The following discussion is intended to assist in understanding the financial condition and results of operations of the Company. The information contained in this section should be read with the December 31, 2008 audited consolidated financial statements and notes to those financial statements included in this 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.

Critical Accounting Policies

The Company's consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. Companies may apply certain critical accounting policies requiring management to make subjective or complex judgments, often as a result of the need to estimate the effect of matters that are inherently uncertain.

The Company considers its most critical accounting estimates to be the allowance for loan losses, other than temporary impairments in the market value of investments and impairment of goodwill.

Allowance for Loan Losses. The allowance for loan losses is established through a provision for loan losses charged against earnings. The balance of the allowance for loan losses is maintained at the amount management believes will be adequate to absorb known and inherent losses in the loan portfolio at the balance sheet date. The allowance for loan losses is determined by applying estimated loss factors to the credit exposure from outstanding loans.

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. A further decline in local and national economic conditions, or other factors, could result in a material increase in the allowance for loan losses and may adversely affect the Company's financial conditions and results of operations.

For additional information regarding the allowance for loan losses, its relation to the provision for loans losses, risk related to asset quality and lending activity, see Part I, Item 1 as well as the "Management's Discussion and Analysis of Financial Condition and Results of Operation-Provision for Loan Losses".

Other Than Temporary Impairments in the Market Value of Investments. Unrealized investment securities losses on available for sale and held to maturity securities are evaluated at least quarterly to determine whether declines in value should be considered "other than temporary" and therefore be subject to immediate loss recognition in income. Although these evaluations involve significant judgment, an unrealized loss in the fair value of a debt security is generally deemed to be temporary when the fair value of the security is below the carrying value primarily due to changes in interest rates, there has not been significant deterioration in the financial condition of the issuer, and we have the intent and ability to hold the security for a sufficient time to recover the carrying value. An unrealized loss in the value of an equity security is generally considered temporary when the fair value of the security is below the carrying value primarily due to current market conditions and not deterioration in the financial condition of the issuer and we have the intent and ability to hold the security for a sufficient time to recover the carrying value. Other factors that may be considered in determining whether a decline in the value of either a debt or an equity security is "other than temporary" include ratings by recognized rating agencies; actions of commercial banks or other lenders relative to the continued extension of credit facilities to the issuer of the security; the financial condition, capital strength and near-term prospects of the issuer and recommendations of investment advisors or market analysts. Therefore continued deterioration of market conditions could result in additional impairment losses recognized within the investment portfolio.

Goodwill. Goodwill represents the costs in excess of net assets acquired arising from the purchases of North Pacific Bank and Western Washington Bancorp. Goodwill is not amortized, but is reviewed for impairment and written down and charged to income during the periods in which the recorded value is more than its fair value. We evaluate any potential impairment of goodwill on an annual basis, or more frequently if events or changes in circumstances indicate that goodwill might be impaired at the Company level and Heritage Bank level. If the Company's market capitalization (total common shares outstanding multiplied by the current stock price) exceeds the common book value, absent other indicators of impairment, goodwill is not considered impaired and no additional analysis is necessary. Despite negative values in the above tests goodwill might not be considered impaired due to current market volatility and control purchase premiums in the banking industry. However, an impairment may be recorded in the future if market capitalization continues to decrease. Any potential non-cash goodwill impairment expense would not affect the Company's regulatory capital ratios since goodwill is not included in the calculation.

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 our commercial banking relationships, market expansion and asset quality.

During the period from 2004 through 2008 our total assets have grown $248.9 million, or 35.7%, with net loans growing $202.2 million during the period. Our emphasis in growing our commercial loan portfolio resulted in an increase in commercial loans of $107.6 million, or 32.0%, since 2004. Overall loan increases have benefited from our emphasis in growing our lending in the Pierce county market.

Deposits increased $237.2 million, or 40.4%, for the period from 2004 through 2008. From 2004 to 2008 noninterest demand deposits and NOW accounts have grown $65.0 million, or 37.7%. Our deposit increases are due to our focus on growing our customer base as well as investors continuing to prefer deposit accounts to uninsured investment products. In turn, equity has increased by $52.2 million since December 31, 2004 due to a combination of earnings and issuances of common and preferred stock partially offset by our stock repurchase programs. Since 1999, we have repurchased 6,017,616 shares totaling $74.1 million. During the period from 2004 through 2008, our annual net income increased through 2007 by 11.7% or $1.1 million and subsequently decreased in 2008 by 33.7% or $3.2 million, mostly due to the increase in the allowance for loan losses and losses incurred from other than temporarily impaired securities.

Our core profitability depends primarily on our net interest income, which is the difference between the income we receive on our loan and investment portfolios, and our cost of funds, which consists of interest paid on deposits and borrowed funds. Like most financial institutions, our interest income and cost of funds are affected significantly by general economic conditions, particularly changes in market interest rates and government policies.

Changes in net interest income result from changes in volume, net interest spread, and net interest margin. Volume refers to the average dollar amounts of interest earning assets and interest bearing liabilities. Net interest spread refers to the difference between the average yield on interest earning assets and the average cost of interest bearing liabilities. Net interest margin refers to net interest income divided by average interest earning assets and is influenced by the level and relative mix of interest earning assets and interest bearing and non-interest bearing liabilities.

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.

                                                                      Years Ended December 31,
                                            2008                                2007                                2006
                                           Interest                            Interest                            Interest
                                Average     Earned/    Average      Average     Earned/    Average      Average     Earned/    Average
                                Balance      Paid       Rate        Balance      Paid       Rate        Balance      Paid       Rate
                                                                       (Dollars in thousands)
Interest Earning Assets:
Loans                          $ 784,514   $  54,919      7.00 %   $ 768,015   $  60,409      7.87 %   $ 690,287   $  53,239      7.71 %
Taxable securities                33,970       1,649      4.86        35,409       1,638      4.63        40,352       1,724      4.27
Nontaxable securities              5,528         197      3.56         4,823         177      3.67         4,586         167      3.64
Interest earning deposits          7,402         152      2.06         2,939         148      5.02         2,137         104      4.88
Federal Home Loan Bank stock       3,348          31      0.92         3,227          19      0.60         3,163           3      0.10

Total interest earning
assets                         $ 834,762   $  56,948      6.82 %   $ 814,413   $  62,391      7.66 %   $ 740,525   $  55,237      7.46 %
Noninterest earning assets        58,812                              58,254                              54,694

Total assets                   $ 893,574                           $ 872,667                           $ 795,219

Interest Bearing
Liabilities:
Certificates of deposit        $ 343,642   $  12,423      3.62 %   $ 352,295   $  17,082      4.85 %   $ 307,902   $  12,902      4.19 %
Savings accounts                  92,648       1,578      1.70        82,526       1,596      1.93        95,075       1,677      1.76
Interest bearing demand and
money market accounts            243,082       4,320      1.78       216,641       5,553      2.56       189,458       3,664      1.93

Total interest bearing
deposits                         679,372      18,321      2.70       651,462      24,231      3.72       592,435      18,243      3.08
FHLB advances and other
borrowings                         7,850         285      3.63        27,044       1,539      5.69        22,784       1,222      5.36

Total interest bearing
liabilities                    $ 687,222   $  18,606      2.71 %   $ 678,506   $  25,770      3.80 %   $ 615,219   $  19,465      3.16 %
Demand and other noninterest
bearing deposits                 108,386                             103,790                              98,567
Other noninterest bearing
liabilities                        6,372                               7,196                               7,038
Stockholders' equity              91,594                              83,175                              74,395

Total liabilities and
stockholders' equity           $ 893,574                           $ 872,667                           $ 795,219

Net interest income                        $  38,342                           $  36,621                           $  35,772
Net interest spread                                       4.11 %                              3.86 %                              4.30 %
Net interest margin                                       4.59 %                              4.50 %                              4.83 %
Average interest earning
assets to average interest
bearing liabilities                                     121.47 %                            120.03 %                            120.37 %

The following table provides the amount of change in our net interest income attributable to changes in volume and changes in interest rates. Changes attributable to the combined effect of volume and interest rates have been allocated proportionately for changes due to volume and interest rates.

                                                                  Years Ended December 31,
                                                2008 Compared to 2007                  2007 Compared to 2006
                                             Increase (Decrease) Due to              Increase (Decrease) Due to
                                          Volume         Rate        Total         Volume          Rate      Total
                                                                   (Dollars in thousands)
Interest Earning Assets:
Loans                                    $   1,155     $ (6,645 )   $ (5,490 )   $    6,114       $ 1,056   $ 7,170
Taxable securities                             (70 )         81           11           (229 )         143       (86 )
Nontaxable securities                           25           (5 )         20              9             1        10
Interest earning deposits                       91          (87 )          4             41             3        44
Federal Home Loan Bank stock                     2           10           12             -             16        16

Interest income                          $   1,203     $ (6,646 )   $ (5,443 )   $    5,935       $ 1,219   $ 7,154

Interest bearing liabilities:
Certificates of deposit                  $    (313 )   $ (4,346 )   $ (4,659 )   $    2,154       $ 2,026   $ 4,180
Savings accounts                               172         (190 )        (18 )         (243 )         162       (81 )
Interest bearing demand and money
market accounts                                470       (1,703 )     (1,233 )          697         1,192     1,889

Total interest bearing deposits                329       (6,239 )     (5,910 )        2,608         3,380     5,988
FHLB advances and other borrowings            (696 )       (558 )     (1,254 )          242            75       317

Interest expense                         $    (367 )   $ (6,797 )   $ (7,164 )   $    2,850       $ 3,455   $ 6,305

Results of Operations for the Years Ended December 31, 2008 and 2007

Net Income. Our net income was $6.4 million or $0.93 per diluted common share for the year ended December 31, 2008 compared to $10.71 million or $1.61 per diluted common share for the previous year. The 40.7% decrease in actual net income was mostly due to an increase in our allowance for loan losses of $6.6 million and by losses totaling $1.9 million ($1.3 million net of tax) relating to the Company's investments in the AMF Ultra Short Mortgage Fund ("the Fund"). These losses resulted from an other-than-temporary impairment charge in the second quarter of 2008 totaling $1.1 million ($0.7 million net of tax), a subsequent third quarter loss on a redemption-in-kind totaling $0.2 million ($95,000 net of tax) in which fund shares were exchanged for a pro-rata share of cash and underlying securities in the fund, and a fourth quarter $0.7 million ($0.4 million net of tax) other-than-temporary impairment charge on eleven of the securities acquired with the redemption-in-kind. Continued deterioration of market conditions could result in additional impairment losses recognized within the investment portfolio.

Net Interest Income. Net interest income increased $1.7 million to $38.3 million for the year ended December 31, 2008 compared with the previous year of $36.6 million. The increase in net interest income resulted primarily from an increase in average loans. Net interest income as a percentage of average earning assets (net interest margin) for the year ended December 31, 2008 increased to 4.59% from 4.50% for the previous year. The increase in net interest margin is due to the decrease in cost of funds exceeding the decrease in loan yields for the same period. Our net interest spread for the year ended December 31, 2008 increased to 4.11% from 3.86% for the prior year. The average rate of interest earning assets decreased to 6.82% for the year ended December 31, 2008 from 7.66% for the same period last year while the average cost of funds decreased to 2.71% for the year ended December 31, 2008 from 3.80% for the same period last year. Overall, our net interest margin of 4.59% is above the median for West Coast publicly traded commercial banks of 4.02% as reported by D.A. Davidson and Companies for the period ended September 30, 2008.

Provision for Loan Losses. During the year ended December 31, 2008, we provided $7.4 million through operations compared to $0.8 million for the year ended December 31, 2007. The increase in the loss loan reserves was mostly related to management's assessment of the increased risk in the construction loan portfolio and the current economic environment as well as increases in nonperforming assets to $5.4 million for the year ended December 31, 2008 compared to $1.2 million for the previous year. The nonperforming assets to total assets ratio was 0.57% at December 31, 2008, up from 0.13% at December 31, 2007. For the year ended December 31, 2008, we experienced net charge-offs of $2.4 million compared to net charge-offs of $0.5 million for the year ended December 31, 2007. The increase in net charge-offs was mostly related to one-to-four family residential construction loans due to continued deterioration in the local market. The increase in provision increased our allowance for loan losses as a percentage of total loans to 1.91% at December 31, 2008 from 1.33% at the end of 2007.

We consider the allowance for loan losses at December 31, 2008 adequate to cover loan losses based on our assessment of various factors affecting the loan portfolio, including the level of problem loans, business conditions, estimated collateral values, loss experience including those related to our courtesy overdraft programs, and credit concentrations. A further decline in local and national economic conditions, or other factors, could result in a material increase in the allowance for loan losses and may adversely affect the Company's financial conditions and results of operations. See the previous discussion on the allowance for loan losses in Item 1 for further information about these factors.

Noninterest Income. Total noninterest income increased $252,000, or 2.9%, for the year ended December 31, 2008 compared with the prior year. Loan sale gains increased $371,000 from the prior year while brokered mortgage income decreased $464,000 from the prior year. This change is due to a decrease in mortgage volumes resulting from lower mortgage loan demand compared to the prior year and higher volumes of SBA and conventional loan sales. Merchant visa income increased $170,000, or 5.9%, due to increased business volumes. Service charges on deposits also increased by $305,000, or 8.0%, due to our continued focus on growing our deposit relationships and a decrease in the earnings credit rate.

Noninterest Expense. Total noninterest expense increased $2,131,000, or 7.5%, for the year ended December 31, 2008 compared to the prior year. The increase is mostly related to the result of the loss on impairment of the Fund. Salaries and employee benefits decreased $75,000, mostly due to a decrease in full time employees. Merchant Visa expenses increased by $158,000, or 6.8%. The increase was in line with the increase in business volumes as well as Merchant Visa income. Other operating expenses increased by $161,000, or 5.3%, due to various increases in other expenses.

Results of Operations for the Years Ended December 31, 2007 and 2006

Net Income. Our net income was $10.71 million or $1.61 per diluted share for the year ended December 31, 2007 compared to $10.55 million or $1.60 per diluted share for the previous year. The 1.5% increase in actual net income was due to a combination of increased net interest income and non-interest income offset by increased non-interest expense.

Net Interest Income. Net interest income increased $0.8 million to $36.6 million for the year ended December 31, 2007 compared with the previous year of $35.8 million. The increase in net interest income resulted primarily from average loans increasing greater than average interest bearing deposits.

Net interest income as a percentage of average earning assets (net interest margin) for the year ended December 31, 2007 decreased to 4.50% from 4.83% for the previous year. The decrease in net interest margin is due to an increase in cost of funds exceeding the increase in yields for the same period. Our net interest spread for the year ended December 31, 2007 decreased to 3.86% from 4.30% for the prior year. The average rate of interest earning assets increased to 7.66% for the year ended December 31, 2007 from 7.46% for the same period last year while the average cost of funds increased to 3.80% for the year ended December 31, 2007 from 3.16%

for the same period last year. Overall, our net interest margin of 4.50% is slightly below the median for West Coast publicly traded commercial banks of 4.64% as reported by D.A. Davidson and Companies for the period ending September 30, 2007.

Provision for Loan Losses. During the year ended December 31, 2007, we provided $810,000 through operations compared to $720,000 for the year ended December 31, 2006. This increase was due primarily to the net recoveries in 2006. For the year ended December 31, 2007, we experienced net charge-offs of $541,000 compared to net recoveries of $140,000 for the year ended December 31, 2006. The net charge offs decreased our allowance for loan losses as a percentage of total loans to 1.33% at December 31, 2007 from 1.35% at the end of 2006. Our asset quality has remained solid as demonstrated by the nonperforming assets to total assets ratio of 0.13% at December 31, 2007, down from 0.36% at December 31, 2006.

We consider the allowance for loan losses at December 31, 2007 adequate to cover loan losses based on our assessment of various factors affecting the loan portfolio, including the level of problem loans, business conditions, estimated collateral values, loss experience including those related to our courtesy overdraft programs, and credit concentrations. See the previous discussion on the allowance for loan losses in Item 1 for further information about these factors.

Noninterest Income. Total noninterest income increased $618,000, or 7.8%, for the year ended December 31, 2007 compared with the prior year. Brokered mortgage income increased $15,000 from the prior year while loan sale gains decreased $69,000 from the prior year. This change is due to a decrease in mortgage volumes resulting from lower mortgage loan demand compared to the prior year. Merchant visa income increased $290,000, or 11.2%, due to increased business volumes. Service charges on deposits also increased by $536,000, or 16.5%, due to our continued focus on growing our deposit relationships.

Noninterest Expense. Total noninterest expense increased $1,206,000, or 4.5%, for the year ended 2007 compared to the 2006 period. Salaries and employee benefits increased $366,000, or 2.5%. The change was primarily due to increases in compensation. Merchant Visa expenses increased by $293,000, or 14.5%. The increase was in line with the increase in business volumes as well as Merchant Visa income. Other operating expenses increased by $403,000, or 15.3%, due to the various increases in other expenses.

Liquidity and Capital Resources

Our primary sources of funds are customer and local government deposits, loan principal and interest payments, loan sales, interest earned on and proceeds from sales and maturities of 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 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 December 31, 2008, cash and cash equivalents totaled $60.6 million, or 6.4% of total assets. At December 31, 2008, our banks maintained an uncommitted credit facility with the FHLB of Seattle for $162.5 million of which there were no borrowings outstanding as of December 31, 2008. Our subsidiary banks also maintain advance lines to purchase federal funds totaling $44.8 million as of December 31, 2008.

During 2008 total assets grew $60.1 million with net loans increasing by $24.4 million over the prior year-end. This growth was funded primarily through $48.2 million in deposit growth and cash flows from operations. Borrowings from the FHLB of Seattle decreased by $15.0 million over the prior year-end. Our strategy has been