** **

**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, 2005**                                                                                                                                                                                                                                              |
|       |       |                                                                                                                                                                                                                                                                                             |
| **o**      | ** ** | **TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                          |
|       |       |                                                                                                                                                                                                                                                                                             |
|       |       | **For the transition period from                        to                       ** |

 

**CommissionFile No. 000-32827**

 

**COAST BANCORP**

(ExactName 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)      |
|                                                            |       |                                     |
| Securities  registered under Section 12(b) of the Exchange Act: |
|                                                            |
| **Title of each class**                                         | ** ** | **Name of exchange on which registered** |
| None                                                            |       | None                                     |
|                                                            |       |                                     |
| Securities  registered under Section 12(g) of the Exchange Act: |
| **Common Stock**                                                |
| (Title  of class)                                               |

 

Check whether the issuer isnot required to file reports pursuant to Section 13 or 15 (d) of the ExchangeAct     o

 

Check whether the issuer (1)filed all reports required to be filed by Section 13 or 15 (d) of the ExchangeAct during the past 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.         Yes  ý    No   o

 

Check if there is nodisclosure of delinquent filers in response to Item 405 of Regulation S-B isnot contained in this form, and no disclosure will be contained, to the best ofregistrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-KSB or any amendment tothis Form 10-KSB.     o

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

Yes  o     No  ý

 

Registrant’s revenues offiscal year ended December 31, 2005 were $11,478,409.

 

The aggregate market valueof the voting stock held by non-affiliates computed by reference to the averagebid and asked prices of such stock, as of March 15, 2006:  $19,178,145.

 

Number of registrant’sshares of Common Stock outstanding as of December 31, 2005 was 674,100.

 

Documents incorporated byreference:     None

 

Transitional Small BusinessDisclosure Format (Check one)               Yes:o     No: ý

 

 

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**FORWARD LOOKING STATEMENTS**

 

**CERTAIN STATEMENTS WITHIN THISANNUAL REPORT ON FORM 10-KSB INCLUDE FORWARD LOOKING INFORMATION WITHIN THEMEANING OF SECTION 27A OF THE SECURITIES ACT OF 1933, AS AMENDED, AND SECTION21E OF THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED, AND ARE SUBJECT TO THE “SAFEHARBOR” CREATED BY THOSE SECTIONS.  THESEFORWARD-LOOKING STATEMENTS INVOLVE CERTAIN RISKS AND UNCERTAINTIES THAT COULDCAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE IN THE FORWARD-LOOKINGSTATEMENTS.  SUCH RISKS AND UNCERTAINTIESINCLUDE, BUT ARE NOT LIMITED TO, THE FOLLOWING FACTORS: COMPETITIVE PRESSURE INTHE BANKING INDUSTRY INCREASES SIGNIFICANTLY; CHANGES IN THE INTEREST RATEENVIRONMENT REDUCE MARGINS; GENERAL ECONOMIC CONDITIONS, EITHER NATIONALLY ORREGIONALLY, ARE LESS FAVORABLE THAN EXPECTED, RESULTING IN, AMONG OTHER THINGSA DETERIORATION 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; VOLATILITY OF RATESENSITIVE DEPOSITS; OPERATIONAL RISKS INCLUDING DATA PROCESSING SYSTEMSFAILURES OR FRAUD; ASSET/LIABILITY MATCHING RISKS AND LIQUIDITY RISKS;  CHANGES IN THE SECURITIES MARKETS; THEABILITY TO SATISFY THE REQUIREMENTS OF THE SARBANES-OXLEY ACT AND OTHERREGULATIONS GOVERNING INTERNAL CONTROLS; AND THE POTENTIAL ECONOMIC EFFECT OFTHE WAR ON TERRORISM AND THE WAR IN IRAQ AND AFGHANISTAN.**

 

**THEREFORE, THE INFORMATIONCONTAINED IN THIS ANNUAL REPORT SHOULD BE CAREFULLY CONSIDERED WHEN EVALUATINGTHE BUSINESS PROSPECTS OF COAST BANCORP AND COAST NATIONAL BANK.**

 

**MOREOVER, WHEREVER PHRASES SUCHAS/OR SIMILAR TO, “IN MANAGEMENT’S OPINION”, “MANAGEMENT BELIEVES”, OR “MANAGEMENTCONSIDERS” ARE USED, SUCH STATEMENTS ARE AS OF, AND BASED UPON THE KNOWLEDGE OFMANAGEMENT, AT THE TIME MADE AND ARE SUBJECT TO CHANGE BY THE PASSAGE OF TIMEAND/OR SUBSEQUENT EVENTS, AND ACCORDINGLY SUCH STATEMENTS ARE SUBJECT TO THESAME RISKS AND UNCERTAINTIES NOTED ABOVE WITH RESPECT TO FORWARD-LOOKINGSTATEMENTS.**

 

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**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 COMMON EQUITY AND  RELATED STOCKHOLDER MATTERS AND SMALL BUSINESS ISSUERS PURCHASE OF EQUITY  SECURITIES |   |
|         |          |                                                                                                                |
|         | 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                                                                                            |   |
|         |          |                                                                                                                |
|         | Item 8B -     | OTHER INFORMATION                                                                                                   |   |
|         |          |                                                                                                                |
| **PART III** |          |                                                                                                                |
|         |          |                                                                                                                |
|         | Item 9 -      | DIRECTORS,  EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS: COMPLIANCE WITH SECTION  16(a) OF THE EXCHANGE ACT   |   |
|         |          |                                                                                                                |
|         | Item 10 -     | EXECUTIVE COMPENSATION                                                                                              |   |
|         |          |                                                                                                                |
|         | Item 11 -     | SECURITY OWNERSHIP OF CERTAIN  BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS                     |   |
|         |          |                                                                                                                |
|         |          |                                                                                                                |
|         | Item 12 -     | CERTAIN RELATIONSHIPS AND RELATED  TRANSACTIONS                                                                     |   |
|         |          |                                                                                                                |
| **PART IV**  |          |                                                                                                                |
|         |          |                                                                                                                |
|         | Item 13 -     | EXHIBITS, FINANCIAL STATEMENT  SCHEDULES, AND REPORTS ON FORM 8-K                                                   |   |
|         |          |                                                                                                                |
|         | Item 14 -     | PRINCIPAL  ACCOUNTANT FEES AND SERVICES                                                                             |   |
|         |          |                                                                                                                |
|         | EXHIBIT INDEX |                                                                                                                |
|         |          |                                                                                                                |
|         | SIGNATURES    |                                                                                                                |

 

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**PART I**

 

**Item 1.       Description of Business**

 

*Coast Bancorp*

 

Coast Bancorp (the “Bancorp”or “Coast Bancorp”), headquartered in San Luis Obispo, California, and is aCalifornia corporation incorporated in 2001. Coast Bancorp became the bank holding company of Coast National Bank onMay 31, 2001 through a corporate reorganization.  In the reorganization, Coast National Bankbecame the wholly-owned subsidiary of Coast Bancorp and the shareholders of theBank became shareholders of Coast Bancorp. Coast Bancorp is operated through a two-tiered corporate structure.  At the holding company level the affairs ofCoast Bancorp are overseen by a Board of Directors elected by the shareholdersof Coast Bancorp at the annual meeting of shareholders.  The business of the Bank is overseen by aBoard of Directors elected by Coast Bancorp, the sole owner of the Bank.  As of the date of this Form 10-KSB, therespective 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.

 

*Coast National Bank*

 

Coast National Bank (the “Bank”)was chartered June 16, 1997, (charter #23222) by The Office of the Comptrollerof the Currency as a national bank.  TheBank commenced operations on that date with two offices, 16 employees and$6,250,000 in capital.  The originalbranch offices were located at 486 Marsh Street, San Luis Obispo and 1199 GrandAvenue, Arroyo Grande, California.  Sincethat time, an additional branch office was opened in June, 1998, at 948 MorroBay Boulevard in Morro Bay, California and another branch office was opened inJuly, 1999, at 1193 Los Osos Valley Road in Los Osos, California.  In July 2002, a loan production office wasoriginally 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 December2005, the office was relocated to 411 Betteravia Rd., Ste 201, Santa Maria,California.  In October 2004, a loanproduction office was opened in Santa Barbara, California at 15 West CarrilloSt. Ste. 252. The original lease on this facility expired and the office wasclosed in September 2005.   The Bank applied for and received approvalfrom the Comptroller of the Currency for another branch office which openedMarch 2005 at 2138 Spring Street, Paso Robles, California.  The Bank also purchased a lot at 2045 SpringStreet, Paso Robles, California with the intention of relocating the PasoRobles branch sometime in the future.  InJune 2005, the Bank opened a new loan production office at 7429 N. First St.,Suite 104, Fresno, California.

 

When the Bank opened forbusiness in June 1997, it purchased the real estate and building that housedthe Arroyo Grande branch office.  OnOctober 14, 1999, the Bank purchased an adjacent lot next to the San LuisObispo main office on Marsh Street.  Afew months later on February 1, 2000, the Bank also purchased the contiguousproperty and building that was home to the San Luis Obispo main office at 486Marsh Street.  Construction of a new headoffice building on the adjacent lot began on October 11, 2001 and was completedon November 25, 2002.  The new mainoffice, located at 500 Marsh Street is approximately 10,700 square feet withthe San Luis Obispo branch operation occupying the ground floor and theadministrative offices occupying the second floor.  Half of the original main office at 486 MarshStreet now houses the Bank’s Small Business Lending Center and the Bank’s NoteDepartment while the other half is leased to various businesses.

 

On March 29, 2002, the Bankpurchased a vacant site on Morro Bay Boulevard in Morro Bay that isapproximately one block from the existing branch with the intention ofeventually relocating the Morro Bay branch. In October 2003 construction began on the new Morro Bay facility whichwas completed and occupied in August 2004. The new branch consists ofapproximately 2700 square feet with two drive-through lanes.

 

The Bank faces competitionin the market area for all of its banking products from branches of most of themajor California money center banks, other community banks, savings & loansand credit unions.  The Bank also facescompetition for some of our 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.

 

*Deposits, Liquidity and LiabilityManagement*

 

Deposits represent the Bank’sprimary source of funds.  As of December31, 2005, the Bank had approximately $40.6 million in non-interest bearingdeposit accounts.  Also, as of that date,the Bank had approximately $45.1 million in interest bearing deposit accounts,$8.9 million in savings accounts and $74.4 million in time certificates ofdeposits.  Of the total time

 

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certificates of deposits, approximately $59million were in amounts of $100,000 or more, or 79.3% of all time certificatesand 34.9% of all deposits.  Most of theBank’s deposits are obtained from individuals, professionals and small andmedium sized businesses.  A materialportion of the Bank’s deposits has not been obtained from a single person or afew persons.

 

Deposit products includeregular checking accounts, savings accounts, certificates of deposit,money-market accounts and IRA accounts. The Bank offers an ATM/ debit card as well as a VISA credit card as partof its retail banking services.  The Bankalso offers internet banking services.

 

In order to attract loan anddeposit business, the Bank maintains lobby hours from 9:00 a.m. to 4:00 p.m.,Monday through Thursday and 9:00 a.m. to 6:00 p.m. on Fridays.  Walk-up window service is also available atthe San Luis Obispo office beginning at 8:00 a.m. until 9:00 a.m. and againfrom 4:00 p.m. until 6:00 p.m., Monday through Friday.  Drive-through service is available at theArroyo Grande and Morro Bay offices beginning at 8:00 a.m. until 5:00 p.m.,Monday through Thursday and 8:00 a.m. until 6:00 p.m. on Friday.  The Bank also provides 24-hour automatedteller service at all of its branch locations.

 

Liquidity is the Bank’sability to meet fluctuations in deposit levels and to provide for the creditneeds of its customers.  The objective inliquidity management is to maintain a balance between the sources and uses offunds.  Principal sources of liquidityinclude interest and principal payments on loans and investments, proceeds fromthe maturity of investments and growth in deposits.  The Bank holds overnight Fed Funds Sold as acushion for temporary liquidity needs. For 2005, Fed Funds Sold averaged $16.6 million representing 9.6% ofaverage assets.  In addition, the Bankmaintains Federal Funds lines of $5.0 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, 2005, the Bank had noborrowings under its Federal Funds lines. Also at December 31, 2005, 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 23.8% and within the Bank’s policy guidelines.

 

*Lending Activities, Underwritingand Credit Administration*

 

The lending activities ofCoast National Bank are guided by the lending policies established by the Bank’sBoard of Directors.  The loan policy ismanaged through periodic reviews and approved annually by the Board.  The Bank’s Loan Committee is made up of allmembers of the Bank’s Board of Directors.

 

The Bank considers itsunderwriting 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 LoanCommittee 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.

 

No material portions of theBank’s loans are concentrated within a single industry or group of relatedindustries.  However, as of December 31,2005 and December 31, 2004 respectively 75.8% and 72.5% of total loans weresecured by real estate.  The interestrates charged by the Bank vary with the degree of risk and the size and maturityof the loans involved and are generally affected by competition, governmentalregulation and current money market rates.

 

The Bank concentrates itslending activities in the following areas:

 

*CommercialLoans*.     The Bank provides financial services todiverse commercial and professional businesses in its primary serviceareas.  Commercial loans consistprimarily of short term loans (normally with a maturity of one year or less)for working capital and business expansion. Commercial loans typically includerevolving lines of credit collateralized by inventory, accounts receivable andequipment.  Emphasis is placed on theborrower’s earnings history, capitalization, secondary sources of repayment,and in some instances, third-party guarantees or highly liquid collateral (suchas time deposits and investment securities). Commercial loan pricing is generally at a variable rate tied to theprime rate as quoted in the Wall Street Journal.

 

The Bank also participatesin several government-guaranteed loan programs administered by the SmallBusiness Administration (SBA) and the US Department of Agriculture.  These programs include the 504 program, the 7-Aprogram, the Cap-Line program, and the Express program through SBA and the Businessand Industry Programs through the USDA. The SBA’s 7-A program presently constitutes the largest volume ofgovernment guaranteed lending engaged in by the Bank and is primarily used forthe financing of real estate, equipment, inventory and working capital needs ofeligible businesses, generally over a seven-to-twenty five year term.  The government guarantees extended by the SBAto the Bank in conjunction with these

 

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transactions substantially reduces the Bank’scredit risk.  Based upon the Bank’sexpertise in this type of lending, the SBA designated the Bank as a PreferredLender in September 2001.  Under the SBA’sPreferred Lender program, the Bank enjoys a significant degree of delegatedapproval authority which in turn allows the Bank to process customer loanrequests more quickly.  This PreferredLender authority covers loan transactions originated by the Bank in thegeographic areas defined by the SBA as their Fresno district (which serves thecounties of Alpine, Fresno, Inyo, Kern, Kings, Madera, Mariposa, Merced, Mono,Monterey, San Benito, San Luis Obispo, Stanislaus, Tulare and Tuolumne) and theLos Angeles district (which serves Los Angeles County, Santa Barbara County andVentura County).

 

*RealEstate 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 the constructionof single family residences in the Bank’s service area.

 

Residential real estateconstruction loans are typically secured by first deeds of trust and requireguarantees of the borrower, when applicable. The economic viability of the project and the borrower’scredit-worthiness are primary considerations in the loan underwritingdecision.  The Bank utilizes independentlocal real estate appraisers that have been pre-approved by the Bank’s LoanCommittee to evaluate the projects. Loan-to-value ratios generally do not exceed 80% of the appraised valueof the property.  The Bank monitorsprojects during the construction phase through regular construction inspectionsand a disbursement program tied to the percentage of completion of eachproject.

 

The Bank also occasionallymakes land loans to individuals who intend to construct a single-familyresidence on a residential parcel, generally within 24 months.  In addition, the Bank makes commercial realestate construction loans to qualified applicants with adequate liquidity forthe construction of office and warehouse properties.  Such loans are typically secured by firstdeeds of trust and require guarantees of the borrowers.

 

*ResidentialMortgage Loans.   *In 2004, the Bank entered into an agreement with Mariner Mortgage,Inc., to be a residential loan referring agent.  Under this agreement, theBank staff refers loan to Mariner Mortgage, Inc. by faxing a referral sheet orby introducing our clients to a designated representative of Mariner Mortgage,Inc.  The loans are underwritten and processed by Mariner Mortgage,Inc.  Bank personnel are not involved in the gathering of financial dataor signing of loan documents.  The Bank does not have any responsibilityfor the underwriting or documentation requirements.  For this service theBank receives a referral fee equivalent to 50 basis points for the dollaramount funded on all loans.  The income generated from this referralprogram has declined with the decline in the residential mortgage refinance boom. Income generated by this referral program for 2005 and 2004 and was $76,000 and$108,000 respectively.

 

*CommercialReal Estate Term Loans*.   The Bank provides medium-term commercialreal estate loans secured by commercial or industrial buildings where theproperty is either used by the owner for business purposes (owner-userproperties) or has income derived from tenants (investment properties).  The Bank’s loan policies require theprincipal balance of the loan to be no more than 75% of the stabilizedappraised value of the underlying real estate collateral, with a minimum 1.25%debt service coverage ratio.  The loans,which are typically secured by first trust deeds, generally have terms of nomore than ten years and are amortized over 25 to 30 years.  Some of these loans have fixed rates but mosthave variable rates that are tied to an independent index such as the WallStreet Journal prime rate, or the Federal Home Loan Bank’s Eleventh Districtcost of funds index.

 

*Consumerand Other Loans.  *The Bank’s consumer and other loan portfoliois divided between installment loans secured by automobiles, personal loans,other consumer purposes and revolving, unsecured consumer debt, such as creditcard 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*

 

As of December 31, 2005, weemployed 58 full-time equivalent employees. Part-time employees are converted to full-time equivalent employeesbased on the percentage of their weekly hours worked compared to 40 hours.  The Bank values its employees.  They are actively engaged individually and asa team in contributing to the Bank’s realization of its vision andmission.  We believe that we enjoysatisfactory working relations with our employees.

 

*Competition*

 

The Bank competes for bothloans and deposits with other commercial banks, savings & loanassociations, credit unions and other entities, both governmental andcorporate, which raise operating capital through the issuance of debtsecurities.  With

 

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regard to loans, the Bank competes with othercommercial banks, savings & loan associations, consumer finance companies,mortgage companies, credit unions and other lending institutions.

 

The Bank reliessubstantially on local promotional activity, personal contacts by its officers,directors and employees, referrals by its shareholders, personalized serviceand its reputation in the community it serves to compete effectively.

 

The banking business inCalifornia generally, and in the Bank’s primary service area specifically, ishighly competitive with respect to both loans and deposits, and is dominated bya relatively small number of major banks with offices operating over a widegeographic area.  Among the advantagessuch major banks have over the Bank are their ability to finance wide-rangingadvertising campaigns and to allocate their investment assets, including loans,to regions of higher yield and demand. Such banks offer certain services such as international banking andtrust services which are not offered directly by the Bank, but which the Bankhas offered indirectly through correspondent institutions when its customerssought these services.  In addition, byvirtue of their greater total capitalization, such banks have substantiallyhigher lending limits than the Bank. (Legal lending limits to an individual customer are limited to apercentage of a bank’s total capital accounts plus reserves for loanlosses.)  As of December 31, 2005, theBank’s loan limits to individual customers were $2,567,448 for unsecured loans,and $4,279,080 for unsecured and secured loans combined.  For borrowers desiring loans in excess of theBank’s lending limits, the Bank may, in the future, make such loans on aparticipation basis with its correspondent banks taking the amount of loans inexcess of the Bank’s lending limits.  Inother cases, the Bank may refer such borrowers to larger banks or other lendinginstitutions.

 

*Trust Preferred Securities*

 

On September 26, 2002, theBancorp completed its offering of trust preferred securities (“TPS”) in theamount of $5.2 million.  Under currentFederal Reserve guidelines, TPS qualify as regulatory capital for theBancorp.  More specifically, undercurrent Federal Reserve guidelines, TPS qualify as Tier 1 Capital up to 25% ofthe Bancorp’s total Tier 1 Capital, with the remainder qualifying as Tier 2Capital.  The Bancorp is reflecting thetrust preferred securities as junior subordinated debt securities on itsconsolidated balance sheet.

 

The securities were issuedby a special purpose trust formed by the Bancorp and were sold to a pooledinvestment vehicle sponsored by Keefe, Bruyette & Woods and FTN Financial,in a private transaction.  The securitieswere sold pursuant to an applicable exemption from registration under theSecurities Act of 1933, as amended (the “Act”), and have not been registeredunder the Act.  FTN Financial assistedthe Bancorp in the placement of the trust preferred securities.  The securities may not be offered or sold inthe United States absent registration or an applicable exemption fromregistration requirements.

 

The $5.2 million in trustpreferred securities have a floating rate of interest, which is resetquarterly, equal to the 3-month LIBOR plus 3.40%.  As of December 31, 2005, the floating rate ofinterest was 7.92%.  The floating rate,however, may not exceed 11.95% for the first five years.

 

If the Bancorp elects todefer interest payments pursuant to the terms of the agreement, 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 or premium,if any, or interest on or repay, repurchase or redeem any debt securities ofthe Bancorp that rank pari passu with or junior in interest to the debtsecurities, other than, among other items, a dividend in the form of stock,warrants, options or other rights in the same stock as that on which thedividend is being paid or ranks pari passu with or junior to such stock.  The prohibition on payment of dividends andpayments on pari passu or junior debt also applies in the case of an event ofdefault under the agreements.

 

As of December 31, 2005, CoastBancorp has down-streamed a total of $3.6 million to the Bank in the form ofTier 1 capital where it will finance future deposit and asset growth.

 

*Other Information*

 

The Bank holds no materialpatents, trademarks, licenses, franchises or concessions.  No expenditures have been made by the Bank,during the last two fiscal years, on material research activities relating tothe development of services or the improvement of existing services.

 

Although there can be noassurance, based upon present business activities, management believes that compliancewith federal, state and local provisions regulating discharge of materials intothe environment will have no material effects upon the capital expenditures,earnings and competitive position of the Bank.

 

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There have been nosignificant changes in the kinds of services rendered, the principal marketsfor or the methods of distribution of such services by the Bank during the lastseven (7) fiscal years.

 

The Bank’s business is notseasonal.  The Bank intends to continuewith the same basic commercial banking activities that have characterized theBank’s operations since its inception. The Bank anticipates continued profitable growth while maintaining soundcredit and management policies.

 

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***Critical Accounting Policies***

 

**Ouraccounting policies are integral to understanding the results reported.  Accounting policies are described in detailin Note 1 of the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.  In preparing its consolidated financialstatements, the Company is required to make judgments and estimates that mayhave a significant impact upon its financial results.  Certain accounting policies require theCompany to make significant estimates and assumptions, which have a materialimpact on the carrying value of certain assets and liabilities, and areconsidered 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.**

 

Allowancefor Loan Losses

 

The allowance for loanlosses represents management’s best estimate of losses inherent in the existingloan portfolio.  The allowance for loanlosses is increased by the provision for loan losses charged to expense andreduced 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.

 

Loans are consideredimpaired if, based on current information and events, it is probable that wewill be unable to collect the scheduled payments of principal or interest whendue according to the contractual terms of the loan agreement.  The measurement of impaired loans isgenerally based on the present value of expected future cash flows discountedat the historical effective interest rate stipulated in the loan agreement,except that all collateral-dependent loans are measured for impairment based onthe fair value of the collateral.  Inmeasuring the fair value of the collateral, management uses assumptions andmethodologies consistent with those that would be utilized by unrelated thirdparties.

 

Changes in the financialcondition of individual borrowers, in economic conditions, in historical lossexperience and in the condition of the various markets in which collateral maybe sold may all affect the required level of the allowance for loan losses andthe associated provision for loan losses.

 

DeferredTax Assets

 

We use an estimate of futureearnings to support our position that the benefit of our deferred tax assetswill be realized.  If future incomeshould prove non-existent or less than the amount of the deferred tax assetswithin the tax years to which they may be applied, the asset may not be realizedand our net income will be reduced.  Ourdeferred tax assets are described further in Note 8 of the NOTES TOCONSOLIDATED FINANCIAL STATEMENTS.

 

Servicing and Related Assets

 

Management estimates thevalue of servicing and related assets primarily by projecting the amount andterm of cash flows and then applying a market discount factor.

 

Gain on Sale of Loans

 

Management estimates the valuation of servicing assets as well as theretained portion of SBA loans sold to arrive at the reported gain on loansales.

 

Stock Options

 

Management estimates****the fair market value of stock options andwarrants granted during the year using the Black-Scholes option pricing modeland assumptions for risk free rates, average option life, expected stock pricevolatility and expected dividends.

 

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**SUPERVISIONAND REGULATION**

 

***Bancorp***

 

Coast Bancorp, as a bankholding company, is subject to regulation under the Bank Holding Company Act of1956, as amended, and is registered with and subject to the supervision of theBoard 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.

 

The Bank Holding Company Actrequires Coast Bancorp to obtain the prior approval of the Federal Reservebefore acquisition of all or substantially all of the assets of any bank orownership or control of the voting shares of any bank if, after giving effectto such acquisition, Coast Bancorp would own or control, directly orindirectly, more than 5% of the voting shares of such bank.  The Bank Holding Company Act has expanded thecircumstances under which a bank holding company may acquire control of or allor substantially all of the assets of a bank located outside the State ofCalifornia.

 

Coast Bancorp may not engagein any business other than managing or controlling banks or furnishing servicesto its subsidiaries, with the exception of certain activities which, in theopinion of the Federal Reserve, are so closely related to banking or tomanaging 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.

 

Coast Bancorp and itssubsidiaries are prohibited from engaging in certain tying arrangements inconnection with any extension of credit, sale or lease of property or provisionof services.  For example, with certainexceptions the Bank may not condition an extension of credit on a customerobtaining other services provided by it, Coast Bancorp or any other subsidiary,or on a promise by the customer not to obtain other services from acompetitor.  In addition, federal lawimposes certain restrictions on transactions between Coast National Bank andits affiliates.  As affiliates, CoastNational Bank and Coast Bancorp are subject with certain exceptions, to theprovisions of federal law imposing limitations on and requiring collateral forextensions of credit by Coast National Bank to any affiliate.

 

***The Bank***

 

The Bank is regulated andsupervised by the Office of the Comptroller of the Currency (the “Comptroller”)and subject to periodic examination by the Comptroller.  Deposits of the Bank’s customers are insuredby the Federal Deposit Insurance Corporation (the “FDIC”) up to the maximumlimit of $100,000, and, as an insured bank, the Bank is subject to certainregulations of the FDIC.  As a nationalbank, the Bank is a member of the Federal Reserve System and is also subject tothe regulations of the Federal Reserve Board (the “FRB”).

 

The regulations of thosefederal bank regulatory agencies govern most aspects of the Bank’s business andoperations, including but not limited to, requiring the maintenance ofnon-interest bearing reserves on deposits, limiting the nature and amount ofinvestments and loans which may be made, regulating the issuance of securities,restricting the payment of dividends and regulating bank expansion and bankactivities and the maximum rates of interest allowed on certain deposits.  The Bank also is subject to requirements andrestrictions of various consumer laws and regulations.

 

The following description ofselected statutory and regulatory provisions and proposals is not intended tobe a complete description of these provisions or of the many laws andregulations to which the Bank is subject, and is qualified in its entirety byreference to the particular statutory or regulatory provisions discussed.

 

***Effect of State Law***

 

The laws of the State ofCalifornia also affect the Bank’s business and operations.  For example, under 12 U.S.C. 36, as amendedby the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994,state laws regarding community reinvestment, consumer protection, fair lendingand establishment of intrastate branches may affect the operations of nationalbanks in states other than their home states. On a similar basis, 12 U.S.C. 85 provides that state law, in mostcircumstances, determines the maximum rate of interest which a national bankmay charge on a loan.  As California lawexempts all state-chartered and national banks from the application of itsusury laws, national banks are also provided such an exemption by 12 U.S.C. 85.

 

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***Change in Bank Control***

 

The Bank Holding Company Actof 1956, as amended and the Change in Bank Control Act of 1978, as amended,together with regulations of the FRB and the Comptroller, require that,depending on the particular circumstances, either FRB approval must be obtainedor notice must be furnished to the Comptroller and not disapproved prior to anyperson or company acquiring “control” of a national bank, such as the Bank,subject to exemptions for some transactions. Control is conclusively presumed to exist if an individual or companyacquires 25% or more of any class of voting securities of the Bank.  Control is rebuttably presumed to exist if aperson acquires 10% or more but less than 25% of any class of voting securitiesand either the company has registered securities under Section 12 of theSecurities Exchange Act of 1934, as amended (the “Exchange Act”), or no otherperson will own a greater percentage of that class of voting securitiesimmediately after the transaction.

 

***Payment of Dividends***

 

Coast Bancorp

 

The shareholders of CoastBancorp are entitled to receive dividends when and as declared by its Board ofDirectors, out of funds legally available, subject to the dividends preference,if any, on preferred shares that may be outstanding and also subject to therestrictions of the California Corporations Code.  At December 31, 2005, Coast Bancorp had nooutstanding shares of preferred stock.

 

The payment of dividends toshareholders by Coast Bancorp may be affected if the Bancorp elects to deferinterest payments pursuant to the terms of the Trust Preferred Securitiesagreement that was entered into on September 26, 2002.  If such an event occurs, then the Bancorp maynot (i) declare or pay any dividends or distributions on, or redeem, purchase,acquire or make a liquidation payment with respect to any of the Bancorp’scapital stock, or (ii) make any payment of principal or premium, if any, orinterest on or repay, repurchase or redeem any debt securities of the Bancorpthat rank pari passu with or junior in interest to the debt securities, otherthan, among other items, a dividend in the form of stock, warrants, optionsor other rights in the same stock as that on which the dividend is being paidor ranks pari passu with or junior to such stock.  The prohibition on payment of dividends andpayments on pari passu or junior debt also applies in the case of an event ofdefault under the agreements.

 

See also the section thatfollows titled “Part II – Item 5: Market for Common Equity and RelatedStockholder Matters – Dividends”.

 

The principal sources ofcash revenue to Coast Bancorp are dividends and management fees received fromCoast National Bank.  The Bank’s abilityto make dividend payments to Coast Bancorp is subject to federal regulatoryrestrictions.

 

Coast National Bank

 

The ability of the Bank tomake dividend payments is subject to statutory and regulatoryrestrictions.  After the first threeyears of operations, the Board of Directors of a national bank may declare thepayment of dividends depending upon earnings, financial condition and cashneeds 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.

 

In addition to the aboverequirements, guidelines adopted by the Comptroller set forth factors which areto be considered by a national bank in determining the payment ofdividends.  A national bank, in assessingthe payment of dividends, is to evaluate the Bank’s capital position, itsmaintenance of an adequate allowance for loan and lease losses, and the need torevise or develop a comprehensive capital plan. See “Capital Standards” below.

 

The Comptroller also hasbroad authority to prohibit a national bank from engaging in banking practiceswhich it considers to be unsafe or unsound. It is possible, depending upon the financial condition of the nationalbank in question and other factors, that the Comptroller may assert that thepayment of dividends or other payments by a bank is considered an unsafe orunsound banking practice and therefore, implement corrective action to addresssuch a practice.

 

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Accordingly, the futurepayment of cash dividends by the Bank will not only depend upon the Bank’searnings during any fiscal period but will also depend upon the assessment ofits Board of Directors of capital requirements and other factors, includingdividend guidelines and the maintenance of an adequate allowance for loan andlease losses.

 

***Capital Standards***

 

The Board of Governors, theComptroller and other federal banking agencies have risk based capital adequacyguidelines intended to provide a measure of capital adequacy that reflects thedegree of risk associated with a banking organization’s operations for bothtransactions reported on the balance sheet as assets, and transactions, such asletters of credit and recourse arrangements, which are reported asoff-balance-sheet items.  Under theseguidelines, nominal dollar amounts of assets and credit equivalent amounts ofoff-balance-sheet items are multiplied by one of several risk adjustmentpercentages, which range from 0% for assets with low credit risk, such ascertain U. S. government securities, to 100% for assets with relatively highercredit risk, such as business loans.

 

A banking organization’srisk based capital ratios are obtained by dividing its qualifying capital byits total risk-adjusted assets and off-balance-sheet items.  The regulators measure risk-adjusted assetsand off-balance-sheet items against both total qualifying capital (the sum ofTier 1 capital and limited amounts of Tier 2 capital) and Tier 1 capital.  Tier 1 capital consists of common stock,retained earnings, non-cumulative perpetual preferred stock and minority interestsin certain subsidiaries, less most other intangible assets.  Tier 2 capital may consist of a limitedamount of the allowance for possible loan and lease losses and certain otherinstruments 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.

 

In addition to therisk-based guidelines, federal banking regulators require banking organizationsto maintain a minimum amount of Tier 1 capital to total assets, referred to asthe leverage ratio.  For a bankingorganization rated in the highest of the five categories used by the regulatorsto rate banking organizations, the minimum leverage ratio of Tier 1 capital tototal assets is 3%.  It is improbablehowever, that an institution with a 3% leverage ratio would receive the highestrating by the regulators since a strong capital position is a significant partof the regulators’ rating.  For allbanking organizations not rated in the highest category, the minimum leverageratio is at least 100 to 200 basis points above the 3% minimum.  Thus, the effective minimum leverage ratio,for all practical purposes, is at least 4% or 5%.  In addition to these uniform risk-basedcapital guidelines and leverage ratios that apply across the industry, theregulators have the discretion to set individual minimum capital requirementsfor specific institutions at rates significantly above the minimum guidelinesand ratios.

 

In addition to evaluatingcapital ratios, an overall assessment of capital adequacy must take account ofeach of these other factors including, in particular, the level and severity ofproblem and adversely classified assets. For this reason, the supervisory judgment on a bank’s capital adequacymay differ significantly from the conclusions that might be drawn solely fromthe absolute level of the Bank’s risk-based capital ratio.  The Comptroller has stated that banksgenerally 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 bankingagencies have adopted modifications to the risk-based capital regulations toinclude 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 withsignificant trading activities must measure and hold capital for exposure togeneral market risk arising from fluctuations in interest rates, equity prices,foreign exchange rates and commodity prices and exposure to specific riskassociated with debt and equity positions in the trading portfolio.  General market risk refers to changes in themarket value of on-balance-sheet assets and off-balance-sheet items resultingfrom broad market movements.  Specificmarket risk refers to changes in the market value of individual positions dueto factors other than broad market movements and includes such risks as thecredit risk of an institution’s issuer. The additional capital requirements apply effective January 1, 1998, toinstitutions with trading assets and liabilities equal to 10% or more of totalassets or trading activity of $1 billion or more.  The

 

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federal banking agencies may apply the marketrisk regulations on a case by case basis to institutions not meeting theeligibility criteria if necessary for safety and soundness reasons.

 

The federal banking agencieswill evaluate an institution in its periodic examination on the degree to whichchanges in interest rates, foreign exchange rates, commodity prices or equityprices can affect a financial institution’s earnings or capital.  In addition, the agencies focus in theexamination on an institution’s ability to monitor and manage its market risk,and will provide management with a clearer and more focused indication ofsupervisory concerns in this area.

 

Under certain circumstances,the Comptroller may determine that the capital ratios for a national bank shallbe maintained at levels which are higher than the minimum levels required bythe guidelines.  A national bank whichdoes not achieve and maintain adequate capital levels as required may besubject to supervisory action by the Comptroller, through the issuance of acapital directive to ensure 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.  Forthe regulatory capital guidelines as well as the actual capitalization for theBank and the company on a consolidated basis as of December 31, 2005 see “Management’sDiscussion and Analysis of Financial Condition and Results of Operations -Capital Resources.”

 

***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.  An institutionthat, based upon its capital levels, is classified as well capitalized,adequately capitalized, or undercapitalized may be treated as though it were inthe next lower capital category if the appropriate federal banking agency,after notice and opportunity for hearing, determines that an unsafe or unsoundcondition or an unsafe or unsound practice warrants such treatment.  At each successive lower capital category, aninsured depository institution is subject to more restrictions.  The federal banking agencies, however, maynot treat a significantly undercapitalized institution as criticallyundercapitalized, unless its capital ratio actually warrants such treatment.

 

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 inwriting by 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 reduces deposit insurance coverage for depositsoffered by undercapitalized institutions for deposits by certain employeebenefit accounts.  The federal bankingagencies may require an institution to submit to an acceptable compliance plan,as well as have the flexibility to pursue other more appropriate or effectivecourses of action given the circumstances and severity of an institution’snoncompliance with one or more standards.

 

***Premiums for DepositInsurance***

 

Through the Bank Insurance Fund(“BIF”), the FDIC insures the deposits of the Bank up to prescribed limits foreach 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.

 

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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 the ratiodrops below 1.25%, it is likely the FDIC will be required to assess premiums onall banks for the first time since 1996. Any increase in the assessments or the assessment rate could have amaterial adverse effect on the Bank’s earnings, depending on the amount of theincrease.

 

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 Insidersand Transactions with Affiliates***

 

The Federal Reserve Act andFRB Regulation O, which are applicable to national banks, place limitations andconditions on loans or extensions of credit to: a bank’s or bank holdingcompany’s executive officers, directors and principal shareholders (i.e., inmost cases, those persons who own, control or have power to vote more than 10%of any class of voting securities); any company controlled by such an executiveofficer, director or principal shareholder; or any political or campaigncommittee controlled by such an executive officer, director or principalshareholder.

 

Loans extended to any of theabove persons must comply with loan-to-one-borrower limits, require prior fullboard approval when aggregate extensions of credit to such persons exceedspecified amounts, must be made on substantially the same terms (includinginterest rates and collateral) as, and follow credit-underwriting proceduresthat are not less stringent than, those prevailing at the time for comparabletransactions with non-insiders, and must not involve more than the normal riskof repayment or present other unfavorable features.  Regulation O also prohibits a bank frompaying an overdraft on an account of an executive officer or director, exceptpursuant to a written pre-authorized interest-bearing extension of credit planthat specifies a method of repayment or a written pre-authorized transfer offunds from another account of the officer or director at the Bank.

 

The provisions of RegulationO summarized above reflect substantial strengthening as a result of theadoption of FDICIA.  FDICIA also resultedin an amendment to Regulation O which provides that the aggregate limit on extensionsof credit to all insiders of a bank as a group cannot exceed the Bank’sunimpaired capital and unimpaired surplus. An exception to this limitation is provided for banks with less than$100,000,000 in deposits.  The aggregatelimit applicable to such banks is two times the Bank’s unimpaired capital andunimpaired surplus, provided the Bank meets or exceeds all applicable capitalrequirements.

 

***Consumer Protection Laws andRegulations***

 

The bank regulatory agenciesare focusing greater attention on compliance with consumer protection laws andtheir implementing regulations. Examination and enforcement have become more intense in nature, andinsured institutions have been advised to monitor carefully compliance withvarious consumer protection laws and their implementing regulations.  The Bank is subject to many federal consumerprotection statutes and regulations, including the Community Reinvestment Act,the Equal Credit Opportunity Act, the Truth in Lending Act, the Fair HousingAct, the Home Mortgage Disclosure Act and the Real Estate Settlement ProceduresAct.  Penalties under these statutes mayinclude fines, reimbursements and other penalties.  Due to heightened regulatory concern relatedto compliance with these and other statutes generally, the Bank may incuradditional compliance costs.

 

**Recent and Proposed Legislation**

 

**Sarbanes-OxleyAct**

 

On July 30, 2002, PresidentBush signed into law the Sarbanes-Oxley Act of 2002 implementing legislativereforms intended to address corporate and accounting fraud.  In addition to the establishment of a newaccounting oversight board which will enforce auditing, quality control andindependence standards and will be funded by fees from all publicly tradedcompanies, the bill restricts provision of both auditing and consultingservices by accounting firms.  To ensureauditor independence, any non-audit services being provided to an audit clientwill require pre-approval by the company’s audit committee members.  In addition, the audit partners must berotated.  The Act requires chiefexecutive officers and chief financial officers, or their

 

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equivalent, to certify to theaccuracy of periodic reports filed with the SEC, subject to civil and criminalpenalties if they knowingly or willfully violate this certificationrequirement.  In addition, under the Act,legal counsel will be required to report evidence of a material violation ofthe securities laws or a breach of fiduciary duty by a company to its chiefexecutive officer or its chief legal officer, and, if such officer does notappropriately respond, to report such evidence to the audit committee or othersimilar committee of the board of directors or the board itself.

 

Longer prison terms andincreased penalties will also be applied to corporate executives who violatefederal securities laws, the period during which certain types of suits can bebrought against a company or its officers has been extended, and bonuses issuedto top executives prior to restatement of a company’s financial statements arenow subject to disgorgement if such restatement was due to corporatemisconduct.  Executives are alsoprohibited from insider trading during retirement plan “blackout” periods, andloans to company executives are restricted. The Act accelerates the time frame for disclosures by public companies,as they must immediately disclose any material changes in their financialcondition or operations.  Directors andexecutive officers must also provide information for most changes in ownershipin a company’s securities within two business days of the change.

 

The Act also prohibits anyofficer or director of a company or any other person acting under theirdirection from taking any action to fraudulently influence, coerce, manipulateor mislead any independent public or certified accountant engaged in the auditof the company’s financial statements for the purpose of rendering thefinancial statement’s materially misleading. The Act also requires the SEC to prescribe rules requiring inclusion ofan internal control report and assessment by management in the annual report tostockholders.  In addition, the Actrequires that each financial report required to be prepared in accordance with(or reconciled to) accounting principles generally accepted in the UnitedStates of America and filed with the SEC reflect all material correctingadjustments that are identified by a “registered public accounting firm” inaccordance with accounting principles generally accepted in the United Statesof America and the rules and regulations of the SEC.

 

As directed by Section 302(a)of Sarbanes-Oxley, the Company’s chief executive officer and chief financialofficer are 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’sdisclosure controls; they have made certain disclosures to Bancorp’s auditorsand the audit committee of the Board of Directors about the Company’s disclosurecontrols; 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 diclosure controls or in other factors that couldsignificantly affect internal controls subsequent to the evaluation.

 

**USAPATRIOT Act**

 

In the wake of the tragicevents of September 11th, on October 26, 2001, President Bush signed theUniting and Strengthening America by Providing Appropriate Tools Required toIntercept and Obstruct Terrorism (USA PATRIOT) Act of 2001.  Under the USA PATRIOT Act, financialinstitutions 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;

 

•              Toascertain the identity of the nominal and beneficial owners of, and the sourceof funds deposited into, each account as needed to guard against moneylaundering and 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 days from enactment to establishanti-money laundering programs.  The USAPATRIOT Act sets forth minimum standards for these programs, including:

 

*      The development of internal policies,procedures, and controls;

 

*      The designation of a compliance officer;

 

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*      An ongoing employee training program; and

 

*      An independent audit function to test theprograms.

 

On June 20, 2002, the Board ofDirectors of the Bank adopted comprehensive policies and procedures to addressthe requirements of the USA PATRIOT Act, and management believes that the Bank iscurrently in full compliance with the Act.

 

**FinancialServices Modernization Legislation**

 

On November 12, 1999, PresidentClinton signed into law the Gramm-Leach-Bliley Act. This legislation eliminatedmany of the barriers that have separated the insurance, securities and bankingindustries since the Great Depression. The federal banking agencies (the Boardof Governors, FDIC and the Office of the Comptroller of the Currency) amongothers, continue to draft regulations 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 theGramm-Leach-Bliley Act are:

 

*FinancialHolding Companies and Financial Activities*

 

Title I establishes acomprehensive framework to permit affiliations among commercial banks,insurance companies, securities firms, and other financial service providers byrevising and expanding the BHC Act framework to permit a holding company systemto engage in a full range of financial activities through qualification as anew entity known as a financial holding company.

 

Activities permissible forfinancial subsidiaries of national banks, and, also permissible for financialsubsidiaries of state member banks, include, but are not limited to, thefollowing:  (a) Lending, exchanging,transferring, investing for others, or safeguarding money or securities; (b)Insuring, guaranteeing, or indemnifying against loss, harm, damage, illness,disability, or death, or providing and issuing annuities, and acting asprincipal, agent, or broker for purposes of the foregoing, in any State; (c)Providing financial, investment, or economic advisory services, includingadvising an investment company; (d) Issuing or selling instruments representinginterests in pools of assets permissible for a bank to hold directly; and (e)Underwriting, dealing in, or making a market in securities.

 

*SecuritiesActivities*

 

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.

 

*Insurance Activities*

 

Title III restates theproposition that the states are the functional regulators for all insuranceactivities, including the insurance activities of federally-chartered banks,and bars the states from prohibiting insurance activities by depositoryinstitutions.

 

*Privacy*.

 

As required under Title V ofthe Gramm-Leach-Bliley Act, federal banking regulators issued final rules onMay 10, 2000 to implement the privacy provisions of Title V. Pursuant to therules, financial institutions must provide (i) initial notices to customersabout their privacy policies, describing the conditions under which they maydisclose nonpublic personal information to nonaffiliated third parties andaffiliates; (ii) annual notices of their privacy policies to current customers;and (iii) a reasonable method for customers to “opt out” of disclosures tononaffiliated third parties.

 

Compliance with the rules wasoptional until July 1, 2001.  As of July1, 2001 the Bank was in compliance with the privacy provisions of the Gramm-Leach-BlileyAct and the implementing regulations promulgated by the FDIC, and subsequently,as necessary, has updated and enhanced its procedure and practice in thiscritical area.

 

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*SafeguardingConfidential Customer Information*.

 

Under Title V of theGramm-Leach-Bliley Act, federal banking regulators were required to adopt rulesrequiring financial institutions to implement a program to protect confidentialcustomer information.  In January 2000,the federal banking agencies adopted guidelines requiring financialinstitutions to establish an information 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 effectiveJuly 1, 2001.  The Bank implemented asecurity program appropriate to its size and complexity and the nature andscope of its operations in advance of the July 1, 2001 effective date, and subsequently,as necessary, has refined and improved its security program.

 

*CommunityReinvestment Act Sunshine Requirements*.

 

In February 2001, the federalbanking agencies adopted final regulations implementing Section 711 of TitleVII, the CRA Sunshine Requirements.  Theregulations require nongovernmental entities or persons and insured depositoryinstitutions and affiliates that are parties to written agreements made inconnection with the fulfillment of the institution’s CRA obligations to makeavailable to the public and the federal banking agencies a copy of each suchagreement.  The regulations impose annualreporting requirements concerning the disbursement, receipt and use of funds orother resources under each such agreement. The effective date of the regulations was April 1, 2001.

 

The Bank is not a party to anyagreement that would be subject of reporting pursuant to the CRA SunshineRequirements.

 

The Bank intends to comply withall provisions of the Gramm-Leach-Bliley Act and all implementing regulations.

 

**CaliforniaFinancial Information Privacy Act/Fair Credit Reporting Act**

 

In 1970, the federal FairCredit Reporting Act (the “FCRA”) was enacted to insure the confidentiality,accuracy, relevancy and proper utilization of consumer credit reportinformation.  Under the framework of theFCRA, the United States has developed a highly advanced and efficient creditreporting system.  The informationcontained in that broad system is used by financial institutions, retailers andother creditors of every size in making a wide variety of decisions regardingfinancial transactions.  Employers andlaw enforcement agencies have also made wide use of the information collectedand maintained 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 FinancialInformation Privacy Act (the “CFIPA”), which was enacted in 2003, requires afinancial institution to provide specific information to a consumer related tothe sharing of that consumer’s nonpublic personal information.  The Act allows a consumer to direct thefinancial institution not to share his or her nonpublic personal informationwith affiliated or nonaffiliated companies with which a financial institutionhas contracted to provide financial products and services, and would requirethat permission from each such consumer be acquired by a financial institutionprior to sharing such information.  Theseprovisions are much more restrictive than the privacy provisions of theFinancial Services Modernization Act, and requires the Bank to adopt newpolicies, procedures and disclosure documentation if implemented asenacted.  As the portion of CFIPA dealingwith affiliates is currently subject to litigation, the cost of complying withthis legislation is not predictable at this time.

 

Congress enacted the FACT Act,(“Fair and Accurate Credit Transaction Act”) of 2003, which will have theeffect of avoiding the sunset preemption provision of the Fair Credit ReportingAct (FCRA) that were due to expire on December 31, 2003.  The President signed the FACT Act into law onDecember 4, 2003.  In general, the FACTAct amends the FCRA and, in addition, provides that, when the implementingregulations have been issued and become effective, the FACT Act will preemptelements 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 identity theftand proof of identity, the FTC’s final regulation on consumer information andrecords disposal, and the FTC’s final summaries and notices.  On January 24, 2005, the FTC issued a finalrule on prescreen notices.

 

17

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**Check 21Act**

 

The Check Clearing for the 21stCentury Act (“Check 21 Act” or “the Act”), enacted in late 2003, becameeffective on October 28, 2004.  The Actcreates a new negotiable instrument, called a “substitute check”:, which banksare required to accept as the legal equivalent of a paper check if it meets therequirements of the Act.  The Act isdesigned to facilitate check truncation, to foster innovation in the checkpayment system, and to improve the payment system by shortening processingtimes and reducing the volume of paper checks.

 

**FederalReserve Board Final Rule on Trust Preferred Securities**

 

On March 1 the Federal Reserve Boardissued a final rule that allows the continued inclusion of trust preferredsecurities in the tier 1 capital of bank holding companies.  Trust preferred securities, however, will besubject 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 bank regulatory system and to limit theinvestments that a depository institution may make with insured funds, isintroduced into Congress or the California Legislature from time to time.  The Bancorp and the Bank cannot determine theultimate effect that any potential legislation, if enacted, or regulationspromulgated there under, would have upon the financial condition or operationsof the Bancorp or the Bank.

 

**Impact of Government MonetaryPolicy**

 

The earnings of the Bancorp and the Bank areand will be affected by the policies of regulatory authorities, including theFederal Reserve.  An important functionof the Federal Reserve is to regulate the national supply of bank credit.  Among the instruments used to implement theseobjectives are open market operations in U.S. Government securities, changes inreserve requirements against bank deposits, and changes in the discount ratewhich banks pay on advances from the Federal Reserve System.  These instruments are used in varying combinationsto influence overall growth and distribution of bank loans, investments anddeposits, and their use may also affect interest rates on loans or interestrates paid for deposits.  The monetarypolicies of the FRB have had a significant effect on the operating results ofcommercial banks in the past and are expected to continue to do so in thefuture.  The effect, if any, of suchpolicies upon the future business earnings of the Bancorp and theBank cannot bepredicted.

 

***Additional Factors That May AffectFuture Results of Operations***

 

Dependence on RealEstate.     A significant portion of theloan portfolio of the Bank is dependent on real estate.  At December 31, 2005, real estate served asthe principal source of collateral with respect to approximately 75.8% percentof the Bank’s loan portfolio.  A declinein current economic conditions or rising interest rates could have an adverseeffect 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.

 

18

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Environmental LiabilityAssociated with Real Estate Ownership Could Result in Losses.     In the course of business, the Bank haspurchased real property.  In the future,the Bancorp and the Bank may acquire additional real properties, throughpurchase, foreclosure or otherwise.  Inreal estate ownership, as well as in commercial real estate lending, there is arisk that hazardous substances could be discovered on these properties.  In this event, the Bank might be required toremove these substances from the affected properties at its sole cost andexpense.  The cost of this removal couldsubstantially exceed the value of the affected properties.  The Bancorp or the Bank, as the case may be,may not have adequate remedies against the prior owner or other responsibleparties or could find it difficult or impossible to sell the affectedproperties.  This could have a materialadverse effect on the Bancorp’s and the Bank’s business, financial conditionand operating results.

 

Interest Rate Changes.   The earnings of the Bancorp and the Bank aresubstantially affected by changes in prevailing interest rates.  Changes in interest rates affect the demandfor new loans, the credit profile of existing loans, the rates received onloans and securities and the rates the Bank must pay on deposits and borrowings.  The difference between the rates the Bankreceives on loans and securities and the rates it must pay on deposits andborrowings is known as the interest rate spread.  Given the Bank’s current volume and mix ofinterest-bearing assets, the Bank’s interest rate spread can be expected toincrease when market interest rates are rising, and to decline when marketinterest rates are declining.  Althoughthe Bank believes its current level of interest rate sensitivity is reasonable,significant fluctuations in interest rates may have an adverse impact on itsbusiness, financial condition and result of operations.

 

Competition.   Competition may adversely affect the Bank’sperformance.  The financial servicesbusiness in the Bank’s market area is highly competitive and becoming more sodue to changes in regulation, technological advances and the accelerating paceof consolidation among financial service providers.  The Bank faces competition both in attractingdeposits and making loans.  The Bankcompetes for loans principally through competitive interest rates and theefficiency 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 Bancorp and the Bank are subject togovernment regulation that could limit or restrict their activities, adverselyaffecting operations.  The financialservices industry is heavily regulated. Federal and state regulation is designed to protect the deposits ofconsumers, not to benefit shareholders. The regulations impose significant limitations on operations, and may bechanged at any time, possibly causing results to vary significantly from pastresults.  Government policy andregulation, particularly as implemented through the Federal Reserve System,significantly affects credit conditions.

 

Borrower’sFailure to Perform.   In the event of aneconomic downturn, a significant number of the Bank’s borrowers and guarantorsmay fail to perform their obligations as required by the terms of their loans,which could result in larger than expected losses. The Bank has adoptedunderwriting and credit policies, and loan monitoring procedures, including theestablishment and monitoring of allowance for credit losses.  Management believes these provisions arereasonable and adequate, and should keep credit losses within expected limitsby assessing the likelihood of nonperformance, tracking loan performance anddiversifying the credit portfolio. However, these policies and procedures may not be adequate to preventunexpected losses that could materially and adversely affect the results of operations.

 

OperationsRisks.   The Bank is subject to certainoperations risks, including, but not limited to, data processing systemfailures and errors, customers or employee fraud and catastrophic failuresresulting 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.

 

Breachof Information Security.   Despite instituted safeguards, Bancorp and theBank cannot be certain that all of its systems are entirely free fromvulnerability to attack or other technological difficulties or failures.  Bancorp and the Bank rely on the services ofa variety of vendors to meet its data processing and communication needs.  If information security is breached or othertechnological difficulties or failures occur, information may be lost ormisappropriated, services and operations may be interrupted and Bancorp and theBank could be exposed to claims from customers. Any of these results could have a materially adverse effect on Bancorp’sand the Bank’s business, financial condition, results of operations orliquidity.

 

GeographicConcentration.   The Company’s operations are located almostentirely in the Central Coast region of California.  As a result of this geographic concentration,our results depend largely upon economic and business conditions in thisregion.  Deterioration in economic andbusiness conditions in our market area could have a material adverse impact onthe

 

19

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quality of our loanportfolio and the demand for our products and services, which in turn may havea material adverse effect on our results of operations.

 

Waron Terrorism.   The terrorist attacks ofSeptember 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 on terrorism,imposes substantial new responsibilities on banks for preventing, detecting andreporting 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.  Thefull impact of the new law and its ongoing implementation on the Bancorp andthe Bank cannot be predicted at this time.

 

**Item 2.       Description of Properties**

 

Constructionof the new San Luis Obispo head office was completed on November 25, 2002, andoccupancy began on that date.  In the newbuilding, 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 office spacein the building at 486 Marsh Street is currently being leased by the Bank tounrelated 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 February2003.  The Bank did not renew thislease.  Office space that previouslyhoused the Bank’s Government Guaranteed Lending Center at 545 Higuera Street inSan Luis Obispo is being leased to unrelated third party tenants.  It is the intention of the Bank to hold thisproperty for future development and expansion. The San Luis Obispo real estate identified as 500 Marsh Street, 486Marsh 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 purchase of avacant site nearby at the corner of Kern Avenue and Morro Bay Boulevard forconstruction 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 August2004.

 

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.  In December 2005, the officewas relocated to 411 Betteravia Rd., Ste 201, Santa Maria, California.  The loan production office was opened toenhance the Bank’s government guaranteed lending opportunities in northernSanta Barbara County.

 

TheBank 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. The original lease on this facility expired and the office was closed inSeptember 2005.

 

InJune 2005, the Bank opened a new loan production office at 7429 N. First St.,Suite 104, Fresno, California.  The loanproduction office was opened to enhance the Bank’s government guaranteedlending opportunities in the Fresno area.

 

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.

 

20

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**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 any associateof any such director, officer, affiliate or 5% shareholder of the Bancorp is aparty, and none of the above persons has a material interest adverse to theBancorp.

 

**Item 4.       Submission of Matters to a Vote ofSecurity Holders**

 

None

 

21

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**PART II**

 

**Item 5.****      ****Market for Common Equity and Related Stockholder Matters and SmallBusiness Issuer Purchase of****EquitySecurities**

 

(a)   As of December 31, 2005, the equity of theBancorp consisted of Preferred Stock 10,000,000 shares authorized, noneoutstanding and 10,000,000 shares authorized with 674,100 shares of the Bancorp’sCommon Stock (having no par value) outstanding. The stock is not listed on any exchange, but is traded over the counterunder the symbol CTBP.OB.  The followinghigh and low bid information as reported and may not represent actualtransactions.

 
|                  | **High** |   | **Low** |   |   | **High** |                  | **Low** |
|-----------------------|----------|--------|---------|--------|--------|----------|-----------------------|---------|
| First Quarter, 2005   | $        | 26.80  |    | $      | 27.50  |     | First Quarter, 2004   | $       | 26.80 |   | $ | 23.00 |
| Second  Quarter, 2005 | $        | 28.50  |    | $      | 26.30  |     | Second  Quarter, 2004 | $       | 28.75 |   | $ | 25.50 |
| Third  Quarter, 2005  | $        | 28.50  |    | $      | 26.50  |     | Third  Quarter, 2004  | $       | 26.50 |   | $ | 25.75 |
| Fourth  Quarter, 2005 | $        | 30.35  |    | $      | 28.50  |     | Fourth  Quarter, 2004 | $       | 28.00 |   | $ | 26.35 |

 

As of December 31, 2005,there were approximately 379 shareholders of record.

 

The Bancorp declared andpaid a cash dividend on December 12, 2005, of $0.175 per share on its CommonStock, to shareholders of record as of the close of business on December 22,2005.  The dividend paid on its CommonStock on December 3, 2004 to its stockholders of record on November 1, 2004,was $0.15 per share.

 

The following chart providesinformation as of December 31, 2005, concerning the Bancorp’s Stock OptionPlans, which represent the Bancorp’s only equity compensation 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                                               |       | 117,100                                                                                                       |       | $17.46                                                                                      |       | 21,300                                                                                                                                                     |   |
| Equity  Compensation                                              |       |                                                                                                          |       |                                                                                        |       |                                                                                                                                                       |   |
| Plans Not Approved                                                |       |                                                                                                          |       |                                                                                        |       |                                                                                                                                                       |   |
| by Security Holders                                               |       | 0                                                                                                             |       | 0                                                                                           |       | 0                                                                                                                                                          |   |
| Total                                                             |       | 117,100                                                                                                       |       | $17.46                                                                                      |       | 21,300                                                                                                                                                     |   |

 

(b)                     None

 

(c)                      None

 

**Dividends**

 

The Bancorp is regulated bythe 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.

 

For the impact of TrustPreferred Securities on the payment of dividends, see the preceding sectiontitled “Part I – SUPERVISION AND REGULATION, *Payment ofDividends* – Coast Bancorp”.

 

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The shareholders of CoastBancorp are entitled to receive dividends when and as declared by its Board ofDirectors out of funds legally available, subject to the restrictions set forthin the California General Corporation Law. The Corporation Law provides that a corporation may make a distributionto its shareholders if the corporation’s retained earnings equal at least theamount of the proposed distribution.  TheCorporation Law further provides that, in the event that sufficient retainedearnings are not available for the proposed distribution, a corporation maynevertheless make a distribution to its shareholders if it meets twoconditions, which generally stated are as follows:  1) the corporation’s assets equal at least1.25 times its liabilities; and 2) the corporation’s current assets equal atleast its current liabilities or, if the average of the corporation’s earningsbefore taxes on income and before interest expense for the two preceding fiscalyears was less than the average of the corporation’s interest expense for suchfiscal years, then the corporation’s current assets must equal at least 1.25times its current liabilities.

 

One of the primary sourcesof income for the Bancorp, on a stand-alone basis, is the receipt of dividendsfrom the Bank.  The availability ofdividends from the Bank is limited by various statutes and regulations.

 

**Item 6.       Management Discussion & Analysis ofFinancial Condition and Results of Operations**

 

The following sections setforth a discussion of the significant operating changes, business trends,financial condition, earnings, capital position, and liquidity that haveoccurred in the two-year period ended December 31, 2005, together with anassessment, when considered appropriate, of external factors that may affect usin the future.  This discussion should beread in conjunction with our consolidated financial statements and notes.

 

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**OVERVIEW**

 

**Earnings Summary**

 

Consolidated net income in2005 was $1,097,866 a decrease of $17,163 or 1.5%, compared to $1,115,029 in2004.  Diluted earnings per share in 2005were $1.56, compared to $1.58 in 2004. The decrease in earnings in 2005 was due primarily a decrease in the salesof the guaranteed portions of government loans.

 

**Balance Sheet Summary**

 

Total assets at December 31,2005 were $185.7 million, a $25.8 million or 16.1% increase from $159.9 millionat December 31, 2004.  Average assets for2005 were $173 million, compared to $154.2 million for 2004.  Total deposits increased $24.5 million or 17%to $168.9 million at December 31, 2005. Gross loans increased $17.4 million or 15%, to $133.7 million atDecember 31, 2005.  Stockholder’s equityincreased $1.3 million or 13.1%, to $11.2 million at December 31, 2005.

 

**Distribution of Assets, Liabilities,and Shareholders’ Equity**

 

The following tablepresents, for the years indicated, the distribution of average assets,liabilities and shareholders’ equity, as well as the total amounts of interestincome from average interest-earning assets and the resultant yields, and thedollar amounts of interest expense and average interest-bearing liabilities,expressed both in dollars and in rates. Non-accrual loans are included in the calculation of the averagebalances of loans, and interest not accrued is excluded.

(dollar amounts in thousands).

 

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| ** **                                      | ** ** | **For the Year Ended December 31,** | ** ** |
|-------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                      | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| ** **                                      | ** ** | **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                           |       | $                                   | 11,932     |   | $ | 307 |   | 2.57 | % | $ | 8,780 |   | $ | 190 |   | 2.16 | % |
| Federal Funds Sold                              |       | 16,610                              |       | 561 |   | 3.38 | % | 12,871 |   | 186 |   | 1.45 | % |
| Other Earning Assets                            |       | 905                                 |       | 54 |   | 5.97 | % | 761 |   | 40 |   | 5.26 | % |
| Loans                                           |       | 125,126                             |       | 9,981 |   | 7.98 | % | 114,258 |   | 7,824 |   | 6.85 | % |
|                                            |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Total Interest-Earning Assets                   |       | 154,573                             |       | 10,903 |   | 7.05 | % | 136,670 |   | 8,240 |   | 6.03 | % |
|                                            |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Cash and Due from Bank                          |       | 9,460                               |       |   |   |   |   | 9,233 |   |   |   |   |   |
| Premises and Equipment                          |       | 8,427                               |       |   |   |   |   | 7,884 |   |   |   |   |   |
| Other Real Estate Owned                         |       | —                              |       |   |   |   |   | — |   |   |   |   |   |
| Accrued Interest and Other Assets               |       | 1,676                               |       |   |   |   |   | 1,651 |   |   |   |   |   |
| Allowance For Loan Losses                       |       | (1,173                              | )          |   |   |   |   | (1,158 | ) |   |   |   |   |
|                                            |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Total Assets                                    |       | $                                   | 172,963    |   |   |   |   |   | $ | 154,280 |   |   |   |   |   |
|                                            |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| **Liabilities and Shareholders’ Equity**   |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Interest-Bearing Liabilities:                   |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Money Market and NOW:                           |       | $                                   | 39,450     |   | $ | 681 |   | 1.73 | % | $ | 36,671 |   | $ | 285 |   | 0.78 | % |
| Savings                                         |       | 8,496                               |       | 79 |   | 0.93 | % | 7,458 |   | 48 |   | 0.64 | % |
| Time Deposits under $100,000                    |       | 14,506                              |       | 361 |   | 2.49 | % | 17,007 |   | 283 |   | 1.66 | % |
| Time Deposits of $100,000 or More               |       | 54,145                              |       | 1,667 |   | 3.08 | % | 41,422 |   | 820 |   | 1.98 | % |
| Trust Preferred Securities                      |       | 5,155                               |       | 380 |   | 7.37 | % | 5,155 |   | 286 |   | 5.55 | % |
| Other                                           |       | 77                                  |       | 3 |   | 3.90 | % | 123 |   | 5 |   | 4.07 | % |
|                                            |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Total Interest-Bearing Liabilities              |       | 121,829                             |       | 3,171 |   | 2.60 | % | 107,836 |   | 1,727 |   | 1.60 | % |
|                                            |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Non-Interest Bearing Liabilities                |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Demand Deposits                                 |       | 40,120                              |       |   |   |   |   | 36,780 |   |   |   |   |   |
| Other Liabilities                               |       | 406                                 |       |   |   |   |   | 271 |   |   |   |   |   |
| Shareholders’ Equity                       |       | 10,608                              |       |   |   |   |   | 9,393 |   |   |   |   |   |
|                                            |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Total Liabilities and Shareholders’ Equity |       | $                                   | 172,963    |   |   |   |   |   | $ | 154,280 |   |   |   |   |   |
|                                            |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Net Interest Income                             |       |                                |       | $ | 7,732 |   |   |   |   |   | $ | 6,513 |   |   |   |
|                                            |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Net Yield on Interest-Earning Assets            |       |                                |       |   |   | 5.00 | % |   |   |   |   | 4.77 | % |

 

**EARNINGS ANALYSIS**

 

**Net Interest Income**

 

A significant component ofour earnings is net interest income.  Netinterest income is the difference between the interest we earn on our loans andinvestments and the interest we pay on deposits and other interest-bearingliabilities.

 

Our net interest income isaffected by changes in the amount and mix of our interest-earning assets andinterest-bearing liabilities, referred to as a “volume change”.  It is also affected by changes in the yieldswe earn on interest-earning assets and rates we pay on interest-bearingdeposits and other borrowed funds, referred to as a “rate change”.

 

25

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The following table sets forthchanges in interest income and interest expense for each major category ofinterest-earning asset and interest-bearing deposit accounts, and the amount ofchange attributable to volume and rate changes for the years indicated.  Changes not solely attributable to rate orvolume have been allocated to volume and rate changes in proportion to therelationship of the absolute dollar amounts of the changes in each (dollaramounts in thousands).

 
| ** **                       | ** ** | **Year Ended December 31, 2005  versus  Year Ended December 31, 2004** | ** ** |
|----------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                       | ** ** | **Increase (Decrease) due to change in**                               | ** ** |
| ** **                       | ** ** | **Volume**                                                             | ** ** | **Rate** | ** ** | **Total** | ** ** |
| **Interest-Earning Assets:**     |       |                                                                   |       |   |   |   |   |
| Investment Securities            |       | $                                                                      | 76         |   | $ | 41 |   | $ | 117 |   |
| Federal Funds Sold               |       | 67                                                                     |       | 308 |   | 375 |   |
| Other Earning Assets             |       | 9                                                                      |       | 5 |   | 14 |   |
| Loans                            |       | 789                                                                    |       | 1,368 |   | 2,157 |   |
| **Total Interest Income**        |       | 941                                                                    |       | 1,722 |   | 2,663 |   |
|                             |       |                                                                   |       |   |   |   |   |
| **Interest-Bearing Liabilities** |       |                                                                   |       |   |   |   |   |
| Transaction Accounts             |       | 25                                                                     |       | 371 |   | 396 |   |
| Savings                          |       | 8                                                                      |       | 23 |   | 31 |   |
| Time Deposits                    |       | (47                                                                    | )          | 125 |   | 78 |   |
| Time Deposits $100,000 or more   |       | 302                                                                    |       | 545 |   | 847 |   |
| Trust Preferred                  |       | —                                                                 |       | 94 |   | 94 |   |
| Other                            |       | (2                                                                     | )          | — |   | (2 | ) |
| **Total Interest Expense**       |       | 286                                                                    |       | 1,158 |   | 1,444 |   |
|                             |       |                                                                   |       |   |   |   |   |
| **Net Interest Income**          |       | $                                                                      | 655        |   | $ | 564 |   | $ | 1,219 |   |

 

**2005 Compared to 2004**

 

Net interest income for 2005was $7.7 million, an increase of 18.7% compared to the $6.5 million reported in2004.  This increase was primarily due tothe 15% increase in loans.  The net yieldon average earning assets also increased from 4.77% in 2004 to 5.00% in 2005.

 

Interest income in 2005 was$10.9 million, representing an increase of $2.7 million or 32.3% over the $8.2million recorded in 2004.   The increasein interest income was primarily due to the average increase in loanbalances.  The Bank was able to increaseloans significantly while maintaining quality. The increase in the prime rate to 7.25% somewhat curtailed interest inrefinancing activities but businesses continued to upgrade systems andfacilities.

 

The ratio of interest andfees earned on loans as a percentage of total interest income decreased from94.95% in 2004 to 91.54% in 2005.  Thisdecrease is a result of a larger proportion of total interest income beingderived from the interest received on federal funds sold from 2.26% of interestand fees in 2004 to 5.15% in 2005.  Theaverage rate on Federal Funds sold increased from 2.24% in January to 4.09% inDecember of 2005.  The portion of loanfees included in the interest income and loan category was $ 798,466 in 2005 ascompared to $529,754 in 2004.

 

Interest expense increasedin 2005 due in large part to interest paid on time deposits of $100,000 ormore, resulting in a net increase of the average rate paid of 1.1 basis pointsfrom 1.98% in 2004 to 3.08% in 2005.

 

**Non-interest Income**

 

The Bank receivesnon-interest income primarily from service charges and fees on accounts, aswell as from the sale of government guaranteed loans and realized gains on thesale of investment securities.  In 2005,non-interest income was $574,908, a decrease of $892,812 or 60.8% compared tothe 2004 amount of $1,467,720.

 

The decrease in non-interestincome was substantially due to a lack of gains from the sale of loans.  Gain on the sale of loans and servicing feestotaled $193,699 in 2005, down 81.1% compared to 2004.

 

26

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The mortgage loan program,through the Mariner Mortgage, Inc., enabled the Bank to facilitate long termmortgage loans for our customers.  TheBank submitted the applications to Mariner Mortgage, Inc, by whom the loanswere underwritten and processed.  TheBank had no responsibility for underwriting or documentation.  For these services the Bank was paid afee.   Our participation in this programbegan in 2004 and continues to 2005.  Theincome generated from this referral program has declined with the decline in theresidential refinance mortgage boom. Income realized from mortgage loans in 2005was $75,927 compared to $107,555 in 2004, a $31,628, or 29%, decrease.

 

Regarding the realized gainson the sale of loans, the most common reason for the Bank to sell the guaranteedportion of a loan is to also meet the liquidity needs of the Bank and tomaintain the Bank’s loan-to-deposit ratio within acceptable ranges.  The Bank also enjoys the opportunity tosupplement, at its discretion, fee income from the sale of the government-guaranteedportions of certain loans.  In 2001 theBank developed a government guaranteed lending center to originate loans thatare partially guaranteed by the U.S. Small Business Administration or the U.S.Department of Agriculture.  While the volumeof lending in this department has decreased, the Bank has still realized gains fromthese loans when the guaranteed portions have been sold.  While we hope this non-interest incomeopportunity continues into the future, there is no assurance that the level ofloan sales and the subsequent realization of fee income enjoyed by the Bank inthe past will continue at prior levels.

 

**Non-interest Expense**

 

Non-interest expensereflects our costs of products and services related to systems, facilities andpersonnel.  The major components ofnon-interest expense stated as a percentage of average assets are as follows:

 
| ** **                       | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|
| Salaries and Employee Benefits   |       | 2.05     | %          | 2.18     | %          |
| Occupancy Expenses               |       | 0.28     | %          | 0.26     | %          |
| Furniture and Equipment          |       | 0.19     | %          | 0.18     | %          |
| Data Processing                  |       | 0.21     | %          | 0.25     | %          |
| Marketing and Business Promotion |       | 0.36     | %          | 0.27     | %          |
| Other Professional Expenses      |       | 0.14     | %          | 0.21     | %          |
| Office Expenses                  |       | 0.13     | %          | 0.14     | %          |
| Other                            |       | 0.32     | %          | 0.36     | %          |
|                             |       | 3.67     | %          | 3.85     | %          |

 

Non-interest expense was $6.4million in 2005, an increase of $.5 million or 8.5% over the $5.9 millionreported in 2004.  The majority of thisincrease is attributable to an increase in marketing and promotion as well as increasedsalaries and employee benefits. The Bank has 58 full time equivalent employees,the same amount as in 2004.  The Bank hasbeen fortunate in retaining long term managerial employees.  Salaries for 2005 and 2004 respectively were$3,539,906 and $3,366,193.

 

**Income Taxes**

 

Income tax expense was$838,874 and $861,632 for the years ended December 31, 2005, and 2004respectively, a decrease of $22,758 or 2.6%. These expenses resulted in an effective tax of 43.3% in 2005, and 43.6%in 2004.  The decrease in income taxexpense in 2005 was due to slight decrease of net income in 2005 over 2004.

 

27

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**BALANCE SHEET ANALYSIS**

 

**Investment Portfolio**

 

The following tablesummarizes the amounts and distribution of our investment securities held as ofthe dates indicated, and the weighted average yields as of December 31, 2005(dollar amounts in thousands):

 
| ** **                                            | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------|------------|------------------|------------|
| ** **                                            | ** ** | **2005**         | ** ** | **2004** | ** ** |
| ** **                                            | ** ** | **Book  Value**  | ** ** | **Market  Value** | ** ** | **Weighted  Average  Yield** | ** ** | **Book  Value** | ** ** | **Market  Value** | ** ** |
| **Available-for-Sale Securities**                     |       |             |       |   |   |   |   |   |   |   |   |
| **U.S. Treasuries:**                                  |       |             |       |   |   |   |   |   |   |   |   |
| Within One Year                                       |       | $                | —     |   | $ | — |   | 0.00 | % | $ | 998,453 |   | $ | 993,780 |   |
| One to Five Years                                     |       | —           |       | — |   | 0.00 | % | — |   | — |   |
| Five to Ten Years                                     |       | —           |       | — |   | 0.00 | % | — |   | — |   |
| After Ten Years                                       |       | —           |       | — |   | 0.00 | % | — |   | — |   |
| Total U.S. Treasury Securities                        |       | —           |       | — |   | 0.00 | % | 998,453 |   | 993,780 |   |
|                                                  |       |             |       |   |   |   |   |   |   |   |   |
| **U.S. Government and Agency Securities**             |       |             |       |   |   |   |   |   |   |   |   |
| Within One Year                                       |       | 4,991,864        |       | 4,920,290 |   | 2.49 | % | 3,959,979 |   | 3,931,168 |   |
| One to Five Years                                     |       | 3,015,158        |       | 2,951,880 |   | 3.25 | % | 8,011,247 |   | 7,941,645 |   |
| Five to Ten Years                                     |       | —           |       | — |   | 0.00 | % | — |   | — |   |
| After Ten Years                                       |       | —           |       | — |   | 0.00 | % | — |   | — |   |
| Total U.S. Treasury and Government Agency  Securities |       | 8,007,022        |       | 7,872,170 |   | 2.87 | % | 11,971,226 |   | 11,872,813 |   |
| **Mutual Funds**                                      |       | —           |       | — |   |   |   | — |   | — |   |
| **Mortgage Backed Securities**                        |       | —           |       | — |   |   |   | — |   | — |   |
| **Total Available-for-Sale Securities**               |       | $                | 8,007,022  |   | $ | 7,872,170 |   | 2.87 | % | $ | 12,969,679 |   | $ | 12,866,593 |   |

 

Securities may be pledged tomeet security requirements imposed as a condition to receipt of deposit ofpublic funds and for other purposes.  AtDecember 31, 2005, the carrying values of securities pledged to secure publicdeposits and other purposes were $984,380 or 12.6% of available for salesecurities.

 

28

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**Loan Portfolio**

 

The following table setsforth the components of total net loans outstanding in each category at thedate indicated (dollar amounts in thousands):

 
| ** **                                        | ** ** | **December** | ** ** |
|---------------------------------------------------|------------|--------------|------------|
| ** **                                        | ** ** | **2005**     | ** ** | **2004** | ** ** |
| **Loans**                                         |       |         |       |   |   |
| Commercial                                        |       | $            | 29,491     |   | $ | 29,430 |   |
| Real Estate - Construction                        |       | 25,213       |       | 17,432 |   |
| Real Estate - Other                               |       | 76,092       |       | 66,897 |   |
| Consumer                                          |       | 2,866        |       | 2,547 |   |
| Other                                             |       | 29           |       | — |   |
| **Total Loans**                                   |       | 133,691      |       | 116,306 |   |
| Net Deferred Loan Costs (Fees)                    |       | (460         | )          | (418 | ) |
| Allowance for Loan Losses                         |       | (1,183       | )          | (1,168 | ) |
| **Net Loans**                                     |       | $            | 132,048    |   | $ | 114,720 |   |
|                                              |       |         |       |   |   |
| **Commitments**                                   |       |         |       |   |   |
| Standby Letters of Credit                         |       | $            | 2,589      |   | $ | 1,674 |   |
| Undisbursed Loans and Commitments to Grant  Loans |       | 57,356       |       | 35,112 |   |
| **Total Commitments**                             |       | $            | 59,945     |   | $ | 36,786 |   |

 

**Risk Elements**

 

Bank management assesses andmanages credit risk on an ongoing basis through our lending policies.  The Bank strives to continue its historicallylow level of credit losses by continuing its emphasis on credit quality in theloan approval process, active credit administration and regularmonitoring.  However, inherent in thelending function is the fact that loan losses will be experienced and that therisk of loss will vary with the type of loan being made, the credit-worthinessof the borrower and the term of the loan. To reflect the currently perceived risks of loss associated with itsloan portfolio, additions are made to the Bank’s allowance for loanlosses.  The Bank’s entire allowance is avaluation allowance; that is, it has been created by direct charges againstoperations through the provision for loan losses.

 

Commitments to extend creditare agreements to lend to a customer as long as established conditions of thecontract have been met.  Standby Lettersof Credit are used to guarantee the performance of a customer to a third party.  Many of these commitments expire withoutbeing drawn upon.  These unfundedcommitments are included in risk based calculations and the effect is notmaterial.

 

In extending credit andcommitments to borrowers, the Bank generally requires collateral and/orguarantees as security.  The repayment ofsuch loans is expected to come from cash flow or from proceeds from the sale ofselected assets of the borrower.  Ourrequirement for collateral and/or guarantees is determined on a case-by-casebasis in connection with its evaluation of the credit worthiness of theborrower.  Collateral held varies but mayinclude accounts receivable, inventory, property, plant and equipment,income-producing properties, residences and other real property.  The Bank secures its collateral by perfectingits interest in business assets, obtaining deeds of trust, or outrightpossession among other means.

 

The Bank believes that itslending policies and underwriting standards will tend to minimize losses in aneconomic downturn, however, there is no assurance that losses will not occurunder such circumstances.

 

29

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The following table showsthe maturity distribution of the fixed rate portion of the loan portfolio inthe amount of $20,143.  (dollar amountsin 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                                             |       | $                     | 450        |                                   | $          | 186                                    |       | $                         | 542        |      | $          | 788 |   | $ | 1,966 |   |
| Real Estate - Construction                             |       | 3,443                 |       | 341                                    |       | —                                 |       | —                    |       | 3,784     |       |
| Real Estate - Other                                    |       | 1,846                 |       | 4,430                                  |       | 2,584                                  |       | 4,050                     |       | 12,910    |       |
| Consumer                                               |       | 334                   |       | 43                                     |       | 519                                    |       | 578                       |       | 1,474     |       |
| Other                                                  |       | —                |       | —                                 |       | 9                                      |       | —                    |       | 9         |       |
| Total Loans                                            |       | $                     | 6,073      |                                   | $          | 5,000                                  |       | $                         | 3,654      |      | $          | 5,416 |   | 20,143 |   |
|                                                   |       |                  |       |                                   |       |                                   |       |                      |       |      |       |
| Loans on Non-Accrual                                   |       |                  |       |                                   |       |                                   |       |                      |       | —    |       |
| Total Fixed Rate Loans, including Loans  Held for Sale |       |                  |       |                                   |       |                                   |       |                      |       | $         | 20,143     |   |

 

The following table showsthe maturity distribution of the variable rate portion of the loan portfolio atDecember 31, 2005 (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                                                |       | $                     | 26,570     |                                   | $          | 27                                     |       | $                         | 325        |      | $          | 588 |   | $ | 27,510 |   |
| Real Estate - Construction                                |       | 21,429                |       | —                                 |       | —                                 |       | —                    |       | 21,429    |       |
| Real Estate - Other                                       |       | 39,228                |       | 5,401                                  |       | 5,360                                  |       | 13,193                    |       | 63,182    |       |
| Consumer                                                  |       | 1,377                 |       | 15                                     |       | —                                 |       | —                    |       | 1,392     |       |
| Other                                                     |       | 20                    |       | —                                 |       | —                                 |       | —                    |       | 20        |       |
| Total Loans                                               |       | $                     | 88,624     |                                   | $          | 5,443                                  |       | $                         | 5,685      |      | $          | 13,781 |   | 113,533 |   |
|                                                      |       |                  |       |                                   |       |                                   |       |                      |       |      |       |
| Loans on Non-Accrual                                      |       |                  |       |                                   |       |                                   |       |                      |       | 15        |       |
| Total Variable Rate Loans, including Loans  Held for Sale |       |                  |       |                                   |       |                                   |       |                      |       | $         | 113,548    |   |

 

30

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**Non-performing Assets**

 

The following table providesinformation with respect to the components of our non-performing assets at thedates indicated (dollar amounts in thousands):

 
| ** **                                                       | ** ** | **For the Year Ended** | ** ** |
|------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                       | ** ** | **2005**               | ** ** | **2004** | ** ** |
| Loans 90 Days Past Due and Still Accruing                        |       | $                      | —     |   | $ | — |   |
| Non-Accrual Loans                                                |       | 15                     |       | — |   |
| Total Non-performing Loans                                       |       | $                      | 15         |   | $ | — |   |
|                                                             |       |                   |       |   |   |
| Other Real Estate Owned                                          |       | $                      | —     |   | $ | — |   |
| Total Non-performing Assets                                      |       | $                      | 15         |   | $ | — |   |
|                                                             |       |                   |       |   |   |
| Interest Foregone on Non-accrual Loans                           |       | $                      | —     |   | $ | — |   |
| Interest Earned on Non-accrual Loans                             |       | $                      | 1          |   | $ | — |   |
| Non-performing Loans as a Percentage of  Total Loans             |       | 0.01                   | %          | n/a |   |
| Allowance for Loan Loss as a Percentage of  Non-performing Loans |       | 7886.67                | %          | n/a |   |

 

As of December 31, 2005, theBank had no loans which are “troubled debt restructurings” as defined in thestatement of Financial Accounting Standards No. 15 (“SFAS 15”), “Accounting byDebtors and Creditors for Troubled Debt Restructurings.”

 

At December 31, 2005, inaddition to loans disclosed above as past due, non-accrual or restructured,management also identified several loans totaling $343,253, where the abilityto comply with present loan payment terms in the future is questionable.  However, the inability of the borrowers tocomply with repayment terms was not sufficiently probable to place the loan onnon-accrual status at December 31, 2005. This amount was determined based on analysis of information known tomanagement about the borrowers’ financial condition and current economicconditions.  Estimated potential lossesfrom these problem loans have been provided for in determining the allowancefor loan losses at December 31, 2005.

 

For reference, the Bank’sfinancial statements are prepared on the accrual basis of accounting, includingthe recognition of interest income on the loan portfolio.  The Bank follows the policy of non-accrual ofinterest 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 secured and in the processof collection.  Interest from non-accrualloans is not accrued on the books. Payments received while the loan is on non-accrual are typically appliedagainst principal.  When a loan is placedon a non-accrual basis, any previously accrued but unpaid interest is reversedand charged against current income unless there is adequate collateral toassure recovery of the accrued interest.

 

**Provision and Allowance for LoanLosses**

 

As previously discussedunder Critical Accounting Policies, the Allowance for Loan Losses representsmanagement’s best estimate of losses inherent in the existing loanportfolio.  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 thatneed 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.

 

The Bank made a contributionof $20,000 to the allowance for loan losses for the twelve months endedDecember 31, 2005, compared to $70,000 for the same period in 2004.  Management believes that the allowance, whichequals .885% of gross loans at December 31, 2005, is adequate to cover futurelosses.  The allowance at December 31,2004, was 1.00% of total loans.

 

31

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The provision for loanlosses charged against operations is based upon the actual net loan lossexpensed plus an amount for other such factors which, in management’s judgment,deserve recognition in estimating possible loan losses, including: specificloan conditions as determined by management and regulatory agencies, thehistorical relationship between charge-offs and the level of allowances, andprevailing economic conditions.  Whilethese factors are essentially judgmental and may not be reduced to amathematical formula, it is management’s view that the $1,182,766 allowance, or..88% of total loans at December 31, 2005, 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 current estimates.

 

The following tablesummarizes, for the years indicated, changes in the allowance for loan lossesarising from loans charged-off, recoveries on loans previously charged-off, andadditions to the allowance which have been charged to operating expenses andcertain ratios relating to the allowance for loan losses (dollar amounts inthousands):

 
| ** **                                                    | ** ** | **For the Year Ended  December 31,** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                    | ** ** | **2005**                             | ** ** | **2004** | ** ** |
| **Outstanding Gross Loans**                                   |       |                                 |       |   |   |
| Average for the Year                                          |       | $                                    | 126,087    |   | $ | 114,258 |   |
| End of the Year                                               |       | $                                    | 133,691    |   | $ | 116,306 |   |
|                                                          |       |                                 |       |   |   |
| **Allowance for Loan Losses:**                                |       |                                 |       |   |   |
| Balance at Beginning of Year                                  |       | $                                    | 1,168      |   | $ | 1,109 |   |
| Actual Charge-Offs:                                           |       |                                 |       |   |   |
| Commercial                                                    |       | —                               |       | 4 |   |
| Consumer                                                      |       | 5                                    |       | 15 |   |
| Real Estate                                                   |       | —                               |       | — |   |
| Total Charge-Offs                                             |       | 5                                    |       | 19 |   |
|                                                          |       |                                 |       |   |   |
| Less Recoveries:                                              |       |                                 |       |   |   |
| Commercial                                                    |       | —                               |       | 7 |   |
| Consumer                                                      |       | —                               |       | 1 |   |
| Real Estate                                                   |       | —                               |       | — |   |
| Total Recoveries                                              |       | —                               |       | 8 |   |
|                                                          |       |                                 |       |   |   |
| Net Loans Charged-Off                                         |       | 5                                    |       | 11 |   |
| Provision for Loan Losses                                     |       | 20                                   |       | 70 |   |
| Balance at End of Year                                        |       | $                                    | 1,183      |   | $ | 1,168 |   |
|                                                          |       |                                 |       |   |   |
| **Ratios:**                                                   |       |                                 |       |   |   |
| Net Loans Charged-Off to Average Loans                        |       | 0.00                                 | %          | 0.01 | % |
| Allowance for Loan Losses to Total Loans                      |       | 0.88                                 | %          | 1.00 | % |
| Net Loans Charged-Off to Beginning  Allowance for Loan Losses |       | 0.43                                 | %          | 0.99 | % |
| Net Loans Charged-Off to Provision for Loan  Losses           |       | 25.00                                | %          | 15.71 | % |
| Allowance for Loan Losses to Non-performing  Loans            |       | n/a                                  |       | n/a |   |

 

32

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The following tablesummarizes the allocation of the allowance for loan losses by loan type for theyears indicated and the percent of loans in each category to total loans(dollar amounts in thousands):

 
| ** **   | ** ** | **December 31,  2005** | ** ** | **December 31,  2004**                 | ** ** |
|--------------|------------|------------------------|------------|----------------------------------------|------------|
| ** **   | ** ** | **Amount**             | ** ** | **ALL as a  percentage of  Total ALL** | ** ** | **Percentage of  Loan  Category to  Total Loans** | ** ** | **Amount** | ** ** | **ALL as a  percentage  of Total  ALL** | ** ** | **Percentage  of Loan  Category to  Total Loans** | ** ** |
| Commercial   |       | $                      | 464        |                                   | 39.22      | % | 22 | % | $ | 574 |   | 49.14 | % | 25 | % |
| Construction |       | 126                    |       | 10.65                                  | %          | 19 | % | 78 |   | 6.68 | % | 15 | % |
| Real Estate  |       | 420                    |       | 35.50                                  | %          | 57 | % | 329 |   | 28.17 | % | 58 | % |
| Consumer     |       | 7                      |       | 0.59                                   | %          | 2 | % | 8 |   | 0.68 | % | 2 | % |
| Unallocated  |       | 166                    |       | 14.03                                  | %          | — |   | 179 |   | 15.33 | % | — |   |
|         |       | $                      | 1,183      |                                   | 100.00     | % | 100 | % | $ | 1,168 |   | 100.00 | % | 100 | % |

 

**Funding**

 

Deposits are our primarysource of funds.  At December 31, 2005,we had a deposit mix of 49.29% in time and savings deposits, 26.69% in money marketand NOW deposits, and 24.02% in non-interest-bearing demand deposits.  Our net interest income is enhanced by ourpercentage of non-interest-bearing deposits.

 

The following tablesummarizes the distribution of average deposits and the average rates paid forthe years indicated (dollar amounts in thousands):

 
| ** **                           | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|--------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                           | ** ** | **Average  Balance**   | ** ** | **Average  Rate**      | ** ** | **Average  Balance** | ** ** | **Average  Rate** | ** ** |
| Money Market and NOW Accounts        |       | $                      | 39,450     |                   | 1.73       | % | $ | 36,671 |   | 0.78 | % |
| Savings Deposits                     |       | 8,496                  |       | 0.93                   | %          | 7,458 |   | 0.64 | % |
| TCD less than $100,000               |       | 14,506                 |       | 2.49                   | %          | 17,007 |   | 1.66 | % |
| TCD $100,000 or more                 |       | 54,145                 |       | 3.08                   | %          | 41,422 |   | 1.98 | % |
| Total Interest-Bearing Deposits      |       | 116,597                |       | 2.39                   | %          | 102,558 |   | 1.37 | % |
|                                 |       |                   |       |                   |       |   |   |   |   |
| Non-Interest-Bearing Demand Deposits |       | 40,120                 |       | n/a                    |       | 36,780 |   | n/a |   |
| Total Average Deposits               |       | $                      | 156,717    |                   | 1.78       | % | $ | 139,338 |   | 1.03 | % |

 

The scheduled maturitydistribution of our time deposits of $100,000 or greater, as of December 31,2005, were as follows (dollar amounts in thousands):

 

|                           |   |   |   |
|--------------------------------|--------|--------|--------|
| Three months or less           |   | $      | 21,224 |   |
| Over three months to six moths |   | 13,748 |   |
| Over six months to one year    |   | 21,241 |   |
| Over one year to three years   |   | 2,471  |   |
|                           |   | $      | 58,984 |   |

 

33

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**Liquidity and Interest Rate****Sensitivity**

 

The objective of the Bank’sasset/liability strategy is to manage liquidity and interest rate risk toensure the safety and soundness of the Bank and its capital base, whilemaintaining adequate net interest margins and spreads to provide an appropriatereturn to our shareholders.

 

The Bank manages itsinterest rate risk exposure by limiting the amount of long-term fixed rateloans we hold for investment, by increasing emphasis on shorter-term, higheryield loans, and increasing or decreasing the relative amounts of deposits.

 

The table below sets forththe interest rate sensitivity of our interest-earning assets andinterest-bearing liabilities as of December 31, 2005, using the interest ratesensitivity gap ratio.  For purposes ofthe following table, an asset or liability is considered rate-sensitive withina specified period when it can be repriced or matures within its contractualterms, (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                           |       | 24,900                    |       | —                                        |       | —                                      |       | —                |       | 24,900    |       |
| Investment Securities and FRB Stock          |       | —                    |       | 5,781                                         |       | 3,014                                       |       | —                |       | 8,795     |       |
| Gross Loans                                  |       | 119,598                   |       | 5,006                                         |       | 4,869                                       |       | 4,218                 |       | 133,691   |       |
|                                         |       | $                         | 144,498    |                                          | $          | 10,787                                      |       | $                     | 7,883      |      | $          | 4,218 |   | $ | 167,386 |   |
|                                         |       |                      |       |                                          |       |                                        |       |                  |       |      |       |
| **Interest-Bearing Liabilities:**            |       |                      |       |                                          |       |                                        |       |                  |       |      |       |
| Money Market and NOW Deposits                |       | $                         | 45,092     |                                          | $          | —                                      |       | $                     | —     |      | $          | — |   | $ | 45,092 |   |
| Savings                                      |       | 8,856                     |       | —                                        |       | —                                      |       | —                |       | 8,856     |       |
| Time Deposits                                |       | 27,376                    |       | 44,451                                        |       | 2,589                                       |       | —                |       | 74,416    |       |
|                                         |       | $                         | 81,324     |                                          | $          | 44,451                                      |       | $                     | 2,589      |      | $          | — |   | $ | 128,364 |   |
|                                         |       |                      |       |                                          |       |                                        |       |                  |       |      |       |
| **Interest Rate Sensitivity Gap**            |       | $                         | 63,174     |                                          | $          | (33,664                                     | )          | $                     | 5,294      |      | $          | 4,218 |   | $ | 39,022 |   |
| **Cumulative Interest Rate Sensitivity Gap** |       | $                         | 63,174     |                                          | $          | 29,510                                      |       | $                     | 34,804     |      | $          | 39,022 |   | $ | 39,022 |   |
|                                         |       |                      |       |                                          |       |                                        |       |                  |       |      |       |
| **Ratios Based on Total Assets:**            |       |                      |       |                                          |       |                                        |       |                  |       |      |       |
| Interst Rate Sensitivity Gap                 |       | 36.52                     | %          | -19.46                                        | %          | 3.06                                        | %          | 2.44                  | %          | 22.56     | %          |
| Cumulative Interest Rate Sensitivity Gap     |       | 36.52                     | %          | 17.06                                         | %          | 20.12                                       | %          | 22.56                 | %          |      |       |

 

Liquidity refers to ourability to maintain a cash flow that is adequate to fund both on-balance sheetand off-balance sheet requirements 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.

 

It should also be noted thatduring 2002, the Bank began to institute interest rate floors on certainvariable rate loans.  Once the interestrates on these variable rate loans reach the floor rate, they temporarily takeon the attributes of a fixed rate loan. This action helps the Bank increase its net interest margin in adeclining rate environment as the rates of our interest-bearing liabilitiesfall.  However, when interest rates rise,the interest rates on our interest-bearing liabilities will also begin to risewhile the interest rates on those variable rate loans with floors will remainat the floor rate.  This may cause theBank’s net interest margins to temporarily shrink until the rates on thoseloans with interest rate floors rise above their floor rates.

 

Finally, the Bank feels thatit faces no material liquidity impact from the undisbursed loans in the loanportfolio.

 

34

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**Return on Equity and Assets**

 

The following table setsforth several key operating ratios for 2005 and 2004:

 
| ** **                                                 | ** ** | **For the Year Ended  December 31,** | ** ** |
|------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                 | ** ** | **2005**                             | ** ** | **2004** | ** ** |
| Return on Average Assets                                   |       | 0.63                                 | %          | 0.72 | % |
| Return on Average Equity                                   |       | 10.35                                | %          | 11.87 | % |
| Dividend Payout Ratio                                      |       | 10.67                                | %          | 8.67 | % |
| Average Stockholder’s Equity to Average  Total Assets |       | 6.13                                 | %          | 6.09 | % |

 

**Capital Resources**

 

Shareholders’ equity atDecember 31, 2005 was $11.2 million, an increase of $1.3 million or 13.1% over$9.9 million at December 31, 2004. Average shareholders’ equity for 2005 was $10.6 million, compared to$9.4 million in 2004.  Shareholders’equity increased primarily from net income of $1,097,866 in 2005.

 

In 1990, the bankingindustry began to phase in new regulatory capital adequacy requirements basedon risk-adjusted assets.  Theserequirements take into consideration the risk inherent in investments, loans,and other assets for both on-balance sheet and off-balance sheet items.  Under these requirements, the regulatoryagencies have set minimum thresholds for Tier 1 Capital, Total Capital and Leverageratios.  At December 31, 2005, the Bank’scapital exceeded the Tier 1 Capital, Total Capital and Leverage ratio’s minimumregulatory requirements.  The Bank wasconsidered to be well-capitalized at December 31, 2005, as defined in theregulations issued by the OCC.  The Bank’srisk-based capital ratios, shown below as of December 31, 2005, have beencomputed in accordance with regulatory accounting policies.  The Bancorp is also subject to capitalrequirements that are within well-capitalized ranges as defined by the FederalReserve Bank.

 
| ** **                      | ** ** | **Requirement**             | ** ** | **Actual**            | ** ** |
|---------------------------------|------------|-----------------------------|------------|-----------------------|------------|
| ** **                      | ** ** | **Adequately  Capitalized** | ** ** | **Well  Capitalized** | ** ** | **Bank** | ** ** | **Company** | ** ** |
| Total risk-based capital ratio  |       | 8.00                        | %          | 10.00                 | %          | 11.52 | % | 11.73 | % |
| Tier 1 risk-based capital ratio |       | 4.00                        | %          | 6.00                  | %          | 10.70 | % | 10.04 | % |
| Tier 1 leverage capital ratio   |       | 4.00                        | %          | 5.00                  | %          | 8.75 | % | 8.61 | % |

 

**Effects of Inflation**

 

The financial statements andrelated financial information presented herein have been prepared in accordancewith GAAP, which require the measurement of financial position and operatingresults in terms of historical dollars without considering changes in therelative purchasing power of money over time due to inflation.  Unlike most industrial companies, virtuallyall of the assets and liabilities of a financial institution are monetary innature.  As a result, interest rates havea more significant impact on a financial institution’s performance than theeffects of general levels of inflation. Interest rates do not necessarily move in the same direction or samemagnitude as the price of goods and services.

 

**Item 7.       Financial Statements are presented on the following pages.**

 

35

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

 

**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FRIM**

 

 

Board of Directors and Stockholders of

Coast Bancorp and Subsidiary

 

We have audited the accompanying consolidatedbalance sheets of Coast Bancorp and Subsidiary as of December 31, 2005 and 2004and the related consolidated statements of income, changes in stockholders’equity, and cash flows for the years then ended.  These consolidated financial statements arethe responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financialstatements based on our audits.

 

We conducted our audits inaccordance with the standards of the Public Company Accounting OversightBoard  (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 consolidatedfinancial statements referred to above present fairly, in all materialrespects, the financial position of Coast Bancorp and Subsidiary as of December31, 2005 and 2004, and the results of its operations and its cash flows foreach of the years then ended, in conformity with accounting principlesgenerally accepted in the United States of America.

 

 

Laguna Hills, California

January 18, 2006

 

 

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

 

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

 

36

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**COASTBANCORP AND SUBSIDIARY**

 

# **CONSOLIDATED BALANCE SHEETS**

 

**December 31, 2005 and 2004**

 
| ** **                                                                                                                                             | ** ** | **2005**    | ** **  | **2004**    | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------|-------------|-------------|------------|
| **ASSETS**                                                                                                                                             |       |        |        |        |       |
| Cash and due from banks                                                                                                                                |       | $           | 9,769,801   |        | $          | 8,639,823 |   |
| Federal funds sold                                                                                                                                     |       | 24,900,000  |        | 12,050,000  |       |
| **TOTAL  CASH AND CASH EQUIVALENTS**                                                                                                                   |       | 34,669,801  |        | 20,689,823  |       |
|                                                                                                                                                   |       |        |        |        |       |
| Investment securities available for sale                                                                                                               |       | 7,872,170   |        | 12,866,593  |       |
|                                                                                                                                                   |       |        |        |        |       |
| Loans:                                                                                                                                                 |       |        |        |        |       |
| Commercial                                                                                                                                             |       | 29,490,713  |        | 29,429,545  |       |
| Real estate - construction                                                                                                                             |       | 25,212,724  |        | 17,432,127  |       |
| Real estate - other                                                                                                                                    |       | 76,092,314  |        | 66,896,995  |       |
| Consumer                                                                                                                                               |       | 2,866,350   |        | 2,547,526   |       |
| Other                                                                                                                                                  |       | 29,199      |        | —      |       |
| **TOTAL  LOANS**                                                                                                                                       |       | 133,691,300 |        | 116,306,193 |       |
| Net deferred loan fees                                                                                                                                 |       | (460,506    | )           | (417,530    | )          |
| Allowance for credit losses                                                                                                                            |       | (1,182,766  | )           | (1,168,423  | )          |
| **NET  LOANS**                                                                                                                                         |       | 132,048,028 |        | 114,720,240 |       |
| Premises and equipment                                                                                                                                 |       | 8,314,102   |        | 8,728,512   |       |
| Deferred taxes                                                                                                                                         |       | 329,000     |        | 360,000     |       |
| Federal Reserve Bank and Federal Home Loan  Bank stock, at cost                                                                                        |       | 922,850     |        | 883,450     |       |
| Accrued interest and other assets                                                                                                                      |       | 1,568,151   |        | 1,665,851   |       |
| **TOTAL  ASSETS**                                                                                                                                      |       | $           | 185,724,102 |        | $          | 159,914,469 |   |
|                                                                                                                                                   |       |        |        |        |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                         |       |        |        |        |       |
| Deposits:                                                                                                                                              |       |        |        |        |       |
| Noninterest-bearing demand                                                                                                                             |       | $           | 40,583,198  |        | $          | 39,660,938 |   |
| Money market and NOW                                                                                                                                   |       | 45,092,195  |        | 37,043,006  |       |
| Savings                                                                                                                                                |       | 8,855,855   |        | 8,785,046   |       |
| Time deposits of $100,000 or more                                                                                                                      |       | 58,983,932  |        | 44,491,705  |       |
| Other time deposits                                                                                                                                    |       | 15,434,000  |        | 14,483,606  |       |
| **TOTAL  DEPOSITS**                                                                                                                                    |       | 168,949,180 |        | 144,464,301 |       |
| Notes payable                                                                                                                                          |       | 44,659      |        | 105,725     |       |
| Junior subordinated debt securities                                                                                                                    |       | 5,155,000   |        | 5,155,000   |       |
| Other liabilities                                                                                                                                      |       | 332,212     |        | 216,521     |       |
| **TOTAL  LIABILITIES**                                                                                                                                 |       | 174,481,051 |        | 149,941,547 |       |
| Commitments and contingencies - Notes # 4  and #12                                                                                                     |       | —      |        | —      |       |
| Stockholders’ equity:                                                                                                                             |       |        |        |        |       |
| Preferred stock - 10,000,000 authorized,  none outstanding                                                                                             |       | —      |        | —      |       |
| Common stock no par value; 10,000,000  shares authorized; issued and outstanding:674,100 in 2005 and 652,700 in 2004                                   |       | 6,950,072   |        | 6,641,100   |       |
| Retained earnings                                                                                                                                      |       | 4,372,542   |        | 3,392,643   |       |
| Accumulated other comprehensive income -  net unrealized losses on available-for-sale securities, net of taxes of  $55,289 in 2005 and $42,265 in 2004 |       | (79,563     | )           | (60,821     | )          |
| **TOTAL  STOCKHOLDERS’ EQUITY**                                                                                                                   |       | 11,243,051  |        | 9,972,922   |       |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                   |       | $           | 185,724,102 |        | $          | 159,914,469 |   |

 

The accompanying notes are an integral part of theseconsolidated financial statements.

 

37

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**COASTBANCORP AND SUBSIDIARY**

 

**CONSOLIDATEDSTATEMENTS OF INCOME**

 

**For theYears Ended December 31, 2005 and 2004**

 
| ** **                                                         | ** ** | **2005**   | ** ** | **2004**  | ** ** |
|--------------------------------------------------------------------|------------|------------|------------|-----------|------------|
| **INTEREST INCOME**                                                |       |       |       |      |       |
| Interest and fees on loans                                         |       | $          | 9,981,156  |      | $          | 7,823,425 |   |
| Interest on investment securities                                  |       | 306,861    |       | 190,341   |       |
| Interest on federal funds sold                                     |       | 561,485    |       | 185,668   |       |
| Other interest income                                              |       | 53,999     |       | 40,121    |       |
| **TOTAL  INTEREST INCOME**                                         |       | 10,903,501 |       | 8,239,555 |       |
| **INTEREST EXPENSE**                                               |       |       |       |      |       |
| Interest on money market and NOW accounts                          |       | 681,367    |       | 284,705   |       |
| Interest on savings deposits                                       |       | 78,902     |       | 48,228    |       |
| Interest on time deposits                                          |       | 2,027,805  |       | 1,102,975 |       |
| Interest on junior subordinated debt  securities                   |       | 380,392    |       | 285,669   |       |
| Interest on other borrowings                                       |       | 2,826      |       | 5,222     |       |
| **TOTAL  INTEREST EXPENSE**                                        |       | 3,171,292  |       | 1,726,799 |       |
| **NET  INTEREST INCOME**                                           |       | 7,732,209  |       | 6,512,756 |       |
| Provision for credit losses                                        |       | 20,000     |       | 70,000    |       |
| **NET  INTEREST INCOME AFTER**                                     |       |       |       |      |       |
| **PROVISION  FOR CREDIT LOSSES**                                   |       | 7,712,209  |       | 6,442,756 |       |
| **NONINTEREST INCOME**                                             |       |       |       |      |       |
| Service charges on deposits accounts and  other noninterest income |       | 252,266    |       | 291,144   |       |
| Gain on sale of loans and servicing fees                           |       | 193,699    |       | 1,025,657 |       |
| Mortgage packaging fees                                            |       | 75,927     |       | 107,555   |       |
| Gain on sale of premises and equipment                             |       | 53,016     |       | —    |       |
| Gain on sale of securities                                         |       | —     |       | 43,364    |       |
| **TOTAL  NONINTEREST INCOME**                                      |       | 574,908    |       | 1,467,720 |       |
| **NONINTEREST EXPENSE**                                            |       |       |       |      |       |
| Salaries and benefits                                              |       | 3,539,906  |       | 3,366,193 |       |
| Net occupancy expenses                                             |       | 488,667    |       | 401,319   |       |
| Equipment expenses                                                 |       | 324,389    |       | 273,204   |       |
| Data processing                                                    |       | 370,235    |       | 386,531   |       |
| Director fees and expenses                                         |       | 121,586    |       | 114,531   |       |
| Insurance                                                          |       | 63,461     |       | 60,130    |       |
| Marketing and business promotion                                   |       | 614,705    |       | 411,845   |       |
| Other professional expenses                                        |       | 233,870    |       | 321,353   |       |
| Office expenses                                                    |       | 225,450    |       | 219,116   |       |
| Regulatory assessments                                             |       | 79,550     |       | 73,617    |       |
| Other expenses                                                     |       | 288,558    |       | 305,976   |       |
| **TOTAL  NONINTEREST EXPENSE**                                     |       | 6,350,377  |       | 5,933,815 |       |
| **INCOME  BEFORE INCOME TAXES**                                    |       | 1,936,740  |       | 1,976,661 |       |
| Income taxes                                                       |       | 838,874    |       | 861,632   |       |
| **NET  INCOME**                                                    |       | $          | 1,097,866  |      | $          | 1,115,029 |   |
| **Per Share Data**                                                 |       |       |       |      |       |
| Net income - basic                                                 |       | $          | 1.64       |      | $          | 1.73 |   |
| Net income - diluted                                               |       | $          | 1.56       |      | $          | 1.58 |   |

 

The accompanying notes are anintegral part of these consolidated financial statements.

 

38

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**COASTBANCORP AND SUBSIDIARY**

 

**CONSOLIDATEDSTATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY**

 

**For theYears Ended December 31, 2005 and 2004**

 
| ** **                                                                                   | ** ** | **Shares  Outstanding** | ** ** | **Common  Stock** | ** ** | **Comprehensive  Income** | ** ** | **Retained  Earnings** | ** ** | **Accumulated  Other  Comprehensive  Income** | ** ** | **Total** | ** ** |
|----------------------------------------------------------------------------------------------|------------|-------------------------|------------|-------------------|------------|---------------------------|------------|------------------------|------------|-----------------------------------------------|------------|-----------|------------|
|                                                                                         |       |                    |       |              |       |                      |       |                   |       |                                          |       |      |       |
| **Balance, January 1, 2004**                                                                 |       | 638,300                 |       | $                 | 6,407,275  |                      |       |                   | $          | 2,374,769                                     |       | $         | 30,488     |   | $ | 8,812,532 |   |
|                                                                                         |       |                    |       |              |       |                      |       |                   |       |                                          |       |      |       |
| Exercise of stock options 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 |       |
|                                                                                         |       |                    |       |              |       |                      |       |                   |       |                                          |       |      |       |
| Exercise of stock options including the  realization of tax benefits of $22,417              |       | 21,400                  |       | 308,972           |       |                      |       |                   |       |                                          |       | 308,972   |       |
| Cash dividends                                                                               |       |                    |       |              |       |                      |       | (117,967               | )          |                                          |       | (117,967  | )          |
| **Comprehensive income:**                                                                    |       |                    |       |              |       |                      |       |                   |       |                                          |       |      |       |
| Net income                                                                                   |       |                    |       |              |       | 1,097,866                 |       | 1,097,866              |       |                                          |       | 1,097,866 |       |
| Unrealized losses on available-for-sale  securities, net of taxes of $13,024                 |       |                    |       |              |       | (18,742                   | )          |                   |       | (18,742                                       | )          | (18,742   | )          |
| **Total comprehensive income**                                                               |       |                    |       |              |       | $                         | 3,126,564  |                   |       |                                          |       |      |       |   |
|                                                                                         |       |                    |       |              |       |                      |       |                   |       |                                          |       |      |       |
| **Balance, December 31, 2005**                                                               |       | 674,100                 |       | $                 | 6,950,072  |                      |       |                   | $          | 4,372,542                                     |       | $         | (79,563    | ) | $ | 11,243,051 |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

39

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# **COAST BANCORP AND SUBSIDIARY**

 

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

 

**For theYears Ended December 31, 2005 and 2004**

 
| ** **                                                               | ** ** | **2005**    | ** ** | **2004**    | ** ** |
|--------------------------------------------------------------------------|------------|-------------|------------|-------------|------------|
| **OPERATING ACTIVITIES**                                                 |       |        |       |        |       |
| Net income                                                               |       | $           | 1,097,866  |        | $          | 1,115,029 |   |
| Adjustments to reconcile net income to net  cash provided by operations: |       |        |       |        |       |
| Depreciation and amortization                                            |       | 502,221     |       | 408,651     |       |
| Provision for credit losses                                              |       | 20,000      |       | 70,000      |       |
| Realized gains in available-for-sale  securities                         |       | —      |       | (43,364     | )          |
| Gain on sale of loans                                                    |       | (146,353    | )          | (865,282    | )          |
| Gain on sale of premises and equipment                                   |       | (53,016     | )          | —      |       |
| Other, net                                                               |       | 451,053     |       | 117,942     |       |
| **NET CASH  PROVIDED BY OPERATING ACTIVITIES**                           |       | 1,871,771   |       | 802,976     |       |
| **INVESTING ACTIVITIES**                                                 |       |        |       |        |       |
| Net increase in loans                                                    |       | (18,894,159 | )          | (17,445,684 | )          |
| Proceeds from loans sold                                                 |       | 1,649,748   |       | 9,564,946   |       |
| Purchase of available-for-sale securities                                |       | —      |       | (8,017,175  | )          |
| Purchase of Federal Reserve Bank and  Federal Home Loan Bank stock       |       | (39,400     | )          | (454,600    | )          |
| Proceeds from sale of available-for-sale  securities                     |       | —      |       | 5,094,101   |       |
| Proceeds from maturities of  available-for-sale securities               |       | 4,950,000   |       | 2,000,000   |       |
| Proceeds from the sale of premises and  equipment                        |       | 404,161     |       | —      |       |
| Purchase of premises and equipment                                       |       | (426,299    | )          | (2,046,155  | )          |
| **NET CASH  USED IN INVESTING ACTIVITIES**                               |       | (12,355,949 | )          | (11,304,567 | )          |
| **FINANCING ACTIVITIES**                                                 |       |        |       |        |       |
| Net increase in demand deposits and savings  accounts                    |       | 8,914,013   |       | 8,083,851   |       |
| Net increase in time deposits                                            |       | 15,442,621  |       | 8,357,052   |       |
| Principal payments on notes payable                                      |       | (61,066     | )          | (58,662     | )          |
| Payments for dividends                                                   |       | (117,967    | )          | (97,155     | )          |
| Proceeds from exercise of stock options                                  |       | 286,555     |       | 233,825     |       |
| **NET CASH  PROVIDED BY FINANCING ACTIVITIES**                           |       | 24,464,156  |       | 16,518,911  |       |
|                                                                     |       |        |       |        |       |
| **INCREASE  IN CASH AND CASH EQUIVALENTS**                               |       | 13,979,978  |       | 6,017,320   |       |
| Cash and cash equivalents at beginning of  period                        |       | 20,689,823  |       | 14,672,503  |       |
| Cash and cash equivalents at end of period                               |       | $           | 34,669,801 |        | $          | 20,689,823 |   |
|                                                                     |       |        |       |        |       |
| **Supplemental disclosure of cash flow  information**                    |       |        |       |        |       |
| Interest paid                                                            |       | $           | 3,094,515  |        | $          | 1,723,216 |   |
| Income taxes paid                                                        |       | $           | 695,000    |        | $          | 902,710 |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

40

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**COASTBANCORP AND SUBSIDIARY**

 

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

 

**December31, 2005 and 2004**

 

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

 

### **Principles ofConsolidation**

 

The financial statements include the accounts of Coast Bancorp and itswholly owned subsidiary, Coast National Bank (“Bank”), collectively referred toherein as the “Company.”  All significantintercompany transactions have been eliminated.

 

*Natureof Operations*

 

CoastBancorp operates Coast National Bank. The Bank has been organized as a single operating segment and operatesfive branches in San Luis Obispo, Arroyo Grande, Morro Bay, Los Osos, and PasoRobles, California and two loan production offices in Santa Maria and Fresno,California.  The Bank’s primary source ofrevenue is providing loans to customers, who are predominantly small andmiddle-market businesses and individuals.

 

*Use ofEstimates 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.

 

### **Presentationof Cash Flows**

 

For the purposes of reporting cash flows, cash and cash equivalentsincludes cash, noninterest-earning deposits and federal funds sold.  Generally, federal funds are sold for one dayperiods.

 

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

 

Banking regulations require that all banks maintain a percentage oftheir deposits as reserves in cash or on deposit with the Federal ReserveBank.  The Bank complied with the reserverequirements as of December 31, 2005.

 

The Company maintains amounts due from banks which exceed federallyinsured limits.  The Company has notexperienced any losses in such accounts.

 

### **Investment Securities**

 

Bonds, notes, and debentures for which the Company has the positiveintent and ability to hold to maturity are reported at cost, adjusted forpremiums and discounts that are recognized in interest income using the interestmethod over the period to maturity.

 

41

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Investments not classified as tradingsecurities nor as held to maturity securities are classified asavailable-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 incomeincluded in stockholders’ equity. Premiums or discounts on held-to-maturity and available-for-salesecurities are amortized or accreted into income using the interestmethod.  Realized gains or losses onsales of held-to-maturity or available-for-sale securities are recorded usingthe specific identification method.

 

Declines in the fair value of individualheld-to-maturity and available-for-sale securities below their cost that areother-than-temporary result in write-downs of the individual securities totheir fair value.  The related write-downs are included in earnings asrealized losses.  In estimating other-than-temporary impairment losses,management considers the length of time and the extent to which the fair valuehas been less than cost, the financial condition and near-term prospects of theissuer, and the intent and ability of the Bank to retain its investment in theissuer for a period of time sufficient to allow for any anticipated recovery infair value.

 

### **Loans**

 

Loans receivable that management has the intent and ability to hold forthe foreseeable 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.

 

Loan origination fees and certain direct origination costs arecapitalized and recognized as an adjustment of the yield of the related loan.

 

Loans on which the accrual of interest has been discontinued aredesignated as nonaccrual loans.  Theaccrual of interest on loans is discontinued when principal or interest is pastdue 90 days 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,all interest 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.

 

The Company considers a loan to be impaired when it is probable thatthe Company will be unable to collect all amounts due (principal and interest)according to the contractual terms of the loan agreement.  Measurement of impairment is based on theexpected future cash flows of an impaired loan which are to be discounted atthe loan’s effective interest rate, or measured by reference to an observablemarket value, if one exists, or the fair value of the collateral for acollateral-dependent loan.  The Companyselects the measurement method on a loan-by-loan basis except thatcollateral-dependent loans for which foreclosure is probable are measured atthe fair value of the collateral.  TheCompany recognizes interest income on impaired loans based on its existingmethods of recognizing interest income on nonaccrual loans.

 

42

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For impairment recognized in accordance with Financial AccountingStandards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”)No. 114, *“Accounting by Creditors for Impairment of a Loan,”*as amended by SFAS No. 118, the entire change in the present value of expectedcash flows is reported as either provision for credit losses in the same mannerin which impairment initially was recognized, or as a reduction in the amountof provision for credit losses that otherwise would be reported.

 

The Company has adopted SFAS No. 140, *“Accountingfor Transfers and Servicing of Financial Assets and Extinguishments ofLiabilities.”*  The Statementprovides accounting and reporting standards for transfers and servicing offinancial assets and extinguishments of liabilities.  Under this Statement, after a transfer offinancial assets, an entity recognizes the financial and servicing assets itcontrols and liabilities it has incurred, derecognizes financial assets whencontrol has been surrendered, and derecognizes liabilities when extinguished.

 

To calculate the gain (loss) on sale of loans, the Company’s investmentin the loan is allocated among the retained portion of the loan, the servicingretained, the interest-only strip and the sold portion of the loan, based onthe relative fair market value of each portion. The gain (loss) on the sold portion of the loan is recognized at thetime of sale based on the difference between the sale proceeds and theallocated investment.  As a result of therelative fair 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.

 

*Provisionand 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**

 

Land is carried at cost. Premises and equipment are carried at cost less accumulated depreciationand amortization.

Depreciation is computed using the straight-line method over theestimated useful lives, which ranges from three to ten years for furniture andfixtures and forty years for buildings. Leasehold improvements are amortized using the straight-line method overthe estimated useful lives of the improvements or the remaining lease term,whichever is shorter.  Expenditures forbetterments or major repairs are capitalized and those for ordinary repairs andmaintenance are charged to operations as incurred.

 

43

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### ** **

### **AdvertisingCosts**

 

TheCompany expenses the costs of advertising in the period incurred.

 

### **Income Taxes**

 

Deferred income taxes are computed using theasset and liability method, which recognizes a liability or asset representingthe tax effects, based on current tax law, of future deductible or taxableamounts attributable to events that have been recognized in the consolidatedfinancial statements.  A valuation allowanceis established to reduce the deferred tax asset to the level at which it is “morelikely than not” that the tax asset or benefits will be realized.  Realization of tax benefits of deductibletemporary differences and operating loss carry forwards depends on havingsufficient taxable income of an appropriate character within the carry forwardperiods.

### ** **

### **Disclosure About Fair Value of FinancialInstruments**

 

SFAS No. 107 specifies the disclosure of theestimated fair value of financial instruments. The Company’s estimated fair value amounts have been determined by theCompany using available market information and appropriate valuationmethodologies.

 

However, considerable judgment is required todevelop the estimates of fair value. Accordingly, the estimates are not necessarily indicative of the amountsthe Company could have realized in a current market exchange.  The use of different market assumptionsand/or estimation methodologies may have a material effect on the estimatedfair value amounts.

 

Although management is not aware of any factorsthat would significantly affect the estimated fair value amounts, such amountshave not been comprehensively revalued for purposes of these financialstatements since the balance sheet date and, therefore, current estimates offair value may differ significantly from the amounts presented in theaccompanying notes.

 

### **Comprehensive Income**

 

Beginning in 1998, the Company adopted SFAS No. 130, *“Reporting Comprehensive Income,”* which requires thedisclosure of comprehensive income and its components.  Changes in unrealized gains (losses) onavailable-for-sale securities net of income taxes is the only component ofaccumulated other comprehensive income for the Company.

 

*FinancialInstruments*

 

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, as described in Note #12. Such financial instruments are recorded in the consolidated financialstatements when they are funded or related fees are incurred or received.

 

44

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*EarningsPer Share (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**

 

SFAS No. 123*, “Accounting forStock-Based Compensation,”* encourages, but does not require,companies to record compensation cost for stock-based employee compensationplans at fair value.  The Company haschosen to continue to account for stock-based compensation using the intrinsicvalue method prescribed in Accounting Principles Board (“APB”) Opinion No. 25, *“Accounting for Stock Issued to Employees,”* and relatedInterpretations.  Accordingly,compensation cost for stock options is measured as the excess, if any, of thequoted market price of the Company’s stock at the date of the grant over theamount an employee must pay to acquire the stock.

 

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 2005 and 2004 to the pro forma amounts indicatedbelow:

 
| ** **                                                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Net income:                                                                                     |       |     |       |     |       |
| As reported                                                                                     |       | $        | 1,097,866  |     | $          | 1,115,029 |   |
| Stock-based compensation using the  intrinsic value method                                      |       | —   |       | —   |       |
| Stock-based compensation that would have  been reported using the fair value method of SFAS 123 |       | (36,247  | )          | (68,335  | )          |
| Pro forma net income                                                                            |       | $        | 1,061,619  |     | $          | 1,046,694 |   |
|                                                                                            |       |     |       |     |       |
| Basic  earnings per share:                                                                      |       |     |       |     |       |
| As reported                                                                                     |       | $        | 1.64       |     | $          | 1.73 |   |
| Pro forma                                                                                       |       | 1.59     |       | 1.63     |       |
|                                                                                            |       |     |       |     |       |
| Diluted  earnings per share:                                                                    |       |     |       |     |       |
| As reported                                                                                     |       | $        | 1.56       |     | $          | 1.58 |   |
| Pro forma                                                                                       |       | 1.55     |       | 1.53     |       |

 

45

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*CurrentAccounting Pronouncements*

 

In December 2004, Financial Accounting Standards Board (“FASB”) revisedSFAS 123 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.

 

The Company must adopt this Statement in 2006for all new stock option awards as well as any existing awards that aremodified, repurchased or cancelled.  Inaddition, the unvested portion of previously awarded options will also berecognized as expense.  The Company isunable to estimate the impact of this Statement on its financial condition andresults of operations as the decision to grant option awards is made annuallyon a case-by-case basis and, accordingly, the Company cannot estimate theamount of stock awards that will be made in 2006.  However, for stock options outstanding as ofDecember 31, 2005, the compensation expense related to shares vesting in 2006will be approximately $68,000, disregarding any future forfeitures.

## ** **

## ***Reclassification***

## ** **

## **Certain reclassifications have been made in the 2004consolidated financial statements to conform to the presentation used in2005.  These classifications are of anormal recurring nature.**

 

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

 

Amortizedcost and market values of securities are as follows:

 

 
| ** **                      | ** ** | **December 31, 2005** | ** ** |
|---------------------------------|------------|-----------------------|------------|
| ** **                      | ** ** | **Amortized  Cost**   | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Market  Value** | ** ** |
| Available-for-sale  securities: |       |                  |       |   |   |   |   |   |   |
| U.S. Agency securities          |       | $                     | 8,007,022  |   | $ | — |   | $ | (134,852 | ) | $ | 7,872,170 |   |
|                                 |            |                       |            |  |  |  |  |  |  |  |  |  |  |

 
|                            |       | **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 securities          |       | 11,971,226                      |       | — |   | (98,413 | ) | 11,872,813 |   |
|                            |       | $                               | 12,969,679 |   | $ | — |   | $ | (103,086 | ) | $ | 12,866,593 |   |

 

46

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Securitieswith a carrying value of $984,380 and $989,334 at December 31, 2005 and 2004,respectively, were pledged to secure public monies as required by law.

 

Gross realized gains on sales ofavailable-for-sale securities were $0 in 2005 and $43,364 in 2004.

 

Theamortized cost and fair values of investment securities available for sale atDecember 31, 2005, by expected maturities are shown below.  Expected maturities may differ fromcontractual maturities because borrowers may have the right to call or prepayobligations with or without call or prepayment penalties.

 

Security maturities are as follows:

 
| ** **                      | ** ** | **Securities  Available for Sale** | ** ** |
|---------------------------------|------------|------------------------------------|------------|
| ** **                      | ** ** | **Amortized  Cost**                | ** ** | **Fair Value** | ** ** |
|                            |       |                               |       |   |   |
| Due in one year or less         |       | $                                  | 4,991,864  |   | $ | 4,920,290 |   |
| Due from one year to five years |       | 3,015,158                          |       | 2,951,880 |   |
|                            |       | $                                  | 8,007,022  |   | $ | 7,872,170 |   |

 

Securities with unrealized losses are as follows:

 
| ** **             | ** ** | **December 31, 2005**       | ** ** |
|------------------------|------------|-----------------------------|------------|
| ** **             | ** ** | **Less than Twelve Months** | ** ** | **Over Twelve Months** | ** ** | **Total** | ** ** |
| ** **             | ** ** | **Unrealized  Losses**      | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
|                   |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| U.S. Agency securities |       | $                           | —     |   | $ | — |   | $ | 134,852 |   | $ | 7,872,170 |   | $ | 134,852 |   | $ | 7,872,170 |   |
|                        |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Management evaluates investment securities forother-than-temporary impairment taking into consideration the extent and lengthof time the fair value has been less than cost, the financial condition of theissuer and whether the Company has the intent and ability to retain theinvestment for a period of time sufficient to allow for any anticipatedrecovery in fair value.  As of December 31, 2005, no declines are deemed tobe other than temporary.

 

47

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**NOTE #3- LOANS**

 

TheCompany’s loan portfolio consists primarily of loans to borrowers within SanLuis Obispo, Santa Maria and Bakersfield, California and its surrounding communities.  Although the Company seeks to avoidconcentrations of loans to a single industry or based upon a single class ofcollateral, real estate and real estate associated businesses are among theprincipal industries in the Company’s market area and, as a result, the Company’sloan and collateral portfolios are, to some degree, concentrated in thoseindustries.

 

The Company alsooriginated SBA loans and other governmental guaranteed loans for sale which itperiodically sells to governmental 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.

 

The Company was servicing approximately $15,345,000 and $21,821,000 inloans previously sold as of December 31, 2005 and 2004, respectively.  The Company has recorded servicing assetsrelated to these loans totaling $246,986 and $419,086 as of December 31, 2005and 2004, respectively.  A summary of thechanges in the related servicing assets and interest-only strips receivable areas follows:

 
| ** **                                    | ** ** | **Servicing Assets** | ** ** |
|-----------------------------------------------|------------|----------------------|------------|
| ** **                                    | ** ** | **2005**             | ** ** | **2004** | ** ** |
| Balance, beginning of year                    |       | $                    | 419,086    |   | $ | 236,931 |   |
| Increase from loan sales                      |       | 26,467               |       | 282,254 |   |
| Amortization charged to income                |       | (110,941             | )          | (91,700 | ) |
| Decrease from loan payoffs charged to  income |       | (87,626              | )          | (8,399 | ) |
| Balance, end of year                          |       | $                    | 246,986    |   | $ | 419,086 |   |

 

The estimated fair value of the servicing assets approximated thecarrying amount at December 31, 2005 and 2004. Fair value is estimated by discounting estimated future cash flows fromthe servicing assets using discount rates that approximate current market ratesover the expected lives of the loans being serviced.  Management has estimated the expected life ofthese loans to be approximately 25% to 30% of the remaining life at the time ofsale.  For purposes of measuringimpairment, the Bank has identified each servicing asset and interest-onlystrip with the underlying loan being serviced. The only loans that are sold and serviced by the Bank are governmentguaranteed loans.  The riskcharacteristics of these underlying assets are considered when the discount ratesare determined for purposes of impairment testing.  A valuation allowance is recorded where thefair value is below the carrying amount of the asset.  At December 31, 2005 and 2004, the estimatedfair value of the servicing asset and the interest-only strip approximated thecarrying amount, so no valuation account has been established.

 

48

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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 hadinterest-only strips of $65,955 and $86,592 as of December 31, 2005 and 2004,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.

 
| ** **                                     | ** ** | **Interest-Only Strips Receivable** | ** ** |
|------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                     | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| Balance, beginning of year                     |       | $                                   | 86,592     |   | $ | 75,607 |   |
| Increase from loan sales                       |       | 16,896                              |       | 26,768 |   |
| Amortization charged to income                 |       | (20,527                             | )          | (15,783 | ) |
| Decreases from loan payoffs charged to  income |       | (17,006                             | )          | — |   |
| Balance, end of year                           |       | $                                   | 65,955     |   | $ | 86,592 |   |

 

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:

 
| ** **                           | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------|------------|----------|------------|----------|------------|
| Balance, beginning of year           |       | $        | 1,168,423  |     | $          | 1,108,717 |   |
| Provision for credit losses          |       | 20,000   |       | 70,000   |       |
| Loans charged off, net of recoveries |       | (5,657   | )          | (10,294  | )          |
| Balance, end of year                 |       | $        | 1,182,766  |     | $          | 1,168,423 |   |

 

The following is a summary of the investment in impaired loans, therelated allowance for loan losses, income recognized thereon and informationpertaining to nonaccrual and past due loans as of December 31:

 
| ** **                                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                         |       |     |       |     |       |
| Recorded investment in impaired loans                        |       | $        | 15,187     |     | $          | — |   |
| Related allowance for loan losses                            |       | $        | —     |     | $          | — |   |
| Average recorded investment in impaired  loans               |       | $        | 6,250      |     | $          | 11,000 |   |
| Interest income recognized for cash  payments                |       | $        | —     |     | $          | — |   |
| Total nonaccrual loans                                       |       | $        | 15,187     |     | $          | — |   |
| Total loans past-due ninety days or more  and still accruing |       | $        | —     |     | $          | — |   |

 

49

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**NOTE #4- PREMISES AND EQUIPMENT**

 

Asummary of premises and equipment as of December 31, 2005 and 2004, follows:

 
| ** **                                       | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|--------------------------------------------------|------------|------------|------------|------------|------------|
|                                             |       |       |       |       |       |
| Land                                             |       | $          | 3,037,669  |       | $          | 3,388,541 |   |
| Building                                         |       | 4,996,698  |       | 4,857,197  |       |
| Leasehold improvements                           |       | 211,676    |       | 200,637    |       |
| Furniture, fixtures and equipment                |       | 1,924,744  |       | 1,675,737  |       |
|                                             |       | 10,170,787 |       | 10,122,112 |       |
| Less: Accumulated depreciation and  amortization |       | (1,856,685 | )          | (1,393,600 | )          |
|                                             |       | $          | 8,314,102  |       | $          | 8,728,512 |   |

 

TheCompany has entered into leases for its branches and operating facilities,which expire at various dates through 2009. These leases include provisions forperiodic variable rent increases as well as payment by the lessee of certainoperating expenses. Rental expense relating to these leases was approximately$101,000 in 2005 and $82,000 in 2004. The Company received sublease income ofapproximately $92,000 in 2005 and $77,000 in 2004. The Company’s subleaseagreements are renewable on a monthly basis. All of the agreements had renewedat December 31, 2005.

 

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

 
| **Year** | ** ** | **Amount** |
|----------|------------|------------|
|     |       |       |
| 2006     |       | $          | 89,808 |
| 2007     |       | 78,833     |
| 2008     |       | 48,677     |
| 2009     |       | 21,474     |
|     |       | $          | 238,792 |

 

Theminimum rental payments shown above are given for the existing lease obligationsand are not a forecast of future rental expense.

 

**NOTE #5- DEPOSITS**

 

AtDecember 31, 2005, all time deposits were scheduled to mature in 2006, exceptfor $2,589,259 that matures in one to two years.

 

50

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

 

Notes payable consist of the following:

 
| ** **                                                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| 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.            |       | $        | 44,659     |     | $          | 105,725 |   |
|                                                                              |            |          |            |          |            |  |  |

 

TheCompany may borrow up to $5,000,000 overnight on an unsecured basis from twocorrespondent banks. As of December 31, 2005, no amounts were outstanding underthese arrangements.

 

TheCompany also has financing availability of approximately $44.8 million from theFederal Home Loan Bank (FHLB). As of December 31, 2005, no amounts wereoutstanding under these arrangements and no loans or securities have beenpledged as collateral.

 

## **NOTE#7 -**JUNIOR SUBORDINATED DEBTSECURITIES

## ** **

On September 26, 2002, the Company issued$5,155,000 of junior subordinated debt securities (the “debt securities”) toCoast Bancorp Statutory Trust I, a statutory trust created under the laws ofthe State of Delaware. These debt securities are subordinated to effectivelyall borrowings of the Company and are due and payable on September 26, 2032. Interestis payable quarterly on these debt securities at 3-Month LIBOR plus 3.4% for aneffective rate of 7.92% as of December 31, 2005. The debt securities can beredeemed for 107.5% of the principal balance through September 26, 2007 and atpar thereafter. The debt securities can also be redeemed at par if certainevents occur that impact the tax treatment or the capital treatment of theissuance.

 

The Company also purchased a 3% minorityinterest in Coast Bancorp Statutory Trust I. The balance of the equity of CoastBancorp Statutory Trust I is comprised of mandatorily redeemable preferredsecurities. In accordance with FASB Interpretation (FIN) No. 46, *“Consolidation of Variable Interest Entities, aninterpretation of ARB No. 51,”* the Company does not consolidateCoast Bancorp Statutory Trust I into the Company financial statements. Prior tothe issuance of FIN No. 46, Bank Holding companies typically consolidated theseentities. As of December 31, 2005, the Company has included the net juniorsubordinated debt in its Tier 1 Capital for regulatory capital purposes.

 

51

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**NOTE #8- INCOME TAXES**

 

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

 
| ** ** | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------|------------|----------|------------|----------|------------|
| Current:   |       |     |       |     |       |
| Federal    |       | $        | 588,111    |     | $          | 570,000 |   |
| State      |       | 206,763  |       | 221,632  |       |
|       |       | 794,874  |       | 791,632  |       |
| Deferred   |       | 44,000   |       | 70,000   |       |
|       |       | $        | 838,874    |     | $          | 861,632 |   |

 

Deferredtaxes are a result of differences between income tax accounting and generallyaccepted accounting principles with respect to income and expense recognition. TheCompany’s principal timing differences are from credit loss provisionaccounting and depreciation differences.

 

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

 
| ** **                                             | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred tax assets:                                   |       |     |       |     |       |
| Allowance for credit losses                            |       | $        | 410,000    |     | $          | 401,000 |   |
| Market value adjustment on investment  securities      |       | 55,000   |       | 42,000   |       |
| Other assets                                           |       | 8,000    |       | 66,000   |       |
|                                                   |       | 473,000  |       | 509,000  |       |
| Deferred tax Liabilities:                              |       |     |       |     |       |
| Premises and equipment due to depreciation  difference |       | (84,000  | )          | (101,000 | )          |
| Other liabilities                                      |       | (60,000  | )          | (48,000  | )          |
|                                                   |       | (144,000 | )          | (149,000 | )          |
| Net deferred tax assets                                |       | $        | 329,000    |     | $          | 360,000 |   |

 

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

 
| ** **                                  | ** ** | **2005**   | ** ** | **2004** | ** ** |
|---------------------------------------------|------------|------------|------------|----------|------------|
| ** **                                  | ** ** | **Amount** | ** ** | **Rate** | ** ** | **Amount** | ** ** | **Rate** | ** ** |
|                                        |       |       |       |     |       |   |   |   |   |
| Statutory federal tax                       |       | $          | 658,000    |     | 34.0       | % | $ | 672,000 |   | 34.0 | % |
| State franchise tax, net of federal benefit |       | 139,000    |       | 7.2      | %          | 143,000 |   | 7.2 | % |
| Other items, net                            |       | 41,874     |       | 2.2      | %          | 46,632 |   | 2.4 | % |
| Actual tax expense                          |       | $          | 838,874    |     | 43.4       | % | $ | 861,632 |   | 43.6 | % |
|                                             |            |            |            |          |            |  |  |  |  |  |  |  |  |

 

52

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

 

Thefollowing is a reconciliation of net income and weighted average sharesoutstanding to the net income and number of shares used to compute EPS:

 
| ** **                                    | ** ** | **2005**       | ** ** | **2004**   | ** ** |
|-----------------------------------------------|------------|----------------|------------|------------|------------|
| ** **                                    | ** ** | **Net Income** | ** ** | **Shares** | ** ** | **Net Income** | ** ** | **Shares** | ** ** |
|                                          |       |           |       |       |       |   |   |   |   |
| Used in basic EPS                             |       | $              | 1,097,866  |       | 668,179    |   | $ | 1,115,029 |   | 643,701 |   |
| Dilutive effect of outstanding stock  options |       |           |       | 33,912     |       |   |   | 62,190 |   |
| Used in dilutive EPS                          |       | $              | 1,097,866  |       | 702,091    |   | $ | 1,115,029 |   | 705,891 |   |

 

**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 APBOpinion No. 25 and related interpretations in accounting for its plan.Accordingly, no compensation cost has been recognized for its fixed stockoption 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 2005 and2004, respectively; risk-free rate of 4.15% and 4%, dividend yields of 0.60%and 0.57%; volatility of 20% and 14%, and an expected life of six and a halfand nine years.

 

Asummary of the status of the Company’s fixed stock option plan as of December31, and changes during the years ending is presented below:

 
| ** **                                                      | ** ** | **2005**   | ** ** | **2004**                                | ** ** |
|-----------------------------------------------------------------|------------|------------|------------|-----------------------------------------|------------|
| ** **                                                      | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** |
|                                                            |       |       |       |                                    |       |   |   |   |   |
| Outstanding, beginning of year                                  |       | 129,600    |       | $                                       | 15.46      |   | 147,500 |   | $ | 12.74 |   |
| Granted                                                         |       | 23,000     |       | $                                       | 28.70      |   | 23,500 |   | $ | 25.81 |   |
| Exercised                                                       |       | (21,400    | )          | $                                       | 13.39      |   | (14,400 | ) | $ | 12.21 |   |
| Cancelled                                                       |       | (14,100    | )          | $                                       | 23.59      |   | (27,000 | ) | $ | 11.36 |   |
| Outstanding, end of year                                        |       | 117,100    |       | $                                       | 17.46      |   | 129,600 |   | $ | 15.46 |   |
|                                                            |       |       |       |                                    |       |   |   |   |   |
| Options exercisable at year-end                                 |       | 81,264     |       | $                                       | 13.77      |   | 89,300 |   | $ | 12.89 |   |
| Weighted-average fair value of options  granted during the year |       |       |       | $                                       | 9.12       |   |   |   | $ | 7.76 |   |

 

53

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Thefollowing table summarizes information about fixed options outstanding atDecember 31, 2005:

 
| ** **              | ** ** | **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            |       | 20,000                  |       | 1.5 Years                                           |       | $ | 10.00 |   | 20,000 |   | $ | 10.00 |   |
| $ 14.00 to  $14.99 |       | 52,300                  |       | 3.1 Years                                           |       | $ | 14.02 |   | 51,100 |   | $ | 14.01 |   |
| $ 15.00 to  $15.99 |       | 10,500                  |       | 3.7 Years                                           |       | $ | 15.12 |   | 5,800 |   | $ | 15.09 |   |
| $ 18.00 to  $26.99 |       | 15,300                  |       | 8.4 Years                                           |       | $ | 26.50 |   | 4,364 |   | $ | 26.50 |   |
| $ 28.00 to  $28.99 |       | 9,000                   |       | 7.6 Years                                           |       | $ | 28.50 |   | — |   | — |   |
| $ 29.00 to  $29.99 |       | 10,000                  |       | 7.0 Years                                           |       | $ | 29.05 |   | — |   | — |   |
|                    |       | 117,100                 |       | 4.3 Years                                           |       | $ | 17.46 |   | 81,264 |   | $ | 13.77 |   |

 

**NOTE#11 - RELATED PARTY TRANSACTIONS**

 

Inthe ordinary course of business, the Company has granted loans to certaindirectors and the companies with which they are associated. In the Company’sopinion, all loans and loan commitments to such parties are made onsubstantially the same terms including interest rates and collateral, as thoseprevailing at the time for comparable transactions with other persons. Thebalance of these loans outstanding at December 31, 2005 and 2004, was asfollows:

 
| ** **        | ** ** | **2005**  | ** ** | **2004** | ** ** |
|-------------------|------------|-----------|------------|----------|------------|
|              |       |      |       |     |       |
| Beginning balance |       | $         | 982,913    |     | $          | 1,051,151 |   |
| Additions         |       | 2,014,797 |       | —   |       |
| Payments          |       | (114,865  | )          | (68,238  | )          |
| Ending balance    |       | $         | 2,882,845  |     | $          | 982,913 |   |

 

Alsoin the ordinary course of business, certain officers, directors, shareholders,and employees of the Company have deposits with the Company. In the Company’sopinion, all deposit relationships with such parties are made on substantiallythe same terms including interest rates and maturities, as those prevailing atthe time of comparable transactions with other persons. The balance of thesedeposits at December 31, 2005 was approximately $1,318,596.

 

**NOTE#12 - COMMITMENTS**

 

Inthe normal course of business, the Bank enters into financial commitments tomeet the financing needs of its customers. These financial commitments includecommitments to extend credit and standby letters of credit. Those instrumentsinvolve to varying degrees, elements of credit and interest rate risk notrecognized in the statement of financial position.

 

54

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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 Bank uses the same credit policies in makingcommitments as it does for loans reflected in the consolidated financialstatements.

 

Asof December 31, 2005 and 2004, the Bank had the following outstanding financialcommitments whose contractual amount represents credit risk:

 
| ** **                   | ** ** | **2005**  | ** ** | **2004**  | ** ** |
|------------------------------|------------|-----------|------------|-----------|------------|
|                         |       |      |       |      |       |
| Commitments to extend credit |       | $         | 57,356,000 |      | $          | 35,112,000 |   |
| Standby letters of credit    |       | 2,589,000 |       | 1,674,000 |       |
|                         |       | $         | 59,945,000 |      | $          | 36,786,000 |   |

 

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 ofcredit are conditional commitments to guarantee the performance of a Bankcustomer to a third party. Since many of the commitments and standby letters ofcredit are expected to expire without being drawn upon, the total amounts donot necessarily represent future cash requirements. The Bank evaluates eachcustomer’s credit worthiness on a case-by-case basis. The amount of collateralobtained if deemed necessary by the Bank is based on management’s creditevaluation 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 aspecific point in time based on relevant market information and informationabout the financial instrument. These estimates do not reflect any premium ordiscount that could result from offering for sale at one time the entireholdings of a particular financial instrument. Because no market value existsfor a significant portion of the financial instruments, fair value estimatesare based on judgments regarding future expected loss experience, currenteconomic conditions, risk characteristics of various financial instruments, andother factors. These estimates are subjective in nature, involve uncertaintiesand matters of judgment, and therefore cannot be determined with precision. Changesin assumptions 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, tax consequences related to the realization of theunrealized gains and losses can have a potential effect on fair value estimatesand have not been considered in many of the estimates.

 

55

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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 approximatefair value. Short term investments include federal funds sold, securitiespurchased under agreements to resell, and interest bearing deposits with Banks.The fair values of investment securities, including available for sale, aregenerally based on quoted market prices. The fair value of loans are estimatedusing a combination of techniques, including discounting estimated future cashflows and quoted market prices of similar 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 fixedmaturity deposits, fair value is estimated by discounting estimated future cashflows using currently offered rates for deposits of similar remainingmaturities. The fair value of long term debt is based on rates currentlyavailable to the Bank for debt with similar terms and remaining maturities.

 

### **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 similar agreements. Thefair value of these financial instruments are not deemed to be material.

 

Theestimated fair value of financial instruments at December 31, 2005 and 2004 aresummarized as follows (dollar amounts in thousands):

 
| ** **                             | ** ** | **2005**             | ** ** | **2004**       | ** ** |
|----------------------------------------|------------|----------------------|------------|----------------|------------|
| ** **                             | ** ** | **Carrying  Amount** | ** ** | **Fair Value** | ** ** | **Carrying  Amount** | ** ** | **Fair Value** | ** ** |
| Assets:                                |       |                 |       |           |       |   |   |   |   |
| Cash and cash equivalents              |       | $                    | 34,670     |           | $          | 34,670 |   | $ | 20,690 |   | $ | 20,690 |   |
| Investment securities                  |       | 7,872                |       | 7,872          |       | 12,867 |   | 12,867 |   |
| Loans, net                             |       | 132,048              |       | 132,914        |       | 114,720 |   | 115,137 |   |
| Federal Reserve Bank and FHLB stock    |       | 923                  |       | 923            |       | 884 |   | 884 |   |
| Accrued interest receivable            |       | 716                  |       | 716            |       | 535 |   | 535 |   |
|                                   |       |                 |       |           |       |   |   |   |   |
| Liabilities:                           |       |                 |       |           |       |   |   |   |   |
| Noninterest-bearing deposits           |       | 40,583               |       | 40,583         |       | 39,661 |   | 39,661 |   |
| Interest-bearing deposits              |       | 128,366              |       | 128,366        |       | 104,803 |   | 104,803 |   |
| Notes payable                          |       | 45                   |       | 45             |       | 106 |   | 106 |   |
| Junior subordinated debt securities    |       | 5,155                |       | 5,155          |       | 5,155 |   | 5,155 |   |
| Accrued interest and other liabilities |       | 332                  |       | 332            |       | 217 |   | 217 |   |
|                                        |            |                      |            |                |            |  |  |  |  |  |  |  |  |

 

56

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**NOTE#14 - REGULATORY MATTERS**

 

TheBank is subject to various regulatory capital requirements administered by thefederal banking agencies. Failure to meet minimum capital requirements caninitiate certain mandatory - and possibly additional discretionary - actions byregulators that, if undertaken, could have a direct material effect on theCompany’s consolidated financial statements. Under capital adequacy guidelinesand the regulatory framework for prompt, corrective action, the Bank must meetspecific capital guidelines that involve quantitative measures of the Bank’sassets, liabilities, and certain off-balance-sheet items as calculated underregulatory 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 (as defined). Managementbelieves, as of December 31, 2005, that the Bank meets all capital adequacyrequirements to which it is subject.

 

Asof December 31, 2005, 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 be categorized as well-capitalized oradequately capitalized, the Bank must maintain minimum ratios as set forth inthe table below. The following table also sets forth the Bank’s actual capitalamounts and ratios (dollar amounts in thousands):

 
| ** **                             | ** ** | ** **         | ** ** | ** **                          | ** ** | **Amount of Capital Required** | ** ** |
|----------------------------------------|------------|--------------------|------------|-------------------------------------|------------|--------------------------------|------------|
| ** **                             | ** ** | **Actual Capital** | ** ** | **To Bed  Adequately  Capitalized** | ** ** | **To Be  Well-Capitalized**    | ** ** |
| ** **                             | ** ** | **Amount**         | ** ** | **Ratio**                           | ** ** | **Amount**                     | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| As of December 31, 2005                |       |               |       |                                |       |                           |       |   |   |   |   |   |   |
| Total capital to risk-weighted assets  |       | $                  | 17,217     |                                | 11.5       | %                              | $          | 11,958 |   | 8.0 | % | $ | 14,947 |   | 10.0 | % |
| Tier 1 capital to risk-weighted assets |       | $                  | 15,989     |                                | 10.7       | %                              | $          | 5,979 |   | 4.0 | % | $ | 8,969 |   | 6.0 | % |
| Tier 1 capital to average assets       |       | $                  | 15,989     |                                | 8.8        | %                              | $          | 7,308 |   | 4.0 | % | $ | 9,135 |   | 5.0 | % |
|                                   |       |               |       |                                |       |                           |       |   |   |   |   |   |   |
| As of December 31, 2004                |       |               |       |                                |       |                           |       |   |   |   |   |   |   |
| Total capital to risk-weighted assets  |       | $                  | 15,740     |                                | 12.6       | %                              | $          | 10,026 |   | 8.0 | % | $ | 12,532 |   | 10.0 | % |
| Tier 1 capital to risk-weighted assets |       | $                  | 14,572     |                                | 11.6       | %                              | $          | 5,013 |   | 4.0 | % | $ | 7,519 |   | 6.0 | % |
| Tier 1 capital to average assets       |       | $                  | 14,572     |                                | 9.0        | %                              | $          | 6,486 |   | 4.0 | % | $ | 8,108 |   | 5.0 | % |

 

57

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TheCompany is subject to similar requirements administered by its primaryregulator, the Federal Reserve Board. For capital adequacy purposes, theCompany must maintain total capital to risk-weighted assets and Tier 1 capitalto risk-weighted assets of 8.0% and 4.0%, respectively. Its total capital torisk-weighted assets and Tier 1 capital to risk-weighted assets was 11.7% and10.04%, respectively, at December 31, 2005 and 12.8% and 10.4%, respectively,at December 31, 2004.

 

TheBank is restricted to the amount of dividends which can be paid. Dividendsdeclared by national banks that exceed the net income (as defined) for thecurrent year plus retained net income for the preceding two years must beapproved by the OCC. The Bank may not pay dividends that would result in itscapital levels being reduced below the minimum requirements shown above.

 

Withcertain exceptions, the Company may not pay a dividend to its shareholdersunless its retained earnings equal at least the amount of the proposeddividend.

 

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

 

Coast Bancorp operatesCoast National Bank. Coast Bancorp commenced operations during 2001. Theearnings of the subsidiary are recognized on the equity method of accounting. Condensedfinancial statements of the parent company only are presented on the followingpage:

 

58

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** **

**CONDENSED BALANCE SHEETS**
| ** **                                     | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| **ASSETS**                                     |       |                   |       |                   |       |
| Cash                                           |       | $                      | 236,073    |                   | $          | 125,966 |   |
| Investment in Coast Bancorp Statutory Trust  I |       | 155,000                |       | 155,000                |       |
| Investment in Coast National Bank              |       | 15,933,952             |       | 14,552,588             |       |
| Other assets                                   |       | 79,830                 |       | 299,479                |       |
|                                           |       | $                      | 16,404,855 |                   | $          | 15,133,033 |   |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY:** |       |                   |       |                   |       |
| Other liabilities                              |       | $                      | 6,804      |                   | $          | 5,111 |   |
| Junior subordinated debt securities            |       | 5,155,000              |       | 5,155,000              |       |
| Stockholders’ equity                      |       | 11,243,051             |       | 9,972,922              |       |
|                                           |       | $                      | 16,404,855 |                   | $          | 15,133,033 |   |

 

**CONDENSED STATEMENTS OF INCOME**

 
|                                                 |   | **Year  Ended**   | ** ** | **Year  Ended**   |   |
|------------------------------------------------------|--------|-------------------|------------|-------------------|--------|
|                                                 |   | **December  31,** | ** ** | **December  31,** |   |
|                                                 |   | **2005**          | ** ** | **2004**          |   |
| **INCOME**                                           |   |              |       |              |   |
| Interest income                                      |   | $                 | 5,387      |              | $      | 3,081 |   |
| Cash dividends from Coast Bancorp Statutory  Trust I |   | 10,532            |       | 7,684             |   |
| **TOTAL  INCOME**                                    |   | 15,919            |       | 10,765            |   |
| **EXPENSES**                                         |   |              |       |              |   |
| Interest on note payable                             |   | —            |       | 7,591             |   |
| Interest on junior subordinated debt  securities     |   | 380,392           |       | 278,078           |   |
| Other                                                |   | 65,768            |       | 139,903           |   |
| Allocated tax benefit                                |   | (128,000          | )          | (100,000          | )      |
| **TOTAL  EXPENSES**                                  |   | 318,160           |       | 325,572           |   |
|                                                 |   |              |       |              |   |
| **LOSS  BEFORE EQUITY IN UNDISTRIBUTED**             |   |              |       |              |   |
| **INCOME  OF SUBSIDIARY**                            |   | (302,241          | )          | (314,807          | )      |
|                                                 |   |              |       |              |   |
| **EQUITY  IN UNDISTRIBUTED**                         |   |              |       |              |   |
| **INCOME  OF SUBSIDIARY**                            |   | 1,400,107         |       | 1,429,836         |   |
| ** **                                           |   |              |       |              |   |
| **NET  INCOME**                                      |   | $                 | 1,097,866  |              | $      | 1,115,029 |   |

 

59

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## **CONDENSED STATEMENT OFCASH FLOWS**

## ** **

| ** **                                | ** ** | **Years Ended**        | ** ** |
|-------------------------------------------|------------|------------------------|------------|
| ** **                                | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
| **CASH FLOWS FROM OPERATING ACTIVITIES:** |       |                   |       |   |   |
| Net income                                |       | $                      | 1,097,866  |   | $ | 1,115,029 |   |
| Noncash items included in net income:     |       |                   |       |   |   |
| Equity in income of Subsidiary            |       | (1,400,107             | )          | (1,429,836 | ) |
| Other                                     |       | 243,761                |       | (43,536 | ) |
| **NET CASH  USED IN**                     |       |                   |       |   |   |
| **OPERATING  ACTIVITIES**                 |       | (58,480                | )          | (358,343 | ) |
|                                      |       |                   |       |   |   |
| **CASH FLOWS FROM FINANCING ACTIVITIES:** |       |                   |       |   |   |
| Proceeds from exercise of stock options   |       | 286,555                |       | 233,825 |   |
| Dividends Paid                            |       | (117,968               | )          | (97,155 | ) |
| **NET CASH  PROVIDED BY**                 |       |                   |       |   |   |
| **FINANCING  ACTIVITIES**                 |       | 168,587                |       | 136,670 |   |
|                                      |       |                   |       |   |   |
| **NET INCREASE  (DECREASE) IN**           |       |                   |       |   |   |
| **CASH AND  CASH EQUIVALENTS**            |       | 110,107                |       | (221,673 | ) |
|                                      |       |                   |       |   |   |
| **CASH AND  CASH EQUIVALENTS**            |       |                   |       |   |   |
| **AT  BEGINNING OF YEAR**                 |       | 125,966                |       | 347,639 |   |
|                                      |       |                   |       |   |   |
| **CASH AND  CASH EQUIVALENTS**            |       |                   |       |   |   |
| **AT END  OF YEAR**                       |       | $                      | 236,073    |   | $ | 125,966 |   |

 

60

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**Item 8.****      ****Changes In and Disagreements with Accountants on Accounting andFinancial Disclosure**

 

None

 

**Item 8A.****   ****Controls and Procedures**

 

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

 

Asof December 31, 2005 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”). Thisevaluation (the “Controls Evaluation”) was done under the supervision and withthe participation of management, including our Chairman and Chief ExecutiveOfficer (“CEO”) and Chief Financial Officer (“CFO”). Rules adopted by the SECrequire that in this section of the Annual Report we present the conclusions ofthe CEO and the CFO about the effectiveness of our Disclosure Controls based onand as of the date of the Controls.

 

**CEO and CFO Certifications.**

 

Appearingimmediately following the Signatures section of this Annual 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 and reportedwithin 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 allerror and all fraud. A control system, no matter how well conceived andoperated, can provide only reasonable, not absolute, assurance that theobjectives of the control system are met. Further, the design of a controlsystem must reflect the fact that there are resource constraints, and thebenefits of controls must be considered relative to their costs. Because of theinherent limitations in all control systems, no evaluation of controls canprovide absolute assurance that all control issues and instances of fraud, ifany, within the Company have been detected. These inherent limitations includethe realities that judgments in decision-making can be faulty, and thatbreakdowns can occur because of simple error or mistake. Additionally, controlscan be circumvented by the individual acts of some persons, by collusion of twoor more people, or by management override of the control. The design of anysystem of controls also is based in part upon certain assumptions about thelikelihood of future events, and there can be no assurance that any design willsucceed in achieving its stated goals under all potential future conditions;over time, control may become inadequate because of changes in conditions, orthe degree of compliance with the policies or procedures may deteriorate.Because of the inherent limitations in a cost-effective control system,misstatements due to error or fraud may occur and not be detected.

 

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**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 generated for use in this AnnualReport. In the course of the Controls Evaluation, we sought to identify dataerrors, controls problems or acts of fraud and to confirm that appropriatecorrective action, including process improvements, were being undertaken. Thistype of evaluation will be done on a quarterly basis so that the conclusionsconcerning controls effectiveness can be reported in our Quarterly Reports onForm 10-QSB and Annual Report on Form 10-KSB. The overall goals of thesevarious evaluation activities are to monitor our Disclosure Controls and ourInternal Controls and to make modifications as necessary; our intent in thisregard is that the Disclosure Controls will be maintained as dynamic systemsthat change (including with improvements and corrections) as conditionswarrant.

 

**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 consolidatedsubsidiaries is made known to management, including the CEO and CFO, particularlyduring the period when our periodic reports are being prepared.

 

**Item 8B.****   ****Other Information**

 

None

 

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**INDEXTO EXHIBITS**

 

## **PART III**

## ** **

**Item 9.****      ****Directors, Executive Officers, Promoters and Control Persons:Compliance with Section 16(a) of the Exchange Act**

 

Boardof Directors:

 

**Marilyn M. Britton**,age 66, graduated from Cal Poly San Luis Obispo. She was involved with the SanLuis Obispo County Farm Bureau for over 27 years, retiring as Executive Directorin December 2001, a position she held for over 16 years. Marilyn is a memberand past director of the San Luis Obispo Rotary, a member of San Luis ObispoCounty Farm Bureau, San Luis Obispo County Farm Bureau Women, San Luis ObispoCounty CattleWomen’s Association, San Luis Obispo County Cattlemen’sAssociation, Paso Robles Agri-Business Tour Committee. Mrs. Britton developedthe San Luis Obispo County Farm Bureau Agriculture Tour Program 25 years agoand has continued as its Tour Coordinator. She was also the Executive Directorfor the San Luis Obispo County Grain Improvement Association for 18 years. Shealso served on the Sheriff’s Parole Board.

 

**Dario A. Domenghini**,age 68, is an original organizer and director of the Bank. Mr. Domenghini is alife-long resident of San Luis Obispo County. His family has been involved inagriculture 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 andranching operation since his childhood.

 

Mr. Domenghini expanded the operation to include vegetable farming. Hehas since closed down the dairy operation, but continues to farm in partnershipwith his nephew. Mr. Domenghini holds an ownership in the real estate interestof Domenghini Brothers and is a 50% partner in Domenghini Farms. Mr. Domenghiniwas educated at Cal Poly San Luis Obispo, majoring in Dairy Science. Mr.Domenghini is active in local farming and ranching activities.

 

**James M. Kaney**,age 59, is an original organizer and director of the Bank. Mr. Kaney has been abusiness owner/operator in San Luis Obispo since 1970 and he is a certifiedpublic accountant. He currently is President/Owner of Anacal Financial Inc., afinancial service and real estate development company. He received his B.S.degree, cum laude, in Accounting/Finance with a minor in Economics and hisMasters of Business Administration Degree from California Polytechnic StateUniversity, San Luis Obispo. He also teaches accounting and commercial bankmanagement at Cal Poly. Mr. Kaney started Kaney Foods, Inc. in San Luis Obispo,a wholesaler to restaurants and institutions in the counties of Monterey, SantaBarbara, Ventura, and San Luis Obispo. Mr. Kaney was responsible for all phasesof the company warehousing, distribution, sales and accounting. The company wassold in 1987. Mr. Kaney is an organizer, founder and past director of CommerceBank of San Luis Obispo N.A., which was sold in March 1996 to Valliwide Bank. Mr.Kaney served for more than twelve years on the Loan Committee and theInvestment Committee of Commerce Bank. Mr. Kaney is a past member of theKiwanis Club and a member and past director of the Rotary Club of San LuisObispo.

 

**Michael A. Lady**,age 54 is an original organizer and director of the Bank. Mr. Lady has been aresident of Arroyo Grande for the past eighteen years and is the owner of LadyFamily Mortuary in Arroyo Grande. In addition to his involvement in themortuary business, Mr. Lady is an investor, as well as the former Mayor of theCity of Arroyo Grande. Mr. Lady, through his development and governmentalactivities, is vitally aware of the future development plans for the ArroyoGrande area.

 

Mr. Lady is active in a large number of civic and fraternalorganizations. He is the past president of the Arroyo Grande Chamber ofCommerce and the Arroyo Valley Kiwanis. He is a member of the Elks Club, MooseLodge, Shriner’s Club, the Freemasons, YMCA, and the Fraternal Order of Eagles.He was named the 1991 Arroyo Grande Citizen of the Year, and he and his wifewere named South County Couple of the Year also in 1991. Mr. Lady is a leaderin the Arroyo Grande community, and his involvement in the formation andmanagement of the Bank has provided the Bank with an impressive base ofvaluable business customers.

 

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**Gene D. Mintz**,age 66, is an original organizer and director of the Bank. Mr. Mintz is abusiness and tax advisor and owner of GSM Business Services, Inc. A life-longresident of San Luis Obispo County, Mr. Mintz is involved in a number ofprofessional, civic, and charitable associations. He is a 36 year member of theGreater Pismo Beach Kiwanis Club. Mr. Mintz is a 34 year member of Oceano/FiveCities Elks Club and is involved in the South County Performing Arts Foundationas a Director and Vice President.

 

Mr. Mintz is active in a number of professional organizations and apast president of the Central Coast Chapter of the California Society ofEnrolled Agents. His professional activities include his business and taxadvisory business, as well as involvement in a number of real estatedevelopment projects. He is currently the Secretary-Treasurer of Burke and Paceof Arroyo Grande, Inc. a major supplier of building materials headquartered inArroyo Grande.

 

**Ron R. Olson**,age 62, is a director of the Bank. Mr. Olson is a Certified Public Accountantand is owner of Platino Management Services, Inc. which provides accounting andtax services, management consulting and property management services in ArroyoGrande and surrounding communities.

 

Mr. Olson has been a resident of Arroyo Grande for 32 years and isactive in local service and professional organizations. Mr. Olson is a memberof the Arroyo Grande Optimists Club and of both the American Institute of CPA’sand 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 78, is Vice Chairman of the board and an original organizing director ofthe Bank. Mr. Robasciotti was born in San Luis Obispo and has been active inbanking since 1951. After an impressive 33 year career with Bank of America,Mr. Robasciotti “retired” to San Luis Obispo, where he worked for 21 years invarious positions, including manager of the main office of Commerce Bank of SanLuis Obispo, N.A. as well as increasingly responsible positions with CoastNational Bank.

 

Mr. Robasciotti has been active in a number of civic, charitable andfraternal organizations in San Luis Obispo. His activities range fromfundraising for the YMCA, to serving as a director and a member oforganizations that provide shelter for abused women (Women’s Shelter), SexualAssault Victim’s Education (SAVE) and (ALPHA) that counsels pregnant women. Mr.Robasciotti is a member of the San Luis Obispo Historical Society, previouslyserving as First Vice President, a past member of Hearst Castle LightingCommittee, and a of other organizations including a committee member of the SanLuis Obispo Old Mission operating groups, De Tolosa Rotary club.

 

**Jack C. Wauchope**,age 70, is Chief Executive Officer and Chairman of the Board of Directors forboth the Bank and the Bancorp. Mr. Wauchope has been in the banking industryfor more than 46 years. For over half of that time, he has served as thePresident and Chief Executive Officer of independent banks. Mr. Wauchope wasthe organizing President of Commerce Bank of San Luis Obispo as well as CoastNational Bank. He is a graduate of Millikin University at Decatur, Illinois andthe Pacific Coast Banking School at the University of Washington, Seattle,Washington.

 

Mr. Wauchope has served on the boards of numerous civic, charitable andtrade organizations which include the Foundation for the Performing ArtsCenter, Hotline of San Luis Obispo County, San Luis Obispo Economics ForecastProject, Community Bankers of Southern California, Western Banking School,Rotary Club of San Luis Obispo Daybreak and the Civic Ballet of San LuisObispo.

 

**Dan H. Wixom**,age 54, is an original organizer and director of the Bank. Mr. Wixom is arancher and an owner/operator of Wixom Trucking, LLC. Mr. Wixom formerly ownedand operated Wixom Concrete, Inc., which was sold in 1997. A graduate of CalPoly San Luis Obispo in Agriculture Management, Mr. Wixom is a fourthgeneration resident of San Luis Obispo County. He has been a member of NativeSons of the Golden West for over twenty-five years and served as a president ofthe organization. Mr. Wixom served on the board of the Morro Bay CommunityFoundation. The foundation helps with youth activities on the Central Coast. Hesupports local educational institutions, volunteering time and donatingmaterials for the Morro Bay FFA and 4H groups and for youth sports teams.

 

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Mr. Wixom is a member of the California Cattlemen’s Association, theNational Cattlemen’s Association, and the San Luis Obispo County Farm Bureau. Hehas operated his own calf/cow operation for 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. His trucking company is involved in thestatewide transportation of construction aggregates, bulk cement and livestock.

 

Executive Officers:

 

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

 

**Julie A. Joslin**,age 46, joined the Bank in 2000 as Senior Vice President and Compliance Officer.She was raised and educated in Atascadero, California, where she began herbanking career with Atascadero Federal Credit Union in 1983. She moved toTempleton National Bank in 1990 where she remained until that bank was sold in1995. Joslin served as a Vice President and Controller while with TempletonNational Bank. Joslin is also a graduate of the California Banking School atthe University of San Diego.

 

**Davina A. Palazzo**,age 37, is Executive Vice President and Manager of the Bank’s Small BusinessLoan Center. She was educated in Southern California, graduating fromCalifornia State University – Fullerton. She has been in banking for the past16 years, concentrating primarily over the last fifteen years in governmentguaranteed lending programs such as the U.S. Small Business Administration. Sheis a graduate of the Pacific Coast Banking School at the University ofWashington. She is a Vice Chairperson of the Board of Directors of the NationalAssociation of Government Guaranteed Lenders. She has testified in front ofCongress numerous times on SBA issues. She is the President-Elect of the Boardof the Paso Robles Sunrise Rotary Club. Ms. Palazzo was the recipient of theSBA’s Financial Service Advocate of the Year Award for 2002. She was recentlynamed one of the Top 20 Professionals Under 40 in San Luis Obispo

 

**Leah M. Pauly**,age 43, is Executive Vice President/Chief Credit Officer for the Bank. She wasraised and educated in Southern California but has lived in northern San LuisObispo county for the past 19 years. She has actively worked in progressivelymore responsible positions in banking for the last 24 years graduated from theABA Stonier Graduate School of Banking in June 2005. Over the years, Pauly hasvolunteered for a number of civic and charitable organizations. She currentlyserves on the Board of Directors of Senior Volunteer Services.

 

**Karan C. Pohl**,age 34, joined the Company on May 5, 2005. She presently serves as Senior VicePresident and Chief Financial Officer of the Company’s subsidiary, CoastNational Bank. Ms. Pohl is a Certified Public Accountant. Prior to acceptingher position, she worked as an Audit Manager for Moss, Levy and Hartzheim, apublic accounting firm located in Santa Maria, California, where she wasemployed from 1998 to 2005. She graduated from California PolytechnicUniversity, San Luis Obispo with a Bachelor’s of Science degree in BusinessAdministration with an emphasis in accounting and finance.

 

The executive officers were each elected by the Board of Directors. Thereare no family relationships between directors and executive officers of theBank.

 

No Director of the Bank holds a directorship in any other company witha class of securities registered pursuant to Section 12 of the SecuritiesExchange of 1934, as amended.

 

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

# ** **

Based solely on its review of Forms 3, 4, and 5, and amendmentsthereto, furnished to Bancorp during the 2005 fiscal year, no person who was adirector, officer, or beneficial owner of more than ten percent of the Bank’sCommon Stock failed to file on a timely basis reports required by Section 16(a)during the 2005 fiscal year except for Karan Pohl, Chief Financial Officer, whowas required to file a Form 3 within 10 days of her hire date of May 5, 2005and filed it instead on July 26, 2005.

 

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**Financial Expert**

 

The Board of Directors has determined, as required, that the AuditCommittee contains three independent financial experts. They perform noservices nor do they receive compensation from the bank other than normaldirector fees. The experts on the committee are James Kaney, Gene Mintz and RonOlson. Each of their qualifications is stated (See “Directors”) elsewhere inthis report.

 

**Code of Ethics**

 

This section of the Sarbanes Oxley Act now requires small businessfilers to adopt and disclose whether the Bancorp has adopted a code of ethicsthat applies to the principal executive officer, principal financial officer,and principal accounting officer or controller, or any person performingsimilar functions. The Bancorp has complied with this requirement and a copy isattached as Exhibit 14.

 

**Independence of Accounting Firms**

 

Amendments to Regulation S-X governs employment relationships betweenfinancial entities and accounting firms. Requirements include “independence” ofthe accounting firm, precluding the performance of any other audit functionssuch as bookkeeping, appraisal services, legal services and a variety of otherfunctions. 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 the leadpartner or concurring partner in the accounting firm may conduct audits withoutsacrificing their “independent” status. The Bancorp is in compliance with thisregulation.

 

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**Item 10.****     ExecutiveCompensation:**

 

The chart below contains information of Jack C. Wauchope,President/CEO, Davina Palazzo and Leah Pauly (the “Named Executives”) as theonly executive officers whose salary and other compensation was $100,000 ormore.

 
| **Name and  Principal Position** | ** ** | **Year** | ** ** | **Salary ($)** | ** ** | **Bonus ($)** | ** ** | **Other Annual  Compensation** | ** ** | **Awards:  Securities  Underlying  Options (#)** | ** ** | **All Other  Compensation** | ** ** |
|----------------------------------|------------|----------|------------|----------------|------------|---------------|------------|--------------------------------|------------|--------------------------------------------------|------------|-----------------------------|------------|
|                             |       |     |       |           |       |          |       |                           |       |                                             |       |                        |       |
| **Jack C. Wauchope**             |       | 2005     |       | $              | 185,000    |          | $          | 25,000                         |       | $                                                | —     |                        | $          | — |   | $ | 12,954 |   |
| President/CEO                    |       | 2004     |       | $              | 180,833    |          | $          | 25,000                         |       | $                                                | —     |                        | $          | — |   | $ | 13,072 |   |
| Chairman of the Board            |       | 2003     |       | $              | 170,833    |          | $          | 25,000                         |       | $                                                | —     |                        | $          | — |   | $ | 13,652 |   |
|                             |       |     |       |           |       |          |       |                           |       |                                             |       |                        |       |
| **Davina A. Palazzo**            |       | 2005     |       | $              | 125,000    |          | $          | 15,000                         |       | $                                                | —     |                        | $          | — |   | $ | 25 |   |
| Executive Vice President         |       | 2004     |       | $              | 120,833    |          | $          | 15,000                         |       | $                                                | —     |                        | $          | — |   | $ | 4,800 |   |
|                             |       | 2003     |       | $              | 108,750    |          | $          | 11,000                         |       | $                                                | —     |                        | $          | — |   | $ | 377 |   |
|                             |       |     |       |           |       |          |       |                           |       |                                             |       |                        |       |
| **Leah M. Pauly**                |       | 2005     |       | $              | 110,000    |          | $          | 20,000                         |       | $                                                | —     |                        | $          | — |   | $ | 5,339 |   |
| Executive Vice President         |       | 2004     |       | $              | 101,667    |          | $          | 12,500                         |       | $                                                | —     |                        | $          | — |   | $ | 5,525 |   |
|                             |       | 2003     |       | $              | 77,333     |          | $          | 7,700                          |       | $                                                | —     |                        | $          | — |   | $ | 11,035 |   |

 

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 are reported in this column for Mr. Wauchope, Ms.Palazzo or Ms. Pauly since the value of perquisites and other personal benefitsdid not exceed the reporting threshold.

 

The Bank has employed Jack C. Wauchope as its Chief Executive Officerand entered into an employment agreement with him, which took effect in June2003. The agreement provided for a term of five years at an annual base salaryof $175,000.00 in year 1, $185,000.00 in year 2 and 3, $200,000.00 in year 4and 5, discretionary bonuses, and a Bank provided automobile, country clubmembership, expense reimbursement, $400,000.00 of life insurance and standardand customary medical and dental insurance benefits. 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 A. Palazzo asits Executive Vice-President and Manager of the Small Business Lending Centerand entered into an employment agreement with her, which took effect in June2003. The agreement provides for a term of five years at an annual base salaryof $115,000.00 in year 1, $125,000.00 in year 2 and 3, $140,000.00 in year 4and 5, discretionary bonuses, country club membership, and standard andcustomary medical and dental insurance benefits. Additionally, Ms. Palazzo willbe entitled to severance benefits equal to one year’s base salary or two years,each dependent upon the occurrence of one or more enumerated events.

 

The Bank has employed Leah M. Pauly as its Executive Vice President andChief Credit Officer and entered into an employment agreement with her, whichtook effect November 2003. The agreement provides for five years at an annualsalary of $100,000.00 in year 1, $110,000.00 in year 2 and 3, $125,000.00 in year4 and 5, discretionary bonuses, and an automobile allowance of $400.00 permonth, and standard and customary medical and dental insurance benefits. Additionally,Ms. Pauly will be entitled to severance benefits equal to one year’s basesalary or two years, each dependant upon the occurrence of one or moreenumerated events.

 

The directors who are not full-time employees of the Bank are presentlyreceiving monthly directors’ fees. Mr. Wauchope does not presently receivedirectors’ fees.

 

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# **EmployeesStock Option Plan**

# ** **

In the course of the formation of Coast Bancorp as of May 31, 2001,Coast Bancorp adopted and assumed the Coast National Bank 1997 Stock OptionPlan, now known as the Coast Bancorp Employee Stock Option Plan (the “EmployeePlan”). The Employee Plan was adopted to strengthen the Company and itssubsidiaries by providing eligible full-time officers and employees an addedincentive to perform at a high level and to reward extraordinary efforts toincrease the earnings of Coast Bancorp and its subsidiary. The incentive willtake the form of an opportunity for officers and employees of Coast Bancorp andits subsidiaries to acquire a proprietary interest in the success of CoastBancorp by purchasing Shares of Coast Bancorp common stock. 125,000 shares ofCoast Bancorp common stock may be issued pursuant to the exercise of Optionsgranted under the Employee Plan, and in no event may the total number of sharesissuable upon exercise of all outstanding options and the total number ofshares provided for under any other stock option plan, stock bonus or similarplan of Coast Bancorp exceed thirty percent (30%) of the then-outstandingcommon stock of the Company. As of December 31, 2005, approximately twenty fiveofficers and employees of Coast Bancorp and its affiliates were eligible tohold options to purchase under the Employee Plan. The Employee Plancontemplates the grant of incentive stock options and nonstatutory stockoptions.

 

The Employee Plan is not a qualified plan under Section 401(a) of theInternal Revenue Code of 1986, as amended (the “Code”) or subject to theprovisions of the Employee Retirement Income Security Act of 1974, as amended.

 

# **Exerciseand Grant of Options**

# ** **

During 2005 no options were granted to the Named Executives. Stock Optionshares were granted during 2005 to Senior Vice-President and Chief FinancialOfficer Karan C. Pohl at an exercise price of $28.50/share.

 

Thefollowing table sets forth information concerning individual grants of stockoptions during fiscal year 2005 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 A.  Palazzo,  Executive Vice  President |       | -0-                                    |       | —                                                     |       | —                              |       | —               |       | —                  |       |
|                                           |       |                                   |       |                                                       |       |                                |       |                 |       |                    |       |
| Leah M.  Pauly,  Executive Vice  President     |       | -0-                                    |       | —                                                     |       | —                              |       | —               |       | —                  |       |

 

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| (1) |   | Present value at date of grant using the  Black-Scholes model |
|-----|--------|---------------------------------------------------------------|

 

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The following table shows exercises of stock options during fiscal year2005 by each of the Named Executives and the value at December 31, 2005 ofunexercised options on an aggregated basis held by each such person:

 

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

## ** **

| **Name**          | ** ** | **Shares Acquired  On Exercise (#)** | ** ** | **Value  Realized ($)** | ** ** | **Number of Securities  Underlying Unexercised Options at FY-End (#)  Exercisable/Unexercisable** | ** **    | **Value of Unexercised  In-the-Money Options  at FY-End ($)  Exercisable/Unexercisable (1)** | ** **              |
|-------------------|------------|--------------------------------------|------------|-------------------------|------------|---------------------------------------------------------------------------------------------------|---------------|----------------------------------------------------------------------------------------------|-------------------------|
|              |       |                                 |       |                    |       |                                                                                              |          |                                                                                         |                    |
| Jack C. Wauchope  |       | 0                                    |       | 0                       |       | 20,000 / 0                                                                                        |          | $ 400,000 / $0                                                                          |                    |
|              |       |                                 |       |                    |       |                                                                                              |          |                                                                                         |                    |
| Davina A. Palazzo |       | 0                                    |       | 0                       |       | 7,500 / 0                                                                                         |          | $ 120,000 / $0                                                                          |                    |
|              |       |                                 |       |                    |       |                                                                                              |          |                                                                                         |                    |
| Leah M. Pauly     |       | 2,000                                |       | $                       | 27,875     |                                                                                              | 2,300 / 3,200 |                                                                                         | $ 28,750 / $25,000 |   |
|                   |            |                                      |            |                         |            |                                                                                                   |               |                                                                                              |                         |  |

 

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(1)          Based on a bid price of  $30.00 at December 31, 2005

 

### **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 Planwas adopted to offer the non-employee directors of Coast Bancorp and itsaffiliates the opportunity to acquire a proprietary interest in the success ofCoast Bancorp by purchasing shares of Coast Bancorp common stock. New optionswere not granted in 2005 to the (8) outside directors.

 

The aggregate number of shares which may be issued pursuant to theexercise of Options granted under the Director Plan is 62,500 shares, and in noevent may the total number of shares issuable upon exercise of all outstandingoptions and the total number of shares provided for under any other stockoption plan, stock bonus or similar plan of Coast Bancorp exceed thirty percent(30%) of the then-outstanding common stock of the Company (the “Shares”). As ofMarch 15, 2006, approximately eight (8) directors of Coast Bancorp and itsaffiliates were eligible to hold options under the Director Plan. The DirectorPlan contemplates the grant of nonstatutory stock options only.

 

### **Item 11.**     Security Ownership ofCertain Beneficial Owners and Management and Related Stockholder Matters

### ** **

a.                                       There are nostockholders with ownership of 5% of the Bank’s stock, except as set forthbelow. Mr. Wauchope’s address is 500 Marsh Street, San Luis Obispo, CA  93401.

 

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b.                                      The followingtable sets forth information as of December 31, 2005 as to common sharesbeneficially owned by the directors and each Named Executive Officer, as wellas all directors and principal officers of the Company as a group. Ownershipinformation is based upon information furnished by the respective individuals.

 
| **Name**                                                    | ** ** | **Relationship to Bank**           | ** ** | **Number of  Shares** | ** ** | **Notes** | ** ** | **Percentage  Owned (1)** | ** ** |
|-------------------------------------------------------------|------------|------------------------------------|------------|-----------------------|------------|-----------|------------|---------------------------|------------|
|                                                        |       |                               |       |                  |       |      |       |                      |       |
| Jack C. Wauchope                                            |       | Chairman of the Board & CEO    |       | 39,000                |       | (2)       |       | 5.62                      | %          |
| Marilyn M. Britton                                          |       | Corporate Secretary & Director |       | 3,383                 |       | (3)       |       | 0.50                      | %          |
| Dario A. Domenghini                                         |       | Director                           |       | 11,733                |       | (4,5)     |       | 1.73                      | %          |
| James M. Kaney                                              |       | Director                           |       | 8,033                 |       | (5)       |       | 1.18                      | %          |
| Michael A. Lady                                             |       | Director                           |       | 6,333                 |       | (5)       |       | 0.93                      | %          |
| Gene D. Mintz                                               |       | Director                           |       | 27,473                |       | (5)       |       | 4.04                      | %          |
| Ron R. Olson                                                |       | Director                           |       | 16,658                |       | (6)       |       | 2.46                      | %          |
| Jack W. Robasciotti                                         |       | Director                           |       | 7,333                 |       | (5)       |       | 1.08                      | %          |
| Dan H. Wixom                                                |       | Director                           |       | 17,133                |       | (5,7)     |       | 2.52                      | %          |
| Davina A. Palazzo                                           |       | EVP & Executive Officer        |       | 7,500                 |       | (8)       |       | 1.10                      | %          |
| Leah M. Pauly                                               |       | EVP & Executive Officer        |       | 2,300                 |       | (8)       |       | 0.34                      | %          |
| Directors & Executive Officers as a  Group (13 persons) |       | 149,479                            |       | (9)                   |       | 20.09     | %          |

 

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Notes Regarding 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)           Includes2,833 shares of Director Stock options that are presently exercisable.

 

(4)           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.

 

(5)           Includes5,333 shares of director stock options that are presently exercisable

 

(6)           Includes2,833 shares of director stock options that are presently exercisable.

 

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

 

(8)           Incentivestock options currently exercisable.

 

(9)           Includes32,400 shares of incentive stock options and 37,664 shares of director stockoptions which are presently exercisable.

 

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**Item 12.****    ****Certain Relationships and Related Transactions.**

 

Thereare no existing or proposed material interests or transactions between Bancorpor the Bank and/or any of its officers or directors outside the ordinary courseof Bancorp or the Bank’s business.

 

Itis anticipated that the directors and officers of Bancorp and the Bank, and thecompanies with which they are associated, will have banking transactions withthe Bank in the ordinary course of business. It is the firm intention of theBoard of Directors that any loans and commitments to lend included in suchtransactions will be made in accordance with all applicable laws andregulations and on substantially the same terms, including interest rates andcollateral, as those prevailing at the time for comparable transactions withother 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 Bancorp or the Bank. It is thefirm policy of the Board that any such transactions between the Bank and anymembers of its Board, or any person directly or indirectly related to a director,be made in strict accordance with applicable rules and regulations and onsubstantially the same terms as those available at the time for comparabletransactions with disinterested persons.

 

**Item13.****    ****Exhibits**

 

a)                                      Exhibits

 

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

 

**Item 14.****    ****Principal Accountant Fees andServices**

 

Vavrinek,Trine, Day & Company LLP’s engagement by Coast Bancorp commenced on April30, 2002. Vavrinek, Trine, Day & Company LLP’s has also audited CoastNational Bank since inception. During the fiscal year ended December 31, 2005,Vavrinek, Trine & Day & Company, LLP provided professional services inconnection with the review of Quarterly Reports on Form 10-QSB for the quartersended March 31, June 30, September 30, 2005, and the audit of the financialstatements of Coast Bancorp for the fiscal year ended December 31, 2005. Aspart of the engagement, Vavrinek, Trine, Day & Company LLP also preparedquarterly tax estimates and 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 2004 and 2005 and the review of the financialstatements included in the Company’s Forms 10-QSB for the Quarters ended March31, June 30, and September 30, 2005 and for the preparation of tax estimatesand federal and state income tax returns were $37,000 and $41,000,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 2004 and 2005.

 

**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 2004 and 2005 were $5,000.00 each year.

 

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**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, and overallinternal control structure. In so doing the Committee shall:

 

•                  Select andrecommend annually, to the Board of Directors, appointment of the Bancorp’sindependent public accountants.

 

•                  Reviewindependence, qualifications, the annual engagement letter, audit scope,accounting principles, related services and fees.

 

•                  Reviewmanagement’s plans for engaging the independent public accountants to performmanagement’s advisory services.

 

•                  Review theBancorp’s audited financial statements in relation to meeting the requirementsof an annual Director’s examination, related notes, the accountant’s opinion tobe rendered in connection therewith, and any unresolved disagreements withmanagement, if any.

 

•                  Review theirreport on management’s assertions on in ternalcontrols and compliance with law and regulations.

 

•                  Reviewsignificant findings reported by bank regulators, management’s relatedresponses, and monitor corrective actions on major deficiencies noted.

 

•                  Reviewmanagement’s annual report on its responsibility for preparing financialstatements, establishing and maintaining internal control structure andprocedures for financial reporting, and for complying with certain laws andregulations.

 

•                  Performadditional functions as are necessary or prudent to fulfill the Committee’sduties and responsibilities.

 

72

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**INDEX TO EXHIBITS**

 
| **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                                                                                                                                                 |       |    (5)**        |
| 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                                                                                                                                                     |       |    (5)**        |
| 10.7                |       | 2005  Executive Bonuses                                                                                                                                                                                                    |       | **                             |
| 10.8                |       | 12/30/04  Summary of Material Modifications for Employee 401K Profit Sharing Plan                                                                                                                                          |       |    (6)**        |
| 10.9                |       | Paso  Robles Lease Agreement                                                                                                                                                                                               |       | (6)                            |
| 10.10               |       | Fresno  SBA Lease Agreement                                                                                                                                                                                                |       | (6)                            |
| 10.11               |       | Santa  Maria SBA Lease Agreement                                                                                                                                                                                           |       | (6)                            |
| 10.12               |       | Directors’  Fee Schedule                                                                                                                                                                                              |       |     (6)**  |
| 10.13               |       | Karan  Pohl Offer Agreement                                                                                                                                                                                                |       |     (6)**  |
| 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                                                                                                                                                                     |       | (5)                            |
| 21.0                |       | Subsidiaries  of the Coast Bancorp – Coast National Bank (100% owned)                                                                                                                                                 |       |                           |
| 23.0                |       | Consent  of Independent Public Accountants                                                                                                                                                                                 |       |                           |
| 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                                                                                                                                           |       |                           |

 

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| **     |   | 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.                               |   |   |

 

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| (3) |   | Filed  as Exhibits 4.1, 4.2, 4.3,4.4,4.5, and 10.5, respectively, to Registrant’s  Annual Report on Form 10-KSB for the Fiscal Year ended December 31, 2002  filed with the SEC and incorporated herein by reference.  |   |   |
|-----|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
| (4) |   | Filed  as Exhibit 10.3 to Registrant’s Annual Report on Form 10-KSB for the Fiscal  Year ended December 31, 2003 filed with the SEC and incorporated herein by  reference.                                             |   |   |
| (5) |   | Filed  as Exhibits 10.4, 10.6, and 14, respectively to Registrant’s Annual Report on  Form 10-KSB for the Fiscal Year ended December 31, 2004 filed with the SEC  and incorporated herein by reference.                |   |   |
| (6) |   | Filed  as Exhibits 10.1, 10.2, 10.3, 10.4, and 10.5, respectively to Registrant’s  Quarterly Report on Form 10-QSB for the Fiscal Quarter ended June 30, 2005  filed with the SEC and incorporated herein by reference |   |   |

 

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**SIGNATURES**

 

Inaccordance with Section 13 or 15(d) of the Securities Exchange Act, theregistrant has duly caused this report to be signed on its behalf by the undersigned,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  30, 2006 |
| Marilyn  Britton         |       |      |
|                     |       |      |
|                     |       |      |
| /s/  Dario Domenghini    |       | Director  | March  30, 2006 |
| Dario  Domenghini        |       |      |
|                     |       |      |
|                     |       |      |
| /s/  James M. Kaney      |       | Director  | March  30, 2006 |
| James  M. Kaney          |       |      |
|                     |       |      |
|                     |       |      |
| /s/  Michael A. Lady     |       | Director  | March  30, 2006 |
| Michael  A. Lady         |       |      |
|                     |       |      |
|                     |       |      |
| /s/  Gene D. Mintz       |       | Director  | March  30, 2006 |
| Gene  D. Mintz           |       |      |
|                     |       |      |
|                     |       |      |
| /s/  Ron Olson           |       | Director  | March  30, 2006 |
| Ron  Olson               |       |      |
|                     |       |      |
|                     |       |      |
| /s/  Jack W. Robasciotti |       | Director  | March  30, 2006 |
| Jack  W. Robasciotti     |       |      |
|                     |       |      |
|                     |       |      |
| /s/  Dan H. Wixom        |       | Director  | March  30, 2006 |
| Dan  H. Wixom            |       |      |
|                          |            |           |                 |          |            |  |

 

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