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 ~~June 30, 2018~~March 31, 2019 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 ~~July 31, 2018~~May 1, 2019 there were ~~36,868,578~~36,899,138 shares of the registrant's common stock, no par value per share, outstanding.

Securities registered pursuant to Section 12(b) of the Act:



Title of each class	Trading symbol(s)	Name of each exchange on which registered
Common stock, no par value	HFWA	NASDAQ

Table of Contents

HERITAGE FINANCIAL CORPORATION

FORM 10-Q

~~June 30, 2018~~March 31, 2019

TABLE OF CONTENTS



				Page
FORWARD LOOKING STATEMENTS

PART I.	FINANCIAL INFORMATION			4
ITEM 1.	FINANCIAL STATEMENTS			4
		CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (UNAUDITED) AS OF ~~JUNE 30, 2018~~MARCH 31, 2019 AND DECEMBER 31, ~~2017~~2018		4
		CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) FOR THE THREE ~~AND SIX~~ MONTHS ENDED ~~JUNE 30,~~MARCH 31, 2019 AND 2018 ~~AND 2017~~		5
		CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED) FOR THE THREE ~~AND SIX~~ MONTHS ENDED ~~JUNE 30,~~MARCH 31, 2019, AND 2018 ~~AND 2017~~		6
		CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (UNAUDITED) FOR THE ~~SIX~~THREE MONTHS ENDED ~~JUNE 30,~~MARCH 31, 2019 AND 2018 ~~AND 2017~~		7
		CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) FOR THE ~~SIX~~THREE MONTHS ENDED ~~JUNE 30,~~MARCH 31, 2019 AND 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	1411
		NOTE 3.	INVESTMENT SECURITIES	1612
		NOTE 4.	LOANS RECEIVABLE	1914
		NOTE 5.	ALLOWANCE FOR LOAN LOSSES	3124
		NOTE 6.	OTHER REAL ESTATE OWNED	3528
		NOTE 7.	GOODWILL AND OTHER INTANGIBLE ASSETS	3528
		NOTE 8.	JUNIOR SUBORDINATED DEBENTURES	3629
		NOTE 9.	REPURCHASE AGREEMENTS	3729
		NOTE 10.	OTHER BORROWINGS	3729
		NOTE 11.	DERIVATIVE FINANCIAL INSTRUMENTS	3830
		NOTE 12.	STOCKHOLDERS’ EQUITY	3831
		NOTE 13.	ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) ~~INCOME~~	4032
		NOTE 14.	FAIR VALUE MEASUREMENTS	4032
		NOTE 15.	~~STOCK-BASED COMPENSATION~~CASH REQUIREMENT	4538
		NOTE 16.	~~CASH REQUIREMENT~~LEASES	47
		~~NOTE 17.~~	~~SUBSEQUENT EVENT~~	4838
ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS			4840
ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK			7258
ITEM 4.	CONTROLS AND PROCEDURES			7258
Part II.	OTHER INFORMATION			7258
ITEM 1.	LEGAL PROCEEDINGS			7258
ITEM 1A.	RISK FACTORS			7259
ITEM 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS			7359
ITEM 3.	DEFAULTS UPON SENIOR SECURITIES			7359
ITEM 4.	MINE SAFETY DISCLOSURES			7359
ITEM 5.	OTHER INFORMATION			7360
ITEM 6.	EXHIBITS			7460
	SIGNATURES			7460

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 mergers with Puget Sound Bancorp, Inc., and Premier Commercial Bancorp, 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 toto: customer and employee retention, which might be greater than expected; the credit risks of lending activities, including changes in the level and trend of loan delinquencies and write-offs and changes in our allowance for loan losses and provision for loan losses that may be 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.~~2018.

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)


	June 30, 2018			December 31, 2017			March 31, 2019			December 31, 2018
ASSETS
Cash on hand and in banks	$	94,210		$	78,293		$	71,252		$	92,704
Interest earning deposits	35,733			24,722			39,918			69,206
Cash and cash equivalents	129,943			103,015			111,170			161,910
Investment securities available for sale, at fair value	873,670			810,530			985,009			976,095
Loans held for sale	3,598			2,288			2,956			1,555
Loans receivable, net	3,328,288			2,849,071			3,696,431			3,654,160
Allowance for loan losses	(33,972		)	(32,086		)	(36,152		)	(35,042		)
Total loans receivable, net	3,294,316			2,816,985			3,660,279			3,619,118
Other real estate owned	434			—			1,904			1,983
Premises and equipment, net	75,364			60,325			80,130			81,100
Federal Home Loan Bank stock, at cost	8,616			8,347			7,377			6,076
Bank owned life insurance	82,031			75,091			94,099			93,612
Accrued interest receivable	13,482			12,244			15,621			15,403
Prepaid expenses and other assets	104,718			99,328			123,026			98,522
Other intangible assets, net	15,767			6,088			19,589			20,614
Goodwill	187,549			119,029			240,939			240,939
Total assets	$	4,789,488		$	4,113,270		$	5,342,099		$	5,316,927
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits	$	3,968,935		$	3,393,060		$	4,393,715		$	4,432,402
Federal Home Loan Bank advances	75,500			92,500			25,000			—
Junior subordinated debentures	20,156			20,009			20,375			20,302
Securities sold under agreement to repurchase	22,168			31,821			24,923			31,487
Accrued expenses and other liabilities	63,206			67,575			99,895			72,013
Total liabilities	4,149,965			3,604,965			4,563,908			4,556,204
Stockholders’ equity:
Preferred stock, no par value, 2,500,000 shares authorized; no shares issued and outstanding at June 30, 2018 and December 31, 2017	—			—
Common stock, no par value, 50,000,000 shares authorized; 34,021,094 and 29,927,746 shares issued and outstanding at June 30, 2018 and December 31, 2017, respectively	491,026			360,590
Preferred stock, no par value, 2,500,000 shares authorized; no shares issued and outstanding at March 31, 2019 and December 31, 2018							—			—
Common stock, no par value, 50,000,000 shares authorized; 36,899,138 and 36,874,055 shares issued and outstanding at March 31, 2019 and December 31, 2018, respectively							591,767			591,806
Retained earnings	159,803			149,013			185,863			176,372
Accumulated other comprehensive loss, net	(11,306		)	(1,298		)
Accumulated other comprehensive income (loss), net							561			(7,455		)
Total stockholders’ equity	639,523			508,305			778,191			760,723
Total liabilities and stockholders’ equity	$	4,789,488		$	4,113,270		$	5,342,099		$	5,316,927

See accompanying Notes to Condensed Consolidated Financial Statements.

Table of Contents

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

(In thousands, except per share amounts)


	Three Months Ended June 30,				Six Months Ended June 30,				Three Months Ended March 31,
	2018		2017		2018		2017		2019		2018
INTEREST INCOME
Interest and fees on loans	$	41,141	$	31,500	$	79,300	$	61,985	$	46,699	$	38,159
Taxable interest on investment securities	4,068		3,141		7,597		6,190		5,823		3,529
Nontaxable interest on investment securities	1,220		1,304		2,561		2,572		950		1,341
Interest on other interest earning assets	242		96		460		143		356		218
Total interest income	46,671		36,041		89,918		70,890		53,828		43,247
INTEREST EXPENSE
Deposits	2,195		1,407		4,155		2,673		3,603		1,960
Junior subordinated debentures	315		249		598		487		354		283
Other borrowings	418		251		585		464		62		167
Total interest expense	2,928		1,907		5,338		3,624		4,019		2,410
Net interest income	43,743		34,134		84,580		67,266		49,809		40,837
Provision for loan losses	1,750		1,131		2,902		1,998		920		1,152
Net interest income after provision for loan losses	41,993		33,003		81,678		65,268		48,889		39,685
NONINTEREST INCOME
Service charges and other fees	4,695		4,426		9,238		8,639		4,485		4,543
Gain on sale of investment securities, net	18		117		53		117		15		35
Gain on sale of loans, net	706		4,138		1,580		5,333		252		874
Interest rate swap fees	309		282		360		415		—		51
Other income	1,845		1,746		3,890		3,568		2,656		2,045
Total noninterest income	7,573		10,709		15,121		18,072		7,408		7,548
NONINTEREST EXPENSE
Compensation and employee benefits	19,321		16,272		40,688		32,296		21,914		21,367
Occupancy and equipment	4,810		3,818		9,437		7,628		5,458		4,627
Data processing	2,507		2,002		5,112		3,917		2,173		2,605
Marketing	823		805		1,631		1,612		1,098		808
Professional services	3,529		1,053		6,366		2,062		1,173		2,837
State and local taxes	716		639		1,404		1,188
State/municipal business and use taxes									798		688
Federal deposit insurance premium	375		357		730		657		285		355
Other real estate owned, net	—		21		—		52		86		—
Amortization of intangible assets	796		323		1,591		647		1,025		795
Other expense	2,829		2,519		5,494		4,973		2,515		2,665
Total noninterest expense	35,706		27,809		72,453		55,032		36,525		36,747
Income before income taxes	13,860		15,903		24,346		28,308		19,772		10,486
Income tax expense	2,003		4,075		3,402		7,164		3,220		1,399
Net income	$	11,857	$	11,828	$	20,944	$	21,144	$	16,552	$	9,087
Basic earnings per common share	$	0.35	$	0.40	$	0.62	$	0.71	$	0.45	$	0.27
Diluted earnings per common share	$	0.35	$	0.40	$	0.62	$	0.71	$	0.45	$	0.27
Dividends declared per common share	$	0.15	$	0.13	$	0.30	$	0.25	$	0.18	$	0.15

See accompanying Notes to Condensed Consolidated Financial Statements.

Table of Contents

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)

(In thousands)

Three Months Ended June 30, Six Months Ended June 30,
2018 2017 2018 2017
Net income $ 11,857
$ 11,828
$ 20,944
$ 21,144
Change in fair value of investment securities available for sale, net of tax of $(630), $1,491, $(2,638) and $2,285, respectively (2,358 ) 2,766
(9,874 ) 4,239
Reclassification adjustment for net gain from sale of investment securities available for sale included in income, net of tax of $(4), $(41), $(12) and $(41), respectively (14 ) (76 ) (41 ) (76 )
Other comprehensive (loss) income (2,372 ) 2,690
(9,915 ) 4,163
Comprehensive income $ 9,485
$ 14,518
$ 11,029
$ 25,307



	Three Months Ended March 31,
	2019			2018
Net income	$	16,552		$	9,087
Change in fair value of investment securities available for sale, net of tax of $2,145 and $(2,008), respectively	8,028			(7,516		)
Reclassification adjustment for net gain from sale of investment securities available for sale included in income, net of tax of $(3) and $(8), respectively	(12		)	(27		)
Other comprehensive income (loss)	8,016			(7,543		)
Comprehensive income	$	24,568		$	1,544

See accompanying Notes to Condensed Consolidated Financial Statements.

Table of Contents

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
Balance at December 31, 2016	29,955		$	359,060		$	125,309		$	(2,606	)	$	481,763
Restricted stock awards forfeited	(7	)	—			—			—			—
Exercise of stock options	8		109			—			—			109
Stock-based compensation expense	—		1,040			—			—			1,040
Common stock repurchased	(28	)	(674		)	—			—			(674		)
Net income	—		—			21,144			—			21,144
Other comprehensive income, net of tax	—		—			—			4,163			4,163
Cash dividends declared on common stock ($0.25 per share)	—		—			(7,497		)	—			(7,497		)
Balance at June 30, 2017	29,928		$	359,535		$	138,956		$	1,557		$	500,048
															Number of common shares		Common stock			Retained earnings			Accumulated other comprehensive income (loss), net			Total stock- holders’ equity
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, net of forfeitures of restricted stock awards	30		—			—			—			—			22		—			—			—			—
Exercise of stock options	3		47			—			—			47			1		21			—			—			21
Stock-based compensation expense	—		1,307			—			—			1,307			—		623			—			—			623
Common stock repurchased	(52	)	(1,688		)	—			—			(1,688		)	(45	)	(1,438		)	—			—			(1,438		)
Net income	—		—			20,944			—			20,944			—		—			9,087			—			9,087
Other comprehensive loss, net of tax	—		—			—			(9,915		)	(9,915		)	—		—			—			(7,543		)	(7,543		)
Common stock issued in business combination	4,112		130,770			—			—			130,770			4,112		130,770			—			—			130,770
Cash dividends declared on common stock ($0.30 per share)	—		—			(10,247		)	—			(10,247		)
ASU 2016-01 implementation	—		—			93			(93		)	—
Balance at June 30, 2018	34,021		$	491,026		$	159,803		$	(11,306	)	$	639,523
Cash dividends declared on common stock ($0.15 per share)															—		—			(5,117		)	—			(5,117		)
Effects of implementation of accounting change related to equity investments, net															—		—			93			(93		)	—
Balance at March 31, 2018															34,018		$	490,566		$	153,076		$	(8,934	)	$	634,708

Balance at December 31, 2018															36,874		$	591,806		$	176,372		$	(7,455	)	$	760,723
Restricted stock units vested, net of forfeitures of restricted stock awards															49		—			—			—			—
Exercise of stock options															2		22			—			—			22
Stock-based compensation expense															—		741			—			—			741
Common stock repurchased															(26	)	(802		)	—			—			(802		)
Net income															—		—			16,552			—			16,552
Other comprehensive income, net of tax															—		—			—			8,016			8,016
Cash dividends declared on common stock ($0.18 per share)															—		—			(6,662		)	—			(6,662		)
Effects of implementation of accounting change related to operating leases															—		—			(399		)	—			(399		)
Balance at March 31, 2019															36,899		$	591,767		$	185,863		$	561		$	778,191

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)


	Six Months Ended June 30,						Three Months Ended March 31,
	2018			2017			2019			2018
Cash flows from operating activities:
Net income	$	20,944		$	21,144		$	16,552		$	9,087
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	5,140			5,459
Depreciation of premises and equipment, amortization of securities available for sale, and amortization of discount of junior subordinated debentures							2,234			2,631
Changes in net deferred loan costs, net of amortization	(254		)	(509		)	276			9
Provision for loan losses	2,902			1,998			920			1,152
Net change in accrued interest receivable, prepaid expenses and other assets, accrued expenses and other liabilities	419			3,482
Net change in accrued interest receivable, prepaid expenses and other assets, and accrued expenses and other liabilities							1,345			(4,191		)
Stock-based compensation expense	1,307			1,040			741			623
Amortization of intangible assets	1,591			647			1,025			795
Origination of loans held for sale	(40,048		)	(54,449		)	(8,607		)	(20,380		)
Proceeds from sale of loans	39,962			71,436			7,458			20,651
Earnings on bank owned life insurance	(666		)	(747		)	(487		)	(335		)
Gain on sale of loans, net	(1,580		)	(5,333		)	(252		)	(874		)
Gain on sale of investment securities, net	(53		)	(117		)	(15		)	(35		)
Gain on sale of assets held for sale	—			(53		)
Impairment of assets held for sale	75			—
Loss on sale or write-off of furniture, equipment and leasehold improvements	—			12
Impairment of right of use asset							117			—
Loss on sale or write-off of premises and equipment, net							5			6
Net cash provided by operating activities	29,739			44,010			21,312			9,139
Cash flows from investing activities:
Loans originated, net of principal payments	(96,127		)	(135,709		)	(42,357		)	(46,959		)
Maturities, calls and payments of investment securities available for sale	41,436			52,461			47,004			24,443
Purchase of investment securities available for sale	(147,360		)	(57,972		)	(57,606		)	(69,352		)
Purchase of premises and equipment	(16,659		)	(1,382		)	(1,030		)	(2,146		)
Proceeds from sales of other loans	4,532			21,319			—			2,813
Proceeds from sales of other real estate owned							79			—
Proceeds from sales of investment securities available for sale	107,579			15,032			10,932			103,032
Proceeds from sale of assets held for sale	—			265
Proceeds from redemption of Federal Home Loan Bank stock	22,138			16,456			2,276			10,130
Purchases of Federal Home Loan Bank stock	(21,784		)	(17,975		)	(3,577		)	(7,984		)
Proceeds from sale of premises and equipment	21			—
Capital contribution to low-income housing tax credit partnership	(8,169		)	(7		)
Capital contributions to low-income housing tax credit partnerships and new market tax credit partnerships, net							(80		)	(7,696		)
Net cash received from acquisitions	80,133			—			—			80,133
Net cash used in investing activities	(34,260		)	(107,512		)
Net cash (used in) provided by investing activities							(44,359		)	86,414
Cash flows from financing activities:
Net increase in deposits	69,990			61,602
Net (decrease) increase in deposits							(38,687		)	5,796
Federal Home Loan Bank advances	536,450			442,700			76,900			191,450
Repayments of Federal Home Loan Bank advances	(553,450		)	(411,400		)	(51,900		)	(253,250		)
Common stock cash dividends paid	(10,247		)	(7,497		)	(6,662		)	(5,117		)
Net decrease in securities sold under agreement to repurchase	(9,653		)	(849		)	(6,564		)	(5,721		)
Proceeds from exercise of stock options	47			109			22			21
Repurchase of common stock	(1,688		)	(674		)	(802		)	(1,438		)
Net cash provided by financing activities	31,449			83,991
Net cash used in financing activities							(27,693		)	(68,259		)

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	Six Months Ended June 30,					Three Months Ended March 31,
	2018			2017		2019			2018
Net increase in cash and cash equivalents	26,928			20,489
Net (decrease) increase in cash and cash equivalents						(50,740		)	27,294
Cash and cash equivalents at beginning of period	103,015			103,745		161,910			103,015
Cash and cash equivalents at end of period	$	129,943		$	124,234	$	111,170		$	130,309

Supplemental disclosures of cash flow information:
Cash paid for interest	$	5,302		$	3,688	$	3,801		$	2,398
Cash paid for income taxes	2,724			1,007		—			—

Supplemental non-cash disclosures of cash flow information:
Transfers of loans receivable to other real estate owned	$	434		$	32
Transfers of loans receivable to loans held for sale	—			5,779
Transfers of properties held for sale recorded in premises and equipment, net to prepaid expenses and other assets	221			2,687		763			—
Purchases of investment securities available for sale not settled	—			2,268
Business Combination:
Business Combinations:
Common stock issued for business combinations	130,770			—		—			130,770
Assets acquired (liabilities assumed) in acquisitions:
Investment securities available for sale	80,353			—		—			80,353
Loans receivable	388,462			—		—			388,462
Premises and equipment	732			—		—			732
Federal Home Loan Bank stock	623			—		—			623
Accrued interest receivable	1,448			—		—			1,448
Bank owned life insurance	6,264			—		—			6,264
Prepaid expenses and other assets	1,354			—		—			1,354
Other intangible assets	11,270			—		—			11,270
Deposits	(505,885		)	—		—			(505,885		)
Accrued expenses and other liabilities	(2,504		)	—		—			(2,504		)

See accompanying Notes to Condensed Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)


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

(a) Description of Business

Heritage Financial Corporation ("Heritage" or the “Company”) is a bank holding company that was incorporated in the State of Washington in August 1997. The Company is primarily engaged in the business of planning, directing and coordinating the business activities of its wholly-owned subsidiary, Heritage Bank (the “Bank”). The Bank is a Washington-chartered commercial bank and its deposits are insured by the Federal Deposit Insurance Corporation ("FDIC"). The Bank is headquartered in Olympia, Washington and conducts business from its 5963 branch offices as of ~~June 30, 2018~~March 31, 2019 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”)~~. See Note (2) Business Combination for additional information~~ and on ~~the merger.~~

~~On March 8,~~July 2, 2018, the Company ~~entered into a definitive agreement to acquire~~completed the acquisition of Premier Commercial Bancorp ("Premier Commercial") ~~and its wholly-owned bank subsidiary,~~, the holding company for Premier Community Bank, both of Hillsboro, Oregon ~~(the "Premier~~("Premier Merger"). ~~The Premier Merger was completed on July 2, 2018.~~ See Note ~~(17) Subsequent Event~~(2) Business Combinations for additional information on the ~~merger.~~Puget Sound Merger and the Premier Merger (collectively the "Premier and Puget Mergers").

(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~~2018 (“~~2017~~2018 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 six~~ months ended ~~June 30, 2018~~March 31, 2019 are not necessarily indicative of the results that may be expected for the year ending December 31, ~~2018.~~2019. 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.

The significant accounting policies used in preparation of the Company's Condensed Consolidated Financial Statements are disclosed in the ~~2017~~2018 Annual Form 10-K. There have not been any material changes in the Company's significant accounting policies from those contained in the ~~2017~~2018 Annual Form 10-K, except for the accounting policy relating to ~~revenue from contracts with customers~~operating leases adopted January 1, ~~2018,~~2019, as discussed below.

~~Revenue from Contracts with Customers~~Operating leases

~~Accounting Standards Codification Topic 606,~~ ~~Revenue from Contracts with Customers,~~ ~~(“ASC 606”),~~The Company enters into noncancelable operating lease agreements, related to certain banking offices, back-office operational facilities, office equipment, and sublease agreements. The agreements are recorded as ~~amended, was adopted by the Company on January 1, 2018. ASC 606 applies to all contracts with customers to provide goods or services~~right of use assets and liabilities within prepaid expenses and other assets and accrued expenses and other liabilities, respectively, 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~~Statements of ~~Income, are~~Financial Condition. The Company elected an exclusion policy for right of use assets and liabilities for operating leases with a term of twelve months or less and a capitalization threshold policy for total contractual lease payments of $25,000 or more. The Company does not account for any leases at a portfolio level. The balance of right of use assets and liabilities was $28.4 million and $29.5 million, respectively, as ~~follows:~~of March 31, 2019.

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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: 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 Company adopted the revenue recognition guidance, as amended, on 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 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 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 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, ASU 2018-11, and ASU 2019-01 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~~adopted the Update on January 1, ~~2019. Upon adoption of the guidance, the Company expects to report increased assets~~2019 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 electingelected an exclusion accounting policy for lease assets and lease liabilities for leases with a term of twelve months or ~~less.~~less and the package of practical expedients permitted under the transition guidance within the new standard, which allowed us to carry forward the historical determination of contracts as leases, lease classification and not reassess initial direct costs for historical lease arrangements. The Company ~~was committed~~applied a capitalization threshold policy of total contractual lease payments of $25,000 or more for recognition under the Update. The adoption of this ASU resulted in the recognition of operating lease right of use assets and liabilities of approximately $29.2 million and $29.8 million, respectively, in prepaid expenses and other assets and accrued expenses and other liabilities in the Condensed Consolidated Statements of Financial Condition related to ~~$13.7 million of minimum lease payments~~certain banking offices, back-office operational facilities, office equipment and sublease agreements under noncancelable operating lease ~~agreements at June 30, 2018. The Company does~~agreements. This change also resulted in a $399,000 net of tax cumulative-effect adjustment to beginning retained earnings under the modified retrospective approach. As a result of electing this transition method, prior periods have not ~~expect the adoption of this Update will have a significant impact to its Condensed Consolidated Financial Statements.~~been restated.

FASB ASU 2016-13, Financial Instruments: Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, as amended by ASU 2018-19, 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 magnitude of the increase and its impact on the Condensed Consolidated Financial Statements. In addition, the current

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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~~to develop and ~~implementing~~implement processes and procedures to ensure it is fully compliant with the amendments at the adoption date. ~~To date,~~During 2018, the CECL steering committee ~~has~~ selected a vendor to assist the Company in the adoption, ~~and has~~ completed the implementation discovery ~~sessions. The~~sessions, and selected appropriate methodologies. During 2019, the CECL steering committee is compiling necessary historical loan data and is in the process of ~~selecting appropriate methodologies and refining key data points in an effort to complete a mock CECL model by fourth quarter 2018.~~

~~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.reviewing qualitative factors. 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 policiesanticipates running parallel existing ALLL and cash 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.CECL models using second quarter 2019 data.

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 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~~2018-13, ~~Receivables—Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities~~Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement, was issued in ~~March 2017~~August 2018 and ~~changes~~modifies 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.disclosure requirements on fair value measurements in Topic 820. The ~~discount would continue to amortize to the maturity date. The~~amendments in this Update isare effective for ~~reporting~~all entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, ~~2018, with early adoption permitted.~~2019. The Company ~~adopted this~~does not expect the Update ~~in January 2018. The adoption did not~~will have a material impact on its Condensed Consolidated Financial ~~Statements as the Company had been accounting for premiums as prescribed under this guidance.~~Statements.

~~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 no share-based payment award was modified during the six months ended June 30, 2018. The 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 and Jobs Act, and allows for entities to report provisional amounts for specific income tax effects of the Tax Cuts and

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


(2)	Business ~~Combination~~Combinations

~~On July 26, 2017,~~There were no acquisitions or mergers completed during the three months ended March 31, 2019. During the three months ended March 31, 2018, the Company ~~along with~~completed the ~~Bank, and~~acquisition of Puget Sound ~~Bancorp, Inc.~~Bancorp. The Premier Merger was completed during the three months ended September 30, 2018 and ~~its wholly owned subsidiary bank,~~ is included below for comparability of results for the quarter ended March 31, 2019 compared to March 31, 2018. The Company finalized the purchase price allocation for both mergers as of December 31, 2018.

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Puget Sound ~~Bank, jointly announced the signing of a definitive agreement.~~ Merger:

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. The primary reason for the transaction 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 of the definitive agreement, all outstanding Puget Sound restricted stock awards became immediately vested prior to 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.

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

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

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

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

Fair value of net assets acquired $ 62,253

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

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

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The operating results of the Company for the three and six months ended June 30, 2018 include the operating results produced by the net assets acquired in the Puget Sound Merger since the January 16, 2018 merger date. The Company has considered the requirement of FASB ASC 805 related to the contribution of the Puget Sound Merger to the Company’s results of operations. The table below presents only the significant results for the acquired business since the January 16, 2018 merger date:

Three Months Ended⁽¹⁾

Six Months Ended⁽¹⁾
June 30, 2018
(In thousands)
Interest income: Interest and fees on loans⁽²⁾
$ 6,130
$ 10,647
Interest income: Interest and fees on investments ⁽³⁾
—
59
Interest income: Other interest earning assets 25
113
Interest expense (180 ) (324 )
Provision for loan losses for loans (350 ) (550 )
Noninterest income 109
257
Noninterest expense ⁽⁴⁾
(2,092 ) (7,672 )
Net effect, pre-tax $ 3,642
$ 2,530

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

⁽²⁾ ~~Includes the accretion of the discount on the purchased loans of~~ ~~$1.1 million~~ ~~and~~ ~~$1.5 million~~ ~~during the three and six months ended June 30, 2018, respectively.~~

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

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

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

During the three ~~and six~~ months ended ~~June 30,~~March 31, 2019 and 2018, the Company incurred acquisition-related costs of approximately ~~$551,000~~$75,000 and ~~$5.0~~$4.5 million, respectively, ~~related to~~for the Puget Sound Merger.

Premier Merger:

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. The Premier Merger resulted in $53.4 million of goodwill.

During the three months ended March 31, 2019 and 2018, the Company incurred acquisition-related costs of approximately $57,000 and $317,000, respectively, for the Premier Merger.


(3)	Investment Securities

As a result of the adoption of ASU 2016-01 on January 1, 2018, equity investments (except for investments accounted for under the equity method of accounting) are now measured at fair value, with changes in fair value recognized in earnings. These investments were previously measured at fair value, with changes in fair value recognized in accumulated other comprehensive loss. Accordingly, these securities are no longer classified as 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 Recently Issued Accounting Pronouncements, as well as Equity Securities section discussed below.

~~Table of Contents~~

~~Available for sale investment securities~~

(a) Securities by Type and Maturity

The following tables present 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:~~indicated:


	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value		Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(In thousands)									(In thousands)
June 30, 2018
March 31, 2019
U.S. Treasury and U.S. Government-sponsored agencies	$	52,256	$	42	$	(234	)	$	52,064	$	98,900	$	398	$	(44	)	$	99,254
Municipal securities	202,918		1,366		(1,262		)	203,022		144,399		2,590		(127		)	146,862
Mortgage-backed securities and collateralized mortgage obligations⁽¹⁾:
Residential	319,492		352		(7,722		)	312,122		349,189		1,224		(3,555		)	346,858
Commercial	257,858		141		(7,778		)	250,221		342,102		2,417		(2,891		)	341,628
Collateralized loan obligations	2,253		3		—			2,256
Corporate obligations	25,617		153		(80		)	25,690		25,684		223		(20		)	25,887
Other asset-backed securities	27,603		692		—			28,295		24,023		500		(3		)	24,520
Total	$	887,997	$	2,749	$	(17,076	)	$	873,670	$	984,297	$	7,352	$	(6,640	)	$	985,009

December 31, 2017
December 31, 2018
U.S. Treasury and U.S. Government-sponsored agencies	$	13,460	$	6	$	(24	)	$	13,442	$	101,595	$	155	$	(147	)	$	101,603
Municipal securities	247,358		3,720		(1,063		)	250,015		158,461		1,209		(806		)	158,864
Mortgage-backed securities and collateralized mortgage obligations⁽¹⁾:
Residential	282,724		422		(2,935		)	280,211		337,295		426		(6,119		)	331,602
Commercial	219,696		444		(3,061		)	217,079		338,250		1,035		(5,524		)	333,761
Collateralized loan obligations	4,561		19		—			4,580
Corporate obligations	16,594		220		(44		)	16,770		25,662		36		(135		)	25,563
Other securities ⁽²⁾	27,781		652		—			28,433
Other asset-backed securities										24,278		424		—			24,702
Total	$	812,174	$	5,483	$	(7,127	)	$	810,530	$	985,541	$	3,285	$	(12,731	)	$	976,095


⁽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 ~~June 30, 2018~~March 31, 2019 or December 31, ~~2017~~2018.

The amortized cost and fair value of investment securities available for sale at ~~June 30, 2018~~,March 31, 2019, 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 $ 24,656
$ 24,690
Due after one year through five years 149,590
148,197
Due after five years through ten years 254,873
248,759
Due after ten years 458,878
452,024
Total $ 887,997
$ 873,670

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	Amortized Cost		Fair Value
	(In thousands)
Due in one year or less	$	31,994	$	31,967
Due after one year through five years	207,244		207,852
Due after five years through ten years	274,601		275,127
Due after ten years	470,458		470,063
Total	$	984,297	$	985,009

(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 ~~June 30, 2018~~March 31, 2019 and December 31, ~~2017~~2018:


	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)
June 30, 2018
March 31, 2019
U.S. Treasury and U.S. Government-sponsored agencies																$	5,079	$	(23	)	$	2,411	$	(21	)	$	7,490	$	(44	)
Municipal securities																827		(4		)	31,990		(123		)	32,817		(127		)
Mortgage-backed securities and collateralized mortgage obligations⁽¹⁾:
Residential																27,725		(170		)	184,166		(3,385		)	211,891		(3,555		)
Commercial																23,798		(231		)	174,130		(2,660		)	197,928		(2,891		)
Corporate obligations																3,874		(12		)	1,992		(8		)	5,866		(20		)
Other asset-backed securities																1,881		(3		)	—		—			1,881		(3		)
Total																$	63,184	$	(443	)	$	394,689	$	(6,197	)	$	457,873	$	(6,640	)

December 31, 2018
U.S. Treasury and U.S. Government-sponsored agencies	$	34,674	$	(223	)	$	536	$	(11	)	$	35,210	$	(234	)	$	46,992	$	(58	)	$	7,350	$	(89	)	$	54,342	$	(147	)
Municipal securities	63,443		(552		)	22,903		(710		)	86,346		(1,262		)	31,157		(159		)	38,792		(647		)	69,949		(806		)
Mortgage-backed securities and collateralized mortgage obligations⁽¹⁾:
Residential	178,865		(3,954		)	78,330		(3,768		)	257,195		(7,722		)	66,620		(247		)	193,726		(5,872		)	260,346		(6,119		)
Commercial	128,298		(3,058		)	94,847		(4,720		)	223,145		(7,778		)	43,531		(272		)	190,585		(5,252		)	234,116		(5,524		)
Corporate obligations	15,482		(80		)	—		—			15,482		(80		)	13,736		(87		)	1,951		(48		)	15,687		(135		)
Total	$	420,762	$	(7,867	)	$	196,616	$	(9,209	)	$	617,378	$	(17,076	)	$	202,036	$	(823	)	$	432,404	$	(11,908	)	$	634,440	$	(12,731	)

December 31, 2017
U.S. Treasury and U.S. Government-sponsored agencies	$	11,436	$	(24	)	$	—	$	—		$	11,436	$	(24	)
Municipal securities	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		)
Commercial	75,121		(700		)	90,822		(2,361		)	165,943		(3,061		)
Corporate obligations	3,472		(44		)	—		—			3,472		(44		)
Total	$	305,174	$	(2,448	)	$	183,711	$	(4,679	)	$	488,885	$	(7,127	)

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

Table of Contents

The Company has evaluated these investment securities available for sale as of ~~June 30, 2018~~March 31, 2019 and December 31, ~~2017~~2018 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 ~~June 30, 2018~~March 31, 2019 or December 31, ~~2017.~~2018. The Company has the ability and intent to hold the investments until recovery of the securities' amortized cost, which may be the maturity date of the securities.

For the three ~~and six~~ months ended ~~June 30,~~March 31, 2019 and 2018, ~~and 2017,~~ there were no other-than-temporary charges recorded to net income.

~~Table of Contents~~

The following table presents the gross realized gains and losses on the sale of securities available for sale for the three ~~and six~~ months ended ~~June 30, 2018~~March 31, 2019 and ~~2017.~~2018:


	Three Months Ended June 30,				Six Months Ended June 30,					Three Months Ended March 31,
	2018		2017		2018			2017		2019			2018
	(In thousands)									(In thousands)
Gross realized gains	$	18	$	117	$	122		$	117	$	89		$	104
Gross realized losses	—		—		(69		)	—		(74		)	(69		)
Net realized gains	$	18	$	117	$	53		$	117	$	15		$	35

(d) Pledged Securities

The following table summarizes the amortized cost and fair value of investment securities available for sale that are pledged as collateral for the following obligations at ~~June 30, 2018~~March 31, 2019 and December 31, ~~2017~~2018:

June 30, 2018 December 31, 2017

Amortized
Cost

Fair
Value

Amortized
Cost

Fair
Value
(In thousands)
Washington and Oregon state to secure public deposits $ 197,047
$ 193,946
$ 206,377
$ 206,425
Repurchase agreements 45,463
44,207
48,750
48,237
Other securities pledged 20,048
19,742
12,484
12,498
Total $ 262,558
$ 257,895
$ 267,611
$ 267,160

~~Equity Securities~~

The Company holds an equity security with a readily determinable fair value of $162,000 and $146,000 as of June 30, 2018 and December 31, 2017, respectively. As a result of the adoption of ASU 2016-01, this security is no longer classified as 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 June 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 six months ended June 30, 2018.



	March 31, 2019				December 31, 2018
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
	(In thousands)
Washington and Oregon state to secure public deposits	$	198,226	$	198,044	$	199,026	$	196,786
Repurchase agreements	47,209		46,872		48,173		47,407
Other securities pledged	20,533		20,549		20,778		20,482
Total	$	265,968	$	265,465	$	267,977	$	264,675


(4)	Loans Receivable

(a) Loan Origination/Risk Management

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~~as they ~~are~~were deemed 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, Receivables—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. There were no PCI loans acquired in the Premier and Puget Mergers.

~~Table of Contents~~

~~(a) Loan Origination/Risk Management~~

The Company categorizes loans in one of the four segments of the total loan portfolio: commercial business, one-to-four family residential, real estate construction and land development and consumer. Within these segments are classes of loans for which management monitors and assesses credit risk in the loan portfolios. The Company has certain lending policies and procedures in place that are designed to maximize loan income within an acceptable level of risk. Management reviews and approves these policies and procedures on a regular basis. A reporting system supplements the review process by providing management with frequent reports related to loan production, loan quality, concentrations of credit, loan delinquencies and nonperforming and 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

2014

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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 ~~June 30, 2018~~March 31, 2019 and December 31, ~~2017~~2018 consisted of the following portfolio segments and classes:


	June 30, 2018			December 31, 2017			March 31, 2019			December 31, 2018
	(In thousands)						(In thousands)
Commercial business:
Commercial and industrial	$	800,043		$	645,396		$	838,403		$	853,606
Owner-occupied commercial real estate	693,330			622,150			785,316			779,814
Non-owner occupied commercial real estate	1,187,548			986,594			1,335,596			1,304,463
Total commercial business	2,680,921			2,254,140			2,959,315			2,937,883
One-to-four family residential	92,518			86,997			106,502			101,763
Real estate construction and land development:
One-to-four family residential	71,934			51,985			110,699			102,730
Five or more family residential and commercial properties	93,315			97,499			126,379			112,730
Total real estate construction and land development	165,249			149,484			237,078			215,460
Consumer	385,987			355,091			390,303			395,545
Gross loans receivable	3,324,675			2,845,712			3,693,198			3,650,651
Net deferred loan costs	3,613			3,359			3,233			3,509
Loans receivable, net	3,328,288			2,849,071			3,696,431			3,654,160
Allowance for loan losses	(33,972		)	(32,086		)	(36,152		)	(35,042		)
Total loans receivable, net	$	3,294,316		$	2,816,985		$	3,660,279		$	3,619,118

(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 June 30, 2018) non-owner occupied commercial real estate, commercial and industrial and owner-occupied commercial real estate. As of ~~June 30, 2018~~March 31, 2019 and December 31, ~~2017,~~2018, there were no concentrations of loans related to any single industry in excess of 10% of the Company’s total loans.

~~Table of Contents~~

As part of the on-going monitoring of the credit quality of the Company’s loan portfolio, management tracks certain credit quality indicators including trends related to (i) the risk grade of the loans, (ii) the level of classified loans, (iii) net charge-offs, (iv) nonperforming loans and (v) the general economic conditions of the United States of America, and specifically the states of Washington and Oregon. The Company utilizes a risk grading matrix to assign a risk grade to each ~~of its loans. Loans are graded~~loan on a scale of 1 to 10. ~~A description of the general characteristics of~~Risk grades are aggregated to create the risk categories of "Pass" for grades ~~is as follows:~~

~~Grades~~ 1 to 5: ~~These grades are considered “pass grade”~~6, Other Asset Especially Mentioned ("OAEM") for grade 7, "Substandard" for grade 8, "Doubtful" for grade 9 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"Loss" for 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.10.

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The following tables present the balance of ~~the~~ loans receivable by credit quality indicator as of ~~June 30, 2018~~March 31, 2019 and December 31, ~~2017~~.2018:


	June 30, 2018										March 31, 2019
	Pass		OAEM		Substandard		Doubtful/Loss		Total		Pass		OAEM		Substandard		Doubtful/Loss		Total
	(In thousands)										(In thousands)
Commercial business:
Commercial and industrial	$	731,265	$	23,559	$	45,219	$	—	$	800,043	$	780,469	$	11,594	$	46,340	$	—	$	838,403
Owner-occupied commercial real estate	656,991		16,402		19,937		—		693,330		747,294		22,576		15,446		—		785,316
Non-owner occupied commercial real estate	1,161,596		10,972		14,980		—		1,187,548		1,310,310		15,149		10,137		—		1,335,596
Total commercial business	2,549,852		50,933		80,136		—		2,680,921		2,838,073		49,319		71,923		—		2,959,315
One-to-four family residential	91,264		—		1,254		—		92,518		105,158		—		1,344		—		106,502
Real estate construction and land development:
One-to-four family residential	70,499		267		1,168		—		71,934		109,748		—		951		—		110,699
Five or more family residential and commercial properties	93,258		57		—		—		93,315		126,330		49		—		—		126,379
Total real estate construction and land development	163,757		324		1,168		—		165,249		236,078		49		951		—		237,078
Consumer	381,341		—		4,121		525		385,987		385,674		—		4,105		524		390,303
Gross loans receivable	$	3,186,214	$	51,257	$	86,679	$	525	$	3,324,675	$	3,564,983	$	49,368	$	78,323	$	524	$	3,693,198


	December 31, 2017										December 31, 2018
	Pass		OAEM		Substandard		Doubtful/Loss		Total		Pass		OAEM		Substandard		Doubtful/Loss		Total
	(In thousands)										(In thousands)
Commercial business:
Commercial and industrial	$	597,697	$	19,536	$	28,163	$	—	$	645,396	$	788,395	$	16,168	$	49,043	$	—	$	853,606
Owner-occupied commercial real estate	595,455		12,668		14,027		—		622,150		741,227		27,724		10,863		—		779,814
Non-owner occupied commercial real estate	955,450		10,494		20,650		—		986,594		1,283,077		9,438		11,948		—		1,304,463
Total commercial business	2,148,602		42,698		62,840		—		2,254,140		2,812,699		53,330		71,854		—		2,937,883
One-to-four family residential	85,762		—		1,235		—		86,997		100,401		—		1,362		—		101,763
Real estate construction and land development:
One-to-four family residential	49,925		537		1,523		—		51,985		101,519		258		953		—		102,730
Five or more family residential and commercial properties	96,404		707		388		—		97,499		112,678		52		—		—		112,730
Total real estate construction and land development	146,329		1,244		1,911		—		149,484		214,197		310		953		—		215,460
Consumer	349,590		—		4,976		525		355,091		390,808		—		4,213		524		395,545
Gross loans receivable	$	2,730,283	$	43,942	$	70,962	$	525	$	2,845,712	$	3,518,105	$	53,640	$	78,382	$	524	$	3,650,651

Potential problem loans are loans classified as OAEM or worse that are currently accruing interest and are not considered impaired, but which management is closely 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 ~~June 30, 2018~~March 31, 2019 and December 31, ~~2017~~2018 were ~~$101.5~~$94.1 million and ~~$83.5~~$101.3 million, respectively.

2316

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(d) Nonaccrual Loans

Nonaccrual loans, segregated by segments and classes of loans, were as follows as of ~~June 30, 2018~~March 31, 2019 and December 31, ~~2017~~:2018:


	June 30, 2018		December 31, 2017		March 31, 2019		December 31, 2018
	(In thousands)				(In thousands)
Commercial business:
Commercial and industrial	$	8,376	$	3,110	$	9,394	$	6,639
Owner-occupied commercial real estate	4,690		4,090		4,465		4,212
Non-owner occupied commercial real estate	2,169		1,898		2,445		1,713
Total commercial business	15,235		9,098		16,304		12,564
One-to-four family residential	77		81		68		71
Real estate construction and land development:
One-to-four family residential	1,084		1,247		923		899
Total real estate construction and land development					923		899
Consumer	127		277		166		169
Nonaccrual loans	$	16,523	$	10,703	$	17,461	$	13,703

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~~policies consistent with regulatory reporting requirements with categories of 30-89 days past due and 90 or more days past due. ~~This policy is consistent with regulatory reporting requirements.~~

Table of Contents

The balances of past due loans, segregated by segments and classes of loans, as of ~~June 30, 2018~~March 31, 2019 and December 31, ~~2017~~2018 were as follows:

June 30, 2018
30-89 Days
90 Days or
Greater

Total Past
Due
Current Total
(In thousands)
Commercial business:
Commercial and industrial $ 3,719
$ 4,122
$ 7,841
$ 792,202
$ 800,043
Owner-occupied commercial real estate 129
868
997
692,333
693,330
Non-owner occupied commercial real estate 1,501
3,238
4,739
1,182,809
1,187,548
Total commercial business 5,349
8,228
13,577
2,667,344
2,680,921
One-to-four family residential —
—
—
92,518
92,518
Real estate construction and land development:
One-to-four family residential —
309
309
71,625
71,934
Five or more family residential and commercial properties —
—
—
93,315
93,315
Total real estate construction and land development —
309
309
164,940
165,249
Consumer 1,634
53
1,687
384,300
385,987
Gross loans receivable $ 6,983
$ 8,590
$ 15,573
$ 3,309,102
$ 3,324,675

~~Table of Contents~~



	March 31, 2019
	30-89 Days		90 Days or Greater		Total Past Due		Current		Total
	(In thousands)
Commercial business:
Commercial and industrial	$	550	$	3,593	$	4,143	$	834,260	$	838,403
Owner-occupied commercial real estate	1,677		349		2,026		783,290		785,316
Non-owner occupied commercial real estate	3,283		1,843		5,126		1,330,470		1,335,596
Total commercial business	5,510		5,785		11,295		2,948,020		2,959,315
One-to-four family residential	38		—		38		106,464		106,502
Real estate construction and land development:
One-to-four family residential	105		258		363		110,336		110,699
Five or more family residential and commercial properties	—		—		—		126,379		126,379
Total real estate construction and land development	105		258		363		236,715		237,078
Consumer	1,347		17		1,364		388,939		390,303
Gross loans receivable	$	7,000	$	6,060	$	13,060	$	3,680,138	$	3,693,198


	December 31, 2017										December 31, 2018
	30-89 Days		90 Days or Greater		Total Past Due		Current		Total		30-89 Days		90 Days or Greater		Total Past Due		Current		Total
	(In thousands)										(In thousands)
Commercial business:
Commercial and industrial	$	2,993	$	1,172	$	4,165	$	641,231	$	645,396	$	2,988	$	2,281	$	5,269	$	848,337	$	853,606
Owner-occupied commercial real estate	1,277		1,225		2,502		619,648		622,150		563		600		1,163		778,651		779,814
Non-owner occupied commercial real estate	870		3,314		4,184		982,410		986,594		5,347		1,461		6,808		1,297,655		1,304,463
Total commercial business	5,140		5,711		10,851		2,243,289		2,254,140		8,898		4,342		13,240		2,924,643		2,937,883
One-to-four family residential	513		—		513		86,484		86,997		227		—		227		101,536		101,763
Real estate construction and land development:
One-to-four family residential	84		1,331		1,415		50,570		51,985		665		234		899		101,831		102,730
Five or more family residential and commercial properties	40		—		40		97,459		97,499		—		—		—		112,730		112,730
Total real estate construction and land development	124		1,331		1,455		148,029		149,484		665		234		899		214,561		215,460
Consumer	1,939		687		2,626		352,465		355,091		2,568		—		2,568		392,977		395,545
Gross loans receivable	$	7,716	$	7,729	$	15,445	$	2,830,267	$	2,845,712	$	12,358	$	4,576	$	16,934	$	3,633,717	$	3,650,651

There were no loans 90 days or more past due that were still accruing interest as of ~~June 30, 2018~~March 31, 2019 or December 31, ~~2017,~~2018, excluding PCI loans.

Table of Contents

(f) Impaired loans

Impaired loans include nonaccrual loans and performing troubled debt restructured ("TDR") loans. The balances of impaired loans as of ~~June 30, 2018~~March 31, 2019 and December 31, ~~2017~~2018 are set forth in the following ~~tables.~~tables:


	June 30, 2018										March 31, 2019
	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	$	5,716	$	12,238	$	17,954	$	18,825	$	1,706	$	4,791	$	17,844	$	22,635	$	24,051	$	2,780
Owner-occupied commercial real estate	930		11,254		12,184		12,493		1,724		463		5,591		6,054		6,451		1,347
Non-owner occupied commercial real estate	4,662		5,923		10,585		10,558		784		5,163		1,800		6,963		7,032		228
Total commercial business	11,308		29,415		40,723		41,876		4,214		10,417		25,235		35,652		37,534		4,355
One-to-four family residential	—		291		291		301		90		—		274		274		289		74
Real estate construction and land development:
One-to-four family residential	775		309		1,084		1,842		5		923		—		923		1,020		—
Total real estate construction and land development	775		309		1,084		1,842		5		923		—		923		1,020		—
Consumer	53		329		382		447		74		—		598		598		607		151
Total	$	12,136	$	30,344	$	42,480	$	44,466	$	4,383	$	11,340	$	26,107	$	37,447	$	39,450	$	4,580



	December 31, 2018
	Recorded Investment With No Specific Valuation Allowance		Recorded Investment With Specific Valuation Allowance		Total Recorded Investment		Unpaid Contractual Principal Balance		Related Specific Valuation Allowance
	(In thousands)
Commercial business:
Commercial and industrial	$	2,523	$	20,119	$	22,642	$	24,176	$	2,607
Owner-occupied commercial real estate	816		5,000		5,816		6,150		1,142
Non-owner occupied commercial real estate	3,352		2,924		6,276		6,414		206
Total commercial business	6,691		28,043		34,734		36,740		3,955
One-to-four family residential	—		279		279		293		76
Real estate construction and land development:
One-to-four family residential	899		—		899		1,662		—
Total real estate construction and land development	899		—		899		1,662		—
Consumer	—		527		527		538		139
Total	$	7,590	$	28,849	$	36,439	$	39,233	$	4,170

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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 six~~ months ended ~~June 30,~~March 31, 2019 and 2018 ~~and 2017~~ are set forth in the following ~~table.~~table:


	Three Months Ended June 30,				Six Months Ended June 30,				Three Months Ended March 31,
	2018		2017		2018		2017		2019		2018
	(In thousands)								(In thousands)
Commercial business:
Commercial and industrial	$	17,299	$	6,925	$	15,534	$	8,742	$	22,639	$	14,261
Owner-occupied commercial real estate	12,643		3,278		12,622		3,760		5,935		12,841
Non-owner occupied commercial real estate	10,426		11,252		10,366		11,274		6,619		10,358
Total commercial business	40,368		21,455		38,522		23,776		35,193		37,460
One-to-four family residential	293		312		295		315		277		297
Real estate construction and land development:
One-to-four family residential	1,116		2,636		1,159		2,781		911		1,197
Five or more family residential and commercial properties	—		1,067		215		1,070		—		322
Total real estate construction and land development	1,116		3,703		1,374		3,851		911		1,519
Consumer	381		235		401		260		562		411
Total	$	42,158	$	25,705	$	40,592	$	28,202	$	36,943	$	39,687

For the three ~~and six~~ months ended ~~June 30,~~March 31, 2019 and 2018, ~~and 2017,~~ no interest income was recognized subsequent to a loan’s classification as nonaccrual. For the three ~~and six~~ months ended ~~June 30,~~March 31, 2019 and 2018, the Bank recorded ~~$360,000~~$301,000 and ~~$686,000, respectively, of interest income related to performing TDR loans. For the three and six months ended June 30, 2017, the Bank recorded $281,000 and $646,000,~~$326,000, respectively, of interest income related to performing TDR loans.

~~Table of Contents~~

(g) Troubled Debt Restructured Loans

A TDR loan is a restructuring in which the Bank, for economic or legal reasons related to a borrower’s financial difficulties, grants a concession to the borrower that it would not otherwise consider. 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 ~~June 30, 2018~~March 31, 2019 and December 31, ~~2017~~2018 were as follows:


	June 30, 2018				December 31, 2017				March 31, 2019				December 31, 2018
	Performing TDRs		Nonaccrual TDRs		Performing TDRs		Nonaccrual TDRs		Performing TDRs		Nonaccrual TDRs		Performing TDRs		Nonaccrual TDRs
	(In thousands)								(In thousands)
TDR loans	$	25,957	$	6,761	$	26,757	$	5,193	$	19,986	$	5,488	$	22,736	$	6,943
Allowance for loan losses on TDR loans	2,492		726		2,635		379		2,181		601		2,257		658

The unfunded commitment to borrowers related to TDR loans was ~~$1.0~~$1.4 million and ~~$1.2 million~~$943,000 at ~~June 30, 2018~~March 31, 2019 and December 31, ~~2017~~,2018, respectively.

Table of Contents

Loans that were modified as TDR loans during the three ~~and six~~ months ended ~~June 30,~~March 31, 2019 and 2018 ~~and 2017~~ are set forth in the following table:

Three Months Ended June 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 9
$ 2,981
5
$ 3,439
Owner-occupied commercial real estate 1
570
—
—
Non-owner occupied commercial real estate —
—
1
947
Total commercial business 10
3,551
6
4,386
Real estate construction and land development:
One-to-four family residential —
—
2
745
Total real estate construction and land development —
—
2
745
Consumer 3
33
1
10
Total loans modified as TDR loans 13
$ 3,584
9
$ 5,141

~~Table of Contents~~


	Six Months Ended June 30,						Three Months Ended March 31,
	2018			2017			2019			2018
	Number of Contracts (1)	Outstanding Principal Balance (1)(2)		Number of Contracts (1)	Outstanding Principal Balance (1)(2)		Number of Contracts (1)	Recorded Investment (1)(2)		Number of Contracts (1)	Recorded Investment (1)(2)
	(Dollars in thousands)						(Dollars in thousands)
Commercial business:
Commercial and industrial	17	$	6,193	10	$	4,913	9	$	10,100	9	$	4,323
Owner-occupied commercial real estate	1	570		1	54		2	934		—	—
Non-owner occupied commercial real estate	2	2,380		1	948		1	2,112		1	2,201
Total commercial business	20	9,143		12	5,915		12	13,146		10	6,524
Real estate construction and land development:
One-to-four family residential	—	—		4	1,889		2	665		—	—
Total real estate construction and land development	—	—		4	1,889		2	665		—	—
Consumer	6	107		2	18		6	122		3	78
Total TDR loans	26	$	9,250	18	$	7,822
Total loans modified as TDR loans							20	$	13,933	13	$	6,602


⁽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 six~~ months ended ~~June 30, 2018~~March 31, 2019 and ~~2017.~~2018.

⁽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 six~~ months ended ~~June 30, 2018~~March 31, 2019 and ~~2017.~~2018.

~~Certain loans included in the~~

The table above ~~may have been~~includes 11 loans that were 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. Of the remaining first-time TDR loans, the concessions granted largely consisted of maturity extensions, interest rate modifications or a combination of both. The potential losses related to ~~these~~TDR loans ~~would have been~~are 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 ~~June 30, 2018 was $738,000~~March 31, 2019 for loans that were modified as TDR loans during the three ~~and six~~ months ended ~~June 30, 2018.~~March 31, 2019 was $1.6 million.

Table of Contents

Loans that were modified during the previous twelve months that subsequently defaulted during the three ~~and six~~ months ended ~~June 30,~~March 31, 2019 and 2018 ~~and 2017~~ are set forth in the following table:

Three Months Ended June 30,
2018 2017

Number of
Contracts

Outstanding
Principal
Balance
Number of
Contracts Outstanding
Principal
Balance
(Dollars in thousands)
Commercial business:
Commercial and industrial 4
$ 2,725
—
$ —
Total commercial business 4
2,725
—
—
Consumer —
—
3
36
Total 4
$ 2,725
3
$ 36

~~Table of Contents~~



	Three Months Ended March 31,
	2019			2018
	Number of Contracts	Recorded Investments		Number of Contracts	Recorded Investments
	(Dollars in thousands)
Commercial business:
Commercial and industrial	1	$	829	1	$	283
Owner-occupied properties	1	717		—	—
Non-owner occupied commercial real estate	1	601		1	75
Total commercial business	3	2,147		2	358
Real estate construction and land development:
One-to-four family residential	—	—		2	838
Total real estate construction and land development	—	—		2	838
Total	3	$	2,147	4	$	1,196

Six Months Ended June 30,
2018 2017

Number of
Contracts

Outstanding
Principal
Balance
Number of
Contracts Outstanding
Principal
Balance
(Dollars in thousands)
Commercial business:
Commercial and industrial 5
$ 3,006
1
$ 234
Non-owner occupied commercial real estate 1
73
—
—
Total commercial business 6
3,079
1
234
Real estate construction and land development:
One-to-four family residential 2
775
—
—
Total real estate construction and land development 2
775
—
—
Consumer —
—
3
36
Total 8
$ 3,854
4
$ 270

During the three ~~and six~~ months ended ~~June 30,~~March 31, 2019, the three loans defaulted because each was past its modified maturity date, and the borrower has not subsequently repaid the credits. The Bank has chosen not to further extend the maturity date on these loans. The Bank had a $314,000 specific valuation allowance at March 31, 2019 related to these TDR loans which defaulted during the three months ended March 31, 2019.

During the three months ended March 31, 2018, ~~two~~the four loans ~~and six loans, respectively,~~ defaulted because they were past their modified maturity dates and the borrowers ~~have~~had not subsequently repaid the credits. The Bank ~~has~~had chosen not to extend the maturities on these loans. In addition, during the three and six months ended June 30, 2018, two loans and two loans, respectively, defaulted because the borrowers were more than 90 days delinquent on their scheduled loan payments. The Bank had no specific valuation allowance at ~~June 30,~~March 31, 2018 related to ~~the credits~~these TDR loans which defaulted during the ~~six~~three months ended ~~June 30,~~March 31, 2018.

~~During the three and six months ended June 30, 2017, three loans and four loans, respectively, defaulted because the borrowers were more than 90 days delinquent on their scheduled loan payments.~~

~~(h) Purchased Credit Impaired Loans~~

The Company acquired certain loans and designated them, as appropriate, as PCI loans, which are accounted for under FASB ASC 310-30. No loans acquired in the Puget Sound Merger effective January 16, 2018 were considered PCI.

2922

Table of Contents

(h) Purchased Credit Impaired Loans

The following table reflects the outstanding principal balance and recorded investment of the PCI loans at ~~June 30, 2018~~March 31, 2019 and December 31, ~~2017:~~2018:


	June 30, 2018				December 31, 2017				March 31, 2019				December 31, 2018
	Outstanding Principal		Recorded Investment		Outstanding Principal		Recorded Investment		Outstanding Principal		Recorded Investment		Outstanding Principal		Recorded Investment
	(In thousands)								(In thousands)
Commercial business:
Commercial and industrial	$	7,307	$	3,819	$	8,818	$	2,912	$	5,521	$	2,713	$	6,319	$	3,433
Owner-occupied commercial real estate	9,737		8,605		12,230		11,515		7,938		7,483		7,830		7,215
Non-owner occupied commercial real estate	12,545		11,033		14,295		13,342		8,245		6,651		8,685		7,059
Total commercial business	29,589		23,457		35,343		27,769		21,704		16,847		22,834		17,707
One-to-four family residential	3,701		3,833		4,120		5,255		3,097		3,251		3,169		3,315
Real estate construction and land development:
One-to-four family residential	107		391		841		89		27		354		67		380
Five or more family residential and commercial properties	193		11		2,361		2,035		185		41		188		43
Total real estate construction and land development	300		402		3,202		2,124		212		395		255		423
Consumer	2,932		4,160		3,974		5,455		1,409		2,680		2,203		3,462
Gross PCI loans	$	36,522	$	31,852	$	46,639	$	40,603	$	26,422	$	23,173	$	28,461	$	24,907

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 six~~ months ended ~~June 30, 2018~~March 31, 2019 and ~~2017.~~2018:


	Three Months Ended June 30,						Six Months Ended June 30,						Three Months Ended March 31,
	2018			2017			2018			2017			2019			2018
	(In thousands)												(In thousands)
Balance at the beginning of the period	$	11,269		$	13,132		$	11,224		$	13,860		$	9,493		$	11,224
Accretion	(587		)	(935		)	(1,368		)	(1,929		)	(581		)	(781		)
Disposal and other	(273		)	(653		)	(1,971		)	(1,143		)	(452		)	(1,698		)
Change in accretable yield	(349		)	752			2,175			1,508
Reclassification from nonaccretable difference													—			2,524
Balance at the end of the period	$	10,060		$	12,296		$	10,060		$	12,296		$	8,460		$	11,269

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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~~table details the activity in the allowance for loan losses disaggregated by segment and class for the three ~~and six~~ months ended ~~June 30, 2018:~~March 31, 2019:


	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 June 30, 2018
Three Months Ended March 31, 2019
Commercial business:
Commercial and industrial	$	9,943	$	(541	)	$	65	$	721		$	10,188	$	11,343	$	(103	)	$	7	$	508		$	11,755
Owner-occupied commercial real estate	5,040		(1		)	3		204			5,246		4,898		—			3		355			5,256
Non-owner occupied commercial real estate	7,589		—			—		137			7,726		7,470		—			149		206			7,825
Total commercial business	22,572		(542		)	68		1,062			23,160		23,711		(103		)	159		1,069			24,836
One-to-four family residential	1,083		(15		)	—		53			1,121		1,203		(15		)	—		59			1,247
Real estate construction and land development:
One-to-four family residential	941		—			2		73			1,016		1,240		—			618		(436		)	1,422
Five or more family residential and commercial properties	1,115		—			—		(71		)	1,044		954		—			—		41			995
Total real estate construction and land development	2,056		—			2		2			2,060		2,194		—			618		(395		)	2,417
Consumer	6,054		(694		)	142		803			6,305		6,581		(586		)	117		368			6,480
Unallocated	1,496		—			—		(170		)	1,326		1,353		—			—		(181		)	1,172
Total	$	33,261	$	(1,251	)	$	212	$	1,750		$	33,972	$	35,042	$	(704	)	$	894	$	920		$	36,152

Six Months Ended June 30, 2018
Commercial business:
Commercial and industrial	$	9,910	$	(622	)	$	564	$	336		$	10,188
Owner-occupied commercial real estate	3,992		(1		)	5		1,250			5,246
Non-owner occupied commercial real estate	8,097		—			—		(371		)	7,726
Total commercial business	21,999		(623		)	569		1,215			23,160
One-to-four family residential	1,056		(15		)	—		80			1,121
Real estate construction and land development:
One-to-four family residential	862		—			2		152			1,016
Five or more family residential and commercial properties	1,190		—			—		(146		)	1,044
Total real estate construction and land development	2,052		—			2		6			2,060
Consumer	6,081		(1,179		)	230		1,173			6,305
Unallocated	898		—			—		428			1,326
Total	$	32,086	$	(1,817	)	$	801	$	2,902		$	33,972

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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 ~~June 30, 2018.~~March 31, 2019:


	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	$	1,706	$	7,564	$	918	$	10,188	$	2,780	$	8,227	$	748	$	11,755
Owner-occupied commercial real estate	1,724		2,736		786		5,246		1,347		3,266		643		5,256
Non-owner occupied commercial real estate	784		6,118		824		7,726		228		7,013		584		7,825
Total commercial business	4,214		16,418		2,528		23,160		4,355		18,506		1,975		24,836
One-to-four family residential	90		879		152		1,121		74		1,061		112		1,247
Real estate construction and land development:
One-to-four family residential	5		787		224		1,016		—		1,222		200		1,422
Five or more family residential and commercial properties	—		957		87		1,044		—		916		79		995
Total real estate construction and land development	5		1,744		311		2,060		—		2,138		279		2,417
Consumer	74		5,601		630		6,305		151		5,897		432		6,480
Unallocated	—		1,326		—		1,326		—		1,172		—		1,172
Total	$	4,383	$	25,968	$	3,621	$	33,972	$	4,580	$	28,774	$	2,798	$	36,152

The following table details the recorded investment balance of the loan receivables disaggregated on the basis of the Company’s impairment method as of ~~June 30, 2018:~~March 31, 2019:


	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	$	17,954	$	778,270	$	3,819	$	800,043	$	22,635	$	813,055	$	2,713	$	838,403
Owner-occupied commercial real estate	12,184		672,541		8,605		693,330		6,054		771,779		7,483		785,316
Non-owner occupied commercial real estate	10,585		1,165,930		11,033		1,187,548		6,963		1,321,982		6,651		1,335,596
Total commercial business	40,723		2,616,741		23,457		2,680,921		35,652		2,906,816		16,847		2,959,315
One-to-four family residential	291		88,394		3,833		92,518		274		102,977		3,251		106,502
Real estate construction and land development:
One-to-four family residential	1,084		70,459		391		71,934		923		109,422		354		110,699
Five or more family residential and commercial properties	—		93,304		11		93,315		—		126,338		41		126,379
Total real estate construction and land development	1,084		163,763		402		165,249		923		235,760		395		237,078
Consumer	382		381,445		4,160		385,987		598		387,025		2,680		390,303
Total	$	42,480	$	3,250,343	$	31,852	$	3,324,675	$	37,447	$	3,632,578	$	23,173	$	3,693,198

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The following tables detail activity in the allowance for loan losses disaggregated by segment and class for the three ~~and six~~ months ended ~~June 30, 2017.~~March 31, 2018:

Balance at Beginning of Period Charge-offs Recoveries Provision for Loan Losses Balance at End of Period
(In thousands)
Three Months Ended June 30, 2017
Commercial business:
Commercial and industrial $ 10,091
$ (63 ) $ 452
$ 171
$ 10,651
Owner-occupied commercial real estate 4,216
(78 ) 2
14
4,154
Non-owner occupied commercial real estate 7,601
—
—
108
7,709
Total commercial business 21,908
(141 ) 454
293
22,514
One-to-four family residential 1,052
—
1
20
1,073
Real estate construction and land development:
One-to-four family residential 791
—
—
30
821
Five or more family residential and commercial properties 1,546
—
—
120
1,666
Total real estate construction and land development 2,337
—
—
150
2,487
Consumer 5,195
(398 ) 110
803
5,710
Unallocated 1,102
—
—
(135 ) 967
Total $ 31,594
$ (539 ) $ 565
$ 1,131
$ 32,751

Six Months Ended June 30, 2017
Commercial business:
Commercial and industrial $ 10,968
$ (358 ) $ 675
$ (634 ) $ 10,651
Owner-occupied commercial real estate 3,661
(85 ) 151
427
4,154
Non-owner occupied commercial real estate 7,753
—
—
(44 ) 7,709
Total commercial business 22,382
(443 ) 826
(251 ) 22,514
One-to-four family residential 1,015
—
1
57
1,073
Real estate construction and land development:
One-to-four family residential 797
—
10
14
821
Five or more family residential and commercial properties 1,359
—
—
307
1,666
Total real estate construction and land development 2,156
—
10
321
2,487
Consumer 5,024
(941 ) 217
1,410
5,710
Unallocated 506
—
—
461
967
Total $ 31,083
$ (1,384 ) $ 1,054
$ 1,998
$ 32,751

~~Table of Contents~~



	Balance at Beginning of Period		Charge-offs			Recoveries		Provision for Loan Losses			Balance at End of Period
	(In thousands)
Three Months Ended March 31, 2018
Commercial business:
Commercial and industrial	$	9,910	$	(81	)	$	499	$	(385	)	$	9,943
Owner-occupied commercial real estate	3,992		—			2		1,046			5,040
Non-owner occupied commercial real estate	8,097		—			—		(508		)	7,589
Total commercial business	21,999		(81		)	501		153			22,572
One-to-four family residential	1,056		—			—		27			1,083
Real estate construction and land development:
One-to-four family residential	862		—			—		79			941
Five or more family residential and commercial properties	1,190		—			—		(75		)	1,115
Total real estate construction and land development	2,052		—			—		4			2,056
Consumer	6,081		(485		)	88		370			6,054
Unallocated	898		—			—		598			1,496
Total	$	32,086	$	(566	)	$	589	$	1,152		$	33,261

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


	Loans Individually Evaluated for Impairment		Loans Collectively Evaluated for Impairment		PCI Loans		Total Allowance for Loan Losses		Loans Individually Evaluated for Impairment		Loans Collectively Evaluated for Impairment		PCI Loans		Total Allowance for Loan Losses
	(In thousands)								(In thousands)
Commercial business:
Commercial and industrial	$	1,326	$	7,558	$	1,026	$	9,910	$	2,607	$	7,913	$	823	$	11,343
Owner-occupied commercial real estate	621		2,557		814		3,992		1,142		3,063		693		4,898
Non-owner occupied commercial real estate	1,222		5,919		956		8,097		206		6,630		634		7,470
Total commercial business	3,169		16,034		2,796		21,999		3,955		17,606		2,150		23,711
One-to-four family residential	93		798		165		1,056		76		1,015		112		1,203
Real estate construction and land development:
One-to-four family residential	2		635		225		862		—		1,040		200		1,240
Five or more family residential and commercial properties	37		1,064		89		1,190		—		875		79		954
Total real estate construction and land development	39		1,699		314		2,052		—		1,915		279		2,194
Consumer	54		5,303		724		6,081		139		5,965		477		6,581
Unallocated	—		898		—		898		—		1,353		—		1,353
Total	$	3,355	$	24,732	$	3,999	$	32,086	$	4,170	$	27,854	$	3,018	$	35,042

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:~~2018:


	Loans Individually Evaluated for Impairment		Loans Collectively Evaluated for Impairment		PCI Loans		Total Gross Loans Receivable		Loans Individually Evaluated for Impairment		Loans Collectively Evaluated for Impairment		PCI Loans		Total Gross Loans Receivable
	(In thousands)								(In thousands)
Commercial business:
Commercial and industrial	$	11,999	$	630,485	$	2,912	$	645,396	$	22,642	$	827,531	$	3,433	$	853,606
Owner-occupied commercial real estate	6,808		603,827		11,515		622,150		5,816		766,783		7,215		779,814
Non-owner occupied commercial real estate	16,019		957,233		13,342		986,594		6,276		1,291,128		7,059		1,304,463
Total commercial business	34,826		2,191,545		27,769		2,254,140		34,734		2,885,442		17,707		2,937,883
One-to-four family residential	299		81,443		5,255		86,997		279		98,169		3,315		101,763
Real estate construction and land development:
One-to-four family residential	1,247		50,649		89		51,985		899		101,451		380		102,730
Five or more family residential and commercial properties	645		94,819		2,035		97,499		—		112,687		43		112,730
Total real estate construction and land development	1,892		145,468		2,124		149,484		899		214,138		423		215,460
Consumer	442		349,194		5,455		355,091		527		391,556		3,462		395,545
Total	$	37,459	$	2,767,650	$	40,603	$	2,845,712	$	36,439	$	3,589,305	$	24,907	$	3,650,651

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(6)	Other Real Estate Owned

Changes in other real estate owned during the three ~~and six~~ months ended ~~June 30, 2017 were~~March 31, 2019 was as follows:


	Three Months Ended June 30,				Six Months Ended June 30,				Three Months Ended March 31,
	2018		2017		2018		2017		2019
	(In thousands)								(In thousands)
Balance at the beginning of the period	$	—	$	786	$	—	$	754	$	1,983
Additions	434		—		434		32		—
Additions from acquisitions									—
Proceeds from dispositions									(79		)
Gain on sales, net									—
Balance at the end of the period	$	434	$	786	$	434	$	786	$	1,904

There was no other real estate owned or activity for the three months ended March 31, 2018. At ~~June 30, 2018,~~March 31, 2019, 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 ~~June 30, 2018, the recorded investment of~~March 31, 2019, there were no 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 $77,000.~~process.


(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; Puget Sound Merger on January 16, ~~2018 and the historical acquisitions of~~2018; 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).

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


	Three Months Ended June 30,				Six Months Ended June 30,				Three Months Ended March 31,
	2018		2017		2018		2017		2019		2018
	(In thousands)								(In thousands)
Balance at the beginning of the period	$	187,549	$	119,029	$	119,029	$	119,029	$	240,939	$	119,029
Additions as a result of acquisitions⁽¹⁾	—		—		68,520		—		—		68,520
Balance at the end of the period	$	187,549	$	119,029	$	187,549	$	119,029	$	240,939	$	187,549

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

The Company performed its annual goodwill impairment test during the fourth quarter of ~~2017~~2018 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. No events or circumstances since the annual impairment test were noted that would indicate it was more likely than not a goodwill impairment exists.

(b) Other Intangible Assets

~~The other~~Other intangible assets represent the core deposit intangible ("CDI") acquired in business combinations. The useful life of the CDI ~~related~~was estimated to be 10 years for the acquisitions of Premier Commercial Bancorp, Puget Sound Bancorp, Washington Banking Company, and Valley Community Bancshares, and ~~Northwest Commercial Bank were~~was estimated to be ~~ten, ten, ten, and five~~5 years ~~respectively.~~for the acquisition of Northwest Commercial Bank.

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


	Three Months Ended June 30,						Six Months Ended June 30,						Three Months Ended March 31,
	2018			2017			2018			2017			2019			2018
	(In thousands)												(In thousands)
Balance at the beginning of the period	$	16,563		$	7,050		$	6,088		$	7,374		$	20,614		$	6,088
Additions as a result of acquisitions ⁽¹⁾	—			—			11,270			—			—			11,270
Amortization	(796		)	(323		)	(1,591		)	(647		)	(1,025		)	(795		)
Balance at the end of the period	$	15,767		$	6,727		$	15,767		$	6,727		$	19,589		$	16,563

⁽¹⁾ See Note (2) Business ~~Combination~~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 June 30, 2018 was 3.90%. The weighted average rate of the junior subordinated debentures was as follows for the indicated periods:~~

Three Months Ended June 30, Six Months Ended June 30,
2018 2017 2018 2017
Weighted average rate ⁽¹⁾
6.28 % 5.04 % 6.01 % 4.96 %

⁽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.~~

~~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 ~~June 30, 2018~~March 31, 2019 and December 31, ~~2017,~~2018, the balance of the junior subordinated debentures, net of unaccreted discount, was ~~$20.2~~$20.4 million and ~~$20.0~~$20.3 million, respectively. ~~All~~

The adjustable rate of the ~~common~~trust preferred securities at March 31, 2019 was 4.16%. The following table presents the weighted average rate 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~~for the ~~Company and held by the Master Trust are reflected as liabilities on the Company's Condensed Consolidated Statements of Financial Condition.~~periods indicated:


⁽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~~


(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~~sale as a supplement 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.funding sources. 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:


	June 30, 2018		December 31, 2017		March 31, 2019		December 31, 2018
	(In thousands)				(In thousands)
U.S. Treasury and U.S. Government-sponsored agencies					$	4,914	$	4,878
Mortgage-backed securities and collateralized mortgage obligations⁽¹⁾:
Residential	$	10,444	$	11,239	9,646		9,335
Commercial	11,724		20,582		10,363		17,274
Total repurchase agreements	$	22,168	$	31,821	$	24,923	$	31,487

⁽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 ~~June 30, 2018,~~March 31, 2019, the Bank maintained a credit facility with the FHLB of Des Moines with available borrowing capacity of ~~$838.1 million and~~$889.8 million. At March 31, 2019 the Bank had short-term FHLB advances outstanding of ~~$75.5~~$25.0 million with maturity dates within 30 days. At December 31, ~~2017 there were~~2018 the Bank had no FHLB advances ~~outstanding~~outstanding.

Table of ~~$92.5 million.~~Contents

The following table sets forth the details of FHLB advances during the three ~~and six~~ months ended ~~June 30, 2018~~March 31, 2019 and ~~2017:~~2018:


	Three Months Ended June 30,						Six Months Ended June 30,						Three Months Ended March 31,
	2018			2017			2018			2017			2019			2018
	(In thousands)												(In thousands)
FHLB Advances:
Average balance during the period	$	79,115		$	107,125		$	57,544		$	104,144		$	1,849		$	35,733
Maximum month-end balance during the period	$	154,500		$	137,450		$	154,500		$	137,450		$	25,000		$	37,200
Weighted average rate during the period	2.04		%	0.89		%	1.93		%	0.86		%	3.29		%	1.70		%

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.

(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 ~~June 30, 2018.~~March 31, 2019. The lines generally mature annually or are reviewed annually. As of ~~June 30, 2018~~March 31, 2019 and December 31, ~~2017,~~2018, there were no federal funds purchased.

The Bank maintains a credit facility with the Federal Reserve Bank of San Francisco ("Federal Reserve Bank") with available borrowing capacity of ~~$58.1~~$38.4 million as of ~~June 30, 2018, on which there~~March 31, 2019. There were no borrowings outstanding as of ~~June 30, 2018 or~~March 31, 2019 and December 31, ~~2017.~~2018. Any advances on the credit facility would have to be first secured by the Bank's investment securities or loans receivable.

~~Table of Contents~~


(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 following table presents the notional amounts and estimated fair values of interest rate derivative contracts outstanding at ~~June 30, 2018~~March 31, 2019 and December 31, ~~2017 are presented in the following table.~~2018:

June 30, 2018 December 31, 2017
Notional Amounts Estimated Fair Value Notional Amounts Estimated Fair Value
(In thousands)
Non-hedging interest rate derivatives
Interest rate swaps with customer ⁽¹⁾
$ 163,257
$ (5,454 ) $ 146,537
$ (882 )
Interest rate swap with third party ⁽¹⁾
163,257
5,454
146,537
882



	March 31, 2019					December 31, 2018
	Notional Amounts		Estimated Fair Value			Notional Amounts		Estimated Fair Value
	(In thousands)
Non-hedging interest rate derivatives
Interest rate swap asset ⁽¹⁾	$	170,714	$	5,285		$	171,798	$	5,095
Interest rate swap liability ⁽¹⁾	170,714		(5,285		)	171,798		(5,095		)

⁽¹⁾The estimated fair value of ~~the derivative included in prepaid~~derivatives with customers was $1,865 and ~~other assets on the Condensed Consolidated Statements of Financial Condition was $6.6 million and $3.4 million~~$(1,643) as of ~~June 30, 2018~~March 31, 2019 and December 31, ~~2017,~~2018, respectively. The estimated fair value of ~~the derivative included in accrued expenses~~derivatives with third parties was $(1,865) and ~~other liabilities on the Condensed Consolidated Statements of Financial Condition was $6.6 million and $3.4 million~~$1,643 as of ~~June 30, 2018~~March 31, 2019 and December 31, ~~2017,~~2018, 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 six~~ months ended ~~June 30, 2018~~March 31, 2019 and ~~2017:~~2018:


	Three Months Ended June 30,						Six Months Ended June 30,						Three Months Ended March 31,
	2018			2017			2018			2017			2019			2018
	(Dollars in thousands)												(In thousands)
Net income:
Net income	$	11,857		$	11,828		$	20,944		$	21,144		$	16,552		$	9,087
Less: Dividends and undistributed earnings allocated to participating securities	(57		)	(83		)	(110		)	(164		)
Dividends and undistributed earnings allocated to participating securities													(52		)	(51		)
Net income allocated to common shareholders	$	11,800		$	11,745		$	20,834		$	20,980		$	16,500		$	9,036
Basic:
Weighted average common shares outstanding	34,023,566			29,939,280			33,680,014			29,945,641			36,881,499			33,332,645
Less: Restricted stock awards	(88,905		)	(183,082		)	(107,897		)	(215,446		)
Restricted stock awards													(55,967		)	(127,099		)
Total basic weighted average common shares outstanding	33,934,661			29,756,198			33,572,117			29,730,195			36,825,532			33,205,546
Diluted:
Basic weighted average common shares outstanding	33,934,661			29,756,198			33,572,117			29,730,195			36,825,532			33,205,546
Effect of potentially dilutive common shares ⁽¹⁾	172,631			83,411			157,819			64,042			185,108			142,556
Total diluted weighted average common shares outstanding	34,107,292			29,839,609			33,729,936			29,794,237			37,010,640			33,348,102


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

~~Table of Contents~~

Potential dilutive shares are excluded from the computation of earnings per share if their effect is anti-dilutive. ~~For the three and six months ended June 30, 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.

(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 ~~six~~three months ended ~~June 30, 2018~~March 31, 2019 and calendar year ~~2017.~~2018:



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
October 24, 2018	$0.17	November 7, 2018	November 21, 2018
October 24, 2018	$0.10	November 7, 2018	November 21, 2018		*
January 23, 2019	$0.18	February 7, 2019	February 21, 2019

* Denotes a special dividend.

The FDIC and the Washington State Department of Financial Institutions, Division of Banks have the authority under their supervisory powers to prohibit the payment of dividends by the Bank to the Company. Additionally, current guidance from the Board of Governors of the Federal Reserve System ("Federal Reserve") 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 six~~ months ended ~~June 30, 2018 and 2017.~~March 31, 2019 or 2018.

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 June 30,				Six Months Ended June 30,				Three Months Ended March 31,
	2018		2017		2018		2017		2019		2018
Repurchased shares to pay withholding taxes ⁽¹⁾	7,394		11,476		52,820		27,367		25,854		45,426
Stock repurchase to pay withholding taxes average share price	$	33.84	$	25.50	$	31.96	$	24.60	$	31.01	$	31.66

⁽¹⁾During the ~~six~~three months ended ~~June 30,~~March 31, 2018, the Company repurchased 26,741 of shares related to the withholding taxes due on the accelerated vesting of the restricted stock units of Puget Sound which were converted to Heritage common stock shares with an average share price of $31.80 under the terms of the ~~merger.~~Puget Sound Merger. See Note (2) Business ~~Combination.~~Combinations.

~~Table of Contents~~

~~(d) Issuance of Common Stock~~

The Puget Sound Merger was effective on January 16, 2018. In conjunction with the merger was the issuance of 4,112,258 shares of the Company's common stock at the merger date share price of $31.80 for a fair value of $130.8 million.


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

The changes in accumulated other comprehensive income (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 the three ~~and six~~ months ended ~~June 30,~~March 31, 2019 and 2018 ~~and 2017~~ are as follows:


	Three Months Ended						Six Months Ended						Three Months Ended March 31,
	2018			2017			2018			2017			2019			2018
	(In thousands)												(In thousands)
Balance of AOCI at the beginning of period	$	(8,934	)	$	(1,133	)	$	(1,298	)	$	(2,606	)	$	(7,455	)	$	(1,298	)
Other comprehensive (loss) income before reclassification	(2,358		)	2,766			(9,874		)	4,239
Other comprehensive income (loss) before reclassification													8,028			(7,516		)
Amounts reclassified from AOCI for gain on sale of investment securities included in net income	(14		)	(76		)	(41		)	(76		)	(12		)	(27		)
Net current period other comprehensive (loss) income	(2,372		)	2,690			(9,915		)	4,163
Net current period other comprehensive income (loss)													8,016			(7,543		)
ASU 2016-01 implementation	—			—			(93		)	—			—			(93		)
Balance of AOCI at the end of period	$	(11,306	)	$	1,557		$	(11,306	)	$	1,557		$	561		$	(8,934	)


(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.

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.

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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.

~~Table of Contents~~

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 ~~June 30, 2018~~March 31, 2019 and December 31, ~~2017~~2018.:


	June 30, 2018								March 31, 2019
	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	$	52,064	$	—	$	52,064	$	—	$	99,254	$	16,001	$	83,253	$	—
Municipal securities	203,022		—		203,022		—		146,862		—		146,862		—
Mortgage-backed securities and collateralized mortgage obligations:
Residential	312,122		—		312,122		—		346,858		—		346,858		—
Commercial	250,221		—		250,221		—		341,628		—		341,628		—
Collateralized loan obligations	2,256		—		2,256		—
Corporate obligations	25,690		—		25,690		—		25,887		—		25,887		—
Other asset-backed securities	28,295		—		28,295		—		24,520		—		24,520		—
Total investment securities available for sale	873,670		—		873,670		—		985,009		16,001		969,008		—
Equity Security									135		135		—		—
Derivative assets - interest rate swaps	6,629		—		6,629		—		5,285		—		5,285		—
Liabilities
Derivative liabilities - interest rate swaps	$	6,629	$	—	$	6,629	$	—	$	5,285	$	—	$	5,285	$	—


	December 31, 2017								December 31, 2018
	Total		Level 1		Level 2		Level 3		Total		Level 1		Level 2		Level 3
	(In thousands)								(In thousands)
Assets
Investment securities available for sale:
U.S. Treasury and U.S. Government-sponsored agencies	$	13,442	$	—	$	13,442	$	—	$	101,603	$	15,936	$	85,667	$	—
Municipal securities	250,015		—		250,015		—		158,864		—		158,864		—
Mortgage-backed securities and collateralized mortgage obligations:
Residential	280,211		—		280,211		—		331,602		—		331,602		—
Commercial	217,079		—		217,079		—		333,761		—		333,761		—
Collateralized loan obligations	4,580		—		4,580		—
Corporate obligations	16,770		—		16,770		—		25,563		—		25,563		—
Other securities	28,433		146		28,287		—
Other asset-backed securities									24,702		—		24,702		—
Total investment securities available for sale	810,530		146		810,384		—		976,095		15,936		960,159		—
Equity Security									114		114		—		—
Derivative assets - interest rate swaps	3,418		—		3,418		—		5,095		—		5,095		—
Liabilities
Derivative liabilities - interest rate swaps	$	3,418	$	—	$	3,418	$	—	$	5,095	$	—	$	5,095	$	—

There were no transfers between Level 1 and Level 2 during the three ~~and six~~ months ended ~~June 30, 2018~~March 31, 2019 and ~~2017.~~2018.

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Nonrecurring Basis

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.

~~Table of Contents~~

The following tables below represent assets measured at fair value on a nonrecurring basis at ~~June 30, 2018~~March 31, 2019 and December 31, ~~2017~~2018 and the net losses recorded in earnings during three ~~and six~~ months ended ~~June 30, 2018~~March 31, 2019 and ~~2017.~~2018:


	Basis⁽¹⁾		Fair Value at June 30, 2018												Basis⁽¹⁾		Fair Value at March 31, 2019
	Basis⁽¹⁾		Total		Level 1		Level 2		Level 3		Net Losses (Gains) Recorded in Earnings During the Three Months Ended June 30, 2018		Net Losses (Gains) Recorded in Earnings During the Six Months Ended June 30, 2018		Basis⁽¹⁾		Total		Level 1		Level 2		Level 3		Net Losses (Gains) Recorded in Earnings During the Three Months Ended March 31, 2019
	(In thousands)														(In thousands)
Impaired loans:
Real estate construction and land development:
One-to-four family residential	$	976	$	304	$	—	$	—	$	304	$	3	3
Commercial business:
Commercial and industrial															$	109	$	98	$	—	$	—	$	98	$	(39	)
Total commercial business															109		98		—		—		98		(39		)
Consumer															9		7		—		—		7		—
Total assets measured at fair value on a nonrecurring basis	$	976	$	304	$	—	$	—	$	304	$	3	$	3	$	118	$	105	$	—	$	—	$	105	$	(39	)


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



	Basis⁽¹⁾		Fair Value at December 31, 2018
	Basis⁽¹⁾		Total		Level 1		Level 2		Level 3		Net Losses Recorded in Earnings During the Three Months Ended March 31, 2018
	(In thousands)
Impaired loans:
Commercial business:
Commercial and industrial	$	117	$	107	$	—	$	—	$	107	$	—
Non-owner occupied commercial real estate	1,378		1,102		—		—		1,102		—
Total commercial business	1,495		1,209		—		—		1,209		—
Consumer	9		7		—		—		7		—
Total assets measured at fair value on a nonrecurring basis	$	1,504	$	1,216	$	—	$	—	$	1,216	$	—


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

Basis⁽¹⁾
Fair Value at December 31, 2017
Total Level 1 Level 2 Level 3
Net Losses
Recorded in
Earnings
During
the Three Months Ended June 30, 2017

Net Losses
(Gains)
Recorded in
Earnings
During
the Six Months Ended June 30, 2017
(In thousands)
Impaired loans:
Real estate construction and land development:
One-to-four family residential $ 976
$ 307
$ —
$ —
$ 307
$ —
—
Total assets measured at fair value on a nonrecurring basis $ 976
$ 307
$ —
$ —
$ 307
$ —
$ —

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

The following ~~table presents~~tables present quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at ~~June 30, 2018~~March 31, 2019 and December 31, ~~2017~~2018.:

June 30, 2018

Fair
Value

Valuation
Technique(s)
Unobservable Input(s)
Range of Inputs; Weighted
Average
(Dollars in thousands)
Impaired loans $ 304
Market approach Adjustment for differences between the comparable sales (91.2%) - (14.4)%; (44.0%)



	March 31, 2019
	Fair Value		Valuation Technique(s)	Unobservable Input(s)	Range of Inputs; Weighted Average
	(Dollars in thousands)
Impaired loans	$	105	Market approach	Adjustment for differences between the comparable sales	N/A⁽¹⁾


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

December 31, 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%)

~~Table of Contents~~



	December 31, 2018
	Fair Value		Valuation Technique(s)	Unobservable Input(s)	Range of Inputs; Weighted Average
	(Dollars in thousands)
Impaired loans	$	1,216	Market approach	Adjustment for differences between the comparable sales	10.4% - (37.3%); (10.9%)

(b) Fair Value of Financial Instruments

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

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


	June 30, 2018										March 31, 2019
	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	$	129,943	$	129,943	$	129,943	$	—	$	—	$	111,170	$	111,170	$	111,170	$	—	$	—
Investment securities available for sale	873,670		873,670		—		873,670		—		985,009		985,009		16,001		969,008		—
Federal Home Loan Bank stock	8,616		N/A		N/A		N/A		N/A
Loans held for sale	3,598		3,708		—		3,708		—		2,956		3,042		—		3,042		—
Total loans receivable, net	$	3,294,316	$	3,277,881	$	—	$	—	$	3,277,881	3,660,279		3,668,110		—		—		3,668,110
Accrued interest receivable	13,482		13,482		28		3,826		9,628		15,621		15,621		93		3,971		11,557
Derivative assets - interest rate swaps	6,629		6,629		—		6,629		—		5,285		5,285		—		5,285		—
Equity security	162		162		162		—		—		135		135		135		—		—
Financial Liabilities:
Noninterest deposits, interest bearing demand deposits, money market accounts and savings accounts	3,508,300		3,508,300		3,508,300		—		—		$	3,872,589	$	3,872,589	$	3,872,589	$	—	$	—
Certificate of deposit accounts	460,635		463,971		—		463,971		—		521,126		525,045		—		525,045		—
Federal Home Loan Bank advances	75,500		75,500		—		75,500		—
Securities sold under agreement to repurchase	22,168		22,168		22,168		—		—		24,923		24,923		24,923		—		—
Junior subordinated debentures	20,156		20,000		—		—		20,000		20,375		20,250		—		—		20,250
Accrued interest payable	198		198		46		107		45		409		409		91		267		51
Derivative liabilities - interest rate swaps	6,629		6,629		—		6,629		—		5,285		5,285		—		5,285		—

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	December 31, 2017										December 31, 2018
	Carrying Value		Fair Value		Fair Value Measurements Using:						Carrying Value		Fair Value		Fair Value Measurements Using:
					Level 1		Level 2		Level 3						Level 1		Level 2		Level 3
	(In thousands)										(In thousands)
Financial Assets:
Cash and cash equivalents	$	103,015	$	103,015	$	103,015	$	—	$	—	$	161,910	$	161,910	$	161,910	$	—	$	—
Investment securities available for sale	810,530		810,530		146		810,384		—		976,095		976,095		15,936		960,159		—
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		—		1,555		1,605		—		1,605		—
Loans receivable, net of allowance for loan losses	2,816,985		2,810,401		—		—		2,810,401		3,619,118		3,617,857		—		—		3,617,857
Accrued interest receivable	12,244		12,244		23		3,772		8,449		15,403		15,403		68		4,091		11,244
Derivative assets - interest rate swaps	3,418		3,418		—		3,418		—		5,095		5,095		—		5,095		—
Equity security											114		114		114		—		—
Financial Liabilities:
Noninterest deposits, interest bearing demand deposits, money market accounts and savings accounts	$	2,994,662	$	2,994,662	$	2,994,662	$	—	$	—	$	3,965,510	$	3,965,510	$	3,965,510	$	—	$	—
Certificate of deposit accounts	398,398		397,039		—		397,039		—		466,892		470,222		—		470,222		—
Federal Home Loan Bank advances	92,500		92,500		—		92,500		—		—		—		—		—		—
Securities sold under agreement to repurchase	31,821		31,821		31,821		—		—		31,487		31,487		31,487		—		—
Junior subordinated debentures	20,009		18,500		—		—		18,500		20,302		20,500		—		—		20,500
Accrued interest payable	162		162		45		79		38		191		191		63		81		47
Derivative liabilities - interest rate swaps	3,418		3,418		—		3,418		—		5,095		5,095		—		5,095		—


(15)	~~Stock-Based Compensation~~

On July 24, 2014, the Company's shareholders approved the Heritage Financial Corporation 2014 Omnibus Equity Plan (the "Plan") that provides for the issuance of 1,500,000 shares of the Company's common stock in the form of stock options, stock appreciation rights, stock awards (which includes restricted stock units, restricted stock, performance units, performance shares or bonus shares) and cash incentive awards. The Company issues new shares of common stock to satisfy share option exercises and restricted stock awards. As of June 30, 2018, shares that remain available for future issuance under the Company's stock-based compensation plans was 964,832.

~~(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 six months ended June 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 six months ended June 30, 2018 was $82,000 and $47,000, respectively. The intrinsic value and cash proceeds from options exercised during the six months ended June 30, 2017 was ~~$98,000~~ ~~and~~ ~~$109,000, respectively.~~

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~~The following table summarizes the stock option activity for the six months ended June 30, 2018 and 2017:~~

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

Aggregate
Intrinsic
Value (In
thousands)
Outstanding at December 31, 2016 37,495
$ 13.77

Exercised (8,372 ) 13.03

Forfeited or expired (1,308 ) 13.53

Outstanding, vested and expected to vest and exercisable at June 30, 2017 27,815
$ 14.00
2.63 $ 348

Outstanding at December 31, 2017 23,231
$ 14.21

Exercised (4,042 ) 11.55

Forfeited or expired (831 ) 14.77

Outstanding, vested and expected to vest and exercisable at June 30, 2018 18,358
$ 14.77
1.90 $ 369

~~(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 six months ended June 30, 2018, the Company recognized compensation expense related to restricted stock awards of $249,000 and $532,000, respectively, and a related tax benefit of $52,000 and $112,000, respectively. For the three and six months ended June 30, 2017, the Company recognized compensation expense related to restricted stock awards of $359,000 and $804,000, respectively, and a related tax benefit of $126,000 and $282,000, respectively. As of June 30, 2018, the total unrecognized compensation expense related to non-vested restricted stock awards was $949,000 and the related weighted average period over which the compensation expense is expected to be recognized is approximately 1.38 years. The vesting date fair value of the restricted stock awards that vested during the six months ended June 30, 2018 and 2017 was $2.1 million and $2.6 million, respectively.

~~The following table summarizes the restricted stock award activity for the six months ended June 30, 2018 and 2017:~~

Shares Weighted-Average Grant Date Fair Value
Nonvested at December 31, 2016 261,296
$ 16.80
Vested (105,972 ) 16.47
Forfeited (7,704 ) 16.78
Nonvested at June 30, 2017 147,620
$ 17.04

Nonvested at December 31, 2017 137,399
$ 17.00
Vested (66,193 ) 16.67
Forfeited (2,394 ) 16.86
Nonvested at June 30, 2018 68,812
$ 17.32

~~(c) Restricted Stock Units~~

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

~~Table of Contents~~

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 February 2018 and 2017:

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

For the three and six months ended June 30, 2018, the Company recognized compensation expense related to the units of $435,000 and $775,000, respectively, and a related tax benefit of $91,000 and $163,000, respectively. For the three and six months ended June 30, 2017, the Company recognized compensation expense related the units of $171,000 and $236,000, respectively, and a related tax benefit of $60,000 and $83,000, respectively. As of June 30, 2018, the total unrecognized compensation expense related to non-vested units was $4.1 million and the related weighted average period over which the compensation expense is expected to be recognized is approximately 2.65 years. The vesting date fair value of the units that vested during the six months ended June 30, 2018 was $1.0 million. There were no units that vested during the six months ended June 30, 2017.

~~The following table summarizes the unit activity for the six months ended June 30, 2018 and 2017:~~

Shares Weighted-Average Grant Date Fair Value
Nonvested at December 31, 2016 —
$ —
Granted 92,019
25.29
Forfeited (909 ) 25.35
Nonvested at June 30, 2017 91,110
$ 25.29

Nonvested at December 31, 2017 90,544
$ 25.31
Granted 114,015
30.61
Vested (32,262 ) 25.42
Forfeited (3,644 ) 27.87
Nonvested at June 30, 2018 168,653
$ 28.51


~~(16)~~	Cash Requirement

The Company 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 ~~June 30, 2018~~March 31, 2019 and December 31, ~~2017~~2018 was ~~$10.9~~$12.2 million and ~~$60,000,~~$9.2 million respectively, and was met by holding cash and maintaining an average balance with the Federal Reserve Bank.


(16)	Leases

On January 1, 2019, the Company adopted ASU 2016-02, Leases, as further explained in Note (1) Description of Business, Basis of Presentation, Significant Accounting Policies and Recently Issued Accounting Pronouncements. The Company enters into noncancelable operating lease agreements related to certain banking offices, back-office operational facilities, office equipment, and sublease agreements. The Company does not have leases designated as finance leases. The Company determines if an arrangement is a lease at inception. Operating lease right-of-use ("ROU") assets and liabilities are included in prepaid expenses and other assets and accrued expenses and other liabilities, respectively, in the Condensed Consolidated Statements of Financial Condition. ROU assets represent the right to use an underlying asset for the lease term and lease liabilities represent the obligation to make lease payments arising from the lease. Operating lease ROU assets and lease liabilities are recognized at commencement date based on the present value of lease payments over the lease term. As the Company's leases do not provide an implicit rate, the Company uses its incremental borrowing rate based on the information available at commencement date in determining the present value of lease payments. The operating lease ROU asset also includes any lease pre-payments made and excludes lease incentives. The Company's lease terms may include options to extend or terminate the lease when it is reasonably certain that the Company will exercise that option. Lease expense for lease payments is recognized on a straight-line basis over the lease term.

As of March 31, 2019 the Company’s lease ROU assets and related lease liabilities were $28.4 million and $29.5 million, respectively.

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The table below summarizes the net lease cost recognized during the period presented:



	Three Months Ended March 31, 2019
	(In thousands)
Operating Lease Cost	$	1,243
Variable Lease Cost	218
Total lease cost ⁽¹⁾	$	1,461


~~(17)~~ ⁽¹⁾	~~Subsequent Event~~Income related to sub-lease activity is immaterial for the Company and not presented herein.

On July 2, 2018, the Company completed the previously announced acquisition of Premier Commercial. As of the acquisition date, Premier Commercial was merged with and into Heritage and Premier Community Bank was merged with and into Heritage Bank. Premier Commercial had six branch locations. The ~~Premier Merger is being accounted for using the acquisition method of accounting.~~

Pursuant the terms of the merger agreement, Premier Commercial shareholders received 0.4863 shares of Heritage common stock for each share of Premier Commercial common stock. Based on the June 29, 2018 closing price of Heritage common stock of $34.85, Heritage issued 2,848,579 shares of the Company's common stock and paid $2,000 in cash for fractional shares for total consideration of $99.3 million, including the value of the outstanding shares of Premier Commercial restricted stock which vested immediately at the merger date.

The operating results of the Company for the three and six months ended June 30, 2018 do not include the operating results related to the assets acquired and liabilities assumed in the Premier Merger as it was not completed until July 2, 2018. As of June 30, 2018, Premier Commercial had total assets of $381.7 million, total loans of $335.3 million and total deposits of $319.3 million. It is not practical to present financialtable below summarizes other information related to the ~~fair value~~Company's operating leases during the period presented:



	Three Months Ended March 31, 2019
	(Dollars in thousands)
Cash paid for amounts included in the measurement of lease liabilities:
Operating cash flows from operating leases	$	1,187
ROU assets obtained in exchange for lease liabilities	$	335
Weighted average remaining lease term of operating leases, in years	8.48
Weighted average discount rate of operating leases	3.33		%

The following table outlines lease payment obligations as outlined in the Company’s lease agreements for each of ~~assets acquired~~the next five years, as of March 31, 2019, and ~~liabilities assumed from Premier Commercial~~thereafter in addition to a reconcilement to the Company’s right of use liability at ~~this time because~~ the ~~fair value information has not been finalized.~~date indicated:



	Year Ending December 31,
	(In thousands)
2019	$	3,667
2020	4,581
2021	4,155
2022	3,730
2023	3,738
Thereafter	14,215
Total lease payments	34,086
Implied interest	(4,542		)
Right of use liability	$	29,544

For ~~the three and six months ended June 30,~~comparative purposes as of December 31, 2018, the estimated future minimum annual rental commitments under noncancelable leases having an original or remaining term of more than one year as calculated prior to applying the modified retrospective method of ASU 2016-02 implementation are as follows:



	Year Ending December 31,
	(In thousands)
2019	4,766
2020	4,251
2021	2,477
2022	1,704
2023	1,568
Thereafter	1,788
	16,554

As of March 31, 2019, the Company ~~incurred acquisition related costs~~had not entered into any material leases that have not yet commenced.

Table of ~~$329,000 and $653,000, respectively, related to the Premier Merger.~~Contents


ITEM 2.	MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion is intended to assist in understanding the financial condition and results of the Company as of and for the three ~~and six~~ months ended ~~June 30, 2018.~~March 31, 2019. 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~~2018 audited Consolidated Financial Statements and the accompanying Notes included in our Annual Report on Form 10-K for the year ended December 31, ~~2017.~~2018.

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 ~~June 30, 2018,~~March 31, 2019, we had total assets of ~~$4.79~~$5.34 billion and total stockholders’ equity of ~~$639.5~~$778.2 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.

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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, data processing and professional ~~services and data processing.~~services. 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 ~~June 30, 2018~~March 31, 2019 to the comparable quarter in the prior year.

Net income was ~~$11.9~~$16.6 million, or ~~$0.35~~$0.45 per diluted common share, for the three months ended ~~June 30, 2018~~March 31, 2019 compared to ~~$11.8~~$9.1 million, or ~~$0.40~~$0.27 per diluted common share, for the three months ended ~~June 30, 2017.~~March 31, 2018. Net income increased ~~$29,000,~~$7.5 million, or ~~0.2%~~82.2%, for the three months ended ~~June 30, 2018~~March 31, 2019 compared to the three months ended ~~June 30, 2017~~March 31, 2018 primarily due to an increase in net interest income of ~~$9.6~~$9.0 million, or ~~28.2%~~22.0%, ~~offset partially by anincrease in noninterest expense of $7.9 million, or 28.4%, and~~primarily as a ~~decrease in noninterest income of $3.1 million, or 29.3%. The increases in net interest income and noninterest expense were primarily the~~ result of the Premier and Puget ~~Sound Merger~~Mergers completed ~~in January 2018. The decrease in noninterest income was due primarily to a gain on sale of a previously classified purchased credit impaired loan~~during 2018 and secondarily by higher market interest rates reflecting increases in the ~~amount of $3.0 million recognized~~targeted federal funds rate during ~~the three months ended June 30, 2017.~~2018.

Net interest income as a percentage of average interest earning assets (net interest margin) increased 3022 basis points to ~~4.22%~~4.34% for the three months ended ~~June 30, 2018~~March 31, 2019 compared to ~~3.92%~~4.12% for the same period in ~~2017.~~2018. The increase in net interest margin was primarily due to increases in ~~loan~~both the average balance and yield on loans and secondarily by increases in both the average balances and yields ~~and investment yields,~~on investments, offset partially by ~~an increase~~increases in both the balance and cost of interest bearing ~~liabilities.~~deposits.

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 ~~69.58%~~63.84% for the three months ended ~~June 30, 2018~~March 31, 2019 compared to ~~62.01%~~75.95% for the three months ended ~~June 30, 2017.~~March 31, 2018. The ~~change~~improvement in the efficiency ratio was primarily attributable to the increase in noninterest expense as a result of the Puget Sound Merger completed in January 2018, acquisition costs associated with the Puget Sound Merger and the Premier Merger, the buy-out of a third party contract in the amount $1.7 million during the three months ended June 30, 2018 and and a gain on sale of a previously classified purchased credit impaired loan in the amount of $3.0 million recognized during the three months ended June 30, 2017.

~~Comparison of six months ended June 30, 2018 to the comparable period in the prior year~~

Net income was $20.9 million, or $0.62 per diluted common share, for the six months ended June 30, 2018 compared to $21.1 million, or $0.71 per diluted common share, for the six months ended June 30, 2017. Net income decreased $200,000, or 0.9%, for the six months ended June 30, 2018 compared to the six months ended June 30, 2017 primarily due to an increase in noninterest expense of $17.4 million, or 31.7% and a decrease in noninterest income of $3.0 million, or 16.3%, partially offset by an increase in net interest income of $17.3 million, or 25.7%. The increases in noninterest expense and net interest income during the six months ended June 30, 2018acquisition-related non-interest expenses as compared to the same ~~period~~quarter in 2017 were primarily the result of the Puget Sound Merger. The decrease in noninterest income was due primarily to a gain on sale of a previously classified purchased credit impaired loan in the amount of $3.0 million recognized during the three months ended June 30, 2017.

The net interest margin increased 26 basis points to 4.17% for the six months ended June 30, 2018 compared to 3.91% for the same period in 2017. Net interest margin increased due to increases in loan yields and in balances and yields on investments, offset partially by increases in the cost of interest bearing deposits.

The Company’s efficiency ratio was 72.67% for the six months ended June 30, 2018 compared to 64.49% for the six months ended June 30, 2017. The change in the efficiency ratio for the six months ended June 30, 2018 compared to the six months ended June 30, 2017 was primarily attributable to additional noninterest expense as a result of the Puget Sound Merger, acquisition costs associate with Puget Sound Merger and Premier Merger, and the buy-out of a third party contract in the amount $1.7 million, further explained in the "Noninterest Expense" section,2018.

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during the three months ended June 30, 2018 as well as a gain on sale of a previously classified purchased credit impaired loan in the amount of $3.0 million recognized during the three months ended June 30, 2017.

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 ~~June 30, 2018~~March 31, 2019 to the comparable quarter in the prior year.

Net interest income increased ~~$9.6~~$9.0 million, or ~~28.2%~~22.0%, to ~~$43.7~~$49.8 million for the three months ended ~~June 30, 2018~~March 31, 2019 compared to ~~$34.1~~$40.8 million for the same period in ~~2017.~~2018. 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 ~~as a result of~~primarily due to higher ~~short-term~~market interest rates reflecting increases in the target federal funds ~~rate over~~rate. These impacts which increased net interest income were offset partially by an increase in the ~~last year.~~cost of total interest bearing liabilities primarily as a result of rising interest rates. The following table provides relevant net interest income information for the dates ~~indicated.~~indicated:

Three Months Ended June 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)}
$ 3,266,092
$ 41,141
5.05 % $ 2,657,946
$ 31,500
4.75 %
Taxable securities 638,092
4,068
2.56
567,066
3,141
2.22
Nontaxable securities ⁽³⁾
201,104
1,220
2.43
224,719
1,304
2.33
Other interest earning assets 51,022
242
1.90
39,403
96
0.98
Total interest earning assets 4,156,310
46,671
4.50 % 3,489,134
36,041
4.14 %
Noninterest earning assets 570,409
420,658

Total assets $ 4,726,719
$ 3,909,792

Interest Bearing Liabilities:
Certificates of deposit $ 418,129
$ 797
0.76 % $ 363,053
$ 479
0.53 %
Savings accounts 512,832
487
0.38
497,033
316
0.26
Interest bearing demand and money market accounts 1,796,095
911
0.20
1,484,767
612
0.17
Total interest bearing deposits 2,727,056
2,195
0.32
2,344,853
1,407
0.24
FHLB advances and other borrowings 79,120
402
2.04
107,132
239
0.89
Securities sold under agreement to repurchase 27,935
16
0.23
22,852
12
0.21
Junior subordinated debentures 20,108
315
6.28
19,822
249
5.04
Total interest bearing liabilities 2,854,219
2,928
0.41 % 2,494,659
1,907
0.31 %
Demand and other noninterest bearing deposits 1,175,331
873,314

Other noninterest bearing liabilities 60,434
44,582

Stockholders’ equity 636,735
497,237

Total liabilities and stockholders’ equity $ 4,726,719
$ 3,909,792

Net interest income
$ 43,743
$ 34,134

Net interest spread 4.09 % 3.83 %
Net interest margin 4.22 % 3.92 %
Average interest earning assets to average interest bearing liabilities 145.62 % 139.86 %


⁽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 $10.6 million, or 29.5%, to $46.7 million for the three months ended June 30, 2018 compared to $36.0 million for the same period in 2017. The balance of average interest earning assets increased $667.2 million, or 19.1%, to $4.16 billion for the three months ended June 30, 2018 from $3.49 billion for the three months ended June 30, 2017 and the yield on total interest earning assets increased 36 basis points to 4.50% for the three months ended June 30, 2018 compared to 4.14% for the three months ended June 30, 2017.

Interest income from interest and fees on loans increased $9.6 million, or 30.6%, to $41.1 million for the three months ended June 30, 2018 from $31.5 million for the same period in 2017 primarily due to an increase in average total loans receivable, net of $608.1 million, or 22.9%, as a result of loan growth which was substantially due to the Puget Sound Merger. The loan yield increased 30 basis points to 5.05% for the three months ended June 30, 2018 from 4.75% for the three months ended June 30, 2017. The increase in loan yield was due to a combination of higher contractual note rates as a result of the increasing interest rate environment, higher loan yields from the loans acquired in the Puget Sound Merger as compared to legacy Heritage loans, and an increase in incremental accretion on purchased loans substantially due to loans acquired in the Puget Sound Merger.

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

Three Months Ended June 30,
2018 2017
(Dollars in thousands)
Loan yield, excluding incremental accretion on purchased loans ⁽¹⁾
4.81 % 4.53 %
Impact on loan yield from incremental accretion on purchased loans ⁽¹⁾
0.24 % 0.22 %
Loan yield 5.05 % 4.75 %

Incremental accretion on purchased loans ⁽¹⁾
$ 1,992
$ 1,481

⁽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 $2.0 million and $1.5 million for the three months ended June 30, 2018 and 2017, respectively. The increase in the incremental accretion during the three months ended June 30, 2018 was primarily due to the accretion of the loans acquired in the Puget Sound Merger. 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 an $843,000, or 19.0%, increase in interest income on investment securities to $5.3 million during the three months ended June 30, 2018 from $4.4 million for the three months ended June 30, 2017. The increase in income on investment securities was primarily 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 secondarily to higher yields on new investment purchases for the three months ended June 30, 2018 compared to the same period in 2017. Yields on taxable securities increased 34 basis points to 2.56% for the three months ended June 30, 2018 from 2.22% for the same period in 2017. Yields on nontaxable securities increased 10 basis points to 2.43% for the three months ended June 30, 2018 from 2.33% for the same period in 2017. The average balance of investment securities increased $47.4 million, or 6.0%, to $839.2 million during the three months ended June 30, 2018 from $791.8 million during the three months ended June 30, 2017. The Company has actively managed its investment securities portfolio to improve performance in an increasing rate environment.

Interest income on other interest earning assets increased $146,000, or 152.1%, due to a combination of an increase in the yields reflecting the rise in interest rates and 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. Average other interest earning assets increased $11.6 million, or 29.5%, to $51.0 million for the three months ended June 30, 2018 compared to $39.4 million for the three months ended June 30, 2017.

~~Table of Contents~~

~~Interest Expense~~

Total interest expense increased $1.0 million, or 53.5%, to $2.9 million for the three months ended June 30, 2018 compared to $1.9 million for the same period in 2017. The average cost of interest bearing liabilities increased 10 basis points to 0.41% for the three months ended June 30, 2018 from 0.31% for the three months ended June 30, 2017 as a result of the rise in market interest rates. Total average interest bearing liabilities increased $359.6 million, or 14.4%, to $2.85 billion for the three months ended June 30, 2018 from $2.49 billion for the three months ended June 30, 2017 substantially due to the Puget Sound Merger.

The average cost of interest bearing deposits increased eight basis points to 0.32% for the three months ended June 30, 2018 from 0.24% for the same period in 2017 primarily as a result of the increase in market interest rates. The cost of certificates of deposit increased 23 basis points to 0.76% for the three months ended June 30, 2018 from 0.53% for the same period in 2017. The Company was able to mitigate the rise in market interest rates by increasing the average balance of noninterest bearing deposits at a higher growth rate than that of interest bearing deposits. The average balance of noninterest bearing deposits increased by $302.0 million, or 34.6%, for the three months ended June 30, 2018 to $1.18 billion the three months ended June 30, 2018 compared to an increase in the average balance of interest bearing demand and money market deposits of $311.3 million, or 21.0%, for the three months ended June 30, 2018 to $1.80 billion at June 30, 2018 and an increase in the average balance of certificate of deposit accounts $55.1 million, or 15.2%, for the three months ended June 30, 2018 to $418.1 million at June 30, 2018. The total cost of deposits increased to 0.23% for the three months ended June 30, 2018 compared to 0.18% for the same period in 2017. The increase in average deposits was primarily as a result of the Puget Sound Merger.

Interest expense on FHLB advances and other borrowings increased $163,000, or 68.2%, to $402,000 for the three months ended June 30, 2018 from $239,000 for the same period in 2017 due to an increase in market rates, partially offset by a decrease in the average balance. The average cost of FHLB advances and other borrowings for the three months ended June 30, 2018 was 2.04%, an increase of 115 basis points from 0.89% for the same period in 2017. The average balance for FHLB advances and other borrowings decreased $28.0 million, or 26.1%, to $79.1 million for the three months ended June 30, 2018 from $107.1 million for the same period in 2017, as a result of repayments 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 June 30, 2018 was 6.28%, an increase of 124 basis points from 5.04% 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 2.34% at June 30, 2018 from 1.30% on June 30, 2017.

~~Net Interest Margin~~

Net interest margin increased 30 basis points for the three months ended June 30, 2018 to 4.22% from 3.92% for the same period in 2017 primarily due to the above mentioned changes in yields and costs of funds. The net interest spread increased 26 basis points for the three months ended June 30, 2018 to 4.09% from 3.83% 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 and effects of the incremental accretion on purchased loans for the three months ended June 30, 2018 and 2017:

Three Months Ended June 30,
2018 2017
Net interest margin, excluding incremental accretion on purchased loans ⁽¹⁾
4.03 % 3.75 %
Impact on net interest margin from incremental accretion on purchased loans ⁽¹⁾
0.19
0.17
Net interest margin 4.22 % 3.92 %

⁽¹⁾

~~Table of Contents~~

~~Comparison of six months ended June 30, 2018 to the comparable period in the prior year~~

Net interest income increased $17.3 million, or 25.7%, to $84.6 million for the six months ended June 30, 2018 compared to $67.3 million for the same period in 2017. The following table provides relevant net interest income information for the dates indicated.


	Six Months Ended June 30,												Three Months Ended March 31,
	2018						2017						2019						2018
	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)	$	3,208,799	$	79,300	4.98	%	$	2,644,953	$	61,985	4.73	%	$	3,622,494	$	46,699	5.23	%	$	3,150,869	$	38,159	4.91	%
Taxable securities	614,488		7,597		2.49		567,192		6,190		2.20		820,981		5,823		2.88		590,623		3,529		2.42
Nontaxable securities (3)	212,305		2,561		2.43		223,499		2,572		2.32		149,825		950		2.57		223,631		1,341		2.43
Other interest earning assets	52,302		460		1.77		31,389		143		0.92		55,959		356		2.58		53,597		218		1.65
Total interest earning assets	4,087,894		89,918		4.44	%	3,467,033		70,890		4.12	%	4,649,259		53,828		4.70	%	4,018,720		43,247		4.36	%
Noninterest earning assets	552,736						427,894						668,066						534,865
Total assets	$	4,640,630					$	3,894,927					$	5,317,325					$	4,553,585
Interest Bearing Liabilities:
Certificates of deposit	$	420,834	$	1,557	0.75	%	$	357,209	$	894	0.50	%	$	502,153	$	1,440	1.16	%	$	423,569	$	760	0.73	%
Savings accounts	509,514		902		0.36		501,571		581		0.23		507,670		674		0.54		506,158		416		0.33
Interest bearing demand and money market accounts	1,771,084		1,696		0.19		1,483,972		1,198		0.16		2,051,046		1,489		0.29		1,745,795		784		0.18
Total interest bearing deposits	2,701,432		4,155		0.31		2,342,752		2,673		0.23		3,060,869		3,603		0.48		2,675,522		1,960		0.30
FHLB advances and other borrowings	57,546		552		1.93		104,148		442		0.86		1,849		15		3.29		35,733		150		1.70
Securities sold under agreement to repurchase	29,094		33		0.23		20,946		22		0.21		33,055		47		0.58		30,265		17		0.23
Junior subordinated debentures	20,071		598		6.01		19,786		487		4.96		20,328		354		7.06		20,035		283		5.73
Total interest bearing liabilities	2,808,143		5,338		0.38	%	2,487,632		3,624		0.29	%	3,116,101		4,019		0.52	%	2,761,555		2,410		0.35	%
Demand and other noninterest bearing deposits	1,144,479						869,910						1,332,223						1,113,286
Other noninterest bearing liabilities	62,094						45,890						102,550						63,770
Stockholders’ equity	625,914						491,495						766,451						614,974
Total liabilities and stockholders’ equity	$	4,640,630					$	3,894,927					$	5,317,325					$	4,553,585
Net interest income			$	84,580					$	67,266					$	49,809					$	40,837
Net interest spread					4.06	%					3.83	%					4.18	%					4.01	%
Net interest margin					4.17	%					3.91	%					4.34	%					4.12	%
Average interest earning assets to average interest bearing liabilities					145.57	%					139.37	%					149.20	%					145.52	%


⁽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 ~~$19.0~~$10.6 million, or ~~26.8%~~24.5%, to ~~$89.9~~$53.8 million for the ~~six~~three months ended ~~June 30, 2018~~March 31, 2019 compared to ~~$70.9~~$43.2 million for the same period in ~~2017.~~2018. The balance of average interest earning assets increased ~~$620.9~~$630.5 million, or ~~17.9%~~15.7%, to ~~$4.09~~$4.65 billion for the ~~six~~three months ended ~~June 30, 2018~~March 31, 2019 from ~~$3.47~~$4.02 billion for the ~~six~~three months ended ~~June 30, 2017~~March 31, 2018 and the yield on total interest earning assets increased 3234 basis points to ~~4.44%~~4.70% for the ~~six~~three months ended ~~June 30, 2018~~March 31, 2019 compared to ~~4.12%~~4.36% for the ~~six~~three months ended ~~June 30, 2017.~~March 31, 2018. 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 ~~$17.3~~$8.5 million, or ~~27.9%~~22.4%, to ~~$79.3~~$46.7 million for the ~~six~~three months ended ~~June 30, 2018~~March 31, 2019 from ~~$62.0~~$38.2 million for the same period in ~~2017~~2018 primarily due ~~primarily~~ to an increase in average total loans receivable, net of $471.6 million, or 15.0%, as a result of loan growth which was substantially due to the Premier and Puget Mergers. Additionally, interest income from interest and fees on loans increased as the loan yield increased 32 basis points to 5.23% for the three months ended March 31, 2019 from 4.91% for the three months ended March 31, 2018. The increase in loan yield was due to a ~~lesser extent by~~combination of higher contractual loan rates as a result of the increasing interest rate environment and an increase in loan ~~yields. Average total~~yields from the loans ~~receivable, net increased $563.8 million, or 21.3%, to $3.21 billion for~~acquired in the ~~six months ended June 30, 2018 compared to $2.64 billion for the six months ended June 30, 2017. Loan yields increased 25 basis points to 4.98% for the six months ended June 30, 2018~~Premier and

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~~from 4.73% for the six months ended June 30, 2017 due primarily~~Puget Mergers as compared to ~~an increase in market interest rates and to~~legacy Heritage loans, offset partially by a ~~lesser extent due to an increase~~decrease in incremental accretion on purchased ~~loans.~~loans substantially due to loans acquired in the Premier and Puget Mergers.

Incremental accretion income was $1.4 million and $1.6 million for the three months ended March 31, 2019 and 2018, respectively. 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 ~~six~~three months ended ~~June 30, 2018~~March 31, 2019 and ~~2017:~~2018:

Six Months Ended June 30,
2018 2017
(Dollars in thousands)
Loan yield, excluding incremental accretion on purchased loans ⁽¹⁾
4.75 % 4.53 %
Impact on loan yield from incremental accretion on purchased loans⁽¹⁾
0.23 % 0.20 %
Loan yield 4.98 % 4.73 %

Incremental accretion on purchased loans ⁽¹⁾
$ 3,624
$ 2,651



	Three Months Ended March 31,
	2019			2018
	(Dollars in thousands)
Loan yield (GAAP)	5.23		%	4.91		%
Exclude impact on loan yield from incremental accretion on purchased loans ⁽¹⁾	0.15			0.21
Loan yield, excluding incremental accretion on purchased loans (non-GAAP) ⁽¹⁾⁽²⁾	5.08		%	4.70		%

Incremental accretion on purchased loans ⁽¹⁾	$	1,373		$	1,632

⁽¹⁾

As of the ~~dates~~date of ~~the~~ completion of each ~~of the~~ merger and acquisition ~~transactions,~~transaction, 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~~accreted into income over the estimated remaining life of the loan or pool of loans, based upon results of the 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.


⁽²⁾	For additional information, see "Non-GAAP Financial Information."

~~Incremental accretion~~Interest income ~~was $3.6~~on investment securities increased $1.9 million, ~~and $2.7~~or 39.1%, to $6.8 million ~~for~~during the ~~six~~three months ended ~~June 30, 2018 and 2017, respectively.~~March 31, 2019 from $4.9 million during the three months ended March 31, 2018. The increase in ~~the incremental accretion~~interest on investment securities was primarily a result of ~~the loans acquired in the Puget Sound Merger, offset partially by~~ a continued decline in purchased loan balances including a decrease in the prepayments of purchased loans during the six months ended June 30, 2018 compared to the same period in 2017. The incremental accretion is expected to decrease as the balance of the purchased loans continues to decrease.

Total interest income increased primarily due to the increase in interest and fees on loans discussed above and secondarily due to a $1.4 million, or 15.9%, increase in interest income on investment securities to $10.2 million during the six months ended June 30, 2018 from $8.8 million for the six months ended June 30, 2017. The increase in interest income on investment securities was the result of a combination of an increase in investment yields for the six months ended June 30, 2018 compared to the same period in 2017 and ansignificant increase in the average balance of ~~investment securities during the periods. Yields on~~higher yielding taxable securities increased 29 basis points to 2.49% for the six months ended June 30, 2018 from 2.20% for the same period in 2017. Yields on nontaxable securities increased 11 basis points to 2.43% for the six months ended June 30, 2018 from 2.32% for the same period in 2017.securities. The average balance of investment securities increased ~~$36.1~~by $156.6 million, or ~~4.6%~~19.2%, to ~~$826.8~~$970.8 million during the ~~six~~three months ended ~~June 30, 2018~~March 31, 2019 from ~~$790.7~~$814.3 million during the ~~six~~three months ended ~~June 30, 2017.~~March 31, 2018. Additionally, interest income increased as a result of 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 March 31, 2019 compared to the same period in 2018. Yields on taxable securities increased 46 basis points to 2.88% for the three months ended March 31, 2019 from 2.42% for the same period in 2018. Yields on nontaxable securities increased 14 basis points to 2.57% for the three months ended March 31, 2019 from 2.43% for the same period in 2018. The Company ~~has~~ actively managed its investment securities portfolio to improve performance in ~~an increasing~~the changing rate ~~environment.~~environment over the past year.

~~Income on other~~Interest Expense

Total interest ~~earning assets~~expense increased ~~$317,000,~~$1.6 million, or ~~221.7%~~66.8%, to ~~$460,000 during~~$4.0 million for the ~~six~~three months ended ~~June 30,~~March 31, 2019 compared to $2.4 million for the same period in 2018. The average cost of interest bearing liabilities increased 17 basis points to 0.52% for the three months ended March 31, 2019 from 0.35% for the three months ended March 31, 2018 as a result of the rise in market interest rates. Total average interest bearing liabilities increased $354.5 million, or 12.8%, to $3.12 billion for the three months ended March 31, 2019 from $2.76 billion for the three months ended March 31, 2018 substantially due to the Premier and Puget Mergers.

The cost of interest bearing deposits increased 18 basis points to 0.48% for the three months ended March 31, 2019 from 0.30% for the same period in 2018 due ~~primarily~~ to a combination of an increase in market interest rates and an increase in the cost of interest bearing deposits acquired in the Premier and Puget Mergers. The increased cost of interest bearing deposits is primarily related to the interest bearing demand and money market deposits and certificates of deposits. The average ~~balances. Average other~~balance of interest ~~earning assets~~bearing demand and money market deposits increased ~~$20.9~~$305.3 million, or ~~66.6%~~17.5%, to ~~$52.3 million for~~$2.05 billion during the ~~six~~three months ended ~~June 30, 2018~~March 31, 2019 compared to $31.4 million for the six months ended June 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$1.75 billion during the same period in ~~2017.~~

~~Interest Expense~~

~~Total~~2018, and the cost of interest ~~expense~~bearing demand and money market deposits increased ~~$1.7~~11 basis points to 0.29% for the three months ended March 31, 2019 from 0.18% for the same period in 2018. The average balance of certificate of deposit accounts increased $78.6 million, or ~~47.3%~~18.6%, to ~~$5.3~~$502.2 million for the ~~six~~three months ended ~~June 30, 2018~~March 31, 2019 compared to ~~$3.6~~$423.6 million for the same period in 2017. The cost of interest bearing liabilities increased nine basis points to 0.38% for the six months ended June 30, 2018 from 0.29% for the six months ended June 30, 2017. Total average interest bearing liabilities increased by $320.5 million, or 12.9%, to $2.81 billion for the six months ended June 30, 2018 from $2.49 billion for the six months ended June 30, 2017. The increase in costs from the prior year was primarily a result of increases in market rates and the increased use of higher cost borrowings to fund asset growth.

The cost of interest bearing deposits increased eight basis points to 0.31% for the six months ended June 30, 2018 from 0.23% for the same period in 2017 due primarily to the increase in market interest rates.2018. The cost of certificates of deposit increased 43 basis points to ~~0.75%~~1.16% for the ~~six~~three months ended ~~June 30, 2018~~March 31, 2019 from ~~0.50%~~0.73% for the same period in ~~2017.~~ 2018.

Table of Contents

The Company was able to ~~mitigate~~reduce the impact of the rising market interest rates by increasing the average balance of noninterest bearing deposits at a higher growth rate than ~~that of~~the interest bearing ~~deposits.~~deposits described above. The average balance of noninterest bearing deposits increased by ~~$274.6~~$218.9 million, or ~~31.6%~~19.7%, ~~during~~to $1.33 billion for the ~~six~~three months ended ~~June 30, 2018 to $1.14 billion at June 30, 2018~~March 31, 2019 compared to ~~an increase in the average interest bearing demand and money market accounts of~~

~~Table of Contents~~

~~$287.1 million, or 19.3%, to $1.77~~$1.11 billion during the six months ended June 30, 2018 and an increase in the average certificates of deposit accounts by $63.6 million, or 17.8%, to $420.8 million for the six months ended June 30, 2018. The cost of all deposit accounts increased to 0.22% for the six months ended June 30, 2018 compared to 0.17% for the six months ended June 30, 2017.

Interest expense on FHLB advances and other borrowings increased $110,000, or 24.9%, to $552,000 for the six months ended June 30, 2018 from $442,000 for the six months ended June 30, 2017 due to a combination of an increase in the cost of funds and a decrease in average balance. The average rate of the FHLB advances and other borrowings for the six months ended June 30, 2018 was 1.93%, an increase of 107 basis points from 0.86% for the same period in ~~2017.~~2018. The ~~average balance for FHLB advances and other borrowings decreased $46.6 million~~total cost of deposits increased 12 basis points to ~~$57.5 million~~0.33% for the ~~six~~three months ended ~~June 30, 2018 from $104.1 million~~March 31, 2019 compared to 0.21% for the same period in ~~2017, due primarily to using cash and cash equivalents and proceeds from the sale of investment securities acquired in the Puget Sound Merger to pay down this higher cost funding source.~~2018.

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 133 basis points to 7.06%for the ~~six~~three months ended ~~June 30, 2018 was 6.01%, an increase of 105 basis points from 4.96%~~March 31, 2019 compared to 5.73% for the same period in ~~2017.~~2018. The rate increase on the debentures was due to an increase in the three-month LIBOR rate to ~~2.34%~~2.60% at ~~June 30, 2018~~March 31, 2019 from ~~1.30%~~2.32% on ~~June 30, 2017.~~

March 31, 2018.

Net Interest Margin

Net interest margin increased 22 basis points for the ~~six~~three months ended ~~June 30, 2018 increased 26 basis points~~March 31, 2019 to ~~4.17%~~4.34% from ~~3.91%~~4.12% for the same period in ~~2017~~2018 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 Puget Sound Merger.~~funds. The net interest spread increased 17 basis points for the ~~six~~three months ended ~~June 30, 2018 increased 23 basis points~~March 31, 2019 to ~~4.06%~~4.18% from ~~3.83%~~4.01% for the same period in ~~2017.~~2018 primarily due to the increase in yield earned on total interest earning assets.

Six Months Ended June 30,
2018 2017
Net interest margin, excluding incremental accretion on purchased loans ⁽¹⁾
3.99 % 3.76 %
Impact on net interest margin from incremental accretion on purchased loans ⁽¹⁾
0.18
0.15
Net interest margin 4.17 % 3.91 %



	Three Months Ended March 31,
	2019		2018
Net interest margin (GAAP)	4.34	%	4.12	%
Exclude impact on net interest margin from incremental accretion on purchased loans ⁽¹⁾	0.12		0.16
Net interest margin, excluding incremental accretion on purchased loans (non-GAAP)⁽¹⁾⁽²⁾	4.22	%	3.96	%

⁽¹⁾


⁽²⁾	For additional information, see "Non-GAAP Financial Information."

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 six~~ months ended ~~June 30,~~March 31, 2019 and 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 June 30, 2018 to the comparable quarter in the prior year.~~

The provision for loan losses ~~increased $619,000,~~decreased $232,000, or ~~54.7%~~20.1%, to ~~$1.8 million~~$920,000 for the three months ended ~~June 30, 2018~~March 31, 2019 from ~~$1.1~~$1.2 million for the three months ended ~~June 30, 2017.~~March 31, 2018. The ~~increase~~decrease in the provision for loan losses for the three months ended ~~June 30, 2018~~March 31, 2019 from the same period in ~~2017~~2018 was primarily the result of ~~changes~~a $167,000 increase in ~~our volume~~net recoveries during the quarter ended March 31, 2019 compared to the same period in 2018 coupled with continued relatively stable and ~~mix of loans, asset~~strong credit quality ~~certain environmental and historical loss factors and as a result of the impact of loan~~

~~Table of Contents~~

~~growth.~~metrics. Based on a thorough review of the loan portfolio, the Bank determined that the provision for loan losses for the three months ended ~~June 30, 2018~~March 31, 2019 was appropriate as it was calculated in accordance with the Bank's methodology for determining the allowance for loan losses.

~~Comparison of six months ended June 30, 2018 to the comparable period in the prior year~~

The provision for loan losses increased $904,000, or 45.2% to $2.9 million for the six months ended June 30, 2018 from $2.0 million for the six months ended June 30, 2017. The increase in the provision for loan losses for the six months ended June 30, 2018 from the same period in 2017 was primarily the result of changes in our volume and mix of loans, asset quality, certain environmental and historical loss factors and as a result of the impact of loan growth. Based on a thorough review of the loan portfolio, the Bank determined that the provision for loan losses for the six months ended June 30, 2018 was appropriate as it was calculated in accordance with the Bank's methodology for determining the allowance for loan losses.

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Noninterest Income

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

Total noninterest income decreased ~~$3.1 million,~~$140,000, or ~~29.3%~~1.9%, to ~~$7.6~~$7.4 million for the three months ended ~~June 30, 2018~~March 31, 2019 compared to ~~$10.7~~$7.5 million for the same period in ~~2017.~~2018. The following table presents the change in the key components of noninterest income for the periods ~~noted.~~noted:


	Three Months Ended June 30,									Three Months Ended March 31,
	2018		2017		Change			Percentage Change		2019		2018		Change			Percentage Change
	(Dollars in thousands)									(Dollars in thousands)
Service charges and other fees	$	4,695	$	4,426	$	269		6.1	%	$	4,485	$	4,543	$	(58	)	(1.3	)%
Gain on sale of investment securities, net	18		117		(99		)	(84.6	)	15		35		(20		)	(57.1	)
Gain on sale of loans, net	706		4,138		(3,432		)	(82.9	)	252		874		(622		)	(71.2	)
Interest rate swap fees	309		282		27			9.6		—		51		(51		)	(100.0	)
Other income	1,845		1,746		99			5.7		2,656		2,045		611			29.9
Total noninterest income	$	7,573	$	10,709	$	(3,136	)	(29.3	)%	$	7,408	$	7,548	$	(140	)	(1.9	)%

Gain on the sale of loans, net decreased $3.4 million, or 82.9%, to $706,000 for the three months ended June 30, 2018 compared to $4.1 million the same period in 2017, due primarily to the gain on sale of a previously classified purchased credit impaired loan of $3.0 million recognized during the three months ended June 30, 2017.

Gain on sale of loans, net ~~additionally~~ decreased ~~based on~~primarily due to a decline in ~~U.S.~~the volume of mortgage loans originated and sold during the quarter ended March 31, 2019 and the Company's decision to continue to portfolio originated Small Business Administration ("SBA") loans. Mortgage loan originations ~~and~~decreased by $11.8 million, or 57.8%, to $8.6 million for the three months ended March 31, 2019 from $20.4 millionfor the three months ended March 31, 2018. Proceeds from mortgage ~~banking activities~~loan sales decreased by $13.2 million, or 63.9%, to $7.5 million for the three months ended March 31, 2019 from $20.7 millionfor the three months ended March 31, 2018. The Company also recognized a decrease in the gain on sale of the guaranteed portion of SBA loans during the three months ended ~~June 30, 2018~~March 31, 2019 compared to the same period in ~~2017.~~2018 as it was more advantageous for the Company to keep these loans in the portfolio based on market rates. The detail of gain on sale of loans, net is included in the following schedule.


	Three Months Ended June 30,									Three Months Ended March 31,
	2018		2017		Change			Percentage Change		2019		2018		Change			Percentage Change
	(Dollars in thousands)									(Dollars in thousands)
Gain on sale of mortgage loans, net	$	572	$	731	$	(159	)	(21.8	)%	$	252	$	652	$	(400	)	(61.3	)%
Gain on sale of guaranteed portion of SBA loans, net	134		409		(275		)	(67.2	)	—		222		(222		)	(100.0	)
Gain on sale of other loans, net	—		2,998		(2,998		)	(100.0	)
Gain on sale of loans, net	$	706	$	4,138	$	(3,432	)	(82.9	)%	$	252	$	874	$	(622	)	(71.2	)%

~~The decrease~~These decreases in noninterest income ~~was~~were offset partially by an increase in ~~service charges and~~ other ~~fees~~income of ~~$269,000,~~$611,000, or ~~6.1%~~29.9% to ~~$4.7~~$2.7 million for the three months ended ~~June 30, 2018~~March 31, 2019 compared to ~~$4.4~~$2.0 million for the same period in ~~2017,~~2018, due primarily to ~~an increase~~increases in deposit balances and changes in fee structures on deposit accounts, including a business deposit consolidation process completed during second quarter 2017. Secondarily, service charges and other fees increased as a resultrecoveries of zero-balance purchased loan notes which were charged-off prior to the consummation of the ~~deposit accounts acquired~~related acquisition and increases in wealth management and trust services income during the ~~Puget Sound Merger.~~three months ended March 31, 2019.

~~Table of Contents~~

~~Comparison of six months ended June 30, 2018 to the comparable period in the prior year~~

Total noninterest income decreased $3.0 million, or 16.3%, to $15.1 million for the six months ended June 30, 2018 compared to $18.1 million for the same period in 2017. The following table presents the change in the key components of noninterest income for the periods noted.

Six Months Ended June 30,
2018 2017 Change Percentage Change
(Dollars in thousands)
Service charges and other fees $ 9,238
$ 8,639
$ 599
6.9 %
Gain on sale of investment securities, net 53
117
(64 ) (54.7 )
Gain on sale of loans, net 1,580
5,333
(3,753 ) (70.4 )
Interest rate swap fees 360
415
(55 ) (13.3 )
Other income 3,890
3,568
322
9.0
Total noninterest income $ 15,121
$ 18,072
$ (2,951 ) (16.3 )%

Service charges and other fees increased $599,000, or 6.9% to $9.2 million for the six months ended June 30, 2018 compared to $8.6 million for the same period in 2017, due primarily to an increase in deposit balances and changes in fee structures on deposit accounts, including a business deposit consolidation process completed during second quarter 2017 and deposit accounts acquired in the Puget Sound Merger.

Gain on sale of loans, net decreased $3.8 million, or 70.4% to $1.6 million for the six months ended June 30, 2018 compared to $5.3 million for the same period in 2017, due primarily the gain on sale of a previously classified as purchased credit impaired loan of $3.0 million recognized during the six months ended June 30, 2017. Gain on sale of mortgage and SBA loans also decreased during the six months ended June 30, 2018 compared to the same period in 2017 primarily due to less activity. Proceeds from sale of loans decreased $31.5 million, or 44.1% to $40.0 million for the six months ended June 30, 2018 from $71.4 million for the same period in 2017. The detail of gain on sale of loans, net is included in the following schedule.

Six Months Ended June 30,
2018 2017 Change Percentage Change
(Dollars in thousands)
Gain on sale of mortgage loans, net $ 1,224
$ 1,640
$ (416 ) (25.4 )%
Gain on sale of guaranteed portion of SBA loans, net 356
695
(339 ) (48.8 )
Gain on sale of other loans, net —
2,998
(2,998 ) (100.0 )
Gain on sale of loans, net $ 1,580
$ 5,333
$ (3,753 ) (70.4 )%

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Noninterest Expense

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

Noninterest expense ~~increased $7.9 million,~~decreased $222,000, or ~~28.4%~~0.6%, to ~~$35.7~~$36.5 million during the three months ended ~~June 30, 2018 compared to $27.8~~March 31, 2019 from $36.7 million ~~for~~during the three months ended ~~June 30, 2017.~~ March 31, 2018. Acquisition-related expenses incurred as a result of the Premier and Puget Mergers were $132,000 during the quarter ended March 31, 2019 as compared to $4.8 million during the quarter ended March 31, 2018. The following table presents changes in the key components of noninterest expense for the periods ~~noted.~~noted:

Three Months Ended June 30,
2018 2017 Change Percentage Change
(Dollars in thousands)
Compensation and employee benefits $ 19,321
$ 16,272
$ 3,049
18.7 %
Occupancy and equipment 4,810
3,818
992
26.0
Data processing 2,507
2,002
505
25.2
Marketing 823
805
18
2.2
Professional services 3,529
1,053
2,476
235.1
State and local taxes 716
639
77
12.1
Federal deposit insurance premium 375
357
18
5.0
Other real estate owned, net —
21
(21 ) (100.0 )
Amortization of intangible assets 796
323
473
146.4
Other expense 2,829
2,519
310
12.3
Total noninterest expense $ 35,706
$ 27,809
$ 7,897
28.4 %

The Company has incurred significant non-recurring acquisition costs. The following table presents these expenses by key component. There were no such expenses incurred during the three months ended June 30, 2017.



	Three Months Ended March 31,
	2019		2018		Change			Percentage Change
	(Dollars in thousands)
Compensation and employee benefits	$	21,914	$	21,367	$	547		2.6	%
Occupancy and equipment	5,458		4,627		831			18.0
Data processing	2,173		2,605		(432		)	(16.6	)
Marketing	1,098		808		290			35.9
Professional services	1,173		2,837		(1,664		)	(58.7	)
State and local taxes	798		688		110			16.0
Federal deposit insurance premium	285		355		(70		)	(19.7	)
Other real estate owned, net	86		—		86			N/A
Amortization of intangible assets	1,025		795		230			28.9
Other expense	2,515		2,665		(150		)	(5.6	)
Total noninterest expense	$	36,525	$	36,747	$	(222	)	(0.6	)%

Three Months Ended June 30,
2018

Compensation and employee benefits $ 67
Occupancy and equipment 28
Data processing 425
Marketing 5
Professional services 337
Other expense 18
Total acquisition costs $ 880

Compensation and employee benefits increased ~~$3.0 million,~~$547,000, or ~~18.7%~~2.6%, to ~~$19.3~~$21.9 million during the three months ended ~~June 30, 2018~~March 31, 2019 from ~~$16.3~~$21.4 million during the three months ended ~~June 30, 2017. The increase in the three months ended June 30,~~March 31, 2018 ~~compared to 2017 was~~ primarily as a result of additional employees, ~~primarily~~substantially due to the Premier and Puget Mergers, offset by recognition of acquisition-related expenses of $2.8 million related to the Puget Sound Merger ~~and standard salary increases.~~during the quarter ended March 31, 2018. The average full time equivalent employees increased to ~~819~~878 for the three months ended ~~June 30, 2018~~March 31, 2019 compared to ~~750~~796 for the same period in ~~2017.~~2018.

~~Professional services~~Occupancy and equipment increased ~~$2.5 million,~~$831,000, or ~~235.1%~~18.0%, to ~~$3.5~~$5.5 million during the three months ended ~~June 30, 2018~~March 31, 2019 from ~~$1.1~~$4.6 million during the three months ended ~~June 30, 2017~~March 31, 2018 due substantially ~~due~~to branch expansion, including additional leased space in the Seattle, Bellevue, Portland and other Oregon markets. The Bellevue expansion included a full quarter of expenses related to the buy-out of a third party contract in the amount $1.7 million. The third party assisted the Company in its deposit product realignment and was compensated based on success factors over the three years subsequent to implementation. The Company assessed the contract and determined that it was advantageous to buy-out the contract prior to the system conversions relating tolease 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. 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. In addition, professional services costs also increased in 2018 compared to 2017 as a result of acquisition costs.

~~Occupancy and equipment increased $992,000,~~Data processing decreased$432,000, or ~~26.0%~~16.6%, to ~~$4.8~~$2.2 million the three months ended March 31, 2019 from $2.6 million during the three months ended ~~June 30,~~March 31, 2018 ~~from $3.8 million~~primarily reflecting acquisition-related expenses of $352,000 incurred during the three months ended ~~June 30, 2017. The increase in the three months ended June 30,~~March 31, 2018 ~~compared to 2017 was substantially related to expansion in the Seattle, Bellevue and Portland branches.~~

~~Table of Contents~~

~~The Bellevue expansion included the lease obtained from the Puget Sound Merger and more space leased subsequent to the merger.~~

Data processing increased $505,000, or 25.2%, to $2.5 million during the three months ended June 30, 2018 from $2.0 million during the three months ended June 30, 2017 substantially due to core system conversion costs related to the Puget Sound Merger recognized during the three months ended June 30, 2018 as well as additional operation costs associated with the increase in balances and transaction volume as a result of the Puget Sound Merger.

~~Amortization of intangible assets increased $473,000,~~Professional services decreased $1.7 million, or ~~146.4%~~58.7%, to ~~$796,000~~$1.2 million during the three months ended ~~June 30, 2018~~March 31, 2019 from ~~$323,000~~$2.8 million during the three months ended ~~June 30, 2017. The increase in the three months ended June 30,~~March 31, 2018 ~~compared to 2017 was~~as a result of ~~the amortization~~non-recurring acquisition-related expenses of ~~the core deposit intangible recorded in~~$1.6 million related to the Puget Sound Merger ~~of $513,000~~ during the ~~three months~~quarter ended ~~June 30,~~March 31, 2018.

The ratio of noninterest expense to average total assets (annualized) was ~~3.03%~~2.79% for the three months ended ~~June 30, 2018~~March 31, 2019 compared to ~~2.85%~~3.27% for the three months ended ~~June 30, 2017.~~March 31, 2018. The ~~increase~~decrease was primarily ~~a result of increased~~due to acquisition-related expenses as a result of the Puget Sound Merger ~~in addition to the buy-out of the third party contract and acquisition costs recognized~~ during the ~~three months~~quarter ended ~~June 30,~~March 31, 2018.

~~Comparison of six months ended June 30, 2018 to the comparable period in the prior year~~

Noninterest expense increased $17.4 million, or 31.7%, to $72.5 million during the six months ended June 30, 2018 compared to $55.0 million for the six months ended June 30, 2017. The following table presents changes in the key components of noninterest expense for the periods noted.

Six Months Ended June 30,
2018 2017 Change Percentage Change
(Dollars in thousands)
Compensation and employee benefits $ 40,688
$ 32,296
$ 8,392
26.0 %
Occupancy and equipment 9,437
7,628
1,809
23.7
Data processing 5,112
3,917
1,195
30.5
Marketing 1,631
1,612
19
1.2
Professional services 6,366
2,062
4,304
208.7
State and local taxes 1,404
1,188
216
18.2
Federal deposit insurance premium 730
657
73
11.1
Other real estate owned, net —
52
(52 ) (100.0 )
Amortization of intangible assets 1,591
647
944
145.9
Other expense 5,494
4,973
521
10.5
Total noninterest expense $ 72,453
$ 55,032
$ 17,421
31.7 %

Six Months Ended June 30,
2018

Compensation and employee benefits $ 2,891
Occupancy and equipment 37
Data processing 777
Marketing 5
Professional services 1,935
Other expense 43
Total acquisition costs $ 5,688

Compensation and employee benefits increased $8.4 million, or 26.0%, to $40.7 million during the six months ended June 30, 2018 from $32.3 million during the six months ended June 30, 2017. The increase in the six months ended June 30, 2018 compared to 2017 was primarily due to increases in employees primarily due to the Puget Sound

~~Table of Contents~~

Merger, increases in senior level staffing, and increases in standard salary in addition to acquisition-related payments related to the Puget Sound Merger of $2.9 million during the six months ended June 30, 2018.

Occupancy and equipment increased $1.8 million, or 23.7%, to $9.4 million during the six months ended June 30, 2018 from $7.6 million during the six months ended June 30, 2017. The increase in the three months ended June 30, 2018 compared to 2017 was substantially related to expansion in the Seattle, Bellevue and Portland branches. The Bellevue expansion included the lease obtained from the Puget Sound Merger and more space leased subsequent to the merger.

Data processing increased $1.2 million, or 30.5%, to $5.1 million during the six months ended June 30, 2018 from $3.9 million during the six months ended June 30, 2017 primarily due to acquisition costs. The increase in the six months ended June 30, 2018 compared to 2017 was additionally due to higher transactional activity in the core operating system and internet banking as a result of the Puget Sound Merger and organic growth in loans and deposits.

Professional services increased $4.3 million, or 208.7%, to $6.4 million during the six months ended June 30, 2018 from $2.1 million during the six months ended June 30, 2017 partially due to acquisition costs incurred during the six months ended June 30, 2018 of $1.9 million. The increase in the six months ended June 30, 2018 compared to 2017 was additionally the result of the buy-out of a third party contract in the amount of $1.7 million during the six months ended June 30, 2018. As previously mentioned, 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.

Amortization of intangible assets increased $944,000, or 145.9%, to $1.6 million during the six months ended June 30, 2018 from $647,000 during the six months ended June 30, 2017. The increase in the three months ended June 30, 2018 compared to 2017 was a result of the amortization of the core deposit intangible recorded in the Puget Sound Merger of $1.0 million during the six months ended June 30, 2018.

The ratio of noninterest expense to average assets was 3.15% for the six months ended June 30, 2018, compared to 2.85% for the six months ended June 30, 2017. The increase was primarily a result of increased expenses as a result of the Puget Sound Merger and acquisition costs recognized during the six months ended June 30, 2018.

Income Tax Expense

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

~~Income~~The effective tax ~~expense decreased $2.1 million, or 50.8%, to $2.0 million~~rate was 16.3% for the three months ended ~~June 30, 2018 from $4.1 million for the three months ended June 30, 2017. The effective tax rate was 14.5% for the three months ended June 30, 2018~~March 31, 2019 compared to ~~25.6%~~13.3% for the same period in ~~2017.~~2018. The ~~decrease~~increase in the income tax expense and effective tax rate during the ~~six~~three months ended ~~June 30, 2018~~March 31, 2019 was primarily due to ~~the impact of the Tax Cuts and Jobs Actenacted in December 2017, which lowered the corporate income tax rate to 21% from 35%.~~

~~Comparison of six months ended June 30, 2018 to the comparable period in the prior year~~

Income tax expense decreased $3.8 million, or 52.5%, to $3.4 million for the six months ended June 30, 2018 from $7.2 million for the six months ended June 30, 2017. The effective tax rate was 14.0% for the six months ended June 30, 2018 compared to 25.3% for the same period in 2017. Thea decrease in ~~the income tax expense~~nontaxable securities, impacts of stock-based compensation activity, and ~~effective tax rate during the six months ended June 30, 2018 was primarily due to the impact of the Tax Cuts and Jobs Act, offset partially by the increase in certain non-deductible acquisition costs.~~an increased Oregon presence.

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Non-GAAP Financial Information

This report contains certain financial information determined by methods other than in accordance with accounting principles generally accepted in the United States of America. These measures include net interest income, interest and fees on loans, and loan yield and net interest margin excluding the effect of the incremental accretion on purchased loans acquired through mergers. Our management uses these non-GAAP measures, together with the related GAAP measures, in its analysis of our performance and in making business decisions. Management also uses these measures for peer comparisons. Management believes that presenting loan yield and net interest margin excluding the effect of the acquisition accounting discount accretion on loans acquired through mergers is useful in assessing the impact of acquisition accounting on loan yield and net interest margin, as the effect of loan discount accretion is expected to decrease as the acquired loans mature or roll off our balance sheet. These disclosures should not be viewed as substitutes for the results determined to be in accordance with GAAP, nor are they necessarily comparable to non-GAAP performance measures that may be presented by other companies.

Reconciliations of the GAAP and non-GAAP financial measures on net interest income, interest and fees on loans, loan yield and net interest margin are presented below:



	March 31, 2019			March 31, 2018
	(Dollars in thousands)
Net interest income and interest and fees on loans:
Net interest income (GAAP)	$	49,809		$	40,837
Exclude incremental accretion on purchased loans	1,373			1,632
Adjusted net interest income (non-GAAP)	$	48,436		$	39,205

Average total interest earning assets, net	$	4,649,259		$	4,018,720
Net interest margin, annualized (GAAP)	4.34		%	4.12		%
Net interest margin, excluding incremental accretion on purchased loans, annualized (non-GAAP)	4.22		%	3.96		%

Interest and fees on loans (GAAP)	$	46,699		$	38,159
Exclude incremental accretion on purchased loans	1,373			1,632
Adjusted interest and fees on loans (non-GAAP)	$	45,326		$	36,527

Average total loans receivable, net	$	3,622,494		$	3,150,869
Loan yield, annualized (GAAP)	5.23		%	4.91		%
Loan yield, excluding incremental accretion on purchased loans, annualized (non-GAAP)	5.08		%	4.70		%

Table of Contents

Financial Condition Overview

The table below provides a comparison of the changes in the Company's financial condition from December 31, ~~2017~~2018 to ~~June 30, 2018, and the results of the Puget Sound Merger effective January 16, 2018:~~March 31, 2019:


	June 30, 2018			December 31, 2017			Change			Percentage Change		Fair Value of Puget Sound at Merger Date		March 31, 2019		December 31, 2018			Change			% Change
	(Dollars in thousands)													(Dollars in thousands)
Assets
Cash and cash equivalents	$	129,943		$	103,015		$	26,928		26.1	%	$	80,136	$	111,170	$	161,910		$	(50,740	)	(31.3	)%
Investment securities available for sale, at fair value	873,670			810,530			63,140			7.8		80,353		985,009		976,095			8,914			0.9
Loans held for sale	3,598			2,288			1,310			57.3		—		2,956		1,555			1,401			90.1
Total loans receivable, net	3,294,316			2,816,985			477,331			16.9		388,462		3,660,279		3,619,118			41,161			1.1
Other real estate owned	434			—			434			N/A		—		1,904		1,983			(79		)	(4.0	)
Premises and equipment, net	75,364			60,325			15,039			24.9		732		80,130		81,100			(970		)	(1.2	)
Federal Home Loan Bank stock, at cost	8,616			8,347			269			3.2		623		7,377		6,076			1,301			21.4
Bank owned life insurance	82,031			75,091			6,940			9.2		6,264		94,099		93,612			487			0.5
Accrued interest receivable	13,482			12,244			1,238			10.1		1,448		15,621		15,403			218			1.4
Prepaid expenses and other assets	104,718			99,328			5,390			5.4		1,354		123,026		98,522			24,504			24.9
Other intangible assets, net	15,767			6,088			9,679			159.0		11,270		19,589		20,614			(1,025		)	(5.0	)
Goodwill	187,549			119,029			68,520			57.6		68,520		240,939		240,939			—			—
Total assets	$	4,789,488		$	4,113,270		$	676,218		16.4	%	$	639,162	$	5,342,099	$	5,316,927		$	25,172		0.5	%

Liabilities
Deposits	$	3,968,935		$	3,393,060		$	575,875		17.0	%	$	505,885	$	4,393,715	$	4,432,402		$	(38,687	)	(0.9	)%
Federal Home Loan Bank advances	75,500			92,500			(17,000		)	(18.4	)	—		25,000		—			25,000			100
Junior subordinated debentures	20,156			20,009			147			0.7		—		20,375		20,302			73			0.4
Securities sold under agreement to repurchase	22,168			31,821			(9,653		)	(30.3	)	—		24,923		31,487			(6,564		)	(20.8	)
Accrued expenses and other liabilities	63,206			67,575			(4,369		)	(6.5	)	2,504		99,895		72,013			27,882			38.7
Total liabilities	4,149,965			3,604,965			545,000			15.1		508,389		4,563,908		4,556,204			7,704			0.2
Stockholders' equity
Common stock	491,026			360,590			130,436			36.2		130,773		591,767		591,806			(39		)	—
Retained earnings	159,803			149,013			10,790			7.2		—		185,863		176,372			9,491			5.4
Accumulated other comprehensive loss, net	(11,306		)	(1,298		)	(10,008		)	771.0		—
Accumulated other comprehensive gain (loss), net														561		(7,455		)	8,016			(107.5	)
Total stockholders' equity	639,523			508,305			131,218			25.8		130,773		778,191		760,723			17,468			2.3
Total liabilities and stockholders' equity	$	4,789,488		$	4,113,270		$	676,218		16.4	%	$	639,162	$	5,342,099	$	5,316,927		$	25,172		0.5	%

Total assets increased ~~$676.2~~$25.2 million, or ~~16.4%~~0.5%, to ~~$4.79~~$5.34 billion as of ~~June 30, 2018~~March 31, 2019 compared to ~~$4.11~~$5.32 billion as of December 31, 2017. The Puget Sound Merger resulted in an increase of total assets, including goodwill, of $639.2 million at the merger date. The Company utilized cash and cash proceeds from the sale of investment securities acquired in the Puget Sound Merger to pay down FHLB advances during the six months ended June 30, 2018.

Total loans receivable, net, ~~excluding loans acquired in the Puget Sound Merger~~ increased ~~$88.9~~$41.2 million, or ~~6.4% annualized,~~1.1%, to $3.66 billion during the ~~six~~three months ended ~~June 30, 2018.~~March 31, 2019. Total loans receivable, net, continued to be impacted by slightly elevated prepayments in addition to the seasonably low loan originations experienced during the three months ended March 31, 2019. The commercial loan pipeline during the first quarter grew by 39% from year-end.

Investment securities available for sale increased ~~$63.1~~$8.9 million, or ~~7.8%~~0.9%, to ~~$873.7~~$985.0 million at ~~June 30, 2018~~March 31, 2019 from ~~$810.5~~$976.1 million at December 31, ~~2017~~2018 primarily as a result of ~~investment purchases, offset partially by maturities, calls~~a decrease in net unrealized losses of $10.2 million due to a decrease in interest rates during the three months ended March 31, 2019 that positively impacted the fair value of our bond portfolio.

Prepaid expenses and ~~payments~~other assets increased $24.5 million, or 24.9%, to $123.0 million at March 31, 2019 from $98.5 million at December 31, 2018 primarily due to the adoption of ~~investment securities. The investment securities acquired in~~Accounting Standards Update 2016-02, Leases, and the ~~Puget Sound Merger were sold shortly after the merger.~~recognition of an operating lease right of use asset. An offsetting operating lease right of use liability

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~~Deposits, excluding Puget Sound Merger, increased $70.0~~was recorded in accrued expenses and other liabilities. As of March 31, 2019, the right of use asset was $28.4 million and the related liability was $29.5 million.

Total deposits decreased $38.7 million or ~~4.2% annualized,~~0.9% during the ~~six~~three months ended ~~June 30, 2018. Brokered~~March 31, 2019. The decrease was due primarily to non-maturity deposits ~~increased $18.0~~declining $92.9 million, or ~~45.6%~~2.3%, to ~~$57.6~~$3.87 billion, offset partially by an increase in certificates of deposit of $54.2 million, ~~at June 30, 2018 compared~~or 11.6%, to ~~$39.6~~$521.1 million. The increase in certificates of deposit was due primarily to an increase in brokered certificates of deposit of $50.1 million during the quarter ended March 31, 2019 in response to the decrease in non-maturity deposits. Non-maturity deposits as a percentage of total deposits decreased to 88.1% as of March 31, 2019 from 89.5% at December 31, 2017. Total non-maturity deposits increased to 88.4% of total deposits at June 30, 2018 from 88.3% at December 31, 2017 and certificates of deposit decreased to 11.6% of total deposits at June 30, 2018 from 11.7% at December 31, 2017.2018.

The Company had $25.0 million Federal Home Loan Bank ("FHLB") advances ~~decreased $17.0 million, or 18.4%, to $75.5 million as of June 30, 2018 from $92.5 million as of December~~at March 31, ~~2017. The decrease was due to the repayment of~~2019. There were no FHLB advances ~~using cash and cash proceeds from the sale of investment securities acquired in the Puget Sound Merger.~~

~~Total stockholders’ equity increased $131.2 million, or 25.8%, to $639.5 million as of June 30, 2018 from $508.3 million~~ at December 31, 2017. The Company’s equity position was 13.4% of total assets as of June 30, 2018 and 12.4% as of December 31, 2017. Changes in stockholders' equity during the six months ended June 30, 2018 were as follows:

Six Months Ended
June 30, 2018
(In thousands)
Balance, beginning of period $ 508,305
   Common stock issued in the Puget Sound Merger 130,770
   Net income 20,944
   Dividends declared (10,247 )
   Accumulated other comprehensive loss (9,915 )
   Other (334 )
Balance, end of period $ 639,523
2018.

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 ~~$477.3~~$41.2 million, or ~~16.9%~~1.1%, to ~~$3.29~~$3.66 billion at ~~June 30, 2018~~March 31, 2019 from ~~$2.82~~$3.62 billion at December 31, 2017. The increase in loans receivable was primarily due to the Puget Sound Merger. At the merger date, the Bank acquired fair value of commercial and industrial loans of $182.0 million, non-owner occupied commercial real estate loans of $101.2 million, and owner-occupied commercial real estate loans of $82.3 million.

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2018.

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


	June 30, 2018				December 31, 2017									March 31, 2019				December 31, 2018
	Balance		% of Total ⁽³⁾		Balance		% of Total ⁽³⁾		Change			%of Balance Change		Balance⁽¹⁾		% of Total ⁽²⁾		Balance⁽¹⁾		% of Total ⁽²⁾		Change			%of Balance Change
	(Dollars in thousands)													(Dollars in thousands)
Commercial business:
Commercial and industrial	$	800,043	24.0	%	$	645,396	22.7	%	$	154,647		24.0	%	$	838,403	22.7	%	$	853,606	23.4	%	$	(15,203	)	(1.8	)%
Owner-occupied commercial real estate	693,330		20.8		622,150		21.8		71,180			11.4		785,316		21.2		779,814		21.3		5,502			0.7
Non-owner occupied commercial real estate	1,187,548		35.7		986,594		34.6		200,954			20.4		1,335,596		36.1		1,304,463		35.7		31,133			2.4
Total commercial business	2,680,921		80.5		2,254,140		79.1		426,781			18.9		2,959,315		80.0		2,937,883		80.4		21,432			0.7
One-to-four family residential ⁽¹⁾⁽³⁾	92,518		2.8		86,997		3.1		5,521			6.3		106,502		2.9		101,763		2.8		4,739			4.7
Real estate construction and land development:
One-to-four family residential	71,934		2.2		51,985		1.8		19,949			38.4		110,699		3.0		102,730		2.8		7,969			7.8
Five or more family residential and commercial properties	93,315		2.8		97,499		3.4		(4,184		)	(4.3	)	126,379		3.4		112,730		3.1		13,649			12.1
Total real estate construction and land development ⁽²⁾⁽³⁾	165,249		5.0		149,484		5.2		15,765			10.5		237,078		6.4		215,460		5.9		21,618			10.0
Consumer	385,987		11.6		355,091		12.5		30,896			8.7		390,303		10.6		395,545		10.8		(5,242		)	(1.3	)
Gross loans receivable	3,324,675		99.9		2,845,712		99.9		478,963			16.8		3,693,198		99.9		3,650,651		99.9		42,547			1.2
Net deferred loan costs	3,613		0.1		3,359		0.1		254			7.6		3,233		0.1		3,509		0.1		(276		)	(7.9	)
Loans receivable, net	$	3,328,288	100.0	%	$	2,849,071	100.0	%	$	479,217		16.8	%	$	3,696,431	100.0	%	$	3,654,160	100.0	%	$	42,271		1.2	%

⁽¹⁾ ~~Excludes loans held for sale of $3.6 million, and $2.3 million as of June 30, 2018 and December 31, 2017, respectively.~~

⁽²⁾ Balances do not include undisbursed loan commitments.

⁽³⁾⁽²⁾ Percent of loans receivable, net.

⁽³⁾Excludes loans held for sale of $3.0 million, and $1.6 million as of March 31, 2019 and December 31, 2018, respectively.

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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.~~dates:


	June 30, 2018			December 31, 2017			March 31, 2019			December 31, 2018
	(Dollars in thousands)						(Dollars in thousands)
Nonaccrual loans:
Commercial business	$	15,235		$	9,098		$	16,304		$	12,564
One-to-four family residential	77			81			68			71
Real estate construction and land development	1,084			1,247			923			899
Consumer	127			277			166			169
Total nonaccrual loans ⁽¹⁾	16,523			10,703			17,461			13,703
Other real estate owned	434			—			1,904			1,983
Total nonperforming assets	$	16,957		$	10,703		$	19,365		$	15,686

Allowance for loan losses	$	33,972		$	32,086		$	36,152		$	35,042
Nonperforming loans to loans receivable, net	0.50		%	0.38		%	0.47		%	0.37		%
Allowance for loan losses to loans receivable, net	1.02		%	1.13		%	0.98		%	0.96		%
Allowance for loan losses to nonperforming loans	205.60		%	299.79		%	207.04		%	255.73		%
Nonperforming assets to total assets	0.35		%	0.26		%	0.36		%	0.30		%

Performing TDR loans:
Commercial business	$	25,488		$	25,729		$	19,348		$	22,170
One-to-four family residential	214			218			206			208
Real estate construction and land development	—			645			—			—
Consumer	255			165			432			358
Total performing TDR loans	$	25,957		$	26,757		$	19,986		$	22,736
Accruing loans past due 90 days or more	$	—		$	—		$	—		$	—
Potential problem loans	101,491			83,543			94,116			101,349


⁽¹⁾	At ~~June 30, 2018~~March 31, 2019 and December 31, ~~2017, $6.8~~2018, $5.5 million and ~~$5.2~~$6.9 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 $6.3 million to $17.0 million, or 0.35% of total assets at June 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 below. Nonperforming assets additionally increased due to the addition of one other real estate owned property of $434,000 during the six months ended June 30, 2018. ~~There was no other real estate owned at December 31, 2017.~~

Nonaccrual Loans. Nonaccrual loans increased ~~$5.8~~$3.8 million to ~~$16.5~~$17.5 million, or ~~0.50%~~0.47% of loans receivable, net, at ~~June 30, 2018~~March 31, 2019 from ~~$10.7~~$13.7 million, or ~~0.38%~~0.37% of loans receivable, net, at December 31, ~~2017.~~2018. The increase was ~~due~~ primarily related to ~~three agricultural loan~~the addition of two commercial lending relationships that were transferred to nonaccrual status during the ~~six~~three months ended ~~June 30, 2018~~March 31, 2019 totaling ~~$4.6~~$5.1 million ~~at June 30, 2018. Two~~that were transferred to nonaccrual status due to increased signs of cash flow deterioration. Management has allocated a specific reserve totaling $781,000 for these two credit relationships are well-secured, and the Company did not record a related allowance for loan losses. The other relationship is partially guaranteed by the SBA and the Company recorded an allowance for loan losses of $91,000 at June 30, 2018 related to the unguaranteed portion of the loan.relationships.

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The following table reflects the changes in nonaccrual loans during the ~~six~~three months ended ~~June 30,~~March 31, 2019 and 2018:


	Six Months Ended			Three Months Ended March 31,
	June 30, 2018			2019			2018
	(In thousands)			(In thousands)
Nonaccrual loans
Balance, beginning of period	$	10,703		$	13,703		$	10,703
Addition of previously classified pass graded loans	4,196			—			4,066
Addition of previously classified potential problem loans	3,691			6,189			2,324
Net principal payments				(2,392		)	(1,365		)
Charge-offs	(438		)	(39		)	—
Net principal payments	(1,629		)
Balance, end of period	$	16,523		$	17,461		$	15,728

At ~~June 30,~~March 31, 2019, nonaccrual loans of $9.7 million had related allowance for loan losses of $2.4 million and nonaccrual loans of $7.8 million had no related allowance for loan losses. At December 31, 2018 nonaccrual loans of ~~$7.8~~$9.5 million had related allowance for loan losses of $1.9 million and nonaccrual loans of ~~$8.7 million had no related allowance for loan losses. At December 31, 2017 nonaccrual loans of $3.8 million had related allowance for loan losses of $720,000 and nonaccrual loans of $6.9~~$4.2 million had no allowance for loan losses.

At ~~June 30, 2018,~~March 31, 2019, nonperforming TDR loans, included in the nonaccrual loan table above, were ~~$6.8~~$5.5 million and had a related allowance for loan losses of ~~$726,000.~~$601,000. At December 31, ~~2017,~~2018, nonperforming TDR loans were ~~$5.2~~$6.9 million and had a related allowance for loan losses of ~~$379,000.~~$658,000.

Nonperforming Assets. Nonperforming assets consist of nonaccrual loans and other real estate owned. Nonperforming assets increased $3.7 million to $19.4 million, or 0.36% of total assets, at March 31, 2019 from $15.7 million, or 0.30% of total assets, at December 31, 2018 due to the increase in nonaccrual loans discussed above, offset partially by a slight decrease in other real estate owned as a result of a disposition of one property during the three months ended March 31, 2019.

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 ~~$800,000,~~$2.8 million, or ~~3.0%~~12.1%, to ~~$26.0~~$20.0 million at ~~June 30, 2018~~March 31, 2019 from ~~$26.8~~$22.7 million at December 31, ~~2017.~~2018. The decrease was due primarily to net principal payments.

The following table reflects the changes in performing TDR loans during ~~six~~three months ended ~~June 30,~~March 31, 2019 and 2018:


	Six Months Ended			Three Months Ended March 31,
	June 30, 2018			2019			2018
	(In thousands)			(In thousands)
Performing TDR loans
Balance, beginning of period	$	26,757		$	22,736		$	26,757
Addition of previously classified pass graded loans	1,236			244			—
Addition of previously classified potential problem loans	551			88			79
Net principal payments	(2,587		)	(3,082		)	(649		)
Balance, end of period	$	25,957		$	19,986		$	26,187

The related allowance for loan losses on performing TDR loans was ~~$2.5~~$2.2 million as of ~~June 30, 2018~~March 31, 2019 and ~~$2.6~~$2.3 million as of December 31, ~~2017.~~2018.

Potential Problem Loans. Potential problem loans ~~increased $17.9~~decreased $7.2 million, or ~~21.5%~~7.1%, to ~~$101.5~~$94.1 million at ~~June 30, 2018 from $83.5~~March 31, 2019 compared to $101.3 million at December 31, ~~2017.~~2018. The ~~increase was due primarily to~~activity for the quarter ended March 31, 2019 includes loans paid in full of $4.9 million, and the significant pay down of two commercial lines of credit totaling $3.2 million, offset partially by the addition of ~~an agricultural lending relationship totaling $14.5 million at June 30, 2018 and the addition~~a non-owner occupied commercial loan of ~~potential problem loans acquired in the Puget Sound Merger with a total outstanding balance of $4.9 million at June 30, 2018.~~$3.0 million.

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The following table reflects the changes in potential problem loans during the ~~six~~three months ended ~~June 30, 2018 (in thousands):~~March 31, 2019 and 2018:


	Six Months Ended			Three Months Ended March 31,
	June 30, 2018			2019			2018
	(In thousands)			(In thousands)
Potential problem loans
Balance, beginning of period	$	83,543		$	101,349		$	83,543
Addition of previously classified pass graded loans	44,955			9,766			25,126
Upgrades to pass graded loan status	(9,043		)	—			(3,636		)
Transfers of loan to nonaccrual or troubled debt restructured status	(4,242		)
Net principal payments				(10,535		)	(9,232		)
Transfers of loans to nonaccrual and TDR status				(6,277		)	(2,403		)
Charge-offs	(257		)	(187		)	(145		)
Net principal payments	(13,465		)
Balance, end of period	$	101,491		$	94,116		$	93,253

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 six~~ months ended ~~June 30, 2018~~March 31, 2019 and ~~2017:~~2018:


	Three Months Ended June 30,						Six Months Ended June 30,						Three Months Ended March 31,
	2018			2017			2018			2017			2019			2018
	(Dollars in thousands)												(Dollars in thousands)
Allowance for loan losses on loans at the beginning of the period	$	33,261		$	31,594		$	32,086		$	31,083		$	35,042		$	32,086
Provision for loan losses	1,750			1,131			2,902			1,998			920			1,152
Charge-offs:
Commercial business	(542		)	(141		)	(623		)	(443		)	(103		)	(81		)
One-to-four family residential	(15		)	—			(15		)	—			(15		)	—
Consumer	(694		)	(398		)	(1,179		)	(941		)	(586		)	(485		)
Total charge-offs	(1,251		)	(539		)	(1,817		)	(1,384		)	(704		)	(566		)
Recoveries:
Commercial business	68			454			569			826			159			501
One-to-four family residential	—			1			—			1
Real estate construction and land development	2			—			2			10			618			—
Consumer	142			110			230			217			117			88
Total recoveries	212			565			801			1,054			894			589
Net (charge-offs) recoveries	(1,039		)	26			(1,016		)	(330		)
Net recoveries													190			23
Allowance for loan losses at the end of the period	$	33,972		$	32,751		$	33,972		$	32,751		$	36,152		$	33,261

Allowance for loan losses to loans receivable, net	1.02		%	1.19		%	1.02		%	1.19		%	0.98		%	1.01		%
Net charge-offs on loans to average loans, annualized	0.13		%	—		%	0.06		%	0.03		%
Net recoveries on loans to average loans, annualized													(0.02		)%	—		%

Loans receivable, net at the end of the period ⁽¹⁾	$	3,328,288		$	2,749,507		$	3,328,288		$	2,749,507		$	3,696,431		$	3,281,915
Average loans receivable during the period ⁽¹⁾	3,266,092			2,657,946			3,208,799			2,644,953			3,622,494			3,150,869

⁽¹⁾ Excludes loans held for sale.

The allowance for loan losses increased ~~$1.9~~$1.1 million, or ~~5.9%~~3.2%, to ~~$34.0~~$36.2 million at ~~June 30, 2018~~March 31, 2019 from ~~$32.1~~$35.0 million at December 31, ~~2017.~~2018. The increase was the result of provision for loan losses of ~~$2.9 million~~$920,000 recognized during the ~~six~~three months ended ~~June 30, 2018, offset partially by~~March 31, 2019 and net ~~charge-offs~~recoveries of ~~$1.0 million~~$190,000 recorded during the same period. The allowance for loan losses to loans receivable, net, ~~decreased~~increased to ~~1.02%~~0.98% at ~~June 30, 2018~~March 31, 2019 from ~~1.13%~~0.96% at December 31, ~~2017 primarily as a result~~2018. Included in the carrying value of ~~an increase~~loans are net fair value discounts on loans purchased in ~~loans from~~mergers and acquisitions which may reduce the ~~Puget Sound Merger with no related~~need for an allowance for loan ~~losses.~~losses on these loans because they are carried at an amount below the outstanding principal balance. As these fair value discounts are accreted, increasing the loan balance, the Company may record an allowance for loan loss, which has the net impact of increasing the allowance for loan losses to loans receivable, net. The remaining net fair value discount on purchased loans was $11.2 million at March 31, 2019 compared to $11.8 million at December 31, 2018.

The Company recorded charge-offs of ~~$1.8 million~~$704,000 during the ~~six~~three months ended ~~June 30, 2018~~March 31, 2019 due primarily to ~~charge-offs of two agricultural relationships in the amount of $438,000, overdrafts on deposit accounts in the amount of $254,000 and~~ a ~~loan that was transferred to other real estate owned of $148,000. The remaining~~ charge-offs ~~were primarily a result~~ of a large volume of small dollar consumer loans. The Company recorded recoveries of ~~$801,000~~$894,000 during the ~~six~~three months ended ~~June 30, 2018~~March 31, 2019 primarily due to the recovery of a residential construction loan of $602,000 as a result of ~~cash received on~~ a ~~commercial and industrial loan of $324,000 and~~bankruptcy resolution in addition to small recoveries on a large volume of small dollar consumer loans. ~~The Company recorded net charge-offs on average loans, annualized, of 0.03% for the six months ended June 30, 2017 which were also primarily due to the large volumes of small dollar consumer loans.~~

As of ~~June 30, 2018,~~March 31, 2019, the Bank identified ~~$16.5~~$17.5 million of nonperforming loans and ~~$26.0~~$20.0 million of performing TDR loans for a total of ~~$42.5~~$37.4 million of impaired loans. Of these impaired loans, ~~$12.1~~$11.3 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~~$26.1 million of impaired loans had related allowances for loan losses totaling ~~$4.4~~$4.6 million. As of December 31, ~~2017,~~2018, the Bank identified ~~$10.7~~$13.7 million of nonperforming loans and ~~$26.8~~$22.7 million of performing TDR

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loans for a total of ~~$37.5~~$36.4 million of impaired loans. Of these impaired loans, ~~$10.4~~$7.6 million had no allowances for loan losses. The remaining ~~$27.1~~$28.8 million of impaired loans had related allowances for loan losses totaling ~~$3.4~~$4.2 million.

The following table outlines the allowance for loan losses and related loan balances on loans at ~~June 30, 2018~~March 31, 2019 and December 31, ~~2017:~~2018:


	June 30, 2018			December 31, 2017			March 31, 2019			December 31, 2018
	(Dollars in thousands)						(Dollars in thousands)
General Valuation Allowance:
Allowance for loan losses	$	25,968		$	24,732		$	28,774		$	27,854
Gross loans, excluding PCI and impaired loans	$	3,250,343		$	2,767,650		$	3,632,578		$	3,589,305
Percentage	0.80		%	0.89		%	0.79		%	0.78		%

PCI Allowance:
Allowance for loan losses	$	3,621		$	3,999		$	2,798		$	3,018
Gross PCI loans	$	31,852		$	40,603		$	23,173		$	24,907
Percentage	11.37		%	9.85		%	12.07		%	12.12		%

Specific Valuation Allowance:
Allowance for loan losses	$	4,383		$	3,355		$	4,580		$	4,170
Gross impaired loans	$	42,480		$	37,459		$	37,447		$	36,439
Percentage	10.32		%	8.96		%	12.23		%	11.44		%

Total Allowance for Loan Losses:
Allowance for loan losses	$	33,972		$	32,086		$	36,152		$	35,042
Gross loans receivable	$	3,324,675		$	2,845,712		$	3,693,198		$	3,650,651
Percentage	1.02		%	1.13		%	0.98		%	0.96		%

Based on the Bank's established comprehensive methodology, management deemed the allowance for loan losses of ~~$34.0~~$36.2 million at ~~June 30, 2018 (1.02%~~March 31, 2019 (0.98% of loans receivable, net and ~~205.60%~~207.04% 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~~2018 of ~~$32.1~~$35.0 million ~~(1.13%~~(0.96% of loans receivable, net and ~~299.79%~~255.73% 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 June 30, 2018 and December 31, 2017, the remaining fair value discount for these purchased loans was $10.6 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.

Deposits and Other Borrowings

Total deposits ~~increased $575.9~~decreased $38.7 million, or ~~17.0%~~0.9%, to ~~$3.97~~$4.39 billion at ~~June 30, 2018~~March 31, 2019 from ~~$3.39~~$4.43 billion at December 31, ~~2017 due primarily to the deposits acquired in the Puget Sound Merger of $505.9 million at the merger date.~~2018. Non-maturity deposits as a percentage of total deposits ~~increased~~decreased to ~~88.4%~~88.1% at ~~June 30, 2018~~March 31, 2019 from ~~88.3%~~89.5% at December 31, ~~2017 primarily as a result~~2018 and the percentage of ~~the mix~~certificates of deposit to total deposits ~~acquired~~increased to 11.9% at March 31, 2019 from ~~Puget Sound Merger, which had non-~~10.5% at December 31, 2018.

6854

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maturity deposits as a percentage of total deposits of 93.6% at the merger date. Based on the change in the mix and volume of deposits, the percentage of certificates of deposit to total deposits decreased to 11.6% at June 30, 2018 from 11.7% at December 31, 2017.

The following table summarizes the Company's deposits as of ~~June 30, 2018~~March 31, 2019 and December 31, ~~2017:~~2018:


	June 30, 2018				December 31, 2017								March 31, 2019				December 31, 2018
	Balance		% of Total		Balance		% of Total		Change		%of Balance Change		Balance		% of Total		Balance		% of Total		Change			%of Balance Change
	(Dollars in thousands)												(Dollars in thousands)
Noninterest demand deposits	$	1,157,630	29.2	%	$	944,791	27.8	%	$	212,839	22.5	%	$	1,338,675	30.5	%	$	1,362,268	30.7	%	$	(23,593	)	(1.7	)%
Interest bearing demand deposits	1,242,622		31.3		1,051,752		31.1		190,870		18.1		1,293,828		29.4		1,317,513		29.7		(23,685		)	(1.8	)
Money market accounts	597,673		15.1		499,618		14.7		98,055		19.6		740,518		16.9		765,316		17.3		(24,798		)	(3.2	)
Savings accounts	510,375		12.8		498,501		14.7		11,874		2.4		499,568		11.3		520,413		11.8		(20,845		)	(4.0	)
Total non-maturity deposits	3,508,300		88.4		2,994,662		88.3		513,638		17.2		3,872,589		88.1		3,965,510		89.5		(92,921		)	(2.3	)
Certificate of deposit accounts	460,635		11.6		398,398		11.7		62,237		15.6		521,126		11.9		466,892		10.5		54,234			11.6
Total deposits	$	3,968,935	100.0	%	$	3,393,060	100.0	%	$	575,875	17.0		$	4,393,715	100.0	%	$	4,432,402	100.0	%	$	(38,687	)	(0.9	)

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 ~~June 30, 2018,~~March 31, 2019, the Bank had securities sold under agreement to repurchase of ~~$22.2~~$24.9 million, a decrease of ~~$9.7~~$6.6 million, or ~~30.3%~~20.8%, from ~~$31.8~~$31.5 million at December 31, ~~2017.~~2018. The decrease was the result of customer activity during the period.

The Company also has junior subordinated debentures with a par value of ~~$25.0~~$25 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 ~~$20.2~~$20.4 million at ~~June 30, 2018,~~March 31, 2019, 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 ~~June 30, 2018,~~March 31, 2019, the Bank maintained credit facilities with the FHLB of Des Moines for ~~$838.1~~$889.8 million and credit facilities with the Federal Reserve Bank for ~~$58.1~~$38.4 million. The Company had $25.0 million of FHLB advances outstanding ~~of $75.5 million~~at March 31, 2019 and ~~$92.5 million~~none at ~~June 30, 2018 and~~ December 31, ~~2017, respectively.~~2018. The average cost of the FHLB advances during the ~~six~~three months ended ~~June 30,~~March 31, 2019 and 2018 ~~and 2017~~ was ~~1.93%~~3.29% and ~~0.86%~~1.70%, respectively. The Bank also maintains lines of credit with four correspondent banks to purchase federal funds totaling $90.0 million as of ~~June 30, 2018.~~March 31, 2019. There were no federal funds purchased as of ~~June 30, 2018~~March 31, 2019 or December 31, ~~2017.~~2018.

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.

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

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Company to meets its ongoing cash obligations. At ~~June 30, 2018,~~March 31, 2019, the Company (on an unconsolidated basis) had cash and cash equivalents of ~~$14.0~~$13.9 million.

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

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maintain sufficient cash and short-term investments to meet short-term liquidity needs. At ~~June 30, 2018,~~March 31, 2019, cash and cash equivalents totaled ~~$129.9~~$111.2 million, or ~~2.7%~~2.1% of total assets. The fair value of investment securities available for sale totaled ~~$873.7~~$985.0 million at ~~June 30, 2018,~~March 31, 2019, of which ~~$257.9~~$265.5 million were pledged to secure public deposits or borrowing arrangements. The fair value of investment securities available for sale that were not pledged totaled ~~$615.8~~$719.5 million, or ~~12.9%,~~13.5% of total assets, at ~~June 30, 2018.~~March 31, 2019. The fair value of investment securities available for sale with maturities of one year or less were ~~$24.7~~$32.0 million, or ~~0.5%,~~0.6% of total assets, at ~~June 30, 2018.~~March 31, 2019.

Consolidated Cash Flows: As disclosed in the Condensed Consolidated Statements of Cash Flows, net cash provided by operating activities was ~~$29.7~~$21.3 million for the ~~six~~three months ended ~~June 30, 2018,~~March 31, 2019, and primarily consisted of net income of ~~$20.9~~$16.6 million. During the ~~six~~three months ended ~~June 30, 2018,~~March 31, 2019, net cash used inby investing activities was ~~$34.3~~$44.4 million, which consisted primarily of net loan originations of ~~$96.1~~$42.4 million and purchases of premises and equipment of ~~$16.7 million, offset partially by net cash received from acquisitions of $80.1~~$1.0 million. Net cash ~~provided~~used by financing activities was ~~$31.4~~$27.7 million for the ~~six~~three months ended ~~June 30, 2018,~~March 31, 2019, and primarily consisted of net ~~increase~~decrease in deposits of ~~$70.0~~$38.7 million and dividends paid of $6.7 million during the period, partially offset by net FHLB ~~repayments~~advances of ~~$17.0 million and dividends paid of $10.2~~$25.0 million.

Capital and Capital Requirements

Stockholders’ equity at ~~June 30, 2018~~March 31, 2019 was ~~$639.5~~$778.2 million compared to ~~$508.3~~$760.7 million at December 31, ~~2017.~~2018. The Company’s stockholders' equity to assets ratio was 14.6% as of March 31, 2019 and 14.3% as of December 31, 2018. The changes to stockholders' equity during the ~~six~~three months ended ~~June 30,~~March 31, 2019 and 2018 is as follows:


	Six Months Ended			Three Months Ended March 31,
	June 30, 2018			2019			2018
	(In Thousands)			(In Thousands)
Balance, beginning of period	$	508,305		$	760,723		$	508,305
Common stock issued in the Puget Sound Merger	130,770
Common stock issued in the Premier and Puget Mergers				—			130,770
Net income	20,944			16,552			9,087
Dividends declared	(10,247		)	(6,662		)	(5,117		)
Accumulated other comprehensive loss	(9,915		)
Other comprehensive income (loss)				8,016			(7,543		)
Effects of implementation of accounting change related to operating leases				(399		)	—
Other	(334		)	(39		)	(794		)
Balance, end of period	$	639,523		$	778,191		$	634,708

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 ~~July~~April 24, ~~2018,~~2019, the Company’s Board of Directors declared a regular dividend of ~~$0.15~~ $0.18per common share which is payable on ~~August 23, 2018~~May 22, 2019 to shareholders of record on ~~August 9, 2018.~~May 8, 2019.

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 ~~June 30, 2018,~~March 31, 2019, the Company and the Bank meet all capital adequacy requirements to which they are subject.

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As of ~~June 30, 2018~~March 31, 2019 and December 31, ~~2017,~~2018, 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~~ The following table represents the minimum required ratios of ~~Contents~~

the Company and the Bank and the actual capital ratios at the periods indicated:

Minimum Requirements Well-Capitalized Requirements Actual
(Dollars in thousands)
As of June 30, 2018:
The Company consolidated
Common equity Tier 1 capital to risk-weighted assets $ 180,827
4.5 % N/A
N/A
$ 450,777
11.2 %
Tier 1 leverage capital to average assets 180,474
4.0
N/A
N/A
470,933
10.4
Tier 1 capital to risk-weighted assets 241,103
6.0
N/A
N/A
470,933
11.7
Total capital to risk-weighted assets 321,471
8.0
N/A
N/A
505,184
12.6
Heritage Bank
Common equity Tier 1 capital to risk-weighted assets 180,660
4.5
$ 260,953
6.5 % 454,393
11.3
Tier 1 leverage capital to average assets 181,505
4.0
226,881
5.0
454,393
10.0
Tier 1 capital to risk-weighted assets 240,880
6.0
321,173
8.0
454,393
11.3
Total capital to risk-weighted assets 321,173
8.0
401,466
10.0
488,644
12.2

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

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



	Minimum Requirements				Well-Capitalized Requirements				Actual
	(Dollars in thousands)
As of March 31, 2019:
The Company consolidated
Common equity Tier 1 capital to risk-weighted assets	$	199,483	4.5	%	N/A		N/A		$	521,095	11.8	%
Tier 1 leverage capital to average assets	202,081		4.0		N/A		N/A		541,470		10.7
Tier 1 capital to risk-weighted assets	265,977		6.0		N/A		N/A		541,470		12.2
Total capital to risk-weighted assets	354,636		8.0		N/A		N/A		577,928		13.0
Heritage Bank
Common equity Tier 1 capital to risk-weighted assets	199,260		4.5		$	287,821	6.5	%	525,285		11.9
Tier 1 leverage capital to average assets	202,662		4.0		253,328		5.0		525,285		10.4
Tier 1 capital to risk-weighted assets	265,681		6.0		354,241		8.0		525,285		11.9
Total capital to risk-weighted assets	354,241		8.0		442,801		10.0		561,743		12.7

As of December 31, 2018:
The Company consolidated
Common equity Tier 1 capital to risk-weighted assets	$	197,189	4.5	%	N/A		N/A		$	510,618	11.7	%
Tier 1 leverage capital to average assets	201,920		4.0		N/A		N/A		530,920		10.5
Tier 1 capital to risk-weighted assets	262,918		6.0		N/A		N/A		530,920		12.1
Total capital to risk-weighted assets	350,558		8.0		N/A		N/A		566,268		12.9
Heritage Bank
Common equity Tier 1 capital to risk-weighted assets	197,004		4.5		$	284,561	6.5	%	513,993		11.7
Tier 1 leverage capital to average assets	203,339		4.0		254,174		5.0		513,993		10.1
Tier 1 capital to risk-weighted assets	262,671		6.0		350,229		8.0		513,993		11.7
Total capital to risk-weighted assets	350,229		8.0		437,786		10.0		549,341		12.5

Under ~~the new~~applicable capital requirements both the Company and the Bank are required to have a common equity Tier 1 capital ratio of 4.5%. In addition, both the Company and the Bank are required to have a Tier 1 leverage ratio of 4.0%, a Tier 1 risk-based ratio of 6.0% and a total risk-based ratio of 8.0%. Both the Company and the Bank are required to establish a “conservation buffer”, consisting of common equity Tier 1 capital of more than 2.5% above the minimum risk-based capital ratios. The capital conservation buffer is designed to ensure that banks build up capital buffers outside periods of stress which can be drawn down as losses are incurred. An institution that does not meet the conservation buffer will be subject to restrictions on certain activities including payment of dividends, stock repurchases and discretionary bonuses to executive officers. The conservation buffer is being phased in beginning in 2016 and will take full effect on January 1, 2019. Certain calculations under the rules will also have phase-in periods. The capital conservation buffer requirement began to be phased-in on January 1, 2016 when more than 0.625% of risk-weighted assets was required, and increases by 0.625% on each subsequent January 1, until it is fully phased-in on January 1, 2019. At ~~June 30, 2018,~~March 31, 2019, the capital conservation buffer was ~~4.57%~~5.0% and ~~4.17%~~4.7% for the Company and the Bank, respectively.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to interest rate risk through our lending and deposit gathering activities. Our results of operations are highly dependent upon our ability to manage interest rate risk. We consider interest rate risk to be a significant market risk that could have a material effect on our financial condition and results of operations. Interest rate risk is measured and assessed on a quarterly basis. In our opinion, there has not been a material change in our interest rate risk exposure since the information disclosed in our Annual Report on Form 10-K for the year ended December 31, ~~2017.~~2018.

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 ~~June 30, 2018~~March 31, 2019 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 ~~June 30, 2018,~~March 31, 2019, 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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2018.

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

(a) Not applicable.

(b) Not applicable.

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. At December 31, 2018, there were approximately 933,004 shares remaining to be purchased 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~~price of $16.67. No shares were repurchased under this plan during the ~~six~~three months ended ~~June 30, 2018 and 2017.~~March 31, 2019 or 2018.


	Three Months Ended June 30,				Six Months Ended June 30,				Three Months Ended March 31,
	2018		2017		2018		2017		2019		2018
Repurchased shares to pay withholding taxes ⁽¹⁾	7,394		11,476		52,820		27,367		25,854		45,426
Stock repurchase to pay withholding taxes average share price	$	33.84	$	25.50	$	31.96	$	24.60	$	31.01	$	31.66

⁽¹⁾During the three ~~and six~~ months ended ~~June 30,~~March 31, 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 agreement.

The following table sets forth information about the Company’s purchases of its outstanding common stock during the quarter ended ~~June 30, 2018.~~March 31, 2019:

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
April 1, 2018— April 30, 2018 —
$ —
7,893,389
935,034
May 1, 2018— May 31, 2018 —
—
7,893,389
935,034
June 1, 2018— June 30, 2018 7,394
33.84
7,893,389
935,034
Total 7,394
$ 33.84



Period	Total Number of Shares Purchased⁽¹⁾	Average Price Paid Per Share⁽¹⁾		Cumulative Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs	Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs
January 1, 2019— January 31, 2019	1,872	$	30.60	7,893,389	935,034
February 1, 2019— February 28, 2019	—	—		7,893,389	935,034
March 1, 2019— March 31, 2019	23,982	31.04		7,893,389	935,034
Total	25,854	$	31.01

⁽¹⁾ All of the common shares repurchased by the Company between ~~April~~January 1, ~~2018~~2019 and ~~June 30, 2018~~March 31, 2019 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

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ITEM 5. OTHER INFORMATION

None

~~Table of Contents~~

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

10.34

Form of First Amendment to Split Dollar Agreements dated August 3, 2015 by and between Heritage and Brian L. Vance, Jeffrey J. Deuel, Donald J. Hinson, Bryan D. McDonald and David Spurling⁽¹⁾

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⁾

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:
~~August 8, 2018~~May 9, 2019		/S/ BRIAN L. VANCE
		Brian L. Vance
		Chief Executive Officer

Date:
~~August 8, 2018~~May 9, 2019		/S/ DONALD J. HINSON
		Donald J. Hinson
		Executive Vice President and Chief Financial Officer

7460



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

Fair value of net assets acquired	$	62,253



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



	Three Months Ended⁽¹⁾			Six Months Ended⁽¹⁾
	June 30, 2018
	(In thousands)
Interest income: Interest and fees on loans⁽²⁾	$	6,130		$	10,647
Interest income: Interest and fees on investments ⁽³⁾	—			59
Interest income: Other interest earning assets	25			113
Interest expense	(180		)	(324		)
Provision for loan losses for loans	(350		)	(550		)
Noninterest income	109			257
Noninterest expense ⁽⁴⁾	(2,092		)	(7,672		)
Net effect, pre-tax	$	3,642		$	2,530



	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 June 30, 2017		Net Losses (Gains) Recorded in Earnings During the Six Months Ended June 30, 2017
	(In thousands)
Impaired loans:
Real estate construction and land development:
One-to-four family residential	$	976	$	307	$	—	$	—	$	307	$	—	—
Total assets measured at fair value on a nonrecurring basis	$	976	$	307	$	—	$	—	$	307	$	—	$	—



	Shares		Weighted-Average Exercise Price		Weighted-Average Remaining Contractual Term (In years)	Aggregate Intrinsic Value (In thousands)
Outstanding at December 31, 2016	37,495		$	13.77
Exercised	(8,372	)	13.03
Forfeited or expired	(1,308	)	13.53
Outstanding, vested and expected to vest and exercisable at June 30, 2017	27,815		$	14.00	2.63	$	348

Outstanding at December 31, 2017	23,231		$	14.21
Exercised	(4,042	)	11.55
Forfeited or expired	(831	)	14.77
Outstanding, vested and expected to vest and exercisable at June 30, 2018	18,358		$	14.77	1.90	$	369



	Shares		Weighted-Average Grant Date Fair Value
Nonvested at December 31, 2016	261,296		$	16.80
Vested	(105,972	)	16.47
Forfeited	(7,704	)	16.78
Nonvested at June 30, 2017	147,620		$	17.04

Nonvested at December 31, 2017	137,399		$	17.00
Vested	(66,193	)	16.67
Forfeited	(2,394	)	16.86
Nonvested at June 30, 2018	68,812		$	17.32



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

Three Months Ended March 31,

Weighted average rate ⁽¹⁾