2 0 1 4
ANNUAL REPORT
Dear Fellow Shareholders:
I am happy to report 2014 was a successful and transformational year for the
Company. Of particular importance was our merger with Washington Banking
Company and its subsidiary, Whidbey Island Bank, which closed on May 1,
2014. As of December 31, 2014 combined total assets were $3.5 billion with
66 branches in Washington and Oregon from the Canadian border to Portland.
Net income for the year was $21.0 million, or $0.82 per diluted common share,
an increase of 119% from net income of $9.6 million, or $0.61 per diluted
common share, for 2013.
The alliance of Heritage Bank and Whidbey Island Bank brings together two strong banks with similar
cultures. We have created an institution of meaningful size and scale which is now better positioned
to compete more effectively and better serve our communities. The Whidbey Island Bank core
operating system conversion was successfully completed during the fourth quarter of 2014 and the
overall integration continues to go well. The combination also provides momentum for additional
growth initiatives by significantly expanding and enhancing our product offerings throughout the
market footprint.
The size and breadth of the post-merger organization has provided increased opportunities resulting
in steady loan and deposit growth and a continued upward trend in our loan pipeline. With solid credit
quality at the forefront, our loan portfolio remains diversified with total loans at year-end of $2.2 billion,
up 85% from the prior year end. We were ranked first in SBA 504 lending and fifth in SBA 7A lending
amongst our peers by the Small Business Administration Seattle District Office—a result of our
long-term commitment to small business lending. Total deposits at the end of 2014 were $2.9 billion,
an increase of 108% from the prior year end, with 82% in non-maturity deposits.
In addition, as a combined management team we developed our first strategic plan for the merged
organization, focused on improving our 2015–2017 financial performance. The plan provides an overall
strategic framework and direction for the company which will be used to measure performance and
select key priorities for each of the next three years.
The significant integration activities and strategic planning processes completed in the past year have
competitively positioned our Company to capitalize on the strength of the combined organization. We
are privileged to have a knowledgeable board, a strong management team and a dedicated staff. The
entire Bank team embraces the Heritage Mission Statement and is committed to being the leading
community bank in the Pacific Northwest by continuously improving customer satisfaction, employee
empowerment, community investment and shareholder value. I am excited about our prospects for
continued growth and stronger financial performance in the coming year and beyond.
Sincerely,
Brian L. Vance
President and Chief Executive Officer
Heritage Financial Corporation
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2014
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
Commission File Number 0-29480
HERITAGE FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
Washington
(State or other jurisdiction of
incorporation or organization)
201 Fifth Avenue SW, Olympia, WA
(Address of principal executive offices)
91-1857900
(I.R.S. Employer
Identification No.)
98501
(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 class
Common Stock
Name of each exchange on which registered
NASDAQ Stock Market LLC
Securities registered pursuant to Section 12(g) of the Act:
None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes No
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the
Act. Yes No
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 and posted on its corporate Web site, if any, every
Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the
preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not
contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller
reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of
the Exchange Act.
Large accelerated filer Accelerated filer Non-accelerated filer Smaller reporting company
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes No
The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant as of June 30,
2014, based on the closing price of its common stock on such date, on the NSADAQ Global Select Market, of $16.09 per share, and
29,423,514 shares held by non-affiliates was $473,242,340.
The registrant had 30,257,691 shares of common stock outstanding as of February 25, 2015.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant’s definitive Proxy Statement for the 2015 Annual Meeting of Shareholders will be incorporated by
reference into Part III of this Form 10-K.
HERITAGE FINANCIAL CORPORATION
FORM 10-K
December 31, 2014
TABLE OF CONTENTS
PART I
BUSINESS................................................................................................................................................
ITEM 1.
3
ITEM 1A. RISK FACTORS ....................................................................................................................................... 27
ITEM 1B. UNRESOLVED STAFF COMMENTS ....................................................................................................... 34
PROPERTIES........................................................................................................................................... 35
ITEM 2.
ITEM 3.
LEGAL PROCEEDINGS .......................................................................................................................... 36
ITEM 4. MINE SAFETY DISCLOSURES ............................................................................................................... 36
Page
PART II
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
ISSUER PURCHASES OF EQUITY SECURITIES ............................................................................... 37
SELECTED FINANCIAL DATA ................................................................................................................. 41
ITEM 6.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS ........................................................................................................................................ 43
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK ...................................... 65
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ................................................................... 66
ITEM 8.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE .................................................................................................................... 66
ITEM 9A. CONTROLS AND PROCEDURES ........................................................................................................... 67
ITEM 9B. OTHER INFORMATION ........................................................................................................................... 67
PART III
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE ........................................ 68
ITEM 11. EXECUTIVE COMPENSATION ............................................................................................................... 68
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS ................................................................................................ 68
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE .... 69
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES ................................................................................ 69
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES ............................................................................... 70
SIGNATURES........................................................................................................................................... 72
PART IV
2
ITEM 1. BUSINESS
General
PART I
Heritage Financial Corporation (the “Company” or "Heritage") is a bank holding company that was incorporated in the
State of Washington in August 1997. We were organized for the purpose of acquiring all of the capital stock of Heritage
Savings Bank upon our reorganization from a mutual holding company form of organization to a stock holding company form of
organization. Effective September 1, 2004, Heritage Savings Bank switched its charter from a state chartered savings bank to
a state chartered commercial bank and changed its legal name from Heritage Savings Bank to Heritage Bank (the "Bank").
Effective September 1, 2005, Central Valley Bank (acquired by the Company in March 1999) changed its charter from a
nationally chartered commercial bank to a state chartered commercial bank. In 1998, the Company acquired North Pacific
Bank. In June 2006, the Company completed the acquisition of Western Washington Bancorp and its wholly owned subsidiary,
Washington State Bank, N.A., at which time Washington State Bank, N.A. was merged into Heritage Bank.
Effective July 30, 2010, Heritage Bank entered into a definitive agreement with the Federal Deposit Insurance Corporation
(the “FDIC”), pursuant to which Heritage Bank acquired certain assets and assumed certain liabilities of Cowlitz Bank, a
Washington state-chartered commercial bank headquartered in Longview, Washington (the “Cowlitz Acquisition”). The Cowlitz
Acquisition included nine branches of Cowlitz Bank, including its division Bay Bank, which opened as branches of Heritage
Bank on August 2, 2010. The acquisition also included the Trust Services Division of Cowlitz Bank. In 2013, the Company
consolidated three of these branches into existing Heritage Bank branches. Effective November 5, 2010, Heritage Bank
entered into a definitive agreement with the FDIC, pursuant to which Heritage Bank acquired certain assets and assumed
certain liabilities of Pierce Commercial Bank, a Washington state-chartered commercial bank headquartered in Tacoma,
Washington (the “Pierce Acquisition”). The Pierce Acquisition included one branch, which opened as a branch of Heritage Bank
on November 8, 2010.
On September 14, 2012, the Company announced that it had entered into a definitive agreement along with Heritage
Bank, to acquire Northwest Commercial Bank (“NCB”), a full service commercial bank headquartered in Lakewood,
Washington that operated two branch locations in Washington State (the “NCB Acquisition”). The NCB Acquisition was
completed on January 9, 2013, at which time NCB was merged with and into Heritage Bank. The Lakewood branch was
subsequently consolidated with an existing Heritage Bank branch in 2013. On March 11, 2013, the Company entered into a
definitive agreement to acquire Valley Community Bancshares, Inc. ("Valley" or "Valley Community Bancshares") and its
wholly-owned subsidiary, Valley Bank, both headquartered in Puyallup, Washington (the “Valley Acquisition”) and its eight
branches. The Valley Acquisition was completed on July 15, 2013. Subsequently, four of these branches were consolidated
into existing branches as of December 31, 2013. See Note 2 - Business Combinations of the Notes to Consolidated Financial
Statements included in "Item 8. Financial Statements and Supplementary Data" for these acquisitions which closed during
fiscal year 2013.
On April 8, 2013, the Company announced the proposed merger of its two wholly-owned bank subsidiaries Central Valley
Bank and Heritage Bank, with Central Valley Bank merging into Heritage Bank (the "Central Valley Merger"). The common
control merger was completed on June 19, 2013. Central Valley Bank now operates as a division of Heritage Bank.
On October 23, 2013, the Company, along with the Bank, and Washington Banking Company (“Washington Banking”) and
its wholly owned subsidiary bank, Whidbey Island Bank ("Whidbey"), jointly announced the signing of a merger agreement
pursuant to which Heritage and Washington Banking entered into a strategic merger with Washington Banking merging into
Heritage (the "Washington Banking Merger"). Washington Banking branches adopted the Heritage Bank name in all markets,
with the exception of six branches in Whidbey Island markets which continued to operate using the Whidbey Island Bank
name. The Washington Banking Merger was completed on May 1, 2014. For additional information on the Washington
Banking Merger, see Note 2 - Business Combinations of the Notes to Consolidated Financial Statements included in "Item 8.
Financial Statements and Supplementary Data."
We are primarily engaged in the business of planning, directing, and coordinating the business activities of our wholly
owned subsidiary, Heritage Bank. The deposits of the Bank are insured by the FDIC. Heritage Bank is headquartered in
Olympia, Washington and conducts business in its sixty-six branch offices located in Washington and the greater Portland,
Oregon area.
3
Our business consists primarily of lending and deposit relationships with small businesses and their owners in our market
areas, and attracting deposits from the general public. We also make real estate construction and land development loans and
consumer loans. The Bank also originates for sale or investment purposes one-to-four family residential loans on residential
properties located primarily in western and central Washington State and the greater Portland, Oregon area.
Market Areas
We offer financial services to meet the needs of the communities we serve through our community-oriented financial
institutions. Headquartered in Olympia, Thurston County, Washington, we conduct business through Heritage Bank and its
sixty-six branch offices located along the I-5 corridor throughout Washington and the greater Portland, Oregon area. We
additionally have offices located in eastern Washington, primarily in Yakima county.
Lending Activities
General. Lending activities are conducted through Heritage Bank. Our focus is on commercial business lending. We
also originate consumer loans, real estate construction and land development loans and one-to-four family residential loans.
Our loans are originated under policies that are reviewed and approved annually by our Board of Directors. In addition, we
have established internal lending guidelines that are updated as needed. These policies and guidelines address underwriting
standards, structure and rate considerations, and compliance with laws, regulations and internal lending limits. We conduct
post-approval reviews on selected loans and routinely perform internal loan reviews of our loan portfolio to check for credit
quality, proper documentation and compliance with laws and regulations.
The Company has also acquired loans through mergers and acquisitions, which are designated as "purchased" loans.
Purchased loans which are covered under FDIC shared-loss agreements are identified as "covered", while purchased loans
not subject to FDIC shared-loss agreements as well as loans originated by the Company are referred to as "noncovered."
Noncovered commercial and industrial loans, including owner occupied commercial real estate loans, totaled $1.09 billion, or
51.2% of total noncovered loans, as of December 31, 2014, and $617.8 million, or 52.9% of total noncovered loans, as of
December 31, 2013 and non-owner occupied commercial real estate loans totaled $616.8 million, or 29.0%, as of December 31,
2014 and $400.0 million, or 34.2% of total noncovered loans, as of December 31, 2013. One-to-four family residential loans totaled
$63.5 million, or 3.0% of total noncovered loans, at December 31, 2014, and $43.1 million, or 3.7% of total noncovered loans, at
December 31, 2013. Real estate construction and land development loans totaled $108.1 million, or 5.1% of total noncovered loans,
at December 31, 2014, and $68.4 million, or 5.9% of total noncovered loans, at December 31, 2013.
Covered loans totaled $126.2 million and $63.8 million at December 31, 2014 and 2013, respectively. The majority of the
covered loans are commercial and industrial loans, including owner occupied commercial real estate loans, totaling $78.4
million, or 62.1% of total covered loans, as of December 31, 2014, and $39.1 million, or 61.3% of total covered loans, as of
December 31, 2013 and non-owner occupied commercial real estate totaled $26.9 million, or 21.3%, as of December 31, 2014
and $14.6 million, or 22.9% of total noncovered loans, as of December 31, 2013.
4
The following table provides information about our noncovered loan portfolio by type of loan at the dates indicated. These
balances are prior to deduction for the allowance for loan losses.
2014
2013
December 31,
2012
2011
2010
Balance
% of
Total
(4)
% of
Total
(4)
Balance
Balance
% of
Total
(4)
% of
Total
(4)
Balance
% of
Total
(4)
Balance
(Dollars in thousands)
$ 1,087,085
51.2%
$ 617,849 52.9%
$ 503,708
53.7%
$ 493,130
53.3%
$ 470,116
53.9%
616,757
29.0
399,979
34.2
276,854
29.5
263,882
28.5
240,174
27.5
1,703,842
80.2
1,017,828 87.1
780,562
83.2
757,012
81.8
710,290
81.4
63,540
3.0
43,082
3.7
41,888
4.5
40,703
4.4
52,491
6.0
46,749
2.2
19,724
1.7
25,688
2.7
23,750
2.5
33,193
3.8
61,360
2.9
48,655
4.2
52,939
5.6
56,032
6.1
29,832
3.4
108,109
250,323
5.1
11.8
2,125,814 100.1
68,379
41,547
5.9
3.5
1,170,836 100.2
78,627
39,627
940,704
8.3
4.2
100.2
79,782
50,401
927,898
8.6
5.4
100.2
63,025
48,585
874,391
7.2
5.6
100.2
(937 )
(0.1)
(2,670)
(0.2)
(2,096)
(0.2)
(1,860)
(0.2)
(1,323)
(0.2)
$ 2,124,877 100.0%
$ 1,168,166 100.0%
$ 938,608
100.0%
$ 926,038
100.0 %
$ 873,068
100.0%
Noncovered loans:
Commercial business:
Commercial and
industrial(1) ..............
Non-owner occupied
commercial real
estate .......................
Total commercial
business ...............
One-to-four family
residential(2) .................
Real estate construction
and land development:
One-to-four family
residential .................
Five or more family
residential and
commercial
properties .................
Total real estate
construction and
land
development(3) ....
Consumer .........................
Gross noncovered loans ...
Less: deferred loan
fees ..............................
Total noncovered
loans ............................
(1) Commercial and industrial loans include owner-occupied commercial real estate loans.
(2) Excludes loans held for sale of $5.6 million, $1.7 million, $1.8 million and $764,000 as of December 31, 2014, 2012, 2011 and 2010, respectively. There
were no loans held for sale at December 31, 2013.
(3) Balances are net of undisbursed loan proceeds.
(4) Percent of total noncovered loans.
5
The following table provides information about our covered loan portfolio by type of loan at the dates indicated. These
balances are the recorded investment balance and are prior to deduction for the allowance for loan losses.
2014
2013
December 31,
2012
2011
2010
Balance
% of
Total
(3)
% of
Total
(3)
Balance
Balance
% of
Total
(3)
Balance
% of
Total
(3)
% of
Total
(3)
Balance
(Dollars in thousands)
$ 78,354
62.1%
$ 39,056
61.3%
$ 60,577
68.6%
$ 76,674
70.1%
92,265
71.7%
26,879
21.3
14,625
22.9
13,028
14.7
15,753
14.4
17,576
13.6
105,233
83.4
53,681
84.2
73,605
83.3
92,427
84.5
109,841
85.3
5,990
4.7
4,777
7.5
5,027
5.7
5,197
4.8
6,224
4.8
2,446
2.0
1,556
2.4
4,433
5.0
5,786
5.3
5,876
4.6
3,560
2.8
—
—
—
—
—
—
—
—
6,006
8,971
4.8
7.1
1,556
3,740
2.4
5.9
4,433
5,265
5.0
6.0
5,786
5,947
5.3
5.4
5,876
6,774
4.6
5.3
Covered loans:
Commercial business:
Commercial and
industrial(1) .....................
Non-owner occupied
commercial real estate ....
Total commercial
business ..................
One-to-four family
residential ...........................
Real estate construction and
land development:
One-to-four family
residential........................
Five or more family
residential and
commercial
properties ................
Total real estate
construction and
land
development(2) .......
Consumer ...............................
Gross purchased covered
loans ................................... $126,200
100.0%
$ 63,754
100.0%
$ 88,330 100.0%
$ 109,357
100.0%
128,715
100.0%
(1) Commercial and industrial loans include owner-occupied commercial real estate.
(2) Balances are net of undisbursed loan proceeds.
(3) Percent of total covered loans.
The following table presents at December 31, 2014 (i) the aggregate contractual maturities of noncovered loans in the
named categories of our noncovered loan portfolio and (ii) the aggregate amounts of fixed rate and variable or adjustable rate
loans in the named categories that mature after one year.
Maturing
Within 1 year
Over 1-5
years
After 5
years
Total
Commercial business .......................................
Real estate construction and land
development .................................................
$ 230,085
$
407,886
$ 1,065,871
$ 1,703,842
(In thousands)
42,411
34,692
31,006
108,109
Total ............................................................
$ 272,496
Fixed rate loans, due after 1 year .....................
Variable or adjustable rate loans, due after 1
year ...............................................................
$
$
442,578
$ 1,096,877
$ 1,811,951
236,357
$ 217,816
$
454,173
206,221
879,061
1,085,282
Total ............................................................
$
442,578
$ 1,096,877
$ 1,539,455
6
Commercial Business Lending
We offer different types of commercial business loans, including lines of credit, term equipment financing and term owner-
occupied commercial real estate loans. We also originate loans that are guaranteed by the Small Business Administration
(“SBA”), for which Heritage Bank is a “preferred lender.” Before extending credit to a business we review and analyze the
borrower’s management ability, financial history, including cash flow of the borrower and all guarantors, and the liquidation
value of the collateral. Emphasis is placed on having a comprehensive understanding of the borrower’s global cash flow and
performing necessary financial due diligence.
At December 31, 2014 we had $1.70 billion, or 80.2%, of our total noncovered loans receivable in commercial business
loans with an average loan size of approximately $306,000, excluding loans with no outstanding balance.
We originate commercial real estate loans within our primary market areas with a preference for loans secured by owner-
occupied properties. Our underwriting standards require that commercial real estate loans not exceed 75% of the lower of
appraised value at origination or cost of the underlying collateral. Cash flow coverage to debt servicing requirements is
generally a minimum of 1.15 times for five or more family residential loans and 1.25 times for commercial real estate loans.
Cash flow coverage is calculated using an “underwriting” interest rate that is higher than the note rate.
Commercial real estate loans typically involve a greater degree of risk than one-to-four family residential loans. Payments
on loans secured by commercial real estate properties are dependent on successful operation and management of the
properties and repayment of these loans may be affected by adverse conditions in the real estate market or the economy. We
seek to minimize these risks by determining the financial condition of the borrower, the quality and value of the collateral, and
the management of the property securing the loan. We also generally obtain personal guarantees from the owners of the
collateral after a thorough review of personal financial statements. In addition, we review our commercial real estate loan
portfolio annually for performance of individual loans, and stress-test loans for potential changes in interest rates, occupancy,
and collateral values.
See “Item 1A. Risk Factors—Our loan portfolio is concentrated in loans with a higher risk of loss—Repayment of our
commercial business loans, consisting of commercial and industrial loans as well as owner-occupied and non-owner occupied
commercial real estate loans, is often dependent on the cash flows of the borrower, which may be unpredictable, and the
collateral securing these loans may fluctuate in value.” See also “Item 1A. Risk Factors—Our loan portfolio is concentrated in
loans with a higher risk of loss—Our non-owner occupied commercial real estate loans, which includes five or more family
residential real estate loans, involve higher principal amounts than other loans and repayment of these loans may be
dependent on factors outside our control or the control of our borrowers.”
One-to-Four Family Residential Loans, Originations and Sales
The majority of our one-to-four family residential loans are secured by single-family residences located in our primary
market areas. Our underwriting standards require that one-to-four family residential loans generally are owner-occupied and do
not exceed 80% of the lower of appraised value at origination or cost of the underlying collateral. Terms typically range from 15
to 30 years.
As part of our asset/liability management strategy, we typically sell a significant portion of our one-to-four family residential
loans in the secondary market. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of
Operations—Asset/Liability Management.” We discontinued this strategy in the second quarter of 2013 through the second
quarter of 2014, and reinstated these operations following the completion of the Washington Banking Merger.
We typically sell the servicing of the sold one-to-four family residential loans, or the collection of principal and interest
payments, to other financial institutions. We did not service any of these sold loans for others for the years ended
December 31, 2014 or 2013.
7
The following table presents summary information concerning our origination and sale of our one-to-four family residential
loans and the gains from the sale of loans.
Years Ended December 31,
2014
2013
2012
2011
2010
One-to-four family residential loans:
Originated (1) ..........................................
Sold ..........................................................
Gains on sales of loans, net (2) .....................
$ 75,500
55,997
1,080
$
18,867
8,460
142
$
35,730
21,187
295
$
23,865
15,888
285
$
18,605
16,187
226
(In thousands)
(1) Includes loans originated for our loan portfolio or for sale in the secondary market.
(2) Excludes net gains on sales of SBA loans.
Real Estate Construction and Land Development
We originate one-to-four family residential construction loans for the construction of custom homes (where the home buyer
is the borrower). We also provide financing to builders for the construction of pre-sold homes and, in selected cases, to
builders for the construction of speculative residential property. Because of the higher risks present in the residential
construction industry, our lending to builders is limited to those who have demonstrated a favorable record of performance and
who are building in markets that management understands.
We further endeavor to limit our construction lending risk through adherence to strict underwriting guidelines and
procedures. Speculative construction loans are short term in nature and have a variable rate of interest. We require builders to
have tangible equity in each construction project and have prompt and thorough documentation of all draw requests, and we
inspect the project prior to paying any draw requests.
See “Item 1A. Risk Factors—Our loan portfolio is concentrated in loans with a higher risk of loss—Our real estate
construction and land development loans are based upon estimates of costs and value associated with the completed project.
These estimates may be inaccurate.”
Consumer
We originate consumer loans and lines of credit that are both secured and unsecured. The majority of our consumer
loans are for relatively small amounts disbursed among many individual borrowers.
As a result of the Washington Banking Merger, we originate indirect consumer loans. These loans are for new and used
automobile and recreational vehicles that are originated indirectly by selected dealers located in our market areas. We have
limited our indirect loans purchased primarily to dealerships that are established and well known in their market areas and to
applicants that are not classified as sub-prime.
8
Commitments and Contingent Liabilities
In the ordinary course of business, we enter into various types of transactions that include commitments to extend credit
that are not included in our Consolidated Financial Statements. We apply the same credit standards to these commitments as
we use in all our lending activities and have included these commitments in our lending risk evaluations. Our exposure to credit
loss 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:
December 31, 2014
December 31, 2013
(In thousands)
Commercial business:
Commercial and industrial .............................................................
Owner-occupied commercial real estate .......................................
Non-owner occupied commercial real estate ................................
$
Total commercial business ......................................................
One-to-four family residential ...............................................................
Real estate construction and land development:
One-to-four family residential.........................................................
Five or more family residential and commercial properties ...........
Total real estate construction and land development ..............
Consumer .............................................................................................
$
288,930
2,648
20,240
311,818
—
24,028
32,653
56,681
122,633
169,079
2,812
2,405
174,296
45
12,236
20,720
32,956
27,480
Total outstanding commitments ...............................................
$
491,132
$
234,777
Delinquencies and Nonperforming Assets
Delinquency Procedures. Delinquencies in the commercial business loan portfolio are handled by the assigned loan
officer. Loan officers are responsible for collecting loans they originate or which are assigned to them. We send a borrower a
delinquency notice 15 days after the due date when the borrower fails to make a required payment on a loan. If the
delinquency is not brought current, additional delinquency notices are mailed at 30 and 45 days for commercial loans.
Additional written and oral contacts are made with the borrower between 60 and 90 days after the due date.
If a real estate loan payment is past due for 45 days or more, the collection manager may perform a review of the
condition of the property. Depending on the nature of the loan and the type of collateral securing the loan, we may negotiate
and accept a modified payment program with the borrower, accept a voluntary deed in lieu of foreclosure or, when considered
necessary, begin foreclosure proceedings. If foreclosed on, real property is generally sold at a public sale and we may bid on
the property to protect our interest. A decision as to whether and when to begin foreclosure proceedings is based on such
factors as the amount of the outstanding loan relative to the value of the property securing the original indebtedness, the extent
of the delinquency, and the borrower’s ability and willingness to cooperate in resolving the delinquency.
Real estate acquired by us in partial or full satisfaction of a loan obligation is classified as other real estate owned until it is
sold. When property is acquired, it is recorded at the estimated fair value (less costs to sell) at the date of acquisition, not to
exceed net realizable value, and any resulting write-down is charged to the allowance for loan losses. Upon acquisition, all
costs incurred in maintaining the property are expensed. Costs relating to the development and improvement of the property,
however, are capitalized to the extent of the property’s net realizable value. If the estimated realizable value of the other real
estate owned property declines after the acquisition date, the adjustment to the value is charged to other real estate owned
expense, net.
Classification of Loans. Federal regulations require that the Bank periodically evaluate the risks inherent in its loan
portfolio. In addition, the Division of Banks of the Washington State Department of Financial Institutions (“Division”) and the
FDIC have the authority to identify problem loans and, if appropriate, require them to be reclassified. There are three
classifications for problem loans: Substandard, Doubtful, and Loss. Substandard loans have one or more defined weaknesses
and are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.
Doubtful loans have the weaknesses of Substandard loans, with additional characteristics that the weaknesses make
9
collection or liquidation in full on the basis of currently existing facts, conditions, and values questionable. There is a high
probability of some loss in loans classified as Doubtful. A loan classified as Loss is considered uncollectible and of such little
value that continuance as a loan of the institution is not warranted. If a loan or a portion of the loan is classified as Loss, the
institution must charge-off this amount. We also have loans we classify as Watch and Other Assets Especially Mentioned
(“OAEM”). Loans classified as Watch are performing assets but have elements of risk that require more monitoring than other
performing loans. Loans classified as OAEM are assets that continue to perform but have shown deterioration in credit quality
and require closer monitoring.
The Bank routinely tests its problem loans for potential impairment. A loan is considered impaired when, based on current
information and events, it is probable that the Bank will be unable to collect all amounts due according to the original
contractual terms of the loan agreement. Problem loans that may be impaired are identified using the Bank's normal loan
review procedures, which include post-approval reviews, monthly reviews by credit administration of criticized loan reports,
scheduled internal reviews, underwriting during extensions and renewals and the analysis of information routinely received on
a borrower’s financial performance.
Impairment is measured using the present value of expected future cash flows, discounted at the loan’s effective interest
rate, unless the loan is collateral dependent, in which case impairment is measured using the fair value of the collateral after
deducting appropriate collateral disposition costs. Furthermore, when it is practically expedient, impairment is measured by the
fair market price of the loan.
Subsequent to an initial measure of impairment, if there is a significant change in the amount or timing of a loan’s
expected future cash flows or a change in the value of collateral or market price of a loan, based on new information received,
the impairment is recalculated. However, the net carrying value of a loan never exceeds the recorded investment in the loan.
10
Nonperforming Assets. Nonperforming assets consist of nonaccrual loans and other real estate owned. The following
table provides information about our noncovered nonaccrual loans and other real estate owned for the indicated dates. We
have also included information regarding our troubled-debt restructured performing noncovered loans for the indicated dates,
although these are not considered nonperforming assets as they continue to accrue interest despite being considered impaired
due to the restructure.
December 31,
2014
2013
2012
2011
2010
(Dollars in thousands)
Nonaccrual noncovered loans:
Commercial business .........................
One-to-four family residential .............
Real estate construction and land
development ................................
Consumer ...........................................
$ 4,719
—
2,652
139
Total nonaccrual noncovered
7,510
loans(1)(2) .............................
$ 5,675
340
1,045
678
7,738
Noncovered other real estate owned........
2,178
4,377
$ 6,068
450
6,420
281
13,219
5,406
$ 8,266
—
14,947
615
23,828
3,710
$10,839
2
15,642
—
26,483
3,030
Total nonperforming noncovered
assets ....................................
Accruing noncovered loans past due 90
days or more(3) ..................................
Potential problem noncovered loans(4) ....
Allowance for loan losses on
noncovered loans ...............................
Nonperforming noncovered loans to total
noncovered loans ...............................
Allowance for loan losses on
noncovered loans to total
noncovered loans ...............................
Allowance for loan losses on
noncovered loans to nonperforming
noncovered loans ...............................
Nonperforming noncovered assets to
total noncovered assets .....................
Restructured performing noncovered
loans: ..................................................
Commercial business .........................
One-to-four family residential .............
Real estate construction and land
development ................................
Consumer ...........................................
Total restructured performing
noncovered loans(5) ............
$ 9,688
$ 12,115
$18,625
$27,538
$29,513
—
$
117,250
6
$
52,814
$ 214
29,183
$ 1,328
31,925
$ 1,313
53,086
22,153
22,657
24,242
26,952
22,062
0.35%
0.66%
1.41%
2.57%
3.03%
1.04%
1.94%
2.58%
2.91%
2.53%
294.98%
292.80%
183.39%
113.11%
83.31%
0.29%
0.76%
1.48%
2.19%
2.38%
$14,408
245
3,927
184
$15,735
252
6,043
101
$15,227
888
$12,606
835
$ 394
—
361
—
364
—
—
—
$18,764
$22,131
$16,476
$13,805
$ 394
(1) At December 31, 2014, 2013, 2012, 2011 and 2010, $4.1 million, $2.6 million, $9.3 million, $11.7 million and $8.7 million of nonaccrual
noncovered loans were considered troubled debt restructured loans, respectively.
(2) At December 31, 2014, 2013, 2012, 2011 and 2010, $1.6 million, $1.7 million, $1.2 million, $1.8 million and $2.3 million of noncovered
nonaccrual loans were guaranteed by government agencies, respectively.
(3) There were no accruing noncovered loans past due 90 days or more that were guaranteed by government agencies at December 31,
2014, 2013, and 2012. There were accruing noncovered loans past due 90 days or more of $6,000 and $92,000 guaranteed by
government agencies at December 31, 2011 and 2010, respectively.
(4) At December 31, 2014, 2013, 2012, 2011 and 2010, $2.0 million, $1.8 million, $2.9 million, $2.8 million and $5.4 million of potential
problem noncovered loans were guaranteed by government agencies, respectively.
11
(5) At December 31, 2014, 2013, 2012 and 2011, $751,000, $1.2 million, $965,000 and $592,000 of restructured performing noncovered
loans were guaranteed by government agencies . There were no restructured performing noncovered loans guaranteed by government
agencies at December 31, 2010.
Nonaccrual Loans. Our Consolidated Financial Statements are prepared on the accrual basis of accounting, including
the recognition of interest income on our loan portfolio, unless a loan is placed on nonaccrual status. Loans are considered to
be impaired and are placed on nonaccrual status when there are serious doubts about the collectability of principal or interest.
Our policy is to place a loan on nonaccrual status when the loan becomes past due for 90 days or more, is less than fully
collateralized, and is not in the process of collection. Payments received on nonaccrual loans generally are applied first to
principal and then to interest only after all principal has been collected.
Nonaccrual noncovered loans decreased to $7.5 million, or 0.35% of total noncovered loans, at December 31, 2014 from
$7.7 million, or 0.66% of total noncovered loans, at December 31, 2013 due to the loan resolution efforts of our credit
department. During the year ended December 31, 2014, approximately $9.6 million in net principal payments were received
on nonaccrual noncovered loans and $322,000 of nonaccrual noncovered loans were transferred back to accrual status. We
also recorded $1.6 million in net charge-offs of nonaccrual noncovered loans. In addition, $414,000 of nonaccrual noncovered
loans were transferred to other real estate owned during the year ended December 31, 2014. The decrease in total
nonaccrual noncovered loans at December 31, 2014 was partially offset by $11.7 million in additions to nonperforming
noncovered loans, of which $1.4 million were previously restructured performing noncovered loans that were transferred to
nonaccrual status.
Nonperforming noncovered assets decreased to $9.7 million, or 0.29% of total noncovered assets, at December 31, 2014
from $12.1 million, or 0.76% of total noncovered assets, at December 31, 2013 due to a decrease in nonperforming
noncovered loans discussed above as well as an overall decrease in noncovered other real estate owned. The noncovered
other real estate owned decreased to $2.2 million at December 31, 2014 from $4.4 million at December 31, 2013 due to
dispositions of $5.6 million, which were offset partially by additions of $3.3 million during the year ended December 31, 2014.
Of the $3.3 million of additions, $1.7 million were acquired with the Washington Banking Merger.
Restructured performing noncovered loans as of December 31, 2014 and December 31, 2013 were $18.8 million and
$22.1 million, respectively. The $3.4 million decrease in restructured performing noncovered loans during 2014 was primarily
due to $7.3 million of net principal reductions and $1.5 million in loans transferred to nonaccrual, offset partially by $3.8 million
of loans restructured during the year ended December 31, 2014 and $2.5 million of advances of existing restructured
performing noncovered loans. The Bank also recorded $372,000 in charge-offs of restructured performing noncovered loans
during the year ended December 31, 2014.
Troubled Debt Restructured Loans. A troubled debt restructured loan (“TDR”) is a restructuring in which the Bank, for
economic or legal reasons related to a borrower’s financial difficulties, grants a concession to a borrower that it would not
otherwise consider. The majority of the Bank's TDRs are a result of granting extensions to troubled credits which have already
been adversely classified. We grant such extensions to reassess the borrower’s financial status and develop a plan for
repayment. Certain modifications with extensions also include interest rate reductions, which is the second most prevalent
concession. The interest rate reductions can be for a period of time or over the remainder of the life of the loan. We may also
bifurcate troubled credits into a “good” loan and a “bad” loan, whereas the good loan continues to accrue under the modified
terms. We perform bifurcations to limit potential losses. The remainder of the Bank's TDRs are the result of converting
revolving lines of credits to amortizing loans, changing amortizing loans to interest-only loans with balloon payments, or re-
amortizing the loan over a longer period of time. These modifications would all be considered a concession for a borrower that
could not obtain financing outside of the Bank. We do not forgive principal for a majority of our TDRs, but in those situations
where principal is forgiven, the entire amount of such principal forgiveness is immediately charged off to the extent not done so
prior to the modification. We sometimes delay the timing on the repayment of a portion of principal (principal forbearance) and
charge-off the amount of forbearance if that amount is not considered fully collectible. We also consider insignificant delays in
payments when determining if a loan should be classified as a TDR.
12
TDRs are considered impaired and are separately measured for impairment under Financial Accounting Standards Board
("FASB") Accounting Standards Codification (“ASC”) 310-10-35, whether on accrual or nonaccrual status. At December 31,
2014 and December 31, 2013, the balance of performing noncovered TDRs was $18.8 million and $22.1 million, respectively.
The related allowance for loan losses on the performing noncovered TDRs was $1.9 million as of December 31, 2014 and $3.0
million as of December 31, 2013. At December 31, 2014, nonperforming noncovered TDRs were $5.0 million and had a related
allowance for loan losses of $1.0 million. At December 31, 2013, nonperforming noncovered TDRs of $2.6 million had a
related allowance for loan losses of $191,000.
A loan may have the TDR classification removed if (a) the restructured interest rate was greater than or equal to the
interest rate of a new loan with comparable risk at the time of the restructure, and (b) the loan is no longer impaired based on
the terms of the restructured agreement. The Bank's policy is that the borrower must demonstrate six consecutive monthly
payments in accordance with the modified loan terms before it can be reviewed for removal of TDR classification under the
second criteria. However, the loan must be reported as a TDR in at least one of the Company’s Annual Reports on Form 10-K.
Once a loan has been classified as a TDR, it will continue to be an impaired loan until paid off or charged-off, even if the loan
subsequently is no longer a TDR.
Potential Problem Loans. Potential problem loans are those loans that are currently accruing interest and are not
considered impaired, but which we are monitoring because the financial information of the borrower causes us concerns as to
their ability to comply with their loan repayment terms. Loans that are past due 90 days or more and still accruing interest are
both well-secured and in the process of collection. Potential problem noncovered loans increased $64.4 million, or 122.0%, to
$117.3 million at December 31, 2014 from $52.8 million at December 31, 2013 primarily due to loans acquired in the
Washington Banking Merger.
Analysis of Allowance for Loan Losses
Management maintains an allowance for loan losses (“ALL”) to provide for estimated probable credit losses inherent in the
loan portfolio. The adequacy of the ALL is monitored through our ongoing quarterly loan quality assessments.
We assess the estimated credit losses inherent in our loan portfolio by considering a number of elements including:
• Historical loss experience in a number of homogeneous segments of the loan portfolio;
• The impact of environmental factors, including:
▪ Levels of and trends in delinquencies and impaired loans;
▪ Levels and trends in charge-offs and recoveries;
▪ Effects of changes in risk selection and underwriting standards, and other changes in lending policies,
procedures and practices;
▪ Experience, ability, and depth of lending management and other relevant staff;
▪ National and local economic trends and conditions;
▪ External factors such as competition, legal, and regulatory requirements; and
▪ Effects of changes in credit concentrations.
We calculate an appropriate ALL for the loans in our loan portfolio by applying historical loss factors for homogeneous
classes of the portfolio, adjusted for changes to the above-noted environmental factors. We may record specific provisions for
impaired loans, including loans on nonaccrual status and TDRs, after a careful analysis of each loan’s credit and collateral
factors. Our analysis of an appropriate ALL combines the provisions made for our non-impaired loans and the specific
provisions made for each impaired loan.
13
While we believe we use the best information available to determine the allowance for loan losses, results of operations
could be significantly affected if circumstances differ substantially from the assumptions used in determining the allowance. A
decline in local and national economic conditions, or other factors, could result in a material increase in the allowance for loan
losses and may adversely affect the Company’s financial condition and results of operations. In addition, the determination of
the amount of the allowance for loan losses is subject to review by bank regulators, as part of their routine examination
process, which may result in the establishment of additional allowance allocations based upon their judgment of information
available to them at the time of their examination.
The following table provides information regarding changes in our allowance for loan losses on noncovered loans at and
for the indicated periods:
Allowance for loan losses on
noncovered loans at beginning of
the year .......................................... $
Provision for loan losses for
noncovered loans ...........................
Charge-offs:
At or For the Years Ended December 31,
2014
2013
2012
2011
2010
(Dollars in thousands)
22,657
$
24,242
$
26,952
$
22,062
$
26,164
2,232
1,784
1,570
10,032
11,990
Commercial business .....................
One-to-four family residential .........
Real estate construction and land
development ............................
Consumer .......................................
(2,305)
—
(376)
(962)
(3,295)
(52)
(565)
(386)
(3,726)
(391)
(1,280)
(620)
(2,972)
(53)
(2,513)
(648)
(8,106)
(169)
(8,344)
(73)
Total charge-offs on
noncovered loans ....................
Recoveries:
Commercial business .....................
One-to-four family residential .........
Real estate construction and land
development ............................
Consumer .......................................
Total recoveries on
noncovered loans ....................
Net charge-offs on
noncovered loans ............
Allowance for loan losses on
noncovered loans at end of the
year................................................. $
(3,643)
(4,298)
(6,017)
(6,186)
(16,692)
716
—
50
141
907
807
—
32
90
929
1,579
—
125
33
821
—
201
22
1,737
1,044
243
15
285
57
600
(2,736)
(3,369)
(4,280)
(5,142)
(16,092)
22,153
$
22,657
$
24,242
$
26,952
$
22,062
Noncovered loans outstanding at end
of the year(1)(2) .............................. $ 2,125,814
Average noncovered loans receivable
during the year(2) ........................... 1,767,821
$ 1,170,836
$ 940,704
$ 927,898
$ 874,391
1,052,552
897,342
862,812
745,819
Ratio of net charge-offs on
noncovered loans to average
noncovered loans receivable .........
(1) Gross loan balances.
(2) Excludes loans held for sale.
(0.15)%
(0.32)%
(0.48)%
(0.60)%
(2.16)%
14
The following table shows the allocation of the allowance for loan losses on noncovered loans at the indicated dates. The
allocation is based upon an evaluation of defined loan problems, historical loan loss ratios, and industry wide and other factors
that affect loan losses in the categories shown below:
2014
2013
2012
2011
2010
Allowance
for Loan
Losses
% of
Total
(1)
Allowance
for Loan
Losses
% of
Total
(1)
Allowance
for Loan
Losses
% of
Total
(1)
Allowance
for Loan
Losses
% of
Total
(1)
Allowance
for Loan
Losses
% of
Total
(1)
December 31,
Commercial
business .........
$ 15,967
80.1% $ 18,020
86.9% $ 16,044
83.0% $ 16,167
81.6% $ 14,350
82.5%
(Dollars in thousands)
One-to-four
family
residential .......
Real estate
construction ....
Consumer ..........
Unallocated ........
Total
allowance
for loan
losses on
noncovered
loans (1) ......
812
3.0
786
3.7
944
4.4
650
4.4
500
6.5
1,954
2,604
816
5.1
11.8
—
1,884
1,366
601
5.8
3.6
—
4,801
1,583
870
8.4
4.2
—
7,978
1,247
910
8.6
5.4
—
5,435
846
931
7.8
3.2
—
$ 22,153
100.0% $ 22,657
100.0% $ 24,242
100.0% $ 26,952
100.0% $ 22,062
100.0%
(1) Represents total noncovered loans outstanding in each category as a percent of gross noncovered loans.
The following table shows the allocation of the allowance for loan losses on covered loans at the indicated dates. The
allocation is based upon an evaluation of defined loan problems, historical loan loss ratios, and industry wide and other factors
that affect loan losses in the categories shown below:
2014
2013
2012
2011
2010 (2)
Allowance
for Loan
Losses
% of
Total
(1)
Allowance
for Loan
Losses
% of
Total
(1)
Allowance
for Loan
Losses
% of
Total
(1)
Allowance
for Loan
Losses
% of
Total
(1)
Allowance
for Loan
Losses
% of
Total
(1)
December 31,
Commercial
business ........
$
4,219
83.4% $
4,833
84.2%
$ 3,258
83.3% $
3,011
84.5% $
—
85.3%
(Dollars in thousands)
One-to-four
family
residential ......
Real estate
construction ...
Consumer .........
Unallocated .......
Total
allowance
for loan
losses on
covered
loans (1) .....
388
4.7
314
7.5
277
5.7
144
4.8
—
4.8
804
165
—
4.8
7.1
—
789
231
—
2.4
5.9
—
639
178
—
5.0
6.0
—
645
163
—
5.3
5.4
—
—
—
—
4.6
5.3
—
$
5,576 100.0% $
6,167
100.0%
$ 4,352
100.0% $
3,963
100.0% $
—
100.0%
(1) Represents total covered loans outstanding in each category as a percent of gross covered loans.
(2) The Company did not have an allowance for loan losses on covered loans at December 31, 2010 as the covered portfolio was acquired in July
2010 and fair value discounts on covered loans established at acquisition date were determined sufficient to absorb known and inherent loan
losses at December 31, 2010.
15
Investment Activities
At December 31, 2014, our investment securities portfolio totaled $778.7 million, which consisted of $742.8 million of
securities available for sale and $35.8 million of securities held to maturity. This compares with a total portfolio of $199.3 million
at December 31, 2013, which was comprised of $163.1 million of securities available for sale and $36.2 million of securities
held to maturity. The increase in our investment securities portfolio in fiscal 2014 is attributable to investment securities
acquired in the Washington Banking Merger. The composition of the investment portfolio by type of security, at each
respective date, is presented in Note 4 - Investment Securities of the Notes to Consolidated Financial Statements included in
"Item 8. Financial Statements and Supplementary Data."
Our investment policy is established by the Board of Directors and monitored by the Audit and Finance Committee of the
Board of Directors. It is designed primarily to provide and maintain liquidity, generate a favorable return on investments without
incurring undue interest rate and credit risk, and complements the Bank's lending activities. The policy dictates the criteria for
classifying securities as either available for sale or held to maturity. The policy permits investment in various types of liquid
assets permissible under applicable regulations, which include U.S. Treasury obligations, U.S. Government agency
obligations, some certificates of deposit of insured banks, mortgage backed and mortgage related securities, corporate notes,
municipal bonds, and federal funds. Investment in non-investment grade bonds and stripped mortgage backed securities are
not permitted under the policy.
The following table provides information regarding our investment securities available for sale at the dates indicated.
December 31, 2014
December 31, 2013
December 31, 2012
Fair Value
% of
Total
Investments
Fair Value
% of
Total
Investments
Fair Value
% of
Total
Investments
(Dollars in thousands)
$
21,427
173,037
2.9%
$
23.3
6,039
49,060
3.7% $ 11,035
47,360
30.1
7.7%
32.8
542,399
4,010
1,973
73.0
0.5
0.3
108,035
—
—
66.2
—
—
85,898
—
—
59.5
—
—
U.S. Treasury and U.S.
Government-sponsored
agencies ............................
Municipal securities ..............
Mortgage backed securities
and collateralized
mortgage obligations-
residential:
U.S. Government-
sponsored agencies .......
Corporate obligations ............
Mutual funds and other
equities ..............................
Total .........................
$ 742,846
100.0%
$ 163,134
100.0% $ 144,293
100.0%
16
The following table provides information regarding our investment securities available for sale, by contractual maturity, at
December 31, 2014.
Less Than One
Year
Over One to Five
Years
Over Five to Ten
Years
Fair
Value
Weighted
Average
Yield(1)
Fair
Value
Weighted
Average
Yield(1)
Fair
Value
Weighted
Average
Yield(1)
Over Ten Years
Fair
Value
Weighted
Average
Yield(1)
(Dollars in thousands)
U.S. Treasury and
U.S.
Government-
sponsored
agencies ............... $ —
—% $ 20,836
1.04% $
591
1.95% $
—
—%
Municipal
securities...............
Mortgage backed
securities and
collateralized
mortgage
obligations-
residential:
U.S.
Government-
sponsored
agencies .........
Corporate
obligations .........
4,171
1.93
26,360
2.50
65,805
3.26
76,701
3.76
—
—
—
—
8,601
2.40
81,540
1.81
452,258
2.09
—
—
4,010
1.15
—
—
Total ............
$ 4,171
1.93% $ 55,797
1.91% $ 151,946
2.42% $ 528,959
2.32%
(1) Taxable equivalent weighted average yield.
The following table provides information regarding our investment securities held to maturity at the dates indicated.
December 31, 2014
% of
Total
Investments
Amortized
Cost
December 31, 2013
% of
Total
Investments
Amortized
Cost
(Dollars in thousands)
December 31, 2012
% of
Total
Investments
Amortized
Cost
1,591
22,486
4.4% $
62.8
1,687
24,290
4.7% $
67.2
1,740
2,946
17.2%
29.2
U.S. Treasury and U.S.
Government-sponsored
agencies ..........................
$
Municipal securities
Mortgage backed
securities and
collateralized mortgage
obligations-residential:
U.S. Government-
sponsored
agencies ....................
Private residential
collateralized
mortgage
obligations .................
Total .......................
10,866
30.4
9,129
25.2
4,245
42.0
871
$ 35,814
2.4
1,048
100.0% $ 36,154
2.9
100.0% $
1,168
10,099
11.6
100.0%
17
The following table provides information regarding our investment securities held to maturity, by contractual maturity, at
December 31, 2014.
Less Than One
Year
Over One to Five
Years
Over Five to Ten
Years
Over Ten Years
Amortized
Cost
Weighted
Average
Yield(1)
Amortized
Cost
Weighted
Average
Yield(1)
Amortized
Cost
Weighted
Average
Yield(1)
Amortized
Cost
Weighted
Average
Yield(1)
(Dollars in thousands)
U.S. Treasury and
U.S.
Government-
sponsored
agencies ..............
Municipal
securities .........
Mortgage backed
securities and
collateralized
mortgage
obligations-
residential:
U.S.
Government-
sponsored
agencies .........
Private
residential
collateralized
mortgage
obligations ......
$
—
—% $
492
3.76% $
1,099
3.91% $
—
—%
2,895
2.53
8,826
3.05
10,557
3.88
208
5.61
—
—
508
2.56
6,902
3.25
3,456
2.88
—
—
—
—
—
—
Total ..........
$
2,895
2.53% $
9,826
3.06% $ 18,558
3.64% $
(1) Taxable equivalent weighted average yield.
871
4,535
5.95
3.59%
The Bank is required to maintain an investment in the stock of the Federal Home Loan Bank (“FHLB”) of Seattle in an
amount equal to the greater of $500,000 or 0.50% of residential mortgage loans and pass-through securities or an advance
requirement to be confirmed on the date of the advance and 5.0% of the outstanding balance of mortgage loans sold to the
FHLB of Seattle. At December 31, 2014 the Bank was required to maintain an investment in the stock of FHLB of Seattle of at
least $3.3 million and had an investment in FHLB stock carried at a cost basis (par value) of $12.2 million.
Consistent with its accounting policy, the Company evaluated its investment in FHLB of Seattle stock for other-than-
temporary impairment. The Company took into consideration that in September 2012, the FHLB of Seattle announced that it
had been reclassified as adequately capitalized by its regulator, the Federal Housing Finance Agency(“FHFA”). Further, during
the year ended December 31, 2012, the FHFA granted the FHLB of Seattle authority to repurchase up to $25 million of excess
capital stock per quarter at par ($100 per share), provided they receive a non-objection for each quarter’s repurchase from the
FHFA. The FHLB of Seattle had been repurchasing stock throughout 2013 and 2014. On December 22, 2014 the FHLB of
Seattle and the FHLB of Des Moines announced that the FHFA had approved their merger application submitted on October
31, 2014, subject to satisfaction of specific closing conditions set forth in the FHFA approval letter, including the receipt of
approvals by members of both FHLBs. The voting process for both FHLBs is anticipated to conclude in late February 2015.
The boards of directors of both FHLBs have unanimously approved the proposed merger. The combined FHLB would be
headquartered in Des Moines and maintain a regional office in Seattle. The members of the combined organization would have
access to an enhanced suite of products and services and benefit from increased economies of scale and greater risk
diversification.
18
Based on the Company’s evaluation of the underlying investment, including the long-term nature of the investment, the
liquidity position of the FHLB of Seattle, the proposed FHLB merger and the Company’s intent and ability to hold the
investment for a period of time sufficient to recover the par value, the Company did not recognize an other-than-temporary
impairment loss on its FHLB of Seattle stock during the years ended December 31, 2014, 2013 and 2012. Despite
improvements in the FHLB of Seattle’s financial condition, any deterioration in the FHLB of Seattle’s financial position may
result in future impairment losses.
Deposit Activities and Other Sources of Funds
General. Our primary sources of funds are deposits, loan repayments and borrowings. Scheduled loan repayments are
a relatively stable source of funds, while deposits and unscheduled loan prepayments, which are influenced significantly by
general interest rate levels, interest rates available on other investments, competition, economic conditions, and other factors
are not. Customer deposits remain an important source of funding, but these balances have been influenced in the past by
adverse market conditions in the industry and may be affected by future developments such as interest rate fluctuations and
new competitive pressures. In addition to customer deposits, management may utilize brokered deposits on an as-needed
basis.
Borrowings may also be used on a short-term basis to compensate for reductions in other sources of funds (such as
deposit inflows at less than projected levels). Borrowings may also be used on a longer-term basis to support expanded
lending activities and match the maturity of repricing intervals of assets. In addition, the Company utilizes repurchase
agreements as a supplement to other funding sources.
During the year ended December 31, 2014, non-maturity deposits (total deposits less certificate of deposit accounts)
increased by $1.29 billion, or 118.5%, to $2.38 billion from $1.09 billion at December 31, 2013. The increase was primarily a
result of the non-maturity deposits acquired in the Washington Banking Merger. The percentage of non-maturity deposits to
total deposits increased to 81.9% at December 31, 2014 compared to 77.9% at December 31, 2013. As a result of this
increase, the certificate of deposit accounts to total deposits decreased to 18.1% at December 31, 2014 from 22.1% at
December 31, 2013.
Deposit Activities. We offer a variety of deposit accounts designed to attract both short-term and long-term deposits.
These accounts include noninterest demand accounts, negotiable order of withdrawal (“NOW”) accounts, money market
accounts, savings accounts and certificates of deposit (“CDs”). These accounts, with the exception of noninterest demand
accounts, generally earn interest at rates established by management based on competitive market factors and management’s
desire to increase or decrease certain types or maturities of deposits. The major categories of deposit accounts are described
below.
Noninterest Demand Deposits. Noninterest demand deposits are noninterest bearing and may be charged service
fees based on activity and balances.
NOW Accounts. NOW accounts are interest bearing and may be charged service fees based on activity and balances.
NOW accounts pay interest, but require a higher minimum balance to avoid service charges.
Money Market Accounts. Money market accounts pay a variable interest rate that is tiered depending on the balance
maintained in the account. Minimum opening balances vary.
Savings Accounts. We offer savings accounts that allow for unlimited deposits and withdrawals, provided that a $300
minimum balance is maintained.
CDs. We offer several types of CDs with maturities ranging from three months to five years, which require a minimum
deposit of $2,500. Negotiable CDs are offered in amounts of $100,000 or more for terms of 30 days to five years.
19
The following table provides the balances outstanding for each major category of deposits at the dates indicated:
December 31, 2014
Amount
Percent
December 31, 2013
Amount
Percent
(Dollars in thousands)
December 31, 2012
Amount
Percent
Noninterest demand deposits ....
NOW accounts ...........................
Money market accounts .............
Savings accounts .......................
$ 709,673
793,362
520,065
357,834
Total non-maturity
2,380,934
deposits ...........................
CDs ............................................
525,397
24.4% $ 349,902
352,051
27.3
232,016
17.9
155,790
12.3
25.0% $ 247,048
303,487
25.2
157,728
16.6
120,781
11.1
81.9
18.1
1,089,759
309,430
77.9
22.1
829,044
288,927
22.1%
27.2
14.1
10.8
74.2
25.8
Total deposits .......................
$ 2,906,331
100.0% $ 1,399,189
100.0% $ 1,117,971
100.0%
The following table provides the average balances outstanding and the weighted average interest rates for each major
category of deposits for the years indicated:
2014
Average
Balance
Average
Yield/Rate
Years Ended December 31,
2013
Average
Balance
Average
Yield/Rate
(Dollars in thousands)
2012
Average
Balance
Average
Yield/Rate
$ 1,049,078
282,150
494,948
0.18% $ 541,793
143,412
0.09
307,464
0.60
0.19%
0.11
0.81
$ 466,268
113,119
306,772
0.27%
0.18
0.98
1,826,176
0.28
992,669
0.37
886,159
0.50
574,692
—
308,582
—
237,888
—
NOW accounts and money
market accounts ...............
Savings accounts.................
CDs ......................................
Total interest bearing
deposits ......................
Noninterest demand
deposits ............................
Total deposits ................
$ 2,400,868
0.21% $ 1,301,251
0.28%
$1,124,047
0.40%
The following table shows the amount and maturity of certificates of deposit of $100,000 or more:
Remaining maturity:
Three months or less .........................................................................
Over three months through twelve months ........................................
Over twelve months through three years ...........................................
Over three years ................................................................................
$
Total .............................................................................................
$
1,441
167,863
79,922
17,356
266,582
December 31, 2014
(In thousands)
Borrowings. Deposits are the primary source of funds for our lending and investment activities and our general business
purposes. We rely upon advances from the FHLB to supplement our supply of lendable funds and meet deposit withdrawal
requirements. The FHLB of Seattle serves as one of our secondary sources of liquidity. Advances from the FHLB of Seattle are
typically secured by our first lien one-to-four family residential loans, commercial real estate loans and stock issued by the
FHLB, which is owned by us. At December 31, 2014, the Bank maintained an uncommitted credit facility with the FHLB of
Seattle of $374.3 million and an uncommitted credit facility with the Federal Reserve Bank of San Francisco of $53.2 million, of
which there were no advances or borrowings outstanding. The Bank also maintains advance lines with Zions Bank, Wells
Fargo Bank, US Bank and Pacific Coast Bankers’ Bank to purchase federal funds of up to $43.0 million as of December 31,
2014. At December 31, 2014 we had securities sold under agreement to repurchase of $32.2 million which were secured by
investment securities available for sale.
20
The FHLB functions provide credit for member financial institutions. As a member, we are required to own capital stock in
the FHLB and are authorized to apply for advances on the security of such stock and certain of our mortgage loans and other
assets (principally securities which are obligations of, or guaranteed by, the United States) provided certain standards related
to creditworthiness have been met. Advances are made pursuant to several different programs. Each credit program has its
own interest rate and range of maturities. Depending on the program, limitations on the amount of advances are based either
on a fixed percentage of an institution’s net worth or on the FHLB’s assessment of the institution’s creditworthiness. Under its
current credit policies, the FHLB of Seattle limits advances to 20% of the Bank's assets.
There were no FHLB advances or federal funds purchased for the years ended December 31, 2014, 2013 or 2012.
Supervision and Regulation
We are subject to extensive Federal and Washington State legislation, regulation, and supervision. These laws and
regulations are primarily intended to protect depositors, the FDIC and shareholders. The laws and regulations affecting banks
and bank holding companies have changed significantly particularly in connection with the enactment of the Dodd-Frank Wall
Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”). Among other changes, the Dodd-Frank Act
established the Consumer Protection Financial Bureau (“CFPB”) as an independent bureau of the Board of Governors of the
Federal Reserve System (“Federal Reserve”). The CFPB assumed responsibility for the implementation of the federal financial
consumer protection and fair lending laws and regulations and has authority to impose new requirements. See “—Other
Regulatory Developments—The Dodd-Frank Act” herein for a discussion of this legislation. Any change in applicable laws,
regulations, or regulatory policies may have a material effect on our business, operations, and prospects. We cannot predict
the nature or the extent of the effects on our business and earnings that any fiscal or monetary policies or new Federal or State
legislation may have in the future.
The following is a summary discussion of certain laws and regulations applicable to Heritage Financial and Heritage Bank
which is qualified in its entirety by reference to the actual laws and regulations.
Heritage Financial. As a registered bank holding company with the Federal Reserve, we are subject to comprehensive
regulation and supervision under the Bank Holding Company Act of 1956, as amended. This regulation and supervision is
generally intended to ensure that we limit our activities to those allowed by law and that we operate in a safe and sound
manner without endangering the financial health of Heritage Bank. As a bank holding company supervised by the Federal
Reserve, we are required to file annual and periodic reports with the Federal Reserve and provide additional information as the
Federal Reserve may require. The Federal Reserve may examine us, and any of our subsidiaries, and assess us for the cost
of such examination.
The Federal Reserve has extensive enforcement authority over bank holding companies, including the ability to assess
civil money penalties and to issue cease and desist or removal orders. The Federal Reserve may also order termination of
non-banking activities by non-banking subsidiaries of bank holding companies, or divestiture of ownership and control of a
non-banking subsidiary by a bank holding company. Some violations may also result in criminal penalties.
Federal Reserve policy provides that a bank holding company is required to serve as a source of financial and managerial
strength to its subsidiary banks and may not conduct its operations in an unsafe or unsound manner. Federal Reserve policy
further provides that in its capacity as a source of strength to its subsidiary banks, a bank holding company should have the
ability to provide financial assistance to its subsidiary banks during periods of financial distress. A bank holding company’s
failure to meet its obligation to serve as a source of strength to its subsidiary banks is generally considered by the Federal
Reserve to be an unsafe and unsound banking practice or a violation of the Federal Reserve’s regulations or both. The Dodd-
Frank Act also extends the "source of strength" doctrine and requires the issuance of implementing regulations by the federal
banking regulatory agencies.
Under the prompt corrective action provisions of the Federal Deposit Insurance Act ("FDIA"), a bank holding company with
an undercapitalized subsidiary bank must guarantee, within limitations, the capital restoration plan that is required to be
implemented of its undercapitalized subsidiary bank. If an undercapitalized subsidiary bank fails to file an acceptable capital
restoration plan or fails to implement an accepted plan the Federal Reserve may prohibit the bank holding company or its
undercapitalized subsidiary bank from, among other restrictions, paying any dividend or making any other form of capital
distribution without the prior approval of the Federal Reserve. In addition, the Federal Reserve policy provides that a bank
holding company may pay cash dividends only to the extent that the company’s net income for the past year is sufficient to
cover both the cash dividend and a rate of earnings retention that is consistent with the company’s capital needs, asset quality
21
and overall financial condition. In addition, under Washington corporate law, companies generally may not pay dividends if
after that payment the company would not be able to pay its liabilities as they become due in the usual course of business, or
its total assets would be less than its total liabilities.
We, and any subsidiaries which we may control, are considered “affiliates” within the meaning of the Federal Reserve Act,
and transactions between our bank subsidiary and affiliates are subject to numerous restrictions. With some exceptions, we
and our subsidiaries are prohibited from tying the provision of various products or services, such as extensions of credit, to
other products or services offered by us, or our affiliates.
Bank regulations require bank holding companies and banks to maintain a minimum “leverage” ratio of core capital to
adjusted quarterly average total assets of at least 4%. In addition, banking regulators have adopted risk-based capital
guidelines under which risk percentages are assigned to various categories of assets and off-balance sheet items to calculate
a risk-adjusted capital ratio. Tier 1 capital generally consists of common stockholders’ equity (which does not include
unrealized gains and losses on investment securities available for sale), less goodwill and certain identifiable intangible assets.
Tier 2 capital includes Tier 1 capital plus the allowance for loan losses and subordinated debt, both subject to some limitations.
Regulatory risk-based capital guidelines require Tier 1 capital of 4% of risk-adjusted assets and minimum total capital ratio
(combined Tier 1 and Tier 2) of 8% of risk-adjusted assets. In July 2013, the Federal Reserve and the FDIC approved a new
rule that will substantially amend the regulatory risk-based capital rules to implement the Basel III regulatory capital reforms
and changes required by the Dodd-Frank Act.
For additional information, see “—Capital Adequacy” below.
Subsidiary Bank. Heritage Bank is a Washington-chartered commercial bank, the deposits of which are insured by the
FDIC. Heritage Bank is subject to regulation by the FDIC and the Division.
Applicable Federal and State statutes and regulations which govern a bank’s operations relate to minimum capital
requirements, required reserves against deposits, investments, loans, legal lending limits, mergers and consolidation,
borrowings, issuance of securities, payment of dividends, establishment of branches, and other aspects of its operations,
among other things. The Division and the FDIC also have authority to prohibit banks under their supervision from engaging in
what they consider to be unsafe and unsound practices.
The Bank is required to file periodic reports with the FDIC and the Division, and is subject to periodic examinations and
evaluations by those regulatory authorities. Based upon these evaluations, the regulators may revalue the assets of an
institution and require that it establish specific reserves to compensate for the differences between the determined value and
the book value of such assets. These examinations must be conducted every 12 months, except that well-capitalized banks
may be examined every 18 months. The FDIC and the Division may each accept the results of an examination by the other in
lieu of conducting an independent examination.
Dividends paid by the Bank provide substantially all of our cash flow. Applicable Federal and Washington State regulations
restrict capital distributions by our Bank, including dividends. Such restrictions are tied to the institution’s capital levels after
giving effect to such distributions. For an additional discussion of restrictions on the payment of dividends, see “Item 5. Market
for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities” herein.
Capital Adequacy. The Federal Reserve and FDIC have issued substantially similar risk-based and leverage capital
guidelines applicable to bank holding companies and banks. In addition, these regulatory agencies may from time to time
require that a bank holding company or bank maintain capital above the minimum levels, based on its financial condition or
actual or anticipated growth.
The Federal Reserve’s risk-based guidelines for bank holding companies establish a two-tier capital framework. Tier 1
capital generally consists of common stockholders’ equity (which does not include unrealized gains and losses on investment
securities available for sale), less goodwill and certain identifiable intangible assets. Tier 2 capital includes Tier 1 capital plus
the allowance for loan losses and subordinated debt, both subject to some limitations. The sum of Tier 1 and Tier 2 capital
represents qualifying total capital, at least 50% of which must consist of Tier 1 capital.
22
Risk-based capital ratios are calculated by dividing Tier 1 and total capital by risk-weighted assets. Assets and off-balance
sheet exposures are assigned to one of four categories of risk-weights, based primarily on relative credit risk. The minimum
Tier 1 risk- based capital ratios under these guidelines at December 31, 2014 were 4% and 8%, respectively. At December 31,
2014, we had consolidated Tier 1 risk-based capital and total risk-based capital of 13.9% and 15.1%, respectively.
The Federal Reserve’s leverage capital guidelines establish a minimum leverage ratio determined by dividing Tier 1
capital by adjusted average total assets. The minimum leverage ratio is 3% for bank holding companies that meet certain
specified criteria, including having the highest regulatory rating. All other bank holding companies generally are required to
maintain a leverage ratio of at least 4%. At December 31, 2014, we had a consolidated leverage ratio of 10.2%.
In July 2013, the Federal banking regulators approved a final rule to implement the revised capital adequacy standards of
the Basel Committee on Banking Supervision, commonly called Basel III, and to address relevant provisions of the Dodd-Frank
Act. The final rule includes new risk-based capital and leverage ratios, which are effective January 1, 2015, and revise the
definition of what constitutes “capital” for purposes of calculating those ratios. The proposed new minimum capital level
requirements applicable to the Company and the Bank will be: (i) a new common equity Tier 1 capital ratio of 4.5%; (ii) a Tier 1
capital ratio of 6% (increased from 4%); (iii) a total capital ratio of 8% (unchanged from current rules); and (iv) a Tier 1 leverage
ratio of 4% for all institutions. The rule eliminates the inclusion of certain instruments, such as trust preferred securities, from
Tier 1 capital. Instruments issued prior to May 19, 2010 will be grandfathered for companies with consolidated assets of $15
billion or less. The rule also establishes a “capital conservation buffer” of 2.5% above the new regulatory minimum capital
requirements, which must consist entirely of common equity Tier 1 capital and would result in the following minimum ratios:
(i) a common equity Tier 1 capital ratio of 7.0%, (ii) a Tier 1 capital ratio of 8.5%, and (iii) a total capital ratio of 10.5%. The new
capital conservation buffer requirement will be phased in beginning in January 2016 at 0.625% of risk-weighted assets and
would increase by that amount each year until fully implemented in January 2019. An institution would be subject to limitations
on paying dividends, engaging in share repurchases, and paying discretionary bonuses if its capital level falls below the buffer
amount. These limitations would establish a maximum percentage of eligible retained income that could be utilized for such
actions.
The FDIC may impose additional restrictions on institutions that are undercapitalized and generally is authorized to
reclassify an institution into a lower capital category and impose the restrictions applicable to such category if the institution is
engaged in unsafe or unsound practices or is in an unsafe or unsound condition. An institution is deemed “well capitalized” if it
has at least a 5.0% Tier 1 capital ratio, a 6.0% Tier 1 risk-based capital ratio and 10.0% total risk-based capital ratio. At
December 31, 2014, the Bank’s current capital levels exceed the required capital amounts to be considered “well capitalized”
and we believe it also meets the fully-phased in minimum capital requirements, including the related capital conservation
buffers, as required by the Basel III capital rules.
For a complete description of the Company’s and the Bank's required and actual capital levels as of December 31, 2014,
see Note 23 - Regulatory Capital Requirements of the Notes to Consolidated Financial Statements included in “Item 8.
Financial Statements and Supplementary Data.”
Prompt Corrective Action. Federal statutes establish a supervisory framework based on five capital categories: well
capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. An
institution’s category depends upon where its capital levels are in relation to relevant capital measures, which include a risk-
based capital measure, a leverage ratio capital measure and certain other factors. The federal banking agencies have adopted
regulations that implement this statutory framework. Under these regulations, an institution is treated as well capitalized if its
ratio of total capital to risk-weighted assets is 10% or more, its ratio of core capital to risk-weighted assets is 6% or more, its
ratio of core capital to adjusted total assets (leverage ratio) is 5% or more, and it is not subject to any federal supervisory order
or directive to meet a specific capital level. In order to be adequately capitalized, an institution must have a total risk-based
capital ratio of not less than 8%, a core capital to risk-weighted assets ratio of not less than 4%, and a leverage ratio of not less
than 4%. An institution that is not well capitalized is subject to certain restrictions on brokered deposits, including restrictions on
the rates it can offer on its deposits generally. Any institution which is neither well capitalized nor adequately capitalized is
considered undercapitalized.
Undercapitalized institutions are subject to certain prompt corrective action requirements, regulatory controls and
restrictions which become more extensive as an institution becomes more severely undercapitalized. Failure by Heritage Bank
to comply with applicable capital requirements would, if unremedied, result in progressively more severe restrictions on its
activities and lead to enforcement actions, including, but not limited to, the issuance of a capital directive to ensure the
maintenance of required capital levels and, ultimately, the appointment of the FDIC as receiver or conservator. Banking
23
regulators will take prompt corrective action with respect to depository institutions that do not meet minimum capital
requirements. Additionally, approval of any regulatory application filed for their review may be dependent on compliance with
capital requirements.
As of December 31, 2014, the Bank met the requirements to be classified as “well capitalized.” See Note 23 - Regulatory
Capital Requirements of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and
Supplementary Data.”
Federal law generally bars institutions which are not well capitalized from soliciting or accepting brokered deposits bearing
interest rates significantly higher than prevailing market rates.
The recently adopted final rule to strengthen regulatory capital standards will adjust the prompt corrective action
categories accordingly.
Deposit Insurance and Other FDIC Programs. The deposits of the Bank are insured up to applicable limits by the
Deposit Insurance Fund (“DIF”), which is administered by the FDIC. The FDIC is an independent federal agency that insures
the deposits, up to applicable limits, of depository institutions. As insurer of the Bank's deposits, the FDIC has supervisory and
enforcement authority over Heritage Bank and this insurance is backed by the full faith and credit of the United States
government. As insurer, the FDIC imposes deposit insurance premiums and is authorized to conduct examinations of and to
require reporting by institutions insured by the FDIC. It also may prohibit any institution insured by the FDIC from engaging in
any activity determined by regulation or order to pose a serious risk to the institution and the DIF. The FDIC also has the
authority to initiate enforcement actions and may terminate the deposit insurance if it determines that an institution has
engaged in unsafe or unsound practices or is in an unsafe or unsound condition.
The Dodd-Frank Act requires the FDIC’s deposit insurance assessments to be based on assets instead of deposits. The
FDIC issued rules under which the assessment base for a bank is equal to its total average consolidated assets less average
tangible capital. The FDIC assessment rates range from approximately five basis points to 35 basis points, depending on
applicable adjustments for unsecured debt issued by an institution and brokered deposits (and to further adjustment for
institutions that hold unsecured debt of other FDIC-insured institutions), until such time as the FDIC’s reserve ratio equals
1.15%. Once the FDIC’s reserve ratio reaches 1.15% and the reserve ratio for the immediately prior assessment period is less
than 2.0%, the applicable assessment rates may range from three basis points to 30 basis points (subject to adjustments as
described above). If the reserve ratio for the prior assessment period is equal to, or greater than 2.0% and less than 2.5%, the
assessment rates may range from two basis points to 28 basis points and if the prior assessment period is greater than 2.5%,
the assessment rates may range from one basis point to 25 basis points (in each case subject to adjustments as described
above). No institution may pay a dividend if it is in default on its federal deposit insurance assessment.
As insurer, the FDIC is authorized to conduct examinations of and to require reporting by FDIC-insured institutions. It also
may prohibit any FDIC-insured institution from engaging in any activity the FDIC determines by regulation or order to pose a
serious threat to the DIF. The FDIC also has the authority to take enforcement actions against banks and savings associations.
Other Regulatory Developments. Significant federal banking legislation has been enacted in recent years. The following
summarizes some of the recent significant federal banking legislation.
The Dodd-Frank Act: The Dodd-Frank-Act imposes new restrictions and an expanded framework of regulatory oversight
for financial institutions, including depository institutions and implements new capital regulations that we will become subject to
and that are discussed above under “- Capital Adequacy.”
The federal banking and securities regulators have issued final rules to implement Section 619 of the Dodd-Frank Act (the
“Volcker Rule”) pursuant to the Dodd-Frank Act. Generally, subject to a transition period and certain exceptions, the Volcker
Rule restricts insured depository institutions and their affiliated companies from engaging in short-term proprietary trading of
certain securities, investing in funds with collateral comprised of less than 100% loans that are not registered with the
Securities and Exchange Commission (“SEC”) and from engaging in hedging activities that do not hedge a specific identified
risk. After the transition period, the Volcker Rule prohibitions and restrictions will apply to banking entities, including the
Company, unless an exception applies. We are continuously reviewing our investment portfolio to determine if changes to our
investment strategies may be required in order to comply with the various provisions of the Volcker Rule regulations.
24
In addition, among other changes, the Dodd-Frank Act requires public companies, like us, to (i) provide their shareholders
with a non-binding vote (a) at least once every three years on the compensation paid to executive officers and (b) at least once
every six years on whether they should have a “say on pay” vote every one, two or three years; (ii) have a separate, non-
binding shareholder vote regarding golden parachutes for named executive officers when a shareholder vote takes place on
mergers, acquisitions, dispositions or other transactions that would trigger the parachute payments; (iii) provide disclosure in
annual proxy materials concerning the relationship between the executive compensation paid and the financial performance of
the issuer; and (iv) amend Item 402 of Regulation S-K to require companies to disclose the ratio of the Chief Executive
Officer's annual total compensation to the median annual total compensation of all other employees. For certain of these
changes, the implementing regulations have not been promulgated, so the full impact of the Dodd-Frank Act on public
companies cannot be determined at this time.
Sarbanes-Oxley Act. As a public company that files periodic reports with the SEC, under the Securities Exchange Act of
1934, Heritage is subject to the Sarbanes-Oxley Act of 2002, which addresses, among other issues, corporate governance,
auditing and accounting, executive compensation and enhanced and timely disclosure of corporate information.
The Sarbanes-Oxley Act represents significant federal involvement in matters traditionally left to state regulatory systems,
such as the regulation of the accounting profession, and to state corporate law, such as the relationship between a board of
directors and management and between a board of directors and its committees. Our policies and procedures have been
updated to comply with the requirements of the Sarbanes-Oxley Act.
Website Access to Company Reports
We post publicly available reports required to be filed with the SEC on our website, www.HF-WA.com, as soon as
reasonably practicable after filing such reports with the SEC. The required reports are available free of charge through our
website.
Code of Ethics
We have adopted a Code of Ethics that applies to our principal executive officer, principal financial officer and controller.
We have posted the text of our code of ethics at www.HF-WA.com in the section titled Investor Information: Corporate
Governance. Any waivers of the code of ethics will be publicly disclosed to shareholders.
Competition
We compete for loans and deposits with other commercial banks, credit unions, mortgage bankers, and other institutions
in the scope and type of services offered, interest rates paid on deposits, pricing of loans, and number and locations of
branches, among other things. Many of our competitors have substantially greater resources than we do. Particularly in times
of high or rising interest rates, we also face significant competition for investors’ funds from short-term money market securities
and other corporate and government securities.
We compete for loans principally through the range and quality of the services we provide, interest rates and loan fees,
and the locations of our Bank's branches. We actively solicit deposit-related clients and compete for deposits by offering
depositors a variety of savings accounts, checking accounts, cash management and other services.
Employees
We had 748 full-time equivalent employees at December 31, 2014. We believe that employees play a vital role in the
success of a service company. Employees are provided with a variety of benefits such as medical, vision, dental and life
insurance, a retirement plan, and paid vacations and sick leave. None of our employees are covered by a collective bargaining
agreement.
25
Executive Officers
The following table sets forth certain information with respect to the executive officers of the Company at December 31,
2014.
Name
Brian L. Vance ............................
Jeffrey J. Deuel ..........................
Donald J. Hinson .......................
David A. Spurling .......................
Bryan McDonald (1) ...................
Age as of
December 31,
2014
Position
Has Served the
Company or
Heritage Bank
Since
60 President and Chief Executive
Officer of Heritage; Chief
Executive Officer of Heritage Bank
56 Executive Vice President, Heritage;
President and Chief Operating
Officer of Heritage Bank
53 Executive Vice President and Chief
Financial Officer of Heritage and
Heritage Bank
61 Executive Vice President and Chief
Credit Officer of Heritage and
Heritage Bank
43 Executive Vice President and Chief
Lending Officer of Heritage Bank
1996
2010
2005
1999
2014
(1) Former executive officer of Washington Banking Company.
The business experience of each executive officer is set forth below.
Brian L. Vance is the President and Chief Executive Officer of Heritage and Chief Executive Officer of Heritage Bank as
well as a director of Heritage. Mr. Vance was appointed President and Chief Executive Officer of Heritage and Heritage Bank
in 2006. In 2003, Mr. Vance was appointed President and Chief Executive Officer of Heritage Bank and in 1998, Mr. Vance
was named President and Chief Operating Officer of Heritage Bank. Mr. Vance joined Heritage Bank in 1996 as its Executive
Vice President and Chief Credit Officer. Prior to joining Heritage Bank, Mr. Vance was employed for 24 years with West One
Bank, a bank with offices in Idaho, Utah, Oregon and Washington. Prior to leaving West One, he was Senior Vice President
and Regional Manager of Banking Operations for the south Puget Sound region.
Jeffrey J. Deuel was promoted to President and Chief Operating Officer of Heritage Bank and Executive Vice President of
Heritage in September 2012. In November 2010, Mr. Deuel was named Executive Vice President and Chief Operating Officer
of Heritage Bank and Executive Vice President of the Company. Mr. Deuel joined Heritage Bank in February 2010 as
Executive Vice President. Mr. Deuel came to the Company with 28 years of banking experience and most recently held the
position of Executive Vice President Commercial Operations with JPMorgan Chase, formerly Washington Mutual. Prior to
joining Washington Mutual Mr. Deuel was based in Philadelphia where he worked for Bank United, First Union Bank,
CoreStates Bank, and First Pennsylvania Bank. During his career Mr. Deuel held a variety of leadership positions in
commercial banking including lending, retail and support services, corporate strategies, credit administration, and portfolio
management. He earned his Bachelor’s degree at Gettysburg College.
Donald J. Hinson became Executive Vice President and Chief Financial Officer of Heritage and Heritage Bank in
September 2012. In 2007, Mr. Hinson was appointed the Senior Vice President and Chief Financial Officer of Heritage and
Heritage Bank. Mr. Hinson joined Heritage Bank in 2005 as Vice President and Controller. Prior to that, he served in the
banking audit practice of local and national accounting firms of Knight, Vale and Gregory and RSM McGladrey from 1994 to
2005. Mr. Hinson holds a Bachelors of Science degree in Accounting from Central Washington University and is a licensed
Certified Public Accountant.
David A. Spurling became Executive Vice President and Chief Credit Officer of Heritage and Heritage Bank in January
2014. Prior to that, he was the Senior Vice President and Chief Credit Officer of Heritage Bank beginning in 2007. Mr. Spurling
joined Heritage Bank in 2001 as a commercial lender, followed by a role as a commercial team leader. He began his banking
career as a middle market lender at Seafirst Bank, followed by positions as a commercial lender at Bank of America in Small
Business Banking and as a regional manager for Bank of America’s government-guaranteed lending division. Mr. Spurling
holds a Master’s Degree in Business Administration from the University of Washington and is Credit Risk Certified by the Risk
Management Association.
26
Bryan McDonald became Executive Vice President and Chief Lending Officer of Heritage Bank upon completion of the
Washington Banking Merger effective on May 1, 2014. Prior to that, Mr. McDonald was President and Chief Executive Officer
of Whidbey Island Bank since January 1, 2012. Mr. McDonald joined Whidbey Island Bank in 2006 as Commercial Banking
Manager and he served as Senior Vice President and Chief Operating Officer of Whidbey Island Bank from April 1, 2010 until
his promotion to Executive Vice President on August 26, 2010. Mr. McDonald has been serving in the banking industry since
1994, including in regional commercial lending management roles since 1996 for Washington Mutual and Peoples Bank. Mr.
McDonald holds a Bachelor's and Master’s Degree in Business Administration from Washington State University.
ITEM 1A. RISK FACTORS
We assume and manage a certain degree of risk in order to conduct our business strategy. The following provides a
discussion of certain risks that management believes are specific to our business. This discussion should not be viewed as an
all inclusive list or in any particular order.
Our strategy of pursuing acquisitions and de novo branching exposes us to financial and operational risks that could
adversely affect us.
We are pursuing a strategy of supplementing organic growth by acquiring other financial institutions or their businesses
that we believe will help us fulfill our strategic objectives and enhance our earnings. There are risks associated with this
strategy, however, including the following:
• we may be exposed to potential asset quality issues or unknown or contingent liabilities of the banks, businesses,
assets and liabilities we acquire. If these issues or liabilities exceed our estimates, our results of operations and
financial condition may be materially negatively affected;
•
•
prices at which acquisitions can be made fluctuate with market conditions. We have experienced times during which
acquisitions could not be made in specific markets at prices we considered acceptable and expect that we may
continue to experience this condition in the future;
the acquisition of other entities generally requires integration of systems, procedures and personnel of the acquired
entity into our company to make the transaction economically successful. This integration process is complicated and
time consuming and can also be disruptive to the customers of the acquired business. If the integration process is not
conducted successfully and with minimal effect on the acquired business and its customers, we may not realize the
anticipated economic benefits of an acquisition within the expected time frame, and we may lose customers or
employees of the acquired business. We may also experience greater than anticipated customer losses even if the
integration process is successful. These risks are present in our completed FDIC-assisted transactions involving our
assumption of deposits and the acquisition of assets of Cowlitz Bank and Pierce Commercial Bank in July 2010 and
November 2010, respectively; and in the completed open-bank acquisitions of NCB and Valley Community
Bancshares in January 2013 and July 2013, respectively, and in the merger of Washington Banking Company in May
2014;
•
to finance an acquisition, we may borrow funds, thereby increasing our leverage and diminishing our liquidity, or raise
additional capital, which could dilute the interests of our existing shareholders;
• we completed two acquisitions during 2010, two acquisitions during 2013 and one merger in 2014 that enhanced our
rate of growth. We may not be able to continue to sustain our past rate of growth or to grow at all in the future;
• we expect our net income will increase following our acquisitions, however, we also expect our general and
administrative expenses and consequently our efficiency ratios will also increase. Ultimately, we would expect our
efficiency ratio to improve; however, if we are not successful in our integration process, this may not occur, and our
acquisitions or branching activities may not be accretive to earnings in the short or long-term; and
•
the purchase and assumption agreement and the shared-loss agreements we entered into with the FDIC in
connection with the Cowlitz Acquisition and the Pierce Acquisition, have specific, detailed and cumbersome
compliance, servicing, notification and reporting requirements. Our failure to comply with the terms of the agreements
or to properly service the loans and real estate owned under the requirements of the shared-loss agreements may
cause individual loans or large pools of loans to lose eligibility for shared-loss payments from the FDIC. This could
result in material losses that are currently not anticipated.
27
Our business strategy includes significant growth plans, and our financial condition and results of operations could
be negatively affected if we are not successful in executing this strategy or if we fail to grow or manage our growth
effectively.
We intend to pursue a significant growth strategy for our business. We regularly evaluate potential acquisitions and
expansion opportunities. If appropriate opportunities present themselves, we expect to engage in selected acquisitions of
financial institutions in the future, including branch acquisitions, or other business growth initiatives or undertakings. There can
be no assurance that we will successfully identify appropriate opportunities, that we will be able to negotiate or finance such
activities or that such activities, if undertaken, will be successful.
Our growth initiatives may require us to recruit experienced personnel to assist in such initiatives, which will increase our
compensation costs. In addition, the failure to identify and retain such personnel would place significant limitations on our
ability to successfully execute our growth strategy. To the extent we expand our lending beyond our current market areas, we
also could incur additional risk related to those new market areas. We may not be able to expand our market presence in our
existing market areas or successfully enter new markets.
If we do not successfully execute our acquisition growth plan, it could adversely affect our business, financial condition,
results of operations, reputation and growth prospects. In addition, if we were to conclude that the value of an acquired
business had decreased and that the related goodwill had been impaired, that conclusion would result in an impairment of
goodwill charge to us, which would adversely affect our results of operations. While we believe we have the executive
management resources and internal systems in place to successfully manage our future growth, there can be no assurance
that suitable growth opportunities will be available or that we will successfully manage our growth. See “-If the goodwill we
have recorded in connection with acquisitions becomes impaired, our earnings and capital could be reduced” and “-Our
strategy of pursuing acquisitions and de novo branching exposes us to financial and operational risks that could adversely
affect us” for additional risks related to our acquisition strategy.
We operate in a highly regulated environment and may be adversely affected by changes in federal and state laws and
regulations.
The financial services industry is extensively regulated. We are subject to extensive examination, supervision and
comprehensive regulation by the Federal Reserve and Heritage Bank is subject to examination, supervision and
comprehensive regulation by the FDIC and the Division. The Federal Reserve, FDIC and Division govern the activities in which
we may engage, primarily for the protection of depositors and the Deposit Insurance Fund. These regulatory authorities have
extensive discretion in connection with their supervisory and enforcement activities, including the ability to impose
requirements for additional capital, restrictions on operations, the reclassification of assets, and the determination of the
adequacy of the allowance for loan losses and level of deposit insurance premiums assessed. In addition, these bank
regulators also have the ability to impose additional conditions in the approval of merger and acquisition transactions.
As discussed under “Item 1. Business - Supervision and Regulation - Capital Adequacy” of this Form 10-K, the Dodd-
Frank Act has significantly changed the bank regulatory structure and will affect the lending, deposit, investment, trading and
operating activities of financial institutions and their holding companies. The Dodd-Frank Act requires various federal agencies
to adopt a broad range of new implementing rules and regulations, and to prepare numerous studies and reports for Congress.
The federal agencies are given significant discretion in drafting and implementing rules and regulations, and consequently,
many of the details and much of the impact of the Dodd-Frank Act may not be known for many months or years. It is difficult at
this time to predict when or how any new standards will ultimately be applied to us or what specific impact the Dodd-Frank Act
and the yet to be written implementing rules and regulations will have on community banks. However, it is expected that at a
minimum they will increase our operating and compliance costs and could increase our noninterest expense.
28
We may face increased compliance costs and uncertainty in residential mortgage lending as a result of the adoption
of consumer protection regulations by the Consumer Financial Protection Bureau.
The Dodd Frank Act created a new Consumer Financial Protection Bureau (“CFPB”) with broad powers to supervise and
enforce consumer protection laws. The CFPB has broad rule-making authority for a wide range of consumer protection laws
that apply to all banks and savings institutions, including the authority to prohibit “unfair, deceptive or abusive” acts and
practices. The CFPB has issued a rule designed to clarify for lenders how they can avoid monetary damages under the Dodd-
Frank Act, which would hold lenders accountable for ensuring a borrower’s ability to repay a mortgage. Loans that meet this
“qualified mortgage” definition will be presumed to have complied with the new ability-to-repay standard. Under the CFPB’s
rule, a “qualified mortgage” loan must not contain certain specified features, including:
•
•
•
•
excessive upfront points and fees (those exceeding 3% of the total loan amount, less “bona fide discount points” for
prime loans);
interest-only payments;
negative-amortization; and
terms longer than 30 years.
Also, to qualify as a “qualified mortgage,” a borrower’s total debt-to-income ratio may not exceed 43%. Lenders must also
verify and document the income and financial resources relied upon to qualify the borrower for the loan and underwrite the
loan based on a fully amortizing payment schedule and maximum interest rate during the first five years, taking into account all
applicable taxes, insurance and assessments. The CFPB’s rule on qualified mortgages could limit our ability or desire to make
certain types of loans or loans to certain borrowers, or could make it more expensive and/or time consuming to make these
loans, which could limit our growth or profitability.
Our loan portfolio is concentrated in loans with a higher risk of loss.
Repayment of our commercial business loans, consisting of commercial and industrial loans as well as owner-occupied
and non-owner occupied commercial real estate loans, is often dependent on the cash flows of the borrower, which may be
unpredictable, and the collateral securing these loans may fluctuate in value. We offer different types of commercial loans to
a variety of businesses with a focus on real estate related industries and businesses in agricultural, healthcare, legal, and other
professions. The types of commercial loans offered are business lines of credit, term equipment financing and term real estate
loans. We also originate loans that are guaranteed by the Small Business Administration, or SBA, and are a “preferred lender”
of the SBA. Commercial business lending involves risks that are different from those associated with real estate lending. Real
estate lending is generally considered to be collateral based lending with loan amounts established on predetermined loan to
collateral values and liquidation of the underlying real estate collateral being viewed as the primary source of repayment in the
event of borrower default. Our commercial business loans are primarily made based on our assessment of the cash flow of the
borrower and secondarily on the underlying collateral provided by the borrower. The borrower's cash flow may be
unpredictable, and collateral securing these loans may fluctuate in value. Although commercial business loans are often
collateralized by equipment, inventory, accounts receivable or other business assets, the liquidation of collateral in the event of
default is often an insufficient source of repayment because accounts receivable may be uncollectible and inventories may be
obsolete or of limited use, among other things. Accordingly, the repayment of commercial business loans depends primarily on
the cash flow and creditworthiness of the borrower and secondarily on the underlying collateral provided by the borrower. In
addition, as part of our commercial business lending activities, we originate agricultural loans. Payments on agricultural loans
are typically dependent on the profitable operation or management of the related farm property. The success of the farm may
be affected by many factors outside the control of the borrower, including adverse weather conditions that prevent the planting
of a crop or limit crop yields, declines in market prices for agricultural products and the impact of government regulations. In
addition, many farms are dependent on a limited number of key individuals whose injury or death may significantly affect the
successful operation of the farm. If the cash flow from a farming operation is diminished, the borrower’s ability to repay the loan
may be impaired.
At December 31, 2014, our noncovered commercial business loans (consisting of commercial and industrial loans, owner-
occupied commercial real estate loans and non-owner occupied commercial real estate loans) totaled $1.70 billion, or
approximately 80.2% of our total noncovered loan portfolio. Approximately $4.7 million, or 0.3%, of our total noncovered
commercial business loans were nonperforming at December 31, 2014. The majority of the nonperforming commercial
business loans were commercial and industrial loans.
29
Our non-owner occupied commercial real estate loans, which includes five or more family residential real estate loans,
involve higher principal amounts than other loans and repayment of these loans may be dependent on factors outside our
control or the control of our borrowers. We originate commercial and five or more family residential real estate loans for
individuals and businesses for various purposes, which are secured by commercial properties. These loans typically involve
higher principal amounts than other types of loans, and repayment is dependent upon income generated, or expected to be
generated, by the property securing the loan in amounts sufficient to cover operating expenses and debt service, which may
be adversely affected by changes in the economy or local market conditions. For example, if the cash flow from the borrower’s
project is reduced as a result of leases not being obtained or renewed, the borrower’s ability to repay the loan may be
impaired.
Commercial and five or more family residential real estate loans also expose us to greater credit risk than loans secured
by residential real estate because the collateral securing these loans typically cannot be sold as easily as residential real
estate. In addition, many of our commercial and five or more family residential real estate loans are not fully amortizing and
contain large balloon payments upon maturity. Such balloon payments may require the borrower to either sell or refinance the
underlying property in order to make the payment, which may increase the risk of default or non-payment. If we foreclose on a
commercial and five or more family residential real estate loan, our holding period for the collateral typically is longer than for
one-to-four family residential loans because there are fewer potential purchasers of the collateral. Additionally, commercial and
five or more family residential real estate loans generally have relatively large balances to single borrowers or related groups of
borrowers. Accordingly, if we make any errors in judgment in the collectability of our commercial and five or more family
residential real estate loans, any resulting charge-offs may be larger on a per loan basis than those incurred with our
residential or consumer loan portfolios.
As of December 31, 2014, our non-owner occupied commercial real estate loans totaled $616.8 million, or 29.0% of our
total noncovered loan portfolio.
Our real estate construction and land development loans are based upon estimates of costs and value associated with the
completed project. These estimates may be inaccurate. Construction lending can involve a higher level of risk than other
types of lending because funds are advanced partially based upon the value of the project, which is uncertain prior to the
project’s completion. Because of the uncertainties inherent in estimating construction costs as well as the market value of a
completed project and the effects of governmental regulation of real property, our estimates with regards to the total funds
required to complete a project and the related loan-to-value ratio may vary from actual results. As a result, construction loans
often involve the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project
and the ability of the borrower to sell or lease the property or refinance the indebtedness. If our estimate of the value of a
project at completion proves to be overstated, it may have inadequate security for repayment of the loan and may incur a loss.
As of December 31, 2014, our noncovered real estate construction and land development loans totaled $108.1 million, or
5.1% of our total noncovered loan portfolio. Of these loans, $46.7 million, or 2.2% of our total noncovered loan portfolio, were
one-to-four family residential construction related and $61.4 million, or 2.9% of our total noncovered loan portfolio, were five-or-
more family residential and commercial property construction related. Approximately $2.7 million, or 2.5%, of our total
noncovered construction loans were nonperforming at December 31, 2014.
Our allowance for loan losses may prove to be insufficient to absorb losses in our loan portfolio.
Lending money is a substantial part of our business. Every loan carries a certain risk that it will not be repaid in
accordance with its terms or that any underlying collateral will not be sufficient to assure repayment. This risk is affected by,
among other things:
•
•
•
•
•
cash flow of the borrower and/or the project being financed;
the changes and uncertainties as to the future value of the collateral, in the case of a collateralized loan;
the character and creditworthiness of a particular borrower;
changes in economic and industry conditions; and
the duration of the loan.
30
We maintain an allowance for loan losses on our loans, which is a reserve established through a provision for loan losses
charged against earnings, which we believe is appropriate to absorb known and inherent losses in our loan portfolio. The
amount of this allowance is determined by our management through a periodic review and consideration of several factors,
including, but not limited to:
•
•
our general reserve, based on our historical default and loss experience;
our specific reserve, based on our evaluation of nonperforming loans and their underlying collateral or discounted
cash flows; and
•
current macroeconomic factors and management’s expectation of future events.
The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity
and requires us to make significant estimates of current credit risks and future trends, all of which may undergo material
changes. Deterioration in economic conditions affecting borrowers, new information regarding existing loans, identification of
additional problem loans and other factors, both within and outside of our control, may require an increase in the allowance for
loan losses. If current conditions in the housing and real estate markets weaken, we expect we will experience increased
delinquencies and credit losses. In addition, bank regulatory agencies periodically review our allowance for loan losses and
may require an increase in the provision for possible loan losses or the recognition of further loan charge-offs, based on
judgments different than those of management. In addition, if charge-offs in future periods exceed the allowance for loan
losses we will need additional provisions to increase the allowance for loan losses. Any increases in the allowance for loan
losses will result in a decrease in net income and possibly capital, and may have a material adverse effect on our financial
condition and results of operations.
If our allowance for loan losses is not adequate, we may be required to make further increases in our provision for
loan losses and to charge-off additional loans, which could adversely affect our results of operations and our capital.
For the year ended December 31, 2014 we recorded a total provision for loan losses of $4.6 million compared to $3.7
million for the year ended December 31, 2013. The provision related to the noncovered portfolio was $2.2 million and $1.8
million for the years ended December 31, 2014 and 2013, respectively. Our provision for loan losses on covered loans was
$2.4 million and $1.9 million for the years ended December 31, 2014 and 2013, respectively. We recorded net loan charge-offs
for noncovered loans of $2.7 million for the year ended December 31, 2014 compared to $3.4 million for the year ended
December 31, 2013. The net charge-offs for covered loans was $3.0 million and $73,000 for the years ended December 31,
2014 and 2013, respectively. At December 31, 2014 our total nonperforming noncovered loans were $7.5 million, or 0.35% of
total noncovered loans, compared to $7.7 million or 0.66% of total noncovered loans at December 31, 2013. Generally, our
nonperforming loans and assets reflect operating difficulties of individual borrowers, which may be the result of current
economic conditions. If economic conditions deteriorate, we expect that we could experience significantly higher delinquencies
and loan charge-offs. As a result, we may be required to make further increases in our provision for loan losses in the future,
which could adversely affect our financial condition and results of operations, perhaps materially.
General economic conditions tend to impact loan segments at varying degrees. Our commercial and industrial loan
portfolio, which represented 46.1% of our nonaccrual noncovered loans at December 31, 2014, generally has the largest
percentage of nonperforming loans as the borrowers are primarily business owners whose business results are influenced by
deteriorating economic conditions. Slower sales and excess inventory in the housing market has been the primary cause of
deterioration in our one-to-four family residential construction loans, which represented 35.3% of our nonperforming
noncovered loans at December 31, 2014.
31
The current economic condition in the market areas we serve may adversely impact our earnings and could increase
the credit risk associated with our loan portfolio.
Substantially all of our loans are to businesses and individuals in the states of Washington and Oregon, and a decline in
the economies of our primary market areas of the Pacific Northwest could have a material adverse effect on our business,
financial condition, results of operations and prospects.
Weakness or a deterioration in economic conditions in the market areas we serve could result in the following
consequences, any of which could have a materially adverse impact on our business, financial condition and results of
operations:
•
loan delinquencies, problem assets and foreclosures may increase;
• we may increase our provision for loan losses;
•
•
•
•
demand for our products and services may decline possibly resulting in a decrease in our total loans;
collateral for loans made may decline further in value, exposing us to increased risk of loss on existing loans;
the net worth and liquidity of loan guarantors may decline, impairing their ability to honor commitments to us; and
the amount of our deposits may decrease and the composition of our deposits may be adversely affected.
If the goodwill we have recorded in connection with acquisitions becomes impaired, our earnings and capital could
be reduced.
Accounting standards require that we account for acquisitions using the purchase method of accounting. Under purchase
accounting, if the purchase price of an acquired company exceeds the fair value of its net assets, the excess is carried on the
acquirer’s balance sheet as goodwill. In accordance with generally accepted accounting principles, our goodwill is evaluated
for impairment on an annual basis or more frequently if events or circumstances indicate that a potential impairment exists.
Such evaluation is based on a variety of factors, including the quoted price of our common stock, market prices of common
stock of other banking organizations, common stock trading multiples, discounted cash flows, and data from comparable
acquisitions. At December 31, 2014, we had goodwill with a carrying amount of $119.0 million.
Declines in our stock price or a prolonged weakness in the operating environment of the financial services industry may
result in a future impairment charge. Any such impairment charge could have a material adverse affect on our operating results
and capital.
Fluctuating interest rates can adversely affect our profitability.
Our profitability is dependent to a large extent upon net interest income, which is the difference (or “spread”) between the
interest earned on loans, securities and other interest earning assets and the interest paid on deposits, borrowings, and other
interest bearing liabilities. Because of the differences in maturities and repricing characteristics of our interest earning assets
and interest bearing liabilities, changes in interest rates do not produce equivalent changes in interest income earned on
interest earning assets and interest paid on interest bearing liabilities. Accordingly, fluctuations in interest rates could adversely
affect our interest rate spread, and, in turn, our profitability.
Although management believes it has implemented effective asset and liability management strategies to reduce the
potential effects of changes in interest rates on our results of operations, any substantial, unexpected or prolonged change in
market interest rates could have a material adverse effect on our financial condition and results of operations. Also, our interest
rate risk modeling techniques and assumptions likely may not fully predict or capture the impact of actual interest rate changes
on our balance sheet.
Historically low interest rates may adversely affect our net interest income and profitability.
During the past several years it has been the policy of the Federal Reserve to maintain interest rates at historically low
levels through its targeted federal funds rate and the purchase of mortgage-backed securities. As a result, market rates on the
loans we have originated and the yields on securities we have purchased have been at lower levels than available prior to
2008. As a general matter, our interest bearing liabilities reprice or mature more quickly than our interest earning assets, which
has been one factor contributing to the increase in our interest rate spread as interest rates decreased. However, our ability to
32
lower our interest expense will be limited at these interest rate levels while the average yield on our interest earning assets
may continue to decrease. The Federal Reserve has recently indicated its intention to maintain low interest rates through at
least late 2015. Accordingly, our net interest income may be adversely affected and may decrease, which may have an
adverse effect on our profitability.
Decreased volumes and lower gains on sales of mortgage loans sold could adversely impact our noninterest income.
We originate and sell one-to-four family residential loans. Our mortgage banking income is a significant portion of our
noninterest income. We generate gains on the sale of one-to-four family residential loans pursuant to programs currently
offered by Freddie Mac and other secondary market purchasers. Any future changes in their purchase programs, our eligibility
to participate in such programs, the criteria for loans to be accepted or laws that significantly affect the activity of such entities
could, in turn, materially adversely affect our results of operations. Further, in a rising or higher interest rate environment, our
originations of mortgage loans may decrease, resulting in fewer loans that are available to be sold to investors. This would
result in a decrease in mortgage banking revenues and a corresponding decrease in noninterest income. In addition, our
results of operations are affected by the amount of noninterest expense associated with mortgage banking activities, such as
salaries and employee benefits, occupancy, equipment and data processing expense and other operating costs. During
periods of reduced loan demand, our results of operations may be adversely affected to the extent that we are unable to
reduce expenses commensurate with the decline in loan originations.
The tightening of available liquidity could limit our ability to replace deposits and fund loan demand, which could
adversely affect our earnings and capital levels.
A tightening of the credit markets and the inability to obtain adequate funding to replace deposits and fund continued loan
growth may negatively affect asset growth and, consequently, our earnings capability and capital levels. In addition to any
deposit growth, maturity of investment securities and loan payments, we rely from time to time on advances from the Federal
Home Loan Bank of Seattle, or FHLB, and certain other wholesale funding sources to fund loans and replace deposits. In the
event of a further downturn in the economy, these additional funding sources could be negatively affected which could limit the
funds available to us. Our liquidity position could be significantly constrained if we were unable to access funds from the FHLB
or other wholesale funding sources.
Our growth or future losses may require us to raise additional capital in the future, but that capital may not be
available when it is needed or the cost of that capital may be very high; further, the resulting dilution of our equity
may adversely affect the market price of our common stock.
We are required by federal and state regulatory authorities to maintain adequate levels of capital to support our
operations. At some point we may need to raise additional capital to support continued internal growth and growth through
acquisitions. Our ability to raise additional capital, however, will depend on conditions in the capital markets at that time, which
are outside our control, and on our financial condition and performance. If we are able to raise capital it may not be on terms
that are acceptable to us. If we cannot raise additional capital when needed, our ability to further expand our operations
through internal growth and acquisitions could be materially impaired and our financial condition and liquidity could be
materially and adversely affected. Accordingly, we cannot make assurances that we will be able to raise additional capital when
needed.
We are not restricted from issuing additional common stock or preferred stock, including any securities that are convertible
into or exchangeable for, or that represent the right to receive, common stock or preferred stock or any substantially similar
securities. The market price of our common stock could decline as a result of sales of a large number of shares of common
stock or preferred stock or similar securities in the market or from the perception that such sales could occur.
Our Board of Directors is authorized generally to cause us to issue additional common stock, as well as series of preferred
stock, without any action on the part of our shareholders except as may be required under the listing requirements of the
NASDAQ Stock Market. In addition, our Board has the power, without shareholder approval, to set the terms of any such
series of preferred stock that may be issued, including voting rights, dividend rights and preferences over the common stock
with respect to dividends or upon the liquidation, dissolution or winding-up of our business and other terms.
In addition, if we issue preferred stock in the future that has a preference over the common stock with respect to the
payment of dividends or upon liquidation, dissolution or winding-up, or if we issue preferred stock with voting rights that dilute
the voting power of the common stock, the rights of holders of the common stock or the market price of the common stock
could be adversely affected.
33
We rely heavily on the proper functioning of our technology.
We rely heavily on communications and information systems to conduct our business. Any failure, interruption or breach in
security of these systems could result in failures or disruptions in our customer relationship management, general ledger,
deposit, loan and other systems. While we have policies and procedures designed to prevent or limit the effect of the failure,
interruption or security breach of our information systems, there can be no assurance that any such failures, interruptions or
security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures,
interruptions or security breaches of our information systems could damage our reputation, result in a loss of customer
business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which
could have a material adverse effect on our financial condition and results of operations.
We rely on third-party service providers for much of our communications, information, operating and financial control
systems technology. If any of our third-party service providers experience financial, operational or technological difficulties, or if
there is any other disruption in our relationships with them, we may be required to locate alternative sources of such services,
and we cannot assure that we could negotiate terms that are as favorable to us, or could obtain services with similar
functionality, as found in our existing systems, without the need to expend substantial resources, if at all. Any of these
circumstances could have an adverse effect on our business.
Changes in accounting standards may affect how we record and report our performance.
Our accounting policies and methods are fundamental to how we record and report our financial condition and results of
operations. From time to time there are changes in the financial accounting and reporting standards that govern the
preparation of our financial statements. These changes can be difficult to predict and can materially impact how we report and
record our financial condition and results of operations. In some cases, we could be required to apply a new or revised
standard retroactively, resulting in a retrospective adjustment to prior financial statements.
We are dependent on key personnel and the loss of one or more of those key personnel may materially and adversely
affect our prospects.
Competition for qualified employees and personnel in the banking industry is intense and there are a limited number of
qualified persons with knowledge of, and experience in, the community banking industry where we conduct our business. The
process of recruiting personnel with the combination of skills and attributes required to carry out our strategies is often lengthy.
Our success depends to a significant degree upon our ability to attract and retain qualified management, loan origination,
finance, administrative, marketing and technical personnel and upon the continued contributions of our management and
personnel. In particular, our success has been and continues to be highly dependent upon the abilities of key executives,
including our President and Chief Executive Officer, Mr. Brian L. Vance, and certain other employees. The loss of key
personnel could adversely affect our ability to successfully conduct our business.
ITEM 1B. UNRESOLVED STAFF COMMENTS
The Company has no unresolved staff comments from the Securities and Exchange Commission ("SEC") as it relates
to the Company's financial information as reported on Form 10-K.
34
ITEM 2. PROPERTIES
Our executive offices and the main office of Heritage Bank are located in approximately 22,000 square feet of the
headquarters building and adjacent office space and main branch office which are owned by Heritage Bank and located in
downtown Olympia. The Company's branch network at December 31, 2014 is comprised of 66 branches located throughout
Washington and Oregon counties. The number of branches per county, as well as occupancy type, is detailed in the following
table.
County
Clark .........................
Cowlitz ......................
Island ........................
Kittitas .......................
King ..........................
Mason .......................
Multnomah ................
Pierce .......................
San Juan ..................
Skagit .......................
Snohomish ...............
Thurston ...................
Whatcom ..................
Yakima ......................
Total ..........................
State
WA
WA
WA
WA
WA
WA
OR
WA
WA
WA
WA
WA
WA
WA
Number of
Branches
2
2
7
1
8
1
1
13
1
4
12
5
4
5
66
Occupancy Type
Owned
1
2
5
—
3
1
—
8
—
3
6
3
3
5
40
Leased
1
—
2
1
5
—
1
5
1
1
6
2
1
—
26
One Snohomish County branch, one Thurston County branch and the branch in Kittitas County have land leases, which
are not included in the leased section above as the building is owned.
For additional information concerning our premises and equipment and lease obligations, see Notes 10 and 17,
respectively, of the Notes to Consolidated Financial Statements included in "Item 8. Financial Statements and Supplementary
Data."
35
ITEM 3. LEGAL PROCEEDINGS
Heritage and Heritage Bank, are not a party to any material pending legal proceedings other than ordinary routine litigation
incidental to the business of the Bank, other than the matter described below.
On April 4, 2014, Washington Banking, its directors and Heritage entered into and documented an agreement in principle
among Washington Banking, its directors, Heritage and the plaintiffs for the settlement of the putative shareholder class action
lawsuit captioned In Re Washington Banking Company Shareholder Litigation, Lead Case No. 13-2-38689-5 SEA, pending
before the Superior Court of the State of Washington in and for King County (the “Action”). The Action alleges that Washington
Banking’s directors breached their fiduciary duties to Washington Banking and its shareholders in connection with the
transactions contemplated by the Agreement and Plan of Merger, dated October 23, 2013 (the “Merger Agreement”), under
which Washington Banking and Heritage combined their organizations in a strategic combination, with Washington Banking
merging with and into Heritage. The Action also alleges, among other things, that Heritage aided and abetted the alleged
breaches of fiduciary duties by Washington Banking's directors and that the public disclosures concerning the Washington
Banking Merger are misleading in various respects.
On December 15, 2014, the Court entered an order preliminarily approving the settlement of the consolidated litigation
and ordering WBCO to provide notice of the proposed settlement to those persons who held WBCO shares during the
purported class period.
On February 27, 2015, the Court held a hearing to consider whether the settlement was fair and reasonable to the class
members and, if so, to approve the settlement and to consider plaintiffs’ counsel’s application for an award of attorneys’ fees
and costs from Washington Banking. At the hearing, the Court approved the settlement and entered a Final Judgment and
Order of Dismissal With Prejudice awarding plaintiffs’ counsel fees and expenses totaling $450,000 and terminating the
litigation.
The settlement of the Action did not affect the Washington Banking Merger consideration paid to Washington Banking’s
shareholders in connection with the completion of the Washington Banking Merger on May 1, 2014. Washington Banking, its
directors and Heritage took the position that the Action was without merit and denied any wrongdoing of any kind. Washington
Banking, its directors and Heritage entered into the settlement solely to eliminate the costs, risks, burden, distraction and
expense of further litigation and to put the claims that were or could have been asserted to rest. Nothing in the stipulation of
settlement or any public filing, including this Annual Report on Form 10-K, shall be deemed an admission of the legal necessity
of filing or the materiality under applicable laws of any of the additional information contained herein or in any public filing
associated with the settlement of the Action.
ITEM 4. MINE SAFETY DISCLOSURES
Not applicable
36
PART II
ITEM 5. MARKET FOR THE REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
ISSUER PURCHASES OF EQUITY SECURITIES
Our common stock is traded on the NASDAQ Global Select Market under the symbol HFWA. At December 31, 2014, we
had approximately 1,514 shareholders of record (not including the number of persons or entities holding stock in nominee or
street name through various brokerage firms) and 30,259,838 outstanding shares of common stock. This total does not reflect
the number of persons or entities who hold stock in nominee or “street” name through various brokerage firms. The last
reported sales price on February 25, 2015 was $16.28 per share. The following table provides sales information per share of
our common stock as reported on the NASDAQ Global Select Market for the indicated quarters.
March 31
June 30
September 30
December 31
2014 Quarter ended,
High ....................................................... $
Low ........................................................ $
18.48 $
16.18 $
17.86 $
15.44 $
16.96 $
15.59 $
17.97
15.80
For the interim period subsequent to the 2014 fiscal year through the last reported sales price on February 25, 2015,
the high and low sales information price per share of our common stock as reported on the NASDAQ Global Selected
Market was $17.16 and $15.52, respectively.
March 31
June 30
September 30
December 31
2013 Quarter ended,
High ................................................................
Low .................................................................
$
$
15.22 $
13.84 $
14.65 $
13.25 $
16.45 $
14.75 $
17.48
15.01
Quarterly, the Company reviews the potential payment of cash dividends to common shareholders. The timing and
amount of cash dividends paid on our common stock depends on the Company’s earnings, capital requirements, financial
condition and other relevant factors.
The dividend activities for the years ended December 31, 2014 and 2013 and subsequent through the date of this
filing are listed below:
Declared
January 30, 2013
April 24, 2013
July 23, 2013
October 23, 2013
January 29, 2014
March 27, 2014
July 24, 2014
October 23, 2014
November 11, 2014
January 28, 2015
Cash
Dividend per Share
$0.08
$0.08
$0.18
$0.08
$0.08
$0.08
$0.09
$0.09
$0.16
$0.10
Record Date
February 8, 2013
May 10, 2013
August 6, 2013
November 5, 2013
February 10, 2014
April 8, 2014
August 7, 2014
November 6, 2014
December 2, 2014
February 10, 2015
Paid
February 22, 2013
May 24, 2013
August 15, 2013
November 15, 2013
February 24, 2014
April 23, 2014
August 21, 2014
November 20, 2014
December 12, 2014
February 24, 2015
37
The primary source for dividends paid to our shareholders is dividends paid to us from Heritage Bank. There are
regulatory restrictions on the ability of our subsidiary bank to pay dividends. Under federal regulations, the dollar amount of
dividends the bank may pay depends upon its capital position and recent net income. Generally, if an institution satisfies its
regulatory capital requirements, it may make dividend payments up to the limits prescribed under state law and FDIC
regulations. However, an institution that has converted to a stock form of ownership, as Heritage Bank has done, may not
declare or pay a dividend on, or repurchase any of, its common stock if the effect thereof would cause the regulatory capital of
the institution to be reduced below the amount required for the liquidation account which was established in connection with
the mutual stock conversion.
As a bank holding company, our ability to pay dividends is subject to the guidelines of the Federal Reserve regarding
capital adequacy and dividends. The Federal Reserve’s policy is that a bank holding company should pay cash dividends only
to the extent that its net income for the past year is sufficient to cover both the cash dividends and a rate of earnings retention
that is consistent with the holding company’s capital needs, asset quality and overall financial condition, and that it is
inappropriate for a bank holding company experiencing serious financial problems to borrow funds to pay dividends. Under
Washington law, we are prohibited from paying a dividend if, after making such dividend payment, we would be unable to pay
our debts as they become due in the usual course of business, or if our total liabilities, plus the amount that would be needed,
in the event we were to be dissolved at the time of the dividend payment, to satisfy preferential rights on dissolution of holders
of preferred stock ranking senior in right of payment to the capital stock on which the applicable distribution is to be made
exceed our total assets.
The Company has had various stock repurchase programs since March 1999. On October 23, 2014, the Company's
Board of Directors authorized the repurchase of up to 5% of the Company's outstanding common shares, or approximately
1,513,000 shares, under the eleventh stock repurchase plan. The number, timing and price of shares repurchased will depend
on business and market conditions, and other factors, including opportunities to deploy the Company's capital. On August 30,
2012, the Board of Directors approved the Company’s tenth stock repurchase plan, authorizing the repurchase of up to 5% of
the Company’s outstanding shares of common stock, or approximately 757,000 shares. The Company will not repurchase the
remaining 52,025 shares available under the tenth plan as the eleventh plan supersedes the tenth stock repurchase program.
On August 30, 2011, the Board of Director approved the Company's ninth stock repurchase plan, authorizing the repurchase of
up to 5% of the Company's outstanding shares of common stock, or approximately 782,000 shares over a period of twelve
months.
The following table provides total repurchased shares and average share prices under the applicable Plans and years:
Ninth Plan ...........................................................................
Repurchased shares ...........................................................
Stock repurchase average share price ...............................
Tenth Plan ..........................................................................
Repurchased shares ...........................................................
Stock repurchase average share price ...............................
Eleventh Plan .....................................................................
Years Ended December 31,
2013
2014
2012
Plan Total
$
—
—
$
—
—
389,627
$ 13.45
590,832
$ 12.83
108,075
$ 16.68
544,000
$ 15.88
52,900
$ 13.88
704,975
$ 15.85
Repurchased shares ...........................................................
Stock repurchase average share price ...............................
$
—
—
$
—
—
$
—
—
$
—
—
During the years ended December 31, 2014, 2013 and 2012, the Company repurchased 48,304, 13,138 and 3,419 shares
at an average price of $16.53, $14.29 and $14.08 to pay withholding taxes on the vesting of restricted stock that vested during
the years ended December 31, 2014, 2013 and 2012, respectively, which are not considered repurchased as part of the
applicable repurchase Plans.
38
The following table sets forth information about the Company’s purchases of its outstanding common stock during the
quarter ended December 31, 2014.
Period
October 1, 2014—October 30, 2014 ...........
November 1, 2014—November 30, 2014 ...
December 1, 2014—December 31, 2014 ...
Total .....................................................
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
277 $
—
2,695
2,972 $
16.79
—
16.97
16.95
7,313,423
7,313,423
7,313,423
7,313,423
1,513,000
1,513,000
1,513,000
1,513,000
(1) Common shares repurchased by the Company between October 1, 2014 and December 31, 2014 included solely the cancellation of
2,972 shares of restricted stock to pay withholding taxes at an average price per share of $16.95.
The information regarding the Company’s equity compensation plan is contained under “Item 12. Security Ownership of
Certain Beneficial Owners and Management and Related Stockholder Matters” of this Form 10-K and is incorporated by
reference herein.
39
Stock Performance Graph
The chart shown below depicts total return to stockholders during the period beginning December 31, 2009 and ending
December 31, 2014. Total return includes appreciation or depreciation in market value of the Company’s common stock as well
as actual cash and stock dividends paid to common stockholders. Indices shown below, for comparison purposes only, are the
Total Return Index for the NASDAQ Stock Market (U.S. Companies), which is a broad nationally recognized index of stock
performance by publicly traded companies and the NASDAQ Bank Index, which is an index that contains securities of
NASDAQ-listed companies classified according to the Industry Classification Benchmark as banks. The chart assumes that the
value of the investment in Heritage’s common stock and each of the three indices was $100 on December 31, 2009, and that
all dividends were reinvested in Heritage common stock.
Heritage Financial Corporation
Total Return Performance
Heritage Financial Corporation
NASDAQ Composite
NASDAQ Bank
240
220
200
180
160
140
120
100
80
e
u
l
a
V
x
e
d
n
I
60
12/31/09
12/31/10
12/31/11
12/31/12
12/31/13
12/31/14
Index
Heritage Financial Corporation .......
NASDAQ Composite .......................
NASDAQ Bank ................................
2009
2010
2011
2012
2013
2014
$
$
100.00
100.00
100.00
$
101.02
118.15
114.16
94.13
117.22
102.17
$
116.47
138.02
121.26
$
$
139.38
193.47
171.86
147.38
222.16
180.31
Years Ended December 31,
40
ITEM 6. SELECTED FINANCIAL DATA
The following tables set forth certain information concerning our consolidated financial position and results of operations at
and for the dates indicated and have been derived from our audited Consolidated Financial Statements. The information below
is qualified in its entirety by the detailed information included elsewhere herein and should be read along with “Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Item 8. Financial Statements
and Supplementary Data.”
Matters affecting comparability in the five-year summary detailed below include the Cowlitz and Pierce Acquisitions in
2010, the Valley and NCB Acquisitions in 2013, and the Washington Banking Merger in 2014. See Note 2 - Business
Combinations in "Item 8. Financial Statements and Supplementary Data" discussing the fiscal 2014 and 2013 mergers and
acquisitions.
Operations Data:
Interest income .........................................
Interest expense .......................................
Net interest income ...................................
Provision for loan losses ...........................
Noninterest income ...................................
Noninterest expense .................................
Income tax expense .................................
Net income ................................................
Net income applicable to common
shareholders ..........................................
Earnings per common share ....................
Basic ......................................................
Diluted ...................................................
Dividend payout ratio to common
shareholders(1) ......................................
Performance Ratios:
Net interest spread(2) ................................
Net interest margin(3) ................................
Efficiency ratio(4) .......................................
Return on average assets .........................
Return on average common equity ...........
2014
Years Ended December 31,
2012
2011
2013
2010
(Dollars in thousands, except per share amounts)
$ 121,106
5,681
115,425
4,594
16,467
99,379
6,905
21,014
$
71,428
3,724
67,704
3,672
9,651
59,515
4,593
9,575
$
69,109
4,534
64,575
2,016
7,272
50,392
6,178
13,261
$
74,120
6,582
67,538
14,430
5,746
49,703
2,633
6,518
21,014
9,575
13,261
6,518
$
$
0.82
0.82
$
0.61
0.61
$
0.87
0.87
0.42
0.42
$
59,522
8,511
51,011
11,990
18,779
38,011
6,435
13,354
11,668
1.05
1.04
60.98%
68.90%
92.00%
90.50%
—%
4.45%
4.53
75.35
0.74
5.61
4.69%
4.80
76.94
0.62
4.58
5.03%
5.17
70.14
0.98
6.52
5.23%
5.41
67.82
0.48
3.17
4.56%
4.78
54.46
1.16
8.15
(1) Dividend payout ratio is declared dividends per common share divided by basic earnings per common share.
(2) Net interest spread is the difference between the average yield on interest earning assets and the average cost of interest bearing
liabilities.
(3) Net interest margin is net interest income divided by average interest earning assets.
(4) The efficiency ratio is noninterest expense divided by the sum of net interest income and noninterest income.
41
Balance Sheet Data:
Total assets ..............................................
Noncovered loans receivable, net ...........
Covered loans receivable, net .................
Total loans receivable, net .......................
Investment securities ...............................
FDIC indemnification asset......................
Goodwill and other intangible assets .......
Deposits ...................................................
Junior subordinated debentures ..............
Securities sold under agreement to
repurchase ...........................................
Stockholders’ equity.................................
Book value per common share ................
Equity to assets ratio ...............................
Capital Ratios:
Total risk-based capital ratio ....................
Tier 1 risk-based capital ratio ..................
Leverage ratio ..........................................
Asset Quality Ratios:
Nonperforming noncovered loans to
total noncovered loans (1) ....................
Allowance for loan losses on
noncovered loans to total noncovered
loans (1) ...............................................
Allowance for loan losses on
noncovered loans to nonperforming
noncovered loans (1)............................
Nonperforming noncovered assets to
total noncovered assets (1) ..................
Other Data:
Number of banking offices .......................
Number of full-time equivalent
employees ............................................
2014
2013
December 31,
2012
(Dollars in thousands)
2011
2010
$ 3,457,750
2,102,724
120,624
2,223,348
778,660
1,116
129,918
2,906,331
19,082
$ 1,659,038
1,145,509
57,587
1,203,096
199,288
4,382
30,980
1,399,189
—
$ 1,345,540
914,366
83,978
998,344
154,392
7,100
14,098
1,117,971
—
$ 1,368,985
899,086
105,394
1,004,480
156,695
10,350
14,525
1,136,044
—
32,181
454,506
15.02
$
29,420
215,762
13.31
$
16,021
198,938
13.16
$
23,091
202,520
13.10
$
$ 1,367,684
851,006
128,715
979,721
138,943
16,071
14,965
1,136,276
—
19,027
202,279
12.99
$
13.1%
13.0%
14.8%
14.8%
14.8%
15.1%
13.9
10.2
16.8%
15.5
11.3
19.9%
18.7
13.6
20.3%
19.0
13.8
21.5%
20.2
13.9
0.35%
0.66%
1.41%
2.57%
3.03%
1.04
1.94
2.58
2.91
294.98
292.80
183.39
113.11
0.29
0.76
1.48
2.19
66
748
35
373
33
363
33
354
2.53
83.31
2.38
31
321
(1) Nonperforming noncovered loan balances include portions guaranteed by governmental agencies of $1.6 million, $1.7 million, $1.2
million, $1.8 million and $2.3 million as of December 31, 2014, 2013, 2012, 2011 and 2010, respectively.
42
ITEM 7. MANGEMENT'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. The information contained in this section should be read with the December 31, 2014 audited Consolidated
Financial Statements and Notes to those financial statements included in this Form 10-K.
This Form 10-K may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act
of 1995. Forward-looking statements often include the words “believes,” “expects,” “anticipates,” “estimates,” “forecasts,”
“intends,” “plans,” “targets,” “potentially,” “probably,” “projects,” “outlook” or similar expressions or future or conditional verbs
such as “may,” “will,” “should,” “would” and “could.” These forward-looking statements are subject to known and unknown risks,
uncertainties and other factors that could cause actual results to differ materially from the results anticipated, including:
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
our ability to successfully integrate any assets, liabilities, customers, systems, and management personnel we have
acquired, including those from Cowlitz Bank, Pierce Commercial Bank, Northwest Commercial Bank, Valley
Community Bancshares and Washington Banking Company, or may in the future 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;
the credit risks of lending activities, including changes in the level and trend of loan delinquencies and write-offs and
changes in our allowance for loan losses and provision for loan losses that may be impacted by deterioration in the
housing and commercial real estate markets, which may lead to increased losses and non-performing assets in our
loan portfolio, and may result in our allowance for loan losses not being adequate to cover actual losses, and require
us to increase our allowance for loan losses and increase our provision for loan losses;
changes in general economic conditions, either nationally or in our market areas;
changes in the levels of general interest rates, and the relative differences between short and long term interest
rates, deposit interest rates, our net interest margin and funding sources;
risks related to acquiring assets in or entering markets in which we have not previously operated and may not be
familiar;
fluctuations in the demand for loans, the number of unsold homes and other properties and fluctuations in real estate
values in our market areas;
results of examinations of us by the bank regulators, including the possibility that any such regulatory authority may,
among other things, require us to increase our allowance for loan losses, write-down assets, change our regulatory
capital position or affect our ability to borrow funds or maintain or increase deposits, which could adversely affect our
liquidity and earnings;
legislative or regulatory changes that adversely affect our business including but not limited to, the Dodd-Frank Act
and implementing regulations, changes in regulatory policies and principles, or the interpretation of regulatory capital
or other rules as a result of Basel III;
our ability to control operating costs and expenses;
increases in premiums for deposit insurance;
the use of estimates in determining fair value of certain of our assets, which estimates may prove to be incorrect and
result in significant declines in valuation;
difficulties in reducing risk associated with the loans on our consolidated statement of financial condition;
staffing fluctuations in response to product demand or the implementation of corporate strategies that affect our
workforce and potential associated charges;
failure or security breach of computer systems on which we depend;
our ability to retain key members of our senior management team;
costs and effects of litigation, including settlements and judgments;
our ability to implement our growth strategies;
43
•
•
•
•
•
•
•
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
other economic, competitive, governmental, regulatory, and technological factors affecting our operations, pricing,
products and services and the other risks described elsewhere in this Form 10-K.
Some of these and other factors are discussed in this Form 10-K under the caption “Item 1A. Risk Factors” and elsewhere
in this Form 10-K. Such developments could have a material adverse impact on our business, financial position and results of
operations.
Any forward-looking statements are based upon management’s beliefs and assumptions at the time they are made. We
undertake no obligation to publicly update or revise any forward-looking statements included in this Form 10-K or to update the
reasons why actual results could differ from those contained in such statements, whether as a result of new information, future
events or otherwise. In light of these risks, uncertainties and assumptions, you should not put undue reliance on any forward-
looking statements discussed in this Form 10-K.
Critical Accounting Policies
The Company’s Consolidated Financial Statements have been prepared in accordance with accounting principles
generally accepted in the United States of America. Companies may apply certain critical accounting policies requiring
management to make subjective or complex judgments, often as a result of the need to estimate the effect of matters that are
inherently uncertain.
The Company considers its most critical accounting estimates to be the allowance for loan losses, estimations of expected
cash flows related to purchased credit impaired loans, business combinations, other than temporary impairments in the market
value of investments and consideration of potential impairment of goodwill.
Allowance for Loan Losses. The allowance for loan losses is established through a provision for loan losses charged
against earnings. The balance of the allowance for loan losses is maintained at the amount management believes will be
appropriate to absorb known and inherent losses in the loan portfolio at the balance sheet date. The allowance for loan losses
is determined by applying estimated loss factors to the credit exposure from outstanding loans.
44
We assess the estimated credit losses inherent in our non-classified and classified loan portfolio by considering a number
of elements including:
•
•
•
•
•
•
•
•
historical loss experience in the portfolio;
levels of and trends in delinquencies and impaired loans;
levels and trends in charge-offs and recoveries;
effects of changes in risk selection and underwriting standards, and other changes in lending policies, procedures
and practices;
experience, ability, and depth of lending management and other relevant staff;
national and local economic trends and conditions;
external factors such as competition, legal, and regulatory; and
effects of changes in credit concentrations.
We calculate an allowance for our loan portfolio based on an appropriate percentage loss factor that is calculated based
on the above-noted elements and trends. We may record specific provisions for each impaired loan after a careful analysis of
that loan’s credit and collateral factors. Our analysis of an allowance combines the provisions made for our non-impaired loans
and the specific provisions made for each impaired loan.
While we believe we use the best information available to determine the allowance for loan losses, our results of
operations could be significantly affected if circumstances differ substantially from the assumptions used in determining the
allowance. A decline in local and national economic conditions, or other factors, could result in a material increase in the
allowance for loan losses and may adversely affect the Company’s financial condition and results of operations. In addition, the
determination of the amount of the allowance for loan losses is subject to review by bank regulators, as part of their routine
examination process, which may result in the establishment of additional allowance for loan losses based upon their judgment
of information available to them at the time of their examination.
For additional information regarding the allowance for loan losses, its relation to the provision for loan losses, risk related
to asset quality and lending activity, see “—Results of Operations for the Years Ended December 31, 2014 and 2013—
Provision for Loan Losses” below, “Item 1. Business—Analysis of Allowance for Loan Losses” as well as Note 7 - Allowance for
Loan Losses of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary
Data.”
Estimated Expected Cash Flows related to Purchased Credit Impaired Loans. Loans purchased with evidence of credit
deterioration since origination for which it is probable that all contractually required payments will not be collected are
accounted for under FASB ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality, formerly AICPA
SOP 03-3 Accounting for Certain Loans or Debt Securities Acquired in a Transfer. In situations where such loans have similar
risk characteristics, loans may be aggregated into pools to estimate cash flows. A pool is accounted for as a single asset with
a single interest rate, cumulative loss rate and cash flow expectation.
The cash flows expected over the life of the loan or pool are estimated using an internal cash flow model that projects
cash flows and calculates the carrying values of the pools, book yields, effective interest income and impairment, if any, based
on pool level events. Assumptions as to default rates, loss severity and prepayment speeds are utilized to calculate the
expected cash flows.
Expected cash flows at the acquisition date in excess of the fair value of loans are considered to be accretable yield,
which is recognized as interest income over the life of the loan or pool using a level yield method if the timing and amounts of
the future cash flows of the pool are reasonably estimable. Subsequent to the acquisition date, any increases in cash flow over
those expected at purchase date in excess of fair value are recorded as interest income prospectively. Any subsequent
decreases in cash flow over those expected at purchase date are recognized by recording an allowance for loan losses. Any
disposals of loans, including sales of loans, payments in full or foreclosures result in the removal of the loan from the loan pool
at the carrying amount.
45
Business Combinations. The Company applies the acquisition method of accounting for business combinations. Under
the acquisition method, the acquiring entity in a business combination recognizes all of the identifiable assets acquired and
liabilities assumed at their acquisition date fair values. Management utilizes prevailing valuation techniques appropriate for the
asset or liability being measured in determining these fair values. Any excess of the purchase price over amounts allocated to
assets acquired, including identifiable intangible assets, and liabilities assumed is recorded as goodwill. Where amounts
allocated to assets acquired and liabilities assumed is greater than the purchase price, a bargain purchase gain is recognized.
Acquisition-related costs are expensed as incurred unless they are directly attributable to the issuance of the Company's
common stock in a business combination.
Other-Than-Temporary Impairments in the Market Value of Investments. Unrealized losses on investment securities
available for sale and held to maturity are evaluated at least quarterly to determine whether declines in value should be
considered “other than temporary” and therefore be subject to immediate loss recognition in income. Although these
evaluations involve significant judgment, an unrealized loss in the fair value of a debt security is generally deemed to be
temporary when the fair value of the security is below the carrying value primarily due to changes in interest rates, there has
not been significant deterioration in the financial condition of the issuer, and it is not more likely than not that the Company will
be required to sell the security before the anticipated recovery of its remaining carrying value. An unrealized loss in the value of
an equity security is generally considered temporary when the fair value of the security is below the carrying value primarily
due to current market conditions and not deterioration in the financial condition of the issuer and it is not more likely than not
that the Company will be required to sell the security before the anticipated recovery of its remaining carrying value. Other
factors that may be considered in determining whether a decline in the value of either a debt or an equity security is “other than
temporary” include ratings by recognized rating agencies; actions of commercial banks or other lenders relative to the
continued extension of credit facilities to the issuer of the security; the financial condition, capital strength and near-term
prospects of the issuer and recommendations of investment advisors or market analysts. Therefore, continued deterioration of
market conditions could result in additional impairment losses recognized within the investment portfolio.
Goodwill. Goodwill represents the excess of the purchase price over the net assets acquired in the of merger of
Washington Banking Company and the acquisitions of Valley Community Bancshares, Western Washington Bancorp and
North Pacific Bank. The Company’s goodwill is assigned to Heritage Bank and is evaluated for impairment at the Heritage
Bank level (reporting unit). Goodwill is not amortized, but is reviewed for impairment annually and between annual tests if an
event occurs or circumstances change that might indicate the Company’s recorded value is more than its implied value. Such
indicators may include, among others: a significant adverse change in legal factors or in the general business climate;
significant decline in the Company’s stock price and market capitalization; unanticipated competition; and an adverse action or
assessment by a regulator. Any adverse changes in these factors could have a significant impact on the recoverability of
goodwill and could have a material impact on the Company’s Consolidated Financial Statements.
When required, the goodwill impairment test involves a two-step process. The first test for goodwill impairment is done by
comparing the reporting unit’s aggregate fair value to its carrying value. Absent other indicators of impairment, if the aggregate
fair value exceeds the carrying value, goodwill is not considered impaired and no additional analysis is necessary. If the
carrying value of the reporting unit were to exceed the aggregate fair value, a second test would be performed to measure the
amount of impairment loss, if any. To measure any impairment loss the implied fair value would be determined in the same
manner as if the reporting unit were being acquired in a business combination. If the implied fair value of goodwill is less than
the recorded goodwill an impairment charge would be recorded for the difference.
During 2011, ASU 2011-08 Intangibles—Goodwill and Other (Topic 350) was issued. Under the ASU, an entity is not
required to calculate the fair value of a reporting unit unless the entity determines that it is more likely than not that its fair value
is less than its carrying amount. In other words, before the first step of the existing guidance, the entity has the option to first
assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that the fair
value of goodwill is less than carrying value. The qualitative assessment includes adverse events or circumstances identified
that could negatively affect the reporting units’ fair value as well as positive and mitigating events. If, after assessing the totality
of events or circumstances, an entity determines it is not more likely than not that the fair value of a reporting unit is less than
its carrying amount, then performing the two-step process is unnecessary. While the Company adopted the ASU in 2011, for
the year ended December 31, 2014, the Company completed step one of the two-step process and concluded that the
reporting unit’s fair value was greater than its carrying value and there was no impairment of goodwill.
46
Our Strategy
Our primary objective is to be a well-capitalized, profitable community banking organization, with balanced growth while
emphasizing lending and deposit relationships with small and medium size businesses along with their owners and the general
public. We consider ourselves to be an innovative team providing financial services focusing on the success of our customers.
Our stated mission is: “We are committed to being the leading community bank in the Pacific Northwest by continuously
improving: Customer Satisfaction, Employee Empowerment, Community Investment and Shareholder Value.” We will seek to
achieve our objective through the following strategies:
Expand geographically as opportunities present themselves. We are committed to continuing the controlled expansion of
our franchise through strategic acquisitions designed to increase our market share and enhance franchise value. We believe
that consolidation across the community bank landscape will continue to take place and further believe that, with our capital
and liquidity positions, our approach to credit management and extensive acquisition experience, we are well positioned to
take advantage of acquisitions or other business opportunities in our market areas. In markets where we wish to enter or
expand our business, we will also consider opening de novo branches. In the past, we have successfully integrated acquired
institutions and opened de novo branches. We will continue to be disciplined and opportunistic as it pertains to future
acquisitions and de novo branching focusing on the Pacific Northwest markets we know and understand.
Focus on Asset Quality. A strong credit culture is a high priority for us. We have a well-developed credit approval
structure that has enabled us to maintain a standard of asset quality that we believe is conservative while at the same time
maintaining our lending objectives. We will continue to focus on loan types and markets that we know well and where we have
a historical record of success. We focus on loan relationships that are well diversified in both size and industry types. With
respect to commercial business lending, which is our predominant lending activity, we view ourselves as cash-flow lenders
obtaining additional support from realistic collateral values, personal guarantees and secondary sources of repayment. We
have a problem loan resolution process that is focused on quick detection and feasible solutions. We seek to maintain strong
internal controls and subject our loans to periodic internal loan reviews.
Maintain Strong Balance Sheet. In addition to our focus on underwriting, we believe that the strength of our balance
sheet has allowed us to endure the economic downturn experienced by the Pacific Northwest more successfully than many of
our competitors. As of December 31, 2014, the ratio of our allowance for loan losses on noncovered loans to total noncovered
loans was 1.04% and the ratio of the allowance for loan losses on noncovered loans to nonperforming noncovered loans was
294.98%. Our liquidity position is also strong, with $121.6 million in cash and cash equivalents as of December 31, 2014. As of
December 31, 2014, the regulatory capital ratios of our subsidiary bank was well in excess of the levels required for “well-
capitalized” status, and our consolidated total risk-based capital, Tier 1 risk-based capital and leverage capital ratios were
15.1%, 13.9% and 10.2%, respectively.
Deposit Growth. Our strategic focus is to continuously grow deposits with emphasis on total relationship banking with
our business and retail customers. We continue to seek to increase our market share in the communities we serve by
providing exceptional customer service, focusing on relationship development with local businesses and strategic branch
expansion. Our primary focus is to maintain a high level of non-maturity deposits to internally fund our loan growth with a low
reliance on maturity (certificate) deposits. At December 31, 2014, as a percentage of our total deposits, non-maturity deposits
were 81.9%. We maintain state-of-the-art technology-based products, including on-line personal financial management,
business cash management, and business remote deposit products that enable us to compete effectively with banks of all
sizes. Our retail management team is well-seasoned and has strong ties to the communities we serve with a strong focus on
relationship building and customer service.
Emphasize business relationships with a focus on commercial lending. We will continue to provide primarily commercial
business, commercial real estate and residential construction loans with an emphasis on owner occupied commercial real
estate and commercial business lending, and the deposit balances that accompany these relationships. Our seasoned lending
staff has extensive knowledge and can add value through a focused advisory role that we believe strengthens our customer
relationships and develops loyalty. We currently have and will seek to maintain a diversified portfolio of lending relationships
without concentrations in any industry.
Recruit and retain highly competent personnel to execute our strategies. Our compensation and staff development
programs are aligned with our strategies to grow our loans and core deposits while maintaining our focus on asset quality. Our
incentive systems are designed to achieve balanced high quality asset growth while maintaining appropriate mechanisms to
reduce or eliminate incentive payments when appropriate. Our equity compensation programs and retirement benefits are
47
designed to build and encourage employee ownership at all levels of the Company and we align employee performance
objectives with corporate growth strategies and shareholder value. We have a strong corporate culture, which is supported by
our commitment to internal development and promotion from within as well as the retention of management and officers in key
roles.
Financial Overview
Heritage Financial Corporation is a bank holding company which primarily engages in the business activities of our wholly
owned 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 has focused on expanding business over the past five years. In 2010, the Company completed two FDIC-
assisted transactions of Cowlitz Bank in July 2010 and Pierce Commercial Bank in November 2010. In 2013, the Company
completed two open-bank acquisitions of Northwest Commercial Bank in January 2013 and Valley Community Bancshares in
July 2013. In May 2014, the Company completed the merger with Washington Banking Company. These acquisitions and
mergers, together with organic growth of the business, has significantly increased the Company's net assets.
During the period from December 31, 2010 through December 31, 2014 our total assets have increased $2.09 billion, or
152.8%, to $3.46 billion as of December 31, 2014 from $1.37 billion at December 31, 2010. The noncovered loans receivable,
net of allowance for loan losses grew $1.25 billion, or 147.1%, to $2.10 billion as of December 31, 2014 from $851.0 million at
December 31, 2010. Our emphasis in growing our commercial business loan portfolio, in addition to mergers and acquisitions,
resulted in an increase in noncovered commercial business loans of $993.6 million, or 139.9%, since December 31, 2010.
Loan increases have benefited from the merger of Washington Banking and the acquisitions of Valley, Northwest Commercial
Bank, Pierce Commercial Bank and Cowlitz Bank and our emphasis on increasing our lending in our market areas.
Deposits increased $1.77 billion, or 155.8%, to $2.91 billion at December 31, 2014 from $1.14 billion at December 31,
2010. From December 31, 2010 to December 31, 2014, non-maturity deposits (total deposits less certificate of deposit
accounts) increased $1.65 billion, or 224.7% to $2.38 billion at December 31, 2014. As a result, the percentage of certificate of
deposit accounts to total deposits decreased to 18.1% at December 31, 2014 from 35.5% at December 31, 2010.
Stockholders’ equity has increased by $252.2 million to $454.5 million at December 31, 2014 from $202.3 million at
December 31, 2010 due primarily to a combination of earnings and issuances of common stock, partially offset by the
redemption of preferred stock, repurchases of common stock and declaration of cash dividends. Our annual net income
increased by 57.4%, or $7.7 million, to $21.0 million for the year ended December 31, 2014 from $13.4 million for the year
ended December 31, 2010 due primarily to an increase of $64.4 million in net interest income that exceeded an increase in
noninterest expense of $61.4 million, and a decrease in the provision for loan losses of $7.4 million.
Our core profitability depends primarily on our net interest income, which is the difference between the income we receive
on our loan and investment portfolios, and our cost of funds, which consists of interest paid on deposits and borrowed funds.
Like most financial institutions, our interest income and cost of funds are affected significantly by general economic conditions,
particularly changes in market interest rates and government policies.
Changes in net interest income result from changes in volume, net interest spread, and net interest margin. Volume refers
to the average dollar amounts of interest earning assets and interest bearing liabilities. Net interest spread refers to the
difference between the average yield on interest earning assets and the average cost of interest bearing liabilities. Net interest
margin refers to net interest income divided by average interest earning assets and is influenced by the level and relative mix
of interest earning assets and interest bearing and noninterest bearing liabilities.
48
The following table provides relevant net interest income information for selected periods. The average daily loan
balances presented in the table are net of allowances for loan losses. Nonaccrual loans have been included in the tables as
loans carrying a zero yield. Yields on tax-exempt securities and loans have not been presented on a tax-equivalent basis.
Years Ended December 31,
2014
Interest
Earned/
Paid
Average
Balance
Average
Yield/
Rate
Average
Balance
2013
Interest
Earned/
Paid
Average
Yield/
Rate
Average
Balance
2012
Interest
Earned/
Paid
Average
Yield/
Rate
(Dollars in thousands)
$ 1,871,696 $ 110,437
7,328
2,886
383,626
145,113
5.90% $ 1,124,828 $ 67,630
1,918
1.91
1,539
1.99
117,132
64,018
6.01% $ 996,186 $ 65,588
1.64
2,195
2.40
1,097
118,124
42,272
150,189
455
0.30
104,770
341
0.33
92,324
229
2,550,624 121,106
4.75 1,410,748 71,428
5.06 1,248,906 69,109
295,666
$ 2,846,290
129,324
$ 1,540,072
105,166
$ 1,354,072
6.58 %
1.86
2.60
0.25
5.53
$ 494,948 $ 2,991
252
282,150
0.60% $ 307,464 $ 2,478
164
0.09
143,412
0.81% $ 306,772 $ 3,016
0.11
204
113,119
0.98 %
0.18
1,049,078
1,907
0.18
541,793
1,031
0.19
466,268
1,249
1,826,176
5,150
0.28
992,669
3,673
0.37
886,159
4,469
12,751
458
3.59
111
—
—
—
—
—
—
—
—
—
—
—
—
0.27
0.50
—
—
27,984
73
0.26
19,102
51
0.27
18,314
65
0.35
1,867,022
5,681
0.30 1,011,771
3,724
0.37
904,473
4,534
0.50
574,692
29,669
374,907
308,582
10,543
209,176
237,888
8,310
203,401
$ 2,846,290
$ 1,540,072
$ 1,354,072
$ 115,425
$ 67,704
$ 64,575
4.45%
4.53%
4.69%
4.80%
5.03 %
5.17 %
136.61%
139.43%
138.08 %
Interest Earning
Assets:
Loans, net .......................
Taxable securities ...........
Nontaxable securities ......
Other interest earning
assets ..........................
Total interest earning
assets ......................
Noninterest earning
assets ..........................
Total assets ............
Interest Bearing
Liabilities:
Certificates of deposit .....
Savings accounts ............
Interest bearing demand
and money market
accounts ......................
Total interest bearing
deposits ...................
Junior subordinated
debentures ..................
FHLB advances and
other borrowings ..........
Securities sold under
agreement to
repurchase ..................
Total interest
bearing
liabilities ................
Demand and other
noninterest bearing
deposits .......................
Other noninterest
bearing liabilities ..........
Stockholders’ equity ........
Total liabilities and
stock-holders’
equity ..................
Net interest income .........
Net interest spread ..........
Net interest margin ..........
Average interest earning
assets to average
interest bearing
liabilities .......................
49
The following table provides the amount of change in our net interest income attributable to changes in volume and
changes in interest rates. Changes attributable to the combined effect of volume and interest rates have been allocated
proportionately for changes due specifically to volume and interest rates.
Years Ended December 31,
2014 Compared to 2013
Increase (Decrease) Due to
Rate
Total
Volume
2013 Compared to 2012
Increase (Decrease) Due to
Rate
Total
Volume
(In thousands)
Interest Earning Assets:
Loans .............................................
Taxable securities...........................
Nontaxable securities .....................
Other interest earning assets .........
Interest income...............................
Interest Bearing Liabilities:
Certificates of deposit ....................
Savings accounts ...........................
Interest bearing demand and
money market accounts ..............
Total interest bearing deposits .......
Junior subordinated debentures ....
FHLB advances and other
borrowings ..................................
Securities sold under agreement
to repurchase ..............................
Interest expense.............................
Net Interest Income ......................
$
$
$
44,068 $
5,090
1,613
138
50,909 $
(1,261) $
320
(266)
(24)
(1,231) $
42,807 $
5,410
1,347
114
49,678 $
7,735 $
(16)
523
40
8,282 $
(5,693) $
(261)
(81)
72
(5,963) $
1,133 $
124
(620) $
(36)
513 $
88
5 $
35
(543) $
(75)
922
2,179
458
—
(46)
(702)
—
—
876
1,477
458
—
144
184
—
—
23
2,660 $
48,249 $
$
$
(1)
(703) $
(528) $
22
1,957 $
47,721 $
2
186 $
8,096 $
(362)
(980)
—
—
(16)
(996) $
(4,967) $
2,042
(277)
442
112
2,319
(538)
(40)
(218)
(796)
—
—
(14)
(810)
3,129
Results of Operations for the Years Ended December 31, 2014 and 2013
Earnings Summary. Net income applicable to common shareholders of $0.82 per diluted common share was recorded
for the year ended December 31, 2014 compared to $0.61 per diluted common share for the year ended December 31, 2013.
Net income for the year ended December 31, 2014 was $21.0 million compared to net income of $9.6 million for the same
period in 2013. The $11.4 million increase was primarily the result of a $49.7 million increase in interest income and a $6.8
million increase in noninterest income, partially offset by a $39.9 million increase in noninterest expense, a $2.3 million
increase in income tax expense, a $2.0 million increase in interest expense and a $922,000 increase in the provision for loan
losses. The Company’s efficiency ratio decreased to 75.3% for the year ended December 31, 2014 from 76.9% for the year
ended December 31, 2013 primarily due to net interest income increases related to the mergers and acquisitions as well as
operating efficiencies gained by the Company which did not increase noninterest expenses by the same extent.
Net Interest Income. Net interest income increased $47.7 million, or 70.5%, to $115.4 million for the year ended
December 31, 2014 compared to $67.7 million for the previous year. The increase in net interest income was due primarily to
increases in average interest earning assets, substantially attributable to the Washington Banking Merger, and the results of
the positive effects of the discount accretion on the acquired loan portfolios for the year ended December 31, 2014. The
increase in net interest income was partially offset by the decrease in the net interest margins due primarily to lower
contractual loan note rates in the current lending environment. Net interest income as a percentage of average interest
earning assets (net interest margin) for the year ended December 31, 2014 decreased 27 basis points to 4.53% from 4.80%
for the previous year. Our net interest spread for the year ended December 31, 2014 decreased 24 basis points to 4.45% from
4.69% for the prior year.
50
Total interest income increased $49.7 million, or 69.5%, to $121.1 million for the year ended December 31, 2014, from
$71.4 million for the year ended December 31, 2013. The increase in interest income was due primarily to the effects of the
Washington Banking Merger and the positive effects of the accretable discount, offset partially by lower yields on interest
earning assets. During the year ended December 31, 2014, the Company recorded approximately $10.8 million of discount
accretion into interest income that related to the Washington Banking Merger. This income would be in addition to the acquired
loans' contractual interest income. The balance of average interest earning assets (including nonaccrual loans) increased
$1.14 billion, or 80.8%, to $2.55 billion for the year ended December 31, 2014 from $1.41 billion for the year ended
December 31, 2013. The majority of this increase in interest earning assets was a result of the Washington Banking Merger.
The Company acquired fair value at the May 1, 2014 merger date of $458.3 million in investment securities, $896.0 million in
noncovered loans, $107.1 million in covered loans and $7.1 million of FHLB stock.
The yield on interest earning assets decreased 31 basis points to 4.75% for the year ended December 31, 2014 from
5.06% for the year ended December 31, 2013. The decrease in the yield on interest earning assets for the year ended
December 31, 2014 reflects the decreased loan yields due primarily to lower contractual note rates, offset partially by the
effects of the overall discount accretion on all the acquired loan portfolios. The effect of discount accretion on net interest
margin for the year ended December 31, 2014 and December 31, 2013 is as follows:
Years Ended
December 31,
2014
2013
Net interest margin, excluding incremental accretion on purchased
loans (1) .......................................................................................................................
Impact on net interest margin from incremental accretion on purchased loans (1) ........
Net interest margin ..........................................................................................................
3.97%
0.56
4.53%
4.32%
0.48
4.80%
(1) The incremental accretion income represents the amount of income recorded on the purchased loans in excess of the contractual
stated interest rate in the individual loan notes. This income results from the discount established at the time these loan portfolios were
acquired and modified quarterly as a result of cash flow re-estimation.
The yield on interest earning assets was reduced by nonaccruing loans. For both the years ended December 31, 2014
and December 31, 2013, nonaccruing loans reduced the yield on interest earning assets by approximately five basis points.
Nonaccrual noncovered loans totaled $7.5 million at December 31, 2014 compared to $7.7 million at December 31, 2013.
Interest income on taxable and nontaxable investment securities increased $6.8 million to $10.2 million for the year ended
December 31, 2014 from $3.5 million for the year ended December 31, 2013 due primarily to an increase in the average
investment securities as a result of the Washington Banking Merger and an increase in yields on taxable investments
securities, offset by lower yields earned on the nontaxable investment securities in 2014 as a result of declining interest rates.
The changes in average balances and interest income on other interest earning had minimal impact on net interest margins for
the years ended December 31, 2014 and 2013.
Total interest expense increased by $2.0 million, or 52.6%, to $5.7 million for the year ended December 31, 2014 from $3.7
million for the year ended December 31, 2013. The increase in interest expense was due to an increase in the average deposit
balance, primarily as a result of the deposits acquired in the Washington Banking Merger which had a fair value at the acquisition
date of $1.43 billion. The effects of the increase in the average deposit balance was offset by lower rates paid on interest bearing
deposits, reflecting the relatively low interest rate environment. The average rate paid on interest bearing deposits decreased to
0.28% for the year ended December 31, 2014 from 0.37% for the year ended December 31, 2013. The Company also acquired
junior subordinated debentures in the Washington Banking Merger with a fair value of $18.9 million at the merger date. The
average rate paid on these liabilities during 2014 was 3.59%. Total average interest bearing liabilities increased by $855.3 million,
or 84.5%, to $1.87 billion for the year ended December 31, 2014 from $1.01 billion for the year ended December 31, 2013 and
the average rate was 0.30% and 0.37%, respectively.
Provision for Loan Losses. The provision for loan losses increased $922,000, or 25.1%, to $4.6 million for the year
ended December 31, 2014 from $3.7 million for the year ended December 31, 2013. The Bank has established a
comprehensive methodology for determining the allowance for loan losses and related provision for loan losses on loans. On a
quarterly basis, the Bank performs an analysis taking into consideration pertinent factors underlying the quality of the loan
portfolio. These factors include changes in the amount and composition of the loan portfolio, historical loss experience for
51
various loan classes, changes in economic conditions, delinquency rates, a detailed analysis of individual loans on nonaccrual
status, and other factors to determine the level of the allowance for loan losses and the related provision for loan losses.
The provision for loan losses on noncovered loans increased $448,000, or 25.1%, to $2.2 million for the year ended
December 31, 2014 from $1.8 million for the year ended December 31, 2013. The increase in provision expense on
noncovered loans was due primarily to the resolution of nonperforming loans and the increase in volume of loans, offset
partially by an improvement in the economy and a decrease in net charge-offs during the year ended December 31, 2014
compared the prior year.
The Bank had net charge-offs on noncovered loans of $2.7 million for the year ended December 31, 2014 compared to
$3.4 million for the year ended December 31, 2013. The ratio of net charge-offs of noncovered to average total noncovered
loans outstanding was 0.15% for the year ended December 31, 2014 and 0.32% for the year ended December 31, 2013. Total
gross balance of noncovered loans at December 31, 2014 and 2013 were $2.13 billion and $1.17 billion, respectively. The
general allowance as a percentage of non-impaired noncovered loans was 0.90% and 1.63% at December 31, 2014 and 2013,
respectively. The decrease in the percentage during the noted periods is due to reduction in the historical loss factors, change
in the mix of loans, and a general improvement in the credit environment. The general allowance as a percentage of non-
impaired noncovered loans also decreased during the year ended December 31, 2014 as a result of the Washington Banking
Merger, since the acquired loans were recorded at a net discount at the merger date and, accordingly, no allowance for loan
losses was initially recorded for the acquired loans. The remaining discount for these acquired loans at December 31, 2014
was deemed sufficient to absorb known and inherent losses in the loan portfolio thereby reducing the need for an additional
general valuation allowance.
The following table outlines the allowance for loan losses and related outstanding loan balances on noncovered loans at
December 31, 2014 and 2013:
December 31, 2014
December 31, 2013
(Dollars in thousands)
General Valuation Allowance:
Allowance for loan losses on noncovered loans ............................
Gross noncovered loan balance of non-impaired loans .................
Percentage .....................................................................................
Specific Valuation Allowance:
Allowance for loan losses on noncovered loans ............................
Gross noncovered loan balance of impaired loans ........................
Percentage .....................................................................................
Total Allowance for Loan Losses on noncovered loans:
Allowance for loan losses on noncovered loans ............................
Gross noncovered loan balance .....................................................
Percentage .....................................................................................
$
$
$
$
$
$
18,918
2,099,658
0.90%
3,235
26,156
12.37%
22,153
2,125,814
1.04%
18,618
1,140,967
1.63%
4,039
29,869
13.52%
22,657
1,170,836
1.94%
The allowance for loan losses on noncovered loans decreased by $504,000, or 2.2%, to $22.2 million at December 31,
2014 from $22.7 million at December 31, 2013. As of December 31, 2014, the Bank identified $7.5 million of nonperforming
noncovered loans and $18.8 million of performing restructured noncovered loans for a total of $26.2 million of impaired
noncovered loans. Of these impaired loans, $6.3 million have no allowances for loan losses as their estimated collateral value
or expected cash flow is equal to or exceeds their carrying costs. The remaining $19.9 million have related allowances for loan
losses totaling $3.2 million. Based on the comprehensive methodology, management deemed the allowance for loan losses on
noncovered loans of $22.2 million at December 31, 2014 (1.04% of total noncovered loans and 294.98% of nonperforming
noncovered loans) appropriate to provide for probable incurred losses based on an evaluation of known and inherent risks in
the loan portfolio at that date.
The provision for loan losses on covered loans increased $474,000, or 25.1%, to $2.4 million for the year ended
December 31, 2014 compared to $1.9 million for the year ended December 31, 2013. The increase in provision for loan losses
on covered loans recorded for the year ended December 31, 2014 was primarily a result of loans acquired in the Washington
52
Banking Merger which had $646,000 of provision expense recorded during the year. The provision expense was necessary
based on loan events that occurred after the May 1, 2014 merger date which caused the estimated loss on the loan to increase
from original expectations. There was also the default of two large borrowers from the Cowlitz Acquisition which caused
$915,000 in provision expense during the year ended December 31, 2014. The impact of these events was partially offset by
the general improvements in the remaining loans' expected cash flows. The gross balance of the covered loans increased to
$126.2 million at December 31, 2014 from $63.8 million at December 31, 2013 as a result of the covered loans acquired in the
Washington Banking Merger. The Bank recorded net charge-offs on covered loans of $3.0 million for the year ended
December 31, 2014 as compared to $73,000 for the year ended December 31, 2013.
The allowance for loan losses on covered loans decreased $591,000, or 9.58% to $5.6 million at December 31, 2014 from
$6.2 million at December 31, 2013. The decrease was primarily the result of the resolution of specific covered loans, offset by
the general improvements in the expected cash flow of the covered loans.
While the Bank believes it has established its existing allowance for loan losses in accordance with GAAP, there can be no
assurance that regulators, in reviewing the Bank's loan portfolios, will not request the Bank to increase significantly its
allowance for loan losses. In addition, because future events affecting borrowers and collateral cannot be predicted with
certainty, there can be no assurance that the existing allowance for loan losses is appropriate or that increased provisions will
not be necessary should the quality of the loans deteriorate. Any material increase in the allowance for loan losses would
adversely affect the Company’s financial condition and results of operations. For additional information, see “Item 1.
Business—Analysis of Allowance for Loan Losses.”
Noninterest Income. Total noninterest income increased $6.8 million, or 70.6%, to $16.5 million for the year ended
December 31, 2014 compared to $9.7 million for the prior year. The components of the noninterest income and the changes
from prior year are as follows:
Years Ended December 31,
2014
2013
Change 2014
vs. 2013
Percentage
Change
Bargain purchase gain on bank acquisition ............
Service charges and other fees ..............................
Merchant Visa income, net ......................................
Change in FDIC indemnification asset ....................
Gain on sale of investment securities, net ..............
Gain on sale of loans, net........................................
Other income ...........................................................
Total noninterest income .........................................
$
— $
11,143
1,076
(2,543)
287
1,518
4,986
$
16,467 $
399
5,936
862
(181)
—
142
2,493
9,651
$
$
(399 )
5,207
214
(2,362 )
287
1,376
2,493
6,816
100.0%
87.7
24.8
(1,305.0)
100.0
969.0
100.0
70.6%
(Dollars in thousands)
The change in FDIC indemnification asset includes amortization of the FDIC indemnification asset and
increases/decreases to the FDIC indemnification asset as a result of changes in projected remaining cash flows of the covered
loans. The $2.4 million decrease was primarily due to a $2.2 million decrease in the loan (recapture) impairment and a
$204,000 increase in amortization expense to $1.5 million for the year ended December 31, 2014 compared to $1.3 million for
the year ended December 31, 2013. The Company recorded loan recaptures during the fourth quarter of 2014 due to the
revised estimated loss projections given the 2015 expiration date of certain shared-loss agreements. While the Bank believes
additional losses may be incurred on the assets, the timing of those losses will not likely occur before the expiration dates.
The increase in the amortization expense was primarily due to the overall improvements of the covered loans because less
loss is anticipated than prior period estimates. The balance of the indemnification asset at December 31, 2014 was $1.1 million
compared to $4.4 million at December 31, 2013.
Service charges and other fees increased $5.2 million, or 87.7%, to $11.1 million for the year ended December 31, 2014
from $5.9 million for the year ended December 31, 2013 primarily as a result of an increase in the deposit accounts acquired in
the Washington Banking Merger. See "Item 1. Business - Deposit Activities and Other Sources of Funds" for additional
information. Total deposits increased $1.51 billion, or 107.7% to $2.91 billion at December 31, 2014 from $1.40 billion at
December 31, 2013.
Gain on sale of loans, net increased $1.4 million, or 969.0%, to $1.5 million for the year ended December 31, 2014 from
$142,000 for the year ended December 31, 2013 as a result of the Bank resuming mortgage banking operations. The Bank
had ceased mortgage banking operations in the second quarter of 2013 and resumed these operations on the May 1, 2014
effective date of the merger as Washington Banking had a strong operational presence in the mortgage banking operations.
53
Other income increased $2.5 million, or 100.0%, to $5.0 million for the year ended December 31, 2014 from $2.5 million
for the year ended December 31, 2013 partially due to recoveries on legacy Washington Banking loans which were fully
charged-off prior to the merger date. The Bank had estimated that there would be no such recoveries for fair value purposes,
but the recovery efforts of the credit department has exceeded anticipated results. Other income also increased by $390,000
in 2014 as a result of earnings on the BOLI from the $32.5 million of BOLI acquired on May 1, 2014 in the Washington Banking
Merger. The increase in other income for 2014 was partially offset by a gain on sale of a bank branch of $596,000 recorded
during the year ended December 31, 2013.
The bargain purchase gain on bank acquisition of $399,000 for the year ended December 31, 2013 was the result of the
NCB Acquisition in January 2013. See Note - 2 Business Combinations of the Notes to Consolidated Financial Statements in
"Item 8. Financial Statements and Supplementary Data" for additional information on the NCB Acquisition.
Noninterest Expense. Noninterest expense increased $39.9 million or 67.0% to $99.4 million for the year ended
December 31, 2014 compared to $59.5 million for the year ended December 31, 2013.
The following table presents the key components of noninterest expense and the changes from prior year:
Years Ended December 31,
2014
2013
Change 2014
vs. 2013
Percentage
Change
$
Compensation and employee benefits ....................................
Occupancy and equipment ......................................................
Data processing .......................................................................
Marketing .................................................................................
Professional services ...............................................................
State and local taxes ...............................................................
Impairment loss on investment securities, net ........................
Federal deposit insurance premium ........................................
Other real estate owned, net ...................................................
Amortization of intangible assets .............................................
Other expense .........................................................................
52,634
13,406
9,243
2,502
6,185
1,976
45
1,718
638
1,920
9,112
(Dollars in thousands)
$
31,612 $
9,724
4,806
1,598
3,936
1,150
38
1,001
309
543
4,798
21,022
3,682
4,437
904
2,249
826
7
717
329
1,377
4,314
39,864
66.5%
37.9
92.3
56.6
57.1
71.8
18.4
71.6
106.5
253.6
89.9
67.0%
Total noninterest expense ........................................................
$
99,379
$
59,515 $
54
The increase in total noninterest expense for the year ended December 31, 2014 was due primarily to the Washington
Banking Merger and additional ongoing operating costs from mergers and acquisitions as well as specific costs identified in the
Company Initiatives table below. These initiatives include the NCB and Valley Acquisitions, the merger of Central Valley Bank
and the merger of Washington Banking Company, all of which are discussed in Notes 1 and 2 of the Notes to Consolidated
Financial Statements in "Item. 8 Financial Statements and Supplementary Data". Additionally, a core system conversion
occurred in fourth quarter of 2013 whereby, after 18 years of using FiServ's Total Plus core system, the Company converted to
FiServ's DNA platform which provides a variety of efficiencies in all operation areas of the Bank. The consolidation of existing
branches also occurred in the fourth quarter of 2013 with the Company consolidating three Heritage branch locations to nearby
branches. The table below includes each of the Company's major initiatives as well as the direct costs associated with the
initiatives for the years ended December 31, 2014 and 2013. The amounts include identifiable costs paid to third party
providers as well as any retention bonuses or severance payment made in conjunction with these initiatives. The amounts do
not include costs of additional staffing required to be maintained or utilized during a period of time in order to complete the
initiatives.
Company Initiatives:
NCB Acquisition ......................................................................
CVB Merger ............................................................................
Valley Acquisition ....................................................................
Core system conversion .........................................................
Consolidation of existing branches .........................................
Washington Banking Merger ...................................................
Years Ended December 31,
2014
2013
(In thousands)
$
$
—
—
443
40
11
9,094
794
220
2,118
842
238
890
Total expense ..........................................................................
$
9,588
$
5,102
The following table further segregates the Company initiative costs by financial statement caption.
Expense Caption:
Compensation and employee benefits ...............................
Occupancy and equipment ................................................
Data processing .................................................................
Marketing ...........................................................................
Professional services .........................................................
Other expense ....................................................................
Total expense .....................................................................
Years Ended December 31,
2014
2013
(In thousands)
$ 1,522
602
3,038
140
3,751
535
$ 9,588
$
475
1,328
1,291
34
1,876
98
$ 5,102
The types of expenses associated with the significant expense categories in the table above are summarized as follows:
• Compensation and employee benefits expense consisted substantially of retention bonus and severances packages
paid to transition employees.
• Occupancy and equipment expense consisted primarily of lease termination costs.
• Data processing expense consisted of costs relating to the Company’s core system conversion as well as data
conversions of the NCB, Valley Bank and Whidbey Island Bank information to the Heritage core system.
• Professional services expense related to fees paid to: (1) financial advisors for the NCB Acquisition, Valley
Acquisition and Washington Banking Merger, (2) attorney, accountant and consultant fees related to mergers and
acquisitions, and (3) consultant fees relating to the Company's core system conversion.
55
Other expense increased $4.3 million, or 89.9%, to $9.1 million for the year ended December 31, 2014 from $4.8 million
for the year ended December 31, 2013. Other expense includes, but is not limited to, items such as courier services, phone
costs, travel expenses, investor relations, and certain employee-related costs such as travel and meals. The increases in
other expense are primarily as a result of the Washington Banking Merger and the general increase due to the growth of the
Company during the year ended December 31, 2014 which is demonstrated by the increase in total assets to $3.46 billion at
December 31, 2014 from $1.66 billion at December 31, 2013.
The efficiency ratio for the year ended December 31, 2014 was 75.3% compared to 76.9% for the same period in the prior
year. The efficiency ratio consists of noninterest expense divided by the sum of net interest income before provision for loan
losses plus noninterest income. The decrease in the ratio for the year ended December 31, 2014 was primarily related to the
increase in net interest income related to mergers and acquisitions as described above which outpaced the increase in the
noninterest expense as described above. As cost savings are realized from the Washington Banking Merger, the Company
expects the efficiency ratio to continue to decrease.
Income Tax Expense. The provision for income taxes increased by $2.3 million to an expense of $6.9 million for the year
ended December 31, 2014 from an expense of $4.6 million for the year ended December 31, 2013. The Company’s effective
income tax rate was 24.7% for the year ended December 31, 2014 compared to 32.4% for the same period in 2013. The
decrease in the Company’s effective income tax rate from the prior year was primarily due to higher levels of tax-exempt
income in 2014, $812,000 in federal tax credits from new market tax credit partnerships and a $728,000 income tax benefit
related to the resolution of a tax position previously taken by Washington Banking Company.
Results of Operations for the Years Ended December 31, 2013 and 2012
Earnings Summary. Net income applicable to common shareholders of $0.61 per diluted common share was recorded
for the year ended December 31, 2013 compared to $0.87 per diluted common share for the year ended December 31, 2012.
Net income for the year ended December 31, 2013 was $9.6 million compared to net income of $13.3 million for the same
period in 2012. The $3.7 million decrease was primarily the result of a $9.1 million increase in noninterest expense and a $1.7
million increase in the provision for loan losses, partially offset by a $2.3 million increase in interest income, a $2.4 million
increase in noninterest income, a $1.6 million decrease in income tax expense and a $810,000 decrease in interest expense.
The Company’s efficiency ratio increased to 76.9% for the year ended December 31, 2013 from 70.1% for the year ended
December 31, 2012 primarily due to increases in the noninterest expense of $4.5 million related to the Company initiatives
including the acquisitions and system conversions of Northwest Commercial Bank and Valley Bank, the merger of Central
Valley Bank, the core system conversion, the consolidation of existing branches and the Washington Banking Company
merger. The details of these expenses are included in the "Noninterest Expense" section below.
Net Interest Income. Net interest income increased $3.1 million, or 4.8%, to $67.7 million for the year ended
December 31, 2013 compared to $64.6 million for the previous year. The increase in net interest income was due primarily to
increases in average interest earning assets, substantially attributable to the NCB and Valley Acquisitions, and the results of
the positive effects of the discount accretion on the acquired loan portfolios for the year ended December 31, 2013. The
increase in net interest income was partially offset by the decrease in the net interest margins due primarily to lower
contractual loan note rates in the current lending environment. Net interest income as a percentage of average interest
earning assets (net interest margin) for the year ended December 31, 2013 decreased 37 basis points to 4.80% from 5.17%
for the previous year. Our net interest spread for the year ended December 31, 2013 decreased to 4.69% from 5.03% for the
prior year.
Total interest income increased $2.3 million, or 3.4%, to $71.4 million for the year ended December 31, 2013, from $69.1
million for the year ended December 31, 2012. The increase in interest income was due primarily to the effects of the NCB and
Valley Acquisitions and the positive effects of the accretable discount, offset partially by lower yields on interest earning assets.
During the year ended December 31, 2013, the Company recorded approximately $2.7 million of discount accretion into
interest income that related to the NCB and Valley Acquisitions. This income would be in addition to the acquired loans'
contractual interest income. The balance of average interest earning assets (including nonaccrual loans) increased $161.8
million, or 13.0%, to $1.41 billion for the year ended December 31, 2013 from $1.25 billion for the year ended December 31,
2012. The majority of this increase in interest earning assets was a result of the NCB and Valley Acquisitions. The Company
acquired combined fair value at respective acquisition dates of $14.9 million in interest earning deposits, $57.1 million in
investment securities and $168.6 million in noncovered loans. The Company additionally generated organic growth by
increasing the noncovered loan receivable balance by $61.0 million, or 6.5% due to loan originations, net of loan payments.
56
The yield on interest earning assets decreased 47 basis points to 5.06% for the year ended December 31, 2013 from
5.53% for the year ended December 31, 2012. The decrease in the yield on interest earning assets for the year ended
December 31, 2013 reflects the decreased loan yields due primarily to lower contractual note rates as well as the effects of the
overall discount accretion on all the acquired loan portfolios. The effect of discount accretion on net interest margin for the year
ended December 31, 2013 and December 31, 2012 is as follows:
Net interest margin, excluding incremental accretion on purchased loans (1) ..............
Impact on net interest margin from incremental accretion on purchased loans (1) .......
Years Ended
December 31,
2013
2012
4.32%
0.48
4.67%
0.50
Net interest margin .........................................................................................................
4.80%
5.17%
(1) The incremental accretion income represents the amount of income recorded on the purchased loans in excess of the contractual
stated interest rate in the individual loan notes. This income results from the discount established at the time these loan portfolios were
acquired and modified quarterly as a result of cash flow re-estimation.
Yield on interest earning assets was additionally reduced by nonaccruing loans. For the years ended December 31, 2013
and December 31, 2012, noncovered nonaccruing loans reduced the yield on interest earning assets by approximately five
basis points and seven basis points, respectively. Nonaccrual noncovered loans totaled $7.7 million at December 31, 2013
compared to $13.2 million at December 31, 2012.
Interest income on taxable and nontaxable investment securities increased $165,000 to $3.5 million for the year ended
December 31, 2013 from $3.3 million for the year ended December 31, 2012 due primarily to an increase in the average
investment securities as a result of the NCB and Valley Acquisitions offset by lower yields earned on the investment securities
in 2013 as a result of declining interest rates. The changes in average balances and interest income on other interest earning
deposits had minimal impact on net interest margins for the years ended December 31, 2013 and 2012.
Total interest expense decreased by $810,000, or 17.9%, to $3.7 million for the year ended December 31, 2013 from $4.5
million for the year ended December 31, 2012. The decrease in interest expense was due to lower rates paid on interest
bearing liabilities, reflecting the relatively low interest rate environment. The average rate paid on interest bearing liabilities
decreased to 0.37% for the year ended December 31, 2013 from 0.50% for the year ended December 31, 2012. Total average
interest bearing liabilities increased by $107.3 million, or 11.9%, to $1.01 billion for the year ended December 31, 2013 from
$904.5 million for the year ended December 31, 2012. The increase in average interest bearing liabilities was due primarily to
the NCB and Valley Acquisitions which had a combined fair value at the acquisitions dates of $267.5 million, offset by deposit
run-off anticipated from the acquisitions and consolidation of existing bank branches.
Provision for Loan Losses. The total provision for loan losses increased $1.7 million, or 82.1%, to $3.7 million for the
year ended December 31, 2013 from $2.0 million for the year ended December 31, 2012. The Bank has established a
comprehensive methodology for determining the allowance for loan losses and related provision for loan losses on loans. On a
quarterly basis, the Bank performs an analysis taking into consideration pertinent factors underlying the quality of the loan
portfolio. These factors include changes in the amount and composition of the loan portfolio, historical loss experience for
various loan classes, changes in economic conditions, delinquency rates, a detailed analysis of individual loans on nonaccrual
status, and other factors to determine the level of the allowance for loan losses and the related provision for loan losses.
57
The provision for loan losses on noncovered loans increased $214,000, or 13.6%, to $1.8 million for the year ended
December 31, 2013 from $1.6 million for the year ended December 31, 2012. The increase in provision expense on
noncovered loans was due primarily to the default of a few acquired borrowing relationships, offset partially by improvements
in the environmental factors as well as lower net charge-offs on noncovered loans which decreased to $3.4 million during the
year ended December 31, 2013 compared to $4.3 million during the year ended December 31, 2012. The ratio of net charge-
offs for noncovered loan to average total noncovered loans outstanding was 0.32% for the year ended December 31, 2013 and
0.48% for the year ended December 31, 2012. Total noncovered loans at December 31, 2013 and 2012 were $1.17 billion and
$940.7 million, respectively. The general allowance as a percentage of non-impaired loans was 1.63% and 2.11% at
December 31, 2013 and 2012, respectively. The decrease in the percentage during the noted periods is due to reduction in
the historical loss factors, change in the mix of loans, and a general improvement in the credit environment.
The following table outlines the allowance for loan losses and related outstanding loan balances on noncovered loans at
December 31, 2013 and 2012:
December 31, 2013
December 31, 2012
(Dollars in thousands)
General Valuation Allowance:
Allowance for loan losses on noncovered loans ........................
Gross noncovered loan balance of non-impaired loans .............
Percentage .................................................................................
Specific Valuation Allowance:
Allowance for loan losses on noncovered loans ........................
Gross noncovered loan balance of impaired loans ....................
Percentage .................................................................................
Total Allowance for Loan Losses on noncovered loans:
Allowance for loan losses on noncovered loans ........................
Gross noncovered loan balance ................................................
Percentage .................................................................................
$
$
$
18,618
1,140,967
1.63%
4,039
29,869
13.52%
22,657
1,170,836
1.94%
$
$
$
19,558
927,485
2.11%
4,684
13,219
35.43%
24,242
940,704
2.58%
The allowance for loan losses on noncovered loans decreased by $1.6 million, or 6.5%, to $22.7 million at December 31,
2013 from $24.2 million at December 31, 2012. As of December 31, 2013, the Bank identified $7.7 million of nonperforming
noncovered loans and $22.1 million of performing restructured noncovered loans for a total of $29.9 million of impaired
noncovered loans. Of these impaired loans, $17.4 million have no allowances for loan losses as their estimated collateral value
or expected cash flow is equal to or exceeds their carrying costs. The remaining $12.4 million have related allowances for loan
losses totaling $4.0 million. Based on the comprehensive methodology, management deemed the allowance for loan losses on
noncovered loans of $22.7 million at December 31, 2013 (1.94% of total noncovered loans and 292.8% of nonperforming
noncovered loans) appropriate to provide for probable incurred losses based on an evaluation of known and inherent risks in
the loan portfolio at that date.
The provision for loan losses on covered loans increased $1.4 million, or 323.3%, to $1.9 million for the year ended
December 31, 2013 compared to $446,000 for the year ended December 31, 2012. The provision for loan losses on covered
loans recorded for the year ended December 31, 2013 was a result of several specific loan events. The Bank resolved one
significant covered loan which generated approximately $585,000 in provision expense. The Bank also experienced significant
collateral deficiencies on two borrowers which added an additional $1.6 million in provision expense. The impact of these
events was partially offset by the general improvements in the remaining loans' expected cash flows which reduced the
provision expense during the year ended December 31, 2013. The Bank recorded net charge-offs of $73,000 for the covered
loans for the year ended December 31, 2013 as compared to $57,000 for the year ended December 31, 2012.
The allowance for loan losses on covered loans increased $1.8 million, or 41.7% to $6.2 million at December 31, 2013
from $4.4 million at December 31, 2012. The increase was primarily the result of the specific covered loans described above,
offset by the general improvements in the expected cash flow of the covered loans.
58
Noninterest Income. Total noninterest income increased $2.4 million, or 32.7%, to $9.7 million for the year ended
December 31, 2013 compared to $7.3 million for the prior year.
The components of the noninterest income and the changes from prior year are as follows:
Years Ended December 31,
2013
2012
Change 2013
vs. 2012
Percentage
Change
(Dollars in thousands)
Bargain purchase gain on bank acquisition ...........
Service charges and other fees .............................
Merchant Visa income, net .....................................
Change in FDIC indemnification asset ...................
Gain on sale of loans .............................................
Other income ..........................................................
$
399 $
— $
5,936
862
(181)
142
2,493
5,516
685
(1,033)
295
1,809
399
420
177
852
(153)
684
100.0%
7.6
25.8
82.5
(51.9)
37.8
Total noninterest income ........................................
$
9,651 $
7,272 $
2,379
32.7%
The change in FDIC indemnification asset includes amortization of the FDIC indemnification asset and increases to the
FDIC indemnification asset as a result of decreases in projected remaining cash flows of the purchased covered loans. The
increase in this income was primarily due to the $609,000 decrease in amortization expense of $1.3 million for the year ended
December 31, 2013 compared to $1.9 million for the year ended December 31, 2012. The decrease in the amortization
expense was primarily due to the declining indemnification asset balance. The balance of the indemnification asset at
December 31, 2013 was $4.4 million compared to $7.1 million at December 31, 2012. The change in FDIC indemnification
asset also increased due to an increase in the loan impairment, which was an increase of income of $1.1 million for the year
ended December 31, 2013 compared to $843,000 in the prior year. Under the symmetrical accounting for acquired covered
loans, an increase in the provision for loan losses for covered loans will generally have a related increase in the loan
impairment. The provision for loan losses on covered loans was $1.9 million for the year ended December 31, 2013 compared
to $446,000 for the year ended December 31, 2012.
Other income increased $684,000, or 37.8%, to $2.5 million for the year ended December 31, 2013 from $1.8 million for
the year ended December 31, 2012 primarily due to the gain on sale of a bank branch of $596,000. The $420,000 increase in
service charges and other fees to $5.9 million for the year ended December 31, 2013 compared to $5.5 million for the prior
year was primarily the result of increased deposits and an expanded customer base. Deposits at December 31, 2013
increased to $1.40 billion at December 31, 2013 from $1.12 billion at December 31, 2012 primarily as a result of the NCB and
Valley Acquisitions. The bargain purchase gain on bank acquisition of $399,000 for the year ended December 31, 2013 was
the result of the NCB Acquisition in January 2013. See Note 2 - Business Combinations of the Notes to Consolidated Financial
Statements in "Item 8. Financial Statements and Supplementary Data" for additional information on the NCB and Valley
Acquisitions.
Noninterest Expense. Noninterest expense increased $9.1 million or 18.1% to $59.5 million for the year ended
December 31, 2013 compared to $50.4 million for the year ended December 31, 2012.
59
The following table presents the key components of noninterest expense and the change from prior year:
Years Ended December 31,
2013
2012
Change 2013
vs. 2012
Percentage
Change
(Dollars in thousands)
Compensation and employee benefits ..............................
Occupancy and equipment ................................................
Data processing .................................................................
Marketing ...........................................................................
Professional services .........................................................
State and local taxes ..........................................................
Impairment loss on investment securities, net ...................
Federal deposit insurance premium ..................................
Other real estate owned, net..............................................
Amortization of intangible assets .......................................
Other expense ...................................................................
Total noninterest expense ..................................................
$ 31,612
9,724
4,806
1,598
3,936
1,150
38
1,001
309
543
4,798
$ 59,515
$ 29,020 $
7,365
2,555
1,517
2,543
1,226
78
1,002
316
427
4,343
$ 50,392 $
2,592
2,359
2,251
81
1,393
(76)
(40)
(1)
(7)
116
455
9,123
8.9%
32.0
88.1
5.3
54.8
(6.2)
(51.3)
(0.1)
(2.2)
27.2
10.5
18.1%
The increase in total noninterest expense for the year ended December 31, 2013 was due primarily to increased expenses
related to 2013 Company initiatives. The table below includes each of the Company's major initiatives as well as the direct
costs associated with the initiatives for the years ended December 31, 2013 and 2012. The amounts include identifiable costs
paid to third party providers as well as any retention bonuses or severance payment made in conjunction with these initiatives.
The amounts do not include costs of additional staffing required to be maintained or utilized during a period of time in order to
complete the initiatives.
Company Initiatives:
NCB Acquisition .................................................................................
CVB Merger .......................................................................................
Valley Acquisition ...............................................................................
Core system conversion ....................................................................
Consolidation of existing branches ....................................................
Washington Banking Merger .............................................................
Years Ended December 31,
2013
2012
(In thousands)
$
794
220
2,118
842
238
890
$ 616
—
—
—
—
—
Total expense
$ 5,102
$ 616
The following table further segregates the Company initiative costs by financial statement caption.
Years Ended December 31,
2013
2012
(In thousands)
Expense Caption:
Compensation and employee benefits .........................................
Occupancy and equipment ...........................................................
Data processing ............................................................................
Marketing ......................................................................................
Professional services ....................................................................
Other expense ..............................................................................
$
$
475
1,328
1,291
34
1,876
98
Total expense ................................................................................
$ 5,102
$
—
—
—
—
610
6
616
60
Other expense includes, but is not limited to, items such as courier services, travel expenses, investor relations, and
certain employee-related costs such as travel and meals. The increase in other expense for the year ended December 31,
2013 as compared to the year ended December 31, 2012 was partly due to the investor relations expense increase of
$115,000 as a result of the NCB and Valley Acquisitions as well as the Washington Banking Merger. The remaining increases
in other expense were the result of general increases due to the growth of the Company during the year ended December 31,
2013 which is demonstrated by the increase in total assets to $1.66 billion at December 31, 2013 from $1.35 billion at
December 31, 2012 .
The efficiency ratio for the year ended December 31, 2013 was 76.9% compared to 70.1% for the same period in the prior
year. The efficiency ratio consists of noninterest expense divided by the sum of net interest income before provision for loan
losses plus noninterest income. The increase in the ratio for the year ended December 31, 2013 was primarily related to the
increase in noninterest expense as described above. While growth strategies are being executed, the Company expects to
incur higher noninterest expenses as evidenced by the current increasing efficiency ratio. Noninterest expenses are expected
to be more in line with income when these growth strategies begin producing long term results.
Income Tax Expense. The provision for income taxes decreased by $1.6 million to an expense of $4.6 million for the
year ended December 31, 2013 from an expense of $6.2 million for the year ended December 31, 2012. The Company’s
effective income tax rate was 32.4% for the year ended December 31, 2013 compared to 31.8% for the same period in 2012.
The increase in the Company’s effective income tax rate from the prior year was primarily due to increased non-deductible
acquisition expenses.
Liquidity and Capital Resources
Our primary sources of funds are customer and local government deposits, loan principal and interest payments, loan
sales, 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.
We must maintain an adequate level of liquidity to ensure the availability of sufficient funds to fund loan originations and
deposit withdrawals, satisfy other financial commitments, and fund operations. We generally maintain sufficient cash and
investments to meet short-term liquidity needs. At December 31, 2014, cash and cash equivalents totaled $121.6 million, or
3.5% of total assets. Other interest earning deposits totaled $10.1 million at December 31, 2014. These assets are easily
converted to liquidity. Investment securities available for sale totaled $742.8 million at December 31, 2014, of which $183.5
million were pledged to secure public deposits or borrowing arrangements. Management considers unpledged investment
securities available for sale to be a viable source of liquidity. The fair value of investment securities available for sale that were
not pledged to secure public deposits or borrowing arrangements totaled $559.3 million, or 16.2% of total assets at December
31, 2014. The fair value of investment securities available for sale with maturities of one year or less amounted to $4.2 million,
or 0.1% of total assets. At December 31, 2014, the Bank maintained credit facilities with the FHLB of Seattle for $374.3 million
and credit facilities with the Federal Reserve Bank of San Francisco for $53.2 million, of which there were no borrowings
outstanding as of December 31, 2014. The Bank also maintains advance lines with Zions Bank, Wells Fargo Bank, US Bank
and Pacific Coast Bankers’ Bank to purchase federal funds totaling $43.0 million as of December 31, 2014. As of
December 31, 2014, there were no overnight federal funds purchased.
61
During 2014 total assets increased $1.80 billion, or 108.4%, to $3.46 billion at December 31, 2014 from $1.66 billion at
December 31, 2013. The increase was primarily due to the assets acquired in the Washington Banking Merger. The
components of the change in assets and the fair value of assets acquired at the May 1, 2014 merger date are included in the
following table:
December 31,
2014
December 31,
2013
Change 2014
vs. 2013
Fair Value of
Washington
Banking at
Merger Date
Cash and cash equivalents ................................
Other interest earning deposits ..........................
Investment securities available for sale .............
Investment securities held to maturity ................
Loans held for sale .............................................
Noncovered loans receivable, net of allowance
for loan losses..............................................
Covered loans receivable, net of allowance for
loan losses ...................................................
FDIC indemnification asset ................................
Other real estate owned .....................................
Premises and equipment, net ............................
FHLB stock, at cost ............................................
Bank owned life insurance .................................
Accrued interest receivable ................................
Prepaid expenses and other assets ...................
Other intangible assets, net ...............................
Goodwill .............................................................
$
$
121,636
10,126
742,846
35,814
5,582
$
(Dollars in thousands)
130,400
15,662
163,134
36,154
—
(8,764)
(5,536)
579,712
(340)
5,582
2,102,724
1,145,509
957,215
120,624
1,116
3,355
64,938
12,188
35,176
9,836
61,871
10,889
119,029
57,587
4,382
4,559
34,348
5,741
2,193
5,462
22,927
1,615
29,365
63,037
(3,266)
(1,204)
30,590
6,447
32,983
4,374
38,944
9,274
89,664
$
74,947
—
458,312
—
3,923
895,978
107,050
7,174
7,121
31,776
7,064
32,519
4,943
14,852
11,194
89,664
Total assets ..................................................
$
3,457,750
$ 1,659,038
$ 1,798,712
$ 1,746,517
Our strategy has been to acquire core deposits (which we define to include all deposits except public funds, brokered CDs
and other wholesale deposits) from our retail accounts, 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 make loans and purchase investment securities.
Stockholders’ equity was $454.5 million at December 31, 2014 and $215.8 million at December 31, 2013. During the year
ended December 31, 2014, we issued 14.0 million shares of common stock valued at $226.2 million related to the Washington
Banking Merger, net of $489,000 of stock issuance costs, realized net income of $21.0 million, paid common stock dividends of
$12.9 million, recorded $4.7 million in net unrealized gains on investment securities available for sale, net of tax, repurchased
$2.6 million in common stock, recorded stock option and restricted stock compensation expense, net of tax, totaling $1.5
million and realized the effects of exercising stock options totaling $921,000.
The Company and the Bank are subject to various regulatory capital requirements as prescribed by the Federal Reserve
and by the FDIC, respectively. As of December 31, 2014, the Company and the Bank were classified as “well capitalized”
institutions under the criteria established by these banking regulators.
62
Quarterly, the Company reviews the potential payment of cash dividends to common shareholders. The timing and
amount of cash dividends paid on our common stock depends on the Company’s earnings, capital requirements, financial
condition and other relevant factors. Dividends on common stock from the Company depend substantially upon receipt of
dividends from the Bank, which is the Company’s predominant sources of income. On January 28, 2015, the Company’s Board
of Directors declared a dividend of $0.10 per share payable on February 24, 2015 to shareholders of record on February 10,
2015.
Contractual Obligations
The following table provides the amounts due under specified contractual obligations for the periods indicated as of
December 31, 2014:
Up to 1 year
Over 1-3 years
Over 3-5 years
More
than
5 years
Other (1)
Total
December 31, 2014
(In thousands)
Contractual payments
by period:
Deposits .............................
Operating leases ................
Total contractual
obligations ................
$ 347,895 $
3,307
143,103 $
5,725
33,770 $
3,780
629 $ 2,380,934 $ 2,906,331
16,535
—
3,723
$
351,202 $
148,828 $
37,550 $
4,352 $ 2,380,934 $ 2,922,866
(1) Represents interest bearing and noninterest bearing checking, money market and checking accounts which can generally be withdrawn
on demand and thereby have an undefined maturity.
Asset/Liability Management
Our primary financial objective is to achieve long-term profitability while controlling our exposure to fluctuations in market
interest rates. To accomplish this objective, we have formulated an interest rate risk management policy that attempts to
manage the mismatch between asset and liability maturities while maintaining an acceptable interest rate sensitivity position.
The principal strategies which we employ to control our interest rate sensitivity are: originating certain commercial business
loans and real estate construction and land development loans at variable interest rates repricing for terms generally one year
or less; and offering noninterest bearing demand deposit accounts to businesses and individuals. The longer-term objective is
to increase the proportion of noninterest bearing demand deposits, low-rate interest bearing demand deposits, money market
accounts, and savings deposits relative to certificates of deposit to reduce our overall cost of funds.
Our asset and liability management strategies have resulted in a negative 0-3 month “gap” of 21.8% and a negative 4-12
month “gap” of 3.4% as of December 31, 2014. These “gaps” measure the difference between the dollar amount of our interest
earning assets and interest bearing liabilities that mature or reprice within the designated period (three months and 4-12
months) as a percentage of total interest earning assets, based on certain estimates and assumptions as discussed below. We
believe that the implementation of our operating strategies has reduced the potential effects of changes in market interest rates
on our results of operations. The negative gap for the 0-3 month period indicates that decreases in market interest rates may
favorably affect our results over that period.
63
The following table provides the estimated maturity or repricing and the resulting interest rate sensitivity gap of our interest
earning assets and interest bearing liabilities at December 31, 2014. We used certain assumptions in presenting this data so
the amounts may not be consistent with other financial information prepared in accordance with generally accepted accounting
principles. The amounts in the tables also could be significantly affected by external factors, such as changes in prepayment
assumptions, early withdrawal of deposits and competition.
December 31, 2014
Estimated Maturity or Repricing Within
Interest Earnings Assets:
Loans Receivable (1) ....................
Investment securities (2) ...............
FHLB stock ...................................
Interest earning deposits ..............
Other interest earning deposits .....
Total interest earning
assets ................................
Percentage of interest earning
assets ........................................
0-3
months
Over 3
months-12
months
1-5
years
Over 5
years -15
years
Over
15 years
Total
(Dollars in thousands)
$1,077,856
34,000
12,188
47,608
818
$
87,449
27,075
—
—
6,572
$ 919,891
136,295
—
—
2,736
$
165,551 $
384,953
—
—
—
1,267
196,337
—
—
—
$ 2,252,014
778,660
12,188
47,608
10,126
$ 1,172,470
$ 121,096
$ 1,058,922
$
550,504 $ 197,604
$ 3,100,596
37.8%
3.9%
34.2%
17.7%
6.4%
100.0%
Interest Bearing Liabilities:
Total interest bearing
deposits(3) ................................
$1,797,371
Junior subordinated
debentures ................................
Securities sold under agreement
to repurchase ................................
Total interest bearing
$ 225,216
$ 173,442
$
629 $
19,082
32,181
—
—
—
—
—
—
—
—
—
—
$ 2,196,658
19,082
32,181
$ 2,247,921
liabilities .............................
$ 1,848,634
$ 225,216
$ 173,442
$
629 $
Interest bearing liabilities, as a
percentage of total interest
earning assets ...........................
Interest rate sensitivity gap .......
Interest rate sensitivity gap, as a
percentage of total interest
earning assets ...........................
Cumulative interest rate
sensitivity gap............................
Cumulative interest rate
sensitivity gap, as a
percentage of total interest
earning assets ...........................
59.6%
7.3%
5.6%
—%
—%
72.5%
$ (676,164)
$ (104,120)
$ 885,480
$
549,875 $ 197,604
$ 852,675
(21.8)%
(3.4)%
28.6%
17.7%
6.4%
27.5%
$ (676,164)
$ (780,284)
$ 105,196
$
655,071 $ 852,675
(21.8)%
(25.2)%
3.4%
21.1%
27.5%
Interest earning investment securities with no stated maturity date are included in 0-3 months as prices may adjust immediately.
(1) Excludes deferred loan fees and allowance for loan losses.
(2)
(3) Adjustable-rate liabilities are included in the period in which interest rates are next scheduled to adjust rather than in the period they are due to mature.
Although regular savings, demand, NOW, and money market deposit accounts are subject to immediate withdrawal, based on historical experience
management considers a substantial amount of such accounts to be core deposits having significantly longer maturities.
64
Certain shortcomings are inherent in the method of analysis presented in the foregoing table. For example, although
certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes
in market interest rates. Also, the interest rates on some types of assets and liabilities may fluctuate in advance of changes in
market interest rates, while interest rates on other types may lag behind changes in market interest rates. Additionally, some
assets, such as adjustable rate mortgages, have features, which restrict changes in the interest rates of those assets both on a
short-term basis and over the lives of such assets. Further, if a change in market interest rates occurs, prepayment and early
withdrawal levels could deviate significantly from those assumed in calculating the tables. Finally, the ability of many borrowers
to service their adjustable rate debt may decrease if market interest rates increase substantially.
Impact of Inflation and Changing Prices
Inflation affects our operations by increasing operating costs and indirectly by affecting the operations and cash flow of our
customers. Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in
nature. As a result, changes in interest rates generally have a more significant impact on a financial institution’s performance
than the effects of general levels of inflation. Although interest rates do not necessarily move in the same direction or the same
extent as the prices of goods and services, increases in inflation generally have resulted in increased interest rates.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to interest rate risk through our lending and deposit gathering activities. For a discussion of how this
exposure is managed and the nature of changes in our interest rate risk profile during the past year, see “Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operation—Asset/Liability Management.”
Neither we, nor the Bank, maintain a trading account for any class of financial instrument, nor do we, or the Bank, engage
in hedging activities or purchase high risk derivative instruments. Moreover, neither we, nor the Bank, are subject to foreign
currency exchange rate risk or commodity price risk.
65
The table below provides information about our financial instruments that are sensitive to changes in interest rates as of
December 31, 2014. The table presents principal cash flows and related weighted average interest rates by expected maturity
dates. The expected maturity is the contractual maturity or earlier call date of the instrument. The data in this table may not be
consistent with the amounts in the preceding table, which represents amounts by the repricing date or maturity date, whichever
occurs sooner.
0-3
months
Over 3
months-
12
months
By Expected Maturity Date
Year Ended December 31,
1-5
years
Over 5
years -15
years
Over
15 years
(Dollars in thousands)
Total
Fair Value
Investment Securities(1)
Amounts maturing:
Fixed rate .....................
Weighted average
interest rate ..............
Adjustable rate .............
Weighted average
interest rate ..............
Total ......................
$
$
$
—
—%
—
—%
—
$
7,066
$ 65,612
$ 404,540
$ 221,315
$ 698,533
$
2.2%
—
$
—%
2.1%
10
2.3%
2.6%
2.4%
2.5%
$
12,322
$ 65,822
$
78,154
1.1%
1.4%
1.4%
$
7,066
$ 65,622
$ 416,862
$ 287,137
$ 776,687
$ 777,747
Loans(2)
Amounts maturing:
Fixed rate .....................
Weighted average
interest rate ..............
Adjustable rate .............
Weighted average
interest rate ..............
Total ......................
Certificates of Deposit
Amounts maturing:
Fixed rate .....................
Weighted average
interest rate ..............
Junior Subordinated
Debentures
Amounts maturing:
Adjustable rate .............
Weighted average
interest rate (3) .........
$ 42,727
$ 51,655
$ 313,953
$ 295,738
$ 79,421
$ 783,494
4.8%
$ 96,471
5.4%
5.0%
4.5%
4.9%
4.8%
$ 142,042
$ 244,540
$ 817,321
$ 168,146
$ 1,468,520
5.3%
5.1%
4.6%
4.7%
4.2%
4.7%
$ 139,198
$ 193,697
$ 558,493
$ 1,113,059
$ 247,567
$ 2,252,014
$ 2,279,081
$ 1,693
$ 346,202
$ 176,873
$
629
$
—
$ 525,397
$ 525,768
0.3%
0.7%
0.9%
0.3%
—%
0.7%
$
—
$
—
$
—
$
—
$ 19,082
$
19,082
$
19,082
—%
—%
—%
—%
3.6%
3.6%
(1) Balances represent carrying value, and excludes investment securities with no stated maturity.
(2) Excludes deferred loan fees and allowance for loan losses.
(3) The contractual interest rate of the junior subordinated debentures was 1.82% at December 31, 2014. The weighted average interest rate includes
the effects of the discount accretion for the Washington Banking Merger purchase accounting adjustment.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
For financial statements, see the Index to Consolidated Financial Statements on page F-1.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE
None
66
ITEM 9A. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures.
Our disclosure controls and procedures are designed to ensure that information the Company must disclose in its reports
filed or submitted under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed,
summarized, and reported on a timely basis. Our management has evaluated, with the participation and under the supervision
of our chief executive officer (“CEO”) and chief financial officer (“CFO”), the effectiveness of our disclosure controls and
procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act) as of the end of the period covered by this
report. Based on this evaluation, our CEO and CFO have concluded that, as of such date, the Company’s disclosure controls
and procedures are effective in ensuring that information relating to the Company, including its consolidated subsidiaries,
required to be disclosed in reports that it files under the Exchange Act is (1) recorded, processed, summarized and reported
within the time periods specified in the SEC’s rules and forms, and (2) accumulated and communicated to our management,
including our CEO and CFO, as appropriate to allow timely decisions regarding required disclosure.
Internal Control Over Financial Reporting.
(a) Management’s report on internal control over financial reporting.
The Company’s management is responsible for establishing and maintaining adequate internal control over financial
reporting. The Company’s internal control system is designed to provide reasonable assurance to our management and the
board of directors regarding the preparation and fair presentation of published financial statements. Nonetheless, all internal
control systems, no matter how well designed, have inherent limitations. Even systems determined to be effective as of a
particular date can provide only reasonable assurance with respect to financial statement preparation and presentation and
may not eliminate the need for restatements.
The Company’s management assessed the effectiveness of the Company’s internal control over financial reporting as of
December 31, 2014. In making this assessment, management used the criteria set forth by the Committee of Sponsoring
Organizations of the Treadway Commission in the 1992 Internal Control—Integrated Framework. Based on our assessment,
we believe that, as of December 31, 2014, the Company’s internal control over financial reporting is effective based on these
criteria.
As permitted, the Company excluded the operations of Washington Banking Company, acquired during 2014, from the
scope of management’s report on internal control over financial reporting.
Crowe Horwath LLP, an independent registered public accounting firm, has audited the effectiveness of our internal control
over financial reporting as of December 31, 2014, and their report is included in “Item 8. Financial Statements and
Supplementary Data.”
(b) Attestation report of the registered public accounting firm.
See “Item 8. Financial Statements and Supplementary Data.”
(c) Changes in internal control over financial reporting.
There were no significant changes in the Company’s internal control over financial reporting during the Company’s
most recent fiscal year that have materially affected, or are reasonably likely to materially affect, the Company’s internal
control over financial reporting.
ITEM 9B. OTHER INFORMATION
None
67
PART III
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Information concerning directors of the registrant is incorporated by reference to the section entitled “Proposal 1 - Election
of Directors” of our definitive proxy statement for the annual meeting of shareholders to be held on May 6, 2015 (“Proxy
Statement”).
For information regarding the executive officers of the Company, see “Item 1. Business—Executive Officers.”
The required information with respect to compliance with Section 16(a) of the Exchange Act is incorporated by reference
to the section entitled “Security Ownership of Certain Beneficial Owners and Management” of the Proxy Statement.
The Company has adopted a written Code of Ethics that applies to our directors, officers and employees. The Code of
Ethics can be accessed electronically by visiting the Company’s website at www.hf-wa.com.
The Audit and Finance Committee of our Board of Directors retains our independent auditors, reviews and approves the
scope and results of the audits with the auditors and management, monitors the adequacy of our system of internal controls
and reviews the annual report, auditors’ fees and non-audit services to be provided by the independent auditors. The members
of our Audit Committee are Deborah J. Gavin, chair of the committee, Brian S. Charneski, John A. Clees, Mark D. Crawford
and Gragg E. Miller, all of whom are considered “independent” as defined by the SEC. Our Board of Directors has determined
that Mrs. Gavin meets the definition of an audit committee financial expert, as determined by the requirements of the SEC.
ITEM 11. EXECUTIVE COMPENSATION
Information concerning executive and director compensation and certain matters regarding participation in the Company’s
Compensation Committee required by this item is incorporated by reference to the headings “Executive Compensation”,
“Directors’ Compensation,” and “Report of the Compensation Committee” of the Proxy Statement.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
STOCKHOLDER MATTERS
The following table summarizes the consolidated activity within the Company’s stock option plans as of December 31,
2014, all of which were approved by shareholders.
Plan Category
Number of
securities
to be issued
upon exercise of
outstanding
options and
awards
Weighted-
average
exercise
price of
outstanding
options
Number of
securities
remaining
available for
future issuance
under equity
compensation
plans
Equity compensation plans, all of which are approved by
security holders ........................................................................
395,076 $
14.56
1,384,105
Information concerning security ownership of certain beneficial owners and management is incorporated by reference to
the section entitled “Security Ownership of Certain Beneficial Owners and Management” of the Proxy Statement.
68
ITEM 13. CERTAIN RELATIONSHIP AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
Information concerning certain relationships and related transactions is incorporated by reference to the sections entitled
“Meetings and Committees of the Board of Directors" and "Corporate Governance” of the Proxy Statement.
Our common stock is listed on the NASDAQ Global Select Market. In accordance with NASDAQ requirements, at least a
majority of our directors must be independent directors. The Board of Directors has determined that twelve of our fourteen
directors are independent. Directors Altom, Charneski, Christensen, Crawford, Clees, Ellwanger, Gavin, Lyon, Miller, Pickering,
Severns, and Watson are all independent. Only Brian L. Vance, who serves as President and Chief Executive Officer of
Heritage Financial Corporation and Chief Executive Officer of Heritage Bank, and David H. Brown, former Chief Executive
Officer of Valley Community Bancshares, Inc. and Valley Bank, were not independent.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
Information concerning principal accounting fees and services is incorporated by reference to the section entitled
“Proposal 3—Ratification of the Appointment of Independent Registered Public Accounting Firm” in the Proxy Statement.
69
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
PART IV
(a)(1) Financial Statements: The Consolidated Financial Statements are contained as listed on the “Index to Consolidated
Financial Statements” on page F-1.
(2) Financial Statements Schedules: All schedules are omitted because they are not required or applicable, or the
required information is shown in the Consolidated Financial Statements or Notes.
(3) Exhibits: Included in schedule below.
Exhibit No.
2.1
Description of Exhibit
Purchase and Assumption Agreement for Cowlitz Acquisition (1)
2.2
Purchase and Assumption Agreement for Pierce Acquisition (2)
2.3 Definitive Agreement for Valley Acquisition (3)
2.4
Agreement and Plan of Merger with Washington Banking Company (4)
3.1 Articles of Incorporation (5)
3.2 Amended and Restated Bylaws of the Company (6)
10.1
10.2
10.3
10.4
1998 Stock Option and Restricted Stock Award Plan (7)
1997 Stock Option and Restricted Stock Award Plan (8)
2002 Incentive Stock Option Plan, Director Nonqualified Stock Option Plan, and Restricted Stock
Option Plan (9)
2006 Incentive Stock Option Plan, Director Nonqualified Stock Option Plan, and Restricted Stock
Option Plan (10)
10.5 Annual Incentive Compensation Plan (11)
10.6
10.7
2010 Omnibus Equity Plan (12)
2014 Omnibus Equity Plan (13)
10.8 Form of Nonqualified Stock Option Award Agreement under the Heritage Financial Corporation 2014
Omnibus Equity Plan (14)
10.9 Form of Restricted Stock Award Agreement under the Heritage Financial Corporation 2014 Omnibus
Equity Plan (14)
10.10 Form of Restricted Stock Unit Award Agreement under the Heritage Financial Corporation 2014
Omnibus Equity Plan (14)
10.11 Deferred Compensation Plan and Participation Agreements by and between Heritage and each of
Brian L. Vance, Jeffrey J. Deuel and Donald J. Hinson (15)
10.12 Employment Agreements by and between Heritage and each of Brian L. Vance, Jeffrey J. Deuel and
Donald J. Hinson (15)
10.13 Employment Agreement and Deferred Compensation Participation Agreement by and between
Heritage and David A. Spurling (16)
10.14 Employment Agreement by and between Heritage and Bryan McDonald (17)
10.15 Employment Agreements by and between Heritage and Edward Eng (17)
10.16 Deferred Compensation Plan and Participation Agreement by and between Heritage and Bryan D.
McDonald (20)
11 Statement regarding computation of earnings per share (18)
14.0 Code of Ethics and Conduct Policy (19)
21.0 Subsidiaries of the Company (20)
23.0 Consent of Independent Registered Public Accounting Firm (20)
70
24.0 Power of Attorney (20)
31.1 Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2 Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1 Certification of Principal Executive Officer and Principal Financial Officer pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002
101 The following materials from Heritage Financial Corporation’s Annual Report on Form 10-K for the year
ended December 31, 2014, formatted in Extensible Business Reporting Language (“XBRL”): (i)
Consolidated Statements of Financial Condition, (ii) Consolidated Statements of Income; (iii)
Consolidated Statements of Comprehensive Income, (iv) Consolidated Statements of Stockholders'
Equity; (v) Consolidated Statements of Cash Flows, and (vi) Notes to Consolidated Financial
Statements (21)
(1) Incorporated by reference to the Current Report on Form 8-K dated July 30, 2010.
(2) Incorporated by reference to the Current Report on Form 8-K dated November 5, 2010.
(3) Incorporated by reference to the Current Report on Form 8-K dated March 11, 2013.
(4) Incorporated by reference to the Current Report on Form 8-K dated October 23, 2013.
(5) Incorporated by reference to the Registration Statement on Form S-1 (Reg. No. 333-35573) declared effective on
November 12, 1997; as amended, said Amendment being incorporated by reference to the Amendment to the Articles of
Incorporation of Heritage Financial Corporation filed with the Current Report on Form 8-K dated November 25, 2008.
(6) Incorporated by reference to the Current Report on Form 8-K dated April 30, 2014.
(7) Incorporated by reference to the Registration Statement on Form S-8 (Reg. No. 333-71415).
(8) Incorporated by reference to the Registration Statement on Form S-8 (Reg. No. 333-57513).
(9) Incorporated by reference to the Registration Statements on Form S-8 (Reg. No. 333-88980; 333-88982;
333-88976).
(10) Incorporated by reference to the Registration Statements on Form S-8 (Reg. No. 333-134473; 333-134474;
333-134475).
(11) Incorporated by reference to the Annual Report on Form 10-K dated March 2, 2010.
(12) Incorporated by reference to the Registration Statement on Form S-8 (Reg. No. 33-167146).
(13) Incorporated by reference to Heritage Financial Corporation's definitive proxy statement dated June 11, 2014.
(14) Incorporated by reference to the Current Report on Form 10-Q dated August 6, 2014.
(15) Incorporated by reference to the Current Report on Form 8-K dated September 7, 2012.
(16) Incorporated by reference to the Current Report on Form 8-K dated January 6, 2014.
(17) Incorporated by reference to the Registration Statement on Form S-4 (Reg. No. 333-192985).
(18) Reference is made to Note 18—Stockholders' Equity in the Notes to Consolidated Financial Statements under Part II Item
8 herein.
(19) Registrant elects to satisfy Regulation S-K §229.406(c) by posting its Code of Ethics on its website at
www.HF-WA.com in the section titled Investor Information: Corporate Governance.
(20) Filed herewith.
(21) Pursuant to Rule 406T of Regulation S-T, these interactive data files are deemed not filed or part of a registration
statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933 or Section 18 of the Securities
Exchange Act of 1934, as amended, and otherwise not subject to liability under those sections.
71
Pursuant to the requirements of Section 13 or 15(d) 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, on March 10, 2015.
SIGNATURES
HERITAGE FINANCIAL CORPORATION
(Registrant)
/S/ BRIAN L. VANCE
Brian L. Vance
President and Chief Executive Officer
72
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the
following persons on behalf of the registrant and in the capacities indicated on March 10, 2015.
Principal Executive Officer:
/S/ BRIAN L. VANCE
Brian L. Vance
President and Chief Executive Officer
Principal Financial Officer:
/S/ DONALD J. HINSON
Donald J. Hinson
Executive Vice President and Chief Financial Officer
Remaining Directors*:
David H. Brown
Brian S. Charneski
John A. Clees
Gary B. Christiansen
Mark D. Crawford
Kimberly T. Ellwanger
Deborah J. Gavin
Jeffrey S. Lyon
Gragg E. Miller
Anthony B. Pickering
Robert T. Severns
Ann Watson
* Brian L. Vance, pursuant to a power of attorney that is being filed with the Annual Report on Form 10-K, has signed
this report as attorney in fact for the following directors who constitute a majority of the Board.
*By
/S/ BRIAN L. VANCE
Brian L. Vance
Attorney-in-Fact
March 10, 2015
73
[THIS PAGE INTENTIONALLY LEFT BLANK]
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2014, 2013 and 2012
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Report of Independent Registered Public Accounting Firm ....................................................................................... F-2
Consolidated Statements of Financial Condition—December 31, 2014 and December 31, 2013 ...........................
F-3
Consolidated Statements of Income—Years ended December 31, 2014, 2013 and 2012 ....................................... F-4
Consolidated Statements of Comprehensive Income—Years ended December 31, 2014, 2013 and 2012 ............ F-5
Consolidated Statements of Stockholders’ Equity—Years ended December 31, 2014, 2013 and 2012 ................. F-6
Consolidated Statements of Cash Flows—Years ended December 31, 2014, 2013 and 2012 ................................
F-7
Notes to Consolidated Financial Statements ............................................................................................................. F-9
Page
F-1
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Heritage Financial Corporation and subsidiaries
Olympia, Washington
We have audited the accompanying consolidated statements of financial condition of Heritage Financial Corporation and
subsidiaries (the “Company”) as of December 31, 2014 and 2013, and the related consolidated statements of income,
comprehensive income, stockholders’ equity, and cash flows for each of the three years in the period ended
December 31, 2014. We also have audited the Company’s internal control over financial reporting as of December 31, 2014,
based on criteria established in the 1992 Internal Control – Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial
statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of
internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial
Reporting. Our responsibility is to express an opinion on these financial statements and an opinion on the Company’s internal
control over financial reporting based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United
States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the
financial statements are free of material misstatement and whether effective internal control over financial reporting was
maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant
estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over
financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a
material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the
assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances.
We believe that our audits provide a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the
reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally
accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures
that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and
dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and
expenditures of the company are being made only in accordance with authorizations of management and directors of the
company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or
disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also,
projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate
because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
As permitted, the Company has excluded the operations of Washington Banking Company acquired during 2014, which is
described in Note 2, Business Combinations, of the Company's consolidated financial statements, from the scope of
management’s report on internal control over financial reporting. As such, it has also been excluded from the scope of our
audit of internal control over financial reporting.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial
position of Heritage Financial Corporation and subsidiaries as of December 31, 2014 and 2013, and the results of their
operations and their cash flows for each of the three years in the period ended December 31, 2014 in conformity with
accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all
material respects, effective internal control over financial reporting as of December 31, 2014, based on criteria established in
the 1992 Internal Control – Integrated Framework issued by COSO.
/s/ Crowe Horwath LLP
San Francisco, California
March 10, 2015
F-2
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
December 31, 2014 and 2013
(Dollars in thousands)
December 31,
2014
December 31,
2013
ASSETS
Cash on hand and in banks .............................................................................................................
Interest earning deposits .................................................................................................................
$
Cash and cash equivalents ...............................................................................................
Other interest earning deposits .......................................................................................................
Investment securities available for sale, at fair value ......................................................................
Investment securities held to maturity (fair value of $36,874 and $36,340, respectively) ................
Loans held for sale ..........................................................................................................................
Noncovered loans receivable, net ...................................................................................................
Allowance for loan losses on noncovered loans ..............................................................................
Noncovered loans receivable, net of allowance for loan losses ........................................
Covered loans receivable, net .........................................................................................................
Allowance for loan losses on covered loans ....................................................................................
Covered loans receivable, net of allowance for loan losses ..............................................
Total loans receivable, net .................................................................................................
FDIC indemnification asset..............................................................................................................
Other real estate owned ($1,177 and $182 covered by FDIC shared-loss agreements,
respectively) ............................................................................................................................
Premises and equipment, net ..........................................................................................................
Federal Home Loan Bank stock, at cost ..........................................................................................
Bank owned life insurance ..............................................................................................................
Accrued interest receivable .............................................................................................................
Prepaid expenses and other assets ................................................................................................
Other intangible assets, net .............................................................................................................
Goodwill ..........................................................................................................................................
Total assets .......................................................................................................................
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits ..........................................................................................................................................
Junior subordinated debentures ......................................................................................................
Securities sold under agreement to repurchase ..............................................................................
Accrued expenses and other liabilities ............................................................................................
Total liabilities ....................................................................................................................
Stockholders’ equity:
$
$
Preferred stock, no par value, 2,500,000 shares authorized; no shares issued and
outstanding at December 31, 2014 and 2013 ...................................................................
Common stock, no par value, 50,000,000 shares authorized; 30,259,838 and 16,210,747
shares issued and outstanding at December 31, 2014 and 2013, respectively ................
Retained earnings ....................................................................................................................
Accumulated other comprehensive income (loss), net .............................................................
Total stockholders’ equity ..................................................................................................
Total liabilities and stockholders’ equity .............................................................................
$
74,028 $
47,608
121,636
10,126
742,846
35,814
5,582
2,124,877
(22,153 )
2,102,724
126,200
(5,576 )
120,624
2,223,348
1,116
3,355
64,938
12,188
35,176
9,836
61,871
10,889
119,029
3,457,750 $
40,162
90,238
130,400
15,662
163,134
36,154
—
1,168,166
(22,657)
1,145,509
63,754
(6,167)
57,587
1,203,096
4,382
4,559
34,348
5,741
2,193
5,462
22,927
1,615
29,365
1,659,038
2,906,331 $
19,082
32,181
45,650
3,003,244
1,399,189
—
29,420
14,667
1,443,276
—
—
364,741
86,387
3,378
454,506
3,457,750 $
138,659
78,265
(1,162)
215,762
1,659,038
See accompanying Notes to Consolidated Financial Statements.
F-3
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
For the Years Ended December 31, 2014, 2013 and 2012
(Dollars in thousands, except per share amounts)
Years Ended December 31,
2013
2014
2012
INTEREST INCOME:
Interest and fees on loans ..........................................................................................
Taxable interest on investment securities ...................................................................
Nontaxable interest on investment securities..............................................................
Interest and dividends on other interest earning assets ..............................................
Total interest income ..................................................................................
INTEREST EXPENSE:
Deposits ......................................................................................................................
Junior subordinated debentures .................................................................................
Other borrowings ........................................................................................................
Total interest expense ................................................................................
Net interest income ....................................................................................
Provision for loan losses on noncovered loans ..................................................................
Provision for loan losses on covered loans ........................................................................
Total provision for loan losses .....................................................................................
Net interest income after provision for loan losses .....................................................
NONINTEREST INCOME:
Bargain purchase gain on bank acquisition ................................................................
Service charges and other fees ..................................................................................
Merchant Visa income, net .........................................................................................
Change in FDIC indemnification asset ........................................................................
Gain on sale of investment securities, net ..................................................................
Gain on sale of loans, net ...........................................................................................
Other income ..............................................................................................................
Total noninterest income ............................................................................
NONINTEREST EXPENSE:
Compensation and employee benefits ........................................................................
Occupancy and equipment .........................................................................................
Data processing ..........................................................................................................
Marketing ....................................................................................................................
Professional services ..................................................................................................
State and local taxes ..................................................................................................
Impairment loss on investment securities, net ............................................................
Federal deposit insurance premium ............................................................................
Other real estate owned, net.......................................................................................
Amortization of intangible assets ................................................................................
Other expense ............................................................................................................
Total noninterest expense ..........................................................................
Income before income taxes .......................................................................................
Income tax expense ....................................................................................................
Net income .................................................................................................
Basic earnings per common share.....................................................................................
Diluted earnings per common share ..................................................................................
Dividends declared per common share ..............................................................................
$ 110,437
7,328
2,886
455
121,106
5,150
458
73
5,681
115,425
2,232
2,362
4,594
110,831
—
11,143
1,076
(2,543)
287
1,518
4,986
16,467
52,634
13,406
9,243
2,502
6,185
1,976
45
1,718
638
1,920
9,112
99,379
27,919
6,905
$ 21,014
0.82
0.82
0.50
$
See accompanying Notes to Consolidated Financial Statements.
$ 67,630
1,918
1,539
341
71,428
3,673
—
51
3,724
67,704
1,784
1,888
3,672
64,032
399
5,936
862
(181)
—
142
2,493
9,651
31,612
9,724
4,806
1,598
3,936
1,150
38
1,001
309
543
4,798
59,515
14,168
4,593
$ 9,575
$ 0.61
0.61
0.42
$ 65,588
2,195
1,097
229
69,109
4,469
—
65
4,534
64,575
1,570
446
2,016
62,559
—
5,516
685
(1,033)
—
295
1,809
7,272
29,020
7,365
2,555
1,517
2,543
1,226
78
1,002
316
427
4,343
50,392
19,439
6,178
$ 13,261
$ 0.87
0.87
0.80
F-4
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
For the Years Ended December 31, 2014, 2013 and 2012
(Dollars in thousands)
Net income
Years Ended December 31,
2013
$ 9,575
2014
$ 21,014
2012
$ 13,261
Change in fair value of securities available for sale, net of tax of $2,531, $(1,596) and
$(34), respectively ...................................................................................................
Reclassification adjustment of net (gain) loss from sale of available for sale securities
included in net income, net of tax of $(101), $0 and $0, respectively
Other-than-temporary impairment on securities held to maturity, net of tax of $0, $0
and $(18), respectively ............................................................................................
Accretion of other-than-temporary impairment on securities held to maturity, net of tax
of $28, $31 and $57, respectively ............................................................................
Other comprehensive income (loss) ........................................................................
Comprehensive income .........................................................................................................
4,676
(2,965)
(186)
—
—
—
(63)
—
(34)
50
4,540
$ 25,554
59
(2,906)
$ 6,669
105
8
$ 13,269
See accompanying Notes to Consolidated Financial Statements.
F-5
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
For the Years Ended December 31, 2014, 2013 and 2012
(Dollars in thousands, except per share amounts)
Balance at December 31, 2011...........................
Restricted and unrestricted stock awards
issued, net of forfeitures ...................................
Stock option compensation expense ..................
Exercise of stock options (including excess tax
benefits from nonqualified stock options) ........
Restricted stock compensation expense ............
Excess tax benefit from restricted stock .............
Common stock repurchased ...............................
Net income .........................................................
Other comprehensive income, net of tax .............
Cash dividends declared on common stock
($0.80 per share) .............................................
Balance at December 31, 2012 ..........................
Restricted and unrestricted stock awards
issued, net of forfeitures ..................................
Stock option compensation expense ..................
Exercise of stock options (including excess tax
benefits from nonqualified stock options) .........
Restricted stock compensation expense .............
Excess tax benefit from restricted stock .............
Common stock repurchased ...............................
Net income .........................................................
Other comprehensive loss, net of tax .................
Common stock issued in business
combination ........................................................
Cash dividends declared on common stock
($0.42 per share) .............................................
Balance at December 31, 2013 ..........................
Restricted and unrestricted stock awards
issued, net of forfeitures ...................................
Stock option compensation expense ..................
Exercise of stock options (including excess tax
benefits from nonqualified stock options) ........
Restricted stock compensation expense ............
Tax benefits from restricted stock ........................
Common stock repurchased ...............................
Net income .........................................................
Other comprehensive income, net of tax ............
Common stock issued in business
combination (1) ...............................................
Cash dividends declared on common stock
($0.50 per share) ............................................
Number of
common
shares
15,456
Common
stock
$126,622
Unearned
Compensation
ESOP
$ (94 )
Retained
earnings
$ 74,256
Accumulated
other
comprehensive
income
(loss), net
$ 1,736
Total
stock-
holders’
equity
$ 202,520
86
—
12
10
—
(446 )
—
—
—
106
129
1,091
(93)
(6,023)
—
—
—
15,118
—
121,832
100
—
17
—
—
(557 )
—
—
—
71
176
1,223
(13)
(8,825)
—
—
1,533
24,195
—
16,211
—
138,659
121
—
84
—
—
(156 )
—
—
—
20
921
1,395
112
(2,601)
—
—
—
—
—
94
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
13,261
—
(12,155)
75,362
—
—
—
—
—
—
9,575
—
—
—
—
—
—
—
—
8
—
1,744
—
—
—
—
—
—
—
(2,906)
—
106
129
1,185
(93)
(6,023)
13,261
8
(12,155)
198,938
—
71
176
1,223
(13)
(8,825)
9,575
(2,906)
—
—
24,195
(6,672)
78,265
—
—
—
—
—
—
21,014
—
—
(1,162)
—
—
—
—
—
—
—
4,540
(6,672)
215,762
—
20
921
1,395
112
(2,601)
21,014
4,540
14,000
226,235
—
—
—
226,235
Balance at December 31, 2014 ...........................
30,260
$364,741
—
—
—
$ —
(12,892)
—
(12,892)
$ 86,387
$ 3,378
$ 454,506
(1) The amount of common stock issued in connection with the merger is net of $489,000 of issuance costs.
See accompanying Notes to Consolidated Financial Statements.
F-6
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Years Ended December 31, 2014, 2013 and 2012
(Dollars in thousands)
Years Ended December 31,
2013
2014
2012
Cash flows from operating activities:
Net income...................................................................................................................
Adjustments to reconcile net income to net cash provided by operating activities:
$ 21,014
$ 9,575
$ 13,261
Depreciation and amortization ..............................................................................
Changes in net deferred loan fees, net of amortization ........................................
Provision for loan losses .......................................................................................
Net change in accrued interest receivable, FDIC indemnification asset, prepaid
expenses and other assets, accrued expenses and other liabilities .................
Restricted and unrestricted stock compensation expense ....................................
Stock option compensation expense ....................................................................
Tax benefits and excess tax benefits from restricted stock ...................................
Amortization of intangible assets ..........................................................................
Bargain purchase gain on bank acquisition ..........................................................
Gain on sale of investment securities, net ............................................................
Impairment loss on investment of securities, net ..................................................
Origination of loans held for sale ..........................................................................
Gain on sale of loans, net .....................................................................................
Proceeds from sale of loans .................................................................................
Earnings on bank owned life insurance ................................................................
Valuation adjustment on other real estate owned .................................................
Gain on other real estate owned, net ....................................................................
Loss (gain) on sale or write-off of furniture, equipment and leasehold
improvements ................................................................................................
Net cash provided by operating activities ....................................................
12,882
(1,733)
4,594
13,230
1,395
20
(112)
1,920
—
(287)
45
(57,656)
(1,518)
57,515
(455)
—
(23)
505
51,336
Cash flows from investing activities:
Loans originated, net of principal payments .........................................................
Maturities of other interest earning deposits .........................................................
Maturities of investment securities available for sale ............................................
Maturities of investment securities held to maturity ..............................................
Purchase of other interest earning deposits .........................................................
Purchase of investment securities available for sale ............................................
Purchase of investment securities held to maturity ...............................................
Purchase of premises and equipment ..................................................................
Proceeds from sales of other real estate owned ...................................................
Proceeds from sales of investment securities available for sale ...........................
Proceeds from redemption of FHLB stock ............................................................
Proceeds from sale of premises and equipment ...................................................
Investment in new market tax credit partnership ..................................................
Net cash received from acquisitions .....................................................................
Net cash used in investing activities............................................................
Cash flows from financing activities:
Net increase (decrease) in deposits .....................................................................
Common stock cash dividends paid .....................................................................
Net increase (decrease) in securities sold under agreement to repurchase .........
Proceeds from exercise of stock options ..............................................................
Excess tax benefits from stock options and restricted and unrestricted stock ......
Repurchase of common stock ..............................................................................
Net cash provided by (used in) financing activities .....................................
Net (decrease) increase in cash and cash equivalents ...............................
Cash and cash equivalents at beginning of year ................................................................
Cash and cash equivalents at end of year ..........................................................................
(21,651)
5,475
66,876
3,284
—
(344,146)
(3,294)
(3,940)
9,914
156,994
617
1,170
(25,000)
32,052
(121,649)
73,248
(12,892)
2,761
921
112
(2,601)
61,549
(8,764)
130,400
$ 121,636
5,411
574
3,672
9,047
1,223
71
13
543
(399)
—
38
(6,784)
(142)
8,602
(70)
371
(264)
(584)
30,897
(43,140)
1,987
51,443
4,192
—
(43,627)
(7,414)
(5,205)
6,003
—
208
700
—
18,260
(16,593)
13,763
(6,672)
13,399
176
(13)
(8,825)
11,828
26,132
104,268
$130,400
4,290
236
2,016
5,878
1,185
106
93
427
—
—
78
(21,035)
(295)
21,482
(80)
824
(587)
3
27,882
(2,790)
—
61,751
2,177
(2,232)
(63,903)
—
(3,859)
5,255
—
99
—
—
—
(3,502)
(18,073)
(12,155)
(7,070)
129
(93)
(6,023)
(43,285)
(18,905)
123,173
$104,268
Supplemental disclosures of cash flow information:
Cash paid for interest ...........................................................................................
Cash paid for income taxes ..................................................................................
$
5,422
15,852
$ 3,678
3,574
$ 4,608
10,713
F-7
Years Ended December 31,
2013
2014
2012
Supplemental non-cash disclosures of cash flow information:
Transfers of loans receivable to other real estate owned .....................................
Seller-financed sale of other real estate owned ....................................................
Investment in low income housing tax credit partnership and related funding
commitment ...................................................................................................
Purchases of investment securities available for sale not settled .........................
Common stock issued for business combinations ................................................
Stock issuance costs in connection with business combinations ..........................
Assets acquired (liabilities assumed) in merger and acquisitions:
$
1,566
—
3,817
1,288
226,235
489
Other interest earning deposits ...................................................................
Investment securities available for sale .......................................................
Investment securities held to maturity .........................................................
Loans held for sale ......................................................................................
Noncovered loans receivable ......................................................................
Covered loans receivable ............................................................................
Other real estate owned ..............................................................................
Premises and equipment ............................................................................
Federal Home Loan Bank stock ..................................................................
FDIC indemnification asset .........................................................................
Accrued interest receivable .........................................................................
Bank owned life insurance ..........................................................................
Prepaid expenses and other assets ............................................................
Other intangible assets ...............................................................................
Deposits ......................................................................................................
Junior subordinated debentures ..................................................................
Accrued expenses and other liabilities ........................................................
—
458,312
—
3,923
895,978
107,050
7,121
31,776
7,064
7,174
4,943
32,519
14,852
11,194
(1,433,894)
(18,937)
(24,067)
$ 2,974
250
—
—
24,195
—
14,869
34,197
22,908
—
168,580
—
2,279
6,772
454
—
697
—
7,135
1,072
(267,455)
—
(1,528)
$ 7,406
732
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
See accompanying Notes to Consolidated Financial Statements.
F-8
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Years Ended December 31, 2014, 2013 and 2012
(1) Description of Business, Basis of Presentation, Significant Accounting Policies and Recently Issued Accounting
Pronouncements
(a) Description of Business
Heritage Financial Corporation ("Heritage" or the “Company”) is a bank holding company that was incorporated in the
State of Washington in August 1997. The Company is primarily engaged in the business of planning, directing and coordinating
the business activities of its wholly-owned bank subsidiary, Heritage Bank (the “Bank”). The Bank is a Washington-chartered
commercial bank and its deposits are insured by the FDIC under the Deposit Insurance Fund. The Bank is headquartered in
Olympia, Washington and conducts business from its sixty-six branch offices located throughout Washington State and the
greater Portland, Oregon area. The Bank’s business consists primarily of lending and deposit relationships with small
businesses and their owners in its market areas and attracting deposits from the general public. The Bank also makes real
estate construction and land development loans and consumer loans and originates first mortgage loans on residential
properties primarily located in its market area which is concentrated along the I-5 corridor from Whatcom County to Clark
County in Washington State and Multnomah County in Oregon, as well as other contiguous markets.
The Company has expanded its footprint through mergers and acquisitions. The largest of these transactions was the
strategic merger of Washington Banking Company (“Washington Banking”) into the Company and the merger of its wholly
owned subsidiary bank, Whidbey Island Bank ("Whidbey") into Heritage Bank. This merger was effective on May 1, 2014 and
is referred to as the "Washington Banking Merger". The strategic merger is described in more detail in "Note 2 - Business
Combinations." The Washington Banking results since May 1, 2014 are included in this Annual Report on Form 10-K. The
Washington Banking Merger has allowed the expansion of the market area north of Seattle, Washington to the Canadian
border.
In connection with the Washington Banking Merger, the Company acquired Washington Banking Master Trust
(the “Master Trust”), which became a wholly-owned subsidiary of the Company. The Master Trust was formed by Washington
Banking in April 2007 for the exclusive purpose of issuing trust preferred securities.
(b) Basis of Presentation
The accounting and reporting policies of the Company and its subsidiaries confirm to U.S. Generally Accepted Accounting
Principles (“GAAP”). In preparing the Consolidated Financial Statements management makes estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the
financial statements and the reported amounts of income and expenses during the reporting periods. Material estimates that
are particularly susceptible to significant change relate to the determination of the allowance for loan losses, other than
temporary impairments in the fair value of investment securities, expected cash flows of purchased loans and related
indemnification asset, fair value measurements, stock-based compensation, impairment of goodwill and other intangible assets
and income taxes. Actual results could differ from these estimates.
The accompanying 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.
For financial reporting purposes, the Company's investment in the Master Trust is accounted for under the equity method
and is included in prepaid expenses and other assets on the Company's Consolidated Statements of Financial Condition. The
junior subordinated debentures issued and guaranteed by the Company and held by the Master Trust are reflected as liabilities
on the Company's Consolidated Statements of Financial Condition.
Certain prior year amounts have been reclassified to conform to the current year’s presentation. Reclassifications had no
effect on the prior year's net income or stockholders’ equity. As a result of the Washington Banking Merger, the Company
reclassified its loan portfolio. Total loans receivable are now presented in two categories: noncovered loans receivable and
covered loans receivable. A description of the categories is included in the significant accounting policies below. Management
made the change to be more comparable to its peers.
F-9
(c) Significant Accounting Policies
Cash and Cash Equivalents
For purposes of reporting cash flows, cash and cash equivalents includes cash on hand and in banks, interest earning
deposits with original maturities of 90 days or less, and federal funds sold. Net cash flows are reported for customer loan and
deposit transactions, other interest bearing deposits, federal funds sold and repurchase agreements.
Investment Securities
The Company identifies investments as held to maturity or available for sale at the time of acquisition. Securities are
classified as held to maturity when the Company has the ability and positive intent to hold them to maturity. Securities
classified as available for sale are available for future liquidity requirements and may be sold prior to maturity.
Investment securities held to maturity are recorded at cost, adjusted for amortization of premiums or accretion of discounts
using the interest method. Securities available for sale are carried at fair value. Unrealized gains and losses on securities
available for sale are generally excluded from earnings and are reported in other comprehensive income (loss), net of related
income taxes. Realized gains and losses on sale of investment securities are computed on the specific identification method.
Management evaluates securities for other-than-temporary impairment (“OTTI”) on at least a quarterly basis, and more
frequently when economic or market conditions warrant such an evaluation. Although these evaluations involve significant
judgment, an unrealized loss in the fair value of a debt security is generally deemed to be temporary when the fair value of the
security is below the carrying value primarily due to changes in interest rates, there has not been significant deterioration in the
financial condition of the issuer, and it is not more likely than not that the Company will be required to, nor does it have the
intent to sell the security before the anticipated recovery of its remaining carrying value. If any of these criteria is not met, the
impairment is split into two components as follows: 1) OTTI related to credit loss, which must be recognized in the income
statement and 2) OTTI related to other factors, which is recognized in other comprehensive income (loss). The credit loss is
defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis. If
any of these criteria are not met, the entire difference between amortized cost and fair value is recognized as impairment
through earnings, and a new cost basis is established for the security. Continued deterioration of market conditions could result
in additional impairment losses recognized within the investment portfolio.
Other factors that may be considered in determining whether a decline in the value of either a debt or an equity security is
“other than temporary” include ratings by recognized rating agencies; actions of commercial banks or other lenders relative to
the continued extension of credit facilities to the issuer of the security; the financial condition, capital strength and near-term
prospects of the issuer and recommendations of investment advisors or market analysts.
Loans Held for Sale
Mortgage loans held for sale are carried at the lower of amortized cost or fair value by loan type. Any loan that
management does not have the intent and ability to hold for the foreseeable future or until maturity or payoff is classified as
held for sale at the time of origination, purchase or securitization, or when such decision is made. Unrealized losses on such
loans are included in income.
Loans Receivable and Loan Commitments
Noncovered Loans:
Noncovered loans includes loans originated by the Bank as well as loans acquired in business combinations with no
related shared-loss agreements. Loans acquired in a business combination are designated as “purchased” loans. These loans
are recorded at their fair value at acquisition date, factoring in credit losses expected to be incurred over the life of the loan.
Accordingly, an allowance for loan losses is not carried over or recorded as of the acquisition date.
Loans purchased with evidence of credit deterioration since origination for which it is probable that all contractually
required payments will not be collected are accounted for under Financial Accounting Standards Board (“FASB”) Accounting
Standards Codification (“FASB ASC”) 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality, formerly
AICPA SOP 03-3 Accounting for Certain Loans or Debt Securities Acquired in a Transfer. These loans are identified as
purchased credit impaired ("PCI") loans. In situations where such loans have similar risk characteristics, loans may be
aggregated into pools to estimate cash flows. A pool is accounted for as a single asset with a single interest rate, cumulative
F-10
loss rate and cash flow expectation. Expected cash flows at the acquisition date in excess of the fair value of loans are
considered to be accretable yield, which is recognized as interest income over the life of the loan or pool using a level yield
method if the timing and amount of the future cash flows of the pool is reasonably estimable.
The cash flows expected over the life of the PCI loan or pool are estimated quarterly using an internal cash flow model
that projects cash flows and calculates the carrying values of the loans or pools, book yields, effective interest income and
impairment, if any, based on loan or pool level events. Assumptions as to default rates, loss severity and prepayment speeds
are utilized to calculate the expected cash flows. To the extent actual or projected cash flows are less than previously
estimated, additional provisions for loan losses on the purchased loan portfolios will be recognized immediately into earnings.
To the extent actual or projected cash flows are more than previously estimated, the increase in cash flows is recognized
immediately as a recapture of provision for loan losses up to the amount of any provision previously recognized for that loan or
pool, if any, then prospectively recognized in interest income as a yield adjustment. Any disposals of a loan in a pool, including
sale of a loan, payment in full or foreclosure results in the removal of the loan from the loan pool at the carrying amount.
Loans accounted for under FASB ASC 310-30 are generally considered accruing and performing loans as the loans accrete
interest income over the estimated life of the loan when cash flows are reasonably estimable. Accordingly, PCI loans that are
contractually past due are still considered to be accruing and performing loans. If the timing and amount of cash flows is not
reasonably estimable, the loans may be classified as nonaccrual loans and interest income may be recognized on a cash basis or
all cash payments may be accounted for a as a reduction of the principal amount outstanding.
Loans purchased that are not accounted for under FASB ASC 310-30 are accounted for under FASB ASC 310-20,
Receivables—Nonrefundable fees and Other Costs, formerly SFAS 91 Nonrefundable fees and Other Costs. These loans are
identified as non-PCI loans, and are initially recorded at their fair value, which is estimated using an internal cash flow model and
assumptions similar to the FASB ASC 310-30 loans. The difference between the estimated fair value and the unpaid principal
balance at acquisition date is recognized as interest income over the life of the loan using an effective interest method for non-
revolving credits or a straight-line method, which approximates the effective interest method, for revolving credits. Any
unrecognized discount for a loan that is subsequently repaid will be recognized immediately into income.
Loans are generally recorded at the unpaid principal balance, net of premiums, unearned discounts and net deferred loan
origination fees and costs. The premiums and unearned discounts may include values determined in purchase accounting.
Interest on loans is calculated using the simple interest method based on the daily balance of the principal amount outstanding
and is credited to income as earned. Loans are considered past due or delinquent when principal or interest payments are past
due 30 days or more. Loans on which the accrual of interest has been discontinued are designated as nonaccrual loans.
Delinquent loans may remain on accrual status between 30 days and 89 days past due. The accrual of interest is discontinued
at the time the loan is 90 days delinquent unless the credit is well secured and in the process of collection. Loans are placed
on nonaccrual at an earlier date if collection of the contractual principal or interest is doubtful. All interest accrued but not
collected on loans deemed nonaccrual during the period is reversed against interest income in that period. The interest
payments received on nonaccrual loans is accounted for on the cost-recovery method whereby the interest payment is applied
to the principal balances. Loans may be returned to accrual status when improvements in credit quality eliminate the doubt as
to the full collectability of both interest and principal and a period of sustained performance has occurred. Substantially all
loans that are nonaccrual are also impaired. Income recognition on impaired loans conforms to that used on nonaccrual loans.
Loans are charged-off if collection of the contractual principal or interest as scheduled in the loan agreement is doubtful.
The Company's policies for placing loans on nonaccrual status, recording payments received on nonaccrual loans, resuming
accrual of interest, determining past due or delinquency status and charging off uncollectible loans generally do not differ by
loan segments or classes. However, credit card loans and other consumer loans are typically charged-off no later than 180
days past due.
Covered Loans:
Purchased loans subject to FDIC shared-loss agreements are identified as “covered” on the Consolidated Statements of
Financial Condition. The covered loans have an additional evaluation separate from noncovered loans as they have shared-
loss attributes which may reduce the Bank’s risk of loss. For further information see Note 8, “FDIC Indemnification Asset”. The
covered loans include the majority of loans from the Company's acquisition of Cowlitz Bank and certain loans from the
Washington Banking Merger, which included loans from Washington Banking's acquisitions of City Bank and North County
Bank. The same accounting principles applicable to noncovered loans receivable apply to covered loans receivable, with the
added benefit of shared-loss agreements.
F-11
Unfunded Loan Commitments:
Unfunded loan commitments are generally related to the unused portion of the total commitment of a loan or providing
credit facilities to clients of the Bank and are not actively traded financial instruments. These unfunded commitments are
disclosed as financial instruments with off-balance sheet risk in Notes 17 and 20 in the Notes to Consolidated Financial
Statements.
Impaired Loans and Troubled Debt Restructures
Impaired Loans:
A loan is considered impaired when, based on current information and events, it is probable the Bank will be unable to
collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement.
Factors considered by management in determining impairment include payment status, collateral value, and the probability of
collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and
payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and
payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the
borrowers, including length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amounts of the
shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis by either the present
value of expected future cash flows discounted at the loan’s effective interest rate, or as a practical expedient the loan’s
observable market price or the fair value of the collateral (less cost to sell) if the loan is collateral dependent.
Troubled Debt Restructures:
A troubled debt restructured loan (“TDR”) is a restructuring in which the Bank, for economic or legal reasons related to a
borrower’s financial difficulties, grants a concession to a borrower that it would not otherwise consider. These concessions may
include changes of the interest rate, forbearance of the outstanding principal or accrued interest, extension of the maturity
date, delay in the timing of the regular payment, or any other actions intended to minimize potential losses. The Bank does not
forgive principal for a majority of its TDRs, but in those situations where principal is forgiven, the entire amount of such
principal forgiveness is immediately charged off to the extent not done so prior to the modification. The Bank also considers
insignificant delays in payments when determining if a loan should be classified as a TDR.
A loan that has been placed on nonaccrual status that is subsequently restructured will usually remain on nonaccrual
status until the borrower is able to demonstrate repayment performance in compliance with the restructured terms for a
sustained period, typically for six months. A restructured loan may return to accrual status sooner based on other significant
events or mitigating circumstances. A loan that has not been placed on nonaccrual status may be restructured and such loan
may remain on accrual status after such restructuring. In these circumstances, the borrower has made payments before the
restructuring and is expected to continue to perform after the restructuring. Generally, this type of restructuring involves a
reduction in the loan interest rate and/or a change to interest-only payments for a period of time. The restructured loan is
considered impaired despite the accrual status and a specific valuation allowance, is any, is calculated in the manner
previously described.
A TDR is considered defaulted if, during the 12-month period after the restructure, the loan has not performed in
accordance to the restructured terms. Defaults include loans whose payments are 90 days or more past due and loans whose
revised maturity date passed and no further modifications will be granted for that borrower.
A loan may subsequently be excluded from the TDR disclosures if: (i) the restructured interest rate was greater than or
equal to the interest rate of a new loan with comparable risk at the time of the restructure, and (ii) the loan is no longer
impaired based on the terms of the restructured agreement. The Bank's policy is that the borrower must demonstrate a
sustained period, typically six consecutive months, of payments in accordance with the modified loan before it can be reviewed
for removal from the TDR disclosure under the second criteria. However, the loan must be reported as a TDR in at least one
annual report on Form 10-K. Once a loan has been classified as a TDR, it will continue to be disclosed as an impaired loan
until paid off or charged-off, even if the loan subsequently is no longer disclosed as a TDR.
F-12
Loan Fees and Costs
Loan origination fees and certain direct origination costs are deferred and amortized as an adjustment of the yields of the
loans over their contractual lives, adjusted for prepayment of the loans, using the effective interest method or the straight-line
method, when the straight-line method approximates the effective interest method. In the event loans are sold, the net deferred
loan origination fees or costs are recognized as a component of the gains or losses on the sales of loans.
Allowance for Loan Losses
Allowance for Loan Losses on Loans:
The allowance for loan losses is a reserve established through a provision for loan losses charged to expense, which
represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans
originated by the Bank. The allowance for loan losses on loans designated as non-PCI loans is similar to the methodology
described below except that for non-PCI loans, the remaining unaccreted discounts resulting from the fair value adjustments
recorded at the time the loans were purchased are additionally factored into the allowance methodology. The allowance for
loan losses on PCI loans is described in the “Allowance for Loan Losses on Purchased Credit Impaired Loans” section below.
The allowance, in the judgment of management, is necessary to reserve for estimated loan losses from risks inherent in
the loan portfolio. The Company’s allowance for loan losses methodology includes allowance allocations calculated in
accordance with FASB ASC 310, Receivables and allowance allocations calculated in accordance with FASB ASC 450,
Contingencies. Accordingly, the methodology is based on historical loss experience by type of credit and internal risk grade,
specific homogeneous risk pools and specific loss allocations, with adjustments for current events and conditions. The
Company’s process for determining the appropriate level of the allowance for loan losses is designed to account for credit
deterioration as it occurs. The provision for loan losses reflects loan quality trends, including the levels of and trends related to
nonaccrual loans, past due loans, potential problem loans, criticized loans and net charge-offs or recoveries, among other
factors. The provision for loan losses also reflects all actions taken on all loans for a particular period. Therefore, the amount of
the provision reflects not only the necessary increases in the allowance for loan losses related to newly identified criticized
loans, but it also reflects actions taken related to other loans including, among other things, any necessary increases or
decreases in specific valuation allowances for impaired loans or loan pools. Losses are charged against the allowance when
management believes the uncollectability of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the
allowance.
The level of the allowance reflects management’s continuing evaluation of known and inherent risks in the loan portfolio.
Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in
management’s judgment, should be charged off.
Loans which management determines are impaired are individually evaluated for impairment, and specific valuation
allowances are recorded, if any, on these loans based on the methodology previously described. Loans that are determined
not to meet management's definition of impaired are collectively evaluated for impairment based on (i) historical loss factor
determined in accordance with FASB ASC 450 based on historical loan loss experience for similar loans with similar
characteristics and trends; and (ii) environmental loss factors that reflect the impact of current conditions, as determined in
accordance with FASB ASC 450 based on general economic conditions and other qualitative risk factors both internal and
external to the Company. The historical loss factors and environmental loss factors are combined and multiplied against the
outstanding principal balances of loans in pools of similar loans with similar characteristics.
The Company evaluates specific loans for credit quality indicators and performs regular analysis and evaluation of
problem loans. Loans are classified based on an internal credit risk grading process that evaluates, among other things: (i) the
obligor’s ability to repay; (ii) the underlying collateral, if any; and (iii) the economic environment and industry in which the
borrower operates. This analysis is performed at the loan officer level for all loans. When a loan is performing but has an
assigned risk grade other than pass, the loan officer analyzes the loan to determine an appropriate monitoring and collection
strategy. When a loan is nonperforming or has been classified as a nonaccrual loan, a member from the special assets
department will analyze the loan to determine if it is impaired. If the loan is considered impaired, the special asset department
will evaluate the need for a specific valuation allowance on the loan. Specific valuation allowances are determined by
analyzing the borrower’s ability to repay amounts owed, collateral deficiencies and economic conditions affecting the
borrower’s industry, among other things.
F-13
Historical loss factors are calculated based on the historical loss experience and recovery experience of specific classes
of loans. The Company calculates historical loss ratios for the classes of loans based on the proportion of actual charge-offs
and recoveries experienced to the total loans in the pool for a rolling twelve quarter average.
Environmental loss factors are based on general economic conditions and other qualitative risk factors both internal and
external to the Company. In general, such valuation allowances are determined by evaluating, among other things: (i) levels of
and trends in delinquencies and impaired loans; (ii) levels and trends in charge-offs and recoveries; (iii) effects of changes in
risk selection and underwriting standards, and other changes in lending policies, procedures, and practices; (iv) experience,
ability, and depth of lending management and other relevant staff; (v) national and local economic trends and conditions;
(vi) external factors such as competition, legal, and regulatory and; (vii) effects of changes in credit concentrations.
Management evaluates the degree of risk that each one of these components has on the quality of the loan portfolio on a
quarterly basis. Each component is determined to be on a scale of risk. The results are then utilized in a matrix to determine an
appropriate environmental loss factor for each class of loan. An additional environmental factor is added after the calculated
matrix factor if the specific loan is risk graded worse than a rating of "watch".
The allowance for loan losses evaluation is inherently subjective, as it requires estimates that are susceptible to significant
revision as more information becomes available. While management utilizes its best judgment and information available to
recognize losses on loans, future additions to the allowance may be necessary based on declines in local and national
economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically
review the Bank’s allowance for loan losses. Such agencies may require the Bank to make adjustments to the allowance
based on their judgments about information available to them at the time of their examinations. The Company believes the
allowance for loan losses is appropriate given all of the above considerations.
Allowance for Loan Losses on Purchased Credit Impaired Loans:
The PCI loans acquired in the Company's mergers and acquisitions are subject to the Company’s internal and external
credit review. Under the accounting guidance of FASB ASC 310-30, the allowance for loan losses on PCI loans is measured at
each financial reporting period, or measurement date, based on expected cash flows. If and when credit deterioration, or
decreases in expected cash flows initially estimated, occurs subsequent to the acquisition date, a provision for loan losses will
be charged to earnings as of the measurement date. For the covered PCI loans, a provision for loan losses is charged to
earnings for the full amount without regard to the FDIC shared-loss agreement, and the portion of the loss reimbursable from
the FDIC is recorded in noninterest income and increases the FDIC indemnification asset.
Allowance for Losses on Unfunded Commitments:
The Bank is also party to financial instruments with off-balance sheet risk in the normal course of business to meet the
financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of
credit. Those instruments involve, to varying degrees, elements of credit risk in excess of the disbursed amounts recognized in
the Consolidated Statements of Financial Condition. The Company has a policy in which it evaluates the risk on a quarterly
basis, and provides for an allowance for credit losses, as necessary. The methodology is similar to the allowance for loan
losses, and includes an estimate of the probability of drawdown of the loan commitment. Based on its analysis, the Company
has recorded an allowance for off-balance sheet financial instruments of $170,000 and $110,000 as of December 31, 2014 and
2013, respectively. This allowance is reported within accrued expenses and other liabilities on the Company's Consolidated
Statements of Financial Condition.
Mortgage Banking Operations
Prior to the second quarter of 2013 and subsequent to the second quarter 2014, the Company sells one-to-four family
residential loans on a servicing released basis and recognized a cash gain or loss. A cash gain or loss is recognized to the
extent that the sales proceeds of the loans sold differ from the net book value at the time of sale. Income from one-to-four
family residential loans brokered to other lenders is recognized into income on date of loan closing.
Commitments to sell one-to-four family residential loans are made primarily during the period between the taking of the
loan application and the closing of the loan. The timing of making these sale commitments is dependent upon the timing of the
borrower’s election to lock-in the mortgage interest rate and fees prior to loan closing. Most of these sale commitments are
made on a best-efforts basis whereby the Bank is only obligated to sell the loan if the loan is approved and closed by the Bank.
Commitments to fund one-to-four family residential loans (interest rate locks) to be sold into the secondary market and forward
commitments for the future delivery of these loans are accounted for as free standing derivatives. Fair values of these
F-14
mortgage derivatives are estimated based on changes in mortgage interest rates between the date the interest on the loan
was locked and the balance sheet date. The Company enters into forward commitments for the future delivery of one-to-four
family residential loans when interest rate locks are entered into, in order to hedge the interest rate risk resulting from its
commitments to fund the loans. Changes in the fair values of these derivatives are included in other income. The fair value of
these derivative instruments was not significant at December 31, 2014. As there were no such commitments at December 31,
2013, there was no associated derivative at that date.
FDIC Indemnification Asset
The FDIC indemnification asset was measured at estimated fair value at acquisition dates on the same basis as the
covered loans, and represents the present value of the estimated losses on covered loans to be reimbursed by the FDIC. The
present value was calculated using the shorter of the shared-loss agreement terms or the life of the loan. Under the terms of
the FDIC shared-loss agreements, the FDIC absorbs 80% of losses and receives 80% of loss recoveries for the covered loans
during the terms of the agreements. Certain shared-loss agreements have loss minimums or tranches which may reduce the
shared-loss percentages during the coverage period. The FDIC indemnification asset is reduced as losses are recognized on
covered loans and shared-loss payments are received from the FDIC. Since the FDIC indemnification asset was initially
recorded at estimated fair value using a discount rate, a portion of the discount is accreted into noninterest income during each
reporting period.
The FDIC indemnification asset is evaluated quarterly. Realized losses in excess of prior estimates immediately increase
the FDIC indemnification asset by a credit to noninterest income. Conversely, if realized losses are less than prior estimates,
the FDIC indemnification asset is reduced by a charge to noninterest income on a prospective basis, and any change in value
would be limited to the contractual terms of the shared-loss agreements.
Other Real Estate and Other Assets Owned
Other real estate acquired by the Company in satisfaction of debt is held for sale and recorded at fair value at time of
foreclosure. When property is acquired, it is recorded at the estimated fair value (less the costs to sell) at the date of
acquisition, not to exceed net realizable value, and any resulting write-down is charged to the allowance for loan losses. After
acquisition, all costs incurred in maintaining the property are expensed. Costs relating to the development and improvement of
the property, however, are capitalized to the extent of the property’s net realizable value.
Premises and Equipment
Premises and equipment, including leasehold improvements, are stated at cost less accumulated depreciation.
Depreciation is computed using the straight-line method over the estimated useful lives of the assets or the lease period,
whichever is shorter. The estimated useful lives used to compute depreciation and amortization for buildings and building
improvements is 15 to 39 years; and for furniture, fixtures and equipment is three to seven years. The Company reviews
buildings, leasehold improvements and equipment for impairment whenever events or changes in the circumstances indicate
that the undiscounted cash flows for the property are less than its carrying value. If identified, an impairment loss is recognized
through a charge to earnings based on the fair value of the property.
Bank Owned Life Insurance
The Company has bank owned life insurance (“BOLI”), the majority of which was acquired in the Washington Banking
Merger with fair value totaling $32.5 million at May 1, 2014. These policies insure the lives of certain current or former Bank
officers or former Whidbey officers, and name the Bank as beneficiary. Noninterest income is generated tax-free (subject to
certain limitations) from the increase in the policies' underlying investments made by the insurance company. The Bank
utilizes BOLI to partially offset costs associated with employee compensation and benefit programs with the earnings on the
BOLI. The Company records BOLI at the amount that can be realized under the insurance contract at the statement of
financial condition date, which is the cash surrender value adjusted for other charges or other amounts due that are probable
at settlement.
F-15
Other Intangible Assets
The other intangible assets represents the Core Deposit Intangible (“CDI”) acquired in business combinations. The fair
value of the CDI stemming from any given business combination is based on the present value of the expected cost savings
attributable to the core deposit funding, relative to an alternative source of funding. The CDI is amortized over an estimated
useful life which approximates the existing deposit relationships acquired on an accelerated method. The Company evaluates
such identifiable intangibles for impairment when an indication of impairment exists.
Goodwill
The Company’s goodwill represents the excess of the purchase price over the fair value of net assets acquired in the
purchases of 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 Heritage Bank and is evaluated for impairment at
the Heritage Bank level (reporting unit).
In accordance with Accounting Standards Update ("ASU") 2011-08 Intangibles – Goodwill and Other (Topic 350), an entity
is not required to calculate the fair value of a reporting unit unless the entity determines that it is more likely than not that its fair
value is less than its carrying amount. In other words, before the first step of the existing guidance, the entity has the option to
first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that the
fair value of goodwill is less than carrying value. The qualitative assessment includes adverse events or circumstances
identified that could negatively affect the reporting units’ fair value as well as positive and mitigating events. Such indicators
may include, among others: a significant change in legal factors or in the general business climate; significant change in the
Company’s stock price and market capitalization; unanticipated competition; and an action or assessment by a regulator. If,
after assessing the totality of events or circumstances, an entity determines it is not more likely than not that the fair value of a
reporting unit is less than its carrying amount, then performing the two-step process is unnecessary. The entity has the option
to bypass the qualitative assessment step for any reporting unit in any period and proceed directly to the first step of the exiting
two-step process. The entity can resume performing the qualitative assessment in any subsequent period.
The first step of the goodwill impairment test is performed, when considered necessary, by comparing the reporting unit’s
aggregate fair value to its carrying value. Absent other indicators of impairment, if the aggregate fair value exceeds the
carrying value, goodwill is not considered impaired and no additional analysis is necessary. If the carrying value of the
reporting unit were to exceed the aggregate fair value, a second step would be performed to measure the amount of
impairment loss, if any. To measure any impairment loss the implied fair value would be determined in the same manner as if
the reporting unit were being acquired in a business combination. If the implied fair value of goodwill is less than the recorded
goodwill, an impairment charge would be recorded for the difference.
Income Taxes
The Company and its bank subsidiary file a United States consolidated federal income tax return and an Oregon State
income tax return. Income tax expense is the total of the current year income tax due or refundable and the change in
deferred tax assets and liabilities. Deferred tax assets and liabilities are recognized for the future tax consequences
attributable to differences between the consolidated financial statement carrying amounts of existing assets and liabilities and
their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates applicable to taxable
income in the periods in which those temporary differences are expected to be recovered or settled. The effect on deferred tax
assets and liabilities of a change in tax rate is recognized in income in the period that includes the enactment date. A valuation
allowance, if needed, reduces deferred tax assets to the amounts expected to be realized.
A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax
examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that
is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax
benefit is recorded.
The Company’s policy is to recognize interest and penalties on unrecognized tax benefits in “income taxes” in the
Consolidated Statements of Income as the amounts are generally insignificant each year.
F-16
Employee Stock Ownership Plan
The Company sponsored an Employee Stock Ownership Plan ("ESOP"). The ESOP purchased 2% of the common stock
issued in a January 1998 stock offering and borrowed $1.3 million from the Company in order to fund the purchase of the
Company’s common stock. The loan to the ESOP was repaid in full as of December 31, 2012. When outstanding, the loan was
repaid principally from the Bank's contributions to the ESOP. The Bank's contributions were sufficient to service the debt over
the 15-year loan term at the interest rate of 8.5% . As the debt was repaid, shares were released and allocated to plan
participants based on the proportion of debt service paid during the year. As shares were released, compensation expense
was recorded equal to the then current market price of the shares and the shares became outstanding for earnings per
common share calculations. Cash dividends on allocated shares were recorded as a reduction of retained earnings and paid or
distributed directly to participants’ accounts. Cash dividends on unallocated shares were recorded as a reduction of debt and
accrued interest.
Stock-Based Compensation
The Company maintains a number of stock-based incentive programs, which are discussed in more detail in Note 21,
"Stock-Based Compensation." Compensation cost is recognized for stock options and restricted stock awards issued to
employees and directors, based on the fair value of these awards at the date of grant. The Company did not grant stock option
awards for the years ended December 31, 2014, 2013 or 2012, other than the options granted in 2014 as part of the
Washington Banking Merger. The fair value of stock options granted would be estimated on the date of grant using the Black-
Scholes-Merton option pricing model. The market price of the Company’s common stock at the date of grant is used for the
restricted stock awards. Compensation cost is recognized over the requisite service period, generally defined as the vesting
period, on a straight-line basis.
Deferred Compensation Plans
The Company has adopted a Deferred Compensation Plan and has entered into arrangements with certain executive
officers. Under the Plan, participants are permitted to elect to defer compensation and the Company has the discretion to make
additional contributions to the Plan on behalf of any participant based on a number of factors. Such discretionary contributions
are generally approved by the Compensation Committee of the Company's Board of Directors. The notional account balances
of participants under the Plan earn interest on an annual basis. The applicable interest rate is the Moody’s Seasoned Aaa
Corporate Bond Yield as of January 1 of each year. Generally, a participant’s account is payable upon the earliest of the
participant’s separation from service with the Company, the participant’s death or disability, or a specified date that is elected
by the participant in accordance with applicable rules of the Internal Revenue Code. The Company’s obligation to make
payments under the Plan is a general obligation of the Company and is to be paid from the Company’s general assets. As
such, participants are general unsecured creditors of the Company with respect to their participation under the Plan. The
Company records a liability within accrued expenses and other liabilities on the Consolidated Statements of Financial
Condition and records compensation expense in a systematic and rationale manner. Since the amounts earned are generally
based on the Company’s annual performance, the Company records deferred compensation expense each year for an amount
calculated based on that year’s financial performance.
Earnings per Share
Basic earnings per common share is net income available to common stockholders divided by the weighted average
number of common shares outstanding during the period. All outstanding unvested share-based payment awards that contain
rights to nonforfeitable dividends are considered participating securities for this calculation. Diluted earnings per common
share includes the dilutive effect of additional potential common shares issuable under stock options. Earnings and dividends
per share are restated for all stock splits and stock dividends through the date of issuance of the financial statements.
Operating Segments
While the Company’s chief decision-makers monitor the revenue streams of the various products and services, operations
are managed and financial performance is evaluated on a Company-wide basis. Operating segments are aggregated into one
as operating results for all segments are similar. Accordingly, all of the financial service operations are considered by
management to be aggregated in one reportable operating segment.
F-17
(d) Recently Issued Accounting Pronouncements
FASB ASU 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, A Similar Tax
Loss, or a Tax Credit Carryforward Exists, was issued in July 2013. This Update provides that an unrecognized tax benefit, or a
portion thereof, be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss
carryforward, a similar tax loss, or a tax credit carryforward, except to the extent that a net operating loss carryforward, a
similar tax loss, or a tax credit carryforward is not available at the reporting date to settle any additional income taxes that
would result from disallowance of a tax position, or the tax law does not require the entity to use, and the entity does not intend
to use, the deferred tax asset for such purpose, then the unrecognized tax benefit should be presented as a liability. This
Update was effective for the Company for the year ended December 31, 2014. The adoption of this Update did not have a
material impact on the Company's Consolidated Financial Statements.
FASB ASU 2014-01, Accounting for Investments in Qualified Affordable Housing Projects, was issued in January 2014.
The objective of this Update is to provide guidance on accounting for investments by a reporting entity in flow-through limited
liability entities that manage or invest in affordable housing projects that qualify for the low-income housing tax credit. The
Update permits reporting entities to make an accounting policy election to account for their investments in qualified affordable
housing projects using the proportional amortization method if certain conditions are met. Under the proportional amortization
method, an entity amortizes the initial cost of the investment in proportion to the tax credits and other tax benefits received and
recognizes the net investment performance in the consolidated statements of income as a component of income tax expense
(benefit). The standard will be effective for the Company beginning January 1, 2015; however, early adoption was permitted.
The Company adopted the provisions of this Update during the year ended December 31, 2014. The adoption of this Update
did not have a material impact on the Company’s Consolidated Financial Statements.
FASB ASU 2014-04, Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon
Foreclosure, was issued in January 2014. This Update intends to reduce variations in practice by clarifying when an in-
substance repossession or foreclosure occurs, that is, when a creditor should be considered to have received physical
possession of residential real estate property collateralizing a consumer mortgage loan such that the loan receivable should be
derecognized and the real estate property recognized. The Update states that the real estate property should be recognized
upon either the creditor obtaining legal title or the borrower conveying all interest through a deed in lieu of foreclosure or similar
legal agreement. The Update is effective for interim and annual reporting periods beginning after December 15, 2014. Early
adoption is permitted. The Company adopted the amendments in the first quarter of 2014. The adoption did not have an
impact on the Company's Consolidated Financial Statements.
FASB ASU 2014-09, Revenue from Contracts with Customers, was issued in May 2014. Under this Update, FASB
created a new Topic 606 which is in response to a joint initiative of FASB and the International Accounting Standards Board to
clarify the principles for recognizing revenue and to develop a common revenue standard for U.S. GAAP and international
financial reporting standards that would:
1. Remove inconsistencies and weaknesses in revenue requirements.
2. Provide a more robust framework for addressing revenue issues.
3.
Improve comparability of revenue recognition practices across entities, industries, jurisdictions, and capital
markets.
4. Provide more useful information to users of financial statements through improved disclosure requirements.
5. Simplify the preparation of financial statements by reducing the number of requirements to which an entity must
refer.
The Update is effective for annual reporting periods beginning after December 15, 2016, including interim periods within that
reporting period. Early application is not permitted. The Company is currently evaluating the impact that this Update will have
on its Consolidated Financial Statements.
FASB ASU 2014-11, Transfers and Servicing: Repurchase-to-Maturity Transactions, Repurchase Financings, and
Disclosures, was issued in June 2014. This Update aligns the accounting for repurchase-to-maturity transactions and
repurchase agreements executed as a repurchase financing with the accounting for other typical repurchase agreements, such
as secured borrowings. The guidance eliminates sale accounting and supersedes the guidance under which a transfer of a
financial asset and a contemporaneous repurchase financing could be accounted for on a combined basis as a forward
agreement. The Update requires new and expanded disclosures that are effective for interim or annual reporting periods
beginning after December 15, 2014. Early adoption for a public company is prohibited. The Company does not anticipate the
adoption of this Update will have a material impact on its Consolidated Financial Statements.
F-18
FASB ASU 2014-14, Receivables - Troubled Debt Restructurings by Creditors: Classification of Certain Government-
Guaranteed Mortgage Loans upon Foreclosure, was issued in August 2014 to reduce the diversity of classification of
government-guaranteed mortgages upon foreclosure. The Update requires that mortgage loans be derecognized and that a
separate other receivable be recognized upon foreclosure if certain conditions are met. The separate other receivable should
be measured based on the amount of the loan balance (principal and interest) expected to be recovered from the guarantor.
The amendments in this Update are effective for interim and annual periods beginning after December 15, 2014. Early
adoption is permitted. The Company adopted the amendment in the third quarter of 2014. The adoption did not have an
impact on the Company's Consolidated Financial Statements.
(2) Business Combinations
During the year ended December 31, 2014, the Company completed the merger of Washington Banking Company,
referred to as the "Washington Banking Merger". During the year ended December 31, 2013, the Company completed the
acquisitions of Northwest Commercial Bank and Valley Community Bancshares, referred to jointly as the "NCB and Valley
Acquisitions." During the year ended December 31, 2013, the Company also completed the merger of its wholly-owned bank
subsidiary Central Valley Bank with and into Heritage Bank. The merger of Central Valley Bank with an into Heritage Bank was
a common control merger which had no accounting impact on the consolidated Company. There were no acquisitions or
mergers completed during the year ended December 31, 2012.
Washington Banking Merger
On October 23, 2013, the Company, along with the Bank, and Washington Banking and its wholly owned subsidiary bank,
Whidbey, jointly announced the signing of a merger agreement for the Washington Banking Merger. The Washington Banking
Merger was effective on May 1, 2014. Pursuant to the terms of the Washington Banking Merger, Washington Banking
branches adopted the Heritage Bank name in all markets, with the exception of six branches in the Whidbey Island markets
which have continued to operate using the Whidbey Island Bank name. The primary reasons for the merger were to expand
the Company's geographic footprint consistent with its ongoing growth strategy and to achieve operational scale and realize
efficiencies of a larger combined organization.
Under the terms of the merger agreement, Washington Banking shareholders received 0.89000 shares of Heritage
common stock and $2.75 in cash for each share of Washington Banking common stock. The terms of the merger agreement
also stipulated immediate vesting of the Washington Banking options and restricted stock awards units. At April 30, 2014, the
number of Washington Banking common shares outstanding was 15,587,154. The closing price of Heritage common stock
was $16.16 as of April 30, 2014. The total consideration transferred by the Company in conjunction with the Washington
Banking Merger was $269.6 million and the total number of Heritage shares of common stock issued were 14,000,178. The
Company also incurred $489,000 in capitalized stock issuance costs.
The total consideration transferred in the Washington Banking Merger consisted of the following:
Consideration transferred
Cash paid (1) .......................................................................................................................................
Fair value of common shares issued (2) .............................................................................................
Fair value of restricted stock unit awards (3) .......................................................................................
Fair value of common stock options ....................................................................................................
Total consideration transferred ......................................................................................................
Washington
Banking
(In thousands)
$ 42,895
224,151
2,092
481
$269,619
(1) Includes $3,000 of cash paid due to fractional shares and $27,000 of cash paid from dissenters.
(2) Total of 13,870,716 shares issued. Excludes 1,686 shares dissented and paid in cash and 165 fractional shares paid in cash.
(3) Total number of converted shares was 129,462. Fair value includes 26,783 shares which were forfeited by the Washington Banking
stockholder to pay applicable taxes, totaling fair value of $433,000.
The transaction qualified as a tax-free reorganization for U.S. federal income tax purposes and Washington Banking
shareholders did not recognize any taxable gain or loss in connection with the share exchange and the stock consideration
received.
F-19
The Washington Banking Merger resulted in $89.7 million of goodwill. This goodwill is not deductible for tax purposes.
Subsequent to the goodwill amounts reported in the Form 10-Q for the quarter ended June 30, 2014, the Company recorded
adjustments to goodwill totaling $722,000 related to a $489,000 correction of the fair value of consumer loans, a $233,000
correction in the FDIC indemnification asset, a $252,000 correction of the net receivable from the FDIC for losses on covered
assets and a $252,000 change in deferred taxes related to correction of tax liabilities. Subsequent to the goodwill amounts
reported in the Form 10-Q for the quarter ended September 30, 2014, the Company recorded adjustments to goodwill totaling
$118,000 related to a $265,000 correction in the BOLI split-dollar obligation, a $342,000 correction of deferred taxes, and a
$489,000 correction in stock issuance costs.
During the years ended December 31, 2014 and 2013, the Company incurred Washington Banking merger-related costs
(including system conversion costs) of approximately $9.1 million and $890,000, respectively.
The Company expects to finalize the purchase price allocation by March 31, 2015 when the valuation of acquired
noncovered and covered loans, related indemnification asset and deferred taxes is completed.
Valley Community Bancshares
On March 11, 2013, the Company entered into a definitive agreement to acquire Valley Community Bancshares ("Valley")
and its wholly-owned subsidiary, Valley Bank, both headquartered in Puyallup, Washington. The Valley Acquisition was
completed on July 15, 2013. Valley operated eight branches prior to acquisition, of which only four were maintained by
Heritage Bank. Of the four other branches, three leases were terminated during the fourth quarter of 2013 and one owned
branch building was considered held for sale at the time of acquisition.
Pursuant to the terms of the merger agreement, the shareholders of Valley common stock received $19.50 per share in
cash and 1.3611 shares of Heritage common stock per Valley share. The merger consideration for Valley consisted of cash
and stock, with $22.0 million paid in cash by the Company and 1,533,267 shares of the Company’s common stock being
issued with fair value of $24.2 million. The Company also recognized $157,000 in capitalized costs related to the issuance of
its securities.
The Valley Acquisition resulted in $16.4 million of goodwill. This goodwill is not deductible for tax purposes.
During the years ended December 31, 2014 and 2013, the Company incurred Valley Acquisition-related costs (including
system conversion costs) of approximately $443,000 and $2.1 million, respectively.
Northwest Commercial Bank
On September 14, 2012, the Company and Heritage Bank entered into a definitive agreement to acquire Northwest
Commercial Bank ("NCB") headquartered in Lakewood, Washington. NCB was a full service commercial bank that operated
two branch locations in Lakewood and Auburn, Washington. Prior to the closing of the transaction, NCB redeemed its
outstanding preferred stock of approximately $2.0 million issued to the U.S. Department of Treasury in connection with its
participation in the Troubled Asset Relief Program Capital Purchase Plan. The NCB Acquisition was completed on January 9,
2013 with the merger of NCB with and into Heritage Bank. After the NCB Acquisition, the NCB Lakewood branch was
consolidated into one of Heritage Bank’s full service banking offices in Lakewood, Washington.
In connection with the NCB Acquisition, the Company paid cash consideration of $3.0 million, or $5.50 per NCB share, to
NCB shareholders on January 9, 2013. In addition, pursuant to the merger agreement, the NCB shareholders had the ability to
potentially receive an additional cash payment based on an earn-out structure from the sale of a NCB asset included in “other
real estate owned.” This contingent payment was factored into the NCB liabilities assumed by Heritage Bank as of the
January 9, 2013 acquisition date. This asset was sold by Heritage Bank in June 2013, and the $491,000 of proceeds from the
sale were paid to the NCB shareholders in July 2013. The payment of these proceeds did not impact the recorded bargain
purchase gain on bank acquisition of $399,000.
During the years ended December 31, 2013 and 2012, the Company incurred NCB Acquisition-related costs (including
system conversion costs) of approximately $794,000 and $616,000. There were no NCB Acquisition-related costs incurred
during the year ended December 31, 2014.
F-20
Business Combination Accounting
The Washington Banking Merger and the NCB and Valley Acquisitions constitute business acquisitions as defined by
FASB ASC 805, Business Combinations. FASB ASC 805 establishes principles and requirements for how the acquirer of a
business recognizes and measures in its financial statements the identifiable assets acquired and the liabilities assumed.
Heritage was considered the acquirer in the referenced mergers and acquisitions. Accordingly, the preliminary estimates of fair
values of the acquired banks' assets, including the identifiable intangible assets, and the assumed liabilities in the merger and
acquisitions were measured and recorded as of the respective effective dates of the merger and acquisitions.
The fair value estimates of the assets acquired and liabilities assumed in the indicated merger and acquisitions were as
follows:
Washington
Banking
May 1, 2014
Valley
July 15, 2013
NCB
January 9, 2013
(In thousands)
Assets
Cash and cash equivalents .................................................................
Other interest earning deposits ...........................................................
Investment securities available for sale ..............................................
Investment securities held to maturity .................................................
Loans held for sale ..............................................................................
Noncovered loans receivable ..............................................................
Covered loans receivable ....................................................................
FDIC indemnification asset .................................................................
Other real estate owned ($5,122, $0, and $0 covered by FDIC
shared-loss agreements, respectively) ........................................
Premises and equipment ....................................................................
Federal Home Loan Bank stock ..........................................................
Bank owned life insurance ..................................................................
Accrued Interest Receivable ...............................................................
Other intangible assets........................................................................
Prepaid expenses and other assets ....................................................
Total assets acquired ....................................................................
Liabilities ............................................................................................
Deposits ..............................................................................................
Junior subordinated debentures ..........................................................
Accrued expenses and other liabilities ................................................
Total liabilities assumed ................................................................
Net assets acquired.............................................................................
$ 74,947
—
458,312
—
3,923
895,978
107,050
7,174
7,121
31,776
7,064
32,519
4,943
11,194
14,852
1,656,853
1,433,894
18,937
24,067
1,476,898
$ 179,955
$ 40,643
13,866
31,444
22,908
—
117,071
—
—
—
6,558
366
—
465
916
3,087
237,324
207,013
—
342
207,355
$ 29,969
$ 2,712
1,003
2,753
—
—
51,509
—
—
2,279
214
88
—
232
156
4,048
64,994
60,442
—
1,186
61,628
$ 3,366
F-21
A summary of the net assets purchased, the fair value adjustments and resulting goodwill recognized from the Washington
Banking Merger and Valley Acquisition and the resulting bargain purchase gain recognized on the NCB Acquisition are
presented in the following table. Goodwill on mergers and acquisitions represents the excess of the consideration transferred
over the estimated fair value of the net assets acquired and liabilities assumed. A bargain purchase gain on bank acquisition
represents the excess of the estimated fair value of the net assets acquired and liabilities assumed over the value of the
consideration paid. The bargain purchase gain in the NCB Acquisition was influenced significantly by the net deferred tax asset
acquired. NCB had significant net operating losses and as a result of its estimate of whether or not it was more likely than not
that the net deferred tax asset would be realized, had recorded a full valuation allowance on the net deferred tax asset. The
Company, however, has reviewed the net deferred tax asset and determined it is more likely than not that the net deferred tax
asset would be realized by the Company.
Washington
Banking
May 1, 2014
Cost basis of net assets on merger date ........................................... $ 181,782
(269,619)
Less: Consideration transferred........................................................
Fair value adjustments:
Other interest earning deposits ...................................................
Investment securities...................................................................
Loans held for sale ......................................................................
Noncovered loans receivable ......................................................
Covered loans receivable ............................................................
FDIC indemnification asset .........................................................
Other real estate owned ..............................................................
Premises and equipment ............................................................
Other intangible assets................................................................
Prepaid expenses and other assets ............................................
Deposits ......................................................................................
Junior subordinated debentures ..................................................
Accrued expenses and other liabilities ........................................
(Goodwill) bargain purchase gain recognized .....................
—
—
86
(12,811)
6,384
357
387
(1,540)
10,216
(6,416)
(1,737)
6,837
(3,590)
$ (89,664)
Valley
July 15, 2013
(In thousands)
$ 29,720
(46,323 )
162
—
—
(3,003 )
—
—
—
1,837
916
198
(9 )
—
149
$(16,353 )
NCB
January 9, 2013
$ 6,113
(2,967)
7
(2)
—
(3,299)
—
—
(1,301)
(69)
156
2,394
(11)
—
(622)
$ 399
The operating results of the Company for the years ended December 31, 2014 and 2013 include the operating results
produced by the net assets acquired in the merger and acquisitions since the respective effective dates. Disclosure of the
amount of revenue and net income (excluding acquisition-related costs) of Washington Banking, Valley and NCB since the
effective dates included in the Company's Consolidated Statements of Income is impracticable due to the integration of the
operations and accounting for the merger and acquisitions.
The Company also considered the pro forma requirements of FASB ASC 805 and deemed it not necessary to provide pro
forma financial statements as required under the standard for the NCB and Valley Acquisitions as they were not material to the
Company. The Company believes that the historical NCB and Valley operating results are not considered of enough
significance to be meaningful to the Company’s results of operations.
F-22
The pro forma requirements of FASB ASC 805 were necessary for the Washington Banking Merger. The following table
presents certain pro forma information, for illustrative purposes only, for the years ended December 31, 2014 and 2013 as if
the Washington Banking Merger had occurred on January 1, 2013. The estimated pro forma information combines the
historical results of Washington Banking with the Company's consolidated historical results and includes certain adjustments
reflecting the estimated impact of certain fair value adjustments for the respective periods. The pro forma information is not
indicative of what would have occurred had the Washington Banking Merger occurred on January 1, 2013. In particular, no
adjustments have been made to eliminate the impact of the Washington Banking loans previously accounted for under ASC
310-30 that may have been necessary if these loans had been recorded at fair value at January 1, 2013. The pro forma
information also does not consider any changes to the provision for loan losses resulting from recorded loans at fair value.
Additionally, Heritage expects to achieve further operating savings and other business synergies, including interest income
growth, as a result of the Washington Banking Merger which are not reflected in the pro forma amounts in the following table.
As a result, actual amounts will differ from the pro forma information presented.
Pro Forma for the Year Ended December 31,
2014
2013
(Dollars In Thousands, except per share amounts)
Net interest income ....................................................................... $
Net income ....................................................................................
Basic earnings per common share ...............................................
Diluted earnings per common share.............................................
$
144,470
35,758
1.19
1.18
$
$
147,267
30,718
1.04
1.04
(3) Cash and Cash Equivalents
From October 2013 through May 2014, the Company was required to maintain an average reserve balance with the
Federal Reserve Bank of San Francisco ("Federal Reserve Bank") or maintain such reserve balance in the form of cash. The
Company did not have a cash reserve requirement at December 31, 2014. The required reserve balance at December 31,
2013 was $46.3 million, and was met by holding cash and maintaining an average balance with the Federal Reserve Bank.
(4) 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. Securities are
classified as either available for sale or held to maturity when acquired.
(a) Securities by Type and Maturity
The amortized cost, gross unrealized gains, gross unrealized losses and fair values of investment securities available for
sale at the dates indicated were as follows:
U.S. Treasury and U.S. Government-sponsored
agencies ......................................................................
Municipal securities ...........................................................
Mortgage backed securities and collateralized mortgage
obligations-residential: .......................................................
U.S. Government-sponsored agencies .......................
Corporate obligations .........................................................
Mutual funds and other equities.........................................
Total ......................................................................
Amortized
Cost
Securities Available for Sale
December 31, 2014
Gross
Unrealized
Gains
Gross
Unrealized
Losses
(In thousands)
Fair
Value
$ 21,414
170,082
$ 44
3,139
$ (31)
(184)
$ 21,427
173,037
539,859
4,034
1,956
$ 737,345
4,015
—
17
$ 7,215
(1,475)
(24)
—
$ (1,714)
542,399
4,010
1,973
$ 742,846
F-23
U.S. Treasury and U.S. Government-sponsored agencies ...
Municipal securities ...............................................................
Mortgage backed securities and collateralized mortgage
obligations-residential:
U.S. Government-sponsored agencies ...........................
Total ..........................................................................
Securities Available for Sale
December 31, 2013
Gross
Unrealized
Gains
Gross
Unrealized
Losses
(In thousands)
$ 3
806
$ (62)
(1,735)
Fair
Value
$ 6,039
49,060
Amortized
Cost
$ 6,098
49,989
108,466
$ 164,553
898
$ 1,707
(1,329)
$ (3,126)
108,035
$ 163,134
The amortized cost, gross unrecognized gains, gross unrecognized losses and fair values of investment securities held to
maturity at the dates indicated were as follows:
U.S. Treasury and U.S. Government-sponsored
agencies .....................................................................
Municipal securities ..........................................................
Mortgage backed securities and collateralized
mortgage obligations-residential:
U.S. Government-sponsored agencies ......................
Private residential collateralized mortgage
obligations ............................................................
Total ...............................................................
Securities Held to Maturity
December 31, 2014
Amortized
Cost
Gross
Unrecognized
Gains
Gross
Unrecognized
Losses
Fair
Value
(In thousands)
$ 1,591
22,486
$ 167
643
$ —
(11)
$ 1,758
23,118
10,866
364
(74)
11,156
871
$ 35,814
75
$1,249
(104)
$ (189)
842
$36,874
Securities Held to Maturity
December 31, 2013
Amortized
Cost
Gross
Unrecognized
Gains
Gross
Unrecognized
Losses
Fair
Value
U.S. Treasury and U.S. Government-sponsored
agencies ........................................................................
Municipal securities .............................................................
Mortgage backed securities and collateralized mortgage
obligations-residential:
U.S. Government-sponsored agencies .........................
Private residential collateralized mortgage
$ 1,687
24,290
9,129
obligations ...............................................................
Total ..................................................................
1,048
$ 36,154
(In thousands)
$153
200
144
185
$682
$ —
(184)
$ 1,840
24,306
(284)
8,989
(28)
$ (496)
1,205
$36,340
F-24
There were no securities classified as trading at December 31, 2014 or December 31, 2013.
The amortized cost and fair value of securities at December 31, 2014, 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.
Securities Available for Sale
Amortized
Cost
Fair
Value
Securities Held to Maturity
Amortized
Cost
Fair Value
Due in one year or less ......................................................
Due after one year through three years .............................
Due after three years through five years ............................
Due after five years through ten years ...............................
Due after ten years .............................................................
Investment securities with no stated maturity ....................
$ 4,148
31,547
23,675
150,635
525,384
1,956
(In thousands)
$ 4,171
31,693
24,104
151,946
528,959
1,973
$ 2,895
4,336
5,490
18,558
4,535
—
Total .............................................................................
$ 737,345
$ 742,846
$ 35,814
$ 2,912
4,385
5,710
19,359
4,508
—
$ 36,874
(b) Unrealized Losses and Other-Than-Temporary Impairments
Available for sale investment securities with unrealized losses as of December 31, 2014 and December 31, 2013 were as
follows:
Less than 12 Months
Securities Available for Sale
December 31, 2014
12 Months or
Longer
Total
Fair
Value
Unrealized
Losses
Fair
Value
Unrealized
Losses
Fair
Value
Unrealized
Losses
(In thousands)
$ 3,567
25,176
$
(31)
(184)
$ —
—
$ —
—
$ 3,567
25,176
$
(31)
(184)
182,970
2,119
$213,832
(1,475)
(24)
$ (1,714)
—
—
$ —
—
—
$ —
182,970
2,119
$213,832
(1,475)
(24)
$(1,714)
U.S. Treasury and U.S. Government-
sponsored agencies .......................
Municipal securities ..............................
Mortgage backed securities and
collateralized mortgage
obligations-residential:
U.S. Government-sponsored
agencies .....................................
Corporate obligations ...........................
Total ......................................................
U.S. Treasury and U.S. Government-
sponsored agencies ...................... $ 3,031
Municipal securities ............................. 21,471
Mortgage backed securities and
collateralized mortgage
obligations-residential:
U.S. Government-sponsored
56,327
Total ..................................................... $ 80,829
agencies ...............................
Less than 12 Months
Unrealized
Fair
Losses
Value
Securities Available for Sale
December 31, 2013
12 Months or
Longer
Total
Fair
Value
Unrealized
Losses
Fair
Value
Unrealized
Losses
(In thousands)
(62)
$
(1,242)
$ —
4,644
$ —
(493)
$ 3,031
26,115
$
(62)
(1,735)
(1,184)
$ (2,488)
7,758
$ 12,402
(145)
$ (638)
64,085
$ 93,231
(1,329)
$ (3,126)
F-25
Held to maturity investment securities with unrecognized losses as of December 31, 2014 and December 31, 2013 were
as follows:
Securities Held to Maturity
December 31, 2014
Less than 12
Months
12 Months or
Longer
Total
Fair
Value
Unrecognized
Losses
Fair
Value
Unrecognized
Losses
Fair
Value
Unrecognized
Losses
Municipal securities ....................... $ 2,196
Mortgage backed securities and
collateralized mortgage
obligations-residential:
U.S. Government-sponsored
agencies ..........................
2,553
Private residential
collateralized mortgage
obligations .......................
558
Total ............................................... $ 5,307
$ (11)
$ —
$ —
$ 2,196
$ (11)
(In thousands)
(74)
—
—
2,553
(74)
(104)
$(189)
—
$ —
—
$ —
558
$ 5,307
(104)
$ (189)
Securities Held to Maturity
December 31, 2013
Less than 12
Months
12 Months or Longer
Total
Fair
Value
Unrecognized
Losses
Fair
Value
Unrecognized
Losses
Fair
Value
Unrecognized
Losses
Municipal securities ........................ $10,967
Mortgage backed securities and
collateralized mortgage
obligations-residential:
U.S. Government-sponsored
agencies ..........................
4,869
Private residential
collateralized mortgage
obligations .......................
211
Total ................................................ $16,047
$ (184)
$ —
$ —
$ 10,967
$ (184)
(In thousands)
(284)
—
—
4,869
(284)
(5)
$ (473)
124
$124
(23)
$ (23)
335
$ 16,171
(28)
$ (496)
The Company has evaluated these securities and has determined that, other than certain private residential collateralized
mortgage obligations discussed below, the decline in their value is temporary. The unrealized losses are primarily due to
increases in market interest rates and larger spreads in the market for mortgage-related products. The fair value of these
securities is expected to recover as the securities approach their maturity date and/or as the pricing spreads narrow on
mortgage-related securities. The Company has the ability and intent to hold the investments until recovery of the market value
which may be the maturity date of the securities.
To analyze the unrealized losses, the Company estimated expected future cash flows of the private residential
collateralized mortgage obligations by estimating the expected future cash flows of the underlying collateral and applying those
collateral cash flows, together with any credit enhancements such as subordination interests owned by third parties, to the
security. The expected future cash flows of the underlying collateral are determined using the remaining contractual cash flows
adjusted for future expected credit losses (which considers current delinquencies and nonperforming assets, future expected
default rates and collateral value by vintage and geographic region) and prepayments. The expected cash flows of the security
are then discounted at the interest rate used to recognize interest income on the security to arrive at a present value amount.
The average discount interest rate used in the valuations of the present value as of December 31, 2014 and 2013 was 9.4%
and 6.4%, respectively, and the average prepayment rate for each period was 6.0%.
F-26
For the years ended December 31, 2014 and 2013, there were four and eight, respectively, private residential
collateralized mortgage obligations determined to be other-than-temporarily impaired. All unrealized losses for the years
ended December 31, 2014 and 2013 were deemed to be credit related, and the Company recorded the impairment in
earnings. No impairment for the years ended December 31, 2014 and 2013 was recorded through other comprehensive
income (loss). For the year ended December 31, 2012, there were eight private residential collateralized mortgage obligations
determined to be other-than-temporarily impaired. A portion of the impairment not related to credit losses was recorded
through other comprehensive (loss) income for the year ended December 31, 2012.
The following table summarizes activity for the years ended December 31, 2014, 2013 and 2012 related to the amount of
impairments on held to maturity securities:
Life-to-Date Gross Other-
Than-Temporary
Impairments (1)
Life-to-Date Other-Than-
Temporary Impairments
Included in Other
Comprehensive Income
(Loss)
Life-to-Date Net
Other-Than-Temporary
Impairments Included in
Earnings
December 31, 2011 .......................
Subsequent impairments ........
December 31, 2012 .......................
Subsequent impairments ........
December 31, 2013 .......................
Subsequent impairments ........
December 31, 2014 .......................
$ 2,435
130
2,565
38
2,603
45
$ 2,648
(In thousands)
$ 1,100
52
1,152
—
1,152
—
$ 1,152
$ 1,335
78
1,413
38
1,451
45
$ 1,496
(1) Life-to-date gross other-than-temporary impairments disclosed in this table are not reflective of subsequent recoveries, if any.
(c) Pledged Securities
The following table summarizes the amortized cost and fair value of available for sale and held to maturity securities that
are pledged as collateral for the following obligations at December 31, 2014 and December 31, 2013:
December 31, 2014
December 31, 2013
Amortized
Cost
Fair
Value
Amortized
Cost
Fair
Value
Washington and Oregon state to secure public deposits ..
Federal Reserve Bank and FHLB to secure borrowing
arrangements ..............................................................
Repurchase agreements ....................................................
Other securities pledged ....................................................
Total .............................................................................
$ 150,507
(In thousands)
$ 153,785
$ 80,386
4,430
43,676
14,828
$ 213,441
4,460
44,457
14,922
$ 217,624
—
34,170
—
$ 114,556
$ 80,881
—
33,893
—
$114,774
At December 31, 2014 and 2013, total carrying value of pledged securities was $216.7 million and $114.8 million,
respectively.
(5) Noncovered Loans Receivable
The Company originates loans in the ordinary course of business and has also acquired loans through FDIC-assisted and
open bank transactions. Loans that are not covered by FDIC shared-loss agreements are referred to as "noncovered loans."
Disclosures related to the Company’s recorded investment in noncovered loans receivable generally exclude accrued interest
receivable and net deferred loan origination fees and costs because they are insignificant.
Loans acquired in a business combination may be further classified as “purchased” loans. Loans purchased with evidence
of credit deterioration since origination for which it is probable that not all contractually required payments will be collected are
accounted for under FASB ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality. These loans are
identified as “purchased credit impaired” ("PCI") loans. Loans purchased that are not accounted for under FASB ASC 310-30
are accounted for under FASB ASC 310-20, Receivables—Nonrefundable Fees and Other Costs.
F-27
(a) Loan Origination/Risk Management
The Company categorizes loans in one of the four segments of the total loan portfolio: commercial business, real estate
construction and land development, one-to-four family residential and consumer. Within these segments are classes of loans
to which management monitors and assesses credit risk in the loan portfolios. The Company has certain lending policies and
procedures in place that are designed to maximize loan income within an acceptable level of risk. Management reviews and
approves these policies and procedures on a regular basis. A reporting system supplements the review process by providing
management with frequent reports related to loan production, loan quality, concentrations of credit, loan delinquencies, and
nonperforming and potential problem loans. The Company also conducts internal loan reviews and validates the credit risk
assessment on a periodic basis and presents the results of these reviews to management. The loan review process
complements and reinforces the risk identification and assessment decisions made by loan officers and credit personnel, as
well as the Company’s policies and procedures.
A discussion of the risk characteristics of each loan portfolio segment is as follows:
Commercial Business:
There are three significant classes of loans in the commercial portfolio segment: commercial and industrial loans, owner-
occupied commercial real estate and non-owner occupied commercial real estate. The owner and non-owner occupied
commercial real estate are both considered commercial real estate loans. As the commercial and industrial loans carry
different risk characteristics than the commercial real estate loans, they are discussed separately below.
Commercial and industrial. Commercial and industrial loans are primarily made based on the identified cash flows of the
borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, may
not be as expected and the collateral securing these loans may fluctuate in value. Most commercial and industrial loans are
secured by the assets being financed or other business assets such as accounts receivable or inventory and may include a
personal guarantee; however, some short-term loans may be made on an unsecured basis. In the case of loans secured by
accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of
the borrower to collect amounts due from its customers.
Commercial real estate. The Company originates commercial real estate loans within its primary market areas. These
loans are subject to underwriting standards and processes similar to commercial and industrial loans, in addition to those of
real estate loans. These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate.
Commercial real estate involves more risk than other classes of loans in that the lending typically involves higher loan principal
amounts, and payments on loans secured by real estate properties are dependent on successful operation and management
of the properties. Repayment of these loans may be more adversely affected by conditions in the real estate market or the
economy. Owner-occupied commercial real estate loans are generally of lower credit risk than non-owner occupied
commercial real estate loans as the borrowers' businesses are likely dependent on the properties.
One-to-Four Family Residential:
The majority of the Company’s one-to-four family residential loans are secured by single-family residences located in its
primary market areas. The Company’s underwriting standards require that single-family portfolio loans generally are owner-
occupied and do not exceed 80% of the lower of appraised value at origination or cost of the underlying collateral. Terms of
maturity typically range from 15 to 30 years. Historically, the Company sold most single-family loans in the secondary market
and retained a smaller portion in its loan portfolio. From the second quarter of 2013 until May 1, 2014, the Company only
originated single-family loans for its loan portfolio. As a result of the Washington Banking Merger, since May 1, 2014 the
Company has once again begun originating and selling a majority of its single-family mortgages.
Real Estate Construction and Land Development:
The Company originates construction loans for one-to-four family residential and for five or more family residential and
commercial properties. The one-to-four family residential construction loans generally include construction of custom homes
whereby the home buyer is the borrower. The Company also provides financing to builders for the construction of pre-sold
homes and, in selected cases, to builders for the construction of speculative residential property. Substantially all construction
loans are short-term in nature and priced with variable rates of interest. Construction lending can involve a higher level of risk
than other types of lending because funds are advanced partially based upon the value of the project, which is uncertain prior
to the project’s completion. Because of the uncertainties inherent in estimating construction costs as well as the market value
F-28
of a completed project and the effects of governmental regulation of real property, the Company’s estimates with regard to the
total funds required to complete a project and the related loan-to-value ratio may vary from actual results. As a result,
construction loans often involve the disbursement of substantial funds with repayment dependent, in part, on the success of
the ultimate project and the ability of the borrower to sell or lease the property or refinance the indebtedness. If the Company’s
estimate of the value of a project at completion proves to be overstated, it may have inadequate security for repayment of the
loan and may incur a loss if the borrower does not repay the loan. Sources of repayment for these types of loans may be pre-
committed permanent loans from approved long-term lenders, sales of developed property or an interim loan commitment from
the Company until permanent financing is obtained. These loans are closely monitored by on-site inspections and are
considered to have higher risks than other real estate loans due to their ultimate repayment being dependent upon successful
completion of the construction project, interest rate changes, government regulation of real property, general economic
conditions and the availability of long-term financing.
Consumer:
The Company originates consumer loans and lines of credit that are both secured and unsecured. The underwriting
process for these loans ensures a qualifying primary and secondary source of repayment. Underwriting standards for home
equity loans are significantly influenced by statutory requirements, which include, but are not limited to, a maximum loan-to-
value percentage of 80%, collection remedies, the number of such loans a borrower can have at one time and documentation
requirements. To monitor and manage consumer loan risk, policies and procedures are developed and modified, as needed.
The majority of consumer loans are for relatively small amounts disbursed among many individual borrowers which reduces
the credit risk for this type of loan. To further reduce the risk, trend reports are reviewed by management on a regular basis.
As a result of the Washington Banking Merger, the Company is originating indirect consumer loans. These loans are for
new and used automobile and recreational vehicles that are originated indirectly by selected dealers located in the Company's
market areas. The Company has limited its indirect loans purchased primarily to dealerships that are established and well
known in their market areas and to applicants that are not classified as sub-prime.
Noncovered loans receivable at December 31, 2014 and December 31, 2013 consisted of the following portfolio segments
and classes:
Commercial business:
December 31, 2014
December 31, 2013
(In thousands)
Commercial and industrial ...............................................................................
Owner-occupied commercial real estate .........................................................
Non-owner occupied commercial real estate ..................................................
Total commercial business ........................................................................
One-to-four family residential .................................................................................
Real estate construction and land development: ...................................................
One-to-four family residential ..........................................................................
Five or more family residential and commercial properties .............................
Total real estate construction and land development ...............................
$
Consumer ..............................................................................................................
Gross noncovered loans receivable .........................................................
Net deferred loan fees ...........................................................................................
Noncovered loans receivable, net ............................................................
Allowance for loan losses ......................................................................................
Noncovered loans receivable, net of allowance for loan losses ...............
$
551,343 $
535,742
616,757
1,703,842
63,540
46,749
61,360
108,109
250,323
2,125,814
(937)
2,124,877
(22,153)
2,102,724 $
336,540
281,309
399,979
1,017,828
43,082
19,724
48,655
68,379
41,547
1,170,836
(2,670 )
1,168,166
(22,657 )
1,145,509
(b) Concentrations of Credit
Most of the Company’s lending activity occurs within Washington State, and to a lesser extent Oregon. The Company’s
primary market areas have been concentrated along the I-5 corridor from Whatcom County to Clark County in Washington
State and Multnomah County in Oregon, as well as other contiguous markets. The Washington Banking Merger has allowed
the expansion of the market area north of Seattle, Washington to the Canadian border. The majority of the Company’s loan
portfolio consists of (in order of balances at December 31, 2014) non-owner occupied commercial real estate, owner-occupied
commercial real estate and commercial and industrial. As of December 31, 2014 and December 31, 2013, there were no
concentrations of loans related to any single industry in excess of 10% of the Company’s total loans.
F-29
(c) Credit Quality Indicators
As part of the on-going monitoring of the credit quality of the Company’s loan portfolio, management tracks certain credit
quality indicators including trends related to (i) the risk grade of the loans, (ii) the level of classified loans, (iii) net charge-offs,
(iv) nonperforming loans, and (v) the general economic conditions of the United States of America, and specifically the states
of Washington and Oregon. The Company utilizes a risk grading matrix to assign a risk grade to each of its loans. Loans are
graded on a scale of 0 to 10. A description of the general characteristics of the risk grades is as follows:
•
Grades 0 to 5: These grades are considered “pass grade” and include loans with negligible to above average but
acceptable risk. These borrowers generally have strong to acceptable capital levels and consistent earnings and debt
service capacity. Loans with the higher grades within the “pass” category may include borrowers who are
experiencing unusual operating difficulties, but have acceptable payment performance to date. Increased monitoring
of financials and/or collateral may be appropriate. Loans with this grade show no immediate loss exposure.
• Grade 6: This grade includes "Watch" loans and is considered a “pass grade”. The grade is intended to be utilized on
a temporary basis for pass grade borrowers where a potentially significant risk-modifying action is anticipated in the
near term.
• Grade 7: This grade includes “Other Assets Especially Mentioned” (“OAEM”) loans in accordance with regulatory
guidelines, and is intended to highlight loans with elevated risks. Loans with this grade show signs of deteriorating
profits and capital, and the borrower might not be strong enough to sustain a major setback. The borrower is typically
higher than normally leveraged, and outside support might be modest and likely illiquid. The loan is at risk of further
decline unless active measures are taken to correct the situation.
• Grade 8: This grade includes “Substandard” loans in accordance with regulatory guidelines, which the Company has
determined have a high credit risk. These loans also have well-defined weaknesses which make payment default or
principal exposure likely, but not yet certain. The borrower may have shown serious negative trends in financial ratios
and performance. Such loans may be dependent upon collateral liquidation, a secondary source of repayment or an
event outside of the normal course of business. Loans with this grade can be placed on accrual or nonaccrual status
based on the Company’s accrual policy.
• Grade 9: This grade includes “Doubtful” loans in accordance with regulatory guidelines, and the Company has
determined these loans to have excessive credit risk. Such loans are placed on nonaccrual status and may be
dependent upon collateral having a value that is difficult to determine or upon some near-term event which lacks
certainty. Additionally, these loans generally have a specific valuation allowance or have been partially charged-off for
the amount considered uncollectible.
• Grade 10: This grade includes “Loss” loans in accordance with regulatory guidelines, and the Company has
determined these loans have the highest risk of loss. Such loans are charged-off or charged-down when payment is
acknowledged to be uncertain or when the timing or value of payments cannot be determined. “Loss” is not intended
to imply that the loan or some portion of it will never be paid, nor does it in any way imply that there has been a
forgiveness of debt.
Numerical loan grades for all commercial business loans and real estate construction and land development loans are
established at the origination of the loan. Prior to November 2014, one-to-four family residential loans and consumer loans
(“non-commercial loans”) were not numerically graded at origination date as these loans were determined to be “pass graded”
loans. A numeric grade was assigned to these non-commercial loans if subsequent to origination, the credit department
evaluated the credit and determined it necessary to classify the loan. Subsequent to November 2014, the non-commercial
loans were designated a loan grade “4” at origination date to reflect a "pass grade". The Bank follows its regulator’s Uniform
Retail Credit Classification and Account Management Policy for subsequent classification in the event of payment
delinquencies or default. Loan grades are reviewed on a quarterly basis, or more frequently if necessary, by the credit
department. 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.
F-30
The loan grades relate to the likelihood of losses in that the higher the grade, the greater the loss potential. Loans with a
pass grade may have some estimated inherent losses, but to a lesser extent than the other loan grades. The OAEM loan
grade is transitory in that the Company is waiting on additional information to determine the likelihood and extent of the
potential loss. The likelihood of loss for OAEM graded loans, however, is greater than Watch graded loans because there has
been measurable credit deterioration. Loans with a Substandard grade are generally loans for which the Company has
individually analyzed for potential impairment. For Doubtful and Loss graded loans, the Company is almost certain of the
losses, and the unpaid principal balances are generally charged-off to the realizable value.
The following tables present the balance of the noncovered loans receivable by credit quality indicator as of December 31,
2014 and December 31, 2013.
Commercial business:
Commercial and industrial ................
Owner-occupied commercial real
estate .........................................
Non-owner occupied commercial
real estate ..................................
Total commercial business .........
One-to-four family residential ..................
Real estate construction and land
development:
One-to-four family residential ...........
Five or more family residential and
commercial properties ................
Total real estate construction
and land development .........
Consumer ................................................
Gross noncovered loans ............
Pass
OAEM
December 31, 2014
Substandard
(In thousands)
Doubtful
Total
$ 509,483
$ 14,487 $
27,049
$
324
$ 551,343
496,234
22,946
16,562
584,262
1,589,979
61,185
17,643
55,076
315
34,356
3,977
57,025
—
91,381
242,836
$1,985,381
3,977
—
$ 59,368 $
14,852
58,463
2,040
8,416
4,335
12,751
7,487
80,741
—
—
324
—
—
—
535,742
616,757
1,703,842
63,540
46,749
61,360
—
—
324
108,109
250,323
$ 2,125,814
$
Pass
OAEM
December 31, 2013
Substandar
d
(In thousands)
Doubtful
Total
Commercial business:
Commercial and industrial ...................................
Owner-occupied commercial real estate .............
Non-owner occupied commercial real estate ......
$
Total commercial business ...........................
One-to-four family residential .....................................
Real estate construction and land development:
One-to-four family residential ..............................
Five or more family residential and commercial
properties .........................................................
Total real estate construction and land
304,959 $ 9,183 $ 20,849 $ 1,549 $
269,130
381,355
8,365 —
864
8,723
3,814
9,037
336,540
281,309
399,979
955,444 22,034
269
40,245
37,937 2,413
2,568 —
1,017,828
43,082
11,582
4,159
3,983 —
19,724
45,332
—
3,323 —
48,655
development .............................................
Consumer ...................................................................
56,914
39,432
4,159
248
7,306 —
1,867 —
68,379
41,547
Gross noncovered loans .............................
$ 1,092,035 $ 26,710 $ 49,678 $ 2,413 $ 1,170,836
Noncovered potential problem loans are loans classified as OAEM or worse that are currently accruing interest and are
not considered impaired, but which management is monitoring because the financial information of the borrower causes
concern as to their ability to meet their loan repayment terms. Noncovered potential problem loans also include PCI loans as
these loans continue to accrete loan discounts established at acquisition based on the guidance of ASC 310-30. Noncovered
potential problem loans as of December 31, 2014 and December 31, 2013 were $117.3 million and $52.8 million, respectively.
The balance of noncovered potential problem loans guaranteed by a governmental agency, which guarantees reduce the
Company's credit exposure, was $2.0 million and $1.8 million as of December 31, 2014 and December 31, 2013, respectively.
F-31
(d) Nonaccrual Loans
Noncovered nonaccrual loans, segregated by segments and classes of loans, were as follows as of December 31, 2014
and December 31, 2013:
December 31, 2014
December 31, 2013
(In thousands)
Commercial business:
Commercial and industrial ...................................................................................
Owner-occupied commercial real estate .............................................................
Non-owner occupied commercial real estate ......................................................
$
Total commercial business ............................................................................
One-to-four family residential .....................................................................................
Real estate construction and land development:
One-to-four family residential ..............................................................................
Total real estate construction and land development ....................................
Consumer ...................................................................................................................
$
3,463
1,163
93
4,719
—
2,652
2,652
139
Gross noncovered nonaccrual loans ............................................................
$
7,510
$
4,648
1,024
3
5,675
340
1,045
1,045
678
7,738
The Company had $1.6 million and $1.7 million of noncovered nonaccrual loans guaranteed by governmental agencies at
December 31, 2014 and December 31, 2013, respectively.
Noncovered PCI loans are not included in the nonaccrual table above because these loans are accounted for under ASC
310-30, which provides that accretable yield is calculated based on a loan's expected cash flow even if the loan is not
performing under its conventional terms.
(e) Past due loans
The Company performs an aging analysis of past due loans using the categories of 30-89 days past due and 90 or more
days past due. This policy is consistent with regulatory reporting requirements.
The balances of noncovered past due loans, segregated by segments and classes of loans, as of December 31, 2014 and
December 31, 2013 were as follows:
December 31, 2014
30-89 Days
90 Days or
Greater
Total Past
Due
Current
Total
(In thousands)
90 Days or
More and
Still
Accruing
(1)
Commercial business:
Commercial and industrial ..............
Owner-occupied commercial real
estate .......................................
Non-owner occupied commercial
real estate ................................
Total commercial business .......
One-to-four family residential ................
Real estate construction and land
development:
One-to-four family residential
Five or more family residential and
commercial properties .............
Total real estate construction
$
2,503
$
1,962
$ 4,465
$ 546,878
$ 551,343 $
1,038
113
3,654
200
62
—
100
1,138
534,604
535,742
75
2,137
—
188
5,791
200
616,569
1,698,051
63,340
616,757
1,703,842
63,540
2,135
2,197
44,552
46,749
376
2,511
125
376
60,984
61,360
2,573
2,538
105,536
247,785
108,109
250,323
and land development .....
Consumer .............................................
62
2,413
Gross noncovered
loans ................................
$
6,329
$
4,773
$ 11,102
$ 2,114,712 $ 2,125,814 $
(1) Excludes PCI loans.
F-32
—
—
—
—
—
—
—
—
—
—
December 31, 2013
30-89 Days
90 Days or
Greater
Total Past
Due
Current
Total
(In thousands)
90 Days
or More
and Still
Accruing
(1)
Commercial business:
Commercial and industrial .............
Owner-occupied commercial real
estate .......................................
Non-owner occupied commercial
real estate ................................
Total commercial business ......
One-to-four family residential ...............
Real estate construction and land
development:
One-to-four family residential.........
Five or more family residential
and commercial properties ......
Total real estate construction
and land development .....
Consumer .............................................
$
2,493
$
4,379 $ 6,872 $ 329,668 $ 336,540 $
808
1,161
4,462
571
821
384
1,205
210
849
179
5,407
509
1,657
279,652
281,309
1,340
9,869
1,080
398,639
399,979
1,007,959 1,017,828
43,082
42,002
1,045
1,866
17,858
19,724
453
837
47,818
48,655
1,498
13
2,703
223
65,676
41,324
68,379
41,547
Gross noncovered loans .........
$
6,448
$
7,427 $ 13,875 $ 1,156,961 $ 1,170,836
$
—
—
6
6
—
—
—
—
—
6
(1) Excludes PCI loans.
F-33
(f) Impaired loans
Noncovered impaired loans includes noncovered nonaccrual loans and noncovered performing TDRs. The balance of
noncovered impaired loans as of December 31, 2014 and December 31, 2013 are set forth in the following tables.
December 31, 2014
Recorded
Investment With
No Specific
Valuation
Allowance
Recorded
Investment With
Specific
Valuation
Allowance
Total
Recorded
Investment
(In thousands)
Unpaid
Contractual
Principal
Balance
Related
Specific
Valuation
Allowance
$
1,134 $
7,906
$
9,040
$
9,349 $
1,325
360
2,421
2,781
2,781
2,459
3,953
—
2,307
—
2,307
33
4,846
15,173
245
2,217
2,056
4,273
172
7,305
19,126
245
4,524
2,056
6,580
205
7,279
19,409
245
4,964
2,056
7,020
208
684
465
2,474
75
396
234
630
56
Commercial business:
Commercial and industrial ............
Owner-occupied commercial real
estate .....................................
Non-owner occupied commercial
real estate ..............................
Total commercial business .....
One-to-four family residential ..............
Real estate construction and land
development:
One-to-four family residential .......
Five or more family residential
and commercial properties ....
Total real estate construction
and land
development ..................
Consumer ...........................................
Gross noncovered loans ........
$
6,293 $
19,863
$
26,156
$
26,882 $
3,235
December 31, 2013
Recorded
Investment With
No Specific
Valuation
Allowance
Recorded
Investment With
Specific
Valuation
Allowance
Total
Recorded
Investment
(In thousands)
Unpaid
Contractual
Principal
Balance
Related
Specific
Valuation
Allowance
$
6,140
$
4,850
$
10,990
$
13,287
$
2,716
1,118
3,300
10,558
592
3,773
2,404
6,177
100
1,880
4,123
10,853
—
911
—
911
678
2,998
3,023
7,423
21,411
592
4,684
2,404
7,088
778
7,412
23,722
619
5,426
2,404
7,830
780
595
364
3,675
—
211
—
211
153
Commercial business:
Commercial and industrial ............
Owner-occupied commercial real
estate .....................................
Non-owner occupied commercial
real estate ..............................
Total commercial business .....
One-to-four family residential ..............
Real estate construction and land
development:
One-to-four family residential .......
Five or more family residential
and commercial properties .....
Total real estate construction
and land development....
Consumer ............................................
Gross noncovered loans ........
$
17,427
$
12,442
$
29,869
$
32,951
$
4,039
F-34
The Company had governmental guarantees of $2.4 million and $2.9 million related to the noncovered impaired loan
balances at December 31, 2014 and December 31, 2013, respectively.
The average recorded investment of noncovered impaired loans for the years ended December 31, 2014, 2013 and 2012
are set forth in the following table.
Commercial business:
Years Ended December 31,
2013
2012
2014
(In thousands)
Commercial and industrial .................................................... $ 10,946
Owner-occupied commercial real
estate ................................................................................
3,215
Non-owner occupied commercial real
estate ................................................................................
7,744
Total commercial business ............................................
One-to-four family residential.......................................................
Real estate construction and land development:
One-to-four family residential ...............................................
Five or more family residential and commercial
properties ..........................................................................
Total real estate construction and land
development ..............................................................
Consumer ....................................................................................
21,905
514
5,416
2,154
7,570
779
$12,628
$ 11,467
2,638
7,897
23,163
880
4,237
2,839
7,076
254
2,141
8,174
21,782
977
4,381
5,415
9,796
427
Gross noncovered impaired loans ........................................
$ 30,768
$31,373
$ 32,982
For the years ended December 31, 2014, 2013 and 2012, no interest income was recognized subsequent to a loan’s
classification as nonaccrual. For the years ended December 31, 2014, 2013 and 2012, the Bank recorded $1.2 million, $1.1
million and $1.0 million, respectively, of interest income related to noncovered performing TDR loans.
(g) Troubled Debt Restructured Loans
A troubled debt restructured loan is a restructuring in which the Bank, for economic or legal reasons related to a
borrower’s financial difficulties, grants a concession to the borrower that it would not otherwise consider. TDRs are considered
impaired and are separately measured for impairment under FASB ASC 310-10-35, whether on accrual ("performing") or
nonaccrual ("nonperforming") status.
The majority of the Bank’s noncovered TDRs 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. Certain modifications with extensions also include interest rate reductions, which is the second most
prevalent concession. Certain TDRs were additionally re-amortized over a longer period of time. The Bank additionally
advanced funds to a troubled speculative home builder to complete established projects. These modifications would all be
considered a concession for a borrower that could not obtain similar financing terms from another source other than from the
Bank.
The financial effects of each modification will vary based on the specific restructure. For the majority of the Bank’s TDRs,
the noncovered loans were interest-only with a balloon payment at maturity. If the interest rate is not adjusted and the modified
terms are consistent with other similar credits being offered, the Bank may not experience any loss associated with the
restructure. If, however, the restructure involves forbearance agreements or interest rate modifications, the Bank may not
collect all the principal and interest based on the original contractual terms. The Bank estimates the necessary allowance for
loan losses on noncovered TDRs using the same methods used for other noncovered impaired loans.
F-35
The recorded investment balance and related allowance for loan losses of noncovered performing and noncovered
nonaccrual TDRs as of December 31, 2014 and December 31, 2013 were as follows:
December 31, 2014
December 31, 2013
Performing
TDRs
Nonaccrual
TDRs
Performing
TDRs
Nonaccrual
TDRs
(In thousands)
Noncovered TDRs ......................................................
Allowance for loan losses on noncovered TDRs .......
$ 18,764
1,908
$
5,010
1,033
$ 22,131
2,957
$
2,634
191
The unfunded commitment to borrowers related to noncovered TDRs was $1.8 million and $4.5 million at December 31,
2014 and December 31, 2013, respectively.
Noncovered loans that were modified as TDRs during the years ended December 31, 2014 and 2013 are set forth in the
following table:
Years Ended December 31,
2014
2013
Number of
Contracts
(1)
Outstanding
Principal Balance
(1)(2)
Number of
Contracts
(1)
Outstanding
Principal Balance
(1)(2)
(Dollars in thousands)
Commercial business:
Commercial and industrial...................................
Owner-occupied commercial real estate .............
Non-owner occupied commercial real estate ......
Total commercial business ...........................
One-to-four family residential ....................................
Real estate construction and land development:
One-to-four family residential ..............................
Five or more family residential and commercial
properties ......................................................
Total real estate construction and land
development .........................................
Consumer ..................................................................
32 $
3
3
38
—
10
—
10
3
Total noncovered TDRs ................................
51 $
5,926
1,063
6,548
13,537
—
3,553
—
3,553
219
17,309
33 $
5
2
40
1
24
1
25
3
6,570
537
192
7,299
252
3,639
2,404
6,043
141
69 $
13,735
(1) Number of contracts and outstanding principal balance represent loans which have balances as of period end as certain loans may
(2)
have been paid-down or charged-off during the years ended December 31, 2014 and 2013.
Includes subsequent payments after modifications and reflects the balance as of period end. As the Bank did not forgive any principal
or interest balance as part of the loan modification, the Bank’s recorded investment in each loan at the date of modification (pre-
modification) did not change as a result of the modification (post-modification), except when the modification was the initial advance on
a one-to-four family residential real estate construction and land development loan under a master guidance line. During the year
ended December 31, 2014, the Company's initial advance at the time of modification on these construction loans totaled $45,000, the
total commitment amount was $190,000 and the outstanding principal balance at December 31, 2014 was $188,000. During the year
ended December 31, 2013, the Company's initial advance at the time of modification on these construction loans totaled $1.1 million,
the total commitment amount was $4.3 million and the outstanding principal balance at December 31, 2013 was $2.5 million.
F-36
Of the 51 noncovered loans modified during the year ended December 31, 2014, 17 loans with a total outstanding
principal balance of $4.7 million had no prior modifications. The remaining noncovered loans included in the tables above for
the year ended December 31, 2014 were previously reported as noncovered TDRs. The Bank typically grants shorter
extension periods to continually monitor the troubled credits despite the fact that the extended date might not be the date the
Bank expects the cash flow. The Company does not consider these modifications a subsequent default of a noncovered TDR
as new loan terms, specifically maturity dates, were granted. The potential losses related to these loans would have been
considered in the period the loan was first reported as a noncovered TDR and adjusted, as necessary, in the current periods
based on more recent information. The related specific valuation allowance for noncovered loans that were modified as TDRs
during the year ended December 31, 2014 was $1.8 million at December 31, 2014.
The noncovered loans modified during the previous twelve months ended December 31, 2014 and 2013 that subsequently
defaulted during the years ended December 31, 2014 and 2013 are included in the following table:
Year Ended December 31, 2014
Number of
Contracts
Outstanding
Principal Balance
Year Ended December 31, 2013
Number of
Contracts
Outstanding
Principal Balance
(Dollars in thousands)
Commercial business:
Commercial and industrial ........................................
Non-owner occupied commercial real estate ...........
Total commercial business .................................
Total noncovered loans receivable ....................
—
1
1
1
$
$
—
75
75
75
3 $
—
3
3 $
918
—
918
918
The one loan included in the above table defaulted during the year ended December 31, 2014 because it was past its
modified maturity date, and the borrower has not repaid the credit. The Bank does not intend to extend the maturity. The three
loans which defaulted during the year ended December 31, 2013 defaulted as the loans were greater than 90 days past due at
December 31, 2013. At December 31, 2014 and 2013, the Bank had a specific valuation allowance of $4,000 and $63,000,
respectively, related to these credits.
(h) Noncovered Purchased Credit Impaired Loans
The Company acquired noncovered PCI loans in the Washington Banking Merger and in previously completed
acquisitions which are accounted for under FASB ASC 310-30. These previous acquisitions include the FDIC-assisted
acquisitions of Cowlitz Bank ("Cowlitz") and Pierce Commercial Bank ("Pierce") on July 30, 2010 and November 8, 2010,
respectively. In addition, the Company completed the acquisitions of NCB on January 9, 2013 and the acquisition of Valley on
July 15, 2013.
The following tables reflect the outstanding principal balance and recorded investment at December 31, 2014 and
December 31, 2013 of the noncovered PCI loans:
December 31, 2014
December 31, 2013
Outstanding
Principal
Recorded
Investment
Outstanding
Principal
Recorded
Investment
(In thousands)
Commercial business:
Commercial and industrial ................................................... $
Owner-occupied commercial real estate .............................
Non-owner occupied commercial real estate ......................
Total commercial business ............................................
One-to-four family residential .....................................................
Real estate construction and land development:
One-to-four family residential ..............................................
Five or more family residential and commercial
properties ......................................................................
Total real estate construction and land development .......
Consumer ...................................................................................
Gross noncovered PCI loans ........................................
$
22,144
18,165
12,684
52,993
2,269
$
18,040
16,208
11,185
45,433
2,235
$
18,193 $ 16,779
5,119
6,785
28,683
3,768
5,510
8,276
31,979
4,055
8,456
4,223
1,967
32
2,721
11,177
5,983
72,422
2,963
7,186
7,055
61,909
$
1,077
3,044
1,150
1,357
1,389
2,177
40,228 $ 36,017
$
F-37
On the acquisition dates, the amount by which the undiscounted expected cash flows of the noncovered PCI loans
exceeded the estimated fair value of the loan is the “accretable yield”. The accretable yield is then measured at each financial
reporting date and represents the difference between the remaining undiscounted expected cash flows and the current
carrying value of the noncovered PCI loans.
The following tables summarize the accretable yield on the noncovered PCI loans resulting from the Pierce, NCB, Valley
and Washington Banking acquisitions for the years ended December 31, 2014, 2013 and 2012.
Years Ended December 31,
2014
2013
2012
Balance at the beginning of the year ........................................................................
Accretion ............................................................................................................
Disposal and other .............................................................................................
Change in accretable yield (1) ...........................................................................
$ 7,714
(4,305)
(3,263)
12,426
(In thousands)
$ 7,352
(4,402)
(318)
5,082
Balance at the end of the year ................................................................................. $ 12,572
$ 7,714
$14,638
(6,238)
(2,798)
1,750
$ 7,352
(1) Includes accretable difference at acquisition.
On the May 1, 2014 merger date for the Washington Banking Merger, the contractual cash flows on noncovered PCI loans
acquired in the Washington Banking Merger were $75.7 million and the expected cash flows were $59.1 million, resulting in a
$16.6 million non-accretable difference. The fair value was estimated at $48.9 million, resulting in a $10.2 million accretable
yield which is included in the table above as a change in accretable yield for the year ended December 31, 2014. The
contractual cash flows on the noncovered non-PCI loans, excluding credit cards, were $1.12 billion and the expected cash
flows were $1.06 billion, resulting in $53.5 million of cash flows not expected to be collected. The fair value of the noncovered
non-PCI loans, excluding credit cards, at May 1, 2014 was $841.3 million. The credit cards loans acquired in the Washington
Banking Merger totaling $5.8 million at merger date were included in noncovered consumer loans totals. The fair value of the
credit cards approximated the carrying values; therefore, there was no cash flows not expected to be collected.
(i) Related Party Loans
In the ordinary course of business, the Company has granted loans to certain directors, executive officers and their
affiliates (collectively referred to as “related parties”).
Activity in related party loans for the years ended December 31, 2014, 2013 and 2012 was as follows (in thousands):
Balance outstanding at December 31, 2011 .....................................................................................................
Principal additions .......................................................................................................................................
Principal reductions .....................................................................................................................................
Balance outstanding at December 31, 2012 .....................................................................................................
Principal additions .......................................................................................................................................
Elimination of outstanding loan balance due to change in related party status ..........................................
Principal reductions .....................................................................................................................................
Balance outstanding at December 31, 2013 .....................................................................................................
Principal additions .......................................................................................................................................
Additional of outstanding loan balance due to change in related party status............................................
Principal reductions .....................................................................................................................................
Balance outstanding at December 31, 2014 .....................................................................................................
$10,391
8,906
(7,855)
11,442
—
(3,045)
(923)
7,474
23
1,858
(191)
$ 9,164
The Company had $228,000 and $184,000 of unfunded commitments to related parties as of December 31, 2014 and
2013, respectively. The Company did not have any borrowings from related parties at December 31, 2014 or 2013.
F-38
(j) Mortgage Banking Activities and SBA Loan Sales
The Bank originates certain one-to-four family residential loans to be sold on the secondary market. These loans were
presented as loans held for sale. The Bank ceased these mortgage banking activities in the second quarter of 2013, and
resumed activities again in the second quarter of 2014 in connection with the Washington Banking Merger. The Bank does not
retain servicing on loans sold in the secondary market. Details of certain mortgage banking activities are as follows:
Years Ended or As of December 31,
2014
2013
(In thousands)
Loans held for sale at lower of cost or market ...................................................................... $ 5,582
One-to-four family residential loans sold during the year ..................................................... 55,997
Commitments to sell mortgage loans ................................................................................... 10,625
Commitments to fund mortgage loans (at interest rates approximating market rates):
Fixed rate ......................................................................................................................... $ 8,467
2,158
Variable or adjustable rate ...............................................................................................
$ —
8,460
—
$ —
—
The Company may chose to sell the conditionally guaranteed portion of certain loans guaranteed by the Small Business
Administration or the U.S. Department of Agriculture (collectively referred to as "SBA loans") and retain a participating interest
in the unguaranteed portion of the loans. These loans are carried at the aggregate cost. SBA loans are sold with servicing
retained. Details of certain SBA loan sales activities are as follows:
December 31, 2014
December 31, 2013
SBA loans serviced for others with participating interest (1) .................................. $
SBA loans serviced for others with no participating interest ...................................
(In thousands)
77,233
—
$
26,854
—
(1) Represents the gross balance of the loan at year end. The participation owned by the Bank totaled $29.0 million and $9.4 million,
respectively, at December 31, 2014 and 2013 and is included in the balance of noncovered loans receivable on the Company's
Consolidated Statements of Financial Condition.
There was $260,000, $106,000 and $139,000 of servicing fee income and fees from SBA loans serviced for others for the
years ended December 31, 2014, 2013 and 2012. Servicing fee income is reported in other income on the Company's
Consolidated Statements of Income.
(6) Covered Loans Receivable
The Company acquired loans through FDIC-assisted transactions which are covered by FDIC shared-loss agreements.
These loans are referred to as "covered loans." Covered loans were acquired in the Cowlitz acquisition in July 2010 and with
the Washington Banking Merger in May 2014. Included in the covered loans acquired from Washington Banking were loans
Washington Banking had acquired from City Bank in April 2010 and North County Bank in September 2010. As part of the
Washington Banking Merger, the shared-loss agreements with these acquisitions were transferred to Heritage Bank.
Loans purchased with evidence of credit deterioration since origination for which it is probable that not all contractually
required payments will be collected are accounted for under FASB ASC 310-30, Loans and Debt Securities Acquired with
Deteriorated Credit Quality and are identified as PCI loans. Loans purchased that are not accounted for under FASB ASC 310-
30 are accounted for under FASB ASC 310-20, Receivables—Nonrefundable Fees and Other Costs.
Disclosures related to the Company’s recorded investment in covered loans receivable generally exclude accrued interest
receivable because it is insignificant.
F-39
(a) Risk Management
The Company categorizes covered loans in the same four segments as the noncovered portfolio: commercial business,
real estate construction and land development, one-to-four family residential and consumer.
The recorded investment of covered loans receivable at December 31, 2014 and December 31, 2013 consisted of the
following portfolio segments and classes:
December 31, 2014
December 31, 2013
(In thousands)
Commercial business:
Commercial and industrial .............................................................................
Owner-occupied commercial real estate .......................................................
Non-owner occupied commercial real estate ................................................
$
Total commercial business ......................................................................
One-to-four family residential ...............................................................................
Real estate construction and land development:
One-to-four family residential ........................................................................
Five or more family residential and commercial properties...........................
Total real estate construction and land development .............................
Consumer ............................................................................................................
Gross covered loans receivable .............................................................
Allowance for loan losses ....................................................................................
$
19,110
59,244
26,879
105,233
5,990
2,446
3,560
6,006
8,971
126,200
(5,576)
14,690
24,366
14,625
53,681
4,777
1,556
—
1,556
3,740
63,754
(6,167)
Covered loans receivable, net ................................................................
$
120,624
$
57,587
At December 31, 2014 and December 31, 2013, the recorded investment balance of loans which are no longer covered
under the FDIC shared-loss agreements, but are included in the covered loan table above as they are included in the loan pool
established at the time of acquisition, was $872,000 and $2.6 million, respectively.
F-40
(b) Credit Quality Indicators
The following tables present the recorded invested balance of the covered loans receivable by credit quality indicator as of
December 31, 2014 and December 31, 2013.
Pass
OAEM
Substandard
Doubtful
Total
December 31, 2014
(In thousands)
Commercial business:
Commercial and industrial....................................... $ 11,297
40,357
Owner-occupied commercial real estate .................
9,656
Non-owner occupied commercial real estate ..........
$ 131 $
4,957
40
5,442 $ 2,240
347
—
13,583
17,183
Total commercial business ...............................
One-to-four family residential ........................................
Real estate construction and land development:
One-to-four family residential ..................................
Five or more family residential and commercial
properties ..........................................................
Total real estate construction and land
development .............................................
Consumer ......................................................................
61,310
5,414
5,128
425
36,208
151
2,587
2,178
—
268
1,758
—
1,802
3,936
7,030
—
—
2,070
1,941
—
—
—
—
$ 19,110
59,244
26,879
105,233
5,990
2,446
3,560
6,006
8,971
Gross covered loans receivable ....................... $77,690
$ 5,553 $
40,370 $ 2,587
$ 126,200
Pass
OAEM
Substandard
Doubtful
Total
December 31, 2013
(In thousands)
Commercial business:
Commercial and industrial ......................................
Owner-occupied commercial real estate ................
Non-owner occupied commercial real estate .........
Total commercial business ..............................
One-to-four family residential .......................................
Real estate construction and land development:
$
$ 9,516
21,084
6,534
37,134
3,739
$ 3,887
2,318
55
6,260
882
702
708
4,631
6,041
156
$
585
256
3,405
4,246
—
One-to-four family residential .................................
Five or more family residential and commercial
properties .........................................................
698
—
—
—
Total real estate construction and land
development ............................................
Consumer .....................................................................
698
3,116
—
106
858
—
858
518
—
—
—
—
Gross covered loans receivable ......................
$44,687
$ 7,248
$
7,573
$ 4,246
$ 14,690
24,366
14,625
53,681
4,777
1,556
—
1,556
3,740
$ 63,754
F-41
(c) Nonaccrual Loans
The recorded investment balance of covered nonaccrual loans, segregated by segments and classes of loans, were as
follows as of December 31, 2014 and December 31, 2013:
December 31, 2014
December 31, 2013
Commercial business:
Commercial and industrial ...........................................................................
Owner-occupied commercial real estate .....................................................
Non-owner-occupied commercial real estate ..............................................
$
Total commercial business ....................................................................
Real estate construction and land development:
One-to-four family residential .............................................................................
Consumer ...........................................................................................................
Gross covered nonaccrual loans ...........................................................
$
(In thousands)
2,321 $
1,132
424
3,877
179
6
4,062 $
—
—
—
—
—
7
7
Covered PCI loans are not included in the nonaccrual table above because the loans are accounted for under ASC 310-
30, whereby accretable yield is calculated based on a loan's expected cash flow even if the loan is not performing under its
contractual terms.
(d) Past Due Loans
The balances of covered past due loans, segregated by segments and classes of loans, as of December 31, 2014 and
December 31, 2013 were as follows:
December 31, 2014
30-89 Days
90 Days or
Greater
Total Past
Due
Current
Total
(In thousands)
90 Days
or More
and Still
Accruing
(1)
$
2,262 $
1,163
$ 3,425
$ 15,685
$ 19,110
$
—
645
1,713
4,620
112
178
—
178
263
2,680
456
4,299
—
90
220
310
727
3,325
55,919
59,244
2,169
8,919
112
24,710
96,314
5,878
26,879
105,233
5,990
268
220
488
990
2,178
3,340
5,518
7,981
2,446
3,560
6,006
8,971
—
—
—
—
—
—
—
—
$
5,173 $
5,336
$ 10,509
$ 115,691
$ 126,200
$
—
Commercial business:
Commercial and industrial ..............
Owner-occupied commercial real
estate ........................................
Non-owner occupied commercial
real estate .................................
Total commercial business .......
One-to-four family residential ................
Real estate construction and land
development:
One-to-four family residential ..........
Five or more family residential and
commercial properties ..............
Total real estate construction
and land development ....
Consumer ..............................................
Gross covered loans
receivable .......................
(1) Excludes covered PCI loans.
F-42
December 31, 2013
30-89 Days
90 Days or
Greater
Total Past
Due
Current
Total
(In thousands)
90 Days
or More
and Still
Accruing
(1)
$
726
$ 1,156
$ 1,882
$12,808
$14,690
$
28
—
754
113
213
—
213
67
147
3,540
4,843
—
644
—
644
78
175
24,191
24,366
3,540
5,597
113
11,085
48,084
4,664
14,625
53,681
4,777
857
—
857
145
699
1,556
—
—
699
3,595
1,556
3,740
$ 1,147
$ 5,565
$ 6,712
$57,042
$63,754
$
—
—
—
—
—
—
—
—
—
—
Commercial business:
Commercial and industrial .............
Owner-occupied commercial real
estate .......................................
Non-owner occupied commercial
real estate ................................
Total commercial business ......
One-to-four family residential ...............
Real estate construction and land
development:
One-to-four family residential.........
Five or more family residential
and commercial properties ......
Total real estate construction
and land development .....
Consumer .............................................
Gross covered loans
receivable ........................
(1) Excludes covered PCI loans.
(e) Impaired Loans
A covered loan, not initially classified as PCI, generally becomes impaired when classified as nonaccrual or when its
modification results in a TDR. Covered impaired loans as of December 31, 2014 and December 31, 2013 are set forth in the
following tables.
December 31, 2014
Recorded
Investment With
No Specific
Valuation
Allowance
Recorded
Investment With
Specific
Valuation
Allowance
Total
Recorded
Investment
(In thousands)
Unpaid
Contractual
Principal
Balance
Related
Specific
Valuation
Allowance
$
2,240 $
94 $
2,334
$
3,696
$
9
Commercial business:
Commercial and industrial ...................
Owner-occupied commercial real
estate ............................................
Non-owner occupied commercial real
estate ............................................
—
—
1,132
1,132
1,156
424
1,650
424
3,890
440
5,292
Total commercial business ............
2,240
Real estate construction and land
development:
One-to-four family residential ................
Total real estate construction and
land development ...................
Consumer ..................................................
—
—
—
179
179
6
179
182
179
6
182
8
295
66
370
51
51
2
Gross covered impaired loans ......
$
2,240 $
1,835 $
4,075
$
5,482
$
423
F-43
December 31, 2013
Recorded
Investment With
No Specific
Valuation
Allowance
Recorded
Investment With
Specific
Valuation
Allowance
Unpaid
Contractual
Principal
Balance
Related
Specific
Valuation
Allowance
Total Recorded
Investment
(In thousands)
Commercial business:
Commercial and industrial ....................
$
10 $
3,751 $
3,761 $
3,761
$
629
Total commercial business .............
One-to-four family residential ......................
Consumer ....................................................
10
—
7
3,751
450
—
3,761
450
7
3,761
423
8
629
31
—
Gross covered impaired loans ........
$
17 $
4,201 $
4,218 $
4,192
$
660
The average recorded investment of covered impaired loans for the years ended December 31, 2014 and 2013 are set
forth in the following table.
Commercial business:
Commercial and industrial ..................................................................
Owner-occupied commercial real estate ............................................
Non-owner occupied commercial real estate .....................................
Total commercial business ..........................................................
One-to-four family residential ...................................................................
Real estate construction and land development:
One-to-four family residential ...............................................................
Total real estate construction and land
development .........................................................................
Consumer .................................................................................................
Gross covered impaired loans ...........................................................
Years Ended December 31,
2013
2014
2012
(In thousands)
$ 3,421
367
171
3,959
90
$ 1,484
—
—
1,484
459
36
—
36
7
$ 4,092
—
20
$ 1,963
$ 21
—
—
21
187
—
—
26
$ 234
For the years ended December 31, 2014, 2013 and 2012, no interest income was recognized subsequent to a covered
loan’s classification as nonaccrual. For the years ended December 31, 2014, 2013 and 2012, the Bank recorded $5,000,
$16,000 and $7,000, respectively, of interest income related to covered performing TDR loans.
(f) Troubled Debt Restructured Loans
The recorded investment balance and related allowance for loan losses of covered performing and covered nonaccrual
TDRs as of December 31, 2014 and December 31, 2013 were as follows:
December 31, 2014
December 31, 2013
Performing
TDRs
Nonaccrual
TDRs
Performing
TDRs
Nonaccrual
TDRs
(In thousands)
2,246
2
$
4,211
660
$
7
—
Covered TDRs ..............................................................
Allowance for loan losses on covered TDRs................
$ 10,289
1
$
F-44
There were no unfunded commitments related to credits classified as covered TDRs at December 31, 2014 and
December 31, 2013.
Covered loans that were modified as TDRs during the years ended December 31, 2014 and 2013 are set forth in the
following table:
Commercial business:
Commercial and industrial
Owner-occupied commercial real estate ..................
Non-owner occupied commercial real
estate .................................................................
Total commercial business .................................
One-to-four family residential ..........................................
Real estate construction and land development:
One-to-four family residential ...................................
Five or more family residential and
commercial properties ................................
Total real estate construction and land
development ...............................................
Consumer ........................................................................
Total covered TDRs ...........................................
Years Ended December 31,
2014
2013
Number of
Contracts
(1)
Outstanding
Principal Balance
(1)(2)
Number of
Contracts
(1)
Outstanding
Principal Balance
(1)(2)
(Dollars in thousands)
7
2
2
11
—
—
1
1
—
12
$
$
3,394
1,133
7,561
12,088
—
—
428
428
—
12,516
3
—
—
3
—
—
—
—
—
3
$
$
3,792
—
—
3,792
—
—
—
—
—
3,792
(1) Number of contracts and outstanding principal balance represent loans which have balances as of year end as certain loans may have
(2)
been paid-down or charged-off during the years ended December 31, 2014 and 2013.
Includes subsequent payments after modifications and reflects the balance as of period end. As the Bank did not forgive any principal
or interest balance as part of the loan modification, the Bank’s recorded investment in each loan at the date of modification (pre-
modification) did not change as a result of the modification (post-modification).
Of the twelve covered loans modified as TDRs during the year ended December 31, 2014, eleven loans totaling $10.3
million were related to PCI loans acquired in the Washington Banking Merger. There was no allowance for loan losses at
December 31, 2014 on these modified loans as the recorded investment was less than the estimated net present value of
future cash flows. Four of these modified loans totaling $7.7 million at December 31, 2014 were modified as a result of
bankruptcy rulings and the courts dictated the future payment terms. One covered TDR totaling $2.2 million at December 31,
2014 was modified during both the years ended December 31, 2014 and 2013 because the loan's maturity date was extended
in each modification. The Bank provided for a shorter maturity date than it expected to receive the cash flows to more closely
monitor the borrower. At December 31, 2014, this loan did not have a specific valuation allowance as the loan had been
charged-down to the net realizable value during fourth quarter 2014. The other two loans modified as TDRs during the year
ended December 31, 2013 also had maturity date extensions. These two loans have outstanding principal balances of
$13,000 and specific valuation of $1,000 at December 31, 2014.
There were no covered loans modified during the previous twelve months ended December 31, 2014 and December 31,
2013 that subsequently defaulted during the years ended December 31, 2014 and 2013.
(g) Covered Purchased Credit Impaired Loans
The Company acquired covered loans which the Bank accounts for under FASB ASC 310-30 as they were deemed PCI at
the time of acquisition.
F-45
The following tables reflect the outstanding principal balance and recorded investment at December 31, 2014 and
December 31, 2013 of the covered PCI loans:
December 31, 2014
December 31, 2013
Outstanding
Principal
Recorded
Investment
Outstanding
Principal
Recorded
Investment
(In thousands)
Commercial business:
Commercial and industrial ............................................................... $
Owner-occupied commercial real estate .........................................
Non-owner occupied commercial real estate ..................................
9,635 $
23,071
20,607
7,134 $
20,666
20,257
Total commercial business ........................................................
One-to-four family residential .................................................................
Real estate construction and land development:
53,313
3,837
48,057
3,478
10,608 $
11,538
10,611
32,757
3,966
8,680
10,923
12,187
31,790
3,530
One-to-four family residential ..........................................................
Five or more family residential and commercial properties.............
103
2,140
1,308
1,802
1,298
—
1,556
—
Total real estate construction and land
development .......................................................................
Consumer ..............................................................................................
2,243
2,945
3,110
2,717
Gross covered PCI loans ..........................................................
$
62,338 $
57,362 $
1,298
2,022
40,043 $
1,556
2,000
38,876
The Bank has the option to modify covered PCI loans; however, modifying the loan may terminate the FDIC shared-loss
coverage on those loans. At December 31, 2014 and December 31, 2013, the recorded investment balance of covered PCI
loans which are no longer covered under the FDIC shared-loss agreements was $476,000 and $1.7 million, respectively. The
Bank continues to report these loans in the covered portfolio as they are in a pool and they continue to be accounted for under
FASB ASC 310-30. The FDIC indemnification asset has been adjusted to reflect the change in the loan status.
(h) Accretable Yield
The following table summarizes the accretable yield on the covered PCI loans resulting from the Cowlitz Acquisition and
Washington Banking Merger for the years ended December 31, 2014, 2013 and 2012.
Years Ended December 31,
2014
2013
2012
Balance at the beginning of the year .........................................................
Accretion ..............................................................................................
Disposal and other ..............................................................................
Change in accretable yield (1).............................................................
$ 9,535
(3,749)
(1,718)
4,452
(In thousands)
$ 14,286
(4,210)
(4,902)
4,361
Balance at the end of the year ...................................................................
$ 8,520
$ 9,535
$ 19,912
(6,679)
(1,140)
2,193
$ 14,286
(1)
Includes accretable difference at acquisition.
On the May 1, 2014 merger date of the Washington Banking Merger, the contractual cash flows on covered PCI loans
acquired in the Washington Banking Merger were $75.1 million and the expected cash flows were $52.2 million, resulting in a
$22.9 million non-accretable difference. The fair value was estimated at $48.7 million, resulting in a $3.5 million accretable
yield which is included in the table above as a change in accretable yield for the year ended December 31, 2014. The
contractual cash flows on the covered non-PCI loans were $70.3 million and the expected cash flows were $66.5 million,
resulting in $3.8 million of cash flows not expected to be collected. The fair value of the covered non-PCI loans acquired in the
Washington Banking Merger at May 1, 2014 was $58.4 million.
F-46
(7) Allowance for Loan Losses
The allowance for loan losses is maintained at a level deemed appropriate by management to provide for probable
incurred credit losses in the loan portfolio.
A summary of the changes in the noncovered loans’ allowance for loan losses for the years ended December 31, 2014,
2013 and 2012 are as follows:
Years Ended December 31,
2014
2013
2012
(In thousands)
Balance at the beginning of the year ............................................................
Charge-offs..............................................................................................
Recoveries of loans previously charged-off ............................................
Provision for loan losses .........................................................................
$ 22,657
(3,643)
907
2,232
Balance at the end of the year ......................................................................
$ 22,153
$ 24,242 $ 26,952
(6,017)
(4,298)
929
1,784
1,737
1,570
$ 22,657 $ 24,242
A summary of the changes in the covered loans’ allowance for loan losses for the years ended December 31, 2014, 2013
and 2012 are as follows:
Years Ended December 31,
2014
2013
2012
Balance at the beginning of the year ...............................................................
Charge-offs ................................................................................................
Recoveries of loans previously charged-off ..............................................
Provision for loan losses ...........................................................................
$ 6,167
(2,954)
1
2,362
(In thousands)
$ 4,352
(73)
—
1,888
Balance at the end of the year .........................................................................
$ 5,576
$ 6,167
$ 3,963
(57)
—
446
$ 4,352
The covered loans acquired in the Cowlitz Acquisition and Washington Banking Merger (including Washington Banking's
prior acquisitions of City Bank and North County Bank and related covered loans) are subject to the Company’s internal credit
review. If and when credit deterioration occurs subsequent to the acquisition dates, a provision for loan losses will be charged
to earnings for the full amount of the covered loan balance without regard to the FDIC shared-loss agreements. The portion of
the estimated loss reimbursable from the FDIC is recorded in noninterest income and increases the FDIC indemnification
asset.
F-47
The following table details the activity in the allowance for loan losses for the year ended December 31, 2014 and the
balance in the allowance for loan losses disaggregated on the basis of the Company’s impairment method as of December 31,
2014:
Commercial
and
industrial
Owner-
occupied
commercial
real estate
Non-owner
occupied
commercial
real estate
One-to-four
family
residential
Real estate
construction
and land
development:
five or more
family
residential
and
commercial
properties
Real estate
construction
and land
development:
one-to-four
family
residential
(In thousands)
Consumer
Unallocated
Total
Allowance for loan losses for the
year ended December 31, 2014:
December 31, 2013 .............................
Charge-offs ..........................................
Recoveries ...........................................
Provisions for loan losses ....................
$
13,478 $
(4,504 )
716
863
4,049 $
(337 )
—
383
5,326 $
(411)
—
623
1,100 $
(31)
7
124
1,720 $
(345)
43
368
953 $
—
—
19
1,597 $
(969)
142
1,999
601 $
—
—
215
28,824
(6,597)
908
4,594
December 31, 2014 .............................
$
10,553 $
4,095 $
5,538 $
1,200 $
1,786 $
972 $
2,769 $
816 $
27,729
Allowance for loan losses as of December
31, 2014 allocated to:
Noncovered loans individually
evaluated for impairment ...................
$
Noncovered loans collectively
evaluated for impairment ...................
Covered loans individually evaluated
for impairment ...................................
Covered loans collectively evaluated
for impairment ...................................
Noncovered PCI loans collectively
evaluated for impairment ...................
Covered PCI loans collectively
evaluated for impairment ...................
1,325 $
684 $
465 $
75 $
396 $
234 $
56 $
— $
3,235
6,449
1,629
2,541
530
322
650
1,931
816
14,868
9
108
295
14
66
6
2,191
330
353
471
1,143
2,107
—
8
207
380
51
—
264
753
—
—
88
—
2
12
617
151
—
—
—
—
423
148
4,050
5,005
December 31, 2014 .............................
$
10,553 $
4,095 $
5,538 $
1,200 $
1,786 $
972 $
2,769 $
816 $
27,729
F-48
The following table details the activity in the allowance for loan losses for the year ended December 31, 2013 and the
balance in the allowance for loan losses disaggregated on the basis of the Company’s impairment method as of December 31,
2013:
Commercial
and
industrial
Owner-
occupied
commercial
real estate
Non-owner
occupied
commercial
real estate
One-to-four
family
residential
Real estate
construction
and land
development:
five or more
family
residential
and
commercial
properties
Real estate
construction
and land
development:
one-to-four
family
residential
(In thousands)
Consumer
Unallocated
Total
Allowance for loan losses for the year
ended December 31, 2013:
December 31, 2012 ........................
Charge-offs .....................................
Recoveries ......................................
Provisions for / (reallocation of)
loan losses ...................................
$
9,912
(2,826 )
248
6,144
$
4,021 $
(247 )
560
5,369 $
—
—
1,221 $
(52 )
—
(285 )
(43 )
(69 )
3,131 $
(423 )
—
(988 )
2,309
(142)
32
(1,246)
$
$
1,761
(681)
89
870
—
—
$ 28,594
(4,371)
929
428
(269)
3,672
December 31, 2013 ........................
$
13,478
$
4,049 $
5,326 $
1,100 $
1,720 $
953
$
1,597
$
601
$ 28,824
Allowance for loan losses as of
December 31, 2013 allocated to:
Noncovered loans individually
evaluated for impairment ..............
$
Noncovered loans collectively
evaluated for impairment ..............
Covered loans individually
evaluated for impairment ................
Covered loans collectively
evaluated for impairment ..............
Noncovered PCI loans collectively
evaluated for impairment ..............
Covered PCI loans collectively
evaluated for impairment ..............
2,716
$
595 $
364 $
— $
211 $
—
$
153
$
—
$ 4,039
6,727
2,101
2,516
629
18
2,294
1,094
—
7
348
998
—
14
359
2,073
570
31
13
216
270
429
—
—
291
789
855
—
—
98
—
575
—
57
638
174
601
14,374
—
—
—
—
660
109
4,244
5,398
December 31, 2013 ........................
$
13,478
$
4,049 $
5,326 $
1,100 $
1,720 $
953
$
1,597
$
601
$ 28,824
The following table details the activity in the allowance for loan losses for the year ended December 31, 2012:
Commercial
and
industrial
Owner-
occupied
commercial
real estate
Non-owner
occupied
commercial
real estate
One-to-four
family
residential
Real estate
construction
and land
development:
five or more
family
residential
and
commercial
properties
Real estate
construction
and land
development:
one-to-four
family
residential
(In thousands)
Consumer
Unallocated
Total
Allowance for loan losses for the
year ended December 31, 2012:
December 31, 2011 ................
Charge-offs ............................
Recoveries .............................
Provisions for / (reallocation
of) loan losses .....................
$
11,805 $
(2,292 )
1,560
2,979 $
(1,142)
8
4,394 $
(292 )
11
(1,161 )
2,176
1,256
$
794
(391)
—
818
4,823
(835 )
125
(982 )
$
3,800 $
(445 )
—
(1,046 )
1,410 $
(677 )
33
910
—
—
$ 30,915
(6,074)
1,737
995
(40)
2,016
December 31, 2012 ................
$
9,912 $
4,021 $
5,369 $
1,221
$
3,131
$
2,309 $
1,761 $
870
$ 28,594
F-49
The following table details the recorded investment balance of the loan receivables disaggregated on the basis of the
Company’s impairment method as of December 31, 2014:
Commercial
and
industrial
Owner-
occupied
commercial
real estate
Non-owner
occupied
commercial
real estate
One-to-four
family
residential
Real estate
construction
and land
development:
one-to-four
family
residential
Real estate
construction
and land
development:
five or more
family
residential
and
commercial
properties
Consumer
Total
Noncovered loans individually evaluated for
impairment ...........................................................
$
Noncovered loans collectively evaluated for
impairment ...........................................................
Covered loans individually evaluated for
impairment ...........................................................
Covered loans collectively evaluated for
impairment ...........................................................
Noncovered PCI loans collectively evaluated for
impairment ...........................................................
Covered PCI loans collectively evaluated for
impairment ...........................................................
Total gross loans receivable as of December 31,
2014 .....................................................................
$
(In thousands)
9,040 $
2,781 $
7,305 $
245
$
4,524
$
2,056
$
205
$
26,156
524,263
516,753
598,267
61,060
38,002
56,341
243,063
2,037,749
2,334
1,132
9,642
37,446
424
6,198
18,040
16,208
11,185
7,134
20,666
20,257
—
2,512
2,235
3,478
179
959
4,223
1,308
—
1,758
2,963
1,802
6
4,075
6,248
64,763
7,055
61,909
2,717
57,362
570,453 $
594,986 $
643,636 $
69,530
$
49,195
$
64,920
$
259,294
$ 2,252,014
The following table details the recorded investment balance of the loan receivables disaggregated on the basis of the
Company’s impairment method as of December 31, 2013:
Commercial
and
industrial
Owner-
occupied
commercial
real estate
Non-owner
occupied
commercial
real estate
One-to-four
family
residential
Real estate
construction
and land
development:
one-to-four
family
residential
Real estate
construction
and land
development:
five or more
family
residential
and
commercial
properties
Consumer
Total
Noncovered loans individually evaluated for
impairment ..........................................................
$
Noncovered loans collectively evaluated for
impairment ..........................................................
Covered loans individually evaluated for
impairment ..........................................................
Covered loans collectively evaluated for
impairment ..........................................................
Noncovered PCI loans collectively evaluated for
impairment ..........................................................
Covered PCI loans collectively evaluated for
impairment ..........................................................
Total gross loans receivable as of December 31,
2013 ................................................................. $
(In thousands)
10,990 $
2,998 $
7,423 $
592 $
4,684
$
2,404
$
778 $
29,869
308,771
273,192
385,771
38,722
15,008
44,894
38,592
1,104,950
3,761
2,249
—
13,443
16,779
5,119
—
2,438
6,785
8,680
10,923
12,187
450
797
3,768
3,530
—
—
32
—
—
7
4,218
1,733
20,660
1,357
2,177
36,017
1,556
—
2,000
38,876
351,230 $
305,675 $
414,604 $
47,859 $
21,280
$
48,655
$
45,287 $ 1,234,590
(8) FDIC Indemnification Asset
Changes in the FDIC indemnification asset during the years ended December 31, 2014, 2013 and 2012 were as follows:
Balance at the beginning of the year ...................................................
Additions as a result of the Washington Banking Merger .............
Cash payments received or receivable from the FDIC .................
Loan (recapture) impairment .........................................................
Net amortization ............................................................................
Balance at the end of the year .............................................................
Years Ended December 31,
2014
2013
2012
$ 4,382
7,174
(7,897)
(1,072)
(1,471)
$ 1,116
(In thousands)
$ 7,100
—
(2,537)
1,086
(1,267)
$ 4,382
$ 10,350
—
(2,217)
843
(1,876)
$ 7,100
F-50
(9) Other Real Estate Owned
Changes in other real estate owned during the years ended December 31, 2014, 2013 and 2012 were as follows:
Balance at the beginning of the year ....................................................
Additions .......................................................................................
Additions from acquisitions ...........................................................
Proceeds from dispositions ...........................................................
Gain on sales, net .........................................................................
Valuation adjustment .....................................................................
Balance at the end of the year .............................................................
Years Ended December 31,
2014
2013
2012
$ 4,559
1,566
7,121
(9,914)
23
—
$ 3,355
(In thousands)
$ 5,666
2,974
2,279
(6,253)
264
(371)
$ 4,559
$ 4,484
7,406
—
(5,987)
587
(824)
$ 5,666
At December 31, 2014 and 2013, the balance of other real estate owned that was covered by shared-loss
agreements were $1.2 million and $182,000, respectively.
(10) Premises and Equipment
A summary of premises and equipment is as follows:
December 31, 2014
December 31, 2013
Land .................................................................................
Buildings and building improvements ..............................
Furniture, fixtures and equipment ....................................
Total premises and equipment .................................
Less accumulated depreciation .......................................
Premises and equipment, net ..................................
$
$
(In thousands)
$
22,364
52,067
14,280
88,711
23,773
64,938
$
10,876
33,482
18,054
62,412
28,064
34,348
Total depreciation expense on premises and equipment was $3.5 million, $2.3 million and $2.1 million for the years ended
December 31, 2014, 2013 and 2012, respectively.
(11) Goodwill and Other Intangible Assets
(a) Goodwill
The Company’s goodwill represents the excess of the purchase price over the fair value of net assets acquired in the
Washington Banking Merger on May 1, 2014, and the acquisitions of Valley Community Bancshares, Inc. on July 15, 2013,
Western Washington Bancorp in 2006 and North Pacific Bank in 1998. The Company’s goodwill is assigned to the Bank and is
evaluated for impairment at the Bank level (reporting unit).
The Company recorded additions of goodwill of $89.7 million during the year ended December 31, 2014 as a result of the
Washington Banking Merger. The Company recorded additions to goodwill of $16.4 million during the year ended December
31, 2013 as a result of the Valley Acquisition. For additional information on the additions to goodwill, see "Note 2. Business
Combinations."
At December 31, 2014, the Company’s step-one analysis concluded that the reporting unit’s fair value was greater than its
carrying value and therefore no goodwill impairment charges were required for the year ended December 31, 2014. The
Company did not record any goodwill impairment charges for the years ended December 31, 2013 and 2012. Even though
there was no goodwill impairment at December 31, 2014, adverse events may impact the recoverability of goodwill and could
result in a future impairment charge which could have a material impact on the Company’s operating results.
F-51
b) Other Intangible Assets
The other intangible assets represent the core deposit intangible ("CDI") acquired in business combinations. The useful
life of the CDI related to the Washington Banking Merger, the acquisitions of Valley, NCB, Pierce, Cowlitz, and Western
Washington Bancorp were estimated to be ten, ten, five, four, nine and eight years, respectively.
The following table presents the change in the other intangible assets for the periods indicated:
Balance at the beginning of the year .............................................................
Additions as a result of acquisitions ........................................................
Less: amortization expense ....................................................................
Years Ended
December 31,
2014
2013
2012
$ 1,615
11,194
1,920
(In thousands)
$ 1,086
1,072
543
$ 1,513
—
427
Balance at the end of the year .......................................................................
$ 10,889
$ 1,615
$ 1,086
The estimated aggregated amortization expense related to these intangible assets for future years is as follows:
Years Ending December 31,
(In thousands)
2015 ...................................................................................
2016 ...................................................................................
2017 ...................................................................................
2018 ...................................................................................
2019 ...................................................................................
Thereafter ...............................................................................
$
$
2,072
1,443
1,285
1,122
1,043
3,924
10,889
(12) Deposits
Deposits consisted of the following:
December 31, 2014
December 31, 2013
Amount
Percent
Amount
Percent
Noninterest demand deposits ..........................
NOW accounts .................................................
Money market accounts ...................................
Savings accounts .............................................
$ 709,673
793,362
520,065
357,834
$
(Dollars in thousands)
24.4%
27.3
17.9
12.3
349,902
352,051
232,016
155,790
Total non-maturity deposits .......................
Certificate of deposit accounts .........................
2,380,934
525,397
81.9
18.1
1,089,759
309,430
25.0 %
25.2
16.6
11.1
77.9
22.1
Total deposits.............................................
$ 2,906,331
100.0%
$ 1,399,189
100.0 %
Accrued interest payable on deposits was $390,000 and $152,000 as of December 31, 2014 and 2013, respectively and is
included in accrued expenses and other liabilities in the Consolidated Statements of Financial Condition.
F-52
Interest expense, by category, is as follows:
Years Ended December 31,
2014
2013
2012
NOW accounts ............................................................
Money market accounts ..............................................
Savings accounts ........................................................
Certificate of deposit accounts ....................................
$ 1,011
896
252
2,991
$
(In thousands)
645
386
164
2,478
$
797
452
204
3,016
$ 5,150
$ 3,673
$ 4,469
Scheduled maturities of certificates of deposit for future years are as follows:
Year Ending December 31,
(In thousands)
2015 ...................................................................................
2016 ...................................................................................
2017 ...................................................................................
2018 ...................................................................................
2019 ...................................................................................
Thereafter ...............................................................................
$
$
347,895
107,849
35,254
13,887
19,883
629
525,397
Certificates of deposit issued in denominations equal to or in excess of $250,000 totaled $79.8 million and $55.0 million as
of December 31, 2014 and 2013, respectively.
(13) Junior Subordinated Debentures
As part of the Washington Banking Merger, the Company assumed trust preferred securities and junior subordinated
debentures with a total fair value of $18.9 million at May 1, 2014.
Washington Banking Master Trust, a statutory business trust, was a wholly-owned subsidiary of Washington Banking
Company created for the exclusive purposes of issuing and selling capital securities and utilizing sale proceeds to acquire
junior subordinated debt issued by Washington Banking Company. During 2007, the Master Trust issued $25.0 million of trust
preferred securities with a 30-year maturity, callable after the fifth year by Washington Banking Company (now callable by
Heritage). The trust preferred securities have a quarterly adjustable rate based upon the three-month London Interbank
Offered Rate (“LIBOR”) plus 1.56%. The rate at December 31, 2014 was 1.82%. The weighted average rate of the junior
subordinated debentures was 3.59% for the year ended December 31, 2014 and included the accretion of the discount
established at the merger date which is amortized over the life of the trust preferred securities.
On the Washington Banking Merger date of May 1, 2014, the Company acquired the Washington Banking Master Trust.
The Trust retained the Washington Banking Master Trust name.
The junior subordinated debentures are the sole assets of the Master Trust, and payments under the junior subordinated
debentures are the sole revenues of the Trust. All of the common securities of the Master Trust are owned by the Company.
Heritage has fully and unconditionally guaranteed the capital securities along with all obligations of the Master Trust under the
trust agreements.
(14) Repurchase Agreements
The Company utilizes repurchase agreements with a one -day maturity as a supplement to funding sources. At
December 31, 2014 and 2013 the Company had securities sold under agreement to repurchase of $32.2 million and $29.4
million, respectively. The weighted average interest rates on the utilized repurchased agreements was 0.26% and 0.27% as of
December 31, 2014 and 2013, respectively. Repurchase agreements are secured by investment securities available for sale.
Upon maturity of the agreements, the pledged investment securities will be returned to the Company.
F-53
(15) Other Borrowings
(a) FHLB Advances
The Federal Home Loan Bank of Seattle functions as a member-owned cooperative providing credit for member financial
institutions. Advances are made pursuant to several different programs. Each credit program has its own interest rate and
range of maturities. Depending on the program, limitations on the amount of advances are based either on a fixed percentage
of an institution’s net worth or on the FHLB’s assessment of the institution’s creditworthiness. At December 31, 2014, the Bank
maintained a credit facility with the FHLB of Seattle for $374.3 million. During the years ended December 31, 2014 and 2013,
there were no FHLB borrowing transactions completed other than minimal amounts necessary to test the facilities. At
December 31, 2014 and 2013 there were no FHLB advances outstanding.
Advances from the FHLB are collateralized by a blanket pledge on FHLB stock owned by the Bank, deposits at the FHLB
and all mortgages or deeds of trust securing such properties. In accordance with the pledge agreement, the Company must
maintain unencumbered collateral in an amount equal to varying percentages ranging from 100% to 125% of outstanding
advances depending on the type of collateral. At December 31, 2014, the Bank was not required to maintain collateral in order
to meet the collateral requirements of the FHLB.
(b) Federal Funds Purchased
The Bank maintains advance lines with Zions Bank, Wells Fargo Bank, US Bank and Pacific Coast Bankers’ Bank to
purchase federal funds of up to $43.0 million as of December 31, 2014. The lines generally mature annually or are reviewed
annually. As of December 31, 2014 and 2013, there were no federal funds purchased.
(c) Credit facilities
The Bank maintains a credit facility with the Federal Reserve Bank of San Francisco for $53.2 million as of December 31,
2014, of which there were no borrowings outstanding as of December 31, 2014 or 2013. Any advances on the credit facility
would have to be first pledged with the Bank's investment securities or loans.
(16) Employee Benefit Plans
(a) 401(k) Plan
Effective October 1, 1999, the Company combined three retirement plans, a money purchase pension plan, a 401(k) plan,
and an employee stock ownership plan ("ESOP") at Heritage Bank, and the 401(k) plan at Central Valley Bank into one plan
called the "Heritage Financial Corporation 401(k) Employee Stock Ownership Plan" (the “Plan”). In 2010, the Company
amended the Plan to provide certain service credit for vesting and/or contribution purposes to employees of Cowlitz Bank and
Pierce Commercial Bank at the time of each acquisition. Effective January 1, 2014, the Plan converted from an ESOP to a
profit sharing plan and changed its name to "Heritage Financial Corporation 401(k) Profit Sharing Plan and Trust."
The profit sharing portion of the Plan is a defined contribution retirement plan. Effective January 1, 2014, the Company
changed the contribution formula to make all profit sharing and discretionary contributions completely discretionary. For the
year ended December 31, 2014, the Company contributed 1.5% of employees' eligible compensation. For the Plan years
2013 and 2012, the Company was required to contribute 2% of the participants’ eligible compensation and it could also provide
discretionary profit sharing contributions beyond the required 2% contribution. For the years ended December 31, 2013 and
2012, the Company contributed 3% of employees' eligible compensation. Participants were eligible for profit sharing
contributions upon credit of 1,000 hours of service during the plan year, the attainment of 18 years of age, and employment on
the last day of the year. It was the Company’s policy to fund plan costs as accrued. Historically, employee vesting in the
profit sharing contribution occurred over a period of six years, at which time they became fully vested. All participants
employed at May 1, 2014 became 100% vested in all employer contributions. All participants hired after May 1, 2014 are
100% vested in all accounts at all times. Employer profit sharing contributions were $475,000, $600,000 and $631,000 for the
years ended December 31, 2014, 2013 and 2012, respectively.
F-54
The Plan also includes the Company’s salary savings 401(k) plan for its employees. All persons employed as of July 1,
1984 automatically participate in the plan. All employees hired after that date who are at least 18 years of age may participate
in the plan the first of the month following thirty days of service. Employees who participate may contribute a portion of their
salary, which is matched by the employer at 50%, not to be greater than 3% of eligible compensation, up to certain Internal
Revenue Service limits. Employee vesting in employer matching is consistent with the vesting periods discussed in the profit
sharing portion above. Employer matching contributions for the years ended December 31, 2014, 2013 and 2012 were
$852,000, $497,000 and $444,000, respectively.
The third portion of the Plan was the ESOP. Heritage Bank established the ESOP and related trust for eligible employees
effective July 1, 1994, which became active upon the former mutual holding company’s conversion to a stock-based holding
company in January 1995. The ESOP provided a contribution to all eligible participants upon completion of one year of service,
the attainment of 18 years of age, and employment on the last day of the year. Employee vesting in the ESOP is consistent
with the vesting periods discussed in the profit sharing portion above. The ESOP was funded by employer contributions in cash
or common stock. During the year ended December 31, 2012, the loan related to the ESOP was paid in full; therefore, there
was no ESOP compensation expense for the years ended December 31, 2014 and 2013. ESOP compensation expense was
$139,000 for the year ended December 31, 2012. As of December 31, 2014 and 2013, the Company had no allocated or
committed shares to be released to the ESOP, and the Company has no unearned, restricted shares remaining to be released
as of December 31, 2014.
(b) Employment Agreements
The Company has entered into contracts with certain senior officers that provide benefits under certain conditions
following termination without cause, and/or following a change in control of the Company.
(c) Deferred Compensation Plan
During 2012, the Company adopted a Deferred Compensation Plan, which provides its directors and select executive
officers with the opportunity to defer current compensation. Under the Plan, participants are permitted to elect to defer
compensation and the Company has the discretion to make additional contributions to the Plan on behalf of any participant
based on a number of factors. Compensation expense under the Deferred Compensation Plan totaled $343,000, $445,000 and
$312,000 for the years ended December 31, 2014, 2013 and 2012, respectively. The Company’s contributions totaled
$414,000, $155,000 and $150,000 for the years ended December 31, 2014, 2013 and 2012, respectively.
(d) Split-Dollar Life Insurance Benefit Plan
In conjunction with the Washington Banking Merger, the Company assumed the split-dollar life insurance benefit plan
previously maintained by Washington Banking. Life insurance policies are maintained for current officers of the Bank or former
Washington Banking officers that are subject to split-dollar life insurance agreements, which continue after the participant's
employment and retirement. All participants are fully vested in their split-dollar life insurance benefits. The accrued benefit
liability for the split-dollar life insurance agreements represents the present value of the future death benefits payable to the
participants' beneficiaries.
The split-dollar life insurance projected benefit obligation is included in accrued expenses and other liabilities on the
Company's Consolidated Statements of Financial Condition. As of December 31, 2014, the carrying value of the obligation
was $1.2 million. The Company had no obligation at December 31, 2013.
(17) Commitments and Contingencies
(a) Lease Commitments
The Bank leases premises and equipment under operating leases. Rental expense of leased premises and equipment
was $3.4 million, $2.3 million and $1.9 million for the years ended December 31, 2014, 2013 and 2012, respectively, which is
included in occupancy and equipment expense.
F-55
The estimated future minimum annual rental commitments under noncancelable leases having an original or remaining
term of more than one year are as follows:
Years Ending December 31,
(In thousands)
2015 ...................................................................................
2016 ...................................................................................
2017 ...................................................................................
2018 ...................................................................................
2019 ...................................................................................
Thereafter ...............................................................................
$
$
3,307
2,984
2,741
2,276
1,504
3,723
16,535
Certain leases contain renewal options from two to ten years and escalation clauses based on increases in property taxes
and other costs.
(b) Commitments to Extend Credit
In the ordinary course of business, the Company may enter into various types of transactions that include commitments to
extend credit that are not included in the Consolidated Financial Statements. The Company 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 Company’s exposure to credit loss 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:
December 31, 2014
December 31, 2013
(In thousands)
Commercial business:
Commercial and industrial .........................................................
Owner-occupied commercial real estate ...................................
Non-owner occupied commercial real estate ............................
$
Total commercial business ..................................................
One-to-four family residential ...........................................................
Real estate construction and land development:
One-to-four family residential ....................................................
Five or more family residential and commercial properties .......
Total real estate construction and land development .........
Consumer ........................................................................................
$
288,930
2,648
20,240
311,818
—
24,028
32,653
56,681
122,633
169,079
2,812
2,405
174,296
45
12,236
20,720
32,956
27,480
Total outstanding commitments ..........................................
$
491,132
$
234,777
(c) Regulatory and Legal Proceedings
The Company is involved in numerous business transactions, which, in some cases, depend on regulatory determination
as to compliance with rules and regulations. Also, the Company has certain litigation and negotiations in progress. All such
matters are attributable to activities arising from normal operations, except the matter related to the class action lawsuit
mentioned below. In the opinion of management, after review with legal counsel, the eventual outcome of the aforementioned
matters, including the class action lawsuit mentioned below, is unlikely to have a materially adverse effect on the Company’s
Consolidated Financial Statements or its financial position.
On April 4, 2014, Washington Banking, its directors and Heritage entered into and documented an agreement in principle
among Washington Banking, its directors, Heritage and the plaintiffs for the settlement of the putative shareholder class action
lawsuit captioned In Re Washington Banking Company Shareholder Litigation, Lead Case No. 13-2-38689-5 SEA, pending
before the Superior Court of the State of Washington in and for King County (the “Action”). The Action alleges that Washington
Banking’s directors breached their fiduciary duties to Washington Banking and its shareholders in connection with the
F-56
transactions contemplated by the Agreement and Plan of Merger, dated October 23, 2013 (the “Merger Agreement”), under
which Washington Banking and Heritage combined their organizations in a strategic combination, with Washington Banking
merging with and into Heritage. The Action also alleges, among other things, that Heritage aided and abetted the alleged
breaches of fiduciary duties by Washington Banking's directors and that the public disclosures concerning the Washington
Banking Merger are misleading in various respects.
On December 15, 2014, the Court entered an order preliminarily approving the settlement of the consolidated litigation
and ordering WBCO to provide notice of the proposed settlement to those persons who held WBCO shares during the
purported class period.
On February 27, 2015, the Court held a hearing to consider whether the settlement was fair and reasonable to the class
members and, if so, to approve the settlement and to consider plaintiffs’ counsel’s application for an award of attorneys’ fees
and costs from Washington Banking. At the hearing, the Court approved the settlement and entered a Final Judgment and
Order of Dismissal With Prejudice awarding plaintiffs’ counsel fees and expenses totaling $450,000 and terminating the
litigation.
The settlement of the Action did not affect the Washington Banking Merger consideration paid to Washington Banking’s
shareholders in connection with the completion of the Washington Banking Merger on May 1, 2014. Washington Banking, its
directors and Heritage took the position that the Action was without merit and denied any wrongdoing of any kind. Washington
Banking, its directors and Heritage entered into the settlement solely to eliminate the costs, risks, burden, distraction and
expense of further litigation and to put the claims that were or could have been asserted to rest. Nothing in the stipulation of
settlement or any public filing, including this Annual Report on Form 10-K, shall be deemed an admission of the legal necessity
of filing or the materiality under applicable laws of any of the additional information contained herein or in any public filing
associated with the settlement of the Action.
(18) Stockholders’ Equity
(a) Earnings Per Common Share
The following table illustrates the reconciliation of weighted average shares used for earnings per common share
computations for the years ended December 31, 2014, 2013 and 2012:
Net income:
Net income .................................................................. $
Less: Dividends and undistributed earnings allocated
to participating securities ....................................
Net income allocated to common stockholders .......... $
Years Ended
December 31,
2013
2014
2012
(Dollars in thousands)
21,014 $
9,575 $
13,261
(163)
20,851 $
(118 )
9,457 $
(162)
13,099
Basic:
Weighted average common shares outstanding ........ 25,641,229 15,667,912 15,262,452
Less: Restricted stock awards ....................................
(182,303)
Total basic weighted average common shares
(191,677 )
(210,690)
outstanding ......................................................... 25,430,539 15,476,235 15,080,149
Diluted:
Basic weighted average common shares
outstanding ......................................................... 25,430,539 15,476,235 15,080,149
14,640
46,750
11,480
Incremental shares from stock options .......................
Total diluted weighted average common shares
outstanding ......................................................... 25,477,289 15,487,715 15,094,789
Potential dilutive shares are excluded from the computation of earnings per share if their effect is anti-dilutive. For the
years ended December 31, 2014, 2013 and 2012 anti-dilutive shares outstanding related to options to acquire common stock
totaled 20,768, 163,863 and 249,215, respectively, as the assumed proceeds from exercise price, tax benefits and future
compensation was in excess of the market value.
F-57
(b) Dividends
The timing and amount of cash dividends paid on the Company's common stock depends on the Company’s earnings,
capital requirements, financial condition and other relevant factors. Dividends on common stock from the Company depend
substantially upon receipt of dividends from the Bank, which is the Company’s predominant source of income. The following
table summarizes the dividend activity for the years ended December 31, 2014, 2013 and 2012.
Declared
February 1, 2012
April 26, 2012
June 26, 2012
July 25, 2012
October 30, 2012
November 30, 2012
January 30, 2013
April 24, 2013
July 23, 2013
October 23, 2013
January 29, 2014
March 27, 2014
July 24, 2014
October 23, 2014
November 11, 2014
Cash Dividend per
Share
Record Date
Paid Date
$ 0.06
$ 0.08
$ 0.20
$ 0.08
$ 0.08
$ 0.30
$ 0.08
$ 0.08
$ 0.18
$ 0.08
$ 0.08
$ 0.08
$ 0.09
$ 0.09
$ 0.16
February 10, 2012
May 10, 2012
July 10, 2012
August 14, 2012
November 9, 2012
November 26, 2012
February 8, 2013
May 10, 2013
August 6, 2013
November 5, 2013
February 10, 2014
April 8, 2014
August 7, 2014
November 6, 2014
December 2, 2014
February 24, 2012
May 24, 2012
July 24, 2012
August 24, 2012
November 21, 2012
December 6, 2012
February 22, 2013
May 24, 2013
August 15, 2013
November 15, 2013
February 24, 2014
April 23, 2014
August 21, 2014
November 20, 2014
December 12, 2014
The FDIC and the Washington State Department of Financial Institutions, Division of Banks have the authority under their
supervisory powers to prohibit the payment of dividends by the Bank to the Company. Additionally, current guidance from the
Board of Governors of the Federal Reserve System ("Federal Reserve Board") provides, among other things, that dividends
per share on the Company’s common stock generally should not exceed earnings per share, measured over the previous four
fiscal quarters. Current regulations allow the Company and the Bank to pay dividends on their common stock if the Company’s
or the Bank’s regulatory capital would not be reduced below the statutory capital requirements set by the Federal Reserve
Board and the FDIC.
(c) Stock Repurchase Program
The Company has had various stock repurchase programs since March 1999. On October 23, 2014, the Company's
Board of Directors authorized the repurchase of up to 5% of the Company's outstanding common shares, or approximately
1,513,000 shares, under the eleventh stock repurchase plan. The number, timing and price of shares repurchased will depend
on business and market conditions, and other factors, including opportunities to deploy the Company's capital. The Company
will not repurchase the remaining 52,025 shares available under the tenth plan described below as the eleventh plan
supersedes the tenth stock repurchase program.
On August 30, 2012, the Board of Directors approved the Company’s tenth stock repurchase plan, authorizing the
repurchase of up to 5% of the Company’s outstanding shares of common stock, or approximately 757,000 shares. On
August 30, 2011, the Board of Director approved the Company's ninth stock repurchase plan, authorizing the repurchase of up
to 5% of the Company's outstanding shares of common stock, or approximately 782,000 shares over a period of twelve
months.
F-58
The following table provides total repurchased shares and average share prices under the applicable Plans and years
indicated:
Years Ended December 31,
2014
2013
2012
Plan
Total
Ninth Plan
Repurchased shares .........................................................
Stock repurchase average share price..............................
—
— $
—
389,627 590,832
— $ 13.45 $ 12.83
$
Tenth Plan
Repurchased shares .........................................................
Stock repurchase average share price..............................
108,075
52,900 704,975
$ 16.68 $ 15.88 $ 13.88 $ 15.85
544,000
Eleventh Plan
Repurchased shares .........................................................
Stock repurchase average share price..............................
—
— $
—
— $
$
—
— $
—
—
During the years ended December 31, 2014, 2013 and 2012, the Company repurchased 48,304, 13,138 and 3,419 shares
at an average price of $16.53, $14.29 and $14.08 to pay withholding taxes on the vesting of restricted stock that vested during
the years ended December 31, 2014, 2013 and 2012, respectively, which are not considered repurchased as part of the
applicable Plans.
(d) Issuance of Common Stock
The Washington Banking Merger was effective on May 1, 2014. In conjunction with the merger was the issuance of
14,000,178 shares of the Company's common stock at a fair value of $226.2 million. The Valley Acquisition was effective on
July 15, 2013. In conjunction with this acquisition was the issuance of 1,533,267 shares of the Company's stock at a fair value
of $24.2 million.
(19) Accumulated Other Comprehensive Income (Loss)
The changes in accumulated other comprehensive income (loss) (“AOCI”) by component, during the years ended
December 31, 2014, 2013 and 2012 are as follows:
Year ended December 31, 2014
Accretion of
other-than-
temporary
impairment on
held to maturity
securities (1)
Changes in
fair value of
available for sale
securities (1)
Balance of AOCI at the beginning of the year ..................................
$
Other comprehensive income before reclassification ................
Amounts reclassified from AOCI for gain on sale of
investment securities available for sale included in net
income .................................................................................
Net current period other comprehensive income.................
(923) $
4,676
(In thousands)
(239)
50
(186)
4,490
—
50
Balance of AOCI at the end of the year ............................................
$
3,567 $
(189)
(1) All amounts are net of tax.
Total
$
(1,162)
4,726
(186)
4,540
$
3,378
F-59
Year ended December 31, 2013
Changes in
fair value of
available for sale
securities (1)
Accretion of
other-than-
temporary
impairment on
held to maturity
securities (1)
(In thousands)
Balance of AOCI at the beginning of the year ....................................
Other comprehensive (loss) income before reclassification .........
Amounts reclassified from AOCI for gain on sale of investment
securities available for sale included in net income.............
$
Net current period other comprehensive (loss) income ..........
2,042 $
(2,965 )
—
(2,965 )
(298)
59
—
59
Total
$
1,744
(2,906)
—
(2,906)
Balance of AOCI at the end of the year .............................................
$
(923 ) $
(239)
$
(1,162)
(1) All amounts are net of tax.
Changes in
fair value of
available for
sale
securities
(1)
Year ended December 31, 2012
Accretion of
other-than-
temporary
impairment
on held to
maturity
securities
(1)
Other-than-
temporary
impairments
on
securities
held to
maturity (1)
(In thousands)
Total
Balance of AOCI at the beginning of the year.........................
$
2,105 $
(369) $
— $
1,736
Other comprehensive (loss) income before
reclassification .............................................................
Amounts reclassified from AOCI for gain on sale of
investment securities available for sale included in
net income .................................................................
Net current period other comprehensive (loss)
income ...................................................................
(63)
105
—
(63)
—
105
Balance of AOCI at the end of the year ..................................
$
2,042 $
(264) $
(34)
—
(34)
(34) $
8
—
8
1,744
(1) All amounts are net of tax.
(20) Fair Value Measurements
Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal
or most advantageous market for the asset or liability in an orderly transaction between market participants on the
measurement date. There are three levels of inputs that may be used to measure fair values:
Level 1: Valuations for assets and liabilities traded in active exchange markets, or interest in open-end mutual funds that
allow the Company to sell its ownership interest back to the fund at net asset value on a daily basis. Valuations are
obtained from readily available pricing sources for market transactions involving identical assets, liabilities, or funds.
Level 2: Valuations for assets and liabilities traded in less active dealer, or broker markets, such as quoted prices for similar
assets or liabilities, quoted prices in markets that are not active or valuations using methodologies with observable inputs.
Level 3: Valuations for assets and liabilities that are derived from other valuation methodologies, such as option pricing
models, discounted cash flow models and similar techniques using unobservable inputs, and not based on market
exchange, dealer, or broker traded transactions. Level 3 valuations incorporate certain assumptions and projections in
determining the fair value assigned to such assets or liabilities.
F-60
(a) Recurring and Nonrecurring Basis
The Company used the following methods and significant assumptions to estimate fair value of certain assets on a
recurring and nonrecurring basis:
Investment Securities Available for Sale and Held to Maturity:
The fair values of all investment securities are based upon the assumptions market participants would use in pricing the
security. If available, investment securities are determined by quoted market prices which is generally the case for mutual
funds and other equities (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). Level 2 includes U.S. Treasury, U.S. government and agency
debt securities, municipal securities, corporate securities and mortgage-backed securities and collateralized mortgage
obligations-residential. For investment securities where quoted prices or market prices of similar securities are not available,
fair values are calculated by using observable and unobservable inputs such as discounted cash flows or other market
indicators (Level 3). Security valuations are obtained from third party pricing services for comparable assets or liabilities.
Impaired Loans:
At the time a loan is considered impaired, its impairment is measured based on the present value of expected future cash
flows discounted at the loan’s effective interest rate, a loan’s observable market price, or fair market value of the collateral if
the loan is collateral-dependent. Impaired loans for which impairment is measured using the discounted cash flow approach
are not considered to be measured at fair value because the loan’s effective interest rate is not a fair value input, and for the
purposes of fair value disclosures, the fair value of these loans are measured commensurate with non-impaired loans.
Generally, the Company utilizes the fair market value of the collateral, which is commonly based on recent real estate
appraisals, to measure impairment. 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 the
independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments
are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. Non-real estate
collateral may be valued using an appraisal, net book value per the borrower’s financial statements, or aging reports, adjusted
or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation, and
management’s expertise and knowledge of the client and client’s business (Level 3). Impaired loans are evaluated on a
quarterly basis for additional impairment and adjusted accordingly.
Other Real Estate Owned:
Assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell when acquired,
establishing a new cost basis. These assets are subsequently accounted for at lower of cost or fair value less estimated costs
to sell. Fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation
approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely
made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and
income data available. Such adjustments are usually significant and typically result in Level 3 classification of the inputs for
determining fair value.
Appraisals for both collateral-dependent impaired loans and other real estate owned are performed by certified general
appraisers for commercial properties or certified residential appraisers for residential properties whose qualifications and
licenses have been reviewed and verified by the Company. Once received, the Company reviews the assumptions and
approaches utilized in the appraisal as well as the resulting fair value in comparison with independent data sources such as
recent market data or industry-wide statistics. On a quarterly basis, the Company compares the actual selling price of collateral
that has been liquidated to the most recent appraised value to determine what additional adjustment should be made to the
appraisal value to arrive at fair value.
F-61
The following tables summarize the balances of assets measured at fair value on a recurring basis as of December 31,
2014 and December 31, 2013.
Investment securities available for sale:
U.S. Treasury and U.S. Government-sponsored
agencies ....................................................................
Municipal securities .........................................................
Mortgage backed securities and collateralized
mortgage obligations—residential:
U.S Government-sponsored agencies ......................
Corporate obligations ......................................................
Mutual funds and other equities ......................................
December 31, 2014
Total
Level 1
Level 2
Level 3
(In thousands)
$ 21,427
173,037
$
—
—
$ 21,427
173,037
$ —
—
542,399
4,010
1,973
—
—
1,973
542,399
4,010
—
—
—
—
Total ..................................................................
$742,846
$ 1,973
$740,873
$ —
December 31, 2013
Total
Level 1
Level 2
Level 3
(In thousands)
Investment securities available for sale:
U.S. Treasury and U.S. Government-sponsored
agencies ....................................................................
Municipal securities .........................................................
Mortgage backed securities and collateralized
mortgage obligations—residential:
U.S Government-sponsored agencies ......................
$ 6,039
49,060
$
108,035
Total ..................................................................
$163,134
$
—
—
—
—
$ 6,039
49,060
108,035
$163,134
$
$
—
—
—
—
There were no transfers between Level 1 and Level 2 during the years ended December 31, 2014, 2013 and 2012.
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.
F-62
The tables below represent assets measured at fair value on a nonrecurring basis at December 31, 2014 and
December 31, 2013 and the net losses (gains) recorded in earnings during years ended December 31, 2014 and 2013.
Fair Value at December 31, 2014
Basis (1)
Total
Level 1
Level 2
Level 3
(In thousands)
Net Losses
(Gains)
Recorded in
Earnings
During
the Year
Ended
December
31, 2014
Noncovered impaired loans:
Commercial business:
Commercial and industrial .............................
$
161 $ 138
$
—
$
— $
138
$
Total commercial business .........................
161
138
Real estate construction and land
development:
One-to-four family residential ........................
Total real estate construction and land
development ...........................................
Consumer.............................................................
2,094 1,725
2,094 1,725
45
49
Total noncovered impaired loans ............
2,304 1,908
—
—
—
—
—
—
138
—
1,725
—
—
1,725
45
—
1,908
Investment securities held to maturity:
Mortgage back securities and collateralized
mortgage obligations—residential:
Private residential collateralized mortgage
obligations ...............................................
36
11
—
11
—
Total.........................................................
$ 2,340 $ 1,919
$
—
$
11 $ 1,908
$
23
23
350
350
5
378
45
423
(1) Basis represents the unpaid principal balance of noncovered impaired loans and amortized cost of investment securities held to maturity.
F-63
Fair Value at December 31, 2013
Basis (1)
Total
Level 1
Level 2
Level 3
(In thousands)
Net Losses
(Gains)
Recorded in
Earnings
During
the Year
Ended
December 31,
2013
Noncovered impaired loans:
Commercial business:
Commercial and industrial ...............................
Owner-occupied commercial real estate .........
$ 4,850 $ 2,134
1,880 1,285
$ —
—
$ —
—
$ 2,134 $
1,285
1,681
594
Non-owner occupied commercial real
estate ...........................................................
Total commercial business ............................
One-to-four family residential .................................
Real estate construction and land development:
4,123 3,759
10,853 7,178
—
—
One-to-four family residential ..........................
911
700
Total real estate construction and land
development .............................................
Consumer ..............................................................
911
678
700
525
Total noncovered impaired loans ...............
12,442 8,403
Covered impaired loans:
Commercial business:
Commercial and industrial ...............................
3,751 3,122
Non-owner occupied commercial real
estate ...........................................................
—
—
Total commercial business ...........................
One-to-four family residential .................................
Consumer ..............................................................
3,751 3,122
419
450
—
—
Total covered impaired loans ....................
4,201 3,541
Investment securities held to maturity:
Mortgage back securities and collateralized
mortgage obligations – residential:
Private residential collateralized mortgage
obligations .................................................
19
19
Other real estate owned:
Commercial properties ....................................
1,720 1,222
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
Total ..................................................
$ 18,382 $ 13,185
$ —
$
—
—
—
—
—
—
—
—
—
—
—
—
—
3,759
(2,409)
7,178
—
(134)
—
700
700
525
8,403
3,122
—
3,122
419
—
3,541
211
211
153
230
628
—
628
(13)
(2)
613
19
—
38
—
19
1,222
$13,166 $
348
1,229
(1) Basis represents the unpaid principal balance of noncovered impaired and covered impaired loans, amortized cost of investment
securities held to maturity, and carrying value at ownership date of other real estate owned.
F-64
The following table presents quantitative information about Level 3 fair value measurements for financial instruments
measured at fair value on a non-recurring basis at December 31, 2014 and December 31, 2013.
Fair
Value
Valuation
Technique(s)
Noncovered impaired loans .....
$
1,908 Market approach
Fair
Value
Valuation
Technique(s)
Noncovered impaired loans ....
Covered impaired loans ..........
Other real estate owned .........
$
$
$
8,403
Market approach
3,541
Market approach
1,222
Market approach
December 31, 2014
Unobservable Input(s)
(Dollars in thousands)
Adjustment for differences
between the comparable
sales
December 31, 2013
Unobservable Input(s)
(Dollars in thousands)
Adjustment for differences
between the comparable
sales
Adjustment for differences
between the comparable
sales
Adjustment for differences
between the comparable
sales
Range of Inputs; Weighted
Average
(47.5%) - 96.2%; 7.0%
Range of Inputs; Weighted
Average
(27.8%) - 19.1%; (6.6%)
(50.0%) - (25.0%); (35.0%)
(60.1)% - 13.6%; (35.2%)
(b) Fair Value of Financial Instruments
Because broadly traded markets do not exist for most of the Company’s financial instruments, the fair value calculations
attempt to incorporate the effect of current market conditions at a specific time. These determinations are subjective in nature,
involve uncertainties and matters of significant judgment and do not include tax ramifications; therefore, the results cannot be
determined with precision, substantiated by comparison to independent markets and may not be realized in an actual sale or
immediate settlement of the instruments. There may be inherent weaknesses in any calculation technique, and changes in the
underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results.
For all of these reasons, the aggregation of the fair value calculations presented herein do not represent, and should not be
construed to represent, the underlying value of the Company.
F-65
The tables below present the carrying value amount of the Company’s financial instruments and their corresponding
estimated fair values at the dates indicated.
December 31, 2014
Fair Value Measurements Using:
Carrying Value
Fair Value
Level 1
Level 2
Level 3
Financial Assets:
Cash and cash equivalents ................. $
Other interest earning deposits ...........
Investment securities available for
sale ..............................................
121,636
10,126
$ 121,636
10,145
$
121,636
—
$
—
10,145
$
742,846
742,846
1,973
740,873
(In thousands)
Investment securities held to
maturity........................................
Federal Home Loan Bank stock ..........
Loans held for sale ..............................
Loans receivable, net of allowance
for loan losses ...............................
Accrued interest receivable .................
Financial Liabilities:
Deposits:
35,814
12,188
5,582
36,874
N/A
5,710
2,223,348
9,836
2,279,081
9,836
—
N/A
—
—
3
—
—
—
—
N/A
—
36,874
N/A
5,710
—
3,009
2,279,081
6,824
Noninterest deposits, NOW
accounts, money market
accounts and savings
accounts .................................
Certificate of deposit accounts......
$
2,380,934
525,397
$ 2,380,934
525,768
$ 2,380,934
—
$
—
525,768
Total deposits .........................
$
2,906,331
$ 2,906,702
$ 2,380,934
$
525,768
Securities sold under agreement to
repurchase .................................. $
Junior subordinated debentures ..........
Accrued interest payable .....................
$
32,181
19,082
411
$
32,181
19,082
411
$
32,181
—
62
—
—
328
$
$
$
—
—
—
—
19,082
21
F-66
Carrying Value
Fair Value
Fair Value Measurements Using:
Level 2
Level 1
Level 3
December 31, 2013
$
Financial Assets:
Cash and cash equivalents ............................
Other interest earning deposits......................
Investment securities available for sale .........
Investment securities held to maturity ...........
Federal Home Loan Bank stock ....................
Loans receivable, net of allowance................
Accrued interest receivable ...........................
Financial Liabilities:
Deposits:
15,662
163,134
36,154
5,741
130,400 $ 130,400
15,747
163,134
36,340
N/A
1,203,096 1,218,192
5,462
5,462
(In thousands)
$ 130,400
—
—
—
N/A
—
26
$
—
15,747
163,134
36,340
N/A
—
910
$
—
—
—
—
N/A
1,218,192
4,526
Noninterest deposits, NOW accounts,
money market accounts and
savings accounts ..............................
Certificate of deposit accounts ................
$ 1,089,759 $ 1,089,759
311,065
309,430
$ 1,089,759
—
$
—
311,065
Total deposits ....................................
$ 1,399,189 $ 1,400,824
$ 1,089,759
$ 311,065
Securities sold under agreement to
repurchase ..............................................
Accrued interest payable ...............................
$
29,420 $
152
29,420
152
$
29,420
17
$
—
135
$
$
$
—
—
—
—
—
The methods and assumptions, not previously presented, used to estimate fair value are described as follows:
Cash and Cash Equivalents:
The fair value of financial instruments that are short-term or reprice frequently and that have little or no risk are considered
to have a fair value equal to carrying value (Level 1).
Other Interest Earning Deposits:
These deposits with other banks have maturities greater than three months. The fair value is calculated based upon
market prices for similar deposits (Level 2).
Federal Home Loan Bank ("FHLB") Stock:
FHLB of Seattle stock is not publicly traded, as such, it is not practicable to determine the fair value of FHLB stock due to
restrictions placed on its transferability.
Loans Held for Sale:
The fair value of loans held for sale is estimated based upon binding contracts or quotes from third party investors.
(Level 2).
Loans Receivable:
Except for impaired loans discussed previously, fair value is based on discounted cash flows using current market rates
applied to the estimated life (Level 3). While these methodologies are permitted under U.S. GAAP, they are not based on
the exit price concept of the fair value required under ASC 820-10, Fair Value Measurements and Disclosures, and
generally produce a higher value.
Accrued Interest Receivable/Payable:
The fair value of accrued interest receivable/payable balances are determined using inputs and fair value measurements
commensurate with the asset or liability from which the accrued interest is generated. The carrying amounts of accrued
interest approximate fair value (Level 1, Level 2 and Level 3).
F-67
Deposits:
For deposits with no contractual maturity, the fair value is assumed to equal the carrying value (Level 1). The fair value of
fixed maturity deposits is based on discounted cash flows using the difference between the deposit rate and the rates
offered by the Company for deposits of similar remaining maturities (Level 2).
Securities Sold Under Agreement to Repurchase:
Securities sold under agreement to repurchase are short-term in nature, repricing on a daily basis. Fair value financial
instruments that are short-term or reprice frequently and that have little or no risk are considered to have a fair value equal
to carrying value (Level 1).
Junior Subordinated Debentures:
The fair value is estimated using discounted cash flow analysis based on current rates for similar types of debt, which
many be unobservable, and considering recent trading activity of similar instrument in markets which can be inactive. At
December 31, 2014, the fair value approximated the carrying value based on these valuation techniques (Level 3).
Off-Balance Sheet Financial Instruments:
The majority of our commitments to extend credit, standby letters of credit and commitments to sell mortgage loans carry
current market interest rates if converted to loans. As such, no premium or discount was ascribed to these commitments
(Level 1). They are excluded from the preceding tables.
(21) Stock-Based Compensation
Stock options generally vest ratably over three years and expire five years after they become exercisable or vest ratably
over four years and expire ten years from date of grant. Restricted stock awards issued generally have a five-year cliff vesting
or four year ratable vesting schedule. The Company issues new shares of common stock to satisfy share option exercises and
restricted stock awards.
On July 24, 2014, the Company's shareholders approved the Heritage Financial Corporation 2014 Omnibus Equity Plan
(the "Plan") under which 1,500,000 shares of the Company's common stock may be issued in the form of nonqualified stock
option awards, restricted stock awards and restricted stock unit awards.
As of December 31, 2014, 1,384,105 shares remain available for future issuances under the Plan.
(a) Stock Option Awards
For the years ended December 31, 2014, 2013 and 2012 the Company recognized compensation expense related to
stock options of $20,000, $71,000 and $106,000, respectively, with related tax benefits of $0, $0 and $1,000, respectively. As
of December 31, 2014, all of the compensation expense related to the outstanding stock options had been recognized. The
intrinsic value from options exercised during the years ended December 31, 2014, 2013 and 2012 were $459,000, $54,000
and $31,000, respectively. The cash proceeds from options exercised during the years ended December 31, 2014, 2013 and
2012 were $915,000, $200,000, and $129,000, respectively.
F-68
The following tables summarize the stock option activity for the years ended December 31, 2014, 2013 and 2012:
Outstanding at December 31, 2011 .......................................
Granted ............................................................................
Exercised .........................................................................
Forfeited or expired .........................................................
Outstanding at December 31, 2012 .......................................
Granted ............................................................................
Exercised .........................................................................
Forfeited or expired .........................................................
Outstanding at December 31, 2013 .......................................
Granted (1) ......................................................................
Exercised .........................................................................
Forfeited or expired .........................................................
Shares
417,123
—
(11,365)
(105,100)
300,658
—
(16,553)
(89,623)
194,482
90,248
(84,189)
(44,134)
Outstanding at December 31, 2014 .......................................
156,407
Vested and expected to vest at December 31, 2014 .............
156,407
Exercisable at December 31, 2014........................................
156,407
Weighted-
Average
Exercise Price
Weighted-
Average
Remaining
Contractual
Term (In years)
Aggregate
Intrinsic
Value (In
thousands)
$
$
$
$
18.33
—
11.35
21.52
17.48
—
12.10
22.07
15.82
10.72
10.86
22.76
13.59
13.59
13.59
2.63 $
2.63 $
2.63 $
647
647
647
(1) Options granted during the year ended December 31, 2014 represent the stock options issued in conjunction with the Washington
Banking Merger. See "Note 2. Business Combinations" for additional information. The weighted average exercise price reflects the
exchange ratio applied to the original Washington Banking exercise price pursuant to the Merger Agreement.
(b) Restricted and Unrestricted Stock Awards
For the years ended December 31, 2014, 2013 and 2012 the Company recognized compensation expense related to
restricted and unrestricted stock awards of $1.4 million, $1.2 million and $1.2 million, respectively, and related tax benefits of
$489,000, $428,000 and $415,000, respectively. As of December 31, 2014, the total unrecognized compensation expense
related to non-vested restricted and unrestricted stock awards was $2.5 million and the related weighted average period over
which it is expected to be recognized is approximately 2.32 years. The vesting date fair value of restricted stock awards that
vested during the years ended December 31, 2014, 2013 and 2012 was $1.4 million, $1.2 million and $842,000, respectively.
F-69
The following tables summarize the restricted and unrestricted stock award activity for the years ended December 31,
2014, 2013 and 2012:
Weighted-Average
Grant Date Fair Value
Nonvested at December 31, 2011 ....................................................................
Granted ......................................................................................................
Vested ........................................................................................................
Forfeited .....................................................................................................
Nonvested at December 31, 2012 ...................................................................
Granted ......................................................................................................
Vested ........................................................................................................
Forfeited .....................................................................................................
Nonvested at December 31, 2013 ...................................................................
Granted ......................................................................................................
Vested ........................................................................................................
Forfeited .....................................................................................................
Nonvested at December 31, 2014 ...................................................................
Shares
164,880 $
91,738
(61,445)
(5,503)
189,670
103,195
(86,819)
(3,107)
202,939
130,548
(85,373)
(9,445)
238,669 $
16.29
14.02
17.41
15.21
14.86
14.31
15.55
14.89
14.29
16.03
14.37
14.67
15.20
(22) Income Taxes
Income tax expense is substantially due to Federal income taxes as the provision for the state of Oregon income taxes is
insignificant. Income tax expense for the years ended December 31, 2014, 2013 and 2012 consisted of the following:
Years Ended December 31,
2014
2013
2012
Current tax expense ...........................................
Deferred tax (benefit) expense ...........................
(Decrease) increase in valuation allowance .......
$ 9,992
(3,087)
—
(In thousands)
$ 4,344
326
(77)
Income tax expense .....................................
$ 6,905
$ 4,593
$ 5,916
185
77
$ 6,178
A reconciliation of the Company's effective income tax rate with the Federal statutory income tax rate of 35% is as follows:
Years Ended December 31,
2014
2013
2012
Income tax expense at Federal statutory rate ....
Tax-exempt instruments ......................................
Non-deductible acquisition costs ........................
Federal tax credits (1) .........................................
Effects of BOLI ....................................................
Tax position resolution (2) ...................................
Valuation allowance ............................................
Other, net ............................................................
$ 9,772
(1,598)
373
(812)
(159)
(728)
—
57
(In thousands)
$ 4,959
(858)
469
—
(25)
—
(77)
125
$ 6,804
(649)
—
—
(28)
—
77
(26)
Income tax expense .....................................
$ 6,905
$ 4,593
$ 6,178
F-70
(1) Federal tax credits are provided for under the New Market Tax Credit program. A subsidiary of Heritage Bank was awarded an
allocation of New Market Tax Credit investments consisting of three tranches totaling $25.0 million. Gross tax credits related to these
tranches totaling $9.8 million are available through 2020. The subsidiary is required to fund 85 percent of a tranche to claim the entire
tax credit, and it has until May 15, 2015 to complete the funding. Tax benefits related to these credits were recognized for financial
reporting purposes in the same period that the credits were recognized in the Company's income tax returns. The Company has
analyzed the three tranches and believes that it is more likely than not that all tranches will be funded to 85 percent by May 15, 2015.
The Company believes that these tax credits will be realized and therefore has reflected the impact of these credits in its estimated
annual effective tax rate for 2014.
(2) Washington Banking Company had recorded a liability for certain tax positions prior to the merger effective date, which the Company
assumed as part of the Washington Banking Merger. These tax positions were resolved as of December 31, 2014, resulting in a
decrease of the Company's income tax expense for the year ended December 31, 2014.
The following table presents major components of the deferred income tax asset (liability) resulting from differences
between financial reporting and tax basis:
December 31, 2014
December 31, 2013
Deferred tax assets:
Allowance for loan losses .......................................................................
Accrued compensation ...........................................................................
Stock compensation ...............................................................................
Capital loss carryforward ........................................................................
$
Unrealized losses charged to earnings on other than temporarily
impaired investment securities ...............................................................
Net unrealized losses charged to other comprehensive income on
securities ................................................................................................
Goodwill and other intangible assets .....................................................
Market discount on purchased loans .....................................................
Foregone interest on nonaccrual loans
Net operating loss carryforward acquired from NCB .............................
Difference in amounts reflected in financial statements and income tax
basis of certain liabilities assumed in business combinations ...............
Other deferred tax assets .......................................................................
Total deferred tax assets ..................................................................
Deferred tax liabilities:
Deferred loan fees, net ...........................................................................
Premises and equipment........................................................................
FHLB stock .............................................................................................
Net unrealized gains charged to other comprehensive income on
securities ................................................................................................
Indemnification asset ..............................................................................
Goodwill and other intangible assets ............................................................
Federal tax credits ........................................................................................
Junior subordinated debentures ...................................................................
Other deferred tax liabilities ..........................................................................
(In thousands)
5,460 $
1,382
818
30
338
—
—
17,949
2,337
553
3,492
1,394
33,753
(1,982)
(1,937)
(2,768)
(1,832)
(392)
(1,560)
(439)
(2,349)
(730)
Total deferred tax liabilities ...........................................................................
(13,989)
Deferred income tax asset, net .....................................................................
$
19,764 $
7,003
821
524
95
622
626
2,107
6,767
1,026
588
—
705
20,884
(867 )
(1,520 )
(1,039 )
—
(1,539 )
—
—
—
(248 )
(5,213 )
15,671
F-71
In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some
portion or all of the deferred tax assets will not be realized. A valuation allowance is required to be recognized for the portion
of the deferred tax asset that will not be realized. The ultimate realization of deferred tax assets is dependent upon the
generation of future taxable income during the periods in which those temporary differences become deductible. Based upon
the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax
assets are deductible, management expects to realize the benefits of these deductible differences at December 31, 2014.
The Company had a net operating loss carryforward of $1.6 million and $1.7 million at December 31, 2014 and 2013,
respectively, that will expire in 2033. The Company is limited to the amount of the net operating loss carryforward that it can
deduct each year. The Company also had $85,000 and $270,000 of federal capital loss carryforwards as of December 31,
2014 and 2013, respectively, which will expire in 2018. A tax planning strategy has been developed that will enable the
Company to deduct all of the net operating loss and capital loss carryforwards prior to their respective expirations. Based on
these estimates, management has not recorded a valuation allowance as of December 31, 2014. During the year ended
December 31, 2013, management reversed the valuation allowance that was established in the prior year resulting in no
valuation allowance at December 31, 2013.
As of December 31, 2014 and December 31, 2013, the Company had an insignificant amount of unrecognized tax
benefits, none of which would materially affect its effective tax rate if recognized. The Company does not anticipate that the
amount of unrecognized tax benefits will significantly increase or decrease in the next 12 months. The amount of interest and
penalties accrued as of December 31, 2014 and 2013 and for the years ended December 31, 2014, 2013 and 2012 were
immaterial.
The Company has qualified under provisions of the Internal Revenue Code to compute income taxes after deductions of
additions to the bad debt reserves when it was registered as a Savings Bank. At December 31, 2014, the Company had a
taxable temporary difference of approximately $2.8 million that arose before 1988 (base-year amount). In accordance with
FASB ASC 740, a deferred tax liability of an estimated $980,000 has not been recognized for the temporary difference.
Management does not expect this temporary difference to reverse in the foreseeable future.
The Company and its subsidiary file a United States consolidated federal income tax return and an Oregon State income
tax return, and the tax years subject to examination by the Internal Revenue Service are the years ended December 31, 2014,
2013, 2012 and 2011.
(23) Regulatory Capital Requirements
The Company is a bank holding company under the supervision of the Federal Reserve Bank of San Francisco. Bank
holding companies are subject to capital adequacy requirements of the Federal Reserve Board under the Bank Holding
Company Act of 1956, as amended, and the regulations of the Federal Reserve Board. Heritage Bank is a federally insured
institution and thereby is subject to the capital requirements established by the FDIC. The Federal Reserve Board capital
requirements generally parallel the FDIC requirements. Failure to meet minimum capital requirements can initiate certain
mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect
on the Company’s consolidated financial statements and operations. Management believes as of December 31, 2014, the
Company and the Bank meet all capital adequacy requirements to which they are subject.
F-72
Pursuant to minimum capital requirements of the FDIC, Heritage Bank is required to maintain a leverage ratio (Tier 1
capital to average assets ratio) of 4.0% and risk-based capital ratios of Tier 1 capital and total capital (to total risk-weighted
assets) of 4.0% and 8.0%, respectively. As of December 31, 2014 and December 31, 2013, the most recent regulatory
notifications categorized Heritage Bank as well capitalized under the regulatory framework for prompt corrective action. There
are no conditions or events since that notification that management believes have changed the Bank's categories.
As of December 31, 2014:
The Company consolidated ..................................
Tier 1 leverage capital to average assets ..........
Tier 1 capital to risk-weighted assets .................
Total capital to risk-weighted assets ..................
Heritage Bank
Tier 1 leverage capital to average assets ..........
Tier 1 capital to risk-weighted assets .................
Total capital to risk-weighted assets ..................
As of December 31, 2013:
The Company consolidated
Tier 1 leverage capital to average assets ..........
Tier 1 capital to risk-weighted assets .................
Total capital to risk-weighted assets ..................
Heritage Bank
Tier 1 leverage capital to average assets ..........
Tier 1 capital to risk-weighted assets .................
Total capital to risk-weighted assets ..................
Minimum
Requirements
%
$
Well-
Capitalized
Requirements
%
$
(Dollars in thousands)
Actual
$
%
$ 132,881
97,620
195,240
132,853
97,585
195,171
$ 65,847
47,853
95,706
65,831
47,807
95,613
4.0%
4.0
8.0
4.0
4.0
8.0
4.0%
4.0
8.0
4.0
4.0
8.0
N/A
N/A
N/A
166,066
146,378
243,964
N/A
N/A
N/A
82,288
71,710
119,517
N/A
N/A
N/A
5.0
6.0
10.0
N/A
N/A
N/A
5.0
6.0
10.0
$ 340,292
340,292
368,198
10.2%
13.9
15.1
332,147
332,147
360,053
10.0
13.6
14.8
$ 185,951
185,951
201,076
11.3%
15.5
16.8
182,543
182,543
197,656
11.1
15.3
16.5
In July 2013, the Federal banking regulators approved a final rule to implement the revised capital adequacy standards of
the Basel Committee on Banking Supervision, commonly called Basel III, and to address relevant provisions of the Dodd-Frank
Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act). The final rule strengthens the definition of regulatory
capital, increases risk-based capital requirements, makes selected changes to the calculation of risk-weighted assets, and
adjusts the prompt corrective action thresholds. Community banking organizations, such as the Company and the Bank,
become subject to the new rule on January 1, 2015 and certain provisions of the new rule will be phased in over the period of
2015 through 2019. The final rule:
• Permits banking organizations that had less than $15 billion in total consolidated assets as of December 31, 2009, or
were mutual holding companies as of May 19, 2010, to include in Tier 1 capital trust preferred securities and
cumulative perpetual preferred stock that were issued and included in Tier 1 capital prior to May 19, 2010, subject to
a limit of 25% of Tier 1 capital elements, excluding any non-qualifying capital instruments and after all regulatory
capital deductions and adjustments have been applied to Tier 1 capital.
• Establishes new qualifying criteria for regulatory capital, including new limitations on the inclusion of deferred tax
assets and mortgage servicing rights.
• Requires a minimum ratio of common equity Tier 1 capital to risk-weighted assets of 4.5%.
•
Increases the minimum Tier 1 capital to risk-weighted assets ratio requirement from 4% to 6%.
• Retains the minimum total capital to risk-weighted assets ratio requirement of 8%.
• Establishes a minimum leverage ratio requirement of 4%.
• Retains the existing regulatory capital framework for 1-4 family residential mortgage exposures.
• Permits banking organizations that are not subject to the advanced approaches rule, such as the Company and the
Bank, to retain, through a one-time election, the existing treatment for most accumulated other comprehensive
income, such that unrealized gains and losses on securities available for sale will not affect regulatory capital
amounts and ratios.
•
Implements a new capital conservation buffer requirement for a banking organization to maintain a common equity
capital ratio more than 2.5% above the minimum common equity Tier 1 capital, Tier 1 capital and total risk-based
capital ratios in order to avoid limitations on capital distributions, including dividend payments, and certain
F-73
discretionary bonus payments. The capital conservation buffer requirement will be phased in beginning on January 1,
2016 at 0.625% and will be fully phased in at 2.50% by January 1, 2019. A banking organization with a buffer of less
than the required amount would be subject to increasingly stringent limitations on such distributions and payments as
the buffer approaches zero. The new rule also generally prohibits a banking organization from making such
distributions or payments during any quarter if its eligible retained income is negative and its capital conservation
buffer ratio was 2.5% or less at the end of the previous quarter. The eligible retained income of a banking
organization is defined as its net income for the four calendar quarters preceding the current calendar quarter, based
on the organization’s quarterly regulatory reports, net of any distributions and associated tax effects not already
reflected in net income.
•
Increases capital requirements for past-due loans, high volatility commercial real estate exposures, and certain short-
term commitments and securitization exposures.
• Expands the recognition of collateral and guarantors in determining risk-weighted assets.
• Removes references to credit ratings consistent with the Dodd-Frank Act and establishes due diligence requirements
for securitization exposures.
The Company’s management is currently evaluating the provisions of the final rule and their expected impact on the
Company.
(24) Heritage Financial Corporation (Parent Company Only)
Following is the condensed financial statements of the Parent Company.
HERITAGE FINANCIAL CORPORATION
(PARENT COMPANY ONLY)
Condensed Statements of Financial Condition
ASSETS
Cash and interest earning deposits ..........................
Investment in subsidiary bank ...................................
Other assets
LIABILITIES AND STOCKHOLDERS’ EQUITY
Junior subordinated debentures ...............................
Other liabilities...........................................................
Total stockholders’ equity ..........................................
December 31, 2014
December 31, 2013
(In thousands)
$
$
$
$
8,835 $
465,442
863
475,140 $
19,082 $
1,552
454,506
475,140 $
2,645
212,354
1,041
216,040
—
278
215,762
216,040
F-74
HERITAGE FINANCIAL CORPORATION
(PARENT COMPANY ONLY)
Condensed Statements of Income
Interest income:
Interest earning deposits and other
assets ....................................................
ESOP loan .............................................
$
Total interest income .............
Interest expense:
Junior subordinated debentures ............
Total interest expense ...........
Net interest (expense) income .....................
Noninterest income: .....................................
Dividends from subsidiary banks ...........
Equity in (excess distributed)
undistributed income of subsidiary
banks .....................................................
Other income .........................................
(40,737)
3
Total noninterest income .......
25,566
Noninterest expense:
Professional services.............................
Other expense .......................................
Total noninterest expense .....
Income before income taxes .................
Income tax benefit .................................
2,943
3,109
6,052
19,073
(1,941)
Years Ended December 31,
2013
2014
2012
(In thousands)
$
17
—
17
458
458
(441)
$
22
—
22
—
—
22
44
8
52
—
—
52
66,300
26,000
14,100
(13,001)
—
12,999
1,718
2,905
4,623
8,398
(1,177)
962
—
15,062
—
2,766
2,766
12,348
(913)
Net income ............................
$ 21,014
$
9,575
$
13,261
F-75
HERITAGE FINANCIAL CORPORATION
(PARENT COMPANY ONLY)
Condensed Statements of Cash Flows
Cash flows from operating activities:
Net income .......................................................................................
Adjustments to reconcile net income to net cash provided by
operating activities:
Equity in excess distributed (undistributed) income of
subsidiary bank ..........................................................................
Tax (benefit) provision realized from stock options exercised,
share-based payment and dividends on unallocated ESOP
shares ........................................................................................
Recognition of compensation related to ESOP shares and
share based payment.............................................................
Stock option compensation expense .........................................
Net change in other assets and liabilities ..................................
Years Ended December 31,
2013
2012
2014
(In thousands)
$
21,014
$
9,575
$
13,261
40,737
13,001
(962)
(112)
1,395
20
811
13
1,223
71
(489)
Net cash provided by operating activities .........................
63,865
23,394
Cash flows from investing activities:
ESOP loan principal repayments .....................................................
Investment in subsidiary ..................................................................
—
(43,215)
Net cash (used in) provided by investing activities ..............
(43,215)
Cash flows from financing activities:
Common stock cash dividends paid ................................................
Proceeds from exercise of stock options .........................................
Tax benefit (provision) realized from stock options exercised,
share-based payment and dividends on unallocated ESOP
shares ...........................................................................................
Repurchase of common stock .........................................................
(12,892)
921
112
(2,601)
Net cash used in financing activities ..................................
(14,460)
Net increase (decrease) in cash and cash equivalents ....
Cash and cash equivalents at beginning of year ...................................
Cash and cash equivalents at end of year .............................................
$
6,190
2,645
8,835
F-76
93
1,185
106
7
13,690
161
—
161
(12,155)
129
(93)
(6,023)
(18,142)
(4,291)
20,542
—
(21,666)
(21,666)
(6,672)
176
(13)
(8,825)
(15,334)
(13,606)
16,251
$
2,645
$
16,251
(25) Selected Quarterly Financial Data (Unaudited)
Results of operations on a quarterly basis were as follows:
Year Ended December 31, 2014
First
Quarter
Second
Quarter
Third
Quarter
Fourth
Quarter
Interest income ...................................................
Interest expense .................................................
Net interest income ......................................
Provision for loan losses ....................................
Net interest income after provision for loan
losses ...........................................................
Noninterest income ............................................
Noninterest expense ..........................................
Income before provision for income taxes ...
Income tax expense ...........................................
Net income ...................................................
Basic earnings per common share .....................
Diluted earnings per common share ..................
Cash dividends declared on common stock .......
Interest income ...................................................
Interest expense .................................................
Net interest income ......................................
Provision for loan losses ....................................
Net interest income after provision for loan
losses ...........................................................
Noninterest income ............................................
Noninterest expense ..........................................
Income before provision for income taxes ...
Income tax expense ...........................................
(Dollars in thousands, except per share amounts)
30,023
$
1,426
28,597
691
35,031
1,724
33,307
594
$
$
17,613
872
16,741
458
16,283
2,307
14,779
3,811
1,268
2,543
0.16
0.16
0.16
$
$
27,906
4,780
26,994
5,692
1,544
4,148
0.16
0.16
—
$
$
32,713
5,483
28,363
9,833
2,765
7,068
0.23
0.23
0.09
$
$
$
$
$
38,439
1,659
36,780
2,851
33,929
3,897
29,243
8,583
1,328
7,255
0.24
0.24
0.25
Year Ended December 31, 2013
First
Quarter
Second
Quarter
Third
Quarter
Fourth
Quarter
(Dollars in thousands, except per share amounts)
16,859
$
919
17,484
946
18,533
952
$
$
16,538
858
15,680
2,282
13,719
4,243
1,358
15,940
1,308
14,632
2,357
13,007
3,982
1,292
2,690
0.18
0.18
0.08
17,581
1,078
16,503
2,582
14,285
4,800
1,510
3,290
0.20
0.20
0.18
$
$
$
$
$
18,552
907
17,645
428
17,217
2,430
18,504
1,143
433
710
0.04
0.04
0.08
Net income ...................................................
$
2,885
Basic earnings per common share .....................
Diluted earnings per common share ..................
Cash dividends declared on common stock .......
$
0.19
0.19
0.08
$
$
(26) Subsequent Event
Subsequent to December 31, 2014, the Company sold the legacy Heritage Bank merchant card portfolio. The noninterest
income related to this portfolio was recorded in the Company's Consolidated Statements of Income in Merchant Visa income,
net. The total consideration of the sale was $2.2 million and will be recognized in noninterest income in the first quarter of
2015. Of this amount, $1.65 million was received by the Company at time of sale and $550,000 is held in escrow and is
contingent on the performance of the portfolio in 2015. If certain performance thresholds are met, the payment will range
between $440,000 and $550,000. If the thresholds are not met, no contingent payment will be made. The contingent payment
is to be paid on or before December 31, 2015. This sale will impact future noninterest income.
F-77
BOARD OF DIRECTORS
Standing left to right: Gary B. Christensen, Deborah J. Gavin, Brian L. Vance, Kimberly T. Ellwanger, Brian S. Charneski,
David H. Brown, Gragg E. Miller, Mark D. Crawford, Ann Watson
Seated left to right: John A. Clees, Jeffrey S. Lyon, Anthony B. Pickering, Robert T. Severns, Rhoda L. Altom
BOARD OF DIRECTORS
Anthony B. Pickering
Chairman of the Board, Former Owner of
Max Dale’s Restaurant and Stanwood Grill
Brian S. Charneski
Vice Chairman of the Board,
President, L&E Bottling Company
Rhoda L. Altom
President and Managing Member, Milestone
Properties and Milestone Manages
David H. Brown
Retired CEO of Valley Community
Bancshares, Inc.
Gary B. Christensen
President, Chief Executive Officer and
Chairman of Powell-Christensen, Inc.;
Chief Executive Officer and Chairman,
MidValley Chrysler, Jeep, Dodge Inc.
John A. Clees
Attorney, Worth Law Group
Mark D. Crawford
Vice President of Smokey Point Concrete/
Skagit Ready Mix
Kimberly T. Ellwanger
Retired Senior Director of Corporate
Affairs and Associate General Counsel,
Microsoft Corporation
Deborah J. Gavin
Retired Vice President of Finance and
Controller of The Boeing Company
Jeffrey S. Lyon, CCIM, SIOR
Chairman and Chief Executive Officer,
Kidder Mathews
Gragg E. Miller
Principal Managing Broker of
Coldwell Banker Bain
Robert T. Severns
Retired President, Chicago
Title Company, Island Division
Brian L. Vance
President and
Chief Executive Officer,
Heritage Financial Corporation
Ann Watson
Chief Financial Officer,
Moss Adams, LLP
HERITAGE FINANCIAL CORPORATION / HERITAGE BANK
Brian L. Vance
Chief Executive Officer
David A. Spurling
Executive Vice President
Chief Credit Officer
Cindy M. Huntley
Senior Vice President
Retail Banking Division
Kaylene M. Lahn
Senior Vice President
Corporate Secretary
Jeffrey J. Deuel
President
Chief Operating Officer
Edward Eng
Executive Vice President
Chief Administrative Officer
Donald J. Hinson
Executive Vice President
Chief Financial Officer
Bryan McDonald
Executive Vice President
Chief Lending Officer
SHAREHOLDER INFORMATION
The annual meeting will be held May 6, 2015, at
10:30 a.m. at the Heritage Room on Capitol Lake,
604 Water Street SW, Olympia, WA.
All shareholders are invited to attend.
TRANSFER AGENT
Computershare
250 Royall Street
Canton, MA 02021
Phone: 800.962.4284
www.computershare.com
201 5th Avenue SW
Olympia, WA 98501
360.943.1500 | 800.455.6126
NASDAQ: HFWA | WWW.HF -WA.COM