**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

----

**Form10-KSB/A**

**(Amendment No. 1)**

**x Annual reportunder section 13 or 15(d) of the Securities Exchange Act of 1934**

**for the fiscal year ended December 31, 2005**

**o  Transition report under section 13 or15(d) of the Securities Exchange Act of 1934**

**for the transition period from       to       .**

**Commission File Number 0-15982**

**NATIONALMERCANTILE BANCORP**

(Exact name of smallbusiness issuer in its charter)

| **California**                                                            |   | **95-3819685**                        |
|---------------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization)          |   | (I.R.S. Employer  Identification No.) |
|                                                                      |   |                                  |
| **1880  Century Park East  Los Angeles, California**                      |   | **90067**                             |
| (Address to  principal executive offices)                                 |   | (Zip Code)                            |
|                                                                      |   |                                  |
| Issuer’s  telephone number, including area code: **(310)  277-2265** |
|                                                                      |
| Securities  registered pursuant to Section 12(b) of the Act: **None**     |
|                                                                      |
| Securities  registered pursuant to Section 12(g) of the Act:              |
|                                                                      |   |                                  |
| **Common  Stock, No Par Value**(Title of Class)                           |

 

Check whether the issuer:  (1) filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.      o Yes         x  No

Check if there is no disclosure of delinquent filersto Item 405 of Regulation S-B contained herein, and no disclosure will becontained, to the registrant’s knowledge, in definitive in response orinformation statements incorporated by reference in Part III of this Form10-KSB. o

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act). o Yes   x  No

The issuer’s revenues for its most recent fiscalyear:  $27.4 million.

The aggregate market value of the voting common equityheld by nonaffiliates of the registrant, based upon the closing sale price ofits Common Stock as reported by the National Association of Securities DealersAutomated Quotation System on March 21, 2006, was approximately $35.0million.

The number of shares of Common Stock, no par value, ofthe issuer outstanding as of September 18, 2006 was 5,550,767.

**DOCUMENTSINCORPORATED BY REFERENCE:**

Certain portions of the Company’s Proxy Statement tobe filed with the Securities and Exchange Commission pursuant to Rule 14a-6under the Securities Exchange Act of 1934 in connection with the Company’s 2006Annual Meeting of Shareholders are incorporated by reference in Part III, Items9-12 and 14 and is of this Annual Report on Form 10-KSB.

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

 

----

 

**Explanatory Note**

National Mercantile Bancorp (the “Company”) is filingthis amendment to Form 10-KSB for the year ended December 31, 2005(and an amendment to Form 10-QSB for the quarter ended March 31,2006), to amend and restate historical financial statements and other financialinformation filed with the Securities and Exchange Commission (“SEC”). Theseamendments are being filed to correct errors in the originally filedForm 10-KSB and Form 10-QSB related to the Company’s derivativeaccounting under Statement of Financial Accounting Standards No. 133,Accounting for Derivative Instruments and Hedging Activities (“SFAS No. 133”).

This amendment restates the consolidated financialstatements and the other financial information for the years ended December 31,2005 and 2004, including the quarters ended March 31, June 30, and September30, 2005 and 2004. The restatement has the following impact on Net Income andDilute Earnings Per Common Share by period:

**Impact by Period**
|            | ** ** | **Net Income  Adjustment**  | ** ** | **Diluted EPS  Adjustment(1)** | ** ** |
|------------|------------|----------------------------------|------------|-------------------------------------|------------|
| ** ** | ** ** | **(Dollars in  thousands)** | ** ** | ** **                          | ** ** |
| 2003       |       | $                                | (239       | )                                   | $          | (0.05 | ) |
| 2004:      |       |                             |       |                                |       |
| 1Q04       |       | 188                              |       | 0.05                                |       |
| 2Q04       |       | (412                             | )          | (0.09                               | )          |
| 3Q04       |       | 392                              |       | 0.07                                |       |
| 4Q04       |       | (34                              | )          | (0.01                               | )          |
| Year       |       | 134                              |       | 0.02                                |       |
|       |       |                             |       |                                |       |
| 2005:      |       |                             |       |                                |       |
| 1Q05       |       | (119                             | )          | (0.02                               | )          |
| 2Q05       |       | 341                              |       | 0.05                                |       |
| 3Q05       |       | (289                             | )          | (0.05                               | )          |
| 4Q05       |       | (164                             | )          | (0.03                               | )          |
| Year       |       | (231                             | )          | (0.04                               | )          |
|       |       |                             |       |                                |       |
| Total      |       | $                                | (336       | )                                   | $          | (0.07 | ) |

 

----

(1)            Some quarters havebeen rounded for presentation purposes.

For additional information relating to the effect ofthe restatement, see the following items:

Part II

Item6 – Management’s Discussion and Analysis or Plan of Operation

Item7 – Financial Statements

Item8A – Controls and Procedures

2

----

 

**NATIONALMERCANTILE BANCORP**

**Table of Contents**

**Form 10-KSB/AFor the Fiscal Year Ended December 31, 2005**
| **PART I**           | ** **                                                                                                             | ** ** |
|----------------------|------------------------------------------------------------------------------------------------------------------------|------------|
| Item  1.             | Description  of Business                                                                                               |       |
| Item  2.             | Description  of Property                                                                                               |       |
| Item 3.              | Legal  Proceedings                                                                                                     |       |
| Item  4.             | Submission  of Matters to a Vote of Security Holders                                                                   |       |
|                 |                                                                                                                   |       |
| **PART II**          | ** **                                                                                                             | ** ** |
| Item  5.             | Market  for Common Equity and Related Shareholder Matters                                                              |       |
| Item  6.             | Management’s  Discussion and Analysis or Plan of Operation                                                        |       |
| Item 7.              | Financial  Statements                                                                                                  |       |
| Item  8.             | Changes  In and Disagreements With Accountants on Accounting and Financial Disclosure                                  |       |
| Item  8A.            | Controls  and Procedures                                                                                               |       |
| Item 8B.             | Other  Information                                                                                                     |       |
|                 |                                                                                                                   |       |
| **PART III**         | ** **                                                                                                             | ** ** |
| Item  9.             | Directors,  Executive Officers, Promoters and Control Persons; Compliance With Section 16(a)  of the Exchange Act |       |
| Item  10.            | Executive  Compensation                                                                                                |       |
| Item  11.            | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                       |       |
| Item  12.            | Certain  Relationships and Related Transactions                                                                        |       |
| Item 13.             | Exhibits                                                                                                               |       |
| Item  14.            | Principal  Accountant Fees and Services                                                                                |       |
|                 |                                                                                                                   |       |
| Signatures           |                                                                                                                   |       |
| Financial Statements |                                                                                                                   |
| Index to Exhibits    |                                                                                                                   |

3

----

 

**ANNUAL REPORT ONFORM 10-KSB/A**

Certain matters discussed in this Form 10-KSB/A mayconstitute forward-looking statements within the meaning of the SecuritiesExchange Act of 1934 (the “Exchange Act”) and as such may involve risks anduncertainties.  These forward-lookingstatements relate to, among other things, expectations of the businessenvironment in which National Mercantile Bancorp (referred to as “we”, “our” or“the Company” when such reference includes National Mercantile Bancorp and itssubsidiaries, collectively, “National Mercantile” when referring only to theparent company and “the Banks” when referring only to National Mercantile’sbanking subsidiaries, Mercantile National Bank and South Bay Bank, N.A.)operates, projections of future performance, perceived opportunities in themarket and statements regarding our mission and vision.  Our actual results, performance, orachievements may differ significantly from the results, performance, or achievementsexpressed or implied in such forward-looking statements.  Statements regarding policies and proceduresare not intended to imply, and should not be interpreted to mean, that we willconduct our business in accordance with such policies for any particular periodof time, as we may at any time and from time to time amend or repeal suchpolicies and adopt new policies.  Fordiscussion of the factors that might cause such a difference, see “Item 6.  Management’s Discussion and Analysis ofFinancial Condition or Plan of Operation— Factors Which May Affect FutureOperating Results”.

**PART I**

**ITEM 1.   DESCRIPTION OF BUSINESS**

National Mercantile is a bank holding company whoseprincipal assets are the capital stock of two bank subsidiaries: MercantileNational Bank (“Mercantile”) and South Bay Bank, N.A.  (“South Bay”).  National Mercantile has been authorized bythe Federal Reserve Bank of San Francisco to engage in lending activitiesseparate from the Banks but to date has not done so.

Our present business strategy is to attract individualand small- to mid-sized business borrowers in specific market niches located inour primary service areas by offering a variety of loan products and a fullrange of banking services coupled with highly personalized service.  Our lending products include revolving linesof credit, term loans, commercial real estate loans, construction loans andconsumer and home equity loans, which often contain terms and conditionstailored to meet the specific demands of the market niche in which the borroweroperates.  Additionally, we provide awide array of deposit and investment products that are also designed to meetspecific customer needs.

We operate throughout the west side of Los AngelesCounty including the South Bay, Century City and San Fernando Valley withbanking offices in Century City, Torrance, Encino and El Segundo and a loanproduction office in Beverly Hills. Additionally, we target Orange County businesses through our loanproduction office in Costa Mesa, California.

Our targeted market niches for businesses include theentertainment industry, the healthcare industry, professional servicesproviders, the real estate escrow industry, property managers, public workscontractors and community-based nonprofit organizations.    Entertainment industry clients include television,music and film production companies, talent agencies, individual performers,directors and producers (whom we attract by establishing relationships withbusiness management firms) and others affiliated with the entertainmentindustry.  Healthcare organizationsinclude primarily outpatient healthcare providers such as physician medicalgroups, independent practice associations and surgery centers.  Professional service customers include legal,accounting, insurance, advertising firms and their individual directors,officers, partners and shareholders.

We also engage in real estate and constructionlending.  Our real estate loans are forthe purchase or finance of principally smaller commercial properties, includingowner-occupied business facilities and retail properties, and to a lesserextent multi-family and single family residential properties.  We make construction loans for smallcommercial, multi-family and single residential properties, including tractdevelopments and luxury homes for resale.

In order to grow and expand our array of products andservices, we may from time to time open de novo branch banking offices oracquire other financial service-related companies including “in-market”acquisitions with banks of similar size and market presence.  No assurance can be made that we willidentify a company which can be acquired on terms and conditions acceptable tous or that we could obtain the necessary regulatory approvals for such anacquisition.

We believe that banking clients value doing businesswith locally managed institutions that can provide a full service commercialbanking relationship through an understanding of the clients’ financial needsand the flexibility to deliver customized solutions through our menu ofproducts and services.  We also believethat our subsidiary Banks are better able to build successful clientrelationships as the holding company provides cost effective administrativesupport services while promoting bank autonomy and flexibility in servingclient needs.

To implement this philosophy, we operate each of ourbank subsidiaries by retaining their independent names.  Each bank subsidiary has established strongclient followings in its market areas through attention to client service andan understanding of client needs.

Inan effort to capitalize on the identities and reputations of the Banks, weintend to continue to market our services under each Bank’s name, primarilythrough each Bank’s relationship managers. The primary focus for the Banks’ relationship managers is to cultivateand nurture their client relationships. Relationship managers are assigned to each borrowing client to providecontinuity in the 

4

----

 

relationship. This emphasis on personalized relationships requires that all of therelationship managers maintain close ties to the communities or industry nichein which they serve, so they are able to capitalize on their efforts throughexpanded business opportunities for the Banks.

Client service decisions and day-to-day operations aremaintained at the Banks.  NationalMercantile offers the advantages of affiliation with a multi-bank holdingcompany by providing expanded client support services, such as increased clientlending capacity, business cash management, and centralized administrativefunctions, including client services, support in credit policy formulation andreview, investment management, data processing, accounting, loan servicing andother specialized support functions.  Allof these centralized services are designed to enhance the ability of therelationship managers to expand their client relationship base.

At December 31, 2005, we had total assets of$448.5 million, total loans, net, of $334.1 million and total deposits of$363.2 million.

**Corporate History**

Mercantile was organized in 1981 as a national bankingassociation and commenced operations through an office in Century City in1982.  In 1983 National Mercantile wasorganized under the laws of the State of California and registered as a bank holdingcompany under the Bank Holding Company Act of 1956, as amended (the ‘‘BHCA’’),to serve as a holding company for Mercantile.

In March 2001, Mercantile opened a regionaloffice in Encino, California which expanded our client-focused niche bankingservices to the San Fernando Valley area of Los Angeles.  In January 2004, Mercantile opened aloan production office in Beverly Hills, California to focus on providingbanking services to those affiliated with the entertainment industry.

In December 2001, National Mercantile acquiredSouth Bay, which had offices in Torrance and El Segundo.   In January 2004, South Bay opened aloan production office in Costa Mesa to expand its lending services to theOrange County area of Southern California.

**Competition**

The banking and financial services industry inCalifornia generally, and in the Banks’ market areas specifically, is highlycompetitive.  The increasinglycompetitive environment is primarily a result of changes in regulation, changesin technology and product delivery systems, and the accelerating pace ofconsolidation among financial services providers.  Our primary service area is dominated by arelatively small number of major banks that have many offices operating over awide geographical area.  We compete forloans, deposits, and customers with other commercial banks, savings and loanassociations, securities and brokerage companies, mortgage companies, insurancecompanies, finance companies, money market funds, credit unions, and othernonbank financial service providers. Many of these competitors are much larger in total assets andcapitalization, have greater access to capital markets and offer a broaderrange of financial services than us. Nondepository institutions can be expected to increase the extent towhich they act as financial intermediaries. Large institutional users and sources of credit may also increase theextent to which they interact directly, meeting business credit needs outsidethe banking system.  Furthermore, thegeographic constraints on portions of the financial services industry can beexpected to erode.  In addition, many ofthe major commercial banks operating in our primary service area offerservices, such as trust services, which are not offered directly by us and, byvirtue of their greater total capitalization, such banks have substantiallyhigher lending limits.

To compete with other financial institutions in ourprimary service area, we rely principally upon personal contact by ourofficers, directors and employees and providing, through third parties, specializedservices such as messenger, accounting and other related services.  For clients whose loan demands exceed ourlegal lending limit, we arrange for such loans on a participation basis withother banks.  We also assist clientsrequiring other services not offered by us in obtaining such services fromother providers.

**EconomicConditions and Government Policies**

Our profitability, like most financial institutions,is primarily dependent on interest rate differentials.  In general, the difference between theinterest rates paid by us on our interest-bearing liabilities, such as depositsand other borrowings, and the interest rates received by us on ourinterest-earning assets, such as loans and investment securities, comprise themajor portion of our earnings.  Theserates are highly sensitive to many factors that are beyond our control, such asinflation, recession and unemployment, and the impact which future changes indomestic and foreign economic conditions might have on us cannot be predicted.

The monetary and fiscal policies of the federalgovernment and the policies of regulatory agencies, particularly the Board ofGovernors of the Federal Reserve System (the “Federal Reserve”), influence ourbusiness.  The Federal Reserve implementsnational monetary policies (with objectives such as curbing inflation andcombating recession) through its open-market operations in U.S.  Government securities by adjusting therequired level of reserves for depository institutions subject to its reserverequirements, and by varying the target federal funds and discount ratesapplicable to borrowings by depository institutions.  The actions of the Federal Reserve in theseareas influence the growth of bank loans, investments, and deposits and alsoaffect interest rates earned on interest-earning assets and paid oninterest-bearing liabilities.  We cannotfully predict the nature and impact on us of any future changes in monetary andfiscal policies.

5

----

**Supervision and Regulation**

 

*General*

Banking is a highly regulated industry.  Congress and the states have enacted numerouslaws that govern banks, bank holding companies and the financial servicesindustry, and have created several largely autonomous regulatory agencies whichhave authority to examine and supervise banks and bank holding companies, andto adopt regulations furthering the purpose of the statutes.  The primary goals of the regulatory schemeare to maintain a safe and sound banking system, to protect depositors and theFederal Deposit Insurance Corporation (“FDIC”) insurance fund, and tofacilitate the conduct of sound monetary policy; they were not adopted for thebenefit of shareholders of the Company. As a result, the Company’s financial condition, results of operations,ability to grow and engage in various business activities can be affected notonly by management decisions and general economic conditions, but therequirements of applicable federal and state laws, regulations and the policiesof the various regulatory authorities.

Further, these laws, regulations and policies arereviewed often by Congress, state legislatures and federal and state regulatoryagencies.  Changes in laws, regulationsand policies can materially increase the cost of doing business, limit certain businessactivities, require additional capital, or materially adversely affectcompetition between banks and other financial intermediaries.  While it can be predicted that significantchanges will occur, what changes, when they will occur, and how they willimpact the Company cannot be predicted.

Set forth below is a summary description of certain ofthe material laws and regulations that relate to the operations of NationalMercantile and the Banks.  Thedescription does not purport to be a complete description of these laws andregulations and is qualified in its entirety by reference to the applicablelaws and regulations.

*National Mercantile*

As a registered bank holding company, NationalMercantile and its subsidiaries are subject to the Federal Reserve’ssupervision, regulation and examination under the Bank Holding Company Act.

National Mercantile is required to obtain the FederalReserve’s prior approval before acquiring ownership or control of more than 5%of the outstanding shares of any class of voting securities, or substantiallyall the assets, of any company, including a bank or bank holding company.  Further, National Mercantile is generallyallowed to engage, directly or indirectly, only in banking and other activitiesthat the Federal Reserve deems to be so closely related to banking or managingor controlling banks as to be a proper incident thereto.

Under Federal Reserve regulations, a bank holdingcompany is required to serve as a source of financial and managerial strengthto its subsidiary banks and may not conduct its operations in an unsafe orunsound manner.  In addition, it is theFederal Reserve’s policy that in serving as a source of strength to itssubsidiary banks, a bank holding company should stand ready to use availableresources to provide adequate capital funds to its subsidiary banks duringperiods of financial stress or adversity and should maintain the financialflexibility and capital-raising capacity to obtain additional resources forassisting its subsidiary banks.  A bankholding company’s failure to meet its obligations to serve as a source ofstrength to its subsidiary banks will generally be considered by the FederalReserve to be an unsafe and unsound banking practice or a violation of theFederal Reserve’s regulations or both.

*The Banks*

Both Banks are national banks and members of theFederal Reserve System.  The Banks aresubject to primary supervision, examination, and regulation by the Office ofthe Comptroller of the Currency (the “OCC”) and are also subject to regulationsof the FDIC and the Federal Reserve.  TheBanks are subject to requirements and restrictions under federal law, includingrequirements to maintain reserves against deposits, restrictions on the typesand amounts of loans that may be granted and limitations on the types ofinvestments that may be made and services that may be offered.  Various consumer laws and regulations alsoaffect the Banks’ operations.  These lawsprimarily protect depositors and other customers of the Banks, rather thanNational Mercantile and its shareholders.

The OCC and the Federal Reserve have various remediesif they should determine that the financial condition, capital resources, assetquality, earnings prospects, management, liquidity, or other aspects of a bank’soperations are unsatisfactory or that a bank or its management is violating orhas violated any law or regulation. These remedies include the power to enjoin “unsafe or unsound”practices, to require affirmative action to correct any conditions resultingfrom any violation or practice, to issue an administrative order that can bejudicially enforced, to direct an increase in capital, to restrict the growthof the bank, to assess civil monetary penalties, to remove officers anddirectors, and ultimately to terminate the bank’s deposit insurance.

*FDIC*

The Banks are subject to examination and regulation bythe FDIC under the Federal Deposit Insurance Act because their deposit accountsare insured by the FDIC.

UnderFDIC regulations, each insured depository institution is assigned to one ofthree capital groups for insurance premium purposes — “well capitalized,” “adequatelycapitalized” and “undercapitalized” — which are defined in the same manner asunder prompt corrective action rules, as discussed under “Capital AdequacyRequirements” below.  These three groupsare then divided into subgroups, which are based on supervisory evaluations bythe institution’s primary federal regulator, resulting in nine assessment 

6

----

 

classifications. Currently, assessment rates for insured banks range from 0% of insured depositsfor well-capitalized banks with minor supervisory concerns to 0.027% of insureddeposits for undercapitalized banks with substantial supervisory concerns.  The FDIC may increase or decrease theassessment rate schedule semiannually.

The FDIC may terminate the deposit insurance of anyinsured depository institution if the FDIC determines, after a hearing, thatthe institution has engaged or is engaging in unsafe or unsound practices.  As with the OCC’s enforcement authority, theFDIC’s authority to terminate deposit insurance is not limited to cases ofcapital inadequacy, financial weakness rendering an institution unable tocontinue operations, violations of any applicable law or regulation orviolation of any order or any condition imposed in writing by the FDIC.  In addition, FDIC regulations provide thatany insured institution that falls below a 2% minimum leverage ratio (seebelow) will be subject to FDIC deposit insurance termination proceedings unlessit has submitted, and is in compliance with, a capital plan with its primaryfederal regulator and the FDIC.  The FDICmay also suspend deposit insurance temporarily during the hearing process ifthe institution has no tangible capital. The FDIC is additionally authorized by statute to appoint itself asconservator or receiver of an insured depository institution (in addition tothe powers of the institution’s primary federal regulatory authority) in cases,among others, of unsafe or unsound conditions or practices or willfulviolations of cease and desist orders.

All FDIC-insured depository institutions must pay anannual assessment to provide funds for the payment of interest on bonds issuedby the Financing Corporation ( “FICO”), a federal corporation chartered underthe authority of the Federal Housing Finance Board.  The bonds, commonly referred to as FICObonds, were issued to capitalize the Federal Savings and Loan InsuranceCorporation.  The FICO has established assessmentrates effective for the first quarter of 2005 at approximately $.0144 per $100annually for assessable deposits. The FICO assessments are adjusted quarterlyto reflect changes in the assessment bases of the FDIC’s insurance funds and donot vary depending on a depository institution’s capitalization or supervisoryevaluations.

*Dividends and Capital Distributions*

Dividends and capital distributions from the Banksconstitute the principal ongoing source of cash to National Mercantile.  National Mercantile is a legal entityseparate and distinct from the Banks, and as such has separate and distinctfinancial obligations including debt service and operating expenses.  The Banks are subject to various statutoryand regulatory restrictions on their ability to pay dividends and capitaldistributions to National Mercantile.

OCC approval is required for a national bank to pay adividend if the total of all dividends declared in any calendar year exceedsthe total of the bank’s net profits (as defined) for that year combined withits retained net profits for the preceding two calendar years, less anyrequired transfer to surplus or a fund for the retirement of any preferredstock.  A national bank may not pay anydividend that exceeds its retained net earnings, as defined by the OCC.   The OCC and the Federal Reserve have alsoissued banking circulars emphasizing that the level of cash dividends shouldbear a direct correlation to the level of a national bank’s current andexpected earnings stream, the bank’s need to maintain an adequate capital baseand other factors.

National banks that are not in compliance withregulatory capital requirements generally are not permitted to paydividends.  The OCC also can prohibit anational bank from engaging in an unsafe or unsound practice in its business.  Depending on the bank’s financial condition,payment of dividends could be deemed to constitute an unsafe or unsoundpractice.  Except under certaincircumstances, and with prior regulatory approval, a bank may not pay adividend if, after so doing, it would be undercapitalized.  The Banks’ ability to pay dividends in thefuture is, and could be, further influenced by regulatory policies oragreements and by capital guidelines.

Mercantile has a substantial accumulated deficit anddoes not anticipate having positive retained earnings for the foreseeablefuture.  South Bay had retained earningsof $3.0 million as of December 31, 2005. Mercantile and South Bay may from time to time be permitted to makecapital distributions to National Mercantile with the consent of the OCC.  It is not anticipated that such consent couldbe obtained unless the distributing bank were to remain “well capitalized”following such distribution.

*Transactions with Affiliates*

The Banks are subject to certain restrictions imposedby federal law on any extensions of credit to, or the issuance of a guaranteeor letter of credit on behalf of, National Mercantile or other affiliates, thepurchase of, or investments in, stock or other securities thereof, the takingof such securities as collateral for loans, and the purchase of assets ofNational Mercantile or other affiliates. Such restrictions prevent National Mercantile and such other affiliatesfrom borrowing from the Banks unless the loans are secured by marketableobligations of designated amounts. Further, such secured loans and investments by the Banks to or inNational Mercantile or to or in any other affiliate are limited, individually,to 10% of the respective Bank’s capital and surplus (as defined by federalregulations), and such secured loans and investments are limited, in theaggregate, to 20% of the respective Bank’s capital and surplus (as defined byfederal regulations).

*Capital Adequacy Requirements*

Boththe Federal Reserve and the OCC have adopted similar, but not identical, “risk-based”and “leverage” capital adequacy guidelines for bank holding companies andnational banks, respectively.  Under therisk-based capital guidelines, different categories of assets are assigneddifferent risk weights, ranging from zero percent for assets consideredrisk-free (e.g., cash) to 100% for assets considered relatively high-risk(e.g., commercial loans).  These riskweights are multiplied by corresponding asset balances to determine arisk-adjusted asset base.  Certainoff-balance sheet items (e.g., standby letters of credit) are added to therisk-adjusted asset base.  The 

7

----

 

minimum required ratio of total capital torisk-weighted assets for both bank holding companies and national banks ispresently 8%.  At least half of the totalcapital is required to be “Tier 1 capital,” consisting principally of commonshareholders’ equity, a limited amount of perpetual preferred stock andminority interests in the equity, less goodwill, intangible assets and certainother items.  The remainder (Tier 2capital) may consist of a limited amount of subordinated debt, certain hybridcapital instruments and other debt securities, preferred stock and a limitedamount of the general loan-loss allowance.

The minimum Tier 1 leverage ratio (Tier 1 capital toaverage adjusted total assets) is 3% for bank holding companies and nationalbanks that have the highest regulatory examination rating and are notcontemplating significant growth or expansion. All other bank holding companies and national banks are expected tomaintain a ratio of at least 1% to 2% or more above the stated minimum.

*Prompt Corrective Action Rules*

The OCC has adopted regulations establishing capitalcategories for national banks and prompt corrective actions forundercapitalized institutions.  Theregulations create five capital categories: well capitalized, adequatelycapitalized, undercapitalized, significantly undercapitalized and criticallyundercapitalized.  A bank may bereclassified by the OCC to the next level below that determined by itsregulatory capital if the OCC finds that it is in an unsafe or unsoundcondition or if it has received a less-than-satisfactory rating for any of thecategories of asset quality, management, earnings or liquidity in its mostrecent examination and the deficiency has not been corrected, except that abank cannot be reclassified as critically undercapitalized for such reasons.

The OCC may subject national banks which are not atleast “adequately capitalized” to a broad range of restrictions and regulatoryrequirements.  An undercapitalized bank maynot pay management fees to any person having control of the institution, nor,except under certain circumstances and with prior regulatory approval, make anycapital distribution.  Undercapitalizedbanks are subject to increased monitoring by the OCC, are restricted in theirasset growth, must obtain regulatory approval for certain corporate activities,such as acquisitions, new branches and new lines of business, and, in mostcases, must submit to the OCC a plan to bring their capital levels to the minimumrequired in order to be classified as adequately capitalized.  The OCC may not approve a capital restorationplan unless each company that controls the bank guarantees that the bank willcomply with it.  Under Federal Reservepolicy, a bank holding company is expected to act as a source of financialstrength to its subsidiary banks and to commit resources to support each suchbank.  In addition, a bank holdingcompany is required to guarantee that its subsidiary bank will comply with anycapital restoration plan.  The amount ofsuch a guarantee is limited to the lesser of (i) 5% of the bank’s total assetsat the time it became undercapitalized, or (ii) the amount which is necessary(or would have been necessary) to bring the bank into compliance with allapplicable capital standards as of the time the bank fails to comply with thecapital restoration plan.  A holdingcompany guarantee of a capital restoration plan results in a priority claim tothe holding company’s assets ahead of its other unsecured creditors andshareholders that is enforceable even in the event of the holding company’sbankruptcy or the subsidiary bank’s insolvency.

If any one or more of a bank’s ratios are below theminimum ratios required to be classified as undercapitalized, it will beclassified as significantly undercapitalized provided that if its ratio oftangible equity to total assets is 2% or less, it will be classified ascritically undercapitalized. Significantly and critically undercapitalized banks are subject toadditional mandatory and discretionary restrictions and, in the case ofcritically undercapitalized institutions, must be placed into conservatorshipor receivership unless the OCC and the FDIC agree otherwise.

*Safety and Soundness Standards*

The federal banking agencies have adopted guidelinesdesigned to assist the federal banking agencies in identifying and addressingpotential safety and soundness concerns before capital becomes impaired. Theguidelines set forth operational and managerial standards relating to (i)internal controls, information systems and internal audit systems; (ii) loandocumentation; (iii) credit underwriting; (iv) asset growth; (v) earnings; and(vi) compensation, fees and benefits.

In addition, the federal banking agencies have alsoadopted safety and soundness guidelines with respect to asset quality andearnings standards.  These guidelinesprovide six standards for establishing and maintaining a system to identifyproblem assets and prevent those assets from deteriorating.  Under these standards, an insured depositoryinstitution should (i) conduct periodic asset quality reviews to identifyproblem assets; (ii) estimate the inherent losses in problem assets andestablish reserves that are sufficient to absorb estimated losses; (iii) compareproblem asset totals to capital; (iv) take appropriate corrective action toresolve problem assets; (v) consider the size and potential risks of materialasset concentrations; and (vi) provide periodic asset quality reports withadequate information for management and the board of directors to assess thelevel of asset risk.

These new guidelines also set forth standards forevaluating and monitoring earnings and for ensuring that earnings aresufficient for the maintenance of adequate capital and reserves.

*Cross Guarantees*

TheBanks are also subject to cross-guaranty liability under federal law.  This means that if one FDIC-insureddepository institution subsidiary of a multi-institution bank holding companyfails or requires FDIC assistance, the FDIC may assess commonly controlleddepository institutions for the estimated losses suffered by the FDIC.  Such a liability could have a materialadverse effect on the financial condition of any assessed subsidiary institutionand on National Mercantile as the common parent.  While the FDIC’s cross-guaranty claim isgenerally junior to the claim of depositors, holders of secured liabilities,general creditors and subordinated creditors, it is generally superior to theclaims of shareholders and affiliates.

8

----

 

*Community Reinvestment Act and Fair Lending*

The Banks are subject to certain fair lendingrequirements and reporting obligations involving home mortgage lendingoperations and Community Reinvestment Act (“CRA”) activities.  A bank may be subject to substantial penaltiesand corrective measures for a violation of certain fair lending laws.  The CRA requires the Banks to ascertain andmeet the credit needs of the communities it serves, including low- andmoderate-income neighborhoods.  The Banks’compliance with the CRA is reviewed and evaluated by the OCC, which assigns theBanks a publicly available CRA rating at the conclusion of the examination.

The CRA regulations emphasize measurements ofperformance in the area of lending (specifically, a bank’s home mortgage, smallbusiness, small farm and community development loans), investment (a bank’scommunity development investments) and service (a bank’s community developmentservices and the availability of its retail banking services), althoughexaminers are still given a degree of flexibility in taking into account uniquecharacteristics and needs of a bank’s community and its capacity andconstraints in meeting such needs.  Theregulations also require certain levels of collection and reporting of dataregarding certain kinds of loans.

Further, the federal banking agencies may takecompliance with such laws and CRA obligations into account when regulating andsupervising other activities.  Anassessment of CRA compliance is required in connection with applications forOCC approval of certain activities, including establishing or relocating abranch office that accepts deposits or merging or consolidating with, oracquiring the assets or assuming the liabilities of, a federally regulatedfinancial institution.  An unfavorablerating may be the basis for OCC denial of such an application, or approval maybe conditioned upon improvement of the applicant’s CRA record.  In the case of a bank holding companyapplying for approval to acquire a bank or other bank holding company, theFederal Reserve will assess the CRA record of each subsidiary bank of theapplicant, and such records may be the basis for denying the application.  The federal banking agencies have establishedannual reporting and public disclosure requirements for certain writtenagreements that are entered into between insured depository institutions ortheir affiliates and nongovernmental entities or persons that are made pursuantto, or in connection with, the fulfillment of the CRA.

In connection with its assessment of CRA performance,the appropriate bank regulatory agency assigns a rating of “outstanding”, “satisfactory”,“needs to improve” or “substantial noncompliance”.  Each of the Banks received a “satisfactory”rating in its most recent exam.

*USA Patriot Act of 2001*

The USA Patriot Act of 2001 (“Patriot Act”) isintended to strengthen the U.S law enforcement and the intelligence communities’abilities to work cohesively to combat terrorism on a variety of fronts. Thepotential impact of the Patriot Act on financial institutions of all kinds issignificant and wide ranging. The Patriot Act contains sweeping anti-moneylaundering and financial transparency laws and requires various regulations,including: (i) due diligence requirements for financial institutions thatadminister, maintain, or manage private bank accounts or correspondent accountsfor non-US persons; (ii) standards for verifying customer identification ataccount opening; (iii) rules to promote cooperation among financialinstitutions, regulators, and law enforcement entities in identifying partiesthat may be involved in terrorism or money laundering; and (iv) reports bynon-financial trades and businesses filed with the Treasury Department’sFinancial Crimes Enforcement Network for transactions exceeding $10,000, andfiling of suspicious activities reports by securities brokers and dealers ifthey believe a customer may be violating U.S. laws and regulations.

*Privacy*

Federal banking rules limit the ability of banks andother financial institutions to disclose non-public information about consumersto nonaffiliated third parties. Pursuant to these rules, financial institutionsmust provide: (i) initial notices to customers about their privacy policies,describing the conditions under which they may disclose nonpublic personalinformation to nonaffiliated third parties and affiliates; (ii) annual noticesof their privacy policies to current customers; and (iii) a reasonable methodfor customers to “opt out” of disclosures to nonaffiliated third parties.

These privacy provisions affect how consumerinformation is transmitted through diversified financial companies and conveyedto outside vendors. We have implemented our privacy policies in accordance withthe law.

In recent years, a number of states have implementedtheir own versions of privacy laws. For example, in 2003, California adoptedstandards that are more restrictive than federal law, allowing bank customersthe opportunity to bar financial companies from sharing information with their affiliates.

**Employees**

AtDecember 31, 2005, we had 77 full-time equivalent employees.  None of the employees is covered by acollective bargaining agreement.  Weconsider our employee relations to be satisfactory.

9

----

 

**ITEM 2.  DESCRIPTION OF PROPERTY.**

National Mercantile leases approximately 13,880 squarefeet in an office building at 1880 Century Park East, Los Angeles, California,which serves as its administrative headquarters.  The rent for the period January 2004 toApril 2014 is $2.23 per square foot or $30,952 per month, subject to anannual CPI adjustment and for changes in property taxes and operating costs.

Mercantile’s principal banking office is located in1,800 square feet in an office building at 1880 Century Park East, Los Angeles,California.  The effective rent is $3.00per square foot or $5,401 per month.  Thelease expires in June 2014.

Mercantile leases approximately 1,650 square feet inan office building in Encino, California for the primary purpose of providingbranch banking operations in the San Fernando Valley.  The effective rent is $2.73 per square footor $4,500 per month.  The lease expiresin June 2008.  Additionally, Mercantileleases 2,559 square feet in an office building in Beverly Hills as a loanproduction office, primarily for the entertainment industry.  The effective rent is $2.88 per square foot,or $7,754 per month and the lease expires June 2009.

South Bay owns a two-story stand-alone office buildingat 2200 Sepulveda Boulevard, Torrance, California, which serves as its principalbanking office.  South Bay also leasesapproximately 3,100 square foot in an office building in El Segundo, Californiafor the primary purpose of providing branch banking operations in the LosAngeles airport area.  The effective rentis $1.85 per month and the lease expires in January 2011.  Additionally, South Bay leases 1,555 squarefeet in an office building in Costa Mesa, California as a loan productionoffice in Orange County.  The office hasbeen designed to serve as a full service branch banking office in thefuture.  The effective rent is $1.85 persquare foot, or $2,877 per month.  Thelease expires February 2009.

We believe our present facilities are adequate for ourpresent needs but anticipate the need for additional facilities as we continueto grow.  We believe that, if necessary,we could secure suitable alternative facilities on similar terms withoutadversely affecting operations.

**ITEM 3.  LEGAL PROCEEDINGS.**

From time to time, we are involved in certain legalproceedings arising in the normal course of our business.  We believe that the outcome of these mattersexisting as of December 31, 2005 will not have a material adverse effecton us.

**ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS.**

There was no submission of matters to a vote ofshareholders during the quarter ended December 31, 2005.

**PART II**

**ITEM 5.   MARKET FOR REGISTRANT’S COMMON EQUITY ANDRELATED SHAREHOLDER MATTERS**

The Common Stock of National Mercantile is traded onthe Nasdaq Small Cap Market under the symbol MBLA.  The following table shows the high and lowtrade prices of the Common Stock for each quarter of 2004 and 2005 (adjustedfor the 5-for 4-stock split paid April 16, 2006) as reported by the Nasdaq.  Additionally, there may have beentransactions at prices other than those shown during that time.
|                         | ** ** | **Common Stock** | ** ** |
|-------------------------|------------|-----------------------|------------|
| **Quarter Ended:** | ** ** | **High**              | ** ** | **Low** | ** ** |
| March 31, 2004          |       | $                     | 9.44       |   | $ | 7.39 |   |
| June 30, 2004           |       | 8.36                  |       | 7.34 |   |
| September 30,  2004     |       | 8.50                  |       | 7.56 |   |
| December 31,  2004      |       | 11.00                 |       | 8.33 |   |
| March 31, 2005          |       | 12.56                 |       | 10.16 |   |
| June 30, 2005           |       | 12.70                 |       | 9.81 |   |
| September 30,  2005     |       | 12.73                 |       | 12.04 |   |
| December 31, 2005       |       | 15.68                 |       | 12.40 |   |
|                         |            |                       |            |  |  |  |  |

 

At March 21, 2006, National Mercantile had 167shareholders of record for its Common Stock. The number of beneficial owners for the Common Stock is higher as manypeople hold their shares in “street” name. At March 21, 2006, approximately 40% of the Common Stock was heldin street name.

NationalMercantile has not paid a cash dividend on its Common Stock for more than 10years.  As a California corporation,under the California General Corporation Law, generally National Mercantile maynot pay dividends in cash or property except (i) out of positive retainedearnings or (ii) if, after giving effect to the distribution, NationalMercantile’s assets would be at least 1.25 times its liabilities and itscurrent assets would exceed its current liabilities (determined on aconsolidated basis under generally accepted accounting principles).  At December 31, 2005, NationalMercantile had an accumulated deficit of $7.0 million.  Further, it is unlikely 

10

----

 

that its assets will ever be at least 1.25 times itsliabilities.  Accordingly, NationalMercantile must generate net income in excess of $7.0 million before it can paya dividend in cash or property.

In addition, National Mercantile may not pay dividendson its capital stock if it is in default or has elected to defer payments ofinterest under its junior subordinated deferred interest debentures.

*Outstanding Awards UnderAll Equity Compensation Plans*.  The following table sets forth as ofDecember 31, 2005 information regarding outstanding options under all ofour equity compensation plans and the number of shares available for futureoption grants under equity compensation plans currently in effect.
|                                                             | ** ** | **(a)**                                                                                                                                              | ** ** | **(b)**                                                                                                         | ** ** | **(c)**                                                                                                                                                                                             | ** ** |
|-------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| **Plan category**                                      | ** ** | **Number of securities to be  issued upon exercise of  outstanding options,  warrants and rights** | ** ** | **Weighted-average exercise  price of outstanding options,  warrants and rights** | ** ** | **Number of securities  remaining available for  issuance under equity  compensation plans  (excluding securities  reflected in column (a)** | ** ** |
|                                                        |       |                                                                                                                                                 |       |                                                                                                            |       |                                                                                                                                                                                                |       |
| Equity compensation  plans approved by security holders (1) |       | 519,358                                                                                                                                              |       | $                                                                                                               | 9.62       |                                                                                                                                                                                                | 160,059    |   |
|                                                             |            |                                                                                                                                                      |            |                                                                                                                 |            |                                                                                                                                                                                                     |            |  |

 

----

(1)             Includes the 2005Stock Incentive Plan, 1996 Stock Incentive Plan and two stock option planswhich have been terminated but under which there remain outstanding options topurchase an aggregate of 2,200 shares of National Mercantile Common Stock.

**ITEM 6.  MANAGEMENT’S DISCUSSION AND ANALYSIS OR PLANOF OPERATION**

**RESTATEMENT**

National Mercantile Bancorp has restated itsconsolidated financial statements for the years ended December 31, 2005,2004 and 2003 and for each of the interim periods in 2005, 2004 and 2003. Thisrestatement corrected errors related to the Company’s derivative accountingunder Statement of Financial Accounting Standards No. 133, Accounting forDerivative Instruments and Hedging Activities (“SFAS No. 133”).

In 2003, the Company entered into an interest rateswap agreement in connection with the trust preferred securities related to theCompany’s junior subordinated deferrable interest debentures (Trust PreferredSwap) that was accounted for as a fair value hedge under SFAS No. 133. TheCompany elected an abbreviated method (the “short-cut” method) of documentingthe effectiveness of the swap as a hedge, which allowed the Company to assumeno ineffectiveness in this transaction. As a result of later technicalinterpretations of SFAS 133, the Company subsequently concluded that the Trust PreferredSwap did not qualify for this method in prior periods.  The presence of an interest deferral featurein the interest rate swap was determined, in retrospect, to have caused theinterest rate swap to not have a fair value of zero at inception, which isrequired under SFAS 133 to qualify for short-cut hedge accountingtreatment.  Hedge accounting underSFAS No. 133 for this swap transaction is not allowed retrospectivelybecause the hedge documentation required for the long-haul method was not inplace at the inception of the hedge. Eliminating the application of fair valuehedge accounting reverses the fair value adjustments that were made to thehedged item, the debt, as an adjustment to the par amount of theTrust Preferred debt. This reversal of fair value hedge accounting alsoresults in reclassification of swap net settlements from interest expense tononinterest income as well as recording of swap mark-to-market adjustments intrading gains (losses) on economic derivatives.

Thefollowing table shows the statements of operations as originally reported andas restated, with the adjustments, for the years ended December 31, 2005 and2004.

11

----

 
|                                                         | ** ** | **Year Ended**                  | ** ** |
|---------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                              | ** ** | **December 31, 2005**      | ** ** | **December 31, 2004** | ** ** |
| ** **                                              | ** ** | **As  Originally  Reported**         | ** ** | **Restated** | ** ** | **As  Originally  Reported** | ** ** | **Restated** | ** ** |
| ** **                                              | ** ** | **(Dollars in thousands)** | ** ** |
| ** **                                              | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net interest  income before provision for credit losses |       | $                                    | 21,129     |   | $ | 21,129 |   | $ | 16,450 |   | $ | 16,450 |   |
| Net cash  settlement of interest rate swap derivative   |       | —                               |       | (347 | ) | — |   | (619 | ) |
| Net interest  income before provision for credit losses |       | 21,129                               |       | 20,782 |   | 16,450 |   | 15,831 |   |
| Provision  (benefit) for credit losses                  |       | (84                                  | )          | (84 | ) | 220 |   | 220 |   |
| Net interest income after provision for credit  losses  |       | 21,213                               |       | 20,866 |   | 16,230 |   | 15,611 |   |
| Total other  operating income                           |       | 1,166                                |       | 1,166 |   | 1,567 |   | 1,567 |   |
| Net cash settlement of interest rate swap derivative    |       | —                               |       | 347 |   | — |   | 619 |   |
| Change in fair value of interest rate swap  derivative  |       | —                               |       | (395 | ) | — |   | 229 |   |
| Total non-interest income                               |       | 1,166                                |       | 1,118 |   | 1,567 |   | 2,415 |   |
| Total other  operating expenses                         |       | 14,376                               |       | 14,376 |   | 14,028 |   | 14,028 |   |
| Income before taxes                                     |       | 8,003                                |       | 7,608 |   | 3,769 |   | 3,998 |   |
| Income tax  expense                                     |       | 3,322                                |       | 3,322 |   | 1,583 |   | 1,583 |   |
| Income tax effect of restatement                        |       | —                               |       | (164 | ) | — |   | 95 |   |
| Total income tax expense                                |       | 3,322                                |       | 3,158 |   | 1,583 |   | 1,678 |   |
| Net income                                              |       | $                                    | 4,681      |   | $ | 4,450 |   | $ | 2,186 |   | $ | 2,320 |   |
|                                                    |       |                                 |       |   |   |   |   |   |   |
| Net income per  share – basic(1)                   |       | $                                    | 1.01       |   | $ | 0.96 |   | $ | 0.60 |   | $ | 0.64 |   |
| Net income per share –  diluted(1)                 |       | $                                    | 0.79       |   | $ | 0.75 |   | $ | 0.38 |   | $ | 0.41 |   |

 

----

(1)            Adjusted for the 5-for 4-stock split paid April 16, 2006

The followingtables shows the statements of operations as originally reported and asrestated, with the adjustments, for the three months ended March 31, June 30,September 30, and December31, 2005 and 2004.
|                                                         | ** ** | **Three Months Ended**     | ** ** |
|---------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                              | ** ** | **December 31, 2005**      | ** ** | **September 30, 2005** | ** ** | **June 30, 2005** | ** ** | **March 31, 2005** | ** ** |
| ** **                                              | ** ** | **As  Originally  Reported**         | ** ** | **Restated** | ** ** | **As  Originally  Reported** | ** ** | **Restated** | ** ** | **As  Originally  Reported** | ** ** | **Restated** | ** ** | **As  Originally  Reported** | ** ** | **Restated** | ** ** |
| ** **                                              | ** ** | **(Dollars in thousands)** | ** ** |
| Net interest  income before provision for credit losses |       | $                                    | 5,739      |   | $ | 5,739 |   | $ | 5,456 |   | $ | 5,456 |   | $ | 5,073 |   | $ | 5,073 |   | $ | 4,861 |   | $ | 4,861 |   |
| Net cash  settlement of interest rate swap derivative   |       | —                               |       | (60 | ) | — |   | (70 | ) | — |   | (100 | ) | — |   | (116 | ) |
| Net interest  income before provision for credit losses |       | 5,739                                |       | 5,679 |   | 5,456 |   | 5,386 |   | 5,073 |   | 4,973 |   | 4,861 |   | 4,745 |   |
| Provision  (benefit) for credit losses                  |       | 40                                   |       | 40 |   | (213 | ) | (213 | ) | — |   | — |   | 89 |   | 89 |   |
| Net interest income after provision for credit  losses  |       | 5,699                                |       | 5,639 |   | 5,669 |   | 5,599 |   | 5,073 |   | 4,973 |   | 4,772 |   | 4,656 |   |
| Total other  operating income                           |       | 267                                  |       | 267 |   | 278 |   | 278 |   | 299 |   | 299 |   | 322 |   | 322 |   |
| Net cash settlement of interest rate swap derivative    |       | —                               |       | 60 |   | — |   | 70 |   | — |   | 100 |   | — |   | 116 |   |
| Change in fair value of interest rate swap  derivative  |       | —                               |       | (280 | ) | — |   | (493 | ) | — |   | 582 |   | — |   | (204 | ) |
| Total non-interest income                               |       | 267                                  |       | 47 |   | 278 |   | (145 | ) | 299 |   | 981 |   | 322 |   | 234 |   |
| Total other  operating expenses                         |       | 3,561                                |       | 3,561 |   | 3,730 |   | 3,730 |   | 3,599 |   | 3,599 |   | 3,486 |   | 3,486 |   |
| Income before taxes                                     |       | 2,405                                |       | 2,125 |   | 2,217 |   | 1,724 |   | 1,773 |   | 2,355 |   | 1,608 |   | 1,404 |   |
| Income tax  expense                                     |       | 999                                  |       | 999 |   | 920 |   | 920 |   | 736 |   | 736 |   | 667 |   | 667 |   |
| Income tax effect of restatement                        |       | —                               |       | (116 | ) | — |   | (205 | ) | — |   | 242 |   | — |   | (85 | ) |
| Total income tax expense                                |       | 999                                  |       | 883 |   | 920 |   | 715 |   | 736 |   | 978 |   | 667 |   | 582 |   |
| Net income                                              |       | $                                    | 1,406      |   | $ | 1,242 |   | $ | 1,297 |   | $ | 1,009 |   | $ | 1,037 |   | $ | 1,378 |   | $ | 941 |   | $ | 822 |   |
|                                                    |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income per  share – basic                      |       | $                                    | 0.26       |   | $ | 0.23 |   | $ | 0.24 |   | $ | 0.19 |   | $ | 0.27 |   | $ | 0.35 |   | $ | 0.25 |   | $ | 0.22 |   |
| Net income per share –  diluted                    |       | $                                    | 0.24       |   | $ | 0.21 |   | $ | 0.22 |   | $ | 0.17 |   | $ | 0.18 |   | $ | 0.23 |   | $ | 0.16 |   | $ | 0.14 |   |

 

12

----

 
|                                                         | ** ** | **Three Months Ended**     | ** ** |
|---------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                              | ** ** | **December 31, 2004**      | ** ** | **September 30, 2004** | ** ** | **June 30, 2004** | ** ** | **March 31, 2004** | ** ** |
| ** **                                              | ** ** | **As  Originally  Reported**         | ** ** | **Restated** | ** ** | **As  Originally  Reported** | ** ** | **Restated** | ** ** | **As  Originally  Reported** | ** ** | **Restated** | ** ** | **As  Originally  Reported** | ** ** | **Restated** | ** ** |
| ** **                                              | ** ** | **(Dollars in thousands)** | ** ** |
| Net interest  income before provision for credit losses |       | $                                    | 4,682      |   | $ | 4,682 |   | $ | 4,695 |   | $ | 4,695 |   | $ | 3,622 |   | $ | 3,622 |   | $ | 3,451 |   | $ | 3,451 |   |
| Net cash  settlement of interest rate swap derivative   |       | —                               |       | (143 | ) | — |   | (137 | ) | — |   | (147 | ) | — |   | (169 | ) |
| Net interest  income before provision for credit losses |       | 4,682                                |       | 4,539 |   | 4,695 |   | 4,558 |   | 3,622 |   | 3,475 |   | 3,451 |   | 3,282 |   |
| Provision for  credit losses                            |       | 100                                  |       | 100 |   | 120 |   | 120 |   | — |   | — |   | — |   | — |   |
| Net interest income after provision for credit losses   |       | 4,582                                |       | 4,439 |   | 4,575 |   | 4,438 |   | 3,622 |   | 3,475 |   | 3,451 |   | 3,282 |   |
| Total other  operating income                           |       | 383                                  |       | 383 |   | 317 |   | 317 |   | 402 |   | 402 |   | 465 |   | 465 |   |
| Net cash settlement of interest rate swap derivative    |       | —                               |       | 143 |   | — |   | 137 |   | — |   | 147 |   | — |   | 169 |   |
| Change in fair value of interest rate swap derivative   |       | —                               |       | (58 | ) | — |   | 670 |   | — |   | (837 | ) | — |   | 453 |   |
| Total non-interest income                               |       | 383                                  |       | 468 |   | 317 |   | 1,124 |   | 402 |   | (288 | ) | 465 |   | 1,087 |   |
| Total other  operating expenses                         |       | 3,788                                |       | 3,788 |   | 3,378 |   | 3,378 |   | 3,439 |   | 3,439 |   | 3,423 |   | 3,423 |   |
| Income before taxes                                     |       | 1,177                                |       | 1,119 |   | 1,514 |   | 2,184 |   | 585 |   | (252 | ) | 493 |   | 946 |   |
| Income tax  expense                                     |       | 499                                  |       | 499 |   | 642 |   | 642 |   | 240 |   | 240 |   | 202 |   | 202 |   |
| Income tax effect of restatement                        |       | —                               |       | (24 | ) | — |   | 278 |   | — |   | (347 | ) | — |   | 188 |   |
| Total income tax expense                                |       | 499                                  |       | 475 |   | 642 |   | 920 |   | 240 |   | (107 | ) | 202 |   | 390 |   |
| Net income                                              |       | $                                    | 678        |   | $ | 644 |   | $ | 872 |   | $ | 1,264 |   | $ | 345 |   | $ | (145 | ) | $ | 291 |   | $ | 556 |   |
|                                                    |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income per  share – basic(1)                   |       | $                                    | 0.18       |   | $ | 0.17 |   | $ | 0.24 |   | $ | 0.35 |   | $ | 0.09 |   | $ | -0.04 |   | $ | 0.08 |   | $ | 0.16 |   |
| Net income per share –  diluted(1)                 |       | $                                    | 0.12       |   | $ | 0.11 |   | $ | 0.15 |   | $ | 0.22 |   | $ | 0.06 |   | $ | -0.03 |   | $ | 0.05 |   | $ | 0.10 |   |

 

**EXECUTIVELEVEL OVERVIEW**

**Table 1**

**Operations Summary**

** **
|                                        | ** ** | **Year Ended**                                 | ** ** | **Increase**   | ** ** | **Year Ended**   | ** ** |
|----------------------------------------|------------|-----------------------------------------------------|------------|----------------|------------|-----------------------|------------|
| ** **                             | ** ** | **December 31,**                               | ** ** | **(Decrease)** | ** ** | **December 31,** | ** ** |
| ** **                             | ** ** | **2005**                                            | ** ** | **Amount**     | ** ** | **%**                 | ** ** | **2004** | ** ** |
| ** **                             | ** ** | **(Dollars in thousands, restated)** | ** ** |
| Interest income                        |       | $                                                   | 26,265     |           | $          | 6,811                 |       | 35.0 | % | $ | 19,454 |   |
| Interest expense                       |       | 5,482                                               |       | 1,859          |       | 51.3                  | %          | 3,623 |   |
|                                   |       |                                                |       |           |       |                  |       |   |   |
| Net interest  income                   |       | 20,783                                              |       | 4,952          |       | 31.3                  | %          | 15,831 |   |
| Provision  (benefit) for credit losses |       | (84                                                 | )          | (304           | )          | (138.2                | )%         | 220 |   |
| Other operating  income                |       | 1,118                                               |       | (1,297         | )          | (53.7                 | )%         | 2,415 |   |
| Other operating  expense               |       | 14,376                                              |       | 348            |       | 2.5                   | %          | 14,028 |   |
|                                   |       |                                                |       |           |       |                  |       |   |   |
| Income before  income taxes            |       | 7,609                                               |       | 3,611          |       | 90.3                  | %          | 3,998 |   |
| Income taxes                           |       | 3,159                                               |       | 1,481          |       | 88.3                  | %          | 1,678 |   |
| Net income                             |       | $                                                   | 4,450      |           | $          | 2,130                 |       | 91.8 | % | $ | 2,320 |   |

 

Werecorded net income of $4.5 million for 2005 compared to net income of $2.3million for 2004. This represents basic earnings per share of $0.96 andfully-diluted earnings per share of $0.75 for 2005 compared to basic earningsper share of $0.64 per share and fully-diluted earnings per share of $0.41 for2004. The increase in net income for 2005 was largely due to a $4.9 millionincrease in net interest income resulting from (i) increases in the prime ratelending index, (ii) a greater volume of interest earning assets, particularlyhigher yielding loans receivable and securities available-for-sale, (iii)interest rate swaps and (iv) a more rapid rise in yield on earning assets thancost of interest-bearing liabilities. Additionally, for 2005 we recorded a netbenefit for credit losses due to a significant recovery of a loan previouslycharged off resulting in a $304,000 positive change compared to 2004. Otheroperating income declined $1.3 million primarily due to (i) a $395,000 tradingloss on non-hedge interest rate swaps compared to a $229,000 trading gain for2004, (ii) a $250,000 decline in net settlement payments from an interest rateswap not designated as a hedge, and (iii) lower deposit account fees resultingfrom greater allowances for compensating balances and changes in deposit feestructures. Other operating expenses increased $348,000 in 2005, largely due togreater salaries and related expense and increased professional services.

Returnon average assets for 2005 was 1.10% compared to 0.61% for 2004. Return onaverage equity for 2005 was 12.15% compared to 7.02% for 2004.

Totalassets at December 31, 2005 were $448.5 million compared to $391.3 millionat year-end 2004. Loans receivable and

13

----

 

securitiesavailable-for-sale increased $24.7 million and $34.8 million, respectively. Theincrease in loans receivable was due to growth in construction and landdevelopment loans partially offset by a decline in commercial real estate loansand commercial loans – secured and unsecured.

Theallowance for loan and lease losses at December 31, 2005 was $4.5 millioncompared to $3.5 million at December 31, 2004 reflecting net recoveries ofloans previously charged off of $1.2 million during the year less the reversalof provision for credit losses of $84,000.

Totaldeposits at December 31, 2005 were $363.2 million compared to $313.5million at year-end 2004. The composition of deposits at December 31, 2005reflects a $46.4 million increase in certificates of deposit $100,000 and over,a $6.9 million increase in money market accounts, $1.1 million increase ininterest-bearing demand deposits and a $2.1 million increase innoninterest-bearing demand deposits offset by a $4.0 million decrease insavings accounts and a $2.7 million decrease in certificates of deposit under$100,000. The significant increase in certificates of deposit $100,000 and overwas due to the execution of a securities leverage strategy for the purpose ofinterest rate risk management. Other borrowed funds were $28.3 million atDecember 31, 2005 compared to $25.9 million at year-end 2004.

**Table 2Ratios to Average Assets**
|                                        | ** ** | **2005**       | ** ** | **2004** | ** ** |
|----------------------------------------|------------|----------------|------------|----------|------------|
| ** **                             | ** ** | **(Restated)** | ** ** |
| Net interest income                    |       | 5.13           | %          | 4.16     | %          |
| Other operating income                 |       | 0.28           | %          | 0.63     | %          |
| Provision (benefit) for  credit losses |       | (0.02          | )%         | 0.06     | %          |
| Other operating expense                |       | 3.55           | %          | 3.68     | %          |
| Income before income  taxes            |       | 1.88           | %          | 1.05     | %          |
|                                   |       |           |       |     |       |
| Net income                             |       | 1.10           | %          | 0.61     | %          |

 

**CRITICAL ACCOUNTINGPOLICIES**

Ouraccounting policies are integral to understanding the results reported. Thesepolicies are described in detail in Note 1 of the Notes to ConsolidatedFinancial Statements. Our most complex accounting policies require management’sjudgment to ascertain the valuation of assets, liabilities, commitments andcontingencies. We have established detailed policies and control proceduresthat are intended to ensure valuation methods are well controlled and appliedconsistently from period to period. In addition, the policies and proceduresare intended to ensure that the process for changing methodologies occurs in anappropriate manner. The following is a brief description of our currentaccounting policies involving significant management valuation judgments.

*Allowance for Loan and Lease Losses*

Theallowance for loan and lease losses is the sum of the allowance for loan andlease losses and the reserve for contingent losses on unfunded commitments. Theallowance for loan and lease losses is a valuation adjustment used to recognizeimpairment of the recorded investment in the Company’s loans receivable on itsbalance sheet before losses have been confirmed resulting in a subsequentcharge-off or write-down. The reserve for contingent losses on unfundedcommitments is a liability accrual for unidentified but probable losses on theCompany’s commitments to fund loans. As of September 30, 2005, the reservefor contingent losses on unfunded commitments was reclassified from theallowance for loan and lease losses to other liabilities. The 2004 year endreserve for contingent losses on unfunded commitments was reclassified toconform to the current presentation.

Theallowance for loan and lease losses represents management’s best estimate ofprobable loan losses in our loans receivable and commitments to fund loans. Theallowance for loan and lease losses is determined based on management’sassessment of several factors: (i) reviews and evaluation of individual loansincluding underlying cash flow and collateral values, (ii) the level of andchanges in classified and nonperforming loans, (iii) historical loan lossexperiences, (iv) changes in the nature and volume of the loan portfolio, and(v) current economic conditions and the related impact on specific borrowersand industry groups.

Wereview and manage the credit quality of the loan portfolio through a processthat includes a risk grading system, uniform underwriting criteria, earlyidentification of problem credits, regular monitoring of any classified assetsgraded as ‘‘criticized’’ by our internal grading system, and an independentloan review process. The calculation of the adequacy of the allowance for loanand lease losses is based on this internal risk grading system as well as otherfactors including loan grade migration trends and collateral values.

Theinternal risk grading utilizes a 10-level grading system – six pass grades forunclassified loans based upon our assessment of the borrower’s ability toservice the loan and the quality of the collateral and four classificationgrades for “criticized” loans depending on the severity of the underwritingweakness and likelihood of loss. We use a statistical grading migration analysisas part of our allowance

14

----

 

for loan and leaselosses evaluation for unclassified loans, which is a method by which the typesand gradings of historical loans charged-off are related to the current loanportfolio. This analysis attempts to use historical trends in loan riskgrading, nonperforming assets and concentrations that are characteristic to ourportfolio and consider other factors affecting loan losses that are specific toour marketplace and customer demographic.

Anallowance based upon the migration analysis is determined for various loantypes and unclassified grades based upon loan risk grades and historical chargeoff experience. Adjustments to these allowance factors are made forconsideration of, among others matters, (i) changes in underwriting standardsand internal risk grading between the current loan portfolio and the historicalsample, (ii) changes in the factors that resulted in historical loanscharged-off, such as industry economic condition, and (iii) differences betweenthe current economic environment and the economic environment during the periodof historical loans charged-off.

Generally,the allowance for loan and lease losses established for classified loans thatare collateral-dependent is based on the net realizable value of thecollateral. In measuring the net realizable value of the collateral, managementuses current appraisals that, among other techniques, observe markettransactions of similar property and adjust for differences. Changes in thefinancial 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 and lease losses and the associated provision for credit losses.

On aperiodic basis we engage an outside loan review firm to review our loanportfolio, risk grade accuracy and the reasonableness of loan evaluations. Annually,this outside loan review team analyzes our methodology for calculating theallowance for loan and lease losses based on our loss histories and policies.

Weutilize our judgment to determine the provision for credit losses and establishthe allowance for loan and lease losses. Each Bank’s board of directors reviewsthe adequacy of that Bank’s allowance for loan and lease losses on a quarterlybasis. We believe, based on information known to management, that the allowancefor loan and lease losses at December 31, 2005 represents the probableloan losses in loans receivable. However, credit quality is affected by manyfactors beyond our control, including local and national economies, and factsmay exist which are not known to us that adversely affect the likelihood ofrepayment of various loans in the loan portfolio and realization of collateralupon a default. Accordingly, no assurance can be given that we will not sustainloan losses materially in excess of the allowance for loan and lease losses. Inaddition, the OCC, as an integral part of its examination process, periodicallyreviews the allowance for loan and lease losses and could develop an estimatethat requires additional provisions for credit losses.

*Goodwilland Other Intangible Assets*

Asdiscussed in Note 2 of the Notes to Consolidated Financial Statements, we mustassess goodwill and other intangible assets each year, or more frequently uponthe occurrence of certain events, for impairment. Impairment is the conditionthat exists when the carrying amount of the asset exceeds its implied fairvalue.

Thegoodwill impairment test involves comparing the fair value of South Bay withits carrying amount, including goodwill. We retained an independent valuationconsultant to evaluate the goodwill as of October 1, 2005. The valuationconsultant conducted the analysis utilizing two valuation methods – the incomeapproach and the market approach.

Theincome approach measures the present worth of anticipated future net cash flowsgenerated by South Bay. Net cash flow forecasts require analysis of thesignificant variables influencing revenues, expenses, working capital andcapital investment as well as residual value and cost of capital. Our forecastswere for a three-year period reflecting average annual asset growth of 11.8%,an average loan to deposit ratio of 106%, an average net interest margin of5.36%, and average annual return on assets of 1.57%. A 10.8% cost of capitaland a $58.4 million residual value was utilized in the analysis to discount theprojected cash flows.

Themarket approach derives a valuation by analyzing the prices at which shares ofcapital stock of reasonably similar companies are trading in the public market,or the transaction price at which similar companies have been acquired. Theanalysis identified eighteen transactions during the period from October 2002through September 2004 involving acquired companies located in the stateof California with similarities to South Bay in size and operatingcharacteristics. Transaction multiples were considered for purchase price to(i) earnings, and (ii) tangible book value. The purchase price to earningsmultiple for the South Bay acquisition was 11.38 compared to a range from 6.88to 91.00 with an average of 28.01 for the transactions studied. The South Baytransaction purchase price to tangible book value multiple was 1.55 compared toa range of 1.35 to 3.93 with an average of 2.53 for the comparabletransactions.

Theconsultant also analyzed our stock price as part of its market approachanalysis. This analysis involved applying price multiples based on our stock priceat or near the valuation date to the performance measures of South Bay. Additionally,the consultant considered guideline companies operating in the same marketsegment as South Bay. The stock trading values of similar companies were notconsidered reliable due to the small volume of trading activity, however, theresults were not inconsistent with those of the transaction method.

Thefair value indications derived from the income approach was $55.9 million andfrom the two market approaches, transaction and stock price analysis, $50.2million and $47.5 million, respectively. The fair value of South Bay under bothapproaches exceeds the carrying value at October 1, 2005 of $22.3 million,therefore, goodwill is not considered impaired. The testing of goodwill andother intangible assets for impairment requires re-measurement of fair values. Ifthe future fair values were materially less than the recorded

15

----

 

value, we would berequired to take a charge against earnings to write down the goodwill and otherintangible assets to the lower value.

*Deferred Tax Assets*

AtDecember 31, 2005 we had total deferred tax assets of $4.3 million ofwhich $2.5 million is represented by (i) federal NOLs of $5.0 million, whichbegin to expire in 2009; and (ii) a federal AMT credit carry forward of$544,000. In order to utilize the benefit of the deferred tax assets related tothe NOLs, we must generate aggregate taxable income equal to the amount of theNOLs during the period prior to their expiration.

Iffuture taxable income should prove non-existent or less than the amount of theNOLs that created the deferred tax assets within the tax years to which theymay be applied, the asset may not be realized. A valuation allowance may beestablished to reduce the deferred tax asset to its realizable value. Anyadjustment required to the valuation allowance is coupled with a related entryto income tax expense. A charge to earnings will be made in the event that wedetermine that a valuation allowance to the deferred tax asset is necessary. Ourdeferred tax assets are described further in Note 6 of the Notes toConsolidated Financial Statements.

We useestimates of future taxable income to evaluate if it is more likely than notthat the benefit of our deferred tax assets will be realized. Our analysisutilizes alternative scenarios reflecting a range of assumptions for assetgrowth rates, loan to deposit ratios, interest rates and inflation rates. Theresults of the analysis support our position that it is more likely than notthat our deferred tax assets will be realized.

*DerivativeInstruments and Hedging*

Weutilize derivative instruments to manage our risk to changes in interest rates.Statement of Financial Accounting Standards No. 133 Accounting for DerivativeInstruments and Hedging Activities (SFAS 133) requires that an entity recognizeall derivatives as either assets or liabilities in the balance sheet andmeasure those instruments at fair value. If certain conditions are met, aderivative may be specifically designated as a hedge and earnings are affectedonly to the extent to which the hedge is not effective in achieving offsettingchanges in fair value or cash flows of the hedged item. We have designatedcertain of our derivative instruments as hedges and consider them highly effective.Circumstances may change increasing the extent that the hedge is not effectiveresulting in a greater portion of the change in value of the derivativeinstruments being reported in earnings.

Wehave other derivatives that hedge exposures when it makes economic sense to doso, including circumstances in which the hedging relationship does not qualifyfor hedge accounting. The changes in the fair value of these derivatives arerecorded as trading gains or losses on economic derivatives in the statement ofoperations.

**OPERATIONSSUMMARY ANALYSIS**

**NetInterest Income**

Ourearnings depend largely upon the difference between the income earned on ourloans and other investments and the interest paid on our deposits and borrowedfunds. This difference is net interest income. Our ability to generate netinterest income is largely dependent on our ability to maintain sound assetquality and appropriate levels of capital and liquidity. In the event that weare unable to maintain sound asset quality, capital or liquidity it mayadversely affect (i) the ability to accommodate desirable borrowing customers,thereby inhibiting growth in quality higher-yielding earning assets; (ii) theability to attract comparatively stable, lower-cost deposits; and (iii) thecosts of wholesale funding sources.

Netinterest income increased $5.0 million to $20.8 million during 2005 compared to2004 due to a $6.8 million increase in interest income offset by a $1.9 millionincrease in interest expense. The restatement eliminating hedge accountingtreatment for the interest rate swap on our junior subordinated debenturesresulted in a reclassification of the interest rate swap net settlement paymentfrom interest expense to other operating income increasing interest expense$347,000 and $597,000 for the years ended December 31, 2005 and 2004,respectively.

Loaninterest income increased $6.1 million due to $30.7 million greater averagevolume of loans receivable and a 133 basis point increase in yield, resultingprimarily from increases in the prime rate lending index and interest rateswaps. During the second half of 2004, the Federal Reserve Bank increasedinterest rates 125 basis points on five occasions after a prolonged period ofaccommodative monetary policy in response to signs of stronger economicactivity and perceived higher inflation risk. Continuing in 2005, the FederalReserve Bank increased interest rates 200 basis points on eight occasions. Approximately75% of our $338.6 million loans receivable at December 31, 2005, adjustableinterest rates; consequently, rising interest rates positively affect interestincome. In order to lessen the impact on interest income in the event of adecline in the prime rate lending index, we have entered into interest rateswaps, in which we exchanged an adjustable rate interest based on the primerate lending index for a fixed rate payment on an aggregate notional amount of$50.0 million. The higher yields earned on our loans receivable during 2005were partially offset by the rising cost of certain interest rate swaps;however, these interest rate swaps still contributed 12 basis points to theincrease in loan yield compared to 2004.

Thegreater volume of loans receivable was due to a $41.8 million increase inconstruction and land development loans reflecting stronger residentialconstruction loan demand and the funding of previously approved constructionloans. Recent data and events, however, reflect slowing of national residentialsales activity and slowing of the growth in residential real estate prices. Whilereal estate activity in western states remains relatively strong, a morepronounced slowing in our lending areas would likely negatively impact the

16

----

 

growth of ourconstruction loans. Consumer loans increased $4.7 million primarily due togrowth in our insurance premium financing.

Offsettingthe growth in these loan categories, real estate loans secured by commercialreal properties declined $14.3 million during 2005 due to more rapid repaymentof loans than funding of newly originated loans. We have experienced rigorousprice competition for commercial real estate loans, and an increase in borrowerrefinancing of our adjustable rate loans for fixed rate loans with otherlenders, particularly as rising short-term interest rates have approachedlonger-term fixed interest rate levels. We have experienced strong activity indeveloping new business relationships, evidenced by growth in unfundedcommitments, however, commercial loans – secured and unsecured, declined $9.0million due to a decrease in utilization of lines of credit. This decrease incredit utilization is due to greater borrower liquidity resulting fromrelatively strong local economic activity.

Interestincome from securities available-for-sale increased $719,000 during 2005 comparedto 2004 due to $10.0 million greater average volume and an 82 basis pointincrease in yield. During the third and fourth quarter of 2005, we acceleratedour investment activity as part of a strategy to further reduce the exposure ofnet interest income to a declining interest rate environment. The additions tosecurities available-for-sale have largely been low-coupon, intermediate-term,15- and 20-year mortgage-backed security pools, purchased at a discount that weexpect to have limited prepayment of principal in the event of declininginterest rates (and muted term extension in rising interest rates). Theseinvestments, as well as loans receivable, have been largely financed withadjustable rate wholesale funds that will decline in cost in a falling interestrate environment. The securities available-for-sale purchased during 2005, in aperiod of higher interest rates, and the maturity of lower yielding securitiesin the portfolio, resulted in an increase in the portfolio yield.

Additionally,during 2005 we reallocated short-term lower-yielding federal funds sold, whichaveraged $6.0 million less than 2004, into higher yielding earning assets. Furthermore,through deposit reclassification utilizing non-transaction sub accounts, wereduced our required reserves at the Federal Reserve Bank resulting in theredeployment of $6.5 million in noninterest-bearing cash and due from banks –demand. Overall, interest-earning assets were $32.3 million greater during 2005than 2004 while the higher interest rates and favorable change in compositionto higher-yielding assets resulted in a 133 basis point increase in weightedaverage yield on interest-earning assets.

Interestexpense increased $1.9 million for 2005 due to a $19.7 million increase inaverage interest-bearing liabilities and a 64 basis point increase in theweighted average cost of interest-bearing liabilities. Interest expense ondeposits increased $1.8 million due to a 75 basis point rise in weightedaverage cost of interest-bearing deposits in addition to $20.2 million greateraverage volume than 2004. Time certificates of deposit $100,000 and overaveraged $24.8 million greater during 2005 than 2004 due to an increased volumeof brokered certificates of deposit (“Brokered CDs”). The volume of money marketand savings deposits declined $4.3 million in 2005 and time certificates ofdeposit under $100,000 declined $1.3 million. Relatively low costinginterest-bearing demand deposits averaged $1.0 million greater in 2005 than in2004.

Duringthe rising interest rate environment experienced during the past six quarters,we strategically elected to only moderately increase transaction deposit ratesand to fund asset growth, and runoff of these deposits, with Brokered CDs. Althoughthis type of funding is typically higher costing and exhibits higher interestrate sensitivity, the Brokered CDs facilitate our liquidity and interest raterisk management that we utilize to reduce our net interest income exposure topossible declining interest rates. The greater interest expense on theincremental Brokered CDs needed to fund asset growth, and any decrease intransaction deposits, is less than the impact of increasing rates on thesignificantly greater volume of transaction accounts. In a sustained risinginterest rate environment, nonetheless, increases in deposit interest rateswill be required to prevent net deposit withdrawals.

Thecost of time certificates of deposit $100,000 and over increased 115 basispoints during 2005 compared to 2004. The cost of money market and savingsdeposits increased 60 basis points while the cost of interest-bearing demanddeposits and time certificates of deposit under $100,000 increased 24 basispoints and 65 basis points, respectively.

Thevolume of other borrowings averaged $12.2 million and $12.6 million in 2005 and2004, respectively. We continue to employ a liquidity strategy of maintainingrelatively low levels of short-term assets and utilize Federal Home Loan Bankovernight advances, against pledged loans and securities, to fund asset anddeposit fluctuations. Minimizing short-term assets and increasing short-termliabilities furthers the management of our asset sensitive balance sheet. Thecost of other borrowings was 3.38% and 2.65% for 2005 and 2004, respectively,representing an increase of 73 basis points in 2005.

Noninterest-bearingdemand deposits increased only slightly averaging $124.8 million and $124.7million in 2005 and 2004, respectively. While we continue to devote resourcesto growing our business accounts, in a rising interest rate environmentdepositors generally deploy their funds into higher yielding deposits andalternative investments outside the Banks. Additionally, our escrow companycustomers maintained lower balances due to reduced mortgage refinancing activityin the higher interest rate environment.

**InterestRate Spread and Net Interest Margin**

Weanalyze earnings performance using, among other measures, the interest ratespread and net interest margin. The interest rate spread represents thedifference between the weighted average yield received on interest earningassets and the weighted average rate paid on interest bearing liabilities. Netinterest margin (also called the net yield on interest earning assets) is netinterest income expressed as a percentage of average total interest earningassets. Our net interest margin is affected by changes in the yields earned onassets and rates paid on liabilities, referred to as rate changes, and changesto the relative amount of interest earning assets and interest bearingliabilities. Interest rates charged on our loans are affected principally bythe demand for such loans, the supply of money

17

----

 

available forlending purposes, and other competitive factors. These factors are in turnaffected by general economic conditions and other factors beyond our control,such as federal economic policies, the general supply of money in the economy,legislative tax policies, governmental budgetary matters, and actions of theFederal Reserve Board. Table 3 presents information concerning the change ininterest income and interest expense attributable to changes in average volumeand average rate. Table 4 presents the weighted average yield on each categoryof interest earning assets, the weighted average rate paid on each category ofinterest bearing liabilities, and the resulting interest rate spread and netyield on interest earning assets for 2005, 2004 and 2003. We had no tax exemptinterest income for 2005, 2004 or 2003.
|                                                                             | ** ** | **2005 vs 2004**                          | ** ** | **2004 vs 2003** | ** ** |
|-----------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                  | ** ** | ** **                                          | ** ** | ** **                 | ** ** | **Net** | ** ** | ** ** | ** ** | ** ** | ** ** | **Net** | ** ** |
| ** **                                                                  | ** ** | **Increase (decrease) due to:**      | ** ** | **Increase**               | ** ** | **Increase (decrease) due to:** | ** ** | **Increase** | ** ** |
| ** **                                                                  | ** ** | **Volume**                                          | ** ** | **Rate**                   | ** ** | **(Decrease)** | ** ** | **Volume** | ** ** | **Rate** | ** ** | **(Decrease)** | ** ** |
| ** **                                                                  | ** ** | **(Dollars in thousands, restated)** | ** ** |
| Interest Income:                                                            |       |                                                |       |                       |       |   |   |   |   |   |   |   |   |
| Federal funds sold and securities purchased under  agreement to resell      |       | $                                                   | (75        | )                          | $          | 30 |   | $ | (45 | ) | $ | (278 | ) | $ | 14 |   | $ | (264 | ) |
| Due from banks - interest bearing                                           |       | (22                                                 | )          | 67                         |       | 45 |   | 29 |   | 10 |   | 39 |   |
| Securities available-for-sale                                               |       | 297                                                 |       | 422                        |       | 719 |   | 565 |   | (241 | ) | 324 |   |
| Securities held-to-maturity                                                 |       | (38                                                 | )          | 6                          |       | (32 | ) | 10 |   | 105 |   | 115 |   |
| Loans receivable (2)                                                        |       | 1,944                                               |       | 4,180                      |       | 6,124 |   | 1,373 |   | 743 |   | 2,116 |   |
| Total interest-earning assets                                               |       | 2,106                                               |       | 4,705                      |       | 6,811 |   | 1,699 |   | 631 |   | 2,330 |   |
|                                                                        |       |                                                |       |                       |       |   |   |   |   |   |   |   |   |
| Interest  Expense:                                                          |       |                                                |       |                       |       |   |   |   |   |   |   |   |   |
| Interest-bearing deposits:                                                  |       |                                                |       |                       |       |   |   |   |   |   |   |   |   |
| Demand                                                                      |       | $                                                   | 3          |                       | $          | 75 |   | $ | 78 |   | $ | 14 |   | $ | (60 | ) | $ | (46 | ) |
| Money market and savings                                                    |       | (30                                                 | )          | 623                        |       | 593 |   | 84 |   | (240 | ) | (156 | ) |
| Time certificates of deposit:                                               |       |                                                |       |                       |       |   |   |   |   |   |   |   |   |
| $100,000 or more                                                            |       | 368                                                 |       | 594                        |       | 962 |   | (36 | ) | (96 | ) | (132 | ) |
| Under $100,000                                                              |       | (23                                                 | )          | 170                        |       | 147 |   | (140 | ) | (170 | ) | (310 | ) |
| Total time certificates of deposit                                          |       | 345                                                 |       | 764                        |       | 1,109 |   | (176 | ) | (266 | ) | (442 | ) |
| Total interest-bearing deposits                                             |       | 318                                                 |       | 1,462                      |       | 1,780 |   | (78 | ) | (566 | ) | (644 | ) |
| Other borrowings                                                            |       | (10                                                 | )          | 90                         |       | 80 |   | 243 |   | (272 | ) | (29 | ) |
| Junior subordinated debentures (3)                                          |       | —                                              |       | —                     |       | — |   | 792 |   | — |   | 792 |   |
| Federal funds purchased and securities sold under  agreements to repurchase |       | (1                                                  | )          | —                     |       | (1 | ) | (13 | ) | (2 | ) | (15 | ) |
| Total interest-bearing liabilities                                          |       | 307                                                 |       | 1,552                      |       | 1,859 |   | 944 |   | (840 | ) | 104 |   |
|                                                                        |       |                                                |       |                       |       |   |   |   |   |   |   |   |   |
| Net interest  income                                                        |       | $                                                   | 1,799      |                       | $          | 3,153 |   | $ | 4,952 |   | $ | 755 |   | $ | 1,471 |   | $ | 2,226 |   |

 

----

(1)            The change in interestincome or interest expense that is attributable to both changes in averagebalance and average rate has been allocated to the changes due to (i) averagebalance and (ii) average rate in proportion to the relationship of the absoluteamounts of changes in each.

(2)            Table does not includeinterest income that would have been earned on nonaccrual loans.

(3)            The implementation ofFASB Interpretation No. 46, effective July 1, 2003 resulted in thereclassification of the Company’s Junior Subordinated Debentures from mezzanineequity to liabilities and the related interest to interest expense after June30, 2003.

18

----

 

**Table 4Average Balance Sheet and Analysis of Net Interest Income**
| ** **                                                                                                                    | ** ** | **2005**                                            | ** ** | **2004**     | ** ** | **2003**     | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|--------------|------------|--------------|------------|
| ** **                                                                                                                    | ** ** | ** **                                          | ** ** | ** **   | ** ** | **Weighted** | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                                                                                                                    | ** ** | ** **                                          | ** ** | **Interest** | ** ** | **Average**  | ** ** | ** ** | ** ** | **Interest** | ** ** | **Average** | ** ** | ** ** | ** ** | **Interest** | ** ** | **Average** | ** ** |
| ** **                                                                                                                    | ** ** | **Average**                                         | ** ** | **Income/**  | ** ** | **Yield/**   | ** ** | **Average** | ** ** | **Income/** | ** ** | **Yield/** | ** ** | **Average** | ** ** | **Income/** | ** ** | **Yield/** | ** ** |
| ** **                                                                                                                    | ** ** | **Amount**                                          | ** ** | **Expense**  | ** ** | **Rate**     | ** ** | **Amount** | ** ** | **Expense** | ** ** | **Rate** | ** ** | **Amount** | ** ** | **Expense** | ** ** | **Rate** | ** ** |
| ** **                                                                                                                    | ** ** | **(Dollars in thousands, restated)** | ** ** |
| Assets:                                                                                                                       |       |                                                |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Federal funds  sold and securities purchased under agreements to resell                                                       |       | $                                                   | 1,647      |         | $          | 50           |       | 3.04 | % | $ | 7,651 |   | $ | 95 |   | 1.24 | % | $ | 33,829 |   | $ | 359 |   | 1.06 | % |
| Due from banks -  interest bearing                                                                                            |       | 2,187                                               |       | 101          |       | 4.62         | %          | 3,566 |   | 56 |   | 1.57 | % | 1,304 |   | 17 |   | 1.30 | % |
| Securities  available-for-sale                                                                                                |       | 51,595                                              |       | 1,954        |       | 3.79         | %          | 41,603 |   | 1,235 |   | 2.97 | % | 25,672 |   | 911 |   | 3.55 | % |
| Securities  held-to-maturity                                                                                                  |       | 3,070                                               |       | 121          |       | 3.94         | %          | 4,085 |   | 153 |   | 3.75 | % | 3,254 |   | 38 |   | 1.17 | % |
| Loans receivable  (1) (2)                                                                                                     |       | 314,164                                             |       | 24,039       |       | 7.65         | %          | 283,415 |   | 17,915 |   | 6.32 | % | 260,756 |   | 15,799 |   | 6.06 | % |
| Total interest earning assets                                                                                                 |       | 372,663                                             |       | $            | 26,265     |         | 7.05       | % | 340,320 |   | $ | 19,454 |   | 5.72 | % | 324,815 |   | $ | 17,124 |   | 5.27 | % |
|                                                                                                                          |       |                                                |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest  earning assets:                                                                                                  |       |                                                |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash and due from banks - demand                                                                                              |       | 16,374                                              |       |         |       |         |       | 22,874 |   |   |   |   |   | 22,171 |   |   |   |   |   |
| Other assets                                                                                                                  |       | 20,775                                              |       |         |       |         |       | 21,529 |   |   |   |   |   | 21,859 |   |   |   |   |   |
| Allowance for loan and lease losses and net  unrealized (loss) gain on sales of securities available-for-sale                 |       | (4,769                                              | )          |         |       |         |       | (3,753 | ) |   |   |   |   | (4,025 | ) |   |   |   |   |
| Total assets                                                                                                                  |       | $                                                   | 405,043    |         |       |         |       |   | $ | 380,970 |   |   |   |   |   | $ | 364,820 |   |   |   |   |   |
|                                                                                                                          |       |                                                |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Liabilities and  shareholders’ equity:                                                                                   |       |                                                |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  deposits:                                                                                                   |       |                                                |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Demand                                                                                                                        |       | $                                                   | 32,497     |         | $          | 158          |       | 0.49 | % | $ | 31,484 |   | $ | 80 |   | 0.25 | % | $ | 28,269 |   | $ | 126 |   | 0.45 | % |
| Money market and savings                                                                                                      |       | 103,648                                             |       | 1,342        |       | 1.29         | %          | 107,981 |   | 749 |   | 0.69 | % | 98,763 |   | 905 |   | 0.92 | % |
| Time certificates  of deposit:                                                                                                |       |                                                |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| $100,000 or more                                                                                                              |       | 51,995                                              |       | 1,365        |       | 2.63         | %          | 27,179 |   | 403 |   | 1.48 | % | 29,150 |   | 535 |   | 1.84 | % |
| Under $100,000                                                                                                                |       | 26,031                                              |       | 620          |       | 2.38         | %          | 27,345 |   | 473 |   | 1.73 | % | 33,316 |   | 783 |   | 2.35 | % |
| Total time certificates of deposit                                                                                            |       | 78,026                                              |       | 1,985        |       | 2.54         | %          | 54,524 |   | 876 |   | 1.61 | % | 62,466 |   | 1,318 |   | 2.11 | % |
| Total interest-bearing deposits                                                                                               |       | 214,171                                             |       | 3,485        |       | 1.63         | %          | 193,989 |   | 1,705 |   | 0.88 | % | 189,498 |   | 2,349 |   | 1.24 | % |
| Other borrowings                                                                                                              |       | 12,186                                              |       | 412          |       | 3.38         | %          | 12,550 |   | 332 |   | 2.65 | % | 7,500 |   | 361 |   | 4.81 | % |
| Junior  subordinated debentures (3)                                                                                           |       | 15,464                                              |       | 1,585        |       | 10.25        | %          | 15,464 |   | 1,585 |   | 10.25 | % | 7,733 |   | 793 |   | 10.25 | % |
| Federal funds  purchased and securities sold under agreements to repurchase                                                   |       | —                                              |       | —       |       | —       |       | 113 |   | 1 |   | 0.88 | % | 609 |   | 16 |   | 2.63 | % |
| Total interest-bearing liabilities                                                                                            |       | 241,821                                             |       | 5,482        |       | 2.27         | %          | 222,116 |   | 3,623 |   | 1.63 | % | 205,340 |   | 3,519 |   | 1.71 | % |
|                                                                                                                          |       |                                                |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  liabilities:                                                                                             |       |                                                |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest bearing demand deposits                                                                                           |       | 124,789                                             |       |         |       |         |       | 124,699 |   |   |   |   |   | 119,789 |   |   |   |   |   |
| Other liabilities                                                                                                             |       | 1,811                                               |       |         |       |         |       | 1,086 |   |   |   |   |   | 845 |   |   |   |   |   |
| Guaranteed  preferred beneficial interests in the Company’s junior subordinated  deferrable interest debentures, net (3) |       | —                                              |       |         |       |         |       | — |   |   |   |   |   | 7,267 |   |   |   |   |   |
| Shareholders’  equity                                                                                                    |       | 36,622                                              |       |         |       |         |       | 33,069 |   |   |   |   |   | 31,579 |   |   |   |   |   |
| Total liabilities  and shareholders’ equity                                                                              |       | $                                                   | 405,043    |         |       |         |       |   | $ | 380,970 |   |   |   |   |   | $ | 364,820 |   |   |   |   |   |
|                                                                                                                          |       |                                                |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest  income (interest rate spread)                                                                                   |       |                                                |       | $            | 20,783     |         | 4.78       | % |   |   | $ | 15,831 |   | 4.09 | % |   |   | $ | 13,606 |   | 3.56 | % |
|                                                                                                                          |       |                                                |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net yield on  interest earning assets (2)                                                                                     |       |                                                |       |         |       | 5.58         | %          |   |   |   |   | 4.65 | % |   |   |   |   | 4.19 | % |

 

----

(1)             The average balanceof nonperforming loans has been included in loans receivable.

(2)             Yields and amountsearned on loans receivable include loan fees of $1,725,000, $1,383,000 and$882,000 for the years ended December 31, 2005, 2004 and 2003, respectively.

(3)             Theimplementation of FASB Interpretation No. 46, effective July 1, 2003 resultedin the reclassification of the Company’s Junior Subordinated Debentures from mezzanineequity to liabilities and the related interest to interest expense after June30, 2003.

19

----

 

Ournet interest margin increased 93 basis points from 4.65% during 2004 to 5.58%in 2005. Our net interest margin remains high in comparison with the interestrate spread due to the continued significance of noninterest-bearing demanddeposits relative to total funding sources. Average noninterest bearing demanddeposits were $124.8 million, representing 36.8% of average deposits, during2005, compared to $124.7 million, representing 39.1% of average deposits,during 2004. Of these noninterest bearing demand deposits during 2005, $14.7million or 11.8% of average noninterest bearing deposits were represented byreal estate title and escrow company deposits, compared to $16.2 million or13.0% of average noninterest bearing deposits during 2004. While these depositsare noninterest bearing, they are not cost free funds. Customer serviceexpenses, primarily costs related to external accounting and data processing servicesprovided to title and escrow company depositors are incurred by us to theextent that such depositors maintain certain average noninterest bearingdeposits. Customer service expense is classified as other operating expense. Ifcustomer service expenses related to escrow customers had been classified asinterest expense, our reported net interest income for 2005 and 2004 would havebeen reduced by $370,000 and $137,000, respectively, and the net interestmargin for 2005 and 2004 would have decreased 36 basis points and 4 basispoints, respectively. Similarly, this would create identical reductions inother operating expense. The expense associated with these deposits increasedin 2005 from 2004 despite the decrease in volume due to a greater allowance forcustomer services provided for these depositors.

Therestatement adjustment increasing interest expense reduced the net yield oninterest earning assets and the interest rate spread 9 basis points and 14basis points, respectively, for the year ended December 31, 2005 and 18 basispoints and 27 basis points, respectively, for the year ended December 31, 2004.

**Provision/Benefitfor Credit Losses**

During2005, we recorded a benefit for credit losses of $84,000 compared to a $220,000provision for credit losses in 2004 following our valuation assessment of theallowance for loan and lease losses and the reserve for contingent losses onunfunded commitments. Impacting the allowance in 2005, among other items, was asignificant recovery of a loan previously charged off partially offset byrelatively strong growth in loans receivable and unfunded loan commitments. In2005 net recoveries were $1.2 million compared to net recoveries $73,000 in2004.

Assumingcontinued loan growth, and based on the relative uncertainty regarding thestate of the economy, and the level of nonperforming loans, it is anticipatedthat regular provisions for credit losses will be made during 2006. Creditquality will be influenced by underlying trends in the economic cycle,particularly in Southern California, and other factors, which are beyondmanagement’s control. Accordingly, no assurance can be given that we will notsustain loan losses that in any particular period are sizable in relation tothe allowance for loan and lease losses. Subsequent evaluation of the loanportfolio, in light of factors then prevailing, by us and our regulators mayindicate a requirement for increases in the allowance for loan and lease lossesthrough additions to the provision for credit losses.

**OtherOperating Income**

Otheroperating income was $1.1 million and $2.4 million in 2005 and 2004,respectively. The decline was due to (i) a $395,000 trading loss on economicderivatives compared to a $229,000 trading gain for 2004, (ii) a $250,000decline in net settlement payments from an interest rate swap not designated asa hedge, and (iii) $592,000 lower deposit account fees resulting from greaterallowances for compensating balances and changes in deposit fee structures. In2004, there was a net loss of $197,000 on sales of securitiesavailable-for-sale. Fee income related to international services was $52,000 in2005 compared to $59,000 in 2004. Investment services fees were $54,000 in 2005compared to $53,000 in 2004.

**OtherOperating Expenses**

Otheroperating expense increased $348,000 to $14.4 million in 2005, compared to$14.0 million during 2004. Salaries and related benefits increased $280,000 or3.7% to $7.8 million, primarily due to the addition of business developmentstaff during the year, as well as larger management bonuses and increasedcommissions paid to business development staff for loan production. Netoccupancy expense decreased $130,000 or 11.5% to $1.0 million primarily due tothe relocation of our administrative offices and the Century City bankingoffice. Other professional services increased $273,000 or 32.0% largely due toincreased audit and tax expense as well as professional services for creditworkouts. Other expenses decreased $150,000 largely due to a $250,000 reserveestablished during 2004 in a dispute over our lien on the collateral for a loanas well as several unrelated and nonrecurring operating losses. The dispute wasresolved during 2005.

**IncomeTaxes**

Deferredtax assets and liabilities are recognized for the expected future taxconsequences of existing differences between financial reporting and taxreporting bases of assets and liabilities, as well as for operating losses andtax credit carryforwards, using enacted tax laws and rates. Deferred tax assetswill be reduced through a valuation allowance whenever it becomes more likelythan not that all or some portion will not be realized. Deferred income taxexpense (benefit) represents the net change in the deferred tax asset orliability balance during the year. This amount, together with income taxescurrently payable or refundable in the current year, represents the total taxexpense for the year.

AtDecember 31, 2005, our deferred tax asset totaled $4.3 million,respectively, with no recorded valuation allowance.

Fortax purposes at December 31, 2005, we had (i) federal NOLs of $5.0million, which begin to expire in 2009; and (ii) a federal

20

----

 

alternativeminimum tax (“AMT”) credit carryforward of $544,000 that carries forwardindefinitely.

Anincome tax provision of $3.2 million was recorded for 2005 compared to $1.7million for 2004.

Federaland state income tax laws provide that following an ownership change of acorporation with NOLs, a net unrealized built-in loss or tax credit carryovers,the amount of annual post-ownership change taxable income that can be offset bypre-ownership change NOLs, built-in losses or tax credit carryovers generallycannot exceed a prescribed annual limitation. The annual limitation generallyequals the product of the fair market value of the corporation immediatelybefore the ownership change (subject to certain adjustments) and the federallong-term tax-exempt rate prescribed monthly by the Internal Revenue Service. Ifsuch limitations were to apply to us, our ability to reduce future taxable incomeby the NOLs could be severely limited.

**AccumulatedOther Comprehensive Income**

Accumulatedother comprehensive income is comprised of the unrealized gain or loss onavailable-for-sale securities and the unrealized gain or loss on our derivativefinancial instruments designated as cash flow hedges, net of taxes. AtDecember 31, 2005 the net unrealized loss on available-for-sale securitieswas $392,000 compared to a net unrealized loss of $39,000 at December 31,2004. The interest rate swaps designated as cash flow hedges had an unrealizedloss of $605,000 at December 31, 2005 compared to an unrealized gain of$314,000 at December 31, 2004. The interest rate floors designated as cash flowhedges had an unrealized loss of $157,000 at December 31, 2005. We had nointerest rate floors as of December 31, 2004.

**FINANCIALCONDITION**

**RegulatoryCapital**

Thefollowing table sets forth (i) the minimum regulatory capital requirements forNational Mercantile and the Banks; (ii) the capital requirements for the Banksto be “well capitalized” under the prompt corrective action rules; and (iii)the regulatory capital ratios of National Mercantile and the Banks as of thedates indicted in 2004 and 2005.

**Table 5Regulatory Capital Information of the National Mercantile and Banks**
|                                         | ** ** | **Minimum**          | ** ** | ** **      | ** ** | ** **             | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|----------------------|------------|-----------------|------------|------------------------|------------|------------|------------|
| ** **                              | ** ** | **For Capital** | ** ** | **Well**        | ** ** | ** **             | ** ** | ** ** | ** ** |
| ** **                              | ** ** | **Adequacy**         | ** ** | **Capitalized** | ** ** | **December 31,**  | ** ** |
| ** **                              | ** ** | **Purposes**         | ** ** | **Standards**   | ** ** | **2005**               | ** ** | **2004**   | ** ** |
| ** **                              | ** ** | ** **           | ** ** | ** **      | ** ** | **(As restated)** | ** ** |
| **National  Mercantile Bancorp:**       |       |                 |       |            |       |                   |       |       |       |
| Tier 1 capital  to average assets       |       | 4.00                 | %          | N/A             |       | 10.74                  | %          | 9.83       | %          |
| Tier 1 capital  to risk weighted assets |       | 4.00                 | %          | N/A             |       | 11.98                  | %          | 10.35      | %          |
| Total capital to  risk weighted assets  |       | 8.00                 | %          | N/A             |       | 13.72                  | %          | 12.39      | %          |
|                                    |       |                 |       |            |       |                   |       |       |       |
| **Mercantile  National Bank:**          | ** ** | ** **           | ** ** | ** **      | ** ** | ** **             | ** ** | ** ** | ** ** |
| Tier 1 capital  to average assets       |       | 4.00                 | %          | 5.00            | %          | 10.49                  | %          | 8.99       | %          |
| Tier 1 capital  to risk weighted assets |       | 4.00                 | %          | 6.00            | %          | 13.59                  | %          | 10.44      | %          |
| Total capital to  risk weighted assets  |       | 8.00                 | %          | 10.00           | %          | 14.84                  | %          | 11.60      | %          |
|                                    |       |                 |       |            |       |                   |       |       |       |
| **South  Bay Bank, NA:**                |       |                 |       |            |       |                   |       |       |       |
| Tier 1 capital  to average assets       |       | 4.00                 | %          | 5.00            | %          | 9.04                   | %          | 9.32       | %          |
| Tier 1 capital  to risk weighted assets |       | 4.00                 | %          | 6.00            | %          | 9.00                   | %          | 9.32       | %          |
| Total capital to risk  weighted assets  |       | 8.00                 | %          | 10.00           | %          | 10.22                  | %          | 10.29      | %          |

 

NationalMercantile’s Tier I capital, which is comprised of shareholders’ equity asmodified by certain regulatory adjustments, was $46.5 million and $38.0 millionat December 31, 2005 and 2004, respectively. National Mercantile’s Tier 1capital increased in 2005 as a result of net income, exercised stock optionsand a reduction of the portion of deferred tax asset disallowed for regulatorycapital purposes. Federal Reserve capital rules allow trust preferredsecurities to represent up to 25% of Tier 1 capital with the balance treated asTier 2 capital for the Total risk-based Capital ratio. At December 31,2005 and 2004, Trust Preferred Securities represented $13.1 million and $11.5million, respectively, of National Mercantile’s Tier 1 capital, and $1.9million and $3.5 million, respectively, of its Tier 2 capital. Disallowedagainst National Mercantile’s Tier 1 capital is $3.2 million of goodwillrecorded in the acquisition of South Bay, $1.4 million of other intangibleassets and $1.1 million of deferred tax asset based upon estimated earnings.

Mercantile’sTier 1 capital was $24.8 million and $19.4 million at December 31, 2005and 2004, respectively. The increase in Tier

21

----

 

1 capital during2005 was due to net income and the decrease of the portion of deferred taxasset disallowed for regulatory capital purposes.

SouthBay’s Tier 1 capital at December 31, 2005 was $18.7 million compared to$17.1 million at December 31, 2004. The increase is due to net income in2005.

**LiquidityManagement**

Theobjective of liquidity management is to maintain cash flow adequate to fund ouroperations and meet obligations and other commitments on a timely and costeffective basis. We manage to this objective primarily through the selection ofasset and liability maturity mixes. Our liquidity position is enhanced by theability to raise additional funds as needed through available borrowings oraccessing the wholesale deposit market.

Ourdeposit base provides the majority of our funding requirements. Deposits, arelatively stable and low-cost source of funds has, along with shareholders’equity, provided 92.7% and 92.3 % of funding for average total assets during2005 and 2004, respectively. The other borrowings, specifically Federal HomeLoan Bank (“FHLB”) advances, which averaged $12.2 million during 2005 comparedto $12.6 million during 2004, and federal funds purchased and securities soldunder agreements to repurchase, which had no balances in 2005 compared to$113,000 in 2004, comprise the balance of the liability funding. The otherborrowings during 2005 and 2004 were used to fund higher yielding loans andsecurities.

Also,federal funds sold and securities purchased under resale agreements that may beimmediately converted to cash at minimal cost. The aggregate of these assetsaveraged $1.6 million during 2005, as compared to $7.7 million during 2004.

Theportfolio of available-for-sale securities is an additional source ofliquidity, which averaged $51.6 million during 2005 compared to $41.6 millionin 2004. The securities available-for-sale increased in 2005 due to thedeployment of funds into securities pending redeployment into loans. Except fora relatively small amount of securities pledged to collateralize public funds,deposits of bankruptcy estates and our swaps, our securities are pledged to theFHLB to secure immediately available borrowings. At December 31, 2005,$64.4 million of securities were pledged to the FHLB and an additional $38.0million borrowing capacity remained. There were no unpledged investmentsecurities at December 31, 2005. Maturing loans also provide liquidity, ofwhich $175.6 million of the Banks’ loans are scheduled to mature in 2006.

Netcash provided by operating activities totaled $7.9 million in 2005 compared to$5.4 million in 2004. The primary source of funds is net income from operationsadjusted for provision for credit losses and depreciation and amortization. Netcash used in investing activities totaled $61.4 million in 2005 compared to$61.0 million net cash used in investing activities in 2004. The increase incash used by investing activities was primarily due to an increase in purchasesof securities available-for-sale partially offset by a decrease in loanoriginations, net of loan paydowns and payoffs. Net cash provided by financingactivities was $52.9 million in 2005 compared to $33.2 million provided byfinancing activities in 2004. The increase in 2005 net cash provided resultedprimarily from an increase in time certificates of deposit offset by a decreasein other borrowed funds.

**InterestRate Risk Management**

Interestrate risk management seeks to maintain a stable growth of income and manage therisk associated with changes in interest rates. Net interest income, theprimary source of earnings, is affected by interest rate movements. Changes ininterest rates have a lesser impact the more that assets and liabilitiesreprice in approximately equivalent amounts at basically the same timeintervals. Imbalances in these repricing opportunities at any point in timeconstitute interest sensitivity gaps, which is the difference between interestsensitive assets and interest sensitive liabilities.

Interestrate risk, including interest rate sensitivity and the repricingcharacteristics of assets and liabilities, is managed by our Balance SheetManagement Committee (“BSMC”). The principal objective of BSMC is to maximizenet interest income within acceptable levels of risk established by policy.

Wemanage interest rate sensitivity by matching the repricing opportunities on ourearning assets to those on our funding liabilities. We use various strategiesto manage the repricing characteristics of our assets and liabilities to ensurethat exposure to interest rate fluctuations is limited within guidelines ofacceptable levels of risk-taking. Hedging strategies, including the terms andpricing of loans and deposits, the use of derivative financial instruments andmanaging the deployment of our securities are used to reduce mismatches ininterest rate repricing opportunities of portfolio assets and their fundingsources.

Interestrate sensitivities are monitored through the use of simulation modelingtechniques that apply alternative interest rate scenarios to periodic forecastsof future business activity and estimate the related impact on net interestincome. The use of simulation modeling assists management in its continuingefforts to achieve earnings growth in varying interest environments. Table 6shows the change in net interest income for one year given a 200 basis pointdecrease and increase in interest rates at December 31, 2005 based upon ourinterest rate simulation model:

22

----

**Table 6**

**Net Interest Income at Risk Modeling**
| ** **                           | ** ** | **Interest rate scenario**              | ** ** |
|--------------------------------------|------------|---------------------------------------------------|------------|
| ** **                           | ** ** | **200 Basis Point  Decrease** | ** ** | ** ** | ** ** | **200 Basis Point Increase** | ** ** |
| ** **                           | ** ** | ** **                                        | ** ** | **Change from** | ** ** | ** ** | ** ** | **Base** | ** ** | ** ** | ** ** | **Change from** | ** ** | ** ** | ** ** |
| ** **                           | ** ** | **Amount**                                        | ** ** | **Base Amount** | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Amount** | ** ** | **Base Amount** | ** ** | **Percent** | ** ** |
| Change in net interest  income:      |       |                                              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Months one  through twelve           |       | $                                                 | 22,034     |   | $ | (1,191 | ) | -5.13 | % | $ | 23,225 |   | $ | 24,187 |   | $ | 962 |   | 2.85 | % |
| Months thirteen  through twenty-four |       | 21,100                                            |       | (2,158 | ) | -9.28 | % | 23,258 |   | 24,904 |   | 1,646 |   | 5.94 | % |
| Total for twenty-four  months        |       | $                                                 | 43,134     |   | $ | (3,349 | ) | -5.91 | % | $ | 46,483 |   | $ | 49,091 |   | $ | 2,608 |   | 4.32 | % |

 

Themodel results reflect a net interest income exposure to declining interestrates.  Our asset sensitivity in adeclining interest rate scenario will have a negative effect on our netinterest income as changes in the rates of interest bearing depositshistorically have not changed proportionately with changes in market interestrates.  Additionally, in low anddeclining interest rate environments, such as the environment experienced in2003, the interest rates paid on funding liabilities may begin to reach floorspreventing further downward adjustments while rates on earning assets continueto adjust downward.  This condition willlikewise have a negative impact on our net interest income.  Conversely, our asset sensitivity in a risinginterest rate environment is expected to have a positive affect on earnings asa greater amount of earning assets than funding liabilities reprice upward andhistorically the rates of interest bearing deposits adjust upward more slowlyand in smaller increments.

Keyassumptions in the model include anticipated prepayments on mortgage-relatedinstruments, contractual cash flow and maturities of all financial instruments,anticipated future business activity, deposit rate sensitivity and changes inmarket conditions.  These assumptions areinherently uncertain and, as a result, these models cannot  precisely estimate the impact that higher or lowerrate environments will have on net interest income.  Actual results will differ from simulatedresults due to the timing, magnitude and frequency of interest rate changes,changes in cash flow patterns and market conditions, as well as changes inmanagement’s strategies.

**InvestmentSecurities**

Weinvest in investment securities consisting primarily of U.S. agency securitiesand mortgage-related securities to: (i) generate interest income pending theability to deploy those funds in loans meeting our lending strategies; (ii)increase net interest income where the rates earned on such investments exceedthe related cost of funds, consistent with the management of interest raterisk; and (iii) provide sufficient liquidity in order to maintain cash flowadequate to fund our operations and meet obligations and other commitments on atimely and cost efficient basis.  During2005 and 2004, we held no tax-exempt securities.

Wegenerally classify our investment securities as available-for-sale except forinvestment securities we have the ability and the positive intent to hold tomaturity which are classified as held-to-maturity securities.

Table7 provides certain information regarding our investment securities.

23

----

**Table 7**

 

**EstimatedFair Values of and Unrealized**

**Gainsand Losses on Investment Securities**

 
| ** **                                                                | ** ** | **December 31, 2005**      | ** ** |
|---------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                | ** ** | **Total**                            | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                                                                | ** ** | **amortized**                        | ** ** | **unrealized** | ** ** | **unrealized** | ** ** | **fair** | ** ** |
| ** **                                                                | ** ** | **cost**                             | ** ** | **gains** | ** ** | **loss** | ** ** | **value** | ** ** |
| ** **                                                                | ** ** | **(Dollars in thousands)** | ** ** |
| **Available-For-Sale:**                                                   | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| U.S. Treasury  securities                                                 |       | $                                    | 599        |   | $ | — |   | $ | — |   | $ | 599 |   |
| GNMA-issued/guaranteed  mortgage pass through certificates                |       | 98                                   |       | 2 |   | — |   | 100 |   |
| Other U.S.  government and federal agency securities                      |       | 17,931                               |       | — |   | 152 |   | 17,779 |   |
| FHLMC/FNMA-issued  mortgage pass through certificates                     |       | 33,982                               |       | 47 |   | 366 |   | 33,663 |   |
| CMO’s and  REMIC’s issued by U.S. government-sponsored agencies |       | 2,528                                |       | 13 |   | — |   | 2,541 |   |
| Privately issued  corporate bonds, CMO and REMIC securities               |       | 17,290                               |       | 3 |   | 217 |   | 17,076 |   |
|                                                                      |       | $                                    | 72,428     |   | $ | 65 |   | $ | 735 |   | $ | 71,758 |   |
|                                                                      |       |                                 |       |   |   |   |   |   |   |
| FRB and other stock                                                       |       | $                                    | 3,809      |   | — |   | — |   | $ | 3,809 |   |

 
| ** **                                            | ** ** | **December 31, 2005**      | ** ** |
|-------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                            | ** ** | **Total**                            | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                                            | ** ** | **amortized**                        | ** ** | **unrealized** | ** ** | **unrealized** | ** ** | **fair** | ** ** |
| ** **                                            | ** ** | **cost**                             | ** ** | **gains** | ** ** | **loss** | ** ** | **value** | ** ** |
| ** **                                            | ** ** | **(Dollars in thousands)** | ** ** |
| **Held-to-Maturity:**                                 | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| FHLMC/FNMA-issued  mortgage pass through certificates | ** ** | $                                    | 2,612      |   | $ | — |   | $ | 40 |   | $ | 2,572 | ** ** |
|                                                  | ** ** | $                                    | 2,612      |   | $ | — |   | $ | 40 |   | $ | 2,572 | ** ** |

 
| ** **                                                                | ** ** | **December 31, 2004**      | ** ** |
|---------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                | ** ** | **Total**                            | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                                                                | ** ** | **amortized**                        | ** ** | **unrealized** | ** ** | **unrealized** | ** ** | **fair** | ** ** |
| ** **                                                                | ** ** | **cost**                             | ** ** | **gains** | ** ** | **loss** | ** ** | **value** | ** ** |
| ** **                                                                | ** ** | **(Dollars in thousands)** | ** ** |
| **Available-For-Sale:**                                                   |       |                                 |       |   |   |   |   |   |   |
| U.S. Treasury  securities                                                 |       | $                                    | 696        |   | $ | — |   | $ | 2 |   | $ | 694 |   |
| GNMA-issued/guaranteed  mortgage pass through certificates                |       | 164                                  |       | 7 |   | — |   | 171 |   |
| Other U.S. government  and federal agency securities                      |       | 23,958                               |       | — |   | 128 |   | 23,830 |   |
| FHLMC/FNMA-issued  mortgage pass through certificates                     |       | 9,288                                |       | 76 |   | 1 |   | 9,363 |   |
| CMO’s and REMIC’s  issued by U.S. government-sponsored agencies |       | 38                                   |       | — |   | — |   | 38 |   |
| Privately issued  corporate bonds, CMO and REMIC securities               |       | 2,876                                |       | 1 |   | 19 |   | 2,858 |   |
|                                                                      |       | $                                    | 37,020     |   | $ | 84 |   | $ | 150 |   | $ | 36,954 |   |
|                                                                      |       |                                 |       |   |   |   |   |   |   |
| FRB and other stock                                                       |       | $                                    | 3,076      |   | — |   | — |   | $ | 3,076 |   |

 
| ** **                                            | ** ** | **December 31, 2004**      | ** ** |
|-------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                            | ** ** | **Total**                            | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                                            | ** ** | **amortized**                        | ** ** | **unrealized** | ** ** | **unrealized** | ** ** | **fair** | ** ** |
| ** **                                            | ** ** | **cost**                             | ** ** | **gains** | ** ** | **loss** | ** ** | **value** | ** ** |
| ** **                                            | ** ** | **(Dollars in thousands)** | ** ** |
| **Held-to-Maturity:**                                 |       |                                 |       |   |   |   |   |   |   |
| FHLMC/FNMA-issued  mortgage pass through certificates |       | $                                    | 3,507      |   | $ | 40 |   | $ | — |   | $ | 3,547 |   |
|                                                  |       | $                                    | 3,507      |   | $ | 40 |   | $ | — |   | $ | 3,547 |   |

 

24

----

 
|                                                                           | ** ** | **December 31, 2003**      | ** ** |
|---------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                | ** ** | **Total**                            | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                                                                | ** ** | **amortized**                        | ** ** | **unrealized** | ** ** | **unrealized** | ** ** | **fair** | ** ** |
| ** **                                                                | ** ** | **cost**                             | ** ** | **gains** | ** ** | **loss** | ** ** | **value** | ** ** |
| ** **                                                                | ** ** | **(Dollars in thousands)** | ** ** |
| **Available-For-Sale:**                                                   |       |                                 |       |   |   |   |   |   |   |
| U.S. Treasury  securities                                                 |       | $                                    | 600        |   | $ | — |   | $ | 1 |   | $ | 599 |   |
| GNMA-issued/guaranteed  mortgage pass through certificates                |       | 351                                  |       | 12 |   | — |   | 363 |   |
| Other U.S. government  and federal agency securities                      |       | 12,758                               |       | 45 |   | 4 |   | 12,799 |   |
| FHLMC/FNMA-issued  mortgage pass through certificates                     |       | 3,828                                |       | 161 |   | — |   | 3,989 |   |
| CMO’s and REMIC’s  issued by U.S. government-sponsored agencies |       | 56                                   |       | 1 |   | — |   | 57 |   |
| Mortgage mutual funds                                                     |       | 10,000                               |       | — |   | 98 |   | 9,902 |   |
| Privately issued  corporate bonds, CMO and REMIC securities               |       | 3,163                                |       | 5 |   | — |   | 3,168 |   |
|                                                                      |       | $                                    | 30,756     |   | $ | 224 |   | $ | 103 |   | $ | 30,877 |   |
|                                                                      |       |                                 |       |   |   |   |   |   |   |
| FRB and other stock                                                       |       | $                                    | 1,872      |   | — |   | — |   | $ | 1,872 |   |

 
|                                                       | ** ** | **December 31, 2003**      | ** ** |
|-------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                            | ** ** | **Total**                            | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                                            | ** ** | **amortized**                        | ** ** | **unrealized** | ** ** | **unrealized** | ** ** | **fair** | ** ** |
| ** **                                            | ** ** | **cost**                             | ** ** | **gains** | ** ** | **loss** | ** ** | **value** | ** ** |
| ** **                                            | ** ** | **(Dollars in thousands)** | ** ** |
| **Held-to-Maturity:**                                 |       |                                 |       |   |   |   |   |   |   |
| FHLMC/FNMA-issued  mortgage pass through certificates |       | $                                    | 4,597      |   | $ | 43 |   | $ | — |   | $ | 4,640 |   |
|                                                  |       | $                                    | 4,597      |   | $ | 43 |   | $ | — |   | $ | 4,640 |   |

 

AtDecember 31, 2005, we held no securities from any issuer other than byU.S. government agencies and corporations in which the aggregate book valueexceeded 10% of our shareholders’ equity.

Ourpresent strategy is to extend the duration of the portfolio to further reduceour balance sheet asset sensitivity with investments with only moderate risk ofterm extension and only limited prepayments. Table 8 sets forth information concerning the contractual maturity ofand weighted average yield of our investment securities at December 31,2005.

25

----

 

**Table 8**

**Maturitiesof and Weighted Average Yields on**

**InvestmentSecurities**

 
| ** **                                                                | ** ** | ** **                           | ** ** | ** **                      | ** ** | **After one but**    | ** ** | **After five but**  | ** ** | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | **Weighted** | ** ** |
|---------------------------------------------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|--------------------------------|------------|-------------------------------|------------|------------|------------|-------------|------------|------------|------------|--------------|------------|
| ** **                                                                | ** ** | **Within one year**        | ** ** | **within five years** | ** ** | **within ten years** | ** ** | **After ten years** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                                                | ** ** | **Amount**                           | ** ** | **Yield**                       | ** ** | **Amount**                     | ** ** | **Yield**                     | ** ** | **Amount** | ** ** | **Yield**   | ** ** | **Amount** | ** ** | **Yield**    | ** ** | **Total** | ** ** | **Yield** | ** ** |
| ** **                                                                | ** ** | **(Dollars in thousands)** | ** ** |
| **Securities  available-for-sale:**                                       |       |                                 |       |                            |       |                           |       |                          |       |       |       |        |       |       |       |         |       |   |   |   |   |
| U.S Treasury securities                                                   |       | $                                    | —     |                            | —     |                           | $          | 599                           |       | 4.32       | %          | $           | —     |       | —     |         | $          | — |   | — |   | $ | 599 |   | 4.32 | % |
| GNMA-issued/guaranteed mortgage pass-through  certificates                |       | —                               |       | —                          |       | —                         |       | —                        |       | —     |       | —      |       | 100        |       | 5.98         | %          | 100 |   | 5.98 | % |
| Other U.S. government and federal agencies                                |       | 7,867                                |       | 2.31                            | %          | 7,940                          |       | 3.12                          | %          | —     |       | —      |       | 1,972      |       | 0            |       | 17,779 |   | 2.77 | % |
| FHLMC/FNMA-issued mortgage pass-through certificates                      |       | —                               |       | —                          |       | 234                            |       | 4.96                          | %          | 2,354      |       | 4.41        | %          | 31,075     |       | 4.96         | %          | 33,663 |   | 4.92 | % |
| CMO’s and REMIC’s issued by U.S. government-sponsored  agencies |       | —                               |       | —                          |       | 2                              |       | 5.93                          | %          | —     |       | —      |       | 2,539      |       | 0            |       | 2,541 |   | 5.49 | % |
| Privately issued corporate bonds, CMO’s and REMIC’s  securities |       | —                               |       | —                          |       | —                         |       | —                        |       | —     |       | —      |       | 17,076     |       | 0            |       | 17,076 |   | 4.95 | % |
|                                                                      |       | $                                    | 7,867      |                            | 2.31       | %                              | $          | 8,775                         |       | 3.25       | %          | $           | 2,354      |       | 4.41       | %            | $          | 52,762 |   | 4.92 | % | $ | 71,758 |   | 4.41 | % |
|                                                                      |       |                                 |       |                            |       |                           |       |                          |       |       |       |        |       |       |       |         |       |   |   |   |   |
| **Amortized  cost**                                                       |       | $                                    | 7,894      |                            |       |                           | $          | 8,873                         |       |       |       | $           | 2,389      |       |       |         | $          | 53,272 |   |   |   | $ | 72,428 |   |   |   |
|                                                                      |       |                                 |       |                            |       |                           |       |                          |       |       |       |        |       |       |       |         |       |   |   |   |   |
| FRB and other  stocks                                                     |       | $                                    | 3,809      |                            | 4.94       | %                              | $          | —                        |       | —     |       | $           | —     |       | —     |         | $          | — |   | — |   | $ | 3,809 |   | 4.94 | % |

 
| ** **                                            | ** ** | ** **                           | ** ** | ** **                      | ** ** | **After one but**    | ** ** | **After five but**  | ** ** | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | **Weighted** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|--------------------------------|------------|-------------------------------|------------|------------|------------|-------------|------------|------------|------------|--------------|------------|
| ** **                                            | ** ** | **Within one year**        | ** ** | **within five years** | ** ** | **within ten years** | ** ** | **After ten years** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                            | ** ** | **Amount**                           | ** ** | **Yield**                       | ** ** | **Amount**                     | ** ** | **Yield**                     | ** ** | **Amount** | ** ** | **Yield**   | ** ** | **Amount** | ** ** | **Yield**    | ** ** | **Total** | ** ** | **Yield** | ** ** |
| ** **                                            | ** ** | **(Dollars in thousands)** | ** ** |
| **Securities held-to-maturity:**                      |       |                                 |       |                            |       |                           |       |                          |       |       |       |        |       |       |       |         |       |   |   |   |   |
| FHLMC/FNMA-issued  mortgage pass-through certificates |       | $                                    | —     |                            | —     |                           | $          | —                        |       | —     |       | $           | 2,612      |       | 4.29       | %            | $          | — |   | — |   | $ | 2,612 |   | 4.29 | % |
|                                                  |       | $                                    | —     |                            | —     |                           | $          | —                        |       | —     |       | $           | 2,612      |       | 4.29       | %            | $          | — |   | — |   | $ | 2,612 |   | 4.29 | % |

 

Actualmaturities may differ from contractual maturities to the extent that borrowershave the right to call or prepay obligations with or without call or repaymentpenalties.

**LendingActivities**

Weengage in commercial banking, serving small to medium-sized businesses in theniche markets of entertainment, healthcare, business banking, real estatedevelopment, operations of multi-family and commercial properties, as well ascommunity-based nonprofit organizations, business executives, professionals andother individuals.  Our primarygeographic focus is the Los Angeles basin of Los Angeles County, with fourbranch banking offices consisting of Mercantile Bank’s offices located inCentury City and Encino, and South Bay Bank’s offices located in Torrance andEl Segundo.  We offer a full range ofloan, deposit and investment products, which are designed to meet specificcustomer needs and are offered with highly personalized service.

Loanproducts include commercial real estate loans, construction financing,revolving lines of credit, term loans and consumer and home equity loans, alongwith an array of deposits and investment accounts that often contain terms andconditions tailored to meet the specific demands of the market niche in whichthe borrower operates, including the ability to evaluate the revenue streamsand other sources of repayment supporting the loan.  In order to provide the personalized servicerequired by these customers, we use a team approach to customer servicecombining an experienced relationship management officer with operationssupport personnel.

Entertainmentindustry customers include television, music and film production companies,talent agencies, individual performers, directors and producers (whom weattract by establishing relationships with business management firms), andothers affiliated with the entertainment industry.   Professional service customers includelegal, accounting, insurance and advertising firms and their individualdirectors, officers, partners and shareholders. Healthcare organizations include primarily outpatient healthcareproviders such as physician medical groups, independent practice associationsand surgery centers.

*Loan Portfolio*

Thefollowing table sets forth the composition of our loan portfolio at the datesindicated**:**

26

----

 

**Table 9**

**LoanPortfolio Composition**

 

 
| ** **                                                            | ** ** | **December 31,**                | ** ** |
|-----------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                            | ** ** | **2005**                             | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                            | ** ** | **Amount**                           | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** | **Amount (1)** | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| ** **                                                            | ** ** | **(Dollars in thousands)** | ** ** |
| Commercial loans  - secured and unsecured                             |       | $                                    | 89,474     |   | 26 | % | $ | 98,429 |   | 31 | % | $ | 76,699 |   | 29 | % | $ | 86,015 |   | 32 | % | $ | 85,292 |   | 33 | % |
| Real estate  loans:                                                   |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Secured by commercial real properties                                 |       | 121,641                              |       | 36 |   | 135,944 |   | 43 |   | 132,320 |   | 51 |   | 119,872 |   | 44 |   | 95,142 |   | 36 |   |
| Secured by one to four family residential properties                  |       | 10,498                               |       | 3 |   | 9,405 |   | 3 |   | 8,167 |   | 3 |   | 10,797 |   | 4 |   | 27,069 |   | 10 |   |
| Secured by multifamily residential properties                         |       | 18,663                               |       | 6 |   | 18,330 |   | 6 |   | 13,071 |   | 5 |   | 12,596 |   | 4 |   | 8,492 |   | 3 |   |
| Total real estate loans                                               |       | 150,802                              |       | 44 |   | 163,679 |   | 52 |   | 153,558 |   | 59 |   | 143,265 |   | 52 |   | 130,703 |   | 49 |   |
| Construction and  land development                                    |       | 92,077                               |       | 27 |   | 50,289 |   | 16 |   | 27,210 |   | 11 |   | 37,934 |   | 14 |   | 30,811 |   | 12 |   |
| Consumer  installment, home equity and unsecured loans to individuals |       | 7,239                                |       | 2 |   | 2,516 |   | 1 |   | 3,510 |   | 1 |   | 5,566 |   | 2 |   | 15,306 |   | 6 |   |
| Total loans outstanding                                               |       | 339,592                              |       | 100 | % | 314,913 |   | 100 | % | 260,977 |   | 100 | % | 272,780 |   | 100 | % | 262,112 |   | 100 | % |
|                                                                  |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Deferred net loan  origination fees and purchased loan discount       |       | (1,034                               | )          |   |   | (1,066 | ) |   |   | (728 | ) |   |   | (458 | ) |   |   | (144 | ) |   |   |
| Loans receivable, net                                                 |       | $                                    | 338,558    |   |   |   | $ | 313,847 |   |   |   | $ | 260,249 |   |   |   | $ | 272,322 |   |   |   | $ | 261,968 |   |   |   |

 

----

(1)Increase in loans receivable commencing in 2001 reflects the acquisition ofSouth Bay in December, 2001.

 

Ourlending officers have limited authority to originate loans and requireapprovals from our more senior credit officers or our loan approval committeefor loans over $150,000.  The Banks maynot make any loan, with certain limited exceptions, in excess of their loan toone borrower limit under applicable regulations ($4.1 million for Mercantileand $3.2 million for South Bay at December 31, 2005).  If a Bank’s borrower requests a loan inexcess of these amounts we may originate the loan with the participation of theother Bank or other lenders.  AtDecember 31, 2005 we had $40.4 million in loans originated and serviced byother banks in which we purchased a non-recourse participation.  These participation loans had $30.4 millionof unfunded commitments as of December 31, 2005.  We generally purchase participations in loansfrom other banks in which we have a reciprocal alliance to purchase loanparticipations from us.  We have nottaken a subordinate credit position on any loan participations purchased orsold.  The bank originating the loanservices the loan, typically without compensation.

*CommercialLoans*.  We offeradjustable and fixed rate secured and unsecured commercial loans for workingcapital, the purchase of assets and other business purposes.  Loan amounts typically  range from $100,000 to $3.0 million. Weunderwrite these loans primarily on the basis of the borrower’s ability toservice the debt from cash flow without reliance on the liquidation of theunderlying collateral, where applicable. These loans generally have maturity terms of 12 months and are typicallyrenewed.

Collateralfor commercial loans may include commercial or residential real property,accounts receivable, inventory, equipment, marketable securities or otherassets.  Unsecured commercial loans includeshort-term term loans and lines of credit. Our underwriting guidelines forthese loans generally require that the borrower have low levels of existingdebt, working capital sufficient to cover the loan and a history of earnings,appropriate liquidity, and positive cash flow from operations. Typically,unsecured lines of credit must be unused for a continuous 30-day period withineach year to demonstrate the borrower’s ability to have sufficient funds tooperate without the credit line.

*RealEstate Loans. *We offeradjustable and fixed rate secured loans to finance the purchase or holding ofcommercial real estate, single family (one to four) residences and multi-familyresidences.  These loans generally havematurities ranging from three to fifteen years and payments based on a 15 to 25years amortization schedule.  Theoriginal principal amount of a real estate loan generally does not exceed 65%to 75% of the appraised value of the property (or the lesser of the appraisedvalue or the purchase price for the property if the loan is made to finance thepurchase of the property).  We require acurrent appraisal in connection with the origination of each real estate loan.

*Constructionand Land Development Loans*. Real estate construction and land development loans are short-termsecured loans made to finance the construction of commercial, one tofour-family and multifamily residential properties or for improvements to rawland.  These loans include financing fordevelopers for the construction of residential tract homes and customhomes.  Our real estate construction andloan development loans are primarily for properties located in SouthernCalifornia.  These loans typically have adjustablerates with terms of twelve to fifteen months. We monitor the progress of the construction and disburse the loanproceeds directly to the various contractors during stages of improvement.  Generally, the amount of a construction loandoes not exceed 65% of the appraised completion value and the borrower’s fundsare disbursed prior to disbursement of the construction loan.

*ConsumerInstallment Loans and Home Equity Lines of Credit*.  We offer consumer loans and home equity linesof credit in

27

----

amounts generallyless than $100,000.  Home equity lines ofcredit provide the borrower with a line of credit in an amount that generallydoes not exceed 80% of the appraised value of the borrower’s residence net ofsenior mortgages.  Consumer loans areprimarily adjustable rate open ended unsecured loans (such as credit cardloans) but also include fixed rate term loans (generally under five years) topurchase personal property, which are secured by that personal property. Theseloans (other than purchase money loans) generally provide for monthly paymentsof interest and a portion of the outstanding principal balance.

*IndustryConcentrations*

Ourboard of directors has limited our exposure to industry concentration by policyand we regularly monitor such concentration based upon our borrowers’ NorthAmerican Industry Classification System codes. The limits range from 5% to 50% of total loans depending on industrytype.  Loans to the entertainmentindustry, healthcare industry and community-based nonprofit organizations,individually, were less than 10% of total loans outstanding at December 31,2005 and 2004.

*Loan RateComposition and Maturities*

Of ourtotal loans outstanding, excluding loans on nonaccrual, 73.7% and 77.1% hadadjustable rates at December 31, 2005 and 2004, respectively.  Adjustable rate loans generally have interestrates tied to the prime rate and adjust with changes in the rate on a daily,monthly or quarterly basis.

Of ourtotal loans outstanding, excluding nonaccrual loans, at December 31, 2005,51.1% were due in one year or less, 33.0% were due in 1-5 years and 15.9% weredue after 5 years.   As is customary inthe banking industry, loans can be renewed by mutual agreement between theborrower and us.  Because we are unableto estimate the extent to which its borrowers will renew their loans, Table 11is based on contractual maturities.

**Table 11**

**LoanMaturities**
|                                                                                         | ** ** | **December 31, 2005**      | ** ** |
|-----------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                              | ** ** | **Adjustable**                       | ** ** | **Fixed** | ** ** | ** ** | ** ** |
| ** **                                                                              | ** ** | **interest rates**              | ** ** | **Interest rates** | ** ** | **Total** | ** ** |
| ** **                                                                              | ** ** | **(Dollars in thousands)** | ** ** |
| Aggregate  maturities of total loans outstanding:                                       |       |                                 |       |   |   |   |   |
| Commercial loans -                                                                      |       |                                 |       |   |   |   |   |
| In one year or less                                                                     |       | $                                    | 40,703     |   | $ | 13,669 |   | $ | 54,372 |   |
| After one year but within five years                                                    |       | 11,801                               |       | 13,895 |   | 25,696 |   |
| After five years                                                                        |       | 8,339                                |       | 748 |   | 9,087 |   |
| Real estate loans -                                                                     |       |                                 |       |   |   |   |   |
| In one year or less                                                                     |       | 28,501                               |       | 5,682 |   | 34,183 |   |
| After one year but within five years                                                    |       | 48,295                               |       | 28,188 |   | 76,483 |   |
| After five years                                                                        |       | 22,111                               |       | 18,025 |   | 40,136 |   |
| Construction and land development loans -                                               |       |                                 |       |   |   |   |   |
| In one year or less                                                                     |       | 79,433                               |       | — |   | 79,433 |   |
| After one year but within five years                                                    |       | 3,770                                |       | 4,103 |   | 7,873 |   |
| After five years                                                                        |       | 4,771                                |       | — |   | 4,771 |   |
| Consumer installment, home equity lines of credit and  unsecured loans to individuals - |       |                                 |       |   |   |   |   |
| In one year or less                                                                     |       | 1,359                                |       | 4,022 |   | 5,381 |   |
| After one year but within five years                                                    |       | 724                                  |       | 1,134 |   | 1,858 |   |
| After five years                                                                        |       | —                               |       | — |   | — |   |
| Total loans outstanding  (1)                                                            |       | $                                    | 249,806    |   | $ | 89,466 |   | $ | 339,273 |   |

----

(1)Excluding nonaccrual loans

*Off-BalanceSheet Loan Commitments and Contingent Obligations*

We area party to financial instruments with off-balance sheet credit risk in thenormal course of business to meet the financing needs of our customers.  In addition to undisbursed commitments toextend credit under loan facilities, these instruments include conditionalobligations under standby and commercial letters of credit.  Our exposure to credit loss in the event of nonperformance by customers isrepresented by the contractual amount of the instruments.

Loancommitments are agreements to lend to a customer a specified amount subject tocertain conditions.  Loan commitmentsgenerally have fixed expiration dates or other termination clauses and mayrequire payment of a fee.  We hadoutstanding loan commitments aggregating $120.8 million at December 31,2005, substantially all of which were for construction loans and commerciallines of credit.

28

----

Standbyletters of credit are conditional commitments issued by us to secure thefinancial performance of a customer to a third party and are primarily issuedto support private borrowing arrangements. The credit risk involved in issuinga letter of credit for a customer is essentially the same as that involved inextending a loan to that customer. We use the same credit underwriting policiesin accepting such contingent obligations as we do for loans. When deemednecessary, we hold appropriate collateral supporting those commitments. Thenature of collateral obtained varies and may include deposits held in financialinstitutions and real properties.  AtDecember 31, 2005 letters of credit amounted to $1.1 million.  Many of these commitments are expected toexpire without being drawn upon and, as such, the total commitment amounts donot necessarily represent future cash requirements.

**AssetQuality and Credit Risk Management**

Weassess and manage credit risk on an ongoing basis through diversificationguidelines, lending limits, credit review and approval policies and internalmonitoring.  As part of the controlprocess, an independent credit review firm regularly examines our loanportfolio, related products, including unused commitments and letters ofcredit, and other credit processes.  Inaddition to this credit review process, our loan portfolio is subject toexamination by external regulators in the normal course of business.  Underlying trends in the economic andbusiness cycle will influence credit quality. We seek to manage and control credit risk through diversification of theportfolio by type of loan, industry concentration and type of borrower.

*NonperformingAssets*

Nonperformingassets consist of nonperforming loans and other real estate owned.  Nonperforming loans are (i) loans which havebeen placed on nonaccrual status, (ii) troubled debt restructurings (“TDR’s”),or (iii) loans which are contractually past due ninety days or more withrespect to principal or interest, and have not been restructured or placed on nonaccrualstatus, and are accruing interest as described below.  Other real estate owned consists of realproperties securing loans of which we have taken title in partial or completesatisfaction of the loan.  Other thanloans included in nonperforming assets at December 31, 2005, we had noloans that cause management to have serious doubts about the ability of theborrower to comply with the present loan repayment terms and we had no otherinterest earning assets that were considered impaired at December 31,2005.  Information about nonperformingassets is presented in Table 12.

**Table 12**

**NonperformingAssets**
| ** **                                                                                                                  | ** ** | **December 31,**                | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                                                  | ** ** | **2005**                             | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                                                                                  | ** ** | **(Dollars in thousands)** | ** ** |
|                                                                                                                        |       |                                 |       |   |   |   |   |   |   |   |   |
| Nonaccrual loans                                                                                                            |       | $                                    | 319        |   | $ | 18 |   | 438 |   | $ | 5,787 |   | $ | 7,807 |   |
| Troubled debt  restructurings                                                                                               |       | —                               |       | — |   | — |   | — |   | 953 |   |
| Loans  contractually past due ninety or more days with respect to either principal  or interest and still accruing interest |       | —                               |       | 1804 |   | — |   | 209 |   | 642 |   |
| Nonperforming  loans                                                                                                        |       | 319                                  |       | 1822 |   | 438 |   | 5,996 |   | 9,402 |   |
| Other real estate  owned                                                                                                    |       | 1,056                                |       | 1056 |   | 925 |   | 1,000 |   | — |   |
| Other assets-SBA  guaranteed loan                                                                                           |       | —                               |       | — |   | — |   | — |   | — |   |
| Total  nonperforming assets                                                                                                 |       | $                                    | 1,375      |   | $ | 2,878 |   | 1,363 |   | $ | 6,996 |   | $ | 9,402 |   |
|                                                                                                                        |       |                                 |       |   |   |   |   |   |   |   |   |
| Allowance for  loan and lease losses as a percent of nonaccrual loans                                                       |       | 1400.6                               | %          | 21822.2 | % | 829.9 | % | 83.7 | % | 83.8 | % |
| Allowance for  loan and lease losses as a percent of nonperforming loans                                                    |       | 1400.6                               | %          | 215.6 | % | 829.9 | % | 80.8 | % | 69.6 | % |
| Total  nonperforming assets as a percent of loans receivable                                                                |       | 0.4                                  | %          | 0.9 | % | 0.5 | % | 2.6 | % | 3.6 | % |
| Total nonperforming assets  as a percent of total shareholders’ equity                                                 |       | 3.6                                  | %          | 7.5 | % | 4.3 | % | 22.4 | % | 36.9 | % |

*NonaccrualLoans.* Nonaccrual loans are those loans for which managementhas discontinued accrual of interest because there exists reasonable doubt asto the full and timely collection of either principal or interest.  Our policy is to place a loan on nonaccrualstatus if either principal or interest payments are past due in excess ofninety days unless the loan is both well secured and in process of collection,or if full collection of interest or principal becomes uncertain, regardless ofthe time period involved.

When aloan is placed on nonaccrual status, all interest previously accrued butuncollected is reversed against current period operating results. Income onsuch loans is then recognized only to the extent that cash is received, and,where the ultimate collection of the carrying amount of the loan is probable,after giving consideration to the borrower’s current financial condition,historical repayment performance and other factors. Accrual of interest isresumed only when (i) principal and interest are brought fully current, and(ii) such loans are either considered, in management’s judgment, to be fullycollectible or otherwise become well secured and in the process of collection.(See ‘‘Net Interest Income’’ for a discussion of the effects on operatingresults of nonperforming loans.)

29

----

Nonaccrualloans increased to $319,000 at December 31, 2005, from $18,000 atDecember 31, 2004, representing a single secured commercial loan.  The value of the collateral securing thisloan may not be adequate to avoid a charge off of a portion of the credit.  The additional interest income that wouldhave been recorded from nonaccrual loans, if the loans had not been onnonaccrual status, was $11,000 and $12,000 for 2005 and 2004,respectively.  Interest payments receivedon nonaccrual loans are applied to principal unless there is no doubt as toultimate full repayment of principal, in which case, the interest payment isrecognized as interest income.  Interestincome not recognized on nonaccrual loans reduced the net yield on earningassets by 1 basis point and 0 basis point for 2005 and 2004, respectively.

*TroubledDebt Restructurings.* A TDR is a loan for which we have, foreconomic or legal reasons related to a borrower’s financial difficulties,granted a concession to the borrower we would not otherwise consider, includingmodifications of loan terms to alleviate the burden of the borrower’s near-termcash flow requirements in order to help the borrower to improve its financialcondition and eventual ability to repay the loan.  At December 31, 2005 and 2004 and forthe years then ended we had no TDRs and accordingly, no interest income wasrecorded in 2005 and 2004 on TDRs.

*Loans ContractuallyPast Due 90 or More Days.* Loans contractually past due 90 ormore days are those loans which have become contractually past due at leastninety days with respect to principal or interest. Interest accruals may becontinued on these loans when such loans are well secured and in the process ofcollection and, accordingly, management has determined such loans to be fullycollectible as to both principal and interest.

Forthis purpose, a loan is considered well secured if the collateral has a realizablevalue in excess of the amount of principal and accrued interest outstandingand/or is guaranteed by a financially capable party. A loan is considered to bein the process of collection if collection of the loan is proceeding in duecourse either through legal action or through other collection efforts whichmanagement reasonably expects to result in repayment of the loan or itsrestoration to a current status in the near future.

We hadno loans contractually past due 90 days and still accruing interest atDecember 31, 2005 and had $1.8 million in such loans at December 31,2004.  This balance at year-end 2004represented a single loan secured by a commercial real estate property.  Our loan amount represents 67% of theappraised value of the property, which the borrower has entered into anagreement for sale and is pending escrow.

*OtherReal Estate Owned.*** **We carry OREO at the lesser of ourrecorded investment or the fair value less estimated costs to sell. Weperiodically revalue OREO properties and charge other expenses for any furtherwrite-downs.  We had $1.1 millionrecorded as OREO at December 31, 2005 and December 31, 2004.  The property was sold in February of 2006 witha small gain.

*ImpairedLoans. *Due to the size and nature of the our loanportfolio, impaired loans are determined by a periodic evaluation on anindividual loan basis.  AtDecember 31, 2005 and 2004, and for the years then ended, none of ourloans were impaired.

Foregoneinterest income attributable to nonperforming loans amounted to $11,000 in 2005and $12,000 in 2004.  This resulted in areduction in yield on average loans receivable of 0 basis point and 1 basispoints for the years ended December 31, 2005 and 2004, respectively.

*OtherInterest Bearing Assets*. We had no other interest bearing assets that were past due, nonaccrualor experiencing credit difficulties.

*Allowancefor Loan and Lease Losses*

Theallowance for credit losses is the sum of the allowance for loan and leaselosses and the reserve for contingent losses on unfunded commitments.  Theallowance for loan and lease losses is a valuation adjustment used to recognizeimpairment of the recorded investment in the loans receivable on our balancesheet before losses have been confirmed resulting in a subsequent charge-off orwrite-down.  The reserve for contingent losses on unfunded commitments isa liability accrual for unidentified but probable losses on our commitments tofund loans.  As of September 30, 2005, the reserve for contingentlosses on unfunded commitments was reclassified from the allowance for creditlosses to other liabilities.  The 2004 year end reserve for contingentlosses on unfunded commitments was reclassified to conform to the currentpresentation.

Thecalculation of the adequacy of the allowance for loan and lease losses is basedon a variety of factors (see Allowance for Loan and Lease Losses under CriticalAccounting Policies).  Table 13 presents,at the dates indicated, the composition of our allocation of the allowance forloan and lease losses to specific loan categories.  Our current practice is to make specificallocations of the allowance for loan and lease losses to criticized andclassified loans, and unspecified allocations to each loan category based onour risk assessment.  This allocationshould not be interpreted as an indication that loan charge-offs will occur inthe future in these amounts or proportions, or as an indication of futurecharge-off trends.  In addition, theportion of the allowance for loan and lease losses allocated to each loancategory does not represent the total amount available for future losses thatmay occur within such categories, since the total allowance for loan and leaselosses is applicable to the entire portfolio.

30

----

**Table13**

**Allocationof Allowance For Loan and Lease Losses**

|                                                                                  | ** ** | **December 31,**                | ** ** |
|---------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                            | ** ** | **2005**                             | ** ** | **%(1)** | ** ** | **2004** | ** ** | **%(1)** | ** ** | **2003** | ** ** | **%(1)** | ** ** | **2002** | ** ** | **%(1)** | ** ** | **2001** | ** ** | **%(1)** | ** ** |
| ** **                                                                            | ** ** | **(Dollars in thousands)** | ** ** |
|                                                                                  |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial loans  - secured and unsecured                                             |       | $                                    | 1,177      |   | 26 | % | $ | 1,097 |   | 31 | % | $ | 1,068 |   | 29 | % | $ | 1,528 |   | 31 | % | $ | 2,128 |   | 33 | % |
| Real estate  loans:                                                                   |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Secured by commercial real properties                                                 |       | 1,600                                |       | 36 |   | 1,516 |   | 43 |   | 1,843 |   | 51 |   | 2,129 |   | 44 |   | 2,376 |   | 36 |   |
| Secured by one to four family residential properties                                  |       | 138                                  |       | 3 |   | 105 |   | 3 |   | 114 |   | 3 |   | 192 |   | 4 |   | 675 |   | 10 |   |
| Secured by multifamily residential properties                                         |       | 246                                  |       | 5 |   | 204 |   | 6 |   | 182 |   | 5 |   | 224 |   | 5 |   | 212 |   | 3 |   |
| Total real estate loans                                                               |       | 1,984                                |       | 44 |   | 1,825 |   | 52 |   | 2,139 |   | 59 |   | 2,545 |   | 53 |   | 3,264 |   | 49 |   |
| Construction and  land development                                                    |       | 1,211                                |       | 27 |   | 561 |   | 16 |   | 379 |   | 11 |   | 674 |   | 14 |   | 769 |   | 12 |   |
| Consumer  installment, home equity lines of credit and unsecured loans to individuals |       | 95                                   |       | 2 |   | 28 |   | 1 |   | 49 |   | 1 |   | 99 |   | 2 |   | 381 |   | 6 |   |
| Allowance  allocable to loans receivable                                              |       | $                                    | 4,468      |   | 100 | % | $ | 3,511 |   | 100 | % | $ | 3,635 |   | 100 | % | $ | 4,846 |   | 100 | % | $ | 6,541 |   | 100 | % |

 

----

(1)Percentage of loans in each category to total loans.

Theallowance for loan and lease losses at December 31, 2005 was $4.5 millioncompared to $3.5 million at December 31, 2004.  The allowance was affected by net recoveriesof $1.2 million partially offset by a $84,000 benefit for credit losses.  Total net loan recoveries in 2004 were$73,000.  The benefit for credit losseswas recorded in 2005 based upon our analysis of the adequacy of allowance forcredit losses.

Theallowance for loan and lease losses for classified loans graded as “criticized”by our internal grading system that are collateral-dependent is based upon thenet realizable value of the collateral that we periodically evaluate.  The allowance for unsecured classified loansis based upon the severity of the credit weakness based upon an analysis of ourhistorical loan loss experience over a 10 year period.  The volume of more severely classified loans— “substandard” and “doubtful” — decreased to $3.5 million at December 31,2005 from $8.8 million at year end 2004.

Table 14 presents ananalysis of changes in the allowance for loan and lease losses during theperiods indicated:

31

----

**Table 14**

**Analysisof Changes in Allowance for Loan and Lease Losses**
|                                                                                                          | ** ** | **December 31,**                | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                               | ** ** | **2005**                             | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                                                               | ** ** | **(Dollars in thousands)** | ** ** |
| ** **                                                                                               | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Balance, beginning of  period                                                                            |       | $                                    | 3,511      |   | $ | 3,635 |   | $ | 4,846 |   | $ | 6,542 |   | $ | 2,597 |   |
| Loan charged off:                                                                                        |       |                                 |       |   |   |   |   |   |   |   |   |
| Commercial loans  - secured and unsecured                                                                |       | 6                                    |       | 49 |   | 2,697 |   | 3,849 |   | 387 |   |
| Real estate  loans:                                                                                      |       |                                 |       |   |   |   |   |   |   |   |   |
| Secured by  commercial real properties                                                                   |       | —                               |       | — |   | 75 |   | 44 |   | — |   |
| Secured by one  to four family residential properties                                                    |       | —                               |       | — |   | 38 |   | — |   | — |   |
| Secured by  multifamily residential properties                                                           |       | —                               |       | — |   | — |   | — |   | — |   |
| Total real  estate loans                                                                                 |       | —                               |       | — |   | 113 |   | 44 |   | — |   |
| Construction and  land development                                                                       |       | —                               |       | — |   | — |   | 31 |   | — |   |
| Consumer  installment, home equity and unsecured loans to individuals                                    |       | 4                                    |       | 8 |   | 41 |   | 138 |   | 104 |   |
| Total loan  charge-offs                                                                                  |       | 10                                   |       | 57 |   | 2,851 |   | 4,062 |   | 491 |   |
|                                                                                                     |       |                                 |       |   |   |   |   |   |   |   |   |
| Recoveries of loans  previously charged off:                                                             |       |                                 |       |   |   |   |   |   |   |   |   |
| Commercial loans  - secured and unsecured                                                                |       | 1,214                                |       | 94 |   | 291 |   | 189 |   | 227 |   |
| Real estate  loans:                                                                                      |       |                                 |       |   |   |   |   |   |   |   |   |
| Secured by  commercial real properties                                                                   |       | —                               |       | 6 |   | 13 |   | — |   | — |   |
| Secured by one  to four family residential properties                                                    |       | —                               |       | — |   | 1 |   | — |   | 6 |   |
| Secured by  multifamily residential properties                                                           |       | —                               |       | — |   | — |   | — |   | — |   |
| Total real  estate loans                                                                                 |       | —                               |       | 6 |   | 14 |   | — |   | 6 |   |
| Construction and  land development                                                                       |       | —                               |       | — |   | — |   | 191 |   | — |   |
| Consumer  installment, home equity and unsecured loans to individuals                                    |       | 2                                    |       | 30 |   | 70 |   | 61 |   | 40 |   |
| Total recoveries  of loans previously charged off                                                        |       | 1,216                                |       | 130 |   | 375 |   | 441 |   | 273 |   |
| Net (recoveries)  charge-offs                                                                            |       | (1,206                               | )          | (73 | ) | 2,476 |   | 3,621 |   | 218 |   |
| Provision  (benefit) for credit losses                                                                   |       | (84                                  | )          | 220 |   | 1,265 |   | 1,925 |   | 517 |   |
| Allowance for  unfunded commitments transferred to other liabilities                                     |       | (165                                 | )          | (417 | ) | — |   | — |   | — |   |
| Allowance  acquired in acquisition of South Bay Bank, N.A                                                |       | —                               |       | — |   | — |   | — |   | 3,646 |   |
| Balance, end of  period                                                                                  |       | $                                    | 4,468      |   | $ | 3,511 |   | $ | 3,635 |   | $ | 4,846 |   | $ | 6,542 |   |
|                                                                                                     |       |                                 |       |   |   |   |   |   |   |   |   |
| Net loan  (recoveries) charge-offs as a percentage of allowance for loan and lease  losses               |       | -26.99                               | %          | -1.86 | % | 68.12 | % | 74.72 | % | 3.33 | % |
| Net loan  (recoveries) charge-offs as a percentage of average gross loans outstanding  during the period |       | -0.38                                | %          | -0.03 | % | 0.95 | % | 1.42 | % | 0.19 | % |
| Recoveries of loans  previously charged off as a percentage of loans charged off in the previous  year   |       | 2133.33                              | %          | 4.56 | % | 9.23 | % | 89.82 | % | 231.36 | % |

 

Theallowance for loan and lease losses increased in 2005 primarily due to (i) thegrowth in loans receivable during 2005, (ii) expansion of higher risk filmproduction lending, (iii) the increased credit risk to adjustable rateborrowers in a rising interest rate environment, and (iv) an increase in theaverage size of individual loans in our portfolio.  There was a negative provision of $84,000 tothe allowance for loan and lease losses credited to earnings in 2005; basedupon our valuation assessment we recorded a benefit for credit losses.  Factors influencing our judgments regardingprovisions for credit losses included: 2004 — growth in loans receivable andunfunded commitments; 2003, 2002, and 2001 — the level of problem credits andcharge offs.

**Deposits**

Weemphasize developing business client relationships at both Banks in order toincrease our core deposit base.  We offerinternet-based cash management services and, for many business customers,provide regular courier service between their business locations and ourbanking offices.  Additionally, weattract deposits in serving the specific market niches of escrow and titlecompanies and community-based nonprofit organizations.  Each Bank offers its own rates in order tocompete in its specific markets.  We haveentered new geographic markets first with loan production offices with theintention of later converting the offices to full service branch bankingoffices.

32

----

** **

**Table 15**

**AverageDeposit Composition**

 

|                                                  | ** ** | **December 31,**                | ** ** |
|--------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                       | ** ** | **2005**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                       | ** ** | **Amount**                           | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| ** **                                       | ** ** | **(Dollars in thousands)** | ** ** |
| ** **                                       | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Noninterest-bearing demand deposits:             |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Real estate title and  escrow company customers. |       | $                                    | 14,692     |   | 4 | % | $ | 16,247 |   | 5 | % | $ | 26,990 |   | 8 | % |
| Other noninterest-bearing demand                 |       | 110,097                              |       | 32 | % | 108,452 |   | 34 | % | 92,799 |   | 29 | % |
| Interest-bearing demand                          |       | 32,497                               |       | 10 | % | 31,484 |   | 10 | % | 28,269 |   | 9 | % |
| Money market and savings                         |       | 103,648                              |       | 31 | % | 107,981 |   | 34 | % | 98,763 |   | 31 | % |
| Time certificates of  deposit:                   |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Other:                                           |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| $100,000 or more                                 |       | 51,995                               |       | 14 | % | 27,179 |   | 9 | % | 29,150 |   | 9 | % |
| Under $100,000                                   |       | 26,031                               |       | 8 | % | 27,345 |   | 9 | % | 33,316 |   | 10 | % |
| Total time certificates  of deposit              |       | 78,026                               |       | 23 | % | 54,524 |   | 17 | % | 62,466 |   | 20 | % |
| Total deposits                                   |       | $                                    | 338,960    |   | 100 | % | $ | 318,688 |   | 100 | % | $ | 309,287 |   | 100 | % |

 

During2005 we increased the use of Brokered CDs which are classified as timecertificates of deposits $100,000 and over. We use Brokered CDs to supplement our liquidity and achieve other assetliability management objectives (see the discussion under Net Interest Income).  Brokered deposits are wholesale certificatesof deposit placed by rate sensitive customers that do not have any othersignificant relationship with us. Professionals operating under established investment criteria managemost wholesale funds and the brokered deposits are typically in amounts thatexceed the FDIC deposit insurance limit. As a result, these funds are generally very sensitive to credit risk andinterest rates, and pose greater liquidity risk to a bank.  They may refuse to renew the certificates ofdeposit at maturity if higher rates are available elsewhere or if they perceivethat creditworthiness is deteriorating. At December 31, 2005 we had total brokered deposits of $37.5 million allof which had maturities within 12 months.

TheFederal Reserve Bank increased the target fed funds rate thirteen timesbeginning in the second half of 2004 and market short term interest rateslikewise increased.  In order to improvenet interest margins, we increased the rates paid on our nonmaturity depositsrelatively little.  Other financialinstitutions have increased the rates paid on their deposits more rapidly.  While our customers are typically less ratesensitive due to the business relationships with us, it is difficult to growdeposits without offering very competitive rates.  Consequently, during the second half of 2004and 2005 we increased Brokered CDs and began offering very competitive rates oncertain certificates of deposit targeted to new customers in order to fund ourasset growth and any deposit runoff. While these sources of funds are relatively high costing deposits, thehigher rates impact only the incremental deposits acquired through these means.

Additionally,the period 2001 through the first half of 2004 experienced historically lowinterest rates.    During periods of lowinterest rates, depositors tend to maintain greater deposit balances in lowyielding but readily accessible transaction accounts due to relatively lowopportunity costs.  As interest ratesrise, and opportunity costs increase, depositors tend to redeploy their fundsinto higher yielding alternatives. Assuming rates continue to rise, we expect continued growth incertificates of deposit and a resulting change in the composition of ourdeposits.

During 2005, competition from other financialinstitutions and a decline in residential purchase and refinance activityresulted in a decline in noninterest-bearing deposits for real estate title andescrow company customers.

33

----

 

**Table 16**

**Maturitiesof Time Certificates of Deposit**

**$100,000or more**

 
|                                                      | ** ** | **December 31,**                | ** ** |
|------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                           | ** ** | **2005**                             | ** ** | **2004** | ** ** |
| ** **                                           | ** ** | **(Dollars in thousands)** | ** ** |
|                                                 |       |                                 |       |   |   |
| Time  certificates of deposit maturing:              |       |                                 |       |   |   |
| In three months  or less                             |       | $                                    | 45,027     |   | $ | 19,680 |   |
| After three  months but within six months            |       | 14,459                               |       | 5,562 |   |
| After six months  but within twelve months           |       | 24,377                               |       | 10,548 |   |
| After twelve  months                                 |       | 3,605                                |       | 5,321 |   |
| Total time certificates  of deposit $100,000 or more |       | $                                    | 87,468     |   | $ | 41,111 |   |

 

*DepositConcentrations*

AtDecember 31, 2005 a single depositor represented $23.1 million, or 6.8%, of ourtotal deposits.  Our ten largestdepositors represented $43.4 million, or 14.3%, of our total deposits.  We maintain contingent sources of liquidity tobuffer changes in our deposit balances.

**BorrowedFunds**

Borrowedfunds and related weighted average rates are summarized below in Table 17.

**Table 17**

**BorrowedFunds**

 
|                                                                          | ** ** | **2005**                             | ** ** | **2004**    | ** ** | **2003**     | ** ** |
|--------------------------------------------------------------------------|------------|--------------------------------------|------------|-------------|------------|--------------|------------|
| ** **                                                               | ** ** | **Year-end**                         | ** ** | **Average** | ** ** | **Year-end** | ** ** | **Average** | ** ** | **Year-end** | ** ** | **Average** | ** ** |
| ** **                                                               | ** ** | **Balance**                          | ** ** | **Rate**    | ** ** | **Balance**  | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Rate** | ** ** |
| ** **                                                               | ** ** | **(Dollars in thousands)** | ** ** |
|                                                                     |       |                                 |       |        |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Federal funds purchased and securities sold  under repurchase agreements |       | $                                    | —     |        | —     |         | $          | — |   | — |   | $ | — |   | — |   | $ | 113 |   | 0.88 |   | $ | 399 |   | 2.20 | % | $ | 609 |   | 2.63 | % |
| FHLB advances                                                            |       | 28,337                               |       | 4.10        | %          | 12,186       |       | 3.38 | % | 28,337 |   | 4.10 | % | 12,186 |   | 3.38 | % | 7,500 |   | 4.70 | % | 7,500 |   | 4.81 | % |
|                                                                          |            |                                      |            |             |            |              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

We hadno securities sold with agreements to repurchase during 2005.  The maximum amount of securities sold withagreements to repurchase at any month end during 2004 and 2003 was zero and$800,000, respectively.

Themaximum amount of other borrowings at any month end was $28.3 million during2005, $31.9 million during 2004 and $7.5 million during 2003.

AtDecember 31, 2005, we had $28.3 million of borrowed funds, all wereovernight borrowings and the balances scheduled to mature during 2006.

**JuniorSubordinated Debentures/Trust Preferred Securities**

In2001, National Mercantile, through National Mercantile Capital Trust I (the “Trust”),issued 15,000 of 10.25% fixed rate securities (the “Trust Preferred Securities”),with an aggregate liquidation amount of $15.0 million due July 25,2031.  The Trust Preferred Securities represent undivided beneficialinterests in the assets of the Trust and are unconditionally guaranteed byNational Mercantile with respect to distributions and payments uponliquidation, redemption and otherwise pursuant to the terms of a GuaranteeAgreement.  National Mercantile issuedthe Trust Preferred Securities to generate regulatory capital at a relativelylow cost (as payments of interest are deductible for income tax purposes).

Theprimary assets of the Trust are $15.5 million aggregate principal amount ofNational Mercantile 10.25% fixed rate junior subordinated deferrable interestdebentures due July 25, 2031 (“Junior Subordinated Debentures”) that payinterest each January 26 and July 26. The interest is deferrable, at National Mercantile’s option, for aperiod up to ten consecutive semi-annual payments, but in any event not beyondJune 25, 2031.  The debentures areredeemable, in whole or in part, at National Mercantile’s option on or afterfive years from issuance at declining premiums to maturity.

**Off-BalanceSheet Arrangements**

*  Guarantees*

NationalMercantile has unconditionally guaranteed the Trust Preferred Securities issuedby the Trust (see Junior Subordinated Debentures/Trust Preferred Securitiesabove).

34

----

 

**ContractualObligations**

Thefollowing table provides the amounts due under specified contractualobligations for the periods indicated as of December 31, 2005.

**Table 18**

**ContractualObligations**

 

|                                      | ** ** | **Payments Due**                 | ** ** |
|--------------------------------------|------------|---------------------------------------|------------|
| ** **                           | ** ** | **Twelve months  and less** | ** ** | **After one year  but within  three years** | ** ** | **After three  years but  within five  years** | ** ** | **After five years** | ** ** | **Total** | ** ** |
| ** **                           | ** ** | **(Dollars in thousands)**  | ** ** |
| Commitment to  fund loans            |       | $                                     | 120,822    |   | $ | — |   | $ | — |   | $ | — |   | $ | 120,822 |   |
| Commitments  under letters of credit |       | 1,052                                 |       | — |   | — |   | — |   | 1,052 |   |
| Deposits                             |       | 355,539                               |       | 7,669 |   | — |   | — |   | 363,208 |   |
| Borrowings                           |       | 28,337                                |       | — |   | — |   | 15,464 |   | 43,801 |   |
| Interest expense                     |       | 1,307                                 |       | 2,614 |   | 2,614 |   | 33,434 |   | 39,968 |   |
| Operating lease  obligations         |       | 693                                   |       | 1,403 |   | 1,012 |   | 1,563 |   | 4,671 |   |
| Other  liabilities                   |       | 3,288                                 |       | — |   | — |   | — |   | 3,288 |   |
| Total                                |       | $                                     | 511,038    |   | $ | 11,686 |   | $ | 3,626 |   | $ | 50,461 |   | $ | 576,810 |   |

 

Theobligations are categorized by their contractual due dates.  Approximately $70.6 million of thecommitments to fund loans relate to real estate construction and are expectedto fund within the next 12 months.  Thebalance of the commitments to fund loans is primarily revolving lines of creditor other commercial loans, and many of these commitments are expected to expirewithout being drawn upon.  Additionally,payments due for deposits reflect the contractual terms with our depositors towithdraw deposits, however, we do not anticipate the withdrawal of thesedeposits.  Total contractual obligations,therefore, do not necessarily represent future cash requirements.  We may, at our option, prepay certainborrowings prior to their maturity date. Furthermore, the actual payment of certain current liabilities may bedeferred into future periods.

**SelectedFinancial Ratios**

The following Table 19sets forth selected financial ratios:

 

**Table 19**

**SelectedPerformance Ratios**

 
|                                                      | ** ** | **For the Year Ended** | ** ** |
|------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                           | ** ** | **December 31,**                 | ** ** |
| ** **                                           | ** ** | **2005**                              | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                           | ** ** | ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Return on average  assets                            |       | 1.10                                  | %          | 0.61 | % | -0.01 | % |
| Return on  average shareholders’ equity         |       | 12.15                                 | %          | 7.02 | % | -0.10 | % |
| Average  shareholders’ equity to average assets |       | 9.04                                  | %          | 8.68 | % | 8.66 | % |

 

**RecentAccounting Pronouncements**

SeeRecent Accounting Pronouncements in Note 1-Summary of Significant AccountingPolicies of Notes to Consolidated Financial Statements.

**FACTORSWHICH MAY AFFECT FUTURE OPERATING RESULTS**

***Weface risk from changes in interest rates.***

Thesuccess of our business depends, to a large extent, on our net interest income.  Changes in market interest rates can affectour net interest income by affecting the spread between our interest-earningassets and interest-bearing liabilities. This may be due to the different maturities of our interest-earningassets and interest-bearing liabilities, as well as an increase in the generallevel of interest rates.  Changes inmarket interest rates also affect, among other things:

·                  Our ability tooriginate loans;

·                  Theability of our borrowers to make payments on their loans;

35

----

 

·                  The value of ourinterest-earning assets and our ability to realize gains from the sale of theseassets;

·                  The average lifeof our interest-earning assets;

·                  Our ability togenerate deposits instead of other available funding alternatives;

·                  Our ability to accessthe wholesale funding market; and

·                  Thefair values of our derivative financial instruments.

Interestrates are highly sensitive to many factors, including governmental monetarypolicies, domestic and international economic and political conditions andother factors beyond our control.

***Weface risk from possible declines in the quality of our assets.***

Ourfinancial condition depends significantly on the quality of our assets.  While we have developed and implementedunderwriting policies and procedures to guide us in the making of loans,compliance with these policies and procedures in making loans does notguarantee repayment of the loans.  If thelevel of our non-performing assets rises, our results of operations andfinancial condition will be affected.  Aborrower’s ability to pay its loan in accordance with its terms can beadversely affected by a number of factors, such as a decrease in the borrower’srevenues and cash flows due to adverse changes in economic conditions or adecline in the demand for the borrower’s products and/or services.

***Ourallowances for loan and lease losses may be inadequate.***

Weestablish allowances for loan and lease losses against each segment of our loanportfolio.  At December 31, 2005,our allowance for loan and lease losses equaled 1.32% of loans receivable and1400.6% of nonperforming loans.  Althoughwe believe that we had established adequate allowances for loan and leaselosses as of December 31, 2005, the credit quality or our assets isaffected by many factors beyond our control, including local and nationaleconomic conditions, and the possible existence of facts which are not known tous which adversely affect the likelihood of repayment of various loans in ourloan portfolio and realization of the collateral upon a default.  Accordingly, we can give no assurance that wewill not sustain loan losses materially in excess of the allowance for loan andlease losses.  In addition, the Office ofthe Comptroller of the Currency, as an integral part of its examination process,periodically reviews our allowance for loan and lease losses and could requireadditional provisions for credit losses. Material future additions to the allowance for loan and lease losses mayalso be necessary due to increases in the size and changes in the compositionof our loan portfolio.  Increases in ourprovisions for credit losses would adversely affect our results of operations.

***Economicconditions may worsen.***

Ourbusiness is strongly influenced by economic conditions in our market area (principally,the Greater Los Angeles metropolitan area) as well as regional and nationaleconomic conditions and in our niche markets, including the real estate andentertainment industries in Southern California.  During the past several years economic conditions,particularly in the real estate industry, have been favorable.  Should the economic condition in this marketarea deteriorate, the financial condition of our borrowers could weaken, whichcould lead to higher levels of loan defaults or a decline in the value ofcollateral for our loans.  In addition,an unfavorable economy could reduce the demand for our loans and other productsand services.

***Becausea significant amount of the loans we make are to borrowers in SouthernCalifornia, our operations could suffer as a result of local recession ornatural disasters in California.***

AtDecember 31, 2005, a large majority of our loans outstanding werecollateralized by real properties located in Southern California.  Because of this concentration in California,our financial position and results of operations have been and are expected tocontinue to be influenced by general trends in the California economy and itsreal estate market.  Real estate marketdeclines may adversely affect the values of the properties collateralizingloans.  If the principal balances of ourloans, together with any primary financing on the mortgaged properties, equalor exceed the value of the mortgaged properties, we could incur higher losses onsales of properties collateralizing foreclosed loans.  In addition, California historically has beenvulnerable to certain natural disaster risks, such as earthquakes anderosion-caused mudslides, which are not typically covered by the standardhazard insurance policies maintained by borrowers.  Uninsured disasters may adversely impact ourability to recover losses on properties affected by such disasters andadversely impact our results of operations.

***Ourbusiness is very competitive.***

Thereis intense competition in Southern California and elsewhere in the UnitedStates for banking customers.  Weexperience competition for deposits from many sources, including credit unions,insurance companies, money market funds and mutual funds, as well as othercommercial banks and savings institutions. We compete for loans and deposits primarily with other commercialbanks,  mortgage companies, commercialfinance companies and savings institutions. In recent years out-of-state financial institutions have entered theCalifornia market, which has also increased competition.  Many of our competitors have greaterfinancial strength, marketing capability and name recognition than we do, andoperate on a statewide or nationwide basis. In addition, recent developments in technology and mass marketing havepermitted larger companies to market loans more aggressively to our smallbusiness customers.  Such advantages maygive our competitors opportunities to realize greater efficiencies andeconomies of scale than we can.  We canprovide no assurance that we will be able to compete effectively against ourcompetition.

36

----

 

***Ourbusiness is heavily regulated.***

BothNational Mercantile, as a bank holding company, and the Banks, are subject tosignificant governmental supervision and regulation, which is intendedprimarily for the protection of depositors. Statutes and regulations affecting us may be changed at any time, andthe interpretation of these statutes and regulations by examining authoritiesalso may change.  We cannot assure youthat future changes in applicable statutes and regulations or in theirinterpretation will not adversely affect our business.

***Ourability to use our net operating losses may be limited.***

As ofDecember 31, 2005, we had NOLs of $5.0 million for federal tax purposes, whichbegin to expire in 2009.  Our ability touse the NOLs in the future would be significantly limited if we experience an “ownershipchange” within the meaning of Section 382 of the Internal  Revenue Code. If our use of these NOLs is limited, we would be required to charge off theportion of our deferred tax asset related to the NOL limitation, and our netincome would be lower.

***Asignificant portion of our loan portfolio consists of construction loans, whichhave greater risks than loans secured by completed real properties***

At December 31,2005, we had outstanding construction and land development loans in the amountof $92.1 million, representing 27% of our loan portfolio, and commitments tofund an additional $52.6  million ofconstruction loans.  These types of loansgenerally have greater risks than loans on completed homes, multifamilyproperties and commercial properties.  Aconstruction loan generally does not cover the full amount of the constructioncosts, so the borrower must have adequate funds to pay for the balance of theproject.  Price increases, delays andunanticipated difficulties can materially increase these costs.  Further, even if completed, there is noassurance that the borrower will be able to sell the project on a timely orprofitable basis, as these are closely related to real estate marketconditions, which can fluctuate substantially between the start and completionof the project.  If the borrower defaultsprior to completion of the project, the value of the project will likely beless than the outstanding loan, and we could be required to completeconstruction with our own funds to minimize losses on the project.

***Wehave goodwill from the acquisition of South Bay, which must be evaluatedregularly for impairment***

Inconnection with the acquisition of South Bay in December 2001, we recordedgoodwill in the amount of $3.2 million. We must evaluate the goodwill regularly for impairment. We had anunaffiliated consultant conduct goodwill impairment testing in the fourthquarter of 2005, and we determined that this goodwill was not impaired.  If in the future we determine that thegoodwill is impaired, we would be required to write-off some or all of thegoodwill, which could have a material adverse effect on our financial conditionand results of operations.

***Wehave a significant deferred tax asset and our ability to realize that assetdepends in part on the certainty of future earnings***

AtDecember 31, 2005, we had a deferred tax asset of $4.2 million relatingprimarily to our NOLs.  If future taxableincome should be less than the amount of the NOLs within the tax years to whichit may be applied, the deferred tax asset may not be realized.  To support our position that the benefits ofthis asset will be realized, we must estimate future earnings.  These estimates are based on many factors,including prior periods results.  If weare unable to generate future earnings in an amount sufficient to support theasset, we would have to establish a valuation allowance and correspondingcharge to earnings to reduce the deferred tax asset to its realizablevalue.  A material valuation allowance onthis asset would have a material adverse effect on our results of operationsand financial condition.

**ITEM 7.  FINANCIALSTATEMENTS**

Theconsolidated financial statements required by this Item are included herewithas a separate section of this Report as follows:

1.     *Financial Statements*

| Report of Independent  Registered Public Accounting Firm — Moss Adams LLP                                        |   |   |
|-----------------------------------------------------------------------------------------------------------------------|--------|--------|
|                                                                                                                  |   |   |
| Report of  Independent Registered Public Accounting Firm — Ernst & Young LLP                                 |   |   |
|                                                                                                                  |   |   |
| Consolidated Balance  Sheet at December 31, 2005                                                                 |   |   |
|                                                                                                                  |   |   |
| Consolidated  Statements of Operations for the years ended December 31, 2005 and 2004                            |   |   |
|                                                                                                                  |   |   |
| Consolidated  Statements of Changes in Shareholders’ Equity for the years ended  December 31, 2005 and 2004 |   |   |
|                                                                                                                  |   |   |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2005 and 2004                            |   |   |
|                                                                                                                  |   |   |
| Notes to  Consolidated Financial Statements for the two years ended December 31,  2005                           |   |   |

 

37

----

 

**ITEM 8**.           **CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING ANDFINANCIAL DISCLOSURE**

Notapplicable.

**ITEM 8A**.  **CONTROLS AND PROCEDURES**

TheCompany maintains disclosure controls and procedures (as defined in ExchangeAct Rule 13a-15(e)) that are designed to assure that information required to bedisclosed in its Exchange Act reports is recorded, processed, summarized andreported within the time periods specified in the Securities and ExchangeCommission’s rules and forms, and that such information is accumulated andcommunicated to management, including the Chief Executive Officer and ChiefFinancial Officer, as appropriate, to allow timely decisions regarding requireddisclosures.

Indesigning and evaluating the disclosure controls and procedures, managementrecognizes that any controls and procedures, no matter how well designed andoperated, can provide reasonable assurance only of achieving the desiredcontrol objectives, and management necessarily is required to apply itsjudgment in weighting the costs and benefits of possible new or differentcontrols and procedures.  Limitations areinherent in all control sysytems, so no evaluation of controls can provide absoluteassurance that all control issues and any fraud within the company have beendetected.

Asrequired by Exchange Act Rule 13a-15(b), as of the end of the period covered bythis report the Company, under  thesupervision and with the participation of our Chief Executive Officer and ChiefFinancial Officer, evaluated the effectiveness of the Company’s disclosurecontrols and procedures.  Based on thisevaluation, our Chief Executive Officer and Chief financial Officer concludedthat the Company’s disclosure controls and procedures were effective as of thatdate.

As aresult of a recent interpretation on the “short cut” method of accounting forderivatives as hedges under of SFAS 133, the Company undertook additionalreview and testing of its internal controls. After initial discussions with its auditors, the Audit Committee held ameeting on August 8, 2006 to review with management the potential impact ofthese matters. After completing further analysis, management recommended to theAudit Committee, at a follow-up meeting held on August 14, 2006, thatpreviously reported financial results be restated to eliminate hedge accountingfor the derivative. The Audit Committee agreed with management’srecommendation.

Inconnection with this amended Form 10-KSB, under the direction of our ChiefExecutive Officer and Chief Financial Officer, we reevaluated our disclosurecontrols and procedures.  We consideredthe reasons why the restatement was necessary and whether the restatementresulted from a material weakness in our disclosure controls and procedures.  Our Chief Executive Officer and ChiefFinancial Officer determined that the restatement does not affect theirconclusion that our disclosure controls and procedures were effective as ofDecember 31, 2005.  Factors that led tothis determination included: (i) we had retained and received advice fromprofessional experts in the accounting for derivatives as hedges transactionsat the time of the transaction and in connection with subsequent financialreporting, including our Form 10-KSB for the year ended December 31, 2005; (ii)the accounting treatment previously used by us was consistent with industrypractice; (iii) our interpretation of the accounting rules under SFAS No. 133was reasonable; and (iv) management, and our Audit Committee, identified the recentinterpretation on the “short cut” method of accounting for derivatives ashedges that resulted in the restatement of our financial statements.

Therewas no change in the Company’s internal control over financial reporting duringthe Company’s most recently completed fiscal quarter that has materiallyaffected, or is reasonably likely to materially affect, the Company’s internalcontrol over financial reporting.

**ITEM 8B**.  **OTHER INFORMATION**

Notapplicable.

38

----

 

**PART III**

ITEM 9.  DIRECTORS,EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH SECTION 16(a) OF THEEXCHANGE ACT

 The information required by this item will appear under thecaptions “Election of Directors,’’ ‘‘ Executive Officers,’’ ‘‘Section 16(a)Beneficial Ownership Reporting Compliance,’’ and “Code of Ethics” in theCompany’s proxy statement for the 2006 Annual Meeting of Shareholders (the‘‘2006 Proxy Statement’’), and such information shall be deemed to beincorporated herein by reference to that portion of the 2006 Proxy Statement,if filed with the Securities and Exchange Commission not later than 120 daysafter the end of  our most recentlycompleted fiscal year.

ITEM 10. EXECUTIVE COMPENSATION

 Theinformation required by this item will appear under the captions “Compensationof Executive Officers,” “Compensation of Directors,’’ ‘‘Summary CompensationTable,’’ “2005 Option Grants,” ‘‘2005 Option Exercises and Year-End OptionValues” and “Employment and Severance Agreements” in the 2006 Proxy Statement,and such information shall be deemed to be incorporated herein by reference tothose portions of the 2006 Proxy Statement, if filed with the Securities andExchange Commission not later than 120 days after the end of our most recentlycompleted fiscal year.

ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ANDRELATED STOCKHOLDERMATTERS

Theinformation required by this item will appear under the caption ‘‘SecurityOwnership of Principal Shareholders and Management’’ and “Equity CompensationPlan Information” in the 2006 Proxy Statement, and such information eithershall be deemed to be incorporated herein by reference to that portion of the2006 Proxy Statement, if filed with the Securities and Exchange Commission notlater than 120 days after the end of our most recently completed fiscal year.

ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Theinformation required by this item will appear under the caption ‘‘CertainRelationships and Related Transactions’’ in the 2006 Proxy Statement, and suchinformation shall be deemed to be incorporated herein by reference to thatportion of the 2006 Proxy Statement, if filed with the Securities and ExchangeCommission not later than 120 days after the end of our most recently completedfiscal year.

ITEM 13.  EXHIBITS

 SeeIndex to Exhibits on page 68 of this Form 10-KSB/A

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

 Theinformation required by this item will appear under the caption “IndependentPublic Accountants” in the 2006 Proxy Statement, and such information shall bedeemed to be incorporated herein by reference to that portion of the 2006 ProxyStatement, if filed with the Securities and Exchange Commission not later than120 days after the end of our most recently completed fiscal year.

39

----

 

*SIGNATURES*

Pursuantto the requirements of Section 13 or 15(d) of the Securities Exchange Actof 1934, the registrant has duly caused this report to be signed on its behalfby the undersigned, thereunto duly authorized.
|                           | NATIONAL MERCANTILE BANCORP |
|---------------------------|-----------------------------|
|                      | (Registrant)                |
|                      |                        |   |
|                      | By                          | /s/ SCOTT A. MONTGOMERY |
|                      |                        | Scott A.  Montgomery |
| Date: September  28, 2006 |                        | Chief Executive  Officer |

 

40

----

 

**Report of Independent Registered Public AccountingFirm**

To the Shareholders andthe Board of Directorsof National Mercantile Bancorp and subsidiaries:

We have audited the consolidated balance sheet ofNational Mercantile Bancorp (a California corporation) and subsidiaries(collectively, the “Company”) as of December 31, 2005, and the relatedconsolidated statements of operations, changes in shareholders’ equity and cashflows for the year ended December 31, 2005. These financial statements are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. We were not engaged to perform an audit of the Company’s internalcontrol over financial reporting. Our audit included consideration of internalcontrol over financial reporting as a basis for designing audit procedures thatare appropriate in the circumstances, but not for the purpose of expressing anopinion on the effectiveness of the Company’s internal control over financialreporting. Accordingly, we express no such opinion. An audit also includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements, assessing the accounting principles used and significantestimates made by management, and evaluating the overall financial statementpresentation. We believe that our audit provides a reasonable basis for ouropinion.

As discussed more fully in Note 1 to the consolidatedfinancial statements, the Company has restated its consolidated financialstatements for the years ended December 31, 2005, and 2004 to correct errorsrelated to the Company’s derivative accounting under Statement of FinancialAccounting Standards No. 133, Accounting for Derivative Instruments and HedgingActivities (“SFAS No. 133”).

In our opinion, the financial statements referred toabove present fairly, in all material respects, the consolidated financialposition of National Mercantile Bancorp and subsidiaries as of December 31, 2005,and the consolidated results of their operations and their cash flows for theyear ended December 31, 2005, in conformity with U.S. generally acceptedaccounting principles.

 
|                                                                  | /s/ Moss Adams  LLP |   |
|------------------------------------------------------------------|---------------------|--------|
| Los Angeles,  California                                         |                |
| March 31, 2006 except for                                        |                |
| Notes 1, 2, 7,  8, 11, 13, 14, 15 and 17 as to which the date is |                |
| September 28,  2006                                              |                |

 

41

----

 

**Report of Independent Registered Public AccountingFirm**

Tothe Shareholders and the Board of Directorsof National Mercantile Bancorp and subsidiaries:

Wehave audited the consolidated statements of operations, shareholders’ equityand cash flows of National Mercantile Bancorp (a California corporation) andsubsidiaries (collectively, the “Company”) for the year ended December 31,2004.  These financial statements are theresponsibility of the Company’s management. Our responsibility is to express an opinion on these financialstatements based on our audits.

Weconducted our audits in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement.  We were notengaged to perform an audit of the Company’s internal control over financialreporting.  Our audit includedconsideration of internal control over financial reporting as a basis fordesigning audit procedures that are appropriate in the circumstances, but notfor the purpose of expressing an opinion on the effectiveness of the Company’sinternal control over financial reporting. Accordingly, we express no suchopinion.  An audit also includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements, assessing the accounting principles used andsignificant estimates made by management, and evaluating the overall financialstatement presentation.  We believe thatour audits provide a reasonable basis for our opinion.

Inour opinion, the financial statements referred to above present fairly, in allmaterial respects, the consolidated results of operations and cash flows ofNational Mercantile Bancorp and subsidiaries for the year ended December 31,2004 in conformity with U.S. generally accepted accounting principles.

 
|                                             | /s/ Ernst &  Young LLP |   |
|---------------------------------------------|----------------------------|--------|
| Los Angeles,  California                    |                       |
| March 28, 2005                              |                       |
| except for Notes  1, 2, 7, 13, 14, and 15   |                       |
| as to which the  date is September 28, 2006 |                       |

 

42

----

 

**NATIONALMERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEET**

 
| ** **                                                                                                                                                                      | ** ** | **December 31,**                       | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                                                      | ** ** | **2005**                                    | ** ** |
| ** **                                                                                                                                                                      | ** ** | **(Dollars in  thousands,  restated)** | ** ** |
| ASSETS                                                                                                                                                                          |       |                                        |       |
| Cash and due  from banks-demand                                                                                                                                                 |       | $                                           | 13,507     |   |
| Due from  banks-interest bearing                                                                                                                                                |       | 2,000                                       |       |
| Federal funds  sold                                                                                                                                                             |       | 685                                         |       |
| Cash and cash equivalents                                                                                                                                                       |       | 16,192                                      |       |
| Securities  available-for-sale, at fair value; aggregate  amortized cost of $72,428                                                                                             |       | 71,758                                      |       |
| Securities  held-to-maturity, at amortized cost; aggregate fair  value of $2,572                                                                                                |       | 2,612                                       |       |
| Federal Reserve  Bank and other stock                                                                                                                                           |       | 3,809                                       |       |
| Loans receivable                                                                                                                                                                |       | 338,558                                     |       |
| Allowance for loan and lease losses                                                                                                                                             |       | (4,468                                      | )          |
| Net loans receivable                                                                                                                                                            |       | 334,090                                     |       |
|                                                                                                                                                                            |       |                                        |       |
| Premises and  equipment, net                                                                                                                                                    |       | 5,861                                       |       |
| Other real  estate owned                                                                                                                                                        |       | 1,056                                       |       |
| Deferred tax  asset, net                                                                                                                                                        |       | 4,442                                       |       |
| Goodwill                                                                                                                                                                        |       | 3,225                                       |       |
| Intangible  assets, net                                                                                                                                                         |       | 1,407                                       |       |
| Accrued interest  receivable and other assets                                                                                                                                   |       | 4,008                                       |       |
| Total assets                                                                                                                                                                    |       | $                                           | 448,460    |   |
|                                                                                                                                                                            |       |                                        |       |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY                                                                                                                                      |       |                                        |       |
| Deposits:                                                                                                                                                                       |       |                                        |       |
| Noninterest-bearing demand                                                                                                                                                      |       | $                                           | 115,924    |   |
| Interest-bearing demand                                                                                                                                                         |       | 36,018                                      |       |
| Money market                                                                                                                                                                    |       | 76,334                                      |       |
| Savings                                                                                                                                                                         |       | 28,208                                      |       |
| Time certificates of deposit:                                                                                                                                                   |       |                                        |       |
| $100,000 or more                                                                                                                                                                |       | 87,468                                      |       |
| Under $100,000                                                                                                                                                                  |       | 19,256                                      |       |
| Total deposits                                                                                                                                                                  |       | 363,208                                     |       |
|                                                                                                                                                                            |       |                                        |       |
| Other borrowings                                                                                                                                                                |       | 28,337                                      |       |
| Junior  subordinated deferrable interest debentures                                                                                                                             |       | 15,464                                      |       |
| Accrued interest  payable and other liabilities                                                                                                                                 |       | 3,288                                       |       |
| Total liabilities                                                                                                                                                               |       | 410,297                                     |       |
|                                                                                                                                                                            |       |                                        |       |
| Shareholders’  equity:                                                                                                                                                     |       |                                        |       |
|                                                                                                                                                                            |       |                                        |       |
| Preferred stock, no par value - authorized 1,000,000  shares: Series B non-cumulative convertible perpetual preferred stock; authorized  1,000 shares; outstanding 1,000 shares |       | 1,000                                       |       |
| Common stock, no par value; authorized 10,000,000 shares;  outstanding 4,403,024 shares                                                                                         |       | 45,697                                      |       |
| Accumulated deficit                                                                                                                                                             |       | (7,380                                      | )          |
| Accumulated other comprehensive loss                                                                                                                                            |       | (1,154                                      | )          |
| Total shareholders’ equity                                                                                                                                                 |       | 38,163                                      |       |
| Total  liabilities and shareholders’ equity                                                                                                                                |       | $                                           | 448,460    |   |

 

See accompanying notes to consolidatedfinancial statements.

43

----

 

**NATIONAL MERCANTILE BANCORP ANDSUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

 
| ** **                                                              | ** ** | **For the Year Ended**                    | ** ** |
|-------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                              | ** ** | **December 31,**                                    | ** ** |
| ** **                                                              | ** ** | **2005**                                                 | ** ** | **2004** | ** ** |
| ** **                                                              | ** ** | **(Dollars in thousands,**                     | ** ** |
| ** **                                                              | ** ** | **except per share data, restated)** | ** ** |
| Interest income:                                                        |       |                                                     |       |   |   |
| Loans, including fees                                                   |       | $                                                        | 24,039     |   | $ | 17,915 |   |
| Securities                                                              |       | 2,075                                                    |       | 1,388 |   |
| Due from banks                                                          |       | 101                                                      |       | 56 |   |
| Federal funds sold and securities purchased under  agreements to resell |       | 50                                                       |       | 95 |   |
| Total interest income                                                   |       | 26,265                                                   |       | 19,454 |   |
| Interest  expense:                                                      |       |                                                     |       |   |   |
| Interest-bearing demand                                                 |       | 158                                                      |       | 80 |   |
| Money market and savings                                                |       | 1,342                                                    |       | 749 |   |
| Time certificates of deposit:                                           |       |                                                     |       |   |   |
| $100,000 or more                                                        |       | 1,365                                                    |       | 403 |   |
| Under $100,000                                                          |       | 620                                                      |       | 473 |   |
| Total interest expense on deposits                                      |       | 3,485                                                    |       | 1,705 |   |
| Junior subordinated deferrable interest debentures                      |       | 1,585                                                    |       | 1,585 |   |
| Other borrowings                                                        |       | 412                                                      |       | 333 |   |
| Total interest expense                                                  |       | 5,482                                                    |       | 3,623 |   |
| Net interest income before provision for credit  losses                 |       | 20,783                                                   |       | 15,831 |   |
| Provision  (benefit) for credit losses                                  |       | (84                                                      | )          | 220 |   |
| Net interest income after provision for credit  losses                  |       | 20,867                                                   |       | 15,611 |   |
| Other operating  income:                                                |       |                                                     |       |   |   |
| Net loss on sale of securities available-for-sale                       |       | —                                                   |       | (197 | ) |
| Trading gains (losses) on non-hedge derivatives                         |       | (395                                                     | )          | 229 |   |
| Net settlement on interest rate swap                                    |       | 347                                                      |       | 619 |   |
| International services                                                  |       | 52                                                       |       | 59 |   |
| Investment division                                                     |       | 54                                                       |       | 53 |   |
| Deposit-related and other customer services                             |       | 1,060                                                    |       | 1,652 |   |
| Total other operating income                                            |       | 1,118                                                    |       | 2,415 |   |
| Other operating  expenses:                                              |       |                                                     |       |   |   |
| Salaries and related benefits                                           |       | 7,788                                                    |       | 7,508 |   |
| Net occupancy                                                           |       | 997                                                      |       | 1,127 |   |
| Furniture and equipment                                                 |       | 506                                                      |       | 485 |   |
| Printing and communications                                             |       | 537                                                      |       | 546 |   |
| Insurance and regulatory assessments                                    |       | 421                                                      |       | 433 |   |
| Client services                                                         |       | 666                                                      |       | 590 |   |
| Computer data processing                                                |       | 882                                                      |       | 965 |   |
| Legal services                                                          |       | 540                                                      |       | 464 |   |
| Other professional services                                             |       | 1,127                                                    |       | 854 |   |
| Amortization of core deposit intangible                                 |       | 223                                                      |       | 223 |   |
| Promotion and other expenses                                            |       | 689                                                      |       | 833 |   |
| Total other operating expenses                                          |       | 14,376                                                   |       | 14,028 |   |
| Income before  income tax provision                                     |       | 7,609                                                    |       | 3,998 |   |
| Income tax  provision                                                   |       | 3,159                                                    |       | 1,678 |   |
| Net income                                                              |       | $                                                        | 4,450      |   | $ | 2,320 |   |
| Earnings per  share:                                                    |       |                                                     |       |   |   |
| Basic                                                                   |       | $                                                        | 0.96       |   | $ | 0.64 |   |
| Diluted                                                                 |       | $                                                        | 0.75       |   | $ | 0.41 |   |

 

See accompanying notes to consolidatedfinancial statements.

44

----

 

**NATIONALMERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY**

 
| ** **                                                    | ** ** | ** **                                                                            | ** ** | ** **                                  | ** ** | ** **                | ** ** | ** **      | ** ** | ** **                | ** ** | ** ** | ** ** | ** **  | ** ** | **Accumulated  Other** | ** ** | ** ** | ** ** |
|---------------------------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|---------------------------|------------|-----------------|------------|---------------------------|------------|------------|------------|-------------|------------|------------------------|------------|------------|------------|
| ** **                                                    | ** ** | **Preferred Stock Series A**                                           | ** ** | **Preferred Stock Series B** | ** ** | **Common Stock**     | ** ** | **Accumulated** | ** ** | **Comprehensive**         | ** ** | ** ** | ** ** |
| ** **                                                    | ** ** | **# of Shares**                                                             | ** ** | **Amount**                                  | ** ** | **# of Shares** | ** ** | **Amount**      | ** ** | **# of Shares** | ** ** | **Amount** | ** ** | **Deficit** | ** ** | **Income**             | ** ** | **Total**  | ** ** |
| ** **                                                    | ** ** | **(Dollars in thousands, except share data, restated)** | ** ** |
| ** **                                                    | ** ** | ** **                                                                            | ** ** | ** **                                  | ** ** | ** **                | ** ** | ** **      | ** ** | ** **                | ** ** | ** ** | ** ** | ** **  | ** ** | ** **             | ** ** | ** ** | ** ** |
| Balance at  December 31, 2003                                 |       | 729,585                                                                               |       | $                                           | 5,959      |                      | 1,000      |            | $          | 1,000                     |       | 2,772,279  |       | $           | 38,602     |                   | $          | (14,150    | )          | $ | 71 |   | $ | 31,482 |   |
| Preferred stock converted into common stock on a 2:1  basis   |       | (63,312                                                                               | )          | (517                                        | )          |                      |       |            |       | 126,624                   |       | 517        |       |        |       |                   |       | —     |       |
| Stock options exercised                                       |       |                                                                                  |       |                                        |       |                      |       |            |       | 55,225                    |       | 372        |       |        |       |                   |       | 372        |       |
| Comprehensive income:                                         |       |                                                                                  |       |                                        |       |                      |       |            |       |                      |       |       |       |        |       |                   |       |       |       |
| Unrealized holding gain during the period, net                |       |                                                                                  |       |                                        |       |                      |       |            |       |                      |       |       |       |        |       | 203                    |       | 203        |       |
| Net income                                                    |       |                                                                                  |       |                                        |       |                      |       |            |       |                      |       |       |       | 2,320       |       |                   |       | 2,320      |       |
| Comprehensive income                                          |       |                                                                                  |       |                                        |       |                      |       |            |       |                      |       |       |       |        |       |                   |       | 2,523      |       |
| Balance at  December 31, 2004                                 |       | 666,273                                                                               |       | 5,442                                       |       | 1,000                     |       | 1,000           |       | 2,954,128                 |       | 39,491     |       | (11,830     | )          | 274                    |       | 34,377     |       |
| Preferred stock converted into common stock on a 2:1  basis   |       | (666,273                                                                              | )          | (5,442                                      | )          |                      |       |            |       | 1,332,546                 |       | 5,442      |       |        |       |                   |       | —     |       |
| Common stock issued                                           |       |                                                                                  |       |                                        |       |                      |       |            |       |                      |       |       |       |        |       |                   |       | —     |       |
| Stock options exercised                                       |       |                                                                                  |       |                                        |       |                      |       |            |       | 116,350                   |       | 764        |       |        |       |                   |       | 764        |       |
| Cumulative effect of change in accounting principal  (Note 1) |       |                                                                                  |       |                                        |       |                      |       |            |       |                      |       |       |       |        |       |                   |       | —     |       |
| Comprehensive income (loss):                                  |       |                                                                                  |       |                                        |       |                      |       |            |       |                      |       |       |       |        |       |                   |       |       |       |
| Unrealized holding gain during the period, net                |       |                                                                                  |       |                                        |       |                      |       |            |       |                      |       |       |       |        |       | (1,428                 | )          | (1,428     | )          |
| Net income                                                    |       |                                                                                  |       |                                        |       |                      |       |            |       |                      |       |       |       | 4,450       |       |                   |       | 4,450      |       |
| Comprehensive income                                          |       |                                                                                  |       |                                        |       |                      |       |            |       |                      |       |       |       |        |       |                   |       | 3,022      |       |
| Balance at December 31,  2005                                 |       | —                                                                                |       | $                                           | —     |                      | 1,000      |            | $          | 1,000                     |       | 4,403,024  |       | $           | 45,697     |                   | $          | (7,380     | )          | $ | (1,154 | ) | $ | 38,163 |   |

 

See accompanyingnotes to consolidated financial statements.

45

----

 

**NATIONALMERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

 
| ** **                                                                                  | ** ** | **For the Year Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                                  | ** ** | **2005**                                                     | ** ** | **2004** | ** ** |
| ** **                                                                                  | ** ** | **(Dollars in thousands, restated)**          | ** ** |
| Cash flows from  operating activities:                                                      |       |                                                         |       |   |   |
| Net income                                                                                  |       | $                                                            | 4,450      |   | $ | 2,320 |   |
| Adjustments to reconcile net income to net cash used  in operating activities:              |       |                                                         |       |   |   |
| Depreciation and amortization                                                               |       | 425                                                          |       | 409 |   |
| Provision (benefit) for credit losses                                                       |       | (84                                                          | )          | 220 |   |
| Trading loss (gain) on non-hedge derivatives                                                |       | 395                                                          |       | (229 | ) |
| Loss on sale of securities available for sale                                               |       | —                                                       |       | 197 |   |
| Net amortization of premium on securities  available-for-sale                               |       | 20                                                           |       | 250 |   |
| Net amortization of premium on securities  held-to-maturity                                 |       | 29                                                           |       | 47 |   |
| Net amortization of core deposit intangible                                                 |       | 223                                                          |       | 223 |   |
| Net amortization of premium on loans purchased                                              |       | 159                                                          |       | 190 |   |
| Utilization of deferred tax assets                                                          |       | 1,083                                                        |       | 1,664 |   |
| Decrease (increase) in accrued interest receivable  and other assets                        |       | 17                                                           |       | (236 | ) |
| Increase in accrued interest payable and other  liabilities                                 |       | 1,137                                                        |       | 329 |   |
| Net cash provided by operating activities                                                   |       | 7,854                                                        |       | 5,384 |   |
|                                                                                        |       |                                                         |       |   |   |
| Cash flows from  investing activities:                                                      |       |                                                         |       |   |   |
| Purchase of securities available-for-sale                                                   |       | (47,884                                                      | )          | (34,987 | ) |
| Proceeds from sales of securities available-for-sale                                        |       | —                                                       |       | 11,759 |   |
| Proceeds from repayments and maturities of  securities available-for-sale                   |       | 12,457                                                       |       | 16,517 |   |
| Proceeds from repayments and maturities of  securities held-to-maturity                     |       | 866                                                          |       | 1,043 |   |
| Loan originations and principal collections, net                                            |       | (25,668                                                      | )          | (53,178 | ) |
| Purchase of Federal Reserve stock and other stocks                                          |       | (733                                                         | )          | (1,204 | ) |
| Expenditures on OREO improvements                                                           |       | —                                                       |       | (132 | ) |
| Purchases of premises and equipment                                                         |       | (482                                                         | )          | (769 | ) |
|                                                                                        |       |                                                         |       |   |   |
| Net cash used in investing activities                                                       |       | (61,444                                                      | )          | (60,951 | ) |
|                                                                                        |       |                                                         |       |   |   |
| Cash flows from  financing activities:                                                      |       |                                                         |       |   |   |
| Net increase in demand deposits, money market and  savings accounts                         |       | 6,041                                                        |       | 6,749 |   |
| Net increase in time certificates of deposit                                                |       | 43,625                                                       |       | 8,076 |   |
| Net decrease in securities sold under agreements to  repurchase and federal funds purchased |       | —                                                       |       | (399 | ) |
| Net increase in other borrowings                                                            |       | 2,437                                                        |       | 18,400 |   |
| Net proceeds from exercise of stock options                                                 |       | 764                                                          |       | 372 |   |
| Net cash provided by financing activities                                                   |       | 52,867                                                       |       | 33,198 |   |
| Net decrease in  cash and cash equivalents                                                  |       | (723                                                         | )          | (22,369 | ) |
| Cash and cash  equivalents, January 1                                                       |       | 16,915                                                       |       | 39,284 |   |
| Cash and cash  equivalents, December 31                                                     |       | $                                                            | 16,192     |   | $ | 16,915 |   |
|                                                                                        |       |                                                         |       |   |   |
| Supplemental  disclosures of cash flow information:                                         |       |                                                         |       |   |   |
| Cash paid for interest                                                                      |       | $                                                            | 4,778      |   | $ | 3,229 |   |
| Cash paid for income taxes                                                                  |       | 1,225                                                        |       | 51 |   |
| Unrealized loss on securitites available-for-sale,  net of tax effect                       |       | (392                                                         | )          | (40 | ) |
| Unrealized gain  (loss) on cash flow hedges, net of tax effect                              |       | $                                                            | (762       | ) | $ | 314 |   |

 

Seeaccompanying notes to consolidated financial statements.

46

----

**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**Note 1—Restatement**

NationalMercantile Bancorp has restated its consolidated financial statements for theyears ended December 31, 2005, 2004 and 2003 and for each of the interimperiods in 2005, 2004 and 2003. This restatement corrected errors related tothe Company’s derivative accounting under Statement of Financial AccountingStandards No. 133, Accounting for Derivative Instruments and HedgingActivities (“SFAS No. 133”).

In2003, the Company entered into an interest rate swap agreement in connectionwith the trust preferred securities related to the Company’s juniorsubordinated deferrable interest debentures (Trust Preferred Swap) that wasaccounted for as a fair value hedge under SFAS No. 133. The Companyelected an abbreviated method (the “short-cut” method) of documenting theeffectiveness of the swap as a hedge, which allowed the Company to assume noineffectiveness in this transaction. As a result of later technicalinterpretations of SFAS 133, the Company subsequently concluded that theTrust Preferred Swap did not qualify for this method in priorperiods.  The presence of an interestdeferral feature in the interest rate swap was determined, in retrospect, to havecaused the interest rate swap to not have a fair value of zero at inception,which is required under SFAS 133 to qualify for short-cut hedge accountingtreatment.  Hedge accounting underSFAS No. 133 for this swap transaction is not allowed retrospectivelybecause the hedge documentation required for the long-haul method was not inplace at the inception of the hedge. Eliminating the application of fair valuehedge accounting reverses the fair value adjustments that were made to thehedged item, the debt, as an adjustment to the par amount of theTrust Preferred debt. This reversal of fair value hedge accounting alsoresults in reclassification of swap net settlements from interest expense tononinterest income as well as recording of swap mark-to-market adjustments intrading gains (losses) on economic derivatives.

Thefollowing table sets forth the effects of the adjustments on net income for theyears 2005 and 2004.  Since the Companycould not apply hedge accounting for the transaction, the Trust Preferred Swaphas been marked-to-market through the consolidated statement of operations withno related offset for hedge accounting.

**Increase(Decrease) in Net Income**
|                                                  | ** ** | **Year Ended December 31,**                                 | ** ** |
|--------------------------------------------------|------------|----------------------------------------------------------------------------|------------|
| ** **                                       | ** ** | **      2005     ** | ** ** | **      2004     ** | ** ** |
| ** **                                       | ** ** | **(Dollars in thousands)**                                       | ** ** |
| Net income as  previously reported               |       | $                                                                          | 4,681      |   | $ | 2,186 |   |
|                                             |       |                                                                       |       |   |   |
| Trading gains  (losses) on non-hedge derivatives |       | (395                                                                       | )          | 229 |   |
| Benefit  (provision) for income taxes            |       | 164                                                                        |       | (95 | ) |
| Total adjustment                                 |       | (231                                                                       | )          | 134 |   |
|                                             |       |                                                                       |       |   |   |
| Restated net  income                             |       | $                                                                          | 4,450      |   | $ | 2,320 |   |
| Percent change                                   |       | (4.93                                                                      | )%         | 6.13 | % |

 

The following tables reflect the previously reportedamounts and the restated results by financial statement line item for theconsolidated balance sheet and statement of stockholders’ equity as of December 31,2005 and the consolidated statements of income for the years endedDecember 31, 2005 and 2004.
|                                                  | ** ** | **December 31,**                | ** ** |
|--------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                       | ** ** | **2005**                             | ** ** |
| ** **                                       | ** ** | **As  Originally  Reported**         | ** ** | **Restated** | ** ** |
| ** **                                       | ** ** | **(Dollars in thousands)** | ** ** |
| Consolidated  balance sheets:                    |       |                                 |       |   |   |
| Deferred tax asset, net                          |       | $                                    | 4,203      |   | $ | 4,442 |   |
| Accrued interest receivable and other assets     |       | 4,583                                |       | 4,008 |   |
| Total assets                                     |       | 448,796                              |       | 448,460 |   |
| Accumulated deficit                              |       | (7,044                               | )          | (7,380 | ) |
| Total shareholders’ equity                  |       | 38,499                               |       | 38,163 |   |
| Total  liabilities and shareholders’ equity |       | 448,796                              |       | 448,460 |   |
|                                                  |            |                                      |            |  |  |  |  |

 

47

----

 
| ** **                                              | ** ** | **Year Ended December 31,**                                      | ** ** |
|---------------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                                              | ** ** | **2005**                                                                        | ** ** | **2004** | ** ** |
| ** **                                              | ** ** | **As  Originally  Reported**                                                    | ** ** | **As Restated** | ** ** | **As  Originally  Reported** | ** ** | **As Restated** | ** ** |
| ** **                                              | ** ** | **(Dollars in thousands, except per share data)** | ** ** |
| Consolidated Statements  of Operations:                 |       |                                                                            |       |   |   |   |   |   |   |
| Interest expense:                                       |       |                                                                            |       |   |   |   |   |   |   |
| Junior subordinated  deferrable interest debentures     |       | $                                                                               | 1,239      |   | $ | 1,585 |   | $ | 966 |   | $ | 1,585 |   |
| Total interest expense                                  |       | 5,136                                                                           |       | 5,482 |   | 3,004 |   | 3,623 |   |
| Net interest income  before provision for credit losses |       | 21,129                                                                          |       | 20,783 |   | 16,450 |   | 15,831 |   |
| Net interest income  after provision for credit losses  |       | 21,213                                                                          |       | 20,867 |   | 16,230 |   | 15,611 |   |
| Trading gains (losses)  on economic derivatives         |       | —                                                                          |       | (395 | ) | — |   | 229 |   |
| Net cash settlement of  interest rate swap derivative   |       | —                                                                          |       | 347 |   | — |   | 619 |   |
| Total other operating  income                           |       | 1,166                                                                           |       | 1,118 |   | 1,567 |   | 2,415 |   |
| Income before income  tax provision                     |       | 8,003                                                                           |       | 7,609 |   | 3,769 |   | 3,998 |   |
| Income tax provision                                    |       | 3,322                                                                           |       | 3,159 |   | 1,583 |   | 1,678 |   |
| Net income                                              |       | 4,681                                                                           |       | 4,450 |   | 2,186 |   | 2,320 |   |
| Earnings per share –  basic(1)                     |       | 1.01                                                                            |       | 0.96 |   | 0.60 |   | 0.64 |   |
| Earnings per share –  diluted(1)                   |       | 0.79                                                                            |       | 0.75 |   | 0.38 |   | 0.41 |   |
|                                                         |            |                                                                                 |            |  |  |  |  |  |  |  |  |  |  |

 

----

(1) Adjusted for the 5-for 4-stock split paid April 16, 2006
| ** **                                                       | ** ** | **Accumulated Deficit**         | ** ** | **Total**    | ** ** |
|------------------------------------------------------------------|------------|--------------------------------------|------------|--------------|------------|
| ** **                                                       | ** ** | **As  Originally  Reported**         | ** ** | **Restated** | ** ** | **As  Originally  Reported** | ** ** | **Restated** | ** ** |
| ** **                                                       | ** ** | **(Dollars in thousands)** | ** ** |
| Consolidated Statement of  Changes in Shareholders’ Equity: |       |                                 |       |         |       |   |   |   |   |
| Balance at December 31,  2003                                    |       | $                                    | (13,911    | )            | $          | (14,150 | ) | $ | 31,721 |   | $ | 31,482 |   |
| For the year ended  December 31, 2004:                           |       |                                 |       |         |       |   |   |   |   |
| Net income                                                       |       | 2,186                                |       | 2,320        |       | 2,186 |   | 2,320 |   |
| Comprehensive income                                             |       |                                 |       |         |       | 2,389 |   | 2,523 |   |
| Balance at December 31,  2004                                    |       | (11,725                              | )          | (11,830      | )          | 34,482 |   | 34,377 |   |
| For the year ended  December 31, 2005:                           |       |                                 |       |         |       |   |   |   |   |
| Net income                                                       |       | 4,681                                |       | 4,450        |       | 4,681 |   | 4,450 |   |
| Comprehensive income                                             |       |                                 |       |         |       | 3,253 |   | 3,022 |   |
| Balance at December 31,  2005                                    |       | (7,044                               | )          | (7,380       | )          | 38,499 |   | 38,163 |   |
|                                                                  |            |                                      |            |              |            |  |  |  |  |  |  |  |  |

 

The following table reflects the previously reportedamounts and the restated results by financial statement line item for theconsolidated balance sheet as of March 31, June 30, and September 30, 2005.
|                                                  | ** ** | **March 31,**                   | ** ** | **June 30,** | ** ** | **September 30,**       | ** ** |
|--------------------------------------------------|------------|--------------------------------------|------------|-------------------|------------|------------------------------|------------|
| ** **                                       | ** ** | **2005**                             | ** ** | **2005**          | ** ** | **2005**                     | ** ** |
| ** **                                       | ** ** | **As  Originally  Reported**         | ** ** | **Restated**      | ** ** | **As  Originally  Reported** | ** ** | **Restated** | ** ** | **As  Originally  Reported** | ** ** | **Restated** | ** ** |
| ** **                                       | ** ** | **(Dollars in thousands)** | ** ** | ** **        | ** ** | ** **                   | ** ** | **(Dollars in thousands)** | ** ** |
| Consolidated  balance sheets:                    |       |                                 |       |              |       |                         |       |   |   |   |   |   |   |
| Deferred tax  asset, net                         |       | $                                    | 5,476      |              | $          | 5,635                        |       | $ | 4,862 |   | $ | 4,780 |   | $ | 4,652 |   | $ | 4,775 |   |
| Accrued interest  receivable and other assets    |       | 3,662                                |       | 3,277             |       | 3,996                        |       | 4,193 |   | 3,893 |   | 3,595 |   |
| Total assets                                     |       | 387,006                              |       | 386,780           |       | 403,684                      |       | 403,799 |   | 428,483 |   | 428,308 |   |
| Accumulated  deficit                             |       | (10,785                              | )          | (11,010           | )          | (9,747                       | )          | (9,631 | ) | (8,450 | ) | (8,623 | ) |
| Total  shareholders’ equity                 |       | 34,801                               |       | 34,576            |       | 36,432                       |       | 36,548 |   | 37,087 |   | 36,914 |   |
| Total  liabilities and shareholders’ equity |       | 387,006                              |       | 386,780           |       | 403,684                      |       | 403,799 |   | 428,483 |   | 428,308 |   |
|                                                  |            |                                      |            |                   |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

48

----

 

The following tables reflect the previously reportedamounts and the restated results by financial statement line item for theconsolidated statements of income for the three month periods ended March 31,June 30, September 30, and December 31, 2005 and 2004.
| ** **                                              | ** ** | **For the three months ended**                              | ** ** |
|---------------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                                              | ** ** | **March 31, 2005**                                                    | ** ** | **June 30, 2005** | ** ** | **September 30, 2005** | ** ** | **December 31, 2005** | ** ** |
| ** **                                              | ** ** | **As  Originally  Reported**                                                    | ** ** | **Restated** | ** ** | **As  Originally  Reported** | ** ** | **Restated** | ** ** | **As  Originally  Reported** | ** ** | **Restated** | ** ** | **As  Originally  Reported** | ** ** | **Restated** | ** ** |
| ** **                                              | ** ** | **(Dollars in thousands, except per share data)** | ** ** |
| Consolidated Statements  of Operations:                 |       |                                                                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest expense:                                       |       |                                                                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Junior subordinated deferrable interest debentures      |       | $                                                                               | 280        |   | $ | 396 |   | $ | 297 |   | $ | 396 |   | $ | 326 |   | $ | 396 |   | $ | 335 |   | $ | 396 |   |
| Total interest expense                                  |       | 976                                                                             |       | 1,092 |   | 1,016 |   | 1,115 |   | 1,298 |   | 1,368 |   | 1,846 |   | 1,907 |   |
| Net interest income before provision for credit  losses |       | 4,861                                                                           |       | 4,745 |   | 5,073 |   | 4,974 |   | 5,456 |   | 5,386 |   | 5,739 |   | 5,678 |   |
| Net interest income after provision for credit losses   |       | 4,772                                                                           |       | 4,656 |   | 5,073 |   | 4,974 |   | 5,669 |   | 5,599 |   | 5,699 |   | 5,638 |   |
| Trading gains (losses) on economic derivatives          |       | —                                                                          |       | (204 | ) | — |   | 582 |   | — |   | (493 | ) | — |   | (280 | ) |
| Net cash settlement of non-hedge interest rate swap     |       | —                                                                          |       | 116 |   | — |   | 99 |   | — |   | 70 |   | — |   | 61 |   |
| Total other operating income                            |       | 322                                                                             |       | 234 |   | 299 |   | 980 |   | 278 |   | (145 | ) | 267 |   | 48 |   |
| Income before income tax provision                      |       | 1,608                                                                           |       | 1,404 |   | 1,773 |   | 2,355 |   | 2,217 |   | 1,724 |   | 2,405 |   | 2,125 |   |
| Income tax provision                                    |       | 667                                                                             |       | 582 |   | 736 |   | 978 |   | 920 |   | 715 |   | 999 |   | 883 |   |
| Net income                                              |       | 941                                                                             |       | 822 |   | 1,037 |   | 1,377 |   | 1,297 |   | 1,009 |   | 1,406 |   | 1,242 |   |
| Earnings per share – basic(1)                      |       | 0.25                                                                            |       | 0.22 |   | 0.27 |   | 0.35 |   | 0.24 |   | 0.19 |   | 0.26 |   | 0.23 |   |
| Earnings per share – diluted(1)                    |       | 0.16                                                                            |       | 0.14 |   | 0.18 |   | 0.23 |   | 0.22 |   | 0.17 |   | 0.24 |   | 0.21 |   |
|                                                         |            |                                                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1) Adjusted for the 5-for 4-stock split paid April 16, 2006
| ** **                                              | ** ** | **For the three months ended**                              | ** ** |
|---------------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                                              | ** ** | **March 31, 2004**                                                    | ** ** | **June 30, 2004** | ** ** | **September 30, 2004** | ** ** | **December 31, 2004** | ** ** |
| ** **                                              | ** ** | **As  Originally  Reported**                                                    | ** ** | **Restated** | ** ** | **As  Originally  Reported** | ** ** | **Restated** | ** ** | **As  Originally  Reported** | ** ** | **Restated** | ** ** | **As  Originally  Reported** | ** ** | **Restated** | ** ** |
| ** **                                              | ** ** | **(Dollars in thousands, except per share data)** | ** ** |
| Consolidated  Statements of Operations:                 |       |                                                                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest expense:                                       |       |                                                                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Junior subordinated deferrable interest debentures      |       | $                                                                               | 226        |   | $ | 396 |   | $ | 228 |   | $ | 375 |   | $ | 259 |   | $ | 396 |   | $ | 253 |   | $ | 396 |   |
| Total interest expense                                  |       | 690                                                                             |       | 860 |   | 694 |   | 841 |   | 792 |   | 929 |   | 828 |   | 971 |   |
| Net interest income before provision for credit  losses |       | 3,451                                                                           |       | 3,281 |   | 3,622 |   | 3,475 |   | 4,695 |   | 4,558 |   | 4,682 |   | 4,539 |   |
| Net interest income after provision for credit losses   |       | 3,451                                                                           |       | 3,281 |   | 3,622 |   | 3,475 |   | 4,575 |   | 4,438 |   | 4,582 |   | 4,439 |   |
| Trading gains (losses) on economic derivatives          |       | —                                                                          |       | 453 |   | — |   | (837 | ) | — |   | 670 |   | — |   | (58 | ) |
| Net cash settlement of non-hedge interest rate swap     |       | —                                                                          |       | 170 |   | — |   | 147 |   | — |   | 137 |   | — |   | 143 |   |
| Total other operating income                            |       | 465                                                                             |       | 1,088 |   | 402 |   | (288 | ) | 317 |   | 1,124 |   | 383 |   | 468 |   |
| Income before income tax provision                      |       | 493                                                                             |       | 946 |   | 585 |   | (252 | ) | 1,514 |   | 2,184 |   | 1,177 |   | 1,119 |   |
| Income tax provision                                    |       | 202                                                                             |       | 390 |   | 240 |   | (107 | ) | 642 |   | 920 |   | 499 |   | 475 |   |
| Net income                                              |       | 291                                                                             |       | 556 |   | 345 |   | (145 | ) | 872 |   | 1,264 |   | 678 |   | 644 |   |
| Earnings per share – basic(1)                      |       | 0.08                                                                            |       | 0.16 |   | 0.09 |   | -0.04 |   | 0.24 |   | 0.35 |   | 0.18 |   | 0.17 |   |
| Earnings per share – diluted(1)                    |       | 0.05                                                                            |       | 0.10 |   | 0.06 |   | -0.03 |   | 0.15 |   | 0.22 |   | 0.12 |   | 0.11 |   |
|                                                         |            |                                                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1) Adjusted for the 5- for 4-stock split paid April16, 2006

Inaddition, the following Notes to Consolidated Financial Statements have beenrestated: 2, 7,13, 14, 15.

**Note 2—Summary ofSignificant Accounting Policies**

*Basis ofPresentation*

The consolidatedfinancial statements include the accounts of National Mercantile Bancorp (“NationalMercantile” when referring only to the parent company or the “Company” whensuch reference includes National Mercantile Bancorp and its subsidiaries,

49

----

 

collectively) andof its wholly owned subsidiaries, Mercantile National Bank (“Mercantile”) andSouth Bay Bank, N.A. (“South Bay”) (and collectively, the “Banks”).  All intercompany transactions and balanceshave been eliminated.  Certain prior yearamounts have been reclassified to conform to the current year presentation.

NationalMercantile Capital Trust I (the “Trust”), a Delaware business trust, was formedby the Company in 2001 for the sole purpose of issuing certain securitiesrepresenting undivided beneficial interests in the assets of the Trust andinvesting the proceeds thereof in the Company’s junior subordinated deferrableinterest debentures.  The Trust’s 464common securities (liquidation amount of $1,000 per common security) are whollyowned by National Mercantile, however, in accordance with FASB InterpretationNo. 46R, Consolidation of Variable Interest Entities, the Trust is notconsolidated in the Company’s financial statements and it is treated as anequity investment.

Theaccounting and reporting policies of the Company conform to accountingprinciples generally accepted in the United States and to prevailing practiceswithin the banking industry.  Thepreparation of the financial statements in conformity with generally acceptedaccounting principles requires management to make certain estimates andassumptions that affect the reported amounts of assets, liabilities, andcontingencies at the date of the financial statements and the reported amountsof revenues and expenses during the reporting period.  The estimates that are particularlysusceptible to significant change in the near term relate to the determinationof the allowance for loan and lease losses, the assessment of goodwill and coredeposit intangible impairment, and the valuation of deferred tax asset. Actualamounts or results could differ from those estimates.

TheCompany, through the Banks, engages in commercial banking in the Los Angelesarea providing commercial and residential real estate financing, real estateconstruction financing and commercial lending serving niche markets representedby professional service providers, entertainment, healthcare andcommunity-based nonprofit borrowers, and associated individuals with commercialbanking and personal banking needs.

*Cash andCash Equivalents*

Forpurposes of reporting cash flows, cash and cash equivalents include cash anddue from banks-demand, due from banks — interest bearing, and federal fundssold.

*Securities*

Securitiesavailable-for-sale are carried at fair value. Unrealized gains or losses on available-for-sale securities are excludedfrom earnings and reported as accumulated other comprehensive income, net ofdeferred income taxes, in a separate component of shareholders’ equity untilrealized.  Realized gains or losses onsales of available-for-sale securities are recorded using the specificidentification method.

Securitiesheld-to-maturity are debt instruments in which management has the positiveintent and ability to hold to maturity and are carried at amortized cost.

Premiumsor discounts on available-for-sale and held-to-maturity securities areamortized or accreted into income using the effective interest method.

FederalReserve Bank and other stock are equity investments without an active secondarymarket; however, the issuers typically redeem the membership stock at thestated value.  Accordingly, they arecarried at historical cost.

We areobligated to assess, at each reporting date, whether there is an “other-than-temporary”impairment to our investment securities. Such impairment must be recognized in current earnings rather than inother comprehensive income. We review all individual securities that are in anunrealized loss position at each reporting date for other-than-temporaryimpairment.  Specific investment levelfactors we examine to assess impairment include the severity and duration ofthe loss, an analysis of the issuers of the securities and if there has beenany cause for default on the securities and any change in the rating of thesecurities by the various rating agencies. Additionally, we review the financial resources and the overall abilitythat the Company has and the intent that management has to hold the securitiesuntil their fair values recover.

*Loans*

Loansare generally carried at principal amounts outstanding less unearnedincome.  Unearned income includesdeferred unamortized fees net of direct incremental loan origination costs.

Interestincome is accrued as earned.  Netdeferred fees are accreted into interest income using the effective yieldmethod.

Loans are placed onnonaccrual status when a loan becomes 90 days past due as to interest orprincipal unless the loan is both well secured and in process ofcollection.  Loans are also placed onnonaccrual status when the full collection of interest or principal becomesuncertain.  When a loan is placed onnonaccrual status, the accrued and unpaid interest receivable is reversed andthe accretion of deferred loan fees is ceased. Thereafter, interest collected on the loan is accounted for on the cashcollection method until qualifying for return to accrual status.  Generally, a loan may be returned to accrualstatus when all delinquent principal and interest are brought current inaccordance with the terms of the loan agreement and certain performancecriteria have been met.

50

----

 

TheCompany considers a loan to be impaired when it is probable that it will beunable to collect all amounts due according to the contractual terms of theloan agreement.  Once a loan is determinedto be impaired, the impairment is measured based on the present value of theexpected future cash flows discounted at the loan’s effective interest rate,except that as a practical expedient, the impairment is measured by using theloan’s observable market price or the fair value of the collateral if the loanis collateral dependent.

Whenthe measurement of the impaired loan is less than the recorded amount of theloan, impairment is recognized by creating a valuation allowance with acorresponding charge to the provision for credit losses or by adjusting anexisting valuation allowance for the impaired loan with a corresponding chargeor credit to the provision for credit losses.

TheCompany’s policy is to record cash receipts received on impaired and nonaccrualloans first as reductions to principal and then to interest income.

*Allowancefor Loan and Lease Losses*

Theprovisions for credit losses charged to operations reflect management’sjudgment of the adequacy of the allowance for loan and lease losses and aredetermined through periodic analysis of the loan portfolio, problem loans andconsideration of such other factors as the Company’s loan loss experience,trends in problem loans, concentrations of credit risk, and economic conditions(particularly Southern California), as well as the results of the Company’songoing examination process and its regulatory examinations.

Thecalculation of the adequacy of the allowance for loan and lease losses is basedon a variety of factors, including loan classifications, migration trends andunderlying cash flow and collateral values. On a periodic basis, management engages an outside loan review firm toreview the Company’s loan portfolio, risk grade accuracy and the reasonablenessof loan evaluations.  Annually, thisoutside loan review team analyzes the Company’s methodology for calculating theallowance for loan and lease losses based on the Company’s loss histories andpolicies.  The Company uses a migrationanalysis as part of its allowance for loan and lease losses evaluation, whichis a method by which specific charge-offs are related to the prior life of thesame loan compared to the total loan pools in which the loan was graded.  This method allows for management to usehistorical trends that are relative to the Company’s portfolio rather than useoutside factors that may not take into consideration trends relative to thespecific loan portfolio.  In addition,this analysis takes into consideration other trends that are qualitative relativeto the Company’s marketplace, demographic trends, amount and trends innonperforming assets and concentration factors.

*Premisesand Equipment, Net*

Premisesand equipment are presented at cost less accumulated amortization anddepreciation.  Depreciation of furniture,fixtures and equipment is determined using the straight-line method over theestimated useful lives (3 years to 5 years) of each type of asset.  Leasehold improvements are amortized usingthe straight-line method over the term of the related leases or the servicelives (10 years to 20 years) of the improvements, whichever is shorter.  Gains and losses on dispositions arereflected in current operations. Maintenance and repairs are charged to other operating expenses asincurred.

*OtherReal Estate Owned*

OtherReal Estate Owned (‘‘OREO’’) is comprised of real estate acquired insatisfaction of loans.  Propertiesacquired by foreclosure or deed in lieu of foreclosure are transferred to OREOand are initially recorded at the lower of the loan balance or fair value atthe date of transfer of the property, establishing a new cost basis.  Subsequently, OREO is carried at the lower ofcost or fair value less costs to sell. The fair value of the OREO property is based upon a currentappraisal.  Losses that result from theongoing periodic valuation of these properties are charged to other operatingexpenses in the period in which they are identified.  Expenses for holding costs are charged toother operating expenses as incurred.

*IncomeTaxes*

TheCompany and the Banks file consolidated federal income tax returns and combinedstate income tax returns.

Deferredtax assets and liabilities are recognized for the expected future taxconsequences of existing differences between financial reporting and taxreporting bases of assets and liabilities, as well as for operating losses andtax credit carryforwards, using enacted tax laws and rates.  Deferred tax assets will be reduced through avaluation allowance whenever it becomes more likely than not that all or someportion will not be realized.  Deferredincome taxes (benefit) represents the net change in deferred tax asset orliability balance during the year.  Thisamount, together with income taxes currently payable or refundable in thecurrent year, represents the total tax expense (benefit) for the year.

*ComprehensiveIncome*

Comprehensiveincome is defined as the change in equity during a period from transactions andother events and circumstances from nonowner sources.  The accumulated balance of othercomprehensive income is displayed as a component of equity in the consolidatedbalance sheet.

Each classification ofother comprehensive income together with total comprehensive income is reportedin the consolidated statements of changes in shareholders’ equity.  The following table presents the accumulatedbalances of each classification of other comprehensive income, and the relatedincome tax expense or benefit, as of the dates indicated:

51

----

 
|                                                                                              | ** ** | **Net gain (loss) on  securities available-  for-sale** | ** ** | **Net gain (loss) on  cash flow hedges** | ** ** | **Accumulated other  comprehensive  income (loss)** | ** ** |
|----------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                                   | ** ** | **(Dollars in thousands)**                                        | ** ** |
| ** **                                                                                   | ** ** | ** **                                                                  | ** ** | ** **                                                        | ** ** | ** **                                                    | ** ** |
| Balance at December 31,  2003                                                                |       | $                                                                           | 71         |                                                              | $          | —                                                        |       | $ | 71 |   |
| Gross unrealized  holding loss during the period                                             |       | (260                                                                        | )          | 537                                                               |       | 277                                                           |       |
| Less: Income tax  benefit (expense).                                                         |       | 108                                                                         |       | (223                                                              | )          | (115                                                          | )          |
| Less:  Reclassification of losses included in net income, net of income tax benefit  of $29. |       | 41                                                                          |       | —                                                            |       | 41                                                            |       |
| Other  comprehensive income (loss).                                                          |       | (111                                                                        | )          | 314                                                               |       | 203                                                           |       |
| Balance at December 31,  2004                                                                |       | (40                                                                         | )          | 314                                                               |       | 274                                                           |       |
| Gross unrealized  holding loss during the period                                             |       | (604                                                                        | )          | (1,838                                                            | )          | (2,442                                                        | )          |
| Less: Income tax  benefit                                                                    |       | 251                                                                         |       | 763                                                               |       | 1,014                                                         |       |
| Other  comprehensive loss                                                                    |       | (353                                                                        | )          | (1,075                                                            | )          | (1,428                                                        | )          |
| Balance at December 31, 2005                                                                 |       | $                                                                           | (392       | )                                                                 | $          | (762                                                          | )          | $ | (1,154 | ) |

 

*Earningsper Share*

Basicearnings per share is computed using the weighted average number of commonshares outstanding during the period. The following table is a reconciliation of net income and shares used inthe computation of basic and diluted earnings per share for the periodsindicated (adjusted for the 5- for4-stock split paid April 16, 2006):
|                                          | ** ** | ** **                                                                                     | ** ** | **Weighted** | ** ** | ** **         | ** ** |
|------------------------------------------|------------|------------------------------------------------------------------------------------------------|------------|--------------|------------|--------------------|------------|
| ** **                               | ** ** | ** **                                                                                     | ** ** | **Average**  | ** ** | **Per Share** | ** ** |
| ** **                               | ** ** | **Net Income**                                                                            | ** ** | **Shares**   | ** ** | **Amount**         | ** ** |
| ** **                               | ** ** | **(Dollars in thousands, except per share data, restated)** | ** ** |
|                                     |       |                                                                                           |       |         |       |               |       |
| *For the  year ended December 31, 2005:* | * *   | * *                                                                                       | * *   | * *     | * *   | * *           | * *   |
| Basic EPS                                |       | $                                                                                              | 4,450      |         | 4,630,186  |               | $          | 0.96 |   |
|                                     |       |                                                                                           |       |         |       |               |       |
| Effect of  dilutive securities:          |       |                                                                                           |       |         |       |               |       |
| Options                                  |       |                                                                                           |       | 261,544      |       |               |       |
| Convertible  preferred stock             |       |                                                                                           |       | 1,006,028    |       |               |       |
| Diluted earnings  per share              |       | $                                                                                              | 4,450      |         | 5,897,758  |               | $          | 0.75 |   |
|                                     |       |                                                                                           |       |         |       |               |       |
| *For the  year ended December 31, 2004:* | * *   | * *                                                                                       | * *   | * *     | * *   | * *           | * *   |
| Basic EPS                                |       | $                                                                                              | 2,320      |         | 3,619,136  |               | $          | 0.64 |   |
|                                     |       |                                                                                           |       |         |       |               |       |
| Effect of  dilutive securities:          |       |                                                                                           |       |         |       |               |       |
| Options                                  |       |                                                                                           |       | 191,826      |       |               |       |
| Convertible  preferred stock             |       |                                                                                           |       | 1,883,565    |       |               |       |
| Diluted earnings per  share              |       | $                                                                                              | 2,320      |         | 5,694,528  |               | $          | 0.41 |   |

 

*FairValue of Financial Instruments*

Estimatedfair value amounts have been determined using available market information andappropriate valuation methodologies. Considerable judgment is required to interpret market data and todevelop the estimates of fair value. Accordingly, the estimates of fair value in the financial statements arenot necessarily indicative of the amounts the Company could realize in acurrent market exchange.  The use ofdifferent market assumptions and estimation methodologies may have a material effecton the estimated fair value amounts.

*StockOptions*

The Company appliesAccounting Principles Board Opinion No. 25 and related Interpretations inaccounting for the stock incentive plans. SFAS No. 123, ‘‘Accounting for Stock-Based Compensation,’’ encourages,but does not require, companies to record compensation cost for stock-basedemployee compensation plans at fair value. Compensation expense is recorded onthe date of grant only if the current market price of the underlying stockexceeded the exercise price.  All optionswere granted at current market prices, accordingly, no compensation cost hasbeen recognized for the plans.  Pro formanet income and pro forma earnings per share disclosures for employee stockoption grants are based on recognition as expense, over the vesting period, thefair value on the date of grant of all stock-based awards made during 2005 and2004.

52

----

 

Theestimated per share weighted average fair value of options granted was $9.86and $7.22 during 2005 and 2004.  TheCompany applies Accounting Principles Board Opinion No. 25 and relatedInterpretations in accounting for the stock incentive plans.  SFAS No. 123, ‘‘Accounting for Stock-BasedCompensation,’’ encourages, but does not require, companies to recordcompensation cost for stock-based employee compensation plans at fairvalue.  Accordingly, no compensation costhas been recognized for the plans.  Hadcompensation cost for the options granted been determined based on the fairvalue at the grant dates for awards under the plans consistent with the methodof SFAS No. 123, the Company’s net earnings for 2005 would have been decreasedby $267,000 and the net earnings for 2004 would have decreased by$196,000.  Basic and diluted earnings pershare would have decreased by $0.07 and $0.06 for 2005, respectively.  Basic and diluted earnings per share wouldhave decreased by $0.05 and $0.03 for 2004, respectively.

Thefair values of options granted during 2005 and 2004 were estimated on the dateof grant using the Black-Scholes option-pricing model with the followingweighted-average assumptions used: 2005— no dividend yield, expected volatilityof 43%, risk-free interest rate of 4.38%, and an expected life of 10 years;2004— no dividend yield, expected volatility of 56%, risk-free interest rate of4.23%, and an expected life of 10 years.

**Note3—Goodwill and Other Intangible Assets**

As ofDecember 31, 2005, the Company had goodwill of $3.2 million and coredeposit intangibles with a carrying amount of $2.3 million less accumulated amortizationof $900,000 from the acquisition of South Bay in 2001.  In accordance with SFAS No. 142 goodwill isnot amortized.  SFAS No. 142 alsorequires an analysis of impairment of goodwill annually or more frequently uponthe occurrence of certain events.    TheCompany has no other indefinite-lived intangible assets.  The core deposit intangibles were estimatedto have an original life of 10 years and 4 months. Amortization of the coredeposit intangibles for 2005 was, and for each of the next four years isestimated to be, $223,000.  During 2005,the required impairment tests of goodwill and core deposit intangibles wereconducted, and based upon these evaluations, the Company’s goodwill and coredeposit intangibles were not impaired at December 31, 2005.

**Note4—Investment Securities**

The following is asummary of amortized cost, gross unrealized gains, gross unrealized losses, andestimated fair values of the Company’s investment securities available-for-saleand held-to-maturity at the date indicated:

53

----

 
|                                                                           | ** ** | **December 31, 2005**      | ** ** |
|---------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                | ** ** | **Total**                            | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                                                                | ** ** | **amortized**                        | ** ** | **unrealized** | ** ** | **unrealized** | ** ** | **fair** | ** ** |
| ** **                                                                | ** ** | **cost**                             | ** ** | **gains** | ** ** | **loss** | ** ** | **value** | ** ** |
| ** **                                                                | ** ** | **(Dollars in thousands)** | ** ** |
| ** **                                                                | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Available-For-Sale**                                                    |       |                                 |       |   |   |   |   |   |   |
|                                                                      |       |                                 |       |   |   |   |   |   |   |
| U.S. Treasury  securities                                                 |       | $                                    | 599        |   | $ | — |   | $ | — |   | $ | 599 |   |
| GNMA-issued/guaranteed  mortgage pass through certificates                |       | 98                                   |       | 2 |   | — |   | 100 |   |
| Other U.S.  government and federal agency securities                      |       | 17,931                               |       | — |   | 152 |   | 17,779 |   |
| FHLMC/FNMA-issued  mortgage pass through certificates                     |       | 33,982                               |       | 47 |   | 366 |   | 33,663 |   |
| CMO’s and  REMIC’s issued by U.S. government-sponsored agencies |       | 2,528                                |       | 13 |   | — |   | 2,541 |   |
| Privately issued  corporate bonds, CMO’s and REMIC’s securities |       | 17,290                               |       | 3 |   | 217 |   | 17,076 |   |
|                                                                      |       | $72,428                              |       | $ | 65 |   | $ | 735 |   | $ | 71,758 |   |
|                                                                      |       |                                 |       |   |   |   |   |   |   |
| FRB and other stocks                                                      |       | $                                    | 3,809      |   | $ | — |   | $ | — |   | $ | 3,809 |   |

 
|                                                       | ** ** | **December 31, 2005**      | ** ** |
|-------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                            | ** ** | **Total**                            | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                                            | ** ** | **amortized**                        | ** ** | **unrealized** | ** ** | **unrealized** | ** ** | **fair** | ** ** |
| ** **                                            | ** ** | **cost**                             | ** ** | **gains** | ** ** | **loss** | ** ** | **value** | ** ** |
| ** **                                            | ** ** | **(Dollars in thousands)** | ** ** |
| ** **                                            | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Held-to-Maturity**                                  |       |                                 |       |   |   |   |   |   |   |
| ** **                                            |       |                                 |       |   |   |   |   |   |   |
| FHLMC/FNMA-issued  mortgage pass through certificates |       | $                                    | 2,612      |   | $ | — |   | $ | 40 |   | $ | 2,572 |   |
|                                                  |       | $                                    | 2,612      |   | $ | — |   | $ | 40 |   | $ | 2,572 |   |

 

TheCompany had no gross proceeds and gross realized losses related to the sale ofinvestment securities for the year ended December 31, 2005.  The Company had gross proceeds and grossrealized losses related to the sale of investment securities of $11.8 millionand $197,000, respectively, for the year ended December 31, 2004.

Theestimated fair value and amortized cost of securities available-for-sale andheld-to-maturity at December 31, 2005 by contractual maturity, are shownbelow:

54

----

 
|                                                                           | ** ** | ** **                           | ** ** | ** **                      | ** ** | **After one but**    | ** ** | **After five but**  | ** ** | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | **Weighted** | ** ** |
|---------------------------------------------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|--------------------------------|------------|-------------------------------|------------|------------|------------|-------------|------------|------------|------------|--------------|------------|
| ** **                                                                | ** ** | **Within one year**        | ** ** | **within five years** | ** ** | **within ten years** | ** ** | **After ten years** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                                                | ** ** | **Amount**                           | ** ** | **Yield**                       | ** ** | **Amount**                     | ** ** | **Yield**                     | ** ** | **Amount** | ** ** | **Yield**   | ** ** | **Amount** | ** ** | **Yield**    | ** ** | **Total** | ** ** | **Yield** | ** ** |
| ** **                                                                | ** ** | **(Dollars in thousands)** | ** ** |
| **Securities available-for-sale:**                                        | ** ** | ** **                           | ** ** | ** **                      | ** ** | ** **                     | ** ** | ** **                    | ** ** | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
| U.S  Treasury securities                                                  |       | $                                    | —     |                            | —     |                           | $          | 599                           |       | 4.32       | %          | $           | —     |       | —     |         | $          | — |   | — |   | $ | 599 |   | 4.32 | % |
| GNMA-issued/guaranteed  mortgage pass-through certificates                |       | —                               |       | —                          |       | —                         |       | —                        |       | —     |       | —      |       | 100        |       | 5.98         | %          | 100 |   | 5.98 | % |
| Other  U.S. government and federal agencies                               |       | 7,867                                |       | 2.31                            | %          | 7,940                          |       | 3.12                          | %          | —     |       | —      |       | 1,972      |       | 0            |       | 17,779 |   | 2.77 | % |
| FHLMC/FNMA-issued  mortgage pass-through certificates                     |       | —                               |       | —                          |       | 234                            |       | 4.96                          | %          | 2,354      |       | 4.41        | %          | 31,075     |       | 4.96         | %          | 33,663 |   | 4.92 | % |
| CMO’s  and REMIC’s issued by U.S. government-sponsored agencies |       | —                               |       | —                          |       | 2                              |       | 5.93                          | %          | —     |       | —      |       | 2,539      |       | 0            |       | 2,541 |   | 5.49 | % |
| Privately  issued corporate bonds, CMO’s and REMIC’s securities |       | —                               |       | —                          |       | —                         |       | —                        |       | —     |       | —      |       | 17,076     |       | 0            |       | 17,076 |   | 4.95 | % |
|                                                                      |       | $                                    | 7,867      |                            | 2.31       | %                              | $          | 8,775                         |       | 3.25       | %          | $           | 2,354      |       | 4.41       | %            | $          | 52,762 |   | 4.92 | % | $ | 71,758 |   | 4.41 | % |
|                                                                      |       |                                 |       |                            |       |                           |       |                          |       |       |       |        |       |       |       |         |       |   |   |   |   |
| **Amortized Cost**                                                        |       | $                                    | 7,894      |                            |       |                           | $          | 8,873                         |       |       |       | $           | 2,389      |       |       |         | $          | 53,272 |   |   |   | $ | 72,428 |   |   |   |
|                                                                      |       |                                 |       |                            |       |                           |       |                          |       |       |       |        |       |       |       |         |       |   |   |   |   |
| FRB and other stocks                                                      |       | $                                    | 3,809      |                            | 4.94       | %                              | $          | —                        |       | —     |       | $           | —     |       | —     |         | $          | — |   | — |   | $ | 3,809 |   | — |   |

 
|                                                     | ** ** | ** **                           | ** ** | **After one but**     | ** ** | **After five but**   | ** ** | ** **                    | ** ** | ** ** | ** ** | ** **  | ** ** | **Weighted** | ** ** |
|-----------------------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|--------------------------------|------------|-------------------------------|------------|------------|------------|-------------|------------|--------------|------------|
| ** **                                          | ** ** | **Within one year**        | ** ** | **within five years** | ** ** | **within ten years** | ** ** | **After ten years** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                          | ** ** | **Amount**                           | ** ** | **Yield**                       | ** ** | **Amount**                     | ** ** | **Yield**                     | ** ** | **Amount** | ** ** | **Yield**   | ** ** | **Amount**   | ** ** | **Yield** | ** ** | **Total** | ** ** | **Yield** | ** ** |
| ** **                                          | ** ** | **(Dollars in thousands)** | ** ** |
| **Securities held-to-maturity:**                    | ** ** | ** **                           | ** ** | ** **                      | ** ** | ** **                     | ** ** | ** **                    | ** ** | ** ** | ** ** | ** **  | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| FHLMC/FNMA-issud mortgage pass-through certificates |       | $                                    | —     |                            | —     |                           | $          | —                        |       | —     |       | $           | 2,612      |         | 4.29       | % | $ | — |   | — |   | $ | 2,612 |   | 4.29 | % |
|                                                |       |                                 |       |                            |       |                           |       |                          |       |       |       |        |       |         |       |   |   |   |   |   |   |
|                                                |       | $                                    | —     |                            | —     |                           | $          | —                        |       | —     |       | $           | 2,612      |         | 4.29       | % | $ | — |   | — |   | $ | 2,612 |   | 4.29 | % |

 

Actualmaturities may differ from contractual maturities to the extent that borrowershave the right to call or prepay obligations with or without call or repaymentpenalties.

Investmentsecurities totaling $3.1 million were pledged to secure government taxdeposits, bankruptcy deposits, or for other purposes required or permitted bylaw at December 31, 2005. Investment securities totaling $70.0 million were pledged to secureFederal Home Loan Bank (FHLB) borrowings and available credit.

*ImpairedSecurities*

TheCompany assessed whether there is an “other-than-temporary” impairment to anyinvestment securities.  Any security forwhich the current fair value is less than the carrying value is consideredimpaired. On a quarterly basis, impaired securities are evaluated to determineif the impairments are other-than-temporary. For those securities that are identified as having another-than-temporary impairment, the loss is reported as a reduction in currentperiod income.  For all other temporaryimpairments, the current period unrealized losses are recorded to other comprehensiveincome.

As ofDecember 31, 2005, temporarily impaired securities had a fair value of$67.4 million and unrealized losses of $775,000.  Securities that were not impaired had a fairvalue of $6.8 million and unrealized gains of $65,000 at December 31,2005.  The following table shows fairvalue and unrealized loss positions of temporarily impaired securities,categorized by whether the securities have been impaired for less than twelvemonths or if they have been impaired for twelve months or more as ofDecember 31, 2005.

55

----

 
|                                                                      | ** ** | **Less than 12 months** | ** ** | **12 months or longer** | ** ** | **Total**           | ** ** |
|----------------------------------------------------------------------|------------|----------------------------------------|------------|----------------------------------------|------------|---------------------|------------|
| ** **                                                           | ** ** | ** **                             | ** ** | **Unrealized**                         | ** ** | ** **          | ** ** | **Unrealized** | ** ** | ** ** | ** ** | **Unrealized** | ** ** |
| ** **                                                           | ** ** | **Fair value**                    | ** ** | **losses**                             | ** ** | **Fair value** | ** ** | **losses** | ** ** | **Fair value** | ** ** | **losses** | ** ** |
| ** **                                                           | ** ** | **(Dollars in thousands)**   | ** ** |
|                                                                 |       |                                   |       |                                   |       |                |       |   |   |   |   |   |   |
| U.S. Treasury  securities                                            |       | $                                      | 599        |                                   | $          | —              |       | $ | — |   | $ | — |   | $ | 599 |   | $ | — |   |
|                                                                 |       |                                   |       |                                   |       |                |       |   |   |   |   |   |   |
| Other U.S.  government and federal agency securities                 |       | 35,147                                 |       | (378                                   | )          | 17,528              |       | (180 | ) | 52,675 |   | (558 | ) |
|                                                                 |       |                                   |       |                                   |       |                |       |   |   |   |   |   |   |
| Privately issued  corporate bonds, CMO’s and REMIC's securities |       | 12,440                                 |       | (169                                   | )          | 1,709               |       | (48 | ) | 14,149 |   | (217 | ) |
| Total temporarily  impaired securities                               |       | $                                      | 48,186     |                                   | $          | (547                | )          | $ | 19,237 |   | $ | (228 | ) | $ | 67,423 |   | $ | (775 | ) |

 

Thesecurities were impaired due to declines in fair values resulting fromincreases in market interest rates from the time of purchase.  The privately issued securities werecollateralized by mortgages.  None ofthese securities has exhibited a notable decline in value as a result ofchanges in credit risk.  These debtsecurities are relatively short in duration, accordingly, any unrealized lossin an individual issue will diminish as the security approaches its maturity,irrespective of market rates of interest.

  Furthermore, the company may borrow fundsutilizing these securities as collateral at market rates of interest in amountsrepresenting nearly all of the market value. For that reason the securities achieve their primary purpose ofproviding liquidity without being sold. As such, the company has the ability to hold the securities to maturityand does not consider the impairment of these securities to beother-than-temporary.

**Note 5 -Loans Receivable and Allowance for Loan and Lease Losses**

The following is a summary of the major categories ofloans outstanding at December 31, 2005:
|                                                                       | ** ** | **2005**                         | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                            | ** ** | **(Dollars in  thousands)** | ** ** |
| Commercial loans  - secured and unsecured                             |       | $                                | 89,474     |   |
| Real estate  loans:                                                   |       |                             |       |
| Secured by commercial real properties                                 |       | 121,641                          |       |
| Secured by one to four family residential properties                  |       | 10,498                           |       |
| Secured by multifamily residential properties                         |       | 18,663                           |       |
| Total real estate loans                                               |       | 150,802                          |       |
| Construction and  land development                                    |       | 92,077                           |       |
| Consumer  installment, home equity and unsecured loans to individuals |       | 7,239                            |       |
| Total loans outstanding                                               |       | 339,592                          |       |
| Deferred net  loan origination fees and purchased loan  discount      |       | (1,034                           | )          |
| Loans receivable, net                                                 |       | $                                | 338,558    |   |
|                                                                  |       |                             |       |
| Weighted average  yield for loans at December 31                 |       | 8.09                             | %          |

 

AtDecember 31, 2005 and 2004, the Company had no impaired loans, andtherefore, no specific allowances established for impaired loans.  No interest income was recognized on impairedloans during the years ended December 31, 2005 and 2004.

In thenormal course of business, the Banks may make loans to officers and directorsas well as loans to companies and individuals affiliated with or guaranteed byofficers and directors of the Company and the Banks.  Such loans are made in the ordinary courseof  business at rates and terms no morefavorable than those offered to other customers with a similar creditstanding.  The outstanding principalbalance of these loans was $4.9 million at December 31, 2005 and $2.0million at December 31, 2004. During 2005 there were $3.4 million of advances and $465,000 ofrepayments.  Interest income recognizedon these loans amounted to $199,000 and $374,000 during 2005 and 2004,respectively.  At December 31, 2005,none of these loans were on nonaccrual status. Based on analysis of informationpresently known to management about the loans to officers and directors andtheir affiliates, management believes all have the ability to comply with thepresent loan repayment terms.

Loansreceivable totaling $37.6 million were pledged to the FHLB to collateralizeborrowing lines.

Thefollowing is a summary of activity in the allowance for loan and lease lossesfor the year ended December 31, 2005:

56

----

 
|                                                                    | ** ** | **2005**                         | ** ** |
|--------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                         | ** ** | **(Dollars in  thousands)** | ** ** |
| ** **                                                         | ** ** | ** **                       | ** ** |
| Balance,  beginning of year                                        |       | $                                | 3,928      |   |
| Provision for  credit losses                                       |       | (84                              | )          |
| Reserve for  unfunded commitments transferred to other liabilities |       | (582                             | )          |
| Loan charge offs                                                   |       | (10                              | )          |
| Recoveries of  previous loan charge offs                           |       | 1,216                            |       |
| Balance, end of year                                               |       | $                                | 4,468      |   |

 

Total loan charge-offs in 2005 were $10,000.  The additional provision for credit losseswas recorded based upon the analysis of the adequacy of allowance for loan andlease losses.  The allowance for loan andlease losses for classified loans graded as “criticized” by the Company’sinternal grading system that are collateral-dependent is based upon the netrealizable value of the collateral that is periodically evaluated.  The allowance for unsecured classified loansis based upon the severity of the credit weakness.

The following is a summary of nonperforming loans atDecember 31, 2005:
|                                                                                                                             | ** ** | **2005**                         | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                                  | ** ** | **(Dollars in  thousands)** | ** ** |
| ** **                                                                                                                  | ** ** | ** **                       | ** ** |
| Nonaccrual loans                                                                                                            |       | $                                | 319        |   |
| Troubled debt  restructurings                                                                                               |       | —                           |       |
| Loans  contractually past due ninety or more days with respect to either principal  or interest and still accruing interest |       | —                           |       |
|                                                                                                                        |       | $                                | 319        |   |

 

Interestforegone on nonperforming loans outstanding at December 31, 2005 and 2004was $11,000 and $12,000, respectively. Foregone interest on nonperforming loans does not include interestforgone on loans on nonperforming status that were restored to performingstatus prior to year end, or subsequent to either being charged off prior toyear end or transferred to OREO prior to year end.

Theability of the Company’s borrowers to fulfill their loan agreements issubstantially dependent upon economic conditions and real estate market valuesthroughout the Company’s market area.  AtDecember 31, 2005, loans aggregating $242.9 million were collateralized byliens on residential and commercial real properties, nearly all of which arelocated in California.  While theCompany’s loan portfolio is generally diversified with regard to the industriesrepresented, at December 31, 2005, the Company’s loans to businesses andindividuals engaged in entertainment industry related activities amounted to$32.0 million.

*TroubledDebt Restructurings (“TDRs”).* A TDR is a loan for which the Company has, foreconomic or legal reasons related to a borrower’s financial difficulties,granted a concession to the borrower it would not otherwise consider, includingmodifications of loan terms to alleviate the burden of the borrower’s near-termcash flow requirements in order to help the borrower to improve its financialcondition and eventual ability to repay the loan.  At December 31, 2005, the Company had noTDRs.

**Note 6 –Premises and Equipment and Lease Commitments**

Thefollowing is a summary of major components of premises and equipment atDecember 31, 2005:
|                                                 | ** ** | **2005**                         | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|
| ** **                                      | ** ** | **(Dollars in  thousands)** | ** ** |
|                                            |       |                             | ** ** |
| Land                                            |       | $                                | 1,392      |   |
| Buildings                                       |       | 3,873                            |       |
| Leasehold  improvements                         |       | 1,764                            |       |
| Furniture,  fixtures and equipment              |       | 6,336                            |       |
|                                            |       | 13,365                           |       |
| Less accumulated  amortization and depreciation |       | (7,504                           | )          |
|                                            |       | $                                | 5,861      |   |

 

Depreciation and amortization expense was $425,000 in2005 and $409,000 in 2004.  Rentalexpense on operating leases included in occupancy expense in the ConsolidatedStatements of Operations was $675,000 in 2005 and $669,000 in 2004.

57

----

 

The future net minimum annualrental commitments at December 31, 2005 are summarized below.
|                                    | ** ** | **2005**                         | ** ** |
|------------------------------------|------------|----------------------------------|------------|
| ** **                         | ** ** | **(Dollars in  thousands)** | ** ** |
| *For the  year ended December 31,* |       |                             |       |
| 2006                               |       | $                                | 693        |   |
| 2007                               |       | 695                              |       |
| 2008                               |       | 708                              |       |
| 2009                               |       | 559                              |       |
| 2010                               |       | 453                              |       |
| Thereafter                         |       | 1,563                            |       |
|                               |       | $                                | 4,671      |   |

 

**Note7—Income Taxes**

The components of income tax provision consisted ofthe following for the years ended December 31:
|                            | ** ** | **2005**                                            | ** ** | **2004** | ** ** |
|----------------------------|------------|-----------------------------------------------------|------------|----------|------------|
| ** **                 | ** ** | **(Dollars in thousands, restated)** | ** ** |
| ** **                 | ** ** | ** **                                          | ** ** |
| Current taxes              |       | $                                                   | 1,112      |     | $          | 65 |   |
| Deferred taxes             |       | 2,047                                               |       | 1,613    |       |
| Total income tax provision |       | $                                                   | 3,159      |     | $          | 1,678 |   |

 

A reconciliation of the amounts computed by applyingthe federal statutory rate of 34% for 2005 and 2004 to the income before incometax provision and the effective tax rate are as follows:
|                                                | ** ** | **2005**                                            | ** ** | **2004** | ** ** |
|------------------------------------------------|------------|-----------------------------------------------------|------------|----------|------------|
| ** **                                     | ** ** | **Amount**                                          | ** ** | **Rate** | ** ** | **Amount** | ** ** | **Rate** | ** ** |
| ** **                                     | ** ** | **(Dollars in thousands, restated)** | ** ** |
| Tax provision at  statutory rate               |       | $                                                   | 2,587      |     | 34.0       | % | $ | 1,359 |   | 34.0 | % |
| Increase  (reduction) in taxes resulting from: |       |                                                |       |     |       |   |   |   |   |
| State taxes                                    |       | 548                                                 |       | 6.8      | %          | 287 |   | 7.6 | % |
| Permanent differences                          |       | 24                                                  |       | 0.3      | %          | 32 |   | 0.8 | % |
|                                           |       | $                                                   | 3,159      |     | 39.5       | % | $ | 1,678 |   | 44.5 | % |

 

The majorcomponents of the net deferred tax asset at December 31, 2004 are as follows:

58

----

 
|                                             | ** ** | **2005**                                            | ** ** | **2004**   | ** ** |
|---------------------------------------------|------------|-----------------------------------------------------|------------|------------|------------|
| ** **                                  | ** ** | **(Dollars in thousands, restated)** | ** ** |
| Deferred tax  assets:                       | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| Net operating losses                        |       | $                                                   | 1,992      |       | $          | 4,725 |   |
| Securities available for sale               |       | 818                                                 |       | —     |       |
| Economic derivatives                        |       | 239                                                 |       | 75         |       |
| Accrued expenses                            |       | 413                                                 |       | 304        |       |
| Alternative minimum tax credits             |       | 544                                                 |       | 384        |       |
| Nonaccrual interest                         |       | 116                                                 |       | 89         |       |
| Loan fees                                   |       | 212                                                 |       | 285        |       |
| Bad debt expense                            |       | 278                                                 |       | 313        |       |
| Core deposits                               |       | 115                                                 |       | 86         |       |
| Securities acquired in business combination |       | 47                                                  |       | 47         |       |
| State taxes                                 |       | 302                                                 |       | 63         |       |
| Other real estate owned                     |       | 31                                                  |       | 31         |       |
| Other                                       |       | 49                                                  |       | 7          |       |
| Total deferred tax assets                   |       | 5,156                                               |       | 6,409      |       |
|                                        |       |                                                |       |       |       |
| Deferred tax  liabilities:                  |       |                                                |       |       |       |
| Depreciation                                |       | (698                                                | )          | (671       | )          |
| Securities available for sale               |       | —                                              |       | (196       | )          |
| FHLB stock dividend                         |       | (56                                                 | )          | (42        | )          |
| Loan premium amortization                   |       | (80                                                 | )          | (145       | )          |
| Total deferred tax liabilities              |       | (834                                                | )          | (1,054     | )          |
| Net deferred tax asset                      |       | $                                                   | 4,322      |       | $          | 5,355 |   |

 

Fortax purposes at December 31, 2005, the Company had (i) federal NOLs of$5.0 million, which begin to expire in 2009; and (ii) a federal AMT credit of$544,000 that carryforwards indefinitely. The Company believes that it is more likely than not that the deferredtax asset will be realized.  Accordingly,no valuation allowance has been established against the deferred tax asset.

**Note8—Benefit Plans**

*StockIncentive Plans*.  AtDecember 31, 2005, the Company had two active stock incentive planspursuant to which up to a total of 1,148,138 shares of common stock may beissued.  Under these plans, the Companymay grant to directors, officers, employees and consultants stock-basedincentive compensation in a variety of forms, including without limitationnonqualified options, incentive options, sales and bonuses of common stock andstock appreciation rights, on such terms and conditions as the Board ofDirectors of the Company determines. However, the exercise price of optionsgranted to nonemployee directors may not be less than the fair market value ofthe common stock on the date of grant. At December 31, 2005, the only outstanding awards under these planswere stock options, and at that date 200,074 shares were available for futureawards.

AtDecember 31, 2005, there were also outstanding options granted under aprior stock incentive plan.

The following summarizes option grants, cancellationsand exercises under the Company’s stock incentive plans for the periodsindicated.

|                                               | ** ** | ** ** | ** ** | **Option Price Range** | ** ** |
|-----------------------------------------------|------------|------------|------------|----------------------------------|------------|
| ** **                                    | ** ** | ** ** | ** ** | **Per Share**               | ** ** |
|                                          |       |       |       |                             |       |   |   |   |   |
| Outstanding,  December 31, 2003               |       | 493,308    |       | $                                | 4.31       |   | — |   | $ | 11.50 |   |
| Granted                                       |       | 81,200     |       | 9.48                             |       | — |   | 11.45 |   |
| Cancelled                                     |       | (39,125    | )          | 4.59                             |       | — |   | 10.26 |   |
| Exercised                                     |       | (55,225    | )          | 4.50                             |       | — |   | 9.75 |   |
| Outstanding,  December 31, 2004               |       | 480,158    |       | $                                | 4.31       |   | — |   | $ | 11.50 |   |
| Granted                                       |       | 161,950    |       | 12.49                            |       | — |   | 19.25 |   |
| Cancelled                                     |       | (116,350   | )          | 4.31                             |       | — |   | 11.20 |   |
| Exercised                                     |       | (6,400     | )          | 4.31                             |       | — |   | 11.14 |   |
| Five-for-four stock split paid April 16, 2006 |       | 129,840    |       | 3.45                             |       | — |   | 15.40 |   |
| Outstanding,  December 31, 2005               |       | 649,198    |       | $                                | 3.45       |   | — |   | $ | 15.40 |   |

 

59

----

 

Of theoutstanding options at December 31, 2005: (i) options to purchase 336,158 shares were vested and exercisable; and(ii) the remaining options become exercisable as follows: 2006 —  113,500 and 2007 — 69,700.  Options granted to employees expire on thetenth anniversary of the date of the grant and vest (i) 100% one year from thedate of the grant for grants less than 500 shares; and (ii) 50% after one yearand 50% after two years from the date of the grant for grants of 500 shares ormore.  Options granted to nonemployeedirectors expire on the sixth anniversary of the date of the grant and vest oneyear from the date of the grant.

*DefinedContribution Retirement Plan.* The Company maintains a definedcontribution retirement plan under section 401(k) of the Internal RevenueCode. Employees are eligible to participate following six months of continuousemployment. Under the plan, the Company has partially matched employee contributionssince May 1, 2001.  Such matchingcontributions become fully vested when the employee reaches three years ofservice.  The Company’s matchingcontributions for 2005 and 2004 were $121,000 and $115,000, respectively.

**Note9—Deposits and Borrowed Funds**

At December 31, 2005 the scheduled maturity of timedeposits are as follows:
|                                                     | ** ** | **$100,000 and over**      | ** ** | **Under $100,000** | ** ** |
|-----------------------------------------------------|------------|--------------------------------------|------------|-------------------------|------------|
| ** **                                          | ** ** | **(Dollars in thousands)** | ** ** |
|                                                |       |                                 |       |                    |       |
| 2006                                                |       | $                                    | 83,863     |                    | $          | 15,193 |   |
| 2007                                                |       | 1,472                                |       | 3,069                   |       |
| 2008                                                |       | 2,133                                |       | 884                     |       |
| 2009                                                |       | —                               |       | —                  |       |
| 2010                                                |       | —                               |       | 69                      |       |
| Thereafter                                          |       | —                               |       | 41                      |       |
| Total time certificates of deposit $100,000 or more |       | $                                    | 87,468     |                    | $          | 19,256 |   |

 

The following table shows borrowed funds at December31, 2005:
|                                  | ** ** | **2005**                             | ** ** |
|----------------------------------|------------|--------------------------------------|------------|
| ** **                       | ** ** | **Year-end**                         | ** ** | **Average** | ** ** |
| ** **                       | ** ** | **Balance**                          | ** ** | **Weighted  Average  Rate** | ** ** | **Balance** | ** ** | **Weighted  Average  Rate** | ** ** |
| ** **                       | ** ** | **(Dollars in thousands)** | ** ** |
|                             |       |                                 |       |   |   |   |   |   |   |
| Federal funds  purchased         |       | $                                    | —     |   | — |   | $ | — |   | — |   |
|                             |       |                                 |       |   |   |   |   |   |   |
| Federal Home Loan Bank  advances |       | $                                    | 28,337     |   | 4.10 | % | $ | 12,186 |   | 3.38 | % |

 

Otherborrowings are comprised of Federal Home Loan Bank (“FHLB”) advances.  At December 31, 2005 FHLB advancesincluded: (i) $28.3 million overnight borrowings maturing  in January 2006 with a fixed annual rate of4.10%. The maximum amount of other borrowings outstanding at any month-endduring 2005 was $28.3 million.

TheBanks had $53.0 million of unused borrowing capacity from the FHLB atDecember 31, 2005 based upon pledged securities and loans.

**Note10—Junior Subordinated Deferrable Interest Debentures**

InJuly 2001 the Company issued $15.5 million aggregate principal amount of 10.25%fixed rate junior subordinated deferrable interest debentures due July 25,2031 (“Junior Subordinated Debentures’) that pay interest each January 26and July 26.  The interest isdeferrable, at the Company’s option, for a period up to ten consecutivesemi-annual payments, but in any event not beyond June 25, 2031.  The debentures are redeemable, in whole or inpart, at the Company’s option on or after five years from issuance at decliningpremiums to maturity.  The recordedbalance of Junior Subordinated Debentures was $15.5 million atDecember 31, 2005.

TheJunior Subordinated Debentures are held by National Mercantile Capital Trust I(the “Trust”), a Delaware business trust, formed by the Company for the solepurpose of issuing certain securities representing undivided beneficialinterests in the assets of the Trust and investing the proceeds thereof in theJunior Subordinated Debentures.  InJuly 2001 the Trust issued and sold: (i) to the Company 464 common securities (liquidation amount of $1,000per common security) of the Trust, representing common beneficial interests inthe assets of the Trust; and (ii) $15,000,000 of 10.25% fixed rate securitiesdue July 26, 2031 (the “Trust Preferred Securities”).  The Trust PreferredSecurities are unconditionally guaranteed by the Company with respect todistributions and payments upon liquidation, redemption and otherwise to theextent provided in and pursuant to the terms of a Guarantee Agreement.

60

----

 

**Note11—Availability to National Mercantile of Funds from Banks; Restrictions onCash Balances; Capital**

NationalMercantile is a legal entity separate and distinct from the Banks, and as suchhas separate and distinct financial obligations including annual deferrabledebt service of $1.6 million on the Junior Subordinated Debenture and othermodest operating expenses.  WhileNational Mercantile from time to time holds short-term investments,  its assets primarily consist of the commonshares of the Banks and it has historically not engaged in any other businessactivity.  Accordingly, dividends andcapital distributions from the Banks constitute the principal source of cash tothe Company.  The Banks are subject tovarious statutory and regulatory restrictions on their ability to pay dividendsto the Company.

OCCapproval is required for a national bank to pay a dividend if the total of alldividends declared in any calendar year exceeds the total of the bank’s netprofits (as defined) for that year combined with its retained net profits forthe preceding two calendar years, less any required transfer to surplus or afund for the retirement of any preferred stock. A national bank may not pay any dividend that exceeds its retained netearnings, as defined by the OCC.  The OCCand the Federal Reserve Board have also issued banking circulars emphasizingthat the level of cash dividends should bear a direct correlation to the levelof a national bank’s current and expected earnings stream, the bank’s need tomaintain an adequate capital base and other factors.

Nationalbanks that are not in compliance with regulatory capital requirements generallyare not permitted to pay dividends.  TheOCC also can prohibit a national bank from engaging in an unsafe or unsoundpractice in its business.  Depending on thebank’s financial condition, payment of dividends could be deemed to constitutean unsafe or unsound practice.  Exceptunder certain circumstances, and with prior regulatory approval, a bank may notpay a dividend if, after so doing, it would be undercapitalized.  The Banks’ ability to pay dividends in thefuture is, and could be, further influenced by regulatory policies oragreements and by capital guidelines.

Mercantilehas no retained earnings, and therefore is presently unable to paydividends.  Mercantile has a substantialaccumulated deficit and does not anticipate having positive retained earningsfor the foreseeable future.  South Bayhad retained earnings of $3.0 million as of December 31, 2005.  Mercantile and South Bay may from time totime be permitted to make capital distributions to National Mercantile with theconsent of the OCC.  It is notanticipated that such consent could be obtained unless the distributing bankwere to remain “well capitalized” following such distribution.

TheCompany is authorized to issue 1,000,000 shares of preferred stock. TheCompany’s Board of Directors has the authority to issue the preferred stock inone or more series, and to fix the designations, rights, preferences,privileges, qualifications and restrictions, including dividend rights,conversion rights, voting rights, rights and terms of redemption, liquidationpreferences, and sinking fund terms.

TheCompany had previously issued 990,000 shares of Series A non-cumulativeconvertible perpetual preferred stock (the “Series A Preferred”).  During 2005, pursuant to an election of theholders of a majority of the outstanding shares of Series A Preferred, eachoutstanding share of the Series A Preferred was automatically converted intotwo shares of the Company’s Common Stock in accordance with the Company’sAmended and Restated Articles of Incorporation, as amended.  As a resultof this conversion, as well as earlier conversions during 2005, 666,273 sharesof Series A Preferred were converted into 1,332,546 shares of Common Stock.

OnDecember 10, 2001, the Company issued 1,000 shares of Series B non-cumulativeconvertible perpetual preferred stock (the “Series B Preferred”) with a $1,000stated value per share. At any time after June 30, 2005 each holder of the SeriesB Preferred has the right, exercisable at the option of the holder, to convertsome or all of such holder’s shares of Series B Preferred into Common Stock ata conversion price of $7.04 per share of Common Stock (the “Conversion Price”).  The number of shares of Common Stock to beissued upon conversion for each share of Series B Preferred is determined bydividing an amount per share then in effect (the “Liquidation Amount”) by theConversion Price.  The Liquidation Amountper share of Series B Preferred as of any date is the sum of (i) the statedvalue of each share of Series B Preferred, adjusted to reflect stock splits,stock dividends, reorganizations, consolidations and similar changes, plus (ii)an amount equal to 8.5% per annum of the stated value of the shares of Series BPreferred commencing from the date of issue. The Company, at its sole option, may redeem all Series B Preferred, atany time, from legally available funds at the Liquidation Amount.  The Series B Preferred contains a liquidationpreference over the Common Stock in the amount of the Liquidation Amount.  

Federallaw restricts the Banks’ extension of credit to, the issuance of a guarantee orletter of credit on behalf of, investments in or taking as collateral stock orother securities of National Mercantile. Restrictions prevent National Mercantile from borrowing from the Banksunless the loans are secured by designated amounts of marketableobligations.  Further, secured loans toand investments in National Mercantile or its affiliates by a bank are limitedto 10% of  the bank’s capital stock andsurplus (as defined by federal regulations) and are limited, in the aggregate,to 20% of the bank’s contributed capital (as defined by federal regulations).

FederalReserve Board regulations require the Banks to maintain certain minimum reservebalances.  Cash balances maintained tomeet reserve requirements are not available for use by the Banks or NationalMercantile.  During 2005 and 2004, theaverage reserve balances for the Banks were approximately $2.7 million and $6.5million, respectively.  Neither NationalMercantile nor the Banks is required to maintain compensating balances toassure credit availability under existing borrowing arrangements.

61

----

 

NationalMercantile and the Banks are subject to various capital requirementsadministered by the federal banking regulatory agencies. Failure to meetminimum capital requirements can initiate certain mandatory—and possiblyadditional discretionary—actions by regulators that, if undertaken, could havea direct material effect on National Mercantile’s financial statements. Undercapital adequacy guidelines and the regulatory framework for prompt correctiveaction, National Mercantile and Banks must meet specific capital guidelinesthat involve quantitative measures of National Mercantile’s and the Banks’assets, liabilities and certain off-balance-sheet items as calculated underregulatory accounting practices. National Mercantile’s and the Banks’ capitalamounts and classification are also subject to qualitative judgment by theregulators about components, risk weightings and other factors.

Quantitativemeasures established by regulation to ensure capital adequacy require NationalMercantile and the Banks to maintain minimum amounts and ratios (set forth inthe table below) of total and Tier 1 capital (as defined in the regulations) torisk-weighted assets (as defined). Management believes, as of December 31, 2005, National Mercantileand Banks meet all capital adequacy requirements to which they are subject.

AtDecember 31, 2005, each Bank was categorized as well capitalized under theregulatory framework for prompt corrective action.  To be categorized as well capitalized underthe prompt corrective action rules, each Bank must maintain minimum totalrisk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in thefollowing table.  There are no conditionsor events since the most recent notification which management believes havechanged the Banks’ category.

The following table presents, at the date indicated,certain information regarding the regulatory capital of National Mercantile andthe Banks and the required amounts of regulatory capital for NationalMercantile and the Banks to meet applicable regulatory capital requirements and,in the case of the Banks, to be well capitalized under the prompt correctiveaction rules.
|                                         | ** ** | ** **                           | ** ** | ** **                 | ** ** | ** **            | ** ** | ** **                 | ** ** | **To be Categorized** | ** ** |
|-----------------------------------------|------------|--------------------------------------|------------|----------------------------|------------|-----------------------|------------|----------------------------|------------|---------------------------------|------------|
| ** **                              | ** ** | ** **                           | ** ** | ** **                 | ** ** | ** **            | ** ** | ** **                 | ** ** | **as Well**                | ** ** |
| ** **                              | ** ** | ** **                           | ** ** | ** **                 | ** ** | ** **            | ** ** | ** **                 | ** ** | **Capitalized under**      | ** ** |
| ** **                              | ** ** | ** **                           | ** ** | ** **                 | ** ** | **For Capital**  | ** ** | **Prompt Corrective** | ** ** |
| ** **                              | ** ** | **Actual**                           | ** ** | **Adequacy Purposes** | ** ** | **Action Rules** | ** ** |
| ** **                              | ** ** | **Amount**                           | ** ** | **Ratio**                  | ** ** | **Amount**            | ** ** | **Ratio**                  | ** ** | **Amount**                      | ** ** | **Ratio** | ** ** |
| ** **                              | ** ** | **(Dollars in thousands, restated)** | ** ** |
| ** **                              | ** ** | ** **                           | ** ** | ** **                 | ** ** | ** **            | ** ** | ** **                 | ** ** | ** **                      | ** ** | ** ** | ** ** |
| As of December  31, 2005                |       |                                 |       |                       |       |                  |       |                       |       |                            |       |   |   |
| Total Capital to  Risk Weighted Assets  |       |                                 |       |                       |       |                  |       |                       |       |                            |       |   |   |
| National Mercantile Bancorp             |       | $                                    | 53,231     |                       | 13.72      | %                     | $          | 29,391                     |       | >=8.0                        | %          | $ | N/A |   | N/A |   |
| Mercantile National Bank                |       | 27,096                               |       | 14.84                      | %          | 14,843                |       | >=8.0                   | %          | 18,554                          |       | >=10.0 | % |
| South Bay Bank, N.A                     |       | 21,239                               |       | 10.22                      | %          | 14,718                |       | >=8.0                   | %          | 18,398                          |       | >=10.0 | % |
| Tier 1 Capital  to Risk Weighted Assets |       |                                 |       |                       |       |                  |       |                       |       |                            |       |   |   |
| National Mercantile Bancorp             |       | 46,483                               |       | 11.98                      | %          | 14,695                |       | >=4.0                   | %          | N/A                             |       | N/A | % |
| Mercantile National Bank                |       | 24,811                               |       | 13.59                      | %          | 7,421                 |       | >=4.0                   | %          | 11,132                          |       | >=6.0 | % |
| South Bay Bank, N.A                     |       | 18,701                               |       | 9.00                       | %          | 7,359                 |       | >=4.0                   | %          | 11,039                          |       | >=6.0 | % |
| Tier 1 Capital  to Average Assets       |       |                                 |       |                       |       |                  |       |                       |       |                            |       |   |   |
| National Mercantile Bancorp             |       | 46,483                               |       | 10.74                      | %          | 15,475                |       | >=4.0                   | %          | N/A                             |       | N/A | % |
| Mercantile National Bank                |       | 24,811                               |       | 10.49                      | %          | 8,619                 |       | >=4.0                   | %          | 10,774                          |       | >=5.0 | % |
| South Bay Bank, N.A                     |       | 18,701                               |       | 9.04                       | %          | 7,356                 |       | >=4.0                   | %          | 9,195                           |       | >=5.0 | % |
|                                         |            |                                      |            |                            |            |                       |            |                            |            |                                 |            |  |  |  |  |  |

 

**Note12—Commitments and Contingencies**

In thenormal course of business, the Company is a party to financial instruments withoff-balance sheet risk.  These financialinstruments include commitments to extend credit, letters of credit andfinancial guarantees.  These instrumentsinvolve, to varying degrees, elements of credit and interest rate risk inexcess of the amount reflected in the consolidated balance sheet.

Exposureto credit loss in the event of nonperformance by the other party to thefinancial instrument for letters of credit and financial guarantees written isrepresented by the contractual notional amount of those instruments.  The Company uses the same credit policies inmaking commitments and conditional obligations as it does for on-balance sheetinstruments.

TheCompany had $1.1 million of outstanding letters of credit at December 31,2005.

Loancommitments are agreements to lend to a customer a specified amount subject tocertain conditions.  Loan commitmentsgenerally have fixed expiration dates or other termination clauses and mayrequire payment of a fee.  Since portionsof the commitments are expected to expire without being drawn upon, the totalamount of commitments does not necessarily represent future cash requirements.The Company had outstanding loan commitments aggregating $120.8 million atDecember 31, 2005, substantially all of which were for adjustable rateloans.

TheCompany from time to time is party to lawsuits that arise in the normal courseof business. The Company does not believe that any pending lawsuit atDecember 31, 2005 will have a material adverse effect on the financialposition or results of operations of the Company.

62

----

 

**Note13—Disclosures about the Fair Value of Financial Instruments**

Thefollowing methods and assumptions were used to estimate the fair value of eachclass of financial instruments for which it is practical to estimate thatvalue.

*Cashand  cash equivalents*:  For these short-term investments, thecarrying amount is a reasonable estimation of fair value.

*Securitiesavailable-for-sale and securities held-to-maturity*:  For securities classified asavailable-for-sale and held-to-maturity, fair value equals quoted marketprices, if available. If a quoted market price is not available, fair value isestimated using quoted market prices for similar securities.

*Federal Reserve Bank (FRB) and other stock*:  FRB and other stock may be redeemed at thecarrying amount, therefore, the carrying amount is a reasonable estimation offair value.

*Loans*:  Variable rate loans have carrying amountsthat approximate fair value. The fair value of fixed rate loans is estimated bydiscounting the future cash flows using the current rates at which similarloans would be made to borrowers with similar credit ratings and for the sameremaining maturities. In establishing the credit risk component of the fairvalue calculations for loans, the Company concluded the allowance for loan and leaselosses represented a reasonable estimate of the credit risk component of thefair value at December 31, 2005.

*Interest rate swaps and floors:* Thefair value of the interest rate swaps and floors is based upon an estimatederived from broker quotations or proprietary broker models that consider therelevant characteristics of the instrument.

*Deposits*:  The fair value of demand and interestchecking deposits, money market accounts and savings accounts is the amountpayable on demand at the reporting date. The fair value of time certificates of deposit is estimated bydiscounting the future cash flows using the rates currently offered fordeposits of similar maturities.

*Federal funds purchased and securities sold under agreementsto repurchase*:  Thefair value of fixed-rate securities sold under agreements to repurchase isestimated by discounting the future cash flows using the rates currentlyoffered for instruments of similar maturities.

*Junior subordinated deferrable interest debentures:* The fair value of the junior subordinated deferrable interest debenturesis estimated as the sum of the carrying amount and the fair value of themirrored interest rate swap hedging the debentures.

*Otherborrowings*:  The fairvalue of fixed-rate borrowings is estimated by discounting the future cashflows using the rates currently offered for borrowings of similarmaturities.  Borrowings with maturitiesgreater than one year bear interest at variable rates and approximate fair value.

Theestimated fair values of financial instruments at the date indicated arepresented below.
|                                                                       | ** ** | **December 31, 2005**                     | ** ** |
|-----------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                            | ** ** | **Carrying**                                        | ** ** | **Fair** | ** ** |
| ** **                                                            | ** ** | **Amount**                                          | ** ** | **Value** | ** ** |
| ** **                                                            | ** ** | **(Dollars in thousands, restated)** | ** ** |
| Financial  assets:                                                    |       |                                                |       |   |   |
| Cash, cash  equivalents and deposit with other financial institutions |       | $                                                   | 16,192     |   | $ | 16,192 |   |
| Securities  available-for-sale                                        |       | 71,758                                              |       | 71,758 |   |
| Securities  held-to-maturity                                          |       | 2,612                                               |       | 2,584 |   |
| FRB and other  stock                                                  |       | 3,809                                               |       | 3,809 |   |
| Loans, net of  allowance for credit losses                            |       | 334,090                                             |       | 333,791 |   |
| Fair value  hedges                                                    |       | (41                                                 | )          | (41 | ) |
| Cash flow  hedges:                                                    |       |                                                |       |   |   |
| Interest rate  swaps                                                  |       | (1,034                                              | )          | (1,034 | ) |
| Interest rate  floors                                                 |       | 286                                                 |       | 286 |   |
| Non-hedge  derivatives                                                |       | (575                                                | )          | (575 | ) |
| Financial  liabilities:                                               |       |                                                |       |   |   |
| Demand deposits,  money market and savings                            |       | 256,484                                             |       | 256,484 |   |
| Time  certificates of deposit                                         |       | 106,724                                             |       | 106,171 |   |
| Junior  subordinated debentures                                       |       | 15,464                                              |       | 16,039 |   |
| Other borrowings                                                      |       | 28,337                                              |       | 28,337 |   |
|                                                                       |            |                                                     |            |  |  |  |  |

 

**Note14—Derivatives**

The Company holds fixedrate and variable rate financial assets that are funded by fixed rate andvariable rate liabilities.

 

63

----

 

Consequently, theyare subject to the effects of changes in interest rates.  In response to this, the Company hasdeveloped an interest rate risk management policy with the objective ofmitigating financial exposure to changing interest rates.  These exposures are managed, in part, withthe use of derivatives but only to the extent necessary to meet the overallgoal of minimizing interest rate risk.

Derivativesare accounted for according to Statement of Financial Accounting Standards No.133, Accounting for Derivative Instruments and Hedging Activities, asamended.  This standard requires that allderivative instruments be recognized in the financial statements and measuredat fair value regardless of the purpose or intent for holding them.  To qualify for hedge accounting, the detailsof the hedging relationship must be formally documented at inception of thearrangement, including the risk management objective, hedging strategy, hedgeditem, specific risks that are being hedged, the derivative instrument and howeffectiveness is being assessed.  Thederivative must be highly effective in offsetting either changes in fair valueor cash flows, as appropriate, for the risk being hedged.  Effectiveness is evaluated on a retrospectiveand prospective basis.  If a hedgerelationship becomes ineffective, it no longer qualifies as a hedge.  Any excess gains or losses attributable tosuch ineffectiveness, as well as subsequent changes in the fair value of thederivative, are recognized in earnings.

Thefollowing is a summary of our risk management strategies and the effect ofthese strategies on the consolidated financial statements.
|                         | ** ** | **December 31, 2005**                     | ** ** | **December 31, 2004** | ** ** |
|-------------------------|------------|-----------------------------------------------------|------------|---------------------------------|------------|
| ** **              | ** ** | **Notional  Amount**                                | ** ** | **Fair Value**             | ** ** | **Notional  Amount** | ** ** | **Fair Value** | ** ** |
| ** **              | ** ** | **(Dollars in thousands, restated)** | ** ** |
| Fair value  hedges:     |       |                                                |       |                            |       |   |   |   |   |
| Interest rate swaps     |       | $                                                   | 30,000     |                            | $          | (41 | ) | $ | — |   | $ | — |   |
|                    |       |                                                |       |                            |       |   |   |   |   |
| Cash flow  hedges:      |       |                                                |       |                            |       |   |   |   |   |
| Interest rate  swaps    |       | $                                                   | 50,000     |                            | $          | (1,034 | ) | $ | 50,000 |   | $ | 406 |   |
| Interest rate  floors   |       | $                                                   | 50,000     |                            | $          | 286 |   | $ | — |   | $ | — |   |
|                    |       |                                                |       |                            |       |   |   |   |   |
| Non-hedge  derivatives: |       |                                                |       |                            |       |   |   |   |   |
| Interest rate  swaps    |       | 15,000                                              |       | (575                            | )          | 15,000 |   | (311 | ) |
| Interest rate  floors   |       | $                                                   | 150,000    |                            | $          | — |   | $ | — |   | $ | — |   |

 

Fairvalue hedges are hedges that reduce the risk of changes in the fair values ofassets, liabilities and certain types of firm commitments.  The Company uses interest rate swaps to hedgethe change in fair value of portions of its wholesale funding.  The interest rate swaps result in the Companypaying or receiving the difference between the fixed and floating rates atspecified intervals calculated on the notional amounts.  The differential paid or received on suchinterest rate swaps is recognized as an adjustment to interest expense.  The net change in fair value of thederivatives and the hedged items is reported in earnings.  The fair value hedges are highly effectiveand therefore no ineffectiveness was recognized in current earnings related tothis swap.

Cashflow hedges are hedges that use simple derivatives to offset the variability ofexpected future cash flows.  The Company’scash flow hedges include certain interest rate swaps and interest rate floorsused to manage the interest rate risk associated with its significant volume ofadjustable rate loans.  At December 31,2005 a loss of $605,000 was recorded in accumulated other comprehensive incomeand no ineffectiveness was recorded to earnings for the year ended December 31,2005 related to these interest rate swaps. As of December 31, 2004, the Company had recorded $314,000 accumulatedother comprehensive income related to the interest rate swaps.  At December 31, 2005 a loss of $157,000 wasrecorded in accumulated other comprehensive income related to the interest ratefloors.  Ineffectiveness related to theinterest rate floors designated as cash flow hedges of $24,000 was charged toearnings for the year ended December 31, 2005. There were no interest rate floors at December 31, 2004.

Non-hedge derivatives areinterest rate swaps and interest rate floors that do not meet the strictcriteria for hedge accounting treatment. We use derivatives to hedge exposures when it makes economic sense to doso, including circumstances in which the hedging relationship does not qualifyfor hedge accounting.  Derivatives notdesignated as hedges are marked to market through earnings.  The Company has entered into an interest rateswap agreement to pay an adjustable rate and receive a fixed rate with termsthat mirror its Junior Subordinated Debentures. At inception of this swap, the Company designated this swap as a fairvalue hedge of its Junior Subordinated Debentures and established the “short-cut”method of documenting the hedge effectiveness. As a result of subsequent technical interpretations of the “short-cut”hedge accounting rules, the Company has treated this swap as a non-hedgederivative and restated its financial statements since inception of thetransaction accordingly.  The effect ofthe non-hedge derivative treatment is to reflect the change in fair value of theswap in current income as a trading gain or loss.  There was a $395,000 trading loss recorded in2005 and a $229,000 trading gain in 2004 reflecting the change in market valueof this swap.  During 2005, the Companypurchased a one year interest rate floor to help protect its net interest incomein the event of a rapid decline in interest rates and permit it to executeother strategies to protect against declining interest rates over time.  There was an $8,000 charge to earnings duringthe year ended December 31, 2005 writing the value of this floor to zero.

 

64

----

 

**Note15—Parent Company Information**

Thefollowing financial information presents the condensed balance sheet of theCompany on a parent-only basis as of December 31, 2005, and the relatedcondensed statements of operations and cash flows for each of the years in thetwo-year period ended December 31, 2005.
|                                                     | ** ** | **December 31,**                       | ** ** |
|-----------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                          | ** ** | **2005**                                    | ** ** |
| ** **                                          | ** ** | **(Dollars in  thousands,  restated)** | ** ** |
|                                                |       |                                        |       |
| Cash with Banks                                     |       | $                                           | 137        |   |
| Due from banks -  time                              |       | 1,015                                       |       |
| Securities  available-for-sale                      |       | 974                                         |       |
| Investment in  the Banks                            |       | 48,558                                      |       |
| Other assets                                        |       | 3,720                                       |       |
| Total assets                                        |       | $                                           | 54,404     |   |
|                                                |       |                                        |       |
| Junior  subordinated deferrable interest debentures |       | $                                           | 15,464     |   |
| Other  liabilities                                  |       | 777                                         |       |
| Total liabilities                                   |       | 16,241                                      |       |
|                                                |       |                                        |       |
| Shareholders’  equity:                         |       |                                        |       |
| Preferred stock                                     |       | 1,000                                       |       |
| Common stock                                        |       | 45,697                                      |       |
| Accumulated deficit                                 |       | (7,380                                      | )          |
| Accumulated other comprehensive income              |       | (1,154                                      | )          |
| Total shareholders’ equity                     |       | 38,163                                      |       |
| Total liabilities and shareholders’ equity     |       | $                                           | 54,404     |   |

 

65

----

 

**Statements of Operations**

 
| ** **                                                  | ** ** | **Year ended December 31,**          | ** ** |
|-------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                  | ** ** | **2005**                                            | ** ** | **2004** | ** ** |
| ** **                                                  | ** ** | **(Dollars in thousands, restated)** | ** ** |
| ** **                                                  | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| Interest income                                             |       | $                                                   | 61         |   | $ | 33 |   |
| Interest expense                                            |       | 1,585                                               |       | 1,563 |   |
| Net interest expense                                        |       | (1,524                                              | )          | (1,530 | ) |
|                                                        |       |                                                |       |   |   |
| Other operating  income                                     |       | (47                                                 | )          | 970 |   |
| Other operating  expense                                    |       | 374                                                 |       | 238 |   |
| Loss before equity in undistributed net income of  the Bank |       | (1,945                                              | )          | (798 | ) |
| Equity in  undistributed net income of subsidiaries         |       | 5,588                                               |       | 2,790 |   |
| Income before  income tax provision (benefit)               |       | 3,643                                               |       | 1,992 |   |
| Income tax  benefit                                         |       | 807                                                 |       | 328 |   |
| Net income                                                  |       | $                                                   | 4,450      |   | $ | 2,320 |   |

 

 

**Statements of Cash Flow**

 
| ** **                                                                         | ** ** | **Year ended December 31,**          | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2005**                                            | ** ** | **2004** | ** ** |
| ** **                                                                         | ** ** | **(Dollars in thousands, restated)** | ** ** |
| ** **                                                                         | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| Cash flows from  operating activities:                                             |       |                                                |       |   |   |
| Net income                                                                         |       | $                                                   | 4,450      |   | $ | 2,320 |   |
| Adjustment to reconcile net income to net cash  provided by operating activities.: |       |                                                |       |   |   |
| Equity in undistributed net income of subsidiaries,  net                           |       | (5,588                                              | )          | (2,790 | ) |
| Trading loss (gain) on economic derivatives                                        |       | 395                                                 |       | (229 | ) |
| Net increase in other assets and other liabilities                                 |       | (1,658                                              | )          | (520 | ) |
| Net cash used in operations                                                        |       | (2,401                                              | )          | (1,219 | ) |
|                                                                               |       |                                                |       |   |   |
| Cash flows from  investing activities:                                             |       |                                                |       |   |   |
| Purchase of available-for-sale securities                                          |       | (536                                                | )          | (1,290 | ) |
| Sales and maturities of available-for-sale  securities                             |       | 1,500                                               |       | 1,800 |   |
| Net cash provided by (used in) investing activities                                |       | 964                                                 |       | 510 |   |
|                                                                               |       |                                                |       |   |   |
| Cash flows from  financing activities:                                             |       |                                                |       |   |   |
| Proceeds from stock options exercised                                              |       | 764                                                 |       | 372 |   |
| Net cash provided by financing activities                                          |       | 764                                                 |       | 372 |   |
| Net decrease in  cash and cash equivalents                                         |       | (673                                                | )          | (337 | ) |
| Cash and cash  equivalents, beginning of the year                                  |       | 1,825                                               |       | 2,162 |   |
| Cash and cash  equivalents, end of the year                                        |       | $                                                   | 1,152      |   | $ | 1,825 |   |
|                                                                               |       |                                                |       |   |   |
| Supplemental  disclosures of cash flow information:                                |       |                                                |       |   |   |
| Cash paid for interest                                                             |       | $                                                   | 1,172      |   | $ | 1,020 |   |
| Cash paid for  income taxes, net                                                   |       | $                                                   | 1,225      |   | $ | 51 |   |

 

66

----

 

**Note 16—RecentAccounting Developments**

*Accountingfor Share-Based Payments*

 In December 2004, the FinancialAccounting Standards Board (“FASB”) issued Statement of Financial AccountingStandards No. 123R, Accounting for Share-Based Payments (“SFAS No. 123R”), whichreplaces SFAS No. 123 and supersedes APB Opinion No. 25. SFAS No. 123R requiresall share-based payments to employees, including grants of employee stockoptions, to be recognized in the financial statements based on their fairvalues, beginning with the first annual period after June 15, 2005, with earlyadoption encouraged.  In addition, SFASNo. 123R will cause unrecognized expense related to options vesting after thedate of initial adoption to be recognized as a charge to results of operationsover the remaining vesting period. The Company is required to adopt SFAS No.123R in its first quarter of 2006, beginning January 1, 2006.  Under SFAS No. 123R, the Company mustdetermine the appropriate fair value model to be used for valuing share-basedpayments, the amortization method for compensation cost and the transitionmethod to be used at the date of adoption. The transition alternatives include prospective and retroactive adoptionmethods.  Under the retroactive methods,prior periods may be restated either as of the beginning of the year ofadoption or for all periods presented. The prospective method requires thatcompensation expense be recorded for all unvested stock options and shareawards at the beginning of the first quarter of adoption of SFAS No. 123R,while the retroactive methods would record compensation expense for allunvested stock options and share awards beginning with the first periodrestated.  The Company is evaluating therequirements of SFAS No. 123R and expects that the adoption of SFAS No. 123Rwill have a material impact on its consolidated results of operations andearnings per common share.  The amount ofshare-based employee compensation cost that would have been determinedconsistent with SFAS No. 123 and the pro forma earnings per share amounts forthe years ended December 31, 2004, 2003 and 2002 are shown in Note 1 of theNOTES TO CONSOLIDATED FINANCIAL STATEMENTS.

In May2005, the FASB issued Statement of Financial Accounting Standards No. 154,“Accounting Changes and Error Corrections” (“SFAS No. 154”).  SFAS No. 154 provides guidance on theaccounting for and reporting of accounting changes and error corrections.  It requires, unless impracticable,retrospective application for reporting changes in accounting principle in theabsence of explicit transition requirements specific to this newly adoptedaccounting principle.  SFAS No. 154is effective for accounting changes and corrections of errors made in fiscalyears beginning after December 15, 2005. The Company does not expect theadoption of SFAS No. 154 to have a material impact on its financialcondition or operating results.

**Note17—Subsequent Event**

*Agreementand Plan of Merger*

On June 15,2006, National Mercantile entered into an Agreement and Plan of Merger (the “MergerAgreement”) with FCB Bancorp, a California corporation (“FCB”), and FirstCalifornia Financial Group, Inc. (“FCFG”), a new Delaware corporationformed by National Mercantile for the purpose of the merger transactions.  The Merger Agreement provides for thereincorporation merger of National Mercantile into FCFG immediately followed bythe merger of FCB into FCFG (together, the “Mergers”).

Consummation of theMergers is subject to a number of closing conditions, including approval by theshareholders of both National Mercantile and FCB and regulatory approval.

 

67

----

 

**INDEX TO EXHIBITS**
| Exhibit | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      | ** ** |
|---------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
|    | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 3.1     |       | Amended and Restated Articles of Incorporation,  dated June 20, 1997 (1); Certificate of Amendment of the Articles of  Incorporation, filed May 4, 2000 (6); Certificate of Determination of Rights,  Preferences and Privileges of Series B Convertible Perpetual Preferred Stock  filed December 14, 2001(8); Certificate of Amendment to Article XIII of  the Articles of Incorporation filed August 9, 2003 (12); Certificate of  Amendment of the Articles of Incorporation, filed June 20, 2005 (13) |
|    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 3.2     |       | Bylaws of the Company, as amended, restated as of  December 18, 1992 (2)                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 4.1     |       | Indenture for Junior Subordinated Debt Securities  dated as of July 16, 2001 (7)                                                                                                                                                                                                                                                                                                                                                                                                                                |
|    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.1    |       | Employment Agreement dated January 1, 1999 between  Mercantile National Bank and Scott A. Montgomery (3); Assignment, Assumption  — Amendment of Employment Agreement among National Mercantile Bancorp,  Mercantile National Bank and Scott A. Montgomery (11)                                                                                                                                                                                                                                            |
|    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.2    |       | Form of Indemnity Agreement between the Company and  its directors (4)                                                                                                                                                                                                                                                                                                                                                                                                                                          |
|    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.3    |       | National Mercantile Bancorp Amended 1996 Stock  Incentive Plan (10)                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.4    |       | Form of Agreement for National Mercantile Bancorp  Amended 1996 Stock Incentive Plan (10)                                                                                                                                                                                                                                                                                                                                                                                                                       |
|    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.5    |       | National Mercantile Bancorp 2005 Stock Incentive  Plan (13)                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
|    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.6    |       | Form of Non-Qualified Stock Option Agreement for  National Mercantile Bancorp 2005 Stock Incentive Plan (13)                                                                                                                                                                                                                                                                                                                                                                                               |
|    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.6    |       | Form of Incentive Stock Option Agreement for  National Mercantile Bancorp 2005 Stock Incentive Plan (13)                                                                                                                                                                                                                                                                                                                                                                                                        |
|    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.6    |       | Amended and Restated Declaration of Trust of  National Mercantile Capital Trust I, dated as of June 27, 2001 (7))                                                                                                                                                                                                                                                                                                                                                                                |
|    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.7    |       | Guarantee Agreement of National Mercantile Bancorp  for trust preferred securities dated July 16, 2001 (7)                                                                                                                                                                                                                                                                                                                                                                                                      |
|    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.8    |       | Severance Agreement dated November 14, 2002 between  National Mercantile Bancorp and David Brown (9)                                                                                                                                                                                                                                                                                                                                                                                                            |
|    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.9    |       | Severance Agreement dated September 26, 2003 between  National Mercantile Bancorp and Robert Bartlett (11)                                                                                                                                                                                                                                                                                                                                                                                                      |
|    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.10   |       | Lease dated as of November 12, 2003 between Century  Park and Mercantile National Bank relating to Suite 800 offices at 1880  Century Park East, Los Angeles, California (11)                                                                                                                                                                                                                                                                                                                                   |
|    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.11   |       | Lease dated as of September 19, 2003 between  Metropolitan Life Insurance Company and Mercantile National Bank relating to  offices at 3070 Bristol Street, Costa Mesa, California (12)                                                                                                                                                                                                                                                                                                                         |
|    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.12   |       | Lease dated as of November 12, 2003 between Century  Park and Mercantile National Bank relating to ground floor offices at 1880  Century Park East, Los Angeles, California (12)                                                                                                                                                                                                                                                                                                                                |
|    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.13   |       | Lease dated as of March 29, 2005 between Brighton  Enterprises, LLC and Mercantile National Bank relating to offices at 9601  Wilshire Boulevard, Beverly Hills, California (12)                                                                                                                                                                                                                                                                                                                                |
|    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.14   |       | Lease dated as of September 10, 2004 between Encino  Corporate Plaza, LP and Mercantile National Bank relating to offices at 16661  Ventura Boulevard, Encino, California (12)                                                                                                                                                                                                                                                                                                                                  |
|    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.15   |       | Mercantile National Bank Deferred Compensation Plan  and Form of Agreement (12)                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 11.     |       | Statement regarding computation of per share  earnings (see ‘‘Note 1-Summary of Significant Accounting Policies-Earnings  Per Share’’—of the ‘‘Notes to the Consolidated Financial Statements’’ in  “Item 7. Financial Statements” in this Annual Report on Form 10-KSB/A)                                                                                                                                                                               |
|    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 21.     |       | Subsidiaries of the Registrant                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |

 

68

----

 
| 23.1   |   | Consent of Moss Adams LLP                                                     |
|--------|--------|-------------------------------------------------------------------------------|
|   |   |                                                                          |
| 23.2   |   | Consent of Ernst & Young LLP                                              |
|   |   |                                                                          |
| 31.1   |   | Certification of Scott A. Montgomery under Section  302 of Sarbanes-Oxley Act |
|   |   |                                                                          |
| 31.2   |   | Certification of David R. Brown under Section 302 of  Sarbanes-Oxley Act      |
|   |   |                                                                          |
| 32.1   |   | Certification of Scott A. Montgomery under Section  906 of Sarbanes-Oxley Act |
|   |   |                                                                          |
| 32.2   |   | Certification of David R. Brown under Section 906 of  Sarbanes-Oxley Act      |

 

----

(1)             Filed as an exhibitto the Company’s Annual Report on Form 10-K for the year ended December 31,1997.

(2)             Filed as an exhibitto the Company’s Annual Report on Form 10-K for the year ended December 31,1992 and incorporated herein by reference.

(3)             Filed as an exhibitto the Company’s Report on Form 10-Q for the quarter ended March 31, 1999 andincorporated herein by reference.

(4)             Filed as an exhibitto Company’s Annual Report on Form 10-K for the year ended December 31, 1990and incorporated herein by reference.

(5)             Filed as an exhibitto the Company’s Registration Statement on Form S-2 dated February 10, 1997 andamendments thereto and incorporated herein by reference.

(6)             Filed as an exhibitto the Company’s Annual Report on Form 10-KSB for the year ended December 21,2000 and incorporated herein by reference.

(7)             Filedas an exhibit to the Company’s Report on Form 10-QSB for the quarter endedSeptember 30, 2001 and incorporated herein by reference.

(8)             Filed as an exhibitto the Company’s Annual Report on Form 10-KSB for the year ended December 21,2001 and incorporated herein by reference.

(9)             Filed as an exhibitto the Company’s Annual Report on Form 10-KSB for the year ended December 21,2002 and incorporated herein by reference.

(10)       Filed as an exhibit to theCompany’s Registration Statement on Form S-8 dated June 20, 2003 andincorporated herein by reference.

(11)       Filed as an exhibit to theCompany’s Annual Report on Form 10-KSB for the year ended December 21, 2003 andincorporated herein by reference.

(12)       Filed as an exhibit to theCompany’s Annual Report on Form 10-KSB for the year ended December 21, 2004 andincorporated herein by reference.

(13)       Filed as an exhibit to theCompany’s Annual Report on Form 10-QSB for the quarter ended June 30, 20053 andincorporated herein by reference.

69

----