hfwa-20220331

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 March 31, 2022 or

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

For the transition period from __________ to __________

Commission File Number 000-29480

HERITAGE FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

Washington

91-1857900

(State or other jurisdiction of
incorporation or organization)

(I.R.S. Employer
Identification No.)

201 Fifth Avenue SW,

Olympia

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 April 25, 2022, there were 35,102,372 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

March 31, 2022

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 MARCH 31, 2022 AND DECEMBER 31, 2021		5
	CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) FOR THE THREE MONTHS ENDED MARCH 31, 2022 AND 2021		6
	CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED) FOR THE THREE MONTHS ENDED MARCH 31, 2022 AND 2021		7
	CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (UNAUDITED) FOR THE THREE MONTHS ENDED MARCH 31, 2022 AND 2021		8
	CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) FOR THE THREE MONTHS ENDED MARCH 31, 2022 AND 2021		9
	NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)		10
	NOTE 1.	DESCRIPTION OF BUSINESS, BASIS OF PRESENTATION, SIGNIFICANT ACCOUNTING POLICIES AND RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS	10
	NOTE 2.	INVESTMENT SECURITIES	11
	NOTE 3.	LOANS RECEIVABLE	13
	NOTE 4.	ALLOWANCE FOR CREDIT LOSSES ON LOANS	21

	NOTE 5.	GOODWILL AND OTHER INTANGIBLE ASSETS	22
	NOTE 6.	DERIVATIVE FINANCIAL INSTRUMENTS	22
	NOTE 7.	STOCKHOLDERS’ EQUITY	23
	NOTE 8.	FAIR VALUE MEASUREMENTS	24
	NOTE 9.	CASH RESTRICTION	28
	NOTE 10.	COMMITMENTS AND CONTINGENCIES	28

ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS		29
	OVERVIEW		29
	RESULTS OF OPERATIONS		30
		AVERAGE BALANCES, YIELDS AND RATES PAID	30
		NET INTEREST INCOME AND MARGIN OVERVIEW	31
		PROVISION FOR CREDIT LOSSES OVERVIEW	32
		NONINTEREST INCOME OVERVIEW	33
		NONINTEREST EXPENSE OVERVIEW	33
		INCOME TAX EXPENSE OVERVIEW	34
	FINANCIAL CONDITION OVERVIEW		34
		INVESTMENT ACTIVITIES OVERVIEW	35
		LOAN PORTFOLIO OVERVIEW	35
		ALLOWANCE FOR CREDIT LOSSES ON LOANS OVERVIEW	37
		DEPOSITS OVERVIEW	37
		STOCKHOLDERS' EQUITY OVERVIEW	38
	REGULATORY REQUIREMENTS OVERVIEW		38
	LIQUIDITY AND CAPITAL RESOURCES		38
	CRITICAL ACCOUNTING POLICIES		39
	RECONCILIATIONS OF NON-GAAP MEASURES		39
ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK		40

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ITEM 4.	CONTROLS AND PROCEDURES	40
PART II.	OTHER INFORMATION	40
ITEM 1.	LEGAL PROCEEDINGS	40
ITEM 1A.	RISK FACTORS	40
ITEM 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	40
ITEM 3.	DEFAULTS UPON SENIOR SECURITIES	41
ITEM 4.	MINE SAFETY DISCLOSURES	41
ITEM 5.	OTHER INFORMATION	41
ITEM 6.	EXHIBITS	41
	SIGNATURES	41

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.


2021 Annual Form 10-K			Company's Annual Report on Form 10-K for the year ended December 31, 2021
ACL			Allowance for credit losses
AOCI			Accumulated other comprehensive income (loss), net

ASU			Accounting Standards Update
Bank			Heritage Bank
CECL			Current Expected Credit Loss
CMO			Collateralized Mortgage Obligation
Company			Heritage Financial Corporation
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

GAAP			U.S. Generally Accepted Accounting Principles
LIBOR			London Interbank Offering Rate
LIHTC			Low-Income Housing Tax Credit
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 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

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any forward-looking statements by, or on behalf of, us, and could negatively affect the Company’s operating results and stock price performance including, but not limited to:

•the effect of the COVID-19 pandemic, including on the Company’s credit quality and business operations, as well as its impact on general economic and financial market conditions and other uncertainties resulting from the COVID-19 pandemic, such as the extent and duration of the impact on public health, the U.S. and global economies, and consumer and corporate customers, including economic activity, employment levels and market liquidity;

•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, including as a result of the COVID-19 Pandemic;

•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 unaudited 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

•other economic, competitive, governmental, regulatory, and technological factors affecting our operations, pricing, products and services, and the other risks detailed from time to time in our filings with the SEC including our 2021 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)


	March 31, 2022		December 31, 2021
ASSETS
Cash on hand and in banks	$	87,907	$	61,377
Interest earning deposits	1,488,815		1,661,915
Cash and cash equivalents	1,576,722		1,723,292
Investment securities available for sale, at fair value, net (amortized cost of $1,085,016 and $883,832, respectively)	1,039,924		894,335
Investment securities held to maturity, at amortized cost, net (fair value of $384,822 and $376,331, respectively)	422,213		383,393
Total investment securities	1,462,137		1,277,728
Loans held for sale	1,142		1,476
Loans receivable	3,821,178		3,815,662
Allowance for credit losses on loans	(40,333)		(42,361)
Loans receivable, net	3,780,845		3,773,301
Other real estate owned	—		—
Premises and equipment, net	78,737		79,370
Federal Home Loan Bank stock, at cost	8,916		7,933
Bank owned life insurance	119,929		120,196
Accrued interest receivable	14,582		14,657
Prepaid expenses and other assets	190,592		183,543
Other intangible assets, net	9,273		9,977
Goodwill	240,939		240,939
Total assets	$	7,483,814	$	7,432,412
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits	$	6,491,500	$	6,394,290

Junior subordinated debentures	21,253		21,180
Securities sold under agreement to repurchase	49,069		50,839
Accrued expenses and other liabilities	100,543		111,671
Total liabilities	6,662,365		6,577,980
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; 35,102,372 and 35,105,779 shares issued and outstanding, respectively	550,096		551,798
Retained earnings	305,581		293,238
Accumulated other comprehensive (loss) income, net	(34,228)		9,396
Total stockholders’ equity	821,449		854,432
Total liabilities and stockholders’ equity	$	7,483,814	$	7,432,412

See accompanying Notes to Condensed Consolidated Financial Statements (Unaudited).

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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 March 31,
	2022		2021
INTEREST INCOME:
Interest and fees on loans	$	41,025	$	49,524
Taxable interest on investment securities	6,003		3,534
Nontaxable interest on investment securities	860		958
Interest on interest earning deposits	706		175
Total interest income	48,594		54,191
INTEREST EXPENSE:
Deposits	1,424		1,728
Junior subordinated debentures	194		187
Other borrowings	32		38
Total interest expense	1,650		1,953
Net interest income	46,944		52,238
Reversal of provision for credit losses	(3,577)		(7,199)
Net interest income after reversal of provision for credit losses	50,521		59,437
NONINTEREST INCOME:
Service charges and other fees	2,296		1,892
Card revenue	2,441		2,097
Gain on sale of investment securities, net	—		29
Gain on sale of loans, net	241		1,370
Interest rate swap fees	279		152
Bank owned life insurance income	1,695		656
Gain on sale of other assets, net	204		22
Other income	1,382		2,033
Total noninterest income	8,538		8,251
NONINTEREST EXPENSE:
Compensation and employee benefits	21,252		22,201
Occupancy and equipment	4,331		4,454
Data processing	4,061		3,812
Marketing	266		513
Professional services	699		1,270
State/municipal business and use taxes	796		972
Federal deposit insurance premium	600		589

Amortization of intangible assets	704		797
Other expense	3,011		2,634
Total noninterest expense	35,720		37,242
Income before income taxes	23,339		30,446
Income tax expense	3,582		5,102
Net income	$	19,757	$	25,344
Basic earnings per share	$	0.56	$	0.70
Diluted earnings per share	$	0.56	$	0.70
Dividends declared per share	$	0.21	$	0.20
Average number of basic shares outstanding	35,094,725		35,926,950
Average number of diluted shares outstanding	35,412,098		36,232,204

See accompanying Notes to Condensed Consolidated Financial Statements (Unaudited).

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)

(In thousands)


	Three Months Ended March 31,
	2022		2021
Net income	$	19,757	$	25,344
Change in fair value of investment securities available for sale, net of tax of $(12,113) and $(3,204), respectively	(43,482)		(11,534)
Amortization of net unrealized gain for the reclassification of investment securities available for sale to held to maturity, net of tax of $(39) and $0, respectively	(142)		—
Reclassification adjustment for net gain from sale of investment securities available for sale included in income, net of tax of $0 and $(6), respectively	—		(23)
Other comprehensive loss	(43,624)		(11,557)
Comprehensive (loss) income	$	(23,867)	$	13,787

See accompanying Notes to Condensed Consolidated Financial Statements (Unaudited).

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Unaudited)

(In thousands, except shares and per share amounts)


	Three Months Ended March 31, 2022
	Number of common shares	Common stock		Retained earnings		AOCI		Total stockholders’ equity
Balance at December 31, 2021	35,105,779	$	551,798	$	293,238	$	9,396	$	854,432

Restricted stock units vested	101,683	—		—		—		—
Stock-based compensation expense	—	950		—		—		950
Common stock repurchased	(105,090)	(2,652)		—		—		(2,652)
Net income	—	—		19,757		—		19,757
Other comprehensive loss, net of tax	—	—		—		(43,624)		(43,624)

Cash dividends declared on common stock ($0.21 per share)	—	—		(7,414)		—		(7,414)
Balance at March 31, 2022	35,102,372	$	550,096	$	305,581	$	(34,228)	$	821,449


	Three Months Ended March 31, 2021
	Number of common shares	Common stock		Retained earnings		AOCI		Total stockholders’ equity
Balance at December 31, 2020	35,912,243	$	571,021	$	224,400	$	25,018	$	820,439

Restricted stock units vested	92,320	—		—		—		—
Stock-based compensation expense	—	870		—		—		870
Common stock repurchased	(23,246)	(687)		—		—		(687)
Net income	—	—		25,344		—		25,344
Other comprehensive loss, net of tax	—	—		—		(11,557)		(11,557)

Cash dividends declared on common stock ($0.20 per share)	—	—		(7,258)		—		(7,258)
Balance at March 31, 2021	35,981,317	$	571,204	$	242,486	$	13,461	$	827,151

See accompanying Notes to Condensed Consolidated Financial Statements (Unaudited).

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HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(In thousands)


	Three Months Ended March 31,
	2022		2021
Cash flows from operating activities:
Net income	$	19,757	$	25,344
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation, amortization and accretion	(1,572)		(6,796)
Reversal of provision for credit losses	(3,577)		(7,199)

Stock-based compensation expense	950		870
Amortization of intangible assets	704		797
Origination of mortgage loans held for sale	(5,833)		(32,254)
Proceeds from sale of mortgage loans held for sale	6,408		31,755
Bank owned life insurance income	(1,695)		(656)

Valuation adjustment on interest rate swaps	(53)		(244)

Gain on sale of mortgage loans held for sale, net	(241)		(1,370)
Gain on sale of investment securities available for sale, net	—		(29)
Gain on sale of assets held for sale	(204)		(22)


Other	(3,716)		(1,115)
Net cash provided by operating activities	10,928		9,081
Cash flows from investing activities:
Loan originations and purchases, net of payments	(988)		(117,892)
Maturities and repayments of investment securities available for sale	42,327		62,675
Maturities and repayments of investment securities held to maturity	6,644		—
Purchase of investment securities available for sale	(244,409)		(166,038)
Purchase of investment securities held to maturity	(45,849)		—
Proceeds from sales of investment securities available for sale	—		1,248
Purchase of premises and equipment	(724)		(475)


Proceeds from sales of assets held for sale	1,173		1,731

Purchases of Federal Home Loan Bank stock	(983)		(1,272)

Purchases of bank owned life insurance	(105)		(105)


Capital contributions to low-income housing tax credit partnerships	—		(12,617)

Net cash used by investing activities	(242,914)		(232,745)
Cash flows from financing activities:
Net increase in deposits	97,210		421,708


Common stock cash dividends paid	(7,372)		(7,183)
Net (decrease) increase in securities sold under agreement to repurchase	(1,770)		820
Repurchase of common stock	(2,652)		(687)
Net cash provided by financing activities	85,416		414,658
Net (decrease) increase in cash and cash equivalents	(146,570)		190,994
Cash and cash equivalents at beginning of period	1,723,292		743,322
Cash and cash equivalents at end of period	$	1,576,722	$	934,316

Supplemental disclosures of cash flow information:
Cash paid for interest	$	1,555	$	1,889
Cash paid for income taxes, net of refunds	—		64






Investment in LIHTC partnership and related funding commitment	670		—
Right of use assets obtained in exchange for new operating lease liabilities	55		7,381
Purchase of investment securities available for sale not settled	—		5,000

See accompanying Notes to Condensed Consolidated Financial Statements (Unaudited).

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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, the Bank. The Bank is headquartered in Olympia, Washington and conducts business from its 49 branch offices 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.

(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 these unaudited Condensed Consolidated Financial Statements and accompanying Notes be read with the audited Consolidated Financial Statements and the accompanying Notes included in the 2021 Annual Form 10-K. In management's opinion, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2022 are not necessarily indicative of the results that may be expected for the year ending December 31, 2022.

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 the judgments, estimates and assumptions used in the preparation of the unaudited 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 the ACL on investment securities, management's estimate of the ACL on loans, management's estimate of the ACL on unfunded commitments, management's evaluation of goodwill impairment and management's estimate of the fair value of financial instruments.

The accompanying unaudited 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.

There have been reclassifications in certain prior year amounts in the unaudited Condensed Consolidated Statements of Financial Condition, the unaudited Condensed Consolidated Statements of Income and the unaudited Condensed Consolidated Statements of Cash Flows. Reclassifications had no effect on the prior year's net income or stockholders’ equity.

The significant accounting policies used in preparation of the unaudited Condensed Consolidated Financial Statements are disclosed in greater detail in the 2021 Annual Form 10-K. There have not been any material changes in the Company's significant accounting policies from those contained in the 2021 Annual Form 10-K during the three months ended March 31, 2022.

(d) Recently Issued or Adopted Accounting Pronouncements

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. Additionally, effective January 1, 2022, the bank is no longer initiating or renewing loans using LIBOR as an index. The Company does not expect this ASU to have a material impact on its business operations and the Consolidated Financial Statements.

FASB ASU 2022-02, Financial Instruments - Credit Losses (Topic 326): Troubled Debt Restructurings and Vintage Disclosures, was issued in March 2022. The ASU eliminates the accounting guidance for TDR loans by creditors while enhancing disclosure requirements for certain loan refinancings and restructurings by creditors when a borrower is experiencing financial difficulty. Additionally, the ASU requires public business entities to disclose current-period gross write-offs by year of origination for financing receivables and net investments in leases. These amendments are effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years, since Heritage previously adopted the amendments in ASU 2016-13, which is commonly referred to as the current expected credit loss methodology, on January 1, 2020. Early adoption is permitted and should be applied prospectively; however, the transition method related to the recognition and

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measurement of TDR loans may be applied under a modified retrospective transition method. The Company is evaluating the effect this ASU will have on its Consolidated Financial Statements and related disclosures.

(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.

There were no investment securities classified as trading at March 31, 2022 or December 31, 2021.

(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 AOCI:


	March 31, 2022
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
	(In thousands)
Investment securities available for sale:
U.S. government and agency securities	$	41,489	$	—	$	(1,934)	$	39,555
Municipal securities	215,488		1,964		(7,213)		210,239
Residential CMO and MBS	378,934		219		(20,744)		358,409
Commercial CMO and MBS	421,696		615		(17,806)		404,505
Corporate obligations	2,005		4		—		2,009
Other asset-backed securities	25,404		88		(285)		25,207
Total	$	1,085,016	$	2,890	$	(47,982)	$	1,039,924

Investment securities held to maturity:
U.S. government and agency securities	$	150,973	$	—	$	(14,344)	$	136,629

Residential CMO and MBS	54,486		—		(2,936)		51,550
Commercial CMO and MBS	216,754		—		(20,111)		196,643


Total	$	422,213	$	—	$	(37,391)	$	384,822


	December 31, 2021
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
	(In thousands)
Investment securities available for sale:
U.S. government and agency securities	$	21,494	$	55	$	(176)	$	21,373
Municipal securities	213,158		8,908		(854)		221,212
Residential CMO and MBS	307,366		2,111		(2,593)		306,884
Commercial CMO and MBS	313,169		3,891		(1,199)		315,861
Corporate obligations	2,007		7		—		2,014
Other asset-backed securities	26,638		369		(16)		26,991
Total	$	883,832	$	15,341	$	(4,838)	$	894,335

Investment securities held to maturity:
U.S. government and agency securities	$	141,011	$	120	$	(1,768)	$	139,363

Residential CMO and MBS	24,529		—		(153)		24,376
Commercial CMO and MBS	217,853		—		(5,261)		212,592


Total	$	383,393	$	120	$	(7,182)	$	376,331

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The amortized cost and fair value of investment securities at March 31, 2022, 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	$	8,733	$	8,777	$	—	$	—
Due after one year through five years	55,551		55,075		—		—
Due after five years through ten years	63,330		62,935		83,202		76,884
Due after ten years	131,368		125,016		67,771		59,745
Total investment securities due at a single maturity date	258,982		251,803		150,973		136,629
Mortgage-backed securities (1)	826,034		788,121		271,240		248,193
Total investment securities	$	1,085,016	$	1,039,924	$	422,213	$	384,822

(1) Mortgage-backed securities, which have prepayment provisions, are not assigned to maturity categories due to fluctuations in their payment speed.

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 March 31, 2022 and December 31, 2021.

(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 ACL on investment securities available for sale has not been recorded, aggregated by investment category and length of time the individual securities have been in a continuous unrealized loss position at the dates indicated:


	March 31, 2022
	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	$	38,002	$	(1,764)	$	1,553	$	(170)	$	39,555	$	(1,934)
Municipal securities	90,266		(5,206)		16,837		(2,007)		107,103		(7,213)
Residential CMO and MBS	307,811		(19,312)		24,731		(1,432)		332,542		(20,744)
Commercial CMO and MBS	307,598		(17,695)		1,717		(111)		309,315		(17,806)

Other asset-backed securities	12,476		(274)		1,004		(11)		13,480		(285)
Total	$	756,153	$	(44,251)	$	45,842	$	(3,731)	$	801,995	$	(47,982)


	December 31, 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	$	14,828	$	(176)	$	—	$	—	$	14,828	$	(176)
Municipal securities	29,774		(619)		9,351		(235)		39,125		(854)
Residential CMO and MBS	204,039		(2,470)		19,862		(123)		223,901		(2,593)
Commercial CMO and MBS	83,283		(1,161)		1,936		(38)		85,219		(1,199)


Other asset-backed securities	2,763		(9)		1,118		(7)		3,881		(16)
Total	$	334,687	$	(4,435)	$	32,267	$	(403)	$	366,954	$	(4,838)

The Company evaluated investment securities available for sale as of March 31, 2022 and December 31, 2021 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 March 31, 2022

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and December 31, 2021. 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 March 31, 2022 and December 31, 2021.

The Company also evaluated investment securities held to maturity for current expected credit losses as of March 31, 2022 and December 31, 2021. There were no investment securities held to maturity classified as nonaccrual or past due as of March 31, 2022 and December 31, 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 had 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 March 31, 2022 and December 31, 2021.

(d) Realized Gains and Losses

The following table presents the gross realized gains and losses on the sale of investment securities available for sale during the following periods:


	Three Months Ended March 31,
	2022		2021
	(In thousands)
Gross realized gains	$	—	$	29

(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 the dates indicated:


	March 31, 2022				December 31, 2021
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
	(In thousands)
Washington and Oregon state public deposits	$	139,817	$	134,625	$	128,216	$	130,217
Federal Reserve Bank credit facility	60,966		54,962		61,057		59,674
Securities sold under agreement to repurchase	63,088		59,144		59,887		59,655
Other securities pledged	53,673		50,333		56,419		55,633
Total	$	317,544	$	299,064	$	305,579	$	305,179

(f) Accrued Interest Receivable

Accrued interest receivable excluded from amortized cost on investment securities available for sale totaled $3.4 million and $3.5 million at March 31, 2022 and December 31, 2021, respectively. Accrued interest receivable excluded from amortized cost on investment securities held to maturity totaled $1.2 million and $1.1 million at March 31, 2022 and December 31, 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 months ended March 31, 2022 and 2021.

(3)Loans Receivable

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.

(a) Loan Origination/Risk Management

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 2021 Annual Form 10-K.

The Bank has certain lending policies and procedures in place that are designed to maximize loan income within an acceptable level of risk. Management reviews and approves these policies and procedures on a regular basis. A reporting system supplements the review process by providing management with frequent reports related to loan production, loan quality, concentrations of credit, loan delinquencies and nonperforming and criticized loans. The Bank also conducts internal loan reviews and validates the credit risk assessment on a periodic basis and presents the results of these reviews to management. The loan review process complements and reinforces the risk identification and assessment decisions made by loan officers and credit personnel.

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The amortized cost of loans receivable, net of ACL on loans, consisted of the following portfolio segments and classes at the dates indicated:


	March 31, 2022		December 31, 2021
	(In thousands)
Commercial business:
Commercial and industrial	$	651,523	$	621,567
SBA PPP	64,962		145,840
Owner-occupied CRE	935,705		931,150
Non-owner occupied CRE	1,505,483		1,493,099
Total commercial business	3,157,673		3,191,656
Residential real estate	223,442		164,582
Real estate construction and land development:
Residential	83,529		85,547
Commercial and multifamily	138,583		141,336
Total real estate construction and land development	222,112		226,883
Consumer	217,951		232,541
Loans receivable	3,821,178		3,815,662
Allowance for credit losses on loans	(40,333)		(42,361)
Loans receivable, net	$	3,780,845	$	3,773,301

Balances included in the amortized cost of loans receivable:
Unamortized net discount on acquired loans	$	(3,354)	$	(3,938)
Unamortized net deferred fee	$	(5,310)	$	(7,952)

(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, the Bank's loan portfolio is concentrated in commercial loans, including commercial business loans and commercial and multifamily real estate construction and land development loans. Commercial loans are generally considered as having more inherent risk of default than residential real estate loans or other consumer loans. Also, the commercial loan balance per borrower is typically larger than that for residential real estate loans and consumer loans, implying higher potential losses on an individual loan basis.

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 2021 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 any 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 accrual loans at risk of being classified as nonaccrual loans and includes all of

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our loans classified as nonaccrual. 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.

The following table presents the amortized cost of loans receivable by risk grade at the dates indicated:


	March 31, 2022
	Term Loans Amortized Cost Basis by Origination Year												Revolving Loans		Revolving Loans Converted (2)		Loans Receivable
	2022		2021(1)		2020		2019		2018		Prior
	(In thousands)
Commercial business:
Commercial and industrial
Pass	$	39,162	$	98,276	$	95,753	$	80,825	$	43,389	$	98,840	$	152,708	$	—	$	608,953
SM	245		1,090		957		5,350		1,306		3,108		1,350		—		13,406
SS	882		283		1,131		4,787		9,415		8,827		2,788		1,051		29,164

Total	40,289		99,649		97,841		90,962		54,110		110,775		156,846		1,051		651,523
SBA PPP
Pass	—		64,379		583		—		—		—		—		—		64,962




Owner-occupied CRE
Pass	30,659		177,833		91,600		181,568		75,692		327,070		—		—		884,422
SM	—		262		2,707		3,627		5,803		16,704		—		—		29,103
SS	—		—		683		—		3,770		17,727		—		—		22,180

Total	30,659		178,095		94,990		185,195		85,265		361,501		—		—		935,705
Non-owner occupied CRE
Pass	62,126		190,931		175,900		244,550		142,711		612,820		—		—		1,429,038
SM	—		—		—		3,686		—		16,802		—		—		20,488
SS	—		—		—		—		3,298		52,659		—		—		55,957

Total	62,126		190,931		175,900		248,236		146,009		682,281		—		—		1,505,483
Total commercial business
Pass	131,947		531,419		363,836		506,943		261,792		1,038,730		152,708		—		2,987,375
SM	245		1,352		3,664		12,663		7,109		36,614		1,350		—		62,997
SS	882		283		1,814		4,787		16,483		79,213		2,788		1,051		107,301

Total	133,074		533,054		369,314		524,393		285,384		1,154,557		156,846		1,051		3,157,673
Residential real estate
Pass(1)	24,214		129,511		26,840		19,330		4,766		18,602		—		—		223,263

SS	—		—		—		—		—		179		—		—		179

Total	24,214		129,511		26,840		19,330		4,766		18,781		—		—		223,442
Real estate construction and land development:
Residential
Pass	8,874		44,379		13,267		12,422		2,898		1,689		—		—		83,529




Commercial and multifamily
Pass	5,197		68,477		39,826		18,620		3,188		1,860		—		—		137,168
SM	—		—		—		60		—		212		—		—		272
SS	—		—		571		—		—		572		—		—		1,143

Total	5,197		68,477		40,397		18,680		3,188		2,644		—		—		138,583
Total real estate construction and land development
Pass	14,071		112,856		53,093		31,042		6,086		3,549		—		—		220,697
SM	—		—		—		60		—		212		—		—		272
SS	—		—		571		—		—		572		—		—		1,143

Total	14,071		112,856		53,664		31,102		6,086		4,333		—		—		222,112

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	March 31, 2022
	Term Loans Amortized Cost Basis by Origination Year												Revolving Loans		Revolving Loans Converted (2)		Loans Receivable
	2022		2021(1)		2020		2019		2018		Prior
Consumer
Pass	937		1,141		13,991		40,242		25,342		22,871		110,749		1		215,274

SS	—		—		175		534		419		1,549		—		—		2,677

Total	937		1,141		14,166		40,776		25,761		24,420		110,749		1		217,951
Loans receivable
Pass	171,169		774,927		457,760		597,557		297,986		1,083,752		263,457		1		3,646,609
SM	245		1,352		3,664		12,723		7,109		36,826		1,350		—		63,269
SS	882		283		2,560		5,321		16,902		81,513		2,788		1,051		111,300

Total	$	172,296	$	776,562	$	463,984	$	615,601	$	321,997	$	1,202,091	$	267,595	$	1,052	$	3,821,178

(1) The 2021 origination year includes $42.2 million of pass grade residential real estate loans purchased during the three months ended March 31, 2022 which were originated during the year ended December 31, 2021.

(2) Represents the loans receivable balance at March 31, 2022 which was converted from a revolving loan to an amortizing loan during the three months ended March 31, 2022.


	December 31, 2021
	Term Loans Amortized Cost Basis by Origination Year												Revolving Loans		Revolving Loans Converted (1)		Loans Receivable
	2021		2020		2019		2018		2017		Prior
	(In thousands)
Commercial business:
Commercial and industrial
Pass	$	95,960	$	100,193	$	94,657	$	54,707	$	28,558	$	77,294	$	127,651	$	1,035	$	580,055
SM	326		884		5,998		1,425		2,223		2,401		2,048		353		15,658
SS	1,443		1,287		5,912		2,809		2,526		6,907		4,402		568		25,854

Total	97,729		102,364		106,567		58,941		33,307		86,602		134,101		1,956		621,567
SBA PPP
Pass	139,253		6,587		—		—		—		—		—		—		145,840




Owner-occupied CRE
Pass	182,742		90,609		188,380		73,714		66,039		273,518		—		72		875,074
SM	264		—		3,079		7,521		3,937		16,724		—		—		31,525
SS	—		1,332		—		3,787		3,014		16,418		—		—		24,551

Total	183,006		91,941		191,459		85,022		72,990		306,660		—		72		931,150
Non-owner-occupied CRE
Pass	187,860		185,650		244,863		149,090		144,896		499,486		—		—		1,411,845
SM	—		—		5,674		—		15,482		2,400		—		—		23,556
SS	—		—		—		3,379		—		54,319		—		—		57,698

Total	187,860		185,650		250,537		152,469		160,378		556,205		—		—		1,493,099
Total commercial business
Pass	605,815		383,039		527,900		277,511		239,493		850,298		127,651		1,107		3,012,814
SM	590		884		14,751		8,946		21,642		21,525		2,048		353		70,739
SS	1,443		2,619		5,912		9,975		5,540		77,644		4,402		568		108,103

Total	607,848		386,542		548,563		296,432		266,675		949,467		134,101		2,028		3,191,656
Residential real estate
Pass	85,089		27,090		23,295		5,672		6,141		16,891		—		—		164,178

SS	—		—		—		—		—		404		—		—		404

Total	85,089		27,090		23,295		5,672		6,141		17,295		—		—		164,582

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	December 31, 2021
	Term Loans Amortized Cost Basis by Origination Year												Revolving Loans		Revolving Loans Converted (1)		Loans Receivable
	2021		2020		2019		2018		2017		Prior
	(In thousands)
Real estate construction and land development:
Residential
Pass	44,892		23,728		12,266		2,921		389		1,351		—		—		85,547




Commercial and multifamily
Pass	56,448		41,616		34,117		5,794		710		1,379		—		—		140,064
SM	—		—		68		—		—		213		—		—		281
SS	—		571		—		—		—		420		—		—		991

Total	56,448		42,187		34,185		5,794		710		2,012		—		—		141,336
Total real estate construction and land development
Pass	101,340		65,344		46,383		8,715		1,099		2,730		—		—		225,611
SM	—		—		68		—		—		213		—		—		281
SS	—		571		—		—		—		420		—		—		991

Total	101,340		65,915		46,451		8,715		1,099		3,363		—		—		226,883
Consumer
Pass	1,286		15,737		46,041		29,819		15,068		13,026		108,492		120		229,589

SS	—		181		657		476		542		1,043		36		17		2,952

Total	1,286		15,918		46,698		30,295		15,610		14,069		108,528		137		232,541
Loans receivable
Pass	793,530		491,210		643,619		321,717		261,801		882,945		236,143		1,227		3,632,192
SM	590		884		14,819		8,946		21,642		21,738		2,048		353		71,020
SS	1,443		3,371		6,569		10,451		6,082		79,511		4,438		585		112,450

Total	$	795,563	$	495,465	$	665,007	$	341,114	$	289,525	$	984,194	$	242,629	$	2,165	$	3,815,662

(1) Represents the loans receivable balance at December 31, 2021 which was converted from a revolving loan to an amortizing loan during the year ended December 31, 2021.

(d) Nonaccrual Loans

The following tables present the amortized cost of nonaccrual loans for the dates indicated:


	March 31, 2022
	Nonaccrual without ACL		Nonaccrual with ACL		Total Nonaccrual
	(In thousands)
Commercial business:
Commercial and industrial	$	4,694	$	1,921	$	6,615
Owner-occupied CRE	1,820		4,223		6,043
Non-owner occupied CRE	—		3,298		3,298
Total commercial business	6,514		9,442		15,956

Real estate construction and land development:

Commercial and multifamily	—		571		571


Total	$	6,514	$	10,013	$	16,527


	December 31, 2021
	Nonaccrual without ACL		Nonaccrual with ACL		Total Nonaccrual
	(In thousands)
Commercial business:
Commercial and industrial	$	6,454	$	3,827	$	10,281
Owner-occupied CRE	3,036		5,138		8,174

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	December 31, 2021
	Nonaccrual without ACL		Nonaccrual with ACL		Total Nonaccrual
	(In thousands)
Non-owner occupied CRE	1,273		3,379		4,652
Total commercial business	10,763		12,344		23,107
Residential real estate	—		47		47
Real estate construction and land development:

Commercial and multifamily	—		571		571

Consumer	—		29		29
Total	$	10,763	$	12,991	$	23,754

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 or sale of previously classified nonaccrual loans during the following periods:


	Three Months Ended March 31, 2022				Three Months Ended March 31, 2021
	Interest Income Reversed		Interest Income Recognized		Interest Income Reversed		Interest Income Recognized
	(In thousands)
Commercial business:
Commercial and industrial	$	(2)	$	139	$	(2)	$	63
Owner-occupied CRE	—		53		—		114
Non-owner occupied CRE	—		774		—		313
Total commercial business	(2)		966		(2)		490
Residential real estate	—		19		—		—
Real estate construction and land development:
Residential	—		—		—		73


Consumer	—		68		—		—
Total	$	(2)	$	1,053	$	(2)	$	563

For the three months ended March 31, 2022 and 2021, 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 or sale.

(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 March 31, 2022 and December 31, 2021 were as follows:


	March 31, 2022
	30-89 Days		90 Days or Greater		Total Past Due		Current		Loans Receivable
	(In thousands)
Commercial business:
Commercial and industrial	$	2,139	$	6,069	$	8,208	$	643,315	$	651,523
SBA PPP	150		—		150		64,812		64,962
Owner-occupied CRE	—		188		188		935,517		935,705
Non-owner occupied CRE	—		—		—		1,505,483		1,505,483
Total commercial business	2,289		6,257		8,546		3,149,127		3,157,673
Residential real estate	994		—		994		222,448		223,442
Real estate construction and land development:
Residential	—		—		—		83,529		83,529
Commercial and multifamily	—		571		571		138,012		138,583
Total real estate construction and land development	—		571		571		221,541		222,112

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	March 31, 2022
	30-89 Days		90 Days or Greater		Total Past Due		Current		Loans Receivable
	(In thousands)
Consumer	575		—		575		217,376		217,951
Total	$	3,858	$	6,828	$	10,686	$	3,810,492	$	3,821,178


	December 31, 2021
	30-89 Days		90 Days or Greater		Total Past Due		Current		Loans Receivable
	(In thousands)
Commercial business:
Commercial and industrial	$	1,858	$	6,821	$	8,679	$	612,888	$	621,567
SBA PPP	223		293		516		145,324		145,840
Owner-occupied CRE	2,397		112		2,509		928,641		931,150
Non-owner occupied CRE	—		—		—		1,493,099		1,493,099
Total commercial business	4,478		7,226		11,704		3,179,952		3,191,656
Residential real estate	420		10		430		164,152		164,582
Real estate construction and land development:
Residential	792		—		792		84,755		85,547
Commercial and multifamily	3,474		571		4,045		137,291		141,336
Total real estate construction and land development	4,266		571		4,837		222,046		226,883
Consumer	1,026		—		1,026		231,515		232,541
Total	$	10,190	$	7,807	$	17,997	$	3,797,665	$	3,815,662

There was one customer relationship and one SBA PPP loan 90 days or more past due and still accruing interest as of March 31, 2022 and December 31, 2021, respectively, with an amortized cost of $1.3 million and $293,000, respectively.

(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 March 31, 2022 and December 31, 2021 was as follows, with balances representing the amortized cost of the loan classified by the primary collateral category of each loan if multiple collateral sources secure the loan:


	March 31, 2022
	CRE		Farmland		Residential Real Estate		Total
	(In thousands)
Commercial business:
Commercial and industrial	$	1,379	$	2,492	$	695	$	4,566
Owner-occupied CRE	1,820		—		—		1,820

Total commercial business	3,199		2,492		695		6,386

Real estate construction and land development:

Commercial and multifamily	571		—		—		571


Total	$	3,770	$	2,492	$	695	$	6,957


	December 31, 2021
	CRE		Farmland		Residential Real Estate		Other		Total
	(In thousands)
Commercial business:
Commercial and industrial	$	1,499	$	4,362	$	1,036	$	245	$	7,142
Owner-occupied CRE	3,035		—		—		—		3,035
Non-owner occupied CRE	1,273		—		—		—		1,273
Total commercial business	5,807		4,362		1,036		245		11,450

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	December 31, 2021
	CRE		Farmland		Residential Real Estate		Other		Total
	(In thousands)
Real estate construction and land development:

Commercial and multifamily	571		—		—		—		571


Total	$	6,378	$	4,362	$	1,036	$	245	$	12,021

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 three months ended March 31, 2022, except changes due to additions or removals of loans from this classification.

(g) Troubled Debt Restructured Loans

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


	Three Months Ended March 31,
	2022			2021
	Number of Contracts (1)	Amortized Cost (1) (2)		Number of Contracts (1)	Amortized Cost (1) (2)
	(Dollars in thousands)
Commercial business:
Commercial and industrial	4	$	2,438	24	$	12,102
Owner-occupied CRE	—	—		2	4,660
Non-owner occupied CRE	—	—		1	1,979
Total commercial business	4	2,438		27	18,741
Residential real estate	—	—		1	180
Real estate construction and land development:

Commercial and multifamily	—	—		1	450

Consumer	5	55		15	379
Total	9	$	2,493	44	$	19,750

(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 months ended March 31, 2022 and 2021.

(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 loans of $56,000 and $2.4 million at March 31, 2022 and March 31, 2021, respectively, related to these TDR loans which were restructured during the three months ended March 31, 2022 and March 31, 2021, respectively.

The unfunded commitment to borrowers related to TDR loans was $3.8 million and $5.7 million at March 31, 2022 and December 31, 2021, respectively.

The following table presents loans that were modified in a TDR and subsequently defaulted within twelve months from the modification date during the periods indicated:


	Three Months Ended March 31,
	2022			2021
	Number of Contracts (1)	Amortized Cost (1)		Number of Contracts (1)	Amortized Cost (1)
	(Dollars in thousands)
Commercial business:
Commercial and industrial	—	$	—	2	$	2,792
Owner-occupied CRE	1	189		—	—

(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 three months ended March 31, 2022 and 2021.

During the three months ended March 31, 2022 the TDR loan defaulted because the borrower was more than 90 days delinquent on their scheduled loan payment. During the three months ended March 31, 2021 both TDR loans defaulted because each was past its modified maturity date and the borrower had not subsequently repaid the credits. The Bank chose not to

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further extend the maturity date on these TDR loans. The Bank had no ACL on loans at March 31, 2022 and $94,000 at March 31, 2021 related to these TDR loans which defaulted during the three months ended March 31, 2022 and 2021.

(h) Accrued interest receivable on loans receivable

Accrued interest receivable on loans receivable totaled $9.9 million and $10.1 million at March 31, 2022 and December 31, 2021, 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 March 31, 2022, 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

The baseline loss rates used to calculate the ACL on loans at March 31, 2022 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 three months ended March 31, 2022. 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 March 31, 2022 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 three months ended March 31, 2022.

The reasonable and supportable period and subsequent reversion period used in the CECL model was five quarters and two quarters, respectively, at December 31, 2021. There were no changes to these assumptions during the three months ended March 31, 2022. Management believes forecasts beyond this seven quarter time period tend to diverge in economic assumptions and may be less comparable to actual future events. As the length of the reasonable and supportable period increases, the degree of judgment involved in estimating the allowance increases.

During the three months ended March 31, 2022, the ACL on loans decreased $2.0 million, or 4.8%, due primarily to a reversal of provision for credit losses on loans of $2.5 million driven by a reduction in the ACL on loans individually evaluated for losses and their related ACL as well as changes in the loan mix and continued improvement in forecasted economic indicators used to calculate credit losses. The ACL on loans at March 31, 2022 and December 31, 2021 did not include a reserve for SBA PPP loans as these loans are fully guaranteed by the SBA.

A summary of the changes in the ACL on loans during the three months ended March 31, 2022 and 2021 is as follows:


	Three Months Ended March 31,
	2022		2021
	(In thousands)
Balance at the beginning of the year	$	42,361	$	70,185
Charge-offs	(355)		(187)
Recoveries of loans previously charged-off	849		362
Reversal of provision for credit losses on loans	(2,522)		(6,135)
Balance at the end of the year	$	40,333	$	64,225

The following tables detail the activity in the ACL on loans by segment and class for the periods indicated:


	Three Months Ended March 31, 2022
	Beginning Balance		Charge-offs		Recoveries		(Reversal of) Provision for Credit Losses		Ending Balance
	(In thousands)
Commercial business:
Commercial and industrial	$	17,777	$	(163)	$	272	$	(2,621)	$	15,265
Owner-occupied CRE	6,411		(36)		—		710		7,085
Non-owner occupied CRE	8,861		—		—		721		9,582
Total commercial business	33,049		(199)		272		(1,190)		31,932
Residential real estate	1,409		(30)		3		421		1,803
Real estate construction and land development:
Residential	1,304		—		8		(188)		1,124

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	Three Months Ended March 31, 2022
	Beginning Balance		Charge-offs		Recoveries		(Reversal of) Provision for Credit Losses		Ending Balance
	(In thousands)
Commercial and multifamily	3,972		—		—		(797)		3,175
Total real estate construction and land development	5,276		—		8		(985)		4,299
Consumer	2,627		(126)		566		(768)		2,299
Total	$	42,361	$	(355)	$	849	$	(2,522)	$	40,333


	Three Months Ended March 31, 2021
	Beginning Balance		Charge-offs		Recoveries		(Reversal of) Provision for Credit Losses		Ending Balance
	(In thousands)
Commercial business:
Commercial and industrial	$	30,010	$	(1)	$	205	$	(8,444)	$	21,770
Owner-occupied CRE	9,486		—		2		976		10,464
Non-owner occupied CRE	10,112		—		—		2,858		12,970
Total commercial business	49,608		(1)		207		(4,610)		45,204
Residential real estate	1,591		—		—		(189)		1,402
Real estate construction and land development:
Residential	1,951		—		16		81		2,048
Commercial and multifamily	11,141		(1)		—		83		11,223
Total real estate construction and land development	13,092		(1)		16		164		13,271
Consumer	5,894		(185)		139		(1,500)		4,348
Total	$	70,185	$	(187)	$	362	$	(6,135)	$	64,225

(5)Goodwill and Other Intangible Assets

(a) Goodwill

There were no additions to goodwill during the three months ended March 31, 2022 and 2021. Additionally, 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 the carrying amount of goodwill exceeds its implied fair value. The Company performed an annual impairment assessment as of December 31, 2021 and concluded that there was no impairment.

(b) Other Intangible Assets

Other intangible assets represent core deposit intangible acquired in business combinations with estimated useful lives of ten years. There were no additions to other intangible assets during the three months ended March 31, 2022 and 2021.

(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 unaudited Condensed Consolidated Statements of Income. The fair value of derivative positions outstanding is included in Prepaid expenses and other assets and Accrued expenses and other liabilities in the unaudited Condensed 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 unaudited Condensed Consolidated Statements of Income, but typically net to zero based on the identical back-to-

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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 the dates indicated:


	March 31, 2022				December 31, 2021
	Notional Amounts		Estimated Fair Value		Notional Amounts		Estimated Fair Value
	(In thousands)
Non-hedging interest rate derivatives
Interest rate swap asset (1)	$	319,526	$	12,975	$	322,726	$	15,219
Interest rate swap liability (1)	319,526		(12,989)		322,726		(15,286)

(1) The estimated fair value of derivatives with customers was $(8.7) million and $9.8 million as of March 31, 2022 and December 31, 2021, respectively. The estimated fair value of derivatives with third-parties was $8.7 million and $(9.8) million as of March 31, 2022 and December 31, 2021, 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 for the periods indicated:


	Three Months Ended March 31,
	2022		2021
	(In thousands, except shares)

Net income	$	19,757	$	25,344


Basic:
Weighted average common shares outstanding	35,094,725		35,926,950


Diluted:
Basic weighted average common shares outstanding	35,094,725		35,926,950
Effect of potentially dilutive common shares (1)	317,373		305,254
Total diluted weighted average common shares outstanding	35,412,098		36,232,204
Potentially dilutive shares that were excluded from the computation of diluted earnings per share because to do so would be anti-dilutive (2)	17,041		15,538

(1)Represents the effect of the vesting of restricted stock units.

(2) Anti-dilution occurs when the unrecognized compensation cost per share of a restricted stock unit exceeds the market price of the Company’s stock.

(b) Dividends

The timing and amount of cash dividends paid on the Company's common stock depends on the Company’s earnings, capital requirements, financial condition and other relevant factors. Dividends on common stock from the Company depend substantially upon receipt of dividends from the Bank, which is the Company’s predominant source of income.

The following table summarizes the dividend activity during the three months ended March 31, 2022 and the calendar year 2021:

Declared

Cash Dividend per Share

Record Date

Paid Date

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

October 20, 2021

$0.21

November 3, 2021

November 17, 2021

January 26, 2022

$0.21

February 9, 2022

February 23, 2022

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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 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. 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 March 31,
	2022		2021		Plan Total(1)





Repurchased shares	80,559		—		1,141,309
Stock repurchase average share price	$	25.17	$	—	$	23.92

(1)Represents shares repurchased and average price per share paid during the duration of the 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 March 31,
	2022		2021
Repurchased shares to pay withholding taxes	24,531		23,246
Stock repurchase to pay withholding taxes average share price	$	25.46	$	29.54

(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

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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's internal appraisal department reviews and approves 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 March 31, 2022 and December 31, 2021, 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 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 unaudited Condensed Consolidated Statements of Financial Condition with any valuation adjustment recorded within other noninterest expense on the unaudited Condensed 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 classification of the inputs for determining fair value. Additionally, the fair value of branches held for sale can be adjusted based on executed agreements of sale to be completed at a future date.

Recurring Basis

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


	March 31, 2022
	Total		Level 1		Level 2		Level 3
	(In thousands)
Assets
Investment securities available for sale:
U.S. government and agency securities	$	39,555	$	—	$	39,555	$	—
Municipal securities	210,239		—		210,239		—
Residential CMO and MBS	358,409		—		358,409		—
Commercial CMO and MBS	404,505		—		404,505		—
Corporate obligations	2,009		—		2,009		—
Other asset-backed securities	25,207		—		25,207		—
Total investment securities available for sale	1,039,924		—		1,039,924		—
Equity security	224		224		—		—
Derivative assets - interest rate swaps	12,975		—		12,975		—
Liabilities
Derivative liabilities - interest rate swaps	$	12,989	$	—	12,989		$	—

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	December 31, 2021
	Total		Level 1		Level 2		Level 3
	(In thousands)
Assets
Investment securities available for sale:
U.S. government and agency securities	$	21,373	$	—	$	21,373	$	—
Municipal securities	221,212		—		221,212		—
Residential CMO and MBS	306,884		—		306,884		—
Commercial CMO and MBS	315,861		—		315,861		—
Corporate obligations	2,014		—		2,014		—
Other asset-backed securities	26,991		—		26,991		—
Total investment securities available for sale	894,335		—		894,335		—
Equity security	240		240		—		—
Derivative assets - interest rate swaps	15,219		—		15,219		—
Liabilities
Derivative liabilities - interest rate swaps	$	15,286	$	—	$	15,286	$	—

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 represent assets measured at fair value on a nonrecurring basis at the dates indicated:


			Fair Value at March 31, 2022
	Basis(1)		Total		Level 1		Level 2		Level 3
	(In thousands)
Collateral-dependent loans:
Commercial business:
Commercial and industrial	$	336	$	215	$	—	$	—	$	215




Real estate construction and land development:

Commercial and multifamily	991		534		—		—		534





Total assets measured at fair value on a nonrecurring basis	$	1,327	$	749	$	—	$	—	$	749

(1) Basis represents the outstanding principal balance of collateral-dependent loans.


			Fair Value at December 31, 2021
	Basis(1)		Total		Level 1		Level 2		Level 3
	(In thousands)
Collateral-dependent loans:
Commercial business:
Commercial and industrial	$	1,911	$	1,049	$	—	$	—	$	1,049
Owner-occupied CRE	613		189		—		—		189

Total commercial business	2,524		1,238		—		—		1,238

Real estate construction and land development:

Commercial and multifamily	991		$	534	—		—		534


Total	3,515		1,772		—		—		1,772
Prepaid expenses and other assets:
Branch held for sale (2)	698		698		—		—		698
Total assets measured at fair value on a nonrecurring basis	$	4,213	$	2,470	$	—	$	—	$	2,470

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

(2) In December 2021, one branch was written down to its net realizable value concurrent with the signing of an agreement for sale at a future date.

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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 March 31,
	2022		2021
	(In thousands)
Collateral-dependent loans:
Commercial business:
Commercial and industrial	$	(12)	$	(34)




Real estate construction and land development:

Commercial and multifamily	—		(14)
Total	(12)		(48)
Prepaid expenses and other assets:
Branch held for sale	—		20
Net loss from nonrecurring fair value adjustments	$	(12)	$	(28)

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:

March 31, 2022

Fair
Value

Valuation
Technique(s)

Unobservable Input(s)

Range of Inputs; Weighted
Average

(Dollars in thousands)

Collateral-dependent loans

749

Market approach

Adjustment for differences between the comparable sales

35.0% - (11.0)%; 13.8%

December 31, 2021

Fair
Value

Valuation
Technique(s)

Unobservable Input(s)

Range of Inputs; Weighted
Average

(Dollars in thousands)

Collateral-dependent loans

1,772

Market approach

Adjustment for differences between the comparable sales

35.0% - (11.0%); 13.8%

Branch held for sale

698

Market approach

Sale agreement

Not applicable

(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:


	March 31, 2022
	Carrying Value		Fair Value		Fair Value Measurements Using:
					Level 1		Level 2		Level 3
	(In thousands)
Financial Assets:
Cash and cash equivalents	$	1,576,722	$	1,576,722	$	1,576,722	$	—	$	—
Investment securities available for sale	1,039,924		1,039,924		—		1,039,924		—
Investment securities held to maturity	422,213		384,822		—		384,822		—
Loans held for sale	1,142		1,181		—		1,181		—
Loans receivable, net	3,780,845		3,808,897		—		—		3,808,897
Accrued interest receivable	14,582		14,582		128		4,593		9,861

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	March 31, 2022
	Carrying Value		Fair Value		Fair Value Measurements Using:
					Level 1		Level 2		Level 3
	(In thousands)
Derivative assets - interest rate swaps	12,975		12,975		—		12,975		—
Equity security	224		224		224		—		—
Financial Liabilities:
Non-maturity deposits	$	6,163,084	$	6,163,084	$	6,163,084	$	—	$	—
Certificates of deposit	328,416		329,358		—		—		329,358

Securities sold under agreement to repurchase	49,069		49,069		49,069		—		—
Junior subordinated debentures	21,253		18,750		—		—		18,750
Accrued interest payable	75		75		33		15		27
Derivative liabilities - interest rate swaps	12,989		12,989		—		12,989		—


	December 31, 2021
	Carrying Value		Fair Value		Fair Value Measurements Using:
					Level 1		Level 2		Level 3
	(In thousands)
Financial Assets:
Cash and cash equivalents	$	1,723,292	$	1,723,292	$	1,723,292	$	—	$	—
Investment securities available for sale	894,335		894,335		—		894,335		—
Investment securities held to maturity	383,393		376,331		—		376,331		—
Loans held for sale	1,476		1,527		—		1,527		—
Loans receivable, net	3,773,301		3,849,602		—		—		3,849,602
Accrued interest receivable	14,657		14,657		14		4,582		10,061
Derivative assets - interest rate swaps	15,219		15,219		—		15,219		—
Equity security	240		240		240		—		—
Financial Liabilities:
Non-maturity deposits	$	6,038,498	$	6,038,498	$	6,038,498	$	—	$	—
Certificates of deposit	342,839		344,025		—		344,025		—

Securities sold under agreement to repurchase	50,839		50,839		50,839		—		—
Junior subordinated debentures	21,180		18,750		—		—		18,750
Accrued interest payable	73		73		33		19		21
Derivative liabilities - interest rate swaps	15,286		15,286		—		15,286		—

(9)Cash Restriction

The Bank had no cash restrictions at March 31, 2022 and had restricted cash included in interest earning deposits of $9.8 million at December 31, 2021 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 unaudited 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.

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


	March 31, 2022		December 31, 2021
	(In thousands)
Commercial business:
Commercial and industrial	$	537,566	$	570,156
Owner-occupied CRE	7,932		2,252
Non-owner occupied CRE	13,620		7,487
Total commercial business	559,118		579,895

Real estate construction and land development:
Residential	55,599		51,838
Commercial and multifamily	194,678		209,217
Total real estate construction and land development	250,277		261,055
Consumer	288,621		285,010
Total outstanding commitments	$	1,098,016	$	1,125,960

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


	Three Months Ended
	March 31, 2022		March 31, 2021
	(In thousands)
Balance, beginning of period	$	2,607	$	4,681
Reversal of provision for credit losses on unfunded commitments	(1,055)		(1,064)
Balance, end of period	$	1,552	$	3,617

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 months ended March 31, 2022. The information contained in this section should be read together with the unaudited Condensed Consolidated Financial Statements and the accompanying Notes included herein, the Forward-Looking Statements included herein and the December 31, 2021 audited Consolidated Financial Statements and the accompanying Notes included in our 2021 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. We additionally originate for sale or for investment purposes residential real estate loans on single family properties located primarily in our markets. During the three months ended March 31, 2020, we ceased indirect auto loan originations, included in our consumer loan portfolio.

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

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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 methodology.

Net income is also affected by noninterest income and noninterest expense. Noninterest income primarily consists of service charges and other fees, card revenue 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 of products and services, internet and mobile banking channels and 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, including 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 March 31, 2022, all Bank branches are open with normal hours and all employees have returned to their go-forward working environments. 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 61 branches during the year ended December 31, 2021, including the consolidation of eight branches and four branches during the three months ended March 31, 2021 and December 31, 2021, respectively. 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.

Results of Operations

Comparison of quarter ended March 31, 2022 to the comparable quarter in the prior year

Net income was $19.8 million, or $0.56 per diluted common share, for the three months ended March 31, 2022 compared to $25.3 million, or $0.70 per diluted common share, for the three months ended March 31, 2021. Net income decreased $5.6 million, or 22.0%, due primarily to lower interest income and fees on loans. The Company’s efficiency ratio was 64.38% for the three months ended March 31, 2022 compared to 61.57% for the three months ended March 31, 2021.

Average Balances, Yields and Rates Paid

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


	Three Months Ended March 31,
	2022						2021						Change
	Average Balance(1)		Interest Earned/ Paid		Average Yield/ Rate		Average Balance(1)		Interest Earned/ Paid		Average Yield/ Rate		Average Balance(1)		Interest Earned/ Paid		Average Yield/ Rate
	(Dollars in thousands)
Interest Earning Assets:
Loans receivable, net (2)(3)	$	3,773,325	$	41,025	4.41	%	$	4,490,499	$	49,524	4.47	%	$	(717,174)	$	(8,499)	(0.06)	%
Taxable securities	1,271,557		6,003		1.91		674,268		3,534		2.13		597,289		2,469		(0.22)
Nontaxable securities (3)	146,409		860		2.38		163,914		958		2.37		(17,505)		(98)		0.01
Interest earning deposits	1,503,287		706		0.19		713,885		175		0.10		789,402		531		0.09
Total interest earning assets	6,694,578		48,594		2.94	%	6,042,566		54,191		3.64	%	652,012		(5,597)		(0.70)	%
Noninterest earning assets	740,209						757,059						(16,850)
Total assets	$	7,434,787					$	6,799,625					$	635,162

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	Three Months Ended March 31,
	2022						2021						Change
	Average Balance(1)		Interest Earned/ Paid		Average Yield/ Rate		Average Balance(1)		Interest Earned/ Paid		Average Yield/ Rate		Average Balance(1)		Interest Earned/ Paid		Average Yield/ Rate
	(Dollars in thousands)
Interest Bearing Liabilities:
Certificates of Deposit	$	336,353	$	338	0.41	%	$	393,268	$	559	0.58	%	$	(56,915)	$	(221)	(0.17)	%
Savings accounts	646,684		87		0.05		560,094		95		0.07		86,590		(8)		(0.02)
Interest bearing demand and money market accounts	3,066,320		999		0.13		2,732,134		1,074		0.16		334,186		(75)		(0.03)
Total interest bearing deposits	4,049,357		1,424		0.14		3,685,496		1,728		0.19		363,861		(304)		(0.05)
Junior subordinated debentures	21,214		194		3.71		20,913		187		3.63		301		7		0.08
Securities sold under agreement to repurchase	50,017		32		0.26		40,074		38		0.38		9,943		(6)		(0.12)

Total interest bearing liabilities	4,120,588		1,650		0.16	%	3,746,483		1,953		0.21	%	374,105		(303)		(0.05)	%
Noninterest bearing demand deposits	2,359,451						2,105,039						254,412
Other noninterest bearing liabilities	108,663						121,082						(12,419)
Stockholders’ equity	846,085						827,021						19,064
Total liabilities and stock-holders’ equity	$	7,434,787					$	6,799,625					$	635,162
Net interest income and spread			$	46,944	2.78	%			$	52,238	3.43	%			$	(5,294)	(0.65)	%
Net interest margin					2.84	%					3.51	%					(0.67)	%

(1) Average balances are calculated using daily balances.

(2) Average loan receivable, net includes loans held for sale and loans classified as nonaccrual, which carry a zero yield. Interest earned on loans receivable, net includes the amortization of net deferred loan fees of $3.4 million and $7.3 million for the three months ended March 31, 2022 and 2021, respectively.

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

Net Interest Income and 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' equity; market interest rate fluctuations; and asset quality.

The following table provides the changes in net interest income for the three months ended March 31, 2022 compared to the three months ended March 31, 2021 due to changes in average asset and liability balances (volume), changes in average rates (rate) and changes attributable to the combined effect of volume and interest rates allocated proportionately to the absolute value of changes due to volume and changes due to interest rates:


	Increase (Decrease) Due to Changes In:
	Volume		Rate		Total		% Change
	(Dollars in thousands)
Interest Earning Assets:
Loans receivable, net	$	(7,774)	$	(725)	$	(8,499)	(17.2)	%
Taxable securities	2,851		(382)		2,469		69.9
Nontaxable securities	(103)		5		(98)		(10.2)
Interest earning deposits	290		241		531		303.4
Total interest income	$	(4,736)	$	(861)	$	(5,597)	(10.3)	%
Interest Bearing Liabilities:
Certificates of deposit	$	(73)	$	(148)	$	(221)	(39.5)	%
Savings accounts	13		(21)		(8)		(8.4)
Interest bearing demand and money market accounts	122		(197)		(75)		(7.0)
Total interest bearing deposits	62		(366)		(304)		(17.6)

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	Increase (Decrease) Due to Changes In:
	Volume		Rate		Total		% Change
	(Dollars in thousands)
Junior subordinated debentures	3		4		7		3.7
Securities sold under agreement to repurchase	8		(14)		(6)		(15.8)

Total interest expense	$	73	$	(376)	$	(303)	(15.5)	%
Net interest income	$	(4,809)	$	(485)	$	(5,294)	(10.1)	%

Comparison of quarter ended March 31, 2022 to the comparable quarter in the prior year

Net interest income decreased due primarily to a decrease in deferred SBA PPP loan fees recognized due to a decrease in the volume of forgiven SBA PPP loans as well as a slightly lower loan yield. The decrease in net interest income was offset partially by a higher average balance of taxable investment securities.

Net interest margin decreased due primarily to the change in the mix of total interest earning assets, including a significant increase in the balance of lower yielding average interest earning deposits, and secondarily due to lower loan yield.

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
	March 31, 2022		March 31, 2021

Loan yield (GAAP)	4.41	%	4.47	%
Exclude impact from SBA PPP loans	(0.21)		0.01
Exclude impact from incremental accretion on purchased loans	(0.06)		(0.12)
Loan yield, excluding SBA PPP loans and incremental accretion on purchased loans (non-GAAP) (1)	4.14	%	4.36	%

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

The impact to loan yield from recoveries of interest and fees on loans classified as nonaccrual was 11 basis points during the first quarter of 2022, including the recovery of $774,000 from a non-owner occupied CRE relationship, compared to five basis points for the same quarter in 2021.

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 unaudited Condensed Consolidated Statements of Income as the provision for credit losses. The ACL on unfunded commitments is included on the unaudited Condensed Consolidated Statements of Financial Condition within accrued expenses and other liabilities.

Comparison of quarter ended March 31, 2022 to the comparable quarter in the prior year

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


	Three Months Ended March 31,
	2022		2021		Change		% Change
	(Dollars in thousands)
Reversal of provision for credit losses on loans	$	(2,522)	$	(6,135)	$	3,613	(58.9)	%
Reversal of provision for credit losses on unfunded commitments	(1,055)		(1,064)		9		(0.8)
Reversal of provision for credit losses	$	(3,577)	$	(7,199)	$	3,622	(50.3)	%

The reversal of provision for credit losses recognized during the three months ended March 31, 2022 was due primarily to a reduction of loans individually evaluated for losses and their related ACL as well as changes in the loan mix and continued improvement in forecasted economic indicators used to calculate credit losses.

The reversal of provision for credit losses recognized during the three months ended March 31, 2021 was due primarily to improvements in the economic forecast at March 31, 2021 as compared to the forecast for at December 31, 2020 and secondarily due to a decrease in total loans receivable, excluding SBA PPP loans.

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Noninterest Income Overview

Comparison of quarter ended March 31, 2022 to the comparable quarter in the prior year

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


	Three Months Ended March 31,
	2022		2021		Change		% Change
	(Dollars in thousands)
Service charges and other fees	$	2,296	$	1,892	$	404	21.4	%
Card revenue	2,441		2,097		344		16.4
Gain on sale of investment securities, net	—		29		(29)		(100.0)
Gain on sale of loans, net	241		1,370		(1,129)		(82.4)
Interest rate swap fees	279		152		127		83.6
Bank owned life insurance income	1,695		656		1,039		158.4
Gain on sale of other assets, net	204		22		182		827.3
Other income	1,382		2,033		(651)		(32.0)
Total noninterest income	$	8,538	$	8,251	$	287	3.5	%

Noninterest income increased slightly due primarily to an increase in bank owned life insurance income due to the recognition of a death benefit of $1.0 million during the current quarter as well as increases in service charges and other fees and card revenue reflecting increased customer transactions as businesses reopened in our market areas, offset partially by reduced gain on sale of loans, net as sales volume of secondary market mortgage loans declined.

Noninterest Expense Overview

Comparison of quarter ended March 31, 2022 to the comparable quarter in the prior year

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


	Three Months Ended March 31,
	2022		2021		Change		% Change
	(Dollars in thousands)
Compensation and employee benefits	$	21,252	$	22,201	$	(949)	(4.3)	%
Occupancy and equipment	4,331		4,454		(123)		(2.8)
Data processing	4,061		3,812		249		6.5
Marketing	266		513		(247)		(48.1)
Professional services	699		1,270		(571)		(45.0)
State/municipal business and use tax	796		972		(176)		(18.1)
Federal deposit insurance premium	600		589		11		1.9

Amortization of intangible assets	704		797		(93)		(11.7)
Other expense	3,011		2,634		377		14.3
Total noninterest expense	$	35,720	$	37,242	$	(1,522)	(4.1)	%

Noninterest expense decreased due primarily to a decrease in compensation and employee benefits from lower headcount and secondarily due to a decrease in professional services which was elevated during the first quarter of 2021 due to costs associated with our participation in the second tranche of the SBA PPP.

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Income Tax Expense Overview

Comparison of quarter ended March 31, 2022 to the comparable quarter in the prior year

The following table presents the income tax expense, related metrics and their changes for the periods indicated:


	Three Months Ended March 31,
	2022			2021			Change			% Change
	(Dollars in thousands)
Income before income taxes	$	23,339		$	30,446		$	(7,107)		(23.3)	%
Income tax expense	$	3,582		$	5,102		$	(1,520)		(29.8)	%
Effective income tax rate	15.3		%	16.8		%	(1.5)		%	(8.9)	%

Income tax expense decreased due primarily to the change in income before income taxes earned between the periods. Additionally, the effective income tax rate was lower due primarily to lower estimated pre-tax income for the year ended December 31, 2022, 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.

Financial Condition Overview

The table below provides a comparison of the changes in the Company's financial condition at the periods indicated:


	March 31, 2022		December 31, 2021		Change		% Change
	(Dollars in thousands)
Assets
Cash and cash equivalents	$	1,576,722	$	1,723,292	$	(146,570)	(8.5)	%
Investment securities available for sale, at fair value, net	1,039,924		894,335		145,589		16.3
Investment securities held to maturity, at amortized cost, net	422,213		383,393		38,820		10.1
Loans held for sale	1,142		1,476		(334)		(22.6)
Loans receivable, net	3,780,845		3,773,301		7,544		0.2

Premises and equipment, net	78,737		79,370		(633)		(0.8)
Federal Home Loan Bank stock, at cost	8,916		7,933		983		12.4
Bank owned life insurance	119,929		120,196		(267)		(0.2)
Accrued interest receivable	14,582		14,657		(75)		(0.5)
Prepaid expenses and other assets	190,592		183,543		7,049		3.8
Other intangible assets, net	9,273		9,977		(704)		(7.1)
Goodwill	240,939		240,939		—		—
Total assets	$	7,483,814	$	7,432,412	$	51,402	0.7	%
Liabilities and Stockholders' Equity
Deposits	$	6,491,500	$	6,394,290	$	97,210	1.5	%

Junior subordinated debentures	21,253		21,180		73		0.3
Securities sold under agreement to repurchase	49,069		50,839		(1,770)		(3.5)
Accrued expenses and other liabilities	100,543		111,671		(11,128)		(10.0)
Total liabilities	6,662,365		6,577,980		84,385		1.3
Common stock	550,096		551,798		(1,702)		(0.3)
Retained earnings	305,581		293,238		12,343		4.2
Accumulated other comprehensive (loss) income, net	(34,228)		9,396		(43,624)		(464.3)
Total stockholders' equity	821,449		854,432		(32,983)		(3.9)
Total liabilities and stockholders' equity	$	7,483,814	$	7,432,412	$	51,402	0.7	%

Total assets increased due primarily to an increase in total investment securities following an increase in total deposits, which is discussed in more detail in the "Deposit Activities Overview" section below. Partially offsetting this increase was a decrease in AOCI following an increase in market interest rates during the three months ended March 31, 2022 which negatively impacted the fair value of our investment securities available for sale at March 31, 2022.

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Investment Activities Overview

The following table provides information regarding our investment securities at the dates indicated:


	March 31, 2022				December 31, 2021
	Balance		% of Total		Balance		% of Total		Change		% Change
	(Dollars in thousands)
Investment securities available for sale, at fair value:
U.S. government and agency securities	$	39,555	2.7	%	$	21,373	1.7	%	$	18,182	85.1	%
Municipal securities	210,239		14.4		221,212		17.3	%	(10,973)		(5.0)
Residential CMO and MBS	358,409		24.5		306,884		24.0	%	51,525		16.8
Commercial CMO and MBS	404,505		27.7		315,861		24.7	%	88,644		28.1
Corporate obligations	2,009		0.1		2,014		0.2	%	(5)		(0.2)
Other asset-backed securities	25,207		1.7		26,991		2.1	%	(1,784)		(6.6)
Total	$	1,039,924	71.1	%	$	894,335	70.0	%	$	145,589	16.3	%

Investment securities held to maturity, at amortized cost:
U.S. government and agency securities	$	150,973	10.3	%	$	141,011	11.0	%	$	9,962	7.1	%

Residential CMO and MBS	54,486		3.7		24,529		1.9		29,957		122.1
Commercial CMO and MBS	216,754		14.9		217,853		17.1		(1,099)		(0.5)


Total	$	422,213	28.9	%	$	383,393	30.0	%	$	38,820	10.1	%

Total investment securities	$	1,462,137	100.0	%	$	1,277,728	100.0	%	$	184,409	14.4	%

Total investment securities increased due primarily to purchases to deploy excess liquidity into higher yielding assets, offset partially by a $55.6 million decrease in the fair value of investment securities available for sale resulting in an unrealized loss at March 31, 2022 compared to an unrealized gain at December 31, 2021 following an increase in market rates during the quarter.

Loan Portfolio Overview

Changes by loan type

The Bank originates a wide variety of loans with a focus on commercial business loans. The following table provides information about our loan portfolio by type of loan at the dates indicated:


	March 31, 2022				December 31, 2021
	Amortized Cost		% of Loans Receivable		Amortized Cost		% of Loans Receivable		Change		% Change
	(Dollars in thousands)
Commercial business:
Commercial and industrial	$	651,523	17.1	%	$	621,567	16.3	%	$	29,956	4.8	%
SBA PPP	64,962		1.7		145,840		3.8		(80,878)		(55.5)
Owner-occupied CRE	935,705		24.5		931,150		24.4		4,555		0.5
Non-owner occupied CRE	1,505,483		39.4		1,493,099		39.2		12,384		0.8
Total commercial business	3,157,673		82.7		3,191,656		83.7		(33,983)		(1.1)
Residential real estate	223,442		5.8		164,582		4.3		58,860		35.8
Real estate construction and land development:
Residential	83,529		2.2		85,547		2.2		(2,018)		(2.4)
Commercial and multifamily	138,583		3.6		141,336		3.7		(2,753)		(1.9)
Total real estate construction and land development	222,112		5.8		226,883		5.9		(4,771)		(2.1)
Consumer	217,951		5.7		232,541		6.1		(14,590)		(6.3)
Total	$	3,821,178	100.0	%	$	3,815,662	100.0	%	$	5,516	0.1	%

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Loans receivable increased due primarily to $42.2 million of purchased residential real estate loans and higher commercial business loan demand, offset partially by repayments of SBA PPP loans.

Loans classified as nonaccrual and performing TDR and nonperforming assets

The following table provides information about our nonaccrual loans, performing TDR loans and nonperforming assets for the dates indicated:


	March 31, 2022			December 31, 2021			Change			% Change
	(Dollars in thousands)
Nonaccrual loans: (1)
Commercial business	$	15,956		$	23,107		$	(7,151)		(30.9)	%
Residential real estate	—			47			(47)			(100.0)
Real estate construction and land development	571			571			—			—
Consumer	—			29			(29)			(100.0)
Total nonaccrual loans	16,527			23,754			(7,227)			(30.4)
Other real estate owned	—			—			—			n/a
Total nonperforming assets	$	16,527		$	23,754		$	(7,227)		(30.4)	%

Accruing loans past due 90 days or more	$	1,318		$	293		$	1,025		349.8	%

Credit quality ratios:
Nonaccrual loans to loans receivable	0.43		%	0.62		%	(0.19)		%	(30.6)	%
Nonaccrual loans to total assets	0.22			0.32			(0.10)			(31.3)

Performing TDR loans: (1)
Commercial business	$	61,111		$	57,142		$	3,969		6.9	%
Residential real estate	179			358			(179)			(50.0)
Real estate construction and land development	450			450			—			—
Consumer	887			1,160			(273)			(23.5)
Total performing TDR loans	$	62,627		$	59,110		$	3,517		5.9	%

(1) At March 31, 2022 and December 31, 2021, $1.4 million and $1.4 million of nonaccrual loans, respectively, and $2.3 million and $1.6 million of performing TDR loans, respectively, were guaranteed by government agencies.

The following table provides the changes in nonaccrual loans during the three months ended March 31, 2022:




	(In thousands)
Balance, beginning of period	$	23,754
Additions to nonaccrual loan classification	—
Net principal payments, sales and transfers to accruing status	(3,804)
Payoffs	(3,369)
Charge-offs	(54)

Balance, end of period	$	16,527

Nonaccrual loans declined $7.2 million, or 30.4%, due primarily to ongoing collection efforts, including the partial payoff of two large commercial and industrial loan relationships, the payoff of one non-owner occupied CRE relationship, and the transfer of two commercial business loan relationships back to accruing status. The Bank also sold a pool of 14 nonaccrual loans during the period ending March 31, 2022 totaling $1.0 million.

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Allowance for Credit Losses on Loans Overview

The following table provides information regarding our ACL on loans for the periods indicated:


	At or For the Three Months Ended March 31,
	2022			2021			Change			% Change
	(Dollars in thousands)
ACL on loans at the end of period	$	40,333		$	64,225		$	(23,892)		(37.2)	%

Credit quality ratios:
ACL on loans to loans receivable	1.06		%	1.40		%	(0.34)		%	(24.3)	%
ACL on loans to loans receivable, excluding SBA PPP loans (1)	1.07			1.73			(0.66)			(38.2)
ACL on loans to nonaccrual loans	244.04		%	121.48		%	122.56		%	100.9	%

Net recoveries	494			175			319			182.3
Average loans receivable, net during the period (2)	3,836,029			4,490,499			(654,470)			(14.6)
Net recoveries on loans to average loans receivable, net (3)	(0.05)		%	(0.02)		%	(0.03)		%	150.0	%

(1) The ACL on loans does not include a reserve for SBA PPP loans as these loans are fully guaranteed by the SBA. See "Reconciliations of Non-GAAP Measures" section below.

(2) Average loan receivable, net includes loans held for sale.

(3) Annualized.

The ACL on loans decreased during the three months ended March 31, 2022 due primarily to a reduction of loans individually evaluated for losses and their related ACL as well as changes in the loan mix and continued improvement in forecasted economic indicators used to calculate credit losses.

The following table presents the ACL on loans by loan portfolio segment at the indicated dates:


	March 31, 2022				December 31, 2021
	ACL on loans		% of Total (1)		ACL on loans		% of Total (1)		Change		% Change
	(Dollars in thousands)
Commercial business	$	31,932	82.7	%	$	33,049	83.7	%	$	(1,117)	(3.4)	%
Residential real estate	1,803		5.8		1,409		4.3		394		28.0
Real estate construction and land development	4,299		5.8		5,276		5.9		(977)		(18.5)
Consumer	2,299		5.7		2,627		6.1		(328)		(12.5)
Total ACL on loans	$	40,333	100.0	%	$	42,361	100.0	%	$	(2,028)	(4.8)	%

(1) Represents the percent of loans receivable by loan category to loans receivable.

Deposits Overview

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


	March 31, 2022				December 31, 2021
	Balance		% of Total		Balance		% of Total		Change		% Change
	(Dollars in thousands)
Noninterest demand deposits	$	2,393,972	36.9	%	$	2,343,909	36.7	%	$	50,063	2.1	%
Interest bearing demand deposits	2,018,032		31.1		1,946,605		30.4		71,427		3.7
Money market accounts	1,099,539		16.9		1,120,174		17.5		(20,635)		(1.8)
Savings accounts	651,541		10.0		640,763		10.0		10,778		1.7
Total non-maturity deposits	6,163,084		94.9		6,051,451		94.6		111,633		1.8
Certificates of deposit	328,416		5.1		342,839		5.4		(14,423)		(4.2)
Total deposits	$	6,491,500	100.0	%	$	6,394,290	100.0	%	$	97,210	1.5	%

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Stockholders' Equity Overview

The Company’s stockholders' equity to assets ratio was 11.0% and 11.5% at March 31, 2022 and December 31, 2021, respectively, and decreased due primarily to a decrease in accumulated other comprehensive income of $43.6 million following an increase in market interest rates during the first quarter, which negatively impacted the fair value of our investment securities available for sale at March 31, 2022.

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 April 20, 2022, the Company’s board of directors declared a regular quarterly dividend of $0.21 per common share payable on May 18, 2022 to shareholders of record on May 4, 2022.

Regulatory Requirements Overview

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 unaudited Condensed Consolidated Financial Statements. Additionally, 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. Management believes that as of March 31, 2022, the Company and the Bank met all capital adequacy requirements to which they are subject.

As of March 31, 2022 and December 31, 2021, the most recent regulatory notifications categorized the Bank as well-capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Bank's categories. The following table presents the actual capital ratios of the Company and the Bank at the periods indicated:


	Company				Heritage Bank
	March 31, 2022		December 31, 2021		March 31, 2022		December 31, 2021
Common equity Tier 1 capital to risk-weighted assets	13.4	%	13.5	%	13.7	%	13.8	%
Tier 1 leverage capital to average assets	8.8		8.7		8.7		8.6
Tier 1 capital to risk-weighted assets	13.9		13.9		13.7		13.8
Total capital to risk-weighted assets	14.7		14.8		14.6		14.7
Capital conservation buffer	6.7		6.8		6.6		6.7

As of both March 31, 2022 and December 31, 2021, 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 until December 31, 2021 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.

Liquidity and Capital Resources

We maintain sufficient cash and cash equivalents and investment securities to meet short-term liquidity needs and actively monitor our long-term liquidity position to ensure the availability of capital resources for contractual obligations, strategic loan growth objectives and to fund operations. Our funding strategy has been to acquire non-maturity deposits from our retail accounts, acquire noninterest bearing demand deposits from our commercial customers and use our borrowing availability to fund growth in assets. We may also acquire brokered deposits when the cost of funds is advantageous to other funding sources. Borrowings may be used on a short-term basis to compensate for reductions in other sources of funds (such as deposit inflows at less than projected levels). Borrowings may also be used on a longer-term basis to support expanded lending activities and match the maturity of repricing intervals of assets. 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 so we adhere to internal management targets assigned to the loan to deposit ratio, liquidity ratio, net short-term non-core funding ratio and non-core liabilities to total assets ratio to ensure an appropriate liquidity position.

Management believes the capital sources are adequate to meet all reasonably foreseeable short-term and long-term cash requirements and there has not been a material change in our liquidity and capital resources since the information disclosed in our 2021 Annual Form 10-K. We are not aware of any reasonably likely material changes in the mix and relative cost of such resources.

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Critical Accounting Policies

Our critical accounting policies are described in detail in the "Critical Accounting Policies" section within Item 7 of our 2021 Annual Form the Form 10-K. The SEC defines "critical accounting policies" as those that require application of management's most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain and may change in future periods. The Company's critical accounting policies include estimates of the ACL on investment securities, the ACL on loans, the ACL on unfunded commitments and goodwill. There have been no material changes in these policies during the three months ended March 31, 2022.

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 they provide useful and comparative information to assess trends in the Company’s performance and asset quality and to 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, nor are they necessarily comparable to non-GAAP performance measures that may be presented 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 its balance sheet. Incremental accretion on purchased loans 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 the adoption of ASU 2016-13. 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. Similarly, presenting loan yield excluding the effect of SBA PPP loans is useful in assessing the impact of these special program loans that are anticipated to substantially decrease within a short time frame.


	Three Months Ended March 31,
	2022			2021
	(Dollars in thousands)
Loan yield, excluding SBA PPP Loans and Incremental Accretion on Purchased Loans, annualized:
Interest and fees on loans (GAAP)	$	41,025		$	49,524
Exclude interest and fees on SBA PPP loans	(3,081)			(9,136)
Exclude incremental accretion on purchased loans	(584)			(1,075)
Adjusted interest and fees on loans (non-GAAP)	$	37,360		$	39,313

Average loans receivable, net (GAAP)	$	3,773,325		$	4,490,499
Exclude average SBA PPP loans	(109,594)			(832,148)
Adjusted average loans receivable, net (non-GAAP)	$	3,663,731		$	3,658,351

Loan yield, annualized (GAAP)	4.41		%	4.47		%
Loan yield, excluding SBA PPP loans and incremental accretion on purchased loans, annualized (non-GAAP)	4.14		%	4.36		%

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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.


	March 31, 2022			December 31, 2021
	(Dollars in thousands)
ACL on Loans to Loans Receivable, excluding SBA PPP Loans:
Allowance for credit losses on loans (GAAP)	$	40,333		$	42,361

Loans receivable (GAAP)	$	3,821,178		$	3,815,662
Exclude SBA PPP loans	64,962			145,840
Loans receivable, excluding SBA PPP (non-GAAP)	$	3,756,216		$	3,669,822

ACL on loans to loans receivable (GAAP)	1.06		%	1.11		%
ACL on loans to loans receivable, excluding SBA PPP loans (non-GAAP)	1.07		%	1.15		%

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

In our opinion, there has not been a material change in our interest rate risk exposure since the information disclosed in our 2021 Annual Form 10-K. Neither we, nor the Bank, maintain a trading account for any class of financial instrument, nor do we, or the Bank, engage in hedging activities or purchase high risk derivative instruments. Moreover, neither we, nor the Bank, are subject to foreign currency exchange rate risk or commodity price risk.

ITEM 4. CONTROLS AND PROCEDURES

(a) Evaluation of Disclosure Controls and Procedures

An evaluation of the Company’s disclosure controls and 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 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 March 31, 2022 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 March 31, 2022, 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 Item 1A of the Company’s 2021 Annual Form 10-K.

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

(a) Not applicable.

(b) Not applicable.

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The following table provides information about repurchases of common stock by the Company during the three months ended March 31, 2022:


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)
January 1, 2022— January 31, 2022	—	$	—	9,886,773	738,304
February 1, 2022— February 28, 2022	30,602	24.84		9,917,332	707,745
March 1, 2022— March 31, 2022	74,488	25.41		9,967,332	657,745
Total	105,090	$	25.24

(1)Of the common shares repurchased by the Company between January 1, 2022 and March 31, 2022, 24,531 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

ITEM 6. EXHIBITS

Incorporated by Reference

Exhibit No.

Description of Exhibit

Form

Exhibit

Filing Date/Period End Date

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)

(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:
May 4, 2022						/S/ JEFFREY J. DEUEL
						Jeffrey J. Deuel
						President and Chief Executive Officer
Date:
May 4, 2022						/S/ DONALD J. HINSON
						Donald J. Hinson
						Executive Vice President and Chief Financial Officer