Heritage Financial Corp (HFWA) 2010 Q2 法說會逐字稿

Welcome to the Heritage Financial release conference call. At this time all participants are in a listen-only mode. Later we will conduct a question and answer session. Instructions will be given at that time. (Operator Instructions) As a reminder the conference call is being recorded. I'd now like to turn the conference over to your host, Mr. Brian Vance, please go ahead, sir.

Thank you, Eddie. Thanks to all of you that have called in for our second quarter 2010 earnings conference call and those also that may be calling in later and listening in on recorded versions. With me today is Don Hanson, our CFO. Our earnings press release went out this morning before market open. Hopefully you have had an opportunity to pull that down and copy it and an opportunity to have reviewed it. And please refer to the forward-looking statements in the press release and I'll read a limited version of that. Statements concerning future performances, developments or events, expectations for growth and market forecasts and other guidance on future periods constitute 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 effect of interest rate changes, risk associated with acquisitions of other banks and opening new branches, the ability to control costs and expenses, credit risk of lending activities including changes in level and transit of loan delinquencies and writeoffs, and changes in general economic conditions either national or in the market areas. These factors could effect the Company's financial result. 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 and specifically disclaims any obligations to revise any potentially forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statement. Additional information on these and other factors are included in the Company's filings with the Securities and Exchange Commission.

I'd like to start with highlights of our second quarter. Strong capital position at June 30, 2010 with a tangible common equity to tangible assets ratio of 12.4% and total capital of risk weighted assets ratio of 21.4%. Solid coverage ratios at June 30, 2010 include an allowance for loan losses to total loans of 3.5% and an allowance for loan losses to nonperforming loans of 88.4%. Earnings per share increased to $0.05 for the quarter ended June 30 from a net loss of $0.04 per share for the prior year quarter ended June 30. The net interest margin remained strong at 4.6% for the quarter ended June 30 compared to 4.58% for the quarter ended March 30, 2010. There's also a subsequent event issue. Over the weekend we announced an FDIC assisted acquisition of Cowlitz Bank and we will be addressing this acquisition later in our presentation.

First of all earnings, we posted second quarter net income of $855,000. The Q2 net income applicable to common shareholders including the preferred stock dividends was $523,000 or $0.05 per share, which was an increase from Q1 2010 net income applicable common shareholders of $365,000 or $0.03 per share and a significant increase from Q2 2009 net loss applicable to common shareholders of $239,000 or $0.04 per share. Our total loan loss provision for Q2 is $3.15 million compared to Q1 2010 provision of $3.75 million. Net charge-offs for the quarter were $1.7 million compared to $5.1 million in Q1 of 2010. Due to the decrease in charge-offs our loan loss allowance to total loans increased slightly to 3.45% at June 30 from 3.27% at March 31. Our pretax preprovision earnings before preferred dividends for Q2 were $4.4 million as compared to $4.6 million from the prior year quarter Q2, a 4.4% decrease. Our pretax preprovision ROA was 1.76% for Q2.

Balance sheet, we believe we have a -- continue to have a strong balance sheet. At quarter end other than $15 million of short-term retail customer repurchase agreements, we still have no debt on our balance sheet. At quarter end we held $94 million in overnight interest bearing funds, primarily for Federal Reserve Bank. Our loan to deposit ratio at quarter end was 88.7%, which is a slight increase from 87.7% at Q1. Local date total loans increased approximately $3.2 million during the quarter. Construction loans decreased by approximately $9.6 million, of which $1.6 million were charge-offs and $1.1 million were transfers to OREO. We have total construction exposure of 9.7% of total loans with only 4.6% represented in residential one to four family construction including land development. Total commercial loans excluding commercial real estate grew during the quarter by approximately $15 million due to increases in commercial term loans, agricultural loans and SBA loans.

Our total quarter to date net deposit decreased $6.9 million. We traditionally see cyclical dip in deposits in Q2 due to payment of income and property taxes by our customers. Our non-maturity deposits, again total deposit less all CDs, as of quarter end decreased approximately $6.2 million from Q2 2010. At the same time total CDs declined approximately $688,000 from Q2. The decline in transaction accounts is also consistent with tax payments in that tax payments typically come from transaction accounts. Our non-maturity deposit ratio, or pure deposits, is a very strong 64.4% of total deposits. Differently said total CDs make only up only 35.6% percent of our total deposit and our core deposits are a very strong 79% of all deposits. Net cost of all deposits was 1.09% for Q2. Net interest margin. Our net interest margin for Q2 was a healthy 4.60%. This is a 2%, I'm sorry, a 2 basis point increase from 4.58% in Q1.

Sustained focus on non-maturity deposit growth in pricing CDs generally below area competitors continues to drive cost of funds lower, which is a primary driver to our strong net interest margin. The effective non-accrual loans on the margin for Q2 was 21 basis points. Non-interest income was $2.1 million for the three months ended June 30 compared to $2.3 million for the three months ended June 30, 2009. The decrease was due substantially to decreases in the gain on sale of loans and the gain on sale of OREO. Non-interest expense was $8.5 million for the quarter ended June 30 compared to $8 million for the quarter ended June 30, 2009. The increase was due to increased salaries and benefit expenses in the amount of $503,000 resulting primarily from a slight increase in full time employees and wages. You may recall in 2009 we did not grant merit increases to our entire officer or staff.

Increased marketing expense in the amount of $189,000 due mostly to our checking acquisition program and increase professional services in the amount of $156,000 from additional consultant and legal expenses. These increases were partially offset by a $404,000 decline in the FDIC insurance, mostly due to a special assessment and posted 2009. Non-interest expense increased $399,000 from prior quarter end March 31 due primarily to the increase in marketing and wages described above. Non-interest expense control has been a focus of ours and will continue to be. However, continuing growth related expenses and other expenses such as loan resolution expenses will make it unlikely that we can maintain our goal of efficiency ratio under 60%. For the quarter ended June 30 our efficiency ratio was 65.7% compared to 63.7% for the quarter ended June 30, '09.

Loan quality. Nonperforming loans increased $897,000 and this is mostly due to a variety of events and I'll describe them. $10 million in residential construction loans to a builder/developer of a condominium project in Pierce County. These loans are reported as potential problem loans at March 31, 2010. This was offset by $1.7 million in charge-offs during the quarter, $1.6 of which were construction loans. Nonperforming construction loan balances totaling $1.1 million that were transferred to other real estate owned and subsequently sold and principle paydowns as mentioned earlier, we reduced total construction loans by $9.5 million or 11.5%. Our residential construction loans as of June 30 total $34.7 million. This total breaks down as follows -- Residential land $6.6 million; Single-family homes $9.5 million; and A&D residential $18.6 million.

Our total nonperforming loans of $29.7 million breaks down as follows -- Commercial $3.7 million; Owner occupied real, commercial real estate $800,000; Investor owned commercial real estate $1.8 million; real estate and mortgages $2.8 million; and real estate construction $20.6 million. And I'll break down that $20.6 million further -- Single-family residential $3 million; A&D lots for sale $7.5 million; Commercial construction $100,000; and condos $10 million. Breakout of all potential problem loans of $36.1 million breaks down as follows -- Construction $15 million; C&I $12.3 million; Owner occupied CRE $2.5 million; investor owned CRE $2.4 million; residential mortgages $3.9 million. And a break out by county of all nonperforming and potential problem loans is -- Thurston County 14%; Pierce County 65%; Mason County nearby Shelton Branch is 3%; King County 7%; and all other counties principally involving Central, our Central Valley affiliate at 11%.

Total nonperforming loans plus total potential problem loans were down $6.6 million quarter over quarter. OREO. We added OREO's other real estate owned totaling $1.1 million in Q2, which was substantially sold -- was subsequently sold leaving an ending balance of $1.6 million, which was the same as Q1. Our coverage ratio ended the quarter at a strong 88.4%, up slightly from Q1, which was 86% and our allowance at quarter end was likewise a strong 3.45%. Our coverage ratio remains one of the strongest in the Pacific Northwest. Liquidity, total available liquidity sources, cash and borrowing lines, is over $339 million and as mentioned earlier we have $94 million in overnight cash. The abnormally large amounts of overnight cash are being held for strategic growth opportunities.

A general review of Q2 2010. I would characterize Q2 as one of continued improvement in most all operating metrics. We continue to fine-tune our overall deposit structure and cost of funds. We continue to reduce our construction exposure. Our loan loss provision decreased 16% quarter over quarter and our total potential problem loans decreased 17.3% quarter over quarter. Our non-interest expense growth was signaled in Q1 earnings conference as we execute our growth initiatives, as well as incurring higher loan administration expense and other higher operating costs that others are also seeing. We have continued to focus on maintaining a strong coverage ratio and our coverage ratio improved, as mentioned earlier, to 88.4%, which is one of the strongest coverage ratios of publicly traded banks in the Pacific Northwest. Just some general outlook comments. Our overall review of 2010 is as follows.

Our net interest margin's likely to perform near recent historical levels for the balance of the year; loan growth in the short run will continue to be muted by exiting construction loans and a slow economy, but I am pleased with the $15 million increase in commercial loans during the quarter. We are hopeful we can begin to see overall loan growth in the last half of the year, as our externally focused loan growth programs begin to gain traction and as we begin to build out our recent acquisition. We will likely to continue to see modest increases in non-interest expenses as we continue to execute growth strategies. And we are likely to see a slight reduction to overall non-interest income as future regulatory changes impact checking account fees and charges. These two factors will likely cause our efficiency ratio to show modest increases. We continue to see stubborn pockets of economic recession in certain markets and continue to see real estate value deterioration and high unemployment.

As we've discussed on several occasions we intend to build, to add two new branches to Heritage Bank in the next six months. And the first will be announced soon and the second later this year or early next year. I'd like to reiterate the following points. We are a strongly capitalized Company with a risk rated capital of 21.4% and a tangible common equity ratio of 12.4%. We have strong liquidity position and a strong net interest margin. Strong coverage ratio of 88.4% and our current single-family construction exposure currently is much lower than most of our peers at 4.6% of total loans. With our strong capital and liquidity positions I believe we are well positioned to strategically grow our Company. And now I'll move on to the subsequent event issue I mentioned earlier.

Perhaps most of you know that on Friday evening we announced the FDIC assisted sale acquisition of Cowlitz Bank. I will highlight the transaction and ask Don Hanson to fill in some color on the numbers. We acquired nine branches of Cowlitz in Bay Bank, which was a division of Cowlitz Bank. The branches are all located directly on the I5 corridor; one branch in downtown Portland, Oregon; another approximately 30 minutes south of Portland in Wilsonville, Oregon; one branch across the river from Portland in Vancouver, Washington; four branches in Cowlitz County with the principal location of their head office in Longview; one branch in Bellevue, Washington; and one branch in downtown Seattle. Bay Bank operates as a division of Cowlitz Banks and operates in the more metropolitan areas of Portland, Vancouver, Seattle and Bellevue.

We also obtained approval for trust powers and we will operate a trust Company owned by Cowlitz previously owned by Cowlitz Bank. The trust Company has approximately $57 million in assets. Cowlitz has a, also has a fully functional, a functioning international department located in Seattle. We believe this acquisition gives us a nice regional bank from Portland to Seattle and all points in between and of course our Central Valley Bank affiliate in central Washington. We realize we have a small presence in these new markets of Portland, Vancouver, Bellevue, and Seattle, but we also believe this gives us an excellent opportunity to build out our franchises in these growth markets. This acquisition also gives us a number one market share presence in Cowlitz County. Our winning bid was under what the FDIC called a modified bank with loss share.

Essentially what this means is certain loans were retained by the FDIC to later sell in a secured [high] pool. They also retained all brokerage CDs. Additionally, they retained all nonperforming assets, all other real estate owned, all past due loans beyond 60 days and all past maturity loans over 30 days. This is about as clean of a bank as one can get in an assisted deal. This does not mean there will be no NPA loans as a result of this acquisition, because undoubtedly there will be certain loans that may evolve into nonperforming status as we move through the analysis and final simulation of this portfolio. All loans acquired, with the exception of approximately $2 million in consumer loans, will be covered under an 80/20 loss share agreement. There are still some remaining so-called Internet CDs or also quick rate CDs, et cetera, that we are acquiring, but we will immediately reduce these rates and we believe most of these deposits will run off over the next 60 days or so.

We also believe the transaction will bring cash with it to substantially cover the runoff of these Internet CDs. Don will cover this in more detail for you. At the conclusion of this we believe we have an attractive, non-maturity deposit base exceeding 70%, which is quite unusual for an assisted transaction. The remaining loans will also be an attractive mix of C&I, owner occupied CRE and investor-owned CRE. We believe because of the relatively clean loan portfolio we can immediately focus the acquired lenders on organic loan growth activities. We believe the lenders are anxious to market Heritage Bank in their markets and to focus on loan growth, something they have not been able to do for some time now.

These new markets also give us an opportunity to potentially acquire other lenders from ongoing market dislocations that previously we have not been able to easily do because of our lack of physical presence in these new market areas. We met with all of the former Cowlitz employees yesterday and it's obvious to us that they are eager to tell the Heritage story and are very excited to be a part of a team focused on growth opportunities. Jeff Deuel, our recent addition to the executive management team of Heritage has the day-to-day responsibilities of integrating our new team at Cowlitz.

As in all FDIC assisted deals, the final settlement has not been completed so all of our numbers are rough estimates that are likely to change in final form, some potentially materially, so please do not rely on our early estimates until we can later report these numbers to you more accurately, but Don will give you a bit more color on some of these numbers. We believe this transaction will be accretive to our shareholders during 2011. However, due to the modified bid structure of this deal, substantial earning assets were removed from the transaction muting future short-term earnings somewhat, but we believe the new markets we obtain in the deal, along with a clean bank structure, provides us with substantial long-term profitable growth opportunities. Or in other words, management needs to build out this franchise and we believe we can do so and are excited about the possibilities this acquisition brings to us. So with that overview I will ask Don to go through some of the numbers for you as well.

Thanks Brian. As Brian mentioned, we have only rough estimates at this time of the assets we will acquire and the liabilities that we will assume. The FDIC has informed us they are providing us with a pro forma balance sheet later this week and that will clarify a lot of the numbers. I knew the (inaudible) that bid on the transaction was $8.8 million. In addition we paid a 1% deposit premium on deposits, excluding broker and marketplace CDs. We have some additional result in a deposit premium of less than $2 million. As stated in their (inaudible) we estimate that we will acquire approximately $280 million of assets and $350 million of deposits. Of the assets acquired we have initially estimated that the loans received would be approximately $152 million. This is a conservative estimate based on the information available at this time. The FDIC in their press release initially estimated that we acquire approximately $161 million in loans.

The most recent information on loans acquired by type are as follows, this is just based off again most recent information on the GL that obtained -- Commercial loans 47%; commercial real estate 38%; construction 4%; one to four family mortgages 5%; and consumer 6%. Included in other assets we acquired is approximately $35 million in securities. The FDIC retained approximately $22 million of the bank's investments as part of the acquisition. Of the investments acquired approximately 52% are US agencies and 40% are mutual securities. The remaining securities are CMOs.

We estimate that we will be assuming approximately $350 million in deposits, approximately half of which are marketplace receiptor CDs. We plan on running these off using the cash obtained in the acquisition. We will be using some of Heritage cash if needed to supplement any cash needed in the run off of these CDs. Of the remaining deposits obtained, approximately 29% are demand deposits, 45% are non-maturity interest bearing deposits; and 26% are in CDs. Therefore exclusive of the marketplace and SEDAR's CDs, we are estimating that approximately 74% of the remaining deposits assumed will be non-maturity deposits. We will be acquiring approximately $74 million in cash and cash equivalents from Cowlitz Bank. In addition we will be receiving cash from the FDIC for the difference between the assets and liabilities acquired adjusted for the net asset bid the deposit premium.

We're estimating that our pro forma tangible common equity to tangible assets ratio will be approximately 9.2%. After the cash has been used to fund the runoff of marketplace CDs we expect it will not be a substantial effect on our go forward net interest margin as we've reported historically. We expect the transaction to be slightly accretive to earnings in 2011. The effect on 2010 earnings will depend on the bargain purchase gain at any recognized during 2010. Again, these are our best estimates at this time on the transaction.

Thank you, Don. I would welcome any questions you have and would once again refer to our forward-looking statements in our press release as answering the questions dealing with any items we have discussed with you here this morning. So with that, Eddie, I would invite you to open the conference up to questions.

(Operator Instructions) Our first question is from Jeff Rulis with DA Davidson, go ahead, please.

Morning.

Hi, Jeff.

Question about the loans that were retained by the FDIC. If you could, from what you know, the process of the loans that they kept. Were they certain classes, were they stratified by quality or from your perspective what was that process like?

Well, that's a difficult one to get our arms around fully and as hopefully everyone can understand that have been involved in these transactions, the FDIC assisted sales, or are involved in evaluating these, in this early on process there is still a variety of lots of things are being settled and so these numbers are estimates. In terms of the numbers, the loan they retained, it appeared to us that they were retaining loans that were fairly easily sold into the secondary market in a securitized pool. Most of them were CRE loans, investor owned CRE loans. It's hard to determine any sort of percentages as to, let's say, overall quality of that pool other than to say that most of them were investor-owned CRE. And that's, I think very candidly, probably the least likely loan we would have wanted to retain just because of CRE concentrations that most community banks are trying to minimize today.

So I'm very comfortable with the loans that the distribution of the loans left behind from the stand point, as Don shared with you, a predominate share are the traditional C&I and I think that's what we saw in this, in Cowlitz Bank. It's traditionally a C&I bank, both with the types of loans they make and the deposits that they have. Yes, they had a very high number of brokage CDs and market rate CDs, which largely funded the strong CRE focus they had, which were essentially the loans that were retained. So, Jeff, roundabout long-winded answer to, but that's about as near as I can get it today.

Got it, okay. So they were -- your bid was excluded -- in other words you weren't shown the portion that they were retaining. That was -- they asked you to bid on that with these investor CRE loans stripped out.

That's correct.

Okay. On the cost size of Cowlitz, obviously you have got to run some numbers, you are not taking the whole thing down. I guess, what are your initial expectations for cost savings or have you budgeted that.

We certainly have taken a quick look in all of our pro forma numbers we are doing and in terms of assuming certain cost saves I think I would probably just stay with the statement that we believe it will be slightly accretive in 2011. I think, Jeff, my statement of in a modified bid structure they do pull out a substantial amount of earning assets, which makes go forward earnings a bit more difficult than just a whole bank transaction. But the flip side of it is that you're getting a relatively clean bank and we have the ability to, I think, remove most if not all of the remaining Internet CDs and be left with a very nice attractive core deposit base and a relatively clean portfolio. So having said that our ability to reduce our costs and to make it accretive in 2011, we believe we can do that, but as I also said I think the bigger opportunity here is building out the franchise in some markets that we haven't been in and I think some nice growth markets for us.

Okay. And then just a last one on sort of the capital, Don, you said that PCE pro forma was 9.2. Is that correct?

Yes, sir, for an estimate.

Okay. And in terms of what that impact, I guess, what does that do if any change your perception of leaving any room for additional deals if your thinking about TARP repayment, obviously not on the TCE side, but your impact on the total risk based. If you could comment on just appetite for additional deals and/or, I guess, maybe timing of the TARP repayment if anything has changed there.

I don't think anything has necessarily changed on the TARP side and as you said, Jeff, you know that doesn't effect the TCE side of things. And I think that with the TCE that's left it still gives us room for additional opportunities and we will certainly be considering additional opportunities as they may materialize.

Okay, thank you.

Thank you, Jeff..

Our next question is from Eric Grubelich, private investor, please go ahead.

Oh, hi. Good afternoon. Just wanted to follow-up on a question about the loan portfolio and the deposits. The first thing on the loan side, do you have an estimate of what the loan yield will be on the acquired loans.

No, because of the and hopefully folks will understand that we've owned the bank for two days now. And yes, we had an opportunity to do due diligence, but because of the loan pools that are being pulled out by the FDIC it's really hard for us to analyze any resulting yield. I think we can say, as Don indicated earlier, we are comfortable that with the loans that are left and the deposits that are left that we can maintain our existing net interest margins.

Okay. And then on the, if I heard you correctly, this is, Cowlitz is primarily a business bank so the nature of the deposits that your retaining are mostly business like your own portfolio of not so much on the retail side?

Yes and I think, as we indicated, the interesting thing is it appears that early analysis that the non-maturity deposits it will actually be accretive to our non-maturity deposit currently, which is a very strong 64%. Don I think you indicated DVA is estimated to be what percentage -- it was. On the non-Internet or the marketplace ones I think we 70% something of what we earned -- sorry, 24% or 29%. And I think any holy Grail in the banking world of NDDA is 20%, so that's a very nice resulting number as well.

Okay thanks for much.

Think you.

Our next question is from [Jah Jemera], KBW, please go ahead, sir.

Hi, it is actually Faki. Goof morning. I just had a few quick questions. For the loans that the FDIC retained, will you be doing the servicing on those?

Yes we will. For a period of time yet to be determined, but yes we will be servicing those.

Okay. And do you see that as being any sort of -- I guess it probably won't be all that meaningful to see income but is it something that will add a bit?

It's hard to say at this point, Jackie, but I don't think it's going to be accretive. I think it will cover our costs and that's basically how we're looking at it.

Okay. And then also you had some nice growth in the commercial, the legacy commercial portfolio this quarter were those new customers or was that just line growth of existing customers?

I don't have a specific color on that. My sense is is that the biggest portion of that is advancing of additional lines of credit. Agricultural lines of credit, build through our Center Valley Bank affiliate build through the summer months, as you would expect. There were a few new relationships in there on the professional side, as we've talked about we're focusing on professionals. We believe we do that well, but we're refocusing on that and we have picked up some new professional business, but I would say 80% of that number, just as a guess, is probably advances from existing customers.

Okay. So do you take that to mean that existing customers are feeling a bit more comfortable and are starting to do a little bit more business.

Well, I would like to say that, but I really think it's probably more just cyclical nature of borrowing relationships. As I indicated we're still seeing some pretty difficult economic times in the Pacific Northwest, so no, I don't think I could go quite that far without sort of a positive statement. Wish I could, but not quite there yet.

Okay. And then just my last question, I know that there were no NPAs acquired, but did the portfolio that you acquired include any 30 to 89 days.

No, because of the, again, as per the modified structure, there are -- they retained, the FDIC retained all past dues beyond 60 days and all past maturities beyond 30 days. So again, you can see as you take out the non-performing, the OREOs and past-dues, again, a relatively clean portfolio left behind.

Okay, great. Thank you very much.

Thank you.

Our next question is from Tim O'Brien with Sandler O'Neill, please go ahead.

Good morning.

Hi, Tim.

It looked like at the end of March Cowlitz had $20 million in construction related loans, on their car port anyway, and $14 million was non-accrual and 30 to 89 day past-due, did you pick up a few construction loans there.

Yes, we did.

Probably about 4% of what we'll get is about construction, probably.

4% of that $152 million?

Yes.

Okay. And then the two branches in metro Seattle. I was looking at the deposit trends at Cowlitz over the past four or five years over the weekend and it looked like they had deposits that shrank materially, maybe 75% or something. In the context of that can you tell us what you think you have there and what you'd like to try to do, what you are going to work towards in the Seattle metro area. Just give a little color there.

Tim, I think that in probably the deposit runoff that Cowlitz has experienced over the last year or so, it's probably not too dissimilar to other troubled banks. I think this is -- I think this typically happens. Again, I really like the deposits that we do have that do come across to us in terms of the percentage of non-maturity deposits, but I think probably that the bigger opportunity and maybe what your question gets to is is that and in talking to the lenders and all of our branch folks in these markets, they're excited about the strength, the balance sheet strength, the capital of the organization, the focus on growth and they're probably, as we speak, are calling these customers with the intent of getting those deposits and relationships back.

Now, I'm not so naive enough to think that is going to happen overnight, because I do believe that this is a longer term strategy that it's going to take us a little bit of time to build the franchise back and to build it out in the metropolitan market. It gives us that exposure and it gives us the entry to the markets and now we need to build it out and I'm excited about the opportunities of building it out over time.

So in the context kind of the overall deal, how did it change your opportunity horizon in your view. Now that you have entry into Oregon and also into the metro Seattle area, what are you -- does it change your thinking based on where you were two weeks ago?

I think it does, Tim, in a couple ways. There have -- we have had opportunities, especially in the King County markets from time to time of potentially bringing on lenders. But without a physical presence is difficult to do that. Now with a physical presence, as we come across lenders and/or lending teams, I think the ability to attract someone into a operating physical presence is quite a bit more attractive to us. It gives us just a market presence that we intend to build off, both organically and the other opportunities it gives, I think, is future FDIC assisted transactions to the extent that any become available in these markets that should we be successful in bidding on those now in the same markets we have the ability to consolidate and reduce costs even that much more or to become more efficient with facilities, marketing dollars, all those sorts of things. So I think the potential long-term synergies that it provides are attractive to us.

Are you comfortable. Do you like the physical plants of the branches that you could potentially be inheriting here and do they fit with what Heritage Financial, the quality of Heritage Financial branches.

Yes, I think so. When we look at the Cowlitz County branches, these again are your traditional commercial banking operations. They're very solid activities in those markets. We now have the number one market share in Cowlitz County. When we get to the metropolitan markets of Vancouver, Portland, Seattle, Bellevue overall like the locations. There may be one or two that we may want to tweak. The other thing is is that there's probably some additional space in some of these facilities, these leased facilities that we will want to reduce costs and may not need as much space, but the overall quality and exposure is -- the quality and market exposure that these branches have we're pleased with your.

And in the long view MSA it looked like looking at last year's data about 49% market share Cowlitz had. If you exclude, I guess, the domiciled deposits that are not really from the local area, brokered CDs, Internet deposits, do you know what that core number would be on a dollar basis relative to the -- . Can you give me that?

No, I don't have that, Tim.

You know how much in Internet deposits they had on a dollar basis?

Yes. Don, can you get that number for you.

Hold on.

Did you leave any of the Internet deposits behind or did those all come over. , the FDIC just for everyone out there th

Well, they all -- the FDIC retained all brokerage CDs and just for everyone out there, there is a legal distinction and a difference between a brokered CD and an Internet CD and so the FDIC retained the brokerage CDs, however the Internet or money desk CDs or quick rate, there's lots of different names for these CDs because they are each individual CDs in the names of individual customers all over the US and those amount to what, Don, roughly..

Internet CDs look like they're about a little less than 170.

Okay. And last question is in the 60 day period between now and when you feel like the effects of your repricing strategy are going to really set in, its reasonable to assume that the cost of those, bearing those CDs even at your adjusted rates are going to have a impact, a negative impact on your overall deposit costs just because there is a substantial amount of those. Is that the right way to of this?

We're going to be lowering those rates quickly and very soon.

But just from a mix endpoint.

Well, I guess I'm not understanding your question, Tim. As far as we expect them to be gone within 60 days. Okay. Because we lower the rates, they are not going to want to keep them here.

Yes. But still even if you price them at your existing -- kind of within the profile of our existing CD pricing structure, the fact that there is a sizable amount, $170 million that -- I don't know, to the degree that some of them stick around even at that cost, that mix affect relative to your legacy core deposit profile might have a negative drag on overall cost of deposits. Does that make sense? Is that possible?

It's possible, but I'm not expecting them with what the price that we're going to be putting on the CDs that they're going to be sticking around.

Okay that's it for me. Thanks, I'll step back.

And, Tim, I'm not sure that you could assume that we will lower the cost to just our normal CD rates. It may even be less than that.

All right. Thanks a lot, you guys.

Thank you, Tim.

Our next question is from Ross Haberman with Haberman Management Corp, please go ahead.

How are you , gentlemen. Nice acquisition. Thank you, Ross. Assuming you do let all these high-cost CDs run off, what percentage of the total deposits could that represent as a runoff.

About half.

Half, okay. So that's about $120 million.

No, I think it is a little bit more than that.

Okay.

We are expecting to get about $350 million in total deposits.

Okay. All right. So you are going to lose perhaps 160 to 170 you are saying.

Correct.

Okay. Assuming that that happens or possibly happens, do some of the branches become uneconomical?

Yes. Most of the, as you would expect with brokered CDs in Internet CDs, they are typically housed at the head office location and that's true with this. I think that when you take whatever total deposits we end up with and you divide them by nine branches you are going to have smaller branches than we are a custom too. I think that's probably the resulting reality here and once again this gets back to building out the franchise. There are some branches that have very strong deposits and I'm talking primarily those that are in the Longview areas, but some of the other branches in more metropolitan areas we really need to focus on deposit growth and core deposit growth and building those into branches that are average deposits of $40 million, $50 million. And that is not going to happen overnight. That is going to be a three to five year build out on some of those, but again that's the growth opportunities that we're actually excited about.

But net, net, net, even with this deposit run off do you think it will be accretive in calendar 2010?

No, 2011.

2011. And just one final question, have you calculated the net gain or because of the way you bought it there's not going to be much net gain or adjustment to your book value after the acquisition?

Of course, we do our estimates, but that's really all they are are estimates. We believe that there is likely a small gain in this transaction.

Got it. Thanks, guys, the best of luck.

Thanks, Ross.

Our next question is from Tim Coffey with FIG Partners. Please go ahead.

Morning, Brian, morning, Don.. Hi, Tim. (inaudible) Brian, do you feel that the go forward volatility in your NPA's are starting to decline compared to the(inaudible) you are seeing about volatility in the first-quarter?

I believe so. When we take a look at the overall NPA's and problem loans, I think it was they decreased $6.6 million quarter over quarter. Yes, there was lots of movement. We had 10 million essentially we had $10 million move into nonperforming represented by the condo construction loan. It's a completed condo project, of which units are still selling, but we also moved out about $9 million of nonperforming loans, so it was kind of a wash. But I think that, yes, the volatility, I think, will slow and I think as we work through the balance of the year we will continue to see our NPAs reduced. I think we hit a high in our NPAs in Q3 of last year and I still do believe that that is a high water mark.

Okay. As we move forward is there a reserve level that you feel comfortable with?

Well, I think the reserve levels are largely driven off of the loan loss methodologies that regulators and accountants like us to work with. I think having said that, I do believe that loan loss allowances are going to higher going forward from a historical point of view, without holding me to this number. I think the number that I am probably going to be looking at is in the 2% range. But of course, that will be driven by the, by a variety of the loan loss methodology process, but, yes, higher than historical.

Okay. That is more of midterm to long-term goal, right. Or target, I should say.

Yes.

Okay. I heard your comments on the new C&I loans that you brought on the books this quarter. Could you drill a little bit deeper what are the balance sheets of your clients looking like right now? Are they improving?

Oh, it depends. A customer -- various customers, like customers, but in a general sense, no, I probably wouldn't say that the balance sheets are improving. I think that we're seeing revenues decline, we're seeing cash balances decline, but I think in some cases when we see a cash balance decline our borrowers are reducing debt, just as banks are across the US. I think they're improving their leverage, they're not making new capital expenditures, but with declining revenues and then depending on how they react to declining revenues, can they react quickly enough to right size the fixed and variable costs to where they can show profitability, that various customer to customer, but I think it's fair to assume that most C&I borrowers are still feeling the stresses of a no growth economy and I think I could continue for some time yet.

Okay. And the -- it sounds like from reading the press release you still expect some possible declines in real estate values in your market the next quarter or two, would it be safe to say the trajectory of those declines are starting to flatten out.

Most definitely. I think that, specially on the single-family side, we are seeing the values, the decline in values decrease, but I think the single -- and again this is in pockets. In some market areas, and there is a few isolated areas that actually showed most recent numbers where single-family values increased slightly. But if you take all of the markets we do business with, it is safe to say that those values are continuing to decline, albeit at a smaller level. And my guess is it will continue to decline until probably well into the 2011, but at a slower pace.

Okay. Those are all my questions. Thank you.

Our next question is from Jeff Rulis with DA Davidson. Please go ahead, sir.

Hi, guys, sorry, I had a follow-up. I guess I'm having some trouble wrapping my head around the modified structure in regards to expenses. I guess in a sense if you're operating the full franchise of Cowlitz with a lower number of assets due to the assets that were retained by the FDIC. Outside of the servicing portion that you mentioned earlier, I guess, does that lead to staff reductions or if I read you right in the near-term I guess you have got elevated costs associated with this and you sort of wait to grow into that current staffing level?

A couple of comments, Jeff. I think your initial analysis in terms of a smaller asset base spread against the existing infrastructure, something's got to give. And we understand that, so we do understand that expenses have to be reduced and we will be focusing on reduced expenses. And we do believe there will be staff reductions. To what extent, we can't determine at this point, but that's probably why we don't believe that it will be accretive in 2010, but will be accretive in 2011. We really do and really will focus on reducing those expenses as quickly as we can as we move through this process.

So initially if we looked at the historical level of cost at Cowlitz, I guess that's a good place to start or a good ballpark and then we can work on efficiencies from there.

Yes, I know what you're getting at. You trying to build your models and I wish I could give you some guidance there, but we -- again, this transaction is two days old, so -- but, yes, we will be reducing expenses, overall expenses.

Right. Okay I appreciate it, Brian, that's helpful. Thanks. Yes, thanks, jeff.

Okay, our next question is from Eric Grubelich, a private investor. Please go ahead.

Yes, just a follow-up on that last question. So under this type of transaction, this modified bank structure, do you still have full leeway to break contracts, leases, IT all of that stuff or not.

Absolutely. That does not change. The modified structure, the 80/20 loss share continues. The modified structure really only deals with the retention of certain assets and certain liabilities. All other aspects of -- it's still a bank in receivership and all contracts are null and void. All of the protections that we get under the loss share agreement under a whole bank transaction in a modified are still present and in force. Thanks for clearing that up. Sure

(Operator Instructions)

Well, if there are no additional questions, again, I certainly appreciate your interest today in tuning into our second quarter earnings conference call. We were excited about the opportunities this acquisition brings to us. It brings us new markets, it brings us an opportunity for growth, we certainly understand and realize we need to get the expense reduction and will do so as quickly as possible. But I think the important story, yes, the important thing I would like to leave you with is is that it gets us into some very strong growth markets and when they say growth markets we understand we're still operating in difficult economic times, but I would say historically and traditionally growth markets that I think that your management team is excited about the opportunities of building out and I think we will be successful to build those out over time. So thanks for your interest today and we will stay in touch as time moves on here.

Ladies and gentlemen, that does conclude the conference today. This conference will be available for replay after 3 PM until August 16th at midnight. You may access the AT&T Executive Playback service at any time by dialing 1-800-475-6701 and entering the access code of 163737. International participants may dial in at 1-320-365-3844. Again those numbers are 1-800-475-6701 or international 1-320-365-3844. That does conclude the call today, thank you for your participation and for using AT&T Executive Teleconference services. You may now disconnect.