HERITAGE FINANCIAL CORP /WA/ - FORM 10-Q

HERITAGE FINANCIAL CORP /WA/ - FORM 10-Q - May 9, 2011

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EX-31.1 - SECTION 302 CEO CERTIFICATION - HERITAGE FINANCIAL CORP /WA/	dex311.htm
EX-31.2 - SECTION 302 CFO CERTIFICATION - HERITAGE FINANCIAL CORP /WA/	dex312.htm
EX-32.1 - SECTION 906 CEO AND CFO CERTIFICATION - HERITAGE FINANCIAL CORP /WA/	dex321.htm

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 March 31, 2011

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

Commission File Number 0-29480

HERITAGE FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)


Washington		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 x No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨ No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 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 x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the last practicable date:

As of May 4, 2011 there were 15,648,809 common shares outstanding, with no par value, of the registrant.

HERITAGE FINANCIAL CORPORATION

FORM 10-Q

INDEX

FORWARD LOOKING STATEMENT


		Page
PART I.	Financial Information

Item 1.	Condensed Consolidated Financial Statements (Unaudited):

	Condensed Consolidated Statements of Financial Condition as of March 31, 2011 and December 31, 2010		4

	Condensed Consolidated Statements of Operations for the Three Months Ended March 31, 2011 and 2010		5

	Condensed Consolidated Statements of Stockholders’ Equity for the Three Months Ended March 31, 2011 and Comprehensive Income (Loss) for the Three Months Ended March 31, 2011 and 2010		6

	Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2011 and 2010		7

	Notes to Condensed Consolidated Financial Statements		8

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		34

Item 3.	Quantitative and Qualitative Disclosures About Market Risk		42

Item 4.	Controls and Procedures		42

PART II.	Other Information

Item 1.	Legal Proceedings		42

Item 1A.	Risk Factors		42

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		42

Item 3.	Defaults Upon Senior Securities		42

Item 4.	[Removed and reserved]		43

Item 5.	Other Information		43

Item 6.	Exhibits		44

	Signatures		45

	Certifications

Forward Looking Statements

“Safe Harbor” statement under the Private Securities Litigation Reform Act of 1995: This Form 10-Q contains forward-looking statements that are subject to risks and uncertainties, including, but not limited to: the credit risks of lending activities, including changes in the level and trend of loan delinquencies and write-offs and changes in our allowance for loan losses and provision for loan losses that may be impacted by deterioration in the housing and commercial real estate markets; 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; 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 Board of Governors of the Federal Reserve System (the “Federal Reserve Board”) and of our bank subsidiaries by the Federal Deposit Insurance Corporation (the “FDIC”), the Washington State Department of Financial Institutions, Division of Banks (the “Washington DFI”) or other regulatory authorities, including the possibility that any such regulatory authority may, among other things, require us to increase our reserve for loan losses, write-down assets, change our regulatory capital position or affect our ability to borrow funds or maintain or increase deposits, which could adversely affect our liquidity and earnings; legislative or regulatory changes that adversely affect our business including changes in regulatory policies and principles, including the interpretation of regulatory capital or other rules including changes from the Dodd-Frank Wall Street Reform and Consumer Protection Act and regulations that have been or will be promulgated thereunder; our ability to control operating costs and expenses; 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 balance sheet; staffing fluctuations in response to product demand or the implementation of corporate strategies that affect our workforce and potential associated charges; computer systems on which we depend could fail or experience a security breach; our ability to retain key members of our senior management team; costs and effects of litigation, including settlements and judgments; our ability to implement our expansion strategy; our ability to successfully integrate any assets, liabilities, customers, systems, and management personnel we have acquired including the Cowlitz Bank and Pierce Commercial Bank transactions or may in the future acquire into our operations and our ability to realize related revenue synergies and cost savings within expected time frames and any goodwill charges related thereto; risks relating to acquiring assets or entering markets in which we have not previously operated and may not be familiar; changes in consumer spending, borrowing and savings habits; the availability of resources to address changes in laws, rules, or regulations or to respond to regulatory actions; adverse changes in the securities markets; inability of key third-party providers to perform their obligations to us; changes in accounting policies and practices, as may be adopted by the financial institution regulatory agencies or the Financial Accounting Standards Board, including additional guidance and interpretation on accounting issues and details of the implementation of new accounting methods; 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.

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 2011 and beyond 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 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.

ITEM 1.

HERITAGE FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Dollars in thousands, except for per share amounts)

(Unaudited)


	March 31, 2011			December 31, 2010
Assets
Cash on hand and in banks	$	26,156		$	37,179
Interest earning deposits		114,764			129,822
Federal funds sold		—			1,990
Investment securities available for sale		134,023			125,175
Investment securities held to maturity (market value of $14,085 and $14,290)		13,494			13,768
Loans held for sale		478			764
Originated loans receivable		753,190			742,019
Less: Allowance for loan losses		(21,382	)		(22,062	)

Originated loans receivable, net		731,808			719,957
Purchased covered loans receivable, net of allowance for loan losses of ($1,512 and $0)		123,452			128,715
Purchased non-covered loans receivable, net of allowance for loan losses of ($266 and $0)		109,860			131,049

Total loans receivable, net		965,120			979,721
FDIC indemnification asset		16,869			16,071
Other real estate owned		3,518			3,030
Premises and equipment, at cost, net		22,413			21,750
Federal Home Loan Bank stock, at cost		5,594			5,594
Accrued interest receivable		5,011			4,626
Prepaid expenses and other assets		8,467			8,974
Deferred income taxes, net		4,246			4,255
Intangible assets, net		1,840			1,953
Goodwill		13,012			13,012

Total assets	$	1,335,005		$	1,367,684

Liabilities and Stockholders’ Equity
Deposits	$	1,099,720		$	1,136,276
Securities sold under agreement to repurchase		24,811			19,027
Accrued expenses and other liabilities		7,141			10,102

Total liabilities		1,131,672			1,165,405
Stockholders’ equity:
Common stock, no par, 50,000,000 shares authorized; 15,648,809 and 15,568,471 shares outstanding at March 31, 2011 and December 31, 2010, respectively		128,688			128,436
Unearned compensation – ESOP and other		(160	)		(182	)
Retained earnings		74,412			73,648
Accumulated other comprehensive income , net		393			377

Total stockholders’ equity		203,333			202,279

Total liabilities and stockholders’ equity	$	1,335,005		$	1,367,684

See Notes to Condensed Consolidated Financial Statements.

HERITAGE FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Dollars in thousands, except for per share amounts)

(Unaudited)


	Three Months Ended March 31,
	2011			2010
INTEREST INCOME:
Interest and fees on loans	$	16,572		$	11,970
Taxable interest on investment securities		663			745
Nontaxable interest on investment securities		179			73
Interest on federal funds sold and interest bearing deposits		79			60

Total interest income		17,493			12,848
INTEREST EXPENSE:
Deposits		1,875			2,163
Other borrowings		22			20

Total interest expense		1,897			2,183

Net interest income		15,596			10,665
Provision for loan losses		2,595			3,750
Provision for loan losses on purchased loans		1,778			—

Net interest income after provision for loan losses		11,223			6,915
NON-INTEREST INCOME:
Gains on sales of loans, net		151			66
Service charges on deposits		1,238			1,025
Merchant Visa income		699			715
FDIC loss sharing income, net		800			—
Other income		590			350

Total non-interest income		3,478			2,156
NON-INTEREST EXPENSE:
Impairment loss on investment securities		46			195
Less: Portion recorded as other comprehensive income		(20	)		(5	)

Impairment loss on investment securities, net		26			190
Salaries and employee benefits		6,637			4,015
Occupancy and equipment		1,846			1,027
Data processing		823			420
Marketing		315			211
Merchant Visa		569			597
Professional services		633			286
State and local taxes		356			217
Federal deposit insurance premium		456			354
Other real estate owned		517			26
Other expense		1,474			732

Total non-interest expense		13,652			8,075

Income before income taxes		1,049			996
Income tax expense		285			300

Net income	$	764		$	696

Dividends accrued and discount accreted on preferred shares		—			331
Net income applicable to common shareholders	$	764		$	365

Earnings per common share:
Basic	$	0.05		$	0.03
Diluted	$	0.05		$	0.03
Dividends declared per common share:	$	—		$	—

See Notes to Condensed Consolidated Financial Statements.

HERITAGE FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY FOR THE THREE MONTHS ENDED

MARCH 31, 2011 AND COMPREHENSIVE INCOME FOR THE THREE MONTHS ENDED

MARCH 31, 2011 AND 2010

(Dollars and shares in thousands)

(Unaudited)


	Number of common shares		Common stock		Unearned Compensation- ESOP and other			Retained earnings		Accumulated other comprehensive income, net			Total stockholders’ equity
Balance at December 31, 2010		15,568	$	128,436	$	(182	)	$	73,648	$	377		$	202,279
Restricted stock awards issued		79		—		—			—		—			—
Stock option compensation expense		—		52		—			—		—			52
Exercise of stock options (including tax benefits from nonqualified stock options)		—		1		—			—		—			1
Share based payment and earned ESOP		2		199		22			—		—			221
Net income		—		—		—			764		—			764
Change in fair value of securities available for sale, net of reclassification adjustments		—		—		—			—		(7	)		(7	)
Other-than-temporary impairment on securities held to maturity, net of tax		—		—		—			—		(13	)		(13	)
Accretion of other-than-temporary impairment on securities held to maturity, net of tax		—		—		—			—		36			36

Balance at March 31, 2011		15,649	$	128,688	$	(160	)	$	74,412	$	393		$	203,333


	Three Months Ended March 31,
Comprehensive Income	2011			2010
Net income	$	764		$	696
Change in fair value of securities available for sale, net of tax of $(4) and $161		(7	)		299
Other-than-temporary impairment on securities held-to-maturity, net of tax of $(7) and $(2)		(13	)		(3	)
Accretion of other-than-temporary impairment in securities held-to-maturity, net of tax of $20 and $54		36			101

Comprehensive income	$	780		$	1,093

See Notes to Condensed Consolidated Financial Statements.

HERITAGE FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

For the three months ended March 31, 2011 and 2010

(Dollars in thousands)

(Unaudited)


	Three Months Ended March 31,
	2011			2010
Cash flows from operating activities:
Net income	$	764		$	696
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		322			404
Deferred loan fees, net of amortization		18			(46	)
Provision for loan losses		4,373			3,750
Net change in accrued interest receivable, prepaid expenses and other assets, accrued expenses and other liabilities		(3,636	)		(102	)
Recognition of compensation related to ESOP shares and share based payment		221			101
Stock option compensation expense		52			41
Tax provision realized from stock options exercised, share based payment and dividends on unallocated ESOP shares		(1	)		4
Amortization of intangible assets		113			20
Deferred income tax		—			15
Impairment loss on investment securities		26			190
Origination of loans held for sale		(3,230	)		(3,373	)
Gain on sale of loans		(151	)		(66	)
Proceeds from sale of loans		3,667			3,630
Valuation adjustment on other real estate owned		361			—
Loss (gain) on sale of other real estate owned		13			(93	)

Net cash provided by operating activities		2,912			5,171

Cash flows from investing activities:
Loans originated, net of principal payments		8,873			8,230
Maturities of investment securities available for sale		5,562			3,719
Maturities of investment securities held to maturity		570			616
Purchase of investment securities available for sale		(14,361	)		(7,976	)
Purchase of investment securities held to maturity		(271	)		(492	)
Purchase of premises and equipment		(1,060	)		(453	)
Proceeds from sales of other real estate owned		475			797

Net cash (used in) provided by investing activities		(212	)		4,441

Cash flows from financing activities:
Net decrease in deposits		(36,556	)		(4,232	)
Preferred stock cash dividends paid		—			(300	)
Net increase (decrease) in securities sold under agreement to repurchase		5,784			(186	)
Proceeds from exercise of stock options		—			201
Tax provision realized from stock options exercised, share based payment and dividends on unallocated ESOP shares		1			(4	)

Net cash used in financing activities		(30,771	)		(4,521	)

Net (decrease) increase in cash and cash equivalents		(28,071	)		5,091

Cash and cash equivalents at beginning of period		168,991			107,231

Cash and cash equivalents at end of period	$	140,920		$	112,322

Supplemental disclosures of cash flow information:
Cash paid for interest	$	1,957		$	2,193
Cash paid for income taxes		1,143			150
Loans transferred to other real estate owned	$	1,337		$	1,590

See Notes to Condensed Consolidated Financial Statements.

HERITAGE FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Three Months Ended March 31, 2011 and 2010

(Unaudited)

NOTE 1. Description of Business and Basis of Presentation

(a) Description of Business

Heritage Financial Corporation (the “Company”) is a bank holding company 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 subsidiaries: Heritage Bank and Central Valley Bank (the “Banks”). is the Banks are Washington-chartered commercial banks and their deposits are insured by the Federal Deposit Insurance Corporation (“FDIC”) under the Deposit Insurance Fund (“DIF”). Heritage Bank conducts business from its main office in Olympia, Washington and its twenty-five branch offices located in western Washington and the greater Portland, Oregon area. Central Valley Bank conducts business from its main office in Toppenish, Washington and its five branch offices located in Yakima and Kittitas counties of Washington State.

The Company’s business consists primarily of lending and deposit relationships with small businesses and their owners in its market areas and attracting deposits from the general public. The Company also makes residential and commercial construction, income property, and consumer loans and originates for sale or investment purposes first mortgage loans on residential properties located in western and central Washington State and the greater Portland, Oregon area.

Effective July 30, 2010, Heritage Bank entered into a definitive agreement with the FDIC, pursuant to which Heritage Bank acquired certain assets and assumed certain liabilities of Cowlitz Bank, a Washington state-chartered commercial bank headquartered in Longview, Washington (the “Cowlitz Acquisition”). The Cowlitz Acquisition included nine branches of Cowlitz Bank, including its division Bay Bank, which became branches of Heritage Bank. It also included the Trust Services Division of Cowlitz Bank. Effective November 5, 2010, Heritage Bank entered into a definitive agreement with the FDIC, pursuant to which Heritage Bank acquired certain assets and assumed certain liabilities of Pierce Commercial Bank, a Washington state-chartered bank headquartered in Tacoma, Washington (the “Pierce Commercial Acquisition”). The Pierce Commercial Acquisition included one branch, which became a branch of Heritage Bank. The Cowlitz Acquisition and the Pierce Commercial Acquisition are collectively referred to as the “Cowlitz and Pierce Acquisitions”.

(b) Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with Generally Accepted Accounting Principles, or GAAP, for interim financial information, 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. Generally Accepted Accounting Principles for complete financial statements. These condensed consolidated financial statements should be read with our December 31, 2010 audited consolidated financial statements and its accompanying notes included in our Annual Report on Form 10-K (“2010 Form 10-K”). In our opinion, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2011 are not necessarily indicative of the results that may be expected for the year ending December 31, 2011. In preparing the condensed consolidated financial statements, we are required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses. Actual results could differ from those estimates.

Certain prior year amounts have been reclassified to conform to the current year’s presentation.

(c) Significant Accounting Policies

The significant accounting policies used in preparation of our consolidated financial statements are disclosed in our 2010 Annual Form 10-K. There have not been any material changes in our significant accounting policies compared to those contained in our Form 10-K disclosure for the year ended December 31, 2010.

(d) Recently Issued Accounting Pronouncements

FASB ASU 2011-02, Receivables (Topic 310): A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring provides additional guidance to clarify when a loan modification or restructuring is considered a troubled debt restructuring (TDR) in order to address current diversity in practice and lead to more consistent application of U.S. GAAP for debt restructurings. In evaluating whether a restructuring constitutes a troubled debt restructuring, a creditor must separately conclude that both of the following exist: (1) the restructuring constitutes a concession, and (2) the debtor is experiencing financial difficulties. The amendments to Topic 310 clarify the guidance regarding the evaluation of both considerations above. Additionally, the amendments clarify that a creditor is precluded from using the effective interest rate test in the debtor’s guidance on restructuring of payables (paragraph 470-60-55-10) when evaluating whether a restructuring constitutes a TDR. This amendment is effective is July 1,

2011. Early adoption is permitted. Retrospective application to the beginning of the annual period of adoption for modifications occurring on or after the beginning of the annual adoption period is required. As a result of applying these amendments, the Company may identify receivables that are newly considered to be impaired. For purposes of measuring impairment of those receivables, an entity should apply the amendments prospectively for the first interim or annual period beginning on or after June 15, 2011.

FASB ASU No. 2011-01, Receivables (Topic 310): Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20, was issued in January 2011. ASU 2011-01 temporarily delays the effective date of the disclosures about troubled debt restructurings in Update 2010-20 for public entities. The delay is intended to allow the FASB time to complete its deliberations on what constitutes a troubled debt restructuring. The effective date of the new disclosures about troubled debt restructurings and the guidance for determining what constitutes a troubled debt restructuring will then be coordinated. Currently, that guidance is anticipated to be effective for interim and annual periods ending after June 15, 2011.

FASB ASU No. 2010-06, Fair Value Measurements and Disclosures (Topic 820)—Improving Disclosures About Fair Value Measurements requires expanded disclosures related to fair value measurements including (i) the amounts of significant transfers of assets or liabilities between Levels 1 and 2 of the fair value hierarchy and the reasons for the transfers, (ii) the reasons for transfers of assets or liabilities in or out of Level 3 of the fair value hierarchy, with significant transfers disclosed separately, (iii) the policy for determining when transfers between levels of the fair value hierarchy are recognized and (iv) for recurring fair value measurements of assets and liabilities in Level 3 of the fair value hierarchy, a gross presentation of information about purchases, sales, issuances and settlements. ASU 2010-06 further clarifies that (i) fair value measurement disclosures should be provided for each class of assets and liabilities (rather than major category), which would generally be a subset of assets or liabilities within a line item in the statement of financial position and (ii) companies should provide disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements for each class of assets and liabilities included in Levels 2 and 3 of the fair value hierarchy. The disclosures related to the gross presentation of purchases, sales, issuances and settlements of assets and liabilities included in Level 3 of the fair value hierarchy are required for the Company beginning January 1, 2011. The remaining disclosure requirements and clarifications made by ASU 2010-06 became effective for the Company on January 1, 2010. See Note 11 “Fair Value of Measurements”.

NOTE 2. Loans Receivable

(a) Loan Origination/Risk Management

The Company originates loans in one of the four segments of the total loan portfolio: commercial business, real estate construction and land development, one-to-four family residential, and consumer. Within these segments are classes of loans to which management monitors and assesses credit risk in the loan portfolios. The Company has certain lending policies and procedures in place that are designed to maximize loan income within an acceptable level of risk. Management reviews and approves these policies and procedures on a regular basis. A reporting system supplements the review process by providing management with frequent reports related to loan production, loan quality, concentrations of credit, loan delinquencies, and nonperforming and potential problem loans. The Company also conducts external loan reviews and validates the credit risk assessment on a periodic basis. Results of these reviews are presented to management. The loan review process complements and reinforces the risk identification and assessment decisions made by lenders and credit personnel, as well as the Company’s policies and procedures.

A discussion of the risk characteristics of each portfolio segments is as follows:

Commercial Business

There are three significant classes of loans in the commercial portfolio segment, including commercial and industrial loans, owner-occupied commercial real estate, and non-owner occupied commercial real estate. The owner and non-owner occupied commercial real estate are both considered commercial real estate loans. As each of the classes carries different risk characteristics, management will discuss them separately.

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 incorporate a personal guarantee; however, some short-term loans may be made on an unsecured basis. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers.

Commercial real estate. The Company originates multifamily and commercial real estate loans within its primary market areas. These loans are subject to underwriting standards and processes similar to commercial and industrial loans, in addition to those of real estate loans. These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Commercial real estate involves more risk than other classes in that the lending typically involves higher loan principal amounts, and payments on loans secured by real estate properties are dependent on successful operation and management of the properties. Repayment of these loans may be more adversely affected by conditions in the real estate market or the economy.

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 typically range from 15 to 30 years. The Company generally sells most single-family loans in the secondary market. Management determines to what extent the Company will retain or sell these loans and other fixed rate mortgages in order to control the Bank’s interest rate sensitivity position, growth and liquidity.

Real Estate Construction and Land Development

The Company originates construction loans for one-to-four family residential and for five or more residential properties 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 a variable rate 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 regards to the total funds required to complete a project and the related loan-to-value ratio may vary from actual results. As a result, construction loans often involve the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project and the ability of the borrower to sell or lease the property or refinance the indebtedness. If 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. 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 sensitive to interest rate changes, governmental 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 is developed to ensure a qualifying primary and secondary source of repayment. Underwriting standards for home equity loans are heavily 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 the consumer loans are relatively small amounts spread across many individual borrowers which minimizes the credit risk. Additionally, trend reports are reviewed by management on a regular basis.

Originated loans receivable at March 31, 2011 and December 31, 2010 consisted of the following portfolio segments and classes:


	March 31, 2011			December 31, 2010
	(In thousands)
Commercial business:
Commercial and industrial	$	255,055		$	232,857
Owner-occupied commercial real estate		158,206			159,444
Non-owner occupied commercial real estate		213,938			221,739

Total commercial business		627,199			614,040
One-to-four family residential		44,686			47,505
Real estate construction and land development:
One-to-four family residential		26,927			29,377
Five or more family residential and commercial properties		32,980			28,588

Total real estate construction and land development		59,907			57,965
Consumer		22,739			23,832

Gross originated loans receivable		754,531			743,342
Deferred loan fees		(1,341	)		(1,323	)

Total originated loans receivable	$	753,190		$	742,019

Loans acquired in a business acquisition are designated as “purchased” loans. Purchased loans subject to loss-sharing agreements with the FDIC are identified as “covered” loans. Loans purchased with evidence of credit deterioration since origination for which it is probable that all contractually required payments will not be collected are accounted for under Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“FASB ASC”) 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality, formerly AICPA SOP 03-3 Accounting for Certain Loans or Debt Securities Acquired in a Transfer. These loans are identified as “impaired” 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, formerly SFAS91 Nonrefundable fees and Other Costs. These loans are identified as “other” loans. Funds advanced on the covered loans subsequent to acquisition, identified as “subsequent advances,” are included in the purchased covered loan balances as these subsequent advances are covered under the loss-sharing agreements. The subsequent advances for loans accounted for under FASB ASC 310-30 are reported with the balances of the purchased impaired covered loans despite the fact that the subsequent advances are not accounted for under FASB ASC 310-30. The total balance of subsequent advances on the purchased impaired covered loans was $7.2 million and $6.0 million as of March 31, 2011 and December 31, 2010, respectively.

The recorded investment of purchased covered loans receivable at March 31, 2011 and December 31, 2010 consisted of the following portfolio segments and classes:


	March 31, 2011			December 31, 2010
	(In thousands)
Commercial business:
Commercial and industrial	$	45,396		$	47,048
Owner-occupied commercial real estate		43,827			45,220
Non-owner occupied commercial real estate		17,027			17,575


Total commercial business		106,250			109,843
One-to-four family residential		9,604			10,022
Real estate construction and land development:
One-to-four family residential		5,734			5,875
Five or more family residential and commercial properties		—			—

Total real estate construction and land development		5,734			5,875
Consumer		3,376			2,975

Total purchased loans receivable		124,964			128,715
Allowance for loan losses		(1,512	)		—

Purchased loans receivable, net	$	123,452		$	128,715

The March 31, 2011 and December 31, 2010 gross recorded investment balance of impaired purchased covered loans accounted for under FASB ASC 310-30 was $86.8 million and $90.1 million, respectively. The gross recorded investment balance of other purchased covered loans was $38.2 million and $38.6 million at March 31, 2011 and December 31, 2010, respectively.

The recorded investment of purchased non-covered loans receivable at March 31, 2011 and December 31, 2010 consisted of the following portfolio segments and classes:


	March 31, 2011			December 31, 2010
	(In thousands)
Commercial business:
Commercial and industrial	$	56,739		$	69,049
Owner-occupied commercial real estate		17,948			18,840
Non-owner occupied commercial real estate		15,343			18,970


Total commercial business		90,030			106,859
One-to-four family residential		10,641			12,209
Real estate construction and land development:
One-to-four family residential		3,833			3,816
Five or more family residential and commercial properties		1,241			1,244

Total real estate construction and land development		5,074			5,060
Consumer		4,381			6,921

Total purchased loans receivable		110,126			131,049
Allowance for loan losses		(266	)		—

Purchased loans receivable, net	$	109,860		$	131,049

During the quarter ended March 31, 2011, the purchased non-covered loans were added to the Heritage Bank’s loan servicing system. At that time, it was determined that certain loans should be reclassified to better represent the class of loan based on the Bank’s methodology. Therefore, the December 31, 2010 loan balances have been re-classified since being reported in the Annual Report on Form 10-K.

The March 31, 2011 and December 31, 2010 gross recorded investment balance of impaired purchased non-covered loans accounted for under FASB ASC 310-30 was $69.7 million and $80.2 million, respectively. The recorded investment balance of other purchased non-covered loans was $40.4 million and $50.8 million at March 31, 2011 and December 31, 2010, respectively.

(b) Concentrations of Credit

Most of the Company’s lending activity occurs within the State of Washington, and to a lesser extent the State of Oregon. The primary market areas include Thurston, Pierce, King, Mason, Cowlitz and Clark counties in Washington and Multnomah County in Oregon, as well as other markets. The majority of the Company’s loan portfolio consists of commercial and industrial, non-owner occupied commercial real estate, and owner occupied commercial real estate. As of March 31, 2011 and December 31, 2010, there were no concentrations of loans related to any single industry in excess of 10% of total loans.

(c) Credit Quality Indicators

As part of the on-going monitoring of the credit quality of the Company’s loan portfolio, management tracks certain credit quality indicators including trends related to (i) the risk grade of the loans, (ii) the level of classified loans, (iii) net charge-offs, (iv) nonperforming loans, and (v) the general economic conditions of the United States of America, and specifically the states of Washington and Oregon. The Company utilizes a risk grading matrix to assign a risk grade to each of its loans. Loans are graded on a scale of 0 to 9, and a “W”. A description of the general characteristics of the nine risk grades is as follows:

•

Grades 0 to 5—These grades are considered “pass grade” with negligible to above average but acceptable risk. These borrowers generally have strong to acceptable capital levels and consistent earnings and debt service capacity. Loans with the higher grades within the “pass” category may include borrowers who are experiencing unusual operating difficulties, but have acceptable payment performance to date. Increased monitoring of financials and/or collateral may be appropriate. Overall, loans with this grade show no immediate loss exposure.

•

Grade “W”—This grade includes loans on management’s “watch list” and is intended to be utilized on a temporary basis for pass grade borrowers where a significant risk-modifying action is anticipated in the near term.

•

Grade 6—This grade is for “Other Assets Especially Mentioned” (OAEM) 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 7—This grade includes “Substandard” loans, in accordance with regulatory guidelines, for which the loan has a high risk. The loan also has 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 are apt to 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 accrual or nonaccrual status based on the Company’s accrual policy.

•

Grade 8—This grade includes “Doubtful” loans in accordance with regulatory guidelines, and the Company has determined these loans to have excessive 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.

•

Grade 9—This grade includes “Loss” loans in accordance with regulatory guidelines. These loans are determined to 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.

Loan grades for all commercial loans are established at the origination of the loan. Non-commercial loans are not graded as a 0 to 9 at origination date as these loans are determined to be “pass graded” loans. These non-commercial loans may subsequently require a 0-9 risk grade if the credit department has evaluated the credit and determined it necessary to classify the loan. Loan grades are reviewed on a quarterly basis, or more frequently if necessary, by the credit department. Typically, an individual loan grade will not be changed from the prior period unless there is a specific indication of credit deterioration or improvement. Credit deterioration is evidenced by delinquency, direct communications with the borrower, or other borrower information that becomes public. 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 are believed to have some inherent losses in the portfolios, but at a lesser extent than the other loan grades. These pass graded loans might have a zero percent loss based on historical experience and current market trends. 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. However, the likelihood of loss is greater than Watch grade because there has been measurable credit deterioration. Loans with a substandard grade are generally loans for which the Company has individually analyzed for potential impairment. For Doubtful and Loss graded loans, the Company is almost certain of the losses, and the unpaid principal balances are generally charged-off.

The following tables present the balance of the originated loans receivable by credit quality indicator as of March 31, 2011 and December 31, 2010.


	March 31, 2011
	Pass		OAEM		Substandard		Doubtful		Total
	(in thousands)
Commercial business:
Commercial and industrial	$	222,154	$	3,471	$	28,640	$	790	$	255,055
Owner-occupied commercial real estate		152,815		1,921		3,470		—		158,206
Non-owner occupied commercial real estate		202,995		6,164		4,779		—		213,938

Total commercial business		577,964		11,556		36,889		790		627,199
One-to-four family residential		44,230		—		456		—		44,686
Real estate construction and land development:
One-to-four family residential		11,040		2,009		13,878		—		26,927
Five or more family residential and commercial properties		19,270		—		13,710		—		32,980

Total real estate construction and land development		30,310		2,009		27,588		—		59,907
Consumer		22,593		—		146		—		22,739

Gross originated loans	$	675,097	$	13,565	$	65,079	$	790	$	754,531


	December 31, 2010
	Pass		OAEM		Substandard		Doubtful		Total
	(in thousands)
Commercial business:
Commercial and industrial	$	199,566	$	2,615	$	29,871	$	805	$	232,857
Owner-occupied commercial real estate		154,910		913		3,621		—		159,444
Non-owner occupied commercial real estate		206,178		12,991		2,570		—		221,739

Total commercial business		560,654		16,519		36,062		805		614,040
One-to-four family residential		46,653		—		850		2		47,505
Real estate construction and land development:
One-to-four family residential		10,287		2,317		16,773		—		29,377
Five or more family residential and commercial properties		19,078		793		8,717		—		28,588

Total real estate construction and land development		29,365		3,110		25,490		—		57,965
Consumer		23,704		—		128		—		23,832

Gross originated loans	$	660,376	$	19,629	$	62,530	$	807	$	743,342

The tables above include impaired loan balances. Potential problem loans are those loans 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 originated loans as of March 31, 2011 and December 31, 2010 were $50.1 million and $56.1 million, respectively. The balance of potential problem originated loans guaranteed by a governmental agency was $4.2 million and $5.9 million as of March 31, 2011 and December 31, 2010, respectively. This guarantee reduces the Company’s credit exposure.

The following tables present the recorded balance of the other purchased loans receivable by credit quality indicator as of March 31, 2011 and December 31, 2010.


	March 31, 2011
	Pass		OAEM		Substandard		Doubtful		Total
	(in thousands)
Commercial business:
Commercial and industrial	$	28,869	$	23	$	359	$	—	$	29,251
Owner-occupied commercial real estate		33,854		—		595		—		34,449
Non-owner occupied commercial real estate		7,368		508		555		—		8,431

Total commercial business		70,091		531		1,509		—		72,131
One-to-four family residential		2,341		—		—		—		2,341
Real estate construction and land development:
One-to-four family residential		54		—		—		—		54
Five or more family residential and commercial properties		—		—		—		—		—

Total real estate construction and land development		54		—		—		—		54
Consumer		4,043		—		—		—		4,043

Gross other purchased covered loans	$	76,529	$	531	$	1,509	$	—	$	78,569


	December 31, 2010
	Pass		OAEM		Substandard		Doubtful		Total
	(in thousands)
Commercial business:
Commercial and industrial	$	20,065	$	117	$	40	$	—	$	20,222
Owner-occupied commercial real estate		34,844		—		398		—		35,242
Non-owner occupied commercial real estate		11,987		575		—		—		12,562

Total commercial business		66,896		692		438		—		68,026
One-to-four family residential		3,665		—		—		—		3,665
Real estate construction and land development:
One-to-four family residential		54		—		—		—		54
Five or more family residential and commercial properties		152		—		—		—		152

Total real estate construction and land development		206		—		—		—		206
Consumer		17,345		144		—		—		17,489

Gross other purchased covered loans	$	88,112	$	836	$	438	$	—	$	89,386

Originated nonaccrual loans, segregated by class of loans, were as follows as of March 31, 2011 and December 31, 2010:


	March 31, 2011(1)		December 31, 2010(1)
	(In thousands)
Commercial business:
Commercial and industrial	$	10,681	$	9,934
Owner-occupied commercial real estate		723		129
Non-owner occupied commercial real estate		778		778

Total commercial business		12,182		10,841
Real estate construction and land development:
One-to-four family residential		6,900		10,226
Five or more family residential and commercial properties		4,877		5,416

Total real estate construction and land development		11,777		15,642
Consumer		—		—

Gross originated loans	$	23,959	$	26,483

(1)	$3.7 million and $3.2 million of nonaccrual originated loans were guaranteed by governmental agencies at March 31, 2011 and December 31, 2010, respectively.

There were no nonaccrual loans recorded in the other purchased covered and non-covered loans as of March 31, 2011 and December 31, 2010, respectively.

The Company performs 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 originated past due loans, segregated by class of loans, as of March 31, 2011 and December 31, 2010 are as follows.


	March 31, 2011
	30-89 Days		Greater Than 90 Days		Total Past Due		Current		Total		> 90 Days and Still Accruing
	(in thousands)
Commercial business:
Commercial and industrial	$	2,996	$	5,684	$	8,680	$	246,375	$	255,055	$	15
Owner-occupied commercial real estate		1,824		851		2,675		155,531		158,206		128
Non-owner occupied commercial real estate		—		778		778		213,160		213,938		—

Total commercial business		4,820		7,313		12,133		615,066		627,199		143
One-to-four family residential		844		47		891		43,795		44,686		47
Real estate construction and land development:
One-to-four family residential		—		6,901		6,901		20,026		26,927		—
Five or more family residential and commercial properties		793		4,876		5,669		27,311		32,980		—

Total real estate construction and land development		793		11,777		12,570		47,337		59,907		—
Consumer		235		—		235		22,504		22,739		—

Gross originated loans	$	6,692	$	19,137	$	25,829	$	728,702	$	754,531	$	190


	December 31, 2010
	30-89 Days		Greater Than 90 Days		Total Past Due		Current		Total		> 90 days and still accruing
	(in thousands)
Commercial business:
Commercial and industrial	$	2,585	$	3,561	$	6,146	$	226,711	$	232,857	$	199
Owner-occupied commercial real estate		187		1,372		1,559		157,885		159,444		594
Non-owner occupied commercial real estate		3,396		1,201		4,597		217,142		221,739		—

Total commercial business		6,168		6,134		12,302		601,738		614,040		793
One-to-four family residential		624		49		673		46,832		47,505		47
Real estate construction and land development:
One-to-four family residential		—		2,844		2,844		26,533		29,377		—
Five or more family residential and commercial properties		941		5,416		6,357		22,231		28,588		381

Total real estate construction and land development		941		8,260		9,201		48,764		57,965		381
Consumer		42		—		42		23,790		23,832		—

Gross originated loans	$	7,775	$	14,443	$	22,218	$	721,124	$	743,342	$	1,221

The balances of other purchased past due loans, segregated by class of loans, as of March 31, 2011 and December 31, 2010 are as follows:


	March 31, 2011
	30-89 Days		Greater Than 90 Days		Total Past Due		Current		Total		> 90 Days and Still Accruing
	(in thousands)
Commercial business:
Commercial and industrial	$	95	$	—	$	95	$	29,156	$	29,251	$	—
Owner-occupied commercial real estate		155		—		155		34,294		34,449		—
Non-owner occupied commercial real estate		445		—		445		7,986		8,431		—

Total commercial business		695		—		695		71,436		72,131		—
One-to-four family residential		131		—		131		2,210		2,341		—
Real estate construction and land development:
One-to-four family residential		—		—		—		54		54		—
Five or more family residential and commercial properties		—		—		—		—		—		—

Total real estate construction and land development		—		—		—		54		54		—
Consumer		65		—		65		3,978		4,043		—

Gross other purchased covered loans	$	891	$	—	$	891	$	77,678	$	78,569	$	—


	December 31, 2010
	30-89 Days		Greater Than 90 Days		Total Past Due		Current		Total		> 90 days and still accruing
	(in thousands)
Commercial business:
Commercial and industrial	$	774	$	—	$	774	$	19,448	$	20,222	$	—
Owner-occupied commercial real estate		9,898		—		9,898		25,344		35,242		—
Non-owner occupied commercial real estate		—		—		—		12,562		12,562		—

Total commercial business		10,672		—		10,672		57,354		68,026		—
One-to-four family residential		—		—		—		3,665		3,665		—
Real estate construction and land development:
One-to-four family residential		—		—		—		54		54		—
Five or more family residential and commercial properties		—		—		—		152		152		—

Total real estate construction and land development		—		—		—		206		206		—
Consumer		184		—		184		17,305		17,489		—

Gross other purchased covered loans	$	10,856	$	—	$	10,856	$	78,530	$	89,386	$	—

Impaired originated loans at March 31, 2011 and December 31, 2010 are set forth in the following tables.


	March 31, 2010
	Recorded Investment With No Specific Valuation Allowance		Recorded Investment With Specific Valuation Allowance		Total Recorded Investment		Unpaid Contractual Principal Balance		Related Specific Valuation Allowance		Average Recorded Investment
	(in thousands)
Commercial business:
Commercial and industrial	$	5,876	$	4,805	$	10,681	$	10,719	$	1,719	$	10,306
Owner-occupied commercial real estate		129		593		722		734		123		426
Non-owner occupied commercial real estate		1,167		—		1,167		1,172		—		1,169

Total commercial business		7,172		5,398		12,570		12,625		1,842		11,901
One-to-four family residential		—		—		—		—		—		—
Real estate construction and land development:
One-to-four family residential		5,988		913		6,901		8,239		323		8,564
Five or more family residential and commercial properties		3,734		5,973		9,707		12,426		308		7,561

Total real estate construction and land development		9,722		6,886		16,608		20,665		631		16,125
Consumer		—		—		—		—		—		—

Gross originated loans	$	16,894	$	12,284	$	29,178	$	33,290	$	2,473	$	28,026


	December 31, 2010
	Recorded Investment With No Specific Valuation Allowance		Recorded Investment With Specific Valuation Allowance		Total Recorded Investment		Unpaid Contractual Principal Balance		Related Specific Valuation Allowance		Average Recorded Investment
	(in thousands)
Commercial business:
Commercial and industrial	$	2,462	$	5,691	$	8,153	$	9,261	$	2,569	$	8,909
Owner-occupied commercial real estate		129		650		779		822		163		771
Non-owner occupied commercial real estate		2,301		—		2,301		3,972		—		2,175

Total commercial business		4,892		6,341		11,233		14,055		2,732		11,855
One-to-four family residential		—		2		2		2		2		2
Real estate construction and land development:
One-to-four family residential		1,804		8,423		10,227		10,183		1,664		11,228
Five or more family residential and commercial properties		—		5,416		5,416		6,453		201		5,697

Total real estate construction and land development		1,804		13,839		15,643		16,636		1,865		16,925
Consumer		—		—		—		—		—		—

Gross originated loans	$	6,696	$	20,182	$	26,878	$	30,693	$	4,599	$	28,782

For the quarter ended March 31, 2011, no interest income was recognized subsequent to a loan’s classification as impaired. For the year ended December 31, 2010, $13,000 of interest income was recognized on impaired loans.

The Company had governmental guarantees of $3.7 million and $3.2 million related to the impaired originated loan balances at March 31, 2011 and December 31, 2010, respectively.

(f) Troubled Debt Restructured Loans

At March 31, 2011, the Company had $11.0 million in originated restructured loans, of which $5.4 million were accruing and $5.6 million were non-accruing and considered impaired. The majority of originated restructured loans were real estate construction commercial loans, in the amount of $5.0 million, followed by $4.7 million of real estate construction one-to-four family residential loans, $868,000 of commercial and industrial loans and $389,000 of non-owner occupied commercial properties. At December 31, 2010, the Company had $9.1 million in originated restructured loans, of which $394,000 were accruing and $8.7 million were non-accruing and considered impaired. The majority of originated restructured loans were real estate construction one-to-four family residential loans in the amount of $7.8 million, followed by commercial and industrial loans of $900,000 and non-owner occupied commercial properties of $400,000.

(g) Impaired Purchased Loans

As indicated above, the Company purchased impaired loans from the Cowlitz and Pierce Commercial Acquisitions which are accounted for under FASB ASC 310-30.

The following tables reflect the outstanding balance at March 31, 2011 and December 31, 2010 of the purchased impaired loans:


	Cowlitz Bank
	March 31, 2011		December 31, 2010
	(In thousands)
Covered purchased loans:
Commercial business:
Commercial and industrial	$	43,112	$	38,636
Owner-occupied commercial real estate		23,006		24,575
Non-owner occupied commercial real estate		19,548		20,771

Total commercial business		85,666		83,982
One-to-four family residential		9,201		9,612
Real estate construction and land development:
One-to-four family residential		10,569		10,858
Five or more family residential and commercial properties		—		—

Total real estate construction and land development		10,569		10,858
Consumer		485		495

Gross impaired purchased covered loans		105,921		104,947
Non-covered purchased loans:
Consumer		632		676

Total impaired purchased loans		106,553		105,623


	Pierce Commercial Bank
	March 31, 2011		December 31, 2010
	(In thousands)
Non-covered purchased loans:
Commercial business:
Commercial and industrial	$	47,771	$	55,556
Owner-occupied commercial real estate		7,652		7,722
Non-owner occupied commercial real estate		8,738		8,926

Total commercial business		64,161		72,214
One-to-four family residential		11,315		12,140
Real estate construction and land development:
One-to-four family residential		11,843		11,925
Five or more family residential and commercial properties		4,323		4,332

Total real estate construction and land development		16,166		16,257
Consumer		3,455		3,862

Gross impaired purchased non-covered loans		95,097		104,473

On acquisition date, the amount by which the undiscounted expected cash flows of the purchased impaired loans exceed the estimate 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 purchased impaired loan.

The following table summarizes the accretable yield on the Cowlitz Bank and Pierce Commercial Bank impaired purchased loans as of December 31, 2010 and the changes therein through March 31, 2011.


	Cowlitz Bank			Pierce Commercial Bank
	(In thousands)
Accretable yield at December 31, 2010	$	20,082		$	10,943
Accretion		(2,068	)		(1,125	)
Disposals and other		1,518			433
Increase in accretable yield		5,953			—

Accretable yield at March 31, 2011	$	25,485		$	10,251

NOTE 3. Allowance for Loan Losses

The allowance for loan losses is maintained at a level deemed appropriate by management to adequately provide for known and inherent risks in the loan portfolio. A summary of the changes in the originated loans’ allowance for loan losses for the three months ended March 31, 2011 and March 31, 2010 are as follows:


	Three months ended
	March 31, 2011			March 31, 2010
	(In thousands)
Balance at the beginning of period	$	22,062		$	26,164
Loans charged off		(3,994	)		(5,437	)
Recoveries of loans charged off		719			320
Provision charged to operations		2,595			3,750

Balance at the end of period	$	21,382		$	24,797

A summary of the changes in the purchased loans’ allowance for loan losses for the three months ended March 31, 2011 are as follows:


	Purchased Covered		Purchased Non-Covered
	(In thousands)
Balance at the beginning of period	$	—	$	—
Provision charged to operations		1,512		266

Balance at the end of period	$	1,512	$	266

The following table details the balance in the allowance for loan losses disaggregated on the basis of the Company’s impairment method for the year ended December 31, 2010:


	Commercial and industrial		Owner- occupied commercial real estate		Non-owner occupied commercial real estate		One-to-four family residential		Real estate construction and land development: one-to-four family residential		Real estate construction and land development: five or more family residential and commercial real estate		Consumer		Unallocated		Total
	(in thousands)
Allowance for loan losses allocated to:
Originated loans individually evaluated for impairment		2,569		163		—		2		1,664		201		—		—		4,599
Originated loans collectively evaluated for impairment		7,897		1,510		2,190		797		2,653		931		554		931		17,463


Balance of allowance for loan losses at December 31, 2010	$	10,466	$	1,673	$	2,190	$	799	$	4,317	$	1,132	$	554	$	931	$	22,062

The following table details activity in the allowance for loan losses disaggregated on the basis of the Company’s impairment method for the quarter ended March 31, 2011:


	Commercial and industrial			Owner- occupied commercial real estate		Non-owner occupied commercial real estate		One-to-four family residential			Real estate construction and land development: one-to-four family residential			Real estate construction and land development: five or more family residential and commercial real estate			Consumer			Unallocated			Total
	(in thousands)
Allowance for loan losses:
Beginning balance	$	10,466		$	1,673	$	2,190	$	799		$	4,317		$	1,132		$	554		$	931		$	22,062
Charge-offs		(1,230	)		—		—		(96	)		(1,905	)		(742	)		(21	)		—			(3,994	)
Recoveries		688			—		25		—			—			—			6			—			719
Provisions		675			738		581		(40	)		1,348			1,427			(67	)		(289	)		4,373

Ending balance		10,599			2,411		2,796		663			3,760			1,817			472			642			23,160
Period-end amount allocated to::
Originated loans individually evaluated for impairment		1,719			123		—		—			323			308			—			—			2,473
Originated loans collectively evaluated for impairment		7,881			1,644		2,741		648			3,398			1,509			446			642			18,909
Purchased other covered loans collectively evaluated for impairment		67			141		2		9			—			—			15			—			234
Purchased other non-covered loans collectively evaluated for impairment		121			75		53		6			—			—			11			—			266
Purchased impaired covered loans collectively evaluated for impairment		811			428		—		—			39			—			—			—			1,278
Purchased impaired non-covered loans collectively evaluated for impairment		—			—		—		—			—			—			—			—			—

Ending balance	$	10,599		$	2,411	$	2,796	$	663		$	3,760		$	1,817		$	472		$	642		$	23,160

The purchased loans acquired in the Cowlitz and Pierce Commercial Acquisitions are subject to the Company’s internal and external credit review. If and when credit deterioration occurs subsequent to the acquisition dates, a provision for loan losses will be charged to earnings for the full amount without regard to the FDIC loss-sharing agreement for the covered loan balances. The portion of the estimated loss reimbursable from the FDIC is recorded in noninterest income and increases the FDIC Indemnification Asset. During the quarter ended March 31, 2011, the Company recorded a $1.3 million provision for loan losses related to further credit deterioration of the purchased impaired covered loans. The related increase in the FDIC indemnification asset was $1.1 million. There were no purchased loans classified as impaired, meaning no purchased loan was individually evaluated for impairment in the table above.

The following table details the recorded investment balance of the loan receivables disaggregated on the basis of the Company’s impairment method for the month ended March 31, 2011:


	Commercial and industrial		Owner- occupied commercial real estate		Non-owner occupied commercial real estate		One-to-four family residential		Real estate construction and land development: one-to-four family residential		Real estate construction and land development: five or more family residential and commercial real estate		Consumer		Total
	(in thousands)
Originated loans individually evaluated for impairment	$	10,681	$	722	$	1,167	$	—	$	6901	$	9,707	$	—	$	29,178
Originated loans collectively evaluated for impairment		244,374		157,484		212,771		44,686		20,026		23,273		22,739		725,353
Other purchased covered loans collectively evaluated for impairment		10,889		22,980		332		1,487		54		—		2,427		38,169
Other purchased non-covered loans collectively evaluated for impairment		18,362		11,469		8,099		854		—		—		1,616		40,400
Impaired purchased covered loans collectively evaluated for impairment		34,507		20,847		16,695		8,117		5,680		—		949		86,795
Impaired purchased non-covered loans collectively evaluated for impairment	$	38,377	$	6,479	$	7,244	$	9,787	$	3,833	$	1,241	$	2,765	$	69,726

NOTE 4. FDIC Indemnification Asset

Changes in the FDIC indemnification asset during the three months ended March 31, 2011 are as follows:


	(in thousands)
December 31, 2010	$	16,071
Cash payments received from the FDIC		(2	)
FDIC share of additional estimated losses		1,221
Net amortization		(421	)

Balance at March 31, 2011	$	16,869

NOTE 5. 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 noted periods:


	Three Months Ended March 31,
	2011			2010
	(Dollars in thousands)
Net income:
Net income	$	764		$	696
Dividends accrued and discount accreted on preferred shares		—			(331	)

Net income applicable to common shareholders		764			365
Dividends and undistributed earnings allocated to participating securities		—			—

Earnings allocated to common shareholders	$	764		$	365
Basic:
Weighted average common shares outstanding		15,448,109			11,069,076
Less: Restricted stock awards		(151,952	)		(68,079	)

Total basic weighted average common shares outstanding		15,296,157			11,000,997

Diluted:
Basic weighted average common shares outstanding		15,296,157			11,000,997
Incremental shares from stock options, restricted stock awards and common stock warrant		75,945			42,449

Weighted average common shares outstanding		15,372,102			11,043,446

Potential dilutive shares are excluded from the computation of earnings per share if their effect is anti-dilutive. For the three months ended March 31, 2011 and March 31, 2010 anti-dilutive shares outstanding related to options and warrants to acquire common stock totaled 561,743 and 550,802, respectively, as the exercise price was in excess of the market value.

(b) Dividends

Common Stock. The timing and amount of cash dividends paid on our common stock depends on the Company’s earnings, capital requirements, financial condition and other relevant factors. Dividends on common stock from the Company depend substantially upon receipt of dividends from the Banks, which are the Company’s predominant sources of income. On May 3, 2011, the Company’s Board of Directors declared a dividend of $0.03 per share payable on May 27, 2011, to shareholders of record on May 13, 2011.

The FDIC and the DFI have the authority under their supervisory powers to prohibit the payment of dividends by Heritage Bank and Central Valley Bank to the Company. Additionally, current guidance from the 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 its subsidiary banks to pay dividends on their common stock if the Company’s or Banks’ regulatory capital would not be reduced below the statutory capital requirements set by the Federal Reserve and the FDIC.

NOTE 6. Share Based Payment

Total stock-based compensation expense (excluding ESOP expense) for the three months ended March 31, 2011 and 2010 were as follows:


	Three Months Ended March 31,
	2011		2010
	(In thousands)
Compensation expense recognized	$	240	$	109
Related tax benefit recognized		69		28

As of March 31, 2011, the total unrecognized compensation expense related to non-vested stock awards was $2.0 million and the related weighted average period over which it is expected to be recognized is approximately 2.8 years.

The fair value of options granted during the three months ended March 31, 2010 was estimated on the date of grant using the Black-Scholes option pricing model based on the assumptions noted in the following table (there were no options granted during the three months ended March 31, 2011.) The expected term of share options was derived from historical data and represents the period of time that share options granted are expected to be outstanding. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant. Expected volatility is based on historical volatility of Company shares. Expected dividend yield is based on dividends expected to be paid during the expected term of the share options.


Three months ended	Weighted Average Risk Free Interest Rate			Expected Term in years		Expected Volatility			Expected Dividend Yield			Weighted Average Fair Value
March 31, 2010		2.33	%		5.00		35	%		2.31	%	$	4.03

NOTE 7. Stock Option and Award Activity

The following table summarizes stock option activity for the three months ended March 31, 2011.


	Shares			Weighted- Average Exercise Price		Weighted- Average Remaining Contractual Term		Aggregate Intrinsic Value (In thousands)
Outstanding at December 31, 2010		550,524		$	18.70
Granted		—			—
Exercised		(50	)		11.35
Forfeited or expired		(104,972	)		20.26

Outstanding at March 31, 2011		445,502		$	18.34		4.1	$	279

Exercisable at March 31, 2011		314,071		$	20.18		2.5	$	186

The total intrinsic value of options exercised during the three months ended March 31, 2011 was $0.

The following table summarizes restricted stock award activity for the three months ended March 31, 2011.


	Shares		Weighted- Average Grant Date Fair Value
Outstanding at December 31, 2010		118,379	$	18.29
Granted		78,403		14.85
Vested		—		—
Forfeited		—		—

Outstanding at March 31, 2011		196,782	$	16.92

NOTE 8. Investment Securities

The amortized cost, gross unrealized gains and losses, and fair values of investment securities at the dates indicated were as follows:


Securities Available for Sale	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(In thousands)
March 31, 2011
U.S. Treasury and U.S. Government agencies	$	42,110	$	330	$	(54	)	$	42,386
Municipal securities		21,431		203		(146	)		21,488
Corporate securities		10,076		168		—			10,244
Mortgage backed securities and collateralized mortgage obligations:
U.S. Government agencies		59,094		1,008		(197	)		59,905

Total	$	132,711	$	1,709	$	(397	)	$	134,023


December 31, 2010
U.S. Treasury and U.S. Government agencies	$	41,124	$	367	$	(62	)	$	41,429
Municipal securities		20,237		169		(193	)		20,213
Corporate securities		10,097		182		(3	)		10,276
Mortgage backed securities and collateralized mortgage obligations:
U.S. Government agencies		52,394		1,034		(171	)		53,257

Total	$	123,852	$	1,752	$	(429	)	$	125,175


Securities Held to Maturity	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(In thousands)
March 31, 2011
U.S. Treasury and U.S. Government agencies	$	1,840	$	84	$	—		$	1,924
Municipal securities		3,677		101		(9	)		3,769
Mortgage backed securities and collateralized mortgage obligations:
U.S. Government agencies		6,192		203		—			6,395
Private residential collateralized mortgage obligations		1,785		282		(70	)		1,997

Total	$	13,494	$	670	$	(79	)	$	14,085


December 31, 2010
U.S. Treasury and U.S. Government agencies	$	1,858	$	93	$	—		$	1,951
Municipal securities		3,410		100		19			3,491
Mortgage backed securities and collateralized mortgage obligations:
U.S. Government agencies		6,592		208		—			6,800
Private residential collateralized mortgage obligations		1,908		250		(110	)		2,048

Total	$	13,768	$	651	$	(129	)	$	14,290

Available for sale and held to maturity investments with unrealized losses as of March 31, 2011, were as follows:


	Less than 12 Months				12 Months or Longer				Total
	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
	(In thousands)
U.S. Treasury and U.S. Government agencies	$	—	$	—	$	10,581	$	54	$	10,581	$	54
Municipal securities		793		22		8,808		133		9,602		155
Mortgage backed securities and collateralized mortgage obligations:
U.S. Government agencies		5,499		170		6,048		27		11,548		197
Private residential collateralized mortgage obligations		422		4		744		66		1,167		70

Total temporarily impaired securities	$	6,714	$	196	$	26,181	$	280	$	32,898	$	476

Available for sale and held to maturity investments with unrealized losses as of December 31, 2010, were as follows:


	Less than 12 Months				12 Months or Longer				Total
	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
	(In thousands)
U.S. Treasury and U.S. Government agencies	$	10,651	$	62	$	—	$	—	$	10,651	$	62
Municipal securities		13,575		212		—		—		13,575		212
Corporate securities		2,067		3		—		—		2,067		3
Mortgage backed securities and collateralized mortgage obligations:
U.S. Government agencies		10,968		171		—		—		10,968		171
Private residential collateralized mortgage obligations		681		7		736		103		1,417		110

Total temporarily impaired securities	$	37,942	$	455	$	736	$	103	$	38,678	$	558

The Company has evaluated these securities and has determined that the decline in their value is temporary. The unrealized losses are primarily due to unusually large pricing spreads in the market for mortgage-related securities. The fair value of the mortgage backed securities and the collateralized mortgage obligations is expected to recover as the securities approach their maturity date and/or as the pricing spreads narrow on mortgage-related securities. Because the Company does not intend to sell these securities nor does the Company consider it more likely than not that it will be required to sell these securities before the recovery of amortized cost basis, which may be maturity, the Company does not consider these investments to be other-than-temporarily impaired at March 31, 2011.

The amortized cost and fair value of securities at March 31, 2011, by contractual maturity, are set forth below. Actual maturities may differ from contractual maturities because certain borrowers have the right to call or prepay obligations with or without call or prepayment penalties.


Securities Available for Sale	Amortized Cost		Fair Value
	(In thousands)
Due in one year or less	$	18,749	$	18,853
Due after one year through three years		36,075		36,479
Due after three years through five years		2,942		2,945
Due after five through ten years		25,044		25,165
Due after ten years		49,901		50,581

Totals	$	132,711	$	134,023


Securities Held to Maturity	Amortized Cost		Fair Value
	(In thousands)
Due in one year or less	$	95	$	96
Due after one year through three years		626		655
Due after three years through five years		1,340		1,410
Due after five years through ten years		3,024		3,109
Due after ten years		8,409		8,815

Totals	$	13,494	$	14,085

For the private residential collateralized mortgage obligations we estimated expected future cash flows of the securities by estimating the expected future cash flows of the underlying collateral and applying those collateral cash flows, together with any credit enhancements such as subordination interests owned by third parties, to the security. The expected future cash flows of the underlying collateral are determined using the remaining contractual cash flows adjusted for future expected credit losses (which considers current delinquencies and nonperforming assets, future expected default rates and collateral value by vintage and geographic region) and prepayments. The expected cash flows of the security are then discounted at the interest rate used to recognize interest income on the security to arrive at a present value amount. For the three months ended March 31, 2011, three private residential collateralized mortgage obligations were determined to be other-than-temporarily impaired resulting in the Company recording $20,000 in impairments on private collateralized mortgage obligations not related to credit losses through other comprehensive income rather than through earnings and $26,000 in impairments related to credit losses through earnings. The average prepayment rate and discount interest rate used in the valuations of the present value were 6.0% and 7.9%, respectively.

The following table summarizes activity related to the amount of other-than-temporary impairments related to credit losses on held to maturity securities during the three months ended March 31, 2011:


	Gross Other- Than- Temporary Impairments		Other-Than- Temporary Impairments Included in Other Comprehensive Loss		Net Other- Than- Temporary Impairments Included in Earnings
	(In thousands)
December 31, 2010	$	2,317	$	1,080	$	1,237
Additions:
Initial impairments		7		—		7
Subsequent impairments		39		20		19

March 31, 2011	$	2,363	$	1,100	$	1,263

Details of private residential collateralized mortgage obligation securities received in 2008 from the redemption-in-kind of the AMF Ultra Short Mortgage Fund (“Fund”) as of March 31, 2011 were as follows:


																Current Ratings
Type and Year of Issuance	Par Value		Amortized Cost		Fair Value (2)		Aggregate Unrealized Gain (loss)		Year-to-date Change in Unrealized Gain (loss)			Year-to- date Impairment Charge		Life-to- date Impairment Charge (1)		AAA			AA			A			BBB			Below Investment Grade
	(Dollars in thousands)
Alt-A		996		260		299		39		(15	)		19		642		1	%		—			—			2	%		97	%
Prime		2,555		1,525		1,698		173		(113	)		7		621		6	%		4	%		3	%		11	%		76	%

Totals	$	3,551	$	1,785	$	1,997	$	212	$	(128	)	$	26	$	1,263		6	%		4	%		2	%		9	%		79	%

(1)	Life-to-date impairment charge represents impairment charges recognized in earnings subsequent to redemption of the Fund.

(2)	Level three valuation assumptions were used to determine the fair value of the held-to-maturity securities in the Fund.

NOTE 9. Federal Home Loan Bank Stock

The Banks are required to maintain an investment in the stock of the Federal Home Loan Bank (“FHLB”) of Seattle in an amount equal to the greater of $500,000 or 0.50% of residential mortgage loans and pass-through securities or an advance requirement to be confirmed on the date of the advance and 5.0% of the outstanding balance of mortgage loans sold to the FHLB of Seattle. At March 31, 2011 and December 31, 2010, the Company was required to maintain an investment in the stock of FHLB of Seattle of at least $1.5 million and $1.4 million, respectively. At March 31, 2011 and December 31, 2010, the Company had an investment in FHLB stock carried at a cost basis (par value) of $5.6 million.

The Company evaluated its investment in FHLB of Seattle stock for other-than-temporary impairment, consistent with its accounting policy. Based on the Company’s evaluation of the underlying investment, including the long-term nature of the investment, the liquidity position of the FHLB of Seattle, the actions being taken by the FHLB of Seattle to address its regulatory situation and the Company’s intent and ability to hold the investment for a period of time sufficient to recover the par value, the Company did not recognize an other-than-temporary impairment loss on its FHLB of Seattle stock. Even though the Company did not recognize an other-than-temporary impairment loss on its FHLB of Seattle stock during the three months ended March 31, 2011, and March 31, 2010, further deterioration in the FHLB of Seattle’s financial position may result in future impairment losses.

NOTE 10. Goodwill

Goodwill represents the excess of the purchase price over the net assets acquired in the purchases of North Pacific Bank and Western Washington Bancorp. The Company’s goodwill is assigned to Heritage Bank and is evaluated for impairment at the Heritage Bank level (reporting unit). Goodwill is not amortized, but is reviewed for impairment annually and between annual tests if an event occurs or circumstances change that might indicate the Company’s recorded value is more than its implied value. Such indicators may include, among others: a significant adverse change in legal factors or in the general business climate; significant decline in the Company’s stock price and market capitalization; unanticipated competition; and an adverse action or assessment by a regulator. Any adverse changes in these factors could have a significant impact on the recoverability of goodwill and could have a material impact on the Company’s financial statements.

When required, the goodwill impairment test involves a two-step process. The first test for goodwill impairment is done by comparing the reporting unit’s aggregate fair value to its carrying value. Absent other indicators of impairment, if the aggregate fair value exceeds the carrying value, goodwill is not considered impaired and no additional analysis is necessary. If the carrying value of the reporting unit were to exceed the aggregate fair value, a second test would be preformed to measure the amount of impairment loss, if any. To measure any impairment loss the implied fair value would be determined in the same manner as if the reporting unit were being acquired in a business combination. If the implied fair value of goodwill is less than the recorded goodwill an impairment charge would be recorded for the difference.

The Company’s annual impairment test was performed during the quarter ended December 31, 2010, and will be conducted during the quarter ending December 31, 2011. For the quarter ended March 31, 2011, the Company determined no triggering events had occurred and, therefore, did not conduct an interim impairment test of goodwill.

NOTE 11. Fair Value Measurements

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.

(a) Cash on Hand and in Banks, Interest Earning Deposits and Federal Funds Sold

The fair value of financial instruments that are short-term or reprice frequently and that have little or no risk are considered to have a fair value equal to carrying value.

(b) Investment Securities Available for Sale and Held to Maturity

The fair value of all investment securities are based upon the assumptions market participants would use in pricing the security. Such assumptions include observable and unobservable inputs such as quoted market prices, dealer quotes and discounted cash flows.

(c) Federal Home Loan Bank stock

FHLB of Seattle stock is not publicly traded, however the recorded value of the stock holdings approximates the fair value, as the FHLB is required to pay par value upon re-acquiring this stock.

(d) Loans Receivable and Loans Held for Sale

Fair value is estimated using the Company’s lending rates that would have been offered at March 31, 2011, and December 31, 2010, for loans, which mirror the attributes of the loans with similar rate structures and average maturities. Commercial loans and construction loans, which are variable rate and short-term are reflected with fair values equal to carrying value. Impaired loans are measured on a loan by loan basis by either the present value of expected future discounted cash flows, the loan’s obtainable market price, or the market value (less selling costs) of the collateral if the loan is collateral dependent.

While these methodologies are permitted under U.S. Generally Accepted Accounting Principles or GAAP for this disclosure, the amounts derived are not intended to reflect an exit price of the asset.

(e) Deposits

For deposits with no contractual maturity, the fair value is equal to the carrying value. The fair value of fixed maturity deposits is based on discounted cash flows using the difference between the deposit rate and the rates currently offered by the Company for deposits of similar remaining maturities.

(f) Securities Sold Under Agreement to Repurchase

Securities sold under agreement to repurchase are short-term in nature, repricing on a daily basis. Fair value financial instruments that are short-term or reprice frequently and that have little or no risk are considered to have a fair value equal to carrying value.

(g) Other Financial Instruments

The majority of our commitments to extend credit, standby letters of credit and commitments to sell mortgage loans carry current market interest rates if converted to loans, as such, carrying value is assumed to equal fair value.

The table below presents the carrying value amount of the Company’s financial instruments and their corresponding fair values. This method of estimating fair value does not incorporate the exit-price concept of fair value prescribed by ASC 820-10, Fair Value Measurements and Disclosures, and generally produces a higher fair value.


	March 31, 2011				December 31, 2010
	Carrying Value		Fair Value		Carrying Value		Fair Value
	(In thousands)
Financial Assets
Cash on hand and in banks	$	26,156	$	26,156	$	37,179	$	37,179
Interest earning deposits		114,764		114,764		129,822		129,822
Federal funds sold		—		—		1,990		1,990
Investment securities available for sale		134,023		134,023		125,175		125,175
Investment securities held to maturity		13,494		14,085		13,768		14,290
Federal Home Loan Bank stock		5,594		5,594		5,594		5,594
Loans receivable and loans held for sale, net of allowance		965,598		972,854		980,485		989,968

Financial Liabilities
Deposits:
Savings, money market and demand	$	740,937	$	740,937	$	733,335	$	733,335
Time certificates		358,783		360,195		402,941		404,676

Total deposits	$	1,099,720	$	1,101,132	$	1,136,276	$	1,138,011

Securities sold under agreement to repurchase	$	24,811	$	24,811	$	19,027	$	19,027

We measure certain financial assets and financial liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:

•

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 (“NAV”) 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 or quoted prices in markets that are not active. Level 2 includes U.S. Treasury, U.S. government and agency debt securities, and mortgage-backed securities. Valuations are usually obtained from third party pricing services for comparable assets or liabilities.

•

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, 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.

The following table summarizes the balances of assets and liabilities measured at fair value on a recurring basis at March 31, 2011.


	Total		Level 1		Level 2		Level 3
	(In thousands)
Investment Securities Available for Sale:
U.S. Treasury and U.S. Government agencies	$	42,386	$	—	$	42,386	$	—
Municipal securities		21,488		—		21,488		—
Corporate securities		10,244		—		10,244		—
Mortgage backed securities and collateralized mortgage obligations:
U.S Government agencies		59,905		—		59,905		—

Total	$	134,023	$	—	$	134,023	$	—

The Company may be required, from time to time, to measure certain assets 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. For assets measured at fair value on a nonrecurring basis during the three months ended March 31, 2011 and year ended December 31, 2010 that were still held in the balance sheet at the end of such periods, the following tables provide the level of valuation assumptions used to determine each adjustment and the carrying value of the related assets at the dates indicated.


	Fair Value at March 31, 2011								Three Months Ended March 31, 2011
	Total		Level 1		Level 2		Level 3		Total Losses
	(In thousands)
Loans receivable(1)	$	6,825	$	—	$	—	$	6,825	$	2,551
Investment securities held to maturity(2):

Large accelerated filer

Accelerated filer

Non-accelerated filer

Smaller reporting company