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, 2008 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 March 31,
                                                     2009                                2008
                                                    Interest                            Interest
                                         Average     Earned/    Average      Average     Earned/    Average
                                         Balance      Paid       Rate        Balance      Paid       Rate
                                                              (Dollars in thousands)
Interest Earning Assets:
Loans                                   $ 783,118   $  12,895      6.68 %   $ 765,350   $  14,168      7.45 %
Taxable securities                         37,200         447      4.88        34,636         392      4.56
Nontaxable securities                       6,278          55      3.52         4,918          45      3.67
Interest earning deposits                  42,317          44      0.42        12,252          88      2.89
Federal Home Loan Bank stock                3,566          -       0.00         3,227           8      1.01

Total interest earning assets           $ 872,479   $  13,441      6.25 %   $ 820,383   $  14,701      7.21 %
Non-interest earning assets                73,661                              57,009

Total assets                            $ 946,140                           $ 877,392

Interest Bearing Liabilities:
Certificates of deposit                 $ 337,738   $   2,248      2.70 %   $ 358,777   $   3,941      4.42 %
Savings accounts                          100,866         310      1.24        81,752         351      1.73
Interest bearing demand and money
market accounts                           278,357         805      1.17       230,956       1,248      2.17

Total interest bearing deposits           716,961       3,363      1.90       671,485       5,540      3.32
FHLB advances and other borrowings             -           -         -          7,640          97      5.10

Total interest bearing liabilities      $ 716,961   $   3,363      1.90 %   $ 679,125   $   5,637      3.34 %
Demand and other non-interest bearing
deposits                                  110,083                             104,022
Other non-interest bearing
liabilities                                 5,117                               7,003
Stockholders' equity                      113,979                              87,242

Total liabilities and stockholders'
equity                                  $ 946,140                           $ 877,392

Net interest income                                 $  10,078                           $   9,064
Net interest spread                                                4.34 %                              3.87 %
Net interest margin                                                4.68 %                              4.44 %
Average interest earning assets to
average interest bearing liabilities                             121.69 %                            120.80 %

Financial Condition Data

Total assets increased $10.2 million or 1.1%, to $956.3 million as of March 31, 2009 from the December 31, 2008 balance of $946.1 million. Deposits increased $15.3 million or 1.9%, to $839.7 million as of March 31, 2009 from the December 31, 2008 balance of $824.5 million. For the same period, net loans, which exclude loans held for sale but are net of the allowance for loan losses, decreased $26.7 million or (3.4%), to $766.6 million as of March 31, 2009 from the December 31, 2008 balance of $793.3 million. Commercial loans continue to be the largest segment of loans at 55.0% and 54.9% as a percentage of total loans as of March 31, 2009 and December 31, 2008, respectively.

Earnings Summary

A net loss of $0.14 per diluted common share was recorded for the three months ended March 31, 2009 compared to net income of $0.40 per diluted common share for the three months ended March 31, 2008. The net loss for the three months ended March 31, 2009 was $594,000 compared to net income of $2,660,000 for the same period in 2008. Earnings for the three months ended March 31, 2009 were significantly affected by increased provisioning for loan losses as described below.

Return on average common equity for the quarter ended March 31, 2009 was (4.1)% compared to 12.3% for the same period last year. Average common equity increased by $3.4 million to $90.6 million for the three months ended March 31, 2009 versus $87.2 million for the same period last year. The Company's capital position remains strong at 11.70% of total assets as of March 31, 2009, an increase from 9.76% at March 31, 2008.

Net Interest Income

Net interest income before provision for loan losses for the three months ended March 31, 2009 increased 11.2% to $10.1 million from $9.1 million for the same quarter in 2008. This increase was driven substantially by an improved net interest margin. The net interest margin (net interest income divided by average earning assets) increased to 4.68% for the quarter ended March 31, 2009 compared to 4.44% for the quarter ended March 31, 2008.

Interest income decreased $1.3 million or 8.6%, for the three months ended March 31, 2009 as compared to the first quarter last year and interest expense decreased $2.3 million or 40.3%, during this same period. Net loans averaged $783.1 million with an average yield of 6.68% for the three months ended March 31, 2009 compared to average net loans of $765.4 million with an average yield of 7.45% for the same period in 2008. Certificates of deposit averaged $337.7 million with an average cost of 2.70% for the three months ended March 31, 2009 compared to $358.8 million with an average cost of 4.42% for the same period in 2008.

Provision for Loan Losses

The provision for loan losses was $5,250,000 for the three months ended March 31, 2009, an increase of $4,890,000 over the provision for loan losses during the first quarter of 2008 of $360,000. The increase in the loan loss reserves was a result of management's continuing assessment of the increased risk in the loan portfolio due to the current economic environment which may lead to increases in potential problem loans and loan losses. Management continues to see weakness specifically within its residential construction portfolio, as well as developing weaknesses in its commercial and industrial portfolio. Management is committed to ongoing and careful review of all existing and new loans to minimize loss exposure.

Non-interest Income

Non-interest income decreased 9.3% to $2,037,000 for the three months ended March 31, 2009 compared with $2,246,000 for the same quarter in 2008. This decrease was due substantially to a $177,000 gain recognized in the first quarter of 2008 on the redemption of Class B common stock received from the Visa Inc. IPO completed in March 2008.

Non-interest Expense

Non-interest expense increased 13.1% to $7,880,000 during the three months ended March 31, 2009 compared to $6,970,000 for the same period during 2008. The increase was due substantially to an assessment from the Washington Public Deposit Protection Commission ("WPDPC") in the amount of $239,000 due to uncollateralized public deposits of a failed bank, costs and net losses in the amount of $127,000 associated with the maintenance and disposal of other real estate owned, increased FDIC assessment rates resulting in an increase in FDIC assessments in the amount of $108,000, an other-than-temporary impairment charge in the amount of $175,000 relating to securities obtained in the 2008 redemption-in-kind of the AMF Ultra Short Mortgage Fund and increased marketing expense in the amount of $123,000 resulting primarily from costs associated with a checking account acquisition program. These additional expenses were the primary reason the efficiency ratio for the quarter ended March 31, 2009 increased to 65.0% compared to 61.6% for the comparable quarter in 2008. 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)
decreased to $788.2 million at March 31, 2009 from $809.0 million at
December 31, 2008.



                                                       At                         At
                                                   March 31,      % of       December 31,      % of
                                                      2009        Total          2008          Total
                                                                (Dollars in thousands)
Commercial                                         $  433,524      55.0 %   $      443,821      54.9 %
Real estate mortgages
One-to-four family residential                         53,546       6.8             57,535       7.1
Five or more family residential and commercial
properties                                            157,538      20.0            157,542      19.5

Total real estate mortgages                           211,084      26.8            215,077      26.6
Real estate construction
One-to-four family residential                         67,406       8.6             71,159       8.8
Five or more family residential and commercial
properties                                             56,465       7.1             59,572       7.3

Total real estate construction                        123,871      15.7            130,731      16.1
Consumer                                               21,439       2.7             21,255       2.6

Gross loans                                           789,918     100.2            810,884     100.2
Less: deferred loan fees                               (1,719 )    (0.2 )           (1,854 )    (0.2 )

Total loans                                        $  788,199     100.0 %   $      809,030     100.0 %

Nonperforming Assets

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



                                                         At                At
                                                      March 31,       December 31,
                                                        2009              2008
                                                         (Dollars in thousands)
  Nonperforming loans                                $    13,416     $        3,397
  Other real estate owned                                  2,022              2,031

  Total nonperforming assets                         $    15,438     $        5,428

  Accruing loans past due 90 days or more            $        40     $          664
  Potential problem loans                                 35,244             43,061
  Allowance for loan losses                               20,155             15,423
  Nonperforming loans to total loans                        1.71 %             0.42 %
  Allowance for loan losses to total loans                  2.56 %             1.91 %
  Allowance for loan losses to nonperforming loans        150.23 %           454.02 %
  Nonperforming assets to total assets                      1.61 %             0.57 %

Nonperforming assets increased to $15,438,000, or 1.61% of total assets at March 31, 2009 from $5,428,000, or 0.57% of total assets at December 31, 2008 due to increases in nonperforming loans. The increase in nonperforming loans is due primarily to construction loans to two borrowers totaling $9.1 million. Given the increases in nonperforming loans and current economic conditions we increased our allowance for loan losses to 2.56% at March 31, 2009 from 1.91% at December 31, 2008. We believe that we are adequately reserved for losses in the portfolio as of March 31, 2009. 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. 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. In addition, the determination of the amount of the allowance for loan losses is subject to review by bank regulators, as part of the routine examination process, which may result in the establishment of additional reserves based upon their judgment of information available to them at the time of their examination.

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

                                                           Three Months Ended March 31,
                                                            2009                   2008
                                                              (Dollars in thousands)
Total loans outstanding at end of period (1)           $      786,797         $      777,195
Average total loans outstanding during period (1)             798,426                775,838
Allowance balance at beginning of period                       15,423                 10,374
Provision for loan losses                                       5,250                    360
Charge offs:
Real estate                                                      (502 )                   -
Commercial                                                         -                      -
Agriculture                                                        -                     (26 )
Consumer                                                          (37 )                  (25 )

Total charge offs                                                (539 )                  (51 )

Recoveries:
Real estate                                                        -                      -
Commercial                                                         -                      -
Agriculture                                                        -                      -
Consumer                                                           21                      7

Total recoveries                                                   21                      7

Net charge offs                                                  (518 )                  (44 )

Allowance balance at end of period                     $       20,155         $       10,690

Allowance for loan losses to total loans                         2.56 %                 1.38 %
Ratio of net charge offs during period to average
total loans outstanding                                         (0.06 )%               (0.01 )%

(1) Excludes loans held for sale

The allowance for loan losses at March 31, 2009 increased by $4,732,000 to $20.2 million from $15.4 million at December 31, 2008. 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 March 31, 2009.

Deposit Activities

As indicated in the table below, total deposits increased to $839.7 million at
March 31, 2009 from $824.5 million at December 31, 2008.



                                           At                       At
                                       March 31,    % of       December 31,    % of
                                          2009      Total          2008        Total
                                                  (Dollars in thousands)
     Non-interest demand deposits      $  115,025    13.7 %   $      115,551    14.0 %
     NOW accounts                         198,403    23.6            122,104    14.8
     Money market accounts                123,390    14.7            141,716    17.2
     Savings accounts                      85,199    10.2             98,715    12.0

     Total core deposits                  522,017    62.2            478,086    58.0
     Certificate of deposit accounts      317,730    37.8            346,394    42.0

     Total deposits                    $  839,747   100.0 %   $      824,480   100.0 %

Since December 31, 2008, core deposits (total deposits less certificate of deposit accounts) have increased $43.9 million, or 9.2%. As a result, the percentage of certificate deposit accounts to total deposits decreased to 37.8% from 42.0%.

Much of the change in mix of deposit accounts was due to public deposits. During the quarter ended March 31, 2009, the Company's subsidiary banks were notified by the WPDPC that the failure of a bank in Washington State had resulted in a shortfall in deposits held by Washington State municipalities. To prevent losses to public entities, Washington State requires that all financial institutions that receive public deposits must pledge collateral to the WPDPC and participate in a collateral pool established to protect public deposits that are not covered by FDIC insurance or the assets of the failed bank. As a result, the Company was assessed $239,000 for its share of the shortfall. Subsequent to the assessment, the WPDPC issued a resolution that all public depositaries shall by June 30, 2009 take all measures necessary to fully collateralize its uninsured public deposits at 100%.

In order to comply with the WPDPC's resolution described above and reduce the Company's exposure to uninsured public deposits, the Company's total public deposit balances have decreased to $104.1 million at March 31, 2009 from $132.1 million at December 31, 2008. Public certificate of deposit accounts have decreased $70.0 million and other public deposits accounts have increased $41.9 million. This lowered the Company's uninsured public deposit accounts to $17.9 million at March 31, 2009 from $125.3 million at December 31, 2008. To compensate for the loss of public deposits, the Company purchased $34 million in brokered deposits during the quarter with terms ranging from six to eighteen months.

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 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 March 31, 2009, cash and cash equivalents totaled $92.3 million, or 9.7% of total assets and investment securities classified as either available for sale or held to maturity with maturities of one year or less amounted to $3.5 million, or 0.4% of total assets. At March 31, 2009, our banks maintained an uncommitted credit facility with the FHLB of Seattle for $159.6 million of which there were no borrowings outstanding as of March 31, 2009. Our subsidiary banks also maintain advance lines to purchase federal funds totaling $44.8 million as of March 31, 2009.

Capital

On November 21, 2008, for an aggregate purchase price of $24.0 million in cash, the Company completed a sale to the U.S. Department of the Treasury ("Treasury") of 24,000 shares of the Company's Fixed Rate Cumulative Perpetual Preferred Stock, Series A, ("preferred shares") with a related warrant to purchase 276,074 shares of the Company's common stock. The warrant has a ten-year term with an exercise price of $13.04 per share, an allocated value of $646,000 and a fair value of $588,000. The issuance of preferred stock significantly increased the Company's capital levels. The preferred stock pays a cumulative dividend of 5% per annum for the first five years and 9% per annum thereafter if not redeemed first.

Stockholders' equity at March 31, 2009 was $111.9 million compared with $113.1 million at December 31, 2008. During the three months ended March 31, 2009, we declared common stock dividends of $670,000, accrued preferred stock dividends of $300,000, realized a net loss of $594,000, recorded $140,000 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 $143,000.

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 10.5% at March 31, 2009 compared to 11.0% at December 31, 2008. 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 12.8% and 14.1%, respectively, at March 31, 2009 compared with 12.5% and 13.7%, respectively, at December 31, 2008.

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 March 31, 2009.

Quarterly, we review the potential payment of cash dividends to common shareholders. Our cash dividend analysis and subsequent decision considers two primary variables: capital adequacy and the dividend payout ratio. Due to the current economic volatility, we believe it is necessary to preserve our strong capital position. Therefore, we will continue to monitor the dividend payout ratio in relation to our profitability levels in order to maintain our strong capital position.

Our capital levels are also modestly impacted by our 401(k) Employee Stock Ownership Plan and Trust ("KSOP"). The Employee Stock Ownership Plan ("ESOP") purchased 2% of the common stock issued in a January 1998 stock offering and borrowed from the Company to fund the purchase of the Company's common stock. The loan to the ESOP will be repaid principally from the Bank's contributions to the ESOP. The Bank's contributions will be sufficient to service the debt over the 15 year loan term at the interest rate of 8.5%. As the debt is repaid, shares are released, and allocated to plan participants based on the proportion of debt service paid during the year. As shares are released, compensation expense is recorded equal to the then current market price of the shares, our capital is increased, and the shares become outstanding for earnings per common share calculations. For the three months ended March 31, 2009, the Company . . .