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HFWA Heritage Financial

Filed: 5 May 21, 2:19pm
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
FORM 10-Q
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2021 or

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from __________ to __________
Commission File Number 000-29480 
HERITAGE FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter) 
 
Washington 91-1857900
(State or other jurisdiction of
incorporation or organization)
 (I.R.S. Employer
Identification No.)
201 Fifth Avenue SW,OlympiaWA 98501
(Address of principal executive offices) (Zip Code)
(360) 943-1500
(Registrant’s telephone number, including area code) 
 Securities registered pursuant to Section 12(b) of the Act:
Title of each classTrading symbolName of each exchange on which registered
Common stock, no par valueHFWANASDAQ

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  ☒    No  ☐
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted 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 such files).    Yes  ☒    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 filerAccelerated filer  
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  ☒
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the last practicable date:
As of April 26, 2021, there were 35,981,317 shares of the registrant's common stock, no par value per share, outstanding.


HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
FORM 10-Q
March 31, 2021
TABLE OF CONTENTS
Page
PART I.
ITEM 1.
NOTE 1.
NOTE 2.
NOTE 3.
NOTE 4.
NOTE 5.
NOTE 6.
NOTE 7.
NOTE 8.
NOTE 9.
NOTE 10.
NOTE 11.
NOTE 12.
NOTE 13.
NOTE 14.
ITEM 2.
ITEM 3.
2


GLOSSARY OF ACRONYMS, ABBREVIATIONS, AND TERMS

The acronyms, abbreviations, and terms listed below are used in various sections of this Form 10-Q. As used throughout this report, the terms “we”, “our”, or “us” refer to Heritage Financial Corporation and its consolidated subsidiaries, unless the context otherwise requires.
2020 Annual Form 10-KCompany's Annual Report on Form 10-K for the year ended December 31, 2020
ACLAllowance for credit losses
ASCAccounting Standards Codification
ASUAccounting Standards Update
BankHeritage Bank
CA ActConsolidated Appropriations Act of 2021
CARES ActCoronavirus Aid, Relief, and Economic Security Act of 2020
CECLCurrent expected credit loss
CECL Adoption
Company's adoption on January 1, 2020 of FASB ASU 2016-13 Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, as amended, which replaces the incurred loss methodology with an expected loss methodology that is referred to as the CECL methodology
CMOCollateralized Mortgage Obligation
CompanyHeritage Financial Corporation
COVID ModificationsLoans with modifications made in compliance with the CARES Act, as amended, and related regulatory guidance
COVID-19 PandemicCoronavirus Disease of 2019 pandemic
CRECommercial real estate
FASBFinancial Accounting Standards Board
FDICFederal Deposit Insurance Corporation
Federal ReserveBoard of Governors of the Federal Reserve System
Federal Reserve BankFederal Reserve Bank of San Francisco
FHLBFederal Home Loan Bank of Des Moines
GAAPU.S. Generally Accepted Accounting Principles
HeritageHeritage Financial Corporation
LIBORLondon Interbank Offering Rate
MBSMortgage-backed security
PPPPaycheck Protection Program
PPP1First tranche of the SBA's PPP commencing in April 2020 through August 8, 2020
PPP2Second tranche of the SBA'S PPP commencing in January 2021 and expiring May 31, 2021
PPPLFPaycheck Protection Program Liquidity Facility
SBASmall Business Administration
SECSecurities and Exchange Commission
SMSpecial Mention
3

SSSubstandard
TDRTroubled debt restructured

CAUTIONARY NOTE REGARDING FORWARD LOOKING STATEMENTS
This Form 10-Q may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements often include the words “believes,” “expects,” “anticipates,” “estimates,” “forecasts,” “intends,” “plans,” “targets,” “potentially,” “probably,” “projects,” “outlook” or similar expressions or future or conditional verbs such as “may,” “will,” “should,” “would” and “could.” 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.
The COVID-19 pandemic is adversely affecting us, our customers, counterparties, employees, and third-party service providers, and the ultimate extent of the impacts on our business, financial position, results of operations, liquidity, and prospects is uncertain. Deterioration in general business and economic conditions, including increases in unemployment rates, or turbulence in domestic or global financial markets could adversely affect our revenues and the values of our assets and liabilities, reduce the availability of funding, lead to a tightening of credit, and increase stock price volatility. In addition, changes to statutes, regulations, or regulatory policies or practices as a result of, or in response to the COVID-19 pandemic, could affect us in substantial and unpredictable ways. Other factors that could cause or contribute to such differences include, but are not limited to:
the credit risks of lending activities, including changes in the level and trend of loan delinquencies and write-offs and changes in our ACL on loans and provision for credit losses on loans that may be effected by deterioration in the housing and CRE markets, which may lead to increased losses and nonperforming assets in our loan portfolio, and may result in our ACL on loans no longer being adequate to cover actual losses, and require us to increase our ACL on loans;
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-term and long-term interest rates, deposit interest rates, our net interest margin and funding sources;
risks related to acquiring assets in or entering markets in which we have not previously operated and may not be familiar;
fluctuations in the demand for loans, the number of unsold homes and other properties and fluctuations in real estate values in our market areas;
results of examinations of us by the bank regulators, including the possibility that any such regulatory authority may, among other things, initiate an enforcement action against the Company or our bank subsidiary which could require us to increase our ACL on loans, write-down assets, change our regulatory capital position, affect our ability to borrow funds or maintain or increase deposits, or impose additional requirements on us, any of which could affect our ability to continue our growth through mergers, acquisitions or similar transactions and adversely affect our liquidity and earnings;
legislative or regulatory changes that adversely affect our business
implementing regulations, changes in regulatory policies and principles, or the interpretation of regulatory capital or other rules;
our ability to control operating costs and expenses;
increases in premiums for deposit insurance;
the use of estimates in determining fair value of certain of our assets, which estimates may prove to be incorrect and result in significant declines in valuation;
difficulties in reducing risk associated with the loans on our Condensed Consolidated Statements of Financial Condition;
staffing fluctuations in response to product demand or the implementation of corporate strategies that affect our workforce and potential associated charges;
disruptions, security breaches, or other adverse events, failures or interruptions in, or attacks on, our information technology systems or on the third-party vendors who perform several of our critical processing functions;
our ability to retain key members of our senior management team;
costs and effects of litigation, including settlements and judgments;
our ability to implement our growth strategies;
our ability to successfully integrate any assets, liabilities, customers, systems, and management personnel we may acquire into our operations and our ability to realize related revenue synergies and cost savings within expected time frames or at all, and any goodwill charges related thereto and costs or difficulties relating to integration matters, including but not limited to customer and employee retention, which might be greater than expected;
increased competitive pressures among financial service companies;
changes in consumer spending, borrowing and savings habits;
the availability of resources to address changes in laws, rules, or regulations or to respond to regulatory actions;
adverse changes in the securities markets;
inability of key third-party providers to perform their obligations to us;
changes in accounting policies and practices, as may be adopted by the financial institution regulatory agencies or the FASB, including additional guidance and interpretation on accounting issues and details of the implementation of new accounting methods and as a result of the CARES Act and the CA Act; and
other economic, competitive, governmental, regulatory, and technological factors affecting our operations, pricing, products and services, including as a result of the CARES Act, CA Act and recent COVID-19 pandemic vaccination efforts, and the other risks detailed from time to time in our filings with the SEC including our 2020 Annual Form 10-K.
4

PART I.     FINANCIAL INFORMATION

ITEM 1.     FINANCIAL STATEMENTS

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (Unaudited)
(In thousands, except shares)
March 31,
2021
December 31,
2020
ASSETS
Cash on hand and in banks$93,306 $91,918 
Interest earning deposits841,010 651,404 
Cash and cash equivalents934,316 743,322 
Investment securities available for sale, at fair value, net (amortized cost of $876,357 and $770,195, respectively)893,558 802,163 
Loans held for sale6,801 4,932 
Loans receivable4,595,869 4,468,647 
Allowance for credit losses on loans(64,225)(70,185)
Loans receivable, net4,531,644 4,398,462 
Other real estate owned
Premises and equipment, net84,533 85,452 
Federal Home Loan Bank stock, at cost7,933 6,661 
Bank owned life insurance108,341 107,580 
Accrued interest receivable19,447 19,418 
Prepaid expenses and other assets188,589 193,301 
Other intangible assets, net12,291 13,088 
Goodwill240,939 240,939 
Total assets$7,028,392 $6,615,318 
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits$6,019,698 $5,597,990 
Junior subordinated debentures20,960 20,887 
Securities sold under agreement to repurchase36,503 35,683 
Accrued expenses and other liabilities124,080 140,319 
Total liabilities6,201,241 5,794,879 
Stockholders’ equity:
Preferred stock, 0 par value, 2,500,000 shares authorized; 0 shares issued and outstanding, respectively
Common stock, 0 par value, 50,000,000 shares authorized; 35,981,317 and 35,912,243 shares issued and outstanding, respectively571,204 571,021 
Retained earnings242,486 224,400 
Accumulated other comprehensive income, net13,461 25,018 
Total stockholders’ equity827,151 820,439 
Total liabilities and stockholders’ equity$7,028,392 $6,615,318 

See accompanying Notes to Condensed Consolidated Financial Statements.
5

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
(In thousands, except per share amounts and shares outstanding)
Three Months Ended
March 31,
20212020
INTEREST INCOME:
Interest and fees on loans$49,524 $46,277 
Taxable interest on investment securities3,534 5,633 
Nontaxable interest on investment securities958 756 
Interest on interest earning deposits175 420 
Total interest income54,191 53,086 
INTEREST EXPENSE:
Deposits1,728 4,216 
Junior subordinated debentures187 285 
Other borrowings38 34 
Total interest expense1,953 4,535 
Net interest income52,238 48,551 
(Reversal of) provision for credit losses(7,199)7,946 
Net interest income after (reversal of) provision for credit losses59,437 40,605 
NONINTEREST INCOME:
Service charges and other fees4,000 4,376 
Gain on sale of investment securities, net29 1,014 
Gain on sale of loans, net1,370 547 
Interest rate swap fees152 296 
Bank owned life insurance income656 885 
Other income2,044 2,368 
Total noninterest income8,251 9,486 
NONINTEREST EXPENSE:
Compensation and employee benefits22,461 22,506 
Occupancy and equipment4,454 4,564 
Data processing3,812 3,527 
Marketing669 866 
Professional services1,331 1,377 
State/municipal business and use taxes972 757 
Federal deposit insurance premium589 
Other real estate owned, net25 
Amortization of intangible assets797 903 
Other expense2,157 2,735 
Total noninterest expense37,242 37,260 
Income before income taxes30,446 12,831 
Income tax expense5,102 640 
Net income$25,344 $12,191 
Basic earnings per share$0.70 $0.34 
Diluted earnings per share$0.70 $0.34 
Dividends declared per share$0.20 $0.20 
Average number of basic shares outstanding35,926,950 36,342,090 
Average number of diluted shares outstanding36,232,204 36,596,641 

See accompanying Notes to Condensed Consolidated Financial Statements.
6

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)
(In thousands)
Three Months Ended
March 31,
20212020
Net income$25,344 $12,191 
Change in fair value of investment securities available for sale, net of tax of $(3,204) and $2,419, respectively(11,534)8,707 
Reclassification adjustment for net gain from sale of investment securities available for sale included in income, net of tax of $(6), and $(221), respectively(23)(793)
Other comprehensive (loss) income(11,557)7,914 
Comprehensive income$13,787 $20,105 

See accompanying Notes to Condensed Consolidated Financial Statements.
7

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Unaudited)
(In thousands, except per share amounts)

Three Months Ended March 31, 2021
Number of
common
shares
Common
stock
Retained
earnings
Accumulated other comprehensive income (loss), netTotal
stockholders’
equity
Balance at December 31, 202035,912 $571,021 $224,400 $25,018 $820,439 
Restricted stock units vested92 — — — — 
Stock-based compensation expense— 870 — — 870 
Common stock repurchased(23)(687)— — (687)
Net income— — 25,344 25,344 
Other comprehensive loss, net of tax— — — (11,557)(11,557)
Cash dividend declared on common stock ($0.20 per share)— — (7,258)— (7,258)
Balance at March 31, 202135,981 $571,204 $242,486 $13,461 $827,151 
Three Months Ended March 31, 2020
Number of
common
shares
Common
stock
Retained
earnings
Accumulated other comprehensive income, netTotal
stockholders’
equity
Balance at December 31, 201936,619 $586,459 $212,474 $10,378 $809,311 
Cumulative effect from change in accounting policy (1)
— — (5,615)— (5,615)
Restricted stock units vested, net of forfeitures of restricted stock awards87 — — — — 
Exercise of stock options71 — — 71 
Stock-based compensation expense— 969 — — 969 
Common stock repurchased(822)(19,060)— — (19,060)
Net income— — 12,191 — 12,191 
Other comprehensive income, net of tax— — — 7,914 7,914 
Cash dividend declared on common stock ($0.20 per share)— — (7,343)— (7,343)
Balance at March 31, 202035,889 $568,439 $211,707 $18,292 $798,438 
(1) Effective January 1, 2020, Company adopted ASU 2016-13, Financial Instruments - Credit Losses.

See accompanying Notes to Condensed Consolidated Financial Statements.
8

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(In thousands)
Three Months Ended
March 31,
20212020
Cash flows from operating activities:
Net income$25,344 $12,191 
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation, amortization and accretion(6,796)67 
(Reversal of) provision for credit losses(7,199)7,946 
Net change in accrued interest receivable, prepaid expenses and other assets, and accrued expenses and other liabilities(1,205)(7,581)
Stock-based compensation expense870 969 
Amortization of intangible assets797 903 
Origination of mortgage loans held for sale(32,254)(16,026)
Proceeds from sale of mortgage loans held for sale31,755 18,298 
Bank owned life insurance income(656)(885)
Valuation adjustment on interest rate swaps(244)
Loss on sale of other real estate owned, net
Gain on sale of mortgage loans held for sale, net(1,370)(547)
Gain on sale of investment securities available for sale, net(29)(1,014)
Gain on sale of assets held for sale(22)(9)
Loss (gain) on sale or write-off of premises and equipment, net90 (9)
Net cash provided by operating activities9,081 14,307 
Cash flows from investing activities:
Loans originated, net of principal payments(117,892)(84,807)
Maturities, calls and payments of investment securities available for sale62,675 74,320 
Purchase of investment securities available for sale(166,038)(90,517)
Proceeds from sales of investment securities available for sale1,248 25,177 
Purchase of premises and equipment(475)(1,423)
Proceeds from sales of other real estate owned266 
Proceeds from sales of assets held for sale1,731 394 
Proceeds from redemption of Federal Home Loan Bank stock760 
Purchases of Federal Home Loan Bank stock(1,272)(1,044)
Proceeds from sales of premises and equipment
Purchases of bank owned life insurance(105)(3,579)
Proceeds from bank owned life insurance death benefit1,324 
Capital contributions to low-income housing tax credit partnerships(12,617)(1,434)
Net cash used by investing activities(232,745)(80,554)
Cash flows from financing activities:
Net increase in deposits421,708 35,272 
Federal Home Loan Bank advances10 19,000 
Repayment of Federal Home Loan Bank advances(10)(19,000)
Common stock cash dividends paid(7,183)(7,314)
Net increase (decrease) in securities sold under agreement to repurchase820 (8,377)
Proceeds from exercise of stock options71 
Repurchase of common stock(687)(19,060)
Net cash provided by financing activities414,658 592 
9

Three Months Ended
March 31,
20212020
Net increase (decrease) in cash and cash equivalents190,994 (65,655)
Cash and cash equivalents at beginning of period743,322 228,568 
Cash and cash equivalents at end of period$934,316 $162,913 
Supplemental disclosures of cash flow information:
Cash paid for interest$1,889 $4,507 
Cash paid for income taxes, net of refunds64 58 
Supplemental non-cash disclosures of cash flow information:
Transfers of loans receivable to other real estate owned$$270 
Purchase of investment securities available for sale not settled5,000 7,303 
Cumulative effect from change in accounting policy (1)
7,175 
Right of use assets obtained in exchange for new operating lease liabilities7,381 591 
(1) Effective January 1, 2020, the Company adopted ASU 2016-13, Financial Instruments - Credit Losses.

See accompanying Notes to Condensed Consolidated Financial Statements.
10

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
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 is headquartered in Olympia, Washington and conducts business from its 53 branch offices as of March 31, 2021 located throughout Washington State and the greater Portland, Oregon area. The Bank’s business consists primarily of commercial lending and deposit relationships with small and medium-sized 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. The Bank's deposits are insured by the FDIC.

(b) Basis of Presentation
The accompanying unaudited Condensed Consolidated Financial Statements have been prepared in accordance with GAAP for interim financial information and pursuant to the rules and regulations of the SEC. Accordingly, they do not include all of the information and footnotes required by 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 2020 Annual Form 10-K. In management's opinion, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2021 are not necessarily indicative of the results that may be expected for the year ending December 31, 2021.
To prepare unaudited Condensed Consolidated Financial Statements in conformity with GAAP, management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided. Management believes that the judgments, estimates, and assumptions used in the preparation of the Condensed Consolidated Financial Statements are appropriate based on the facts and circumstances at the time. Actual results, however, could differ significantly from those estimates. Material estimates that are particularly susceptible to significant change relate to management's estimate of ACL on loans, management's estimate of ACL on unfunded commitments, management's evaluation of goodwill impairment and the fair value of financial instruments. It is reasonably possible that management's estimate of the ACL on loans of $64.2 million at March 31, 2021 as disclosed in Note (4) Allowance for Credit Losses on Loans, management's estimate of the ACL on unfunded commitments of $3.6 million as disclosed in Note (14) Commitments and Contingencies, management's conclusion that the fair value of the reporting unit more likely than not exceeds its carrying value at March 31, 2021 as disclosed in Note (6) Goodwill and Other Intangible Assets and the estimates of fair value of financial instruments as disclosed in Note (12) Fair Value Measurements could materially change. In particular, these estimates have been and will continue to be affected by the ongoing COVID-19 pandemic. The severity, magnitude and duration, as well as the economic consequences of the COVID-19 pandemic, are uncertain, rapidly changing and difficult to predict. As a result, our accounting estimates and assumptions may change over time in response to the COVID-19 pandemic.
The accompanying Condensed Consolidated Financial Statements include the accounts of the Company and its wholly-owned subsidiary, the Bank. All significant intercompany balances and transactions among the Company and the Bank have been eliminated in consolidation.
Certain prior year amounts in the Condensed Consolidated Statements of Income and the Condensed Consolidated Statements of Cash Flows have been reclassified to conform to the current year’s presentation. Reclassifications had no effect on the prior years' net income or stockholders’ equity.

(c) Significant Accounting Policies
The significant accounting policies used in preparation of the Condensed Consolidated Financial Statements are disclosed in greater detail in the 2020 Annual Form 10-K. There have not been any material changes in the Company's significant accounting policies from those contained in the 2020 Annual Form 10-K during the three months ended March 31, 2021.

(d) Recently Issued or Adopted Accounting Pronouncements
FASB ASU 2016-13Financial Instruments: Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, as amended by ASU 2018-19, ASU 2019-04, ASU 2019-05, ASU 2019-10, ASU 2019-11, and ASU 2020-02, was originally issued in June 2016. This ASU replaced the incurred loss methodology with an expected loss methodology, which is commonly referred to as the "CECL" methodology. The measurement of expected credit losses under the CECL methodology is applicable to financial assets measured at amortized cost, including loans receivable. It also applies to off-balance sheet credit exposures such as loan commitments, standby letters of credit, financial guarantees, and other similar instruments. In addition, CECL Adoption made changes to the accounting for credit losses on investment securities available for sale. This ASU requires financial assets measured at amortized cost basis to be presented at the net amount expected to be collected. For public
11

business entities, this ASU 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 and can be delayed under a provision of the CARES Act until the end of the official health emergency declaration. The Bank adopted ASU 2016-13 using the modified retrospective method for all financial assets measured at amortized cost and unfunded commitments. At adoption, the Bank elected not to measure an ACL on accrued interest receivable on loans receivable or accrued interest receivable on investment securities available for sale as Bank policy is to reverse interest income for uncollectible accrued interest receivable balances in a timely manner.
The adoption of ASU 2016-13 included an increase to the ACL on loans of $3.4 million and an increase to the ACL on unfunded commitments of $3.7 million, resulting in a pretax cumulative-effect adjustment of $7.1 million. The impact of this adjustment to beginning retained earnings on January 1, 2020 was $5.6 million, net of tax.
FASB ASU 2020-04, Reference Rate Reform (Topic 848), as amended by ASU 2021-01, was issued in March 2020 and provides optional expedients and exceptions for applying GAAP to loan and lease agreements, derivative contracts, and other transactions affected by the anticipated transition away from LIBOR toward new interest rate benchmarks. For transactions that are modified because of reference rate reform and that meet certain scope guidance (i) modifications of loan agreements should be accounted for by prospectively adjusting the effective interest rate and the modification will be considered "minor" so that any existing unamortized origination fees/costs would carry forward and continue to be amortized and (ii) modifications of lease agreements should be accounted for as a continuation of the existing agreement with no reassessments of the lease classification and the discount rate or remeasurements of lease payments that otherwise would be required for modifications not accounted for as separate contracts. ASU 2020-04 also provides numerous optional expedients for derivative accounting and is effective March 12, 2020 through December 31, 2022. An entity may elect to apply the ASU for contract modifications as of January 1, 2020, or prospectively from a date within an interim period that includes or is subsequent to March 12, 2020, up to the date that the financial statements are available to be issued. Once elected for a Topic or an Industry Subtopic within the Codification, the amendments in this ASU must be applied prospectively for all eligible contract modifications for that Topic or Industry Subtopic. The Bank’s swap related transactions are the majority of the Company's LIBOR exposure. Effective January 25, 2021, the Company has agreed to adhere to the Interbank Offered Rate Fallbacks Protocol as published by the International Swaps and Derivatives Association, Inc. and recommended by the Alternative Reference Rates Committee. The Company further anticipates this ASU will simplify any modifications executed between the selected start date (yet to be determined) and December 31, 2022 that are directly related to LIBOR transition by allowing prospective recognition of the continuation of the contract, rather than extinguishment of the old contract resulting in writing off unamortized net deferred fees. The Company does not expect this ASU to have a material impact on its business operations and the 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.
There were 0 securities classified as trading or held to maturity at March 31, 2021 or December 31, 2020.
(a) Securities by Type and Maturity
The following tables present the amortized cost and fair value of investment securities available for sale at the dates indicated and the corresponding amounts of gross unrealized gains and losses recognized in accumulated other comprehensive income:
March 31, 2021
Amortized
Cost
Gross
Unrealized
Gains
Gross
Unrealized
Losses
Fair
Value
(In thousands)
U.S. government and agency securities$96,415 $630 $(2,188)$94,857 
Municipal securities219,373 10,001 (1,711)227,663 
Residential CMO and MBS179,680 4,233 (917)182,996 
Commercial CMO and MBS341,620 9,168 (2,619)348,169 
Corporate obligations10,989 66 11,055 
Other asset-backed securities28,280 548 (10)28,818 
Total$876,357 $24,646 $(7,445)$893,558 

12

December 31, 2020
Amortized
Cost
Gross
Unrealized
Gains
Gross
Unrealized
Losses
Fair
Value
(In thousands)
U.S. government and agency securities$44,713 $947 $$45,660 
Municipal securities197,634 12,561 (227)209,968 
Residential CMO and MBS196,956 5,125 (209)201,872 
Commercial CMO and MBS290,638 13,198 (90)303,746 
Corporate obligations10,971 125 11,096 
Other asset-backed securities29,283 565 (27)29,821 
Total$770,195 $32,521 $(553)$802,163 

The amortized cost and fair value of investment securities available for sale at March 31, 2021, 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 CostFair
Value
(In thousands)
Due in one year or less$48,897 $49,279 
Due after one year through five years134,310 140,053 
Due after five years through ten years285,906 290,676 
Due after ten years407,244 413,550 
Total$876,357 $893,558 

There were no holdings of investment securities of any one issuer, other than the U.S. government and its agencies, in an amount greater than 10% of stockholders’ equity at March 31, 2021 and December 31, 2020.
(b) Unrealized Losses and Other-Than-Temporary Impairments
The following tables show the gross unrealized losses and fair value of the Company's investment securities available for sale aggregated by investment category and length of time that the individual securities have been in continuous unrealized loss positions as of March 31, 2021 and December 31, 2020:
March 31, 2021
Less than 12 Months12 Months or LongerTotal
Fair
Value
Unrealized
Losses
Fair
Value
Unrealized
Losses
Fair
Value
Unrealized
Losses
(In thousands)
U.S. government and agency securities$54,549 $(2,188)$$$54,549 $(2,188)
Municipal securities48,130 (1,558)2,312 (153)50,442 (1,711)
Residential CMO and MBS16,359 (768)24,221 (149)40,580 (917)
Commercial CMO and MBS79,240 (2,612)2,606 (7)81,846 (2,619)
Other asset-backed securities1,330 (10)1,330 (10)
Total$198,278 $(7,126)$30,469 $(319)$228,747 $(7,445)

13

December 31, 2020
Less than 12 Months12 Months or LongerTotal
Fair
Value
Unrealized
Losses
Fair
Value
Unrealized
Losses
Fair
Value
Unrealized
Losses
(In thousands)
Municipal securities10,264 (227)10,264 (227)
Residential CMO and MBS25,293 (209)25,293 (209)
Commercial CMO and MBS11,404 (29)7,499 (61)18,903 (90)
Other asset-backed securities4,570 (27)4,570 (27)
Total$21,668 $(256)$37,362 $(297)$59,030 $(553)

The Company evaluated investment securities available for sale as of March 31, 2021 and December 31, 2020 and determined that any declines in fair value were attributable to changes in interest rates relative to where these investments fall within the yield curve and individual characteristics. Management monitors published credit ratings for adverse changes for all rated investment securities and none of these securities had a below investment grade credit rating as of both March 31, 2021 and December 31, 2020. In addition, the Company does not intend to sell these securities nor does the Company consider it more likely than not that it will be required to sell these securities before the recovery of the amortized cost basis, which may be upon maturity. Therefore, 0 ACL on investment securities available for sale was recorded as of March 31, 2021 and December 31, 2020.
(c) Realized Gains and Losses
The following table presents the gross realized gains and losses on the sale of investment securities available for sale for the three months ended March 31, 2021 and 2020:
Three Months Ended
March 31,
20212020
(In thousands)
Gross realized gains$29 $1,028 
Gross realized losses(14)
Net realized gains$29 $1,014 

(d) Pledged Securities
The following table summarizes the amortized cost and fair value of investment securities available for sale that are pledged as collateral for the following obligations at March 31, 2021 and December 31, 2020:
March 31, 2021December 31, 2020
Amortized
Cost
Fair
Value
Amortized
Cost
Fair
Value
(In thousands)
Washington and Oregon state public deposits$118,333 $122,419 $119,652 $124,228 
Securities sold under agreement to repurchase47,467 48,178 38,630 39,945 
Other securities pledged27,928 28,679 29,665 30,717 
Total$193,728 $199,276 $187,947 $194,890 

(e) Accrued Interest Receivable
Accrued interest receivable excluded from amortized cost on investment securities available for sale totaled $3.4 million and $3.6 million at March 31, 2021 and December 31, 2020, respectively. No amounts of accrued interest receivable on investment securities available for sale were reversed against interest income on investment securities available for sale during the three months ended March 31, 2021 and March 31, 2020.

14

(3)Loans Receivable
(a) Loan Origination/Risk Management
The Bank originates loans in the ordinary course of business and has also acquired loans through mergers and acquisitions. Accrued interest receivable was excluded from disclosures presenting the Bank's amortized cost of loans receivable as it was deemed insignificant.
The Bank categorizes the individual loans in the total loan portfolio into 4 segments: commercial business; residential real estate; 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. A detailed description of the portfolio segments and classes is contained in the 2020 Annual Form 10-K.
The amortized cost of loans receivable, net of ACL on loans at March 31, 2021 and December 31, 2020 consisted of the following portfolio segments and classes:
March 31,
2021
December 31,
2020
(In thousands)
Commercial business:
Commercial and industrial$693,539 $733,098 
SBA PPP886,761 715,121 
Owner-occupied CRE881,168 856,684 
Non-owner occupied CRE1,427,953 1,410,303 
Total commercial business3,889,421 3,715,206 
Residential real estate114,856 122,756 
Real estate construction and land development:
Residential79,878 78,259 
Commercial and multifamily217,815 227,454 
Total real estate construction and land development297,693 305,713 
Consumer293,899 324,972 
Loans receivable4,595,869 4,468,647 
Allowance for credit losses on loans(64,225)(70,185)
Loans receivable, net$4,531,644 $4,398,462 
Balances included in the amortized cost of Loans receivable:
Unamortized net discount on acquired loans$(5,501)$(6,575)
Unamortized net deferred fee$(24,017)$(15,458)

(b) Concentrations of Credit
Most of the Bank’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 and Washington County in Oregon, as well as other contiguous markets and represents a geographic concentration. Additionally, our loan portfolio is concentrated in commercial-type loans, including commercial business loans and commercial and multifamily real estate construction and land development loans.

(c) Credit Quality Indicators
As part of the on-going monitoring of the credit quality of the Bank’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, (v) past due status and (vi) the general economic conditions of the United States of America, and specifically the states of Washington and Oregon. The Bank 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. Risk grades are aggregated to create the risk categories of Pass for grades 1 to 6, Special Mention or "SM" for grade 7, Substandard or "SS" for grade 8, Doubtful for grade 9 and Loss for grade 10. Descriptions of the general characteristics of the risk grades, including qualitative information on how the risk grades relate to the risk of loss, are contained in the 2020 Annual Form 10-K.
Numerical loan grades for loans are established at the origination of the loan. Changes to loan grades are considered at the time new information about the performance of a loan becomes available, including the receipt of updated financial information from the borrower, results of annual term loan reviews performed by the Bank's Credit department and scheduled
15

loan reviews performed by the Bank’s Loan Review department. For consumer loans, 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.
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 SM loan grade is transitory in that the Bank is waiting on additional information to determine the likelihood and extent of the potential loss. The likelihood of loss for SM graded loans, however, is greater than Watch graded loans because there has been measurable credit deterioration. Loans with a SS grade are generally loans with higher risk of loss if the deficiencies are not corrected. For Doubtful and Loss graded loans, the Bank is almost certain of the losses and the outstanding principal balances are generally charged off to the realizable value.
Regulatory agencies provided guidance regarding credit risk ratings, delinquency reporting and nonaccrual status for loans adversely impacted by COVID-19. The Bank has and will continue to exercise judgment in determining the risk rating for impacted borrowers and will not automatically adversely classify credits that are affected by COVID-19. The Bank also will not designate loans with payment deferrals granted due to COVID-19 as past due because of the deferral. Due to the short-term nature of the forbearance and other relief programs we are offering as a result of the COVID-19 pandemic, we expect that borrowers granted relief under these programs will generally not be reported as nonaccrual during the deferral period.
The following table presents the amortized cost of loans receivable by risk grade as of March 31, 2021 and December 31, 2020:
March 31, 2021
Term Loans
Amortized Cost Basis by Origination Year
Revolving Loans
Revolving Loans Converted to Term Loans (1)
Loans Receivable
20212020201920182017Prior
(In thousands)
Commercial business:
Commercial and industrial
Pass$24,439 $120,602 $122,697 $64,991 $39,950 $124,627 $98,202 $1,473 $596,981 
SM1,287 2,714 7,917 9,504 3,704 9,272 7,334 35 41,767 
SS463 2,255 12,178 3,982 8,941 6,816 16,478 3,678 54,791 
Total26,189 125,571 142,792 78,477 52,595 140,715 122,014 5,186 693,539 
SBA PPP
Pass339,326 547,435 886,761 
Total339,326 547,435 886,761 
Owner-occupied CRE
Pass41,278 88,959 170,718 93,917 76,142 312,775 783,789 
SM5,336 5,269 12,453 10,406 18,755 52,219 
SS695 3,942 7,234 33,289 45,160 
Total41,278 94,990 175,987 110,312 93,782 364,819 881,168 
Non-owner occupied CRE
Pass34,753 194,272 186,003 140,023 171,127 631,974 1,358,152 
SM1,979 357 2,371 10,282 14,989 
SS3,623 51,189 54,812 
Total34,753 194,272 187,982 144,003 173,498 693,445 1,427,953 
Total commercial business
Pass439,796 951,268 479,418 298,931 287,219 1,069,376 98,202 1,473 3,625,683 
SM1,287 8,050 15,165 22,314 16,481 38,309 7,334 35 108,975 
SS463 2,950 12,178 11,547 16,175 91,294 16,478 3,678 154,763 
Total441,546 962,268 506,761 332,792 319,875 1,198,979 122,014 5,186 3,889,421 
Residential real estate
Pass5,373 28,990 35,889 12,518 9,606 21,699 114,075 
SS58 723 781 
Total5,373 28,990 35,889 12,518 9,664 22,422 114,856 
16

March 31, 2021
Term Loans
Amortized Cost Basis by Origination Year
Revolving Loans
Revolving Loans Converted to Term Loans (1)
Loans Receivable
20212020201920182017Prior
Real estate construction and land development:
Residential
Pass11,483 39,217 24,441 2,515 408 1,814 79,878 
Commercial and multifamily
Pass1,023 34,068 148,787 28,018 1,961 2,432 216,289 
SS637 450 439 1,526 
Total1,023 34,705 149,237 28,018 1,961 2,871 217,815 
Total real estate construction and land development
Pass12,506 73,285 173,228 30,533 2,369 4,246 296,167 
SS637 450 439 1,526 
Total12,506 73,922 173,678 30,533 2,369 4,685 297,693 
Consumer
Pass3,984 41,029 68,276 46,869 25,950 23,893 80,090 417 290,508 
SS95 594 611 681 1,271 78 61 3,391 
Total3,984 41,124 68,870 47,480 26,631 25,164 80,168 478 293,899 
Loans receivable
Pass461,659 1,094,572 756,811 388,851 325,144 1,119,214 178,292 1,890 4,326,433 
SM1,287 8,050 15,165 22,314 16,481 38,309 7,334 35 108,975 
SS463 3,682 13,222 12,158 16,914 93,727 16,556 3,739 160,461 
Total$463,409 $1,106,304 $785,198 $423,323 $358,539 $1,251,250 $202,182 $5,664 $4,595,869 
(1) Represents loans receivable balance at March 31, 2021 which was converted from a revolving loan to an amortizing loan during the three months ended March 31, 2021.
December 31, 2020
Term Loans
Amortized Cost Basis by Origination Year
Revolving Loans
Revolving Loans Converted to Term Loans (1)
Loans Receivable
20202019201820172016Prior
(In thousands)
Commercial business:
Commercial and industrial
Pass118,971 127,919 70,766 44,231 37,658 95,958 121,440 819 617,762 
SM14,430 9,162 10,878 4,171 5,700 3,579 11,790 814 60,524 
SS2,199 11,835 3,416 9,348 1,052 7,651 15,484 3,827 54,812 
Total135,600 148,916 85,060 57,750 44,410 107,188 148,714 5,460 733,098 
SBA PPP
Pass715,121 715,121 
Owner-occupied CRE
Pass89,224 167,095 94,830 80,138 74,902 254,864 761,053 
SM6,146 4,540 16,386 11,231 5,464 12,105 55,872 
SS114 7,320 3,313 29,012 39,759 
Total95,370 171,635 111,330 98,689 83,679 295,981 856,684 
Non-owner-occupied CRE
Pass197,548 173,153 148,830 172,438 240,614 406,817 1,339,400 
SM1,979 357 2,448 6,210 3,539 14,533 
SS3,623 35,455 17,292 56,370 
Total197,548 175,132 152,810 174,886 282,279 427,648 1,410,303 
17

Total commercial business
Pass1,120,864 468,167 314,426 296,807 353,174 757,639 121,440 819 3,433,336 
SM20,576 15,681 27,621 17,850 17,374 19,223 11,790 814 130,929 
SS2,199 11,835 7,153 16,668 39,820 53,955 15,484 3,827 150,941 
Total1,143,639 495,683 349,200 331,325 410,368 830,817 148,714 5,460 3,715,206 
Residential real estate
Pass30,141 41,829 15,730 10,362 7,322 16,825 122,209 
SS59 488 547 
Total30,141 41,829 15,730 10,421 7,322 17,313 122,756 
Real estate construction and land development:
Residential
Pass33,801 36,697 2,725 1,097 971 1,042 76,333 
SS1,926 1,926 
Total33,801 36,697 2,725 3,023 971 1,042 78,259 
Commercial and multifamily
Pass27,423 151,020 38,682 5,660 689 1,407 224,881 
SM67 1,011 29 1,107 
SS572 450 444 1,466 
Total28,062 152,481 38,682 5,660 689 1,880 227,454 
Total real estate construction and land development
Pass61,224 187,717 41,407 6,757 1,660 2,449 301,214 
SM67 1,011 29 1,107 
SS572 450 1,926 444 3,392 
Total61,863 189,178 41,407 8,683 1,660 2,922 305,713 
Consumer
Pass43,742 77,083 53,195 30,559 13,443 15,453 87,547 315 321,337 
SS34 404 684 648 420 1,319 78 48 3,635 
Total43,776 77,487 53,879 31,207 13,863 16,772 87,625 363 324,972 
Loans receivable
Pass1,255,971 774,796 424,758 344,485 375,599 792,366 208,987 1,134 4,178,096 
SM20,643 16,692 27,621 17,850 17,374 19,252 11,790 814 132,036 
SS2,805 12,689 7,837 19,301 40,240 56,206 15,562 3,875 158,515 
Total$1,279,419 $804,177 $460,216 $381,636 $433,213 $867,824 $236,339 $5,823 $4,468,647 
(1) Represents loans receivable balance at December 31, 2020 which was converted from a revolving loan to an amortizing loan during the year ended December 31, 2020.
Potential problem loans are risk rated SM or worse that are not classified as a performing TDR or nonaccrual loan and are not individually evaluated for credit loss, but which management is closely monitoring because the financial information of the borrower causes concern as to their ability to meet their loan repayment terms. Potential problem loans as of March 31, 2021 and December 31, 2020 were $163.8 million and $182.3 million, respectively.

18

(d) Nonaccrual Loans
The following table presents the amortized cost of nonaccrual loans for the dates indicated:
March 31, 2021
Nonaccrual without ACLNonaccrual with ACLTotal Nonaccrual
(In thousands)
Commercial business:
Commercial and industrial$17,400 $12,872 $30,272 
Owner-occupied CRE4,518 11,918 16,436 
Non-owner occupied CRE1,424 3,623 5,047 
Total commercial business23,342 28,413 51,755 
Residential real estate66 66 
Real estate construction and land development:
Commercial and multifamily1,021 1,021 
Consumer26 26 
Total$23,434 $29,434 $52,868 

December 31, 2020
Nonaccrual without ACLNonaccrual with ACLTotal Nonaccrual
(In thousands)
Commercial business:
Commercial and industrial$22,039 $9,208 $31,247 
Owner-occupied CRE4,693 13,700 18,393 
Non-owner occupied CRE3,424 3,722 7,146 
Total commercial business30,156 26,630 56,786 
Residential real estate67 117 184 
Real estate construction and land development:
Commercial and multifamily572 450 1,022 
Consumer31 69 100 
Total$30,826 $27,266 $58,092 
The following table presents the reversal of interest income on loans due to the write-off of accrued interest receivable upon the initial classification of loans as nonaccrual loans and the interest income recognized due to payment in full of previously classified nonaccrual loans during the following periods:
Three Months Ended
March 31, 2021
Three Months Ended
March 31, 2020
Interest Income ReversedInterest Income RecognizedInterest Income ReversedInterest Income Recognized
(In thousands)
Commercial business:
Commercial and industrial$(2)$63 $(16)$219 
Owner-occupied CRE114 46 
Non-owner occupied CRE313 45 
Total commercial business(2)490 (16)310 
Real estate construction and land development:
Residential73 
Consumer10 
Total$(2)$563 $(16)$320 
19

For the three months ended March 31, 2021 and 2020, 0 interest income was recognized subsequent to a loan’s classification as nonaccrual, except as indicated in the tables above due to payment in full.

(e) Past due loans
The Bank performs an aging analysis of past due loans using policies consistent with regulatory reporting requirements with categories of 30-89 days past due and 90 or more days past due. The amortized cost of past due loans as of March 31, 2021 and December 31, 2020 were as follows:
March 31, 2021
30-89 Days90 Days or
Greater
Total Past 
Due
CurrentLoans Receivable
(In thousands)
Commercial business:
Commercial and industrial$4,393 $8,178 $12,571 $680,968 $693,539 
SBA PPP886,761 886,761 
Owner-occupied CRE881,168 881,168 
Non-owner occupied CRE482 482 1,427,471 1,427,953 
Total commercial business4,875 8,178 13,053 3,876,368 3,889,421 
Residential real estate46 46 114,810 114,856 
Real estate construction and land development:
Residential79,878 79,878 
Commercial and multifamily571 571 217,244 217,815 
Total real estate construction and land development571 571 297,122 297,693 
Consumer739 739 293,160 293,899 
Total$5,614 $8,795 $14,409 $4,581,460 $4,595,869 

December 31, 2020
30-89 Days90 Days or
Greater
Total Past 
Due
CurrentLoans Receivable
(In thousands)
Commercial business:
Commercial and industrial$4,621 $8,082 $12,703 $720,395 $733,098 
SBA PPP715,121 715,121 
Owner-occupied CRE991 403 1,394 855,290 856,684 
Non-owner occupied CRE412 1,970 2,382 1,407,921 1,410,303 
Total commercial business6,024 10,455 16,479 3,698,727 3,715,206 
Residential real estate765 16 781 121,975 122,756 
Real estate construction and land development:
Residential— 78,259 78,259 
Commercial and multifamily2,225 2,225 225,229 227,454 
Total real estate construction and land development2,225 2,225 303,488 305,713 
Consumer1,407 30 1,437 323,535 324,972 
Total$10,421 $10,501 $20,922 $4,447,725 $4,468,647 

There were 0 loans 90 days or more past due that were still accruing interest as of March 31, 2021 or December 31, 2020.

20

(f) Collateral-dependent Loans
The type of collateral securing loans individually evaluated for credit losses and for which the repayment was expected to be provided substantially through the operation or sale of the collateral as of March 31, 2021 and December 31, 2020 were as follows:
March 31, 2021
CRE(1)
Farmland(1)
Residential Real Estate(1)
Non-real property business assets(1)
Total(1)
(In thousands)
Commercial business:
Commercial and industrial$1,967 $13,760 $825 $592 $17,144 
Owner-occupied CRE4,517 4,517 
Non-owner occupied CRE1,424 1,424 
Total commercial business7,908 13,760 825 592 23,085 
Residential real estate66 66 
Real estate construction and land development:
Commercial and multifamily571 571 
Consumer30 30 
Total$8,479 $13,760 $921 $592 $23,752 
(1) Balances represent the amortized cost of the loan. If multiple collateral sources secure the loan, the entire balance is presented in the primary collateral category.
December 31, 2020
CRE(1)
Farmland(1)
Residential Real Estate(1)
Non-real property business assets(1)
Other(1)
Total(1)
(In thousands)
Commercial business:
Commercial and industrial$1,893 $18,738 $584 $774 $631 $22,620 
Owner-occupied CRE4,693 4,693 
Non-owner occupied CRE3,424 3,424 
Total commercial business10,010 18,738 584 774 631 30,737 
Residential real estate67 67 
Real estate construction and land development:
Commercial and multifamily572 572 
Consumer30 30 
Total$10,582 $18,738 $681 $774 $631 $31,406 
(1) Balances represent the amortized cost of the loan. If multiple collateral sources secure the loan, the entire balance is presented in the primary collateral category.
There have been no significant changes to the collateral securing individually evaluated loans for credit losses and for which repayment was expected to be provided substantially through the operation or sale of the collateral during the three months ended March 31, 2021, except changes due to payoffs and additions of loans to this classification.

21

(g) Troubled Debt Restructured Loans
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 concession was the result of COVID Modifications, including payment deferrals and maturity extensions. The Bank has also accommodated re-amortizing loans over a longer period of time. Each of these modifications were 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. The Bank has a policy that it does not forgive principal or accrued interest as modified terms. The Bank’s TDR loans are primarily fully amortizing term loans. 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 interest rate modifications, the Bank may not collect all interest based on the original contractual terms.
The CARES Act, CA Act and regulatory agencies provided guidance around the modification of loans as a result of the COVID-19 pandemic, and outlined, among other criteria, that short-term modifications made on a good faith basis to borrowers who were current as defined by the guidance are not TDRs. This includes short-term (e.g. six months) modifications such as payment deferrals, fee waivers, extensions of repayment terms, or other delays in payment that are insignificant. Borrowers were considered current if they were less than 30 days past due on the contractual payments as of December 31, 2019 under the CARES Act and at the time a modification program is implemented under related regulatory guidance. The CA Act extended relief offered under the CARES Act through January 1, 2022 or 60 days after the end of the national emergency declared by the President, whichever is earlier. The Bank elected to apply the temporary relief under the applicable guidance to certain eligible short-term modifications and did not classify the modifications as TDRs for accounting or disclosure purposes. However, COVID Modifications whose payment deferral exceeded 180 days following the loans' initial modification were classified as TDRs based on the Bank's internal policy.
The unfunded commitment to borrowers related to TDR loans was $5.0 million and $2.6 million at March 31, 2021 and December 31, 2020, respectively.
For the three months ended March 31, 2021 and March 31, 2020, the Bank recorded $1.8 million and $608,000, respectively, of interest income related to performing TDR loans.
Loans that were modified as TDR loans are set forth in the following table for the periods indicated:
Three Months Ended March 31,
20212020
Number of
Contracts
Amortized Cost (1) (2)
Number of
Contracts
Amortized Cost (1) (2)
(Dollars in thousands)
Commercial business:
Commercial and industrial24$12,102 13$3,688 
Owner-occupied CRE24,660 42,183 
Non-owner occupied CRE11,979 32,210 
Total commercial business2718,741 208,081 
Residential real estate1180 0
Real estate construction and land development:
Residential041,516 
Commercial and multifamily1450 
Total real estate construction and land development1450 41,516 
Consumer15379 593 
Total44$19,750 29$9,690 
(1) Number of contracts and amortized cost represent loans which have balances as of period end, net of subsequent payments after modifications. Certain modified loans may have been paid-down or charged-off during the three months ended March 31, 2021 and March 31, 2020.
(2) As the Bank did not forgive any principal or interest balance as part of the loan modifications, the Bank’s amortized cost in each loan at the date of modification (pre-modification) did not change as a result of the modification (post-modification).
The table above includes 19 and 11 loans for the three months ended March 31, 2021 and 2020, respectively, that were previously reported as TDR loans. The Bank typically grants shorter extension periods to continually monitor these TDR loans despite the fact that the extended date might not be the date the Bank expects sufficient cash flow from these borrowers. The Bank does not consider these modifications a subsequent default of a TDR as new loan terms, specifically new maturity dates, were granted. Of the remaining, first-reported TDR loans, the concessions granted largely consisted of maturity extensions. The
22

Bank had a related ACL on loans that were modified as TDR loans of $2.4 million and $644,000 at March 31, 2021 and March 31, 2020, respectively.
The following table presents loans that were modified in a troubled debt restructure and subsequently defaulted within twelve months from the modification date during the periods indicated:
Three Months Ended March 31,
20212020
Number of
Contracts (1)
Amortized Cost (1)
Number of
Contracts (1)
Amortized Cost (1)
(Dollars in thousands)
Commercial business:
Commercial and industrial2$2,792 2$1,873 
Non-owner occupied CRE03590 
Total commercial business22,792 52,463 
Total2$2,792 5$2,463 
(1) Number of contracts and amortized cost represent loans which have balances as of period end, net of subsequent payments after modifications. Certain modified loans may have been paid-down or charged-off during the three months ended March 31, 2021 and March 31, 2020.
During the three months ended March 31, 2021 and March 31, 2020 these TDR loans defaulted because each was past its modified maturity date and the borrower had not subsequently repaid the credits. The Bank chose not to extend further the maturity date on these loans. The Bank had an ACL on loans of $94,000 and $334,000 at March 31, 2021 and March 31, 2020, respectively, related to these TDR loans which defaulted during the three months ended March 31, 2021.

(h) Accrued interest receivable on loans receivable
Accrued interest receivable on loans receivable totaled $16.0 million and $15.8 million at March 31, 2021 and December 31, 2020, respectively. It is excluded from the calculation of the ACL on loans as interest accrued, but not received, is reversed timely. However, management completed an analysis for an ACL on accrued interest receivable on loans receivable based on the significance of loan modifications in accordance with the CARES Act, CA Act and regulatory guidance and concluded no ACL on accrued interest receivable on loans should be recorded at March 31, 2021 and December 31, 2020.

(4)Allowance for Credit Losses on Loans
Effective January 1, 2020, the Bank adopted ASU 2016-13. Risk characteristics by segment considered in the CECL model are the same as those disclosed in the 2020 Annual Form 10-K.
The baseline loss rates used to calculate the ACL on loans at March 31, 2021 utilized the Bank's average quarterly historical loss information from December 31, 2012 through the balance sheet date. There were no changes to this assumption during the three months ended March 31, 2021. The Bank believes the historic loss rates are viable inputs to the current CECL model as the Bank's lending practice and business has remained relatively stable throughout the periods. While the Bank's assets have grown, the credit culture has stayed relatively consistent.
Prepayments included in the CECL model at March 31, 2021 were based on the 48-month rolling historical averages for each segment, which management believes is an accurate representation of future prepayment activity. There were no changes to this assumption during the three months ended March 31, 2021.
The reasonable and supportable period used in the CECL model as of March 31, 2021 was five quarters. There were no changes to this assumption during the three months ended March 31, 2021. Management believes that forecasts beyond this five quarter time period tend to diverge in economic assumptions and may be less comparable to actual future events. As the length of the reasonable and supportable period increases, the degree of judgment involved in estimating the allowance will likely increase.
The Bank used a two-quarter reversion period in calculating the ACL on loans as of March 31, 2021 as it believes the historical loss information is relevant to the expected credit losses and recognizes the declining precision and increasing uncertainty of estimating credit losses in those periods beyond which it can make reasonable and supportable forecasts. There were no changes to this assumption during the three months ended March 31, 2021.
During the three months ended March 31, 2021, the ACL on loans decreased $6.0 million, or 8.5%, due primarily to a reversal of provision for credit losses on loans of $6.1 million following improvements in the economic forecast at March 31, 2021 as compared to the forecast for the three months ended December 31, 2020 and secondarily due to a decrease in total loans receivable, excluding SBA PPP which are fully guaranteed by the SBA and not provisioned for in the ACL on loans.
23

A summary of the changes in the ACL on loans during the three months ended March 31, 2021 and 2020 is as follows:
Three Months Ended March 31,
20212020
(In thousands)
Balance at the beginning of the year$70,185 $36,171 
Impact of CECL Adoption1,822 
Balance at the beginning of the year, as adjusted70,185 37,993 
Charge-offs(187)(1,597)
Recoveries of loans previously charged-off362 1,180 
(Reversal of) provision for loan losses(6,135)9,964 
Balance at the end of the year$64,225 $47,540 

The following tables detail the activity in the ACL on loans disaggregated by segment and class for the three months ended March 31, 2021 and 2020:
Three Months Ended March 31, 2021
Beginning BalanceCharge-offsRecoveries(Reversal of) Provision for Credit LossesEnding Balance
(In thousands)
Commercial business:
Commercial and industrial$30,010 $(1)$205 $(8,444)$21,770 
SBA PPP
Owner-occupied CRE9,486 976 10,464 
Non-owner occupied CRE10,112 2,858 12,970 
Total commercial business49,608 (1)207 (4,610)45,204 
Residential real estate1,591 (189)1,402 
Real estate construction and land development:
Residential1,951 16 81 2,048 
Commercial and multifamily11,141 (1)83 11,223 
Total real estate construction and land development13,092 (1)16 164 13,271 
Consumer5,894 (185)139 (1,500)4,348 
Total$70,185 $(187)$362 $(6,135)$64,225 

Three Months Ended March 31, 2020
Beginning BalanceImpact of CECL AdoptionBeginning Balance,
as Adjusted
Charge-offsRecoveries(Reversal of) Provision for Credit LossesEnding Balance
(In thousands)
Commercial business:
Commercial and industrial$11,739 $(1,348)$10,391 $(1,087)$1,057 $3,539 $13,900 
SBA PPP
Owner-occupied CRE4,512 452 4,964 (135)12 1,375 6,216 
Non-owner occupied CRE7,682 (2,039)5,643 2,107 7,750 
Total commercial business23,933 (2,935)20,998 (1,222)1,069 7,021 27,866 
Residential real estate1,458 1,471 2,929 94 3,026 
24

Three Months Ended March 31, 2020
Beginning BalanceImpact of CECL AdoptionBeginning Balance,
as Adjusted
Charge-offsRecoveries(Reversal of) Provision for Credit LossesEnding Balance
(In thousands)
Real estate construction and land development:
Residential1,455 (571)884 14 (34)864 
Commercial and multifamily1,605 7,240 8,845 2,599 11,444 
Total real estate construction and land development3,060 6,669 9,729 14 2,565 12,308 
Consumer6,821 (2,484)4,337 (375)94 284 4,340 
Unallocated899 (899)
Total$36,171 $1,822 $37,993 $(1,597)$1,180 $9,964 $47,540 

(5)Other Real Estate Owned
Changes in other real estate owned during the periods indicated were as follows:
Three Months Ended
March 31,
20212020
(In thousands)
Balance at the beginning of the period$$841 
Additions270 
Proceeds from dispositions(266)
Loss on sale, net(4)
Balance at the end of the period$$841 

At March 31, 2021, there were 0 consumer mortgage loans secured by residential real estate properties (included in loans receivable on the Condensed Consolidated Statements of Financial Position) for which formal foreclosure proceedings were in process.

(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 following mergers: Premier Commercial Bancorp and Puget Sound Bancorp in 2018; Washington Banking Company in 2014; Valley Community Bancshares in 2013; Western Washington Bancorp in 2006 and North Pacific Bank in 1998. The Company’s goodwill is assigned to the Bank and is evaluated for impairment at the Bank level (reporting unit).
There were no additions to goodwill during the three months ended March 31, 2021 and 2020.
Management analyzes its goodwill on an annual basis on December 31 and between annual tests in certain circumstances such as material adverse changes in legal, business, regulatory and economic factors. An impairment loss is recorded to the extent that the carrying amount of goodwill exceeds its implied fair value. The Company performed an annual impairment assessment as of December 31, 2020 and concluded that there was no impairment.

(b) Other Intangible Assets
Other intangible assets represent core deposit intangibles acquired in business combinations. The useful life of the core deposit intangibles was estimated to be ten years for the acquisitions of Premier Commercial Bancorp, Puget Sound Bancorp, Washington Banking Company, and Valley Community Bancshares.
25

The following table presents the change in other intangible assets for the periods indicated:
Three Months Ended
March 31,
20212020
(In thousands)
Balance at the beginning of the period$13,088 $16,613 
Amortization(797)(903)
Balance at the end of the period$12,291 $15,710 
    
(7)Junior Subordinated Debentures
As part of the acquisition of Washington Banking Company on May 1, 2014, the Company assumed trust preferred securities and junior subordinated debentures with a total carrying value of $25.0 million and a total fair value of $18.9 million at the merger date. At March 31, 2021 and December 31, 2020, the balance of the junior subordinated debentures, net of unaccreted discount, was $21.0 million and $20.9 million, respectively.
The adjustable rate of the trust preferred securities at March 31, 2021 was and December 31, 2020 was 1.75% and 1.80%, respectively. The weighted average rate of the junior subordinated debentures for the years ended March 31, 2021, and 2020 was 3.63%, and 5.56%, 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.

(8)Securities Sold Under Agreement to Repurchase
The Bank utilizes securities sold under agreement to repurchase with one day maturities as a supplement to funding sources. Securities sold under agreement to repurchase are secured by pledged investment securities available for sale and the Bank is required to maintain an aggregate market value of securities pledged greater than the balance of the securities sold under agreement to repurchase. The Bank is required to pledge additional securities to cover any declines below the balance of the securities sold under agreement to repurchase. For additional information on the total value of investment securities pledged for securities sold under agreement to repurchase see Note (2) Investment Securities.
The following table presents the balance of Bank's securities sold under agreement to repurchase obligations by class of collateral pledged at the dates indicated:
March 31,
2021
December 31,
2020
(In thousands)
Residential CMO and MBS$8,083 $7,388 
Commercial CMO and MBS28,420 28,295 
Total$36,503 $35,683 

(9)Other Borrowings
(a) FHLB
At March 31, 2021, the Bank maintained a credit facility with the FHLB with available borrowing capacity of $926.3 million. At March 31, 2021 and December 31, 2020, the Bank had 0 FHLB advances outstanding. Advances from the FHLB are collateralized by a blanket pledge on FHLB stock owned by the Bank, deposits at the FHLB, certain commercial and residential real estate loans, and investment securities which are obligations of or guaranteed by the United States or other assets.
(b) Federal Funds Purchased
The Bank maintains advance lines with Wells Fargo Bank, US Bank, The Independent Bankers Bank, Pacific Coast Bankers’ Bank and JP Morgan Chase to purchase federal funds of up to $215.0 million as of March 31, 2021. The lines generally mature annually or are reviewed annually. As of March 31, 2021 and December 31, 2020, there were 0 federal funds purchased.
(c) Credit Facilities
The Bank maintains a credit facility with the Federal Reserve Bank with available borrowing capacity of $48.9 million as of March 31, 2021. There were 0 Federal Reserve Bank borrowings outstanding as of March 31, 2021 and December 31, 2020. Any advances on the credit facility would be secured by certain types of the Bank's loans receivable.
(d) PPPLF Facility
The Federal Reserve established the PPPLF under Section 13(3) of the Federal Reserve Act to bolster the effectiveness of the SBA's PPP. The Bank was approved to utilize the PPPLF at March 31, 2021 with an available borrowing capacity of $909.7 million, which is the outstanding principal balance of SBA PPP loans that would serve as collateral for any
26

extensions of credit from the Federal Reserve. There were 0 PPPLF borrowings outstanding as of March 31, 2021 and December 31, 2020.

(10)Derivative Financial Instruments
The Bank has entered into certain interest rate swap contracts that are not designated as hedging instruments. The following table presents the notional amounts and estimated fair values of interest rate derivative contracts outstanding at March 31, 2021 and December 31, 2020:
March 31, 2021December 31, 2020
Notional AmountsEstimated Fair ValueNotional AmountsEstimated Fair Value
(In thousands)
Non-hedging interest rate derivatives
Interest rate swap asset (1)
$315,681 $16,955 $308,126 $25,740 
Interest rate swap liability (1)
315,681 (17,133)308,126 (26,162)
 (1) The estimated fair value of derivatives with customers was $9.5 million and $25.4 million as of March 31, 2021 and December 31, 2020, respectively. The estimated fair value of derivatives with third parties was $(9.7) million and $(25.9) million as of March 31, 2021 and December 31, 2020, respectively.

Credit risk for derivatives with customers is concentrated within our primary market areas. Credit risk for derivatives with third-parties is concentrated among four well-known broker dealers.

(11)Stockholders’ Equity
(a) Earnings Per Common Share
The following table illustrates the calculation of weighted average shares used for earnings per common share computations at March 31, 2021 and March 31, 2020:
Three Months Ended
March 31,
20212020
(In thousands, except shares)
Net income:
Net income$25,344 $12,191 
Dividends and undistributed earnings allocated to participating securities (1)
(6)
Net income allocated to common shareholders$25,344 $12,185 
Basic:
Weighted average common shares outstanding35,926,950 36,357,812 
Restricted stock awards(15,722)
Total basic weighted average common shares outstanding35,926,950 36,342,090 
Diluted:
Basic weighted average common shares outstanding35,926,950 36,342,090 
Effect of potentially dilutive common shares (2)
305,254 254,551 
Total diluted weighted average common shares outstanding36,232,204 36,596,641 
Potentially dilutive shares that were excluded from the computation of diluted earnings per share because to do so would be anti-dilutive (3)
15,538 21,475 
(1)Represents dividends paid and undistributed earnings allocated to unvested restricted stock awards.
(2)Represents the effect of the assumed exercise of stock options and vesting of restricted stock awards and units.
(3) Anti-dilution occurs when the exercise price of a stock option or the unrecognized compensation cost per share of a restricted stock award exceeds the market price of the Company’s stock.

(b) Dividends
The timing and amount of cash dividends paid on the Company's common stock depends on the Company’s earnings, capital requirements, financial condition and other relevant factors. Dividends on common stock from the Company depend substantially upon receipt of dividends from the Bank, which is the Company’s predominant source of income.
27

The following table summarizes the dividend activity during the three months ended March 31, 2021 and the calendar year 2020:
DeclaredCash Dividend per ShareRecord DatePaid Date
January 22, 2020$0.20February 6, 2020February 20, 2020
April 29, 2020$0.20May 13, 2020May 27, 2020
July 22, 2020$0.20August 5, 2020August 19, 2020
October 21, 2020$0.20November 4, 2020November 18, 2020
January 27, 2021$0.20February 10, 2021February 24, 2021

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 Federal Reserve provides, among other things, that dividends per share on the Company’s common stock generally should not exceed earnings per share, measured over the previous four fiscal quarters. Current regulations allow the Company and the Bank to pay dividends on their common stock if the Company’s or the Bank’s regulatory capital would not be reduced below the statutory capital requirements set by the Federal Reserve and the FDIC.

(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. On March 12, 2020 the Company's Board of Directors additionally authorized the repurchase of up to 5% of the Company's outstanding common shares, or 1,799,054 shares, under the twelfth stock repurchase plan after all shares under the eleventh stock repurchase plan had been repurchased. The number, timing and price of shares repurchased under the twelfth stock repurchase plan 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 plans for the periods indicated:
Three Months Ended
March 31,
20212020
Plan Total(1)
Eleventh Stock Repurchase Plan
Repurchased shares639,922 1,512,600 
Stock repurchase average share price$$23.95 $21.69 
Twelfth Stock Repurchase Plan
Repurchased shares155,778 155,778 
Stock repurchase average share price$$20.34 $20.34 
(1)Represents shares repurchased and average price per share paid during the duration of each plan.
In addition to the stock repurchases under a stock repurchase plan, the Company repurchases shares to pay withholding taxes on the vesting of restricted stock awards and units. The following table provides total shares repurchased to pay withholding taxes during the periods indicated:
Three Months Ended
March 31,
20212020
Repurchased shares to pay withholding taxes23,246 25,882 
Stock repurchase to pay withholding taxes average share price$29.54 $21.79 

(12)Fair Value Measurements
Fair value is the price that would be received to sell 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 at 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.
28

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.
Collateral-Dependent Loans:
Collateral-dependent loans are identified as part of the calculation of the ACL on loans. The fair value used to measure credit loss for this type of loan is commonly based on recent real estate appraisals which are generally obtained at least every 18 months or earlier if there are changes to risk characteristics of the underlying loan. 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. The Bank also incorporates an estimate of cost to sell the collateral when the sale is probable. Such adjustments may be significant and 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 customer and customer’s business (Level 3). Individually evaluated loans are analyzed for credit loss on a quarterly basis and the ACL on loans is adjusted as required based on the results.
Appraisals on collateral-dependent loans are performed by certified general appraisers for commercial properties or certified residential appraisers for residential properties whose qualifications and licenses have been reviewed and verified by the Bank. Once received, the Bank 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.
Derivative Financial Instruments:
The Bank 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), and incorporates credit valuation adjustments to reflect nonperformance risk in the measurement of fair value (Level 3). Although the Bank has determined that the majority of the inputs used to value its interest rate swap derivatives fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with its derivatives utilize Level 3 inputs, such as borrower risk ratings, to evaluate the likelihood of default by itself and its counterparties. As of March 31, 2021 and December 31, 2020, the Bank assessed the significance of the impact of the credit valuation adjustment on the overall valuation of its interest rate swap derivatives and determined that the credit valuation adjustment was not significant to the overall valuation of its interest rate swap derivatives. As a result, the Bank has classified its interest rate swap derivative valuations in Level 2 of the fair value hierarchy.
Branches held for sale:
Branches held for sale are recorded at fair value less costs to sell when transferred from Premises and equipment, net to Prepaid expenses and other assets on the Consolidated Statements of Financial Condition with any valuation adjustment recorded within Other noninterest expense on the Consolidated Statements of Income. The fair value of branches held for sale is determined based on a real estate appraisal or broker price opinion. Adjustments are routinely made in the appraisal and broker price opinion process by independent appraisers and commercial real estate brokers, respectively, 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.

29

Recurring Basis
The following tables summarize the balances of assets and liabilities measured at fair value on a recurring basis at the dates indicated:
March 31, 2021
TotalLevel 1Level 2Level 3
(In thousands)
Assets
Investment securities available for sale:
U.S. government and agency securities$94,857 $5,000 $89,857 $
Municipal securities227,663 1,632 226,031 
Residential CMO and MBS182,996 182,996 
Commercial CMO and MBS348,169 348,169 
Corporate obligations11,055 11,055 
Other asset-backed securities28,818 28,818 
Total investment securities available for sale893,558 6,632 886,926 
Equity security180 180 
Derivative assets - interest rate swaps16,955 16,955 
Liabilities
Derivative liabilities - interest rate swaps$17,133 $$17,133 $
December 31, 2020
TotalLevel 1Level 2Level 3
(In thousands)
Assets
Investment securities available for sale:
U.S. government and agency securities$45,660 $$45,660 $
Municipal securities209,968 209,968 
Residential CMO and MBS201,872 201,872 
Commercial CMO and MBS303,746 303,746 
Corporate obligations11,096 11,096 
Other asset-backed securities29,821 29,821 
Total investment securities available for sale802,163 802,163 
Equity security131 131 
Derivative assets - interest rate swaps25,740 25,740 
Liabilities
Derivative liabilities - interest rate swaps$26,162 $$26,162 $

Nonrecurring Basis
The Company may be required to measure certain financial assets and liabilities at fair value on a nonrecurring basis. These adjustments to fair value usually result from application of lower-of-cost-or-market accounting or write-downs of individual assets.
The following tables below represent assets measured at fair value on a nonrecurring basis at the dates indicated:
Fair Value at March 31, 2021
Basis(1)
TotalLevel 1Level 2Level 3
(In thousands)
Collateral-dependent loans:
Commercial business:
Commercial and industrial$474 $424 $$$424 
30

Fair Value at March 31, 2021
Basis(1)
TotalLevel 1Level 2Level 3
(In thousands)
Real estate construction and land development:
Commercial and multifamily991 557 557 
Total assets measured at fair value on a nonrecurring basis$1,465 $981 $$$981 
(1) Basis represents the outstanding principal balance of collateral-dependent loans.
Fair Value at December 31, 2020
Basis(1)
TotalLevel 1Level 2Level 3
(In thousands)
Collateral-dependent loans:
Commercial business:
Commercial and industrial$1,305 $1,289 $$$1,289 
Prepaid expenses and other assets:
Branch held for sale (2)
1,330 1,330 1,330 
Total assets measured at fair value on a nonrecurring basis$2,635 $2,619 $$$2,619 
(1) Basis represents the outstanding principal balance of collateral-dependent loans and the carrying value of the branch held for sale.
(2) In October 2020, one branch was reclassified as held for sale in accordance with ASC 360-10. As part of the transfer, the branch was written down to its net realizable value at that time.

The following table represents the net realized losses (gains) recorded in earnings as a result of nonrecurring fair value adjustments recorded during the periods indicated:
Three Months Ended
March 31,
20212020
(In thousands)
Collateral-dependent loans:
Commercial business:
Commercial and industrial$34 $
Real estate construction and land development:
Commercial and multifamily14 
Total48 
Prepaid expenses and other assets:
Branch held for sale(20)
Net losses from nonrecurring fair value adjustments$28 $

The following tables present quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at the dates indicated:
March 31, 2021
Fair
Value
Valuation
Technique(s)
Unobservable Input(s)Range of Inputs; Weighted
Average
(Dollars in thousands)
Collateral-dependent loans$981 Market approachAdjustment for differences between the comparable sales47.0% - (11.0)%; 18.8%

31

December 31, 2020
Fair
Value
Valuation
Technique(s)
Unobservable Input(s)Range of Inputs; Weighted
Average
(Dollars in thousands)
Collateral-dependent loans$1,289 Market approachAdjustment for differences between the comparable sales0.6% - (40.1%); (24.1%)
Branch held for sale$1,330 Market approachAdjustment for differences between the comparable sales140.7% - (40.3%); 33.2%

(b) Fair Value of Financial Instruments
Broadly traded markets do not exist for most of the Company’s financial instruments; therefore, 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.
The following tables present the carrying value amount of the Company’s financial instruments and their corresponding estimated fair values at the dates indicated:
March 31, 2021
Carrying
Value
Fair
Value
Fair Value Measurements Using:
Level 1Level 2Level 3
(In thousands)
Financial Assets:
Cash and cash equivalents$934,316 $934,316 $934,316 $$
Investment securities available for sale893,558 893,558 6,632 886,926 
Loans held for sale6,801 7,070 7,070 
Loans receivable, net4,531,644 4,660,232 4,660,232 
Accrued interest receivable19,447 19,447 32 3,373 16,042 
Banked owned life insurance108,341 108,341 108,341 
Derivative assets - interest rate swaps16,955 16,955 16,955 
Equity security180 180 180 
Financial Liabilities:
Noninterest deposits, interest bearing demand deposits, money market accounts and savings accounts$5,633,295 $5,633,295 $5,633,295 $$
Certificates of deposit386,403 388,488 388,488 
Securities sold under agreement to repurchase36,503 36,503 36,503 
Junior subordinated debentures20,960 18,250 18,250 
Accrued interest payable85 85 39 26 20 
Derivative liabilities - interest rate swaps17,133 17,133 17,133 

December 31, 2020
Carrying
Value
Fair
Value
Fair Value Measurements Using:
Level 1Level 2Level 3
(In thousands)
Financial Assets:
Cash and cash equivalents$743,322 $743,322 $743,322 $$
Investment securities available for sale802,163 802,163 802,163 
Loans held for sale4,932 5,156 5,156 
32

December 31, 2020
Carrying
Value
Fair
Value
Fair Value Measurements Using:
Level 1Level 2Level 3
(In thousands)
Loans receivable, net4,398,462 4,556,862 4,556,862 
Accrued interest receivable19,418 19,418 3,648 15,768 
Bank owned life insurance107,580 107,580 107,580 
Derivative assets - interest rate swaps25,740 25,740 25,740 
Equity security131 131 131 
Financial Liabilities:
Noninterest deposits, interest bearing demand deposits, money market accounts and savings accounts$5,198,456 $5,198,456 $5,198,456 $$
Certificates of deposit399,534 402,701 402,701 
Securities sold under agreement to repurchase35,683 35,683 35,683 
Junior subordinated debentures20,887 18,500 18,500 
Accrued interest payable94 94 42 33 19 
Derivative liabilities - interest rate swaps26,162 26,162 26,162 

(13)Cash Restriction
The Bank had restricted cash included in interest earning deposits on the Condensed Consolidated Statements of Financial Condition of $10.5 million and $25.9 million as of March 31, 2021 and December 31, 2020, respectively, relating to collateral required on interest rate swaps from third-parties as discussed in Note (10) Derivative Financial Instruments. The Bank does not have a collateral requirement with customers.

(14)Commitments and Contingencies
In the ordinary course of business, the Bank may enter into various types of transactions that include commitments to extend credit that are not included in its Condensed Consolidated Financial Statements. The Bank applies the same credit standards to these commitments as it uses in all its lending activities and has included these commitments in its lending risk evaluations. The majority of the commitments presented below are variable rate. Loan commitments can be either revolving or non-revolving. The Bank’s exposure to credit and market risk under commitments to extend credit is represented by the amount of these commitments.
The following table presents outstanding commitments to extend credit, including letters of credit, at the dates indicated:
 March 31, 2021December 31, 2020
 (In thousands)
Commercial business:
Commercial and industrial$627,702 $640,018 
Owner-occupied CRE4,494 3,488 
Non-owner occupied CRE14,523 18,396 
Total commercial business646,719 661,902 
Real estate construction and land development:
Residential60,099 52,453 
Commercial and multifamily142,432 127,821 
Total real estate construction and land development202,531 180,274 
Consumer269,516 263,249 
Total outstanding commitments$1,118,766 $1,105,425 

Upon CECL adoption, as described in Note (1) Description of Business, Basis of Presentation, Significant Accounting Policies and Recently Issued Accounting Pronouncements, the Bank recorded an increase in the beginning ACL on unfunded commitments of $3.7 million as of January 1, 2020, representing the change in methodology from an estimate of incurred losses
33

at the balance sheet date, with an estimated probability of funding, to an estimate of credit losses on future utilization over the entire contractual period.
The following table details the activity in the ACL on unfunded commitments during the periods indicated:
Three Months Ended
March 31,
2021
March 31,
2020
(In thousands)
Balance, beginning of period$4,681 $306 
Impact of CECL Adoption3,702 
Adjusted balance, beginning of period4,681 4,008 
Reversal of provision for credit losses on unfunded commitments(1,064)(2,018)
Balance, end of period$3,617 $1,990 

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 operations of the Company as of and for the three months ended March 31, 2021. The information contained in this section should be read with the unaudited Condensed Consolidated Financial Statements and the accompanying Notes included herein, the Forward Looking Statements included herein and the December 31, 2020 audited Consolidated Financial Statements and the accompanying Notes included in our 2020 Annual Form 10-K.

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. 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 to medium sized 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 residential real estate loans on single family properties located primarily in our markets. During the three months ended March 31, 2020, we ceased indirect auto loan originations.
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 Company's 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 credit losses on loans. The provision for credit losses on loans 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. Management believes that the ACL on loans reflects the amount that is appropriate to provide for current expected credit losses in our loan portfolio based on our consistent methodology.
Net income is also affected by noninterest income and noninterest expense. Noninterest income primarily consists of service charges and other fees and other income. Noninterest expense consists primarily of compensation and employee benefits, occupancy and equipment, data processing and professional services. Compensation and employee benefits consist primarily of the salaries and wages paid to our employees, payroll taxes, expenses for retirement and other employee benefits. Occupancy and equipment expenses are the fixed and variable costs of buildings and equipment, and consists primarily of lease expenses, depreciation charges, maintenance and utilities. Data processing consists primarily of processing and network services related to the Bank’s core operating system, including the account processing system, electronic payments processing of products and services, and internet and mobile banking channels as well as software-as-a-service providers. Professional services consists primarily of third party service providers, such as consultants, and legal fees.
Results of operations may also be affected significantly by general and local economic and competitive conditions, governmental policies and actions of regulatory authorities, especially changes resulting from the COVID-19 pandemic and the governmental actions taken to address it. Net income is also impacted by growth of operations and growth in the number of loan and deposit accounts through acquisitions and core banking business growth.
34

COVID-19 Pandemic Response
The Company maintains its commitment to supporting its community and customers during the COVID-19 pandemic and remains focused on keeping its employees safe and the Bank running effectively to serve its customers. The Bank is managing branch access and occupancy levels in relation to cases and close contact scenarios, following governmental restrictions and public health authority guidelines, and encouraging remote work for its employees. All non-metro, full-service branch lobby locations reopened with normal hours on March 22, 2021, which represents 46 out of 53 branches at March 31, 2021.

Earnings Summary
Net income was $25.3 million, or $0.70 per diluted common share, for the three months ended March 31, 2021 compared to net income of $12.2 million, or $0.34 per diluted common share, for the three months ended March 31, 2020. Net income increased $13.2 million, or 107.9%, for the three months ended March 31, 2021 compared to the same period in 2020 due primarily to a reversal of provision for credit losses of $7.2 million during the three months ended March 31, 2021 compared to a provision for credit losses of $7.9 million for the same period in 2020.
Net interest income as a percentage of average interest earning assets, or net interest margin, decreased 55 basis points to 3.51% for the three months ended March 31, 2021 compared to 4.06% for the same period in 2020. The decrease in net interest margin was due primarily to decreases in yields on adjustable-rate interest earning assets following decreases in short-term market rates and the change in the mix of total interest earning assets, including a significant increase in average interest earning deposits to 11.8% of total earning assets at March 31, 2021 compared to 2.6% at March 31, 2020. The decrease in net interest margin was offset partially by decreases in the cost of total interest bearing deposits.
The efficiency ratio consists of noninterest expense divided by the sum of net interest income plus noninterest income. The Company’s efficiency ratio was 61.57% for the three months ended March 31, 2021 compared to 64.20% for the three months ended March 31, 2020. The change in the efficiency ratio was attributable primarily to the increase in net interest income.

Net Interest Income Overview
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 earning assets, noninterest bearing demand deposits, other noninterest bearing liabilities and stockholders' equity; market interest rate fluctuations; and asset quality.
Net interest income increased $3.7 million, or 7.6%, to $52.2 million for the three months ended March 31, 2021 compared to $48.6 million for the same period in 2020.
The following table provides relevant net interest income information for the periods indicated:
 Three Months Ended March 31,
 20212020Change
 Average
Balance
Interest
Earned/
Paid
Average
Yield/
Rate
(1)
Average
Balance
Interest
Earned/
Paid
Average
Yield/
Rate
(1)
Average
Balance
Interest
Earned/
Paid
Average
Yield/
Rate
 (Dollars in thousands)
Interest Earning Assets:
Loans receivable, net (2) (3)
$4,490,499 $49,524 4.47 %$3,748,573 $46,277 4.97 %$741,926 $3,247 (0.50)%
Taxable securities674,268 3,534 2.13 815,686 5,633 2.78 (141,418)(2,099)(0.65)
Nontaxable securities (3)
163,914 958 2.37 122,153 756 2.49 41,761 202 (0.12)
Interest earning deposits713,885 175 0.10 125,357 420 1.35 588,528 (245)(1.25)
Total interest earning assets6,042,566 54,191 3.64 %4,811,769 53,086 4.44 %1,230,797 1,105 (0.80)%
Noninterest earning assets757,059 748,443 8,616 
Total assets$6,799,625 $5,560,212 $1,239,413 
Interest Bearing Liabilities:
Certificates of Deposit$393,268 $559 0.58 %$528,009 $2,012 1.53 %$(134,741)$(1,453)(0.95)%
Savings accounts560,094 95 0.07 434,459 188 0.17 125,635 (93)(0.10)
Interest bearing demand and money market accounts2,732,134 1,074 0.16 2,201,921 2,016 0.37 530,213 (942)(0.21)
Total interest bearing deposits3,685,496 1,728 0.19 3,164,389 4,216 0.54 521,107 (2,488)(0.35)
35

 Three Months Ended March 31,
 20212020Change
 Average
Balance
Interest
Earned/
Paid
Average
Yield/
Rate
(1)
Average
Balance
Interest
Earned/
Paid
Average
Yield/
Rate
(1)
Average
Balance
Interest
Earned/
Paid
Average
Yield/
Rate
 (Dollars in thousands)
Junior subordinated debentures20,913 187 3.63 20,620 285 5.56 293 (98)(1.93)
Securities sold under agreement to repurchase40,074 38 0.38 19,246 33 0.69 20,828 (0.31)
FHLB advances and other borrowings— — — 989 0.41 (989)(1)(0.41)
Total interest bearing liabilities3,746,483 1,953 0.21 %3,205,244 4,535 0.57 %541,239 (2,582)(0.36)%
Noninterest bearing demand deposits2,091,359 1,420,247 671,112 
Other noninterest bearing liabilities134,762 128,650 6,112 
Stockholders’ equity827,021 806,071 20,950 
Total liabilities and stock-holders’ equity$6,799,625 $5,560,212 $1,239,413 
Net interest income$52,238 $48,551 $3,687 
Net interest spread3.43 %3.87 %(0.44)%
Net interest margin3.51 %4.06 %(0.55)%
Average interest earning assets to average interest bearing liabilities161.29 %150.12 %11.17 %
Cost of total deposits0.12 %0.37 %(0.25)%
(1) Annualized
(2) The average loan balances are net of ACL on loans. Nonaccrual loans have been included 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
Interest and fees on loans increased due primarily to an increase in average loans receivable balances and specifically the addition of SBA PPP loans with an average balance of $832.1 million during the three months ended March 31, 2021. The increase was offset partially by a decrease in loan yields following decreases in short-term market rates. The yield on SBA PPP loans was 4.45%, inclusive of the recognition of the related deferred fee, for the three months ended March 31, 2021. The SBA PPP loans will impact loan yields during any period due to the recognition of deferred fees due to the volume of prepayments, including forgiveness payments from the SBA.
The following table presents the loan yield and the impacts of the balances and interest and fees earned on SBA PPP loans and the incremental accretion on purchased loans on this financial measure for the periods presented below:
 Three Months Ended
 March 31,
2021
March 31,
2020
Non-GAAP Measure:(1)
Loan yield (GAAP)4.47 %4.97 %
Exclude impact from SBA PPP loans0.01 — 
Exclude impact from incremental accretion on purchased loans(2)
(0.12)(0.11)
Loan yield, excluding SBA PPP loans and incremental accretion on purchased loans (non-GAAP)4.36 %4.86 %
(1) See Non-GAAP Financial Measures section.
(2) Represents the amount of interest income recorded on purchased loans in excess of the contractual stated interest rate in the individual loan notes due to incremental accretion of purchased discount or premium. Purchased discount or premium is the difference between the contractual loan balance and the fair value of acquired loans at the acquisition date, or as modified by CECL Adoption. The purchased discount is accreted into income over the remaining life of the loan. The impact of incremental accretion on loan yield will change during any period based on the volume of prepayments, but it is expected to decrease over time as the balance of the purchased loans decreases.
Interest income on investment securities decreased due primarily to a decrease in market interest rates impacting adjustable rate securities and decreases in yields on investment securities purchased during the current, low-rate environment. Additionally, the average balance of investment securities decreased 10.6% for the same time periods.
36

Interest income on interest earning deposits decreased due primarily to a decrease in their yield following a decrease in short-term market rates, offset partially by an increase in the average balance.
Interest Expense
Interest expense on total interest bearing deposits decreased due primarily to the Bank reducing its cost of deposits following the decrease in short-term market rates, offset partially by an increase in total interest bearing liabilities, which increased primarily as a result of proceeds from SBA PPP loans originated during the three months ended March 31, 2021 which were deposited directly into the customers' deposit accounts.

Provision for Credit Losses Overview
Effective January 1, 2020, the Bank completed the CECL Adoption. The aggregate of the provision for credit losses on loans and the provision for credit losses on unfunded commitments is presented on the Condensed Consolidated Statements of Income as the provision for credit losses. The ACL on unfunded commitments is included on the Condensed Consolidated Statements of Financial Condition within Accrued expenses and other liabilities.
The following table presents the provision for credit losses for the periods indicated:
Three Months Ended
March 31,
20212020ChangePercentage Change
(Dollars in thousands)
(Reversal of) provision for credit losses on loans$(6,135)$9,964 $(16,099)(161.6)%
Reversal of provision for credit losses on unfunded commitments(1,064)(2,018)954 (47.3)
(Reversal of) provision for credit losses$(7,199)$7,946 $(15,145)(190.6)%

Provision for Credit Losses on Loans
The Bank has established a comprehensive methodology for determining its ACL on loans. The ACL on loans is increased by the provision for credit losses on loans which is calculated based on a thorough review of the loan portfolio in accordance with the Bank's CECL methodology for determining the current expected credit losses on loans receivable. The provision for credit losses on loans 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, including as a result of the COVID-19 pandemic, could increase future provisions for credit losses on loans and have a material adverse effect on the Company’s net income.
The reversal of provision for credit losses on loans recognized during the three months ended March 31, 2021 was primarily due to improvements in the economic forecast at March 31, 2021 compared to the forecast at December 31, 2020, as further explained in the "Analysis of Allowance for Credit Losses on Loans" below.
The provision for credit losses on loans of $10.0 million for the three months ended March 31, 2020 was due primarily to the economic forecast at that date reflecting the COVID-19 pandemic in addition to the impact of the CECL methodology and life of loan considerations.

Provision for Credit Losses on Unfunded Commitments
The Bank has established a comprehensive methodology for determining its ACL on unfunded commitments, which uses loss rates calculated in the ACL on loans by loan type with an additional estimate of the likelihood of utilization of the unfunded commitment, both applied to the outstanding balance of unfunded commitments by loan type.
The reversal of provision for credit losses on unfunded commitments recognized during the three months ended March 31, 2021 was primarily due to improvements in the economic forecast reducing the loss rates calculated for the ACL on loans, offset partially by a decrease in utilization rates during the period.
The reversal of provision for credit losses on unfunded commitments recognized during the three months ended March 31, 2020 was primarily due to a decrease in the unfunded commercial construction loan balance, resulting from increased funding of commercial construction projects during the three months ended March 31, 2020, offset partially by an increase in the loss rates calculated for the ACL on loans.

37

Noninterest Income Overview
The following table presents the key components of noninterest income and the change for the periods noted:
Three Months Ended
March 31,
20212020ChangePercentage Change
(Dollars in thousands)
Service charges and other fees$4,000 $4,376 $(376)(8.6)%
Gain on sale of investment securities, net29 1,014 (985)(97.1)
Gain on sale of loans, net1,370 547 823 150.5 
Interest rate swap fees152 296 (144)(48.6)
Bank owned life insurance income656 885 (229)(25.9)
Other income2,044 2,368 (324)(13.7)
Total noninterest income$8,251 $9,486 $(1,235)(13.0)%

Service charges and other fees decreased due primarily to a decrease in overdraft fees of $498,000 from changes in customer spending habits during the COVID-19 pandemic.
Gain on sale of investment securities, net decreased due primarily to fewer sales of investment securities during the three months ended March 31, 2021 as compared to the same period last year.
Gain on sale of loans, net increased from the combination of higher origination and sales volumes and higher earned sales margins reflecting an increased demand for residential loans due to the low interest rate environment during the three months ended March 31, 2021. Originations of mortgage loans held for sale increased $16.2 million, or 101.3%, to $32.3 million for the three months ended March 31, 2021 from $16.0 million for the three months ended March 31, 2020.
Bank owned life insurance income decreased due primarily to death benefit income of $332,000 recognized during the three months ended March 31, 2020. No death benefits were recognized during the three months ended March 31, 2021.
Other income decreased primarily as a result of the divestiture of our trust department in October 2020, which provided other income of $276,000 during the three months ended March 31, 2020.

Noninterest Expense Overview
The following table presents the key components of noninterest expense and the change for the periods noted:
Three Months Ended
March 31,
20212020ChangePercentage Change
(Dollars in thousands)
Compensation and employee benefits$22,461 $22,506 $(45)(0.2)%
Occupancy and equipment4,454 4,564 (110)(2.4)
Data processing3,812 3,527 285 8.1 
Marketing669 866 (197)(22.7)
Professional services1,331 1,377 (46)(3.3)
State/municipal business and use tax972 757 215 28.4 
Federal deposit insurance premium589 — 589 100.0 
Other real estate owned, net— 25 (25)(100.0)
Amortization of intangible assets797 903 (106)(11.7)
Other expense2,157 2,735 (578)(21.1)
Total noninterest expense$37,242 $37,260 $(18)— %

The Company completed its plan to consolidate nine branches, including eight branches in January 2021 and one branch in October 2020, integrating them into other branches within its network to create a more efficient branch footprint. These actions are a result of the Company’s increased focus on balancing physical locations and digital banking channels, driven by increased client usage of online and mobile banking and a commitment to improve digital banking technology. The Company started to recognize the benefit from this effort primarily through reduced compensation and employee benefits expense and occupancy and equipment expense during the quarter ended March 31, 2021.
38

Federal deposit insurance premium increased as the Bank's FDIC's small bank credit offset the full assessment during the quarter ended March 31, 2020. The remaining credit available at March 31, 2020 was fully utilized during second quarter of 2020.
Other expense decreased due primarily to a reduction of discretionary expenses, including employee business travel as a result of the Company's suspension of non-essential travel due to the COVID-19 pandemic.
The ratio of noninterest expense to average total assets (annualized) was 2.22% for the three months ended March 31, 2021 compared to 2.70% for the three months ended March 31, 2020. The decrease in the ratio of noninterest expense to average total assets was primarily due to an increase in average total assets primarily due to the origination of SBA PPP loans and secondarily due to the increase in interest earning deposits.

Income Tax Expense Overview
The following table presents the income tax expense and related metrics and the change for the periods noted:
Three Months Ended
March 31,
20212020ChangePercentage Change
(Dollars in thousands)
Pre-tax income$30,446 $12,831 $17,615 137.3 %
Income tax expense5,102 640 4,462 697.2 
Effective tax rate16.8 %5.0 %11.8 %236.0 

Income tax expense and the effective income tax rate both increased due primarily to a nonrecurring provision in the CARES Act which permitted the Company to recognize a $1.0 million benefit from net operating losses related to prior acquisitions during the three months ended March 31, 2020. This tax benefit was not replicated in the current quarter. Additionally, estimated annual pre-tax income was higher for the quarter ended March 31, 2021 than the recorded pre-tax income for the quarter ended March 31, 2020 which decreased the impact of favorable permanent tax items such as tax-exempt investments, investments in bank owned life insurance, and low-income housing tax credits. Finally, there are no gross tax credits remaining related to the Company's New Market Tax Credit as these credits were fully utilized during the seven year period ending December 31, 2020.

Consolidated Financial Condition Overview
The table below provides a comparison of the changes in the Company's financial condition from December 31, 2020 to March 31, 2021:
March 31,
2021
December 31, 2020ChangePercentage Change
(Dollars in thousands)
Assets
Cash and cash equivalents$934,316 $743,322 $190,994 25.7 %
Investment securities available for sale, at fair value, net893,558 802,163 91,395 11.4 
Loans held for sale6,801 4,932 1,869 37.9 
Loans receivable, net4,531,644 4,398,462 133,182 3.0 
Other real estate owned— — — n/a
Premises and equipment, net84,533 85,452 (919)(1.1)
Federal Home Loan Bank stock, at cost7,933 6,661 1,272 19.1 
Bank owned life insurance108,341 107,580 761 0.7 
Accrued interest receivable19,447 19,418 29 0.1 
Prepaid expenses and other assets188,589 193,301 (4,712)(2.4)
Other intangible assets, net12,291 13,088 (797)(6.1)
Goodwill240,939 240,939 — — 
Total assets$7,028,392 $6,615,318 $413,074 6.2 %
39

March 31,
2021
December 31, 2020ChangePercentage Change
(Dollars in thousands)
Liabilities
Deposits$6,019,698 $5,597,990 $421,708 7.5 %
Junior subordinated debentures20,960 20,887 73 0.3 
Securities sold under agreement to repurchase36,503 35,683 820 2.3 
Accrued expenses and other liabilities124,080 140,319 (16,239)(11.6)
Total liabilities6,201,241 5,794,879 406,362 7.0 
Stockholders' equity
Common stock571,204 571,021 183 — 
Retained earnings242,486 224,400 18,086 8.1 
Accumulated other comprehensive income, net13,461 25,018 (11,557)(46.2)
Total stockholders' equity827,151 820,439 6,712 0.8 
Total liabilities and stockholders' equity$7,028,392 $6,615,318 $413,074 6.2 %

Total assets increased due primarily to an increase in loans receivable, which is discussed in more detail below in the "Lending Activities Overview" section; an increase in cash and cash equivalents due primarily to an increase in total deposits, and an increase in investment securities available for sale primarily as a result of purchases of $166.0 million.
Total liabilities and stockholder's equity increased due primarily to an increase in deposits, which is discussed in more detail in the "Deposit Activities Overview" section below.

Lending Activities Overview
Changes by loan type
The Bank is a full-service commercial bank, which originates a wide variety of loans with a focus on commercial business loans. Loans receivable increased compared to December 31, 2020 due primarily to an increase in SBA PPP loans as the Bank originated PPP2 loans, offset partially by a decrease in PPP1 loans as a result of principal forgiveness payments received from the SBA. The increase in loans receivable was offset partially by a decrease in the utilization of commercial and industrial lines of credit and a decrease in consumer loans from continued runoff of the indirect auto loan portfolio following the cessation of this business line during the quarter ended March 31, 2020.
The following table provides a comparison of the changes in the Company's loan portfolio by type of loan from December 31, 2020 to March 31, 2021:
March 31, 2021December 31, 2020
Balance (1)
% of Total (2)
Balance (1)
% of Total (2)
ChangePercentage Change
(Dollars in thousands)
Commercial business:
Commercial and industrial$693,539 15.1 %$733,098 16.4 %$(39,559)(5.4)%
SBA PPP886,761 19.3 715,121 16.0 171,640 24.0 
Owner-occupied CRE881,168 19.2 856,684 19.2 24,484 2.9 
Non-owner occupied CRE1,427,953 31.1 1,410,303 31.5 17,650 1.3 
Total commercial business3,889,421 84.7 3,715,206 83.1 174,215 4.7 
Residential real estate (3)
114,856 2.5 122,756 2.7 (7,900)(6.4)
Real estate construction and land development:
Residential79,878 1.7 78,259 1.8 1,619 2.1 
Commercial and multifamily217,815 4.7 227,454 5.1 (9,639)(4.2)
Total real estate construction and land development297,693 6.4 305,713 6.9 (8,020)(2.6)
Consumer293,899 6.4 324,972 7.3 (31,073)(9.6)
Total$4,595,869 100.0 %$4,468,647 100.0 %$127,222 2.8 %
(1) Balances do not include unfunded loan commitments.
(2) Percent of loans receivable.
(3) Excludes loans held for sale of $6.8 million and $4.9 million at March 31, 2021 and December 31, 2020, respectively.
40


COVID Modifications
The Company continues to accommodate a variety of loan modifications under the CARES Act, CA Act and related regulatory guidance as a direct result of COVID-19 pandemic issues impacting these borrowers. At March 31, 2021, approximately 67 loans totaling $46.7 million were in payment deferral modification status compared to 177 loans totaling $92.5 million at December 31, 2020.

SBA Paycheck Protection Program
On April 6, 2020, the Bank began to offer SBA PPP1 loans to its existing and new customers as a result of provisions in the CARES Act for customers directly impacted by the COVID-19 pandemic. The Bank earns 1% interest on these loans as well as a fee from the SBA to cover processing costs, which is amortized over the life of the loan. The Bank began processing loan forgiveness applications and receiving SBA PPP1 loan forgiveness payments during the three months ended December 31, 2020.
The CA Act extended the SBA's PPP with a second tranche of funding beginning in 2021 and effective until May 31, 2021. As a result, the Bank began originating SBA PPP2 loans starting in January 2021.
The following are key statistics from inception of the SBA's PPP through March 31, 2021:
As of March 31, 2021
PPP1PPP2Total PPP
(Dollars in thousands)
Number of funded loans4,642 2,235 6,877 
Total amount funded$897,353 $353,491 $1,250,844 
Average funded loan size$193 $158 $182 
Net fees deferred at funding$28,805 $14,627 $43,432 

The following table summarizes the activity for both tranches of the SBA's PPP as of and for the period indicated:
As of or for the Three Months Ended
March 31, 2021
PPP1PPP2Total PPP
(In thousands)
Net deferred fees recognized during the period$6,592 $448 $7,040 
Net deferred fees unrecognized as of period end8,814 14,165 22,979 
Principal payments received during the period, including forgiveness payments from the SBA174,264 — 174,264 
Principal balance remaining as of period end556,249 353,491 909,740 
Amortized cost as of period end547,435 339,326 886,761 

Nonperforming Assets and Credit Quality Metrics
The following table provides information about our nonaccrual loans, other real estate owned and performing TDR loans for the dates indicated:
March 31,
2021
December 31, 2020
(Dollars in thousands)
Nonaccrual loans:
Commercial business$51,755 $56,786 
Residential real estate66 184 
Real estate construction and land development1,021 1,022 
Consumer26 100 
Total nonaccrual loans52,868 58,092 
Other real estate owned— — 
Total nonperforming assets$52,868 $58,092 
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March 31,
2021
December 31, 2020
(Dollars in thousands)
ACL on loans$64,225 $70,185 
Nonperforming loans to loans receivable1.15 %1.30 %
ACL on loans to loans receivable1.40 1.57 
ACL on loans to loans receivable, excluding SBA PPP loans (1)
1.73 1.87 
ACL on loans to nonperforming loans121.48 120.82 
Nonperforming assets to total assets0.75 %0.88 %
Performing TDR loans:
Commercial business$54,075 $49,403 
Residential real estate365 188 
Real estate construction and land development— 1,926 
Consumer1,251 1,355 
Total performing TDR loans$55,691 $52,872 
Accruing loans past due 90 days or more$— $— 
Potential problem loans (2)
$163,813 $182,342 
(1) See "Non-GAAP Financial Measures" section.
(2) Potential problem loans are risk rated SM or worse that are not classified as a performing TDR or nonaccrual loan and are not individually evaluated for credit loss, but which management is closely monitoring because the financial information of the borrower causes concern as to their ability to meet their loan repayment terms.
Nonaccrual Loans
Nonaccrual loans decreased $5.2 million to 1.15% of loans receivable at March 31, 2021 from 1.30% of loans receivable at December 31, 2020 primarily due to a decline in nonaccrual commercial business loans.
The following table reflects the changes in nonaccrual loans during the periods indicated:
Three Months Ended
March 31,
20212020
(In thousands)
Nonaccrual loans
Balance, beginning of period$58,092 $44,525 
Addition of previously classified pass graded loans24 255 
Addition of previously classified performing TDR loans and potential problem loans444 2,579 
Net principal payments and transfers to accruing status(5,690)(12,300)
Charge-offs(2)(626)
Transfer to OREO— (270)
Balance, end of period$52,868 $34,163 
Nonperforming Assets
Nonperforming assets consist of nonaccrual loans and other real estate owned. Nonperforming assets decreased $5.2 million, or 0.75% of total assets, at March 31, 2021 from $58.1 million, or 0.88% of total assets, at December 31, 2020 due to the decrease in nonaccrual loans discussed above. Nonperforming assets consisted only of nonaccrual loans at March 31, 2021 and December 31, 2020.
Troubled Debt Restructured Loans
Performing TDR loans are TDRs on accrual status. They may be individually or collectively evaluated for ACL based on criteria outlined in our accounting policies. Performing TDR loans are not considered nonperforming assets as they continue to accrue interest despite the restructured status. Performing TDR loans increased $2.8 million, or 5.3%, at March 31, 2021 compared to December 31, 2020.
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The following table reflects the changes in performing TDR loans during the periods indicated:
Three Months Ended
March 31,
20212020
(In thousands)
Performing TDR loans
Balance, beginning of period$52,872 $14,469 
Addition of previously classified pass graded loans1,031 1,008 
Addition of previously classified potential problem loans4,451 2,660 
Addition of previously classified nonaccrual loans994 177 
Net principal payments(3,657)(266)
Balance, end of period$55,691 $18,048 

The increase in performing TDR loans reflects further migration of COVID Modifications to TDR status. It is the Bank's policy to classify COVID Modifications where the payment deferral period exceeded 180-days as a TDR.
Potential Problem Loans
Potential problem loans are loans classified as SM or worse that are not classified as a TDR or nonaccrual loan and are not individually evaluated for credit loss, but which management is closely monitoring because the financial information of the borrower causes concern as to their ability to meet their loan repayment terms. This classification of loans decreased $18.5 million, or 10.2%, compared to December 31, 2020.
The following table reflects the changes in potential problem loans during the periods indicated:
Three Months Ended
March 31,
20212020
(in thousands)
Potential problem loans
Balance, beginning of period$182,342 $87,788 
Addition of previously classified pass graded loans6,831 31,180 
Addition of previously classified nonaccrual loans1,138 — 
Upgrades to pass graded loan status(2,395)(476)
Net principal payments(19,208)(9,824)
Transfers of loans to nonaccrual status(444)(2,579)
Transfers of loans to TDR status(4,451)(2,660)
Balance, end of period$163,813 $103,429 

Analysis of Allowance for Credit Losses on Loans
CECL Adoption, by which the Bank adopted a historic loss, open pool CECL methodology to calculate the ACL on loans, was effective January 1, 2020. The same methodology is applied to all loans consistent with the guidance of the accounting standard which does not require undue complexity. Under this allowance approach, the Bank has identified segments of loans with similar risk characteristics that align with its identified loan classes. Nonaccrual loans and certain performing TDR loans are not considered to have similar risk characteristics as other loans; therefore, they are evaluated for credit loss on an individual basis. The allowance for individually evaluated loans is calculated using either the collateral value method, which considers the likely source of repayment as the value of the collateral, less estimated costs to sell if applicable, or the net present value method, which considers the contractual principal and interest terms and estimated cash flows available from the borrower to satisfy the debt.
For each loan segment collectively measured, baseline loss rates are separately calculated using the Bank's average quarterly historical loss information. The baseline loss rates are applied to each loan's estimated cash flows over the life of the loan under the remaining life method, including prepayment estimates, to determine the baseline loss estimate for each loan. The CECL methodology also includes consideration of the forecasted direction of the economic and business environment and its likely impact to the estimated allowance as compared to the historical losses over the reasonable and supportable time frame. The impact of those macroeconomic factors to each segment, positive or negative, using the reasonable and supportable period, are added to the calculated baseline loss rate and are used to establish a macroeconomic allowance. After the reasonable and supportable period, the estimated credit losses revert back to historical baseline loss levels under a reversion period on a
43

straight-lined, input reversion basis. Management can also consider other qualitative factors to adjust the ACL on loans if internal or external conditions suggest changes to the modeled ACL on loans are appropriate.
The following table provides information regarding changes in the ACL on loans at and for the periods indicated:
Three Months Ended
March 31,
20212020
(Dollars in thousands)
ACL on loans at the beginning of the period$70,185 $36,171 
Impact of CECL adoption— 1,822 
Adjusted ACL on loans, beginning of period70,185 37,993 
Charge-offs:
Commercial business(1)(1,222)
Real estate construction and land development(1)— 
Consumer(185)(375)
Total charge-offs(187)(1,597)
Recoveries:
Commercial business207 1,069 
Residential real estate— 
Real estate construction and land development16 14 
Consumer139 94 
Total recoveries362 1,180 
Net recoveries (charge-offs)175 (417)
(Reversal of) provision for credit losses on loans(6,135)9,964 
ACL on loans at the end of period$64,225 $47,540 
ACL on loans to loans receivable1.40 %1.23 %
ACL on loans to loans receivable, excluding SBA PPP loans (1)
1.73 1.23 
Net recoveries (charge-offs) on loans to average loans receivable, net (2)
0.02 %(0.04)%
Loans receivable at the end of the period (3)
$4,595,869 $3,852,376 
Average loans receivable, net during the period4,490,499 3,748,573 
(1) See "Reconciliations of Non-GAAP Measures" herein.
(2) Annualized.
(3) Excludes loans held for sale.
The ACL on loans decreased $6.0 million, or 8.5%, to $64.2 million at March 31, 2021 from $70.2 million at December 31, 2020. The decrease in the ACL on loans was due primarily to a reversal of provision for credit losses on loans of $6.1 million recorded during the three months ended March 31, 2021 following improvements in the economic forecast used in the CECL model at March 31, 2021 as compared to the forecast at December 31, 2020 and secondarily due to a decrease in total loans receivable, excluding SBA PPP loans. The ACL on loans does not include a reserve for SBA PPP loans as these loans are fully guaranteed by the SBA.
Based on the Bank's established comprehensive CECL methodology, management deemed the ACL on loans at March 31, 2021 equal to 1.40% of loans receivable and 121.48% of nonperforming loans is appropriate to provide for current expected credit losses in the loan portfolio. The ACL on loans was 1.57% of loans receivable and 120.82% of nonperforming loans at December 31, 2020.
While we believe we used the best information available to determine the ACL on loans, 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, as a result of the COVID-19 pandemic or other factors, could result in a material increase in the ACL on loans and may adversely affect the Company’s financial condition and results of operations. In addition, the determination of the amount of the ACL on loans is subject to review by bank regulators, as part of their routine examination process, which may result in the establishment of an additional ACL on loans based upon their judgment of information available to them at the time of their examination. Because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing ACL on loans is appropriate or that increased provisions will not be necessary should the quality of the loans deteriorate. Any material increase in the ACL on loans could adversely affect the Company’s financial condition and results of operations.

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Deposits and Other Borrowings Overview
The following table summarizes the Company's deposits at the dates indicated:
March 31, 2021December 31, 2020
Balance% of TotalBalance% of TotalChangePercentage Change
(Dollars in thousands)
Noninterest demand deposits$2,205,562 36.6 %$1,980,531 35.4 %$225,031 11.4 %
Interest bearing demand deposits1,796,949 29.9 1,716,123 30.7 80,826 4.7 
Money market accounts1,046,202 17.4 962,983 17.2 83,219 8.6 
Savings accounts584,582 9.7 538,819 9.6 45,763 8.5 
Total non-maturity deposits5,633,295 93.6 5,198,456 92.9 434,839 8.4 
Certificates of deposit386,403 6.4 399,534 7.1 (13,131)(3.3)
Total deposits$6,019,698 100.0 %$5,597,990 100.0 %$421,708 7.5 %

The increase in deposits is primarily due to the proceeds from SBA PPP loans originated during the three months ended March 31, 2021 which were deposited directly into the customers' deposit accounts.
In addition to deposits, borrowings may be used on a short-term basis to compensate for reductions in other sources of funds. 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 utilizes securities sold under agreement to repurchase, which are secured by available for sale investment securities, as a supplement to its funding sources. As of March 31, 2021 and December 31, 2020, only three customers utilized this product with total balances of $36.5 million and $35.7 million, respectively.
The Company also has junior subordinated debentures with a par value of $25.0 million which pay quarterly interest based on the three-month LIBOR plus 1.56% and mature in 2037. The balance of the junior subordinated debentures was $21.0 million at March 31, 2021, which reflects the fair value of the junior subordinated debentures established as part of the merger with Washington Banking Company on May 1, 2014, adjusted for the accretion of discount from purchase accounting fair value adjustment.
Additionally, the Bank maintained credit facilities with the FHLB for $926.3 million and credit facilities with the Federal Reserve Bank for $48.9 million at March 31, 2021 with no borrowings outstanding at both March 31, 2021 and December 31, 2020. There were no FHLB or Federal Reserve Bank advances outstanding during the three months ended March 31, 2021. The average balance of FHLB advances was $989,000 during the three months ended March 31, 2020.
The Bank also maintains lines of credit with five correspondent banks to purchase federal funds totaling $215.0 million as of March 31, 2021. There were no federal funds purchased as of March 31, 2021 and December 31, 2020 and the lines were not utilized during the three months ended March 31, 2021 and 2020.
The Bank was approved to utilize the PPPLF with the Federal Reserve Bank for $909.7 million, which is the principal balance of SBA PPP loans outstanding at March 31, 2021. There were no PPPLF advances outstanding as of both March 31, 2021 and December 31, 2020.
Our strategy has been to acquire non-maturity deposits from our retail customers, acquire noninterest bearing demand deposits from our commercial customers, and use our available borrowing capacity to fund growth in assets. We anticipate that we will continue to rely on the same sources of funds in the future and use those funds primarily to originate loans and purchase investment securities.

Liquidity and Cash Flows
Our primary sources of funds are customer and local government deposits, loan principal and interest payments, loan sales and payments of interest earned on and proceeds from sales and maturities of investment securities. These funds, together with retained earnings, equity and other borrowed funds, are used to make loans, acquire investment securities and other assets, and fund continuing operations. While maturities and scheduled amortization of loans are a predictable source of funds, deposit flows and loan prepayments are greatly influenced by the level of interest rates, economic conditions and competition.
Heritage Bank: The principal objective of the Bank’s liquidity management program is to maintain the ability to meet day-to-day cash flow requirements of its customers who either wish to withdraw funds or to draw upon credit facilities to meet their cash needs. The Bank monitors the sources and uses of funds on a daily basis to maintain an acceptable liquidity position. In addition to liquidity from core deposits and the repayment and maturities of loans and investment securities, the Bank can utilize established credit facilities and lines with correspondent banks totaling $1.2 billion as discussed above or initiate the sale of investment securities.
45

Heritage Financial Corporation: The Company is a separate legal entity from the Bank and must provide for its own liquidity. Substantially all of the Company’s revenues are obtained from dividends declared and paid by the Bank. There are statutory and regulatory provisions that could limit the ability of the Bank to pay dividends to the Company. However, management believes that such restrictions will not have an adverse impact on the ability of the Company to meets its ongoing cash obligations. At March 31, 2021, the Company (on an unconsolidated basis) had cash and cash equivalents of $9.0 million.
We are required to maintain an adequate level of liquidity to ensure the availability of sufficient funds for loan originations and deposit withdrawals, satisfy other financial commitments and fund operations. We generally maintain sufficient cash and investments to meet short-term liquidity needs. At March 31, 2021, cash and cash equivalents totaled $934.3 million, or 13.3% of total assets. Investment securities available for sale totaled $893.6 million, of which $199.3 million were pledged to secure public deposits, borrowing arrangements or securities sold under agreement to repurchase. Management considers unpledged investment securities available for sale to be a variable source of liquidity. The fair value of investment securities available for sale that were unpledged totaled $694.3 million, or 9.9% of total assets, at March 31, 2021. The fair value of investment securities available for sale with maturities of one year or less totaled $49.3 million, or 0.7% of total assets, at March 31, 2021.
Consolidated Cash Flows: As disclosed in the Condensed Consolidated Statements of Cash Flows, net cash provided by operating activities was $9.1 million for the three months ended March 31, 2021, and primarily consisted of net income of $25.3 million, offset partially by non-cash adjustments, including reversal of provision for credit losses of $7.2 million and depreciation, amortization, and accretion of $6.8 million. During the three months ended March 31, 2021, net cash used by investing activities was $232.7 million, which consisted primarily of net loan originations of $117.9 million (including SBA PPP2 originations of $353.5 million and SBA PPP1 principal reduction of $174.3 million) and net activity in investment securities available for sale of $102.1 million (including $166.1 million of purchases). Net cash provided by financing activities was $414.7 million for the three months ended March 31, 2021 and primarily consisted of a net increase in deposits of $421.7 million primarily due to the proceeds from SBA PPP loans deposited directly into the customers' deposit accounts, offset partially by dividends paid of $7.2 million.

Stockholders' Equity and Regulatory Capital Requirements Overview
The Company’s stockholders' equity to assets ratio was 11.8% and 12.4% at March 31, 2021 and December 31, 2020, respectively. The following table reflects the changes to stockholders' equity during the periods indicated:
Three Months Ended
March 31,
20212020
(In thousands)
Balance, beginning of period$820,439 $809,311 
Cumulative effect from change in accounting policy (1)
— (5,615)
Net income25,344 12,191 
Dividends declared(7,258)(7,343)
Other comprehensive (loss) income, net of tax(11,557)7,914 
Repurchase of common stock(687)(19,060)
Other870 1,040 
Balance, end of period$827,151 $798,438 
(1) Effective January 1, 2020, the Company adopted ASU 2016-13, Financial Instruments - Credit Losses.
No shares were repurchased under the Company's stock repurchase plans during the three months ended March 31, 2021. During the three months ended March 31, 2020, the Company repurchased the remaining 639,922 shares available under the eleventh stock repurchase plan at a weighted average price per share of $23.95 and repurchased 155,778 shares at a weighted average share price of $20.34 under the twelfth stock repurchase plan, totaling 795,700 shares repurchased under both plans at a weighted average share price of $23.25. In addition to the stock repurchases under a plan, the Company repurchases shares to pay withholding taxes on the vesting of restricted stock awards and units.
The Company has historically paid cash dividends to its common shareholders. Payments of future cash dividends, if any, will be at the discretion of our Board of Directors after taking into account various factors, including our business, operating results and financial condition, capital requirements, current and anticipated cash needs, plans for expansion, any legal or contractual limitation on our ability to pay dividends and other relevant factors. Dividends on common stock from the Company depend substantially upon receipt of dividends from the Bank, which is the Company’s predominant source of income. On April 21, 2021, the Company’s Board of Directors declared a regular quarterly dividend of $0.20 per common share which is payable on May 19, 2021 to shareholders of record on May 5, 2021.
46

Three Months Ended
March 31,
20212020
Dividends paid per common share$0.20 $0.20 
Dividend payout ratio (1)
28.6 %58.8 %
(1) Dividend payout ratio is declared dividends per common share divided by diluted earnings per common share.
The Company is a bank holding company under the supervision of the Federal Reserve Bank. Bank holding companies are subject to capital adequacy requirements of the Federal Reserve under the Bank Holding Company Act of 1956, as amended, and the regulations of the Federal Reserve. Heritage Bank is a federally insured institution and thereby is subject to the capital requirements established by the FDIC. The Federal Reserve capital requirements generally parallel the FDIC requirements. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Condensed Consolidated Financial Statements. Management believes that as of March 31, 2021, the Company and the Bank met all capital adequacy requirements to which they are subject.
As of March 31, 2021 and December 31, 2020, the most recent regulatory notifications categorized the Bank as well-capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Bank's categories. The following table represents the minimum required ratios of the Company and the Bank and the actual capital ratios at the periods indicated:
 Minimum RequirementsWell-Capitalized RequirementsActual
 (Dollars in thousands)
As of March 31, 2021:
The Company consolidated
Common equity Tier 1 capital to risk-weighted assets$202,080 4.5 %N/AN/A$572,953 12.8 %
Tier 1 leverage capital to average assets261,184 4.0 N/AN/A593,913 9.1 
Tier 1 capital to risk-weighted assets269,440 6.0 N/AN/A593,913 13.2 
Total capital to risk-weighted assets359,253 8.0 N/AN/A649,967 14.5 
Heritage Bank
Common equity Tier 1 capital to risk-weighted assets201,833 4.5 $291,537 6.5 %581,240 13.0 
Tier 1 leverage capital to average assets260,991 4.0 326,239 5.0 581,240 8.9 
Tier 1 capital to risk-weighted assets269,111 6.0 358,815 8.0 581,240 13.0 
Total capital to risk-weighted assets358,815 8.0 448,518 10.0 636,951 14.2 
As of December 31, 2020:
The Company consolidated
Common equity Tier 1 capital to risk-weighted assets$203,314 4.5 %N/AN/A$555,644 12.3 %
Tier 1 leverage capital to average assets256,216 4.0 N/AN/A576,531 9.0 
Tier 1 capital to risk-weighted assets271,086 6.0 N/AN/A576,531 12.8 
Total capital to risk-weighted assets361,448 8.0 N/AN/A633,061 14.0 
Heritage Bank
Common equity Tier 1 capital to risk-weighted assets203,112 4.5 $293,383 6.5 %563,630 12.5 
Tier 1 leverage capital to average assets256,051 4.0 320,064 5.0 563,630 8.8 
Tier 1 capital to risk-weighted assets270,815 6.0 361,087 8.0 563,630 12.5 
Total capital to risk-weighted assets361,087 8.0 451,359 10.0 620,124 13.7 

As of both March 31, 2021 and December 31, 2020, the capital measures reflect the revised CECL capital transition provisions adopted by the Federal Reserve and the FDIC that allow the Bank the option to delay for two years an estimate of CECL’s effect on regulatory capital, relative to the incurred loss methodology’s effect on regulatory capital, followed by a three-year transition period.
Under applicable capital requirements both the Company and the Bank are required to maintain a capital conservation buffer of common equity Tier 1 capital above 2.5% to avoid restrictions on certain activities including payment of dividends, stock
47

repurchases and discretionary bonuses to executive officers. At March 31, 2021, the capital conservation buffer was 6.5% and 6.2% for the Company and the Bank, respectively.

Reconciliations of Non-GAAP Measures
This Form 10-Q contains certain financial measures not presented in accordance with GAAP in addition to financial measures presented in accordance with GAAP. The Company has presented these non-GAAP financial measures in this Form 10-Q because it believes that they provide useful and comparative information to assess trends in the Company’s capital reflected in the current quarter and comparable period results and facilitate comparison of its performance with the performance of its peers. These non-GAAP measures have inherent limitations, are not required to be uniformly applied and are not audited. They should not be considered in isolation or as a substitute for financial measures presented in accordance with GAAP. These non-GAAP measures may not be comparable to similarly titled measures reported by other companies. Reconciliations of the GAAP and non-GAAP financial measures are presented below.
The Company believes presenting loan yield excluding the effect of discount accretion on purchased loans is useful in assessing the impact of acquisition accounting on loan yield as the effect of loan discount accretion is expected to decrease as the acquired loans mature or roll off our balance sheet. Similarly, presenting loan yield excluding the effect of SBA PPP loans is useful in assessing the impact of these special program loans that are anticipated to substantially decrease upon forgiveness by the SBA within a short time frame.
Three Months Ended
March 31,
 20212020
(Dollars in thousands)
Loan yield, excluding SBA PPP loans and incremental accretion on purchased loans, annualized:
Interest and fees on loans (GAAP)$49,524 $46,277 
Exclude SBA PPP loan interest and fees(9,136)— 
Exclude incremental accretion on purchased loans(1,075)(1,012)
Adjusted interest and fees on loans (non-GAAP)$39,313 $45,265 
Average loans receivable, net (GAAP)$4,490,499 $3,748,573 
Exclude average SBA PPP loans(832,148)— 
Adjusted average loans receivable, net (non-GAAP)$3,658,351 $3,748,573 
Loan yield, annualized (GAAP)4.47 %4.97 %
Loan yield, excluding SBA PPP loans and incremental accretion on purchased loans, annualized (non-GAAP)4.36 %4.86 %
The Company considers presenting the ratio of ACL on loans to loans receivable, excluding SBA PPP loans, to be a useful measurement in evaluating the adequacy of the Company's ACL on loans as the balance of SBA PPP loans is significant to the loan portfolio, and since SBA PPP loans are guaranteed by the SBA, the Company has not provided an ACL on loans for SBA PPP loans.
March 31,
2021
December 31,
2020
(Dollars in thousands)
ACL on loans to loans receivable, excluding SBA PPP loans:
Allowance for credit losses on loans (GAAP)$64,225 $70,185 
Loans receivable (GAAP)$4,595,869 $4,468,647 
Exclude SBA PPP loans886,761 715,121 
Loans receivable, excluding SBA PPP (non-GAAP)$3,709,108 $3,753,526 
ACL on loans to loans receivable (GAAP)1.40 %1.57 %
ACL on loans to loans receivable, excluding SBA PPP loans (non-GAAP)1.73 %1.87 %
The Company believes that presenting pre-tax pre-provision income, which reflects its profitability before income taxes and provision for credit losses, is a useful measurement in assessing its operating income and expenses by removing the volatility that may be associated with credit loss provisions. The Company also believes that during a crisis such as the
48

COVID-19 pandemic, this information is useful as the impact of the pandemic on credit loss provisions of various institutions will likely vary based on the geography of the communities served by a particular institution and the decision to adopt or defer CECL.
Three Months Ended
March 31,
20212020
(Dollars in thousands)
Pre-tax, Pre-provision Income:
Net income (GAAP)$25,344 $12,191 
Exclude income tax expense5,102 640 
Exclude (reversal of) provision for credit losses(7,199)7,946 
Pre-tax, pre-provision income (non-GAAP)$23,247 $20,777 

ITEM 3.     QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to interest rate risk through our lending and deposit gathering activities. Our results of operations are highly dependent upon our ability to manage interest rate risk. We consider interest rate risk to be a significant market risk that could have a material effect on our financial condition and results of operations. Interest rate risk is measured and assessed on a quarterly basis. In our opinion, there has not been a material change in our interest rate risk exposure since the information disclosed in our 2020 Annual Form 10-K.
Neither the Company nor the Bank maintains a trading account for any class of financial instrument or engages in hedging activities or purchases high risk derivative instruments. Moreover, neither the Company nor the Bank is subject to foreign currency exchange rate risk or commodity price risk.

ITEM 4.     CONTROLS AND PROCEDURES
(a) Evaluation of Disclosure Controls and Procedures
An evaluation of the Company’s disclosure controls and procedures (as defined in Section 13a-15(e) or 15d-15(e) of the Securities Exchange Act of 1934 (the “Act”)) was carried out under the supervision and with the participation of the Company’s Chief Executive Officer, Chief Financial Officer and the Company’s Disclosure Committee as of the end of the period covered by this quarterly report. In designing and evaluating the Company’s disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure controls and procedures, management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Based on their evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures as of March 31, 2021 are effective in ensuring that the information required to be disclosed by the Company in the reports it files or submits under the Act is (i) accumulated and communicated to the Company’s management (including the Chief Executive Officer and Chief Financial Officer) in a timely manner, and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.
(b) Changes in Internal Control Over Financial Reporting
There have been no changes in the Company’s internal control over financial reporting (as defined in Rule 13a-15(f) of the Act) that occurred during the quarter ended March 31, 2021, 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

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ITEM 1.     LEGAL PROCEEDINGS
Neither the Company nor the Bank is 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 2020 Annual Form 10-K.

ITEM 2.     UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
(a) Not applicable.
(b) Not applicable.
(c) Repurchase Plans
The following table provides information about repurchases of common stock by the Company during the three months ended March 31, 2021:
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 (2)
January 1, 2021— January 31, 2021759 $25.95 8,981,801 1,643,276 
February 1, 2021— February 28, 2021— — 8,981,801 1,643,276 
March 1, 2021— March 31, 202122,487 29.66 8,981,801 1,643,276 
Total23,246 $29.54 
(1)Of the common shares repurchased by the Company between January 1, 2021 and March 31, 2021, all of the shares represented the cancellation of stock to pay withholding taxes on vested restricted stock awards or units.
(2)On March 12, 2020 the Company's Board of Directors authorized the repurchase of up to 5% of the Company's outstanding common shares, or 1,799,054 shares, under the twelfth stock repurchase plan.

ITEM 3.     DEFAULTS UPON SENIOR SECURITIES
None
ITEM 4.     MINE SAFETY DISCLOSURES
Not applicable
ITEM 5.        OTHER INFORMATION
None
ITEM 6.     EXHIBITS
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101.DEF
XBRL Taxonomy Extension Definition Linkbase Document (1)
101.LAB
XBRL Taxonomy Extension Label Linkbase Document (1)
101.PRE
XBRL Taxonomy Extension Presentation Linkbase Document (1)
*Indicates management contract or compensatory plan or arrangement.
(1) Filed herewith.

SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
HERITAGE FINANCIAL CORPORATION
Date:
May 5, 2021/S/ JEFFREY J. DEUEL
Jeffrey J. Deuel
President and Chief Executive Officer
Date:
May 5, 2021/S/ DONALD J. HINSON
Donald J. Hinson
Executive Vice President and Chief Financial Officer
51