10-K 1 d442850d10k.htm FORM 10-K Form 10-K
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

 

 

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

For the fiscal year ended December 31, 2012

 

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

Commission File No. 0-29480

 

 

HERITAGE FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

 

 

 

Washington   91-1857900

(State or other jurisdiction of

incorporation or organization)

 

(IRS Employer

Identification No.)

201 Fifth Avenue SW, Olympia, Washington   98501
(Address of principal executive offices)   (Zip Code)

(360) 943-1500

(Registrant’s telephone number, including area code)

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

 

Title of each class

  

Name of each exchange on which registered

Common Stock    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  x

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  x

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  x    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  x    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  x      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  x

The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant was $204,600,054 and was based upon the last sales price as quoted on the NASDAQ Stock Market for June 30, 2012.

The registrant had 15,117,253 shares of common stock outstanding as of February 21, 2013.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s definitive Proxy Statement for the 2013 Annual Meeting of Shareholders will be incorporated by reference into Part III of this Form 10-K.

 

 

 


Table of Contents

HERITAGE FINANCIAL CORPORATION

FORM 10-K

December 31, 2012

TABLE OF CONTENTS

 

          Page  
   PART I   

ITEM 1.

  

BUSINESS

     3   

ITEM 1A.

  

RISK FACTORS

     28   

ITEM 1B.

  

UNRESOLVED STAFF COMMENTS

     38   

ITEM 2.

  

PROPERTIES

     38   

ITEM 3.

  

LEGAL PROCEEDINGS

     38   

ITEM 4.

  

MINE SAFETY DISCLOSURES

     38   
   PART II   

ITEM 5.

  

MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

     39   

ITEM 6.

  

SELECTED FINANCIAL DATA

     41   

ITEM 7.

  

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     43   

ITEM 7A.

  

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     59   

ITEM 8.

  

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

     59   

ITEM 9.

  

CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

     59   

ITEM 9A.

  

CONTROLS AND PROCEDURES

     60   

ITEM 9B.

  

OTHER INFORMATION

     61   
   PART III   

ITEM 10.

  

DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

     62   

ITEM 11.

  

EXECUTIVE COMPENSATION

     62   

ITEM 12.

  

SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

     62   

ITEM 13.

  

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS; AND DIRECTOR INDEPENDENCE

     62   

ITEM 14.

  

PRINCIPAL ACCOUNTING FEES AND SERVICES

     63   
   PART IV   

ITEM 15.

  

EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

     64   
  

SIGNATURES

     66   

 

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Table of Contents

PART I

 

ITEM 1. BUSINESS

General

Heritage Financial Corporation (the “Company”) 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. 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 June 2006, the Company completed the acquisition of Western Washington Bancorp and its wholly owned subsidiary, Washington State Bank, N.A. Washington State Bank, N.A. was merged into Heritage Bank on the date of acquisition. 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. 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 Commercial Acquisition”). The Pierce Commercial 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 (“Northwest Commercial Acquisition”). The acquisition of NCB was completed on January 9, 2013, at which time NCB was merged with and into Heritage Bank.

We are primarily engaged in the business of planning, directing, and coordinating the business activities of our wholly owned subsidiaries: Heritage Bank and Central Valley Bank (the “Banks”). The deposits of the Banks are insured by the FDIC. Heritage Bank conducts business from its main office in Olympia, Washington and its twenty-seven branch offices located in western Washington and the greater Portland, Oregon area. The number of branches includes an additional branch from the Northwest Commercial Acquisition which opened as a Heritage Bank branch on January 10, 2013. Central Valley Bank conducts business from its main office in Toppenish, Washington and its five branch offices located in Yakima and Kittitas counties of Washington State.

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, one-to-four family residential loans, and consumer loans and originate for sale or investment purposes first mortgage loans on residential properties located in western and central Washington State and the greater Portland, Oregon area.

The Company was a participant in the U.S. Department of the Treasury’s (“Treasury”) Troubled Asset Relief Program (“TARP”) Capital Purchase Plan, pursuant to which the Company sold (i) 24,000 shares of the Company’s Fixed Rate Cumulative Perpetual Preferred Stock, Series A (“Series A Preferred Stock”) and (ii) a warrant (the “Warrant”) to purchase 276,074 shares of the Company’s common stock at $13.04 per share for an aggregate purchase price of $24.0 million in cash. Effective December 22, 2010, the Company redeemed all of the Series A Preferred Stock held by the Treasury. Effective August 17, 2011, the Company repurchased the

 

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Warrant and has no other obligations under TARP. For additional information, see Note 13 of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data.”

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 Central Valley Bank. Heritage Bank conducts business from its main office in Olympia, Washington and its twenty-seven branch offices, including the branch acquired in the Northwest Commercial Acquisition, located in western Washington and the greater Portland, Oregon area. Mortgage loan operations are performed in one office located in Thurston County. Central Valley Bank operates six full service offices, with five in Yakima County and one in Kittitas County.

Lending Activities

General.     Lending activities are conducted through Heritage Bank and Central Valley 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. Most of our one-to-four family residential loans are originated for sale in the secondary market, although some of these loans are retained in our loan portfolio. Commercial and industrial loans, including owner occupied commercial real estate loans, totaled $465.7 million, or 53.3% of total originated loans, as of December 31, 2012 and $440.5 million, or 52.5% of total originated loans, as of December 31, 2011 and non-owner occupied commercial real estate totaled $265.8 million, or 30.4% of total originated loans, as of December 31, 2012 and $251.0 million, or 30.0% of total originated loans, as of December 31, 2011. One-to-four family residential loans totaled $38.8 million, or 4.4% of total originated loans, at December 31, 2012, and $38.0 million, or 4.5% of total originated loans, at December 31, 2011. Real estate construction and land development loans totaled $77.3 million, or 8.8% of total originated loans, at December 31, 2012, and $77.3 million, or 9.3% of total originated loans, at December 31, 2011.

We lend 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 engage external loan specialists to perform reviews of our loan portfolio to check for credit quality, proper documentation and compliance with laws and regulations.

 

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

 

    December 31,  
    2012     2011     2010     2009     2008  
    Balance     % of
Total
Originated
Loans
    Balance     % of
Total
Originated
Loans
    Balance     % of
Total
Originated
Loans
    Balance     % of
Total
Originated
Loans
    Balance     % of
Total
Originated
Loans
 
    (Dollars in thousands)  

Originated Loans:

                   

Commercial business:

                   

Commercial and industrial(1)(2)

  $ 465,734        53.3   $ 440,471        52.5   $ 392,301        52.8   $ 408,622        52.8   $ 410,657        50.9

Non-owner occupied commercial real estate(1)

    265,835        30.4        251,049        30.0        221,739        29.9        194,613        25.2        190,706        23.5   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total commercial business

    731,569        83.7        691,520        82.5        614,040        82.7        603,235        78.0        601,363        74.4   

One-to-four family residential(3)

    38,848        4.4        37,960        4.5        47,505        6.5        53,623        7.0        57,231        7.1   

Real estate construction and land development:

                   

One-to-four family residential

    25,175        2.9        22,369        2.7        29,377        4.0        46,060        6.0        71,159        8.8   

Five or more family residential and commercial properties

    52,075        5.9        54,954        6.6        28,588        3.8        49,665        6.4        59,572        7.3   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total real estate
construction and land development(4)

    77,250        8.8        77,323        9.3        57,965        7.8        95,725        12.4        130,731        16.1   

Consumer

    28,914        3.3        32,981        3.9        23,832        3.2        21,261        2.8        21,255        2.6   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross originated loans

    876,581        100.2        839,784        100.2        743,342        100.2        773,844        100.2        810,580        100.2   

Less: deferred loan fees

    (2,096     (0.2     (1,860     (0.2     (1,323     (0.2     (1,597     (0.2     (1,854     (0.2
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total originated loans

  $ 874,485        100.0   $ 837,924        100.0   $ 742,019        100.0   $ 772,247        100.0   $ 808,726        100.0
 

 

 

     

 

 

     

 

 

     

 

 

     

 

 

   

 

(1)

Commercial and industrial loans include owner-occupied commercial real estate

(2)

During the year ended December 31, 2009 certain loan balances previously categorized as commercial business were reclassified as real estate construction and land development five or more family residential and commercial properties. The amounts reclassified were $33.2 million as of December 31, 2008.

(3)

Excludes loans held for sale of $1.7 million, $1.8 million, $764,000, $825,000, and $304,000 as of December 31, 2012, 2011, 2010, 2009, and 2008, respectively.

(4)

Balances are net of undisbursed loan proceeds.

The following table provides information about our purchased covered loan portfolio by type of loan for the years ended December 31, 2012, 2011 and 2010. There were no purchased covered loans for the years ended December 31, 2009 and 2008. These balances are the recorded investment balance and are prior to deduction for the allowance for loan losses.

 

     December 31,  
     2012     2011     2010  
     Balance      % of
Total
Originated
Loans
    Balance      % of
Total
Originated
Loans
    Balance      % of
Total
Originated
Loans
 
     (Dollars in thousands)  

Purchased Covered Loans:

               

Commercial business:

               

Commercial and industrial(1)

   $ 60,577         68.6   $ 76,674         70.1   $ 92,265         71.7

Non-owner occupied commercial real estate(1)

     13,028         14.7        15,753         14.4        17,576         13.6   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total commercial business

     73,605         83.3        92,427         84.5        109,841         85.3   

One-to-four family residential

     5,027         5.7        5,197         4.8        6,224         4.8   

Real estate construction and land development:

               

One-to-four family residential

     4,433         5.0        5,786         5.3        5,876         4.6   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total real estate construction and land development(2)

     4,433         5.0        5,786         5.3        5,876         4.6   

Consumer

     5,265         6.0        5,947         5.4        6,774         5.3   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Gross purchased covered loans

   $ 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.

 

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The following table provides information about our purchased non-covered loan portfolio by type of loan for the years ended December 31, 2012, 2011 and 2010. There were no purchased non-covered loans for the years ended December 31, 2009 and 2008. These balances are the recorded investment balance and are prior to deduction for the allowance for loan losses.

 

     December 31,  
     2012     2011     2010  
     Balance      % of
Total
Originated
Loans
    Balance      % of
Total
Originated
Loans
    Balance      % of
Total
Originated
Loans
 
     (Dollars in thousands)  

Purchased Non-Covered Loans:

               

Commercial business:

               

Commercial and industrial(1)

   $ 37,974         59.2   $ 52,659         59.8   $ 77,815         59.4

Non-owner occupied commercial real estate(1)

     11,019         17.2        12,833         14.5        18,435         14.0   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total commercial business

     48,993         76.4        65,492         74.3        96,250         73.4   

One-to-four family residential

     3,040         4.7        2,743         3.1        4,986         3.8   

Real estate construction and land development:

               

One-to-four family residential

     513         0.8        1,381         1.6        3,816         2.9   

Five or more family residential and commercial properties

     864         1.4        1,078         1.2        1,244         1.0   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total real estate construction and land development(2)

     1,377         2.2        2,459         2.8        5,060         3.9   

Consumer

     10,713         16.7        17,420         19.8        24,753         18.9   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Gross purchased non-covered loans

   $ 64,123         100.0   $ 88,114         100.0   $ 131,049         100.0
  

 

 

      

 

 

      

 

 

    

 

(1)

Commercial and industrial loans include owner-occupied commercial real estate

(2)

Balances are net of undisbursed loan proceeds.

The following table presents at December 31, 2012 (i) the aggregate contractual maturities of loans in the named categories of our originated 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  
     (In thousands)  

Commercial business

   $ 155,867       $ 186,047       $ 389,655       $ 731,569   

Real estate construction and land development

     61,821         11,076         4,353         77,250   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 217,688       $ 197,123       $ 394,008       $ 808,819   
  

 

 

    

 

 

    

 

 

    

 

 

 

Fixed rate loans

      $ 113,519       $ 157,606       $ 271,125   

Variable or adjustable rate loans

        83,604         236,402         320,006   
     

 

 

    

 

 

    

 

 

 

Total

      $ 197,123       $ 394,008       $ 591,131   
     

 

 

    

 

 

    

 

 

 

Commercial Business Lending

We offer different types of commercial business loans. The types of commercial business loans offered are business 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

 

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is a “preferred lender.” Before extending credit to a business we inspect and examine 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, 2012 we had $731.6 million, or 83.7%, of our total originated loans receivable in commercial business loans with an average loan size of approximately $312,000.

We originate commercial real estate loans within our primary market areas with a preference for owner-occupied commercial real estate loans. 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 1.10 times for five or more family residential loans and 1.15 times for commercial real estate loans. Cash flow coverage is calculated using an “underwriting” interest rate equal to the note rate plus 2%.

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 non-owner occupied loan portfolio is concentrated in loans with a higher risk of loss—Our 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

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. We generally sell a significant portion of our one-to-four family residential loans in the secondary market. Management determines to what extent we will retain or sell these loans and other fixed rate mortgages in order to control the Banks’ interest rate sensitivity position, growth and liquidity.

See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Asset/Liability Management.”

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.

 

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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 priced with 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.”

Origination and Sales of One-to-Four Family Residential Loans

Consistent with our asset/liability management strategy, we sell a significant portion of our one-to-four family residential loans into the secondary market. Commitments to sell these mortgage loans generally are made during the period between the taking of the loan application and the closing of the mortgage loan. Most of these sale commitments are made on a “best efforts” basis whereby we are only obligated to sell the mortgage if the mortgage loan is approved and closed. As a result, management believes that market risk is minimal. In addition, some of our mortgage loan production is brokered to other lenders prior to funding.

When we sell mortgage loans, we typically sell the servicing of the loans (i.e., collection of principal and interest payments). However, we serviced a minimal $49,000, $84,000 and $115,000 in mortgage loans for others as of December 31, 2012, 2011 and 2010, respectively.

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.

 

     Year Ended December 31,  
     2012      2011      2010      2009      2008  
     (In thousands)  

One-to-four family residential loans:

              

Originated(1)

   $ 35,730       $ 23,865       $ 18,605       $ 34,183       $ 24,115   

Sold

     21,187         15,888         16,187         25,338         16,463   

Gains on sales of loans, net(2)

   $ 295       $ 285       $ 226       $ 288       $ 265   

 

(1)

Includes loans originated for the purpose of inclusion in our loan portfolio or for the purpose of sale in the secondary market.

(2)

Excludes gains on sales of SBA loans.

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.

 

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The following table presents outstanding commitments to extend credit, including letters of credit, at the dates indicated:

 

     December 31,  
     2012      2011  
     (In thousands)  

Commercial business:

     

Commercial and industrial

   $ 126,162       $ 138,118   

Owner-occupied commercial real estate

     2,151         2,328   

Non-owner occupied commercial real estate

     7,006         6,225   
  

 

 

    

 

 

 

Total commercial business

     135,319         146,671   

One-to-four family residential

     —           —     

Real estate construction and land development:

     

One-to-four family residential

     4,662         4,247   

Five or more family residential and commercial properties

     26,301         15,305   
  

 

 

    

 

 

 

Total real estate construction and land development

     30,963         19,552   

Consumer

     34,525         37,251   
  

 

 

    

 

 

 

Total outstanding commitments

   $ 200,807       $ 203,474   
  

 

 

    

 

 

 

Delinquencies and Nonperforming Assets

Delinquency Procedures.    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 if suspect. We may negotiate and accept a repayment 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 sold at a public sale and we 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 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.

Delinquencies in the commercial business loan portfolio are handled by the assigned loan officer. Generally, notices are sent and personal contact is made with the borrower when the loan is 15 days past due. Loan officers are responsible for collecting loans they originate or which are assigned to them. Depending on the nature of the loan and the type of collateral securing the loan, we may negotiate and accept a modified payment program or take other actions as circumstances warrant.

Classification of Loans.    Federal regulations require that our Banks periodically evaluate the risks inherent in their respective loan portfolios. 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

 

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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 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 close monitoring.

The Banks routinely test their problem loans for potential impairment. A loan is considered impaired when, based on current information and events, it is probable that the Banks 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 Banks’ 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.

 

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Nonperforming Assets.    Nonperforming assets consist of nonaccrual loans and other real estate owned. The following table provides information about our originated nonaccrual loans, restructured loans, and other real estate owned for the indicated dates.

 

     December 31,  
     2012     2011     2010     2009     2008  
     (Dollars in thousands)  

Nonaccrual originated loans:

          

Commercial business

   $ 5,492      $ 8,266      $ 10,667      $ 9,728      $ 1,176   

One-to-four family residential

     389        —         —         —         —    

Real estate construction and land development

     6,420        14,947        15,816        25,108        2,221   

Consumer

     157        125        —         —         —    
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total nonaccrual originated loans(1)(2)

     12,458        23,338        26,483        34,836        3,397   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Noncovered other real estate owned

     5,406        3,710        3,030        704        2,031   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total nonperforming originated assets

   $ 17,864      $ 27,048      $ 29,513      $ 35,540      $ 5,428   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Restructured originated performing loans:

          

Commercial business

   $ 14,237     $ 12,606     $ 394     $ 425     $ —    

One-to-four family residential

     422       835       —         —         —    

Real estate construction and land development

     361       364       —         —         —    

Consumer

     19       —         —         —         —    
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total restructured originated performing loans(3)

   $ 15,039      $ 13,805      $ 394      $ 425      $ —    

Accruing originated loans past due 90 days or more(4)

   $ 214      $ 1,328      $ 1,313      $ 277      $ 664   

Potential problem originated loans(5)

   $ 28,270      $ 29,742      $ 56,088      $ 53,086      $ 43,061   

Allowance for loan losses on originated loans

   $ 19,125      $ 22,317      $ 22,062      $ 26,164      $ 15,423   

Nonperforming originated loans to total originated loans(6)

     1.28     2.57     3.14     4.21     0.42

Allowance for loan losses on originated loans to total originated loans

     2.19     2.66     2.97     3.38     1.91

Allowance for loan losses on originated loans to nonperforming originated loans(6)

     170.44     103.52     94.73     79.34     454.02

Nonperforming originated assets to total originated assets(6)

     1.39     2.14     2.38     3.32     0.57

 

(1)

$9.3 million, $11.7 million, $8.7 million and $17.0 million of originated nonaccrual loans were considered troubled debt restructures at December 31, 2012, 2011, 2010 and 2009, respectively. There were no troubled debt restructures at December 31, 2008.

(2)

$1.2 million, $1.8 million, $3.2 million and $2.3 million of originated nonaccrual loans were guaranteed by government agencies at December 31, 2012, 2011, 2010 and 2009, respectively. There were no nonaccrual loans guaranteed by government agencies at December 31, 2008.

(3)

$679,000 and $592,000 of originated performing restructured loans were guaranteed by government agencies at December 31, 2012 and 2011. There were no originated performing restructured loans guaranteed by government agencies at December 31, 2010, 2009 and 2008.

(4)

There were no accruing originated loans past due 90 days or more that were guaranteed by government agencies at December 31, 2012, 2009, and 2008. $6,000 and $92,000 of accruing originated loans past due 90 days or more were guaranteed by government agencies at December 31, 2011 and 2010, respectively.

(5)

$3.2 million, $2.8 million, $5.4 million and $7.2 million of originated potential problem loans were guaranteed by government agencies at December 31, 2012, 2011, 2010 and 2009, respectively. There were no potential problem originated loans guaranteed by government agencies at December 31, 2008.

(6)

Excludes portions guaranteed by government agencies.

 

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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 originated loans decreased to $12.5 million, or 1.28% of total originated loans, at December 31, 2012 from $23.3 million, or 2.57% of total originated loans, at December 31, 2011 due to the loan resolution efforts of our credit department. During the year ended December 31, 2012, there were $3.9 million in net charge-offs of originated loans of which $2.1 million related to nonperforming commercial business loans and $1.2 million related to nonperforming real estate construction and land development loans. In addition, $7.4 million of loans were transferred to other real estate owned during the year ended December 31, 2012. This decrease in total nonperforming originated loans was partially offset by $1.3 million in additions to nonperforming originated loans which were outstanding as of December 31, 2012.

Nonperforming originated assets decreased to $17.9 million, or 1.39% of total originated assets, at December 31, 2012 from $27.0 million, or 2.14% of total originated assets, at December 31, 2011 due to a decrease in nonperforming originated loans discussed above offset partially by an increase in other real estate owned.

Originated restructured performing loans as of December 31, 2012 and December 31, 2011 were $15.0 million and $13.8 million, respectively. The increase in originated restructured performing loans was primarily due to the addition of 14 commercial and industrial loans that were modified during the year and were considered troubled debt restructured loans with an outstanding principal balance of $2.4 million at December 31, 2012.

Originated potential problem loans as of December 31, 2012 and December 31, 2011 were $28.3 million and $29.7 million, respectively. Potential problem loans are those loans that are currently accruing interest and are not considered impaired, but which we are monitoring because the financial information of the borrower causes 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.

Troubled Debt Restructured Loans.    A troubled debt restructured loan (“TDR”) is a restructuring in which the Banks, for economic or legal reasons related to a borrower’s financial difficulties, grant a concession to a borrower that it would not otherwise consider. The majority of the Banks’ 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 remainders of the Banks’ 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 Banks. 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.

TDRs are considered impaired and are separately measured for impairment under Financial Accounting Standards Board Accounting Standards Codification (“FASB ASC”) 310-10-35, whether on accrual or

 

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nonaccrual status. At December 31, 2012 and December 31, 2011, the balance of accruing TDRs was $15.0 million and $13.8 million, respectively. The related allowance for loan losses on the accruing TDRs was $2.1 million as of December 31, 2012 and $1.4 million as of December 31, 2011. At December 31, 2012, non-accruing TDRs were $9.3 million and had a related allowance for loan losses of $2.0 million. At December 31, 2011, non-accruing TDRs of $11.7 million had a related allowance for loan losses of $1.8 million.

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 Banks’ policy is that the borrower must demonstrate six consecutive monthly payments in accordance with the modified loan 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 Report on Form 10-K.

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. Originated potential problem loans decreased $1.5 million to $28.3 million at December 31, 2012 from $29.7 million at December 31, 2011.

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 non-classified and classified performing 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-classified loans, classified 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, results of operations could be significantly affected if circumstances differ substantially from the assumptions used in determining the allowance. A further decline in local and national economic conditions, or other factors, could

 

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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 originated loan losses at and for the indicated periods:

 

     Year Ended December 31,  
     2012     2011     2010     2009     2008  
     (Dollars in thousands)  

Originated loans outstanding at end of period(1)

   $ 874,485      $ 837,924      $ 742,019      $ 772,247      $ 808,726   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Average originated loans receivable during period(1)

   $ 855,923      $ 833,441      $ 717,159      $ 787,527      $ 795,752   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Allowance for loan losses on originated loans at beginning of period

   $ 22,317      $ 22,062      $ 26,164      $ 15,423      $ 10,374   

Provision for loan losses on originated loans

     695        5,180        11,990        19,390        7,420   

Charge-offs:

          

Commercial business

     (3,702     (2,690     (8,106     (2,668     (144

One-to-four family residential

     (349     (15     (169     (189     (280

Real estate construction and land development

     (1,280     (2,948     (8,344     (5,774     (1,818

Consumer

     (293     (316     (73     (192     (165
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total charge-offs

     (5,624     (5,969     (16,692     (8,823     (2,407
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Recoveries:

          

Commercial business

     1,579        821        243        1        1   

One-to-four family residential

     —          —          15        1        —    

Real estate construction and land development

     125        201        285        50        —    

Consumer

     33        22        57        122        35   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total recoveries

     1,737        1,044        600        174        36   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net charge-offs

     (3,887     (4,925     (16,092     (8,649     (2,371
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Allowance for originated loan losses at end of period

   $ 19,125      $ 22,317      $ 22,062      $ 26,164      $ 15,423   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Ratio of net charge-offs during period to average originated loans receivable

     (0.45 )%      (0.59 )%      (2.24 )%      (1.10 )%      (0.30 )% 
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1)

Excludes loans held for sale.

 

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The following table shows the allocation of the allowance for loan losses for originated loans at the indicated periods. 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:

 

    December 31,  
    2012     2011     2010     2009     2008  
    Allowance
for Loan
Losses
    % of
Total
Originated
Loans(1)
    Allowance
for Loan
Losses
    % of
Total
Originated
Loans(1)
    Allowance
for Loan
Losses
    % of
Total
Originated
Loans(1)
    Allowance
for Loan
Losses
    % of
Total
Originated
Loans(1)
    Allowance
for Loan
Losses
    % of
Total
Originated
Loans(1)
 
    (Dollars in thousands)  

Commercial business

  $ 12,554        83.5   $ 12,888        82.3   $ 14,350        82.5   $ 12,137        77.8   $ 2,785        74.2

One-to-four family residential

    637        4.4        416        4.5        500        6.5        550        7.0        5,797        7.1   

Real estate construction

    4,316        8.8        7,556        9.3        5,435        7.8        12,892        12.4        6,587        16.1   

Consumer

    748        3.3        547        3.9        846        3.2        361        2.8        254        2.6   

Unallocated

    870        —          910        —          931        —          224        —          —         —     
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total allowance for originated loan losses

  $ 19,125        100.0   $ 22,317        100.0   $ 22,062        100.0   $ 26,164        100.0   $ 15,423        100.0
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Represents total originated loans outstanding in each category as a percent of gross originated loans.

Investment Activities

At December 31, 2012, our investment securities portfolio totaled $154.4 million, which consisted of $144.3 million of securities available for sale and $10.1 million of securities held to maturity. This compares with a total portfolio of $156.7 million at December 31, 2011, which was comprised of $144.6 million of securities available for sale and $12.1 million of securities held to maturity. The composition of the two investment portfolios by type of security, at each respective date, is presented in Note 6 to the Notes to Consolidated Financial Statements.

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 our Banks’ 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.

 

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The following table provides information regarding our investment securities available for sale at the dates indicated.

 

    December 31,  
    2012     2011     2010  
    Fair Value     % of
Total
Investments
    Fair Value     % of
Total
Investments
    Fair Value     % of
Total
Investments
 
    (Dollars in thousands)  

U.S. Treasury and U.S. Government-sponsored agencies

  $ 11,035        7.7   $ 31,307        21.7   $ 41,429        33.1

Municipal securities

    47,360        32.8        33,423        23.1        20,213        16.1   

Corporate securities

    —          —          8,097        5.6        10,276        8.2   

Mortgage backed securities and collateralized mortgage obligations-residential:

           

U.S. Government-sponsored agencies

    85,898        59.5        71,775        49.6        53,257        42.6   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 144,293        100.0   $ 144,602        100.0   $ 125,175        100.0
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

The following table provides information regarding our investment securities available for sale, by contractual maturity, at December 31, 2012.

 

    Less Than One Year     Over One to Five Years     Over Five to Ten Years     Over Ten Years  
    Fair Value     Weighted
Average
Yield(1)
    Fair Value     Weighted
Average
Yield(1)
    Fair Value     Weighted
Average
Yield(1)
    Fair Value     Weighted
Average
Yield(1)
 
    (Dollars in thousands)  

U.S. Treasury and U.S. Government-sponsored agencies

  $ 10,535        1.27   $ —         —     $ —         —     $ 500        1.00

Municipal securities

    1,415        3.47        6,287        4.05        22,432        3.96        17,226        4.36   

Mortgage backed securities and collateralized mortgage obligations-residential:

               

U.S. Government-sponsored agencies

    —         —         105        5.42        13,363        4.22        72,430        4.55   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 11,950        1.53   $ 6,392        4.07   $ 35,795        4.06   $ 90,156        4.50
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1)

Taxable equivalent weighted average yield.

 

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The following table provides information regarding our investment securities held to maturity at the dates indicated.

 

    December 31,  
    2012     2011     2010  
    Amortized
Cost
    % of
Total
Investments
    Amortized
Cost
    % of
Total
Investments
    Amortized
Cost
    % of
Total
Investments
 
    (Dollars in thousands)  

U.S. Treasury and U.S. Government-sponsored agencies

  $ 1,740        17.2   $ 1,799        14.9   $ 1,858        13.5

Municipal securities

    2,946        29.2        3,566        29.5        3,410        24.8   

Mortgage backed securities and collateralized mortgage obligations-residential:

           

U.S. Government-sponsored agencies

    4,245        42.0        5,412        44.7        6,592        47.9   

Private residential collateralized mortgage obligations

    1,168        11.6        1,316        10.9        1,908        13.8   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 10,099        100.0   $ 12,093        100.0   $ 13,768        100.0
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

The following table provides information regarding our investment securities held to maturity, by contractual maturity, at December 31, 2012.

 

    Less Than One Year     Over One to Five Years     Over Five to Ten Years     Over Ten Years  
    Fair Value     Weighted
Average
Yield(1)
    Fair Value     Weighted
Average
Yield(1)
    Fair Value     Weighted
Average
Yield(1)
    Fair Value     Weighted
Average
Yield(1)
 
    (Dollars in thousands)  

U.S. Treasury and U.S. Government-sponsored agencies

  $ —         —     $ 113        5.05   $ 1,911        3.74   $ —         —  

Municipal securities

    225        5.74        1,269        4.81        1,435        4.79        229        5.32   

Mortgage backed securities and collateralized mortgage obligations-residential:

               

U.S. Government-sponsored agencies

    —         —         43       8.02       26        2.22        4,453        3.50   

Private residential collateralized mortgage obligations

    —         —         —         —         —         —         1,306        3.50   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 225        5.74   $ 1,425        4.93   $ 3,372        4.17   $ 5,988        3.57
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1)

Taxable equivalent weighted average yield.

The Banks are 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, 2012 the Banks were required to maintain an investment in the stock of FHLB of Seattle of at least $1.2 million and the Banks had an investment in FHLB stock carried at a cost basis (par value) of $5.5 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

 

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Finance Agency. 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 actions being taken by the FHLB of Seattle to address its regulatory situation 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 year ended December 31, 2012. Despite improvements in the FHLB of Seattle’s regulatory situation, 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, since 2009 the Company has utilized repurchase agreements as a supplement to other funding sources.

During the year ended December 31 2012, non-maturity deposits (total deposits less certificate of deposit accounts) increased $22.6 million, or 2.8%, to $829.0 million. As a result, the percentage of certificate of deposit accounts to total deposits decreased to 25.8% at December 31, 2012 from 29.0% at December 31, 2011.

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 $100 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.

 

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The following table provides the balances outstanding for each major category of deposits for the periods indicated:

 

     December 31,  
     2012     2011     2010  
     Amount      Percent     Amount      Percent     Amount      Percent  
     (Dollars in thousands)  

Noninterest demand deposits

   $ 247,048         22.1   $ 230,993         20.4   $ 194,583         17.1 %

NOW accounts

     303,487         27.2        304,818         26.8        287,247         25.3   

Money market accounts

     157,728         14.1        166,913         14.7        150,953         13.3   

Savings accounts

     120,781         10.8        103,716         9.1        100,552         8.8   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total non-maturity deposits

     829,044         74.2        806,440         71.0        733,335         64.5   

CDs

     288,927         25.8        329,604         29.0        402,941         35.5   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total deposits

   $ 1,117,971         100.0   $ 1,136,044         100.0   $ 1,136,276         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:

 

     Year ended December 31,  
     2012     2011     2010  
     Average
Balance
     Average
Yield/Rate
    Average
Balance
     Average
Yield/Rate
    Average
Balance
     Average
Yield/Rate
 
     (Dollars in thousands)  

NOW accounts and money market accounts

   $ 466,268         0.27   $ 453,509         0.41   $ 376,245         0.58

Savings accounts

     113,119         0.18        103,170         0.35        89,978         0.56   

CDs

     306,772         0.98        355,167         1.20        351,191         1.62   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total interest bearing deposits

     886,159         0.50        911,846         0.71        817,414         1.02   

Noninterest demand deposits

     237,888         —         205,862         —         150,906         —    
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total deposits

   $ 1,124,047         0.40   $ 1,117,708         0.58   $ 968,320         0.87
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

The following table shows the amount and maturity of certificates of deposit of $100,000 or more:

 

     December 31,
2012
 
     (In thousands)  

Remaining maturity:

  

Three months or less

   $ 30,623   

Over three months through six months

     24,120   

Over six months through twelve months

     30,895   

Over twelve months

     79,250   
  

 

 

 

Total

   $ 164,888   
  

 

 

 

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 single family mortgage loans, commercial real estate loans and stock issued by the FHLB, which is owned by us. At December 31, 2012, the Banks maintained an uncommitted credit facility with the FHLB of Seattle in a collective amount of $156.3 million and an uncommitted credit facility with the Federal Reserve Bank of San Francisco in a collective amount of $61.1 million, of which there were no advances or borrowings outstanding. The Banks also maintain

 

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advance lines with Zions Bank, Wells Fargo Bank, US Bank and Pacific Coast Bankers’ Bank to purchase federal funds in a collective amount of up to $57.8 million as of December 31, 2012. At December 31, 2012 we had securities sold under agreement to repurchase of $16.0 million which were secured by available for sale investment securities.

The FHLB functions provide credit for member financial institutions. As members, 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 assets for Heritage Bank and Central Valley Bank.

The following table is a summary of FHLB advances for the periods indicated:

 

     Year ended December 31,  
     2012      2011      2010  
     (Dollars in thousands)  

Balance at period end

   $ —        $ —        $ —    

Average balance during the period

     —          —          1,330   

Maximum amount outstanding at any month end

     —          —          17,486   

Average interest rate:

        

During the period

     —          —          1.67

At period end

     —          —          —    

There were no federal funds purchased for the years ended December 31, 2012, 2011 and 2010.

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”). 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 brief discussion of certain laws and regulations applicable to Heritage Financial and the Banks which is qualified in its entirety by reference to the actual laws and regulations.

Heritage Financial.    We are subject to regulation as a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended, and are supervised by the Board of Governors of the Federal Reserve System (“Federal Reserve”). The Federal Reserve has the authority to order bank holding companies to cease and desist from unsound practices and violations of conditions imposed on them. The Federal Reserve is also empowered to assess civil money penalties against companies and individuals who violate the Bank Holding Company Act or orders or regulations thereunder in amounts up to $1.0 million per day. The Federal Reserve may 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. The FDIC is authorized to exercise comparable authority under the Federal Deposit Insurance Act and other statutes for state nonmember banks such as Heritage Bank and Central Valley Bank.

 

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The Federal Reserve has a policy 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. The Dodd-Frank Act and earlier Federal Reserve policy provide that a bank holding company should serve as a source of strength to its subsidiary banks by having 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 will generally be 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 requires new regulations to be promulgated concerning the source of strength. The Federal Deposit Insurance Act requires an undercapitalized bank to develop a capital restoration plan, approved by the FDIC, with a guaranty by the company having control of the bank, of the bank’s compliance with the plan.

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 charge us for the cost of the examination.

We, and any subsidiaries which we may control, are considered “affiliates” within the meaning of the Federal Reserve Act, and transactions between our bank subsidiaries 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 3%. 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 securities), 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. The Dodd-Frank Act requires new capital regulations to be adopted; however, the adoption of the capital regulations as proposed in December 2011 have been delayed. For additional information, see “—Capital Adequacy” below.

Subsidiaries.    Heritage Bank and Central Valley Bank are Washington-chartered commercial banks, the deposits of which are insured by the FDIC. Heritage Bank and Central Valley Bank are 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 Banks are required to file periodic reports with the FDIC and the Division, and are 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 Banks provide substantially all of our cash flow. Applicable Federal and Washington State regulations restrict capital distributions by our Banks, 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 Part II of “Item 5. Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchased of Equity Securities” herein.

 

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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 securities), 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.

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, 2012 were 4% and 8%, respectively. At December 31, 2012, we had consolidated Tier 1 risk-based capital and total risk-based capital of 18.7% and 19.9%, 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, 2012, we had a consolidated leverage ratio of 13.6%.

In connection with the enactment of the Dodd-Frank Act in June 2012, the Federal Reserve, FDIC and the Office of the Comptroller of the Currency approved proposed rules that would substantially amend the regulatory risk-based capital rules applicable to the Company and the Banks. The proposed rules implement the “Basel III” regulatory capital reforms and changes required by the Dodd-Frank Act. “Basel III” refers to various documents released by the Basel Committee on Banking Supervision. The proposed rules were subject to a public comment period that has expired and there is no date set for the adoption of final rules.

The proposed rules include new minimum risk-based capital and leverage ratios, which would be phased in during 2013 and 2014, and would refine the definitions of what constitutes “capital” for purposes of calculating those ratios. The proposed new minimum capital level requirements applicable to the Company and the Banks under the proposals would 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%. The proposed rules would also establish a “capital conservation buffer” of 2.5% above each of the new regulatory minimum capital ratios 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 would be phased in beginning in January 2016 at 0.625% of risk-weighted assets and would increase 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 proposed rules also implement other revisions to the current capital rules such as recognition of all unrealized gains and losses on available for sale debt and equity securities, and provide that instruments that will no longer qualify as capital would be phased out over time.

The federal bank regulatory agencies also proposed revisions to the prompt corrective action framework, which is designed to place restrictions on insured depository institutions, including the Banks, if their capital levels begin to show signs of weakness. These revisions would take effect January 1, 2015. Under the prompt corrective action requirements, insured depository institutions would be required to meet the following increased capital level requirements in order to qualify as “well capitalized:” (i) a new common equity Tier 1 risk-based

 

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capital ratio of 6.5%; (ii) a Tier 1 risk-based capital ratio of 8% (increased from 6%); (iii) a total risk-based capital ratio of 10% (unchanged from current rules); and (iv) a Tier 1 leverage ratio of 5% (unchanged from the current rules).

The proposed rules set forth certain changes for the calculation of risk-weighted assets and utilize an increased number of credit risk and other exposure categories and risk weights. In addition, the proposed rules also address: (i) a proposed alternative standard of creditworthiness consistent with Section 939A of the Dodd-Frank Act; (ii) revisions to recognition of credit risk mitigation; (iii) rules for risk weighting of equity exposures and past due loans; and (iv) revised capital treatment for derivatives and repo-style transactions.

In particular, the proposed rules would expand the risk-weighting categories from the current four categories (0%, 20%, 50% and 100%) to a much larger and more risk-sensitive number of categories, generally ranging from 0% for U.S. government and agency securities, to 600% for certain equity exposures. Higher risk weights would apply to a variety of exposure categories. Specifics include, among others:

 

   

Applying a 150% risk weight instead of a 100% risk weight for certain high volatility commercial real estate acquisition, development and construction loans.

 

   

For residential mortgage exposures, the current approach of a 50% risk weight for high-quality seasoned mortgages and a 100% risk-weight for all other mortgages is replaced with a risk weight of between 35% and 200% depending upon the mortgage’s loan-to-value ratio and whether the mortgage is a “category 1” or “category 2” residential mortgage exposure (based on eight criteria that include, among others, the term, seniority of the lien, use of negative amortization, balloon payments and certain rate increases).

 

   

Assigning a 150% risk weight to exposures (other than residential mortgage exposures) that are 90 days past due.

 

   

Providing for a 20% credit conversion factor for the unused portion of a commitment with an original maturity of one year or less that is not unconditionally cancellable (currently set at 0%).

 

   

Providing for a 100% risk weight for claims on securities firms.

 

   

Eliminating the current 50% cap on the risk weight for OTC derivatives.

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% Tier 1 capital ratio, a 6.0% Tier 1 risk-based capital ratio and 10.0% total risk-based capital ratio. At December 31, 2012, the Banks were considered “well capitalized” institutions. For a complete description of the Company’s and the Banks required and actual capital levels as of December 31, 2012, see Note 15 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

 

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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 either Heritage Bank and Central Valley 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 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, 2012, the Banks met the requirements to be classified as “well-capitalized.”

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.

Deposit Insurance and Other FDIC Programs.    The deposits of the Banks 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 Banks’ deposits, the FDIC has supervisory and enforcement authority over Heritage Bank and Central Valley 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.

As a result of a decline in the reserve ratio (the ratio of the net worth of the DIF to estimated insured deposits) and concerns about expected failure costs and available liquid assets in the DIF, the FDIC adopted a rule requiring each insured institution to prepay on December 30, 2009 the estimated amount of its quarterly assessments for the fourth quarter of 2009 and all quarters through the end of 2012 (in addition to the regular quarterly assessment for the third quarter due on December 30, 2009). The prepaid amount is recorded as an asset with a zero risk weight and the institution will continue to record quarterly expenses for deposit insurance. For purposes of calculating the prepaid amount, assessments are measured at the institution’s assessment rate as of September 30, 2009, with a uniform increase of three basis points effective January 1, 2011, and are based on the institution’s assessment base for the third quarter of 2009, with growth assumed quarterly at annual rate of 5%. If events cause actual assessments during the prepayment period to vary from the prepaid amount, institutions will pay excess assessments in cash, or receive a rebate of prepaid amounts not exhausted after collection of assessments due on June 13, 2013, as applicable. Collection of the prepayment does not preclude the FDIC from changing assessment rates or revising the risk-based assessment system in the future. The rule includes a process for exemption from the prepayment for institutions whose safety and soundness would be affected adversely.

The Dodd-Frank Act requires the FDIC’s deposit insurance assessments to be based on assets instead of deposits. The FDIC issued rules, effective as of the second quarter of 2011, which specify that 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

 

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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:    On July 21, 2010, the Dodd-Frank Act was signed into law. The Dodd-Frank Act implements far-reaching changes across the financial regulatory landscape, including provisions that, among other things, has or will:

 

   

Centralized responsibility for consumer financial protection by creating a new agency within the Federal Reserve Board, the Bureau of Consumer Financial Protection, with broad rulemaking, supervision and enforcement authority for a wide range of consumer protection laws that applies to all banks and thrifts. Smaller financial institutions, including the Banks, are subject to the supervision and enforcement of their primary federal banking regulator with respect to the federal consumer financial protection laws.

 

   

Required the federal banking regulators to promulgate new capital regulations and seek to make their capital requirements countercyclical, so that capital requirements increase in times of economic expansion and decrease in times of economic contraction.

 

   

Provided for new disclosure and other requirements relating to executive compensation and corporate governance.

 

   

Made permanent the $250,000 limit for federal deposit insurance and provide unlimited federal deposit insurance until January 1, 2013 for noninterest bearing demand transaction accounts at all insured depository institutions.

 

   

Effective July 21, 2011, repealed the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts.

 

   

Required all depository institution holding companies to serve as a source of financial strength to their depository institution subsidiaries in the event such subsidiaries suffer from financial distress.

Many aspects of the Dodd-Frank Act are subject to rulemaking and will take effect over several years, making it difficult to anticipate the overall financial impact on the Company and the financial services industry more generally. The elimination of the prohibition on the payment of interest on demand deposits could materially increase our interest expense, depending on our competitors’ responses. Provisions in the legislation that require revisions to the capital requirements of the Company and the Banks could require the Company and the Banks to seek additional sources of capital in the future.

Sarbanes-Oxley Act.    On July 30, 2002, the Sarbanes-Oxley Act of 2002 was signed into law in response to public concerns regarding corporate accountability in connection with various accounting scandals. The stated goals of the Sarbanes-Oxley Act are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the

 

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accuracy and reliability of corporate disclosures pursuant to the securities laws. The Sarbanes-Oxley Act generally applies to all companies that file or are required to file periodic reports with the Securities and Exchange Commission (“SEC”), under the Securities Exchange Act of 1934.

The Sarbanes-Oxley Act includes very specific additional disclosure requirements and corporate governance rules, requires the SEC and securities exchanges to adopt extensive additional disclosure, corporate governance and other related rules. 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.

Financial Services Reform Legislation.    On November 12, 1999, the Gramm-Leach-Bliley Act (“GLBA”) was enacted into law. The GLBA removes various barriers imposed by the Glass-Steagall Act of 1933, specifically those prohibiting banks and bank holding companies from engaging in the securities and insurance business. The GLBA also expands the bank holding company act framework to permit bank holding companies with subsidiary banks meeting certain capital and management requirements to elect to become a “financial holding company”.

Financial holding companies may engage in a full range of financial activities, including not only banking, insurance, and securities activities, but also merchant banking and additional activities determined to be “financial in nature” or “complementary” to an activity that is financial in nature. The GLBA also provides that the list of permissible financial activities will be expanded as necessary for a financial holding company to keep abreast of competitive and technological changes.

In addition, the GLBA expands the activities in which insured state banks may engage. Under the GLBA, insured state banks are given the ability to engage in financial activities through a subsidiary, as long as the bank and its affiliates meet and comply with certain requirements. First, each bank must be “well capitalized”. Second, the bank must comply with certain capital deduction and financial statement requirements provided under the GLBA. Third, the bank must comply with certain financial and operational safeguards provided under the GLBA. Fourth, the bank must comply with the limits imposed by the GLBA on transactions with affiliates.

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 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 the 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.

 

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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 Banks’ 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 363 full-time equivalent employees at December 31, 2012. 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.

Executive Officers

The following table set forth certain information with respect to the executive officers of the Company.

 

Name

   Age as of
December 31,
2012
    

Position

   Has Served the Company,
Heritage Bank or Central
Valley Bank Since
 

Brian L. Vance

     58       President and Chief Executive Officer of Heritage; Chief Executive Officer of Heritage Bank; Vice Chairman and Chief Executive Officer of Central Valley Bank      1996   

Jeffrey J. Deuel

     54       Executive Vice President, Heritage; President and Chief Operating Officer of Heritage Bank      2010   

Donald J. Hinson

     51       Executive Vice President and Chief Financial Officer of Heritage, Heritage Bank and Central Valley Bank      2005   

D. Michael Broadhead

     67       President of Central Valley Bank      1986   

David A. Spurling

     59       Senior Vice President and Chief Credit Officer of Heritage Bank      1999   

The business experience of each executive officer is set forth below.

Brian L. Vance is the President and Chief Executive Officer of Heritage; Chief Executive Officer of Heritage Bank and the Vice Chairman and Chief Executive Officer of Central Valley Bank. Mr. Vance was named President and Chief Executive Officer of Heritage and Heritage Bank, and Vice Chairman and Chief Executive Officer of Central Valley 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 became President and Chief Operating Officer of Heritage Bank in 2012. Mr. Deuel joined Heritage Bank in February 2010 as Executive Vice President. 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 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

 

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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.

Donald J. Hinson became Executive Vice President and Chief Financial Officer of Heritage Bank in 2012. In 2007 Mr. Hinson was appointed the Senior Vice President and Chief Financial Officer of Heritage, Heritage Bank and Central Valley 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.

D. Michael Broadhead joined Central Valley Bank in 1986 and has been President of Central Valley Bank since 1990. The Company acquired Central Valley Bank in March 1999. Previously, Mr. Broadhead held positions with Farmers Home Administration and First Bank and Trust of Idaho. Prior to leaving First Bank and Trust of Idaho, he held the position of Chief Executive Officer.

David A. Spurling became Senior Vice President and Chief Credit Officer of Heritage Bank 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.

 

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, execution 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 and in the recently completed acquisition of Northwest Commercial Bank;

 

 

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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 and one in January 2013 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 and Pierce Commercial Acquisitions, 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 loss share payments from the FDIC. This could result in material losses that are currently not anticipated.

Our business strategy includes significant growth plans, and our financial condition and results of operations could be negatively affected if we fail to grow or fail to 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 FDIC-assisted transactions, 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, execution and operational risks that could adversely affect us” for additional risks related to our acquisition strategy.

Failure to comply with the terms of the shared-loss agreements with the FDIC may result in significant losses.

In connection with the Cowlitz Bank Acquisition, Heritage Bank entered into shared-loss agreements with the FDIC that significantly reduce the Bank’s credit loss exposure. The purchase and assumption agreement and the shared-loss agreements for the Cowlitz Bank 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 other real estate owned under the requirements of the shared-loss agreement may cause individual loans or large pools of loans to lose eligibility for loss share payments from the FDIC. This could result in material losses that are currently not anticipated.

 

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We may engage in additional FDIC-assisted transactions, which could present additional risks to our business.

We may have additional opportunities to acquire the assets and liabilities of failed banks in FDIC-assisted transactions. Although these FDIC-assisted transactions typically provide for FDIC assistance to an acquirer to mitigate certain risks, such as sharing exposure to loan losses and providing indemnification against certain liabilities of the failed institution, we are (and would be in future transactions) subject to many of the same risks we would experience in acquiring another bank in a negotiated transaction, including risks associated with maintaining customer relationships and failure to realize the anticipated acquisition benefits in the amounts and within the timeframes we expect. In addition, because these acquisitions are structured in a manner that would not allow us the time and access to information normally associated with preparing for and evaluating a negotiated acquisition, we may face additional risks in FDIC-assisted transactions, including additional pressure on management resources, management of problem loans, problems related to integration of personnel and operating systems, and the resulting impact to our capital resources that may require us to raise additional capital. We may not be successful in overcoming these risks or any other problems encountered in connection with FDIC-assisted transactions. Our inability to overcome these risks could have a material adverse effect on our business, financial condition and results of operations.

We operate in a highly regulated environment and may be adversely affected by changes in federal and state laws and regulations, including new financial reform legislation recently enacted by Congress that is expected to increase our costs of operations.

We are subject to extensive examination, supervision and comprehensive regulation by the Federal Reserve and Heritage Bank and Central Valley Bank are 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 restrictions on an institution’s operations, reclassify assets, determine the adequacy of an institution’s allowance for loan losses and determine the level of deposit insurance premiums assessed.

Additionally, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”) has significantly changed the bank regulatory structure and has affected 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.

Certain provisions of the Dodd-Frank Act are expected to have a near term impact on our operations. For example, a provision of the Dodd-Frank Act eliminates the federal prohibitions on paying interest on demand deposits, thus allowing businesses to have interest bearing checking accounts. Depending on competitive responses, this significant change to existing law could have an adverse impact on our interest expense.

The Dodd-Frank Act also broadens the base for FDIC insurance assessments. Assessments are now based on the average consolidated total assets less tangible equity capital of a financial institution. The Dodd-Frank Act also permanently increased the maximum amount of deposit insurance for banks, savings institutions and credit unions to $250,000 per depositor.

The Dodd-Frank Act requires publicly traded companies to give stockholders a non-binding vote on executive compensation and so-called “golden parachute” payments and authorizes the SEC to promulgate rules that would allow stockholders to nominate their own candidate using a company’s proxy materials. The legislation also directs the Federal Reserve to promulgate rules prohibiting excessive compensation paid to bank holding company executives, regardless of whether the company is publicly traded.

 

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The Dodd-Frank Act creates a new Consumer Financial Protection Bureau with broad powers to supervise and enforce consumer protection laws. The Consumer Financial Protection Bureau 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 Consumer Financial Protection Bureau has examination and enforcement authority over all banks and savings institutions with more than $10 billion in assets. Financial institutions such as Heritage Bank and Central Valley Bank with $10 billion or less in assets will continue to be examined for compliance with the consumer laws by their primary bank regulators.

It is difficult to predict at this time 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 interest expense. Any additional changes in our regulation and oversight, whether in the form of new laws, rules or regulations, could make compliance more difficult or expensive or otherwise materially adversely affect our business, financial condition or prospects.

As the Company and Banks continue to monitor developments under the Dodd-Frank Act and to assess the ultimate impact of the legislation and yet to be written implementing rules and regulations on community banks, at a minimum we expect to experience an increase in our operating and compliance costs, which is expected to continue and further impact our interest expense.

The short-term and long-term impact of the changing regulatory capital requirements and anticipated new capital rules is uncertain.

In June 2012, the Federal Reserve, FDIC and the OCC proposed rules that would substantially amend the regulatory risk-based capital rules applicable to the us, Heritage Bank and Central Valley Bank. The proposed rules were subject to a public comment period that has expired and there is no date set for the adoption of final rules.

Various provisions of the Dodd-Frank Act increase the capital requirements of bank holding companies, such as Heritage Financial Corporation. The leverage and risk-based capital ratios of these entities may not be lower than the leverage and risk-based capital ratios for insured depository institutions. The proposed rules include new minimum risk-based capital and leverage ratios, which would be phased in during 2013 and 2014, and would refine the definition of what constitutes “capital” for purposes of calculating those ratios. The proposed new minimum capital level requirements applicable to us, Heritage Bank and Central Valley Bank under the proposals would 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 proposed rules would also establish a “capital conservation buffer” of 2.5% above the new regulatory minimum capital ratios, 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 would be phased in beginning in January 2016 at 0.625% of risk-weighted assets and would increase 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. While the proposed Basel III changes and other regulatory capital requirements will likely result in generally higher regulatory capital standards, it is difficult at this time to predict when or how any new standards will ultimately be applied to us, Heritage Bank and Central Valley Bank.

In addition, in the current economic and regulatory environment, regulators of banks and bank holding companies have become more likely to impose capital requirements on bank holding companies and banks that are more stringent than those required by applicable existing regulations.

 

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The application of more stringent capital requirements for us, Heritage Bank and Central Valley Bank could, among other things, result in lower returns on invested capital, require the raising of additional capital, and result in regulatory actions if we were to be unable to comply with such requirements. Furthermore, the imposition of liquidity requirements in connection with the implementation of Basel III could result in our having to lengthen the term of our funding, restructure our business models, and/or increase our holdings of liquid assets. Implementation of changes to asset risk weightings for risk based capital calculations, items included or deducted in calculating regulatory capital and/or additional capital conservation buffers could result in management modifying its business strategy and could limit our ability to make distributions, including paying out dividends or buying back shares.

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 borrowers’ 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, 2012, our originated commercial business loans (consisting of commercial and industrial loans, owner-occupied commercial real estate loans and non-owner occupied commercial real estate loans) totaled $731.6 million, or approximately 83.7% of our total originated loan portfolio.

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.

 

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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 mortgage 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, 2012, our non-owner occupied commercial real estate loans totaled $265.8 million, or 30.4% of our total originated 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, 2012, our originated real estate construction and land development loans totaled $77.3 million, or 8.8% of our total originated loan portfolio. Of these loans, $25.2 million, or 2.9%, were one-to-four family residential construction related and $52.1 million, or 5.9%, were five-or-more family residential and commercial construction related. Approximately $6.4 million, or 8.3%, of our total originated construction loans were nonperforming at December 31, 2012.

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.

We maintain an allowance for loan losses on our loans, which is a reserve established through a provision for loan losses charged against income, which we believe is appropriate to provide for probable 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;

 

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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. Continuing 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 weak conditions in the housing and real estate markets continue, we expect we will continue to experience further 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, 2012 we recorded a total provision for loan losses of $2.0 million compared to $14.4 million for the year ended December 31, 2011. The provision related to the originated portfolio was $695,000 and $5.2 for the years ended December 31, 2012 and 2011, respectively. Our provision for loan losses on purchased loans was $1.3 million and $9.3 million for the years ended December 31, 2012 and 2011, respectively. We also recorded net loan charge-offs of $4.3 million for the year ended December 31, 2012 compared to $5.6 million for the year ended December 31, 2011. The net charge-offs related to the originated portfolio was $3.9 million and $4.9 million for the years ended December 31, 2012 and 2011, respectively. Recently, we have been experiencing decreasing loan delinquencies and decreasing loan charge-offs. Generally, our nonperforming loans and assets reflect operating difficulties of individual borrowers resulting from weakness in the local economy. The deterioration in the general economy has been a significant contributing factor to our current level of delinquencies and nonperforming loans. The economy has significantly impacted our commercial and industrial loan portfolio, which represented 36.6% of our nonaccrual originated loans at December 31, 2012. Slower sales and excess inventory in the housing market has been the primary cause of the increase in foreclosures for one-to-four family residential construction loans, which represented 24.6% of our nonperforming originated loans at December 31, 2012. At December 31, 2012 our total nonperforming originated loans were $12.5 million, or 1.28% of total originated loans, compared to $23.3 million or 2.57% of total originated loans at December 31, 2011. Moreover, if weak economic conditions persist, 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.

The current economic condition in the market areas we serve may continue to 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 continuing 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. In particular, in the current downturn, the Puget Sound and Portland, Oregon areas have experienced substantial home price declines, increased foreclosures and above-average unemployment rates. Many large Pacific Northwest businesses have implemented substantial employee layoffs and scaled back plans for future growth. The Yakima Valley also has similarly experienced an increased unemployment rate and a continued decline in housing prices.

 

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Continued weakness or a further 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, 2012, we had goodwill with a carrying amount of $13.0 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.

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.

 

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Increases in deposit insurance premiums and special FDIC assessments will negatively impact our earnings.

The Dodd-Frank Act established 1.35% of total insured deposits as the minimum reserve ratio. The FDIC has adopted a plan under which it will meet this ratio by the statutory deadline of September 30, 2020, which has increased assessments. The Dodd-Frank Act requires the FDIC to offset the effect on institutions with assets less than $10 billion of the increase in the minimum reserve ratio to 1.35% from the former minimum of 1.15%. The FDIC has not announced how it will implement this offset. In addition to the statutory minimum ratio, the FDIC must set a designated reserve ratio, which may exceed the statutory minimum. The FDIC has set 2.0% as the designated reserve ratio.

As required by the Dodd-Frank Act, the FDIC has adopted final regulations under which insurance premiums are based on an institution’s total assets minus its tangible equity instead of its deposits. While our FDIC insurance premiums initially may be reduced by these regulations, it is possible that our future insurance premiums will increase under the final regulations.

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, the 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.

Continued deterioration in the financial position of the Federal Home Loan Bank of Seattle may result in future impairment losses of our investment in Federal Home Loan Bank stock.

At December 31, 2012, we owned $5.5 million of stock of the FHLB of Seattle. As a condition of membership at the FHLB, we are required to purchase and hold a certain amount of FHLB stock. Our stock purchase requirement is based, in part, upon the outstanding principal balance of advances from the FHLB and is calculated in accordance with the Capital Plan of the FHLB. Our FHLB stock has a par value of $100, is carried

 

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at cost, and is subject to impairment testing. In December 2008, the FHLB has announced that it had a risk-based capital deficiency under the regulations of the Federal Housing Finance Agency, or the FHFA, its primary regulator, and that it would suspend future dividends and the repurchase and redemption of outstanding common stock. As a result, the FHLB has not paid a dividend since the fourth quarter of 2008. In addition, the FHLB communicated that it believes the calculation of risk-based capital under the current rules of the FHFA significantly overstates the market risk of the FHLB’s private-label mortgage-backed securities in the current market environment and that it has enough capital to cover the risks reflected in its balance sheet. As a result, we have not recorded an other-than-temporary impairment on our investment in FHLB stock. In addition, on October 25, 2010, the FHLB received a consent order from the FHFA, which it has been operating under since that time. In September 2012, the FHLB of Seattle announced that its financial condition had improved, that it continues to address the requirements of the Consent Agreement and that it met all minimum financial metrics required under the Consent Agreement. Further, the FHLB of Seattle reported that the FHFA had reclassified the FHLB of Seattle to be adequately capitalized and that the FHFA had authorized the FHLB Seattle to repurchase up to $25 million of excess capital stock per quarter at par ($100 per share) as long as its financial condition does not deteriorate. Any dividends on, or repurchases of, the FHLB of Seattle stock continue to require consent of the FHFA. After receiving FHFA approval, the FHLB of Seattle repurchased $24.1 million in excess capital stock in late September 2012. We will continue to monitor the financial condition of the FHLB as it relates to, among other things, the recoverability of our investment.

New or changing tax, accounting, and regulatory rules and interpretations could significantly impact strategic initiatives, results of operations, cash flows, and financial condition.

The financial services industry is extensively regulated. Federal and state banking regulations are designed primarily to protect the deposit insurance funds and consumers, not to benefit a company’s stockholders. Regulatory authorities have extensive discretion in connection with their supervisory and enforcement activities, including the imposition of restrictions on the operation of an institution, the classification of assets by the institution and the adequacy of an institution’s allowance for loan losses. Additionally, actions by regulatory agencies or significant litigation against us could require us to devote significant time and resources to defending our business and may lead to penalties that materially affect us. These regulations, along with the currently existing tax, accounting, securities, insurance, and monetary laws, regulations, rules, standards, policies, and interpretations control the methods by which financial institutions conduct business, implement strategic initiatives and tax compliance, and govern financial reporting and disclosures. These laws, regulations, rules, standards, policies, and interpretations are constantly evolving and may change significantly over time. For information regarding the significant federal and state banking regulations that affect us, see “Item 1. Business—Supervision and Regulation.”

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

 

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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

There are no unresolved staff comments from the Securities and Exchange Commission.

 

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. At December 31, 2012, Heritage Bank had ten offices located in Tacoma and surrounding areas of Pierce County (all but five of which are owned), five offices located in Thurston County (all of which are owned with one office located on leased land), four offices in King County (all of which are leased), one office in Mason County (which is owned), one office in Clark County (which is leased), four offices in Cowlitz County (all of which are owned with the exception of one leased office) and two offices in Multnomah Country (all of which are leased). Central Valley Bank had six offices, five located in Yakima County and one in Kittitas County (all of which are owned with one on leased land).

 

ITEM 3. LEGAL PROCEEDINGS

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

 

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable

 

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PART II

 

ITEM 5. MARKET FOR THE REGISTRANT’S 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, 2012, we had approximately 1,112 shareholders of record (not including the number of persons or entities holding stock in nominee or street name through various brokerage firms) and 15,117,980 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 8, 2013 was $14.09 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.

 

     2012 Quarter ended,  
     March 31      June 30      September 30      December 31  

High

   $ 14.56       $ 14.65       $ 15.57       $ 15.23   

Low

   $ 12.25       $ 12.37       $ 13.44       $ 13.50   

 

     2011 Quarter ended,  
     March 31      June 30      September 30      December 31  

High

   $ 15.12       $ 14.86       $ 13.15       $ 13.57   

Low

   $ 13.50       $ 12.53       $ 10.20       $ 10.24   

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 year ended December 31, 2012 and subsequent through the date of this filing are listed below:

 

Declared

 

Cash
Dividend
        per Share        

 

        Record Date        

           Paid        

February 1, 2012

  $0.06   February 10, 2012    February 24, 2012

April 26, 2012

  $0.08   May 10, 2012    May 24, 2012

June 26, 2012

  $0.20   July 10, 2012    July 24, 2012

July 25, 2012

  $0.08   August 14, 2012    August 24, 2012

October 30, 2012

  $0.08   November 9, 2012    November 21, 2012

November 30, 2012

  $0.30   November 26, 2012    December 6, 2012

January 30, 2013

  $0.08   February 8, 2013    February 22, 2013

The primary source for dividends paid to our shareholders is dividends paid to us from Heritage Bank and Central Valley Bank. There are regulatory restrictions on the ability of our subsidiary banks to pay dividends. Under federal regulations, the dollar amount of dividends the Banks may pay depends upon their 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 Board regarding capital adequacy and dividends. The Federal Reserve Board’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

 

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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. In August 2011, the Board of Directors approved the ninth stock repurchase plan, allowing the Company to repurchase up to 5% of the then outstanding shares, or approximately 782,000 shares over a period of twelve months. During the year ended December 31, 2012, the Company repurchased 389,627 shares at an average price of $13.45 per share under this plan. In total, the Company repurchased 590,832 shares at an average price of $12.83 per share under this plan. 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 or approximately 757,000 shares. For the year ended December 31, 2012, 52,900 shares have been repurchased at an average price of $13.88 per share under this plan. The Company also repurchased 3,419 shares at an average price of $14.08 to pay withholding taxes on the vesting of restricted stock for the year ended December 31, 2012.

The following table sets forth information about the Company’s purchases of its outstanding common stock during the quarter ended December 31, 2012.

 

Period

  Total Number  of
Shares Purchased(1)
    Average Price
Paid Per Share(1)
    Total Number of  Shares
Purchased as Part of Publicly
Announced Plans or
Programs
    Maximum Number of
Shares that May Yet
Be Purchased Under
the Plans or
Programs
 

October 1, 2012—October 31, 2012

    263      $ 14.23        6,608,448        757,000   

November 1, 2012—November 30, 2012

    44,689        13.86        6,652,648        712,800   

December 1, 2012—December 31, 2012

    8,748        13.83        6,661,348        704,100   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total

    53,700      $ 13.86        6,661,348        704,100   

 

(1)

Common shares repurchased by the Company between September 1, 2012 and December 31, 2012 included the cancellation of 800 shares of restricted stock to pay withholding taxes at an average price per share of $14.08.

The information regarding the Company’s equity compensation plan is contained under Part III, “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.

Stock Performance Graph

The chart shown below depicts total return to stockholders during the period beginning December 31, 2007 and ending December 31, 2012. 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

 

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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, 2007, and that all dividends were reinvested in Heritage common stock.

 

LOGO

 

     Year Ended December 31,  

Index

   2007      2008      2009      2010      2011      2012  

Heritage Financial Corporation

   $ 100.00       $ 64.75       $ 73.45       $ 74.20       $ 69.14       $ 85.55   

NASDAQ Composite

     100.00         60.02         87.24         103.08         102.26         120.42   

NASDAQ Bank

     100.00         78.46         65.67         74.97         67.10         79.64   

 

ITEM 6. SELECTED FINANCIAL DATA

The following table sets 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.”

 

    Year Ended December 31,  
    2012     2011     2010     2009     2008  
    (Dollars in thousands, except per share amounts)  

Operations Data:

         

Interest income

  $ 69,109      $ 74,120      $ 59,522      $ 53,341      $ 56,948   

Interest expense

    4,534        6,582        8,511        11,645        18,606   

Net interest income

    64,575        67,538        51,011        41,696        38,342   

Provision for loan losses

    2,016        14,430        11,990        19,390        7,420   

Noninterest income

    7,272        5,746        18,779        5,988        6,358   

Noninterest expense

    50,392        49,703        38,011        28,216        27,953   

 

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    Year Ended December 31,  
    2012     2011     2010     2009     2008  
    (Dollars in thousands, except per share amounts)  

Income tax expense (benefit)

    6,178        2,633        6,435        (503     2,976   

Net income

    13,261        6,518        13,354        581        6,351   

Net income (loss) applicable to common shareholders

    13,261        6,518        11,668        (739     6,208   

Earnings (loss) per common share(1)

         

Basic

    0.87        0.42        1.05        (0.10     0.93   

Diluted

    0.87        0.42        1.04        (0.10     0.93   

Dividend payout ratio to common shareholders(2)

    92.0     90.5     —         (100.0 )%      60.2

Performance Ratios:

         

Net interest spread(3)

    5.03     5.23     4.56     4.25     4.11

Net interest margin(4)

    5.17     5.41     4.78     4.57     4.59

Efficiency ratio(5)

    70.14     67.82     54.46     59.17     62.53

Return on average assets

    0.98     0.48     1.16     0.06     0.71

Return on average common equity

    6.52     3.17     8.15     (0.72 )%      6.98

 

    December 31,  
    2012     2011     2010     2009     2008  
    (Dollars in thousands)  

Balance Sheet Data:

         

Total assets

  $ 1,345,540      $ 1,368,985      $ 1,367,684      $ 1,014,859      $ 946,145   

Originated loans receivable, net

    855,360        815,607        719,957        746,083        793,303   

Purchased covered loans receivable, net

    83,978        105,394        128,715        —          —     

Purchased noncovered loans receivable, net

    59,006        83,479        131,049        —          —     

Loans receivable, net

    998,344        1,004,480        979,721        746,083        793,303   

Loans held for sale

    1,676        1,828        764        825        304   

FDIC indemnification asset

    7,100        10,350        16,071        —          —     

Deposits

    1,117,971        1,136,044        1,136,276        840,128        824,480   

FHLB advances

    —         —         —         —          —     

Securities sold under agreement to repurchase

    16,021        23,091        19,027        10,440        —     

Stockholders’ equity

    198,938        202,520        202,279        158,498        113,147   

Book value per common share

    13.16        13.10        12.99        12.21        13.40   

Equity to assets ratio

    14.8     14.8     14.8     15.6     12.0

Capital Ratios:

         

Total risk-based capital ratio

    19.9     20.3     21.5     20.7     13.7

Tier 1 risk-based capital ratio

    18.7     19.0     20.2     19.4     12.5

Leverage ratio

    13.6     13.8     13.9     14.6     11.0

Asset Quality Ratios:

         

Nonperforming originated loans to total originated loans (6)

    1.28     2.57     3.14     4.21     0.42

Allowance for loan losses on originated loans to total originated loans (6)

    2.19     2.66     2.97     3.38     1.91

Allowance for loan losses on originated loans to nonperforming originated loans (6)

    170.44     103.52     94.73     79.34     454.02

Nonperforming originated assets to total originated assets (6)

    1.39     2.14     2.38     3.32     0.57

Other Data:

         

Number of banking offices

    33        33        31        20        20   

Number of full-time equivalent employees

    363        354        321        222        217   

 

(1)

Effective January 1, 2009, the Company adopted FASB ASC 03-6-1. Earnings per share data for the prior periods have been revised to reflect the retrospective adoption of the FASB ASC.

(2)

Dividend payout ratio is declared dividends per common share divided by basic earnings (loss) per common share.

(3)

Net interest spread is the difference between the average yield on interest earning assets and the average cost of net interest bearing liabilities.

(4)

Net interest margin is net interest income divided by average interest earning assets.

(5)

The efficiency ratio is recurring noninterest expense divided by the sum of net interest income and noninterest income.

(6)

Nonperforming originated loan balances exclude portions guaranteed by governmental agencies of $1.2 million, $1.8 million, $3.2 million and $2.3 million as of December 31, 2012, 2011, 2010 and 2009, respectively. There were no governmental guarantees on nonperforming originated loans as of December 31, 2008.

 

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion is intended to assist in understanding the financial condition and results of operations of the Company. The information contained in this section should be read with the December 31, 2012 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 the Cowlitz Bank, Pierce Commercial Bank and the Northwest Commercial Bank transactions described in this Form 10-K, 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;

 

   

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 Federal Reserve and of our bank subsidiaries by the FDIC, the Division or other regulatory authorities, 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 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;

 

   

the impact of the Dodd-Frank Act and implementing regulations;

 

   

further 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;

 

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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 expansion strategy of pursuing acquisitions and de novo branching;

 

   

our ability to successfully integrate any assets, liabilities, customers, systems, and management personnel we have acquired or may in the future acquire into our operations and our ability to realize related revenue synergies and cost savings within expected time frames and any goodwill charges related thereto;

 

   

increased competitive pressures among financial service companies;

 

   

changes in consumer spending, borrowing and savings habits;

 

   

the availability of resources to address changes in laws, rules, or regulations or to respond to regulatory actions;

 

   

adverse changes in the securities markets;

 

   

inability of key third-party providers to perform their obligations to us;

 

   

changes in accounting policies and practices, as may be adopted by the financial institution regulatory agencies or the Financial Accounting Standards Board, 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 impaired loans, 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.

 

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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 the non-classified and classified portion of 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-classified loans, classified 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 further 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, 2012 and 2011—Provision for Loan Losses” below, Part I of “Item 1. Business—Analysis of Allowance for Loan Losses” as well as Note 3 of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data.”

Estimated Expected Cash Flows related to Purchased 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

 

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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.

Other-Than-Temporary Impairments in the Market Value of Investments.    Unrealized losses on investment securities available for sale and held to maturity securities 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 purchases of North Pacific Bank and Western Washington Bancorp. 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 for the quarter ended December 31, 2011, for the year ended December 31, 2012, 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.

 

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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: “Continuously Improve Customer Satisfaction, Employee Empowerment 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 plan to acquire or build one to two branches per year in strategic growth locations. 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 review as well as a third party loan review process.

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 afflicting the Pacific Northwest better than many of our competitors. As of December 31, 2012, the ratio of our allowance for loan losses on originated loans to total originated loans was 2.19% and the ratio of the allowance for loan losses on originated loans to nonperforming originated loans was 170.44%. Our liquidity position is also strong, with $107.1 million in cash and cash equivalents as of December 31, 2012. As of December 31, 2012, the regulatory capital ratios of our subsidiary banks were 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 19.9%, 18.7% and 13.6%, 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, 2012, as a percentage of our total deposits, non-maturity deposits were 74.2%. 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

 

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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 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 subsidiaries: Heritage Bank and Central Valley Bank. We provide financial services to our local communities with an ongoing strategic focus on our commercial banking relationships, market expansion and asset quality.

During the period from December 31, 2008 through December 31, 2012 our total assets have grown $399.4 million, or 42.2%, to $1.3 billion as of December 31, 2012 with originated loans receivable, net growing $62.1 million, or 7.8%, to $855.4 million as of December 31, 2012. Our emphasis in growing our commercial business loan portfolio resulted in an increase in originated commercial business loans of $130.2 million, or 21.7%, since December 31, 2008. Overall loan increases have benefited from our emphasis in increasing our lending in our market areas, including the acquisitions of Cowlitz Bank and Pierce Commercial Bank in 2010 and the acquisition of Northwest Commercial Bank in January 2013.

Deposits increased $293.5 million, or 35.6%, to $1.12 billion at December 31, 2012 from $824.5 million at December 31, 2008. From December 31, 2008 to December 31, 2012, non-maturity deposits (total deposits less certificate of deposit accounts) increased $351.0 million, or 73.4%. As a result, the percentage of certificate of deposit accounts to total deposits decreased to 25.8% at December 31, 2012 from 42.0% at December 31, 2008.

Stockholders’ equity has increased by $85.8 million to $198.9 million at December 31, 2012 from $113.1 million at December 31, 2008 due primarily to a combination of earnings and issuances of common stock, partially offset by redemption of preferred stock, repurchases of common stock and declaration of cash dividends. Our annual net income increased by 108.8%, or $6.9 million, to $13.3 million for the year ended December 31, 2012 from $6.4 million for the year ended December 31, 2008 due primarily to an increase of $26.2 million in net interest income that exceeded an increase in noninterest expense of $22.4 million, and a decrease in the provision for loan losses of $5.4 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.

 

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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.

 

    Year Ended December 31,  
    2012     2011     2010  
    Average
Balance
    Interest
Earned/
Paid
    Average
Yield/
Rate
    Average
Balance
    Interest
Earned/
Paid
    Average
Yield/
Rate
    Average
Balance
    Interest
Earned/
Paid
    Average
Yield/
Rate
 
    (Dollars in thousands)  

Interest Earning Assets:

                 

Loans

  $ 996,186      $ 65,588        6.58   $ 981,848      $ 70,114        7.14   $ 810,177      $ 56,054        6.92

Taxable securities

    121,543        2,195        1.81        129,217        2,912        2.25        105,815        2,661        2.52   

Nontaxable securities

    38,853        1,097        2.83        25,122        821        3.27        13,411        470        3.50   

Interest earning deposits and Federal funds sold

    86,686        229        0.26        105,836        273        0.26        133,277        337        0.25   

FHLB stock

    5,578        —          —          5,594        —         —         4,204        —         —    
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest earning assets

  $ 1,248,846      $ 69,109        5.53   $ 1,247,617      $ 74,120        5.94   $ 1,066,884      $ 59,522        5.58

Noninterest earning assets

    105,226            102,691            86,039       
 

 

 

       

 

 

       

 

 

     

Total assets

  $ 1,354,072          $ 1,350,308          $ 1,152,923       
 

 

 

       

 

 

       

 

 

     

Interest Bearing Liabilities:

                 

Certificates of deposit

  $ 306,772      $ 3,016        0.98   $ 355,167      $ 4,274        1.20   $ 351,191      $ 5,677        1.62

Savings accounts

    113,119        204        0.18        103,170        361        0.35        89,978        501        0.56   

Interest bearing demand and money market accounts

    466,268        1,249        0.27        453,509        1,868        0.41        376,245        2,200        0.58   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest bearing deposits

    886,159        4,469        0.50        911,846        6,503        0.71        817,414        8,378        1.02   

FHLB advances and other borrowings

    —         —         —         1        —         0.30        1,896        48        2.53   

Securities sold under agreement to repurchase

    18,314        65        0.35        19,301        79        0.41        13,750        85        0.62   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest bearing liabilities

  $ 904,473      $ 4,534        0.50   $ 931,148      $ 6,582        0.71   $ 833,060      $ 8,511        1.02

Demand and other noninterest bearing deposits

    237,888            205,862            150,906       

Other noninterest bearing liabilities

    8,310            7,795            2,993       

Preferred stock

                          22,889       

Stockholders’ equity

    203,401            205,503            165,964       
 

 

 

       

 

 

       

 

 

     

Total liabilities and stockholders’ equity

  $ 1,354,072          $ 1,350,308          $ 1,152,923       
 

 

 

       

 

 

       

 

 

     

Net interest income

    $ 64,575          $ 67,538          $ 51,011     

Net interest spread

        5.03         5.23         4.56

Net interest margin

        5.17         5.41         4.78

Average interest earning assets to average interest bearing liabilities

        138.08         133.99         128.07

 

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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.

 

 

     Year Ended December 31,  
     2012 Compared to 2011
Increase (Decrease) Due to
    2011 Compared to 2010
Increase (Decrease) Due to
 
     Volume     Rate     Total     Volume     Rate     Total  
     (In thousands)  

Interest Earning Assets:

            

Loans

   $ 944      $ (5,470   $ (4,526   $ 12,273      $ 1,786      $ 14,059   

Taxable securities

     (139     (578     (717     527        (277     250   

Nontaxable securities

     388        (112     276        383        (31     352   

Interest earning deposits and federal funds sold

     (50     6        (45     (71     6        (65

FHLB stock

     —         —         —          —         —         —    
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Interest income

   $ 1,143      $ (6,154   $ (5,012   $ 13,112      $ 1,484      $ 14,596   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Interest Bearing Liabilities:

            

Certificates of deposit

   $ (475   $ (783   $ (1,258   $ 48      $ (1,450   $ (1,402

Savings accounts

     18        (174     (156     46        (187     (141

Interest bearing demand and money market accounts

     34        (653     (619     318        (649     (331
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest bearing deposits

     (423     (1,610     (2,033     412        (2,286     (1,874

FHLB advances and other borrowings

     —         —         —         (6     (44     (50

Securities sold under agreement to repurchase

     (4     (11     (15     23        (29     (6
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Interest expense

   $ (427   $ (1,621   $ (2,048   $ 429      $ (2,359   $ (1,930
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net Interest Income

   $ 1,570      $ (4,533   $ (2,964   $ 12,683      $ 3,843      $ 16,526   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Results of Operations for the Years Ended December 31, 2012 and 2011

Earnings Summary.    Net income applicable to common shareholders of $0.87 per diluted common share was recorded for the year ended December 31, 2012 compared to $0.42 per diluted common share for the year ended December 31, 2011. Net income for the year ended December 31, 2012 was $13.3 million compared to net income of $6.5 million for the same period in 2011. The $6.7 million increase was primarily the result of a $12.4 million decrease in the provision for loan losses and a $2.0 million decrease in interest expense, partially offset by a $5.0 million decrease in interest income and a $3.5 million increase in income tax expense. The Company’s efficiency ratio increased to 70.1% for the year ended December 31, 2012 from 67.8% for the year ended December 31, 2011 partially due to increases in the compensation and employee benefits expense and expenses related to the acquisition of Northwest Commercial Bank which closed in January 2013.

Net Interest Income.    Net interest income decreased $3.0 million, or 4.4%, to $64.6 million for the year ended December 31, 2012 compared to $67.5 million for the previous year. The decrease in net interest income was due to the decline in net interest margins. Net interest income as a percentage of average earning assets (net interest margin) for the year ended December 31, 2012 decreased 24 basis points to 5.17% from 5.41% for the previous year. The decline in net interest margin was due to a combination of lower contractual note rates and the overall lessening impact of the discount accretion on the acquired loan portfolios. Our net interest spread for the year ended December 31, 2012 decreased to 5.03% from 5.23% for the prior year.

 

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Total interest income decreased $5.0 million, or 6.8%, to $69.1 million for the year ended December 31, 2012, from $74.1 million for the year ended December 31, 2011. The decrease in interest income was due primarily to lower yields on interest earning assets. The balance of average interest earning assets (including nonaccrual loans) increased $1.2 million, or 0.1%, from $1.248 billion for the year ended December 31, 2011 to $1.249 billion for the year ended December 31, 2012. The yield on interest earning assets decreased 41 basis points from 5.94% for the year ended December 31, 2011 to 5.53% for the year ended December 31, 2012. The decrease in the yield on earning assets for the year ended December 31, 2012 reflects the decreased loan yields due primarily to lower contractual note rates as well as the effects of the discount accretion on the acquired loan portfolios. The effect of discount accretion on net interest margin for the year ended December 31, 2012 and December 31, 2011 was approximately 50 basis points and 62 basis points, respectively. For the years ended December 31, 2012 and December 31, 2011, originated nonaccruing loans reduced the yield on interest earning assets by approximately seven basis points and 11 basis points, respectively. Originated nonaccrual loans totaled $12.5 million at December 31, 2012 compared to $23.3 million at December 31, 2011. Interest income on taxable and nontaxable investment securities decreased $441,000 to $3.3 million for the year ended December 31, 2012 from $3.7 million for the year ended December 31, 2011 due primarily to lower yields earned on the investment securities in 2012 as a result of declining interest rates.

Total interest expense decreased by $2.0 million, or 31.1%, to $4.5 million for the year ended December 31, 2012 from $6.6 million for the year ended December 31, 2011. The decrease in interest expense was due to a combination of lower balances of average interest bearing liabilities and lower rates paid on interest bearing liabilities. The average rate paid on interest bearing liabilities decreased to 0.50% for the year ended December 31, 2012 from 0.71% for the year ended December 31, 2011. Total average interest bearing liabilities decreased by $26.7 million, or 2.9%, to $904.5 million for the year ended December 31, 2012 from $931.1 million for the year ended December 31, 2011. The decrease in average interest bearing liabilities was due primarily to the $48.4 million decrease in certificates of deposits to $306.8 million for the year ended December 31, 2012 from $355.2 million for the year ended December 31, 2011. Deposit interest expense decreased $2.0 million, or 31.3%, to $4.5 million for the year ended December 31, 2012 compared to $6.5 million for the prior year. The decrease in deposit interest expense for the year ended December 31, 2012 is primarily a result of a 21 basis point decrease in the average cost of interest-bearing deposits, reflecting the relatively low interest rate environment.

Provision for Loan Losses.    The provision for loan losses decreased $12.4 million, or 86.0%, to $2.0 million for the year ended December 31, 2012 from $14.4 million for the year ended December 31, 2011.

The provision for loan losses on originated loans decreased $4.5 million, or 86.6%, to $695,000 for the year ended December 31, 2012 from $5.2 million for the year ended December 31, 2011. The Banks had net charge-offs on originated loans of $3.9 million for the year ended December 31, 2012 compared to $4.9 million for the year ended December 31, 2011. The decrease in provision expense for originated loans was substantially due to an improvement in the environmental factors as well as lower net charge-offs on originated loans during the year ended December 31, 2012 compared the prior year. The ratio of net charge-offs to average total originated loans outstanding was 0.45% for the year ended December 31, 2012 and 0.59% for the year ended December 31, 2011.

The Banks have established comprehensive methodologies for determining the allowance for loan losses on originated loans. On a quarterly basis the Banks perform 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. The allowance for loan losses on originated loans decreased by $3.2 million, or 14.3%, to $19.1 million at December 31, 2012 from $22.3 million at December 31, 2011. As of December 31, 2012, the Banks identified $12.5 million of originated impaired loans and $15.0 million of originated performing restructured loans. Of those impaired and performing restructured loans, $12.6 million have no allowances for credit losses as their estimated collateral value is equal to or exceeds their carrying costs. The remaining $14.9 million have related allowances for credit losses totaling $4.4 million. Based on the comprehensive methodology,

 

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management deemed the allowance for loan losses on originated loans of $19.1 million at December 31, 2012 (2.19% of total originated loans and 170.44% of nonperforming originated loans, excluding government guarantees) 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 purchased loans for the year ended December 31, 2012 totaled $1.3 million compared to $9.3 million for the year ended December 31, 2011. As of the acquisition date, purchased loans were recorded at their estimated fair value, incorporating our estimate of future expected cash flows until the ultimate resolution of these credits. To the extent actual or remaining projected cash flows are less than originally estimated, additional provisions for loan losses on the purchased loan portfolios will be recognized. However, provisions on the purchased covered loans would be primarily offset by a corresponding increase in the FDIC indemnification asset recognized within noninterest income. To the extent actual or remaining projected cash flows are more than originally estimated, the increase in cash flows is recognized prospectively in interest income. The decrease in the provision for the year ended December 31, 2012 as compared to the year ended December 31, 2011 is a result of less decreases in remaining projected cash flows on purchased loans, offset partially by specific loans that were charged-off during the year which caused decreases in projected cash flows.

The allowance for loan losses on purchased loans increased $871,000, or 10.1% to $9.5 million at December 31, 2012 from $8.6 million at December 31, 2011. The increase was the result of specific purchased loans that had remaining expected cash flows less than previously expected, which was usually the result of a charge-off.

While the Banks believe they have established their existing allowances for loan losses in accordance with GAAP, there can be no assurance that regulators, in reviewing the Banks’ loan portfolios, will not request the Banks to increase significantly their 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 $1.5 million, or 26.6%, to $7.3 million for the year ended December 31, 2012 compared to $5.7 million for the prior year. The increase was due primarily to the net FDIC loss sharing income, which was a reduction of income of $2.3 million for the year ended December 31, 2012 compared to a reduction of income of $1.0 million for the year ended December 31, 2011. The FDIC loss sharing income, net 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.

Noninterest Expense.    Noninterest expense increased $689,000 or 1.4% to $50.4 million for the year ended December 31, 2012 compared to $49.7 million for the year ended December 31, 2011. The increase was due primarily to increased compensation and employee benefits expense in the amount of $1.9 million and a $481,000 increase in professional services partially offset by decreases of $605,000 in net other real estate owned expense and $556,000 in Federal deposit insurance premium expense. The increase in professional services was primarily due to the costs related to the Northwest Commercial Acquisition which closed in January 2013. Total expenses related to this acquisition were $285,000 for the year ended December 31, 2012.

The efficiency ratio for the year ended December 31, 2012 was 70.1% compared to 67.8% for the same period in the prior year. The increase in the ratio for the year ended December 31, 2012 was primarily related to the increase in noninterest expense and the decrease in net interest income. The net interest income was reduced because of the low interest rate environment. Additionally, 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 revenue when these growth strategies begin producing long term results. The efficiency ratio consists of noninterest expense divided by the sum of net interest income before provision for loan losses plus noninterest income.

 

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Income Tax Expense.    The provision for income taxes increased by $3.5 million to an expense of $6.2 million for the year ended December 31, 2012 from an expense of $2.6 million for the year ended December 31, 2011. The Company’s effective tax rate was 31.8% for the year ended December 31, 2012 compared to 28.8% for the same period in 2011. The increase in the Company’s income tax expense from the prior year was primarily due to increases in pre-tax income. The increase in the Company’s effective tax rate for the year ended December 31, 2012 is due substantially to increases in the level of net income before income taxes relative to the more modest amount of increase in the amount of tax-exempt income.

Results of Operations for the Years Ended December 31, 2011 and 2010

Earnings Summary.    Net income applicable to common shareholders of $0.42 per diluted common share was recorded for the year ended December 31, 2011 compared to $1.04 per diluted common share for the year ended December 31, 2010. Net income for the year ended December 31, 2011 was $6.5 million compared to net income of $13.4 million for the same period in 2010. The decrease was primarily the result of an $11.8 million gain on bank acquisitions in 2010, a $2.4 million increase in the provision for loan losses and an $11.7 million increase in noninterest expense partially offset by a $16.5 million increase in net interest income. The Company’s efficiency ratio increased to 67.8% for the year ended December 31, 2011 from 54.5% for the year ended December 31, 2010.

Net Interest Income.    Net interest income increased $16.5 million, or 32.4%, to $67.5 million for the year ended December 31, 2011 compared with the previous year of $51.0 million. The increase in net interest income was due primarily to increased earning assets acquired from the Cowlitz and Pierce Commercial Acquisitions and an increased net interest margin. Net interest income as a percentage of average interest earning assets (net interest margin) for the year ended December 31, 2011 increased 63 basis points to 5.41% from 4.78% for the previous year. The increase in net interest margin was due primarily to increased loan yields as a result of discount accretion on the acquired loan portfolios balances and offset by low interest yields on interest earning overnight cash deposits in the Cowlitz and Pierce Commercial Acquisitions. Our net interest spread for the year ended December 31, 2011 increased to 5.23% from 4.56% for the prior year.

Total interest income increased $14.6 million, or 24.5%, to $74.1 million for the year ended December 31, 2011, from $59.5 million for the year ended December 31, 2010. The increase in interest income was due to a combination of higher balances of average interest earning assets and higher yields on interest earning assets. The balance of average interest earning assets (including nonaccrual loans) increased $180.7 million, or 16.9%, from $1.07 billion for the year ended December 31, 2010 to $1.25 billion for the year ended December 31, 2011. The increase in average interest earning assets for the year ended December 31, 2011 was primarily due to the Cowlitz and Pierce Commercial Acquisitions as well as increases in investment securities available for sale. The yield on average interest earning assets increased 36 basis points from 5.58% for the year ended December 31, 2010 to 5.94% for the year ended December 31, 2011. The increase in the yield on average interest earning assets for the year ended December 31, 2011 reflects the increased loan yields due to discount accretion on the acquired loan portfolios. The effect of discount accretion on loan yields for the year ended December 31, 2011 and December 31, 2010 was approximately 80 basis points and 37 basis points, respectively. For the years ended December 31, 2011 and December 31, 2010, originated nonaccruing loans reduced the yield earned on loans by approximately 14 basis points and 20 basis points, respectively. Originated nonaccrual loans totaled $23.3 million at December 31, 2011 as compared to $26.5 million at December 31, 2010. Interest income on taxable and nontaxable investment securities increased $602,000 due to purchases of investment securities available for sale.

Total interest expense decreased by $1.9 million, or 22.7%, to $6.6 million for the year ended December 31, 2011 from $8.5 million for the year ended December 31, 2010. The decrease in interest expense was attributable to lower average rates paid on interest bearing liabilities partially offset by higher balances of interest bearing liabilities. The average rate paid on interest bearing liabilities decreased to 0.71% for the year ended December 31, 2011 from 1.02% for the year ended December 31, 2010. Total average interest bearing liabilities

 

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increased by $98.1 million, or 11.8%, to $931.1 million for the year ended December 31, 2011 from $833.1 million for the year ended December 31, 2010. The increase in average interest bearing liabilities was due primarily to the Cowlitz and Pierce Commercial Acquisitions. Deposit interest expense decreased $1.9 million, or 22.4%, to $6.5 million for the year ended December 31, 2011 compared to $8.4 million for the prior year. The decrease in deposit interest expense for the year ended December 31, 2011 is primarily a result of a 31 basis point decrease in the average cost of interest-bearing deposits, reflecting the relatively low interest rate environment.

Provision for Loan Losses.    The provision for loan losses increased $2.4 million, or 20.4%, to $14.4 million for the year ended December 31, 2011 from $12.0 million for the year ended December 31, 2010.

The provision for loan losses on originated loans decreased $6.8 million, or 56.8%, to $5.2 million for the year ended December 31, 2011 from $12.0 million for the year ended December 31, 2010. The Banks had net charge-offs of $4.9 million for the year ended December 31, 2011 compared to $16.1 million for the year ended December 31, 2010. The decrease in provision expense was substantially due to lower net charge-offs on originated loans during the year ended December 31, 2011 as compared the prior year. The ratio of net charge-offs to average total originated loans outstanding was 0.59% for the year ended December 31, 2011 and 2.24% for the year ended December 31, 2010.

The Banks have established comprehensive methodologies for determining the allowance for loan losses. On a quarterly basis the Banks perform 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. The allowance for loan losses on originated loans increased slightly by $255,000 to $22.3 million at December 31, 2011 from $22.1 million at December 31, 2010. As of December 31, 2011, the Banks identified $23.3 million of originated impaired loans and $13.8 million of originated performing restructured loans. Of those impaired and performing restructured loans, $10.9 million have no allowances for credit losses as their estimated collateral value is equal to or exceeds their carrying costs. The remaining $26.3 million have related allowances for credit losses totaling $4.5 million.

Based on the comprehensive methodology, management deemed the allowance for loan losses on originated loans of $22.3 million at December 31, 2011 (2.66% of total originated loans and 103.5% of nonperforming originated loans, excluding governmental guarantees) 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 purchased loans for the year ended December 31, 2011 totaled $9.3 million compared to no provision for loan losses on purchased loans for the year ended December 31, 2010.

Noninterest Income.    Total noninterest income decreased $13.0 million, or 69.4%, to $5.7 million for the year ended December 31, 2011 compared to $18.8 million for the prior year. The decrease was due substantially to an $11.8 million pretax gain on bank acquisitions in 2010 and a $2.3 million decrease in net FDIC loss sharing income partially offset by a $206,000 increase in service charges on deposits due mostly to deposits acquired through the Cowlitz and Pierce Commercial Acquisitions.

Noninterest Expense.    Noninterest expense increased $11.7 million or 30.8% to $49.7 million for the year ended December 31, 2011 compared to $38.0 million for the year ended December 31, 2010. The increase was due to increased compensation and employee benefits expense in the amount of $7.2 million, increased occupancy and equipment expense of $1.8 million and increased net other real estate owned expense (including valuation adjustments) of $652,000. These increases were substantially due to the Cowlitz and Pierce Commercial Acquisitions.

 

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The efficiency ratio for the year ended December 31, 2011 was 67.8% compared to 54.5% for the same period in the prior year. While growth strategies are being executed, the Company expects to incur higher noninterest expense as evidenced by the increasing efficiency ratio.

Income Tax Expense (Benefit).    The provision for income taxes decreased by $3.8 million to an expense of $2.6 million for the year ended December 31, 2011 from an expense of $6.4 million for the year ended December 31, 2010. The Company’s effective tax rate was 28.8% for the year ended December 31, 2011 compared to 32.5% for the same period in 2010. The decrease in the Company’s effective tax rate for the year ended December 31, 2011 is due substantially to an increase in balances of tax exempt securities and the lower level of net income before income taxes relative to the amount of tax-exempt income.

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, and advances from the FHLB of Seattle. 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 short-term investments to meet short-term liquidity needs. At December 31, 2012, cash and cash equivalents totaled $107.1 million, or 8.0% of total assets. Available for sale investment securities totaled $144.3 million at December 31, 2012; however, management generally does not consider those with maturities beyond one year to be a viable source of liquidity given that many available for sale securities are pledged to secure borrowing arrangements. Investment securities classified as either available for sale or held to maturity with maturities of one year or less amounted to $12.1 million, or 0.9% of total assets. At December 31, 2012, the Banks maintained credit facilities with the FHLB of Seattle for $156.3 million and credit facilities with the Federal Reserve Bank of San Francisco for $61.1 million, of which there were no borrowings outstanding as of December 31, 2012. The Banks also maintain advance lines with Zions Bank, Wells Fargo Bank, US Bank and Pacific Coast Bankers’ Bank to purchase federal funds totaling $57.8 million as of December 31, 2012. As of December 31, 2012, there were no overnight federal funds purchased.

During 2012 total assets decreased $23.4 million with cash on hand and in banks increasing $7.0 million, interest earning deposits decreasing $23.7 million, investment securities decreasing $2.3 million and net loans decreasing by $6.1 million as compared to the prior year-end. 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 $198.9 million at December 31, 2012 and $202.5 million at December 31, 2011. During the year ended December 31, 2012, we paid common stock dividends of $12.2 million, repurchased $6.0 million in common stock, realized net income of $13.3 million, recorded $63,000 in net unrealized losses on securities available for sale, net of tax, recorded $34,000 of market loss related to other than temporary impairment on securities held to maturity, net of tax, recorded $105,000 of accretion of market loss related to other than temporary impairment on securities held to maturity, net of tax, and realized the effects of exercising stock options, stock option compensation and earned ESOP and restricted stock shares totaling $1.3 million.

The Company and the Banks are subject to various regulatory capital requirements. As of December 31, 2012, the Company and the Banks were classified as “well capitalized” institutions under the criteria established by the Federal Deposit Insurance Act. Our initial public offering in January of 1998 significantly increased our

 

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capital to levels well in excess of regulatory requirements and our internal needs. Furthermore, on September 22, 2009, the Company completed the sale of 4.3 million shares of common stock in a public offering. The purchase price was $11.50 per share and net proceeds from the sale totaled approximately $46.6 million. On December 15, 2010, the Company completed the sale of 4.4 million shares of common stock in a public offering. The purchase price was $13.00 per share and net proceeds from the sale totaled approximately $54.1 million.

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 Banks, which are the Company’s predominant sources of income. On January 30, 2013, the Company’s Board of Directors declared a dividend of $0.08 per share payable on February 22, 2013 to shareholders of record on February 8, 2013.

Our capital levels are also modestly impacted by our 401(k) Employee Stock Ownership Plan and Trust (“KSOP”). The Employee Stock Ownership Plan (“ESOP”) purchased 2% of the common stock issued in the January 1998 stock offering and borrowed from the Company to fund the purchase of the Company’s common stock. The loan to the ESOP was repaid in full as of December 31, 2012. While outstanding, the loan was repaid principally from the Banks’ contributions to the ESOP. The Banks’ 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, our capital was increased, and the shares became outstanding for earnings per common share calculations. For the year ended December 31, 2012, the Company allocated or committed to be released to the ESOP 10,029 earned shares and has no unearned, restricted shares remaining to be released.

Contractual Obligations

The following table provides the amounts due under specified contractual obligations for the periods indicated as of December 31, 2012:

 

     December 31, 2012  
     Less than
1 year
     Over 1-3
years
     Over 3-5
years
     More
than
5 years
     Indeterminate
maturity(1)
     Total  
     (In thousands)  

Contractual payments by period:

                 

Deposits

   $ 160,610       $ 107,700       $ 20,407       $ 210       $ 829,044       $ 1,117,971   

Operating leases

     1,545         2,976         2,465         3,314         —          10,300   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total contractual obligations

   $ 162,155       $ 110,676       $ 22,872       $ 3,524       $ 829,044       $ 1,128,271   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1)

Represents interest bearing and noninterest bearing checking, money market and checking accounts which can generally be withdrawn on demand.

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: selling most long term, fixed rate, single-family residential mortgage loan originations; originating commercial loans and residential construction loans at variable interest rates repricing for terms generally one year or less; and offering noninterest bearing demand deposit accounts to businesses and

 

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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 positive 0-3 month “gap” of 18.6% and a positive 4-12 month “gap” of 14.2% as of December 31, 2012. These “gaps” measure the difference between the dollar amount of our interest