(2) Business Combinations

On April 16, 2010, the Bank acquired certain assets and assumed certain liabilities of City Bank, Lynnwood, Washington, from the Federal Deposit Insurance Corporation (“FDIC”), as receiver of City Bank, in an FDIC-assisted transaction. As part of the Purchase and Assumption Agreement, the Bank and the FDIC entered into loss share agreements (each, a “loss share agreement” and collectively, the “loss share agreements”). The Bank will share in the losses, which begins with the Bank incurring the first 2% of losses, on the covered assets. After the first 2% of losses on covered assets, the FDIC will absorb 80% of losses and share in 80% of loss recoveries on 100% of the covered loan portfolio. The loss share agreement for commercial and single family residential mortgage loans are in effect for five years and ten years, respectively, from the April 16, 2010 acquisition date and the loss recovery provisions for such loans are in effect for eight years and ten years, respectively, from the acquisition date.

In April 2020, approximately ten years following the acquisition date, the Bank is required to make a payment to the FDIC in the event that losses on covered assets under the loss share agreements have been less than the stated threshold level. The payment amount will be 50% of the excess, if any, of (i) 20% of the intrinsic loss estimate ($111.0 million) minus (ii) the sum of (a) 25% of the asset discount (or 25% of the asset discount of ($50.7 million)), plus (b) 25% of cumulative loss share payments (as defined in the Agreement), plus (c) the cumulative servicing amount received by the Bank from the FDIC on covered assets. At December 31, 2011, the Bank estimates that there will be no liability under this provision.

The Bank purchased certain assets of City Bank from the FDIC including (at fair value) approximately $321.6 million in loans, $280.0 million of cash and cash equivalents and $9.1 million in investment securities. The Bank also assumed liabilities with fair value of approximately $650.1 million in deposits, $50.1 million in FHLB advances and $17.8 million in other liabilities. The expected net reimbursements under the loss share agreements were recorded at estimated fair value of $84.4 million on the acquisition date. In addition to assuming certain liabilities in the transaction, the Company issued an equity appreciation instrument to the FDIC as part of the consideration. This instrument was valued at $2.1 million when issued. On April 27, 2010, the FDIC exercised its equity appreciation instrument. The application of the acquisition method of accounting resulted in the recognition goodwill of $3.2 million, which has been reported in the Consolidated Statements of Financial Condition.

On September 24, 2010, the Bank assumed certain deposit liabilities and acquired certain assets of North County Bank, Arlington, Washington from the FDIC as receiver for North County Bank and entered into a Purchase and Assumption Agreement with the FDIC. As part of the Agreement, the Bank and the FDIC entered into a loss sharing arrangement covering future losses incurred on acquired or “covered” loans and other real estate owned (“OREO”). On single family loans and OREO, the FDIC will absorb: (i) 80% of losses on the first $7.8 million of losses incurred; (ii) 0% of losses on $7.8 million to $12.3 million of losses incurred; and (iii) 80% of losses above $12.3 million of losses incurred. On commercial and non-single family loans and OREO, the FDIC will absorb: (i) 80% of losses on the first $33.9 million of losses incurred; (ii) 0% of losses on $33.9 million to $47.9 million of losses incurred; and (iii) 80% of losses above $47.9 million of losses incurred. The FDIC will share in loss recoveries on the covered loan and OREO portfolio.

In September 2020, approximately ten years following the acquisition date, the Bank is required to make a payment to the FDIC in the event that losses on covered assets under the loss share agreements have been less than the stated threshold level. The payment amount will be 50% of the excess, if any, of (i) 20% of the intrinsic loss estimate ($46.9 million) minus (ii) the sum of (a) 20% of the net loss amount, plus (b) 25% of the asset discount bid ($62.5 million), plus (c) 3.5% of total loss share assets at acquisition. At December 31, 2011, the Bank estimated a liability of $3.5 million under this provision.

The Bank purchased certain assets of North County Bank from the FDIC including (at fair value) approximately $133.1 million in loans, $71.3 million of cash and cash equivalents, $21.3 million in investment securities and $12.4 million in OREO. The Bank also assumed liabilities with fair values of approximately $257.8 million in deposits and $9.5 million in other liabilities. The expected reimbursements under the loss share agreements were recorded at estimated fair value of $39.0 million on the acquisition date. The application of the acquisition method of accounting resulted in a net after-tax gain of $13.0 million, which has been reported as a component of noninterest income.

Merger-related expenses of $324 thousand and $2.1 million have been incurred in connection with the acquisitions of City Bank and North County Bank for the years ended December 31, 2011 and 2010, respectively, and have been recognized as a separate line item on the Consolidated Statements of Income.

The Company refers to the acquired loan portfolios and other real estate owned as “covered loans” and “covered other real estate owned”, respectively, and these are presented as separate line items in the Consolidated Statement of Condition. Collectively, these balances are referred to as “covered assets.”

The assets acquired and liabilities assumed from the City Bank and North County Bank acquisitions have been accounted for under the acquisition method of accounting (formerly the purchase method). The assets and liabilities, both tangible and intangible, were recorded at estimated fair values as of the acquisition date. The fair values of the assets acquired and liabilities assumed were determined based on the requirements of FASB ASC 805. The foregoing fair value amounts are subject to change for up to one year after the closing date of the acquisitions as additional information relating to closing date fair values becomes available. The amounts are also subject to adjustments based upon final settlement with the FDIC. In addition, the tax treatment of FDIC-assisted acquisitions is complex and subject to interpretations that may result in future adjustments of deferred taxes as of the acquisition date. The terms of the agreements provide for the FDIC to indemnify the Bank against claims with respect to liabilities of City Bank and North County Bank not assumed by the Bank and certain other types of claims identified in the agreements. The application of the acquisition method of accounting resulted in the recognition of goodwill of $3.2 million in the City Bank acquisition and a pre-tax bargain purchase gain of $19.9 million in the North County Bank acquisition.

During 2011, the Company discovered an error related to the initial accounting for the assets acquired and liabilities assumed related to the acquisition of City Bank. Subsequent to the one year adjustment window, the Company determined that goodwill was overstated and the deferred tax assset was understated. The correction of the error on the December 31, 2011 and December 31, 2010 Consolidated Statements of Condition decreased goodwill by $1.7 million and increased the deferred tax asset by $1.7 million. The Company deemed the correction of the error as immaterial to the financial statements and had no impact on the Consolidated Statement of Income for the years ended December 31, 2011, 2010 or 2009.

A summary of the net assets (liabilities) received from the FDIC and the estimated fair value adjustments are presented below:

(dollars in thousands)	City Bank			North County Bank
	April 16, 2010			September 24, 2010
Cost basis net assets (liabilities)	$	(54,943	)	$	11,217
Cash payment received from the FDIC		99,445			46,860
Net assets acquired before fair value adjustments		44,502			58,077

Fair value adjustments:
Covered loans		(126,378	)		(67,360	)
Covered other real estate owned		(551	)		(6,842	)
Core deposit intangible		3,293			50
FDIC indemnification asset		84,393			39,000
Visa Class B common stock		2,025			-
Other assets		(597	)		(89	)
Deposits		(6,000	)		(956	)
FHLB advances		(103	)		-
Other liabilities		(3,271	)		(1,955	)
FDIC equity appreciation instrument		(2,131	)		-
Pre-tax bargain purchase gain on acquisition		(4,818	)		19,925
Deferred income tax asset (liability)		1,653			(6,974	)
Bargain purchase gain (goodwill) on acquisition	$	(3,165	)	$	12,951

In FDIC-assisted transactions, only certain assets and liabilities are transferred to the acquirer and, depending on the nature and amount of the acquirer's bid, the FDIC may be required to make a cash payment to the acquirer. In the City Bank acquisition, cost basis net liabilities of $54.9 million and a cash payment received from the FDIC of $99.4 million were transferred to the Company. The goodwill represents the excess of the estimated fair value of the liabilities assumed over the estimated fair value of the assets acquired.

In the North County Bank acquisition, cost basis net assets of $11.2 million and a cash payment received from the FDIC of $46.9 million were transferred to the Company. The bargain purchase gain represents the excess of the estimated fair value of the assets acquired over the estimated fair value of the liabilities assumed.

The Bank did not immediately acquire all the real estate, banking facilities, furniture or equipment of City Bank or North County Bank as part of the purchase and assumption agreements. However, the Bank had the option to purchase or lease the real estate and furniture and equipment from the FDIC. The term of this option expired 90 days from the acquisition dates. Acquisition costs of the real estate and furniture and equipment are based on current mutually agreed upon appraisals. Prior to the expiration of option terms, the Bank exercised its option and acquired the facilities and furnishings of the eight City Bank locations for $11.1 million. For North County Bank, the Bank exercised its option to assumed the lease of three North County Bank locations and acquired furnishings for $145 thousand.

The statement of assets acquired and liabilities assumed at their estimated fair values of City Bank and North County Bank are presented below:

(dollars in thousands)	City Bank		North County Bank
	April 16, 2010		September 24, 2010
Assets
Cash and due from banks	$	277,907	$	66,770
Interest-bearing deposits		2,078		4,532
Total cash and cash equivalents		279,985		71,302

Investment securities, available for sale		9,120		21,286
Covered loans		321,581		133,136
FHLB stock		4,744		402
Goodwill		3,165		-
Core deposit intangible		3,293		50
Covered other real estate owned		5,798		12,412
FDIC indemnification asset		84,393		39,000
Other assets		5,940		2,695
Total assets acquired	$	718,019	$	280,283

Liabilities
Deposits	$	650,104	$	257,845
FHLB advances		50,152		-
Other liabilities		17,763		9,487
Total liabilities assumed		718,019		267,332
Net assets acquired/bargain purchase gain on acquisition		-		12,951
Total liabilities assumed and net assets acquired	$	718,019	$	280,283

The acquisition of assets and liabilities of City Bank and North County Bank were significant at a level to require disclosure of one year of historical financial statements and related pro forma financial disclosure. However, given the pervasive nature of the loss sharing agreement entered into with the FDIC, the historical information of City Bank and North County Bank are much less relevant for purposes of assessing the future operations of the combined entity. In addition, prior to closure, City Bank had not completed an audit of their financial statements, and the Company determined that audited financial statements are not and will not be reasonably available for the year ended December 31, 2009. Given these considerations, the Company requested, and received, relief from the Securities and Exchange Commission from submitting certain historical and proforma financial information of City Bank and North County Bank.