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HFWA Heritage Financial

Filed: 8 Nov 17, 7:00pm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549
 
 
 
FORM 10-Q
 
 
 
xQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2017
OR
¨TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission File Number 000-29480 
 
HERITAGE FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter) 
 
 
 
Washington 91-1857900
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
  
201 Fifth Avenue SW, Olympia, WA 98501
(Address of principal executive offices) (Zip Code)
(360) 943-1500
(Registrant’s telephone number, including area code) 

 
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ý    No  ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ý    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer¨ Accelerated filerx
Non-accelerated filer¨ Smaller reporting company¨
Emerging Growth Company
¨

   
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨  �� No  ý
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the last practicable date:
As of November 1, 2017 there were 29,929,106 shares of the registrant's common stock, no par value per share, outstanding.




HERITAGE FINANCIAL CORPORATION
FORM 10-Q
INDEX
September 30, 2017




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FORWARD LOOKING STATEMENTS:

“Safe Harbor” statement under the Private Securities Litigation Reform Act of 1995: This Quarterly Report on Form 10-Q ("Form 10-Q") contains forward-looking statements that are subject to risks and uncertainties, including, but not limited to: the expected revenues, cost savings, synergies and other benefits from our pending merger with Puget Sound Bancorp, Inc., ("Puget Sound") might not be realized within the expected time frames or at all, and costs or difficulties relating to integration matters, including but not limited to, customer and employee retention might be greater than expected; the proposed Puget Sound merger may not close when expected or at all because required regulatory, shareholder or other approvals and conditions to closing are not received or satisfied on a timely basis or at all or adverse regulatory conditions may be imposed in connection with governmental approvals of the merger; the credit risks of lending activities, including changes in the level and trend of loan delinquencies and write-offs and changes in our allowance for loan losses and provision for loan losses that may be effected by deterioration in the housing and commercial real estate markets, which may lead to increased losses and nonperforming assets in our loan portfolio, and may result in our allowance for loan losses no longer being adequate to cover actual losses, and require us to increase our allowance for loan losses; changes in general economic conditions, either nationally or in our market areas; changes in the levels of general interest rates, and the relative differences between short and long term interest rates, deposit interest rates, our net interest margin and funding sources; risks related to acquiring assets in or entering markets in which we have not previously operated and may not be familiar; fluctuations in the demand for loans, the number of unsold homes and other properties and fluctuations in real estate values in our market areas; results of examinations of us by the Board of Governors of the Federal Reserve System and of our bank subsidiary by the Federal Deposit Insurance Corporation ("FDIC"), the Washington State Department of Financial Institutions, Division of Banks or other regulatory authorities, 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; our ability to control operating costs and expenses; increases in premiums for deposit insurance; the use of estimates in determining fair value of certain of our assets, which estimates may prove to be incorrect and result in significant declines in valuation; difficulties in reducing risk associated with the loans on our Condensed Consolidated Statements of Financial Condition; staffing fluctuations in response to product demand or the implementation of corporate strategies that affect our workforce and potential associated charges; failure or security breach of computer systems on which we depend; our ability to retain key members of our senior management team; costs and effects of litigation, including settlements and judgments; our ability to implement our growth strategies; increased competitive pressures among financial service companies; changes in consumer spending, borrowing and savings habits; the availability of resources to address changes in laws, rules, or regulations or to respond to regulatory actions; adverse changes in the securities markets; inability of key third-party providers to perform their obligations to us; changes in accounting policies and practices, as may be adopted by the financial institution regulatory agencies or the Financial Accounting Standards Board ("FASB"), including additional guidance and interpretation on accounting issues and details of the implementation of new accounting methods; and other economic, competitive, governmental, regulatory, and technological factors affecting our operations, pricing, products and services and other risks detailed from time to time in our filings with the Securities and Exchange Commission including our Annual Report on Form 10-K for the year ended December 31, 2016.
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.


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PART I.     FINANCIAL INFORMATION

ITEM 1.     FINANCIAL STATEMENTS

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(Unaudited)
  September 30, 2017 December 31, 2016
  (Dollars in thousands)
ASSETS    
Cash on hand and in banks $82,905

$77,117
Interest earning deposits 28,353

26,628
Cash and cash equivalents 111,258

103,745
Investment securities available for sale, at fair value 800,060

794,645
Loans held for sale 5,368
 11,662
Loans receivable, net 2,797,513
 2,640,749
Allowance for loan losses (31,400) (31,083)
Total loans receivable, net 2,766,113
 2,609,666
Other real estate owned 523

754
Premises and equipment, net 60,457

63,911
Federal Home Loan Bank stock, at cost 9,343

7,564
Bank owned life insurance 71,474
 70,355
Accrued interest receivable 12,295

10,925
Prepaid expenses and other assets 87,728

79,351
Other intangible assets, net 6,408

7,374
Goodwill 119,029

119,029
Total assets $4,050,056

$3,878,981
LIABILITIES AND STOCKHOLDERS' EQUITY    
Deposits $3,320,818
 $3,229,648
Federal Home Loan Bank advances 117,400
 79,600
Junior subordinated debentures 19,936
 19,717
Securities sold under agreement to repurchase 28,668
 22,104
Accrued expenses and other liabilities 55,626
 46,149
Total liabilities 3,542,448
 3,397,218
Stockholders’ equity:    
Preferred stock, no par value, 2,500,000 shares authorized; no shares issued and outstanding at September 30, 2017 and December 31, 2016 
 
Common stock, no par value, 50,000,000 shares authorized; 29,929,106 and 29,954,931 shares issued and outstanding at September 30, 2017 and December 31, 2016, respectively 360,113
 359,060
Retained earnings 145,677
 125,309
Accumulated other comprehensive income (loss), net 1,818
 (2,606)
Total stockholders’ equity 507,608
 481,763
Total liabilities and stockholders’ equity $4,050,056
 $3,878,981
See accompanying Notes to Condensed Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
  Three Months Ended September 30, Nine Months Ended September 30,
  2017 2016 2017 2016
  (Dollars in thousands, except per share amounts)
INTEREST INCOME        
Interest and fees on loans $32,595
 $30,915
 $94,580
 $91,595
Taxable interest on investment securities 3,117
 2,888
 9,307
 8,522
Nontaxable interest on investment securities 1,354
 1,235
 3,926
 3,599
Interest and dividends on other interest earning assets 258
 76
 461
 225
Total interest income 37,324
 35,114
 108,274
 103,941
INTEREST EXPENSE        
Deposits 1,628
 1,269
 4,301
 3,765
Junior subordinated debentures 261
 221
 748
 647
Other borrowings 444
 18
 908
 78
Total interest expense 2,333
 1,508
 5,957
 4,490
Net interest income 34,991
 33,606
 102,317
 99,451
Provision for loan losses 884
 1,495
 2,882
 3,754
Net interest income after provision for loan losses 34,107
 32,111
 99,435
 95,697
NONINTEREST INCOME        
Service charges and other fees 4,769
 3,630
 13,408
 10,462
Gain on sale of investment securities, net 44
 345
 161
 1,106
Gain on sale of loans, net 1,229
 3,435
 6,562
 5,406
Interest rate swap fees 328
 742
 743
 1,105
Other income 2,024
 1,715
 5,532
 5,354
Total noninterest income 8,394
 9,867
 26,406
 23,433
NONINTEREST EXPENSE        
Compensation and employee benefits 15,823
 15,633
 48,119
 45,652
Occupancy and equipment 3,979
 3,926
 11,607
 11,873
Data processing 2,090
 1,943
 6,007
 5,564
Marketing 933
 745
 2,545
 2,254
Professional services 1,453
 830
 3,515
 2,508
State and local taxes 640
 820
 1,828
 2,031
Federal deposit insurance premium 433
 296
 1,090
 1,316
Other real estate owned, net (88) (142) (36) 330
Amortization of intangible assets 319
 359
 966
 1,057
Other expense 2,373
 2,408
 7,346
 7,079
Total noninterest expense 27,955
 26,818
 82,987
 79,664
Income before income taxes 14,546
 15,160
 42,854
 39,466
Income tax expense 3,922
 4,121
 11,086
 10,441
Net income $10,624
 $11,039
 $31,768
 $29,025
Basic earnings per common share $0.35
 $0.37
 $1.06
 $0.97
Diluted earnings per common share $0.35
 $0.37
 $1.06
 $0.97
Dividends declared per common share $0.13
 $0.12
 $0.38
 $0.35
See accompanying Notes to Condensed Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)

  Three Months Ended September 30, Nine Months Ended September 30,
  2017 2016 2017 2016
  (Dollars in thousands)
Net income $10,624
 $11,039
 $31,768
 $29,025
Change in fair value of investment securities available for sale, net of tax of $157, $(570), $2,442 and $4,983, respectively 289
 (1,055) 4,528
 9,223
Reclassification adjustment for net gain from sale of investment securities available for sale included in income, net of tax of $(16), $(121), $(57) and $(388), respectively (28) (224) (104) (718)
Other comprehensive income (loss) 261
 (1,279) 4,424
 8,505
Comprehensive income $10,885
 $9,760
 $36,192
 $37,530
See accompanying Notes to Condensed Consolidated Financial Statements.


6


HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(Unaudited)
 
Number of
common
shares
 
Common
stock
 
Retained
earnings
 
Accumulated
other
comprehensive income (loss), net
 
Total
stock-
holders’
equity
 (Dollars in thousands, except per share amounts)
Balance at December 31, 201529,975
 $359,451
 $107,960
 $2,559
 $469,970
Restricted stock awards granted, net of forfeitures111
 
 
 
 
Exercise of stock options (including excess tax benefits from nonqualified stock options)28
 421
 
 
 421
Stock-based compensation expense
 1,367
 
 
 1,367
Net excess tax benefits from vesting of restricted stock
 99
 
 
 99
Common stock repurchased(167) (2,887) 
 
 (2,887)
Net income
 
 29,025
 
 29,025
Other comprehensive income, net of tax
 
 
 8,505
 8,505
Cash dividends declared on common stock ($0.35 per share)
 
 (10,488) 
 (10,488)
Balance at September 30, 201629,947
 $358,451
 $126,497
 $11,064
 $496,012
          
Balance at December 31, 201629,955
 $359,060
 $125,309
 $(2,606) $481,763
Restricted stock awards forfeited(10) 
 
 
 
Exercise of stock options12
 159
 
 
 159
Stock-based compensation expense
 1,568
 
 
 1,568
Common stock repurchased(28) (674) 
 
 (674)
Net income
 
 31,768
 
 31,768
Other comprehensive income, net of tax
 
 
 4,424
 4,424
Cash dividends declared on common stock ($0.38 per share)
 
 (11,400) 
 (11,400)
Balance at September 30, 201729,929
 $360,113
 $145,677
 $1,818
 $507,608
See accompanying Notes to Condensed Consolidated Financial Statements.


7


HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
  Nine Months Ended September 30,
  2017 2016
  (Dollars in thousands)
Cash flows from operating activities:    
Net income $31,768
 $29,025
Adjustments to reconcile net income to net cash provided by operating activities:    
Depreciation and amortization 8,117
 9,543
Changes in net deferred loan costs, net of amortization (656) (971)
Provision for loan losses 2,882
 3,754
Net change in accrued interest receivable, prepaid expenses and other assets, accrued expenses and other liabilities 8,315
 (193)
Stock-based compensation expense 1,568
 1,367
Net excess tax benefit from exercise of stock options and vesting of restricted stock 
 (119)
Amortization of intangible assets 966
 1,057
Origination of loans held for sale (82,767) (99,513)
Proceeds from sale of loans 91,576
 101,574
Earnings on bank owned life insurance (1,108) (1,086)
Valuation adjustment on other real estate owned 
 383
Gain on sale of loans, net (6,562) (5,406)
Gain on sale of investment securities, net (161) (1,106)
Gain on sale of assets held for sale (53) 
Gain on sale of other real estate owned, net (111) (173)
Loss on sale or write-off of furniture, equipment and leasehold improvements 12
 107
Net cash provided by operating activities 53,786
 38,243
Cash flows from investing activities:    
Loans originated, net of principal payments (178,800) (190,798)
Maturities of other interest earning deposits 
 1,248
Maturities, calls and payments of investment securities available for sale 75,800
 94,328
Purchase of investment securities available for sale (101,017) (188,164)
Purchase of premises and equipment (2,221) (5,128)
Proceeds from sales of other loans 24,142
 12,931
Proceeds from sales of other real estate owned 374
 2,486
Proceeds from sales of investment securities available for sale 21,850
 94,380
Proceeds from sale of assets held for sale 265
 
Proceeds from redemption of Federal Home Loan Bank stock 21,788
 15,416
Purchases of Federal Home Loan Bank stock (23,567) (16,356)
Proceeds from sale of premises and equipment 
 659
Purchase of bank owned life insurance 
 (8,000)
Capital contribution to low-income housing tax credit partnership (8,506) (3,315)
Net cash used in investing activities (169,892) (190,313)

8


  Nine Months Ended September 30,
  2017 2016
  (Dollars in thousands)
Cash flows from financing activities:    
Net increase in deposits 91,170
 134,134
Federal Home Loan Bank advances 582,500
 403,100
Repayments of Federal Home Loan Bank advances (544,700) (385,400)
Common stock cash dividends paid (11,400) (10,488)
Net increase (decrease) in securities sold under agreement to repurchase 6,564
 (789)
Proceeds from exercise of stock options 159
 401
Net excess tax benefit from exercise of stock options and vesting of restricted stock 
 119
Repurchase of common stock (674) (2,887)
Net cash provided by financing activities 123,619
 138,190
Net increase (decrease) in cash and cash equivalents 7,513
 (13,880)
Cash and cash equivalents at beginning of period 103,745
 126,640
Cash and cash equivalents at end of period $111,258
 $112,760
     
Supplemental disclosures of cash flow information:    
Cash paid for interest $6,024
 $4,533
Cash paid for income taxes 1,500
 9,000
     
Supplemental non-cash disclosures of cash flow information:    
Transfers of loans receivable to other real estate owned $32
 $677
Transfers of premises and equipment, net to prepaid expenses and other assets for properties held for sale 2,687
 
Investment in low income housing tax credit partnership and related funding commitment 14,267
 19,663
See accompanying Notes to Condensed Consolidated Financial Statements.

9


HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

(1)Description of Business, Basis of Presentation, Significant Accounting Policies and Recently Issued Accounting Pronouncements
(a) Description of Business
Heritage Financial Corporation ("Heritage" or the “Company”) is a bank holding company that was incorporated in the State of Washington in August 1997. The Company is primarily engaged in the business of planning, directing and coordinating the business activities of its wholly-owned subsidiary, Heritage Bank (the “Bank”). The Bank is a Washington-chartered commercial bank and its deposits are insured by the FDIC. The Bank is headquartered in Olympia, Washington and conducts business from its 59 branch offices located throughout Washington State and the greater Portland, Oregon area. The Bank’s business consists primarily of commercial lending and deposit relationships with small businesses and their owners in its market areas and attracting deposits from the general public. The Bank also makes real estate construction and land development loans, consumer loans and originates first mortgage loans on residential properties primarily located in its market areas.
On July 26, 2017, the Company announced the execution of a definitive agreement to purchase Puget Sound Bancorp, Inc., ("Puget Sound"), the holding company of Puget Sound Bank, a business bank headquartered in downtown Bellevue, Washington with one branch location and $567.2 million in total assets, $366.6 million in total loans receivables, net and $505.1 million in total deposits as of June 30, 2017. Upon consummation of the merger, the shareholders of Puget Sound will own approximately 13.5% of the combined company and Puget Sound will be merged into Heritage Bank. For additional information regarding the proposed transaction, see Note (16), Definitive Agreement.
(b) Basis of Presentation
The accompanying unaudited Condensed Consolidated Financial Statements have been prepared in accordance with the accounting principles generally accepted in the United States (“U.S. GAAP”) for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC"). Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. It is recommended that these unaudited Condensed Consolidated Financial Statements and accompanying Notes be read with the audited Consolidated Financial Statements and the accompanying Notes included in the Company's Annual Report on Form 10-K for the year ended December 31, 2016 (“2016 Annual Form 10-K”). In management's opinion, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three and nine months ended September 30, 2017 are not necessarily indicative of the results that may be expected for the year ending December 31, 2017. 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.
(c) Significant Accounting Policies
The significant accounting policies used in preparation of the Company's Condensed Consolidated Financial Statements are disclosed in the 2016 Annual Form 10-K. There have not been any material changes in the Company's significant accounting policies from those contained in the 2016 Annual Form 10-K, except for accounting policies for stock-based compensation relating to the issuance of restricted stock units, including grants subject to performance-based and market-based vesting conditions, adopted January 1, 2017 as discussed below.
Stock-Based Compensation
Compensation cost is recognized for stock options, restricted stock awards and restricted stock units issued to employees and directors, based on the fair value of these awards at the date of grant. Compensation cost is recognized over the requisite service period, generally defined as the vesting period, on a straight-line basis. Compensation cost for restricted stock units with market-based vesting is recognized over the service period to the extent the restricted stock units are expected to vest. With the adoption of FASB Accounting Standards Update ("ASU" or "Update") 2016-09 on January 1, 2017, forfeitures are recognized as they occur.
The market price of the Company’s common stock at the date of grant is used to determine the fair value of the restricted stock awards and restricted stock units. The fair value of stock options granted is estimated based on the date of grant using the Black-Scholes-Merton option pricing model. Certain restricted stock unit grants are subject to performance-based vesting as well as other approved vesting conditions and

10


cliff vest based on those conditions, and the fair value is estimated using a Monte Carlo simulation pricing model. The assumptions used in the Black-Scholes-Merton option pricing model and the Monte Carlo simulation pricing model include the expected term based on the valuation date and the remaining contractual term of the award; the risk-free interest rate based on the U.S. Treasury curve at the valuation date of the award; the expected dividend yield based on expected dividends being payable to the holders; and the expected stock price volatility over the expected term based on the historical volatility over the equivalent historical term.
(d) Recently Issued Accounting Pronouncements
FASB ASU 2014-09, Revenue from Contracts with Customers, was issued in May 2014. Under this Update, FASB created a new Topic 606 which is in response to a joint initiative of FASB and the International Accounting Standards Board to clarify the principles for recognizing revenue and to develop a common revenue standard for U.S. GAAP and international financial reporting standards that would:
Remove inconsistencies and weaknesses in revenue requirements.
Provide a more robust framework for addressing revenue issues.
Improve comparability of revenue recognition practices across entities, industries, jurisdictions and capital markets.
Provide more useful information to users of financial statements through improved disclosure requirements.
Simplify the preparation of financial statements by reducing the number of requirements to which an entity must refer.
The original effective date for this Update was deferred in FASB ASU 2015-14 below.
FASB ASU 2015-14Revenue from Contracts with Customers (Topic 606), was issued in August 2015 and defers the effective date of the above-mentioned FASB ASU 2014-09 for certain entities. Public business entities, certain not-for-profit entities and certain employee benefit plans should apply the guidance in Update 2014-09 to annual reporting periods beginning after December 15, 2017, including interim reporting periods within that reporting period. Earlier application is now permitted, but only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. The Company expects to adopt the revenue recognition guidance on January 1, 2018 using the modified retrospective approach.  A significant amount of the Company’s revenues are derived from net interest income on financial assets and liabilities, which are excluded from the scope of the amended guidance.  With respect to noninterest income and related disclosures, the Company is in its preliminary stages of identifying and evaluating the revenue streams and underlying revenue contracts within the scope of the guidance. To date, the Company has not yet identified any significant changes in the timing of revenue recognition when considering the amended accounting guidance; however, the Company’s implementation efforts are ongoing and such assessments may change prior to the January 1, 2018 implementation date. The Company expects to develop processes and procedures to ensure it is fully compliant with these amendments at the adoption date.
FASB ASU 2016-01Recognition and Measurement of Financial Assets and Financial Liabilities (Subtopic 825-10), was issued in January 2016, to enhance the reporting model for financial instruments to provide users of financial statements with more decision-useful information. This Update contains several provisions, including but not limited to 1) requiring equity investments, with certain exceptions, to be measured at fair value with changes in fair value recognized in net income; 2) simplifying the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment; 3) eliminating the requirement to disclose the method(s) and significant assumptions used to estimate fair value; and 4) requiring separate presentation of financial assets and liabilities by measurement category and form of financial asset on the balance sheet or the accompanying notes to the financial statements. The Update also changes certain financial statement disclosure requirements, including requiring disclosures of the fair value of financial instruments be made on the basis of exit price. The Update is effective for public entities for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company does not expect the adoption of this Update will have a significant impact on the Company’s statements of financial condition or income.  Management is in the planning stages of developing processes and procedures to comply with the disclosures requirements of this Update, which could impact the disclosures the Company makes related to fair value of its financial instruments.
FASB ASU 2016-02Leases (Topic 842) was originally issued in February 2016, to increase transparency and comparability of leases among organizations and to disclose key information about leasing arrangements. The Update sets out the principles for the recognition, measurement, presentation and disclosure of leases for both lessees and lessors. The Update requires lessees to apply a dual approach, classifying leases as either a finance or operating lease. This classification will determine whether the lease expense is recognized based on an effective interest method or on a straight-line basis over the term of the lease. A lessee is also required to record a right-of-use asset and a

11


lease liability for all leases with a term greater than 12 months regardless of their classification. All cash payments will be classified within operating activities in the statement of cash flows. In transition, lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. The Update is effective for public entities for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The Company anticipates adopting the Update on January 1, 2019. Upon adoption of the guidance, the Company expects to report increased assets and increased liabilities on its Condensed Consolidated Statements of Financial Condition as a result of recognizing right-of-use assets and lease liabilities related to certain banking offices and certain equipment under noncancelable operating lease agreements, which currently are not reflected in its Condensed Consolidated Statements of Financial Condition.  During 2017, management began its evaluation of its leasing contracts and activities. Management is in the initial stages of developing its methodology to estimate the right-of use assets and lease liabilities. The Company anticipates electing an accounting policy to not recognize lease assets and lease liabilities for leases with a term of twelve months or less. The Company was committed to $14.7 million of minimum lease payments under noncancelable operating lease agreements at December 31, 2016. The Company does not expect the adoption of this amendment will have a significant impact to its Condensed Consolidated Financial Statements.
FASB ASU 2016-08Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations, was issued in March 2016 and it clarifies the implementation guidance of the above-mentioned FASB ASU 2014-09 as it relates to principal versus agent considerations. The Update addresses identifying the unit of account and nature of the goods or services as well as applying the control principle and interactions with the control principle. The amendments to the Update do not change the core principle of the guidance. The effective date, transition requirements and impact on the Company's Condensed Consolidated Financial Statements for this Update are the same as those described in FASB ASU 2015-14 above.
FASB ASU 2016-09Stock Compensation (Topic 718), issued in March 2016, is intended to simplify several aspects of the accounting for share-based payment award transactions. For public business entities, the guidance is effective for annual periods after December 15, 2016, including interim periods within those annual periods with early adoption permitted. Certain amendments are required to be applied using a modified retrospective transition method by means of a cumulative-effect adjustment to equity as of the beginning of the period in which the guidance is adopted. Other amendments are applied retroactively (such as presentation of employee taxes paid on the statement of cash flows) or prospectively (such as recognition of excess tax benefits on the income statement). The Company adopted this standard effective January 1, 2017. The Company made an accounting policy election to account for forfeitures as they occur and this change resulted in a cumulative adjustment that was immaterial to all periods presented. Changes to the statement of cash flows have been applied prospectively and the Company recorded excess tax benefits in its income tax expense. Adoption of all other changes under this Update did not have a material impact on the Condensed Consolidated Financial Statements.
FASB ASU 2016-10Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing, was issued in April 2016 which clarifies the implementation guidance of the above-mentioned FASB ASU 2014-09 as it relates to identifying performance obligations and licensing. The effective date, transition requirements and impact on the Company's Condensed Consolidated Financial Statements for this Update are the same as those described in FASB ASU 2015-14 above.
FASB ASU 2016-12Revenue from Contracts with Customers (Topic 606): Narrow-scope Improvements and Practical Expedients, was issued in May 2016. The amendments in this Update do not change the core principle of the guidance in Topic 606. Rather, the amendments in this Update affect only the narrow aspects of Topic 606. The effective date, transition requirements and impact on the Company's Condensed Consolidated Financial Statements for this Update are the same as those described in FASB ASU 2015-14 above.
FASB ASU 2016-13Financial Instruments: Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, was issued in June 2016. Commonly referred to as the current expected credit loss model ("CECL"), this Update requires financial assets measured at amortized cost basis to be presented at the net amount expected to be collected. The allowance for credit losses is a valuation account that is deducted from the amortized cost basis of the financial asset to present the net carrying value at the amount expected to be collected on the financial asset. The measurement of expected credit losses is based on relevant information about past events including historical experience, current conditions and reasonable and supportable forecasts that affect the collectibility of the reported amount. The amendment affects loans, debt securities, trade receivables, net investments in leases, off-balance-sheet credit exposures, reinsurance receivables and any other financial asset not excluded from the scope that have the contractual right to receive cash. The Update replaces the incurred loss impairment methodology, which generally only considered past events and current conditions, with a methodology that reflects the expected credit losses and required consideration of a broader range of reasonable and supportable information to estimate all expected

12


credit losses. The Update additionally addresses purchased assets and introduces the purchased financial asset with a more-than-insignificant amount of credit deterioration since origination ("PCD"). The accounting for these PCD assets is similar to the existing accounting guidance of FASB Accounting Standards Codification ("ASC") 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality, for purchased credit impaired ("PCI") assets, except the subsequent improvements in estimated cash flows will be immediately recognized into income, similar to the immediate recognition of subsequent deteriorations in cash flows. Current guidance only allows for the prospective recognition of these cash flow improvements. Because the terminology has been changed to a "more-than-insignificant" amount of credit deterioration, the presumption is that more assets might qualify for this accounting under the Update than those under current guidance. For public business entities, the Update is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years with early adoption permitted for fiscal years after December 15, 2018. An entity will apply the Update through a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is adopted. A prospective transition approach is required for debt securities. An entity that has previously applied the guidance of FASB ASC 310-30 will prospectively apply the guidance in this Update for PCD assets. A prospective transition approach should be used for PCD assets where upon adoption, the amortized cost basis should be adjusted to reflect the addition of the allowance for credit losses. The Company is anticipating adopting the Update on January 1, 2020. Upon adoption, the Company expects a change in the processes, internal controls and procedures to calculate the allowance for loan losses, including changes in assumptions and estimates to consider expected credit losses over the life of the loan versus the current accounting practice that utilizes the incurred loss model. The new guidance may result in an increase in the allowance for loan losses which will also reflect the new requirement to include the nonaccretable principal differences on PCI loans; however, the Company is still in the process of determining the magnitude of the increase and its impact on the Condensed Consolidated Financial Statements. In addition, the current accounting policy and procedures for other-than-temporary impairment on investment securities available for sale will be replaced with an allowance approach. During 2017, the Company's management created a CECL steering committee which will begin developing and implementing processes and procedures to ensure it is fully compliant with the amendments at the adoption date. To date, the CECL steering committee has reviewed proposals from several vendors to assist the Company in the adoption.
FASB ASU 2016-15Statement 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 is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Early adoption is permitted and must be applied using a retrospective transitional method to each period presented. The Company has evaluated the new guidance and does not anticipate that its adoption of this Update on January 1, 2018 will have a significant impact on its Condensed Consolidated Financial Statements.
FASB ASU 2017-03, Accounting Changes and Error Corrections (Topic 250) and Investments—Equity Method and Joint Ventures (Topic 323): Amendments to SEC Paragraphs Pursuant to Staff Announcements at the September 22, 2016 and November 17, 2016 EITF Meetings (SEC Update), was issued in January 2017. The SEC staff view is that a registrant should evaluate FASB ASC Updates that have not yet been adopted to determine the appropriate financial disclosures about the potential material effects of the updates on the financial statements when adopted. If a registrant does not know or cannot reasonably estimate the impact of an update, then in addition to making a statement to that effect, the registrant should consider additional qualitative financial statement disclosures to assist the reader in assessing the significance of the impact. The staff expects the additional qualitative disclosures to include a description of the effect of the accounting policies expected to be applied compared to current accounting policies. Also, the registrant should describe the status of its process to implement the new standards and the significant implementation matters yet to be addressed. The amendments specifically addressed recent FASB ASC amendments to Topic 326, Financial Instruments - Credit Losses; Topic 842, Leases; and Topic 606, Revenue from Contracts with Customers; although, the amendments apply to any subsequent amendments to guidance in the FASB ASC. The Company adopted the amendments in this Update during the fourth quarter of 2016 and appropriate disclosures have been included in this Note for each recently issued accounting standard.
FASB ASU 2017-04Goodwill (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.

13



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

FASB ASU 2017-09, Compensation—Stock Compensation (Topic 718): Scope of Modification Accounting was issued in May 2017 to provide clarity as to when to apply modification accounting when there is a change in the terms or conditions of a share-based payment award. According to this Update, an entity should account for the effects of a modification unless the fair value, vesting conditions and balance sheet classification of the award is the same after the modification as compared to the original award prior to the modification. The Update is effective for reporting periods beginning after December 15, 2017, with early adoption permitted. The Company does not expect the Update will have a material impact on its Condensed Consolidated Financial Statements.

(2)Investment Securities
The Company’s investment policy is designed primarily to provide and maintain liquidity, generate a favorable return on assets without incurring undue interest rate and credit risk, and complement the Bank’s lending activities.

14


(a) Securities by Type and Maturity
The amortized cost, gross unrealized gains, gross unrealized losses and fair values of investment securities available for sale at the dates indicated were as follows:
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
 (In thousands)
September 30, 2017       
U.S. Treasury and U.S. Government-sponsored agencies$9,464
 $12
 $(73) $9,403
Municipal securities248,420
 5,429
 (1,043) 252,806
Mortgage-backed securities and collateralized mortgage obligations(1):
       
Residential275,128
 879
 (1,646) 274,361
Commercial214,793
 699
 (2,209) 213,283
Collateralized loan obligations6,007
 15
 
 6,022
Corporate obligations15,583
 247
 
 15,830
Other securities27,850
 505
 
 28,355
Total$797,245
 $7,786
 $(4,971) $800,060
        
December 31, 2016       
U.S. Treasury and U.S. Government-sponsored agencies$1,563
 $6
 $
 $1,569
Municipal securities237,305
 2,427
 (2,476) 237,256
Mortgage-backed securities and collateralized mortgage obligations(1):
       
Residential310,391
 985
 (2,200) 309,176
Commercial211,259
 599
 (3,540) 208,318
Collateralized loan obligations10,505
 4
 (31) 10,478
Corporate obligations16,611
 104
 (9) 16,706
Other securities11,005
 156
 (19) 11,142
Total$798,639
 $4,281
 $(8,275) $794,645

(1)Issued and guaranteed by U.S. Government-sponsored agencies.
There were no securities classified as trading or held to maturity at September 30, 2017 or December 31, 2016.
The amortized cost and fair value of investment securities available for sale at September 30, 2017, by contractual maturity, are set forth below. Actual maturities may differ from contractual maturities because certain borrowers have the right to call or prepay obligations with or without call or prepayment penalties.
 Amortized Cost Fair Value
 (In thousands)
Due in one year or less$6,556
 $6,595
Due after one year through five years121,518
 122,740
Due after five years through ten years248,291
 248,603
Due after ten years420,835
 421,972
Investment securities with no stated maturities45
 150
Total$797,245
 $800,060

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(b) Unrealized Losses and Other-Than-Temporary Impairments
The following table shows the gross unrealized losses and fair value of the Company's investment securities available for sale that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that the individual securities have been in continuous unrealized loss positions as of September 30, 2017 and December 31, 2016:
 Less than 12 Months 12 Months or Longer Total
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
 (In thousands)
September 30, 2017           
U.S. Treasury and U.S. Government-sponsored agencies$6,484
 $(73) $
 $
 $6,484
 $(73)
Municipal securities24,415
 (362) 23,629
 (681) 48,044
 (1,043)
Mortgage-backed securities and collateralized mortgage obligations(1):
           
Residential135,648
 (1,111) 23,937
 (535) 159,585
 (1,646)
Commercial112,595
 (1,478) 38,099
 (731) 150,694
 (2,209)
Total$279,142
 $(3,024) $85,665
 $(1,947) $364,807
 $(4,971)
            
December 31, 2016           
Municipal securities$90,188
 $(2,476) $
 $
 $90,188
 $(2,476)
Mortgage-backed securities and collateralized mortgage obligations(1):
           
Residential181,562
 (2,148) 10,854
 (52) 192,416
 (2,200)
Commercial157,055
 (3,446) 12,597
 (94) 169,652
 (3,540)
Collateralized loan obligations2,976
 (1) 2,969
 (30) 5,945
 (31)
Corporate obligations4,032
 (9) 
 
 4,032
 (9)
Other securities6,998
 (19) 
 
 6,998
 (19)
Total$442,811
 $(8,099) $26,420
 $(176) $469,231
 $(8,275)
(1) Issued and guaranteed by U.S. Government-sponsored agencies.
The Company has evaluated these investment securities available for sale as of September 30, 2017 and December 31, 2016 and has determined that the decline in their value is temporary. The unrealized losses are primarily due to increases in market interest rates and larger spreads in the market for mortgage-related products. The fair value of these securities is expected to recover as the securities approach their maturity date and/or as the pricing spreads narrow on mortgage-related securities. None of the underlying issuers of the municipal securities had credit ratings that were below investment grade levels at September 30, 2017 or December 31, 2016. The Company has the ability and intent to hold the investments until recovery of the securities' amortized cost, which may be the maturity date of the securities.
For the three and nine months ended September 30, 2017 and 2016, there were no investment securities determined to be other-than-temporarily impaired.

16


        
(c) Pledged Securities
The following table summarizes the amortized cost and fair value of investment securities available for sale that are pledged as collateral for the following obligations at September 30, 2017 and December 31, 2016:
 September 30, 2017 December 31, 2016
 
Amortized
Cost
 
Fair
Value
 
Amortized
Cost
 
Fair
Value
 (In thousands)
Washington and Oregon state to secure public deposits$40,997
 $40,772
 $214,834
 $215,247
Repurchase agreements12,620
 12,724
 29,481
 29,294
Other securities pledged201,783
 203,482
 3,557
 3,546
Total$255,400
 $256,978
 $247,872
 $248,087

(3)Loans Receivable
The Company originates loans in the ordinary course of business and has also acquired loans through FDIC-assisted and open bank transactions. Disclosures related to the Company's recorded investment in loans receivable generally exclude accrued interest receivable and net deferred costs because they are insignificant.
Loans acquired in a business combination are further classified as “purchased” loans. Loans purchased with evidence of credit deterioration since origination for which it is probable that not all contractually required payments will be collected are accounted for under FASB ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality. These loans are identified as "PCI" loans. Loans purchased that are not accounted for under FASB ASC 310-30 are accounted for under FASB ASC 310-20, Receivables—Nonrefundable Fees and Other Costs, and are referred to as "non-PCI" loans.
(a) Loan Origination/Risk Management
The Company categorizes loans in one of the four segments of the total loan portfolio: commercial business, one-to-four family residential, real estate construction and land development and consumer. Within these segments are classes of loans for which management monitors and assesses credit risk in the loan portfolios. The Company has certain lending policies and procedures in place that are designed to maximize loan income within an acceptable level of risk. Management reviews and approves these policies and procedures on a regular basis. A reporting system supplements the review process by providing management with frequent reports related to loan production, loan quality, concentrations of credit, loan delinquencies and nonperforming and potential problem 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 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.

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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 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.

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Loans receivable at September 30, 2017 and December 31, 2016 consisted of the following portfolio segments and classes:
 September 30, 2017 December 31, 2016
 (In thousands)
Commercial business:   
Commercial and industrial$665,582
 $637,773
Owner-occupied commercial real estate602,238
 558,035
Non-owner occupied commercial real estate930,188
 880,880
Total commercial business2,198,008
 2,076,688
One-to-four family residential81,422
 77,391
Real estate construction and land development:   
One-to-four family residential51,451
 50,414
Five or more family residential and commercial properties122,981
 108,764
Total real estate construction and land development174,432
 159,178
Consumer340,643
 325,140
Gross loans receivable2,794,505
 2,638,397
Net deferred loan costs3,008
 2,352
 Loans receivable, net2,797,513
 2,640,749
Allowance for loan losses(31,400) (31,083)
 Total loans receivable, net$2,766,113
 $2,609,666
(b) Concentrations of Credit
Most of the Company’s lending activity occurs within its primary market areas which are concentrated along the I-5 corridor from Whatcom County to Clark County in Washington State and Multnomah County in Oregon, as well as other contiguous markets. The majority of the Company’s loan portfolio consists of (in order of balances at September 30, 2017) non-owner occupied commercial real estate, commercial and industrial and owner-occupied commercial real estate. As of September 30, 2017 and December 31, 2016, there were no concentrations of loans related to any single industry in excess of 10% of the Company’s total loans.
(c) Credit Quality Indicators
As part of the on-going monitoring of the credit quality of the Company’s loan portfolio, management tracks certain credit quality indicators including trends related to (i) the risk grade of the loans, (ii) the level of classified loans, (iii) net charge-offs, (iv) nonperforming loans and (v) the general economic conditions of the United States of America, and specifically the states of Washington and Oregon. The Company utilizes a risk grading matrix to assign a risk grade to each of its loans. Loans are graded on a scale of 1 to 10. A description of the general characteristics of the risk grades is as follows:
Grades 1 to 5: These grades are considered “pass grade” and include loans with negligible to above average but acceptable risk. These borrowers generally have strong to acceptable capital levels and consistent earnings and debt service capacity. Loans with the higher grades within the “pass” category may include borrowers who are experiencing unusual operating difficulties, but have acceptable payment performance to date. Increased monitoring of financial information and/or collateral may be appropriate. Loans with this grade show no immediate loss exposure.
Grade 6: This grade includes "Watch" loans and is considered a “pass grade”. The grade is intended to be utilized on a temporary basis for pass grade borrowers where a potentially significant risk-modifying action is anticipated in the near term.
Grade 7: This grade includes “Other Assets Especially Mentioned” (“OAEM”) loans in accordance with regulatory guidelines, and is intended to highlight loans with elevated risks. Loans with this grade show signs of deteriorating profits and capital, and the borrower might not be strong enough to sustain a major setback. The borrower is typically higher than normally leveraged, and outside support might be modest and likely illiquid. The loan is at risk of further decline unless active measures are taken to correct the situation.

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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.

20


The following tables present the balance of the loans receivable by credit quality indicator as of September 30, 2017 and December 31, 2016.
 September 30, 2017
 Pass OAEM Substandard Doubtful/Loss Total
 (In thousands)
Commercial business:         
Commercial and industrial$625,387
 $11,067
 $29,128
 $
 $665,582
Owner-occupied commercial real estate576,313
 8,305
 17,620
 
 602,238
Non-owner occupied commercial real estate897,677
 15,790
 16,721
 
 930,188
Total commercial business2,099,377
 35,162
 63,469
 
 2,198,008
One-to-four family residential79,882
 
 1,540
 
 81,422
Real estate construction and land development:         
One-to-four family residential48,101
 273
 3,077
 
 51,451
Five or more family residential and commercial properties121,854
 722
 405
 
 122,981
Total real estate construction and land development169,955
 995
 3,482
 
 174,432
Consumer335,073
 
 5,045
 525
 340,643
Gross loans receivable$2,684,287
 $36,157
 $73,536
 $525
 $2,794,505

 December 31, 2016
 Pass OAEM Substandard Doubtful/Loss Total
 (In thousands)
Commercial business:         
Commercial and industrial$601,273
 $5,048
 $31,452
 $
 $637,773
Owner-occupied commercial real estate532,585
 4,437
 21,013
 
 558,035
Non-owner occupied commercial real estate841,383
 14,573
 24,924
 
 880,880
Total commercial business1,975,241
 24,058
 77,389
 
 2,076,688
One-to-four family residential76,020
 
 1,371
 
 77,391
Real estate construction and land development:         
One-to-four family residential44,752
 500
 5,162
 
 50,414
Five or more family residential and commercial properties105,723
 1,150
 1,891
 
 108,764
Total real estate construction and land development150,475
 1,650
 7,053
 
 159,178
Consumer320,140
 
 5,000
 
 325,140
Gross loans receivable$2,521,876
 $25,708
 $90,813
 $
 $2,638,397

Potential problem loans are loans classified as OAEM or worse that are currently accruing interest and are not considered impaired, but which management is monitoring because the financial information of the borrower causes concern as to their ability to meet their loan repayment terms. Potential problem loans may include PCI loans as these loans continue to accrete loan discounts established at acquisition based on the guidance of FASB ASC 310-30. Potential problem loans as of September 30, 2017 and December 31, 2016 were $84.1 million and $87.8 million, respectively. The balance of potential problem loans guaranteed by a governmental agency, which guarantee reduces

21


the Company's credit exposure, was $1.7 million and $1.1 million as of September 30, 2017 and December 31, 2016, respectively.
(d) Nonaccrual Loans
Nonaccrual loans, segregated by segments and classes of loans, were as follows as of September 30, 2017 and December 31, 2016:
 September 30, 2017 December 31, 2016
 (In thousands)
Commercial business:   
Commercial and industrial$4,056
 $3,531
Owner-occupied commercial real estate3,720
 3,728
Non-owner occupied commercial real estate1,907
 1,321
Total commercial business9,683
 8,580
One-to-four family residential84
 94
Real estate construction and land development:   
One-to-four family residential869
 2,008
Consumer316
 227
Nonaccrual loans$10,952
 $10,909
The Company had $2.5 million and $2.8 million of nonaccrual loans guaranteed by governmental agencies at September 30, 2017 and December 31, 2016, respectively.
PCI loans are not included in the nonaccrual loan table above because these loans are accounted for under FASB ASC 310-30, which provides that accretable yield is calculated based on a loan's expected cash flow even if the loan is not performing under its contractual terms.
(e) Past due loans
The Company performs an aging analysis of past due loans using the categories of 30-89 days past due and 90 or more days past due. This policy is consistent with regulatory reporting requirements.
The balances of past due loans, segregated by segments and classes of loans, as of September 30, 2017 and December 31, 2016 were as follows:
 September 30, 2017
 30-89 Days 
90 Days or
Greater
 
Total Past 
Due
 Current Total
 (In thousands)
Commercial business:         
Commercial and industrial$790
 $1,014
 $1,804
 $663,778
 $665,582
Owner-occupied commercial real estate498
 1,270
 1,768
 600,470
 602,238
Non-owner occupied commercial real estate
 2,085
 2,085
 928,103
 930,188
Total commercial business1,288
 4,369
 5,657
 2,192,351
 2,198,008
One-to-four family residential
 
 
 81,422
 81,422
Real estate construction and land development:         
One-to-four family residential1,038
 309
 1,347
 50,104
 51,451
Five or more family residential and commercial properties366
 
 366
 122,615
 122,981
Total real estate construction and land development1,404
 309
 1,713
 172,719
 174,432
Consumer1,738
 657
 2,395
 338,248
 340,643
Gross loans receivable$4,430
 $5,335
 $9,765
 $2,784,740
 $2,794,505


22


 December 31, 2016
 30-89 Days 
90 Days or
Greater
 
Total Past 
Due
 Current Total
 (In thousands)
Commercial business:         
Commercial and industrial$2,687
 $1,733
 $4,420
 $633,353
 $637,773
Owner-occupied commercial real estate1,807
 2,915
 4,722
 553,313
 558,035
Non-owner occupied commercial real estate733
 
 733
 880,147
 880,880
Total commercial business5,227
 4,648
 9,875
 2,066,813
 2,076,688
One-to-four family residential523
 
 523
 76,868
 77,391
Real estate construction and land development:         
One-to-four family residential90
 2,008
 2,098
 48,316
 50,414
Five or more family residential and commercial properties
 377
 377
 108,387
 108,764
Total real estate construction and land development90
 2,385
 2,475
 156,703
 159,178
Consumer2,292
 105
 2,397
 322,743
 325,140
Gross loans receivable$8,132
 $7,138
 $15,270
 $2,623,127
 $2,638,397

There were no loans 90 days or more past due that were still accruing interest as of September 30, 2017 or December 31, 2016, excluding PCI loans.

(f) Impaired loans
Impaired loans include nonaccrual loans and performing troubled debt restructured ("TDR") loans. The balances of impaired loans as of September 30, 2017 and December 31, 2016 are set forth in the following tables.
 September 30, 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$3,131
 $8,581
 $11,712
 $12,060
 $1,254
Owner-occupied commercial real estate1,082
 4,676
 5,758
 6,068
 767
Non-owner occupied commercial real estate4,749
 6,034
 10,783
 10,927
 895
Total commercial business8,962
 19,291
 28,253
 29,055
 2,916
One-to-four family residential
 304
 304
 311
 96
Real estate construction and land development:         
One-to-four family residential1,347
 
 1,347
 2,305
 
Five or more family residential and commercial properties
 658
 658
 658
 39
Total real estate construction and land development1,347
 658
 2,005
 2,963
 39
Consumer160
 274
 434
 457
 60
Total$10,469
 $20,527
 $30,996
 $32,786
 $3,111

23


 December 31, 2016
 
Recorded
Investment With
No Specific
Valuation
Allowance
 
Recorded
Investment With
Specific
Valuation
Allowance
 
Total
Recorded
Investment
 
Unpaid
Contractual
Principal
Balance
 
Related
Specific
Valuation
Allowance
 (In thousands)
Commercial business:         
Commercial and industrial$1,739
 $10,636
 $12,375
 $13,249
 $1,199
Owner-occupied commercial real estate1,150
 3,574
 4,724
 5,107
 511
Non-owner occupied commercial real estate4,905
 6,413
 11,318
 11,386
 797
Total commercial business7,794
 20,623
 28,417
 29,742
 2,507
One-to-four family residential
 321
 321
 325
 97
Real estate construction and land development:         
One-to-four family residential2,243
 828
 3,071
 3,755
 6
Five or more family residential and commercial properties
 1,079
 1,079
 1,079
 60
Total real estate construction and land development2,243
 1,907
 4,150
 4,834
 66
Consumer48
 262
 310
 325
 64
Total$10,085
 $23,113
 $33,198
 $35,226
 $2,734

The Company had governmental guarantees of $3.9 million and $3.5 million related to the impaired loan balances at September 30, 2017 and December 31, 2016, respectively.
The average recorded investment of impaired loans for the three and nine months ended September 30, 2017 and 2016 are set forth in the following table.
 Three Months Ended September 30, Nine Months Ended September 30,
 2017 2016 2017 2016
 (In thousands)
Commercial business:       
Commercial and industrial$11,171
 $9,625
 $11,190
 $9,750
Owner-occupied commercial real estate5,289
 4,553
 5,049
 4,560
Non-owner occupied commercial real estate11,037
 12,107
 11,198
 12,232
Total commercial business27,497
 26,285
 27,437
 26,542
One-to-four family residential307
 265
 312
 267
Real estate construction and land development:       
One-to-four family residential2,157
 3,177
 2,530
 3,253
Five or more family residential and commercial properties860
 1,619
 967
 1,746
Total real estate construction and land development3,017
 4,796
 3,497
 4,999
Consumer346
 885
 328
 907
Total$31,167
 $32,231
 $31,574
 $32,715
For the three and nine months ended September 30, 2017 and 2016, no interest income was recognized subsequent to a loan’s classification as nonaccrual. For the three and nine months ended September 30, 2017, the Bank recorded $366,000 and $1.0 million, respectively, of interest income related to performing TDR loans. For the

24


three and nine months ended September 30, 2016, the Bank recorded $156,000 and $501,000, respectively, of interest income related to performing TDR loans.
(g) Troubled Debt Restructured Loans
A TDR loan is a restructuring in which the Bank, for economic or legal reasons related to a borrower’s financial difficulties, grants a concession to the borrower that it would not otherwise consider. TDRs are considered impaired and are separately measured for impairment under FASB ASC 310-10-35, whether on accrual ("performing") or nonaccrual ("nonperforming") status. The Company has more stringent definitions of concessions and impairment measures for PCI loans as these loans have known credit deterioration and are generally accreting income at a lower discounted rate as compared to the contractual note rate based on the guidance of FASB ASC 310-30.
The majority of the Bank’s TDR loans are a result of granting extensions of maturity on troubled credits which have already been adversely classified. The Bank grants such extensions to reassess the borrower’s financial status and to develop a plan for repayment. The second most prevalent concessions are certain modifications with extensions that also include interest rate reductions. Certain TDRs were additionally re-amortized over a longer period of time. These modifications would all be considered a concession for a borrower that could not obtain similar financing terms from another source other than from the Bank.
The financial effects of each modification will vary based on the specific restructure. For the majority of the Bank’s TDR loans, the loans were interest-only with a balloon payment at maturity. If the interest rate is not adjusted and the modified terms are consistent with other similar credits being offered, the Bank may not experience any loss associated with the restructure. If, however, the restructure involves forbearance agreements or interest rate modifications, the Bank may not collect all the principal and interest based on the original contractual terms. The Bank estimates the necessary allowance for loan losses on TDRs using the same guidance as used for other impaired loans.
The recorded investment balance and related allowance for loan losses of performing and nonaccrual TDR loans as of September 30, 2017 and December 31, 2016 were as follows:
 September 30, 2017 December 31, 2016
 
Performing
TDRs
 
Nonaccrual
TDRs
 
Performing
TDRs
 Nonaccrual
TDRs
 (In thousands)
TDR loans$20,044
 $5,903
 $22,288
 $6,900
Allowance for loan losses on TDR loans2,136
 555
 1,965
 437

The unfunded commitment to borrowers related to TDRs was $160,000 and $249,000 at September 30, 2017 and December 31, 2016, respectively.

25


Loans that were modified as TDRs during the three and nine months ended September 30, 2017 and 2016 are set forth in the following tables:
 Three Months Ended September 30,
 2017 2016
 
Number of
Contracts
(1)
 Outstanding
Principal Balance 
(1)(2)
 
Number of
Contracts
(1)
 
Outstanding
Principal Balance 
(1)(2)
 (Dollars in thousands)
Commercial business:       
Commercial and industrial4
 $1,353
 8
 $2,324
Owner-occupied commercial real estate2
 1,299
 2
 576
Non-owner occupied commercial real estate1
 655
 1
 818
Total commercial business7
 3,307
 11
 3,718
Real estate construction and land development:       
One-to-four family residential
 
 5
 2,274
Five or more family residential and commercial properties
 
 1
 1,606
Total real estate construction and land development
 
 6
 3,880
Consumer4
 52
 2
 26
Total TDR loans11
 $3,359
 19
 $7,624

 Nine Months Ended September 30,
 2017 2016
 
Number of
Contracts
(1)
 Outstanding
Principal Balance 
(1)(2)
 
Number of
Contracts
(1)
 
Outstanding
Principal Balance 
(1)(2)
 (Dollars in thousands)
Commercial business:       
Commercial and industrial13
 $5,564
 15
 $2,915
Owner-occupied commercial real estate3
 1,351
 2
 576
Non-owner occupied commercial real estate2
 1,596
 1
 818
Total commercial business18
 8,511
 18
 4,309
Real estate construction and land development:       
One-to-four family residential2
 1,038
 5
 2,274
Five or more family residential and commercial properties
 
 1
 1,606
Total real estate construction and land development2
 1,038
 6
 3,880
Consumer5
 60
 6
 70
Total TDR loans25
 $9,609
 30
 $8,259

(1)Number of contracts and outstanding principal balance represent loans which have balances as of period end as certain loans may have been paid-down or charged-off during the three and nine months ended September 30, 2017 and 2016.
(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).

Of the 11 loans modified during the three months ended September 30, 2017, seven loans with a total outstanding principal balance of $2.1 million had no prior modifications. Of the 25 loans modified during the nine months

26


ended September 30, 2017, 15 loans with a total outstanding principal balance of $5.0 million had no prior modifications. Of the 19 loans modified during the three months ended September 30, 2016, eight loans with a total outstanding principal balance of $1.4 million had no prior modifications. Of the 30 loans modified during the nine months ended September 30, 2016, 15 loans with a total outstanding principal balance of $1.7 million had no prior modifications. The remaining loans included in the table above for the three and nine months ended September 30, 2017 and 2016 were previously reported as TDRs. The Bank typically grants shorter extension periods to continually monitor these TDRs despite the fact that the extended date might not be the date the Bank expects sufficient cash flow from these borrowers. The Company does not consider these modifications a subsequent default of a TDR as new loan terms, specifically new maturity dates, were granted. The potential losses related to these loans would have been considered in the period the loan was first reported as a TDR and are adjusted, as necessary, in the current period based on more recent information. The related specific valuation allowance at September 30, 2017 was $1.1 million for loans that were modified as TDRs during the nine months ended September 30, 2017.
There was one commercial and industrial loan totaling $234,000 at September 30, 2017 that was modified during the previous twelve months that subsequently defaulted during the three and nine months ended September 30, 2017 because the borrower was more than 90 days delinquent on their scheduled loan payments. There were no loans that were modified during the previous twelve months that subsequently defaulted during the three and nine months ended September 30, 2016.
        
        
(h) Purchased Credit Impaired Loans
The Company acquired loans and designated them as PCI loans, which are accounted for under FASB ASC 310-30, in the Washington Banking Merger on May 1, 2014 and in previously completed acquisitions, including the FDIC-assisted acquisitions of Cowlitz Bank ("Cowlitz") and Pierce Commercial Bank ("Pierce") on July 30, 2010 and November 8, 2010, respectively, and the acquisitions of Northwest Commercial Bank ("NCB") on January 9, 2013 and Valley Community Bancshares, Inc. ("Valley") on July 15, 2013.
The following table reflects the outstanding principal balance and recorded investment of the PCI loans at September 30, 2017 and December 31, 2016:
 September 30, 2017 December 31, 2016
 Outstanding Principal Recorded Investment Outstanding Principal Recorded Investment
 (In thousands)
Commercial business:       
Commercial and industrial$9,220
 $5,001
 $13,067
 $9,317
Owner-occupied commercial real estate14,059
 12,492
 17,639
 15,973
Non-owner occupied commercial real estate15,026
 13,058
 25,037
 23,360
Total commercial business38,305
 30,551
 55,743
 48,650
One-to-four family residential4,426
 3,983
 5,120
 4,905
Real estate construction and land development:       
One-to-four family residential2,928
 1,749
 2,958
 2,123
Five or more family residential and commercial properties2,392
 2,284
 2,614
 2,488
Total real estate construction and land development5,320
 4,033
 5,572
 4,611
Consumer3,998
 5,129
 5,296
 6,282
Gross PCI loans$52,049
 $43,696
 $71,731
 $64,448

27


On the acquisition dates, the amount by which the undiscounted expected cash flows of the PCI loans exceeded the estimated fair value of the loan is the “accretable yield.” The accretable yield is then measured at each financial reporting date and represents the difference between the remaining undiscounted expected cash flows and the current carrying value of the PCI loans.
The following table summarizes the accretable yield on the PCI loans for the three and nine months ended September 30, 2017 and 2016.
  Three Months Ended September 30, Nine Months Ended September 30,
  2017 2016 2017 2016
  (In thousands)
Balance at the beginning of the period $12,296
 $15,359
 $13,860
 $17,592
Accretion (796) (1,178) (2,725) (3,900)
Disposal and other (1,287) (491) (2,430) (2,921)
Change in accretable yield 939
 1,214
 2,447
 4,133
Balance at the end of the period $11,152
 $14,904
 $11,152
 $14,904

(4)Allowance for Loan Losses
The allowance for loan losses is maintained at a level deemed appropriate by management to provide for probable incurred credit losses in the loan portfolio. The following tables detail the activity in the allowance for loan losses disaggregated by segment and class for the three and nine months ended September 30, 2017:

28


 Balance at Beginning of Period Charge-offs Recoveries Provision for Loan Losses Balance at End of Period
 (In thousands)
Three Months Ended September 30, 2017         
Commercial business:         
Commercial and industrial$10,651
 $(3) $4
 $(772) $9,880
Owner-occupied commercial real estate4,154
 (1,494) 4
 1,397
 4,061
Non-owner occupied commercial real estate7,709
 
 
 (415) 7,294
Total commercial business22,514
 (1,497) 8
 210
 21,235
One-to-four family residential1,073
 (15) 
 (21) 1,037
Real estate construction and land development:         
One-to-four family residential821
 (556) 191
 337
 793
Five or more family residential and commercial properties1,666
 
 
 (271) 1,395
Total real estate construction and land development2,487
 (556) 191
 66
 2,188
Consumer5,710
 (478) 112
 453
 5,797
Unallocated967
 
 
 176
 1,143
Total$32,751
 $(2,546) $311
 $884
 $31,400
          
Nine Months Ended September 30, 2017         
Commercial business:         
Commercial and industrial$10,968
 $(361) $679
 $(1,406) $9,880
Owner-occupied commercial real estate3,661
 (1,579) 155
 1,824
 4,061
Non-owner occupied commercial real estate7,753
 
 
 (459) 7,294
Total commercial business22,382
 (1,940) 834
 (41) 21,235
One-to-four family residential1,015
 (15) 1
 36
 1,037
Real estate construction and land development:         
One-to-four family residential797
 (556) 201
 351
 793
Five or more family residential and commercial properties1,359
 
 
 36
 1,395
Total real estate construction and land development2,156
 (556) 201
 387
 2,188
Consumer5,024
 (1,419) 329
 1,863
 5,797
Unallocated506
 
 
 637
 1,143
Total$31,083
 $(3,930) $1,365
 $2,882
 $31,400


29


The following table details the allowance for loan losses disaggregated on the basis of the Company's impairment method as of September 30, 2017.
 Loans Individually Evaluated for Impairment Loans Collectively Evaluated for Impairment PCI Loans Total Allowance for Loan Losses
 (In thousands)
Commercial business:       
Commercial and industrial$1,254
 $7,589
 $1,037
 $9,880
Owner-occupied commercial real estate767
 2,434
 860
 4,061
Non-owner occupied commercial real estate895
 5,389
 1,010
 7,294
Total commercial business2,916
 15,412
 2,907
 21,235
One-to-four family residential96
 740
 201
 1,037
Real estate construction and land development:       
One-to-four family residential
 568
 225
 793
Five or more family residential and commercial properties39
 1,259
 97
 1,395
Total real estate construction and land development39
 1,827
 322
 2,188
Consumer60
 4,991
 746
 5,797
Unallocated
 1,143
 
 1,143
Total$3,111
 $24,113
 $4,176
 $31,400
The following table details the recorded investment balance of the loan receivables disaggregated on the basis of the Company’s impairment method as of September 30, 2017:
 Loans Individually Evaluated for Impairment Loans Collectively Evaluated for Impairment PCI Loans Total Gross Loans Receivable
 (In thousands)
Commercial business:       
Commercial and industrial$11,712
 $648,869
 $5,001
 $665,582
Owner-occupied commercial real estate5,758
 583,988
 12,492
 602,238
Non-owner occupied commercial real estate10,783
 906,347
 13,058
 930,188
Total commercial business28,253
 2,139,204
 30,551
 2,198,008
One-to-four family residential304
 77,135
 3,983
 81,422
Real estate construction and land development:       
One-to-four family residential1,347
 48,355
 1,749
 51,451
Five or more family residential and commercial properties658
 120,039
 2,284
 122,981
Total real estate construction and land development2,005
 168,394
 4,033
 174,432
Consumer434
 335,080
 5,129
 340,643
Total$30,996
 $2,719,813
 $43,696
 $2,794,505

30


The following tables detail activity in the allowance for loan losses disaggregated by segment and class for the three and nine months ended September 30, 2016.
 Balance at Beginning of Period Charge-offs Recoveries Provision for Loan Losses Balance at End of Period
 (In thousands)
Three Months Ended September 30, 2016         
Commercial business:         
Commercial and industrial$9,970
 $(240) $993
 $182
 $10,905
Owner-occupied commercial real estate3,578
 (88) 
 222
 3,712
Non-owner occupied commercial real estate6,924
 
 
 303
 7,227
Total commercial business20,472
 (328) 993
 707
 21,844
One-to-four family residential950
 
 
 26
 976
Real estate construction and land development:         
One-to-four family residential754
 
 
 96
 850
Five or more family residential and commercial properties1,277
 
 
 5
 1,282
Total real estate construction and land development2,031
 
 
 101
 2,132
Consumer4,816
 (572) 197
 665
 5,106
Unallocated157
 
 
 (4) 153
Total$28,426
 $(900) $1,190
 $1,495
 $30,211
          
Nine Months Ended September 30, 2016         
Commercial business:         
Commercial and industrial$9,972
 $(2,810) $1,352
 $2,391
 $10,905
Owner-occupied commercial real estate4,370
 (538) 
 (120) 3,712
Non-owner occupied commercial real estate7,722
 (350) 
 (145) 7,227
Total commercial business22,064
 (3,698) 1,352
 2,126
 21,844
One-to-four family residential1,157
 
 2
 (183) 976
Real estate construction and land development:         
One-to-four family residential1,058
 (100) 83
 (191) 850
Five or more family residential and commercial properties813
 (54) 
 523
 1,282
Total real estate construction and land development1,871
 (154) 83
 332
 2,132
Consumer4,309
 (1,370) 496
 1,671
 5,106
Unallocated345
 
 
 (192) 153
Total$29,746
 $(5,222) $1,933
 $3,754
 $30,211








31


The following table details the allowance for loan losses disaggregated on the basis of the Company's impairment method as of December 31, 2016.
 Loans Individually Evaluated for Impairment Loans Collectively Evaluated for Impairment PCI Loans Total Allowance for Loan Losses
 (In thousands)
Commercial business:       
Commercial and industrial$1,199
 $8,048
 $1,721
 $10,968
Owner-occupied commercial real estate511
 1,834
 1,316
 3,661
Non-owner occupied commercial real estate797
 5,142
 1,814
 7,753
Total commercial business2,507
 15,024
 4,851
 22,382
One-to-four family residential97
 643
 275
 1,015
Real estate construction and land development:       
One-to-four family residential6
 538
 253
 797
Five or more family residential and commercial properties60
 1,168
 131
 1,359
Total real estate construction and land development66
 1,706
 384
 2,156
Consumer64
 3,912
 1,048
 5,024
Unallocated
 506
 
 506
Total$2,734
 $21,791
 $6,558
 $31,083
The following table details the recorded investment balance of the loan receivables disaggregated on the basis of the Company’s impairment method as of December 31, 2016:
 Loans Individually Evaluated for Impairment Loans Collectively Evaluated for Impairment PCI Loans Total Gross Loans Receivable
 (In thousands)
Commercial business:       
Commercial and industrial$12,375
 $616,081
 $9,317
 $637,773
Owner-occupied commercial real estate4,724
 537,338
 15,973
 558,035
Non-owner occupied commercial real estate11,318
 846,202
 23,360
 880,880
Total commercial business28,417
 1,999,621
 48,650
 2,076,688
One-to-four family residential321
 72,165
 4,905
 77,391
Real estate construction and land development:       
One-to-four family residential3,071
 45,220
 2,123
 50,414
Five or more family residential and commercial properties1,079
 105,197
 2,488
 108,764
Total real estate construction and land development4,150
 150,417
 4,611
 159,178
Consumer310
 318,548
 6,282
 325,140
Total$33,198

$2,540,751
 $64,448
 $2,638,397


32


(5)Other Real Estate Owned
Changes in other real estate owned during the three and nine months ended September 30, 2017 and 2016 were as follows:
 Three Months Ended September 30, Nine Months Ended September 30,
 2017 2016 2017 2016
 (In thousands)
Balance at the beginning of the period$786
 $1,560
 $754
 $2,019
Additions
 25
 32
 677
Proceeds from dispositions(374) (1,716) (374) (2,486)
Gain on sales, net111
 131
 111
 173
Valuation adjustment
 
 
 (383)
Balance at the end of the period$523
 $
 $523
 $

At September 30, 2017, the carrying amount of other real estate owned that was the result of foreclosure and obtaining physical possession of residential real estate properties was $523,000. At September 30, 2017, the recorded investment of consumer mortgage loans secured by residential real estate properties (included in the one-to-four family residential loan class in Note (3) Loans Receivable) for which formal foreclosure proceedings were in process was $657,000.

(6)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 Washington Banking Merger on May 1, 2014, and the acquisitions of Valley 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).
There were no additions to goodwill during the three and nine months ended September 30, 2017 and 2016.
At September 30, 2017, the Company’s step-one analysis concluded that the reporting unit’s fair value was greater than its carrying value and therefore no goodwill impairment charges were required, or recorded, for the three and nine months ended September 30, 2017. Similarly, no goodwill impairment charges were required, or recorded, for the three and nine months ended September 30, 2016. Even though there was no goodwill impairment at September 30, 2017, adverse events may impact the recoverability of goodwill and could result in a future impairment charge which could have a material impact on the Company’s operating results.
(b) Other Intangible Assets
The other intangible assets represent the core deposit intangible ("CDI") acquired in business combinations. The useful life of the CDI related to the Washington Banking Merger, the acquisitions of Valley, NCB and Cowlitz were estimated to be ten, ten, five and nine years, respectively.
The following table presents the change in the other intangible assets for the periods indicated:
  Three Months Ended September 30, Nine Months Ended September 30,
  2017 2016 2017 2016
  (In thousands)
Balance at the beginning of the period $6,727
 $8,091
 $7,374
 $8,789
Less: Amortization 319
 359
 966
 1,057
Balance at the end of the period $6,408
 $7,732
 $6,408
 $7,732

(7)Other Borrowings
(a) Federal Home Loan Bank Advances
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

33


has its own interest rate and range of maturities. Limitations on the amount of advances are based on a percentage of the Bank's assets or on the FHLB’s assessment of the institution’s creditworthiness. At September 30, 2017, the Bank maintained a credit facility with the FHLB of Des Moines for $662.4 million and had short-term FHLB advances outstanding of $117.4 million with maturity dates within 30 days. At December 31, 2016 there were FHLB advances outstanding of $79.6 million.
The following table sets forth the details of FHLB advances during the three and nine months ended September 30, 2017 and 2016:
 Three Months Ended September 30, Nine Months Ended September 30,
 2017 2016 2017 2016
 (Dollars in thousands)
Average balance during the period$111,293
 $5,618
 $106,553
 $11,608
Maximum month-end balance during the period$126,200
 $17,700
 $137,450
 $57,300
Weighted average rate during the period1.53% 0.57% 1.09% 0.54%
Advances from the FHLB are collateralized by a blanket pledge on FHLB stock owned by the Bank, deposits at the FHLB, certain one-to-four single family residential loans or other assets, principally investment securities which are obligations of or guaranteed by the United States or other assets. In accordance with the pledge agreement, the Company must maintain unencumbered collateral in an amount equal to varying percentages ranging from 100% to 160% of outstanding advances depending on the type of collateral.

(b) Federal Funds Purchased
The Bank maintains advance lines with Wells Fargo Bank, US Bank, The Independent Bankers Bank and Pacific Coast Bankers’ Bank to purchase federal funds of up to $90.0 million as of September 30, 2017. The lines generally mature annually or are reviewed annually. As of September 30, 2017 and December 31, 2016, there were no federal funds purchased.
(c) Credit facilities
The Bank maintains a credit facility with the Federal Reserve Bank of San Francisco for $50.6 million as of September 30, 2017, of which there were no borrowings outstanding as of September 30, 2017 or December 31, 2016. Any advances on the credit facility would have to be first secured by the Bank's investment securities or loans receivable.

(8)Junior Subordinated Debentures
As part of the Washington Banking Merger, the Company assumed trust preferred securities and junior subordinated debentures with a total fair value of $18.9 million at the May 1, 2014 merger date.
Washington Banking Master Trust, a Delaware statutory business trust, was a wholly-owned subsidiary of Washington Banking created for the exclusive purposes of issuing and selling capital securities and utilizing sale proceeds to acquire junior subordinated debt issued by Washington Banking. During 2007, the Trust issued $25.0 million of trust preferred securities with a 30-year maturity, callable after the fifth year by Washington Banking. The trust preferred securities have a quarterly adjustable rate based upon the three-month London Interbank Offered Rate (“LIBOR”) plus 1.56%. On the Washington Banking Merger date of May 1, 2014, the Company acquired the Trust, which retained the Washington Banking Master Trust name, and assumed the performance and observance of the covenants under the indenture related to the trust preferred securities.
The adjustable rate of the trust preferred securities at September 30, 2017 was 2.89%. The weighted average rate of the junior subordinated debentures was 5.20% and 5.05% for the three and nine months ended September 30, 2017, respectively, and 4.49% and 4.43% for the three and nine months ended September 30, 2016, respectively. 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 September 30, 2017 and December 31, 2016, the balance of the junior subordinated debentures, net of unaccreted discount, was $19.9 million and $19.7 million, respectively. All of the common securities of the Trust are owned by the Company. Heritage has fully and unconditionally guaranteed the capital securities along with all obligations of the Trust under the trust agreements.

34



(9)Repurchase Agreements
The Company utilizes repurchase agreements with one-day maturities as a supplement to funding sources. Repurchase agreements are secured by pledged investment securities available for sale. Under the repurchase agreements, the Company is required to maintain an aggregate market value of securities pledged greater than the balance of the repurchase agreements. The Company is required to pledge additional securities to cover any declines below the balance of the repurchase agreements. For additional information on the total value of investment securities pledged for repurchase agreements see Note (2) Investment Securities.
The following table presents the Company's repurchase agreement obligations by class of collateral pledged:
 September 30, 2017 December 31, 2016
 (In thousands)
U.S. Treasury and U.S. Government-sponsored agencies$
 $2,944
Mortgage-backed securities and collateralized mortgage obligations(1):
   
Residential12,336
 5,191
Commercial16,332
 13,969
Total repurchase agreements$28,668
 $22,104
(1) Issued and guaranteed by U.S. Government-sponsored agencies.

(10)Derivative Financial Instruments
The Company has entered into certain interest rate swap contracts that are not designated as hedging instruments. The purpose of these derivative contracts is primarily to provide commercial business loan customers the ability to convert their loans from variable to fixed interest rates. Upon the origination of a derivative contract with a customer, the Company simultaneously enters into an offsetting derivative contract with a third party in order to offset its exposure on the variable and fixed rate components of the customer agreement. The Company recognizes immediate income based upon the difference in the bid/ask spread of the underlying transactions with its customers and the third party, which is recorded in interest rate swap fees on the Condensed Consolidated Statements of Income. Because the Company acts only as an intermediary for its customer, subsequent changes in the fair value of the underlying derivative contracts offset each other and do not significantly impact the Company’s results of operations.
The notional amounts and estimated fair values of interest rate derivative contracts outstanding at September 30, 2017 and December 31, 2016 are presented in the following table.
  September 30, 2017 December 31, 2016
  Notional Amounts Estimated Fair Value Notional Amounts Estimated Fair Value
  (In thousands)
Non-hedging interest rate derivatives        
Interest rate swaps with customer (1)
 $134,295
 $74
 $102,709
 $(1,099)
Interest rate swap with third party (1)
 134,295
 (74) 102,709
 1,099
 (1) The estimated fair value of the derivative included in prepaid and other assets on the Condensed Consolidated Statements of Financial Condition was $3.3 million and $2.8 million as of September 30, 2017 and December 31, 2016, respectively. The estimated fair value of the derivative included in accrued expenses and other liabilities on the Condensed Consolidated Statements of Financial Condition was $3.3 million and $2.8 million as of September 30, 2017 and December 31, 2016, respectively.


35


(11)Stockholders’ Equity
(a) Earnings Per Common Share
The following table illustrates the reconciliation of weighted average shares used for earnings per common share computations for the three and nine months ended September 30, 2017 and 2016:
 Three Months Ended September 30, Nine Months Ended September 30,
 2017 2016 2017 2016
 (Dollars in thousands)
Net income:       
Net income$10,624
 $11,039
 $31,768
 $29,025
Less: Dividends and undistributed earnings allocated to participating securities(64) (102) (228) (280)
Net income allocated to common shareholders$10,560
 $10,937
 $31,540
 $28,745
Basic:       
Weighted average common shares outstanding29,929,721
 29,962,270
 29,940,276
 29,968,034
Less: Restricted stock awards(146,425) (277,495) (192,186) (292,832)
Total basic weighted average common shares outstanding29,783,296
 29,684,775
 29,748,090
 29,675,202
Diluted:       
Basic weighted average common shares outstanding29,783,296
 29,684,775
 29,748,090
 29,675,202
Effect of potentially dilutive common shares (1)
107,414
 11,031
 86,004
 12,543
Total diluted weighted average common shares outstanding29,890,710
 29,695,806
 29,834,094
 29,687,745

(1)Represents the effect of the assumed exercise of stock options and vesting of restricted stock units.
Potential dilutive shares are excluded from the computation of earnings per share if their effect is anti-dilutive. For the three and nine months ended September 30, 2017 and the three months ended September 30, 2016, there were no anti-dilutive shares outstanding related to options to acquire common stock. For the nine months ended September 30, 2016, anti-dilutive shares outstanding related to options to acquire common stock totaled 580 as the assumed proceeds from exercise price, tax benefits and future compensation were in excess of the market value.
(b) Dividends
The timing and amount of cash dividends paid on the Company's common stock depends on the Company’s earnings, capital requirements, financial condition and other relevant factors. Dividends on common stock from the Company depend substantially upon receipt of dividends from the Bank, which is the Company’s predominant source of income.
The following table summarizes the dividend activity for the nine months ended September 30, 2017 and calendar year 2016.
Declared Cash Dividend per Share Record Date Paid Date 
January 27, 2016 $0.11 February 10, 2016 February 24, 2016 
April 20, 2016 $0.12 May 5, 2016 May 19, 2016 
July 20, 2016 $0.12 August 4, 2016 August 18, 2016 
October 26, 2016 $0.12 November 8, 2016 November 22, 2016 
October 26, 2016 $0.25 November 8, 2016 November 22, 2016*
January 25, 2017 $0.12 February 9, 2017 February 23, 2017 
April 25, 2017 $0.13 May 10, 2017 May 24, 2017 
July 25, 2017 $0.13 August 10, 2017 August 24, 2017 
* Denotes a special dividend.

36


The FDIC and the Washington State Department of Financial Institutions, Division of Banks have the authority under their supervisory powers to prohibit the payment of dividends by the Bank to the Company. Additionally, current guidance from the Board of Governors of the Federal Reserve System ("Federal Reserve Board") provides, among other things, that dividends per share on the Company’s common stock generally should not exceed earnings per share, measured over the previous four fiscal quarters. Current regulations allow the Company and the Bank to pay dividends on their common stock if the Company’s or the Bank’s regulatory capital would not be reduced below the statutory capital requirements set by the Federal Reserve Board and the FDIC.
(c) Stock Repurchase Program
The Company has had various stock repurchase programs since March 1999. On October 23, 2014, the Company's Board of Directors authorized the repurchase of up to 5% of the Company's outstanding common shares, or approximately 1,513,000 shares, under the eleventh stock repurchase plan. The number, timing and price of shares repurchased will depend on business and market conditions and other factors, including opportunities to deploy the Company's capital.
The following table provides total repurchased shares and average share prices under the plan for the periods indicated:
 Three Months Ended September 30, Nine Months Ended September 30,  
 2017 2016 2017 2016 
Plan Total (1)
Eleventh Plan         
Repurchased shares
 38,000
 
 138,000
 579,996
Stock repurchase average share price$
 $17.46
 $
 $17.16
 $16.76
(1) Represents shares repurchased and average price per share paid during the duration of the plan.
In addition to the stock repurchases disclosed in the table above, the Company repurchased shares to pay withholding taxes on the vesting of restricted stock. During the three and nine months ended September 30, 2017, the Company repurchased 344 and 27,711 shares of common stock at an average price per share of $25.80 and $24.61 to pay withholding taxes on the vesting of restricted stock that vested during the respective periods. During the three and nine months ended September 30, 2016, the Company repurchased 5,276 and 29,206 shares of common stock at an average price per share of $18.64 and $17.77 to pay withholding taxes on the vesting of restricted stock that vested during the respective periods.

(12)Accumulated Other Comprehensive Income
The changes in accumulated other comprehensive income (loss) (“AOCI”) by component, during the three and nine months ended September 30, 2017 and 2016 are as follows:
  
Three Months Ended September 30, 2017 (1)
 
Nine Months Ended September 30, 2017 (1)
  (In thousands)
Balance of AOCI at the beginning of period $1,557
 $(2,606)
Other comprehensive income before reclassification 289
 4,528
Amounts reclassified from AOCI for gain on sale of investment securities included in net income (28) (104)
Net current period other comprehensive income 261
 4,424
Balance of AOCI at the end of period $1,818
 $1,818
(1) All amounts are due to the changes in fair value of available for sale securities and are net of tax.


37


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

(13)Stock-Based Compensation
Stock options generally vest ratably over three years and expire five years after they become exercisable or vest ratably over four years and expire ten years from date of grant. Restricted stock awards issued generally have a four-year cliff vesting or four-year ratable vesting schedule. Restricted stock units vest ratably over three years. Performance restricted stock units issued generally have a three-year cliff vesting schedule. Additionally, performance restricted stock unit grants may be subject to performance-based vesting as well as other approved vesting conditions. The Company issues new shares of common stock to satisfy share option exercises, restricted stock awards and restricted stock units.
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.
Under the Company's stock-based compensation plans, 1,073,146 shares remain available for future issuance as of September 30, 2017.
(a) Stock Option Awards
For the three and nine months ended September 30, 2017 and 2016, the Company did not recognize any compensation expense or related tax benefit related to stock options as all of the compensation expense related to the outstanding stock options had been previously recognized. The intrinsic value and cash proceeds from options exercised during the nine months ended September 30, 2017 was $156,000 and $159,000, respectively. The intrinsic value and cash proceeds from options exercised during the nine months ended September 30, 2016 was $99,000 and $401,000, respectively.
The following table summarizes the stock option activity for the nine months ended September 30, 2017 and 2016:
 Shares Weighted-Average Exercise Price 
Weighted-Average
Remaining
Contractual
Term (In years)
 
Aggregate
Intrinsic
Value (In
thousands)
Outstanding at December 31, 201579,408
 $14.19
    
Exercised(27,867) 14.37
    
Forfeited or expired(4,200) 16.80
    
Outstanding at September 30, 201647,341
 $13.85
 2.80 $194
        
Outstanding at December 31, 201637,495
 $13.77
    
Exercised(12,304) 12.92
    
Forfeited or expired(1,308) 13.53
    
Outstanding, vested and expected to vest and exercisable at September 30, 201723,883
 $14.23
 2.45 $365


38


(b) Restricted Stock Awards
For the three and nine months ended September 30, 2017, the Company recognized compensation expense related to restricted stock awards of $292,000 and $1.1 million, respectively, and a related tax benefit of $102,000 and $384,000, respectively. For the three and nine months ended September 30, 2016, the Company recognized compensation expense related to restricted stock awards of $494,000 and $1.4 million, respectively, and a related tax benefit of $173,000 and $479,000, respectively. As of September 30, 2017, the total unrecognized compensation expense related to non-vested restricted stock awards was $1.8 million and the related weighted average period over which the compensation expense is expected to be recognized is approximately 1.78 years. The vesting date fair value of the restricted stock awards that vested during the nine months ended September 30, 2017 and 2016 was $2.7 million and $2.0 million, respectively.
The following table summarizes the restricted stock award activity for the nine months ended September 30, 2017 and 2016:
 Shares Weighted-Average Grant Date Fair Value
Nonvested at December 31, 2015264,521
 $15.92
Granted119,939
 17.53
Vested(111,357) 15.62
Forfeited(9,216) 16.57
Nonvested at September 30, 2016263,887
 $16.76
    
Nonvested at December 31, 2016261,296
 $16.80
Granted
 
Vested(107,202) 16.49
Forfeited(10,418) 16.80
Nonvested at September 30, 2017143,676
 $17.02

(c) Restricted Stock Units
For the three and nine months ended September 30, 2017, the Company recognized compensation expense related to restricted stock units of $236,000 and $472,000, respectively, and a related tax benefit of $83,000 and $165,000, respectively. As of September 30, 2017, the total unrecognized compensation expense related to non-vested restricted stock units was $1.8 million and the related weighted average period over which the compensation expense is expected to be recognized is approximately 2.26 years.
The following table summarizes the restricted stock unit activity for the nine months ended September 30, 2017:
 Shares Weighted-Average Grant Date Fair Value
Nonvested at December 31, 2016
 $
Granted92,019
 25.29
Vested
 
Forfeited(1,812) 25.35
Nonvested at September 30, 201790,207
 $25.29
The following table summarizes the assumptions used in the Monte Carlo model for restricted stock unit grants with market-based conditions during the nine months ended September 30, 2017:
Shares Expected Term in Years Weighted-Average Risk Free Interest Rate Expected Volatility Expected Dividend Yield Weighted-Average Fair Value
6,089 2.85 1.40% 21.8% % $24.39


39



(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.
Level 3: Valuations for assets and liabilities that are derived from other valuation methodologies, such as option pricing models, discounted cash flow models and similar techniques using unobservable inputs, and not based on market exchange, dealer, or broker traded transactions. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities.
(a) Recurring and Nonrecurring Basis
The Company used the following methods and significant assumptions to measure the fair value of certain assets on a recurring and nonrecurring basis:
Investment Securities Available for Sale:
The fair values of all investment securities are based upon the assumptions that market participants would use in pricing the security. If available, fair values of investment securities are determined by quoted market prices (Level 1). For investment securities where quoted market prices are not available, fair values are calculated based on market prices on similar securities (Level 2). For investment securities where quoted prices or market prices of similar securities are not available, fair values are calculated by using observable and unobservable inputs such as discounted cash flows or other market indicators (Level 3). Security valuations are obtained from third party pricing services for comparable assets or liabilities.
Impaired Loans:
At the time a loan is considered impaired, its impairment is measured based on either the present value of expected future cash flows discounted at the loan’s effective interest rate, the observable market price, or the fair market value of the collateral if the loan is collateral-dependent. Impaired loans for which impairment is measured using the discounted cash flow approach are not considered to be measured at fair value because the loan’s effective interest rate is generally not a fair value input, and for the purposes of fair value disclosures, the fair value of these loans are measured commensurate with non-impaired loans. If the Company utilizes the fair market value of the collateral method, the fair value used to measure impairment is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. Non-real estate collateral may be valued using an appraisal, net book value based on the borrower’s financial statements, or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation and management’s expertise and knowledge of the client and client’s business (Level 3). Impaired loans are evaluated on a quarterly basis for additional impairment and adjusted accordingly.
Other Real Estate Owned:
Assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. These assets are subsequently accounted for at lower of cost or fair value less estimated costs to sell. Fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by 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

40


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.
Derivative Financial Instruments:
The Company obtains broker or dealer quotes to value its interest rate derivative contracts, which use valuation models using observable market data as of the measurement date (Level 2).
The following tables summarize the balances of assets and liabilities measured at fair value on a recurring basis as of September 30, 2017 and December 31, 2016.
 September 30, 2017
 Total Level 1 Level 2 Level 3
 (In thousands)
Assets       
Investment securities available for sale:       
U.S. Treasury and U.S. Government-sponsored agencies$9,403
 $
 $9,403
 $
Municipal securities252,806
 
 252,806
 
Mortgage-backed securities and collateralized mortgage obligations:       
Residential274,361
 
 274,361
 
Commercial213,283
 
 213,283
 
Collateralized loan obligations6,022
 
 6,022
 
Corporate obligations15,830
 
 15,830
 
Other securities28,355
 150
 28,205
 
Total investment securities available for sale800,060
 150
 799,910
 
Derivative assets - interest rate swaps3,308
 
 3,308
 
Liabilities       
Derivative liabilities - interest rate swaps$3,308
 $
 $3,308
 $
 December 31, 2016
 Total Level 1 Level 2 Level 3
 (In thousands)
Assets       
Investment securities available for sale:       
U.S. Treasury and U.S. Government-sponsored agencies$1,569
 $
 $1,569
 $
Municipal securities237,256
 
 237,256
 
Mortgage-backed securities and collateralized mortgage obligations:       
Residential309,176
 
 309,176
 
Commercial208,318
 
 208,318
 
Collateralized loan obligations10,478
 
 10,478
 
Corporate obligations16,706
 
 16,706
 
Other securities11,142
 123
 11,019
 
Total investment securities available for sale794,645
 123
 794,522
 
Derivative assets - interest rate swaps2,804
 
 2,804
 
Liabilities       
Derivative liabilities - interest rate swaps$2,804
 $
 $2,804
 $

41


There were no transfers between Level 1 and Level 2 during the three and nine months ended September 30, 2017 and 2016.
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.
The tables below represent assets measured at fair value on a nonrecurring basis at September 30, 2017 and December 31, 2016 and the net losses (gains) recorded in earnings during three and nine months ended September 30, 2017 and 2016.
 
Basis(1)
 Fair Value at September 30, 2017    
 Total Level 1 Level 2 Level 3 
Net Losses
Recorded in
Earnings 
During
the Three Months Ended September 30, 2017
 
Net Losses
(Gains)
Recorded in
Earnings 
During
the Nine Months Ended
September 30, 2017
 (In thousands)
Impaired loans:             
Commercial business:             
Commercial and industrial$172
 $163
 $
 $
 $163
 $
 $7
Owner-occupied commercial real estate182
 179
 
 
 179
 
 8
Total commercial business354
 342
 
 
 342
 
 15
Total assets measured at fair value on a nonrecurring basis$354
 $342
 $
 $
 $342
 $
 $15
(1) 
Basis represents the unpaid principal balance of impaired loans.

 
Basis(1)
 Fair Value at December 31, 2016    
 Total Level 1 Level 2 Level 3 
Net Losses
(Gains)
Recorded in
Earnings 
During
the Three Months Ended September 30, 2016
 
Net Losses
(Gains)
Recorded in
Earnings 
During
the Nine Months Ended September 30, 2016
 (In thousands)
Impaired loans:             
Commercial business:             
Commercial and industrial$205
 $200
 $
 $
 $200
 $24
 $25
Owner-occupied commercial real estate780
 603
 
 
 603
 23
 (2)
 Total commercial business985
 803
 
 
 803
 47
 23
Real estate construction and land development:             
One-to-four family residential828
 822
 
 
 822
 (13) (26)
Total real estate construction and land development828
 822
 
 
 822
 (13) (26)
Consumer16
 9
 
 
 9
 
 
Total assets measured at fair value on a nonrecurring basis$1,829
 $1,634
 $
 $
 $1,634
 $34
 $(3)
(1) 
Basis represents the unpaid principal balance of impaired loans.


42


The following table presents quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at September 30, 2017 and December 31, 2016.
 September 30, 2017
 
Fair
Value
 
Valuation
Technique(s)
 Unobservable Input(s) 
Range of Inputs; Weighted
Average
 (Dollars in thousands)
Impaired loans$342
 Market approach Adjustment for differences between the comparable sales (23.8%) - 23.0%; (2.8%)
 December 31, 2016
 
Fair
Value
 
Valuation
Technique(s)
 Unobservable Input(s) 
Range of Inputs; Weighted
Average
 (Dollars in thousands)
Impaired loans$1,634
 Market approach Adjustment for differences between the comparable sales (23.8%) - 63.9%; 20.4%

(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.

43


The tables below present the carrying value amount of the Company’s financial instruments and their corresponding estimated fair values at the dates indicated.
 September 30, 2017
 Carrying Value
Fair Value
Fair Value Measurements Using:
 
Level 1
Level 2
Level 3
 (In thousands)
Financial Assets:         
Cash and cash equivalents$111,258
 $111,258
 $111,258
 $
 $
Investment securities available for sale800,060
 800,060
 150
 799,910
 
Federal Home Loan Bank stock9,343
 N/A
 N/A
 N/A
 N/A
Loans held for sale5,368
 5,553
 
 5,553
 
Total loans receivable, net2,766,113
 2,772,338
 
 
 2,772,338
Accrued interest receivable12,295
 12,295
 3
 3,770
 8,522
Derivative assets - interest rate swaps3,308
 3,308
 

3,308
 
Financial Liabilities:         
Noninterest deposits, interest bearing demand deposits, money market accounts and savings accounts2,925,637
 2,925,637
 2,925,637
 
 
Certificate of deposit accounts395,181
 394,164
 
 394,164
 
Federal Home Loan Bank advances117,400
 117,400
 
 117,400
 
Securities sold under agreement to repurchase28,668
 28,668
 28,668
 
 
Junior subordinated debentures19,936
 15,250
 
 
 15,250
Accrued interest payable148
 148
 42
 73
 33
Derivative liabilities - interest rate swaps3,308
 3,308
 
 3,308
 

44


 December 31, 2016
 Carrying Value Fair Value Fair Value Measurements Using:
  Level 1 Level 2 Level 3
 (In thousands)
Financial Assets:         
Cash and cash equivalents$103,745
 $103,745
 $103,745
 $
 $
Investment securities available for sale794,645
 794,645
 123
 794,522
 
Federal Home Loan Bank stock7,564
 N/A
 N/A
 N/A
 N/A
Loans held for sale11,662
 11,988
 
 11,988
 
Loans receivable, net of allowance for loan losses2,609,666
 2,675,811
 
 
 2,675,811
Accrued interest receivable10,925
 10,925
 3
 3,472
 7,450
Derivative assets - interest rate swaps2,804
 2,804
 
 2,804
 
Financial Liabilities:         
Noninterest deposits, interest bearing demand deposits, money market accounts and savings accounts$2,872,247
 $2,872,247
 $2,872,247
 $
 $
Certificate of deposit accounts357,401
 357,536
 
 357,536
 
Federal Home Loan Bank advances79,600
 79,600
 
 79,600
 
Securities sold under agreement to repurchase22,104
 22,104
 22,104
 
 
Junior subordinated debentures19,717
 15,000
 
 
 15,000
Accrued interest payable215
 215
 44
 142
 29
Derivative liabilities - interest rate swaps2,804
 2,804
 
 2,804
 
The methods and assumptions, not previously presented, used to estimate fair value are described as follows:
Cash and Cash Equivalents:
The fair value of financial instruments that are short-term or reprice frequently and that have little or no risk are considered to have a fair value equal to carrying value (Level 1).
Federal Home Loan Bank Stock:
FHLB stock is not publicly traded; thus, it is not practicable to determine the fair value of FHLB stock due to restrictions placed on its transferability.
Loans Held for Sale:
The fair value of loans held for sale is estimated based upon binding contracts or quotes from third party investors for similar loans. (Level 2).
Loans Receivable:
Except for certain impaired loans discussed previously, fair value is based on discounted cash flows using current market rates applied to the estimated life (Level 3). While these methodologies are permitted under U.S. GAAP, they are not based on the exit price concept of the fair value required under FASB ASC 820-10, Fair Value Measurements and Disclosures, and generally produce a higher value.
Accrued Interest Receivable/Payable:
The fair value of accrued interest receivable/payable balances approximates the carrying value. The fair value measurements are commensurate with the asset or liability from which the accrued interest is generated (Level 1, Level 2 and Level 3).

45


Deposits:
For deposits with no contractual maturity, the fair value is assumed to equal the carrying value (Level 1). The fair value of certificate of deposit accounts is based on discounted cash flows using the difference between the deposit rate and the rates offered by the Company for deposits of similar remaining maturities (Level 2).
Federal Home Loan Bank advances:
The fair value of FHLB advances is estimated based on discounting the future cash flows using the market rate currently offered (Level 2).
Securities Sold Under Agreement to Repurchase:
Securities sold under agreement to repurchase are short-term in nature and they reprice on a daily basis. Fair value financial instruments that are short-term or reprice frequently and that have little or no risk are considered to have a fair value equal to carrying value (Level 1).
Junior Subordinated Debentures:
The fair value is estimated using discounted cash flow analysis based on current rates for similar types of debt, which many be unobservable, and considering recent trading activity of similar instruments in markets which can be inactive (Level 3).
Off-Balance Sheet Financial Instruments:
The majority of our commitments to extend credit, standby letters of credit and commitments to sell mortgage loans carry current market interest rates if converted to loans. As such, no premium or discount was ascribed to these commitments (Level 1). They are excluded from the preceding tables.

(15)Commitments and Contingencies
In June 2016, the Company received preliminary findings from the Washington State Department of Revenue ("DOR") regarding its business and occupation ("B&O") tax audit on the B&O tax returns of Whidbey Island Bank for the years 2010-2014. The state B&O tax is a gross receipts tax and is calculated on the gross income from activities. It is measured on the value of products, gross proceeds of sale, or gross income of the business. A substantial portion of the preliminary findings related to the receipt of FDIC shared-loss payments from the FDIC to Washington Banking Company in connection with its acquisitions of City Bank in April 2010 and North County Bank in September 2010. In their preliminary findings, the DOR is considering those payments as taxable for B&O tax purposes. The total amount of this preliminary finding, along with calculated back interest, is approximately $1.6 million. Management is in discussions with the DOR as to whether these payments should be taxable for B&O tax purposes. Given the uncertainty of the outcome of these discussions, management's estimates of the Company's ultimate liability, if any, involve significant judgment and are based on currently available information and an assessment of the validity of facts and calculations assumed by the DOR. Management does not believe a material loss is probable at this time and there are significant factual and legal issues to be resolved. Management believes that it is reasonably possible that future changes to the Company's estimates of loss and the ultimate amount paid for resolution of this B&O audit could impact the Company's results of operations in future periods. Any such losses would be reported as a noninterest expense in the Company's Consolidated Statement of Income.
 
(16)Definitive Agreement
On July 26, 2017 the Company announced the execution of a definitive agreement with Puget Sound under which Heritage will acquire Puget Sound in an all-stock transaction valued at approximately $126.1 million based on the closing price of Heritage common stock of $27.15 on July 26, 2017. Puget Sound is a business bank headquartered in Bellevue, Washington with one branch location. Under the terms of the agreement, Puget Sound shareholders will receive 1.320 shares of Heritage common stock for each share of Puget Sound common stock, subject to potential adjustment. The value of the consideration will fluctuate until closing based on the value of Heritage's stock price and may be adjusted by a cap and collar in certain circumstances. The definitive agreement has been unanimously approved by the boards of directors of both Heritage and Puget Sound. The merger is subject to regulatory approvals, approval by Puget Sound shareholders and certain other customary closing conditions and is expected to close in the first quarter of 2018.


46


ITEM 2.MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion is intended to assist in understanding the financial condition and results of the Company as of and for the three and nine months ended September 30, 2017. The information contained in this section should be read with the unaudited Condensed Consolidated Financial Statements and the accompanying Notes included herein, and the December 31, 2016 audited Consolidated Financial Statements and the accompanying Notes included in our Annual Report on Form 10-K for the year ended December 31, 2016.

Overview
Heritage Financial Corporation is a bank holding company which primarily engages in the business activities of our wholly-owned financial institution subsidiary, Heritage Bank. We provide financial services to our local communities with an ongoing strategic focus on our commercial banking relationships, market expansion and asset quality. At September 30, 2017, we had total assets of $4.05 billion and total stockholders’ equity of $507.6 million. The Company’s business activities generally are limited to passive investment activities and oversight of its investment in the Bank. Accordingly, the information set forth in this report relates primarily to the Bank’s operations.
Our business consists primarily of commercial lending and deposit relationships with small businesses and their owners in our market areas and attracting deposits from the general public. We also make real estate construction and land development loans and consumer loans. We additionally originate for sale or for investment purposes one-to-four family residential loans on residential properties located primarily in our markets.
Our core profitability depends primarily on our net interest income. Net interest income is the difference between interest income, which is the income that we earn on interest earning assets, comprised primarily of loans and investment securities, and interest expense, which is the amount we pay on our interest bearing liabilities, consisting primarily of deposits. Management strives to match the repricing characteristics of the interest earning assets and interest bearing liabilities to protect net interest income from changes in market interest rates and changes in the shape of the yield curve. Like most financial institutions, our net interest income is affected significantly by general and local economic conditions, particularly changes in market interest rates, and by governmental policies and actions of regulatory agencies. Net interest income is additionally affected by changes on the volume and mix of interest earning assets, interest earned on these assets, the volume and mix of interest bearing liabilities and interest paid on these liabilities.
Our net income is affected by many factors, including the provision for loan losses. The provision for loan losses is dependent on changes in the loan portfolio and management’s assessment of the collectability of the loan portfolio as well as prevailing economic and market conditions. The allowance for loan losses reflects the amount that we believe is appropriate to provide for probable incurred credit losses in our loan portfolio.
Net income is also affected by noninterest income and noninterest expense. Noninterest income primarily consists of service charges and other fees, gain on sale of loans (net) and other income. Noninterest expense consists primarily of compensation and employee benefits, occupancy and equipment, and data processing. Compensation and employee benefits consist primarily of the salaries and wages paid to our employees, payroll taxes, expenses for retirement and other employee benefits. Occupancy and equipment expenses are the fixed and variable costs of buildings and equipment, and consist primarily of lease payments, depreciation charges, maintenance, and costs of utilities. Data processing consists primarily of processing and network services related to the Bank’s core operating system, including account processing systems, electronic payments processing of products and services, and internet and mobile banking channels.
Results of operations may also be affected significantly by general and local economic and competitive conditions, governmental policies and actions of regulatory authorities. Other income and other expenses are also impacted by growth of operations and growth in the number of loan and deposit accounts through acquisitions and core banking business growth.

Earnings Summary
Comparison of quarter ended September 30, 2017 to the comparable quarter in the prior year
Net income was $10.6 million, or $0.35 per diluted common share, for the three months ended September 30, 2017 compared to $11.0 million, or $0.37 per diluted common share, for the three months ended September 30, 2016. The $415,000, or 3.8% decrease in net income for the three months ended September 30, 2017 compared to the three months ended September 30, 2016 was primarily the result of a $1.5 million, or 14.9% decrease in noninterest

47


income and a $1.1 million, or 4.2% increase in noninterest expense, partially offset by a $1.4 million, or 4.1%, increase in net interest income and a $611,000, or 40.9%, decrease in provision for loan losses.
Net interest income as a percentage of average interest earning assets (net interest margin) decreased 10 basis points to 3.85% for the three months ended September 30, 2017 compared to 3.95% for the same period in 2016.
The efficiency ratio consists of noninterest expense divided by the sum of net interest income before provision for loan losses plus noninterest income. The Company’s efficiency ratio was 64.4% for the three months ended September 30, 2017 compared to 61.7% for the three months ended September 30, 2016 and the change was attributable to the decrease in noninterest income and the increase in noninterest expense.
Comparison of nine months ended September 30, 2017 to the comparable period in the prior year
Net income was $31.8 million, or $1.06 per diluted common share, for the nine months ended September 30, 2017 compared to $29.0 million, or $0.97 per diluted common share, for the nine months ended September 30, 2016. The $2.7 million, or 9.5% increase in net income for the nine months ended September 30, 2017 compared to the nine months ended September 30, 2016 was primarily the result of a $3.0 million, or 12.7% increase in noninterest income and a $2.9 million, or 2.9%, increase in net interest income, partially offset by a $3.3 million, or 4.2% increase in noninterest expense.
The net interest margin decreased 11 basis points to 3.89% for the nine months ended September 30, 2017 compared to 4.00% for the same period in 2016.
The Company’s efficiency ratio improved to 64.5% for the nine months ended September 30, 2017 from 64.8% for the nine months ended September 30, 2016. The improvement in the efficiency ratio for the nine months ended September 30, 2017 compared to the nine months ended September 30, 2016 was primarily attributable to the increases in noninterest income and net interest income.
Net Interest Income
One of the Company's key sources of earnings is net interest income. There are several factors that affect net interest income including, but not limited to, the volume, pricing, mix and maturity of interest earning assets and interest bearing liabilities; the volume of noninterest bearing deposits and other liabilities and stockholders' equity; the volume of noninterest earning assets; market interest rate fluctuations; and asset quality.
Comparison of quarter ended September 30, 2017 to the comparable quarter in the prior year
Net interest income increased $1.4 million, or 4.1%, to $35.0 million for the three months ended September 30, 2017 compared to $33.6 million for the same period in 2016. The following table provides relevant net interest income information for the dates indicated.

48


 Three Months Ended September 30,
 2017 2016
 
Average
Balance
 
Interest
Earned/
Paid
 
Average
Yield/
Rate (1)
 
Average
Balance
 
Interest
Earned/
Paid
 
Average
Yield/
Rate
(1)
 (Dollars in thousands)
Interest Earning Assets:           
Total loans receivable, net (2) (3)
$2,737,535
 $32,595
 4.72% $2,526,150
 $30,915
 4.87%
Taxable securities562,256
 3,117
 2.20
 588,749
 2,888
 1.95
Nontaxable securities (3) 
229,683
 1,354
 2.34
 225,994
 1,235
 2.17
Other interest earning assets72,643
 258
 1.41
 42,934
 76
 0.70
Total interest earning assets3,602,117
 37,324
 4.11% 3,383,827
 35,114
 4.13%
Noninterest earning assets418,100
     408,634
    
Total assets$4,020,217
     $3,792,461
    
Interest Bearing Liabilities:           
Certificates of deposit$394,345
 $633
 0.64% $378,407
 $468
 0.49%
Savings accounts494,990
 360
 0.29
 507,523
 214
 0.17
Interest bearing demand and money market accounts1,499,335
 635
 0.17
 1,480,220
 587
 0.16
Total interest bearing deposits2,388,670
 1,628
 0.27
 2,366,150
 1,269
 0.21
FHLB advances and other borrowings111,293
 428
 1.53
 5,618
 8
 0.57
Securities sold under agreement to repurchase28,999
 16
 0.22
 18,861
 10
 0.21
Junior subordinated debentures19,897
 261
 5.20
 19,602
 221
 4.49
Total interest bearing liabilities2,548,859
 2,333
 0.36% 2,410,231
 1,508
 0.25%
Demand and other noninterest bearing deposits916,074
     844,468
    
Other noninterest bearing liabilities50,022
     44,378
    
Stockholders’ equity505,262
     493,384
    
Total liabilities and stockholders’ equity$4,020,217
     $3,792,461
    
Net interest income
 $34,991
     $33,606
  
Net interest spread    3.75%     3.88%
Net interest margin    3.85%     3.95%
Average interest earning assets to average interest bearing liabilities    141.32%     140.39%

(1) 
Annualized
(2)  
The average loan balances presented in the table are net of allowances for loan losses. Nonaccrual loans have been included in the table as loans carrying a zero yield.
(3)  
Yields on tax-exempt securities and loans have not been stated on a tax-equivalent basis.
Interest Income
Total interest income increased $2.2 million, or 6.3%, to $37.3 million for the three months ended September 30, 2017 compared to $35.1 million for the same period in 2016. The balance of average interest earning assets increased $218.3 million, or 6.5%, to $3.60 billion for the three months ended September 30, 2017 from $3.38 billion for the three months ended September 30, 2016 and the average yield on total interest earning assets decreased two basis points to 4.11% for the three months ended September 30, 2017 compared to 4.13% for the three months ended September 30, 2016.
Interest income from interest and fees on loans increased $1.7 million, or 5.4%, to $32.6 million for the three months ended September 30, 2017 from $30.9 million for the same period in 2016 primarily due to an increase in average loans receivable of $211.4 million, or 8.4%, as a result of loan growth, offset partially by a 15 basis point decrease in the average loan yield to 4.72% for the three months ended September 30, 2017 from 4.87% for the three months ended September 30, 2016. The decrease in average loan yield was due primarily to a decrease in incremental accretion income on purchased loans and secondarily to a decrease in contractual note rates.

49


The following table presents the average loan yield and effects of the incremental accretion on purchased loans for the three months ended September 30, 2017 and 2016:
  Three Months Ended September 30,
  2017 2016
  (Dollars in thousands)
Average loan yield, excluding incremental accretion on purchased loans (1)
 4.57% 4.63%
Impact on average loan yield from incremental accretion on purchased loans (1) 0.15% 0.24%
Average loan yield 4.72% 4.87%
     
Incremental accretion on purchased loans (1)
 $1,036
 $1,530
(1) 
As of the dates of the completion of each of the merger and acquisition transactions, purchased loans were recorded at their estimated fair value, including our estimate of future expected cash flows until the ultimate resolution of these credits. The difference between the contractual loan balance and the fair value represents the purchased discount. The purchased discount is modified quarterly as a result of cash flow re-estimation. The incremental accretion income represents the amount of income recorded on the purchased loans in excess of the contractual stated interest rate in the individual loan notes.
Incremental accretion income was $1.0 million and $1.5 million for the three months ended September 30, 2017 and 2016, respectively. The decrease in the incremental accretion was primarily a result of a continued decline in the purchased loan balances and a decrease in the prepayments of purchased loans during the three months ended September 30, 2017 compared to the same period in 2016. The incremental accretion is expected to continue to decrease as the balance of the purchased loans continues to decrease.
Total interest income increased primarily due to the increase in interest and fees on loans discussed above and secondarily due to a $348,000, or 8.4%, increase in interest income on investment securities to $4.5 million during the three months ended September 30, 2017 from $4.1 million for the three months ended September 30, 2016. The increase in income on investment securities was a result of an increase in average investment yields for the three months ended September 30, 2017 compared to the same period in 2016, offset partially by a decrease in the average balance of investment securities. Average yields on taxable securities increased 25 basis points to 2.20% for the three months ended September 30, 2017 from 1.95% for the same period in 2016. Average yields on nontaxable securities increased 17 basis points to 2.34% for the three months ended September 30, 2017 from 2.17% for the same period in 2016. The average balance of investment securities decreased $22.8 million, or 2.8%, to $791.9 million during the three months ended September 30, 2017 from $814.7 million during the three months ended September 30, 2016. The Company has actively managed its investment securities portfolio to mitigate declining trends in loan yields.
Average other interest earning assets increased $29.7 million, or 69.2%, to $72.6 million for the three months ended September 30, 2017 compared to $42.9 million for the three months ended September 30, 2016. The increase was due primarily to an increase in interest earning deposits, as the Bank held more funds in interest earning accounts at the Federal Reserve Bank of San Francisco compared to the same period in the prior year.
Interest Expense
Total interest expense increased $825,000, or 54.7%, to $2.3 million for the three months ended September 30, 2017 compared to $1.5 million for the same period in 2016. The average cost of interest bearing liabilities increased 11 basis points to 0.36% for the three months ended September 30, 2017 from 0.25% for the three months ended September 30, 2016 as a result of increases in market rates. Total average interest bearing liabilities increased by $138.6 million, or 5.8%, to $2.55 billion for the three months ended September 30, 2017 from $2.41 billion for the three months ended September 30, 2016.
The average cost of interest bearing deposits increased six basis points to 0.27% for the three months ended September 30, 2017 from 0.21% for the same period in 2016 primarily as a result of increases in both the average balance and cost of certificates of deposit and an increase in the average cost of savings accounts.
Interest expense on certificates of deposit increased $165,000, or 35.3%, to $633,000 during the three months ended September 30, 2017 from $468,000 for the same period in 2016 due to increases in the average balance and the cost of the certificates of deposits accounts. The average balance of certificates of deposits increased $15.9 million, or 4.2%, to $394.3 million, for the three months ended September 30, 2017 from $378.4 million for the same period in 2016. The cost of certificates of deposits increased 15 basis points to 0.64% for the three months ended September 30, 2017 from 0.49% for the same period in 2016.

50


Interest expense on savings accounts increased $146,000, or 68.2%, to $360,000 during the three months ended September 30, 2017 from $214,000 for the same period in 2016 due primarily to the 12 basis point increase of the cost of the savings accounts to 0.29% for the three months ended September 30, 2017 from 0.17% for the same period in 2016.
Interest expense on FHLB advances and other borrowings increased $420,000, or 52.5%, to $428,000 for the three months ended September 30, 2018 from $8,000 for the same period in 2016 due to a combination of an increase in both average balances and cost of funds. The average balance for FHLB advances and other borrowings increased $105.7 million, or 1,881.0%, to $111.3 million for the three months ended September 30, 2017 from $5.6 million for the same period in 2016, due primarily to fund loan growth. The average rate of the FHLB advances for the three months ended September 30, 2017 was 1.53%, an increase of 96 basis points from 0.57% for the same period in 2016, due primarily to continued increases in short-term borrowing rates over the last year.
The average rate of the junior subordinated debentures, including the effects of accretion of the discount established as of the date of the merger with Washington Banking Company, for the three months ended September 30, 2017 was 5.20%, an increase of 71 basis points from 4.49% for the same period in 2016. The rate increase on the debentures was due to an increase in the three-month LIBOR rate to 1.33% at September 30, 2017 from 0.85% on September 30, 2016.

Net Interest Margin
Net interest margin for the three months ended September 30, 2017 decreased ten basis points to 3.85% from 3.95% for the same period in 2016 primarily due to the decline in the incremental accretion on purchased loans, as discussed below. The net interest spread for the three months ended September 30, 2017 decreased 13 basis points to 3.75% from 3.88% for the same period in 2016. The decrease was primarily due to the above mentioned increases in the cost of funds of interest bearing liabilities.
Net interest margin is impacted by the incremental accretion on purchased loans. The following table presents the net interest margin and effects of the incremental accretion on purchased loans for the three months ended September 30, 2017 and 2016:
  Three Months Ended September 30,
  2017 2016
Net interest margin, excluding incremental accretion on purchased loans (1)
 3.74% 3.77%
Impact on net interest margin from incremental accretion on purchased loans (1)
 0.11
 0.18
Net interest margin 3.85% 3.95%
(1) 
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.
Comparison of nine months ended September 30, 2017 to the comparable period in the prior year
Net interest income increased $2.9 million, or 2.9%, to $102.3 million for the nine months ended September 30, 2017 compared to $99.5 million for the same period in 2016. The following table provides relevant net interest income information for the dates indicated.

51


 Nine Months Ended September 30,
 2017 2016
 
Average
Balance
 
Interest
Earned/
Paid
 
Average
Yield/
Rate (1)
 
Average
Balance
 
Interest
Earned/
Paid
 Average
Yield/
Rate (1)
 (Dollars in thousands)
Interest Earning Assets:           
Total loans receivable, net (2) (3)$2,676,153
 $94,580
 4.73% $2,461,856
 $91,595
 4.97%
Taxable securities565,528
 9,307
 2.20
 594,301
 8,522
 1.92
Nontaxable securities (3)225,583
 3,926
 2.33
 220,038
 3,599
 2.18
Other interest earning assets51,049
 461
 1.21
 47,829
 225
 0.63
Total interest earning assets3,518,313
 108,274
 4.11% 3,324,024
 103,941
 4.18%
Noninterest earning assets418,837
     391,342
    
Total assets$3,937,150
     $3,715,366
    
Interest Bearing Liabilities:           
Certificates of deposit$369,724
 $1,527
 0.55% $397,070
 $1,496
 0.50%
Savings accounts499,353
 940
 0.25
 478,762
 540
 0.15
Interest bearing demand and money market accounts1,489,149
 1,834
 0.16
 1,457,399
 1,729
 0.16
Total interest bearing deposits2,358,226
 4,301
 0.24
 2,333,231
 3,765
 0.22
FHLB advances and other borrowings106,556
 870
 1.09
 11,608
 47
 0.54
Securities sold under agreement to repurchase23,660
 38
 0.21
 20,031
 31
 0.21
Junior subordinated debentures19,823
 748
 5.05
 19,527
 647
 4.43
Total interest bearing liabilities2,508,265
 5,957
 0.32% 2,384,397
 4,490
 0.25%
Demand and other noninterest bearing deposits885,467
     811,043
    
Other noninterest bearing liabilities47,283
     35,266
    
Stockholders’ equity496,135
     484,660
    
Total liabilities and stockholders’ equity$3,937,150
     $3,715,366
    
Net interest income  $102,317
     $99,451
  
Net interest spread    3.79%     3.93%
Net interest margin    3.89%     4.00%
Average interest earning assets to average interest bearing liabilities    140.27%     139.41%

(1) 
Annualized
(2)  
The average loan balances presented in the table are net of allowances for loan losses. Nonaccrual loans have been included in the table as loans carrying a zero yield.
(3)  
Yields on tax-exempt securities and loans have not been stated on a tax-equivalent basis.
Interest Income
Total interest income increased $4.3 million, or 4.2%, to $108.3 million for the nine months ended September 30, 2017 compared to $103.9 million for the same period in 2016. The balance of average interest earning assets increased $194.3 million, or 5.8%, to $3.52 billion for the nine months ended September 30, 2017 from $3.32 billion for the nine months ended September 30, 2016 and the yield on total interest earning assets decreased seven basis points to 4.11% for the nine months ended September 30, 2017 compared to 4.18% for the nine months ended September 30, 2016.
Interest income from interest and fees on loans increased $3.0 million, or 3.3%, to $94.6 million for the nine months ended September 30, 2017 from $91.6 million for the same period in 2016 due primarily to an increase in average loans receivable, offset partially by a decrease in average loan yields. Average loans receivable increased $214.3 million, or 8.7%, to $2.68 billion for the nine months ended September 30, 2017 compared to $2.46 billion for the nine months ended September 30, 2016. Average loan yields decreased 24 basis points to 4.73% for the nine months ended September 30, 2017 from 4.97% for the nine months ended September 30, 2016 due mostly to a decrease in incremental accretion income.

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The following table presents the average loan yield and effects of the incremental accretion on purchased loans for the nine months ended September 30, 2017 and 2016:
  Nine Months Ended September 30,
  2017 2016
  (Dollars in thousands)
Average loan yield, excluding incremental accretion on purchased loans (1)
 4.55% 4.66%
Impact on average loan yield from incremental accretion on purchased loans (1) 0.18% 0.31%
Average loan yield 4.73% 4.97%
     
Incremental accretion on purchased loans (1)
 $3,687
 $5,669
(1) 
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 $3.7 million and $5.7 million for the nine months ended September 30, 2017 and 2016, respectively. The decrease in the incremental accretion was primarily a result of a continued decline in the purchased loan balances and a decrease in the prepayments of purchased loans during the nine months ended September 30, 2017 compared to the same period in 2016. The incremental accretion is expected to continue to decrease as the balance of the purchased loans continues to decrease.
Total interest income increased primarily due to the increase in interest and fees on loans discussed above and secondarily due to a $1.1 million, or 9.2%, increase in interest income on investment securities to $13.2 million during the nine months ended September 30, 2017 from $12.1 million for the nine months ended September 30, 2016. The increase in interest income on investment securities was the result of an increase in average investment yields for the nine months ended September 30, 2017 compared to the same period in 2016, offset partially by a decrease in the average balance of investment securities. Average yields on taxable securities increased 28 basis points to 2.20% for the nine months ended September 30, 2017 from 1.92% for the same period in 2016. Average yields on nontaxable securities increased 15 basis points to 2.33% for the nine months ended September 30, 2017 from 2.18% for the same period in 2016. The average balance of investment securities decreased $23.2 million, or 2.9%, to $791.1 million during the nine months ended September 30, 2017 from $814.3 million during the nine months ended September 30, 2016. The Company has actively managed its investment securities portfolio to mitigate declining, but recently improving, loan yields.
Average other interest earning assets increased $3.2 million, or 6.7%, to $51.0 million for the nine months ended September 30, 2017 compared to $47.8 million for the nine months ended September 30, 2016. The increase was due primarily to an increase in interest earning deposits, as the Bank held more funds in interest earning accounts at the Federal Reserve Bank of San Francisco compared to the same period in 2016.
Interest Expense
Total interest expense increased $1.5 million, or 32.7%, to $6.0 million for the nine months ended September 30, 2017 compared to $4.5 million for the same period in 2016. The average cost of interest bearing liabilities increased seven basis points to 0.32% for the nine months ended September 30, 2017 from 0.25% for the nine months ended September 30, 2016. Total average interest bearing liabilities increased by $123.9 million, or 5.2%, to $2.51 billion for the nine months ended September 30, 2017 from $2.38 billion for the nine months ended September 30, 2016.
The average cost of interest bearing deposits increased two basis points to 0.24% for the nine months ended September 30, 2017 from 0.22% for the same period in 2016 due primarily to the changes in savings accounts.
Interest expense on savings accounts increased $400,000, or 74.1%, to $940,000 for the nine months ended September 30, 2017 from $540,000 for the same period in 2016 due to increases in both the average balance and cost of the savings accounts. The average balance of savings accounts increased $20.6 million, or 4.3%, to $499.4 million for the nine months ended September 30, 2017 from $478.8 million for the same period in 2016. The cost of savings accounts increased ten basis points to 0.25% for the nine months ended September 30, 2017 from 0.15% for the same period in 2016.
Interest expense of certificates of deposit accounts increased only $31,000, or 2.1%, to $1.5 million for the nine months ended September 30, 2017. The average balance of certificates of deposit decreased $27.3 million, or

53


6.9%, to $369.7 million for the nine months ended September 30, 2017 compared to $397.1 million for the nine months ended September 30, 2016 while the cost of certificates of deposits increased to 0.55% for the nine months ended September 30, 2017 from 0.50% for the same period in 2016.
Interest expense on FHLB advances and other borrowings increased $823,000 to $870,000 for the nine months ended September 30, 2017 from $47,000 for the nine months ended September 30, 2016 due to a combination of an increase in average balances and an increase in the cost of funds. The average balance for FHLB advances and other borrowings increased $94.9 million to $106.6 million for the nine months ended September 30, 2017 from $11.6 million for the same period in 2016, due primarily to fund loan growth. The average rate of the FHLB advances and other borrowings for the nine months ended September 30, 2017 was 1.09%, an increase of 55 basis points from 0.54% for the same period in 2016.
The average rate of the junior subordinated debentures, including the effects of accretion of the discount established as of the date of the merger with Washington Banking Company, for the nine months ended September 30, 2017 was 5.05%, an increase of 62 basis points from 4.43% for the same period in 2016. The rate increase on the debentures was due to an increase in the three-month LIBOR rate to 1.33% at September 30, 2017 from 0.85% on September 30, 2016.

Net Interest Margin
Net interest margin for the nine months ended September 30, 2017 decreased 11 basis points to 3.89% from 4.00% for the same period in 2016 primarily due to the decline in the incremental accretion on purchased loans, as discussed below. The net interest spread for the nine months ended September 30, 2017 decreased 14 basis points to 3.79% from 3.93% for the same period in 2016. This decrease was primarily due to the above mentioned decrease in average yields on total interest earning assets and increase in the average cost of funds of total interest bearing liabilities.
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 nine months ended September 30, 2017 and 2016:
  Nine Months Ended September 30,
  2017 2016
Net interest margin, excluding incremental accretion on purchased loans (1)
 3.75% 3.77%
Impact on net interest margin from incremental accretion on purchased loans (1)
 0.14
 0.23
Net interest margin 3.89% 4.00%
(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.

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. For additional information, see the section entitled "Analysis of Allowance for Loan Losses" below.
The provision for loan losses is dependent on the Bank’s ability to manage asset quality and control the level of net charge-offs through prudent underwriting standards. In addition, a decline in general economic conditions could increase future provisions for loan losses and have a material effect on the Company’s net income.
Comparison of quarter ended September 30, 2017 to the comparable quarter in the prior year
The provision for loan losses decreased $611,000, or 40.9% to $884,000 for the three months ended September 30, 2017 from $1.5 million for the three months ended September 30, 2016. The decrease in the provision for loan losses for the three months ended September 30, 2017 from the same period in 2016 was primarily the result of a change in the composition of the loan portfolio, changes in certain environmental factors and improvements in certain historical loss factors. Based on a thorough review of the loan portfolio, the Bank determined that the provision for

54


loan losses for the three months ended September 30, 2017 was appropriate as it was calculated in accordance with the Bank's methodology for determining the allowance for loan losses.
Comparison of nine months ended September 30, 2017 to the comparable period in the prior year
The provision for loan losses decreased $872,000, or 23.2% to $2.9 million for the nine months ended September 30, 2017 from $3.8 million for the nine months ended September 30, 2016. The decrease in the provision for loan losses for the nine months ended September 30, 2017 from the same period in 2016 was primarily the result of a change in the volume and mix of loans, changes in certain environmental factors and improvements in certain historical loss factors. Based on a thorough review of the loan portfolio, the Bank determined that the provision for loan losses for the nine months ended September 30, 2017 was appropriate as it was calculated in accordance with the Bank's methodology for determining the allowance for loan losses.

Noninterest Income
Comparison of quarter ended September 30, 2017 to the comparable quarter in the prior year
Total noninterest income decreased $1.5 million, or 14.9%, to $8.4 million for the three months ended September 30, 2017 compared to $9.9 million for the same period in 2016. The following table presents the change in the key components of noninterest income for the periods noted.
 Three Months Ended September 30,    
 2017 2016 Change Percentage Change
 (Dollars in thousands)
Service charges and other fees$4,769
 $3,630
 $1,139
 31.4 %
Gain on sale of investment securities, net44
 345
 (301) (87.2)
Gain on sale of loans, net1,229
 3,435
 (2,206) (64.2)
Interest rate swap fees328
 742
 (414) (55.8)
Other income2,024
 1,715
 309
 18.0
Total noninterest income$8,394
 $9,867
 $(1,473) (14.9)%
Gain on the sale of loans, net decreased $2.2 million, or 64.2% to $1.2 million for the three months ended September 30, 2017 compared to $3.4 million the same period in 2016, due primarily to a $2.1 million gain on sale of a previously classified purchased credit impaired loan recognized in 2016. The detail of gain on sale of loans, net is included in the following schedule.
 Three Months Ended September 30,  
 2017 2016 Change Percentage Change
 (Dollars in thousands)
Mortgage loans$875
 $1,087
 $(212) (19.5)%
SBA loans354
 285
 69
 24.2
Other loans
 2,063
 (2,063) (100.0)
Total gain on sale of loans, net$1,229
 $3,435
 $(2,206) (64.2)%
Interest rate swap fees decreased $414,000, or 55.8% to $328,000 for the three months ended September 30, 2017 compared to $742,000 the same period in 2016, due primarily to a decrease in the number of swaps executed during the three months ended September 30, 2017 compared to the three months ended September 30, 2016.
The decrease in noninterest income was partially offset by an increase in service charges and other fees of $1.1 million, or 31.4% to $4.8 million for the three months ended September 30, 2017 compared to $3.6 million for the same period in 2016, due primarily to a consumer deposit account consolidation process completed at the end of 2016 and a business deposit consolidation process completed during second quarter 2017 and the related changes in fee structures, as well as increases in deposit balances.

55


Comparison of nine months ended September 30, 2017 to the comparable period in the prior year
Total noninterest income increased $3.0 million, or 12.7%, to $26.4 million for the nine months ended September 30, 2017 compared to $23.4 million for the same period in 2016. The following table presents the change in the key components of noninterest income for the periods noted.
 Nine Months Ended September 30,    
 2017 2016 Change Percentage Change
 (Dollars in thousands)
Service charges and other fees$13,408
 $10,462
 $2,946
 28.2 %
Gain on sale of investment securities, net161
 1,106
 (945) (85.4)
Gain on sale of loans, net6,562
 5,406
 1,156
 21.4
Interest rate swap fees743
 1,105
 (362) (32.8)
Other income5,532
 5,354
 178
 3.3
Total noninterest income$26,406
 $23,433
 $2,973
 12.7 %
Service charges and other fees increased $2.9 million, or 28.2% to $13.4 million for the nine months ended September 30, 2017 compared to $10.5 million for the same period in 2016, due primarily to a consumer deposit account consolidation process completed at the end of 2016 and a business deposit consolidation process completed during second quarter 2017 and the related changes in fee structures, as well as increases in deposit balances.
Gain on sale of loans, net increased $1.2 million, or 21.4% to $6.6 million for the nine months ended September 30, 2017 compared to $5.4 million for the same period in 2016, due primarily to a $935,000 increase in sale of other loans. During each of the nine months ended September 30, 2017 and 2016, the Bank sold one loan previously classified as purchased credit impaired. In addition, gain on sale of SBA loans increased $272,000 due primarily to an increase in proceeds from sale of SBA loans of $7.8 million, or 90.9%, to $16.4 million for the nine months ended September 30, 2017 compared to $8.6 million for the same period in 2016. The detail of gain on sale of loans, net is included in the following schedule.
 Nine Months Ended September 30,  
 2017 2016 Change Percentage Change
 (Dollars in thousands)
Mortgage loans$2,515
 $2,566
 $(51) (2.0)%
SBA loans1,049
 777
 272
 35.0
Other loans2,998
 2,063
 935
 45.3
Total gain on sale of loans, net$6,562
 $5,406
 $1,156
 21.4 %
The increase in noninterest income was partially offset by a decrease in gain on sale of investment securities, net of $945,000, or 85.4%, to $161,000 for the nine months ended September 30, 2017 from $1.1 million for the nine months ended September 30, 2016. The decrease was primarily the result of fewer sales as the Bank actively managed its investment portfolio. The proceeds from sale of investment securities was $21.9 million for the nine months ended September 30, 2017 compared to $94.4 million for the same period in 2016.
    
Noninterest Expense
Comparison of quarter ended September 30, 2017 to the comparable quarter in the prior year
Noninterest expense increased $1.1 million, or 4.2%, to $28.0 million during the three months ended September 30, 2017 compared to $26.8 million for the three months ended September 30, 2016. The following table presents changes in the key components of noninterest expense for the periods noted.

56


 Three Months Ended September 30,    
 2017 2016 Change Percentage Change
 (Dollars in thousands)
Compensation and employee benefits$15,823
 $15,633
 $190
 1.2 %
Occupancy and equipment3,979
 3,926
 53
 1.3
Data processing2,090
 1,943
 147
 7.6
Marketing933
 745
 188
 25.2
Professional services1,453
 830
 623
 75.1
State and local taxes640
 820
 (180) (22.0)
Federal deposit insurance premium433
 296
 137
 46.3
Other real estate owned, net(88) (142) 54
 (38.0)
Amortization of intangible assets319
 359
 (40) (11.1)
Other expense2,373
 2,408
 (35) (1.5)
Total noninterest expense$27,955
 $26,818
 $1,137
 4.2 %
Professional services increased $623,000, or 75.1%, to $1.5 million during the three months ended September 30, 2017 from $830,000 during the three months ended September 30, 2016. The increase in the three months ended September 30, 2017 compared to the same period in 2016 was primarily due to legal costs incurred for our pending merger with Puget Sound as discussed in Note (16) Definitive Agreement as well as benefit-based consulting fees related to the consumer and business deposit account consolidation processes, which correspondingly generated an increase in service charges and other fees.
Compensation and employee benefits increased $190,000, or 1.2%, to $15.8 million during the three months ended September 30, 2017 from $15.6 million during the three months ended September 30, 2016. The increase in the three months ended September 30, 2017 compared to the same period in 2016 was primarily due to senior level staffing increases and standard salary increases.
The ratio of noninterest expense to average assets (annualized) was 2.76% for the three months ended September 30, 2017 compared to 2.81% for the three months ended September 30, 2016. The decrease was primarily a result of an increase in assets and cost efficiencies gained through efforts by the Company to manage noninterest expenses.
Comparison of nine months ended September 30, 2017 to the comparable period in the prior year
Noninterest expense increased $3.3 million, or 4.2%, to $83.0 million during the nine months ended September 30, 2017 compared to $79.7 million for the nine months ended September 30, 2016. The following table presents changes in the key components of noninterest expense for the periods noted.
 Nine Months Ended September 30,    
 2017 2016 Change Percentage Change
 (Dollars in thousands)
Compensation and employee benefits$48,119
 $45,652
 $2,467
 5.4 %
Occupancy and equipment11,607
 11,873
 (266) (2.2)
Data processing6,007
 5,564
 443
 8.0
Marketing2,545
 2,254
 291
 12.9
Professional services3,515
 2,508
 1,007
 40.2
State and local taxes1,828
 2,031
 (203) (10.0)
Federal deposit insurance premium1,090
 1,316
 (226) (17.2)
Other real estate owned, net(36) 330
 (366) (110.9)
Amortization of intangible assets966
 1,057
 (91) (8.6)
Other expense7,346
 7,079
 267
 3.8
Total noninterest expense$82,987
 $79,664
 $3,323
 4.2 %

57


Compensation and employee benefits increased $2.5 million, or 5.4%, to $48.1 million during the nine months ended September 30, 2017 from $45.7 million during the nine months ended September 30, 2016. The increase in the nine months ended September 30, 2017 compared to the same period in 2016 was primarily due to senior level staffing increases, including the addition of the new Portland, Oregon lending team members who started in May 2017, and standard salary increases.
Professional services increased $1.0 million, or 40.2%, to $3.5 million during the nine months ended September 30, 2017 from $2.5 million during the nine months ended September 30, 2016. The increase in the nine months ended September 30, 2017 compared to the same period in 2016 was primarily due to due to benefit-based consulting fees related to the consumer deposit account consolidation process, which correspondingly generated an increase in service charges and other fees. Professional services also increased as a result of Trust-related expenses based on a renegotiated contract for 2017, which also increased other noninterest income, and legal costs incurred for our pending merger with Puget Sound as discussed in Note (16) Definitive Agreement.
Data processing increased $443,000, or 8.0%, to $6.0 million during the nine months ended September 30, 2017 from $5.6 million during the nine months ended September 30, 2016 primarily due to higher transactional activity in the core operating system and internet banking as a result of the growth in loans and deposits..
Other real estate owned, net decreased $366,000 or 110.9%, to income of $36,000 during the nine months ended September 30, 2017 compared to expense of $330,000 during the nine months ended September 30, 2016. The income recorded during the nine months ended September 30, 2017 was due to gain on sale of properties of $111,000, offset by maintenance expense of $75,000. For the nine months ended September 30, 2016, the Bank recorded a valuation adjustment of $383,000 and maintenance expense of $120,000, which was offset by the gain on sale of properties of $173,000.
The ratio of noninterest expense to average assets (annualized) was 2.82% for the nine months ended September 30, 2017, compared to 2.86% for the nine months ended September 30, 2016. The decrease was primarily a result of an increase in assets and cost efficiencies gained through efforts by the Company to manage noninterest expenses.
Income Tax Expense
Comparison of quarter ended September 30, 2017 to the comparable quarter in the prior year
Income tax expense decreased by $199,000, or 4.8%, to $3.9 million for the three months ended September 30, 2017 from $4.1 million for the three months ended September 30, 2016. The effective tax rate was 27.0% for the three months ended September 30, 2017 compared to 27.2% for the same period in 2016. The decrease in the effective tax rate during the three months ended September 30, 2017 compared to the same period in 2016 was due primarily to an increase in tax benefits from low income housing tax credits, offset partially by the implementation of FASB ASU 2016-09 requiring the excess tax benefits on option exercises and restricted stock vesting to be recognized in earnings prospectively starting on January 1, 2017.
Comparison of nine months ended September 30, 2017 to the comparable period in the prior year
Income tax expense increased by $645,000, or 6.2%, to $11.1 million for the nine months ended September 30, 2017 from $10.4 million for the nine months ended September 30, 2016. The effective tax rate was 25.9% for the nine months ended September 30, 2017 compared to 26.5% for the same period in 2016. The decrease in the effective tax rate during the nine months ended September 30, 2017 compared to the same period in 2016 was due primarily to the implementation of FASB ASU 2016-09 requiring the excess tax benefits on option exercises and restricted stock vesting to be recognized in earnings prospectively starting on January 1, 2017.

Financial Condition Overview
Total assets increased $171.1 million, or 4.4%, to $4.05 billion as of September 30, 2017 compared to $3.88 billion as of December 31, 2016. Total loans receivable, net, increased $156.4 million, or 6.0%, to $2.77 billion at September 30, 2017 compared to $2.61 billion at December 31, 2016. Loans were mostly funded through an increase in deposits. Deposits increased by $91.2 million, or 2.8%, to $3.32 billion as of September 30, 2017 compared to $3.23 billion as of December 31, 2016. Total non-maturity deposits decreased to 88.1% of total deposits at September 30, 2017 from 88.9% at December 31, 2016 and certificates of deposits increased to 11.9% of total deposits at September 30, 2017 from 11.1% at December 31, 2016.
Prepaid expenses and other assets increased $8.4 million, or 10.6%, to $87.7 million at September 30, 2017 from $79.4 million at December 31, 2016 primarily as a result of the Company's investment in two new low income housing tax credit partnerships totaling $14.3 million. These investments had corresponding obligations recorded in accrued expenses and other liabilities of $14.3 million at September 30, 2017. These obligations will decrease as

58


projects in the partnerships are funded. During the nine months ended September 30, 2017 the Company made capital contributions related to other low income housing tax credit partnerships of $8.5 million, partially offsetting the increase in accrued expenses and other liabilities.
Federal Home Loan Bank advances increased $37.8 million, or 47.5%, to $117.4 million as of September 30, 2017 from $79.6 million as of December 31, 2016. The increase in advances was required as a supplement to deposits in order to fund loan growth.
Total stockholders’ equity increased $25.8 million, or 5.4%, to $507.6 million as of September 30, 2017 from $481.8 million at December 31, 2016. The increase during the nine months ended September 30, 2017 was due primarily to net income of $31.8 million and a $4.4 million improvement in accumulated other comprehensive income, net of tax, offset partially by cash dividends declared of $11.4 million. The Company’s equity position was 12.5% of total assets as of September 30, 2017 and 12.4% as of December 31, 2016.
The table below provides a comparison of the changes in the Company's financial condition from December 31, 2016 to September 30, 2017.
  September 30, 2017 December 31, 2016 Change Percent Change
  (Dollars in thousands)
Assets        
Cash and cash equivalents $111,258
 $103,745
 $7,513
 7.2 %
Investment securities 800,060
 794,645
 5,415
 0.7
Loans held for sale 5,368
 11,662
 (6,294) (54.0)
Total loans receivable, net 2,766,113
 2,609,666
 156,447
 6.0
Other real estate owned 523
 754
 (231) (30.6)
Premises and equipment, net 60,457
 63,911
 (3,454) (5.4)
Federal Home Loan Bank stock, at cost 9,343
 7,564
 1,779
 23.5
Bank owned life insurance 71,474
 70,355
 1,119
 1.6
Accrued interest receivable 12,295
 10,925
 1,370
 12.5
Prepaid expenses and other assets 87,728
 79,351
 8,377
 10.6
Other intangible assets, net 6,408
 7,374
 (966) (13.1)
Goodwill 119,029
 119,029
 
 
Total assets $4,050,056
 $3,878,981
 $171,075
 4.4 %
         
Liabilities        
Deposits $3,320,818
 $3,229,648
 $91,170
 2.8
Federal Home Loan Bank advances 117,400
 79,600
 37,800
 47.5
Junior subordinated debentures 19,936
 19,717
 219
 1.1
Securities sold under agreement to repurchase 28,668
 22,104
 6,564
 29.7
Accrued expenses and other liabilities 55,626
 46,149
 9,477
 20.5
Total liabilities 3,542,448
 3,397,218
 145,230
 4.3
Stockholders' equity     
  
Common stock 360,113
 359,060
 1,053
 0.3
Retained earnings 145,677
 125,309
 20,368
 16.3
Accumulated other comprehensive income (loss), net 1,818
 (2,606) 4,424
 169.8
Total stockholders' equity 507,608
 481,763
 25,845
 5.4
Total liabilities and stockholders' equity $4,050,056
 $3,878,981
 $171,075
 4.4 %


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Lending Activities
As indicated in the table below, loans receivable, net was $2.80 billion at September 30, 2017, an increase of $156.8 million, or 5.9%, from $2.64 billion at December 31, 2016. The increase in loans receivable for the nine months ended September 30, 2017 was primarily due to increases in commercial business loans of $121.3 million, consumer loans of $15.5 million and real estate construction and land development loans of $15.3 million.
 September 30, 2017 December 31, 2016
 Balance % of Total Balance % of Total
 (Dollars in thousands)
Commercial business:       
Commercial and industrial$665,582
 23.8% $637,773
 24.2%
Owner-occupied commercial real estate602,238
 21.5
 558,035
 21.1
Non-owner occupied commercial real estate930,188
 33.3
 880,880
 33.4
Total commercial business2,198,008
 78.6
 2,076,688
 78.7
One-to-four family residential81,422
 2.9
 77,391
 2.9
Real estate construction and land development:      
One-to-four family residential51,451
 1.8
 50,414
 1.9
Five or more family residential and commercial properties122,981
 4.4
 108,764
 4.1
Total real estate construction and land development174,432
 6.2
 159,178
 6.0
Consumer340,643
 12.2
 325,140
 12.3
Gross loans receivable2,794,505
 99.9
 2,638,397
 99.9
Deferred loan costs, net3,008
 0.1
 2,352
 0.1
Loans receivable, net$2,797,513
 100.0% $2,640,749
 100.0%


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Nonperforming Assets and Credit Quality Metrics
The following table describes our nonperforming assets and other credit quality metrics at the dates indicated:
 September 30, 2017 December 31, 2016
 (Dollars in thousands)
Nonaccrual loans:   
Commercial business$9,683
 $8,580
One-to-four family residential84
 94
Real estate construction and land development869
 2,008
Consumer316
 227
Total nonaccrual loans (1)(2)10,952
 10,909
Other real estate owned523
 754
Total nonperforming assets$11,475
 $11,663
    
Allowance for loan losses$31,400
 $31,083
Allowance for loan losses to loans receivable, net1.12% 1.18%
Allowance for loan losses to nonperforming loans286.71% 284.93%
Nonperforming loans to loans receivable, net0.39% 0.41%
Nonperforming assets to total assets0.28% 0.30%
    
Performing TDR loans:   
Commercial business$18,571
 $19,837
One-to-four family residential219
 227
Real estate construction and land development1,136
 2,141
Consumer118
 83
Total performing TDR loans (3)$20,044
 $22,288
Accruing loans past due 90 days or more (4)$
 $
Potential problem loans (5)84,089
 87,762
(1) 
At September 30, 2017 and December 31, 2016, $5.9 million and $6.9 million of nonperforming loans, respectively, were considered TDR loans.
(2) 
At September 30, 2017 and December 31, 2016, $2.5 million and $2.8 million of nonperforming loans, respectively, were guaranteed by government agencies.
(3) 
At September 30, 2017 and December 31, 2016, $1.4 million and $682,000 of performing TDR loans, respectively, were guaranteed by government agencies.
(4) 
There were no accruing loans past due 90 days or more that were guaranteed by government agencies at September 30, 2017 or December 31, 2016.
(5) 
At September 30, 2017 and December 31, 2016, $1.7 million and $1.1 million of potential problem loans, respectively, were guaranteed by government agencies.

Nonperforming assets were $11.5 million, or 0.28% of total assets and $11.7 million, or 0.30% of total assets as of September 30, 2017 and December 31, 2016, respectively. The balance of nonaccrual loans increased $43,000, or 0.4%, to $11.0 million ($2.5 million guaranteed by governmental agencies) at September 30, 2017 from $10.9 million ($2.8 million guaranteed by governmental agencies) at December 31, 2016. For the nine months ended September 30, 2017, the increase in nonaccrual loans was primarily due to additions to nonaccrual loans of $5.1 million, offset partially by net principal reductions of $4.3 million and charge-offs of $750,000. The other real estate owned balance decreased to $523,000 at September 30, 2017 from $754,000 at December 31, 2016 primarily as a result of the sale of two properties.
Performing TDR loans were $20.0 million and $22.3 million as of September 30, 2017 and December 31, 2016, respectively. The $2.2 million, or 10.1%, decrease in performing TDR loans for the nine months ended September 30, 2017 was primarily the result of net principal payments of $8.3 million and loans transferred to nonaccrual of $1.1 million, partially offset by troubled loans restructured during the period of $7.1 million. At September 30, 2017 and

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December 31, 2016, the Company had an allowance for loan losses on the performing TDR loans of $2.1 million and $2.0 million, respectively.
Potential problem loans as of September 30, 2017 and December 31, 2016 were $84.1 million and $87.8 million, respectively. Potential problem loans are those loans that are currently accruing interest and are not considered impaired, but which we are monitoring because the financial information of the borrower causes concerns as to their ability to meet their loan repayment terms. Loans that are past due 90 days or more and still accruing interest are both well secured and in the process of collection. The $3.7 million, or 4.2%, decrease in potential problem loans was primarily the result of net principal payments of $18.9 million, loans transferred to held for sale of $5.8 million, loans transferred to nonaccrual status of $4.6 million and loan grade improvements of $4.4 million, partially offset by the addition of loans graded as potential problem loans of $31.4 million during the nine months ended September 30, 2017.

Analysis of Allowance for Loan Losses
Management maintains an allowance for loan losses (“ALL”) to provide for estimated probable incurred losses in the loan portfolio at the balance sheet date. The adequacy of the ALL is monitored through our ongoing quarterly loan quality assessments.
We assess the estimated credit losses inherent in our loan portfolio by considering a number of elements including:
Historical loss experience in the loan portfolio;
Impact of environmental factors, including:
Levels of and trends in delinquencies and classified and impaired loans;
Levels of and trends in charge-offs and recoveries;
Trends in volume and terms of loans;
Effects of changes in risk selection and underwriting standards and other changes in lending policies, procedures and practices;
Experience, ability and depth of lending management and other relevant staff;
National and local economic trends and conditions;
Other external factors such as competition, legal and regulatory;
Effects of changes in credit concentrations; and
Other factors
We calculate an appropriate ALL for loans in our loan portfolio, except PCI loans, by applying historical loss factors for homogeneous classes of the portfolio, adjusted for changes to the above-noted environmental factors. We may record specific provisions for impaired loans, including loans on nonaccrual status and TDRs, after a careful analysis of each loan’s credit and collateral factors. Our analysis of an appropriate ALL combines the provisions made for our non-impaired loans and the specific provisions made for each impaired loan.
The allowance for loan losses on loans designated as non-PCI loans is similar to the methodology described above except that for non-PCI loans, the remaining unaccreted discounts resulting from the fair value adjustments recorded at the time the loans were purchased are additionally factored into the allowance methodology.
For the PCI loans, the acquisition date fair value incorporated our estimate of future expected cash flows until the ultimate resolution of these credits. To the extent actual or projected cash flows are less than previously estimated, additional provisions for loan losses on the PCI loan portfolio will be recognized immediately into earnings. To the extent actual or projected cash flows are more than previously estimated, the increase in cash flows is recognized immediately as a recapture of provision for loan losses up to the previously recognized provision for that loan or pool of loans, if any, and then prospectively recognized in interest income as a yield adjustment.
While we believe we use the best information available to determine the allowance for loan losses, our results of operations could be significantly affected if circumstances differ substantially from the assumptions used in determining the allowance. A decline in national and local economic conditions, or other factors, could result in a material increase in the allowance for loan losses and may adversely affect the Company’s financial condition and results of operations. In addition, the determination of the amount of the allowance for loan losses is subject to review by bank regulators, as part of their routine examination process, which may result in the establishment of additional allowance for loan losses based upon their judgment of information available to them at the time of their examination.

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The following table provides information regarding changes in our allowance for loan losses as of and for the three and nine months ended September 30, 2017 and 2016:
 Three Months Ended September 30, Nine Months Ended September 30,
 2017 2016 2017 2016
 (Dollars in thousands)
Loans receivable, net at the end of the period$2,797,513
 $2,578,977
 $2,797,513
 $2,578,977
Average loans receivable during the period2,737,535
 2,526,150
 2,676,153
 2,461,856
        
Allowance for loan losses on loans at the beginning of the period$32,751
 $28,426
 $31,083
 $29,746
Provision for loan losses884
 1,495
 2,882
 3,754
Charge-offs:       
Commercial business(1,497) (328) (1,940) (3,698)
One-to-four family residential(15) 
 (15) 
Real estate construction and land development(556) 
 (556) (154)
Consumer(478) (572) (1,419) (1,370)
Total charge-offs(2,546) (900) (3,930) (5,222)
Recoveries:       
Commercial business8
 993
 834
 1,352
One-to-four family residential
 
 1
 2
Real estate construction and land development191
 
 201
 83
Consumer112
 197
 329
 496
Total recoveries311
 1,190
 1,365
 1,933
Net (charge-offs) recoveries(2,235) 290
 (2,565) (3,289)
Allowance for loan losses at the end of the period$31,400
 $30,211
 $31,400
 $30,211
        
Allowance for loan losses to loans receivable, net1.12% 1.17 % 1.12% 1.17%
Net charge-offs (recoveries) on loans to average loans, annualized0.32% (0.05)% 0.13% 0.18%
The allowance for loan losses increased to $31.4 million at September 30, 2017 from $31.1 million at December 31, 2016. The increase was the result of provision for loan losses of $2.9 million, partially offset by net charge-offs of $2.6 million recorded during the nine months ended September 30, 2017, which included PCI loan pool charge-offs of $1.7 million. The allowance for loan losses to loans receivable, net, decreased to 1.12% at September 30, 2017 from 1.18% at December 31, 2016.
The ratio of net charge-offs (recoveries) on loans to average loans, annualized deteriorated to net charge-off of 0.32% for the three months ended September 30, 2017 compared to net recoveries of 0.05% for the three months ended September 30, 2016, primarily due to PCI loan pool charge-offs of $1.5 million for the three months ended September 30, 2017. The ratio of net charge-offs (recoveries) on loans to average loans, annualized improved to a net charge-off of 0.13% for the nine months ended September 30, 2017 from 0.18% for the nine months ended September 30, 2016. The improvement of the ratio was due primarily to fewer net charge-offs recorded during the nine months ended September 30, 2017 compared to the same period in 2016 in addition to growth in the loan portfolio.
Nonperforming loans were $11.0 million and $10.9 million at September 30, 2017 and December 31, 2016, respectively, or 0.39% and 0.41% of loans receivable, net, respectively. The allowance for loan losses to nonperforming loans was 286.71% at September 30, 2017 and 284.93% at December 31, 2016. As of September 30, 2017, the Bank identified $31.0 million of impaired loans, of which $10.5 million had no specific valuation allowance as their estimated collateral value or discounted estimated cash flow was equal to or exceeds their carrying value. The remaining $20.5 million of impaired loans at September 30, 2017 had related specific valuation allowances totaling $3.1 million. Impaired loans totaled $33.2 million at December 31, 2016, of which $10.1 million had no specific valuation allowance and $23.1 million had $2.7 million of specific valuation allowance.

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Based on the established comprehensive methodology, management deemed the allowance for loan losses of $31.4 million at September 30, 2017 appropriate to provide for probable incurred credit losses based on an evaluation of known and inherent risks in the loan portfolio at that date. This compares to an allowance for loan losses at December 31, 2016 of $31.1 million. 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. At September 30, 2017 and December 31, 2016, the remaining fair value discount for these purchased loans was $11.7 million and $13.5 million, respectively.
The following table outlines the allowance for loan losses and related loan balances at September 30, 2017 and December 31, 2016:
 September 30, 2017 December 31, 2016
 (Dollars in thousands)
General Valuation Allowance:   
Allowance for loan losses$24,113
 $21,791
Gross loans, excluding PCI and impaired loans$2,719,813
 $2,540,751
Percentage0.89% 0.86%
    
PCI Allowance:   
Allowance for loan losses$4,176
 $6,558
Gross PCI loans$43,696
 $64,448
Percentage9.56% 10.18%
    
Specific Valuation Allowance:   
Allowance for loan losses$3,111
 $2,734
Gross impaired loans$30,996
 $33,198
Percentage10.04% 8.24%
    
Total Allowance for Loan Losses:   
Allowance for loan losses$31,400
 $31,083
Gross loans receivable$2,794,505
 $2,638,397
Percentage1.12% 1.18%
While the Bank believes it has established its existing allowances for loan losses in accordance with U.S. GAAP, there can be no assurance that bank regulators, in reviewing the Bank’s loan portfolio, will not request the Bank to increase significantly its allowance for loan losses. In addition, because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses is appropriate or that increased provisions will not be necessary should the credit quality of the loans deteriorate. Any material increase in the allowance for loan losses would adversely affect the Company’s financial condition and results of operations.
Based on management’s assessment of loan quality and current economic conditions, the Company believes that its allowance for loan losses was appropriate to absorb the probable incurred losses and inherent risks of loss in the loan portfolio at September 30, 2017.


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Deposits and Other Borrowings
As indicated in the table below, total deposits were $3.32 billion at September 30, 2017, an increase of $91.2 million, or 2.8%, from $3.23 billion at December 31, 2016.
 September 30, 2017 December 31, 2016
 Balance % of Total Balance % of Total
 (Dollars in thousands)
Noninterest bearing demand deposits$916,265
 27.6% $882,091
 27.3%
Interest bearing demand deposits1,031,449
 31.0
 963,821
 29.8
Money market accounts480,899
 14.5
 523,875
 16.2
Savings accounts497,024
 15.0
 502,460
 15.6
Total non-maturity deposits2,925,637
 88.1
 2,872,247
 88.9
Certificates of deposit395,181
 11.9
 357,401
 11.1
Total deposits$3,320,818
 100.0% $3,229,648
 100.0%
Non-maturity deposits (total deposits less certificates of deposit) increased $53.4 million, or 1.9%, to $2.93 billion at September 30, 2017 from $2.87 billion at December 31, 2016. Certificate of deposit accounts increased $37.8 million, or 10.6%, to $395.2 million at September 30, 2017 from $357.4 million at December 31, 2016 due primarily to the addition of $44.1 million of brokered certificates of deposit, which were used to supplement deposit growth in the funding of loan growth. Based on the change in the mix and volume of deposits, the percentage of certificates of deposit to total deposits increased to 11.9% at September 30, 2017 from 11.1% at December 31, 2016.
Borrowings may be used on a short-term basis to compensate for reductions in other sources of funds (such as deposit inflows at less than projected levels). Borrowings may also be used on a longer-term basis to support expanded lending activities and match the maturity of repricing intervals of assets. The Bank is utilizing securities sold under agreement to repurchase as a supplement to its funding sources. Our repurchase agreements are secured by available for sale investment securities. At September 30, 2017, the Bank had securities sold under agreement to repurchase of $28.7 million, an increase of $6.6 million, or 29.7%, from $22.1 million at December 31, 2016. The increase was the result of customer activity during the period.
The Company also has junior subordinated debentures with a par value of $25.0 million which pay quarterly interest based on three-month LIBOR plus 1.56%. The debentures mature in 2037. The balance of the junior subordinated debentures was $19.9 million at September 30, 2017, which reflects the fair value of the debentures established during the Washington Banking Merger, adjusted for the accretion of discount from purchase accounting fair value adjustment.
At September 30, 2017, the Bank maintained credit facilities with the FHLB of Des Moines for $662.4 million and credit facilities with the Federal Reserve Bank of San Francisco for $50.6 million. The Company had FHLB advances outstanding of $117.4 million and $79.6 million at September 30, 2017 and December 31, 2016, respectively. The average cost of the FHLB advances during the nine months ended September 30, 2017 was 1.09%. The Bank also maintains lines of credit with four correspondent banks to purchase federal funds totaling $90.0 million as of September 30, 2017. There were no federal funds purchased as of September 30, 2017 or December 31, 2016.
We are required to maintain an adequate level of liquidity to ensure the availability of sufficient funds to fund loan originations and deposit withdrawals, satisfy other financial commitments and fund operations. We generally maintain sufficient cash and short-term investments to meet short-term liquidity needs. At September 30, 2017, cash and cash equivalents totaled $111.3 million, or 2.7% of total assets. The fair value of investment securities available for sale totaled $800.1 million at September 30, 2017 of which $257.0 million were pledged to secure public deposits or borrowing arrangements. The fair value of investment securities available for sale that were not pledged totaled $543.1 million, or 13.4%, of total assets at September 30, 2017. The fair value of investment securities available for sale with maturities of one year or less were $6.6 million, or 0.2%, of total assets at September 30, 2017.

Liquidity and Cash Flows
Our primary sources of funds are customer and local government deposits, loan principal and interest payments, loan sales and interest earned on and proceeds from sales and maturities of investment securities. These funds, together with retained earnings, equity and other borrowed funds, are used to make loans, acquire investment

65


securities and other assets, and fund continuing operations. While maturities and scheduled amortization of loans are a predictable source of funds, deposit flows and loan prepayments are greatly influenced by the level of interest rates, economic conditions and competition.
Heritage Bank: The principal objective of the Bank’s liquidity management program is to maintain the ability to meet day-to-day cash flow requirements of its customers who either wish to withdraw funds or to draw upon credit facilities to meet their cash needs. The Bank monitors the sources and uses of funds on a daily basis to maintain an acceptable liquidity position. In addition to liquidity from core deposits and the repayment and maturities of loans, the Bank can utilize established credit facilities and lines with correspondent banks or sale of investment securities.
Heritage Financial Corporation: The Company is a separate legal entity from the Bank and must provide for its own liquidity. Substantially all of the Company’s revenues are obtained from dividends declared and paid by the Bank. There are statutory and regulatory provisions that could limit the ability of the Bank to pay dividends to the Company. However, management believes that such restrictions will not have an adverse impact on the ability of the Company to meets its ongoing cash obligations. At September 30, 2017, the Company (on an unconsolidated basis) had cash and cash equivalents and investment securities available for sale with no stated maturities of $11.6 million.
Consolidated Cash Flows: As disclosed in the Condensed Consolidated Statements of Cash Flows, net cash provided by operating activities was $53.8 million for the nine months ended September 30, 2017, and primarily consisted of net income of $31.8 million, net proceeds from origination and sale of loans held for sale of $2.2 million and net change in accrued interest receivable, prepaid expenses and other assets, accrued expenses and other liabilities of $8.3 million. During the nine months ended September 30, 2017, net cash used in investing activities was $169.9 million, which consisted primarily of net loan originations of $178.8 million, investment in low income housing tax credit partnerships of $8.5 million and net proceeds from purchase and sale of investment securities available for sale of $3.4 million. Net cash provided by financing activities was $123.6 million for the nine months ended September 30, 2017, and primarily consisted of a net increase in deposits of $91.2 million, net FHLB advances of $37.8 million and a net increase in securities sold under agreements to repurchase of $6.6 million, offset partially by cash dividends on common stock of $11.4 million during the period.

Capital and Capital Requirements
Stockholders’ equity at September 30, 2017 was $507.6 million compared with $481.8 million at December 31, 2016. During the nine months ended September 30, 2017, the Company realized net income of $31.8 million, declared cash dividends of $11.4 million, recorded other comprehensive income of $4.4 million, recognized stock-based compensation expense of $1.6 million, and recorded a net decrease to common stock due to common stock repurchases and exercises of stock options, net of tax, of $515,000.
Pursuant to minimum capital requirements of the FDIC effective on January 1, 2015, all FDIC-insured financial institutions, including Heritage Bank, are required to maintain a minimum common equity Tier 1 risk-based capital to risk-weighted assets ratio of 4.5%, a minimum Tier 1 leverage ratio to average assets of 4.0% and minimum risk-based capital ratios of Tier 1 capital to risk-weighted assets and total capital to risk-weighted assets of 6.0% and 8.0%, respectively.
As of September 30, 2017 and December 31, 2016, the most recent regulatory notifications categorized Heritage 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. The following table provides our capital requirements and actual results.

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  Minimum Requirements Well-Capitalized Requirements Actual
  (Dollars in thousands)
As of September 30, 2017:            
The Company consolidated            
Common equity Tier 1 capital to risk-weighted assets $151,086
 4.5% N/A
 N/A
 $383,546
 11.4%
Tier 1 leverage capital to average assets 155,761
 4.0
 N/A
 N/A
 403,444
 10.4
Tier 1 capital to risk-weighted assets 201,448
 6.0
 N/A
 N/A
 403,444
 12.0
Total capital to risk-weighted assets 268,598
 8.0
 N/A
 N/A
 435,119
 13.0
Heritage Bank            
Common equity Tier 1 capital to risk-weighted assets 150,874
 4.5
 $217,929
 6.5% 388,852
 11.6
Tier 1 leverage capital to average assets 155,582
 4.0
 194,478
 5.0
 388,852
 10.0
Tier 1 capital to risk-weighted assets 201,165
 6.0
 268,221
 8.0
 388,852
 11.6
Total capital to risk-weighted assets 268,221
 8.0
 335,276
 10.0
 420,422
 12.5
             
As of December 31, 2016:            
The Company consolidated            
Common equity Tier 1 capital to risk-weighted assets $142,688
 4.5% N/A
 N/A
 $362,350
 11.4%
Tier 1 leverage capital to average assets 148,144
 4.0
 N/A
 N/A
 381,989
 10.3
Tier 1 capital to risk-weighted assets 190,250
 6.0
 N/A
 N/A
 381,989
 12.0
Total capital to risk-weighted assets 253,667
 8.0
 N/A
 N/A
 413,320
 13.0
Heritage Bank            
Common equity Tier 1 capital to risk-weighted assets 142,573
 4.5
 $205,938
 6.5% 369,915
 11.7
Tier 1 leverage capital to average assets 148,024
 4.0
 185,030
 5.0
 369,915
 10.0
Tier 1 capital to risk-weighted assets 190,097
 6.0
 253,462
 8.0
 369,915
 11.7
Total capital to risk-weighted assets 253,462
 8.0
 316,828
 10.0
 401,168
 12.7
Although new capital requirements were effective on January 1, 2015, certain provisions of the new rule will be phased-in from the effective date through 2019, including, among others, a new capital conservation buffer requirement, which requires financial institutions to maintain a common equity capital ratio more than 2.5% above the required minimum levels in order to avoid limitations on capital distributions, including dividend payments, and certain discretionary bonus payments based on percentages of eligible retained income that could be utilized for such actions. The new capital conservation buffer requirement began to be phased-in on January 1, 2016 at 0.625% of risk-weighted assets and will continue to increase by 0.625% on each subsequent January 1, until it reaches 2.5% on January 1, 2019. At September 30, 2017, the capital conservation buffer was 5.07% and 4.65% for the Company and the Bank, respectively, and the minimum conservation buffer requirement was 1.25%.
Quarterly, the Company reviews the potential payment of cash dividends to its common shareholders. The timing and amount of cash dividends paid on our common stock depends on the Company’s earnings, capital requirements, financial condition and other relevant factors. Dividends on common stock from the Company depend substantially upon receipt of dividends from the Bank, which is the Company’s predominant source of income. On October 25, 2017, the Company’s Board of Directors declared a regular dividend of $0.13 per common share and a special dividend of $0.10 per common share payable on November 22, 2017 to shareholders of record on November 8, 2017.

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ITEM 3.     QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our results of operations are highly dependent upon our ability to manage interest rate risk. We consider interest rate risk to be a significant market risk that could have a material effect on our financial condition and results of operations. Interest rate risk is measured and assessed on a quarterly basis. In our opinion, there has not been a material change in our interest rate risk exposure since the information disclosed in our Annual Report on Form 10-K for the year ended December 31, 2016.
We do not maintain a trading account for any class of financial instrument nor do we engage in hedging activities or purchase high-risk derivative instruments. Moreover, we have no material foreign currency exchange rate risk or commodity price risk.

ITEM 4.     CONTROLS AND PROCEDURES
(a) Evaluation of Disclosure Controls and Procedures
An evaluation of the Company’s disclosure controls and procedure (as defined in Section 13a-15(e) or 15d-15(e) of the Securities Exchange Act of 1934 (the “Act”)) was carried out under the supervision and with the participation of the Company’s Chief Executive Officer, Chief Financial Officer and the Company’s Disclosure Committee as of the end of the period covered by this quarterly report. In designing and evaluating the Company’s disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure controls and procedures, management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Based on their evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures as of September 30, 2017 are effective in ensuring that the information required to be disclosed by the Company in the reports it files or submits under the Act is (i) accumulated and communicated to the Company’s management (including the Chief Executive Officer and Chief Financial Officer) in a timely manner, and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.
(b) Changes in Internal Control Over Financial Reporting
There have been no changes in the Company’s internal control over financial reporting (as defined in Rule 13a-15(f) of the Act) that occurred during the quarter ended September 30, 2017, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. The Company does not expect that its internal control over financial reporting will prevent all error and all fraud. A control procedure, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control procedure are met. Because of the inherent limitations in all control procedures, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any control procedure also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control procedure, misstatements due to error or fraud may occur and not be detected.
 
PART II.    OTHER INFORMATION

ITEM 1.     LEGAL PROCEEDINGS
Heritage and Heritage Bank are not a party to any material pending legal proceedings other than ordinary routine litigation incidental to the business of the Bank.

ITEM 1A.     RISK FACTORS
There have been no material changes to the risk factors set forth in Part I. Item 1A of the Company’s Annual Report on Form 10-K for the year ended December 31, 2016.

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

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

The following table provides total repurchased shares and average share prices under the applicable plan for the periods indicated:
 Three Months Ended September 30, Nine Months Ended September 30,  
 2017 2016 2017 2016 Plan Total (1)
Eleventh Plan         
Repurchased shares
 38,000
 
 138,000
 579,996
Stock repurchase average share price$
 $17.46
 $
 $17.16
 $16.76
(1)Represents shares repurchased and average price per share paid during the duration of the plan.
In addition to the stock repurchases disclosed in the table above, the Company repurchased shares to pay withholding taxes on the vesting of restricted stock. During the three and nine months ended September 30, 2017, the Company repurchased 344 and 27,711 shares of common stock at an average price per share of $25.80 and $24.61 to pay withholding taxes on the vesting of restricted stock that vested during the respective periods. During the three and nine months ended September 30, 2016, the Company repurchased 5,276 and 29,206 shares of common stock at an average price per share of $18.64 and $17.77 to pay withholding taxes on the vesting of restricted stock that vested during the respective periods.
The following table sets forth information about the Company’s purchases of its outstanding common stock during the quarter ended September 30, 2017.
Period 
Total Number 
of Shares 
Purchased(1)
 
Average Price
Paid Per 
Share(1)
 
Total Number of  Shares Purchased as 
Part of Publicly
Announced Plans or Programs
 
Maximum Number 
of Shares that May
Yet Be Purchased
Under the Plans or
Programs
July 1, 2017— July 31, 2017 
 $
 7,893,389
 935,034
August 1, 2017— August 31, 2017 
 
 7,893,389
 935,034
September 1, 2017— September 30, 2017 344
 25.80
 7,893,389
 935,034
Total 344
 $25.80
 7,893,389
 935,034
(1)All of the common shares repurchased by the Company between July 1, 2017 and September 30, 2017 were shares of restricted stock that represented the cancellation of stock to pay withholding taxes.

ITEM 3.     DEFAULTS UPON SENIOR SECURITIES
None

ITEM 4.     MINE SAFETY DISCLOSURES
Not applicable

ITEM 5.        OTHER INFORMATION
None

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ITEM 6.     EXHIBITS

    Incorporated by Reference
Exhibit No. Description of Exhibit Form Exhibit Filing Date/Period End Date
         
2.5
  8-K 2.1 7/27/17
         
31.1
       
         
31.2
       
         
32.1
       
         
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 The following financial information from Heritage Financial Corporation’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2017 is formatted in XBRL: (i) the Unaudited Condensed Consolidated Statements of Financial Condition, (ii) the Unaudited Condensed Consolidated Statements of Income, (iii) the Unaudited Condensed Consolidated Statements Comprehensive Income, (iv) the Unaudited Condensed Consolidated Statements of Stockholders’ Equity, (v) the Unaudited Condensed Consolidated Statements of Cash Flows and (vi) the Unaudited Notes to Condensed Consolidated Financial Statements.      

SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

  HERITAGE FINANCIAL CORPORATION
   
Date:  
November 9, 2017 /S/ BRIAN L. VANCE
  Brian L. Vance
  President and Chief Executive Officer
  (Duly Authorized Officer)
   
Date:  
November 9, 2017 /S/ DONALD J. HINSON
  Donald J. Hinson
  Executive Vice President and Chief Financial Officer
  (Principal Financial and Accounting Officer)



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