**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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**Form 10-KSB**

 

**ý****Annual report under section 13 or 15(d) ofthe Securities Exchange Act of 1934****for thefiscal year ended December 31, 2005**

 

**o****Transition report under section 13 or 15(d) ofthe Securities Exchange Act of 1934****for thetransition period from        to      .**

 

**Commission File Number 0-15982**

 

**NATIONAL MERCANTILE BANCORP**

(Exactname of small business issuer in its charter)

 

| **California**                            | ** ** | **95-3819685**                        |
|-------------------------------------------|------------|---------------------------------------|
| (State or  other jurisdiction of          |       | (I.R.S.  Employer Identification No.) |
| incorporation  or organization)           |       |                                  |
|                                      |       |                                  |
| **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 befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.     ý Yes       o No

 

Check if there is no disclosure of delinquentfilers to Item 405 of Regulation S-B contained herein, and no disclosure willbe contained, to the registrant’s knowledge, in definitive in response orinformation statements incorporated by reference in Part III of this Form 10-KSB.o

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).o Yes    ý No

 

The issuer’s revenues for its most recentfiscal year:  $27.4 million.

 

The aggregate market value of the votingcommon equity held by nonaffiliates of the registrant, based upon the closingsale price of its Common Stock as reported by the National Association ofSecurities Dealers Automated Quotation System on March 21, 2006, wasapproximately $35.0 million.

 

The number of shares of Common Stock, no parvalue, of the issuer outstanding as of March 21, 2006 was 4,427,174.

 

**DOCUMENTSINCORPORATED BY REFERENCE**:

 

Certain portions of the Company’s ProxyStatement to be 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,Items 9-12 and 14 and is of this Annual Report on Form 10-KSB.

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

 

 

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**NATIONALMERCANTILE BANCORP**

 

**Table ofContents**

 

**Form 10-KSB**

**For theFiscal 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**    |                                                                                                                        |

 

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**ANNUALREPORT ON FORM 10-K**

 

Certain matters discussed in this Form 10-KSBmay constitute forward-looking statements within the meaning of theSecurities Exchange Act of 1934 (the “Exchange Act”) and as such may involverisks and uncertainties. These forward-looking statements relate to, amongother things, expectations of the business environment in which NationalMercantile Bancorp (referred to as “we”, “our” or “the Company” when suchreference includes National Mercantile Bancorp and its subsidiaries,collectively, “National Mercantile” when referring only to the parent companyand “the Banks” when referring only to National Mercantile’s bankingsubsidiaries, Mercantile National Bank and South Bay Bank, N.A.) operates,projections of future performance, perceived opportunities in the market andstatements regarding our mission and vision. Our actual results, performance,or achievements may differ significantly from the results, performance, orachievements expressed or implied in such forward-looking statements. Statementsregarding policies and procedures are not intended to imply, and should not beinterpreted to mean, that we will conduct our business in accordance with suchpolicies for any particular period of time, as we may at any time and fromtime to time amend or repeal such policies and adopt new policies. Fordiscussion of the factors that might cause such a difference, see “Item 6. Management’sDiscussion and Analysis of Financial Condition or Plan of Operation— FactorsWhich May Affect Future Operating Results”.

 

**PART I**

** **

***ITEM 1. DESCRIPTION OF BUSINESS***

*** ***

National Mercantile is a bank holding companywhose principal assets are the capital stock of two bank subsidiaries:Mercantile National Bank (“Mercantile”) and South Bay Bank, N.A. (“South Bay”).National Mercantile has been authorized by the Federal Reserve Bank of SanFrancisco to engage in lending activities separate from the Banks but to datehas not done so.

 

Our present business strategy is to attractindividual and small- to mid-sized business borrowers in specific market nicheslocated in our primary service areas by offering a variety of loan products anda full range of banking services coupled with highly personalized service. Ourlending products include revolving lines of credit, term loans, commercial realestate loans, construction loans and consumer and home equity loans, whichoften contain terms and conditions tailored to meet the specific demands of themarket niche in which the borrower operates. Additionally, we provide a widearray of deposit and investment products that are also designed to meetspecific customer needs.

 

We operate throughout the west side of LosAngeles County including the South Bay, Century City and San Fernando Valleywith banking offices in Century City, Torrance, Encino and El Segundo and aloan production office in Beverly Hills. Additionally, we target Orange Countybusinesses through our loan production office in Costa Mesa, California.

 

Our targeted market niches for businessesinclude the entertainment industry, the healthcare industry, professionalservices providers, the real estate escrow industry, property managers, publicworks contractors and community-based nonprofit organizations. Entertainmentindustry clients 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. Healthcare organizationsinclude primarily outpatient healthcare providers such as physician medicalgroups, independent practice associations and surgery centers. Professionalservice customers include legal, accounting, insurance, advertising firms andtheir individual directors, officers, partners and shareholders.

 

We also engage in real estate andconstruction lending. Our real estate loans are for the purchase or finance ofprincipally smaller commercial properties, including owner-occupied businessfacilities and retail properties, and to a lesser extent multi-family andsingle 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 ofproducts and services, we may from time to time open de novo branchbanking offices or acquire other financial service-related companies including “in-market”acquisitions with banks of similar size and market presence. No assurance canbe made that we will identify a company which can be acquired on terms andconditions acceptable to us or that we could obtain the necessary regulatoryapprovals for such an acquisition.

 

We believe that banking clients value doingbusiness with locally managed institutions that can provide a full servicecommercial banking relationship through an understanding of the clients’financial needs and the flexibility to deliver customized solutions through ourmenu of products and services. We also believe that our subsidiary Banks arebetter able to build successful client relationships as the holding companyprovides cost effective administrative support services while promoting bankautonomy and flexibility in serving client needs.

 

To implement this philosophy, we operate eachof our bank subsidiaries by retaining their independent names. Each banksubsidiary has established strong client followings in its market areas throughattention to client service and an understanding of client needs.

 

In an effort to capitalize on the identitiesand reputations of the Banks, we intend to continue to market our servicesunder each Bank’s name, primarily through each Bank’s relationship managers. Theprimary focus for the Banks’ relationship managers is to cultivate and nurturetheir client relationships. Relationship managers are assigned to eachborrowing client to provide continuity in the

 

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relationship. This emphasis on personalized relationships requires thatall of the relationship managers maintain close ties to the communities orindustry niche in which they serve, so they are able to capitalize on theirefforts through expanded business opportunities for the Banks.

 

Client service decisions and day-to-dayoperations are maintained at the Banks. National Mercantile offers theadvantages of affiliation with a multi-bank holding company by providing expandedclient support services, such as increased client lending capacity, businesscash management, and centralized administrative functions, including clientservices, support in credit policy formulation and review, investmentmanagement, data processing, accounting, loan servicing and other specializedsupport functions. All of these centralized services are designed to enhancethe ability of the relationship managers to expand their client relationshipbase.

 

At December 31, 2005, we had totalassets of $448.8 million, total loans, net, of $334.1 million and totaldeposits of $363.2 million.

 

**Corporate History**

 

Mercantile was organized in 1981 as anational banking association and commenced operations through an office inCentury City in 1982. In 1983 National Mercantile was organized under the lawsof the State of California and registered as a bank holding company under theBank Holding Company Act of 1956, as amended (the “BHCA”), to serve as aholding company for Mercantile.

 

In March 2001, Mercantile opened aregional office in Encino, California which expanded our client-focused nichebanking services to the San Fernando Valley area of Los Angeles. In January 2004,Mercantile opened a loan production office in Beverly Hills, California tofocus on providing banking services to those affiliated with the entertainmentindustry.

 

In December 2001, National Mercantileacquired South Bay, which had offices in Torrance and El Segundo. In January 2004,South Bay opened a loan production office in Costa Mesa to expand its lendingservices to the Orange County area of Southern California.

 

**Competition**

 

The banking and financial services industryin California generally, and in the Banks’ market areas specifically, is highlycompetitive. The increasingly competitive environment is primarily a result ofchanges in regulation, changes in technology and product delivery systems, andthe accelerating pace of consolidation among financial services providers. Ourprimary service area is dominated by a relatively small number of major banksthat have many offices operating over a wide 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 largerin total assets and capitalization, have greater access to capital markets andoffer a broader range of financial services than us. Nondepository institutionscan be expected to increase the extent to which they act as financialintermediaries. Large institutional users and sources of credit may alsoincrease the extent to which they interact directly, meeting business creditneeds outside the banking system. Furthermore, the geographic constraints onportions of the financial services industry can be expected to erode. Inaddition, many of the major commercial banks operating in our primary servicearea offer services, such as trust services, which are not offered directly byus and, by virtue of their greater total capitalization, such banks havesubstantially higher lending limits.

 

To compete with other financial institutionsin our primary service area, we rely principally upon personal contact by ourofficers, directors and employees and providing, through third parties,specialized services such as messenger, accounting and other related services. Forclients whose loan demands exceed our legal lending limit, we arrange for suchloans on a participation basis with other banks. We also assist clientsrequiring other services not offered by us in obtaining such services fromother providers.

 

**Economic Conditions and Government Policies**

 

Our profitability, like most financialinstitutions, is primarily dependent on interest rate differentials. Ingeneral, the difference between the interest rates paid by us on ourinterest-bearing liabilities, such as deposits and other borrowings, and theinterest rates received by us on our interest-earning assets, such as loans andinvestment securities, comprise the major portion of our earnings. These ratesare 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 federal government and the policies of regulatory agencies, particularly the Board of Governors of the Federal Reserve System (the “Federal Reserve”), influence our business. The Federal Reserve implements national monetary policies (with objectives such as curbing inflation and combating recession) through its open-market operations in U.S. Government securities by adjusting the required level of reserves for depository institutions subject to its reserve requirements, and by varying the target federal funds and discount rates applicable to borrowings by depository institutions. The actions of the Federal Reserve in these areas influence the growth of bank loans, investments, and deposits and also affect interest rates earned on interest-earning assets and paid on interest-bearing liabilities. We cannot fully predict the nature and impact on us of any future changes in monetary and fiscal policies.

 

4

 

**Supervision and Regulation**

 

*General*

 

Banking is a highly regulated industry. Congressand the states have enacted numerous laws that govern banks, bank holdingcompanies and the financial services industry, and have created several largelyautonomous regulatory agencies which have authority to examine and supervisebanks and bank holding companies, and to adopt regulations furthering thepurpose of the statutes. The primary goals of the regulatory scheme are tomaintain a safe and sound banking system, to protect depositors and the FederalDeposit Insurance Corporation (“FDIC”) insurance fund, and to facilitate theconduct of sound monetary policy; they were not adopted for the benefit ofshareholders of the Company. As a result, the Company’s financial condition,results of operations, ability to grow and engage in various businessactivities can be affected not only by management decisions and general economicconditions, but the requirements of applicable federal and state laws,regulations and the policies of the various regulatory authorities.

 

Further, these laws, regulations and policiesare reviewed often by Congress, state legislatures and federal and stateregulatory agencies. Changes in laws, regulations and policies can materiallyincrease the cost of doing business, limit certain business activities, requireadditional capital, or materially adversely affect competition between banksand 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 ofcertain of the material laws and regulations that relate to the operations ofNational Mercantile and the Banks. The description does not purport to be acomplete description of these laws and regulations and is qualified in itsentirety by reference to the applicable laws and regulations.

 

*National Mercantile*

 

As a registered bank holding company,National Mercantile 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 theFederal Reserve’s prior approval before acquiring ownership or control of morethan 5% of the outstanding shares of any class of voting securities, orsubstantially all the assets, of any company, including a bank or bank holdingcompany. Further, National Mercantile is generally allowed to engage, directlyor indirectly, only in banking and other activities that the Federal Reservedeems to be so closely related to banking or managing or controlling banks asto be a proper incident thereto.

 

Under Federal Reserve regulations, a bankholding company is required to serve as a source of financial and managerialstrength to its subsidiary banks and may not conduct its operations in anunsafe or unsound manner. In addition, it is the Federal Reserve’s policy thatin serving as a source of strength to its subsidiary banks, a bank holdingcompany should stand ready to use available resources to provide adequatecapital funds to its subsidiary banks during periods of financial stress oradversity and should maintain the financial flexibility and capital-raisingcapacity to obtain additional resources for assisting its subsidiary banks. Abank holding 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 ofthe Federal Reserve System. The Banks are subject to primary supervision,examination, and regulation by the Office of the Comptroller of the Currency(the “OCC”) and are also subject to regulations of the FDIC and the FederalReserve. The Banks are subject to requirements and restrictions under federallaw, including requirements to maintain reserves against deposits, restrictionson the types and amounts of loans that may be granted and limitations onthe types of investments that may be made and services that may beoffered. Various consumer laws and regulations also affect the Banks’operations. These laws primarily protect depositors and other customers of theBanks, rather than National Mercantile and its shareholders.

 

The OCC and the Federal Reserve have variousremedies if they should determine that the financial condition, capitalresources, asset quality, earnings prospects, management, liquidity, or otheraspects of a bank’s operations are unsatisfactory or that a bank or itsmanagement is violating or has violated any law or regulation. These remediesinclude the power to enjoin “unsafe or unsound” practices, to requireaffirmative action to correct any conditions resulting from any violation orpractice, to issue an administrative order that can be judicially enforced, todirect an increase in capital, to restrict the growth of the bank, to assesscivil monetary penalties, to remove officers and directors, and ultimately toterminate the bank’s deposit insurance.

 

*FDIC*

 

The Banks are subject to examination andregulation by the FDIC under the Federal Deposit Insurance Act because theirdeposit accounts are insured by the FDIC.

 

Under FDIC regulations, each insureddepository institution is assigned to one of three capital groups for insurancepremium purposes — “well capitalized,” “adequately capitalized” and “undercapitalized”– which are defined in the same manner as under prompt corrective action rules,as discussed under “Capital Adequacy Requirements” below. These three groupsare then divided into

 

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subgroups, which are based on supervisory evaluations by theinstitution’s primary federal regulator, resulting in nine assessmentclassifications. Currently, assessment rates for insured banks range from 0% ofinsured deposits for well-capitalized banks with minor supervisory concerns to0.027% of insured deposits for undercapitalized banks with substantialsupervisory concerns. The FDIC may increase or decrease the assessmentrate schedule semiannually.

 

The FDIC may terminate the depositinsurance of any insured depository institution if the FDIC determines, after ahearing, that the institution has engaged or is engaging in unsafe or unsoundpractices. As with the OCC’s enforcement authority, the FDIC’s authority toterminate deposit insurance is not limited to cases of capital inadequacy,financial weakness rendering an institution unable to continue operations,violations of any applicable law or regulation or violation of any order or anycondition imposed in writing by the FDIC. In addition, FDIC regulations providethat any 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 FDIC may also suspend depositinsurance temporarily during the hearing process if the institution has notangible capital. The FDIC is additionally authorized by statute to appointitself as conservator or receiver of an insured depository institution (inaddition to the powers of the institution’s primary federal regulatoryauthority) in cases, among others, of unsafe or unsound conditions or practicesor willful violations of cease and desist orders.

 

All FDIC-insured depository institutions mustpay an annual assessment to provide funds for the payment of interest on bondsissued by the Financing Corporation ( “FICO”), a federal corporation charteredunder the authority of the Federal Housing Finance Board. The bonds, commonlyreferred to as FICO bonds, were issued to capitalize the Federal Savings andLoan Insurance Corporation. The FICO has established assessment rates effectivefor the first quarter of 2005 at approximately $.0144 per $100 annually forassessable deposits. The FICO assessments are adjusted quarterly to reflectchanges in the assessment bases of the FDIC’s insurance funds and do not varydepending on a depository institution’s capitalization or supervisoryevaluations.

 

*Dividends and Capital Distributions*

 

Dividends and capital distributions from theBanks constitute the principal ongoing source of cash to National Mercantile. NationalMercantile is a legal entity separate and distinct from the Banks, and as suchhas separate and distinct financial obligations including debt service andoperating expenses. The Banks are subject to various statutory and regulatoryrestrictions on their ability to pay dividends and capital distributions toNational Mercantile.

 

OCC approval is required for a national bank topay a dividend if the total of all dividends declared in any calendar yearexceeds the total of the bank’s net profits (as defined) for that year combinedwith its 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 any dividend that exceeds its retainednet 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 compliancewith regulatory capital requirements generally are not permitted to paydividends. The OCC also can prohibit a national bank from engaging in an unsafeor unsound practice in its business. Depending on the bank’s financialcondition, payment of dividends could be deemed to constitute an unsafe orunsound practice. Except under certain circumstances, and with prior regulatoryapproval, a bank may not pay a dividend if, after so doing, it would beundercapitalized. The

 

Banks’ ability to pay dividends in the futureis, and could be, further influenced by regulatory policies or agreements andby capital guidelines.

 

Mercantile has a substantial accumulateddeficit and does not anticipate having positive retained earnings for theforeseeable future. South Bay had retained earnings of $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 isnot anticipated that such consent could be obtained unless the distributingbank were to remain “well capitalized” following such distribution.

 

*Transactions with Affiliates*

 

The Banks are subject to certain restrictionsimposed by federal law on any extensions of credit to, or the issuance of aguarantee or letter of credit on behalf of, National Mercantile or otheraffiliates, the purchase of, or investments in, stock or other securitiesthereof, the taking of such securities as collateral for loans, and thepurchase of assets of National Mercantile or other affiliates. Suchrestrictions prevent National Mercantile and such other affiliates fromborrowing from the Banks unless the loans are secured by marketable obligationsof designated amounts. Further, such secured loans and investments by the Banksto or in National Mercantile or to or in any other affiliate are limited,individually, to 10% of the respective Bank’s capital and surplus (as definedby federal regulations), and such secured loans and investments are limited, inthe aggregate, to 20% of the respective Bank’s capital and surplus (as definedby federal regulations).

 

*Capital Adequacy Requirements*

 

Both the Federal Reserve and the OCC haveadopted similar, but not identical, “risk-based” and “leverage” capitaladequacy guidelines for bank holding companies and national banks, respectively.Under the risk-based capital guidelines, different categories of assets areassigned different risk weights, ranging from zero percent for assetsconsidered risk-free (e.g., cash) to 100% for assets considered relativelyhigh-risk (e.g., commercial loans). These risk weights are multiplied bycorresponding asset balances to determine

 

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a risk-adjusted asset base. Certain off-balance sheet items (e.g.,standby letters of credit) are added to the risk-adjusted asset base. Theminimum required ratio of total capital to risk-weighted assets for both bankholding companies and national banks is presently 8%. At least half of thetotal capital is required to be “Tier 1 capital,” consisting principally ofcommon shareholders’ equity, a limited amount of perpetual preferred stock andminority interests in the equity, less goodwill, intangible assets and certainother items. The remainder (Tier 2 capital) may consist of a limited amountof subordinated debt, certain hybrid capital instruments and other debtsecurities, preferred stock and a limited amount of the general loan-lossallowance.

 

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

 

*Prompt Corrective Action Rules*

 

The OCC has adopted regulations establishingcapital categories for national banks and prompt corrective actions forundercapitalized institutions. The regulations create five capital categories:well capitalized, adequately capitalized, undercapitalized, significantlyundercapitalized and critically undercapitalized. 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 whichare not at least “adequately capitalized” to a broad range of restrictions andregulatory requirements. An undercapitalized bank may not pay managementfees to any person having control of the institution, nor, except under certaincircumstances and with prior regulatory approval, make any capital distribution.Undercapitalized banks are subject to increased monitoring by the OCC, arerestricted in their asset growth, must obtain regulatory approval for certaincorporate activities, such as acquisitions, new branches and new lines ofbusiness, and, in most cases, must submit to the OCC a plan to bring theircapital levels to the minimum required in order to be classified as adequatelycapitalized. The OCC may not approve a capital restoration plan unlesseach company that controls the bank guarantees that the bank will comply withit. Under Federal Reserve policy, a bank holding company is expected to act asa source of financial strength to its subsidiary banks and to commit resourcesto support each such bank. In addition, a bank holding company is required toguarantee that its subsidiary bank will comply with any capital restorationplan. The amount of such a guarantee is limited to the lesser of (i) 5% ofthe bank’s total assets at the time it became undercapitalized, or (ii) theamount which is necessary (or would have been necessary) to bring the bank intocompliance with all applicable capital standards as of the time the bank failsto comply with the capital restoration plan. A holding company guarantee of acapital restoration plan results in a priority claim to the holding company’sassets ahead of its other unsecured creditors and shareholders that isenforceable even in the event of the holding company’s bankruptcy or thesubsidiary bank’s insolvency.

 

If any one or more of a bank’s ratios arebelow the minimum ratios required to be classified as undercapitalized, it willbe classified 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 undercapitalizedbanks are subject to additional mandatory and discretionary restrictions and,in the case of critically undercapitalized institutions, must be placed intoconservatorship or receivership unless the OCC and the FDIC agree otherwise.

 

*Safety and Soundness Standards*

 

The federal banking agencies have adoptedguidelines designed to assist the federal banking agencies in identifying andaddressing potential safety and soundness concerns before capital becomesimpaired. The guidelines set forth operational and managerial standardsrelating to (i) internal controls, information systems and internal auditsystems; (ii) loan documentation; (iii) credit underwriting; (iv) assetgrowth; (v) earnings; and (vi) compensation, fees and benefits.

 

In addition, the federal banking agencieshave also adopted safety and soundness guidelines with respect to asset qualityand earnings standards. These guidelines provide six standards for establishingand maintaining a system to identify problem assets and prevent those assetsfrom deteriorating. Under these standards, an insured depository institutionshould (i) conduct periodic asset quality reviews to identify problemassets; (ii) estimate the inherent losses in problem assets and establishreserves that are sufficient to absorb estimated losses; (iii) compare problemasset totals to capital; (iv) take appropriate corrective action toresolve problem assets; (v) consider the size and potential risks ofmaterial asset concentrations; and (vi) provide periodic asset qualityreports with adequate information for management and the board of directors toassess the level of asset risk.

 

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

 

*Cross Guarantees*

 

The Banks are also subject to cross-guarantyliability under federal law. This means that if one FDIC-insured depositoryinstitution subsidiary of a multi-institution bank holding company fails orrequires FDIC assistance, the FDIC may assess commonly controlleddepository institutions for the estimated losses suffered by the FDIC. Such aliability could have a material adverse effect on the financial condition ofany assessed subsidiary institution and on National Mercantile as the commonparent. While the FDIC’s cross-guaranty claim is generally junior to the claimof depositors, holders of secured liabilities, general creditors andsubordinated creditors, it

 

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is generally superior to the claims of shareholders and affiliates.

 

*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 besubject to substantial penalties and corrective measures for a violation ofcertain fair lending laws. The CRA requires the Banks to ascertain and meet thecredit needs of the communities it serves, including low- and moderate-incomeneighborhoods. The Banks’ compliance with the CRA is reviewed and evaluated bythe OCC, which assigns the Banks a publicly available CRA rating at theconclusion 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. The regulations also require certain levelsof collection and reporting of data regarding certain kinds of loans.

 

Further, the federal banking agencies may takecompliance with such laws and CRA obligations into account when regulating andsupervising other activities. An assessment of CRA compliance is required inconnection with applications for OCC approval of certain activities, includingestablishing or relocating a branch office that accepts deposits or merging orconsolidating with, or acquiring the assets or assuming the liabilities of, a federallyregulated financial institution. An unfavorable rating may be the basisfor OCC denial of such an application, or approval may be conditioned uponimprovement of the applicant’s CRA record. In the case of a bank holdingcompany applying for approval to acquire a bank or other bank holding company,the Federal Reserve will assess the CRA record of each subsidiary bank of theapplicant, and such records may be the basis for denying the application. Thefederal banking agencies have established annual reporting and publicdisclosure requirements for certain written agreements that are entered intobetween insured depository institutions or their affiliates and nongovernmentalentities or persons that are made pursuant to, or in connection with, the fulfillmentof the CRA.

 

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

 

*USA Patriot Act of 2001*

 

The USA Patriot Act of 2001 (“Patriot Act”)is intended to strengthen the U.S law enforcement and the intelligencecommunities’ abilities to work cohesively to combat terrorism on a variety offronts. The potential impact of the Patriot Act on financial institutions ofall kinds is significant and wide ranging. The Patriot Act contains sweepinganti-money laundering and financial transparency laws and requires variousregulations, including: (i) due diligence requirements for financialinstitutions that administer, maintain, or manage private bank accounts orcorrespondent accounts for non-US persons; (ii) standards for verifyingcustomer identification at account opening; (iii) rules to promote cooperationamong financial institutions, regulators, and law enforcement entities inidentifying parties that may be involved in terrorism or money laundering;and (iv) reports by non-financial trades and businesses filed with theTreasury Department’s Financial Crimes Enforcement Network for transactionsexceeding $10,000, and filing of suspicious activities reports by securitiesbrokers and dealers if they believe a customer may be violating U.S. lawsand regulations.

 

*Privacy*

 

Federal banking rules limit the abilityof banks and other financial institutions to disclose non-public informationabout consumers to nonaffiliated third parties. Pursuant to these rules,financial institutions must provide: (i) initial notices to customersabout their privacy policies, describing the conditions under which they may disclosenonpublic personal information to nonaffiliated third parties and affiliates; (ii) annualnotices of their privacy policies to current customers; and (iii) areasonable method for customers to “opt out” of disclosures to nonaffiliatedthird parties.

 

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 haveimplemented their own versions of privacy laws. For example, in 2003,California adopted standards that are more restrictive than federal law,allowing bank customers the opportunity to bar financial companies from sharinginformation with their affiliates.

 

**Employees**

 

At December 31, 2005, we had 77full-time equivalent employees. None of the employees is covered by acollective bargaining agreement. We consider our employee relations to besatisfactory.

 

8

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**ITEM 2. DESCRIPTION OF PROPERTY.**

 

National Mercantile leases approximately13,880 square feet in an office building at 1880 Century Park East, LosAngeles, California, which serves as its administrative headquarters. The rentfor the period January 2004 to April 2014 is $2.23 per square foot or$30,952 per month, subject to an annual CPI adjustment and for changes inproperty taxes and operating costs.

 

Mercantile’s principal banking office islocated in 1,800 square feet in an office building at 1880 Century Park East,Los Angeles, California. The effective rent is $3.00 per square foot or $5,401per month. The lease expires in June 2014.

 

Mercantile leases approximately 1,650 squarefeet in an office building in Encino, California for the primary purpose ofproviding branch banking operations in the San Fernando Valley. The effectiverent is $2.73 per square foot or $4,500 per month. The lease expires in June 2008.Additionally, Mercantile leases 2,559 square feet in an office building inBeverly Hills as a loan production office, primarily for the entertainmentindustry. The effective rent is $2.88 per square foot, or $7,754 per month andthe lease expires June 2009.

 

South Bay owns a two-story stand-alone officebuilding at 2200 Sepulveda Boulevard, Torrance, California, which serves as itsprincipal banking office. South Bay also leases approximately 3,100 square footin an office building in El Segundo, California for the primary purpose ofproviding branch banking operations in the Los Angeles airport area. Theeffective rent is $1.85 per month and the lease expires in January 2011. Additionally,South Bay leases 1,555 square feet in an office building in Costa Mesa,California as a loan production office in Orange County. The office has beendesigned to serve as a full service branch banking office in the future. Theeffective rent is $1.85 per square foot, or $2,877 per month. The lease expiresFebruary 2009.

 

We believe our present facilities are adequatefor our present needs but anticipate the need for additional facilities as wecontinue to grow. We believe that, if necessary, we could secure suitablealternative facilities on similar terms without adversely affecting operations.

 

**ITEM 3. LEGAL PROCEEDINGS.**

 

From time to time, we are involved in certainlegal proceedings arising in the normal course of our business. We believe thatthe outcome of these matters existing as of December 31, 2005 will nothave a material adverse effect on us.

 

**ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.**

 

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

 

###### **PART II**

###### ** **

***ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATEDSHAREHOLDER MATTERS***

*** ***

The Common Stock of National Mercantile istraded on the Nasdaq Small Cap Market under the symbol MBLA. The followingtable shows the high and low trade prices of the Common Stock for each quarterof 2004 and 2005 as reported by the Nasdaq. Additionally, there may havebeen transactions at prices other than those shown during that time.

 
| ** **               | ** ** | **Common Stock** | ** ** |
|--------------------------|------------|-----------------------|------------|
| **Quarter Ended:**  | ** ** | **High**              | ** ** | **Low** | ** ** |
| March 31,  2004     |       | $                     | 11.80      |   | $ | 9.24 |   |
| June 30,  2004      |       | 10.45                 |       | 9.18 |   |
| September 30,  2004 |       | 10.63                 |       | 9.45 |   |
| December 31,  2004  |       | 13.75                 |       | 10.41 |   |
| March 31,  2005     |       | 15.70                 |       | 12.70 |   |
| June 30,  2005      |       | 15.87                 |       | 12.26 |   |
| September 30,  2005 |       | 15.91                 |       | 15.05 |   |
| December 31,  2005  |       | 19.60                 |       | 15.50 |   |
|                          |            |                       |            |  |  |  |  |

 

At March 21, 2006, National Mercantilehad 167 shareholders of record for its Common Stock. The number of beneficialowners for the Common Stock is higher as many people hold their shares in “street”name. At March 21, 2006, approximately 40% of the Common Stock was held instreet name.

 

National Mercantile has not paid a cashdividend on its Common Stock for more than 10 years. As a Californiacorporation, under the California General Corporation Law, generally NationalMercantile may not pay dividends in cash or property except (i) outof positive retained earnings or (ii) if, after giving effect to thedistribution, National Mercantile’s assets would be at least 1.25 times itsliabilities and its current assets would exceed its current liabilities(determined on a consolidated basis under generally accepted accountingprinciples). At December 31, 2005, National Mercantile had an accumulateddeficit of $7.0 million. Further, it is unlikely that its assets will ever beat least 1.25 times its liabilities. Accordingly, National Mercantile mustgenerate net income in excess of $7.0 million before it can pay a dividend incash or property.

 

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In addition, National Mercantile may notpay dividends on its capital stock if it is in default or has elected to deferpayments of interest under its junior subordinated deferred interestdebentures.

 

*Outstanding AwardsUnder All Equity Compensation Plans*. The followingtable sets forth as of December 31, 2005 information regarding outstandingoptions under all of our equity compensation plans and the number of sharesavailable for future option grants under equity compensation plans currently ineffect.

 
| ** **                                                  | ** ** | **(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    |   |
|                                                             |            |                                                                                                    |            |                                                                                   |            |                                                                                                                                              |            |  |

 

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(1) Includes the 2005 Stock Incentive Plan, 1996 Stock IncentivePlan and two stock option plans which have been terminated but under whichthere remain outstanding options to purchase an aggregate of 2,200 shares ofNational Mercantile Common Stock.

 

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

 

**EXECUTIVE LEVEL OVERVIEW**

 

**Table 1**

**Operations Summary**

 
| ** **                            | ** ** | **Year Ended  December 31,** | ** ** | **Increase  (Decrease)** | ** ** | **Year Ended  December 31,** | ** ** |
|---------------------------------------|------------|-----------------------------------|------------|--------------------------|------------|-----------------------------------|------------|
| ** **                            | ** ** | **2005**                          | ** ** | **Amount**               | ** ** | **%**                             | ** ** | **2004** | ** ** |
| ** **                            | ** ** | **(Dollars in thousands)**        | ** ** |
| Interest income                       |       | $                                 | 26,265     |                     | $          | 6,811                             |       | 35.0 | % | $ | 19,454 |   |
| Interest expense                      |       | 5,136                             |       | 2,132                    |       | 71.0                              | %          | 3,004 |   |
| Net interest income                   |       | 21,129                            |       | 4,679                    |       | 28.4                              | %          | 16,450 |   |
| Provision (benefit) for credit losses |       | (84                               | )          | (304                     | )          | (138.2                            | )%         | 220 |   |
| Other operating income                |       | 1,166                             |       | (401                     | )          | (25.6                             | )%         | 1,567 |   |
| Other operating expense               |       | 14,376                            |       | 348                      |       | 2.5                               | %          | 14,028 |   |
| Income before income taxes            |       | 8,003                             |       | 4,234                    |       | 112.3                             | %          | 3,769 |   |
| Income taxes                          |       | 3,322                             |       | 1,739                    |       | 109.9                             | %          | 1,583 |   |
| Net income                            |       | $                                 | 4,681      |                     | $          | 2,495                             |       | 114.1 | % | $ | 2,186 |   |

 

We recorded net income of $4.7 million for2005 compared to net income of $2.2 million for 2004. This represents basicearnings per share of $1.26 and fully-diluted earnings per share of $0.99 for2005 compared to basic earnings per share of $0.75 per share and fully-dilutedearnings per share of $0.48 for 2004. The increase in net income for 2005 waslargely due to a $4.7 million increase in net interest income resulting from (i) increasesin the prime rate lending index, (ii) a greater volume of interest earningassets, particularly higher yielding loans receivable and securitiesavailable-for-sale, (iii) interest rate swaps and (iv) a more rapidrise in yield on earning assets than cost of interest-bearing liabilities. Additionally,for 2005 we recorded a net benefit for credit losses due to a significantrecovery of a loan previously charged off resulting in a $304,000 positivechange compared to 2004. Other operating income declined $401,000 due togreater allowances for compensating balances and changes in deposit fee structures.Other operating expenses increased $348,000 in 2005, largely due to greatersalaries and related expense and increased professional services.

 

Return on average assets for 2005 was 1.16%compared to 0.57% for 2004. Return on average equity for 2005 was 12.78%compared to 6.61% for 2004.

 

Total assets at December 31, 2005 were$448.8 million compared to $391.5 million at year-end 2004. Loans receivableand securities available-for-sale increased $24.7 million and $34.8 million,respectively. The increase in loans receivable was due to growth inconstruction and land development loans partially offset by a decline incommercial real estate loans and commercial loans - secured and unsecured.

 

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The allowance for loan and lease losses at December 31,2005 was $4.5 million compared to $3.5 million at December 31, 2004reflecting net recoveries of loans previously charged off of $1.2 millionduring the year less the reversal of provision for credit losses of $84,000.

 

Total deposits at December 31, 2005 were$363.2 million compared to $313.5 million at year-end 2004. The composition ofdeposits at December 31, 2005 reflects a $46.4 million increase incertificates of deposit $100,000 and over, a $6.9 million increase in moneymarket accounts, $1.1 million increase in interest-bearing demand deposits anda $2.1 million increase in noninterest-bearing demand deposits offset by a $4.0million decrease in savings accounts and a $2.7 million decrease in certificatesof deposit under $100,000. The significant increase in certificates of deposit$100,000 and over was due to the execution of a securities leverage strategyfor the purpose of interest rate risk management. Other borrowed funds were$28.3 million at December 31, 2005 compared to $25.9 million at year-end2004.

 

**Table 2**

**Ratios to Average Assets**

 
| ** **                  | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------|------------|----------|------------|----------|------------|
| Net interest income         |       | 5.22     | %          | 4.32     | %          |
| Other operating income      |       | 0.29     | %          | 0.41     | %          |
| Provision for credit losses |       | 0.02     | %          | (0.06    | )%         |
| Other operating expense     |       | (3.55    | )%         | (3.68    | )%         |
| Income before income taxes  |       | 1.98     | %          | 0.99     | %          |
|                        |       |     |       |     |       |
| Net income                  |       | 1.16     | %          | 0.57     | %          |

 

**CRITICAL ACCOUNTING POLICIES**

 

Our accounting policies are integral tounderstanding the results reported. These policies are described in detail inNote 1 of the Notes to Consolidated Financial Statements. Our most complexaccounting policies require management’s judgment to ascertain the valuation ofassets, liabilities, commitments and contingencies. We have establisheddetailed policies and control procedures that are intended to ensure valuationmethods are well controlled and applied consistently from period to period. Inaddition, the policies and procedures are intended to ensure that the processfor changing methodologies occurs in an appropriate manner. The following is abrief description of our current accounting policies involving significantmanagement valuation judgments.

 

*Allowance for Loan and Lease Losses*

 

The allowance for loan and lease losses isthe sum of the allowance for loan and lease losses and the reserve forcontingent losses on unfunded commitments. The allowance for loan and leaselosses is a valuation adjustment used to recognize impairment of the recordedinvestment in the Company’s loans receivable on its balance sheet before losseshave been confirmed resulting in a subsequent charge-off or write-down. Thereserve for contingent losses on unfunded commitments is a liability accrualfor unidentified but probable losses on the Company’s commitments to fund loans.As of September 30, 2005, the reserve for contingent losses on unfundedcommitments was reclassified from the allowance for loan and lease losses toother liabilities. The 2004 year end reserve for contingent losses on unfundedcommitments was reclassified to conform to the current presentation.

 

The allowance for loan and lease lossesrepresents management’s best estimate of probable loan losses in our loansreceivable and commitments to fund loans. The allowance for loan and leaselosses is determined based on management’s assessment of several factors: (i) reviewsand evaluation of individual loans including underlying cash flow andcollateral values, (ii) the level of and changes in classified andnonperforming loans, (iii) historical loan loss experiences, (iv) changesin the nature and volume of the loan portfolio, and (v) current economicconditions and the related impact on specific borrowers and industry groups.

 

We review and manage the credit quality ofthe loan portfolio through a process that includes a risk grading system, uniform underwritingcriteria, early identification of problem credits, regular monitoring of anyclassified assets graded as “criticized” by our internal grading system, and anindependent loan review process. The calculation of the adequacy of theallowance for loan and lease losses is based on this internal risk gradingsystem as well as other factors including loan grade migration trends andcollateral values.

 

The internal risk grading utilizes a 10-levelgrading system – six pass grades for unclassified loans based upon ourassessment of the borrower’s ability to service the loan and the quality of thecollateral and four classification grades for “criticized” loans depending onthe severity of the underwriting weakness and likelihood of loss. We use astatistical grading migration analysis as part of our allowance for loanand lease losses evaluation for unclassified loans, which is a method by whichthe types and gradings of historical loans charged-off are related to thecurrent loan portfolio. This analysis attempts to use historical trends in loanrisk grading, nonperforming assets and concentrations that are characteristicto our portfolio and consider other factors affecting loan losses that arespecific to our marketplace and customer demographic.

 

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An allowance based upon the migrationanalysis is determined for various loan types and unclassified grades basedupon loan risk grades and historical charge off experience. Adjustments tothese allowance factors are made for consideration of, among others matters, (i) changesin underwriting standards and internal risk grading between the current loanportfolio and the historical sample, (ii) changes in the factors thatresulted in historical loans charged-off, such as industry economic condition,and (iii) differences between the current economic environment and theeconomic environment during the period of historical loans charged-off.

 

Generally, the allowance for loan and leaselosses established for classified loans that are collateral-dependent is basedon the net realizable value of the collateral. In measuring the net realizablevalue of the collateral, management uses current appraisals that, among othertechniques, observe market transactions of similar property and adjust fordifferences. Changes in the financial condition of individual borrowers, ineconomic conditions, in historical loss experience and in the condition of thevarious markets in which collateral may be sold may all affect therequired level of the allowance for loan and lease losses and the associatedprovision for credit losses.

 

On a periodic basis we engage an outside loanreview firm to review our loan portfolio, risk grade accuracy and thereasonableness of loan evaluations. Annually, this outside loan review teamanalyzes our methodology for calculating the allowance for loan and leaselosses based on our loss histories and policies.

 

We utilize our judgment to determine theprovision for credit losses and establish the allowance for loan and leaselosses. Each Bank’s board of directors reviews the adequacy of that Bank’sallowance for loan and lease losses on a quarterly basis. We believe, based oninformation known to management, that the allowance for loan and lease lossesat December 31, 2005 represents the probable loan losses in loansreceivable. However, credit quality is affected by many factors beyond ourcontrol, including local and national economies, and facts may exist whichare not known to us that adversely affect the likelihood of repayment ofvarious loans in the loan portfolio and realization of collateral upon adefault. Accordingly, no assurance can be given that we will not sustain loanlosses materially in excess of the allowance for loan and lease losses. Inaddition, the OCC, as an integral part of its examination process,periodically reviews the allowance for loan and lease losses and could developan estimate that requires additional provisions for credit losses.

 

*Goodwill and Other IntangibleAssets*

 

As discussed in Note 2 of the Notes toConsolidated Financial Statements, we must assess goodwill and other intangibleassets each year, or more frequently upon the occurrence of certain events, forimpairment. Impairment is the condition that exists when the carrying amount ofthe asset exceeds its implied fair value.

 

The goodwill impairment test involves comparing thefair value of South Bay with its carrying amount, including goodwill. Weretained an independent valuation consultant to evaluate the goodwill as of October 1,2005. The valuation consultant conducted the analysis utilizing two valuationmethods – the income approach and the market approach.

 

The income approach measures the present worth ofanticipated future net cash flows generated by South Bay. Net cash flowforecasts require analysis of the significant variables influencing revenues,expenses, working capital and capital investment as well as residual value andcost of capital. Our forecasts were for a three-year period reflecting averageannual asset growth of 11.8%, an average loan to deposit ratio of 106%, anaverage net interest margin of 5.36%, and average annual return on assets of1.57%. A 10.8% cost of capital and a $58.4 million residual value was utilizedin the analysis to discount the projected cash flows.

 

The market approach derives a valuation by analyzingthe prices at which shares of capital stock of reasonably similar companies aretrading in the public market, or the transaction price at which similarcompanies have been acquired. The analysis identified eighteen transactionsduring the period from October 2002 through September 2004 involvingacquired companies located in the state of California with similarities toSouth Bay in size and operating characteristics. Transaction multiples wereconsidered for purchase price to (i) earnings, and (ii) tangible bookvalue. The purchase price to earnings multiple for the South Bay acquisitionwas 11.38 compared to a range from 6.88 to 91.00 with an average of 28.01 for thetransactions studied. The South Bay transaction purchase price to tangible bookvalue multiple was 1.55 compared to a range of 1.35 to 3.93 with an average of2.53 for the comparable transactions.

 

The consultant also analyzed our stock price as part ofits market approach analysis. This analysis involved applying price multiplesbased on our stock price at or near the valuation date to the performancemeasures of South Bay. Additionally, the consultant considered guidelinecompanies operating in the same market segment as South Bay. The stock tradingvalues of similar companies were not considered reliable due to the smallvolume of trading activity, however, the results were not inconsistent withthose of the transaction method.

 

The fair value indications derived from the incomeapproach was $55.9 million and from the two market approaches, transaction andstock price analysis, $50.2 million and $47.5 million, respectively. The fairvalue of South Bay under both approaches exceeds the carrying value at October 1,2005 of $22.3 million, therefore, goodwill is not considered impaired. Thetesting of goodwill and other intangible assets for impairment requiresre-measurement of fair values. If the future fair values were materially lessthan the recorded value, we would be required to take a charge against earningsto write down the goodwill and other intangible assets to the lower value.

 

*Deferred Tax Assets*

 

At December 31, 2005 we had totaldeferred tax assets of $4.2 million of which $2.5 million is represented by (i) federalNOLs of $5.0 million, which begin to expire in 2009; and (ii) a federalAMT credit carry forward of $544,000. In order to utilize the benefit of 

 

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the deferred tax assets related to the NOLs, we must generate aggregatetaxable income equal to the amount of the NOLs during the period prior to theirexpiration.

 

If future taxable income should provenon-existent or less than the amount of the NOLs that created the deferred taxassets within the tax years to which they may be applied, the asset may notbe realized. A valuation allowance may be established to reduce thedeferred tax asset to its realizable value. Any adjustment required to thevaluation allowance is coupled with a related entry to income tax expense. Acharge to earnings will be made in the event that we determine that a valuationallowance to the deferred tax asset is necessary. Our deferred tax assets aredescribed further in Note 6 of the Notes to Consolidated Financial Statements.

 

We use estimates of future taxable income toevaluate if it is more likely than not that the benefit of our deferred taxassets will be realized. Our analysis utilizes alternative scenarios reflectinga range of assumptions for asset growth rates, loan to deposit ratios, interestrates and inflation rates. The results of the analysis support our positionthat it is more likely than not that our deferred tax assets will be realized.

 

*Derivative Instruments and Hedging*

 

Weutilize derivative instruments to manage our risk to changes in interest rates.Statement of Financial Accounting Standards No. 133 Accounting forDerivative Instruments and Hedging Activities (SFAS 133) requires thatan entity recognize all derivatives as either assets or liabilities in thebalance sheet and measure those instruments at fair value. If certainconditions are met, a derivative may be specifically designated as a hedgeand earnings are affected only to the extent to which the hedge is noteffective in achieving offsetting changes in fair value or cash flows of thehedged item. We have designated certain of our derivative instruments as hedgesand consider them highly effective. Circumstances may change increasing the extent that the hedge isnot effective resulting in a greater portion of the change in value of thederivative instruments being reported in earnings.

 

**OPERATIONS SUMMARY ANALYSIS**

 

**Net Interest Income**

 

Our earnings depend largely upon thedifference between the income earned on our loans and other investments and theinterest paid on our deposits and borrowed funds. This difference is netinterest income. Our ability to generate net interest income is largelydependent on our ability to maintain sound asset quality and appropriate levelsof capital and liquidity. Our inability to maintain sound asset quality,capital or liquidity may adversely affect (i) the ability toaccommodate desirable borrowing customers, thereby inhibiting growth in qualityhigher-yielding earning assets; (ii) the ability to attract comparativelystable, lower-cost deposits; and (iii) the costs of wholesale fundingsources.

 

Net interest income increased $4.7 million to$21.1 million during 2005 due to a $6.8 million increase in interest incomeoffset by a $2.1 million increase in interest expense.

 

Loan interest income increased $6.1 milliondue to $30.7 million greater average volume of loans receivable and a 133 basispoint increase in yield, resulting primarily from increases in the prime ratelending index and interest rate swaps. During the second half of 2004, theFederal Reserve Bank increased interest rates 125 basis points on fiveoccasions after a prolonged period of accommodative monetary policy in responseto signs of stronger economic activity and perceived higher inflation risk. Continuingin 2005, the Federal Reserve Bank increased interest rates 200 basis points oneight occasions. Approximately 75% of our $338.6 million loans receivable at December 31,2005, adjustable interest rates; consequently, rising interest rates positivelyaffect interest income. In order to lessen the impact on interest income in theevent of a decline in the prime rate lending index, we have entered intointerest rate swaps, in which we exchanged an adjustable rate interest based onthe prime rate lending index for a fixed rate payment on an aggregate notionalamount of $50.0 million. The higher yields earned on our loans receivableduring 2005 were partially offset by the rising cost of the interest rateswaps; however, the interest rate swaps still contributed 12 basis points tothe increase in loan yield compared to 2004.

 

The greater volume of loans receivable wasdue to a $41.8 million increase in construction and land development loansreflecting stronger residential construction loan demand and the funding ofpreviously approved construction loans. Recent data and events, however,reflect slowing of national residential sales activity and slowing of thegrowth in residential real estate prices. While real estate activity in westernstates remains relatively strong, a more pronounced slowing in our lendingareas would likely negatively impact the growth of our construction loans. Consumerloans increased $4.7 million primarily due to growth in our insurance premiumfinancing.

 

Offsetting the growth in these loancategories, real estate loans secured by commercial real properties declined$14.3 million during 2005 due to more rapid repayment of loans than funding ofnewly originated loans. We have experienced rigorous price competition for commercialreal estate loans, and an increase in borrower refinancing of our adjustablerate loans for fixed rate loans with other lenders, particularly as risingshort-term interest rates have approached longer-term fixed interest ratelevels. We have experienced strong activity in developing new businessrelationships, evidenced by growth in unfunded commitments, however, commercialloans – secured and unsecured, declined $9.0 million due to a decrease inutilization of lines of credit. This decrease in credit utilization is due togreater borrower liquidity resulting from relatively strong local economicactivity.

 

Interest income from securitiesavailable-for-sale increased $719,000 during 2005 compared to 2004 due to $10.0million greater average volume and an 82 basis point increase in yield. Duringthe third and fourth quarter of 2005, we accelerated our investment activity aspart of a strategy to further reduce the exposure of net interest incometo a declining interest rate environment. The additions

 

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to securities available-for-sale have largely been low-coupon,intermediate-term, 15- and 20-year mortgage-backed security pools, purchased ata discount that we expect to have limited prepayment of principal in the eventof declining interest rates (and muted term extension in rising interest rates).These investments, 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 reallocatedshort-term lower-yielding federal funds sold, which averaged $6.0 million lessthan 2004, into higher yielding earning assets. Furthermore, through depositreclassification utilizing non-transaction sub accounts, we reduced ourrequired reserves at the Federal Reserve Bank resulting in the redeployment of$6.5 million in noninterest-bearing cash and due from banks – demand. Overall,interest-earning assets were $32.3 million greater during 2005 than 2004 whilethe higher interest rates and favorable change in composition tohigher-yielding assets resulted in a 133 basis point increase in weightedaverage yield on interest-earning assets.

 

Interest expense increased $2.1 million for2005 due to a $19.7 million increase in average interest-bearing liabilitiesand a 77 basis point increase in the weighted average cost of interest-bearingliabilities. Interest expense on deposits increased $1.8 million due to a 75basis point rise in weighted average cost of interest-bearing deposits inaddition to $20.2 million greater average volume than 2004. Time certificatesof deposit $100,000 and over averaged $24.8 million greater during 2005 than2004 due to an increased volume of brokered certificates of deposit (“BrokeredCDs”). The volume of money market and savings deposits declined $4.3 million in2005 and time certificates of deposit under $100,000 declined $1.3 million. Relativelylow costing interest-bearing demand deposits averaged $1.0 million greater in2005 than in 2004.

 

During the rising interest rate environmentexperienced during the past six quarters, we strategically elected to onlymoderately increase transaction deposit rates and to fund asset growth, andrunoff of these deposits, with Brokered CDs. Although this type of funding istypically higher costing and exhibits higher interest rate sensitivity, theBrokered CDs facilitate our liquidity and interest rate risk management that weutilize to reduce our net interest income exposure to possible declininginterest rates. The greater interest expense on the incremental Brokered CDsneeded to fund asset growth, and any decrease in transaction deposits, is lessthan the impact of increasing rates on the significantly greater volume oftransaction accounts. In a sustained rising interest rate environment,nonetheless, increases in deposit interest rates will be required to preventnet deposit withdrawals.

 

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

 

The volume of other borrowings averaged $12.2million and $12.6 million in 2005 and 2004, respectively. We continue to employa liquidity strategy of maintaining relatively low levels of short-term assetsand utilize Federal Home Loan Bank overnight advances, against pledged loansand securities, to fund asset and deposit fluctuations. Minimizing short-termassets and increasing short-term liabilities furthers the management of ourasset sensitive balance sheet. The cost of other borrowings was 3.38% and 2.65%for 2005 and 2004, respectively, representing an increase of 73 basis points in2005.

 

Noninterest-bearing demand deposits increasedonly slightly averaging $124.8 million and $124.7 million in 2005 and 2004,respectively. While we continue to devote resources to growing our businessaccounts, in a rising interest rate environment depositors generally deploytheir funds into higher yielding deposits and alternative investments outsidethe Banks. Additionally, our escrow company customers maintained lower balancesdue to reduced mortgage refinancing activity in the higher interest rateenvironment.

 

**Interest Rate Spread and Net Interest Margin**

 

We analyze earnings performance using, amongother measures, the interest rate spread and net interest margin. The interestrate spread represents the difference between the weighted average yieldreceived on interest earning assets and the weighted average rate paid oninterest bearing liabilities. Net interest margin (also called the net yield oninterest earning assets) is net interest income expressed as a percentage ofaverage total interest earning assets. Our net interest margin is affected bychanges in the yields earned on assets and rates paid on liabilities, referredto as rate changes, and changes to the relative amount of interest earningassets and interest bearing liabilities. Interest rates charged on our loansare affected principally by the demand for such loans, the supply of moneyavailable for lending purposes, and other competitive factors. These factorsare in turn affected by general economic conditions and other factors beyondour control, such as federal economic policies, the general supply of money inthe economy, legislative tax policies, governmental budgetary matters, andactions of the Federal Reserve Board. Table 3 presents information concerningthe change in interest income and interest expense attributable to changes inaverage volume and average rate. Table 4 presents the weighted average yield oneach category of interest earning assets, the weighted average rate paid oneach category of interest bearing liabilities, and the resulting interest ratespread and net yield on interest earning assets for 2005, 2004 and 2003. We hadno tax exempt interest income for 2005, 2004 or 2003.

 

14

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**Table 3**

**Increase (Decrease) in Interest Income/Expense Due toChange in**

**Average Volume and Average Rate (1)**

 
| ** **                                                                  | ** ** | **2005 vs 2004**                | ** ** | **2004 vs 2003**  | ** ** |
|-----------------------------------------------------------------------------|------------|---------------------------------|------------|-------------------|------------|
| ** **                                                                  | ** ** | **Increase (decrease) due to:** | ** ** | **Net  Increase** | ** ** | **Increase (decrease) due to:** | ** ** | **Net  Increase** | ** ** |
| ** **                                                                  | ** ** | **Volume**                      | ** ** | **Rate**          | ** ** | **(Decrease)** | ** ** | **Volume** | ** ** | **Rate** | ** ** | **(Decrease)** | ** ** |
| ** **                                                                  | ** ** | **(Dollars in thousands)**      | ** ** |
| 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)                                         |       | —                          |       | 273               |       | 273 |   | 512 |   | 0 |   | 512 |   |
| Federal  funds purchased and securities sold under agreements to repurchase |       | (1                              | )          | —            |       | (1 | ) | (13 | ) | (2 | ) | (15 | ) |
| Total  interest-bearing liabilities                                         |       | 307                             |       | 1,825             |       | 2,132 |   | 664 |   | (840 | ) | (176 | ) |
|                                                                        |       |                            |       |              |       |   |   |   |   |   |   |   |   |
| Net interest  income                                                        |       | $                               | 1,799      |              | $          | 2,880 |   | $ | 4,679 |   | $ | 1,035 |   | $ | 1,471 |   | $ | 2,506 |   |

 

----

(1)   Thechange in interest income or interest expense that is attributable to bothchanges in average balance and average rate has been allocated to the changesdue to (i) average balance and (ii) average rate in proportion to therelationship of the absolute amounts of changes in each.

(2)   Tabledoes not include interest income that would have been earned on nonaccrualloans.

(3)   Theimplementation of FASB Interpretation No. 46, effective July 1, 2003resulted in the reclassification of the Company’s Junior Subordinated Debenturesfrom mezzanine equity to liabilities and the related interest to interestexpense after June 30, 2003.

 

15

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**Table 4**

**Average Balance Sheet and**

**Analysis of Net Interest Income**

 
| ** **                                                                                                                         | ** ** | **2005**                       | ** ** | **2004**                            | ** ** | **2003**            | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|-------------------------------------|------------|---------------------|------------|
| **Average  Amount**                                                                                                                | ** ** | **Interest  Income/  Expense** | ** ** | **Weighted  Average  Yield/  Rate** | ** ** | **Average  Amount** | ** ** | **Interest  Income/  Expense** | ** ** | **Weighted  Average  Yield/  Rate** | ** ** | **Average  Amount** | ** ** | **Interest  Income/  Expense** | ** ** | **Weighted  Average  Yield/  Rate** | ** ** |
| **(Dollars in thousands)**                                                                                                         | ** ** |
| 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                         |       | 1,239                               |       | 8.01                | %          | 15,464 |   | 966 |   | 6.25 | % | 7,733 |   | 454 |   | 5.87 | % |
| Federal funds purchased and securities sold under  agreements to repurchase                                                        |       | —                         |       | —                              |       | —              |       | 113 |   | 1 |   | 0.88 | % | 609 |   | 16 |   | 2.63 | % |
| Total interest-bearing liabilities                                                                                                 |       | 241,821                        |       | 5,136                               |       | 2.12                | %          | 222,116 |   | 3,004 |   | 1.35 | % | 205,340 |   | 3,180 |   | 1.55 | % |
|                                                                                                                               |       |                           |       |                                |       |                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| 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)                                                                                         |       |                           |       | $                                   | 21,129     |                | 4.92       | % |   |   | $ | 16,450 |   | 4.36 | % |   |   | $ | 13,944 |   | 3.72 | % |
|                                                                                                                               |       |                           |       |                                |       |                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net yield on interest earning assets (2)                                                                                           |       |                           |       |                                |       | 5.67                | %          |   |   |   |   | 4.83 | % |   |   |   |   | 4.29 | % |

 

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(1)     The average balance ofnonperforming loans has been included in loans receivable.

(2)     Yields and amounts earned onloans receivable include loan fees of $1,725,000, $1,383,000 and $882,000 forthe years ended December 31, 2005, 2004 and 2003, respectively.

(3)     The implementation of FASBInterpretation 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 June 30,2003.

 

16

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Our net interest margin increased 84 basispoints from 4.83% during 2004 to 5.67% in 2005. Our net interest margin remainshigh in comparison with the interest rate spread due to the continuedsignificance of noninterest-bearing demand deposits relative to total fundingsources. Average noninterest bearing demand deposits were $124.8 million,representing 36.8% of average deposits, during 2005, compared to $124.7million, representing 39.1% of average deposits, during 2004. Of thesenoninterest bearing demand deposits during 2005, $14.7 million or 11.8% ofaverage noninterest bearing deposits were represented by real estate title andescrow company deposits, compared to $16.2 million or 13.0% of averagenoninterest bearing deposits during 2004. While these deposits are noninterestbearing, they are not cost free funds. Customer service expenses, primarilycosts related to external accounting and data processing services provided totitle and escrow company depositors are incurred by us to the extent that suchdepositors maintain certain average noninterest bearing deposits. Customerservice expense is classified as other operating expense. If customer serviceexpenses related to escrow customers had been classified as interest expense,our reported net interest income for 2005 and 2004 would have been reduced by$370,000 and $137,000, respectively, and the net interest margin for 2005 and2004 would have decreased 36 basis points and 4 basis points, respectively. Similarly,this would create identical reductions in other operating expense. The expenseassociated with these deposits increased in 2005 from 2004 despite the decreasein volume due to a greater allowance for customer services provided for thesedepositors.

 

**Provision/Benefit for Credit Losses**

 

During 2005, we recorded a benefit for creditlosses of $84,000 compared to a $220,000 provision for credit losses in 2004following our valuation assessment of the allowance for loan and lease lossesand the reserve for contingent losses on unfunded commitments. Impacting theallowance in 2005, among other items, was a significant recovery of a loanpreviously charged off partially offset by relatively strong growth in loansreceivable and unfunded loan commitments. In 2005 net recoveries were $1.2million compared to net recoveries $73,000 in 2004.

 

Assuming continued loan growth, and based onthe relative uncertainty regarding the state of the economy, and the level ofnonperforming loans, it is anticipated that regular provisions for creditlosses will be made during 2006. Credit quality will be influenced byunderlying trends in the economic cycle, particularly in Southern California,and other factors, which are beyond management’s control. Accordingly, noassurance can be given that we will not sustain loan losses that in anyparticular period are sizable in relation to the allowance for loan and leaselosses. Subsequent evaluation of the loan portfolio, in light of factors thenprevailing, by us and our regulators may indicate a requirement forincreases in the allowance for loan and lease losses through additions to theprovision for credit losses.

 

**Other Operating Income**

 

Other operating income was $1.2 million and$1.6 million in 2005 and 2004, respectively. The decline was due to lower feesfor deposit related services of $1.1 million in 2005 as compared to $1.7million in 2004, due to higher compensating balance rates in the risinginterest rate environment and a change in the deposit account fee structure. 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.

 

**Other Operating Expenses**

 

Other operating expense increased $348,000 to$14.4 million in 2005, compared to $14.0 million during 2004. Salaries andrelated benefits increased $280,000 or 3.7% to $7.8 million, primarily due tothe addition of business development staff during the year, as well as largermanagement bonuses and increased commissions paid to business development stafffor loan production. Net occupancy expense decreased $130,000 or 11.5% to $1.0million primarily due to the relocation of our administrative offices and theCentury City banking office. Other professional services increased $273,000 or32.0% largely due to increased audit and tax expense as well as professionalservices for credit workouts. Other expenses decreased $150,000 largely due toa $250,000 reserve established during 2004 in a dispute over our lien on thecollateral for a loan as well as several unrelated and nonrecurring operatinglosses. The dispute was resolved during 2005.

 

**Income Taxes**

 

Deferred tax assets and liabilities arerecognized for the expected future tax consequences of existing differencesbetween financial reporting and tax reporting bases of assets and liabilities,as well as for operating losses and tax credit carryforwards, using enacted taxlaws and rates. Deferred tax assets will be reduced through a valuationallowance whenever it becomes more likely than not that all or some portionwill not be realized. Deferred income tax expense (benefit) represents the netchange in the deferred tax asset or liability balance during the year. Thisamount, together with income taxes currently payable or refundable in thecurrent year, represents the total tax expense for the year.

 

At December 31, 2005, our deferred taxasset totaled $4.2 million, respectively, with no recorded valuation allowance.

 

For tax purposes at December 31, 2005,we had (i) federal NOLs of $5.0 million, which begin to expire in 2009;and (ii) a federal alternative minimum tax (“AMT”) credit carryforward of$544,000 that carries forward indefinitely.

 

An income tax provision of $3.3 million wasrecorded for 2005 compared to $1.6 million for 2004.

 

17

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Federal and state income tax laws providethat following an ownership change of a corporation with NOLs, a net unrealizedbuilt-in loss or tax credit carryovers, the amount of annual post-ownershipchange taxable income that can be offset by pre-ownership change NOLs, built-inlosses or tax credit carryovers generally cannot exceed a prescribed annuallimitation. The annual limitation generally equals the product of the fairmarket value of the corporation immediately before the ownership change(subject to certain adjustments) and the federal long-term tax-exempt rateprescribed monthly by the Internal Revenue Service. If such limitations were toapply to us, our ability to reduce future taxable income by the NOLs could beseverely limited.

 

**Accumulated Other Comprehensive Income**

 

Accumulated other comprehensive income iscomprised of the unrealized gain or loss on available-for-sale securities andthe unrealized gain or loss on our derivative financial instruments designatedas cash flow hedges, net of taxes. At December 31, 2005 the net unrealizedloss on available-for-sale securities was $392,000 compared to a net unrealizedloss of $39,000 at December 31, 2004. The interest rate swaps designatedas cash flow hedges had an unrealized loss of $605,000 at December 31,2005 compared to an unrealized gain of $314,000 at December 31, 2004. Theinterest rate floors designated as cash flow hedges had an unrealized loss of$157,000 at December 31, 2005. We had no interest rate floors as of December 31,2004.

 

**FINANCIAL CONDITION**

 

**Regulatory Capital**

 

The following table sets forth (i) theminimum regulatory capital requirements for National Mercantile and the Banks; (ii) thecapital requirements for the Banks to be “well capitalized” under the promptcorrective action rules; and (iii) the regulatory capital ratios ofNational Mercantile and the Banks as of the dates indicted in 2004 and 2005.

 

**Table 5**

**Regulatory Capital Information**

**of the National Mercantile andBanks**

 
| ** **                             | ** ** | **Minimum  For Capital  Adequacy** | ** ** | **Well  Capitalized** | ** ** | **December 31,** | ** ** |
|----------------------------------------|------------|------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                             | ** ** | **Purposes**                       | ** ** | **Standards**         | ** ** | **2005**              | ** ** | **2004** | ** ** |
| **National Mercantile Bancorp:**       |       | ** **                         | ** ** | ** **            |       |                  |       |   |   |
| Tier 1 capital to average assets       |       | 4.00                               | %          | N/A                   |       | 10.80                 | %          | 9.87 | % |
| Tier 1 capital to risk weighted assets |       | 4.00                               | %          | N/A                   |       | 12.06                 | %          | 10.39 | % |
| Total capital to risk weighted assets  |       | 8.00                               | %          | N/A                   |       | 13.87                 | %          | 12.42 | % |
|                                   |       |                               |       |                  |       |                  |       |   |   |
| **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 | % |

 

National Mercantile’s Tier I capital, whichis comprised of shareholders’ equity as modified by certain regulatoryadjustments, was $46.8 million and $38.2 million at December 31, 2005 and2004, respectively. National Mercantile’s Tier 1 capital increased in 2005 as aresult of net income, exercised stock options and a reduction of the portion ofdeferred tax asset disallowed for regulatory capital purposes. Federal Reservecapital rules allow trust preferred securities to represent up to 25% ofTier 1 capital with the balance treated as Tier 2 capital for the Totalrisk-based Capital ratio. At December 31, 2005 and 2004, Trust PreferredSecurities represented $12.8 million and $11.5 million, respectively, ofNational Mercantile’s Tier 1 capital, and $2.2 million and $3.5 million,respectively, of its Tier 2 capital. Disallowed against National Mercantile’sTier 1 capital is $3.2 million of goodwill recorded in the acquisition of SouthBay, $1.4 million of other intangible assets and $1.1 million of deferred taxasset based upon estimated earnings.

 

Mercantile’s Tier 1 capital was $24.8 millionand $19.4 million at December 31, 2005 and 2004, respectively. Theincrease in Tier 1 capital during 2005 was due to net income and the decreaseof the portion of deferred tax asset disallowed for regulatory capitalpurposes.

 

South Bay’s Tier 1 capital at December 31,2005 was $18.7 million compared to $17.1 million at December 31, 2004. Theincrease is due to net income in 2005.

 

18

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**Liquidity Management**

 

The objective of liquidity management is tomaintain cash flow adequate to fund our operations and meet obligations andother commitments on a timely and cost effective basis. We manage to thisobjective primarily through the selection of asset and liability maturity mixes.Our liquidity position is enhanced by the ability to raise additional funds asneeded through available borrowings or accessing the wholesale deposit market.

 

Our deposit base provides the majority of ourfunding requirements. Deposits, a relatively stable and low-cost source offunds has, along with shareholders’ equity, provided 92.7% and 92.3 % offunding for average total assets during 2005 and 2004, respectively. The otherborrowings, specifically Federal Home Loan Bank (“FHLB”) advances, whichaveraged $12.2 million during 2005 compared to $12.6 million during 2004, andfederal funds purchased and securities sold under agreements to repurchase,which had no balances in 2005 compared to $113,000 in 2004, comprise thebalance of the liability funding. The other borrowings during 2005 and 2004were used to fund higher yielding loans and securities.

 

Also, federal funds sold and securitiespurchased under resale agreements that may be immediately converted tocash at minimal cost. The aggregate of these assets averaged $1.6 millionduring 2005, as compared to $7.7 million during 2004.

 

The portfolio of available-for-salesecurities is an additional source of liquidity, which averaged $51.6 millionduring 2005 compared to $41.6 million in 2004. The securitiesavailable-for-sale increased in 2005 due to the deployment of funds intosecurities pending redeployment into loans. Except for a relatively smallamount of securities pledged to collateralize public funds, deposits ofbankruptcy estates and our swaps, our securities are pledged to the FHLB tosecure immediately available borrowings. At December 31, 2005, $64.4million of securities were pledged to the FHLB and an additional $38.0 millionborrowing capacity remained. There were no unpledged investment securities at December 31,2005. Maturing loans also provide liquidity, of which $175.6 million of theBanks’ loans are scheduled to mature in 2006.

 

Net cash provided by operating activities totaled$7.9 million in 2005 compared to $5.4 million in 2004. The primary source offunds is net income from operations adjusted for provision for credit lossesand depreciation and amortization. Net cash used in investing activitiestotaled $61.4 million in 2005 compared to $61.0 million net cash used ininvesting activities in 2004. The increase in cash used by investing activitieswas primarily due to an increase in purchases of securities available-for-salepartially offset by a decrease in loan originations, net of loan paydowns andpayoffs. Net cash provided by financing activities was $52.9 million in 2005compared to $33.2 million provided by financing activities in 2004. Theincrease in 2005 net cash provided resulted primarily from an increase in timecertificates of deposit offset by a decrease in other borrowed funds.

 

**Interest Rate Risk Management**

 

Interest rate risk management seeks tomaintain a stable growth of income and manage the risk associated with changesin interest rates. Net interest income, the primary source of earnings, isaffected by interest rate movements. Changes in interest rates have a lesserimpact the more that assets and liabilities reprice in approximately equivalentamounts at basically the same time intervals. Imbalances in these repricingopportunities at any point in time constitute interest sensitivity gaps, whichis the difference between interest sensitive assets and interest sensitiveliabilities.

 

Interest rate risk, including interest ratesensitivity and the repricing characteristics of assets and liabilities, ismanaged by our Balance Sheet Management Committee (“BSMC”). The principalobjective of BSMC is to maximize net interest income within acceptable levelsof risk established by policy.

 

We manage interest rate sensitivity bymatching the repricing opportunities on our earning assets to those on ourfunding liabilities. We use various strategies to manage the repricingcharacteristics of our assets and liabilities to ensure that exposure tointerest rate fluctuations is limited within guidelines of acceptable levels ofrisk-taking. Hedging strategies, including the terms and pricing of loans anddeposits, the use of derivative financial instruments and managing thedeployment of our securities are used to reduce mismatches in interest raterepricing opportunities of portfolio assets and their funding sources.

 

Interest rate sensitivities are monitoredthrough the use of simulation modeling techniques that apply alternativeinterest rate scenarios to periodic forecasts of future business activity andestimate the related impact on net interest income. The use of simulationmodeling assists management in its continuing efforts to achieve earningsgrowth in varying interest environments. Table 6 shows the change in netinterest income for one year given a 200 basis point decrease and increase ininterest rates at December 31, 2005 based upon our interest ratesimulation model:

 

19

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**Table 6**

**Net Interest Income at Risk Modeling**

 
| ** **                           | ** ** | **Interest rate scenario**   | ** ** |
|--------------------------------------|------------|------------------------------|------------|
| ** **                           | ** ** | **200 Basis Point Decrease** | ** ** | **Base** | ** ** | **200 Basis Point Increase** | ** ** |
| ** **                           | ** ** | **Amount**                   | ** ** | **Change from  Base Amount** | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Amount** | ** ** | **Change from  Base Amount** | ** ** | **Percent** | ** ** |
| Change in  net interest income:      |       |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Months one through  twelve           |       | $                            | 22,334     |   | $ | (891 | ) | 3.84 | % | $ | 23,225 |   | $ | 23,887 |   | $ | 662 |   | 2.85 | % |
| Months  thirteen through twenty-four |       | 21,400                       |       | (1,825 | ) | -7.86 | % | 23,258 |   | 24,604 |   | 1,379 |   | 5.94 | % |
| Total for  twenty-four months        |       | $                            | 43,734     |   | $ | (2,716 | ) | 5.91 | % | $ | 46,483 |   | $ | 48,491 |   | $ | 2,041 |   | 4.32 | % |

 

The model results reflect a net interestincome exposure to declining interest rates. 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 and declining interest rate environments, such asthe environment experienced in 2003, the interest rates paid on fundingliabilities may begin to reach floors preventing further downwardadjustments while rates on earning assets continue to adjust downward. Thiscondition will likewise have a negative impact on our net interest income. Conversely,our asset sensitivity in a rising interest rate environment is expected to havea positive affect on earnings as a greater amount of earning assets thanfunding liabilities reprice upward and historically the rates of interestbearing deposits adjust upward more slowly and in smaller increments.

 

Key assumptions in the model includeanticipated prepayments on mortgage-related instruments, contractual cash flowand maturities of all financial instruments, anticipated future businessactivity, deposit rate sensitivity and changes in market conditions. Theseassumptions are inherently uncertain and, as a result, these models cannotprecisely estimate the impact that higher or lower rate environments will haveon net interest income. Actual results will differ from simulated results dueto the timing, magnitude and frequency of interest rate changes, changes incash flow patterns and market conditions, as well as changes in management’sstrategies.

 

**Investment Securities**

 

We invest in investment securities consistingprimarily of U.S. agency securities and mortgage-related securities to: (i) generateinterest income pending the ability to deploy those funds in loans meeting ourlending strategies; (ii) increase net interest income where the ratesearned on such investments exceed the related cost of funds, consistent withthe management of interest rate risk; and (iii) provide sufficientliquidity in order to maintain cash flow adequate to fund our operations andmeet obligations and other commitments on a timely and cost efficient basis. During2005 and 2004, we held no tax-exempt securities.

 

We generally classify our investmentsecurities as available-for-sale except for investment securities we have theability and the positive intent to hold to maturity which are classified asheld-to-maturity securities.

 

Table 7 provides certain informationregarding our investment securities.

 

20

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**Table 7**

 

**Estimated Fair Values of and Unrealized Gains andLosses on Investment Securities**

 
| ** **                                                                | ** ** | **December 31, 2005**   | ** ** |
|---------------------------------------------------------------------------|------------|------------------------------|------------|
| **Total  amortized  cost**                                                | ** ** | **Gross  unrealized  gains** | ** ** | **Gross  unrealized  loss** | ** ** | **Estimated  fair  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  amortized  cost** | ** ** | **Gross  unrealized  gains** | ** ** | **Gross  unrealized  loss** | ** ** | **Estimated  fair  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  amortized  cost**                                                | ** ** | **Gross  unrealized  gains** | ** ** | **Gross  unrealized  loss** | ** ** | **Estimated  fair  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  amortized  cost**                            | ** ** | **Gross  unrealized  gains** | ** ** | **Gross  unrealized  loss** | ** ** | **Estimated  fair  value** |   |
| ** **                                            |       | **(Dollars in thousands)**   |       |
| **Held-to-Maturity:**                                 |       |                         |       |   |   |   |   |   |   |
| FHLMC/FNMA-issued  mortgage pass through certificates |       | $                            | 3,507      |   | $ | 40 |   | $ | — |   | $ | 3,547 |   |
|                                                       |            |                              |            |  |  |  |  |  |  |  |  |  |  |

 

21

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

 

At December 31, 2005, we held nosecurities from any issuer other than by U.S. government agencies andcorporations in which the aggregate book value exceeded 10% of our shareholders’equity.

 

Our present strategy is to extend theduration of the portfolio to further reduce our balance sheet asset sensitivitywith investments with only moderate risk of term extension and only limitedprepayments. Table 8 sets forth information concerning the contractual maturityof and weighted average yield of our investment securities at December 31,2005.

 

22

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**Table 8**

**Maturities of and Weighted Average Yields on InvestmentSecurities**

 
| ** **                                                                | ** ** | **Within one year**        | ** ** | **After one but  within five years** | ** ** | **After five but  within ten years** | ** ** | **After ten years** | ** ** | **Total**  | ** ** | **Weighted  Average  Yield** | ** ** |
|---------------------------------------------------------------------------|------------|--------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------------|------------|-------------------------------|------------|------------|------------|------------------------------|------------|
| ** **                                                                | ** ** | **Amount**                           | ** ** | **Yield**                                           | ** ** | **Amount**                                               | ** ** | **Yield**                     | ** ** | **Amount** | ** ** | **Yield**                    | ** ** | **Amount** | ** ** | **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 | % |

 
| ** **                                           | ** ** | **Within one year** | ** ** | **After one but  within five years** | ** ** | **After five but  within ten years** | ** ** | **After ten years** | ** ** | **Total**  | ** ** | **Weighted  Average  Yield** | ** ** |
|------------------------------------------------------|------------|-------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|-------------------------------|------------|------------|------------|------------------------------|------------|
| ** **                                           | ** ** | **Amount**                    | ** ** | **Yield**                                                | ** ** | **Amount**                                               | ** ** | **Yield**                     | ** ** | **Amount** | ** ** | **Yield**                    | ** ** | **Amount** | ** ** | **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 | % |

 

Actual maturities may differ fromcontractual maturities to the extent that borrowers have the right to call orprepay obligations with or without call or repayment penalties.

 

**Lending Activities**

 

We engage in commercial banking, servingsmall to medium-sized businesses in the niche markets of entertainment,healthcare, business banking, real estate development, operations ofmulti-family and commercial properties, as well as community-based nonprofitorganizations, business executives, professionals and other individuals. Ourprimary geographic focus is the Los Angeles basin of Los Angeles County, withfour branch 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 of loan, deposit and investment products,which are designed to meet specific customer needs and are offered with highlypersonalized service.

 

Loan products include commercial real estateloans, construction financing, revolving lines of credit, term loans andconsumer and home equity loans, along with an array of deposits and investmentaccounts that often contain terms and conditions tailored to meet the specificdemands of the market niche in which the borrower operates, including theability to evaluate the revenue streams and other sources of repaymentsupporting the loan. In order to provide the personalized service required bythese customers, we use a team approach to customer service combining anexperienced relationship management officer with operations support personnel.

 

Entertainment industry customers includetelevision, music and film production companies, talent agencies, individualperformers, directors and producers (whom we attract by establishingrelationships with business management firms), and others affiliated with theentertainment industry. Professional service customers include legal,accounting, insurance and advertising firms and their individual directors,officers, partners and shareholders. Healthcare organizations include primarilyoutpatient healthcare providers such as physician medical groups, independentpractice associations and surgery centers.

 

*Loan Portfolio*

 

The following table sets forth thecomposition of our loan portfolio at the dates indicated**:**

 

23

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**Table 9**

**Loan Portfolio 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 |   |   |   |

 

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(1) Increase in loans receivable commencing in2001 reflects the acquisition of South Bay in December, 2001.

 

Our lending officers have limited authorityto originate loans and require approvals from our more senior credit officersor our loan approval committee for loans over $150,000. The Banks may notmake any loan, with certain limited exceptions, in excess of their loan to oneborrower limit under applicable regulations ($4.1 million for Mercantile and$3.2 million for South Bay at December 31, 2005). If a Bank’s borrowerrequests a loan in excess of these amounts we may originate the loan withthe participation of the other Bank or other lenders. At December 31, 2005we had $40.4 million in loans originated and serviced by other banks in which wepurchased a non-recourse participation. These participation loans had $30.4million of unfunded commitments as of December 31, 2005. We generallypurchase participations in loans from other banks in which we have a reciprocalalliance to purchase loan participations from us. We have not taken asubordinate credit position on any loan participations purchased or sold. Thebank originating the loan services the loan, typically without compensation.

 

*Commercial Loans*. Weoffer adjustable and fixed rate secured and unsecured commercial loans forworking capital, the purchase of assets and other business purposes. Loanamounts typically range from $100,000 to $3.0 million. We underwrite theseloans primarily on the basis of the borrower’s ability to service the debt fromcash flow without reliance on the liquidation of the underlying collateral,where applicable. These loans generally have maturity terms of 12 months andare typically renewed.

 

Collateral for commercial loans may includecommercial or residential real property, accounts receivable, inventory,equipment, marketable securities or other assets. Unsecured commercial loansinclude short-term term loans and lines of credit. Our underwriting guidelinesfor these 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.

 

*Real Estate Loans.*Weoffer adjustable and fixed rate secured loans to finance the purchase orholding of commercial real estate, single family (one to four) residences andmulti-family residences. These loans generally have maturities ranging fromthree to fifteen years and payments based on a 15 to 25 years amortizationschedule. The original principal amount of a real estate loan generally doesnot exceed 65% to 75% of the appraised value of the property (or the lesser ofthe appraised value or the purchase price for the property if the loan is madeto finance the purchase of the property). We require a current appraisal inconnection with the origination of each real estate loan.

 

*Construction and Land Development Loans*.Real estate construction and land development loans are short-term securedloans made to finance the construction of commercial, one to four-family andmultifamily residential properties or for improvements to raw land. These loansinclude financing for developers for the construction of residential tracthomes and custom homes. Our real estate construction and loan development loansare primarily for properties located in Southern California. These loanstypically have adjustable rates with terms of twelve to fifteen months. Wemonitor the progress of the construction and disburse the loan proceedsdirectly to the various contractors during stages of improvement. Generally, theamount of a construction loan does not exceed 65% of the appraised completionvalue and the borrower’s funds are disbursed prior to disbursement of theconstruction loan.

 

*Consumer Installment Loans and Home EquityLines of Credit*. We offer consumer loans and homeequity lines of credit in

 

24

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amounts generally less than $100,000. Home equity lines of creditprovide the borrower with a line of credit in an amount that generally does notexceed 80% of the appraised value of the borrower’s residence net of seniormortgages. Consumer loans are primarily adjustable rate open ended unsecuredloans (such as credit card loans) but also include fixed rate term loans(generally under five years) to purchase personal property, which are securedby that personal property. These loans (other than purchase money loans)generally provide for monthly payments of interest and a portion of theoutstanding principal balance.

 

*Industry Concentrations*

 

Our board of directors has limited ourexposure to industry concentration by policy and we regularly monitor suchconcentration based upon our borrowers’ North American Industry ClassificationSystem codes. The limits range from 5% to 50% of total loans depending onindustry type. Loans to the entertainment industry, healthcare industry andcommunity-based nonprofit organizations, individually, were less than 10% oftotal loans outstanding at December 31, 2005 and 2004.

 

*Loan Rate Composition and Maturities*

 

Of our total loans outstanding, excludingloans on nonaccrual, 73.7% and 77.1% had adjustable 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 our total loans outstanding, excludingnonaccrual loans, at December 31, 2005, 51.1% were due in one year orless, 33.0% were due in 1-5 years and 15.9% were due after 5 years. As iscustomary in the banking industry, loans can be renewed by mutual agreementbetween the borrower and us. Because we are unable to estimate the extent towhich its borrowers will renew their loans, Table 11 is based on contractualmaturities.

 

**Table 11**

**Loan Maturities**
| ** **                                                                              | ** ** | **December 31, 2005**      | ** ** |
|-----------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                              | ** ** | **Adjustable  interest rates**  | ** ** | **Fixed  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-Balance Sheet Loan Commitments andContingent Obligations*

 

We are a party to financial instruments withoff-balance sheet credit risk in the normal course of business to meet thefinancing 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 tocredit loss in the event of nonperformance by customers is represented by thecontractual amount of the instruments.

 

Loan commitments are agreements to lend to acustomer a specified amount subject to certain conditions. Loan commitmentsgenerally have fixed expiration dates or other termination clauses and may requirepayment of a fee. We had outstanding loan commitments aggregating $120.8million at December 31, 2005, substantially all of which were forconstruction loans and commercial lines of credit.

 

25

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Standby letters of credit are conditionalcommitments issued by us to secure the financial performance of a customer to athird party and are primarily issued to support private borrowing arrangements.The credit risk involved in issuing a letter of credit for a customer isessentially the same as that involved in extending a loan to that customer. Weuse the same credit underwriting policies in accepting such contingentobligations as we do for loans. When deemed necessary, we hold appropriatecollateral supporting those commitments. The nature of collateral obtainedvaries and may include deposits held in financial institutions and realproperties. At December 31, 2005 letters of credit amounted to $1.1million. Many of these commitments are expected to expire without being drawnupon and, as such, the total commitment amounts do not necessarily representfuture cash requirements.

 

**Asset Quality and Credit Risk Management**

 

We assess and manage credit risk on anongoing basis through diversification guidelines, lending limits, credit reviewand approval policies and internal monitoring. 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. In addition to this credit review process,our loan portfolio is subject to examination by external regulators in thenormal course of business. Underlying trends in the economic and business cyclewill influence credit quality. We seek to manage and control credit riskthrough diversification of the portfolio by type of loan, industryconcentration and type of borrower.

 

*Nonperforming Assets*

 

Nonperforming assets consist of nonperformingloans and other real estate owned. Nonperforming loans are (i) loans whichhave been 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 ownedconsists of real properties securing loans of which we have taken title inpartial or complete satisfaction of the loan. Other than loans included innonperforming assets at December 31, 2005, we had no loans that causemanagement to have serious doubts about the ability of the borrower to complywith the present loan repayment terms and we had no other interest earningassets that were considered impaired at December 31, 2005. Informationabout nonperforming assets 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 | % |

 

*Nonaccrual Loans.*Nonaccrual loans are those loans for which management has discontinued accrualof interest because there exists reasonable doubt as to the full and timelycollection of either principal or interest. Our policy is to place a loan onnonaccrual status if either principal or interest payments are past due inexcess of ninety days unless the loan is both well secured and in process ofcollection, or if full collection of interest or principal becomes uncertain,regardless of the time period involved.

 

When a loan is placed on nonaccrual status,all interest previously accrued but uncollected is reversed against currentperiod operating results. Income on such loans is then recognized only to theextent that cash is received, and, where the ultimate collection of thecarrying amount of the loan is probable, after giving consideration to theborrower’s current financial condition, historical repayment performance andother factors. Accrual of interest is resumed only when (i) principal andinterest are brought fully current, and (ii) such loans are eitherconsidered, in management’s judgment, to be fully collectible or otherwisebecome well secured and in the process of collection. (See “Net Interest Income”for a discussion of the effects on operating results of nonperforming loans.)

 

26

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Nonaccrual loans increased to $319,000 at December 31,2005, from $18,000 at December 31, 2004, representing a single securedcommercial loan. The value of the collateral securing this loan may not beadequate to avoid a charge off of a portion of the credit. The additionalinterest income that would have been recorded from nonaccrual loans, if theloans had not been on nonaccrual status, was $11,000 and $12,000 for 2005 and2004, respectively. Interest payments received on nonaccrual loans are appliedto principal unless there is no doubt as to ultimate full repayment ofprincipal, in which case, the interest payment is recognized as interest income.Interest income not recognized on nonaccrual loans reduced the net yield onearning assets by 1 basis point and 0 basis point for 2005 and 2004, respectively.

 

*Troubled Debt Restructurings.*A TDR is a loan for which we have, for economic or legal reasons related to aborrower’s financial difficulties, granted a concession to the borrower wewould not otherwise consider, including modifications of loan terms toalleviate the burden of the borrower’s near-term cash flow requirements inorder to help the borrower to improve its financial condition and eventualability to repay the loan. At December 31, 2005 and 2004 and for the yearsthen ended we had no TDRs and accordingly, no interest income was recorded in2005 and 2004 on TDRs.

 

*Loans Contractually Past Due 90 or More Days.*Loans contractually past due 90 or more days are those loans which have becomecontractually past due at least ninety days with respect to principal orinterest. Interest accruals may be continued on these loans when suchloans are well secured and in the process of collection and, accordingly,management has determined such loans to be fully collectible as to bothprincipal and interest.

 

For this purpose, a loan is considered wellsecured if the collateral has a realizable value in excess of the amount ofprincipal and accrued interest outstanding and/or is guaranteed by afinancially capable party. A loan is considered to be in the process ofcollection if collection of the loan is proceeding in due course either throughlegal action or through other collection efforts which management reasonablyexpects to result in repayment of the loan or its restoration to a currentstatus in the near future.

 

We had no loans contractually past due 90days and still accruing interest at December 31, 2005 and had $1.8 millionin such loans at December 31, 2004. This balance at year-end 2004represented a single loan secured by a commercial real estate property. Ourloan amount represents 67% of the appraised value of the property, which theborrower has entered into an agreement for sale and is pending escrow.

 

*Other Real Estate Owned.*Wecarry OREO at the lesser of our recorded investment or the fair value lessestimated costs to sell. We periodically revalue OREO properties and chargeother expenses for any further write-downs. We had $1.1 million recorded asOREO at December 31, 2005 and December 31, 2004. The property wassold in February of 2006 with a small gain.

 

*Impaired Loans.*Due to the size and nature of the ourloan portfolio, impaired loans are determined by a periodic evaluation on anindividual loan basis. At December 31, 2005 and 2004, and for the yearsthen ended, none of our loans were impaired.

 

Foregone interest income attributable tononperforming loans amounted to $11,000 in 2005 and $12,000 in 2004. Thisresulted in a reduction in yield on average loans receivable of 0 basis pointand 1 basis points for the years ended December 31, 2005 and 2004,respectively.

 

*Other Interest Bearing Assets*.We had no other interest bearing assets that were past due, nonaccrual orexperiencing credit difficulties.

 

*Allowance for Loan and Lease Losses*

 

The allowance for credit losses is the sum ofthe allowance for loan and lease losses and the reserve for contingent losseson unfunded commitments. The allowance for loan and lease losses is a valuationadjustment used to recognize impairment of the recorded investment in the loansreceivable on our balance sheet before losses have been confirmed resulting ina subsequent charge-off or write-down. The reserve for contingent losses onunfunded commitments is a liability accrual for unidentified but probablelosses on our commitments to fund loans. As of September 30, 2005, thereserve for contingent losses on unfunded commitments was reclassified from theallowance for credit losses to other liabilities. The 2004 year end reserve forcontingent losses on unfunded commitments was reclassified to conform tothe current presentation.

 

The calculation of the adequacy of theallowance for loan and lease losses is based on a variety of factors (seeAllowance for Loan and Lease Losses under Critical Accounting Policies). Table13 presents, at the dates indicated, the composition of our allocation of theallowance for loan and lease losses to specific loan categories. Our currentpractice is to make specific allocations of the allowance for loan and leaselosses to criticized and classified loans, and unspecified allocations to eachloan category based on our risk assessment. This allocation should not beinterpreted as an indication that loan charge-offs will occur in the future inthese amounts or proportions, or as an indication of future charge-off trends. Inaddition, the portion of the allowance for loan and lease losses allocated toeach loan category does not represent the total amount available for futurelosses that may occur within such categories, since the total allowancefor loan and lease losses is applicable to the entire portfolio.

 

27

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**Table 13**

**Allocation of 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 categoryto total loans.

 

The allowance for loan and lease losses at December 31,2005 was $4.5 million compared to $3.5 million at December 31, 2004. Theallowance was affected by net recoveries of $1.2 million partially offset by a$84,000 benefit for credit losses. Total net loan recoveries in 2004 were73,000. The benefit for credit losses was recorded in 2005 based upon ouranalysis of the adequacy of allowance for credit losses.

 

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

 

Table 14 presents an analysis of changes in theallowance for loan and lease losses during the periods indicated:

 

28

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**Table 14**

**Analysis of Changes in Allowance for Loan and LeaseLosses**
| ** **                                                                                               | ** ** | **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 | % |
|                                                                                                          |            |                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The allowance for loan and lease lossesincreased in 2005 primarily due to (i) the growth in loans receivableduring 2005, (ii) expansion of higher risk film production lending, (iii) theincreased credit risk to adjustable rate borrowers in a rising interest rateenvironment, and (iv) an increase in the average size of individual loansin our portfolio. There was no addition to the allowance for loan and leaselosses charged to earnings in 2005; based upon our valuation assessment werecorded a benefit for credit losses as a result of the recovery of a loanpreviously charged off. Factors influencing our judgments regarding provisionsfor credit losses included: 2004 – growth in loans receivable and unfundedcommitments; 2003, 2002, and 2001 – the level of problem credits and chargeoffs.

 

**Deposits**

 

We emphasize developing business clientrelationships at both Banks in order to increase our core deposit base. Weoffer internet-based cash management services and, for many business customers,provide regular courier service between their business locations and ourbanking offices. Additionally, we attract deposits in serving the specificmarket niches of escrow and title companies and community-based nonprofitorganizations. Each Bank offers its own rates in order to compete in itsspecific markets. We have entered new geographic markets first with loanproduction offices with the intention of later converting the offices to fullservice branch banking offices.

 

29

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**Table 15**

**Average Deposit 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 | % |

 

During 2005 we increased the use of BrokeredCDs which are classified as time certificates of deposits $100,000 and over. Weuse Brokered CDs to supplement our liquidity and achieve other asset liability managementobjectives (see the discussion under Net Interest Income). Brokered depositsare wholesale certificates of deposit placed by rate sensitive customers thatdo not have any other significant relationship with us. Professionals operatingunder established investment criteria manage most wholesale funds and thebrokered deposits are typically in amounts that exceed the FDIC depositinsurance limit. As a result, these funds are generally very sensitive tocredit risk and interest rates, and pose greater liquidity risk to a bank. Theymay refuse to renew the certificates of deposit at maturity if higherrates are available elsewhere or if they perceive that creditworthiness isdeteriorating. At December 31, 2005 we had total brokered deposits of$37.5 million all of which had maturities within 12 months.

 

The Federal Reserve Bank increased the targetfed funds rate thirteen times beginning in the second half of 2004 and marketshort term interest rates likewise increased. In order to improve net interestmargins, we increased the rates paid on our nonmaturity deposits relativelylittle. Other financial institutions have increased the rates paid on theirdeposits more rapidly. While our customers are typically less rate sensitivedue to the business relationships with us, it is difficult to grow depositswithout offering very competitive rates. Consequently, during the second halfof 2004 and 2005 we increased Brokered CDs and began offering very competitiverates on certain certificates of deposit targeted to new customers in order tofund our asset growth and any deposit runoff. While these sources of funds arerelatively high costing deposits, the higher rates impact only the incrementaldeposits acquired through these means.

 

Additionally, the period 2001 through thefirst half of 2004 experienced historically low interest rates. During periodsof low interest rates, depositors tend to maintain greater deposit balances inlow yielding but readily accessible transaction accounts due to relatively lowopportunity costs. As interest rates rise, and opportunity costs increase,depositors tend to redeploy their funds into higher yielding alternatives. Assumingrates continue to rise, we expect continued growth in certificates of depositand a resulting change in the composition of our deposits.

 

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.

 

30

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**Table 16**

**Maturities of Time Certificates of Deposit**

**$100,000 or 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 |   |

 

*Deposit Concentrations*

 

At December 31, 2005 a single depositorrepresented $23.1 million, or 6.8%, of our total deposits. Our ten largestdepositors represented $43.4 million, or 14.3%, of our total deposits. Wemaintain contingent sources of liquidity to buffer changes in our depositbalances.

 

**Borrowed Funds**

 

Borrowed funds and related weighted averagerates are summarized below in Table 17.

 

**Table 17**

**Borrowed Funds**

 
| ** **                                                               | ** ** | **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 had no securities sold with agreements torepurchase during 2005. The maximum amount of securities sold with agreementsto repurchase at any month end during 2004 and 2003 was zero and $800,000,respectively.

 

The maximum amount of other borrowings at anymonth end was $28.3 million during 2005, $31.9 million during 2004 and $7.5million during 2003.

 

At December 31, 2005, we had $28.3million of borrowed funds, all were overnight borrowings and the balancesscheduled to mature during 2006.

 

**Junior Subordinated Debentures/TrustPreferred Securities**

 

In 2001, National Mercantile, throughNational Mercantile Capital Trust I (the “Trust”), issued 15,000 of 10.25%fixed rate securities (the “Trust Preferred Securities”), with an aggregateliquidation amount of $15.0 million due July 25, 2031. The Trust PreferredSecurities represent undivided beneficial interests in the assets of the Trustand are unconditionally guaranteed by National Mercantile with respect todistributions and payments upon liquidation, redemption and otherwise pursuantto the terms of a Guarantee Agreement. National Mercantile issued the TrustPreferred Securities to generate regulatory capital at a relatively low cost(as payments of interest are deductible for income tax purposes).

 

The primary assets of the Trust are $15.5million aggregate principal amount of National Mercantile 10.25% fixed ratejunior subordinated deferrable interest debentures due July 25, 2031 (“JuniorSubordinated Debentures”) that pay interest each January 26 and July 26.The interest is deferrable, at National Mercantile’s option, for a period up toten consecutive semi-annual payments, but in any event not beyond June 25,2031. The debentures are redeemable, in whole or in part, at NationalMercantile’s option on or after five years from issuance at declining premiums tomaturity.

 

In January 2003, National Mercantileentered into a interest rate swap agreement pursuant to which it exchanged afixed rate payment obligation of 10.25% on a notional principal amount of $15.0million for a floating interest rate based on the six-month London InterBankOffered Rate plus 458 basis points for a 29-year period ending July 25,2031. The interest rate swap agreement results in National Mercantile paying orreceiving the difference between the fixed and floating rates at specified intervalscalculated based on the notional amounts. The differential paid or received onthe interest rate swap is recognized as an adjustment to interest expense. At

 

31

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December 31, 2004, we were paying an interest rate of 6.51% underthe terms of the swap. The counter party to the swap has the option to call theswap under a declining premium schedule beginning July 2006.

 

The interest rate swap reduces the adverseimpact of our 10.25% fixed rate Trust Preferred Securities in a low interestrate environment. We do not utilize derivatives for speculative purposes. UnderStatement of Financial Accounting Standards No. 133 this swap transactionis designated as a fair value hedge. Accordingly, the effective portion of thechange in the fair value of the swap transaction is recorded each period incurrent income. The terms of the swap are symmetrical with the terms of theTrust Preferred Securities, including the payment deferral terms, andconsidered highly effective in offsetting changes in fair value of the TrustPreferred Securities. Accordingly, no ineffectiveness will be recorded tocurrent earnings related to the interest rate swap.

 

**Off-Balance Sheet Arrangements**

 

*Interest Rate Swaps*

 

We utilize interest rate swaps to manage therisk associated with changes in interest rates and to help us maintain a stablegrowth of income (see Interest Rate Risk Management above and Note 13 of theNotes to the Consolidated Financial Statements). Our interest rate swaps increasedinterest income $372,000 and increased interest expense $3,000 for the yearended December 31, 2005. Certain of our interest rate swaps are designatedcash flow hedges. The change in market value of cash flow hedges, net of incometaxes, is included in Accumulated Other Comprehensive Income. As of December 31,2005 we had $605,000 Accumulated Other Comprehensive Income related to ourinterest rate swaps. During periods of declining interest rates, the benefitsfrom our interest rate swaps will increase partially offsetting the negativeeffect that declining interest rates have on our income. Conversely, duringperiods of rising interest rates, the benefits from our interest rate swapswill decline but will be more than offset by the positive effect that risinginterest rates have on our income from loans.

 

**Contractual Obligations**

 

The following table provides the amounts dueunder specified contractual obligations for the periods indicated as of December 31,2005.

 

**Table 18**

**Contractual Obligations**

 
| ** **                           | ** ** | **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 |   |

 

The obligations are categorized by theircontractual due dates. Approximately $70.6 million of the commitments to fundloans relate to real estate construction and are expected to fund within thenext 12 months. The balance of the commitments to fund loans is primarilyrevolving lines of credit or other commercial loans, and many of thesecommitments are expected to expire without 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 necessarilyrepresent future cash requirements. We may, at our option, prepay certainborrowings prior to their maturity date. Furthermore, the actual payment ofcertain current liabilities may be deferred into future periods.

 

**Selected Financial Ratios**

 

The following Table 19 sets forth selectedfinancial ratios:

 

32

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**Table 19**

**SelectedPerformance Ratios**

 
| ** **                                           | ** ** | **For the Year Ended  December 31,** | ** ** |
|------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                           | ** ** | **2005**                                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                 |       |                                                     |       |   |   |   |   |
| Return on  average assets                            |       | 1.16                                                     | %          | 0.57 | % | 0.06 | % |
| Return on  average shareholders’ equity         |       | 12.78                                                    | %          | 6.61 | % | 0.66 | % |
| Average  shareholders’ equity to average assets |       | 9.04                                                     | %          | 8.68 | % | 8.66 | % |

 

**Recent Accounting Pronouncements**

 

See Recent Accounting Pronouncements in Note1-Summary of Significant Accounting Policies of Notes to Consolidated FinancialStatements.

 

**FACTORS WHICH MAY AFFECT FUTUREOPERATING RESULTS**

 

***We face risk from changes in interest rates.***

 

The success of our business depends, to alarge extent, on our net interest income. Changes in market interest rates canaffect our net interest income by affecting the spread between ourinterest-earning assets and interest-bearing liabilities. This may be dueto the different maturities of our interest-earning assets and interest-bearingliabilities, as well as an increase in the general level of interest rates. Changesin market interest rates also affect, among other things:

 

•                  Our ability tooriginate loans;

•                  The ability ofour borrowers to make payments on their loans;

•                  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; and

•                  Our ability toaccess the wholesale funding market.

 

Interest rates are highly sensitive to manyfactors, including governmental monetary policies, domestic and internationaleconomic and political conditions and other factors beyond our control.

 

***We face risk from possible declines in thequality of our assets.***

 

Our financial condition depends significantlyon 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 the level of our non-performing assetsrises, our results of operations and financial 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.

 

***Our allowances for loan and lease losses may beinadequate.***

 

We establish allowances for loan and leaselosses against each segment of our loan portfolio. At December 31, 2005,our allowance for loan and lease losses equaled 1.32% of loans receivable and1400.6% of nonperforming loans. Although we believe that we had establishedadequate allowances for loan and lease losses as of December 31, 2005, thecredit quality or our assets is affected by many factors beyond our control,including local and national economic conditions, and the possible existence offacts which are not known to us which adversely affect the likelihood ofrepayment of various loans in our loan portfolio and realization of thecollateral upon a default. Accordingly, we can give no assurance that we willnot sustain loan losses materially in excess of the allowance for loan andlease losses. In addition, the Office of the Comptroller of the Currency, as anintegral part of its examination process, periodically reviews ourallowance for loan and lease losses and could require additional provisions forcredit losses. Material future additions to the allowance for loan and leaselosses may also be necessary due to increases in the size and changes inthe composition of our loan portfolio. Increases in our provisions for creditlosses would adversely affect our results of operations.

 

***Economic conditions may worsen.***

 

Our business is strongly influenced byeconomic conditions in our market area (principally, the Greater Los Angelesmetropolitan area) as well as regional and national economic conditions and inour niche markets, including the real estate and entertainment industries inSouthern California. During the past several years economic conditions,particularly in the real estate industry, have been favorable. Should theeconomic condition in this market area deteriorate, the financial condition ofour borrowers could weaken, which could lead to higher levels of loan defaultsor a decline in the value of collateral for our loans. In addition, anunfavorable economy could reduce the demand for our loans and other productsand services.

 

33

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***Because a significant amount of the loans wemake are to borrowers in Southern California, our operations could suffer as aresult of local recession or natural disasters in California.***

 

At December 31, 2005, a large majorityof our loans outstanding were collateralized by real properties located inSouthern California. Because of this concentration in California, our financialposition and results of operations have been and are expected to continue to beinfluenced by general trends in the California economy and its real estatemarket. Real estate market declines may adversely affect the values of theproperties collateralizing loans. If the principal balances of our loans,together with any primary financing on the mortgaged properties, equal orexceed the value of the mortgaged properties, we could incur higher losses onsales of properties collateralizing foreclosed loans. In addition, California historicallyhas been vulnerable 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 adverselyimpact our ability to recover losses on properties affected by such disastersand adversely impact our results of operations.

 

***Our business is very competitive.***

 

There is intense competition in SouthernCalifornia and elsewhere in the United States 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 depositsprimarily with other commercial banks, mortgage companies, commercial financecompanies and savings institutions. In recent years out-of-state financialinstitutions have entered the California market, which has also increasedcompetition. Many of our competitors have greater financial strength, marketingcapability and name recognition than we do, and operate on a statewide ornationwide basis. In addition, recent developments in technology and massmarketing have permitted larger companies to market loans more aggressively toour small business customers. Such advantages may give our competitorsopportunities to realize greater efficiencies and economies of scale than wecan. We can provide no assurance that we will be able to compete effectivelyagainst our competition.

 

***Our business is heavily regulated.***

 

Both National Mercantile, as a bank holdingcompany, and the Banks, are subject to significant governmental supervision andregulation, which is intended primarily for the protection of depositors. Statutesand regulations affecting us may be changed at any time, and theinterpretation of these statutes and regulations by examining authorities also may change.We cannot assure you that future changes in applicable statutes and regulationsor in their interpretation will not adversely affect our business.

 

***Our ability to use our net operating losses may belimited.***

 

As of December 31, 2005, we had NOLs of$5.0 million for federal tax purposes, which begin to expire in 2009. Ourability to use the NOLs in the future would be significantly limited if weexperience an “ownership change” within the meaning of Section 382 of theInternal Revenue Code. If our use of these NOLs is limited, we would berequired to charge off the portion of our deferred tax asset related to the NOLlimitation, and our net income would be lower.

 

***A significant portion of our loan portfolioconsists of construction loans, which have greater risks than loans secured bycompleted real properties***

 

At December 31, 2005, we had outstandingconstruction and land development loans in the amount of $92.1 million,representing 27% of our loan portfolio, and commitments to fund an additional$52.6  million of construction loans. Thesetypes of loans generally have greater risks than loans on completed homes,multifamily properties and commercial properties. A construction loan generallydoes not cover the full amount of the construction costs, so the borrower musthave adequate funds to pay for the balance of the project. Price increases,delays and unanticipated difficulties can materially increase these costs. Further,even if completed, there is no assurance that the borrower will be able to sellthe project on a timely or profitable basis, as these are closely related toreal estate market conditions, which can fluctuate substantially between thestart and completion of the project. If the borrower defaults prior tocompletion of the project, the value of the project will likely be less thanthe outstanding loan, and we could be required to complete construction withour own funds to minimize losses on the project.

 

***We have goodwill from the acquisition ofSouth Bay, which must be evaluated regularly for impairment***

 

In connection with the acquisition of SouthBay in December 2001, we recorded goodwill in the amount of $3.2 million. Wemust evaluate the goodwill regularly for impairment. We had an unaffiliatedconsultant conduct goodwill impairment testing in the fourth quarter of 2005,and we determined that this goodwill was not impaired. If in the future wedetermine that the goodwill is impaired, we would be required to write-off someor all of the goodwill, which could have a material adverse effect on ourfinancial condition and results of operations.

 

***We have a significant deferred tax asset andour ability to realize that asset depends in part on the certainty offuture earnings***

 

At December 31, 2005, we had a deferredtax asset of $4.2 million relating primarily 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. Tosupport our position that the benefits of this asset will be realized, we mustestimate future earnings. These estimates are based on many factors, includingprior periods results. If we are unable to generate future earnings in anamount sufficient to support the asset, we

 

34

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would have to establish a valuation allowance and corresponding chargeto earnings to reduce the deferred tax asset to its realizable value. Amaterial valuation allowance on this asset would have a material adverse effecton our results of operations and financial condition.

 

***ITEM 7.***     FINANCIAL STATEMENTS

*** ***

The consolidated financial statementsrequired by this Item are included herewith as a separate section of thisReport 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                           |   |   |

 

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

 

Not applicable.

 

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

 

The Company maintains disclosure controls andprocedures (as defined in Exchange Act Rule 13a-15(e)) that are designedto assure that information required to be disclosed in its Exchange Act reportsis recorded, processed, summarized and reported within the time periodsspecified in the Securities and Exchange Commission’s rules and forms, andthat such information is accumulated and communicated to management, includingthe Chief Executive Officer and Chief Financial Officer, as appropriate, toallow timely decisions regarding required disclosures.

 

In designing and evaluating the disclosurecontrols and procedures, management recognizes that any controls andprocedures, no matter how well designed and operated, can provide reasonableassurance only of achieving the desired control objectives, and managementnecessarily is required to apply its judgment in weighting the costs andbenefits of possible new or different controls and procedures. Limitations areinherent in all control sysytems, so no evaluation of controls can provideabsolute assurance that all control issues and any fraud within the companyhave been detected.

 

As required by Exchange Act Rule 13a-15(b),as of the end of the period covered by this 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 this evaluation, our Chief Executive Officerand Chief financial Officer concluded that the Company’s disclosure controlsand procedures were effective as of that date.

 

There was no change in the Company’s internalcontrol over financial reporting during the Company’s most recently completedfiscal quarter that has materially affected, or is reasonably likely tomaterially affect, the Company’s internal control over financial reporting.

 

**ITEM 8B**. **OTHERINFORMATION**

 

Not applicable.

 

35

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**PART III**

 

ITEM 9.     DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCEWITH SECTION 16(a) OF THE EXCHANGE ACT

 

 The information requiredby this item will appear under the captions “Election of Directors,” “Executive Officers,” “Section 16(a) Beneficial Ownership ReportingCompliance,” and “Code of Ethics” in the Company’s proxy statement for the 2006Annual Meeting of Shareholders (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 10. EXECUTIVE COMPENSATION

 

 The information required by this itemwill appear under the captions “Compensation of Executive Officers,” “Compensationof Directors,” “Summary Compensation Table,” “2005 Option Grants,” “2005 OptionExercises and Year-End Option Values” and “Employment and Severance Agreements”in the 2006 Proxy Statement, and such information shall be deemed to beincorporated herein by reference to those portions of the 2006 Proxy Statement,if filed with the Securities and Exchange Commission not later than 120 daysafter the end of our most recently completed fiscal year.

 

ITEM 11. SECURITY OWNERSHIP OF CERTAINBENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

 

The information required by this item willappear under the caption “Security Ownership of Principal Shareholders andManagement” and “Equity Compensation Plan Information” in the 2006 ProxyStatement, and such information either shall be deemed to be incorporatedherein by reference to that portion of the 2006 Proxy Statement, if filed withthe Securities and Exchange Commission not later than 120 days after the end ofour most recently completed fiscal year.

 

ITEM 12. CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS

 

The information required by this item willappear under the caption “Certain Relationships and Related Transactions” inthe 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 recently completed fiscal year.

 

ITEM 13. EXHIBITS

 

 See Index to Exhibits on page 62 of this Form 10-KSB

 

ITEM 14. PRINCIPAL ACCOUNTANT FEES ANDSERVICES

 

 The information required by this itemwill appear under the caption “Independent Public Accountants” in the 2006Proxy Statement, and such information shall be deemed to be incorporated hereinby reference to that portion of the 2006 Proxy Statement, if filed with theSecurities and Exchange Commission not later than 120 days after the end of ourmost recently completed fiscal year.

 

36

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*SIGNATURES*

 

Pursuant to the requirements of Section 13or 15(d) of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 

 
|                      | NATIONAL MERCANTILE BANCORP |
|---------------------------|-----------------------------|
|                      | (Registrant)                |
|                      |                        |   |
|                      | By                          | /s/ SCOTT A. MONTGOMERY |
|                      |                        | Scott A.  Montgomery |   |
| Date: March 31, 2006 |                        | Chief  Executive Officer |   |

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, this report has been signed below by thefollowing persons on behalf of the registrant and in the capacities and on thedates indicated.

 

 
| **Signature** | ** **                  | **Title**                                             | ** **          | **Date** |
|---------------|-----------------------------|-------------------------------------------------------|---------------------|----------|
|          |                        |                                                  |                |
| /s/           | ROBERT E.  GIPSON           |                                                  |                |     |
|          | Robert E.  Gipson           | Chairman of the Board                                 | March 31, 2006 |
|          |                        |                                                  |                |
| /s/           | ROBERT E.  THOMSON          |                                                  |                |     |
|          | Robert E.  Thomson          | Vice Chair                                            | March 31, 2006 |
|          |                        |                                                  |                |
| /s/           | DONALD E.  BENSON           |                                                  |                |     |
|          | Donald E.  Benson           | Director                                              | March 31, 2006 |
|          |                        |                                                  |                |
| /s/           | JOSEPH N.  COHEN            |                                                  |                |     |
|          | Joseph N.  Cohen            | Director                                              | March 31, 2006 |
|          |                        |                                                  |                |
| /s/           | W. DOUGLAS  HILE            |                                                  |                |     |
|          | W. Douglas  Hile            | Director                                              | March 31, 2006 |
|          |                        |                                                  |                |
| /s/           | ANTOINETTE  HUBENETTE, M.D. |                                                  |                |     |
|          | Antoinette  Hubenette, M.D. | Director                                              | March 31, 2006 |
|          |                        |                                                  |                |
| /s/           | SCOTT A.  MONTGOMERY        |                                                  |                |     |
|          | Scott A.  Montgomery        | Director, Chief Executive Officer                     | March 31, 2006 |
|          |                        |                                                  |                |
| /s/           | DION G.  MORROW             |                                                  |                |     |
|          | Dion G.  Morrow             | Director                                              | March 31, 2006 |
|          |                        |                                                  |                |
| /s/           | CARL R.  TERZIAN            |                                                  |                |     |
|          | Carl R.  Terzian            | Director                                              | March 31, 2006 |
|          |                        |                                                  |                |
| /s/           | DAVID R.  BROWN             |                                                  |                |     |
|          | David R.  Brown             | Principal Financial and Principal  Accounting Officer | March 31, 2006 |

 

37

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**Report of Independent Registered Public Accounting Firm**

 

Tothe Shareholders and the Board of Directors

ofNational Mercantile Bancorp and subsidiaries:

 

Wehave audited the consolidated balance sheet of National Mercantile Bancorp (aCalifornia corporation) and subsidiaries (collectively, the “Company”) as of December 31,2005, and the related consolidated statements of operations, changes inshareholders’ equity and cash flows for the year ended December 31, 2005. Thesefinancial statements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audit.

 

Weconducted our audit in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that weplan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement. We were not engagedto perform an audit of the Company’s internal control over financialreporting. Our audit included consideration of internal control over financialreporting as a basis for designing audit procedures that are appropriate in thecircumstances, but not for the purpose of expressing an opinion on theeffectiveness of the Company’s internal control over financial reporting. Accordingly,we express no such opinion. An audit also includes examining, on a test basis,evidence supporting the amounts and disclosures in the financial statements,assessing the accounting principles used and significant estimates made bymanagement, and evaluating the overall financial statement presentation. Webelieve that our audit provides a reasonable basis for our opinion.

 

Inour opinion, the financial statements referred to above present fairly, in allmaterial respects, the consolidated financial position of National MercantileBancorp and subsidiaries as of December 31, 2005, and the consolidatedresults of their operations and their cash flows for the year ended December 31,2005, in conformity with U.S. generally accepted accounting principles.

 

 
|   | /s/  Moss Adams LLP |   |
|--------|---------------------|--------|

 

LosAngeles, California

March 31,2006

 

38

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**Report of Independent Registered Public Accounting Firm**

 

Tothe Shareholders and the Board of Directors

ofNational 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 the responsibility of the Company’smanagement. 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 weplan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement. We were not engagedto perform an audit of the Company’s internal control over financialreporting. Our audit included consideration of internal control over financialreporting as a basis for designing audit procedures that are appropriate in thecircumstances, but not for the purpose of expressing an opinion on theeffectiveness of the Company’s internal control over financial reporting.Accordingly, we express no such opinion. An audit also includes examining, on atest basis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimatesmade by management, and evaluating the overall financial statement presentation.We believe that our 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 |   |
|--------|--------|--------|--------|--------|---------------------------------|--------|

 

LosAngeles, California

March 28,2005

 

39

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**NATIONALMERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATED BALANCE SHEET**

 
|                                                                                                                    |   | **December 31,  2005**      |    |
|-------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------|---------|
|                                                                                                                    |   | **(Dollars in  thousands)** |    |
|                                                                                                                    |   |                             |    |
| ASSETS                                                                                                                  |   |                             |    |
| Cash and due  from banks-demand                                                                                         |   | $                                | 13,507  |   |
| Due from  banks-interest bearing                                                                                        |   | 2,000                            |    |
| Federal  funds sold and securities purchased under agreements to resell                                                 |   | 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 $2,572                                            |   | 2,612                            |    |
| Federal  Reserve Bank and other stock                                                                                   |   | 3,809                            |    |
| Loans  receivable                                                                                                       |   | 338,558                          |    |
| Allowance  for credit losses                                                                                            |   | (4,468                           | )       |
| Net loans  receivable                                                                                                   |   | 334,090                          |    |
|                                                                                                                    |   |                             |    |
| Premises and  equipment, net                                                                                            |   | 5,861                            |    |
| Other real  estate owned                                                                                                |   | 1,056                            |    |
| Deferred tax  asset, net                                                                                                |   | 4,203                            |    |
| Goodwill                                                                                                                |   | 3,225                            |    |
| Intangible  assets, net                                                                                                 |   | 1,407                            |    |
| Accrued  interest receivable and other assets                                                                           |   | 4,583                            |    |
| Total assets                                                                                                            |   | $                                | 448,796 |   |
|                                                                                                                    |   |                             |    |
| 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                                        |   | 45,697                           |    |
| Accumulated  deficit                                                                                                    |   | (7,044                           | )       |
| Accumulated  other comprehensive loss                                                                                   |   | (1,154                           | )       |
| Total  shareholders’ equity                                                                                        |   | 38,499                           |    |
| Total  liabilities and shareholders’ equity                                                                        |   | $                                | 448,796 |   |

 

See accompanying notes to consolidated financial statements.

 

40

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**NATIONALMERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

 
| ** **                                                              | ** ** | **For the Year Ended  December 31,**                    | ** ** |
|-------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                                                              | ** ** | **2005**                                                                    | ** ** | **2004** | ** ** |
| ** **                                                              | ** ** | **(Dollars in thousands,  except per share data)** | ** ** |
| 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                     |       | 1,239                                                                       |       | 966 |   |
| Other  borrowings                                                       |       | 412                                                                         |       | 333 |   |
| Total  interest expense                                                 |       | 5,136                                                                       |       | 3,004 |   |
| Net interest  income before provision for credit losses                 |       | 21,129                                                                      |       | 16,450 |   |
| Provision  (benefit) for credit losses                                  |       | (84                                                                         | )          | 220 |   |
| Net interest  income after provision for credit losses                  |       | 21,213                                                                      |       | 16,230 |   |
| Other  operating income:                                                |       |                                                                        |       |   |   |
| Net loss on  sale of securities available-for-sale                      |       | —                                                                      |       | (197 | ) |
| International  services                                                 |       | 52                                                                          |       | 59 |   |
| Investment  division                                                    |       | 54                                                                          |       | 53 |   |
| Deposit-related  and other customer services                            |       | 1,060                                                                       |       | 1,652 |   |
| Total other  operating income                                           |       | 1,166                                                                       |       | 1,567 |   |
| 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                                     |       | 8,003                                                                       |       | 3,769 |   |
| Income tax  provision                                                   |       | 3,322                                                                       |       | 1,583 |   |
| Net income                                                              |       | $                                                                           | 4,681      |   | $ | 2,186 |   |
| Earnings per  share:                                                    |       |                                                                        |       |   |   |
| Basic                                                                   |       | $                                                                           | 1.26       |   | $ | 0.75 |   |
| Diluted                                                                 |       | $                                                                           | 0.99       |   | $ | 0.48 |   |

 

See accompanying notes to consolidated financial statements.

 

41

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**NATIONALMERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CHANGES INSHAREHOLDERS’ EQUITY**

 
| ** **                                                         | ** ** | ** **                                   | ** ** | ** **                                  | ** ** | ** **            | ** ** | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Accumulated  Other  Comprehensive  Income  (Loss)** | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|-----------------------|------------|-------------------------|------------|------------|------------|------------|------------|------------|------------|-------------------------------------------------------|------------|------------|------------|
| ** **                                                         | ** ** | ** **                                   | ** ** | ** **                                  | ** ** | ** **            | ** ** | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                                            | ** ** | ** ** |
| ** **                                                         | ** ** | ** **                                   | ** ** | ** **                                  | ** ** | ** **            | ** ** | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                                            | ** ** | ** ** |
| ** **                                                         | ** ** | **Preferred Stock Series A**  | ** ** | **Preferred Stock Series B** | ** ** | **Common Stock** | ** ** | **Accumulated Deficit** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                         | ** ** | **Shares**                                   | ** ** | **Amount**                                  | ** ** | **Shares**            | ** ** | **Amount**              | ** ** | **Shares** | ** ** | **Amount** | ** ** | ** ** | **Total**  | ** **                                            |
| ** **                                                         |       | **(Dollars in thousands except share data)** |       |
| Balance at December 31, 2003                                  |       | 729,585                                      |       | $                                           | 5,959      |                  | 1,000      |                    | $          | 1,000      |       | 2,772,279  |       | $          | 38,602     |                                                  | $          | (13,911    | )          | $ | 71 |   | $ | 31,721 |   |
| 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:                                              |       |                                         |       |                                        |       |                  |       |                    |       |       |       |       |       |       |       |                                                  |       |       |       |
| Change in unrealized gain (loss) on:                               |       |                                         |       |                                        |       |                  |       |                    |       |       |       |       |       |       |       |                                                  |       |       |       |
| Securities available for sale, net                                 |       |                                         |       |                                        |       |                  |       |                    |       |       |       |       |       |       |       | (152                                                  | )          | (152       | )          |
| Less: Reclassification of losses included in net  income, net      |       |                                         |       |                                        |       |                  |       |                    |       |       |       |       |       |       |       | 41                                                    |       | 41         |       |
| Derivative financial instruments designated cash flow  hedges, net |       |                                         |       |                                        |       |                  |       |                    |       |       |       |       |       |       |       | 314                                                   |       | 314        |       |
| Net income                                                         |       |                                         |       |                                        |       |                  |       |                    |       |       |       |       |       | 2,186      |       |                                                  |       | 2,186      |       |
| Comprehensive income                                               |       |                                         |       |                                        |       |                  |       |                    |       |       |       |       |       |       |       |                                                  |       | 2,389      |       |
| Balance at December 31, 2004                                  |       | 666,273                                      |       | $                                           | 5,442      |                  | 1,000      |                    | $          | 1,000      |       | 2,954,128  |       | $          | 39,491     |                                                  | $          | (11,725    | )          | $ | 274 |   | $ | 34,482 |   |
| Preferred stock converted into common stock on a 2:1  basis        |       | (666,273                                     | )          | (5,442                                      | )          |                  |       |                    |       | 1,332,546  |       | 5,442      |       |       |       |                                                  |       | —     |       |
| Stock options exercised                                            |       |                                         |       |                                        |       |                  |       |                    |       | 116,350    |       | 764        |       |       |       |                                                  |       | 764        |       |
| Comprehensive income:                                              |       |                                         |       |                                        |       |                  |       |                    |       |       |       |       |       |       |       |                                                  |       |       |       |
| Change in unrealized gain (loss) on:                               |       |                                         |       |                                        |       |                  |       |                    |       |       |       |       |       |       |       |                                                  |       |       |       |
| Securities available for sale, net                                 |       |                                         |       |                                        |       |                  |       |                    |       |       |       |       |       |       |       | (353                                                  | )          | (353       | )          |
| Derivative financial instruments designated cash flow  hedges      |       |                                         |       |                                        |       |                  |       |                    |       |       |       |       |       |       |       | (1,075                                                | )          | (1,075     | )          |
| Net income                                                         |       |                                         |       |                                        |       |                  |       |                    |       |       |       |       |       | 4,681      |       |                                                  |       | 4,681      |       |
| Comprehensive income                                               |       |                                         |       |                                        |       |                  |       |                    |       |       |       |       |       |       |       |                                                  |       | 3,253      |       |
| Balance at December 31, 2005                                  |       | —                                       |       | $                                           | —     |                  | 1,000      |                    | $          | 1,000      |       | 4,403,024  |       | $          | 45,697     |                                                  | $          | (7,044     | )          | $ | (1,154 | ) | $ | 38,499 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

42

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**NATIONALMERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

 
| ** **                                                                                  | ** ** | **For the Year Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                                  | ** ** | **2005**                                                     | ** ** | **2004** | ** ** |
| ** **                                                                                  | ** ** | **(Dollars in thousands)**                         | ** ** |
| Cash flows  from operating activities:                                                      |       |                                                         |       |   |   |
| Net income                                                                                  |       | $                                                            | 4,681      |   | $ | 2,186 |   |
| Adjustments  to reconcile net income to net cash used in operating activities:              |       |                                                         |       |   |   |
| Depreciation  and amortization                                                              |       | 425                                                          |       | 409 |   |
| Provision  (benefit) for credit losses                                                      |       | (84                                                          | )          | 220 |   |
| 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                        |       | 181                                                          |       | (331 | ) |
| 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 swap, net of tax effect                                          |       | $                                                            | (762       | ) | $ | 314 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

43

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**NATIONALMERCANTILE BANCORP AND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

## **Note 1—Summary ofSignificant Accounting Policies**

## ** **

*Basis of Presentation*

 

The consolidated financial statements includethe accounts of National Mercantile Bancorp (“National Mercantile” whenreferring only to the parent company or the “Company” when such referenceincludes National Mercantile Bancorp and its subsidiaries, collectively) and ofits wholly owned subsidiaries, Mercantile National Bank (“Mercantile”) andSouth Bay Bank, N.A. (“South Bay”) (and collectively, the “Banks”). Allintercompany transactions and balances have been eliminated. Certain prior yearamounts have been reclassified to conform to the current yearpresentation.

 

National Mercantile Capital Trust I (the “Trust”),a Delaware business trust, was formed by the Company in 2001 for the solepurpose of issuing certain securities representing undivided beneficialinterests in the assets of the Trust and investing the proceeds thereof in theCompany’s junior subordinated deferrable interest debentures. The Trust’s 464common securities (liquidation amount of $1,000 per common security) are whollyowned by National Mercantile, however, in accordance with FASB Interpretation No. 46R,Consolidation of Variable Interest Entities, the Trust is not consolidated inthe Company’s financial statements and it is treated as an equity investment.

 

The accounting and reporting policies of theCompany conform to accounting principles generally accepted in the UnitedStates and to prevailing practices within the banking industry. The preparationof the financial statements in conformity with generally accepted accountingprinciples requires management to make certain estimates and assumptions thataffect the reported amounts of assets, liabilities, and contingencies at thedate of the financial statements and the reported amounts of revenues andexpenses 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.

 

The Company, through the Banks, engages incommercial banking in the Los Angeles area providing commercial and residentialreal estate financing, real estate construction financing and commerciallending serving niche markets represented by professional service providers, entertainment,healthcare and community-based nonprofit borrowers, and associated individualswith commercial banking and personal banking needs.

 

*Cash and Cash Equivalents*

 

For purposes of reporting cash flows, cashand cash equivalents include cash and due from banks-demand, due from banks –interest bearing, and federal funds sold.

 

*Securities*

 

Securities available-for-sale are carried atfair value. Unrealized gains or losses on available-for-sale securities areexcluded from earnings and reported as accumulated other comprehensive income,net of deferred income taxes, in a separate component of shareholders’ equityuntil realized. Realized gains or losses on sales of available-for-salesecurities are recorded using the specific identification method.

 

Securities held-to-maturity are debtinstruments in which management has the positive intent and ability to hold tomaturity and are carried at amortized cost.

 

Premiums or discounts on available-for-saleand held-to-maturity securities are amortized or accreted into income using theeffective interest method.

 

Federal Reserve Bank and other stock areequity investments without an active secondary market; however, the issuerstypically redeem the membership stock at the stated value. Accordingly, theyare carried at historical cost.

 

We are obligated to assess, at each reportingdate, whether there is an “other-than-temporary” impairment to our investmentsecurities. Such impairment must be recognized in current earnings rather thanin other comprehensive income. We review all individual securities that are inan unrealized loss position at each reporting date for other-than-temporaryimpairment. Specific investment level factors we examine to assess impairmentinclude the severity and duration of the loss, an analysis of the issuers ofthe securities and if there has been any cause for default on the securitiesand any change in the rating of the securities by the various rating agencies. Additionally,we review the financial resources and the overall ability that the Company hasand the intent that management has to hold the securities until their fairvalues recover.

 

*Loans*

 

Loans are generally carried at principalamounts outstanding less unearned income. Unearned income includes deferredunamortized fees net of direct incremental loan origination costs.

 

 

44

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

 

Loans are placed on nonaccrual status when aloan becomes 90 days past due as to interest or principal unless the loan isboth well secured and in process of collection. Loans are also placed onnonaccrual status when the full collection of interest or principal becomesuncertain. When a loan is placed on nonaccrual status, the accrued and unpaidinterest receivable is reversed and the accretion of deferred loan fees isceased. Thereafter, interest collected on the loan is accounted for on the cashcollection method until qualifying for return to accrual status. Generally, aloan may be returned to accrual status when all delinquent principal andinterest are brought current in accordance with the terms of the loan agreementand certain performance criteria have been met.

 

The Company considers a loan to be impairedwhen it is probable that it will be unable to collect all amounts due accordingto the contractual terms of the loan agreement. Once a loan is determined to beimpaired, the impairment is measured based on the present value of the expectedfuture cash flows discounted at the loan’s effective interest rate, except thatas a practical expedient, the impairment is measured by using the loan’sobservable market price or the fair value of the collateral if the loan iscollateral dependent.

 

When the measurement of the impaired loan isless than the recorded amount of the loan, impairment is recognized by creatinga valuation allowance with a corresponding charge to the provision for creditlosses or by adjusting an existing valuation allowance for the impaired loanwith a corresponding charge or credit to the provision for credit losses.

 

The Company’s policy is to record cashreceipts received on impaired and nonaccrual loans first as reductions toprincipal and then to interest income.

 

*Allowance for Loan and Lease Losses*

 

The provisions for credit losses charged tooperations reflect management’s judgment of the adequacy of the allowance forloan and lease losses and are determined through periodic analysis of the loanportfolio, problem loans and consideration of such other factors as the Company’sloan loss experience, trends in problem loans, concentrations of credit risk,and economic conditions (particularly Southern California), as well as theresults of the Company’s ongoing examination process and its regulatoryexaminations.

 

The calculation of the adequacy of theallowance for loan and lease losses is based on a variety of factors, includingloan classifications, migration trends and underlying cash flow and collateralvalues. 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, this outside loan review team analyzes theCompany’s methodology for calculating the allowance for loan and lease lossesbased on the Company’s loss histories and policies. The Company uses amigration analysis as part of its allowance for loan and lease lossesevaluation, which is a method by which specific charge-offs are related to theprior life of the same loan compared to the total loan pools in which the loanwas graded. This method allows for management to use historical trends that arerelative to the Company’s portfolio rather than use outside factors that may nottake into consideration trends relative to the specific loan portfolio. Inaddition, this analysis takes into consideration other trends that arequalitative relative to the Company’s marketplace, demographic trends, amountand trends in nonperforming assets and concentration factors.

 

*Premises and Equipment, Net*

 

Premises and equipment are presented at costless accumulated amortization and depreciation. Depreciation of furniture,fixtures and equipment is determined using the straight-line method over the estimateduseful lives (3 years to 5 years) of each type of asset. Leasehold improvementsare amortized using the straight-line method over the term of the relatedleases or the service lives (10 years to 20 years) of the improvements,whichever is shorter. Gains and losses on dispositions are reflected in currentoperations. Maintenance and repairs are charged to other operating expenses asincurred.

 

*Other Real Estate Owned*

 

Other Real Estate Owned (“OREO”) is comprisedof real estate acquired in satisfaction of loans. Properties acquired byforeclosure or deed in lieu of foreclosure are transferred to OREO and areinitially recorded at the lower of the loan balance or fair value at the dateof transfer of the property, establishing a new cost basis. Subsequently, OREOis carried at the lower of cost or fair value less costs to sell. The fairvalue of the OREO property is based upon a current appraisal. Losses thatresult from the ongoing periodic valuation of these properties are charged toother operating expenses in the period in which they are identified. Expensesfor holding costs are charged to other operating expenses as incurred.

 

*Income Taxes*

 

The Company and the Banks file consolidatedfederal income tax returns and combined state income tax returns.

 

Deferred tax assets and liabilities arerecognized for the expected future tax consequences of existing differencesbetween financial reporting and tax reporting bases of assets and liabilities,as well as for operating losses and tax credit carryforwards, using enacted taxlaws and rates. Deferred tax assets will be reduced through a valuationallowance whenever it becomes more likely than not that all or some portionwill not be realized. Deferred income taxes (benefit) represents the net changein deferred tax asset or liability balance during the year. This amount,together with income taxes currently payable or refundable in the current year,represents the total tax expense (benefit) for the year.

 

45

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*Comprehensive Income*

 

Comprehensive income is defined as the changein equity during a period from transactions and other events and circumstancesfrom nonowner sources. The accumulated balance of other comprehensive income isdisplayed as a component of equity in the consolidated balance sheet.

 

Each classification of other comprehensiveincome together with total comprehensive income is reported in the consolidatedstatements of changes in shareholders’ equity. The following table presents theaccumulated balances of each classification of other comprehensive income, andthe related income tax expense or benefit, as of the dates indicated:

 

| ** **                                                                                  | ** ** | **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 | ) |

 

*Earnings per Share*

 

Basic earnings per share is computed usingthe weighted average number of common shares outstanding during the period. Thefollowing table is a reconciliation of net income and shares used in thecomputation of basic and diluted earnings per share for the periods indicated:

 
| ** **                                    | ** ** | **Earnings  available to  shareholders** | ** ** | **Weighted  Average  Shares** | ** ** | **Per share  amount** | ** ** |
|-----------------------------------------------|------------|-----------------------------------------------|------------|-------------------------------|------------|----------------------------|------------|
| ** **                                    | ** ** | **(in thousands)**                       | ** ** | ** **                    | ** ** | ** **                 | ** ** |
|                                          |       |                                          |       |                          |       |                       |       |
| *For the  year ended December 31, 2005:* |       |                                          |       |                          |       |                       |       |
| Basic EPS                                     |       | $4,681                                        |       | 3,704,149                     |       | $1.26                      |       |
|                                          |       |                                          |       |                          |       |                       |       |
| Effect of  dilutive securities:               |       |                                          |       |                          |       |                       |       |
| Options                                       |       |                                          |       | 209,235                       |       |                       |       |
| Convertible  preferred stock                  |       |                                          |       | 804,822                       |       |                       |       |
| Diluted  earnings per share                   |       | $4,681                                        |       | 4,718,206                     |       | $0.99                      |       |
|                                          |       |                                          |       |                          |       |                       |       |
| *For the  year ended December 31, 2004:* |       |                                          |       |                          |       |                       |       |
| Basic EPS                                     |       | $2,186                                        |       | 2,895,309                     |       | $0.75                      |       |
|                                          |       |                                          |       |                          |       |                       |       |
| Effect of  dilutive securities:               |       |                                          |       |                          |       |                       |       |
| Options                                       |       |                                          |       | 153,461                       |       |                       |       |
| Convertible  preferred stock                  |       |                                          |       | 1,506,852                     |       |                       |       |
| Diluted  earnings per share                   |       | 2,186                                         |       | 4,555,622                     |       | $0.48                      |       |

 

*Fair Value of Financial Instruments*

 

Estimated fair value amounts have beendetermined using available market information and appropriate valuationmethodologies. Considerable judgment is required to interpret market data andto develop the estimates of fair value. Accordingly, the estimates of fairvalue in the financial statements are not necessarily indicative of the amountsthe Company could realize in a current market exchange. The use of differentmarket assumptions and estimation methodologies may have a material effecton the estimated fair value amounts.

 

46

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* *

*Stock Options*

 

The Company applies Accounting PrinciplesBoard Opinion No. 25 and related Interpretations in accounting for the stockincentive plans. SFAS No. 123, “Accounting for Stock-Based Compensation,”encourages, but does not require, companies to record compensation cost forstock-based employee compensation plans at fair value. Compensation expense isrecorded on the date of grant only if the current market price of theunderlying stock exceeded the exercise price. All options were granted at currentmarket prices, accordingly, no compensation cost has been recognized for theplans. Pro forma net income and pro forma earnings per share disclosures foremployee stock option grants are based on recognition as expense, over thevesting period, the fair value on the date of grant of all stock-based awardsmade during 2005 and 2004.

 

The estimated per share weighted average fairvalue of options granted was $9.86 and $7.22 during 2005 and 2004. The Companyapplies Accounting Principles Board Opinion No. 25 and related Interpretationsin accounting for the stock incentive plans. SFAS No. 123, “Accounting forStock-Based Compensation,” encourages, but does not require, companies torecord compensation cost for stock-based employee compensation plans at fairvalue. Accordingly, no compensation cost has 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. Basicand diluted earnings per share would have decreased by $0.07 and $0.06 for2005, respectively. Basic and diluted earnings per share would have decreasedby $0.05 and $0.03 for 2004, respectively.

 

The fair values of options granted during2005 and 2004 were estimated on the date of grant using the Black-Scholesoption-pricing model with the following weighted-average assumptions used:2005— no dividend yield, expected volatility of 43%, risk-free interest rate of4.38%, and an expected life of 10 years; 2004— no dividend yield, expectedvolatility of 56%, risk-free interest rate of 4.23%, and an expected life of 10years.

 

**Note 2—Goodwill and Other Intangible Assets**

 

As of December 31, 2005, the Company hadgoodwill of $3.2 million and core deposit intangibles with a carrying amount of$2.3 million less accumulated amortization of $900,000 from the acquisition ofSouth Bay in 2001. In accordance with SFAS No. 142 goodwill is not amortized. SFASNo. 142 also requires an analysis of impairment of goodwill annually or morefrequently upon the occurrence of certain events. The Company has no otherindefinite-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 ofgoodwill and core deposit intangibles were conducted, and based upon theseevaluations, the Company’s goodwill and core deposit intangibles were notimpaired at December 31, 2005.

 

**Note 3—Investment Securities**

 

The following is a summary of amortized cost,gross unrealized gains, gross unrealized losses, and estimated fair values ofthe Company’s investment securities available-for-sale and held-to-maturity atthe date indicated:

 

47

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

 

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

 

The estimated fair value and amortized costof securities available-for-sale and held-to-maturity at December 31, 2005by contractual maturity, are shown below:

 

48

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| ** **                                                                | ** ** | **Within  one year** | ** ** | **After  one but  within five years** | ** ** | **After  five but  within ten years** | ** ** | **After  ten years** | ** ** | ** ** | ** ** | **Weighted  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 |   | — |   |

 
| ** **                                            | ** ** | **Within  one year** | ** ** | **After  one but  within five years** | ** ** | **After  five but  within ten years** | ** ** | **After  ten years** | ** ** | ** ** | ** ** | **Weighted  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 | % |

 

Actual maturities may differ from contractualmaturities to the extent that borrowers have the right to call or prepayobligations with or without call or repayment penalties.

 

Investment securities totaling $3.1 millionwere pledged to secure government tax deposits, bankruptcy deposits, or forother purposes required or permitted by law at December 31, 2005. Investmentsecurities totaling $70.0 million were pledged to secure Federal Home Loan Bank(FHLB) borrowings and available credit.

 

*Impaired Securities*

 

The Company assessed whether there is an “other-than-temporary”impairment to any investment securities. Any security for which the currentfair value is less than the carrying value is considered impaired. On aquarterly basis, impaired securities are evaluated to determine if theimpairments are other-than-temporary. For those securities that are identifiedas having an other-than-temporary impairment, the loss is reported as a reductionin current period income. For all other temporary impairments, the currentperiod unrealized losses are recorded to other comprehensive income.

 

As of December 31, 2005, temporarilyimpaired securities had a fair value of $67.4 million and unrealized losses of$775,000. Securities that were not impaired had a fair value of $6.8 millionand unrealized gains of $65,000 at December 31, 2005. The following tableshows fair value and unrealized loss positions of temporarily impairedsecurities, categorized by whether the securities have been impaired for lessthan twelve months or if they have been impaired for twelve months or more asof December 31, 2005.

 

49

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| ** **                                                                | ** ** | **Less than 12 months** | ** ** | **12 months or longer** | ** ** | **Total**              | ** ** |
|---------------------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|------------------------|------------|
| **Fair value**                                                            | ** ** | **Unrealized  losses**  | ** ** | **Fair value**          | ** ** | **Unrealized  losses** | ** ** | **Fair value** | ** ** | **Unrealized  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 | ) |

 

The securities were impaired due to declinesin fair values resulting from increases in market interest rates from the timeof purchase. The privately issued securities were collateralized by mortgages. Noneof these securities has exhibited a notable decline in value as a result ofchanges in credit risk. These debt securities are relatively short in duration,accordingly, any unrealized loss in an individual issue will diminish as thesecurity 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 securitiesachieve their primary purpose of providing liquidity without being sold. Assuch, the company has the ability to hold the securities to maturity and doesnot consider the impairment of these securities to be other-than-temporary.

 

**Note 4 - Loans Receivable and Allowance forLoan and Lease Losses**

 

The following is a summary of the majorcategories of loans 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                        | %          |
|                                                                       |            |                             |            |  |  |

 

At December 31, 2005 and 2004, theCompany had no impaired loans, and therefore, no specific allowancesestablished for impaired loans. No interest income was recognized on impairedloans during the years ended December 31, 2005 and 2004.

 

In the normal course of business, the Banksmay make loans to officers and directors as well as loans to companies andindividuals affiliated with or guaranteed by officers and directors of theCompany and the Banks. Such loans are made in the ordinary course of  business at rates and terms no more favorablethan those offered to other customers with a similar credit standing. Theoutstanding principal balance of these loans was $4.9 million atDecember 31, 2005 and $2.0 million at December 31, 2004. During 2005there were $3.4 million of advances and $465,000 of repayments. Interest incomerecognized on these loans amounted to $199,000 and $374,000 during 2005 and2004, respectively. At December 31, 2005, none of these loans were onnonaccrual status. Based on analysis of information presently known to managementabout the loans to officers and directors and their affiliates, managementbelieves all have the ability to comply with the present loan repayment terms.

 

Loans receivable totaling $37.6 million werepledged to the FHLB to collateralize borrowing lines.

 

The following is a summary of activity in theallowance for loan and lease losses for the year ended December 31, 2005:

 

50

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| ** **                                                         | ** ** | **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 losses was recorded based upon the analysisof the adequacy of allowance for loan and lease losses. The allowance for loanand lease 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. Theallowance for unsecured classified loans is based upon the severity of thecredit weakness.

 

The following is a summary of nonperformingloans at December 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        |   |

 

Interest foregone on nonperforming loansoutstanding at December 31, 2005 and 2004 was $11,000 and $12,000,respectively. Foregone interest on nonperforming loans does not includeinterest forgone on loans on nonperforming status that were restored toperforming status prior to year end, or subsequent to either being charged offprior to year end or transferred to OREO prior to year end.

 

The ability of the Company’s borrowers tofulfill their loan agreements is substantially dependent upon economicconditions and real estate market values throughout the Company’s market area.At December 31, 2005, loans aggregating $242.9 million were collateralizedby liens on residential and commercial real properties, nearly all of which arelocated in California. While the Company’s loan portfolio is generallydiversified with regard to the industries represented, at December 31,2005, the Company’s loans to businesses and individuals engaged inentertainment industry related activities amounted to $32.0 million.

 

*Troubled Debt Restructurings (“TDRs”).*ATDR is a loan for which the Company has, for economic or legal reasons relatedto a borrower’s financial difficulties, granted a concession to the borrower itwould not otherwise consider, including modifications of loan terms toalleviate the burden of the borrower’s near-term cash flow requirements inorder to help the borrower to improve its financial condition and eventualability to repay the loan. At December 31, 2005, the Company had no TDRs.

 

**Note 5 – Premises and Equipment and LeaseCommitments**

 

The following is a summary of major components of premises andequipment at December 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 in 2005 and $409,000 in 2004. Rental expense on operating leasesincluded in occupancy expense in the Consolidated Statements of Operations was$675,000 in 2005 and $669,000 in 2004.

 

51

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The future minimum annual rental commitmentsat 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      |   |

 

**Note 6—Income Taxes**

 

The components of income tax provisionconsisted of the following for the years ended December 31:

 
| ** **                 | ** ** | **2005**                             | ** ** | **2004** | ** ** |
|----------------------------|------------|--------------------------------------|------------|----------|------------|
| ** **                 | ** ** | **(Dollars in thousands)** | ** ** |
| ** **                 | ** ** | ** **                           | ** ** |
| Current taxes              |       | $                                    | 1,112      |     | $          | 65 |   |
| Deferred taxes             |       | 2,210                                |       | 1,518    |       |
| Total income tax provision |       | $                                    | 3,322      |     | $          | 1,583 |   |

 

A reconciliation of the amounts computed byapplying the federal statutory rate of 34% for 2005 and 2004 to the incomebefore income tax provision and the effective tax rate are as follows:

 
| ** **                                     | ** ** | **2005**                             | ** ** | **2004** | ** ** |
|------------------------------------------------|------------|--------------------------------------|------------|----------|------------|
| ** **                                     | ** ** | **Amount**                           | ** ** | **Rate** | ** ** | **Amount** | ** ** | **Rate** | ** ** |
| ** **                                     | ** ** | **(Dollars in thousands)** | ** ** |
| Tax provision at statutory rate                |       | $                                    | 2,721      |     | 34.0       | % | $ | 1,281 |   | 34.0 | % |
| Increase (reduction) in taxes resulting  from: |       |                                 |       |     |       |   |   |   |   |
| State taxes                                    |       | 577                                  |       | 7.2      | %          | 270 |   | 7.2 | % |
| Permanent differences                          |       | 24                                   |       | 0.3      | %          | 32 |   | 0.8 | % |
|                                           |       | $                                    | 3,322      |     | 41.5       | % | $ | 1,583 |   | 42.0 | % |

 

52

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The major components of the net deferred taxasset at December 31, 2005 are as follows:

 
| ** **                                 | ** ** | **2005**                             | ** ** | **2004** | ** ** |
|--------------------------------------------|------------|--------------------------------------|------------|----------|------------|
| ** **                                 | ** ** | **(Dollars in thousands)** | ** ** |
| Deferred tax assets:                       |       |                                 |       |     |       |
| Net operating losses                       |       | $                                    | 1,992      |     | $          | 4,725 |   |
| Securities available for sale              |       | 818                                  |       | —   |       |
| 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                              |       | 11.5                                 |       | 86       |       |
| Securities aquired in business combination |       | 47                                   |       | 47       |       |
| State taxes                                |       | 302                                  |       | 63       |       |
| Other real estate owned                    |       | 31                                   |       | 31       |       |
| Other                                      |       | 49                                   |       | 7        |       |
| Total deferred tax assets                  |       | 4,917                                |       | 6,334    |       |
|                                       |       |                                 |       |     |       |
| 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                     |       | $                                    | 4,083      |     | $          | 5,280 |   |

 

For tax purposes at December 31, 2005, theCompany 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. TheCompany believes that it is more likely than not that the  deferredtax asset will be realized. Accordingly, no valuation allowance has been establishedagainst the deferred tax asset. 

** **

**Note 7—Benefit Plans**

 

*Stock Incentive Plans*.At December 31, 2005, the Company had two active stock incentive planspursuant to which up to a total of 918,510 shares of common stock may beissued. Under these plans, the Company may grant to directors, officers,employees and consultants stock-based incentive compensation in a variety offorms, including without limitation nonqualified options, incentive options,sales and bonuses of common stock and stock appreciation rights, on such termsand conditions as the Board of Directors of the Company determines. However,the exercise price of options granted to nonemployee directors may not be lessthan the fair market value of the common stock on the date of grant. AtDecember 31, 2005, the only outstanding awards under these plans werestock options, and at that date 160,059 shares were available for futureawards.

 

At December 31, 2005, there were alsooutstanding options granted under a prior stock incentive plan.

 

The following summarizes option grants,cancellations and exercises under the Company’s stock incentive plans for theperiods indicated.

 
| ** **                     | ** ** | ** ** | ** ** | **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 |   |
| Outstanding, December 31, 2005 |       | 519,358    |       | $                                                | 4.47       |   | - |   | $ | 19.25 |   |

 

53

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Of the outstanding options atDecember 31, 2005:  (i) options topurchase 336,158 shares were vested and exercisable; and (ii) the remainingoptions become exercisable as follows: 2006 —  113,500 and 2007 — 69,700.Options granted to employees expire on the tenth anniversary of the date of thegrant and vest (i) 100% one year from the date of the grant for grants lessthan 500 shares; and (ii) 50% after one year and 50% after two years from thedate of the grant for grants of 500 shares or more. Options granted tononemployee directors expire on the sixth anniversary of the date of the grantand vest one year from the date of the grant.

 

*Defined Contribution Retirement Plan.*The Company maintains a defined contribution retirement plan undersection 401(k) of the Internal Revenue Code. Employees are eligible toparticipate following six months of continuous employment. Under the plan, theCompany has partially matched employee contributions since May 1, 2001. Suchmatching contributions become fully vested when the employee reaches threeyears of service. The Company’s matching contributions for 2005 and 2004 were$121,000 and $115,000, respectively.

 

**Note 8—Deposits and Borrowed Funds**

 

At December 31, 2005 the scheduled maturityof time deposits 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 atDecember 31, 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 | % |

 

Other borrowings are comprised of FederalHome 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.

 

The Banks had $53.0 million of unusedborrowing capacity from the FHLB at December 31, 2005 based upon pledgedsecurities and loans.

 

**Note 9—Junior Subordinated DeferrableInterest Debentures**

 

In July 2001 the Company issued $15.5 millionaggregate principal amount of 10.25% fixed rate junior subordinated deferrableinterest debentures due July 25, 2031 (“Junior Subordinated Debentures’)that pay interest each January 26 and July 26. The interest is deferrable,at the Company’s option, for a period up to ten consecutive semi-annualpayments, but in any event not beyond June 25, 2031. The debentures areredeemable, in whole or in part, at the Company’s option on or after five yearsfrom issuance at declining premiums to maturity. The recorded balance of JuniorSubordinated Debentures was $15.5 million at December 31, 2005.

 

The Junior Subordinated Debentures are heldby National Mercantile Capital Trust I (the “Trust”), a Delaware businesstrust, formed by the Company for the sole purpose of issuing certain securitiesrepresenting undivided beneficial interests in the assets of the Trust andinvesting the proceeds thereof in the Junior 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.

 

54

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** **

**Note 10—Availability to National Mercantileof Funds from Banks; Restrictions on Cash Balances; Capital**

 

National Mercantile is a legal entityseparate and distinct from the Banks, and as such has separate and distinctfinancial obligations including annual deferrable debt service of $1.6 millionon the Junior Subordinated Debenture and other modest operating expenses. WhileNational Mercantile from time to time holds short-term investments, its assetsprimarily consist of the common shares of the Banks and it has historically notengaged in any other business activity. Accordingly, dividends and capitaldistributions from the Banks constitute the principal source of cash to theCompany. The Banks are subject to various statutory and regulatory restrictionson their ability to pay dividends to the Company.

 

OCC approval is required for a national bankto pay a dividend if the total of all dividends declared in any calendar yearexceeds the total of the bank’s net profits (as defined) for that year combinedwith its 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 any dividend that exceeds its retained netearnings, as defined by the OCC. The OCC and the Federal Reserve Board havealso issued banking circulars emphasizing that the level of cash dividendsshould bear 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 compliancewith regulatory capital requirements generally are not permitted to paydividends. The OCC also can prohibit a national bank from engaging in an unsafeor unsound practice in its business. Depending on the bank’s financialcondition, payment of dividends could be deemed to constitute an unsafe orunsound practice. Except under certain circumstances, and with prior regulatoryapproval, a bank may not pay a dividend if, after so doing, it would beundercapitalized. The Banks’ ability to pay dividends in the future is, andcould be, further influenced by regulatory policies or agreements and bycapital guidelines.

 

Mercantile has no retained earnings, andtherefore is presently unable to pay dividends. Mercantile has a substantialaccumulated deficit and does not anticipate having positive retained earningsfor the foreseeable future. South Bay had retained earnings of $3.0 million asof December 31, 2005. Mercantile and South Bay may from time to time bepermitted to make capital distributions to National Mercantile with the consentof the OCC. It is not anticipated that such consent could be obtained unlessthe distributing bank were to remain “well capitalized” following suchdistribution.

 

The Company is authorized to issue 1,000,000shares of preferred stock. The Company’s Board of Directors has the authorityto issue the preferred stock in one or more series, and to fix thedesignations, rights, preferences, privileges, qualifications and restrictions,including dividend rights, conversion rights, voting rights, rights and termsof redemption, liquidation preferences, and sinking fund terms.

 

The Company had previously issued 990,000shares of Series A non-cumulative convertible perpetual preferred stock (the“Series A Preferred”). During 2005, pursuant to an election of the holders of amajority of the outstanding shares of Series A Preferred, each outstanding shareof the Series A Preferred was automatically converted into two shares of theCompany’s Common Stock in accordance with the Company’s Amended and RestatedArticles of Incorporation, as amended.  As a result of this conversion, aswell as earlier conversions during 2005, 666,273 shares of Series A Preferredwere converted into 1,332,546 shares of Common Stock.

 

On December 10, 2001, the Company issued1,000 shares of Series B non-cumulative convertible perpetual preferred stock(the “Series B Preferred”) with a $1,000 stated value per share. At any timeafter June 30, 2005 each holder of the Series B Preferred has the right,exercisable at the option of the holder, to convert some or all of suchholder’s shares of Series B Preferred into Common Stock at a conversion priceof $7.04 per share of Common Stock (the “Conversion Price”). The number ofshares of Common Stock to be issued upon conversion for each share of Series BPreferred is determined by dividing an amount per share then in effect (the“Liquidation Amount”) by the Conversion Price. The Liquidation Amount per shareof Series B Preferred as of any date is the sum of (i) the stated value of eachshare of Series B Preferred, adjusted to reflect stock splits, stock dividends,reorganizations, consolidations and similar changes, plus (ii) an amount equalto 8.5% per annum of the stated value of the shares of Series B Preferredcommencing from the date of issue. The Company, at its sole option, may redeemall Series B Preferred, at any time, from legally available funds at theLiquidation Amount. The Series B Preferred contains a liquidation preferenceover the Common Stock in the amount of the Liquidation Amount.

 

Federal law restricts the Banks’ extension ofcredit to, the issuance of a guarantee or letter of credit on behalf of,investments in or taking as collateral stock or other securities of NationalMercantile. Restrictions prevent National Mercantile from borrowing from theBanks unless the loans are secured by designated amounts of marketable obligations.Further, secured loans to and investments in National Mercantile or itsaffiliates by a bank are limited to 10% of the bank’s capital stock and surplus(as defined by federal regulations) and are limited, in the aggregate, to 20%of the bank’s contributed capital (as defined by federal regulations).

 

Federal Reserve Board regulations require theBanks to maintain certain minimum reserve balances. Cash balances maintained tomeet reserve requirements are not available for use by the Banks or NationalMercantile. During 2005 and 2004, the average reserve balances for the Bankswere approximately $2.7 million and $6.5 million, respectively. NeitherNational Mercantile nor the Banks is required to maintain compensating balancesto assure credit availability under existing borrowing arrangements.

 

55

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National Mercantile and the Banks are subjectto various capital requirements administered by the federal banking regulatoryagencies. Failure to meet minimum capital requirements can initiate certainmandatory—and possibly additional discretionary—actions by regulators that, ifundertaken, could have a direct material effect on National Mercantile’sfinancial statements. Under capital adequacy guidelines and the regulatoryframework for prompt corrective action, National Mercantile and Banks must meetspecific capital guidelines that involve quantitative measures of NationalMercantile’s and the Banks’ assets, liabilities and certain off-balance-sheetitems as calculated under regulatory accounting practices. NationalMercantile’s and the Banks’ capital amounts and classification are also subjectto qualitative judgment by the regulators about components, risk weightings andother factors.

 

Quantitative measures established byregulation to ensure capital adequacy require National Mercantile and the Banksto maintain minimum amounts and ratios (set forth in the table below) of totaland Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined).Management believes, as of December 31, 2005, National Mercantile andBanks meet all capital adequacy requirements to which they are subject.

 

At December 31, 2005, each Bank wascategorized as well capitalized under the regulatory framework for promptcorrective action. To be categorized as well capitalized under the promptcorrective action rules, each Bank must maintain minimum total risk-based, Tier1 risk-based and Tier 1 leverage ratios as set forth in the following table.There are no conditions or events since the most recent notification whichmanagement believes have changed the Banks’ category.

 

The following table presents, at the dateindicated, certain information regarding the regulatory capital of NationalMercantile and the Banks and the required amounts of regulatory capital forNational Mercantile and the Banks to meet applicable regulatory capitalrequirements and, in the case of the Banks, to be well capitalized under theprompt corrective action 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)** | ** ** |
| As of December 31, 2005                |                        |       |       |                  |       |             |       |                  |       |                  |       |   |   |
| Total Capital to Risk Weighted Assets  |                        |       |       |                  |       |             |       |                  |       |                  |       |   |   |
| National Mercantile Bancorp            |                        | $          | 53,806     |                  | 13.87      | %                | $          | 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            |                        | 46,787     |       | 12.06                 | %          | 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            |                        | 46,787     |       | 10.80                 | %          | 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 | % |
|                                        |                             |            |            |                       |            |                  |            |                       |            |                       |            |  |  |  |  |  |

 

**Note 11—Commitments and Contingencies**

 

In the normal course of business, the Companyis a party to financial instruments with off-balance sheet risk. Thesefinancial instruments include commitments to extend credit, letters of creditand financial guarantees. These instruments involve, to varying degrees,elements of credit and interest rate risk in excess of the amount reflected inthe consolidated balance sheet.

 

Exposure to credit loss in the event ofnonperformance by the other party to the financial instrument for letters ofcredit and financial guarantees written is represented by the contractualnotional amount of those instruments. The Company uses the same credit policiesin making commitments and conditional obligations as it does for on-balancesheet instruments.

 

The Company had $1.1 million of outstandingletters of credit at December 31, 2005.

 

Loan commitments are agreements to lend to acustomer a specified amount subject to certain conditions. Loan commitmentsgenerally have fixed expiration dates or other termination clauses and mayrequire payment of a fee. Since portions of the commitments are expected toexpire without being drawn upon, the total amount of commitments does notnecessarily represent future cash requirements. The Company had outstandingloan commitments aggregating $120.8 million at December 31, 2005,substantially all of which were for adjustable rate loans.

 

The Company from time to time is party tolawsuits that arise in the normal course of business. The Company does notbelieve that any pending lawsuit at December 31, 2005 will have a materialadverse effect on the financial position or results of operations of theCompany.

 

56

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**Note 12—Disclosures about the Fair Value ofFinancial Instruments**

 

The following methods and assumptions wereused to estimate the fair value of each class of financial instruments forwhich it is practical to estimate that value.

 

*Cash and cash equivalents*:For these short-term investments, the carrying amount is a reasonableestimation of fair value.

 

*Securities available-for-sale and securitiesheld-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 beredeemed at the carrying amount, therefore, the carrying amount is a reasonableestimation of fair value.

 

*Loans*: Variable rateloans have carrying amounts that approximate fair value. The fair value offixed rate loans is estimated by discounting the future cash flows using thecurrent rates at which similar loans would be made to borrowers with similarcredit ratings and for the same remaining maturities. In establishing thecredit risk component of the fair value calculations for loans, the Companyconcluded the allowance for loan and lease losses represented a reasonableestimate of the credit risk component of the fair value at December 31,2005.

 

*Interest rate swapsand floors:* The fair value of the interest rateswaps and floors is based upon an estimate derived from broker quotations orproprietary broker models that consider the relevant characteristics of theinstrument.

 

*Deposits*: The fairvalue of demand and interest checking deposits, money market accounts andsavings accounts is the amount payable on demand at the reporting date. Thefair value of time certificates of deposit is estimated by discounting thefuture cash flows using the rates currently offered for deposits of similarmaturities.

 

*Federal fundspurchased and securities sold under agreements to repurchase*:The fair 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 subordinateddeferrable interest debentures:*  The fair valueof the junior subordinated deferrable interest debentures is estimated as thesum of the carrying amount and the fair value of the mirrored interest rateswap hedging the debentures.

 

*Other borrowings*: Thefair value of fixed-rate borrowings is estimated by discounting the future cashflows using the rates currently offered for borrowings of similar maturities.Borrowings with maturities greater than one year bear interest at variablerates and approximate fair value.

 

The estimated fair values of financialinstruments at the date indicated are presented below.

 
| ** **                                                            | ** ** | **December 31, 2005**      | ** ** |
|-----------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                            | ** ** | **Carrying**                         | ** ** | **Fair** | ** ** |
| ** **                                                            | ** ** | **Amount**                           | ** ** | **Value** | ** ** |
| ** **                                                            | ** ** | **(Dollars in thousands)** | ** ** |
| 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 |   |
| Interest rate floors                                                  |       | 286                                  |       | 286 |   |
| 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                               |       | 14,889 |   |
| Other borrowings                                                      |       | 28,337                               |       | 28,337 |   |
| Interest rate swaps designated as:                                    |       |                                 |       |   |   |
| Cash flow hedges                                                      |       | 1,034                                |       | 1,034 |   |
| Fair value hedges                                                     |       | —                               |       | 575 |   |
|                                                                       |            |                                      |            |  |  |  |  |

 

**Note 13—Derivatives**

 

The Company holds fixed rate and variablerate financial assets that are funded by fixed rate and variable rate liabilities.Consequently, they are subject to the effects of changes in interest rates. Inresponse to this, the Company has developed an interest rate risk managementpolicy with the objective of mitigating financial exposure to changing interestrates. These exposures are managed, in

 

57

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part, with the use of derivatives but only to the extent necessary tomeet the overall goal of minimizing interest rate risk.

 

Derivatives are accounted for according toStatement of Financial Accounting Standards No. 133, Accounting for DerivativeInstruments and Hedging Activities, as amended. 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 qualifyfor hedge accounting, the details of the hedging relationship must be formallydocumented at inception of the arrangement, including the risk managementobjective, hedging strategy, hedged item, specific risks that are being hedged,the derivative instrument and how effectiveness 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 evaluatedon a retrospective and prospective basis. If a hedge relationship becomesineffective, it no longer qualifies as a hedge. Any excess gains or lossesattributable to such ineffectiveness, as well as subsequent changes in the fairvalue of the derivative, 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**                         | ** ** | ** **                      | ** ** | **Notional** | ** ** | ** ** | ** ** |
| ** **           | ** ** | **Amount**                           | ** ** | **Fair Value**             | ** ** | **Amount** | ** ** | **Fair Value** | ** ** |
| ** **           | ** ** | **(Dollars in thousands)** | ** ** |
| Fair value hedges:   |       |                                 |       |                            |       |   |   |   |   |
| Interest rate swaps  |       | $                                    | 45,000     |                            | $          | (575 | ) | $ | 15,000 |   | $ | (311 | ) |
|                 |       |                                 |       |                            |       |   |   |   |   |
| Cash flow hedges:    |       |                                 |       |                            |       |   |   |   |   |
| Interest rate swaps  |       | $                                    | 50,000     |                            | $          | (1,034 | ) | $ | 50,000 |   | $ | 406 |   |
| Interest rate floors |       | $                                    | 50,000     |                            | $          | 286 |   | $ | — |   | $ | — |   |
|                 |       |                                 |       |                            |       |   |   |   |   |
| Other derivatives:   |       |                                 |       |                            |       |   |   |   |   |
| Interest rate floors |       | $                                    | 150,000    |                            | $          | — |   | $ | — |   | $ | — |   |

 

Fair value hedges are hedges that minimizethe risk of changes in the fair values of assets, liabilities and certain typesof firm commitments. The Company uses interest rate swaps to hedge the changein fair value of its junior subordinated deferrable interest debentures andportions 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 paidor received on such interest rate swaps is recognized as an adjustment tointerest expense. The net change in fair value of the derivatives and thehedged items is reported in earnings. The fair value hedges are highlyeffective and therefore no ineffectiveness was recognized in current earningsrelated to this swap.

 

Cash flow hedges are hedges that use simplederivatives to offset the variability of expected future cash flows. TheCompany’s cash flow hedges include certain interest rate swaps and interestrate floors used to manage the interest rate risk associated with itssignificant volume of adjustable rate loans. At December 31, 2005 a loss of$605,000 was recorded in accumulated other comprehensive income and noineffectiveness was recorded to earnings for the year ended December 31, 2005related to these interest rate swaps. As of December 31, 2004, the Company hadrecorded $314,000 accumulated other comprehensive income related to theinterest rate swaps. At December 31, 2005 a loss of $157,000 was recorded inaccumulated other comprehensive income related to the interest rate floors.Ineffectiveness related to the interest rate floors designated as cash flowhedges of $24,000 was charged to earnings for the year ended December 31, 2005.There were no interest rate floors at December 31, 2004.

 

Other derivatives not designated as hedgesare interest rate floors that do not meet the strict criteria for hedgeaccounting treatment. We use derivatives to hedge exposures when it makeseconomic sense to do so, including circumstances in which the hedgingrelationship does not qualify for hedge accounting. Derivatives not designatedas hedges are marked to market through earnings. During 2005, the Companypurchased a one year interest rate floor to help protect its net interestincome in the event of a rapid decline in interest rates and permit it to executeother strategies to protect against declining interest rates over time. Therewas an $8,000 charge to earnings during the year ended December 31, 2005writing the value of this floor to zero.

 

**Note 14—Parent Company Information**

 

The following financial information presentsthe condensed balance sheet of the Company on a parent-only basis as ofDecember 31, 2005, and the related condensed statements of operations andcash flows for each of the years in the two-year period ended December 31,2005.

 

58

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**Balance Sheet**

 

| ** **                                          | ** ** | **December 31,**           | ** ** |
|-----------------------------------------------------|------------|---------------------------------|------------|
| ** **                                          | ** ** | **2005**                        | ** ** |
| ** **                                          | ** ** | **(Dollars in  thousands** | ** ** |
| ** **                                          | ** ** | ** **                      | ** ** |
| Cash with Banks                                     |       | $                               | 137        |   |
| Due from banks - time                               |       | 1,015                           |       |
| Securities available-for-sale                       |       | 974                             |       |
| Investment in the Banks                             |       | 48,558                          |       |
| Other assets                                        |       | 4,056                           |       |
| Total assets                                        |       | $                               | 54,740     |   |
|                                                |       |                            |       |
| 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                                 |       | (7,044                          | )          |
| Accumulated other comprehensive income              |       | (1,154                          | )          |
| Total shareholders’ equity                     |       | 38,499                          |       |
| Total liabilities and shareholders’ equity     |       | $                               | 54,740     |   |

 

59

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**Statementsof Operations**

 
| ** **                                                  | ** ** | **Year ended December 31,** | ** ** |
|-------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                  | ** ** | **2005**                                   | ** ** | **2004** | ** ** |
| ** **                                                  | ** ** | **(Dollars in thousands)**       | ** ** |
|                                                        |       |                                       |       |   |   |
| Interest income                                             |       | $                                          | 61         |   | $ | 33 |   |
| Interest expense                                            |       | 1,238                                      |       | 966 |   |
| Net interest expense                                        |       | (1,177                                     | )          | (933 | ) |
|                                                        |       |                                       |       |   |   |
| Other operating income                                      |       | 1                                          |       | 144 |   |
| Other operating expense                                     |       | 374                                        |       | 238 |   |
| Loss before equity in undistributed net  income of the Bank |       | (1,550                                     | )          | (1,027 | ) |
| Equity in undistributed net income of  subsidiaries         |       | 5,588                                      |       | 2,790 |   |
| Income before income tax provision  (benefit)               |       | 4,038                                      |       | 1,763 |   |
| Income tax benefit                                          |       | 643                                        |       | 423 |   |
| Net income                                                  |       | $                                          | 4,681      |   | $ | 2,186 |   |

 

**Statementsof Cash Flow**

 
| ** **                                                                         | ** ** | **Year ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                         | ** ** | **2005**                                   | ** ** | **2004** | ** ** |
| ** **                                                                         | ** ** | **(Dollars in thousands)**       | ** ** |
| Cash flows from operating activities:                                              |       |                                       |       |   |   |
| Net income                                                                         |       | $                                          | 4,681      |   | $ | 2,186 |   |
| Adjustment to reconcile net income to net  cash provided by operating activities.: |       |                                       |       |   |   |
| Equity in undistributed net income of  subsidiaries, net                           |       | (5,588                                     | )          | (2,790 | ) |
| Net increase in other assets and other  liabilities                                |       | (1,494                                     | )          | (615 | ) |
| 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 |   |

 

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**Note 15—Recent Accounting Developments**

 

*Accounting for Share-Based Payments*

 

In December 2004, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standards No.123R, Accounting for Share-Based Payments (“SFAS No. 123R”), which replacesSFAS No. 123 and supersedes APB Opinion No. 25. SFAS No. 123R requires allshare-based payments to employees, including grants of employee stock options,to be recognized in the financial statements based on their fair values,beginning with the first annual period after June 15, 2005, with early adoptionencouraged. In addition, SFAS No. 123R will cause unrecognized expense relatedto options vesting after the date of initial adoption to be recognized as acharge to results of operations over the remaining vesting period. The Companyis required to adopt SFAS No. 123R in its first quarter of 2006, beginningJanuary 1, 2006. Under SFAS No. 123R, the Company must determine theappropriate fair value model to be used for valuing share-based payments, theamortization method for compensation cost and the transition method to be usedat the date of adoption. The transition alternatives include prospective andretroactive adoption methods. Under the retroactive methods, prior periods maybe restated either as of the beginning of the year of adoption or for allperiods presented. The prospective method requires that compensation expense berecorded for all unvested stock options and share awards at the beginning ofthe first quarter of adoption of SFAS No. 123R, while the retroactive methodswould record compensation expense for all unvested stock options and shareawards beginning with the first period restated. 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 of share-based employee compensation costthat would have been determined consistent with SFAS No. 123 and the pro formaearnings per share amounts for the years ended December 31, 2004, 2003 and 2002are shown in Note 1 of the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.

 

In May 2005, the FASB issued Statement ofFinancial Accounting Standards No. 154, “Accounting Changes and ErrorCorrections” (“SFAS No. 154”). SFAS No. 154 provides guidance on theaccounting for and reporting of accounting changes and error corrections. Itrequires, unless impracticable, retrospective application for reporting changesin accounting principle in the absence of explicit transition requirementsspecific to this newly adopted accounting principle. SFAS No. 154 iseffective for accounting changes and corrections of errors made in fiscal yearsbeginning 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.

 

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**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) |
|        |       |                                                                                                                                                                                                                                                                                                          |
| 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                                               |
|        |       |                                                                                                                                                                                                                                                                                                          |
| 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                                                                                                                                                                                                                          |
|        |       |                                                                                                                                                                                                                                                                                                          |
| 10.5        |       | Registration Rights Agreement between the Company and Conrad Company  (5)                                                                                                                                                                                                                                     |
|        |       |                                                                                                                                                                                                                                                                                                          |
| 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                                                                                                                            |
|        |       |                                                                                                                                                                                                                                                                                                          |
| 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                                                                                                                                   |
|        |       |                                                                                                                                                                                                                                                                                                          |
| 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                                                                                                                                   |
|        |       |                                                                                                                                                                                                                                                                                                          |
| 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                                                                                                                                     |
|        |       |                                                                                                                                                                                                                                                                                                          |
| 10.15       |       | Mercantile National Bank Deferred Compensation Plan and Form of  Agreement                                                                                                                                                                                                                                    |
|        |       |                                                                                                                                                                                                                                                                                                          |
| 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)       |
|        |       |                                                                                                                                                                                                                                                                                                          |
| 21.         |       | Subsidiaries of the Registrant                                                                                                                                                                                                                                                                                |
|        |       |                                                                                                                                                                                                                                                                                                          |
| 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                                                                                                                                                                                                                                 |

 

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| 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      |

 

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

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

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

(4)           Filed as an exhibit toCompany’s Annual Report on Form 10-K for the year ended December 31, 1990 andincorporated herein by reference.

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

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

(7)           Filed as an exhibit tothe Company’s Report on Form 10-Q for the quarter ended September 30, 2001 andincorporated herein by reference.

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

(9)           Filed as an exhibit tothe Company’s Annual Report on Form 10-K for the year ended December 21, 2002and 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-K for the year ended December 21, 2003 andincorporated herein by reference.

 

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