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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549
 
 
 
FORM 10-Q
 
 


x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2018 or

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from __________ to __________
Commission File Number 000-29480 

 
HERITAGE FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter) 
 
 
 
Washington
 
91-1857900
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
 
 
201 Fifth Avenue SW, Olympia, WA
 
98501
(Address of principal executive offices)
 
(Zip Code)
(360) 943-1500
(Registrant’s telephone number, including area code) 

 
 
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  ý    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  ý    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer  ý
 
Accelerated filer  ¨
 
 
Non-accelerated filer  ¨ (Do not check if a smaller reporting company)
 
Smaller reporting company  ¨
 
 
 
 
Emerging growth company  ¨
 
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).   Yes  ¨    No  ý
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the last practicable date:
As of July 31, 2018 there were 36,868,578 shares of the registrant's common stock, no par value per share, outstanding.


Table of Contents


HERITAGE FINANCIAL CORPORATION
FORM 10-Q
June 30, 2018
TABLE OF CONTENTS

 
 
 
 
Page
 
 
 
 
 
 
PART I.
ITEM 1.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
NOTE 1.
 
 
NOTE 2.
 
 
NOTE 3.
 
 
NOTE 4.
 
 
NOTE 5.
 
 
NOTE 6.
 
 
NOTE 7.
 
 
NOTE 8.
 
 
NOTE 9.
 
 
NOTE 10.
 
 
NOTE 11.
 
 
NOTE 12.
 
 
NOTE 13.
 
 
NOTE 14.
 
 
NOTE 15.
 
 
NOTE 16.
 
 
NOTE 17.
ITEM 2.
ITEM 3.
ITEM 4.
Part II.
ITEM 1.
ITEM 1A.
ITEM 2.
ITEM 3.
ITEM 4.
ITEM 5.
ITEM 6.
 

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FORWARD LOOKING STATEMENTS:
This Quarterly Report on Form 10-Q ("Form 10-Q") may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements often include the words “believes,” “expects,” “anticipates,” “estimates,” “forecasts,” “intends,” “plans,” “targets,” “potentially,” “probably,” “projects,” “outlook” or similar expressions or future or conditional verbs such as “may,” “will,” “should,” “would” and “could.” 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 from our recent mergers with Puget Sound Bancorp, Inc., and Premier Commercial Bancorp, 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 effected by deterioration in the housing and commercial real estate markets, which may lead to increased losses and nonperforming assets in our loan portfolio, and may result in our allowance for loan losses no longer 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 bank regulators, including the possibility that any such regulatory authority may, among other things, initiate an enforcement action against the Company or our bank subsidiary which could require us to increase our allowance for loan losses, write-down assets, change our regulatory capital position, affect our ability to borrow funds or maintain or increase deposits, or impose additional requirements on us, any of which could affect our ability to continue our growth through mergers, acquisitions or similar transactions and adversely affect our liquidity and earnings; legislative or regulatory changes that adversely affect our business including but not limited to, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and implementing regulations, changes in regulatory policies and principles, or the interpretation of regulatory capital or other rules as a result of Basel III; our ability to control operating costs and expenses; increases in premiums for deposit insurance; the use of estimates in determining fair value of certain of our assets, which estimates may prove to be incorrect and result in significant declines in valuation; difficulties in reducing risk associated with the loans on our Condensed Consolidated Statements of Financial Condition; staffing fluctuations in response to product demand or the implementation of corporate strategies that affect our workforce and potential associated charges; disruptions, security breaches, or other adverse events, failures or interruptions in, or attacks on, our information technology systems or on the third-party vendors who perform several of our critical processing functions; our ability to retain key members of our senior management team; costs and effects of litigation, including settlements and judgments; our ability to implement our growth strategies; 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 ("FASB"), including additional guidance and interpretation on accounting issues and details of the implementation of new accounting methods; and other economic, competitive, governmental, regulatory, and technological factors affecting our operations, pricing, products and services and other risks detailed from time to time in our filings with the Securities and Exchange Commission including our Annual Report on Form 10-K for the year ended December 31, 2017.
The Company cautions readers not to place undue reliance on any forward-looking statements. Moreover, you should treat these statements as speaking only as of the date they are made and based only on information then actually known to the Company. The Company does not undertake and specifically disclaims any obligation to revise any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements. These risks could cause our actual results for future periods to differ materially from those expressed in any forward-looking statements by, or on behalf of, us, and could negatively affect the Company’s operating results and stock price performance.
As used throughout this report, the terms “we”, “our”, “us”, or the “Company” refer to Heritage Financial Corporation and its consolidated subsidiaries, unless the context otherwise requires.

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PART I.     FINANCIAL INFORMATION

ITEM 1.     FINANCIAL STATEMENTS

HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (Unaudited)
(In thousands, except shares)
 
 
June 30, 2018
 
December 31, 2017
ASSETS
 
 
 
 
Cash on hand and in banks
 
$
94,210


$
78,293

Interest earning deposits
 
35,733


24,722

Cash and cash equivalents
 
129,943


103,015

Investment securities available for sale, at fair value
 
873,670


810,530

Loans held for sale
 
3,598

 
2,288

Loans receivable, net
 
3,328,288

 
2,849,071

Allowance for loan losses
 
(33,972
)
 
(32,086
)
Total loans receivable, net
 
3,294,316

 
2,816,985

Other real estate owned
 
434


—

Premises and equipment, net
 
75,364


60,325

Federal Home Loan Bank stock, at cost
 
8,616


8,347

Bank owned life insurance
 
82,031

 
75,091

Accrued interest receivable
 
13,482


12,244

Prepaid expenses and other assets
 
104,718


99,328

Other intangible assets, net
 
15,767


6,088

Goodwill
 
187,549


119,029

Total assets
 
$
4,789,488


$
4,113,270

LIABILITIES AND STOCKHOLDERS' EQUITY
 
 
 
 
Deposits
 
$
3,968,935

 
$
3,393,060

Federal Home Loan Bank advances
 
75,500

 
92,500

Junior subordinated debentures
 
20,156

 
20,009

Securities sold under agreement to repurchase
 
22,168

 
31,821

Accrued expenses and other liabilities
 
63,206

 
67,575

Total liabilities
 
4,149,965

 
3,604,965

Stockholders’ equity:
 
 
 
 
Preferred stock, no par value, 2,500,000 shares authorized; no shares issued and outstanding at June 30, 2018 and December 31, 2017
 
—

 
—

Common stock, no par value, 50,000,000 shares authorized; 34,021,094 and 29,927,746 shares issued and outstanding at June 30, 2018 and December 31, 2017, respectively
 
491,026

 
360,590

Retained earnings
 
159,803

 
149,013

Accumulated other comprehensive loss, net
 
(11,306
)
 
(1,298
)
Total stockholders’ equity
 
639,523

 
508,305

Total liabilities and stockholders’ equity
 
$
4,789,488

 
$
4,113,270

See accompanying Notes to Condensed Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
(In thousands, except per share amounts)
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2018
 
2017
 
2018
 
2017
INTEREST INCOME
 
 
 
 
 
 
 
 
Interest and fees on loans
 
$
41,141

 
$
31,500

 
$
79,300

 
$
61,985

Taxable interest on investment securities
 
4,068

 
3,141

 
7,597

 
6,190

Nontaxable interest on investment securities
 
1,220

 
1,304

 
2,561

 
2,572

Interest on other interest earning assets
 
242

 
96

 
460

 
143

Total interest income
 
46,671

 
36,041

 
89,918

 
70,890

INTEREST EXPENSE
 
 
 
 
 
 
 
 
Deposits
 
2,195

 
1,407

 
4,155

 
2,673

Junior subordinated debentures
 
315

 
249

 
598

 
487

Other borrowings
 
418

 
251

 
585

 
464

Total interest expense
 
2,928

 
1,907

 
5,338

 
3,624

Net interest income
 
43,743

 
34,134

 
84,580

 
67,266

Provision for loan losses
 
1,750

 
1,131

 
2,902

 
1,998

Net interest income after provision for loan losses
 
41,993

 
33,003

 
81,678

 
65,268

NONINTEREST INCOME
 
 
 
 
 
 
 
 
Service charges and other fees
 
4,695

 
4,426

 
9,238

 
8,639

Gain on sale of investment securities, net
 
18

 
117

 
53

 
117

Gain on sale of loans, net
 
706

 
4,138

 
1,580

 
5,333

Interest rate swap fees
 
309

 
282

 
360

 
415

Other income
 
1,845

 
1,746

 
3,890

 
3,568

Total noninterest income
 
7,573

 
10,709

 
15,121

 
18,072

NONINTEREST EXPENSE
 
 
 
 
 
 
 
 
Compensation and employee benefits
 
19,321

 
16,272

 
40,688

 
32,296

Occupancy and equipment
 
4,810

 
3,818

 
9,437

 
7,628

Data processing
 
2,507

 
2,002

 
5,112

 
3,917

Marketing
 
823

 
805

 
1,631

 
1,612

Professional services
 
3,529

 
1,053

 
6,366

 
2,062

State and local taxes
 
716

 
639

 
1,404

 
1,188

Federal deposit insurance premium
 
375

 
357

 
730

 
657

Other real estate owned, net
 
—

 
21

 
—

 
52

Amortization of intangible assets
 
796

 
323

 
1,591

 
647

Other expense
 
2,829

 
2,519

 
5,494

 
4,973

Total noninterest expense
 
35,706

 
27,809

 
72,453

 
55,032

Income before income taxes
 
13,860

 
15,903

 
24,346

 
28,308

Income tax expense
 
2,003

 
4,075

 
3,402

 
7,164

Net income
 
$
11,857

 
$
11,828

 
$
20,944

 
$
21,144

Basic earnings per common share
 
$
0.35

 
$
0.40

 
$
0.62

 
$
0.71

Diluted earnings per common share
 
$
0.35

 
$
0.40

 
$
0.62

 
$
0.71

Dividends declared per common share
 
$
0.15

 
$
0.13

 
$
0.30

 
$
0.25

See accompanying Notes to Condensed Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)
(In thousands)

 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2018
 
2017
 
2018
 
2017
Net income
 
$
11,857

 
$
11,828

 
$
20,944

 
$
21,144

Change in fair value of investment securities available for sale, net of tax of $(630), $1,491, $(2,638) and $2,285, respectively
 
(2,358
)
 
2,766

 
(9,874
)
 
4,239

Reclassification adjustment for net gain from sale of investment securities available for sale included in income, net of tax of $(4), $(41), $(12) and $(41), respectively
 
(14
)
 
(76
)
 
(41
)
 
(76
)
Other comprehensive (loss) income
 
(2,372
)
 
2,690

 
(9,915
)
 
4,163

Comprehensive income
 
$
9,485

 
$
14,518

 
$
11,029

 
$
25,307

See accompanying Notes to Condensed Consolidated Financial Statements.


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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Unaudited)
(In thousands, except per share amounts)
 
Number of
common
shares
 
Common
stock
 
Retained
earnings
 
Accumulated
other
comprehensive income (loss), net
 
Total
stock-
holders’
equity
Balance at December 31, 2016
29,955

 
$
359,060

 
$
125,309

 
$
(2,606
)
 
$
481,763

Restricted stock awards forfeited
(7
)
 
—

 
—

 
—

 
—

Exercise of stock options
8

 
109

 
—

 
—

 
109

Stock-based compensation expense
—

 
1,040

 
—

 
—

 
1,040

Common stock repurchased
(28
)
 
(674
)
 
—

 
—

 
(674
)
Net income
—

 
—

 
21,144

 
—

 
21,144

Other comprehensive income, net of tax
—

 
—

 
—

 
4,163

 
4,163

Cash dividends declared on common stock ($0.25 per share)
—

 
—

 
(7,497
)
 
—

 
(7,497
)
Balance at June 30, 2017
29,928

 
$
359,535

 
$
138,956

 
$
1,557

 
$
500,048

 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2017
29,928

 
$
360,590

 
$
149,013

 
$
(1,298
)
 
$
508,305

Restricted stock units vested, net of forfeitures of restricted stock awards
30

 
—

 
—

 
—

 
—

Exercise of stock options
3

 
47

 
—

 
—

 
47

Stock-based compensation expense
—

 
1,307

 
—

 
—

 
1,307

Common stock repurchased
(52
)
 
(1,688
)
 
—

 
—

 
(1,688
)
Net income
—

 
—

 
20,944

 
—

 
20,944

Other comprehensive loss, net of tax
—

 
—

 
—

 
(9,915
)
 
(9,915
)
Common stock issued in business combination
4,112

 
130,770

 
—

 
—

 
130,770

Cash dividends declared on common stock ($0.30 per share)
—

 
—

 
(10,247
)
 
—

 
(10,247
)
ASU 2016-01 implementation
—

 
—

 
93

 
(93
)
 
—

Balance at June 30, 2018
34,021

 
$
491,026

 
$
159,803

 
$
(11,306
)
 
$
639,523

See accompanying Notes to Condensed Consolidated Financial Statements.


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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(In thousands)
 
 
Six Months Ended June 30,
 
 
2018
 
2017
Cash flows from operating activities:
 
 
 
 
Net income
 
$
20,944

 
$
21,144

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
Depreciation and amortization
 
5,140

 
5,459

Changes in net deferred loan costs, net of amortization
 
(254
)
 
(509
)
Provision for loan losses
 
2,902

 
1,998

Net change in accrued interest receivable, prepaid expenses and other assets, accrued expenses and other liabilities
 
419

 
3,482

Stock-based compensation expense
 
1,307

 
1,040

Amortization of intangible assets
 
1,591

 
647

Origination of loans held for sale
 
(40,048
)
 
(54,449
)
Proceeds from sale of loans
 
39,962

 
71,436

Earnings on bank owned life insurance
 
(666
)
 
(747
)
Gain on sale of loans, net
 
(1,580
)
 
(5,333
)
Gain on sale of investment securities, net
 
(53
)
 
(117
)
Gain on sale of assets held for sale
 
—

 
(53
)
Impairment of assets held for sale
 
75

 
—

Loss on sale or write-off of furniture, equipment and leasehold improvements
 
—

 
12

Net cash provided by operating activities
 
29,739

 
44,010

Cash flows from investing activities:
 
 
 
 
Loans originated, net of principal payments
 
(96,127
)
 
(135,709
)
Maturities, calls and payments of investment securities available for sale
 
41,436

 
52,461

Purchase of investment securities available for sale
 
(147,360
)
 
(57,972
)
Purchase of premises and equipment
 
(16,659
)
 
(1,382
)
Proceeds from sales of other loans
 
4,532

 
21,319

Proceeds from sales of investment securities available for sale
 
107,579

 
15,032

Proceeds from sale of assets held for sale
 
—

 
265

Proceeds from redemption of Federal Home Loan Bank stock
 
22,138

 
16,456

Purchases of Federal Home Loan Bank stock
 
(21,784
)
 
(17,975
)
Proceeds from sale of premises and equipment
 
21

 
—

Capital contribution to low-income housing tax credit partnership
 
(8,169
)
 
(7
)
Net cash received from acquisitions
 
80,133

 
—

Net cash used in investing activities
 
(34,260
)
 
(107,512
)
Cash flows from financing activities:
 
 
 
 
Net increase in deposits
 
69,990

 
61,602

Federal Home Loan Bank advances
 
536,450

 
442,700

Repayments of Federal Home Loan Bank advances
 
(553,450
)
 
(411,400
)
Common stock cash dividends paid
 
(10,247
)
 
(7,497
)
Net decrease in securities sold under agreement to repurchase
 
(9,653
)
 
(849
)
Proceeds from exercise of stock options
 
47

 
109

Repurchase of common stock
 
(1,688
)
 
(674
)
Net cash provided by financing activities
 
31,449

 
83,991


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Six Months Ended June 30,
 
 
2018
 
2017
Net increase in cash and cash equivalents
 
26,928

 
20,489

Cash and cash equivalents at beginning of period
 
103,015

 
103,745

Cash and cash equivalents at end of period
 
$
129,943

 
$
124,234

 
 
 
 
 
Supplemental disclosures of cash flow information:
 
 
 
 
Cash paid for interest
 
$
5,302

 
$
3,688

Cash paid for income taxes
 
2,724

 
1,007

 
 
 
 
 
Supplemental non-cash disclosures of cash flow information:
 
 
 
 
Transfers of loans receivable to other real estate owned
 
$
434

 
$
32

Transfers of loans receivable to loans held for sale
 
—

 
5,779

Transfers of properties held for sale recorded in premises and equipment, net to prepaid expenses and other assets
 
221

 
2,687

Purchases of investment securities available for sale not settled
 
—

 
2,268

     Business Combination:
 
 
 
 
Common stock issued for business combinations
 
130,770

 
—

Assets acquired (liabilities assumed) in acquisitions:
 
 
 
 
Investment securities available for sale
 
80,353

 
—

Loans receivable
 
388,462

 
—

Premises and equipment
 
732

 
—

Federal Home Loan Bank stock
 
623

 
—

Accrued interest receivable
 
1,448

 
—

Bank owned life insurance
 
6,264

 
—

Prepaid expenses and other assets
 
1,354

 
—

Other intangible assets
 
11,270

 
—

Deposits
 
(505,885
)
 
—

Accrued expenses and other liabilities
 
(2,504
)
 
—

See accompanying Notes to Condensed Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

(1)
Description of Business, Basis of Presentation, Significant Accounting Policies and Recently Issued Accounting Pronouncements
(a) Description of Business
Heritage Financial Corporation ("Heritage" or the “Company”) is a bank holding company that was incorporated in the State of Washington in August 1997. The Company is primarily engaged in the business of planning, directing and coordinating the business activities of its wholly-owned subsidiary, Heritage Bank (the “Bank”). The Bank is a Washington-chartered commercial bank and its deposits are insured by the Federal Deposit Insurance Corporation ("FDIC"). The Bank is headquartered in Olympia, Washington and conducts business from its 59 branch offices as of June 30, 2018 located throughout Washington State and the greater Portland, Oregon area. The Bank’s business consists primarily of commercial lending and deposit relationships with small businesses and their owners in its market areas and attracting deposits from the general public. The Bank also makes real estate construction and land development loans, consumer loans and originates first mortgage loans on residential properties primarily located in its market areas.
On January 16, 2018, the Company completed the acquisition of Puget Sound Bancorp, Inc. (“Puget Sound”), the holding company for Puget Sound Bank, both of Bellevue, Washington (“Puget Sound Merger”). See Note (2) Business Combination for additional information on the merger.
On March 8, 2018, the Company entered into a definitive agreement to acquire Premier Commercial Bancorp, ("Premier Commercial") and its wholly-owned bank subsidiary, Premier Community Bank, both of Hillsboro, Oregon (the "Premier Merger"). The Premier Merger was completed on July 2, 2018. See Note (17) Subsequent Event for additional information on the merger.

(b) Basis of Presentation
The accompanying unaudited Condensed Consolidated Financial Statements have been prepared in accordance with the accounting principles generally accepted in the United States (“U.S. GAAP”) for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC"). Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. It is recommended that these unaudited Condensed Consolidated Financial Statements and accompanying Notes be read with the audited Consolidated Financial Statements and the accompanying Notes included in the Company's Annual Report on Form 10-K for the year ended December 31, 2017 (“2017 Annual Form 10-K”). In management's opinion, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three and six months ended June 30, 2018 are not necessarily indicative of the results that may be expected for the year ending December 31, 2018. In preparing the unaudited Condensed Consolidated Financial Statements, management is required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures. Management believes that the judgments, estimates and assumptions used in the preparation of the financial statements are appropriate based on the facts and circumstances at the time. Actual results, however, could differ significantly from those estimates.

(c) Significant Accounting Policies
The significant accounting policies used in preparation of the Company's Condensed Consolidated Financial Statements are disclosed in the 2017 Annual Form 10-K. There have not been any material changes in the Company's significant accounting policies from those contained in the 2017 Annual Form 10-K, except for the accounting policy relating to revenue from contracts with customers adopted January 1, 2018, as discussed below.
Revenue from Contracts with Customers
Accounting Standards Codification Topic 606, Revenue from Contracts with Customers, (“ASC 606”), as amended, was adopted by the Company on January 1, 2018. ASC 606 applies to all contracts with customers to provide goods or services in the ordinary course of business, except for contracts that are specifically excluded from its scope.  The Company's revenues are primarily composed of interest income on financial instruments, such as loans and investment securities, which are excluded from the scope of ASC 606.  Descriptions of our revenue-generating activities that are within the scope ASC 606, which are presented in Service Charges and Other Fees and Other Income on the Company’s Condensed Consolidated Statement of Income, are as follows:

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•
Service Charges on Deposit Accounts: The Company earns fees from its deposit customers from a variety of deposit products and services.  Non-transaction based fees such as account maintenance fees and monthly statement fees are considered to be provided to the customer under a day-to-day contract with ongoing renewals. Revenues for these non-transaction fees are earned over the course of a month, representing the period over which the Company satisfies the performance obligation.  Transaction-based fees such as non-sufficient fund charges, stop payment charges and wire fees are recognized at the time the transaction is executed as the contract duration does not extend beyond the service performed. 
•
Wealth Management and Trust Services: The Company earns fees from contracts with customers for fiduciary and brokerage activities. Revenues are generally recognized on a monthly basis and are generally based on a percentage of the customer’s assets under management or based on investment or insurance solutions that are implemented for the customer.
•
Merchant Processing Services and Debit and Credit Card Fees: The Company earns fees from cardholder transactions conducted through third party payment network providers which consist of (i) interchange fees earned from the payment network as a debit card issuer, (ii) referral fee income, and (iii) ongoing merchant fees earned for referring customers to the payment processing provider.  These fees are recognized when the transaction occurs, but may settle on a daily or monthly basis. 
    
(d) Recently Issued Accounting Pronouncements
FASB ASU 2014-09, Revenue from Contracts with Customers, (as amended by FASB ASU 2015-14; FASB ASU 2016-08; FASB ASU 2016-10 and FASB ASU 2016-12), was issued in May 2014. Under this Accounting Standard Update ("ASU" or "Update"), the Financial Accounting Standards Board ("FASB") created a new Topic 606 which is in response to a joint initiative of FASB and the International Accounting Standards Board to clarify the principles for recognizing revenue and to develop a common revenue standard for U.S. GAAP and international financial reporting standards that would:
•
Remove inconsistencies and weaknesses in revenue requirements.
•
Provide a more robust framework for addressing revenue issues.
•
Improve comparability of revenue recognition practices across entities, industries, jurisdictions and capital markets.
•
Provide more useful information to users of financial statements through improved disclosure requirements.
•
Simplify the preparation of financial statements by reducing the number of requirements to which an entity must refer.
The Company adopted the revenue recognition guidance, as amended, on January 1, 2018 using the modified retrospective approach. A significant amount of the Company’s revenues are derived from interest income on financial assets, which are excluded from the scope of the amended guidance. With respect to noninterest income and related disclosures, the Company has identified and evaluated the revenue streams and underlying revenue contracts within the scope of the guidance. The Company did not identify any significant changes in the timing of revenue recognition when considering the amended accounting guidance. The adoption of the Update did not have a material impact on the Company's Condensed Consolidated Financial Statements, but the adoption did change certain disclosure requirements as described in Significant Accounting Policies above.
FASB ASU 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities (Subtopic 825-10), was issued in January 2016, to enhance the reporting model for financial instruments to provide users of financial statements with more decision-useful information. This Update contains several provisions, including but not limited to (1) requiring equity investments, with certain exceptions, to be measured at fair value with changes in fair value recognized in net income; (2) simplifying the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment; (3) eliminating the requirement to disclose the method(s) and significant assumptions used to estimate fair value; and (4) requiring separate presentation of financial assets and liabilities by measurement category and form of financial asset on the balance sheet or the accompanying notes to the financial statements. The Update also changes certain financial statement disclosure requirements, including requiring disclosures of the fair value of financial instruments be made on the basis of exit price. The Company adopted this Update effective January 1, 2018 using the cumulative catch-up transition method. This change resulted in a cumulative adjustment of $93,000 from accumulated other comprehensive loss, net to retained earnings for the unrealized gain related to the Company's equity security. The Company's processes and procedures utilized to estimate the fair value of loans receivable and certificate of deposit accounts for disclosure

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requirements were additionally changed due to adoption of this Update. Previously, the Company valued these items using an entry price notion. This ASU emphasized that these instruments be measured using the exit price notion; accordingly, the Company refined its calculation as part of adopting this Update. Prior period information has not been updated to conform with the new guidance. See the Condensed Consolidated Statements of Stockholders' Equity and Note (14) Fair Value Measurements.
FASB ASU 2016-02, Leases (Topic 842) was originally issued in February 2016, to increase transparency and comparability of leases among organizations and to disclose key information about leasing arrangements. The Update sets out the principles for the recognition, measurement, presentation and disclosure of leases for both lessees and lessors. The Update requires lessees to apply a dual approach, classifying leases as either a finance or operating lease. This classification will determine whether the lease expense is recognized based on an effective interest method or on a straight-line basis over the term of the lease. A lessee is also required to record a right-of-use asset and a lease liability for all leases with a term greater than 12 months regardless of their classification. All cash payments will be classified within operating activities in the statement of cash flows. In transition, lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. The Update is effective for public entities for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The Company anticipates adopting the Update on January 1, 2019. Upon adoption of the guidance, the Company expects to report increased assets and increased liabilities on its Condensed Consolidated Statements of Financial Condition as a result of recognizing right-of-use assets and lease liabilities related to certain banking offices and certain equipment under noncancelable operating lease agreements, which currently are not reflected in its Condensed Consolidated Statements of Financial Condition.  During 2017, management developed its methodology to estimate the right-of use assets and lease liabilities. The Company anticipates electing an exclusion accounting policy for lease assets and lease liabilities for leases with a term of twelve months or less. The Company was committed to $13.7 million of minimum lease payments under noncancelable operating lease agreements at June 30, 2018. The Company does not expect the adoption of this Update will have a significant impact to its Condensed Consolidated Financial Statements.
FASB ASU 2016-13, Financial Instruments: Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, was issued in June 2016. Commonly referred to as the current expected credit loss model ("CECL"), this Update requires financial assets measured at amortized cost basis to be presented at the net amount expected to be collected. The allowance for credit losses is a valuation account that is deducted from the amortized cost basis of the financial asset to present the net carrying value at the amount expected to be collected on the financial asset. The measurement of expected credit losses is based on relevant information about past events including historical experience, current conditions and reasonable and supportable forecasts that affect the collectibility of the reported amount. The amendment affects loans, debt securities, trade receivables, net investments in leases, off-balance-sheet credit exposures, reinsurance receivables and any other financial asset not excluded from the scope that have the contractual right to receive cash. The Update replaces the incurred loss impairment methodology, which generally only considered past events and current conditions, with a methodology that reflects the expected credit losses and required consideration of a broader range of reasonable and supportable information to estimate all expected credit losses. The Update additionally addresses purchased assets and introduces the purchased financial asset with a more-than-insignificant amount of credit deterioration since origination ("PCD"). The accounting for these PCD assets is similar to the existing accounting guidance of FASB ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality, for PCI assets, except the subsequent improvements in estimated cash flows will be immediately recognized into income, similar to the immediate recognition of subsequent deteriorations in cash flows. Current guidance only allows for the prospective recognition of these cash flow improvements. Because the terminology has been changed to a "more-than-insignificant" amount of credit deterioration, the presumption is that more assets might qualify for this accounting under the Update than those under current guidance. For public business entities, the Update is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years with early adoption permitted for fiscal years after December 15, 2018. An entity will apply the Update through a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is adopted. A prospective transition approach is required for debt securities. An entity that has previously applied the guidance of FASB ASC 310-30 will prospectively apply the guidance in this Update for PCD assets. A prospective transition approach should be used for PCD assets where upon adoption, the amortized cost basis should be adjusted to reflect the addition of the allowance for credit losses. The Company is anticipating adopting the Update on January 1, 2020. Upon adoption, the Company expects a change in the processes, internal controls and procedures to calculate the allowance for loan losses, including changes in assumptions and estimates to consider expected credit losses over the life of the loan versus the current accounting practice that utilizes the incurred loss model. The new guidance may result in an increase in the allowance for loan losses which will also reflect the new requirement to include the nonaccretable principal differences on PCI loans; however, the Company is still in the process of determining the magnitude of the increase and its impact on the Condensed Consolidated Financial Statements. In addition, the current

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accounting policy and procedures for other-than-temporary impairment on investment securities available for sale will be replaced with an allowance approach. During 2017, the Company's management created a CECL steering committee which has begun developing and implementing processes and procedures to ensure it is fully compliant with the amendments at the adoption date. To date, the CECL steering committee has selected a vendor to assist the Company in the adoption and has completed the implementation discovery sessions. The CECL steering committee is in the process of selecting appropriate methodologies and refining key data points in an effort to complete a mock CECL model by fourth quarter 2018.
FASB ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments, was issued in August 2016. The Update addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice. For public business entities, the guidance was effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years, and must be applied using a retrospective transitional method to each period presented. The Company adopted this Update on January 1, 2018. The adoption did not have a significant impact on its Condensed Consolidated Financial Statements as cash proceeds received from the settlement of bank-owned life insurance policies and cash payments for premiums on bank-owned life insurance policies were previously classified as cash inflows and outflows, respectively, from investing activities in the Condensed Consolidated Statements of Cash Flows.
FASB ASU 2017-04, Goodwill (Topic 350), was issued in January 2017 and eliminates Step 2 from the goodwill impairment test. Under the amendments, an entity should perform its goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An entity should recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value. The loss recognized, however, should not exceed the total amount of goodwill allocated to that reporting unit. Additionally, an entity should consider income tax effects from any tax deductible goodwill on the carrying amount of the reporting unit when measuring the goodwill impairment loss, if applicable.  The Update is effective for annual periods or any interim goodwill impairment tests beginning after December 15, 2019 using a prospective transition method and early adoption is permitted. The Company does not expect the Update will have a material impact on its Condensed Consolidated Financial Statements.
FASB ASU 2017-08, Receivables—Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities was issued in March 2017 and changes the accounting for certain purchased callable debt securities held at a premium to shorten the amortization period for the premium to the earliest call date rather than to the maturity date. Accounting for purchased callable debt securities held at a discount does not change. The discount would continue to amortize to the maturity date. The Update is effective for reporting periods beginning after December 15, 2018, with early adoption permitted. The Company adopted this Update in January 2018. The adoption did not have a material impact on its Condensed Consolidated Financial Statements as the Company had been accounting for premiums as prescribed under this guidance.
FASB ASU 2017-09, Compensation—Stock Compensation (Topic 718): Scope of Modification Accounting was issued in May 2017 to provide clarity as to when to apply modification accounting when there is a change in the terms or conditions of a share-based payment award. According to this Update, an entity should account for the effects of a modification unless the fair value, vesting conditions and balance sheet classification of the award is the same after the modification as compared to the original award prior to the modification. The Update was effective for reporting periods beginning after December 15, 2017. The Company adopted the Update on January 1, 2018. The adoption did not have a material impact on its Condensed Consolidated Financial Statements because no share-based payment award was modified during the six months ended June 30, 2018. The Company will apply this Update prospectively for any subsequent modifications of share-based payment awards.
FASB ASU 2018-02, Income Statement - Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income was issued to address the income tax accounting treatment of the stranded tax effects within other comprehensive income due to the prohibition of backward tracing due to an income tax rate change that was initially recorded in other comprehensive income. This issue came about from the enactment of the Tax Cuts and Jobs Act on December 22, 2017 ("Tax Cuts and Jobs Act") that changed the Company’s income tax rate from 35% to 21%. The Update changed current accounting whereby an entity may elect to reclassify the stranded tax effect from accumulated other comprehensive income to retained earnings. The Update is effective for periods beginning after December 15, 2018 although early adoption is permitted. The Company early adopted ASU 2018-02 effective December 31, 2017 and elected a portfolio policy to reclassify the stranded tax effects of the change in the federal corporate tax rate of the net unrealized gains on our available-for-sale investment securities from accumulated other comprehensive loss, net to retained earnings.
FASB ASU 2018-05, Income Taxes (Topic 740): Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin No. 118 was issued to provide guidance on the income tax accounting implications of the Tax Cuts and Jobs Act, and allows for entities to report provisional amounts for specific income tax effects of the Tax Cuts and

13
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Jobs Act for which the accounting under ASC Topic 740 was not yet complete but a reasonable estimate could be determined. A measurement period of one-year is allowed to complete the accounting effects under ASC Topic 740 and revise any previous estimates reported. Any provisional amounts or subsequent adjustments included in an entity’s financial statements during the measurement period should be included in income from continuing operations as an adjustment to tax expense in the reporting period the amounts are determined. The Company adopted this Update with the provisional adjustments as reported in the Consolidated Financial Statements on Form 10-K as of December 31, 2017. As of June 30, 2018, the Company did not incur any adjustments to the provisional recognition.

(2)
Business Combination
On July 26, 2017, the Company, along with the Bank, and Puget Sound Bancorp, Inc. and its wholly owned subsidiary bank, Puget Sound Bank, jointly announced the signing of a definitive agreement. The Puget Sound Merger was effective on January 16, 2018. As of the acquisition date, Puget Sound merged into Heritage and Puget Sound Bank merged into Heritage Bank. The primary reason for the transaction was to create depth in the Company's geographic footprint consistent with its ongoing growth strategy, focused heavily on metro markets, and to achieve operational scale and realize efficiencies of a larger combined organization.
Pursuant to the terms of the definitive agreement, all outstanding Puget Sound restricted stock awards became immediately vested prior to the Puget Sound Merger and Puget Sound shareholders received 1.1688 shares of Heritage common stock per share of Puget Sound stock. Heritage issued an aggregate of 4,112,258 shares of its common stock based on the January 12, 2018 closing price of Heritage Common stock of $31.80 for total fair value of common shares issued of $130.8 million and paid cash of $3,000 for fractional shares in the transaction for total consideration paid of $130.8 million. Total consideration includes $851,000 representing 26,741 shares which were forfeited by the Puget Sound shareholders to pay applicable taxes.
The Puget Sound Merger resulted in $68.5 million of goodwill. This goodwill is not deductible for tax purposes.
The Puget Sound Merger constitutes a business acquisition as defined by FASB ASC 805, Business Combinations. FASB ASC 805 establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired and the liabilities assumed. Heritage was considered the acquirer in this transaction. Accordingly, the preliminary estimates of fair values of the Puget Sound assets, including the identifiable intangible assets, and the assumed liabilities in the Puget Sound Merger were measured and recorded as of January 16, 2018. Fair values on the acquisition date are preliminary and represent management’s best estimates based on available information and facts and circumstances in existence on the acquisition date. Fair values are subject to refinement for up to one year after the closing date of the acquisition as additional information regarding the closing date fair values becomes available. The Company expects to finalize the purchase price allocation by the third quarter of 2018 when the valuation of tax-related matters is complete.

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The preliminary fair value estimates of the assets acquired and liabilities assumed in the Puget Sound Merger were as follows:
 
Puget Sound Merger
 
(In thousands)
Assets
 
Cash and cash equivalents
$
25,889

Interest earning deposits
54,247

Investment securities available for sale
80,353

Loans receivable
388,462

Premises and equipment, net
732

Federal Home Loan Bank stock, at cost
623

Bank owned life insurance
6,264

Accrued interest receivable
1,448

Prepaid expenses and other assets
1,354

Other intangible assets
11,270

Total assets acquired
$
570,642

Liabilities
 
Deposits
$
505,885

Accrued expenses and other liabilities
2,504

Total liabilities acquired
$
508,389

 
 
Fair value of net assets acquired
$
62,253


A summary of the net assets purchased and the preliminary estimated fair value adjustments and resulting goodwill recognized from the Puget Sound Merger are presented in the following tables. Goodwill represents the excess of the consideration transferred over the estimated fair value of the net assets acquired and liabilities assumed.
 
Puget Sound Merger
 
(In thousands)
Cost basis of net assets on merger date
$
54,405

Consideration transferred
(130,773
)
Fair value adjustments:
 
Investment securities
(348
)
Total loans receivable, net
1,400

Premises and equipment
(121
)
Other intangible assets
9,207

Prepaid expenses and other assets
(2,282
)
Deposits
(62
)
Accrued expenses and other liabilities
54

Goodwill recognized from the Puget Sound Merger
$
(68,520
)



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The operating results of the Company for the three and six months ended June 30, 2018 include the operating results produced by the net assets acquired in the Puget Sound Merger since the January 16, 2018 merger date. The Company has considered the requirement of FASB ASC 805 related to the contribution of the Puget Sound Merger to the Company’s results of operations. The table below presents only the significant results for the acquired business since the January 16, 2018 merger date:
 
Three Months Ended(1)
 
Six Months Ended(1)
 
June 30, 2018
 
(In thousands)
Interest income: Interest and fees on loans(2)
$
6,130

 
$
10,647

Interest income: Interest and fees on investments (3)
—

 
59

Interest income: Other interest earning assets
25

 
113

Interest expense
(180
)
 
(324
)
Provision for loan losses for loans
(350
)
 
(550
)
Noninterest income
109

 
257

Noninterest expense (4)
(2,092
)
 
(7,672
)
Net effect, pre-tax
$
3,642

 
$
2,530

(1) The Puget Sound Merger was completed on January 16, 2018.
(2) Includes the accretion of the discount on the purchased loans of $1.1 million and $1.5 million during the three and six months ended June 30, 2018, respectively.
(3) All securities were sold with trade date of January 16, 2018 and settlement dates on or before February 14, 2018.
(4) Excludes certain compensation and employee benefits for management as it is impracticable to determine due to the integration of the operations for this merger. Also includes certain merger-related costs incurred by the Company.
The Company also considered the pro forma requirements of FASB ASC 805 and deemed it not necessary to provide pro forma financial statements as required under the standard as the Puget Sound Merger is not material to the Company. The Company believes that the historical Puget Sound operating results are not considered of enough significance to be meaningful to the Company’s results of operations.
During the three and six months ended June 30, 2018, the Company incurred acquisition-related costs of approximately $551,000 and $5.0 million, respectively, related to the Puget Sound Merger.

(3)
Investment Securities

As a result of the adoption of ASU 2016-01 on January 1, 2018, equity investments (except for investments accounted for under the equity method of accounting) are now measured at fair value, with changes in fair value recognized in earnings. These investments were previously measured at fair value, with changes in fair value recognized in accumulated other comprehensive loss. Accordingly, these securities are no longer classified as investment securities available-for-sale and their presentation is not comparable to the presentation as of December 31, 2017. See Note (1) Description of Business, Basis of Presentation, Significant Accounting Policies and Recently Issued Accounting Pronouncements, as well as Equity Securities section discussed below.


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Available for sale investment securities
(a) Securities by Type and Maturity
The amortized cost, gross unrealized gains, gross unrealized losses and fair values of investment securities available for sale at the dates indicated were as follows:
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
 
(In thousands)
June 30, 2018
 
 
 
 
 
 
 
U.S. Treasury and U.S. Government-sponsored agencies
$
52,256

 
$
42

 
$
(234
)
 
$
52,064

Municipal securities
202,918

 
1,366

 
(1,262
)
 
203,022

Mortgage-backed securities and collateralized mortgage obligations(1):
 
 
 
 
 
 
 
Residential
319,492

 
352

 
(7,722
)
 
312,122

Commercial
257,858

 
141

 
(7,778
)
 
250,221

Collateralized loan obligations
2,253

 
3

 
—

 
2,256

Corporate obligations
25,617

 
153

 
(80
)
 
25,690

Other asset-backed securities
27,603

 
692

 
—

 
28,295

Total
$
887,997

 
$
2,749

 
$
(17,076
)
 
$
873,670

 
 
 
 
 
 
 
 
December 31, 2017
 
 
 
 
 
 
 
U.S. Treasury and U.S. Government-sponsored agencies
$
13,460

 
$
6

 
$
(24
)
 
$
13,442

Municipal securities
247,358

 
3,720

 
(1,063
)
 
250,015

Mortgage-backed securities and collateralized mortgage obligations(1):
 
 
 
 
 
 
 
Residential
282,724

 
422

 
(2,935
)
 
280,211

Commercial
219,696

 
444

 
(3,061
)
 
217,079

Collateralized loan obligations
4,561

 
19

 
—

 
4,580

Corporate obligations
16,594

 
220

 
(44
)
 
16,770

Other securities (2)
27,781

 
652

 
—

 
28,433

Total
$
812,174

 
$
5,483

 
$
(7,127
)
 
$
810,530

(1) 
Issued and guaranteed by U.S. Government-sponsored agencies.
(2) 
Primarily asset-backed securities.
There were no securities classified as trading or held to maturity at June 30, 2018 or December 31, 2017.
The amortized cost and fair value of investment securities available for sale at June 30, 2018, by contractual maturity, are set forth below. Actual maturities may differ from contractual maturities because certain borrowers have the right to call or prepay obligations with or without call or prepayment penalties.
 
Amortized Cost
 
Fair Value
 
(In thousands)
Due in one year or less
$
24,656

 
$
24,690

Due after one year through five years
149,590

 
148,197

Due after five years through ten years
254,873

 
248,759

Due after ten years
458,878

 
452,024

Total
$
887,997

 
$
873,670


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(b) Unrealized Losses and Other-Than-Temporary Impairments
The following table shows the gross unrealized losses and fair value of the Company's investment securities available for sale that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that the individual securities have been in continuous unrealized loss positions as of June 30, 2018 and December 31, 2017:
 
Less than 12 Months
 
12 Months or Longer
 
Total
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
 
(In thousands)
June 30, 2018
 
 
 
 
 
 
 
 
 
 
 
U.S. Treasury and U.S. Government-sponsored agencies
$
34,674

 
$
(223
)
 
$
536

 
$
(11
)
 
$
35,210

 
$
(234
)
Municipal securities
63,443

 
(552
)
 
22,903

 
(710
)
 
86,346

 
(1,262
)
Mortgage-backed securities and collateralized mortgage obligations(1):
 
 
 
 
 
 
 
 
 
 
 
Residential
178,865

 
(3,954
)
 
78,330

 
(3,768
)
 
257,195

 
(7,722
)
Commercial
128,298

 
(3,058
)
 
94,847

 
(4,720
)
 
223,145

 
(7,778
)
Corporate obligations
15,482

 
(80
)
 
—

 
—

 
15,482

 
(80
)
Total
$
420,762

 
$
(7,867
)
 
$
196,616

 
$
(9,209
)
 
$
617,378

 
$
(17,076
)
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2017
 
 
 
 
 
 
 
 
 
 
 
U.S. Treasury and U.S. Government-sponsored agencies
$
11,436

 
$
(24
)
 
$
—

 
$
—

 
$
11,436

 
$
(24
)
Municipal securities
39,298

 
(384
)
 
26,509

 
(679
)
 
65,807

 
(1,063
)
Mortgage-backed securities and collateralized mortgage obligations(1):
 
 
 
 
 
 
 
 
 
 
 
Residential
175,847

 
(1,296
)
 
66,380

 
(1,639
)
 
242,227

 
(2,935
)
Commercial
75,121

 
(700
)
 
90,822

 
(2,361
)
 
165,943

 
(3,061
)
Corporate obligations
3,472

 
(44
)
 
—

 
—

 
3,472

 
(44
)
Total
$
305,174

 
$
(2,448
)
 
$
183,711

 
$
(4,679
)
 
$
488,885

 
$
(7,127
)
(1) Issued and guaranteed by U.S. Government-sponsored agencies.
The Company has evaluated these investment securities available for sale as of June 30, 2018 and December 31, 2017 and has determined that the decline in their value is not other-than-temporary. The unrealized losses are primarily due to increases in market interest rates. The fair value of these securities is expected to recover as the securities approach their maturity date. None of the underlying issuers of the municipal securities and corporate obligations had credit ratings that were below investment grade levels at June 30, 2018 or December 31, 2017. The Company has the ability and intent to hold the investments until recovery of the securities' amortized cost, which may be the maturity date of the securities.
For the three and six months ended June 30, 2018 and 2017, there were no other-than-temporary charges recorded to net income.

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(c) Realized Gains and Losses
The following table presents the gross realized gains and losses on the sale of securities available for sale for the three and six months ended June 30, 2018 and 2017.
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2018
 
2017
 
2018
 
2017
 
(In thousands)
Gross realized gains
$
18

 
$
117

 
$
122

 
$
117

Gross realized losses
—

 
—

 
(69
)
 
—

   Net realized gains
$
18

 
$
117

 
$
53

 
$
117

    
(d) Pledged Securities
The following table summarizes the amortized cost and fair value of investment securities available for sale that are pledged as collateral for the following obligations at June 30, 2018 and December 31, 2017:
 
June 30, 2018
 
December 31, 2017
 
Amortized
Cost
 
Fair
Value
 
Amortized
Cost
 
Fair
Value
 
(In thousands)
Washington and Oregon state to secure public deposits
$
197,047

 
$
193,946

 
$
206,377

 
$
206,425

Repurchase agreements
45,463

 
44,207

 
48,750

 
48,237

Other securities pledged
20,048

 
19,742

 
12,484

 
12,498

Total
$
262,558

 
$
257,895

 
$
267,611

 
$
267,160


Equity Securities
The Company holds an equity security with a readily determinable fair value of $162,000 and $146,000 as of June 30, 2018 and December 31, 2017, respectively. As a result of the adoption of ASU 2016-01, this security is no longer classified as investment security available for sale and has been reclassified to prepaid expenses and other assets on the Company's Condensed Consolidated Statements of Financial Condition as of June 30, 2018. As such, its presentation is not comparable to the presentation as of December 31, 2017. The Company recorded the tax-effected unrealized gain on the equity security through an adjustment to accumulated other comprehensive loss, net and retained earnings in the Condensed Consolidated Statement of Stockholders' Equity during the six months ended June 30, 2018.

(4)
Loans Receivable
The Company originates loans in the ordinary course of business and has also acquired loans through FDIC-assisted and open bank transactions. Disclosures related to the Company's recorded investment in loans receivable generally exclude accrued interest receivable and net deferred fees or costs because they are insignificant.
Loans acquired in a business combination are further classified as “purchased” loans. Loans purchased with evidence of credit deterioration since origination for which it is probable that not all contractually required payments will be collected are accounted for under FASB ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality. These loans are identified as "PCI" loans. Loans purchased that are not accounted for under FASB ASC 310-30 are accounted for under FASB ASC 310-20, Receivables—Nonrefundable Fees and Other Costs, and are referred to as "non-PCI" loans.

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(a) Loan Origination/Risk Management
The Company categorizes loans in one of the four segments of the total loan portfolio: commercial business, one-to-four family residential, real estate construction and land development and consumer. Within these segments are classes of loans for which management monitors and assesses credit risk in the loan portfolios. The Company has certain lending policies and procedures in place that are designed to maximize loan income within an acceptable level of risk. Management reviews and approves these policies and procedures on a regular basis. A reporting system supplements the review process by providing management with frequent reports related to loan production, loan quality, concentrations of credit, loan delinquencies and nonperforming and criticized loans. The Company also conducts internal loan reviews and validates the credit risk assessment on a periodic basis and presents the results of these reviews to management. The loan review process complements and reinforces the risk identification and assessment decisions made by loan officers and credit personnel, as well as the Company’s policies and procedures.
A discussion of the risk characteristics of each loan portfolio segment is as follows:
Commercial Business:
There are three significant classes of loans in the commercial business portfolio segment: commercial and industrial, owner-occupied commercial real estate and non-owner occupied commercial real estate. The owner and non-owner occupied commercial real estate classes are both considered commercial real estate loans. As the commercial and industrial loans carry different risk characteristics than the commercial real estate loans, they are discussed separately below.
Commercial and industrial. Commercial and industrial loans are primarily made based on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, may not be as expected and the collateral securing these loans may fluctuate in value. Most commercial and industrial loans are secured by the assets being financed or other business assets such as accounts receivable or inventory and may include a personal guarantee; however, some short-term loans may be made on an unsecured basis. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers. Commercial and industrial loans carry more risk than other loans because the borrowers’ cash flow is less predictable, and in the event of a default, the amount of loss is potentially greater and more difficult to quantify because the value of the collateral securing these loans may fluctuate, may be uncollectible, or may be obsolete or of limited use, among other things.
Commercial real estate. The Company originates commercial real estate loans primarily within its primary market areas. These loans are subject to underwriting standards and processes similar to commercial and industrial loans in that these loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate properties. Commercial real estate lending typically involves higher loan principal amounts and payments on loans, and repayment is dependent on successful operation and management of the properties. The value of the real estate securing these loans can be adversely affected by conditions in the real estate market or the economy. There is little difference in risk between owner-occupied commercial real estate loans and non-owner occupied commercial real estate loans.
One-to-Four Family Residential:
The majority of the Company’s one-to-four family residential loans are secured by single-family residences located in its primary market areas. The Company’s underwriting standards require that single-family portfolio loans generally are owner-occupied and do not exceed 80% of the lower of appraised value at origination or cost of the underlying collateral. Terms of maturity typically range from 15 to 30 years. The Company sells most of its single-family loans in the secondary market and retains a smaller portion in its loan portfolio.
Real Estate Construction and Land Development:
The Company originates construction loans for one-to-four family residential and for five or more family residential and commercial properties. The one-to-four family residential construction loans generally include construction of custom homes whereby the home buyer is the borrower. The Company also provides financing to builders for the construction of pre-sold homes and, in selected cases, to builders for the construction of speculative residential property. Substantially all construction loans are short-term in nature and priced with variable rates of interest. Construction lending can involve a higher level of risk than other types of lending because funds are advanced partially based upon the value of the project, which is uncertain prior to the project’s completion. Because of the uncertainties inherent in estimating construction costs as well as the market value of a completed project and the effects of governmental regulation of real property, the Company’s estimates with regard to the total funds required to complete a project and the related loan-to-value ratio may vary from actual results. As a result, construction loans often

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involve the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project and the ability of the borrower to sell or lease the property or refinance the indebtedness. If the Company’s estimate of the value of a project at completion proves to be overstated, it may have inadequate security for repayment of the loan and may incur a loss if the borrower does not repay the loan. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property or an interim loan commitment from the Company until permanent financing is obtained. These loans are closely monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being dependent upon successful completion of the construction project, interest rate changes, government regulation of real property, general economic conditions and the availability of long-term financing.
Consumer:
The Company originates consumer loans and lines of credit that are both secured and unsecured. The underwriting process for these loans ensures a qualifying primary and secondary source of repayment. Underwriting standards for home equity loans are significantly influenced by statutory requirements, which include, but are not limited to, a maximum loan-to-value percentage of 80%, collection remedies, the number of such loans a borrower can have at one time and documentation requirements. To monitor and manage consumer loan risk, policies and procedures are developed and modified, as needed. The majority of consumer loans are for relatively small amounts disbursed among many individual borrowers which reduces the credit risk for this type of loan. To further reduce the risk, trend reports are reviewed by management on a regular basis.
The Company also originates indirect consumer loans. These loans are for new and used automobile and recreational vehicles that are originated indirectly by selected dealers located in the Company's market areas. The Company has limited its purchase of indirect loans primarily to dealerships that are established and well-known in their market areas and to applicants that are not classified as sub-prime.
Loans receivable at June 30, 2018 and December 31, 2017 consisted of the following portfolio segments and classes:
 
June 30, 2018
 
December 31, 2017
 
(In thousands)
Commercial business:
 
 
 
Commercial and industrial
$
800,043

 
$
645,396

Owner-occupied commercial real estate
693,330

 
622,150

Non-owner occupied commercial real estate
1,187,548

 
986,594

Total commercial business
2,680,921

 
2,254,140

One-to-four family residential
92,518

 
86,997

Real estate construction and land development:
 
 
 
One-to-four family residential
71,934

 
51,985

Five or more family residential and commercial properties
93,315

 
97,499

Total real estate construction and land development
165,249

 
149,484

Consumer
385,987

 
355,091

Gross loans receivable
3,324,675

 
2,845,712

Net deferred loan costs
3,613

 
3,359

 Loans receivable, net
3,328,288

 
2,849,071

Allowance for loan losses
(33,972
)
 
(32,086
)
 Total loans receivable, net
$
3,294,316

 
$
2,816,985

(b) Concentrations of Credit
Most of the Company’s lending activity occurs within its primary market areas which are concentrated along the I-5 corridor from Whatcom County to Clark County in Washington State and Multnomah County in Oregon, as well as other contiguous markets. The majority of the Company’s loan portfolio consists of (in order of balances at June 30, 2018) non-owner occupied commercial real estate, commercial and industrial and owner-occupied commercial real estate. As of June 30, 2018 and December 31, 2017, there were no concentrations of loans related to any single industry in excess of 10% of the Company’s total loans.

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(c) Credit Quality Indicators
As part of the on-going monitoring of the credit quality of the Company’s loan portfolio, management tracks certain credit quality indicators including trends related to (i) the risk grade of the loans, (ii) the level of classified loans, (iii) net charge-offs, (iv) nonperforming loans and (v) the general economic conditions of the United States of America, and specifically the states of Washington and Oregon. The Company utilizes a risk grading matrix to assign a risk grade to each of its loans. Loans are graded on a scale of 1 to 10. A description of the general characteristics of the risk grades is as follows:
•
Grades 1 to 5: These grades are considered “pass grade” and include loans with negligible to above average but acceptable risk. These borrowers generally have strong to acceptable capital levels and consistent earnings and debt service capacity. Loans with the higher grades within the “pass” category may include borrowers who are experiencing unusual operating difficulties, but have acceptable payment performance to date. Increased monitoring of financial information and/or collateral may be appropriate. Loans with this grade show no immediate loss exposure.
•
Grade 6: This grade includes "Watch" loans and is considered a “pass grade”. The grade is intended to be utilized on a temporary basis for pass grade borrowers where a potentially significant risk-modifying action is anticipated in the near term.
•
Grade 7: This grade includes “Other Assets Especially Mentioned” (“OAEM”) loans in accordance with regulatory guidelines and is intended to highlight loans with elevated risks. Loans with this grade show signs of deteriorating profits and capital, and the borrower might not be strong enough to sustain a major setback. The borrower is typically higher than normally leveraged, and outside support might be modest and likely illiquid. The loan is at risk of further decline unless active measures are taken to correct the situation.
•
Grade 8: This grade includes “Substandard” loans in accordance with regulatory guidelines, which the Company has determined have a high credit risk. These loans also have well-defined weaknesses which make payment default or principal exposure likely, but not yet certain. The borrower may have shown serious negative trends in financial ratios and performance. Such loans may be dependent upon collateral liquidation, a secondary source of repayment or an event outside of the normal course of business. Loans with this grade can be placed on accrual or nonaccrual status based on the Company’s accrual policy.
•
Grade 9: This grade includes “Doubtful” loans in accordance with regulatory guidelines, and the Company has determined these loans to have excessive credit risk. Such loans are placed on nonaccrual status and may be dependent upon collateral having a value that is difficult to determine or upon some near-term event which lacks certainty. Additionally, these loans generally have a specific valuation allowance or have been partially charged-off for the amount considered uncollectible.
•
Grade 10: This grade includes “Loss” loans in accordance with regulatory guidelines, and the Company has determined these loans have the highest risk of loss. Such loans are charged-off or charged-down when payment is acknowledged to be uncertain or when the timing or value of payments cannot be determined. “Loss” is not intended to imply that the loan or some portion of it will never be paid, nor does it in any way imply that there has been a forgiveness of debt.
Numerical loan grades for loans are established at the origination of the loan. Loan grades are reviewed on a quarterly basis, or more frequently if necessary, by the credit department. The Bank follows the FDIC’s Uniform Retail Credit Classification and Account Management Policy for subsequent classification in the event of payment delinquencies or default. Typically, an individual loan grade will not be changed from the prior period unless there is a specific indication of credit deterioration or improvement. Credit deterioration is evidenced by delinquency, direct communications with the borrower, or other borrower information that becomes known to management. Credit improvements are evidenced by known facts regarding the borrower or the collateral property.
The loan grades relate to the likelihood of losses in that the higher the grade, the greater the loss potential. Loans with a pass grade may have some estimated inherent losses, but to a lesser extent than the other loan grades. The OAEM loan grade is transitory in that the Company is waiting on additional information to determine the likelihood and extent of the potential loss. The likelihood of loss for OAEM graded loans, however, is greater than Watch graded loans because there has been measurable credit deterioration. Loans with a Substandard grade are generally loans for which the Company has individually analyzed for potential impairment. For Doubtful and Loss graded loans, the Company is almost certain of the losses, and the outstanding principal balances are generally charged-off to the realizable value.

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The following tables present the balance of the loans receivable by credit quality indicator as of June 30, 2018 and December 31, 2017.
 
June 30, 2018
 
Pass
 
OAEM
 
Substandard
 
Doubtful/Loss
 
Total
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
 
 
Commercial and industrial
$
731,265

 
$
23,559

 
$
45,219

 
$
—

 
$
800,043

Owner-occupied commercial real estate
656,991

 
16,402

 
19,937

 
—

 
693,330

Non-owner occupied commercial real estate
1,161,596

 
10,972

 
14,980

 
—

 
1,187,548

Total commercial business
2,549,852

 
50,933

 
80,136

 
—

 
2,680,921

One-to-four family residential
91,264

 
—

 
1,254

 
—

 
92,518

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
One-to-four family residential
70,499

 
267

 
1,168

 
—

 
71,934

Five or more family residential and commercial properties
93,258

 
57

 
—

 
—

 
93,315

Total real estate construction and land development
163,757

 
324

 
1,168

 
—

 
165,249

Consumer
381,341

 
—

 
4,121

 
525

 
385,987

Gross loans receivable
$
3,186,214

 
$
51,257

 
$
86,679

 
$
525

 
$
3,324,675


 
December 31, 2017
 
Pass
 
OAEM
 
Substandard
 
Doubtful/Loss
 
Total
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
 
 
Commercial and industrial
$
597,697

 
$
19,536

 
$
28,163

 
$
—

 
$
645,396

Owner-occupied commercial real estate
595,455

 
12,668

 
14,027

 
—

 
622,150

Non-owner occupied commercial real estate
955,450

 
10,494

 
20,650

 
—

 
986,594

Total commercial business
2,148,602

 
42,698

 
62,840

 
—

 
2,254,140

One-to-four family residential
85,762

 
—

 
1,235

 
—

 
86,997

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
One-to-four family residential
49,925

 
537

 
1,523

 
—

 
51,985

Five or more family residential and commercial properties
96,404

 
707

 
388

 
—

 
97,499

Total real estate construction and land development
146,329

 
1,244

 
1,911

 
—

 
149,484

Consumer
349,590

 
—

 
4,976

 
525

 
355,091

Gross loans receivable
$
2,730,283

 
$
43,942

 
$
70,962

 
$
525

 
$
2,845,712


Potential problem loans are loans classified as OAEM or worse that are currently accruing interest and are not considered impaired, but which management is monitoring because the financial information of the borrower causes concern as to their ability to meet their loan repayment terms. Potential problem loans may include PCI loans as these loans continue to accrete loan discounts established at acquisition based on the guidance of FASB ASC 310-30. Potential problem loans as of June 30, 2018 and December 31, 2017 were $101.5 million and $83.5 million, respectively.

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(d) Nonaccrual Loans
Nonaccrual loans, segregated by segments and classes of loans, were as follows as of June 30, 2018 and December 31, 2017:
 
June 30, 2018
 
December 31, 2017
 
(In thousands)
Commercial business:
 
 
 
Commercial and industrial
$
8,376

 
$
3,110

Owner-occupied commercial real estate
4,690

 
4,090

Non-owner occupied commercial real estate
2,169

 
1,898

Total commercial business
15,235

 
9,098

One-to-four family residential
77

 
81

Real estate construction and land development:
 
 
 
One-to-four family residential
1,084

 
1,247

Consumer
127

 
277

Nonaccrual loans
$
16,523

 
$
10,703

PCI loans are not included in the nonaccrual loan table above because these loans are accounted for under FASB ASC 310-30, which provides that accretable yield is calculated based on a loan's expected cash flow even if the loan is not performing under its contractual terms.
(e) Past due loans
The Company performs an aging analysis of past due loans using the categories of 30-89 days past due and 90 or more days past due. This policy is consistent with regulatory reporting requirements.
The balances of past due loans, segregated by segments and classes of loans, as of June 30, 2018 and December 31, 2017 were as follows:
 
June 30, 2018
 
30-89 Days
 
90 Days or
Greater
 
Total Past 
Due
 
Current
 
Total
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
 
 
Commercial and industrial
$
3,719

 
$
4,122

 
$
7,841

 
$
792,202

 
$
800,043

Owner-occupied commercial real estate
129

 
868

 
997

 
692,333

 
693,330

Non-owner occupied commercial real estate
1,501

 
3,238

 
4,739

 
1,182,809

 
1,187,548

Total commercial business
5,349

 
8,228

 
13,577

 
2,667,344

 
2,680,921

One-to-four family residential
—

 
—

 
—

 
92,518

 
92,518

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
One-to-four family residential
—

 
309

 
309

 
71,625

 
71,934

Five or more family residential and commercial properties
—

 
—

 
—

 
93,315

 
93,315

Total real estate construction and land development
—

 
309

 
309

 
164,940

 
165,249

Consumer
1,634

 
53

 
1,687

 
384,300

 
385,987

Gross loans receivable
$
6,983

 
$
8,590

 
$
15,573

 
$
3,309,102

 
$
3,324,675



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December 31, 2017
 
30-89 Days
 
90 Days or
Greater
 
Total Past 
Due
 
Current
 
Total
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
 
 
Commercial and industrial
$
2,993

 
$
1,172

 
$
4,165

 
$
641,231

 
$
645,396

Owner-occupied commercial real estate
1,277

 
1,225

 
2,502

 
619,648

 
622,150

Non-owner occupied commercial real estate
870

 
3,314

 
4,184

 
982,410

 
986,594

Total commercial business
5,140

 
5,711

 
10,851

 
2,243,289

 
2,254,140

One-to-four family residential
513

 
—

 
513

 
86,484

 
86,997

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
One-to-four family residential
84

 
1,331

 
1,415

 
50,570

 
51,985

Five or more family residential and commercial properties
40

 
—

 
40

 
97,459

 
97,499

Total real estate construction and land development
124

 
1,331

 
1,455

 
148,029

 
149,484

Consumer
1,939

 
687

 
2,626

 
352,465

 
355,091

Gross loans receivable
$
7,716

 
$
7,729

 
$
15,445

 
$
2,830,267

 
$
2,845,712


There were no loans 90 days or more past due that were still accruing interest as of June 30, 2018 or December 31, 2017, excluding PCI loans.

(f) Impaired loans
Impaired loans include nonaccrual loans and performing troubled debt restructured ("TDR") loans. The balances of impaired loans as of June 30, 2018 and December 31, 2017 are set forth in the following tables.
 
June 30, 2018
 
Recorded
Investment With
No Specific
Valuation
Allowance
 
Recorded
Investment With
Specific
Valuation
Allowance
 
Total
Recorded
Investment
 
Unpaid
Contractual
Principal
Balance
 
Related
Specific
Valuation
Allowance
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
 
 
Commercial and industrial
$
5,716

 
$
12,238

 
$
17,954

 
$
18,825

 
$
1,706

Owner-occupied commercial real estate
930

 
11,254

 
12,184

 
12,493

 
1,724

Non-owner occupied commercial real estate
4,662

 
5,923

 
10,585

 
10,558

 
784

Total commercial business
11,308

 
29,415

 
40,723

 
41,876

 
4,214

One-to-four family residential
—

 
291

 
291

 
301

 
90

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
One-to-four family residential
775

 
309

 
1,084

 
1,842

 
5

Total real estate construction and land development
775

 
309

 
1,084

 
1,842

 
5

Consumer
53

 
329

 
382

 
447

 
74

Total
$
12,136

 
$
30,344

 
$
42,480

 
$
44,466

 
$
4,383


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December 31, 2017
 
Recorded
Investment With
No Specific
Valuation
Allowance
 
Recorded
Investment With
Specific
Valuation
Allowance
 
Total
Recorded
Investment
 
Unpaid
Contractual
Principal
Balance
 
Related
Specific
Valuation
Allowance
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
 
 
Commercial and industrial
$
2,127

 
$
9,872

 
$
11,999

 
$
12,489

 
$
1,326

Owner-occupied commercial real estate
2,452

 
4,356

 
6,808

 
7,054

 
621

Non-owner occupied commercial real estate
4,722

 
11,297

 
16,019

 
16,172

 
1,222

Total commercial business
9,301

 
25,525

 
34,826

 
35,715

 
3,169

One-to-four family residential
—

 
299

 
299

 
308

 
93

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
One-to-four family residential
938

 
309

 
1,247

 
2,200

 
2

Five or more family residential and commercial properties
—

 
645

 
645

 
645

 
37

Total real estate construction and land development
938

 
954

 
1,892

 
2,845

 
39

Consumer
160

 
282

 
442

 
466

 
54

Total
$
10,399

 
$
27,060

 
$
37,459

 
$
39,334

 
$
3,355

The average recorded investment of impaired loans for the three and six months ended June 30, 2018 and 2017 are set forth in the following table.
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2018
 
2017
 
2018
 
2017
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
Commercial and industrial
$
17,299

 
$
6,925

 
$
15,534

 
$
8,742

Owner-occupied commercial real estate
12,643

 
3,278

 
12,622

 
3,760

Non-owner occupied commercial real estate
10,426

 
11,252

 
10,366

 
11,274

Total commercial business
40,368

 
21,455

 
38,522

 
23,776

One-to-four family residential
293

 
312

 
295

 
315

Real estate construction and land development:
 
 
 
 
 
 
 
One-to-four family residential
1,116

 
2,636

 
1,159

 
2,781

Five or more family residential and commercial properties
—

 
1,067

 
215

 
1,070

Total real estate construction and land development
1,116

 
3,703

 
1,374

 
3,851

Consumer
381

 
235

 
401

 
260

Total
$
42,158

 
$
25,705

 
$
40,592

 
$
28,202

For the three and six months ended June 30, 2018 and 2017, no interest income was recognized subsequent to a loan’s classification as nonaccrual. For the three and six months ended June 30, 2018, the Bank recorded $360,000 and $686,000, respectively, of interest income related to performing TDR loans. For the three and six months ended June 30, 2017, the Bank recorded $281,000 and $646,000, respectively, of interest income related to performing TDR loans.

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(g) Troubled Debt Restructured Loans
A TDR loan is a restructuring in which the Bank, for economic or legal reasons related to a borrower’s financial difficulties, grants a concession to the borrower that it would not otherwise consider. TDR loans are considered impaired and are separately measured for impairment under FASB ASC 310-10-35, whether on accrual ("performing") or nonaccrual ("nonperforming") status. The Company has more stringent definitions of concessions and impairment measures for PCI loans as these loans have known credit deterioration and are generally accreting income at a lower discounted rate as compared to the contractual note rate based on the guidance of FASB ASC 310-30.
The majority of the Bank’s TDR loans are a result of granting extensions of maturity on troubled credits which have already been adversely classified. The Bank grants such extensions to reassess the borrower’s financial status and to develop a plan for repayment. The second most prevalent concessions are certain modifications with extensions that also include interest rate reductions. Certain TDR loans were additionally re-amortized over a longer period of time. These modifications would all be considered a concession for a borrower that could not obtain similar financing terms from another source other than from the Bank.
The financial effects of each modification will vary based on the specific restructure. For the majority of the Bank’s TDR loans, the loans were interest-only with a balloon payment at maturity. If the interest rate is not adjusted and the modified terms are consistent with other similar credits being offered, the Bank may not experience any loss associated with the restructure. If, however, the restructure involves forbearance agreements or interest rate modifications, the Bank may not collect all the principal and interest based on the original contractual terms. The Bank estimates the necessary allowance for loan losses on TDR loans using the same guidance as used for other impaired loans.
The recorded investment balance and related allowance for loan losses of performing and nonaccrual TDR loans as of June 30, 2018 and December 31, 2017 were as follows:
 
June 30, 2018
 
December 31, 2017
 
Performing
TDRs
 
Nonaccrual
TDRs
 
Performing
TDRs
 
Nonaccrual
TDRs
 
(In thousands)
TDR loans
$
25,957

 
$
6,761

 
$
26,757

 
$
5,193

Allowance for loan losses on TDR loans
2,492

 
726

 
2,635

 
379


The unfunded commitment to borrowers related to TDR loans was $1.0 million and $1.2 million at June 30, 2018 and December 31, 2017, respectively.
Loans that were modified as TDR loans during the three and six months ended June 30, 2018 and 2017 are set forth in the following table:
 
Three Months Ended June 30,
 
2018
 
2017
 
Number of
Contracts
(1)
 
Outstanding
Principal Balance 
(1)(2)
 
Number of
Contracts
(1)
 
Outstanding
Principal Balance 
(1)(2)
 
(Dollars in thousands)
Commercial business:
 
 
 
 
 
 
 
Commercial and industrial
9

 
$
2,981

 
5

 
$
3,439

Owner-occupied commercial real estate
1

 
570

 
—

 
—

Non-owner occupied commercial real estate
—

 
—

 
1

 
947

Total commercial business
10

 
3,551

 
6

 
4,386

Real estate construction and land development:
 
 
 
 
 
 
 
One-to-four family residential
—

 
—

 
2

 
745

Total real estate construction and land development
—

 
—

 
2

 
745

Consumer
3

 
33

 
1

 
10

Total loans modified as TDR loans
13

 
$
3,584

 
9

 
$
5,141



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Six Months Ended June 30,
 
2018
 
2017
 
Number of
Contracts
(1)
 
Outstanding
Principal Balance 
(1)(2)
 
Number of
Contracts
(1)
 
Outstanding
Principal Balance 
(1)(2)
 
(Dollars in thousands)
Commercial business:
 
 
 
 
 
 
 
Commercial and industrial
17

 
$
6,193

 
10

 
$
4,913

Owner-occupied commercial real estate
1

 
570

 
1

 
54

Non-owner occupied commercial real estate
2

 
2,380

 
1

 
948

Total commercial business
20

 
9,143

 
12

 
5,915

Real estate construction and land development:
 
 
 
 
 
 
 
One-to-four family residential
—

 
—

 
4

 
1,889

Total real estate construction and land development
—

 
—

 
4

 
1,889

Consumer
6

 
107

 
2

 
18

Total TDR loans
26

 
$
9,250

 
18

 
$
7,822

(1) 
Number of contracts and outstanding principal balance represent loans which have balances as of period end as certain loans may have been paid-down or charged-off during the three and six months ended June 30, 2018 and 2017.
(2) 
Includes subsequent payments after modifications and reflects the balance as of period end. As the Bank did not forgive any principal or interest balance as part of the loan modification, the Bank’s recorded investment in each loan at the date of modification (pre-modification) did not change as a result of the modification (post-modification), except when the modification was the initial advance on a one-to-four family residential real estate construction and land development loan under a master guidance line. There were no advances on these types of loans during the three and six months ended June 30, 2018 and 2017.

Certain loans included in the table above may have been previously reported as TDR loans. The Bank typically grants shorter extension periods to continually monitor these TDR loans despite the fact that the extended date might not be the date the Bank expects sufficient cash flow from these borrowers. The Bank does not consider these modifications a subsequent default of a TDR as new loan terms, specifically new maturity dates, were granted. The potential losses related to these loans would have been considered in the period the loan was first reported as a TDR loan and are adjusted, as necessary, in the current period based on more recent information. The related specific valuation allowance at June 30, 2018 was $738,000 for loans that were modified as TDR loans during the three and six months ended June 30, 2018.
Loans that were modified during the previous twelve months that subsequently defaulted during the three and six months ended June 30, 2018 and 2017 are set forth in the following table:
 
Three Months Ended June 30,
 
2018
 
2017
 
Number of
Contracts
 
Outstanding
Principal 
Balance
 
Number of
Contracts
 
Outstanding
Principal 
Balance
 
(Dollars in thousands)
Commercial business:
 
 
 
 
 
 
 
Commercial and industrial
4

 
$
2,725

 
—

 
$
—

Total commercial business
4

 
2,725

 
—

 
—

Consumer
—

 
—

 
3

 
36

Total
4

 
$
2,725

 
3

 
$
36


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Table of Contents


 
Six Months Ended June 30,
 
2018
 
2017
 
Number of
Contracts
 
Outstanding
Principal 
Balance
 
Number of
Contracts
 
Outstanding
Principal 
Balance
 
(Dollars in thousands)
Commercial business:
 
 
 
 
 
 
 
Commercial and industrial
5

 
$
3,006

 
1

 
$
234

Non-owner occupied commercial real estate
1

 
73

 
—

 
—

Total commercial business
6

 
3,079

 
1

 
234

Real estate construction and land development:
 
 
 
 
 
 
 
One-to-four family residential
2

 
775

 
—

 
—

Total real estate construction and land development
2

 
775

 
—

 
—

Consumer
—

 
—

 
3

 
36

Total
8

 
$
3,854

 
4

 
$
270

During the three and six months ended June 30, 2018, two loans and six loans, respectively, defaulted because they were past their modified maturity dates, and the borrowers have not subsequently repaid the credits. The Bank has chosen not to extend the maturities on these loans. In addition, during the three and six months ended June 30, 2018, two loans and two loans, respectively, defaulted because the borrowers were more than 90 days delinquent on their scheduled loan payments. The Bank had no specific valuation allowance at June 30, 2018 related to the credits which defaulted during the six months ended June 30, 2018.     
During the three and six months ended June 30, 2017, three loans and four loans, respectively, defaulted because the borrowers were more than 90 days delinquent on their scheduled loan payments.

(h) Purchased Credit Impaired Loans
The Company acquired certain loans and designated them, as appropriate, as PCI loans, which are accounted for under FASB ASC 310-30. No loans acquired in the Puget Sound Merger effective January 16, 2018 were considered PCI.

29
Table of Contents


The following table reflects the outstanding principal balance and recorded investment of the PCI loans at June 30, 2018 and December 31, 2017:
 
June 30, 2018
 
December 31, 2017
 
Outstanding Principal
 
Recorded Investment
 
Outstanding Principal
 
Recorded Investment
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
Commercial and industrial
$
7,307

 
$
3,819

 
$
8,818

 
$
2,912

Owner-occupied commercial real estate
9,737

 
8,605

 
12,230

 
11,515

Non-owner occupied commercial real estate
12,545

 
11,033

 
14,295

 
13,342

Total commercial business
29,589

 
23,457

 
35,343

 
27,769

One-to-four family residential
3,701

 
3,833

 
4,120

 
5,255

Real estate construction and land development:
 
 
 
 
 
 
 
One-to-four family residential
107

 
391

 
841

 
89

Five or more family residential and commercial properties
193

 
11

 
2,361

 
2,035

Total real estate construction and land development
300

 
402

 
3,202

 
2,124

Consumer
2,932

 
4,160

 
3,974

 
5,455

Gross PCI loans
$
36,522

 
$
31,852

 
$
46,639

 
$
40,603

On the acquisition dates, the amount by which the undiscounted expected cash flows of the PCI loans exceeded the estimated fair value of the loan is the “accretable yield.” The accretable yield is then measured at each financial reporting date and represents the difference between the remaining undiscounted expected cash flows and the current carrying value of the PCI loans.
The following table summarizes the accretable yield on the PCI loans for the three and six months ended June 30, 2018 and 2017.
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2018
 
2017
 
2018
 
2017
 
 
(In thousands)
Balance at the beginning of the period
 
$
11,269

 
$
13,132

 
$
11,224

 
$
13,860

Accretion
 
(587
)
 
(935
)
 
(1,368
)
 
(1,929
)
Disposal and other
 
(273
)
 
(653
)
 
(1,971
)
 
(1,143
)
Change in accretable yield
 
(349
)
 
752

 
2,175

 
1,508

Balance at the end of the period
 
$
10,060

 
$
12,296

 
$
10,060

 
$
12,296



30
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(5)
Allowance for Loan Losses
The allowance for loan losses is maintained at a level deemed appropriate by management to provide for probable incurred credit losses in the loan portfolio. The following tables detail the activity in the allowance for loan losses disaggregated by segment and class for the three and six months ended June 30, 2018:
 
Balance at Beginning of Period
 
Charge-offs
 
Recoveries
 
Provision for Loan Losses
 
Balance at End of Period
 
(In thousands)
Three Months Ended June 30, 2018
 
 
 
 
 
 
 
 
 
Commercial business:
 
 
 
 
 
 
 
 
 
Commercial and industrial
$
9,943

 
$
(541
)
 
$
65

 
$
721

 
$
10,188

Owner-occupied commercial real estate
5,040

 
(1
)
 
3

 
204

 
5,246

Non-owner occupied commercial real estate
7,589

 
—

 
—

 
137

 
7,726

Total commercial business
22,572

 
(542
)
 
68

 
1,062

 
23,160

One-to-four family residential
1,083

 
(15
)
 
—

 
53

 
1,121

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
One-to-four family residential
941

 
—

 
2

 
73

 
1,016

Five or more family residential and commercial properties
1,115

 
—

 
—

 
(71
)
 
1,044

Total real estate construction and land development
2,056

 
—

 
2

 
2

 
2,060

Consumer
6,054

 
(694
)
 
142

 
803

 
6,305

Unallocated
1,496

 
—

 
—

 
(170
)
 
1,326

Total
$
33,261

 
$
(1,251
)
 
$
212

 
$
1,750

 
$
33,972

 
 
 
 
 
 
 
 
 
 
Six Months Ended June 30, 2018
 
 
 
 
 
 
 
 
 
Commercial business:
 
 
 
 
 
 
 
 
 
Commercial and industrial
$
9,910

 
$
(622
)
 
$
564

 
$
336

 
$
10,188

Owner-occupied commercial real estate
3,992

 
(1
)
 
5

 
1,250

 
5,246

Non-owner occupied commercial real estate
8,097

 
—

 
—

 
(371
)
 
7,726

Total commercial business
21,999

 
(623
)
 
569

 
1,215

 
23,160

One-to-four family residential
1,056

 
(15
)
 
—

 
80

 
1,121

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
One-to-four family residential
862

 
—

 
2

 
152

 
1,016

Five or more family residential and commercial properties
1,190

 
—

 
—

 
(146
)
 
1,044

Total real estate construction and land development
2,052

 
—

 
2

 
6

 
2,060

Consumer
6,081

 
(1,179
)
 
230

 
1,173

 
6,305

Unallocated
898

 
—

 
—

 
428

 
1,326

Total
$
32,086

 
$
(1,817
)
 
$
801

 
$
2,902

 
$
33,972



31
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The following table details the allowance for loan losses disaggregated on the basis of the Company's impairment method as of June 30, 2018.
 
Loans Individually Evaluated for Impairment
 
Loans Collectively Evaluated for Impairment
 
PCI Loans
 
Total Allowance for Loan Losses
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
Commercial and industrial
$
1,706

 
$
7,564

 
$
918

 
$
10,188

Owner-occupied commercial real estate
1,724

 
2,736

 
786

 
5,246

Non-owner occupied commercial real estate
784

 
6,118

 
824

 
7,726

Total commercial business
4,214

 
16,418

 
2,528

 
23,160

One-to-four family residential
90

 
879

 
152

 
1,121

Real estate construction and land development:
 
 
 
 
 
 
 
One-to-four family residential
5

 
787

 
224

 
1,016

Five or more family residential and commercial properties
—

 
957

 
87

 
1,044

Total real estate construction and land development
5

 
1,744

 
311

 
2,060

Consumer
74

 
5,601

 
630

 
6,305

Unallocated
—

 
1,326

 
—

 
1,326

Total
$
4,383

 
$
25,968

 
$
3,621

 
$
33,972

The following table details the recorded investment balance of the loan receivables disaggregated on the basis of the Company’s impairment method as of June 30, 2018:
 
Loans Individually Evaluated for Impairment
 
Loans Collectively Evaluated for Impairment
 
PCI Loans
 
Total Gross Loans Receivable
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
Commercial and industrial
$
17,954

 
$
778,270

 
$
3,819

 
$
800,043

Owner-occupied commercial real estate
12,184

 
672,541

 
8,605

 
693,330

Non-owner occupied commercial real estate
10,585

 
1,165,930

 
11,033

 
1,187,548

Total commercial business
40,723

 
2,616,741

 
23,457

 
2,680,921

One-to-four family residential
291

 
88,394

 
3,833

 
92,518

Real estate construction and land development:
 
 
 
 
 
 
 
One-to-four family residential
1,084

 
70,459

 
391

 
71,934

Five or more family residential and commercial properties
—

 
93,304

 
11

 
93,315

Total real estate construction and land development
1,084

 
163,763

 
402

 
165,249

Consumer
382

 
381,445

 
4,160

 
385,987

Total
$
42,480

 
$
3,250,343

 
$
31,852

 
$
3,324,675


32
Table of Contents


The following tables detail activity in the allowance for loan losses disaggregated by segment and class for the three and six months ended June 30, 2017.
 
Balance at Beginning of Period
 
Charge-offs
 
Recoveries
 
Provision for Loan Losses
 
Balance at End of Period
 
(In thousands)
Three Months Ended June 30, 2017
 
 
 
 
 
 
 
 
 
Commercial business:
 
 
 
 
 
 
 
 
 
Commercial and industrial
$
10,091

 
$
(63
)
 
$
452

 
$
171

 
$
10,651

Owner-occupied commercial real estate
4,216

 
(78
)
 
2

 
14

 
4,154

Non-owner occupied commercial real estate
7,601

 
—

 
—

 
108

 
7,709

Total commercial business
21,908

 
(141
)
 
454

 
293

 
22,514

One-to-four family residential
1,052

 
—

 
1

 
20

 
1,073

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
One-to-four family residential
791

 
—

 
—

 
30

 
821

Five or more family residential and commercial properties
1,546

 
—

 
—

 
120

 
1,666

Total real estate construction and land development
2,337

 
—

 
—

 
150

 
2,487

Consumer
5,195

 
(398
)
 
110

 
803

 
5,710

Unallocated
1,102

 
—

 
—

 
(135
)
 
967

Total
$
31,594

 
$
(539
)
 
$
565

 
$
1,131

 
$
32,751

 
 
 
 
 
 
 
 
 
 
Six Months Ended June 30, 2017
 
 
 
 
 
 
 
 
 
Commercial business:
 
 
 
 
 
 
 
 
 
Commercial and industrial
$
10,968

 
$
(358
)
 
$
675

 
$
(634
)
 
$
10,651

Owner-occupied commercial real estate
3,661

 
(85
)
 
151

 
427

 
4,154

Non-owner occupied commercial real estate
7,753

 
—

 
—

 
(44
)
 
7,709

Total commercial business
22,382

 
(443
)
 
826

 
(251
)
 
22,514

One-to-four family residential
1,015

 
—

 
1

 
57

 
1,073

Real estate construction and land development:
 
 
 
 
 
 
 
 
 
One-to-four family residential
797

 
—

 
10

 
14

 
821

Five or more family residential and commercial properties
1,359

 
—

 
—

 
307

 
1,666

Total real estate construction and land development
2,156

 
—

 
10

 
321

 
2,487

Consumer
5,024

 
(941
)
 
217

 
1,410

 
5,710

Unallocated
506

 
—

 
—

 
461

 
967

Total
$
31,083

 
$
(1,384
)
 
$
1,054

 
$
1,998

 
$
32,751









33
Table of Contents


The following table details the allowance for loan losses disaggregated on the basis of the Company's impairment method as of December 31, 2017.
 
Loans Individually Evaluated for Impairment
 
Loans Collectively Evaluated for Impairment
 
PCI Loans
 
Total Allowance for Loan Losses
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
Commercial and industrial
$
1,326

 
$
7,558

 
$
1,026

 
$
9,910

Owner-occupied commercial real estate
621

 
2,557

 
814

 
3,992

Non-owner occupied commercial real estate
1,222

 
5,919

 
956

 
8,097

Total commercial business
3,169

 
16,034

 
2,796

 
21,999

One-to-four family residential
93

 
798

 
165

 
1,056

Real estate construction and land development:
 
 
 
 
 
 
 
One-to-four family residential
2

 
635

 
225

 
862

Five or more family residential and commercial properties
37

 
1,064

 
89

 
1,190

Total real estate construction and land development
39

 
1,699

 
314

 
2,052

Consumer
54

 
5,303

 
724

 
6,081

Unallocated
—

 
898

 
—

 
898

Total
$
3,355

 
$
24,732

 
$
3,999

 
$
32,086

The following table details the recorded investment balance of the loan receivables disaggregated on the basis of the Company’s impairment method as of December 31, 2017:
 
Loans Individually Evaluated for Impairment
 
Loans Collectively Evaluated for Impairment
 
PCI Loans
 
Total Gross Loans Receivable
 
(In thousands)
Commercial business:
 
 
 
 
 
 
 
Commercial and industrial
$
11,999

 
$
630,485

 
$
2,912

 
$
645,396

Owner-occupied commercial real estate
6,808

 
603,827

 
11,515

 
622,150

Non-owner occupied commercial real estate
16,019

 
957,233

 
13,342

 
986,594

Total commercial business
34,826

 
2,191,545

 
27,769

 
2,254,140

One-to-four family residential
299

 
81,443

 
5,255

 
86,997

Real estate construction and land development:
 
 
 
 
 
 
 
One-to-four family residential
1,247

 
50,649

 
89

 
51,985

Five or more family residential and commercial properties
645

 
94,819

 
2,035

 
97,499

Total real estate construction and land development
1,892

 
145,468

 
2,124

 
149,484

Consumer
442

 
349,194

 
5,455

 
355,091

Total
$
37,459


$
2,767,650

 
$
40,603

 
$
2,845,712



34
Table of Contents


(6)
Other Real Estate Owned
Changes in other real estate owned during the three and six months ended June 30, 2017 were as follows:
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2018
 
2017
 
2018
 
2017
 
(In thousands)
Balance at the beginning of the period
$
—

 
$
786

 
$
—

 
$
754

Additions
434

 
—

 
434

 
32

Balance at the end of the period
$
434

 
$
786

 
$
434

 
$
786


At June 30, 2018, the carrying amount of other real estate owned that was the result of foreclosure and obtaining physical possession of residential real estate properties was $434,000. At June 30, 2018, the recorded investment of consumer mortgage loans secured by residential real estate properties (included in the one-to-four family residential loans in Note (4) Loans Receivable) for which formal foreclosure proceedings were in process was $77,000.

(7)
Goodwill and Other Intangible Assets

(a) Goodwill
The Company’s goodwill represents the excess of the purchase price over the fair value of net assets acquired in the recent Puget Sound Merger on January 16, 2018 and the historical acquisitions of Washington Banking Company on May 1, 2014; Valley Community Bancshares on July 15, 2013; Western Washington Bancorp in 2006 and North Pacific Bank in 1998. The Company’s goodwill is assigned to the Bank and is evaluated for impairment at the Bank level (reporting unit).
The following table presents the change in goodwill for the periods indicated:
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2018
 
2017
 
2018
 
2017
 
 
(In thousands)
Balance at the beginning of the period
 
$
187,549

 
$
119,029

 
$
119,029

 
$
119,029

Additions as a result of acquisitions (1)
 
—

 
—

 
68,520

 
—

Balance at the end of the period
 
$
187,549

 
$
119,029

 
$
187,549

 
$
119,029

(1) See Note (2) Business Combination
The Company performed its annual goodwill impairment test during the fourth quarter of 2017 and determined based on its Step 1 analysis that the fair value of the reporting unit exceeded the carrying value, such that the Company's goodwill was not considered impaired. Changes in the economic environment, operations of the reporting unit or other adverse events could result in future impairment charges which could have a material impact on the Company’s operating results.
(b) Other Intangible Assets
The other intangible assets represent the core deposit intangible ("CDI") acquired in business combinations. The useful life of the CDI related to the acquisitions of Puget Sound Bancorp, Washington Banking Company, Valley Community Bancshares, and Northwest Commercial Bank were estimated to be ten, ten, ten, and five years, respectively.

35
Table of Contents


The following table presents the change in other intangible assets for the periods indicated:
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2018
 
2017
 
2018
 
2017
 
 
(In thousands)
Balance at the beginning of the period
 
$
16,563

 
$
7,050

 
$
6,088

 
$
7,374

Additions as a result of acquisitions (1)
 
—

 
—

 
11,270

 
—

Amortization
 
(796
)
 
(323
)
 
(1,591
)
 
(647
)
Balance at the end of the period
 
$
15,767

 
$
6,727

 
$
15,767

 
$
6,727

(1) See Note (2) Business Combination

(8)
Junior Subordinated Debentures
As part of the acquisition of Washington Banking Company on May 1, 2014, the Company assumed trust preferred securities and junior subordinated debentures with a total fair value of $18.9 million at the merger date.
Washington Banking Master Trust, a Delaware statutory business trust, was a wholly-owned subsidiary of the Washington Banking Company created for the exclusive purposes of issuing and selling capital securities and utilizing sale proceeds to acquire junior subordinated debentures issued by the Washington Banking Company. During 2007, the Trust issued $25.0 million of trust preferred securities with a 30-year maturity, callable after the fifth year by the Washington Banking. The trust preferred securities have a quarterly adjustable rate based upon the three-month London Interbank Offered Rate (“LIBOR”) plus 1.56%. On the merger date, the Company acquired the Trust, which retained the Washington Banking Master Trust name, and assumed the performance and observance of the covenants under the indenture related to the trust preferred securities.
The adjustable rate of the trust preferred securities at June 30, 2018 was 3.90%. The weighted average rate of the junior subordinated debentures was as follows for the indicated periods:
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2018
 
2017
 
2018
 
2017
Weighted average rate (1)
 
6.28
%
 
5.04
%
 
6.01
%
 
4.96
%
(1) The weighted average rate includes the accretion of the discount established at the merger date which is amortized over the life of the trust preferred securities.
The junior subordinated debentures are the sole assets of the Trust and payments under the junior subordinated debentures are the sole revenues of the Trust. At June 30, 2018 and December 31, 2017, the balance of the junior subordinated debentures, net of unaccreted discount, was $20.2 million and $20.0 million, respectively. All of the common securities of the Trust are owned by the Company. Heritage has fully and unconditionally guaranteed the capital securities along with all obligations of the Trust under the trust agreements. For financial reporting purposes, the Company's investment in the Master Trust is accounted for under the equity method and is included in prepaid expenses and other assets on the Company's Condensed Consolidated Statements of Financial Condition. The junior subordinated debentures issued and guaranteed by the Company and held by the Master Trust are reflected as liabilities on the Company's Condensed Consolidated Statements of Financial Condition.


36
Table of Contents


(9)
Repurchase Agreements
The Company utilizes repurchase agreements with one-day maturities as a supplement to funding sources. Repurchase agreements are secured by pledged investment securities available for sale. Under the repurchase agreements, the Company is required to maintain an aggregate market value of securities pledged greater than the balance of the repurchase agreements. The Company is required to pledge additional securities to cover any declines below the balance of the repurchase agreements. For additional information on the total value of investment securities pledged for repurchase agreements see Note (3) Investment Securities.
The following table presents the Company's repurchase agreement obligations by class of collateral pledged:
 
June 30, 2018
 
December 31, 2017
 
(In thousands)
Mortgage-backed securities and collateralized mortgage obligations(1):
 
 
 
Residential
$
10,444

 
$
11,239

Commercial
11,724

 
20,582

Total repurchase agreements
$
22,168

 
$
31,821

(1) Issued and guaranteed by U.S. Government-sponsored agencies.

(10)
Other Borrowings
(a) FHLB
The Federal Home Loan Bank ("FHLB") of Des Moines functions as a member-owned cooperative providing credit for member financial institutions. Advances are made pursuant to several different programs. Each credit program has its own interest rate and range of maturities. Limitations on the amount of advances are based on a percentage of the Bank's assets or on the FHLB’s assessment of the institution’s creditworthiness. At June 30, 2018, the Bank maintained a credit facility with the FHLB of Des Moines with available borrowing capacity of $838.1 million and had short-term FHLB advances outstanding of $75.5 million with maturity dates within 30 days. At December 31, 2017 there were FHLB advances outstanding of $92.5 million.
The following table sets forth the details of FHLB advances during the three and six months ended June 30, 2018 and 2017:
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2018
 
2017
 
2018
 
2017
 
(In thousands)
FHLB Advances:
 
 
 
 
 
 
 
Average balance during the period
$
79,115

 
$
107,125

 
$
57,544

 
$
104,144

Maximum month-end balance during the period
$
154,500

 
$
137,450

 
$
154,500

 
$
137,450

Weighted average rate during the period
2.04
%
 
0.89
%
 
1.93
%
 
0.86
%
Advances from the FHLB are collateralized by a blanket pledge on FHLB stock owned by the Bank, deposits at the FHLB, certain one-to-four single family residential loans or other assets, investment securities which are obligations of or guaranteed by the United States, or other assets. In accordance with the pledge agreement, the Company must maintain unencumbered collateral in an amount equal to varying percentages ranging from 100% to 160% of outstanding advances depending on the type of collateral.

(b) Federal Funds Purchased
The Bank maintains advance lines with Wells Fargo Bank, US Bank, The Independent Bankers Bank ("TIB") and Pacific Coast Bankers’ Bank to purchase federal funds of up to $90.0 million as of June 30, 2018. The lines generally mature annually or are reviewed annually. As of June 30, 2018 and December 31, 2017, there were no federal funds purchased.

(c) Credit Facilities
The Bank maintains a credit facility with the Federal Reserve Bank of San Francisco ("Federal Reserve Bank") with available borrowing capacity of $58.1 million as of June 30, 2018, on which there were no borrowings outstanding as of June 30, 2018 or December 31, 2017. Any advances on the credit facility would have to be first secured by the Bank's investment securities or loans receivable.

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(11)
Derivative Financial Instruments
The Company has entered into certain interest rate swap contracts that are not designated as hedging instruments. The purpose of these derivative contracts is primarily to provide commercial business loan customers the ability to convert their loans from variable to fixed interest rates. Upon the origination of a derivative contract with a customer, the Company simultaneously enters into an offsetting derivative contract with a third party in order to offset its exposure on the variable and fixed rate components of the customer agreement. The Company recognizes immediate income based upon the difference in the bid/ask spread of the underlying transactions with its customers and the third party, which is recorded in interest rate swap fees on the Condensed Consolidated Statements of Income. Because the Company acts only as an intermediary for its customer, subsequent changes in the fair value of the underlying derivative contracts offset each other and do not significantly impact the Company’s results of operations.
The notional amounts and estimated fair values of interest rate derivative contracts outstanding at June 30, 2018 and December 31, 2017 are presented in the following table.
 
 
June 30, 2018
 
December 31, 2017
 
 
Notional Amounts
 
Estimated Fair Value
 
Notional Amounts
 
Estimated Fair Value
 
 
(In thousands)
Non-hedging interest rate derivatives
 
 
 
 
 
 
 
 
Interest rate swaps with customer (1)
 
$
163,257

 
$
(5,454
)
 
$
146,537

 
$
(882
)
Interest rate swap with third party (1)
 
163,257

 
5,454

 
146,537

 
882

 (1) The estimated fair value of the derivative included in prepaid and other assets on the Condensed Consolidated Statements of Financial Condition was $6.6 million and $3.4 million as of June 30, 2018 and December 31, 2017, respectively. The estimated fair value of the derivative included in accrued expenses and other liabilities on the Condensed Consolidated Statements of Financial Condition was $6.6 million and $3.4 million as of June 30, 2018 and December 31, 2017, respectively.

(12)
Stockholders’ Equity
(a) Earnings Per Common Share
The following table illustrates the reconciliation of weighted average shares used for earnings per common share computations for the three and six months ended June 30, 2018 and 2017:
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2018
 
2017
 
2018
 
2017
 
(Dollars in thousands)
Net income:
 
 
 
 
 
 
 
Net income
$
11,857

 
$
11,828

 
$
20,944

 
$
21,144

Less: Dividends and undistributed earnings allocated to participating securities
(57
)
 
(83
)
 
(110
)
 
(164
)
Net income allocated to common shareholders
$
11,800

 
$
11,745

 
$
20,834

 
$
20,980

Basic:
 
 
 
 
 
 
 
Weighted average common shares outstanding
34,023,566

 
29,939,280

 
33,680,014

 
29,945,641

Less: Restricted stock awards
(88,905
)
 
(183,082
)
 
(107,897
)
 
(215,446
)
Total basic weighted average common shares outstanding
33,934,661

 
29,756,198

 
33,572,117

 
29,730,195

Diluted:
 
 
 
 
 
 
 
Basic weighted average common shares outstanding
33,934,661

 
29,756,198

 
33,572,117

 
29,730,195

Effect of potentially dilutive common shares (1)
172,631

 
83,411

 
157,819

 
64,042

Total diluted weighted average common shares outstanding
34,107,292

 
29,839,609

 
33,729,936

 
29,794,237

(1) 
Represents the effect of the assumed exercise of stock options and vesting of restricted stock units.

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Potential dilutive shares are excluded from the computation of earnings per share if their effect is anti-dilutive. For the three and six months ended June 30, 2018 and 2017, there were no anti-dilutive shares outstanding related to options to acquire common stock. Anti-dilution occurs when the exercise price of a stock option or the unrecognized compensation cost per share of a restricted stock award exceeds the market price of the Company’s stock.
(b) Dividends
The timing and amount of cash dividends paid on the Company's common stock depends on the Company’s earnings, capital requirements, financial condition and other relevant factors. Dividends on common stock from the Company depend substantially upon receipt of dividends from the Bank, which is the Company’s predominant source of income.
The following table summarizes the dividend activity for the six months ended June 30, 2018 and calendar year 2017.
Declared
 
Cash Dividend per Share
 
Record Date
 
Paid Date
 
January 25, 2017
 
$0.12
 
February 9, 2017
 
February 23, 2017
 
April 25, 2017
 
$0.13
 
May 10, 2017
 
May 24, 2017
 
July 25, 2017
 
$0.13
 
August 10, 2017
 
August 24, 2017
 
October 25, 2017
 
$0.13
 
November 8, 2017
 
November 22, 2017
 
October 25, 2017
 
$0.10
 
November 8, 2017
 
November 22, 2017
*
January 24, 2018
 
$0.15
 
February 7, 2018
 
February 21, 2018
 
April 25, 2018
 
$0.15
 
May 10, 2018
 
May 24, 2018
 
* Denotes a special dividend.
The FDIC and the Washington State Department of Financial Institutions, Division of Banks have the authority under their supervisory powers to prohibit the payment of dividends by the Bank to the Company. Additionally, current guidance from the Board of Governors of the Federal Reserve System ("Federal Reserve") provides, among other things, that dividends per share on the Company’s common stock generally should not exceed earnings per share, measured over the previous four fiscal quarters. Current regulations allow the Company and the Bank to pay dividends on their common stock if the Company’s or the Bank’s regulatory capital would not be reduced below the statutory capital requirements set by the Federal Reserve and the FDIC.
(c) Stock Repurchase Program
The Company has had various stock repurchase programs since March 1999. On October 23, 2014, the Company's Board of Directors authorized the repurchase of up to 5% of the Company's outstanding common shares, or approximately 1,513,000 shares, under the eleventh stock repurchase plan. The number, timing and price of shares repurchased will depend on business and market conditions and other factors, including opportunities to deploy the Company's capital.
Since the inception of the eleventh plan, the Company has repurchased 579,996 shares at an average share prices of $16.67. No shares were repurchased under this plan during the three and six months ended June 30, 2018 and 2017.
In addition to the stock repurchases under a plan, the Company repurchases shares to pay withholding taxes on the vesting of restricted stock awards and units. The following table provides total repurchased shares for the periods indicated:
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2018
 
2017
 
2018
 
2017
Repurchased shares to pay withholding taxes (1)
7,394

 
11,476

 
52,820

 
27,367

Stock repurchase to pay withholding taxes average share price
$
33.84

 
$
25.50

 
$
31.96

 
$
24.60

(1) During the six months ended June 30, 2018, the Company repurchased 26,741 of shares related to the withholding taxes due on the accelerated vesting of the restricted stock units of Puget Sound which were converted to Heritage common stock shares with an average share price of $31.80 under the terms of the merger. See Note (2) Business Combination.

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Table of Contents


(d) Issuance of Common Stock
The Puget Sound Merger was effective on January 16, 2018. In conjunction with the merger was the issuance of 4,112,258 shares of the Company's common stock at the merger date share price of $31.80 for a fair value of $130.8 million.

(13)
Accumulated Other Comprehensive (Loss) Income
The changes in accumulated other comprehensive (loss) income (“AOCI”), all of which are due to changes in the fair value of available for sale securities and are net of tax, during the three and six months ended June 30, 2018 and 2017 are as follows:
 
Three Months Ended
 
Six Months Ended
 
2018
 
2017
 
2018
 
2017
 
(In thousands)
Balance of AOCI at the beginning of period
$
(8,934
)
 
$
(1,133
)
 
$
(1,298
)
 
$
(2,606
)
Other comprehensive (loss) income before reclassification
(2,358
)
 
2,766

 
(9,874
)
 
4,239

Amounts reclassified from AOCI for gain on sale of investment securities included in net income
(14
)
 
(76
)
 
(41
)
 
(76
)
Net current period other comprehensive (loss) income
(2,372
)
 
2,690

 
(9,915
)
 
4,163

ASU 2016-01 implementation
—

 
—

 
(93
)
 
—

Balance of AOCI at the end of period
$
(11,306
)
 
$
1,557

 
$
(11,306
)
 
$
1,557



(14)
Fair Value Measurements
Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. There are three levels of inputs that may be used to measure fair values:
Level 1: Valuations for assets and liabilities traded in active exchange markets, or interest in open-end mutual funds that allow the Company to sell its ownership interest back to the fund at net asset value on a daily basis. Valuations are obtained from readily available pricing sources for market transactions involving identical assets, liabilities, or funds.
Level 2: Valuations for assets and liabilities traded in less active dealer or broker markets, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or valuations using methodologies with observable inputs.
Level 3: Valuations for assets and liabilities that are derived from other valuation methodologies, such as option pricing models, discounted cash flow models and similar techniques using unobservable inputs, and not based on market exchange, dealer, or broker traded transactions. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities.
(a) Recurring and Nonrecurring Basis
The Company used the following methods and significant assumptions to measure the fair value of certain assets on a recurring and nonrecurring basis:
Investment Securities Available for Sale:
The fair values of all investment securities are based upon the assumptions that market participants would use in pricing the security. If available, fair values of investment securities are determined by quoted market prices (Level 1). For investment securities where quoted market prices are not available, fair values are calculated based on market prices on similar securities (Level 2). For investment securities where quoted prices or market prices of similar securities are not available, fair values are calculated by using observable and unobservable inputs such as discounted cash flows or other market indicators (Level 3). Security valuations are obtained from third party pricing services for comparable assets or liabilities.

40
Table of Contents


Impaired Loans:
At the time a loan is considered impaired, its impairment is measured based on either the present value of expected future cash flows discounted at the loan’s effective interest rate, the observable market price, or the fair market value of the collateral (less costs to sell) if the loan is collateral-dependent. Impaired loans for which impairment is measured using the discounted cash flow approach are not considered to be measured at fair value because the loan’s effective interest rate is generally not a fair value input, and for the purposes of fair value disclosures, the fair value of these loans are measured commensurate with non-impaired loans. If the Company utilizes the fair market value of the collateral method, the fair value used to measure impairment is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. Non-real estate collateral may be valued using an appraisal, net book value based on the borrower’s financial statements, or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation and management’s expertise and knowledge of the client and client’s business (Level 3). Impaired loans are evaluated on a quarterly basis and impairment and is adjusted accordingly.
Other Real Estate Owned:
Assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. These assets are subsequently accounted for at lower of cost or fair value less costs to sell. Fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in Level 3 classification of the inputs for determining fair value.
Appraisals for both collateral-dependent impaired loans and other real estate owned are performed by certified general appraisers for commercial properties or certified residential appraisers for residential properties whose qualifications and licenses have been reviewed and verified by the Company. Once received, the Company reviews the assumptions and approaches utilized in the appraisal as well as the resulting fair value in comparison with independent data sources such as recent market data or industry-wide statistics. On a quarterly basis, the Company compares the actual selling price of collateral that has been liquidated to the most recent appraised value to determine what additional adjustment should be made to the appraisal value to arrive at fair value.

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Table of Contents


Derivative Financial Instruments:
The Company obtains broker or dealer quotes to value its interest rate derivative contracts, which use valuation models using observable market data as of the measurement date (Level 2).
The following tables summarize the balances of assets and liabilities measured at fair value on a recurring basis as of June 30, 2018 and December 31, 2017.
 
June 30, 2018
 
Total
 
Level 1
 
Level 2
 
Level 3
 
(In thousands)
Assets
 
 
 
 
 
 
 
Investment securities available for sale:
 
 
 
 
 
 
 
U.S. Treasury and U.S. Government-sponsored agencies
$
52,064

 
$
—

 
$
52,064

 
$
—

Municipal securities
203,022

 
—

 
203,022

 
—

Mortgage-backed securities and collateralized mortgage obligations:
 
 
 
 
 
 
 
Residential
312,122

 
—

 
312,122

 
—

Commercial
250,221

 
—

 
250,221

 
—

Collateralized loan obligations
2,256

 
—

 
2,256

 
—

Corporate obligations
25,690

 
—

 
25,690

 
—

Other asset-backed securities
28,295

 
—

 
28,295

 
—

Total investment securities available for sale
873,670

 
—

 
873,670

 
—

Derivative assets - interest rate swaps
6,629

 
—

 
6,629

 
—

Liabilities
 
 
 
 
 
 
 
Derivative liabilities - interest rate swaps
$
6,629

 
$
—

 
$
6,629

 
$
—

 
December 31, 2017
 
Total
 
Level 1
 
Level 2
 
Level 3
 
(In thousands)
Assets
 
 
 
 
 
 
 
Investment securities available for sale:
 
 
 
 
 
 
 
U.S. Treasury and U.S. Government-sponsored agencies
$
13,442

 
$
—

 
$
13,442

 
$
—

Municipal securities
250,015

 
—

 
250,015

 
—

Mortgage-backed securities and collateralized mortgage obligations:
 
 
 
 
 
 
 
Residential
280,211

 
—

 
280,211

 
—

Commercial
217,079

 
—

 
217,079

 
—

Collateralized loan obligations
4,580

 
—

 
4,580

 
—

Corporate obligations
16,770

 
—

 
16,770

 
—

Other securities
28,433

 
146

 
28,287

 
—

Total investment securities available for sale
810,530

 
146

 
810,384

 
—

Derivative assets - interest rate swaps
3,418

 
—

 
3,418

 
—

Liabilities
 
 
 
 
 
 
 
Derivative liabilities - interest rate swaps
$
3,418

 
$
—

 
$
3,418

 
$
—

There were no transfers between Level 1 and Level 2 during the three and six months ended June 30, 2018 and 2017.
The Company may be required to measure certain financial assets and liabilities at fair value on a nonrecurring basis. These adjustments to fair value usually result from application of lower-of-cost-or-market accounting or write-downs of individual assets.

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Table of Contents


The tables below represent assets measured at fair value on a nonrecurring basis at June 30, 2018 and December 31, 2017 and the net losses recorded in earnings during three and six months ended June 30, 2018 and 2017.
 
Basis(1)
 
Fair Value at June 30, 2018
 
 
 
 
 
Total
 
Level 1
 
Level 2
 
Level 3
 
Net Losses (Gains)
Recorded in
Earnings 
During
the Three Months Ended June 30, 2018
 
Net Losses
(Gains)
Recorded in
Earnings 
During
the Six Months Ended
June 30, 2018
 
(In thousands)
Impaired loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
Real estate construction and land development:
 
 
 
 
 
 
 
 
 
 
 
 
 
One-to-four family residential
$
976

 
$
304

 
$
—

 
$
—

 
$
304

 
$
3

 
3

Total assets measured at fair value on a nonrecurring basis
$
976

 
$
304

 
$
—

 
$
—

 
$
304

 
$
3

 
$
3

(1) 
Basis represents the unpaid principal balance of impaired loans.

 
Basis(1)
 
Fair Value at December 31, 2017
 
 
 
 
 
Total
 
Level 1
 
Level 2
 
Level 3
 
Net Losses
Recorded in
Earnings 
During
the Three Months Ended June 30, 2017
 
Net Losses
(Gains)
Recorded in
Earnings 
During
the Six Months Ended June 30, 2017
 
(In thousands)
Impaired loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
Real estate construction and land development:
 
 
 
 
 
 
 
 
 
 
 
 
 
One-to-four family residential
$
976

 
$
307

 
$
—

 
$
—

 
$
307

 
$
—

 
—

Total assets measured at fair value on a nonrecurring basis
$
976

 
$
307

 
$
—

 
$
—

 
$
307

 
$
—

 
$
—

(1) 
Basis represents the unpaid principal balance of impaired loans.

The following table presents quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at June 30, 2018 and December 31, 2017.
 
June 30, 2018
 
Fair
Value
 
Valuation
Technique(s)
 
Unobservable Input(s)
 
Range of Inputs; Weighted
Average
 
(Dollars in thousands)
Impaired loans
$
304

 
Market approach
 
Adjustment for differences between the comparable sales
 
(91.2%) - (14.4)%; (44.0%)
 
December 31, 2017
 
Fair
Value
 
Valuation
Technique(s)
 
Unobservable Input(s)
 
Range of Inputs; Weighted
Average
 
(Dollars in thousands)
Impaired loans
$
307

 
Market approach
 
Adjustment for differences between the comparable sales
 
(91.5%) - (14.4%); (44.0%)


43
Table of Contents


(b) Fair Value of Financial Instruments
Because broadly traded markets do not exist for most of the Company’s financial instruments, the fair value calculations attempt to incorporate the effect of current market conditions at a specific time. These determinations are subjective in nature, involve uncertainties and matters of significant judgment and do not include tax ramifications; therefore, the results cannot be determined with precision, substantiated by comparison to independent markets and may not be realized in an actual sale or immediate settlement of the instruments. There may be inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results. For all of these reasons, the aggregation of the fair value calculations presented herein do not represent, and should not be construed to represent, the underlying value of the Company.
The tables below present the carrying value amount of the Company’s financial instruments and their corresponding estimated fair values at the dates indicated.
 
June 30, 2018
 
Carrying Value

Fair Value

Fair Value Measurements Using:
 

Level 1

Level 2

Level 3
 
(In thousands)
Financial Assets:
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
129,943

 
$
129,943

 
$
129,943

 
$
—

 
$
—

Investment securities available for sale
873,670

 
873,670

 
—

 
873,670

 
—

Federal Home Loan Bank stock
8,616

 
N/A

 
N/A

 
N/A

 
N/A

Loans held for sale
3,598

 
3,708

 
—

 
3,708

 
—

Total loans receivable, net
$
3,294,316

 
$
3,277,881

 
$
—

 
$
—

 
$
3,277,881

Accrued interest receivable
13,482

 
13,482

 
28

 
3,826

 
9,628

Derivative assets - interest rate swaps
6,629

 
6,629

 
—


6,629

 
—

Equity security
162

 
162

 
162

 
—

 
—

Financial Liabilities:
 
 
 
 
 
 
 
 
 
Noninterest deposits, interest bearing demand deposits, money market accounts and savings accounts
3,508,300

 
3,508,300

 
3,508,300

 
—

 
—

Certificate of deposit accounts
460,635

 
463,971

 
—

 
463,971

 
—

Federal Home Loan Bank advances
75,500

 
75,500

 
—

 
75,500

 
—

Securities sold under agreement to repurchase
22,168

 
22,168

 
22,168

 
—

 
—

Junior subordinated debentures
20,156

 
20,000

 
—

 
—

 
20,000

Accrued interest payable
198

 
198

 
46

 
107

 
45

Derivative liabilities - interest rate swaps
6,629

 
6,629

 
—

 
6,629

 
—


44
Table of Contents


 
December 31, 2017
 
Carrying Value
 
Fair Value
 
Fair Value Measurements Using:
 
 
Level 1
 
Level 2
 
Level 3
 
(In thousands)
Financial Assets:
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
103,015

 
$
103,015

 
$
103,015

 
$
—

 
$
—

Investment securities available for sale
810,530

 
810,530

 
146

 
810,384

 
—

Federal Home Loan Bank stock
8,347

 
N/A

 
N/A

 
N/A

 
N/A

Loans held for sale
2,288

 
2,364

 
—

 
2,364

 
—

Loans receivable, net of allowance for loan losses
2,816,985

 
2,810,401

 
—

 
—

 
2,810,401

Accrued interest receivable
12,244

 
12,244

 
23

 
3,772

 
8,449

Derivative assets - interest rate swaps
3,418

 
3,418

 
—

 
3,418

 
—

Financial Liabilities:
 
 
 
 
 
 
 
 
 
Noninterest deposits, interest bearing demand deposits, money market accounts and savings accounts
$
2,994,662

 
$
2,994,662

 
$
2,994,662

 
$
—

 
$
—

Certificate of deposit accounts
398,398

 
397,039

 
—

 
397,039

 
—

Federal Home Loan Bank advances
92,500

 
92,500

 
—

 
92,500

 
—

Securities sold under agreement to repurchase
31,821

 
31,821

 
31,821

 
—

 
—

Junior subordinated debentures
20,009

 
18,500

 
—

 
—

 
18,500

Accrued interest payable
162

 
162

 
45

 
79

 
38

Derivative liabilities - interest rate swaps
3,418

 
3,418

 
—

 
3,418

 
—


(15)
Stock-Based Compensation
On July 24, 2014, the Company's shareholders approved the Heritage Financial Corporation 2014 Omnibus Equity Plan (the "Plan") that provides for the issuance of 1,500,000 shares of the Company's common stock in the form of stock options, stock appreciation rights, stock awards (which includes restricted stock units, restricted stock, performance units, performance shares or bonus shares) and cash incentive awards. The Company issues new shares of common stock to satisfy share option exercises and restricted stock awards. As of June 30, 2018, shares that remain available for future issuance under the Company's stock-based compensation plans was 964,832.
(a) Stock Option Awards
Stock options generally vest ratably over three years and expire five years after they become exercisable or vest ratably over four years and expire ten years from date of grant. For the three and six months ended June 30, 2018 and 2017, the Company did not recognize any compensation expense or related tax benefit related to stock options as all of the compensation expense related to the outstanding stock options had been previously recognized. The intrinsic value and cash proceeds from options exercised during the six months ended June 30, 2018 was $82,000 and $47,000, respectively. The intrinsic value and cash proceeds from options exercised during the six months ended June 30, 2017 was $98,000 and $109,000, respectively.

45
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The following table summarizes the stock option activity for the six months ended June 30, 2018 and 2017:
 
Shares
 
Weighted-Average Exercise Price
 
Weighted-Average
Remaining
Contractual
Term (In years)
 
Aggregate
Intrinsic
Value (In
thousands)
Outstanding at December 31, 2016
37,495

 
$
13.77

 
 
 
 
Exercised
(8,372
)
 
13.03

 
 
 
 
Forfeited or expired
(1,308
)
 
13.53

 
 
 
 
Outstanding, vested and expected to vest and exercisable at June 30, 2017
27,815

 
$
14.00

 
2.63
 
$
348

 
 
 
 
 
 
 
 
Outstanding at December 31, 2017
23,231

 
$
14.21

 
 
 
 
Exercised
(4,042
)
 
11.55

 
 
 
 
Forfeited or expired
(831
)
 
14.77

 
 
 
 
Outstanding, vested and expected to vest and exercisable at June 30, 2018
18,358

 
$
14.77

 
1.90
 
$
369


(b) Restricted Stock Awards
Restricted stock awards granted generally have a four-year cliff vesting or four-year ratable vesting schedule. For the three and six months ended June 30, 2018, the Company recognized compensation expense related to restricted stock awards of $249,000 and $532,000, respectively, and a related tax benefit of $52,000 and $112,000, respectively. For the three and six months ended June 30, 2017, the Company recognized compensation expense related to restricted stock awards of $359,000 and $804,000, respectively, and a related tax benefit of $126,000 and $282,000, respectively. As of June 30, 2018, the total unrecognized compensation expense related to non-vested restricted stock awards was $949,000 and the related weighted average period over which the compensation expense is expected to be recognized is approximately 1.38 years. The vesting date fair value of the restricted stock awards that vested during the six months ended June 30, 2018 and 2017 was $2.1 million and $2.6 million, respectively.
The following table summarizes the restricted stock award activity for the six months ended June 30, 2018 and 2017:
 
Shares
 
Weighted-Average Grant Date Fair Value
Nonvested at December 31, 2016
261,296

 
$
16.80

Vested
(105,972
)
 
16.47

Forfeited
(7,704
)
 
16.78

Nonvested at June 30, 2017
147,620

 
$
17.04

 
 
 
 
Nonvested at December 31, 2017
137,399

 
$
17.00

Vested
(66,193
)
 
16.67

Forfeited
(2,394
)
 
16.86

Nonvested at June 30, 2018
68,812

 
$
17.32


(c) Restricted Stock Units
During 2017, the Company began issuing performance-based stock-settled restricted stock unit awards ("PRSU") and stock-settled restricted stock unit awards ("RSU"), collectively called "units". Restricted stock units granted vest ratably over three years. Performance restricted stock units granted generally have a three-year cliff vesting schedule. Additionally, performance restricted stock unit grants may be subject to performance-based vesting as well as other approved vesting conditions. The number of shares of actually delivered pursuant to the PRSUs depends on the performance of the Company's Total Shareholder Return and Return on Average Assets over the performance period in relation to the performance of the common stock of a predetermined peer group. The conditions of the grants allow for an actual payout ranging between no payout and 150% of target. The payout level is calculated based on actual performance achieved during the performance period compared to a defined peer group. The fair

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value of such PRSUs was determined using a Monte Carlo simulation and will be recognized over the subsequent three years. The Monte-Carlo simulation model uses the same input assumptions as the Black-Scholes model; however, it also further incorporates into the fair value determination the possibility that the market condition may not be satisfied. Compensation costs related to these awards are recognized regardless of whether the market condition is satisfied, provided that the requisite service has been provided.
Expected volatilities in the model were estimated using a historical period consistent with the performance period of approximately three years. The risk-free interest rate was based on the United States Treasury rate for a term commensurate with the expected life of the grant. The Company used the following assumptions to estimate the fair value of PRSUs granted during February 2018 and 2017:
 
2018
 
2017
Shares issued
5,550

 
6,089

Expected Term in Years
2.84

 
2.85

Weighted-Average Risk Free Interest Rate
2.39
%
 
1.40
%
Expected Dividend Yield
—
%
 
—
%
Weighted-Average Fair Value
27.69

 
24.39

Correlation coefficient
ABA NASDAQ Community Bank Index

 
ABA NASDAQ Community Bank Index

Range of peer company volatilities
18.99% - 51.42%

 
17.8% - 63.1%

Range of peer company correlation coefficients
28.16% - 94.29%

 
8.24% - 89.79%

Heritage volatility
22.3
%
 
21.8
%
Heritage correlation coefficient
76.44
%
 
75.93
%
For the three and six months ended June 30, 2018, the Company recognized compensation expense related to the units of $435,000 and $775,000, respectively, and a related tax benefit of $91,000 and $163,000, respectively. For the three and six months ended June 30, 2017, the Company recognized compensation expense related the units of $171,000 and $236,000, respectively, and a related tax benefit of $60,000 and $83,000, respectively. As of June 30, 2018, the total unrecognized compensation expense related to non-vested units was $4.1 million and the related weighted average period over which the compensation expense is expected to be recognized is approximately 2.65 years. The vesting date fair value of the units that vested during the six months ended June 30, 2018 was $1.0 million. There were no units that vested during the six months ended June 30, 2017.
The following table summarizes the unit activity for the six months ended June 30, 2018 and 2017:
 
Shares
 
Weighted-Average Grant Date Fair Value
Nonvested at December 31, 2016
—

 
$
—

Granted
92,019

 
25.29

Forfeited
(909
)
 
25.35

Nonvested at June 30, 2017
91,110

 
$
25.29

 
 
 
 
Nonvested at December 31, 2017
90,544

 
$
25.31

Granted
114,015

 
30.61

Vested
(32,262
)
 
25.42

Forfeited
(3,644
)
 
27.87

Nonvested at June 30, 2018
168,653

 
$
28.51


(16)
Cash Requirement
The Company is required to maintain an average reserve balance with the Federal Reserve Bank or maintain such reserve balance in the form of cash. The required reserve balance at June 30, 2018 and December 31, 2017 was $10.9 million and $60,000, respectively, and was met by holding cash and maintaining an average balance with the Federal Reserve Bank.


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(17)
Subsequent Event

On July 2, 2018, the Company completed the previously announced acquisition of Premier Commercial. As of the acquisition date, Premier Commercial was merged with and into Heritage and Premier Community Bank was merged with and into Heritage Bank. Premier Commercial had six branch locations. The Premier Merger is being accounted for using the acquisition method of accounting.
Pursuant the terms of the merger agreement, Premier Commercial shareholders received 0.4863 shares of Heritage common stock for each share of Premier Commercial common stock. Based on the June 29, 2018 closing price of Heritage common stock of $34.85, Heritage issued 2,848,579 shares of the Company's common stock and paid $2,000 in cash for fractional shares for total consideration of $99.3 million, including the value of the outstanding shares of Premier Commercial restricted stock which vested immediately at the merger date.
The operating results of the Company for the three and six months ended June 30, 2018 do not include the operating results related to the assets acquired and liabilities assumed in the Premier Merger as it was not completed until July 2, 2018. As of June 30, 2018, Premier Commercial had total assets of $381.7 million, total loans of $335.3 million and total deposits of $319.3 million. It is not practical to present financial information related to the fair value of assets acquired and liabilities assumed from Premier Commercial at this time because the fair value information has not been finalized.
For the three and six months ended June 30, 2018, the Company incurred acquisition related costs of $329,000 and $653,000, respectively, related to the Premier Merger.

ITEM 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion is intended to assist in understanding the financial condition and results of the Company as of and for the three and six months ended June 30, 2018. The information contained in this section should be read with the unaudited Condensed Consolidated Financial Statements and the accompanying Notes included herein, and the December 31, 2017 audited Consolidated Financial Statements and the accompanying Notes included in our Annual Report on Form 10-K for the year ended December 31, 2017.

Overview
Heritage Financial Corporation is a bank holding company which primarily engages in the business activities of our wholly-owned financial institution subsidiary, Heritage Bank. We provide financial services to our local communities with an ongoing strategic focus on our commercial banking relationships, market expansion and asset quality. At June 30, 2018, we had total assets of $4.79 billion and total stockholders’ equity of $639.5 million. The Company’s business activities generally are limited to passive investment activities and oversight of its investment in the Bank. Accordingly, the information set forth in this report relates primarily to the Bank’s operations.
Our business consists primarily of commercial lending and deposit relationships with small businesses and their owners in our market areas and attracting deposits from the general public. We also make real estate construction and land development loans and consumer loans. We additionally originate for sale or for investment purposes one-to-four family residential loans on residential properties located primarily in our markets.
Our core profitability depends primarily on our net interest income. Net interest income is the difference between interest income, which is the income that we earn on interest earning assets, comprised primarily of loans and investment securities, and interest expense, which is the amount we pay on our interest bearing liabilities, consisting primarily of deposits. Management strives to match the repricing characteristics of the interest earning assets and interest bearing liabilities to protect net interest income from changes in market interest rates and changes in the shape of the yield curve. Like most financial institutions, our net interest income is affected significantly by general and local economic conditions, particularly changes in market interest rates, and by governmental policies and actions of regulatory agencies. Net interest income is additionally affected by changes on the volume and mix of interest earning assets, interest earned on these assets, the volume and mix of interest bearing liabilities and interest paid on these liabilities.
Our net income is affected by many factors, including the provision for loan losses. The provision for loan losses is dependent on changes in the loan portfolio and management’s assessment of the collectability of the loan portfolio as well as prevailing economic and market conditions. The allowance for loan losses reflects the amount that we believe is appropriate to provide for probable incurred credit losses in our loan portfolio.

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Net income is also affected by noninterest income and noninterest expense. Noninterest income primarily consists of service charges and other fees, gain on sale of loans (net) and other income. Noninterest expense consists primarily of compensation and employee benefits, occupancy and equipment, professional services and data processing. Compensation and employee benefits consist primarily of the salaries and wages paid to our employees, payroll taxes, expenses for retirement and other employee benefits. Occupancy and equipment expenses are the fixed and variable costs of buildings and equipment, and consist primarily of lease payments, depreciation charges, maintenance, and costs of utilities. Data processing consists primarily of processing and network services related to the Bank’s core operating system, including account processing systems, electronic payments processing of products and services, and internet and mobile banking channels.
Results of operations may also be affected significantly by general and local economic and competitive conditions, governmental policies and actions of regulatory authorities. Other income and other expenses are also impacted by growth of operations and growth in the number of loan and deposit accounts through acquisitions and core banking business growth.

Earnings Summary
Comparison of quarter ended June 30, 2018 to the comparable quarter in the prior year.
Net income was $11.9 million, or $0.35 per diluted common share, for the three months ended June 30, 2018 compared to $11.8 million, or $0.40 per diluted common share, for the three months ended June 30, 2017. Net income increased $29,000, or 0.2%, for the three months ended June 30, 2018 compared to the three months ended June 30, 2017 primarily due to an increase in net interest income of $9.6 million, or 28.2%, offset partially by an increase in noninterest expense of $7.9 million, or 28.4%, and a decrease in noninterest income of $3.1 million, or 29.3%. The increases in net interest income and noninterest expense were primarily the result of the Puget Sound Merger completed in January 2018. The decrease in noninterest income was due primarily to a gain on sale of a previously classified purchased credit impaired loan in the amount of $3.0 million recognized during the three months ended June 30, 2017.
Net interest income as a percentage of average interest earning assets (net interest margin) increased 30 basis points to 4.22% for the three months ended June 30, 2018 compared to 3.92% for the same period in 2017. The increase in net interest margin was primarily due to increases in loan yields and investment yields, offset partially by an increase in the cost of interest bearing liabilities.
The efficiency ratio consists of noninterest expense divided by the sum of net interest income before provision for loan losses plus noninterest income. The Company’s efficiency ratio was 69.58% for the three months ended June 30, 2018 compared to 62.01% for the three months ended June 30, 2017. The change in the efficiency ratio was primarily attributable to the increase in noninterest expense as a result of the Puget Sound Merger completed in January 2018, acquisition costs associated with the Puget Sound Merger and the Premier Merger, the buy-out of a third party contract in the amount $1.7 million during the three months ended June 30, 2018 and and a gain on sale of a previously classified purchased credit impaired loan in the amount of $3.0 million recognized during the three months ended June 30, 2017.
Comparison of six months ended June 30, 2018 to the comparable period in the prior year
Net income was $20.9 million, or $0.62 per diluted common share, for the six months ended June 30, 2018 compared to $21.1 million, or $0.71 per diluted common share, for the six months ended June 30, 2017. Net income decreased $200,000, or 0.9%, for the six months ended June 30, 2018 compared to the six months ended June 30, 2017 primarily due to an increase in noninterest expense of $17.4 million, or 31.7% and a decrease in noninterest income of $3.0 million, or 16.3%, partially offset by an increase in net interest income of $17.3 million, or 25.7%. The increases in noninterest expense and net interest income during the six months ended June 30, 2018 compared to the same period in 2017 were primarily the result of the Puget Sound Merger. The decrease in noninterest income was due primarily to a gain on sale of a previously classified purchased credit impaired loan in the amount of $3.0 million recognized during the three months ended June 30, 2017.
The net interest margin increased 26 basis points to 4.17% for the six months ended June 30, 2018 compared to 3.91% for the same period in 2017. Net interest margin increased due to increases in loan yields and in balances and yields on investments, offset partially by increases in the cost of interest bearing deposits.
The Company’s efficiency ratio was 72.67% for the six months ended June 30, 2018 compared to 64.49% for the six months ended June 30, 2017. The change in the efficiency ratio for the six months ended June 30, 2018 compared to the six months ended June 30, 2017 was primarily attributable to additional noninterest expense as a result of the Puget Sound Merger, acquisition costs associate with Puget Sound Merger and Premier Merger, and the buy-out of a third party contract in the amount $1.7 million, further explained in the "Noninterest Expense" section,

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during the three months ended June 30, 2018 as well as a gain on sale of a previously classified purchased credit impaired loan in the amount of $3.0 million recognized during the three months ended June 30, 2017.
Net Interest Income
One of the Company's key sources of earnings is net interest income. There are several factors that affect net interest income including, but not limited to, the volume, pricing, mix and maturity of interest earning assets and interest bearing liabilities; the volume of noninterest bearing deposits and other liabilities and stockholders' equity; the volume of noninterest earning assets; market interest rate fluctuations; and asset quality.
Comparison of quarter ended June 30, 2018 to the comparable quarter in the prior year.
Net interest income increased $9.6 million, or 28.2%, to $43.7 million for the three months ended June 30, 2018 compared to $34.1 million for the same period in 2017. The increase in net interest income was primarily due to increases in average interest earning assets primarily as a result of the Puget Sound Merger and, to a lesser extent, organic growth. Net interest income also increased due to increases in yields on interest earning assets as a result of higher short-term interest rates reflecting increases in the target federal funds rate over the last year. The following table provides relevant net interest income information for the dates indicated.
 
Three Months Ended June 30,
 
2018
 
2017
 
Average
Balance
 
Interest
Earned/
Paid
 
Average
Yield/
Rate (1)
 
Average
Balance
 
Interest
Earned/
Paid
 
Average
Yield/
Rate (1)
 
(Dollars in thousands)
Interest Earning Assets:
 
 
 
 
 
 
 
 
 
 
 
Total loans receivable, net (2) (3)
$
3,266,092

 
$
41,141

 
5.05
%
 
$
2,657,946

 
$
31,500

 
4.75
%
Taxable securities
638,092

 
4,068

 
2.56

 
567,066

 
3,141

 
2.22

Nontaxable securities (3) 
201,104

 
1,220

 
2.43

 
224,719

 
1,304

 
2.33

Other interest earning assets
51,022

 
242

 
1.90

 
39,403

 
96

 
0.98

Total interest earning assets
4,156,310

 
46,671

 
4.50
%
 
3,489,134

 
36,041

 
4.14
%
Noninterest earning assets
570,409

 
 
 
 
 
420,658

 
 
 
 
Total assets
$
4,726,719

 
 
 
 
 
$
3,909,792

 
 
 
 
Interest Bearing Liabilities:
 
 
 
 
 
 
 
 
 
 
 
Certificates of deposit
$
418,129

 
$
797

 
0.76
%
 
$
363,053

 
$
479

 
0.53
%
Savings accounts
512,832

 
487

 
0.38

 
497,033

 
316

 
0.26

Interest bearing demand and money market accounts
1,796,095

 
911

 
0.20

 
1,484,767

 
612

 
0.17

Total interest bearing deposits
2,727,056

 
2,195

 
0.32

 
2,344,853

 
1,407

 
0.24

FHLB advances and other borrowings
79,120

 
402

 
2.04

 
107,132

 
239

 
0.89

Securities sold under agreement to repurchase
27,935

 
16

 
0.23

 
22,852

 
12

 
0.21

Junior subordinated debentures
20,108

 
315

 
6.28

 
19,822

 
249

 
5.04

Total interest bearing liabilities
2,854,219

 
2,928

 
0.41
%
 
2,494,659

 
1,907

 
0.31
%
Demand and other noninterest bearing deposits
1,175,331

 
 
 
 
 
873,314

 
 
 
 
Other noninterest bearing liabilities
60,434

 
 
 
 
 
44,582

 
 
 
 
Stockholders’ equity
636,735

 
 
 
 
 
497,237

 
 
 
 
Total liabilities and stockholders’ equity
$
4,726,719

 
 
 
 
 
$
3,909,792

 
 
 
 
Net interest income

 
$
43,743

 
 
 
 
 
$
34,134

 
 
Net interest spread
 
 
 
 
4.09
%
 
 
 
 
 
3.83
%
Net interest margin
 
 
 
 
4.22
%
 
 
 
 
 
3.92
%
Average interest earning assets to average interest bearing liabilities
 
 
 
 
145.62
%
 
 
 
 
 
139.86
%
(1) 
Annualized
(2)  
The average loan balances presented in the table are net of allowances for loan losses. Nonaccrual loans have been included in the table as loans carrying a zero yield.
(3)  
Yields on tax-exempt securities and loans have not been stated on a tax-equivalent basis.

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Interest Income
Total interest income increased $10.6 million, or 29.5%, to $46.7 million for the three months ended June 30, 2018 compared to $36.0 million for the same period in 2017. The balance of average interest earning assets increased $667.2 million, or 19.1%, to $4.16 billion for the three months ended June 30, 2018 from $3.49 billion for the three months ended June 30, 2017 and the yield on total interest earning assets increased 36 basis points to 4.50% for the three months ended June 30, 2018 compared to 4.14% for the three months ended June 30, 2017.
Interest income from interest and fees on loans increased $9.6 million, or 30.6%, to $41.1 million for the three months ended June 30, 2018 from $31.5 million for the same period in 2017 primarily due to an increase in average total loans receivable, net of $608.1 million, or 22.9%, as a result of loan growth which was substantially due to the Puget Sound Merger. The loan yield increased 30 basis points to 5.05% for the three months ended June 30, 2018 from 4.75% for the three months ended June 30, 2017. The increase in loan yield was due to a combination of higher contractual note rates as a result of the increasing interest rate environment, higher loan yields from the loans acquired in the Puget Sound Merger as compared to legacy Heritage loans, and an increase in incremental accretion on purchased loans substantially due to loans acquired in the Puget Sound Merger.
The following table presents the loan yield and effects of the incremental accretion on purchased loans for the three months ended June 30, 2018 and 2017:
 
 
Three Months Ended June 30,
 
 
2018
 
2017
 
 
(Dollars in thousands)
Loan yield, excluding incremental accretion on purchased loans (1)
 
4.81
%
 
4.53
%
Impact on loan yield from incremental accretion on purchased loans (1)
 
0.24
%
 
0.22
%
Loan yield
 
5.05
%
 
4.75
%
 
 
 
 
 
Incremental accretion on purchased loans (1)
 
$
1,992

 
$
1,481

(1) 
As of the dates of the completion of each of the merger and acquisition transactions, purchased loans were recorded at their estimated fair value, including our estimate of future expected cash flows until the ultimate resolution of these credits. The difference between the contractual loan balance and the fair value represents the purchased discount. The purchased discount is modified quarterly as a result of cash flow re-estimation. The incremental accretion income represents the amount of income recorded on the purchased loans in excess of the contractual stated interest rate in the individual loan notes.
Incremental accretion income was $2.0 million and $1.5 million for the three months ended June 30, 2018 and 2017, respectively. The increase in the incremental accretion during the three months ended June 30, 2018 was primarily due to the accretion of the loans acquired in the Puget Sound Merger. The incremental accretion and the impact to loan yield will change during any quarter based on the volume of prepayments, but is expected to decrease over time as the balance of the purchased loans continues to decrease.
Total interest income increased primarily due to the increase in interest and fees on loans discussed above and secondarily due to an $843,000, or 19.0%, increase in interest income on investment securities to $5.3 million during the three months ended June 30, 2018 from $4.4 million for the three months ended June 30, 2017. The increase in income on investment securities was primarily a result of an increase in investment yields, primarily reflecting the effect of the rise in interest rates on our adjustable rate investment securities, and secondarily to higher yields on new investment purchases for the three months ended June 30, 2018 compared to the same period in 2017. Yields on taxable securities increased 34 basis points to 2.56% for the three months ended June 30, 2018 from 2.22% for the same period in 2017. Yields on nontaxable securities increased 10 basis points to 2.43% for the three months ended June 30, 2018 from 2.33% for the same period in 2017. The average balance of investment securities increased $47.4 million, or 6.0%, to $839.2 million during the three months ended June 30, 2018 from $791.8 million during the three months ended June 30, 2017. The Company has actively managed its investment securities portfolio to improve performance in an increasing rate environment.
Interest income on other interest earning assets increased $146,000, or 152.1%, due to a combination of an increase in the yields reflecting the rise in interest rates and an increase in interest earning deposits as the Bank held more funds in interest earning accounts at the Federal Reserve Bank compared to the same period in 2017, substantially due to the Puget Sound Merger. Average other interest earning assets increased $11.6 million, or 29.5%, to $51.0 million for the three months ended June 30, 2018 compared to $39.4 million for the three months ended June 30, 2017.

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Interest Expense
Total interest expense increased $1.0 million, or 53.5%, to $2.9 million for the three months ended June 30, 2018 compared to $1.9 million for the same period in 2017. The average cost of interest bearing liabilities increased 10 basis points to 0.41% for the three months ended June 30, 2018 from 0.31% for the three months ended June 30, 2017 as a result of the rise in market interest rates. Total average interest bearing liabilities increased $359.6 million, or 14.4%, to $2.85 billion for the three months ended June 30, 2018 from $2.49 billion for the three months ended June 30, 2017 substantially due to the Puget Sound Merger.
The average cost of interest bearing deposits increased eight basis points to 0.32% for the three months ended June 30, 2018 from 0.24% for the same period in 2017 primarily as a result of the increase in market interest rates. The cost of certificates of deposit increased 23 basis points to 0.76% for the three months ended June 30, 2018 from 0.53% for the same period in 2017. The Company was able to mitigate the rise in market interest rates by increasing the average balance of noninterest bearing deposits at a higher growth rate than that of interest bearing deposits. The average balance of noninterest bearing deposits increased by $302.0 million, or 34.6%, for the three months ended June 30, 2018 to $1.18 billion the three months ended June 30, 2018 compared to an increase in the average balance of interest bearing demand and money market deposits of $311.3 million, or 21.0%, for the three months ended June 30, 2018 to $1.80 billion at June 30, 2018 and an increase in the average balance of certificate of deposit accounts $55.1 million, or 15.2%, for the three months ended June 30, 2018 to $418.1 million at June 30, 2018. The total cost of deposits increased to 0.23% for the three months ended June 30, 2018 compared to 0.18% for the same period in 2017. The increase in average deposits was primarily as a result of the Puget Sound Merger.
Interest expense on FHLB advances and other borrowings increased $163,000, or 68.2%, to $402,000 for the three months ended June 30, 2018 from $239,000 for the same period in 2017 due to an increase in market rates, partially offset by a decrease in the average balance. The average cost of FHLB advances and other borrowings for the three months ended June 30, 2018 was 2.04%, an increase of 115 basis points from 0.89% for the same period in 2017. The average balance for FHLB advances and other borrowings decreased $28.0 million, or 26.1%, to $79.1 million for the three months ended June 30, 2018 from $107.1 million for the same period in 2017, as a result of repayments from using cash and cash proceeds from the sale of investment securities acquired in the Puget Sound Merger.
The average rate of the junior subordinated debentures, including the effects of accretion of the discount established as of the date of the merger with Washington Banking Company, for the three months ended June 30, 2018 was 6.28%, an increase of 124 basis points from 5.04% for the same period in 2017. The rate increase on the junior subordinated debentures was due to an increase in the three-month LIBOR rate to 2.34% at June 30, 2018 from 1.30% on June 30, 2017.

Net Interest Margin
Net interest margin increased 30 basis points for the three months ended June 30, 2018 to 4.22% from 3.92% for the same period in 2017 primarily due to the above mentioned changes in yields and costs of funds. The net interest spread increased 26 basis points for the three months ended June 30, 2018 to 4.09% from 3.83% for the same period in 2017 primarily due to the increase in yields on total interest earning assets.
Net interest margin is impacted by the incremental accretion on purchased loans. The following table presents the net interest margin and effects of the incremental accretion on purchased loans for the three months ended June 30, 2018 and 2017:
 
 
Three Months Ended June 30,
 
 
2018
 
2017
Net interest margin, excluding incremental accretion on purchased loans (1)
 
4.03
%
 
3.75
%
Impact on net interest margin from incremental accretion on purchased loans (1)
 
0.19

 
0.17

Net interest margin
 
4.22
%
 
3.92
%
(1) 
As of the dates of the completion of each of the merger and acquisition transactions, purchased loans were recorded at their estimated fair value, including our estimate of future expected cash flows until the ultimate resolution of these credits. The difference between the contractual loan balance and the fair value represents the purchased discount. The purchased discount is modified quarterly as a result of cash flow re-estimation. The incremental accretion income represents the amount of income recorded on the purchased loans in excess of the contractual stated interest rate in the individual loan notes.

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Comparison of six months ended June 30, 2018 to the comparable period in the prior year
Net interest income increased $17.3 million, or 25.7%, to $84.6 million for the six months ended June 30, 2018 compared to $67.3 million for the same period in 2017. The following table provides relevant net interest income information for the dates indicated.
 
Six Months Ended June 30,
 
2018
 
2017
 
Average
Balance
 
Interest
Earned/
Paid
 
Average
Yield/
Rate (1)
 
Average
Balance
 
Interest
Earned/
Paid
 
Average
Yield/
Rate (1)
 
(Dollars in thousands)
Interest Earning Assets:
 
 
 
 
 
 
 
 
 
 
 
Total loans receivable, net (2) (3)
$
3,208,799

 
$
79,300

 
4.98
%
 
$
2,644,953

 
$
61,985

 
4.73
%
Taxable securities
614,488

 
7,597

 
2.49

 
567,192

 
6,190

 
2.20

Nontaxable securities (3)
212,305

 
2,561

 
2.43

 
223,499

 
2,572

 
2.32

Other interest earning assets
52,302

 
460

 
1.77

 
31,389

 
143

 
0.92

Total interest earning assets
4,087,894

 
89,918

 
4.44
%
 
3,467,033

 
70,890

 
4.12
%
Noninterest earning assets
552,736

 
 
 
 
 
427,894

 
 
 
 
Total assets
$
4,640,630

 
 
 
 
 
$
3,894,927

 
 
 
 
Interest Bearing Liabilities:
 
 
 
 
 
 
 
 
 
 
 
Certificates of deposit
$
420,834

 
$
1,557

 
0.75
%
 
$
357,209

 
$
894

 
0.50
%
Savings accounts
509,514

 
902

 
0.36

 
501,571

 
581

 
0.23

Interest bearing demand and money market accounts
1,771,084

 
1,696

 
0.19

 
1,483,972

 
1,198

 
0.16

Total interest bearing deposits
2,701,432

 
4,155

 
0.31

 
2,342,752

 
2,673

 
0.23

FHLB advances and other borrowings
57,546

 
552

 
1.93

 
104,148

 
442

 
0.86

Securities sold under agreement to repurchase
29,094

 
33

 
0.23

 
20,946

 
22

 
0.21

Junior subordinated debentures
20,071

 
598

 
6.01

 
19,786

 
487

 
4.96

Total interest bearing liabilities
2,808,143

 
5,338

 
0.38
%
 
2,487,632

 
3,624

 
0.29
%
Demand and other noninterest bearing deposits
1,144,479

 
 
 
 
 
869,910

 
 
 
 
Other noninterest bearing liabilities
62,094

 
 
 
 
 
45,890

 
 
 
 
Stockholders’ equity
625,914

 
 
 
 
 
491,495

 
 
 
 
Total liabilities and stockholders’ equity
$
4,640,630

 
 
 
 
 
$
3,894,927

 
 
 
 
Net interest income
 
 
$
84,580

 
 
 
 
 
$
67,266

 
 
Net interest spread
 
 
 
 
4.06
%
 
 
 
 
 
3.83
%
Net interest margin
 
 
 
 
4.17
%
 
 
 
 
 
3.91
%
Average interest earning assets to average interest bearing liabilities
 
 
 
 
145.57
%
 
 
 
 
 
139.37
%
(1) 
Annualized
(2)  
The average loan balances presented in the table are net of allowances for loan losses. Nonaccrual loans have been included in the table as loans carrying a zero yield.
(3)  
Yields on tax-exempt securities and loans have not been stated on a tax-equivalent basis.
Interest Income
Total interest income increased $19.0 million, or 26.8%, to $89.9 million for the six months ended June 30, 2018 compared to $70.9 million for the same period in 2017. The balance of average interest earning assets increased $620.9 million, or 17.9%, to $4.09 billion for the six months ended June 30, 2018 from $3.47 billion for the six months ended June 30, 2017 and the yield on total interest earning assets increased 32 basis points to 4.44% for the six months ended June 30, 2018 compared to 4.12% for the six months ended June 30, 2017.
Interest income from interest and fees on loans increased $17.3 million, or 27.9%, to $79.3 million for the six months ended June 30, 2018 from $62.0 million for the same period in 2017 due primarily to an increase in average loans receivable, net and to a lesser extent by an increase in loan yields. Average total loans receivable, net increased $563.8 million, or 21.3%, to $3.21 billion for the six months ended June 30, 2018 compared to $2.64 billion for the six months ended June 30, 2017. Loan yields increased 25 basis points to 4.98% for the six months ended June 30, 2018

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from 4.73% for the six months ended June 30, 2017 due primarily to an increase in market interest rates and to a lesser extent due to an increase in incremental accretion on purchased loans.
The following table presents the loan yield and effects of the incremental accretion on purchased loans for the six months ended June 30, 2018 and 2017:
 
 
Six Months Ended June 30,
 
 
2018
 
2017
 
 
(Dollars in thousands)
Loan yield, excluding incremental accretion on purchased loans (1)
 
4.75
%
 
4.53
%
Impact on loan yield from incremental accretion on purchased loans (1)
 
0.23
%
 
0.20
%
Loan yield
 
4.98
%
 
4.73
%
 
 
 
 
 
Incremental accretion on purchased loans (1)
 
$
3,624

 
$
2,651

(1) 
As of the dates of the completion of each of the merger and acquisition transactions, purchased loans were recorded at their estimated fair value, including our estimate of future expected cash flows until the ultimate resolution of these credits. The difference between the contractual loan balance and the fair value represents the purchased discount. The purchased discount is modified quarterly as a result of cash flow re-estimation. The incremental accretion income represents the amount of income recorded on the purchased loans in excess of the contractual stated interest rate in the individual loan notes.
Incremental accretion income was $3.6 million and $2.7 million for the six months ended June 30, 2018 and 2017, respectively. The increase in the incremental accretion was primarily a result of the loans acquired in the Puget Sound Merger, offset partially by a continued decline in purchased loan balances including a decrease in the prepayments of purchased loans during the six months ended June 30, 2018 compared to the same period in 2017. The incremental accretion is expected to decrease as the balance of the purchased loans continues to decrease.
Total interest income increased primarily due to the increase in interest and fees on loans discussed above and secondarily due to a $1.4 million, or 15.9%, increase in interest income on investment securities to $10.2 million during the six months ended June 30, 2018 from $8.8 million for the six months ended June 30, 2017. The increase in interest income on investment securities was the result of a combination of an increase in investment yields for the six months ended June 30, 2018 compared to the same period in 2017 and an increase in the average balance of investment securities during the periods. Yields on taxable securities increased 29 basis points to 2.49% for the six months ended June 30, 2018 from 2.20% for the same period in 2017. Yields on nontaxable securities increased 11 basis points to 2.43% for the six months ended June 30, 2018 from 2.32% for the same period in 2017. The average balance of investment securities increased $36.1 million, or 4.6%, to $826.8 million during the six months ended June 30, 2018 from $790.7 million during the six months ended June 30, 2017. The Company has actively managed its investment securities portfolio to improve performance in an increasing rate environment.
Income on other interest earning assets increased $317,000, or 221.7%, to $460,000 during the six months ended June 30, 2018 due primarily to an increase in market interest rates and an increase in the average balances. Average other interest earning assets increased $20.9 million, or 66.6%, to $52.3 million for the six months ended June 30, 2018 compared to $31.4 million for the six months ended June 30, 2017. The increase was due primarily to an increase in interest earning deposits, as the Bank held more funds in interest earning accounts at the Federal Reserve Bank of San Francisco compared to the same period in 2017.
Interest Expense
Total interest expense increased $1.7 million, or 47.3%, to $5.3 million for the six months ended June 30, 2018 compared to $3.6 million for the same period in 2017. The cost of interest bearing liabilities increased nine basis points to 0.38% for the six months ended June 30, 2018 from 0.29% for the six months ended June 30, 2017. Total average interest bearing liabilities increased by $320.5 million, or 12.9%, to $2.81 billion for the six months ended June 30, 2018 from $2.49 billion for the six months ended June 30, 2017. The increase in costs from the prior year was primarily a result of increases in market rates and the increased use of higher cost borrowings to fund asset growth.
The cost of interest bearing deposits increased eight basis points to 0.31% for the six months ended June 30, 2018 from 0.23% for the same period in 2017 due primarily to the increase in market interest rates. The cost of certificates of deposit increased to 0.75% for the six months ended June 30, 2018 from 0.50% for the same period in 2017. The Company was able to mitigate the rising interest rates by increasing the average balance of noninterest bearing deposits at a higher growth rate than that of interest bearing deposits. The average balance of noninterest bearing deposits increased by $274.6 million, or 31.6%, during the six months ended June 30, 2018 to $1.14 billion at June 30, 2018 compared to an increase in the average interest bearing demand and money market accounts of

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$287.1 million, or 19.3%, to $1.77 billion during the six months ended June 30, 2018 and an increase in the average certificates of deposit accounts by $63.6 million, or 17.8%, to $420.8 million for the six months ended June 30, 2018. The cost of all deposit accounts increased to 0.22% for the six months ended June 30, 2018 compared to 0.17% for the six months ended June 30, 2017.
Interest expense on FHLB advances and other borrowings increased $110,000, or 24.9%, to $552,000 for the six months ended June 30, 2018 from $442,000 for the six months ended June 30, 2017 due to a combination of an increase in the cost of funds and a decrease in average balance. The average rate of the FHLB advances and other borrowings for the six months ended June 30, 2018 was 1.93%, an increase of 107 basis points from 0.86% for the same period in 2017. The average balance for FHLB advances and other borrowings decreased $46.6 million to $57.5 million for the six months ended June 30, 2018 from $104.1 million for the same period in 2017, due primarily to using cash and cash equivalents and proceeds from the sale of investment securities acquired in the Puget Sound Merger to pay down this higher cost funding source.
The average rate of the junior subordinated debentures, including the effects of accretion of the discount established as of the date of the merger with Washington Banking Company, for the six months ended June 30, 2018 was 6.01%, an increase of 105 basis points from 4.96% for the same period in 2017. The rate increase on the debentures was due to an increase in the three-month LIBOR rate to 2.34% at June 30, 2018 from 1.30% on June 30, 2017.

Net Interest Margin
Net interest margin for the six months ended June 30, 2018 increased 26 basis points to 4.17% from 3.91% for the same period in 2017 primarily due to the above mentioned changes in yields and costs of funds in addition to an increase in incremental accretion on purchased loans as a result of the Puget Sound Merger. The net interest spread for the six months ended June 30, 2018 increased 23 basis points to 4.06% from 3.83% for the same period in 2017.
Net interest margin is impacted by the incremental accretion on purchased loans. The following table presents the net interest margin and effects of the incremental accretion on purchased loans for the six months ended June 30, 2018 and 2017:
 
 
Six Months Ended June 30,
 
 
2018
 
2017
Net interest margin, excluding incremental accretion on purchased loans (1)
 
3.99
%
 
3.76
%
Impact on net interest margin from incremental accretion on purchased loans (1)
 
0.18

 
0.15

Net interest margin
 
4.17
%
 
3.91
%
(1) 
As of the dates of the completion of each of the merger and acquisition transactions, purchased loans were recorded at their estimated fair value, including our estimate of future expected cash flows until the ultimate resolution of these credits. The difference between the contractual loan balance and the fair value represents the purchased discount. The purchased discount is modified quarterly as a result of cash flow re-estimation. The incremental accretion income represents the amount of income recorded on the purchased loans in excess of the contractual stated interest rate in the individual loan notes.

Provision for Loan Losses
The Bank has established a comprehensive methodology for determining its allowance for loan losses. The allowance for loan losses is increased by provisions for loan losses charged to expense, and is reduced by loans charged-off, net of loan recoveries or a recovery of previous provision. The amount of the provision expense recognized during the three and six months ended June 30, 2018 and 2017 was calculated in accordance with the Bank's methodology. For additional information, see the section entitled "Analysis of Allowance for Loan Losses" below.
The provision for loan losses is dependent on the Bank’s ability to manage asset quality and control the level of net charge-offs through prudent underwriting standards. In addition, a decline in general economic conditions could increase future provisions for loan losses and have a material effect on the Company’s net income.
Comparison of quarter ended June 30, 2018 to the comparable quarter in the prior year.
The provision for loan losses increased $619,000, or 54.7%, to $1.8 million for the three months ended June 30, 2018 from $1.1 million for the three months ended June 30, 2017. The increase in the provision for loan losses for the three months ended June 30, 2018 from the same period in 2017 was primarily the result of changes in our volume and mix of loans, asset quality, certain environmental and historical loss factors and as a result of the impact of loan

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growth. Based on a thorough review of the loan portfolio, the Bank determined that the provision for loan losses for the three months ended June 30, 2018 was appropriate as it was calculated in accordance with the Bank's methodology for determining the allowance for loan losses.
Comparison of six months ended June 30, 2018 to the comparable period in the prior year
The provision for loan losses increased $904,000, or 45.2% to $2.9 million for the six months ended June 30, 2018 from $2.0 million for the six months ended June 30, 2017. The increase in the provision for loan losses for the six months ended June 30, 2018 from the same period in 2017 was primarily the result of changes in our volume and mix of loans, asset quality, certain environmental and historical loss factors and as a result of the impact of loan growth. Based on a thorough review of the loan portfolio, the Bank determined that the provision for loan losses for the six months ended June 30, 2018 was appropriate as it was calculated in accordance with the Bank's methodology for determining the allowance for loan losses.
Noninterest Income
Comparison of quarter ended June 30, 2018 to the comparable quarter in the prior year.
Total noninterest income decreased $3.1 million, or 29.3%, to $7.6 million for the three months ended June 30, 2018 compared to $10.7 million for the same period in 2017. The following table presents the change in the key components of noninterest income for the periods noted.
 
Three Months Ended June 30,
 
 
 
 
 
2018
 
2017
 
Change
 
Percentage Change
 
(Dollars in thousands)
Service charges and other fees
$
4,695

 
$
4,426

 
$
269

 
6.1
 %
Gain on sale of investment securities, net
18

 
117

 
(99
)
 
(84.6
)
Gain on sale of loans, net
706

 
4,138

 
(3,432
)
 
(82.9
)
Interest rate swap fees
309

 
282

 
27

 
9.6

Other income
1,845

 
1,746

 
99

 
5.7

Total noninterest income
$
7,573

 
$
10,709

 
$
(3,136
)
 
(29.3
)%
Gain on the sale of loans, net decreased $3.4 million, or 82.9%, to $706,000 for the three months ended June 30, 2018 compared to $4.1 million the same period in 2017, due primarily to the gain on sale of a previously classified purchased credit impaired loan of $3.0 million recognized during the three months ended June 30, 2017.
Gain on sale of loans, net additionally decreased based on a decline in U.S. Small Business Administration ("SBA") loan originations and mortgage banking activities during the three months ended June 30, 2018 compared to the same period in 2017. The detail of gain on sale of loans, net is included in the following schedule.
 
Three Months Ended June 30,
 
 
 
 
 
2018
 
2017
 
Change
 
Percentage Change
 
(Dollars in thousands)
Gain on sale of mortgage loans, net
$
572

 
$
731

 
$
(159
)
 
(21.8
)%
Gain on sale of guaranteed portion of SBA loans, net
134

 
409

 
(275
)
 
(67.2
)
Gain on sale of other loans, net
—

 
2,998

 
(2,998
)
 
(100.0
)
     Gain on sale of loans, net
$
706

 
$
4,138

 
$
(3,432
)
 
(82.9
)%
The decrease in noninterest income was offset partially by an increase in service charges and other fees of $269,000, or 6.1% to $4.7 million for the three months ended June 30, 2018 compared to $4.4 million for the same period in 2017, due primarily to an increase in deposit balances and changes in fee structures on deposit accounts, including a business deposit consolidation process completed during second quarter 2017. Secondarily, service charges and other fees increased as a result of the deposit accounts acquired in the Puget Sound Merger.


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Comparison of six months ended June 30, 2018 to the comparable period in the prior year
Total noninterest income decreased $3.0 million, or 16.3%, to $15.1 million for the six months ended June 30, 2018 compared to $18.1 million for the same period in 2017. The following table presents the change in the key components of noninterest income for the periods noted.
 
Six Months Ended June 30,
 
 
 
 
 
2018
 
2017
 
Change
 
Percentage Change
 
(Dollars in thousands)
Service charges and other fees
$
9,238

 
$
8,639

 
$
599

 
6.9
 %
Gain on sale of investment securities, net
53

 
117

 
(64
)
 
(54.7
)
Gain on sale of loans, net
1,580

 
5,333

 
(3,753
)
 
(70.4
)
Interest rate swap fees
360

 
415

 
(55
)
 
(13.3
)
Other income
3,890

 
3,568

 
322

 
9.0

Total noninterest income
$
15,121

 
$
18,072

 
$
(2,951
)
 
(16.3
)%
Service charges and other fees increased $599,000, or 6.9% to $9.2 million for the six months ended June 30, 2018 compared to $8.6 million for the same period in 2017, due primarily to an increase in deposit balances and changes in fee structures on deposit accounts, including a business deposit consolidation process completed during second quarter 2017 and deposit accounts acquired in the Puget Sound Merger.
Gain on sale of loans, net decreased $3.8 million, or 70.4% to $1.6 million for the six months ended June 30, 2018 compared to $5.3 million for the same period in 2017, due primarily the gain on sale of a previously classified as purchased credit impaired loan of $3.0 million recognized during the six months ended June 30, 2017. Gain on sale of mortgage and SBA loans also decreased during the six months ended June 30, 2018 compared to the same period in 2017 primarily due to less activity. Proceeds from sale of loans decreased $31.5 million, or 44.1% to $40.0 million for the six months ended June 30, 2018 from $71.4 million for the same period in 2017. The detail of gain on sale of loans, net is included in the following schedule.
 
Six Months Ended June 30,
 
 
 
2018
 
2017
 
Change
 
Percentage Change
 
(Dollars in thousands)
Gain on sale of mortgage loans, net
$
1,224

 
$
1,640

 
$
(416
)
 
(25.4
)%
Gain on sale of guaranteed portion of SBA loans, net
356

 
695

 
(339
)
 
(48.8
)
Gain on sale of other loans, net
—

 
2,998

 
(2,998
)
 
(100.0
)
     Gain on sale of loans, net
$
1,580

 
$
5,333

 
$
(3,753
)
 
(70.4
)%


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Noninterest Expense
Comparison of quarter ended June 30, 2018 to the comparable quarter in the prior year.
Noninterest expense increased $7.9 million, or 28.4%, to $35.7 million during the three months ended June 30, 2018 compared to $27.8 million for the three months ended June 30, 2017. The following table presents changes in the key components of noninterest expense for the periods noted.
 
Three Months Ended June 30,
 
 
 
 
 
2018
 
2017
 
Change
 
Percentage Change
 
(Dollars in thousands)
Compensation and employee benefits
$
19,321

 
$
16,272

 
$
3,049

 
18.7
 %
Occupancy and equipment
4,810

 
3,818

 
992

 
26.0

Data processing
2,507

 
2,002

 
505

 
25.2

Marketing
823

 
805

 
18

 
2.2

Professional services
3,529

 
1,053

 
2,476

 
235.1

State and local taxes
716

 
639

 
77

 
12.1

Federal deposit insurance premium
375

 
357

 
18

 
5.0

Other real estate owned, net
—

 
21

 
(21
)
 
(100.0
)
Amortization of intangible assets
796

 
323

 
473

 
146.4

Other expense
2,829

 
2,519

 
310

 
12.3

Total noninterest expense
$
35,706

 
$
27,809

 
$
7,897

 
28.4
 %
The Company has incurred significant non-recurring acquisition costs. The following table presents these expenses by key component. There were no such expenses incurred during the three months ended June 30, 2017.
 
Three Months Ended June 30,
 
2018
 
 
Compensation and employee benefits
$
67

Occupancy and equipment
28

Data processing
425

Marketing
5

Professional services
337

Other expense
18

Total acquisition costs
$
880

Compensation and employee benefits increased $3.0 million, or 18.7%, to $19.3 million during the three months ended June 30, 2018 from $16.3 million during the three months ended June 30, 2017. The increase in the three months ended June 30, 2018 compared to 2017 was primarily as a result of additional employees, primarily due to the Puget Sound Merger, and standard salary increases. The average full time equivalent employees increased to 819 for the three months ended June 30, 2018 compared to 750 for the same period in 2017.
Professional services increased $2.5 million, or 235.1%, to $3.5 million during the three months ended June 30, 2018 from $1.1 million during the three months ended June 30, 2017 substantially due to the buy-out of a third party contract in the amount $1.7 million. The third party assisted the Company in its deposit product realignment and was compensated based on success factors over the three years subsequent to implementation. The Company assessed the contract and determined that it was advantageous to buy-out the contract prior to the system conversions relating to the Puget Sound Merger and Premier Merger. The Company expects the accumulated savings in future professional services expenses to fully offset the cost of the buy-out by the end of 2019. In addition, professional services costs also increased in 2018 compared to 2017 as a result of acquisition costs.
Occupancy and equipment increased $992,000, or 26.0%, to $4.8 million during the three months ended June 30, 2018 from $3.8 million during the three months ended June 30, 2017. The increase in the three months ended June 30, 2018 compared to 2017 was substantially related to expansion in the Seattle, Bellevue and Portland branches.

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The Bellevue expansion included the lease obtained from the Puget Sound Merger and more space leased subsequent to the merger.
Data processing increased $505,000, or 25.2%, to $2.5 million during the three months ended June 30, 2018 from $2.0 million during the three months ended June 30, 2017 substantially due to core system conversion costs related to the Puget Sound Merger recognized during the three months ended June 30, 2018 as well as additional operation costs associated with the increase in balances and transaction volume as a result of the Puget Sound Merger.
Amortization of intangible assets increased $473,000, or 146.4%, to $796,000 during the three months ended June 30, 2018 from $323,000 during the three months ended June 30, 2017. The increase in the three months ended June 30, 2018 compared to 2017 was a result of the amortization of the core deposit intangible recorded in the Puget Sound Merger of $513,000 during the three months ended June 30, 2018.
The ratio of noninterest expense to average assets (annualized) was 3.03% for the three months ended June 30, 2018 compared to 2.85% for the three months ended June 30, 2017. The increase was primarily a result of increased expenses as a result of the Puget Sound Merger in addition to the buy-out of the third party contract and acquisition costs recognized during the three months ended June 30, 2018.
Comparison of six months ended June 30, 2018 to the comparable period in the prior year
Noninterest expense increased $17.4 million, or 31.7%, to $72.5 million during the six months ended June 30, 2018 compared to $55.0 million for the six months ended June 30, 2017. The following table presents changes in the key components of noninterest expense for the periods noted.
 
Six Months Ended June 30,
 
 
 
 
 
2018
 
2017
 
Change
 
Percentage Change
 
(Dollars in thousands)
Compensation and employee benefits
$
40,688

 
$
32,296

 
$
8,392

 
26.0
 %
Occupancy and equipment
9,437

 
7,628

 
1,809

 
23.7

Data processing
5,112

 
3,917

 
1,195

 
30.5

Marketing
1,631

 
1,612

 
19

 
1.2

Professional services
6,366

 
2,062

 
4,304

 
208.7

State and local taxes
1,404

 
1,188

 
216

 
18.2

Federal deposit insurance premium
730

 
657

 
73

 
11.1

Other real estate owned, net
—

 
52

 
(52
)
 
(100.0
)
Amortization of intangible assets
1,591

 
647

 
944

 
145.9

Other expense
5,494

 
4,973

 
521

 
10.5

Total noninterest expense
$
72,453

 
$
55,032

 
$
17,421

 
31.7
 %
The Company has incurred significant non-recurring acquisition costs. The following table presents these expenses by key component. There were no such expenses incurred during the six months ended June 30, 2017.
 
Six Months Ended June 30,
 
2018
 
 
Compensation and employee benefits
$
2,891

Occupancy and equipment
37

Data processing
777

Marketing
5

Professional services
1,935

Other expense
43

Total acquisition costs
$
5,688

Compensation and employee benefits increased $8.4 million, or 26.0%, to $40.7 million during the six months ended June 30, 2018 from $32.3 million during the six months ended June 30, 2017. The increase in the six months ended June 30, 2018 compared to 2017 was primarily due to increases in employees primarily due to the Puget Sound

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Merger, increases in senior level staffing, and increases in standard salary in addition to acquisition-related payments related to the Puget Sound Merger of $2.9 million during the six months ended June 30, 2018.
Occupancy and equipment increased $1.8 million, or 23.7%, to $9.4 million during the six months ended June 30, 2018 from $7.6 million during the six months ended June 30, 2017. The increase in the three months ended June 30, 2018 compared to 2017 was substantially related to expansion in the Seattle, Bellevue and Portland branches. The Bellevue expansion included the lease obtained from the Puget Sound Merger and more space leased subsequent to the merger.
Data processing increased $1.2 million, or 30.5%, to $5.1 million during the six months ended June 30, 2018 from $3.9 million during the six months ended June 30, 2017 primarily due to acquisition costs. The increase in the six months ended June 30, 2018 compared to 2017 was additionally due to higher transactional activity in the core operating system and internet banking as a result of the Puget Sound Merger and organic growth in loans and deposits.
Professional services increased $4.3 million, or 208.7%, to $6.4 million during the six months ended June 30, 2018 from $2.1 million during the six months ended June 30, 2017 partially due to acquisition costs incurred during the six months ended June 30, 2018 of $1.9 million. The increase in the six months ended June 30, 2018 compared to 2017 was additionally the result of the buy-out of a third party contract in the amount of $1.7 million during the six months ended June 30, 2018. As previously mentioned, the Company expects the accumulated savings in future professional services expenses to fully offset the cost of the buy-out by the end of 2019.
Amortization of intangible assets increased $944,000, or 145.9%, to $1.6 million during the six months ended June 30, 2018 from $647,000 during the six months ended June 30, 2017. The increase in the three months ended June 30, 2018 compared to 2017 was a result of the amortization of the core deposit intangible recorded in the Puget Sound Merger of $1.0 million during the six months ended June 30, 2018.
The ratio of noninterest expense to average assets was 3.15% for the six months ended June 30, 2018, compared to 2.85% for the six months ended June 30, 2017. The increase was primarily a result of increased expenses as a result of the Puget Sound Merger and acquisition costs recognized during the six months ended June 30, 2018.

Income Tax Expense
Comparison of quarter ended June 30, 2018 to the comparable quarter in the prior year.
Income tax expense decreased $2.1 million, or 50.8%, to $2.0 million for the three months ended June 30, 2018 from $4.1 million for the three months ended June 30, 2017. The effective tax rate was 14.5% for the three months ended June 30, 2018 compared to 25.6% for the same period in 2017. The decrease in the income tax expense and effective tax rate during the six months ended June 30, 2018 was primarily due to the impact of the Tax Cuts and Jobs Act enacted in December 2017, which lowered the corporate income tax rate to 21% from 35%.
Comparison of six months ended June 30, 2018 to the comparable period in the prior year
Income tax expense decreased $3.8 million, or 52.5%, to $3.4 million for the six months ended June 30, 2018 from $7.2 million for the six months ended June 30, 2017. The effective tax rate was 14.0% for the six months ended June 30, 2018 compared to 25.3% for the same period in 2017. The decrease in the income tax expense and effective tax rate during the six months ended June 30, 2018 was primarily due to the impact of the Tax Cuts and Jobs Act, offset partially by the increase in certain non-deductible acquisition costs.


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Financial Condition Overview
The table below provides a comparison of the changes in the Company's financial condition from December 31, 2017 to June 30, 2018, and the results of the Puget Sound Merger effective January 16, 2018:
 
 
June 30, 2018
 
December 31, 2017
 
Change
 
Percentage Change
 
Fair Value of Puget Sound at Merger Date
 
 
(Dollars in thousands)
 
 
Assets
 
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
 
$
129,943

 
$
103,015

 
$
26,928

 
26.1
 %
 
$
80,136

Investment securities available for sale, at fair value
 
873,670

 
810,530

 
63,140

 
7.8

 
80,353

Loans held for sale
 
3,598

 
2,288

 
1,310

 
57.3

 
—

Total loans receivable, net
 
3,294,316

 
2,816,985

 
477,331

 
16.9

 
388,462

Other real estate owned
 
434

 
—

 
434

 
N/A

 
—

Premises and equipment, net
 
75,364

 
60,325

 
15,039

 
24.9

 
732

Federal Home Loan Bank stock, at cost
 
8,616

 
8,347

 
269

 
3.2

 
623

Bank owned life insurance
 
82,031

 
75,091

 
6,940

 
9.2

 
6,264

Accrued interest receivable
 
13,482

 
12,244

 
1,238

 
10.1

 
1,448

Prepaid expenses and other assets
 
104,718

 
99,328

 
5,390

 
5.4

 
1,354

Other intangible assets, net
 
15,767

 
6,088

 
9,679

 
159.0

 
11,270

Goodwill
 
187,549

 
119,029

 
68,520

 
57.6

 
68,520

Total assets
 
$
4,789,488

 
$
4,113,270

 
$
676,218

 
16.4
 %
 
$
639,162

 
 
 
 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
 
 
 
Deposits
 
$
3,968,935

 
$
3,393,060

 
$
575,875

 
17.0
 %
 
$
505,885

Federal Home Loan Bank advances
 
75,500

 
92,500

 
(17,000
)
 
(18.4
)
 
—

Junior subordinated debentures
 
20,156

 
20,009

 
147

 
0.7

 
—

Securities sold under agreement to repurchase
 
22,168

 
31,821

 
(9,653
)
 
(30.3
)
 
—

Accrued expenses and other liabilities
 
63,206

 
67,575

 
(4,369
)
 
(6.5
)
 
2,504

Total liabilities
 
4,149,965

 
3,604,965

 
545,000

 
15.1

 
508,389

Stockholders' equity
 
 
 
 
 
 
 
 
 
 
Common stock
 
491,026

 
360,590

 
130,436

 
36.2

 
130,773

Retained earnings
 
159,803

 
149,013

 
10,790

 
7.2

 
—

Accumulated other comprehensive loss, net
 
(11,306
)
 
(1,298
)
 
(10,008
)
 
771.0

 
—

Total stockholders' equity
 
639,523

 
508,305

 
131,218

 
25.8

 
130,773

Total liabilities and stockholders' equity
 
$
4,789,488

 
$
4,113,270

 
$
676,218

 
16.4
 %
 
$
639,162

Total assets increased $676.2 million, or 16.4%, to $4.79 billion as of June 30, 2018 compared to $4.11 billion as of December 31, 2017. The Puget Sound Merger resulted in an increase of total assets, including goodwill, of $639.2 million at the merger date. The Company utilized cash and cash proceeds from the sale of investment securities acquired in the Puget Sound Merger to pay down FHLB advances during the six months ended June 30, 2018.
Total loans receivable, net, excluding loans acquired in the Puget Sound Merger increased $88.9 million, or 6.4% annualized, during the six months ended June 30, 2018.
Investment securities increased $63.1 million, or 7.8%, to $873.7 million at June 30, 2018 from $810.5 million at December 31, 2017 primarily as a result of investment purchases, offset partially by maturities, calls and payments of investment securities. The investment securities acquired in the Puget Sound Merger were sold shortly after the merger.

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Deposits, excluding Puget Sound Merger, increased $70.0 million, or 4.2% annualized, during the six months ended June 30, 2018. Brokered deposits increased $18.0 million, or 45.6%, to $57.6 million at June 30, 2018 compared to $39.6 million at December 31, 2017. Total non-maturity deposits increased to 88.4% of total deposits at June 30, 2018 from 88.3% at December 31, 2017 and certificates of deposit decreased to 11.6% of total deposits at June 30, 2018 from 11.7% at December 31, 2017.
Federal Home Loan Bank advances decreased $17.0 million, or 18.4%, to $75.5 million as of June 30, 2018 from $92.5 million as of December 31, 2017. The decrease was due to the repayment of FHLB advances using cash and cash proceeds from the sale of investment securities acquired in the Puget Sound Merger.
Total stockholders’ equity increased $131.2 million, or 25.8%, to $639.5 million as of June 30, 2018 from $508.3 million at December 31, 2017. The Company’s equity position was 13.4% of total assets as of June 30, 2018 and 12.4% as of December 31, 2017. Changes in stockholders' equity during the six months ended June 30, 2018 were as follows:
 
Six Months Ended
 
June 30, 2018
 
(In thousands)
Balance, beginning of period
$
508,305

   Common stock issued in the Puget Sound Merger
130,770

   Net income
20,944

   Dividends declared
(10,247
)
   Accumulated other comprehensive loss
(9,915
)
   Other
(334
)
Balance, end of period
$
639,523


Lending Activities
The Bank is a full service commercial bank, which originates a wide variety of loans with a focus on commercial business loans. Total loans receivable, net of allowance for loan losses, increased $477.3 million, or 16.9%, to $3.29 billion at June 30, 2018 from $2.82 billion at December 31, 2017. The increase in loans receivable was primarily due to the Puget Sound Merger. At the merger date, the Bank acquired fair value of commercial and industrial loans of $182.0 million, non-owner occupied commercial real estate loans of $101.2 million, and owner-occupied commercial real estate loans of $82.3 million.

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The following table provides information about our loan portfolio by type of loan at the dates indicated and the change between these dates. These balances are prior to deduction for the allowance for loan losses.
 
June 30, 2018
 
December 31, 2017
 
 
 
Balance
 
% of Total (3)
 
Balance
 
% of Total (3)
 
Change
 
%of Balance Change
 
(Dollars in thousands)
Commercial business:
 
 
 
 
 
 
 
 
 
 
 
Commercial and industrial
$
800,043

 
24.0
%
 
$
645,396

 
22.7
%
 
$
154,647

 
24.0
 %
Owner-occupied commercial real estate
693,330

 
20.8

 
622,150

 
21.8

 
71,180

 
11.4

Non-owner occupied commercial real estate
1,187,548

 
35.7

 
986,594

 
34.6

 
200,954

 
20.4

Total commercial business
2,680,921

 
80.5

 
2,254,140

 
79.1

 
426,781

 
18.9

One-to-four family residential (1)
92,518

 
2.8

 
86,997

 
3.1

 
5,521

 
6.3

Real estate construction and land development:
 
 
 
 
 
 

 
 
 
 
One-to-four family residential
71,934

 
2.2

 
51,985

 
1.8

 
19,949

 
38.4

Five or more family residential and commercial properties
93,315

 
2.8

 
97,499

 
3.4

 
(4,184
)
 
(4.3
)
Total real estate construction and land development (2)
165,249

 
5.0

 
149,484

 
5.2

 
15,765

 
10.5

Consumer
385,987

 
11.6

 
355,091

 
12.5

 
30,896

 
8.7

Gross loans receivable
3,324,675

 
99.9

 
2,845,712

 
99.9

 
478,963

 
16.8

Net deferred loan costs
3,613

 
0.1

 
3,359

 
0.1

 
254

 
7.6

Loans receivable, net
$
3,328,288

 
100.0
%
 
$
2,849,071

 
100.0
%
 
$
479,217

 
16.8
 %
(1) Excludes loans held for sale of $3.6 million, and $2.3 million as of June 30, 2018 and December 31, 2017, respectively.
(2) Balances do not include undisbursed loan commitments.
(3) Percent of loans receivable, net.

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Nonperforming Assets and Credit Quality Metrics
The following table provides information about our nonaccrual loans, other real estate owned and performing TDR loans for the indicated dates.
 
June 30, 2018
 
December 31, 2017
 
(Dollars in thousands)
Nonaccrual loans:
 
 
 
Commercial business
$
15,235

 
$
9,098

One-to-four family residential
77

 
81

Real estate construction and land development
1,084

 
1,247

Consumer
127

 
277

Total nonaccrual loans (1)
16,523

 
10,703

Other real estate owned
434

 
—

Total nonperforming assets
$
16,957

 
$
10,703

 
 
 
 
Allowance for loan losses
$
33,972

 
$
32,086

Nonperforming loans to loans receivable, net
0.50
%
 
0.38
%
Allowance for loan losses to loans receivable, net
1.02
%
 
1.13
%
Allowance for loan losses to nonperforming loans
205.60
%
 
299.79
%
Nonperforming assets to total assets
0.35
%
 
0.26
%
 
 
 
 
Performing TDR loans:
 
 
 
Commercial business
$
25,488

 
$
25,729

One-to-four family residential
214

 
218

Real estate construction and land development
—

 
645

Consumer
255

 
165

Total performing TDR loans
$
25,957

 
$
26,757

Accruing loans past due 90 days or more
$
—

 
$
—

Potential problem loans
101,491

 
83,543

(1) 
At June 30, 2018 and December 31, 2017, $6.8 million and $5.2 million of nonaccrual loans were considered TDR loans, respectively.

Nonperforming Assets.    Nonperforming assets consist of nonaccrual loans and other real estate owned. Nonperforming assets increased $6.3 million to $17.0 million, or 0.35% of total assets at June 30, 2018 from $10.7 million, or 0.26% of total assets, at December 31, 2017 due to primarily to the increase in nonaccrual loans discussed below. Nonperforming assets additionally increased due to the addition of one other real estate owned property of $434,000 during the six months ended June 30, 2018. There was no other real estate owned at December 31, 2017.
Nonaccrual Loans.    Nonaccrual loans increased $5.8 million to $16.5 million, or 0.50% of loans receivable, net, at June 30, 2018 from $10.7 million, or 0.38% of loans receivable, net, at December 31, 2017. The increase was due primarily to three agricultural loan relationships that were transferred to nonaccrual status during the six months ended June 30, 2018 totaling $4.6 million at June 30, 2018. Two of these credit relationships are well-secured, and the Company did not record a related allowance for loan losses. The other relationship is partially guaranteed by the SBA and the Company recorded an allowance for loan losses of $91,000 at June 30, 2018 related to the unguaranteed portion of the loan.

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The following table reflects the changes in nonaccrual loans during the six months ended June 30, 2018:
 
Six Months Ended
 
June 30, 2018
 
(In thousands)
Nonaccrual loans
 
Balance, beginning of period
$
10,703

   Addition of previously classified pass graded loans
4,196

   Addition of previously classified potential problem loans
3,691

   Charge-offs
(438
)
   Net principal payments
(1,629
)
Balance, end of period
$
16,523

At June 30, 2018, nonaccrual loans of $7.8 million had related allowance for loan losses of $1.9 million and nonaccrual loans of $8.7 million had no related allowance for loan losses. At December 31, 2017 nonaccrual loans of $3.8 million had related allowance for loan losses of $720,000 and nonaccrual loans of $6.9 million had no allowance for loan losses.
At June 30, 2018, nonperforming TDR loans, included in the nonaccrual loan table above, were $6.8 million and had a related allowance for loan losses of $726,000. At December 31, 2017, nonperforming TDR loans were $5.2 million and had a related allowance for loan losses of $379,000.
Troubled Debt Restructured Loans. TDR loans are considered impaired and are separately measured for impairment whether on accrual or nonaccrual status. The performing TDR loans are not considered nonperforming assets as they continue to accrue interest despite being considered impaired due to the restructured status. Performing TDR loans decreased $800,000, or 3.0%, to $26.0 million at June 30, 2018 from $26.8 million at December 31, 2017.
The following table reflects the changes in performing TDR loans during six months ended June 30, 2018:
 
Six Months Ended
 
June 30, 2018
 
(In thousands)
Performing TDR loans
 
Balance, beginning of period
$
26,757

   Addition of previously classified pass graded loans
1,236

   Addition of previously classified potential problem loans
551

   Net principal payments
(2,587
)
Balance, end of period
$
25,957

The related allowance for loan losses on performing TDR loans was $2.5 million as of June 30, 2018 and $2.6 million as of December 31, 2017.
Potential Problem Loans. Potential problem loans increased $17.9 million, or 21.5%, to $101.5 million at June 30, 2018 from $83.5 million at December 31, 2017. The increase was due primarily to the addition of an agricultural lending relationship totaling $14.5 million at June 30, 2018 and the addition of potential problem loans acquired in the Puget Sound Merger with a total outstanding balance of $4.9 million at June 30, 2018.

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The following table reflects the changes in potential problem loans during the six months ended June 30, 2018 (in thousands):
 
Six Months Ended
 
June 30, 2018
 
(In thousands)
Potential problem loans
 
Balance, beginning of period
$
83,543

   Addition of previously classified pass graded loans
44,955

   Upgrades to pass graded loan status
(9,043
)
   Transfers of loan to nonaccrual or troubled debt restructured status
(4,242
)
   Charge-offs
(257
)
   Net principal payments
(13,465
)
Balance, end of period
$
101,491


Analysis of 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 probable incurred credit 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.
We assess the estimated credit losses inherent in our loan portfolio by considering a number of elements including:
•
historical loss experience in the loan portfolio;
•
impact of environmental factors, including:
◦
levels of and trends in delinquencies, classified and impaired loans;
◦
levels of and trends in charge-offs and recoveries;
◦
trends in volume and terms of loans;
◦
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;
◦
other external factors such as competition, legal and regulatory;
◦
effects of changes in credit concentrations; and
◦
other factors
We calculate an appropriate allowance for loan losses for the loans in our loan portfolio by applying historical loss factors for homogeneous classes of the portfolio, adjusted for changes to the above-noted environmental factors. We may record specific provisions for impaired loans, including loans on nonaccrual status and TDR loans, after a careful analysis of each loan’s credit and collateral factors. Our analysis of an appropriate allowance for loan losses combines the provisions made for our non-impaired loans and the specific provisions made for each impaired loan.
The allowance for loan losses on loans designated as non-PCI loans is similar to the methodology described above except that for non-PCI loans, the remaining unaccreted discounts resulting from the fair value adjustments recorded at the time the loans were purchased are additionally factored into the allowance methodology.
For the PCI loans, the acquisition date fair value incorporated our estimate of future expected cash flows until the ultimate resolution of these credits. To the extent actual or projected cash flows are less than previously estimated, additional provisions for loan losses on the PCI loan portfolio will be recognized immediately into earnings. To the extent actual or projected cash flows are more than previously estimated, the increase in cash flows is recognized immediately as a recapture of provision for loan losses up to the previously recognized provision for that loan or pool of loans, if any, and then prospectively recognized in interest income as a yield adjustment.
While we believe we use the best information available to determine the allowance for loan losses, our results of operations could be significantly affected if circumstances differ substantially from the assumptions used in determining the allowance. A decline in national and local 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

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by bank regulators, as part of their routine examination process, which may result in the establishment of an additional allowance for loan losses based upon their judgment of information available to them at the time of their examination.
The following table provides information regarding changes in our allowance for loan losses at and for the three and six months ended June 30, 2018 and 2017:
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2018
 
2017
 
2018
 
2017
 
(Dollars in thousands)
Allowance for loan losses on loans at the beginning of the period
$
33,261

 
$
31,594

 
$
32,086

 
$
31,083

Provision for loan losses
1,750

 
1,131

 
2,902

 
1,998

Charge-offs:
 
 
 
 
 
 
 
Commercial business
(542
)
 
(141
)
 
(623
)
 
(443
)
One-to-four family residential
(15
)
 
—

 
(15
)
 
—

Consumer
(694
)
 
(398
)
 
(1,179
)
 
(941
)
Total charge-offs
(1,251
)
 
(539
)
 
(1,817
)
 
(1,384
)
Recoveries:
 
 
 
 
 
 
 
Commercial business
68

 
454

 
569

 
826

One-to-four family residential
—

 
1

 
—

 
1

Real estate construction and land development
2

 
—

 
2

 
10

Consumer
142

 
110

 
230

 
217

Total recoveries
212

 
565

 
801

 
1,054

Net (charge-offs) recoveries
(1,039
)
 
26

 
(1,016
)
 
(330
)
Allowance for loan losses at the end of the period
$
33,972

 
$
32,751

 
$
33,972

 
$
32,751

 
 
 
 
 
 
 
 
Allowance for loan losses to loans receivable, net
1.02
%
 
1.19
 %
 
1.02
%
 
1.19
%
Net charge-offs on loans to average loans, annualized
0.13
%
 
—
 %
 
0.06
%
 
0.03
%
 
 
 
 
 
 
 
 
Loans receivable, net at the end of the period (1)
$
3,328,288

 
$
2,749,507

 
$
3,328,288

 
$
2,749,507

Average loans receivable during the period (1)
3,266,092

 
2,657,946

 
3,208,799

 
2,644,953

(1) Excludes loans held for sale.
The allowance for loan losses increased $1.9 million, or 5.9%, to $34.0 million at June 30, 2018 from $32.1 million at December 31, 2017. The increase was the result of provision for loan losses of $2.9 million recognized during the six months ended June 30, 2018, offset partially by net charge-offs of $1.0 million recorded during the same period. The allowance for loan losses to loans receivable, net, decreased to 1.02% at June 30, 2018 from 1.13% at December 31, 2017 primarily as a result of an increase in loans from the Puget Sound Merger with no related allowance for loan losses.
The Company recorded charge-offs of $1.8 million during the six months ended June 30, 2018 due primarily to charge-offs of two agricultural relationships in the amount of $438,000, overdrafts on deposit accounts in the amount of $254,000 and a loan that was transferred to other real estate owned of $148,000. The remaining charge-offs were primarily a result of a large volume of small dollar consumer loans. The Company recorded recoveries of $801,000 during the six months ended June 30, 2018 primarily a result of cash received on a commercial and industrial loan of $324,000 and small recoveries on a large volume of small dollar consumer loans. The Company recorded net charge-offs on average loans, annualized, of 0.03% for the six months ended June 30, 2017 which were also primarily due to the large volumes of small dollar consumer loans.
As of June 30, 2018, the Bank identified $16.5 million of nonperforming loans and $26.0 million of performing TDR loans for a total of $42.5 million of impaired loans. Of these impaired loans, $12.1 million had no allowances for loan losses as their estimated collateral value or discounted expected cash flow is equal to or exceeds their carrying costs. The remaining $30.3 million of impaired loans had related allowances for loan losses totaling $4.4 million. As of December 31, 2017, the Bank identified $10.7 million of nonperforming loans and $26.8 million of performing TDR

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loans for a total of $37.5 million of impaired loans. Of these impaired loans, $10.4 million had no allowances for loan losses. The remaining $27.1 million of impaired loans had related allowances for loan losses totaling $3.4 million.
The following table outlines the allowance for loan losses and related loan balances on loans at June 30, 2018 and December 31, 2017:
 
June 30, 2018
 
December 31, 2017
 
(Dollars in thousands)
General Valuation Allowance:
 
 
 
Allowance for loan losses
$
25,968

 
$
24,732

Gross loans, excluding PCI and impaired loans
$
3,250,343

 
$
2,767,650

Percentage
0.80
%
 
0.89
%
 
 
 
 
PCI Allowance:
 
 
 
Allowance for loan losses
$
3,621

 
$
3,999

Gross PCI loans
$
31,852

 
$
40,603

Percentage
11.37
%
 
9.85
%
 
 
 
 
Specific Valuation Allowance:
 
 
 
Allowance for loan losses
$
4,383

 
$
3,355

Gross impaired loans
$
42,480

 
$
37,459

Percentage
10.32
%
 
8.96
%
 
 
 
 
Total Allowance for Loan Losses:
 
 
 
Allowance for loan losses
$
33,972

 
$
32,086

Gross loans receivable
$
3,324,675

 
$
2,845,712

Percentage
1.02
%
 
1.13
%
Based on the Bank's established comprehensive methodology, management deemed the allowance for loan losses of $34.0 million at June 30, 2018 (1.02% of loans receivable, net and 205.60% of nonperforming loans) appropriate to provide for probable incurred credit losses based on an evaluation of known and inherent risks in the loan portfolio at that date. This compares to an allowance for loan losses at December 31, 2017 of $32.1 million (1.13% of loans receivable, net and 299.79% of nonperforming loans). At the applicable acquisition or merger dates, no allowance for loan losses was established on purchased loans as the loans were accounted for at their fair value and a discount was established for the loans in accordance with U.S. GAAP. At June 30, 2018 and December 31, 2017, the remaining fair value discount for these purchased loans was $10.6 million and $10.1 million, respectively.
While we believe we use the best information available to determine the allowance for loan losses, our results of operations could be significantly affected if circumstances differ substantially from the assumptions used in determining the allowance. A decline in national and local 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 an additional allowance for loan losses based upon their judgment of information available to them at the time of their examination. Because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing 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.

Deposits and Other Borrowings
Total deposits increased $575.9 million, or 17.0%, to $3.97 billion at June 30, 2018 from $3.39 billion at December 31, 2017 due primarily to the deposits acquired in the Puget Sound Merger of $505.9 million at the merger date. Non-maturity deposits as a percentage of total deposits increased to 88.4% at June 30, 2018 from 88.3% at December 31, 2017 primarily as a result of the mix of deposits acquired from Puget Sound Merger, which had non-

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maturity deposits as a percentage of total deposits of 93.6% at the merger date. Based on the change in the mix and volume of deposits, the percentage of certificates of deposit to total deposits decreased to 11.6% at June 30, 2018 from 11.7% at December 31, 2017.
The following table summarizes the Company's deposits as of June 30, 2018 and December 31, 2017:
 
June 30, 2018
 
December 31, 2017
 
 
 
 
 
Balance
 
% of Total
 
Balance
 
% of Total
 
Change
 
%of Balance Change
 
(Dollars in thousands)
 
 
Noninterest demand deposits
$
1,157,630

 
29.2
%
 
$
944,791

 
27.8
%
 
$
212,839

 
22.5
%
Interest bearing demand deposits
1,242,622

 
31.3

 
1,051,752

 
31.1

 
190,870

 
18.1

Money market accounts
597,673

 
15.1

 
499,618

 
14.7

 
98,055

 
19.6

Savings accounts
510,375

 
12.8

 
498,501

 
14.7

 
11,874

 
2.4

Total non-maturity deposits
3,508,300

 
88.4

 
2,994,662

 
88.3

 
513,638

 
17.2

Certificate of deposit accounts
460,635

 
11.6

 
398,398

 
11.7

 
62,237

 
15.6

Total deposits
$
3,968,935

 
100.0
%
 
$
3,393,060

 
100.0
%
 
$
575,875

 
17.0

Borrowings may 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. The Bank is utilizing securities sold under agreement to repurchase as a supplement to its funding sources. Our repurchase agreements are secured by available for sale investment securities. At June 30, 2018, the Bank had securities sold under agreement to repurchase of $22.2 million, a decrease of $9.7 million, or 30.3%, from $31.8 million at December 31, 2017. The decrease was the result of customer activity during the period.
The Company also has junior subordinated debentures with a par value of $25.0 million which pay quarterly interest based on three-month LIBOR plus 1.56%. The debentures mature in 2037. The balance of the junior subordinated debentures was $20.2 million at June 30, 2018, which reflects the fair value of the junior subordinated debentures established during the Washington Banking Merger, adjusted for the accretion of discount from purchase accounting fair value adjustment.
At June 30, 2018, the Bank maintained credit facilities with the FHLB of Des Moines for $838.1 million and credit facilities with the Federal Reserve Bank for $58.1 million. The Company had FHLB advances outstanding of $75.5 million and $92.5 million at June 30, 2018 and December 31, 2017, respectively. The average cost of the FHLB advances during the six months ended June 30, 2018 and 2017 was 1.93% and 0.86%, respectively. The Bank also maintains lines of credit with four correspondent banks to purchase federal funds totaling $90.0 million as of June 30, 2018. There were no federal funds purchased as of June 30, 2018 or December 31, 2017.

Liquidity and Cash Flows
Our primary sources of funds are customer and local government deposits, loan principal and interest payments, loan sales and interest earned on and proceeds from sales and maturities of investment securities. These funds, together with retained earnings, equity and other borrowed funds, are used to make loans, acquire investment securities and other assets, and fund continuing operations. While maturities and scheduled amortization of loans are a predictable source of funds, deposit flows and loan prepayments are greatly influenced by the level of interest rates, economic conditions and competition.
Heritage Bank: The principal objective of the Bank’s liquidity management program is to maintain the ability to meet day-to-day cash flow requirements of its customers who either wish to withdraw funds or to draw upon credit facilities to meet their cash needs. The Bank monitors the sources and uses of funds on a daily basis to maintain an acceptable liquidity position. In addition to liquidity from core deposits and the repayment and maturities of loans, the Bank can utilize established credit facilities and lines with correspondent banks or sale of investment securities.
Heritage Financial Corporation: The Company is a separate legal entity from the Bank and must provide for its own liquidity. Substantially all of the Company’s revenues are obtained from dividends declared and paid by the Bank. There are statutory and regulatory provisions that could limit the ability of the Bank to pay dividends to the Company. However, management believes that such restrictions will not have an adverse impact on the ability of the

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Company to meets its ongoing cash obligations. At June 30, 2018, the Company (on an unconsolidated basis) had cash and cash equivalents of $14.0 million.
We are required to 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 June 30, 2018, cash and cash equivalents totaled $129.9 million, or 2.7% of total assets. The fair value of investment securities available for sale totaled $873.7 million at June 30, 2018, of which $257.9 million were pledged to secure public deposits or borrowing arrangements. The fair value of investment securities available for sale that were not pledged totaled $615.8 million, or 12.9%, of total assets at June 30, 2018. The fair value of investment securities available for sale with maturities of one year or less were $24.7 million, or 0.5%, of total assets at June 30, 2018.
Consolidated Cash Flows: As disclosed in the Condensed Consolidated Statements of Cash Flows, net cash provided by operating activities was $29.7 million for the six months ended June 30, 2018, and primarily consisted of net income of $20.9 million. During the six months ended June 30, 2018, net cash used in investing activities was $34.3 million, which consisted primarily of net loan originations of $96.1 million and purchases of premises and equipment of $16.7 million, offset partially by net cash received from acquisitions of $80.1 million. Net cash provided by financing activities was $31.4 million for the six months ended June 30, 2018, and primarily consisted of net increase in deposits of $70.0 million during the period, partially offset by net FHLB repayments of $17.0 million and dividends paid of $10.2 million.

Capital and Capital Requirements
Stockholders’ equity at June 30, 2018 was $639.5 million compared to $508.3 million at December 31, 2017. The changes to stockholders' equity during the six months ended June 30, 2018 is as follows:
 
Six Months Ended
 
June 30, 2018
 
(In Thousands)
Balance, beginning of period
$
508,305

   Common stock issued in the Puget Sound Merger
130,770

   Net income
20,944

   Dividends declared
(10,247
)
   Accumulated other comprehensive loss
(9,915
)
   Other
(334
)
Balance, end of period
$
639,523

The Company has historically paid cash dividends to its common shareholders. Payments of future cash dividends, if any, will be at the discretion of our board of directors after taking into account various factors, including our business, operating results and financial condition, capital requirements, current and anticipated cash needs, plans for expansion, any legal or contractual limitation on our ability to pay dividends and other relevant factors. Dividends on common stock from the Company depend substantially upon receipt of dividends from the Bank, which is the Company’s predominant source of income. On July 24, 2018, the Company’s Board of Directors declared a regular dividend of $0.15 per common share payable on August 23, 2018 to shareholders of record on August 9, 2018.
The Company is a bank holding company under the supervision of the Federal Reserve Bank. Bank holding companies are subject to capital adequacy requirements of the Federal Reserve under the Bank Holding Company Act of 1956, as amended, and the regulations of the Federal Reserve. Heritage Bank is a federally insured institution and thereby is subject to the capital requirements established by the FDIC. The Federal Reserve capital requirements generally parallel the FDIC requirements. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company’s consolidated financial statements and operations. Management believes as of June 30, 2018, the Company and the Bank meet all capital adequacy requirements to which they are subject.
As of June 30, 2018 and December 31, 2017, the most recent regulatory notifications categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Bank's categories.


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Minimum Requirements
 
Well-Capitalized Requirements
 
Actual
 
 
(Dollars in thousands)
As of June 30, 2018:
 
 
 
 
 
 
 
 
 
 
 
 
The Company consolidated
 
 
 
 
 
 
 
 
 
 
 
 
Common equity Tier 1 capital to risk-weighted assets
 
$
180,827

 
4.5
%
 
N/A

 
N/A

 
$
450,777

 
11.2
%
Tier 1 leverage capital to average assets
 
180,474

 
4.0

 
N/A

 
N/A

 
470,933

 
10.4

Tier 1 capital to risk-weighted assets
 
241,103

 
6.0

 
N/A

 
N/A

 
470,933

 
11.7

Total capital to risk-weighted assets
 
321,471

 
8.0

 
N/A

 
N/A

 
505,184

 
12.6

Heritage Bank
 
 
 
 
 
 
 
 
 
 
 
 
Common equity Tier 1 capital to risk-weighted assets
 
180,660

 
4.5

 
$
260,953

 
6.5
%
 
454,393

 
11.3

Tier 1 leverage capital to average assets
 
181,505

 
4.0

 
226,881

 
5.0

 
454,393

 
10.0

Tier 1 capital to risk-weighted assets
 
240,880

 
6.0

 
321,173

 
8.0

 
454,393

 
11.3

Total capital to risk-weighted assets
 
321,173

 
8.0

 
401,466

 
10.0

 
488,644

 
12.2

 
 
 
 
 
 
 
 
 
 
 
 
 
As of December 31, 2017:
 
 
 
 
 
 
 
 
 
 
 
 
The Company consolidated
 
 
 
 
 
 
 
 
 
 
 
 
Common equity Tier 1 capital to risk-weighted assets
 
$
154,522

 
4.5
%
 
N/A

 
N/A

 
$
386,689

 
11.3
%
Tier 1 leverage capital to average assets
 
159,494

 
4.0

 
N/A

 
N/A

 
406,687

 
10.2

Tier 1 capital to risk-weighted assets
 
206,029

 
6.0

 
N/A

 
N/A

 
406,687

 
11.8

Total capital to risk-weighted assets
 
274,706

 
8.0

 
N/A

 
N/A

 
439,044

 
12.8

Heritage Bank
 
 
 
 
 
 
 
 
 
 
 
 
Common equity Tier 1 capital to risk-weighted assets
 
154,400

 
4.5

 
$
223,023

 
6.5
%
 
391,092

 
11.4

Tier 1 leverage capital to average assets
 
159,300

 
4.0

 
199,125

 
5.0

 
391,092

 
9.8

Tier 1 capital to risk-weighted assets
 
205,867

 
6.0

 
274,490

 
8.0

 
391,092

 
11.4

Total capital to risk-weighted assets
 
274,490

 
8.0

 
343,112

 
10.0

 
423,348

 
12.3

Effective January 1, 2015 (with some changes transitioned into full effectiveness over two to four years), the Company became subject to new capital adequacy requirements approved by the Federal Reserve and the FDIC that implement the revised standards of the Basel Committee on Banking Supervision, commonly called Basel III, and address relevant provisions of the Dodd-Frank Act.
Under the new capital requirements both the Company and the Bank are required to have a common equity Tier 1 capital ratio of 4.5%. In addition, both the Company and the Bank are required to have a Tier 1 leverage ratio of 4.0%, a Tier 1 risk-based ratio of 6.0% and a total risk-based ratio of 8.0%. Both the Company and the Bank are required to establish a “conservation buffer”, consisting of common equity Tier 1 capital of more than 2.5% above the minimum risk-based capital ratios. The capital conservation buffer is designed to ensure that banks build up capital buffers outside periods of stress which can be drawn down as losses are incurred. An institution that does not meet the conservation buffer will be subject to restrictions on certain activities including payment of dividends, stock repurchases and discretionary bonuses to executive officers. The conservation buffer is being phased in beginning in 2016 and will take full effect on January 1, 2019. Certain calculations under the rules will also have phase-in periods. The capital conservation buffer requirement began to be phased-in on January 1, 2016 when more than 0.625% of risk-weighted assets was required, and increases by 0.625% on each subsequent January 1, until it is fully phased-in on January 1, 2019. At June 30, 2018, the capital conservation buffer was 4.57% and 4.17% for the Company and the Bank, respectively.

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ITEM 3.     QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to interest rate risk through our lending and deposit gathering activities. Our results of operations are highly dependent upon our ability to manage interest rate risk. We consider interest rate risk to be a significant market risk that could have a material effect on our financial condition and results of operations. Interest rate risk is measured and assessed on a quarterly basis. In our opinion, there has not been a material change in our interest rate risk exposure since the information disclosed in our Annual Report on Form 10-K for the year ended December 31, 2017.
Neither we, nor the Bank, maintain a trading account for any class of financial instrument, nor do we, or the Bank, engage in hedging activities or purchase high risk derivative instruments. Moreover, neither we, nor the Bank, are subject to foreign currency exchange rate risk or commodity price risk.

ITEM 4.     CONTROLS AND PROCEDURES
(a) Evaluation of Disclosure Controls and Procedures
An evaluation of the Company’s disclosure controls and procedure (as defined in Section 13a-15(e) or 15d-15(e) of the Securities Exchange Act of 1934 (the “Act”)) was carried out under the supervision and with the participation of the Company’s Chief Executive Officer, Chief Financial Officer and the Company’s Disclosure Committee as of the end of the period covered by this quarterly report. In designing and evaluating the Company’s disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure controls and procedures, management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Based on their evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures as of June 30, 2018 are effective in ensuring that the information required to be disclosed by the Company in the reports it files or submits under the Act is (i) accumulated and communicated to the Company’s management (including the Chief Executive Officer and Chief Financial Officer) in a timely manner, and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.
(b) Changes in Internal Control Over Financial Reporting
There have been no changes in the Company’s internal control over financial reporting (as defined in Rule 13a-15(f) of the Act) that occurred during the quarter ended June 30, 2018, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. The Company does not expect that its internal control over financial reporting will prevent all error and all fraud. A control procedure, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control procedure are met. Because of the inherent limitations in all control procedures, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any control procedure also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control procedure, misstatements due to error or fraud may occur and not be detected.
 
PART II.    OTHER INFORMATION

ITEM 1.     LEGAL PROCEEDINGS
We, and our Bank, are not a party to any material pending legal proceedings other than ordinary routine litigation incidental to the business of the Bank.
ITEM 1A.     RISK FACTORS
There have been no material changes to the risk factors set forth in Part I. Item 1A of the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.

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ITEM 2.     UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

(a) Not applicable.
(b) Not applicable.
(c) Repurchase Plans
The Company has had various stock repurchase programs since March 1999. On October 23, 2014, the Company's Board of Directors authorized the repurchase of up to 5% of the Company's outstanding common shares, or approximately 1,513,000 shares, under the eleventh stock repurchase plan. The number, timing and price of shares repurchased will depend on business and market conditions and other factors, including opportunities to deploy the Company's capital.
Since the inception of the eleventh plan, the Company has repurchased 579,996 shares at an average share prices of $16.67. No shares were repurchased under this plan during the six months ended June 30, 2018 and 2017.
In addition to the stock repurchases under a plan, the Company repurchases shares to pay withholding taxes on the vesting of restricted stock awards and units. The following table provides total repurchased shares for the periods indicated:
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2018
 
2017
 
2018
 
2017
Repurchased shares to pay withholding taxes (1)
7,394

 
11,476

 
52,820

 
27,367

Stock repurchase to pay withholding taxes average share price
$
33.84

 
$
25.50

 
$
31.96

 
$
24.60

(1) During the three and six months ended June 30, 2018, 26,741 of the shares repurchased related to the withholding taxes due on the accelerated vesting of the restricted stock units of Puget Sound which were converted to Heritage common stock shares with an average share price of $31.80 under the terms of the merger agreement.
The following table sets forth information about the Company’s purchases of its outstanding common stock during the quarter ended June 30, 2018.
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 (2)
 
Maximum Number 
of Shares that May
Yet Be Purchased
Under the Plans or
Programs
April 1, 2018— April 30, 2018
 
—

 
$
—

 
7,893,389

 
935,034

May 1, 2018— May 31, 2018
 
—

 
—

 
7,893,389

 
935,034

June 1, 2018— June 30, 2018
 
7,394

 
33.84

 
7,893,389

 
935,034

Total
 
7,394

 
$
33.84

 


 


(1) All of the common shares repurchased by the Company between April 1, 2018 and June 30, 2018 represented the cancellation of stock to pay withholding taxes on vested restricted stock awards or units.
(2) Represents cumulative life-to-date shares repurchased.
ITEM 3.     DEFAULTS UPON SENIOR SECURITIES
None

ITEM 4.     MINE SAFETY DISCLOSURES
Not applicable

ITEM 5.        OTHER INFORMATION
None

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ITEM 6.     EXHIBITS

 
 
 
 
Incorporated by Reference
Exhibit No.
 
Description of Exhibit
 
Form
 
Exhibit
 
Filing Date/Period End Date
 
 
 
 
 
 
 
 
 
2.5

 
 
8-K
 
2.1
 
7/27/2017
 
 
 
 
 
 
 
 
 
2.6

 
 
8-K
 
2.1
 
3/9/2018
 
 
 
 
 
 
 
 
 
31.1

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
31.2

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
32.1

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
101.INS

 
XBRL Instance Document (1)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
101.SCH

 
XBRL Taxonomy Extension Schema Document (1)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
101.CAL

 
XBRL Taxonomy Extension Calculation Linkbase Document (1)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
101.DEF

 
XBRL Taxonomy Extension Definition Linkbase Document (1)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
101.LAB

 
XBRL Taxonomy Extension Label Linkbase Document (1)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
101.PRE

 
XBRL Taxonomy Extension Presentation Linkbase Document (1)
 
 
 
 
 
 
(1) Filed herewith.

SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 
 
HERITAGE FINANCIAL CORPORATION
 
 
 
Date:
 
 
August 8, 2018
 
/S/ BRIAN L. VANCE
 
 
Brian L. Vance
 
 
Chief Executive Officer
 
 
 
Date:
 
 
August 8, 2018
 
/S/ DONALD J. HINSON
 
 
Donald J. Hinson
 
 
Executive Vice President and Chief Financial Officer



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