The following discussion is intended to assist in understanding the financial condition and results of the Company. The information contained in this section should be read with the unaudited condensed consolidated financial statements and its accompanying notes, and the December 31, 2007 audited consolidated financial statements and its accompanying notes included in our recent Annual Report on Form 10-K.

Statements concerning future performance, developments or events, expectations for growth and market forecasts, and any other guidance on future periods, constitute forward-looking statements and are subject to a number of risks and uncertainties, which might cause actual results to differ materially from stated expectations. Specific factors include, but are not limited to, the effect of interest rate changes, risks associated with acquisition of other banks and opening new branches, the ability to control costs and expenses, and general economic conditions. Additional information on these and other factors, which could affect our financial results, are included in our filings with the Securities and Exchange Commission.

Overview

Heritage Financial Corporation is a bank holding company, which primarily engages in the business activities of our wholly owned subsidiaries: Heritage Bank and Central Valley Bank. We provide financial services to our local communities with an ongoing strategic focus in expanding our commercial lending relationships, market expansion and a continual focus on asset quality. Effective January 8, 1998, our common stock began to trade on the NASDAQ National Market under the symbol "HFWA".

The following table provides relevant net interest income information for selected time periods. The average loan balances presented in the table are net of allowances for loan losses. Nonaccrual loans have been included in the tables as loans carrying a zero yield. Yields on tax-exempt securities and loans have not been stated on a tax-equivalent basis.

                                                     For the Three Months Ended September 30,
                                                     2008                                2007
                                                    Interest                            Interest
                                         Average     Earned/    Average      Average     Earned/    Average
                                         Balance      Paid       Rate        Balance      Paid       Rate
                                                              (Dollars in thousands)
Interest Earning Assets:
Loans                                   $ 795,093   $  13,692      6.85 %   $ 789,752   $  15,779      7.93 %
Taxable securities                         31,550         425      5.36        35,153         415      4.68
Nontaxable securities                       5,638          50      3.54         4,761          44      3.68
Interest earning deposits                   2,944          15      1.98         1,928          25      5.23
Federal Home Loan Bank stock                3,392          11      1.33         3,227           5      0.60

Total interest earning assets           $ 838,617   $  14,193      6.73 %   $ 834,821   $  16,268      7.73 %
Non-interest earning assets                59,626                              58,344

Total assets                            $ 898,243                           $ 893,165

Interest Bearing Liabilities:
Certificates of deposit                 $ 335,209   $   2,762      3.28 %   $ 359,543   $   4,423      4.88 %
Savings accounts                           96,363         428      1.77        79,445         382      1.91
Interest bearing demand and money
market accounts                           250,682       1,062      1.69       226,007       1,539      2.70

Total interest bearing deposits           682,254       4,252      2.48       644,995       6,344      3.78
FHLB advances and other borrowings         10,768          85      3.15        31,135         446      5.69

Total interest bearing liabilities      $ 693,022   $   4,337      2.49 %   $ 696,130   $   6,790      3.87 %
Demand and other non-interest bearing
deposits                                  105,598                             105,884
Other non-interest bearing
liabilities                                 5,382                               7,324
Stockholders' equity                       89,241                              83,827

Total liabilities and stockholders'
equity                                  $ 893,243                           $ 893,165

Net interest income                                 $   9,856                           $   9,478
Net interest spread                                                4.24 %                              3.86 %
Net interest margin                                                4.66 %                              4.50 %
Average interest earning assets to
average interest bearing liabilities                             121.01 %                            119.92 %

                                                      For the Nine Months Ended September 30,
                                                     2008                                2007
                                                    Interest                            Interest
                                         Average     Earned/    Average      Average     Earned/    Average
                                         Balance      Paid       Rate        Balance      Paid       Rate
                                                              (Dollars in thousands)
Interest Earning Assets:
Loans                                   $ 779,546   $  41,366      7.09 %   $ 764,240   $  45,329      7.93 %
Taxable securities                         33,555       1,194      4.75        35,703       1,240      4.64
Nontaxable securities                       5,404         145      3.58         4,784         133      3.71
Interest earning deposits                   7,046         134      2.55         2,649         105      5.31
Federal Home Loan Bank stock                3,284          31      1.25         3,227          13      0.53

Total interest earning assets           $ 828,835   $  42,870      6.91 %   $ 810,603   $  46,820      7.72 %
Non-interest earning assets                57,773                              58,263

Total assets                            $ 886,608                           $ 868,866

Interest Bearing Liabilities:
Certificates of deposit                 $ 346,397   $   9,827      3.79 %   $ 349,388   $  12,702      4.86 %
Savings accounts                           89,537       1,155      1.72        83,816       1,217      1.94
Interest bearing demand and money
market accounts                           239,601       3,318      1.85       211,563       4,051      2.56

Total interest bearing deposits           675,535      14,300      2.83       644,767      17,970      3.73
FHLB advances and other borrowings          8,844         261      3.95        32,094       1,372      5.71

Total interest bearing liabilities      $ 684,379   $  14,561      2.84 %   $ 676,861   $  19,342      3.82 %
Demand and other non-interest bearing
deposits                                  107,290                             102,452
Other non-interest bearing
liabilities                                 6,526                               7,180
Stockholders' equity                       88,413                              82,373

Total liabilities and stockholders'
equity                                  $ 886,608                           $ 868,866

Net interest income                                 $  28,309                           $  27,478
Net interest spread                                                4.07 %                              3.90 %
Net interest margin                                                4.56 %                              4.53 %
Average interest earning assets to
average interest bearing liabilities                             121.11 %                            119.76 %

Financial Condition Data

Total assets increased $19.1 million (2.2%) to $905.2 million as of September 30, 2008 from the December 31, 2007 balance of $886.1 million. Deposits increased $18.8 million (2.4%) to $795.1 million as of September 30, 2008 from the December 31, 2007 balance of $776.3 million. For the same period, net loans, which exclude loans held for sale but are net of the allowance for loan losses, increased $30.4 million (4.0%) to $799.3 million as of September 30, 2008 from the December 31, 2007 balance of $768.9 million. Commercial loans continue to be the largest segment of loans at 54.9% and 54.0% as a percentage of total loans as of September 30, 2008 and December 31, 2007, respectively.

Earnings Summary

Earnings for the nine months ended September 30, 2008 were significantly affected by losses totaling $1,259,000 ($818,000 net of tax) relating to the Company's investments in the AMF Ultra Short Mortgage Fund. These losses resulted from an other-than-temporary impairment charge in the second quarter of 2008 totaling $1,112,000 ($723,000 net of tax) and a subsequent third quarter redemption-in-kind totaling $147,000 ($95,000 net of tax) in which fund shares were exchanged for a pro-rata share of cash and underlying securities in the fund.

Net income was $0.31 per diluted share for the three months ended September 30, 2008 compared to $0.44 per diluted share for the three months ended September 30, 2007, a decrease of 29.5%. Net earnings for the three months ended September 30, 2008 were $2,081,000 compared to $2,933,000 for the same period in 2007, a decrease of 29.0%. Net income for the nine months ended September 30, 2008 was $0.99 per diluted share compared to $1.19 per diluted share for the same period last year, a decrease of 16.8%. Net earnings for the nine months ended September 30, 2008 were $6,545,000 compared to $7,933,000 for the same period in 2007, a decrease of 17.5%.

Return on average equity for the quarter ended September 30, 2008 was 9.3% compared to 13.9% for the same period last year. Average equity increased by $5.4 million to $89.2 million for the three months ended September 30, 2008 versus $83.8 million for the same period last year. For the nine months ended September 30, 2008, the Company's return on average equity was 9.9% compared to 12.9% for the nine months ended September 30, 2007. Average equity for the nine months ended September 30, 2008 increased $6.0 million to $88.4 million from $82.4 million for the nine months ended September 30, 2007. The Company's capital position remains strong at 9.81% of total assets as of September 30, 2008, an increase from 9.19% at September 30, 2007.

Net Interest Income

Net interest income before provision for loan losses for the three months ended September 30, 2008 increased 4.0% to $9,856,000 from $9,478,000 for the same quarter in 2007. Net interest income before provision for loan losses for the nine months ended September 30, 2008 increased 3.0% to $28,309,000 from $27,478,000 for the same period in 2007. The net interest margin (net interest income divided by average interest earning assets) increased to 4.66% for the current quarter from 4.50% for the same quarter last year. The net interest margin increased to 4.56% for the nine months ended September 30, 2008 from 4.53% for the same period in 2007.

Interest income decreased $2.1 million or 12.8%, for the three months ended September 30, 2008 as compared to the third quarter last year and interest expense decreased $2.5 million or 36.1%, during this same period. Interest income for the nine months ended September 30, 2008 decreased $4.0 million, or 8.4%, as compared to the same period last year and interest expense decreased $4.8 million, or 24.7%, during this same period. Net loans averaged $795.1 million with an average yield of 6.85% for the three months ended September 30, 2008 compared to average net loans of $789.8 million with an average yield of 7.93% for the same period in 2007. Net loans averaged $779.5 million with an average yield of 7.09% for the nine months ended September 30, 2008 compared to average net loans of $764.2 million with an average yield of 7.93% for the same period in 2007. Certificates of deposit averaged $335.2 million with an average cost of 3.28% for the three months ended September 30, 2008 compared to $359.5 million with an average cost of 4.88% for the same period in 2007. Certificates of deposit averaged $346.4 million with an average cost of 3.79% for the nine months ended September 30, 2008 compared to $349.4 million with an average cost of 4.86% for the same period in 2007.

Provision for Loan Losses

The provision for loan losses was $1,760,000 for the three months ended September 30, 2008, an increase of $1,550,000 over the provision for loan losses during the third quarter of 2007 of $210,000. The provision for loan losses was $2,830,000 for the nine months ended September 30, 2008 an increase of $2,260,000 over the provision for loan losses during the same period of 2007 of $570,000. The increase in the loss loan reserves was mostly related to management's assessment of the increased risk in the construction loan portfolio and its current economic environment as well as increases in nonperforming loans.

Non-interest Income

Non-interest income increased 2.7% to $2,251,000 for the three months ended September 30, 2008 compared with $2,191,000 for the same quarter in 2007. Non-interest income increased 4.9% to $6,771,000 for the nine months ended September 30, 2008 from $6,453,000 for same period in 2007. The increases for both the three and nine month periods are the result of service charges on deposits mostly related to the increase in deposit volumes, merchant visa income and the gain on the sale of loans mostly related to higher volumes of SBA and conventional loan sales.

Non-interest Expense

Non-interest expense increased 3.3% to $7,260,000 during the three months ended September 30, 2008 compared to $7,028,000 for the same period during 2007. Non-interest expense increased 5.3% to $22,516,000 for the nine months ended September 30, 2008 from $21,390,000 for the same period last year. The increases for both the three and nine month periods are mostly related to the result of the loss on impairment of the Fund. The efficiency ratio for the quarter ended September 30, 2008 was 60.0% compared to 60.2% for the comparable quarter in 2007. The efficiency ratio for the nine months ended September 30, 2008 was 64.2% compared to 63.0% for the same period last year. The efficiency ratio consists of non-interest expense divided by the sum of net interest income before provision for loan losses plus non-interest income.

Lending Activities

As indicated in the table below, total loans (including loans held for sale)
increased to $812.5 million at September 30, 2008 from $779.8 million at
December 31, 2007.



                                                     At                              At
                                                September 30,       % of        December 31,       % of
                                                    2008            Total           2007           Total
                                                                (Dollars in thousands)
Commercial                                     $       445,948       54.9 %    $      421,405       54.0 %
Real estate mortgages
One-to-four family residential                          57,727        7.1              57,579        7.4
Five or more family residential and
commercial properties                                  160,879       19.8             163,715       21.0

Total real estate mortgages                            218,606       26.9             221,294       28.4
Real estate construction
One-to-four family residential                          77,790        9.6              82,165       10.6
Five or more family residential and
commercial properties                                   52,009        6.4              40,342        5.2

Total real estate construction                         129,799       16.0             122,507       15.8
Consumer                                                20,106        2.4              16,641        2.1

Gross loans                                            814,459      100.2             781,847      100.3
Less: deferred loan fees                                (1,926 )     (0.2 )            (2,081 )     (0.3 )

Total loans                                    $       812,533      100.0 %    $      779,766      100.0 %

Nonperforming Assets

The following table describes our nonperforming assets for the dates indicated.



                                                         At                  At
                                                    September 30,       December 31,
                                                        2008                2007
                                                         (Dollars in thousands)
Nonaccrual loans                                   $         8,283     $        1,021
Other real estate owned                                        169                169

Total nonperforming assets                         $         8,452     $        1,190

Accruing loans past due 90 days or more            $         2,834     $        2,084
Potential problem loans                                     25,260             22,023
Allowance for loan losses                                   12,628             10,374
Nonperforming loans to loans                                  1.02 %             0.13 %
Allowance for loan losses to loans                            1.56 %             1.33 %
Allowance for loan losses to nonperforming loans            152.46 %         1,016.06 %
Nonperforming assets to total assets                          0.93 %             0.13 %

Nonperforming assets increased to $8,452,000, or 0.93% of total assets at September 30, 2008 from $1,190,000, or 0.13% of total assets at December 31, 2007 due substantially to increases in nonperforming loans. The increase in nonperforming loans is due primarily to construction loans to two borrowers totaling $6.3 million. Given the increases in nonperforming loans, growth in our overall loan portfolio and current economic conditions we increased our allowance for loan losses to 1.56% at September 30, 2008 from 1.33% at December 31, 2007. We believe that we are adequately reserved for losses in the portfolio as of September 30, 2008. Potential problem loans are those loans that are currently accruing interest and are not considered impaired, but which we are monitoring because the financial information of the borrower causes us concerns as to their ability to comply with the present repayment program.

Analysis of Allowance for Loan Losses

Management maintains an allowance for loan losses to absorb estimated credit losses associated with the loan portfolio, including all binding commitments to lend. We determine an adequate allowance through our ongoing quarterly loan quality assessments.

We assess the estimated credit losses inherent in our non-classified and classified loan portfolio by considering a number of elements including:

• Historical loss experience in the portfolio;

• Levels of and trends in delinquencies and impaired loans;

• Levels and trends in charge offs and recoveries;

• Effects of changes in risk selection and underwriting standards, and other changes in lending policies, procedures and practices;

• Experience, ability, and depth of lending management and other relevant staff;

• National and local economic trends and conditions;

• External factors such as competition, legal, and regulatory; and

• Effects of changes in credit concentrations.

We calculate an adequate allowance for the non-classified and classified portion of our loan portfolio based on an appropriate percentage loss factor that is calculated based on the above-noted elements and trends. We may record specific provisions for each impaired loan after a careful analysis of that loan's credit and collateral factors. Our analysis of an adequate allowance combines the provisions made for our non-classified loans, classified loans, and the specific provisions made for each impaired loan.

While we believe we use the best information available to determine the allowance for loan losses, net income could be significantly affected if circumstances differ substantially from the assumptions used in determining the allowance, unforeseen market conditions arise or if we are directed to make adjustments to the allowance for loan losses by our regulators.

The following table summarizes the changes in our allowance for loan losses:

                                                          Nine Months Ended September 30,
                                                           2008                     2007
                                                               (Dollars in thousands)
Total loans outstanding at end of period(1)           $       811,964          $       802,285
Average total loans outstanding during period(1)              790,035                  774,222
Allowance balance at beginning of period                       10,374                   10,105
Provision for loan losses                                       2,830                      570
Charge offs:
Real estate                                                      (356 )                     -
Commercial                                                       (103 )                   (380 )
Agriculture                                                       (30 )                    (20 )
Consumer                                                         (112 )                    (75 )

Total charge offs                                                (601 )                   (475 )

Recoveries:
Real estate                                                         1                        1
Commercial                                                          1                        2
Agriculture                                                        -                        -
Consumer                                                           23                       21

Total recoveries                                                   25                       24

Net charge offs                                                  (576 )                   (451 )

Allowance balance at end of period                    $        12,628          $        10,224

Allowance for loan losses to loans                               1.56 %                   1.27 %
Ratio of net charge offs during period to average
loans outstanding                                               (0.07 )%                 (0.06 )%

(1) Excludes loans held for sale

While pursuing our growth strategy, we continue to employ prudent underwriting and sound monitoring procedures to maintain asset quality. The allowance for loan losses at September 30, 2008 increased by $2,254,000 to $12.6 million from $10.4 million at December 31, 2007. Based on management's assessment of loan quality and current economic conditions, the Company believes that its allowance for loan losses is at an appropriate level at September 30, 2008.

Liquidity and Sources of Funds

Our primary sources of funds are customer and local government deposits, loan principal and interest payments, loan sales, interest earned on and proceeds from investment securities, and advances from the Federal Home Loan Bank (FHLB) of Seattle. 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. While maturities and scheduled amortization of loans are a predictable source of funds, deposit flows and mortgage prepayments are greatly influenced by the level of interest rates, economic conditions, and competition.

We must maintain an adequate level of liquidity to ensure the availability of sufficient funds to fund loan originations and deposit withdrawals, satisfy other financial commitments, and fund operations. We generally maintain sufficient cash and short-term investments to meet short-term liquidity needs. At September 30, 2008, cash and cash equivalents totaled $21.1 million, and investment securities classified as either available for sale or held to maturity with maturities of one year or less amounted to $1.0 million, or 0.1% of total assets. At September 30, 2008, our banks maintained a credit facility with the FHLB of Seattle for $171.1 million, with $13.9 million in FHLB borrowings as of September 30, 2008.

Capital

Stockholders' equity at September 30, 2008 was $88.8 million compared with $85.0 million at December 31, 2007. During the nine months ended September 30, 2008, we declared dividends of $3.7 million, realized income of $6.5 million, recorded $271,000 in unrealized gains on securities available for sale, net of tax, and realized the effects of exercising stock options, stock option compensation and earned ESOP and restricted stock shares totaling $771,000.

Banking regulations require bank holding companies and banks to maintain a minimum leverage ratio of core capital to adjusted quarterly average total assets of at least 3%. Our leverage ratio was 8.5% at September 30, 2008 compared to 8.2% at December 31, 2007. In addition, banking regulators have adopted risk-based capital guidelines, under which risk percentages are assigned to various categories of assets and off-balance sheet items to calculate a risk-adjusted capital ratio. Tier I capital generally consists of common shareholders' equity, while Tier II capital includes the allowance for loan losses, subject to certain limitations. Regulatory minimum risk-based capital guidelines require Tier I capital of 4% of risk-adjusted assets and total capital (combined Tier I and Tier II) of 8%. Our Tier I and total risk based capital ratios were 9.3% and 10.6%, respectively, at September 30, 2008 compared with 9.5% and 10.7%, respectively, at December 31, 2007.

During 1992, the FDIC published the qualifications necessary to be classified as a "well-capitalized" bank, primarily for assignment of FDIC insurance premium rates beginning in 1993. To qualify as "well-capitalized", banks must have a Tier I risk based capital ratio of at least 6%, a total risk based capital ratio of at least 10%, and a leverage ratio of at least 5%. Heritage Bank and Central Valley Bank qualified as "well-capitalized" at September 30, 2008.