HFWA 10-Q Quarterly Report Sept. 30, 2021

HERITAGE FINANCIAL CORP /WA/

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hfwa-20210930

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2021 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 CORP ORATION

(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

98501

(Address of principal executive offices)

(Zip Code)

( 360 ) 943-1500

(Registrant’s telephone number, including area code)

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


Title of each class	Trading symbol	Name of each exchange on which registered
Common stock, no par value	HFWA	NASDAQ

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 ☒ No ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted 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 such files). Yes ☒ 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

☒

Accelerated filer

☐

Non-accelerated filer

☐

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 ☒

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

As of October 29, 2021, there were 35,166,599 shares of the registrant's common stock, no par value per share, outstanding.

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

FORM 10-Q

September 30, 2021

TABLE OF CONTENTS


				Page
GLOSSARY OF ACRONYMS, ABBREVIATIONS AND TERMS				3
CAUTIONARY NOTE REGARDING FORWARD LOOKING STATEMENTS				3

PART I.	FINANCIAL INFORMATION			5
ITEM 1.	FINANCIAL STATEMENTS			5
		CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (UNAUDITED) AS OF SEPTEMBER 30, 2021 AND DECEMBER 31, 2020		5
		CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2021 AND 2020		6
		CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED) FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2021 AND 2020		7
		CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (UNAUDITED) FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2021 AND 2020		8
		CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2021 AND 2020		10
		NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS		12
		NOTE 1.	DESCRIPTION OF BUSINESS, BASIS OF PRESENTATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS	12
		NOTE 2.	INVESTMENT SECURITIES	13
		NOTE 3.	LOANS RECEIVABLE	16
		NOTE 4.	ALLOWANCE FOR CREDIT LOSSES ON LOANS	25

		NOTE 5.	GOODWILL AND OTHER INTANGIBLE ASSETS	28



		NOTE 6.	DERIVATIVE FINANCIAL INSTRUMENTS	28
		NOTE 7.	STOCKHOLDERS’ EQUITY	29
		NOTE 8.	FAIR VALUE MEASUREMENTS	31
		NOTE 9.	CASH RESTRICTION	35
		NOTE 10.	COMMITMENTS AND CONTINGENCIES	35


ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS			36
	OVERVIEW			36
	EARNINGS SUMMARY			37
	NET INTEREST INCOME AND NET INTEREST MARGIN OVERVIEW			37
	PROVISION FOR CREDIT LOSSES OVERVIEW			40
	NONINTEREST INCOME OVERVIEW			41
	NONINTEREST EXPENSE OVERVIEW			42
	INCOME TAX EXPENSE OVERVIEW			43
	CONSOLIDATED FINANCIAL CONDITION OVERVIEW			44
	LENDING ACTIVITIES OVERVIEW			44
	NONPERFORMING ASSETS AND CREDIT QUALITY METRICS			46
	ANALYSIS OF ALLOWANCE FOR CREDIT LOSSES ON LOANS			47
	DEPOSITS AND OTHER BORROWINGS OVERVIEW			48
	LIQUIDITY AND CASH FLOWS			48
	STOCKHOLDERS' EQUITY AND REGULATORY CAPITAL REQUIREMENTS OVERVIEW			49
	RECONCILIATIONS OF NON-GAAP MEASURES			50
ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK			51
ITEM 4.	CONTROLS AND PROCEDURES			51
PART II.	OTHER INFORMATION			52
ITEM 1.	LEGAL PROCEEDINGS			52
ITEM 1A.	RISK FACTORS			52

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ITEM 2.

UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

ITEM 3.

DEFAULTS UPON SENIOR SECURITIES

ITEM 4.

MINE SAFETY DISCLOSURES

ITEM 5.

OTHER INFORMATION

ITEM 6.

EXHIBITS

SIGNATURES

GLOSSARY OF ACRONYMS, ABBREVIATIONS, AND TERMS

The acronyms, abbreviations, and terms listed below are used in various sections of this Form 10-Q. As used throughout this report, the terms “we”, “our”, or “us” refer to Heritage Financial Corporation and its consolidated subsidiaries, unless the context otherwise requires.


2020 Annual Form 10-K			Company's Annual Report on Form 10-K for the year ended December 31, 2020
ACL			Allowance for credit losses

ASC			Accounting Standards Codification
ASU			Accounting Standards Update
Bank			Heritage Bank

CA Act			Consolidated Appropriations Act of 2021
CARES Act			Coronavirus Aid, Relief, and Economic Security Act of 2020
CECL			Current Expected Credit Loss
CECL Adoption			Company's adoption on January 1, 2020 of FASB ASU 2016-13 Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments , as amended, which replaces the incurred loss methodology with an expected loss methodology that is referred to as the CECL methodology
CMO			Collateralized Mortgage Obligation
Company			Heritage Financial Corporation
COVID Modifications			Loans with modifications made in compliance with the CARES Act, as amended, and related regulatory guidance
COVID-19 Pandemic			Coronavirus Disease of 2019 pandemic
CRE			Commercial real estate
FASB			Financial Accounting Standards Board
FDIC			Federal Deposit Insurance Corporation
Federal Reserve			Board of Governors of the Federal Reserve System
Federal Reserve Bank			Federal Reserve Bank of San Francisco
FHLB			Federal Home Loan Bank of Des Moines
GAAP			U.S. Generally Accepted Accounting Principles
LIBOR			London Interbank Offering Rate
MBS			Mortgage-backed security


PPP			Paycheck Protection Program


SBA			Small Business Administration
SEC			Securities and Exchange Commission

SM			Special Mention
SS			Substandard
TDR			Troubled debt restructured

CAUTIONARY NOTE REGARDING FORWARD LOOKING STATEMENTS

This 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.” 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

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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.

The COVID-19 pandemic is adversely affecting us, our customers, counterparties, employees, and third-party service providers, and the ultimate extent of the impacts on our business, financial position, results of operations, liquidity, and prospects is uncertain. Deterioration in general business and economic conditions, including increases in unemployment rates, or turbulence in domestic or global financial markets could adversely affect our revenues and the values of our assets and liabilities, reduce the availability of funding, lead to a tightening of credit, and increase stock price volatility. In addition, changes to statutes, regulations, or regulatory policies or practices as a result of, or in response to the COVID-19 pandemic, could affect us in substantial and unpredictable ways. Other factors that could cause or contribute to such differences include, but are 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 ACL on loans and provision for credit losses on loans that may be affected by deterioration in the housing and CRE markets, which may lead to increased losses and nonperforming assets in our loan portfolio, and may result in our ACL on loans no longer being adequate to cover actual losses, and require us to increase our ACL on loans;

• 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-term 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 ACL on loans, 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;

• implementing regulations, changes in regulatory policies and principles, or the interpretation of regulatory capital or other rules;

• 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;

• our ability to successfully integrate any assets, liabilities, customers, systems, and management personnel we may acquire into our operations and our ability to realize related revenue synergies and cost savings within expected time frames or at all, and any goodwill charges related thereto and costs or difficulties relating to integration matters, including but not limited to customer and employee retention, which might be greater than expected;

• 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 FASB, including additional guidance and interpretation on accounting issues and details of the implementation of new accounting methods and as a result of the CARES Act and the CA Act; and

• other economic, competitive, governmental, regulatory, and technological factors affecting our operations, pricing, products and services, including as a result of the CARES Act, CA Act and recent COVID-19 pandemic vaccination efforts, and the other risks detailed from time to time in our filings with the SEC including our 2020 Annual Form 10-K.

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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)


	September 30, 2021		December 31, 2020
ASSETS
Cash on hand and in banks	$	86,954	$	91,918
Interest earning deposits	1,547,785		651,404
Cash and cash equivalents	1,634,739		743,322
Investment securities available for sale, at fair value, net (amortized cost of $ 744,336 and $ 770,195 , respectively)	761,526		802,163
Investment securities held to maturity, at amortized cost, net (fair value of $ 307,330 and $ 0 , respectively)	311,074		—
Total investment securities	1,072,600		802,163
Loans held for sale	2,636		4,932
Loans receivable	3,953,884		4,468,647
Allowance for credit losses on loans	( 48,317 )		( 70,185 )
Loans receivable, net	3,905,567		4,398,462
Other real estate owned	—		—
Premises and equipment, net	79,958		85,452
Federal Home Loan Bank stock, at cost	7,933		6,661
Bank owned life insurance	109,634		107,580
Accrued interest receivable	14,802		19,418
Prepaid expenses and other assets	179,494		193,301
Other intangible assets, net	10,736		13,088
Goodwill	240,939		240,939
Total assets	$	7,259,038	$	6,615,318
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits	$	6,215,558	$	5,597,990

Junior subordinated debentures	21,107		20,887
Securities sold under agreement to repurchase	44,096		35,683
Accrued expenses and other liabilities	129,873		140,319
Total liabilities	6,410,634		5,794,879
Stockholders’ equity:
Preferred stock, no par value, 2,500,000 shares authorized; no shares issued and outstanding, respectively	—		—
Common stock, no par value, 50,000,000 shares authorized; 35,166,599 and 35,912,243 shares issued and outstanding, respectively	552,385		571,021
Retained earnings	281,285		224,400
Accumulated other comprehensive income, net	14,734		25,018
Total stockholders’ equity	848,404		820,439
Total liabilities and stockholders’ equity	$	7,259,038	$	6,615,318

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 and shares outstanding)


	Three Months Ended September 30,				Nine Months Ended September 30,
	2021		2020		2021		2020
INTEREST INCOME:
Interest and fees on loans	$	46,863	$	47,647	$	147,137	$	142,328
Taxable interest on investment securities	4,711		3,865		12,295		14,068
Nontaxable interest on investment securities	931		953		2,836		2,686
Interest on interest earning deposits	537		98		975		561
Total interest income	53,042		52,563		163,243		159,643
INTEREST EXPENSE:
Deposits	1,444		2,639		4,696		10,272
Junior subordinated debentures	184		196		557		699
Other borrowings	36		50		109		130
Total interest expense	1,664		2,885		5,362		11,101
Net interest income	51,378		49,678		157,881		148,542
(Reversal of) provision for credit losses	( 3,149 )		2,730		( 24,335 )		39,239
Net interest income after (reversal of) provision for credit losses	54,527		46,948		182,216		109,303
NONINTEREST INCOME:
Service charges and other fees	4,566		4,039		12,988		12,015
Gain on sale of investment securities, net	—		40		29		1,463
Gain on sale of loans, net	765		1,443		3,138		3,125
Interest rate swap fees	126		396		487		1,461
Bank owned life insurance income	647		909		2,020		2,439
Other income	2,124		1,383		6,114		5,441
Total noninterest income	8,228		8,210		24,776		25,944
NONINTEREST EXPENSE:
Compensation and employee benefits	22,176		21,416		66,725		65,849
Occupancy and equipment	4,373		4,348		12,918		13,247
Data processing	4,029		3,691		11,839		10,735
Marketing	775		755		2,336		2,317
Professional services	816		1,086		3,249		4,632
State/municipal business and use taxes	1,071		964		3,034		2,626
Federal deposit insurance premium	550		848		1,478		1,086
Other real estate owned, net	—		—		—		( 145 )
Amortization of intangible assets	758		860		2,352		2,666
Other expense	2,618		2,077		6,873		7,365
Total noninterest expense	37,166		36,045		110,804		110,378
Income before income taxes	25,589		19,113		96,188		24,869
Income tax expense	4,997		2,477		17,550		2,181
Net income	$	20,592	$	16,636	$	78,638	$	22,688
Basic earnings per share	$	0.58	$	0.46	$	2.19	$	0.63
Diluted earnings per share	$	0.58	$	0.46	$	2.18	$	0.63
Dividends declared per share	$	0.20	$	0.20	$	0.60	$	0.60
Average number of basic shares outstanding	35,644,192		35,908,845		35,854,258		36,049,369
Average number of diluted shares outstanding	35,929,518		35,988,734		36,152,052		36,193,615

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 September 30,				Nine Months Ended September 30,
	2021		2020		2021		2020
Net income	$	20,592	$	16,636	$	78,638	$	22,688
Change in fair value of investment securities available for sale, net of tax of $( 362 ), $( 206 ), $( 2,844 ) and $ 4,437 , respectively	( 1,305 )		( 741 )		( 10,239 )		15,975
Reclassification adjustment for net gain from sale of investment securities available for sale included in income, net of tax of $ 0 , $( 8 ), $( 6 ) and $( 318 ), respectively	—		( 32 )		( 23 )		( 1,145 )
Amortization of net unrealized gain for the reclassification of investment securities available for sale to held to maturity, net of tax of $( 6 ), $ 0 , $( 6 ) and $ 0 , respectively	( 22 )		—		( 22 )		—

Other comprehensive (loss) income	( 1,327 )		( 773 )		( 10,284 )		14,830
Comprehensive income	$	19,265	$	15,863	$	68,354	$	37,518

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)


	Three Months Ended September 30, 2021
	Number of common shares	Common stock		Retained earnings		Accumulated other comprehensive income (loss), net		Total stockholders’ equity
Balance at June 30, 2021	36,006	$	572,060	$	267,863	$	16,061	$	855,984

Restricted stock units vested	2	—		—		—		—

Stock-based compensation expense	—	966		—		—		966
Common stock repurchased	( 841 )	( 20,641 )		—		—		( 20,641 )
Net income	—	—		20,592				20,592
Other comprehensive loss, net of tax	—	—		—		( 1,327 )		( 1,327 )

Cash dividends declared on common stock ($ 0.20 per share)	—	—		( 7,170 )		—		( 7,170 )
Balance at September 30, 2021	35,167	$	552,385	$	281,285	$	14,734	$	848,404


	Nine Months Ended September 30, 2021
	Number of common shares	Common stock		Retained earnings		Accumulated other comprehensive income (loss), net		Total stockholders’ equity
Balance at December 31, 2020	35,912	$	571,021	$	224,400	$	25,018	$	820,439

Restricted stock units vested	122	—		—		—		—

Stock-based compensation expense	—	2,762		—		—		2,762
Common stock repurchased	( 867 )	( 21,398 )		—		—		( 21,398 )
Net income	—	—		78,638		—		78,638
Other comprehensive loss, net of tax	—	—		—		( 10,284 )		( 10,284 )

Cash dividends declared on common stock ($ 0.60 per share)	—	—		( 21,753 )		—		( 21,753 )
Balance at September 30, 2021	35,167	$	552,385	$	281,285	$	14,734	$	848,404


	Three Months Ended September 30, 2020
	Number of common shares	Common stock		Retained earnings		Accumulated other comprehensive income (loss), net		Total stockholders’ equity
Balance at June 30, 2020	35,909	$	569,329	$	198,342	$	25,981	$	793,652

Restricted stock units vested	2	—		—		—		—

Stock-based compensation expense	—	848		—		—		848
Common stock repurchased	( 1 )	( 7 )		—		—		( 7 )
Net income	—	—		16,636				16,636
Other comprehensive loss, net of tax	—	—		—		( 773 )		( 773 )

Cash dividends declared on common stock ($ 0.20 per share)	—	—		( 7,227 )		—		( 7,227 )
Balance at September 30, 2020	35,910	$	570,170	$	207,751	$	25,208	$	803,129

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	Nine Months Ended September 30, 2020
	Number of common shares	Common stock		Retained earnings		Accumulated other comprehensive income, net		Total stockholders’ equity
Balance at December 31, 2019	36,619	$	586,459	$	212,474	$	10,378	$	809,311
Cumulative effect from change in accounting policy (1)	—	—		( 5,615 )		—		( 5,615 )
Restricted stock units vested	108	—		—		—		—
Exercise of stock options	8	122		—		—		122
Stock-based compensation expense	—	2,694		—		—		2,694
Common stock repurchased	( 825 )	( 19,105 )		—		—		( 19,105 )
Net income	—	—		22,688		—		22,688
Other comprehensive income, net of tax	—	—		—		14,830		14,830

Cash dividends declared on common stock ($ 0.60 per share)	—	—		( 21,796 )		—		( 21,796 )
Balance at September 30, 2020	35,910	$	570,170	$	207,751	$	25,208	$	803,129

(1) Effective January 1, 2020, Company adopted ASU 2016-13, Financial Instruments - Credit Losses .

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)


	Nine Months Ended September 30,
	2021		2020
Cash flows from operating activities:
Net income	$	78,638	$	22,688
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation, amortization and accretion	( 18,356 )		( 5,926 )
(Reversal of) provision for credit losses	( 24,335 )		39,239
Net change in accrued interest receivable, prepaid expenses and other assets, and accrued expenses and other liabilities	11,043		( 12,298 )
Stock-based compensation expense	2,762		2,694
Amortization of intangible assets	2,352		2,666
Origination of mortgage loans held for sale	( 74,325 )		( 93,422 )
Proceeds from sale of mortgage loans held for sale	79,759		93,830
Bank owned life insurance income	( 2,020 )		( 2,439 )

Valuation adjustment on interest rate swaps	( 296 )		—
Gain on sale of other real estate owned, net	—		( 179 )
Gain on sale of mortgage loans held for sale, net	( 3,138 )		( 3,125 )
Gain on sale of investment securities available for sale, net	( 29 )		( 1,463 )
Gain on sale of assets held for sale	( 1,691 )		( 9 )
Impairment of assets held for sale	38		—
Impairment of right of use asset	160		102
Loss (gain) on sale or write-off of premises and equipment, net	91		( 25 )
Net cash provided by operating activities	50,653		42,333
Cash flows from investing activities:
Loan repayments (originations), net	555,784		( 890,667 )
Maturities and repayments of investment securities available for sale	200,242		207,955
Maturities and repayments of investment securities held to maturity	423		—
Purchase of investment securities available for sale	( 421,566 )		( 117,456 )
Purchase of investment securities held to maturity	( 66,821 )		—
Proceeds from sales of investment securities available for sale	1,248		44,970
Purchase of premises and equipment	( 2,148 )		( 6,136 )

Proceeds from sales of other real estate owned	—		1,290
Proceeds from sales of assets held for sale	5,642		394
Proceeds from redemption of Federal Home Loan Bank stock	—		2,560
Purchases of Federal Home Loan Bank stock	( 1,272 )		( 2,844 )
Proceeds from sales of premises and equipment	12		53
Purchases of bank owned life insurance	( 104 )		( 3,580 )
Proceeds from bank owned life insurance death benefit	—		1,324
Cash received from return of New Market Tax Credit equity method investment	9,642		—
Capital contributions to low-income housing tax credit partnerships	( 23,349 )		( 7,109 )

Net cash provided (used) by investing activities	257,733		( 769,246 )
Cash flows from financing activities:
Net increase in deposits	617,568		1,106,372
Federal Home Loan Bank advances	10		19,000
Repayment of Federal Home Loan Bank advances	( 10 )		( 19,000 )
Common stock cash dividends paid	( 21,552 )		( 21,676 )
Net increase in securities sold under agreement to repurchase	8,413		8,874

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	Nine Months Ended September 30,
	2021		2020
Proceeds from exercise of stock options	—		122
Repurchase of common stock	( 21,398 )		( 19,105 )
Net cash provided by financing activities	583,031		1,074,587
Net increase in cash and cash equivalents	891,417		347,674
Cash and cash equivalents at beginning of period	743,322		228,568
Cash and cash equivalents at end of period	$	1,634,739	$	576,242

Supplemental disclosures of cash flow information:
Cash paid for interest	$	5,162	$	10,972
Cash paid for income taxes, net of refunds	10,944		8,279

Supplemental non-cash disclosures of cash flow information:
Transfers of loans receivable to other real estate owned	$	—	$	270
Transfer of investment securities available for sale to held to maturity	244,778		—
Loans received from return of New Market Tax Credit equity method investment	15,596		—
Transfers of properties classified as held for sale to prepaid expenses and other assets from premises and equipment, net	3,556		—
Investment in low-income housing tax credit partnership and related funding commitment	17,458		10,237

Cumulative effect from change in accounting policy (1)	—		7,175

Right of use assets obtained in exchange for new operating lease liabilities	12,134		273

(1) Effective January 1, 2020, the Company adopted ASU 2016-13, Financial Instruments - Credit Losses .

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

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 is headquartered in Olympia, Washington and conducts business from its 53 branch offices as of September 30, 2021 located throughout Washington State and the greater Portland, Oregon area. The Bank’s business consists primarily of commercial lending and deposit relationships with small and medium-sized 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. The Bank's deposits are insured by the FDIC.

The Company consolidated four branches during October 2021 to create a more efficient branch footprint. This consolidation reduced the number of branches from 53 to 49 . The Company integrated these locations into other branches within its network.

(b) Basis of Presentation

The accompanying unaudited Condensed Consolidated Financial Statements have been prepared in accordance with GAAP for interim financial information and pursuant to the rules and regulations of the SEC. Accordingly, they do not include all of the information and footnotes required by 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 2020 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 nine months ended September 30, 2021 are not necessarily indicative of the results that may be expected for the year ending December 31, 2021.

To prepare unaudited Condensed Consolidated Financial Statements in conformity with GAAP, management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided. Management believes that the judgments, estimates, and assumptions used in the preparation of the Condensed Consolidated Financial Statements are appropriate based on the facts and circumstances at the time. Actual results, however, could differ significantly from those estimates. Material estimates that are particularly susceptible to significant change relate to management's estimate of ACL on loans, management's estimate of ACL on unfunded commitments, management's evaluation of goodwill impairment and management's estimate of the fair value of financial instruments.

The accompanying Condensed Consolidated Financial Statements include the accounts of the Company and its wholly-owned subsidiary, the Bank. All significant intercompany balances and transactions among the Company and the Bank have been eliminated in consolidation.

Certain prior year amounts in the Condensed Consolidated Statements of Income and the Condensed Consolidated Statements of Cash Flows have been reclassified to conform to the current year’s presentation. Reclassifications had no effect on the prior year's net income or stockholders’ equity.

The significant accounting policies used in preparation of the Condensed Consolidated Financial Statements are disclosed in greater detail in the 2020 Annual Form 10-K. There have not been any material changes in the Company's significant accounting policies from those contained in the 2020 Annual Form 10-K during the nine months ended September 30, 2021 except for accounting policies related to investment securities and the ACL on investment securities held to maturity as follows:

Investment Securities

Investment securities for which the Bank has the positive intent and ability to hold to maturity are classified as held to maturity and are carried at amortized cost. Investment securities held primarily for the purpose of selling in the near term are classified as trading securities and are reported at fair value, with unrealized gains and losses included in income. Investment securities not classified as held to maturity or trading are classified as available for sale and are reported at fair value with unrealized gains and losses, net of income taxes, as a separate component of other comprehensive income. The Bank determines the appropriate classification of investment securities at the time of purchase and reassesses the classification at each reporting date. When the Company acquires another entity, all investment securities are recorded at fair value and classified as available for sale at the acquisition date.

Realized gains and losses on sales of investment securities are recorded on the trade date in gain on sale of investment securities, net on the Consolidated Statements of Income and determined using the specific identification method. Premiums and discounts on investment securities available for sale and held to maturity are amortized or accreted into income using the interest method. The objective of the interest method is to calculate periodic interest income at a constant effective

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yield. An investment security available for sale or held to maturity is placed on nonaccrual status at the time any principal or payments become more than 90 days delinquent and classified as past due after 30 days of nonpayment. Interest accrued, but not received for an investment security classified as nonaccrual is reversed against interest income during the period that the investment security is placed on nonaccrual status.

ACL on Investment Securities Held to Maturity

The Company measures expected credit losses on investment securities held to maturity on a pooled, collective basis by major investment security type with similar risk characteristics. A historical lifetime probability of default and severity of loss in the event of default is derived or obtained from external sources and adjusted for the expected effects of reasonable and supportable forecasts over the expected lives of the investment securities on those historical credit losses. Expected credit losses on investment securities in the held to maturity portfolio that do not share similar risk characteristics with any of the pools are individually measured based on net realizable value, or the difference between the discounted value of the expected future cash flows, based on the original effective interest rate, and the recorded amortized cost basis of the investment securities.

Accrued interest receivable on investment securities held to maturity is excluded from the estimate of expected credit losses. Changes in the ACL on investment securities held to maturity are recorded as provision for credit losses expense. Losses are charged against the ACL when management believes the uncollectability of an investment security held to maturity is confirmed.

(d) Recently Issued or Adopted Accounting Pronouncements

FASB ASU 2016-13 , Financial Instruments: Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments , as amended by ASU 2018-19, ASU 2019-04, ASU 2019-05, ASU 2019-10, ASU 2019-11, and ASU 2020-02, was originally issued in June 2016. This ASU replaced the incurred loss methodology with an expected loss methodology, which is commonly referred to as the "CECL" methodology. The measurement of expected credit losses under the CECL methodology is applicable to financial assets measured at amortized cost, including loans receivable. It also applies to off-balance sheet credit exposures such as loan commitments, standby letters of credit, financial guarantees, and other similar instruments. In addition, CECL Adoption made changes to the accounting for credit losses on investment securities available for sale. This ASU requires financial assets measured at amortized cost basis to be presented at the net amount expected to be collected. For public business entities, this ASU 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 and can be delayed under a provision of the CARES Act until the end of the official health emergency declaration. The Bank adopted ASU 2016-13 on January 1, 2020 using the modified retrospective method for all financial assets measured at amortized cost and unfunded commitments. At adoption, the Bank elected not to measure an ACL on accrued interest receivable on loans receivable or accrued interest receivable on investment securities available for sale as Bank policy is to reverse interest income for uncollectible accrued interest receivable balances in a timely manner.

The adoption of ASU 2016-13 included an increase to the ACL on loans of $ 3.4 million and an increase to the ACL on unfunded commitments of $ 3.7 million, resulting in a pretax cumulative-effect adjustment of $ 7.1 million. The impact of this adjustment to beginning retained earnings on January 1, 2020 was $ 5.6 million, net of tax.

FASB ASU 2020-04 , Reference Rate Reform (Topic 848) , as amended by ASU 2021-01, was issued in March 2020 and provides optional guidance for a limited period of time to ease the potential burden in accounting for (or recognizing the effects of) reference rate reform on financial reporting. The amendments in this ASU are effective for all entities as of March 12, 2020 through December 31, 2022. The amendments are elective, apply to all entities, and provide optional expedients and exceptions for applying GAAP to contracts, hedging relationships, and other transactions affected by reference rate reform if certain criteria are met. The Bank’s interest rate swap-related transactions are the majority of the Company's LIBOR exposure. Effective January 25, 2021, the Company adhered to the Interbank Offered Rate Fallbacks Protocol as published by the International Swaps and Derivatives Association, Inc. and recommended by the Alternative Reference Rates Committee. The Company does not expect this ASU to have a material impact on its business operations and the Condensed Consolidated Financial Statements.

(2) Investment Securities

The Company’s investment policy is designed primarily to provide and maintain liquidity, generate a favorable return on assets without incurring undue interest rate and credit risk, and complement the Bank’s lending activities.

During the three months ended September 30, 2021, the Company reassessed and transferred, at fair value, $ 244.8 million of U.S. government and agency securities from the available for sale classification to the held to maturity classification. The net unrealized after tax gain of $ 1.3 million remained in accumulated other comprehensive income to be amortized over the remaining life of the securities, offsetting the related amortization of discount or premium on the transferred securities. No gains or losses were recognized at the time of the transfer.

There were no investment securities classified as trading at September 30, 2021 or December 31, 2020. There were no investment securities classified as held to maturity at December 31, 2020.

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(a) Investment Securities by Classification, Type and Maturity

The following tables present the amortized cost and fair value of investment securities at the dates indicated and the corresponding amounts of gross unrealized gains and losses, including the corresponding amounts of gross unrealized gains and losses on investment securities available for sale recognized in accumulated other comprehensive income:


	September 30, 2021
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
	(In thousands)
Investment securities available for sale:
U.S. government and agency securities	$	26,000	$	146	$	( 40 )	$	26,106
Municipal securities	219,737		9,385		( 956 )		228,166

Residential CMO and MBS	240,018		3,065		( 390 )		242,693
Commercial CMO and MBS	229,518		5,861		( 361 )		235,018
Corporate obligations	2,009		14		—		2,023
Other asset-backed securities	27,054		475		( 9 )		27,520
Total	$	744,336	$	18,946	$	( 1,756 )	$	761,526

Investment securities held to maturity:
U.S. government and agency securities	$	82,577	$	46	$	( 563 )	$	82,060

Residential CMO and MBS	10,000		—		—		10,000
Commercial CMO and MBS	218,497		—		( 3,227 )		215,270


Total	$	311,074	$	46	$	( 3,790 )	$	307,330


	December 31, 2020
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
	(In thousands)
Investment securities available for sale:
U.S. government and agency securities	$	44,713	$	947	$	—	$	45,660
Municipal securities	197,634		12,561		( 227 )		209,968

Residential CMO and MBS	196,956		5,125		( 209 )		201,872
Commercial CMO and MBS	290,638		13,198		( 90 )		303,746
Corporate obligations	10,971		125		—		11,096
Other asset-backed securities	29,283		565		( 27 )		29,821
Total	$	770,195	$	32,521	$	( 553 )	$	802,163

The amortized cost and fair value of investment securities at September 30, 2021, 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				Securities Held to Maturity
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
	(In thousands)
Due in one year or less	$	36,745	$	37,158	$	—	$	—
Due after one year through five years	122,029		126,853		—		—
Due after five years through ten years	174,729		179,546		205,748		203,119
Due after ten years	410,833		417,969		105,326		104,211
Total	$	744,336	$	761,526	$	311,074	$	307,330

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There were no holdings of investment securities of any one issuer, other than the U.S. government and its agencies, in an amount greater than 10% of stockholders’ equity at September 30, 2021 and December 31, 2020.

(b) Unrealized Losses on Investment Securities Available for Sale

The following tables show the gross unrealized losses and fair value of the Company’s investment securities available for sale for which an allowance for credit losses has not been recorded, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position as of September 30, 2021 and December 31, 2020:


	September 30, 2021
	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. government and agency securities	$	1,695	$	( 40 )	$	—	$	—	$	1,695	$	( 40 )
Municipal securities	42,397		( 675 )		6,427		( 281 )		48,824		( 956 )
Residential CMO and MBS	74,409		( 267 )		21,480		( 123 )		95,889		( 390 )
Commercial CMO and MBS	30,070		( 354 )		2,583		( 7 )		32,653		( 361 )

Other asset-backed securities	—		—		1,209		( 9 )		1,209		( 9 )
Total	$	148,571	$	( 1,336 )	$	31,699	$	( 420 )	$	180,270	$	( 1,756 )


	December 31, 2020
	Less than 12 Months				12 Months or Longer				Total
	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
	(In thousands)


Municipal securities	$	10,264	$	( 227 )	$	—	$	—	$	10,264	$	( 227 )

Residential CMO and MBS	—		—		25,293		( 209 )		25,293		( 209 )
Commercial CMO and MBS	11,404		( 29 )		7,499		( 61 )		18,903		( 90 )


Other asset-backed securities	—		—		4,570		( 27 )		4,570		( 27 )
Total	$	21,668	$	( 256 )	$	37,362	$	( 297 )	$	59,030	$	( 553 )

The Company evaluated investment securities available for sale as of September 30, 2021 and December 31, 2020 and determined that any declines in fair value were attributable to changes in interest rates relative to where these investments fall within the yield curve and individual characteristics. Management monitors published credit ratings for adverse changes for all rated investment securities and none of these securities had a below investment grade credit rating as of both September 30, 2021 and December 31, 2020. In addition, 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 the amortized cost basis, which may be upon maturity. Therefore, no ACL on investment securities available for sale was recorded as of September 30, 2021 and December 31, 2020.

The Company also evaluated investment securities held to maturity for current expected credit losses. There were no investment securities held to maturity classified as nonaccrual or past due as of September 30, 2021 and all were issued by the U.S. government and its agencies and either explicitly or implicitly guaranteed by the U.S. government, highly rated by major credit rating agencies and have a long history of no credit losses. Accordingly, the Company did not measure expected credit losses on investment securities held to maturity since the historical credit loss information adjusted for current conditions and reasonable and supportable forecasts results in an expectation that nonpayment of the amortized cost basis is zero. Therefore, no ACL on investment securities held to maturity was recorded as of September 30, 2021.

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(d) Realized Gains and Losses

The following table presents the gross realized gains and losses on the sale of investment securities available for sale for the three and nine months ended September 30, 2021 and 2020:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2021		2020		2021		2020
	(In thousands)
Gross realized gains	$	—	$	40	$	29	$	1,482
Gross realized losses	—		—		—		( 19 )
Net realized gains	$	—	$	40	$	29	$	1,463

(e) Pledged Securities

The following table summarizes the amortized cost and fair value of investment securities that are pledged as collateral for the following obligations at September 30, 2021 and December 31, 2020:


	September 30, 2021				December 31, 2020
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
	(In thousands)
Washington and Oregon state public deposits	$	127,486	$	130,675	$	119,652	$	124,228

Securities sold under agreement to repurchase	68,297		68,424		38,630		39,945
Other securities pledged	57,728		57,307		29,665		30,717
Total	$	253,511	$	256,406	$	187,947	$	194,890

(f) Accrued Interest Receivable

Accrued interest receivable excluded from amortized cost on investment securities available for sale totaled $ 3.0 million and $ 3.6 million at September 30, 2021 and December 31, 2020, respectively. Accrued interest receivable excluded from amortized cost on investment securities held to maturity totaled $ 0.6 million at September 30, 2021.

No amounts of accrued interest receivable on investment securities available for sale or held to maturity were reversed against interest income on investment securities during the three and nine months ended September 30, 2021 and September 30, 2020.

(3) Loans Receivable

(a) Loan Origination/Risk Management

The Bank originates loans in the ordinary course of business and has also acquired loans through mergers and acquisitions. Accrued interest receivable was excluded from disclosures presenting the Bank's amortized cost of loans receivable as it was deemed insignificant.

The Bank categorizes the individual loans in the total loan portfolio into four segments: commercial business; residential real estate; 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. A detailed description of the portfolio segments and classes is contained in the 2020 Annual Form 10-K.

The amortized cost of loans receivable, net of ACL on loans at September 30, 2021 and December 31, 2020 consisted of the following portfolio segments and classes:


	September 30, 2021		December 31, 2020
	(In thousands)
Commercial business:
Commercial and industrial	$	652,776	$	733,098
SBA PPP	266,896		715,121
Owner-occupied CRE	907,568		856,684

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	September 30, 2021		December 31, 2020
	(In thousands)
Non-owner occupied CRE	1,459,795		1,410,303
Total commercial business	3,287,035		3,715,206
Residential real estate	125,697		122,756
Real estate construction and land development:
Residential	90,081		78,259
Commercial and multifamily	205,516		227,454
Total real estate construction and land development	295,597		305,713
Consumer	245,555		324,972
Loans receivable	3,953,884		4,468,647
Allowance for credit losses on loans	( 48,317 )		( 70,185 )
Loans receivable, net	$	3,905,567	$	4,398,462

Balances included in the amortized cost of Loans receivable:
Unamortized net discount on acquired loans	$	( 4,325 )	$	( 6,575 )
Unamortized net deferred fee	$	( 11,497 )	$	( 15,458 )

(b) Concentrations of Credit

Most of the Bank’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 and Washington County in Oregon, as well as other contiguous markets and represents a geographic concentration. Additionally, our loan portfolio is concentrated in commercial-type loans, including commercial business loans and commercial and multifamily real estate construction and land development loans.

As part of the on-going monitoring of the credit quality of the Bank’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, (v) past due status, and (vi) the general economic conditions of the United States of America, and specifically the states of Washington and Oregon.

The Bank 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. Risk grades are aggregated to create the risk categories of Pass for grades 1 to 6, Special Mention or "SM" for grade 7, Substandard or "SS" for grade 8, Doubtful for grade 9 and Loss for grade 10. Descriptions of the general characteristics of the risk grades, including qualitative information on how the risk grades relate to the risk of loss, are contained in the 2020 Annual Form 10-K. Numerical loan grades for loans are established at the origination of the loan. Changes to loan grades are considered at the time new information about the performance of a loan becomes available, including the receipt of updated financial information from the borrower, results of annual term loan reviews and scheduled loan reviews. For consumer loans, 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.

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 SM loan grade is transitory in that the Bank is waiting on additional information to determine the likelihood and extent of the potential loss. The likelihood of loss for SM graded loans, however, is greater than Watch graded loans because there has been measurable credit deterioration. Loans with a SS grade are generally loans with higher risk of loss if the deficiencies are not corrected. For Doubtful and Loss graded loans, the Bank is almost certain of the losses and the outstanding principal balances are generally charged off to the realizable value.

Regulatory agencies provided guidance regarding credit risk ratings, delinquency reporting and nonaccrual status for loans adversely impacted by the COVID-19 pandemic. The Bank has and will continue to exercise judgment in determining the risk rating for impacted borrowers and will not automatically adversely classify credits that are affected by the COVID-19 pandemic. The Bank also will not designate loans with payment deferrals granted due to the COVID-19 pandemic as past due because of the deferral. Due to the short-term nature of the forbearance and other relief programs the Bank is offering as a result

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of the COVID-19 pandemic, management expects that borrowers granted relief under these programs will generally not be reported as nonaccrual during the deferral period.

The following table presents the amortized cost of loans receivable by risk grade as of September 30, 2021 and December 31, 2020:


	September 30, 2021
	Term Loans Amortized Cost Basis by Origination Year												Revolving Loans		Revolving Loans Converted to Term Loans (1)		Loans Receivable
	2021		2020		2019		2018		2017		Prior
	(In thousands)
Commercial business:
Commercial and industrial
Pass	$	74,653	$	107,406	$	103,431	$	55,513	$	34,254	$	102,143	$	120,622	$	877	$	598,899
SM	532		700		6,192		6,682		1,252		5,716		2,693		242		24,009
SS	1,057		1,369		5,533		1,219		3,034		6,276		10,772		608		29,868

Total	76,242		109,475		115,156		63,414		38,540		114,135		134,087		1,727		652,776
SBA PPP
Pass	247,213		19,683		—		—		—		—		—		—		266,896




Owner-occupied CRE
Pass	114,176		86,004		183,540		92,201		70,672		277,948		—		73		824,614
SM	—		5,102		3,086		12,366		4,504		24,793		—		—		49,851
SS	—		691		—		3,803		6,995		21,614		—		—		33,103

Total	114,176		91,797		186,626		108,370		82,171		324,355		—		73		907,568
Non-owner occupied CRE
Pass	132,922		182,994		218,203		155,131		164,632		530,818		—		—		1,384,700
SM	—		5,034		5,715		352		2,215		2,713		—		—		16,029
SS	—		—		—		3,460		—		55,606		—		—		59,066

Total	132,922		188,028		223,918		158,943		166,847		589,137		—		—		1,459,795
Total commercial business
Pass	568,964		396,087		505,174		302,845		269,558		910,909		120,622		950		3,075,109
SM	532		10,836		14,993		19,400		7,971		33,222		2,693		242		89,889
SS	1,057		2,060		5,533		8,482		10,029		83,496		10,772		608		122,037

Total	570,553		408,983		525,700		330,727		287,558		1,027,627		134,087		1,800		3,287,035
Residential real estate
Pass	43,126		24,715		25,443		6,619		7,275		17,821		—		—		124,999

SS	—		—		—		—		—		698		—		—		698

Total	43,126		24,715		25,443		6,619		7,275		18,519		—		—		125,697
Real estate construction and land development:
Residential
Pass	35,506		30,987		19,044		2,781		394		1,369		—		—		90,081




Commercial and multifamily
Pass	38,144		50,546		106,428		5,587		1,606		1,542		—		—		203,853
SM	—		—		450		—		—		215		—		—		665
SS	—		571		—		—		—		427		—		—		998

Total	38,144		51,117		106,878		5,587		1,606		2,184		—		—		205,516
Total real estate construction and land development
Pass	73,650		81,533		125,472		8,368		2,000		2,911		—		—		293,934
SM	—		—		450		—		—		215		—		—		665
SS	—		571		—		—		—		427		—		—		998

Total	73,650		82,104		125,922		8,368		2,000		3,553		—		—		295,597

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	September 30, 2021
	Term Loans Amortized Cost Basis by Origination Year												Revolving Loans		Revolving Loans Converted to Term Loans (1)		Loans Receivable
	2021		2020		2019		2018		2017		Prior
Consumer
Pass	20,185		18,083		52,803		34,571		18,109		15,863		82,780		200		242,594

SS	—		186		685		549		564		939		38		—		2,961

Total	20,185		18,269		53,488		35,120		18,673		16,802		82,818		200		245,555
Loans receivable
Pass	705,925		520,418		708,892		352,403		296,942		947,504		203,402		1,150		3,736,636
SM	532		10,836		15,443		19,400		7,971		33,437		2,693		242		90,554
SS	1,057		2,817		6,218		9,031		10,593		85,560		10,810		608		126,694

Total	$	707,514	$	534,071	$	730,553	$	380,834	$	315,506	$	1,066,501	$	216,905	$	2,000	$	3,953,884

(1) Represents loans receivable balance at September 30, 2021 which was converted from a revolving loan to an amortizing loan during the nine months ended September 30, 2021.


	December 31, 2020
	Term Loans Amortized Cost Basis by Origination Year												Revolving Loans		Revolving Loans Converted to Term Loans (1)		Loans Receivable
	2020		2019		2018		2017		2016		Prior
	(In thousands)
Commercial business:
Commercial and industrial
Pass	$	118,971	$	127,919	$	70,766	$	44,231	$	37,658	$	95,958	$	121,440	$	819	$	617,762
SM	14,430		9,162		10,878		4,171		5,700		3,579		11,790		814		60,524
SS	2,199		11,835		3,416		9,348		1,052		7,651		15,484		3,827		54,812

Total	135,600		148,916		85,060		57,750		44,410		107,188		148,714		5,460		733,098
SBA PPP
Pass	715,121		—		—		—		—		—		—		—		715,121




Owner-occupied CRE
Pass	89,224		167,095		94,830		80,138		74,902		254,864		—		—		761,053
SM	6,146		4,540		16,386		11,231		5,464		12,105		—		—		55,872
SS	—		—		114		7,320		3,313		29,012		—		—		39,759

Total	95,370		171,635		111,330		98,689		83,679		295,981		—		—		856,684
Non-owner-occupied CRE
Pass	197,548		173,153		148,830		172,438		240,614		406,817		—		—		1,339,400
SM	—		1,979		357		2,448		6,210		3,539		—		—		14,533
SS	—		—		3,623		—		35,455		17,292		—		—		56,370

Total	197,548		175,132		152,810		174,886		282,279		427,648		—		—		1,410,303
Total commercial business
Pass	1,120,864		468,167		314,426		296,807		353,174		757,639		121,440		819		3,433,336
SM	20,576		15,681		27,621		17,850		17,374		19,223		11,790		814		130,929
SS	2,199		11,835		7,153		16,668		39,820		53,955		15,484		3,827		150,941

Total	1,143,639		495,683		349,200		331,325		410,368		830,817		148,714		5,460		3,715,206
Residential real estate
Pass	30,141		41,829		15,730		10,362		7,322		16,825		—		—		122,209

SS	—		—		—		59		—		488		—		—		547

Total	30,141		41,829		15,730		10,421		7,322		17,313		—		—		122,756

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Real estate construction and land development:
Residential
Pass	33,801		36,697		2,725		1,097		971		1,042		—		—		76,333

SS	—		—		—		1,926		—		—		—		—		1,926

Total	33,801		36,697		2,725		3,023		971		1,042		—		—		78,259
Commercial and multifamily
Pass	27,423		151,020		38,682		5,660		689		1,407		—		—		224,881
SM	67		1,011		—		—		—		29		—		—		1,107
SS	572		450		—		—		—		444		—		—		1,466

Total	28,062		152,481		38,682		5,660		689		1,880		—		—		227,454
Total real estate construction and land development
Pass	61,224		187,717		41,407		6,757		1,660		2,449		—		—		301,214
SM	67		1,011		—		—		—		29		—		—		1,107
SS	572		450		—		1,926		—		444		—		—		3,392

Total	61,863		189,178		41,407		8,683		1,660		2,922		—		—		305,713
Consumer
Pass	43,742		77,083		53,195		30,559		13,443		15,453		87,547		315		321,337

SS	34		404		684		648		420		1,319		78		48		3,635

Total	43,776		77,487		53,879		31,207		13,863		16,772		87,625		363		324,972
Loans receivable
Pass	1,255,971		774,796		424,758		344,485		375,599		792,366		208,987		1,134		4,178,096
SM	20,643		16,692		27,621		17,850		17,374		19,252		11,790		814		132,036
SS	2,805		12,689		7,837		19,301		40,240		56,206		15,562		3,875		158,515

Total	$	1,279,419	$	804,177	$	460,216	$	381,636	$	433,213	$	867,824	$	236,339	$	5,823	$	4,468,647

(1) Represents loans receivable balance at December 31, 2020 which was converted from a revolving loan to an amortizing loan during the year ended December 31, 2020.

(d) Nonaccrual Loans

The following table presents the amortized cost of nonaccrual loans for the dates indicated:


	September 30, 2021
	Nonaccrual without ACL		Nonaccrual with ACL		Total Nonaccrual
	(In thousands)
Commercial business:
Commercial and industrial	$	6,952	$	4,013	$	10,965
Owner-occupied CRE	3,714		5,786		9,500
Non-owner occupied CRE	1,318		3,460		4,778
Total commercial business	11,984		13,259		25,243
Residential real estate	—		51		51
Real estate construction and land development:

Commercial and multifamily	—		571		571

Consumer	—		29		29
Total	$	11,984	$	13,910	$	25,894

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	December 31, 2020
	Nonaccrual without ACL		Nonaccrual with ACL		Total Nonaccrual
	(In thousands)
Commercial business:
Commercial and industrial	$	22,039	$	9,208	$	31,247
Owner-occupied CRE	4,693		13,700		18,393
Non-owner occupied CRE	3,424		3,722		7,146
Total commercial business	30,156		26,630		56,786
Residential real estate	67		117		184
Real estate construction and land development:

Commercial and multifamily	572		450		1,022

Consumer	31		69		100
Total	$	30,826	$	27,266	$	58,092

The following table presents the reversal of interest income on loans due to the write-off of accrued interest receivable upon the initial classification of loans as nonaccrual loans and the interest income recognized due to payment in full of previously classified nonaccrual loans during the following periods:


	Three Months Ended September 30, 2021				Three Months Ended September 30, 2020
	Interest Income Reversed		Interest Income Recognized		Interest Income Reversed		Interest Income Recognized
	(In thousands)
Commercial business:
Commercial and industrial	$	( 1 )	$	184	$	( 59 )	$	111
Owner-occupied CRE	—		—		( 219 )		29
Non-owner occupied CRE	—		—		( 102 )		—
Total commercial business	( 1 )		184		( 380 )		140
Residential real estate	—		—		( 1 )		2
Real estate construction and land development:

Commercial and multifamily	—		—		( 11 )		—

Consumer	—		32		—		—
Total	$	( 1 )	$	216	$	( 392 )	$	142


	Nine Months Ended September 30, 2021				Nine months ended September 30, 2020
	Interest Income Reversed		Interest Income Recognized		Interest Income Reversed		Interest Income Recognized
	(in thousands)
Commercial business:
Commercial and industrial	$	( 11 )	$	2,228	$	( 75 )	$	419
Owner-occupied CRE	—		117		( 219 )		89
Non-owner occupied CRE	—		313		( 102 )		67
Total commercial business	( 11 )		2,658		( 396 )		575
One-to-four family residential					( 1 )		2
Real estate construction and land development:
Residential	—		73		—		—
Commercial and multifamily	—		—		( 11 )		—

Consumer	—		32		—		47
Total	$	( 11 )	$	2,763	$	( 408 )	$	624

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For the three and nine months ended September 30, 2021 and 2020, no interest income was recognized subsequent to a loan’s classification as nonaccrual, except as indicated in the tables above due to payment in full.

(e) Past due loans

The Bank performs an aging analysis of past due loans using policies consistent with regulatory reporting requirements with categories of 30-89 days past due and 90 or more days past due. The amortized cost of past due loans as of September 30, 2021 and December 31, 2020 were as follows:


	September 30, 2021
	30-89 Days		90 Days or Greater		Total Past Due		Current		Loans Receivable
	(In thousands)
Commercial business:
Commercial and industrial	$	440	$	6,219	$	6,659	$	646,117	$	652,776
SBA PPP	—		—		—		266,896		266,896
Owner-occupied CRE	283		—		283		907,285		907,568
Non-owner occupied CRE	6,165		—		6,165		1,453,630		1,459,795
Total commercial business	6,888		6,219		13,107		3,273,928		3,287,035
Residential real estate	25		—		25		125,672		125,697
Real estate construction and land development:
Residential	—		—		—		90,081		90,081
Commercial and multifamily	—		571		571		204,945		205,516
Total real estate construction and land development	—		571		571		295,026		295,597
Consumer	643		—		643		244,912		245,555
Total	$	7,556	$	6,790	$	14,346	$	3,939,538	$	3,953,884


	December 31, 2020
	30-89 Days		90 Days or Greater		Total Past Due		Current		Loans Receivable
	(In thousands)
Commercial business:
Commercial and industrial	$	4,621	$	8,082	$	12,703	$	720,395	$	733,098
SBA PPP	—		—		—		715,121		715,121
Owner-occupied CRE	991		403		1,394		855,290		856,684
Non-owner occupied CRE	412		1,970		2,382		1,407,921		1,410,303
Total commercial business	6,024		10,455		16,479		3,698,727		3,715,206
Residential real estate	765		16		781		121,975		122,756
Real estate construction and land development:
Residential	—		—		—		78,259		78,259
Commercial and multifamily	2,225		—		2,225		225,229		227,454
Total real estate construction and land development	2,225		—		2,225		303,488		305,713
Consumer	1,407		30		1,437		323,535		324,972
Total	$	10,421	$	10,501	$	20,922	$	4,447,725	$	4,468,647

There were no loans 90 days or more past due that were still accruing interest as of September 30, 2021 and December 31, 2020.

(f) Collateral-dependent Loans

The type of collateral securing loans individually evaluated for credit losses and for which the repayment was expected to be provided substantially through the operation or sale of the collateral as of September 30, 2021 and December 31, 2020

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were as follows, with b alances representing the amortized cost of the loan classified by the primary collateral category of each loan if multiple collateral sources secure the loan :


	September 30, 2021
	CRE		Farmland		Residential Real Estate		Other		Total
	(In thousands)
Commercial business:
Commercial and industrial	$	1,504	$	4,384	$	727	$	595	$	7,210
Owner-occupied CRE	4,261		—		—		—		4,261
Non-owner occupied CRE	1,318		—		—		—		1,318
Total commercial business	7,083		4,384		727		595		12,789

Real estate construction and land development:

Commercial and multifamily	571		—		—		—		571


Total	$	7,654	$	4,384	$	727	$	595	$	13,360


	December 31, 2020
	CRE		Farmland		Residential Real Estate		Other		Total
	(In thousands)
Commercial business:
Commercial and industrial	$	1,893	$	18,738	$	584	$	1,405	$	22,620
Owner-occupied CRE	4,693		—		—		—		4,693
Non-owner occupied CRE	3,424		—		—		—		3,424
Total commercial business	10,010		18,738		584		1,405		30,737
Residential real estate	—		—		67		—		67
Real estate construction and land development:

Commercial and multifamily	572		—		—		—		572

Consumer	—		—		30		—		30
Total	$	10,582	$	18,738	$	681	$	1,405	$	31,406

There have been no significant changes to the collateral securing loans individually evaluated for credit losses and for which repayment was expected to be provided substantially through the operation or sale of the collateral during the nine months ended September 30, 2021, except changes due to additions or removals of loans in this classification.

(g) Troubled Debt Restructured Loans

A TDR is a restructuring in which the Bank, for economic or legal reasons related to a borrower’s financial difficulties, grants a concession to a borrower that it would not otherwise consider. The TDR modifications or concessions are made to increase the likelihood that these borrowers with financial difficulties will be able to satisfy their debt obligations as amended.

The concessions granted in the restructurings largely consisted of maturity extensions. 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 the scheduled 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 CARES Act, CA Act and regulatory agencies provided guidance around the modification of loans as a result of the COVID-19 pandemic, and outlined, among other criteria, that short-term modifications made on a good faith basis to borrowers who were current as defined by the guidance are not TDRs. This includes short-term (e.g. six months) modifications such as payment deferrals, fee waivers, extensions of repayment terms, or other delays in payment that are insignificant. Borrowers were considered current if they were less than 30 days past due on the contractual payments as of December 31, 2019 under the CARES Act and at the time a modification program is implemented under related regulatory guidance. The CA Act extended relief offered under the CARES Act through January 1, 2022 or 60 days after the end of the national emergency declared by the President, whichever is earlier. The Bank elected to apply the temporary relief under the applicable guidance to certain eligible short-term modifications and did not classify the modifications as TDRs for accounting or disclosure purposes. However, COVID Modifications whose payment deferral exceeded 180 days following the loans' initial modification were classified as TDRs based on the Bank's internal policy.

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Loans that were modified as TDR loans are set forth in the following tables for the periods indicated:


	Three Months Ended September 30,
	2021			2020
	Number of Contracts	Amortized Cost (1) (2)		Number of Contracts	Amortized Cost (1) (2)
	(Dollars in thousands)
Commercial business:
Commercial and industrial	5	$	1,861	12	$	7,217
Owner-occupied CRE	2	7,124		5	2,312
Non-owner occupied CRE	—	—		2	438
Total commercial business	7	8,985		19	9,967
Residential real estate	—	—		1	22
Real estate construction and land development:
Residential	—	—		4	1,812
Commercial and multifamily	1	450		—	—
Total real estate construction and land development	1	450		4	1,812
Consumer	5	94		9	127
Total	13	$	9,529	33	$	11,928


	Nine Months Ended September 30,
	2021			2020
	Number of Contracts	Amortized Cost (1) (2)		Number of Contracts	Amortized Cost (1) (2)
	(Dollars in thousands)
Commercial business:
Commercial and industrial	32	$	10,380	37	$	17,694
Owner-occupied CRE	6	16,710		7	3,227
Non-owner occupied CRE	3	5,673		4	2,417
Total commercial business	41	32,763		48	23,338
Residential real estate	1	180		1	22
Real estate construction and land development:
Residential	—	—		4	1,812
Commercial and multifamily	1	450		—	—
Total real estate construction and land development	1	450		4	1,812
Consumer	22	487		20	251
Total	65	$	33,880	73	$	25,423

(1) Number of contracts and amortized cost represent loans which have balances as of period end, net of subsequent payments after modifications. Certain TDR loans may have been paid-down or charged-off during the three or nine months ended September 30, 2021 and September 30, 2020.

(2) As the Bank did not forgive any principal or interest balance as part of the loan modifications, the Bank’s amortized cost in each loan at the date of modification (pre-modification) did not change as a result of the modification (post-modification).

The Bank had an ACL on loa ns of $ 3.4 million an d $ 1.6 million at September 30, 2021 and September 30, 2020, respectively, related to these TDR loans which were restructured during the nine months ended September 30, 2021 and September 30, 2020, respectively.

The unfunded commitment to borrowers related to TDR loans was $ 4.3 million and $ 2.6 million at September 30, 2021 and December 31, 2020, respectively.

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The following tables present loans that were modified in a troubled debt restructure and subsequently defaulted within twelve months from the modification date during the periods indicated:


	Three Months Ended September 30,
	2021			2020
	Number of Contracts (1)	Amortized Cost (1)		Number of Contracts (1)	Amortized Cost (1)
	(Dollars in thousands)
Commercial business:
Commercial and industrial	1	$	336	1	$	229








Total	1	$	336	1	$	229


	Nine Months Ended September 30,
	2021			2020
	Number of Contracts (1)	Amortized Cost (1)		Number of Contracts (1)	Amortized Cost (1)
	(Dollars in thousands)
Commercial business:
Commercial and industrial	3	$	976	4	$	2,152
Owner-occupied CRE	—	—		1	431
Non-owner occupied CRE	—	—		2	376






Total	3	$	976	7	$	2,959

(1) Number of contracts and amortized cost represent TDR loans which have balances as of period end, net of subsequent payments after modifications. Certain TDR loans may have been paid-down or charged-off during the nine months ended September 30, 2021 and September 30, 2020.

During the three and nine months ended September 30, 2021 and 2020 all of the TDR loans in the tables above defaulted because each was past its modified maturity date and the borrower had not subsequently repaid the credits. The Bank chose not to extend further the maturity date on these TDR loans. The Bank had an ACL on lo ans of $ 13,000 and $ 512,000 at September 30, 2021 and September 30, 2020, respectively, related to these TDR loans which defaulted during the nine months ended September 30, 2021 and 2020.

(h) Accrued interest receivable on loans receivable

Accrued interest receivable on loans receivable totaled $ 11.2 million and $ 15.8 million at September 30, 2021 and December 31, 2020, respectively. It is excluded from the calculation of the ACL on loans as interest accrued, but not received, is reversed timely.

(i) Foreclosure proceedings in process

At September 30, 2021, there were no consumer mortgage loans secured by residential real estate properties for which formal foreclosure proceedings were in process.

(4) Allowance for Credit Losses on Loans

Effective January 1, 2020, the Bank adopted ASU 2016-13. Risk characteristics by segment considered in the CECL model are the same as those disclosed in the 2020 Annual Form 10-K.

The baseline loss rates used to calculate the ACL on loans at September 30, 2021 utilized the Bank's average quarterly historical loss information from December 31, 2012 through the balance sheet date. There were no changes to this assumption during the nine months ended September 30, 2021. The Bank believes the historic loss rates are viable inputs to the current CECL model as the Bank's lending practice and business has remained relatively stable throughout the periods. While the Bank's assets have grown, the credit culture has stayed relatively consistent.

Prepayments included in the CECL model at September 30, 2021 were based on the 48-month rolling historical averages for each segment, which management believes is an accurate representation of future prepayment activity. There were no changes to this assumption during the nine months ended September 30, 2021.

The reasonable and supportable period used in the CECL model as of September 30, 2021 was five quarters. There were no changes to this assumption during the nine months ended September 30, 2021. Management believes that forecasts beyond this five quarter time period tend to diverge in economic assumptions and may be less comparable to actual future

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events. As the length of the reasonable and supportable period increases, the degree of judgment involved in estimating the allowance will likely increase.

The Bank used a two-quarter reversion period in calculating the ACL on loans as of September 30, 2021 as it believes the historical loss information is relevant to the expected credit losses and recognizes the declining precision and increasing uncertainty of estimating credit losses in those periods beyond which it can make reasonable and supportable forecasts. There were no changes to this assumption during the nine months ended September 30, 2021.

During the nine months ended September 30, 2021 , the ACL on loans decrease d $ 21.9 million , or 31.2 % , due primarily to a reversal of provision for credit losses on loans of $ 21.8 million. The reversal of provision for credit losses was primarily driven by improvements in the economic forecast at September 30, 2021 as compared to the forecast at December 31, 2020.

A summary of the changes in the ACL on loans during the nine months ended September 30, 2021 and 2020 is as follows:


	Nine Months Ended September 30,
	2021		2020
	(In thousands)
Balance at the beginning of the year	$	70,185	$	36,171
Impact of CECL Adoption	—		1,822
Balance at the beginning of the year, as adjusted	70,185		37,993
Charge-offs	( 1,267 )		( 4,694 )
Recoveries of loans previously charged-off	1,207		1,816
(Reversal of) provision for credit losses on loans	( 21,808 )		38,225
Balance at the end of the year	$	48,317	$	73,340

The following tables detail the activity in the ACL on loans disaggregated by segment and class for the three and nine months ended September 30, 2021 and 2020:


	Three Months Ended September 30, 2021
	Beginning Balance		Charge-offs		Recoveries		(Reversal of) Provision for Credit Losses		Ending Balance
	(In thousands)
Commercial business:
Commercial and industrial	$	17,485	$	( 743 )	$	373	$	1,531	$	18,646
SBA PPP	—		—		—		—		—
Owner-occupied CRE	8,562		—		12		( 1,644 )		6,930
Non-owner occupied CRE	10,630		—		—		( 1,133 )		9,497
Total commercial business	36,677		( 743 )		385		( 1,246 )		35,073
Residential real estate	1,153		—		—		( 67 )		1,086
Real estate construction and land development:
Residential	1,636		—		8		136		1,780
Commercial and multifamily	8,835		—		—		( 1,530 )		7,305
Total real estate construction and land development	10,471		—		8		( 1,394 )		9,085
Consumer	3,261		( 204 )		161		( 145 )		3,073
Total	$	51,562	$	( 947 )	$	554	$	( 2,852 )	$	48,317


	Nine Months Ended September 30, 2021
	Beginning Balance		Charge-offs		Recoveries		Reversal of Provision for Credit Losses		Ending Balance
	(In thousands)
Commercial business:
Commercial and industrial	$	30,010	$	( 757 )	$	710	$	( 11,317 )	$	18,646
SBA PPP	—		—		—		—		—

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	Nine Months Ended September 30, 2021
	Beginning Balance		Charge-offs		Recoveries		Reversal of Provision for Credit Losses		Ending Balance
	(In thousands)
Owner-occupied CRE	9,486		—		25		( 2,581 )		6,930
Non-owner occupied CRE	10,112		—		—		( 615 )		9,497
Total commercial business	49,608		( 757 )		735		( 14,513 )		35,073
Residential real estate	1,591		—		—		( 505 )		1,086
Real estate construction and land development:
Residential	1,951		—		28		( 199 )		1,780
Commercial and multifamily	11,141		( 1 )		—		( 3,835 )		7,305
Total real estate construction and land development	13,092		( 1 )		28		( 4,034 )		9,085
Consumer	5,894		( 509 )		444		( 2,756 )		3,073
Total	$	70,185	$	( 1,267 )	$	1,207	$	( 21,808 )	$	48,317


	Three Months Ended September 30, 2020
	Beginning Balance		Charge-offs		Recoveries		Provision for (Reversal of Provision for) Credit Losses		Ending Balance
	(In thousands)
Commercial business:
Commercial and industrial	$	29,773	$	( 507 )	$	78	$	1,815	$	31,159
SBA PPP	—		—		—		—		—
Owner-occupied CRE	10,003		—		2		3,027		13,032
Non-owner occupied CRE	10,666		—		—		( 124 )		10,542
Total commercial business	50,442		( 507 )		80		4,718		54,733
Residential real estate	2,223		—		—		( 398 )		1,825
Real estate construction and land development:
Residential	567		—		139		( 42 )		664
Commercial and multifamily	8,557		—		—		70		8,627
Total real estate construction and land development	9,124		—		139		28		9,291
Consumer	9,712		( 335 )		142		( 2,028 )		7,491

Total	$	71,501	$	( 842 )	$	361	$	2,320	$	73,340


	Nine Months Ended September 30, 2020
	Beginning Balance		Impact of CECL Adoption		Beginning Balance, as Adjusted		Charge-offs		Recoveries		Provision for (Reversal of Provision for) Credit Losses		Ending Balance
	(In thousands)
Commercial business:
Commercial and industrial	$	11,739	$	( 1,348 )	$	10,391	$	( 3,418 )	$	1,204	$	22,982	$	31,159
SBA PPP	—		—		—		—		—		—		—
Owner-occupied CRE	4,512		452		4,964		( 135 )		16		8,187		13,032
Non-owner occupied CRE	7,682		( 2,039 )		5,643		—		—		4,899		10,542
Total commercial business	23,933		( 2,935 )		20,998		( 3,553 )		1,220		36,068		54,733
Residential real estate	1,458		1,471		2,929		—		3		( 1,107 )		1,825

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	Nine Months Ended September 30, 2020
	Beginning Balance		Impact of CECL Adoption		Beginning Balance, as Adjusted		Charge-offs		Recoveries		Provision for (Reversal of Provision for) Credit Losses		Ending Balance
	(In thousands)
Real estate construction and land development:
Residential	1,455		( 571 )		884		—		160		( 380 )		664
Commercial and multifamily	1,605		7,240		8,845		—		—		( 218 )		8,627
Total real estate construction and land development	3,060		6,669		9,729		—		160		( 598 )		9,291
Consumer	6,821		( 2,484 )		4,337		( 1,141 )		433		3,862		7,491
Unallocated	899		( 899 )		—		—		—		—		—
Total	$	36,171	$	1,822	$	37,993	$	( 4,694 )	$	1,816	$	38,225	$	73,340

(5) 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 following mergers: Premier Commercial Bancorp and Puget Sound Bancorp in 2018; Washington Banking Company in 2014; Valley Community Bancshares in 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).

There were no additions to goodwill during the three and nine months ended September 30, 2021 and 2020.

Management analyzes its goodwill on an annual basis on December 31 and between annual tests in certain circumstances such as material adverse changes in legal, business, regulatory and economic factors. An impairment loss is recorded to the extent that the carrying amount of goodwill exceeds its implied fair value. The Company performed an annual impairment assessment as of December 31, 2020 and concluded that there was no impairment.

(b) Other Intangible Assets

Other intangible assets represent core deposit intangibles acquired in business combinations. The useful life of the core deposit intangibles was estimated to be ten years for the acquisitions of Premier Commercial Bancorp, Puget Sound Bancorp, Washington Banking Company, and Valley Community Bancshares.

The following table presents the change in other intangible assets for the periods indicated:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2021		2020		2021		2020
	(In thousands)
Balance at the beginning of the period	$	11,494	$	14,807	$	13,088	$	16,613

Amortization	( 758 )		( 860 )		( 2,352 )		( 2,666 )
Balance at the end of the period	$	10,736	$	13,947	$	10,736	$	13,947

(6) Derivative Financial Instruments

The Company utilizes interest rate swap derivative contracts to facilitate the needs of its commercial customers whereby it enters into an interest rate swap with a customer while at the same time entering into an offsetting interest rate swap with another financial institution. The transaction allows the Company’s customer to effectively convert a variable rate loan to a fixed rate and 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. These interest rate swaps are not designated as hedging instruments.

The Company is exposed to interest rate risk as part of the transaction. However, the Company acts as an intermediary for its customer therefore changes in the fair value of the underlying derivative contracts for the most part offset each other and do not significantly impact the Company’s results of operations.

Fee income related to interest rate swap derivative contract transactions is recorded in Interest rate swap fees on the Consolidated Statements of Income. The fair value of derivative positions outstanding is included in Prepaid expenses and other

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assets and Accrued expenses and other liabilities in the Consolidated Statements of Financial Condition. The gains and losses due to changes in fair value and all cash flows are included in Other income in the Consolidated Statements of Income, but typically net to zero based on the identical back-to-back interest rate swap derivative contracts unless a credit valuation adjustment is recorded to appropriately reflect nonperformance risk in the fair value measurement. Various factors impact changes in the credit valuation adjustments over time, including changes in the risk ratings of the parties to the contracts, as well as changes in market rates and volatilities, which affect the total expected exposure of the derivative instruments.

The following table presents the notional amounts and estimated fair values of interest rate derivative contracts outstanding at September 30, 2021 and December 31, 2020:


	September 30, 2021				December 31, 2020
	Notional Amounts		Estimated Fair Value		Notional Amounts		Estimated Fair Value
	(In thousands)
Non-hedging interest rate derivatives
Interest rate swap asset (1)	$	323,706	$	17,843	$	308,126	$	25,740
Interest rate swap liability (1)	323,706		( 17,970 )		308,126		( 26,162 )

(1) The estimated fair value of derivatives with customers was $ 13.0 million and $ 25.4 million as of September 30, 2021 and December 31, 2020, respectively. The estimated fair value of derivatives with third parties was $( 13.2 ) million and $( 25.9 ) million as of September 30, 2021 and December 31, 2020, respectively.

The Company is exposed to credit-related losses in the event of nonperformance by the counterparty to these agreements. Credit risk for derivatives with the customer is controlled through the credit approval process, amount limits, and monitoring procedures and is concentrated within our primary market areas. Credit risk for derivatives with third-parties is concentrated among four well-known broker dealers.

(7) Stockholders’ Equity

(a) Earnings Per Common Share

The following table illustrates the calculation of weighted average shares used for earnings per common share computations at September 30, 2021 and September 30, 2020:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2021		2020		2021		2020
	(In thousands, except shares)
Net income:
Net income	$	20,592	$	16,636	$	78,638	$	22,688
Dividends and undistributed earnings allocated to participating securities (1)	—		—		—		( 5 )
Net income allocated to common shareholders	$	20,592	$	16,636	$	78,638	$	22,683
Basic:
Weighted average common shares outstanding	35,644,192		35,909,148		35,854,258		36,054,906
Restricted stock awards	—		( 303 )		—		( 5,537 )
Total basic weighted average common shares outstanding	35,644,192		35,908,845		35,854,258		36,049,369
Diluted:
Basic weighted average common shares outstanding	35,644,192		35,908,845		35,854,258		36,049,369
Effect of potentially dilutive common shares (2)	285,326		79,889		297,794		144,246
Total diluted weighted average common shares outstanding	35,929,518		35,988,734		36,152,052		36,193,615
Potentially dilutive shares that were excluded from the computation of diluted earnings per share because to do so would be anti-dilutive (3)	16,002		222,818		7,083		140,217

(1) Represents dividends paid and undistributed earnings allocated to unvested restricted stock awards.

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

(3) 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.

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(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 during the nine months ended September 30, 2021 and the calendar year 2020:

Declared

Cash Dividend per Share

Record Date

Paid Date

January 22, 2020

$ 0.20

February 6, 2020

February 20, 2020

April 29, 2020

$ 0.20

May 13, 2020

May 27, 2020

July 22, 2020

$ 0.20

August 5, 2020

August 19, 2020

October 21, 2020

$ 0.20

November 4, 2020

November 18, 2020

January 27, 2021

$ 0.20

February 10, 2021

February 24, 2021

April 21, 2021

$ 0.20

May 5, 2021

May 19, 2021

July 21, 2021

$ 0.20

August 4, 2021

August 18, 2021

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 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.

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 1,512,600 shares, under the eleventh stock repurchase plan. On March 12, 2020, the Company's Board of Directors authorized the repurchase of up to 5 % of the Company's outstanding common shares, or 1,799,054 shares, under the twelfth stock repurchase plan after all shares under the eleventh stock repurchase plan had been repurchased. The number, timing and price of shares repurchased under the twelfth stock repurchase plan will depend on business and market conditions and other factors, including opportunities to deploy the Company's capital.

The following table provides total repurchased shares and average share prices under the applicable plans for the periods indicated:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2021		2020		2021		2020		Plan Total (1)
Eleventh Stock Repurchase Plan
Repurchased shares	—		—		—		639,922		1,512,600
Stock repurchase average share price	$	—	$	—	$	—	$	23.95	$	21.69

Twelfth Stock Repurchase Plan
Repurchased shares	841,088		—		841,088		155,778		996,866
Stock repurchase average share price	$	24.54	$	—	$	24.54	$	20.34	$	23.88

(1) Represents shares repurchased and average price per share paid during the duration of each plan.

In addition to the stock repurchases under a stock repurchase plan, the Company repurchases shares to pay withholding taxes on the vesting of restricted stock awards and units. The following table provides total shares repurchased to pay withholding taxes during the periods indicated:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2021		2020		2021		2020
Repurchased shares to pay withholding taxes	220		378		26,023		28,306
Stock repurchase to pay withholding taxes average share price	$	23.91	$	19.84	$	29.29	$	21.54

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(8) Fair Value Measurements

Fair value is the price that would be received to sell 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 at 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 :

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). Investment security valuations are obtained from third-party pricing services.

Collateral-Dependent Loans :

Collateral-dependent loans are identified for the calculation of the ACL on loans. The fair value used to measure credit loss for this type of loan is commonly based on recent real estate appraisals which are generally obtained at least every 18 months or earlier if there are changes to risk characteristics of the underlying loan. 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. The Bank also incorporates an estimate of cost to sell the collateral when the sale is probable. Such adjustments may be significant and 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 customer and customer’s business (Level 3). Individually evaluated loans are analyzed for credit loss on a quarterly basis and the ACL on loans is adjusted as required based on the results.

Appraisals on collateral-dependent loans 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 Bank. Once received, the Bank 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.

Derivative Financial Instruments:

The Bank 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), and incorporates credit valuation adjustments to reflect nonperformance risk in the measurement of fair value (Level 3). Although the Bank has determined that the majority of the inputs used to value its interest rate swap derivatives fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with its derivatives utilize Level 3 inputs, such as borrower risk ratings, to evaluate the likelihood of default by itself and its counterparties. As of September 30, 2021 and December 31, 2020, the Bank assessed the significance of the impact of the credit valuation adjustment on the overall valuation of its interest rate swap derivatives and determined that the credit valuation adjustment was not significant to the overall valuation of its interest rate swap derivatives. As a result, the Bank has classified its interest rate swap derivative valuations in Level 2 of the fair value hierarchy.

Branches held for sale :

Branches held for sale are recorded at fair value less costs to sell when transferred from Premises and equipment, net to Prepaid expenses and other assets on the Consolidated Statements of Financial Condition with any valuation adjustment recorded within Other noninterest expense on the Consolidated Statements of Income. The fair value of branches held for sale is determined based on a real estate appraisal or broker price opinion. Adjustments are routinely made in the appraisal and broker price opinion process by independent appraisers and commercial real estate brokers, respectively, to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in Level 3

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classification of the inputs for determining fair value.

Recurring Basis

The following tables summarize the balances of assets and liabilities measured at fair value on a recurring basis at the dates indicated:


	September 30, 2021
	Total		Level 1		Level 2		Level 3
	(In thousands)
Assets
Investment securities available for sale:
U.S. government and agency securities	$	26,106	$	—	$	26,106	$	—
Municipal securities	228,166		—		228,166		—

Residential CMO and MBS	242,693		—		242,693		—
Commercial CMO and MBS	235,018		—		235,018		—

Corporate obligations	2,023		—		2,023		—
Other asset-backed securities	27,520		—		27,520		—
Total investment securities available for sale	761,526		—		761,526		—
Equity security	210		210		—		—
Derivative assets - interest rate swaps	17,843		—		17,843		—
Liabilities
Derivative liabilities - interest rate swaps	$	17,970	$	—	17,970		$	—


	December 31, 2020
	Total		Level 1		Level 2		Level 3
	(In thousands)
Assets
Investment securities available for sale:
U.S. government and agency securities	$	45,660	$	—	$	45,660	$	—
Municipal securities	209,968		—		209,968		—

Residential CMO and MBS	201,872		—		201,872		—
Commercial CMO and MBS	303,746		—		303,746		—

Corporate obligations	11,096		—		11,096		—
Other asset-backed securities	29,821		—		29,821		—
Total investment securities available for sale	802,163		—		802,163		—
Equity security	131		131		—		—
Derivative assets - interest rate swaps	25,740		—		25,740		—
Liabilities
Derivative liabilities - interest rate swaps	$	26,162	$	—	$	26,162	$	—

Nonrecurring Basis

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.

The following tables below represent assets measured at fair value on a nonrecurring basis at the dates indicated:


			Fair Value at September 30, 2021
	Basis (1)		Total		Level 1		Level 2		Level 3
	(In thousands)
Collateral-dependent loans:
Commercial business:
Commercial and industrial	$	2,058	$	1,222	$	—	$	—	$	1,222

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			Fair Value at September 30, 2021
	Basis (1)		Total		Level 1		Level 2		Level 3
	(In thousands)
Owner-occupied CRE	613		486		—		—		486

Total commercial business	2,671		1,708		—		—		1,708

Real estate construction and land development:

Commercial and multifamily	991		534		—		—		534


Total	$	3,662	$	2,242	$	—	$	—	$	2,242
Prepaid expenses and other assets:
Branch held for sale (2)	805		805		—		—		805
Total assets measured at fair value on a nonrecurring basis	$	4,467	$	3,047	$	—	$	—	$	3,047

(1) Basis represents the outstanding principal balance of collateral-dependent loans and the carrying value of the branch held for sale.

(2) In July 2021, three branches were reclassified as held for sale in accordance with ASC 360-10. As part of the transfer, one branch was written down to its net realizable value at that time.


			Fair Value at December 31, 2020
	Basis (1)		Total		Level 1		Level 2		Level 3
	(In thousands)
Collateral-dependent loans:
Commercial business:
Commercial and industrial	$	1,305	$	1,289	$	—	$	—	$	1,289










Prepaid expenses and other assets:
Branch held for sale (2)	1,330		1,330		—		—		1,330
Total assets measured at fair value on a nonrecurring basis	$	2,635	$	2,619	$	—	$	—	$	2,619

(1) Basis represents the outstanding principal balance of collateral-dependent loans and the carrying value of the branch held for sale.

(2) In October 2020, one branch was reclassified as held for sale in accordance with ASC 360-10. As part of the transfer, the branch was written down to its net realizable value at that time.

The following table represents the net (loss) gain recorded in earnings as a result of nonrecurring fair value adjustments recorded during the periods indicated:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2021		2020		2021		2020
	(In thousands)
Collateral-dependent loans:
Commercial business:
Commercial and industrial	$	( 54 )	$	—	$	( 563 )	$	( 10 )
Owner-occupied CRE	15		—		( 61 )		—

Total commercial business	( 39 )		—		( 624 )		( 10 )

Real estate construction and land development:

Commercial and multifamily	—		—		( 38 )		—
Total	( 39 )		—		( 662 )		( 10 )
Prepaid expenses and other assets:
Branch held for sale	( 38 )		—		( 38 )		—
Net loss from nonrecurring fair value adjustments	$	( 77 )	$	—	$	( 700 )	$	( 10 )

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The following tables present quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at the dates indicated:

September 30, 2021

Fair
Value

Valuation
Technique(s)

Unobservable Input(s)

Range of Inputs; Weighted
Average

(Dollars in thousands)

Collateral-dependent loans

2,242

Market approach

Adjustment for differences between the comparable sales

55.0 % - ( 20.0 )%; 9.6 %

Branch held for sale

805

Market approach

Adjustment for differences between the comparable sales

51.8 % - ( 26.0 )%; 6.4 %

December 31, 2020

Fair
Value

Valuation
Technique(s)

Unobservable Input(s)

Range of Inputs; Weighted
Average

(Dollars in thousands)

Collateral-dependent loans

1,289

Market approach

Adjustment for differences between the comparable sales

0.6 % - ( 40.1 %); ( 24.1 %)

Branch held for sale

1,330

Market approach

Adjustment for differences between the comparable sales

140.7 % - ( 40.3 %); 33.2 %

(b) Fair Value of Financial Instruments

Broadly traded markets do not exist for most of the Company’s financial instruments; therefore, 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 following tables present the carrying value amount of the Company’s financial instruments and their corresponding estimated fair values at the dates indicated:


	September 30, 2021
	Carrying Value		Fair Value		Fair Value Measurements Using:
					Level 1		Level 2		Level 3
	(In thousands)
Financial Assets:
Cash and cash equivalents	$	1,634,739	$	1,634,739	$	1,634,739	$	—	$	—
Investment securities available for sale	761,526		761,526		—		761,526		—
Investment securities held to maturity	311,074		307,330		—		307,330		—
Loans held for sale	2,636		2,726		—		—		2,726
Loans receivable, net	3,905,567		4,014,701		—		—		4,014,701
Accrued interest receivable	14,802		14,802		51		3,578		11,173
Bank owned life insurance	109,634		109,634		109,634		—		—
Derivative assets - interest rate swaps	17,843		17,843		—		17,843		—
Equity security	210		210		210		—		—
Financial Liabilities:
Noninterest deposits, interest bearing demand deposits, money market accounts and savings accounts	$	5,859,762	$	5,859,762	$	5,859,762	$	—	$	—
Certificates of deposit	355,796		357,266		—		357,266		—

Securities sold under agreement to repurchase	44,096		44,096		44,096		—		—
Junior subordinated debentures	21,107		18,250		—		—		18,250
Accrued interest payable	74		74		31		25		18
Derivative liabilities - interest rate swaps	17,970		17,970		—		17,970		—

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	December 31, 2020
	Carrying Value		Fair Value		Fair Value Measurements Using:
					Level 1		Level 2		Level 3
	(In thousands)
Financial Assets:
Cash and cash equivalents	$	743,322	$	743,322	$	743,322	$	—	$	—
Investment securities available for sale	802,163		802,163		—		802,163		—
Loans held for sale	4,932		5,156		—		—		5,156
Loans receivable, net	4,398,462		4,556,862		—		—		4,556,862
Accrued interest receivable	19,418		19,418		2		3,648		15,768
Bank owned life insurance	107,580		107,580		107,580		—		—
Derivative assets - interest rate swaps	25,740		25,740		—		25,740		—
Equity security	131		131		131		—		—

Financial Liabilities:
Noninterest deposits, interest bearing demand deposits, money market accounts and savings accounts	$	5,198,456	$	5,198,456	$	5,198,456	$	—	$	—
Certificates of deposit	399,534		402,701		—		402,701		—

Securities sold under agreement to repurchase	35,683		35,683		35,683		—		—
Junior subordinated debentures	20,887		18,500		—		—		18,500
Accrued interest payable	94		94		42		33		19
Derivative liabilities - interest rate swaps	26,162		26,162		—		26,162		—

(9) Cash Restriction

The Bank had restricted cash included in interest earning deposits on the Condensed Consolidated Statements of Financial Condition of $ 13.2 million and $ 25.9 million as of September 30, 2021 and December 31, 2020, respectively, relating to collateral required on interest rate swaps from third-parties as discussed in Note (6) Derivative Financial Instruments. The Bank does not have a collateral requirement with customers.

(10) Commitments and Contingencies

In the ordinary course of business, the Bank may enter into various types of transactions that include commitments to extend credit that are not included in its Condensed Consolidated Financial Statements. The Bank applies the same credit standards to these commitments as it uses in all its lending activities and has included these commitments in its lending risk evaluations. The majority of the commitments presented below are variable rate. Loan commitments can be either revolving or non-revolving. The Bank’s exposure to credit and market risk under commitments to extend credit is represented by the amount of these commitments.

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


	September 30, 2021		December 31, 2020
	(In thousands)
Commercial business:
Commercial and industrial	$	577,284	$	640,018
Owner-occupied CRE	1,533		3,488
Non-owner occupied CRE	8,311		18,396
Total commercial business	587,128		661,902

Real estate construction and land development:
Residential	46,911		52,453
Commercial and multifamily	137,161		127,821
Total real estate construction and land development	184,072		180,274
Consumer	282,850		263,249
Total outstanding commitments	$	1,054,050	$	1,105,425

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Upon CECL adoption, as described in Note (1) Description of Business, Basis of Presentation, Significant Accounting Policies and Recently Issued Accounting Pronouncements, the Bank recorded an increase in the beginning ACL on unfunded commitments of $ 3.7 million as of January 1, 2020, representing the change in methodology from an estimate of incurred losses at the balance sheet date, with an estimated probability of funding, to an estimate of credit losses on future utilization over the entire contractual period.

The following table details the activity in the ACL on unfunded commitments during the periods indicated:


	Three Months Ended				Nine Months Ended
	September 30, 2021		September 30, 2020		September 30, 2021		September 30, 2020
	(In thousands)
Balance, beginning of period	$	2,451	$	4,612	$	4,681	$	306
Impact of CECL Adoption	—		—		—		3,702
Adjusted balance, beginning of period	2,451		4,612		4,681		4,008
(Reversal of) provision for credit losses on unfunded commitments	( 297 )		410		( 2,527 )		1,014
Balance, end of period	$	2,154	$	5,022	$	2,154	$	5,022

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 operations of the Company as of and for the three and nine months ended September 30, 2021. The information contained in this section should be read with the unaudited Condensed Consolidated Financial Statements and the accompanying Notes included herein, the Forward Looking Statements included herein and the December 31, 2020 audited Consolidated Financial Statements and the accompanying Notes included in our 2020 Annual Form 10-K.

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. 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 to medium sized 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. During the three months ended March 31, 2020, we ceased indirect auto loan originations, included in our consumer portfolio. We additionally originate for sale or for investment purposes residential real estate loans on single family 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 manages the repricing characteristics of the Company's 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 significantly affected 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 in 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 credit losses on loans. The provision for credit losses on loans 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. Management believes that the ACL on loans reflects the amount that is appropriate to provide for current expected credit losses in our loan portfolio based on our consistent methodology.

Net income is also affected by noninterest income and noninterest expense. Noninterest income primarily consists of service charges and other fees and other income. Noninterest expense consists primarily of compensation and employee benefits, occupancy and equipment, data processing and professional services. 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 consists primarily of lease expenses, depreciation charges, maintenance and utilities. Data processing consists primarily of processing and network services related to the Bank’s core operating system, including the account processing system, electronic payments processing

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of products and services, and internet and mobile banking channels as well as software-as-a-service providers. Professional services consists primarily of third party service providers, such as auditors, consultants and lawyers.

Results of operations may also be significantly affected by general and local economic and competitive conditions, governmental policies and actions of regulatory authorities, especially changes resulting from the COVID-19 pandemic and the governmental actions taken to address it. Net income is also impacted by growth of operations through organic growth or acquisitions.

COVID-19 Pandemic Response

The Company maintains its commitment to supporting its community and customers during the COVID-19 pandemic and remains focused on keeping its employees safe and the Bank running effectively to serve its customers. As of September 30, 2021, all Bank branches are open with normal hours, remote employees commenced a phased-in return to the office and substantially all employees are expected to return to their go-forward working environments by the end of 2021. The Bank will continue to monitor branch access and occupancy levels in relation to cases and close contact scenarios and follow governmental restrictions and public health authority guidelines.

Branch Consolidation Plan

The Company reduced the branch count to 49 from 62 branches at September 30, 2020, including the consolidation of one branch during the three months ended December 31, 2020, eight branches during the three months ended March 31, 2021, and four branches in October 2021. The Company integrated these locations into other branches within its network. These actions were the result of the Company’s increased focus on balancing physical locations and digital banking channels, driven by increased customer usage of online and mobile banking and a commitment to improve digital banking technology. All significant expenses related to the Branch Consolidation Plan for the four branches closed during October 2021 have been included in results of operations for the three months ended September 30, 2021.

Earnings Summary

Comparison of quarter ended September 30, 2021 to the comparable quarter in the prior year

Net income was $20.6 million , or $0.58 per diluted common share, for the three months ended September 30, 2021 compared to $16.6 million, or $0.46 per diluted common share, for the three months ended September 30, 2020. Net income increased $4.0 million, or 23.8%, due primarily to a reversal of provision for credit losses of $3.1 million during the three months ended September 30, 2021 compared to a provision for credit losses of $2.7 million for the same period in 2020.

The efficiency ratio consists of noninterest expense divided by the sum of net interest income plus noninterest income. The Company’s efficiency ratio was 62.35% for the three months ended September 30, 2021 compared to 62.27% for the three months ended September 30, 2020.

Comparison of nine months ended September 30, 2021 to the comparable period in the prior year.

Net income was $78.6 million, or $2.18 per diluted common share, for the nine months ended September 30, 2021 compared t o $22.7 million, or $0.63 per diluted common share, for the nine months ended September 30, 2020. Net income increased $56.0 million, or 246.6% , due primarily to a reversal o f provision for credit losses of $24.3 million during the nine months ended September 30, 2021 compared to a provision for credit losses of $39.2 million for the same period in 2020.

The Company’s efficiency ratio was 60.66% for the nine months ended September 30, 2021 compared to 63.26% for the nine months ended September 30, 2020. The improvement in the efficiency ratio was attributable primarily to the increase in net interest income.

Net Interest Income and Net Interest Margin Overview

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 earning assets, noninterest bearing demand deposits, other noninterest bearing liabilities and stockholders' eq uity; market interest rate fluctuations; and asset quality.

Comparison of quarter ended September 30, 2021 to the comparable quarter in the prior year

Net interest income increased $1.7 million, or 3.4%, to $51.4 million for the three months ended September 30, 2021 compared to $49.7 million for the same period in 2020 due primarily to the Bank decreasing deposit rates following decreases in short-term market interest rates. Additionally, net interest income benefited from the recognition of a $412,000 prepayment penalty on an investment security.

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The following table provides relevant net interest income information for the periods indicated:


	Three Months Ended September 30,
	2021						2020						Change
	Average Balance		Interest Earned/ Paid		Average Yield/ Rate (1)		Average Balance		Interest Earned/ Paid		Average Yield/ Rate (1)		Average Balance		Interest Earned/ Paid		Average Yield/ Rate
	(Dollars in thousands)
Interest Earning Assets:
Loans receivable, net (2) (3)	$	4,005,585	$	46,863	4.64	%	$	4,605,389	$	47,647	4.12	%	$	(599,804)	$	(784)	0.52	%
Taxable securities	893,374		4,711		2.09		697,128		3,865		2.21		196,246		846		(0.12)
Nontaxable securities (3)	157,907		931		2.34		163,070		953		2.32		(5,163)		(22)		0.02
Interest earning deposits	1,417,661		537		0.15		389,653		98		0.10		1,028,008		439		0.05
Total interest earning assets	6,474,527		53,042		3.25	%	5,855,240		52,563		3.57	%	619,287		479		(0.32)	%
Noninterest earning assets	740,433						765,740						(25,307)
Total assets	$	7,214,960					$	6,620,980					$	593,980

Interest Bearing Liabilities:
Certificates of Deposit	$	365,278	$	407	0.44	%	$	466,920	$	1,133	0.97	%	$	(101,642)	$	(726)	(0.53)	%
Savings accounts	609,818		90		0.06		514,072		117		0.09		95,746		(27)		(0.03)
Interest bearing demand and money market accounts	2,881,567		947		0.13		2,639,511		1,389		0.21		242,056		(442)		(0.08)
Total interest bearing deposits	3,856,663		1,444		0.15		3,620,503		2,639		0.29		236,160		(1,195)		(0.14)
Junior subordinated debentures	21,060		184		3.47		20,766		196		3.75		294		(12)		(0.28)
Securities sold under agreement to repurchase	52,197		36		0.27		32,856		50		0.61		19,341		(14)		(0.34)

Total interest bearing liabilities	3,929,920		1,664		0.17	%	3,674,125		2,885		0.31	%	255,795		(1,221)		(0.14)	%
Noninterest bearing demand deposits	2,300,795						1,998,772						302,023
Other noninterest bearing liabilities	128,537						148,345						(19,808)
Stockholders’ equity	855,708						799,738						55,970
Total liabilities and stock-holders’ equity	$	7,214,960					$	6,620,980					$	593,980
Net interest income			$	51,378					$	49,678					$	1,700
Net interest spread					3.08	%					3.26	%					(0.18)	%
Net interest margin					3.15	%					3.38	%					(0.23)	%
Average interest earning assets to average interest bearing liabilities					164.75	%					159.36	%					5.39	%
Cost of total deposits					0.09	%					0.19	%					(0.10)	%

(1) Annualized

(2) Average loan balances are net of ACL on loans. Nonaccrual loans have been included as loans carrying a zero yield.

(3) Yields on tax-exempt securities and loans have not been stated on a tax-equivalent basis.

Net interest income as a percentage of average interest earning assets, or net interest margin, decreased due primarily to the decrease in the average yield on interest earning assets, primarily reflecting a significant increase in average interest earning deposits to 21.9% of total earning assets at September 30, 2021 compared to 6.7% at September 30, 2020, offset partially by a decrease in the cost of total interest bearing liabilities. The decrease in net interest margin was also offset partially by an increase in deferred SBA PPP loan fees recognized due to an increase in the volume of forgiven SBA PPP loans during the three months ended September 30, 2021 which benefited net interest margin compared to a reduction in net interest margin from the Company's participation in the SBA PPP loans during the same period in 2020.

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The following table presents the loan yield and the impacts of SBA PPP loans and the incremental accretion on purchased loans on this financial measure for the periods presented below:


	Three Months Ended
	September 30, 2021		September 30, 2020
Non-GAAP reconciliation of loan yield: (1)





Loan yield (GAAP)	4.64	%	4.12	%
Exclude impact from SBA PPP loans	(0.38)		0.33
Exclude impact from incremental accretion on purchased loans (2)	(0.07)		(0.10)
Loan yield, excluding SBA PPP loans and incremental accretion on purchased loans (non-GAAP)	4.19	%	4.35	%

(1) For additional information, see "Reconciliations of Non-GAAP Measures."

(2) Represents the amount of interest income recorded on purchased loans in excess of the contractual stated interest rate in the individual loan notes due to incremental accretion of purchased discount or premium. Purchased discount or premium is the difference between the contractual loan balance and the fair value of acquired loans at the acquisition date, or as modified by CECL Adoption. The purchased discount is accreted into income over the remaining life of the loan. The impact of incremental accretion on loan yield will change during any period based on the volume of prepayments, but it is expected to decrease over time as the balance of the purchased loans decreases.

The impact to loan yield from net recoveries of interest and fees on loans classified as nonaccrual was an increase of two basis points during the three months ended September 30, 2021. The impact to loan yield from net charge-offs of interest and fees on loans classified as nonaccrual was a decrease of two basis points during the three months ended September 30, 2020.

Comparison of nine months ended September 30, 2021 to the comparable period in the prior year

Net interest income increased $9.3 million, or 6.3%, to $157.9 million f or the nine months ended September 30, 2021 compared to $148.5 million for the same period in 2020 due primarily to the Bank decreasing deposit rates following decreases in short-term market interest rates and secondarily due to an increase in the yield of loans receivable, net, predominately from higher deferred SBA PPP loan fees recognized from forgiven SBA PPP loans and higher recoveries of interest and fees on loans classified as nonaccrual. The increase in net interest income was offset partially by decreases in the yield for all interest earning assets, excluding the impact of SBA PPP loans and recoveries of interest and fees on loans classified as nonaccrual.

The following table provides relevant net interest income information for the periods indicated:


	Nine Months Ended September 30,
	2021						2020						Change
	Average Balance		Interest Earned/ Paid		Average Yield/ Rate (1)		Average Balance		Interest Earned/ Paid		Average Yield/ Rate (1)		Average Balance		Interest Earned/ Paid		Average Yield/ Rate
	(Dollars in thousands)
Interest Earning Assets:
Loans receivable, net (2) (3)	$	4,297,875	$	147,137	4.58	%	$	4,266,598	$	142,328	4.46	%	$	31,277	$	4,809	0.12	%
Taxable securities	789,691		12,295		2.08		758,941		14,068		2.48		30,750		(1,773)		(0.40)
Nontaxable securities (3)	160,748		2,836		2.36		148,560		2,686		2.42		12,188		150		(0.06)
Interest earning deposits	1,034,690		975		0.13		234,040		561		0.32		800,650		414		(0.19)
Total interest earning assets	6,283,004		163,243		3.47	%	5,408,139		159,643		3.94	%	874,865		3,600		(0.47)	%
Noninterest earning assets	749,781						757,269						(7,488)
Total assets	$	7,032,785					$	6,165,408					$	867,377

Interest Bearing Liabilities:
Certificates of deposit	$	379,885	$	1,447	0.51	%	$	502,691	$	4,955	1.32	%	$	(122,806)	$	(3,508)	(0.81)	%
Savings accounts	587,358		274		0.06		475,091		420		0.12		112,267		(146)		(0.06)
Interest bearing demand and money market accounts	2,817,353		2,975		0.14		2,428,148		4,897		0.27		389,205		(1,922)		(0.13)
Total interest bearing deposits	3,784,596		4,696		0.17		3,405,930		10,272		0.40		378,666		(5,576)		(0.23)

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	Nine Months Ended September 30,
	2021						2020						Change
	Average Balance		Interest Earned/ Paid		Average Yield/ Rate (1)		Average Balance		Interest Earned/ Paid		Average Yield/ Rate (1)		Average Balance		Interest Earned/ Paid		Average Yield/ Rate
	(Dollars in thousands)
Junior subordinated debentures	20,987		557		3.55		20,693		699		4.51		294		(142)		(0.96)
Securities sold under agreement to repurchase	45,221		109		0.32		25,296		122		0.64		19,925		(13)		(0.32)
FHLB advances and other borrowings	—		—		—		1,959		8		0.55		(1,959)		(8)		(0.55)
Total interest bearing liabilities	3,850,804		5,362		0.19	%	3,453,878		11,101		0.43	%	396,926		(5,739)		(0.24)	%
Noninterest bearing demand deposits	2,213,795						1,768,260						445,535
Other noninterest bearing liabilities	128,584						138,837						(10,253)
Stockholders’ equity	839,602						804,433						35,169
Total liabilities and stockholders’ equity	$	7,032,785					$	6,165,408					$	867,377
Net interest income			$	157,881					$	148,542					$	9,339
Net interest spread					3.28	%					3.51	%					(0.23)	%
Net interest margin					3.36	%					3.67	%					(0.31)	%
Average interest earning assets to average interest bearing liabilities					163.16	%					156.58	%					6.58	%
Cost of total deposits					0.10	%					0.27	%					(0.17)	%

(1) Annualized

(2) Average loan balances are net of ACL on loans. Nonaccrual loans have been included as loans carrying a zero yield.

(3) Yields on tax-exempt securities and loans have not been stated on a tax-equivalent basis.

Net interest margin decreased due primarily t o the significant increase in average interest earning deposits to 16.5% of total earning assets during the nine months ended September 30, 2021 compared to 4.3% for the same period in the prior year.

The following table presents the loan yield and the impacts of SBA PPP loans and the incremental accretion on purchased loans on this financial measure for the periods presented below :


	Nine Months Ended September 30,
	2021		2020
Non-GAAP reconciliation of loan yield: (1)
Loan yield (GAAP)	4.58	%	4.46	%
Exclude Impact on loan yield from SBA PPP loans	(0.17)		0.22
Exclude impact on loan yield from incremental accretion on purchased loans (2)	(0.08)		(0.09)
Loan yield excluding SBA PPP loans and incremental accretion on purchased loans (non-GAAP)	4.33	%	4.59	%

(1) For additional information, see "Reconciliations of Non-GAAP Measures."

The impact to loan yield from net recoveries of interest and fees on loans classified as nonaccrual was nine basis points and one basis point, during the nine months ended September 30, 2021 and 2020, respectively.

Provision for Credit Losses Overview

The aggregate of the provision for credit losses on loans and the provision for credit losses on unfunded commitments is presented on the Condensed Consolidated Statements of Income as the provision for credit losses. The ACL on unfunded commitments is included on the Condensed Consolidated Statements of Financial Condition within Accrued expenses and other liabilities. The methodology for determining the ACL on loans is disclosed in the Analysis of Allowance for Credit Losses on Loans section below. The methodology for determining the ACL on unfunded commitments uses loss rates calculated in the ACL

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on loans by segment and an estimate of the likelihood of utilization of the unfunded commitment, both applied to the outstanding balance of unfunded commitments by segment.

Comparison of quarter ended September 30, 2021 to the comparable quarter in the prior year

The following table presents the provision for credit losses for the periods indicated:


	Three Months Ended September 30,
	2021		2020		Change		Percentage Change
	(Dollars in thousands)
(Reversal of) provision for credit losses on loans	$	(2,852)	$	2,320	$	(5,172)	(222.9)	%
(Reversal of) provision for credit losses on unfunded commitments	(297)		410		(707)		(172.4)
(Reversal of) provision for credit losses	$	(3,149)	$	2,730	$	(5,879)	(215.3)	%

The reversal of provision for credit losses recognized during the three months ended September 30, 2021 was due primarily to the reduction of the ACL on nonaccrual loans of $2.0 million following a decrease in nonaccrual loan balances of $9.4 million as well as changes in the loan mix. The provision for credit losses on loans of $2.3 million for the three months ended September 30, 2020 was due primarily to the economic forecast at that time reflecting the uncertain economic conditions stemming from the continued impacts from the COVID-19 pandemic.

Comparison of nine months ended September 30, 2021 to the comparable period in the prior year

The following table presents the provision for credit losses for the periods indicated:


	Nine Months Ended September 30,
	2021		2020		Change		Percentage Change
	(Dollars in thousands)
(Reversal of) provision for credit losses on loans	$	(21,808)	$	38,225	$	(60,033)	(157.1)	%
(Reversal of) provision for credit losses on unfunded commitments	(2,527)		1,014		(3,541)		(349.2)
(Reversal of) provision for credit losses	$	(24,335)	$	39,239	$	(63,574)	(162.0)	%

The reversal of provision for credit losse s recognized during the nine months ended September 30, 2021 was primarily due to improvements in the economic forecast during the nine months ended September 30, 2021 compared to the worsening of economic conditions during the nine months ended September 30, 2020 stemming from the onset of the COVID-19 pandemic.

Noninterest Income Overview

Comparison of quarter ended September 30, 2021 to the comparable quarter in the prior year

The following table presents the key components of noninterest income and the change for the periods indicated:


	Three Months Ended September 30,
	2021		2020		Change		Percentage Change
	(Dollars in thousands)
Service charges and other fees	$	4,566	$	4,039	$	527	13.0	%
Gain on sale of investment securities, net	—		40		(40)		(100.0)
Gain on sale of loans, net	765		1,443		(678)		(47.0)
Interest rate swap fees	126		396		(270)		(68.2)
Bank owned life insurance income	647		909		(262)		(28.8)
Other income	2,124		1,383		741		53.6
Total noninterest income	$	8,228	$	8,210	$	18	0.2	%

Noninterest income slightly increased due primarily to an increase in other income as a result of gain on sale of branches held for sale and an increase in service charges and other fees due mostly to higher interchange income and increased deposit fee income, offset partially by a decrease in gain on sale of loans due primarily to lower sales volume of secondary market mortgage loans. Included in other income was gain on sale of $0.9 million during the three months ended September 30, 2021 from branches classified as held for sale as part of the Branch Consolidation Plan.

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Comparison of nine months ended September 30, 2021 to the comparable period in the prior year

The following table presents the change in the key components of noninterest income for the periods indicated:


	Nine Months Ended September 30,
	2021		2020		Change		Percentage Change
	(Dollars in thousands)
Service charges and other fees	$	12,988	$	12,015	$	973	8.1	%
Gain on sale of investment securities, net	29		1,463		(1,434)		(98.0)
Gain on sale of loans, net	3,138		3,125		13		0.4
Interest rate swap fees	487		1,461		(974)		(66.7)
Bank owned life insurance income	2,020		2,439		(419)		(17.2)
Other income	6,114		5,441		673		12.4
Total noninterest income	$	24,776	$	25,944	$	(1,168)	(4.5)	%

Nonintere st income decreased due primarily to reduced gain on sale of investment securities due to fewer sales and a decline in interest rate swap fees due to fewer executions of interest rate swap contracts. Partially offsetting these decreases was an increase in service charges and other fees due primarily to higher interchange income and an increase in other income as a result of gains on sale of branches of $1.6 million related to the Branch Consolidation Plan, previously discussed.

Noninterest Expense Overview

Comparison of quarter ended September 30, 2021 to the comparable quarter in the prior year

The following table presents the key components of noninterest expense and the change for the periods indicated:


	Three Months Ended September 30,
	2021		2020		Change		Percentage Change
	(Dollars in thousands)
Compensation and employee benefits	$	22,176	$	21,416	$	760	3.5	%
Occupancy and equipment	4,373		4,348		25		0.6
Data processing	4,029		3,691		338		9.2
Marketing	775		755		20		2.6
Professional services	816		1,086		(270)		(24.9)
State/municipal business and use tax	1,071		964		107		11.1
Federal deposit insurance premium	550		848		(298)		(35.1)

Amortization of intangible assets	758		860		(102)		(11.9)
Other expense	2,618		2,077		541		26.0
Total noninterest expense	$	37,166	$	36,045	$	1,121	3.1	%

Noninterest expense increased due primarily to an increase in compensation and employee benefits from upward market pressure on salaries and wages and an increase in other expenses related to the Branch Consolidation Plan.

Comparison of nine months ended September 30, 2021 to the comparable period in the prior year

The following table presents changes in the key components of noninterest expense for the periods indicated:


	Nine Months Ended September 30,
	2021		2020		Change		Percentage Change
	(Dollars in thousands)
Compensation and employee benefits	$	66,725	$	65,849	$	876	1.3	%
Occupancy and equipment	12,918		13,247		(329)		(2.5)
Data processing	11,839		10,735		1,104		10.3
Marketing	2,336		2,317		19		0.8
Professional services	3,249		4,632		(1,383)		(29.9)

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	Nine Months Ended September 30,
	2021		2020		Change		Percentage Change
	(Dollars in thousands)
State/municipal business and use tax	3,034		2,626		408		15.5
Federal deposit insurance premium	1,478		1,086		392		36.1
Other real estate owned, net	—		(145)		145		(100.0)
Amortization of intangible assets	2,352		2,666		(314)		(11.8)
Other expense	6,873		7,365		(492)		(6.7)
Total noninterest expense	$	110,804	$	110,378	$	426	0.4	%

Noninterest expense increase d due primari ly to an increase in data processing expense as the Bank continues to invest in technology and an increase in compensation and employee benefits from upward market pressure on salaries and wages . The increase in noninterest expense was offset partially by lower professional services expense due to costs incurred during the nine months ended September 30, 2020 related to the launch of the new mobile and online commercial banking platform, "Heritage Direct" last year and secondarily due to t he decrease in ot her expense driven primarily by a reduction of discretionary expenses, including employee business travel as a result of the Company's suspension of non-essential travel due to the COVID-19 pandemic.

Income Tax Expense Overview

Comparison of quarter ended September 30, 2021 to the comparable quarter in the prior year

The following table presents the income tax expense and related metrics and the change for the periods indicated:


	Three Months Ended September 30,
	2021			2020			Change			Percentage Change
	(Dollars in thousands)
Income before income taxes	$	25,589		$	19,113		$	6,476		33.9	%
Income tax expense	$	4,997		$	2,477		$	2,520		101.7	%
Effective income tax rate	19.5		%	13.0		%	6.5		%	50.0	%

Income tax expense increased due primarily to a higher effective income tax rate and secondarily due to higher income before income taxes. The effective income tax rate increased due primarily to an increase in the estimated annual pre-tax income for the year ended December 31, 2021, which decreased the impact of favorable permanent tax items such as tax-exempt investments, investments in bank owned life insurance and low-income housing tax credits. Additionally, there remain no gross tax credits related to the Company's New Market Tax Credit as these credits were fully utilized during the seven year period ending December 31, 2020.

Comparison of nine months ended September 30, 2021 to the comparable period in the prior year.

The following table presents the income tax expense and related metrics and the change for the periods indicated:


	Nine Months Ended September 30,
	2021			2020			Change			Percentage Change
	(Dollars in thousands)
Income before income taxes	$	96,188		$	24,869		$	71,319		286.8	%
Income tax expense	$	17,550		$	2,181		$	15,369		704.7	%
Effective income tax rate	18.2		%	8.8		%	9.4		%	106.8	%

Inco me tax expense and the effective income tax rate both increased due primarily to higher pre-tax income , which decreased the impact of favorable permanent tax items such as tax-exempt investments, investments in bank owned life insurance and low-income housing tax credits, and secondarily due to a provision in the CARES Act, which permitted the Company to recognize a $1.0 million benefit from net operating losses related to prior acquisitions during the nine months ended September 30, 2020. Additionally, there remain no gross tax credits related to the Company's New Market Tax Credit as these credits were fully utilized during the seven year period ending December 31, 2020.

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Consolidated Financial Condition Overview

The table below provides a comparison of the changes in the Company's financial condition from December 31, 2020 to September 30, 2021:


	September 30, 2021		December 31, 2020		Change		Percentage Change
	(Dollars in thousands)
Assets
Cash and cash equivalents	$	1,634,739	$	743,322	$	891,417	119.9	%
Investment securities available for sale, at fair value, net	761,526		802,163		(40,637)		(5.1)
Investment securities held to maturity, at amortized cost, net	311,074		—		311,074		100.0
Loans held for sale	2,636		4,932		(2,296)		(46.6)
Loans receivable, net	3,905,567		4,398,462		(492,895)		(11.2)
Other real estate owned	—		—		—		—
Premises and equipment, net	79,958		85,452		(5,494)		(6.4)
Federal Home Loan Bank stock, at cost	7,933		6,661		1,272		19.1
Bank owned life insurance	109,634		107,580		2,054		1.9
Accrued interest receivable	14,802		19,418		(4,616)		(23.8)
Prepaid expenses and other assets	179,494		193,301		(13,807)		(7.1)
Other intangible assets, net	10,736		13,088		(2,352)		(18.0)
Goodwill	240,939		240,939		—		—
Total assets	$	7,259,038	$	6,615,318	$	643,720	9.7	%

Liabilities
Deposits	$	6,215,558	$	5,597,990	$	617,568	11.0	%

Junior subordinated debentures	21,107		20,887		220		1.1
Securities sold under agreement to repurchase	44,096		35,683		8,413		23.6
Accrued expenses and other liabilities	129,873		140,319		(10,446)		(7.4)
Total liabilities	6,410,634		5,794,879		615,755		10.6

Stockholders' equity
Common stock	552,385		571,021		(18,636)		(3.3)
Retained earnings	281,285		224,400		56,885		25.3
Accumulated other comprehensive income, net	14,734		25,018		(10,284)		(41.1)
Total stockholders' equity	848,404		820,439		27,965		3.4
Total liabilities and stockholders' equity	$	7,259,038	$	6,615,318	$	643,720	9.7	%

Total assets increased due primarily to increases in cash and cash equivalents and total investment securities. The change in total investment securities included the transfer of $244.8 million of investment securities available for sale to investment securities held to maturity in order to mitigate market price volatility and its impact to accumulated comprehensive income within stockholders' equity. These increases were primarily the result of the significant increase in total deposits, which is discussed in more detail in the "Deposit Activities Overview" section below. The increase in total assets was offset partially by a decrease in loan receivable, net, which is discussed in more detail in the "Lending Activities Overview" section below.

Lending Activities Overview

Changes by loan type

The Bank is a full-service commercial bank which originates a wide variety of loans with a focus on commercial business loans. Loans receivable decrease d $514.8 million compared to December 31, 2020 due primarily to a decrease in SBA PPP loans as a result of forgiveness payments received from the SBA in excess of originations, a decrease in demand for commercial and industrial loans and a decrease in consumer loans primarily from continued runoff of the indirect auto loan portfolio following the cessation of this business line during the three months ended March 31, 2020. Offsetting these decreases was an increase in CRE loans which includes the transfer of completed projects from real estate construction and land development loans.

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The following table provides a comparison of the changes in the Company's loan portfolio by type of loan at the dates indicated:


	September 30, 2021				December 31, 2020
	Balance (1)		% of Total (2)		Balance (1)		% of Total (2)		Change		Percentage Change
	(Dollars in thousands)
Commercial business:
Commercial and industrial	$	652,776	16.5	%	$	733,098	16.4	%	$	(80,322)	(11.0)	%
SBA PPP	266,896		6.8		715,121		16.0		(448,225)		(62.7)
Owner-occupied CRE	907,568		23.0		856,684		19.2		50,884		5.9
Non-owner occupied CRE	1,459,795		36.8		1,410,303		31.5		49,492		3.5
Total commercial business	3,287,035		83.1		3,715,206		83.1		(428,171)		(11.5)
Residential real estate (3)	125,697		3.2		122,756		2.7		2,941		2.4
Real estate construction and land development:
Residential	90,081		2.3		78,259		1.8		11,822		15.1
Commercial and multifamily	205,516		5.2		227,454		5.1		(21,938)		(9.6)
Total real estate construction and land development	295,597		7.5		305,713		6.9		(10,116)		(3.3)
Consumer	245,555		6.2		324,972		7.3		(79,417)		(24.4)
Total	$	3,953,884	100.0	%	$	4,468,647	100.0	%	$	(514,763)	(11.5)	%

(1) Balances do not include unfunded loan commitments.

(2) Percent of loans receivable.

(3) Excludes loans held for sale o f $2.6 million and $4.9 million at September 30, 2021 and December 31, 2020, respectively.

SBA Paycheck Protection Program

The Company has supported its community and customers during the COVID-19 pandemic through its participation in the SBA's PPP. The Company has identified its SBA PPP loans separately in two tranches based on the date of origination with the first tranche comprised of the SBA PPP loans originated in accordance with the CARES Act ("PPP1") and the second tranche comprised of SBA PPP loans originated under the SBA's PPP in accordance with the CA Act ("PPP2"). The SBA PPP ended on May 31, 2021.

The Bank earns 1% interest on these loans as well as a fee from the SBA to cover processing costs, which is amortized over the life of the loan and recognized fully at payoff or forgiveness. The Bank began processing loan forgiveness applications and receiving SBA PPP forgiveness payments during the three months ended December 31, 2020.

The following are key statistics of the Company's SBA PPP loan activity for both tranches since inception:


	As of September 30, 2021
	PPP1		PPP2		Total SBA PPP
	(Dollars in thousands)
Total number of funded loans	4,642		2,542		7,184
Total amount funded	$	897,353	$	380,014	$	1,277,367
Average funded loan size	$	193	$	149	$	178
Total net fees deferred at funding	$	28,805	$	16,041	$	44,846

The following table summarizes key statistics of the SBA PPP loans as of and for the period indicated:


	As of or for the Three Months Ended
	September 30, 2021
	PPP1		PPP2		Total SBA PPP
	(In thousands)
Net deferred fees recognized during the period	$	2,276	$	4,754	$	7,030
Net deferred fees unrecognized as of period end	280		9,055		9,335
Principal payments received during the period, including forgiveness payments from the SBA	179,030		105,355		284,385

Amortized cost as of period end	19,683		247,213		266,896

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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 dates indicated:


	September 30, 2021			December 31, 2020
	(Dollars in thousands)
Nonaccrual loans:
Commercial business	$	25,243		$	56,786
Residential real estate	51			184
Real estate construction and land development	571			1,022
Consumer	29			100
Total nonaccrual loans	25,894			58,092
Other real estate owned	—			—
Total nonperforming assets	$	25,894		$	58,092

ACL on loans	$	48,317		$	70,185
Nonperforming loans to loans receivable	0.65		%	1.30		%


ACL on loans to nonperforming loans	186.60			120.82
Nonperforming assets to total assets	0.36			0.88

Performing TDR loans:
Commercial business	$	58,633		$	49,403
Residential real estate	361			188
Real estate construction and land development	450			1,926
Consumer	1,240			1,355
Total performing TDR loans	$	60,684		$	52,872

Accruing loans past due 90 days or more	$	—		$	—

Nonaccrual Loans

N onaccrual loans decrease d $32.2 million to 0.65% of loans receivable and 0.36% of total assets at September 30, 2021 from 1.30% of loans receivable and 0.88% of total assets at December 31, 2020. The following table reflects the changes in nonaccrual loans during the periods indicated:


	Nine Months Ended September 30,
	2021		2020
	(In thousands)
Nonaccrual loans
Balance, beginning of period	$	58,092	$	44,525
Additions to nonaccrual loan classification	1,162		24,679



Net principal payments and transfers to accruing status	(13,351)		(4,277)
Payoffs	(19,317)		(10,951)
Charge-offs	(692)		(1,102)
Transfer to OREO	—		(270)
Balance, end of period	$	25,894	$	52,604

The decrease in nonaccrual loans during the nine months ended September 30, 2021 was due primarily to payoffs, including a payoff of an agricultural business relationship of $10.7 million, which was initially classified as nonaccrual during the three months ended September 30, 2019, and the return to accrual status of an owner-occupied CRE relationship of $7.0 million. The Company recovered $1.5 million of interest and fees on loans related to the payoff of the agricultural business relationship.

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Analysis of Allowance for Credit Losses on Loans

We adopted CECL on January 1, 2020. Under this methodology, certain nonaccrual loans and certain performing TDR loans are not considered to have similar risk characteristics as other loans; therefore, they are evaluated for credit loss on an individual basis. The allowance for individually evaluated loans is calculated using either the collateral value method, which considers the likely source of repayment as the value of the collateral, less estimated costs to sell if applicable, or the net present value method, which considers the contractual principal and interest terms and estimated cash flows available from the borrower to satisfy the debt.

The remaining loans not individually evaluated are disaggregated based on similar risk characteristics into segments and collectively evaluated for ACL using baseline loss rates that are calculated using the Bank's average quarterly historical loss information for those segments. The baseline loss rates are applied to each loan's estimated cash flows over the life of the loan under the remaining life method, including prepayment estimates, to determine the baseline loss estimate for each loan. The CECL methodology also includes consideration of the forecasted direction of the economic and business environment and its likely impact to the estimated allowance as compared to the historical losses over the reasonable and supportable time frame. The impact of those macroeconomic factors to each segment, positive or negative, using the reasonable and supportable period, are added to the calculated baseline loss rate and are used to establish a macroeconomic allowance. After the reasonable and supportable period, the estimated credit losses revert back to historical baseline loss levels under a reversion period on a straight-lined, input reversion basis. Management can also consider other qualitative factors to adjust the ACL on loans if internal or external conditions suggest changes to the modeled ACL on loans are appropriate.

The following table provides information regarding changes in the ACL on loans at and for the periods indicated:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2021			2020			2021			2020
	(Dollars in thousands)
ACL on loans at the beginning of the period	$	51,562		$	71,501		$	70,185		$	36,171
Impact of CECL Adoption	—			—			—			1,822
Adjusted ACL on loans, beginning of period	51,562			71,501			70,185			37,993
Charge-offs:
Commercial business	(743)			(507)			(757)			(3,553)

Real estate construction and land development	—			—			(1)			—
Consumer	(204)			(335)			(509)			(1,141)
Total charge-offs	(947)			(842)			(1,267)			(4,694)
Recoveries:
Commercial business	385			80			735			1,220
Residential real estate	—			—			—			3
Real estate construction and land development	8			139			28			160
Consumer	161			142			444			433
Total recoveries	554			361			1,207			1,816
Net charge-offs	(393)			(481)			(60)			(2,878)
(Reversal of) provision for credit losses on loans	(2,852)			2,320			(21,808)			38,225
ACL on loans at the end of period	$	48,317		$	73,340		$	48,317		$	73,340



Net charge-offs on loans to average loans receivable, net (1)	(0.04)		%	(0.04)		%	—		%	(0.09)		%

Loans receivable at the end of the period	$	3,953,884		$	4,666,730		$	3,953,884		$	4,666,730
Average loans receivable, net during the period (2)	4,005,585			4,605,389			4,297,875			4,266,598

(1) Annualized.

(2) The average loan balances are net of the ACL on loans and include loans held for sale.

The ACL on loans decreased $21.9 million, or 31.2%, to $48.3 million, or 1.22% o f loans receivable, at September 30, 2021 from $70.2 million, or 1.57% of loans receivable, at December 31, 2020. The decrease in the ACL on loans was due primarily to a reversal of prov ision for credit losses on loans of $21.8 million recorded during the nine months ended September 30, 2021 following improvements in the economic forecast used in the CECL model at September 30, 2021 as compared to the forecast at December 31, 2020 . The ACL on loans does not include a reserve for SBA PPP loans as these loans are fully guaranteed by the SBA. The ACL on loans receivable, excluding SBA PPP loans was 1.31% and 1.87% at September 30, 2021 and December 31, 2020, respectively. See "Reconciliations of Non-GAAP Measures" for the calculation of the ACL on loans receivable, excluding SBA PPP.

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Deposits and Other Borrowings Overview

The following table summarizes the Company's deposits at the dates indicated:


	September 30, 2021				December 31, 2020
	Balance		% of Total		Balance		% of Total		Change		Percentage Change
	(Dollars in thousands)
Noninterest demand deposits	$	2,299,248	37.0	%	$	1,980,531	35.4	%	$	318,717	16.1	%
Interest bearing demand deposits	1,870,618		30.1		1,716,123		30.7		154,495		9.0
Money market accounts	1,072,427		17.3		962,983		17.2		109,444		11.4
Savings accounts	617,469		9.9		538,819		9.6		78,650		14.6
Total non-maturity deposits	5,859,762		94.3		5,198,456		92.9		661,306		12.7
Certificates of deposit	355,796		5.7		399,534		7.1		(43,738)		(10.9)
Total deposits	$	6,215,558	100.0	%	$	5,597,990	100.0	%	$	617,568	11.0	%

The increase in deposits is primarily due to proceeds from SBA PPP loans originated during the nine months ended September 30, 2021 which were deposited directly into the customers' deposit accounts.

The Bank also utilizes securities sold under agreement to repurchase, which are secured by investment securities, as a supplement to its funding sources. As of September 30, 2021 and December 31, 2020, three customers utilized this product with total balances of $44.1 million and $35.7 million, respectively.

In addition to deposits and securities sold under agreement to repurchase, borrowings may be used on a short-term basis to compensate for reductions in other sources of funds. 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 Company has junior subordinated debentures with a par value of $25.0 million which pay quarterly interest based on the three-month LIBOR plus 1.56% and mature in 2037. The balance of the junior subordinated debentures was $21.1 million at September 30, 2021, which reflects the fair value of the junior subordinated debentures established as part of the merger with Washington Banking Company on May 1, 2014, adjusted for the accretion of discount from purchase accounting fair value adjustment.

Additionally, the Bank maintained credit facilities with the FHLB for $992.3 million and credit facilities with the Federal Reserve Bank for $50.2 million at September 30, 2021. There were no FHLB or Federal Reserve Bank advances outstanding under either facility at September 30, 2021 and these credit facilities were not utilized during the nine months ended September 30, 2021. The average balance of FHLB advances was $2.0 million during the nine months ended September 30, 2020. The credit facility with the Federal Reserve Bank was not utilized during the nine months ended September 30, 2020.

The Bank also maintains lines of credit with five correspondent banks to purchase federal funds totaling $215.0 million as of September 30, 2021. These lines of credit were not utilized during both the nine months ended September 30, 2021 and 2020.

Liquidity and Cash Flows

Our primary sources of funds are customer and local government deposits, loan principal and interest payments, loan sales and payments of 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 and investment securities, the Bank can utilize established credit facilities and lines of credit totaling $1.26 billion, as discussed in the Deposits and Other Borrowings Overview section above or may initiate the 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 Company to meets its ongoing cash obligations. At September 30, 2021, the Company (on an unconsolidated basis) had cash and cash equivalents of $9.8 million.

We are required to maintain an adequate level of liquidity to ensure the availability of sufficient funds for loan originations and deposit withdrawals, satisfy other financial commitments and fund operations. We generally maintain sufficient

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cash and investments to meet short-term liquidity needs. At September 30, 2021, cash and cash equivalents totaled $1.63 billion, or 22.5% of total assets. Management considers unpledged investment securities available for sale to be another source of liquidity. The fair value of investment securities available for sale that were unpledged totaled $589.7 million, or 8.1% of total assets, at September 30, 2021. The fair value of investment securities available for sale with maturities of one year or less totaled $37.2 million, or 0.5% of total assets, at September 30, 2021.

Consolidated Cash Flows: As disclosed in the Condensed Consolidated Statements of Cash Flows, net cash provided by operating activities was $50.7 million for the nine months ended September 30, 2021, and primarily consisted of net income of $78.6 million, offset partially by non-cash adjustments, including reversal of provision for credit losses of $24.3 million and depreciation, amortization, and accretion of $18.4 million. During the nine months ended September 30, 2021, net cash provided by investing activities was $257.7 million, which consisted primarily of net loan repayments of $555.8 million (including SBA PPP loan principal reduction of $834.4 million compared to SBA PPP originations of $380.0 million) and net cash use in investment securities of $286.5 million (including $488.4 million of purchases). Net cash provided by financing activities was $583.0 million for the nine months ended September 30, 2021 and primarily consisted of a net increase in deposits of $617.6 million, as discussed above.

Stockholders' Equity and Regulatory Capital Requirements Overview

The Company’s stockholders' equity to assets ratio was 11.7% and 12.4% at September 30, 2021 and December 31, 2020, respectively. The following table reflects the changes to stockholders' equity during the periods indicated:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2021		2020		2021		2020
	(In thousands)
Balance, beginning of period	$	855,984	$	793,652	$	820,439	$	809,311
Cumulative effect from change in accounting policy (1)	—		—		—		(5,615)
Net income	20,592		16,636		78,638		22,688
Dividends declared	(7,170)		(7,227)		(21,753)		(21,796)
Other comprehensive (loss) income, net of tax	(1,327)		(773)		(10,284)		14,830
Repurchase of common stock	(20,641)		(7)		(21,398)		(19,105)
Other	966		848		2,762		2,816
Balance, end of period	$	848,404	$	803,129	$	848,404	$	803,129

(1) Effective January 1, 2020, the Company adopted ASU 2016-13, Financial Instruments - Credit Losses .

The Company repurchased 841,088 and 797,700 shares under the Company's stock repurchase plans during the nine months ended September 30, 2021 and 2020, respectively. In addition to the stock repurchases under a plan, the Company repurchased shares to pay withholding taxes on the vesting of restricted stock awards and units.

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 October 20, 2021, the Company’s Board of Directors declared a regular quarterly dividend of $0.21 per common share which is payable on November 17, 2021 to shareholders of record on November 3, 2021.

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 Condensed Consolidated Financial Statements. Management believes that as of September 30, 2021, the Company and the Bank met all capital adequacy requirements to which they are subject.

As of September 30, 2021 and December 31, 2020, 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

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notification that management believes have changed the Bank's categories. The following table represents the minimum required ratios of the Company and the Bank and the actual capital ratios at the periods indicated:


	Minimum Requirements				Well-Capitalized Requirements				Actual
	(Dollars in thousands)
As of September 30, 2021:
The Company consolidated
Common equity Tier 1 capital to risk-weighted assets	$	199,287	4.5	%	N/A		N/A		$	590,146	13.3	%
Tier 1 leverage capital to average assets	277,963		4.0		N/A		N/A		611,253		8.8
Tier 1 capital to risk-weighted assets	265,716		6.0		N/A		N/A		611,253		13.8
Total capital to risk-weighted assets	354,289		8.0		N/A		N/A		654,014		14.8
Heritage Bank
Common equity Tier 1 capital to risk-weighted assets	199,130		4.5		$	287,632	6.5	%	598,297		13.5
Tier 1 leverage capital to average assets	277,867		4.0		347,334		5.0		598,297		8.6
Tier 1 capital to risk-weighted assets	265,507		6.0		354,009		8.0		598,297		13.5
Total capital to risk-weighted assets	354,009		8.0		442,512		10.0		641,058		14.5

As of December 31, 2020:
The Company consolidated
Common equity Tier 1 capital to risk-weighted assets	$	203,314	4.5	%	N/A		N/A		$	555,644	12.3	%
Tier 1 leverage capital to average assets	256,216		4.0		N/A		N/A		576,531		9.0
Tier 1 capital to risk-weighted assets	271,086		6.0		N/A		N/A		576,531		12.8
Total capital to risk-weighted assets	361,448		8.0		N/A		N/A		633,061		14.0
Heritage Bank
Common equity Tier 1 capital to risk-weighted assets	203,112		4.5		$	293,383	6.5	%	563,630		12.5
Tier 1 leverage capital to average assets	256,051		4.0		320,064		5.0		563,630		8.8
Tier 1 capital to risk-weighted assets	270,815		6.0		361,087		8.0		563,630		12.5
Total capital to risk-weighted assets	361,087		8.0		451,359		10.0		620,124		13.7

As of both September 30, 2021 and December 31, 2020, the capital measures reflect the revised CECL capital transition provisions adopted by the Federal Reserve and the FDIC that allow the Bank the option to delay for two years an estimate of CECL’s effect on regulatory capital, relative to the incurred loss methodology’s effect on regulatory capital, followed by a three-year transition period.

Under applicable capital requirements both the Company and the Bank are required to maintain a capital conservation buffer of common equity Tier 1 capital above 2.5% to avoid restrictions on certain activities including payment of dividends, stock repurchases and discretionary bonuses to executive officers. At September 30, 2021, the capital conservation buffer was 6.8% and 6.5% for the Company and the Bank, respectively.

Reconciliations of Non-GAAP Measures

This Form 10-Q contains certain financial measures not presented in accordance with GAAP in addition to financial measures presented in accordance with GAAP. The Company has presented these non-GAAP financial measures in this Form 10-Q because it believes that they provide useful and comparative information to assess trends in the Company’s performance and asset quality reflected in the current quarter and comparable period results and facilitate comparison of its performance with the performance of its peers. These non-GAAP measures have inherent limitations, are not required to be uniformly applied and are not audited. They should not be considered in isolation or as a substitute for financial measures presented in accordance with GAAP. These non-GAAP measures may not be comparable to similarly titled measures reported by other companies. Reconciliations of the GAAP and non-GAAP financial measures are presented below.

The Company believes presenting loan yield, excluding the effect of discount accretion on purchased loans, is useful in assessing the impact of acquisition accounting on loan yield as the effect of loan discount accretion is expected to decrease as the acquired loans mature or roll off our balance sheet. Similarly, presenting loan yield, excluding the effect of SBA PPP loans, is

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useful in assessing the impact of these special program loans that are anticipated to substantially decrease upon forgiveness by the SBA within a short time frame.


	Three Months Ended September 30,						Nine Months Ended September 30,
	2021			2020			2021			2020
	(Dollars in thousands)
Loan yield, excluding SBA PPP loans and incremental accretion on purchased loans, annualized:
Interest and fees on loans (GAAP)	$	46,863		$	47,647		$	147,137		$	142,328
Exclude SBA PPP loan interest and fees	(8,042)			(5,810)			(27,180)			(10,733)
Exclude incremental accretion on purchased loans	(681)			(944)			(2,250)			(2,651)
Adjusted interest and fees on loans (non-GAAP)	$	38,140		$	40,893		$	117,707		$	128,944

Average loans receivable, net (GAAP)	$	4,005,585		$	4,605,389		$	4,297,875		$	4,266,598
Exclude average SBA PPP loans	(392,570)			(863,127)			(665,681)			(511,461)
Adjusted average loans receivable, net (non-GAAP)	$	3,613,015		$	3,742,262		$	3,632,194		$	3,755,137

Loan yield, annualized (GAAP)	4.64		%	4.12		%	4.58		%	4.46		%
Loan yield, excluding SBA PPP loans and incremental accretion on purchased loans, annualized (non-GAAP)	4.19		%	4.35		%	4.33		%	4.59		%

The Company considers presenting the ratio of ACL on loans to loans receivable, excluding SBA PPP loans, to be a useful measurement in evaluating the adequacy of the Company's ACL on loans as the balance of SBA PPP loans is significant to the loan portfolio, and since SBA PPP loans are guaranteed by the SBA, the Company has not provided an ACL on loans for SBA PPP loans.


	September 30, 2021			December 31, 2020
	(Dollars in thousands)
ACL on loans to loans receivable, excluding SBA PPP loans:
Allowance for credit losses on loans (GAAP)	$	48,317		$	70,185

Loans receivable (GAAP)	$	3,953,884		$	4,468,647
Exclude SBA PPP loans	266,896			715,121
Loans receivable, excluding SBA PPP (non-GAAP)	$	3,686,988		$	3,753,526

ACL on loans to loans receivable (GAAP)	1.22		%	1.57		%
ACL on loans to loans receivable, excluding SBA PPP loans (non-GAAP)	1.31		%	1.87		%

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 2020 Annual Form 10-K.

Neither the Company nor the Bank maintains a trading account for any class of financial instrument or engages in hedging activities or purchases high risk derivative instruments. Moreover, neither the Company nor the Bank is 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 procedures (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

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Chief Executive Officer, Chief Financial Officer and the Company’s Disclosure Committee as of the end of the period covered by this quarterly report. 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 September 30, 2021 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 three months ended September 30, 2021, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

Neither the Company nor the Bank is 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 2020 Annual Form 10-K.

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

(a) Not applicable.

(b) Not applicable.

The following table provides information about repurchases of common stock by the Company during the three months ended September 30, 2021:


Period	Total Number of Shares Purchased (1)	Average Price Paid Per Share (1)		Total number of shares purchased as part of publicly announced plans or programs	Maximum number of shares that may yet be purchased under the plans or programs (2)
July 1, 2021— July 31, 2021	95,631	$	23.39	9,077,432	1,547,645
August 1, 2021— August 31, 2021	453,319	24.71		9,530,751	1,094,326
September 1, 2021— September 30, 2021	292,358	24.64		9,822,889	802,188
Total	841,308	$	24.54

(1) Of the common shares repurchased by the Company between July 1, 2021 and September 30, 2021, 220 of the shares represented the cancellation of stock to pay withholding taxes on vested restricted stock awards or units.

(2) On March 12, 2020 the Company's Board of Directors authorized the repurchase of up to 5% of the Company's outstanding common shares, or 1,799,054 shares, under the twelfth stock repurchase plan.

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

10.29*

Addendum to Employment Agreement - Bryan D. McDonald

8-K

10.1

07/06/2021

10.34*

Form of Split Dollar Agreement, dated May 3, 2021, by and between Heritage Bank and Tony Chalfant

10-Q

10.34

05/05/2021

31.1

Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (1)

31.2

Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (1)

32.1

Certification of Principal Executive Officer and Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (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)

*Indicates management contract or compensatory plan or arrangement.

(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:
November 8, 2021						/S/ JEFFREY J. DEUEL
						Jeffrey J. Deuel
						President and Chief Executive Officer

Date:
November 8, 2021						/S/ DONALD J. HINSON
						Donald J. Hinson
						Executive Vice President and Chief Financial Officer

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Part I. Financial Information Item 1. Financial Statements Item 2. Management's Discussion and Analysis Of Financial Condition and Results Of Operations Item 3. Quantitative and Qualitative Disclosures About Market Risk Item 4. Controls and Procedures Part II. Other Information Item 1. Legal Proceedings Item 1A. Risk Factors Item 2. Unregistered Sales Of Equity Securities and Use Of Proceeds Item 3. Defaults Upon Senior Securities Item 4. Mine Safety Disclosures Item 5. Other Information Item 6. Exhibits

Exhibits

10.29* Addendum to Employment Agreement - Bryan D. McDonald 8-K 10.1 07/06/2021 10.34* Form of Split Dollar Agreement, dated May 3, 2021, by and between Heritage Bank and Tony Chalfant 10-Q 10.34 05/05/2021 31.1 Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002(1) 31.2 Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002(1) 32.1 Certification of Principal Executive Officer and Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002(1)

HFWA 10-Q Quarter ended Sept. 30, 2021

Exhibits