**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20429**

**FORM 10-KSB/A**

**Amendment No. 1**

 
| **x**      | **ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                           |
|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** **                                                                                                                                                                                                                    |
| ** ** | **For the annual period ending December 31, 2006**                                                                                                                                                                            |
| ** ** | ** **                                                                                                                                                                                                                    |
| **o**      | **TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                       |
| ** ** | ** **                                                                                                                                                                                                                    |
| ** ** | **For the transition period from                   to                ** |

 

**Commission File No. 000-32827**

**COAST BANCORP**

(Exact Name ofRegistrant 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 theissuer is not required to file reports pursuant to Section 13 or 15 (d) of theExchange Act     o

Checkwhether the issuer (1) filed all reports required to be filed by Section 13 or15 (d) of the Exchange Act during the past 12 months (or for such shorterperiod that the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.         Yes x    No o

Checkif there is no disclosure of delinquent filers in response to Item 405 ofRegulation S-B is not contained in this form, and no disclosure will becontained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form10-KSB or any amendment to this Form 10-KSB.    o

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act).

Yes o    No x

Registrant’s revenues of fiscal year ended December31, 2006 were $14,742,801.

Theaggregate market value of the voting stock held by non-affiliates computed byreference to the average bid and asked prices of such stock, as of March 15,2006:  $23,106,400.

Number of registrant’s shares of Common Stockoutstanding as of December 31, 2006 was 679,600.

Documents incorporated by reference:     None

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

**Explanationof Amendment**

This Form 10-KSB/A amends the Form 10-KSB filed onMarch 30, 2007 in order to disclose the corrected 2005 allowance for loanlosses as compared to total loans located in the Management’s Discussion andAnalysis section of the Report and to disclose Director Dan Wixom’s 2006compensation.   Unaffected items have notbeen repeated in this filing.

 

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**FORWARDLOOKING STATEMENTS**

**CERTAINSTATEMENTS WITHIN THIS ANNUAL REPORT ON FORM 10-KSB INCLUDE FORWARD LOOKINGINFORMATION WITHIN THE MEANING OF SECTION 27A OF THE SECURITIES ACT OF 1933, ASAMENDED, AND SECTION 21E OF THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED,AND ARE SUBJECT TO THE “SAFE HARBOR” CREATED BY THOSE SECTIONS.  THESE FORWARD-LOOKING STATEMENTS INVOLVECERTAIN RISKS AND UNCERTAINTIES THAT COULD CAUSE ACTUAL RESULTS TO DIFFERMATERIALLY FROM THOSE IN THE FORWARD-LOOKING STATEMENTS.  SUCH RISKS AND UNCERTAINTIES INCLUDE, BUT ARENOT LIMITED TO, THE FOLLOWING FACTORS: COMPETITIVE PRESSURE IN THE BANKINGINDUSTRY INCREASES SIGNIFICANTLY; CHANGES IN THE INTEREST RATE ENVIRONMENTREDUCE MARGINS; GENERAL ECONOMIC CONDITIONS, EITHER NATIONALLY OR REGIONALLY,ARE LESS FAVORABLE THAN EXPECTED, RESULTING IN, AMONG OTHER THINGS ADETERIORATION IN CREDIT QUALITY AND AN INCREASE IN THE PROVISION FOR POSSIBLELOAN LOSSES; CHANGES IN THE REGULATORY ENVIRONMENT; CHANGES IN BUSINESSCONDITIONS, PARTICULARLY IN SAN LUIS OBISPO COUNTY; 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 INFORMATION CONTAINED IN THIS ANNUAL REPORT SHOULD BE CAREFULLY CONSIDEREDWHEN EVALUATING THE BUSINESS PROSPECTS OF COAST BANCORP AND COAST NATIONALBANK.**

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

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**INDEX**
|              | ** ** | ** **                                                                                                          | ** ** | **Page** |
|--------------|------------|---------------------------------------------------------------------------------------------------------------------|------------|----------|
| **PART I**   |       |                                                                                                                |       |     |
| ** **   |       |                                                                                                                |       |     |
| Item 1 -     |       | DESCRIPTION OF  BUSINESS                                                                                            |       | 4        |
|         |       |                                                                                                                |       |     |
| Item 2 -     |       | DESCRIPTION OF  PROPERTIES                                                                                          |       | 20       |
|         |       |                                                                                                                |       |     |
| Item 3 -     |       | LEGAL PROCEEDINGS                                                                                                   |       | 21       |
|         |       |                                                                                                                |       |     |
| Item 4 -     |       | SUBMISSION  OF MATTERS TO A VOTE OF SECURITY HOLDERS                                                                |       | 21       |
|         |       |                                                                                                                |       |     |
| **PART II**  |       |                                                                                                                |       |     |
| ** **   |       |                                                                                                                |       |     |
| Item 5 -     |       | MARKET FOR  COMMON EQUITY AND RELATED STOCKHOLDER MATTERS AND SMALL BUSINESS ISSUERS PURCHASE  OF EQUITY SECURITIES |       | 22       |
|         |       |                                                                                                                |       |     |
| Item 6 -     |       | MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS                         |       | 23       |
|         |       |                                                                                                                |       |     |
| Item 7 -     |       | FINANCIAL  STATEMENTS                                                                                               |       | 35       |
|         |       |                                                                                                                |       |     |
| Item 8 -     |       | CHANGES IN  AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE                               |       | 60       |
|         |       |                                                                                                                |       |     |
| Item 8A -    |       | CONTROLS AND  PROCEDURES                                                                                            |       | 60       |
|         |       |                                                                                                                |       |     |
| Item 8B -    |       | OTHER INFORMATION                                                                                                   |       | 61       |
|         |       |                                                                                                                |       |     |
| **PART III** |       |                                                                                                                |       |     |
| ** **   |       |                                                                                                                |       |     |
| Item 9 -     |       | DIRECTORS,  EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS: COMPLIANCE WITH SECTION  16(a) OF THE EXCHANGE ACT   |       | 62       |
|         |       |                                                                                                                |       |     |
| Item 10 -    |       | EXECUTIVE  COMPENSATION                                                                                             |       | 66       |
|         |       |                                                                                                                |       |     |
| Item 11 -    |       | SECURITY  OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER  MATTERS                    |       | 70       |
|         |       |                                                                                                                |       |     |
| Item 12 -    |       | CERTAIN  RELATIONSHIPS AND RELATED TRANSACTIONS                                                                     |       | 71       |
|         |       |                                                                                                                |       |     |
| **PART IV**  |       |                                                                                                                |       |     |
| ** **   |       |                                                                                                                |       |     |
| Item 13 -    |       | EXHIBITS                                                                                                            |       | 72       |
|         |       |                                                                                                                |       |     |
| Item 14 -    |       | PRINCIPAL  ACCOUNTANT FEES AND SERVICES                                                                             |       | 72       |
|         |       |                                                                                                                |       |     |
|         |       | EXHIBIT  INDEX                                                                                                      |       | 73       |
|         |       |                                                                                                                |       |     |
|         |       | SIGNATURES                                                                                                          |       | 75       |

 

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**PART I**

**Item 1.    Description of Business**

**CoastBancorp**

CoastBancorp (the “Bancorp” or “Coast Bancorp”), headquartered in San Luis Obispo,California, and is a California corporation incorporated in 2001.  Coast Bancorp became the bank holding companyof Coast National Bank on May 31, 2001 through a 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.

**CoastNational Bank**

CoastNational Bank (the “Bank”) was chartered June 16, 1997, (charter #23222) by TheOffice of the Comptroller of the Currency as a national bank.  The Bank commenced operations on that datewith two offices, 16 employees and $6,250,000 in capital.  The original branch offices were located at486 Marsh Street, San Luis Obispo and 1199 Grand Avenue, Arroyo Grande,California.  Since that time, anadditional branch office was opened in June, 1998, at 948 Morro Bay Boulevard inMorro Bay, California and another branch office was opened in July, 1999, at1193 Los Osos Valley Road in Los Osos, California.  In July 2002, a loan production 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 Bankapplied for and received approval from the Comptroller of the Currency foranother branch office which opened March 2005 at 2138 Spring Street, PasoRobles, California.  The Bank alsopurchased a lot at 2045 Spring Street, Paso Robles, California with theintention of relocating the Paso Robles branch. However, the lot was not adequate for the relocation of the branch andon October 26, 2006, the Bank purchased a new lot at 2110 Spring St, PasoRobles, California.  The Bank intends torelocate the Paso Robles branch to this larger lot, sometime in the future. InJune 2005, the Bank opened a new loan production office at 7429 N. First St.,Ste. 104, Fresno, California.  In July of2006, the Fresno office was relocated to 466 W. Fallbrook Ave., #109, Fresno,California.

Whenthe Bank opened for business in June 1997, it purchased the real estate andbuilding that housed the Arroyo Grande branch office.  On October 14, 1999, the Bank purchased anadjacent lot next to the San Luis Obispo main office on Marsh Street.  A few months later on February 1, 2000, theBank also purchased the contiguous property and building that was home to theSan Luis Obispo main office at 486 Marsh Street.  Construction of a new head office building onthe adjacent lot began on October 11, 2001 and was completed on November 25,2002.  The new main office, located at500 Marsh Street is approximately 10,700 square feet with the San Luis Obispobranch operation occupying the ground floor and the administrative officesoccupying the second floor.  Half of theoriginal main office at 486 Marsh Street now houses the Bank’s Small BusinessLending Center and the Bank’s Note Department while the other half is leased tovarious businesses.

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

**BusinessStrategy**

TheBank’s primary market focus is to provide commercial bank services tobusinesses, professionals, and individuals with constant attention paid tosafety, soundness and exceptional returns for our shareholders.  The Bank emphasizes the development ofmeaningful customer relationships with a commitment to caring, quality servicewhile supporting the communities we serve. We will expand our presence whenever possible within our current servicearea and beyond, in a continuing effort to enjoy opportunities for growth andprofitability.  Finally, the Bank’semployees are well-trained banking professionals who are committed to theseobjectives.

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**Marketing**

Inthe second half of 2005, Coast National Bank has established an award winning “ItTakes” marketing campaign.  Instead offocusing the campaign on the bank itself, we are celebrating the “heroic”stories of customers who had a dream they turned into a successful business inthe region.  Through the use of artisticlocal scenery, compelling, true stories and identifiable business leaders in “non-work”settings, the campaign forges an immediate, familiar connection with theaudience. It invokes feelings of pride in our community and reinforces themessage that Coast National Bank “understands doing business on the CentralCoast.”

**Deposits,Liquidity and Liability Management**

Depositsrepresent the Bank’s primary source of funds. As of December 31, 2006, the Bank had approximately $39.5 million innon-interest bearing deposit accounts. Also, as of that date, the Bank had approximately $50.0 million ininterest bearing deposit accounts, $6.7 million in savings accounts and $66.3million in time certificates of deposits. Of the total time certificates of deposits, approximately $50.7 millionwere in amounts of $100,000 or more, or 76.5% of all time certificates and31.2% of all deposits.  Most of the Bank’sdeposits are obtained from individuals, professionals and small and mediumsized businesses.  No material portion ofthe Bank’s deposits has been obtained from either a single person or a fewpersons.

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

Inorder to attract loan and deposit business, the Bank maintains lobby hours from9:00 a.m. to 4:00 p.m., Monday through Thursday and 9:00 a.m. to 6:00 p.m. onFridays.  Walk-up window service is alsoavailable at the San Luis Obispo office beginning at 8:00 a.m. until 9:00 a.m.and again from 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.

Liquidityis the Bank’s ability to meet fluctuations in deposit levels and to provide forthe credit needs of its customers.  Theobjective in liquidity management is to maintain a balance between the sourcesand uses of funds.  Principal sources ofliquidity include interest and principal payments on loans and investments,proceeds from the maturity of investments and growth in deposits.  The Bank holds overnight Fed Funds Sold as acushion for temporary liquidity needs. For 2006, Fed Funds Sold averaged $16.1 million representing 8.9% 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, 2006, the Bank had noborrowings under its Federal Funds lines. Also at December 31, 2006, 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 19.0% and within the Bank’s policy guidelines.

**LendingActivities, Underwriting and Credit Administration**

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

TheBank considers its underwriting practices to be conservative in nature.  Each loan must meet minimum underwriting criteriaestablished 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.

Nomaterial portions of the Bank’s loans are concentrated within a single industryor group of related industries.  However,as of December 31, 2006 and December 31, 2005 respectively 66.1% and 75.8% oftotal loans were secured by real estate. The interest rates charged by the Bank vary with the degree of risk andthe size and maturity of the loans involved and are generally affected bycompetition, governmental regulation and current money market rates.

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TheBank concentrates its lending activities in the following areas:

*CommercialLoans*

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

TheBank also participates in several government-guaranteed loan programsadministered by the Small Business Administration (SBA) and the US Departmentof Agriculture.  These programs includethe 504 program, the 7-A program, the Cap-Line program, and the Express programthrough SBA and the Business and Industry Programs through the USDA.  The SBA’s 7-A program presently constitutesthe largest volume of government guaranteed lending engaged in by the Bank andis primarily used for the financing of real estate, equipment, inventory andworking capital needs of eligible businesses, generally over a seven to twentyfive year term.  The governmentguarantees extended by the SBA to the Bank in conjunction with thesetransactions substantially reduces the Bank’s credit risk.  Based upon the Bank’s expertise in this typeof lending, the SBA designated the Bank as a Preferred Lender in September2001.  Under the SBA’s Preferred Lenderprogram, the Bank enjoys a significant degree of delegated approval authoritywhich in turn allows the Bank to process customer loan requests morequickly.  This Preferred Lender authoritycovers loan transactions originated by the Bank in the geographic areas definedby the SBA as their Fresno district (which serves the counties of Alpine,Fresno, Inyo, Kern, Kings, Madera, Mariposa, Merced, Mono, Monterey, SanBenito, San Luis Obispo, Stanislaus, Tulare and Tuolumne) and the Los Angelesdistrict (which serves Los Angeles County, Santa Barbara County and VenturaCounty).

*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 theconstruction of single family residences in the Bank’s service area.

Residentialreal estate construction loans are typically secured by first deeds of trustand require guarantees of the borrower, when applicable.  The economic viability of the project and theborrower’s credit-worthiness are primary considerations in the loanunderwriting decision.  The Bank utilizesindependent local real estate appraisers that have been pre-approved by theBank’s Loan Committee to evaluate the projects. Loan-to-value ratios generally do not 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.

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

*ResidentialMortgage Loans*

In2004, the Bank entered into an agreement with Mariner Mortgage, Inc., to be aresidential loan referring agent.  Under this agreement, the Bank staffrefers loans to Mariner Mortgage, Inc. by faxing a referral sheet or byintroducing 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 refinanceboom.  Income generated by this referral program for 2006 and 2005 and was$42,000 and $76,000 respectively.

*CommercialReal Estate Term Loans*

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

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*Consumerand Other Loans*

TheBank’s consumer and other loan portfolio is divided between installment loanssecured by automobiles, personal loans, other consumer purposes and revolving,unsecured consumer debt, such as credit card lines of credit and overdraftlines of credit.  Installment loans tendto be fixed rate and longer term (one-to-five year maturity).  The Bank’s portfolio of revolving creditplans tend to be small in size and meant to be an accommodation to ourcustomers.

**Employees**

Asof December 31, 2006, we employed 70 full-time equivalent employees.  Part-time employees are converted tofull-time equivalent employees based on the percentage of their weekly hoursworked compared to 40 hours.  The Bankvalues its employees.  They are activelyengaged individually and as a team in contributing to the Bank’s realization ofits vision and mission.  We believe thatwe enjoy satisfactory working relations with our employees.

**Competition**

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

TheBank relies substantially on our marketing campaign, personal contacts by itsofficers, directors and employees, referrals by its shareholders, personalizedservice and its reputation in the community it serves to compete effectively.

Thebanking business in California generally, and in the Bank’s primary servicearea specifically, is highly competitive with respect to both loans anddeposits, and is dominated by a relatively small number of major banks withoffices operating over a wide geographic area. Among the advantages such major banks have over the Bank are theirability to finance wide-ranging advertising campaigns and to allocate theirinvestment assets, including loans, to regions of higher yield and demand.  Such banks offer certain services such asinternational banking and trust services which are not offered directly by theBank, but which the Bank has offered indirectly through correspondentinstitutions when its customers sought these services.  In addition, by virtue of their greater totalcapitalization, such banks have substantially higher lending limits than theBank.  (Legal lending limits to anindividual customer are limited to a percentage of a bank’s total capitalaccounts plus reserves for loan losses.) As of December 31, 2006, the Bank’s loan limits to individual customerswere $2,804,548 for unsecured loans, and $4,674,247 for unsecured and securedloans combined.  For borrowers desiringloans in excess of the Bank’s lending limits, the Bank may, in the future, makesuch loans on a participation basis with its correspondent banks taking theamount of loans in excess of the Bank’s lending limits.  In other cases, the Bank may refer suchborrowers to larger banks or other lending institutions.

Inaddition to the major banks, Coast National Bank faces significant competitivechallenges from local Credit Unions.  Ascredit unions currently enjoy an exemption from income tax, they are able tooffer higher deposit rates and lower loan rates than we can on a comparablebasis.  Credit unions are also notsubject to certain regulatory restraints. Adhering to such regulatory requirements raises the costs associatedwith our lending activities, and reduces potential operating profits.  Accordingly we compete by focusing onbuilding customer relations and providing superior service and productofferings.

**TrustPreferred Securities**

OnSeptember 26, 2002, the Bancorp completed its offering of trust preferredsecurities (“TPS”) in the amount of $5.2 million.  Under current Federal Reserve guidelines, TPSqualify as regulatory capital for the Bancorp. More specifically, under current Federal Reserve guidelines, TPS qualifyas Tier 1 Capital up to 25% of the Bancorp’s total Tier 1 Capital, with theremainder qualifying as Tier 2 Capital. The Bancorp is reflecting the trust preferred securities as juniorsubordinated debt securities on its consolidated balance sheet.

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

The$5.2 million in trust preferred securities have a floating rate of interest,which is reset quarterly, equal to the 3-month LIBOR plus 3.40%.  As of December 31, 2006, the floating rate ofinterest was 8.77%.  The floating rate,however, may not exceed 11.95% for the first five years.

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Ifthe Bancorp elects to defer interest payments pursuant to the terms of the agreement,then the Bancorp may not (i) declare or pay any dividends or distributions on,or redeem, purchase, acquire or make a liquidation payment with respect to anyof the Bancorp’s capital stock, or (ii) make any payment of principal orpremium, if any, or interest on or repay, repurchase or redeem any debtsecurities of the Bancorp that rank pari passu with or junior in interest tothe debt securities, other than, among other items, a dividend in the form ofstock, 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.

Asof December 31, 2006, Coast Bancorp has down-streamed a total of $3.6 millionto the Bank in the form of Tier 1 capital where it will finance future depositand asset growth.

**OtherInformation**

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

Althoughthere can be no assurance, based upon present business activities, managementbelieves that compliance with federal, state and local provisions regulatingdischarge of materials into the environment will have no material effects uponthe capital expenditures, earnings and competitive position of the Bank.

Therehave been no significant changes in the kinds of services rendered, theprincipal markets for or the methods of distribution of such services by theBank during the last eight (8) fiscal years.

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

**CriticalAccounting 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 loan losses represents management’sbest estimate of losses inherent in the existing loan portfolio.  The allowance for loan losses is increased bythe provision for loan losses charged to expense and reduced by loans chargedoff, net of recoveries.  The allowancefor loan losses is determined based on management’s assessment of severalfactors: reviews and evaluation of individual loans, changes in the nature andvolume of the loan portfolio, current economic conditions and the relatedimpact on specific borrowers and industry groups, historical loan lossexperiences and the levels of classified and nonperforming loans.

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

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

*DeferredTax Assets*

We use an estimate of future earnings to support ourposition that the benefit of our deferred tax assets will be realized.  If future income should prove non-existent orless than the amount of the deferred tax assets within the tax years to whichthey may be applied, the asset may not be realized and our net income will bereduced.  Our deferred tax assets aredescribed further in Note 8 of the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.

*Servicing and Related Assets*

Managementestimates the value of servicing and related assets primarily by projecting theamount and term of cash flows and then applying a market discount factor.

*Gain on Sale of Loan.*

Managementestimates the valuation of servicing assets as well as the retained portion ofSBA loans sold to arrive at the reported gain on loan sales.

*Stock Options*

Management estimates****the fair market value of stock options and warrants granted duringthe year using the Black-Scholes option pricing model and assumptions for riskfree rates, average option life, expected stock price volatility and expecteddividends.

**Supervisionand Regulation**

*Bancorp*

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

TheBank Holding Company Act requires Coast Bancorp to obtain the prior approval ofthe Federal Reserve before acquisition of all or substantially all of theassets of any bank or ownership or control of the voting shares of any bank if,after giving effect to such acquisition, Coast Bancorp would own or control,directly or indirectly, more than 5% of the voting shares of such bank.  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.

CoastBancorp may not engage in any business other than managing or controlling banksor furnishing services to its subsidiaries, with the exception of certainactivities which, in the opinion of the Federal Reserve, are so closely relatedto banking or to managing or controlling banks as to be incidental tobanking.  The Gramm-Leach-Bliley Act,federal legislation enacted in 2000, offers bank holding companies anopportunity to broaden the scope of activities engaged in by electing to betreated as a financial holding company. A financial holding company enjoys broader powers than a bank holdingcompany, specifically including the ability to own securities and insurancecompanies in addition to financial institutions.  Coast Bancorp has not determined whether ornot to become a financial holding company. Coast Bancorp is generally prohibited from acquiring direct or indirectownership or control of more than 5% of the voting shares of any company unlessthat company is engaged in such authorized activities and the Federal Reserveapproves the acquisition.

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

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*The Bank*

TheBank is regulated and supervised by the Office of the Comptroller of theCurrency (the “Comptroller”) and subject to periodic examination by theComptroller.  Deposits of the Bank’scustomers are insured by the Federal Deposit Insurance Corporation (the “FDIC”)up to the maximum limit of $100,000, and, as an insured bank, the Bank issubject to certain regulations of the FDIC. As a national bank, the Bank is a member of the Federal Reserve Systemand is also subject to the regulations of the Federal Reserve Board (the “FRB”).

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

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

**Effect ofState Law**

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

**Change inBank Control**

TheBank Holding Company Act of 1956, as amended and the Change in Bank Control Actof 1978, as amended, together with regulations of the FRB and the Comptroller,require that, depending on the particular circumstances, either FRB approvalmust be obtained or notice must be furnished to the Comptroller and notdisapproved prior to any person or company acquiring “control” of a nationalbank, such as the Bank, subject to exemptions for some transactions.  Control is conclusively presumed to exist ifan individual or company acquires 25% or more of any class of voting securitiesof the Bank.  Control is rebuttablypresumed to exist if a person acquires 10% or more but less than 25% of anyclass of voting securities and either the company has registered securitiesunder Section 12 of the Securities Exchange Act of 1934, as amended (the “ExchangeAct”), or no other person will own a greater percentage of that class of votingsecurities immediately after the transaction.

**Paymentof Dividends**

*Coast Bancorp*

Theshareholders of Coast Bancorp are entitled to receive dividends when and asdeclared by its Board of Directors, out of funds legally available, subject tothe dividends preference, if any, on preferred shares that may be outstandingand also subject to the restrictions of the California Corporations Code.  At December 31, 2006, Coast Bancorp had nooutstanding shares of preferred stock.

Thepayment of dividends to shareholders by Coast Bancorp may be affected if theBancorp elects to defer interest payments pursuant to the terms of the TrustPreferred Securities agreement that was entered into on September 26,2002.  If such an event occurs, then theBancorp may not (i) declare or pay any dividends or distributions on, orredeem, purchase, acquire or make a liquidation payment with respect to any ofthe Bancorp’s capital stock, or (ii) make any payment of principal 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 ofstock, 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.

Seealso the section that follows titled “Part II – Item 5: Market for CommonEquity and Related Stockholder Matters – Dividends.”

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Theprincipal sources of cash revenue to Coast Bancorp are dividends and managementfees received from Coast National Bank. The Bank’s ability to make dividend payments to Coast Bancorp is subjectto federal regulatory restrictions.

*Coast National Bank*

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

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

TheComptroller also has broad authority to prohibit a national bank from engagingin banking practices which it considers to be unsafe or unsound.  It is possible, depending upon the financialcondition of the national bank in question and other factors, that theComptroller may assert that the payment of dividends or other payments by abank is considered an unsafe or unsound banking practice and therefore,implement corrective action to address such a practice.

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

**CapitalStandards**

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

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

Inaddition to the risk-based guidelines, federal banking regulators requirebanking organizations to maintain a minimum amount of Tier 1 capital to totalassets, referred to as the leverage ratio. For a banking organization rated in the highest of the five categoriesused by the regulators to rate banking organizations, the minimum leverageratio of Tier 1 capital to total assets is 3%. It is improbable however, that an institution with a 3% leverage ratio wouldreceive the highest rating by the regulators since a strong capital position isa significant part of the regulators’ rating. For all banking organizations not rated in the highest category, theminimum leverage ratio is at least 100 to 200 basis points above the 3%minimum.  Thus, the effective minimumleverage 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.

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Inaddition to evaluating capital ratios, an overall assessment of capitaladequacy must take account of each of these other factors including, inparticular, the level and severity of problem and adversely classifiedassets.  For this reason, the supervisoryjudgment on a bank’s capital adequacy may differ significantly from theconclusions that might be drawn solely from the absolute level of the Bank’srisk-based capital ratio.  TheComptroller has stated that banks generally are expected to operate above theminimum risk-based capital ratio.  Bankscontemplating significant expansion plans, as well as those institutions withhigh or inordinate levels of risk, should hold capital consistent with thelevel and nature of the risks to which they are exposed.

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

Finally,institutions with significant trading activities must measure and hold capitalfor exposure to general market risk arising from fluctuations in interestrates, equity prices, foreign exchange rates and commodity prices and exposureto specific risk associated with debt and equity positions in the tradingportfolio.  General market risk refers tochanges in the market value of on-balance-sheet assets and off-balance-sheetitems resulting from broad market movements. Specific market risk refers to changes in the market value of individualpositions due to factors other than broad market movements and includes suchrisks as the credit risk of an institution’s issuer.  The additional capital requirements applyeffective January 1, 1998, to institutions with trading assets and liabilitiesequal to 10% or more of total assets or trading activity of $1 billion ormore.  The federal banking agencies mayapply the market risk regulations on a case by case basis to institutions notmeeting the eligibility criteria if necessary for safety and soundness reasons.

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

Undercertain circumstances, the Comptroller may determine that the capital ratiosfor a national bank shall be maintained at levels which are higher than theminimum levels required by the guidelines. A national bank which does not achieve and maintain adequate capitallevels as required may be subject to supervisory action by the Comptroller,through the issuance of a capital directive to ensure the maintenance of requiredcapital levels.  In addition, the Bank isrequired to meet certain guidelines of the Comptroller concerning themaintenance of an adequate allowance for loan and lease losses.  For the regulatory capital guidelines as wellas the actual capitalization for the Bank and the company on a consolidatedbasis as of December 31, 2006 see “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations - Capital Resources.”

**Prompt Corrective Action andOther Enforcement Mechanisms**

Federal bankingagencies possess broad powers to take corrective and other supervisory actionsto resolve the problems of insured depository institutions, including, but notlimited to those institutions that fall below one or more prescribed minimumcapital ratios described above.  Aninstitution that, based upon its capital levels, is classified as wellcapitalized, adequately capitalized, or undercapitalized may be treated asthough it were in the next lower capital category if the appropriate federalbanking agency, after notice and opportunity for hearing, determines that anunsafe or unsound condition or an unsafe or unsound practice warrants suchtreatment.  At each successive lowercapital category, an insured depository institution is subject to 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 tomeasures taken under the prompt corrective action provisions, commercialbanking organizations may be subject to potential enforcement actions by thefederal regulators for unsafe or unsound practices in conducting theirbusinesses or for violations of any law, rule, regulation, or any conditionimposed in writing by the agency, or any written agreement with theagency.  Enforcement actions may includethe imposition 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

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agreements, the issuanceof removal and prohibition orders against institution-affiliated parties andthe enforcement of such actions through injunctions or restraining orders basedupon a judicial determination that the agency would be harmed if such equitablerelief was not granted.  Additionally, aholding company’s inability to serve as a source of strength to its subsidiarybanking organizations could serve as an additional basis for a regulatoryaction against the holding company.

**Safetyand Soundness Standards**

The Federal Deposit Insurance Corporation ImprovementAct (“FDICIA”) imposes certain specific restrictions on transactions andrequires federal banking regulators to adopt overall safety and soundnessstandards for depository institutions related to internal control, loanunderwriting 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.

**Premiumsfor Deposit Insurance**

Through the BankInsurance Fund (“BIF”), the FDIC insures the deposits of the Bank up toprescribed limits for each depositor. The amount of FDIC assessments paid by each BIF member institution isbased on its relative risk of default as measured by regulatory capital ratiosand other factors.  Specifically, theassessment rate is based on the institution’s capitalization risk category andsupervisory subgroup category.  Aninstitution’s capitalization risk category is based on the FDIC’s determinationof whether the institution is well capitalized, adequately capitalized or lessthan adequately capitalized.  Aninstitution’s supervisory subgroup category is based on the FDIC’s assessmentof the financial condition of the institution and the probability that FDICintervention or other corrective action will be required.

TheBank’s deposits are insured by the Bank Insurance Fund administered by theFDIC.  Prior to 2006, the FDIC wasrequired to maintain insurance fund reserves of $1.25 for each $100 of insureddeposits. The FDIC has authority to levy special assessments against insuredfinancial institutions based upon insured deposits.

OnFebruary 8, 2006, President Bush signed into law the Federal Deposit InsuranceReform Act of 2005 as part of the Deficit Reduction Act of 2005 and signed acompanion bill, the Federal Deposit Insurance Reform Conforming Amendments Actof 2005, on February 15, 2006. This legislation provides for:

·                  mergingthe BIF and SAIF deposit insurance funds;

·                  annuallyadjusting the minimum insurance fund reserve ratio between $1.15 and $1.50 per$100 of insured deposits;

·                  increasingdeposit coverage for retirement accounts to $250,000,

·                  indexingthe insurance level for inflation, with any increases approved by the FDIC andNational Credit Union Administration on a five-year cycle beginning in 2010after review of the state of the deposit insurance fund and related factors;

·                  creditsof up to $4.7 billion to offset premiums for banks that were members ofthe FDIC and paid deposit insurance premiums by 1996; and

·                  ahistorical basis concept for distributing credits and dividends to reflect pastcontributions to the insurance funds.

Inthe fourth quarter of 2006, the FDIC adopted two final rules implementing theFederal Deposit Insurance Reform Act of 2005:

·                  arule creating  a new system for risk-based assessments and sets assessment rates beginning January 1, 2007.Assessment rates are three basis points above the base rates, ranging from 5 to7 basis points for Risk Category I institutions, 10 basis points for RiskCategory II institutions, 28 basis points for Risk Category III institutions,and 43 basis points for Risk Category IV institutions; and

·                  arule setting the designated reserve ratio at 1.25 percent. In October of2006, FDIC’s Board adopted a final rule governing the distribution and use ofthe $4.7 billion one-time assessment credit and a temporary final rule thatexpires at the end of 2009 governing dividends from the insurance fund.  The Bank had no assessment credits as of December31, 2006.

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All FDIC-insureddepository institutions must also pay an annual assessment to provide funds forthe payment of interest on bonds issued by the Financing Corporation (FICO), afederal corporation chartered under the authority of the Federal Housing FinanceBoard.  The bonds, commonly referred toas FICO bond, were issued to capitalize the Federal Savings and Loan InsuranceCorporation.  The FICO assessment ratefor the fourth quarter of the fiscal year 2006 was 1.24 basis points for each$100 of assessable deposits.  The FICOassessments are adjusted quarterly to reflect changes in the assessment basesof the FDIC’s insurance funds and do not vary depending on a depositoryinstitution’s capitalization or supervisory evaluations.

The FDIC isauthorized to terminate a depository institution’s deposit insurance upon afinding by the FDIC that the institution’s financial condition is unsafe, orunsound, or that the institution has engaged in unsafe, or unsound practices,or has violated any applicable rule, regulation, order or condition enacted orimposed by the institution’s regulatory agency. The termination of deposit insurance for the Bank would have a materialadverse effect on the Bancorp’s condition since it would result in therevocation of the Bank’s charter and the cessation of its operations as a goingconcern.

**Extensionsof Credit to Insiders and Transactions with Affiliates**

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

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

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

**ConsumerProtection Laws and Regulations**

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

**Recentand Proposed Legislation**

*Sarbanes-OxleyAct*

OnJuly 30, 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002implementing legislative reforms intended to address corporate and accountingfraud.  In addition to the establishmentof a new accounting oversight board which will enforce auditing, qualitycontrol and independence standards and will be funded by fees from all publiclytraded companies, 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 equivalent, tocertify to the accuracy of periodic reports filed with the SEC, subject tocivil and criminal penalties if they knowingly or willfully violate thiscertification requirement.  In addition,under the Act, legal counsel will be required to report evidence of a materialviolation of the securities laws or a breach of fiduciary duty by a company to

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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.

Longerprison terms and increased penalties will also be applied to corporate executiveswho violate federal securities laws, the period during which certain types ofsuits can be brought against a company or its officers has been extended, andbonuses issued to top executives prior to restatement of a company’s financialstatements are now subject to disgorgement if such restatement was due tocorporate misconduct.  Executives arealso prohibited from insider trading during retirement plan “blackout” periods,and loans 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.

TheAct also prohibits any officer or director of a company or any other personacting under their direction from taking any action to fraudulently influence,coerce, manipulate or mislead any independent public or certified accountantengaged in the audit of the company’s financial statements for the purpose ofrendering the financial statement’s materially misleading.  The Act also requires the SEC to prescriberules requiring inclusion of an internal control report and assessment bymanagement in the annual report to stockholders.  In addition, the Act requires that eachfinancial report required to be prepared in accordance with (or reconciled to)accounting principles generally accepted in the United States of America andfiled with the SEC reflect all material correcting adjustments that areidentified by a “registered public accounting firm” in accordance withaccounting principles generally accepted in the United States of America andthe rules and regulations of the SEC.

Asdirected by Section 302(a) of Sarbanes-Oxley, the Company’s chief executiveofficer and chief financial officer are each required to certify that theCompany’s Quarterly and Annual Reports do not contain any untrue statement of amaterial fact.  The rules have severalrequirements, including having these officers certify that: they areresponsible for establishing, maintaining and regularly evaluating theeffectiveness of Company’s disclosure controls; they have made certaindisclosures to Bancorp’s auditors and the audit committee of the Board ofDirectors about the Company’s disclosure controls; and they have includedinformation in the Company’s Quarterly and Annual Reports about theirevaluation and whether there have been significant changes in the Company’sdisclosure controls or in other factors that could significantly affectinternal controls subsequent to the evaluation.

*USAPATRIOT Act*

Inthe wake of the tragic events of September 11th, on October 26, 2001, PresidentBush signed the Uniting and Strengthening America by Providing AppropriateTools Required to Intercept and Obstruct Terrorism (USA PATRIOT) Act of2001.  Under the USA PATRIOT Act,financial institutions are subject to prohibitions against specified financialtransactions and account relationships as well as enhanced due diligence and “knowyour customer” standards in their dealings with foreign financial institutionsand foreign customers. For example, the enhanced due diligence policies,procedures, and controls generally require financial institutions to takereasonable steps:

·  To conductenhanced scrutiny of account relationships to guard against money launderingand 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.

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Underthe USA PATRIOT Act, financial institutions were given 180 days from enactmentto establish anti-money laundering programs. The USA PATRIOT Act sets forth minimum standards for these programs,including:

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

·      The designation of a compliance officer;

·      An ongoing employee training program; and

·      An independent audit function to test theprograms.

OnJune 20, 2002, the Board of Directors of the Bank adopted comprehensivepolicies and procedures to address the requirements of the USA PATRIOT Act, andmanagement believes that the Bank is currently in full compliance with the Act.

*FinancialServices Modernization Legislation*

OnNovember 12, 1999, President Clinton signed into law the Gramm-Leach-BlileyAct. This legislation eliminated many of the barriers that have separated theinsurance, securities and banking industries since the Great Depression. Thefederal banking agencies (the Board of Governors, FDIC and the Office of theComptroller of the Currency), among others, continue to draft regulations toimplement the Gramm-Leach-Bliley Act. The Gramm-Leach-Bliley Act is the result of a decade of debate in theCongress regarding a fundamental reformation of the nation’s financial system.The law is subdivided into seven titles, by functional area.

Themajor provisions of the Gramm-Leach-Bliley Act are:

·      *Financial HoldingCompanies and Financial Activities*

Title I establishes a comprehensive framework topermit affiliations among commercial banks, insurance companies, securitiesfirms, and other financial service providers by revising and expanding the BHCAct framework to permit a holding company system to engage in a full range offinancial activities through qualification as a new entity known as a financialholding company.

Activities permissible for financial subsidiaries ofnational banks, and, also permissible for financial subsidiaries of statemember banks, include, but are not limited to, the following:  (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 as principal, agent,or broker for purposes of the foregoing, in any State; (c) Providing financial,investment, or economic advisory services, including advising an investmentcompany; (d) Issuing or selling instruments representing interests in pools ofassets permissible for a bank to hold directly; and (e) Underwriting, dealingin, or making a market in securities.

·      *Securities Activities*

Title II narrows the exemptions from the securitieslaws previously enjoyed by banks.  TheBoard of Governors and the SEC continue to work together to draft rulesgoverning certain securities activities of banks and creates a new, voluntaryinvestment bank holding company.

·      *Insurance Activities*

Title III restates the proposition that the states arethe functional regulators for all insurance activities, including the insuranceactivities of federally-chartered banks, and bars the states from prohibitinginsurance activities by depository institutions.

·      *Privacy*

As required under Title V of the Gramm-Leach-BlileyAct, federal banking regulators issued final rules on May 10, 2000 to implementthe privacy provisions of Title V. Pursuant to the rules, financialinstitutions must provide (i) initial notices to customers about their privacypolicies, describing the conditions under which they may disclose nonpublicpersonal information to nonaffiliated third parties and affiliates; (ii) annualnotices of their privacy policies to current customers; and (iii) a reasonablemethod for customers to “opt out” of disclosures to nonaffiliated third parties.

Compliance with the rules was optional until July 1,2001.  As of July 1, 2001 the Bank  was in compliance with the privacy provisionsof the Gramm-Leach-Bliley Act and the implementing regulations promulgated bythe FDIC, and subsequently, as necessary, has updated and enhanced itsprocedure and practice in this critical area.

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·      *Safeguarding ConfidentialCustomer Information*

Under Title V of the Gramm-Leach-Bliley Act, federalbanking regulators were required to adopt rules requiring financial institutionsto implement a program to protect confidential customer information.  In January 2000, the federal banking agenciesadopted guidelines requiring financial institutions to establish an informationsecurity program to:

·      identifyand assess the risks that may threaten customer information;

·      developa written plan containing policies and procedures to manage and control theserisks;

·      implementand test the plan; and

·                  adjustthe plan on a continuing basis to account for changes in technology, the sensitivityof customer information and internal or external threats to informationsecurity.

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

*CommunityReinvestment Act Sunshine Requirements*

InFebruary 2001, the federal banking agencies adopted final regulations implementingSection 711 of Title VII, the CRA Sunshine Requirements.  The regulations require nongovernmentalentities or persons and insured depository institutions and affiliates that areparties to written agreements made in connection with the fulfillment of theinstitution’s CRA obligations to make available to the public and the federalbanking agencies a copy of each such agreement. The regulations impose annual reporting requirements concerning thedisbursement, receipt and use of funds or other resources under each suchagreement.  The effective date of theregulations was April 1, 2001.

The Bankis not a party to any agreement that would be subject of reporting pursuant tothe CRA Sunshine Requirements.

The Bankintends to comply with all provisions of the Gramm-Leach-Bliley Act and allimplementing regulations.

*CaliforniaFinancial Information Privacy Act/Fair Credit Reporting Act*

In1970, the federal Fair Credit Reporting Act (the “FCRA”) was enacted to insurethe confidentiality, accuracy, relevancy and proper utilization of consumercredit report information.  Under theframework of the FCRA, the United States has developed a highly advanced andefficient credit reporting system.  Theinformation contained in that broad system is used by financial institutions,retailers and other creditors of every size in making a wide variety ofdecisions regarding financial transactions. Employers and law enforcement agencies have also made wide use of theinformation collected and maintained in databases made possible by theFCRA.  The FCRA affirmatively preemptsstate law in a number of areas, including the ability of entities affiliated bycommon ownership to share and exchange information freely, and the requirementson credit bureaus to reinvestigate the contents of reports in response toconsumer complaints, among others.

TheCalifornia Financial Information Privacy Act (the “CFIPA”), which was enactedin 2003, requires a financial institution to provide specific information to aconsumer related to the sharing of that consumer’s nonpublic personalinformation.  The Act allows a consumerto direct the financial institution not to share his or her nonpublic personalinformation with affiliated or nonaffiliated companies with which a financialinstitution has contracted to provide financial products and services, andwould require that permission from each such consumer be acquired by afinancial institution prior to sharing such information.  These provisions are much more restrictivethan the privacy provisions of the Financial Services Modernization Act, andrequire the Bank to adopt new policies, procedures and disclosure documentationif implemented as enacted.  As theportion of CFIPA dealing with affiliates is currently subject to litigation,the cost of complying with this legislation is not predictable at this time.

Congressenacted the FACT Act, (“Fair and Accurate Credit Transaction Act”) of 2003,which will have the effect of avoiding the sunset preemption provision of theFair Credit Reporting Act (FCRA) that were due to expire on December 31,2003.  The President signed the FACT Actinto law on December 4, 2003.  Ingeneral, the FACT Act amends the FCRA and, in addition, provides that, when theimplementing regulations have been issued and become effective, the FACT Actwill preempt elements of the California Financial Information Privacy Act.  A series of regulations and announcementswere promulgated during 2004, including a joint FTC/FRB announcement ofeffective dates for FCRA amendments, the FTC’s free credit report rule,revisions to the FTC’s FACT Act rules, the FTC’s final rules on 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.

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*Check 21Act*

TheCheck Clearing for the 21st Century Act (“Check21 Act” or “the Act”), enacted in late 2003, became effective on October 28,2004.  The Act creates a new negotiableinstrument, called a “substitute check”, which banks are required to accept asthe legal equivalent of a paper check if it meets the requirements of theAct.  The Act is designed to facilitatecheck truncation, to foster innovation in the check payment system, and to improvethe payment system by shortening processing times and reducing the volume ofpaper checks.

*FederalReserve Board Final Rule on Trust Preferred Securities*

On March 1, 2005 the Federal Reserve Board issueda final rule that allows the continued inclusion of trust preferred securitiesin 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:

·                  Trustpreferred securities, together with other “restricted core capital elements”,can be included in a bank holding company’s tier 1 capital up to 25% of the sumof core capital elements, including “restricted core capital elements”;

·                  Restrictedcore capital elements are defined to include:

·                  qualifyingtrust preferred securities;

·                  qualifyingcumulative perpetual preferred stock (and related surplus);

·                  minorityinterest related to qualifying cumulative perpetual preferred stock directlyissued by a consolidated U.S. depository institution  or foreign bank subsidiary; and

·                  minorityinterest related to qualifying common or qualifying perpetual preferred stockissued by a consolidated subsidiary that is neither a U.S. depositoryinstitution  or foreign bank subsidiary

·                  Thesum of core capital elements will be calculated net of goodwill, less anyassociated deferred tax liability;

·                  Internationallyactive bank holding companies are further limited, and must limit restrictedcore capital elements to 15% of the sum of core capital elements, includingrestricted core capital elements, net of goodwill, although they may includequalifying mandatory convertible preferred securities up to the 25% limit;

·                  Afive year transition period for application of quantitative limits, endingMarch 31, 2009.

**Other**

Variousother legislation, including proposals to overhaul the bank regulatory systemand to limit the investments that a depository institution may make withinsured funds, is introduced into Congress or the California Legislature fromtime to time.  The Bancorp and the Bankcannot determine the ultimate effect that any potential legislation, ifenacted, or regulations promulgated there under, would have upon the financialcondition or operations of the Bancorp or the Bank.

**Impact ofGovernment Monetary Policy**

Theearnings of the Bancorp and the Bank are and will be affected by the policiesof regulatory authorities, including the Federal Reserve.  An important function of the Federal Reserveis 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 varyingcombinations to influence overall growth and distribution of bank loans,investments and deposits, and their use may also affect interest rates on loansor interest rates paid for deposits.  Themonetary policies of the FRB have had a significant effect on the operatingresults of commercial banks in the past and are expected to continue to do soin the future.  The effect, if any, ofsuch policies upon the future business earnings of the Bancorp and the Bankcannot be predicted.

**AdditionalFactors That May Affect Future Results of Operations**

*Dependenceon Real Estate*

Asignificant portion of the loan portfolio of the Bank is dependent on realestate.  At December 31, 2006, realestate served as the principal source of collateral with respect toapproximately 66.1% percent of the Bank’s loan portfolio.  A decline in current economic conditions orrising interest rates could have an adverse effect on the demand for new loans,the ability of borrowers to repay outstanding loans, the value of real estateand other collateral securing loans and the value of real estate owned by theBank, as well as the Bancorp’s financial condition and results of operations ingeneral and the market value of the Bancorp’s common stock.  Acts of nature, including earthquakes andfloods, which may cause uninsured damage and other loss of value to real estatethat secures these loans, may also negatively impact the Bancorp’s financialcondition.

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*EnvironmentalLiability Associated with Real Estate Ownership Could Result in Losses*

Inthe course of business, the Bank has purchased real property.  In the future, the Bancorp and the Bank mayacquire additional real properties, through purchase, foreclosure or otherwise.  In real estate ownership, as well as in commercialreal estate lending, there is a risk that hazardous substances could bediscovered on these properties.  In thisevent, the Bank might be required to remove these substances from the affectedproperties at its sole cost and expense. The cost of this removal could substantially exceed the value of theaffected properties.  The Bancorp or theBank, as the case may be, may not have adequate remedies against the priorowner or other responsible parties or could find it difficult or impossible tosell the affected properties.  This couldhave a material adverse effect on the Bancorp’s and the Bank’s business,financial condition and operating results.

*InterestRate Changes*

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

*Competition*

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

*Regulation*

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

*Borrower’s Failure to Perform*

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

*Operations Risks*

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

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*Breach ofInformation Security*

Despiteinstituted safeguards, Bancorp and the Bank cannot be certain that all of its systemsare entirely free from vulnerability to attack or other technologicaldifficulties or failures.  Bancorp andthe Bank rely on the services of a variety of vendors to meet its dataprocessing and communication needs.  Ifinformation security is breached or other technological difficulties orfailures occur, information may be lost or misappropriated, services andoperations may be interrupted and Bancorp and the Bank could be exposed toclaims from customers.  Any of theseresults could have a materially adverse effect on Bancorp’s and the Bank’sbusiness, financial condition, results of operations or liquidity.

*GeographicConcentration*

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

*War onTerrorism*

Theterrorist attacks of September 11, 2001 and ensuing worldwide war on terrorismmay lead to unexpected shifts in cash flows, deposit levels, and generaleconomic activity.  Banking agencies inthe United States have warned of the possible impact of such events on thecapital ratios of banks.  In addition,the USA PATRIOT Act, which became effective December 25, 2001 as part of thewar on terrorism, imposes substantial new responsibilities on banks forpreventing, detecting and reporting flows of funds to terroristorganizations.  The act also directs theTreasury Department to prepare detailed regulations for these purposes, such asnew record-keeping requirements, verification standards for customeridentification and sharing information with the government.  The full impact of the new law and itsongoing implementation on the Bancorp and the Bank cannot be predicted at thistime.

**Item2.  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 the administrativeoffices are located on the second floor. The new head office address is 500 Marsh Street, San Luis Obispo,California, and is across the parking lot from the previous San Luis Obispobranch office at 486 Marsh Street.  Theprevious San Luis Obispo branch office is now home to the Bank’s GovernmentGuaranteed Lending Center and the Bank’s Note Department.  Additional surplus office space in thebuilding at 486 Marsh Street is currently being leased by the Bank to unrelatedthird party tenants.  Leased office spacethat previously housed the Bank’s administrative offices at 553 B HigueraStreet in San Luis Obispo has been vacated. The lease on this space expired in February 2003.  The Bank did not renew this lease.  Office space that previously housed the Bank’sGovernment Guaranteed Lending Center at 545 Higuera Street in San Luis Obispois 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.

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InJune 2005, the Bank entered into a month to month lease for a new loanproduction office at 7429 N. First St., Suite 104, Fresno, California.  The loan production office was opened toenhance the Bank’s government guaranteed lending opportunities in the Fresnoarea.  In July of 2006, a new month tomonth lease was entered into when the Fresno office was relocated to 466 W.Fallbrook Ave., #109, Fresno, California.

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. In August 2004, the Bank purchased alot at 2045 Spring Street, Paso Robles, California with the intention ofrelocating the Paso Robles branch. However, the lot was not adequate for the relocation of the branch andon October 26, 2006, the Bank purchased a new lot at 2110 Spring St, PasoRobles, California.  The Bank intends torelocate the Paso Robles branch to this larger lot, sometime in the future.

**Item3.  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 material pending legal or administrative proceedings(including ordinary routine litigation incidental to their business) and nosuch proceedings are known to be contemplated.

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

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

None

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**PART II**

**Item 5.****           Market for CommonEquity and Related Stockholder Matters and Small Business Issuer Purchase of EquitySecurities**

(a)   As of December 31, 2006, the equity of theBancorp consisted of Preferred Stock 10,000,000 shares authorized, noneoutstanding and 10,000,000 shares authorized with 679,600 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** | ** ** |
|-----------------------|------------|----------|------------|---------|------------|
| First Quarter,  2006  |       | $        | 30.00      |    | $          | 27.50 |   |
| Second Quarter,  2006 |       | $        | 30.35      |    | $          | 28.80 |   |
| Third Quarter,  2006  |       | $        | 31.00      |    | $          | 29.50 |   |
| Fourth Quarter, 2006  |       | $        | 36.50      |    | $          | 30.30 |   |

 
|                       | ** ** | **High** | ** ** | **Low** | ** ** |
|-----------------------|------------|----------|------------|---------|------------|
| First Quarter,  2005  |       | $        | 29.50      |    | $          | 27.50 |   |
| Second Quarter,  2005 |       | $        | 28.50      |    | $          | 26.30 |   |
| Third Quarter,  2005  |       | $        | 28.50      |    | $          | 26.50 |   |
| Fourth Quarter, 2005  |       | $        | 30.35      |    | $          | 28.50 |   |

 

(b)   As ofDecember 31, 2006, there were approximately 367 shareholders of record.

(c)   **Restriction on Dividends**

OnNovember 15, 2006, the Bancorp declared a cash dividend of $0.20 per share onits Common Stock shareholders of record as of the close of business on November27, 2006.  The dividend was paid onDecember 7, 2006.  In 2005, a cashdividend of $0.175 per share was declared on Bancorp Common Stock toshareholders of record at the close of business on December 12, 2005 and waspaid on December 22, 2005.

TheBancorp is regulated by the Board of Governors of the Federal ReserveSystem.  Federal Reserve Boardregulations prohibit cash dividends, except under limited circumstances, if thedistribution would result in a withdrawal of capital or exceed the Bancorp’snet profits then on hand after deducting its losses and bad debts.  Furthermore, cash dividends cannot be paidwithout the prior written approval of the Federal Reserve Board if the total ofall dividends declared in one year exceeds the total of net profits for thatyear, plus the preceding two calendar years, and less any required transfers tosurplus under state or federal law.

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

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

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

(d)   The following chart provides information asof December 31, 2006, concerning the Bancorp’s Stock Option Plans, whichrepresent the Bancorp’s only equity compensation plans:

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**Plan Categories:**

 

|                                                             | ** ** | ** **                           | ** ** | ** **                        | ** ** | **Number of Securities**         | ** ** |
|-------------------------------------------------------------|------------|--------------------------------------|------------|-----------------------------------|------------|--------------------------------------------|------------|
| ** **                                                  | ** ** | **Number of Securities**   | ** ** | ** **                        | ** ** | **Remaining Available for**      | ** ** |
| **Employee**                                                | ** ** | **to be Issued Upon** | ** ** | **Weighted-average**              | ** ** | **Future Issuance Under**        | ** ** |
| **and Director**                                       | ** ** | **Exercise of**                 | ** ** | **Exercise Price of**   | ** ** | **Equity Compensation**               | ** ** |
| **Stock Option**                                       | ** ** | **Outstanding Options,**        | ** ** | **Outstanding Options,**     | ** ** | **Plans (excluding securities**  | ** ** |
| **Plans**                                                   | ** ** | **Warrants, and Rights**   | ** ** | **Warrants and Rights** | ** ** | **Reflected in column [a]** | ** ** |
| ** **                                                  | ** ** | **[a]**                              | ** ** | **[b]**                           | ** ** | **[c]**                                    | ** ** |
| Equity Compensation  Plans Approved by Security Holders     |       | 114,800                              |       | $                                 | 17.99      |                                       | 18,100     |   |
| Equity Compensation  Plans Not Approved by Security Holders |       | 0                                    |       | 0                                 |       | 0                                          |       |
| Total                                                       |       | 114,800                              |       | $                                 | 17.99      |                                       | 18,100     |   |

 

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

Thefollowing sections set forth a discussion of the significant operating changes,business trends, financial condition, earnings, capital position, and liquiditythat have occurred in the two-year period ended December 31, 2006, togetherwith an assessment, when considered appropriate, of external factors that mayaffect us in the future.  This discussionshould be read in conjunction with our consolidated financial statements andnotes.

**OVERVIEW**

**EarningsSummary**

Consolidatednet income in 2006 was $1,374,139, an increase of $276,273 or 25.16%, comparedto $1,097,866 in 2005.  Diluted earningsper share in 2006 were $1.93, compared to $1.56 in 2005.  The increase in earnings in 2006 was dueprimarily to an increase in interest income. Net interest income after provisions for credit losses in 2006 was$8,770,666, an increase of $1,058,457 or 13.7%, compared to $7,712,209 in 2005.

**BalanceSheet Summary**

Totalassets at December 31, 2006 were $180.7 million, a $5.0 million or 2.7%decrease from $185.7 million at December 31, 2005.  Average assets for 2006 were $180.8 million,compared to $173.0 million for 2005. Total deposits decreased $6.4 million or 3.8% to $162.5 million atDecember 31, 2006.  Gross loans increased$3.2 million or 2.4%, to $136.9 million at December 31, 2006.  Stockholder’s equity increased $1.5 millionor 13.1%, to $12.7 million at December 31, 2006.

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

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

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**Average Rates and Balances**

*(dollarsin thousands)*
| ** **                                      | ** ** | **For the Year Ended December 31,** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                      | ** ** | **2006**                                                     | ** ** | **2005** | ** ** |
| ** **                                      | ** ** | ** **                                                   | ** ** | **Interest** | ** ** | **Average** | ** ** | ** ** | ** ** | **Interest** | ** ** | **Average** | ** ** |
| ** **                                      | ** ** | **Average**                                                  | ** ** | **Earned** | ** ** | **Yield or** | ** ** | **Average** | ** ** | **Earned** | ** ** | **Yield or** | ** ** |
| ** **                                      | ** ** | **Balance**                                                  | ** ** | **or Paid** | ** ** | **Rate Paid** | ** ** | **Balance** | ** ** | **or Paid** | ** ** | **Rate Paid** | ** ** |
| **Assets**                                      |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |
| Interest-Earning Assets:                        |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |
| Investment Securities                           |       | $                                                            | 7,505      |   | $ | 243 |   | 3.24 | % | $ | 11,932 |   | $ | 307 |   | 2.57 | % |
| Federal Funds Sold                              |       | 16,143                                                       |       | 792 |   | 4.91 | % | 16,610 |   | 561 |   | 3.38 | % |
| Other Earning Assets                            |       | 936                                                          |       | 55 |   | 5.88 | % | 905 |   | 54 |   | 5.97 | % |
| Loans                                           |       | 139,621                                                      |       | 12,777 |   | 9.15 | % | 125,126 |   | 9,981 |   | 7.98 | % |
|                                            |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |
| Total Interest-Earning Assets                   |       | 164,205                                                      |       | 13,867 |   | 8.44 | % | 154,573 |   | 10,903 |   | 7.05 | % |
|                                            |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |
| Cash and Due from Banks                         |       | 7,627                                                        |       |   |   |   |   | 9,460 |   |   |   |   |   |
| Premises and Equipment                          |       | 8,491                                                        |       |   |   |   |   | 8,427 |   |   |   |   |   |
| Other Real Estate Owned                         |       | —                                                       |       |   |   |   |   | — |   |   |   |   |   |
| Accrued Interest and Other Assets               |       | 1,715                                                        |       |   |   |   |   | 1,676 |   |   |   |   |   |
| Allowance for Loan Losses                       |       | (1,252                                                       | )          |   |   |   |   | (1,173 | ) |   |   |   |   |
|                                            |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |
| Total Assets                                    |       | $                                                            | 180,786    |   |   |   |   |   | $ | 172,963 |   |   |   |   |   |
|                                            |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |
| **Liabilities and Shareholders’ Equity**   |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |
| Interest-Bearing Liabilities:                   |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |
| Money Market and NOW:                           |       | $                                                            | 47,363     |   | $ | 1,420 |   | 3.00 | % | $ | 39,450 |   | $ | 681 |   | 1.73 | % |
| Savings                                         |       | 7,515                                                        |       | 129 |   | 1.72 | % | 8,496 |   | 79 |   | 0.93 | % |
| Time Deposits under  $100,000                   |       | 15,008                                                       |       | 582 |   | 3.88 | % | 14,506 |   | 361 |   | 2.49 | % |
| Time Deposits of  $100,000 or More              |       | 53,243                                                       |       | 2,255 |   | 4.24 | % | 54,145 |   | 1,667 |   | 3.08 | % |
| Trust Preferred  Securities                     |       | 5,155                                                        |       | 474 |   | 9.19 | % | 5,155 |   | 380 |   | 7.37 | % |
| Other                                           |       | 21                                                           |       | — |   | 0.00 | % | 77 |   | 3 |   | 3.90 | % |
|                                            |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |
| Total Interest-Bearing Liabilities              |       | 128,305                                                      |       | 4,860 |   | 3.79 | % | 121,829 |   | 3,171 |   | 2.60 | % |
|                                            |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |
| Non-Interest Bearing Liabilities                |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |
| Demand Deposits                                 |       | 40,041                                                       |       |   |   |   |   | 40,120 |   |   |   |   |   |
| Other Liabilities                               |       | 463                                                          |       |   |   |   |   | 406 |   |   |   |   |   |
| Shareholders’ Equity                       |       | 11,977                                                       |       |   |   |   |   | 10,608 |   |   |   |   |   |
|                                            |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |
| Total Liabilities and Shareholders’ Equity |       | $                                                            | 180,786    |   |   |   |   |   | $ | 172,963 |   |   |   |   |   |
|                                            |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |
| Net Interest Income                             |       |                                                         |       | $ | 9,007 |   |   |   |   |   | $ | 7,732 |   |   |   |
|                                            |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |
| Net Yield on Interest-Earning Assets            |       |                                                         |       |   |   | 5.49 | % |   |   |   |   | 5.00 | % |

 

**EARNINGSANALYSIS**

**NetInterest Income**

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

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

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

**Rate/Volume Analysis**

*(dollaramounts in thousands)*

|                                  | ** ** | **Year Ended December 31, 2006**              | ** ** |
|----------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                       | ** ** | **versus**                                                        | ** ** |
| ** **                       | ** ** | **Year Ended December 31, 2005**              | ** ** |
| ** **                       | ** ** | **Increase (Decrease) due to change in** | ** ** |
| ** **                       | ** ** | **Volume**                                                        | ** ** | **Rate** | ** ** | **Total** | ** ** |
| **Interest-Earning Assets:**     |       |                                                              |       |   |   |   |   |
| Investment  Securities           |       | $                                                                 | (131       | ) | $ | 67 |   | $ | (64 | ) |
| Federal Funds  Sold              |       | (16                                                               | )          | 247 |   | 231 |   |
| Other Earning  Assets            |       | 2                                                                 |       | (1 | ) | 1 |   |
| Loans                            |       | 1,231                                                             |       | 1,565 |   | 2,796 |   |
| **Total  Interest Income**       |       | 1,086                                                             |       | 1,878 |   | 2,964 |   |
|                             |       |                                                              |       |   |   |   |   |
| **Interest-Bearing Liabilities** |       |                                                              |       |   |   |   |   |
| Transaction  Accounts            |       | 158                                                               |       | 581 |   | 739 |   |
| Savings                          |       | (10                                                               | )          | 60 |   | 50 |   |
| Time Deposits                    |       | 12                                                                |       | 209 |   | 221 |   |
| Time Deposits  $100,000 or more  |       | (28                                                               | )          | 616 |   | 588 |   |
| Trust Preferred                  |       | —                                                            |       | 94 |   | 94 |   |
| Other                            |       | (1                                                                | )          | (2 | ) | (3 | ) |
| **Total  Interest Expense**      |       | 131                                                               |       | 1,558 |   | 1,689 |   |
|                             |       |                                                              |       |   |   |   |   |
| **Net Interest Income**          |       | $                                                                 | 955        |   | $ | 320 |   | $ | 1,275 |   |

 

**2006Compared to 2005**

Netinterest income before the provision for credit losses for 2006 was $9.0million, $8.8 million after the provision for loan loss compared to $7.7million of net interest income, before and after loan loss provision, in2005.  The percentage increase in netinterest income before the loan loss provision was 16.5% and 13.4% after theprovision for loan loss.  This increasewas primarily due to the 2.4% increase in loans.  The net yield on average earning assets alsoincreased from 5.00% in 2005 to 5.49% in 2006.

Interestincome in 2006 was $13.9 million, representing an increase of $3.0 million or27.2% over the $10.9 million recorded in 2005.  The increase in interest income was primarily due to the averageincrease in loan rates.  The increase inthe prime rate from 7.25% at December 2005 to 8.25% at December 2006contributed to the Bank’s increase in interest income.  The ratio of interest and fees earned onloans as a percentage of total interest income increased from 91.54% in 2005 to92.13% in 2006.  Also contributing to theincreased interest income was the interest received on federal funds sold whichincreased from 5.15% of interest and fees in 2005 to 5.71% in 2006.  The average rate on Federal Funds soldincreased from 4.26% in January 2006 to 5.12% in December of 2006.  The portion of loan fees included in theinterest income and loan fee category was $880,800 in 2006 as compared to$798,466 in 2005.

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Interestexpense increased 53.3% in 2006 due to an increase in interest paid on timedeposits of $100,000 or more, resulting in a net increase of the average ratepaid for time deposits of $100,000 or more of 120 basis points from 3.08% in2005 to 4.24% in 2006.

**Non-interestIncome**

TheBank receives non-interest income primarily from service charges and fees onaccounts, as well as from the sale of government guaranteed loans and realizedgains on the sale of investment securities. In 2006, non-interest income was $875,543, an increase of $300,635 or52.3% compared to the 2005 amount of $574,908.

Theincrease in non-interest income was substantially due to an increase in thesale of SBA loans.  Gain on the sale ofloans and servicing fees totaled $426,121 in 2006, up 120.0% compared to 2005.

Themortgage loan program, through the Mariner Mortgage, Inc., enabled the Bank tofacilitate long term mortgage loans for our customers.  The Bank submitted the applications toMariner Mortgage, Inc, by whom the loans were underwritten and processed.  The Bank had no responsibility for underwritingor documentation.  For these services theBank was paid a fee.   Our participationin this program began in 2004 and continues to 2006.  The income generated from this referralprogram has declined with the decline in the residential refinance mortgageboom. Income realized from mortgage loan packaging fees in 2006 was $88,367compared to $75,927 in 2005, a $12,440, or 16.38%, increase.

Regardingthe realized gains on the sale of loans, the most common reason for the Bank tosell the guaranteed portion of a loan is to meet the liquidity needs of theBank and to maintain the Bank’s loan-to-deposit ratio within acceptableranges.  The Bank also enjoys theopportunity to supplement, at its discretion, fee income from the sale of thegovernment-guaranteed portions of certain loans.  In 2001 the Bank developed a governmentguaranteed lending center to originate loans that are partially guaranteed bythe U.S. Small Business Administration or the U.S. Department ofAgriculture.  While the volume of lendingin this department has decreased, the Bank has still realized gains from theseloans 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-interestExpense**

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

**Non-Interest Expense as a Percentage of AverageAssets**

|                                   | ** ** | **2006** | ** ** | **2005** | ** ** |
|-----------------------------------|------------|----------|------------|----------|------------|
| Salaries and Employee  Benefits   |       | 2.24     | %          | 2.05     | %          |
| Occupancy Expenses                |       | 0.28     | %          | 0.28     | %          |
| Furniture and Equipment           |       | 0.18     | %          | 0.19     | %          |
| Data Processing                   |       | 0.26     | %          | 0.21     | %          |
| Marketing and Business  Promotion |       | 0.47     | %          | 0.36     | %          |
| Other Professional  Expenses      |       | 0.13     | %          | 0.14     | %          |
| Office Expenses                   |       | 0.14     | %          | 0.13     | %          |
| Other                             |       | 0.37     | %          | 0.32     | %          |
|                              |       | 4.07     | %          | 3.68     | %          |

 

Non-interestexpense was $7.4 million in 2006, an increase of $1.0 million or 15.8% over the$6.4 million reported in 2005.  Themajority of this increase is attributable to an increase in marketing andpromotion as well as increased salaries and employee benefits. The Bank has 70full time equivalent employees as compared to 58 in 2005.  The Bank has been fortunate in retaininglong-term managerial employees.  Salariesfor 2006 and 2005 respectively were $4,047,582 and $3,539,906 a 14.3% increase.

**IncomeTaxes**

Incometax expense was $918,500 and $838,874 for the years ended December 31, 2006,and 2005 respectively, an increase of $79,626 or 9.5%.  These expenses resulted in an effective taxof 40.1% in 2006, and 43.4% in 2005.  Theincrease in income tax expense in 2006 was due to the increase of net income in2006 over 2005.

26

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**BALANCESHEET ANALYSIS**

**InvestmentPortfolio**

Thefollowing table summarizes the amounts and distribution of our investmentsecurities held as of the dates indicated, and the weighted average yields asof December 31, 2006:

**Maturity Distribution ofInvestment Securities**

*(dollaramounts in thousands)*
| ** **                                            | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------|------------|-----------------------|------------|
| ** **                                            | ** ** | **2006**              | ** ** | **2005** | ** ** |
| ** **                                            | ** ** | ** **            | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                            | ** ** | **Book**              | ** ** | **Market** | ** ** | **Average** | ** ** | **Book** | ** ** | **Market** | ** ** |
| ** **                                            | ** ** | **Value**             | ** ** | **Value** | ** ** | **Yield** | ** ** | **Value** | ** ** | **Value** | ** ** |
| **Available-for-Sale  Securities**                    |       |                  |       |   |   |   |   |   |   |   |   |
| **U.S. Treasuries:**                                  |       |                  |       |   |   |   |   |   |   |   |   |
| Within One Year                                       |       | $                     | —     |   | $ | — |   | 0.00 | % | $ | — |   | $ | — |   |
| One to Five  Years                                    |       | —                |       | — |   | 0.00 | % | — |   | — |   |
| Five to Ten  Years                                    |       | —                |       | — |   | 0.00 | % | — |   | — |   |
| After Ten Years                                       |       | —                |       | — |   | 0.00 | % | — |   | — |   |
| Total U.S. Treasury  Securities                       |       | —                |       | — |   | 0.00 | % | — |   | — |   |
|                                                  |       |                  |       |   |   |   |   |   |   |   |   |
| **U.S. Government and Agency  Securities**            |       |                  |       |   |   |   |   |   |   |   |   |
| Within One Year                                       |       | 2,984,407             |       | 2,971,870 |   | 3.25 | % | 4,991,864 |   | 4,920,290 |   |
| One to Five  Years                                    |       | 4,960,373             |       | 4,954,080 |   | 4.47 | % | 3,015,158 |   | 2,951,880 |   |
| Five to Ten  Years                                    |       | —                |       | — |   | 0.00 | % | — |   | — |   |
| After Ten Years                                       |       | —                |       | — |   | 0.00 | % | — |   | — |   |
| Total U.S. Treasury and  Government Agency Securities |       | 7,944,780             |       | 7,925,950 |   | 3.86 | % | 8,007,022 |   | 7,872,170 |   |
| **Mutual Funds**                                      |       | —                |       | — |   | — |   | — |   | — |   |
| **Mortgage Backed Securities**                        |       | —                |       | — |   | — |   | — |   | — |   |
| **Total Available-for-Sale  Securities**              |       | $                     | 7,944,780  |   | $ | 7,925,950 |   | 3.86 | % | $ | 8,007,022 |   | $ | 7,872,170 |   |

 

Securitiesmay be pledged to meet security requirements imposed as a condition to receiptof deposit of public funds and for other purposes.  At December 31, 2006, the carrying values ofsecurities pledged to secure public deposits and other purposes were $993,052or 12.5% of available-for-sale securities.

27

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**LoanPortfolio**

Thefollowing table sets forth the components of total net loans outstanding ineach category at the date indicated:

**Loan Portfolio Composition**

*(dollaramounts in thousands)*

|                                                   | ** ** | **December** | ** ** |
|---------------------------------------------------|------------|--------------|------------|
| ** **                                        | ** ** | **2006**     | ** ** | **2005** | ** ** |
| **Loans**                                         |       |         |       |   |   |
| Commercial                                        |       | $            | 41,726     |   | $ | 29,491 |   |
| Real Estate -  Construction                       |       | 28,126       |       | 25,213 |   |
| Real Estate -  Other                              |       | 62,298       |       | 76,092 |   |
| Consumer                                          |       | 4,705        |       | 2,895 |   |
| **Total  Loans**                                  |       | 136,855      |       | 133,691 |   |
| Net Deferred  Loan Costs (Fees)                   |       | (352         | )          | (460 | ) |
| Allowance for  Loan Losses                        |       | (1,388       | )          | (1,183 | ) |
| **Net  Loans**                                    |       | $            | 135,115    |   | $ | 132,048 |   |
|                                              |       |         |       |   |   |
| **Commitments**                                   |       |         |       |   |   |
| Standby Letters  of Credit                        |       | $            | 2,012      |   | $ | 2,589 |   |
| Undisbursed  Loans and Commitments to Grant Loans |       | 48,768       |       | 57,356 |   |
| **Total Commitments**                             |       | $            | 50,780     |   | $ | 59,945 |   |

 

**RiskElements**

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

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

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

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

28

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The following table shows the maturity distribution ofthe fixed rate portion of the loan portfolio at December 31, 2006:

**Maturity Distribution of FixedRate Loans**

*(dollaramounts in thousands)*
| ** **                  | ** ** | ** **                | ** ** | **Over 3**     | ** ** | ** **                | ** ** | ** **          | ** ** | ** ** | ** ** |
|-----------------------------|------------|---------------------------|------------|---------------------|------------|---------------------------|------------|---------------------|------------|------------|------------|
| ** **                  | ** ** | ** **                | ** ** | **Months**          | ** ** | **Due after**        | ** ** | ** **          | ** ** | ** ** | ** ** |
| ** **                  | ** ** | **3 Months or** | ** ** | **through 12** | ** ** | **one year to** | ** ** | **Due after**  | ** ** | ** ** | ** ** |
| ** **                  | ** ** | **Less**                  | ** ** | **Months**          | ** ** | **five years**       | ** ** | **five years** | ** ** | **Total**  | ** ** |
|                        |       |                      |       |                |       |                      |       |                |       |       |       |
| **Loans**                   |       |                      |       |                |       |                      |       |                |       |       |       |
| Commercial                  |       | $                         | 237        |                | $          | 1,492                     |       | $                   | 972        |       | $          | 1,203 |   | $ | 3,904 |   |
| Real Estate -  Construction |       | —                    |       | —              |       | 253                       |       | —              |       | 253        |       |
| Real Estate -  Other        |       | 985                       |       | 359                 |       | 2,941                     |       | 6,908               |       | 11,193     |       |
| Consumer                    |       | 70                        |       | 438                 |       | 426                       |       | 353                 |       | 1,287      |       |
| Other                       |       | —                    |       | —              |       | —                    |       | —              |       | —     |       |
| Total Loans                 |       | $                         | 1,292      |                | $          | 2,289                     |       | $                   | 4,592      |       | $          | 8,464 |   | 16,637 |   |
|                        |       |                      |       |                |       |                      |       |                |       |       |       |
| Loans on  Non-Accrual       |       |                      |       |                |       |                      |       |                |       | 450        |       |
| Total Fixed Rate Loans      |       |                      |       |                |       |                      |       |                |       | $          | 17,087     |   |

 

Thefollowing table shows the maturity distribution of the variable rate portion ofthe loan portfolio at December 31, 2006:

**Maturity Distribution of VariableRate Loans**

*(dollaramounts in thousands)*
| ** **                  | ** ** | ** **                | ** ** | **Over 3**     | ** ** | ** **                | ** ** | ** **          | ** ** | ** ** | ** ** |
|-----------------------------|------------|---------------------------|------------|---------------------|------------|---------------------------|------------|---------------------|------------|------------|------------|
| ** **                  | ** ** | ** **                | ** ** | **Months**          | ** ** | **Due after**        | ** ** | ** **          | ** ** | ** ** | ** ** |
| ** **                  | ** ** | **3 Months or** | ** ** | **through 12** | ** ** | **one year to** | ** ** | **Due after**  | ** ** | ** ** | ** ** |
| ** **                  | ** ** | **Less**                  | ** ** | **Months**          | ** ** | **five years**       | ** ** | **five years** | ** ** | **Total**  | ** ** |
|                        |       |                      |       |                |       |                      |       |                |       |       |       |
| **Loans**                   |       |                      |       |                |       |                      |       |                |       |       |       |
| Commercial                  |       | $                         | 28,274     |                | $          | 4,757                     |       | $                   | 4,341      |       | $          | — |   | $ | 37,372 |   |
| Real Estate -  Construction |       | 24,692                    |       | 2,065               |       | 1,116                     |       | —              |       | 27,873     |       |
| Real Estate -  Other        |       | 32,046                    |       | 2,780               |       | 12,014                    |       | 2,172               |       | 49,012     |       |
| Consumer                    |       | 3,407                     |       | 11                  |       | —                    |       | —              |       | 3,418      |       |
| Other                       |       | —                    |       | —              |       | —                    |       | —              |       | —     |       |
| Total Loans                 |       | $                         | 88,419     |                | $          | 9,613                     |       | $                   | 17,471     |       | $          | 2,172 |   | 117,675 |   |
|                        |       |                      |       |                |       |                      |       |                |       |       |       |
| Loans on  Non-Accrual       |       |                      |       |                |       |                      |       |                |       | 2,093      |       |
| Total Variable Rate  Loans  |       |                      |       |                |       |                      |       |                |       | $          | 119,768    |   |

 

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**Non-performingAssets**

Thefollowing table provides information with respect to the components of ournon-performing assets at the dates indicated:

**Non-Performing Assets**

*(dollaramounts in thousands)*

|                                                                  | ** ** | **For the Year Ended** | ** ** |
|------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                       | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| Loans 90 Days Past Due  and Still Accruing                       |       | $                                     | —     |   | $ | — |   |
| Non-Accrual Loans                                                |       | 2,543                                 |       | 15 |   |
| Total Non-performing  Loans                                      |       | $                                     | 2,543      |   | $ | 15 |   |
|                                                             |       |                                  |       |   |   |
| Other Real Estate Owned                                          |       | $                                     | —     |   | $ | — |   |
| Total Non-performing  Assets                                     |       | $                                     | 2,543      |   | $ | 15 |   |
|                                                             |       |                                  |       |   |   |
| Interest Foregone on  Non-accrual Loans                          |       | $                                     | 106        |   | $ | — |   |
| Interest Earned on  Non-accrual Loans                            |       | $                                     | 5          |   | $ | 1 |   |
| Non-performing Loans as  a Percentage of Total Loans             |       | 1.86                                  | %          | 0.01 | % |
| Allowance for Loan Loss  as a Percentage of Non-performing Loans |       | 54.58                                 | %          | 7886.67 | % |
| Non-performing Assets as a Percentage of Total Assets            |       | 1.41                                  | %          | 0.00 | % |

 

Asof December 31, 2006, the Bank had no loans which are “troubled debtrestructurings” as defined in the statement of Financial Accounting StandardsNo. 15 (“SFAS 15”), “Accounting by Debtors and Creditors for Troubled DebtRestructurings.”

Non-accrualloans increased from $15,000 or 0.01% of total loans at December 31, 2005 to$2,543,000 at December 31, 2006 or 1.86% of total loans.  As of December 31, 2006, non-accrual loansconsisted of five relationships; four of which were SBA guaranteed loans. The majority of these transactions are well collateralized.

AtDecember 31, 2006, in addition to loans disclosed above as past due,non-accrual or restructured, management also identified several loans totaling$39,894, where the ability to comply with present loan payment terms in thefuture is questionable.  However, the inabilityof the borrowers to comply with repayment terms was not sufficiently probableto place the loan on non-accrual status at December 31, 2006.  This amount was determined based on analysisof information known to management about the borrowers’ financial condition andcurrent economic conditions.  Estimatedpotential losses from these problem loans have been provided for in determiningthe allowance for loan losses at December 31, 2006.

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

30

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**Provisionand Allowance for Loan Losses**

Aspreviously discussed under Critical Accounting Policies, the Allowance for LoanLosses represents management’s best estimate of losses inherent in the existingloan portfolio.  Management of the Bankbelieves that the allowance for loan losses is adequate.  The Bank has established a monitoring systemfor loans in order to identify impaired loans and potential problem loans andto permit periodic evaluation of impairment and adequacy of the allowance forloan losses in a timely manner.  Themonitoring system and allowance for loan losses methodology have evolved over aperiod of years, and loan classifications have been incorporated into thedetermination of the allowance for loan losses. This monitoring system and allowance methodology includes a loan-by-loananalysis for all classified loans as well as loss factors for the balance ofthe unclassified portfolio.  Classifiedloans are reviewed individually to estimate the amount of probable losses 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.

Inorder to maintain our allowance for loan losses at a level acceptable to ourBoard of Directors and Management, and to keep up with our increased loanportfolio, a larger loan loss contribution was made in 2006 versus 2005.  The Bank made a contribution of $236,000 tothe allowance for loan losses for the twelve months ended December 31, 2006,compared to $20,000 for the same period in 2005.  Management believes that the allowance, whichequals 1.01% of gross loans at December 31, 2006, is adequate to cover futurelosses.  The allowance at December 31,2005, was .89% of gross loans.

Theprovision for loan losses charged against operations is based upon the actualnet loan loss expensed plus an amount for other such factors which, inmanagement’s judgment, deserve recognition in estimating possible loan losses,including: specific loan conditions as determined by management and regulatoryagencies, the historical relationship between charge-offs and the level ofallowances, and prevailing economic conditions. While these factors are essentially judgmental and may not be reduced toa mathematical formula, it is management’s view that the $1,388,310 allowance,or 1.01% of total loans at December 31, 2006, was adequate.  However, there can be no assurance that inany given period the Bank might not sustain charge-offs, which are substantialin relation to the size of the allowance. It is the policy of management to make additions to the allowance sothat it remains adequate to cover all anticipated loan charge-offs.  Periodic fluctuations in the provision forloan losses result from management’s assessment of the adequacy of theallowance for loan losses: however, actual loan losses may vary from currentestimates.

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

31

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**Activity in Allowance for LoanLosses**

*(dollaramounts in thousands)*

|                                                               | ** ** | **For the Year Ended** | ** ** |
|---------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                    | ** ** | **December 31,**                 | ** ** |
| ** **                                                    | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| **Outstanding Gross Loans**                                   |       |                                  |       |   |   |
| Average for the  Year                                         |       | $                                     | 139,621    |   | $ | 125,126 |   |
| End of the Year                                               |       | $                                     | 136,856    |   | $ | 133,691 |   |
|                                                          |       |                                  |       |   |   |
| **Allowance for Loan Losses:**                                |       |                                  |       |   |   |
| Balance at Beginning of  Year                                 |       | $                                     | 1,183      |   | $ | 1,168 |   |
| Actual Charge-Offs:                                           |       |                                  |       |   |   |
| Commercial                                                    |       | —                                |       | — |   |
| Consumer                                                      |       | 31                                    |       | 5 |   |
| Real Estate                                                   |       | —                                |       | — |   |
| Total Charge-Offs                                             |       | 31                                    |       | 5 |   |
|                                                          |       |                                  |       |   |   |
| Less Recoveries:                                              |       |                                  |       |   |   |
| Commercial                                                    |       | —                                |       | — |   |
| Consumer                                                      |       | —                                |       | — |   |
| Real Estate                                                   |       | —                                |       | — |   |
| Total Recoveries                                              |       | —                                |       | — |   |
|                                                          |       |                                  |       |   |   |
| Net Loans Charged-Off                                         |       | 31                                    |       | 5 |   |
| Provision for Loan  Losses                                    |       | 236                                   |       | 20 |   |
| Balance at End of Year                                        |       | $                                     | 1,388      |   | $ | 1,183 |   |
|                                                          |       |                                  |       |   |   |
| **Ratios:**                                                   |       |                                  |       |   |   |
| Net Loans  Charged-Off to Average Loans                       |       | 0.02                                  | %          | 0.00 | % |
| Allowance for  Loan Losses to Total Loans                     |       | 1.01                                  | %          | 0.89 | % |
| Net Loans  Charged-Off to Beginning Allowance for Loan Losses |       | 2.62                                  | %          | 0.43 | % |
| Net Loans  Charged-Off to Provision for Loan Losses           |       | 13.14                                 | %          | 25.00 | % |
| Allowance for Loan  Losses to Non-performing Loans            |       | 54.58                                 | %          | n/a |   |

 

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

**Allowance for Loan LossesComposition**

*(dollaramounts in thousands)*
| ** **   | ** ** | **December 31,** | ** ** | **December 31,**  | ** ** |
|--------------|------------|-----------------------|------------|------------------------|------------|
| ** **   | ** ** | **2006**              | ** ** | **2005**               | ** ** |
| ** **   | ** ** | ** **            | ** ** | ** **             | ** ** | **Percentage of** | ** ** | ** ** | ** ** | **ALL as a** | ** ** | **Percentage** | ** ** |
| ** **   | ** ** | ** **            | ** ** | **ALL as a** | ** ** | **Loan** | ** ** | ** ** | ** ** | **Percentage** | ** ** | **of Loan** | ** ** |
| ** **   | ** ** | ** **            | ** ** | **percentage of** | ** ** | **Category to** | ** ** | ** ** | ** ** | **of Total** | ** ** | **Category to** | ** ** |
| ** **   | ** ** | **Amount**            | ** ** | **Total ALL**     | ** ** | **Total Loans** | ** ** | **Amount** | ** ** | **ALL** | ** ** | **Total Loans** | ** ** |
|         |       |                  |       |                   |       |   |   |   |   |   |   |   |   |
| Commercial   |       | $                     | 363        |                   | 26.15      | % | 30.49 | % | $ | 464 |   | 39.22 | % | 22.00 | % |
| Construction |       | 154                   |       | 11.10                  | %          | 20.55 | % | 126 |   | 10.65 | % | 19.00 | % |
| Real Estate  |       | 831                   |       | 59.87                  | %          | 45.52 | % | 420 |   | 35.50 | % | 57.00 | % |
| Consumer     |       | 11                    |       | 0.79                   | %          | 3.44 | % | 7 |   | 0.59 | % | 2.00 | % |
| Unallocated  |       | 29                    |       | 2.09                   | %          | — |   | 166 |   | 14.03 | % | — |   |
|         |       | $                     | 1,388      |                   | 100.00     | % | 100.00 | % | $ | 1,183 |   | 100.00 | % | 100.00 | % |

** **

32

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**Funding**

Depositsare our primary source of funds.  AtDecember 31, 2006, we had a deposit mix of 44.88% in time and savings deposits,30.78% in money market and NOW deposits, and 24.34% in non-interest-bearingdemand deposits.  Our net interest incomeis enhanced by our percentage of non-interest-bearing deposits.

Thefollowing table summarizes the distribution of average deposits and the averagerates paid for the years indicated:

**Distribution of Average Deposits& Corresponding Rates Paid**

*(dollaramounts in thousands)*
|                                       | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
|---------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                            | ** ** | **2006**              | ** ** | **2005**              | ** ** |
| ** **                            | ** ** | **Average**           | ** ** | **Average**           | ** ** | **Average** | ** ** | **Average** | ** ** |
| ** **                            | ** ** | **Balance**           | ** ** | **Rate**              | ** ** | **Balance** | ** ** | **Rate** | ** ** |
| Money Market and NOW  Accounts        |       | $                     | 47,363     |                  | 3.00       | % | $ | 39,450 |   | 1.73 | % |
| Savings Deposits                      |       | 7,515                 |       | 1.72                  | %          | 8,496 |   | 0.93 | % |
| TCD less than $100,000                |       | 15,008                |       | 3.88                  | %          | 14,506 |   | 2.49 | % |
| TCD $100,000 or more                  |       | 53,243                |       | 4.24                  | %          | 54,145 |   | 3.08 | % |
| Total Interest-Bearing  Deposits      |       | 123,129               |       | 3.56                  | %          | 116,597 |   | 2.39 | % |
|                                  |       |                  |       |                  |       |   |   |   |   |
| Non-Interest-Bearing  Demand Deposits |       | 40,041                |       | n/a                   |       | 40,120 |   | n/a |   |
| Total Average Deposits                |       | $                     | 163,170    |                  | 2.69       | % | $ | 156,717 |   | 1.78 | % |

 

Thescheduled maturity distribution of our time deposits of $100,000 or greater, asof December 31, 2006, were as follows:

**Maturity Distribution of TimeDeposits $100,000 and Greater**

*(dollaramounts in thousands)*

| Three months or less             |   | $      | 14,676 |   |
|----------------------------------|--------|--------|--------|--------|
| Over three  months to six months |   | 17,424 |   |
| Over six months  to one year     |   | 18,331 |   |
| Over one year to  three years    |   | 278    |   |
|                             |   | $      | 50,709 |   |

 

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

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

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

Thetable below sets forth the interest rate sensitivity of our interest-earningassets and interest-bearing liabilities as of December 31, 2006, using the interestrate sensitivity gap ratio.  For purposesof the following table, an asset or liability is considered rate-sensitivewithin a specified period when it can be repriced or matures within itscontractual terms:

33

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**Interest Sensitivity GAP**

*(dollaramounts in thousands)*
| ** **                                    | ** ** | ** ** | ** ** | **After**             | ** ** | **After One**  | ** ** | ** **          | ** ** | ** ** | ** ** |
|-----------------------------------------------|------------|------------|------------|-----------------------|------------|---------------------|------------|---------------------|------------|------------|------------|
| ** **                                    | ** ** | **Within** | ** ** | **Three Months** | ** ** | **Year But**   | ** ** | ** **          | ** ** | ** ** | ** ** |
| ** **                                    | ** ** | **Three**  | ** ** | **But Within**   | ** ** | **Within**          | ** ** | **After**           | ** ** | ** ** | ** ** |
| ** **                                    | ** ** | **Months** | ** ** | **One Year**     | ** ** | **Five Years** | ** ** | **Five Years** | ** ** | **Total**  | ** ** |
|                                          |       |       |       |                  |       |                |       |                |       |       |       |
| **Interest-Earning Assets:**                  |       |       |       |                  |       |                |       |                |       |       |       |
| Interest Bearing  Deposits                    |       | $          | —     |                  | $          | —              |       | $                   | —     |       | $          | — |   | $ | — |   |
| Federal Funds  Sold                           |       | 17,800     |       | —                |       | —              |       | —              |       | 17,800     |       |
| Investment  Securities and FRB Stock          |       | —     |       | 3,918                 |       | 4,954               |       | —              |       | 8,872      |       |
| Gross Loans                                   |       | 126,758    |       | 2,505                 |       | 4,165               |       | 3,428               |       | 136,856    |       |
|                                          |       | $          | 144,558    |                  | $          | 6,423               |       | $                   | 9,119      |       | $          | 3,428 |   | $ | 163,528 |   |
|                                          |       |       |       |                  |       |                |       |                |       |       |       |
| **Interest-Bearing Liabilities:**             |       |       |       |                  |       |                |       |                |       |       |       |
| Money Market and  NOW Deposits                |       | $          | 50,035     |                  | $          | —              |       | $                   | —     |       | $          | — |   | $ | 50,035 |   |
| Savings                                       |       | 6,674      |       | —                |       | —              |       | —              |       | 6,674      |       |
| Time Deposits                                 |       | 25,485     |       | 40,387                |       | 393                 |       | —              |       | 66,265     |       |
|                                          |       | $          | 82,194     |                  | $          | 40,387              |       | $                   | 393        |       | $          | — |   | $ | 122,974 |   |
|                                          |       |       |       |                  |       |                |       |                |       |       |       |
| **Interest Rate Sensitivity Gap**             |       | $          | 62,364     |                  | $          | (33,964             | )          | $                   | 8,726      |       | $          | 3,428 |   | $ | 40,554 |   |
| **Cumulative Interest Rate  Sensitivity Gap** |       | $          | 62,364     |                  | $          | 28,400              |       | $                   | 37,126     |       | $          | 40,554 |   | $ | 40,554 |   |
|                                          |       |       |       |                  |       |                |       |                |       |       |       |
| **Ratios Based on Total Assets:**             |       |       |       |                  |       |                |       |                |       |       |       |
| Interst Rate  Sensitivity Gap                 |       | 34.50      | %          | -18.79                | %          | 4.83                | %          | 1.90                | %          | 22.43      | %          |
| Cumulative Interest  Rate Sensitivity Gap     |       | 34.50      | %          | 15.71                 | %          | 20.54               | %          | 22.43               | %          |       |       |

 

Liquidityrefers to our ability to maintain a cash flow that is adequate to fund bothon-balance sheet and off-balance sheet requirements on a timely andcost-effective basis.  Potentiallysignificant liquidity requirements include funding of commitments to loanclients and withdrawals from deposit accounts. The Gap ratio is the ability to reprice assets and liabilities in thechanging economic environment.  Forinstance, the Bank is asset sensitive within three months, allowing the Bank toincrease income in a rising interest rate environment.  The Bank then becomes liability sensitivebetween four months and one year, which will increase interest expense in arising interest rate environment.  Afterone year, the Bank is again asset sensitive.

Itshould also be noted that during 2002, the Bank began to institute interestrate floors on certain variable rate loans. Once the interest rates on these variable rate loans reach the floorrate, they temporarily take on the attributes of a fixed rate loan.  This action helps the Bank increase its netinterest margin in a declining rate environment as the rates of our interest-bearingliabilities fall.  However, when interestrates rise, the interest rates on our interest-bearing liabilities will alsobegin to rise while the interest rates on those variable rate loans with floorswill remain at the floor rate.  This maycause the Bank’s net interest margins to temporarily shrink until the rates onthose loans with interest rate floors rise above their floor rates. 

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

**Return onEquity and Assets**

Thefollowing table sets forth several key operating ratios for 2006 and 2005:

34

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**OperatingRatios**

|                                                           | ** ** | **For the Year Ended** | ** ** |
|-----------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                | ** ** | **December 31,**                 | ** ** |
| ** **                                                | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| Return on Average  Assets                                 |       | 0.76                                  | %          | 0.63 | % |
| Return on Average  Equity                                 |       | 11.47                                 | %          | 10.35 | % |
| Dividend Payout Ratio                                     |       | 9.85                                  | %          | 10.67 | % |
| Average Stockholder’s Equity to Average Total Assets |       | 6.62                                  | %          | 6.13 | % |

 

**CapitalResources**

Shareholders’equity at December 31, 2006 was $12.7 million, an increase of $1.5 million or13.1% over $11.2 million at December 31, 2005. Average shareholders’ equity for 2006 was $12.0 million, compared to$10.6 million in 2005.  Shareholders’equity increased primarily from net income of $1,374,139 in 2006.  

In1990, the banking industry began to phase in new regulatory capital adequacyrequirements based on risk-adjusted assets. These requirements take into consideration the risk inherent ininvestments, loans, and other assets for both on-balance sheet and off-balancesheet items.  Under these requirements,the regulatory agencies have set minimum thresholds for Tier 1 Capital, TotalCapital and Leverage ratios.  At December31, 2006, the Bank’s capital exceeded the Tier 1 Capital, Total Capital andLeverage ratio’s minimum regulatory requirements.  The Bank was considered to bewell-capitalized at December 31, 2006, as defined in the regulations issued bythe OCC.  The Bank’s risk-based capitalratios, shown below as of December 31, 2006, have been computed in accordancewith regulatory accounting policies.  TheBancorp is also subject to capital requirements that are withinwell-capitalized ranges as defined by the Federal Reserve Bank.

**CapitalRatios**

|                                  | ** ** | **Requirement** | ** ** | **Actual**      | ** ** |
|----------------------------------|------------|-----------------|------------|-----------------|------------|
| ** **                       | ** ** | **Adequately**  | ** ** | **Well**        | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                       | ** ** | **Capitalized** | ** ** | **Capitalized** | ** ** | **Bank** | ** ** | **Company** | ** ** |
| Total risk-based  capital ratio  |       | 8.00            | %          | 10.00           | %          | 12.50 | % | 12.56 | % |
| Tier 1 risk-based  capital ratio |       | 4.00            | %          | 6.00            | %          | 11.55 | % | 11.15 | % |
| Tier 1 leverage capital ratio    |       | 4.00            | %          | 5.00            | %          | 9.65 | % | 9.33 | % |

 

**Effectsof Inflation**

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

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

35

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

 

 

**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

 

Boardof Directors and Stockholders of

Coast Bancorp and Subsidiary

We have audited the accompanying consolidated balancesheets of Coast Bancorp and Subsidiary as of December 31, 2006 and 2005 and therelated consolidated statements of income, changes in stockholders’ equity, andcash flows for the years then ended. These financial statements are the responsibility of the Company’smanagement.  Our responsibility is toexpress an opinion on these financial statements based on our audits.

We conducted ouraudits in accordance with the standards of the Public Company AccountingOversight Board (United States).  Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement.  An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements.  An audit alsoincludes assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall financial statementpresentation.  We believe that our auditsprovide a reasonable basis for our opinion.

In our opinion,the consolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of Coast Bancorp and Subsidiary as ofDecember 31, 2006 and 2005, and the results of its operations and its cashflows for each of the years then ended, in conformity with accountingprinciples generally accepted in the United States of America.

LagunaHills, California

February 15, 2007

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

***FRESNO ***·***  LAGUNAHILLS ***·***  PALOALTO ***·*** PLEASANTON ***·***  RANCHOCUCAMONGA***

36

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**COAST BANCORP AND SUBSIDIARY**

 

**CONSOLIDATED BALANCE SHEETS**

 

**December 31, 2006 and 2005**
| ** **                                                                                                                                            | ** ** | **2006**    | ** **  | **2005**    | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------|-------------|-------------|------------|
| **ASSETS**                                                                                                                                            |       |        |        |        |       |
| Cash and due from banks                                                                                                                               |       | $           | 7,173,159   |        | $          | 9,769,801 |   |
| Federal funds sold                                                                                                                                    |       | 17,800,000  |        | 24,900,000  |       |
| **TOTAL  CASH AND CASH EQUIVALENTS**                                                                                                                  |       | 24,973,159  |        | 34,669,801  |       |
| ** **                                                                                                                                            |       |        |        |        |       |
| Investment securities  available for sale                                                                                                             |       | 7,925,950   |        | 7,872,170   |       |
|                                                                                                                                                  |       |        |        |        |       |
| Loans:                                                                                                                                                |       |        |        |        |       |
| Commercial                                                                                                                                            |       | 41,725,900  |        | 29,490,713  |       |
| Real estate -  construction                                                                                                                           |       | 28,126,176  |        | 25,212,724  |       |
| Real estate -  other                                                                                                                                  |       | 62,298,552  |        | 76,092,314  |       |
| Consumer                                                                                                                                              |       | 4,705,259   |        | 2,895,549   |       |
| **TOTAL  LOANS**                                                                                                                                      |       | 136,855,887 |        | 133,691,300 |       |
| Net deferred loan fees                                                                                                                                |       | (352,195    | )           | (460,506    | )          |
| Allowance for credit  losses                                                                                                                          |       | (1,388,310  | )           | (1,182,766  | )          |
| **NET  LOANS**                                                                                                                                        |       | 135,115,382 |        | 132,048,028 |       |
| Premises and equipment                                                                                                                                |       | 9,739,660   |        | 8,314,102   |       |
| Deferred taxes                                                                                                                                        |       | 472,000     |        | 329,000     |       |
| Federal Reserve Bank  and Federal Home Loan Bank stock, at cost                                                                                       |       | 945,650     |        | 922,850     |       |
| Accrued interest and  other assets                                                                                                                    |       | 1,567,341   |        | 1,568,151   |       |
| **TOTAL  ASSETS**                                                                                                                                     |       | $           | 180,739,142 |        | $          | 185,724,102 |   |
|                                                                                                                                                  |       |        |        |        |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                        | ** ** | ** **  | ** **  | ** **  | ** ** |
| Deposits:                                                                                                                                             |       |        |        |        |       |
| Non-interest-bearing  demand                                                                                                                          |       | $           | 39,556,425  |        | $          | 40,583,198 |   |
| Money market and  NOW                                                                                                                                 |       | 50,035,815  |        | 45,092,195  |       |
| Savings                                                                                                                                               |       | 6,673,615   |        | 8,855,855   |       |
| Time deposits of  $100,000 or more                                                                                                                    |       | 50,708,688  |        | 58,983,932  |       |
| Other time  deposits                                                                                                                                  |       | 15,555,896  |        | 15,434,000  |       |
| **TOTAL  DEPOSITS**                                                                                                                                   |       | 162,530,439 |        | 168,949,180 |       |
| Notes payable                                                                                                                                         |       | —      |        | 44,659      |       |
| Junior subordinated  debt securities                                                                                                                  |       | 5,155,000   |        | 5,155,000   |       |
| Other liabilities                                                                                                                                     |       | 342,474     |        | 332,212     |       |
| **TOTAL  LIABILITIES**                                                                                                                                |       | 168,027,913 |        | 174,481,051 |       |
| 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:679,600 in  2006 and 674,100 in 2005                                 |       | 7,035,163   |        | 6,950,072   |       |
| Additional  paid-in capital                                                                                                                           |       | 76,416      |        | —      |       |
| Retained  earnings                                                                                                                                    |       | 5,610,760   |        | 4,372,542   |       |
| Accumulated  other comprehensive income - net unrealized losses on available-for-sale  securities, net of taxes of $7,720 in 2006 and $55,289 in 2005 |       | (11,110     | )           | (79,563     | )          |
| **TOTAL  STOCKHOLDERS’ EQUITY**                                                                                                                  |       | 12,711,229  |        | 11,243,051  |       |
| **TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY**                                                                                                  |       | $           | 180,739,142 |        | $          | 185,724,102 |   |

 

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

37

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**COASTBANCORP AND SUBSIDIARY**

**CONSOLIDATEDSTATEMENTS OF INCOME**

**For theYears Ended December 31, 2006 and 2005**
| ** **                                                                   | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **INTEREST INCOME**                                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest and  fees on loans                                                  |       | $          | 12,776,501 |       | $          | 9,981,156 |   |
| Interest on  investment securities                                           |       | 243,553    |       | 306,861    |       |
| Interest on  federal funds sold                                              |       | 792,308    |       | 561,485    |       |
| Other interest  income                                                       |       | 54,896     |       | 53,999     |       |
| **TOTAL  INTEREST INCOME**                                                   |       | 13,867,258 |       | 10,903,501 |       |
| **INTEREST EXPENSE**                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest on  money market and NOW accounts                                   |       | 1,420,141  |       | 681,367    |       |
| Interest on  savings deposits                                                |       | 129,492    |       | 78,902     |       |
| Interest on time  deposits                                                   |       | 2,836,756  |       | 2,027,805  |       |
| Interest on  junior subordinated debt securities                             |       | 474,048    |       | 380,392    |       |
| Interest on other  borrowings                                                |       | 155        |       | 2,826      |       |
| **TOTAL  INTEREST EXPENSE**                                                  |       | 4,860,592  |       | 3,171,292  |       |
| **NET  INTEREST INCOME**                                                     |       | 9,006,666  |       | 7,732,209  |       |
| Provision for credit  losses                                                 |       | 236,000    |       | 20,000     |       |
| ** **                                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| **NET  INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES**                   |       | 8,770,666  |       | 7,712,209  |       |
| **NON-INTEREST INCOME**                                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service charges  on deposits accounts and other noninterest income           |       | 341,283    |       | 252,266    |       |
| Gain on sale of  loans, servicing fees, and amortization of servicing assets |       | 426,121    |       | 193,699    |       |
| Mortgage  packaging fees                                                     |       | 88,367     |       | 75,927     |       |
| Gain on sale of  premises and equipment                                      |       | 19,772     |       | 53,016     |       |
| **TOTAL  NON-INTEREST INCOME**                                               |       | 875,543    |       | 574,908    |       |
| **NON-INTEREST EXPENSE**                                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Salaries and  benefits                                                       |       | 4,047,582  |       | 3,539,906  |       |
| Net occupancy  expenses                                                      |       | 501,087    |       | 488,667    |       |
| Equipment  expenses                                                          |       | 327,585    |       | 324,389    |       |
| Data processing                                                              |       | 470,131    |       | 370,235    |       |
| Director fees  and expenses                                                  |       | 148,000    |       | 121,586    |       |
| Insurance                                                                    |       | 61,486     |       | 63,461     |       |
| Marketing and  business promotion                                            |       | 845,924    |       | 614,705    |       |
| Other  professional expenses                                                 |       | 232,660    |       | 233,870    |       |
| Office expenses                                                              |       | 253,514    |       | 225,450    |       |
| Regulatory assessments                                                       |       | 86,289     |       | 79,550     |       |
| Other expenses                                                               |       | 379,312    |       | 288,558    |       |
| **TOTAL  NON-INTEREST EXPENSE**                                              |       | 7,353,570  |       | 6,350,377  |       |
| **INCOME  BEFORE INCOME TAXES**                                              |       | 2,292,639  |       | 1,936,740  |       |
| Income taxes                                                                 |       | 918,500    |       | 838,874    |       |
| **NET  INCOME**                                                              |       | $          | 1,374,139  |       | $          | 1,097,866 |   |
| **Per Share Data**                                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income -  basic                                                          |       | $          | 2.03       |       | $          | 1.64 |   |
| Net income - diluted                                                         |       | $          | 1.93       |       | $          | 1.56 |   |

 

*The accompanying notes are an integral part ofthese consolidated financial statements.*

38

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**COASTBANCORP AND SUBSIDIARY**

 

**CONSOLIDATEDSTATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY**

**For theYears Ended December 31, 2006 and 2005**
| ** **                                                                       | ** ** | ** **        | ** ** | ** **            | ** ** | ** **     | ** ** | ** **  | ** ** | ** **   | ** ** | **Accumulated**   | ** ** | ** ** | ** ** |
|----------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|----------------|------------|-------------|------------|--------------|------------|-------------------|------------|------------|------------|
| ** **                                                                       | ** ** | ** **        | ** ** | **Common Stock** | ** ** | **Additional** | ** ** | ** **  | ** ** | **Other**    | ** ** | ** **        | ** ** |
| ** **                                                                       | ** ** | **Comprehensive** | ** ** | **Number of**    | ** ** | ** **     | ** ** | **Paid-In** | ** ** | **Retained** | ** ** | **Comprehensive** | ** ** | ** ** | ** ** |
| ** **                                                                       | ** ** | **Income**        | ** ** | **Shares**            | ** ** | **Amount**     | ** ** | **Capital** | ** ** | **Earnings** | ** ** | **Income**        | ** ** | **Total**  | ** ** |
| **Balance at January 1, 2005**                                                   |       |              |       | 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**                                                  |       | $                 | 1,079,124  |                  |       |           |       |        |       |         |       |              |       |       |       |   |
|                                                                             |       |              |       |                  |       |           |       |        |       |         |       |              |       |       |       |
| **Balance at December 31, 2005**                                                 |       |              |       | 674,100               |       | $              | 6,950,072  |        | $          | —       |       | $                 | 4,372,542  |       | $          | (79,563 | ) | $ | 11,243,051 |   |
| ** **                                                                       |       |              |       |                  |       |           |       |        |       |         |       |              |       |       |       |
| Exercise of stock  options, including the realization of tax benefits of $7,716  |       |              |       | 5,500                 |       | 85,091         |       |        |       |         |       |              |       | 85,091     |       |
| Stock-based compensation  expense                                                |       |              |       |                  |       |           |       | 76,416      |       |         |       |              |       | 76,416     |       |
| Cash dividends                                                                   |       |              |       |                  |       |           |       |        |       | (135,921     | )          |              |       | (135,921   | )          |
| **Comprehensive  Income**                                                        |       |              |       |                  |       |           |       |        |       |         |       |              |       |       |       |
| Net income                                                                       |       | $                 | 1,374,139  |                  |       |           |       |        |       |         | 1,374,139  |              |       |       | 1,374,139  |   |
| Unrealized gain on  available-for-sale securities, net of taxes of $47,569       |       | 68,453            |       |                  |       |           |       |        |       |         |       | 68,453            |       | 68,453     |       |
| **Total  comprehensive income**                                                  |       | $                 | 1,442,592  |                  |       |           |       |        |       |         |       |              |       |       |       |   |
|                                                                             |       |              |       |                  |       |           |       |        |       |         |       |              |       |       |       |
| **Balance at December 31, 2006**                                                 |       |              |       | 679,600               |       | $              | 7,035,163  |        | $          | 76,416       |       | $                 | 5,610,760  |       | $          | (11,110 | ) | $ | 12,711,229 |   |

 

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

 

39

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# **COAST BANCORP AND SUBSIDIARY**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**For theYears Ended December 31, 2006 and 2005**
| ** **                                                               | ** ** | **2006**   | ** ** | **2005**    | ** ** |
|--------------------------------------------------------------------------|------------|------------|------------|-------------|------------|
| **OPERATING ACTIVITIES**                                                 | ** ** | ** ** | ** ** | ** **  | ** ** |
| Net income                                                               |       | $          | 1,374,139  |        | $          | 1,097,866 |   |
| Adjustments to  reconcile net income to net cash provided by operations: |       |       |       |        |       |
| Depreciation and  amortization                                           |       | 472,801    |       | 502,221     |       |
| Provision for  credit losses                                             |       | 236,000    |       | 20,000      |       |
| Stock-based  compensation                                                |       | 76,416     |       | —      |       |
| Gain on sale of  loans                                                   |       | (466,318   | )          | (146,353    | )          |
| Gain on sale of  premises and equipment                                  |       | (19,772    | )          | (53,016     | )          |
| Other, net                                                               |       | (287,808   | )          | 451,053     |       |
| **NET  CASH PROVIDED BY OPERATING ACTIVITIES**                           |       | 1,385,458  |       | 1,871,771   |       |
| **INVESTING ACTIVITIES**                                                 | ** ** | ** ** | ** ** | ** **  | ** ** |
| Net increase in  loans                                                   |       | (8,607,961 | )          | (18,894,159 | )          |
| Proceeds from  loans sold                                                |       | 5,879,236  |       | 1,649,748   |       |
| Purchase of  available-for-sale securities                               |       | (5,937,515 | )          | —      |       |
| Purchase of  Federal Reserve Bank and Federal Home Loan Bank stock       |       | (22,800    | )          | (39,400     | )          |
| Proceeds from  maturities of available-for-sale securities               |       | 6,000,000  |       | 4,950,000   |       |
| Proceeds from  the sale of premises and equipment                        |       | 24,500     |       | 404,161     |       |
| Purchase of  premises and equipment                                      |       | (1,903,330 | )          | (426,299    | )          |
| **NET  CASH USED IN INVESTING ACTIVITIES**                               |       | (4,567,870 | )          | (12,355,949 | )          |
| **FINANCING ACTIVITIES**                                                 | ** ** | ** ** | ** ** | ** **  | ** ** |
| Net increase in  demand deposits and savings accounts                    |       | 1,734,607  |       | 8,914,013   |       |
| Net increase in  time deposits                                           |       | (8,153,348 | )          | 15,442,621  |       |
| Principal  payments on notes payable                                     |       | (44,659    | )          | (61,066     | )          |
| Payments for  dividends                                                  |       | (135,921   | )          | (117,967    | )          |
| Proceeds from  exercise of stock options                                 |       | 85,091     |       | 286,555     |       |
| **NET  CASH PROVIDED (USED) BY FINANCING ACTIVITIES**                    |       | (6,514,230 | )          | 24,464,156  |       |
| ** **                                                               | ** ** | ** ** | ** ** | ** **  | ** ** |
| **INCREASE  (DECREASE) IN CASH AND CASH EQUIVALENTS**                    |       | (9,696,642 | )          | 13,979,978  |       |
| Cash and cash  equivalents at beginning of period                        |       | 34,669,801 |       | 20,689,823  |       |
| Cash and cash equivalents  at end of period                              |       | $          | 24,973,159 |        | $          | 34,669,801 |   |
|                                                                     |       |       |       |        |       |
| **Supplemental disclosure of cash  flow information**                    | ** ** | ** ** | ** ** | ** **  | ** ** |
| Interest paid                                                            |       | $          | 4,835,589  |        | $          | 3,094,515 |   |
| Income taxes paid                                                        |       | $          | 1,110,000  |        | $          | 695,000 |   |

 

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

40

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**COAST BANCORP AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**December 31, 2006 and 2005**

**NOTE #1 - SUMMARY OF SIGNIFICANT ACCOUNTINGPOLICIES**

### **Principlesof Consolidation**

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

*Nature of Operations*

Coast Bancorp operates Coast National Bank.  The Bank has been organized as a singleoperating segment and operates five branches in San Luis Obispo, Arroyo Grande,Morro Bay, Los Osos, and Paso Robles, California and two loan productionoffices in Santa Maria and Fresno, California. The Bank’s primary source of revenue is providing loans to customers,who are predominantly small and middle-market businesses and individuals.

*Use of Estimates in the Preparation of FinancialStatements*

The preparation of financial statements in conformitywith generally accepted accounting principles in the United States of Americarequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the reporting period.  Actual results could differ from thoseestimates.

### **Presentationof Cash Flows**

For the purposes ofreporting cash flows, cash and cash equivalents includes cash,non-interest-earning deposits and federal funds sold.  Generally, federal funds are sold for one dayperiods.

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

Banking regulationsrequire that all banks maintain a percentage of their deposits as reserves incash or on deposit with the Federal Reserve Bank.  The Bank complied with the reserverequirements as of December 31, 2006 and 2005.

The Company maintainsamounts due from banks which exceed federally insured limits.  The Company has not experienced any losses insuch accounts.

### **Investment Securities**

Bonds, notes, anddebentures for which the Company has the positive intent and ability to hold tomaturity are reported at cost, and adjusted for premiums and discounts that arerecognized in interest income using the interest method over the period tomaturity.

Investments notclassified as trading securities nor as held to maturity securities areclassified as available-for-sale securities and recorded at fair value.  Unrealized gains or losses onavailable-for-sale securities are excluded from net income and reported as anamount net of taxes as a separate component of other comprehensive incomeincluded in stockholders’ equity. Premiums or discounts on held-to-maturity and available-for-salesecurities are amortized or accreted into income using the interest method.  Realized gains or losses on sales ofheld-to-maturity or available-for-sale securities are recorded using thespecific identification method.

41

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Declines in thefair value of individual held-to-maturity and available-for-sale securitiesbelow their cost that are other than temporary result in write-downs of theindividual securities to their fair value.  The related write-downs areincluded in earnings as realized losses.  In estimating other thantemporary impairment losses, management considers the length of time and theextent to which the fair value has been less than cost, the financial conditionand near-term prospects of the issuer, and the intent and ability of the Bankto retain its investment in the issuer for a period of time sufficient to allowfor any anticipated recovery in fair value.

### **Loans**

Loans receivable thatmanagement has the intent and ability to hold for the foreseeable future oruntil maturity or payoff are reported at their outstanding unpaid principalbalances reduced by any charge-offs or specific valuation accounts and net ofany deferred fees or costs on originated loans, or unamortized premiums ordiscounts on purchased loans.

Loan origination fees andcertain direct origination costs are capitalized and recognized as an adjustmentof the yield of the related loan.

Interest income isaccrued daily as earned on all loans. Loans on which the accrual of interest has been discontinued aredesignated as non-accrual 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 non-accrual status,all interest previously accrued but not collected is reversed against currentperiod interest income.  Income onnon-accrual 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 loans onlywhen they are brought current with respect to interest and principal and when,in the judgment of management, the loans are estimated to be fully collectibleas to all principal and interest.

The Company considers aloan to be impaired when it is probable that the Company will be unable tocollect all amounts due (principal and interest) according to the contractualterms of the loan agreement.  Measurementof impairment is based on the expected future cash flows of an impaired loanwhich are to be discounted at the loan’s effective interest rate, or measuredby reference to an observable market value, if one exists, or the fair value ofthe collateral for a collateral-dependent loan. The Company selects the measurement method on a loan-by-loan basis exceptwhen collateral-dependent loans for which foreclosure is probable are measuredat the fair value of the collateral.  TheCompany recognizes interest income on impaired loans based on its existingmethods of recognizing interest income on non-accrual loans.

For impairment recognizedin accordance with Financial Accounting Standards Board (“FASB”) Statement ofFinancial Accounting Standards (“SFAS”) No. 114, *“Accountingby Creditors for Impairment of a Loan,”* as amended by SFAS No. 118,the entire change in the present value of expected cash flows is reported aseither provision for credit losses in the same manner in which impairmentinitially was recognized, or as a reduction in the amount of provision forcredit losses that otherwise would be reported.

The Company has adoptedSFAS No. 140, *“Accounting for Transfers and Servicing ofFinancial Assets and Extinguishments of Liabilities.”*  The Statement provides accounting andreporting standards for transfers and servicing of financial assets andextinguishments of liabilities.  Underthis Statement, after a transfer of financial assets, an entity recognizes thefinancial and servicing assets it controls and liabilities it has incurred,derecognizes financial assets when control has been surrendered, and derecognizesliabilities when extinguished.

42

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To calculate the gain(loss) on sale of loans, the Company’s investment in the loan is allocatedamong the retained portion of the loan, the servicing retained, theinterest-only strip and the sold portion of the loan, based on the relativefair market value of each portion.  Thegain (loss) on the sold portion of the loan is recognized at the time of salebased on the difference between the sale proceeds and the allocated investment.  As a result of the relative fair valueallocation, the carrying value of the retained portion is discounted, with thediscount accreted to interest income over the life of the loan.  That portion of the excess servicing feesthat represent contractually specified servicing fees (contractual servicing)are reflected as a servicing asset which is amortized over an estimated lifeusing a method approximating the level yield method; in the event futureprepayments exceed management’s estimates and future expected cash flows areinadequate to cover the unamortized servicing asset, additional amortizationwould be recognized.  The portion ofexcess servicing fees in excess of the contractual servicing fees is reflectedas interest-only (I/O) strips receivable, which are classified as interest-onlystrips receivable available for sale and are carried at fair value.

*Provision and Allowance for Credit Losses*

The allowance for credit losses is increased by theprovision, which is charged to expense and decreased by charge-offs (net ofrecoveries).  Management’s periodicevaluation of the adequacy of the allowance is based on the Company’s past loanloss experience, known and inherent risks in the portfolio, adverse situationsthat may affect the borrower’s ability to repay, the estimated value of anyunderlying collateral, and current economic conditions.

### **Premises and Equipment**

Land is carried atcost.  Premises and equipment are carriedat cost less accumulated depreciation and amortization.  Depreciation is computed using thestraight-line method over the estimated useful lives, which ranges from threeto ten years for furniture and fixtures and forty years for buildings.  Leasehold improvements are amortized usingthe straight-line method over the estimated useful lives of the improvements orthe remaining lease term, whichever is shorter. Expenditures for betterments or major repairs are capitalized and thosefor ordinary repairs and maintenance are charged to operations as incurred.

### **AdvertisingCosts**

TheCompany expenses the costs of advertising in the period incurred.

### **IncomeTaxes**

Deferred incometaxes are computed using the asset and liability method, which recognizes aliability or asset representing the tax effects, based on current tax law, offuture deductible or taxable amounts attributable to events that have beenrecognized in the consolidated financial statements.  A valuation allowance is established toreduce the deferred tax asset to the level at which it is “more likely than not”that the tax asset or benefits will be realized.  Realization of tax benefits of deductibletemporary differences and operating loss carry forwards depend on havingsufficient taxable income of an appropriate character within the carry forwardperiods.

### **Comprehensive Income**

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

43

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*Financial Instruments*

In the ordinary course of business, the Company hasentered into off-balance sheet financial instruments consisting of commitmentsto extend credit, commitments under credit card arrangements, commercialletters of credit, and standby letters of credit, as described in Note#12.  Such financial instruments arerecorded in the consolidated financial statements when they are funded orrelated fees are incurred or received.

*Earnings Per Share (EPS)*

Basic EPS excludes dilution and is computed bydividing income available to common stockholders by the weighted-average numberof common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if optionsor other contracts to issue common stock were exercised or converted intocommon stock or resulted in the issuance of common stock that then shared inthe earnings of the entity.

### **Stock-Based Compensation**

The Bank hasadopted SFAS No. 123(R) “*Shared-Based Payment.”  *This Statement generally requiresentities to recognize the cost of employee services received in exchange forawards of stock options, or other equity instruments, based on the grant-datefair value of those awards.  This cost isrecognized over the period which an employee is required to provide services inexchange for the award, generally the vesting period.

*Change inAccounting Principle*

The Bank adoptedSFAS No. 123 (R) on January 1, 2006 using the “modified prospective method.”  Under this method compensation expense isrecognized using the fair-value method for all new stock option awards as wellas any existing awards that are modified, repurchased or cancelled afterJanuary 1, 2006 and prior periods are not restated.  In addition, the unvested portion ofpreviously awarded options outstanding as of January 1, 2006 will also berecognized as expense over the requisite service period based on the fair valueof those options as previously calculated at the grant date under the pro-formadisclosures of SFAS No. 123.  The fairvalue of each grant is estimated using the Black-Scholes option pricingmodel.  During 2006 the Bank recognizedpre-tax stock-based compensation expense of $76,416, as a result of adoptingSFAS No. 123 (R).

Prior to theadoption of SFAS No. 123 (R), the Bank accounted for stock-based awards usingthe intrinsic value method prescribed in Accounting Principles Board (“APB”)Opinion No. 25, “*Accounting for Stock Issued to Employees,”*and related interpretations. Accordingly, compensation cost for stock options was measured as theexcess, if any, of the quoted market price of the Bank’s stock at the date ofthe grant over the amount an employee must pay to acquire the stock.  All of the Bank’s stock option grantsincluded exercise prices equal to the Bank’s current market price per share;accordingly, no compensation expense was reported using the intrinsic valuemethod of APB Opinion No. 25.

44

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Had compensationcost for the Bank’s stock option plans been determined based on the fair valueat the grant dates for awards under those plans consistent with the method ofSFAS No. 123, the Bank’s net income and income per share for 2005 would havechanged to the pro forma amounts indicated below:

|                                                                                                 | ** ** | **2005** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|----------|------------|
| Net income:                                                                                     |       |     |       |
| As reported                                                                                     |       | $        | 1,097,866  |   |
| 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  | )          |
| Pro forma net income                                                                            |       | $        | 1,061,619  |   |
|                                                                                            |       |     |       |
| Basic earnings  per share:                                                                      |       |     |       |
| As reported                                                                                     |       | $        | 1.64       |   |
| Pro forma                                                                                       |       | $        | 1.59       |   |
|                                                                                            |       |     |       |
| Diluted earnings  per share:                                                                    |       |     |       |
| As reported                                                                                     |       | $        | 1.56       |   |
| Pro forma                                                                                       |       | $        | 1.55       |   |

 

*Current Accounting Pronouncements*

In March 2006, theFASB issued SFAS No. 156, *“Accounting for Servicingof Financial Assets, an amendment of FASB Statement No. 140.”* The statement amends SFAS No. 140 by  (1) requiring the separate accounting forservicing assets and servicing liablilties, which arise from the sale offinancial assets; (2) requiring all separately recognized serving assets andservicing liabilities to be initially measured at fair value, if practicable;and (3) permitting an entity to choose between an amortization method or a fairvalue method for subsequent measurement for each class of separately recognizedservicing assets and servicing liabilities. The Company must adopt the statement no later than January 1, 2007.  Management does not expect that the adoptionof this new standard will have a material impact on the Company’s financialposition, results of operations or cash flows.

In June 2006, theFASB issued FASB Interpretation No. 48 (“FIN 48”), *“Accountingfor Uncertainty in Income Taxes*.” This interpretation applies to all tax positions accounted for inaccordance with SFAS No. 109, *“Accounting for IncomeTaxes.”* FIN 48 clarifies theapplication of SFAS No. 109 by defining the criteria that an individual taxposition must meet in order for the position to be recognized within thefinancial statements and provides guidance on measurement, derecognition,classification, interest and penalties, accounting in interim periods,disclosure and transition for tax positions. The Company must adopt the interpretation by January 1, 2007.  Management does not expect that the adoptionof this new interpretation will have a material impact on the Company’sfinancial position, results of operations or cash flows.

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### **Disclosure about Fair Value of FinancialInstruments**

SFAS No. 107specifies the disclosure of the estimated fair value of financialinstruments.  The Company’s estimatedfair value amounts have been determined by the Company using available marketinformation and appropriate valuation methodologies.

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

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

## *Reclassification*

## Certain reclassifications have been made inthe 2005 consolidated financial statements to conform to the presentation usedin 2006.  These classifications are of anormal recurring nature.

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

Amortized cost and market values of securities are asfollows:
| ** **                      | ** ** | **December 31, 2006** | ** ** |
|---------------------------------|------------|---------------------------------|------------|
| ** **                      | ** ** | ** **                      | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                      | ** ** | **Amortized**                   | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Market** | ** ** |
| ** **                      | ** ** | **Cost**                        | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
| Available-for-sale  securities: |       |                            |       |   |   |   |   |   |   |
| U.S. Agency  securities         |       | $                               | 7,944,780  |   | $ | — |   | $ | (18,830 | ) | $ | 7,925,950 |   |
|                                 |            |                                 |            |  |  |  |  |  |  |  |  |  |  |

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

 

Securities with acarrying value of $993,052 and $984,380 at December 31, 2006 and 2005,respectively, were pledged to secure public monies as required by law.

The amortized cost and fair values of investmentsecurities available for sale at December 31, 2006, by expected maturitiesare shown below.  Expected maturities maydiffer from contractual maturities because borrowers may have the right to callor prepay obligations with or without call or prepayment penalties.

46

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## Security maturities are as follows:

|                                | ** ** | **December 31, 2006**              | ** ** |
|--------------------------------|------------|----------------------------------------------|------------|
| ** **                     | ** ** | **Securities  Available for Sale** | ** ** |
| ** **                     | ** ** | **Amortized Cost**                      | ** ** | **Fair Value** | ** ** |
|                           |       |                                         |       |   |   |
| Due in one year  or less       |       | $                                            | 2,984,407  |   | $ | 2,971,870 |   |
| Due in one year  to five years |       | 4,960,373                                    |       | 4,954,080 |   |
|                           |       | $                                            | 7,944,780  |   | $ | 7,925,950 |   |

 

Securities withunrealized losses are as follows:
| ** **             | ** ** | **December 31, 2006**            | ** ** |
|------------------------|------------|--------------------------------------------|------------|
| ** **             | ** ** | **Less than Twelve Months** | ** ** | **Over Twelve Months** | ** ** | **Total** | ** ** |
| ** **             | ** ** | **Unrealized**                             | ** ** | ** ** | ** ** | **Unrealized** | ** ** | ** ** | ** ** | **Unrealized** | ** ** | ** ** | ** ** |
| ** **             | ** ** | **Losses**                                 | ** ** | **Fair Value** | ** ** | **Losses** | ** ** | **Fair Value** | ** ** | **Losses** | ** ** | **Fair Value** | ** ** |
|                   |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| U.S. Agency Securities |       | $                                          | (4,129     | ) | $ | 5,937,830 |   | $ | (14,701 | ) | $ | 1,988,120 |   | $ | (18,830 | ) | $ | 7,925,950 |   |
|                        |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **             | ** ** | **December 31, 2005**            | ** ** |
|------------------------|------------|--------------------------------------------|------------|
| ** **             | ** ** | **Less than Twelve Months** | ** ** | **Over Twelve Months** | ** ** | **Total** | ** ** |
| ** **             | ** ** | **Unrealized**                             | ** ** | ** ** | ** ** | **Unrealized** | ** ** | ** ** | ** ** | **Unrealized** | ** ** | ** ** | ** ** |
| ** **             | ** ** | **Losses**                                 | ** ** | **Fair Value** | ** ** | **Losses** | ** ** | **Fair Value** | ** ** | **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, 2006, no declines were deemedto be other than temporary.

**NOTE #3 - LOANS**

The Company’s loan portfolio consists primarily ofloans to borrowers within San Luis Obispo, Santa Maria and Fresno, Californiaand its surrounding communities. Although the Company seeks to avoid concentrations of loans to a singleindustry or based upon a single class of collateral, real estate and realestate associated businesses are among the principal industries in the Company’smarket area and, as a result, the Company’s loan and collateral portfolios are,to some degree, concentrated in those industries.

47

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The Company alsooriginates SBA loans and other governmental guaranteed loans which itperiodically sells to governmental agencies and institutional investors.  Revenues generated from the origination ofloans guaranteed by the Small Business Administration under its variousprograms and sale of the guaranteed portions of those loans contribute to theCompany’s income.  Funding for these SBAprograms depends on annual appropriations by the U.S. Congress.

The Company was servicingapproximately $11,957,000 and $15,345,000 in loans previously sold as ofDecember 31, 2006 and 2005, respectively. The Company has recorded servicing assets related to these loanstotaling $150,287 and $246,986 as of December 31, 2006 and 2005,respectively.  A summary of the changesin the related servicing assets are as follows:

|                                               | ** ** | **Servicing Assets** | ** ** |
|-----------------------------------------------|------------|---------------------------|------------|
| ** **                                    | ** ** | **2006**                  | ** ** | **2005** | ** ** |
| Balance,  beginning of year                   |       | $                         | 246,986    |   | $ | 419,086 |   |
| Increase from  loan sales                     |       | 90,104                    |       | 26,467 |   |
| Amortization  charged to income               |       | (59,402                   | )          | (110,941 | ) |
| Decrease from  loan payoffs charged to income |       | (127,401                  | )          | (87,626 | ) |
| Balance, end of year                          |       | $                         | 150,287    |   | $ | 246,986 |   |

 

The estimated fair valueof the servicing assets approximated the carrying amount at December 31, 2006and 2005.  Fair value is estimated bydiscounting estimated future cash flows from the servicing assets usingdiscount rates that approximate current market rates over the expected lives ofthe loans being serviced.  Management hasestimated the expected life of these loans to be approximately 25% to 30% ofthe remaining life at the time of sale. For purposes of measuring impairment, the Bank has identified eachservicing asset and interest-only strip with the underlying loan beingserviced.  The only loans that are soldand serviced by the Bank are government guaranteed loans.  The risk characteristics of these underlyingassets are considered when the discount rates are determined for purposes ofimpairment testing.  A valuationallowance is recorded where the fair value is below the carrying amount of theasset.  At December 31, 2006 and 2005,the estimated fair value of the servicing asset and the interest-only stripapproximated the carrying amount, so no valuation account has been established.

TheCompany may also receive a portion of subsequent interest collections on loanssold that exceed the contractual servicing fee. In that case the Company records an interest-only strip based on therelative fair market value of it and the other components of the loan. TheCompany had interest-only strips of $35,915 and $65,955 as of December 31, 2006and 2005, respectively, which approximated fair value.   Fair value is estimated by discountingestimated future cash flows from the interest-only strips using assumptionssimilar to those used in valuing servicing assets.
| ** **                                     | ** ** | **Interest-Only Strips Receivable** | ** ** |
|------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                     | ** ** | **2006**                                      | ** ** | **2005** | ** ** |
| Balance,  beginning of year                    |       | $                                             | 65,955     |   | $ | 86,592 |   |
| Increase from  loan sales                      |       | 12,577                                        |       | 16,896 |   |
| Amortization  charged to income                |       | (31,748                                       | )          | (20,527 | ) |
| Decreases from  loan payoffs charged to income |       | (10,869                                       | )          | (17,006 | ) |
| Balance, end of year                           |       | $                                             | 35,915     |   | $ | 65,955 |   |

 

48

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As described in Note #12, these consolidated financialstatements do not reflect other various commitments to extend credit or lettersof credit, which arise in the normal course of business.

A summary of the changes in the allowance for creditlosses follows:

|                                       | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------------------------|------------|----------|------------|----------|------------|
| Balance,  beginning of year           |       | $        | 1,182,766  |     | $          | 1,168,423 |   |
| Provision for  credit losses          |       | 236,000  |       | 20,000   |       |
| Loans charged  off, net of recoveries |       | (30,456  | )          | (5,657   | )          |
| Balance, end of year                  |       | $        | 1,388,310  |     | $          | 1,182,766 |   |

 

The following is asummary of the investment in impaired loans, the related allowance for loanlosses, income recognized thereon and information pertaining to non-accrual andpast due loans as of December 31:

|                                                              | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                         |       |     |       |     |       |
| Recorded  investment in impaired loans                       |       | $        | 2,543,253  |     | $          | 15,187 |   |
| Related  allowance for loan losses                           |       | $        | 491,558    |     | $          | — |   |
| Average recorded  investment in impaired loans               |       | $        | 666,000    |     | $          | 6,250 |   |
| Interest income  recognized for cash payments                |       | $        | 4,868      |     | $          | — |   |
| Total nonaccrual  loans                                      |       | $        | 2,543,253  |     | $          | 15,187 |   |
| Total loans past-due  ninety days or more and still accruing |       | $        | —     |     | $          | — |   |

 

**NOTE #4 - PREMISES AND EQUIPMENT**

A summary of premises and equipment as of December 31,2006 and 2005 follows:

|                                                  | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|--------------------------------------------------|------------|------------|------------|------------|------------|
|                                             |       |       |       |       |       |
| Land                                             |       | $          | 4,645,661  |       | $          | 3,037,669 |   |
| Building                                         |       | 4,998,779  |       | 4,996,698  |       |
| Leasehold  improvements                          |       | 222,784    |       | 211,676    |       |
| Furniture,  fixtures and equipment               |       | 2,082,353  |       | 1,924,744  |       |
| Work In Progress                                 |       | 8,218      |       | —     |       |
|                                             |       | 11,957,795 |       | 10,170,787 |       |
| Less:  Accumulated depreciation and amortization |       | (2,218,135 | )          | (1,856,685 | )          |
|                                             |       | $          | 9,739,660  |       | $          | 8,314,102 |   |

49

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The Company has enteredinto leases for its branches and operating facilities, which expire at variousdates through 2009. These leases include provisions for periodic variable rentincreases as well as payment by the lessee of certain operating expenses.  Rental expense relating to these leases wasapproximately $113,000 in 2006 and $101,000 in 2005.

The approximate future minimum annual payments forthese leases by year are as follows:

| Year   | ** ** | **Amount** | ** ** |
|--------|------------|------------|------------|
|   |       |       |       |
| 2007   |       | $          | 81,384     |   |
| 2008   |       | 49,150     |       |
| 2009   |       | 21,474     |       |
|   |       | $          | 152,008    |   |

 

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

TheCompany leases surplus office space that it owns to various third parties.   The Company received lease income ofapproximately $104,000 in 2006, and $92,000 in 2005 from the leased portions ofthe buildings at 486 Marsh Street and 545 Higuera in San Luis Obispo.  It is the intention of the Bank to hold thisproperty for future development and expansion.

**NOTE #5 - DEPOSITS**

At December 31, 2006 all time deposits were scheduledto mature in 2007 except for $392,524 that matures in one to two years.

**NOTE #6 - NOTES PAYABLE AND OTHER BORROWINGARRANGEMENTS**

Notes payable consist of the following:
| ** **                                                                                                                                                                                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| 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, paid in full January 13, 2006. |       | $        | —     |     | $     | 44,659 |   |
|                                                                                                                                                                                                                     |            |          |            |          |            |  |  |

 

The Company may borrow up to $5,000,000 overnight onan unsecured basis from two correspondent banks.  As of December 31, 2006, no amounts were outstandingunder these arrangements.

As of December 31, 2006, the Company also hasfinancing availability of approximately $44.6 million from the Federal HomeLoan Bank (FHLB) which was secured by a blanket pledge of the Company’s loanportfolio which is valued by the most recent Federal Financial InstitutionsExamination Council’s (FFIEC) Uniform Bank Performance Report. The pledgedamount is determined by the amount of funds borrowed from the FHLB.  As of December 31, 2006, no amounts wereoutstanding under these arrangements.

50

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

On September 26, 2002, the Company issued $5,155,000 ofjunior subordinated debt securities (the “debt securities”) to Coast BancorpStatutory Trust I, a statutory trust created under the laws of the State of Delaware.  These debt securities are subordinated toeffectively all borrowings of the Company and are due and payable on September26, 2032.  Interest is payable quarterlyon these debt securities at 3-Month LIBOR plus 3.4% for an effective rate of8.77% as of December 31, 2006.  The debtsecurities can be redeemed for 107.5% of the principal balance throughSeptember 26, 2007 and at par thereafter. The debt securities can also be redeemed at par if certain events occurthat impact the tax treatment or the capital treatment of the issuance.

The Company also purchased a 3% minority interest in CoastBancorp Statutory Trust I.  The balanceof the equity of Coast Bancorp Statutory Trust I is comprised of mandatorilyredeemable preferred securities.  Inaccordance with FASB Interpretation (FIN) No. 46, *“Consolidation of Variable Interest Entities, an interpretation of ARBNo. 51,”* the Company does not consolidate Coast Bancorp StatutoryTrust I into the Company financial statements. Prior to the issuance of FIN No. 46, Bank Holding companies typicallyconsolidated these entities.  As ofDecember 31, 2006, the Company has included the net junior subordinated debt inits Tier 1 Capital for regulatory capital purposes.

**NOTE #8 - INCOME TAXES**

The provisions for income taxes included in theconsolidated statements of income consist of the following:

|          | ** ** | **2006**  | ** ** | **2005** | ** ** |
|----------|------------|-----------|------------|----------|------------|
| Current: |       |      |       |     |       |
| Federal  |       | $         | 824,170    |     | $          | 588,111 |   |
| State    |       | 284,330   |       | 206,763  |       |
|     |       | 1,108,500 |       | 794,874  |       |
| Deferred |       | (190,000  | )          | 44,000   |       |
|     |       | $         | 918,500    |     | $          | 838,874 |   |

 

Deferred taxes are a result of differences betweenincome tax accounting and generally accepted accounting principles with respectto income and expense recognition.  TheCompany’s principal timing differences are from credit loss provisionaccounting and depreciation differences.

51

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The following is a summary of the components of the net deferred taxasset accounts recognized in the accompanying statements of financialcondition:

 
|                                                        | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred tax assets:                                   |       |     |       |     |       |
| Allowance for  credit losses                           |       | $        | 507,000    |     | $          | 410,000 |   |
| Market value  adjustment on investment securities      |       | 8,000    |       | 55,000   |       |
| Other assets                                           |       | 138,000  |       | 8,000    |       |
|                                                   |       | 653,000  |       | 473,000  |       |
| Deferred tax  liabilities:                             |       |     |       |     |       |
| Premises and  equipment due to depreciation difference |       | (86,000  | )          | (84,000  | )          |
| Other  liabilities                                     |       | (95,000  | )          | (60,000  | )          |
|                                                   |       | (181,000 | )          | (144,000 | )          |
| Net deferred tax assets                                |       | $        | 472,000    |     | $          | 329,000 |   |

 

A comparison of thefederal statutory income tax rates to the Company’s effective income tax ratesfollow:
|                                              | ** ** | **2006**   | ** ** | **2005** | ** ** |
|----------------------------------------------|------------|------------|------------|----------|------------|
| ** **                                   | ** ** | **Amount** | ** ** | **Rate** | ** ** | **Amount** | ** ** | **Rate** | ** ** |
|                                         |       |       |       |     |       |   |   |   |   |
| Statutory federal tax                        |       | $          | 779,000    |     | 34.0       | % | $ | 658,000 |   | 34.0 | % |
| State franchise tax,  net of federal benefit |       | 171,000    |       | 7.5      | %          | 139,000 |   | 7.2 | % |
| Other items, net                             |       | (31,500    | )          | (1.4     | )%         | 41,874 |   | 2.2 | % |
| Actual tax expense                           |       | $          | 918,500    |     | 40.1       | % | $ | 838,874 |   | 43.4 | % |

 

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

The following is areconciliation of net income and weighted average shares outstanding to the netincome and number of shares used to compute EPS:
|                                               | ** ** | **2006**            | ** ** | **2005**   | ** ** |
|-----------------------------------------------|------------|---------------------|------------|------------|------------|
| ** **                                    | ** ** | **Net Income** | ** ** | **Shares** | ** ** | **Net Income** | ** ** | **Shares** | ** ** |
|                                          |       |                |       |       |       |   |   |   |   |
| Used in basic EPS                             |       | $                   | 1,374,139  |       | 676,182    |   | $ | 1,097,866 |   | 668,179 |   |
| Dilutive effect of  outstanding stock options |       |                |       | 37,424     |       |   |   | 33,912 |   |
| Used in dilutive EPS                          |       | $                   | 1,374,139  |       | 713,606    |   | $ | 1,097,866 |   | 702,091 |   |

 

52

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**NOTE #10- STOCK OPTION PLAN**

In May 2001, the Coast Bancorp Employee Stock OptionPlan and the Director’s’ Stock Option Plan were approved by the shareholders,under which 187,500 shares of the Company’s common stock may be issued at notless than 100% of the fair market value at the date the options aregranted.  Under the terms of the StockPlan, officers and key employees may be granted both nonqualified and incentivestock options and directors, who are not also an officer or employee, may onlybe granted nonqualified stock options. Stock options expire no later than ten years from the date of the grantand generally vest over three to five years. The Bank recognized stock-based compensation cost of $76,416 in2006.  The Bank also recognized incometax benefits related to stock-based compensation of $7,716 in 2006.

The fair value of each option granted was estimated onthe date of grant using the Black-Scholes option pricing model with thefollowing assumptions presented below:

|                                         | ** ** | **2006**      | ** ** | **2005**  | ** ** |
|-----------------------------------------|------------|---------------|------------|-----------|------------|
|                                    |       |          |       |      |       |
| Expected  Volatility                    |       | 20.03         | %          | 20.00     | %          |
| Expected Term                           |       | 4 - 6.5 years |       | 6.5 years |       |
| Expected  Dividends                     |       | 0.60          | %          | 0.60      | %          |
| Risk Free Rate                          |       | 4.81          | %          | 4.15      | %          |
| Weighted-Average Grant  Date Fair Value |       | $             | 7.62       |      | $          | 9.12 |   |
|                                         |            |               |            |           |            |  |  |

 

The expectedvolatility is based on the historical volatility of the Bank’s stock.  The expected term represents the estimatedaverage period of time that the options remain outstanding.  The expected term is based on the “simplified”method that measures the expected term as the average of the vesting period andthe contractual term.  The risk free rateof return reflects the grant date interest rate offered for zero coupon U.S.Treasury bonds over the expected term of the options.

A summary of the status of the Company’s fixed stockoption plan as of December 31, 2006 and changes during the years ending thereonis presented below:
|                                    | ** ** | **2006**   | ** ** |
|------------------------------------|------------|------------|------------|
| ** **                         | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted-** | ** ** | ** ** | ** ** |
| ** **                         | ** ** | ** ** | ** ** | **Weighted-** | ** ** | **Average** | ** ** | ** ** | ** ** |
| ** **                         | ** ** | ** ** | ** ** | **Average** | ** ** | **Remaining** | ** ** | **Aggregate** | ** ** |
| ** **                         | ** ** | ** ** | ** ** | **Exercise** | ** ** | **Contractual** | ** ** | **Intrinsic** | ** ** |
| ** **                         | ** ** | **Shares** | ** ** | **Price** | ** ** | **Term** | ** ** | **Value** | ** ** |
|                               |       |       |       |   |   |   |   |   |   |
| Outstanding, beginning  of year    |       | 117,100    |       | $ | 17.46 |   |   |   |   |   |
| Granted                            |       | 3,500      |       | $ | 30.30 |   |   |   |   |   |
| Exercised                          |       | (5,500     | )          | $ | 14.07 |   |   |   |   |   |
| Forfeited or expired               |       | (300       | )          | $ | 26.50 |   |   |   |   |   |
|                               |       |       |       |   |   |   |   |   |   |
| Outstanding at end of  year        |       | 114,800    |       | $ | 17.99 |   | 3.5 Years |   | $ | 1,838,000 |   |
|                               |       |       |       |   |   |   |   |   |   |
| Options exercisable at end of year |       | 85,500     |       | $ | 14.78 |   | 4.8 Years |   | $ | 1,643,000 |   |

 

53

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The total intrinsic value of options exercised during the years endedDecember 31, 2006 and 2005 were $109,615 and $355,454, respectively.  As of December 31, 2006, there was $176,720of total unrecognized compensation cost related to the outstanding stockoptions that will be recognized over a weighted average period of 2.3 years.

 

**NOTE #11 - RELATED PARTY TRANSACTIONS**

In the ordinary course of business, the Company hasgranted loans to certain directors and the companies with which they areassociated.  In the Company’s opinion,all loans and loan commitments to such parties are made on substantially the sameterms including interest rates and collateral, as those prevailing at the timefor comparable transactions with other persons. The balance of these loans outstanding at December 31, 2006 and 2005,was as follows:
|                    | ** ** | **2006**   | ** ** | **2005**  | ** ** |
|--------------------|------------|------------|------------|-----------|------------|
|               |       |       |       |      |       |
| Beginning  balance |       | $          | 2,882,845  |      | $          | 982,913 |   |
| Additions          |       | —     |       | 2,014,797 |       |
| Payments           |       | (1,654,407 | )          | (114,865  | )          |
| Ending balance     |       | $          | 1,228,438  |      | $          | 2,882,845 |   |

 

Also in theordinary course of business, certain officers, directors, shareholders, andemployees of the Company have deposits with the Company.  In the Company’s opinion, all depositrelationships with such parties are made on substantially the same termsincluding interest rates and maturities, as those prevailing at the time ofcomparable transactions with other persons. The balance of director and officer deposits at December 31, 2006 andDecember 31, 2005 was approximately $2,029,000 and $1,319,000 respectively.

**NOTE #12 - COMMITMENTS**

In the normal course of business, the Bank enters intofinancial commitments to meet the financing needs of its customers.  These financial commitments includecommitments to extend credit and standby letters of credit.  Those instruments involve to varying degrees,elements of credit and interest rate risk not recognized in the statement offinancial position.

The Bank’s exposure to loan loss in the event ofnonperformance on commitments to extend credit and standby letters of credit isrepresented by the contractual amount of those instruments.  The Bank uses the same credit policies inmaking commitments as it does for loans reflected in the consolidated financialstatements.

As of December 31, 2006 and 2005, the Bank had thefollowing outstanding financial commitments whose contractual amount representscredit risk:
|                               | ** ** | **2006**  | ** ** | **2005**  | ** ** |
|-------------------------------|------------|-----------|------------|-----------|------------|
|                          |       |      |       |      |       |
| Commitments to  extend credit |       | $         | 48,768,000 |      | $          | 57,356,000 |   |
| Standby letters  of credit    |       | 2,012,000 |       | 2,589,000 |       |
|                          |       | $         | 50,780,000 |      | $          | 59,945,000 |   |

 

54

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Commitments to extend credit are agreements to lend to a customer as longas there is no violation of any condition established in the contract.  Standby letters of credit are conditionalcommitments to guarantee the performance of a Bank customer to a third party.  Since many of the commitments and standbyletters of credit are expected to expire without being drawn upon, the totalamounts do not necessarily represent future cash requirements.  The Bank evaluates each customer’s creditworthiness on a case-by-case basis.  Theamount of collateral obtained if deemed necessary by the Bank is based onmanagement’s credit evaluation of the customer.

 

The Company is involved in various litigation, whichhave arisen in the ordinary course of its business.  In the opinion ofmanagement, the disposition of such pending litigation will not have a materialeffect on the Company’s financial statements.

**NOTE #13 - FAIR VALUE OFFINANCIAL INSTRUMENTS**

The fair value of afinancial instrument is the amount at which the asset or obligation could beexchanged in a current transaction between willing parties, other than in aforced or liquidation sale.  Fair valueestimates are made at a specific point in time based on relevant marketinformation and information about 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 exists for a significant portion of thefinancial instruments, fair value estimates are based on judgments regardingfuture expected loss experience, current economic conditions, riskcharacteristics of various financial instruments, and other factors.  These estimates are subjective in nature,involve uncertainties and matters of judgment, and therefore cannot be determinedwith precision.  Changes in assumptionscould significantly affect the estimates.

Fair value estimates arebased on financial instruments both on and off the balance sheet withoutattempting to estimate the value of anticipated future business and the valueof assets and liabilities that are not considered financial instruments.  Additionally, tax consequences related to therealization of the unrealized gains and losses can have a potential effect onfair value estimates and have not been considered in many of the estimates.

The following methods andassumptions were used to estimate the fair value of significant financialinstruments:

### **Financial Assets**

The carrying amounts ofcash, short term investments, due from customers on acceptances, and Bank acceptancesoutstanding are considered to approximate fair value.  Short term investments include federal fundssold, securities purchased under agreements to resell, and interest bearingdeposits with Banks.  The fair values ofinvestment securities, including available for sale, are generally based onquoted market prices.  The fair value ofloans are estimated using a combination of techniques, including discountingestimated future cash flows and quoted market prices of similar instrumentswhere available.

### **Financial Liabilities**

The carrying amounts ofdeposit liabilities payable on demand, commercial paper, and other borrowedfunds are considered to approximate fair value. For fixed maturity deposits, fair value is estimated by discountingestimated future cash flows using currently offered rates for deposits ofsimilar remaining maturities.  The fairvalue of long term debt is based on rates currently available to the Bank fordebt with similar terms and remaining maturities.

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

The fair value ofcommitments to extend credit and standby letters of credit is estimated usingthe fees currently charged to enter into similar agreements.  The fair value of these financial instrumentsis not deemed to be material.

55

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The estimated fair valueof financial instruments at December 31, 2006 and 2005 are summarized asfollows (dollar amounts in thousands):
| ** **                              | ** ** | **2006**     | ** ** | **2005**            | ** ** |
|-----------------------------------------|------------|--------------|------------|---------------------|------------|
| ** **                              | ** ** | **Carrying** | ** ** | ** **          | ** ** | **Carrying** | ** ** | ** ** | ** ** |
| ** **                              | ** ** | **Amount**   | ** ** | **Fair Value** | ** ** | **Amount** | ** ** | **Fair Value** | ** ** |
| Assets:                                 |       |         |       |                |       |   |   |   |   |
| Cash and cash  equivalents              |       | $            | 24,973     |                | $          | 24,973 |   | $ | 34,670 |   | $ | 34,670 |   |
| Investment  securities                  |       | 7,926        |       | 7,926               |       | 7,872 |   | 7,872 |   |
| Loans, net                              |       | 135,115      |       | 135,774             |       | 132,048 |   | 132,914 |   |
| Federal Reserve  Bank and FHLB stock    |       | 946          |       | 946                 |       | 923 |   | 923 |   |
| Accrued interest  receivable            |       | 830          |       | 830                 |       | 716 |   | 716 |   |
|                                    |       |         |       |                |       |   |   |   |   |
| Liabilities:                            |       |         |       |                |       |   |   |   |   |
| Noninterest-bearing  deposits           |       | 39,556       |       | 39,556              |       | 40,583 |   | 40,583 |   |
| Interest-bearing  deposits              |       | 122,974      |       | 122,974             |       | 128,366 |   | 128,366 |   |
| Notes payable                           |       | —       |       | —              |       | 45 |   | 45 |   |
| Junior  subordinated debt securities    |       | 5,155        |       | 5,155               |       | 5,155 |   | 5,155 |   |
| Accrued interest and  other liabilities |       | 342          |       | 342                 |       | 332 |   | 332 |   |
|                                         |            |              |            |                     |            |  |  |  |  |  |  |  |  |

 

**NOTE #14 - REGULATORY MATTERS**

The Bank is subject to various regulatory capitalrequirements administered by the federal banking agencies.  Failure to meet minimum capital requirementscan initiate certain mandatory - and possibly additional discretionary -actions by regulators that, if undertaken, could have a direct material effecton the Company’s consolidated financial statements.  Under capital adequacy guidelines and theregulatory framework for prompt, corrective action, the Bank must meet specificcapital guidelines that involve quantitative measures of the Bank’s assets,liabilities, and certain off-balance-sheet items as calculated under regulatoryaccounting practices.  The Bank’s capitalamounts and classification are also subject to qualitative judgments by theregulators about components, risk weightings, and other factors.

Quantitative measures established by regulation toensure capital adequacy require the Bank to maintain minimum amounts and ratios(set forth in the table below) of total and Tier 1 capital (as defined in theregulations) to risk-weighted assets (as defined), and of Tier 1 capital (asdefined) to average assets (as defined). Management believes, as of December 31, 2006, that the Bank meets allcapital adequacy requirements to which it is subject.

56

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As of December 31, 2006, the most recent notificationfrom the Office of the Comptroller of the Currency (“OCC”) categorized the Bankas well-capitalized under the regulatory framework for prompt corrective action(there are no conditions or events since that notification that managementbelieves have changed the Bank’s category). To be categorized as well-capitalized or adequately capitalized, theBank must maintain minimum ratios as set forth in the table below.  The following table also sets forth the Bank’sactual capital amounts and ratios (dollar amounts in thousands):
|                                         | ** ** | ** **              | ** ** | ** **      | ** ** | **Amount of Capital Required** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|-----------------|------------|-----------------------------------------------|------------|
| ** **                              | ** ** | ** **              | ** ** | ** **      | ** ** | **To Be**                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                              | ** ** | ** **              | ** ** | ** **      | ** ** | **Adequately**                                | ** ** | **To Be** | ** ** |
| ** **                              | ** ** | **Actual Capital** | ** ** | **Capitalized** | ** ** | **Well-Capitalized**                          | ** ** |
| ** **                              | ** ** | **Amount**              | ** ** | **Ratio**       | ** ** | **Amount**                                    | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| As of December 31, 2006                 |       |                    |       |            |       |                                          |       |   |   |   |   |   |   |
| Total capital to  risk-weighted assets  |       | $                       | 19,003     |            | 12.5       | %                                             | $          | 12,159 |   | 8.0 | % | $ | 15,198 |   | 10.0 | % |
| Tier 1 capital  to risk-weighted assets |       | $                       | 17,560     |            | 11.6       | %                                             | $          | 6,079 |   | 4.0 | % | $ | 9,119 |   | 6.0 | % |
| Tier 1 capital  to average assets       |       | $                       | 17,560     |            | 9.7        | %                                             | $          | 7,276 |   | 4.0 | % | $ | 9,095 |   | 5.0 | % |
|                                    |       |                    |       |            |       |                                          |       |   |   |   |   |   |   |
| 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 | % |

 

The Company issubject to similar requirements administered by its primary regulator, theFederal Reserve Board.  For capitaladequacy purposes, the Company must maintain total capital to risk-weightedassets and Tier 1 capital to risk-weighted assets of 8.0% and 4.0%, respectively.  Its total capital to risk-weighted assets andTier 1 capital to risk-weighted assets was 12.6% and 11.2%, respectively, atDecember 31, 2006 and 11.7% and 10.04%, respectively, at December 31, 2005.

The Bank is restricted to the amount of dividendswhich can be paid.  Dividends declared bynational banks that exceed the net income (as defined) for the current yearplus retained net income for the preceding two years must be approved by theOCC.  The Bank may not pay dividends thatwould result in its capital levels being reduced below the minimum requirementsshown 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**

CoastBancorp operates Coast National Bank. Coast Bancorp commenced operations during 2001.  The earnings of the subsidiary are recognizedon the equity method of accounting. Condensed financial statements of the parent company only are presentedon the following pages:

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**CONDENSEDBALANCE SHEETS**

 
|                                                 | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2006**              | ** ** | **2005**              | ** ** |
| **ASSETS**                                      |       |                  |       |                  |       |
| Cash                                            |       | $                     | 48,480     |                  | $          | 236,073 |   |
| Investment in  Coast Bancorp Statutory Trust I  |       | 155,000               |       | 155,000               |       |
| Investment in  Coast National Bank              |       | 17,563,647            |       | 15,933,952            |       |
| Other assets                                    |       | 106,633               |       | 79,830                |       |
|                                            |       | $                     | 17,873,760 |                  | $          | 16,404,855 |   |
|                                            |       |                  |       |                  |       |
| **LIABILITIES AND SHAREHOLDERS’  EQUITY:** |       |                  |       |                  |       |
| Other  liabilities                              |       | $                     | 7,531      |                  | $          | 6,804 |   |
| Junior  subordinated debt securities            |       | 5,155,000             |       | 5,155,000             |       |
| Stockholders’  equity                      |       | 12,711,229            |       | 11,243,051            |       |
| ** **                                      |       | $                     | 17,873,760 |                  | $          | 16,404,855 |   |

 

**CONDENSEDSTATEMENTS OF INCOME**

 
| ** **                                                    | ** ** | **Year Ended**   | ** ** | **Year Ended**   | ** ** |
|---------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                    | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **                                                    | ** ** | **2006**              | ** ** | **2005**              | ** ** |
| **INCOME**                                                    |       |                  |       |                  |       |
| Interest income                                               |       | $                     | 5,127      |                  | $          | 5,387 |   |
| Cash dividends  from Coast Bancorp Statutory Trust I          |       | 13,348                |       | 10,532                |       |
| **TOTAL  INCOME**                                             |       | 18,475                |       | 15,919                |       |
|                                                          |       |                  |       |                  |       |
| **EXPENSES**                                                  |       |                  |       |                  |       |
| Interest on  junior subordinated debt securities              |       | 474,047               |       | 380,392               |       |
| Other                                                         |       | 62,898                |       | 65,768                |       |
| Allocated tax  benefit                                        |       | (215,500              | )          | (128,000              | )          |
| **TOTAL  EXPENSES**                                           |       | 321,445               |       | 318,160               |       |
| ** **                                                    |       |                  |       |                  |       |
| **LOSS  BEFORE EQUITY IN UNDISTRIBUTED INCOME OF SUBSIDIARY** |       | (302,970              | )          | (302,241              | )          |
| ** **                                                    |       |                  |       |                  |       |
| **EQUITY  IN UNDISTRIBUTED INCOME OF SUBSIDIARY**             |       | 1,677,109             |       | 1,400,107             |       |
| ** **                                                    |       |                  |       |                  |       |
| **NET INCOME**                                                |       | $                     | 1,374,139  |                  | $          | 1,097,866 |   |

 

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## **CONDENSED STATEMENT OF CASH FLOWS**

|                                                           | ** ** | **Years Ended**  | ** ** |
|-----------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **                                                | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **CASH FLOWS FROM OPERATING  ACTIVITIES:**                |       |                  |       |   |   |
| Net income                                                |       | $                     | 1,374,139  |   | $ | 1,097,866 |   |
| Noncash items  included in net income:                    |       |                  |       |   |   |
| Equity in income  of Subsidiary                           |       | (1,677,109            | )          | (1,400,107 | ) |
| Other                                                     |       | (33,793               | )          | 243,761 |   |
| ** **                                                |       |                  |       |   |   |
| **NET  CASH USED IN OPERATING ACTIVITIES**                |       | (336,763              | )          | (58,480 | ) |
| ** **                                                |       |                  |       |   |   |
| **CASH FLOWS FROM INVESTING  ACTIVITIES:**                |       |                  |       |   |   |
| Dividends  Received from Subsidiary                       |       | 200,000               |       | — |   |
| ** **                                                |       |                  |       |   |   |
| **NET  CASH PROVIDED BY INVESTING ACTIVITIES**            |       | 200,000               |       | — |   |
| ** **                                                |       |                  |       |   |   |
| **CASH FLOWS FROM FINANCING  ACTIVITIES:**                |       |                  |       |   |   |
| Proceeds from  exercise of stock options                  |       | 85,091                |       | 286,555 |   |
| Dividends Paid                                            |       | (135,921              | )          | (117,968 | ) |
| ** **                                                |       |                  |       |   |   |
| **NET  CASH PROVIDED (USED) BY FINANCING ACTIVITIES**     |       | (50,830               | )          | 168,587 |   |
|                                                      |       |                  |       |   |   |
| **NET  INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS** |       | (187,593              | )          | 110,107 |   |
|                                                      |       |                  |       |   |   |
| **CASH  AND CASH EQUIVALENTS AT BEGINNING OF YEAR**       |       | 236,073               |       | 125,966 |   |
|                                                      |       |                  |       |   |   |
| **CASH AND CASH EQUIVALENTS AT  END OF YEAR**             |       | $                     | 48,480     |   | $ | 236,073 |   |

 

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

None

**Item 8A. Controls and Procedures**

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

Asof December 31, 2006 and prior to the date of this Annual Report on Form10-KSB, the Company evaluated the effectiveness of the design and operation ofits “disclosure controls and procedures” (Disclosure Controls).  This evaluation (Controls Evaluation) wasdone under the supervision and with the participation of management, includingour Chairman and Chief Executive Officer (CEO) and Chief Financial Officer(CFO). Rules adopted by the SEC require that in this section of the AnnualReport we present the conclusions of the CEO and the CFO about theeffectiveness of our Disclosure Controls based on and as of the date of theControls.

**CEO and CFO Certifications.**

Appearingimmediately following the Signatures section of this 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 andreported within the time periods specified in the Commission’s rules and forms.Disclosure Controls are also designed with the objective of ensuring that suchinformation is accumulated and communicated to our management, including theCEO and CFO, as appropriate to allow timely decisions regarding requireddisclosure.

**Limitations on the Effectiveness of Controls.**

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

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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 the effectof the controls on the information generated for use in this Annual Report. Inthe course of the Controls Evaluation, we sought to identify data errors,controls problems or acts of fraud and to confirm that appropriate correctiveaction, including process improvements, were being undertaken. This type ofevaluation will be done on a quarterly basis so that the conclusions concerningcontrols effectiveness can be reported in our Quarterly Reports on Form 10-QSBand Annual Report on Form 10-KSB. The overall goals of these various evaluationactivities are to monitor our Disclosure Controls and our Internal Controls andto make modifications as necessary; our intent in this regard is that theDisclosure Controls will be maintained as dynamic systems that change(including with improvements and corrections) as conditions warrant.

**Conclusions.**

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

**Item 8B. Other Information**

None

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## **PART III**

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

Boardof Directors:

**Marilyn M. Britton**, age 67,graduated from Cal Poly San Luis Obispo. She was involved with the San Luis Obispo County Farm Bureau for over 27years, retiring as Executive Director in December 2001, a position she held forover 16 years.  Marilyn is a member ofSan Luis Obispo County Farm Bureau, San Luis Obispo County Farm Bureau Women,San Luis Obispo County Cattlemen’s Association, Paso Robles Agri-Business TourCommittee, a member and past director of the San Luis Obispo Rotary, and is amember of, and currently serving as director of, the San Luis Obispo CountyCattle Women’s Association.  Mrs. Brittondeveloped the San Luis Obispo County Farm Bureau Agriculture Tour Program 27years ago and has continued as its Tour Coordinator.  She was also the Executive Director for theSan Luis Obispo County Grain Improvement Association for 18 years.  She also served on the Sheriff’s ParoleBoard.

**Dario A. Domenghini**, age 69,is an original organizer and director of the Bank.  Mr. Domenghini is a life-long resident of SanLuis Obispo County.  His family has beeninvolved in agriculture in the County of San Luis Obispo since the early 1920’s.  Mr. Domenghini has been involved inagriculture, working in his family’s dairy and ranching operation since hischildhood.

Mr. Domenghini expanded the operation to includevegetable farming.  He has since closeddown the dairy operation, but continues to farm in partnership with hisnephew.  Mr. Domenghini is a 50% partnerin Domenghini Farms.  Mr. Domenghini waseducated at Cal Poly San Luis Obispo, majoring in Dairy Science.  Mr. Domenghini is active in local farming andranching activities.

**James M. Kaney**, age 60, isan original organizer and director of the Bank. Mr. Kaney has been a business owner/operator in San Luis Obispo since1970 and he is a certified public accountant. He currently is President/Owner of Anacal Financial Inc., a financialservice and real estate development company. He received his B.S. degree, cum laude, in Accounting/Finance with aminor in Economics and his Masters of Business Administration Degree fromCalifornia Polytechnic State University, San Luis Obispo.  He also teaches accounting and commercialbank management at Cal Poly.  Mr. Kaneystarted Kaney Foods, Inc. in San Luis Obispo, a wholesaler to restaurants andinstitutions in the counties of Monterey, Santa Barbara, Ventura, and San LuisObispo.  Mr. Kaney was responsible forall phases of the company warehousing, distribution, sales and accounting.  The company was sold in 1987.  Mr. Kaney is an organizer, founder and pastdirector of Commerce Bank of San Luis Obispo N.A., which was sold in March 1996to Valliwide Bank.  Mr. Kaney served formore than twelve years on the Loan Committee and the Investment Committee ofCommerce Bank.  Mr. Kaney is a pastmember of the Kiwanis Club and a member and past director of the Rotary Club ofSan Luis Obispo.

**Michael A. Lady**, age 55 isan original organizer and director of the Bank. Mr. Lady has been a resident of Arroyo Grande for the past nineteenyears and is the owner of Lady Family 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 governmental activities, is vitally aware of thefuture development plans for the Arroyo Grande area.

Mr. Lady is active in a large number of civic andfraternal organizations.  He is the pastpresident of the Arroyo Grande Chamber of Commerce and the Arroyo ValleyKiwanis.  He is a member of the ElksClub, Moose Lodge, Shriner’s Club, the Freemasons, YMCA, and the FraternalOrder of Eagles. He was named the 1991 Arroyo Grande Citizen of the Year, andhe and his wife were named South County Couple of the Year also in 1991. Mr.Lady is a leader in the Arroyo Grande community, and his involvement in theformation and management of the Bank has provided the Bank with an impressivebase of valuable business customers.

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**Gene D. Mintz**, age 67, is anoriginal organizer and director of the Bank. Mr. Mintz is a business and tax advisor and owner of GSM BusinessServices, Inc.  A life-long resident ofSan Luis Obispo County, Mr. Mintz is involved in a number of professional,civic, and charitable associations.  Heis a 37 year member of the Greater Pismo Beach Kiwanis Club.  Mr. Mintz is a 35 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 professionalorganizations and a past president of the Central Coast Chapter of theCalifornia Society of Enrolled Agents. His professional activities include his business and tax advisorybusiness, as well as involvement in a number of real estate developmentprojects.  He is currently theSecretary-Treasurer of Burke and Pace of Arroyo Grande, Inc. a major supplierof building materials headquartered in Arroyo Grande.

**Ronald R. Olson**, age 63, isa director of the Bank.  Mr. Olson is aCertified Public Accountant and is owner of Platino Management Services, Inc.which provides accounting and tax services, management consulting and propertymanagement services in Arroyo Grande and surrounding communities.

Mr. Olson has been a resident of Arroyo Grande for 33years and is active in local service and professional organizations.  Mr. Olson is a member of the Arroyo GrandeOptimists Club and of both the American Institute of CPA’s and the CaliforniaSociety of CPA’s.  Mr. Olson is aninvestor and director of a privately held chain of food supermarkets and a fastfood restaurant franchising company.

**Jack W. Robasciotti**, age 79,is Vice Chairman of the board and an original organizing director of theBank.  Mr. Robasciotti was born in SanLuis Obispo and has been active in banking since 1951.  After an impressive 33 year career with Bankof America, Mr. Robasciotti “retired” to San Luis Obispo, where he worked for21 years in various positions, including manager of the main office of CommerceBank of San Luis Obispo, N.A. as well as increasingly responsible positionswith Coast National Bank.

Mr. Robasciotti has been active in a number of civic,charitable and fraternal organizations in San Luis Obispo.  His activities range from fundraising for theYMCA, to serving as a director and a member of organizations that provideshelter for abused women (Women’s Shelter), Sexual Assault Victim’s Education (SAVE)and (ALPHA) that counsels pregnant women.  Mr. Robasciotti is a member of the San Luis Obispo Historical Society,previously serving as First Vice President, a past member of Hearst CastleLighting Committee, and a of other organizations.

**Jack C. Wauchope**, age 71, isChief Executive Officer and Chairman of the Board of Directors for both theBank and the Bancorp.  Mr. Wauchope hasbeen in the banking industry for more than 47 years.  Over half of that time, he has served as thePresident and Chief Executive Officer of independent banks.   Mr. Wauchope was the organizing President ofCommerce Bank of San Luis Obispo as well as Coast National Bank.  He is a graduate of Millikin University atDecatur, Illinois and the Pacific Coast Banking School at the University ofWashington, Seattle, Washington.

Mr. Wauchope has served on the boards of numerouscivic, charitable and trade organizations which include the Foundation for thePerforming Arts Center, Hotline of San Luis Obispo County, San Luis Obispo EconomicsForecast Project, Community Bankers of Southern California, Western BankingSchool, Rotary Club of San Luis Obispo Daybreak and the Civic Ballet of SanLuis Obispo.

**Dan H. Wixom**, age 56, is anoriginal organizer and director of the Bank. Mr. Wixom is a rancher and an owner/operator of Wixom Trucking,LLC.  Mr. Wixom formerly owned andoperated Wixom Concrete, Inc., which was sold in 1997.  A graduate of Cal Poly San Luis Obispo inAgriculture Management, Mr. Wixom is a fourth generation resident of San LuisObispo County.  He has been a member ofNative Sons of the Golden West for over twenty-five years and served as apresident of the organization.  Mr. Wixomserved on the board of the Morro Bay Community Foundation.  The foundation helps with youth activities onthe Central Coast.  He supports localeducational institutions, volunteering time and donating materials for theMorro Bay FFA and 4H groups and for youth sports teams.

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Mr. Wixom is a member of the California Cattlemen’sAssociation, the National Cattlemen’s Association, and the San Luis ObispoCounty Farm Bureau.  He has operated hisown calf/cow operation for more than 30 years. Currently he runs over 300 mother cows on over 3,000 acres, with anadditional 100 acres set aside for oat and hay production.  His trucking company is involved in thestatewide transportation of construction aggregates, bulk cement and livestock.

ExecutiveOfficers:

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

**Davina A. Palazzo**, age 38, ExecutiveVice President. Davina serves as Manager of the Bank’s Small Business LoanCenter and Marketing Director for the bank.  She was educated in SouthernCalifornia, graduating from California State University – Fullerton.  Shehas been in banking for the past 20 years, concentrating primarily over thelast sixteen years in government guaranteed lending programs such as the U.S.Small Business Administration.  She is a graduate of the Pacific CoastBanking School at the University of Washington and the American Banker’sAssociation School of Bank Marketing and Management.  She is a ViceChairperson of the Board of Directors of the National Association of GovernmentGuaranteed Lenders.  She has testified in front of Congress numerous timeson SBA issues.   She is the President of the Paso Robles SunriseRotary Club.  Ms. Palazzo was the recipient of the SBA’s Financial ServiceAdvocate of the Year Award for 2002.  She was recently named one of theTop 20 Professionals Under 40 in San Luis Obispo.   She has beennamed to the Pacific Coast Business Times “Who’s Who in Banking and Finance”for the past five consecutive years.   Under her direction, the bank’smarketing campaign was recently awarded “Best of Show” by the American Banker’sAssociation in a national competition.

**Leah M. Pauly**, age **44**, is Executive Vice President/Chief Credit Officer for theBank.  She was raised and educated inSouthern California but has lived in northern San Luis Obispo county for thepast 19 years.  She has actively workedin progressively more responsible positions in banking for the last 25 yearsand graduated from the ABA Stonier Graduate School of Banking in June2005.  Over the years, Pauly hasvolunteered for a number of civic and charitable organizations.  She currently serves on the Board ofDirectors of Senior Volunteer Services.

**Karan C. Pohl**, age 35,joined the Company on May 5, 2005.  Shepresently serves as Senior Vice President and Chief Financial Officer of theCompany’s subsidiary, Coast National Bank. Ms. Pohl is a Certified Public Accountant.  Prior to accepting her position, she workedas an Audit Manager for Moss, Levy and Hartzheim, a public accounting firm locatedin Santa Maria, California, where she was employed 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.  She currently serves on the Board ofDirectors for the Central Coast Chapter of the California Society of CertifiedPublic Accountants as well as the Cal Poly Alumni Association.

The executive officers were each elected by the Boardof Directors.  There are no familyrelationships between directors and executive officers of the Bank.

No Director of the Bank holds a directorship in anyother company with a class of securities registered pursuant to Section 12 ofthe Securities Exchange of 1934, as amended.

# **Compliance with Section 16(a) of the SecuritiesExchange Act**

Based solely on its review of Forms 3, 4, and 5, andamendments thereto, furnished to Bancorp during the 2006 fiscal year, no personwho was a director, officer, or beneficial owner of more than ten percent ofthe Bank’s Common Stock failed to file on a timely basis reports required bySection 16(a) during the 2006 fiscal year except for Jack Wauchope, ChiefExecutive Officer, who was required to file a Form 4 within 2 days of stocktransaction filed the form 4 on March 16 instead of March 15, 2006.

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**Nomination Procedures**

There have been nomaterial changes to the procedures by which security holders may recommendnominees to the Bancorp’s Board of Directors described in the Bancorp’s proxymaterial for its 2006 annual meeting of shareholders.

**Audit Committee**

The Audit Committee ofthe Company’s Board of Directors (the “Audit Committee”) consists of DirectorsGene D. Mintz as Chairman, Marilyn M. Britton, Dario A. Domenghini, James M.Kaney and Ronald R. Olson.  Each memberis an “independent director” and satisfies the additional requirements forindependence of Audit Committee members as defined by the rules of the NASDAQStock Market.

**Financial Expert**

The Board of Directorshas determined, as required, that the Audit Committee contains threeindependent financial experts.  Theyperform no services nor do they receive compensation from the bank other thannormal director fees.  The experts on thecommittee are James Kaney, Gene Mintz and Ron Olson.  Each of their qualifications is stated (See “Directors”)elsewhere in this report.

**Code of Ethics**

This section of theSarbanes Oxley Act now requires small business filers to adopt and disclosewhether the Bancorp has adopted a code of ethics that applies to the principalexecutive officer, principal financial officer, and principal accountingofficer or controller, or any person performing similar functions.  The Bancorp has complied with thisrequirement and a copy is attached as Exhibit 14.

**Independence of Accounting Firms**

Amendments to RegulationS-X governs employment relationships between financial entities and accountingfirms.  Requirements include “independence”of the accounting firm, precluding the performance of any other audit functionssuch as bookkeeping, appraisal services, legal services and a variety of otherfunctions.  The requirements alsopreclude the Bancorp from having any interest, capital balances, nor influenceover the accounting firm’s operations or policies. This amendment also requiresapproval, by the Audit Committee, of the accounting firm prior to engagementand limits the number of years that the lead partner or concurring partner inthe accounting firm may conduct audits without sacrificing their “independent”status.  The Bancorp is in compliancewith this regulation.

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**Item 10. Executive Compensation:**

The chart below contains the compensation paid oraccrued during the last fiscal year to Jack C. Wauchope, Karan Pohl, DavinaPalazzo, and Leah Pauly, (the “Named Executives”) as the chief executiveofficer, the chief financial officer and the two most highly compensatedprincipal officers of the Company, whose total compensation during the lastfiscal year exceeded $100,000.

Thevalue of perquisites and other personal benefits are disclosed in other annualcompensation if they exceed, in the aggregate, the lesser of $25,000 or 10% ofsalary and bonus.

**Summary Officer CompensationTable**
|                             | ** ** | ** ** | ** ** | ** **          | ** ** | ** **         | ** ** | ** ** | ** ** | **Option** | ** ** | **Non-Equity**          | ** ** | **All Other**  | ** ** | ** ** | ** ** |
|-----------------------------|------------|------------|------------|---------------------|------------|--------------------|------------|------------|------------|------------|------------|-------------------------|------------|---------------------|------------|------------|------------|
| ** **                  | ** ** | ** ** | ** ** | ** **          | ** ** | ** **         | ** ** | **Stock**  | ** ** | **Awards** | ** ** | **Incentive Plan** | ** ** | **Compensation**    | ** ** | ** ** | ** ** |
| **Name and**           | ** ** | ** ** | ** ** | ** **          | ** ** | ** **         | ** ** | **Awards** | ** ** | **($)**    | ** ** | **Compensation**        | ** ** | **($)**             | ** ** | ** ** | ** ** |
| **Principal Position** | ** ** | **Year**   | ** ** | **Salary ($)** | ** ** | **Bonus ($)** | ** ** | **($)**    | ** ** | **(1)**    | ** ** | **Earnings ($)**   | ** ** | **(2),(3),(4),(5)** | ** ** | **Total**  | ** ** |
|                        |       |       |       |                |       |               |       |       |       |       |       |                    |       |                |       |       |       |
| **Jack C. Wauchope**        |       |       |       |                |       |               |       |       |       |       |       |                    |       |                |       |       |       |
| President/CEO               |       |       |       |                |       |               |       |       |       |       |       |                    |       |                |       |       |       |
| Chairman of the Board       |       | 2006       |       | $                   | 193,750    |               | $          | 27,500     |       | $          | —     |                    | $          | —              |       | $          | —     |   | $ | 22,632 |   | $ | 243,882 |   |
|                        |       |       |       |                |       |               |       |       |       |       |       |                    |       |                |       |       |       |
| **Davina A. Palazzo**       |       |       |       |                |       |               |       |       |       |       |       |                    |       |                |       |       |       |
| Executive Vice President    |       |       |       |                |       |               |       |       |       |       |       |                    |       |                |       |       |       |
| Small Business Lending      |       |       |       |                |       |               |       |       |       |       |       |                    |       |                |       |       |       |
| Center Manager              |       | 2006       |       | $                   | 133,750    |               | $          | 17,500     |       | $          | —     |                    | $          | —              |       | $          | —     |   | $ | 14,173 |   | $ | 165,423 |   |
|                        |       |       |       |                |       |               |       |       |       |       |       |                    |       |                |       |       |       |
| **Leah M. Pauly**           |       |       |       |                |       |               |       |       |       |       |       |                    |       |                |       |       |       |
| Executive Vice President    |       |       |       |                |       |               |       |       |       |       |       |                    |       |                |       |       |       |
| Chief Credit Officer        |       | 2006       |       | $                   | 135,000    |               | $          | 25,000     |       | $          | —     |                    | $          | 3,880               |       | $          | —     |   | $ | 4,136 |   | $ | 168,016 |   |
|                        |       |       |       |                |       |               |       |       |       |       |       |                    |       |                |       |       |       |
| **Karan C. Pohl**           |       |       |       |                |       |               |       |       |       |       |       |                    |       |                |       |       |       |
| Senior Vice President       |       |       |       |                |       |               |       |       |       |       |       |                    |       |                |       |       |       |
| Chief Financial Officer     |       | 2006       |       | $                   | 68,625     |               | $          | 4,000      |       | $          | —     |                    | $          | 8,154               |       | $          | —     |   | $ | 2,514 |   | $ | 83,293 |   |

 

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Notes RegardingPercentages All Other Compensation:

(1)          Reflects thedollar amount recognized for financial statement reporting purposes for thefiscal year ended December 31, 2006. Includes stock options granted in 2004 and 2005 to the extent thevesting period for such grants fell in 2006. Please refer to Note 10, “StockOption Plan” of our financial statements for a discussion of the assumptionsrelated to the calculation of such value.

(2)          Includesprofit sharing contributions accrued by the Bank during 2006 for the benefit ofWauchope, Palazzo, and Pauly in the amount of $3,616 each.  The profit sharing contribution accrued bythe Bank during 2006 for Pohl was $1,994.

(3)          Includeslife insurance premiums paid by the Bank during 2006 on behalf of Wauchope inthe amount of $135 and on behalf of Palazzo, Pauly and Pohl in the amount of$270 each.

(4)          Includespersonal benefits of Bank owned vehicle paid by the Bank during 2006 on behalfof Wauchope, Palazzo, Pauly and Pohl in the amounts of $3,617, $4,391, $4,433,$4,800 respectively.

(5)          Includespersonal benefits of Club dues paid by the Bank during 2006 on behalf ofWauchope, and Palazzo in the amounts of $6,329 and $5,896 respectively.

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The Bank has employed Jack C. Wauchope as its ChiefExecutive Officer and entered into an employment agreement with him, which tookeffect in June 2003.  The agreementprovided for a term of five years at an annual base salary of $175,000.00 inyear 1, $185,000.00 in year 2 and 3, $200,000.00 in year 4 and 5, discretionarybonuses, and a Bank provided automobile, country club membership, expensereimbursement, $400,000.00 of life insurance and standard and customary medicaland dental insurance benefits. Additionally, Mr. Wauchope will be entitled to severance benefits equalto one year’s base salary or two years, each dependent upon the occurrence ofone or more enumerated events.  In theevent that Mr. Wauchope was terminated prior to a change in control, withoutcause, at December 31, 2006, he would have been paid $200,000 in one lump sumpayment on the effective date of termination. In the event that Mr. Wauchope was terminated after a change in control,without cause or resigned for good reason, he would have been paid $400,000 inone lump sum payment on the effective date of termination/resignation.

The Bank has employed Davina A. Palazzo as itsExecutive Vice-President and Manager of the Small Business Lending Center andentered into an employment agreement with her, which took effect in June2003.  The agreement provides for a termof five years at an annual base salary of $115,000.00 in year 1, $125,000.00 inyear 2 and 3, $140,000.00 in year 4 and 5, discretionary bonuses, and a Bankprovided automobile, country club membership, and standard and customarymedical and dental insurance benefits. Additionally, Ms. Palazzo will be entitled to severance benefits equalto one year’s base salary or two years, each dependent upon the occurrence ofone or more enumerated events. In the event that Ms. Palazzo was terminatedprior to a change in control, without cause, at December 31, 2006, she wouldhave been paid $140,000 in one lump sum payment on the effective date oftermination.  In the event that Ms.Palazzo was terminated after a change in control, without cause or resigned forgood reason, she would have been paid $280,000 in one lump sum payment on theeffective date of termination/resignation.

The Bank has employed Leah M. Pauly as its ExecutiveVice President and Chief Credit Officer and entered into an employmentagreement with her, which took effect November 2003.  The agreement provides for five years at anannual salary of $100,000.00 in year 1, $110,000.00 in year 2 and 3, $125,000.00in year 4 and 5, discretionary bonuses, and a Bank provided automobile, andstandard and customary medical and dental insurance benefits.  Additionally, Ms. Pauly will be entitled toseverance benefits equal to six month’s base salary or one year, each dependantupon the occurrence of one or more enumerated events.  In the event that Ms. Pauly was terminatedprior to a change in control, without cause, at December 31, 2006, she wouldhave been paid $62,500 in one lump sum payment on the effective date oftermination.  In the event that Ms. Paulywas terminated after a change in control, without cause or resigned for goodreason, she would have been paid $125,000 in one lump sum payment on theeffective date of termination/resignation.

The Bank has employed Karan C. Pohl as its Senior VicePresident and Chief Financial Officer since May 5, 2005.  Ms. Pohl does not have an employment contractwith the Bank and is an “At Will” employee. Her current salary is $72,000 and receives discretionary bonuses and anautomobile allowance of $4,000 per year.

# **Employees Stock Option Plan**

In thecourse of the formation of Coast Bancorp as of May 31, 2001, Coast Bancorpadopted and assumed the Coast National Bank 1997 Stock Option Plan, now knownas the Coast Bancorp Employee Stock Option Plan (the “Employee Plan”).  The Employee Plan was adopted to strengthenthe Company and its subsidiaries by providing eligible full-time officers andemployees an added incentive to perform at a high level and to rewardextraordinary efforts to increase the earnings of Coast Bancorp and itssubsidiary.  The incentive will take theform of an opportunity for officers and employees of Coast Bancorp and itssubsidiaries to acquire a proprietary interest in the success of Coast Bancorpby purchasing Shares of Coast Bancorp common stock.  125,000 shares of Coast Bancorp common stockmay be issued pursuant to the exercise of Options granted under the EmployeePlan, and in no event may the total number of shares issuable upon exercise ofall outstanding options and the total number of shares provided for under anyother stock option plan, stock bonus or similar plan of Coast Bancorp exceedthirty percent (30%) of the then-outstanding common stock of the Company.  As of December 31, 2006, approximately thirtytwo officers and employees of Coast Bancorp and its affiliate were eligible tohold options to purchase under the Employee Plan.  The Employee Plan contemplates the grant ofincentive stock options and nonstatutory stock options.

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The Employee Plan is not a qualified plan underSection 401(a) of the Internal Revenue Code of 1986, as amended (the “Code”) orsubject to the provisions of the Employee Retirement Income Security Act of1974, as amended.

# **Exercise and Grant of Options**

During 2006 no options were granted to the NamedExecutives.

The followingtable sets forth information concerning individual grants of stock optionsduring fiscal year 2006 to each of the Named Executive Officers.:

**Options Granted in LastFiscal 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-                                           |       | —                                                                                          |       | —                                         |       | —               |       | —                              |       |
|                                         |       |                                          |       |                                                                                            |       |                                           |       |                 |       |                                |       |
| Karan C. Pohl, Senior Vice President         |       | -0-                                           |       | —                                                                                          |       | —                                         |       | —               |       | —                              |       |

 

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(1) Present value at dateof grant using the Black-Scholes model

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The following table shows for the fiscal year ending2006, the outstanding stock option awards, both vested and unvested, for eachof the Named Executives, including the option exercise price and expirationdate.  The chart includes only stockoption award information as it is the only equity plan the bank currently hasin place.

## **Outstanding Equity Awards at Fiscal Year End**

|                   | ** ** | **Option Awards**                                                                         | ** ** |
|-------------------|------------|------------------------------------------------------------------------------------------------|------------|
| **Name**          | ** ** | **Number of Securities  Underlying  Unexercised Options  (#) Exercisable** | ** ** | **Number of Securitites  Underlying  Unexercised  Unearned Options (#)  Unexercisable** | ** ** | **Option  Exercise Price  ($)** | ** ** | **Option  Expiration Date** | ** ** |
|              |       |                                                                                           |       |   |   |   |   |   |   |
| Jack C. Wauchope  |       | 20,000                                                                                         | (1)        | 0 |   | 10.00 |   | 06/12/07 |   |
|              |       |                                                                                           |       |   |   |   |   |   |   |
| Davina A. Palazzo |       | 7,500                                                                                          | (2)        | 0 |   | 14.00 |   | 07/05/10 |   |
|              |       |                                                                                           |       |   |   |   |   |   |   |
| Leah M. Pauly     |       | 2,400                                                                                          | (3)        | 600 |   | 15.00 |   | 04/16/12 |   |
|                   |       | 1,000                                                                                          | (4)        | 1,500 |   | 26.50 |   | 11/17/14 |   |
|              |       |                                                                                           |       |   |   |   |   |   |   |
| Karan C. Pohl     |       | 1,000                                                                                          | (5)        | 4,000 |   | 28.50 |   | 05/18/15 |   |

 

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Notesregarding outstanding equity awards.

(1)           Thesestock options were granted on June 12, 1997. These options vest and become exercisable in five equal installmentswith the first installment vesting on January 1, 1998.

(2)           Thesestock options were granted on July 5, 2000. These options vest and become exercisable in five equal installmentswith the first installment vesting on January 1, 2001.

(3)           Thesestock options were granted on April 16, 2002. These options vest and become exercisable in five equal installmentswith the first installment vesting on January 1, 2003.

(4)           Thesestock options were granted on November 17, 2004.  These options vest and become exercisable infive equal installments with the first installment vesting on January 1, 2005.

(5)           These stockoptions were granted on May 18, 2005. These options vest and become exercisable in five equal installmentswith the first installment vesting on January 1, 2006.

### **DirectorsCompensation**

The directors who are not full-time employees of theBank are presently receiving monthly directors’ fees of $1,250 per month.  Certain committee chairmen receive anadditional stipend commensurate with their augmented duties.  Mr. Wauchope does not presently receivedirectors’ fees.  The following tablesets forth information regarding director compensation.

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**Summary Director Compensation Table**
| ** **           | ** ** | ** **                | ** ** | ** ** | ** ** | **Option** | ** ** | **Non-Equity**          | ** ** | **Nonqualified**      | ** ** | **All Other** | ** ** | ** **         | ** ** |
|----------------------|------------|---------------------------|------------|------------|------------|------------|------------|-------------------------|------------|-----------------------|------------|--------------------|------------|--------------------|------------|
| ** **           | ** ** | **Fees Earned**      | ** ** | **Stock**  | ** ** | **Awards** | ** ** | **Incentive Plan** | ** ** | **Deferred**          | ** ** | **Compensation**   | ** ** | ** **         | ** ** |
| ** **           | ** ** | **or Paid**          | ** ** | **Awards** | ** ** | **($)**    | ** ** | **Compensation**        | ** ** | **Compensation**      | ** ** | **($)**            | ** ** | ** **         | ** ** |
| **Name**             | ** ** | **in Cash ($)** | ** ** | **($)**    | ** ** | **(1)**    | ** ** | **($)**                 | ** ** | **Earnings ($)** | ** ** | **(2)**            | ** ** | **Total ($)** | ** ** |
|                 |       |                      |       |       |       |       |       |                    |       |                  |       |               |       |               |       |
| Marilyn M.  Britton  |       | $                         | 15,000     |       | —     |       | $          | 2,586                   |       | —                |       | —             |       | $                  | 176        |   | $ | 17,762 |   |
| Dario A.  Domenghini |       | $                         | 15,000     |       | —     |       | $          | 2,586                   |       | —                |       | —             |       | $                  | 176        |   | $ | 17,762 |   |
| James M. Kaney       |       | $                         | 15,000     |       | —     |       | $          | 2,586                   |       | —                |       | —             |       | $                  | 270        |   | $ | 17,856 |   |
| Michael A. Lady      |       | $                         | 15,000     |       | —     |       | $          | 2,586                   |       | —                |       | —             |       | $                  | 270        |   | $ | 17,856 |   |
| Gene D. Mintz        |       | $                         | 18,000     |       | —     |       | $          | 2,586                   |       | —                |       | —             |       | $                  | 176        |   | $ | 20,762 |   |
| Ronald R. Olson      |       | $                         | 16,500     |       | —     |       | $          | 2,586                   |       | —                |       | —             |       | $                  | —     |   | $ | 19,086 |   |
| Jack W.  Robasciotti |       | $                         | 15,000     |       | —     |       | $          | 2,586                   |       | —                |       | —             |       | $                  | 135        |   | $ | 17,721 |   |
| Dan H. Wixom         |       | $                         | 15,000     |       | —     |       | $          | 2,586                   |       | —                |       | —             |       | $                  | 270        |   | $ | 17,856 |   |

 

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Notes RegardingDirector Compensation:

(1)          Reflects thedollar amount recognized for financial statement reporting purposes for thefiscal year ended December 31, 2006. Includes stock options granted in 2004 and 2005 to the extent thevesting period for such grants fell in 2006. Please refer to Note 10, “StockOption Plan” of our financial statements for a discussion of the assumptionsrelated to the calculation of such value.

(2)   Includeslife insurance premiums paid by the Bank during 2006 on behalf of theDirectors.

### **DirectorsStock Option Plan**

In the course of the formationof Coast Bancorp as of May 31, 2001, Coast Bancorp adopted and assumed theCoast National Bank 1998 Directors’ Stock Option Plan, now known as the CoastBancorp Directors Stock Option Plan (the “Director Plan”).  The Director Plan was adopted to offer thenon-employee directors of Coast Bancorp and its affiliates the opportunity toacquire a proprietary interest in the success of Coast Bancorp by purchasingshares of Coast Bancorp common stock. New options were not granted in 2006 to the (8) outside directors.

The aggregate number of shares which may be issuedpursuant to the exercise of Options granted under the Director Plan is 62,500shares, and in no event may the total number of shares issuable upon exerciseof all outstanding options and the total number of shares provided for underany other stock option plan, stock bonus or similar plan of Coast Bancorpexceed thirty percent (30%) of the then-outstanding common stock of the Company(the “Shares”).  As of March 15, 2007,approximately eight (8) directors of Coast Bancorp and its affiliates wereeligible to hold options under the Director Plan.  The Director Plan contemplates the grant ofnonstatutory stock options only.

### **Item11.  Security Ownership of CertainBeneficial Owners and Management and Related Stockholder Matters**

a.                                       Thereare no stockholders with ownership of 5% of the Bank’s stock, except as setforth below.  Mr. Wauchope’s address is500 Marsh Street, San Luis Obispo, CA 93401.

b.                                      Thefollowing table sets forth information as of December 31, 2006 as to commonshares beneficially owned by the directors and each Named Executive Officer, aswell as all directors and principal officers of the Company as a group.  Except as indicated in the footnotes to thetable, none of the shares listed below have been pledged as security.  Ownership information is based uponinformation furnished by the respective individuals.

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**Officerand Director Beneficial Ownership**
| ** **                                                  | ** ** | ** **                          | ** ** | **Number of** | ** ** | ** ** | ** ** | **Percentage**     | ** ** |
|-------------------------------------------------------------|------------|-------------------------------------|------------|--------------------|------------|------------|------------|--------------------|------------|
| **Name**                                                    | ** ** | **Relationship to Bank**  | ** ** | **Shares**         | ** ** | **Notes**  | ** ** | **Owned (1)** | ** ** |
|                                                        |       |                                |       |               |       |       |       |               |       |
| Jack C. Wauchope                                            |       | Chairman  of the Board & CEO    |       | 36,000             |       | (2         | )          | 5.15               | %          |
| Marilyn M.  Britton                                         |       | Corporate  Secretary & Director |       | 3,717              |       | (3         | )          | 0.54               | %          |
| Dario A.  Domenghini                                        |       | Director                            |       | 11,401             |       | (4),(5     | )          | 1.66               | %          |
| James M. Kaney                                              |       | Director                            |       | 8,367              |       | (5         | )          | 1.22               | %          |
| Michael A. Lady                                             |       | Director                            |       | 6,667              |       | (5         | )          | 0.97               | %          |
| Gene D. Mintz                                               |       | Director                            |       | 28,598             |       | (5         | )          | 4.17               | %          |
| Ronald R. Olson                                             |       | Director                            |       | 16,992             |       | (3         | )          | 2.49               | %          |
| Jack W.  Robasciotti                                        |       | Director                            |       | 7,667              |       | (5         | )          | 1.12               | %          |
| Dan H. Wixom                                                |       | Director                            |       | 17,467             |       | (5),(6     | )          | 2.55               | %          |
| Davina A.  Palazzo                                          |       | EVP  & Executive Officer        |       | 7,500              |       | (8         | )          | 1.10               | %          |
| Leah M. Pauly                                               |       | EVP  & Executive Officer        |       | 5,400              |       | (7         | )          | 0.79               | %          |
| Karan C. Pohl                                               |       | SVP  & Executive Officer        |       | 1,000              |       | (8         | )          | 0.15               | %          |
| Directors &  Executive Officers as a Group (12 persons) |       | 150,776                             |       | (9                 | )          | 20.05      | %          |

 

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NotesRegarding Percentages Owned:

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

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

(3)           Includes3,167 shares of Director Stock options that are presently exercisable.

(4)           Includes 300shares held by Domenghini Farms, a California General Partnership

(5)           Includes5,667 shares of director stock options that are presently exercisable.

(6)           Includes4,500 shares held by the Wixom Trucking Co., LLC Profit Sharing Trust overwhich Mr. Wixom is trustee with sole voting and investment power.

(7)           Includes3,400 shares of incentive stock options that are presently exercisable.

(8)           Incentivestock options currently exercisable.

(9)           Includes31,900 shares of incentive stock options and 40,336 shares of director stockoptions which are presently exercisable.

TheBancorp is not aware of any arrangement that might result in a change ofcontrol of the Bancorp.

**Item 12.  CertainRelationships 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 the Board of Directors that any loans andcommitments to lend included in such transactions will be made in accordancewith all applicable laws and regulations and on substantially the same terms,including interest rates and collateral, as those prevailing at the time forcomparable transactions with other persons of similar creditworthiness.

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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 the firm policy of the Board that anysuch transactions between the Bank and any members of its Board, or any persondirectly or indirectly related to a director, be made in strict accordance withapplicable rules and regulations and on substantially the same terms as thoseavailable at the time for comparable transactions with disinterestedpersons.  There have been no transactionsof this sort since January 1, 2006.

**PART IV**

**Item 13. Exhibits**

a)                                      Exhibits

Seeindex to exhibits at page 74 of this Annual Report on Form 10-KSB.

**Item 14. Principal Accountant Fees and Services**

Vavrinek, Trine, Day & Company LLP’sengagement by Coast Bancorp commenced on April 30, 2002. Vavrinek, Trine, Day& Company LLP’s has also audited Coast National Bank since inception.  During the fiscal year ended December 31,2006, Vavrinek, Trine & Day & Company, LLP provided professionalservices in connection with the review of Quarterly Reports on Form 10-QSB forthe quarters ended March 31, June 30, September 30, 2006, and the audit of thefinancial statements of Coast Bancorp for the fiscal year ended December 31,2006.  As part of the engagement,Vavrinek, Trine, Day & Company LLP also prepared quarterly tax estimatesand the federal and state income tax returns.

**Audit Fees**

The aggregate fees billed by Vavrinek, Trine,Day & Company LLP for professional services rendered for the audit of theCompany’s annual financial statements and review of its Form 10-KSB for fiscalyears 2005 and 2006 and for the review of the financial statements and theCompany’s Forms 10-QSB for the Quarters ended March 31, June 30, and September30, 2006 were $41,000.00 and $50,000.00, respectively.

**Audit Related Fees**

There were no fees billed by Vavrinek, Trine,Day & Company, LLP for assurance and related services provided to theCompany that are reasonably related to the performance of the audit or reviewof the Company’s financial statements that have not been reported under “AuditFees” for fiscal years 2005 and 2006.

**Tax Fees**

The aggregate fees billed by Vavrinek, Trine,Day & Company, LLP for professional services rendered to the Company fortax compliance, advice, and planning including the preparation of tax estimatesand federal and state income tax returns, for fiscal years 2005 and 2006 were$5,000.00 each year.

**AllOther Fees**

Other than as provided above, no other fees werepaid to Vavrinek, Trine, Day & Company, LLP during 2005 or 2006.

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**Audit Committee’s Pre-ApprovalPolicies and Procedures**

All services provided byVavrinek, Trine, Day & Company, LLP require the pre-approval of Bancorp’sAudit Committee.  All tax relatedservices and all other services provided by Vavrinek, Trine, Day & Company,LLP for 2005 and 2006 were pre-approved by the Audit Committee.

 

**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            |       | 2006 Executive Bonuses                                                                                                                                                                                                     |       |         | (8)** |
| 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)** |
| 10.14           |       | Fresno SBA Lease Agreement                                                                                                                                                                                                 |       |         | (7) |
| 10.15           |       | Paso Robles Land Purchase Agreement                                                                                                                                                                                        |       |         | (7) |
| 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 dated  March 28, 2007                                                                                                                                                            |       |         |   |
| 23.1            |       | Consent of Independent Public Accountant dated April  18, 2007                                                                                                                                                             |       |         |   |
| 24.0            |       | Power of Attorney                                                                                                                                                                                                          |       |         | (8) |
| 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.                                              |
|   |   |                                                                                                                                                                                                                         |
| (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  |
|   |   |                                                                                                                                                                                                                         |
| (7)    |   | Filed as Exhibits 10.1, and 10.2 respectively to  Registrant’s Quarterly Report on Form 10-QSB for the Fiscal Quarter ended  September 30, 2006 filed with the SEC and incorporated herein by reference                 |
|   |   |                                                                                                                                                                                                                         |
| (8)    |   | Previously Filed                                                                                                                                                                                                             |

 

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**SIGNATURES**

Pursuant to therequirements of the section 13 or 15(d) of the Securities and Exchange Act of1934, the Registrant has caused this Amendment No. 1 to Report to be signed onits behalf by the undersigned, thereunto duly authorized in the City of SanLuis Obispo, State of California, on April 18, 2007.
| COAST NATIONAL BANK |
|---------------------|
|                |
| By:                 | /s/ Jack C.  Wauchope |   |
|                | Jack C. Wauchope |
|                | Chief Executive  Officer |
|                | Chairman of the  Board |

 

Pursuant to therequirements of the Securities and Exchange Act of 1934, this Amendment No. 1to Report has been signed by the following persons in the capacities and on thedate indicated.
| Signature                 | ** ** | **Title** | ** **   | **Date** |
|---------------------------|------------|-----------|--------------|----------|
|                      |       |      |         |     |
| /s/ Marilyn M.  Britton*  |       |      | Director     |     | April 18, 2007 |
| Marilyn M.  Britton       |       |      |         |     |
|                      |       |      |         |     |
| /s/ Dario A.  Domenghini* |       |      | Director     |     | April 18, 2007 |
| Dario A.  Domenghini      |       |      |         |     |
|                      |       |      |         |     |
| /s/ James M.  Kaney*      |       |      | Director     |     | April 18, 2007 |
| James M. Kaney            |       |      |         |     |
|                      |       |      |         |     |
| /s/ Michael A.  Lady*     |       |      | Director     |     | April 18, 2007 |
| Michael A. Lady           |       |      |         |     |
|                      |       |      |         |     |
| /s/ Gene D.  Mintz*       |       |      | Director     |     | April 18, 2007 |
| Gene D. Mintz             |       |      |         |     |
|                      |       |      |         |     |
| /s/ Ronald R.  Olson*     |       |      | Director     |     | April 18, 2007 |
| Ronald R. Olson           |       |      |         |     |
|                      |       |      |         |     |
| /s/ Karan C.  Pohl        |       |      | SVP/CFO      |     | April 18, 2007 |
| Karan C. Pohl             |       |      |         |     |
|                      |       |      |         |     |
| /s/ Jack W.  Robasciotti* |       |      | Director     |     | April 18, 2007 |
| Jack W.  Robasciotti      |       |      |         |     |
|                      |       |      |         |     |
| /s/ Jack C.  Wauchope     |       |      | Director/CEO |     | April 18, 2007 |
| Jack C. Wauchope          |       |      |         |     |
|                      |       |      |         |     |
| /s/ Dan H.  Wixom*        |       |      | Director     |     | April 18, 2007 |
| Dan H. Wixom              |       |      |         |     |

 

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| * /s/ Jack C. Wauchope                     |   |
|--------------------------------------------|--------|
| by: Jack C.  Wauchope, as attorney-in-fact |

 

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