Heritage Financial Corp (HFWA) 2009 Q4 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the Heritage Financial investor conference call. At the request of your host, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will be given at that time.

(Operator Instructions). As a reminder, this conference is being recorded. I would now like to turn the call over to your host, Mr. Brian Vance. Please go ahead, Mr. Vance.

Thank you, George. Welcome to everybody on the call this morning; our January 28, 2010 conference call. I'd like to welcome all that called in and even those that may be listening later to the recorded version. Tuning with me this morning is Donald Hinson, our Chief Financial Officer. Our press release went out this morning before the market opened. Hopefully, you've had an opportunity to review the press release prior to this call.

I believe it is appropriate to read the obligatory forward-looking statement, and bear with me for just a minute. Statements concerning future performance, developments, or events, expectations for growth and market forecasts, and other guidance on future periods constitutes forward-looking statements. Forward-looking statements are subject to a number of risks and uncertainties that might cause actual results to differ materially from stated expectations.

Specific factors include, but are not limited to, the effective interest rate changes, risks associated with acquisition of other banks, and opening new branches, the ability to control costs and expenses, credit risk of lending activities, including changes in level and trend of loan delinquencies and write-offs, and changes in general economic conditions, either nationally or in our market areas. These factors could affect the Company's financial results. You should not place undue reliance on forward-looking statements and we undertake no obligation to update any such statements.

The Company does not undertake or specifically disclaim any obligation to revise any potentially forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements. Additional information on these and other factors are included in the Company's filings with the Security and Exchange Commission.

First of all, I'd like to start this morning with some highlights of our fourth quarter and full year for 2009. We had a strong capital position at December 31, 2009 with a tangible common equity to tangible assets of 12.1% and a total capital to risk weighted asset ratio of 20.7%. Solid coverage ratios at December 31, 2009 including an allowance for loan losses to total loans of 3.4% and an allowance for loan losses to nonperforming loans or coverage ratio of 79.3%. Strong liquidity position at December 31, 2009 with over 10% of total assets in cash and cash equivalents.

Nonmaturity deposits, those are total deposits less certificate of deposit accounts as of December 31, 2009 increased 12.2% from December 31, 2008. Average interest earning assets for the quarter ended December 31, '09, increased 12.5% from the quarter ending December 31, '08. Our efficiency ratio improved to 61.3% for the year ended '09 from 64.5% for year ended '08.

I'll talk a little bit about the different portions of our earnings and balance sheets. I'll start with earnings first. We posted a Q4 net income of $772,000. The Q4 net -- the Company net income applicable to common shareholders included the preferred stock dividends was $441,000 or $0.04 per diluted share, which was an improvement over Q3 net loss applicable to common shareholders of $18,000 or $0.003.

Our total loan loss provision for Q4 was $4.95 million compared to a Q3 provision of $4.65 million. Net charge outs for the quarter were $3.8 million compared to $3.3 million in Q3. Even with the increased charge ups, we increased our loan loss allowance to 3.39% at year end from 3.20% as of September 30. Our pretax preprovision earnings before preferred dividends for Q4 were $5.6 million as compared to $5 million from linked quarter Q3 '09, a 12% increase. The same numbers for the full year 2009 were $19.5 million as compared to 2008 amount of $16.7 million, a 16% increase year-over-year. We believe this is a significantly strong overall pretax preprovision year-over-year improvement. Our pretax preprovision ROA was 2.18% for Q4.

Balance sheet comments on miscellaneous balance sheets items. We believe we have an overall strong balance sheet. At year end, other than $10 million in short term retail customer repurchase agreements, we have no debt on our balance sheet. I know I've said this several previous times, but I think it bears repeating, we have no flub borrowings of federal home loan bank borrowings. no sold trust preferred securities and no other debt. At year end, we held $87 million in overnight interest bearing funds, primarily at the Federal Reserve Bank.

Our loan deposit ratio at year end was 88.9% which improved from 96.3% at prior year end. Local date loans increased approximately $11 million during the quarter -- correction, local date loans decreased approximately $11 million during the quarter and $36 million for the year. However, construction loans decreased by approximately $9 million during the quarter and $35 million for the year. Or in other words, allowing for the drop in construction loan exposure our loans were basically flat for the year.

We have total construction exposure of 12.4% of total loans with only 6% represented in residential one to four family construction, which includes land development. Total commercial loans including commercial real estate increased a modest $1 million during the quarter. Nonmaturity deposits, total deposits less all CDs, as of quarter end increased 12.2% from prior year and total CDs declined 12% year-over-year.

As a result of the Washington Public Deposit Protection Commission regulation change mid-year, which was in response to a failure of a Washington State Bank earlier in 2009, our total public deposits decreased $63 million since year end and $11 million in Q4 2009. In addition, our wholesale broker deposits decreased $11 million during the fourth quarter and is currently only $23 million. Therefore, although total deposits decreased $5 million during the quarter, nonpublic nonbrokered deposits increased $17 million during the quarter. Net costs of all deposits was a low 1.18% for Q4.

I believe measuring the quality components of your overall deposit structures is as important as measuring net deposit growth, and most important in my opinion is measuring the growth of nonmaturity deposits. The most valuable deposit franchises are those that rely on low cost nonmaturity deposit relationships that tend to be stickier and more loyal, and are banking with you because of service rather than rate. Our nonmaturity deposit ratio or [PUR] deposits is a very strong 64% of total deposits. Differently said, our total CDs make up only 36% of our total deposits and our core deposits which are all deposits less CDs over $100,000 is a very strong 79% of all deposits.

Net interest margin, a few comments about our net interest margin, for Q4 was a healthy 4.5% -- 4.45%. This is a decrease from 4.58% in Q3 or 13 basis points and from 4.67% in Q4 of 2008. For the full year 2009, our net margin decreased two basis points to 4.57% as compared to last year of 4.59%.

The effective nonaccrual loans on the margin for Q4 was 14 basis points. Although our net interest margin showed reduction, the primary reasons were the effect of the nonaccrual loans as well as the excess cash received from our capital raised, of which a large portion was invested in overnight funds, primarily the Fed, earning approximately 25 basis points.

Noninterest income was $2.3 million for the three months ended December 31, 2009, compared to $2.1 million for the three months ended December 31, 2008. The increase was primarily due to increased SDA loan sales. Noninterest income decreased slightly to $8.7 million for year ended December 31, 2009 from $8.8 million for the same period in 2008.

Noninterest expense was $7.4 million for the quarter ended December 31, 2009, compared to $7.9 million for quarter ended -- for the quarter ended December 31, 2008. The primary reason for this variance was the recapture of a previously accrued incentive payment of approximately $530,000 as management made the decision to significantly reduce any payments for 2009. For the year ended December 31, 2009 noninterest expense was $30.9 million compared to $30.4 million for the year ended December 31, 2008.

The variances in noninterest expenses were primarily the result of the following. For the three months and year ended 12/31/2009, FDIC insurance expenses increased $211,000 and $1.2 million respectively for the same periods in the prior year. For the three months into 12/31/2009, impairment loss on securities was $236,000 compared to $668,000 for the three months ended 12/31/08. For the year ended 12/31/09, impairment losses on securities was $500,000 compared $1.9 million for the year ended 12/31/08. For the three months and year end 12/31/09, salary and employee benefits decreased $571,000 and $430,000 respectively from the same periods in the prior year. For the year ended 12/31/09, marketing expense increased $288,000 from the same period in the prior year. A significant amount of this increase was the result of costs associated with a successful checking account acquisition program that has been ongoing for the last couple of years.

Noninterest expense control has been a focus of ours and will continue to be. However, items such as expected increases in the FDIC assessments as well as potential future OTTI charges will make it difficult to maintain our goal of efficiency ratio under 60%. For the quarter ended 12/31/09, our efficiency ratio was 56.7% and for the year ended 12/31/09, our efficiency ratio was 61.3%.

I'll speak a bit to overall loan quality. Nonperforming loans decreased $2.7 million, however primarily due to $3.8 million in net charge offs during the quarter. As mentioned earlier, year-over-year we reduced total construction loans by $35 million or 27% of construction loans. Our residential construction loans as of 12/31 totaled $46.1 million

This breaks down as follows; residential land $7.7 million, single family homes $8.6 million and A&D residential and this is -- I'm sorry, $29.8 million and this is completed, finished A&D residential lots ready for sale. Our total nonperforming loans of $33 million breaks down as follows; commercial or C&I $7.3 million, restructured loans $400,000, and real estate construction at $25.3 million. I'll break down that $25.3 million for you you as well; residential land $700,000, single family residential $1.9 million and that would be construction loans for single family residential, $1.9 million, and A&D lots for sale $21.3 million and commercial construction at $1.4 million.

I also have a breakout by county of all nonperforming and potential problem loans combined. Thurston County here in Olympia represents 17% of all nonperforming and potential problem loans. Pierce County or Tacoma is 60%. Mason County which is an adjoining county in Shelton where we have a branch is 7%. And King County, home county to Seattle is 6%. Then all other Washington counties at 10%. This primarily includes counties in the central part of the state which are associated with our Central Valley Bank affiliate.

Total nonperforming loans plus total potential problem loans was up $5.9 million quarter-over-quarter. The primary reasons for this were single family residential construction was up $6 million and C&I was up $2.5 million, while owner occupied commercial real estate and investor owned real estate was down about $2.5 million. Our REO balances, we begin Q4 with an REO balance of $151,000, added two additional REO loans totaling $679,000, and a write down of $126,000 in an end of the year with an REO balance of $704,000. Quick comment on the liquidity. Total available liquidity sources cash and borrowing lines is over $330 million for the Company.

I'd like to give you just my own thoughts on a general review of 2009. From a relative and comparative point of view I believe our overall 2009 performance was respectable. I'm disappointed we posted a modest lost for the year, but I'm encouraged with our overall improvement trends especially the modest profit we posted for Q4. Year-over-year we reduced overall construction exposure by $35 million or 27%. And our total one to four residential exposure now sits at only 6% of total loans.

During this past year, we resisted the temptation to grow deposits by accepting CD refugees from closed or troubled banks, but instead grew total nonmaturity deposits by 12% while at the same time reducing the total CD deposits by 12% year-over-year. Consequently, our nonmaturity deposits total 64% of total deposits and our core deposits including CDs less than $100,000 was 79% at year end. We have continued to focus on maintaining a strong coverage ratio, and at year end our coverage ratio improved to 79% which is one of the strongest coverage ratios of publicly traded banks in the Pacific Northwest.

I'd like to give you some general comments about outlook for 2010. We see a continuing, but modest and slowing decline in the overall Pacific Northwest economy. While our region's unemployment increases have moderated, we don't believe it has peeked yet, nor have our residential or commercial real estate values reached the bottom, although again the rate of decline has slowed. Until these two factors hit bottom and begin to show sustainable improvement, we cannot say the Pacific Northwest is on the mend. We are hopeful to begin to see improvements in these metrics by the third or fourth quarter of this year.

We expect to see modest loan growth. We will continue to manage our overall construction totals down which will mute future new loan growth. We also do not see much in the way of new loan growth opportunities as most businesses are still stressed and focused on liquidating debt as opposed to expanding their businesses.

We will likely see an increase in noninterest expense -- I'm sorry, as loan administration costs increase and we are likely to see a slight reduction to overall noninterest income as future regulatory changes impact checking account fees and charges. These two factors will likely cause our efficiency ratio to show on increase. We continue to see some modest weakness in our C&I portfolio, but have not yet seen material performance weaknesses in our commercial real estate loans.

Another issue we will all have to do with is the ongoing bank dealers in the Pacific Northwest which will continue to add to real estate valuation deterioration as more product comes to market. This issue was a wild card for 2003 that concerns me and could mute or slow the Pacific Northwest's overall recovery. However despite the above challenges, we are optimistic that we will see a more positive overall operating results for our Company in 2010 than 2009.

I'd like to close with the following points. We are a well capitalized company with a risk rated capital of 20.7% and a tangible common equity to tangible asset ratio of 12.1%. We have a strong liquidity position and a strong net interest margin. We have consistently strong pretax, preprovision return on assets of 2.18% for Q4 and 1.99% for the entire year 2009 as well as a 2.04% pretax provision ROA for 2008.

We have a very strong coverage ratio of 79%. And our current single family construction exposure currently is much lower than most of our peers at 6% of total loans. With our strong capital and liquidity positions, I believe we are well positioned to strategically grow our Company as we move through this year and beyond. I would welcome any questions you may have. Once again, refer you to our forward-look being statements in our press release, and as I answer any of these questions dealing with forward-looking statements. That completes my prepared remarks and I'd be pleased to take any questions. George, are you there?

(Operator Instructions). Our first question is from the line of Mr. Robert Bohlen from KBW. Please go ahead, sir.

I wonder if you could talk about the tax rate a little bit, both in the quarter and the go forward, how we should think about tax rate. I know in -- lower that there are more items that affect the tax rate, but I was wondering if you could just shed some light on that.

Bobby, I will have Don speak to that.

I think this is a very unusual year as far as taxes go. We have been working with it all year, working with our tax accountants trying to come up with a good estimate, as far as each quarter what our tax expense would be. Of course as we get near the end of the year, we had more charge offs at the end of the year and other trueups.

We didn't end up making a $250,000 adjustment to expense right at year end to get them where we needed to be for the year. And that was unusual. I think going forward, hopefully as we return to profitability that you can probably go back and use tax rates as we have in previous years. We really haven't changed a lot of our, what I call permit tax differences, as far as the number of munis I think have increased some, but proportionately not significant. I think going forward, I think our tax rates as we have in previous years should work as we return to profitability.

Think about that on an FDA basis, around that 34% range.

I think it was below that for that -- effective tax rate, I think it was more in the 32% or 33% range.

Okay. That's helpful. Thank you.

Thank you, Bobby.

Our next question is from the line of Mr. Jeffrey Rulis. Please go ahead.

Good morning, guys.

Hi, Jeff.

Brian, if you could comment on total risk based capital going to 20%, a strategic question and more specifically if you could prioritize thoughts on TARP repayment, depleting an FDI assisted transaction. And lastly, keeping a buffer for additional credit strength.

Good questions, Jeff. My comments shouldn't come as a surprise to folks that follow us. I'm a pretty cautious guy as it pertains to TARP. I've stated before and it is still my position at this point that we certainly have the ability to liquidate the $24 million in preferred securities we sold to Treasury. We have gotten much more than that in overnight cash so it is not a question of ability.

But as I've stated previously, I really don't want to repay that TARP until we know that we are through the downturn of this economic cycle here in the Pacific Northwest. I think the Pacific Northwest is going to be slower in hitting the bottom. I also believe it will probably be a little more quickly coming out of the cycle than some of the other areas of the country, but I do believe we have yet to hit bottom. And until we do, I am not likely to repay TARP, which I think speaks to part of your question in terms of continuing credit concerns.

While I realize our total problem loans increased a bit quarter-over-quarter, I look to the difficulties in the Pacific Northwest economy and I do believe we have seen the worst of it in 2009. But as I've said, I still see some potential downward pressure to real estate valuations. We probably haven't peeked on unemployment rate and a variety of things that I think will continue to drag on our local economies. There is nothing that concerns me when I look at -- most of the increases in our nonperforming loans -- correction -- in our potential problem loans came once again from our construction sector. That continues to be a very troubled sector. I think as we look at our total construction portfolio today, we have only one remaining significant credit that is a performing loan.

Let me restate that, is a performing or a past credit. And we feel good about that builder and the relationship, but what I'm saying is we have crippled almost about every construction loan we have got on the portfolio. But as I said, we have not seen a bottom yet to the economy.

I think to the last portion of your question, using capital for acquisition, as we did the Cap rates I shared with everybody that our primary focus was to look at FDIC assisted sale opportunities. And while I'm not going to speak to specific activities in that regard, I will tell you that we are active in that process. A long answer to a short question, but hopefully that answers your questions, Jeff.

No, no. I appreciate the commentary. Switching gears a little bit. Was there a change in the philosophy on the restructured loans versus NPAs from quarter to quarter, from Q3 to Q4?

No, I don't think so.

Okay, given the level of nonperformers. Okay, I'll take a look at that. Another question on the -- I understand -- did you have an exam in the quarter?

No, we did not.

Okay.

I think probably I had indicated in previous calls that we are expecting a state of Washington DFI exam, and we are expecting a DFI exam later in February.

And then just more of a line item. Looks like salaries comp expense line item had a sequential drop, pretty sizeable. Anything seasonal or year end or is that a sustainable rate going forward or level?

Jeff, the primary reason for the drop was a recapture of the year long accrual in anticipation of potentially paying bonuses to our officers. As I indicated in our comments, we've made a decision to significantly reduce bonus payouts and therefore, we recaptured most if not all that previous accrual.

We could -- not giving guidance, but we could see a resumption at your core level in the new year.

Yes, you should.

All right. Thanks.

You bet. Thank you.

Our next question is from the line of Ross Haberman from the Haberman Fund.

How are you, Brian?

I'm doing well, Ross. Thank you.

Is there much room on the deposit side to keep lowering your rates? You mentioned that you're replacing CDs with money markets or nonterm loans -- or deposits. Yet I saw your spread did drop. What happened there, given the replacements with nonCD deposit rates?

I'll ask Don to fill in here. From a big picture point of view, I do not see our deposit costs lowering much beyond where they are. I think we have [rung] the last little bit out of that one. There may be some CDs that are maturing that are higher than the reprices, but we are also continuing to focus on nonmaturity deposits. We might have to tick up the rates there a little bit to continue to throw growth there, but overall I don't see that we are going to improve much out of the interest expense side. Don?

The same thing you were saying is that we may see some repricing of some CDs over probably the first half of the year, as some of the longer term CDs we had before are repricing. But the transaction accounts are not really going to move down any further than they already have.

Just one follow-up question. I think in your press release you showed about $95 million in real estate construction loans still performing on the balance sheets, roughly half commercial and half residential. How much of those are spec or land development loans?

The residential construction loans, roughly $46 million, about $30 million is A&D residential. That would be development loans that have been completed and lots are available for sale. And an additional $7.7 million in land that is being held for development, but yet has not been developed. And on the $49 million of commercial real estate construction? That's a variety of multifamily commercial construction, et cetera.

Is that $90 million your biggest concern going forward for this year?

Certainly, we have not seen any weakness on the commercial construction side. I would say that the residential construction -- that entire bucket continues to be a concern going forward because as I indicated, Ross, I don't think we have seen a bottom yet to residential values, whether they be homes or lots. Yes, I think it is fair to say that's the biggest portion of our concern going forward. But I think it is important to remember that residential land construction in total is only 6% of our total portfolio.

How is the Central Valley operation faring, vis-a-vis your other your main operation in terms of profitability. I know you don't break it out per se.

Central Valley Bank has performed pretty well over the last couple of years. Ag commodity prices have been strong, but we certainly have seen a weakness to the ag prices as we closed out this past year. I think most commodity prices showed deterioration. There is an oversupply on a variety of crops that are grown in the central part of the state that we are seeing some stress to those prices. I think we will continue to see stress to commodity prices as we work through 2010. Looking back in '08 and '09, really the Central Valley affiliate has done quite well overall.

Could you see FDA deals in that region or you are not focused on that region for any of those deals really?

Ross, I won't foreclose the option of a deal in central Washington. I think it would have to be exactly the right deal. As I said before, I think when we take a look at using our capital dollar it's probably best leveraged in the I-5 corridor so that's going to continue to be our primary focus.

Thanks again. Best of luck.

Thanks, Ross. Appreciate it.

Our next question is from the line of [Mr. Theodore Cogalla]. Please go ahead.

Wonder if you could give a little bit more granularity onto the type of assisted acquisition that you might like in terms of size, location, et cetera.

Sure. As I've indicated, I think our primary focus is going to be the I-5 corridor. I think we would probably look at anything I-5 corridor, primarily in the state of Washington. But I think our primary focus would be the Puget Sound region. I think we can best leverage our knowledge of the markets, and close logistics of those markets to the best advantage of the bank. When we talk about Puget Sound market, just to orient everyone, it is essentially from Olympia here on the south end of the Puget Sound all the way north to the Canadian border. But the biggest -- congregation of opportunities are going to be probably from Olympia to sNohomish County, north of Seattle.

In terms of size of deal, we do have a lot of capital. And the beauty of an assisted sale is that it does not affect the risk weighted capital side of the equation much because those assets are not heavily risk weighted that you pick up an assisted sale. But it affect the tangible equity side. I think that's going to be more of our limiting factor. From a size point of view, we could comfortably handle an acquisition 50% of our given size today and possibly even a bit larger if it was an acquisition that was more logistic to our current operations. I think that that's generally what we are looking for. And again, I won't comment on specific activities, but I will repeat, we are active.

Our next question if the line of Mr. Tim O'Brien from Sandler O'Neill. Please go ahead, sir.

Good morning,.

Hi, Tim.

The securities that you took the impairment charge on, can you update us on what those securities were and what they are booked at right now versus their par value? And if there is any potentially any more impairment?

Sure, Tim. I'll ask Don to give a little more color. But I will just remind everybody that the OTTI charges that we are taking are on a mutual fund that was purchased a number of years ago, seven, eight years ago, the Shea Fund which was a mortgage backed fund. And all of our OTT charges are coming from those continued assets. We do not have any trust preferred securities. To my knowledge, no other OTTI charges. It is only on those former Shea funds and I will have Don give you a little bit more color.

Yes, Tim, we are down to $2.3 million in book value on par value of about $4.9 million left on these. The overall decrease in book value during the year was $1.9 million, $1.3 million of that turned out to be in OTTI. We actually had about $600,000 pay downs on that. But our book value is again down to about $2.3 million.

The total unrealized losses in this portfolio is down to under $200,000. And actually of the investment grade portion of that the unrealized loss is down to $52,000. Of course we got these at -- we did the redemption in kind. A lot of these were basically purchased at quite a discount so even though it is an investment grade, it doesn't necessarily mean we will take any losses on some of this. They are getting reduced quite a bit. They are becoming less and less significant to our investor portfolio.

It is safe to say that there is potential for additional OTTI as we work through it, but I think you can see the significance of it is lessening as we march forward.

Right. The accrual rate -- that reversal of your incentive comp, $520,000, $530,000. That was three quarters worth of the run rate -- about $175,000 per quarter so that gives us something to work with. Is that correct?

Yes. Actually, we had accrued through essentially 11 months and then reversed the entire accrual the twelfth month.

All right. Great. That helps. And then another question is regarding your public deposits, another $11 million reduction. Last quarter you talked about how the balances I think of the uninsured deposits were basically $500,000. Those balances are continuing to come down. Should we expect that to continue on a go forward basis?

I think we've probably worked through the biggest chunk of public deposits, in terms of working them out of the bank. We had somewhere -- don't quote me on this, Tim, but I think we had somewhere around $135 million when we started this a year ago. And we have worked it down to somewhere around $60 million today, in terms of public deposits that we still have on our balance sheet.

Our general philosophy has been to run out -- to run the public deposits out of the bank that were just transaction CDs. I think we are probably going to be in the $50 million to $60 million range on a go forward basis of those public entities that we have a total relationship with. We are their bank. We have transaction accounts. We have a number of different services. We will be required I think mid-year this year to -- no, I think we are now. No -- June of this year where we have to fully collateralize it. We are very comfortable in doing that. Have no concerns. That will be about the level we will be on on a go forward basis.

How are those booked? How do they show up on the balance sheet? What deposits do they fall in ? What bucket?.

They are scattered throughout depending on what -- a lot of them are in now accounts. Some are transaction DDAs. They are scattered, depending on the need of the municipality.

No concentrations to speak of?

No.

Switching gears real quick. SBA loan sales, you said overall demand for loans is weak right now, but is the opposite true for SBA demand? Do you think that's sustainable? Could we see some growth beyond this? Is there any chance you would retain those loans and not sell them?

In terms of the potential for growth, I think there is continued potential for growth in the SBA, both on the 7A side and on the 504 side. I don't know yet. I heard portions of the President's speech last night, in terms of the set aside. I think $60 billion for small business loans. I'm assuming that's for the SBA program, but I don't know the details. I'm going to guess that the federal government will continue to augment the SBA program as they have in the last six to 12 months. I think that's going to continue to be an attractive product going forward and I think we've got a pretty good lending unit in that regard.

Yes, I think there will be some opportunities, even though you've got the SBA guarantee you've need to be pretty selective because of the overall environment we are in. As to selling or keeping them, my guess is we will probably continue to sell the guaranteed portion of those loans. We continue to evaluate -- and a lot of that, Tim, has to do on what premiums we can get as we're looking at selling them. If the premiums narrow, then we may keep them to portfolio, but it is really dependent on the premium.

Are SBA premium still 8% to 10%?

A little lower, probably in the 6% to 8%.

Okay. Great. Then just one macro question, with the expectation that loan growth is going to be slow, if nonexistent, I'll look for adding securities. If you continue to bring in these deposits and see good deposit growth, can you give us -- triangulate your strategy for managing risk, but still capturing some -- leveraging those deposits to come in with regard to purchasing securities? And what -- as an ancillary question, what securities did you guys add in the quarter?

Okay, in terms of just a strategy, some of you out there on the call may look at our cash position and say, Brian, why are you keeping so much catch on your balance sheet. Youve got 25 basis points. There is a meaning behind my madness here, A, I like the liquidity. But probably more importantly as we look to the opportunities of FGA assisted sales, many of these broken banks have funding issues. They have federal home loan bank debt. There is a variety of things that are going on with these broken banks and that debt comes across in a purchase.

I want to keep a fairly significant amount of cash so that -- we could use to reduce debt of an acquisition should we be successful in doing so. And by putting it in securities and pulling them out later, you've got interest rate risk in a variety of things. I'm willing to keep a little bit of a war chest there for that primary purpose. In terms of the types of securities we purchased in last quarter, Don, will given you a little more color on that.

We purchased a combination of treasuries and -- treasury purchases for the most were pretty short, two, three years. We also did some CMOs and municipals and a few just plain mortgage backs, pass throughs. It was scattered for different products. Most of what we did purchase we purchased -- even the CMOs were purchased on a short average life basis.

Thank you so much, guys. Appreciate the help.

Our next call is from the line of Mr. Tim Coffey with FIG Partners. Please go ahead.

Thank you. How are you doing? You have been talking about the commercial loan portfolio, commercial industrial loan portfolio for awhile now. I'm wondering since -- at this point, has any trim started to emerge? Has it gotten worse? Has it gotten better?

I don't think any trends -- I said -- as you accurately pointed out, I said for the past couple quarters that we are continuing to see modest deterioration in our CNI portfolio. That's a true statement. I think I mentioned $2.5 million in increases of our potential problem loans came from the CNI sector. I don't see that as an alarming number. I don't see that as a concern. But I think I would be less than honest if I didn't tell you that the CNI customers, I think in this market as well as across the nation, are continuing to experience slowdown in receivables, a slow down in inventory turns, a drop of profitability.

They are feeling the effects of this economy and it is showing in their performance, and that performance is showing up in our potential problem loans. But I don't think it is a number that alarms me, but it is a number that I think we need to stay on top of an we are in terms of managing it. But I see a continued weakness there because, again, I don't think we have hit the bottom of this cycle. But when you put it -- when you compare the CNI difficulties in our portfolio to let's say the construction, no comparison in terms of level of problem loans and severity of problem loans.

Okay. You figure it is wise to keep an eye on it?

I'm sorry.

I'm summarizing what you are saying. The trends are stable, but you think it is worth keeping an eye on?

Absolutely, yes.

What were the total MPAs and problem loans for this quarter?

Let's see. I mentioned that number. Let me find it real quick.

Total nonperforming assets are $33.7 million. Potential problem loans $45.8 million.

Thanks. And do you have any maturing schedule or any idea how much lower -- what movement construction loans will have in the first quarter?

Movement in terms of continued reductions?

Yes.

Yes. We have had I think some pretty strong reduction year-over-year. I think it was 35%. Was that the number? I'm sorry, $35 million, 27%. I do not see that level of reduction continuing. I think as you get into the deepest part of the cycles, typically the deals that are left are the A&D, the dirt deals, that will take some time to work through. I see that piece of the credit -- or piece of the portfolio probably the most problematic in managing out. As a result, I think we can expect the rate of reduction to decline as we move forward.

On the other hand, I think we have adequately allowed for those loans. That's somewhat reflected in our very strong coverage ratio. But if I understood your correction correctly, I think we will see the rate of decline slow a bit as we move through the year.

That's what I was asking for. And then do you have a dollar amount on your commercial real estate exposure -- commercial real estate loans right now?

Yes. I will pull that number in just a moment here.

Commercial real estate is about $400 million.

That includes owner occupied as well as investment real estate. Is that correct, Don?

Mm-hmm.

Thank you very much.

Our next question is from the line of Mr. Eric Grubelich. Please go ahead.

Just as a follow-up to that question on the commercial real estate. If you looked at your portfolio on the investor property side, how much of it would you say was originated before 2007?

I had those numbers in our last quarterly call in and I forgot to bring them with me. We have a significant portion of our commercial real estate that originated prior to 2007. I want to say it was some 60% that was originated prior to '07.

That's fine. The other question I had for you, on another call, another bank in your general area was implying that the month supply of finished lots had come in quite a bit over the last couple of quarters. And I was just curious if you would concur with that trend?

I'm sorry, go ahead.

I was going to ask if you would concur with that view. And then also with respect to your own -- the MPLs and construction and AMD category. Do you see those eventually migrating through foreclosed property or do you see them fixing themselves in another way?

In terms of the reduction in the back log or the inventory of lots, I think that's highly selective to the area that you might be in. We can find pockets of even -- within a county that is substantially different in terms of backlog working down. I will tell you that Thurston County here in Olympia area is one of the stronger counties in the Puget Sound region, in terms of a lack -- in terms of the number of lots in the backlog. In other words, we are in better condition here.

Pierce County, Snohomish County north of Seattle, they are probably fighting neck in neck for ground zero for the problems of backlog of residential housing lots. And I know Pierce County much better than I do Snohomish, so speaking specifically to Pierce County and Tacoma, we might have seen a little bit of improvement. But it is still a very troubled market in that regard. And as I said in my comments, one of the bigger concerns I have as we continue to see bank failures, we are going to see more of that product dumped on the market which is going to put a strain on valuation issues. But we have to do that to work through these problems. In a nutshell, it is highly selective to individual neighborhoods and markets. But overall, yes, slight improvement.

As to the construction migration, again, I think as you get later into the cycle, I think you're probably going -- there is probably opportunities in deeds and lieu activity. But I think we will likely see higher levels of foreclosure activity because as we say around here, we have got to reduce the pile of rocks. We are working hard with strategies to figure out how we reduce the pile of rocks. I'll say, our pile of rocks is a lot lower than most of our folks and we have a bigger coverage ratio. But still, our focus has got to be and it will be on continuing to reduce that, whether it is through deeds and lieu or whether it's through foreclosures. We are going to aggressively focus on that in 2010.

Thanks very much.

You bet. Thanks for the question.

Our next question is from the line of Mr. [Joe Steven from Steven Capital].

Every single question I had has been answered. Keep up the good job.

Appreciate it, Joe. Thank you for the interest.

We have a follow-up question for Mr. Bobby Bohlen.

Yes, as a follow-up to Eric Grubelich's first question on commercial real estate, looking at when they originated. Could you remind us on the investor type property, when do they come up for some type of renewal that you would have to relook at the loans? Follow on to that, what was your impression of the interagency guidance on the commercial real estate workouts?

I'm going to apologize to you. I don't have maturities. Again, I have those and I just didn't bring those with me. But I'm going to tell you that -- maybe Don has them here. Excuse me for just one moment.

I've got it broken down by nonowner occupied and owner occupied, but let me just give you total CRE maturing in 2010 is 7.8%, maturing in 2011 is 5.8%. That gives you an idea. It is not as big a number as we look forward to the next couple years. In terms of -- I'm sorry, I forget the second piece.

Are they generally renewed after ten years?

No. It depends on what you call a renewal. Most of our commercial real estate loans have a five-year rate review which gives us the opportunity to review and reset the rate to a previously established index with a ten-year maturity. Most of them are drawn in that manner.

Okay. A follow-up question was looking at the interagency guidance on commercial real estate workout, I was wondering if you had any comments on guidance at all.

Our credit administration folks have spent a good deal of time with that document. I think generally speaking, we see some positives in terms of how they will have to look at it. I think the key will be the interpretation of the field examiner in each one of these cases because I have seen issues in the past where there is guidance, but there is considerable difference in the interpretation of any one field examiner.

But overall, I think the FDIC -- and in fact -- because of the interagency guidelines, I think all of the regulatory bodies have recognized a need for a little bit of common sense as we look at these performing loans. I think generally speaking that will be a positive factor as we move through this cycle.

Thank you very much.

Thanks for the question.

No more questions, Mr. Vance.

George, I appreciate you're hosting today and all out there that have listened in on the call. I appreciate your interest in Heritage Financial. And as always, I'm available to any of our investors for follow-up discussions. Thanks for your interest and we will conclude the call today.

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