** **

**FORM 10-KSB**

** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20429**

 
| **ý**                             | ** ** | **ANNUAL REPORT UNDER SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                  |
|----------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                   |       |                                                                                                                                                                           |
|                                   |       | **For  the annual period ending December 31, 2004**                                                                                                                       |
|                                   |       |                                                                                                                                                                           |
| **o**                                  | ** ** | **TRANSITION REPORT UNDER SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                              |
|                                   |       |                                                                                                                                                                           |
|                                   |       | **For  the transition period from              to             ** |
|                                   |       | ** **                                                                                                                                                                     |
| **Commission File No. 000-32827** |

 

**COAST BANCORP**

(Exact Name of Registrant as Specified in its Charter)

 
| **California**                                                                      | ** ** | **77-0567091**                       |
|-------------------------------------------------------------------------------------|------------|--------------------------------------|
| (State of incorporation or organization)                                            |       | (IRS Employer Identification Number) |
|                                                                                |
| **500 Marsh Street, San Luis Obispo, CA 93401**                                     |
| (Address of principal executive offices)                                            |
|                                                                                |
| **(805) 541-0400**                                                                  |
| (Registrant’s telephone number, including area code)                           |
|                                                                                |
| (Former name, former address and former fiscal year, if changed since  last report) |

 

Checkwhether the issuer (1) filed all reports required to be filed by Section 13or 15 (d) of the Exchange Act during the past 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.        Yesý    No o

 

Checkif there is no disclosure of delinquent filers in response to Item 405 ofRegulation S-B is not contained in this form, and no disclosure will becontained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-KSBor any amendment to this Form 10-KSB.    ý

 

Registrant’srevenues of fiscal year ended December 31, 2004 were $9,707,000.

 

Theaggregate market value of the voting stock held by non-affiliates computed byreference to the average bid and asked prices of such stock, as of March 17,2005:  $18,928,300.

 

Numberof registrant’s shares of Common Stock outstanding as of December 31, 2004was 652,700.

 

Documentsincorporated by reference:     None

 

TransitionalSmall Business Disclosure Format (Check one)          Yes:o    No: ý

 

 

----

 

**FORWARDLOOKING STATEMENTS**

 

**CERTAINSTATEMENTS WITHIN THIS ANNUAL REPORT ON FORM 10-KSB INCLUDE FORWARDLOOKING INFORMATION WITHIN THE MEANING OF SECTION 27A OF THE SECURITIESACT OF 1933, AS AMENDED, AND SECTION 21E OF THE SECURITIES EXCHANGE ACT OF1934, AS AMENDED, AND ARE SUBJECT TO THE “SAFE HARBOR” CREATED BY THOSESECTIONS.  THESE FORWARD-LOOKINGSTATEMENTS INVOLVE CERTAIN RISKS AND UNCERTAINTIES THAT COULD CAUSE ACTUALRESULTS TO DIFFER MATERIALLY FROM THOSE IN THE FORWARD-LOOKING STATEMENTS.  SUCH RISKS AND UNCERTAINTIES INCLUDE, BUT ARENOT LIMITED TO, THE FOLLOWING FACTORS: COMPETITIVE PRESSURE IN THE BANKINGINDUSTRY INCREASES SIGNIFICANTLY; CHANGES IN THE INTEREST RATE ENVIRONMENTREDUCE MARGINS; GENERAL ECONOMIC CONDITIONS, EITHER NATIONALLY OR REGIONALLY,ARE LESS FAVORABLE THAN EXPECTED, RESULTING IN, AMONG OTHER THINGS ADETERIORATION IN CREDIT QUALITY AND AN INCREASE IN THE PROVISION FOR POSSIBLELOAN LOSSES; CHANGES IN THE REGULATORY ENVIRONMENT; CHANGES IN BUSINESSCONDITIONS, PARTICULARLY IN SAN LUIS OBISPO COUNTY; VIOLATILITY OF RATE SENSITIVEDEPOSITS; OPERATIONAL RISKS INCLUDING DATA PROCESSING SYSTEMS FAILURES ORFRAUD; ASSET/LIABILITY MATCHING RISKS AND LIQUIDITY RISKS;  CHANGES IN THE SECURITIES MARKETS; THEABILITY TO SATISFY THE REQUIREMENTS OF THE SARBANES-OXLEY ACT AND OTHER REGULATIONSGOVERNING INTERNAL CONTROLS; AND THE POTENTIAL ECONOMIC EFFECT OF THE WAR ONTERRORISM AND THE WAR IN IRAQ.**

 

**THEREFORE,THE INFORMATION CONTAINED IN THIS ANNUAL REPORT SHOULD BE CAREFULLY CONSIDEREDWHEN EVALUATING THE BUSINESS PROSPECTS OF COAST BANCORP AND COAST NATIONALBANK.**

 

**MOREOVER,WHEREVER PHRASES SUCH AS/OR SIMILAR TO, “IN MANAGEMENT’S OPINION”, “MANAGEMENTBELIEVES”, OR “MANAGEMENT CONSIDERS” ARE USED, SUCH STATEMENTS ARE AS OF, ANDBASED UPON THE KNOWLEDGE OF MANAGEMENT, AT THE TIME MADE AND ARE SUBJECT TOCHANGE BY THE PASSAGE OF TIME AND/OR SUBSEQUENT EVENTS, AND ACCORDINGLY SUCHSTATEMENTS ARE SUBJECT TO THE SAME RISKS AND UNCERTAINTIES NOTED ABOVE WITHRESPECT TO FORWARD-LOOKING STATEMENTS.**

 

2

----

 

**INDEX**

 
| **PART I**   | ** ** |                                                                                        |   |
|-------------------|------------|---------------------------------------------------------------------------------------------|--------|
|              |       |                                                                                        |   |
| Item 1 -          |       | DESCRIPTION OF BUSINESS                                                                     |   |
|              |       |                                                                                        |   |
| Item 2 -          |       | DESCRIPTION OF  PROPERTIES                                                                  |   |
|              |       |                                                                                        |   |
| Item 3 -          |       | LEGAL PROCEEDINGS                                                                           |   |
|              |       |                                                                                        |   |
| Item  4 -         |       | SUBMISSION  OF MATTERS TO A VOTE OF SECURITY HOLDERS                                        |   |
|              |       |                                                                                        |   |
| **PART II**  |       |                                                                                        |   |
|              |       |                                                                                        |   |
| Item  5 -         |       | MARKET  FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS                 |   |
|              |       |                                                                                        |   |
| Item  6 -         |       | MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |   |
|              |       |                                                                                        |   |
| Item  7 -         |       | FINANCIAL  STATEMENTS AND SUPPLEMENTARY DATA                                                |   |
|              |       |                                                                                        |   |
| Item  8 -         |       | CHANGES  IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE       |   |
|              |       |                                                                                        |   |
| Item 8A -         |       | CONTROLS AND  PROCEDURES                                                                    |   |
|              |       |                                                                                        |   |
| **PART III** |       |                                                                                        |   |
|              |       |                                                                                        |   |
| Item  9 -         |       | DIRECTORS  AND EXECUTIVE OFFICERS OF REGISTRANT                                             |   |
|              |       |                                                                                        |   |
| Item 10 -         |       | EXECUTIVE  COMPENSATION                                                                     |   |
|              |       |                                                                                        |   |
| Item  11 -        |       | SECURITY  OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT                             |   |
|              |       |                                                                                        |   |
| Item  12 -        |       | CERTAIN  RELATIONSHIPS AND RELATED TRANSACTIONS                                             |   |
|              |       |                                                                                        |   |
| **PART IV**  |       |                                                                                        |   |
|              |       |                                                                                        |   |
| Item 13 -         |       | EXHIBITS, FINANCIAL STATEMENT  SCHEDULES, AND REPORTS ON FORM 8-K                      |   |
|              |       |                                                                                        |   |
| Item  14 -        |       | AUDIT  FEES AND SERVICES                                                                    |   |
|              |       |                                                                                        |   |
|              |       | EXHIBIT INDEX                                                                               |   |
|              |       |                                                                                        |   |
|              |       | SIGNATURES                                                                                  |   |

 

3

----

 

**PART I**

 

**Item 1.****          ****Description of Business**

 

*Coast Bancorp*

 

CoastBancorp (the “Bancorp” or “Coast Bancorp”), headquartered in San Luis Obispo,California, and is a California corporation incorporated in 2001.  Coast Bancorp became the bank holding companyof Coast National Bank on May 31, 2001 through a corporatereorganization.  In the reorganization,Coast National Bank became the wholly-owned subsidiary of Coast Bancorp and theshareholders of the Bank became shareholders of Coast Bancorp.  Coast Bancorp is operated through atwo-tiered corporate structure.  At theholding company level the affairs of Coast Bancorp are overseen by a Board ofDirectors elected by the shareholders of Coast Bancorp at the annual meeting ofshareholders.  The business of the Bankis overseen by a Board of Directors elected by Coast Bancorp, the sole owner ofthe Bank.  As of the date of this Form 10-KSB,the respective members of the Board of Directors of the Bank and the Board ofDirectors of Coast Bancorp are identical. Coast Bancorp is subject to the regulations of, and examination by, theBoard of Governors of the Federal Reserve System.  At present, Coast Bancorp does not engage inany material business activities other than the ownership of the Bank.

 

*CoastNational Bank*

 

CoastNational Bank (the “Bank”) was chartered June 16, 1997, (charter #23222)by The Office of the Comptroller of the Currency as a national bank.  The Bank commenced operations on that datewith two offices, 16 employees and $6,250,000 in capital.  The original branch offices were located at486 Marsh Street, San Luis Obispo and 1199 Grand Avenue, Arroyo Grande,California.  Since that time, anadditional branch office was opened in June, 1998, at 948 Morro Bay Boulevardin Morro Bay, California and another branch office was opened in July, 1999, at1193 Los Osos Valley Road in Los Osos, California.  In July 2002, a loan production officewas originally opened at 930 South Broadway Street in Santa Maria and in July 2004moved to 301 S. Miller Street, Ste 110 in Santa Maria, California.  In October 2004 a loan production officewas opened in Santa Barbara, California at 15 West Carrillo St. Ste. 252.  The Bank applied for and received approvalfrom the Comptroller of the Currency for another branch office which will open March 2005at 2138 Spring Street, Paso Robles, California. The Bank also purchased a lot at 2045 Spring Street, Paso Robles,California with the intention of relocating the Paso Robles branch sometime inthe future.

 

Whenthe Bank opened for business in June 1997, it purchased the real estateand building that housed the Arroyo Grande branch office.  On October 14, 1999, the Bank purchasedan adjacent lot next to the San Luis Obispo main office on Marsh Street.  A few months later on February 1, 2000,the Bank also purchased the contiguous property and building that was home tothe San Luis Obispo main office at 486 Marsh Street.  Construction of a new head office building onthe adjacent lot began on October 11, 2001 and was completed on November 25,2002.  The new main office, located at 500Marsh Street is approximately 10,700 square feet with the San Luis Obispobranch operation occupying the ground floor and the administrative officesoccupying the second floor.  The originalmain office at 486 Marsh Street now houses the Bank’s Government GuaranteedLending Center and the Bank’s Note Department.

 

OnMarch 29, 2002, the Bank purchased a vacant site on Morro Bay Boulevard inMorro Bay that is approximately one block from the existing branch with theintention of eventually relocating the Morro Bay branch.  In October 2003 construction began onthe new Morro Bay facility which was completed and occupied in August 2004.The new branch consists of approximately 2700 square feet with twodrive-through lanes.

 

Asof December 31, 2004, the Bank had a total of 66 employees.  A number of these employees are part-timehowever. Part-time employees are converted to full-time equivalent employees onthe percentage of their weekly hours worked compared to 40 hours.  On a full-time equivalent basis, employeesrepresent 58 positions.  The Bank valuesits employees and feels that it enjoys satisfactory working relations withthem.  The employees are actively engagedindividually and as a team in contributing to the Bank’s realization of itsvision and mission.

 

TheBank faces competition in the market area for all of its banking products frombranches of most of the major California money center banks, other communitybanks, savings & loans and credit unions.  The Bank also faces competition for some ofour deposit products from large securities firms.  The Bank’s primary market focus is to providecommercial bank services to businesses, professionals, and individuals.  The Bank emphasizes the development ofmeaningful customer relationships and a high level of service. Its employeesare well-trained banking professionals who are committed to these objectives.

 

4

----

 

*Deposits,Liquidity and Liability Management*

 

Depositsrepresent the Bank’s primary source of funds.  As of December 31, 2004, the Bank hadapproximately $39.6 million in non-interest bearing deposit accounts.  Also, as of that date, the Bank hadapproximately $37.0 million in interest bearing deposit accounts, $9.0 millionin savings accounts and $58.9 million in time certificates of deposits.  Of the total time certificates of deposits,approximately $44.4 million were in amounts of $100,000 or more, or 75.4% ofall time certificates and 30.8% of all deposits.  Most of the Bank’s deposits are obtained fromindividuals, professionals and small and medium sized businesses.  A material portion of the Bank’s deposits hasnot been obtained from a single person or a few persons.

 

Depositproducts include regular checking accounts, savings accounts, certificates ofdeposit, money-market accounts and IRA accounts.  The Bank offers an ATM/ debit card as well asa VISA credit card as part of its retail banking services.  The Bank also offers internet bankingservices.

 

Inorder to attract loan and deposit business, the Bank maintains lobby hours from9:00 a.m. to 4:00 p.m., Monday through Thursday and 9:00 a.m. to6:00 p.m. on Fridays.  Walk-upwindow service is also available at the San Luis Obispo office beginning at8:00 a.m. until 9:00 a.m. and again from 4:00 p.m. until 6:00 p.m.,Monday through Friday.  Drive-throughservice is available at the Arroyo Grande and Morro Bay offices beginning at8:00 a.m. until 5:00 p.m., Monday through Thursday and 8:00 a.m.until 6:00 p.m. on Friday.  The Bankalso provides 24-hour automated teller service at all of its branch locations.

 

Liquidityis the Bank’s ability to meet fluctuations in deposit levels and to provide forthe credit needs of its customers.  Theobjective in liquidity management is to maintain a balance between the sourcesand uses of funds.  Principal sources ofliquidity include interest and principal payments on loans and investments,proceeds from the maturity of investments and growth in deposits.  The Bank holds overnight Fed Funds Sold as acushion for temporary liquidity needs. For 2004, Fed Funds Sold averaged $12.9 million representing 8.34% ofaverage assets.  In addition, the Bankmaintains Federal Funds lines of $7.0 million with major correspondents,subject to customary terms for such arrangements.  The Bank has also been approved formembership in the Federal Home Loan Bank of San Francisco (FHLBSF).  At December 31, 2004, the Bank had noborrowings under its Federal Funds lines. Also at December 31, 2004, the Bank’s internally calculated liquidityratio, which measures the percentage of total liabilities (excluding equity)which are used to fund cash, cash equivalents and non-pledged marketablesecurities, was within the Bank’s policy guidelines.

 

*LendingActivities, Underwriting and Credit Administration*

 

Thelending activities of Coast National Bank are guided by the lending policiesestablished by the Bank’s Board of Directors. The loan policy is managed through periodic reviews and approvedannually by the Board.  The Bank’s LoanCommittee is made up of all members of the Bank’s Board of Directors.

 

TheBank considers its underwriting practices to be conservative in nature.  Each loan must meet minimum underwritingcriteria established in the Bank’s loan policy. Lending authority is granted to lending officers of the Bank on alimited basis, dependent upon individual knowledge and experience.  Loan requests exceeding individual officerapproval limits are approved by the Board Loan Committee.  The Board meets weekly in order to providetimely responses to the Bank’s clients. Concerning matters of credit administration oversight, the Board’s AuditCommittee also schedules the services of an outside loan review firm on abi-monthly basis to monitor the quality of all loans originated by the Bank’slending officers.

 

Nomaterial portion of the Bank’s loans are concentrated within a single industryor group of related industries.  However,as of December 31, 2004 and December 31, 2003 respectively 72.5% and70.2% of total loans were secured by real estate.  The interest rates charged by the Bank varywith the degree of risk and the size and maturity of the loans involved and aregenerally affected by competition, governmental regulation and current moneymarket rates.

 

TheBank concentrates its lending activities in the following areas:

 

*Commercial Loans*.  TheBank provides financial services to diverse commercial and professionalbusinesses in its primary service areas. Commercial loans consist primarily of short term loans (normally with amaturity of one year or less) for working capital and business expansion.Commercial loans typically include revolving lines of credit collateralized byinventory, accounts receivable and equipment. Emphasis is placed on the borrower’s earnings history, capitalization,secondary sources of repayment, and in some instances, third-party guaranteesor highly liquid collateral (such as time deposits and investmentsecurities).  Commercial loan pricing isgenerally at a variable rate tied to the prime rate as quoted in the WallStreet Journal.

 

5

----

 

TheBank also participates in several government-guaranteed loan programsadministered by the Small Business Administration (SBA).  These programs include the 7-A program, the Low-Docprogram, the Cap-Line program, the Builder Cap-Line program and the Expressprogram.  The SBA’s 7-A program presentlyconstitutes the largest volume of government guaranteed lending engaged in bythe Bank and is primarily used for the financing of real estate, equipment,inventory and working capital needs of eligible businesses, generally over aseven-to-twenty five year term.  Thegovernment guarantees extended by the SBA to the Bank in conjunction with thesetransactions substantially reduces the Bank’s credit risk.  Based upon the Bank’s expertise in this typeof lending, the SBA designated the Bank as a Preferred Lender in September 2001.  Under the SBA’s Preferred Lender program, theBank enjoys a significant degree of delegated approval authority which in turnallows the Bank to process customer loan requests more quickly.  This Preferred Lender authority covers loantransactions originated by the Bank in the geographic areas defined by the SBAas their Fresno district (which serves the counties of Alpine, Fresno, Inyo,Kern, Kings, Madera, Mariposa, Merced, Mono, Monterey, San Benito, San LuisObispo, Stanislaus, Tulare and Tuolumne) and the Los Angeles district (whichserves Los Angeles County, Santa Barbara County and Ventura County).

 

*Real Estate Construction and Development Loans*.  TheBank’s real estate construction loan activity has always focused on providingshort-term (maturity of one year or less) loans to individuals and developerswith whom the Bank has established relationships, primarily for theconstruction of single family residences in the Bank’s service area.

 

Residentialreal estate construction loans are typically secured by first deeds of trustand require guarantees of the borrower, when applicable.  The economic viability of the project and theborrower’s credit-worthiness are primary considerations in the loanunderwriting decision.  The Bank utilizesindependent local real estate appraisers that have been pre-approved by theBank’s Loan Committee to evaluate the projects.  Loan-to-value ratios generally do not exceed80% of the appraised value of the property. The Bank monitors projects during the construction phase through regularconstruction inspections and a disbursement program tied to the percentage ofcompletion of each project.

 

TheBank also occasionally makes land loans to individuals who intend to constructa single-family residence on a residential parcel, generally within 24months.  In addition, the Bank makescommercial real estate construction loans to qualified applicants with adequateliquidity for the construction of office and warehouse properties.  Such loans are typically secured by firstdeeds of trust and require guarantees of the borrowers.

 

*Residential Mortgage Loans. *In January 2003, the Bank entered intoan operating agreement with Fremont Bank’s Community Bank Lending Exchange(CBLX) division, to be the exclusive residential loan referring agent for SanLuis Obispo County and the City of Santa Maria. Under the directives of this agreement, the Bank staff refers loans byinputting them into the online system of CBLX. The loans are underwritten and processed by CBLX, with the Bankparticipating in the gathering of financial data and signing loan documents.  The Bank does not have any responsibility forthe underwriting or documentation requirements. For these services the Bank receives a referral fee equivalent to 75basis points for the dollar amount funded on all loans.  The program was very successful in the firstyear, allowing the Bank to earn over $250,000. In 2004 mortgage refinancingslowed and our income was reduced to $108,000.

 

*Commercial Real Estate Term Loans*.  TheBank provides medium-term commercial real estate loans secured by commercial orindustrial buildings where the property is either used by the owner forbusiness purposes (owner-user properties) or has income derived from tenants(investment properties).  The Bank’s loanpolicies require the principal balance of the loan to be no more than 75% ofthe stabilized appraised value of the underlying real estate collateral, with aminimum 1.25% debt service coverage ratio. The loans, which are typically secured by first trust deeds, generallyhave terms of no more than ten years and are amortized over 25 to 30years.  Some of these loans have fixedrates but most have variable rates that are tied to an independent index suchas the Wall Street Journal prime rate, or the Federal Home Loan Bank’s EleventhDistrict cost of funds index.

 

*Consumer and Other Loans*.  The Bank’s consumer and otherloan portfolio is divided between installment loans secured by automobiles,personal loans, other consumer purposes and revolving, unsecured consumer debt,such as credit card lines of credit and overdraft lines of credit.  Installment loans tend to be fixed rate andlonger term (one-to-five year maturity). The Bank’s portfolio of revolving credit plans tend to be small in sizeand meant to be an accommodation to our customers.

 

*Employees*

 

Asof December 31, 2004, we employed 58 full-time equivalent employees.  Part-time employees are converted tofull-time equivalent employees based on the percentage of their weekly hoursworked compared to 40 hours.  The Bankvalues its employees.  They are activelyengaged individually and as a team in contributing to the Bank’s realization ofits vision and mission.  We believe thatwe enjoy satisfactory working relations with our employees.

 

6

----

 

*Competition*

 

TheBank competes for both loans and deposits with other commercial banks, savings &loan associations, credit unions and other entities, both governmental andcorporate, which raise operating capital through the issuance of debtsecurities.  With regard to loans, theBank competes with other commercial banks, savings & loanassociations, consumer finance companies, mortgage companies, credit unions andother lending institutions.

 

TheBank relies substantially on local promotional activity, personal contacts byits officers, directors and employees, referrals by its shareholders,personalized service and its reputation in the community it serves to competeeffectively.

 

Thebanking business in California generally, and in the Bank’s primary servicearea specifically, is highly competitive with respect to both loans anddeposits, and is dominated by a relatively small number of major banks withoffices operating over a wide geographic area. Among the advantages such major banks have over the Bank are theirability to finance wide-ranging advertising campaigns and to allocate theirinvestment assets, including loans, to regions of higher yield and demand.  Such banks offer certain services such asinternational banking and trust services which are not offered directly by theBank, but which the Bank has offered indirectly through correspondentinstitutions when its customers sought these services.  In addition, by virtue of their greater totalcapitalization, such banks have substantially higher lending limits than theBank.  (Legal lending limits to anindividual customer are limited to a percentage of a bank’s total capitalaccounts plus reserves for loan losses.) As of December 31, 2004, the Bank’s loan limits to individualcustomers were $2,383,215 for unsecured loans, and $3,972,026 for unsecured andsecured loans combined.  For borrowersdesiring loans in excess of the Bank’s lending limits, the Bank may, in thefuture, make such loans on a participation basis with its correspondent bankstaking the amount of loans in excess of the Bank’s lending limits.  In other cases, the Bank may refer suchborrowers to larger banks or other lending institutions.

 

*TrustPreferred Securities*

 

OnSeptember 26, 2002, the Bancorp completed its offering of trust preferredsecurities (“TPS”) in the amount of $5.1million.  Under current Federal Reserve guidelines, TPSqualify as regulatory capital for the Bancorp. More specifically, under current Federal Reserve guidelines, TPS qualifyas Tier 1 Capital up to 25% of the Bancorp’s total Tier 1 Capital, with theremainder qualifying as Tier 2 Capital. The Bancorp is reflecting the trust preferred securities as juniorsubordinated debt securities on its consolidated balance sheet.

 

Thesecurities were issued by a special purpose trust formed by the Bancorp andwere sold to a pooled investment vehicle sponsored by Keefe, Bruyette &Woods and FTN Financial, in a private transaction.  The securities were sold pursuant to anapplicable exemption from registration under the Securities Act of 1933, asamended (the “Act”), and have not been registered under the Act.  FTN Financial assisted the Bancorp in theplacement of the trust preferred securities. The securities may not be offered or sold in the United States absentregistration or an applicable exemption from registration requirements.

 

The$5.1 million in trust preferred securities have a floating rate of interest,which is reset quarterly, equal to the 3-month LIBOR plus 3.40%.  As of December 31, 2004, the floatingrate of interest was 5.95%.  The floatingrate, however, may not exceed 11.95% for the first five years.

 

Ifthe Bancorp elects to defer interest payments pursuant to the terms of theagreement, then the Bancorp may not (i) declare or pay any dividends ordistributions on, or redeem, purchase, acquire or make a liquidation paymentwith respect to any of the Bancorp’s capital stock, or (ii) make anypayment of principal or premium, if any, or interest on or repay, repurchase orredeem any debt securities of the Bancorp that rank pari passu with or juniorin interest to the debt securities, other than, among other items, adividend in the form of stock, warrants, options or other rights in the samestock as that on which the dividend is being paid or ranks pari passu with orjunior to such stock.  The prohibition onpayment of dividends and payments on pari passu or junior debt also applies inthe case of an event of default under the agreements.

 

Asof December 31, 2004, the Coast Bancorp has down-streamed a total of $3.6million to the Bank in the form of Tier I capital where it will finance futuredeposit and asset growth.

 

*OtherInformation*

 

TheBank holds no material patents, trademarks, licenses, franchises orconcessions.  No expenditures have beenmade by the Bank, during the last two fiscal years, on material research activitiesrelating to the development of services or the improvement of existingservices.

 

7

----

 

Basedupon present business activities, compliance with federal, state and localprovisions regulating discharge of materials into the environment will have nomaterial effects upon the capital expenditures, earnings and competitiveposition of the Bank.

 

Therehave been no significant changes in the kinds of services rendered, theprincipal markets for or the methods of distribution of such services by theBank during the last seven (7) fiscal years.

 

TheBank’s business is not seasonal.  TheBank intends to continue with the same basic commercial banking activities thathave characterized the Bank’s operations since its inception.  The Bank anticipates continued profitablegrowth while maintaining sound credit and management policies.

 

8

----

 

***Critical Accounting Policies***

 

**Our accounting policies are integral to understanding the resultsreported.  Accounting policies aredescribed in detail in Note 1 of the NOTES TO CONSOLIDATED FINANCIALSTATEMENTS.  In preparing itsconsolidated financial statements, the Company is required to make judgmentsand estimates that may have a significant impact upon its financialresults.  Certain accounting policiesrequire the Company to make significant estimates and assumptions, which have amaterial impact on the carrying value of certain assets and liabilities, andare considered critical accounting policies. The estimates and assumptions used are based on the historicalexperiences and other factors, which are believed to be reasonable under thecircumstances.  Actual results coulddiffer significantly from these estimates and assumptions, which could have amaterial impact on the carrying value of assets and liabilities at the balancesheet dates and results of operations for the reporting periods.  For example, the Company’s determination ofthe adequacy of its allowance for loan losses is particularly susceptible tomanagement’s judgment and estimates.  Thefollowing is a brief description of our current accounting policies involvingsignificant management valuation judgments.**

 

Allowance for Loan Losses

 

Theallowance for loan losses represents management’s best estimate of lossesinherent in the existing loan portfolio. The allowance for loan losses is increased by the provision for loanlosses charged to expense and reduced by loans charged off, net of recoveries.  The allowance for loan losses is determinedbased on management’s assessment of several factors: reviews and evaluation ofindividual loans, changes in the nature and volume of the loan portfolio,current economic conditions and the related impact on specific borrowers andindustry groups, historical loan loss experiences and the levels of classifiedand nonperforming loans.

 

Loansare considered impaired if, based on current information and events, it isprobable that we will be unable to collect the scheduled payments of principalor interest when due according to the contractual terms of the loanagreement.  The measurement of impairedloans is generally based on the present value of expected future cash flowsdiscounted at the historical effective interest rate stipulated in the loanagreement, except that all collateral-dependent loans are measured forimpairment based on the fair value of the collateral.  In measuring the fair value of thecollateral, management uses assumptions and methodologies consistent with thosethat would be utilized by unrelated third parties.

 

Changesin the financial condition of individual borrowers, in economic conditions, inhistorical loss experience and in the condition of the various markets in whichcollateral may be sold may all affect the required level of the allowance forloan losses and the associated provision for loan losses.

 

Available for Sale Securities

 

Thefair value of most securities classified as available for sale are based onquoted market prices.  If quoted marketprices are not available, fair values are extrapolated from the quoted pricesof similar instruments.

 

Deferred Tax Assets

 

Weuse an estimate of future earnings to support our position that the benefit ofour deferred tax assets will be realized. If future income should prove non-existent or less than the amount ofthe deferred tax assets within the tax years to which they may be applied, theasset may not be realized and our net income will be reduced.  Our deferred tax assets are described furtherin Note 8 of the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.

 

9

----

 

**SUPERVISION AND REGULATION**

 

***Bancorp***

 

CoastBancorp, as a bank holding company, is subject to regulation under the BankHolding Company Act of 1956, as amended, and is registered with and subject tothe supervision of the Board of Governors of the Federal Reserve System.  It is the policy of the Federal Reserve thateach bank holding company serves as a source of financial and managerialstrength to its subsidiary banks.  TheFederal Reserve has the authority to examine Coast Bancorp.

 

TheBank Holding Company Act requires Coast Bancorp to obtain the prior approval ofthe Federal Reserve before acquisition of all or substantially all of theassets of any bank or ownership or control of the voting shares of any bank if,after giving effect to such acquisition, Coast Bancorp would own or control,directly or indirectly, more than 5% of the voting shares of such bank.  Recent amendments to the Bank Holding CompanyAct expand the circumstances under which a bank holding company may acquirecontrol of or all or substantially all of the assets of a bank located outsidethe State of California.

 

CoastBancorp may not engage in any business other than managing or controlling banksor furnishing services to its subsidiaries, with the exception of certainactivities which, in the opinion of the Federal Reserve, are so closely relatedto banking or to managing or controlling banks as to be incidental to banking.  The Gramm-Leach-Bliley Act, federallegislation enacted in 2000, offers bank holding companies an opportunity tobroaden the scope of activities engaged in by electing to be treated as afinancial holding company.  A financialholding company enjoys broader powers than a bank holding company, specificallyincluding the ability to own securities and insurance companies in addition tofinancial institutions.  Coast Bancorphas not determined whether or not to become a financial holding company.  Coast Bancorp is generally prohibited fromacquiring direct or indirect ownership or control of more than 5% of the votingshares of any company unless that company is engaged in such authorizedactivities and the Federal Reserve approves the acquisition.

 

CoastBancorp and its subsidiaries are prohibited from engaging in certain tie-inarrangements in connection with any extension of credit, sale or lease ofproperty or provision of services.  Forexample, with certain exceptions the Bank may not condition an extension ofcredit on a customer obtaining other services provided by it, Coast Bancorp orany other subsidiary, or on a promise by the customer not to obtain otherservices from a competitor.  In addition,federal law imposes certain restrictions on transactions between Coast NationalBank and its affiliates.  As affiliates,Coast National Bank and Coast Bancorp are subject with certain exceptions, tothe provisions of federal law imposing limitations on and requiring collateralfor extensions of credit by Coast National Bank to any affiliate.

 

***The Bank***

 

TheBank is regulated and supervised by the Comptroller of the Currency and subjectto periodic examination by the Comptroller. Deposits of the Bank’s customers are insured by the FDIC up to themaximum limit of $100,000, and, as an insured bank, the Bank is subject tocertain regulations of the FDIC.  As anational bank, the Bank is a member of the Federal Reserve System and is alsosubject to the regulations of the Federal Reserve Board (the “FRB”).

 

Theregulations of those federal bank regulatory agencies govern most aspects ofthe Bank’s business and operations, including but not limited to, requiring themaintenance of non-interest bearing reserves on deposits, limiting the natureand amount of investments and loans which may be made, regulating the issuanceof securities, restricting the payment of dividends and regulating bankexpansion and bank activities and the maximum rates of interest allowed oncertain deposits.  The Bank also is subjectto requirements and restrictions of various consumer laws and regulations.

 

Thefollowing description of selected statutory and regulatory provisions andproposals is not intended to be a complete description of these provisions orof the many laws and regulations to which the Bank is subject, and is qualifiedin its entirety by reference to the particular statutory or regulatoryprovisions discussed.

 

***Effect of State Law***

 

Thelaws of the State of California also affect the Bank’s business andoperations.  For example, under 12 U.S.C.36, as amended by the Riegle-Neal Interstate Banking and Branching EfficiencyAct of 1994, state laws regarding community reinvestment, consumer protection,fair lending and establishment of intrastate branches may affect the operationsof national banks in states other than their home states.  On a similar basis, 12 U.S.C. 85 providesthat state law, in most circumstances, determines the maximum rate of interestwhich a national bank may charge on a loan. As California law exempts all state-chartered and national banks fromthe application of its usury laws, national banks are also provided such anexemption by 12 U.S.C. 85.

 

10

----

 

***Change in Bank Control***

 

TheBank Holding Company Act of 1956, as amended and the Change in Bank Control Actof 1978, as amended, together with regulations of the FRB and the Comptroller,require that, depending on the particular circumstances, either FRB approvalmust be obtained or notice must be furnished to the Comptroller and not disapprovedprior to any person or company acquiring “control” of a national bank, such asthe Bank, subject to exemptions for some transactions.  Control is conclusively presumed to exist ifan individual or company acquires 25% or more of any class of voting securitiesof the Bank.  Control is rebuttablypresumed to exist if a person acquires 10% or more but less than 25% of anyclass of voting securities and either the company has registered securitiesunder Section 12 of the Securities Exchange Act of 1934, as amended (the “ExchangeAct”), or no other person will own a greater percentage of that class of votingsecurities immediately after the transaction.

 

***Payment of Dividends***

 

CoastBancorp

 

Theshareholders of Coast Bancorp are entitled to receive dividends when and asdeclared by its Board of Directors, out of funds legally available, subject tothe dividends preference, if any, on preferred shares that may be outstandingand also subject to the restrictions of the California Corporations Code.  At December 31, 2004, Coast Bancorp hadno outstanding shares of preferred stock.

 

Thepayment of dividends to shareholders by Coast Bancorp may be affected if theBancorp elects to defer interest payments pursuant to the terms of the TrustPreferred Securities agreement that was entered into on September 26,2002.  If such an event occurs, then theBancorp may not (i) declare or pay any dividends or distributions on, orredeem, purchase, acquire or make a liquidation payment with respect to any ofthe Bancorp’s capital stock, or (ii) make any payment of principal orpremium, if any, or interest on or repay, repurchase or redeem any debtsecurities of the Bancorp that rank pari passu with or junior in interest tothe debt securities, other than, among other items, a dividend in theform of stock, warrants, options or other rights in the same stock as that onwhich the dividend is being paid or ranks pari passu with or junior to suchstock.  The prohibition on payment ofdividends and payments on pari passu or junior debt also applies in the case ofan event of default under the agreements.

 

Seealso the section that follows titled “Part II - Item 5: Market forCommon Equity and Related Stockholder Matters - Dividends”.

 

Theprincipal sources of cash revenue to Coast Bancorp will be dividends andmanagement fees received from Coast National Bank.  The Bank’s ability to make dividend paymentsto Coast Bancorp is subject to federal regulatory restrictions.

 

CoastNational Bank

 

Theability of the Bank to make dividend payments is subject to statutory andregulatory restrictions.  After the firstthree years of operations, the Board of Directors of a national bank maydeclare the payment of dividends depending upon earnings, financial conditionand cash needs of the Bank and general business conditions.  A national bank may not pay dividends fromits capital.  All dividends must be paidout of net profits then on hand, after deducting losses and bad debts.  A national bank is further prohibited fromdeclaring a dividend on its shares of common stock until its surplus fundequals the amount of capital stock or until 10% of the Bank’s net profits ofthe preceding half-year in the case of quarterly or semiannual dividends, orthe preceding two consecutive half-year periods in the case of an annualdividend, are transferred to the surplus fund. The approval of the Comptroller is required for the payment of dividendsif the total of all dividends declared by the Bank in any calendar year wouldexceed the total of its net profits of that year combined with its retained netprofits of the two preceding years, less any required transfers to surplus or afund for the retirement of any preferred stock.

 

Inaddition to the above requirements, guidelines adopted by the Comptroller setforth factors which are to be considered by a national bank in determining thepayment of dividends.  A national bank,in assessing the payment of dividends, is to evaluate the Bank’s capitalposition, its maintenance of an adequate allowance for loan and lease losses,and the need to revise or develop a comprehensive capital plan.  See “Capital Standards” below.

 

TheComptroller also has broad authority to prohibit a national bank from engagingin banking practices which it considers to be unsafe or unsound.  It is possible, depending upon the financialcondition of the national bank in question and other

 

11

----

 

factors,that the Comptroller may assert that the payment of dividends or other paymentsby a bank is considered an unsafe or unsound banking practice and therefore,implement corrective action to address such a practice.

 

Accordingly,the future payment of cash dividends by the Bank will not only depend upon theBank’s earnings during any fiscal period but will also depend upon theassessment of its Board of Directors of capital requirements and other factors,including dividend guidelines and the maintenance of an adequate allowance forloan and lease losses.

 

***Capital Standards***

 

TheBoard of Governors, the Comptroller and other federal banking agencies haverisk based capital adequacy guidelines intended to provide a measure of capitaladequacy that reflects the degree of risk associated with a bankingorganization’s operations for both transactions reported on the balance sheetas assets, and transactions, such as letters of credit and recoursearrangements, which are reported as off-balance-sheet items.  Under these guidelines, nominal dollaramounts of assets and credit equivalent amounts of off-balance-sheet items aremultiplied by one of several risk adjustment percentages, which range from 0%for assets with low credit risk, such as certain U. S. government securities,to 100% for assets with relatively higher credit risk, such as business loans.

 

Abanking organization’s risk based capital ratios are obtained by dividing itsqualifying capital by its total risk-adjusted assets and off-balance-sheetitems.  The regulators measurerisk-adjusted assets and off-balance-sheet items against both total qualifyingcapital (the sum of Tier 1 capital and limited amounts of Tier 2 capital) andTier 1 capital.  Tier 1 capital consistsof common stock, retained earnings, non-cumulative perpetual preferred stockand minority interests in certain subsidiaries, less most other intangibleassets.  Tier 2 capital may consist of alimited amount of the allowance for possible loan and lease losses and certainother instruments with some characteristics of equity.  The inclusions of elements of Tier 2 capitalare subject to certain other requirements and limitations of the federalbanking agencies.  Since December 31,1992, the federal banking agencies have required a minimum ratio of qualifyingtotal capital to risk-adjusted assets and off-balance-sheet item of 8%, and aminimum ratio of Tier 1 capital to risk-adjusted assets and off-balance-sheetitems of 4%.  At least one-half of thequalifying capital must be in the form of Tier 1 capital.

 

Inaddition to the risk-based guidelines, federal banking regulators requirebanking organizations to maintain a minimum amount of Tier 1 capital to totalassets, referred to as the leverage ratio. For a banking organization rated in the highest of the five categoriesused by the regulators to rate banking organizations, the minimum leverageratio of Tier 1 capital to total assets is 3%. It is improbable however, that an institution with a 3% leverage ratiowould receive the highest rating by the regulators since a strong capitalposition is a significant part of the regulators’ rating.  For all banking organizations not rated inthe highest category, the minimum leverage ratio is at least 100 to 200 basispoints above the 3% minimum.  Thus, theeffective minimum leverage ratio, for all practical purposes, is at least 4% or5%.  In addition to these uniformrisk-based capital guidelines and leverage ratios that apply across theindustry, the regulators have the discretion to set individual minimum capitalrequirements for specific institutions at rates significantly above the minimumguidelines and ratios.

 

Inaddition to evaluating capital ratios, an overall assessment of capitaladequacy must take account of each of these other factors including, inparticular, the level and severity of problem and adversely classified assets.  For this reason, the supervisory judgment ona bank’s capital adequacy may differ significantly from the conclusions thatmight be drawn solely from the absolute level of the Bank’s risk-based capitalratio.  The Comptroller has stated thatbanks generally are expected to operate above the minimum risk-based capitalratio.  Banks contemplating significantexpansion plans, as well as those institutions with high or inordinate levelsof risk, should hold capital consistent with the level and nature of the risksto which they are exposed.

 

Further,the banking agencies have adopted modifications to the risk-based capitalregulations to include standards for interest rate risk exposures.  Interest rate risk is the exposure of a bank’scurrent and future earnings and equity capital arising from movements ininterest rates.  While interest rate riskis inherent in a bank’ role as a financial intermediary, it introducesvolatility to bank earnings and to the economic value of the Bank.  The banking agencies have addressed thisproblem by implementing changes to the capital standards to include a bank’sexposure to declines in the economic value of its capital due to changes ininterest rates as a factor that the banking agencies consider in evaluating aninstitution’s capital adequacy.  Bankexaminers consider a bank’s historical financial performance and its earningsexposure to interest rate movements as well as qualitative factors such as theadequacy of a bank’s internal interest rate risk management.

 

Finally,institutions with significant trading activities must measure and hold capitalfor exposure to general market risk arising from fluctuations in interestrates, equity prices, foreign exchange rates and commodity prices and exposureto specific risk associated with debt and equity positions in the tradingportfolio.  General market risk refers tochanges in the market value of on-balance-sheet assets and off-balance-sheetitems resulting from broad market movements. Specific market risk refers to changes in the market value of individualpositions due to factors other than broad market movements and includes

 

12

----

 

suchrisks as the credit risk of an institution’s issuer.  The additional capital requirements applyeffective January 1, 1998, to institutions with trading assets andliabilities equal to 10% or more of total assets or trading activity of $1billion or more.  The federal bankingagencies may apply the market risk regulations on a case by case basis toinstitutions not meeting the eligibility criteria if necessary for safety andsoundness reasons.

 

Thefederal banking agencies will evaluate an institution in its periodicexamination on the degree to which changes in interest rates, foreign exchangerates, commodity prices or equity prices can affect a financial institution’searnings or capital.  In addition, theagencies focus in the examination on an institution’s ability to monitor andmanage its market risk, and will provide management with a clearer and morefocused indication of supervisory concerns in this area.

 

Undercertain circumstances, the Comptroller may determine that the capital ratiosfor a national bank shall be maintained at levels which are higher than theminimum levels required by the guidelines.  A national bank which does not achieve andmaintain adequate capital levels as required may be subject to supervisoryaction by the Comptroller, through the issuance of a capital directive toensure the maintenance of required capital levels.  In addition, the Bank is required to meetcertain guidelines of the Comptroller concerning the maintenance of an adequateallowance for loan and lease losses.  Theregulatory capital guidelines as well as the actual capitalization for the Bankand the company on a consolidated basis as of December 31, 2004 follow:

 

Setforth below is the Bank and the company’s risk based and leverage capitalratios as of December 31, 2004:

 
| ** **                      | ** ** | **Requirement**             | ** ** | **Actual**            | ** ** |
|---------------------------------|------------|-----------------------------|------------|-----------------------|------------|
| ** **                      | ** ** | **Adequately  Capitalized** | ** ** | **Well  Capitalized** | ** ** | **Bank** | ** ** | **Company** | ** ** |
| Total risk-based capital ratio  |       | 8.00                        | %          | 10.00                 | %          | 12.56 | % | 12.78 | % |
| Tier 1 risk-based capital ratio |       | 4.00                        | %          | 6.00                  | %          | 11.63 | % | 10.44 | % |
| Tier 1 leverage capital ratio   |       | 4.00                        | %          | 5.00                  | %          | 8.99 | % | 8.30 | % |

 

***Prompt Corrective Actionand Other Enforcement Mechanisms***

 

Federal banking agenciespossess broad powers to take corrective and other supervisory actions toresolve the problems of insured depository institutions, including, but notlimited to those institutions that fall below one or more prescribed minimumcapital ratios described above.  Aninstitution that, based upon its capital levels, is classified as wellcapitalized, adequately capitalized, or undercapitalized may be treated asthough it were in the next lower capital category if the appropriate federalbanking agency, after notice and opportunity for hearing, determines that anunsafe or unsound condition or an unsafe or unsound practice warrants suchtreatment.  At each successive lowercapital category, an insured depository institution is subject to morerestrictions.  The federal bankingagencies, however, may not treat a significantly undercapitalized institutionas critically undercapitalized, unless its capital ratio actually warrants suchtreatment.

 

In addition to measurestaken under the prompt corrective action provisions, commercial bankingorganizations may be subject to potential enforcement actions by the federalregulators for unsafe or unsound practices in conducting their businesses orfor violations of any law, rule, regulation, or any condition imposed in writingby the agency, or any written agreement with the agency.  Enforcement actions may include theimposition of a conservator or receiver, the issuance of a cease-and-desistorder that can be judicially enforced, the termination of insurance of deposits(in the case of a depository institution), the imposition of civil moneypenalties, the issuance of directives to increase capital, the issuance offormal and informal agreements, the issuance of removal and prohibition ordersagainst institution-affiliated parties and the enforcement of such actionsthrough injunctions or restraining orders based upon a judicial determinationthat the agency would be harmed if such equitable relief was not granted.  Additionally, a holding company’s inabilityto serve as a source of strength to its subsidiary banking organizations couldserve as an additional basis for a regulatory action against the holdingcompany.

 

***Safety and SoundnessStandards***

 

The Federal DepositInsurance Corporation Improvement Act (“FDICIA”) imposes certain specificrestrictions on transactions and requires federal banking regulators to adoptoverall safety and soundness standards for depository institutions related tointernal control, loan underwriting and documentation and asset growth.  Among other things, FDICIA limits theinterest rates paid on deposits by undercapitalized institutions, restricts theuse of brokered deposits, limits the aggregate extensions of credit by adepository institution to an executive officer, director, principal shareholderor related interest, and

 

13

----

 

reducesdeposit insurance coverage for deposits offered by undercapitalizedinstitutions for deposits by certain employee benefit accounts.  The federal banking agencies may require aninstitution to submit to an acceptable compliance plan, as well as have theflexibility to pursue other more appropriate or effective courses of actiongiven the circumstances and severity of an institution’s noncompliance with oneor more standards.

 

***Premiums for DepositInsurance***

 

Through the Bank InsuranceFund (“BIF”), the FDIC insures the deposits of the Bank up to prescribed limitsfor each depositor.  The amount of FDICassessments paid by each BIF member institution is based on its relative riskof default as measured by regulatory capital ratios and other factors.  Specifically, the assessment rate is based onthe institution’s capitalization risk category and supervisory subgroupcategory.  An institution’scapitalization risk category is based on the FDIC’s determination of whetherthe institution is well capitalized, adequately capitalized or less thanadequately capitalized.  An institution’ssupervisory subgroup category is based on the FDIC’s assessment of thefinancial condition of the institution and the probability that FDICintervention or other corrective action will be required.

 

The assessment ratecurrently ranges from zero to 27 cents per $100 of domestic deposits.  The FDIC may increase or decrease theassessment rate schedule on a semi-annual basis.  Due to continued growth in deposits and somerecent bank failures, the BIF is nearing its minimum ratio of 1.25% of insureddeposits as mandated by law.  If theratio drops below 1.25%, it is likely the FDIC will be required to assesspremiums on all banks for the first time since 1996.  Any increase in the assessments or theassessment rate could have a material adverse effect on the Bank’s earnings,depending on the amount of the increase.

 

The FDIC is authorized toterminate a depository institution’s deposit insurance upon a finding by theFDIC that the institution’s financial condition is unsafe, or unsound, or thatthe institution has engaged in unsafe, or unsound practices, or has violatedany applicable rule, regulation, order or condition enacted or imposed by theinstitution’s regulatory agency.  Thetermination of deposit insurance for the Bank would have a material adverseeffect on the Bancorp’s condition since it would result in the revocation ofthe Bank’s charter and the cessation of its operations as a going concern.

 

***Extensions of Credit to Insiders and Transactions with Affiliates***

 

TheFederal Reserve Act and FRB Regulation O, which are applicable to nationalbanks, place limitations and conditions on loans or extensions of credit to: abank’s or bank holding company’s executive officers, directors and principalshareholders (i.e., in most cases, those persons who own, control or have powerto vote more than 10% of any class of voting securities); any company controlledby such an executive officer, director or principal shareholder; or anypolitical or campaign committee controlled by such an executive officer,director or principal shareholder.

 

Loansextended to any of the above persons must comply with loan-to-one-borrowerlimits, require prior full board approval when aggregate extensions of creditto such persons exceed specified amounts, must be made on substantially thesame terms (including interest rates and collateral) as, and followcredit-underwriting procedures that are not less stringent than, thoseprevailing at the time for comparable transactions with non-insiders, and mustnot involve more than the normal risk of repayment or present other unfavorablefeatures.  Regulation O also prohibits abank from paying an overdraft on an account of an executive officer ordirector, except pursuant to a written pre-authorized interest-bearingextension of credit plan that specifies a method of repayment or a writtenpre-authorized transfer of funds from another account of the officer ordirector at the Bank.

 

Theprovisions of Regulation O summarized above reflect substantial strengtheningas a result of the adoption of FDICIA. FDICIA also resulted in an amendment to Regulation O which provides thatthe aggregate limit on extensions of credit to all insiders of a bank as agroup cannot exceed the Bank’s unimpaired capital and unimpaired surplus.  An exception to this limitation is providedfor banks with less than $100,000,000 in deposits.  The aggregate limit applicable to such banksis two times the Bank’s unimpaired capital and unimpaired surplus, provided theBank meets or exceeds all applicable capital requirements.

 

***Consumer Protection Laws and Regulations***

 

Thebank regulatory agencies are focusing greater attention on compliance withconsumer protection laws and their implementing regulations.  Examination and enforcement have become moreintense in nature, and insured institutions have been advised to monitor carefullycompliance with various consumer protection laws and their implementingregulations.  The Bank is subject to manyfederal consumer protection statutes and regulations, including the CommunityReinvestment Act, the Equal Credit Opportunity Act, the Truth in Lending Act,the Fair Housing Act, the Home Mortgage Disclosure Act and the Real EstateSettlement Procedures Act.  Penaltiesunder these statutes may include fines, reimbursements and other penalties.

 

14

----

 

Dueto heightened regulatory concern related to compliance with these and otherstatutes generally, the Bank may incur additional compliance costs.

 

**Recentand Proposed Legislation**

 

**Sarbanes-Oxley Act**

 

On July 30, 2002, President Bush signed into law theSarbanes-Oxley Act of 2002 implementing legislative reforms intended to addresscorporate and accounting fraud.  Inaddition to the establishment of a new accounting oversight board which willenforce auditing, quality control and independence standards and will be fundedby fees from all publicly traded companies, the bill restricts provision ofboth auditing and consulting services by accounting firms.  To ensure auditor independence, any non-auditservices being provided to an audit client will require pre-approval by thecompany’s audit committee members.  Inaddition, the audit partners must be rotated. The Act requires chief executive officers and chief financial officers,or their equivalent, to certify to the accuracy of periodic reports filed withthe SEC, subject to civil and criminal penalties if they knowingly or willfullyviolate this certification requirement. In addition, under the Act, legal counsel will be required to reportevidence of a material violation of the securities laws or a breach offiduciary duty by a company to its chief executive officer or its chief legalofficer, and, if such officer does not appropriately respond, to report suchevidence to the audit committee or other similar committee of the board ofdirectors or the board itself.

 

Longer prison terms and increased penalties will also be applied tocorporate executives who violate federal securities laws, the period duringwhich certain types of suits can be brought against a company or its officershas been extended, and bonuses issued to top executives prior to restatement ofa company’s financial statements are now subject to disgorgement if suchrestatement was due to corporate misconduct. Executives are also prohibited from insider trading during retirementplan “blackout” periods, and loans to company executives are restricted.  The Act accelerates the time frame fordisclosures by public companies, as they must immediately disclose any materialchanges in their financial condition or operations.  Directors and executive officers must alsoprovide information for most changes in ownership in a company’s securitieswithin two business days of the change.

 

The Act also prohibits any officer or director of a company or anyother person acting under their direction from taking any action tofraudulently influence, coerce, manipulate or mislead any independent public orcertified accountant engaged in the audit of the company’s financial statementsfor the purpose of rendering the financial statement’s materiallymisleading.  The Act also requires theSEC to prescribe rules requiring inclusion of an internal control reportand assessment by management in the annual report to stockholders.  In addition, the Act requires that eachfinancial report required to be prepared in accordance with (or reconciled to)accounting principles generally accepted in the United States of America andfiled with the SEC reflect all material correcting adjustments that areidentified by a “registered public accounting firm” in accordance withaccounting principles generally accepted in the United States of America andthe rules and regulations of the SEC.

 

Effective for filings due after August 29, 2002, as directed by Section 302(a) ofSarbanes-Oxley, the Company’s chief executive officer and chief financialofficer were each required to certify that the Company’s Quarterly and AnnualReports do not contain any untrue statement of a material fact.  The rules have several requirements,including having these officers certify that: they are responsible forestablishing, maintaining and regularly evaluating the effectiveness of Company’sinternal controls; they have made certain disclosures to Bancorp’s auditors andthe audit committee of the Board of Directors about the Company’s internalcontrols; and they have included information in the Company’s Quarterly andAnnual Reports about their evaluation and whether there have been significantchanges in the Company’s internal controls or in other factors that couldsignificantly affect internal controls subsequent to the evaluation.

 

**USA PATRIOT Act**

 

In the wake of the tragic events of September 11th, on October 26,2001, President Bush signed the Uniting and Strengthening America by ProvidingAppropriate Tools Required to Intercept and Obstruct Terrorism (USA PATRIOT)Act of 2001.  Under the USA PATRIOT Act,financial institutions are subject to prohibitions against specified financialtransactions and account relationships as well as enhanced due diligence and “knowyour customer” standards in their dealings with foreign financial institutionsand foreign customers. For example, the enhanced due diligence policies,procedures, and controls generally require financial institutions to takereasonable steps:

 

•                                          Toconduct enhanced scrutiny of account relationships to guard against moneylaundering and report any suspicious transaction;

 

15

----

 

•                                          Toascertain the identity of the nominal and beneficial owners of, and the sourceof funds deposited into, each account as needed to guard against money launderingand report any suspicious transactions;

 

•                                          Toascertain for any foreign bank, the shares of which are not publicly traded,the identity of the owners of the foreign bank, and the nature and extent ofthe ownership interest of each such owner; and

 

•                                          Toascertain whether any foreign bank provides correspondent accounts to otherforeign banks and, if so, the identity of those foreign banks and related duediligence information.

 

Under the USA PATRIOT Act, financial institutions were given 180 daysfrom enactment to establish anti-money laundering programs.  The USA PATRIOT Act sets forth minimumstandards for these programs, including:

 

• Thedevelopment of internal policies, procedures, and controls;

 

• Thedesignation of a compliance officer;

 

• An ongoingemployee training program; and

 

• Anindependent audit function to test the programs.

 

On June 20, 2002, the Board of Directors of the Bank adoptedcomprehensive policies and procedures to address the requirements of the USAPATRIOT Act, and management believes that both of the Bank are currently infull compliance with the Act.

 

**Financial Services Modernization Legislation**

 

On November 12, 1999, President Clinton signed into law theGramm-Leach-Bliley Act. This legislation eliminated many of the barriers thathave separated the insurance, securities and banking industries since the GreatDepression. The federal banking agencies (the Board of Governors, FDIC and theOffice of the Comptroller of the Currency) among others, continue to draftregulations to implement the Gramm-Leach-Bliley Act.  The Gramm-Leach-Bliley Act is the result of adecade of debate in the Congress regarding a fundamental reformation of thenation’s financial system. The law is subdivided into seven titles, byfunctional area.

 

The major provisions of the Gramm-Leach-Bliley Act are:

 

*Financial Holding Companies and Financial Activities*

 

Title I establishes a comprehensive framework to permit affiliationsamong commercial banks, insurance companies, securities firms, and other financialservice providers by revising and expanding the BHC Act framework to permit aholding company system to engage in a full range of financial activitiesthrough qualification as a new entity known as a financial holding company.

 

Activities permissible for financial subsidiaries of national banks,and, also permissible for financial subsidiaries of state member banks,include, but are not limited to, the following: (a) Lending, exchanging, transferring, investing for others, orsafeguarding money or securities; (b) Insuring, guaranteeing, orindemnifying against loss, harm, damage, illness, disability, or death, orproviding and issuing annuities, and acting as principal, agent, or broker forpurposes of the foregoing, in any State; (c) Providing financial,investment, or economic advisory services, including advising an investmentcompany; (d) Issuing or selling instruments representing interests inpools of assets permissible for a bank to hold directly; and (e) Underwriting,dealing in, or making a market in securities.

 

*Securities Activities*

 

 Title II narrows the exemptionsfrom the securities laws previously enjoyed by banks.  The Board of Governors and the SEC continueto work together to draft rules governing certain securities activities ofbanks and creates a new, voluntary investment bank holding company.

 

16

----

 

*Insurance Activities*

 

Title III restates the proposition that the states are the functionalregulators for all insurance activities, including the insurance activities offederally-chartered banks, and bars the states from prohibiting insuranceactivities by depository institutions.

 

*Privacy*.

 

As required under Title V of the Gramm-Leach-Bliley Act, federalbanking regulators issued final rules on May 10, 2000 to implementthe privacy provisions of Title V. Pursuant to the rules, financialinstitutions must provide (i) initial notices to customers about theirprivacy policies, describing the conditions under which they may disclosenonpublic personal information to nonaffiliated third parties and affiliates; (ii) annualnotices of their privacy policies to current customers; and (iii) areasonable method for customers to “opt out” of disclosures to nonaffiliatedthird parties.

 

Compliance with the rules was optional until July 1,2001.  As of July 1, 2001 the Bankwas in compliance with the privacy provisions of the Gramm-Leach-Bliley Act andthe implementing regulations promulgated by the FDIC, and subsequently, asnecessary, has updated and enhanced its procedure and practice in this criticalarea.

 

*Safeguarding Confidential Customer Information*.

 

Under Title V of the Gramm-Leach-Bliley Act, federal banking regulatorswere required to adopt rules requiring financial institutions to implementa program to protect confidential customer information.  In January 2000, the federal bankingagencies adopted guidelines requiring financial institutions to establish aninformation security program to:

 

•                  identify andassess the risks that may threaten customer information;

•                  develop awritten plan containing policies and procedures to manage and control theserisks;

•                  implement andtest the plan; and

•                  adjust the planon a continuing basis to account for changes in technology, the sensitivity ofcustomer information and internal or external threats to information security.

 

The guidelines were effective July 1, 2001.  The Bank implemented a security programappropriate to its size and complexity and the nature and scope of itsoperations in advance of the July 1, 2001 effective date, andsubsequently, as necessary, has refined and improved its security program.

 

*Community Reinvestment Act Sunshine Requirements*.

 

In February 2001, the federal banking agencies adopted finalregulations implementing Section 711 of Title VII, the CRA SunshineRequirements.  The regulations requirenongovernmental entities or persons and insured depository institutions andaffiliates that are parties to written agreements made in connection with thefulfillment of the institution’s CRA obligations to make available to thepublic and the federal banking agencies a copy of each such agreement.  The regulations impose annual reportingrequirements concerning the disbursement, receipt and use of funds or otherresources under each such agreement.  Theeffective date of the regulations was April 1, 2001.

 

The Bank is not a party to any agreement that would be subject ofreporting pursuant to the CRA Sunshine Requirements.

 

The Bank intends to comply with all provisions of the Gramm-Leach-BlileyAct and all implementing regulations.

 

**California Financial Information Privacy Act/Fair Credit Reporting Act**

 

In 1970, the federal Fair Credit Reporting Act (the “FCRA”) was enactedto insure the confidentiality, accuracy, relevancy and proper utilization ofconsumer credit report information. Under the framework of the FCRA, the United States has developed ahighly advanced and efficient credit reporting system.  The information contained in that broadsystem is used by financial institutions, retailers and other creditors ofevery size in making a wide variety of decisions regarding financialtransactions.  Employers and lawenforcement agencies have also made wide use of the information collected andmaintained in databases made possible by the FCRA.  The FCRA affirmatively preempts state law ina number of areas, including the ability of entities affiliated by commonownership to share and exchange information freely, and the requirements oncredit bureaus to reinvestigate the contents of reports in response to consumercomplaints, among others.

 

The California Financial Information Privacy Act, which was enacted in2003, requires a financial institution to provide specific information to aconsumer related to the sharing of that consumer’s nonpublic personalinformation.  The Act would allow aconsumer to direct the financial institution not to share his or her nonpublicpersonal information with affiliated or

 

17

----

 

nonaffiliated companies with which a financial institution hascontracted to provide financial products and services, and would require thatpermission from each such consumer be acquired by a financial institution priorto sharing such information.  Theseprovisions are much more restrictive than the privacy provisions of theFinancial Services Modernization Act, and would require the Bank to adopt newpolicies, procedures and disclosure documentation if implemented asenacted.  The cost of complying with thislegislation is not predictable at this time.

 

Congress enacted the FACT Act, (“Fair and Accurate Credit TransactionAct”) of 2003, which will have the effect of avoiding the sunset preemptionprovision of the Fair Credit Reporting Act (FCRA) that were due to expire on December 31,2003.  The President signed the FACT Actinto law on December 4, 2003.  Ingeneral, the FACT Act amends the FCRA and, in addition, provides that, when theimplementing regulations have been issued and become effective, the FACT Actwill preempt elements of the California Financial Information Privacy Act.  A series of regulations and announcementswere promulgated during 2004, including a joint FTC/FRB announcement ofeffective dates for FCRA amendments, the FTC’s free credit report rule,revisions to the FTC’s FACT Act rules, the FTC’s final rules on identitytheft and proof of identity, the FTC’s final regulation on consumer informationand records disposal, and the FTC’s final summaries and notices.  On January 24, 2005, the FTC issued afinal rule on prescreen notices.

 

**Check 21 Act**

 

The Check Clearing for the 21st Century Act (“Check 21 Act”or “the Act”), enacted in late 2003, became effective on October 28,2004.  The Act creates a new negotiableinstrument, called a “substitute check”:, which banks are required to accept asthe legal equivalent of a paper check if it meets the requirements of theAct.  The Act is designed to facilitatecheck truncation, to foster innovation in the check payment system, and toimprove the payment system by shortening processing times and reducing thevolume of paper checks.

 

**Federal Reserve Board Final Rule on Trust Preferred Securities**

 

OnMarch 1 the Federal Reserve Board issued a final rule that allows thecontinued inclusion of trust preferred securities in the tier 1 capital of bankholding companies.  Trust preferredsecurities, however, will be subject to stricter quantitative limits.  Key components of the final rule are:

 

•                  Trust preferred securities, together withother “restricted core capital elements”, can be included in a bank holdingcompany’s tier 1 capital up to 25% of the sum of core capital elements,including “restricted core capital elements”;

•                  Restricted core capital elements are definedto include:

•                  qualifying trust preferred securities;

•                  qualifying cumulative perpetual preferredstock (and related surplus);

•                  minority interest related to qualifyingcumulative perpetual preferred stock directly issued by a consolidated U.S.depository institution or foreign bank subsidiary; and

•                  minority interest related to qualifyingcommon or qualifying perpetual preferred stock issued by a consolidatedsubsidiary that is neither a U.S. depository institution or foreign banksubsidiary

•                  The sum of core capital elements will becalculated net of goodwill, less any associated deferred tax liability;

•                  Internationally active bank holding companiesare further limited, and must limit restricted core capital elements to 15% ofthe sum of core capital elements, including restricted core capital elements,net of goodwill, although they may include qualifying mandatory convertiblepreferred securities up to the 25% limit;

•                  A five year transition period for applicationof quantitative limits, ending March 31, 2009.

 

**Other**

 

Various other legislation, including proposals to overhaul the bankregulatory system and to limit the investments that a depository institutionmay make with insured funds, is introduced into Congress or the CaliforniaLegislature from time to time.  TheBancorp and the Bank cannot determine the ultimate effect that any potentiallegislation, if enacted, or regulations promulgated thereunder, would have uponthe financial condition or operations of the Bancorp or the Bank.

 

18

----

 

**Impactof Government Monetary Policy**

 

Theearnings of the Bank are and will be affected by the policies of regulatoryauthorities, including the Federal Reserve. An important function of the Federal Reserve is to regulate the nationalsupply of bank credit.  Among theinstruments used to implement these objectives are open market operations inU.S. Government securities, changes in reserve requirements against bankdeposits, and changes in the discount rate which banks pay on advances from theFederal Reserve System.  Theseinstruments are used in varying combinations to influence overall growth anddistribution of bank loans, investments and deposits, and their use may alsoaffect interest rates on loans or interest rates paid for deposits.  The monetary policies of the FRB have had asignificant effect on the operating results of commercial banks in the past andare expected to continue to do so in the future.  The effect, if any, of such policies upon thefuture business earnings of the Bank cannot be predicted.

 

***Additional Factors That May Affect Future Results of Operations***

 

Dependenceon Real Estate.      A significant portionof the loan portfolio of the Bank is dependent on real estate.  At December 31, 2004, real estate servedas the principal source of collateral with respect to approximately 72.5%percent of the Bank’s loan portfolio.  Adecline in current economic conditions or rising interest rates could have anadverse effect on the demand for new loans, the ability of borrowers to repayoutstanding loans, the value of real estate and other collateral securing loansand the value of real estate owned by the Bank, as well as the Bancorp’sfinancial condition and results of operations in general and the market valueof the Bancorp’s common stock.  Acts ofnature, including earthquakes and floods, which may cause uninsured damage andother loss of value to real estate that secures these loans, may alsonegatively impact the Bancorp’s financial condition.

 

Environmental Liability Associated with Real Estate Ownership CouldResult in Losses.         In the course ofbusiness, the Bank has purchased real property. In the future, the Bancorp and the Bank may acquire additional realproperties, through purchase, foreclosure or otherwise.  In real estate ownership, as well as incommercial real estate lending, there is a risk that hazardous substances couldbe discovered on these properties.  Inthis event, the Bank might be required to remove these substances from theaffected properties at its sole cost and expense.  The cost of this removal could substantiallyexceed the value of the affected properties. The Bancorp or the Bank, as the case may be, may not have adequateremedies against the prior owner or other responsible parties or could find itdifficult or impossible to sell the affected properties.  This could have a material adverse effect onthe Bancorp’s and the Bank’s business, financial condition and operatingresults.

 

Interest Rate Changes.       Theearnings of the Bancorp and the Bank are substantially affected by changes inprevailing interest rates.  Changes ininterest rates affect the demand for new loans, the credit profile of existingloans, the rates received on loans and securities and the rates the Bank mustpay on deposits and borrowings.  Thedifference between the rates the Bank receives on loans and securities and therates it must pay on deposits and borrowings is known as the interest ratespread.  Given the Bank’s current volumeand mix of interest-bearing assets, the Bank’s interest rate spread can beexpected to increase when market interest rates are rising, and to decline whenmarket interest rates are declining. Although the Bank believes its current level of interest ratesensitivity is reasonable, significant fluctuations in interest rates may havean adverse impact on its business, financial condition and result ofoperations.

 

Competition.       Competition mayadversely affect the Bank’s performance. The financial services business in the Bank’s market area is highlycompetitive and becoming more so due to changes in regulation, technologicaladvances and the accelerating pace of consolidation among financial serviceproviders.  The Bank faces competitionboth in attracting deposits and making loans. The Bank competes for loans principally through competitive interestrates and the efficiency and quality of the services provided.  Increasing levels of competition in thebanking and financial services businesses may reduce the market share or causethe prices charged for services to fall. Results may differ in future periods depending on the nature or level ofcompetition.

 

Regulation.       Both the Bancorpand the Bank are subject to government regulation that could limit or restricttheir activities, adversely affecting operations.  The financial services industry is heavilyregulated.  Federal and state regulationis designed to protect the deposits of consumers, not to benefitshareholders.  The regulations imposesignificant limitations on operations, and may be changed at any time, possiblycausing results to vary significantly from past results.  Government policy and regulation,particularly as implemented through the Federal Reserve System, significantlyaffects credit conditions.

 

Borrower’s Failure to Perform.        Inthe event of an economic downturn, a significant number of the Bank’s borrowersand guarantors may fail to perform their obligations as required by the termsof their loans, which could result in larger than expected losses. The Bank hasadopted underwriting and credit policies, and loan monitoring procedures,including the establishment and monitoring of allowance for credit losses.  Management believes these provisions arereasonable and

 

19

----

 

adequate,and should keep credit losses within expected limits by assessing thelikelihood of nonperformance, tracking loan performance and diversifying thecredit portfolio.  However, thesepolicies and procedures may not be adequate to prevent unexpected losses thatcould materially and adversely affect the results of operations.

 

Operations Risks.       The Bankis subject to certain operations risks, including, but not limited to, dataprocessing system failures and errors, customers or employee fraud andcatastrophic failures resulting from terrorist acts or natural disasters.  The Bank maintains a system of internalcontrols to mitigate against such occurrences and maintains insurance coveragewhen available to protect against such risks, but should such an event occurthat is not prevented or detected by the Bank’s internal controls, or isuninsured or in excess of applicable insurance limits, it could have asignificant adverse impact on the Bancorp’s business, financial condition orresults of operations.

 

Geographic Concentration.       TheCompany’s operations are located almost entirely in the Central Coast region ofCalifornia.  As a result of thisgeographic concentration, our results depend largely upon economic and businessconditions in this region.  Deteriorationin economic and business conditions in our market area could have a materialadverse impact on the quality of our loan portfolio and the demand for ourproducts and services, which in turn may have a material adverse effect on ourresults of operations.

 

Waron Terrorism.        The terrorist attacksof September 11, 2001 and ensuing worldwide war on terrorism may lead tounexpected shifts in cash flows, deposit levels, and general economicactivity.  Banking agencies in the UnitedStates have warned of the possible impact of such events on the capital ratiosof banks.  In addition, the USA PATRIOTAct, which became effective December 25, 2001 as part of the war onterrorism, imposes substantial new responsibilities on banks for preventing,detecting and reporting flows of funds to terrorist organizations.  The act also directs the Treasury Departmentto prepare detailed regulations for these purposes, such as new record-keepingrequirements, verification standards for customer identification and sharinginformation with the government.  The fullimpact of the new law and its ongoing implementation on the Bancorp and theBank cannot be predicted at this time.

 

***Other Information***

 

Variousother legislation, including proposals to overhaul the bank regulatory systemand to limit the investments that a depository institution may make withinsured funds, is introduced into the Congress or the California Legislaturefrom time to time.  The Bancorp and theBank cannot determine the ultimate effect that any potential legislation, ifenacted, or regulations promulgated there under, would have upon the financialcondition or operations of the Bancorp or the Bank.

 

TheBancorp holds no material patents, trademarks, licenses, franchises orconcessions.  No expenditures have beenmade by the Bancorp, during the last two fiscal years, on material research.

 

**Item2.  Description of Properties**

 

Constructionof the new San Luis Obispo head office was completed on November 25, 2002,and occupancy began on that date.  In thenew building, the branch operation is located on the first floor and theadministrative offices are located on the second floor.  The new head office address is 500 MarshStreet, San Luis Obispo, California, and is across the parking lot from theprevious San Luis Obispo branch office at 486 Marsh Street.  The previous San Luis Obispo branch office isnow home to the Bank’s Government Guaranteed Lending Center and the Bank’s NoteDepartment.  Additional surplus officespace in the building at 486 Marsh Street is currently being leased by the Bankto unrelated third party tenants.  Leasedoffice space that previously housed the Bank’s administrative offices at 553 BHiguera Street in San Luis Obispo has been vacated.  The lease on this space expired in February 2003.  The Bank did not to renew this lease.  Office space that previously housed the Bank’sGovernment Guaranteed Lending Center at 545 Higuera Street in San Luis Obispois currently vacant.  It is the intentionof the Bank to hold this property for future development and expansion.  The San Luis Obispo real estate identified as500 Marsh Street, 486 Marsh Street and 545 Higuera Street is owned by the Bank.

 

TheArroyo Grande location is also owned by the Bank and is located at 1199 GrandAvenue, Arroyo Grande, California.  TheBank leases a lot that is contiguous to the Arroyo Grande branch on GrandAvenue for additional parking.  Thislease expires in March 2008.

 

Recognizingthat the Morro Bay facility had become too small to accommodate the growth ofthat branch, in March 2002, the Board of Directors authorized the purchaseof a vacant site nearby at the corner of Kern Avenue and Morro Bay Boulevardfor construction of a larger facility with drive-through capability.  Construction on the new branch at 898 MorroBay Boulevard commenced in October 2003 and was completed and occupied August 2004.

 

20

----

 

TheLos Osos branch located at 1193 Los Osos Valley Road, Los Osos, California, isa leased facility.  The current leaseexpires in July 2007, with two five-year options to renew.

 

InJuly 2002, the Bank entered into a lease to establish a loan production officeat 930 South Broadway in Santa Maria, California.  The original lease on this facility expiredand the office was moved in October 2004 to 301 S. Miller St., Santa Maria,California.  The loan production officewas opened to enhance the Bank’s government guaranteed lending opportunities innorthern Santa Barbara County.

 

TheBank has entered into a lease to establish a loan production office at 15 WestCarrillo Street, Ste. 252, Santa Barbara, California.  This office was opened to expand the Bank’sgovernment guaranteed lending opportunities in Santa Barbara County’s southernarea.

 

InDecember 2004, the Bank entered into a five year lease for an office located at2138 Spring Street, Suite A, Paso Robles, California, for the establishment ofthe Bank’s fifth full service branch. The office opened March 14,  2005.

 

**Item 3.  Legal Proceedings**

 

CoastBancorp and Coast National Bank may be, from time to time, subject to variouspending and threatened legal actions which arise out of the normal course ofits business.  The Bancorp and the Bankare not a party to any pending legal or administrative proceedings (includingordinary routine litigation incidental to their business) and no suchproceedings are known to be contemplated.

 

Thereare no material proceedings adverse to the Bancorp to which any director,officer, affiliate of the Bancorp, or 5% shareholder of the Bancorp, or anyassociate of any such director, officer, affiliate or 5% shareholder of theBancorp is a party, and none of the above persons has a material interestadverse to the Bancorp.

 

**Item4.  Submission of Matters to a Vote ofSecurity Holders**

 

None

 

21

----

 

**PART II**

 

**Item5.  Market for Common Equity and RelatedStockholder Matters**

 

Asof December 31, 2004, the equity of the Bancorp consisted of Preferred Stock10,000,000 shares authorized, none outstanding and 10,000,000 shares authorizedwith 652,700 shares of the Bancorp’s Common Stock (having no par value)outstanding.  The stock is not listed onany exchange, but is traded over the counter under the symbol CTBP.OB.  The following high and low bid information asreported and may not represent actual transactions.

 
| ** **           | ** ** | **High** | ** ** | **Low** | ** ** | ** ** | ** ** | **High**             | ** ** | **Low** | ** ** |
|----------------------|------------|----------|------------|---------|------------|------------|------------|----------------------|------------|---------|------------|
| First Quarter, 2004  |       | $        | 26.80      |    | $          | 23.00      |       | First Quarter, 2003  |       | $       | 16.25      |   | $ | 15.15 |   |
| Second Quarter, 2004 |       | $        | 28.75      |    | $          | 25.50      |       | Second Quarter, 2003 |       | $       | 16.50      |   | $ | 15.00 |   |
| Third Quarter, 2004  |       | $        | 26.50      |    | $          | 25.75      |       | Third Quarter, 2003  |       | $       | 19.25      |   | $ | 16.00 |   |
| Fourth Quarter, 2004 |       | $        | 28.00      |    | $          | 26.35      |       | Fourth Quarter, 2003 |       | $       | 24.00      |   | $ | 18.00 |   |

 

Asof December 31, 2004, there were approximately 396 shareholders of record.

 

TheBancorp declared and paid a cash dividend on December 3, 2004, of $0.15 pershare on its Common Stock, to shareholders of record as of the close ofbusiness on November 1, 2004.  Thedividend paid on its Common Stock on December 5, 2003 to its stockholders ofrecord on November 1, 2003, was $0.10 per share.

 

Thefollowing chart provides information as of December 31, 2004, concerning theBancorp’s Stock Option Plans, which represent the Bancorp’s only equitycompensation plans:

 

**Plan Categories:**

 
| **Employee  and Director  Stock Option  Plans**             | ** ** | **Number  of Securities  to be Issued Upon  Exercise of  Outstanding Options,  Warrants, and Rights  [a]** | ** ** | **Weighted-average  Exercise Price of  Outstanding Options,  Warrants and Rights  [b]** | ** ** | **Number  of Securities  Remaining Available for  Future Issuance Under  Equity Compensation  Plans (excluding securities  Reflected in column [a]  [c]** | ** ** |
|-------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity Compensation Plans Approved by  Security Holders     |       | 129,600                                                                                                    |       | $                                                                                       | 15.46      |                                                                                                                                                      | 30,200     |   |
| Equity Compensation Plans Not Approved by  Security Holders |       | 0                                                                                                          |       | 0                                                                                       |       | 0                                                                                                                                                         |       |
| Total                                                       |       | 129,600                                                                                                    |       | $                                                                                       | 15.46      |                                                                                                                                                      | 30,200     |   |

 

**Dividends**

 

TheBancorp is regulated by the Board of Governors of the Federal Reserve System.  Federal Reserve Board regulations prohibitcash dividends, except under limited circumstances, if the distribution wouldresult in a withdrawal of capital or exceed the Bancorp’s net profits then onhand after deducting its losses and bad debts. Furthermore, cash dividends cannot be paid without the prior writtenapproval of the Federal Reserve Board if the total of all dividends declared inone year exceeds the total of net profits for that year, plus the preceding twocalendar years, and less any required transfers to surplus under state orfederal law.

 

Forthe impact of Trust Preferred Securities on the payment of dividends, see thepreceding section titled “Part I – SUPERVISION AND REGULATION, *Payment of Dividends* – Coast Bancorp”.

 

22

----

 

Theshareholders of Coast Bancorp are entitled to receive dividends when and asdeclared by its Board of Directors out of funds legally available, subject tothe restrictions set forth in the California General Corporation Law.  The Corporation Law provides that acorporation may make a distribution to its shareholders if the corporation’sretained earnings equal at least the amount of the proposed distribution.  The Corporation Law further provides that, inthe event that sufficient retained earnings are not available for the proposeddistribution, a corporation may nevertheless make a distribution to itsshareholders if it meets two conditions, which generally stated are asfollows:  1) the corporation’s assetsequal at least 1.25 times its liabilities; and 2) the corporation’s currentassets equal at least its current liabilities or, if the average of thecorporation’s earnings before taxes on income and before interest expense forthe two preceding fiscal years was less than the average of the corporation’sinterest expense for such fiscal years, then the corporation’s current assetsmust equal at least 1.25 times its current liabilities.

 

Oneof the primary sources of income for the Bancorp, on a stand-alone basis, isthe receipt of dividends from the Bank. The availability of dividends from the Bank is limited by variousstatutes and regulations.

 

**Item6.  Management Discussion & Analysisof Analysis of Financial Condition and Results of Operations**

 

Thefollowing sections set forth a discussion of the significant operating changes,business trends, financial condition, earnings, capital position, and liquiditythat have occurred in the two-year period ended December 31, 2004, togetherwith an assessment, when considered appropriate, of external factors that mayaffect us in the future.  This discussionshould be read in conjunction with our consolidated financial statements andnotes.

 

23

----

 

**OVERVIEW**

 

**EarningsSummary**

 

Consolidatednet income in 2004 was $1,115,029, an increase of $132,860 or 13.5%, comparedto $982,169 in 2003.  Diluted earningsper share in 2004 were $1.58, compared to $1.46 in 2003.  The increase in earnings in 2004 was dueprimarily to the gain on sale of guaranteed portions of government loans, andto the increase in the net interest margin.

 

**BalanceSheet Summary**

 

Totalassets at December 31, 2004 were $159.9 million, a $17.7 million or 12.4%increase from $142.2 million at December 31, 2003.  Average assets for 2004 were $154.2 million,compared to $136.1 million for 2003. Total deposits increased $16.4 million or 12.8% to $144.4 million atDecember 31, 2004.  Gross loans increased$8.4 million or 7.8%, to $116.3 million at December 31, 2004.  Stockholder’s equity increased $1.1million or13.1%, to $9.9 million at December 31, 2004.

 

Thefollowing table sets forth several key operating ratios for 2004 and 2003:

 
| ** **                                                 | ** ** | **For the Year Ended  December 31,** | ** ** |
|------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                 | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| Return on Average Assets                                   |       | 0.72                                 | %          | 0.72 | % |
| Return on Average Equity                                   |       | 11.87                                | %          | 11.82 | % |
| Average Stockholder’s Equity to Average  Total Assets |       | 6.09                                 | %          | 6.10 | % |

 

24

----

 

**Distributionof Assets, Liabilities, and Shareholders’ Equity**

 

Thefollowing table presents, for the years indicated, the distribution of averageassets, liabilities and shareholders’ equity, as well as the total amounts ofinterest income from average interest-earning assets and the resultant yields,and the dollar amounts of interest expense and average interest-bearingliabilities, expressed both in dollars and in rates.  Non-accrual loans are included in thecalculation of the average balances of loans, and interest not accrued isexcluded.

(dollaramounts in thousands).

 
| ** **                                      | ** ** | **For the Year Ended December 31,** | ** ** |
|-------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                      | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| ** **                                      | ** ** | **Average  Balance**                | ** ** | **Interest  Earned  or Paid** | ** ** | **Average  Yield or  Rate Paid** | ** ** | **Average  Balance** | ** ** | **Interest  Earned  or Paid** | ** ** | **Average  Yield or  Rate Paid** | ** ** |
| **Assets**                                      |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Interest-Earning Assets:                        |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Investment Securities                           |       | $                                   | 8,780      |   | $ | 190 |   | 2.16 | % | $ | 5,756 |   | $ | 148 |   | 2.57 | % |
| Federal Funds Sold                              |       | 12,871                              |       | 186 |   | 1.45 | % | 13,269 |   | 139 |   | 1.05 | % |
| Other Earning Assets                            |       | 761                                 |       | 40 |   | 5.26 | % | 1,224 |   | 27 |   | 2.21 | % |
| Loans                                           |       | 114,258                             |       | 7,824 |   | 6.85 | % | 100,558 |   | 7,119 |   | 7.08 | % |
|                                            |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Total Interest-Earning Assets                   |       | 136,670                             |       | 8,240 |   | 6.03 | % | 120,807 |   | 7,433 |   | 6.15 | % |
|                                            |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Cash and Due from Bank                          |       | 9,233                               |       |   |   |   |   | 8,335 |   |   |   |   |   |
| Premises and Equipment                          |       | 7,884                               |       |   |   |   |   | 6,905 |   |   |   |   |   |
| Other Real Estate Owned                         |       | —                              |       |   |   |   |   | — |   |   |   |   |   |
| Accrued Interest and Other Assets               |       | 1,651                               |       |   |   |   |   | 1,186 |   |   |   |   |   |
| Allowance For Loan Losses                       |       | (1,158                              | )          |   |   |   |   | (1,044 | ) |   |   |   |   |
|                                            |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Total Assets                                    |       | $                                   | 154,280    |   |   |   |   |   | $ | 136,189 |   |   |   |   |   |
|                                            |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| **Liabilities and Shareholders’  Equity**  |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Interest-Bearing Liabilities:                   |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Money Market and NOW:                           |       | $                                   | 36,671     |   | $ | 285 |   | 0.78 | % | $ | 34,120 |   | $ | 238 |   | 0.70 | % |
| Savings                                         |       | 7,458                               |       | 48 |   | 0.64 | % | 6,831 |   | 56 |   | 0.82 | % |
| Time Deposits under $100,000                    |       | 17,007                              |       | 283 |   | 1.66 | % | 18,074 |   | 376 |   | 2.08 | % |
| Time Deposits of $100,000 or More               |       | 41,422                              |       | 820 |   | 1.98 | % | 31,250 |   | 731 |   | 2.34 | % |
| Trust Preferred Securities                      |       | 5,155                               |       | 286 |   | 5.55 | % | 5,155 |   | 271 |   | 5.26 | % |
| Other                                           |       | 123                                 |       | 5 |   | 4.07 | % | 398 |   | 29 |   | 7.29 | % |
|                                            |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Total Interest-Bearing Liabilities              |       | 107,836                             |       | 1,727 |   | 1.60 | % | 95,828 |   | 1,701 |   | 1.78 | % |
|                                            |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Non-Interest Bearing Liabilities                |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Demand Deposits                                 |       | 36,780                              |       |   |   |   |   | 31,730 |   |   |   |   |   |
| Other Liabilities                               |       | 271                                 |       |   |   |   |   | 324 |   |   |   |   |   |
| Shareholders’ Equity                       |       | 9,393                               |       |   |   |   |   | 8,307 |   |   |   |   |   |
|                                            |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Total Liabilities and Shareholders’ Equity |       | $                                   | 154,280    |   |   |   |   |   | $ | 136,189 |   |   |   |   |   |
|                                            |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Net Interest Income                             |       |                                |       | $ | 6,513 |   |   |   |   |   | $ | 5,732 |   |   |   |
|                                            |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Net Yield on Interest-Earning Assets            |       |                                |       |   |   | 4.77 | % |   |   |   |   | 4.74 | % |

 

25

----

 

**EARNINGSANALYSIS**

 

NetInterest Income

 

Asignificant component of our earnings is net interest income.  Net interest income is the difference betweenthe interest we earn on our loans and investments and the interest we pay ondeposits and other interest-bearing liabilities.

 

Ournet interest income is affected by changes in the amount and mix of ourinterest-earning assets and interest-bearing liabilities, referred to as a “volumechange”.  It is also affected by changesin the yields we earn on interest-earning assets and rates we pay oninterest-bearing deposits and other borrowed funds, referred to as a “ratechange”.

 

Thefollowing table sets forth changes in interest income and interest expense foreach major category of interest-earning asset and interest-bearing depositaccounts, and the amount of change attributable to volume and rate changes forthe years indicated.  Changes not solelyattributable to rate or volume have been allocated to volume and rate changesin proportion to the relationship of the absolute dollar amounts of the changesin each (dollar amounts in thousands).

 
| ** **                        | ** ** | **Year Ended December 31, 2004**         | ** ** |
|-----------------------------------|------------|------------------------------------------|------------|
| ** **                        | ** ** | **versus**                               | ** ** |
| ** **                        | ** ** | **Year Ended December 31, 2003**         | ** ** |
| ** **                        | ** ** | **Increase (Decrease) due to change in** | ** ** |
| ** **                        | ** ** | **Volume**                               | ** ** | **Rate** | ** ** | **Total** | ** ** |
| **Interest-Earning  Assets:**     |       |                                     |       |   |   |   |   |
| Investment Securities             |       | $                                        | 68         |   | $ | (26 | ) | $ | 42 |   |
| Federal Funds Sold                |       | (4                                       | )          | 51 |   | 47 |   |
| Other Earning Assets              |       | (13                                      | )          | 26 |   | 13 |   |
| Loans                             |       | 944                                      |       | (239 | ) | 705 |   |
| **Total  Interest Income**        |       | 995                                      |       | (188 | ) | 807 |   |
|                              |       |                                     |       |   |   |   |   |
| **Interest-Bearing  Liabilities** |       |                                     |       |   |   |   |   |
| Transaction Accounts              |       | 19                                       |       | 28 |   | 47 |   |
| Savings                           |       | 5                                        |       | (13 | ) | (8 | ) |
| Time Deposits                     |       | (21                                      | )          | (72 | ) | (93 | ) |
| Time Deposits $100,000 or more    |       | 213                                      |       | (124 | ) | 89 |   |
| Trust Preferred                   |       | —                                   |       | 15 |   | 15 |   |
| Other                             |       | (15                                      | )          | (9 | ) | (24 | ) |
| **Total  Interest Expense**       |       | 201                                      |       | (175 | ) | 26 |   |
| **Net  Interest Income**          |       | $                                        | 794        |   | $ | (13 | ) | $ | 781 |   |

 

**2004Compared to 2003**

 

Netinterest income for 2004 was $6.5 million, an increase of 13.6% compared to the$5.7 million reported in 2003.  Thisincrease was primarily due to the increase in loans and the downward pricing inthe rates paid by the Bank on interest bearing liabilities.

 

Interestincome in 2004 was $8.2 million, representing an increase of $800.0 thousand or10.8% over the $7.4 million recorded in 2003. The increase in interest income was primarily due to the averageincrease in loan balances.  The Bank wasable to increase loans significantly while maintaining quality.  The increase in the prime rate to 5.25%somewhat curtailed interest in refinancing activities but businesses continuedto upgrade systems and facilities. While net interest income was greater, thenet yield on average earning assets increased slightly from 4.74% in 2003 to4.77% in 2004.

 

Interestexpense increased in 2004 due to the Trust Preferred Securities, resulting in anet decline of the average rate paid of .17 basis points from 1.78% in 2003 to1.60% in 2004.

 

26

----

 

**Non-interest Income**

 

TheBank receives non-interest income primarily from service charges and fees onaccounts, as well as from the sale of government guaranteed loans and realizedgains on the sale of investment securities. In 2004, non-interest income was $1,467,720, an increase of $378,724 or34.80% compared to the 2003 amount of $1,088,996.

 

Theincrease in non-interest income was substantially derived from the gain on thesale of loans.  Gain on the sale of loansand servicing fees totaled $1,025,657 in 2004, up 99% compared to 2003.

 

Themortgage loan program, through the Community Bank Lending Exchange (CBLX),enabled the Bank to facilitate long term mortgage loans for our customers.  The Bank submitted the applications to CBLX,by whom the loans were underwritten and processed.  The Bank had no responsibility forunderwriting or documentation.  For theseservices the Bank was paid a fee.  Ourparticipation in this program began in January 2003 and continued in 2004although the level of income realized in 2003 was not repeated.  Income realized from mortgage loans in 2004was $107,555, while 2003 brought $251,056.

 

Regardingthe realized gains on the sale of loans, the most common reason for the Bank tosell the guaranteed portion of a loan is to also meet the liquidity needs ofthe Bank and to maintain the Bank’s loan-to-deposit ratio within acceptableranges.  The Bank also enjoys theopportunity to supplement its fee income from the sale of thegovernment-guaranteed portions of certain loans.  In 2001 the Bank developed a governmentguaranteed lending center to originate loans that are partially guaranteed bythe U.S. Small Business Administration or the U.S. Department ofAgriculture.  Given the volume of lendingin this department during 2003 and 2004, the Bank has been able to realizegains when the guaranteed portions of these loans have been sold.  While we hope this non-interest incomeopportunity to continue into the future, there is no assurance that the levelof loan sales and the subsequent realization of fee income enjoyed by the Bankin the past will continue at prior levels.

 

**Non-interestExpense**

 

Non-interestexpense reflects our costs of products and services related to systems,facilities and personnel.  The majorcomponents of non-interest expense stated as a percentage of average assets areas follows:

 
| ** **                       | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|
| Salaries and Employee Benefits   |       | 2.18     | %          | 2.05     | %          |
| Occupancy Expenses               |       | 0.26     | %          | 0.25     | %          |
| Furniture and Equipment          |       | 0.18     | %          | 0.19     | %          |
| Data Processing                  |       | 0.25     | %          | 0.27     | %          |
| Marketing and Business Promotion |       | 0.27     | %          | 0.26     | %          |
| Other Professional Expenses      |       | 0.21     | %          | 0.19     | %          |
| Office Expenses                  |       | 0.14     | %          | 0.14     | %          |
| Other                            |       | 0.36     | %          | 0.29     | %          |
|                             |       | 3.85     | %          | 3.64     | %          |

 

Non-interestexpense was $5.9 million in 2004, an increase of $1.0 million or 19.7% over the$4.9 million reported in 2003.  Themajority of this increase is attributable to increased salaries and employeebenefits and occupancy expense as a result of our expansion.  The Bank has 58 full time equivalentemployees, an increase of two employees from 2003 with the accompanying benefits.  The Bank has been fortunate in retaining longterm managerial employees.  Salaries for2004 and 2003 respectively were $3,366,193 and $2,795,592.

 

**IncomeTaxes**

 

Incometax expense was $861,632 and $677,500 for the years ended December 31, 2004,and 2003 respectively, an increase of $184,132 or 27.2%.  These expenses resulted in an effective taxof 43.6% in 2004, and 40.8% in 2003.  Theincrease in income tax expense in 2004 was due to increased profitability in 2004over 2003.

 

27

----

 

**BALANCESHEET ANALYSIS**

 

**InvestmentPortfolio**

 

Thefollowing table summarizes the amounts and distribution of our investmentsecurities held as of the dates indicated, and the weighted average yields asof December 31, 2004 (dollar amounts in thousands):

 
| ** **                                 | ** ** | **December 31,** | ** ** |
|--------------------------------------------|------------|------------------|------------|
| ** **                                 | ** ** | **2004**         | ** ** | **2003** | ** ** |
| ** **                                 | ** ** | **Book  Value**  | ** ** | **Market  Value** | ** ** | **Weighted  Average  Yield** | ** ** | **Book  Value** | ** ** | **Market  Value** | ** ** |
| **Available-for-Sale  Securities**         |       |             |       |   |   |   |   |   |   |   |   |
| **U.S.  Treasuries:**                      |       |             |       |   |   |   |   |   |   |   |   |
| Within One Year                            |       | $                | 998,453    |   | $ | 993,780 |   | 1.50 | % | $ | — |   | $ | — |   |
| One to Five Years                          |       |             |       |   |   | 0.00 | % | 1,987,107 |   | 1,994,062 |   |
| Five to Ten Years                          |       | —           |       | — |   | 0.00 | % | — |   | — |   |
| After Ten Years                            |       | —           |       | — |   | 0.00 | % | — |   | — |   |
| Total U.S. Treasury Securities             |       | 998,453          |       | 993,780 |   | 1.50 | % | 1,987,107 |   | 1,994,062 |   |
|                                       |       |             |       |   |   |   |   |   |   |   |   |
| **U.S.  Government and Agency Securities** |       |             |       |   |   |   |   |   |   |   |   |
| Within One Year                            |       | 3,959,979        |       | 3,931,168 |   | 2.37 | % | — |   | — |   |
| One to Five Years                          |       | 8,011,247        |       | 7,941,645 |   | 2.80 | % | 10,033,801 |   | 10,078,520 |   |
| Five to Ten Years                          |       | —           |       | — |   | 0.00 | % | — |   | — |   |
| After Ten Years                            |       | —           |       | — |   | 0.00 | % | — |   | — |   |
| Total U.S. Treasury and Government         |       | 11,971,226       |       | 11,872,813 |   | 2.58 | % | 10,033,801 |   | 10,078,520 |   |
| Agency Securities                          |       |             |       |   |   |   |   |   |   |   |   |
| **Mutual  Funds**                          |       | —           |       | — |   |   |   | — |   | — |   |
| **Mortgage  Backed Securities**            |       | —           |       | — |   |   |   | — |   | — |   |
| **Total  Available-for-Sale Securities**   |       | $                | 12,969,679 |   | $ | 12,866,593 |   | 2.22 | % | $ | 12,020,908 |   | $ | 12,072,582 |   |

 

28

----

 

Nosecurities were held to maturity.

 

Securitiesmay be pledged to meet security requirements imposed as a condition to receiptof deposit of public funds and for other purposes.  At December 31, 2004, the carrying values ofsecurities pledged to secure public deposits and other purposes were $989,334or 8% of available for sale securities.

 

**LoanPortfolio**

 

Thefollowing table sets forth the components of total net loans outstanding ineach category at the date indicated (dollar amounts in thousands):

 
| ** **                                        | ** ** | **December** | ** ** |
|---------------------------------------------------|------------|--------------|------------|
| ** **                                        | ** ** | **2004**     | ** ** | **2003** | ** ** |
| **Loans**                                         |       |         |       |   |   |
| Commercial                                        |       | $            | 29,430     |   | $ | 28,244 |   |
| Real Estate - Construction                        |       | 17,432       |       | 13,501 |   |
| Real Estate - Other                               |       | 66,897       |       | 62,282 |   |
| Consumer                                          |       | 2,547        |       | 3,849 |   |
| **Total  Loans**                                  |       | 116,306      |       | 107,876 |   |
| Net Deferred Loan Costs (Fees)                    |       | (418         | )          | (414 | ) |
| Allowance for Loan Losses                         |       | (1,168       | )          | (1,109 | ) |
| **Net  Loans**                                    |       | $            | 114,720    |   | $ | 106,353 |   |
|                                              |       |         |       |   |   |
| **Commitments**                                   |       |         |       |   |   |
| Standby Letters of Credit                         |       | $            | 1,674      |   | $ | 1,946 |   |
| Undisbursed Loans and Commitments to Grant  Loans |       | 35,112       |       | 36,708 |   |
| **Total  Commitments**                            |       | $            | 36,786     |   | $ | 38,654 |   |

 

**RiskElements**

 

Bankmanagement assesses and manages credit risk on an ongoing basis through ourlending policies.  The Bank strives tocontinue its historically low level of credit losses by continuing its emphasison credit quality in the loan approval process, active credit administrationand regular monitoring.  However,inherent in the lending function is the fact that loan losses will beexperienced and that the risk of loss will vary with the type of loan beingmade, the credit-worthiness of the borrower and the term of the loan.  To reflect the currently perceived risks ofloss associated with its loan portfolio, additions are made to the Bank’sallowance for loan losses.  The Bank’sentire allowance is a valuation allowance; that is, it has been created bydirect charges against operations through the provision for loan losses.

 

Commitmentsto extend credit are agreements to lend to a customer as long as establishedconditions of the contract have been met. Standby Letters of Credit are used to guarantee the performance of acustomer to a third party.  Many of thesecommitments expire without being drawn upon. These unfunded commitments are included in risk based calculations andthe effect is not material.

 

Inextending credit and commitments to borrowers, the Bank generally requirescollateral and/or guarantees as security. The repayment of such loans is expected to come from cash flow or fromproceeds from the sale of selected assets of the borrower.  Our requirement for collateral and/orguarantees is determined on a case-by-case basis in connection with itsevaluation of the credit worthiness of the borrower.  Collateral held varies but may includeaccounts receivable, inventory, property, plant and equipment, income-producingproperties, residences and other real property. The Bank secures its collateral by perfecting its interest in businessassets, obtaining deeds of trust, or outright possession among other means.

 

TheBank believes that its lending policies and underwriting standards will tend tominimize losses in an economic downturn, however, there is no assurance thatlosses will not occur under such circumstances.

 

29

----

 

Thefollowing table shows the maturity distribution of the fixed rate portion ofthe loan portfolio in the amount of $12,396. (dollar amounts in thousands):

 
| ** **                 | ** ** | **3 Months  or Less** | ** ** | **Over 3  Months  through 12  Months**     | ** ** | **Due after  one year to**

**five years** | ** ** | **Due after  five years** | ** ** | **Total** | ** ** |
|----------------------------|------------|-----------------------|------------|--------------------------------------------|------------|--------------------------------------------|------------|---------------------------|------------|-----------|------------|
|                       |       |                  |       |                                       |       |                                       |       |                      |       |      |       |
| **Loans**                  |       |                  |       |                                       |       |                                       |       |                      |       |      |       |
|                       |       |                  |       |                                       |       |                                       |       |                      |       |      |       |
| Commercial                 |       | $                     | 265        |                                       | $          | 303                                        |       | $                         | 224        |      | $          | 1,479 |   | $ | 2,271 |   |
| Real Estate - Construction |       | 777                   |       | 1,866                                      |       | 51                                         |       |                      |       | 2,694     |       |
| Real Estate - Other        |       | 100                   |       | 1,779                                      |       | 51                                         |       | 4,009                     |       | 5,939     |       |
| Consumer                   |       | 193                   |       | 195                                        |       | 441                                        |       | 663                       |       | 1,492     |       |
| Total Loans                |       | $                     | 1,335      |                                       | $          | 4,143                                      |       | $                         | 767        |      | $          | 6,151 |   | 12,396 |   |
|                       |       |                  |       |                                       |       |                                       |       |                      |       |      |       |
|                       |       |                  |       | Loans on Non-Accrual                       |       | —                                     |       |
|                       |       |                  |       | Total Loans, including Loans Held for Sale |       | $                                          | 12,396     |                      |
|                            |            |                       |            |                                            |            |                                            |            |                           |            |           |            |  |  |  |  |  |  |

 

Thefollowing table shows the maturity distribution of the variable rate portion ofthe loan portfolio at December 31, 2004 (dollar amounts in thousands):

 
| ** **                 | ** ** | **3 Months  or Less** | ** ** | **Over 3  Months  through 12  Months**     | ** ** | **Due after  one year to  five years** | ** ** | **Due after  five years** | ** ** | **Total** | ** ** |
|----------------------------|------------|-----------------------|------------|--------------------------------------------|------------|----------------------------------------|------------|---------------------------|------------|-----------|------------|
|                       |       |                  |       |                                       |       |                                   |       |                      |       |      |       |
| **Loans**                  |       |                  |       |                                       |       |                                   |       |                      |       |      |       |
|                       |       |                  |       |                                       |       |                                   |       |                      |       |      |       |
| Commercial                 |       | $                     | 23,974     |                                       | $          | 518                                    |       | $                         | 1,266      |      | $          | 1,401 |   | $ | 27,159 |   |
| Real Estate - Construction |       | 11,946                |       | 2,792                                      |       | —                                 |       | —                    |       | 14,738    |       |
| Real Estate - Other        |       | 37,587                |       | 2,492                                      |       | 5,030                                  |       | 15,849                    |       | 60,958    |       |
| Consumer                   |       | 935                   |       | 120                                        |       | —                                 |       | —                    |       | 1,055     |       |
| Total Loans                |       | $                     | 74,442     |                                       | $          | 5,922                                  |       | $                         | 6,296      |      | $          | 17,250 |   | 103,910 |   |
|                       |       |                  |       |                                       |       |                                   |       |                      |       |      |       |
|                       |       |                  |       | Loans on Non-Accrual                       |       | —                                 |       |
|                       |       |                  |       | Total Loans, including Loans Held for Sale |       | $                                      | 103,910    |                      |
|                            |            |                       |            |                                            |            |                                        |            |                           |            |           |            |  |  |  |  |  |  |

 

30

----

 

**Non-performingAssets**

 

Thefollowing table provides information with respect to the components of ournon-performing assets at the dates indicated (dollar amounts in thousands):

 
| ** **                                                       | ** ** | **For the Year Ended** | ** ** |
|------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                       | ** ** | **2004**               | ** ** | **2003** | ** ** |
| Loans 90 Days Past Due and Still Accruing                        |       | $                      | —     |   | $ | — |   |
| Non-Accrual Loans                                                |       | —                 |       | 32 |   |
| Total Non-performing Loans                                       |       | $                      | —     |   | $ | 32 |   |
|                                                             |       |                   |       |   |   |
| Other Real Estate Owned                                          |       | $                      | —     |   | $ | — |   |
| Total Non-performing Assets                                      |       | $                      | —     |   | $ | 32 |   |
|                                                             |       |                   |       |   |   |
| Non-performing Loans as a Percentage of  Total Loans             |       | n/a                    |       | 0.03 | % |
| Allowance for Loan Loss as a Percentage of  Non-performing Loans |       | n/a                    |       | 3464.74 | % |
| Non-performing Assets as a Percentage of  Total Assets           |       | n/a                    |       | 0.02 | % |

 

AtDecember 31, 2004, in addition to loans disclosed above as past due, non-accrualor restructured, management also identified several loans totaling $599,831,where the ability to comply with present loan payment terms in the future isquestionable.  However, the inability ofthe borrowers to comply with repayment terms was not sufficiently probable toplace the loan on non-accrual status at December 31, 2004.  This amount was determined based on analysisof information known to management about the borrowers’ financial condition andcurrent economic conditions.  Estimatedpotential losses from these problem loans have been provided for in determiningthe allowance for loan losses at December 31, 2004.

 

Forreference, the Bank’s financial statements are prepared on the accrual basis ofaccounting, including the recognition of interest income on the loanportfolio.  The Bank follows the policyof non-accrual of interest on a loan at the time the loan is past due ninety(90) days or more, as to interest or principal, unless the loan is well securedand in the process of collection.  Interestfrom non-accrual loans is not accrued on the books.  Payments received while the loan is onnon-accrual are typically applied against principal.  When a loan is placed on a non-accrual basis,any previously accrued but unpaid interest is reversed and charged againstcurrent income unless there is adequate collateral to assure recovery of theaccrued interest.

 

**Provisionand Allowance for Loan Losses**

 

Aspreviously discussed under Critical Accounting Policies, the Allowance for LoanLosses represents management’s best estimate of losses inherent in the existingloan portfolio.  Management of the Bankbelieves that the allowance for loan losses is adequate.  The Bank has established a monitoring systemfor loans in order to identify impaired loans and potential problem loans andto permit periodic evaluation of impairment and adequacy of the allowance forloan losses in a timely manner.  Themonitoring system and allowance for loan losses methodology have evolved over aperiod of years, and loan classifications have been incorporated into thedetermination of the allowance for loan losses. This monitoring system and allowance methodology includes a loan-by-loananalysis for all classified loans as well as loss factors for the balance ofthe unclassified portfolio.  Classifiedloans are reviewed individually to estimate the amount of probable losses thatneeds to be included in the allowance. These reviews include analysis of financial information as well asevaluation of collateral securing the credit. Loss factors on the unclassified portion of the portfolio are based onsuch factors as historical loss experience, current portfolio delinquency andtrends, and other inherent risk factors such as economic conditions,concentrations in the portfolio, risk levels of particular loan categories,internal loan review and management oversight.

 

TheBank made a contribution of $70,000 to the allowance for loan losses for thetwelve months ended December 31, 2004, compared to $204,345 for the same periodin 2003.  Management believes that theallowance, which equals 1.01% of net loans at December 31, 2004, is adequate tocover future losses.  The allowance atDecember 31, 2003, was 1.03% of total loans.

 

31

----

 

Theprovision for loan losses charged against operations is based upon the actualnet loan loss expensed plus an amount for other such factors which, inmanagement’s judgment, deserve recognition in estimating possible loan losses,including: specific loan conditions as determined by management and regulatoryagencies, the historical relationship between charge-offs and the level ofallowances, and prevailing economic conditions. While these factors are essentially judgmental and may not be reduced toa mathematical formula, it is management’s view that the $1,168,423 allowance,or 1.01% of total loans at December 31, 2004, was adequate.  However, there can be no assurance that inany given period the Bank might not sustain charge-offs, which are substantialin relation to the size of the allowance. It is the policy of management to make additions to the allowance sothat it remains adequate to cover all anticipated loan charge-offs.  Periodic fluctuations in the provision forloan losses result from management’s assessment of the adequacy of theallowance for loan losses: however, actual loan losses may vary from currentestimates.

 

32

----

 

Thefollowing table summarizes, for the years indicated, changes in the allowancefor loan losses arising from loans charged-off, recoveries on loans previouslycharged-off, and additions to the allowance which have been charged tooperating expenses and certain ratios relating to the allowance for loan losses(dollar amounts in thousands):

 
| ** **                                                    | ** ** | **For the Year Ended  December 31,** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                    | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| **Outstanding  Loans**                                        |       |                                 |       |   |   |
| Average for the Year                                          |       | $                                    | 114,258    |   | $ | 100,558 |   |
| End of the Year                                               |       | $                                    | 115,888    |   | $ | 107,462 |   |
|                                                          |       |                                 |       |   |   |
| **Allowance  for Loan Losses:**                               |       |                                 |       |   |   |
| Balance at Beginning of Year                                  |       | $                                    | 1,109      |   | $ | 1,000 |   |
| Actual Charge-Offs:                                           |       |                                 |       |   |   |
| Commercial                                                    |       | 4                                    |       | 92 |   |
| Consumer                                                      |       | 15                                   |       | 18 |   |
| Real Estate                                                   |       | —                               |       | — |   |
| Total Charge-Offs                                             |       | 19                                   |       | 110 |   |
|                                                          |       |                                 |       |   |   |
| Less Recoveries:                                              |       |                                 |       |   |   |
| Commercial                                                    |       | 7                                    |       | 8 |   |
| Consumer                                                      |       | 1                                    |       | 7 |   |
| Real Estate                                                   |       | —                               |       | — |   |
| Total Recoveries                                              |       | 8                                    |       | 15 |   |
|                                                          |       |                                 |       |   |   |
| Net Loans Charged-Off                                         |       | 11                                   |       | 95 |   |
| Provision for Loan Losses                                     |       | 70                                   |       | 204 |   |
| Balance at End of Year                                        |       | $                                    | 1,168      |   | $ | 1,109 |   |
|                                                          |       |                                 |       |   |   |
| **Ratios:**                                                   |       |                                 |       |   |   |
| Net Loans Charged-Off to Average Loans                        |       | 0.01                                 | %          | 0.09 | % |
| Allowance for Loan Losses to Total Loans                      |       | 1.01                                 | %          | 1.03 | % |
| Net Loans Charged-Off to Beginning  Allowance for Loan Losses |       | 0.99                                 | %          | 9.50 | % |
| Net Loans Charged-Off to Provision for Loan  Losses           |       | 15.71                                | %          | 46.57 | % |
| Allowance for Loan Losses to Non-performing  Loans            |       | n/a                                  |       | n/a |   |

 

Thefollowing table summarizes the allocation of the allowance for loan losses byloan type for the years indicated and the percent of loans in each category tototal loans (dollar amounts in thousands):

 
| ** **                  | ** ** | **December 31,  2004** | ** ** | **December 31,  2003** | ** ** |
|-----------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                  | ** ** | **Amount**             | ** ** | **Loan  Percent**      | ** ** | **Amount** | ** ** | **Loan  Percent** | ** ** |
| Commercial                  |       | $                      | 67         |                   | 5.74       | % | $ | 96 |   | 8.66 | % |
| Construction                |       | 78                     |       | 6.68                   | %          | 86 |   | 7.75 | % |
| Real Estate                 |       | 329                    |       | 28.17                  | %          | 323 |   | 29.13 | % |
| Consumer                    |       | 8                      |       | 0.68                   | %          | 19 |   | 1.71 | % |
| Government Guaranteed Loans |       | 507                    |       | 43.41                  | %          | 566 |   | 51.04 | % |
| General Economic Conditions |       | 179                    |       | 15.33                  | %          | 19 |   | 1.71 | % |
|                        |       | $                      | 1,168      |                   | 100.00     | % | $ | 1,109 |   | 100.00 | % |

 

33

----

 

**Funding**

 

Depositsare our primary source of funds.  AtDecember 31, 2004, we had a deposit mix of 46.91% in time and savings deposits,25.72% in money market and NOW deposits, and 27.37% in non-interest-bearingdemand deposits.  Our net interest incomeis enhanced by our percentage of non-interest-bearing deposits.

 

Thefollowing table summarizes the distribution of average deposits and the averagerates paid for the years indicated (dollar amounts in thousands):

 
| ** **                           | ** ** | **December 31,  2004** | ** ** | **December 31,  2003** | ** ** |
|--------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                           | ** ** | **Average  Balance**   | ** ** | **Average  Rate**      | ** ** | **Average  Balance** | ** ** | **Average  Rate** | ** ** |
| Money Market and NOW Accounts        |       | $                      | 36,671     |                   | 0.78       | % | $ | 34,120 |   | 0.70 | % |
| Savings Deposits                     |       | 7,458                  |       | 0.64                   | %          | 6,831 |   | 0.82 | % |
| TCD less than $100,000               |       | 17,007                 |       | 1.66                   | %          | 18,074 |   | 2.08 | % |
| TCD $100,000 or more                 |       | 41,422                 |       | 1.98                   | %          | 31,250 |   | 2.34 | % |
| Total Interest-Bearing Deposits      |       | 102,558                |       | 1.37                   | %          | 90,275 |   | 1.56 | % |
|                                 |       |                   |       |                   |       |   |   |   |   |
| Non-Interest-Bearing Demand Deposits |       | 36,780                 |       | n/a                    |       | 31,730 |   | n/a |   |
| Total Average Deposits               |       | $                      | 139,338    |                   | 1.03       | % | $ | 122,005 |   | 1.15 | % |

 

Thescheduled maturity distribution of our time deposits of $100,000 or greater, asof December 31, 2004, were as follows (dollar amounts in thousands):

 

| Three months or less          |   | $ | 14,353 |   |
|-------------------------------|--------|---|--------|--------|
| Over three months to one year |   | $ | 29,197 |   |
| Over one year to three years  |   | $ | 942    |   |
|                          |   | $ | 44,492 |   |

 

34

----

 

**Liquidityand Interest Rate****Sensitivity**

 

Theobjective of the Bank’s asset/liability strategy is to manage liquidity andinterest rate risk to ensure the safety and soundness of the Bank and itscapital base, while maintaining adequate net interest margins and spreads toprovide an appropriate return to our shareholders.

 

TheBank manages its interest rate risk exposure by limiting the amount oflong-term fixed rate loans we hold for investment, by increasing emphasis onshorter-term, higher yield loans, and increasing or decreasing the relativeamounts of deposits.

 

Thetable below sets forth the interest rate sensitivity of our interest-earningassets and interest-bearing liabilities as of December 31, 2004, using theinterest rate sensitivity gap ratio.  Forpurposes of the following table, an asset or liability is consideredrate-sensitive within a specified period when it can be repriced or matureswithin its contractual terms, (dollar amounts in thousands):

 
| ** **                                    | ** ** | **Within  Three  Months** | ** ** | **After  Three Months  But Within  One Year** | ** ** | **After One  Year But  Within  Five Years** | ** ** | **After  Five Years** | ** ** | **Total** | ** ** |
|-----------------------------------------------|------------|---------------------------|------------|-----------------------------------------------|------------|---------------------------------------------|------------|-----------------------|------------|-----------|------------|
|                                          |       |                      |       |                                          |       |                                        |       |                  |       |      |       |
| **Interest-Earning  Assets:**                 |       |                      |       |                                          |       |                                        |       |                  |       |      |       |
| Interest Bearing Deposits                     |       | $                         | —     |                                          | $          | —                                      |       | $                     | —     |      | $          | — |   | $ | — |   |
| Federal Funds Sold                            |       | 12,050                    |       | —                                        |       | 0                                           |       | —                |       | 12,050    |       |
| Investment Securities and FRB Stock           |       | —                    |       | 5,809                                         |       | 7,941                                       |       | —                |       | 13,750    |       |
| Gross Loans                                   |       | 82,342                    |       | 5,704                                         |       | 20,777                                      |       | 7,483                 |       | 116,306   |       |
|                                          |       | $                         | 94,392     |                                          | $          | 11,513                                      |       | $                     | 28,718     |      | $          | 7,483 |   | $ | 142,106 |   |
|                                          |       |                      |       |                                          |       |                                        |       |                  |       |      |       |
| **Interest-Bearing  Liabilities:**            |       |                      |       |                                          |       |                                        |       |                  |       |      |       |
| Money Market and NOW Deposits                 |       | $                         | 37,043     |                                          | $          | —                                      |       | $                     | —     |      | $          | — |   | $ | 37,043 |   |
| Savings                                       |       | 8,785                     |       | —                                        |       | —                                      |       | —                |       | 8,785     |       |
| Time Deposits                                 |       | 20,792                    |       | 36,418                                        |       | 1,765                                       |       | —                |       | 58,975    |       |
|                                          |       | $                         | 66,620     |                                          | $          | 36,418                                      |       | $                     | 1,765      |      | $          | — |   | $ | 104,803 |   |
|                                          |       |                      |       |                                          |       |                                        |       |                  |       |      |       |
| **Interest  Rate Sensitivity Gap**            |       | $                         | 27,772     |                                          | $          | (24,905                                     | )          | $                     | 26,953     |      | $          | 7,483 |   | $ | 37,303 |   |
| **Cumulative  Interest Rate Sensitivity Gap** |       | $                         | 27,772     |                                          | $          | 2,867                                       |       | $                     | 29,820     |      | $          | 37,303 |   | $ | 37,303 |   |
|                                          |       |                      |       |                                          |       |                                        |       |                  |       |      |       |
| **Ratios  Based on Total Assets:**            |       |                      |       |                                          |       |                                        |       |                  |       |      |       |
| Interst Rate Sensitivity Gap                  |       | 26.55                     | %          | -23.81                                        | %          | 25.77                                       | %          | 7.15                  | %          | 35.66     | %          |
| Cumulative Interest Rate Sensitivity Gap      |       | 26.55                     | %          | 2.74                                          | %          | 28.51                                       | %          | 35.66                 | %          |      |       |

 

 Liquidity refers to our ability to maintain acash flow that is adequate to fund both on-balance sheet and off-balance sheetrequirements on a timely and cost-effective basis.  Potentially significant liquidity requirementsinclude funding of commitments to loan clients and withdrawals from depositaccounts.  The Gap ratio is the abilityto reprice assets and liabilities in the changing economic environment.  For instance, the Bank is asset sensitivewithin three months, allowing the Bank to increase income in a rising interestrate environment.  The Bank then becomesliability sensitive between four months and one year, which will increaseinterest expense in a rising interest rate environment.

 

Itshould also be noted that during 2002, the Bank began to institute interestrate floors on certain variable rate loans. Once the interest rates on these variable rate loans reach the floorrate, they temporarily take on the attributes of a fixed rate loan.  This action has helped the Bank increase itsnet interest margin as the rates on our interest-bearing liabilities havecontinued to fall.  However, wheninterest rates begin to rise again in the future, the interest rates on our interest-bearingliabilities will also begin to rise while the interest rates on those variablerate loans with floors will remain at the floor rate.  This may cause the Bank’s net interestmargins to shrink until the rates on those loans with interest rate floors riseabove their floor rates.

 

Finally,the Bank feels that it faces no material liquidity impact from the undisbursedloans in the loan portfolio.

 

35

----

 

**CapitalResources**

 

Shareholders’equity at December 31, 2004 was $9.9 million, an increase of $1.1 million or12.5% over $8.8 million at December 31, 2003. Average shareholders’ equity for 2004 was $9.4 million, compared to $8.3million in 2003.  Shareholders’ equityincreased primarily from net income of $1,115,029 in 2004.

 

In1990, the banking industry began to phase in new regulatory capital adequacyrequirements based on risk-adjusted assets. These requirements take into consideration the risk inherent ininvestments, loans, and other assets for both on-balance sheet and off-balancesheet items.  Under these requirements,the regulatory agencies have set minimum thresholds for Tier 1 Capital, TotalCapital and Leverage ratios.  At December31, 2004, the Bank’s capital exceeded the Tier 1 Capital, Total Capital andLeverage ratio’s minimum regulatory requirements.  The Bank was considered to bewell-capitalized at December 31, 2004, as defined in the regulations issued bythe OCC.  The Bank’s risk-based capitalratios, shown below as of December 31, 2004, have been computed in accordancewith regulatory accounting policies.  TheBancorp is also subject to capital requirements that are withinwell-capitalized ranges as defined by the Federal Reserve Bank.

 
| ** **                      | ** ** | **Requirement**             | ** ** | **Actual**            | ** ** |
|---------------------------------|------------|-----------------------------|------------|-----------------------|------------|
| ** **                      | ** ** | **Adequately  Capitalized** | ** ** | **Well  Capitalized** | ** ** | **Bank** | ** ** | **Company** | ** ** |
| Total risk-based capital ratio  |       | 8.00                        | %          | 10.00                 | %          | 12.56 | % | 12.78 | % |
| Tier 1 risk-based capital ratio |       | 4.00                        | %          | 6.00                  | %          | 11.63 | % | 10.44 | % |
| Tier 1 leverage capital ratio   |       | 4.00                        | %          | 5.00                  | %          | 8.99 | % | 8.30 | % |

 

**Effectsof Inflation**

 

Thefinancial statements and related financial information presented herein havebeen prepared in accordance with GAAP, which require the measurement offinancial position and operating results in terms of historical dollars withoutconsidering changes in the relative purchasing power of money over time due toinflation.  Unlike most industrialcompanies, virtually all of the assets and liabilities of a financialinstitution are monetary in nature.  As aresult, interest rates have a more significant impact on a financialinstitution’s performance than the effects of general levels of inflation.  Interest rates do not necessarily move in thesame direction or same magnitude as the price of goods and services.

 

**Item7.  Financial Statements are presented onthe following pages.**

 

36

----

 
|  | **Vavrinek,  Trine, Day & Co., LLP**Certified Public Accountants & Consultants | VALUE THE DIFFERENCE |
|--|----------------------------------------------------------------------------------------|----------------------|

 

 

**REPORT OF INDEPENDENT REGISTERED PUBLICACCOUNTING FIRM**

 

 

Board of Directors and Stockholders of

Coast Bancorp and Subsidiary

 

We have audited the accompanying consolidated balance sheets of CoastBancorp and Subsidiary as of December 31, 2004 and 2003 and the relatedconsolidated statements of income, changes in stockholders’ equity, and cashflows for the years then ended.  Thesefinancial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the PublicCompany Accounting Oversight Board (United States).  Those standards require that we plan andperform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting theamounts and disclosures in the financial statements.  An audit also includes assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

 

In our opinion, the financial statements referred to above presentfairly, in all material respects, the financial position of Coast Bancorp andSubsidiary as of December 31, 2004 and 2003, and the results of its operationsand its cash flows for each of the years then ended, in conformity withaccounting principles generally accepted in the United States of America.

 

 
|                          |   |
|--------------------------|--------|
|                     |
| Laguna Hills, California |
| January25, 2005          |

 

 

25231 Paseo De Alicia, Suite    100Laguna Hills, CA 92653    Tel: 949.768.0833    Fax:949.768.8408    www.vtdcpa.com

 

### ***FRESNO ***•* LAGUNA HILLS *•* PALO ALTO *•* PLEASANTON *•* RANCHO CUCAMONGA *•*  SANJOSE*

 

37

----

 

# **COASTBANCORP AND SUBSIDIARY**

# ** **

# **CONSOLIDATEDBALANCE SHEETS**

# ** **

**December 31, 2004 and 2003**

 
| ** **                                                                                                                                                     | ** ** | **2004**   | ** **  | **2003**    | ** **  |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|-------------|-------------|-------------|
| **ASSETS**                                                                                                                                                     |       |       |        |        |        |
| Cash and due from banks                                                                                                                                        |       | $          | 8,639,823   |        | $           | 9,272,503 |   |
| Federal funds sold                                                                                                                                             |       | 12,050,000 |        | 5,400,000   |        |
| **TOTAL  CASH AND CASH EQUIVALENTS**                                                                                                                           | ** ** |       | 20,689,823  |        | 14,672,503  |   |
|                                                                                                                                                           |       |       |        |        |        |
| Investment securities available for sale                                                                                                                       |       | 12,866,593 |        | 12,072,582  |        |
|                                                                                                                                                           |       |       |        |        |        |
| Loans:                                                                                                                                                         |       |       |        |        |        |
| Commercial                                                                                                                                                     |       | 29,429,545 |        | 28,244,407  |        |
| Real estate - construction                                                                                                                                     |       | 17,432,127 |        | 13,500,870  |        |
| Real estate - other                                                                                                                                            |       | 66,896,995 |        | 62,281,542  |        |
| Consumer                                                                                                                                                       |       | 2,547,526  |        | 3,849,258   |        |
| **TOTAL  LOANS**                                                                                                                                               | ** ** |       | 116,306,193 |        | 107,876,077 |   |
| Net deferred loan fees                                                                                                                                         |       | (417,530   | )           | (414,115    | )           |
| Allowance for credit losses                                                                                                                                    |       | (1,168,423 | )           | (1,108,717  | )           |
| **NET  LOANS**                                                                                                                                                 | ** ** |       | 114,720,240 |        | 106,353,245 |   |
| Premises and equipment                                                                                                                                         |       | 8,728,512  |        | 7,091,566   |        |
| Deferred taxes                                                                                                                                                 |       | 360,000    |        | 367,000     |        |
| Federal Reserve Bank and Federal Home Loan  Bank stock, at cost                                                                                                |       | 883,450    |        | 415,150     |        |
| Accrued interest and other assets                                                                                                                              |       | 1,665,851  |        | 1,312,120   |        |
| **TOTAL  ASSETS**                                                                                                                                              | ** ** |       | $           | 159,914,469 |        | $ | 142,284,166 |   |
|                                                                                                                                                           |       |       |        |        |        |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                 | ** ** | ** ** | ** **  | ** **  | ** **  |
| Deposits:                                                                                                                                                      |       |       |        |        |        |
| Noninterest-bearing demand                                                                                                                                     |       | $          | 39,660,938  |        | $           | 34,635,873 |   |
| Money market and NOW                                                                                                                                           |       | 37,043,006 |        | 35,753,653  |        |
| Savings                                                                                                                                                        |       | 8,785,046  |        | 7,015,613   |        |
| Time deposits of $100,000 or more                                                                                                                              |       | 44,491,705 |        | 32,412,154  |        |
| Other time deposits                                                                                                                                            |       | 14,483,606 |        | 18,206,105  |        |
| **TOTAL  DEPOSITS**                                                                                                                                            | ** ** |       | 144,464,301 |        | 128,023,398 |   |
| Notes payable                                                                                                                                                  |       | 105,725    |        | 164,387     |        |
| Junior subordinated debt securities                                                                                                                            |       | 5,155,000  |        | 5,155,000   |        |
| Other liabilities                                                                                                                                              |       | 216,521    |        | 128,849     |        |
| **TOTAL  LIABILITIES**                                                                                                                                         | ** ** |       | 149,941,547 |        | 133,471,634 |   |
| Commitments and contingencies - Note # 4  and #12                                                                                                              |       | —     |        | —      |        |
| Stockholders’ equity:                                                                                                                                     |       |       |        |        |        |
| Preferred stock - 10,000,000 authorized,  none outstanding                                                                                                     |       | 6,641,100  |        | 6,407,275   |        |
| Common stock no par value; 10,000,000  shares authorized; issued and outstanding: 652,700 in 2004 and 638,300 in  2003                                         |       |       |        |        |        |
| Retained earnings                                                                                                                                              |       | 3,392,643  |        | 2,374,769   |        |
| Accumulated other comprehensive income -  net unrealized gains (losses) on available-for-sale securities, net of taxes  of $42,265 in 2004 and $21,186 in 2003 |       | (60,821    | )           | 30,488      |        |
| **TOTAL  STOCKHOLDERS’ EQUITY**                                                                                                                           | ** ** |       | 9,972,922   |        | 8,812,532   |   |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                           | ** ** |       | $           | 159,914,469 |        | $ | 142,284,166 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

38

----

 

# **COASTBANCORP AND SUBSIDIARY**

# ** **

**CONSOLIDATED STATEMENTS OF INCOME**

 

**For the Years Ended December 31, 2004 and2003**

 
| ** **                                                         | ** ** | **2004**  | ** ** | **2003**  | ** ** |
|--------------------------------------------------------------------|------------|-----------|------------|-----------|------------|
| **INTEREST  INCOME**                                               |       |      |       |      |       |
| Interest and fees on loans                                         |       | $         | 7,823,425  |      | $          | 7,119,325 |   |
| Interest on investment securities                                  |       | 190,341   |       | 147,534   |       |
| Interest on federal funds sold                                     |       | 185,668   |       | 139,528   |       |
| Other interest income                                              |       | 40,121    |       | 27,372    |       |
| **TOTAL  INTEREST INCOME**                                         |       | 8,239,555 |       | 7,433,759 |       |
| **INTEREST  EXPENSE**                                              |       |      |       |      |       |
| Interest on money market and NOW accounts                          |       | 284,705   |       | 237,541   |       |
| Interest on savings deposits                                       |       | 48,228    |       | 56,036    |       |
| Interest on time deposits                                          |       | 1,102,975 |       | 1,107,419 |       |
| Interest on junior subordinated debt  securities                   |       | 285,669   |       | 270,805   |       |
| Interest on other borrowings                                       |       | 5,222     |       | 29,702    |       |
| **TOTAL  INTEREST EXPENSE**                                        |       | 1,726,799 |       | 1,701,503 |       |
| **NET  INTEREST INCOME**                                           |       | 6,512,756 |       | 5,732,256 |       |
| Provision for credit losses                                        |       | 70,000    |       | 204,345   |       |
| **NET  INTEREST INCOME AFTER**                                     |       |      |       |      |       |
| **PROVISION  FOR CREDIT LOSSES**                                   |       | 6,442,756 |       | 5,527,911 |       |
| **NONINTEREST  INCOME**                                            |       |      |       |      |       |
| Service charges on deposits accounts and  other noninterest income |       | 291,144   |       | 297,381   |       |
| Gain on sale of loans and servicing fees                           |       | 1,025,657 |       | 515,368   |       |
| Mortgage packaging fees                                            |       | 107,555   |       | 251,056   |       |
| Gain on sale of securities                                         |       | 43,364    |       | 25,191    |       |
| **TOTAL NONINTEREST  INCOME**                                      |       | 1,467,720 |       | 1,088,996 |       |
| **NONINTEREST  EXPENSE**                                           |       |      |       |      |       |
| Salaries and benefits                                              |       | 3,366,193 |       | 2,795,592 |       |
| Net occupancy expenses                                             |       | 401,319   |       | 335,650   |       |
| Equipment and equipment expenses                                   |       | 273,204   |       | 252,964   |       |
| Data processing                                                    |       | 386,531   |       | 361,562   |       |
| Director fees and expenses                                         |       | 114,531   |       | 96,032    |       |
| Insurance                                                          |       | 60,130    |       | 38,068    |       |
| Marketing and business promotion                                   |       | 411,845   |       | 350,173   |       |
| Other professional expenses                                        |       | 321,353   |       | 252,278   |       |
| Office expenses                                                    |       | 219,116   |       | 193,688   |       |
| Regulatory assessments                                             |       | 73,617    |       | 66,285    |       |
| Other expenses                                                     |       | 305,976   |       | 214,946   |       |
| **TOTAL  NONINTEREST EXPENSE**                                     |       | 5,933,815 |       | 4,957,238 |       |
| **INCOME  BEFORE INCOME TAXES**                                    |       | 1,976,661 |       | 1,659,669 |       |
| Income taxes                                                       |       | 861,632   |       | 677,500   |       |
| **NET  INCOME**                                                    |       | $         | 1,115,029  |      | $          | 982,169 |   |
| **Per  Share Data**                                                |       |      |       |      |       |
| Net income - basic                                                 |       | $         | 1.73       |      | $          | 1.55 |   |
| Net income - diluted                                               |       | $         | 1.58       |      | $          | 1.46 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

39

----

 

**COAST BANCORP AND SUBSIDIARY**

 

**CONSOLIDATED STATEMENT OF CHANGES INSTOCKHOLDERS’ EQUITY**

 

**For the Years Ended December 31, 2004 and2003**

 
| ** **                                                                                   | ** ** | **Shares  Outstanding** | ** ** | **Common  Stock** | ** ** | **Comprehensive  Income** | ** ** | **Retained  Earnings** | ** ** | **Accumulated  Other  Comprehensive  Income** | ** ** | **Total** | ** ** |
|----------------------------------------------------------------------------------------------|------------|-------------------------|------------|-------------------|------------|---------------------------|------------|------------------------|------------|-----------------------------------------------|------------|-----------|------------|
| **Balance,  January 1, 2003**                                                                |       | 632,400                 |       | $                 | 6,324,000  |                      |       |                   | $          | 1,455,930                                     |       | $         | 48,824     |   | $ | 7,828,754 |   |
|                                                                                         |       |                    |       |              |       |                      |       |                   |       |                                          |       |      |       |
| Exercise of stock options                                                                    |       | 5900                    |       | 83,275            |       |                      |       |                   |       |                                          |       | 83,275    |       |
| Cash dividends                                                                               |       |                    |       |              |       |                      |       | (63,330                | )          |                                          |       | (63,330   | )          |
| **Comprehensive  income:**                                                                   |       |                    |       |              |       |                      |       |                   |       |                                          |       |      |       |
| Net income                                                                                   |       |                    |       |              |       | $                         | 982,169    |                   | 982,169    |                                          |       |      | 982,169    |   |
| Unrealized gains on available-for-sale  securities, net of taxes of $2,414                   |       |                    |       |              |       | (3,473                    | )          |                   |       | (3,473                                        | )          | (3,473    | )          |
| Less reclassification adjustments for gains  included in net income, net of taxes of $10,238 |       |                    |       |              |       | (14,863                   | )          |                   |       | (14,863                                       | )          | (14,863   | )          |
| **Total  comprehensive income**                                                              |       |                    |       |              |       | $                         | 963,833    |                   |       |                                          |       |      |       |   |
|                                                                                         |       |                    |       |              |       |                      |       |                   |       |                                          |       |      |       |
| **Balance,  December 31, 2003**                                                              |       | 638,300                 |       | 6,407,275         |       |                      |       | 2,374,769              |       | 30,488                                        |       | 8,812,532 |       |
|                                                                                         |       |                    |       |              |       |                      |       |                   |       |                                          |       |      |       |
| Exercise of stock options, including the  realization of tax benefits of $58,000             |       | 14,400                  |       | 233,825           |       |                      |       |                   |       |                                          |       | 233,825   |       |
| Cash dividends                                                                               |       |                    |       |              |       |                      |       | (97,155                | )          |                                          |       | (97,155   | )          |
| **Comprehensive  income:**                                                                   |       |                    |       |              |       |                      |       |                   |       |                                          |       |      |       |
| Net income                                                                                   |       |                    |       |              |       | $                         | 1,115,029  |                   | 1,115,029  |                                          |       |      | 1,115,029  |   |
| Unrealized losses on available-for-sale  securities, net of taxes of $45,672                 |       |                    |       |              |       | (65,724                   | )          |                   |       | (65,724                                       | )          | (65,724   | )          |
| Less reclassification adjustments for gains  included in net income, net of taxes of $17,779 |       |                    |       |              |       | (25,585                   | )          |                   |       | (25,585                                       | )          | (25,585   | )          |
| **Total  comprehensive income**                                                              |       |                    |       |              |       | $                         | 1,023,720  |                   |       |                                          |       |      |       |   |
|                                                                                         |       |                    |       |              |       |                      |       |                   |       |                                          |       |      |       |
| **Balance,  December 31, 2004**                                                              |       | 652,700                 |       | $                 | 6,641,100  |                      |       |                   | $          | 3,392,643                                     |       | $         | (60,821    | ) | $ | 9,972,922 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

40

----

** **

**COAST BANCORP AND SUBSIDIARY**

** **

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

** **

**For the Years Ended December 31, 2004 and2003**

 
| ** **                                                               | ** ** | **2004**    | ** ** | **2003**    | ** ** |
|--------------------------------------------------------------------------|------------|-------------|------------|-------------|------------|
| **OPERATING  ACTIVITIES**                                                |       |        |       |        |       |
| Net Income                                                               |       | $           | 1,115,029  |        | $          | 982,169 |   |
| Adjustments to reconcile net income to net  cash provided by operations: |       |        |       |        |       |
| Depreciation and amortization                                            |       | 408,651     |       | 349,981     |       |
| Provision for credit losses                                              |       | 70,000      |       | 204,345     |       |
| Realized gains in available-for-sale  securities                         |       | (43,364     | )          | (25,191     | )          |
| Deferred taxes                                                           |       | 70,000      |       | (68,000     | )          |
| Gain on sale of loans                                                    |       | (865,282    | )          | (433,718    | )          |
| Net change in accrued interest, other  assets and other liabilities      |       | 47,942      |       | (133        | )          |
| **NET CASH  PROVIDED BY OPERATING ACTIVITIES**                           |       | 802,976     |       | 1,009,453   |       |
| **INVESTING  ACTIVITIES**                                                |       |        |       |        |       |
| Net increase in loans                                                    |       | (17,445,684 | )          | (22,924,791 | )          |
| Proceeds from loans sold                                                 |       | 9,564,946   |       | 5,029,582   |       |
| Purchase of available-for-sale securities                                |       | (8,017,175  | )          | (11,036,186 | )          |
| Purchase of Federal Reserve Bank and  Federal Home Loan Bank stock       |       | (454,600    | )          | (124,900    | )          |
| Proceeds from sale of available-for-sale  securities                     |       | 5,094,101   |       | 1,027,188   |       |
| Proceeds from maturities of  available-for-sale securities               |       | 2,000,000   |       | —      |       |
| Purchase of premises and equipment                                       |       | (2,046,155  | )          | (1,169,903  | )          |
| **NET CASH  USED IN INVESTING ACTIVITIES**                               |       | (11,304,567 | )          | (29,199,010 | )          |
| **FINANCING  ACTIVITIES**                                                |       |        |       |        |       |
| Net increase in demand deposits and savings  accounts                    |       | 8,083,851   |       | 15,422,349  |       |
| Net increase in time deposits                                            |       | 8,357,052   |       | 4,764,586   |       |
| Principal payments on notes payable                                      |       | (58,662     | )          | (556,379    | )          |
| Payments for dividends                                                   |       | (97,155     | )          | (63,330     | )          |
| Proceeds from exercise of stock options                                  |       | 233,825     |       | 83,275      |       |
| **NET CASH  PROVIDED BY FINANCING ACTIVITIES**                           |       | 16,518,911  |       | 19,650,501  |       |
|                                                                     |       |        |       |        |       |
| **INCREASE  (DECREASE) IN CASH AND CASH EQUIVALENTS**                    |       | 6,017,320   |       | (8,539,056  | )          |
| Cash and cash equivalents at beginning of  period                        |       | 14,672,503  |       | 23,211,559  |       |
| Cash and cash equivalents at end of period                               |       | $           | 20,689,823 |        | $          | 14,672,503 |   |
|                                                                     |       |        |       |        |       |
| **Supplemental  disclosure of cash flow information**                    |       |        |       |        |       |
| Interest paid                                                            |       | $           | 1,723,216  |        | $          | 1,696,917 |   |
| Income taxes paid                                                        |       | $           | 902,710    |        | $          | 687,164 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

41

----

 

**COAST BANCORP AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**December 31, 2004 and 2003**

 

**NOTE #1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

### **Principlesof Consolidation**

### ** **

The financial statementsinclude the accounts of Coast Bancorp and its wholly owned subsidiary, CoastNational Bank (“Bank”), collectively referred to herein as the “Company.”  All significant intercompany transactionshave been eliminated.

 

**Nature ofOperations**

 

Coast Bancorp operatesCoast National Bank.  The Bank has beenorganized as a single operating segment and operates four branches in San LuisObispo, Arroyo Grande, Morro Bay, and Los Osos, California and three loanproduction offices in Santa Barbara, Santa Maria and Bakersfield,California.  The Bank’s primary source ofrevenue is providing loans to customers, who are predominantly small andmiddle-market businesses and individuals.

 

**Use of Estimates in the Preparation of Financial Statements**

 

Thepreparation of financial statements in conformity with generally acceptedaccounting principles in the United States of America requires management tomake estimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expensesduring the reporting period.  Actualresults could differ from those estimates.

 

### **Presentation of Cash Flows**

### ** **

Forthe purposes of reporting cash flows, cash and cash equivalents includes cash,noninterest-earning deposits and federal funds sold.  Generally, federal funds are sold for one dayperiods.

 

### **Cash and Due From Banks**

### ** **

Bankingregulations require that all banks maintain a percentage of their deposits asreserves in cash or on deposit with the Federal Reserve Bank.  The Bank complied with the reserverequirements as of December 31, 2004.

 

TheCompany maintains amounts due from banks which exceed federally insuredlimits.  The Company has not experiencedany losses in such accounts.

 

### **Investment Securities**

### ** **

Bonds,notes, and debentures for which the Company has the positive intent and abilityto hold to maturity are reported at cost, adjusted for premiums and discountsthat are recognized in interest income using the interest method over theperiod to maturity.

 

Investmentsnot classified as trading securities nor as held to maturity securities are classifiedas available-for-sale securities and recorded at fair value.  Unrealized gains or losses onavailable-for-sale securities are excluded from net income and reported as anamount net of taxes as a separate component of other comprehensive income includedin stockholders’ equity.  Premiums ordiscounts on held-to-maturity and available-for-sale securities are amortizedor accreted into income using the interest method.  Realized gains or losses on sales ofheld-to-maturity or available-for-sale securities are recorded using thespecific identification method.

 

42

----

 

### **Loans**

### ** **

Loansreceivable that management has the intent and ability to hold for theforeseeable future or until maturity or payoff are reported at theiroutstanding unpaid principal balances reduced by any charge-offs or specificvaluation accounts and net of any deferred fees or costs on originated loans,or unamortized premiums or discounts on purchased loans.

 

Loanorigination fees and certain direct origination costs are capitalized andrecognized as an adjustment of the yield of the related loan.

 

Loanson which the accrual of interest has been discontinued are designated asnonaccrual loans.  The accrual ofinterest on loans is discontinued when principal or interest is past due 90days based on contractual terms of the loan or when, in the opinion ofmanagement, there is reasonable doubt as to collectibility.  When loans are placed on nonaccrual status, allinterest previously accrued but not collected is reversed against currentperiod interest income.  Income onnonaccrual loans is subsequently recognized only to the extent that cash isreceived and the loan’s principal balance is deemed collectible.  Interest accruals are resumed on such loansonly when they are brought current with respect to interest and principal andwhen, in the judgment of management, the loans are estimated to be fullycollectible as to all principal and interest.

 

TheBank considers a loan to be impaired when it is probable that the Bank will beunable to collect all amounts due (principal and interest) according to thecontractual terms of the loan agreement. Measurement of impairment is based on the expected future cash flows ofan impaired loan which are to be discounted at the loan’s effective interestrate, or measured by reference to an observable market value, if one exists, orthe fair value of the collateral for a collateral-dependent loan.  The Bank selects the measurement method on aloan-by-loan basis except that collateral-dependent loans for which foreclosureis probable are measured at the fair value of the collateral.  The Bank recognizes interest income onimpaired loans based on its existing methods of recognizing interest income onnonaccrual loans.

 

Tocalculate the gain (loss) on sale of loans, the Bank’s investment in the loanis allocated among the retained portion of the loan, the servicing retained,the interest-only strip and the sold portion of the loan, based on the relativefair market value of each portion.  Thegain (loss) on the sold portion of the loan is recognized at the time of salebased on the difference between the sale proceeds and the allocatedinvestment.  As a result of the relativefair value allocation, the carrying value of the retained portion isdiscounted, with the discount accreted to interest income over the life of theloan.  That portion of the excessservicing fees that represent contractually specified servicing fees(contractual servicing) are reflected as a servicing asset which is amortizedover an estimated life using a method approximating the level yield method; inthe event future prepayments exceed Management’s estimates and future expectedcash flows are inadequate to cover the unamortized servicing asset, additionalamortization would be recognized.  Theportion of excess servicing fees in excess of the contractual servicing fees isreflected as interest-only (I/O) strips receivable, which are classified asinterest-only strips receivable available for sale and are carried at fairvalue.

 

43

----

 

**Provision and Allowance for Credit Losses**

 

Theallowance for credit losses is increased by charges to income and decreased bycharge-offs (net of recoveries). Management’s periodic evaluation of the adequacy of the allowance isbased on the Company’s past loan loss experience, known and inherent risks inthe portfolio, adverse situations that may affect the borrower’s ability torepay, the estimated value of any underlying collateral, and current economicconditions.

 

### **Premises and Equipment**

### ** **

Landis carried at cost.  Premises andequipment are carried at cost less accumulated depreciation and amortization.

Depreciationis computed using the straight-line method over the estimated useful lives,which ranges from three to ten years for furniture and fixtures and forty yearsfor buildings.  Leasehold improvementsare amortized using the straight-line method over the estimated useful lives ofthe improvements or the remaining lease term. Whichever is shorter.  Expenditures for betterments or major repairsare capitalized and those for ordinary repairs and maintenance are charged tooperations as incurred.

 

### **AdvertisingCosts**

### ** **

TheCompany expenses the costs of advertising in the period incurred.

 

### **IncomeTaxes**

### ** **

Deferredincome taxes are computed using the asset and liability method, whichrecognizes a liability or asset representing the tax effects, based on currenttax law, of future deductible or taxable amounts attributable to events thathave been recognized in the consolidated financial statements.  A valuation allowance is established toreduce the deferred tax asset to the level at which it is “more likely than not”that the tax asset or benefits will be realized.  Realization of tax benefits of deductibletemporary differences and operating loss carryforwards depends on havingsufficient taxable income of an appropriate character within the carryforwardperiods.

 

### **DisclosureAbout Fair Value of Financial Instruments**

### ** **

Statementof Financial Accounting Standard (“SFAS”) No. 107 specifies the disclosure ofthe estimated fair value of financial instruments.  The Company’s estimated fair value amountshave been determined by the Company using available market information andappropriate valuation methodologies.

 

However,considerable judgment is required to develop the estimates of fair value.  Accordingly, the estimates are notnecessarily indicative of the amounts the Company could have realized in acurrent market exchange.  The use of differentmarket assumptions and/or estimation methodologies may have a material effecton the estimated fair value amounts.

 

Althoughmanagement is not aware of any factors that would significantly affect theestimated fair value amounts, such amounts have not been comprehensivelyrevalued for purposes of these financial statements since the balance sheetdate and, therefore, current estimates of fair value may differ significantlyfrom the amounts presented in the accompanying notes.

 

44

----

 

### **Comprehensive Income**

### ** **

Beginningin 1998, the Company adopted SFAS No. 130, *“Reporting ComprehensiveIncome,”* which requires the disclosure of comprehensive income andits components.  Changes in unrealizedgains (losses) on available-for-sale securities net of income taxes is the onlycomponent of accumulated other comprehensive income for the Bank.

 

***Financial Instruments***

 

Inthe ordinary course of business, the Company has entered into off-balance sheetfinancial instruments consisting of commitments to extend credit, commitmentsunder credit card arrangements, commercial letters of credit, and standbyletters of credit, see Note #12.  Suchfinancial instruments are recorded in the consolidated financial statementswhen they are funded or related fees are incurred or received.

 

**Earnings Per Shares (EPS)**

 

BasicEPS excludes dilution and is computed by dividing income available to commonstockholders by the weighted-average number of common shares outstanding forthe period.  Diluted EPS reflects thepotential dilution that could occur if options or other contracts to issuecommon stock were exercised or converted into common stock or resulted in theissuance of common stock that then shared in the earnings of the entity.

 

### **Stock-Based Compensation**

### ** **

SFASNo. 123*, “Accounting for Stock-Based Compensation,”*encourages, but does not require, companies to record compensation cost forstock-based employee compensation plans at fair value.  The Company has chosen to continue to accountfor stock-based compensation using the intrinsic value method prescribed inAccounting Principles Board (“APB”) Opinion No. 25, *“Accountingfor Stock Issued to Employees,”* and related Interpretations.  Accordingly, compensation cost for stockoptions is measured as the excess, if any, of the quoted market price of theCompany’s stock at the date of the grant over the amount an employee must payto acquire the stock.

 

45

----

 

Hadcompensation costs for the Company’s stock option plan been determined based onthe fair value at the grant dates for awards under this plan consistent withthe method of SFAS No. 123, the Company’s net income and earnings per sharewould have been reduced for 2004 and 2003 to the pro forma amounts indicatedbelow:

 
| ** **                                                                                      | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Net income:                                                                                     |       |     |       |     |       |
| As reported                                                                                     |       | $        | 1,115,029  |     | $          | 982,169 |   |
| Stock-Based compensation using the  intrinsic value method                                      |       | —   |       | —   |       |
| Stock-Based compensation that would have  been reported using the fair value method of SFAS 123 |       | (68,335  | )          | (50,560  | )          |
| Pro Forma net income                                                                            |       | $        | 1,046,694  |     | $          | 931,609 |   |
|                                                                                            |       |     |       |     |       |
| Basic earnings per share:                                                                       |       |     |       |     |       |
| As reported                                                                                     |       | $        | 1.73       |     | $          | 1.55 |   |
| Pro forma                                                                                       |       | 1.63     |       | 1.47     |       |
|                                                                                            |       |     |       |     |       |
| Diluted earnings per share:                                                                     |       |     |       |     |       |
| As reported                                                                                     |       | $        | 1.58       |     | $          | 1.46 |   |
| Pro forma                                                                                       |       | 1.53     |       | 1.39     |       |

 

**Current Accounting Pronouncements**

 

InDecember 2004, Financial Accounting Standards Board (“FASB”) revised SFAS123 and issued it under its new name, *“Share-BasedPayment”. *This statementeliminates the alternative to use Opinion 25’s intrinsic value method ofaccounting discussed in the previous paragraph. Instead, this Statement generally requires entities to recognize thecost of employee services received in exchange for awards of stock options, orother equity instruments, based on the grant-date fair value of those awards.This cost will be recognized over the period during which an employee isrequired to provide service in exchange for the award, generally the vestingperiod.

 

TheBank must adopt this Statement in 2006 for all new stock option awards as wellas any existing awards that are modified, repurchased or cancelled.  In addition, the unvested portion ofpreviously awarded options will also be recognized as expense.  The Bank is unable to estimate the impact ofthis Statement on its financial condition and results of operations as thedecision to grant option awards is made annually on a case-by-case basis and,accordingly, the Bank cannot estimate the amount of stock awards that will bemade in 2006.

 

## **Reclassification**

## ** **

## **Certain reclassifications have been made in the 2003consolidated financial statements to conform to the presentation used in2004.  These classifications are of anormal recurring nature.**

 

46

----

 

## **NOTE#2 - INVESTMENT SECURITIES**

## ** **

Amortizedcost and market values of securities are as follows:

 
| ** **                     | ** ** | **December 31, 2004** | ** ** |
|--------------------------------|------------|----------------------------|------------|
| ** **                     | ** ** | **Amortized  Cost**        | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Market  Value** | ** ** |
| Available-for-sale securities: |       |                       |       |   |   |   |   |   |   |
| U.S. Treasury obligations      |       | $                          | 998,453    |   |   |   | $ | (4,673 | ) | $ | 993,780 |   |
| U.S. Agency obligations        |       | 11,971,226                 |       |   |   | (98,413 | ) | 11,872,813 |   |
|                           |       | $                          | 12,969,679 |   | $ | — |   | $ | (103,086 | ) | $ | 12,866,593 |   |
|                                |            |                            |            |  |  |  |  |  |  |  |  |  |  |

 
| ** **                     | ** ** | **December 31, 2003** | ** ** |
|--------------------------------|------------|----------------------------|------------|
| ** **                     | ** ** | **Amortized  Cost**        | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Market  Value** | ** ** |
| Available-for-sale securities: |       |                       |       |   |   |   |   |   |   |
| U.S. Treasury obligations      |       | $                          | 1,987,107  |   | $ | 6,955 |   | $ | — |   | $ | 1,994,062 |   |
| U.S. Agency obligations        |       | 10,033,801                 |       | 44,719 |   | — |   | 10,078,520 |   |
|                           |       | $                          | 12,020,908 |   | $ | 51,674 |   | $ | — |   | $ | 12,072,582 |   |

 

Securitieswith a carrying value of $989,334 and $1,032,394 at December 31, 2004 and2003, respectively, were pledged to secure public monies as required by law.

 

Grossrealized gains on sales of available-for-sale securities were $43,364 in 2004and $25,191 in 2003.

 

TheBank had no investments that have been in a continuous unrealized-loss positionfor more than twelve months as of December 31, 2004.

 

Theamortized cost and fair values of investment securities available-for-sale at December 31,2004, by expected maturities are shown below. Expected maturities may differ from contractual maturities becauseborrowers may have the right to call or prepay obligations with or without callor prepayment penalties.

 
| ** **                      | ** ** | **Securities  Available for Sale** | ** ** |
|---------------------------------|------------|------------------------------------|------------|
| ** **                      | ** ** | **Amortized  Cost**                | ** ** | **Fair Value** | ** ** |
| Due in one year or less         |       | $                                  | 4,958,432  |   | $ | 4,924,948 |   |
| Due from one year to five years |       | 8,011,247                          |       | 7,941,645 |   |
|                            |       | $                                  | 12,969,679 |   | $ | 12,866,593 |   |

 

47

----

 

**NOTE #3 - LOANS**

 

TheBank’s loan portfolio consists primarily of loans to borrowers within San LuisObispo, Santa Maria and Bakersfield, California and its surroundingcommunities.  Although the Bank seeks toavoid concentrations of loans to a single industry or based upon a single classof collateral, real estate and real estate associated businesses are among theprincipal industries in the Bank’s market area and, as a result, the Bank’sloan and collateral portfolios are, to some degree, concentrated in thoseindustries.

 

The Company alsooriginated SBA loans and other governmental guaranteed loans for sale togovernmental agencies and institutional investors.  Substantial portions of the Company’srevenues are from origination of loans guaranteed by the Small BusinessAdministration under its various programs and sale of the guaranteed portionsof those loans.  Funding for these SBAprograms depends on annual appropriations by the U.S. Congress.

 

TheCompany was servicing approximately $21,821,000 and $14,674,000 in loanspreviously sold as of December 31, 2004 and 2003, respectively.  The Company has recorded servicing assetsrelated to these loans totaling $419,086 and $236,931 as of December 31,2004 and 2003, respectively.  Theestimated fair value of the servicing assets approximated the carrying amountat December 31, 2004.  Fair value isestimated by discounting estimated future cash flows from the servicing assetsusing discount rates that approximate current market rates over the expectedlives of the loans being serviced.  Forpurposes of measuring impairment, the Company has identified each servicingasset with the underlying loan being serviced. A valuation allowance is recorded where the fair value is below thecarrying amount of the asset.

 

The Company may alsoreceive a portion of subsequent interest collections on loans sold that exceedthe contractual servicing fee.  In thatcase the Company records an interest-only strip based on the relative fairmarket value of it and the other components of the loan. The Company had interest-onlystrips of $86,592 and $75,607 as of December 31, 2004 and 2003,respectively, which approximated fair value. Fair value is estimated by discounting estimated future cash flows fromthe interest-only strips using assumptions similar to those used in valuingservicing assets.

 

Asdescribed in Note #12, these consolidated financial statements do not reflectother various commitments to extend credit or letters of credit, which arise inthe normal course of business.

 

Asummary of the changes in the allowance for credit losses follows:

 
| ** **                           | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------|------------|----------|------------|----------|------------|
| Balance, beginning of year           |       | $        | 1,108,717  |     | $          | 1,000,000 |   |
| Provision for credit losses          |       | 70,000   |       | 204,345  |       |
| Loans charged off, net of recoveries |       | (10,294  | )     | (95,628  | )     |
| Balance, end of year                 |       | $        | 1,168,423  |     | $          | 1,108,717 |   |

 

48

----

 

Thefollowing is a summary of the investment in impaired loans, the relatedallowance for loan losses, income recognized thereon and information pertainingto nonaccrual and past due loans as of December 31:

 
| ** **                                                   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|--------------------------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Recorded investment in impaired loans                        |       | $          | —     |       | $          | 31,991 |   |
| Related allowance for loan losses                            |       | $          | —     |       | $          | 6,708 |   |
| Average recorded investment in impaired  loans               |       | $          | 11,000     |       | $          | 33,750 |   |
| Interest income recognized for cash  payments                |       | $          | —     |       | $          | — |   |
| Total nonaccrual loans                                       |       | $          | —     |       | $          | 31,991 |   |
| Total loans past-due ninety days or more  and still accruing |       | $          | —     |       | $          | — |   |

 

**NOTE #4 - PREMISES AND EQUIPMENT**

 

Asummary of premises and equipment as of December 31, 2004 and 2003follows:

 
| ** **                                       | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|--------------------------------------------------|------------|------------|------------|------------|------------|
|                                             |       |       |       |       |       |
| Land                                             |       | $          | 3,388,541  |       | $          | 2,736,721 |   |
| Building                                         |       | 4,857,197  |       | 3,635,710  |       |
| Leasehold improvements                           |       | 200,637    |       | 267,960    |       |
| Furniture, fixtures and equipment                |       | 1,675,737  |       | 1,361,024  |       |
| Construction in progress                         |       | —     |       | 280,383    |       |
|                                             |       | 10,122,112 |       | 8,281,798  |       |
| Less: Accumulated depreciation and  amortization |       | (1,393,600 | )          | (1,190,232 | )          |
|                                             |       | $          | 8,728,512  |       | $          | 7,091,566 |   |

 

The Bank has entered intoleases for its branches and operating facilities, which expire at various datesthrough 2009. These leases include provisions for periodic rent increases aswell as payment by the lessee of certain operating expenses.  Rental expenses relating to these leases wereapproximately $82,000 in 2004 and $83,000 in 2003.

 

49

----

 

Theapproximate future minimum annual payments for these leases by year are asfollows:

 

| **Year** | ** ** | **Amount** | ** ** |
|----------|------------|------------|------------|
|     |       |       |       |
| 2005     |       | $          | 79,774     |   |
| 2006     |       | 70,728     |       |
| 2007     |       | 60,618     |       |
| 2008     |       | 33,090     |       |
| 2009     |       | 21,474     |       |
|     |       | $          | 265,684    |   |
|          |            |            |            |  |  |

 

The minimum rentalpayments shown above are given for the existing lease obligations and are not aforecast of future rental expense.

 

**NOTE #5 - DEPOSITS**

 

AtDecember 31, 2004, all time deposits were scheduled to mature in 2005,except for $1,764,691 that matures in one to two years.

 

**NOTE #6 - NOTES PAYABLE AND OTHER BORROWING ARRANGEMENTS**

 

Notes payable consist ofthe following:

 
| ** **                                                                                                                                                                                                       | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| 4% note payable to an individual, secured  by real property. Payable in monthly installments of $1,954 including  principal and interest, plus annual principal payments of $40,000, due  January 14, 2006. |       | $        | 105,725    |     | $          | 164,387 |   |
|                                                                                                                                                                                                                  |            |          |            |          |            |  |  |

 

The Bank may borrow up to$7,000,000 overnight on an unsecured basis from three correspondent banks.  As of December 31, 2004, no amounts wereoutstanding under these arrangements.

 

50

----

 

## **NOTE#7 -**JUNIORSUBORDINATED DEBT SECURITIES

## ** **

On September 26,2002, the Company issued $5,155,000 of junior subordinated debt securities (the“debt securities”) to Coast Bancorp Statutory Trust I, a statutory trustcreated under the laws of the State of Delaware.  These debt securities are subordinated toeffectively all borrowings of the Company and are due and payable on September 26,2032.  Interest is payable quarterly onthese debt securities at 3-Month LIBOR plus 3.4% for an effective rate of 5.95%as of December 31, 2004.  The debtsecurities can be redeemed for 107.5% of the principal balance through September 26,2007 and at par thereafter.  The debtsecurities can also be redeemed at par if certain events occur that impact thetax treatment or the capital treatment of the issuance.

 

The Company alsopurchased a 3% minority interest in Coast Bancorp Statutory Trust I.  The balance of the equity of Coast BancorpStatutory Trust I is comprised of mandatorily redeemable preferredsecurities.  Under FASB Interpretation(FIN) No. 46, “Consolidation of Variable Interest Entities, an interpretationof ARB No. 51,” the Company is not allowed to consolidate Coast BancorpStatutory Trust I into the Company financial statements.  Prior to the issuance of FIN No. 46, BankHolding companies typically consolidated these entities.  As of December 31, 2004, the Company hasincluded the net junior subordinated debt in its Tier 1 Capital for regulatorycapital purposes.

 

**NOTE #8 - INCOME TAXES**

 

Theprovisions for income taxes included in the consolidated statements of incomeconsist of the following:

 
| ** ** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------|------------|----------|------------|----------|------------|
| Current:   |       |     |       |     |       |
| Federal    |       | $        | 570,000    |     | $          | 545,500 |   |
| State      |       | 221,632  |       | 200,000  |       |
|       |       | 791,632  |       | 745,500  |       |
| Deferred   |       | 70,000   |       | (68,000  | )          |
|       |       | $        | 861,632    |     | $          | 677,500 |   |

 

Deferred taxes are aresult of differences between income tax accounting and generally acceptedaccounting principles with respect to income and expense recognition.  The Company’s principal timing differencesare from credit loss provision accounting and depreciation differences.

 

51

----

 

Thefollowing is a summary of the components of the net deferred tax asset accountsrecognized in the accompanying statements of financial condition:

 
| ** **                                             | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred tax assets:                                   |       |     |       |     |       |
| Allowance for credit losses                            |       | $        | 401,000    |     | $          | 373,000 |   |
| Market value adjustment on investment  securities      |       | 42,000   |       | —   |       |
| Other assets/liabilities                               |       | 18,000   |       | 55,000   |       |
|                                                   |       | 461,000  |       | 428,000  |       |
| Deferred tax Liabilities:                              |       |     |       |     |       |
| Premises and equipment due to depreciation  difference |       | (101,000 | )          | (40,000  | )          |
| Market value adjustment on investment  securities      |       | —   |       | (21,000  | )          |
|                                                   |       | (101,000 | )          | (61,000  | )          |
| Net deferred tax assets                                |       | $        | 360,000    |     | $          | 367,000 |   |

 

Acomparison of the federal statutory income tax rates to the Company’s effectiveincome tax rates follow:

 
| ** **                                  | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|---------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                  | ** ** | **Amount** | ** ** | **Rate**   | ** ** | **Amount** | ** ** | **Rate** | ** ** |
| ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Statutory federal tax                       |       | $          | 672,000    |       | 34.0       | % | $ | 564,000 |   | 34.0 | % |
| State franchise tax, net of federal benefit |       | 143,000    |       | 7.2        | %          | 117,000 |   | 7.0 | % |
| Other items, net                            |       | 46,632     |       | 2.4        | %          | (3,500 | ) | (0.2 | )% |
| Actual tax expense                          |       | $          | 861,632    |       | 43.6       | % | $ | 677,500 |   | 40.8 | % |

 

**NOTE #9 - EARNINGS PER SHARE (EPS)**

 

Thefollowing is a reconciliation of net income and shares outstanding to the netincome and number of shares used to compute EPS:

 
| ** **                                    | ** ** | **2004**       | ** ** | **2003**   | ** ** |
|-----------------------------------------------|------------|----------------|------------|------------|------------|
| ** **                                    | ** ** | **Net Income** | ** ** | **Shares** | ** ** | **Net Income** | ** ** | **Shares** | ** ** |
| ** **                                    | ** ** | ** **     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Used in basic EPS                             |       | $              | 1,115,029  |       | 643,701    |   | $ | 982,169 |   | 633,356 |   |
| Dilutive effect of outstanding stock  options |       |           |       | 62,190     |       |   |   | 38,289 |   |
| Used in dilutive EPS                          |       | $              | 1,115,029  |       | 705,891    |   | $ | 982,169 |   | 671,645 |   |

 

52

----

 

## **NOTE#10 - STOCK OPTION PLAN**

## ** **

AtDecember 31, 2003, the Company had a fixed option plan under which 187,500shares of the Company’s common stock may be issued at not less than 100% of thefair market value at the date the options are granted.  The Company applies APB Opinion No. 25 andrelated interpretations in accounting for its plan. Accordingly, nocompensation cost has been recognized for its fixed stock option plan.

 

Thefair value of each option granted was estimated on the date of grant using theBlack-Scholes option pricing model with the following assumptions for 2004 and2003, respectively; risk-free rate of 4% and 3%, dividend yields of 0.57% and0.65%; volatility of 14% and 33%, and an expected life of nine and six years.

 

Asummary of the status of the Company’s fixed stock option plan as of December 31,and changes during the years ending is presented below:

 

 
| ** **                                                       | ** ** | **2004**   | ** ** | **2003**                                | ** ** |
|------------------------------------------------------------------|------------|------------|------------|-----------------------------------------|------------|
| ** **                                                       | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** |
| ** **                                                       | ** ** | ** ** | ** ** | ** **                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Outstanding, beginning of year                                   |       | 147,500    |       | $                                       | 12.74      |   | 145,900 |   | $ | 12.62 |   |
| Granted                                                          |       | 23,500     |       | $                                       | 25.81      |   | 9,500 |   | $ | 15.50 |   |
| Exercised                                                        |       | (14,400    | )          | $                                       | 12.21      |   | (5,900 | ) | $ | 14.11 |   |
| Cancelled                                                        |       | (27,000    | )          | $                                       | 11.36      |   | (2,000 | ) | $ | 13.00 |   |
| Outstanding, end of year                                         |       | 129,600    |       | $                                       | 15.46      |   | 147,500 |   | $ | 12.74 |   |
|                                                             |       |       |       |                                    |       |   |   |   |   |
| Options exercisable at year-end                                  |       | 89,300     |       | $                                       | 12.89      |   | 112,167 |   | $ | 12.11 |   |
| Weighted-average fair value of options  granted  during the year |       |       |       | $                                       | 7.76       |   |   |   | $ | 5.40 |   |

 

Thefollowing table summarizes information about fixed options outstanding at December 31,2004:

 
| ** **          | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**                             | ** ** |
|---------------------|------------|-------------------------|------------|-----------------------------------------------------|------------|
| **Exercise  Price** | ** ** | **Number  Outstanding** | ** ** | **Weighted-  Average  Remaining  Contractual Life** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** |
| ** **          | ** ** | ** **              | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| $10.00              |       | 27,500                  |       | 2.45 Years                                          |       | $ | 10.00 |   | 27,500 |   | $ | 10.00 |   |
| $14.00 to $14.99    |       | 64,100                  |       | 3.95 Years                                          |       | $ | 14.07 |   | 56,500 |   | $ | 14.07 |   |
| $15.00 to $15.99    |       | 14,500                  |       | 4.40 Years                                          |       | $ | 15.23 |   | 4,900 |   | $ | 15.09 |   |
| $16.00 to $26.99    |       | 23,500                  |       | 8.51 Years                                          |       | $ | 25.81 |   | 400 |   | $ | 18.00 |   |
|                |       | 129,600                 |       | 4.51 Years                                          |       | $ | 15.46 |   | 89,300 |   | $ | 12.89 |   |

 

53

----

 

**NOTE #11 - RELATED PARTY TRANSACTIONS**

 

Inthe ordinary course of business, the Bank has granted loans to certaindirectors and the companies with which they are associated.  In the Bank’s opinion, all loans and loancommitments to such parties are made on substantially the same terms includinginterest rates and collateral, as those prevailing at the time for comparabletransactions with other persons.  The balanceof these loans outstanding at December 31, 2004 and 2003 was as follows:

 
| ** **        | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------|------------|----------|------------|----------|------------|
|              |       |     |       |     |       |
| Beginning balance |       | $        | 1,051,151  |     | $          | 1,185,703 |   |
| Additions         |       | —   |       | 42,893   |       |
| Payments          |       | (68,238  | )          | (177,445 | )          |
| Ending balance    |       | $        | 982,913    |     | $          | 1,051,151 |   |

 

Also in the ordinarycourse of business, certain officers, directors, shareholders, and employees ofthe Bank have deposits with the Bank.  Inthe Bank’s opinion, all deposit relationships with such parties are made onsubstantially the same terms including interest rates and maturities, as thoseprevailing at the time of comparable transactions with other persons.  The balance of these deposits at December 31,2004 was approximately $1,191,000.

 

**NOTE #12 - COMMITMENTS**

 

Inthe normal course of business, the Bank enters into financial commitments tomeet the financing needs of its customers. These financial commitments include commitments to extend credit andstandby letters of credit.  Thoseinstruments involve to varying degrees, elements of credit and interest raterisk not recognized in the statement of financial position.

 

TheBank’s exposure to loan loss in the event of nonperformance on commitments toextend credit and standby letters of credit is represented by the contractualamount of those instruments.  The Bankuses the same credit policies in making commitments as it does for loansreflected in the consolidated financial statements.

 

Asof December 31, 2004 and 2003, the Bank had the following outstandingfinancial commitments whose contractual amount represents credit risk:

 
| ** **                   | ** ** | **2004**  | ** ** | **2003**  | ** ** |
|------------------------------|------------|-----------|------------|-----------|------------|
|                         |       |      |       |      |       |
| Commitments to extend credit |       | $         | 35,112,000 |      | $          | 36,708,000 |   |
| Standby letters of credit    |       | 1,674,000 |       | 1,946,000 |       |
|                         |       | $         | 36,786,000 |      | $          | 38,654,000 |   |

 

54

----

 

Commitmentsto extend credit are agreements to lend to a customer as long as there is noviolation of any condition established in the contract.  Standby letters of credit are conditionalcommitments to guarantee the performance of a Bank customer to a thirdparty.  Since many of the commitments andstandby letters of credit are expected to expire without being drawn upon, thetotal amounts do not necessarily represent future cash requirements.  The Bank evaluates each customer’s creditworthiness on a case-by-case basis.  Theamount of collateral obtained if deemed necessary by the Bank is based onmanagement’s credit evaluation of the customer.

 

**NOTE #13 - FAIR VALUE OF FINANCIAL INSTRUMENTS**

 

Thefair value of a financial instrument is the amount at which the asset orobligation could be exchanged in a current transaction between willing parties,other than in a forced or liquidation sale. Fair value estimates are made at a specific point in time based onrelevant market information and information about the financialinstrument.  These estimates do notreflect any premium or discount that could result from offering for sale at onetime the entire holdings of a particular financial instrument.  Because no market value exists for asignificant portion of the financial instruments, fair value estimates arebased on judgments regarding future expected loss experience, current economicconditions, risk characteristics of various financial instruments, and otherfactors.  These estimates are subjectivein nature, involve uncertainties and matters of judgment, and therefore cannot bedetermined with precision.  Changes inassumptions could significantly affect the estimates.

 

Fairvalue estimates are based on financial instruments both on and off the balancesheet without attempting to estimate the value of anticipated future businessand the value of assets and liabilities that are not considered financialinstruments.  Additionally, taxconsequences related to the realization of the unrealized gains and losses canhave a potential effect on fair value estimates and have not been considered inmany of the estimates.

 

Thefollowing methods and assumptions were used to estimate the fair value ofsignificant financial instruments:

 

### **Financial Assets**

### ** **

Thecarrying amounts of cash, short term investments, due from customers onacceptances and Bank acceptances outstanding are considered to approximate fairvalue.  Short term investments includefederal funds sold, securities purchased under agreements to resell, andinterest bearing deposits with Banks. The fair values of investment securities, including available for sale,are generally based on quoted market prices. The fair value of loans are estimated using a combination of techniques,including discounting estimated future cash flows and quoted market prices ofsimilar instruments where available.

 

### **Financial Liabilities**

### ** **

Thecarrying amounts of deposit liabilities payable on demand, commercial paper,and other borrowed funds are considered to approximate fair value.  For fixed maturity deposits, fair value isestimated by discounting estimated future cash flows using currently offeredrates for deposits of similar remaining maturities.  The fair value of long term debt is based onrates currently available to the Bank for debt with similar terms and remainingmaturities.

 

55

----

 

### **Off-Balance Sheet Financial Instruments**

### ** **

Thefair value of commitments to extend credit and standby letters of credit isestimated using the fees currently charged to enter into similaragreements.  The fair value of thesefinancial instruments is not deemed to be material.

 

Theestimated fair value of financial instruments at December 31, 2004 and2003 are summarized as follows (dollar amounts in thousands):

 
| ** **                             | ** ** | **2004**             | ** ** | **2003**       | ** ** |
|----------------------------------------|------------|----------------------|------------|----------------|------------|
| ** **                             | ** ** | **Carrying  Amount** | ** ** | **Fair Value** | ** ** | **Carrying  Amount** | ** ** | **Fair Value** | ** ** |
| Assets:                                |       |                 |       |           |       |   |   |   |   |
| Cash and cash equivalents              |       | $                    | 20,690     |           | $          | 20,690 |   | $ | 14,673 |   | $ | 14,673 |   |
| Investment securities                  |       | 12,867               |       | 12,867         |       | 12,073 |   | 12,073 |   |
| Loans, net                             |       | 114,720              |       | 115,137        |       | 106,353 |   | 107,152 |   |
| Accrued interest receivable            |       | 535                  |       | 535            |       | 521 |   | 521 |   |
| Federal Reserve and FHLB Bank stock    |       | 884                  |       | 884            |       | 415 |   | 415 |   |
|                                   |       |                 |       |           |       |   |   |   |   |
| Liabilities:                           |       |                 |       |           |       |   |   |   |   |
| Noninterest-bearing deposits           |       | 39,661               |       | 39,661         |       | 34,636 |   | 34,636 |   |
| Interest-bearing deposits              |       | 104,803              |       | 104,803        |       | 93,387 |   | 93,387 |   |
| Notes payable                          |       | 106                  |       | 106            |       | 164 |   | 164 |   |
| Junior subordinated debt securities    |       | 5,155                |       | 5,155          |       | 5,155 |   | 5,155 |   |
| Accrued interest and other liabilities |       | 217                  |       | 217            |       | 129 |   | 129 |   |
|                                        |            |                      |            |                |            |  |  |  |  |  |  |  |  |

 

**NOTE #14 - REGULATORY MATTERS**

 

CoastBancorp and the Bank are subject to various regulatory capital requirementsadministered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certainmandatory - and possibly additional discretionary - actions by regulators that,if undertaken, could have a direct material effect on the Company’s consolidatedfinancial statements.  Under capitaladequacy guidelines and the regulatory framework for prompt, corrective action,the Bank must meet specific capital guidelines that involve quantitativemeasures of the Bank’s assets, liabilities, and certain off-balance-sheet itemsas calculated under regulatory accounting practices.  The Bank’s capital amounts and classificationare also subject to qualitative judgments by the regulators about components,risk weightings, and other factors.

 

Quantitativemeasures established by regulation to ensure capital adequacy require the Bankto maintain minimum amounts and ratios (set forth in the table below) of totaland Tier 1 capital (as defined in the regulations) to risk-weighted assets (asdefined), and of Tier 1 capital (as defined) to average assets (asdefined).  Management believes, as ofDecember 31, 2004, that the Bank meets all capital adequacy requirements towhich it is subject.

 

56

----

 

Asof December 31, 2004, the most recent notification from the Office of theComptroller of the Currency (“OCC”) categorized the Bank as well-capitalizedunder the regulatory framework for prompt corrective action (there are noconditions or events since that notification that management believes havechanged the Bank’s category).  To becategorized as well-capitalized or adequately capitalized, the Bank mustmaintain minimum ratios as set forth in the table below.  The following table also sets forth theBank’s actual capital amounts and ratios (dollar amounts in thousands):

 
| ** **                             | ** ** | ** **         | ** ** | ** **                         | ** ** | **Amount of Capital Required** | ** ** |
|----------------------------------------|------------|--------------------|------------|------------------------------------|------------|--------------------------------|------------|
| ** **                             | ** ** | **Actual Capital** | ** ** | **To Be  Adequately  Capitalized** | ** ** | **To Be  Well-Capitalized**    | ** ** |
| ** **                             | ** ** | **Amount**         | ** ** | **Ratio**                          | ** ** | **Amount**                     | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| As of December 31, 2004                |       |               |       |                               |       |                           |       |   |   |   |   |   |   |
| Total capital to risk-weighted assets  |       | $                  | 15,740     |                               | 12.56      | %                              | $          | 10,026 |   | 8.0 | % | $ | 12,532 |   | 10.0 | % |
| Tier 1 capital to risk-weighted assets |       | $                  | 14,572     |                               | 11.63      | %                              | $          | 5,013 |   | 4.0 | % | $ | 7,519 |   | 6.0 | % |
| Tier 1 capital to average assets       |       | $                  | 14,572     |                               | 8.99       | %                              | $          | 6,486 |   | 4.0 | % | $ | 8,108 |   | 5.0 | % |
|                                   |       |               |       |                               |       |                           |       |   |   |   |   |   |   |
| As of December 31, 2003                |       |               |       |                               |       |                           |       |   |   |   |   |   |   |
| Total capital to risk-weighted assets  |       | $                  | 14,269     |                               | 12.51      | %                              | $          | 9,122 |   | 8.0 | % | $ | 11,403 |   | 10.0 | % |
| Tier 1 capital to risk-weighted assets |       | $                  | 13,160     |                               | 11.54      | %                              | $          | 4,561 |   | 4.0 | % | $ | 6,842 |   | 6.0 | % |
| Tier 1 capital to average assets       |       | $                  | 13,160     |                               | 9.49       | %                              | $          | 5,545 |   | 4.0 | % | $ | 6,931 |   | 5.0 | % |

 

The Company is subject tosimilar requirements administered by its primary regulator, the Federal ReserveBoard.  For capital adequacy purposes,the Company must maintain total capital to risk-weighted assets and Tier 1capital to risk-weighted assets of 8.0% and 4.0%, respectively.  Its total capital to risk-weighted assets andTier 1 capital to risk-weighted assets was 12.8% and 10.4%, respectively, atDecember 31, 2004 and 13.0% and 10.2%, respectively, at December 31, 2003.

 

TheBank is restricted to the amount of dividends which can be paid.  Dividends declared by national banks thatexceed the net income (as defined) for the current year plus retained netincome for the preceding two years must be approved by the OCC.  The Bank may not pay dividends that wouldresult in its capital levels being reduced below the minimum requirements shownabove.

 

With certain exceptions,the Company may not pay a dividend to its shareholders unless its retainedearnings equal at least the amount of the proposed dividend.

 

57

----

 

**NOTE #15- CONDENSED FINANCIAL INFORMATION OF PARENT COMPANY ONLY**

 

Coast Bancorp operatesCoast National Bank.  Coast Bancorpcommenced operations during 2001.  Theearnings of the subsidiary are recognized on the equity method of accounting.  Condensed financial statements of the parentcompany only are presented below:

 

**CONDENSED BALANCE SHEETS**

 
| ** **                                      | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|------------------|------------|------------------|------------|
| ** **                                      | ** ** | **2004**         | ** ** | **2003**         | ** ** |
| **ASSETS**                                      |       |             |       |             |       |
| Cash                                            |       | $                | 125,966    |             | $          | 347,639 |   |
| Investment in Coast Bancorp Statutory Trust  I  |       | 155,000          |       | 155,000          |       |
| Investment in Coast National Bank               |       | 14,552,588       |       | 13,214,061       |       |
| Other assets                                    |       | 299,479          |       | 254,758          |       |
|                                            |       | $                | 15,133,033 |             | $          | 13,971,458 |   |
|                                            |       |             |       |             |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY:** |       |             |       |             |       |
| Other liabilities                               |       | $                | 5,111      |             | $          | 3,926 |   |
| Junior subordinated debt securities             |       | 5,155,000        |       | 5,155,000        |       |
| Stockholders’ equity                       |       | 9,972,922        |       | 8,812,532        |       |
|                                            |       | $                | 15,133,033 |             | $          | 13,971,458 |   |

 

**CONDENSED STATEMENTS OF INCOME**

 
| ** **                                                     | ** ** | **Year Ended**   | ** ** | **Year Ended**   | ** ** |
|----------------------------------------------------------------|------------|------------------|------------|------------------|------------|
| ** **                                                     | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **                                                     | ** ** | **2004**         | ** ** | **2003**         | ** ** |
| **INCOME**                                                     |       |             |       |             |       |
| Interest income                                                |       | $                | 3,081      |             | $          | 5,352 |   |
| Cash dividends from Coast Bancorp Statutory  Trust I           |       | 7,684            |       | 7,237            |       |
| **TOTAL  INCOME**                                              |       | 10,765           |       | 12,589           |       |
|                                                           |       |             |       |             |       |
| **EXPENSES**                                                   |       |             |       |             |       |
| Interest on note payable                                       |       | 7,591            |       | 21,738           |       |
| Interest on junior subordinated debt  securities               |       | 278,078          |       | 270,805          |       |
| Other                                                          |       | 139,903          |       | 64,319           |       |
| Allocated tax benefit                                          |       | (100,000         | )          | (142,000         | )          |
| **TOTAL  EXPENSES**                                            |       | 325,572          |       | 214,862          |       |
|                                                           |       |             |       |             |       |
| **LOSS  BEFORE EQUITY IN UNDISTRIBUTED  INCOME OF SUBSIDIARY** |       | (314,807         | )          | (202,273         | )          |
| ** **                                                     |       |             |       |             |       |
| **EQUITY  IN UNDISTRIBUTED  INCOME OF SUBSIDIARY**             |       | 1,429,836        |       | 1,184,442        |       |
|                                                           |       |             |       |             |       |
| **NET  INCOME**                                                |       | $                | 1,115,029  |             | $          | 982,169 |   |

 

58

----

 

## **CONDENSEDSTATEMENT OF CASH FLOWS**

 
| ** **                                             | ** ** | **Years Ended**  | ** ** |
|--------------------------------------------------------|------------|------------------|------------|
| ** **                                             | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **                                             | ** ** | **2004**         | ** ** | **2003** | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**             |       |             |       |   |   |
| Net income                                             |       | $                | 1,115,029  |   | $ | 982,169 |   |
| Noncash items included in net income:                  |       |             |       |   |   |
| Equity in income of Subsidiary                         |       | (1,429,836       | )          | (1,184,442 | ) |
| Other                                                  |       | (43,536          | )          | (16,836 | ) |
| **NET CASH  USED IN  OPERATING ACTIVITIES**            |       | (358,343         | )          | (219,109 | ) |
|                                                   |       |             |       |   |   |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**             |       |             |       |   |   |
| Principal payment on note payable                      |       | —           |       | (500,000 | ) |
| Proceeds from junior subordinated debt  securities     |       | —           |       | — |   |
| Proceeds from exercise of stock options                |       | 233,825          |       | 83,275 |   |
| Dividends Paid                                         |       | (97,155          | )          | (63,330 | ) |
| **NET CASH  PROVIDED (USED) BY  FINANCING ACTIVITIES** |       | 136,670          |       | (480,055 | ) |
|                                                   |       |             |       |   |   |
| **NET  DECREASE IN  CASH AND CASH EQUIVALENTS**        |       | (221,673         | )          | (699,164 | ) |
|                                                   |       |             |       |   |   |
| **CASH AND  CASH EQUIVALENTS  AT BEGINNING OF YEAR**   |       | 347,639          |       | 1,046,803 |   |
|                                                   |       |             |       |   |   |
| **CASH AND  CASH EQUIVALENTS  AT END OF YEAR**         |       | $                | 125,966    |   | $ | 347,639 |   |

 

59

----

 

**Item8.  Changes In and Disagreements withAccountants on Accounting and Financial Disclosure**

 

None

 

**Item 8A. Controls and Procedures**

 

**Quarterly Evaluation of the Company’s Disclosure Controls .**

 

Asof December 31, 2004 and prior to the date of this Annual Report on Form10-KSB, the Company evaluated the effectiveness of the design and operation ofits “disclosure controls and procedures” (“Disclosure Controls”).  This evaluation (the “Controls Evaluation”)was done under the supervision and with the participation of management,including our Chairman and Chief Executive Officer (“CEO”) and Chief FinancialOfficer (“CFO”). Rules adopted by the SEC require that in this section of theAnnual Report we present the conclusions of the CEO and the CFO about theeffectiveness of our Disclosure Controls based on and as of the date of theControls

 

**CEO and CFO Certifications.**

 

Appearingimmediately following the Signatures section of this Quarterly Report there aretwo separate forms of “Certifications” of the CEO and the CFO. The first formof Certification is required in accord with Section 302 of the Sarbanes-OxleyAct of 2002 (the “Section 302 Certification”). The section of the Annual Reportwhich you are currently reading is the information concerning the ControlsEvaluation referred to in the Section 302 Certifications and this informationshould be read in conjunction with the Section 302 Certifications for a morecomplete understanding of the topics presented.

 

**Disclosure Controls .**

 

DisclosureControls are procedures that are designed with the objective of ensuring thatinformation required to be disclosed in our reports filed under the ExchangeAct, such as this Annual Report, is recorded, processed, summarized andreported within the time periods specified in the Commission’s rules and forms.Disclosure Controls are also designed with the objective of ensuring that suchinformation is accumulated and communicated to our management, including theCEO and CFO, as appropriate to allow timely decisions regarding requireddisclosure.

 

**Limitations on the Effectiveness of Controls.**

 

TheCompany’s management, including the CEO and CFO, does not expect that ourDisclosure Controls will prevent all error and all fraud. A control system, nomatter how well conceived and operated, can provide only reasonable, notabsolute, assurance that the objectives of the control system are met. Further,the design of a control system must reflect the fact that there are resourceconstraints, and the benefits of controls must be considered relative to theircosts. Because of the inherent limitations in all control systems, noevaluation of controls can provide absolute assurance that all control issuesand instances of fraud, if any, within the Company have been detected. Theseinherent limitations include the realities that judgments in decision-makingcan be faulty, and that breakdowns can occur because of simple error ormistake. Additionally, controls can be circumvented by the individual acts ofsome persons, by collusion of two or more people, or by management override ofthe control. The design of any system of controls also is based in part uponcertain assumptions about the likelihood of future events, and there can be noassurance that any design will succeed in achieving its stated goals under allpotential future conditions; over time, control may become inadequate becauseof changes in conditions, or the degree of compliance with the policies orprocedures may deteriorate. Because of the inherent limitations in acost-effective control system, misstatements due to error or fraud may occurand not be detected.

 

**Scope of the Controls Evaluation.**

 

TheCEO/CFO evaluation of our Disclosure Controls included a review of the controls’objectives and design, the controls’ implementation by the Company and theeffect of the controls on the information

 

60

----

 

generatedfor use in this Quarterly Report. In the course of the Controls Evaluation, wesought to identify data errors, controls problems or acts of fraud and toconfirm that appropriate corrective action, including process improvements,were being undertaken. This type of evaluation will be done on a quarterlybasis so that the conclusions concerning controls effectiveness can be reportedin our Quarterly Reports on Form 10-QSB and Annual Report on Form 10-KSB. Theoverall goals of these various evaluation activities are to monitor our DisclosureControls and our Internal Controls and to make modifications as necessary; ourintent in this regard is that the Disclosure Controls will be maintained asdynamic systems that change (including with improvements and corrections) asconditions warrant.

 

**Conclusions.**

 

Basedupon the Controls Evaluation, our CEO and CFO have concluded that, subject tothe limitations noted above, our Disclosure Controls are effective to ensurethat material information relating to the Company and its consolidated subsidiariesis made known to management, including the CEO and CFO, particularly during theperiod when our periodic reports are being prepared.

 

**Item 8B.  Other Information**

 

None

 

61

----

 

**INDEXTO EXHIBITS**

 

## **PART III**

 

**Item9.  Directors, Executive Officers,Promoters and Control Persons: Compliance with Section 16(a) of the ExchangeAct**

 

Boardof Directors:

 

**Marilyn Britton**, age 65, graduated from Cal Poly San Luis Obispo.  She was involved with the San Luis Obispo CountyFarm Bureau for over 26 years, retiring as Executive Director in December 2001,a position she held for over 16 years. Marilyn is a member and past director of the San Luis Obispo Rotary, amember of San Luis Obispo County Farm Bureau, San Luis Obispo County FarmBureau Women, San Luis Obispo County CattleWomen’s Association, San Luis ObispoCounty Cattlemen’s Association, Paso Robles Agri-Business Tour Committee.  Mrs. Britton developed the San Luis ObispoCounty Farm Bureau Agriculture Tour Program 25 years ago and has continued asits Tour Coordinator.  She was also theExecutive Director for the San Luis Obispo County Grain Improvement Associationfor 18 years.  She also serves on theSheriff’s Parole Board.

 

**Dario A. Domenghini**, age 67, is an original organizer and director of the Bank.  Mr. Domenghini is a life-long resident of SanLuis Obispo County.  His family has beeninvolved in agriculture in the County of San Luis Obispo since the early 1920’s.  Mr. Domenghini has been involved in agriculture,working in his family’s dairy and ranching operation since his childhood.

 

Mr.Domenghini expanded the operation to include vegetable farming.  He has since closed down the dairy operation,but continues to farm in partnership with his nephew.  Mr. Domenghini holds an ownership in the realestate interest of Domenghini Brothers and is a 50% partner in DomenghiniFarms.  Mr. Domenghini was educated atCal Poly San Luis Obispo, majoring in Dairy Science.  Mr. Domenghini is active in local farming andranching activities.

 

**James Kaney**,age 58, is an original organizer and director of the Bank.  Mr. Kaney has been a business owner/operatorin San Luis Obispo since 1970 and he is a certified public accountant.  He received his B.S. degree, cum laude, inAccounting/Finance with a minor in Economics and his Masters of BusinessAdministration Degree from California Polytechnic State University, San LuisObispo.  He also teaches accounting andcommercial bank management at Cal Poly. Mr. Kaney started Kaney Foods, Inc. in San Luis Obispo, a wholesaler torestaurants and institutions in the counties of Monterey, Santa Barbara,Ventura, and San Luis Obispo.  Mr. Kaneywas responsible for all phases of the company warehousing, distribution, salesand accounting.  The company was sold in1987.  Mr. Kaney is partially disabledand is actively involved in his investments. Mr. Kaney is an organizer, founder and past director of Commerce Bank ofSan Luis Obispo N.A., which was sold in March 1996 to Valliwide Bank.  Mr. Kaney served for more than twelve yearson the Loan Committee and the Investment Committee of Commerce Bank.  Mr. Kaney is a past member of the KiwanisClub and a member and past director of the Rotary Club of San Luis Obispo.

 

**Michael A. Lady**, age 53 is an original organizer and director of the Bank.  Mr. Lady has been a resident of Arroyo Grandefor the past seventeen years and is the owner of Lady Family Mortuary in ArroyoGrande and Nipomo.  In addition to hisinvolvement in the mortuary business, Mr. Lady is an investor, as well as theformer Mayor of the City of Arroyo Grande.  Mr. Lady, through his development and governmental activities, isvitally aware of the future development plans for the Arroyo Grande area,including plans for the possible annexation of unincorporated lands borderingArroyo Grande to provide the space for a major increase in commercialdevelopment in the community.

 

Mr.Lady is active in a large number of civic and fraternal organizations.  He is the past president of the Arroyo GrandeChamber of Commerce and the Arroyo Valley Kiwanis.  He is a member of the Elks Club, Moose Lodge,Shriner’s Club, the Freemasons, YMCA, and the Fraternal Order of Eagles. He wasnamed the 1991 Arroyo Grande Citizen of the Year, and he and his wife werenamed South County Couple of the Year also in 1991. Mr. Lady is a leader in theArroyo Grande community, and his involvement in the formation and management ofthe Bank has provided the Bank with an impressive base of valuable businesscustomers.

 

62

----

 

**Gene Mintz**,age 65, is an original organizer and director of the Bank.  Mr. Mintz is a business and tax advisor forthe Arroyo Grande area and owner of GSM Business Services, Inc., an ArroyoGrande business and tax advisory service. A life-long resident of San Luis Obispo County, Mr. Mintz is involved ina number of professional, civic, and charitable associations.  He is the past president and director of theKiwanis Club of greater Pismo Beach, and a 28 year member of the Elks club ofthe Pismo Beach area.  Mr. Mintz is ageneral partner in, a Real Estate Investment Partnership. He is also theSecretary/Treasurer of Lanco Development Co., Inc., a Real Estate DevelopmentCompany.

 

Mr.Mintz is active in a number of professional organizations, serving as a pastpresident of the Central Coast Chapter of the California Society of EnrolledAgents.  His professional activitiesinclude his active accounting and tax advisory business, as well as involvementin a number of real estate development projects.  He is the Secretary-Treasurer of Burke andPace, a major supplier of building materials headquartered in ArroyoGrande.  Mr. Mintz is involved in theSouth County Performing Arts Foundation, as a Director and Vice President forthis cultural organization.

 

**Ron Olson**,age 61, is a director of the Bank.  Mr.Olson is a Certified Public Accountant and is owner of Platino ManagementServices, Inc. which provides accounting and tax services, managementconsulting and property management services in Arroyo Grande and surroundingcommunities.

 

Mr.Olson has been a resident of Arroyo Grande for 31 years and is active in localservice and professional organizations. Mr. Olson is a member of the Arroyo Grande Optimists Club and of boththe American Institute of CPA’s and the California Society of CPA’s.  Mr. Olson is an investor and director of aprivately held chain of food supermarkets and a fast food restaurantfranchising company.

 

**Jack W. Robasciotti**, age 77, is Vice Chairman of the board and an original organizingdirector of the Bank.  Mr. Robasciottiwas born in San Luis Obispo and has been active in banking since 1951.  After an impressive 33 year career with Bankof America, Mr. Robasciotti “retired” to San Luis Obispo, where he worked for21 years in various positions, including manager of the main office of CommerceBank of San Luis Obispo, N.A. as well as increasingly responsible positionswith Coast National Bank.

 

Mr.Robasciotti has been active in a number of civic, charitable and fraternalorganizations in San Luis Obispo.  Hisactivities range from fundraising for the YMCA, to serving as a director and amember of organizations that provide shelter for abused women (Women’sShelter), Sexual Assault Victim’s Education (SAVE) and (ALPHA) that counselspregnant women.   Mr. Robasciotti is amember of the San Luis Obispo Historical Society, previously serving as FirstVice President, a past member of Hearst Castle Lighting Committee, and a memberof other organizations including a committee member of the San Luis Obispo OldMission operating groups.  He is also anactive member in the De Tolosa Rotary club.

 

**Jack C. Wauchope**, age 69, is Chief Executive Officer and Chairman of the Board ofDirectors for both the Bank and the Bancorp. Mr. Wauchope has been in the banking industry for more than 45years.  For over half of that time, hehas served as the President and Chief Executive Officer of independentbanks.   Mr. Wauchope was the organizingPresident of Commerce Bank of San Luis Obispo as well as Coast NationalBank.  He is a graduate of MillikinUniversity at Decatur, Illinois and the Pacific Coast Banking School at theUniversity of Washington, Seattle, Washington.

 

Mr.Wauchope has served on the boards of numerous civic, charitable and tradeorganizations which include the Foundation for the Performing Arts Center,Hotline of San Luis Obispo County, San Luis Obispo Economics Forecast Project,Community Bankers of Southern California, Western Banking School, Rotary Clubof San Luis Obispo Daybreak and the Civic Ballet of San Luis Obispo.

 

**Dan H. Wixom**,age 54, is an original organizer and director of the Bank.  Mr. Wixom is a rancher and an owner/operatorof Wixom Trucking, LLC.  Mr. Wixomformerly owned and operated Wixom Concrete, Inc., which was sold in 1997.  A graduate of Cal Poly San Luis Obispo inAgriculture Management, Mr. Wixom is a fourth generation resident of San LuisObispo County.  He has been a member ofNative Sons of the Golden West for over twenty-five years and served as apresident of the organization.  Mr. Wixomserved on the board of the Morro Bay Community Foundation.  The foundation helps with youth activities onthe Central Coast.  He supports localeducational institutions, volunteering time and donating materials for theMorro Bay FFA and 4H groups and for youth sports teams.

 

63

----

 

Mr.Wixom is a member of the California Cattlemen’s Association, the NationalCattlemen’s Association, and the San Luis Obispo County Farm Bureau.  He has operated his own calf/cow operationfor more than 30 years.  Currently heruns over 200 mother cows on over 3,000 acres, with an additional 100 acres setaside for oat and hay production.  Histrucking company is involved in the statewide transportation of constructionaggregates, bulk cement and livestock.

 

ExecutiveOfficers:

 

JackC. Wauchope – Chief Executive Officer/President and Chairman of the Board – See“Directors”

 

JackRobasciotti – Vice-Chairman of the Board, Business Development Officer – See “Directors”

 

**Julie Joslin**,age 45, joined the Bank in 2000 as Senior Vice President and ComplianceOfficer.   She was raised and educated inAtascadero, California, where she began her banking career with Atascadero FederalCredit Union in 1983.  She moved toTempleton National Bank in 1990 where she remained until that bank was sold in1995.  Joslin served as a Vice Presidentand Controller while with Templeton National Bank.  Joslin is also a graduate of the California BankingSchool at the University of San Diego.

 

**Berta Olson**,age 65, was an original employee of the Bank. She currently serves as Senior Vice President, Controller and OperationsAdministrator.  She was raised andeducated in Santa Barbara, California, where she began her banking career 48years ago.  Berta is a graduate of theGraduate School of Banking at the University of Wisconsin at Madison.  Over the years, Berta has volunteered for anumber of civic and charitable organizations.

 

**Davina Palazzo**, age 36, is Executive Vice President and Manager of the Bank’s SmallBusiness Loan Center.  She was educatedin Southern California, graduating from California State University —Fullerton.  She has been in banking forthe past 16 years, concentrating primarily over the last ten years ingovernment guaranteed lending programs such as the U.S. Small BusinessAdministration.  She is a graduate of thePacific Coast Banking School at the University of Washington.  She is an executive director of the Board ofDirectors of the National Association of Government Guaranteed Lenders andChairs their Small Bank Committee.  Shehas testified in front of Congress numerous times on SBA issues.   She is the President-Elect of the Board ofthe Paso Robles Sunrise Rotary Club.  Ms.Palazzo was the recipient of the SBA’s Financial Service Advocate of the YearAward for 2002.

 

**Leah Pauly**,age 42, is Executive Vice President and Chief Credit Officer for the Bank.  She was raised and educated in SouthernCalifornia but has lived in northern San Luis Obispo county for the past 18years.  She has actively worked inprogressively more responsible positions in banking for the last 23 years andis scheduled to graduate from the ABA Stonier Graduate School of Banking.  Over the years, Pauly has volunteered for anumber of civic and charitable organizations. She currently serves on the Board of Directors of Senior VolunteerServices.

 

Theexecutive officers were each elected by the Board of Directors.  There are no family relationships betweendirectors and executive officers of the Bank.

 

NoDirector of the Bank holds a directorship in any other company with a class ofsecurities registered pursuant to Section 12 of the Securities Exchange of1934, as amended.

 

# **Compliancewith Section 16(a) of the Securities Exchange Act**

 

Basedsolely on its review of Forms 3, 4, and 5, and amendments thereto, furnished toBancorp during the 2004 fiscal year, no person who was a director, officer, orbeneficial owner of more than ten percent of the Bank’s Common Stock failed tofile on a timely basis reports required by Section 16(a) during the 2004 fiscalyear.

 

**FinancialExpert**

 

TheBoard of Directors has determined, as required, that the Audit Committeecontains three

 

64

----

 

independentfinancial experts.  They perform noservices nor do they receive compensation from the bank other than normaldirector fees.  The experts on thecommittee are James Kaney, Gene Mintz and Ron Olson.  Each of their qualifications is stated (See “Directors”)elsewhere in this report.

 

**Code ofEthics**

 

Thissection of the Sarbanes Oxley Act now requires small business filers to adoptand disclose whether the Bancorp has adopted a code of ethics that applies tothe principal executive officer, principal financial officer, and principalaccounting officer or controller, or any person performing similarfunctions.  The Bancorp has complied withthis requirement and a copy is attached as Exhibit 14.

 

**Independenceof Accounting Firms**

 

Amendmentsto Regulation S-X governs employment relationships between financial entitiesand accounting firms.  Requirementsinclude “independence” of the accounting firm, precluding the performance ofany other audit functions such as bookkeeping, appraisal services, legalservices and a variety of other functions. The requirements also preclude the Bancorp from having any interest,capital balances, nor influence over the accounting firm’s operations orpolicies. This amendment also requires approval, by the Audit Committee, of theaccounting firm prior to engagement and limits the number of years that thelead partner or concurring partner in the accounting firm may conduct auditswithout sacrificing their “independent” status. The Bancorp is in compliance with this regulation.

 

65

----

 

**Item 10.  Executive Compensation:**

 

Thechart below contains information of Jack C. Wauchope, President/CEO, DavinaPalazzo and Leah Pauly as the only executive officers whose salary and othercompensation was $100,000 or more.
| ** **               | ** ** | ** ** | ** ** | ** **     | ** ** | ** **    | ** ** | ** **       | ** ** | **Awards:**     | ** ** | ** **       | ** ** |
|--------------------------|------------|------------|------------|----------------|------------|---------------|------------|------------------|------------|-----------------|------------|------------------|------------|
| ** **               | ** ** | ** ** | ** ** | ** **     | ** ** | ** **    | ** ** | ** **       | ** ** | **Securities**  | ** ** | ** **       | ** ** |
| **Name  and**            | ** ** | ** ** | ** ** | ** **     | ** ** | ** **    | ** ** | **Other Annual** | ** ** | **Underlying**  | ** ** | **All Other**    | ** ** |
| **Principal  Position**  | ** ** | **Year**   | ** ** | **Salary ($)** | ** ** | **Bonus ($)** | ** ** | **Compensation** | ** ** | **Options (#)** | ** ** | **Compensation** | ** ** |
|                     |       |       |       |           |       |          |       |             |       |            |       |             |       |
| **Jack C.  Wauchope**    |       | 2004       |       | $              | 180,833    |          | $          | 25,000           |       | $               | —     |             | $          | — |   | $ | 13,072 |   |
| President/CEO            |       | 2003       |       | $              | 170,833    |          | $          | 25,000           |       | $               | —     |             | $          | — |   | $ | 13,652 |   |
| Chairman of the Board    |       | 2002       |       | $              | 158,750    |          | $          | 7,800            |       | $               | —     |             | $          | — |   | $ | 14,650 |   |
|                     |       |       |       |           |       |          |       |             |       |            |       |             |       |
| **Davina  Palazzo**      |       | 2004       |       | $              | 120,833    |          | $          | 15,000           |       | $               | —     |             | $          | — |   | $ | 4,800 |   |
| Executive Vice President |       | 2003       |       | $              | 108,750    |          | $          | 11,000           |       | $               | —     |             | $          | — |   | $ | 377 |   |
|                     |       | 2002       |       | $              | 92,500     |          | $          | 6,000            |       | $               | —     |             | $          | — |   | $ | 4,224 |   |
|                     |       |       |       |           |       |          |       |             |       |            |       |             |       |
| **Leah  Pauly**          |       | 2004       |       | $              | 101,667    |          | $          | 12,500           |       | $               | —     |             | $          | — |   | $ | 5,525 |   |
| Executive Vice President |       | 2003       |       | $              | 77,333     |          | $          | 7,700            |       |            |       |             |       | $ | 11,035 |   |
|                     |       | 2002       |       | N/A            |       | N/A           |       |             |       |            |       |             |       |

 

Thevalue of perquisites and other personal benefits are disclosed in other annualcompensation if they exceed, in the aggregate, the lesser of $50,000 or 10% ofsalary and bonus.  No amounts arereported in this column for Mr. Wauchope or Mrs. Palazzo since the value ofperquisites and other personal benefits did not exceed the reporting threshold.

 

TheBank has employed Jack C. Wauchope as its Chief Executive Officer and enteredinto an employment agreement with him, which took effect in June 2003.  The agreement provided for a term of fiveyears at an annual base salary of $175,000.00 in year 1, $185,000.00 in year 2and 3, $200,000.00 in year 4 and 5, discretionary bonuses, and a Bank providedautomobile, country club membership, expense reimbursement, $400,000.00 of lifeinsurance and standard and customary medical and dental insurancebenefits.  Additionally, Mr. Wauchopewill be entitled to severance benefits equal to one year’s base salary or twoyears, each dependent upon the occurrence of one or more enumerated events.

 

The Bank has employed Davina Palazzo as its ExecutiveVice-President and Manager of the Small Business Lending Center and enteredinto an employment agreement with her, which took effect in June 2003.  The agreement provides for a term of fiveyears at an annual base salary of $115,000.00 in year 1, $125,000.00 in year 2and 3, $140,000.00 in year 4 and 5, discretionary bonuses, and an automobileallowance of $400.00 per month, country club membership, and standard andcustomary medical and dental insurance benefits.  Additionally, Ms. Palazzo will be entitled toseverance benefits equal to one year’s base salary or two years, each dependentupon the occurrence of one or more enumerated events.

 

TheBank has employed Leah Pauly as its Executive Vice President and Chief CreditOfficer and entered into an employment agreement with her, which took effectNovember 2003.  The agreement providesfor five years at an annual salary of $100,000.00 in year 1, $110,000.00 inyear 2 and 3, $125,000.00 in year 4 and 5, discretionary bonuses, and anautomobile allowance of $400.00 per month, and standard and customary medicaland dental insurance benefits. Additionally, Ms. Pauly will be entitled to severance benefits equal toone year’s base salary or two years, each dependant upon the occurrence of oneor more enumerated events.

 

Thedirectors who are not full-time employees of the Bank are presently receivingmonthly directors’ fees.  Mr. Wauchopedoes not presently receive directors’ fees.

 

66

----

 

# **EmployeesStock Option Plan**

 

Inthe course of the formation of Coast Bancorp as of May 31, 2001, Coast Bancorpadopted and assumed the Coast National Bank 1997 Stock Option Plan, now knownas the Coast Bancorp Employee Stock Option Plan (the “Employee Plan”).  The Employee Plan was adopted to strengthenthe Company and its subsidiaries by providing eligible full-time officers andemployees an added incentive to perform at a high level and to rewardextraordinary efforts to increase the earnings of Coast Bancorp and itssubsidiaries.  The incentive will take theform of an opportunity for officers and employees of Coast Bancorp and itssubsidiaries to acquire a proprietary interest in the success of Coast Bancorpby purchasing Shares of Coast Bancorp common stock.  125,000 shares of Coast Bancorp common stockmay be issued pursuant to the exercise of Options granted under the EmployeePlan, and in no event may the total number of shares issuable upon exercise ofall outstanding options and the total number of shares provided for under anyother stock option plan, stock bonus or similar plan of Coast Bancorp exceedthirty percent (30%) of the then-outstanding common stock of the Company.  As of December 31, 2004, approximately twentythree officers and employees of Coast Bancorp and its affiliates were eligibleto hold options to purchase under the Employee Plan.  The Employee Plan contemplates the grant ofincentive stock options and nonstatutory stock options.

 

TheEmployee Plan is a qualified plan under Section 401(a) of the Internal RevenueCode of 1986, as amended (the “Code”) or subject to the provisions of theEmployee Retirement Income Security Act of 1974, as amended.

 

# **Exerciseand Grant of Options**

 

During2004 no options were granted to President and Chief Executive Officer Jack C.Wauchope.  Stock Options were grantedduring 2004 to Executive Vice President Leah Pauly and to Senior Vice-PresidentJulie Joslin.

 

Thefollowing table sets forth information concerning individual grants of stockoptions during fiscal year 2004 to each of the Named Executive Officers.:

 

**Options Granted in Last Fiscal Year**

** **
| **Name**                                    | ** ** | **No. of  Underlying  Options  Granted** | ** ** | **% of Total Options  Granted to Employees  in Fiscal Year** | ** ** | **Exercise or  Base  Price($/Sh.)** | ** ** | **Expiration  Date** | ** ** | **Grant Date  Value(1)** | ** ** |
|---------------------------------------------|------------|------------------------------------------|------------|--------------------------------------------------------------|------------|-------------------------------------|------------|----------------------|------------|--------------------------|------------|
|                                        |       |                                     |       |                                                         |       |                                |       |                 |       |                     |       |
| Jack C. Wauchope,  President and CEO        |       | -0-                                      |       | —                                                       |       | —                              |       | —               |       | —                   |       |
|                                        |       |                                     |       |                                                         |       |                                |       |                 |       |                     |       |
| Davina Palazzo,  Execcutive Vice  President |       | -0-                                      |       | —                                                       |       | —                              |       | —               |       | —                   |       |
|                                        |       |                                     |       |                                                         |       |                                |       |                 |       |                     |       |
| Leah, Executive  Vice President             |       | 2,500                                    |       | 19.2                                                         | %          | $                                   | 26.50      |                 | 11/17/2014 |                     | $          | 26.50 |   |
|                                             |            |                                          |            |                                                              |            |                                     |            |                      |            |                          |            |  |  |

 

----

(1)          Present value at date of grant using theBlack-Scholes model

 

 

Thefollowing table shows exercises of stock options during fiscal year 2004 by CEOPresident/Chairman of the Board Jack C. Wauchope, Executive Vice PresidentDavina Palazzo, Leah Pauly, Executive Vice-President and the value at December31, 2004 of unexercised options on an aggregated basis held by each suchperson:

 

67

----

 

## **Aggregated OptionExercises in Last Fiscal Year and FY-End Option Values**

 
| ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | **Number of Securities**      | ** ** | **Value of Unexercised**          | ** ** |
|------------------|------------|---------------------|------------|------------------|------------|-------------------------------|------------|-----------------------------------|------------|
| ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | **Underlying Unexercised**    | ** ** | **In-the-Money Options**          | ** ** |
| ** **       | ** ** | **Shares Acquired** | ** ** | **Value**        | ** ** | **Options at FY-End (#)**     | ** ** | **at FY-End ($)**                 | ** ** |
| **Name**         | ** ** | **On Exercise (#)** | ** ** | **Realized ($)** | ** ** | **Exercisable/Unexercisable** | ** ** | **Exercisable/Unexercisable (1)** | ** ** |
|             |       |                |       |             |       |                          |       |                              |       |
| Jack C. Wauchope |       | 0                   |       | 0                |       | 20,000 / 0                    |       | $360,000 / $0                     |       |
|             |       |                |       |             |       |                          |       |                              |       |
| Davina Palazzo   |       | 0                   |       | 0                |       | 6,000/1,500                   |       | $84,000 / $21,000                 |       |
|             |       |                |       |             |       |                          |       |                              |       |
| Leah Pauly       |       | 0                   |       | 0                |       | 3,100/4,400                   |       | $41,075 / $28,550                 |       |

 

----

(1)           Based on a bid price of $28.00 at December 31, 2004

 

### **Directors Stock Option Plan**

 

In the course of the formationof Coast Bancorp as of May 31, 2001, Coast Bancorp adopted and assumed theCoast National Bank 1998 Directors’ Stock Option Plan, now known as the CoastBancorp Directors Stock Option Plan (the “Director Plan”).  The Director Plan was adopted to offer thenon-employee directors of Coast Bancorp and its affiliates the opportunity toacquire a proprietary interest in the success of Coast Bancorp by purchasingshares of Coast Bancorp common stock. New options were granted in 2004 in the amount of 1000 shares to each(8) outside director exercisable beginning in 2005 and expiring in 2014.

 

Theaggregate number of shares which may be issued pursuant to the exercise ofOptions granted under the Director Plan is 62,500 shares, and in no event maythe total number of shares issuable upon exercise of all outstanding optionsand the total number of shares provided for under any other stock option plan,stock bonus or similar plan of Coast Bancorp exceed thirty percent (30%) of thethen-outstanding common stock of the Company (the “Shares”).  As of March 15, 2004, approximately eight (8)directors of Coast Bancorp and its affiliates were eligible to hold optionsunder the Director Plan.  The DirectorPlan contemplates the grant of nonstatutory stock options only.

 

### **Item 11.  SecurityOwnership of Certain Beneficial Owners and Management**

 

a.                                       There are no stockholders with ownership of5% of the Bank’s stock, except as set forth below.  Mr. Wauchope’s address is 500 Marsh Street,San Luis Obispo, CA 93401.

 

68

----

 
| ** **                                                  | ** ** | ** **                          | ** ** | **Number of** | ** ** | ** ** | ** ** | **Percentage** | ** ** |
|-------------------------------------------------------------|------------|-------------------------------------|------------|---------------|------------|------------|------------|----------------|------------|
| **Name**                                                    | ** ** | **Relationship to Bank**            | ** ** | **Shares**    | ** ** | **Notes**  | ** ** | **Owned (1)**  | ** ** |
|                                                        |       |                                |       |          |       |       |       |           |       |
| Jack  C. Wauchope                                           |       | Chairman  of the Board & CEO    |       | 41,000        |       | (2)        |       | 6.09           | %          |
| Marilyn  Britton                                            |       | Corporate  Secretary & Director |       | 3,050         |       | (7)        |       | 0.47           | %          |
| Dario  Domenghini                                           |       | Director                            |       | 11,400        |       | (3),(5)    |       | 1.73           | %          |
| James  M. Kaney                                             |       | Director                            |       | 7,700         |       | (5)        |       | 1.17           | %          |
| Michael  A. Lady                                            |       | Director                            |       | 6,000         |       | (5)        |       | 0.91           | %          |
| Gene  D. Mintz                                              |       | Director                            |       | 25,140        |       | (5)        |       | 3.82           | %          |
| Ron  Olson                                                  |       | Director                            |       | 15,325        |       | (6)        |       | 2.34           | %          |
| Jack  W. Robasciotti                                        |       | Vice  Chairman & Director       |       | 7,000         |       | (5)        |       | 1.06           | %          |
| Dan  H. Wixom                                               |       | Director                            |       | 16,800        |       | (4),(5)    |       | 2.55           | %          |
| Davina  Palazzo                                             |       | EVP  & Executive Officer        |       | 6,000         |       | (7)        |       | 0.92           | %          |
| Leah  Pauly                                                 |       | EVP  & Executive Officer        |       | 3,100         |       | (7)        |       | 0.47           | %          |
| Julie  Joslin                                               |       | SVP  & Executive Officer        |       | 1,600         |       | (7)        |       | 0.25           | %          |
| Berta  Olson                                                |       | SVP  & Executive Officer        |       | 2,200         |       | (9)        |       | 0.34           | %          |
| Directors  & Executive Officers as a Group (14 persons) |       | 146,315                             |       | (8)           |       | 20.70      | %          |
|                                                             |            |                                     |            |               |            |            |            |                |            |  |

 

b.

 

----

NotesRegarding Percentages Owned:

 

(1)           Except asotherwise noted, may include shares held by such person’s spouse (except wherelegally separated) and minor children; shares held by any other relative ofsuch person who has the same home; shares held by a family trust as to whichperson is a beneficiary and trustee with sole voting and investment power (orshared power with a spouse); shares held in street name for the benefit of suchperson; or shares held in an Individual Retirement Account or pension plan asto which person is the sole beneficiary and has pass-through voting rights andinvestment power.

 

(2)           Includes20,000 shares of incentive stock options that are presently exercisable.

 

(3)           Includes 300shares held by Domenghini Farms, a California General Partnership and 1,000shares held by Domenghini Brothers, A California General Partnership, overwhich Mr. Domenghini has shared voting and investment power.

 

(4)           Includes4,500 shares held by the Wixom Concrete, Inc. Profit Sharing Trust over whichMr. Wixom is trustee with sole voting and investment power.

 

(5)           Includes5,000 shares of director stock options that are presently exercisable.

 

(6)           Includes2,500 shares of director stock options that are presently exercisable.

 

(7)           Incentivestock options currently exercisable.

 

(8)           Includes31,900 shares of incentive stock options and 35,000 shares of director stockoptions which are presently exercisable.

 

(9)           Includes1,400 shares held in the Olson Family Trust.

 

**Item 12.  CertainRelationships and Related Transactions.**

 

Thereare no existing or proposed material interests or transactions between the Bankand/or any of its officers or directors outside the ordinary course of the Bank’sbusiness.

 

69

----

 

Itis anticipated that the directors and officers of the Bank, and the companies,with which they are associated, will have banking transactions with the Bank inthe ordinary course of business.  It isthe firm intention of the Board of Directors that any loans and commitments tolend included in such transactions will be made in accordance with allapplicable laws and regulations and on substantially the same terms, includinginterest rates and collateral, as those prevailing at the time for comparabletransactions with other persons of similar creditworthiness.

 

Itis also possible that one or more members of the Board of Directors may fromtime to time provide services and equipment to the Bank.  It is the firm policy of the Board that anysuch transactions between the Bank and any members of its Board, or any persondirectly or indirectly related to a director, be made in strict accordance withapplicable rules and regulations and on substantially the same terms as thoseavailable at the time for comparable transactions with disinterested persons.

 

**Item 13.  Exhibits**

 

a)             Exhibits

 

Seeindex to exhibits at page 73 of this Annual Report on Form 10-KSB.

 

**Item14.  Principal Accountant Fees andServices**

 

Vavrinek,Trine, Day & Company LLP’s engagement by Coast Bancorp commenced on April30, 2002.  During the fiscal year endedDecember 31, 2004, Vavrinek, Trine & Day & Company, LLP providedprofessional services in connection with the review of Coast Bancorp’sregistration statement filed with the SEC in connection with the company’spublic offering, the review of Quarterly Reports on Form 10-QSB for thequarters ended March 31, June 30, September 30, 2004, preparation for the auditof financial statements of Coast Bancorp for the fiscal year ended December 31,2003, and consulted with Coast Bancorp’s management regarding year end taxplanning.  As part of the engagement,Vavrinek, Trine, Day & Company LLP also prepared quarterly tax estimatesand the federal and state income tax returns.

 

**AuditFees**

 

Theaggregate fees billed by Vavrinek, Trine, Day & Company LLP forprofessional services rendered for the audit of the Company’s annual financialstatements for fiscal years 2003 and 2004 and the review of the financialstatements included in the Company’s Forms 10-QSB for the Quarters ended March31, June 30, and September 30, 2004 and for the preparation of tax estimatesand federal and state income tax returns were $39,000.00 and $42,000.00,respectively.

 

 

**AuditRelated Fees**

 

Therewere no fees billed by Vavrinek, Trine, Day & Company, LLP for assuranceand related services provided to the Company that are reasonably related to theperformance of the audit or review of the Company’s financial statements thathave not been reported under “Audit Fees” for fiscal years 2003 and 2004.

 

**TaxFees**

 

Theaggregate fees billed by Vavrinek, Trine, Day & Company, LLP forprofessional services rendered to the Company for tax compliance, tax advice,and tax planning for fiscal years 2003 and 2004 were $5,000.00 each year.

 

70

----

 

**AuditCommittee’s Pre-Approval Policies and Procedures**

 

TheAudit Committee, acting on behalf of the Board of Directors of Coast Bancorpand Coast National Bank has been charged with assisting the Board in fulfillingthe fiduciary responsibility to the shareholders, depositors and investmentcommunity relating to the quality and integrity of the company’s accountingsystems, accounting principles applied, financial reporting process, andoverall internal control structure.  Inso doing the Committee shall:

 

•      Select and recommend annually, to theBoard of Directors, appointment of the Bancorp’s independent publicaccountants.

 

•      Review independence, qualifications, theannual engagement letter, audit scope, accounting principles, related servicesand fees.

 

•      Review management’s plans for engagingthe independent public accountants to perform management’s advisory services.

 

•      Review the Bancorp’s audited financialstatements in relation to meeting the requirements of an annual Director’sexamination, related notes, the accountant’s opinion to be rendered inconnection therewith, and any unresolved disagreements with management, if any.

 

•      Review their report on management’sassertions on internal controls and compliance with law and regulations.

 

•      Review significant findings reported bybank regulators, management’s related responses, and monitor corrective actionson major deficiencies noted.

 

•      Review management’s annual report on itsresponsibility for preparing financial statements, establishing and maintaininginternal control structure and procedures for financial reporting, and forcomplying with certain laws and regulations.

 

•      Perform additional functions as arenecessary or prudent to fulfill the Committee’s duties and responsibilities.

 

71

----

** **

**INDEX TOEXHIBITS**

 
| **Exhibit** | ** ** | ** **                                                                                                                                                                                                                 | ** ** | ** **   |
|-------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------|
| **Number**  | ** ** | **Description of Exhibit**                                                                                                                                                                                                 | ** ** | **Footnote** |
| ** **  | ** ** | ** **                                                                                                                                                                                                                 | ** ** | ** **   |
| 2.0         |       | Plan  of Acquisition and Agreement of Merger dated March 1, 2001                                                                                                                                                           |       | (1)          |
| 3.1         |       | Articles  of Incorporation of Coast Bancorp                                                                                                                                                                                |       | (1)          |
| 3.2         |       | Bylaws  of Coast Bancorp                                                                                                                                                                                                   |       | (1)          |
| 4.1         |       | Certificate  Evidencing Floating Rate Capital Securities                                                                                                                                                                   |       | (3)          |
| 4.2         |       | Floating  Rate Junior Subordinated Deferrable Interest Debenture                                                                                                                                                           |       | (3)          |
| 4.3         |       | Certificate  Evidencing Floating Rate Common Securities                                                                                                                                                                    |       | (3)          |
| 4.4         |       | Guarantee  Agreement                                                                                                                                                                                                       |       | (3)          |
| 4.5         |       | Indenture  dated September 26, 2002, Coast Bancorp Issuer, State Street Bank and Trust  Company of Connecticut, N.A., as Trustee for Floating Rate Junior  Subordinated Deferrable Interest Debenture                      |       | (3)          |
| 10.1        |       | Coast  Bancorp Stock Option Plan and specimen Non-Statutory and Incentive Stock  Option Agreements                                                                                                                         |       | (2)  **      |
| 10.2        |       | Coast  Bancorp Directors Stock Option Plan and specimen Non-Statutory Agreement                                                                                                                                            |       | (2)  **      |
| 10.3        |       | Employment  contract by and between Jack C. Wauchope and Coast National Bank                                                                                                                                               |       | (4)  **      |
| 10.4        |       | Employment  contract by and between Davina Palazzo and Coast National Bank                                                                                                                                                 |       | **           |
| 10.5        |       | Amended  and Restated Declaration of Trust by and Among State Street Bank and Trust  Company of Connecticut, N.A., as Institutional Trustee, Coast Bancorp as  Sponsor, and Administrators, dated as of September 26, 2002 |       | (3)          |
| 10.6        |       | Employment  contract by and between Leah Pauly and Coast National Bank                                                                                                                                                     |       | **           |
| 11.0        |       | Statement  regarding computation of per share earnings. Included in footnote 9 to the  Registrant’s audited financial statements included in this Annual Report.                                                      |       |         |
| 14.0        |       | Code  of Ethics required by Item 406 of Regulation S-B                                                                                                                                                                     |       |         |
| 21.0        |       | Subsidiaries  of the Coast Bancorp – Coast National Bank (100% owned)                                                                                                                                                 |       |         |
| 23.0        |       | Consent  of Independent Public Accountants                                                                                                                                                                                 |       |         |
| 24.0        |       | Power  of Attorney                                                                                                                                                                                                         |       |         |
| 31.1        |       | Certificate of Principal Executive Officer Pursuant to SEC Release  33-8238.                                                                                                                                               |       |         |
| 31.2        |       | Certificate of Principal Financial Officer Pursuant to SEC Release  33-8238.                                                                                                                                               |       |         |
| 32.1        |       | Certification  of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350                                                                                                                                           |       |         |
| 32.2        |       | Certification  of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350                                                                                                                                           |       |         |

 

----

| **  |   | Employment  contracts and compensation plans                                                                                                                                                                   |   |   |
|-----|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
| (1) |   | Filed  as Exhibits 2 and 3.1, and 10.4, respectively, to Registrant’s Annual Report  on Form 10-KSB for the Fiscal Year ended December 31, 2001 filed with the SEC  and incorporated herein by reference. |   |   |
| (2) |   | Filed  as Exhibits 99.1 and 99.2, respectively, to Registrant’s Registration  Statement on Form S-8 No. 333-84518 filed with the SEC and incorporated  herein by reference.                               |   |   |

 

72

----

 

**SIGNATURES**

 

Inaccordance with Section 13 or 15(d) of the Securities Exchange Act,the registrant has duly caused this report to be signed on its behalf by theundersigned, thereto duly authorized.

 

COASTNATIONAL BANK

 

 
| By:    | /s/  Jack C. Wauchope    |   |
|--------|--------------------------|--------|
|   | Jack C. Wauchope         |
|   | Chief Executive  Officer |
|   | Chairman of the Board    |

 

Inaccordance with the Securities Exchange Act, this report has been signed by thefollowing persons on behalf of the registrant and in the capacities on thedates indicated:

 
| **Signature**            | ** ** | **Title** | ** ** | **Date** |
|--------------------------|------------|-----------|------------|----------|
|                     |       |      |       |     |
|                     |       |      |       |     |
| /s/  Marilyn Britton     |       |      | Director   |     | March 25,  2005 |
| Marilyn  Britton         |       |      |       |     |   |
|                     |       |      |       |     |   |
|                     |       |      |       |     |   |
| /s/  Dario Domenghini    |       |      | Director   |     | March 25,  2005 |
| Dario  Domenghini        |       |      |       |     |   |
|                     |       |      |       |     |   |
|                     |       |      |       |     |   |
| /s/  James M. Kaney      |       |      | Director   |     | March 25,  2005 |
| James  M. Kaney          |       |      |       |     |   |
|                     |       |      |       |     |   |
|                     |       |      |       |     |   |
| /s/  Michael A. Lady     |       |      | Director   |     | March 25,  2005 |
| Michael  A. Lady         |       |      |       |     |   |
|                     |       |      |       |     |   |
|                     |       |      |       |     |   |
| /s/  Gene D. Mintz       |       |      | Director   |     | March 25,  2005 |
| Gene  D. Mintz           |       |      |       |     |   |
|                     |       |      |       |     |   |
|                     |       |      |       |     |   |
| /s/  Ron Olson           |       |      | Director   |     | March 25,  2005 |
| Ron  Olson               |       |      |       |     |   |
|                     |       |      |       |     |   |
|                     |       |      |       |     |   |
| /s/  Jack W. Robasciotti |       |      | Director   |     | March 25,  2005 |
| Jack  W. Robasciotti     |       |      |       |     |   |
|                     |       |      |       |     |   |
|                     |       |      |       |     |   |
| /s/  Dan H. Wixom        |       |      | Director   |     | March 25,  2005 |
| Dan  H. Wixom            |       |      |       |     |   |

 

73

----