NOTE 2 - BUSINESS COMBINATION

On November 15, 2018, the Company completed its acquisition of Anchor Bancorp, pursuant to the Agreement and Plan of Merger dated as of July 17, 2018 by and between FS Bancorp and Anchor. Under the terms of the Merger Agreement, Anchor merged with and into FS Bancorp, with FS Bancorp as the surviving corporation. Immediately after the Anchor Acquisition, FS Bancorp merged Anchor Bank, a wholly-owned subsidiary of Anchor, with and into 1st Security Bank of Washington, a wholly-owned subsidiary of FS Bancorp, with 1st Security Bank of Washington as the surviving bank. Anchor’s principal business activities prior to the acquisition were attracting retail deposits from the general public and utilizing those deposits to originate loans including one-to-four-family residences, commercial real estate, and multi-family residences located in Western Washington. Anchor’s principal lending activity had consisted of the origination of loans secured by first mortgages on owner-occupied, one-to-four-family residences and loans for the construction of one-to-four-family residences, as well as consumer loans, with an emphasis on home equity loans and lines of credit. The primary objective for the acquisition was to significantly expand FS Bancorp’s presence throughout Western Washington, increase nonmaturity deposits, and offer additional banking and lending products to former Anchor customers as well as new customers.

The Anchor Acquisition was accounted for under the acquisition method of accounting and accordingly, the assets and liabilities were recorded at their fair values on November 15, 2018, the date of acquisition. Determining the fair value of assets and liabilities is a complicated process involving significant judgment regarding methods and assumptions used to calculate estimated fair values. For the years ended December 31, 2019 and 2018, there were no refinements to the fair value of these assets acquired and liabilities assumed.

The following table summarizes the estimated fair values of assets acquired and liabilities assumed at the date of acquisition:


	Acquired Book		Fair Value			Amount
November 15, 2018	Value		Adjustments			Recorded
Assets
Cash and cash equivalents	$	54,558	$	—		$	54,558
Securities available-for-sale		19,609		(54)			19,555
Loans receivable, net		361,596		(5,321)	(1)		356,275
Premises and equipment, net		8,411		3,354	(2)		11,765
Other real estate owned		689		—			689
Deferred tax asset		4,097		(3,358)			739
Mortgage servicing rights		218		564			782
Core deposit intangible ("CDI")		—		5,251	(3)		5,251
Other assets		25,231		18			25,249
Total assets acquired	$	474,409	$	454		$	474,863
Liabilities
Deposits	$	357,863	$	(1,052)	(4)	$	356,811
Borrowings		37,000		(282)			36,718
Other liabilities		9,286		63			9,349
Total liabilities assumed	$	404,149	$	(1,271)		$	402,878

Explanation of Fair Value Adjustments

(1) The fair value discount for acquired loans from Anchor was $5.3 million and was determined by separate adjustments to reflect a credit risk and marketability component and a yield component reflecting the differential between portfolio and market yields. The discount on acquired loans will be accreted back into interest income using the effective yield method.

(2) The fair value adjustment represents the difference between the fair value of the premises and the book value of those assets acquired. The Company utilized third-party valuations including appraisals, comparative market analysis, and tax-assessed values to assist in the determination of the fair value.

(3) The fair value adjustment of $5.3 million represents the value of the core deposit base assumed. This amount was recorded by the Company as an identifiable intangible asset and will be amortized as an expense on a straight-line basis over an estimated 10 year life of the core deposit base and will be reviewed for impairment annually. See “Note 22- Goodwill and Other Intangible Assets.”

(4) The fair value of transaction and savings accounts was determined to be equal to their carrying values. The fair value of time deposits was calculated using a discounted cash flow analysis that calculated the present value of the projected cash flows from the portfolio versus the present value of a similar portfolio with a similar maturity profile at current market rates. As of the acquisition date, the portfolio of time deposits was valued at a pre-tax discount of $1.1 million, or 0.65% of certificates of deposit acquired in the Anchor Acquisition of $162.9 million. This adjustment represents a difference in interest rates from the time deposits acquired and the estimated wholesale funding rates used in the application of fair value accounting. The discounted amount will be accreted into expense as an increase in interest expense over the maturity profile of the acquired time deposits.

The following table summarizes the consideration paid, the aggregate amount recognized for each major class of assets acquired and liabilities assumed by 1st Security Bank in the Anchor Acquisition:


	At November 15, 2018
Purchase price of Anchor
Fair value of FS Bancorp common stock at $46.54 (1) per share for 725,518 shares			$	33,766
Cash paid				30,805
Total purchase price				64,571

Fair value of assets acquired:
Cash and cash equivalents	$	54,558
Securities available-for-sale		19,555
Loans receivable, net		356,275
Premises and equipment		11,765
OREO		689
Deferred tax asset		739
Mortgage servicing rights		782
Intangible assets – CDI		5,251
Other assets		25,249
Total assets and identifiable intangible assets acquired	$	474,863

Fair value of liabilities assumed:
Deposits	$	356,811
Borrowings		36,718
Other liabilities		9,349
Total liabilities assumed	$	402,878

Fair value of net assets and identifiable intangible assets acquired				71,985
Bargain purchase gain			$	(7,414)

_________________________

(1)

Stock price is as of the closing date.

The application of the acquisition method of accounting resulted in a bargain purchase gain of $7.4 million for the year ended December 31, 2018 and was reported as a component of noninterest income on our Consolidated Statements of Income. The bargain purchase gain was primarily due to the decline in the value of the stock portion of the merger consideration between signing and closing the Anchor Acquisition which resulted in the purchase price for Anchor being less than the fair market value of the net assets acquired. In the merger, each Anchor shareholder received 0.291 of a share of FS Bancorp common stock for each share of Anchor common stock along with $12.40 in cash.

The Company determined that the disclosure requirements related to the amounts of revenues and earnings of Anchor included in the consolidated statements of operations since the November 15, 2018 acquisition date is impracticable. The financial activity and operating results of Anchor were commingled with the Company’s financial activity and operating results as of the acquisition date.