Annual Report (10-k)

PART II

Item 5.  Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

The Company’s common stock is traded on the Nasdaq Global Select Market System under the symbol “WBCO.”

The Company is aware that blocks of its stock are held in street name by brokerage firms. As a result, the number of shareholders of record does not include the actual number of beneficial owners of the Company’s stock.  As of March 7, 2014, the Company’s common stock was held of record by approximately 424 shareholders, a number which does not include beneficial owners who hold shares in “street name.”

The following are the high and low sales prices for the Company’s stock as reported by Nasdaq and the quarterly cash dividends paid by the Company to its shareholders on a per share basis during 2013 and 2012:

 

		2013												2012
		High				Low				Dividend				High				Low				Dividend
First quarter		$	14.25			$	13.49			$	0.150			$	14.48			$	11.74			$	0.120
Second quarter		14.25				12.52				0.150				14.47				12.85				0.140
Third quarter		15.65				13.55				0.090				15.03				13.19				0.090
Fourth quarter		18.24				13.84				0.145				14.55				13.00				0.150

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The Company’s dividend policy requires the Board of Directors to review the Company’s financial performance, capital adequacy, cash resources, regulatory restrictions, economic conditions and other factors, and if such review is favorable, the Board may declare and pay dividends. The ability of the Company to pay dividends will depend on the profitability of the Bank, the need to retain or increase capital, the dividend restrictions imposed upon the Bank by applicable banking law and dividend restrictions imposed upon the Company under applicable corporate and banking law regulation. Although the Company anticipates payment of a regular quarterly cash dividend, future dividends are subject to these limitations and to the discretion of the Board of Directors, and could be reduced or eliminated.

Equity Compensation Plan Information

The following table sets forth information about equity compensation plans that provide for the award of securities or the grant of options to purchase securities to employees and directors of the Company, its subsidiaries and its predecessors by merger that were in effect at December 31, 2013.

		Equity Compensation Plan Information
		(A)			(B)				(C)
Plan category		Number of securities to be issued upon exercise of outstanding options, warrants and rights			Weighted average exercise price of outstanding options, warrants and rights (2)				Number of securities remaining available for future issuance under equity compensation plans excluding securities reflected in column (A)
Equity compensation plans approved by security holders
2005 stock incentive plan (1)		222,676		(3)	$	4.92			361,219
Equity compensation plans not approved by security holder		—			—				—
Total		222,676			$	4.92			361,219

(1)	The 2005 plan is currently the only stock award plan available for new grants.

(2)	Weighted average exercise price is based solely on securities with an exercise price.

(3)	Includes 95,367 outstanding stock options and 127,309 restricted stock units (each unit represents one share), which are subject to issuance upon vesting of the awards. Of the 127,309 RSU awards outstanding at 12/31/13, 57,631 are scheduled to vest during 2014.

Sales of Unregistered Securities

The Company had no sales of unregistered securities during the fourth quarter of 2013.

Purchases of Equity Securities

The Company had no purchases of its equity securities during the fourth quarter of 2013.

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Five-Year Stock Performance Graph

 

The following chart, which is furnished not filed, compares the yearly percentage change in the cumulative shareholder return on the Company’s common stock during the five years ended December 31, 2013, with (1) the Total Return for the NASDAQ Stock Market Index (which is a broad nationally recognized index of stock performance by companies traded on the NASDAQ Market System and the NASDAQ Small Cap Market) (2) the Total Return Index for SNL Bank NASDAQ (comprised of banks listed on the NASDAQ National Market System) and (3) Total Return for SNL Bank $1 Billion to $5 Billion Bank Index (comprised of publicly-traded banks located in the U.S. with total assets between $1 billion and $5 billion).

 

The graph assumes $100 was invested on December 31, 2008, in the Company’s common stock and the comparison groups and assumes the reinvestment of all cash dividends prior to any tax effect and retention of all stock dividends.

		Period Ending
Index		12/31/2008				12/31/2009				12/31/2010				12/31/2011				12/31/2012				12/31/2013
Washington Banking Company		$	100.00			$	140.15			$	162.59			$	14,347.00			$	170.11			$	229.70
NASDAQ Composite		100.00				145.36				171.74				170.38				200.63				281.22
SNL Bank NASDAQ		100.00				81.12				95.71				84.92				101.22				145.48
SNL Bank $1B-$5B		100.00				71.68				81.25				74.10				91.37				132.87

 

Source : SNL Financial LC, Charlottesville, VA © 2014

www.snl.com

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Item 6. Selected Financial Data

 

Consolidated Five-Year Statements of Income and Selected Financial Data

 

The following table sets forth selected audited consolidated financial information and certain financial ratios for the Company. This information is derived in part from the audited consolidated financial statements and notes thereto of the Company set forth in Item 8- Financial Statements and Supplementary Data and should be read in conjunction with the Company’s financial statements and the management discussion set forth in Item 7- Management’s Discussion and Analysis of Financial Condition and Results of Operations .

(dollars in thousands, except per share amounts)		As of or for the Years Ended December 31,
		2013				2012				2011				2010				2009
Operating data:
Total interest income		$	75,359			$	89,710			$	89,707			$	75,949			$	54,392
Total interest expense		5,420				7,113				9,981				11,830				14,019
Net interest income		69,939				82,597				79,726				64,119				40,373
Provision for loan losses		14,615				9,744				10,050				13,486				10,200
Net interest income after provision		55,324				72,853				69,676				50,633				30,173
Service charges on deposits		3,401				3,560				3,818				3,346				3,426
Other noninterest income		18,944				4,686				5,394				30,185				4,235
Total noninterest income		22,345				8,246				9,212				33,531				7,661
Noninterest expense		56,301				56,399				55,825				46,797				28,734
Income before income taxes		21,368				24,700				23,063				37,367				9,100
Provision for income taxes		6,872				7,856				7,111				11,797				2,886
Net income before preferred dividends		14,496				16,844				15,952				25,570				6,214
Preferred dividends		—				—				1,084				1,659				1,600
Net income available to common shareholders		$	14,496			$	16,844			$	14,868			$	23,911			$	4,614
Average number of shares outstanding, basic		15,495,000				15,422,000				15,329,000				15,307,000				10,011,000
Average number of shares outstanding, diluted		15,551,000				15,455,000				15,393,000				15,465,000				10,079,000
Per share data:
Net income per common share, basic		$	0.94			$	1.09			$	0.97			$	1.56			$	0.46
Net income per common share, diluted		0.93				1.09				0.97				1.55				0.46
Tangible book value per common share		11.22				11.41				10.67				9.76				8.79
Dividends per common share		0.54				0.50				0.20				0.14				0.18
Balance sheet data:
Total assets		$	1,683,988			$	1,687,677			$	1,670,682			$	1,704,939			$	1,045,871
Non-covered loans		888,686				853,134				812,830				834,293				813,852
Covered loans		151,955				217,339				269,081				366,153				—
Allowance for loan losses, non-covered loans		17,093				17,147				18,032				18,812				16,212
Allowance for loan losses, covered loans		14,622				3,252				870				1,336				—
Non-covered OREO		3,067				3,023				1,976				4,122				4,549
Covered OREO		5,980				13,460				26,622				29,766				—
Deposits		1,467,492				1,462,973				1,466,344				1,492,220				846,671
Other borrowed funds		—				—				—				—				10,000
Junior subordinated debentures		25,774				25,774				25,774				25,774				25,774
Preferred securities		—				—				—				25,334				24,995
Total shareholders' equity		179,930				182,624				170,820				182,098				159,521

 

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(dollars in thousands, except per share amounts)		As of or for the Years Ended December 31,
		2013			2012			2011			2010			2009
Selected performance ratios:
Return on average assets		0.88	%		1.01	%		0.95	%		1.72	%		0.66	%
Return on average common equity		7.99	%		9.56	%		9.17	%		16.87	%		7.11	%
Net interest margin (fully tax-equivalent)		4.65	%		5.54	%		5.47	%		4.90	%		4.63	%
Net interest spread		4.56	%		5.45	%		5.39	%		4.76	%		4.28	%
Noninterest expense to average assets		3.41	%		3.37	%		3.32	%		3.16	%		3.05	%
Efficiency ratio (fully tax-equivalent)		60.43	%		61.31	%		62.06	%		47.48	%		59.01	%
Dividend payout ratio		57.25	%		45.81	%		20.63	%		8.64	%		37.23	%
Asset quality ratios:
Nonperforming non-covered loans to
period end non-covered loans		0.95	%		1.82	%		2.72	%		3.10	%		0.42	%
Allowance for loan losses, non-covered
loans to period end non-covered loans		1.92	%		2.01	%		2.22	%		2.25	%		1.99	%
Allowance for loan losses, covered loans
to period end covered loans		9.62	%		1.50	%		0.32	%		0.36	%		—
Allowance for loan losses, non-covered
loans to nonperforming non-covered loans		203.27	%		110.26	%		81.59	%		72.79	%		477.53	%
Nonperforming non-covered assets to
total assets		0.68	%		1.10	%		1.44	%		1.76	%		0.76	%
Net loan charge-offs to average non-covered
loans outstanding		0.22	%		0.97	%		1.37	%		1.15	%		0.76	%
Total risk-based capital		19.76	%		19.39	%		19.73	%		20.96	%		22.15	%
Tier 1 risk-based capital		18.49	%		18.13	%		18.47	%		19.70	%		20.89	%
Leverage ratio		12.41	%		11.78	%		11.16	%		11.42	%		18.73	%
Average equity to average assets		11.01	%		10.54	%		9.64	%		11.26	%		11.86	%
Other data:
Number of banking offices		31			31			30			30			18
Number of full time equivalent employees		464			467			450			448			281

Summary of Quarterly Financial Information

See Item 8- Financial Statements and Supplementary Data , Note (24) Selected Quarterly Financial Data (Unaudited) in the consolidated financial statements.

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis should be read in conjunction with Item 8- Financial Statements and Supplementary Data.

Executive Overview

Significant items for the year ended December 31, 2013 were as follows:

•	Net income available to common shareholders per diluted share was $0.93 for the year ended December 31, 2013 , compared to $1.09 for the year ended December 31, 2012 .

•	Net interest margin, on a tax equivalent basis, was 4.65% for the year ended December 31, 2013 , compared to 5.54% a year ago.

•	Non-covered loans, net of allowance for loan losses, totaled $871.6 million at December 31, 2013 , compared to $836.0 million at December 31, 2012 .

•	Nonperforming non-covered assets to total assets improved to 0.68% at December 31, 2013 , compared to 1.10% at December 31, 2012 .

•	Continued progress in resolving acquired loans which declined to $137.3 million at December 31, 2013, compared to $214.1 million a year ago.

•	Total risk-based capital for the Company was 19.76% at December 31, 2013 , compared to 19.39% at December 31, 2012 .  The FDIC requires a minimum total risk-based capital ratio of 10% to be considered “well-capitalized.”

•	Tangible book value per common share totaled $11.22 at December 31, 2013 , compared to $11.41 at December 31, 2012 .

Summary of Critical Accounting Policies

Significant accounting policies are described in the consolidated financial statements in Note (1) Summary of Significant Accounting Policies . Several of these accounting policies require management to make difficult, subjective or complex judgments or estimates.  Management believes that the following accounting policies could be considered critical under the SEC’s definition.

Allowance for Loan Losses: The allowance for loan losses is established to absorb known and inherent losses attributable to loans outstanding. The adequacy of the allowance is monitored on a regular basis and is based on management’s evaluation of numerous quantitative and qualitative factors. Quantitative factors include our historical loss experience, delinquency and charge-off trends, estimates of, and changes in, collateral values, changes in risk ratings on loans and other factors. Qualitative factors include the general economic environment in our markets and, in particular, the state of the real estate market and specific relevant industries. Other qualitative factors that are considered in our methodology include, size and complexity of individual loans in relation to the lending officer’s background and experience levels, loan structure, extent and nature of waivers of existing loan policies, and pace of loan portfolio growth.

As the Company adds new products, increases the complexity of the loan portfolio, and expands its geographic coverage, the Company intends to enhance and adapt its methodology to keep pace with the size and complexity of the loan portfolio. Changes in any of the above factors could have a significant effect on the calculation of the allowance for credit losses in any given period. The Company believes that its systematic methodology continues to be appropriate given our size and level of complexity.

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Covered Loans: Covered loans are aggregated into pools, based on individually evaluated common risk characteristics, and aggregate expected cash flows were estimated for each pool. A pool is accounted for as a single asset with a single interest rate, cumulative loss rate and cash flow expectation. The Bank aggregated all of the loans acquired in the FDIC-assisted acquisitions of City Bank and North County Bank into 18 and 14 pools, respectively. A loan will be removed from a pool of loans only if the loan is sold, foreclosed, assets are received in satisfaction of the loan, or the loan is written off, and will be removed from the pool at the carrying value. If an individual loan is removed from a pool of loans due to a payoff, the difference between its carrying amount and the cash received will be recognized in income immediately and would not affect the effective yield used to recognize the accretable difference on the remaining pool. Loans originally placed into a performing pool will not be reported individually as 30-89 days past due, non-performing (90+ days past due or nonaccrual) or accounted for as a troubled debt restructuring as the pool is the unit of accounting. Rather, these metrics related to the underlying loans within a performing pool will be considered in our ongoing assessment and estimates of future cash flows. If, at acquisition, the loans are collateral dependent and acquired primarily for the rewards of ownership of the underlying collateral, or if cash flows expected to be collected cannot be reasonably estimated, accrual of income is inappropriate. Such loans will be placed into nonperforming (nonaccrual) loan pools.

The cash flows expected to be received over the life of the pool were estimated by management with the assistance of a third party valuation specialist. These cash flows were input into an accounting loan system which calculates the carrying values of the pools and underlying loans, book yields, effective interest income and impairment, if any, based on actual and projected events. Default rates, loss severity and prepayment speed assumptions will be periodically reassessed and updated within the accounting model to update the expectation of future cash flows. The excess of the cash flows expected to be collected over the pool’s carrying value is considered to be the accretable yield and is recognized as interest income over the estimated life of the loan or pool using the effective yield method. The accretable yield will change due to changes in the timing and amounts of expected cash flows. For the performing loan pools, a prepayment assumption as documented by the valuation specialist is initially applied. Changes in the accretable yield will be disclosed quarterly.

The excess of the contractual balances due over the cash flows expected to be collected is considered to be the nonaccretable difference. The nonaccretable difference represents the estimate of the credit losses expected to occur and was considered in determining the fair value of the loans as of the acquisition date. Subsequent to the acquisition date, any increases in expected cash flows over those expected at purchase date in excess of fair value are adjusted through the accretable difference on a prospective basis. Any subsequent decreases in expected cash flows over those expected at purchase date are recognized by recording a provision for loan losses. Any disposals of loans, including sales of loans, payments in full or foreclosures, result in the removal of the loan from the pool at its carrying amount.

FDIC Indemnification Asset: The Company has elected to account for amounts receivable under the loss share agreement as an indemnification asset. The FDIC indemnification asset is initially recorded at fair value, based on the discounted value of expected future cash flows under the loss share agreement. The difference between the present value and the undiscounted cash flows the Company expects to collect from the FDIC will be accreted into noninterest income over the life of the FDIC indemnification asset.

 

The FDIC indemnification asset is reviewed periodically and adjusted for any changes in expected cash flows based on recent performance and expectations for future performance of the covered portfolio. These adjustments are measured on the same basis as the related covered loans and covered other real estate owned. Any increases in cash flow of the covered assets over those expected will reduce the FDIC indemnification asset and any decreases in cash flow of the covered assets under those expected will increase the FDIC indemnification asset. Increases and decreases to the FDIC indemnification asset are recorded as adjustments to noninterest income.

Fair Value: FASB ASC 820, Fair Value Measurements and Disclosures , establishes a hierarchical disclosure framework associated with the level of pricing observability utilized in measuring financial instruments at fair value. The degree of judgment utilized in measuring the fair value of financial instruments generally correlates to the level of pricing observability. Financial instruments with readily available active quoted prices or for which fair value can be measured from actively quoted prices generally will have a higher degree of pricing observability and a lesser degree of judgment utilized in measuring fair value. Conversely, financial instruments rarely traded or not quoted will generally have little or no pricing observability and a higher degree of judgment utilized in measuring fair value. Pricing observability is impacted by a number of factors, including the type of financial instrument, whether the financial instrument is new to the market and not yet established and the characteristics specific to the transaction.

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Results of Operations Overview

For year ended December 31, 2013, net income available to common shareholders totaled $14.5 million, or $0.93 per diluted common share, compared to net income available to common shareholders of $16.8 million, or $1.09 per diluted common share, for the year ended December 31, 2012, and $14.9 million, or $0.97 per diluted common share, for the year ended December 31, 2011.  

In addition to results presented in accordance with generally accepted accounting principles in the United States of America (“GAAP”), this filing presents certain non-GAAP financial measures. Management believes that certain non-GAAP financial measures provide investors with information useful in understanding the Company's financial performance; however, readers of this report are urged to review these non-GAAP measures in conjunction with the GAAP results, as reported.

Operating earnings are not a measure of performance calculated in accordance with GAAP.  However, management believes that operating earnings are an important indication of the ability to generate earnings through the Company's fundamental banking business.  Since operating earnings exclude the effects of certain items that are unusual and/or difficult to predict, management believes that operating earnings provide useful supplemental information to both management and investors in evaluating the Company's financial results.

Operating earnings should not be considered in isolation or as a substitute for net income, cash flows from operating activities or other income or cash flow statement data calculated in accordance with GAAP.  Moreover, the manner in which the Company calculates operating earnings may differ from that of other companies reporting measures with similar names.

The following table provides the reconciliation of the Company's GAAP earnings to operating earnings (non-GAAP) for the periods presented:

 

(dollars in thousands)	For the Year Ended December 31,
	2013				2012				2011
GAAP earnings available to common shareholders	$	14,496			$	16,844			$	14,868
Provision for income tax	6,872				7,856				7,111
GAAP earnings available to common shareholders
before provision for income tax	21,368				24,700				21,979
Adjustments to GAAP earnings available to common shareholders:
Merger related expenses	652				—				324
Accelerated accretion of remaining preferred stock discount	—				—				1,046
Operating earnings before tax	22,020				24,700				23,349
Provision for income tax	7,100				7,856				7,224
Net operating earnings	$	14,920			$	16,844			$	16,125
Diluted GAAP earnings per common share	$	0.93			$	1.09			0.97
Diluted operating earnings per common share	$	0.96			$	1.09			1.05

Fully tax-equivalent net interest income and fully tax-equivalent net interest margin are non-GAAP performance measurements that management believes provide investors with a more accurate picture of the Company's operational performance and are consistent with industry practice. The calculation for both measurements involves grossing up interest income on tax-exempt loans and investments by an amount that makes it comparable to taxable income.

Neither fully tax-equivalent net interest income nor fully tax-equivalent net interest margin should be considered in isolation nor as a substitute for net interest income or net interest margin or any other measure calculated in accordance with GAAP. Moreover, the manner in which the Company calculates fully tax-equivalent net interest income and fully tax-equivalent net interest margin may differ from that of other companies reporting measures with similar names.

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The following table provides the reconciliation of the Company's net interest income (GAAP) to a fully tax-equivalent net interest income (non-GAAP) and net interest margin (GAAP) to a fully tax-equivalent net interest margin (non-GAAP) for the periods presented:

(dollars in thousands)	For the Year Ended December 31,
	2013				2012				2011
GAAP net interest income	$	69,939			$	82,597			$	79,726
Tax-equivalent adjustment	881				1,144				1,021
Tax-equivalent net interest income	$	70,820			$	83,741			$	80,747
Average interest earning assets	$	1,522,068			$	1,510,471			$	1,475,834
Net interest margin	4.59		%		5.47		%		5.40		%
Tax-equivalent net interest margin	4.65		%		5.54		%		5.47		%

Tangible common equity, tangible assets and tangible book value per common share are measures that are not calculated in accordance with GAAP.  However, management uses these non-GAAP measures in their analysis of the Company's performance. Management believes that these non-GAAP measures are an important indication of the Company's ability to grow both organically and through business combinations, and with respect to tangible common equity, the Company's ability to pay dividends and to engage in various capital management strategies.

Neither tangible common equity, tangible assets nor tangible book value per common share should be considered in isolation or as a substitute for common shareholders' equity or book value per common share or any other measure calculated in accordance with GAAP. Moreover, the manner in which the Company calculates tangible common equity, tangible assets and tangible book value per share may differ from that of other companies reporting measures with similar names.

The following table provides the reconciliation of the Company's shareholders' equity (GAAP) to tangible common equity (non-GAAP) and total assets (GAAP) to tangible assets (non-GAAP) for the periods presented:

(dollars in thousands)	December 31, 2013				December 31, 2012
Total shareholders' equity	$	179,930			$	182,624
Adjustments to shareholders' equity
Goodwill and other intangible assets, net	(5,588		)		(6,027		)
Tangible common equity	$	174,342			$	176,597
Total assets	$	1,683,988			$	1,687,677
Adjustments to total assets
Goodwill and other intangible assets, net	(5,588		)		(6,027		)
Total tangible assets	$	1,678,400			$	1,681,650
Common shares outstanding at end of period	15,538,969				15,483,598
Tangible common equity ratio	10.39		%		10.50		%
Tangible book value per common share	$	11.22			$	11.41

Net Interest Income: One of the Company’s key sources of earnings is net interest income. To make it easier to compare results among several periods and the yields on various types of earning assets (some of which are taxable and others which are not), net interest income is presented in this discussion on a “taxable-equivalent basis” (i.e., as if it were all taxable at the same rate).  There are several factors that affect net interest income including:

•	The volume, pricing, mix and maturity of interest-earning assets and interest-bearing liabilities;

•	The volume of free funds (consisting of noninterest-bearing deposits and other liabilities and shareholders’ equity);

•	The volume of noninterest-earning assets;

•	Market interest rate fluctuations; and

•	Asset quality.

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The following tables set forth various components of the balance sheet that affect interest income and expense and their respective yields or rates:

(dollars in thousands)	For the Year Ended December 31,
	2013											2012											2011
					Interest											Interest											Interest
	Average				earned/				Average			Average				earned/				Average			Average				earned/				Average
	balance				paid				yield/rate			balance				paid				yield/rate			balance				paid				yield/rate
Assets
Non-covered loans (1)(2)	$	864,049			$	44,234			5.12	%		$	831,179			$	47,061			5.66	%		$	831,997			$	50,313			6.05	%
Covered loans	176,611				23,710				13.43	%		242,552				36,418				15.01	%		307,836				34,819				11.31	%
Federal funds sold	—				—				—	%		8				—				—	%		519				1				0.20	%
Interest-bearing deposits	80,554				206				0.26	%		98,169				251				0.26	%		101,683				258				0.25	%
Investments:
Taxable	328,911				5,720				1.74	%		291,836				5,333				1.83	%		205,426				3,967				1.93	%
Non-taxable (2)	71,943				2,370				3.29	%		46,727				1,791				3.83	%		28,373				1,370				4.83	%
Interest-earning assets	1,522,068				76,240				5.01	%		1,510,471				90,854				6.02	%		1,475,834				90,728				6.15	%
Noninterest-earning assets	126,692											161,432											205,420
Total assets	$	1,648,760										$	1,671,903										$	1,681,254
Liabilities and shareholders' equity
Deposits:
NOW accounts and MMA	$	647,965			$	1,052			0.16	%		$	611,477			$	1,352			0.22	%		$	581,189			$	2,394			0.41	%
Savings	119,518				60				0.05	%		105,085				105				0.10	%		96,892				199				0.21	%
Time deposits	403,478				3,830				0.95	%		497,812				5,124				1.03	%		606,771				6,899				1.14	%
Total interest-bearing deposits	1,170,961				4,942				0.42	%		1,214,374				6,581				0.54	%		1,284,852				9,492				0.74	%
Federal funds purchased	11				—							61				—				—	%		3				—				—	%
Junior subordinated debentures	25,774				478				1.85	%		25,774				532				2.06	%		25,774				489				1.90	%
Total interest-bearing liabilities	1,196,746				5,420				0.45	%		1,240,209				7,113				0.57	%		1,310,629				9,981				0.76	%
Noninterest-bearing deposits	257,314											243,522											202,297
Other liabilities	13,240											12,035											6,263
Total liabilities	1,467,300											1,495,766											1,519,189
Total shareholders' equity	181,460											176,137											162,065
Total liabilities and
shareholders' equity	$	1,648,760										$	1,671,903										$	1,681,254
Net interest income/spread					$	70,820			4.56	%						$	83,741			5.45	%						$	80,747			5.39	%
Credit for interest-bearing funds									0.09	%										0.09	%										0.08	%
Net interest margin (2)									4.65	%										5.54	%										5.47	%

⁽¹⁾ Average balance includes nonaccrual loans.

⁽²⁾ Interest income on non-taxable investments and loans is presented on a taxable-equivalent basis using the federal statutory rate of 35%. These adjustments totaled $881 thousand, $1.1 million and $1.0 million for the years ended December 31, 2013, 2012 and 2011, respectively. Taxable-equivalent is a non-GAAP performance measurement that management believes provides investors with a more accurate picture of the net interest margin and efficiency ratio for comparative purposes.

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The following table details the effects of changes in rates and volume on interest income and expense for the periods indicated:

(dollars in thousands)	2013 compared to 2012												2012 compared to 2011
	Increase (decrease) in interest income and expense due to changes in (2)												Increase (decrease) in interest income and expense due to changes in (2)
	Volume				Rate				Total				Volume				Rate				Total
Assets
Non-covered loans (1)(3)	$	1,987			$	(4,814	)		$	(2,827	)		$	(48	)		$	(3,204	)		$	(3,252	)
Covered loans	(9,146		)		(3,562		)		(12,708		)		(2,940		)		4,539				1,599
Federal funds sold	—				—				—				(1		)		—				(1		)
Interest-bearing deposits	(45		)		—				(45		)		(9		)		2				(7		)
Investments: (1)
Taxable	625				(238		)		387				1,566				(200		)		1,366
Non-taxable	783				(204		)		579				618				(197		)		421
Interest-earning assets	$	(5,796	)		$	(8,818	)		$	(14,614	)		$	(814	)		$	940			$	126
Liabilities
Deposits:
NOW accounts and money market	$	77			$	(377	)		$	(300	)		$	119			$	(1,161	)		$	(1,042	)
Savings	13				(58		)		(45		)		16				(110		)		(94		)
Time deposits	(917		)		(377		)		(1,294		)		(1,162		)		(613		)		(1,775		)
Total interest-bearing deposits	(827		)		(812		)		(1,639		)		(1,027		)		(1,884		)		(2,911		)
Junior subordinated debentures	—				(54		)		(54		)		—				43				43
Total interest-bearing liabilities	$	(827	)		$	(866	)		$	(1,693	)		$	(1,027	)		$	(1,841	)		$	(2,868	)

⁽¹⁾ Interest income on non-taxable investments and loans are presented on a fully tax-equivalent basis using the federal statutory rate of 35% for the years ended December 31, 2013 , 2012 and 2011.

⁽²⁾ The changes attributable to the combined effect of volume and interest rates have been allocated proportionately.

⁽³⁾ Interest income previously accrued on nonaccrual loans is reversed in the period the loan is placed on nonaccrual status.

Net interest income on a taxable-equivalent basis totaled $70.8 million for the year ended December 31, 2013, compared to $83.7 million for the same period in 2012.  The $12.9 million year-over-year decrease was primarily related to decreases in volume and in the yield earned on covered loans and decreases in the yield earned on non-covered loans. Net interest margin (net interest income as a percentage of average interest-earning assets) on a taxable-equivalent basis was 4.65% for 2013, compared to 5.54% for 2012, a decrease of 89 basis points.

Net interest income on a taxable-equivalent basis totaled $83.7 million for the year ended December 31, 2012, compared to $80.7 million for the same period in 2011.  The $3.0 million year-over-year increase was primarily attributable to decreases in the average balance and the average rate paid on interest-bearing deposits.  For the period, average interest-bearing deposits decreased $70.5 million and the average rate decreased 20 basis points.  For the period, interest earned on interest-earning assets remaining relatively flat. Net interest margin (net interest income as a percentage of average interest-earning assets) on a taxable-equivalent basis was 5.54% for 2012, an increase of 7 basis points as compared to 2011.

Due to the current low interest rate environment, together with the projected principal reduction in higher yielding covered loans, management expects the net interest margin will decline in future periods.

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Provision for Loan Losses: The provision for loan losses is highly dependent on the Company’s ability to manage asset quality and control the level of net charge-offs through prudent underwriting standards. In addition, decline in general economic conditions could increase future provisions for loan losses and materially impact the Company’s net income. For further discussion of the Company’s asset quality see the Credit Risks and Asset Quality section found in Item 2- Management’s Discussion and Analysis of Financial Condition and Results of Operations.

For the year ended December 31, 2013 , the Company recorded a provision for non-covered loan losses of $1.9 million compared to $7.1 million and $10.5 million for the years ended December 31, 2012 and 2011, respectively. Net charge-offs for the year ended December 31, 2013 were $1.9 million, compared to $8.0 million and $11.3 million for the years ended December 31, 2012 and 2011, respectively.  At December 31, 2013 and 2012 , the allowance for non-covered loan losses, as a percent of total non-covered loans, was 1.92% and 2.01%, respectively.

The Company recorded a $12.7 million provision for covered loan losses for the year ended December 31, 2013 , compared to a provision for covered loan losses of $2.6 million for the year ended December 31, 2012, and a recovery for covered loan losses of $450 thousand for the year ended December 31, 2011. For the year ended December 31, 2013 , the provision for covered loan losses was primarily attributable to the deterioration of cash flows associated with several covered loan pools acquired from City Bank, particularly those in the hospitality portfolio. This provision, however, was partially offset by a significantly greater change in the FDIC indemnification asset, included in noninterest income, as noted in the table on the next page.

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Noninterest Income:   Noninterest income remains a key focus of the Company. The Company has focused on diversifying the noninterest income mix through the sale of mortgage loans and the guaranteed portion of SBA loans and through the introduction of nondeposit investment products consisting primarily of annuity sales and investment service fees and income from the Company's Bank Owned Life Insurance policies. The following table presents the key components of noninterest income:

(dollars in thousands)	Years Ended December 31,												Change				Change
	2013				2012				2011				2013 vs. 2012				2012 vs. 2011
Service charges and fees	$	3,401			$	3,560			$	3,818			$	(159	)		$	(258	)
Electronic banking income	4,101				3,666				3,197				435				469
Investment products	771				1,295				1,072				(524		)		223
Gain on sale of investment securities, net	556				931				—				(375		)		931
Bank owned life insurance income	132				191				311				(59		)		(120		)
Income from the sale of mortgage loans	3,267				3,848				1,197				(581		)		2,651
SBA premium income	894				602				444				292				158
Change in FDIC indemnification asset	5,735				(9,126		)		(9,232		)		14,861				106
Gain on disposition of covered assets	2,315				1,877				6,312				438				(4,435		)
Other	1,173				1,402				2,093				(229		)		(691		)
Total noninterest income	$	22,345			$	8,246			$	9,212			$	14,099			$	(966	)

The increases in electronic banking income for the periods presented were primarily attributable to increases in interchange fees on new deposit accounts and increases in ATM fee income. Additionally, the Company received a fee from Visa during 2013 for its exclusive branding of the Company's debit and credit cards.

The decrease in investment products income for 2013 compared to 2012 was primarily attributable to a change in the mix of investment products sold. For the year ended December 31, 2013, the Company sold $24.5 million in annuities and $17.5 million in mutual funds, compared to $40.7 million in annuities and $1.5 million in mutual funds a year ago. Typically, the Company earns a one-time fee on annuities at the time of sale, compared to a lesser and recurring annual fee on mutual funds.

Gain on sale of investment securities, net represents the net gain recognized on the sale of available for sale investment securities.  Management reviews the investment securities portfolio regularly for opportunities to adjust the portfolio and may have additional sales in future periods.

The decrease in income from the sale of mortgage loans in 2013 compared to 2012 was primarily attributable to a decline in sales volume of loans held for sale due to a decline in mortgage activity. The increase in income from the sale of mortgage loans in 2012 compared to 2011 was primarily attributable to the increase in sales volume of loans held for sale due to significant mortgage activity as a result of historically low interest rates.  For the years ended December 31, 2013, 2012 and 2011, proceeds from the sale of loans held for sale totaled $155.5 million, $211.8 million and $129.0 million, respectively.

SBA premium income is the income the Company recognizes when it sells the guaranteed portion of each SBA loan to investors in the secondary market. For the year ended December 31, 2013 , the Company sold total guaranteed portions of SBA loans in the amounts of $7.8 million, compared to $5.0 million for the year ended December 31, 2012 and $1.7 million for the year ended December 31, 2011.

The change in FDIC indemnification asset for the year ended December 31, 2013 represents the accretion of income on the FDIC indemnification asset, compared to the amortization of expense for the years ended December 31, 2012 and 2011. Based upon the collections made   on the indemnification asset and the subsequent quarterly revaluations of the estimated remaining cash flows of covered loans, accretion was required to increase the asset in order to match the projected cashflows over the remaining term of the asset. For the year ended December 31, 2013 , the Company recorded a $12.7 million impairment charge related to the credit deterioration in the covered loan portfolio. Related to the impairment charge, the Company also recorded a $10.2 million write up of the indemnification asset and a $626 thousand reversal of a portion of the FDIC clawback liability.

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The gain on disposition of covered assets is the income the Company recognizes when a covered asset is paid off or sold and the proceeds exceed its carrying value.   The gain on disposition of covered assets is expected to continue to decline as the balance of covered assets decrease.  At December 31, 2013, covered assets totaled $143.3 million, compared to $227.5 million at December 31, 2012 and $294.8 million at December 31, 2011.

The decrease in other noninterest income in 2012 compared to 2011 was primarily attributable to a $670 thousand gain generated from the sale of the merchant card processing portfolio to a new provider in the second quarter of 2011.

Noninterest Expense: The Company continues to focus on controlling noninterest expense and addressing long term operating expenses. The following table presents the key elements of noninterest expense:

(dollars in thousands)	Years Ended December 31,												Change				Change
	2013				2012				2011				2013 vs. 2012				2012 vs. 2011
Salaries and benefits	$	30,909			$	29,944			$	27,496			$	965			$	2,448
Occupancy and equipment	7,287				6,883				6,553				404				330
Office supplies and printing	1,501				1,643				1,665				(142		)		(22		)
Data processing	2,185				2,134				1,916				51				218
Consulting and professional fees	849				904				1,152				(55		)		(248		)
Intangible amortization	439				512				622				(73		)		(110		)
Merger related expenses	652				—				324				652				(324		)
FDIC premiums	1,091				1,281				1,818				(190		)		(537		)
FDIC clawback liability adjustment	(88		)		1,680				1,576				(1,768		)		104
Non-covered OREO and repossession expenses, net	2,227				1,841				1,358				386				483
Covered OREO and repossession expenses, net	1,696				1,699				2,192				(3		)		(493		)
Other	7,553				7,878				9,153				(325		)		(1,275		)
Total noninterest expense	$	56,301			$	56,399			$	55,825			$	(98	)		$	574

The increase in salaries and benefits in 2013 compared to 2012 was primarily attributable to an increase in salaries due to annual merit increases. The increase in salaries and benefits in 2012 compared to 2011 was primarily due to increases in real estate loan commissions, employee health insurance expense and stock-based compensation expense.  Additionally, the Company paid year-end bonuses of $1.2 million and $1.1 million in 2013 and 2012, respectively.  The Company did not pay any bonuses in 2011.  

The increases in occupancy and equipment were primarily attributable to additional depreciation expense on furniture and equipment and computer software and additional building lease expense.  

Merger related expenses incurred in 2013 relate to the proposed merger with Heritage Financial Corporation and consisted primarily of professional and consulting services. Merger related expenses incurred in 2011 relate to the City Bank and North County Bank acquisitions and consisted primarily of conversion expense, severance and professional and consulting services.

FDIC clawback liability expense represents the Bank’s provision for the estimated liabilities under the loss sharing arrangements entered into with the FDIC for the acquisitions of City Bank on April 16, 2010 and North County Bank on September 24, 2010.  Approximately ten years following the respective acquisition dates, the Bank is required to make a payment to the FDIC in the event that losses on covered assets under the loss share agreements have been less than the stated thresholds in the agreements.

Non-covered and covered OREO and repossession expense represents costs the Company incurs in reclaiming, repairing and selling real estate properties and automobiles, as well as any write-downs or losses on the sale of non-covered and covered OREO properties. The expense on covered OREO is expected to continue to decline as the balance of covered OREO decreases and credit quality and economic conditions improve. At December 31, 2013 , covered OREO totaled $6.0 million, down from $13.5 million at December 31, 2012 .

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The decrease in other noninterest expense in 2013 compared to 2012 was primarily attributable to a decrease in advertising expense. The decrease in other noninterest expense in 2012 compared to 2011 was primarily attributable to the decreases in advertising, sales development, telephone and Business and Occupation (B&O) tax.  During the first quarter of 2011, the Bank paid the B&O tax on the bargain purchase gain on acquisition recognized during the third quarter of 2010.  

Income Taxes: The Company’s consolidated effective tax rate for the year ended December 31, 2013 , was 32.2%, compared to 31.8% and 30.8% for the years ended December 31, 2012 and 2011, respectively. The annual effective tax rates are below the federal statutory rate of 35% principally due to nontaxable income generated from investments in bank owned life insurance, tax-exempt municipal bonds and loans. Additionally, the Company’s tax rate for the years ended December 31, 2012 and 2011 reflect a benefit from the New Market Tax Credit Program. The tax benefits related to these credits were recognized in the same periods that the credits were recognized on the Company’s income tax returns and expired at the ended of 2012. Additional information on income taxes is provided in Item 8- Financial Statements and Supplementary Data, Note (14) Income Taxes of the consolidated financial statements.

Financial Condition Overview

Total assets at December 31, 2013 , were $1.68 billion, compared to $1.69 billion at December 31, 2012.  For the period, net covered loans decreased $76.8 million, investment securities increased $59.5 million and total non-covered loans, net of allowance for loan losses, increased $35.6 million.  Total shareholders’ equity was $179.9 million at December 31, 2013 , compared to $182.6 million at December 31, 2012, a decrease of $2.7 million. The decrease in shareholders’ equity was primarily attributable to net income of $14.5 million reduced by a $9.9 million other comprehensive loss related to the investment securities portfolio and $8.3 million in cash dividends paid on common stock during the year.

Investment Securities:   The composition of the Company's investment portfolio reflects management's investment strategy of maintaining an appropriate level of liquidity while providing a relatively stable source of investment income. The investment securities portfolio provides a vehicle for the investment of available funds and a source of liquidity. At December 31, 2013 , total investment securities increased $59.5 million to $432.5 million, compared to $373.0 million at December 31, 2012. The increase was a result of the Company actively purchasing investment securities during the year as it continued to deploy funds generated through the resolution of acquired assets and the reinvestment of funds generated from maturities and principal payments of investment securities.

At December 31, 2013 , net unrealized losses on investment securities totaled $8.0 million, compared to unrealized gains of $7.2 million at December 31, 2012. The increase in net unrealized losses for the period can be attributed to the increase in interest rates during 2013.

The Company’s investment portfolio mix, based upon fair value, is outlined in the table below:

(dollars in thousands)	December 31, 2013				December 31, 2012
U.S. government agencies	$	85,672			$	88,586
Residential pass-through securities	180,809				168,423
State and political subdivisions	77,275				64,297
Corporate obligations	10,933				10,435
Agency-issued collateralized mortgage obligations	54,145				14,046
Asset-backed securities	21,816				25,188
Investments in mutual funds and other equity securities	1,892				1,993
Total investment securities available for sale (1)	$	432,542			$	372,968

^{(1) Other than securities issued by the U.S. Government and U.S Government agencies and corporations, no investment in aggregate, in a single issuer, exceeds 10% of shareholders’ equity.}  

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The weighted average life of the Company’s investment portfolio in 2013 increased to 5.7 years from 5.3 years in 2012. The following table further details the contractual maturities of the Company’s investment portfolio, based upon fair value at December 31, 2013. Expected maturities may differ from contractual maturities because issuers may have the right to call or repay obligations with or without prepayment penalties.  Additional information about the investment portfolio is provided in Item 8- Financial Statements and Supplementary Data, Note (4) Investment Securities of the consolidated financial statements.

(dollars in thousands)		Dates of Maturities
		Under 1 year				1 - 5 years				5 - 10 years				Over 10 years				Total
U.S. government agencies		$	4,050			$	81,622			$	—			$	—			$	85,672
Weighted average yield		2.83		%		1.15		%		—		%		—				1.22		%
Residential pass-through securities		5,431				21				19,480				155,877				180,809
Weighted average yield		1.51		%		2.07		%		2.06		%		2.14		%		2.11		%
Taxable state and political subdivisions		—				1,098				1,370				—				2,468
Weighted average yield		—		%		4.38		%		4.26		%		—		%		4.31		%
Tax exempt state and political subdivisions		—				2,280				51,869				20,658				74,807
Weighted average yield		—		%		4.71		%		3.15		%		3.72		%		3.37		%
Corporate obligations		—				10,933				—				—				10,933
Weighted average yield		—				1.14		%		—		%		—				1.14		%
Agency-issued collateralized mortgage obligations		—				—				—				54,145				54,145
Weighted average yield		—				—				—				2.05		%		2.05		%
Asset-backed securities		—				—				—				21,816				21,816
Weighted average yield		—				—				—				2.01		%		2.01		%
Investments in mutual funds and other equities		—				—				—				1,892				1,892
Weighted average yield		—				—				—				3.41		%		3.41		%
Total		$	9,481			$	95,954			$	72,719			$	254,388			$	432,542
Weighted average yield		2.08		%		1.38		%		2.88		%		2.22		%		2.13		%

Residential pass-through securities in the table above include both pooled mortgage-backed securities and high quality collateralized mortgage obligation structures, with a weighted average life of 4.9 years.  These mortgage-related securities provide yield spread comparable to U.S. Treasuries or U.S. government agencies; however, the cash flows arising from them can be volatile due to prepayments of the underlying mortgage loans.

Federal Home Loan Bank (FHLB) stock: FHLB stock totaled $7.2 million at December 31, 2013 and $7.4 million at December 31, 2012.

FHLB stock is carried at par and does not have a readily determinable fair value. Ownership of FHLB stock is restricted to the FHLB and member institutions, and can only be purchased and redeemed at par. The remaining restricted equity securities primarily represent investments in Pacific Coast Bankers’ Bancshares stock.

In September 2012, the FHLB of Seattle was notified by the Federal Housing Finance Agency (“Finance Agency”) that it is now classified as “adequately capitalized” as compared to the prior classification of “undercapitalized.” Under Finance Agency regulations, the FHLB of Seattle may repurchase excess capital stock under certain conditions, however they may not redeem stock or pay a dividend without Finance Agency approval. Based on the above, the Company has determined there is not an other-than-temporary impairment on the FHLB stock investment as of December 31, 2013.

Management periodically evaluates FHLB stock for other-than-temporary or permanent impairment. Management’s determination of whether these investments are impaired is based on its assessment of the ultimate recoverability of cost rather than by recognizing temporary declines in value. The determination of whether a decline affects the ultimate recoverability of the cost is influenced by criteria such as (1) the significance of any decline in net assets of the FHLB as compared to the capital stock amount of the FHLB and the length of time this situation has persisted, (2) the compliance with the minimum financial metrics required as part of the Consent Arrangement the FHLB has with the Finance Agency, (3) the impact of legislative and regulatory changes on institutions and, accordingly, the customer base of the FHLB and (4) the liquidity position of the FHLB.

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Non-Covered Loans: Interest and fees earned on the Company’s loan portfolio is the primary source of revenue. The Company attempts to balance the diversity of its portfolio, believing that this provides a good means of minimizing risk. Active portfolio management has resulted in solid loan growth and a diversified portfolio that is not heavily concentrated in any one industry or in any one community.  The composition of the Company’s non-covered loan portfolio is as follows:

 

	December 31,
(dollars in thousands)	2013							2012							2011							2010							2009
	Balance				% of total			Balance				% of total			Balance				% of total			Balance				% of total			Balance				% of total
Commercial	$	179,914			20.3	%		$	162,481			19.1	%		$	150,386			18.5	%		$	145,319			17.5	%		$	93,295			11.5	%
Real estate mortgages:
One-to-four family residential	41,811				4.7	%		36,873				4.3	%		40,331				5.0	%		46,717				5.6	%		53,313				6.5	%
Multi-family and commercial	447,337				50.4	%		415,754				48.8	%		370,782				45.7	%		348,548				41.9	%		360,745				44.5	%
Total real estate mortgages	489,148				55.1	%		452,627				53.1	%		411,113				50.7	%		395,265				47.5	%		414,058				51.0	%
Real estate construction:
One-to-four family residential	33,928				3.8	%		46,472				5.5	%		58,810				7.3	%		72,945				8.8	%		76,046				9.4	%
Multi-family and commercial	22,320				2.6	%		34,926				4.1	%		31,546				3.9	%		42,664				5.1	%		34,231				4.2	%
Total real estate construction	56,248				6.4	%		81,398				9.6	%		90,356				11.2	%		115,609				13.9	%		110,277				13.6	%
Consumer:
Indirect	79,900				9.0	%		77,596				9.1	%		80,396				9.9	%		90,231				10.8	%		100,697				12.4	%
Direct	81,773				9.2	%		77,294				9.1	%		78,726				9.7	%		85,665				10.3	%		93,051				11.5	%
Total consumer	161,673				18.2	%		154,890				18.2	%		159,122				19.6	%		175,896				21.1	%		193,748				23.9	%
Subtotal	886,983				100.0	%		851,396				100.0	%		810,977				100.0	%		832,089				100.0	%		811,378				100.0	%
Deferred loan costs, net	1,703							1,738							1,853							2,204							2,474
Allowance for loan losses	(17,093		)					(17,147		)					(18,032		)					(18,812		)					(16,212		)
Total non-covered loans	$	871,593						$	835,987						$	794,798						$	815,481						$	797,640

The Company’s loan portfolio is comprised of the following loan types:

•	Commercial Loans :  Commercial loans include both secured and unsecured loans for working capital and expansion.  Short-term working capital loans generally are secured by accounts receivable, inventory and/or equipment, while longer-term commercial loans are usually secured by equipment.

•	Real Estate Mortgage Loans : Real estate loans consist of two types: one-to-four family residential and commercial properties.

◦	One-to-Four Family Residential Loans :  One-to-four family residential loans are secured principally by 1st deeds of trust on residential properties principally located within the Company’s market area.

◦

Commercial Real Estate Loans : Commercial real estate loans are secured principally by manufacturing facilities, apartment buildings and commercial buildings for office, storage and warehouse space.  Loans secured by commercial real estate may involve a greater degree of risk than one-to-four family residential loans.  Payments on such loans are often dependent on business cash flows or third party lease payments.

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The composition of the commercial real estate loan portfolio by loan type is as follows:

		December 31,
(dollars in thousands)		2013							2012							2011							2010							2009
		Balance				% of total			Balance				% of total			Balance				% of total			Balance				% of total			Balance				% of total
Commercial real estate:
Office		$	131,396			29.4	%		$	109,152			26.3	%		$	103,470			27.9	%		$	90,875			26.1	%		$	113,694			31.5	%
Retail		141,049				31.5	%		138,356				33.3	%		133,949				36.1	%		135,191				38.8	%		144,102				39.9	%
Industrial		96,984				21.7	%		98,295				23.6	%		73,003				19.7	%		58,520				16.8	%		57,545				16.0	%
Hospitality		31,966				7.1	%		29,880				7.2	%		22,090				6.0	%		22,208				6.4	%		21,659				6.0	%
Other		45,942				10.3	%		40,071				9.6	%		38,270				10.3	%		41,754				11.9	%		23,745				6.6	%
Total commercial real estate		$	447,337			100.0	%		$	415,754			100.0	%		$	370,782			100.0	%		$	348,548			100.0	%		$	360,745			100.0	%

 The composition of the commercial real estate loan portfolio by occupancy type is as follows:

		December 31,
(dollars in thousands)		2013							2012							2011							2010							2009
		Balance				% of total			Balance				% of total			Balance				% of total			Balance				% of total			Balance				% of total
Commercial real estate:
Owner occupied		$	240,721			53.8	%		$	210,149			50.5	%		$	210,681			56.8	%		$	190,351			54.6	%		$	183,137			50.8	%
Non-owner occupied		206,616				46.2	%		205,605				49.5	%		160,101				43.2	%		158,197				45.4	%		177,608				49.2	%
Total commercial real estate		$	447,337			100.0	%		$	415,754			100.0	%		$	370,782			100.0	%		$	348,548			100.0	%		$	360,745			100.0	%

•	Real Estate Construction Loans : Real estate construction loans consist of four types: 1) commercial real estate, 2) one-to-four family residential construction, 3) land development and 4) raw land.

◦	Commercial Real Estate :  Commercial real estate construction loans are primarily for owner-occupied properties.

◦	One-to-Four Family Residential :  One-to-four family residential construction loans are for the construction of custom homes, where the homeowner is the borrower.

◦	Land Development :  Land development loans are principally secured by land, which has been improved with the installation of utilities and infrastructure, to support building construction.

◦	Raw Land :  Raw land loans are principally secured by unimproved land where the borrower intends future development of the property.

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The composition of the real estate construction loan portfolio is as follows:

 

		December 31,
(dollars in thousands)		2013							2012							2011							2010							2009
		Balance				% of total			Balance				% of total			Balance				% of total			Balance				% of total			Balance				% of total
Real estate construction:
Commercial		$	7,471			13.3	%		$	25,693			31.6	%		$	16,252			18.0	%		$	26,134			22.6	%		$	13,805			12.5	%
Residential		6,925				12.3	%		8,027				9.9	%		10,805				12.0	%		11,900				10.3	%		11,867				10.8	%
Land development commercial		3,680				6.5	%		1,603				1.9	%		5,043				5.6	%		5,876				5.1	%		6,608				6.0	%
Land development residential		17,752				31.6	%		25,230				31.0	%		29,358				32.5	%		37,467				32.4	%		37,623				34.1	%
Raw land commercial		11,169				19.9	%		7,631				9.4	%		10,251				11.3	%		10,653				9.2	%		13,087				11.9	%
Raw land residential		9,251				16.4	%		13,214				16.2	%		18,647				20.6	%		23,579				20.4	%		27,287				24.7	%
Total real estate construction		$	56,248			100.0	%		$	81,398			100	%		$	90,356			100	%		$	115,609			100	%		$	110,277			100	%

•	Consumer Loans : The Company’s consumer loan portfolio consists of automobile loans, boat and recreational vehicle financing, home equity and home improvement loans, and miscellaneous secured and unsecured personal loans.

◦	Direct Consumer Loans : Direct consumer loans consist of automobile loans, boat and recreational vehicle financing, home equity and home improvement loans, and miscellaneous secured and unsecured personal loans originated directly by the Bank’s loan officers.

◦	Indirect Consumer Loans : The Company makes loans for new and used automobile and recreational vehicles that are originated indirectly by selected dealers located in the Company’s market areas. The Company has limited its indirect loan purchases primarily to dealerships that are established and well known in their market areas and to applicants that are not classified as sub-prime.

The Company makes certain loans which are guaranteed by the SBA. The SBA, an independent agency of the federal government, provides loan guarantees to qualifying small and medium sized businesses for up to 85% of the principal loan amount. The Company generally sells the guaranteed portion of each loan to investors in the secondary market. The guaranteed portion of an SBA loan is generally sold at a premium. In 2013, the Company sold total guaranteed portions of SBA loans in the amount of $7.8 million, compared with $5.0 million in 2012.  The Company retains the unguaranteed portion of the loan. The retained portion of the SBA loan is classified within the portfolio by loan type.

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Specific types of loans within the Company’s portfolio are more sensitive to interest rate changes. Commercial and real estate construction loan interest rates are primarily based upon current market rates plus a basis point spread charged by the Company. To better understand the Company’s risk associated with these loans, the following table sets forth the maturities by loan type at December 31, 2013:

(dollars in thousands)		Maturing
		Within 1 year				1 - 5 years				After 5 years				Total
Commercial		$	54,426			$	60,017			$	65,471			$	179,914
Real estate construction:
One-to-four family residential		17,327				14,765				1,836				33,928
Multi-family and commercial		1,271				4,418				16,631				22,320
Total real estate construction		18,598				19,183				18,467				56,248
Total		$	73,024			$	79,200			$	83,938			$	236,162
Fixed-rate loans		$	13,564			$	42,043			$	12,369			$	67,976
Variable-rate loans		59,460				37,157				71,569				168,186
Total		$	73,024			$	79,200			$	83,938			$	236,162

At December 31, 2013, approximately 73% of these variable rate loans had an interest rate floor in place.

Covered Loans: The composition of the Company’s covered loan portfolio is as follows:

(dollars in thousands)	December 31,
	2013				2012				2011				2010
Commercial	$	17,285			$	29,011			$	43,588			$	32,837
Real estate mortgages:
One-to-four family residential	10,969				14,195				15,753				17,724
Multi-family residential and commercial	122,072				184,583				230,310				282,034
Total real estate mortgages	133,041				198,778				246,063				299,758
Real estate construction:
One-to-four family residential	1,327				7,764				11,875				70,885
Multi-family and commercial	9,243				18,743				34,470				78,679
Total real estate construction	10,570				26,507				46,345				149,564
Consumer - direct	6,796				10,219				14,768				22,626
Subtotal	167,692				264,515				350,764				504,785
Fair value discount	(15,737		)		(47,176		)		(81,683		)		(138,632		)
Total covered loans	151,955				217,339				269,081				366,153
Allowance for loan losses	(14,622		)		(3,252		)		(870		)		(1,336		)
Total covered loans, net	$	137,333			$	214,087			$	268,211			$	364,817

On April 16, 2010, the Bank acquired certain assets and assumed certain liabilities of City Bank, Lynnwood, Washington, from the Federal Deposit Insurance Corporation (“FDIC”), as receiver of City Bank, in an FDIC-assisted transaction. As part of the Purchase and Assumption Agreement, the Bank and the FDIC entered into loss share agreements (each, a “loss share agreement” and collectively, the “loss share agreements”). The Bank will share in the losses, which begins with the Bank incurring the first 2% of losses, on the covered assets. After the first 2% of losses on covered assets, the FDIC will absorb 80% of losses and share in 80% of loss recoveries on 100% of the covered loan portfolio. The loss share agreement for commercial and single family residential mortgage loans are in effect for five years and ten years, respectively, from the April 16, 2010 acquisition date and the loss recovery provisions for such loans are in effect for eight years and ten years, respectively, from the acquisition date.

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In April 2020, approximately ten years following the acquisition date, the Bank is required to make a payment to the FDIC in the event that losses on covered assets under the loss share agreements have been less than the stated threshold level. The payment amount will be 50% of the excess, if any, of (i) 20% of the intrinsic loss estimate ($111.0 million) minus (ii) the sum of (a) 25% of the asset discount (or 25% of the asset discount of ($50.7 million)), plus (b) 25% of cumulative loss share payments (as defined in the Agreement), plus (c) the cumulative servicing amount received by the Bank from the FDIC on covered assets. The Bank recorded an estimated liability of $913 thousand under this provision at December 31, 2013.

On September 24, 2010, the Bank assumed certain deposit liabilities and acquired certain assets of North County Bank, Arlington, Washington from the FDIC as receiver for North County Bank and entered into a Purchase and Assumption Agreement with the FDIC. As part of the Agreement, the Bank and the FDIC entered into a loss sharing arrangement covering future losses incurred on acquired or “covered” loans and other real estate owned (“OREO”).  On single family loans and OREO, the FDIC will absorb: (i) 80% of losses on the first $7.8 million of losses incurred; (ii) 0% of losses on $7.8 million to $12.3 million of losses incurred; and (iii) 80% of losses above $12.3 million of losses incurred. On commercial and non-single family loans and OREO, the FDIC will absorb: (i) 80% of losses on the first $33.9 million of losses incurred; (ii) 0% of losses on $33.9 million to $47.9 million of losses incurred; and (iii) 80% of losses above $47.9 million of losses incurred.  The FDIC will share in loss recoveries on the covered loan and OREO portfolio. 

In September 2020, approximately ten years following the acquisition date, the Bank is required to make a payment to the FDIC in the event that losses on covered assets under the loss share agreements have been less than the stated threshold level. The payment amount will be 50% of the excess, if any, of (i) 20% of the intrinsic loss estimate ($46.9 million) minus (ii) the sum of (a) 20% of the net loss amount, plus (b) 25% of the asset discount bid ($62.5 million), plus (c) 3.5% of total loss share assets at acquisition. The Bank recorded an estimated liability of $4.2 million under this provision at December 31, 2013.

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Credit Risks and Asset Quality

Credit Risks: The extension of credit, in the form of loans or other credit substitutes, to individuals and businesses is a major portion of the Company’s principal business activity.  Company policies and applicable laws and regulations require risk analysis as well as ongoing portfolio and credit management.

 

The Company manages its credit risk through lending limits, credit review, approval policies and extensive, ongoing internal monitoring. Through this monitoring process, nonperforming loans are identified. Nonperforming assets consist of nonaccrual loans, nonaccruing restructured loans, past due loans and other real estate owned. Additional information on nonperforming assets is provided in Item 8- Financial Statements and Supplementary Data, Note (1) Significant Accounting Policies of the consolidated financial statements. Nonperforming assets are assessed for potential loss exposure on an individual or homogeneous group basis. Further details on the loss analysis are provided in the Allowance for Loan Losses   section.

The following table summarizes the Company’s nonperforming non-covered assets for the past five years:

 

	December 31,
(dollars in thousands)	2013				2012				2011				2010				2009
Non-covered nonperforming loans	$	8,409			$	15,551			$	22,100			$	25,846			$	3,395
Non-covered other real estate owned	3,067				3,023				1,976				4,122				4,549
Total non-covered nonperforming assets	$	11,476			$	18,574			$	24,076			$	29,968			$	7,944
Restructured Loans (1)	$	24,409			$	26,303			$	26,493			$	19,936			$	—
Total non-covered impaired loans	$	32,818			$	41,854			$	48,593			$	45,782			$	3,395
Non-covered accruing loans past due 90 days or more	$	—			$	—			$	—			$	—			$	—
Non-covered potential problem loans (2)	$	798			$	2,601			$	2,179			$	5,178			$	4,586
Allowance for loan losses	$	17,093			$	17,147			$	18,032			$	18,812			$	16,212
Non-covered nonperforming loans to total gross
non-covered loans	0.95		%		1.82		%		2.72		%		3.10		%		0.42		%
Allowance for loan losses to total gross non-covered loans	1.92		%		2.01		%		2.22		%		2.25		%		1.99		%
Allowance for loan losses to total non-covered
nonperforming loans	203.27		%		110.26		%		81.59		%		72.79		%		477.53		%
Non-covered nonperforming assets to total assets	0.68		%		1.10		%		1.44		%		1.76		%		0.76		%

^{(1) Represents accruing restructured loans performing according to their restructured terms.}  

^{(2) Potential problem loans represent loans where known information about possible credit problems of borrowers causes management to have serious doubts about the ability of such borrowers to comply with the present loan repayment terms but the loans do not presently meet the criteria to be classified as impaired.}  

 

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Asset Quality: The following table sets forth historical information regarding the Company's net charge-offs and average non-covered loans for the past five years:

(dollars in thousands)		December 31,
		2013				2012				2011				2010				2009
Indirect net charge-offs		$	325			$	391			$	626			$	954			$	1,574
Other net charge-offs		1,604				7,594				10,654				8,596				4,664
Total net charge-offs		$	1,929			$	7,985			$	11,280			$	9,550			$	6,238
Average indirect loans		$	80,118			$	81,043			$	88,054			$	98,360			$	104,871
Average other loans		777,329				738,335				737,574				730,800				714,830
Total average loans (1)		$	857,447			$	819,378			$	825,628			$	829,160			$	819,701
Indirect net charge-offs to average indirect loans		0.41		%		0.48		%		0.71		%		0.97		%		1.50		%
Other net charge-offs to average other loans		0.21		%		1.03		%		1.44		%		1.18		%		0.65		%
Net charge-offs to average loans		0.22		%		0.97		%		1.37		%		1.15		%		0.76		%

^{(1) Excludes average loans held for sale.}  

Allowance for Loan Losses

The allowance for loan losses is maintained at a level considered adequate by management to provide for potential loan losses inherent in the portfolio. The Company assesses the allowance for loan losses on a quarterly basis. The Company's methodology for making such assessments and determining the adequacy of the allowance includes the following key elements:

•	Specific Allowances: A specific allowance is established when management has identified unique or particular risks that are related to a specific loan that demonstrate risk characteristics consistent with impairment. Specific allowances may also be established to address the unique risks associated with a group of loans or particular type of credit exposure.

•	Formula Allowance: The calculations of expected loss rates are determined utilizing a two factor approach; loss given default (“LGD”) and probability of default (“PD”). Taken together, these two factors produce the expected loss rate.

◦

LGD is defined as the rate of loss as determined by dividing the expected net charge-off by defaulted loans, where defaulted loans are defined as loans that have 30 days or greater payment delinquency plus non-accrual and gross loans charged off.  LGD rates utilized reflect industry experience as determined by state and loan type, and are based upon banks with total assets below $1 billion.  Banks falling into these size and state groupings will better capture state/geographic differences that occur in LGD rates, as well as provide a sufficient number of observations to be statistically meaningful. LGD rates are based upon industry experience starting in 1992 and applied at a two standard deviation level. Bank specific LGD rates are utilized when there are sufficient observations to generate a meaningful result, and these observations should include at least three observations as observed over a minimum of at least one full economic cycle for each type/sector/subsector/geographic combination to be considered meaningful.

◦

PD is defined as the actual payment default rate (defined as the number of times a loan has been delinquent 30 or more days divided by the number of months the loan has been outstanding from the origination date to the valuation date), or for loans which have not generated an actual payment default rate, the rate applied is based upon industry experience for such loans as applied by loan type and state in which the loan applies to (in the case of real estate loans, the state determination is based upon were the collateral resides), where the expected payment default rate is defined as the sum loans where payment delinquencies are 30 or more days delinquent, plus non-accrual and gross loans charged off divided by total loans for each group. Expected payment default rates are then scaled against the bank’s loan risk grades with the bank’s lowest pass/non-watch grade set to equal the industry PD and then scaled lower or higher against the bank’s remaining loan grades.

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Management believes that the allowance for loan losses was adequate as of December 31, 2013. There is, however, no assurance that future loan losses will not exceed the levels provided for in the allowance for loan losses and could possibly result in additional charges to the provision for loan and lease losses. In addition, bank regulatory authorities, as part of their periodic examination of the Bank, may require additional charges to the provision for loan and lease losses in future periods if warranted as a result of their review. Approximately 82% of our loan portfolio is secured by real estate, and a significant decline in real estate market values may require an increase in the allowance for loan and lease losses. The U.S. recession, the housing market downturn and declining real estate values in our markets have negatively impacted aspects of our residential development, commercial real estate, commercial construction and commercial loan portfolios. A continued deterioration in our markets may adversely affect our loan portfolio and may lead to additional charges to the provision for loan losses.

The following table sets forth historical information regarding changes in the Company's allowance for loan losses:

 

(dollars in thousands)	December 31,
	2013				2012				2011				2010				2009
Balance at beginning of period	$	17,147			$	18,032			$	18,812			$	16,212			$	12,250
Provision for non-covered loan losses	1,875				7,100				10,500				12,150				10,200
Charge-offs:
Commercial	(562		)		(1,640		)		(1,707		)		(2,071		)		(964		)
Real estate mortgage	(225		)		(3,311		)		(8,547		)		(2,868		)		(1,640		)
Real estate construction	(70		)		(2,706		)		(144		)		(3,516		)		(2,600		)
Consumer:
Direct	(1,766		)		(725		)		(1,335		)		(632		)		(650		)
Indirect	(673		)		(801		)		(1,208		)		(1,691		)		(2,416		)
Total charge-offs	(3,296		)		(9,183		)		(12,941		)		(10,778		)		(8,270		)
Recoveries:
Commercial	235				248				269				214				655
Real estate mortgage	183				438				688				47				359
Real estate construction	442				11				2				131				48
Consumer:
Direct	159				91				120				99				128
Indirect	348				410				582				737				842
Total recoveries	1,367				1,198				1,661				1,228				2,032
Net charge-offs	(1,929		)		(7,985		)		(11,280		)		(9,550		)		(6,238		)
Balance at end of period	$	17,093			$	17,147			$	18,032			$	18,812			$	16,212

The following table shows the allocation of the allowance for loan losses, by loan type, for the past five years:

(dollars in thousands)	December 31,
	2013							2012							2011							2010							2009
	Amount				% of Loans (1)			Amount				% of Loans (1)			Amount				% of Loans (1)			Amount				% of Loans (1)			Amount				% of Loans (1)
Commercial	$	4,323			20.3	%		$	4,405			19.1	%		$	4,034			18.5	%		$	3,915			17.5	%		$	1,515			11.5	%
Real estate mortgage	6,827				55.1	%		6,516				53.1	%		6,500				50.7	%		6,507				47.5	%		8,060				51.0	%
Real estate construction	3,050				6.4	%		3,050				9.6	%		4,046				11.2	%		4,947				13.9	%		2,330				13.6	%
Consumer	2,893				18.2	%		3,176				18.2	%		3,452				19.6	%		3,443				21.1	%		4,307				23.9	%
Total	$	17,093			100.0	%		$	17,147			100.0	%		$	18,032			100.0	%		$	18,812			100.0	%		$	16,212			100.0	%

   ^{(1) Represents the total of outstanding loans in each category as a percent of total loans outstanding.}  

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The allocation of the allowance for loan losses should not be interpreted as an indication of specific amounts or loan categories in which future charge-offs may occur.

Deposits: In 2013, the Company focused its efforts on maintaining its deposit base through competitive pricing and delivery of quality service. Additional information regarding deposits is provided in Item 8- Financial Statements and Supplementary Data, Note (11) Deposits .

 

(dollars in thousands)		December 31,
		2013							2012							2011
		Average balance				Average rate			Average balance				Average rate			Average balance				Average rate
Interest-bearing demand and MMA deposits		$	647,965			0.16	%		$	611,477			0.22	%		$	581,189			0.41	%
Savings deposits		119,518				0.05	%		105,085				0.10	%		96,892				0.21	%
Time deposits		403,478				0.95	%		497,812				1.03	%		606,771				1.14	%
Total interest-bearing deposits		1,170,961				0.42	%		1,214,374				0.54	%		1,284,852				0.74	%
Demand and other noninterest-bearing deposits		257,314							243,522							202,297
Total average deposits		$	1,428,275						$	1,457,896						$	1,487,149

Wholesale Deposits: The following table further details wholesale deposits, which are included in total deposits shown above:

 

(dollars in thousands)		December 31,
		2013							2012							2011
		Balance				% of total			Balance				% of total			Balance				% of total
Mutual fund money market deposits		14,704				97.8	%		14,704				53.9	%		24,704				75.1	%
CDARS deposits		327				2.2	%		12,579				46.1	%		8,174				24.9	%
Total wholesale deposits		$	15,031			100.0	%		$	27,283			100.0	%		$	32,878			100.0	%
Wholesale deposits to total deposits		1.0		%					1.9		%					2.2		%

Mutual fund money market deposits are obtained from an intermediary that provides cash sweep services to broker-dealers and clearing firms. Currently, the Company anticipates limiting the growth of these types of deposits. The deposits are payable upon demand.

Certificate Deposit Account Registry System (“CDARS”) deposits are obtained through a broker and represent a reciprocal agreement, whereby the Company obtains a portion of time deposits from another financial institution, not to exceed $250,000 per customer. In return, the other financial institution obtains a portion of the Company’s time deposits. All CDARS deposits represent direct customer relationships with the Company, but for regulatory purposes are required to be classified as brokered deposits. Deposit maturities range between four weeks and twenty four months.

Although a significant amount of time deposits will mature and reprice in the next twelve months, the Company expects to retain the majority of such deposits. In the short term, time deposits have limited impact on the liquidity of the Company and these deposits can generally be retained and expanded with increases in rates paid which might, however, increase the cost of funds more than anticipated.

The following table sets forth the amounts and maturities of time deposits:

 

(dollars in thousands)		December 31, 2013
		Less than 3 months				3 - 6 months				6 to 12 months				Over 12 months				Total
Time deposits of $100,000 or more		$	24,180			$	21,578			$	63,701			$	47,083			$	156,542
All other time deposits		30,570				35,917				87,874				48,747				203,108
Total		$	54,750			$	57,495			$	151,575			$	95,830			$	359,650

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Borrowings: Total borrowings outstanding totaled $25.8 million at December 31, 2013 and 2012, and represents junior subordinated debentures.  The Company’s sources of funds from borrowings consist of borrowings from correspondent banks, the FHLB, the Federal Reserve Bank and junior subordinated debentures.

•

FHLB Overnight Borrowings and Other Borrowed Funds : The Company can use advances from the FHLB to supplement funding needs. The FHLB provides credit for member financial institutions in the form of overnight borrowings, short term and long term advances. As a member, the Bank is required to own capital stock in the FHLB and is authorized to apply for advances on the pledge of certain of its mortgage loans and other assets (principally, securities which are obligations of, or guaranteed by, the United States) provided certain standards related to creditworthiness have been met.

At December 31, 2013 and 2012, the Company had no outstanding overnight borrowings.  At December 31, 2013, the Company had an unused line of credit of $201.2 million, subject to certain collateral and stock requirements. Additional information regarding FHLB borrowings is provided in Item 8- Financial Statements and Supplementary Data, Note (12) FHLB Borrowings and Fed Funds Purchased .

•	Federal Funds Purchased : The Company also uses lines of credit at correspondent banks to purchase federal funds for short-term funding. There were no outstanding borrowings at December 31, 2013 and 2012. Available borrowings under these lines of credit totaled $45.0 million at December 31, 2013.

•

Federal Reserve Bank Overnight Borrowings : The Company can use advances from the Federal Reserve Bank (“FRB”) of San Francisco to supplement funding needs. The FRB provides credit for financial institutions in the form of overnight borrowings. The Bank is required to pledge certain of its loans and other assets (principally, securities which are obligations of, or guaranteed by, the United States) provided certain standards related to creditworthiness have been met.  There were no outstanding overnight borrowings at December 31, 2013 and 2012.  Available overnight borrowings under these lines of credit totaled $17.2 million at December 31, 2013.

 

Junior Subordinated Debentures: On April 2, 2007, a newly created wholly-owned subsidiary of the Company issued $10.3 million of trust preferred securities with a quarterly adjustable rate based upon the London Interbank Offered Rate (“LIBOR”) plus 1.56%. Additionally, on June 29, 2007, the Company prepaid $15.0 million of outstanding trust preferred securities with a quarterly adjustable rate of LIBOR plus 3.65%. On the same day, the Company replaced the called securities with another issuance of $15.5 million of trust preferred securities with a quarterly adjustable rate of LIBOR plus 1.56%. Junior subordinated debentures totaled $25.8 million at December 31, 2013 and 2012.  At December 31, 2013 and 2012, $25.0 million of the debentures were considered Tier 1 capital for regulatory capital requirements.

Capital

Shareholders’ Equity: Shareholders’ equity decreased $2.7 million to $179.9 million at December 31, 2013 from $182.6 million at December 31, 2012. The decrease in shareholders’ equity was primarily due to net income available to common shareholders of $14.5 million reduced by a $9.9 million other comprehensive loss related to the investment securities portfolio and $8.3 million in cash dividends paid on common stock for the year ended December 31, 2013.

TARP-CPP Capital:  On January 16, 2009, in exchange for an aggregate purchase price of $26.4 million, the Company issued and sold to the United States Department of the Treasury pursuant to the Troubled Asset Relief Program Capital Purchase Program the following: (i) 26,380 shares of the Company’s newly designated Fixed Rate Cumulative Perpetual Preferred Stock, Series A, no par value per share, and liquidation preference $1,000 per share ($26.4 million liquidation preference in the aggregate) and (ii) a warrant to purchase up to 492,164 shares of the Company’s common stock, no par value per share, at an exercise price of $8.04 per share, subject to certain anti-dilution and other adjustments.

In connection with the issuance and sale of the Company’s securities, the Company entered into a Letter Agreement including the Securities Purchase Agreement - Standard Terms, dated January 16, 2009, with the United States Department of the Treasury (the “Agreement”). The Agreement contained limitations on the payment of quarterly cash dividends on the Company’s common stock in excess of $0.065 per share and on the Company’s ability to repurchase its common stock.

The Series A Preferred Stock paid cumulative dividends at a rate of 5% per annum, applied to the $1,000 per share liquidation preference, as and if declared by the Company’s Board of Directors out of funds legally available. The Series A Preferred Stock had no maturity date and ranked senior to common stock with respect to the payment of dividends and distributions and amounts payable upon liquidation, dissolution and winding up of the Company.

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On January 12, 2011, the Company redeemed all 26,380 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A.  The Company paid a total of $26.6 million to the Treasury, consisting of $26.4 million in principal and $209 thousand in accrued and unpaid dividends. The Company's redemption of the shares was not subject to additional conditions.

On March 2, 2011, the Company completed the repurchase of Warrant to Purchase Common Stock issued to the U.S. Department of the Treasury pursuant to the Troubled Asset Relief Program Capital Purchase Program. The Company repurchased the Warrant for $1.6 million. The Warrant repurchase, together with the Company’s earlier redemption of the entire amount of Fixed Rate Cumulative Perpetual Preferred Stock, Series A, issued to the U.S. Treasury, represents full repayment of all TARP obligations and cancellation of all equity interests in the Company held by the U.S. Treasury.

 

Common Stock Capital: The Company entered into an Underwriting Agreement dated November 24, 2009 with RBC Capital Markets Corporation, as representative of the underwriters listed therein (collectively the “Underwriters”), providing for the offer and sale in a firm commitment offering of 5,000,000 shares of the Company’s common stock, no par value per share, sold by the Company at a price of $9.00 per share ($8.55 per share, net of underwriting discounts).

In addition, pursuant to the terms of the Underwriting Agreement, the Company granted the Underwriters a 30-day option to purchase up to 750,000 additional shares of the Company’s common stock to cover over-allotments.

On November 30, 2009, the Company completed the public sale of a total of 5,750,000 shares of common stock at a price of $9.00 per share, after giving effect to the sale of the shares being sold pursuant to the over-allotment option, for gross proceeds of approximately $51.8 million. The Company received net proceeds, after underwriting, legal and accounting expenses, of $49.0 million. In connection with the Company’s public offering in the fourth quarter of 2009, the number of shares of common stock underlying the warrant held by the U.S. Treasury was reduced by 50%, to 246,082 shares.

 

The following table represents the common stock cash dividends declared and the dividend payout ratio for the past three years:

 

		Years Ended December 31,
		2013				2012				2011
Dividends declared per share		$	0.535			$	0.50			$	0.20
Dividend payout ratio		57.25		%		45.81		%		20.63		%

Cash dividends are approved by the Board of Directors in connection with its review of the Company’s capital plan. The cash dividend is subject to regulatory limitation as described in Item 1- Business, Supervision and Regulation Section. There is no assurance that future cash dividends will be declared or increased. For further information on shareholders’ equity, see Item 8- Financial Statements and Supplementary Data, Consolidated Statements of Shareholders’ Equity.

Regulatory Capital Requirements: The Company (on a consolidated basis) and the Bank are subject to minimum capital requirements, under which risk percentages are assigned to various categories of assets and off-balance sheet items to calculate a risk-adjusted capital ratio.  The Federal Reserve and FDIC regulations set forth the qualifications necessary for bank holding companies and banks to be classified as “well capitalized,” primarily for assignment of insurance premium rates.  Failure to qualify as “well capitalized” can: (a) negatively impact a bank’s ability to expand and to engage in certain activities, (b) cause an increase in insurance premium rates, and (c) impact a bank holding company’s ability to utilize certain expedited filing procedures, among other things. The Company’s and Bank’s current capital ratios are located in Item 8- Financial Statements and Supplementary Data , Note (19) Regulatory Capital Matters of the consolidated financial statements.

On July 2, 2013, the Federal Reserve Board approved the final rules implementing the Basel Committee on Banking Supervision's capital guidelines for U.S. banks. Under the final rules, minimum requirements will increase for both the quantity and quality of capital held by the Bank. The rules include a new common equity Tier 1 capital to risk-weighted assets ratio of 4.5% and a common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets. The final rules also raise the minimum ratio of Tier 1 capital to risk-weighted assets from 4.0% to 6.0% and require a minimum leverage ratio of 4.0%. The final rules also implement strict eligibility criteria for regulatory capital instruments. On July 9, 2013, the FDIC also approved, as an interim final rule, the regulatory capital requirements for U.S. banks, following the actions of the Federal Reserve Board. The FDIC's rule is identical in substance to the final rules issued by the FRB.   The phase-in period for the final rules will begin for us on January 1, 2015, with full compliance with all of the final rule's requirements phased in over a multi-year schedule. We are currently evaluating the provisions of the final rules and their expected impact on us. Based on a preliminary analysis of the new rules, management believes that it would be fully compliant with the revised standards as of December 31, 2013 if they were effective on that date.

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Liquidity and Cash Flows

Whidbey Island Bank: The principal objective of the Bank’s liquidity management program is to maintain the ability to meet day-to-day cash flow requirements of its customers who either wish to withdraw funds or to draw upon credit facilities to meet their cash needs. The Bank monitors the sources and uses of funds on a daily basis to maintain an acceptable liquidity position. In addition to liquidity from core deposits and the repayment and maturities of loans, the Bank can utilize established lines of credit with correspondent banks, sale of investment securities or borrowings from the FHLB.

 

Washington Banking Company: The Company is a separate legal entity from the Bank and must provide for its own liquidity. Substantially all of the Company’s revenues are obtained from dividends declared and paid by the Bank. There are statutory and regulatory provisions that could limit the ability of the Bank to pay or increase the level of dividends to the Company. However, management believes that such restrictions will not have an adverse impact on the ability of the Company to meets its ongoing cash obligations, which consist principally of debt service on the $25.8 million of outstanding junior subordinated debentures, which totaled approximately $478 thousand in 2013. Further information on the Company’s cash flows can be found in Item 8- Financial Statements and Supplementary Data , Note (21) Washington Banking Company Information of the consolidated financial statements.

Consolidated Cash Flows: The consolidated cash flows of the Company and its subsidiary the Bank are disclosed in the Consolidated Statement of Cash Flows found in Item 8- Financial Statements and Supplementary Data. Net cash provided by operating activities was $63.6 million for the year ended December 31, 2013. The principal source of cash provided by operating activities was net income from continuing operations and proceeds from the sale of loans held for sale. For 2013, $36.2 million was used in investing activities of the Company, primarily net purchases of available for sale investment securities partially offset by proceeds from the sale of covered other real estate owned.  Financing activities used $3.7 million in net cash, primarily due to the cash dividends paid on common stock partially offset by an increase in deposits.

Capital Resources

 

Off-Balance Sheet Commitments:   Standby letters of credit, commercial letters of credit and financial guarantees written, are conditional commitments issued by the Company to guarantee the performance of a customer to a third party or payment by a customer to a third party.  Those guarantees are primarily issued in international trade or to support public and private borrowing arrangements, including commercial paper, bond financing and similar transactions.  Except for certain long-term guarantees, the majority of guarantees expire in one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.  Collateral supporting those commitments, for which collateral is deemed necessary, generally amounts to one hundred percent of the commitment.  The Company routinely charges a fee for these credit facilities. The Company was not required to perform on any financial guarantees in 2013.

The following table summarizes the Company’s commitments to extend credit:

(dollars in thousands)		December 31, 2013
Loan commitments:
Fixed rate		$	10,380
Variable rate		183,344
Total loan commitments		193,724
Standby letters of credit		1,114
Total commitments		$	194,838

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Contractual Commitments: The Company is party to many contractual financial obligations, including repayment of borrowings and operating lease payments. The following table summarizes the contractual obligations of the Company as of December 31, 2013:

(dollars in thousands)		Future Contractual Obligations
		Within 1 year				1 - 3 years				3 - 5 years				Over 5 years				Total
Operating leases		$	1,392			$	2,467			$	2,029			$	1,683			$	7,571
Junior subordinated debentures		—				—				—				25,774				25,774
Total		$	1,392			$	2,467			$	2,029			$	27,457			$	33,345

Item 7A. Quantitative and Qualitative Disclosures about Market Risk

Asset/Liability Management

The purpose of asset/liability management is to provide stable net interest income by protecting the Company’s earnings from undue interest rate risk that arises from volatile interest rates and changes in the balance sheet mix, and by managing the risk/return relationships between liquidity, interest rate risk, market risk, and capital adequacy.  The Company maintains an asset/liability management policy that provides guidelines for controlling exposure to interest rate risk by utilizing the following ratios and trend analysis: liquidity, equity, volatile liability dependence, portfolio maturities, maturing assets and maturing liabilities.  The Company’s policy is to control the exposure of its earnings to changing interest rates by generally endeavoring to maintain a position within a narrow range around an “earnings neutral position,” which is defined as the mix of assets and liabilities that generate a net interest margin that is least affected by interest rate changes.

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Market Risk

Interest Rate Risk: The Company is exposed to interest rate risk.  Interest rate risk is the risk that financial performance will decline over time due to changes in prevailing interest rates and resulting yields on interest-earning assets and costs of interest-bearing liabilities.  Generally, there are three sources of interest rate risk as described below:

•	Re-pricing Risk: Generally, re-pricing risk is the risk of adverse consequences from a change in interest rates that arises because of differences in the timing of when those interest rate changes affect an institution’s assets and liabilities.

•	Basis Risk: Basis risk is the risk of adverse consequences resulting from unequal changes in the spread between two or more rates for different instruments with the same maturity.

•	Option Risk: In banking, option risks are known as borrower options to prepay loans and depositor options to make deposits, withdrawals, and early redemptions.  Option risk arises whenever bank products give customers the right, but not the obligation, to alter the quantity of the timing of cash flows.

A number of measures are used to monitor and manage interest rate risk, including income simulations and interest sensitivity (gap) analysis.  An income simulation model is the primary tool used to assess the direction and magnitude of changes in net interest income resulting from changes in interest rates.  Key assumptions in the model include prepayment speeds on fixed rate assets, cash flows and maturities of other investment securities, and loan and deposit volumes and pricing.  These assumptions are inherently uncertain and, as a result, the model cannot precisely estimate net interest income or precisely predict the impact of higher or lower interest rates on net interest income.  Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes, changes in market conditions and management strategies, among other factors.

 

(dollars in thousands)		2013							2012
		1 year change in net interest income from scenario				Percentage change			1 year change in net interest income from scenario				Percentage change
Scenario
Up 100 basis points		$	(469	)		(0.7	)%		$	(862	)		(1.2	)%
Up 200 basis points		$	(592	)		(0.9	)%		$	(1,280	)		(1.7	)%
Up 300 basis points		$	(767	)		(1.2	)%		$	(1,531	)		(2.1	)%

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Interest Rate Sensitivity: The analysis of an institution’s interest rate gap (the difference between the repricing of interest-earning assets and interest-bearing liabilities during a given period of time) is another standard tool for the measurement of the exposure to interest rate risk.  The Company believes that because interest rate gap analysis does not address all factors that can affect earnings performance, it should be used in conjunction with other methods of evaluating interest rate risk.

The following table sets forth the estimated maturity or repricing, and the resulting interest rate gap of the Company’s interest-earning assets and interest-bearing liabilities at December 31, 2013.  The interest rate gaps reported in the table arise when assets are funded with liabilities having different repricing intervals.  The amounts shown in the following table could be significantly affected by external factors such as changes in prepayment assumptions, early withdrawals of deposits and competition:

 

(dollars in thousands)		0 - 3 months				4 - 12 months				1 - 5 years				Over 5 years				Total
Interest-earning assets:
Interest-earning deposits		$	103,869			$	—			$	—			$	—			$	103,869
Investment securities		2,011				4,320				290,764				135,447				432,542
Investment in subsidiary		—				—				—				774				774
FHLB stock		7,172				—				—				—				7,172
Loans held for sale		3,389				—				—				—				3,389
Total loans		180,814				113,379				336,025				410,423				1,040,641
Total interest-earning assets		$	297,255			$	117,699			$	626,789			$	546,644			$	1,588,387
Percent of interest-earning assets		18.7		%		7.4		%		39.5		%		34.4		%		100.0		%
Interest-bearing liabilities:
Interest-bearing demand deposits		$	370,244			$	—			$	—			$	—			$	370,244
Money market deposits		347,670				—				—				—				347,670
Savings deposits		124,516				—				—				—				124,516
Time deposits		54,750				209,070				95,830				—				359,650
Junior subordinated debentures		25,774				—				—				—				25,774
Total interest-bearing liabilities		$	922,954			$	209,070			$	95,830			$	—			$	1,227,854
Percent of interest-bearing liabilities		75.2		%		17.0		%		7.8		%		—		%		100.0		%
Interest sensitivity gap		$	(625,699	)		$	(91,371	)		$	530,959			$	546,644			$	360,533
Interest sensitivity gap, as a
percentage of total assets		(37.2		)%		(5.4		)%		31.5		%		32.5		%
Cumulative interest sensitivity gap		$	(625,699	)		$	(717,070	)		$	(186,111	)		$	360,533
Cumulative interest sensitivity gap, as a
percentage of total assets		(37.2		)%		(42.6		)%		(11.1		)%		21.4		%

Impact of Inflation and Changing Prices

The primary impact of inflation on the Company’s operations is increased operating costs. Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature.  As a result, interest rates generally have a more significant impact on a financial institution’s performance than the effects of general levels of inflation.  Although interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services, increases in inflation generally have resulted in increased interest rates.

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Item 8. Financial Statements and Supplementary Data

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

	Page
Management's Report on Internal Control over Financial Reporting	48
Report of Independent Registered Public Accounting Firm	49
Consolidated Statements of Financial Condition at December 31, 2013 and 2012	50
Consolidated Statements of Income for the years ended December 31, 2013, 2012 and 2011	51
Consolidated Statements of Comprehensive Income for the years ended December 31, 2013, 2012 and 2011	52
Consolidated Statements of Shareholders' Equity for the years ended December 31, 2013, 2012 and 2011	53
Consolidated Statements of Cash Flows for the years ended December 31, 2013, 2012 and 2011	53
Notes to Consolidated Financial Statements	55

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MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

The Company’s management, including its Chief Executive Officer and its Chief Financial Officer, together with its consolidated subsidiary, is responsible for establishing, maintaining and assessing adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934). The Company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Company’s financial statements for external reporting purposes in accordance with accounting principles generally accepted in the United States of America.

The Company’s internal control over financial reporting includes policies and procedures that pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect transactions and dispositions of assets; provide reasonable assurances that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures are being made only in accordance with authorizations of management and the directors of the Company; and provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the Company’s financial statements.

Management recognizes that there are inherent limitations in the effectiveness of any system of internal control, and accordingly, even effective internal control can provide only reasonable assurance with respect to financial statement preparation and fair presentation. Further, because of changes in conditions, the effectiveness of internal control may vary over time.

The Company’s management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2013. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in the Internal Control-Integrated Framework (1992). Based on this assessment, management believes that, as of December 31, 2013, the Company’s internal control over financial reporting was effective based on those criteria.

The Company’s independent registered public accounting firm has audited the Company’s consolidated financial statements as of and for the year ended December 31, 2013 that are included in this annual report and issued their Report of Independent Registered Public Accounting Firm, appearing under Item 8, which includes an attestation report on the Company’s internal control over financial reporting. The attestation report expresses an unqualified opinion on the effectiveness of the Company’s internal controls over financial reporting as of December 31, 2013.

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders

Washington Banking Company and Subsidiaries

We have audited the accompanying consolidated statements of financial condition of Washington Banking Company and Subsidiaries (the Company) as of December 31, 2013 and 2012, and the related consolidated statements of income, comprehensive income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2013. We also have audited the Company’s internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control - Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Report of Management on Internal Control over Financial Reporting. Our responsibility is to express an opinion on these consolidated financial statements and an opinion on the Company’s internal control over financial reporting based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the consolidated financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall consolidated financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Washington Banking Company and Subsidiaries as of December 31, 2013 and 2012, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2013, in conformity with generally accepted accounting principles in the United States of America. Also in our opinion, Washington Banking Company and Subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control - Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission.

/s/ Moss Adams LLP

Everett, Washington

March 14, 2014

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WASHINGTON BANKING COMPANY AND SUBSIDIARIES

Consolidated Statements of Financial Condition

 (Dollars in thousands, except share data)

	December 31, 2013				December 31, 2012
Assets
Cash and due from banks ($3,835 and $3,801, respectively, are restricted)	$	27,489			$	32,145
Interest-bearing deposits	103,869				75,428
Total cash and cash equivalents	131,358				107,573
Investment securities available for sale, at fair value	432,542				372,968
Federal Home Loan Bank stock	7,172				7,441
Loans held for sale	3,389				18,043
Non-covered loans, net of allowance for loan losses	871,593				835,987
Covered loans, net of allowance for loan losses	137,333				214,087
Total loans	1,008,926				1,050,074
Premises and equipment, net	35,038				36,751
Bank owned life insurance	17,836				17,704
Goodwill and other intangible assets, net	5,588				6,027
Non-covered other real estate owned	3,067				3,023
Covered other real estate owned	5,980				13,460
FDIC indemnification asset	14,536				34,571
Other assets	18,556				20,042
Total assets	$	1,683,988			$	1,687,677
Liabilities and Shareholders' Equity
Liabilities:
Deposits
Noninterest-bearing demand	$	265,412			$	261,310
Interest-bearing	1,202,080				1,201,663
Total deposits	1,467,492				1,462,973
Junior subordinated debentures	25,774				25,774
Other liabilities	10,792				16,306
Total liabilities	1,504,058				1,505,053
Commitments and contingencies
Shareholders' Equity:
Common stock, no par value; 35,000,000 shares authorized; 15,538,969 and 15,483,598 shares issued and outstanding at December 31, 2013 and 2012, respectively	86,714				85,707
Retained earnings	98,431				92,234
Accumulated other comprehensive (loss) income, net of tax	(5,215		)		4,683
Total shareholders' equity	179,930				182,624
Total liabilities and shareholders' equity	$	1,683,988			$	1,687,677

See notes to consolidated financial statements

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WASHINGTON BANKING COMPANY AND SUBSIDIARIES

Consolidated Statements of Income

(Dollars in thousands, except per share data)

		For the Year Ended December 31,
		2013				2012				2011
Interest income:
Interest and fees on non-covered loans		$	44,166			$	46,530			$	49,760
Interest and fees on covered loans		23,710				36,418				34,819
Interest on taxable investment securities		5,720				5,333				3,967
Interest on tax-exempt investment securities		1,557				1,178				902
Other		206				251				259
Total interest income		75,359				89,710				89,707
Interest expense:
Interest on deposits		4,942				6,581				9,492
Interest on junior subordinated debentures		478				532				489
Total interest expense		5,420				7,113				9,981
Net interest income		69,939				82,597				79,726
Provision for loan losses, non-covered loans		1,875				7,100				10,500
Provision (recovery) of loan losses, covered loans		12,740				2,644				(450		)
Net interest income after provision for loan losses		55,324				72,853				69,676
Noninterest income:
Service charges and fees		3,401				3,560				3,818
Electronic banking income		4,101				3,666				3,197
Investment products		771				1,295				1,072
Gain on sale of investment securities, net		556				931				—
Bank owned life insurance income		132				191				311
Income from the sale of mortgage loans		3,267				3,848				1,197
SBA premium income		894				602				444
Change in FDIC indemnification asset		5,735				(9,126		)		(9,232		)
Gain on disposition of covered assets		2,315				1,877				6,312
Other		1,173				1,402				2,093
Total noninterest income		22,345				8,246				9,212
Noninterest expense:
Salaries and benefits		30,909				29,944				27,496
Occupancy and equipment		7,287				6,883				6,553
Office supplies and printing		1,501				1,643				1,665
Data processing		2,185				2,134				1,916
Consulting and professional fees		849				904				1,152
Intangible amortization		439				512				622
Merger related expenses		652				—				324
FDIC premiums		1,091				1,281				1,818
FDIC clawback liability adjustment		(88		)		1,680				1,576
Non-covered OREO and repossession expenses, net		2,227				1,841				1,358
Covered OREO and repossession expenses, net		1,696				1,699				2,192
Other		7,553				7,878				9,153
Total noninterest expense		56,301				56,399				55,825
Income before provision for income tax		21,368				24,700				23,063
Provision for income tax		6,872				7,856				7,111
Net income before preferred dividends		14,496				16,844				15,952
Preferred stock dividends and discount accretion		—				—				1,084
Net income available to common shareholders		$	14,496			$	16,844			$	14,868
Net income available per common share, basic		$	0.94			$	1.09			$	0.97
Net income available per common share, diluted		$	0.93			$	1.09			$	0.97
Average number of common shares outstanding, basic		15,495,000				15,422,000				15,329,000
Average number of common shares outstanding, diluted		15,551,000				15,455,000				15,393,000

See notes to consolidated financial statements

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Consolidated Statements of Comprehensive Income

(Dollars in thousands)

		For the Year Ended December 31,
		2013				2012				2011
Net income before preferred dividends		$	14,496			$	16,844			$	15,952
Investment securities available for sale:
Unrealized (losses) gains arising in period		(14,672		)		3,292				4,548
Reclassification adjustment for net gains realized in earnings (net of tax expense of $195 and $325 for the years ended December 31, 2013 and 2012, respectively.)		(361		)		(606		)		—
Income tax (benefit) provision related to unrealized (losses) gains		(5,135		)		1,152				1,592
Other comprehensive (loss) income, net of tax		(9,898		)		1,534				2,956
Total comprehensive income		$	4,598			$	18,378			$	18,908

See notes to consolidated financial statements

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Consolidated Statements of Shareholders’ Equity

 (Dollars and shares in thousands, except per share data)

					Common stock											Accumulated other comprehensive income (loss)				Total shareholders' equity
	Preferred stock amount				Shares			Amount				Retained earnings
Balance at January 1, 2011	$	25,334			15,321			$	85,264			$	71,307			$	193			$	182,098
Comprehensive income:
Net income	—				—			—				15,952				—				15,952
Other comprehensive income, net	—				—			—				—				2,956				2,956
Redemption of preferred stock
issued to U.S. Treasury	(26,380		)		—			—				—				—				(26,380		)
Repurchase of warrant issued
to U.S. Treasury	—				—			(1,625		)		—				—				(1,625		)
Preferred stock dividends and accretion	1,046				—			—				(1,084		)		—				(38		)
Cash dividends on common stock,
$0.20 per share	—				—			—				(3,068		)		—				(3,068		)
Stock-based compensation expense	—				—			623				—				—				623
Issuance of common stock under stock plans	—				77			301				—				—				301
Tax benefit associated with stock awards	—				—			1				—				—				1
Balance at December 31, 2011	$	—			15,398			$	84,564			$	83,107			$	3,149			$	170,820
Balance at January 1, 2012	$	—			15,398			$	84,564			$	83,107			$	3,149			$	170,820
Comprehensive income:
Net income	—				—			—				16,844				—				16,844
Other comprehensive income, net	—				—			—				—				1,534				1,534
Cash dividends on common stock,
$0.50 per share	—				—			—				(7,717		)		—				(7,717		)
Stock-based compensation expense	—				—			811				—				—				811
Issuance of common stock under stock plans	—				86			301				—				—				301
Tax benefit associated with stock awards	—				—			31				—				—				31
Balance at December 31, 2012	$	—			15,484			$	85,707			$	92,234			$	4,683			$	182,624
Balance at January 1, 2013	$	—			15,484			$	85,707			$	92,234			$	4,683			$	182,624
Comprehensive income:
Net income	—				—			—				14,496				—				14,496
Other comprehensive loss, net	—				—			—				—				(9,898		)		(9,898		)
Cash dividends on common stock,
$0.54 per share	—				—			—				(8,299		)		—				(8,299		)
Stock-based compensation expense	—				—			878				—				—				878
Issuance of common stock under stock plans	—				55			124				—				—				124
Tax benefit associated with stock awards	—				—			5				—				—				5
Balance at December 31, 2013	$	—			15,539			$	86,714			$	98,431			$	(5,215	)		$	179,930

See notes to consolidated financial statements

WASHINGTON BANKING COMPANY AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(Dollars in thousands)

	For the Year Ended December 31,
	2013				2012				2011
Cash flows from operating activities:
Net income	$	14,496			$	16,844			$	15,952
Adjustments to reconcile net income to net cash provided by operating activities:
Amortization of investment security premiums, net	2,894				2,435				1,007
Depreciation	2,564				2,419				2,101
Intangible amortization	439				512				622
Provision for loan losses, non-covered loans	1,875				7,100				10,500
Provision (recovery) for loan losses, covered loans	12,740				2,644				(450		)
Earnings on bank owned life insurance	(132		)		(191		)		(311		)
Net gain on sale of investment securities	(556		)		(931		)		—
Net loss (gain) on sale of premises and equipment	2				11				(74		)
Net gain on sale of non-covered other real estate owned	(54		)		(145		)		(62		)
Net gain on sale of covered other real estate owned	(1,535		)		(2,733		)		(6,526		)
Net gain on sale of loans held for sale	(3,267		)		(3,848		)		(1,197		)
Origination of loans held for sale	(137,575		)		(203,550		)		(139,264		)
Proceeds from sales of loans held for sale	155,496				211,776				129,016
Valuation adjustment on non-covered other real estate owned	1,323				844				272
Valuation adjustment on covered other real estate owned	2,033				3,704				6,672
Deferred taxes	2,503				(3,198		)		2,419
Change in FDIC indemnification asset	(5,735		)		9,126				9,232
Stock-based compensation	878				811				623
Excess tax benefit from stock awards	(5		)		(31		)		(1		)
Net change in assets and liabilities:
Net decrease in other assets	20,763				18,745				18,349
Net (decrease) increase in other liabilities	(5,514		)		8,562				2,897
Net cash provided by operating activities	63,633				70,906				51,777
Cash flows from investing activities:
Purchases of investment securities available for sale	(143,563		)		(197,558		)		(189,494		)
Proceeds from investment securities available for sale	66,423				121,402				95,306
Redemption of Federal Home Loan Bank stock	269				135				—
Net decrease (increase) in non-covered loans and covered loans	19,519				(5,553		)		91,750
Purchases of premises and equipment	(853		)		(1,698		)		(2,209		)
Proceeds from the sale of premises and equipment	—				9				537
Proceeds from sale of non-covered other real estate owned	2,754				2,866				5,181
Proceeds from sale of covered other real estate owned	19,495				21,907				28,760
Capitalization of non-covered other real estate owned improvements	(241		)		—				—
Capitalization of covered other real estate owned improvements	—				—				(697		)
Net cash (used in) provided by investing activities	$	(36,197	)		$	(58,490	)		$	29,134

See notes to consolidated financial statements

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Consolidated Statements of Cash Flows (continued)

(Dollars in thousands)

	For the Year Ended December 31,
	2013				2012				2011
Cash flows from financing activities:
Net increase (decrease) in deposits	$	4,519			$	(3,371	)		$	(25,876	)
Redemption of preferred stock	—				—				(26,380		)
Repurchase of common stock warrant	—				—				(1,625		)
Proceeds from exercise of stock options	124				301				301
Excess tax benefits from stock awards	5				31				1
Dividends paid on preferred stock	—				—				(38		)
Dividends paid on common stock	(8,299		)		(7,717		)		(3,068		)
Net cash used in financing activities	(3,651		)		(10,756		)		(56,685		)
Net change in cash and cash equivalents	23,785				1,660				24,226
Cash and cash equivalents at beginning of period	107,573				105,913				81,687
Cash and cash equivalents at end of period	$	131,358			$	107,573			$	105,913
Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest	$	5,548			$	7,350			$	10,285
Income taxes	$	10,500			$	1,500			$	7,400
Supplemental disclosures about noncash investing and financing activities:
Change in fair value of investment securities available for sale, net of tax	$	(9,898	)		$	1,534			$	2,956
Transfer of non-covered loans to non-covered other real estate owned	$	3,826			$	4,612			$	3,245
Transfer of covered loans to covered other real estate owned	$	12,513			$	9,716			$	25,065

See notes to consolidated financial statements

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WASHINGTON BANKING COMPANY AND SUBSIDIARIES

  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(1) Description of Business and Summary of Significant Accounting Policies

( a)  Description of Business : Washington Banking Company (the “Company”) was formed on April 30, 1996, and is a registered bank holding company whose primary business is conducted by its wholly-owned subsidiary, Whidbey Island Bank (the “Bank”). The business of the Bank, which is focused in the northern area of Western Washington, consists primarily of attracting deposits from the general public and originating loans. The Company and the Bank have formed several subsidiaries for various purposes as follows:

•	Washington Banking Capital Trust I (the “Trust”) was a wholly-owned subsidiary of the Company. The Trust was formed in June 2002 for the exclusive purpose of issuing trust preferred securities. During the second quarter of 2007 the Trust was closed after the trust preferred securities were paid off. See Note (13) Trust Preferred Securities and Junior Subordinated Debentures for further details.

•	Washington Banking Master Trust (the “Master Trust”) is a wholly-owned subsidiary of the Company. The Master Trust was formed in April 2007 for the exclusive purpose of issuing trust preferred securities. See Note (13) Trust Preferred Securities and Junior Subordinated Debenture s for further details.

•

Rural One, LLC (“Rural One”) is a majority-owned subsidiary of the Bank and is certified as a Community Development Entity by the Community Development Financial Institutions Fund of the United States Department of Treasury. Rural One was formed in September 2006, for the exclusive purpose of investing in Federal tax credits related to the New Markets Tax Credit program. See Note (14) Income Taxes for further details.

(b) Basis of Presentation:   The accompanying consolidated financial statements include the accounts of the Company and its subsidiaries Whidbey Island Bank and Rural One LLC, as described above.  The consolidated financial statements of the Company have been prepared in conformity with accounting principles generally accepted in the United States of America. All significant intercompany balances and transactions have been eliminated in consolidation. In preparing the consolidated financial statements, in conformity with generally accepted accounting principles, management makes estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of income and expense during the reported periods.  Actual results could differ from these estimates. Management considers the estimates used in developing the allowance for loan losses, the valuation of covered loans and the FDIC indemnification asset and determining the fair value of financial assets and liabilities to be particularly sensitive estimates that may be subject to revision in the near term.

(c)  Recent Financial Accounting Pronouncements: In December 2011, the FASB issued ASU No. 2011-11, Disclosures about Offsetting Assets and Liabilities . The ASU requires an entity to offset, and present as a single net amount, a recognized eligible asset and a recognized eligible liability when it has an unconditional and legally enforceable right of setoff and intends either to settle the asset and liability on a net basis or to realize the asset and settle the liability simultaneously. The ASU requires an entity to disclose information about offsetting and related arrangements to enable users of its financial statements to understand the effect of those arrangements on its financial position. The Company adopted the provisions of this ASU effective January 1, 2013. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.

In July 2012, the FASB issued ASU No. 2012-2, Testing Indefinite-Lived Intangible Assets for Impairment .  This ASU states that an entity has the option to first assess qualitative factors to determine whether the existence of events and circumstances indicates that it is more likely than not that the indefinite-lived intangible asset is impaired. If, after assessing the totality of events and circumstances, an entity concludes that it is not more likely than not that the indefinite-lived intangible asset is impaired, then the entity is not required to take further action. However, if an entity concludes otherwise, it is required to determine the fair value of the indefinite-lived intangible asset and perform the quantitative impairment test by comparing the fair value with the carrying amount, in accordance with Codification Subtopic 350-30, Intangibles—Goodwill and Other, General Intangibles Other than Goodwill. Under guidance in this ASU, an entity also has the option to bypass the qualitative assessment for any indefinite-lived intangible asset in any period and proceed directly to performing the quantitative impairment test. An entity will be able to resume performing the qualitative assessment in any subsequent period. The amendments in this ASU are effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. Early adoption is permitted, including for annual and interim impairment tests performed as of a date before July 27, 2012, if a public entity’s financial statements for the most recent annual or interim period have not yet been issued. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.

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WASHINGTON BANKING COMPANY AND SUBSIDIARIES

  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(1) Description of Business and Summary of Significant Accounting Policies (continued)

In October 2012, the FASB issued ASU No. 2012-06, Subsequent Accounting for an Indemnification Asset Recognized at the Acquisition Date as a Result of a Government-Assisted Acquisition of a Financial Institution .  The ASU clarifies that when an entity recognizes an indemnification asset as a result of a government-assisted acquisition of a financial institution and subsequently, a change in the cash flows expected to be collected on the indemnification asset occurs, as a result of a change in cash flows expected to be collected on the assets subject to indemnification, the reporting entity should subsequently account for the change in the measurement of the indemnification asset on the same basis as the change in the assets subject to indemnification. Any amortization of changes in value should be limited to the contractual term of the indemnification agreement. The amendments are effective for annual and interim reporting periods beginning on or after December 15, 2012. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.

In January 2013, the FASB issued ASU No. 2013-01, Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities . ASU No. 2013-01 clarifies that ASU No. 2011-11 applies only to derivatives, including bifurcated embedded derivatives, repurchase agreements and reverse repurchase agreements, and securities borrowing and securities lending transactions that are either offset or subject to an enforceable master netting arrangement or similar agreement. Entities with other types of financial assets and financial liabilities subject to a master netting arrangement or similar agreement are no longer subject to the disclosure requirements in ASU No. 2011-11. The amendments are effective for annual and interim reporting periods beginning on or after January 1, 2013. The adoption of this ASU did not have a material impact on the Company's consolidated financial statements.

In February 2013, the FASB issued ASU No. 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income , to improve the transparency of reporting these reclassifications. The ASU does not amend any existing requirements for reporting net income or other comprehensive income in the financial statements but requires an entity to disaggregate the total change of each component of other comprehensive income and separately present reclassification adjustments and current period other comprehensive income. The provisions of this ASU also requires that entities present either in a single note or parenthetically on the face of the financial statements, the effect of significant amounts reclassified from each component of accumulated other comprehensive income based on its source and the income statement line item affected by the reclassification. If a component is not required to be reclassified to net income in its entirety, entities would instead cross reference to the related note to the financial statements for additional information. The Company adopted the provisions of this ASU effective January 1, 2013. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.

In July 2013, the FASB issued ASU No. 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists . The ASU requires an entity to present an unrecognized tax benefit, or a portion of an unrecognized tax benefit, as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward, except to the extent a net operating loss carryforward, a similar tax loss, or a tax credit carryforward is not available at the reporting date under the tax law of the applicable jurisdiction to settle any additional income taxes that would result from the disallowance of a tax position or the tax law of the applicable jurisdiction does not require the entity to use, and the entity does not intend to use, the deferred tax asset for such purpose, the unrecognized tax benefit should be presented in the financial statements as a liability and should not be combined with deferred tax assets. No new recurring disclosures are required. The amendments are effective for annual and interim reporting periods beginning on or after December 15, 2013, and are to be applied prospectively to all unrecognized tax benefits that exist at the effective date. Retrospective application is permitted. The adoption of this ASU is not expected to have a material impact on the Company's consolidated financial statements.

In January 2014, the FASB issued ASU No. 2014-01, Accounting for Investments in Qualified Affordable Housing Projects . ASU 2014-04 permits an entity to make an accounting policy election to account for their investments in qualified affordable housing projects using the proportional amortization method if certain conditions are met. Under the proportional amortization method, an entity amortizes the initial cost of the investment in proportion to the tax credits and other tax benefits received and recognize the net investment performance in the income statement as a component of income tax expense (benefit). The amendments are effective for annual and interim reporting periods beginning on or after December 15, 2014 and should be applied prospectively. The Company is currently reviewing the requirements of ASU No. 2014-01, but does not expect the ASU to have a material impact on the Company's consolidated financial statements.

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WASHINGTON BANKING COMPANY AND SUBSIDIARIES

  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(1) Description of Business and Summary of Significant Accounting Policies (continued)

In January 2014, the FASB issued ASU No. 2014-04, Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans Upon Foreclosure . ASU 2014-04 clarifies that an in substance repossession or foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either (1) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure or (2) the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. Additionally, the amendments require interim and annual disclosure of both (1) the amount of foreclosed residential real estate property held by the creditor and (2) the recorded investment in consumer mortgage loans collateralized by residential real estate property that are in the process of foreclosure according to local requirements of the applicable jurisdiction. The amendments are effective for annual and interim reporting periods beginning on or after December 15, 2014 and can be applied with a modified retrospective transition method or prospectively. The adoption of ASU No. 2014-04 is not expected to have a material impact on the Company's consolidated financial statements.

(d)  Cash and Cash Equivalents:   For purposes of reporting cash flows, cash and cash equivalents include cash on hand and due from banks, interest-earning deposits and federal funds sold, all of which have original maturities of three months or less.

( e)  Investment Securities:   Investment securities available for sale include securities that management intends to use as part of its overall asset/liability management strategy and that may be sold in response to changes in interest rates and resultant prepayment risk and other related factors.  Securities available for sale are carried at market value, and unrealized gains and losses (net of related tax effects) are excluded from net income but are included as a separate component of comprehensive income. Upon realization, such gains and losses will be included in net income using the specific identification method. Declines in the fair value of individual securities available-for-sale below their cost that are other than temporary result in write-downs of the individual securities to their fair value. Such write-downs are included in earnings as realized losses.

Accounting guidance related to the recognition and presentation of other-than-temporary impairment (“OTTI”) of debt securities became effective in the second quarter of 2009.  A company must consider whether it intends to sell a security or if it is likely that they would be required to sell the security before recovery of the amortized cost basis of the investment, which may be maturity. For debt securities, if we intend to sell the security or it is likely that we will be required to sell the security before recovering its cost basis, the entire impairment loss would be recognized in earnings as an OTTI. If we do not intend to sell the security and it is not likely that we will be required to sell the security but we do not expect to recover the entire amortized cost basis of the security, only the portion of the impairment loss representing credit losses would be recognized in earnings. The credit loss on a security is measured as the difference between the amortized cost basis and the present value of the cash flows expected to be collected. Projected cash flows are discounted by the original or current effective interest rate depending on the nature of the security being measured for potential OTTI. The remaining impairment related to all other factors, the difference between the present value of the cash flows expected to be collected and fair value, is recognized as a charge to other comprehensive income (“OCI”). Impairment losses related to all other factors are presented as separate categories within OCI. For investment securities held to maturity, this amount is accreted over the remaining life of the debt security prospectively based on the amount and timing of future estimated cash flows. The accretion of the amount recorded in OCI increases the carrying value of the investment and does not affect earnings. If there is an indication of additional credit losses the security is re-evaluated according to the procedures described above.

Investment securities held to maturity are comprised of debt securities for which the Company has positive intent and ability to hold to maturity and are carried at cost, adjusted for amortization of premiums and accretion of discounts using the interest method over the estimated lives of the securities. Amortization of premiums and accretion of discounts are recognized in interest income over the period to maturity.  Premiums are amortized to the earliest call date while discounts are accreted to maturity.

(f)  Federal Home Loan Bank Stock: The Bank’s investment in FHLB stock is carried at par value, which approximates its fair value.  As a member of the FHLB system, the Bank is required to maintain a minimum level of investment in FHLB stock based on specific percentages of the Bank’s outstanding mortgages, total assets or FHLB advances. At December 31, 2013, the Bank’s minimum required investment was approximately $1.6 million . Amounts in excess of the required minimum for FHLB membership may be redeemed at par at FHLB’s discretion, which is subject to their capital plan, bank policies, and regulatory requirements, which may be amended or revised periodically.

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  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(1) Description of Business and Summary of Significant Accounting Policies (continued)

Management periodically evaluates FHLB stock for other-than-temporary or permanent impairment. Management’s determination of whether these investments are impaired is based on its assessment of the ultimate recoverability of cost rather than by recognizing temporary declines in value. The determination of whether a decline affects the ultimate recoverability of cost is influenced by criteria such as (1) the significance of any decline in net assets of the FHLB as compared to the capital stock amount for the FHLB and the length of time this situation has persisted, (2) commitments by the FHLB to make payments required by law or regulation and the level of such payments in relation to the operating performance of the FHLB, (3) the impact of legislative and regulatory changes on institutions and, accordingly, the customer base of the FHLB and (4) the liquidity position of the FHLB.

In September 2012, the FHLB of Seattle was notified by the Federal Housing Finance Agency (“Finance Agency”) that it is now classified as “adequately capitalized” as compared to the prior classification of “undercapitalized.” Under Finance Agency regulations, the FHLB of Seattle may repurchase excess capital stock under certain conditions; however, they may not redeem stock or pay a dividend without Finance Agency approval. Based on the above, the Company has determined there is not an other-than-temporary impairment on the FHLB stock investment as of December 31, 2013.

(g)  Loans Held for Sale:   Mortgage loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated market value in the aggregate. Net unrealized losses are recognized through a valuation allowance by charges to income. When a loan is sold, the gain is recognized in the consolidated statement of income as the proceeds less the book value of the loan including unamortized fees and capitalized direct costs.

(h)  Non-Covered   Loans:   Loans are stated at the unpaid principal balance, net of premiums, unearned discounts, net deferred loan origination fees and costs and the allowance for loan losses.

Interest on loans is calculated using the simple interest method based on the daily balance of the principal amount outstanding and is credited to income as earned.

Loans are placed on nonaccrual status when collection of principal or interest is considered doubtful (generally, loans are 90 days or more past due). Indirect consumer loans are charged-off immediately when collection of principal or interest is considered doubtful (generally, loans are 90 days or more past due).

Loans are reported as restructured when the Bank grants a concession(s) to a borrower experiencing financial difficulties that it would not otherwise consider. Examples of such concessions include forgiveness of principal or accrued interest, extending the maturity date(s) or providing a lower interest rate than would be normally available for a transaction of similar risk. As a result of these concessions, restructured loans are impaired as the Bank will not collect all amounts due, both principal and interest, in accordance with the terms of the original loan agreement.

A loan is considered impaired when, based upon currently known information, it is deemed probable that the Company will be unable to collect all amounts due as scheduled according to the original terms of the agreement.  Impaired loans are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate or, as a practical expedient, based on the loan’s observable market price or the fair value of collateral, if the loan is collateral dependent.

Interest income previously accrued on nonaccrual loans, but not yet received, is reversed in the period the loan is placed on nonaccrual status.  Subsequent payments received are generally applied to principal.  However, based on management’s assessment of the ultimate collectability of an impaired or nonaccrual loan, interest income may be recognized on a cash basis.  Nonaccrual loans are returned to an accrual status when management determines the circumstances have improved to the extent that there has been a sustained period of repayment performance and both principal and interest are deemed collectible.

Loan fees and certain direct loan origination costs are deferred and the net fee or cost is recognized in interest income using the interest method over the estimated life of the individual loans, adjusted for actual prepayments.

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WASHINGTON BANKING COMPANY AND SUBSIDIARIES

  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(1) Description of Business and Summary of Significant Accounting Policies (continued)

(i)  Covered Loans: Loans acquired in a FDIC-assisted acquisition, that are subject to a loss share agreement, are referred to as “covered loans” and are reported separately in our consolidated balance sheets.  Covered loans are reported exclusive of the expected cash flow reimbursements expected from the FDIC.

Acquired loans are valued as of acquisition date in accordance with Financial Accounting Standards Board Accounting Standards Codification (“FASB ASC”) 805, Business Combinations . Loans purchased with evidence of credit deterioration since origination for which it is probable that all contractually required payments will not be collected are accounted for under FASB ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality . In addition, because of the significant discounts associated with the acquired portfolios, the Company elected to account for all acquired loans under ASC 310-30.

In accordance with FASB ASC 310-30, acquired loans are aggregated into pools, based on individually evaluated common risk characteristics, and aggregate expected cash flows were estimated for each pool. A pool is accounted for as a single asset with a single interest rate, cumulative loss rate and cash flow expectation. The Bank aggregated all of the loans acquired in the FDIC-assisted acquisitions of City Bank and North County Bank into 18 and 14 pools, respectively. A loan will be removed from a pool of loans only if the loan is sold, foreclosed, assets are received in satisfaction of the loan (paid off), or the loan is written off, and will be removed from the pool at the carrying value. If an individual loan is removed from a pool of loans, the difference between its carrying amount and the cash, fair value of the collateral, or other assets received will be recognized in income immediately and would not affect the effective yield used to recognize the accretable difference on the remaining pool. Loans originally placed into a performing pool will not be reported individually as 30 - 89 days past due, non-performing (90+ days past due or nonaccrual) or accounted for as a troubled debt restructuring as the pool is the unit of accounting. Rather, these metrics related to the underlying loans within a performing pool will be considered in our ongoing assessment and estimates of future cash flows. If, at acquisition, the loans are collateral dependent and acquired primarily for the rewards of ownership of the underlying collateral, or if cash flows expected to be collected cannot be reasonably estimated, accrual of income is inappropriate. Such loans will be placed into nonperforming (nonaccrual) loan pools.

The cash flows expected to be received over the life of the pool were estimated by management with the assistance of a third party valuation specialist. These cash flows were input into a ASC 310-30 compliant accounting loan system which calculates the carrying values of the pools and underlying loans, book yields, effective interest income and impairment, if any, based on actual and projected events. Default rates, loss severity and prepayment speed assumptions will be periodically reassessed and updated within the accounting model to update the expectation of future cash flows. The excess of the cash flows expected to be collected over the pool’s carrying value is considered to be the accretable yield and is recognized as interest income over the estimated life of the loan or pool using the effective yield method. The accretable yield will change due to changes in the timing and amounts of expected cash flows. For the performing loan pools, a prepayment assumption, as documented by the valuation specialist, is initially applied. Changes in the accretable yield will be disclosed quarterly.

The excess of the contractual balances due over the cash flows expected to be collected is considered to be the nonaccretable difference. The nonaccretable difference represents the estimate of the credit losses expected to occur and was considered in determining the fair value of the loans as of the acquisition date. Subsequent to the acquisition date, any increases in expected cash flows over those expected at purchase date in excess of fair value are adjusted through the accretable difference on a prospective basis. Any subsequent decreases in expected cash flows over those expected at purchase date are recognized by recording a provision for loan losses. Any disposals of loans, including sales of loans, payments in full or foreclosures result in the removal of the loan from the pool at its carrying amount. 

The covered loans acquired are and will continue to be subject to the Company’s internal and external credit review and monitoring. If credit deterioration is experienced subsequent to the initial acquisition fair value amount, such deterioration will be measured, and a provision for credit losses will be charged to earnings. These provisions will be mostly offset by an increase to the FDIC indemnification asset, and will be recognized in noninterest income.

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  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(1) Description of Business and Summary of Significant Accounting Policies (continued)

(j) Allowance for Loan Losses:   The allowance for loan losses is based upon the Company’s estimates. The Company determines the adequacy of the allowance for loan losses based on evaluations of the loan portfolio, recent loss experience and other factors, including economic and market conditions. The Company determines the amount of the allowance for loan losses required for certain sectors based on relative risk characteristics of the loan portfolio. Actual losses may vary from current estimates. These estimates are reviewed periodically and as adjustments become necessary, are reported in earnings in the periods in which they become known. The allowance for loan losses is increased by charging to the provision for loan losses. Losses are charged to the allowance and recoveries are credited to the allowance.

(k) Premises and Equipment: Premises and equipment are stated at cost, less accumulated depreciation and amortization.  Depreciation and amortization are computed using the straight-line method over the estimated useful lives of the assets.  The estimated useful lives used to compute depreciation and amortization include buildings and building improvements, 15 to 40 years ; land improvements, 15 to 25 years ; furniture, fixtures and equipment, 3 to 7 years ; and leasehold improvements, lesser of useful life or life of the lease.

(l)  Bank Owned Life Insurance:  During the second quarters of 2007 and 2004, the Bank made $5.0 million and $10.0 million investments, respectively, in bank owned life insurance (“BOLI”). These policies insure the lives of officers of the Bank, and name the Bank as beneficiary. Noninterest income is generated tax-free (subject to certain limitations) from the increase in the policies' underlying investments made by the insurance company.  The Bank is capitalizing on the ability to partially offset costs associated with employee compensation and benefit programs with the BOLI.

(m)  Goodwill and Other Intangible Assets, Net: Intangible assets are comprised of goodwill and other intangibles acquired in business combinations. Goodwill and intangible assets with indefinite useful lives are not amortized. Intangible assets with definite useful lives are amortized to their estimated residual values over their respective estimated useful lives, and also reviewed for impairment. Amortization of intangible assets is included as a separate line item in the Consolidated Statements of Income .

The Company performs a goodwill impairment analysis on an annual basis as of December 31. Additionally, the Company performs a goodwill impairment evaluation on an interim basis when events or circumstances indicate impairment potentially exists. A significant amount of judgment is involved in determining if an indicator of impairment has occurred. Such indicators may include, among others, a significant decline in our expected future cash flows; a sustained, significant decline in our stock price and market capitalization; a significant adverse change in legal factors or in the business climate; adverse action or assessment by a regulator; and unanticipated competition.

The goodwill impairment test involves a two-step process. The first step compares the fair value of a reporting unit to its carrying value. If the reporting unit’s fair value is less than its carrying value, the Company would be required to proceed to the second step. In the second step the Company calculates the implied fair value of the reporting unit’s goodwill. The implied fair value of goodwill is determined in the same manner as goodwill recognized in a business combination. The estimated fair value of the Company is allocated to all of the Company’s assets and liabilities, including any unrecognized identifiable intangible assets, as if the Company had been acquired in a business combination and the estimated fair value of the reporting unit is the price paid to acquire it. The allocation process is performed only for purposes of determining the amount of goodwill impairment. No assets or liabilities are written up or down, nor are any additional unrecognized identifiable intangible assets recorded as a part of this process. Any excess of the estimated purchase price over the fair value of the reporting unit’s net assets represents the implied fair value of goodwill. If the carrying amount of the goodwill is greater than the implied fair value of that goodwill, an impairment loss would be recognized as a charge to earnings in an amount equal to that excess.

GAAP also permits an entity an option to first perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If an entity believes, as a result of its qualitative assessment, that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, the Step 1 quantitative impairment analysis described above is required. Otherwise, no further impairment testing is required. During the fourth quarter of 2013, the Company performed its annual evaluation for goodwill impairment. This evaluation indicated no impairment of the Company's goodwill.

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  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(1) Description of Business and Summary of Significant Accounting Policies (continued)

(n)  Non-Covered Other Real Estate Owned:   Non-covered other real estate owned includes properties acquired through foreclosure. These properties are recorded at the lower of cost or estimated fair value less estimated selling costs.  Losses arising from the initial acquisition of property, in full or partial satisfaction of loans, are charged to the allowance for loan losses.

Subsequent to the transfer to other real estate owned, these assets continue to be recorded at the lower of cost or fair value (less estimated cost to sell), based on periodic evaluations.  Generally, legal and professional fees associated with foreclosures are expensed as incurred.  However, in no event are recorded costs allowed to exceed fair value.  Subsequent gains, losses or expenses recognized on the sale of these properties are included in noninterest income or expense.

(o) Covered Other Real Estate Owned: All other real estate owned (“OREO”) acquired in FDIC-assisted acquisitions that are subject to an FDIC loss-share agreement are referred to as “covered other real estate owned” and reported separately in our statements of financial position. Covered OREO is reported exclusive of expected reimbursement cash flows from the FDIC. Foreclosed covered loan collateral is transferred into covered OREO at the carrying value or fair value, less selling costs, whichever is less.

Covered OREO was initially recorded at its estimated fair value on the acquisition date based on similar market comparable valuations less estimated selling costs. Any subsequent valuation adjustments due to declines in fair value will be charged to noninterest expense, and will be mostly offset by noninterest income representing the corresponding increase to the FDIC indemnification asset for the offsetting loss reimbursement amount. Any recoveries of previous valuation adjustments will be credited to noninterest expense with a corresponding charge to noninterest income for the portion of the recovery that is due to the FDIC.

(p)  FDIC Indemnification Asset: The Company has elected to account for amounts receivable under the loss share agreement as an indemnification asset in accordance with FASB ASC 805. The FDIC indemnification asset was initially recorded at fair value, based on the discounted value of expected future cash flows under the loss share agreement. The difference between the present value and the undiscounted cash flows the Company expects to collect from the FDIC will be accreted into noninterest income over the life of the FDIC indemnification asset.

The FDIC indemnification asset is reviewed quarterly and adjusted for any changes in expected cash flows based on recent performance and expectations for future performance of the covered portfolio. These adjustments are measured on the same basis as the related covered loans and covered other real estate owned. Any increases in cash flow of the covered assets over those expected will reduce the FDIC indemnification asset and any decreases in cash flow of the covered assets under those expected will increase the FDIC indemnification asset. Increases and decreases to the FDIC indemnification asset are recorded as adjustments to noninterest income.

(q)  Federal Income Taxes:   The Company files a consolidated federal income tax return. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis.  Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the periods in which those temporary differences are expected to be recovered or settled.  The effect on deferred tax assets and liabilities for a change in tax rate is recognized in income in the period that includes the enactment date.

A valuation allowance is required on deferred tax assets if it is “more likely than not” that the deferred tax asset will not be realized. The determination of the realization of the deferred tax assets is highly subjective and dependent upon judgment concerning management’s evaluation of both positive and negative evidence, including income and losses in recent years, the forecast of future income, applicable tax planning strategies, and assessments of the current and future economic and business conditions. The Company considers both positive and negative evidence regarding the ultimate realization of deferred tax assets. The calculation of our provision for federal income taxes is complex and requires the use of estimates and significant judgments in arriving at the amount of tax benefits to be recognized in the financial statements for a given tax position. It is possible that the tax benefits realized upon the ultimate resolution of a tax position may result in tax benefits that are significantly different from those estimated.

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  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(1) Description of Business and Summary of Significant Accounting Policies (continued)

The Company had no unrecognized tax benefits at December 31, 2013, 2012 or 2011. The Company recognizes interest accrued and penalties related to unrecognized tax benefits in tax expense. During the years ended December 31, 2013, 2012 and 2011, the Company recognized no interest or penalties.

The Company files income tax returns in the U.S. Federal jurisdiction. With few exceptions, the Company is no longer subject to U.S. federal income tax examinations by tax authorities for years before 2010.

(r)  Stock-Based Compensation: The Company has one active stock-based compensation plan. In accordance with FASB ASC 718, Stock Compensation ,   the Company recognizes in the income statement the grant date fair value of stock options and other equity-based forms of compensation issued to employees over the employee’s requisite service period (generally the vesting period). Stock options vest over a period of no greater than five years from the date of grant. Additionally, the right to exercise the option terminates ten years from the date of grant.

The Company measures the fair value of each stock option grant at the date of the grant, using the Black-Scholes option pricing model. Expected volatility is based on the historical volatility of the price of the Company’s common stock. The Company uses historical data to estimate option exercise and stock option forfeiture rates within the valuation model. The expected term of options granted is determined based on historical experience with similar options, giving consideration to the contractual terms and vesting schedules, and represents the period of time that options granted are expected to be outstanding. The expected dividend yield is based on dividend trends and the market value of the Company’s common stock at the time of grant. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant.  The Company did not grant any options for the years ended December 31, 2013, 2012 or 2011.

(s)  Earnings Per Share: According to the revised provisions of FASB ASC 260, Earnings Per Share , nonvested share-based payment awards that contain non-forfeitable rights to dividends or dividend equivalents are participating securities and are included in the computation of EPS pursuant to the two-class method. The two-class method is an earnings allocation formula that determines earnings per share for each class of common stock and participating security according to dividends declared (or accumulated) and participation rights in undistributed earnings. Net income, less any preferred dividends accumulated for the period (whether or not declared), is allocated between the common stock and participating securities pursuant to the two-class method, based on their rights to receive dividends, participate in earnings or absorb losses. Basic earnings per common share   is computed by dividing net earnings available to common shareholders by the weighted average number of common shares outstanding during the period, excluding participating nonvested restricted shares.

(t)  Advertising Expenses: Advertising costs are generally expensed as incurred.  Advertising costs were $524 thousand , $917 thousand and $1.1 million for the years ended December 31, 2013, 2012 and 2011, respectively.

(u) F air Value Measurements: FASB ASC 820, Fair Value Measurements and Disclosures, defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. FASB ASC 820 establishes a three-level hierarchy for disclosure of assets and liabilities recorded at fair value. The classification of assets and liabilities within the hierarchy is based on whether the inputs to the valuation methodology used for measurement are observable or unobservable. Observable inputs reflect market-derived or market-based information obtained from independent sources, while unobservable inputs reflect our estimates about market data.

In general, fair values determined by Level 1 inputs utilize quoted prices for identical assets or liabilities traded in active markets that the Company has the ability to access. Fair values determined by Level 2 inputs utilize inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets and liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals. Level 3 inputs are unobservable inputs for the asset or liability, and include situations where there is little, if any, market activity for the asset or liability. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the level in the fair value hierarchy within which the fair value measurement in its entirety falls has been determined based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.

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  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(1) Description of Business and Summary of Significant Accounting Policies (continued)

(v)  Reclassifications:   Certain amounts in previous years may have been reclassified to conform to the 2013 financial statement presentation. These reclassifications had no significant impact on the Company’s previously reported results of operations or financial condition.

(w)  Subsequent Events: The Company has evaluated events and transactions subsequent to December 31, 2013, for potential recognition or disclosure.  See Note (25) Subsequent Events for further details.

(2) Proposed Merger with Heritage Financial Corporation

On October 23, 2013, the Company and Heritage Financial Corporation (“Heritage”) jointly announced the signing of a definitive agreement under which the Company and Heritage will enter into a strategic merger to create one of the premier community banking franchises in Western Washington and the Pacific Northwest. Consummation of the transaction remains subject to customary closing conditions, including receipt of requisite shareholder approvals.

In connection with the proposed merger, the Company has incurred merger related expenses of approximately $652 thousand , principally legal and professional services, for the year ended December 31, 2013.

(3) Restrictions on Cash Balance

The Company is required to maintain an average reserve balance with the Federal Reserve Bank or maintain such reserve balance in the form of cash.  The amount of the required reserve balance was $3.8 million at December 31, 2013 and 2012, and was met by holding cash with the Federal Reserve Bank.

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  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(4) Investment Securities

The following table presents the amortized cost, unrealized gains, unrealized losses and fair value of investment securities available for sale at December 31, 2013 and 2012.  At December 31, 2013 and 2012, there were no investment securities classified as held to maturity or trading.

(dollars in thousands)	December 31, 2013
	Amortized cost				Unrealized gains				Unrealized losses				Fair value
U.S. government agencies	$	85,631			$	706			$	(665	)		$	85,672
Residential pass-through securities	185,677				589				(5,457		)		180,809
Taxable state and political subdivisions	2,294				174				—				2,468
Tax exempt state and political subdivisions	74,761				1,420				(1,374		)		74,807
Corporate obligations	11,000				21				(88		)		10,933
Agency-issued collateralized mortgage obligations	55,579				18				(1,452		)		54,145
Asset-backed securities	23,597				—				(1,781		)		21,816
Investments in mutual funds and other equities	2,018				—				(126		)		1,892
Total investment securities available for sale	$	440,557			$	2,928			$	(10,943	)		$	432,542

(dollars in thousands)	December 31, 2012
	Amortized cost				Unrealized gains				Unrealized losses				Fair value
U.S. government agencies	$	87,297			$	1,321			$	(32	)		$	88,586
Residential pass-through securities	165,175				3,430				(182		)		168,423
Taxable state and political subdivisions	4,759				553				—				5,312
Tax exempt state and political subdivisions	56,431				2,703				(149		)		58,985
Corporate obligations	11,000				—				(565		)		10,435
Agency-issued collateralized mortgage obligations	13,967				79				—				14,046
Asset-backed securities	25,108				150				(70		)		25,188
Investments in mutual funds and other equities	2,018				—				(25		)		1,993
Total investment securities available for sale	$	365,755			$	8,236			$	(1,023	)		$	372,968

 

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  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(4)  Investment Securities (continued)

Investment securities that were in an unrealized loss position at December 31, 2013 and 2012, are presented in the following tables, based on the length of time individual securities have been in an unrealized loss position. In the opinion of management, these securities are considered only temporarily impaired due to changes in market interest rates or the widening of market spreads subsequent to the initial purchase of the securities, and not due to concerns regarding the underlying credit of the issuers or the underlying collateral.

(dollars in thousands)	December 31, 2013
	Less than 12 Months								12 Months or Longer								Total
	Fair value				Unrealized losses				Fair value				Unrealized losses				Fair value				Unrealized losses
U.S. government agencies	$	40,528			$	(665	)		$	—			$	—			$	40,528			$	(665	)
Residential pass-through securities	$	110,071			$	(3,262	)		$	31,494			$	(2,195	)		$	141,565			$	(5,457	)
Tax exempt state and political subdivisions	35,360				(990		)		6,593				(384		)		41,953				(1,374		)
Corporate obligations	2,997				(4		)		2,916				(84		)		5,913				(88		)
Agency-issued collateralized mortgage obligations	49,230				(1,452		)		—				—				49,230				(1,452		)
Asset-backed securities	8,718				(482		)		13,097				(1,299		)		21,815				(1,781		)
Investments in mutual funds and other equities	—				—				2,018				(126		)		2,018				(126		)
Total investment securities available for sale	$	246,904			$	(6,855	)		$	56,118			$	(4,088	)		$	303,022			$	(10,943	)

 

(dollars in thousands)	December 31, 2012
	Less than 12 Months								12 Months or Longer								Total
	Fair value				Unrealized losses				Fair value				Unrealized losses				Fair value				Unrealized losses
U.S. government agencies	$	12,056			$	(32	)		$	—			$	—			$	12,056			$	(32	)
Residential pass-through securities	27,680				(182		)		—				—				27,680				(182		)
Tax exempt state and political subdivisions	10,113				(149		)		—				—				10,113				(149		)
Corporate obligations	—				—				10,435				(565		)		10,435				(565		)
Asset-backed securities	9,856				(70		)		—				—				9,856				(70		)
Investments in mutual funds and other equities	—				—				1,993				(25		)		1,993				(25		)
Total investment securities available for sale	$	59,705			$	(433	)		$	12,428			$	(590	)		$	72,133			$	(1,023	)

At December 31, 2013 and 2012, there were 96 and 25 investment securities in unrealized loss positions, respectively.  For each security in an unrealized loss position, the Company assesses whether it intends to sell the security, or it is more likely than not that it will be required to sell the security before recovery of its amortized cost basis. For debt securities that are considered other-than-temporarily impaired and that the Company does not intend to sell and will not be required to sell prior to recovery of its amortized cost basis, the Company will separate the amount of the impairment into the amount that is credit related (credit loss component) and the amount due to all other factors. The credit loss component is recognized in earnings and is calculated as the difference between the security’s amortized cost basis and the present value of its expected future cash flows. The remaining difference between the security’s fair value and the present value of future expected cash flows is deemed to be due to factors that are not credit related and is recognized in other comprehensive income.

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  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(4)  Investment Securities (continued)

The Company does not intend to sell the securities that are temporarily impaired, and it is more likely than not that the Company will not have to sell those securities before recovery of the cost basis. Additionally, the Company has evaluated the credit ratings of its investment securities and their issuers and/or insurers, as applicable. Based on the Company’s evaluation, management has determined that no investment security in the Company’s investment portfolio was other-than-temporarily impaired at December 31, 2013 or 2012.

The amortized cost and fair value of investment securities, by maturity, are shown in the table below.  The amortized cost and fair value of residential pass-through securities, agency-issued collateralized mortgage obligations and asset-backed securities are presented by expected average life, rather than contractual maturity.  Expected maturities may differ from contractual maturities because issuers of the securities may have the right to call or prepay obligations with or without call or prepayment penalties.

(dollars in thousands)	December 31, 2013
	Amortized cost				Fair value
Three months or less	$	2,000			$	2,011
Over three months to one year	4,231				4,320
After one year through three years	54,220				55,008
After three years through five years	241,061				235,756
After five years through ten years	80,002				78,254
After ten years	59,043				57,193
Total	$	440,557			$	432,542

The following table presents investment securities which were pledged to secure borrowings and public deposits as permitted or required by law:

(dollars in thousands)	December 31, 2013
	Amortized cost				Fair value
To state and local governments to secure public deposits	$	71,045			$	71,078
To Federal Reserve Bank to secure borrowings	17,921				17,865
To Federal Home Loan Bank to secure borrowings	521				539
Other securities pledged, principally to secure deposits	12,568				12,965
Total pledged investment securities	$	102,055			$	102,447

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

(dollars in thousands)	For the Year Ended December 31,
	2013				2012			2011
Gross realized gains	556				933			—
Gross realized losses	—				(2		)	—
Gain on sale of investment securities, net	$	556			$	931		$	—

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  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(5)  Non-Covered Loans

The following table presents the major types of non-covered loans. The classification of non-covered loan balances presented is reported in accordance with regulatory reporting requirements.

(dollars in thousands)	December 31, 2013				December 31, 2012
Commercial	$	179,914			$	162,481
Real estate mortgage	489,148				452,627
Real estate construction	56,248				81,398
Consumer	161,673				154,890
	886,983				851,396
Deferred loan costs, net	1,703				1,738
Allowance for loan losses	(17,093		)		(17,147		)
Total non-covered loans, net	$	871,593			$	835,987

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  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(6) Allowance for Non-Covered Loan Losses and Credit Quality

Activity in the Allowance for Non-Covered Loan Losses

The following table summarizes activity related to the allowance for loan losses on non-covered loans, by portfolio segment:

(dollars in thousands)	For the Year Ended December 31, 2013
	Commercial				Real estate mortgage				Real estate construction				Consumer				Total
Beginning balance	$	4,405			$	6,516			$	3,050			$	3,176			$	17,147
Provision	245				353				(372		)		1,649				1,875
Charge-offs	(562		)		(225		)		(70		)		(2,439		)		(3,296		)
Recoveries	235				183				442				507				1,367
Ending Balance	$	4,323			$	6,827			$	3,050			$	2,893			$	17,093

(dollars in thousands)	For the Year Ended December 31, 2012
	Commercial				Real estate mortgage				Real estate construction				Consumer				Total
Beginning balance	$	4,034			$	6,500			$	4,046			$	3,452			$	18,032
Provision	1,763				2,889				1,699				749				7,100
Charge-offs	(1,640		)		(3,311		)		(2,706		)		(1,526		)		(9,183		)
Recoveries	248				438				11				501				1,198
Ending Balance	$	4,405			$	6,516			$	3,050			$	3,176			$	17,147

The Company had an additional allowance for loan losses for covered loans of $14.6 million , $3.3 million and $870 thousand for the years ended December 31, 2013, 2012 and 2011, respectively.  See Note (7) for discussion on covered assets.

The following tables provides a summary of the allowance for non-covered loan losses and related non-covered loans, by portfolio segment:

(dollars in thousands)	December 31, 2013
	Commercial				Real estate mortgage				Real estate construction				Consumer				Total
Allowance for non-covered loan losses:
Individually evaluated for impairment	$	1,578			$	1,558			$	1,226			$	44			$	4,406
Collectively evaluated for impairment	2,745				5,269				1,824				2,849				12,687
Total allowance for non-covered loan losses	$	4,323			$	6,827			$	3,050			$	2,893			$	17,093
Non-covered loans:
Individually evaluated for impairment	$	8,254			$	12,612			$	11,513			$	439			$	32,818
Collectively evaluated for impairment	171,660				476,536				44,735				161,234				854,165
Total non-covered loans (1)	$	179,914			$	489,148			$	56,248			$	161,673			$	886,983

 

⁽¹⁾ Total non-covered loans excludes deferred loan costs of $1.7 million .

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  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(6) Allowance for Non-Covered Loan Losses and Credit Quality (continued)

(dollars in thousands)	December 31, 2012
	Commercial				Real estate mortgage				Real estate construction				Consumer				Total
Allowance for non-covered loan losses:
Individually evaluated for impairment	$	1,468			$	1,154			$	881			$	52			$	3,555
Collectively evaluated for impairment	2,937				5,362				2,169				3,124				13,592
Total allowance for non-covered loan losses	$	4,405			$	6,516			$	3,050			$	3,176			$	17,147
Non-covered loans:
Individually evaluated for impairment	$	9,974			$	11,357			$	19,607			$	916			$	41,854
Collectively evaluated for impairment	152,507				441,270				61,791				153,974				809,542
Total non-covered loans (1)	$	162,481			$	452,627			$	81,398			$	154,890			$	851,396

   

⁽¹⁾ Total non-covered loans excludes deferred loan costs of $1.7 million .

Credit Quality and Nonperforming Non-Covered Loans

The Company manages credit quality and controls its credit risk through lending limits, credit review, approval policies and extensive, ongoing internal monitoring. Through this monitoring process, nonperforming loans are identified. Non-covered nonperforming loans consist of non-covered nonaccrual loans.  Non-covered nonperforming loans are assessed for potential loss exposure on an individual or homogeneous group basis.

A loan is considered impaired when, based upon currently known information, it is deemed probable that the Company will be unable to collect all amounts due as scheduled according to the original terms of the agreement. Impaired loans are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate or, as a practical expedient, based on the loan’s observable market price or the fair value of collateral, if the loan is collateral dependent.

Loans are placed on nonaccrual status when collection of principal or interest is considered doubtful (generally when loans are 90 days or more past due).   Loans placed on nonaccrual will typically remain on nonaccrual status until all principal and interest payments are brought current, there has been a sustained period of repayment performance (generally six months) and the prospects for future payments, in accordance with the loan agreement, appear relatively certain.

Interest income previously accrued on nonaccrual loans, but not yet received, is reversed in the period the loan is placed on nonaccrual status. Payments received are generally applied to principal. However, based on management’s assessment of the ultimate collectability of an impaired or nonaccrual loan, interest income may be recognized on a cash basis. Nonaccrual loans are returned to an accrual status when management determines the circumstances have improved to the extent that there has been a sustained period of repayment performance and both principal and interest are deemed collectible.

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(6) Allowance for Non-Covered Loan Losses and Credit Quality (continued)

Non-Covered Impaired Loans

At December 31, 2013 and 2012, the Company had non-covered impaired loans which consisted of nonaccrual loans and restructured loans.  As of December 31, 2013 , the Company had no commitments to extend additional credit on these non-covered impaired loans.  Non-covered impaired loans and the related allowance for loan losses were as follows:

(dollars in thousands)	December 31, 2013								December 31, 2012
	Recorded investment				Allowance				Recorded investment				Allowance
With no related allowance recorded:
Nonaccrual loans	$	8,123			$	—			$	15,479			$	—
Restructured loans	4,118				—				8,635				—
Total with no related allowance	$	12,241			$	—			$	24,114			$	—
With an allowance recorded:
Nonaccrual loans	$	286			$	10			$	72			$	5
Restructured loans	20,291				4,396				17,668				3,550
Total with an allowance recorded	20,577				4,406				17,740				3,555
Total	$	32,818			$	4,406			$	41,854			$	3,555

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(6) Allowance for Non-Covered Loan Losses and Credit Quality (continued)

The following table further summarizes impaired non-covered loans, by class:

(dollars in thousands)	December 31, 2013												December 31, 2012
	Recorded investment				Unpaid principal balance				Related allowance				Recorded investment				Unpaid principal balance				Related allowance
With no related allowance recorded:
Commercial	$	2,558			$	3,036			$	—			$	3,737			$	4,231			$	—
Real estate mortgages:
One-to-four family residential	544				629				—				938				1,132				—
Multi-family and commercial	2,766				2,981				—				3,605				4,283				—
Total real estate mortgages	3,310				3,610				—				4,543				5,415				—
Real estate construction:
One-to-four family residential	6,255				9,773				—				15,251				23,133				—
Total real estate construction	6,255				9,773				—				15,251				23,133				—
Consumer:
Direct	118				269				—				583				1,017				—
Total consumer	118				269				—				583				1,017				—
Total with no related allowance recorded	$	12,241			$	16,688			$	—			$	24,114			$	33,796			$	—
With an allowance recorded:
Commercial	$	5,696			$	5,711			$	1,578			$	6,237			$	6,237			$	1,468
Real estate mortgages:
One-to-four family residential	728				728				81				524				524				53
Multi-family and commercial	8,574				8,960				1,477				6,290				6,657				1,101
Total real estate mortgages	9,302				9,688				1,558				6,814				7,181				1,154
Real estate construction:
One-to-four family residential	5,010				5,010				1,182				4,094				4,112				855
Multi-family and commercial	248				248				44				262				262				26
Total real estate construction	5,258				5,258				1,226				4,356				4,374				881
Consumer:
Direct	321				322				44				333				333				52
Total consumer	321				322				44				333				333				52
Total with an allowance recorded	20,577				20,979				4,406				17,740				18,125				3,555
Total impaired non-covered loans	$	32,818			$	37,667			$	4,406			$	41,854			$	51,921			$	3,555

The average recorded investment in non-covered impaired loans for the years ended December 31, 2013, 2012 and 2011 was $37.3 million , $45.2 million and $47.2 million , respectively. Interest income recognized on non-covered impaired loans was $438 thousand , $605 thousand and $375 thousand for the years ended December 31, 2013, 2012 and 2011, respectively.  Additional interest income of $151 thousand , $599 thousand and $1.7 million would have been recognized had the non-covered impaired loans accrued interest, in accordance with their original terms, for the years ended December 31, 2013, 2012 and 2011, respectively.

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  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(6) Allowance for Non-Covered Loan Losses and Credit Quality (continued)

Troubled Debt Restructurings

A troubled debt restructured loan is classified as a restructuring when the Company grants a concession(s) to a borrower experiencing financial difficulties that it would not otherwise consider. Examples of such concessions include forgiveness of principal or accrued interest, extending the maturity date(s) or providing a lower interest rate than would be normally available for a transaction of similar risk. As a result of these concessions, restructured loans are considered impaired as the Company will not collect all amounts due, both principal and interest, in accordance with the terms of the original loan agreement.

Troubled debt restructurings were as follows:

(dollars in thousands)	December 31, 2013												December 31, 2012
	Accrual status				Nonaccrual status				Total modifications				Accrual status				Nonaccrual status				Total modifications
Troubled debt restructurings:
Commercial	$	6,077			$	506			$	6,583			$	7,008			$	1,160			$	8,168
Real estate mortgages:
One-to-four family residential	765			320				1,085				573				340				913
Multi-family and commercial	10,457				843				11,300				7,993				1,823				9,816
Total real estate mortgage	11,222				1,163				12,385				8,566				2,163				10,729
Real estate construction:
One-to-four family residential	6,540				4,664				11,204				10,135				9,013				19,148
Multi-family and commercial	248				—				248				262				—				262
Total real estate construction	6,788				4,664				11,452				10,397				9,013				19,410
Consumer:
Direct	322				32				354				332				20				352
Total consumer	322				32				354				332				20				352
Total restructured loans	$	24,409			$	6,365			$	30,774			$	26,303			$	12,356			$	38,659

The Company’s policy is that loans placed on nonaccrual will typically remain on nonaccrual status until all principal and interest payments are brought current and the prospect for future payment in accordance with the loan agreement appear relatively certain.  The Company’s policy generally refers to six months of payment performance as sufficient to warrant a return to accrual status.

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(6) Allowance for Non-Covered Loan Losses and Credit Quality (continued)

Troubled Debt Restructurings Modification Terms

The Company offers a variety of modifications to borrowers. In restructuring a loan with a borrower, the Company normally employs several types of modifications terms. The modification terms offered by the Company are as follows:

Rate Modification: A modification in which the interest rate is changed.

Term Modification: A modification in which the maturity date, the timing of payments, or frequency of payments is changed.

Interest Only Modification: A modification in which the loan is converted to interest only payments for a period of time.

Payment Modification: A modification in which the dollar amount of the payment is changed, other than an interest only modification described above.

Combination Modification: Any other type of modification, including the use of multiple terms above.

The following tables present loans restructured for the years ended December 31, 2013 and 2012. During the periods presented, all modification terms were a combination of terms employed by the Company.

(dollars in thousands)	For the Year Ended December 31, 2013
	Number of contracts			Pre-modification recorded investment				Post-modification recorded investment
Troubled debt restructurings:
Commercial	2			$	107			$	106
Real estate mortgages:
One-to-four family residential	1			213				213
Multi-family and commercial	7			3,266				3,266
Total real estate mortgage	8			3,479				3,479
Real estate construction:
One-to-four family residential	2			175				85
Total real estate construction	2			175				85
Consumer:
Direct	1			23				20
Total consumer	1			23				20
Total restructured loans	13			$	3,784			$	3,690

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(6) Allowance for Non-Covered Loan Losses and Credit Quality (continued)

(dollars in thousands)	For the Year Ended December 31, 2012
	Number of contracts			Pre-modification recorded investment				Post-modification recorded investment
Troubled debt restructurings:
Commercial	18			$	4,812			$	4,403
Real estate mortgages:
One-to-four family residential	3			565				561
Multi-family and commercial	2			701				694
Total real estate mortgage	5			1,266				1,255
Real estate construction:
One-to-four family residential	2			1,064				933
Multi-family and commercial	1			262				262
Total real estate construction	3			1,326				1,195
Total restructured loans	26			$	7,404			$	6,853

There were no loans modified as troubled debt restructurings, within the previous twelve months , for which there was a payment default for the year ended December 31, 2013 . For the year ended December 31, 2012, there was a $557 thousand commercial loan and a $37 thousand real estate mortgage multi-family and commercial loan that had been restructured within the previous twelve months that subsequently defaulted.

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(6) Allowance for Non-Covered Loan Losses and Credit Quality (continued)

Non-Covered Nonaccrual Loans and Loans Past Due

The following table summarizes non-covered nonaccrual loans and past due loans, by class:

(dollars in thousands)	December 31, 2013
	30 - 59 Days past due				60 - 89 Days past due				Greater than 90 days and accruing				Total past due				Nonaccrual				Current				Total non-covered loans
Commercial	$	449			$	51			$	—			$	500			$	2,176			$	177,238			$	179,914
Real estate mortgages:
One-to-four family residential	—				211				—				211				507				41,093				41,811
Multi-family and commercial	939				—				—				939				883				445,515				447,337
Total real estate mortgages	939				211				—				1,150				1,390				486,608				489,148
Real estate construction:
One-to-four family residential	59				—				—				59				4,725				29,144				33,928
Multi-family and commercial	—				—				—				—				—				22,320				22,320
Total real estate construction	59				—				—				59				4,725				51,464				56,248
Consumer:
Indirect	798				101								899				—				79,001				79,900
Direct	565				5				—				570				118				81,085				81,773
Total consumer	1,363				106				—				1,469				118				160,086				161,673
Total	$	2,810			$	368			$	—			$	3,178			$	8,409			$	875,396			886,983
Deferred loan costs, net																									1,703
Total non-covered loans																									$	888,686

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(6) Allowance for Non-Covered Loan Losses and Credit Quality (continued)

(dollars in thousands)	December 31, 2012
	30 - 59 Days past due				60 - 89 Days past due				Greater than 90 days and accruing				Total past due				Nonaccrual				Current				Total non-covered loans
Commercial	$	232			$	373			$	—			$	605			$	2,966			$	158,910			$	162,481
Real estate mortgages:
One-to-four family residential	—				—				—				—				889				35,984				36,873
Multi-family and commercial	—				—				—				—				1,903				413,851				415,754
Total real estate mortgages	—				—				—				—				2,792				449,835				452,627
Real estate construction:
One-to-four family residential	—				63				—				63				9,210				37,199				46,472
Multi-family and commercial	—				—				—				—				—				34,926				34,926
Total real estate construction	—				63				—				63				9,210				72,125				81,398
Consumer:
Indirect	966				112				—				1,078				—				76,518				77,596
Direct	469				415				—				884				583				75,827				77,294
Total consumer	1,435				527				—				1,962				583				152,345				154,890
Total	$	1,667			$	963			$	—			$	2,630			$	15,551			$	833,215			851,396
Deferred loan costs, net																									1,738
Total non-covered loans																									$	853,134

Non-Covered Credit Quality Indicators

The Company’s internal risk rating methodology assigns risk ratings from 1 to 9 , where a higher rating represents higher risk.  The nine risk ratings can be generally described by the following groups:

Pass/Watch: Pass/watch loans, risk rated 1 through 5 , range from minimal credit risk to lower than average, but still acceptable, credit risk.

Special Mention:   Special mention loans, risk rated 6 ,   are loans that present certain potential weaknesses that require management’s attention.  Those weaknesses, if left uncorrected, may result in deterioration of the borrower’s repayment ability or the Company’s credit position in the future.

Substandard:   Substandard loans, risk rated 7 , are inadequately protected by the current worth and paying capacity of the borrower or of the collateral pledged, if any.  There are well-defined weaknesses that may jeopardize the repayment of debt.  Such weaknesses include deteriorated financial condition of the borrower resulting from insufficient income, excessive expenses or other factors that result in inadequate cash flows to meet all scheduled obligations.

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(6) Allowance for Non-Covered Loan Losses and Credit Quality (continued)

Doubtful/Loss:   Doubtful/loss loans are risk rated 8 and 9 .  Loans assigned as doubtful have all the weaknesses inherent with substandard loans, with the added characteristic that the weaknesses make collection in full, on the basis of currently existing facts, conditions and values, highly questionable.  The possibility of loss is high, but because of certain important and reasonably specific pending factors that may work to the advantage of, and strengthen the credit, its classification as an estimated loss is deferred until a more exact status may be determined.  The Company charges off loans that would otherwise be classified loss.

The following table summarizes our internal risk rating, by class:

(dollars in thousands)	December 31, 2013
	Pass/Watch				Special mention				Substandard				Doubtful/Loss				Total
Commercial	$	158,571			$	6,340			$	15,003			$	—			$	179,914
Real estate mortgages:
One-to-four family residential	37,720				30				4,061				—				41,811
Multi-family and commercial	387,392				29,540				30,405				—				447,337
Total real estate mortgages	425,112				29,570				34,466				—				489,148
Real estate construction:
One-to-four family residential	21,173				3,162				9,593				—				33,928
Multi-family and commercial	20,224				—				2,096				—				22,320
Total real estate construction	41,397				3,162				11,689				—				56,248
Consumer:
Indirect	78,661				11				1,228				—				79,900
Direct	76,501				1,509				3,763				—				81,773
Total consumer	155,162				1,520				4,991				—				161,673
Total	$	780,242			$	40,592			$	66,149			$	—			886,983
Deferred loan costs, net																	1,703
																	$	888,686

 

(dollars in thousands)	December 31, 2012
	Pass/Watch				Special mention				Substandard				Doubtful/Loss				Total
Commercial	$	140,809			$	4,412			$	17,260			$	—			$	162,481
Real estate mortgages:
One-to-four family residential	31,511				1,139				4,223				—				36,873
Multi-family and commercial	363,408				26,287				26,059				—				415,754
Total real estate mortgages	394,919				27,426				30,282				—				452,627
Real estate construction:
One-to-four family residential	25,389				776				20,307				—				46,472
Multi-family and commercial	32,166				472				2,288				—				34,926
Total real estate construction	57,555				1,248				22,595				—				81,398
Consumer:
Indirect	76,076				16				1,504				—				77,596
Direct	71,176				450				5,668				—				77,294
Total consumer	147,252				466				7,172				—				154,890
Total	$	740,535			$	33,552			$	77,309			$	—			851,396
Deferred loan costs, net																	1,738
																	$	853,134

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(7)  Covered Assets and FDIC Indemnification Asset

(a) Covered Loans : Loans acquired in an FDIC-assisted acquisition that are subject to a loss share agreement are referred to as “covered loans” and reported separately in the Consolidated Statements of Financial Condition .  Covered loans are reported exclusive of the expected cash flow reimbursements from the FDIC.

The following table presents the major types of covered loans. The classification of covered loan balances presented is reported in accordance with the regulatory reporting requirements.

(dollars in thousands)	December 31, 2013
	City Bank				North County Bank				Total
Commercial	$	8,670			$	8,615			$	17,285
Real estate mortgages:
One-to-four family residential	2,630				8,339				10,969
Multi-family residential and commercial	79,338				42,734				122,072
Total real estate mortgages	81,968				51,073				133,041
Real estate construction:
One-to-four family residential	—				1,327				1,327
Multi-family and commercial	5,223				4,020				9,243
Total real estate construction	5,223				5,347				10,570
Consumer - direct	2,043				4,753				6,796
Subtotal	97,904				69,788				167,692
Fair value discount	(7,172		)		(8,565		)		(15,737		)
Total covered loans	90,732				61,223				151,955
Allowance for loan losses	(13,026		)		(1,596		)		(14,622		)
Total covered loans, net	$	77,706			$	59,627			$	137,333

(dollars in thousands)	December 31, 2012
	City Bank				North County Bank				Total
Commercial	$	13,863			$	15,148			$	29,011
Real estate mortgages:
One-to-four family residential	3,783				10,412				14,195
Multi-family residential and commercial	132,280				52,303				184,583
Total real estate mortgages	136,063				62,715				198,778
Real estate construction:
One-to-four family residential	4,764				3,000				7,764
Multi-family and commercial	12,369				6,374				18,743
Total real estate construction	17,133				9,374				26,507
Consumer - direct	2,698				7,521				10,219
Subtotal	169,757				94,758				264,515
Fair value discount	(28,980		)		(18,196		)		(47,176		)
Total covered loans	140,777				76,562				217,339
Allowance for loan losses	(2,727		)		(525		)		(3,252		)
Total covered loans, net	$	138,050			$	76,037			$	214,087

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(7)  Covered Assets and FDIC Indemnification Asset (continued)

The following table presents the changes in the accretable yield for each respective acquired loan portfolio:

(dollars in thousands)	For the Year Ended December 31,
	2013								2012
	City Bank				North County Bank				City Bank				North County Bank
Balance, beginning of period	$	49,168			$	19,567			$	78,004			$	29,574
Accretion to interest income	(13,315		)		(10,133		)		(21,282		)		(14,905		)
Disposals	(13,985		)		(3,487		)		(8,866		)		(6,546		)
Reclassification (to) from nonaccretable difference	(3,364		)		6,937				1,312				11,444
Balance, end of period	$	18,504			$	12,884			$	49,168			$	19,567

(b) Covered Other Real Estate Owned: All OREO acquired in FDIC-assisted acquisitions that are subject to an FDIC loss share agreement are referred to as “covered OREO” and reported separately in the Consolidated Statements of Financial Condition .  Covered OREO is reported exclusive of expected reimbursed cash flows from the FDIC. Foreclosed covered loan collateral is transferred into covered OREO at the lower of the loan’s appraised value, less selling costs, or the carrying value.

The following tables summarize the activity related to covered OREO:

(dollars in thousands)	For the Year Ended December 31, 2013
	City Bank				North County Bank				Total
Balance, beginning of period	$	7,399			$	6,061			$	13,460
Additions to covered OREO	10,065				2,448				12,513
Dispositions of covered OREO, net	(12,321		)		(5,639		)		(17,960		)
Valuation adjustments	(1,145		)		(888		)		(2,033		)
Balance, end of period	$	3,998			$	1,982			$	5,980

 

(dollars in thousands)	For the Year Ended December 31, 2012
	City Bank				North County Bank				Total
Balance, beginning of period	$	19,341			$	7,281			$	26,622
Additions to covered OREO	2,515				7,201				9,716
Dispositions of covered OREO, net	(11,991		)		(7,183		)		(19,174		)
Valuation adjustments	(2,466		)		(1,238		)		(3,704		)
Balance, end of period	$	7,399			$	6,061			$	13,460

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(7)  Covered Assets and FDIC Indemnification Asset (continued)

(c) FDIC Indemnification Asset:  

The following table summarizes the activity related to the FDIC indemnification asset:

(dollars in thousands)	For the Year December 31, 2013
	City Bank				North County Bank				Total
Balance, beginning of period	$	20,390			$	14,181			$	34,571
Change in FDIC indemnification asset	5,331				404				5,735
Reduction due to loans paid in full	(7,179		)		(2,146		)		(9,325		)
Transfers due from FDIC	(7,674		)		(8,771		)		(16,445		)
Balance, end of period	$	10,868			$	3,668			$	14,536

(dollars in thousands)	For the Year Ended December 31, 2012
	City Bank				North County Bank				Total
Balance, beginning of period	$	43,235			$	22,351			$	65,586
Change in FDIC indemnification asset	(8,704		)		(422		)		(9,126		)
Reduction due to loans paid in full	(2,987		)		(2,597		)		(5,584		)
Transfers due from FDIC	(11,154		)		(5,151		)		(16,305		)
Balance, end of period	$	20,390			$	14,181			$	34,571

(8) Premises and Equipment

Premises and equipment consisted of the following:

 

		December 31,
(dollars in thousands)		2013				2012
Land and buildings		$	36,207			$	35,892
Furniture and equipment		14,322				13,477
Land improvements		3,580				3,561
Computer software		3,706				3,689
Construction in progress		134				600
Subtotal		57,949				57,219
Less: accumulated depreciation		(22,911		)		(20,468		)
Total		$	35,038			$	36,751

Depreciation expense on premises and equipment totaled $2.6 million , $2.4 million and $2.1 million for the years ended December 31, 2013, 2012 and 2011, respectively.

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(9) Goodwill and Other Intangible Assets

The following table summarizes the changes in the Company’s goodwill and other intangible assets:

(dollars in thousands)						Other intangible assets
		Goodwill				Gross				Accumulated amortization				Net
Balance, December 31, 2010		$	4,490			$	3,343			$	(672	)		$	2,671
Amortization		—				—				(622		)		(622		)
Balance, December 31, 2011		4,490				3,343				(1,294		)		2,049
Amortization		—				—				(512		)		(512		)
Balance, December 31, 2012		4,490				3,343				(1,806		)		1,537
Amortization		—				—				(439		)		(439		)
Balance, December 31, 2013		$	4,490			$	3,343			$	(2,245	)		$	1,098

Goodwill relates to the 2010 City Bank acquisition and represents the excess of the total purchase price paid over the fair values of the assets acquired, net of the fair values of liabilities assumed.

The other intangible assets relate to the 2010 City Bank and North County Bank acquisitions and represent core deposits.  The values of the core deposit intangible assets were determined by an analysis of the cost differential between the core deposits and alternative funding sources.  Intangible assets with definite useful lives are amortized to their estimated residual values over their respective estimated useful lives, and are also reviewed for impairment. The Company is amortizing its other intangible assets related to the City Bank and North County Bank acquisitions on an accelerated basis over an estimated nine year life and two year life, respectively. No impairment losses separate from the scheduled amortization have been recognized in the periods presented.

The Company conducted its annual evaluation of goodwill for impairment at December 31, 2013 and 2012.  At both dates, in the first step of the goodwill impairment test, the Company determined that the fair value of the Company exceeded its carrying amount; therefore, no impairment was recognized.  The significant assumptions and methodology utilized to test for goodwill impairment as of December 31, 2013 were consistent with those used at December 31, 2012. 

The following table presents the expected amortization expense for other intangible assets:

 

(dollars in thousands)		Year		Expected amortization
		2014		$	366
		2015		293
		2016		220
		2017		146
		2018		73
		Thereafter		—
				$	1,098

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(10) Non-Covered Other Real Estate Owned

The following table presents the changes in non-covered other real estate owned for the years ended December 31:

(dollars in thousands)
	2013				2012
Balance, beginning of period	$	3,023			$	1,976
Additions to OREO	3,826				4,612
Capitalized improvements	241				—
Dispositions of OREO, net	(2,700		)		(2,721		)
Valuation adjustments	(1,323		)		(844		)
Balance, end of period	$	3,067			$	3,023

(11) Deposits

The following table presents the major types of deposits at December 31:

 

(dollars in thousands)		2013				2012
Noninterest-bearing demand		$	265,412			$	261,310
NOW accounts		370,244				345,599
Money market		347,670				295,441
Savings		124,516				112,725
Time deposits		359,650				447,898
Total		$	1,467,492			$	1,462,973

The following table presents the scheduled maturities of time deposits:

 

(dollars in thousands)		December 31, 2013
		Less than 1 year				1 - 2 years				2 - 3 years				3 - 4 years				4 - 5 years				Over 5 years				Total
Time deposits of $100,000 or more		$	109,459			$	32,900			$	6,345			$	5,256			$	2,582			$	—			$	156,542
All other time deposits		154,362				37,050				4,904				3,519				3,273				—				203,108
Total		$	263,821			$	69,950			$	11,249			$	8,775			$	5,855			$	—			$	359,650

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(12) Federal Home Loan Bank Borrowings and Federal Funds Purchased

A credit line has been established by the FHLB for the Bank. At December 31, 2013 , the line of credit available to the Bank was $201.2 million . The Bank may borrow from the FHLB in amounts up to 20% of its total assets, subject to certain restrictions and collateral, with interest payable at the then stated rate. Advances on the line are collateralized by securities pledged and held in safekeeping by the FHLB, as well as supported by eligible real estate loans.  As of December 31, 2013 , collateral consisted almost entirely of eligible real estate loans in the amount of $365.4 million .

The Company also uses lines of credit at correspondent banks to purchase federal funds for short-term funding. There were no outstanding borrowings at December 31, 2013 and 2012 .  Available borrowings under these lines of credit totaled $45.0 million at December 31, 2013 .

(dollars in thousands)		December 31,
		2013				2012
Year to date average balance		$	—			$	61
Maximum amount outstanding at any month end		—				—
Weighted average interest rate on amount outstanding at year end		—				—

(13) Trust Preferred Securities and Junior Subordinated Debentures

Washington Banking Capital Trust I, a statutory business trust, was a wholly-owned subsidiary of the Company created for the exclusive purposes of issuing and selling capital securities and utilizing sale proceeds to acquire junior subordinated debt issued by the Company. On June 27, 2002, the Trust issued $15.0 million of trust preferred securities with a 30 -year maturity, callable after the fifth year by the Company. On June 29, 2007, the Company called the $15.0 million of trust preferred securities issued. The Trust was subsequently closed.

Washington Banking Master Trust, a statutory business trust, is a wholly-owned subsidiary of the Company created for the exclusive purposes of issuing and selling capital securities and utilizing sale proceeds to acquire junior subordinated debt issued by the Company. During the second quarter of 2007, the Master Trust issued $25.0 million of trust preferred securities with a 30 -year maturity, callable after the fifth year by the Company. The trust preferred securities have a quarterly adjustable rate based upon the London Interbank Offered Rate (“LIBOR”) plus 1.56% . On December 31, 2013 , the rate was 1.81% .

The junior subordinated debentures are the sole assets of the Master Trust, and payments under the junior subordinated debentures are the sole revenues of the Trust. All of the common securities of the Master Trust are owned by the Company. Washington Banking Company has fully and unconditionally guaranteed the capital securities along with all obligations of the Master Trust under the trust agreements.

(14) Income Taxes

The following table presents the components of income tax expense attributable to continuing operations included in the consolidated statements of income:

(dollars in thousands)		December 31,
		2013				2012				2011
Current tax expense		$	4,369			$	11,054			$	4,692
Deferred tax expense (benefit)		2,503				(3,198		)		2,419
Total		$	6,872			$	7,856			$	7,111

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(14) Income Taxes (continued)

Reconciliation between the statutory federal income tax rate and the effective tax rate is as follows:

(dollars in thousands)		December 31,
		2013							2012							2011
Income tax expense at federal statutory rate		$	7,479			35.0	%		$	8,645			35.0	%		$	8,072			35.0	%
Federal tax credits		—				—	%		(480		)		(1.9	)%		(480		)		(2.1	)%
Interest income on tax-exempt securities		(588		)		(2.7	)%		(512		)		(2.1	)%		(471		)		(2.0	)%
Other		(19		)		(0.1	)%		203				0.8	%		(10		)		(0.1	)%
Total		$	6,872			32.2	%		$	7,856			31.8	%		$	7,111			30.8	%

Federal tax credits are related to the New Markets Tax Credit program, whereby a subsidiary of the Bank was awarded $3.1 million in future Federal tax credits which were available through 2012. Tax benefits related to these credits were recognized for financial reporting purposes in the same periods that the credits were recognized in the Company’s income tax returns. The Company believes that it has complied with the various regulatory provisions of the New Markets Tax Credit program for all years presented, and therefore has reflected the impact of these credits in its estimated annual effective tax rate for all years presented.

The following table presents major components of the net deferred income tax asset resulting from differences between financial reporting and tax basis:

 

(dollars in thousands)		December 31,
		2013				2012
Deferred tax assets:
Covered assets		$	3,410			$	19,877
Allowance for loan losses		11,100				7,139
Fair value adjustment of investment securities available for sale		2,799				—
Deferred compensation		535				473
Other		1,199				848
Total deferred tax assets		$	19,043			$	28,337
Deferred tax liabilities:
FDIC indemnification asset		$	6,190			$	13,943
Deferred loan fees		1,600				1,518
Premises and equipment		590				629
FHLB stock dividend		144				152
Investment in partnership		1,092				1,092
Prepaid expenses		295				217
Fair value adjustment of investment securities available for sale		—				2,531
Purchase accounting		4,277				6,451
Other		278				54
Total deferred tax liabilities		14,466				26,587
Deferred tax assets (liabilities), net		$	4,577			$	1,750

There was no valuation allowance for deferred tax assets as of December 31, 2013 or 2012. The Company has determined that it is not required to establish a valuation allowance for the deferred tax assets as management believes it is more likely than not that the deferred tax asset will be realized in the normal course of business.

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(15) Earnings per Common Share

Basic earnings per share is computed by dividing net income available to common shareholders by the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share is computed in the same manner as basic earnings per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if certain shares issuable upon exercise of options and non-vested restricted stock were included.

The following table reconciles the numerators and denominators of the basic and diluted earnings per common share computations:

(dollars in thousands)	December 31,
	2013				2012				2011
Income available to common shareholders	$	14,496			$	16,844			$	14,868
Weighted average number of common shares, basic	15,495,000				15,422,000				15,329,000
Effect of dilutive stock awards	56,000				33,000				64,000
Weighted average number of common shares, diluted	15,551,000				15,455,000				15,393,000
Earnings per common share
Basic	$	0.94			$	1.09			$	0.97
Diluted	$	0.93			$	1.09			$	0.97
Antidulitive stock awards excluded from the
computation of diluted earnings per common share (in shares)	25,000				45,000				53,000

(16) Employee Benefit Plans

(a) 401(k) and Profit Sharing Plan: During 1993, the Board of Directors approved a defined contribution plan (“the Plan”). The Plan covers substantially all full-time employees and many part-time employees once they meet the age and length of service requirements. The Plan allows for a voluntary salary reduction, under which eligible employees are permitted to defer a portion of their salaries, with the Company contributing a percentage of the employee’s contribution to the employee’s account. Employees are fully vested in their elected and employer-matching contributions at all times.   At the discretion of the Board of Directors, an annual profit sharing contribution may be made to eligible employees. Profit sharing contributions vest over a six -year period.

The Company’s contributions for the years ended December 31, 2013, 2012 and 2011; under the employee matching feature of the plan, were $428 thousand , $431 thousand and $372 thousand , respectively. This represents a match of the participating employees’ salary deferral of 50% of the first 6% of the compensation deferred for 2013, 2012 and 2011. There were no contributions under the profit sharing portion of the plan for the years presented.

(b) Deferred Compensation Plan: In December 2000, the Bank approved the adoption of an Executive Deferred Compensation Plan (“Comp Plan”) to take effect January 2001, under which select participants may elect to defer receipt of a portion of eligible compensation. The following is a summary of the principal provisions of the Compensation Plan:

Purpose : The purpose of the Comp Plan is to (1) provide a deferred compensation arrangement for a select group of management or highly compensated employees within the meaning of Sections 201(2) and 301(a)(3) of ERISA and directors of the Bank, and (2) attract and retain the best available personnel for positions of responsibility with the Bank and its subsidiaries.  The Comp Plan is intended to be an unfunded deferred compensation agreement.  Participation in the Comp Plan is voluntary.

Source of Benefits : Benefits under the Comp Plan are payable solely by the Bank.  To enable the Bank to meet its financial commitment under the Comp Plan, assets may be set aside in a corporate-owned vehicle.  These assets are available to all general creditors of the Bank in the event of the Bank’s insolvency.  Participants of the Comp Plan are unsecured general creditors of the Bank with respect to the Comp Plan benefits. Deferrals under the Comp Plan may reduce compensation used to calculate benefits under the Bank’s 401(k) Plan.

At December 31, 2013 and 2012, liabilities recorded in connection with deferred compensation plan benefits totaled $781 thousand and $833 thousand , respectively, and are recorded in other liabilities.

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(16) Employee Benefit Plans (continued)

(c) Bank Owned Life Insurance:   During the second quarters of 2004 and 2007, the Bank made $10.0 million and $5.0 million investments, respectively, in BOLI. These policies insure the lives of officers of the Bank, and name the Bank as beneficiary. Noninterest income is generated tax-free (subject to certain limitation) from the increase in the policies' underlying investments made by the insurance company.

(17) Stock-Based Compensation

The Company adopted the 2005 Stock Incentive Plan (“2005 Plan”) following stockholders’ approval at the 2005 Annual Meeting of Stockholders. Subsequent to the adoption of the 2005 Plan, no additional grants may be issued under the prior plans.

The 2005 Plan provides grants of up to 833,333 shares, which includes any remaining shares subject to stock awards under the prior plans for future awards, or which have been forfeited, cancelled or expire. Grants from the 2005 Plan may take any of the following forms: incentive stock options, nonqualified stock options, restricted stock, restricted units, performance shares, performance units, stock appreciation rights or dividend equivalent rights. As of December 31, 2013, the Company had 361,219 shares available for grant.

(a) Stock Options:   Under the terms of the 2005 Plan, the exercise price of each incentive stock option must be greater than or equal to the market price of the Company’s stock on the date of the grant. The plan further provides that no incentive stock option granted to a single grantee may exceed $100 thousand in aggregate fair market value in a single calendar year. Stock options vest over a period of no greater than five years from the date of grant. Additionally, the right to exercise the option terminates ten years from the date of grant.

The following table summarizes information on stock option activity during 2013 :

	Shares			Weighted average exercise price per share				Weighted average remaining contractual terms (in years)		Total intrinsic value (in thousands)
Outstanding, January 1, 2013	107,845			$	11.58
Granted	—			—
Exercised	(10,715	)		11.60						$	46
Forfeited, expired or cancelled	(1,763	)		15.98
Outstanding, December 31, 2013	95,367			$	11.50			3.74		$	594
Exercisable at December 31, 2013	95,367			$	11.50			3.74		$	594

The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (i.e., the difference between the Company’s closing stock price on December 31, 2013 , and the exercise price, times the number of shares) that would have been received by the option holders had all the option holders exercised their options on December 31, 2013 .  This amount changes based upon the fair market value of the Company’s stock. The total intrinsic value of options exercised for the years ended December 31, 2013, 2012 and 2011 was $46 thousand , $238 thousand and $191 thousand , respectively.

The Company recognizes compensation expense for stock option grants on a straight-line basis over the requisite service period of the grant.   No stock-based compensation expense was recognized for the year ended December 31, 2013 .  The Company recognized $8 thousand and $86 thousand in stock-based compensation expense, as a component of salaries and benefits, for the years ended December 31, 2012 and 2011, respectively. As of December 31, 2013 , there was no remaining unrecognized compensation costs related to nonvested stock option grants.

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(17) Stock-Based Compensation (continued)

(b) Restricted Stock Awards: The Company grants restricted stock periodically for the benefit of employees.  Recipients of restricted stock do not pay any cash consideration to the Company for the shares and receive all dividends with respect to such shares, whether or not the shares have vested. Restrictions are based on continuous service requirements with the Company.

At December 31, 2013 and 2012, there were no restricted stock awards outstanding.  The total intrinsic value of restricted stock vested for the year ended December 31, 2011 was $16 thousand .

For the years ended December 31, 2013 and 2012, the Company did not recognize any restricted stock compensation expense as a component of salaries and benefits, compared to $8 thousand for the year ended December 31, 2011.

(c) Restricted Stock Units: The Company grants restricted stock units (“RSU”) periodically for the benefit of employees and directors. Recipients of RSUs receive shares of the Company’s stock upon the lapse of their related restrictions and do not pay any cash consideration to the Company for the shares.  Restrictions are based on continuous service.

The following table summarizes information on RSU activity during 2013 :

	Shares			Weighted average fair value per share				Weighted average remaining contractual terms (in years)
Outstanding, January 1, 2013	99,811			$	13.16
Granted	81,300			13.91
Vested	(47,605	)		13.16
Forfeited, expired or cancelled	(6,197	)		13.53
Outstanding, December 31, 2013	127,309			$	13.62			1.83

For the year ended December 31, 2013 , 2012 and 2011, the Company recognized $ 878 thousand , $ 803 thousand and $529 thousand in RSU compensation expense, respectively, as a component of salaries and benefits.  As of December 31, 2013 , there was $1.1 million of total unrecognized compensation costs related to nonvested RSUs which is expected to be recognized over a weighted-average period of 1.7 years .

(18) Shareholders' Equity

(a) Preferred Stock: On January 16, 2009, in exchange for an aggregate purchase price of $26.4 million , the Company issued and sold to the United States Department of the Treasury pursuant to the Trouble Asset Relief Program Capital Purchase Program (“TARP”) the following: (i) 26,380 shares of the Company’s newly designated Fixed Rate Cumulative Perpetual Preferred Stock, Series A, no par value per share, and liquidation preference of $1,000 per share ( $26.4 million liquidation preference in the aggregate) and (ii) a warrant to purchase up to 492,164 shares of the Company’s common stock, no par value per share, at an exercise price of $8.04 per share, subject to certain anti-dilution and other adjustments. As described below, the number of shares of common stock subject to the Warrant was reduced pursuant to the terms of the Warrant. The Warrant was exercisable for up to ten years after it is issued.

In connection with the issuance and sale of the Company’s securities, the Company entered into a Letter Agreement including the Securities Purchase Agreement-Standard Terms, dated January 16, 2009, with the United States Department of the Treasury (the “Agreement”). The Agreement contained limitations on the payment of quarterly cash dividends on the Company’s common stock in excess of $0.065 per share and on the Company’s ability to repurchase its common stock. The Agreement also granted the holders of the Series A Preferred Stock, the Warrant and the common stock to be issued under the Warrant registration rights, and subjected the Company to executive compensation limitations included in the Emergency Economic Stabilization Act of 2008, as amended. Participants in the TARP Capital Purchase Program are required to have in place limitations on the compensation of Senior Executive Officers and other highly compensated employees.

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(18) Shareholders' Equity (continued)

The Company paid cumulative dividends at a rate of 5% per annum on the Series A Preferred Stock, which would have increased to 9% per annum after the first five years , in each case, applied to the $1,000 per share liquidation preference, but only paid when, as and if declared by the Company’s Board of Directors out of funds legally available. The Series A Preferred Stock had no maturity date and ranked senior to the Company’s common stock with respect to the payment of dividends and distributions and amounts payable upon liquidation, dissolution and winding up of the Company.

In February 2009, following passage of the American Recovery and Reinvestment Act of 2009, the program terms were changed and the Company was no longer required to conduct a qualified equity offering prior to retirement of the preferred stock, however prior approval of the Company's primary regulator was required.

The preferred stock was not subject to any contractual restrictions on transfer. The holders of the preferred stock had no general voting rights, only limited class voting rights including, authorization or issuance of shares ranking senior to the preferred stock, any amendment to the rights of the preferred stock, or any merger, exchange or similar transaction which would adversely affect the rights of the preferred stock. If dividends on the preferred stock were not paid in full for six dividend periods, whether or not consecutive, the preferred stock holders would have the right to elect two directors until dividends had been paid for four consecutive dividend periods. The preferred stock was not subject to sinking fund requirements and had no participation rights.

On January 13, 2009, the Company’s shareholders approved an amendment to the Company’s Restated Articles of Incorporation setting the specific terms and conditions of the preferred stock and designating such shares as the Series A Preferred Stock. The amendment was filed with the Secretary of State of the State of Washington on January 13, 2009.

In accordance with the relevant accounting pronouncements and a letter from the SEC’s Office of the Chief Accountant, the Company recorded the preferred stock and detachable warrants within Shareholders’ Equity on the Consolidated Balance Sheets . The preferred stock and detachable warrants were initially recognized based on their relative fair values at the date of issuance. As a result, the preferred stock’s carrying value is at a discount to the liquidation value or stated value. The discount is considered an unstated dividend cost that shall be amortized over the period preceding commencement of the perpetual dividend using the effective interest method, by charging the imputed dividend cost against retained earnings and increasing the carrying amount of the preferred stock by a corresponding amount. The discount was  being amortized over five years using a 6.52% effective interest rate. The total stated dividends (whether or not declared) and unstated dividend cost combined represents a period’s total preferred stock dividend, which is deducted from net income to arrive at net income available to common shareholders on the Consolidated Statements of Income.

On January 12, 2011, the Company redeemed all 26,380 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A, originally issued in January 2009 to the U.S. Department of the Treasury under the Troubled Asset Relief Program Capital Purchase Program.  The Company paid a total of $26.6 million to the Treasury, consisting of $26.4 million in principal and $209 thousand in accrued and unpaid dividends. The Company's redemption of the shares is not subject to additional conditions.  At December 31, 2010, the preferred stock had a carrying value of $25.3 million (net of a $1 million unaccreted discount) on the Company's statement of financial condition. The Company accelerated the accretion of the remaining discount in the first quarter of 2011, reducing net income available to common shareholders by $1 million .

(b) Stock Warrants:   On January 16, 2009, in connection with the issuance of the preferred stock, the Company issued a warrant to the U.S. Treasury to purchase up to 492,164 shares of the Company’s common stock, no par value per share, at an exercise price of $8.04 per share, subject to certain customary anti-dilution and other adjustments. The warrants issued were immediately exercisable, in whole or in part, and had a ten year term. The warrants were not subject to any other contractual restrictions on transfer. The Company granted the warrant holder piggyback registration rights for the warrants and the common stock underlying the warrants and agreed to take such other steps as reasonably requested to facilitate the transfer of the warrants and the common stock underlying the warrants. The holders of the warrants were not entitled to any common stockholder rights. The U.S. Treasury agreed not to exercise voting power with respect to any shares of common stock of the Company issued to it upon exercise of the warrants.

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(18) Shareholders' Equity (continued)

The preferred stock and detachable warrants were initially recognized based on their relative fair values at the date of issuance.  As a result, the value allocated to the warrants was different than the estimated fair value of the warrants as of the grant date. The following assumptions were used to determine the fair value of the warrants as of the grant date:

Dividend yield	5.00		%
Expected life (years)	10
Expected volatility	49.56		%
Risk-free rate	2.80		%
Fair value per warrant at grant date	$	3.27
Relative fair value per warrant at grant date	$	3.49

On March 2, 2011, the Company completed the repurchase of Warrant to Purchase Common Stock issued to the U.S. Department of the Treasury pursuant to the Troubled Asset Relief Program Capital Purchase Program. The Company repurchased the Warrant for $1.6 million . The Warrant repurchase, together with the Company’s earlier redemption of the entire amount of Fixed Rate Cumulative Perpetual Preferred Stock, Series A, issued to the U.S. Treasury, represents full repayment of all TARP obligations and cancellation of all equity interests in the Company held by the U.S. Treasury.

(19) Regulatory Capital Matters

The Company (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and Bank must meet specific capital guidelines that involve quantitative measures of the Company’s and Bank's assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The Company’s and Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about risk components, asset risk weighting and other factors.

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(19) Regulatory Capital Matters (continued)

Risk-based capital guidelines issued by the FDIC establish a risk-adjusted ratio relating capital to different categories of assets and off-balance sheet exposures for banks. The Bank’s Tier 1 capital is comprised primarily of common equity and excludes accumulate other comprehensive income. Total capital also includes a portion of the allowance for loan losses, as defined according to regulatory guidelines. In addition, under Washington State banking regulations, the Bank is limited as to the ability to declare or pay dividends to the Company up to the amount of the Bank’s retained earnings then on hand. Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier 1 capital to risk-weighted assets (as defined in the regulations), and of Tier 1 capital to average assets (as defined in the regulations). As of December 31, 2013 , the Company and Bank met the minimum capital requirements to which it is subject and is considered to be “well-capitalized.”

The following tables describe the Company’s and Bank’s regulatory capital and threshold requirements:

 

		Actual							For capital adequacy purposes							To be well-capitalized under prompt corrective action provisions
December 31, 2013		Amount				Ratio			Amount				Minimum ratio			Amount			Minimum ratio
Total risk-based capital ratio
Company (consolidated)		$	218,470			19.76	%		$	88,435			8.00	%		N/A
Whidbey Island Bank		211,954				19.20	%		88,330				8.00	%		110,413			10.00	%
Tier 1 risk-based capital ratio
Company (consolidated)		204,431				18.49	%		44,217				4.00	%		N/A
Whidbey Island Bank		197,931				17.93	%		44,165				4.00	%		66,248			6.00	%
Tier 1 leverage ratio
Company (consolidated)		204,431				12.41	%		65,887				4.00	%		N/A
Whidbey Island Bank		197,931				12.02	%		65,855				4.00	%		82,319			5.00	%

		Actual							For capital adequacy purposes							To be well-capitalized under prompt corrective action provisions
December 31, 2012		Amount				Ratio			Amount				Minimum ratio			Amount			Minimum ratio
Total risk-based capital ratio
Company (consolidated)		$	210,545			19.39	%		$	86,856			8.00	%		N/A
Whidbey Island Bank		203,471				18.77	%		86,715				8.00	%		108,393			10.00	%
Tier 1 risk-based capital ratio
Company (consolidated)		196,889				18.13	%		43,428				4.00	%		N/A
Whidbey Island Bank		189,837				17.51	%		43,357				4.00	%		65,036			6.00	%
Tier 1 leverage ratio
Company (consolidated)		196,889				11.78	%		66,858				4.00	%		N/A
Whidbey Island Bank		189,837				11.36	%		66,820				4.00	%		83,525			5.00	%

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  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(20) Fair Value Measurements

(a) Fair Value Hierarchy and Fair Value Measurement : The Company groups its assets and liabilities that are recorded at fair value in three levels, based on the markets, if any, in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:

Level 1:  Quoted prices for identical instruments in active markets.

 

Level 2:  Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable.

 

Level 3:   Significant inputs to the valuation model are unobservable.

The following table presents the Company’s financial instruments measured at fair value on a recurring basis:

(dollars in thousands)		Fair Value at December 31, 2013
		Level 1				Level 2				Level 3				Total
U.S. government agencies		$	—			$	85,672			$	—			$	85,672
Residential pass-through securities		—				180,809				—				180,809
Taxable state and political subdivisions		—				2,468				—				2,468
Tax exempt state and political subdivisions		—				74,807				—				74,807
Corporate obligations		—				10,933				—				10,933
Agency-issued collateralized mortgage obligations		—				54,145				—				54,145
Asset-backed securities		—				21,816				—				21,816
Investments in mutual funds and other equities		1,892				—				—				1,892
Total		$	1,892			$	430,650			$	—			$	432,542

 

(dollars in thousands)		Fair Value at December 31, 2012
		Level 1				Level 2				Level 3				Total
U.S. government agencies		$	—			$	88,586			$	—			$	88,586
Residential pass-through securities		—				168,423				—				168,423
Taxable state and political subdivisions		—				5,312				—				5,312
Tax exempt state and political subdivisions		—				58,985				—				58,985
Corporate obligations		—				10,435				—				10,435
Agency-issued collateralized mortgage obligations		—				14,046				—				14,046
Asset-backed securities		—				25,188				—				25,188
Investments in mutual funds and other equities		1,993				—				—				1,993
Total		$	1,993			$	370,975			$	—			$	372,968

There were no transfers between Level 1, Level 2 and Level 3 during the years ended December 31, 2013 or 2012.

When available, the Company uses quoted market prices to determine the fair value of investment securities. These investments are included in Level 1. When quoted market prices are unobservable, the Company uses quotes from independent pricing vendors based on recent trading activity and other relevant information including market interest rate curves, referenced credit spreads and estimated prepayment rates where applicable. These investments are included in Level 2 and comprise the Company’s portfolio of U.S. agency securities, U.S. treasury securities, residential pass-through securities, municipal bonds and other corporate bonds.

Certain financial assets of the Company may be measured at fair value on a non-recurring basis. These assets are subject to fair value adjustments that result from application of lower-of-cost-or-market accounting or write-downs of individual assets.

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WASHINGTON BANKING COMPANY AND SUBSIDIARIES

  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(20) Fair Value Measurements (continued)

The following table presents the carrying value of financial instruments by level within the fair value hierarchy, for which a non-recurring change in fair value has been recorded:

(dollars in thousands)		Fair Value at December 31, 2013
		Level 1				Level 2				Level 3				Total				Total losses for the period
Non-covered impaired loans (1)		$	—			$	—			$	28,412			$	28,412			$	(4,552	)
Non-covered other real estate owned (2)		—				—				3,067				3,067				(1,323		)
Covered other real estate owned (2)		—				—				5,980				5,980				(2,033		)
Total		$	—			$	—			$	37,459			$	37,459			$	(7,908	)

(dollars in thousands)		Fair Value at December 31, 2012
		Level 1				Level 2				Level 3				Total				Total losses for the period
Non-covered impaired loans (1)		$	—			$	—			$	38,299			$	38,299			$	(8,485	)
Non-covered other real estate owned (2)		—				—				3,023				3,023				(844		)
Covered other real estate owned (2)		—				—				13,460				13,460				(3,704		)
Total		$	—			$	—			$	54,782			$	54,782			$	(13,033	)

⁽¹⁾ Represents carrying value and related specific valuation allowances, which are included in the allowance for loan losses.

⁽²⁾ Represents the fair value and related losses of foreclosed real estate and other collateral owned that were measured at fair value subsequent to their initial classification as non-covered other real estate owned and covered other real estate owned.

Following is a description of methods and assumptions used to estimate the fair value of each class of financial instrument for which a non-recurring change in fair value has been recorded:

Non-covered impaired loans : A loan is considered impaired when, based upon currently known information, it is deemed probable that the Company will be unable to collect all amounts due as scheduled according to the original terms of the agreement.  Non-covered impaired loans are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate or, as a practical expedient, based on the loan’s observable market price or the fair value of the collateral, if the loan is collateral dependent.

The Company generally obtains appraisals for collateral dependent loans on an annual basis.  Depending on the loan, the Company may obtain appraisals more frequently than 12 months , particularly if the credit is deteriorating.  If the loan is performing and market conditions are stable, the Company may not obtain appraisals on an annual basis. This policy does not vary by loan type.

Impaired loans that are collateral dependent are reviewed quarterly.  The review involves a collateral valuation review, which also contemplates an assessment of whether the last appraisal is outdated.  Recent appraisals, adjustments to outdated appraisals, knowledgeable third party opinions of value and current market conditions are combined to determine whether a specific reserve and/or a loan charge-off is required.  Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.  For the period ended December 31, 2013 , one non-covered impaired loan totaling $105 thousand had an adjustment to the appraisal, based on unobservable inputs, of 30% .

In the rare case where an appraisal is not available, the Company consults with third party industry specific experts for estimates as well as relies upon the Company’s market knowledge and expertise.

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  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(20) Fair Value Measurements (continued)

Non-covered and covered other real estate owned : Non-covered and covered other real estate owned includes properties acquired through foreclosure. These properties are recorded at the lower of cost or estimated fair value, less estimated cost to sell, based on periodic evaluations.

The Company deducts 10% of the appraised value for selling costs on non-covered and covered other real estate owned.  If the property has been actively listed for sale for more than nine months and has had limited interest, the Company will typically reduce the fair value further based upon input from third party industry experts and knowledgeable management and may include adjustments for outdated appraisals (Level 3).

(b) Disclosures about Fair Value of Financial Instruments: The tables below are a summary of fair value estimates for financial instruments, excluding financial instruments recorded at fair value on a recurring and nonrecurring basis (summarized in the table above). The carrying amounts in the following table are recorded in the statement of financial condition under the indicated captions. The Company has excluded non-financial assets and non-financial liabilities such as Bank premises and equipment, deferred taxes and other liabilities.  

(dollars in thousands)		December 31, 2013
						Fair value measurements using:
		Carrying value				Total				Level 1				Level 2				Level 3
Financial assets:
Cash and cash equivalents		$	27,489			$	27,489			$	27,489			$	—			$	—
Interest-bearing deposits		103,869				103,869				103,869				—				—
Investment securities available for sale		432,542				432,542				1,892				430,650				—
FHLB stock		7,172				7,172				7,172				—				—
Loans held for sale		3,389				3,389				—				3,389				—
Non-covered loans		888,686				885,627				—				—				885,627
Covered loans		151,955				144,450				—				—				144,450
Bank owned life insurance		17,836				17,836				17,836				—				—
FDIC indemnification asset		14,536				16,833				—				—				16,833
Financial liabilities:
Deposits		1,467,492				1,471,214				1,107,842				363,372				—
Junior subordinated debentures		25,774				17,578				—				—				17,578

 

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  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(20) Fair Value Measurements (continued)

(dollars in thousands)		December 31, 2012
						Fair value measurements using:
		Carrying value				Total				Level 1				Level 2				Level 3
Financial assets:
Cash and cash equivalents		$	32,145			$	32,145			$	32,145			$	—			$	—
Interest-bearing deposits		75,428				75,428				75,428				—				—
Investment securities available for sale		372,968				372,968				1,993				370,975				—
FHLB stock		7,441				7,441				7,441				—				—
Loans held for sale		18,043				18,043				—				18,043				—
Non-covered loans		853,134				858,660				—				—				858,660
Covered loans		217,339				234,396				—				—				234,396
Bank owned life insurance		17,704				17,704				17,704				—				—
FDIC indemnification asset		34,571				22,630				—				—				22,630
Financial liabilities:
Deposits		1,462,973				1,468,189				1,015,075				453,114				—
Junior subordinated debentures		25,774				12,155				—				—				12,155

Following is a description of methods and assumptions used to estimate the fair value of each class of financial instrument not recorded at fair value but required for disclosure purposes:

Cash and Cash Equivalents:   The carrying value of cash and cash equivalent instruments approximates fair value.

Interest-bearing Deposits:   The carrying values of interest-bearing deposits maturing within ninety days approximate their fair values. Fair values of other interest-earning deposits are estimated using discounted cash flow analysis based on current rates for similar types of deposits.

Investment Securities: Fair values of investment securities are based on quoted market prices when available or through the use of alternative approaches, such as matrix or model pricing, or broker indicative bids, when market quotes are not readily accessible or available.

FHLB stock: The Bank’s investment in FHLB stock is carried at par value, which approximates its fair value.

Loans Held for Sale:   The carrying value of loans held for sale approximates fair value.

Non-covered Loans:   The loan portfolio is composed of commercial, consumer, real estate construction and real estate loans.  The carrying value of variable rate loans approximates their fair value. The fair value of fixed rate loans is estimated by discounting the estimated future cash flows of loans, sorted by type and security, by the weighted average rate of such loans and rising rates currently offered by the Bank for similar loans.

Covered Loans: Covered loans are measured at estimated fair value on the date of acquisition. Subsequent to acquisition, the fair value of covered loans is measured using the same methodology as that of non-covered loans.

Bank Owned Life Insurance: Fair values of insurance policies owned are based on the insurance contract’s cash surrender value.

FDIC Indemnification Asset: The FDIC indemnification asset is calculated as the expected future cash flows under the loss share agreement discounted by a rate reflective of a U.S. government agency security.

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WASHINGTON BANKING COMPANY AND SUBSIDIARIES

  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(20) Fair Value Measurements (continued)

Deposits: For deposits with no contractual maturity such as checking accounts, money market accounts and savings accounts, fair values approximate book values. The fair value of certificates of deposit are based on discounted cash flows using the difference between the actual deposit rate and an alternative cost of funds rate, currently offered by the Bank for similar types of deposits.

Trust Preferred Securities/Junior Subordinated Debentures: The fair value of trust preferred securities is estimated using discounted cash flow analysis based on current rates for similar types of debt.

Off-Balance Sheet Items: Commitments to extend credit represent the principal category of off-balance sheet financial instruments. The fair value of these commitments are not material since they are for relatively short periods of time and are subject to customary credit terms, which would not include terms that would expose the Company to significant gains or losses.

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WASHINGTON BANKING COMPANY AND SUBSIDIARIES

  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(21) Washington Banking Company Information

The summarized condensed financial statements for Washington Banking Company (parent company only) are presented in the following tables:

Condensed Balance Sheets

(dollars in thousands)		December 31,
		2013				2012
Assets
Cash and cash equivalents		$	5,323			$	5,327
Investment in subsidiaries		199,204				201,345
Other assets		1,284				1,747
Total assets		$	205,811			$	208,419
Liabilities
Junior subordinated debentures		$	25,774			$	25,774
Other liabilities		107				21
Total liabilities		25,881				25,795
Shareholders' Equity
Common stock		86,714				85,707
Retained earnings		98,431				92,234
Accumulated other comprehensive (loss) income, net		(5,215		)		4,683
Total shareholders' equity		179,930				182,624
Total liabilities and shareholders' equity		$	205,811			$	208,419

Condensed Statements of Income

 

(dollars in thousands)		For the Year Ended December 31,
		2013				2012				2011
Interest income:
Interest on taxable investment securities		$	14			$	16			$	15
Total interest income		14				16				15
Interest expense:
Junior subordinated debentures		478				532				489
Total interest expense		478				532				489
Noninterest expense		1,432				1,057				905
Loss before income tax benefit and undistributed earnings of subsidiaries		(1,896		)		(1,573		)		(1,379		)
Income tax benefit		664				550				482
Loss before undistributed earnings of subsidiaries		(1,232		)		(1,023		)		(897		)
Undistributed earnings of subsidiaries		6,878				8,967				11,949
Dividend income from Bank		8,850				8,900				4,900
Net income before preferred dividends		14,496				16,844				15,952
Preferred dividends		—				—				1,084
Net income available to common shareholders		$	14,496			$	16,844			$	14,868

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WASHINGTON BANKING COMPANY AND SUBSIDIARIES

  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(21) Washington Banking Company Information (continued)

Condensed Statements of Cash Flows

 

(dollars in thousands)		For the Year Ended December 31,
		2013				2012				2011
Operating activities:
Net income		$	14,496			$	16,844			$	15,952
Adjustments to reconcile net income to net cash used in operating activities:
Equity in undistributed earnings of subsidiaries		(6,878		)		(8,967		)		(11,949		)
Net decrease (increase) in other assets		467				(524		)		(490		)
Net increase (decrease) in other liabilities		86				(3		)		(168		)
Cash flows provided by operating activities		8,171				7,350				3,345
Investing activities:
Investment in subsidiaries		—				—				31,382
Cash flows provided by investing activities		—				—				31,382
Financing activities:
Redemption of preferred stock		—				—				(26,380		)
Repurchase of common stock warrant		—				—				(1,625		)
Dividends paid on preferred stock		—				—				(38		)
Dividends paid on common stock		(8,299		)		(7,717		)		(3,068		)
Proceeds from issuance of common stock under stock plans		124				301				301
Cash flows used in financing activities		(8,175		)		(7,416		)		(30,810		)
Net change in cash and cash equivalents		(4		)		(66		)		3,917
Cash and cash equivalents at beginning of period		5,327				5,393				1,476
Cash and cash equivalents at end of period		$	5,323			$	5,327			$	5,393

(22)  Commitments and Contingencies

(a) Leasing Arrangements: The Company is obligated under a number of non-cancelable operating leases for land and buildings.  The majority of these leases have renewal options.  In addition, some o the leases contain escalation clauses tied to the consumer price index with caps.

At December 31, 2013, the Company’s future minimum rental payments required under land, buildings and equipment operating leases that have initial or remaining non-cancelable lease terms of one year or more are as follows:

 

(dollars in thousands)		2014				2015				2016				2017				2018				Thereafter				Total
Minimum payments		$	1,392			$	1,285			$	1,182			$	1,107			$	922			$	1,683			$	7,571

Rent expense applicable to operating leases was $1.7 million for the year ended December 31, 2013 and $1.5 million for the years ended December 31, 2012 and 2011.

(b) Commitments to Extend Credit:  Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.  The amount of collateral obtained, if it is deemed necessary by the Bank upon extension of credit, is based on management’s credit evaluation of the counter party.  Collateral held varies, but may include: property, plant and equipment; accounts receivable; inventory; and income-producing commercial properties.

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  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(22)  Commitments and Contingencies (continued)

Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party.  Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions.  Except for certain long-term guarantees, the majority of guarantees expire in one year .  The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.  Collateral supporting those commitments, for which collateral is deemed necessary, generally amounts to one hundred percent of the commitment amount at December 31, 2013.

For the years ended December 31, 2013, 2012 and 2011, the Bank has not been required to perform on any financial guarantees and no losses were incurred.

Commitments to extend credit were as follows:

 

(dollars in thousands)		December 31, 2013
Loan commitments:
Fixed rate		$	10,380
Variable rate		183,344
Total loan commitments		193,724
Standby letters of credit		1,114
Total commitments		$	194,838

(c) Contingencies: The Company and its subsidiaries are from time to time defendants in and are threatened with various legal proceedings arising from regular business activities.  Management believes the ultimate liability, if any, arising from such claims or contingencies will not have a material adverse effect on the Company’s results of operations or financial condition.

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  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(23) Related Party Transactions

At December 31, 2013 and 2012 , the Bank had loans to persons serving as directors and executive officers, and to entities related to such individuals.  All loans were made on essentially the same terms and conditions as comparable transactions with other persons, and do not involve more than the normal risk of collectability.  The following table details the loan activity of related party transactions for the years ended December 31:

 

(dollars in thousands)		2013				2012
Beginning balance		$	2,403			$	3,804
New loans or advances		121				1,772
Payments		(259		)		(3,173		)
Reclassifications (1)		(396		)		—
Ending balance		$	1,869			$	2,403
Available credit		$	525			$	755

 

^{(1) Represents loans that were once considered related party but are no longer considered related party, or loans that were not related party that subsequently became related party loans.}  

The Bank held deposits from related parties totaling $1.5 million and $2.3 million at December 31, 2013 and 2012 , respectively.

(24) Selected Quarterly Financial Data (Unaudited)

Results of operations on a quarterly basis were as follows:

 

(dollars in thousands, except per share data)		For the Year Ended December 31, 2013
		First quarter				Second quarter				Third quarter				Fourth quarter
Interest income		$	19,610			$	18,726			$	18,469			$	18,554
Interest expense		1,428				1,369				1,322				1,301
Net interest income		18,182				17,357				17,147				17,253
Provision for loan losses		1,950				11,764				525				376
Net interest income after provision for loan losses		16,232				5,593				16,622				16,877
Noninterest income		4,346				11,697				3,137				3,165
Noninterest expense		13,867				12,926				13,072				16,436
Income before provision for income tax		6,711				4,364				6,687				3,606
Provision for income tax		2,127				1,456				2,185				1,104
Net income available to common shareholders		$	4,584			$	2,908			$	4,502			$	2,502
Basic earnings per share		$	0.30			$	0.19			$	0.29			$	0.16
Diluted earnings per share		$	0.30			$	0.19			$	0.29			$	0.16
Cash dividends declared per share		$	0.15			$	0.15			$	0.09			$	0.15

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  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(dollars in thousands, except per share data)		For the Year Ended December 31, 2012
		First quarter				Second quarter				Third quarter				Fourth quarter
Interest income		$	23,283			$	22,726			$	22,262			$	21,439
Interest expense		1,981				1,837				1,710				1,585
Net interest income		21,302				20,889				20,552				19,854
Provision for loan losses		2,000				2,748				1,250				3,746
Net interest income after provision for loan losses		19,302				18,141				19,302				16,108
Noninterest income		1,297				988				1,358				4,603
Noninterest expense		13,655				15,109				13,663				13,972
Income before provision for income tax		6,944				4,020				6,997				6,739
Provision for income tax		2,171				1,173				2,359				2,153
Net income available to common shareholders		$	4,773			$	2,847			$	4,638			$	4,586
Basic earnings per share		$	0.31			$	0.18			$	0.30			$	0.30
Diluted earnings per share		$	0.31			$	0.18			$	0.30			$	0.30
Cash dividends declared per share		$	0.12			$	0.14			$	0.09			$	0.15

(25) Subsequent Events

On January 30, 2014 , the Company announced that its Board of Directors declared a cash dividend of $0.08 per common share to shareholders of record as of February 10, 2014 , payable on February 26, 2014 .

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Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

None

Item 9A. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

As of the end of the period covered by this report, management, including our Chief Executive Officer and Chief Financial Officer (Principal Financial and Accounting Officer), evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures.  Based on this evaluation, they concluded that the Company’s disclosure controls and procedures are effective in timely alerting them to material information required to be included in the periodic reports to the SEC.  The design of any system of controls is based in part upon various assumptions about the likelihood of future events, and there can be no assurance that any of the Company’s plans, products, services or procedures will succeed in achieving their intended goals under future conditions. Management found no facts that would require the Company to take any corrective actions with regard to significant deficiencies or material weaknesses.

 

Changes in Internal Control over Disclosure and Reporting

 

There was no change in the Company’s internal control over financial reporting that occurred during the period ended December 31, 2013 , that has materially affected, or is reasonably likely to materially affect, the internal control over financial reporting.

Management’s Report on Internal Control over Financial Reporting

See “Management’s Report on Internal Control Over Financial Reporting” set forth in Item 8- Financial Statements and Supplementary Data , immediately preceding the financial statement audit report of Moss Adams LLP.

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Item 9B. Other Information

None