuations in the demand for loans, the number of unsold homes and other properties and fluctuations in real estate values in our market areas; results of examinations of us by the bank 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 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; disruptions, security breaches, or other adverse events, failures or interruptions in, or attacks on, our information technology systems or on the third-party vendors who perform several of 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, 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)

(In thousands, except shares)


	March 31, 2018			December 31, 2017			September 30, 2018			December 31, 2017
ASSETS
Cash on hand and in banks	$	86,608		$	78,293		$	120,833		$	78,293
Interest earning deposits	43,701			24,722			49,310			24,722
Cash and cash equivalents	130,309			103,015			170,143			103,015
Investment securities available for sale, at fair value	821,567			810,530			920,737			810,530
Loans held for sale	2,669			2,288			1,882			2,288
Loans receivable, net	3,281,915			2,849,071			3,649,054			2,849,071
Allowance for loan losses	(33,261		)	(32,086		)	(34,475		)	(32,086		)
Total loans receivable, net	3,248,654			2,816,985			3,614,579			2,816,985
Other real estate owned	—			—			2,032			—
Premises and equipment, net	62,147			60,325			80,439			60,325
Federal Home Loan Bank stock, at cost	6,824			8,347			6,076			8,347
Bank owned life insurance	81,700			75,091			93,296			75,091
Accrued interest receivable	13,602			12,244			15,735			12,244
Prepaid expenses and other assets	104,666			99,328			108,730			99,328
Other intangible assets, net	16,563			6,088			21,728			6,088
Goodwill	187,549			119,029			240,837			119,029
Total assets	$	4,676,250		$	4,113,270		$	5,276,214		$	4,113,270
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits	$	3,904,741		$	3,393,060		$	4,398,127		$	3,393,060
Federal Home Loan Bank advances	30,700			92,500			—			92,500
Junior subordinated debentures	20,083			20,009			20,229			20,009
Securities sold under agreement to repurchase	26,100			31,821			32,233			31,821
Accrued expenses and other liabilities	59,918			67,575			79,492			67,575
Total liabilities	4,041,542			3,604,965			4,530,081			3,604,965
Stockholders’ equity:
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
Preferred stock, no par value, 2,500,000 shares authorized; no shares issued and outstanding at September 30, 2018 and December 31, 2017							—			—
Common stock, no par value, 50,000,000 shares authorized; 36,873,123 and 29,927,746 shares issued and outstanding at September 30, 2018 and December 31, 2017, respectively							591,065			360,590
Retained earnings	153,101			149,013			169,758			149,013
Accumulated other comprehensive loss, net	(8,959		)	(1,298		)	(14,690		)	(1,298		)
Total stockholders’ equity	634,708			508,305			746,133			508,305
Total liabilities and stockholders’ equity	$	4,676,250		$	4,113,270		$	5,276,214		$	4,113,270

See accompanying Notes to Condensed Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

(In thousands, except per share amounts)


	Three Months Ended March 31,				Three Months Ended September 30,					Nine Months Ended September 30,
	2018		2017		2018		2017			2018		2017
INTEREST INCOME
Interest and fees on loans	$	38,159	$	30,485	$	48,301	$	32,595		$	127,601	$	94,580
Taxable interest on investment securities	3,529		3,049		4,662		3,117			12,259		9,307
Nontaxable interest on investment securities	1,341		1,268		1,085		1,354			3,646		3,926
Interest and dividends on other interest earning assets	299		61
Interest on other interest earning assets					528		209			988		352
Total interest income	43,328		34,863		54,576		37,275			144,494		108,165
INTEREST EXPENSE
Deposits	1,960		1,266		3,014		1,628			7,169		4,301
Junior subordinated debentures	283		238		330		261			928		748
Other borrowings	167		213		136		444			721		908
Total interest expense	2,410		1,717		3,480		2,333			8,818		5,957
Net interest income	40,918		33,146		51,096		34,942			135,676		102,208
Provision for loan losses	1,152		867		1,065		884			3,967		2,882
Net interest income after provision for loan losses	39,766		32,279		50,031		34,058			131,709		99,326
NONINTEREST INCOME
Service charges and other fees	4,543		4,213		4,824		4,769			14,062		13,408
Gain on sale of investment securities, net	35		—		82		44			135		161
Gain on sale of loans, net	874		1,195		706		1,229			2,286		6,562
Interest rate swap fees	51		133		—		328			360		743
Other income	1,964		1,808		2,468		2,073			6,358		5,641
Total noninterest income	7,467		7,349		8,080		8,443			23,201		26,515
NONINTEREST EXPENSE
Compensation and employee benefits	21,367		16,024		23,804		15,823			64,492		48,119
Occupancy and equipment	4,627		3,810		5,020		3,979			14,457		11,607
Data processing	2,605		1,915		2,343		2,090			7,455		6,007
Marketing	808		807		876		933			2,507		2,545
Professional services	2,837		1,009		2,119		1,453			8,485		3,515
State and local taxes	688		549		931		640			2,335		1,828
Federal deposit insurance premium	355		300		375		433			1,105		1,090
Other real estate owned, net	—		31		18		(88		)	18		(36		)
Amortization of intangible assets	795		324		1,114		319			2,705		966
Other expense	2,665		2,454		2,997		2,373			8,491		7,346
Total noninterest expense	36,747		27,223		39,597		27,955			112,050		82,987
Income before income taxes	10,486		12,405		18,514		14,546			42,860		42,854
Income tax expense	1,399		3,089		3,010		3,922			6,412		11,086
Net income	$	9,087	$	9,316	$	15,504	$	10,624		$	36,448	$	31,768
Basic earnings per common share	$	0.27	$	0.31	$	0.42	$	0.35		$	1.04	$	1.06
Diluted earnings per common share	$	0.27	$	0.31	$	0.42	$	0.35		$	1.04	$	1.06
Dividends declared per common share	$	0.15	$	0.12	$	0.15	$	0.13		$	0.45	$	0.38

See accompanying Notes to Condensed Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)

(In thousands)

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



	Three Months Ended September 30,						Nine Months Ended September 30,
	2018			2017			2018			2017
Net income	$	15,504		$	10,624		$	36,448		$	31,768
Change in fair value of investment securities available for sale, net of tax of $(887), $157, $(3,525) and $2,442, respectively	(3,319		)	289			(13,193		)	4,528
Reclassification adjustment for net gain from sale of investment securities available for sale included in income, net of tax of $(17), $(16), $(29) and $(57), respectively	(65		)	(28		)	(106		)	(104		)
Other comprehensive (loss) income	(3,384		)	261			(13,299		)	4,424
Comprehensive income	$	12,120		$	10,885		$	23,149		$	36,192

See accompanying Notes to Condensed Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (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			Number of common shares		Common stock			Retained earnings			Accumulated other comprehensive income (loss), net			Total stock- holders’ equity
Balance at December 31, 2016	29,955		$	359,060		$	125,309		$	(2,606	)	$	481,763		29,955		$	359,060		$	125,309		$	(2,606	)	$	481,763
Restricted stock awards forfeited	(5	)	—			—			—			—			(10	)	—			—			—			—
Exercise of stock options	8		109			—			—			109			12		159			—			—			159
Stock-based compensation expense	—		510			—			—			510			—		1,568			—			—			1,568
Common stock repurchased	(16	)	(381		)	—			—			(381		)	(28	)	(674		)	—			—			(674		)
Net income	—		—			9,316			—			9,316			—		—			31,768			—			31,768
Other comprehensive income, net of tax	—		—			—			1,473			1,473			—		—			—			4,424			4,424
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
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

Balance at December 31, 2017	29,928		$	360,590		$	149,013		$	(1,298	)	$	508,305		29,928		$	360,590		$	149,013		$	(1,298	)	$	508,305
Restricted stock units vested	22		—			—			—			—
Restricted stock units vested, net of forfeitures of restricted stock awards															29		—			—			—			—
Exercise of stock options	1		21			—			—			21			9		118			—			—			118
Stock-based compensation expense	—		623			—			—			623			—		2,016			—			—			2,016
Common stock repurchased	(45	)	(1,438		)	—			—			(1,438		)	(53	)	(1,702		)	—			—			(1,702		)
Net income	—		—			9,087			—			9,087			—		—			36,448			—			36,448
Other comprehensive loss, net of tax	—		—			—			(7,543		)	(7,543		)	—		—			—			(13,299		)	(13,299		)
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		)
Common stock issued in business combinations															6,960		230,043			—			—			230,043
Cash dividends declared on common stock ($0.45 per share)															—		—			(15,796		)	—			(15,796		)
ASU 2016-01 implementation	—		—			118			(118		)	—			—		—			93			(93		)	—
Balance at March 31, 2018	34,018		$	490,566		$	153,101		$	(8,959	)	$	634,708
Balance at September 30, 2018															36,873		$	591,065		$	169,758		$	(14,690	)	$	746,133

See accompanying Notes to Condensed Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(In thousands)


	Three Months Ended March 31,						Nine Months Ended September 30,
	2018			2017			2018			2017
Cash flows from operating activities:
Net income	$	9,087		$	9,316		$	36,448		$	31,768
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	2,631			2,808
Depreciation of premises and equipment, amortization of securities available for sale, and amortization of discount of junior subordinated debentures							7,538			8,117
Changes in net deferred loan costs, net of amortization	9			(338		)	(38		)	(656		)
Provision for loan losses	1,152			867			3,967			2,882
Net change in accrued interest receivable, prepaid expenses and other assets, accrued expenses and other liabilities	(4,191		)	802			4,231			8,315
Stock-based compensation expense	623			510			2,016			1,568
Amortization of intangible assets	795			324			2,705			966
Origination of loans held for sale	(20,380		)	(27,209		)	(60,994		)	(82,767		)
Proceeds from sale of loans	20,651			35,956			63,330			91,576
Earnings on bank owned life insurance	(335		)	(375		)	(1,079		)	(1,108		)
Gain on sale of other real estate owned							—			(111		)
Gain on sale of loans, net	(874		)	(1,195		)	(2,286		)	(6,562		)
Gain on sale of investment securities, net	(35		)	—			(135		)	(161		)
Gain on sale of assets held for sale							(382		)	(53		)
Impairment of assets held for sale							75			—
Loss on sale or write-off of furniture, equipment and leasehold improvements	6			3			31			12
Net cash provided by operating activities	9,139			21,469			55,427			53,786
Cash flows from investing activities:
Loans originated, net of principal payments	(46,959		)	(33,249		)	(93,047		)	(178,800		)
Maturities, calls and payments of investment securities available for sale	24,443			20,094			64,625			75,800
Purchase of investment securities available for sale	(69,352		)	(7,932		)	(262,429		)	(101,017		)
Purchase of premises and equipment	(2,146		)	(847		)	(21,468		)	(2,221		)
Proceeds from sales of other loans	2,813			4,465			9,993			24,142
Proceeds from sales of other real estate owned							198			374
Proceeds from sales of investment securities available for sale	103,032			—			156,946			21,850
Proceeds from sale of assets held for sale							603			265
Proceeds from redemption of Federal Home Loan Bank stock	10,130			7,682			26,010			21,788
Purchases of Federal Home Loan Bank stock	(7,984		)	(7,435		)	(21,996		)	(23,567		)
Proceeds from sale of premises and equipment							26			—
Capital contribution to low-income housing tax credit partnership	(7,696		)	(7		)	(8,269		)	(8,506		)
Net cash received from acquisitions	80,133			—			105,974			—
Net cash provided by (used in) investing activities	86,414			(17,229		)
Net cash used in investing activities							(42,834		)	(169,892		)
Cash flows from financing activities:
Net increase in deposits	5,796			13,767			180,465			91,170
Federal Home Loan Bank advances	191,450			184,600			541,450			582,500
Repayments of Federal Home Loan Bank advances	(253,250		)	(197,450		)	(649,950		)	(544,700		)
Common stock cash dividends paid	(5,117		)	(3,594		)	(15,796		)	(11,400		)
Net decrease in securities sold under agreement to repurchase	(5,721		)	(664		)
Net (decrease)/increase in securities sold under agreement to repurchase							(50		)	6,564
Proceeds from exercise of stock options	21			109			118			159
Repurchase of common stock	(1,438		)	(381		)	(1,702		)	(674		)
Net cash used in financing activities	(68,259		)	(3,613		)
Net cash provided by financing activities							54,535			123,619

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	Three Months Ended March 31,					Nine Months Ended September 30,
	2018			2017		2018			2017
Net increase in cash and cash equivalents	27,294			627		67,128			7,513
Cash and cash equivalents at beginning of period	103,015			103,745		103,015			103,745
Cash and cash equivalents at end of period	$	130,309		$	104,372	$	170,143		$	111,258

Supplemental disclosures of cash flow information:
Cash paid for interest	$	2,398		$	1,775	$	8,717		$	6,024
Cash paid for income taxes	—			—		4,647			1,500

Supplemental non-cash disclosures of cash flow information:
Transfers of loans receivable to other real estate owned	$	—		$	32	$	434		$	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:
Transfers of properties held for sale recorded in premises and equipment, net to prepaid expenses and other assets						1,835			2,687
Investment in low income housing tax credit partnership and related funding commitment						—			14,267
Purchase of investment securities available for sale not settled						5,454			—
Business Combinations:
Common stock issued for business combinations	130,770			—		230,043			—
Assets acquired (liabilities assumed) in acquisitions:
Investment securities available for sale	80,353			—		84,846			—
Loans receivable	388,462			—		718,547			—
Other real estate owned						1,796			—
Premises and equipment	732			—		3,785			—
Federal Home Loan Bank stock	623			—		1,743			—
Accrued interest receivable	1,448			—		2,454			—
Bank owned life insurance	6,264			—		17,116			—
Prepaid expenses and other assets	1,354			—		3,182			—
Other intangible assets	11,270			—		18,345			—
Goodwill						121,808			—
Deposits	(505,885		)	—		(824,602		)	—
Federal Home Loan Bank advances						(16,000		)	—
Securities sold under agreement to repurchase						(462		)	—
Accrued expenses and other liabilities	(2,504		)	—		(8,489		)	—

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 Federal Deposit Insurance Corporation ("FDIC"). The Bank is headquartered in Olympia, Washington and conducts business from its 6064 branch offices as of September 30, 2018 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.

OnEffective January 16, 2018, the Company completed the acquisition of Puget Sound Bancorp, Inc. (“Puget Sound”), the holding company for Puget Sound Bank, both of Bellevue, Washington (“Puget Sound Merger”) and on July 2, 2018, the Company completed the acquisition of Premier Commercial Bancorp ("Premier Commercial"), the holding company for Premier Community Bank, both of Hillsboro, Oregon ("Premier Merger"). See Note (2), Business ~~Combination~~Combinations for additional information on the ~~merger.~~

~~On March 8, 2018,~~Puget Sound Merger and the ~~Company entered into a definitive agreement (the "Agreement") with~~ Premier ~~Commercial Bancorp, of Hillsboro, Oregon ("Premier Commercial"), pursuant to which Premier Commercial will be merged with~~Merger (collectively the "Premier 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"~~Puget Mergers"). Premier Commercial Bank has six branch locations. Under the terms of the Agreement, Premier Commercial shareholders will receive 0.4863 shares of Heritage common stock for each share of Premier Commercial common stock. Based on the closing price of Heritage common stock of $31.10 on March 8, 2018, the consideration value per share of Premier Commercial was $15.12, or approximately $88.6 million in aggregate, including the value of the outstanding shares of Premier Commercial restricted stock. The value of the merger consideration will fluctuate until closing based on the value of Heritage's stock price. At December 31, 2017, Premier Commercial had total assets of $400.5 million, total loans of $339.3 million and 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 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 be required to pay Heritage a termination fee of $3.45 million in cash. All of the directors and executive officers of Premier Commercial have agreed to vote their shares of Premier Commercial common stock in favor of approval of the 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, 2017 (“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 ~~March 31,~~September 30, 2018 are not necessarily indicative of the results that may be expected for the year ending December 31, 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 2017 Annual Form 10-K. There have not been any material changes in the Company's significant accounting policies from those contained in the 2017 Annual Form 10-K, except for the accounting policy relating to revenue from contracts with customers adopted January 1, 2018, as discussed below.

Revenue from Contracts with Customers

Accounting Standards Codification Topic 606, Revenue from Contracts with Customers, (“ASC 606”), as amended, was adopted by the Company on January 1, 2018. ASC 606 applies to all contracts with customers to provide goods or services in the ordinary course of 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:

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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 the contract duration does not extend beyond the service performed.

Wealth Management and Trust ~~Services.~~Services: The 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 customer’s assets under management or based on investment or insurance solutions that are implemented for the 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 (i) interchange fees earned from the payment network as a debit card issuer, (ii) referral fee income, and (iii) ongoing merchant fees earned for referring customers to the payment processing provider. These fees are recognized when the transaction occurs, but may settle on a daily or monthly basis.

(d) Recently Issued Accounting Pronouncements

FASB ASU 2014-09, Revenue from Contracts with Customers, (as amended by FASB ASU 2015-14; FASB ASU 2016-08; FASB ASU 2016-10 and FASB ASU 2016-12), was issued in May 2014. Under this Accounting Standard Update ("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 permitted, but only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. The Company adopted the revenue recognition guidance, as amended, on

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January 1, 2018 using the modified retrospective approach. A significant amount of the Company’s revenues are derived from interest income on financial assets, which are excluded from the scope of the amended guidance. With respect to noninterest income and related disclosures, the Company has identified and evaluated the revenue streams and underlying revenue contracts within the scope of the guidance. The Company did not identify any significant changes in the timing of revenue recognition when considering the amended accounting guidance. The adoption of the Update did not have a material impact on the Company's Condensed Consolidated Financial Statements, but the adoption did change certain disclosure requirements ~~included~~as described 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) requiring equity investments, with certain exceptions, to be measured at fair value with changes in fair value recognized in net income; (2) simplifying the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment; (3) eliminating the requirement to disclose the method(s) and significant assumptions used to estimate fair value; and (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 was effective for public entities for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The~~ Company adopted this Update effective January 1, 2018 using the cumulative catch-up transition method. This change resulted in a cumulative adjustment of $93,000 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

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requirements were additionally changed due to adoption of this Update. Previously, the Company valued these items using an entry price notion. This ASU emphasized that these instruments be measured using the exit price notion; accordingly, the Company refined its calculation as part of adopting this ~~standard.~~Update. Prior period information has not been updated to conform with the new guidance. See the Condensed Consolidated Statements of Stockholders' Equity and Note (14) Fair Value Measurements.

FASB ASU 2016-02, Leases (Topic 842), as amended by ASU 2017-13, 2018-01, 2018-10 and ASU 2018-11, was originally issued in February 2016, to increase transparency and comparability of leases among organizations and to disclose key information about leasing arrangements. The Update sets out the principles for the recognition, measurement, presentation and disclosure of leases for both lessees and lessors. The Update requires lessees to apply a dual approach, classifying leases as either a finance or operating lease. This classification will determine whether the lease expense is recognized based on an effective interest method or on a straight-line basis over the term of the lease. A lessee is also required to record a right-of-use asset and a lease liability for all leases with a term greater than 12 months regardless of their classification. All cash payments will be classified within operating activities in the statement of cash flows. In transition, lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. The Update is effective for public entities for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The Company anticipates adopting the Update on January 1, 2019. Upon adoption of the guidance, the Company expects to report increased assets and increased liabilities on its Condensed Consolidated Statements of Financial Condition as a result of recognizing right-of-use assets and lease liabilities related to certain banking offices and certain equipment under noncancelable operating lease agreements, which currently are not reflected in its Condensed Consolidated Statements of Financial Condition. During 2017, management developed its methodology to estimate the right-of use assets and lease liabilities. The Company anticipates electing an exclusion accounting policy for lease assets and lease liabilities for leases with a term of twelve months or less. The Company was committed to ~~$13.9~~$14.5 million of minimum lease payments under noncancelable operating lease agreements at ~~March 31,~~September 30, 2018. The Company does not expect the adoption of this ~~amendment~~Update 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 2016-10~~, ~~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 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 ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality, for 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

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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 has begun developing and implementing processes and procedures to ensure it is fully compliant with the amendments at the adoption date. To date, the CECL steering committee has selected a vendor to assist the Company in the adoption and has ~~begun~~completed the implementation discovery sessions. The CECL steering committee is in the process of selecting appropriate methodologies and refining key data to process through its CECL models. The Company anticipates running parallel models by second quarter 2019.

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 was effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years, and must be applied using a retrospective transitional method to each period presented. The Company adopted this Update on January 1, 2018. The adoption did not have a significant impact on its Condensed Consolidated Financial Statements as cash proceeds received from the settlement of bank-owned life insurance policies and cash ~~payment~~payments for premiums on bank-owned life insurance policies were previously classified as cash inflows and outflows, respectively, from investing activities in the Condensed Consolidated Statements of 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.

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

FASB ASU 2017-09, Compensation—Stock Compensation (Topic 718): Scope of Modification Accounting was issued in May 2017 to provide clarity as to when to apply modification accounting when there is a change in the terms or conditions of a share-based payment award. According to this Update, an entity should account for the effects of a modification unless the fair value, vesting conditions and balance sheet classification of the award is the same after the modification as compared to the original award prior to the modification. The Update was effective for reporting periods beginning after December 15, 2017. The Company adopted the Update on January 1, 2018. The adoption did not have a material impact on its Condensed Consolidated Financial Statements because ~~we did not modify any~~no share-based payment award was modified during the ~~first quarter~~nine months ended ~~March 31,~~September 30, 2018. WeThe Company 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

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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,~~September 30, 2018, the Company did not incur any adjustments to the provisional recognition.

FASB ASU 2018-13, Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement, was issued in August 2018 and modifies the disclosure requirements on fair value measurements in Topic 820. The amendments in this Update are effective for all entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. The Company does not expect the Update will have a material impact on its Condensed Consolidated Financial Statements.


(2)	Business ~~Combination~~Combinations

During the nine months ended September 30, 2018, the Company completed the acquisitions of Puget Sound Bancorp and Premier Commercial Bancorp. There were no acquisitions completed during the nine months ended September 30, 2017.

Puget Sound:

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 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.

Pursuant to the terms of the Puget Sound Merger, all outstanding Puget Sound restricted stock awards became immediately vested on the acquisition date of the Puget Sound Merger and 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 based on the January 12, 2018 closing price of Heritage Common stock of $31.80 for total fair value of common shares issued of $130.8 million and paid cash of $3,000 for fractional shares in the transaction for total consideration paid of $130.8 million. Total consideration includes $851,000 representing 26,741 shares which were forfeited by the Puget Sound shareholders to pay applicable taxes.

During the three and nine months ended September 30, 2018, the Company incurred acquisition-related costs of approximately $67,000 and $5.1 million, respectively, for the Puget Sound Merger. The Company incurred acquisition related costs of $387,000 for the three and nine months ended September 30, 2017 for the Puget Sound Merger.

Premier Commercial:

On March 24, 2018, the Company, along with the Bank, and Premier Commercial Bancorp and its wholly owned subsidiary bank, Premier Community Bank, jointly announced the signing of a definitive agreement. The Premier Merger was effective on July 2, 2018. As of the acquisition date, Premier merged into Heritage and Premier Commercial Bank merged into Heritage Bank.

Pursuant to the terms of the Premier Merger, Premier Commercial shareholders received 0.4863 shares of Heritage common stock in exchange for each share of Premier Commercial common stock based on the closing date price per share of Heritage common stock on June 29, 2018 of $34.85. Heritage issued an aggregate of 2,848,579 shares of its common stock and paid cash of $2,000 for fractional shares in the transaction for total consideration paid of $99.3 million.

During the three and nine months ended September 30, 2018, the Company incurred acquisition-related costs of approximately $3.3 million and $4.0 million, respectively, for the Premier Merger. The Company did not incur acquisition related costs for the three and nine months ended September 30, 2017 for the Premier Merger.

Business Combination Accounting:

The Premier Merger and Puget Sound Merger resulted in $53.3 million and $68.5 million, respectively, of goodwill. This goodwill is not deductible for tax purposes.

The primary reason for the ~~merger~~Premier and Puget Mergers was to create depth in the Company's geographic footprint consistent with its ongoing growth strategy, focused heavily on metro markets, and to achieve operational scale and realize efficiencies of a larger combined organization.

Pursuant to the terms to the Puget Sound Merger, all outstanding Puget Sound restricted stock awards became immediately vested prior to the 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 paid cash of $3,000 for fractional The mergers constitute business acquisitions as

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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.~~these transactions. Accordingly, the preliminary estimates of fair values of ~~the~~Premier Commercial and Puget Sound assets, including the identifiable intangible assets, and the assumed liabilities in the Premier Merger and Puget Sound Merger were measured and recorded as of July 2, 2018 and January 16, ~~2018.~~2018, respectively. Fair values on the acquisition ~~date~~dates 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~~acquisitions as additional information regarding the closing date fair values becomes available. The Company expects to finalize the purchase price allocation for both mergers by the ~~second~~end of the fourth quarter of 2018 when the valuation of certain matters, including tax-related ~~matters~~balances, is complete.

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


	Puget Sound Merger		Premier Merger		Puget Sound Merger
	(In thousands)		(In thousands)
Assets
Cash and cash equivalents	$	25,889	$	22,534	$	25,889
Interest earning deposits	54,247		3,309		54,247
Investment securities available for sale	80,353		4,493		80,353
Loans receivable	388,462		330,085		388,462
Other real estate owned			1,796		—
Premises and equipment, net	732		3,053		732
Federal Home Loan Bank stock, at cost	623		1,120		623
Bank owned life insurance	6,264		10,852		6,264
Accrued interest receivable	1,448		1,006		1,448
Prepaid expenses and other assets	1,354		1,828		1,354
Other intangible assets	11,270		7,075		11,270
Total assets acquired	$	570,642	$	387,151	$	570,642
Liabilities
Deposits	$	505,885	$	318,717	$	505,885
Federal Home Loan Bank advances			16,000		—
Securities sold under agreement to repurchase			462		—
Accrued expenses and other liabilities	2,504		5,985		2,504
Total liabilities acquired	$	508,389	$	341,164	$	508,389

Fair value of net assets acquired	$	62,253	$	45,987	$	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 Premier and Puget Sound ~~Merger~~Mergers 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			Premier Merger			Puget Sound Merger
	(In thousands)			(In thousands)
Cost basis of net assets on merger date	$	54,405		$	40,579		$	54,405
Consideration transferred	(130,773		)	(99,275		)	(130,773		)
Fair value adjustments:
Investment securities	(348		)	(135		)	(348		)
Total loans receivable, net	1,400			(184		)	1,400
Other real estate owned				(1,017		)	—
Premises and equipment	(121		)	1,312			(121		)
Other intangible assets	9,207			7,075			9,207
Prepaid expenses and other assets	(2,282		)	(1,686		)	(2,282		)
Deposits	(62		)	(310		)	(62		)
Accrued expenses and other liabilities	54			353			54
Goodwill recognized from the Puget Sound Merger	$	(68,520	)
Goodwill recognized from the mergers				$	(53,288	)	$	(68,520	)

The operating results of the Company for the three and nine months ended ~~March 31,~~September 30, 2018 include the operating results produced by the net assets acquired in the Premier and Puget ~~Sound Merger~~Mergers since the July 2, 2018 and January 16, 2018 merger ~~date.~~dates. The Company has considered the requirement of FASB ASC 805 related to the contribution of the Premier and Puget ~~Sound Merger~~Mergers to the Company’s results of operations. The table below presents only the significant results for the acquired ~~business~~businesses since the July 2, 2018 and January 16, 2018 merger ~~date:~~dates:


				Premier Merger ⁽¹⁾						Puget Sound Merger⁽¹⁾						Total
				Three Months Ended			Nine Months Ended			Three Months Ended			Nine Months Ended			Three Months Ended			Nine Months Ended
	Three Months Ended⁽¹⁾			September 30, 2018
	(In thousands)			(In thousands)
Interest income: Interest and fees on loans⁽²⁾	$	4,518		$	5,422		$	5,422		$	5,959		$	16,606		$	11,381		$	22,028
Interest income: Interest and fees on investments ⁽³⁾	59			39			39			—			59			39			98
Interest income: Other interest earning assets	88			115			115			—			113			115			228
Interest expense	(144		)	(232		)	(232		)	(179		)	(503		)	(411		)	(735		)
Provision for loan losses for loans	(200		)	(150		)	(150		)	(350		)	(900		)	(500		)	(1,050		)
Noninterest income	148			44			44			110			367			154			411
Noninterest expense ⁽⁴⁾	(5,580		)	(5,435		)	(5,435		)	(1,619		)	(9,291		)	(7,054		)	(14,726		)
Net effect, pre-tax	$	(1,111	)	$	(197	)	$	(197	)	$	3,921		$	6,451		$	3,724		$	6,254

⁽¹⁾ The Premier Merger was completed on July 2, 2018. The Puget Sound Merger was completed on January 16, 2018.

⁽²⁾ Includes the accretion of the discount on the purchased loans of ~~$479,000.~~$1.9 million and $3.4 million during the three and nine months ended September 30, 2018, respectively.

⁽³⁾ All securities acquired in the Puget Sound Merger 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.

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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 Premier and Puget ~~Sound Merger is~~Mergers are individually and collectively not material to the Company. The Company believes that the historical Premier Commercial and Puget Sound operating results, individually or collectively, 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 FASB 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.~~accumulated other comprehensive loss. Accordingly, these securities are no longer classified as ~~available-for-sale~~investment securities 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~~Recently Issued Accounting ~~Policies,~~Pronouncements, as well as the Equity Securities section discussed below.

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Available for sale investment securities

(a) Securities by Type and Maturity

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


	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value		Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(In thousands)									(In thousands)
March 31, 2018
September 30, 2018
U.S. Treasury and U.S. Government-sponsored agencies	$	23,448	$	43	$	(102	)	$	23,389	$	84,252	$	51	$	(505	)	$	83,798
Municipal securities	203,771		1,747		(1,226		)	204,292		164,641		887		(1,456		)	164,072
Mortgage-backed securities and collateralized mortgage obligations⁽¹⁾:
Residential	307,655		365		(6,743		)	301,277		321,145		207		(9,436		)	311,916
Commercial	250,489		222		(6,351		)	244,360		318,165		162		(9,213		)	309,114
Collateralized loan obligations	3,266		5		—			3,271		967		—		—			967
Corporate obligations	16,589		131		(91		)	16,629		25,639		137		(67		)	25,709
Other asset-backed securities	27,670		679		—			28,349		24,543		618		—			25,161
Total	$	832,888	$	3,192	$	(14,513	)	$	821,567	$	939,352	$	2,062	$	(20,677	)	$	920,737

December 31, 2017
U.S. Treasury and U.S. Government-sponsored agencies	$	13,460	$	6	$	(24	)	$	13,442	$	13,460	$	6	$	(24	)	$	13,442
Municipal securities	247,358		3,720		(1,063		)	250,015		247,358		3,720		(1,063		)	250,015
Mortgage-backed securities and collateralized mortgage obligations⁽¹⁾:
Residential	282,724		422		(2,935		)	280,211		282,724		422		(2,935		)	280,211
Commercial	219,696		444		(3,061		)	217,079		219,696		444		(3,061		)	217,079
Collateralized loan obligations	4,561		19		—			4,580		4,561		19		—			4,580
Corporate obligations	16,594		220		(44		)	16,770		16,594		220		(44		)	16,770
Other securities ⁽²⁾	27,781		652		—			28,433		27,781		652		—			28,433
Total	$	812,174	$	5,483	$	(7,127	)	$	810,530	$	812,174	$	5,483	$	(7,127	)	$	810,530


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


⁽²⁾	Primarily asset-backed securities.

There were no securities classified as trading or held to maturity at ~~March 31,~~September 30, 2018 or December 31, 2017.

The amortized cost and fair value of investment securities available for sale at ~~March 31,~~September 30, 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	$	20,658	$	20,682
Due after one year through five years	185,956		183,968
Due after five years through ten years	256,795		249,376
Due after ten years	475,943		466,711
Total	$	939,352	$	920,737

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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 ~~March 31,~~September 30, 2018 and December 31, 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)
March 31, 2018
September 30, 2018
U.S. Treasury and U.S. Government-sponsored agencies	$	7,353	$	(102	)	$	—	$	—		$	7,353	$	(102	)	$	77,217	$	(492	)	$	530	$	(13	)	$	77,747	$	(505	)
Municipal securities	63,636		(607		)	16,842		(619		)	80,478		(1,226		)	61,743		(549		)	27,912		(907		)	89,655		(1,456		)
Mortgage-backed securities and collateralized mortgage obligations⁽¹⁾:
Residential	181,058		(3,509		)	70,098		(3,234		)	251,156		(6,743		)	139,277		(2,927		)	136,045		(6,509		)	275,322		(9,436		)
Commercial	127,395		(2,698		)	87,284		(3,653		)	214,679		(6,351		)	142,747		(2,242		)	139,847		(6,971		)	282,594		(9,213		)
Corporate obligations	9,483		(91		)	—		—			9,483		(91		)	12,695		(44		)	1,977		(23		)	14,672		(67		)
Total	$	388,925	$	(7,007	)	$	174,224	$	(7,506	)	$	563,149	$	(14,513	)	$	435,733	$	(6,254	)	$	306,311	$	(14,423	)	$	742,044	$	(20,677	)

December 31, 2017
U.S. Treasury and U.S. Government-sponsored agencies	$	11,436	$	(24	)	$	—	$	—		$	11,436	$	(24	)	$	11,436	$	(24	)	$	—	$	—		$	11,436	$	(24	)
Municipal securities	$	39,298	$	(384	)	$	26,509	$	(679	)	$	65,807	$	(1,063	)	39,298		(384		)	26,509		(679		)	65,807		(1,063		)
Mortgage-backed securities and collateralized mortgage obligations⁽¹⁾:
Residential	175,847		(1,296		)	66,380		(1,639		)	242,227		(2,935		)	175,847		(1,296		)	66,380		(1,639		)	242,227		(2,935		)
Commercial	75,121		(700		)	90,822		(2,361		)	165,943		(3,061		)	75,121		(700		)	90,822		(2,361		)	165,943		(3,061		)
Corporate obligations	3,472		(44		)	—		—			3,472		(44		)	3,472		(44		)	—		—			3,472		(44		)
Total	$	305,174	$	(2,448	)	$	183,711	$	(4,679	)	$	488,885	$	(7,127	)	$	305,174	$	(2,448	)	$	183,711	$	(4,679	)	$	488,885	$	(7,127	)

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

The Company has evaluated these investment securities available for sale as of ~~March 31,~~September 30, 2018 and December 31, 2017 and has determined that the decline in their value is not other-than-temporary. The unrealized losses are primarily due to increases in market interest rates. The fair value of these securities is expected to recover as the securities approach their maturity date. None of the underlying issuers of the municipal securities and corporate obligations had credit ratings that were below investment grade levels at ~~March 31,~~September 30, 2018 or December 31, 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.

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For the three and nine months ended ~~March 31,~~September 30, 2018 and 2017, there were no other-than-temporary charges recorded to net income.

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The following table presents the gross realized gains and losses on the sale of securities available for sale for the three and nine months ended ~~March 31,~~September 30, 2018 and 2017.


	Three Months Ended March 31,					Three Months Ended September 30,						Nine Months Ended September 30,
	2018			2017		2018			2017			2018			2017
	(In thousands)					(In thousands)
Gross realized gains	$	104		$	—	$	145		$	75		$	267		$	192
Gross realized losses	(69		)	—		(63		)	(31		)	(132		)	(31		)
Net realized gains	$	35		$	—	$	82		$	44		$	135		$	161

(d) Pledged Securities

The following table summarizes the amortized cost and fair value of investment securities available for sale that are pledged as collateral for the following obligations at ~~March 31,~~September 30, 2018 and December 31, 2017:


	March 31, 2018				December 31, 2017				September 30, 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	$	202,048	$	199,605	$	206,377	$	206,425	$	194,052	$	189,917	$	206,377	$	206,425
Repurchase agreements	46,979		45,864		48,750		48,237		46,097		44,706		48,750		48,237
Other securities pledged	17,300		17,096		12,484		12,498		21,237		20,571		12,484		12,498
Total	$	266,327	$	262,565	$	267,611	$	267,160	$	261,386	$	255,194	$	267,611	$	267,160

Equity Securities

The Company holds an equity security with a readily determinable fair value of ~~$162,000~~$132,000 and $146,000 as of ~~March 31,~~September 30, 2018 and December 31, 2017, respectively. As a result of the adoption of FASB ASU 2016-01, this security is no longer classified as an investment security 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,~~September 30, 2018. As such, its presentation is not comparable to the presentation as of December 31, 2017. The Company recorded the tax-effected 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~~nine months ended ~~March 31,~~September 30, 2018.


(4)	Loans Receivable

The Company originates loans in the ordinary course of business and has also acquired loans through ~~FDIC-assisted~~mergers and ~~open bank transactions.~~acquisitions. 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 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.

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.

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


	March 31, 2018			December 31, 2017			September 30, 2018			December 31, 2017
	(In thousands)						(In thousands)
Commercial business:
Commercial and industrial	$	811,678		$	645,396		$	861,530		$	645,396
Owner-occupied commercial real estate	702,356			622,150			785,416			622,150
Non-owner occupied commercial real estate	1,133,394			986,594			1,283,160			986,594
Total commercial business	2,647,428			2,254,140			2,930,106			2,254,140
One-to-four family residential	89,180			86,997			96,333			86,997
Real estate construction and land development:
One-to-four family residential	73,295			51,985			107,148			51,985
Five or more family residential and commercial properties	98,387			97,499			120,787			97,499
Total real estate construction and land development	171,682			149,484			227,935			149,484
Consumer	370,275			355,091			391,283			355,091
Gross loans receivable	3,278,565			2,845,712			3,645,657			2,845,712
Net deferred loan costs	3,350			3,359			3,397			3,359
Loans receivable, net	3,281,915			2,849,071			3,649,054			2,849,071
Allowance for loan losses	(33,261		)	(32,086		)	(34,475		)	(32,086		)
Total loans receivable, net	$	3,248,654		$	2,816,985		$	3,614,579		$	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 ~~March 31,~~September 30, 2018) non-owner occupied commercial real estate, commercial and industrial and owner-occupied commercial real estate. As of ~~March 31,~~September 30, 2018 and December 31, 2017,, there were no concentrations of loans related to any single industry in excess of 10% of the Company’s total loans.

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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.

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


	March 31, 2018										September 30, 2018
	Pass		OAEM		Substandard		Doubtful/Loss		Total		Pass		OAEM		Substandard		Doubtful/Loss		Total
	(In thousands)										(In thousands)
Commercial business:
Commercial and industrial	$	754,720	$	25,050	$	31,908	$	—	$	811,678	$	797,284	$	15,793	$	48,453	$	—	$	861,530
Owner-occupied commercial real estate	663,770		19,988		18,598		—		702,356		745,548		21,260		18,608		—		785,416
Non-owner occupied commercial real estate	1,106,904		10,415		16,075		—		1,133,394		1,256,115		12,889		14,156		—		1,283,160
Total commercial business	2,525,394		55,453		66,581		—		2,647,428		2,798,947		49,942		81,217		—		2,930,106
One-to-four family residential	87,962		—		1,218		—		89,180		95,023		—		1,310		—		96,333
Real estate construction and land development:
One-to-four family residential	71,735		275		1,285		—		73,295		105,703		261		1,184		—		107,148
Five or more family residential and commercial properties	98,328		59		—		—		98,387		120,733		54		—		—		120,787
Total real estate construction and land development	170,063		334		1,285		—		171,682		226,436		315		1,184		—		227,935
Consumer	365,577		—		4,172		526		370,275		386,566		—		4,193		524		391,283
Gross loans receivable	$	3,148,996	$	55,787	$	73,256	$	526	$	3,278,565	$	3,506,972	$	50,257	$	87,904	$	524	$	3,645,657



	December 31, 2017
	Pass		OAEM		Substandard		Doubtful/Loss		Total
	(In thousands)
Commercial business:
Commercial and industrial	$	597,697	$	19,536	$	28,163	$	—	$	645,396
Owner-occupied commercial real estate	595,455		12,668		14,027		—		622,150
Non-owner occupied commercial real estate	955,450		10,494		20,650		—		986,594
Total commercial business	2,148,602		42,698		62,840		—		2,254,140
One-to-four family residential	85,762		—		1,235		—		86,997
Real estate construction and land development:
One-to-four family residential	49,925		537		1,523		—		51,985
Five or more family residential and commercial properties	96,404		707		388		—		97,499
Total real estate construction and land development	146,329		1,244		1,911		—		149,484
Consumer	349,590		—		4,976		525		355,091
Gross loans receivable	$	2,730,283	$	43,942	$	70,962	$	525	$	2,845,712

Potential problem loans are loans classified as OAEM or worse that are currently accruing interest and are not considered impaired, but which management is monitoring because the financial information of the borrower causes concern as to their ability to meet their loan repayment terms. Potential problem loans may include PCI loans as these loans continue to accrete loan discounts established at acquisition based on the guidance of FASB ASC 310-30. Potential problem loans as of ~~March 31,~~September 30, 2018 and December 31, 2017 were ~~$93.3~~$105.7 million and $83.5 million, respectively.

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(d) Nonaccrual Loans

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


	March 31, 2018		December 31, 2017		September 30, 2018		December 31, 2017
	(In thousands)				(In thousands)
Commercial business:
Commercial and industrial	$	7,627	$	3,110	$	5,918	$	3,110
Owner-occupied commercial real estate	4,544		4,090		5,565		4,090
Non-owner occupied commercial real estate	2,185		1,898		2,004		1,898
Total commercial business	14,356		9,098		13,487		9,098
One-to-four family residential	80		81		74		81
Real estate construction and land development:
One-to-four family residential	1,147		1,247		1,076		1,247
Consumer	145		277		143		277
Nonaccrual loans	$	15,728	$	10,703	$	14,780	$	10,703

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

(e) Past due loans

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

The balances of past due loans, segregated by segments and classes of loans, as of ~~March 31,~~September 30, 2018 and December 31, 2017 were as follows:


	March 31, 2018										September 30, 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	$	16,944	$	1,449	$	18,393	$	793,285	$	811,678	$	685	$	1,946	$	2,631	$	858,899	$	861,530
Owner-occupied commercial real estate	1,310		989		2,299		700,057		702,356		1,666		1,385		3,051		782,365		785,416
Non-owner occupied commercial real estate	931		3,282		4,213		1,129,181		1,133,394		1,985		1,103		3,088		1,280,072		1,283,160
Total commercial business	19,185		5,720		24,905		2,622,523		2,647,428		4,336		4,434		8,770		2,921,336		2,930,106
One-to-four family residential	535		—		535		88,645		89,180		—		—		—		96,333		96,333
Real estate construction and land development:
One-to-four family residential	—		1,147		1,147		72,148		73,295		—		309		309		106,839		107,148
Five or more family residential and commercial properties	408		—		408		97,979		98,387		—		—		—		120,787		120,787
Total real estate construction and land development	408		1,147		1,555		170,127		171,682		—		309		309		227,626		227,935
Consumer	1,896		—		1,896		368,379		370,275		1,445		—		1,445		389,838		391,283
Gross loans receivable	$	22,024	$	6,867	$	28,891	$	3,249,674	$	3,278,565	$	5,781	$	4,743	$	10,524	$	3,635,133	$	3,645,657

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	December 31, 2017
	30-89 Days		90 Days or Greater		Total Past Due		Current		Total
	(In thousands)
Commercial business:
Commercial and industrial	$	2,993	$	1,172	$	4,165	$	641,231	$	645,396
Owner-occupied commercial real estate	1,277		1,225		2,502		619,648		622,150
Non-owner occupied commercial real estate	870		3,314		4,184		982,410		986,594
Total commercial business	5,140		5,711		10,851		2,243,289		2,254,140
One-to-four family residential	513		—		513		86,484		86,997
Real estate construction and land development:
One-to-four family residential	84		1,331		1,415		50,570		51,985
Five or more family residential and commercial properties	40		—		40		97,459		97,499
Total real estate construction and land development	124		1,331		1,455		148,029		149,484
Consumer	1,939		687		2,626		352,465		355,091
Gross loans receivable	$	7,716	$	7,729	$	15,445	$	2,830,267	$	2,845,712

There were no loans 90 days or more past due that were still accruing interest as of ~~March 31,~~September 30, 2018 or December 31, 2017, excluding PCI loans.

(f) Impaired loans

Impaired loans include nonaccrual loans and performing troubled debt restructured ("TDR") loans. The balances of impaired loans as of ~~March 31,~~September 30, 2018 and December 31, 2017 are set forth in the following tables.


	March 31, 2018										September 30, 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	$	5,135	$	11,390	$	16,525	$	17,191	$	1,769	$	2,409	$	11,821	$	14,230	$	14,738	$	1,711
Owner-occupied commercial real estate	936		12,165		13,101		13,386		1,727		1,566		11,315		12,881		12,907		1,825
Non-owner occupied commercial real estate	4,692		5,776		10,468		10,630		811		4,484		5,863		10,347		10,483		739
Total commercial business	10,763		29,331		40,094		41,207		4,307		8,459		28,999		37,458		38,128		4,275
One-to-four family residential	—		295		295		305		93		—		285		285		297		80
Real estate construction and land development:
One-to-four family residential	838		309		1,147		1,892		2		767		309		1,076		1,838		6
Total real estate construction and land development	838		309		1,147		1,892		2		767		309		1,076		1,838		6
Consumer	—		379		379		450		73		—		410		410		398		113
Total	$	11,601	$	30,314	$	41,915	$	43,854	$	4,475	$	9,226	$	30,003	$	39,229	$	40,661	$	4,474

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


	Three Months Ended March 31,				Three Months Ended September 30,				Nine Months Ended September 30,
	2018		2017		2018		2017		2018		2017
	(In thousands)				(In thousands)
Commercial business:
Commercial and industrial	$	14,261	$	9,834	$	16,252	$	11,171	$	15,258	$	11,190
Owner-occupied commercial real estate	12,841		4,017		12,533		5,289		12,687		5,049
Non-owner occupied commercial real estate	10,358		11,265		10,265		11,037		10,311		11,198
Total commercial business	37,460		25,116		39,050		27,497		38,256		27,437
One-to-four family residential	297		317		288		307		292		312
Real estate construction and land development:
One-to-four family residential	1,197		2,904		1,080		2,157		1,139		2,530
Five or more family residential and commercial properties	322		1,075		—		860		161		967
Total real estate construction and land development	1,519		3,979		1,080		3,017		1,300		3,497
Consumer	411		289		396		346		403		328
Total	$	39,687	$	29,701	$	40,814	$	31,167	$	40,251	$	31,574

For the three and nine months ended ~~March 31,~~September 30, 2018 and 2017, no interest income was recognized subsequent to a loan’s classification as nonaccrual. For the three and nine months ended ~~March 31,~~September 30, 2018, the Bank recorded $361,000 and $1.0 million, respectively, of interest income related to performing TDR loans. For the three and nine months ended September 30, 2017, the Bank recorded ~~$326,000~~$366,000 and ~~$365,000,~~$1.0 million, respectively, of interest income related to performing TDR loans.

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(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. 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 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 TDR loans using the same guidance as used for other impaired loans.

The recorded investment balance and related allowance for loan losses of performing and nonaccrual TDR loans as of ~~March 31,~~September 30, 2018 and December 31, 2017 were as follows:


	March 31, 2018				December 31, 2017				September 30, 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	$	26,187	$	8,214	$	26,757	$	5,193	$	24,449	$	6,461	$	26,757	$	5,193
Allowance for loan losses on TDR loans	2,613		336		2,635		379		2,237		713		2,635		379

The unfunded commitment to borrowers related to TDR loans was ~~$517,000~~$1.3 million and $1.2 million at ~~March 31,~~September 30, 2018 and December 31, 2017, respectively.

~~Table of Contents~~

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


	Three Months Ended March 31,						Three Months Ended September 30,
	2018			2017			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	9	$	4,323	8	$	3,245	11	$	2,352	4	$	1,353
Owner-occupied commercial real estate	—	—		1	56		2	1,081		2	1,299
Non-owner occupied commercial real estate	1	2,201		1	184		2	2,776		1	655
Total commercial business	10	6,524		10	3,485		15	6,209		7	3,307
Real estate construction and land development:
One-to-four family residential	—	—		2	1,143
Total real estate construction and land development	—	—		2	1,143
Consumer	3	78		1	9		1	25		4	52
Total loans modified as TDR loans	13	$	6,602	13	$	4,637	16	$	6,234	11	$	3,359

Table of Contents



	Nine Months Ended September 30,
	2018			2017
	Number of Contracts (1)	Outstanding Principal Balance (1)(2)		Number of Contracts (1)	Outstanding Principal Balance (1)(2)
	(Dollars in thousands)
Commercial business:
Commercial and industrial	22	$	4,445	13	$	5,564
Owner-occupied commercial real estate	3	1,639		3	1,351
Non-owner occupied commercial real estate	3	2,976		2	1,596
Total commercial business	28	9,060		18	8,511
Real estate construction and land development:
One-to-four family residential	2	767		2	1,038
Total real estate construction and land development	2	767		2	1,038
Consumer	8	133		5	60
Total TDR loans	38	$	9,960	25	$	9,609


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

The related specific valuation allowance at September 30, 2018 for loans that were modified as TDR loans during the nine months ended September 30, 2018 was $1.0 million. Certain loans included in the ~~table~~tables above may have been previously reported as TDR loans. The Bank typically grants shorter extension periods to continually monitor these TDR loans despite the fact that the extended date might not be the date the Bank expects sufficient cash flow from these borrowers. The Bank does not consider these modifications a subsequent default of a TDR as new loan terms, specifically new maturity dates, were granted. The potential losses related to these loans would have been considered in the period the loan was first reported as a TDR loan and are adjusted, as necessary, in the current period based on more recent information. ~~The related specific valuation allowance at March 31, 2018 was $195,000 for loans that were modified as TDR loans during the three months ended 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 ~~March 31,~~September 30, 2018 and 2017 are set forth in the following table:


	Three Months Ended March 31,						Three Months Ended September 30,
	2018			2017			2018			2017
	Number of Contracts	Outstanding Principal Balance		Number of Contracts	Outstanding Principal Balance		Number of Contracts	Outstanding Principal Balance		Number of Contracts	Outstanding Principal Balance
	(Dollars in thousands)						(Dollars in thousands)
Commercial business:
Commercial and industrial	1	$	283	1	$	234	2	$	1,742	1	$	234
Non-owner occupied commercial real estate	1	75		—	—
Total commercial business	2	358		1	234		2	1,742		1	234
Real estate construction and land development:
One-to-four family residential	2	838		—	—
Total	4	$	1,196	1	$	234	2	$	1,742	1	$	234

Table of Contents



	Nine Months Ended September 30,
	2018			2017
	Number of Contracts	Outstanding Principal Balance		Number of Contracts	Outstanding Principal Balance
	(Dollars in thousands)
Commercial business:
Commercial and industrial	7	$	2,020	1	$	234
Owner-occupied commercial real estate	1	69		—	—
Non-owner occupied commercial real estate	—	—		—	—
Total commercial business	8	2,089		1	234
Real estate construction and land development:
One-to-four family residential	2	767		—	—
Total real estate construction and land development	2	767		—	—
Total	10	$	2,856	1	$	234

During the ~~three~~nine months ended ~~March 31,~~September 30, 2018, ~~the four~~one owner-occupied commercial real estate TDR loan and two commercial and industrial TDR loans with a total outstanding balance of $69,000 and $1.7 million, respectively, defaulted because ~~they were~~each was past ~~their~~its modified maturity ~~dates,~~date, and the ~~borrowers have~~borrower has not subsequently repaid the credits. The Bank has chosen not to further extend the ~~maturities~~maturity date on these loans. In addition, during the nine months ended September 30, 2018, one commercial and industrial TDR loan and two construction TDR loans with total outstanding balances of $279,000 and $767,000, respectively, defaulted because the borrowers were more than 90 days delinquent on their scheduled loan payments. Also, four commercial and industrial TDR loans defaulted and subsequently repaid their credits during nine months ended September 30, 2018. The Bank had noa $320,000 specific valuation allowance at ~~March 31,~~September 30, 2018 related to ~~the credits~~these TDR loans which defaulted during the ~~three~~nine months ended ~~March 31,~~September 30, 2018.

~~The~~During both the three and nine months ended September 30, 2017, the one commercial and industrial TDR 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.~~payment.

(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. No loans acquired in the Premier and Puget ~~Sound Merger effective January 16, 2018~~Mergers were considered PCI.

Table of Contents

The following table reflects the outstanding principal balance and recorded investment of the PCI loans at ~~March 31,~~September 30, 2018 and December 31, 2017:

March 31, 2018 December 31, 2017
Outstanding Principal Recorded Investment Outstanding Principal Recorded Investment
(In thousands)
Commercial business:
Commercial and industrial $ 8,269
$ 2,091
$ 8,818
$ 2,912
Owner-occupied commercial real estate 10,392
9,840
12,230
11,515
Non-owner occupied commercial real estate 11,855
11,088
14,295
13,342
Total commercial business 30,516
23,019
35,343
27,769
One-to-four family residential 3,891
5,039
4,120
5,255
Real estate construction and land development:
One-to-four family residential 275
—
841
89
Five or more family residential and commercial properties 1,820
1,552
2,361
2,035
Total real estate construction and land development 2,095
1,552
3,202
2,124
Consumer 3,324
4,861
3,974
5,455
Gross PCI loans $ 39,826
$ 34,471
$ 46,639
$ 40,603

~~Table of Contents~~



	September 30, 2018				December 31, 2017
	Outstanding Principal		Recorded Investment		Outstanding Principal		Recorded Investment
	(In thousands)
Commercial business:
Commercial and industrial	$	7,182	$	3,758	$	8,818	$	2,912
Owner-occupied commercial real estate	9,277		8,258		12,230		11,515
Non-owner occupied commercial real estate	9,051		8,020		14,295		13,342
Total commercial business	25,510		20,036		35,343		27,769
One-to-four family residential	3,279		3,416		4,120		5,255
Real estate construction and land development:
One-to-four family residential	87		387		841		89
Five or more family residential and commercial properties	1,787		1,268		2,361		2,035
Total real estate construction and land development	1,874		1,655		3,202		2,124
Consumer	2,500		3,746		3,974		5,455
Gross PCI loans	$	33,163	$	28,853	$	46,639	$	40,603

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 ~~March 31,~~September 30, 2018 and 2017.


	Three Months Ended March 31,						Three Months Ended September 30,						Nine Months Ended September 30,
	2018			2017			2018			2017			2018			2017
	(In thousands)						(In thousands)
Balance at the beginning of the period	$	11,224		$	13,860		$	10,060		$	12,296		$	11,224		$	13,860
Accretion	(781		)	(994		)	(644		)	(796		)	(2,011		)	(2,725		)
Disposal and other	(1,698		)	(490		)	(164		)	(1,287		)	(2,136		)	(2,430		)
Change in accretable yield	2,524			756			1,198			939			3,373			2,447
Balance at the end of the period	$	11,269		$	13,132		$	10,450		$	11,152		$	10,450		$	11,152

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(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 ~~March 31,~~September 30, 2018:


	Balance at Beginning of Period		Charge-offs			Recoveries		Provision for Loan Losses			Balance at End of Period		Balance at Beginning of Period		Charge-offs			Recoveries		Provision for Loan Losses			Balance at End of Period
	(In thousands)												(In thousands)
Three Months Ended March 31, 2018
Three Months Ended September 30, 2018
Commercial business:
Commercial and industrial	$	9,910	$	(81	)	$	499	$	(385	)	$	9,943	$	10,188	$	(151	)	$	119	$	122		$	10,278
Owner-occupied commercial real estate	3,992		—			2		1,046			5,040		5,246		—			2		181			5,429
Non-owner occupied commercial real estate	8,097		—			—		(508		)	7,589		7,726		(149		)	—		71			7,648
Total commercial business	21,999		(81		)	501		153			22,572		23,160		(300		)	121		374			23,355
One-to-four family residential	1,056		—			—		27			1,083		1,121		(15		)	—		50			1,156
Real estate construction and land development:
One-to-four family residential	862		—			—		79			941		1,016		—			3		156			1,175
Five or more family residential and commercial properties	1,190		—			—		(75		)	1,115		1,044		—			—		(15		)	1,029
Total real estate construction and land development	2,052		—			—		4			2,056		2,060		—			3		141			2,204
Consumer	6,081		(485		)	88		370			6,054		6,305		(530		)	159		474			6,408
Unallocated	898		—			—		598			1,496		1,326		—			—		26			1,352
Total	$	32,086	$	(566	)	$	589	$	1,152		$	33,261	$	33,972	$	(845	)	$	283	$	1,065		$	34,475

Nine Months Ended September 30, 2018
Commercial business:
Commercial and industrial													$	9,910	$	(773	)	$	683	$	458		$	10,278
Owner-occupied commercial real estate													3,992		(1		)	7		1,431			5,429
Non-owner occupied commercial real estate													8,097		(149		)	—		(300		)	7,648
Total commercial business													21,999		(923		)	690		1,589			23,355
One-to-four family residential													1,056		(30		)	—		130			1,156
Real estate construction and land development:
One-to-four family residential													862		—			5		308			1,175
Five or more family residential and commercial properties													1,190		—			—		(161		)	1,029
Total real estate construction and land development													2,052		—			5		147			2,204
Consumer													6,081		(1,709		)	389		1,647			6,408
Unallocated													898		—			—		454			1,352
Total													$	32,086	$	(2,662	)	$	1,084	$	3,967		$	34,475

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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 ~~March 31,~~September 30, 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	$	1,769	$	7,251	$	923	$	9,943	$	1,711	$	7,674	$	893	$	10,278
Owner-occupied commercial real estate	1,727		2,513		800		5,040		1,825		2,871		733		5,429
Non-owner occupied commercial real estate	811		5,837		941		7,589		739		6,236		673		7,648
Total commercial business	4,307		15,601		2,664		22,572		4,275		16,781		2,299		23,355
One-to-four family residential	93		832		158		1,083		80		946		130		1,156
Real estate construction and land development:
One-to-four family residential	2		714		225		941		6		947		222		1,175
Five or more family residential and commercial properties	—		1,028		87		1,115		—		950		79		1,029
Total real estate construction and land development	2		1,742		312		2,056		6		1,897		301		2,204
Consumer	73		5,304		677		6,054		113		5,729		566		6,408
Unallocated	—		1,496		—		1,496		—		1,352		—		1,352
Total	$	4,475	$	24,975	$	3,811	$	33,261	$	4,474	$	26,705	$	3,296	$	34,475

The following table details the recorded investment balance of the loan receivables disaggregated on the basis of the Company’s impairment method as of ~~March 31,~~September 30, 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	$	16,525	$	793,062	$	2,091	$	811,678	$	14,230	$	843,542	$	3,758	$	861,530
Owner-occupied commercial real estate	13,101		679,415		9,840		702,356		12,881		764,277		8,258		785,416
Non-owner occupied commercial real estate	10,468		1,111,838		11,088		1,133,394		10,347		1,264,793		8,020		1,283,160
Total commercial business	40,094		2,584,315		23,019		2,647,428		37,458		2,872,612		20,036		2,930,106
One-to-four family residential	295		83,846		5,039		89,180		285		92,632		3,416		96,333
Real estate construction and land development:
One-to-four family residential	1,147		72,148		—		73,295		1,076		105,685		387		107,148
Five or more family residential and commercial properties	—		96,835		1,552		98,387		—		119,519		1,268		120,787
Total real estate construction and land development	1,147		168,983		1,552		171,682		1,076		225,204		1,655		227,935
Consumer	379		365,035		4,861		370,275		410		387,127		3,746		391,283
Total	$	41,915	$	3,202,179	$	34,471	$	3,278,565	$	39,229	$	3,577,575	$	28,853	$	3,645,657

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The following tables detail activity in the allowance for loan losses disaggregated by segment and class for the three and nine months ended ~~March 31,~~September 30, 2017.


	Balance at Beginning of Period		Charge-offs			Recoveries		Provision for Loan Losses			Balance at End of Period		Balance at Beginning of Period		Charge-offs			Recoveries		Provision for Loan Losses			Balance at End of Period
	(In thousands)												(In thousands)
Three Months Ended March 31, 2017
Three Months Ended September 30, 2017
Commercial business:
Commercial and industrial	$	10,968	$	(295	)	$	223	$	(805	)	$	10,091	$	10,651	$	(3	)	$	4	$	(772	)	$	9,880
Owner-occupied commercial real estate	3,661		(7		)	149		413			4,216		4,154		(1,494		)	4		1,397			4,061
Non-owner occupied commercial real estate	7,753		—			—		(152		)	7,601		7,709		—			—		(415		)	7,294
Total commercial business	22,382		(302		)	372		(544		)	21,908		22,514		(1,497		)	8		210			21,235
One-to-four family residential	1,015		—			—		37			1,052		1,073		(15		)	—		(21		)	1,037
Real estate construction and land development:
One-to-four family residential	797		—			10		(16		)	791		821		(556		)	191		337			793
Five or more family residential and commercial properties	1,359		—			—		187			1,546		1,666		—			—		(271		)	1,395
Total real estate construction and land development	2,156		—			10		171			2,337		2,487		(556		)	191		66			2,188
Consumer	5,024		(543		)	107		607			5,195		5,710		(478		)	112		453			5,797
Unallocated	506		—			—		596			1,102		967		—			—		176			1,143
Total	$	31,083	$	(845	)	$	489	$	867		$	31,594	$	32,751	$	(2,546	)	$	311	$	884		$	31,400

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

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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 December 31, 2017.



	Loans Individually Evaluated for Impairment		Loans Collectively Evaluated for Impairment		PCI Loans		Total Allowance for Loan Losses
	(In thousands)
Commercial business:
Commercial and industrial	$	1,326	$	7,558	$	1,026	$	9,910
Owner-occupied commercial real estate	621		2,557		814		3,992
Non-owner occupied commercial real estate	1,222		5,919		956		8,097
Total commercial business	3,169		16,034		2,796		21,999
One-to-four family residential	93		798		165		1,056
Real estate construction and land development:
One-to-four family residential	2		635		225		862
Five or more family residential and commercial properties	37		1,064		89		1,190
Total real estate construction and land development	39		1,699		314		2,052
Consumer	54		5,303		724		6,081
Unallocated	—		898		—		898
Total	$	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, 2017:



	Loans Individually Evaluated for Impairment		Loans Collectively Evaluated for Impairment		PCI Loans		Total Gross Loans Receivable
	(In thousands)
Commercial business:
Commercial and industrial	$	11,999	$	630,485	$	2,912	$	645,396
Owner-occupied commercial real estate	6,808		603,827		11,515		622,150
Non-owner occupied commercial real estate	16,019		957,233		13,342		986,594
Total commercial business	34,826		2,191,545		27,769		2,254,140
One-to-four family residential	299		81,443		5,255		86,997
Real estate construction and land development:
One-to-four family residential	1,247		50,649		89		51,985
Five or more family residential and commercial properties	645		94,819		2,035		97,499
Total real estate construction and land development	1,892		145,468		2,124		149,484
Consumer	442		349,194		5,455		355,091
Total	$	37,459	$	2,767,650	$	40,603	$	2,845,712

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


	Three Months Ended March 31,		Three Months Ended September 30,						Nine Months Ended September 30,
	2017		2018			2017			2018			2017
	(In thousands)		(In thousands)
Balance at the beginning of the period	$	754	$	434		$	786		$	—		$	754
Additions	32		—			—			434			32
Additions from acquisitions			1,796			—			1,796			—
Proceeds from dispositions			(198		)	(374		)	(198		)	(374		)
Gain on sales, net			—			111			—			111
Balance at the end of the period	$	786	$	2,032		$	523		$	2,032		$	523

At ~~March 31,~~September 30, 2018, the carrying amount of other real estate owned that was the result of foreclosure and obtaining physical possession of residential real estate properties was $434,000. At September 30, 2018, the recorded investment of consumer mortgage loans secured by residential real estate properties (included in the one-to-four family residential loans in Note (4) Loans Receivable) for which formal foreclosure proceedings were in process was ~~$80,000.~~$258,000.


(7)	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 Premier Merger on July 2, 2018 and Puget Sound Merger on January 16, 2018 and the historical acquisitions of Washington Banking Company on May 1, 2014; Valley Community Bancshares on July 15, 2013; Western Washington Bancorp in 2006 and North Pacific Bank in 1998. The Company’s goodwill is assigned to the Bank and is evaluated for impairment at the Bank level (reporting unit).

~~Table of Contents~~

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


	Three Months Ended March 31,				Three Months Ended September 30,				Nine Months Ended September 30,
	2018		2017		2018		2017		2018		2017
	(In thousands)				(In thousands)
Balance at the beginning of the period	$	119,029	$	119,029	$	187,549	$	119,029	$	119,029	$	119,029
Additions as a result of acquisitions⁽¹⁾	68,520		—		53,288		—		121,808		—
Impairment	—		—
Balance at the end of the period	$	187,549	$	119,029	$	240,837	$	119,029	$	240,837	$	119,029

⁽¹⁾ See Note (2) Business ~~Combination~~Combinations

The Company performed its annual goodwill impairment test during the fourth quarter of 2017 and determined based on its Step 1 analysis that the fair value of the reporting unit exceeded the carrying value, such that the Company's goodwill was not considered impaired. Changes in the economic environment, operations of the reporting unit or other adverse events could result in future impairment 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 Premier Commercial Bancorp, Puget Sound Bancorp, Washington Banking Company, Valley Community Bancshares, and Northwest Commercial Bank were estimated to be ten, ten, ten, ten, and five years, respectively.

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


	Three Months Ended March 31,						Three Months Ended September 30,						Nine Months Ended September 30,
	2018			2017			2018			2017			2018			2017
	(In thousands)						(In thousands)
Balance at the beginning of the period	$	6,088		$	7,374		$	15,767		$	6,727		$	6,088		$	7,374
Additions as a result of acquisitions(1)	11,270			—			7,075			—			18,345			—
Amortization	(795		)	(324		)	(1,114		)	(319		)	(2,705		)	(966		)
Balance at the end of the period	$	16,563		$	7,050		$	21,728		$	6,408		$	21,728		$	6,408

⁽¹⁾ See Note (2) Business Combinations


(8)	Junior Subordinated Debentures

As part of the acquisition of Washington Banking 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 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 debentures issued by the Washington 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 merger date, the Company acquired the Trust, which retained the Washington Banking Master Trust name, and assumed the performance and observance of the covenants under the indenture related to the trust preferred securities.

The adjustable rate of the trust preferred securities at ~~March 31,~~September 30, 2018 was ~~3.88%~~3.96%. The weighted average rate of the junior subordinated debentures ~~were~~was as follows for the indicated periods:

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



	Three Months Ended September 30,				Nine Months Ended September 30,
	2018		2017		2018		2017
Weighted average rate ⁽¹⁾	6.49	%	5.20	%	6.17	%	5.05	%

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

~~Table of Contents~~

The junior subordinated debentures are the sole assets of the Trust and payments under the junior subordinated debentures are the sole revenues of the Trust. At ~~March 31,~~September 30, 2018 and December 31, 2017, the balance of the junior subordinated debentures, net of unaccreted discount, was ~~$20.1~~$20.2 million and $20.0 million, respectively. All of the common securities of the Trust are owned by the Company. Heritage has fully and unconditionally guaranteed the capital securities along with all obligations of the Trust under the trust agreements. For financial reporting purposes, the Company's investment in the Master Trust is accounted for under the equity method and is included in prepaid expenses and other assets on the Company's Condensed Consolidated Statements of Financial Condition. The junior subordinated debentures issued and guaranteed by the Company and held by the Master Trust are reflected as liabilities on the Company's Condensed Consolidated Statements of Financial Condition.

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(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 (3) Investment Securities.

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


	March 31, 2018		December 31, 2017		September 30, 2018		December 31, 2017
	(In thousands)				(In thousands)
U.S. Treasury and U.S. Government-sponsored agencies					$	4,890	$	—
Mortgage-backed securities and collateralized mortgage obligations⁽¹⁾:
Residential	$	11,424	$	11,239	9,971		11,239
Commercial	14,676		20,582		17,372		20,582
Total repurchase agreements	$	26,100	$	31,821	$	32,233	$	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,~~September 30, 2018, the Bank maintained a credit facility with the FHLB of Des Moines ~~for $913.0 million and~~with available borrowing capacity of $826.8 million. The Bank had ~~short-term~~no FHLB advances outstanding ~~of $30.7 million with maturity dates within~~at September 30, ~~days.~~2018. 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 and nine months ended ~~March 31,~~September 30, 2018 and 2017:


	Three Months Ended March 31,						Three Months Ended September 30,						Nine Months Ended September 30,
	2018			2017			2018			2017			2018			2017
	(In thousands)						(In thousands)
FHLB Advances:
Average balance during the period	$	35,733		$	101,130		$	20,892		$	111,293		$	45,193		$	106,553
Maximum month-end balance during the period	$	37,200		$	126,300		$	50,500		$	126,200		$	154,500		$	137,450
Weighted average rate during the period	1.70		%	0.81		%	2.22		%	1.53		%	1.98		%	1.09		%

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

~~Table of Contents~~

(b) Federal Funds Purchased

The Bank maintains advance lines with Wells Fargo Bank, US Bank, The Independent Bankers Bank ("TIB") and Pacific Coast Bankers’ Bank to purchase federal funds of up to $90.0 million as of ~~March 31,~~September 30, 2018. The lines generally mature annually or are reviewed annually. As of ~~March 31,~~September 30, 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~~with available borrowing capacity of $45.2 million as of ~~March 31, 2018, of which there~~September 30, 2018. There were no borrowings outstanding

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


	March 31, 2018					December 31, 2017					September 30, 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⁾	$	148,238	$	(4,553	)	$	146,537	$	(882	)	$	162,275	$	(7,050	)	$	146,537	$	(882	)
Interest rate swap with third party ⁽¹⁾	148,238		4,553			146,537		882			162,275		7,050			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 ~~$4.8~~$7.7 million and $3.4 million as of ~~March 31,~~September 30, 2018 and December 31, 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 ~~$4.8~~$7.7 million and $3.4 million as of ~~March 31,~~September 30, 2018 and December 31, 2017, respectively.

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


	Three Months Ended March 31,						Three Months Ended September 30,						Nine Months Ended September 30,
	2018			2017			2018			2017			2018			2017
	(Dollars in thousands)						(Dollars in thousands)
Net income:
Net income	$	9,087		$	9,316		$	15,504		$	10,624		$	36,448		$	31,768
Less: Dividends and undistributed earnings allocated to participating securities	(51		)	(78		)	(48		)	(64		)	(252		)	(228		)
Net income allocated to common shareholders	$	9,036		$	9,238		$	15,456		$	10,560		$	36,196		$	31,540
Basic:
Weighted average common shares outstanding	33,332,645			29,952,074			36,839,615			29,929,721			34,744,788			29,940,276
Less: Restricted stock awards	(127,099		)	(248,170		)	(67,669		)	(146,425		)	(94,340		)	(192,186		)
Total basic weighted average common shares outstanding	33,205,546			29,703,904			36,771,946			29,783,296			34,650,448			29,748,090
Diluted:
Basic weighted average common shares outstanding	33,205,546			29,703,904			36,771,946			29,783,296			34,650,448			29,748,090
Effect of potentially dilutive common shares ⁽¹⁾	142,556			49,085			191,298			107,414			170,154			86,004
Total diluted weighted average common shares outstanding	33,348,102			29,752,989			36,963,244			29,890,710			34,820,602			29,834,094


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

Potential dilutive shares are excluded from the computation of earnings per share if their effect is anti-dilutive. ~~For the three months ended March 31, 2018 and 2017, there were no anti-dilutive shares outstanding related to options to acquire common stock.~~ Anti-dilution occurs when the exercise price of a stock option or the unrecognized compensation cost per share of a restricted stock award exceeds the market price of the Company’s stock. For the three and nine months ended September 30, 2018 and 2017, there were no anti-dilutive shares outstanding related to options to acquire common 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 ~~three~~nine months ended ~~March 31,~~September 30, 2018 and calendar year 2017.



Declared	Cash Dividend per Share	Record Date	Paid Date
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
April 25, 2018	$0.15	May 10, 2018	May 24, 2018
July 24, 2018	$0.15	August 9, 2018	August 23, 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") 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 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.

Since the inception of the eleventh plan, the Company has repurchased 579,996 shares at an average share prices of $16.67. No shares were repurchased under this plan during the three and nine months ended ~~March 31,~~September 30, 2018 and 2017.

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


	Three Months Ended March 31,				Three Months Ended September 30,				Nine Months Ended September 30,
	2018		2017		2018		2017		2018		2017
Repurchased shares to pay withholding taxes ⁽¹⁾	45,426		15,891		368		344		53,188		27,711
Stock repurchase to pay withholding taxes average share price	$	31.66	$	23.95	$	36.34	$	25.80	$	31.99	$	24.61

⁽¹⁾During the ~~three~~nine months ended ~~March 31,~~September 30, 2018, the Company repurchased 26,741 ~~of the~~ shares ~~repurchased~~ 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.~~Combinations. There were no shares repurchased as a result of the accelerated vesting of the restricted stock awards of Premier.

(d) Issuance of Common Stock

~~The~~In conjunction with the Premier Merger effective on July 2, 2018 and the Puget Sound Merger ~~was~~ effective on January 16, ~~2018. In conjunction with the merger was the issuance of~~2018, Heritage issued 2,848,579 and 4,112,258 shares, respectively, of the Company's common stock at the merger date share price of $34.85 and $31.80, respectively, for a fair value of $99.3 million and $130.8 ~~million.~~million, respectively.

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(13)	Accumulated Other Comprehensive (Loss) Income

The changes in accumulated other comprehensive (loss) income (“AOCI”), all of which are due to changes in the fair value of available for sale securities and are net of tax ~~during~~for the ~~three months ended March 31, 2018 and 2017 are as follows:~~periods provided.


	Three Months Ended						Three Months Ended September 30,						Nine Months Ended September 30,
	2018			2017			2018			2017			2018			2017
	(In thousands)						(In thousands)
Balance of AOCI at the beginning of period	$	(1,298	)	$	(2,606	)	$	(11,306	)	$	1,557		$	(1,298	)	$	(2,606	)
Other comprehensive (loss) income before reclassification	(7,516		)	1,473			(3,319		)	289			(13,193		)	4,528
Amounts reclassified from AOCI for gain on sale of investment securities included in net income	(27		)	—			(65		)	(28		)	(106		)	(104		)
Net current period other comprehensive (loss) income	(7,543		)	1,473			(3,384		)	261			(13,299		)	4,424
ASU 2016-01 implementation	(118		)	—			—			—			(93		)	—
Balance of AOCI at the end of period	$	(8,959	)	$	(1,133	)	$	(14,690	)	$	1,818		$	(14,690	)	$	1,818


(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.

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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 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 costs to sell. Fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in Level 3 classification of the inputs for determining fair value.

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

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


	March 31, 2018								September 30, 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	$	23,389	$	—	$	23,389	$	—	$	83,798	$	15,879	$	67,919	$	—
Municipal securities	204,292		—		204,292		—		164,072		—		164,072		—
Mortgage-backed securities and collateralized mortgage obligations:
Residential	301,277		—		301,277		—		311,916		—		311,916		—
Commercial	244,360		—		244,360		—		309,114		—		309,114		—
Collateralized loan obligations	3,271		—		3,271		—		967		—		967		—
Corporate obligations	16,629		—		16,629		—		25,709		—		25,709		—
Other asset-backed securities	28,349		—		28,349		—		25,161		—		25,161		—
Total investment securities available for sale	821,567		—		821,567		—		920,737		15,879		904,858		—
Derivative assets - interest rate swaps	4,793		—		4,793		—		7,659		—		7,659		—
Liabilities
Derivative liabilities - interest rate swaps	$	4,793	$	—	$	4,793	$	—	$	7,659	$	—	$	7,659	$	—



	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 ~~March 31,~~September 30, 2018 and 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 ~~March 31,~~September 30, 2018 and December 31, 2017 and the net losses recorded in earnings during three and nine months ended ~~March 31,~~September 30, 2018 and 2017.


	Basis⁽¹⁾		Fair Value at March 31, 2018										Basis⁽¹⁾		Fair Value at September 30, 2018
	Basis⁽¹⁾		Total		Level 1		Level 2		Level 3		Net Losses (Gains) Recorded in Earnings During the Three Months Ended March 31, 2018		Basis⁽¹⁾		Total		Level 1		Level 2		Level 3		Net Losses (Gains) Recorded in Earnings During the Three Months Ended September 30, 2018		Net Losses (Gains) Recorded in Earnings During the Nine Months Ended September 30, 2018
	(In thousands)												(In thousands)
Impaired loans:
Commercial business:
Commercial and industrial													$	224	$	187	$	—	$	—	$	187	$	36	$	36
Real estate construction and land development:
One-to-four family residential	$	976	$	307	$	—	$	—	$	307	$	—	976		303		—		—		303		1		4
Total assets measured at fair value on a nonrecurring basis	$	976	$	307	$	—	$	—	$	307	$	—	$	1,200	$	490	$	—	$	—	$	490	$	37	$	40


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


	Basis⁽¹⁾		Fair Value at December 31, 2017										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		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)												(In thousands)
Impaired loans:
Real estate construction and land development:
One-to-four family residential	$	976	$	307	$	—	$	—	$	307	$	—	$	976	$	307	$	—	$	—	$	307	$	—	$	—
Total assets measured at fair value on a nonrecurring basis	$	976	$	307	$	—	$	—	$	307	$	—	$	976	$	307	$	—	$	—	$	307	$	—	$	—


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

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The following table presents quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at ~~March 31,~~September 30, 2018 and December 31, 2017.

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%)



	September 30, 2018
	Fair Value		Valuation Technique(s)	Unobservable Input(s)	Range of Inputs; Weighted Average
	(Dollars in thousands)
Impaired loans	$	490	Market approach	Adjustment for differences between the comparable sales	(91.2%) - (14.4)%; (25.5%)



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

(b) Fair Value of Financial Instruments

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

~~Table of Contents~~

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

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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.


	March 31, 2018										September 30, 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	$	130,309	$	130,309	$	130,309	$	—	$	—	$	170,143	$	170,143	$	170,143	$	—	$	—
Investment securities available for sale	821,567		821,567		—		821,567		—		920,737		920,737		15,879		904,858		—
Federal Home Loan Bank stock	6,824		N/A		N/A		N/A		N/A		6,076		N/A		N/A		N/A		N/A
Loans held for sale	2,669		2,763		—		2,763		—		1,882		1,937		—		1,937		—
Total loans receivable, net	3,248,654		3,240,722		—		—		3,240,722		3,614,579		3,604,468		—		—		3,604,468
Accrued interest receivable	13,602		13,602		3		3,698		9,901		15,735		15,735		13		3,992		11,730
Derivative assets - interest rate swaps	4,793		4,793		—		4,793		—		7,659		7,659		—		7,659		—
Equity security	162		162		162		—		—		132		132		132		—		—
Financial Liabilities:
Noninterest deposits, interest bearing demand deposits, money market accounts and savings accounts	3,482,365		3,482,365		3,482,365		—		—		$	3,894,524	$	3,894,524	$	3,894,524	$	—	$	—
Certificate of deposit accounts	422,376		425,324		—		425,324		—		503,603		506,405		—		506,405		—
Federal Home Loan Bank advances	30,700		30,700		—		30,700		—
Securities sold under agreement to repurchase	26,100		26,100		26,100		—		—		32,233		32,233		32,233		—		—
Junior subordinated debentures	20,083		19,500		—		—		19,500		20,229		20,000		—		—		20,000
Accrued interest payable	174		174		42		87		45		263		263		64		160		39
Derivative liabilities - interest rate swaps	4,793		4,793		—		4,793		—		7,659		7,659		—		7,659		—

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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 awards, 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,~~September 30, 2018, 955,539 shares ~~that~~ remain ~~available~~ for future issuance under the ~~Company's stock-based compensation plans was 970,132.~~Plan.

(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 and nine months ended ~~March 31,~~September 30, 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~~nine months ended ~~March 31,~~September 30, 2018 was ~~$24,000~~$184,000 and ~~$21,000,~~$118,000, respectively. The intrinsic value and cash proceeds from options exercised during the ~~three~~nine months ended ~~March 31,~~September 30, 2017 was $~~98,000~~156,000 and $~~109,000~~159,000, respectively.

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The following table summarizes the stock option activity for the ~~three~~nine months ended ~~March 31,~~September 30, 2018 and 2017:


	Shares		Weighted-Average Exercise Price		Weighted-Average Remaining Contractual Term (In years)	Aggregate Intrinsic Value (In thousands)		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				37,495		$	13.77
Exercised	(8,372	)	13.03					(12,304	)	12.92
Forfeited or expired	(550	)	11.35					(1,308	)	13.53
Outstanding, vested and expected to vest and exercisable at March 31, 2017	28,573		$	14.03	2.81	$	306
Outstanding, vested and expected to vest and exercisable at September 30, 2017								23,883		$	14.23	2.45	$	365

Outstanding at December 31, 2017	23,231		$	14.21				23,231		$	14.21
Exercised	(1,428	)	14.77					(8,842	)	13.30
Forfeited or expired	(831	)	14.77					(831	)	14.77
Outstanding, vested and expected to vest and exercisable at March 31, 2018	20,972		$	14.15	1.96	$	345
Outstanding, vested and expected to vest and exercisable at September 30, 2018								13,558		$	14.77	1.64	$	276

(b) Restricted Stock Awards

Restricted stock awards granted generally have a four-year cliff vesting or four-year ratable vesting schedule. For the three and nine months ended ~~March 31,~~September 30, 2018, the Company recognized compensation expense related to restricted stock awards of ~~$283,000~~$186,000 and $718,000, respectively, and a related tax benefit of ~~$60,000.~~$39,000 and $151,000, respectively. For the three and nine months ended ~~March 31,~~September 30, 2017, the Company recognized compensation expense related to restricted stock awards of ~~$445,000~~$292,000 and $1.1 million, respectively, and a related tax benefit of ~~$156,000.~~$102,000 and $384,000, respectively. As of ~~March 31,~~September 30, 2018,, the total unrecognized compensation expense related to non-vested restricted stock awards was ~~$1.2 million~~$745,000 and the related weighted average period over which the compensation expense is expected to be recognized is approximately ~~1.31~~1.15 years. The vesting date fair value of the restricted stock awards that vested during the ~~three~~nine months ended ~~March 31,~~September 30, 2018 and 2017 was ~~$1.3~~$2.2 million ~~for both periods.~~and $2.7 million, respectively.

The following table summarizes the restricted stock award activity for the ~~three~~nine months ended ~~March 31,~~September 30, 2018 and 2017:


	Shares		Weighted-Average Grant Date Fair Value		Shares		Weighted-Average Grant Date Fair Value
Nonvested at December 31, 2016	261,296		$	16.80	261,296		$	16.80
Granted	—		—
Vested	(52,201	)	16.60		(107,202	)	16.49
Forfeited	(5,270	)	16.78		(10,418	)	16.80
Nonvested at March 31, 2017	203,825		$	16.85
Nonvested at September 30, 2017					143,676		$	17.02

Nonvested at December 31, 2017	137,399		$	17.00	137,399		$	17.00
Granted	—		—
Vested	(42,137	)	16.92		(67,602	)	16.70
Forfeited	—		—		(3,489	)	16.92
Nonvested at March 31, 2018	95,262		$	17.04
Nonvested at September 30, 2018					66,308		$	17.31

During 2017, the Company began issuing stock-settled restricted stock unit awards ("RSU") and performance-based stock-settled restricted stock unit awards ("PRSU") ~~and stock-settled restricted stock unit awards ("RSU")~~, collectively called "units". ~~Restricted stock units~~RSUs granted vest ratably over three years. ~~Performance restricted stock units~~PRSUs granted generally have a three-year cliff vesting schedule. Additionally, ~~performance restricted stock unit~~PRSU 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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peer group. The conditions of the grants allow for an actual payout ranging between no payout and 150% of target. The payout level is calculated based on actual performance achieved during the performance period compared to a defined peer group. The fair value of such PRSUs was determined using a Monte Carlo simulation and will be recognized over the subsequent three years. The Monte-Carlo simulation model uses the same input assumptions as the Black-Scholes model; however, it also further incorporates into the fair value determination the possibility that the market condition may not be satisfied. Compensation costs related to these awards are recognized regardless of whether the market condition is satisfied, provided that the requisite service has been provided.

Expected volatilities in the model were estimated using a historical period consistent with the performance period of approximately three years. The risk-free interest rate was based on the United States Treasury rate for a term commensurate with the expected life of the grant. The Company used the following assumptions to estimate the fair value of PRSUs granted during ~~the periods indicated:~~February 2018 and 2017:


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

For the three and nine months ended ~~March 31,~~September 30, 2018, the Company recognized compensation expense related to the units of ~~$340,000,~~$523,000 and $1.3 million, respectively, and a related tax benefit of ~~$72,000.~~$110,000 and $274,000, respectively. For the three and nine months ended ~~March 31,~~September 30, 2017, the Company recognized compensation expense related the units of ~~$65,000.~~$236,000 and $472,000, respectively, and a related tax benefit of $83,000 and $165,000, respectively. As of ~~March 31,~~September 30, 2018, the total unrecognized compensation expense related to non-vested units was ~~$4.3~~$4.0 million and the related weighted average period over which the compensation expense is expected to be recognized is approximately ~~2.83~~2.43 years. The vesting date fair value of the units that vested during the ~~three~~nine months ended ~~March 31,~~September 30, 2018 was ~~$711,000.~~$1.0 million. There were no units that vested during the ~~three~~nine months ended ~~March 31,~~September 30, 2017.

The following table summarizes the unit activity for the ~~three~~nine months ended ~~March 31, 2018:~~September 30, 2018 and 2017:


	Shares		Weighted-Average Grant Date Fair Value		Shares		Weighted-Average Grant Date Fair Value
Nonvested at December 31, 2016	—		$	—	—		$	—
Granted	80,735		25.23		92,019		25.29
Vested	—		—
Forfeited	—		—		(1,812	)	25.35
Nonvested at March 31, 2017	80,735		$	25.23
Nonvested at September 30, 2017					90,207		$	25.29

Nonvested at December 31, 2017	90,544		$	25.31	90,544		$	25.31
Granted	102,939		29.79		125,376		30.62
Vested	(22,274	)	25.30		(32,375	)	25.44
Forfeited	(262	)	25.35		(4,617	)	27.82
Nonvested at March 31, 2018	170,947		$	28.01
Nonvested at September 30, 2018					178,928		$	28.94

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(16)	Cash Requirement

~~Beginning on January 16, 2018, the~~The Company ~~was~~is 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~~September 30, 2018 and December 31, ~~2018~~2017 was ~~$25.0~~$22.6 million and $60,000, respectively, and was met by holding cash and ~~maintained~~maintaining 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 ~~March 31,~~September 30, 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, 2017 audited Consolidated Financial Statements and the accompanying Notes included in our Annual Report on Form 10-K for the year ended December 31, 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 ~~March 31,~~September 30, 2018, we had total assets of ~~$4.68~~$5.28 billion and total stockholders’ equity of ~~$634.7~~$746.1 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, professional services 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.

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Earnings Summary

Comparison of quarter ended September 30, 2018 to the comparable quarter in the prior year.

Net income was ~~$9.1~~$15.5 million, or ~~$0.27~~$0.42 per diluted common share, for the three months ended ~~March 31,~~September 30, 2018 compared to ~~$9.3~~$10.6 million, or ~~$0.31~~$0.35 per diluted common share, for the three months ended ~~March 31,~~September 30, 2017. Net income ~~decreased $229,000,~~increased $4.9 million, or ~~2.5%~~45.9%, for the three months ended ~~March 31,~~September 30, 2018 compared to the three months ended ~~March 31,~~September 30, 2017 primarily due to an increase in net interest income of $16.2 million, or 46.2%, offset partially by anincrease in noninterest expense of ~~$9.5~~$11.6 million, or ~~35.0%, partially offset by an increase~~41.6%. The increases in net interest income and noninterest expense were primarily the result of ~~$7.8 million, or 23.4%.~~the Premier and Puget Mergers with effective dates of January 16 and July 2, 2018.

Net interest income as a percentage of average interest earning assets (net interest margin) increased 2355 basis points to ~~4.12%~~4.41% for the three months ended ~~March 31,~~September 30, 2018 compared to ~~3.89%~~3.86% for the same period in 2017. The increase in net interest margin was primarily due to increases in both the average loan balance and loan yield and secondarily in increases in both average balances and yields on investments, offset partially by an increase in ~~average total loan receivable, net balances, and increases in loan yields and investment yields.~~the cost of interest bearing liabilities.

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 ~~75.95%~~66.91% for the three months ended ~~March 31,~~September 30, 2018 compared to ~~67.23%~~64.43% for the three months ended ~~March 31,~~September 30, 2017. The change in the efficiency ratio was primarily attributable to the increase in noninterest expense as a result of the Premier and Puget ~~Sound Merger~~Mergers, including increases in compensation and ~~certain acquisition costs.~~employee benefits expense due to additional employees, occupancy and equipment expense primarily due to additional rent expense, and data processing expense due to an increase in transactional accounts and balances. Noninterest expense also increased $795,000 during the three months ended September 30, 2018 compared to the same period in 2017 due to amortization of intangible assets acquired in the Premier and Puget Mergers.

Comparison of nine months ended September 30, 2018 to the comparable period in the prior year.

Net income was $36.4 million, or $1.04 per diluted common share, for the nine months ended September 30, 2018 compared to $31.8 million, or $1.06 per diluted common share, for the nine months ended September 30, 2017. Net income increased $4.7 million, or 14.7%, for the nine months ended September 30, 2018 compared to the nine months ended September 30, 2017 primarily due to an increase in net interest income of $33.5 million, or 32.7%, partially offset by an increase in noninterest expense of $29.1 million or 35.0%. The increases in net interest income and noninterest expense during the nine months ended September 30, 2018 compared to the same period in 2017 were primarily the result of the Premier and Puget Mergers.

The net interest margin increased 37 basis points to 4.26% for the nine months ended September 30, 2018 compared to 3.89% for the same period in 2017. The increase in net interest margin was primarily due to increases in both the average loan balance and loan yield and secondarily due to increases in both the balances and yields on investments, offset partially by an increase in the cost of interest bearing liabilities.

The Company’s efficiency ratio was 70.53% for the nine months ended September 30, 2018 compared to 64.47% for the nine months ended September 30, 2017. The change in the efficiency ratio for the nine months ended September 30, 2018 compared to the nine months ended September 30, 2017 was primarily attributable to additional noninterest expense as a result of the Premier and Puget Mergers, including increases in compensation and employee benefits expense due to additional employees, occupancy and equipment expense primarily due to additional rent expense, and data processing expense due to an increase in transactional accounts and balances. Noninterest expense also increased $1.7 million during the nine months ended September 30, 2018 compared to the same period in 2017 due to the amortization of intangible assets acquired in the Premier and Puget Mergers.

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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, 2018 to the comparable quarter in the prior year.

Net interest income increased ~~$7.8~~$16.2 million, or ~~23.4%~~46.2%, to ~~$40.9~~$51.1 million for the three months ended ~~March 31,~~September 30, 2018 compared to ~~$33.1~~$34.9 million for the same period in 2017. The increase in net interest income was primarily due to ~~increases~~an increase in average interest earning assets, ~~primarily~~which increased substantially as a result of the Premier and Puget ~~Sound Merger and, to a lesser extent, organic growth.~~Mergers. Net interest income also increased due to increases in yields on interest earning assets primarily due to higher market interest rates reflecting increases in the target federal funds rate. The increase in net interest income was offset partially by an increase in the cost of total interest bearing liabilities primarily as a result of ~~a higher yield curve in the current market.~~rising interest rates. The following table provides relevant net interest income information for the dates indicated.

~~Table of Contents~~


	Three Months Ended March 31,												Three Months Ended September 30,
	2018						2017						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)}	$	3,150,869	$	38,159	4.91	%	$	2,631,816	$	30,485	4.70	%	$	3,618,031	$	48,301	5.30	%	$	2,737,535	$	32,595	4.72	%
Taxable securities	599,015		3,529		2.39		567,318		3,049		2.18		707,597		4,662		2.61		562,256		3,117		2.20
Nontaxable securities ⁽³⁾	223,631		1,341		2.43		222,266		1,268		2.31		176,322		1,085		2.44		229,683		1,354		2.34
Other interest earning assets	52,123		299		2.33		31,721		61		0.78		94,784		528		2.21		63,544		209		1.30
Total interest earning assets	4,025,638		43,328		4.37	%	3,453,121		34,863		4.09	%	4,596,734		54,576		4.71	%	3,593,018		37,275		4.12	%
Noninterest earning assets	527,947						426,777						681,831						427,199
Total assets	$	4,553,585					$	3,879,898					$	5,278,565					$	4,020,217
Interest Bearing Liabilities:
Certificates of deposit	$	423,569	$	760	0.73	%	$	351,300	$	416	0.48	%	$	512,547	$	1,184	0.92	%	$	394,345	$	633	0.64	%
Savings accounts	506,158		416		0.33		506,159		264		0.21		518,937		541		0.41		494,990		360		0.29
Interest bearing demand and money market accounts	1,745,795		784		0.18		1,483,168		586		0.16		2,044,236		1,289		0.25		1,499,335		635		0.17
Total interest bearing deposits	2,675,522		1,960		0.30		2,340,627		1,266		0.22		3,075,720		3,014		0.39		2,388,670		1,628		0.27
FHLB advances and other borrowings	35,733		150		1.70		101,130		203		0.81		20,892		117		2.22		111,293		428		1.53
Securities sold under agreement to repurchase	30,265		17		0.23		19,019		10		0.21		33,394		19		0.23		28,999		16		0.22
Junior subordinated debentures	20,035		283		5.73		19,750		238		4.89		20,181		330		6.49		19,897		261		5.20
Total interest bearing liabilities	2,761,555		2,410		0.35	%	2,480,526		1,717		0.28	%	3,150,187		3,480		0.44	%	2,548,859		2,333		0.36	%
Demand and other noninterest bearing deposits	1,113,286						866,469						1,314,203						916,074
Other noninterest bearing liabilities	63,770						47,213						69,786						50,022
Stockholders’ equity	614,974						485,690						744,389						505,262
Total liabilities and stockholders’ equity	$	4,553,585					$	3,879,898					$	5,278,565					$	4,020,217
Net interest income			$	40,918					$	33,146					$	51,096					$	34,942
Net interest spread					4.02	%					3.81	%					4.27	%					3.76	%
Net interest margin					4.12	%					3.89	%					4.41	%					3.86	%
Average interest earning assets to average interest bearing liabilities					145.77	%					139.21	%					145.92	%					140.97	%


⁽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.

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Interest Income

Total interest income increased ~~$8.5~~$17.3 million, or ~~24.3%~~46.4%, to ~~$43.3~~$54.6 million for the three months ended ~~March 31,~~September 30, 2018 compared to ~~$34.9~~$37.3 million for the same period in 2017. The balance of average interest earning assets increased ~~$572.5 million,~~$1.00 billion, or ~~16.6%~~27.9%, to ~~$4.03~~$4.60 billion for the three months ended ~~March 31,~~September 30, 2018 from ~~$3.45~~$3.59 billion for the three months ended ~~March 31,~~September 30, 2017 and the yield on total interest earning assets increased 2859 basis points to ~~4.37%~~4.71% for the three months ended ~~March 31,~~September 30, 2018 compared to ~~4.09%~~4.12% for the three months ended ~~March 31,~~September 30, 2017. The increase in the interest income was due primarily to interest income from interest and fees on loans and interest income on investment securities.

Interest income from interest and fees on loans increased ~~$7.7~~$15.7 million, or ~~25.2%~~48.2%, to ~~$38.2~~$48.3 million for the three months ended ~~March 31,~~September 30, 2018 from ~~$30.5~~$32.6 million for the same period in 2017 primarily due to an increase in average total loans receivable, net of ~~$519.1~~$880.5 million, or ~~19.7%~~32.2%, as a result of loan growth which was substantially due to the Premier and Puget ~~Sound Merger. The~~Mergers. Additionally, interest income from interest and fees on loans increased as the loan yield increased 2158 basis points to ~~4.91%~~5.30% for the three months ended ~~March 31,~~September 30, 2018 from ~~4.70%~~4.72% for the three months ended ~~March 31,~~September 30, 2017. The increase in loan yield was due to a combination of higher contractual ~~note~~loan rates as a result of the increasing interest rate environment, ~~higher~~an increase in loan yields from the loans acquired in the Premier and Puget ~~Sound Merger~~Mergers as compared to legacy Heritage loans, and an increase in incremental accretion on purchased loans substantially due ~~from~~to loans acquired in the Premier and Puget ~~Sound Merger.~~Mergers.

~~Table of Contents~~

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

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 ~~$1.6~~$2.6 million and ~~$1.2~~$1.0 million for the three months ended ~~March 31,~~September 30, 2018 and 2017, respectively. The 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~~September 30, 2018 was primarily due to accretion ~~yield for~~of loans acquired in the Premier and Puget ~~Sound Merger in future periods as nearly $316,000 of the accretion was a result of unanticipated pay-offs of three significant loans during the three months ended March 31, 2018.~~Mergers. The incremental accretion and the impact to loan yield will change during any quarter based on the volume of prepayments, but is expected 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 $553,000, or 12.8%, increase in interest income on investment securities to $4.9 million during the three months ended March 31, 2018 from $4.3 million for the three months ended March 31, 2017. The increase in income on investment securities was a result of an increase in investment yields, primarily reflecting the effect of the rise in interest rates on our adjustable rate investment securities, and an increase in the average balance of investment securities for the three months ended March 31, 2018 compared to the same period in 2017. Yields on taxable securities increased 21 basis points to 2.39% for the three months ended March 31, 2018 from 2.18% for the same period in 2017. Yields on nontaxable securities increased 12 basis points to 2.43% for the three months ended March 31, 2018 from 2.31% for the same period in 2017. The average balance of investment securities increased $33.1 million, or 4.2%, to $822.6 million during the three months ended March 31, 2018 from $789.6 million during the three months ended March 31, 2017. The Company has actively managed its investment securities portfolio to improve performance in an increasing rate environment.

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

~~Interest Expense~~

Total interest expense increased $693,000, or 40.4%, to $2.4 million for the three months ended March 31, 2018 compared to $1.7 million for the same period in 2017. The average cost of interest bearing liabilities increased seven basis points to 0.35% for the three months ended March 31, 2018 from 0.28% for the three months ended March 31, 2017 as a result of the rise in market rates. Total average interest bearing liabilities increased $281.0 million, or 11.3%, to $2.76 billion for the three months ended March 31, 2018 from $2.48 billion for the three months ended March 31, 2017 substantially due to the Puget Sound Merger.

The average cost of interest bearing deposits increased eight basis points to 0.30% for the three months ended March 31, 2018 from 0.22% for the same period in 2017 primarily as a result of the increase in market rates. The average balance of interest bearing demand and money market deposits increased $262.6 million, or 17.7%, for the three months ended March 31, 2018 to $1.75 billion at March 31, 2018 from $1.48 billion at December 31, 2017 primarily as a result of the Puget Sound Merger. The cost of certificates of deposits increased 25 basis points to 0.73%

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~~for the three months ended March 31, 2018 from 0.48% for the same period in 2017 primarily as a result of the rise in interest rates.~~

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

The average rate of the junior subordinated debentures, including the effects of accretion of the discount established as of the date of the merger with Washington Banking Company, for the three months ended March 31, 2018 was 5.73%, an increase of 84 basis points from 4.89% for the same period in 2017. The rate increase on the junior subordinated debentures was due to an increase in the three-month LIBOR rate to 2.32% at March 31, 2018 from 1.15% on March 31, 2017.

~~Net Interest Margin~~

Net interest margin increased 23 basis points for the three months ended March 31, 2018 to 4.12% from 3.89% for the same period in 2017 primarily due to the above mentioned increase in net interest income. The net interest spread increased 21 basis points for the three months ended March 31, 2018 to 4.02% from 3.81% for the same period in 2017 primarily due to the increase in yields on total interest earning assets.

~~Net interest margin is impacted by the incremental accretion on purchased loans.~~ The following table presents the ~~net interest margin~~loan yield and effects of the incremental accretion on purchased loans for the three months ended ~~March 31,~~September 30, 2018 and 2017:

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



	Three Months Ended September 30,
	2018			2017
	(Dollars in thousands)
Loan yield, excluding incremental accretion on purchased loans ⁽¹⁾	5.01		%	4.57		%
Impact on loan yield from incremental accretion on purchased loans ⁽¹⁾	0.29			0.15
Loan yield	5.30		%	4.72		%

Incremental accretion on purchased loans ⁽¹⁾	$	2,637		$	1,036

⁽¹⁾

Interest income on investment securities increased $1.3 million, or 28.5%, to $5.7 million during the three months ended September 30, 2018 from $4.5 million during the three months ended September 30, 2017. The increase in interest on investment securities was primarily a result of an increase in the average balance of investment securities of $92.0 million, or 11.6%, to $883.9 million during the three months ended September 30, 2018 from $791.9 million during the three months ended September 30, 2017. Additionally, interest income increased as a result an increase in the investment yields, reflecting the effect of the rise in interest rates on our adjustable rate investment securities and secondarily due to higher yields on new investment purchases for the three months ended September 30, 2018 compared to the same period in 2017. Yields on taxable securities increased 41 basis points to 2.61% for the three months ended September 30, 2018 from 2.20% for the same period in 2017. Yields on nontaxable securities increased 10 basis points to 2.44% for the three months ended September 30, 2018 from 2.34% for the same period in 2017. The Company has actively managed its investment securities portfolio to improve performance in the increasing rate environment.

Interest income on other interest earning assets increased $319,000, or 152.6%, due to a combination of an increase in interest earning deposits as the Bank held more funds in interest earning accounts at the Federal Reserve Bank compared to the same period in 2017 and an increase in the yields reflecting the rise in interest rates. Average

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other interest earning assets increased $31.2 million, or 49.2%, to $94.8 million for the three months ended September 30, 2018 compared to $63.5 million for the three months ended September 30, 2017.

Interest Expense

Total interest expense increased $1.1 million, or 49.2%, to $3.5 million for the three months ended September 30, 2018 compared to $2.3 million for the same period in 2017. The average cost of interest bearing liabilities increased eight basis points to 0.44% for the three months ended September 30, 2018 from 0.36% for the three months ended September 30, 2017 as a result of the rise in market interest rates. Total average interest bearing liabilities increased $601.3 million, or 23.6%, to $3.15 billion for the three months ended September 30, 2018 from $2.55 billion for the three months ended September 30, 2017 substantially due to the Premier and Puget Mergers.

The cost of interest bearing deposits increased 12 basis points to 0.39% for the three months ended September 30, 2018 from 0.27% for the same period in 2017 due to a combination of an increase in market interest rates and an increase in the average balance due primarily to the Premier and Puget Mergers. The cost of interest bearing deposits is primarily due to the interest bearing demand and money market deposits and certificates of deposits. The average balance of interest bearing demand and money market deposits increased $544.9 million, or 36.3%, to $2.04 billion during the three months ended September 30, 2018 compared to $1.50 billion during the same period in 2017, and the cost of interest bearing demand and money market deposits increased eight basis points to 0.25% for the three months ended September 30, 2018 from 0.17% for the same period in 2017. The average balance of certificate of deposit accounts increased $118.2 million, or 30.0%, to $512.5 million for the three months ended September 30, 2018 compared to $394.3 million for the same period in 2017. The cost of certificates of deposit increased 28 basis points to 0.92% for the three months ended September 30, 2018 from 0.64% for the same period in 2017.

The Company was able to reduce the impact of the rising market interest rates by increasing the average balance of noninterest bearing deposits at a higher growth rate than the interest bearing deposits described above. The average balance of noninterest bearing deposits increased by $398.1 million, or 43.5%, to $1.31 billion for the three months ended September 30, 2018 compared to $916.0 million for the same period in 2017. The total cost of deposits increased seven basis points to 0.27% for the three months ended September 30, 2018 compared to 0.20% for the same period in 2017.

Interest expense on FHLB advances and other borrowings decreased $311,000, or 72.7%, to $117,000 for the three months ended September 30, 2018 from $428,000 for the same period in 2017 due to the decrease in average balance of FHLB advances during the quarter. The average balance for FHLB advances and other borrowings decreased $90.4 million, or 81.2%, to $20.9 million for the three months ended September 30, 2018 from $111.3 million for the same period in 2017. The Company was able to use the increase in the deposit balances to repay the FHLB advances as of September 30, 2018. The average cost of FHLB advances and other borrowings increase of 69 basis points to 2.22% for the three months ended September 30, 2018 compared to 1.53% for the same period in 2017 was due to increases in market rates.

Net Interest Margin

Net interest margin increased 55 basis points for the three months ended September 30, 2018 to 4.41% from 3.86% for the same period in 2017 primarily due to the above mentioned changes in asset yields and costs of funds. The net interest spread increased 51 basis points for the three months ended September 30, 2018 to 4.27% from 3.76% for the same period in 2017 primarily due to the increase in yield earned on total interest earning assets.

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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, 2018 and 2017:



	Three Months Ended September 30,
	2018		2017
Net interest margin, excluding incremental accretion on purchased loans ⁽¹⁾	4.18	%	3.75	%
Impact on net interest margin from incremental accretion on purchased loans ⁽¹⁾	0.23		0.11
Net interest margin	4.41	%	3.86	%

⁽¹⁾

Comparison of nine months ended September 30, 2018 to the comparable period in the prior year

Net interest income increased $33.5 million, or 32.7%, to $135.7 million for the nine months ended September 30, 2018 compared to $102.2 million for the same period in 2017. The following table provides relevant net interest income information for the dates indicated.

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	Nine Months Ended September 30,
	2018						2017
	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)	$	3,346,709	$	127,601	5.10	%	$	2,676,153	$	94,580	4.73	%
Taxable securities	645,866		12,259		2.54		565,528		9,307		2.20
Nontaxable securities (3)	200,179		3,646		2.44		225,583		3,926		2.33
Other interest earning assets	66,619		988		1.98		42,225		352		1.11
Total interest earning assets	4,259,373		144,494		4.54	%	3,509,489		108,165		4.12	%
Noninterest earning assets	596,239						427,661
Total assets	$	4,855,612					$	3,937,150
Interest Bearing Liabilities:
Certificates of deposit	$	451,741	$	2,741	0.81	%	$	369,724	$	1,527	0.55	%
Savings accounts	512,689		1,443		0.38		499,353		940		0.25
Interest bearing demand and money market accounts	1,863,135		2,985		0.21		1,489,149		1,834		0.16
Total interest bearing deposits	2,827,565		7,169		0.34		2,358,226		4,301		0.24
FHLB advances and other borrowings	45,194		669		1.98		106,556		870		1.09
Securities sold under agreement to repurchase	30,543		52		0.23		23,660		38		0.21
Junior subordinated debentures	20,108		928		6.17		19,823		748		5.05
Total interest bearing liabilities	2,923,410		8,818		0.40	%	2,508,265		5,957		0.32	%
Demand and other noninterest bearing deposits	1,201,676						885,467
Other noninterest bearing liabilities	64,686						47,283
Stockholders’ equity	665,840						496,135
Total liabilities and stockholders’ equity	$	4,855,612					$	3,937,150
Net interest income			$	135,676					$	102,208
Net interest spread					4.14	%					3.80	%
Net interest margin					4.26	%					3.89	%
Average interest earning assets to average interest bearing liabilities					145.70	%					139.92	%


⁽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 $36.3 million, or 33.6%, to $144.5 million for the nine months ended September 30, 2018 compared to $108.2 million for the same period in 2017. The balance of average interest earning assets increased $749.9 million, or 21.4%, to $4.26 billion for the nine months ended September 30, 2018 from $3.51 billion for the nine months ended September 30, 2017 and the yield on total interest earning assets increased 42 basis points to 4.54% for the nine months ended September 30, 2018 compared to 4.12% for the nine months ended September 30, 2017. The increase in the interest income was due primarily to interest income from interest and fees on loans and interest income on investment securities.

Interest income from interest and fees on loans increased $33.0 million, or 34.9%, to $127.6 million for the nine months ended September 30, 2018 from $94.6 million for the same period in 2017 due primarily to an increase in average loans receivable, net and an increase in loan yields. Average total loans receivable, net increased $670.6 million, or 25.1%, to $3.35 billion for the nine months ended September 30, 2018 compared to $2.68 billion for the nine months ended September 30, 2017 primarily as a result of the Premier and Puget Mergers. Loan yields increased 37 basis points to 5.10% for the nine months ended September 30, 2018 from 4.73% for the nine months ended September 30, 2017 due to a combination of higher contractual loan rates as a result of the increasing interest rate environment, an increase in loan yields from the loans acquired in the Premier and Puget Mergers as compared to

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legacy Heritage loans, and an increase in incremental accretion on purchased loans substantially due to loans acquired in the Premier and Puget Mergers.

Incremental accretion income was $6.3 million and $3.7 million for the nine months ended September 30, 2018 and 2017, respectively. The increase in the incremental accretion was primarily due to the accretion of the loans acquired in the Premier and Puget Sound Mergers. The incremental accretion and the impact to loan yield will change during any quarter based on the volume of prepayments, but is expected to decrease over time as the balance of the purchased loans continues to decrease.

The following table presents the loan yield and effects of the incremental accretion on purchased loans for the nine months ended September 30, 2018 and 2017:



	Nine Months Ended September 30,
	2018			2017
	(Dollars in thousands)
Loan yield, excluding incremental accretion on purchased loans ⁽¹⁾	4.85		%	4.55		%
Impact on loan yield from incremental accretion on purchased loans⁽¹⁾	0.25			0.18
Loan yield	5.10		%	4.73		%

Incremental accretion on purchased loans ⁽¹⁾	$	6,261		$	3,687

⁽¹⁾

Interest income on investment securities increased $2.7 million, or 20.2%, to $15.9 million during the nine months ended September 30, 2018 compared to $13.2 million for the nine months ended September 30, 2017. The increase in interest income on investment securities was the result of a combination of an increase in investment yields for the nine months ended September 30, 2018 compared to the same period in 2017 and an increase in the average balance of investment securities during the period. Yields on taxable securities increased 34 basis points to 2.54% for the nine months ended September 30, 2018 compared to 2.20% for the same period in 2017. Yields on nontaxable securities increased 11 basis points to 2.44% for the nine months ended September 30, 2018 from 2.33% for the same period in 2017. The average balance of investment securities increased $54.9 million, or 6.9%, to $846.0 million during the nine months ended September 30, 2018 from $791.1 million during the nine months ended September 30, 2017. The Company reduced the balance of its tax exempt securities during the three months ended September 30, 2018 compared to the same period in 2017 as the tax effected yield was not as beneficial given the decrease in the federal corporate tax rate in 2018. The Company has actively managed its investment securities portfolio to improve performance in the increasing rate environment.

Income on other interest earning assets increased $636,000, or 180.7%, to $988,000 during the nine months ended September 30, 2018 compared to $352,000 during the same period in 2017 due to a combination of an increase in the average balances and an increase in market interest rates. Average other interest earning assets increased $24.4 million, or 57.8%, to $66.6 million for the nine months ended September 30, 2018 compared to $42.2 million for the nine months ended September 30, 2017. 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 2017. The yield on other interest earning assets increased 87 basis points to 1.98% during the nine months ended September 30, 2018 compared to 1.11% during the same period in 2017, reflecting a rise in market rates.

Interest Expense

Total interest expense increased $2.9 million, or 48.0%, to $8.8 million for the nine months ended September 30, 2018 compared to $6.0 million for the same period in 2017. The cost of interest bearing liabilities increased eight basis points to 0.40% for the nine months ended September 30, 2018 from 0.32% for the nine months ended September 30, 2017. The increase in costs was primarily a result of increases in market rates. Total average interest bearing liabilities increased by $415.1 million, or 16.6%, to $2.92 billion for the nine months ended September 30, 2018 from $2.51 billion for the nine months ended September 30, 2017 primarily as a result of the Premier and Puget Mergers.

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The cost of interest bearing deposits increased 10 basis points to 0.34% for the nine months ended September 30, 2018 from 0.24% for the same period in 2017 due to a combination of an increase in market interest rates and an increase in the average balance due primarily to the Premier and Puget Mergers. The cost of interest bearing deposits is primarily due to the interest bearing demand and money market deposits and certificates of deposits. The average balance of interest bearing demand and money market deposits increased $374.0 million, or 25.1%, to $1.86 billion during the nine months ended September 30, 2018 compared to $1.49 billion during the same period in 2017, and the cost of interest bearing demand and money market deposits increased five basis points to 0.21% for the nine months ended September 30, 2018 from 0.16% for the same period in 2017. The average balance of certificate of deposit accounts increased $82.0 million, or 22.2%, to $451.7 million for the nine months ended September 30, 2018 compared to $369.7 million for the same period in 2017. The cost of certificates of deposit increased 26 basis points to 0.81% for the nine months ended September 30, 2018 from 0.55% for the same period in 2017.

The Company was able to reduce the impact of the rising market interest rates by increasing the average balance of noninterest bearing deposits at a higher growth rate than the noninterest bearing deposits described above. The average balance of noninterest bearing deposits increased by $316.2 million, or 35.7%, during the nine months ended September 30, 2018 to $1.20 billion compared to $885.5 million for the same period in 2017. The cost of all deposit accounts increased to 0.24% for the nine months ended September 30, 2018 compared to 0.18% for the nine months ended September 30, 2017.

Interest expense on FHLB advances and other borrowings decreased $201,000, or 23.1%, to $669,000 for the nine months ended September 30, 2018 from $870,000 for the nine months ended September 30, 2017 due to a decrease in the average balance, partially offset by an increase in the cost. The average balance for FHLB advances and other borrowings decreased $61.4 million to $45.2 million for the nine months ended September 30, 2018 from $106.6 million for the same period in 2017 due to the increase in the average deposit balances. The average rate of the FHLB advances and other borrowings increased 89 basis points to 1.98% for the nine months ended September 30, 2018 compared to 1.09% for the same period in 2017 as a result of the increase in market rates.

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, increased 112 basis points to 6.17% for the nine months ended September 30, 2018 compared to 5.05% for the same period in 2017. The rate increase on the debentures was due to an increase in the three-month LIBOR rate to 2.40% at September 30, 2018 from 1.33% on September 30, 2017.

Net Interest Margin

Net interest margin for the nine months ended September 30, 2018 increased 37 basis points to 4.26% from 3.89% for the same period in 2017 primarily due to the above mentioned changes in asset yields and costs of funds in addition to an increase in incremental accretion on purchased loans as a result of the Premier and Puget Mergers. The net interest spread for the nine months ended September 30, 2018 increased 34 basis points to 4.14% from 3.80% for the same period in 2017 primarily due to the increase in yield on total interest earning assets.



	Nine Months Ended September 30,
	2018		2017
Net interest margin, excluding incremental accretion on purchased loans ⁽¹⁾	4.06	%	3.75	%
Impact on net interest margin from incremental accretion on purchased loans ⁽¹⁾	0.20		0.14
Net interest margin	4.26	%	3.89	%

⁽¹⁾

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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 and nine months ended ~~March 31,~~September 30, 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, 2018 to the comparable quarter in the prior year.

The provision for loan losses increased ~~$285,000,~~$181,000, or ~~32.9%~~20.5%, to ~~$1.2~~$1.1 million for the three months ended ~~March 31,~~September 30, 2018 from ~~$867,000~~$884,000 for the three months ended ~~March 31,~~September 30, 2017. The increase in the provision for loan losses for the three months ended ~~March 31,~~September 30, 2018 from the same period in 2017 was primarily the result of ~~changes~~increases in ~~our asset quality, volume and mix of loans, certain environmental and historical loss factors and~~total loan balances as a result of ~~the impact of loan growth.~~mergers. Based on a thorough review of the loan portfolio, the Bank determined that the provision for loan losses for the three months ended ~~March 31,~~September 30, 2018 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, 2018 to the comparable period in the prior year

The provision for loan losses increased $1.1 million, or 37.6% to $4.0 million for the nine months ended September 30, 2018 from $2.9 million for the nine months ended September 30, 2017. The increase in the provision for loan losses for the nine months ended September 30, 2018 from the same period in 2017 was primarily the result of the same changes mentioned above for the increase during the three months ended September 30, 2018. Based on a thorough review of the loan portfolio, the Bank determined that the provision for loan losses for the nine months ended September 30, 2018 was appropriate as it was calculated in accordance with the Bank's methodology for determining the allowance for loan losses.

Noninterest Income

~~Table~~Comparison of ~~Contents~~

~~Noninterest Income~~quarter ended September 30, 2018 to the comparable quarter in the prior year.

Total noninterest income ~~increased $118,000,~~decreased $363,000, or ~~1.6%~~4.3%, to ~~$7.5~~$8.1 million for the three months ended ~~March 31,~~September 30, 2018 compared to ~~$7.3~~$8.4 million for the same period in 2017. The following table presents the change in the key components of noninterest income for the periods noted.


	Three Months Ended March 31,									Three Months Ended September 30,
	2018		2017		Change			Percentage Change		2018		2017		Change			Percentage Change
	(Dollars in thousands)									(Dollars in thousands)
Service charges and other fees	$	4,543	$	4,213	$	330		7.8	%	$	4,824	$	4,769	$	55		1.2	%
Gain on sale of investment securities, net	35		—		35			100.0		82		44		38			86.4
Gain on sale of loans, net	874		1,195		(321		)	(26.9	)	706		1,229		(523		)	(42.6	)
Interest rate swap fees	51		133		(82		)	(61.7	)	—		328		(328		)	(100.0	)
Other income	1,964		1,808		156			8.6		2,468		2,073		395			19.1
Total noninterest income	$	7,467	$	7,349	$	118		1.6	%	$	8,080	$	8,443	$	(363	)	(4.3	)%

~~Service charges~~Gain on sale of loans, net and interest rate swap fees decreased based on a decline in volume of U.S. Small Business Administration ("SBA") loan sales and new swap contracts, respectively, during the three months ended September 30, 2018 compared to the same period in 2017. These declines are attributed primarily to the increasing market rates. The detail of gain on sale of loans, net is included in the following schedule.

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	Three Months Ended September 30,
	2018		2017		Change			Percentage Change
	(Dollars in thousands)
Gain on sale of mortgage loans, net	$	706	$	875	$	(169	)	(19.3	)%
Gain on sale of guaranteed portion of SBA loans, net	—		354		(354		)	(100.0	)
Gain on sale of loans, net	$	706	$	1,229	$	(523	)	(42.6	)%

These decreases in noninterest income were offset partially by an increase in other ~~fees increased $330,000,~~income of $395,000, or ~~7.8%~~19.1% to ~~$4.5~~$2.5 million for the three months ended ~~March 31,~~September 30, 2018 compared to ~~$4.2~~$2.1 million for the same period in 2017, due primarily to ~~an increase~~a gain on sale of a branch held for sale of $382,000 recognized during the three months ended September 30, 2018.

Comparison of nine months ended September 30, 2018 to the comparable period 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. Secondarily, service charges and other fees increased as a result of the Puget Sound Merger.~~prior year

~~The increase in~~Total noninterest income ~~was offset by a decrease~~decreased $3.3 million, or 12.5%, to $23.2 million for the nine months ended September 30, 2018 compared to $26.5 million for the same period in ~~gain~~2017. The following table presents the change in the key components of noninterest income for the periods noted.



	Nine Months Ended September 30,
	2018		2017		Change			Percentage Change
	(Dollars in thousands)
Service charges and other fees	$	14,062	$	13,408	$	654		4.9	%
Gain on sale of investment securities, net	135		161		(26		)	(16.1	)
Gain on sale of loans, net	2,286		6,562		(4,276		)	(65.2	)
Interest rate swap fees	360		743		(383		)	(51.5	)
Other income	6,358		5,641		717			12.7
Total noninterest income	$	23,201	$	26,515	$	(3,314	)	(12.5	)%

Gain on ~~the~~ sale of loans, net ~~of $321,000,~~decreased $4.3 million, or ~~26.9%,~~65.2% to ~~$874,000~~$2.3 million for the ~~three~~nine months ended ~~March 31,~~September 30, 2018 compared to ~~$1.2~~$6.6 million for the same period in 2017, due primarily to the gain on sale of a ~~decrease~~purchased credit impaired loan of $3.0 million recognized during the nine months ended September 30, 2017. Gain on sale of mortgage and SBA loans also decreased during the nine months ended September 30, 2018 compared to the same period in ~~mortgage banking activities.~~2017 primarily due to less activity. Proceeds from sale of mortgage loans and the guaranteed portion of SBA loans decreased ~~$15.3~~$33.4 million, or ~~42.6%~~31.3% to ~~$20.7~~$73.3 million for the ~~three~~nine months ended ~~March 31,~~September 30, 2018 from ~~$35.7~~$106.7 million for the same period in 2017. The detail of gain on sale of loans, net is included in the following schedule.


	Three Months Ended March 31,									Nine Months Ended September 30,
	2018		2017		Change			Percentage Change		2018		2017		Change			Percentage Change
	(Dollars in thousands)									(Dollars in thousands)
Gain on sale of mortgage loans, net	$	652	$	909	$	(257	)	(28.3	)%	$	1,930	$	2,515	$	(585	)	(23.3	)%
Gain on sale of guaranteed portion of SBA loans, net	222		286		(64		)	(22.4	)	356		1,049		(693		)	(66.1	)
Gain on sale of other loans, net										—		2,998		(2,998		)	(100.0	)
Gain on sale of loans, net	$	874	$	1,195	$	(321	)	(26.9	)%	$	2,286	$	6,562	$	(4,276	)	(65.2	)%

The decrease in gain on sale of loans, net was offset partially by an increase in other income of $717,000, or 12.7% to $6.4 million for the nine months ended September 30, 2018 compared to $5.6 million for the same period in 2017, due primarily to a gain on sale of a branch held for sale of $382,000 recognized during the three months ended September 30, 2018 and an increase in merchant VISA income of $198,000 primarily due to an increase in customer account activity and a favorable contract renewal with the existing vendor.

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Service charges and other fees also increased $654,000, or 4.9% to $14.1 million for the nine months ended September 30, 2018 compared to $13.4 million for the same period in 2017, due primarily to an increase in deposit balances from acquisition and organic growth and changes in fee structures on deposit accounts, including a business deposit consolidation process completed during second quarter 2017.

Noninterest Expense

Comparison of quarter ended September 30, 2018 to the comparable quarter in the prior year.

Noninterest expense increased ~~$9.5~~$11.6 million, or ~~35.0%~~41.6%, to ~~$36.7~~$39.6 million during the three months ended ~~March 31,~~September 30, 2018 compared to ~~$27.2~~$28.0 million for the three months ended ~~March 31,~~September 30, 2017. The following table presents changes in the key components of noninterest expense for the periods noted.


	Three Months Ended March 31,									Three Months Ended September 30,
	2018		2017		Change			Percentage Change		2018		2017			Change			Percentage Change
	(Dollars in thousands)									(Dollars in thousands)
Compensation and employee benefits	$	21,367	$	16,024	$	5,343		33.3	%	$	23,804	$	15,823		$	7,981		50.4	%
Occupancy and equipment	4,627		3,810		817			21.4		5,020		3,979			1,041			26.2
Data processing	2,605		1,915		690			36.0		2,343		2,090			253			12.1
Marketing	808		807		1			0.1		876		933			(57		)	(6.1	)
Professional services	2,837		1,009		1,828			181.2		2,119		1,453			666			45.8
State and local taxes	688		549		139			25.3		931		640			291			45.5
Federal deposit insurance premium	355		300		55			18.3		375		433			(58		)	(13.4	)
Other real estate owned, net	—		31		(31		)	(100.0	)	18		(88		)	106			(120.5	)
Amortization of intangible assets	795		324		471			145.4		1,114		319			795			249.2
Other expense	2,665		2,454		211			8.6		2,997		2,373			624			26.3
Total noninterest expense	$	36,747	$	27,223	$	9,524		35.0	%	$	39,597	$	27,955		$	11,642		41.6	%

The Company has incurred significant non-recurring acquisition costs in the Premier and Puget Mergers. The following table presents these expenses by key component in the following table.



	Three Months Ended September 30,
	2018		2017
	(Dollars in thousands)
Compensation and employee benefits	$	1,907	$	—
Occupancy and equipment	7		—
Data processing	370		—
Marketing	1		—
Professional services	1,081		384
Other expense	36		3
Total acquisition costs	$	3,402	$	387

Compensation and employee benefits increased ~~$5.3~~$8.0 million, or ~~33.3%~~50.4%, to ~~$21.4~~$23.8 million during the three months ended ~~March 31,~~September 30, 2018 from ~~$16.0~~$15.8 million during the three months ended ~~March 31,~~September 30, 2017 primarily as a result of additional employees, primarily due to the Premier and Puget Mergers. The average full time equivalent employees increased to 878 for the three months ended September 30, 2018 compared to 747 for the same period in 2017, including employees acquired in the Premier Merger. Compensation and employee benefits additionally increased due to standard salary increases and acquisition-related payments related primarily to the Premier Merger of $1.9 million during the three months ended September 30, 2018.

Occupancy and equipment increased $1.0 million, or 26.2%, to $5.0 million during the three months ended September 30, 2018 from $4.0 million during the three months ended September 30, 2017 due substantially to branch expansion in the Seattle, Bellevue, Portland and other Oregon markets. The Bellevue expansion included the lease

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acquired from the Puget Sound Merger and additional space leased subsequent to the merger. The Oregon expansion included five leases acquired in the Premier Merger.

Amortization of intangible assets increased $795,000, or 249.2%, to $1.1 million during the three months ended September 30, 2018 from $319,000 during the three months ended September 30, 2017 primarily a result of additional amortization related to acquired core deposit intangibles from the Premier and Puget Mergers of $836,000 during the three months ended September 30, 2018.

Professional services increased $666,000, or 45.8%, to $2.1 million during the three months ended September 30, 2018 from $1.5 million during the three months ended September 30, 2017 as a result of merger activities including legal and conversion consulting costs.

The ratio of noninterest expense to average total assets (annualized) was 2.98% for the three months ended September 30, 2018 compared to 2.76% for the three months ended September 30, 2017. The increase was primarily a result of increased expenses as a result of the Premier and Puget Mergers.

Comparison of nine months ended September 30, 2018 to the comparable period in the prior year

Noninterest expense increased $29.1 million, or 35.0%, to $112.1 million during the nine months ended September 30, 2018 compared to $83.0 million for the nine months ended September 30, 2017. The following table presents changes in the key components of noninterest expense for the periods noted.



	Nine Months Ended September 30,
	2018		2017			Change			Percentage Change
	(Dollars in thousands)
Compensation and employee benefits	$	64,492	$	48,119		$	16,373		34.0	%
Occupancy and equipment	14,457		11,607			2,850			24.6
Data processing	7,455		6,007			1,448			24.1
Marketing	2,507		2,545			(38		)	(1.5	)
Professional services	8,485		3,515			4,970			141.4
State and local taxes	2,335		1,828			507			27.7
Federal deposit insurance premium	1,105		1,090			15			1.4
Other real estate owned, net	18		(36		)	54			(150.0	)
Amortization of intangible assets	2,705		966			1,739			180.0
Other expense	8,491		7,346			1,145			15.6
Total noninterest expense	$	112,050	$	82,987		$	29,063		35.0	%

The Company has incurred significant non-recurring acquisition costs in the Premier and Puget Mergers. The following table presents these expenses by key component in the following table.



	Nine Months Ended September 30,
	2018		2017
	(Dollars in thousands)
Compensation and employee benefits	$	4,798	$	—
Occupancy and equipment	44		—
Data processing	1,147		—
Marketing	6		—
Professional services	3,016		384
Other expense	79		3
Total acquisition costs	$	9,090	$	387

Compensation and employee benefits increased $16.4 million, or 34.0%, to $64.5 million during the nine months ended September 30, 2018 from $48.1 million during the nine months ended September 30, 2017. The increase in the ~~three~~nine months ended ~~March 31,~~September 30, 2018 compared to 2017 was primarily as a result of additional employees, primarily due to the Premier and ~~acquisition-related payments from~~ Puget ~~Sound Merger of approximately $2.7 million.~~Mergers, including increases in senior level staffing. The average full time equivalent employees increased to ~~796~~831 for the ~~three~~nine months ended ~~March 31,~~September 30, 2018 compared to ~~761~~754 for the same

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period in ~~2017.~~2017, including employees acquired in the Premier and Puget Mergers. Compensation and employee benefits additionally increased due to increases in standard salary and acquisition-related payments related to the Premier and Puget Mergers of $4.8 million during the nine months ended September 30, 2018.

Professional services increased ~~$1.8~~$5.0 million, or ~~181.2%~~141.4%, to ~~$2.8~~$8.5 million during the ~~three~~nine months ended ~~March 31,~~September 30, 2018 from ~~$1.0~~$3.5 million during the ~~three~~nine months ended ~~March 31, 2017. The increase in the three months ended March 31, 2018 compared to~~September 30, 2017 ~~was~~ primarily due to ~~costs~~an increase of ~~approximately $1.6~~$2.6 million ~~incurred for~~in professional services acquisition costs. The increase was additionally the result of the buy-out of a third party contract in the amount of $1.7 million during the nine months ended September 30, 2018. The Company expects the accumulated savings in future professional services expenses to fully offset the cost of the buy-out by the end of 2019.

Occupancy and equipment increased $2.9 million, or 24.6%, to $14.5 million during the nine months ended September 30, 2018 from $11.6 million during the nine months ended September 30, 2017 due substantially to branch expansion in the Seattle, Bellevue, Portland and other Oregon markets. The Bellevue expansion included the lease acquired from the Puget Sound Merger and additional space leased subsequent to the ~~proposed Premier Merger during the three months ended March 31, 2018.~~

~~Occupancy and equipment increased $817,000, or 21.4%, to $4.6 million during the three months ended March 31, 2018 from $3.8 million during the three months ended March 31, 2017.~~merger. The ~~increase~~Oregon expansion included five leases acquired in the ~~three months ended March 31, 2018 compared to 2017 was substantially related to on-going costs associated with the Puget Sound Merger.~~

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

Amortization of intangible assets increased ~~$471,000,~~$1.7 million, or ~~145.4%~~180.0%, to ~~$795,000~~$2.7 million during the ~~three~~nine months ended ~~March 31,~~September 30, 2018 from ~~$324,000~~$966,000 during the ~~three~~nine months ended ~~March 31, 2017.~~September 30, 2017 primarily a result of additional amortization related to acquired core deposit intangibles from the Premier and Puget Mergers of $1.9 million during the nine months ended September 30, 2018.

Data processing increased $1.4 million, or 24.1%, to $7.5 million during the nine months ended September 30, 2018 from $6.0 million during the nine months ended September 30, 2017 primarily due to acquisition costs. The increase in the ~~three~~nine months ended ~~March 31,~~September 30, 2018 compared to 2017 was additionally due to higher transactional activity as a result of the ~~amortization of the core deposit intangible recorded~~Premier and Puget Mergers and organic growth in ~~the Puget Sound Merger of $513,000 during the three months ended March 31, 2018.~~loans and deposits.

The ratio of noninterest expense to average total assets (annualized) was ~~3.27%~~3.09% for the ~~three~~nine months ended ~~March 31,~~September 30, 2018, compared to ~~2.85%~~2.82% for the ~~three~~nine months ended ~~March 31,~~September 30, 2017. The increase was primarily a result of increased expenses including acquisition related costs ~~totaling $4.7 million~~as a result of the Premier and Puget Mergers during the ~~three~~nine months ended ~~March 31,~~September 30, 2018.

Income Tax Expense

Comparison of quarter ended September 30, 2018 to the comparable quarter in the prior year.

Income tax expense decreased ~~$1.7 million,~~$912,000, or ~~54.7%~~23.3%, to ~~$1.4~~$3.0 million for the three months ended ~~March 31,~~September 30, 2018 from ~~$3.1~~$3.9 million for the three months ended ~~March 31,~~September 30, 2017. The effective tax rate was 16.3% for the three months ended September 30, 2018 compared to 27.0% for the same period in 2017. The decrease in the income tax expense and effective tax rate during the ~~three~~nine months ended ~~March 31,~~September 30, 2018 was primarily due to the impact of the Tax Cuts and Jobs Act enacted in December 2017, which lowered the corporate income tax rate to 21% from 35%.

Comparison of nine months ended September 30, 2018 to the comparable period in the prior year

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Income tax expense decreased $4.7 million, or 42.2%, to $6.4 million for the nine months ended September 30, 2018 from $11.1 million for the nine months ended September 30, 2017. The effective tax rate was ~~13.3%~~15.0% for the ~~three~~nine months ended ~~March 31,~~September 30, 2018 compared to ~~24.9%~~25.9% for the same period in 2017. The decrease in the income tax expense and effective tax rate during the ~~three~~nine months ended ~~March 31,~~September 30, 2018 ~~compared~~was primarily due to the ~~same period in 2017 was due primarily to~~impact of the Tax Cuts and Jobs ~~Act.~~Act, offset partially by an increase in certain non-deductible acquisition costs.

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Financial Condition Overview

The table below provides a comparison of the changes in the Company's financial condition from December 31, 2017 to ~~March 31,~~September 30, 2018, and the results of the Puget Sound Merger effective January 16, 2018 and the Premier Merger effective July 2, 2018:


	March 31, 2018			December 31, 2017			Change			Percentage Change		Fair Value of Puget Sound at Merger Date		September 30, 2018			December 31, 2017			Change			% Change		Fair Value of Premier and Puget Mergers at Respective Merger Dates
	(Dollars in thousands)													(Dollars in thousands)
Assets
Cash and cash equivalents	$	130,309		$	103,015		$	27,294		26.5	%	$	80,136	$	170,143		$	103,015		$	67,128		65.2	%	$	105,974
Investment securities available for sale, at fair value	821,567			810,530			11,037			1.4		80,353		920,737			810,530			110,207			13.6		84,846
Loans held for sale	2,669			2,288			381			16.7		—		1,882			2,288			(406		)	(17.7	)	—
Total loans receivable, net	3,248,654			2,816,985			431,669			15.3		388,462		3,614,579			2,816,985			797,594			28.3		718,547
Other real estate owned	—			—			—			—		—		2,032			—			2,032			N/A		1,796
Premises and equipment, net	62,147			60,325			1,822			3.0		732		80,439			60,325			20,114			33.3		3,785
Federal Home Loan Bank stock, at cost	6,824			8,347			(1,523		)	(18.2	)	623		6,076			8,347			(2,271		)	(27.2	)	1,743
Bank owned life insurance	81,700			75,091			6,609			8.8		6,264		93,296			75,091			18,205			24.2		17,116
Accrued interest receivable	13,602			12,244			1,358			11.1		1,448		15,735			12,244			3,491			28.5		2,454
Prepaid expenses and other assets	104,666			99,328			5,338			5.4		1,354		108,730			99,328			9,402			9.5		3,182
Other intangible assets, net	16,563			6,088			10,475			172.1		11,270		21,728			6,088			15,640			256.9		18,345
Goodwill	187,549			119,029			68,520			57.6		68,520		240,837			119,029			121,808			102.3		121,808
Total assets	$	4,676,250		$	4,113,270		$	562,980		13.7	%	$	639,162	$	5,276,214		$	4,113,270		$	1,162,944		28.3	%	$	1,079,596

Liabilities
Deposits	$	3,904,741		$	3,393,060		$	511,681		15.1	%	$	505,885	$	4,398,127		$	3,393,060		$	1,005,067		29.6	%	$	824,602
Federal Home Loan Bank advances	30,700			92,500			(61,800		)	(66.8	)	—		—			92,500			(92,500		)	(100.0	)	16,000
Junior subordinated debentures	20,083			20,009			74			0.4		—		20,229			20,009			220			1.1		—
Securities sold under agreement to repurchase	26,100			31,821			(5,721		)	(18.0	)	—		32,233			31,821			412			1.3		462
Accrued expenses and other liabilities	59,918			67,575			(7,657		)	(11.3	)	2,504		79,492			67,575			11,917			17.6		8,489
Total liabilities	4,041,542			3,604,965			436,577			12.1		508,389		4,530,081			3,604,965			925,116			25.7		849,553
Stockholders' equity
Common stock	490,566			360,590			129,976			36.0		130,773		591,065			360,590			230,475			63.9		230,043
Retained earnings	153,101			149,013			4,088			2.7		—		169,758			149,013			20,745			13.9		—
Accumulated other comprehensive loss, net	(8,959		)	(1,298		)	(7,661		)	590.2		—		(14,690		)	(1,298		)	(13,392		)	1,031.7		—
Total stockholders' equity	634,708			508,305			126,403			24.9		130,773		746,133			508,305			237,828			46.8		230,043
Total liabilities and stockholders' equity	$	4,676,250		$	4,113,270		$	562,980		13.7	%	$	639,162	$	5,276,214		$	4,113,270		$	1,162,944		28.3	%	$	1,079,596

Total assets increased ~~$563.0 million,~~$1.16 billion, or ~~13.7%~~28.3%, to ~~$4.68~~$5.28 billion as of ~~March 31,~~September 30, 2018 compared to $4.11 billion as of December 31, 2017. The Premier and Puget ~~Sound Merger~~Mergers resulted in an increase of total assets, including goodwill, of ~~$639.0 million~~$1.08 billion at their respective 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.~~dates.

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Total loans receivable, net, excluding loans acquired in the Premier and Puget ~~Sound Merger~~Mergers increased ~~$43.2~~$79.0 million, or ~~6.2%~~3.8% annualized, during the ~~three~~nine months ended ~~March 31,~~September 30, 2018.

Investment securities increased ~~$11.0~~$110.2 million, or ~~1.4%~~13.6%, to ~~$821.6~~$920.7 million at ~~March 31,~~September 30, 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 the Premier and Puget ~~Sound Merger,~~Mergers, increased ~~$5.8~~$180.5 million, or ~~0.7%~~7.1% annualized, during the ~~three~~nine months ended ~~March~~September 30, 2018. Brokered deposits increased $18.6 million, or 46.9%, to $58.1 million at September 30, 2018 compared to $39.6 million at December 31, ~~2018.~~2017. Total non-maturity deposits increased to ~~89.2%~~88.5% of total deposits at ~~March 31,~~September 30, 2018 from 88.3% at December 31, 2017 and certificates of ~~deposits~~deposit decreased to ~~10.8%~~11.5% of total deposits at ~~March 31,~~September 30, 2018 from 11.7% at December 31, 2017.

The Company had no Federal Home Loan Bank advances ~~decreased $61.8 million, or 66.8%, to $30.7 million as of March 31,~~at September 30, 2018, ~~from~~a $92.5 million ~~as of~~decrease from December 31, 2017. The ~~decrease~~Company was ~~due~~able to repay the ~~pay down~~higher cost of ~~FHLB advances using cash acquired~~funding based on the increase in the ~~Puget Sound Merger and proceeds from the sale~~deposit balances primarily as a result of the ~~investments acquired in the~~Premier and Puget ~~Sound Merger.~~Mergers.

Total stockholders’ equity increased ~~$126.4~~$237.8 million, or ~~24.9%~~46.8%, to ~~$634.7~~$746.1 million as of ~~March 31,~~September 30, 2018 from $508.3 million at December 31, 2017. The Company’s stockholders' equity position was ~~13.6%~~14.1% of total assets as of ~~March 31,~~September 30, 2018 and 12.4% as of December 31, 2017. Changes in stockholders' equity during the ~~three~~nine months ended ~~March 31,~~September 30, 2018 were as ~~follows (in thousands):~~follows:


				Nine Months Ended
	Three Months Ended			September 30, 2018
	March 31, 2018			(In thousands)
Balance, beginning of period	$	508,305		$	508,305
Common stock issued in the Puget Sound Merger	130,770
Common stock issued in the Premier and Puget Mergers				230,043
Net income	9,087			36,448
Dividends paid	(5,117		)
Dividends declared				(15,796		)
Accumulated other comprehensive loss	(7,543		)	(13,299		)
Other	(794		)	432
Balance, end of period	$	634,708		$	746,133

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~~$797.6 million, or ~~15.3%~~28.3%, to ~~$3.25~~$3.61 billion at ~~March 31,~~September 30, 2018 from $2.82 billion at December 31, 2017. The increase in loans receivable was primarily indue to the Premier and Puget Mergers. At the merger dates, the Bank acquired fair value of commercial and industrial loans ~~which increased $166.3~~of $271.8 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~~of $185.0 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.~~of $183.6 million.

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


	March 31, 2018				December 31, 2017				September 30, 2018				December 31, 2017
	Balance		% of Total ⁽³⁾		Balance		% of Total ⁽³⁾		Balance		% of Total ⁽³⁾		Balance		% of Total ⁽³⁾		Change		%of Balance Change
	(Dollars in thousands)								(Dollars in thousands)
Commercial business:
Commercial and industrial	$	811,678	24.7	%	$	645,396	22.7	%	$	861,530	23.6	%	$	645,396	22.7	%	$	216,134	33.5	%
Owner-occupied commercial real estate	702,356		21.4		622,150		21.8		785,416		21.5		622,150		21.8		163,266		26.2
Non-owner occupied commercial real estate	1,133,394		34.6		986,594		34.6		1,283,160		35.2		986,594		34.6		296,566		30.1
Total commercial business	2,647,428		80.7		2,254,140		79.1		2,930,106		80.3		2,254,140		79.1		675,966		30.0
One-to-four family residential ⁽¹⁾	89,180		2.7		86,997		3.1		96,333		2.7		86,997		3.1		9,336		10.7
Real estate construction and land development:
One-to-four family residential	73,295		2.2		51,985		1.8		107,148		2.9		51,985		1.8		55,163		106.1
Five or more family residential and commercial properties	98,387		3.0		97,499		3.4		120,787		3.3		97,499		3.4		23,288		23.9
Total real estate construction and land development ⁽²⁾	171,682		5.2		149,484		5.2		227,935		6.2		149,484		5.2		78,451		52.5
Consumer	370,275		11.3		355,091		12.5		391,283		10.7		355,091		12.5		36,192		10.2
Gross loans receivable	3,278,565		99.9		2,845,712		99.9		3,645,657		99.9		2,845,712		99.9		799,945		28.1
Net deferred loan costs	3,350		0.1		3,359		0.1		3,397		0.1		3,359		0.1		38		1.1
Loans receivable, net	$	3,281,915	100.0	%	$	2,849,071	100.0	%	$	3,649,054	100.0	%	$	2,849,071	100.0	%	$	799,983	28.1	%

⁽¹⁾ Excludes loans held for sale of ~~$2.7~~$1.9 million, and $2.3 million as of ~~March 31,~~September 30, 2018 and December 31, ~~2017.~~2017, respectively.

⁽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 provides information about our nonaccrual loans, other real estate owned and performing TDR loans for the indicated dates.


	March 31, 2018			December 31, 2017			September 30, 2018			December 31, 2017
	(Dollars in thousands)						(Dollars in thousands)
Nonaccrual loans:
Commercial business	$	14,356		$	9,098		$	13,487		$	9,098
One-to-four family residential	80			81			74			81
Real estate construction and land development	1,147			1,247			1,076			1,247
Consumer	145			277			143			277
Total nonaccrual loans ⁽¹⁾	15,728			10,703			14,780			10,703
Other real estate owned	—			—			2,032			—
Total nonperforming assets	$	15,728		$	10,703		$	16,812		$	10,703

Allowance for loan losses	$	33,261		$	32,086		$	34,475		$	32,086
Nonperforming loans to loans receivable, net	0.48		%	0.38		%	0.41		%	0.38		%
Allowance for loan losses to loans receivable, net	1.01		%	1.13		%	0.94		%	1.13		%
Allowance for loan losses to nonperforming loans	211.48		%	299.79		%	233.25		%	299.79		%
Nonperforming assets to total assets	0.34		%	0.26		%	0.32		%	0.26		%

Performing TDR loans:
Commercial business	$	25,737		$	25,729		$	23,970		$	25,729
One-to-four family residential	215			218			211			218
Real estate construction and land development	—			645			—			645
Consumer	235			165			268			165
Total performing TDR loans	$	26,187		$	26,757		$	24,449		$	26,757
Accruing loans past due 90 days or more	$	—		$	—		$	—		$	—
Potential problem loans	93,253			83,543			105,742			83,543


⁽¹⁾	At ~~March 31,~~September 30, 2018 and December 31, 2017, ~~$8.2~~$6.5 million and $5.2 million of nonaccrual loans were considered TDR loans, respectively.

~~Nonperforming Assets~~. Nonperforming assets consist of nonaccrual loans and other real estate owned. Nonperforming assets increased $5.0 million to $15.7 million, or 0.34% of total assets at March 31, 2018 from $10.7 million, or 0.26% of total assets, at December 31, 2017 due to the increase in nonaccrual loans discussed below. There was no other real estate owned at March 31, 2018 or December 31, 2017.

Nonaccrual Loans. Nonaccrual loans increased ~~$5.0~~$4.1 million to ~~$15.7~~$14.8 million, or ~~0.48%~~0.41% of loans receivable, net, at ~~March 31,~~September 30, 2018 from $10.7 million, or 0.38% of loans receivable, net, at December 31, 2017. The increase was due primarily to ~~one~~two agricultural loan ~~relationship in the amount of $3.1 million~~relationships and two commercial business relationships that ~~was classified as~~were transferred to nonaccrual status during the ~~period~~nine months ended ~~March 31,~~September 30, 2018 totaling $1.7 million and $1.9 million, respectively, at September 30, 2018. ~~As this credit relationship~~One of the agricultural relationships is well-secured and the Company did not record a related allowance for loan ~~losses. The increase in~~losses and the ~~nonaccrual loans was also due to two commercial credit relationships with an outstanding balance of $1.9 million at March 31, 2018 of which approximately $1.0 million~~other agricultural relationship is partially guaranteed by the ~~Small Business Administration.~~SBA and the Company recorded an allowance for loan losses of $76,000 at September 30, 2018 related to the unguaranteed portion of the loan. We recorded an allowance for loan losses of $564,000 for the two commercial business relationships at September 30, 2018.

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The following table reflects the changes in nonaccrual loans during the ~~three~~nine months ended ~~March 31, 2018 (in thousands):~~September 30, 2018:


				Nine Months Ended
	Three Months Ended			September 30, 2018
	March 31, 2018			(In thousands)
Nonaccrual loans
Balance, beginning of period	$	10,703		$	10,703
Addition of previously classified pass graded loans	4,066			5,373
Addition of previously classified potential problem loans	2,324			4,336
Addition of acquired loans				130
Charge-offs				(724		)
Net principal payments	(1,365		)	(5,038		)
Balance, end of period	$	15,728		$	14,780

At ~~March 31,~~September 30, 2018, nonaccrual loans of ~~$7.6~~$8.9 million had related allowance for loan losses of ~~$1.9~~$2.2 million and nonaccrual loans of ~~$8.2~~$5.9 million had no related allowance for loan losses. At December 31, 2017 nonaccrual loans of ~~$3.2~~$3.8 million had related allowance for loan losses of $720,000 and nonaccrual loans of ~~$7.5~~$6.9 million had no allowance for loan losses.

At ~~March 31,~~September 30, 2018, nonperforming TDR loans, included in the nonaccrual loan table above, were ~~$8.2~~$6.5 million and had a related allowance for loan losses of ~~$336,000.~~$713,000. At December 31, 2017, nonperforming TDR loans were $5.2 million and had a related allowance for loan losses of $379,000.

Nonperforming Assets. Nonperforming assets consist of nonaccrual loans and other real estate owned. Nonperforming assets increased $6.1 million to $16.8 million, or 0.32% of total assets at September 30, 2018 from $10.7 million, or 0.26% of total assets, at December 31, 2017 due to primarily to the increase in nonaccrual loans discussed above. Nonperforming assets additionally increased due to the additions of other real estate owned, primarily as a result of other real estate owned acquired in the Premier Merger. There was no other real estate owned at December 31, 2017.

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,~~$2.3 million, or ~~2.1%~~8.6%, to ~~$26.2~~$24.4 million at ~~March 31,~~September 30, 2018 from $26.8 million at December 31, 2017.

The following table reflects the changes in performing TDR loans during ~~the three~~nine months ended ~~March 31, 2018 (in thousands):~~September 30, 2018:


				Nine Months Ended
	Three Months Ended			September 30, 2018
	March 31, 2018			(In thousands)
Performing TDR loans
Balance, beginning of period	$	26,757		$	26,757
Addition of previously classified pass graded loans				1,909
Addition of previously classified potential problem loans	79			907
Net principal payments	(649		)	(5,124		)
Balance, end of period	$	26,187		$	24,449

The related allowance for loan losses on performing TDR loans was $2.2 million as of September 30, 2018 and $2.6 million as of ~~both March 31, 2018 and~~ December 31, 2017.

Potential Problem Loans. Potential problem loans increased ~~$9.7~~$22.2 million, or ~~11.6%~~26.6%, to ~~$93.3~~$105.7 million at ~~March 31,~~September 30, 2018 from $83.5 million at December 31, 2017. The increase was due primarily to the addition of an agricultural lending relationship totaling $15.7 million at September 30, 2018 and the addition of potential problem loans acquired in the Premier and Puget ~~Sound Merger~~Mergers with a total outstanding balance of ~~$6.1~~$10.1 million ~~at March 31, 2018.~~and $4.5 million, respectively.

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The following table reflects the changes in potential problem loans during the ~~three~~nine months ended ~~March 31,~~September 30, 2018 (in thousands):


				Nine Months Ended
	Three Months Ended			September 30, 2018
	March 31, 2018			(In thousands)
Potential problem loans
Balance, beginning of period	$	83,543		$	83,543
Addition of previously classified pass graded loans	25,126			48,915
Acquired in Premier and Puget Mergers				14,630
Net principal payments				(20,530		)
Upgrades to pass graded loan status	(3,636		)	(15,273		)
Transfers of loan to nonaccrual or troubled debt restructured status	(2,403		)	(5,243		)
Charge-offs	(145		)	(300		)
Net principal payments	(9,232		)
Balance, end of period	$	93,253		$	105,742

Analysis of Allowance for Loan Losses

The allowance for loan losses is established through a provision for loan losses charged against earnings. The balance of the allowance for loan losses is maintained at the amount management believes will be appropriate to absorb probable incurred credit losses in the loan portfolio at the balance sheet date. The allowance for loan losses is determined by applying estimated loss factors to the credit exposure from outstanding loans.

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

historical loss experience in the loan portfolio;

impact of environmental factors, including:


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


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


◦	trends in volume and terms of loans;


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


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


◦	national and local economic trends and conditions;


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


◦	effects of changes in credit concentrations; and


◦	other factors

We calculate an appropriate allowance for loan losses for the loans in our loan portfolio by applying historical loss factors for homogeneous classes of the portfolio, adjusted for changes to the above-noted environmental factors. We may record specific provisions for impaired loans, including loans on nonaccrual status and TDR loans, after a careful analysis of each loan’s credit and collateral factors. Our analysis of an appropriate 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.

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


	Three Months Ended March 31,						Three Months Ended September 30,						Nine Months Ended September 30,
	2018			2017			2018			2017			2018			2017
	(Dollars in thousands)						(Dollars in thousands)
Allowance for loan losses on loans at the beginning of the period	$	32,086		$	31,083		$	33,972		$	32,751		$	32,086		$	31,083
Provision for loan losses	1,152			867			1,065			884			3,967			2,882
Charge-offs:
Commercial business	(81		)	(302		)	(300		)	(1,497		)	(923		)	(1,940		)
One-to-four family residential							(15		)	(15		)	(30		)	(15		)
Real estate construction and land development							—			(556		)	—			(556		)
Consumer	(485		)	(543		)	(530		)	(478		)	(1,709		)	(1,419		)
Total charge-offs	(566		)	(845		)	(845		)	(2,546		)	(2,662		)	(3,930		)
Recoveries:
Commercial business	501			372			121			8			690			834
One-to-four family residential							—			—			—			1
Real estate construction and land development	—			10			3			191			5			201
Consumer	88			107			159			112			389			329
Total recoveries	589			489			283			311			1,084			1,365
Net recoveries (charge-offs)	23			(356		)
Net (charge-offs) recoveries							(562		)	(2,235		)	(1,578		)	(2,565		)
Allowance for loan losses at the end of the period	$	33,261		$	31,594		$	34,475		$	31,400		$	34,475		$	31,400

Allowance for loan losses to loans receivable, net	1.01		%	1.19		%	0.94		%	1.12		%	0.94		%	1.12		%
Net (recoveries) charge-offs on loans to average loans, annualized	—		%	0.05		%
Net charge-offs on loans to average loans, annualized							0.06		%	0.32		%	0.06		%	0.13		%

Loans receivable, net at the end of the period ⁽¹⁾	$	3,281,915		$	2,663,704		$	3,649,054		$	2,797,513		$	3,649,054		$	2,797,513
Average loans receivable during the period ⁽¹⁾	3,150,869			2,631,816			3,618,031			2,737,535			3,346,709			2,676,153

⁽¹⁾ Excludes loans held for sale.

The allowance for loan losses increased $2.4 million, or 7.4%, to ~~$33.3~~$34.5 million at ~~March 31,~~September 30, 2018 from $32.1 million at December 31, 2017. The increase was ~~primarily~~ the result of provision for loan losses of ~~$1.2~~$4.0 million recognized during the ~~three~~nine months ended ~~March 31, 2018.~~September 30, 2018, offset partially by net charge-offs of $1.6 million recorded during the same period. The allowance for loan losses to loans receivable, net, decreased to ~~1.01%~~0.94% at ~~March 31,~~September 30, 2018 from 1.13% at December 31, 2017 primarily as a result of an increase in loans from the Premier and Puget ~~Sound~~ Merger with no related allowance for loan ~~losses.~~losses in accordance with GAAP. Included in the carrying value of loans are net discounts on loans purchased in mergers and acquisitions which may reduce the need for an allowance for loan losses on these loans because they are carried at an amount below the outstanding principal balance. The remaining net discount on purchased loans, including the related fair value discount acquired in the Premier and Puget Mergers, was $13.4 million at September 30, 2018 compared to $10.1 million at December 31, 2017.

The Company recorded ~~net recoveries~~charge-offs of $2.7 million during the ~~three~~nine months ended ~~March 31,~~September 30, 2018 due primarily as a result of a large volume of small dollar consumer loans. The largest charge-offs recognized during the nine months ended September 30, 2018 related to two agricultural relationships and one commercial relationship in the amount of $724,000. The Company recorded recoveries of $1.1 million during the nine months ended September 30, 2018 primarily a ~~recovery on a commercial and industrial loan~~result of ~~$324,000, offset partially by charge-offs~~small recoveries on a large volume of small dollar consumer loans. ~~The Company recorded net charge-offs on average loans, annualized,~~

Table 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.~~Contents

As of ~~March 31,~~September 30, 2018, the Bank identified ~~$15.7~~$14.8 million of nonperforming loans and ~~$26.2~~$24.4 million of performing TDR loans for a total of ~~$41.9~~$39.2 million of impaired loans. Of these impaired loans, ~~$11.6~~$9.2 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~~$30.0 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 outlines the allowance for loan losses and related loan balances on loans at ~~March 31,~~September 30, 2018 and December 31, 2017:


	March 31, 2018			December 31, 2017			September 30, 2018			December 31, 2017
	(Dollars in thousands)						(Dollars in thousands)
General Valuation Allowance:
Allowance for loan losses	$	24,975		$	24,732		$	26,705		$	24,732
Gross loans, excluding PCI and impaired loans	$	3,202,179		$	2,767,650		$	3,577,575		$	2,767,650
Percentage	0.78		%	0.89		%	0.75		%	0.89		%

PCI Allowance:
Allowance for loan losses	$	3,811		$	3,999		$	3,296		$	3,999
Gross PCI loans	$	34,471		$	40,603		$	28,853		$	40,603
Percentage	11.06		%	9.85		%	11.42		%	9.85		%

Specific Valuation Allowance:
Allowance for loan losses	$	4,475		$	3,355		$	4,474		$	3,355
Gross impaired loans	$	41,915		$	37,459		$	39,229		$	37,459
Percentage	10.68		%	8.96		%	11.40		%	8.96		%

Total Allowance for Loan Losses:
Allowance for loan losses	$	33,261		$	32,086		$	34,475		$	32,086
Gross loans receivable	$	3,278,565		$	2,845,712		$	3,645,657		$	2,845,712
Percentage	1.01		%	1.13		%	0.95		%	1.13		%

Based on the Bank's established comprehensive methodology, management deemed the allowance for loan losses of ~~$33.3~~$34.5 million at ~~March 31,~~September 30, 2018 ~~(1.01%~~(0.94% of loans receivable, net and ~~211.48%~~233.25% 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, 2017 of $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 in accordance with U.S. GAAP. At March 31, 2018 and December 31, 2017, the remaining fair value discount for these purchased loans was $12.7 million and $10.1 million, respectively.

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 by bank regulators, as part of their routine examination process, which may result in the establishment of an additional allowance for loan 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 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.

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Deposits and Other Borrowings

Total deposits increased ~~$511.7 million,~~$1.01 billion, or ~~15.1%~~29.6%, to ~~$3.90~~$4.40 billion at ~~March 31,~~September 30, 2018 from $3.39 billion at December 31, 2017 due primarily to the deposits acquired in the Premier and Puget ~~Sound Merger~~Mergers of ~~$505.9~~$824.6 million at the respective merger ~~date.~~dates. Non-maturity deposits as a percentage of total deposits increased to ~~89.2%~~88.5% at ~~March 31,~~September 30, 2018 from 88.3% at December 31, 2017 and the percentage of certificates of deposit to total deposits decreased to 11.5% at September 30, 2018 from 11.7% at December 31, 2017 primarily as a result of the mix of deposits acquired from the Premier and Puget ~~Sound Merger, which had non-maturity deposits as a percentage of total deposits of 93.6% at merger date. Based on the change in the mix and~~

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~~volume of deposits, the percentage of certificates of deposit to total deposits decreased to 10.8% at March 31, 2018 from 11.7% at December 31, 2017.~~Mergers.

The following table summarizes the Company's deposits as of ~~March 31,~~September 30, 2018 and December 31, 2017:


	March 31, 2018				December 31, 2017								September 30, 2018				December 31, 2017
	Balance		% of Total		Balance		% of Total		Change		% Change		Balance		% of Total		Balance		% of Total		Change		%of Balance Change
	(Dollars in thousands)												(Dollars in thousands)
Noninterest demand deposits	$	1,178,202	30.2	%	$	944,791	27.8	%	$	233,411	24.7	%	$	1,311,825	29.8	%	$	944,791	27.8	%	$	367,034	38.8	%
Interest bearing demand deposits	1,099,855		28.2		1,051,752		31.1		48,103		4.6		1,294,105		29.4		1,051,752		31.1		242,353		23.0
Money market accounts	692,931		17.7		499,618		14.7		193,313		38.7		768,998		17.5		499,618		14.7		269,380		53.9
Savings accounts	511,377		13.1		498,501		14.7		12,876		2.6		519,596		11.8		498,501		14.7		21,095		4.2
Total non-maturity deposits	3,482,365		89.2		2,994,662		88.3		487,703		16.3		3,894,524		88.5		2,994,662		88.3		899,862		30.0
Certificate of deposit accounts	422,376		10.8		398,398		11.7		23,978		6.0		503,603		11.5		398,398		11.7		105,205		26.4
Total deposits	$	3,904,741	100.0	%	$	3,393,060	100.0	%	$	511,681	15.1		$	4,398,127	100.0	%	$	3,393,060	100.0	%	$	1,005,067	29.6

Borrowings may be used on a short-term basis to compensate for reductions in other sources of funds (such as deposit inflows at less than projected levels). Borrowings may also be used on a longer-term basis to support expanded lending activities and match the maturity of repricing intervals of assets. The Bank is utilizing securities sold under agreement to repurchase as a supplement to its funding sources. Our repurchase agreements are secured by available for sale investment securities. At ~~March 31,~~September 30, 2018, the Bank had securities sold under agreement to repurchase of ~~$26.1~~$32.2 million, ~~a decrease~~an increase of ~~$5.7 million,~~$412,000, or ~~18.0%~~1.3%, from $31.8 million at December 31, 2017. The ~~decrease~~increase was the result of customer activity during the ~~period.~~period and to a lesser extent securities sold under agreement to repurchase acquired in the Premier Merger.

The Company also has junior subordinated debentures with a par value of $25.0 million which pay quarterly interest based on three-month LIBOR plus 1.56%. The debentures mature in 2037. The balance of the junior subordinated debentures was ~~$20.1~~$20.2 million at ~~March 31,~~September 30, 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 ~~March 31,~~September 30, 2018, the Bank maintained credit facilities with the FHLB of Des Moines for ~~$913.0~~$826.8 million and credit facilities with the Federal Reserve Bank for ~~$81.4~~$45.2 million. The Company had no FHLB advances outstanding ~~of $30.7 million~~at September 30, 2018 and $92.5 million at ~~March 31, 2018 and~~ December 31, ~~2017, respectively.~~2017. The average cost of the FHLB advances during the ~~three~~nine months ended ~~March 31,~~September 30, 2018 and 2017 was ~~1.70%~~1.98% and ~~0.81%~~1.09%, respectively. The Bank also maintains lines of credit with four correspondent banks to purchase federal funds totaling $90.0 million as of ~~March 31,~~September 30, 2018. There were no federal funds purchased as of ~~March 31,~~September 30, 2018 or December 31, 2017.

Liquidity and Cash Flows

Our primary sources of funds are customer and local government deposits, loan principal and interest payments, loan sales and interest earned on and proceeds from sales and maturities of investment securities. These funds, together with retained earnings, equity and other borrowed funds, are used to make loans, acquire investment securities and other assets, and fund continuing operations. While maturities and scheduled amortization of loans are a predictable source of funds, deposit flows and loan prepayments are greatly influenced by the level of interest rates, economic conditions and competition.

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

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Heritage Financial Corporation: The Company is a separate legal entity from the Bank and must provide for its own liquidity. Substantially all of the Company’s revenues are obtained from dividends declared and paid by the Bank. There are statutory and regulatory provisions that could limit the ability of the Bank to pay dividends to the Company. However, management believes that such restrictions will not have an adverse impact on the ability of the Company to meets its ongoing cash obligations. At ~~March 31,~~September 30, 2018, the Company (on an unconsolidated basis) had cash and cash equivalents of ~~$11.7~~$14.5 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,~~September 30, 2018, cash and cash equivalents totaled ~~$130.3~~$170.1 million, or ~~2.8%~~3.2% of total assets. The fair value of investment securities available for sale totaled ~~$821.6~~$920.7 million at ~~March 31,~~September 30, 2018, of which ~~$262.6~~$255.2 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~~$665.5 million, or ~~12.0%~~12.6%, of total assets at ~~March 31,~~September 30, 2018. The fair value of investment securities available for sale with maturities of one year or less were ~~$8.2~~$20.7 million, or ~~0.2%~~0.4%, of total assets at ~~March 31,~~September 30, 2018.

Consolidated Cash Flows: As disclosed in the Condensed Consolidated Statements of Cash Flows, net cash provided by operating activities was ~~$9.1~~$55.4 million for the ~~three~~nine months ended ~~March 31,~~September 30, 2018, and primarily consisted of net income of ~~$9.1~~$36.4 million. During the ~~three~~nine months ended ~~March 31,~~September 30, 2018, net cash ~~provided by~~used in investing activities was ~~$86.4~~$42.8 million, which consisted primarily of net ~~proceeds from purchase and sale~~loan originations of $93.0 million, net purchases of investment securities ~~available~~ for sale of ~~$58.1~~$40.9 million, and purchases of premises and equipment of $21.5 million, offset partially by net cash received from acquisitions of ~~$80.1 million, offset partially by net loan originations of $47.0~~$106.0 million. Net cash ~~used in~~provided by financing activities was ~~$68.3~~$54.5 million for the ~~three~~nine months ended ~~March 31,~~September 30, 2018, and primarily consisted of net ~~FHLB repayments of $61.8 million, offset partially by net~~ increase in deposits of ~~$5.8~~$180.5 million during the ~~period.~~period, partially offset by net FHLB repayments of $108.5 million and dividends paid of $15.8 million

Capital and Capital Requirements

Stockholders’ equity at ~~March 31,~~September 30, 2018 was ~~$634.7~~$746.1 million compared to $508.3 million at December 31, 2017. The changes to stockholders' equity during the ~~three~~nine months ended ~~March 31,~~September 30, 2018 is as follows:


				Nine Months Ended
	Three Months Ended			September 30, 2018
	March 31, 2018			(In Thousands)
Balance, beginning of period	$	508,305		$	508,305
Common stock issued in the Puget Sound Merger	130,770
Common stock issued in the Premier and Puget Mergers				230,043
Net income	9,087			36,448
Dividends paid	(5,117		)
Dividends declared				(15,796		)
Accumulated other comprehensive loss	(7,543		)	(13,299		)
Other	(794		)	432
Balance, end of period	$	634,708		$	746,133

The Company has historically paid cash dividends to its common shareholders. Payments of future cash dividends, 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 ability to pay dividends and other relevant factors. Dividends on common stock from the Company depend substantially upon receipt of dividends from the Bank, which is the Company’s predominant source of income. On ~~April 25,~~October 24, 2018, the Company’s Board of Directors declared a regular dividend of ~~$0.15~~$0.17 per common share and a special dividend in the amount of $0.10 per common share which are both payable on ~~May 24,~~November 21, 2018 to shareholders of record on ~~May 10,~~November 7, 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,~~September 30, 2018, the Company and the Bank meet all capital adequacy requirements to which they are subject.

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As of ~~March 31,~~September 30, 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.

~~Table of Contents~~


	Minimum Requirements				Well-Capitalized Requirements				Actual				Minimum Requirements				Well-Capitalized Requirements				Actual
	(Dollars in thousands)												(Dollars in thousands)
As of March 31, 2018:
As of September 30, 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	%	$	198,182	4.5	%	N/A		N/A		$	501,520	11.4	%
Tier 1 leverage capital to average assets	178,471		4.0		N/A		N/A		462,900		10.4		200,197		4.0		N/A		N/A		521,749		10.4
Tier 1 capital to risk-weighted assets	234,878		6.0		N/A		N/A		462,900		11.8		264,243		6.0		N/A		N/A		521,749		11.8
Total capital to risk-weighted assets	313,170		8.0		N/A		N/A		496,557		12.7		352,324		8.0		N/A		N/A		556,530		12.6
Heritage Bank
Common equity Tier 1 capital to risk-weighted assets	175,986		4.5		$	254,203	6.5	%	446,596		11.4		197,997		4.5		$	285,996	6.5	%	504,538		11.5
Tier 1 leverage capital to average assets	178,346		4.0		222,933		5.0		446,596		10.0		201,185		4.0		251,481		5.0		504,538		10.0
Tier 1 capital to risk-weighted assets	234,649		6.0		312,865		8.0		446,596		11.4		263,996		6.0		351,995		8.0		504,538		11.5
Total capital to risk-weighted assets	312,865		8.0		391,081		10.0		480,136		12.3		351,995		8.0		439,993		10.0		539,319		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	%	$	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		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		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		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		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		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		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		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. Certain calculations under the rules will

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also have phase-in periods. At ~~March 31,~~September 30, 2018, the capital conservation buffer was ~~4.69%~~4.64% and ~~4.28%~~4.26% for the Company and the Bank, respectively.

~~Table of Contents~~

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to interest rate risk through our lending and deposit gathering activities. Our results of operations are highly dependent upon our ability to manage interest rate risk. We consider interest rate risk to be a significant market risk that could have a material effect on our financial condition and results of operations. Interest rate risk is measured and assessed on a quarterly basis. In our opinion, there has not been a material change in our interest rate risk exposure since the information disclosed in our Annual Report on Form 10-K for the year ended December 31, 2017.

Neither we, nor the Bank, maintain a trading account for any class of financial instrument, nor do we, or the Bank, engage in hedging activities or purchase high risk derivative instruments. Moreover, neither we, nor the Bank, are subject to foreign currency exchange rate risk or commodity price risk.

ITEM 4. CONTROLS AND PROCEDURES

(a) Evaluation of Disclosure Controls and Procedures

An evaluation of the Company’s disclosure controls and procedure (as defined in Section 13a-15(e) or 15d-15(e) of the Securities Exchange Act of 1934 (the “Act”)) was carried out under the supervision and with the participation of the Company’s Chief Executive Officer, Chief Financial Officer and the Company’s Disclosure Committee as of the end of the period covered by this quarterly report. In designing and evaluating the Company’s disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure controls and procedures, management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Based on their evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures as of ~~March 31,~~September 30, 2018 are effective in ensuring that the information required to be disclosed by the Company in the reports it files or submits under the Act is (i) accumulated and communicated to the Company’s management (including the Chief Executive Officer and Chief Financial Officer) in a timely manner, and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

(b) Changes in Internal Control Over Financial Reporting

There have been no changes in the Company’s internal control over financial reporting (as defined in Rule 13a-15(f) of the Act) that occurred during the quarter ended ~~March 31,~~September 30, 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

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

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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, 2017.

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

(a) Not applicable.

(b) Not applicable.

Since the inception of the eleventh plan, the Company has repurchased 579,996 shares at an average share prices of $16.67. No shares were repurchased under this plan during the ~~three~~nine months ended ~~March 31,~~September 30, 2018 and 2017.


	Three Months Ended March 31,				Three Months Ended September 30,				Nine Months Ended September 30,
	2018		2017		2018		2017		2018		2017
Repurchased shares to pay withholding taxes ⁽¹⁾	45,426		15,891		368		344		53,188		27,711
Stock repurchase to pay withholding taxes average share price	$	31.66	$	23.95	$	36.34	$	25.80	$	31.99	$	24.61

⁽¹⁾During the ~~three~~nine months ended ~~March 31,~~September 30, 2018, 26,741 of the shares repurchased 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.~~merger agreement.

The following table sets forth information about the Company’s purchases of its outstanding common stock during the quarter ended ~~March 31,~~September 30, 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 ⁽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



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
July 1, 2018— July 31, 2018	—	$	—	7,893,389	935,034
August 1, 2018— August 31, 2018	—	—		7,893,389	935,034
September 1, 2018— September 30, 2018	368	36.64		7,893,389	935,034
Total	368	$	36.64

⁽¹⁾ All of the common shares repurchased by the Company between ~~January~~July 1, 2018 and ~~March 31,~~September 30, 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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None

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 Bancorp, Inc

8-K

2.1

7/27/2017

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

Agreement and Plan of Merger with Premier Commercial Bancorp, Inc

8-K

2.1

3/9/2018

31.1

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

31.2

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

32.1

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

101.INS

XBRL Instance Document ⁽¹⁾

101.SCH

XBRL Taxonomy Extension Schema Document ⁽¹⁾

101.CAL

XBRL Taxonomy Extension Calculation Linkbase Document ⁽¹⁾

101.DEF

XBRL Taxonomy Extension Definition Linkbase Document ⁽¹⁾

101.LAB

XBRL Taxonomy Extension Label Linkbase Document ⁽¹⁾

101.PRE

XBRL Taxonomy Extension Presentation Linkbase Document ⁽¹⁾

⁽¹⁾ 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:
~~May 10,~~November 6, 2018		/S/ BRIAN L. VANCE
		Brian L. Vance
		~~President and~~ Chief Executive Officer

Date:
~~May 10,~~November 6, 2018		/S/ DONALD J. HINSON
		Donald J. Hinson
		Executive Vice President and Chief Financial Officer

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