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Item 7. Management’s Discussion and Analysis

2022-02-25 compared with 2021-02-26 · 388 added, 900 removed, 178 unchanged (88% of the section changed)

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion is intended to assist in understanding the financial condition and results of operations of the Company for the year ended December 31, 2020.

The information contained in this section should be read together with the December 31, 2020 audited Consolidated Financial Statements and Notes thereto included in Item 8.

The following discussion is intended to assist in understanding the financial condition and results of operations of the Company as of and for the year ended December 31, 2021.

The information contained in this section should be read together with the December 31, 2021 audited Consolidated Financial Statements and the accompanying Notes included in Item 8.

Financial Statements And Supplementary Data of this Form 10-K.

1 unchanged sentence

Discussions of 2019 items and year-to-year comparisons between 2020 and 2019 that are not included in this Form 10-K can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of the Company’s Form 10-K for the fiscal year ended December 31, 2020.

COVID-19 Impacts

In response to the COVID-19 pandemic, and in an effort to mitigate the adverse impact on our employees, customers and the communities we serve, the Bank implemented various lending measures to address customer and community needs, including commercial, mortgage and consumer lending assistance.

The Bank also implemented various retail-impacting measures for the safety and health of customers and employees.

The following provides details of the Bank's special programs and policies.

Commercial Lending Assistance

The Bank made available the following initial short-term COVID Modifications to commercial borrowers affected by COVID-19:

• Interest only payments on term debt for up to 90 days;

• Temporary increases to line of credit commitments when supported by underlying assets, including changing the borrowing base formula or changing existing commitment restrictions to allow higher advance rates;

• Full payment deferrals for up to 90 days when an interest only period does not provide sufficient relief (contingent on credit administration approval);

• Loan re-amortization, especially in cases where significant prepayments of principal have occurred;

• Covenant waivers and resets;

• Processing new loan requests, such as a line of credit for working capital support;

• Maturity extensions of up to 90 days for maturing lines of credit or term loans.

In the second quarter of 2020, the Bank implemented a special, streamlined initial 90-day interest only payment modification process for borrowers in certain industries as a result of the COVID-19 "stay at home" orders.

Once the initial 90-day relief option expired, the Bank extended similar relief options for a subsequent or second COVID Modification to certain commercial borrowers.

The Bank maintained a preference for offering interest only payments on those secondary modifications.

The Bank determined that in most instances, a request for a third payment deferral modification, where total modifications exceed 180 days, was considered a TDR status loan instead of a COVID Modification as the Bank incorporated policies consistent with regulatory guidance.

The Bank will work constructively with commercial borrowers to identify loan modifications that are based on the facts and circumstances of each borrower, and to protect the safety and soundness of the Bank.

All commercial COVID Modification loans were risk rated "Watch" or worse at initial modification date, except in certain cases where a borrower had performed well prior to the modification request and exhibited a strong financial position, or the loan had significant guarantor support, or if a more severe risk rating was determined appropriate given facts and circumstances of the borrower.

Further requests for relief beyond the initial modification were reassessed for a more severe risk rating as part of the review process to grant further relief.

For additional information regarding the Bank’s loan risk ratings see Note (4) Loans Receivable of the Notes to Consolidated Financial Statements included in Item 8.

Financial Statements And Supplementary Data.

Mortgage and Consumer Lending Assistance

In order to effectively manage or mitigate adverse impacts on mortgage and consumer borrowers affected by COVID-19, the Bank implemented the initial COVID Modification through a streamlined approval process to include 90-day payment deferrals when the borrower met the following criteria:

• The borrower's ability to pay had been negatively impacted by COVID-19;

• The loan was not over 30 days past due on the date of the request;

• The loan was risk rated "Pass" prior to the request for payment deferral.

Mortgage and consumer loans that did not meet the criteria to receive streamlined approval qualifications were considered outside of the automatic deferral process and were evaluated on a case-by-case basis by the Bank's credit team.

Certain consumer term loans with current balances over $100,000 and original terms over 96 months were reviewed on a case-by-case basis and did not qualify for the streamlined approval process.

For consumer lines of credit, for borrowers that had sufficient available credit on their line, the borrower could draw on their line of credit to make payments in lieu of payment deferrals, and for borrowers that did not have sufficient available credit, the Bank offered a 90-day payment deferral.

However, after the deferral period, these borrowers were billed for the deferred months of accrued interest and the Bank worked with those borrowers unable to pay all months of interest at that time.

For credit card customers, a skip payment option was included in the borrowers' billing statements between April 1, 2020 and May 30, 2020.

Based on the depth and breadth of the COVID-19 pandemic, the Bank extended similar relief options for a subsequent or second COVID Modification to certain consumer borrowers.

The Bank had a preference for offering interest only payments, or partial principal and interest payments, on these secondary COVID Modifications.

All initial COVID Modifications on mortgage and consumer loans remained risk rated "Pass" through the initial 90-day relief period.

This risk rating was subject to change if the Bank received additional information within the 90-day relief period that the borrower did not intend to repay the loan, which resulted in a risk rating downgrade and the implementation of further collection efforts unless facts and circumstances of the borrower mitigated additional risk of nonperformance.

Risk ratings were reviewed for a more severe classification for any borrower requesting a secondary COVID Modification.

Borrowers with COVID Modifications did not have negative data reported to the credit reporting agencies.

Credit reporting was not turned off on these accounts, but contractual due dates were advanced in the core loan system with appropriate loan documentation to legally support the new due dates.

COVID-19 Modifications:

During the year ended December 31, 2020 and as a direct result of COVID-19 issues cited by the borrower and the Bank's lending assistance programs described above, the Bank made COVID Modifications on loans.

These modifications were not classified as TDR status in accordance with the CARES Act and related regulatory guidance unless the payment deferment period exceeded 180-days.

The following table details the amortized cost and count by each loan class of modifications that were made during the year ended December 31, 2020, with amortized costs presented as of March 31, 2020, the date before the prolonged impacts of the COVID-19 pandemic:

Amortized Cost Count

(Dollars in thousands)

Commercial business:

Commercial and industrial $ 153,009 586

Owner-occupied CRE 210,126 186

Non-owner occupied CRE 233,296 135

Total commercial business 596,431 907

Residential real estate 18,441 38

Real estate construction and land development:

Residential 7,002 29

Commercial and multifamily

Total real estate construction and land development 24,529 52

Consumer 27,238 1,044

Total $ 666,639 2,041

The following table presents COVID Modifications from the table above that were downgraded during the year ended December 31, 2020 that also had loan balances at December 31, 2020:

Watch Special Mention Substandard Total

Amortized Cost Count Amortized Cost Count Amortized Cost Count Amortized Cost Count Amortized Cost Count

Heritage Financial Corporation is a bank holding company which primarily engages in the business activities of our wholly-owned financial institution subsidiary, Heritage Bank.

We provide financial services to our local communities with an ongoing strategic focus on our commercial banking relationships, market expansion and asset quality.

The Company’s business activities generally are limited to passive investment activities and oversight of its investment in the Bank.

Accordingly, the information set forth in this report relates primarily to the Bank’s operations.

Our business consists primarily of commercial lending and deposit relationships with small to medium sized businesses and their owners in our market areas and attracting deposits from the general public.

We also make real estate construction and land development loans and consumer loans.

We additionally originate for sale or for investment purposes residential real estate loans on single family properties located primarily in our markets.

During the three months ended March 31, 2020, we ceased indirect auto loan originations, included in our consumer loan portfolio.

Our core profitability depends primarily on our net interest income.

Net interest income is the difference between interest income, which is the income that we earn on interest earning assets, comprised primarily of loans and investment securities, and interest expense, which is the amount we pay on our interest bearing liabilities, consisting primarily of deposits.

Management manages the repricing characteristics of the Company's interest earning assets and interest bearing liabilities to protect net interest income from changes in market interest rates and changes in the shape of the yield curve.

Like most financial institutions, our net interest income is significantly affected by general and local economic conditions, particularly changes in market interest rates, and by governmental policies and actions of regulatory agencies.

Net interest income is additionally affected by changes in the volume and mix of interest earning assets, interest earned on these assets, the volume and mix of interest bearing liabilities and interest paid on these liabilities.

Our net income is affected by many factors, including the provision for credit losses on loans.

The provision for credit losses on loans is dependent on changes in the loan portfolio and management’s assessment of the collectability of the loan portfolio as well as prevailing economic and market conditions.

Management believes that the ACL on loans reflects the amount that is appropriate to provide for current expected credit losses in our loan portfolio based on our methodology.

Net income is also affected by noninterest income and noninterest expense.

Noninterest income primarily consists of service charges and other fees and other income.

Noninterest expense consists primarily of compensation and employee benefits, occupancy and equipment, data processing and professional services.

Compensation and employee benefits consist primarily of the salaries and wages paid to our employees, payroll taxes, expenses for retirement and other employee benefits.

Occupancy and equipment expenses are the fixed and variable costs of buildings and equipment and consists primarily of lease expenses, depreciation charges, maintenance and utilities.

Data processing consists primarily of processing and network services related to the Bank’s core operating system, including the account processing system, electronic payments processing of products and services, internet and mobile banking channels and software-as-a-service providers.

Professional services consists primarily of third-party service providers such as auditors, consultants and lawyers.

Results of operations may also be significantly affected by general and local economic and competitive conditions, governmental policies and actions of regulatory authorities, especially changes resulting from the COVID-19 Pandemic and the governmental actions taken to address it.

Net income is also impacted by growth of operations through organic growth or acquisitions.

COVID-19 Pandemic Response

The Company maintains its commitment to supporting its community and customers during the COVID-19 Pandemic and remains focused on keeping its employees safe and the Bank running effectively to serve its customers.

As of December 31, 2021, nearly all Bank branches are open with normal hours and substantially all employees are expected to return to their go-forward working environments during the three months ended March 31, 2022.

The Bank will continue to monitor branch access and occupancy levels in relation to cases and close contact scenarios and follow governmental restrictions and public health authority guidelines.

Branch Consolidation Plan

The Company reduced the branch count to 49 from 61 branches at December 31, 2020, including the consolidation of

eight branches during the three months ended March 31, 2021 and four branches in October 2021.

The Company integrated these locations into other branches within its network.

These actions were the result of the Company’s increased focus on balancing physical locations and digital banking channels, driven by increased customer usage of online and mobile banking and a commitment to improve digital banking technology.

Results of Operations

Net income was $98.0 million, or $2.73 per diluted common share, for the year ended December 31, 2021 compared t o $46.6 million, or $1.29 per diluted common share, for the year ended December 31, 2020.

Net income increased $51.5 million, or 110.5% , due primarily to a reversal o f provision for credit losses of $29.4 million during the year ended December 31, 2021 compared to a provision for credit losses of $36.1 million for the same period in 2020.

The Company’s efficiency ratio was 62.09% for the year ended December 31, 2021 compared to 62.52% for the year ended December 31, 2020.

Average Balances, Yields and Rates Paid

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

Year Ended December 31,

2021 2020 2019

(Dollars in thousands)

Commercial business:

Commercial and industrial $ 5,552 20 $ 12,768 64 $ 18,525 34 $ 17,050 33 $ 53,895 151

Owner-occupied CRE 36,713 15 20,033 29 16,352 7 17,365 8 90,463 59

Non-owner occupied CRE 12,754 6 34,154 27 10,427 5 49,407 6 106,742 44

Total commercial business 55,019 41 66,955 120 45,304 46 83,822 47 251,100 254

Real estate construction and land development:

Commercial and multifamily

Interest Earning Assets:

Loans receivable, net (2)(3)

$ 4,181,464 $ 189,832 4.54 % $ 4,335,564 $ 192,417 4.44 % $ 3,668,665 $ 189,515 5.17 %

Consumer — — — — — — 840 23 840 23

Total $ 56,156 43 $ 66,955 120 $ 45,304 46 $ 85,112 71 $ 253,527 280

(1) Downgraded within the "Pass" rating scale of 1 to 5.

Of the $130.4 million of "Special Mention" or "Substandard" downgrades, $59.1 million was classified as nonaccrual or performing TDR and the rest were classified as potential problem loans.

The following table details the amortized cost and count of modifications by each loan class for any loan that was in active payment modification deferral status as of December 31, 2020, with balances and count at December 31, 2020:

Amortized Cost Count

Taxable securities 846,892 17,492 2.07 731,378 17,541 2.40 827,822 23,045 2.78

Nontaxable securities (3)

158,968 3,899 2.45 152,447 3,659 2.40 135,245 3,396 2.51

Interest earning deposits 1,193,724 1,608 0.13 315,847 703 0.22 98,153 1,894 1.93

Total interest earning assets 6,381,048 212,831 3.34 % 5,535,236 214,320 3.87 % 4,729,885 217,850 4.61 %

Noninterest earning assets 745,202 758,386 681,193

Total assets $ 7,126,250 $ 6,293,622 $ 5,411,078

Interest Bearing Liabilities:

Certificates of Deposit $ 372,279 $ 1,811 0.49 % $ 482,316 $ 5,675 1.18 % $ 512,732 $ 7,021 1.37 %

Savings accounts 598,492 367 0.06 489,471 526 0.11 506,073 2,633 0.52

Interest bearing demand and money market accounts 2,862,504 3,982 0.14 2,491,477 6,064 0.24 2,052,573 6,695 0.33

Total interest bearing deposits 3,833,275 6,160 0.16 3,463,264 12,265 0.35 3,071,378 16,349 0.53

Junior subordinated debentures 21,025 742 3.53 20,730 890 4.29 20,438 1,339 6.55

Securities sold under agreement to repurchase 45,655 140 0.31 27,805 160 0.58 28,457 175 0.61

FHLB advances and other borrowings — — — 1,466 8 0.55 11,899 305 2.56

Total interest bearing liabilities 3,899,955 7,042 0.18 % 3,513,265 13,323 0.38 % 3,132,172 18,168 0.58 %

Noninterest bearing demand deposits 2,256,608 1,835,165 1,389,721

Other noninterest bearing liabilities 127,620 139,612 99,683

Stockholders’ equity 842,067 805,580 789,502

Total liabilities and stock-holders’ equity $ 7,126,250 $ 6,293,622 $ 5,411,078

Net interest income and spread $ 205,789 3.16 % $ 200,997 3.49 % $ 199,682 4.03 %

Net interest margin 3.23 % 3.63 % 4.22 %

(1) Average balances are calculated using daily balances.

(2) Average loan receivable, net includes loans held for sale and loans classified as nonaccrual, which carry a zero yield.

Interest earned on loans receivable, net includes the amortization of net deferred loan fees of $28.4 million, $14.4 million and $776,000 for the years ended December 31, 2021, 2020, and 2019, respectively.

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

Net Interest Income and Margin Overview

One of the Company's key sources of earnings is net interest income.

There are several factors that affect net interest income, including, but not limited to, the volume, pricing, mix and maturity of interest earning assets and interest bearing liabilities;

the volume of noninterest earning assets, noninterest bearing demand deposits, other noninterest bearing liabilities and stockholders' equity;

market interest rate fluctuations;

and asset quality.

The following table provides the changes in net interest income due to changes in average asset and liability balances (volume), changes in average rates (rate) and changes attributable to the combined effect of volume and interest rates allocated proportionately to the absolute value of changes due to volume and changes due to interest rates:

2021 Compared to 2020

Increase (Decrease) Due to changes in 2020 Compared to 2019

Increase (Decrease) Due to changes in

Volume Rate Total Volume Rate Total

(Dollars in thousands) (Dollars in thousands)

Interest Earning Assets:

Loans receivable, net $ (6,934) $ 4,349 $ (2,585) $ 31,716 $ (28,814) $ 2,902

Taxable securities 2,566 (2,615) (49) (2,515) (2,989) (5,504)

Nontaxable securities 159 81 240 418 (155) 263

Interest earning deposits 1,278 (373) 905 1,544 (2,735) (1,191)

Total interest income $ (2,931) $ 1,442 $ (1,489) $ 31,163 $ (34,693) $ (3,530)

Interest Bearing Liabilities:

Certificates of deposit $ (1,082) $ (2,782) $ (3,864) $ (399) $ (947) $ (1,346)

Savings accounts 100 (259) (159) (84) (2,023) (2,107)

Interest bearing demand and money market accounts 803 (2,885) (2,082) 1,265 (1,896) (631)

Total interest bearing deposits (179) (5,926) (6,105) 782 (4,866) (4,084)

Junior subordinated debentures 12 (160) (148) 19 (468) (449)

Securities sold under agreement to repurchase 75 (95) (20) (4) (11) (15)

FHLB advances and other borrowings (4) (4) (8) (157) (140) (297)

Total interest expense $ (96) $ (6,185) $ (6,281) $ 640 $ (5,485) $ (4,845)

Net interest income $ (2,835) $ 7,627 $ 4,792 $ 30,523 $ (29,208) $ 1,315

Net interes t income increased $4.8 million, or 2.4%, to $205.8 million for the year ended December 31, 2021 compared to $201.0 million for 2020 due primarily to the Bank decreasing deposit rates following decreases in short-term market interest rates and secondarily due to an increase in the yield of loans receivable, net, predominately from higher amortization of deferred SBA PPP loan fees recognized from forgiven SBA PPP loans and higher recoveries of interest and fees on loans classified as nonaccrual.

These factors increasing net interest income were offset partially by a decrease in average loans receivable, net and a decrease in the yield on taxable securities.

Net interest margin decreased due primarily to the significant increase in low-yielding average interest earning deposits to average total earning assets of 18.7% during the year ended December 31, 2021 compared to 5.7% for the same period in 2020, reducing the yield on interest earning assets for 2021.

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

Year Ended December 31,

(Dollars in thousands)

Commercial business:

Commercial and industrial $ 20,258 44

Owner-occupied CRE 25,679 13

Non-owner occupied CRE 39,950 11

Total commercial business 85,887 68

Real estate construction and land development:

One-to-four family residential 45 1

Commercial and multifamily

Total real estate construction and land development 3,984 3

Consumer 2,660 106

Total $ 92,531 177

Of the loans in active payment modification deferral status at December 31, 2020, $67.7 million, or 73.2%, were on their second or third loan deferral modification.

Included in the total of active payment modification deferral status are loans classified as nonaccrual of $22.9 million and loans classified as performing TDR of $39.0 million.

The risk classification of loans in active payment modification deferral status includes "Pass" rated of $10.8 million, "Watch" rated of $16.2 million, "Special Mention" rated of $3.0 million and "Substandard" rated of $62.5 million.

COVID-19 Downgrades:

The Bank downgraded loans due to heightened risk as a direct result of COVID-19 issues cited by the borrower.

All COVID-19 downgrades, including those with and without a modification, as of December 31, 2020 are as follows:

Watch Special Mention Substandard Total

Amortized Cost Count Amortized Cost Count Amortized Cost Count Amortized Cost Count Amortized Cost Count

Loan yield (GAAP) 4.54 % 4.44 %

Exclude impact from SBA PPP loans (0.20) % 0.16 %

Exclude impact from incremental accretion on purchased loans (0.07) % (0.08) %

Loan yield excluding SBA PPP loans and incremental accretion on purchased loans (non-GAAP) 4.27 % 4.52 %

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

Provision for Credit Losses Overview

The aggregate of the provision for credit losses on loans and the provision for credit losses on unfunded commitments is presented on the Consolidated Statements of Income as the provision for credit losses.

The ACL on unfunded commitments is included on the Consolidated Statements of Financial Condition within accrued expenses and other liabilities.

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

Year Ended December 31,

(In thousands)

Provision for credit losses on loans $ (27,298) $ 35,433

Provision for credit losses on unfunded commitments (2,074) 673

Provision for credit losses $ (29,372) $ 36,106

The reversal of provision for credit losses recognized during the year ended December 31, 2021 was due primarily to improvements in forecasted economic indicators used to calculate credit losses during the year ended December 31, 2021 compared to the worsening of economic indicators during the year ended December 31, 2020 stemming from the onset of the COVID-19 Pandemic.

Noninterest Income Overview

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

Year Ended December 31,

2021 2020 Change % Change

(Dollars in thousands)

Commercial business:

Commercial and industrial $ 13,348 68 $ 24,352 134 $ 45,249 74 $ 17,506 39 $ 100,455 315

Owner-occupied CRE 58,558 29 28,670 42 31,919 15 23,031 10 142,178 96

Non-owner occupied CRE 47,429 18 59,406 34 13,048 7 49,408 6 169,291 65

Total commercial business 119,335 115 112,428 210 90,216 96 89,945 55 411,924 476

Residential 979 7 — — — — — — 979 7

Real estate construction and land development:

One-to-four family residential — — — — — — — — — —

Commercial and multifamily

Service charges and other fees $ 17,597 $ 16,228 $ 1,369 8.4 %

Gain on sale of investment securities, net 29 1,518 (1,489) (98.1)

Gain on sale of loans, net 3,644 5,044 (1,400) (27.8)

Interest rate swap fees 661 1,691 (1,030) (60.9)

Bank owned life insurance income

2,520 4,319 (1,799) (41.7)

Total real estate construction and land development 8,335 3 1,175 1 1,077 3 450 1 11,037 8

Consumer — — — — — — 840 23 840 23

Total $ 128,649 125 $ 113,603 211 $ 91,293 99 $ 91,235 79 $ 424,780 514

(1) Downgraded within the "Pass" rating scale of 1 to 5.

Loans in the table above which were downgraded to Special Mention or worse are classified as potential problem loans, except for loans totaling $21.6 million and $37.5 million that were classified as nonaccrual and performing TDR, respectively, at December 31, 2020.

SBA Paycheck Protection Program

Beginning April 6, 2020, the Bank began to offer SBA PPP loans to its existing and new customers as a results of provisions in the CARES Act for customers directly impacted by the COVID-19 pandemic.

SBA PPP loans are designed to provide a direct incentive for small businesses to keep their workers on the payroll.

The CARES Act and its subsequent amendments allocated $669.0 billion to the program.

Utilizing our internal technology solutions team, the Bank was able to develop an automated platform to control and manage processing for SBA PPP loans and immediately began originations under this program.

The Bank accepted applications for SBA PPP loans, including loans to independent contractors, sole proprietors and partnerships as allowed under the guidance from the U.S.

Treasury and SBA that was issued April 14, 2020.

The Bank funded 4,642 loans totaling $897.4 million through the program's conclusion on August 8, 2020.

The average loan balance for funded loans was $193,000.

Of the funded loans, approximately 21% of both the number of loans funded and amount originated were to customers with no prior banking relationship to the Bank.

The Bank earns 1% interest on these loans as well as a fee from the SBA to cover processing costs, which is amortized over the life of the loan.

The balance of unamortized net deferred fees on SBA PPP loans was $15.4 million at December 31, 2020.

The CA Act renews and extends the PPP until March 31, 2021 by authorizing an additional $284.5 billion for the program.

As a result, the Bank began originating SBA PPP loans again starting in January 2021.

Additionally, the Federal Reserve established the PPPLF under Section 13(3) of the Federal Reserve Act to bolster the effectiveness of the SBA's PPP.

Under the PPPLF, the Bank may pledge its SBA PPP loans as collateral at face value to obtain Federal Reserve Bank non-recourse loans.

The maturity date of any PPPLF advance (the “Maturity Date”) will be the maturity date of the SBA PPP loan pledged to secure the PPPLF advance.

The Maturity Date of any PPPLF advance will be accelerated on and to the extent of (i) the date of any loan forgiveness reimbursement by the SBA for any SBA PPP loan securing the PPPLF advance;

or (ii) the date of purchase by the SBA from the Bank of any SBA PPP loan securing the PPPLF loan advance to realize on the SBA’s guarantee of the SBA PPP loan.

PPPLF advances may be obtained until December 31, 2020.

Although the Bank was approved to utilize the PPPLF, the Bank chose not to participate in PPPLF during the year ended December 31, 2020.

See Note (25) Subsequent Events of the Notes to Consolidated Financial Statements included in Item 8.

Financial Statements And Supplementary Data for a discussion about the renewal of this facility subsequent to December 31, 2020.

The Bank began processing loan forgiveness applications, as allowed under the SBA's PPP, during the fourth quarter of 2020.

As of December 31, 2020, the Bank received principal and interest forgiveness payment of $159.2 million from the SBA.

Heritage is an active SBA lender in the Pacific Northwest and had SBA loans totaling $62.0 million and $64.1 million at December 31, 2020 and December 31, 2019, respectively.

During the year ended December 31, 2020, Heritage participated in the SBA's Debt Relief Program under the CARES Act.

The CARES Act appropriated $17.0 billion to subsidize small business loans.

Under this program, the SBA paid principal and interest for existing current SBA loans for a period of six months, commencing with payments due after March 27, 2020 as well as new SBA 7(a), 504, and microloans disbursed prior to September 27, 2020.

Under this program, the borrowers did not have to reimburse the SBA or the Bank for these payments.

If a borrower had already requested a payment deferral, and the deferral was granted, the six month period began after the deferment period.

There was no limitation to the monthly principal and interest amount that the SBA would pay on behalf of the borrower.

The borrower could also make other principal-only payments during the six month period.

The Bank did not consider any loans for which the SBA was making the principal and interest payment as a COVID Modification loan as only the source of payment was changed and not the payment terms of the SBA loan.

Retail Policy Changes

The COVID-19 pandemic caused significant disruptions to the Bank's operations and resulted in the implementation by the Bank of various social distancing measures to address customer and community needs.

• Branch Lobby Closures.

To ensure the safety of our customers and employees, branch lobbies have been closed since March 2020 with most services processed through the drive-up or by appointment, except three branches located within Island County, which opened temporarily during the summer and fall as was allowed under Washington State's Phased Approach:

Reopening Business and Modifying Physical Distancing Measures.

• Early Withdrawal Penalty Waivers.

For customers that may need access to funds in their certificate of deposits to assist with living expenses during the COVID-19 pandemic, the Bank assisted these customers by waiving early withdrawal penalties for withdrawals up to $25,000.

• Overdraft & Fee Reversals.

Overdraft and fee reversals were waived on a case-by-case basis.

The Bank was cautious when paying overdrafts beyond the customer's total deposit relationship, overdraft protection options or their overdraft coverage limits.

Employee Changes

Heritage has committed to keeping its employees safe during this COVID-19 pandemic.

As a result, many policy changes have been implemented including the following measures:

• Heritage follows the guidelines recommended by the Centers for Disease Control and/or local officials, such as social distancing and maintaining six feet of separation between employees.

• Heritage has provided additional cleaning and disinfecting solutions to each location.

• A significant number of back-office employees are working remotely.

• Essential business travel is limited to those situations where business cannot reasonably be conducted without face-to-face interaction or visits to specific locations.

• Certain front-line employees were given additional hourly pay.

• Heritage offered up to 80 hours for full time employees of COVID-19 related absences, to use in lieu of sick or vacation time, for the employee's own illness, to care for an ill family member, due to a required self-isolation/quarantine or school/day care closures.

Heritage continues to monitor the situation and makes additional accommodations as necessary.

Critical Accounting Policies

The Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America.

Companies may apply certain critical accounting policies requiring management to make subjective or complex judgments, often as a result of the need to estimate the effect of matters that are inherently uncertain.

The Company considers its most critical accounting estimates to be as follows:

ACL on Investment Securities Available for Sale

Management evaluates the need for an ACL on investment securities available for sale on at least a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation.

For investment securities available for sale in an unrealized loss position, the Company first assesses whether it intends to sell or it is more likely than not that it will be required to sell the security before the recovery of its amortized cost basis.

If either of the criteria regarding intent or requirement to sell is met, the security’s amortized cost basis is written down to fair value through a provision for credit loss against income.

For investment securities available for sale that do not meet the aforementioned criteria, the Company evaluates whether the decline in fair value has resulted from credit losses or other factors.

In making this assessment, management considers the extent to which fair value is less than amortized cost, any changes to the rating of the security by a rating agency and adverse conditions specifically related to the security, among other factors.

The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis.

If the present value of cash flows expected to be collected is less than the amortized cost basis, a credit loss exists and an ACL on investment securities available for sale is recorded for the credit loss, limited by the amount that the fair value is less than the amortized cost basis.

unrealized decline in fair value that has not been recorded through an ACL on investment securities available for sale is recognized in other comprehensive income.

For additional information regarding the ACL on investment securities available for sale, see Note (3) Investment Securities of the Notes to Consolidated Financial Statements included in Item 8.

Financial Statements And Supplementary Data.

Management utilizes a historic loss, open pool CECL methodology to calculate the ACL on loans.

Under this methodology, nonaccrual loans are evaluated for credit losses on an individual basis and the remainder of the portfolio is disaggregated into similar segments of loans which are collectively evaluated for ACL on loans at the segment level.

The determination of the evaluation method applied to each loan in the portfolio is a subjective management estimate based on the facts and circumstances surrounding each loan.

The allowance for individually evaluated loans is calculated using either the collateral value method, which considers the likely source of repayment as the value of the collateral, less estimated costs to sell if applicable, or the net present value method, which considers the contractual principal and interest terms and estimated cash flows available from the borrower to satisfy the debt.

The determination of which method to apply and the application of either method, including evaluating the contractual principal and interest terms and estimated cash flows for the net present value method or the valuation of the collateral, less an estimate of selling costs, are subjective management estimates.

For each loan segment collectively evaluated for an ACL on loans, a baseline allowance and a macroeconomic allowance is calculated in the model.

For the baseline allowance, a baseline loss rate is calculated at the segment level using the Bank's historical loss rates which are calculated using the Bank's average quarterly historical loss information.

The calculated loss rates are applied to each loan's estimated cash flows over the life of the loan under the remaining life method to determine the loss estimate for each loan.

Estimated cash flows consider the principal and interest in accordance with the contractual term of the loan and estimated prepayments.

Prepayments are a subjective management estimate established for each segment based on rolling historical averages for the segments, which management believes is an accurate representation of future prepayment activity.

Management reviews the adequacy of the prepayment period assumption on a quarterly basis.

The Company utilizes a macroeconomic sensitive model to adjust each segment's baseline loss rate over a reasonable and supportable forecast period and then reverts to the Bank's historical baseline loss rates for the remainder of the expected life of the loan segment.

The macroeconomic sensitive model is developed for each segment given the current and forecasted economic conditions and a macroeconomic multiplier is calculated for each forecasted period considering the forecasted losses as compared to the long-term average actual losses of the dataset.

The impact of those macroeconomic factors to each segment, both positive or negative, using the reasonable and supportable period, are considered the macroeconomic allowance.

After the reasonable and supportable period, forecasted loss rates revert to historical baseline loss levels over the predetermined reversion period on a straight-lined basis.

The reasonable and supportable forecast period, the reversion period, and the period used to calculate the Bank's average quarterly historical loss information at the segment level are based on subjective management estimates.

Management also considers other qualitative risk factors to adjust the estimated ACL on loans calculated by the above-mentioned model for internal or external factors outside of those considered in its historical losses or macroeconomic forecast.

The qualitative adjustments are also based on subjective management estimates.

In general, management's estimate of the ACL on loans uses relevant available information, from internal and external sources, relating to past events, current conditions, and reasonable and supportable forecasts.

The evaluation of ACL on loans is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

While management utilizes its best judgment and information available to recognize credit losses on loans, future additions to the allowance may be necessary based on further declines in local and national economic conditions.

In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s ACL on loans.

Such agencies may require the Bank to make adjustments to the allowance based on their judgments about information available to them at the time of their examinations.

The Company believes the ACL on loans is appropriate at December 31, 2020 given all of the above considerations.

For additional information regarding the ACL on loans, its relation to the provision for credit losses, its risk related to asset quality and lending activity, see “Provision for credit losses overview” and “Analysis of allowance for credit losses on loans” below, Item 1A.

Risk Factors—Our ACL on loans may prove to be insufficient to absorb losses in our loan portfolio as well as Note (5) Allowance for Credit Losses on Loans of the Notes to Consolidated Financial Statements included in Item 8.

Financial Statements And Supplementary Data.

ACL on Unfunded Commitments

The Bank estimates expected credit losses on unfunded, off-balance sheet commitments over the contractual period in which the Bank is exposed to credit risk from a contractual obligation to extend credit, unless the obligation is unconditionally cancellable by the Bank.

The Bank has determined that no allowance is necessary for the off-balance sheet portion of the credit card portfolio as it has the ability to unconditionally cancel the available lines of credit.

The allowance methodology for unfunded commitments is similar to the ACL on loans, but additionally includes considerations of the current utilization of the commitment and an estimate of the future utilization as determined appropriate by historical commitment utilization and the Bank's estimates of future utilization given current economic forecasts.

For additional information regarding the ACL on unfunded commitments, see Note (15) Commitments and Contingencies of the Notes to Consolidated Financial Statements included in Item 8.

Financial Statements And Supplementary Data.

Business Combinations

The Company applies the acquisition method of accounting for business combinations.

Under the acquisition method, the acquiring entity in a business combination recognizes all of the identifiable assets acquired and liabilities assumed at their acquisition date fair values.

Management utilizes prevailing valuation techniques appropriate for the asset or liability being measured in determining these fair values.

Any excess of the purchase price over amounts allocated to assets acquired, including identifiable intangible assets, and liabilities assumed is recorded as goodwill.

Where amounts allocated to assets acquired and liabilities assumed is greater than the purchase price, a bargain purchase gain is recognized.

Acquisition-related costs are expensed as incurred unless they are directly attributable to the issuance of the Company's common stock in a business combination and the Company chooses to record these acquisition-related costs through stockholders' equity.

There were no business combinations during the years ended December 31, 2020 and 2019.

For additional information see Note (2) Business Combination of the Notes to Consolidated Financial Statements included in Item 8.

Financial Statements And Supplementary Data for information regarding the business combinations completed during the year ended December 31, 2018.

The Company’s goodwill is assigned to Heritage Bank and is evaluated for impairment at the Heritage Bank level (reporting unit).

Goodwill is reviewed for impairment annually and between annual tests if an event occurs or circumstances change that might indicate the Company’s recorded value is more than its implied value.

Such indicators may include, among others:

a significant adverse change in legal factors or in the general business climate;

significant decline in the Company’s stock price and market capitalization;

unanticipated competition;

and an adverse action or assessment by a regulator.

Any adverse changes in these factors could have a significant impact on the recoverability of goodwill and could have a material impact on the Consolidated Financial Statements.

The Company typically performed a quantitative goodwill impairment test as of December 31st using the Company's market capitalization as an indicator of fair value.

During the second quarter of 2020, the Company determined a triggering event occurred due to the deteriorating financial market and economic conditions as a result of the COVID-19 pandemic and consequently engaged a third-party valuation specialist to perform a detailed quantitative assessment of goodwill as of May 31, 2020.

Management estimated the fair value of the reporting unit by weighting results from the market approach and the income approach.

Significant assumptions inherent in the valuation methodologies for goodwill were employed and included, but were not limited to, prospective financial information, growth rates, terminal value, discount rates, and comparable multiples from publicly traded companies in our industry.

Based on this quantitative test, management determined that the fair value of the reporting unit more likely than not exceeded the carrying value.

The Company performed its annual goodwill impairment test during the fourth quarter of 2020 and determined, based on a qualitative assessment utilizing the Company's market capitalization, that it is more likely than not that the fair value of the reporting unit exceeded the carrying value, such that the Company's goodwill was not considered impaired for the year ended December 31, 2020.

Changes in the economic environment, operations of the reporting unit or other adverse events, including as a result of COVID-19, could result in future impairment charges which could have a material adverse impact on the Company’s operating results.

For additional information regarding goodwill, see Note (8) Goodwill and Other Intangible Assets of the Notes to Consolidated Financial Statements included in Item 8.

Financial Statements And Supplementary Data.

Financial Overview

Heritage Financial Corporation is a bank holding company which primarily engages in the business activities of our wholly-owned financial institution subsidiary, Heritage Bank.

We provide financial services to our local communities with an ongoing strategic focus on our commercial banking relationships, market expansion and asset quality.

Consolidated Financial Condition Overview

The table below provides a comparison of the changes in the Company's financial condition from December 31, 2019 to December 31, 2020:

Gain on sale of other assets, net 4,405 955 3,450 361.3

Other income 5,759 7,474 (1,715) (22.9)

Total noninterest income $ 34,615 $ 37,229 $ (2,614) (7.0) %

Nonintere st income decreased due primarily to lower bank owned life insurance income as the year ended December 31, 2020 included the recognition of death benefits of $1.9 million and lower other income as last year included trust income of $1.6 million, including a termination fee of $651,000 from the divestiture of our trust department.

Additionally, noninterest income was lower due to reduced gain on sale of investment securities due to fewer sales, a decrease in gain on sale of loans due primarily to lower sales volume of secondary market mortgage loans and a decline in interest rate swap fees due to fewer executions of interest rate swap contracts.

Partially offsetting these decreases was an increase in gain on sale of other assets, net for the year ended December 31, 2021, including a $2.7 million gain from the sale and leaseback of the Company's headquarters in Olympia, Washington.

Noninterest Expense Overview

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

Year Ended December 31,

2021 2020 Change % Change

(Dollars in thousands)

Compensation and employee benefits $ 89,880 $ 88,106 $ 1,774 2.0 %

Occupancy and equipment 17,243 17,611 (368) (2.1)

Data processing 16,533 14,449 2,084 14.4

Marketing 3,039 3,100 (61) (2.0)

Professional services 4,065 5,921 (1,856) (31.3)

State/municipal business and use tax 3,884 3,754 130 3.5

Federal deposit insurance premium 2,106 1,789 317 17.7

Other real estate owned, net — (145) 145 (100.0)

Year Ended December 31,

2021 2020 Change % Change

(Dollars in thousands)

Amortization of intangible assets 3,111 3,525 (414) (11.7)

Other expense 9,408 10,830 (1,422) (13.1)

Total noninterest expense $ 149,269 $ 148,940 $ 329 0.2 %

Noninterest expen se increased slightly due primari ly to an increase in data processing expense as the Bank continues to invest in technology.

Additionally, noninterest expense increased due to compensation and employee benefits primarily as a result of severance payments following a strategic reduction in force and an increase in accrual for incentive payments.

The increase in noninterest expense was offset partially by lower professional services expense due to costs incurred during the year ended December 31, 2020 related to the launch of the new mobile and online commercial banking platform "Heritage Direct" last year and secondarily due to t he decrease in ot her expense from lower branch consolidation costs recognized during the year ended December 31, 2021 compared to the same period in 2020.

Income Tax Expense Overview

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

Year Ended December 31,

2021 2020 Change % Change

(Dollars in thousands)

Income before income taxes $ 120,507 $ 53,180 $ 67,327 126.6 %

Income tax expense $ 22,472 $ 6,610 $ 15,862 240.0 %

Effective income tax rate 18.6 % 12.4 % 6.2 % 50.0 %

Inco me tax expense and the effective income tax rate both increased due primarily to higher pre-tax income , which decreased the impact of favorable permanent tax items such as tax-exempt investments, investments in bank owned life insurance and low-income housing tax credits, and secondarily due to a provision in the CARES Act, which permitted the Company to recognize a $1.0 million benefit from net operating losses related to prior acquisitions during the year ended December 31, 2020 .

Additionally, the Bank's New Market Tax Credit was fully utilized during the seven year period ending December 31, 2020 and the related entiti es were dissolved in May 2021.

In 2021, the Bank formed HBCDE, LLC which was certified as a Community Development Entity by the Department of the Treasury Community Development Financial Institutions Fund in September 2021.

The newly created entity is expected to commence funding eligible loans during the year ended December 31, 2022 and apply for New Market Tax Credits in future years.

Financial Condition Overview

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

December 31, 2021 December 31, 2020 Change % Change

2 unchanged sentences

Investment securities available for sale, at fair value, net 894,335 802,163 92,172 11.5

Investment securities held to maturity, at amortized cost, net 383,393 — 383,393 100.0

Loans held for sale 1,476 4,932 (3,456) (70.1)

Loans receivable, net 3,773,301 4,398,462 (625,161) (14.2)

Other real estate owned — 841 (841) (100.0)

Premises and equipment, net 79,370 85,452 (6,082) (7.1)

6 unchanged sentences

Total assets $ 7,432,412 $ 6,615,318 $ 817,094 12.4 %

December 31, 2021 December 31, 2020 Change % Change

(Dollars in thousands)

Liabilities and Stockholders' Equity

Deposits $ 6,381,337 $ 5,597,990 $ 783,347 14.0 %

3 unchanged sentences

Total liabilities 6,577,980 5,794,879 783,101 13.5

Stockholders' equity

Common stock 551,798 571,021 (19,223) (3.4)

3 unchanged sentences

Total liabilities and stockholders' equity $ 7,432,412 $ 6,615,318 $ 817,094 12.4 %

Total assets increased $1.06 billion, or 19.1%, to $6.62 billion as of December 31, 2020 compared to $5.55 billion as of December 31, 2019 due primarily to an increase in loans receivable, which is discussed in more detail below in the "Lending Activities Overview" section, and in cash and cash equivalents due primarily to an increase in total deposits, offset partially by a decrease in investment securities available for sale, which is discussed in more detail below in the "Investment Activities Overview" section.

Prepaid expenses and other assets increased $29.2 million, or 17.8%, to $193.3 million at December 31, 2020 from $164.1 million at December 31, 2019 primarily as a result of an increase in the fair value of interest rate swap contracts of $17.4 million and a new investment in a low income housing tax credit partnership of $10.2 million, both of which had a nearly corresponding increase in accrued expenses and other liabilities.

Accrued expenses and other liabilities increased $20.1 million, or 16.7%, to $140.3 million at December 31, 2020 compared to $120.2 million as of December 31, 2019 due to the changes described above for prepaid expenses and other assets, partially offset by a decrease related to capital contributions to low income housing tax credit partnerships of $7.1 million.

Total deposits increased $1.02 billion, or 22.2%, to $5.60 billion at December 31, 2020 from $4.58 billion at December 31, 2019 due primarily to increases in noninterest bearing demand deposits of $534.0 million, or 36.9%, to $1.98 billion, money market accounts of $209.3 million, or 27.8%, to $963.0 million, and interest bearing demand deposits of $367.3 million, or 27.2%, to $1.72 billion, offset partially by a decrease in certificate of deposit accounts of $125.0 million, or 23.8%, to $399.5 million.

The increase in total deposits was due primarily to proceeds from SBA PPP loans deposited directly into customer deposit accounts and an increase in customer deposits due to changes in customer spending habits due to the COVID-19 pandemic and an increase in new deposit accounts, offset partially by a decrease in a public depositor relationship of $95.7 million.

Non-maturity deposits as a percentage of total deposits increased to 92.9% as of December 31, 2020 from 88.6% at December 31, 2019.

Total assets increased due primarily to increases in cash and cash equivalents and total investment securities due primarily to the significant increase in total deposits, which is discussed in more detail in the "Deposit Activities Overview" section below.

The increase in total assets was offset partially by a decrease in loans receivable, net, which is discussed in more detail in the "Lending Activities Overview" section below.

Investment Activities Overview

Our investment policy is established by the Board of Directors and monitored by the Risk Committee of the Board of Directors.

Our investment policy is established by the Company's board of directors and monitored by the Risk Committee of the board of directors.

It is designed primarily to provide and maintain liquidity, generate a favorable return on investments without incurring undue interest rate and credit risk, and complements the Bank's lending activities.

The policy dictates the criteria for classifying securities as either available for sale or held to maturity.

The policy permits investment in various types of liquid assets permissible under applicable regulations, which include U.S.

Treasury obligations, U.S.

government agency obligations, some certificates of deposit of insured banks, mortgage-backed and mortgage-related securities, corporate notes, municipal bonds, and federal funds.

The policy permits investment in various types of liquid assets permissible under applicable regulations.

Investment in non-investment grade bonds and stripped mortgage-backed securities is not permitted under the policy.

Investment securities available for sale decreased $150.1 million, or 15.8%, to $802.2 million at December 31, 2020 from $952.3 million at December 31, 2019.

The decrease was due primarily to maturities, calls and payments of investment securities of $264.2 million and sales of investment securities of $55.0 million, offset partially by purchases of investment securities of $152.6 million.

In addition, we recorded net unrealized gains of $18.8 million due to a decrease in market interest rates during the year ended December 31, 2020 that positively impacted the fair value of our bond portfolio.

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

December 31, 2020 December 31, 2019 December 31, 2018

Fair Value % of

Investments Fair Value % of

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

December 31, 2021 December 31, 2020

Total Balance % of

Total Change % Change

(Dollars in thousands)

Investment securities available for sale, at fair value:

government and agency securities $ 21,373 1.7 % $ 45,660 5.7 % $ (24,287) (53.2) %

5 unchanged sentences

Total $ 894,335 70.0 % $ 802,163 100.0 % $ 92,172 11.5 %

The following table provides information regarding our investment securities available for sale, by contractual maturity, at December 31, 2020:

One Year or Less Over One to Five

Years Over Five to Ten

Years Over Ten Years Total

Value Yield (1)

Investment securities held to maturity, at amortized cost:

government and agency securities $ 141,011 11.0 % $ — — % $ 141,011 100.0 %

Residential CMO and MBS 24,529 1.9 % — — 24,529 100.0

Commercial CMO and MBS 217,853 17.1 % — — 217,853 100.0

Total $ 383,393 30.0 % $ — — % $ 383,393 100.0 %

Total investment securities $ 1,277,728 100.0 % $ 802,163 100.0 % $ 475,565 59.3 %

Total investment securities increased due primarily to purchases of $756.4 million, offset partially by maturities, calls and payments of investment securities of $255.9 million.

Additionally, we transferred $244.8 million of investment securities available for sale to investment securities held to maturity in order to mitigate market price volatility and its impact to AOCI within stockholders' equity.

The following table provides the weighted average yield at December 31, 2021 calculated based upon the fair values of our investment securities available for sale and held to maturity and excluding any income tax benefits of tax-exempt bonds:

In one year or less After one year through five years After five years through ten years After ten years Total

Value Yield Fair

(Dollars in thousands)

Investment securities available for sale:

government and agency securities $ — — % $ 1,493 3.01 % $ 11,682 2.07 % $ 8,198 2.32 % $ 21,373 2.23 %

5 unchanged sentences

Total $ 27,120 2.42 % $ 122,354 2.56 % $ 287,779 1.82 % $ 457,082 1.93 % $ 894,335 1.99 %

(1) Taxable equivalent weighted average yield.

Lending Activities Overview

The Bank is a full-service commercial bank, which originates a wide variety of loans with a focus on commercial business loans.

Loans receivable increased $700.8 million, or 18.6%, to $4.47 billion at December 31, 2020 from $3.77 billion at December 31, 2019 due primarily to SBA PPP loans of $715.1 million outstanding at December 31, 2020, following principal and interest forgiveness payments from the SBA of $159.2 million during the year ended December 31, 2020.

Loans receivable also increased due to increases in non-owner occupied CRE loans of $121.5 million, owner-occupied CRE loans of $51.5 million and real estate construction and land development loans of $31.1 million, offset partially by decreases in commercial and industrial

loans of $119.1 million and consumer loans of $90.4 million.

The decrease in commercial and industrial loans was due primarily to a decrease in the utilization rate of commercial and industrial lines of credit to 24.9% at December 31, 2020 from 34.5% at December 31, 2019.

The decrease in consumer loans was primarily due to the cessation of indirect auto loan originations in March 2020.

Investment securities held to maturity:

government and agency securities $ — — % $ — — % $ 68,014 1.95 % $ 71,349 1.67 % $ 139,363 1.81 %

Residential CMO and MBS — — — — — — 24,376 1.74 24,376 1.74

Commercial CMO and MBS — — — — 181,393 1.50 31,199 1.62 212,592 1.52

Total $ — — % $ — — % $ 249,407 1.62 % $ 126,924 1.67 % $ 376,331 1.64 %

Loan Portfolio Overview

Changes by loan type

The Bank originates a wide variety of loans with a focus on commercial business loans.

The following table provides information about our loan portfolio by type of loan at the dates indicated:

2020 2019 2018 2017 2016

Amortized Cost (1)

% of Total (2)

Amortized Cost (1)

% of Total (2)

Amortized Cost (1)

% of Total (2)

Amortized Cost (1)

% of Total (2)

Amortized Cost (1)

% of Total (2)

December 31, 2021 December 31, 2020

Amortized Cost % of Loans Receivable Amortized Cost % of Loans Receivable Change % Change

(Dollars in thousands)

13 unchanged sentences

Total $ 3,815,662 100.0 % $ 4,468,647 100.0 % $ (652,985) (14.6) %

(1) Balances do not include unfunded loan commitments.

(2) Percent of loans receivable.

(3) Excludes loans held for sale o f $4.9 million, $5.5 million, $1.6 million, $2.3 million, and $11.7 million as of December 31, 2020, 2019, 2018, 2017 and 2016, respectively.

Included in the amortized cost of loans are net discounts on loans purchased in mergers and acquisitions.

Upon CECL Adoption, the Bank increased the net discount for PCD loans by $1.6 million related to the PCI to PCD transition.

The remaining total net discount for purchased loans, including PCD loans and non-PCD loans, was $6.6 million at December 31, 2020 compared to $8.4 million at December 31, 2019.

The following table presents the amortized cost of the loan portfolio by segment and the aggregate amount of fixed rate and variable or adjustable rate loans in our portfolio at December 31, 2020 for the following categories of contractual maturities:

One Year or Less Over One to Five Years Over Five Years Total

Loans receivable decreased due primarily to a decrease in SBA PPP loans as a result of forgiveness payments received from the SBA in excess of SBA PPP originations and elevated prepayments of commercial and industrial loans.

Additionally, the consumer loan portfolio decreased due partially to continued runoff of the indirect auto loan portfolio following the cessation of this business line during the three months ended March 31, 2020.

Offsetting these decreases was an increase in CRE loans which includes the transfer of several completed projects from real estate construction and land development loans.

SBA Paycheck Protection Program

The Bank has supported its community and customers during the COVID-19 Pandemic through its participation in the SBA's PPP.

The SBA PPP ended on May 31, 2021.

The Bank earns 1% interest on these loans as well as a fee from the SBA to cover processing costs, which is amortized over the life of the loan and recognized fully at payoff or forgiveness.

The Bank began processing loan forgiveness applications and receiving SBA PPP forgiveness payments during the three months ended December 31, 2020.

Composition of loans receivable by contractual maturity and interest type

The following table presents the amortized cost of the loan portfolio by segment and contractual maturity at December 31, 2021:

In one year or less After one year through five years After five years through 15 years After 15 years Total

(In thousands)

Commercial business:

Commercial and industrial $ 142,248 $ 227,589 $ 244,025 $ 7,705 $ 621,567

SBA PPP 5,921 139,919 — — 145,840

Owner-occupied CRE 21,919 190,612 674,344 44,275 931,150

Non-owner occupied CRE 78,879 398,844 981,290 34,086 1,493,099

Total commercial business 248,967 956,964 1,899,659 86,066 3,191,656

Residential real estate

— 1,045 29,067 134,470 164,582

Real estate construction and land development:

Residential 65,861 2,563 8,936 8,187 85,547

Commercial and multifamily 58,009 12,563 59,099 11,665 141,336

Total real estate construction and land development 123,870 15,126 68,035 19,852 226,883

Consumer 11,953 94,359 29,972 96,257 232,541

Loans receivable $ 420,441 $ 1,612,861 $ 2,435,345 $ 4,468,647

Fixed rate loans $ 137,825 $ 1,316,578 $ 980,384 $ 2,434,787

Variable or adjustable rate loans (1)

Total $ 384,790 $ 1,067,494 $ 2,026,733 $ 336,645 $ 3,815,662

The following table presents the amortized cost of the loan portfolio by segment and interest rate type that are due after one year at December 31, 2021:

Have predetermined interest rates (1)

Have floating or adjustable interest rates (1)

(In thousands)

Commercial business:

Commercial and industrial $ 317,892 $ 161,427 $ 479,319

SBA PPP 139,919 — 139,919

Owner-occupied CRE 453,836 455,395 909,231

Non-owner occupied CRE 589,292 824,928 1,414,220

Total commercial business 1,500,939 1,441,750 2,942,689

Residential real estate (3)

119,966 44,616 164,582

Loans receivable $ 420,441 $ 1,612,861 $ 2,435,345 $ 4,468,647

(1) Includes certain commercial loans in which the Bank entered into non-hedge interest rate swap contracts with the borrower and a third-party.

Real estate construction and land development:

Residential 8,181 11,505 19,686

Commercial and multifamily 39,457 43,870 83,327

Total real estate construction and land development 47,638 55,375 103,013

Consumer 118,471 102,117 220,588

Total $ 1,787,014 $ 1,643,858 $ 3,430,872

(1) Includes $2.2 million of real estate construction and land development loans with predetermined interest rates and $329.2 million of commercial business loans with floating or adjustable interest rates in which the Bank entered into non-hedge interest rate swap contracts with the borrower and a third-party.

Under these derivative contract arrangements, the Bank effectively earns a variable rate of interest based on the one-month LIBOR plus a margin, except for interest rate swap contracts on construction loans that earn fixed rates until the end of the construction period and the variable rate swap becomes effective.

At December 31, 2020, the Bank had 84 separate interest rate swap contracts with borrowers with a total notional value (which approximates amortized cost) of $308.1 million compared to 60 separate interest rate swap contracts with borrowers with notional value of $221.4 million at December 31, 2019.

All but nine interest rate swap contracts with borrowers with a total notional value of $31.1 million at December 31, 2020 have a maturity of over five years.

Nonperforming Assets and Credit Quality Metrics

The following table provides information about our nonaccrual loans, other real estate owned and performing TDR loans for the dates indicated:

2020 2019 2018 2017 2016

Loans classified as nonaccrual and performing TDR and nonperforming assets

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

2021 December 31, 2020 Change % Change

(Dollars in thousands)

2 unchanged sentences

Residential real estate

47 184 (137) (74.5)

Real estate construction and land development 571 1,022 (451) (44.1)

1 unchanged sentence

Total nonaccrual loans 23,754 58,092 (34,338) (59.1)

58,092 44,525 13,696 10,688 10,909

Other real estate owned — 841 1,983 — 754

Other real estate owned — — — n/a

Total nonperforming assets 23,754 58,092 (34,338) (59.1) %

ACL on loans $ 70,185 $ 36,171 $ 35,042 $ 32,086 $ 31,083

Nonperforming loans to loans receivable 1.30 % 1.18 % 0.37 % 0.38 % 0.41 %

ACL on loans to loans receivable 1.57 0.96 0.96 1.13 1.18

ACL on loans to loans receivable, excluding SBA PPP loans (2)

1.87 0.96 0.96 1.13 1.18

ACL on loans to nonperforming loans 120.82 81.24 255.86 300.21 284.93

Nonperforming assets to total assets 0.88 % 0.82 % 0.29 % 0.26 % 0.30 %

Accruing loans past due 90 days or more $ 293 $ — $ 293 100.0 %

Credit quality ratios:

Nonaccrual loans to loans receivable 0.62 % 1.30 % (0.68) % (52.3) %

Nonaccrual loans to total assets 0.32 0.88 (0.56) (63.6)

Performing TDR loans:

4 unchanged sentences

Total performing TDR loans $ 59,110 $ 52,872 $ 6,238 11.8 %

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

Potential problem loans (3)

$ 182,342 $ 87,788 $ 101,320 $ 83,558 $ 87,762

(1) At December 31, 2020, 2019, 2018, 2017 and 2016 , $43.1 million, $26.3 million, $6.9 million, $5.2 million and $6.9 million of nonaccrual loans were considered nonperforming TDR loans, respectively, with a related ACL on loans of $6.3 million, $218,000, $658,000, $379,000, and $437,000, respectively.

(2) See the "Reconciliations of Non-GAAP Measures" section below.

(3) Potential problem loans are risk rated "Special Mention" or worse that are not classified as a performing TDR or nonaccrual loan and are not individually evaluated for credit loss, but which management is closely monitoring because the financial information of the borrower causes concern as to their ability to meet their loan repayment terms.

Nona ccrual Loans .

Nonaccrual loans increased $13.6 million to $58.1 million, or 1.30% of loans receivable at December 31, 2020, from $44.5 million, or 1.18% of loans receivable at December 31, 2019.

The increase was due primarily to the addition of $23.4 million of loans that were previously COVID Modifications and which exhibited a continued decline in credit

quality, warranting transfer to nonaccrua l status.

Within these additions were six commercial business lending relationships totaling $23.2 million, including loans in industries heavily impacted by the COVID-19 pandemic such as hospitality, entertainment and leisure facilities.

The Bank is actively working with the borrowers to secure a positive resolution.

These additions to nonaccrual loans were offset partially by principal payments which included full payoffs of $11.0 million, including a significant agricultural lending relationship of $6.8 million.

The ratio of ACL on loans to nonperforming loans inc reased to 120.82% a t December 31, 2020 compared to 81.24% at December 31, 2019 due primarily to an increase in the ACL on loans.

The following table reflects the changes in nonaccrual loans during the periods indicated:

(1) At December 31, 2021 and December 31, 2020, $1.4 million and $3.2 million of nonaccrual loans, respectively, and $1.6 million and $1.9 million of performing TDR loans, respectively, were guaranteed by government agencies.

The following table provides the changes in nonaccrual loans during the periods indicated:

Year Ended December 31,

2021 2020 Change % Change

(In thousands)

Nonaccrual loans

Balance, beginning of period $ 58,092 $ 44,525 $ 13,567 30.5 %

Addition of previously classified pass graded loans 19,430 4,620

Addition of previously classified potential problem loans 8,993 23,032

Addition of previously classified performing TDR loans 4,601 11,734

Net principal payments (17,215) (6,609)

Additions to nonaccrual loan classification 1,495 33,024 (31,529) (95.5)

Net principal payments and transfers to accruing status (14,786) (6,463) (8,323) 128.8

Payoffs (19,857) (11,033) (8,824) 80.0

Charge-offs (1,190) (1,691) 501 (29.6)

Transfer to accruing status (281) —

Transfer to OREO — (270) 270 (100.0)

Balance, end of period $ 23,754 $ 58,092 $ (34,338) (59.1) %

At December 31, 2020, nonaccrual loans of $27.3 million had a related ACL on loans of $6.7 million and nonaccrual loans of $30.8 million had no related ACL on loans.

At December 31, 2019 nonaccrual loans of $4.4 million had a related ACL of $763,000 and nonaccrual loans of $40.1 million had no ACL.

Nonp erforming Assets .

Nonperforming assets consist of nonaccrual loans and other real estate owned.

Nonperforming assets increased $12.7 million to $58.1 million, or 0.88% of total assets, at December 31, 2020 from $45.4 million, or 0.82% of total assets, at December 31, 2019 due primarily to the increase in n onaccrual loans discussed above partially offset by a decrease in other real estate owned resulting from the disposition of the two remaining properties during the year ended December 31, 2020.

Troubled Debt Restructured Loans .

Performing TDR loans are TDRs on accrual status which are collectively evaluated for ACL based on criteria outlined in our accounting policies.

Performing TDR loans are not considered nonperforming assets as they continue to accrue interest despite the restructured status.

Pe rforming TDR loans increased $38.4 million, or 265.4%, to $52.9 million at December 31, 2020 from $14.5 million at December 31, 2019.

The increase w as due to the addition of $39.0 million of loans with COVID Modifications that were subsequently modified to extend beyond the COVID Modification's 180-days payment deferment period in accordance with Bank policy for COVID Modifications.

The increase in performing TDR loans was offset partially by one predominately commercial and industrial loan relationship totaling $4.2 million which transferred to nonaccrual status as the loan continued to show credit deterioration.

Included in the net principal payments of performing TDR loans was loans paid in full of $3.7 million.

The following table reflects the changes in performing TDR loans during the periods indicated:

Year Ended December 31,

(In thousands)

Performing TDR loans

Balance, beginning of period $ 14,469 $ 22,744

Addition of previously classified pass graded loans 6,967 6,846

Addition of previously classified potential problem loans 40,860 9,424

Loans added formerly nonaccrual loans 281 —

Transfers of loans to nonaccrual status (4,601) (11,734)

Charge-offs — (220)

Net principal payments (5,104) (12,591)

Balance, end of period $ 52,872 $ 14,469

The related ACL on loans for performing TDR loans was $1.3 million as of both December 31, 2020 and December 31, 2019.

Potential Problem Loans .

Potential problem loans are loans risk rated special mention or worse that are not classified as a TDR or nonaccrual loan and are not individually evaluated for credit loss, but which management is closely monitoring because the financial information of the borrower causes concern as to their ability to meet their loan repayment terms.

Potential problem loans increased $94.6 million, or 107.7%, to $182.3 million at December 31, 2020 from $87.8 million at December 31, 2019.

The increase was primarily attributed to risk downgrades related to borrowers experiencing COVID-19 related issues.

Included in the balance of potential problem loans at December 31, 2020 are COVID Modifications of $86.8 million and loans that were downgraded due to COVID-19 issues with no loan modification of $52.1 million.

At December 31, 2020, potential problem loans totaling $149.9 million and $32.4 million were rated special mention and substandard, respectively.

The increase in potential problem loans for the year ended December 31, 2020 was offset partially by net principal payments of $37.8 million, including payments in full of $23.8 million, and transfers of loans to nonaccrual and TDR status of $49.9 million due primarily to loans that showed additional credit deterioration due to the COVID-19 pandemic or which were modified beyond the Bank's 180-day deferral policy and transferred to TDR status.

The following table reflects the changes in potential problem loans during the periods indicated:

Year Ended December 31,

(In thousands)

Potential problem loans

Balance, beginning of period $ 87,788 $ 101,320

Addition of previously classified pass graded loans 194,589 69,775

Net principal payments (37,847) (33,158)

Upgrades to pass graded loan status (12,335) (17,183)

Transfers of loans to nonaccrual and TDR status (49,853) (32,456)

Charge-offs — (510)

Balance, end of period $ 182,342 $ 87,788

Analysis of Allowance for Credit Losses on Loans

Effective January 1, 2020, the Bank adopted ASU 2016-13.

The adoption replaced the ALL with the ACL on loans on the Consolidated Statements of Financial Condition and replaced the related provision for loan losses with the provision for credit losses on loans on the Consolidated Statements of Income.

Management adopted a historic loss, open pool CECL methodology to calculate the ACL on loans.

The same methodology is applied to all loans consistent with the guidance of the accounting standard which does not require undue complexity.

Under this allowance approach, the Company has identified segments of loans with similar risk characteristics that align with its identified loan classes.

Nonaccrual loans are not considered to have similar risk characteristics as other loans;

therefore, they are evaluated for credit loss on an individual basis.

For each loan segment collectively measured, baseline loss rates are separately calculated using the Bank's average quarterly historical loss information.

The baseline loss rates are applied to each loan's estimated cash flows over the life of the loan under the remaining life method, including prepayment estimates, to determine the baseline loss estimate for each loan.

The CECL methodology also includes consideration of the forecasted direction of the economic and business environment and its likely impact to the estimated allowance as compared to the historical losses over the reasonable and supportable time frame.

The impact of those macroeconomic factors to each segment, positive or negative, using the reasonable and supportable period, are added to the calculated baseline loss rate and are used to establish a macroeconomic allowance.

After the reasonable and supportable period, the estimated credit losses revert back to historical baseline loss levels under a reversion period on a straight-lined, input reversion basis.

Management can also consider other qualitative factors to adjust the ACL on loans if internal or external conditions suggest changes to the modeled ACL on loans are appropriate.

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

The decrease in nonaccrual loans during the year ended December 31, 2021 was due primarily to payoffs, including a payoff of an agricultural business relationship of $10.7 million, which was initially classified as nonaccrual during the three months ended September 30, 2019, and the return to accrual status of an owner-occupied CRE relationship of $7.0 million.

The Bank recovered $1.5 million of interest and fees on loans related to the payoff of the agricultural business relationship.

Additionally, the volume of additions to the nonaccrual loan classification decreased to $1.5 million during the year ended December 31, 2021 compared to $33.0 million last year which contributed to the lower ending balance of loans classified as nonaccrual.

The decrease in nonaccrual loans improved the Bank's credit quality ratios.

Allowance for Credit Losses on Loans Overview

The following table provides information regarding changes in our ACL on loans for the years indicated:

At or For the Years Ended December 31,

2020 2019 2018 2017 2016

2021 2020 Change % Change

(Dollars in thousands)

3 unchanged sentences

Commercial business (1,276) (3,751) 2,475 (66.0)

Residential real estate — (60) (45) (30) —

Real estate construction and land development (1) (417) 416 (99.8)

9 unchanged sentences

ACL on loans at the end of period $ 42,361 $ 70,185 $ (27,824) (39.6) %

Credit quality ratios:

ACL on loans to loans receivable 1.11 % 1.57 % (0.46) % (29.3) %

1 unchanged sentence

1.15 1.87 (0.72) (38.5)

Net charge-offs on loans to average loans receivable, net 0.07 % 0.09 % 0.06 % 0.12 % 0.14 %

Loans receivable at the end of the period (2)

$ 4,468,647 $ 3,767,879 $ 3,654,160 $ 2,849,071 $ 2,638,397

Average loans receivable, net during the period 4,335,564 3,668,665 3,414,424 2,703,934 2,489,730

ACL on loans to nonaccrual loans 178.33 % 120.82 % 57.51 % 47.6 %

Average balances outstanding during the period:

Commercial business $ 3,540,728 $ 3,569,851 $ (29,123) (0.8) %

Residential real estate 123,875 131,171 (7,296) (5.6)

Real estate construction and land development 301,532 303,591 (2,059) (0.7)

Consumer 271,834 384,134 (112,300) (29.2)

Total $ 4,237,969 $ 4,388,747 $ (150,778) (3.4) %

Net charge-offs (recoveries) during the period to average balances outstanding during the period:

Commercial business 0.01 % 0.06 % (0.05) % (83.3) %

Residential real estate — — — n/a

Real estate construction and land development (0.01) 0.05 (0.06) (120.0)

Consumer 0.04 0.23 (0.19) (82.6)

Total 0.01 % 0.07 % (0.06) % (85.7) %

(1) The ACL on loans does not include a reserve for SBA PPP loans as these loans are fully guaranteed by the SBA.

See "Reconciliations of Non-GAAP Measures" section below.

(2) Excludes loans held for sale.

The following table shows the ACL on loans by segment at the indicated dates:

2020 2019 2018 2017 2016

ACL on loans % of

(2) Average balances exclude the ACL on loans and loans held for sale, but include loans classified as nonaccrual.

The ACL on loans decreased due primarily to a reversal of prov ision for credit losses on loans recorded during the year ended December 31, 2021 following improvements in the economic forecast used in the CECL model at December 31, 2021 as compared to the economic forecast at December 31, 2020 .

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

December 31, 2021 December 31, 2020

ACL on loans Percent of

Change % Change

(Dollars in thousands)

1 unchanged sentence

Residential real estate 1,409 4.3 1,591 2.7 (182) (11.4)

Real estate construction 13,092 6.9 3,060 7.3 2,194 5.9 2,052 5.2 2,156 6.0

Real estate construction and land development 5,276 5.9 13,092 6.9 (7,816) (59.7)

Consumer 2,627 6.1 5,894 7.3 (3,267) (55.4)

Unallocated — — 899 — 1,353 — 898 — 506 —

Total ACL on loans $ 42,361 100.0 % $ 70,185 100.0 % $ (27,824) (39.6) %

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

The ACL on loans increased $34.0 million, or 94.0%, to $70.2 million at December 31, 2020 from $36.2 million at December 31, 2019, and increased $32.2 million, or 84.7%, from the adjusted beginning balance of $38.0 million.

The increase in the ACL on loans was primarily the result of the provision for credit losses on loans of $35.4 million during the year ended December 31, 2020 due primarily to forecasted credit deterioration reflecting economic conditions as a result of the COVID-19 pandemic .

The macroeconomic forecast used in the CECL model as of January 1, 2020 predicted continued economic expansion with steady GDP growth of 1.8% and low unemployment rate averages of 3.5% in 2020, among other factors.

The onset of the COVID-19 pandemic resulted in the identification of an economic recession during the second quarter of 2020 as evidenced by certain economic forecasts signaling prolonged, profound, and pervasive contraction in economic activities due to the COVID-19 pandemic.

The GDP contracted 3.4% during the year ended December 31, 2020 and unemployment rates averaged 8.1%.

The macroeconomic forecast used in the CECL model as of December 31, 2020 reflected a slow recovery from the COVID-19 recession modeled to last through the end of 2021, including an anticipated GDP growth of 4.3% for 2021 and GDP growth slightly above 2.0% thereafter.

The unemployment rate is anticipated to remain above 6.0% during 2021 and steadily decrease to a stabilized 4.0% in 2025.

The macroeconomic forecast as of December 31, 2020 considered the COVID-19 vaccine progress as well as anticipated government stimulus plans;

however, uncertainty remained over the time necessary to return the economy to pre-pandemic levels.

The Bank recog nized net charge-offs of $3.2 million during the year ended December 31, 2020 primarily due to a commercial and industrial charge-off of $1.7 million related to issues surrounding control of the underlying loan collateral.

The Bank determined it appropriate to charge-off this entire loan relationship balance and pursue an aggressive collection strategy.

Net charge-offs also included two commercial and industrial loan relationships totaling $447,000 as a result of impacts from the COVID-19 pandemic, a partial charge-off of one commercial and multifamily real estate construction and land development loan totaling $417,000 as a result of cost overruns and delays in constructio n and small dollar net charge-offs on a large volume of consumer loans of $884,000.

Net charge-offs were offset partially by the full recovery of a commercial and industrial agricultural lending relationship of $963,000 during the year ended December 31, 2020, which was charged-off during the year ended December 31, 2019.

Based on the Bank's established comprehensive CECL methodology, management deemed the ACL on loans of $70.2 million at December 31, 2020 (1.57% of loans receivable and 120.82% of nonperforming loans) appropriate to provide for current expected credit losses in the loan portfolio.

This compares to an ALL of $36.2 million (0.96% of loans receivable and 81.24% of nonperforming loans) at December 31, 2019 under the probable incurred loss methodology.

While we believe we used the best information available to determine the ACL on loans, our results of operations could be significantly affected if circumstances differ substantially from the assumptions used in determining the allowance.

A further decline in national and local economic conditions, as a result of the COVID-19 pandemic or other factors, could result in a material increase in the ACL on loans and may adversely affect the Company’s financial condition and results of operations.

In addition, the determination of the amount of the ACL on loans is subject to review by bank regulators, as part of their routine examination process, which may result in the establishment of an additional ACL on loans based upon their judgment of information available to them at the time of their examination.

Because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing ACL on loans is appropriate or that increased provisions will not be necessary should the quality of the loans deteriorate.

Any material increase in the ACL on loans could adversely affect the Company’s financial condition and results of operations.

Deposits and Other Borrowings Overview

Total deposits increased $1.02 billion, or 22.2%, to $5.60 billion at December 31, 2020 from $4.58 billion at December 31, 2019 due primarily to proceeds from SBA PPP loans deposited directly into the customers' deposit accounts, an increase in customer deposit accounts based on changes in spending habits during the COVID-19 pandemic, and an increase in new deposit accounts.

At December 31, 2020, the Bank had approximately 473 deposit accounts with balances of approximately $80.5 million related to new customers that received a SBA PPP loan from the Bank.

The increase in total deposits included an increase in noninterest bearing demand deposits of $534.0 million, or 36.9%, to $1.98 billion at December 31, 2020 from $1.45 billion at December 31, 2019, in interest bearing demand deposits of $367.3 million, or 27.2%, to $1.72 billion at December 31, 2020 from $1.35 billion at December 31, 2019 and in money market accounts of $209.3 million, or 27.8%, to $963.0 million at December 31, 2020 from $753.7 million at December 31, 2019.

These increases were offset partially by a decrease in certificates of deposit accounts of $125.0 million, or 23.8%, to $399.5 million at December 31, 2020 from $524.6 million at December 31, 2019.

Non-maturity deposits as a percentage of total deposits increased to 92.9% at December 31, 2020 from 88.6% at December 31, 2019 and the percentage of certificates of deposit to total deposits decreased to 7.1% at December 31, 2020 from 11.4% at December 31, 2019 due primarily to promotional certificates of deposit balances maturing during the year ended December 31, 2020.

Deposits Overview

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

December 31, 2020 December 31, 2019 December 31, 2018

Balance Percent of Total Balance Percent of Total Balance Percent of Total

December 31, 2021 December 31, 2020

Balance Percent of Total Balance Percent of Total Change % Change

(Dollars in thousands)

6 unchanged sentences

Total deposits $ 6,381,337 100.0 % $ 5,597,990 100.0 % $ 783,347 14.0 %

The following table provides the average balances outstanding and the weighted average interest rates for each major category of deposits for the periods indicated:

Year Ended December 31,

2020 2019 2018

Balance Average

Yield/Rate Average

Balance Average

Yield/Rate Average

Balance Average

(Dollars in thousands)

Interest bearing demand deposits and money market accounts $ 2,491,477 0.24 % $ 2,052,573 0.33 % $ 1,916,319 0.23 %

Savings accounts 489,471 0.11 506,073 0.52 513,680 0.40

Certificates of deposit 482,316 1.18 512,732 1.37 463,124 0.85

Total interest bearing deposits 3,463,264 0.35 3,071,378 0.53 2,893,123 0.36

Noninterest demand deposits 1,835,165 — 1,389,721 — 1,240,621 —

Total deposits $ 5,298,429 0.23 % $ 4,461,099 0.37 % $ 4,133,744 0.25 %

The following table shows the amount and maturity of certificate of deposit accounts of $100,000 or more:

December 31, 2020

Total deposits increased due primarily to proceeds from SBA PPP loans originated during the year ended December 31, 2021 which were deposited directly into the customers' deposit accounts.

Total deposits includes uninsured deposits of $2.68 billion and $2.17 billion at December 31, 2021 and 2020, respectively, calculated in accordance with FDIC guidelines.

The Bank does not hold any foreign deposits.

The following table provides the uninsured portion of certificates of deposit at December 31, 2021, by account, with a maturity of:

(In thousands)

Remaining maturity:

Three months or less $ 10,264

3 unchanged sentences

Total $ 51,531

Borrowings may be used on a short-term basis to compensate for reductions in other sources of funds (such as deposit inflows at less than projected levels).

Borrowings may also be used on a longer-term basis to support expanded lending activities and match the maturity of repricing intervals of assets.

The Bank also utilizes securities sold under agreement to repurchase as a supplement to its funding sources, which are secured by available for sale investment securities.

As of December 31, 2020 and December 31, 2019, only three customers utilized this product with total balances of $35.7 million at December 31, 2020, an increase of $15.5 million, or 76.9%, from $20.2 million at December 31, 2019 due primarily to customer activity during the period.

The Company also has junior subordinated debentures with a par value of $25.0 million which pay quarterly interest based on three-month LIBOR plus 1.56%.

The debentures mature in 2037.

The balance of the junior subordinated debentures was $20.9 million at December 31, 2020, which reflects the fair value of the junior subordinated debentures established as part of the merger with Washington Banking Company on May 1, 2014, adjusted for the accretion of discount from purchase accounting fair value adjustment.

At December 31, 2020, the Bank maintained credit facilities with the FHLB for $991.7 million and credit facilities with the Federal Reserve Bank for $54.3 million.

The Company had no FHLB or Federal Reserve Bank advances outstanding at both the years ended December 31, 2020 and 2019.

The average balance of FHLB advances and other borrowings was $1.5 million and $11.9 million during the years ended December 31, 2020 and 2019, respectively.

The Bank also maintains lines of credit with five correspondent banks to purchase federal funds totaling $215.0 million as of December 31, 2020.

There were no federal funds purchased as of December 31, 2020 or December 31, 2019 and the lines were not utilized during the years ended December 31, 2020 and 2019.

The Bank was approved to utilize the PPPLF during the year ended December 31, 2020;

however, the Bank chose not to participate.

Stockholders' Equity and Regulatory Capital Requirements Overview

Stockholders’ equity was $820.4 million at December 31, 2020 compared to $809.3 million at December 31, 2019.

Stockholders' Equity Overview

The Company’s stockholders' equity to assets ratio was 11.5% as of December 31, 2021 and 12.4% as of December 31, 2020.

The following table reflects the changes to stockholders' equity during the periods indicated:

The following table provides the changes to stockholders' equity during the periods indicated:

Year Ended December 31,

2021 2020 Change % Change

(In thousands)

4 unchanged sentences

Dividends declared (29,197) (29,029) (168) 0.6

Year Ended December 31,

2021 2020 Change % Change

(In thousands)

Other comprehensive income, net of tax (15,622) 14,640 (30,262) (206.7)

2 unchanged sentences

Balance, end of period $ 854,432 $ 820,439 $ 33,993 4.1 %

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

Effective January 1, 2019, the Company adopted ASU 2016-02, Leases .

During the year ended December 31, 2020, the Company repurchased the remaining 639,922 shares available under the eleventh stock repurchase plan at a weighted average price per share of $23.95 and repurchased 155,778 shares at a weighted average share price of $20.34 under the twelfth stock repurchase plan, which is a total of 795,700 shares under both plans at a weighted average share price of $23.25.

During the year ended December 31, 2019, the Company repurchased 292,712 shares available under the eleventh stock repurchase plan at a weighted average price per share of $26.50.

No shares were repurchased under the eleventh stock repurchase plan during the year ended December 31, 2018.

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

The Company repurchased 904,972 and 795,700 shares of its common stock under the Company's stock repurchase plans during the year ended December 31, 2021 and 2020, respectively.

The repurchases represented approximately 2.5% and 2.2% of the Company's stock outstanding at the beginning of each year.

The Company has historically paid cash dividends to its common shareholders.

2 unchanged sentences

On January 26, 2022, the Company’s board of directors declared a regular quarterly dividend of $0.21 per common share payable on February 23, 2022 to shareholders of record on February 9, 2022.

Year Ended December 31,

2020 2019 2018

Dividends paid per common share $ 0.80 $ 0.84 $ 0.72

Dividend payout ratio (1)

62.0 % 45.9 % 48.3 %

(1) Dividend payout ratio is declared dividends per common share divided by diluted earnings per common share.

The Company is a bank holding company under the supervision of the Federal Reserve Bank.

Bank holding companies are subject to capital adequacy requirements of the Federal Reserve under the Bank Holding Company Act of 1956, as amended, and the regulations of the Federal Reserve.

Heritage Bank is a federally insured institution and thereby is subject to the capital requirements established by the FDIC.

The Federal Reserve capital requirements generally parallel the FDIC requirements.

Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Consolidated Financial Statements.

Management believes that as of December 31, 2020, the Company and the Bank meet all capital adequacy requirements to which they are subject.

For additional information regarding the Company’s and the Bank’s regulatory capital requirements, see “Supervision and Regulation-Capital Adequacy” in Item 1.

Business and Note (22) Regulatory Capital Requirements included in Item 8.

Financial Statements And Supplementary Data.

Off-Balance Sheet Arrangements

In the ordinary course of business, we enter into various types of transactions that include commitments to extend credit that are not included in our Consolidated Financial Statements.

We apply the same credit standards to these commitments as we use in all our lending activities and have included these commitments in our lending risk evaluations.

Our exposure to credit loss under commitments to extend credit is represented by the amount of these commitments.

The Company had off-balance sheet loan commitments, including letters of credit, of $1.11 billion at December 31, 2020, a decrease of $106.9 million, or 8.8%, from $1.21 billion at December 31, 2019.

For additional information, see Note (15) Commitments and Contingencies included in Item 8.

Financial Statements And Supplementary Data.

Average Balances, Yields and Rates Paid for the Years Ended December 31, 2020, 2019 and 2018

Our core profitability depends primarily on our net interest income, which is the difference between the income we receive on our loan and investment portfolios, and our interest expense, which consists of interest paid on deposits and borrowed funds.

Like most financial institutions, our interest income and interest expense are affected significantly by general economic conditions, particularly changes in market interest rates and government policies.

Changes in net interest income result from changes in volume, net interest spread, and net interest margin.

Volume refers to the average dollar amounts of interest earning assets and interest bearing liabilities.

Net interest spread refers to the difference between the average yield on interest earning assets and the average cost of interest bearing liabilities.

Net interest margin refers to net interest income divided by average interest earning assets and is influenced by the level and relative mix of interest earning assets and interest bearing and noninterest bearing liabilities.

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

Year Ended December 31,

2020 2019 2018

Balance Interest

(Dollars in thousands)

Interest Earning Assets:

Loans receivable, net (1) (2)

$ 4,335,564 $ 192,417 4.44 % $ 3,668,665 $ 189,515 5.17 % $ 3,414,424 $ 175,466 5.14 %

Taxable securities 731,378 17,541 2.40 827,822 23,045 2.78 677,893 17,602 2.60

Nontaxable securities (2)

152,447 3,659 2.40 135,245 3,396 2.51 190,209 4,649 2.44

Interest earning deposits 315,847 703 0.22 98,153 1,894 1.93 76,117 1,689 2.22

Total interest earning assets 5,535,236 214,320 3.87 % 4,729,885 217,850 4.61 % 4,358,643 199,406 4.57 %

Noninterest earning assets 758,386 681,193 615,372

Total assets $ 6,293,622 $ 5,411,078 $ 4,974,015

Year Ended December 31,

2020 2019 2018

Balance Interest

(Dollars in thousands)

Interest Bearing Liabilities:

Certificates of Deposit $ 482,316 $ 5,675 1.18 % $ 512,732 $ 7,021 1.37 % $ 463,124 $ 3,959 0.85 %

Savings accounts 489,471 526 0.11 506,073 2,633 0.52 513,680 2,056 0.40

Interest bearing demand and money market accounts 2,491,477 6,064 0.24 2,052,573 6,695 0.33 1,916,319 4,382 0.23

Total interest bearing deposits 3,463,264 12,265 0.35 3,071,378 16,349 0.53 2,893,123 10,397 0.36

Junior subordinated debentures 20,730 890 4.29 20,438 1,339 6.55 20,145 1,263 6.27

Securities sold under agreement to repurchase 27,805 160 0.58 28,457 175 0.61 31,426 82 0.26

FHLB advances and other borrowings 1,466 8 0.55 11,899 305 2.56 33,914 671 1.98

Total interest bearing liabilities 3,513,265 13,323 0.38 % 3,132,172 18,168 0.58 % 2,978,608 12,413 0.42 %

Noninterest bearing demand deposits 1,835,165 1,389,721 1,240,621

Other noninterest bearing liabilities 139,612 99,683 67,692

Stockholders’ equity 805,580 789,502 687,094

Total liabilities and stock-holders’ equity $ 6,293,622 $ 5,411,078 $ 4,974,015

Net interest income $ 200,997 $ 199,682 $ 186,993

Net interest spread 3.49 % 4.03 % 4.15 %

Net interest margin 3.63 % 4.22 % 4.29 %

Average interest earning assets to average interest bearing liabilities 157.55 % 151.01 % 146.33 %

(1) The average loan balances presented in the table are net of ACL on loans.

Nonaccrual loans have been included in the table as loans carrying a zero yield.

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

The following table provides the amount of change in our net interest income attributable to changes in volume and changes in interest rates.

Changes attributable to the combined effect of volume and interest rates have been allocated proportionately for changes due specifically to volume and interest rates.

Year Ended December 31,

2020 Compared to 2019

Increase (Decrease) Due to 2019 Compared to 2018

Increase (Decrease) Due to

Volume Rate Total Volume Rate Total

Liquidity and Capital Resources

The following table provides the material cash requirements and capital resources from known contractual and other obligations and sources as of December 31, 2021:

One Year or Less Over One Year Other (1)

(Dollars in thousands)

Interest Earning Assets:

Loans receivable, net (1) (2)

$ 29,598 $ (26,696) $ 2,902 $ 13,134 $ 915 $ 14,049

Taxable securities (2,313) (3,191) (5,504) 4,174 1,269 5,443

Nontaxable securities (2)

413 (150) 263 (1,380) 127 (1,253)

Interest earning deposits 485 (1,676) (1,191) 425 (220) 205

Total interest income $ 28,183 $ (31,713) $ (3,530) $ 16,353 $ 2,091 $ 18,444

Interest Bearing Liabilities:

Certificates of deposit $ (358) $ (988) $ (1,346) $ 680 $ 2,382 $ 3,062

Savings accounts (18) (2,089) (2,107) (40) 617 577

Interest bearing demand and money market accounts 1,068 (1,699) (631) 444 1,869 2,313

Total interest bearing deposits 692 (4,776) (4,084) 1,084 4,868 5,952

Cash requirements:

Unfunded commitments - loans and letters of credits $ 1,125,960 $ — $ — $ 1,125,960

Maturing certificates of deposit 290,497 52,342 — 342,839

Unfunded commitment of LIHTCs 10,648 30,835 — 41,483

Operating leases 4,750 26,571 — 31,321

Junior subordinated debentures — 25,000 — 25,000

Non-maturity deposits — — 6,038,498 6,038,498

Securities sold under agreement to repurchase — — 50,839 50,839

FHLB advances and other borrowings (57) (240) (297) (564) 198 (366)

Total interest expense $ 644 $ (5,489) $ (4,845) $ 521 $ 5,234 $ 5,755

Net interest income $ 27,539 $ (26,224) $ 1,315 $ 15,832 $ (3,143) $ 12,689

(1) The average loan balances presented in the table are net of ACL on loans.

Nonaccrual loans have been included in the table as loans carrying a zero yield.

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

Earnings Summary

Results of Operations for the Years Ended December 31, 2020 and 2019

Net income was $46.6 million , or $1.29 per diluted common share, for the year ended December 31, 2020 compared to $67.6 million, or $1.83 per diluted common share, for the year ended December 31, 2019.

Net income decreased $21.0 million, or 31.1% , for the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily due to an increase in the provision for credit losses of $31.8 million as a result of estimated credit losses forecasted due to the COVID-19 pandemic and its impact on the economy, offset partially by a decrease in income tax expense of $6.9 million due to lower pre-tax income as well as a provision in the CARES Act permitting the recognition of a benefit from net operating losses related to prior acquisitions.

The net interest margin decreased 59 basis points to 3.63% for the year ended December 31, 2020 compared to 4.22% for the year ended December 31, 2019.

The decrease in net interest margin was due primarily to decreases in yields of total interest earning assets as a result of decreases in short-term market interest rates and changes in the mix of total interest earning assets, including the origination of lower-yielding SBA PPP loans with an average balance of $589.6 million, offset partially by decreases in the cost of total interest bearing liabilities during the year ended December 31, 2020.

The Company’s efficiency ratio was 62.52% for the year ended December 31, 2020 compared to 63.23% for the year ended December 31, 2019.

The improvement in the efficiency ratio was primarily due to the increase in noninterest income.

Net Interest Income Overview

One of the Company's key sources of earnings is net interest income.

There are several factors that affect net interest income, including, but not limited to, the volume, pricing, mix and maturity of interest earning assets and interest bearing liabilities;

the volume of noninterest earning assets, noninterest bearing demand deposits, other noninterest bearing liabilities and stockholders' equity;

market interest rate fluctuations;

and asset quality.

Market rates impact the results of the Company's net interest income, including the significant decreases in the federal funds target rate by the Federal Reserve in response to the COVID-19 pandemic during March 2020.

The following table provides the federal funds target rate history and changes from each period since December 31, 2018:

Change Date Rate (%) Rate Change (%)

December 31, 2018 2.25 - 2.50% N/A

July 31, 2019 2.00 - 2.25% -0.25%

September 18, 2019 1.75 - 2.00% -0.25%

October 30, 2019 1.50 - 1.75% -0.25%

March 3, 2020 1.00 - 1.25% -0.50%

March 16, 2020 0.00 - 0.25% -1.00%

Net interes t income increased $1.3 million, or 0.7%, to $201.0 million for the year ended December 31, 2020 compared to $199.7 million for the year ended December 31, 2019.

The increase in net interest income was primarily due to an increase in the average balance of total interest earning assets and a decrease in the cost of total interest bearing liabilities.

These increases were offset partially by decreases in the yield on interest earning assets following the decreases in market rates identified in the table above.

Interest Income

Total interest income decreased $3.5 million, or 1.6%, to $214.3 million for the year ended December 31, 2020 compared to $217.9 million for the year ended December 31, 2019 due primarily to decreases in yields on adjustable rate instruments following several decreases in short-term market rates, offset partially by increases in the average balance of total interest earning assets, primarily due to the originations of SBA PPP loans and increases in interest earning deposits .

T he yield on total interest ea rning assets decreased 74 basis points to 3.87% for the year ended December 31, 2020 compared to 4.61% for the year ended December 31, 2019.

The balance of average total interest ear ning assets increased $805.4 million, or 17.0%, to $5.54 billion for the year ended December 31, 2020 from $4.73 billion for the year ended December 31, 2019, including increases in the average balance of SBA PPP loans of $589.6 million and interest earning deposits of $217.7 million.

Interest income from i nterest and fees on loans increased $2.9 million, or 1.5%, to $192.4 million for the year ended December 31, 2020 from $189.5 million for the year ended December, 31, 2019 due pri marily to an increase i n the average balance of loans receivable, net , offset by decreases in the loan yield.

Average loans receivable , net increased $666.9 million, or 18.2% , to $4.34 billion fo r the year ended December 31, 2020 compared to $3.67 billion for the year ended December 31, 2019 due primarily to the impact of SBA PPP loans.

There were no SBA PPP loans outstanding during the year ended December 31, 2019.

Loan yield decreased 73 basis points to 4.44% for t he year ended December 31, 2020 from 5.17% for the year ended December 31, 2019 due primarily to the multiple and sustained decreases in short-term market rates and secondarily due to the impact of low-yielding SBA PPP loans .

L oan yield, excluding SBA PPP loans and incremental accretion on purchased loans, decrea sed 52 basis p oints to 4.52% for the year ended December 31, 2020 compared to 5.04% for the year ended December 31, 2019 .

SBA PPP loans had a negative impact on loan yield of 16 basis points as a result of the low-yielding 1% loan interest rate, offset by the impact of the deferred fee which increased the yield to 3.30% for the year ended December 31, 2020 .

Incremental accretion represents the amount of interest income recorded on purchased loans in excess of the contractual stated interest rate in the individual loan notes due to incremental accretion of purchased discount or premium.

Purchased discount or premium is the difference between the contractual loan balance and the fair value of acquired loans at the acquisition date, or as modified by CECL Adoption.

The purchased discount is accreted into income over the remaining life of the loan.

The impact of incremental accretion on loan yield will change during any period based on the volume of prepayments, but it is expected to decrease over time as the balance of the purchased loans decreases.

Incremental accretion income was $3.4 million and $4.9 million for the years ended December 31, 2020 and 2019, respectively.

The impact on loan yield from incremental accretion on purchased loans was 0.08% and 0.13% for the years ended December 31, 2020 and 2019, respectively.

The incremental accretion and the impact to loan yield will change during any year based on the volume of prepayments, but is expected to decrease over time as the balance of the purchased loans continues to decrease.

At December 31, 2020 and December 31, 2019, the remaining unamortized net purchase discount was $6.6 million and $8.4 million, respectively.

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

Year Ended December 31,

(Dollars in thousands)

Non-GAAP reconciliation of loan yield:

Loan yield (GAAP) 4.44 % 5.17 %

Exclude Impact on loan yield from SBA PPP loans 0.16 % — %

Exclude impact on loan yield from incremental accretion on purchased loans (0.08) % (0.13) %

Loan yield excluding SBA PPP loans and incremental accretion on purchased loans (non-GAAP) 4.52 % 5.04 %

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

Interest income on invest ment securities decreased $5.2 million, or 19.8%, to $21.2 million for the year ended December 31, 2020 compared to $26.4 million for the year ended December 31, 2019 due to a combination of decreases in yield and average balance.

The yield on the aggregate investment portfolio decreased 35 points to 2.40% for the year ended December 31, 2020 from 2.75% for the same period in 2019, including decreases of 38 basis points and 11 basis points on the yield on taxable securities and nontaxable securities, respectively.

The decrease in yield was due primarily to decreases in market rate on adjustable securities and secondarily due to lower yields on current year purchases of investment securities compared to the existing portfolios.

Also contributing to the decline in interest income on investment securities was a decrease in the average balance of total investment securities of $79.2 million, or 8.2%, to $883.8 million for the year ended December 31, 2020 from $963.1 million for the year ended December 31, 2019 due primarily to principal reduction from prepayments and calls of securities as a result of the currently low interest rate environment.

Interest income on interest earning deposits decreased $1.2 million, or 62.9%, to $703,000 during the year ended December 31, 2020 compared to $1.9 million for the year ended December 31, 2019 due to a decrease in the yield on interest earning deposits, offset partially by an increase in the average balance.

The yield on interest earning deposits decreased 171 basis points to 0.22% for the year ended December 31, 2020 compared to 1.93% for the year ended December 31, 2019 due to decreases in short-term market rates.

The average balance of interest earning deposits increased $217.7 million, or 221.8%, to $315.8 million for the year ended December 31, 2020 compared to $98.2 million for the year ended December 31, 2019 due primarily to excess liquidity.

Interest Expense

Total int erest expense decreased $4.8 million, or 26.7%, to $13.3 million for the year ended December 31, 2020 compared to $18.2 million for the year ended December 31, 2019 due primarily to decreases in market interest rates following decreases in the federal funds target rate mentioned previously, offset partially by an increase in the average balance of total interest bearing liabilities.

The cost of total interest beari ng liabilities decreased 20 basis points to 0.38% for the year ended December 31, 2020 from 0.58% for the year ended December 31, 2019.

The average balance of total interest bearing liabilities increased $381.1 million, or 12.2%, to $3.51 billion for the year ended December 31, 2020 from $3.13 billion for the year ended December 31, 2019.

Interest expense on total interest bearing deposits decreased $4.1 million, or 25.0%, to $12.3 million for the year ended December 31, 2020 compared to $16.3 million for the year ended December 31, 2019 due primarily to decreases in market interest rates, offset partially by an increase in the average balance.

The cost of total interest bearing deposits decreased 18 basis points to 0.35% for the year ended December 31, 2020 from 0.53% for the year ended December 31, 2019 due primarily to a decrease in the cost of savings accounts of 41 basis points to 0.11% for the year ended December 31, 2020 from 0.52% for the year ended December 31, 2019 and secondarily to a decrease in the cost of certificates of deposits of 19 basis points to 1.18% from 1.37% for the years ended December 31, 2020 and 2019, respectively.

T he decrease in cost of total interest bearing deposits was offset partially by an increase in the average balance of total interest bearing deposits of $391.9 million, or 12.8%, to $3.46 billion for the year ended December 31, 2020 compared to $3.07 billion for the year ended December 31, 2019 as a result of the Bank's participation in the SBA's PPP as well as a change in customer's spending behaviors due to the COVID-19 pandemic and new deposit accounts .

The Company's deposit costs were favorably impacted by the increase in the average balance of noninterest bearing demand deposits compared to total interest bearing deposits.

The average balance of noninterest bearing demand deposits increased $445.4 million, or 32.1%, to $1.84 billion for the year ended December 31, 2020 compared to $1.39 billion for the year ended December 31, 2019 .

The increase in the average balance of noninterest bearing deposits caused a decrease in the total cost of all deposits of 14 basis points to 0.23% for the year ended December 31, 2020 from 0.37% for the same period in 2019.

Provision for Credit Losses Overview

Effective January 1, 2020, CECL Adoption replaced the ALL with the ACL on loans and replaced the related provision for loan losses with the provision for credit losses on loans.

CECL Adoption also replaced the allowance for unfunded commitments with the ACL on unfunded commitments and replaced the related provision for unfunded commitments with the provision for credit losses on unfunded commitments.

The ACL on unfunded commitments is included on the Consolidated Statements of Financial Condition within accrued expenses and other liabilities.

For additional information, see “—Critical Accounting Policies” above.

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

Year Ended December 31,

(In thousands)

Provision for credit losses on loans $ 35,433 $ 4,311

Provision for credit losses on unfunded commitments 673 —

Provision for credit losses $ 36,106 $ 4,311

Provision for Credit Losses on Loans

The Bank has established a comprehensive methodology for determining its ACL on loans.

The ACL on loans is increased by the provision for credit losses on loans which is charged against earnings.

The amount of the provision expense recognized during the year ended December 31, 2020 was calculated based on a thorough review of the loan portfolio and in accordance with the Bank's CECL methodology for determining the current expected credit losses on loans.

The amount of the provision expense recognized during the year ended December 31, 2019 was calculated in accordance with the Bank's probable incurred loss methodology.

For additional information, see the section entitled "Analysis of Allowance for Credit Losses on Loans" above.

The provision for credit losses on loans is dependent on the Bank’s ability to manage asset quality and control the level of net charge-offs through prudent underwriting standards.

In addition, a further decline in general economic conditions, including as a result of the COVID-19 pandemic, could increase future provisions for credit losses on loans and have a material adverse effect on the Company’s net income.

The provision for credit losses on loans increased $31.1 million, or 721.9%, to $35.4 million for the year ended December 31, 2020 from $4.3 million for the year ended December 31, 2019 due primarily to the credit deterioration estimated as a result of the COVID-19 pandemic, as further explained in the "Analysis of Allowance for Credit Losses on Loans" above.

Additionally, the Bank recorded net charge-offs of $3.2 million during both the years ended December 31, 2020 and 2019, increasing the need for provision expense.

Provision for Credit Losses on Unfunded Commitments

The Bank has established a comprehensive methodology for determining its ACL on unfunded commitments, which is similar to the ACL on loans with additional considerations for the likelihood of funding over the contractual life of the commitment.

The ACL on unfunded commitments is increased by the provision for credit losses on unfunded commitments which is charged against earnings.

The amount of the provision expense recognized during the year ended December 31, 2019 was calculated in accordance with the Bank's incurred loss methodology.

The Bank recorded a provision for credit losses on unfun ded commitments of $673,000 during the year ended December 31, 2020 primarily as a result of an increased in the estimated losses as a result of credit deterioration due to the COVID-19 pandemic (as reflected in the ACL on loans) and partially offset a decrease in the utilization rates for revolving lines of credit to 38.6% at December 31, 2020 compared to 39.2% at December 31, 2019.

Noninterest Income Overview

Total noninterest income increased $4.8 million, or 14.7%, to $37.2 million for the year ended December 31, 2020 compared to $32.5 million for the same period in 2019.

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

Year Ended December 31,

2020 2019 Change Percentage Change

(Dollars in thousands)

Service charges and other fees $ 16,228 $ 18,712 $ (2,484) (13.3) %

Gain on sale of investment securities, net 1,518 330 1,188 360.0

Gain on sale of loans, net 5,044 2,424 2,620 108.1

Interest rate swap fees 1,691 1,232 459 37.3

Bank owned life insurance income

Total cash requirements $ 1,431,855 $ 134,748 $ 6,089,337 $ 7,655,940

Capital resources:

Unrestricted cash and cash equivalents $ 1,713,474 $ — $ — $ 1,713,474

FHLB and FRB borrowing availability (2)

1,113,208 — — 1,113,208

Other income 8,429 7,604 825 10.8

Total noninterest income $ 37,229 $ 32,462 $ 4,767 14.7 %

Gain on sale of loan s, net increased $2.6 million, or 108.1%, to $5.0 million f or the year ended December 31, 2020 compared to $2.4 million for the same period in 2019 from the combination of higher origination and sales volumes and higher earned sales margins reflecting an increased demand for residential loans due to the low interest rate environment during the year ended December 31, 2020.

Originations of mortgage loans held for sale increased $64.9 million, or 90.1%, to $137.0 million for the year ended December 31, 2020 from $72.2 million for the year ended December 31, 2019.

Bank owned life insurance income increased $2.2 million, or 100.0%, to $4.3 million during the year ended December 31, 2020 compared to $2.2 million during the year ended December 31, 2019 due primarily to life insurance death benefit income of $1.9 million recognized during the year ended December 31, 2020.

No death benefits were recognized during the year ended December 31, 2019.

Gain on sale of investment se curities, net increased $1.2 million, or 360.0%, to $1.5 million for the year ended December 31, 2020 from $330,000 during the same period in 2019 as a result of the Bank's active management of the investment portfolio in the current low interest rate environment.

Other income increased $825,000, or 10.8%, to $8.4 million for the year ended December 31, 2020 compared to $7.6 million for the year ended December 31, 2019 primarily as a result of a net gain on sale of two branches held for sale of $935,000 and a termination fee from the divestiture of our trust department of $651,000, offset partially by a counterparty valuation adjustment on our back-to-back interest rate swa ps of $422,000 due to the lower interest rate environment.

The increase in noninterest income was offset partially by a decrease in service charges and other fees of $2.5 million, or 13.3%, to $16.2 million fo r the year ended December 31, 2020 compared to $18.7 million for the year ended December 31, 2019 due primarily to a decrease in overdraft fees of $1.8 million and decreases in other activity-based fees on deposit accounts based on changes in customer spending habits as a result of the COVID-19 pandemic.

Noninterest Expense Overview

Noninterest expe nse increased $2.2 million, or 1.5%, to $148.9 million during the year ended December 31, 2020 compared to $146.8 million for the year ended December 31, 2019.

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

Year Ended December 31,

2020 2019 Change Percentage Change

(Dollars in thousands)

Compensation and employee benefits $ 88,106 $ 87,568 $ 538 0.6 %

Occupancy and equipment 22,664 21,690 974 4.5

Data processing 9,396 8,976 420 4.7

Marketing 3,100 3,481 (381) (10.9)

Professional services 5,921 5,192 729 14.0

State/municipal business and use tax 3,754 3,754 — —

Federal deposit insurance premium 1,789 725 1,064 146.8

Other real estate owned, net (145) 352 (497) (141.2)

Year Ended December 31,

2020 2019 Change Percentage Change

(Dollars in thousands)

Amortization of intangible assets 3,525 4,001 (476) (11.9)

Other expense 10,830 11,049 (219) (2.0)

Total noninterest expense $ 148,940 $ 146,788 $ 2,152 1.5 %

Federal deposit insurance premium expen se increased $1.1 million, or 146.8%, to $1.8 million during the year ended December 31, 2020 from $725,000 during the year ended December 31, 2019 due primarily to the impact of the decrease in the Bank's Tier 1 leverage ratio on the Bank's assessment rate, offset partially by the use of a small bank credit of $518,000 during the year ended December 31, 2020 compared to $726,000 during the year ended December 31, 2019 .

All small bank credits were fully utilized as of December 31, 2020.

Occupancy and equipment increased $974,000, or 4.5%, to $22.7 million during the year ended December 31, 2020 from $21.7 million during the year ended December 31, 2019 due primarily to costs, including depreciation expense, related to the Southern Operations Center location placed into operation in December 2019.

Professional services increased $729,000 , or 14.0%, to $5.9 million during the year ended December 31, 2020 from $5.2 million during the year ended December 31, 2019 related primarily t o the launch of the new mobile and online commercial banking platform, "Heritage Direct." The implementation of the new banking platform was completed during the second quarter of 2020.

The increases in noninterest expense were partially offset by a decrease in expense on other real estate owned, net of $497,000, or 141.2%, to a net gain of $145,000 during the year ended December 31, 2020 from a net expense of $352,000 during the year ended December 31, 2019 as a result of net gain on sales recognized during the year ended December 31, 2020 compared to net loss on sales recognized during the year ended December 31, 2019 .

The ratio of noninterest expense to average total assets was 2.37% fo r the year ended December 31, 2020 compared to 2.71% for the year ended December 31, 2019 .

The decrease in the r atio of noninterest expense to average total assets was primarily due to an increase in average total assets as discussed in the Net Interest Income Overview section .

Income Tax Expense Overview

Income tax expense decreased $6.9 million, or 51.0%, to $6.6 million for the year ended December 31, 2020 from $13.5 million for the year ended December 31, 2019.

The effective tax rate was 12.4% for the year ended December 31, 2020 compared to 16.6% for the year ended December 31, 2019.

The decrease in income tax expense and effective tax rate during the year ended December 31, 2020 was primarily due to a provision in the CARES Act which permitted the Company to recognize a $1.0 million benefit from net operating losses related to prior acquisitions during the year ended December 31, 2020 and secondarily due to a decrease in pre-tax income which increased the impact of favorable permanent tax items such as tax-exempt investments, investments in bank owned life insurance and low-income housing tax credits .

Unencumbered investment securities available for sale 737,454 — — 737,454

Loans receivable scheduled repayments, by contractual maturity date 384,790 3,430,872 — 3,815,662

Fed funds line borrowing availability 215,000 — — 215,000

Investment securities held to maturity, by contractual maturity date — 367,331 — 367,331

Total capital resources $ 4,163,926 $ 3,798,203 $ — $ 7,962,129

(1) Represents the undefined maturity of non-maturity deposits, including noninterest bearing demand deposits, interest bearing demand deposits, money market accounts and savings accounts, and securities sold under agreement to repurchase, which can generally both be withdrawn on demand.

(2) Includes FHLB borrowing availability of $1.06 billion at December 31, 2021 based on pledged assets, however, maximum credit capacity is 45% of the Bank's total assets one quarter in arrears or $3.26 billion.

We maintain sufficient cash and cash equivalents and investment securities to meet short-term liquidity needs and actively monitor our long-term liquidity position to ensure the availability of capital resources for contractual obligations, strategic loan growth objectives and to fund operations.

Our funding strategy has been to acquire non-maturity deposits from our retail accounts, acquire noninterest bearing demand deposits from our commercial customers and use our borrowing availability to

fund growth in assets.

We may also acquire brokered deposits when the cost of funds is advantageous to other funding sources.

Borrowings may be used on a short-term basis to compensate for reductions in other sources of funds (such as deposit inflows at less than projected levels).

Borrowings may also be used on a longer-term basis to support expanded lending activities and match the maturity of repricing intervals of assets.

While maturities and scheduled amortization of loans are a predictable source of funds, deposit flows and loan prepayments are greatly influenced by the level of interest rates, economic conditions and competition so we adhere to internal management targets assigned to the loan to deposit ratio, liquidity ratio, net short-term non-core funding ratio and non-core liabilities to total assets ratio to ensure an appropriate liquidity position.

The Company pays dividends to our shareholders and the primary source of the Company's liquidity is cash obtained from dividends from the Bank.

We expect to continue our current practice of paying quarterly cash dividends on our common stock subject to our board of directors’ discretion to modify or terminate this practice at any time and for any reason without prior notice.

Our current quarterly common stock dividend rate is $0.21 per share, as approved by our board of directors, which we believe is a dividend rate per share which enables us to balance our multiple objectives of managing and investing in the Bank and returning a substantial portion of our cash to our shareholders.

Assuming continued payment during 2022 at this rate of $0.21 per share, our average total dividend paid each quarter would be approximately $7.4 million based on the number of our current outstanding shares (which assumes no increases or decreases in the number of shares).

Management believes the capital sources are adequate to meet all reasonably foreseeable short-term and intermediate-term cash requirements.

Critical Accounting Policies

Critical accounting estimates are those estimates made in accordance with generally accepted accounting principles that involve a significant level of estimation uncertainty and have had or are reasonably likely to have a material impact on the financial condition or results of operations of the registrant.

The Company considers its critical accounting estimates to be as follows:

ACL on Investment Securities

Investment securities issued by the U.S.

government and its agencies are either explicitly or implicitly guaranteed by the U.S.

government, highly rated by major credit rating agencies and have a long history of no credit losses and therefore management concluded any declines in fair value were attributable to changes in interest rates relative to where these investments fall within the yield curve and individual characteristics.

The remainder of investment securities available for sale were issued by municipal or corporate issuers.

Management examined the combination of credit ratings, at the individual security level, and an analysis of historical defaults by credit rating for municipal and corporate securities since 1970 and determined the probability and magnitude of loss was insignificant.

Management's reliance on credit ratings and an analysis of historical defaults is subjective and these historical inputs may not be suitable predictors of future performance.

Unanticipated changes in the credit ratings or the historical defaults could have a significant impact on our financial condition and results of operations.

For additional information regarding the ACL on investment securities, see Note (1) Description of Business, Basis of Presentation, Significant Accounting Policies and Recently Issued Accounting Pronouncements and Note (2) Investment Securities of the Notes to Consolidated Financial Statements included in Item 8.

Financial Statements And Supplementary Data.

Management's estimate of the ACL on loans relies on the identification, stratification and separate estimates of loss for loans individually evaluated for loss and loans collectively evaluated for loss.

The estimate of loss for loans collectively evaluated for loss particularly involves a significant level of estimation uncertainty due to its complexity and quantity of inputs including:

management's determination of baseline loss rate multipliers based on a third-party forecast of economic conditions, an estimate of the reasonable and supportable forecast period, an estimate of the baseline loss rate lookback period, an estimate of the reversion period from the reasonable and supportable forecast period to the baseline loss rate, and an estimate of the prepayment rate and related lookback period.

Additionally, management considers other qualitative risk factors to further adjust the estimated ACL on loans through a qualitative allowance.

Management's estimates for these inputs are based on past events and current conditions, are inherently subjective, and are susceptible to significant revision as more information becomes available.

While management utilizes its best judgment and information available to recognize credit losses on loans, future additions to the allowance may be necessary based on declines in local and national economic conditions.

In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s ACL on loans.

Such agencies may require the Bank to make adjustments to the allowance based on their judgments about information available to them at the time of their examinations.

Unanticipated changes in any of these inputs could have a significant impact on our financial condition and results of operations.

For additional information regarding the ACL on loans, its relation to the provision for credit losses, its risk related to asset quality and lending activity, see Item 1A.

Risk Factors—Our ACL on loans may prove to be insufficient to absorb losses in our loan portfolio as well as Note (1) Description of Business, Basis of Presentation, Significant Accounting Policies and Recently Issued Accounting Pronouncements and Note (4) Allowance for Credit Losses on Loans of the Notes to Consolidated Financial Statements included in Item 8.

Financial Statements And Supplementary Data.

ACL on Unfunded Commitments

The allowance methodology for unfunded commitments is similar to the ACL on loans, but additionally includes considerations of the current utilization of the commitment, an estimate of the future utilization, an estimate of utilization of construction loans prior to completion and an estimate of construction loan advance rates as determined appropriate by historical commitment utilization and the Bank's estimates of future utilization given current economic forecasts.

Unanticipated changes in loss rates estimated in the ACL on loans, as utilized in the methodology for the ACL on unfunded commitments, or the expected utilization of unfunded commitments could have a significant impact on our financial condition and results of operations.

For additional information regarding the ACL on unfunded commitments, see Note (1) Description of Business, Basis of Presentation, Significant Accounting Policies and Recently Issued Accounting Pronouncements and Note (20) Commitments and Contingencies of the Notes to Consolidated Financial Statements included in Item 8.

Financial Statements And Supplementary Data.

The Company performed its annual goodwill impairment test during the fourth quarter of 2021 and determined, based on a qualitative assessment utilizing the Company's market capitalization, that it is more likely than not that the fair value of the reporting unit exceeded the carrying value, such that the Company's goodwill was not considered impaired for the year ended December 31, 2021.

For additional information regarding goodwill, see Note (1) Description of Business, Basis of Presentation, Significant Accounting Policies and Recently Issued Accounting Pronouncements and Note (7) Goodwill and Other Intangible Assets of the Notes to Consolidated Financial Statements included in Item 8.

Financial Statements And Supplementary Data.

Reconciliations of Non-GAAP Measures

This section contains certain financial information determined by methods other than in accordance with GAAP.

Our management uses these non-GAAP measures, together with the related GAAP measures, in its analysis of our performance and in making business decisions.

Management also uses these measures for peer comparisons.

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

Management believes that presenting loan yield excluding the effect of SBA PPP loans is useful in assessing the impact of the special program loans that are anticipated to substantially decrease upon forgiveness by the SBA within a short time frame.

This also applies to the ratio of ACL on loans to loans receivable excluding the effect of SBA PPP.

Management believes that presenting pre-tax pre-provision income, which reflects our profitability before income taxes and provision for credit losses, is useful in assessing our operating income and expenses by removing the volatility that is associated with credit loss provisions.

We also believe that during a crisis such as the COVID-19 pandemic, this information is useful as the impact of the pandemic on credit loss provisions of various institutions will likely vary based on the geography of the communities served by a particular institution, and the decision to adopt or defer ASC 2016-13.

This Form 10-K contains certain financial measures not presented in accordance with GAAP in addition to financial measures presented in accordance with GAAP.

The Company has presented these non-GAAP financial measures in this Form 10-K because it believes that they provide useful and comparative information to assess trends in the Company’s performance and asset quality and to facilitate comparison of its performance with the performance of its peers.

These non-GAAP measures have inherent limitations, are not required to be uniformly applied and are not audited.

They should not be considered in isolation or as substitutes for the results determined to be in accordance with GAAP, nor are they necessarily comparable to non-GAAP performance measures that may be presented by other companies.

Where applicable, comparable earnings information using GAAP financial measures is also presented.

Reconciliations of the GAAP and non-GAAP financial measures are presented below for the periods indicated:

They should not be considered in isolation or as a substitute for financial measures presented in accordance with GAAP, nor are they necessarily comparable to non-GAAP performance measures that may be presented by other companies.

Reconciliations of the GAAP and non-GAAP financial measures are presented in the tables below.

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

Incremental accretion on purchased loans represents the amount of interest income recorded on purchased loans in excess of the contractual stated interest rate in the individual loan notes due to incremental accretion of purchased discount or premium.

Purchased discount or premium is the difference between the contractual loan balance and the fair value of acquired loans at the acquisition date, or as modified by the adoption of ASU 2016-13.

The purchased discount is accreted into income over the remaining life of the loan.

Similarly, presenting loan yield excluding the effect of SBA PPP loans is useful in assessing the impact of these special program loans that are anticipated to substantially decrease within a short time frame.

Year Ended December 31,

5 unchanged sentences

Adjusted interest and fees on loans (non-GAAP) $ 155,085 $ 169,499

Average loans receivable, net $ 4,335,564 $ 3,668,665

Average loans receivable, net (GAAP) $ 4,181,464 $ 4,335,564

Exclude average SBA PPP loans (549,422) (589,635)

2 unchanged sentences

Loan yield, excluding SBA PPP loans and incremental accretion on purchased loans (non-GAAP) 4.27 % 4.52 %

Year Ended December 31,

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

2021 December 31, 2020

(Dollars in thousands)

6 unchanged sentences

ACL on loans to loans receivable, excluding SBA PPP loans (non-GAAP) 1.15 % 1.87 %

Year Ended December 31,

2020 2019 2018 2017 2016

(Dollars in thousands)

Pre-tax, Pre-provision Income:

Net income (loss) (GAAP)

$ 46,570 $ 67,557 $ 53,057 $ 41,791 $ 38,918

Exclude income tax (benefit) expense 6,610 13,488 11,238 18,356 13,803

Exclude provision for (reversal of provision for) credit losses

36,106 4,311 5,129 4,220 4,931

Pre-tax, pre-provision income (non-GAAP)

$ 89,286 $ 85,356 $ 69,424 $ 64,367 $ 57,652

Liquidity and Capital Resources

Our primary sources of funds are customer and local government deposits, loan principal and interest payments, loan sales and interest earned on and proceeds from sales and maturities of investment securities.

These funds, together with retained earnings, equity and other borrowed funds, are used to make loans, acquire investment securities and other assets, and fund continuing operations.

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

We generally maintain sufficient

cash and investments to meet short-term liquidity needs.

At December 31, 2020, cash and cash equivalents totaled $743.3 million, or 11.2%, of total assets.

Investment securities available for sale totaled $802.2 million at December 31, 2020, of which $194.9 million were pledged to secure public deposits, borrowing arrangements or securities sold under agreement to repurchase .

Management considers unpledged investment securities available for sale to be a viable source of liquidity.

The fair value of investment securities available for sale that were unpledged totaled $607.3 million, or 9.2% of total assets at December 31, 2020.

The fair value of investment securities available for sale with maturities of one year or less totaled $56.1 million, or 0.8% of total assets at December 31, 2020.

At December 31, 2020, the Bank maintained credit facilities with the FHLB for $991.7 million and credit facilities with the Federal Reserve Bank for $54.3 million, of which there were no borrowings outstanding under either facility as of December 31, 2020.

The Bank also maintains advance lines with Wells Fargo Bank, US Bank, The Independent Bankers Bank, Pacific Coast Bankers’ Bank, and JP Morgan Chase to purchase federal funds totaling $215.0 million as of December 31, 2020, of which there were none outstanding as of December 31, 2020.

Our strategy has been to acquire non-maturity deposits from our retail accounts, acquire noninterest bearing demand deposits from our commercial customers, and use our available borrowing capacity to fund growth in assets.

We anticipate that we will continue to rely on the same sources of funds in the future and use those funds primarily to make loans and purchase investment securities.

Contractual Obligations

The following table provides the amounts due under specified contractual obligations for the periods indicated as of December 31, 2020:

December 31, 2020

One Year or Less One to Three Years Over Three to Five Years Over Five Years Other (1)

(In thousands)

Contractual payments by period:

Deposits $ 325,686 $ 61,643 $ 12,175 $ 30 $ 5,198,456 $ 5,597,990

Securities sold under agreement to repurchase — — — — 35,683 35,683

Junior subordinated debentures — — — 25,000 — 25,000

Operating leases 3,547 6,241 5,267 6,611 — 21,666

Total contractual obligations $ 329,233 $ 67,884 $ 17,442 $ 31,641 $ 5,234,139 $ 5,680,339

(1) Represents noninterest bearing demand deposits, interest bearing demand deposits, money market accounts and savings accounts which can generally be withdrawn on demand and thereby have an undefined maturity.

Asset and Liability Management

Our primary financial objective is to achieve long-term profitability while controlling our exposure to fluctuations in market interest rates.

To accomplish this objective, we have formulated an interest rate risk management policy that attempts to manage the mismatch between asset and liability maturities while maintaining an acceptable interest rate sensitivity position.

The principal strategies which we employ to control our interest rate sensitivity are:

originating certain commercial business loans and real estate construction and land development loans at variable interest rates repricing for terms generally one year or less;

and offering noninterest bearing demand deposit accounts to businesses and individuals.

The longer-term objective is to increase the proportion of noninterest bearing demand deposits and low-rate interest bearing demand deposits, money market accounts, and savings deposits relative to certificate of deposit accounts to reduce our overall cost of funds.

A number of measures are used to monitor and manage interest rate risk, including income simulations, interest sensitivity (gap) analysis and economic value of equity sensitivity.

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 loans and investment securities, decay rates on non-maturity deposits, and pricing on investment securities, loans, deposits and borrowings.

In order to measure the interest rate risk sensitivity as of December 31, 2020, this simulation model uses a “no growth” assumption and assumes an instantaneous and sustained uniform change in market interest rates at all maturities.

These assumptions are inherently uncertain and, as a result, the net interest income projections should be viewed as an estimate of the net interest income sensitivity at the time of the analysis.

Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes and changes in market conditions and management strategies, among other factors.

Based on the results of the simulation model, the following table presents the change in our net interest income as a result of parallel rate shock scenarios for the presented periods after the dates shown:

2020 December 31,

(Dollars in thousands)

Modeled increase in market interest rates of 100 basis points

Increase in net interest income in Year 1 $ 15,281 $ 8,149

Increase in net interest income in Year 2 26,389 15,572

Modeled increase in market interest rates of 200 basis points

Increase in net interest income in Year 1 28,507 15,933

Increase in net interest income in Year 2 51,021 29,806

Modeled decrease in market interest rates of 100 basis points

Decrease in net interest income in Year 1 (3,014) (7,415)

Decrease in net interest income in Year 2 (7,034) (15,178)

These scenarios are based on interest rates as of the last day of a reporting period published by independent sources and incorporate relevant spread of instruments that are actively traded in the open market.

Given that the short-term rates have drastically declined during the year ended December 31, 2020, we do not believe that the results of the "Down 200" analysis provide meaningful output and have been excluded.

For the "Down 100" scenario, the Bank's modeling assumption is that all deposit rates are floored to one or two basis points and new loan production is recalibrated to incorporate a chosen net interest spread over index.

The simulations used to manage market risk are based on numerous assumptions regarding the effect of changes in interest rates on the timing and extent of reprice characteristics, future cash flows and customer behavior.

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 net interest income.

Actual results will differ from simulated results due to the timing, magnitude, and frequency of interest rate changes as well as changes in market condition, customer behavior and management strategies, among other factors.

Our asset and liability management strategies have resulted in a negative three month or less “gap” of 30.8% as of December 31, 2020.

This “gap” measures the difference between the dollar amount of our interest earning assets and interest bearing liabilities that mature or reprice within the designated period (three months or less) as a percentage of total interest earning assets, based on certain estimates and assumptions as discussed below.

We believe that the implementation of our operating strategies has reduced the potential effects of changes in market interest rates on our results of operations.

The negative gap for the three month or less period indicates that decreases in market interest rates may favorably affect our results over that period.

The following table provides the estimated maturity or repricing and the resulting interest rate sensitivity gap of our interest earning assets and interest bearing liabilities at December 31, 2020.

We used certain assumptions in presenting this data so the amounts may not be consistent with other financial information prepared in accordance with generally accepted accounting principles.

The amounts in the tables also could be significantly affected by external factors, such as changes in prepayment assumptions, early withdrawal of deposits and competition.

December 31, 2020

Estimated Maturity or Repricing Within

Three Months or Less Over Three Months to 12

Months Over One to Five Years Over Five to 15

15 Years Total

(Dollars in thousands)

Interest Earnings Assets:

Loans receivable, net $ 783,053 $ 271,512 $ 2,261,786 $ 977,246 $ 104,865 $ 4,398,462

Investment securities 134,865 72,612 247,260 227,864 119,562 802,163

Interest earning deposits 651,404 — — — — 651,404

Total interest earning assets $ 1,569,322 $ 344,124 $ 2,509,046 $ 1,205,110 $ 224,427 $ 5,852,029

Percentage of interest earning assets 26.8 % 5.9 % 42.9 % 20.6 % 3.8 % 100.0 %

December 31, 2020

Estimated Maturity or Repricing Within

Three Months or Less Over Three Months to 12

Months Over One to Five Years Over Five to 15

15 Years Total

(Dollars in thousands)

Interest Bearing Liabilities:

Total interest bearing deposits (1)

$ 3,317,442 $ 226,158 $ 73,829 $ 30 $ — $ 3,617,459

Junior subordinated debentures 20,887 — — — — 20,887

Securities sold under agreement to repurchase 35,683 — — — — 35,683

Total interest bearing liabilities $ 3,374,012 $ 226,158 $ 73,829 $ 30 $ — $ 3,674,029

Interest bearing liabilities, as a percentage of total interest earning assets 57.7 % 3.9 % 1.3 % — % — % 62.8 %

Interest rate sensitivity gap $ (1,804,690) $ 117,966 $ 2,435,217 $ 1,205,080 $ 224,427 $ 2,178,000

Interest rate sensitivity gap, as a percentage of total interest earning assets (30.8) % 2.0 % 41.6 % 20.6 % 3.8 % 37.2 %

Cumulative interest rate sensitivity gap $ (1,804,690) $ (1,686,724) $ 748,493 $ 1,953,573 $ 2,178,000

Cumulative interest rate sensitivity gap, as a percentage of total interest earning assets (30.8) % (28.8) % 12.8 % 33.4 % 37.2 %

(1) Adjustable-rate liabilities are included in the period in which interest rates are next scheduled to adjust rather than in the period they are due to mature.

Although noninterest demand deposits, interest bearing demand deposits, money market accounts, and saving accounts are subject to immediate withdrawal, based on historical experience, management considers a substantial amount of such accounts to be core deposits having significantly longer maturities.

Certain shortcomings are inherent in the method of analysis presented in the foregoing table.

For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates.

Also, the interest rates on some types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market interest rates.

Additionally, some assets, such as adjustable rate residential real estate mortgages, have features, which restrict changes in the interest rates of those assets both on a short-term basis and over the lives of such assets.

Further, if a change in market interest rates occurs, prepayment and early withdrawal levels could deviate significantly from those assumed in calculating the tables.

Finally, the ability of many borrowers to service their adjustable rate debt may decrease if market interest rates increase substantially.

The table below provides information about our financial instruments that are sensitive to changes in interest rates as of December 31, 2020.

The table presents principal cash flows and related weighted average interest rates by expected maturity dates.

The expected maturity is the contractual maturity or earlier call date of the instrument.

The data in this table may not be consistent with the amounts in the preceding table, which represents amounts by the estimated repricing date or maturity date, whichever occurs sooner.

By Expected Maturity Date

Year Ended December 31, 2020

Three Months or Less Over Three Months to 12 Months Over One Year to Five Years Over Five Years to 15 Years Over

15 Years Total Fair Value

(Dollars in thousands)

Investment Securities

Amounts maturing:

Fixed rate $ 28,950 $ 58,341 $ 216,633 $ 225,698 $ 119,562 $ 649,184

Weighted average interest rate 3.08 % 2.62 % 2.92 % 2.63 % 2.29 % 2.68 %

By Expected Maturity Date

Year Ended December 31, 2020

Three Months or Less Over Three Months to 12 Months Over One Year to Five Years Over Five Years to 15 Years Over

15 Years Total Fair Value

(Dollars in thousands)

Adjustable rate $ 4,043 $ 1,001 $ 2,034 $ 65,550 $ 80,351 $ 152,979

Weighted average interest rate 0.66 % 2.13 % 1.05 % 0.91 % 1.37 % 1.16 %

Total $ 32,993 $ 59,342 $ 218,667 $ 291,248 $ 199,913 $ 802,163 $ 802,163

Loans Receivable

Amounts maturing:

Fixed rate $ 40,786 $ 96,637 $ 1,316,720 $ 874,645 $ 105,959 $ 2,434,747

Weighted average interest rate 4.31 % 4.50 % 2.50 % 4.22 % 4.07 % 3.30 %

Adjustable rate $ 108,290 $ 174,366 $ 296,282 $ 1,251,530 $ 203,432 $ 2,033,900

Weighted average interest rate 5.32 % 4.23 % 4.34 % 3.93 % 4.01 % 4.10 %

Total $ 149,076 $ 271,003 $ 1,613,002 $ 2,126,175 $ 309,391 $ 4,468,647 $ 4,556,862

Certificate of Deposit Accounts

Amounts maturing:

Fixed rate $ 99,528 $ 226,158 $ 73,818 $ 30 $ — $ 399,534 $ 402,071

Weighted average interest rate 0.56 % 0.39 % 1.42 % 0.80 % — % 0.62 %

Junior Subordinated Debentures

Amounts maturing:

Adjustable rate $ — $ — $ — $ — $ 20,887 $ 20,887 $ 18,500

Weighted average interest rate (1)

— % — % — % — % 4.29 % 4.29 %

(1) The contractual interest rate of the junior subordinated debentures was 1.80% at December 31, 2020.

The weighted average rate includes the accretion of the discount established at the merger date which is amortized over the life of the trust preferred securities.

Impact of Inflation and Changing Prices

Inflation affects our operations by increasing operating costs and indirectly by affecting the operations and cash flow of our customers.

Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature.

As a result, changes in 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 the same extent as the prices of goods and services, increases in inflation generally have resulted in increased interest rates.

Compared sentence by sentence after normalising whitespace, quotation marks, case and digits, so re-formatting and restated figures do not read as changed language. Wording changes appear as one removal and one addition. The current filing and the prior one are authoritative.

What changed 10-K

Item 7. Management’s Discussion and Analysis