**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**Form 10-KSB**

 

**ý****Annual report undersection 13 or 15(d) of the Securities Exchange Act of 1934**

**for the fiscal year ended December 31,2004**

 

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

**for the transition period from       to       .**

 

**Commission File Number 0-15982**

 

**NATIONAL MERCANTILE BANCORP**

(Exact name of small businessissuer in its charter)

 

| **California**                                                                                                                                                                                                      | ** ** | **95-3819685**                       |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of  incorporation or organization)                                                                                                                                                     |       | (I.R.S. Employer Identification No.) |
|                                                                                                                                                                                                                |       |                                 |
| **1880 Century Park East  Los Angeles, California**                                                                                                                                                                 |       | **90067**                            |
| (Address to principal executive offices)                                                                                                                                                                            |       | (Zip Code)                           |
|                                                                                                                                                                                                                |       |                                 |
| Issuer’s telephone number, including area  code:  **(310) 277-2265**

Securities registered pursuant to Section  12(b) of the Act: **None**

Securities registered pursuant to Section  12(g) of the Act: |
|                                                                                                                                                                                                                |
| **Common Stock, No Par Value  Series A Noncumulative Convertible Perpetual Preferred Stock  (Title of Class)**                                                                                                      |

 

Check whether the issuer:  (1)filed all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2)has been subject to such filing requirements for the past 90 days.     ý Yes         o   No

 

Check if there is no disclosure of delinquent filers to Item 405 ofRegulation S-B contained herein, and no disclosure will be contained, to theregistrant’s knowledge, in definitive in response or information statementsincorporated by reference in Part III of this Form 10-KSB. o

 

The issuer’s revenues for its most recent fiscal year:  $21.0 million.

 

The aggregate market value of the voting common equity held bynonaffiliates of the registrant, based upon the closing sale price of itsCommon Stock as reported by the National Association of Securities DealersAutomated Quotation System on March 21, 2004, was approximately $39.1million.

 

The number of shares of Common Stock, no par value, of the issueroutstanding as of March 21, 2004 was 3,004,334.

** **

**DOCUMENTS INCORPORATED BY REFERENCE**:

 

Certain portions of the Company’s Proxy Statement to be filed with theSecurities and Exchange Commission pursuant to Rule 14a-6 under the SecuritiesExchange Act of 1934 in connection with the Company’s 2005 Annual Meeting ofShareholders are incorporated by reference in Part III, Items 9-12 and 14 andis of this Annual Report on Form 10-KSB.

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

 

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**NATIONAL MERCANTILE BANCORP**

 

**Table of Contents**

 

**Form 10-KSB**

**For the Fiscal Year Ended December 31,2004**

 
| **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-KSB may constituteforward-looking statements within the meaning of the Securities Exchange Act of1934 (the “Exchange Act”) and as such may involve risks and uncertainties.  These forward-looking statements relate to,among other things, expectations of the business environment in which NationalMercantile Bancorp (referred to as “we” or “the Company” when such referenceincludes National Mercantile Bancorp and its subsidiaries, collectively,“National Mercantile” when referring only to the parent company and “the Banks”when referring only to National Mercantile’s banking subsidiaries, MercantileNational Bank and South Bay Bank, N.A.) operates, projections of futureperformance, perceived opportunities in the market and statements regarding ourmission and vision.  Our actual results,performance, or achievements may differ significantly from the results,performance, or achievements expressed or implied in such forward-looking statements.  Statements regarding policies and proceduresare not intended to imply, and should not be interpreted to mean, that we willconduct our business in accordance with such policies for any particular periodof time, as we may at any time and from time to time amend or repeal suchpolicies and adopt new policies.  Fordiscussion of the factors that might cause such a difference, see “Item 6.  Management’s Discussion and Analysis ofFinancial Condition or Plan of Operation— Factors Which May Affect FutureOperating Results”.

 

**PART I**

 

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

 

 

National Mercantile is a bank holding company whose 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 San Francisco to engage in lending activities separate from the Banks but to date has not done so.

 

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

 

We operate throughout the west side of Los Angeles County including theSouth Bay, Century City and San Fernando Valley with banking offices in CenturyCity, Torrance, Encino and El Segundo and a loan production office in BeverlyHills.  Additionally, we target OrangeCounty businesses through our loan production office in Costa Mesa, California.  

 

Our targeted market niches for businesses include the entertainmentindustry, the healthcare industry, professional services providers, the realestate escrow industry, property managers, public works contractors andcommunity-based nonprofit organizations.   Entertainment industry clients include television, music and filmproduction companies, talent agencies, individual performers, directors andproducers (whom we attract by establishing relationships with businessmanagement firms) and others affiliated with the entertainment industry.  Healthcare organizations include primarilyoutpatient healthcare providers such as physician medical groups, independentpractice associations and surgery centers. Professional service customers include legal, accounting, insurance,advertising firms and their individual directors, officers, partners andshareholders.  

 

We also engage in real estate andconstruction lending.  Our real estateloans are for the purchase or finance of principally smaller commercialproperties, including owner-occupied business facilities and retail properties,and to a lesser extent multi-family and single family residentialproperties.  We make construction loansfor small commercial, multi-family and single residential properties, includingtract developments and luxury homes for resale.  

 

In order to grow and expand our array of products and services, we mayfrom time to time open de novo branch banking offices or acquire otherfinancial service-related companies including “in-market” acquisitions withbanks of similar size and market presence. No assurance can be made that we will identify a company which can beacquired on terms and conditions acceptable to us or that we could obtain thenecessary regulatory approvals for such an acquisition.

 

We believe that banking clients value doing business with locallymanaged institutions that can provide a full service commercial bankingrelationship through an understanding of the clients’ financial needs and theflexibility to deliver customized solutions through our menu of products andservices.  We also believe that oursubsidiary Banks are better able to build successful client relationships asthe holding company provides cost effective administrative support serviceswhile promoting bank autonomy and flexibility in serving client needs.

 

To implement this philosophy, we operate each of our bank subsidiariesby retaining their independent names.  Eachbank

 

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subsidiary has established strong client followings in its market areasthrough attention to client service and an understanding of client needs.

 

In an effort to capitalize on the identities and reputations of theBanks, we intend to continue to market our services under each Bank’s name,primarily through each Bank’s relationship managers.  The primary focus for the Banks’ relationshipmanagers is to cultivate and nurture their client relationships.  Relationship managers are assigned to eachborrowing client to provide continuity in the relationship.  This emphasis on personalized relationshipsrequires that all of the relationship managers maintain close ties to thecommunities or industry niche in which they serve, so they are able tocapitalize on their efforts through expanded business opportunities for theBanks.

 

Client service decisions and day-to-day operations are maintained atthe Banks.  National Mercantile offersthe advantages of affiliation with a multi-bank holding company by providingexpanded client support services, such as increased client lending capacity,business cash management, and centralized administrative functions, includingclient services, support in credit policy formulation and review, investmentmanagement, data processing, accounting, loan servicing and other specializedsupport functions.  All of these centralizedservices are designed to enhance the ability of the relationship managers toexpand their client relationship base.

 

At December 31, 2004, we had total assets of  $391.1 million, total loans, net, of $309.9million and total deposits of $313.5 million.

 

**Corporate History**

 

Mercantile was organized in 1981 as a national banking association andcommenced operations through an office in Century City in 1982.  In 1983 National Mercantile was organizedunder the laws of the State of California and registered as a bank holdingcompany under the Bank Holding Company Act of 1956, as amended (the ‘‘BHCA’’),to serve as a holding company for Mercantile.

 

In March 2001, Mercantile opened a regional office in Encino,California which expanded our client-focused niche banking services to the SanFernando Valley area of Los Angeles.  InJanuary 2004, Mercantile opened a loan production office in Beverly Hills,California to focus on providing banking services to those affiliated with theentertainment industry.

 

In December 2001, National Mercantile acquired South Bay, whichhad offices in Torrance and El Segundo.  In January 2004, South Bay opened a loan production office in CostaMesa, California to expand our lending services to the Orange County area ofSouthern California.

 

**Competition**

 

The banking and financial services industry in California generally,and in the Banks’ market areas specifically, is highly competitive.  The increasingly competitive environment isprimarily a result of changes in regulation, changes in technology and productdelivery systems, and the accelerating pace of consolidation among financialservices providers.  Our primary servicearea is dominated by a relatively small number of major banks that have manyoffices operating over a wide geographical area.  We compete for loans, deposits, and customerswith other commercial banks, savings and loan associations, securities andbrokerage companies, mortgage companies, insurance companies, finance companies,money market funds, credit unions, and other nonbank financial serviceproviders.  Many of these competitors aremuch larger in total assets and capitalization, have greater access to capitalmarkets and offer a broader range of financial services than us.  Nondepository institutions can be expected toincrease the extent to which they act as financial intermediaries.  Large institutional users and sources ofcredit may also increase the extent to which they interact directly, meetingbusiness credit needs outside the banking system.  Furthermore, the geographic constraints onportions of the financial services industry can be expected to erode.  In addition, many of the major commercialbanks operating in our primary service area offer services, such as trustservices, which are not offered directly by us and, by virtue of their greatertotal capitalization, such banks have substantially higher lending limits.

 

To compete with other financial institutions in our primary servicearea, we rely principally upon personal contact by our officers, directors andemployees and providing, through third parties, specialized services such asmessenger, accounting and other related services.  For clients whose loan demands exceed ourlegal lending limit, we arrange for such loans on a participation basis withother banks.  We also assist clientsrequiring other services not offered by us in obtaining such services fromother providers.

 

 

**Economic Conditions and Government Policies**

 

Our profitability, like most financial institutions, is primarily dependent on interest rate differentials.  In general, the difference between the interest rates paid by us on our interest-bearing liabilities, such as deposits and other borrowings, and the interest rates received by us on our interest-earning assets, such as loans and investment securities, comprise the major portion of our earnings.  

 

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These rates are highly sensitive to many factors that are beyond our control, such as inflation, recession and unemployment, and the impact which future changes in domestic 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.

 

**Supervision and Regulation**

 

*General*

 

Banking is ahighly regulated industry.  Congress andthe states have enacted numerous laws that govern banks, bank holding companiesand 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 primarygoals of the regulatory scheme are to maintain a safe and sound banking system,to protect depositors and the Federal Deposit Insurance Corporation (“FDIC”)insurance fund, and to facilitate the conduct of sound monetary policy; theywere not adopted for the benefit of shareholders of the Company.  As a result, the Company’s financialcondition, results of operations, ability to grow and engage in variousbusiness activities can be affected not only by management decisions andgeneral economic conditions, but the requirements of applicable federal andstate laws, regulations and the policies of the various regulatory authorities.

 

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

 

Set forth below is a summary description of certain of the material laws and regulations that relate to the operations of National Mercantile and the Banks.  The description does not purport to be a complete description of these laws and regulations and is qualified in its entirety 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’s supervision, regulation and examination under the Bank Holding Company Act.

 

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

 

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

 

 

*The Banks*

 

Both Banks are national banks and members of the 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 Federal Deposit Insurance Corporation (“FDIC”) and the Federal Reserve.  The Banks are subject to requirements and restrictions

 

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under federal and state law, including requirements to maintain reserves against deposits, restrictions on the types and amounts of loans that may be granted and limitations on the types of investments that may be made and services that may be offered.  Various consumer laws and regulations also affect the Banks’ operations.  These laws primarily protect depositors and other customers of the Banks, rather than National Mercantile and its shareholders.

 

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

 

*USAPatriot Act of 2001*

 

The USA Patriot Act of2001 (“Patriot Act”) is intended to strengthen the U.S law enforcement and theintelligence communities’ abilities to work cohesively to combat terrorism on avariety of fronts. The potential impact of the Patriot Act on financialinstitutions of all kinds is significant and wide ranging. The Patriot Actcontains sweeping anti-money laundering and financial transparency laws andrequires various regulations, including: (i) due diligence requirements forfinancial institutions that administer, maintain, or manage private bankaccounts or correspondent accounts for non-US persons; (ii) standards forverifying customer identification at account opening; (iii) rules to promotecooperation among financial institutions, regulators, and law enforcemententities in identifying parties that may be involved in terrorism or moneylaundering; and (iv) reports by non-financial trades and businesses filed withthe Treasury 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. laws andregulations.

 

On April 30, 2003,the U.S. Treasury issued final regulations to implement section 326 of thePatriot Act requiring institutions to incorporate into their written moneylaundering policies a customer identification program implementing reasonableprocedures for: (i) verifying the identity of any person seeking to open anaccount, to the extent reasonable and practicable; (ii) maintaining records ofthe information used to verify the person’s identity; and (iii) determiningwhether the person appears on any list of known or suspected terrorists orterrorist organizations.  We haveestablished policies and procedures implementing the requirements of thePatriot Act.

 

*Privacy*

 

Federal banking ruleslimit the ability of banks and other financial institutions to disclosenon-public information about consumers to nonaffiliated third parties. Pursuantto these rules, financial institutions must provide: (i) initial notices tocustomers about their privacy policies, describing the conditions under whichthey may disclose nonpublic personal information to nonaffiliated third partiesand affiliates; (ii) annual notices of their privacy policies to currentcustomers; and (iii) a reasonable method for customers to “opt out” ofdisclosures to nonaffiliated third parties.

 

These privacy provisionsaffect how consumer information is transmitted through diversified financialcompanies and conveyed to outside vendors. We have implemented our privacypolicies in accordance with the law.

 

In recent years, a numberof states have implemented their own versions of privacy laws. For example, in2003, California adopted standards that are more restrictive than federal law,allowing bank customers the opportunity to bar financial companies from sharinginformation with their affiliates.

 

*InteragencyGuidance on Response Programs to Protect Against Identity Theft*

 

On August 12, 2003,the Federal bank and thrift regulatory agencies requested public comment onproposed guidance that would require financial institutions to develop programsto respond to incidents of unauthorized access to customer information, includingprocedures for notifying customers under certain circumstances. The proposedguidance: (i) interprets previously issued interagency customer informationsecurity guidelines that require financial institutions to implementinformation security programs designed to protect their customers’ information;and (ii) describes the components of a response program and sets a standard forproviding notice to customers affected by unauthorized access to or use ofcustomer information that could result in substantial harm or inconvenience tothose customers, thereby reducing the risk of losses due to fraud or identitytheft.

 

*FDIC*

 

The Banks are subject to examination and regulation by the FDIC underthe Federal Deposit Insurance Act because their deposit accounts are insured bythe FDIC under the Bank Insurance Fund (“BIF”).

 

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Under FDIC regulations, each insured depository institution is assignedto one of three capital groups for insurance premium purposes — “well capitalized,”“adequately capitalized” and “undercapitalized” — which are defined in the samemanner as under prompt corrective action rules, as discussed under “CapitalAdequacy Requirements” below.  Thesethree groups are then divided into subgroups, which are based on supervisoryevaluations by the institution’s primary federal regulator, resulting in nineassessment classifications.  Currently,assessment rates for BIF-insured banks range from 0% of insured deposits for well-capitalizedbanks with minor supervisory concerns to 0.027% of insured deposits forundercapitalized banks with substantial supervisory concerns.  The FDIC may increase or decrease theassessment rate schedule semiannually.

 

The FDIC may terminate the deposit insurance of any insured depositoryinstitution if the FDIC determines, after a hearing, that the institution hasengaged or is engaging in unsafe or unsound practices.  As with the OCC’s enforcement authority, theFDIC’s authority to terminate deposit insurance is not limited to cases ofcapital inadequacy, financial weakness rendering an institution unable  to continue operations, violations of anyapplicable law or regulation or violation of any order or any condition imposedin writing by the FDIC.  In addition,FDIC regulations provide that any insured institution that falls below a 2%minimum leverage ratio (see below) will be subject to FDIC deposit insurancetermination proceedings unless it has submitted, and is in compliance with, acapital plan with its primary federal regulator and the FDIC.  The FDIC may also suspend deposit insurancetemporarily during the hearing process if the institution has no tangiblecapital.  The FDIC is additionallyauthorized by statute to appoint itself as conservator or receiver of aninsured depository institution (in addition to the powers of the institution’sprimary federal regulatory authority) in cases, among others, of unsafe orunsound conditions or practices or willful violations of cease and desistorders.

 

All FDIC-insured depository institutions must pay an annual assessment to provide funds for the payment of interest on bonds issued by the Financing Corporation ( “FICO”), a federal corporation chartered under the authority of the Federal Housing Finance Board.  The bonds, commonly referred to as FICO bonds, were issued to capitalize the Federal Savings and Loan Insurance Corporation.  The FICO has established assessment rates effective for the first quarter of 2005 at approximately $.0144 per $100 annually for assessable deposits. The FICO assessments are adjusted quarterly to reflect changes in the assessment bases of the FDIC’s insurance funds and do not vary depending on a depository institution’s capitalization or supervisory evaluations.

 

*Dividends and Capital Distributions*

 

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

 

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

 

National banks that are not in compliance with regulatory capital requirementsgenerally are not permitted to pay dividends. The OCC also can prohibit a national bank from engaging in an unsafe orunsound practice in its business. Depending on the bank’s financial condition, payment of dividends couldbe deemed to constitute an unsafe or unsound practice.  Except under certain circumstances, and withprior regulatory approval, a bank may not pay a dividend if, after so doing, itwould be undercapitalized.  The

Banks’ ability to pay dividends in the future is, and could be, furtherinfluenced by regulatory policies or agreements and by capital guidelines.

 

Mercantile has a substantial accumulated deficit and does notanticipate having positive retained earnings for the foreseeable future.  South Bay had retained earnings of $1.6million as of December 31, 2004. Mercantile and South Bay may from time to time be permitted to makecapital distributions to National Mercantile with the consent of the OCC.  It is not anticipated that such consent couldbe obtained unless the distributing bank were to remain “well capitalized”following such distribution.

 

 

*Transactions with Affiliates*

 

The Banks are subject to certain restrictions imposed by federal law onany extensions of credit to, or the issuance of a guarantee or letter of crediton behalf of, National Mercantile or other affiliates, the purchase of, orinvestments in, stock or other securities thereof, the taking of suchsecurities as collateral for loans, and the purchase of assets of NationalMercantile 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, suchsecured loans and investments by the Banks to or in National Mercantile or toor in any other affiliate are limited, individually, to 10% of the respectiveBank’s capital and surplus (as defined by federal

 

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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 have adopted similar, but notidentical, “risk-based” and “leverage” capital adequacy guidelines for bankholding companies and national banks, respectively.  Under the risk-based capital guidelines,different categories of assets are assigned different risk weights, rangingfrom zero percent for assets considered risk-free (e.g., cash) to 100% forassets considered relatively high-risk (e.g., commercial loans).  These risk weights are multiplied bycorresponding asset balances to determine a risk-adjusted asset base.  Certain off-balance sheet items (e.g.,standby letters of credit) are added to the risk-adjusted asset base.  The minimum required ratio of total capitalto risk-weighted assets for both bank holding companies and national banks ispresently 8%.  At least half of the totalcapital is required to be “Tier 1 capital,” consisting principally of commonshareholders’ equity, a limited amount of perpetual preferred stock andminority interests in the equity, less goodwill, intangible assets and certainother items.  The remainder (Tier 2capital) may consist of a limited amount of subordinated debt, certain hybridcapital instruments and other debt securities, preferred stock and a limitedamount of the general loan-loss allowance.

 

The minimum Tier 1 leverage ratio (Tier 1 capital to average adjustedtotal assets) is 3% for bank holding companies and national banks that have thehighest regulatory examination rating and are not contemplating significantgrowth or expansion.  All other bankholding companies and national banks are expected to maintain a ratio of atleast 1% to 2% or more above the stated minimum.

 

*Prompt Corrective Action Rules*

 

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

 

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

 

If any one or more of a bank’s ratios are below the minimum ratiosrequired to be classified as undercapitalized, it will be classified assignificantly undercapitalized provided that if its ratio of tangible equity tototal assets is 2% or less, it will be classified as criticallyundercapitalized.  Significantly and criticallyundercapitalized banks are subject to additional mandatory and discretionaryrestrictions and, in the case of critically undercapitalized institutions, mustbe placed into conservatorship or receivership unless the OCC and the FDICagree otherwise.

 

 

*Safety and Soundness Standards*

 

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

 

In addition, the federal banking agencies have also adopted safety and soundness guidelines with respect to asset quality and earnings standards.  These guidelines provide six standards for establishing and maintaining a system to identify problem assets and prevent those assets from deteriorating.  Under these standards, an insured depository institution should (i) conduct periodic asset

 

8

 

quality reviews to identify problem assets; (ii) estimate the inherent losses in problem assets and establish reserves that are sufficient to absorb estimated losses; (iii) compare problem asset totals to capital; (iv) take appropriate corrective action to resolve problem assets; (v) consider the size and potential risks of material asset concentrations; and (vi) provide periodic asset quality reports with adequate information for management and the board of directors to assess the level of asset risk.

 

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

 

*CrossGuarantees*

 

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

 

*Community Reinvestment Act and Fair Lending*

 

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

 

The CRA regulations emphasize measurements of performance in the area of lending (specifically, a bank’s home mortgage, small business, small farm and community development loans), investment (a bank’s community development investments) and service (a bank’s community development services and the availability of its retail banking services), although examiners are still given a degree of flexibility in taking into account unique characteristics and needs of a bank’s community and its capacity and constraints in meeting such needs.  The regulations also require certain levels of collection and reporting of data regarding certain kinds of loans.

 

Further, the federal banking agencies may take compliance with such laws and CRA obligations into account when regulating and supervising other activities.  An assessment of CRA compliance is required in connection with applications for OCC approval of certain activities, including establishing or relocating a branch office that accepts deposits or merging or consolidating with, or acquiring the assets or assuming the liabilities of, a federally regulated financial institution.  An unfavorable rating may be the basis for OCC denial of such an application, or approval may be conditioned upon improvement of the applicant’s CRA record.  In the case of a bank holding company 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 the applicant, and such records may be the basis for denying the application.  The federal banking agencies have established annual reporting and public disclosure requirements for certain written agreements that are entered into between insured depository institutions or their affiliates and nongovernmental entities or persons that are made pursuant to, or in connection with, the fulfillment of the CRA.

 

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

 

**Employees**

 

At December 31, 2004, we had 80 full-time equivalent employees.  None of the employees is covered by a collective bargaining agreement.  We consider our employee relations to be satisfactory.

 

**ITEM 2****.  DESCRIPTION OF PROPERTY.**

 

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

 

Mercantile’s principal banking office is located 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 $5,401 per month.  The lease expires in June 2014.  

 

9

 

Mercantile leases approximately 1,650 square feet in an office building in Encino, California for the primary purpose of providing branch banking operations in the San Fernando Valley.  The effective rent is $2.73 per square foot or $4,500 per month.  The lease expires in June 2008.  Mercantile also leases 1,555 square feet in an office building in Costa Mesa, California as a loan production office in Orange County.  The office has been designed to serve as a full service branch banking office in the future.  The effective rent is $1.85 per square foot, or $2,877 per month.  The lease expires February 2009.  Additionally, Mercantile leases 2,559 square feet in an office building in Beverly Hills as a loan production office, primarily for the entertainment industry.  The effective rent is $2.88 per square foot, or $7,754 per month and the lease expires June 2009.

 

South Bay owns a two-story stand alone office building at 2200 Sepulveda Boulevard, Torrance, California, which serves as its principal banking office.  South Bay also leases approximately 1,500 square foot in a retail shopping center in El Segundo, California for the primary purpose of providing branch banking operations in the Los Angeles airport area.  The El Segundo lease expires in May 2005 and we anticipate relocating the branch in a nearby office building.

 

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

 

**ITEM 3****.  LEGAL PROCEEDINGS.**

 

From time to time, we are involved in certain legal proceedings arising in the normal course of our business.  We believe that the outcome of these matters existing as of December 31, 2004 will not have 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 vote of shareholders during the quarter ended December 31, 2004.

 

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

###### ** **

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

 

The Common Stock of National Mercantile is traded on the Nasdaq SmallCap Market under the symbol MBLA.  TheSeries A Noncumulative Convertible Perpetual Preferred Stock (the “Series APreferred”) traded on the Nasdaq Small Cap Market through December 1,2004.  Since that date it trades on theOTC Bulletin Board.  The following tableshows the high and low trade prices of the Common Stock and Series A Preferredfor each quarter of 2003 and 2004 as reported by the Nasdaq. Additionally,there may have been transactions at prices other than those shown during thattime.

 
| ** **         | ** ** | **Common Stock** | ** ** | **Series A  Preferred** |
|--------------------|------------|------------------|------------|-------------------------|
| **Quarter Ended:** | ** ** | **High**         | ** ** | **Low**                 | ** ** | **High** | ** ** | **Low** |
| March 31, 2003     |       | $                | 7.45       |                    | $ | 6.52 |   | $ | 15.75 |   | $ | 12.00 |
| June 30, 2003      |       | 7.35             |       | 6.57                    |   | 14.60 |   | 13.00 |
| September 30, 2003 |       | 8.39             |       | 7.09                    |   | 16.50 |   | 14.25 |
| December 31, 2003  |       | 12.32            |       | 7.45                    |   | 25.50 |   | 16.00 |
| March 31, 2004     |       | 11.80            |       | 9.24                    |   | 26.00 |   | 22.00 |
| June 30, 2004      |       | 10.45            |       | 9.18                    |   | 26.00 |   | 15.00 |
| September 30, 2004 |       | 10.63            |       | 9.45                    |   | 15.00 |   | 15.00 |
| December 31, 2004  |       | 13.75            |       | 10.41                   |   | 15.00 |   | 15.00 |
|                    |            |                  |            |                         |  |  |  |  |  |  |  |  |

 

At March 21, 2005, National Mercantile had 163 shareholders ofrecord for its Common Stock and 15 shareholders of record for its Series APreferred.  The number of beneficialowners for the Common Stock and Series A Preferred is higher as many peoplehold their shares in “street” name.  AtMarch 21, 2005, approximately 20% and 10% of the Common Stock and Series APreferred, respectively, were held in street name.

 

National Mercantile has not paid a cash dividend on its Common Stockfor more than 10 years, and has never paid a cash dividend on the Series APreferred.  The Series A Preferred isentitled to a noncumulative cash dividend at a rate of 6.5% of its liquidationpreference quarterly on the first day of January, April, July andOctober of each year, before any dividend may be declared upon or paidupon the Common Stock.  As a Californiacorporation, under the California General Corporation Law, generally NationalMercantile may not pay dividends in cash or property except (i) out of positiveretained earnings or (ii) if, after giving effect to the distribution, NationalMercantile’s assets would be at least 1.25 times its liabilities and itscurrent assets would exceed its current liabilities (determined on aconsolidated basis under generally accepted accounting principles).  At December 31, 2004, National

 

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Mercantile had an accumulated deficit of $11.7 million.  Further, it is unlikely that its assets willever be at least 1.25 times its liabilities. Accordingly, National Mercantile must generate net income in excess of$11.7 million before it can pay a dividend in cash or property.

 

In addition, National Mercantile may not pay dividends on its capitalstock if it is in default or has elected to defer payments of interest underits trust preferred securities.

 

*Outstanding Awards Under All EquityCompensation Plans*. The following table sets forth as of December 31, 2004 informationregarding outstanding options under all of our equity compensation plans andthe number of shares available for future option grants under equitycompensation plans currently in effect.

 
| ** **                                                 | ** ** | **(a)**                                                                                      | ** ** | **(b)**                                                                      | ** ** | **(c)**                                                                                                                               |
|------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------|
| Plan category                                              |       | Number of securities to be issued upon exercise of outstanding  options, warrants and rights |       | Weighted-average exercise price of outstanding options, warrants and  rights |       | Number of securities remaining available for issuance under equity  compensation plans (excluding securities reflected in column (a)) |
|                                                       |       |                                                                                         |       |                                                                         |       |                                                                                                                                  |
| Equity compensation plans approved by security holders (1) |       | 480,158                                                                                      |       | $                                                                            | 7.34       |                                                                                                                                  | 63,509 |
|                                                            |            |                                                                                              |            |                                                                              |            |                                                                                                                                       |  |

 

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(1) Includes the 1996 Stock Incentive Plan and two stock option planswhich have been terminated but under which there remain outstanding options topurchase an aggregate of 50,779 shares of National Mercantile Common Stock.

 

 

 

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

 

**EXECUTIVE LEVEL OVERVIEW**

 

We recorded net income of $2.2 million for 2004 compared to net incomeof $207,000 for 2003.  This representsfor 2004 basic earnings per share of $0.75 and fully-diluted earnings per shareof $0.48 compared to basic earnings per share of $0.08 per share andfully-diluted earnings per share of $0.05 for 2003. The increase in net incomefor 2004 was largely due to a $2.5 million increase in net interest incomeresulting from interest rate swaps, increases in the prime rate lending index,a greater volume of interest earning assets, particularly higher yielding loansreceivable and securities available-for-sale, and a favorable change in earningasset and funding liability composition. Additionally, the provision for credit losses declined $1.0 million for2004 compared to 2003 due to improved credit quality in the loanportfolio.  Other operating expensesincreased $732,000 in 2004, largely due to greater salaries and relatedexpense.

 

Return on average assets for 2004 was 0.57% compared to 0.06% for2003.  Return on average equity for 2004was 6.61% compared to 0.66% for 2003.

 

Total assets at December 31, 2004 were $391.1 million compared to$355.2 million at year-end 2003.  Loansreceivable and securities available-for-sale increased $53.3 million and $6.1million, respectively.  Partly offsettingthis growth, cash and due from banks-demand declined $10.4 million and federalfunds sold and securities purchased under agreements to resell declined $10.0million.  The increase in loansreceivable was due to added business development staff, the funding of previouslyapproved construction loans and stronger new construction and commercial realestate loan demand.

 

The allowance for credit losses at December 31, 2004 was $3.9million compared to $3.6 million at December 31, 2003 reflecting theprovision for loan losses during the year of $220,000 as well as net recoveriesof loans previously charged off of $73,000.

 

Total deposits at December 31, 2004 were $313.5 million comparedto $298.7 million at year-end 2003.  Thecomposition of deposits at December 31, 2004 reflects a $14.0 millionincrease in money market accounts, a $13.8 million increase in certificates ofdeposit $100,000 and over and a $5.6 million increase in interest-bearingdemand deposits, offset by a $6.1 million decrease in noninterest-bearingdemand deposits, a $6.7 million decrease in savings accounts and a $5.7 milliondecrease in certificates of deposit under $100,000.  Other borrowed funds were $25.0 million atDecember 31, 2004 compared to $7.5 million at year-end 2003. 

 

In July 2001, National Mercantile formed National MercantileCapital Trust (the “Trust”) as a Delaware statutory business trust

 

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for the exclusive purpose of issuing and selling trust preferredsecurities (the “Trust Preferred Securities”). The trust utilized the proceeds from the issuance of the Trust PreferredSecurities to purchase National Mercantile’s junior subordinated interestdebentures (the “Junior Subordinated Debentures”).  Through June 30, 2003, the Company’sfinancial statements reflected the Trust as a consolidated subsidiary, with itsTrust Preferred Securities reflected on the consolidated balance sheet asmezzanine equity, shown as guaranteed preferred beneficial interests in theCompany’s Junior Subordinated Debentures, net, and interest payments on theTrust Preferred Securities set forth as expenses and classified as minorityinterest in the Company’s income of the guaranteed preferred beneficialinterest in the Junior Subordinated Debentures.

 

The Company implemented FASB Interpretation No. 46 (“FIN 46”)Consolidation of Variable Interest Entities effective July 1, 2003resulting in the Trust no longer being a consolidated subsidiary of the Companyfor financial reporting purposes.  As aresult: (i) the Company’s balance sheets as of dates on or after July 1,2003 no longer reflect the Trust Preferred Securities as mezzanine equity butinstead reflect the Junior Subordinated Debentures as liabilities, and (ii) theCompany’s statements of operations incorporating periods on or after July 1,2003, no longer reflect interest payments on the Junior Subordinated Debenturesfor periods on or after July 1, 2003 as expenses classified as minorityinterest  in the Company’s income of theguaranteed preferred beneficial interest in the Company’s Junior SubordinatedDebentures but rather as interest expense. As discussed below, this change in accounting has a significant effecton comparisons of net interest income for periods prior to July 1, 2003and after implementation.

 

**Table 1**

**Operations Summary**

 
| ** **                                                                                                             | ** ** | **Year Ended**              | ** ** | **Increase**   | ** ** | **Year Ended**   | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|----------------|------------|------------------|------------|
| ** **                                                                                                             | ** ** | **December 31,**            | ** ** | **(Decrease)** | ** ** | **December 31,** | ** ** |
| ** **                                                                                                             | ** ** | **2004**                    | ** ** | **Amount**     | ** ** | **%**            | ** ** | **2003** | ** ** |
| ** **                                                                                                             | ** ** | **(Dollars  in thousands)** | ** ** |
| Interest income                                                                                                        |       | $                           | 19,454     |           | $          | 2,330            |       | 13.6 | % | $ | 17,124 |   |
| Interest expense                                                                                                       |       | 3,004                       |       | (176           | )          | (5.5             | )%         | 3,180 |   |
| Net interest income                                                                                                    |       | 16,450                      |       | 2,506          |       | 18.0             | %          | 13,944 |   |
| Provision for credit losses                                                                                            |       | 220                         |       | (1,045         | )          | (82.6            | )%         | 1,265 |   |
| Other operating income                                                                                                 |       | 1,567                       |       | 191            |       | 13.9             | %          | 1,376 |   |
| Other operating expense                                                                                                |       | 14,028                      |       | 732            |       | 5.5              | %          | 13,296 |   |
| Minority interest in the Company’s income  of the:                                                                |       |                        |       |           |       |             |       |   |   |
| Guaranteed preferred beneficial interests  in the Company’s junior subordinated deferrable interest debenture-net |       | —                      |       | (456           | )          | (100.0           | )%         | 456 |   |
| Series A Preferred Stock of South Bay  Bank, N.A                                                                       |       | —                      |       | —         |       | N/A              |       | — |   |
| Income before income taxes                                                                                             |       | 3,769                       |       | 3,466          |       | 1143.9           | %          | 303 |   |
| Income taxes                                                                                                           |       | 1,583                       |       | 1,487          |       | 1549.0           | %          | 96 |   |
| Net income                                                                                                             |       | $                           | 2,186      |           | $          | 1,979            |       | 956.0 | % | $ | 207 |   |

 

**CRITICAL ACCOUNTING POLICIES**

Our accountingpolicies are integral to understanding the results reported.  These policies are described in detail inNote 1 of the Notes to Consolidated Financial Statements.  Our most complex accounting policies requiremanagement’s judgment to ascertain the valuation of assets, liabilities,commitments and contingencies.  We haveestablished detailed policies and control procedures that are intended toensure valuation methods are well controlled and applied consistently fromperiod to period.  In addition, thepolicies and procedures are intended to ensure that the process for changingmethodologies occurs in an appropriate manner. The following is a brief description of our current accounting policiesinvolving significant management valuation judgments.

* *

*Allowancefor Credit Losses*

The allowance for credit losses representsmanagement’s best estimate of losses inherent in the existing loan portfolio.The allowance for credit losses is increased by the provision for credit lossescharged to expense and reduced by loans charged off, net of recoveries. Theallowance for credit losses is determined based on management’s assessment ofseveral factors: (i) reviews and evaluation of individual loans includingunderlying cash flow and collateral values, (ii) the level of and changes inclassified and nonperforming loans, (iii) historical loan loss experiences,(iv) changes in the nature and volume of the loan portfolio, and (v) currenteconomic conditions and the related impact on specific borrowers and industrygroups.

We review and manage the credit quality ofthe loan portfolio through a process that includes a risk grading system,uniform underwriting criteria, early identification of problem credits, regularmonitoring of any classified assets graded as ‘‘criticized’’ by our internalgrading system, and an independent loan review process.  The calculation of the adequacy of theallowance for credit losses is based on this internal risk grading system aswell as other factors including loan grade migration trends and collateralvalues.

 

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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 on theseverity of the underwriting weakness and likelihood of loss.  We use a statistical grading migrationanalysis as part of our allowance for credit losses evaluation for unclassifiedloans, which is a method by which the types and gradings of historical loanscharged-off are related to the current loan portfolio.  This analysis attempts to use historicaltrends in loan risk grading, nonperforming assets and concentrations that arecharacteristic to our portfolio and consider other factors affecting loan lossesthat are specific to our marketplace and customer demographic.

An allowance based upon the migrationanalysis is established for various loan types and unclassified grades rangingfrom zero for loans secured by cash or marketable securities to 1.0% forunsecured commercial loans.  Thismethodology assumes, among other things, (i) consistency in underwritingstandards and internal risk grading between the current loan portfolio and thehistorical sample, (ii) that the factors that resulted in historical loanscharged-off, such as industry economic condition, will be the same factors thatcause future loans to be charged-off, and (iii) the economic environmentexperienced during the period of historical loans charged-off is similar to thefuture economic environment.

Generally, the allowance for credit lossesestablished for classified loans that are collateral-dependent is based on thenet realizable value of the collateral. In measuring the net realizable value of the collateral, management usescurrent appraisals that, among other techniques, observe market transactions ofsimilar property and adjust for differences. Changes in the financial condition of individual borrowers, in economicconditions, in historical loss experience and in the condition of the variousmarkets in which collateral may be sold may all affect the required level ofthe allowance for credit losses and the associated provision for credit losses.

On a periodic basis -twice in 2004- we engagean outside loan review firm to review our loan portfolio, risk grade accuracyand the reasonableness of loan evaluations. Annually, this outside loan review team analyzes our methodology forcalculating the allowance for credit losses based on our loss histories andpolicies.

Each Bank’s board of directors reviews theadequacy of that Bank’s allowance for credit losses on a quarterly basis.  We utilize our judgment to determine theprovision for credit losses and establish the allowance for credit losses.  We believe, based on information known tomanagement, that the allowance for credit losses at December 31, 2004 wasadequate to absorb inherent losses in the existing loan portfolio.  However, credit quality is affected by manyfactors beyond our control, including local and national economies, and factsmay exist which are not known to us that adversely affect the likelihood ofrepayment of various loans in the loan portfolio and realization of collateralupon a default.  Accordingly, noassurance can be given that we will not sustain loan losses materially inexcess of the allowance for credit losses. In addition, the OCC, as an integral part of its examination process,periodically reviews the allowance for credit losses and could requireadditional provisions for credit losses.

*Goodwill and Other Intangible Assets*

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 conditionthat exists when the carrying amount of the asset exceeds its implied fairvalue.

The goodwill impairment test involves comparing thefair value of South Bay with its carrying amount, including goodwill.  We retained an independent valuation consultantto evaluate the goodwill as of October 1, 2004. 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 flow forecasts require analysis ofthe significant variables influencing revenues, expenses, working capital andcapital investment as well as residual value and cost of capital.  Our forecasts were for a three-year periodreflecting average annual asset growth of 11%, an average loan to deposit ratioof 110%, an average net interest margin of 5.54%, and average annual return onassets of 1.65%.  A 10.7% cost of capitaland a $59.7 million residual value was utilized in the analysis to discount theprojected 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.  Theanalysis identified eighteen transactions during the period fromOctober 2002 through September 2004 involving acquired companieslocated in the state of California with similarities to South Bay in size andoperating characteristics.  Transactionmultiples were considered for purchase price to (i) earnings, and (ii) tangiblebook value.  The purchase price toearnings multiple for the South Bay acquisition was 11.38 compared to a rangefrom 6.88 to 91.00 with an average of 27.56 for the transactions studied.  The South Bay transaction purchase price totangible book value multiple was 1.55 compared to a range of 1.33 to 3.08 withan average of 2.17 for the comparable transactions.

The consultant also analyzed our stock price as partof its market approach analysis.  Thisanalysis involved applying price multiples based on our stock price at or nearthe valuation date to the performance measures of South Bay.  Additionally, the consultant consideredguideline companies operating in the same market segment as South Bay.  The stock trading values of similar companieswere not considered reliable due to the small volume of trading activity,however, the results were not inconsistent with those of the transactionmethod.

The fair value indications derived from the incomeapproach was $55.7 million and from the two market approaches, transaction

 

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andstock price analysis, $35.6 million and $30.1 million, respectively.  The fair value of South Bay under bothapproaches exceeds the carrying value at October 1, 2004 of $22.1 million,therefore, goodwill is not considered impaired. The testing of goodwill and other intangible assets for impairmentrequires re-measurement of fair values. If the future fair values were materially less than the recorded value,we would be required to take a charge against earnings to write down thegoodwill and other intangible assets to the lower value.

*Deferred Tax Assets*

At December 31, 2004 we had totaldeferred tax assets of $5.3 million of which $4.7 million is represented by (i)federal NOLs of $13.1 million, which begin to expire in 2009; (ii) a federalAMT credit carry forward of $364,000 and (iii) a California AMT creditcarryforward of $20,000.  In order toutilize the benefit of the deferred tax assets related to the NOLs, we mustgenerate aggregate taxable income equal to the amount of the NOLs during theperiod prior to their expiration.

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 not berealized.  A valuation allowance may beestablished to reduce the deferred tax asset to its realizable value.  Anyadjustment required to the valuation allowance is coupled with a related entryto income tax expense.  A charge to earnings will be made in the eventthat we determine that a valuation allowance to the deferred tax asset isnecessary.  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 utilizesalternative scenarios reflecting a range of assumptions for asset growth rates,loan to deposit ratios, interest rates and inflation rates.  The results of the analysis support ourposition that it is more likely than not that our deferred tax assets will berealized.

*Loss Contingencies*

 

From time to time, we are involved in certainconditions, situations, or set of circumstances involving uncertainty as topossible loss that will ultimately be resolved when one or more future eventsoccur or fail to occur.  We establishreserves for loss contingencies when both (i) available information indicatesthat it is probable that an asset has been impaired or a liability has beenincurred, and (ii) the amount of loss can be reasonably estimated.  In estimating the loss, we assess therelative merits of our position in the contingency and the various risks of thesituation taking into account legal counsel guidance.  If we are unaware of certain facts inperforming our assessment or the circumstances surrounding the contingencychange, our actual losses may be larger than our reserves for losscontingencies and can materially affect our operating results for anyparticular period.

 

*Derivative Instruments and Hedging*

 

We utilize derivative instruments to manage our riskto changes in interest rates.  Statementof Financial Accounting Standards No. 133 Accounting for Derivative Instrumentsand Hedging Activities (SFAS 133)requires that an entity recognize all derivatives as either assets orliabilities in the balance sheet and measure those instruments at fairvalue.  If certain conditions are met, aderivative may be specifically designated as a hedge and earnings are affectedonly to the extent to which the hedge is not effective in achieving offsettingchanges in fair value or cash flows of the hedged item.  We have designated our derivative instrumentsas hedges and consider them highly effective. Circumstancesmay change increasing the extent that the hedge is not effective resulting in agreater portion of the change in value of the derivative instruments beingreported in earnings.

 

 

**OPERATIONS SUMMARY ANALYSIS**

 

**Net Interest Income**

 

Our earnings depend largely upon the difference between the incomeearned on our loans and other investments and the interest paid on our depositsand borrowed funds.  This difference isnet interest income.  Our ability togenerate net interest income is largely dependent on our ability to maintainsound asset quality and appropriate levels of capital and liquidity.  Our inability to maintain strong assetquality, 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 comparatively stable,lower-cost deposits; and (iii) the costs of wholesale funding sources.

 

Net interest income increased $2.5 million to $16.5 million during 2004compared to $13.9 million during 2003 due to a $2.3 million increase ininterest income and a $176,000 decrease in interest expense.

 

Loan interest income increased $2.1 million due to $22.7 milliongreater average volume of loans receivable and a 26 basis point increase inyield, resulting primarily from interest rate swaps and increases in the primerate lending index.  The increase inloans receivable is due to the added business development staff, the funding ofpreviously approved construction loans and stronger new construction andcommercial real estate loan demand.   OnJuly 1, 2004, we entered into interest rate swaps in which we exchanged anadjustable rate interest based on the prime rate lending index for a fixed ratepayment of 6.925% on an aggregate notional principal

 

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amount of$50.0 million (see Note 13 of Notes to the Consolidated Financial Statementsfor details of the swap terms).  Theinterest rate swaps contributed 20 basis points to the increase in loanyield.  During the second half of 2004,the Federal Reserve Bank increased interest rates 25 basis points on fiveoccasions after a prolonged period of accommodative monetary policy in responseto signs of stronger expansion of the economy. Approximately 77% of our $313.8 million loans receivable have adjustableinterest rates; accordingly, rising interest rates positively affect interestincome partially offset by greater payments for the $50 million interest rateswaps.

 

Interest income from securities available-for-sale increased $324,000during 2004 compared to 2003 due to $15.9 million greater average volume anddespite a 58 basis point decline in yield. The decline in the yield from securities available-for-sale was due tolower yields on the newly purchased securities and the maturity or pay down ofhigher-yielding securities in the portfolio acquired in earlier periods ofhigher interest rates.  The growth insecurities was a result of the redeployment of lower yielding federal fundssold, which averaged $26.2 million less than 2003.  The decline in average federal funds soldmore than offset an 18 basis point increase in yield resulting in a $264,000decline in interest income on federal funds sold in 2004.

 

Overall, interest-earning assets were $15.5 million greater during 2004than 2003 and the higher yields and favorable change in composition tohigher-yielding assets resulted in a 44 basis point increase in weightedaverage yield on interest-earning assets. 

 

Interest expense decreased $176,000 for 2004 despite a $16.8 millionincrease in average interest-bearing liabilities, due to a lower cost of fundsand a favorable change in deposit composition. Interest expense would have reflected an even greater decrease but forthe inclusion of interest on the Junior Subordinated Debentures due to the accountingchange discussed above.  Averageinterest-bearing deposits were $4.5 million greater than 2003; however,interest expense on deposits decreased $644,000 due to a 36 basis point declinein weighted average cost.  Relatively lowcosting interest-bearing demand deposits and money market and savings depositsaveraged $3.2 million and $9.2 million greater, respectively, in 2004 comparedto 2003.  Relatively high cost timecertificates of deposit averaged $7.9 million less during 2004 than 2003.  This favorable change in deposit compositionis due to a combination of emphasis on developing business banking, whichresults in greater volumes of transactional deposits, and limited increases inpricing on typically retail certificates of deposit.  The cost of certificates of deposit declined50 basis points due to the maturity of higher yielding deposits and repricingduring the sustained low interest rate environment.  While market rates of interest increasedduring the second half of 2004, the cost of interest-bearing demand depositsand money market and savings deposits declined 19 basis points and 22 basispoints, respectively, compared to 2003. We strategically elected to generally hold deposit rates stable and fundearning asset growth mostly with relatively inexpensive overnight other borrowings.  Other borrowings during 2004 averaged $12.6million, or $5.1 million greater than 2003. The cost of other borrowings was 2.65% and 4.81% for 2004 and 2003,respectively, representing a decline of 216 basis points in 2004.  In a sustained rising interest rateenvironment, increases in deposit interest rates will be required to preventnet deposit withdrawals. Noninterest-bearing demand deposits averaged $124.7 million in 2004, a$4.9 million increase compared to 2003.

 

The Company altered its liquidity strategy during 2004, maintaining asignificantly lower level of short-term assets, primarily federal funds sold,and relying on overnight other borrowings, against pledged loans andsecurities, to fund loan growth and deposit outflows.  Liquidity was supplemented with brokered timecertificates of deposit.

 

**Table 2**

**Ratios to Average Assets**

 

| ** **                                                                                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Net interest income                                                                            |       | 4.32     | %          | 3.82     | %          |
| Other operating income                                                                         |       | 0.41     | %          | 0.38     | %          |
| Provision for credit losses                                                                    |       | (0.06    | )%         | (0.35    | )%         |
| Other operating expense                                                                        |       | (3.68    | )%         | (3.64    | )%         |
| Minority interest in the Company’s junior subordinated  deferrable interest debenture-net |       | —   |       | (0.12    | )%         |
| Income before income taxes                                                                     |       | 0.99     | %          | 0.09     | %          |
|                                                                                           |       |     |       |     |       |
| Net income                                                                                     |       | 0.57     | %          | 0.06     | %          |

 

 

15

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**Interest Rate Spread and Net Interest Margin**

 

We analyze earnings performance using, among other measures, theinterest rate spread and net interest margin. The interest rate spread represents the difference between the weightedaverage yield received on interest earning assets and the weighted average ratepaid on interest bearing liabilities. Net interest margin (also called the net yield on interest earningassets) is net interest income expressed as a percentage of average totalinterest earning assets.  Our netinterest margin is affected by changes in the yields earned on assets and ratespaid on liabilities, referred to as rate changes, and changes to the relativeamount of interest earning assets and interest bearing liabilities.  Interest rates charged on our loans areaffected principally by the demand for such loans, the supply of moneyavailable for lending purposes, and other competitive factors.  These factors are in turn affected by generaleconomic conditions and other factors beyond our control, such as federaleconomic policies, the general supply of money in the economy, legislative taxpolicies, governmental budgetary matters, and actions of the Federal ReserveBoard.  Table 3 presents information concerningthe change in interest income and interest expense attributable to changes inaverage volume and average rate.  Table 4presents the weighted average yield on each category of interest earningassets, the weighted average rate paid on each category of interest bearingliabilities, and the resulting interest rate spread and net yield on interestearning assets for 2004, 2003 and 2002. We had no tax exempt interest income for 2004, 2003 or 2002.

 

Our net interest margin increased 54 basis points from 4.29% during2003 to 4.83% in 2004.  Our net interestmargin remains high in comparison with the interest rate spread due to thecontinued significance of noninterest-bearing demand deposits relative to totalfunding sources.  Average noninterestbearing demand deposits totaled $124.7 million, representing 39.1% of averagedeposits, during 2004, compared to $119.8 million, representing 38.7% ofaverage deposits, during 2003.  Of thesenoninterest bearing demand deposits during 2004, $16.2 million or 13.0% ofaverage noninterest bearing deposits were represented by real estate title andescrow company deposits, compared to $27.0 million or 22.5% of averagenoninterest bearing deposits during 2003. While these deposits are noninterest bearing, they are not cost freefunds.  Customer service expenses,primarily costs related to external accounting and data processing servicesprovided to title and escrow company depositors are incurred by us to theextent that such depositors maintain certain average noninterest bearingdeposits.  Customer service expense isclassified as other operating expense. If customer service expenses related to escrow customers had beenclassified as interest expense, our reported net interest income for 2004 and2003, would have been reduced by $137,000 and $132,000, respectively, and thenet interest margin for 2004 and 2003 would have decreased 4 basis points and 6basis points, respectively.  Similarly,this would create identical reductions in other operating expense.  The expense associated with these depositsincreased in 2004 from 2003 despite the decrease in volume due to a greaterallowance for customer services provided for these depositors.

 

16

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**Table 3**

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

**AverageVolume and Average Rate (1)**

 
| ** **                                                                  | ** ** | **2004 vs 2003**           | ** ** | **2003 vs 2002** | ** ** |
|-----------------------------------------------------------------------------|------------|----------------------------|------------|------------------|------------|
| ** **                                                                  | ** ** | **Increase (decrease)**    | ** ** | **Net**          | ** ** | **Increase  (decrease)** | ** ** | **Net** | ** ** |
| ** **                                                                  | ** ** | **due to:**                | ** ** | **Increase**     | ** ** | **due to:** | ** ** | **Increase** | ** ** |
| ** **                                                                  | ** ** | **Volume**                 | ** ** | **Rate**         | ** ** | **(Decrease)** | ** ** | **Volume** | ** ** | **Rate** | ** ** | **(Decrease)** | ** ** |
| ** **                                                                  | ** ** | **(Dollars in thousands)** | ** ** |
| Interest Income:                                                            |       |                       |       |             |       |   |   |   |   |   |   |   |   |
| Federal funds sold and securities purchased  under agreement to resell      |       | $                          | (278       | )                | $          | 14 |   | $ | (264 | ) | $ | 119 |   | $ | (192 | ) | $ | (73 | ) |
| Due from banks - interest bearing                                           |       | 29                         |       | 10               |       | 39 |   | 5 |   | — |   | 5 |   |
| Securities available-for-sale                                               |       | 565                        |       | (241             | )          | 324 |   | (370 | ) | (371 | ) | (741 | ) |
| Securities held-to-maturity                                                 |       | 10                         |       | 105              |       | 115 |   | 38 |   | — |   | 38 |   |
| Loans receivable (2)                                                        |       | 1,373                      |       | 743              |       | 2,116 |   | 435 |   | (2,112 | ) | (1,677 | ) |
| Total interest-earning assets                                               |       | 1,699                      |       | 631              |       | 2,330 |   | 227 |   | (2,675 | ) | (2,448 | ) |
|                                                                        |       |                       |       |             |       |   |   |   |   |   |   |   |   |
| Interest Expense:                                                           |       |                       |       |             |       |   |   |   |   |   |   |   |   |
| Interest-bearing deposits:                                                  |       |                       |       |             |       |   |   |   |   |   |   |   |   |
| Demand                                                                      |       | $                          | 14         |             | $          | (60 | ) | $ | (46 | ) | $ | 3 |   | $ | (199 | ) | $ | (196 | ) |
| Money market and savings                                                    |       | 84                         |       | (240             | )          | (156 | ) | 203 |   | (724 | ) | (521 | ) |
| Time certificates of deposit:                                               |       |                       |       |             |       |   |   |   |   |   |   |   |   |
| $100,000 or more                                                            |       | (36                        | )          | (96              | )          | (132 | ) | (307 | ) | (3 | ) | (310 | ) |
| Under $100,000                                                              |       | (140                       | )          | (170             | )          | (310 | ) | (200 | ) | (476 | ) | (676 | ) |
| Total time certificates of deposit                                          |       | (176                       | )          | (266             | )          | (442 | ) | (507 | ) | (479 | ) | (986 | ) |
| Total interest-bearing deposits                                             |       | (78                        | )          | (566             | )          | (644 | ) | (301 | ) | (1,402 | ) | (1,703 | ) |
| Other borrowings                                                            |       | 243                        |       | (272             | )          | (29 | ) | (161 | ) | 44 |   | (117 | ) |
| Junior subordinated debentures (3)                                          |       | 512                        |       | —           |       | 512 |   | 454 |   | — |   | 454 |   |
| Federal funds purchased and securities sold  under agreements to repurchase |       | (13                        | )          | (2               | )          | (15 | ) | (98 | ) | (20 | ) | (118 | ) |
| Total interest-bearing liabilities                                          |       | 664                        |       | (840             | )          | (176 | ) | (106 | ) | (1,378 | ) | (1,484 | ) |
|                                                                        |       |                       |       |             |       |   |   |   |   |   |   |   |   |
| Net interest income                                                         |       | $                          | 1,035      |             | $          | 1,471 |   | $ | 2,506 |   | $ | 333 |   | $ | (1,297 | ) | $ | (964 | ) |
|                                                                             |            |                            |            |                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)           The change in interest income or interestexpense that is attributable to both changes in average balance and averagerate 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)           Table does not include interest income thatwould have been earned on nonaccrual loans.

(3)           The implementation of FASB Interpretation No.46, effective July 1, 2003 resulted in the reclassification of the Company’sJunior Subordinated Debentures from mezzanine equity to liabilities and therelated interest to interest expense after June 30, 2003.

 

17

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**Table 4**

**Average Balance Sheet and**

**Analysis of Net Interest Income**

 
| ** **                                                                                                                   | ** ** | **2004**                    | ** ** | **2003**     | ** ** | **2002**     | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|--------------|------------|--------------|------------|
| ** **                                                                                                                   | ** ** | ** **                  | ** ** | ** **   | ** ** | **Weighted** | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                                                                                                                   | ** ** | ** **                  | ** ** | **Interest** | ** ** | **Average**  | ** ** | ** ** | ** ** | **Interest** | ** ** | **Average** | ** ** | ** ** | ** ** | **Interest** | ** ** | **Average** | ** ** |
| ** **                                                                                                                   | ** ** | **Average**                 | ** ** | **Income/**  | ** ** | **Yield/**   | ** ** | **Average** | ** ** | **Income/** | ** ** | **Yield/** | ** ** | **Average** | ** ** | **Income/** | ** ** | **Yield/** | ** ** |
| ** **                                                                                                                   | ** ** | **Amount**                  | ** ** | **Expense**  | ** ** | **Rate**     | ** ** | **Amount** | ** ** | **Expense** | ** ** | **Rate** | ** ** | **Amount** | ** ** | **Expense** | ** ** | **Rate** | ** ** |
| ** **                                                                                                                   | ** ** | **(Dollars  in thousands)** | ** ** |
| Assets:                                                                                                                      |       |                        |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Federal funds sold and securities purchased under  agreements to resell                                                      |       | $                           | 7,651      |         | $          | 95           |       | 1.24 | % | $ | 33,829 |   | $ | 359 |   | 1.06 | % | $ | 26,514 |   | $ | 432 |   | 1.63 | % |
| Due from banks -interest bearing                                                                                             |       | 3,566                       |       | 56           |       | 1.57         | %          | 1,304 |   | 17 |   | 1.30 | % | 1,348 |   | 12 |   | 0.89 | % |
| Securities available-for-sale                                                                                                |       | 41,603                      |       | 1,235        |       | 2.97         | %          | 25,672 |   | 911 |   | 3.55 | % | 33,077 |   | 1,652 |   | 4.99 | % |
| Securities held-to-maturity                                                                                                  |       | 4,085                       |       | 153          |       | 3.75         | %          | 3,254 |   | 38 |   | 1.17 | % | — |   | — |   | — |   |
| Loans receivable (1) (2)                                                                                                     |       | 283,415                     |       | 17,915       |       | 6.32         | %          | 260,756 |   | 15,799 |   | 6.06 | % | 254,424 |   | 17,476 |   | 6.87 | % |
| Total interest earning assets                                                                                                |       | 340,320                     |       | $            | 19,454     |         | 5.72       | % | 324,815 |   | $ | 17,124 |   | 5.27 | % | 315,363 |   | $ | 19,572 |   | 6.21 | % |
| Noninterest earning assets:                                                                                                  |       |                        |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash and due from banks - demand                                                                                             |       | 22,874                      |       |         |       |         |       | 22,171 |   |   |   |   |   | 20,775 |   |   |   |   |   |
| Other assets                                                                                                                 |       | 463                         |       |         |       |         |       | 21,859 |   |   |   |   |   | 28,348 |   |   |   |   |   |
| Allowance for credit losses and net                                                                                          |       | 21,066                      |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| unrealized  (loss) gain on sales of securities available-for-sale                                                            |       | (3,753                      | )          |         |       |         |       | (4,025 | ) |   |   |   |   | (5,652 | ) |   |   |   |   |
| Total assets                                                                                                                 |       | $                           | 380,970    |         |       |         |       |   | $ | 364,820 |   |   |   |   |   | $ | 358,834 |   |   |   |   |   |
|                                                                                                                         |       |                        |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Liabilities and shareholders’ equity:                                                                                   |       |                        |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing deposits:                                                                                                   |       |                        |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Demand                                                                                                                       |       | $                           | 31,484     |         | $          | 80           |       | 0.25 | % | $ | 28,269 |   | $ | 126 |   | 0.45 | % | $ | 28,024 |   | $ | 322 |   | 1.15 | % |
| Money market and savings                                                                                                     |       | 107,981                     |       | 749          |       | 0.69         | %          | 98,763 |   | 905 |   | 0.92 | % | 86,444 |   | 1,426 |   | 1.65% |   |
| Time certificates of deposit:                                                                                                |       |                        |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| $100,000 or more                                                                                                             |       | 27,179                      |       | 403          |       | 1.48         | %          | 29,150 |   | 535 |   | 1.84 | % | 45,770 |   | 845 |   | 1.85% |   |
| Under $100,000                                                                                                               |       | 27,345                      |       | 473          |       | 1.73         | %          | 33,316 |   | 783 |   | 2.35 | % | 38,606 |   | 1,459 |   | 3.78% |   |
| Total time certificates of deposit                                                                                           |       | 54,524                      |       | 876          |       | 1.61         | %          | 62,466 |   | 1,318 |   | 2.11 | % | 84,376 |   | 2,304 |   | 2.73% |   |
| Total interest-bearing deposits                                                                                              |       | 193,989                     |       | 1,705        |       | 0.88         | %          | 189,498 |   | 2,349 |   | 1.24 | % | 198,844 |   | 4,052 |   | 2.04% |   |
| Other borrowings                                                                                                             |       | 12,550                      |       | 332          |       | 2.65         | %          | 7,500 |   | 361 |   | 4.81 | % | 11,308 |   | 478 |   | 4.23% |   |
| Junior subordinated debentures (3)                                                                                           |       | 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 | % | 2,294 |   | 134 |   | 5.84% |   |
| Total interest-bearing liabilities                                                                                           |       | 222,116                     |       | 3,004        |       | 1.35         | %          | 205,340 |   | 3,180 |   | 1.55 | % | 212,446 |   | 4,664 |   | 2.20% |   |
|                                                                                                                         |       |                        |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing liabilities:                                                                                             |       |                        |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest bearing demand deposits                                                                                          |       | 124,699                     |       |         |       |         |       | 119,789 |   |   |   |   |   | 102,213 |   |   |   |   |   |
| Other liabilities                                                                                                            |       | 1,086                       |       |         |       |         |       | 845 |   |   |   |   |   | 3,716 |   |   |   |   |   |
| Guaranteed preferred beneficial interests in the  Company’s junior subordinated deferrable interest debentures, net (3) |       | —                      |       |         |       |         |       | 7,267 |   |   |   |   |   | 14,525 |   |   |   |   |   |
| Shareholders’ equity                                                                                                    |       | 33,069                      |       |         |       |         |       | 31,579 |   |   |   |   |   | 25,934 |   |   |   |   |   |
| Total liabilities and shareholders’ equity                                                                              |       | $                           | 380,970    |         |       |         |       |   | $ | 364,820 |   |   |   |   |   | $ | 358,834 |   |   |   |   |   |
|                                                                                                                         |       |                        |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest income (interest rate spread)                                                                                   |       |                        |       | $            | 16,450     |         | 4.36       | % |   |   | $ | 13,944 |   | 3.72 | % |   |   | $ | 14,908 |   | 4.01 | % |
|                                                                                                                         |       |                        |       |         |       |         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net yield on earning assets (2)                                                                                              |       |                        |       |         |       | 4.83         | %          |   |   |   |   | 4.29 | % |   |   |   |   | 4.73 | % |

----

(1)           The average balance of nonperforming loanshas been included in loans receivable.

(2)           Yields and amounts earned on loansreceivable include loan fees of $1,383,000, $882,000 and $645,000 for the yearsended December 31, 2004,  2003 and 2002,respectively.

(3)           The implementation of FASB InterpretationNo. 46, effective July 1, 2003 resulted in the reclassification of theCompany’s Junior Subordinated Debentures from mezzanine equity to liabilitiesand the related interest to interest expense after June 30, 2003.

18

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**Provision for Credit Losses**

** **

Provisions for credit losses charged to operations reflect management’sjudgment of the adequacy of the allowance for credit losses and are determinedthrough periodic analysis of the loan portfolio.  This analysis includes a detailed review ofthe classification and categorization of problem loans and loans to be chargedoff; an assessment of the overall quality and collectibility of the loanportfolio; and consideration of the loan loss experience, trends in problemloan concentrations of credit risk, as well as current and expected futureeconomic conditions (particularly Southern California).  Management, in combination with an outsidefirm, performs a periodic risk and credit analysis, the results of which arereported to the Board of Directors.

 

During 2004, we provided $220,000 to the allowance for credit losses tomaintain an adequate allowance following relatively significant growth in loansreceivable.  In 2004 net recoveries were$73,000 compared to net charge offs of $2.5 million in 2003.

 

Assuming continued loan growth, and based on the relative uncertaintyregarding the state of the economy, the level of nonperforming loans and arelatively constant level of charge offs, it is anticipated that regularprovisions for credit losses will be made during 2005.  Credit quality will be influenced byunderlying trends in the economic cycle, particularly in Southern California, andother factors, which are beyond management’s control.  Accordingly, no assurance can be given thatwe will not sustain loan losses that in any particular period are sizable inrelation to the allowance for credit losses. Subsequent evaluation of the loan portfolio, in light of factors then prevailing,by us and our regulators may indicate a requirement for increases in theallowance for credit losses through additions to the provision for creditlosses.

 

**Other Operating Income**

 

Other operating income was $1.6 million and $1.4 million in 2004 and2003, respectively.  During 2004 werecorded a net loss of $197,000 on sales of securities available-for-sale.  In 2003, there was a net gain of $51,000 onsales of securities available-for-sale. Fee income related to international services was $59,000 in 2004compared to $44,000 in 2003.  Investmentservices fees were $53,000 in 2004 compared to $84,000 in 2003.  Fees for deposit related services were $1.7million in 2004 as compared to $1.3 million in 2003, a $319,000 increase due tonew services offered and increases in fee rates.  In 2003 we recorded a loss of $136,000 on thesale or write-down of OREO compared to no loss in 2004.

 

**Other Operating Expenses**

 

Other operating expense increased $732,000 to $14.0 million in 2004,compared to $13.3 million during 2003. Salaries and related benefits increased $351,000 or 4.9% to $7.5million, primarily due to the addition of business development staff in late2003 and early 2004, as well as greater commissions paid to businessdevelopment staff for loan production. Net occupancy expense decreased $202,000 or 15.2% to $1.1 millionprimarily due to the relocation of our administrative offices and the CenturyCity banking office.  The decrease in netoccupancy expense was partially offset by the opening of loan productionoffices in Beverly Hills and Costa Mesa, California. Insurance and regulatoryexpenses increased 13.6% to $433,000 during 2004 from $381,000 during 2003 dueto increased premiums and increased assessments.  Other expenses increased $458,000 largely dueto a $250,000 reserve established in a dispute over our lien on the collateralfor a loan as well as several unrelated and nonrecurring operating losses.

 

**Income Taxes**

 

Deferred tax assets and liabilities are recognized for the expectedfuture tax consequences of existing differences between financial reporting andtax reporting bases of assets and liabilities, as well as for operating lossesand tax credit carryforwards, using enacted tax laws and rates.  Deferred tax assets will be reduced through avaluation allowance whenever it becomes more likely than not that all or someportion will not be realized.  Deferredincome tax expense (benefit) represents the net change in the deferred taxasset or liability balance during the year. This amount, together with incometaxes currently payable or refundable in the current year, represents the totaltax expense for the year.

 

At December 31, 2004, our deferred tax asset totaled $5.3 million,respectively, with no recorded valuation allowance.

 

For tax purposes at December 31, 2004, we had (i) federal NOLs of$13.1 million, which begin to expire in 2009; (ii) a federal alternativeminimum tax (“AMT”) credit carryforward of $364,000, and (iii) a California AMTcredit carryforward of $20,000.  The AMTcredits carryforward indefinitely.

 

An income tax provision of $1.6 million was recorded for 2004.  During 2003, a $96,000 income tax provisionwas recorded.

 

Federal and state income tax laws provide that following an ownershipchange of a corporation with NOLs, a net unrealized built-in loss or tax creditcarryovers, the amount of annual post-ownership change taxable income that canbe offset by pre-ownership change NOLs, built-in losses or tax creditcarryovers generally cannot exceed a prescribed annual limitation.  The annual limitation generally equals theproduct of the fair market value of the corporation immediately before theownership change (subject to certain

 

19

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adjustments) and the federal long-term tax-exempt rate prescribedmonthly by the Internal Revenue Service. If such limitations were to apply to us, our ability to reduce futuretaxable income by the NOLs could be severely limited.

 

## **Accumulated OtherComprehensive Income**

 

Accumulated other comprehensive income is comprised of the unrealizedgain or loss on available-for-sale securities and the unrealized gain or losson interest rate swaps designated as cash flow hedges, net of taxes.  At December 31, 2004 the net unrealizedloss on available-for-sale securities was $39,000 compared to a net unrealizedgain of $71,000 at December 31, 2003. The interest rate swaps designated as cash flow hedges had an unrealizedgain of $314,000 at December 31, 2004. There were no such swaps at December 31, 2003.

 

 

 

**FINANCIAL CONDITION**

 

## **Regulatory Capital**

## ** **

The following table sets forth, as of December 31, 2004:  (i) the minimum regulatory capitalrequirements for National Mercantile and the Banks; (ii) the capitalrequirements for the Banks to be “well capitalized” under the prompt correctiveaction rules; and (iii) the regulatory capital ratios of National Mercantileand the Banks.

 

**Table 5**

**Regulatory Capital Information**

**of the National Mercantile and Banks**

 
| ** **                             | ** ** | **Minimum**     | ** ** | ** **      | ** ** | ** **       | ** ** | ** ** | ** ** |
|----------------------------------------|------------|-----------------|------------|-----------------|------------|------------------|------------|------------|------------|
| ** **                             | ** ** | **For Capital** | ** ** | **Well**        | ** ** | ** **       | ** ** | ** ** | ** ** |
| ** **                             | ** ** | **Adequacy**    | ** ** | **Capitalized** | ** ** | **December 31,** | ** ** |
| ** **                             | ** ** | **Purposes**    | ** ** | **Standards**   | ** ** | **2004**         | ** ** | **2003**   | ** ** |
| **National Mercantile Bancorp:**       |       |            |       |            |       |             |       |       |       |
| Tier 1 capital to average assets       |       | 4.00            | %          | N/A             |       | 9.87             | %          | 8.69       | %          |
| Tier 1 capital to risk weighted assets |       | 4.00            | %          | N/A             |       | 10.39            | %          | 11.02      | %          |
| Total capital to risk weighted assets  |       | 8.00            | %          | N/A             |       | 12.42            | %          | 13.84      | %          |
|                                   |       |            |       |            |       |             |       |       |       |
| **Mercantile National Bank:**          |       |            |       |            |       |             |       |       |       |
| Tier 1 capital to average assets       |       | 4.00            | %          | 5.00            | %          | 8.99             | %          | 8.13       | %          |
| Tier 1 capital to risk weighted assets |       | 4.00            | %          | 6.00            | %          | 10.44            | %          | 10.88      | %          |
| Total capital to risk weighted assets  |       | 8.00            | %          | 10.00           | %          | 11.60            | %          | 12.13      | %          |
|                                   |       |            |       |            |       |             |       |       |       |
| **South Bay Bank, NA:**                |       |            |       |            |       |             |       |       |       |
| Tier 1 capital to average assets       |       | 4.00            | %          | 5.00            | %          | 9.32             | %          | 9.44       | %          |
| Tier 1 capital to risk weighted assets |       | 4.00            | %          | 6.00            | %          | 9.32             | %          | 11.18      | %          |
| Total capital to risk weighted assets  |       | 8.00            | %          | 10.00           | %          | 10.29            | %          | 12.37      | %          |

 

National Mercantile’s Tier I capital, whichis comprised of shareholders’ equity as modified by certain regulatoryadjustments, was $38.2 million and $31.2 million at December 31, 2004 and2003, respectively.  NationalMercantile’s Tier 1 capital increased in 2004 as a result of net income,exercised stock options and a reduction of the portion of deferred tax assetdisallowed for regulatory capital purposes. Federal Reserve capital rules allow trust preferred securities torepresent up to 25% of Tier 1 capital with the balance treated as Tier 2capital for the Total risk-based Capital ratio. At December 31, 2004 and 2003, Trust Preferred Securities represented$11.5 million and $10.6 million, respectively, of National Mercantile’s Tier 1capital, and $3.5 million and $4.4 million, respectively, of its Tier 2capital.  Disallowed against NationalMercantile’s Tier 1 capital is $3.2 million of goodwill recorded in theacquisition of South Bay, $1.6 million of other intangible assets and $2.7million of deferred tax asset based upon estimated earnings.  

 

Mercantile’s Tier 1 capital was $19.4 million and $15.7 million atDecember 31, 2004 and 2003, respectively. The increase in Tier 1 capital during 2004 was due to net income and thedecrease of the portion of deferred taxasset disallowed for regulatory capital purposes.  

 

20

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South Bay’s Tier 1 capital at December 31, 2004 was $17.1 millioncompared to $15.4 million at December 31, 2003.  The increase is due to net income in 2004.

 

## **LiquidityManagement**

 

The objective of liquidity management is to maintain cash flow adequateto fund our operations and meet obligations and other commitments on a timelyand cost effective basis.  We manage tothis objective primarily through the selection of asset and liability maturitymixes.  Our liquidity position isenhanced by the ability to raise additional funds as needed through availableborrowings or accessing the wholesale deposit market.

 

Our deposit base provides the majority of our fundingrequirements.  Deposits, a relativelystable and low-cost source of funds has, along with shareholders’ equity,provided 92.3% and 84.8 % of funding for average total assets during 2004 and2003, respectively.  The otherborrowings, specifically Federal Home Loan Bank (“FHLB”) advances, whichaveraged $12.6 million during 2004 compared to $7.5 million during 2003, andfederal funds purchased and securities sold under agreements to repurchase,which averaged $113,000 in 2004 compared to $609,000 in 2003, comprise thebalance of the liability funding.  Theincrease in relatively high-cost other borrowings during 2004 was used to fundhigher yielding loans and securities.

 

Also, federal funds sold and securities purchased under resaleagreements that may be immediately converted to cash at minimal cost. Theaggregate of these assets averaged $7.7 million during 2004, as compared to$33.8 million during 2003.

 

The portfolio of available-for-sale securities is an additional sourceof liquidity, which averaged $41.6 million during 2004 compared to $25.7million in 2003.  The securitiesavailable-for-sale increased in 2004 due to the deployment of funds intosecurities pending redeployment into loans. Except for a relatively small amount of securities pledged tocollateralize public funds, deposits of bankruptcy estates and our swaps, oursecurities are pledged to the FHLB to secure immediately availableborrowings.   At December 31, 2004,$27.0 million of securities were pledged to the FHLB and an additional $2.1million borrowing capacity remained.  Theunpledged portion of investment securities at December 31, 2004 totaled$4.1 million and was available as collateral for additional borrowings.  Maturing loans also provide liquidity, ofwhich $112.4 million of the Banks’ loans are scheduled to mature in 2005.

 

Net cash provided by operating activities totaled $5.4 million in 2004compared to $2.4 million in 2003.  Theprimary source of funds is net income from operations adjusted for provisionfor credit losses and depreciation and amortization.  Net cash used in investing activities totaled$61.0 million in 2004 compared to $426,000 net cash provided by investingactivities in 2003.  The increase in cashused by investing activities was primarily due to an increase in loanoriginations, net of loan paydowns and payoffs. Net cash provided by financing activities was $33.2 million in 2004compared to $581,000 used in financing activities in 2003.  The increase in 2004 net cash providedresulted primarily from an increase in other borrowed funds and by an increasein certificates of deposit.

 

**Interest Rate Risk Management**

 

Interest rate risk management seeks to maintain a stable growth of incomeand manage the risk associated with changes in interest rates.  Net interest income, the primary source ofearnings, is affected 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 repricing opportunities at any point in timeconstitute interest sensitivity gaps, which is the difference between interestsensitive assets and interest sensitive liabilities.

 

Interest rate risk, including interest rate sensitivity and therepricing characteristics of assets and liabilities, is managed by our BalanceSheet Management Committee (“BSMC”).  Theprincipal objective of BSMC is to maximize net interest income withinacceptable levels of risk established by policy.

 

We manage interest rate sensitivity by matching the repricingopportunities on our earning assets to those on our funding liabilities.  We use various strategies to manage therepricing characteristics of our assets and liabilities to ensure that exposureto interest rate fluctuations is limited within guidelines of acceptable levelsof risk-taking.  Hedging strategies,including the terms and pricing of loans and deposits, the use of derivativefinancial instruments and managing the deployment of our securities are used toreduce mismatches in interest rate repricing opportunities of portfolio assetsand their funding sources.  Interest raterisk is measured using financial modeling techniques, including stress tests,to measure the impact of changes in interest rates on future earnings.  These static measurements do not reflect theresults of any projected activity and are best used as early indicators ofpotential interest rate exposures.

 

An asset sensitive gap means an excess of interest sensitive assetsover interest sensitive liabilities, whereas a liability sensitive gap means anexcess of interest sensitive liabilities over interest sensitive assets.  In a changing rate environment, a mismatchedgap

 

21

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position generally indicates that changes in the income from interestearning assets will not be proportionate to changes in the cost of interestbearing liabilities, resulting in net interest income volatility.

 

Table 6 compares our interest rate gap position as of December 31,2004 and 2003.  The gap report shows acumulative one year interest rate asset sensitivity gap of $55.8 million atDecember 31, 2004, a change from an asset sensitivity gap of $85.9 millionat December 31, 2003.  The decreasein asset sensitivity was due to: (i) a reduction of $10.0 million of federalfunds sold and securities purchased under agreements to resell maturing or repricingin less than one year, (ii) a decrease of $7.5 million in securities-available-for-sale maturing or repricing inless than one year, (iii) a decrease of $2.0 million of due from banks-timematuring or repricing in less than one year, (iv) an increase in immediatelyrepricable interest-bearing demand, money market and savings deposits of $12.9million, (v) an increase in time certificates of deposit of $5.6 millionmaturing in less than one year and (vi) an increase of $25.5 million of otherborrowings maturing or repricing in less than one year partially offset by(vii) an $33.4 million increase in loans receivable maturing or repricing inless than one year.  The greater volumeof loans repricing within one year is due to the greater emphasis on growth incommercial loans, which are typically adjustable rate loans.  The increase in interest-bearing demand,money market and savings deposits is due similarly to the emphasis oncommercial borrowers.  In the low interestrate environment, depositors have moved maturing time certificates of depositsto savings deposits.

 

Since interest rate changes do not affect all categories of assets andliabilities equally or simultaneously, a cumulative gap analysis alone cannotbe used to evaluate the interest rate sensitivity position.  To supplement traditional gap analysis,interest rate sensitivities are also monitored through the use of simulationmodeling techniques that apply alternative interest rate scenarios to periodicforecasts of future business activity and estimate the related impact on net interestincome.  The use of simulation modelingassists management in its continuing efforts to achieve earnings growth invarying interest environments.

 

Key assumptions in the model include anticipated prepayments onmortgage-related instruments, contractual cash flow and maturities of allfinancial instruments, anticipated future business activity, deposit ratesensitivity and changes in market conditions. These assumptions are inherently uncertain and, as a result, thesemodels cannot  precisely estimate theimpact that higher or lower rate environments will have on net interestincome.  Actual results will differ fromsimulated results due to the timing, magnitude and frequency of interest ratechanges, changes in cash flow patterns and market conditions, as well aschanges in management’s strategies.  Themodel results are consistent with the gap analysis reflecting our assetsensitivity position.

 

Our asset sensitive position during a period of slowly declininginterest rates is not expected to have a significant negative impact on netinterest income since we have a large base of immediately adjustable interestbearing demand, savings and money market deposits.  However, since we are asset sensitive, in aperiod of rapidly declining interest rates, the rapid decline will have anegative effect on our net interest income as changes in the rates of interestbearing deposits historically have not changed proportionately with changes inmarket interest rates.  Additionally, inlow and declining interest rate environments, such as the environmentexperienced in 2003, the interest rates paid on funding liabilities may beginto reach floors preventing further downward adjustments while rates on earningassets 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 environmentis expected to have a positive affect on earnings as a greater amount ofearning assets than funding liabilities reprice upward and historically therates of interest bearing deposits adjust upward more slowly and in smallerincrements.

 

22

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**Table 6**

**Rate-Sensitive Assets and Liabilities**

 
| ** **                                                                | ** ** | **December 31, 2004**        | ** ** |
|---------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                | ** ** | **Maturing or repricing in** | ** ** |
| ** **                                                                | ** ** | **Less**                     | ** ** | **After three** | ** ** | **After one** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                | ** ** | **than**                     | ** ** | **months** | ** ** | **year** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                | ** ** | **three**                    | ** ** | **but within** | ** ** | **but within** | ** ** | **After** | ** ** | ** ** | ** ** |
| ** **                                                                | ** ** | **months**                   | ** ** | **one year** | ** ** | **5 years** | ** ** | **5 years** | ** ** | **Total** | ** ** |
| ** **                                                                | ** ** | **(Dollars  in thousands)**  | ** ** |
| Rate-Sensitive Assets:                                                    |       |                         |       |   |   |   |   |   |   |   |   |
| Securities available-for-sale, at amortized  cost                         |       | $                            | 500        |   | $ | 6,696 |   | $ | 15,885 |   | $ | 13,939 |   | $ | 37,020 |   |
| Securities held to maturity                                               |       | —                       |       | — |   | — |   | 3,507 |   | 3,507 |   |
| Due from banks - time                                                     |       | 2,728                        |       | — |   | — |   | — |   | 2,728 |   |
| FRB and other stock, at cost                                              |       | —                       |       | — |   | — |   | 3,076 |   | 3,076 |   |
| Loans receivable (1)                                                      |       | 251,134                      |       | 10,468 |   | 40,991 |   | 11,236 |   | 313,829 |   |
| Total rate-sensitive assets                                               |       | 254,362                      |       | 17,164 |   | 56,876 |   | 31,758 |   | 360,160 |   |
|                                                                      |       |                         |       |   |   |   |   |   |   |   |   |
| Rate-Sensitive Liabilities: (2)                                           |       |                         |       |   |   |   |   |   |   |   |   |
| Interest bearing deposits:                                                |       |                         |       |   |   |   |   |   |   |   |   |
| Demand, money market and savings.                                         |       | 136,591                      |       | — |   | — |   | — |   | 136,591 |   |
| Time certificates of deposit                                              |       | 26,708                       |       | 26,543 |   | 9,848 |   | — |   | 63,099 |   |
| Other borrowings                                                          |       | 25,900                       |       | — |   | — |   | — |   | 25,900 |   |
| Total rate-sensitive liabilities                                          |       | 189,199                      |       | 26,543 |   | 9,848 |   | — |   | 225,590 |   |
| Interest rate-sensitivity gap                                             |       | 65,163                       |       | (9,379 | ) | 47,028 |   | 31,758 |   | 134,570 |   |
| Cumulative interest rate-sensitivity gap                                  |       | $                            | 65,163     |   | $ | 55,784 |   | $ | 102,812 |   | $ | 134,570 |   |   |   |
| Cumulative ratio of rate sensitive assets  to  rate-sensitive liabilities |       | 134                          | %          | 126 | % | 146 | % | 160 | % |   |   |
|                                                                           |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)           Loans receivable excludes nonaccrual loans.

(2)           Deposits which are subject to immediatewithdrawal are presented as repricing within three months or less. Thedistribution of other time deposits is based on scheduled maturities.

 

 

23

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**Rate-Sensitive Assets and Liabilities**

 
| ** **                                                               | ** ** | **December 31, 2003**        | ** ** |
|--------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                               | ** ** | **Maturing or repricing in** | ** ** |
| ** **                                                               | ** ** | **Less**                     | ** ** | **After three** | ** ** | **After one** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                               | ** ** | **than**                     | ** ** | **months** | ** ** | **year** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                               | ** ** | **three**                    | ** ** | **but within** | ** ** | **but within** | ** ** | **After** | ** ** | ** ** | ** ** |
| ** **                                                               | ** ** | **months**                   | ** ** | **one year** | ** ** | **5 years** | ** ** | **5 years** | ** ** | **Total** | ** ** |
| ** **                                                               | ** ** | **(Dollars in thousands)**   | ** ** |
| Rate-Sensitive Assets:                                                   |       |                         |       |   |   |   |   |   |   |   |   |
| Federal funds sold and securities purchased  under agreements to resell  |       | $                            | 10,000     |   | $ | — |   | $ | — |   | $ | — |   | $ | 10,000 |   |
| Securities available-for-sale, at amortized  cost                        |       | 10,507                       |       | 4,186 |   | 4,875 |   | 11,309 |   | 30,877 |   |
| Securities held to maturity                                              |       | —                       |       | — |   | — |   | 4,597 |   | 4,597 |   |
| Due from banks - time                                                    |       | —                       |       | 4,728 |   | — |   | — |   | 4,728 |   |
| FRB and other stock, at cost                                             |       | —                       |       | — |   | — |   | 1,872 |   | 1,872 |   |
| Loans receivable (1)                                                     |       | 221,578                      |       | 6,647 |   | 27,973 |   | 4,341 |   | 260,539 |   |
| Total rate-sensitive assets                                              |       | 242,085                      |       | 15,561 |   | 32,848 |   | 22,119 |   | 312,613 |   |
|                                                                     |       |                         |       |   |   |   |   |   |   |   |   |
| Rate-Sensitive Liabilities: (2)                                          |       |                         |       |   |   |   |   |   |   |   |   |
| Interest bearing deposits:                                               |       |                         |       |   |   |   |   |   |   |   |   |
| Demand, money market and savings                                         |       | 123,696                      |       | — |   | — |   | — |   | 123,696 |   |
| Time certificates of deposit                                             |       | 28,427                       |       | 19,263 |   | 7,333 |   | — |   | 55,023 |   |
| Other borrowings                                                         |       | —                       |       | 399 |   | — |   | — |   | 399 |   |
| Total rate-sensitive liabilities                                         |       | 152,123                      |       | 19,662 |   | 7,333 |   | — |   | 179,118 |   |
| Interest rate-sensitivity gap                                            |       | 89,962                       |       | (4,101 | ) | 25,515 |   | 22,119 |   | 133,495 |   |
| Cumulative interest rate-sensitivity gap                                 |       | $                            | 89,962     |   | $ | 85,861 |   | $ | 111,376 |   | $ | 133,495 |   |   |   |
| Cumulative ratio of rate sensitive assets  to rate-sensitive liabilities |       | 159                          | %          | 150 | % | 162 | % | 175 | % |   |   |
|                                                                          |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)           Loans receivable excludes nonaccrual loans.

(2)           Deposits which are subject to immediatewithdrawal are presented as repricing within three months or less. Thedistribution of other time deposits is based on scheduled maturities.

 

 

24

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**Investment Securities**

 

We invest in investment securities consisting primarily of U.S. agencysecurities and mortgage-related securities to: (i) generate interest incomepending the ability to deploy those funds in loans meeting our lendingstrategies; (ii) increase net interest income where the rates earned on suchinvestments exceed the related cost of funds, consistent with the management ofinterest rate risk; and (iii) provide sufficient liquidity in order to maintaincash flow adequate to fund our operations and meet obligations and othercommitments on a timely and cost efficient basis.

 

We generally classify our investment securities as available-for-saleexcept for investment securities we have the ability and the positive intent tohold to maturity which are classified as held-to-maturity securities.   

 

Table 7 provides certain information regarding our investmentsecurities.

 

25

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** **

**Table 7**

**EstimatedFair Values of and Unrealized**

**Gains andLosses on Investment Securities**

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

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

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

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

 

26

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At December 31, 2004, we held no securities from any issuer otherthan by U.S. government agencies and corporations in which the aggregate bookvalue exceeded 10% of our shareholders’ equity.

 

Our present strategy is to stagger the maturities of investmentsecurities to meet our overall liquidity requirements.  Table 8 sets forth information concerning thecontractual maturity of and weighted average yield of our investment securitiesat December 31, 2004.

 

**Table 8**

**Maturities of and Weighted Average Yields on**

**Investment Securities**

 
| ** **                                                                | ** ** | ** **                 | ** ** | ** **            | ** ** | **After one but**    | ** ** | **After five but**  | ** ** | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | **Weighted** | ** ** |
|---------------------------------------------------------------------------|------------|----------------------------|------------|-----------------------|------------|----------------------|------------|---------------------|------------|------------|------------|-------------|------------|------------|------------|--------------|------------|
| ** **                                                                | ** ** | **Within one year**        | ** ** | **within five years** | ** ** | **within ten years** | ** ** | **After ten years** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                                                | ** ** | **Amount**                 | ** ** | **Yield**             | ** ** | **Amount**           | ** ** | **Yield**           | ** ** | **Amount** | ** ** | **Yield**   | ** ** | **Amount** | ** ** | **Yield**    | ** ** | **Total** | ** ** | **Yield** | ** ** |
| ** **                                                                | ** ** | **(Dollars in thousands)** | ** ** |
| **Securities  available  for-sale:**                                      |       |                       |       |                  |       |                 |       |                |       |       |       |        |       |       |       |         |       |   |   |   |   |
| U.S Treasury  securities                                                  |       | $                          | 694        |                  | 2.56       | %                    | $          | —              |       | —     |       | $           | —     |       | —     |         | $          | — |   | — |   | $ | 694 |   | 2.56 | % |
| GNMA-issued/guaranteed  mortgage pass-through certificates                |       | —                     |       | —                |       | —               |       | —              |       | —     |       | —      |       | 171        |       | 5.11         | %          | 171 |   | 5.11 | % |
| Other U.S. government  and federal agencies                               |       | 6,451                      |       | 1.98                  | %          | 15,401               |       | 2.74                | %          | 1,977      |       | 3.16        | %          | —     |       | —       |       | 23,829 |   | 2.57 | % |
| FHLMC/FNMA-issued  mortgage pass-through certificates                     |       | —                     |       | —                |       | 427                  |       | 4.93                | %          | 206        |       | 6.93        | %          | 8,731      |       | 4.64         | %          | 9,364 |   | 4.70 | % |
| CMO’s and REMIC’s  issued by U.S. government-sponsored agencies |       | —                     |       | —                |       | —               |       | —              |       | 3          |       | 5.51        | %          | 35         |       | —       |       | 38 |   | 0.44 | % |
| Privately issued  corporate bonds, CMO’s and REMIC’s securities |       | —                     |       | —                |       | —               |       | —              |       | 721        |       | 2.97        | %          | 2,137      |       | —       |       | 2,858 |   | 0.75 | % |
|                                                                      |       | $                          | 7,145      |                  | 2.04       | %               | $          | 15,828              |       | 2.80       | %     | $           | 2,907      |       | 3.38       | %       | $          | 11,074 |   | 3.74 | %  | $ | 36,954 |   | 2.98 | %  |
|                                                                      |       |                       |       |                  |       |                 |       |                |       |       |       |        |       |       |       |         |       |   |   |   |   |
| **Amortized  Cost**                                                       |       | $                          | 7,196      |                  |       |                 | $          | 15,885              |       |       |       | $           | 2,913      |       |       |         | $          | 11,026 |   |   |   | $ | 37,020 |   |   |   |
|                                                                      |       |                       |       |                  |       |                 |       |                |       |       |       |        |       |       |       |         |       |   |   |   |   |
| Federal Reserve  Bank and other equity stocks                             |       | $                          | 3,076      |                  | —     |                 | $          | —              |       | —     |       | $           | —     |       | —     |         | $          | — |   | — |   | $ | 3,076 |   | — |   |
|                                                                           |            |                            |            |                       |            |                      |            |                     |            |            |            |             |            |            |            |              |            |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                           | ** ** | ** **                  | ** ** | ** **            | ** ** | ** **           | ** ** | ** **          | ** ** | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------------------------------------------------|------------|-----------------------------|------------|-----------------------|------------|----------------------|------------|---------------------|------------|------------|------------|-------------|------------|------------|------------|--------------|------------|------------|------------|------------|------------|
| ** **                                           | ** ** | ** **                  | ** ** | ** **            | ** ** | ** **           | ** ** | ** **          | ** ** | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                           | ** ** | ** **                  | ** ** | ** **            | ** ** | ** **           | ** ** | ** **          | ** ** | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                           | ** ** | ** **                  | ** ** | ** **            | ** ** | **After one but**    | ** ** | **After five but**  | ** ** | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                                           | ** ** | **Within one year**         | ** ** | **within five years** | ** ** | **within ten years** | ** ** | **After ten years** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                           | ** ** | **Amount**                  | ** ** | **Yield**             | ** ** | **Amount**           | ** ** | **Yield**           | ** ** | **Amount** | ** ** | **Yield**   | ** ** | **Amount** | ** ** | **Yield**    | ** ** | **Total**  | ** ** | **Yield**  | ** ** |
| ** **                                           | ** ** | **(Dollars  in thousands)** | ** ** |
| **Securities  held-to-maturity:**                    |       |                        |       |                  |       |                 |       |                |       |       |       |        |       |       |       |         |       |       |       |       |       |
| FHLMC/FNMA-issued  mortgage pass-through certificate |       | $                           | —     |                  | —     |                 | $          | —              |       | —     |       | $           | 3,507      |       | 4.07       | %            | $          | —     |       | —     |       | $ | 3,507 |   | 4.07 | % |
|                                                 |       |                        |       |                  |       |                 |       |                |       |       |       |        |       |       |       |         |       |       |       |       |       |
|                                                 |       | $                           | —     |                  | —     |                 | $          | —              |       | —     |       | $           | 3,507      |       | 4.07       | %            | $          | —     |       | —     |       | $ | 3,507 |   | 4.07 | %  |

 

Actual maturities may differ from contractual maturities to the extentthat borrowers have the right to call or prepay obligations with or withoutcall or repayment penalties.

 

**Lending Activities**

 

We engage in commercial banking, serving small to medium-sizedbusinesses in the niche markets of entertainment, healthcare, business banking,real estate development, operations of multi-family and commercial properties,as well as community-based nonprofit organizations, 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 ofloan, deposit and investment products, which are designed to meet specificcustomer needs and are offered with highly personalized 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

27

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and other sources of repayment supporting the loan.  In order to provide the personalized servicerequired by these customers, we use a team approach to customer servicecombining an experienced relationship management officer with operationssupport personnel.

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.   Professionalservice customers include legal, accounting, insurance, advertising firms andtheir 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**:**

**Table 9**

**Loan Portfolio Composition**

 
|                                                                  |   | **December 31,** |          |
|-----------------------------------------------------------------------|--------|------------------|---------------|
|                                                                  |   | **2004**         |          | **2003** |   | **2002** |   | **2001** |   | **2000** |   |
|                                                                  |   | **Amount**       |          | **Percent** |   | **Amount** |   | **Percent** |   | **Amount(1)** |   | **Percent** |   | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   |
| Commercial loans  - secured and unsecured                             |   | $                |  98,429  |   | 31 | % | $ |  76,699 |   | 29 | % | $ |  86,015 |   | 32 | % | $ |  85,292 |   | 33 | % | $ |  53,433 |   | 48 | % |
| Real estate  loans:                                                   |   |             |          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Secured by  commercial real properties                                |   | 135,944          |          | 43 |   | 132,320 |   | 51 |   | 119,872 |   | 44 |   | 95,142 |   | 36 |   | 40,540 |   | 37 |   |
| Secured by one to  four family residential properties                 |   | 9,405            |          | 3 |   | 8,167 |   | 3 |   | 10,797 |   | 4 |   | 27,069 |   | 10 |   | 6,578 |   | 6 |   |
| Secured by  multifamily residential properties                        |   | 18,330           |          | 6 |   | 13,071 |   | 5 |   | 12,596 |   | 4 |   | 8,492 |   | 3 |   | 3,765 |   | 3 |   |
| Total real estate  loans                                              |   | 163,679          |          | 52 |   | 153,558 |   | 59 |   | 143,265 |   | 52 |   | 130,703 |   | 49 |   | 50,883 |   | 46 |   |
| Construction and  land development                                    |   | 50,289           |          | 16 |   | 27,210 |   | 11 |   | 37,934 |   | 14 |   | 30,811 |   | 12 |   | 1,890 |   | 2 |   |
| Consumer installment,  home equity and unsecured loans to individuals |   | 2,516            |          | 1 |   | 3,510 |   | 1 |   | 5,566 |   | 2 |   | 15,306 |   | 6 |   | 4,373 |   | 4 |   |
| Total loans  outstanding                                              |   | 314,913          |          | 100 | % | 260,977 |   | 100 | % | 272,780 |   | 100 | % | 262,112 |   | 100 | % | 110,579 |   | 100 | % |
|                                                                  |   |             |          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Deferred net loan  origination fees and purchased loan discount       |   | (1,066           | )             |   |   | (728 | ) |   |   | (458 | ) |   |   | (144 | )  |   |   | (331 | )  |   |   |
| Loans receivable,  net                                                |   | $                |  313,847 |   |   |   | $ |  260,249 |   |   |   | $ |  272,322 |   |   |   | $ |  261,968 |   |   |   | $ |  110,248 |   |   |   |
|                                                                       |        |                  |               |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

 

Most of the commercial loans are generallywithin $100,000 to $3.0 million and our consumer and home equity loansgenerally are less than $100,000.  Ourlending officers have limited authority to originate loans and requireapprovals from our more senior credit officers or our loan approval committeefor loans over $150,000.  The Banks maynot make any loan, with certain limited exceptions, in excess of their loan toone borrower limit under applicable regulations ($3.2 million for Mercantileand $2.8 million for South Bay at December 31, 2004).  If a Bank’s borrower requests a loan inexcess of these amounts we may originate the loan with the participation of theother Bank or other lenders.  AtDecember 31, 2004 we had $13.5 million in loans originated and serviced byother banks in which we purchased a non-recourse participation.  These participation loans had $21.5 millionof unfunded commitments as of December 31, 2004.  We generally purchase participations in loansfrom other banks in which we have a reciprocal alliance to purchase loanparticipations from us.  We have nottaken a subordinate credit position on any loan participations purchased orsold.  The bank originating the loan servicesthe loan, typically without compensation, and retains the right to repurchasethe participation.

*Commercial Loans*.  We offer adjustable and fixed rate securedand unsecured commercial loans for working capital, the purchase of assets andother business purposes.  We underwritethese loans primarily on the basis of the borrower’s ability to service thedebt from cash flow without reliance on the liquidation of the underlyingcollateral, where applicable.  Theseloans generally have maturity terms of 12 months and are typically renewed.

 

Collateral for commercial loans may include commercial or residentialreal property, accounts receivable, inventory, equipment, marketable securitiesor other assets.  Unsecured commercialloans include short-term term loans and lines of credit. Our underwritingguidelines for these loans generally require that the borrower have low levelsof existing debt, working capital sufficient to cover the loan and a history ofearnings, appropriate liquidity, and positive cash flow from operations.Typically, unsecured lines of credit must be unused for a continuous 30-dayperiod within each year to demonstrate the borrower’s ability to havesufficient funds to operate without the credit line.

 

28

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*Real Estate Loans. *We offer adjustableand fixed rate secured loans to finance the purchase or holding of commercialreal estate, one to four family residences and multi-family residences.  These loans generally have maturities rangingfrom three to fifteen years and payments based on a 15 to 25 years amortizationschedule.  The original principal amountof a real estate loan generally does not exceed 65% to 75% of the appraisedvalue of the property (or the lesser of the appraised value or the purchaseprice for the property if the loan is made to finance the purchase of theproperty).

*Construction and Land Development Loans*.  Real estate construction and land developmentloans are short-term secured loans made to finance the construction ofcommercial, one to four-family and multifamily residential properties or forimprovements to raw land.  These loansinclude financing for developers for the construction of residential tracthomes and custom homes.  Our real estateconstruction and loan development loans are primarily for properties located inSouthern California.  These loanstypically have adjustable rates with terms of twelve to fifteen months.  We monitor the progress of the constructionand disburse the loan proceeds directly to the various contractors duringstages 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 home equity lines of credit. Home equitylines of credit provide the borrower with a line of credit in an amount thatgenerally does not exceed 80% of the appraised value of the borrower’sresidence net of senior mortgages. Consumer loans are primarily adjustable rate open ended unsecured loans(such as credit card loans) but also include fixed rate term loans (generallyunder five years) to purchase personal property, which are secured by thatpersonal property. These loans (other than purchase money loans) generallyprovide for monthly payments of interest and a portion of the outstandingprincipal balance.

 

*Industry Concentrations*

 

We provide banking services to the entertainment industry in SouthernCalifornia.  Table 10 below presentsinformation about the loans outstanding to entertainment related customers atDecember 31, 2004 and 2003.

 

**Table 10**

**Industry Concentrations of Loans**

 
| ** **                                                                                             | ** ** | **December 31,**      | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                                             | ** ** | **2004**                   | ** ** | **2003** | ** ** |
| ** **                                                                                             | ** ** | **(Dollars in thousands)** | ** ** |
| Entertainment industry-related loans:                                                                  |       |                       |       |   |   |
| Loans for single production motion picture  and television feature films                               |       | $                          | 5,630      |   | $ | 9,218 |   |
| Other loans to entertainment-related  enterprises, such as television, music, film and talent agencies |       | 23,229                     |       | 15,508 |   |
| Loans to individuals involved primarily in  the entertainment industry                                 |       | 176                        |       | 1,796 |   |
| Total entertainment industry-related loans                                                             |       | $                          | 29,035     |   | $ | 26,522 |   |
| Percent of total loans outstanding                                                                     |       | 9.2                        | %          | 10.2 | % |

 

Other loans to entertainment related enterprises, such as television,music film and talent agencies include commercial real estate loans andcommercial loans representing working capital lines of credit and term loanssecured by direct assignments of equipment or contracts.

 

The Board has limited our exposure to industry concentration by policyand we regularly monitor such concentration based upon our borrowers’ NorthAmerican Industry Classification System codes. Loans to the healthcare industry and community-based nonprofitorganizations, individually, were less than 10% of total loans outstanding atDecember 31, 2004 and 2003.

 

*Loan Rate Composition and Maturities*

 

Of our total loans outstanding, excluding loans on nonaccrual, 77.1%and 81.7% had adjustable rates at December 31, 2004 and 2003,respectively.  Adjustable rate loansgenerally have interest rates tied to the prime rate and adjust with changes inthe rate on a daily, monthly or quarterly basis.

 

Of our total loans outstanding, excluding nonaccrual loans, atDecember 31, 2004, 36.3% were due in one year or less, 46.9% were due in1-5 years and 16.8% were due after 5 years.  As is customary in the banking industry, loans can be renewed by mutualagreement between the borrower and us. Because we are unable to estimate the extent to which its borrowers willrenew their loans, Table 11 is based on contractual maturities.

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** **

**Table 11**

**Loan Maturities**

 
| ** **                                                                              | ** ** | **December 31, 2004**      | ** ** |
|-----------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                              | ** ** | **Interest rates**         | ** ** | **Interest rates** | ** ** | ** ** | ** ** |
| ** **                                                                              | ** ** | **are floating**           | ** ** | **are fixed or** | ** ** | ** ** | ** ** |
| ** **                                                                              | ** ** | **or adjustable**          | ** ** | **predetermined** | ** ** | **Total** | ** ** |
| ** **                                                                              | ** ** | **(Dollars in thousands)** | ** ** |
| Aggregate maturities of total loans  outstanding:                                       |       |                       |       |   |   |   |   |
| Commercial loans -                                                                      |       |                       |       |   |   |   |   |
| In one year or less                                                                     |       | $                          | 35,638     |   | $ | 13,818 |   | $ | 49,456 |   |
| After one year but within five years                                                    |       | 24,648                     |       | 10,323 |   | 34,971 |   |
| After five years                                                                        |       | 4,599                      |       | 5,000 |   | 9,599 |   |
| Real estate loans -                                                                     |       |                       |       |   |   |   |   |
| In one year or less                                                                     |       | 10,537                     |       | 4,384 |   | 14,921 |   |
| After one year but within five years                                                    |       | 69,618                     |       | 25,165 |   | 94,783 |   |
| After five years                                                                        |       | 35,910                     |       | 5,361 |   | 41,271 |   |
| Construction and land development loans -                                               |       |                       |       |   |   |   |   |
| In one year or less.                                                                    |       | 47,341                     |       | 548 |   | 47,889 |   |
| After one year but within five years                                                    |       | 12,158                     |       | 5,372 |   | 17,530 |   |
| After five years                                                                        |       | 1,502                      |       | 481 |   | 1,983 |   |
| Consumer installment, home equity lines of  credit and unsecured loans to individuals - |       |                       |       |   |   |   |   |
| In one year or less                                                                     |       | 796                        |       | 1,381 |   | 2,177 |   |
| After one year but within five years                                                    |       | 143                        |       | 132 |   | 275 |   |
| After five years                                                                        |       | —                     |       | 40 |   | 40 |   |
| Total loans outstanding (1)                                                             |       | $                          | 242,890    |   | $ | 72,005 |   | $ | 314,895 |   |

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(1) Excluding nonaccrual loans

 

*Off-Balance Sheet Loan Commitments and Contingent Obligations*

 

We are a party to financial instruments with off-balance sheet creditrisk in the normal course of business to meet the financing needs of ourcustomers.  In addition to undisbursedcommitments to extend credit under loan facilities, these instruments includeconditional obligations under standby and commercial letters of credit.  Our exposure to credit loss in the event of nonperformance by customers isrepresented by the contractual amount of the instruments.

 

Loan commitments are agreements to lend to a customer a specifiedamount subject to certain conditions. Loan commitments generally have fixed expiration dates or othertermination clauses and may require payment of a fee.  We had outstanding loan commitmentsaggregating $130.5 million at December 31, 2004, substantially all ofwhich were for real estate construction and commercial lines of credit.

 

Standby letters of credit are conditional commitments issued by us tosecure the financial performance of a customer to a third party and areprimarily issued to support private borrowing arrangements. The credit riskinvolved in issuing a letter of credit for a customer is essentially the sameas that involved in extending a loan to that customer. We use the same creditunderwriting policies in accepting such contingent obligations as we do forloans. When deemed necessary, we hold appropriate collateral supporting thosecommitments. The nature of collateral obtained varies and may include depositsheld in financial institutions and real properties.  At December 31, 2004 letters of creditamounted to $272,000.  Many of thesecommitments are expected to expire without being drawn upon and, as such, thetotal commitment amounts do not necessarily represent future cash requirements.

 

**Asset Quality and Credit Risk Management**

 

We assess and manage credit risk on an ongoing basis throughdiversification guidelines, lending limits, credit review and approval policiesand internal monitoring.  As part of thecontrol process, an independent credit review firm regularly examines our 

loan portfolio, related products, including unused commitments andletters of credit, and other credit processes. In addition to this credit review process, our loan portfolio is subjectto examination by external regulators in the normal course of business.  Underlying trends in the economic andbusiness cycle will influence credit quality. We seek to manage and control credit risk through diversification of theportfolio by type of loan, industry concentration and type of borrower.

 

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*Nonperforming Assets*

 

Nonperformingassets consist of nonperforming loans and other real estate owned.  Nonperforming loans are (i) loans which havebeen placed on nonaccrual status, (ii) troubleddebt restructurings (“TDR’s”), or (iii) loans which are contractually past dueninety days or more with respect to principal or interest, and have not beenrestructured or placed on nonaccrual status, and are accruing interest asdescribed 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 in nonperforming assets at December 31,2004, we had no loans that cause management to have serious doubts about theability of the borrower to comply with the present loan repayment terms and wehad no other interest earning assets that were considered impaired at December 31,2004.  Information about nonperformingassets is presented in Table 12.

 

**Table 12**

**NonperformingAssets**
| ** **                                                                                                                 | ** ** | **December 31,**           | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                                                                 | ** ** | **2004**                   | ** ** | **2003** | ** ** |
| ** **                                                                                                                 | ** ** | **(Dollars in thousands)** | ** ** |
|                                                                                                                       |       |                       |       |   |   |
| Nonaccrual loans                                                                                                           |       | $                          | 18         |   | $ | 438 |   |
| Troubled debt restructurings                                                                                               |       | —                     |       | — |   |
| Loans contractually past due ninety or more  days with respect to either principal or interest and still accruing interest |       | 1,804                      |       | — |   |
| Nonperforming loans                                                                                                        |       | 1,822                      |       | 438 |   |
| Other real estate owned                                                                                                    |       | 1,056                      |       | 925 |   |
|                                                                                                                       |       |                       |       |   |   |
| Total nonperforming assets                                                                                                 |       | $                          | 2,878      |   | $ | 1,363 |   |
|                                                                                                                       |       |                       |       |   |   |
| Allowance for credit losses as a percent of  nonaccrual loans                                                              |       | 21822.2                    | %          | 829.9 | % |
| Allowance for credit losses as a percent of  nonperforming loans                                                           |       | 215.6                      | %          | 829.9 | % |
| Total nonperforming assets as a percent of  loans receivable                                                               |       | 0.9                        | %          | 0.5 | % |
| Total nonperforming assets as a percent of  total shareholders’ equity                                                |       | 8.3                        | %          | 4.3 | % |

 

*Nonaccrual Loans.*Nonaccrual loans are those loans for which management has discontinued accrualof interest because there exists reasonable doubt as to the full and timely collectionof either principal or interest.  Ourpolicy is to place a loan on nonaccrual status if either principal or interestpayments are past due in excess of ninety days unless the loan is both wellsecured and in process of collection, or if full collection of interest orprincipal becomes uncertain, regardless of the time period involved.

 

When a loan is placed on nonaccrual status, all interest previouslyaccrued but uncollected is reversed against current period operating results.Income on such loans is then recognized only to the extent that cash isreceived, and, where the ultimate collection of the carrying amount of the loanis probable, after giving consideration to the borrower’s current financialcondition, historical repayment performance and other factors. Accrual ofinterest is resumed only when (i) principal and interest are brought fullycurrent, and (ii) such loans are either considered, in management’s judgment,to be fully collectible or otherwise become well secured and in the process ofcollection. (See ‘‘Net Interest Income’’ for a discussion of the effects onoperating results of nonperforming loans.)

 

Nonaccrual loans decreased to $18,000 at December 31, 2004, from$438,000 at December 31, 2003.  Thedecrease was primarily due to the charge off and collection of nonaccrualloans.  Nonaccrual loans atDecember 31, 2004 were comprised primarily of secured commercialloans.  The value of the collateral securingthese loans may not be adequate to avoid a charge off of a portion of the credit.  The additional interest income that wouldhave been recorded from nonaccrual loans, if the loans had not been onnonaccrual status, was $12,000 and $48,000 for 2004 and 2003, respectively.  Interest payments received on nonaccrualloans are applied to principal unless there is no doubt as to ultimate fullrepayment of principal, in which case, the interest payment is recognized asinterest income.  Interest income notrecognized on nonaccrual loans reduced the net yield on earning assets by 0basis points and 1 basis point for 2004 and 2003, 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.  AtDecember 31, 2004 and 2003 and for the years then ended we had no TDRs andaccordingly, no

 

31

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interest income was recorded in 2004 and 2003 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 such loans arewell secured and in the process of collection and, accordingly, management hasdetermined such loans to be fully collectible as to both principal andinterest.

 

For this purpose, a loan is considered well secured if the collateralhas a realizable value in excess of the amount of principal and accrued interestoutstanding and/or is guaranteed by a financially capable party. A loan isconsidered to be in the process of collection if collection of the loan isproceeding in due course either through legal action or through othercollection efforts which management reasonably expects to result in repaymentof the loan or its restoration to a current status in the near future.

 

There was $1.8 million in loans contractually past due 90 days andstill accruing interest at December 31, 2004 and no loans at December 31,2003.  This balance at year-end 2004represents a single loan secured by a commercial real estate property.  Our loan amount represents 67% of theappraised value of the property, which the borrower has entered into anagreement for sale and is pending escrow.

 

*Other Real Estate Owned.*** **We carry OREO at thelesser of our recorded investment or the fair value less estimated costs tosell. We periodically revalue OREO properties and charge other expenses for anyfurther write-downs.  At December 31,2004 we had $1.1 million recorded as OREO and at December 31, 2003 we had$925,000 recorded as OREO.  The increasein OREO during 2004 represents amounts that we expended for developmentimprovements to the property.

 

*Impaired Loans. *Due to the size andnature of the our loan portfolio, impaired loans are determined by a periodicevaluation on an individual loan basis. At December 31, 2004 none of our loans were impaired.  At December 31, 2003 we had classified$408,000 of our loans as impaired for which $408,000 of specific reserves wereallocated.  The impaired loans areincluded in nonaccrual loans.  Theaverage recorded investment in impaired loans during the year ended December 31,2004, was $265,000 and no interest income was recognized on these loans.

 

Foregone interest income attributable to nonperforming loans amountedto $12,000 in 2004 and $48,000 in 2003. This resulted in a reduction in yield on average loans receivable of 1basis point and 2 basis points for the years ended December 31, 2004 and2003, respectively.

 

*Allowance for Credit Losses*

 

The calculation of the adequacy of the allowance for credit losses isbased on a variety of factors (see Allowance for Credit Losses under CriticalAccounting Policies).  Table 13 presents,at December 31, 2004 and the prior four years, the composition of ourallocation of the allowance for credit losses to specific loan categories.  Our current practice is to make specificallocations of the allowance for credit losses to criticized and classifiedloans, and unspecified allocations to each loan category based on our riskassessment.  This allocation should notbe interpreted as an indication that loan charge-offs will occur in the futurein these amounts or proportions, or as an indication of future charge-offtrends.  In addition, the portion of theallowance for credit losses allocated to each loan category does not representthe total amount available for future losses that may occur within suchcategories, since the total allowance for credit losses is applicable to theentire portfolio.

 

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** **

**Table 13**

**Allocationof Allowance For Credit Losses**

 
| ** **                                                                                 | ** ** | **December 31,**           | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                                 | ** ** | **2004**                   | ** ** | **%****(1)** | ** ** | **2003** | ** ** | **%(1)** | ** ** | **2002** | ** ** | **%****(****1)** | ** ** | **2001** | ** ** | **%(1)** | ** ** | **2000** | ** ** | **%(1)** | ** ** |
| ** **                                                                                 | ** ** | **(Dollars in thousands)** | ** ** |
|                                                                                       |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial loans  - secured and unsecured                                                  |       | $                          | 1,228      |   | 31 | % | $ | 1,068 |   | 29 | % | $ | 1,528 |   | 31 | % | $ | 2,128 |   | 33 | % | $ | 1,355 |   | 48 | % |
| Real estate  loans:                                                                        |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Secured by  commercial real properties                                                     |       | 1,696                      |       | 43 |   | 1,843 |   | 51 |   | 2,129 |   | 44 |   | 2,376 |   | 36 |   | 842 |   | 37 |   |
| Secured by one to  four family residential properties                                      |       | 117                        |       | 3 |   | 114 |   | 3 |   | 192 |   | 4 |   | 675 |   | 10 |   | 155 |   | 6 |   |
| Secured by  multifamily residential properties                                             |       | 229                        |       | 6 |   | 182 |   | 5 |   | 224 |   | 5 |   | 212 |   | 3 |   | 73 |   | 3 |   |
| Total real estate  loans                                                                   |       | 2,042                      |       | 52 |   | 2,139 |   | 59 |   | 2,545 |   | 53 |   | 3,264 |   | 49 |   | 1,070 |   | 46 |   |
| Construction and  land development                                                         |       | 627                        |       | 16 |   | 379 |   | 11 |   | 674 |   | 14 |   | 769 |   | 12 |   | 47 |   | 2 |   |
| Consumer  installment, home equity lines of credit and unsecured loans to individuals  (1) |       | 31                         |       | 1 |   | 49 |   | 1 |   | 99 |   | 2 |   | 381 |   | 6 |   | 125 |   | 4 |   |
| Allowance  allocable to loans receivable                                                   |       | $                          | 3,928      |   | 100 | % | $ | 3,635 |   | 100 | % | $ | 4,846 |   | 100 | % | $ | 6,541 |   | 100 | % | $ | 2,597 |   | 100 | % |

----

(1) Percentage of loans ineach category to total loans.

 

The allowance for credit lossesat December 31, 2004 was $3.9 million compared to $3.6 million atDecember 31, 2003.  The increase isdue to $220,000 provision for credit losses and net recoveries of $73,000.  Total loans charged-off in 2004 were $57,000.

 

The additional provisions to the allowance were recorded based upon ouranalysis of the adequacy of allowance for credit losses.  The allowance for credit 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.  Theallowance for unsecured classified loans is based upon the severity of thecredit weakness ranging from 3.0% for “special mention”, 15.0% for “substandard”to 50% for “doubtful”.  The volume ofmore severely classified loans – “substandard” and “doubtful” – increased to$8.8 million at December 31, 2004 from $690,000 at year end 2003.

 

The increase in the more severely classified loans at December 31, 2004was primarily due to three borrowers. Loans to one corporate borrower in the aggregate amount of $2.3 million(including loan commitments) was classified “substandard” due to a significantlegal judgment rendered against the borrower and its principals.  Our collateral includes: (i) a first lien onthe borrower’s assets with a book value of approximately $7.0 million atDecember 31, 2004; and (ii) a second trust deed in the amount of $1.5 millionon a commercial property with an appraised value of $3.3 million and anunderlying first trust deed of $1.6 million. Our liens are superior to the legal judgment against the borrower.  All scheduled principal and interest paymentshave been made on a timely basis.  We arecurrently receiving accelerated monthly principal reductions from the net freecash flow of the borrower.  At this timewe expect to receive all amounts contractually due on this loan.  

 

We have classified another loan with an outstanding principal balanceof $1.8 million as “substandard” as a result of being contractually past duemore than 90 days and issues with the borrower. This loan is secured by a first trust deed on a commercial property withan appraised value of $2.7 million.  Theborrower has entered into an agreement to sell the property for $2.4 millionwith a closing expected to occur by May 2005. If this property is sold pursuant to this agreement, we expect toreceive all amounts due on the loan upon such sale. 

 

We have classified two loans to one borrower with aggregate outstanding balance of $4.0 million as “substandard” because of a significantrecent balance sheet adjustment to the borrower’s assets and the borrower’sdeteriorating financial performance.  Oneloan to this borrower is a term loan with an outstanding balance of $3.1million secured by a first trust deed on a commercial property that wasrecently appraised at $4.2 million.  Theother loan to this borrower is a term loan with an outstanding balance of$900,000 secured by a first rust deed on a commercial property that wasrecently appraised at $1.7 million.  Allprincipal and interest payment on both loans have been made on a timelybasis.  Both loans amortize over a20-year term and mature in May 2007.  Atthis time we expect to receive all amounts contractually due us on these loans.

 

Table 14 presents an analysis of changes in the allowance for creditlosses during the periods indicated:

 

33

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** **

**Table 14**

**Analysis of Changes in Allowance for Credit Losses**

 

| ** **                                                                                                | ** ** | **December 31,**           | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                                                | ** ** | **2004**                   | ** ** | **2003** | ** ** |
| ** **                                                                                                | ** ** | **(Dollars in thousands)** | ** ** |
| ** **                                                                                                | ** ** | ** **                 | ** ** | ** ** | ** ** |
| Balance, beginning of period                                                                              |       | $                          | 3,635      |   | $ | 4,846 |   |
| Loans  charged off:                                                                                       |       |                       |       |   |   |
| Commercial  loans - secured and unsecured                                                                 |       | 49                         |       | 2,697 |   |
| Real estate  loans:                                                                                       |       | —                     |       | — |   |
| Secured by  commercial real properties                                                                    |       | —                     |       | 75 |   |
| Secured by  one to four family residential properties                                                     |       | —                     |       | 38 |   |
| Secured by  multifamily residential properties                                                            |       | —                     |       | — |   |
| Total real  estate loans                                                                                  |       | —                     |       | 113 |   |
| Construction  and land development                                                                        |       | —                     |       | — |   |
| Consumer  installment, home equity and unsecured loans to individuals                                     |       | 8                          |       | 41 |   |
| Total loans  charged-off                                                                                  |       | 57                         |       | 2,851 |   |
|                                                                                                      |       |                       |       |   |   |
| Recoveries  of loans previously charged off:                                                              |       |                       |       |   |   |
| Commercial  loans - secured and unsecured                                                                 |       | 94                         |       | 291 |   |
| Real estate  loans:                                                                                       |       |                       |       |   |   |
| Secured by  commercial real properties                                                                    |       | —                     |       | 13 |   |
| Secured by  one to four family residential properties                                                     |       | —                     |       | 1 |   |
| Secured by  multifamily residential properties                                                            |       | —                     |       | — |   |
| Total real  estate loans                                                                                  |       | —                     |       | 14 |   |
| Construction  and land development                                                                        |       | 6                          |       | — |   |
| Consumer  installment, home equity and unsecured loans to individuals                                     |       | 30                         |       | 70 |   |
| Total  recoveries of loans previously charged off                                                         |       | 130                        |       | 375 |   |
|                                                                                                      |       |                       |       |   |   |
| Net  (recoveries) charge-offs                                                                             |       | (73                        | )          | 2,476 |   |
|                                                                                                      |       |                       |       |   |   |
| Provision  for credit losses                                                                              |       | 220                        |       | 1,265 |   |
|                                                                                                      |       |                       |       |   |   |
| Balance, end  of period                                                                                   |       | $                          | 3,928      |   | $ | 3,635 |   |
|                                                                                                      |       |                       |       |   |   |
| Net loans  (recoveries) charged-off as a percentage of allowance for credit losses                        |       | -1.86                      | %          | 68.12 | % |
| Net loans  (recoveries) charged-off as a percentage of average gross loans outstanding  during the period |       | -0.03                      | %          | 0.95 | % |
| Recoveries  of loans previously charged off as a percentage of loans charged off in the  previous year    |       | 4.56                       | %          | 9.23 | % |

** **

**Deposits**

 

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

 

34

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** **

**Table 15**

**AverageDeposit Composition**

 
| ** **                                      | ** ** | **December 31,**           | ** ** |
|-------------------------------------------------|------------|----------------------------|------------|
| ** **                                      | ** ** | **2004**                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                      | ** ** | **Amount**                 | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| ** **                                      | ** ** | **(Dollars in thousands)** | ** ** |
|                                            |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing demand deposits:            |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Real estate title and escrow company  customers |       | $                          | 16,247     |   | 5 | % | $ | 26,990 |   | 9 | % | $ | 26,104 |   | 9 | % |
| Other noninterest-bearing demand                |       | 108,452                    |       | 34 | % | 92,799 |   | 30 | % | 76,109 |   | 25 | % |
| Interest-bearing demand                         |       | 31,484                     |       | 10 | % | 28,269 |   | 9 | % | 28,024 |   | 9 | % |
| Money market and savings                        |       | 107,981                    |       | 34 | % | 98,763 |   | 32 | % | 86,444 |   | 29 | % |
| Time certificates of deposit:                   |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Money desk                                      |       | —                     |       | — |   | — |   | — |   | 2,558 |   | 1 | % |
| Other:                                          |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| $100,000 or more                                |       | 27,179                     |       | 8 | % | 29,150 |   | 9 | % | 43,212 |   | 14 | % |
| Under $100,000                                  |       | 27,345                     |       | 9 | % | 33,316 |   | 11 | % | 38,606 |   | 13 | % |
| Total time certificates of deposit              |       | 54,524                     |       | 17 | % | 62,466 |   | 20 | % | 84,376 |   | 27 | % |
| Total deposits                                  |       | $                          | 318,688    |   | 100 | % | $ | 309,287 |   | 100 | % | $ | 301,057 |   | 100 | % |

 

During 2003 and 2004 we added business development officers tospecifically increase our emphasis on business banking.  This emphasis resulted in increases innoninterest-bearing demand deposits and money market and savings accounts andprovided for an orchestrated reduction in higher-costing certificates ofdeposit.  During 2004, competition fromother financial institutions and a decline in residential purchase andrefinance activity resulted in a decline in noninterest-bearing deposits forreal estate title and escrow company customers.

 

The Federal Reserve Bank increased the target fed funds rate five timesbeginning in the second half of 2004 and market short term interest rateslikewise increased.  In order to improvenet interest margins, we increased the rates paid on our nonmaturity depositsrelatively little.  Other financialinstitutions have increased the rates paid on their deposits more rapidly.  While our customers are typically less ratesensitive due to the business relationships with us, it is difficult to growdeposits without offering very competitive rates.  Consequently, during the second half of 2004we began offering very competitive rates on certain certificates of deposittargeted to new customers in order to fund our asset growth and any depositrunoff.  While certificates of depositare relatively high costing deposits, the higher rates impact only theincremental deposits acquired through these means.

 

Additionally, the period 2001 through the first half of 2004experienced historically low interest rates.   During periods of low interest rates, depositors tend to maintaingreater deposit balances in low yielding but readily accessible transactionaccounts due to relatively low opportunity costs.  As interest rates rise, and opportunity costsincrease, depositors tend to redeploy their funds into higher yieldingalternatives.  Assuming rates continue torise, we expect continued growth in certificates of deposit and a resultingchange in the composition of our deposits.

 

We use brokered deposits to supplement our liquidity.  Brokered deposits are wholesale certificatesof deposit placed by rate sensitive customers that do not have any othersignificant relationship with us. Professionals operating under established investment criteria managemost wholesale funds and the brokered deposits are typically in amounts thatexceed the FDIC deposit insurance limit. As a result, these funds are generally very sensitive to credit risk andinterest rates, and pose greater liquidity risk to a bank.  They may refuse to renew the certificates ofdeposit at maturity if higher rates are available elsewhere or if they perceivethat creditworthiness is deteriorating. At December 31, 2004 we had total brokered deposits of $6.9 million allof which had maturities less than nine months.

 

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** **

**Table 16**

**Maturities of Time Certificates of Deposit**

**$100,000 or more**

 
| ** **                                           | ** ** | **December 31,**           | ** ** |
|------------------------------------------------------|------------|----------------------------|------------|
| ** **                                           | ** ** | **2004**                   | ** ** | **2003** | ** ** |
| ** **                                           | ** ** | **(Dollars in thousands)** | ** ** |
| Time certificates of deposit maturing:               |       |                       |       |   |   |
| In three months or less                              |       | $                          | 19,680     |   | $ | 15,494 |   |
| After three months but within six months             |       | 5,562                      |       | 4,176 |   |
| After six months but within twelve months            |       | 10,548                     |       | 5,570 |   |
| After twelve months                                  |       | 5,321                      |       | 2,068 |   |
| Total time certificates of deposit $100,000  or more |       | $                          | 41,111     |   | $ | 27,308 |   |
|                                                      |            |                            |            |  |  |  |  |  |  |

 

*Deposit Concentration*

 

At December 31, 2004 no single depositor represented more than 1% oftotal deposits and the ten largest depositors represented 4.4% of totaldeposits.

 

## **Borrowed Funds**

 

Borrowed funds and related weighted average rates are summarized belowin Table 17.

 

**Table 17**

**Borrowed Funds**

 
| ** **                                                               | ** ** | **2004**                   | ** ** | **2003**    | ** ** | **2002**     | ** ** |
|--------------------------------------------------------------------------|------------|----------------------------|------------|-------------|------------|--------------|------------|
| ** **                                                               | ** ** | **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 | % | $ | 1,476 |   | 4.65 | % | $ | 2,294 |   | 5.84 | % |
| Other borrowings                                                         |       | 25,900                     |       | 2.32        | %          | 12,550       |       | 2.65 | % | 7,500 |   | 4.70 | % | 7,500 |   | 4.81 | % | 7,500 |   | 4.70 | % | 11,308 |   | 4.23 | % |
|                                                                          |            |                            |            |             |            |              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

We had no securities sold with agreements to repurchase during2004.  The maximum amount of securities soldwith agreements to repurchase at any month end during 2003 and 2002 was$800,000 and $11.7 million, respectively.

 

The maximum amount of other borrowings at any month end was $31.9million during 2004, $7.5 million during 2003 and $17.5 million during 2002. .

 

At December 31, 2004, we had $25.9 million of borrowed funds,including $19.0 million of overnight borrowings and the balances scheduled tomature during 2005.

 

 

## ** **

## ** **

## **JuniorSubordinated Debentures/Trust Preferred Securities**

 

In 2001, National Mercantile, through National Mercantile Capital TrustI (the “Trust”), issued 15,000 of 10.25% fixed rate securities (the “TrustPreferred Securities”), with an aggregate liquidation amount of $15.0 milliondue July 25, 2031.  The Trust Preferred Securities representundivided beneficial interests in the assets of the Trust and areunconditionally guaranteed by National Mercantile with respect to distributionsand payments upon liquidation, redemption and otherwise pursuant to the termsof a Guarantee Agreement.  NationalMercantile issued the Trust Preferred Securities to generate regulatory capitalat a relatively low cost

 

36

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(as payments of interest are deductible for income tax purposes).

 

The primary assets of the Trust are $15.5 million aggregate principalamount of National Mercantile 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 NationalMercantile’s option, for a period up to ten 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 premiumsto maturity.

 

In January 2003, National Mercantile entered into a interest rate swapagreement pursuant to which it exchanged a fixed rate payment obligation of10.25% on a notional principal amount of $15.0 million for a floating interestrate based on the six-month London InterBank Offered Rate plus 458 basis pointsfor a 29-year period ending July 25, 2031. The interest rate swap agreement results in the company paying or receivingthe difference between the fixed and floating rates at specified intervalscalculated based on the notional amounts. The differential paid or received on the interest rate swap isrecognized as an adjustment to interest expense.  At

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

 

The interest rate swap reduces the adverse impact of our 10.25% fixedrate Trust Preferred Securities in a low interest rate environment.  We do not utilize derivatives for speculativepurposes.  Under Statement of Financial AccountingStandards No. 133 this swap transaction is designated as a fair valuehedge.  Accordingly, the effectiveportion of the change in the fair value of the swap transaction is recordedeach period in current income. The terms of the swap are symmetrical with the terms of the TrustPreferred Securities, including the payment deferral terms, and consideredhighly effective in offsetting changes in fair value of the Trust PreferredSecurities.  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 the risk associated withchanges in interest rates and to help us maintain a stable growth of income(see Interest Rate Risk Management above and Note 13 of the Notes to theConsolidated Financial Statements).  Ourinterest rate swaps increased interest income $571,000 and reduced interestexpense $597,000 for the year ended December 31, 2004.  Certain of our interest rate swaps aredesignated cash flow hedges.  The changein market value of cash flow hedges, net of income taxes, is included in AccumulatedOther Comprehensive Income.  As ofDecember 31, 2004 we had $314,000 Accumulated Other Comprehensive Incomerelated to our interest rate swaps.  During periods of declining interest rates, the benefits from ourinterest rate swaps will increase partially offsetting the negative effect thatdeclining interest rates have on our income. Conversely, during periods of rising interest rates, the benefits fromour interest rate swaps will decline but will be more than offset by thepositive effect that rising interest rates have on our income from loans.

 

**Contractual Obligations**

 

The following table provides the amounts due under specifiedcontractual obligations for the periods indicated as of December 31, 2004.

 

37

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**Table 18**

**ContractualObligations**

 
| ** **                          | ** ** | **Payments Due**           | ** ** |
|-------------------------------------|------------|----------------------------|------------|
| ** **                          | ** ** | ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                          | ** ** | ** **                 | ** ** | **After one** | ** ** | **After three** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                          | ** ** | ** **                 | ** ** | **year** | ** ** | **years** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                          | ** ** | **Twelve months**          | ** ** | **but within** | ** ** | **but within** | ** ** | **After** | ** ** | ** ** | ** ** |
| ** **                          | ** ** | **and less**               | ** ** | **three years** | ** ** | **five years** | ** ** | **five years** | ** ** | **Total** | ** ** |
| ** **                          | ** ** | **(Dollars in thousands)** | ** ** |
| Commitment to fund loans            |       | $                          | 130,529    |   | $ | — |   | $ | — |   | $ | — |   | $ | 130,529 |   |
| Commitments under letters of credit |       | 272                        |       | — |   | — |   | — |   | 272 |   |
| Deposits                            |       | 303,694                    |       | 9,848 |   | — |   | — |   | 313,542 |   |
| Borrowings                          |       | 25,900                     |       | — |   | — |   | 15,464 |   | 41,364 |   |
| Interest expense                    |       | 1,629                      |       | 3,170 |   | 3,170 |   | 42,136 |   | 50,106 |   |
| Operating lease obligations         |       | 705                        |       | 1,349 |   | 1,231 |   | 1,942 |   | 5,227 |   |
| Other liabilities                   |       | 1,734                      |       | — |   | — |   | — |   | 1,734 |   |
| Total                               |       | $                          | 464,463    |   | $ | 14,367 |   | $ | 4,401 |   | $ | 59,542 |   | $ | 542,774 |   |
|                                     |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The obligations are categorized by their contractual due dates.  Approximately $65.7 million of thecommitments to fund loans relate to real estate construction and are expectedto fund within the next 12 months.  Thebalance of the commitments to fund loans is primarily revolving lines of creditor other commercial loans, and many of these commitments are expected to expirewithout being drawn upon.  Additionally,payments due for deposits reflect the contractual terms with our depositors towithdraw deposits, however, we do not anticipate the withdrawal of thesedeposits.  Total contractual obligations,therefore, do not necessarily represent future cash requirements.  We may, at our option, prepay certainborrowings prior to their maturity date. Furthermore, the actual payment of certain current liabilities may bedeferred into future periods.

 

## **Selected FinancialRatios**

 

The following Table 19 sets forth selected financial ratios:

 

**Table 19**

**SelectedPerformance Ratios**

 
| ** **                                           | ** ** | **For the Year Ended** | ** ** |
|------------------------------------------------------|------------|------------------------|------------|
| ** **                                           | ** ** | **December 31,**       | ** ** |
| ** **                                           | ** ** | **2004**               | ** ** | **2003** | ** ** | **2002** | ** ** |
| Return on average assets                             |       | 0.57                   | %          | 0.06 | % | -0.07 | % |
| Return on average shareholders’ equity          |       | 6.61                   | %          | 0.66 | % | -0.98 | % |
| Average shareholders’ equity to average  assets |       | 8.68                   | %          | 8.66 | % | 7.23 | % |

 

**Recent Accounting Pronouncements**

 

See Recent Accounting Pronouncements in Note1-Summary of Significant Accounting Policies of the Notes to ConsolidatedFinancial Statements.

 

 

**FACTORS WHICH MAY AFFECT FUTURE OPERATING RESULTS**

 

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

** **

The success of our business depends, to a large extent, on our netinterest income.  Changes in marketinterest rates can affect our net interest income by affecting the spreadbetween our interest-earning assets and interest-bearing liabilities.  This may be due to the different maturitiesof our interest-earning assets and interest-bearing liabilities, as well as anincrease in the general level of interest rates.  Changes in market interest rates also affect,among other things:

 

38

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•                    Our ability to originate loans;

•                    The ability of our borrowers tomake payments on their loans;

•                    The value of our interest-earningassets and our ability to realize gains from the sale of these assets;

•                    The average life of ourinterest-earning assets;

•                    Our ability to generate depositsinstead of other available funding alternatives; and

•                    Our ability to access the wholesalefunding market.

 

Interest rates are highly sensitive to many factors, includinggovernmental monetary policies, domestic and international economic and politicalconditions and other factors beyond our control.

 

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

 

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

 

***Our allowances for credit losses may beinadequate.***

 

We establish allowances for credit losses against each segment of ourloan portfolio.  At December 31,2004, our allowance for credit losses equaled 1.25% of loans receivable and215.6% of nonperforming loans.  Althoughwe believed that we had established adequate allowances for credit losses as ofDecember 31, 2004, the credit quality or our assets is affected by manyfactors beyond our control, including local and national economic conditions,and the possible existence of facts which are not known to us which adverselyaffect the likelihood of repayment of various loans in our loan portfolio andrealization of the collateral upon a default. Accordingly, we can give no assurance that we will not sustain loanlosses materially in excess of the allowance for credit losses.  In addition, the Office of the Comptroller ofthe Currency, as an integral part of its examination process, periodically reviewsour allowance for credit losses and could require additional provisions forcredit losses.  Material future additionsto the allowance for credit losses may also be necessary due to increases inthe size and changes in the composition of our loan portfolio.  Increases in our provisions for credit losseswould adversely affect our results of operations.

 

***Economic conditions may worsen.***

 

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

 

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

** **

At December 31, 2004, almost all of our loans outstanding werecollateralized by real properties located in California.  Because of this concentration in California,our financial position and results of operations have been and are expected tocontinue to be influenced by general trends in the California economy and itsreal estate market.  Real estate marketdeclines may adversely affect the values of the properties collateralizingloans.  If the principal balances of ourloans, together with any primary financing on the mortgaged properties, equalor exceed the value of the mortgaged properties, we could incur higher losseson sales of properties collateralizing foreclosed loans.  In addition, California historically has beenvulnerable to certain natural disaster risks, such as earthquakes anderosion-caused mudslides, which are not typically covered by the standardhazard insurance policies maintained by borrowers.  Uninsured disasters may adversely impact ourability to recover losses on properties affected by such disasters andadversely impact our results of operations.

 

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

** **

There is intense competition in Southern California and elsewhere inthe United States for banking customers. We experience competition for deposits from many sources, includingcredit unions, insurance companies, money market funds and mutual funds, aswell as other commercial banks and savings institutions.  We compete for loans and deposits primarilywith other commercial banks,  mortgagecompanies, commercial finance companies and savings institutions.  In recent years out-of-state financialinstitutions have entered the California market, which has also increasedcompetition.  Many of our competitorshave greater financial strength,

 

39

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marketing capability and name recognition than we do, and operate on astatewide or nationwide basis.  Inaddition, recent developments in technology and mass marketing have permittedlarger companies to market loans more aggressively to our small businesscustomers.  Such advantages may give ourcompetitors opportunities to realize greater efficiencies and economies ofscale than we can.  We can provide noassurance that we will be able to compete effectively against our competition.

 

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

 

Both National Mercantile, as a bank holding company, and the Banks, aresubject to significant governmental supervision and regulation, which isintended primarily for the protection of depositors.  Statutes and regulations affecting us may bechanged at any time, and the interpretation of these statutes and regulationsby examining authorities also may change. We cannot assure you that future changes in applicable statutes andregulations or in their interpretation will not adversely affect our business.

 

***Recent accountingchanges may give rise to a future regulatory capital event that would reduceour consolidated capital ratios.***

 

Inaccordance with the provisions of Financial Accounting Standard Board (“FASB”)Interpretation No. (“FIN”) 46, “Consolidation of Variable Interest Entities”(“FIN 46”), we have deconsolidated the subsidiary trust which issued TrustPreferred Securities for National Mercantile, and effective July 1, 2003its financial position and results of operations are not included in ourconsolidated financial position and results of operations.  Accordingly, the Trust Preferred Securities,which had previously been reported as a minority interest have been replaced bythe subordinated debt, issued by National Mercantile to the trusts and arereported as a liability.

 

Undercurrent regulatory guidelines, a portion of the Trust Preferred Securitiesqualifies as Tier I capital, and the remaining portion qualifies as Tier IIcapital.  In July 2003, the FederalReserve Board issued Supervisory Letter (SR 03-13) affirming the historicalcapital treatment of trust preferred securities as Tier I capital despite thedeconsolidation of the trusts holding the securities. SR 03-13 remained ineffect at December 31, 2004, and we continue to include these securitiesin our Tier I capital. There remains the potential that the Federal ReserveBoard may change the regulatory capital treatment of trust preferred securitiesin the future. 

 

IfTier I capital treatment for our Trust Preferred Securities were disallowed,there would be a reduction in our consolidated capital ratios. The followingtable shows as of December 31, 2004 (i) National Mercantile’s regulatorycapital position, (ii) its pro forma capital position if the trust preferredsecurities qualify only as Tier II capital, (iii) its pro forma capitalposition if the Federal Reserve Board excludes trust preferred securities fromcapital, and (iv) the minimum regulatory capital requirements.

 
| ** **                                                                         | ** ** | **Leverage ratio** | ** ** | **Tier I**

**risk-based**

**capital ratio** | ** ** | **Total**

**risk-based**

**capital ratio** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------|------------|----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                         | ** ** | ** **         | ** ** | ** **                                         | ** ** | ** **                                        | ** ** |
| (i) National Mercantile Bancorp                                                    |       | 9.87               | %          | 10.39                                              | %          | 12.42                                             | %          |
| (ii) Assuming Trust Preferred Securities  only qualified as Tier II capital   |       | 6.90               | %          | 7.26                                               | %          | 12.42                                             | %          |
| (iii) Assuming Trust Preferred Securities  are excluded entirely from capital |       | 6.90               | %          | 7.26                                               | %          | 8.33                                              | %          |
| (iv) Minimum regulatory requirements                                               |       | 4.00               | %          | 4.00                                               | %          | 8.00                                              | %          |

 

 

 

***Our ability to use our net operating lossesmay be limited.***

** **

As of December 31, 2004, we had NOLs of $13.1 million for federal taxpurposes, which begin to expire in 2009. Our ability to use the NOLs in the future would be significantly limitedif we experience an “ownership change” within the meaning of Section 382 of theInternal  Revenue Code.  If our use of these NOLs is limited, we wouldbe required to charge off the portion of our deferred tax asset related to theNOL limitation, 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, 2004, we had outstanding construction and landdevelopment loans in the amount of $50.3 million, representing 16.0% of ourloan portfolio, and commitments to fund an additional $40.6  million of construction loans.  These types of loans generally have greaterrisks than loans on completed homes, multifamily properties and commercialproperties.  A construction loangenerally does not cover the full amount of the construction costs, so theborrower must have adequate funds to pay for the balance of the project.  Price increases, delays and unanticipateddifficulties can materially increase these costs.  Further, even if completed, there is no assurancethat the borrower will be able to sell the project on a timely or profitablebasis, as these are closely related to real estate market conditions, which canfluctuate substantially between the start and completion of the project.  If the borrower defaults prior to

 

40

----

 

completion of the project, the value of the project will likely be lessthan the outstanding loan, and we could be required to complete constructionwith our 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 South Bay in December 2001,we recorded goodwill in the amount of $2.2 million.  We must evaluate the goodwill regularly forimpairment. We had an unaffiliated consultant conduct goodwill impairmenttesting in the fourth quarter of 2004, and we determined that this goodwill wasnot impaired.  If in the future we determinethat the goodwill is impaired, we would be required to write-off some or all ofthe goodwill, which could have a material adverse effect on our financialcondition and results of operations.

 

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

** **

At December 31, 2004, we had a deferred tax asset of $5.3 millionrelating primarily to our NOLs.  Iffuture taxable income should be less than the amount of the NOLs within the taxyears to which it may be applied, the deferred tax asset may not berealized.  To support our position thatthe benefits of this asset will be realized, we must estimate futureearnings.  These estimates are based onmany factors, including prior periods results. If we are unable to generate future earnings in an amount sufficient tosupport the asset, we would have to establish a valuation allowance andcorresponding charge to earnings to reduce the deferred tax asset to itsrealizable value.  A material valuationallowance on this asset would have a material adverse effect on our results ofoperations and financial condition.

 

***ITEM 7***.     FINANCIALSTATEMENTS

*** ***

The consolidated financial statements required by this Item areincluded herewith as a separate section of this Report as follows:

 

1.               *Financial Statements*

 
| Report of Independent Registered Public Accounting Firm – Ernst &  Young LLP                                |   |
|----------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                 |   |
| Consolidated Balance Sheet at December 31, 2004                                                                 |   |
|                                                                                                                 |   |
| Consolidated Statements of Operations for the years ended  December 31, 2004 and 2003                           |   |
|                                                                                                                 |   |
| Consolidated Statements of Changes in Shareholders’ Equity for the  years ended December 31, 2004 and 2003 |   |
|                                                                                                                 |   |
| Consolidated Statements of Cash Flows for the years ended  December 31, 2004 and 2003                           |   |
|                                                                                                                 |   |
| Notes to Consolidated Financial Statements for the two years ended December 31,  2004                           |   |

 

** **

**ITEM 8**.           **CHANGES INAND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

Not applicable.

 

 

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

 

Our management, including the Chief Executive Officer and ChiefFinancial Officer, has conducted an evaluation of the effectiveness of ourdisclosure controls and procedures pursuant to Rule 13a-14 under the SecuritiesExchange Act of 1934, as amended, within 90 days of the filing of this annualreport.  Based on that evaluation, theChief Executive Officer and the Chief Financial Officer believe that ourdisclosure controls and procedures were effective in ensuringthat information required to be disclosed by the Company in this annualreport has been made known to them in a timely manner.

 

During the quarter ended December 31, 2004, there were nosignificant changes in our internal controls or in other factors that couldsignificantly affect those controls.

 

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

 

Not applicable.

 

41

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**PART III**
| ***ITEM 9***. | *** *** | ***DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL  PERSONS; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT*** |
|---------------|--------------|------------------------------------------------------------------------------------------------------------------------|

*** ***

*** ***

The information required by this item will appear under the captions“Election of Directors,’’ ‘‘ Executive Officers,’’ and ‘‘Compliance withSection 16(a) Beneficial Ownership Reporting’’ in the Company’s proxystatement for the 2005 Annual Meeting of Shareholders (the ‘‘2005 ProxyStatement’’), and such information shall be deemed to be incorporated herein byreference to that portion of the 2005 Proxy Statement, if filed with theSecurities and Exchange Commission not later than 120 days after the endof  our most recently completed fiscalyear.

 
| ***ITEM 10*** | *** *** | ***EXECUTIVE COMPENSATION*** |
|---------------|--------------|------------------------------|

*** ***

The information required by this item will appear under the captions“Compensation of Executive Officers,” “Compensation of Directors,’’ ‘‘SummaryCompensation Table,’’ ‘‘Report on Executive Compensation for 2004,’’ ‘‘2004Option Exercises and Year-End Option Values” and “Compensation CommitteeInterlocks and Insider Participation’’ in the 2005 Proxy Statement, and suchinformation shall be deemed to be incorporated herein by reference to thoseportions of the 2005 Proxy Statement, if filed with the Securities and ExchangeCommission not later than 120 days after the end of our most recently completedfiscal year.

 
| ***ITEM 11***. | *** *** | ***SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND  MANAGEMENT AND RELATED STOCKHOLDER MATTERS*** |
|----------------|--------------|-------------------------------------------------------------------------------------------------------|

*** ***

 

The information required by this item will appear under the caption ‘‘SecurityOwnership of Principal Shareholders and Management’’ in the 2005 ProxyStatement, and such information either shall be deemed to be incorporatedherein by reference to that portion of the 2005 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 RELATED TRANSACTIONS*** |
|----------------|--------------|------------------------------------------------------|

*** ***

The information required by this item will appear under the caption‘‘Certain Relationships and Related Transactions’’ in the 2005 Proxy Statement,and such information shall be deemed to be incorporated herein by reference tothat portion of the 2005 Proxy Statement, if filed with the Securities andExchange Commission not later than 120 days after the end of our most recentlycompleted fiscal year.

 

 
| ***ITEM 13***. | *** *** | ***EXHIBITS*** |
|----------------|--------------|----------------|

 

 

See Index to Exhibits on page 66 of this Form 10-KSB

 

 

 
| ***ITEM 14***. | *** *** | ***PRINCIPAL ACCOUNTANT FEES AND  SERVICES*** |
|----------------|--------------|-----------------------------------------------|

*** ***

The information required by this item will appear under the caption“Independent Public Accountants” in the 2005 Proxy Statement, and suchinformation shall be deemed to be incorporated herein by reference to thatportion of the 2005 Proxy Statement, if filed with the Securities and ExchangeCommission not later than 120 days after the end of our most recently completedfiscal year.

 

42

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*SIGNATURES*

 

Pursuant to the requirements of Section 13 or 15(d) of theSecurities Exchange Act of 1934, the registrant has duly caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized.

 

 
|                      | NATIONAL MERCANTILE BANCORP |
|---------------------------|-----------------------------|
|                      | (Registrant)                |
|                      |                        |   |
|                      | By                          | /s/  SCOTT A. MONTGOMERY |
|                      |                        | Scott A. Montgomery |
| Date: March 31, 2005 |                        | Chief Executive Officer |

 

Pursuant to the requirements of the Securities Exchange Act of 1934,this report has been signed below by the following persons on behalf of theregistrant and in the capacities and on the dates indicated.

 
| **Signature** | ** **                 | **Title** | ** **                                           | **Date** |
|---------------|----------------------------|-----------|------------------------------------------------------|----------|
|          |                       |      |                                                 |     |   |
| /s/           | ROBERT E. GIPSON           |      |                                                 |     |   |
|          | Robert E. Gipson           |      | Chairman of the Board                                |     | March 31, 2005 |
|          |                       |      |                                                 |     |   |
| /s/           | ROBERT E. THOMSON          |      |                                                 |     |   |
|          | Robert E. Thomson          |      | Vice Chair                                           |     | March 31, 2005 |
|          |                       |      |                                                 |     |   |
| /s/           | DONALD E. BENSON           |      |                                                 |     |   |
|          | Donald E. Benson           |      | Director                                             |     | March 31, 2005 |
|          |                       |      |                                                 |     |   |
| /s/           | JOSEPH N. COHEN            |      |                                                 |     |   |
|          | Joseph N. Cohen            |      | Director                                             |     | March 31, 2005 |
|          |                       |      |                                                 |     |   |
| /s/           | W. DOUGLAS HILE            |      |                                                 |     |   |
|          | W. Douglas Hile            |      | Director                                             |     | March 31, 2005 |
|          |                       |      |                                                 |     |   |
| /s/           | ANTOINETTE HUBENETTE, M.D. |      |                                                 |     |   |
|          | Antoinette Hubenette, M.D. |      | Director                                             |     | March 31, 2005 |
|          |                       |      |                                                 |     |   |
| /s/           | SCOTT A. MONTGOMERY        |      |                                                 |     |   |
|          | Scott A. Montgomery        |      | Director, Chief Executive Officer                    |     | March 31, 2005 |
|          |                       |      |                                                 |     |   |
| /s/           | DION G. MORROW             |      |                                                 |     |   |
|          | Dion G. Morrow             |      | Director                                             |     | March 31, 2005 |
|          |                       |      |                                                 |     |   |
| /s/           | CARL R. TERZIAN            |      |                                                 |     |   |
|          | Carl R. Terzian            |      | Director                                             |     | March 31, 2005 |
|          |                       |      |                                                 |     |   |
| /s/           | DAVID R. BROWN             |      |                                                 |     |   |
|          | David R. Brown             |      | Principal Financial and Principal Accounting Officer |     | March 31, 2005 |

 

43

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**Report of Independent Registered Public Accounting Firm**

 

To the Shareholders and theBoard of Directors

of National MercantileBancorp and subsidiaries:

 

We have audited theconsolidated balance sheet of National Mercantile Bancorp (a Californiacorporation) and subsidiaries (collectively, the “Company”) as of December 31,2004, and the related consolidated statements of operations, shareholders’equity and cash flows for each of the two years in the period ended December31, 2004.  These financial statements arethe responsibility of the Company’s management. Our responsibility is to express an opinion on these financialstatements based on our audits.

 

We conducted our audits inaccordance with the standards of the Public Company Accounting Oversight Board(United States).  Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement.  We were not engaged to perform an audit ofthe Company’s internal control over financial reporting.  Our audit included consideration of internalcontrol over financial reporting as a basis for designing audit procedures thatare appropriate in the circumstances, but not for the purpose of expressing anopinion on the effectiveness of the Company’s internal control over financialreporting. Accordingly, we express no such opinion.  An audit also includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimatesmade by management, and evaluating the overall financial statementpresentation.  We believe that our auditsprovide a reasonable basis for our opinion.

 

In our opinion, thefinancial statements referred to above present fairly, in all materialrespects, the consolidated financial position of National Mercantile Bancorpand subsidiaries as of December 31, 2004, and the consolidated results of theiroperations and their cash flows for each of the two years in the period endedDecember 31, 2004, in conformity with U.S. generally accepted accountingprinciples.

 
|   | /s/  Ernst & Young LLP |   |
|--------|----------------------------|--------|

 

Los Angeles, California

March 28, 2005

 

44

----

 

**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATED BALANCE SHEET**

 
| ** **                                                                                                             | ** ** | **December 31,  2004**      | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                             | ** ** | **(Dollars in  thousands)** | ** ** |
| ASSETS                                                                                                                 |       |                        |       |
| Cash and due from banks-demand                                                                                         |       | $                           | 14,187     |   |
| Due from banks-interest bearing                                                                                        |       | 2,728                       |       |
| Cash and cash equivalents                                                                                              |       | 16,915                      |       |
| Securities available-for-sale, at fair  value; aggregate amortized cost of $37,020                                     |       | 36,954                      |       |
| Securities held-to-maturity, at amortized  cost                                                                        |       | 3,507                       |       |
| Federal Reserve Bank and other stock                                                                                   |       | 3,076                       |       |
| Loans receivable                                                                                                       |       | 313,847                     |       |
| Allowance for credit losses                                                                                            |       | (3,928                      | )          |
| Net loans receivable                                                                                                   |       | 309,919                     |       |
|                                                                                                                   |       |                        |       |
| Premises and equipment, net                                                                                            |       | 5,804                       |       |
| Other real estate owned                                                                                                |       | 1,056                       |       |
| Deferred tax asset, net                                                                                                |       | 5,286                       |       |
| Goodwill                                                                                                               |       | 3,225                       |       |
| Intangible assets, net                                                                                                 |       | 1,630                       |       |
| Accrued interest receivable and other  assets                                                                          |       | 3,750                       |       |
| Total assets                                                                                                           |       | $                           | 391,122    |   |
|                                                                                                                   |       |                        |       |
| LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                              |       |                        |       |
| Deposits:                                                                                                              |       |                        |       |
| Noninterest-bearing demand                                                                                             |       | $                           | 113,852    |   |
| Interest-bearing demand                                                                                                |       | 34,961                      |       |
| Money market                                                                                                           |       | 69,431                      |       |
| Savings                                                                                                                |       | 32,199                      |       |
| Time certificates of deposit:                                                                                          |       |                        |       |
| $100,000 or more                                                                                                       |       | 41,111                      |       |
| Under $100,000                                                                                                         |       | 21,988                      |       |
| Total deposits                                                                                                         |       | 313,542                     |       |
|                                                                                                                   |       |                        |       |
| Other borrowings                                                                                                       |       | 25,900                      |       |
| Junior subordinated deferrable interest  debentures                                                                    |       | 15,464                      |       |
| Accrued interest payable and other  liabilities                                                                        |       | 1,734                       |       |
| Total liabilities                                                                                                      |       | 356,640                     |       |
|                                                                                                                   |       |                        |       |
| Shareholders’ equity:                                                                                             |       |                        |       |
| Preferred stock, no par value - authorized  1,000,000 shares:                                                          |       |                        |       |
| Series A non-cumulative convertible  perpetual preferred stock; authorized 990,000 shares; outstanding 666,273  shares |       | 5,442                       |       |
| 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 2,954,128 shares                                |       | 39,491                      |       |
| Accumulated deficit                                                                                                    |       | (11,725                     | )          |
| Accumulated other comprehensive income                                                                                 |       | 274                         |       |
| Total shareholders’ equity                                                                                        |       | 34,482                      |       |
| Total liabilities and shareholders’ equity                                                                        |       | $                           | 391,122    |   |

 

See accompanying notes to consolidated financial statements.

 

45

----

 

**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

 
| ** **                                                                                                               | ** ** | **For the Year Ended  December 31,**               | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                                                                               | ** ** | **2004**                                           | ** ** | **2003** | ** ** |
| ** **                                                                                                               | ** ** | **(Dollars in thousands,  except per share data)** | ** ** |
| Interest income:                                                                                                         | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| Loans, including fees                                                                                                    |       | $                                                  | 17,915     |   | $ | 15,799 |   |
| Securities                                                                                                               |       | 1,388                                              |       | 949 |   |
| Due from banks - interest bearing                                                                                        |       | 56                                                 |       | 17 |   |
| Federal funds sold and securities purchased  under agreements to resell                                                  |       | 95                                                 |       | 359 |   |
| Total interest income                                                                                                    |       | 19,454                                             |       | 17,124 |   |
| Interest expense:                                                                                                        |       |                                               |       |   |   |
| Interest-bearing demand                                                                                                  |       | 80                                                 |       | 126 |   |
| Money market and savings                                                                                                 |       | 749                                                |       | 905 |   |
| Time certificates of deposit:                                                                                            |       |                                               |       |   |   |
| $100,000 or more                                                                                                         |       | 403                                                |       | 535 |   |
| Under $100,000                                                                                                           |       | 473                                                |       | 783 |   |
| Total interest expense on deposits                                                                                       |       | 1,705                                              |       | 2,349 |   |
| Federal funds purchased and securities sold  under agreements to repurchase                                              |       | 1                                                  |       | 16 |   |
| Junior subordinated deferrable interest  debentures                                                                      |       | 966                                                |       | 454 |   |
| Other borrowings                                                                                                         |       | 332                                                |       | 361 |   |
| Total interest expense                                                                                                   |       | 3,004                                              |       | 3,180 |   |
| Net interest income before provision for  credit losses                                                                  |       | 16,450                                             |       | 13,944 |   |
| Provision for credit losses                                                                                              |       | 220                                                |       | 1,265 |   |
| Net interest income after provision for  credit losses                                                                   |       | 16,230                                             |       | 12,679 |   |
| Other operating income:                                                                                                  |       |                                               |       |   |   |
| Net gain (loss) on sale of securities  available-for-sale                                                                |       | (197                                               | )          | 51 |   |
| International services                                                                                                   |       | 59                                                 |       | 44 |   |
| Investment division                                                                                                      |       | 53                                                 |       | 84 |   |
| Deposit-related and other customer services                                                                              |       | 1,652                                              |       | 1,333 |   |
| Loss on sale of other real estate owned                                                                                  |       | —                                             |       | (136 | ) |
| Total other operating income                                                                                             |       | 1,567                                              |       | 1,376 |   |
| Other operating expenses:                                                                                                |       |                                               |       |   |   |
| Salaries and related benefits                                                                                            |       | 7,508                                              |       | 7,157 |   |
| Net occupancy                                                                                                            |       | 1,127                                              |       | 1,329 |   |
| Furniture and equipment                                                                                                  |       | 485                                                |       | 464 |   |
| Printing and communications                                                                                              |       | 546                                                |       | 504 |   |
| Insurance and regulatory assessments                                                                                     |       | 433                                                |       | 381 |   |
| Client services                                                                                                          |       | 590                                                |       | 563 |   |
| Computer data processing                                                                                                 |       | 965                                                |       | 994 |   |
| Legal services                                                                                                           |       | 464                                                |       | 473 |   |
| Other professional services                                                                                              |       | 854                                                |       | 833 |   |
| Amortization of core deposit intangible                                                                                  |       | 223                                                |       | 223 |   |
| Promotion and other expenses                                                                                             |       | 833                                                |       | 375 |   |
| Total other operating expenses                                                                                           |       | 14,028                                             |       | 13,296 |   |
| Income before income tax provision and  minority interests                                                               |       | 3,769                                              |       | 759 |   |
|                                                                                                                     |       |                                               |       |   |   |
| Minority interest in the Company’s income  of the:                                                                  |       |                                               |       |   |   |
| Guaranteed preferred beneficial interests  in the Company’s junior subordinated deferrable interest debentures, net |       | —                                             |       | 456 |   |
| Income before income tax provision                                                                                       |       | 3,769                                              |       | 303 |   |
| Income tax provision                                                                                                     |       | 1,583                                              |       | 96 |   |
| Net income                                                                                                               |       | $                                                  | 2,186      |   | $ | 207 |   |
| Earnings per share:                                                                                                      |       |                                               |       |   |   |
| Basic                                                                                                                    |       | $                                                  | 0.75       |   | $ | 0.08 |   |
| Diluted                                                                                                                  |       | $                                                  | 0.48       |   | $ | 0.05 |   |

 

See accompanying notes to consolidated financial statements.

 

46

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**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CHANGES INSHAREHOLDERS’ EQUITY**

 
| ** **                                                    | ** ** | ** **                                    | ** ** | ** **                    | ** ** | ** **        | ** ** | ** **  | ** ** | ** **       | ** ** | ** **        | ** ** | ** **     | ** ** | ** **  | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
|---------------------------------------------------------------|------------|-----------------------------------------------|------------|-------------------------------|------------|-------------------|------------|-------------|------------|------------------|------------|-------------------|------------|----------------|------------|-------------|------------|-----------------|------------|------------|------------|
| ** **                                                    | ** ** | ** **                                    | ** ** | ** **                    | ** ** | ** **        | ** ** | ** **  | ** ** | ** **       | ** ** | ** **        | ** ** | **Additional** | ** ** | ** **  | ** ** | **Other**       | ** ** | ** ** | ** ** |
| ** **                                                    | ** ** | **Preferred  Stock Series A**                 | ** ** | **Preferred  Stock Series B** | ** ** | **Common  Stock** | ** ** | **Paid-in** | ** ** | **Accumulated**  | ** ** | **Comprehensive** | ** ** | ** **     | ** ** |
| ** **                                                    | ** ** | **# of  Shares**                              | ** ** | **Amount**                    | ** ** | **# of  Shares**  | ** ** | **Amount**  | ** ** | **# of  Shares** | ** ** | **Amount**        | ** ** | **Capital**    | ** ** | **Deficit** | ** ** | **Income**      | ** ** | **Total**  | ** ** |
| ** **                                                    | ** ** | **(Dollars  in thousands except share data)** | ** ** |
|                                                          |       |                                          |       |                          |       |              |       |        |       |             |       |              |       |           |       |        |       |            |       |       |       |
| Balance at  December 31, 2002                                 |       | 734,985                                       |       | $                             | 6,003      |              | 1,000      |        | $          | 1,000            |       | 2,679,544         |       | $              | 38,054     |        | $          | —          |       | $          | (14,055    | ) | $ | 202 |   | $ | 31,204 |   |
| Preferred stock  converted into common stock on a 2:1 basis   |       | (5,400                                        | )          | (44                           | )          |              |       |        |       | 10,800           |       | 44                |       |           |       |        |       |            |       | —     |       |
| Stock options  exercised                                      |       |                                          |       |                          |       |              |       |        |       | 81,935           |       | 504               |       |           |       |        |       |            |       | 504        |       |
| Cumulative effect  of change in accounting principal (Note 1) |       |                                          |       |                          |       |              |       |        |       |             |       |              |       |           |       | (63         | )          |            |       | (63        | )          |
| Comprehensive  income (loss):                                 |       |                                          |       |                          |       |              |       |        |       |             |       |              |       |           |       |        |       |            |       |       |       |
| Unrealized  holding loss during the period, net               |       |                                          |       |                          |       |              |       |        |       |             |       |              |       |           |       |        |       | (131            | )          | (131       | )          |
| Net income                                                    |       |                                          |       |                          |       |              |       |        |       |             |       |              |       |           |       | 207         |       |            |       | 207        |       |
| Comprehensive income                                          |       |                                          |       |                          |       |              |       |        |       |             |       |              |       |           |       |        |       |            |       | 76         |       |
| 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:                                        |       |                                          |       |                          |       |              |       |        |       |             |       |              |       |           |       |        |       |            |       |       |       |
| Unrealized  holding gain during the period, net               |       |                                          |       |                          |       |              |       |        |       |             |       |              |       |           |       |        |       | 203             |       | 203        |       |
| 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 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

47

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**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

 
| ** **                                                                                  | ** ** | **For the Year Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                  | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| ** **                                                                                  | ** ** | **(Dollars in thousands)**          | ** ** |
| Cash flows from operating activities:                                                       |       |                                |       |   |   |
| Net income                                                                                  |       | $                                   | 2,186      |   | $ | 207 |   |
| Adjustments to reconcile net income to net  cash used in operating activities:              |       |                                |       |   |   |
| Depreciation and amortization                                                               |       | 409                                 |       | 479 |   |
| Provision for credit losses                                                                 |       | 220                                 |       | 1,265 |   |
| Valuation allowance for OREO                                                                |       | —                              |       | 75 |   |
| Loss (gain) on sale of securities available  for sale                                       |       | 197                                 |       | (51 | ) |
| Loss on sales of OREO                                                                       |       | —                              |       | 61 |   |
| Net amortization of premium on securities  available-for-sale                               |       | 250                                 |       | 239 |   |
| Net amortization of premium on securities  held-to-maturity                                 |       | 47                                  |       | 24 |   |
| Net amortization of core deposit intangible                                                 |       | 223                                 |       | 223 |   |
| Net amortization of premium on loans  purchased                                             |       | 190                                 |       | 281 |   |
| Decrease in accrued interest receivable and  other assets                                   |       | 1,333                               |       | 132 |   |
| Increase (decrease) in accrued interest  payable and other liabilities                      |       | 329                                 |       | (545 | ) |
| Net cash provided by operating activities                                                   |       | 5,384                               |       | 2,390 |   |
| Cash flows from investing activities:                                                       |       |                                |       |   |   |
| Purchase of securities available-for-sale                                                   |       | (34,987                             | )          | (33,339 | ) |
| Proceeds from sales of securities  available-for-sale                                       |       | 11,759                              |       | 2,545 |   |
| Proceeds from repayments and maturities of  securities available-for-sale                   |       | 16,517                              |       | 25,674 |   |
| Purchase of securities held-to-maturity                                                     |       | —                              |       | (5,021 | ) |
| Proceeds from repayments and maturities of  securities held-to-maturity                     |       | 1,043                               |       | 400 |   |
| Proceeds from sales of OREO                                                                 |       | —                              |       | 474 |   |
| Loan originations and principal  collections, net                                           |       | (53,178                             | )          | 8,782 |   |
| Redemption (purchase) of Federal Reserve  stock and other stocks                            |       | (1,204                              | )          | 146 |   |
| Expenditures on OREO improvements                                                           |       | (132                                | )          | — |   |
| Purchases of premises and equipment                                                         |       | (769                                | )          | (87 | ) |
| Net cash used in investing activities                                                       |       | (60,951                             | )          | (426 | ) |
| Cash flows from financing activities:                                                       |       |                                |       |   |   |
| Net increase in demand deposits, money  market and savings accounts                         |       | 6,749                               |       | 20,333 |   |
| Net increase (decrease) in time  certificates of deposit                                    |       | 8,076                               |       | (20,341 | ) |
| Net decrease in securities sold under  agreements to repurchase and federal funds purchased |       | (399                                | )          | (1,077 | ) |
| Net increase in other borrowings                                                            |       | 18,400                              |       | — |   |
| Net proceeds from exercise of stock options                                                 |       | 372                                 |       | 504 |   |
| Net cash provided by (used in) financing  activities                                        |       | 33,198                              |       | (581 | ) |
| Net increase (decrease) in cash and cash  equivalents                                       |       | (22,369                             | )          | 1,383 |   |
| Cash and cash equivalents, January 1                                                        |       | 39,284                              |       | 37,901 |   |
| Cash and cash equivalents, December 31                                                      |       | $                                   | 16,915     |   | $ | 39,284 |   |
|                                                                                        |       |                                |       |   |   |
| Supplemental disclosures of cash flow  information:                                         |       |                                |       |   |   |
| Cash paid for interest                                                                      |       | $                                   | 3,229      |   | $ | 3,885 |   |
| Cash paid for income taxes                                                                  |       | 51                                  |       | — |   |
| Unrealized loss (gain) on securitites  available-for-sale, net of tax effect                |       | (40                                 | )          | 71 |   |
| Unrealized gain on swap, net of tax effect                                                  |       | 314                                 |       | — |   |
| Transfers to OREO from loans receivable,  net                                               |       | $                                   | —     |   | $ | 535 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

48

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**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

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

## ** **

*Basis of Presentation*

 

The consolidated financial statements include the accounts of NationalMercantile Bancorp (“National Mercantile” when referring only to the parent companyor the “Company” when such reference includes National Mercantile Bancorp andits subsidiaries, collectively) and of its wholly owned subsidiaries,Mercantile National Bank (“Mercantile”) and South Bay Bank, N.A. (“South Bay”)(and collectively, the “Banks”).  Allintercompany transactions and balances have been eliminated.  Certain prior year amounts have beenreclassified to conform to the current year presentation.

 

The accounting and reporting policies of the Company conform toaccounting principles generally accepted in the United States and to prevailingpractices within the banking industry. The preparation of these consolidated financial statements requiresmanagement to make estimates and assumptions that affect the reported amount ofassets and liabilities, and disclosure of contingent assets and liabilities atthe date of the consolidated financial statements and the reported amounts ofrevenues and expenses during reported periods. Actual results could differ from those estimates.

 

The Company, through the Banks, engages in commercial banking in theLos Angeles area providing commercial and residential real estate financing,real estate construction financing and commercial lending serving niche marketsrepresented by professional service providers, entertainment, healthcare andcommunity-based nonprofit borrowers, and associated individuals with commercialbanking and personal banking needs.

 

*Cash and Cash Equivalents*

 

For purposes of reporting cash flows, cash and cash equivalents includecash and due from banks-demand, due from banks – interest bearing, federalfunds sold and securities purchased under agreements to resell.

 

*Securities*

 

Securities available-for-sale are carried at fair value.  Unrealized gains or losses on available-for-salesecurities are excluded from earnings and reported as accumulated othercomprehensive income, net of deferred income taxes, in a separate component ofshareholders’ equity until realized. Realized gains or losses on sales of available-for-sale securities arerecorded using the specific identification method.

 

Securities held-to-maturity are debt instruments in which managementhas the positive intent and ability to hold to maturity and are carried atamortized cost.

 

Premiums or discounts on available-for-sale and held-to-maturitysecurities are amortized or accreted into income using the effective interestmethod.

 

*Loans*

 

Loans are generally carried at principal amounts outstanding lessunearned income.  Unearned incomeincludes deferred unamortized fees net of direct incremental loan originationcosts.

 

Interest income is accrued as earned. Net deferred fees are accreted into interest income using the effectiveyield method.

 

Loans are placed on nonaccrual status when a loan becomes 90 days pastdue as to interest or principal unless the loan is both well secured and inprocess of collection.  Loans are alsoplaced on nonaccrual status when the full collection of interest or principalbecomes uncertain.  When a loan is placedon nonaccrual status, the accrued and unpaid interest receivable is reversedand the accretion of deferred loan fees is ceased.  Thereafter, interest collected on the loan isaccounted for on the cash collection method until qualifying for return toaccrual status.  Generally, a loan may bereturned to accrual status when all delinquent principal and interest arebrought current in accordance with the terms of the loan agreement and certainperformance criteria have been met.

 

49

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The Company considers a loan to be impaired when it is probable that itwill be unable to collect all amounts due according to the contractual terms ofthe loan agreement.  Once a loan isdetermined to be impaired, the impairment is measured based on the present valueof the expected future cash flows discounted at the loan’s effective interestrate, except that as a practical expedient, the impairment is measured by usingthe loan’s observable market price or the fair value of the collateral if theloan is collateral dependent.

 

When the measurement of the impaired loan is less than the recordedamount of the loan, impairment is recognized by creating a valuation allowancewith a corresponding charge to the provision for credit losses or by adjustingan existing valuation allowance for the impaired loan with a correspondingcharge or credit to the provision for credit losses.

 

The Company’s policy is to record cash receipts received on impairedand nonaccrual loans first as reductions to principal and then to interestincome.

 

*Allowance for Credit Losses*

 

The provisions for credit losses charged to operations reflectmanagement’s judgment of the adequacy of the allowance for credit losses andare determined through periodic analysis of the loan portfolio, problem loansand consideration of such other factors as the Company’s loan loss experience,trends in problem loans, concentrations of credit risk, and economic conditions(particularly Southern California), as well as the results of the Company’songoing examination process and its regulatory examinations.

 

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

 

*Premises and Equipment, Net*

 

Premises and equipment are presented at cost less accumulatedamortization and depreciation. Depreciation of furniture, fixtures and equipment is determined usingthe straight-line method over the estimated useful lives (3 years to 5 years)of each type of asset.  Leaseholdimprovements are amortized using the straight-line method over the term of therelated leases or the service lives (10 years to 20 years) of the improvements,whichever is shorter.  Gains and losseson dispositions are reflected in current operations.  Maintenance and repairs are charged to otheroperating expenses as incurred.

 

*Other Real Estate Owned*

 

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

 

*Income Taxes*

 

The Company and the Banks file consolidated federal income tax returnsand combined state income tax returns.

 

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

 

50

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*Comprehensive Income*

 

Comprehensive income is defined as the change in equity during a periodfrom transactions and other events and circumstances from nonownersources.  The accumulated balance ofother comprehensive income is required to be displayed separately from retainedearnings in the consolidated balance sheet.

 

The components of other comprehensive income together with totalcomprehensive income are reported in the consolidated statements of changes inshareholders’ equity.  The accumulatedbalance of other comprehensive income is reported as a net amount after taxes.

 

*Earnings per Share*

 

Basic earnings per share is computed using the weighted average numberof common shares outstanding during the period. The weighted average number of common shares outstanding used incomputing basic earnings per share for the years ended December 31, 2004and 2003 was 2,895,309 and 2,707,931, respectively.  Diluted earnings per share for the year endedDecember 31, 2004 was $0.48.  Theweighted average number of common shares and common share equivalentsoutstanding used in computing diluted earnings per share for the year endedDecember 31, 2004 was 4,555,622. The following table is a reconciliation of net income and shares used inthe computation of basic and diluted earnings per share:

 
| ** **                              | ** ** | **Earnings  available to  shareholders** | ** ** | **Weighted  Average  Shares** | ** ** | **Per share  amount** | ** ** |
|-----------------------------------------|------------|------------------------------------------|------------|-------------------------------|------------|-----------------------|------------|
| ** **                              | ** ** | **(in thousands)**                       | ** ** | ** **                    | ** ** | ** **            | ** ** |
|                                    |       |                                     |       |                          |       |                  |       |
| *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 |   |
|                                    |       |                                     |       |                          |       |                  |       |
| *For the year ended December 31, 2003*  |       |                                     |       |                          |       |                  |       |
| Basic EPS                               |       | $                                        | 207        |                          | 2,707,931  |                  | $          | 0.08 |   |
|                                    |       |                                     |       |                          |       |                  |       |
| Effect of dilutive securities:          |       |                                     |       |                          |       |                  |       |
| Options                                 |       |                                     |       | 76,294                        |       |                  |       |
| Convertible preferred stock             |       |                                     |       | 1,626,169                     |       |                  |       |
| Diluted earnings per share              |       | $                                        | 207        |                          | 4,410,394  |                  | $          | 0.05 |   |
|                                         |            |                                          |            |                               |            |                       |            |  |  |  |

 

*Fair Value of Financial Instruments*

 

Estimated fair value amounts have been determined using availablemarket information and appropriate valuation methodologies.  Considerable judgment is required tointerpret market data and to develop the estimates of fair value.  Accordingly, the estimates of fair value inthe financial statements are not necessarily indicative of the amounts theCompany could realize in a current market exchange.  The use of different market assumptions andestimation methodologies may have a material effect on the estimated fair valueamounts.

 

*Stock Options*

 

The Company applies Accounting Principles Board Opinion No. 25 andrelated Interpretations in accounting for the stock incentive plans.  SFAS No. 123, ‘‘Accounting for Stock-BasedCompensation,’’ encourages, but does not require, companies to recordcompensation cost for stock-based employee compensation plans at fair value.Compensation expense is recorded on the date of grant 

 

51

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only if the current market price of the underlying stock exceeded theexercise price.  All options were grantedat current market prices, accordingly, no compensation cost has been recognizedfor the plans.  Pro forma net income andpro forma earnings per share disclosures for employee stock option grants arebased on recognition as expense, over the vesting period, the fair value on thedate of grant of all stock-based awards made during 2004 and 2003.

 

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

 

As of December 31, 2004, the Company had goodwill of $3.2 millionand core deposit intangibles of $1.6 million from the acquisition of South Bayin 2001.  In accordance with SFAS No. 142goodwill is not amortized.  SFAS No. 142also requires an analysis of impairment of goodwill annually or more frequentlyupon the occurrence of certain events.   The Company has no other indefinite-lived intangible assets.  The core deposit intangibles were estimatedto have an original life of 10 years and 4 months. Amortization for intangiblesfor 2004 was, and for each of the next five years is estimated to be,$223,000.  During 2004, the requiredimpairment tests of goodwill and core deposit intangibles were conducted, andbased upon these evaluations, the Company’s goodwill and core depositintangibles were not impaired at December 31, 2004.

 

**Note 3—Investment Securities**

 

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

 

 
| ** **                                                                | ** ** | **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’s and  REMIC’s securities |       | 2,876                       |       | 1 |   | 19 |   | 2,858 |   |
|                                                                      |       |                        |       |   |   |   |   |   |   |
|                                                                      |       | $                           | 37,020     |   | $ | 84 |   | $ | 150 |   | $ | 36,954 |   |
|                                                                      |       |                        |       |   |   |   |   |   |   |
| FRB and other equity stocks                                               |       | $                           | 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 |   |
|                                                  |       |                        |       |   |   |   |   |   |   |
|                                                  |       | $                           | 3,507      |   | $ | 40 |   | $ | — |   | $ | 3,547 |   |
|                                                       |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |

 

52

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The Company had gross proceeds and gross realized losses related to thesale of investment securities of $11.8 million and $197,000, respectively, forthe year ended December 31, 2004. The Company had gross proceeds and gross realized gains related to thesale of investment securities of $2.5 million and $100,000, respectively, andgross realized losses related to a valuation reserve of $49,000 established onother-than-temporarily impaired securities, for the year endedDecember 31, 2003.

 

The estimated fair value and amortized cost of securitiesavailable-for-sale and held-to-maturity at December 31, 2004 bycontractual maturity, are shown below:

 

**Maturitiesof and Weighted Average Yields on Investment Securities**

 
| ** **                                                                |   | **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                                                  |   | $                           | 694        |                                   | 2.56       | %                                      | $          | —               |       | —                  |       | $ | — |   | — |   | $ | — |   | — |   | $ | 694 |   | 2.56 | % |
| GNMA-issued/guaranteed  mortgage pass-through certificates                |   | —                      |       | —                                 |       | —                                 |       | —               |       | —                  |       | — |   | 171 |   | 5.11 | % | 171 |   | 5.11 | % |
| Other U.S.  government and federal agencies                               |   | 6,451                       |       | 1.98                                   | %          | 15,401                                 |       | 2.74                 | %          | 1,977                   |       | 3.16 | % | — |   | — |   | 23,829 |   | 2.57 | % |
| FHLMC/FNMA-issued  mortgage pass-through certificates                     |   | —                      |       | —                                 |       | 427                                    |       | 4.93                 | %          | 206                     |       | 6.93 | % | 8,731 |   | 4.64 | % | 9,364 |   | 4.70 | % |
| CMO’s and REMIC’s  issued by U.S. government-sponsored agencies |   | —                      |       | —                                 |       | —                                 |       | —               |       | 3                       |       | 5.51 | % | 35 |   | — |   | 38 |   | 0.44 | % |
| Privately issued  corporate bonds, CMO’s and REMIC’s securities |   | —                      |       | —                                 |       | —                                 |       | —               |       | 721                     |       | 2.97 | % | 2,137 |   | — |   | 2,858 |   | 0.75 | % |
|                                                                      |   | $                           | 7,145      |                                   | 2.04       | %                                      | $          | 15,828               |       | 2.80                    | %          | $ | 2,907 |   | 3.38 | % | $ | 11,074 |   | 3.74 | % | $ | 36,954 |   | 2.98 | % |
|                                                                      |   |                        |       |                                   |       |                                   |       |                 |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| **Amortized  Cost**                                                       |   | $                           | 7,196      |                                   |       |                                   | $          | 15,885               |       |                    |       | $ | 2,913 |   |   |   | $ | 11,026 |   |   |   | $ | 37,020 |   |   |   |
|                                                                      |   |                        |       |                                   |       |                                   |       |                 |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Federal Reserve  Bank and  other equity stocks                       |   | $                           | 3,076      |                                   | —     |                                   | $          | —               |       | —                  |       | $ | — |   | — |   | $ | — |   | — |   | $ | 3,076 |   | — |   |

 
| ** **                                            |   | **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 |   | $                           | —     |                                   | —     |                                   | $          | —               |       | —     |       | $                       | 3,507      |   | 4.07 | % | $ | — |   | — |   | $ | 3,507 |   | 4.07 | % |
|                                                  |   | $                           | —     |                                   | —     |                                   | $          | —               |       | —     |       | $                       | 3,507      |   | 4.07 | % | $ | — |   | — |   | $ | 3,507 |   | 4.07 | % |

 

Actual maturities may differ from contractual maturities to the extentthat borrowers have the right to call or prepay obligations with or withoutcall or repayment penalties.

 

Investment securities totaling $1.1 million were pledged to securegovernment tax deposits, bankruptcy deposits, or for other purposes required orpermitted by law at December 31, 2004.

 

*Impaired Securities*

 

InNovember 2003, the FASB’s Emerging Issues Task Force (“EITF”) reached aconsensus requiring certain disclosures for impaired securities as described inEITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and ItsApplication to Certain Investments”.  Anysecurity for which the current fair value is less than the carrying value isconsidered impaired. On a quarterly basis, impaired securities are evaluated todetermine if the impairments are other-than-temporary.  For those securities that are identified ashaving an other-than-temporary impairment, the loss is reported as a reductionin current period income.  For all othertemporary impairments, the current period unrealized losses are recorded toother comprehensive income.

 

53

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Asof December 31, 2004, temporarily impaired securities had a fair value of$27.5 million and unrealized losses of $185,000.  Securities that were not impaired had a fairvalue of $13.0 million and unrealized gains of $119,000 at December 31, 2004.  The following table shows fair value andunrealized loss positions of temporarily impaired securities, categorized bywhether the securities have been impaired for less than twelve months or ifthey have been impaired for twelve months or more as of December 31, 2004.

 
| ** **                                                                | ** ** | **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                                                  |       | $                          | 694        |                    | $          | (2             | )          | $ | — |   | $ | — |   | $ | 694 |   | $ | (2 | ) |
| Other U.S. government and federal agency  securities                      |       | 24,639                     |       | (164                    | )          | —         |       | — |   | 24,639 |   | (164 | ) |
| Privately issued corporate bonds, CMO’s and  REMIC’s securities |       | 2,137                      |       | (19                     | )          | —         |       | — |   | 2,137 |   | (19 | ) |
| Total temporarily impaired securities                                     |       | $                          | 27,470     |                    | $          | (185           | )          | $ | — |   | $ | — |   | $ | 27,470 |   | $ | (185 | ) |

 

TheU.S. Treasury securities and other U.S. government and federal agencysecurities are impaired due to declines in fair values resulting from increasesin market interest rates from the time of purchase.  In total, there are fourteen impairedsecurities at December 31, 2004.  None ofthese securities has exhibited a notable decline in value as a result ofchanges in credit risk.  These debtsecurities are relatively short in duration, accordingly, any unrealized lossin an individual issue will diminish as the security approaches its maturity,irrespective of market rates of interest. Furthermore, we may borrow funds utilizing these securities ascollateral at market rates of interest in amounts representing nearly all ofthe market value.  For that reason thesecurities achieve their primary purpose of providing liquidity without beingsold.  As such, management does notconsider the impairments on these securities to be other-than-temporary.

 

**Note 4 - Loans Receivable and Allowance for Credit Losses**

 

The followingis a summary of the major categories of loans outstanding at December 31, 2004:

 
| ** **                                                            | ** ** | **2004**                    | ** ** |
|-----------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                            | ** ** | **(Dollars in  thousands)** | ** ** |
| Commercial loans - secured and unsecured                              |       | $                           | 98,429     |   |
| Real estate loans:                                                    |       |                        |       |
| Secured by commercial real properties                                 |       | 135,944                     |       |
| Secured by one to four family residential  properties                 |       | 9,405                       |       |
| Secured by multifamily residential  properties                        |       | 18,330                      |       |
| Total real estate loans                                               |       | 163,679                     |       |
| Construction and land development                                     |       | 50,289                      |       |
| Consumer installment, home equity and  unsecured loans to individuals |       | 2,516                       |       |
| Total loans outstanding                                               |       | 314,913                     |       |
| Deferred net loan origination fees and  purchased loan discount       |       | (1,066                      | )          |
| Loans receivable, net                                                 |       | $                           | 313,847    |   |
|                                                                  |       |                        |       |
| Weighted average yield for loans at December  31                      |       | 6.71                        | %          |

 

At December 31, 2004, the Company had no impaired loans and nospecific allowances established for impaired loans.   The average recorded investment of impairedloans was $265,000 and $1.7 million during 2004 and 2003, respectively.  No interest income was recognized on impairedloans during the years ended December 31, 2004 and 2003.

 

In the normal course of business, the Banks may make loans to officersand directors as well as loans to companies and individuals affiliated with orguaranteed by officers and directors of the Company and the Banks.  Such loans are made in the ordinary courseof  business at rates and terms no morefavorable than those offered to other customers with a similar creditstanding.  The 

 

54

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outstanding principal balance of these loans was $4.5 million atDecember 31, 2004 and December 31, 2003.  During 2004 there were $4.5 million ofadvances and $5.3 million of repayments. Interest income recognized on these loans amounted to $374,000 and$322,000 during 2004 and 2003, respectively. At December 31, 2004, none of these loans were on nonaccrualstatus. Based on analysis of information presently known to management aboutthe loans to officers and directors and their affiliates, management believesall have the ability to comply with the present loan repayment terms.

 

The following is a summary of activity in the allowance for creditlosses for the year ended December 31, 2004:

 
| ** **                                 | ** ** | **2004**                    | ** ** |
|--------------------------------------------|------------|-----------------------------|------------|
| ** **                                 | ** ** | **(Dollars in  thousands)** | ** ** |
|                                       |       |                        |       |
| Balance, beginning of year                 |       | $                           | 3,635      |   |
| Provision for credit losses                |       | 220                         |       |
| Loans charged off                          |       | (57                         | )          |
| Recoveries of loans previously charged off |       | 130                         |       |
| Balance, end of year                       |       | $                           | 3,928      |   |

 

Total loans charged-off in 2004 were $57,000.  The additional provision for credit losseswas recorded based upon the analysis of the adequacy of allowance for creditlosses.  The allowance for credit lossesfor classified loans graded as “criticized” by the Company’s internal gradingsystem that are collateral-dependent is based upon the net realizable value ofthe collateral that is periodically evaluated. The allowance for unsecured classified loans is based upon the severityof the credit weakness.

 

The following is a summary of nonperforming loans at December 31,2004:

 
| ** **                                                                                                                 | ** ** | **2004**                    | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                 | ** ** | **(Dollars in  thousands)** | ** ** |
|                                                                                                                       |       |                        |       |
| Nonaccrual loans                                                                                                           |       | $                           | 18         |   |
| Troubled debt restructurings                                                                                               |       | —                      |       |
| Loans contractually past due ninety or more  days with respect to either principal or interest and still accruing interest |       | 1,804                       |       |
|                                                                                                                       |       | $                           | 1,822      |   |

 

Interest foregone on nonperforming loans outstanding atDecember 31, 2004 and 2003 was $12,000 and $47,000, respectively.  Foregone interest on nonperforming loans doesnot include interest forgone on loans on nonperforming status that wererestored to performing status prior to year end, or subsequent to either beingcharged off prior to year end or transferred to OREO prior to year end.

 

The ability of the Company’s borrowers to honor their loan agreementsis substantially dependent upon economic conditions and real estate marketvalues throughout the Company’s market area. At December 31, 2004, loans aggregating $214.0 million werecollateralized by liens on residential and commercial real properties, nearlyall of which are located in California. While the Company’s loan portfolio is generally diversified with regardto the industries represented, at December 31, 2004, the Company’s loansto businesses and individuals engaged in entertainment industry relatedactivities amounted to $29.0 million.

 

*Troubled Debt Restructurings.*A TDR is a loan for which the Company has, for economic or legal reasonsrelated to a borrower’s financial difficulties, granted a concession to theborrower it would not otherwise consider, including modifications of loan termsto alleviate 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.  AtDecember 31, 2004, the Company had no TDRs.

 

**Note 5 – Premises and Equipment and Lease Commitments**

 

The followingis a summary of major components of premises and equipment at December 31,2004:

 

55

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| ** **                                      | ** ** | **2004**                    | ** ** |
|-------------------------------------------------|------------|-----------------------------|------------|
| ** **                                      | ** ** | **(Dollars in  thousands)** | ** ** |
|                                            |       |                        |       |
| Land                                            |       | $                           | 1,392      |   |
| Buildings.                                      |       | 3,870                       |       |
| Leasehold improvements                          |       | 1,764                       |       |
| Furniture, fixtures and equipment               |       | 5,858                       |       |
|                                            |       | 12,883                      |       |
| Less accumulated amortization and  depreciation |       | (7,080                      | )          |
|                                            |       | $                           | 5,804      |   |

 

Depreciation and amortization expense was $409,000 in 2004 and $479,000in 2003.  Rental expense on operatingleases included in occupancy expense in the Consolidated Statements ofOperations was $669,000 in 2004 and $808,000 in 2003.

 

The future minimum annual rental commitments at December 31, 2004are summarized below.

 
| ** **                        | ** ** | **2004**                    | ** ** |
|-----------------------------------|------------|-----------------------------|------------|
| ** **                        | ** ** | **(Dollars in  thousands)** | ** ** |
| *For the year ended December 31,* |       |                        |       |
| 2005                              |       | $                           | 705        |   |
| 2006                              |       | 673                         |       |
| 2007                              |       | 676                         |       |
| 2008                              |       | 689                         |       |
| 2009                              |       | 542                         |       |
| Thereafter                        |       | 1,942                       |       |
|                              |       | $                           | 5,227      |   |

 

**Note 6—Income Taxes**

 

The components of income tax provision consisted of the following forthe years ended December 31:

 
| ** **                 | ** ** | **2004**                   | ** ** | **2003** | ** ** |
|----------------------------|------------|----------------------------|------------|----------|------------|
| ** **                 | ** ** | **(Dollars in thousands)** | ** ** |
| Current taxes (benefit)    |       | $                          | 65         |     | $          | (679 | ) |
|                       |       |                       |       |     |       |
| Deferred taxes             |       | 1,518                      |       | 775      |       |
|                       |       |                       |       |     |       |
| Total income tax provision |       | $                          | 1,583      |     | $          | 96 |   |

 

56

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A reconciliation of the amounts computed by applying the federalstatutory rate of 34% for 2004 and 2003 to the income before income taxprovision and the effective tax rate are as follows:

 
| ** **                                     | ** ** | **2004**                   | ** ** | **2003** | ** ** |
|------------------------------------------------|------------|----------------------------|------------|----------|------------|
| ** **                                     | ** ** | **(Dollars in thousands)** | ** ** |
|                                           |       |                       |       |     |       |
| Tax provision at statutory rate                |       | $                          | 1,281      |     | $          | 103 |   |
| Increase (reduction) in taxes resulting  from: |       |                       |       |     |       |
| State taxes                                    |       | 270                        |       | —   |       |
| Book deductions without tax benefit            |       | —                     |       | (22      | )          |
| Permanent differences                          |       | 32                         |       | 15       |       |
|                                           |       | $                          | 1,583      |     | $          | 96 |   |

 

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

 
| ** **                      | ** ** | **2004**                   | ** ** |
|---------------------------------|------------|----------------------------|------------|
| ** **                      | ** ** | **(Dollars in thousands)** | ** ** |
| Deferred tax assets:            |       |                       |       |
| Net operating losses            |       | $                          | 4,725      |   |
| Accrued expenses                |       | 304                        |       |
| Alternative minimum tax credits |       | 384                        |       |
| Nonaccrual interest             |       | 89                         |       |
| Loan fees                       |       | 285                        |       |
| Bad debt expense                |       | 313                        |       |
| Core deposits                   |       | 86                         |       |
| Securities                      |       | 47                         |       |
| State taxes                     |       | 63                         |       |
| Other real estate owned         |       | 31                         |       |
| Other                           |       | 7                          |       |
| Total deferred tax assets       |       | 6,334                      |       |
|                            |       |                       |       |
| Deferred tax liabilities:       |       |                       |       |
| Depreciation                    |       | (671                       | )          |
| Securities available for sale   |       | (196                       | )          |
| FHLB stock dividend             |       | (42                        | )          |
| Loan premium amortization       |       | (145                       | )          |
| Total deferred tax liabilities  |       | (1,054                     | )          |
| Net deferred tax asset          |       | $                          | 5,280      |   |

 

For tax purposes at December 31, 2004, the Company had (i) federalNOLs of $13.1 million, which begin to expire in 2009;  (ii) a federal AMT credit carryforwardof $364,000; and (iii) a California AMT credit carryforward of$20,000.  The AMT credits carryforwardindefinitely.

 

The Company believes that it is more likely than not that the deferredtax asset will be realized.  Accordingly,no valuation allowance has been established against the deferred tax asset.

 

**Note 7—Benefit Plans**

 

*Stock Incentive Plans*.  At December 31, 2004, the Company hadactive one stock incentive plan pursuant to which up to a total of 668,510shares of common stock may be issued. Under this plan, the Company may grant to directors, officers, employeesand consultants stock-based incentive compensation in a variety of forms,including without limitation nonqualified options, incentive options, sales andbonuses of common stock and stock appreciation rights, on such terms andconditions as the Board determines. However, the exercise price of optionsgranted to nonemployee directors may not be less than the fair market value ofthe common

 

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stock on the date of grant.  At December 31,2004, the only outstanding awards under this plan were stock options, and atthat date 63,509 shares were available for future awards.

 

At December 31, 2004, there were also outstanding options andtandem stock appreciation rights granted under two prior stock incentive plans.

 

The following summarizes option grants, cancellations and exercisesunder the stock incentive plans for the periods indicated .

 
|                                |   |    |   | **Option Price Range   Per Share** |
|-------------------------------------|--------|---------|--------|------------------------------------|
|                                |   |    |   |                               |   |   |   |   |   |
| Outstanding, December 31, 2002 |   | 420,843 |   | $                                  | 4.31 |   | - |   | $ | 8.52 |   |
| Granted                             |   | 165,200 |   | 6.75                               |   | - |   | 11.50 |   |
| Cancelled                           |   | (10,800 | )      | 5.75                               |   | - |   | 8.52 |   |
| Exercised                           |   | (81,935 | )      | 4.47                               |   | - |   | 8.52 |   |
| 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 |   |

 

Of the outstanding options at December 31, 2004:  (i) options to purchase 356,133 shares werevested and exercisable; and (ii) the remaining options become exercisable asfollows: 2005  — 97,850 and 2006 —26,175.  Options granted to employeesexpire on the tenth anniversary of the date of the grant and vest (i) 100% oneyear from the date of the grant for grants less than 500 shares; and (ii) 50%after one year and 50% after two years from the date of the grant for grants of500 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.

 

The estimated per share weighted average fair value of options grantedwas $7.22 and $8.83 during 2004 and 2003. The Company applies Accounting Principles Board Opinion No. 25 andrelated Interpretations in 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 costhas been recognized for the plans.  Hadcompensation cost for the options granted been determined based on the fairvalue at the grant dates for awards under the plans consistent with the methodof SFAS No. 123, the Company’s net earnings for 2004 would have beendecreased by $156,000 and the net earnings for 2003 would have decreased by$141,000.  Basic and diluted earnings pershare would have decreased by $0.05 and $0.03 for 2004, respectively. Basic and diluted earnings per share would have decreased by $0.05 and$0.03 for 2003, respectively.

 

The fair values of options granted during 2004 and 2003 were estimatedon the date of grant using the Black-Scholes option-pricing model with thefollowing weighted-average assumptions used: 2004— no dividend yield, expectedvolatility of 56%, risk-free interest rate of 4.23%, and an expected life of 10years; 2003— no dividend yield, expected volatility of 62%, risk-free interestrate of 4.28%, and an expected life of 10 years.

 

*Defined Contribution Retirement Plan*.The Company maintains a defined contribution retirement plan under section 401(k)of the Internal Revenue Code. Employees are eligible to participate following****six months of continuous employment. Under the plan, theCompany has partially matched employee contributions since May 1,2001.  Such matching contributions becomefully vested when the employee reaches three years of service.  The Company’s matching contributions for 2004and 2003 were $115,000 and $89,000, respectively.

 

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**Note 8 - Borrowed Funds**

 
| ** **                                                               | ** ** | **2004**                   | ** ** |
|--------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                               | ** ** | **Year-end**               | ** ** | **Average** | ** ** |
| ** **                                                               | ** ** | **Balance**                | ** ** | **Weighted  Average  Rate** | ** ** | **Balance** | ** ** | **Weighted  Average  Rate** | ** ** |
| ** **                                                               | ** ** | **(Dollars in thousands)** | ** ** |
|                                                                     |       |                       |       |   |   |   |   |   |   |
| Federal funds purchased and securities sold  under repurchase agreements |       | $                          | —     |   | — |   | $ | 113 |   | 0.88 | % |
| Other borrowings                                                         |       | 25,900                     |       | 2.32 | % | 12,550 |   | 2.65 | % |
|                                                                          |            |                            |            |  |  |  |  |  |  |  |  |

 

The maximum amount of federal funds purchased and securities sold underagreements to repurchase at any month-end was $3.0 million during 2004.

 

Other borrowings are primarily comprised of Federal Home Loan Bank (“FHLB”)advances.  At December 31, 2004 FHLBadvances included: (i) a $19.0 million overnight borrowing maturing January 2005with a fixed annual rate of 2.25%, (ii) fixed-rate borrowings of $2.0million maturing February 2005 with an annual rate of 1.74%; (iii) fixed-rateborrowings of $2.0 million maturing April 2005 with an annual rate of4.45%; (iv) fixed-rate borrowings of $1.9 million maturing April 2005with an annual rate of 1.56%; and (v) fixed-rate borrowings of $1.0million maturing May 2005 with an annual rate of 2.01%.  The maximum amount of other borrowingsoutstanding at any month-end during 2004 was $31.9 million.

 

The Banks had $2.1 million of unused borrowing capacity from the FHLBat December 31, 2004 based upon pledged securities.

 

**Note 9—Junior Subordinated Deferrable Interest Debentures**

 

In July 2001 the Company issued $15.5 million aggregate principalamount of 10.25% fixed rate junior subordinated deferrable interest debenturesdue July 25, 2031 (“Junior Subordinated Debentures’) that pay interest eachJanuary 26 and July 26.  The interest isdeferrable, at the Company’s option, for a period up to ten consecutivesemi-annual payments, but in any event not beyond June 25, 2031.  The debentures are redeemable, in whole or inpart, at the Company’s option on or after five years from issuance at decliningpremiums to maturity.  The recordedbalance of Junior Subordinated Debentures was $15.5 million at December 31,2004

 

The Junior Subordinated Debentures are held by National MercantileCapital Trust I (the “Trust”), a Delaware business trust, formed by the Companyfor the sole purpose of issuing certain securities representing undividedbeneficial interests in the assets of the Trust and investing the proceedsthereof in the Junior Subordinated Debentures. In July 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 Preferred Securities areunconditionally guaranteed by the Company with respect to distributions andpayments upon liquidation, redemption and otherwise to the extent provided inand pursuant to the terms of a Guarantee Agreement.

 

 

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

 

National Mercantile is a legal entity separate and distinct from theBanks, and as such has separate and distinct financial obligations includingannual deferrable debt service of $1.6 million on the Junior Subordinated Debentureand other modest operating expenses. While National Mercantile from time to time holds short-terminvestments,  its assets primarilyconsist of the common shares of the Banks and it has historically not engagedin any other business activity.  Accordingly,dividends and capital distributions from the Banks constitute the principalsource of cash to the Company.  The Banksare subject to various statutory and regulatory restrictions on their abilityto pay dividends to the Company.

 

OCC approval is required for a national bank to pay a dividend if thetotal of all dividends declared in any calendar year exceeds the total of thebank’s net profits (as defined) for that year combined with its retained netprofits for the preceding two calendar years, less any required transfer tosurplus or a fund for the retirement of any preferred stock.  A national bank may not pay any dividend thatexceeds its retained net earnings, 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.

 

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

 

Mercantile has no retained earnings, and therefore is presently unableto pay dividends.  Mercantile has asubstantial accumulated deficit and does not anticipate having positiveretained earnings for the foreseeable future. South Bay had retained earnings of $1.6 million as of December 31,2004.  Mercantile and South Bay may fromtime to time be permitted to make capital distributions to National Mercantilewith the consent of the OCC.  It is notanticipated that such consent could be obtained unless the distributing bankwere to remain “well capitalized” following such distribution.

 

Federal law restricts the Banks’ extension of credit to, the issuanceof a guarantee or letter of credit on behalf of, investments in or taking ascollateral stock or other securities of National Mercantile.  Restrictions prevent National Mercantile fromborrowing from the Banks unless the loans are secured by designated amounts ofmarketable obligations.  Further, securedloans to and investments in National Mercantile or its affiliates by a bank arelimited to 10% of  the bank’s capitalstock and surplus (as defined by federal regulations) and are limited, in theaggregate, to 20% of the bank’s contributed capital (as defined by federalregulations).

 

Federal Reserve Board regulations require the Banks to maintain certainminimum reserve balances.  Cash balancesmaintained to meet reserve requirements are not available for use by the Banksor National Mercantile.  During 2004 and2003, the average reserve balances for the Banks were approximately $6.5million and $6.2 million, respectively. Neither National Mercantile nor the Banks is required to maintaincompensating balances to assure credit availability under existing borrowingarrangements.

 

National Mercantile and the Banks are subject to various capitalrequirements administered by the federal banking regulatory agencies. Failureto meet minimum capital requirements can initiate certain mandatory—andpossibly additional discretionary—actions by regulators that, if undertaken,could have a direct material effect on National Mercantile’s financialstatements. Under capital adequacy guidelines and the regulatory framework forprompt corrective action, National Mercantile and Banks must meet specificcapital guidelines that involve quantitative measures of National Mercantile’sand the Banks’ assets, liabilities and certain off-balance-sheet items ascalculated under regulatory accounting practices. National Mercantile’s and theBanks’ capital amounts and classification are also subject to qualitativejudgment by the regulators about components, risk weightings and other factors.

 

Quantitative measures established by regulation to ensure capitaladequacy require National Mercantile and the Banks to maintain minimum amountsand ratios (set forth in the table below) of total and Tier 1 capital (as definedin the regulations) to risk-weighted assets (as defined).  Management believes, as of December 31,2004, National Mercantile and Banks meet all capital adequacy requirements towhich they are subject.

 

At December 31, 2004, each Bank was categorized as wellcapitalized under the regulatory framework for prompt corrective action.  To be categorized as well capitalized underthe prompt corrective action rules, each Bank must maintain minimum totalrisk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in thefollowing table.  There are no conditionsor events since the most recent notification which management believes havechanged the Banks’ category.

 

The following table presents, at the dates indicated, certaininformation regarding the regulatory capital of National Mercantile and theBanks and the required amounts of regulatory capital for National Mercantileand the Banks to meet applicable regulatory capital requirements and, in thecase of the Banks, to be well capitalized under the prompt corrective actionrules.

 

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| ** **                             | ** ** | ** **                 | ** ** | ** **            | ** ** | ** **       | ** ** | ** **            | ** ** | **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, 2004           |       |                       |       |                  |       |             |       |                  |       |                  |       |   |   |
| Total Capital to Risk Weighted Assets  |       |                       |       |                  |       |             |       |                  |       |                  |       |   |   |
| National Mercantile Bancorp            |       | $                          | 45,617     |                  | 12.42      | %                | $          | 29,391                |       | >=8.0              | %          | $ | N/A |   | N/A |   |
| Mercantile National Bank               |       | 21,515                     |       | 11.60                 | %          | 14,843           |       | >=8.0              | %          | 18,554                |       | >=10.0 | % |
| South Bay Bank, N.A                    |       | 18,930                     |       | 10.29                 | %          | 14,718           |       | >=8.0              | %          | 18,398                |       | >=10.0 | % |
| Tier 1 Capital to Risk Weighted Assets |       |                       |       |                  |       |             |       |                  |       |                  |       |   |   |
| National Mercantile Bancorp            |       | 38,182                     |       | 10.39                 | %          | 14,695           |       | >=4.0              | %          | N/A                   |       | N/A |   |
| Mercantile National Bank               |       | 19,375                     |       | 10.44                 | %          | 7,421            |       | >=4.0              | %          | 11,132                |       | >=6.0 | % |
| South Bay Bank, N.A                    |       | 17,142                     |       | 9.32                  | %          | 7,359            |       | >=4.0              | %          | 11,039                |       | >=6.0 | % |
| Tier 1 Capital to Average Assets       |       |                       |       |                  |       |             |       |                  |       |                  |       |   |   |
| National Mercantile Bancorp            |       | 38,182                     |       | 9.87                  | %          | 15,475           |       | >=4.0              | %          | N/A                   |       | N/A |   |
| Mercantile National Bank               |       | 19,375                     |       | 8.99                  | %          | 8,619            |       | >=4.0              | %          | 10,774                |       | >=5.0 | % |
| South Bay Bank, N.A                    |       | 17,142                     |       | 9.32                  | %          | 7,356            |       | >=4.0              | %          | 9,195                 |       | >=5.0 | % |
|                                        |            |                            |            |                       |            |                  |            |                       |            |                       |            |  |  |  |  |  |

 

**Note 11—Commitments and Contingencies**

 

In the normal course of business, the Company is a party to financialinstruments with off-balance sheet risk. These financial instruments include commitments to extend credit,letters of credit and financial guarantees. These instruments involve, to varying degrees, elements of credit andinterest rate risk in excess of the amount reflected in the consolidatedbalance sheet.

 

Exposure to credit loss in the event of nonperformance by the otherparty to the financial instrument for letters of credit and financialguarantees written is represented by the contractual notional amount of thoseinstruments.  The Company uses the samecredit policies in making commitments and conditional obligations as it doesfor on-balance sheet instruments.

 

The Company had $272,000 of outstanding letters of credit at December 31,2004.

 

Loan commitments are agreements to lend to a customer a specifiedamount subject to certain conditions. Loan commitments generally have fixed expiration dates or othertermination clauses and may require payment of a fee.  Since portions of the commitments areexpected to expire without being drawn upon, the total amount of commitmentsdoes not necessarily represent future cash requirements. The Company hadoutstanding loan commitments aggregating $130.5 million at December 31,2004, substantially all of which were for adjustable rate loans.

 

The Company from time to time is party to lawsuits, which arise in thenormal course of business. The Company does not believe that any pendinglawsuit at December 31, 2004 will have a material adverse effect on thefinancial position or results of operations of the Company.

 

**Note12—Disclosures about the Fair Value of Financial Instruments**

 

The following methods and assumptions were used to estimate the fairvalue of each class of financial instruments for which it is practical toestimate that value.

 

*Cash, cash equivalents and interest bearingdeposits*:  Forthese short-term investments, the carrying amount is a reasonable estimation offair value.

 

*Securities available-for-sale and securitiesheld-to-maturity*: For securities classified as available-for-sale, fair value equalsquoted market prices, if available. If a quoted market price is not available,fair value is estimated using quoted market prices for similar securities.

 

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

 

*Loans*:  Variable rate loans have carrying amountsthat approximate fair value. The fair value of fixed rate loans is estimated bydiscounting the future cash flows using the current rates at which similarloans would be made to borrowers with similar credit ratings and for the sameremaining maturities. In establishing the credit risk component of the fairvalue calculations for loans, the Company concluded the allowance for creditlosses represented a reasonable estimate of the credit risk component of thefair value at December 31, 2004.

 

62

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*Interest rate swaps:* Thefair value of the interest rate swap is based upon an estimate derived frombroker quotations or proprietary broker models that consider the relevantcharacteristics of the instrument.

 

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

 

*Federal funds purchased and securities soldunder agreements to repurchase*:  The fair value of fixed-rate securities soldunder agreements to repurchase is estimated by discounting the future cash flowsusing the rates currently offered for instruments of similar maturities.

 

*Junior subordinated debentures:* The fair value of the junior subordinated debentures is estimated bydiscounting the future cash flows using a rate determined by applying (i) the spreadbetween the fixed rate of the junior subordinated debentures and the rate ofthirty-year U.S. Treasury securities at the time of issuance of the juniorsubordinated debentures to (ii) the rate of current U.S. Treasury securitiesfor a term similar to the remaining term of the junior subordinated debentures.

 

*Other borrowings*:  The fair value of fixed-rate borrowings isestimated by discounting the future cash flows using the rates currentlyoffered for borrowings of similar maturities. Borrowings with maturities greater than one year bear interest atvariable rates and approximate fair value.

 

The estimated fair values of financial instruments at the dateindicated are presented below.

 
| ** **                                                            | ** ** | **December 31, 2004** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                            | ** ** | **Carrying**               | ** ** | **Fair** | ** ** |
| ** **                                                            | ** ** | **Amount**                 | ** ** | **Value** | ** ** |
| ** **                                                            | ** ** | **(Dollars in thousands)** | ** ** |
| Financial assets:                                                     |       |                       |       |   |   |
| Cash, cash equivalents and deposit with  other financial institutions |       | $                          | 16,915     |   | $ | 16,915 |   |
| Securities available-for-sale                                         |       | 36,954                     |       | 36,954 |   |
| Securities held-to-maturity                                           |       | 3,507                      |       | 3,547 |   |
| FRB and other stock .                                                 |       | 3,076                      |       | 3,076 |   |
| Loans, net of allowance for credit losses                             |       | 309,919                    |       | 309,847 |   |
| Interest rate swaps.                                                  |       | 355                        |       | 355 |   |
| Financial liabilities:                                                |       |                       |       |   |   |
| Demand deposits, money market and savings                             |       | 250,443                    |       | 250,443 |   |
| Time certificates of deposit                                          |       | 63,099                     |       | 63,400 |   |
| Junior subordinated debentures                                        |       | 15,464                     |       | 16,731 |   |
| Other borrowings                                                      |       | 25,900                     |       | 25,898 |   |
|                                                                       |            |                            |            |  |  |  |  |

 

**Note 13—Derivatives**

 

In January 2003, National Mercantile entered into an interest rateswap agreement pursuant to which it exchanged a fixed rate payment obligationof 10.25% on a notional principal amount of $15.0 million for a floating rateinterest based on the six-month London InterBank Offered Rate plus 458 basispoints for a 29-year period ending July 25, 2031.  The interest rate swap agreement results inNational Mercantile paying or receiving the difference between the fixed andfloating rates at specified intervals calculated based on the notionalamounts.  The differential paid orreceived on the interest rate swap is recognized as an adjustment to interestexpense.  At December 31, 2004, theCompany was paying an interest rate of 6.51% under the terms of the swap.  The counter party to the swap has the optionto call the swap under a declining premium schedule beginning July 2006.

 

The interest rate swap reduces the adverse impact of the Company’s10.25% Junior Subordinated Debentures in a declining interest rateenvironment.  The Company does notutilize 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 the change in the fair value ofthe swap transaction is recorded each period in current income.  The terms of the swap are symmetrical withthe terms of the Trust Preferred Securities, including the payment deferralterms, and considered highly effective in offsetting changes in fair value ofthe Trust Preferred Securities. Accordingly, no ineffectivenesswill be recorded to current earnings related to the interest rate swap.

 

On July 1, 2004, the Banks entered into interest rate swaps inwhich they exchanged an adjustable rate interest based on the prime ratelending index for a fixed rate payment of 6.925% on an aggregate notionalprincipal amount beginning at $50.0 million for a 4-year period,declining to $30.0 million for the fifth year and $10.0 million for the sixthyear with a final maturity of June 30, 2010.  The interest rate swaps result in the Bankspaying or receiving the difference between the fixed and floating rates atmonthly intervals calculated on the notional amounts.  The differential paid or received on theinterest rate swaps has been recognized as an adjustment to interest income.  At December 31, 2004, the Banks werepaying an interest rate of 5.25% under the terms of the swaps.

 

63

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These interest rate swaps reduce the current asset sensitivity of theCompany’s balance sheet moderating the potential negative impact on earnings inthe event of declining interest rates. The Company does not utilize derivatives for speculative purposes.  Under Statement of Financial AccountingStandards No. 133 these swap transactions have been designated as cashflow hedges.  Accordingly, the change infair value of the swaps is recorded each period as other comprehensive incomeand any ineffective portion of the change in the fair value is recorded incurrent income.  The Company has a largeportion of its loan portfolio that adjusts to changes in the prime rate lendingindex and therefore the swaps are currently considered highly effective inoffsetting changes in the cash flows of the loan portfolio.

 

**Note 14—Parent Company Information**

 

The following financial information presents the condensed balancesheet of the Company on a parent-only basis as of December 31, 2004, andthe related condensed statements of operations and cash flows for each of theyears in the two-year period ended December 31, 2004.

 

**Balance Sheet**

 
| ** **                                          | ** ** | **December 31,**       | ** ** |
|-----------------------------------------------------|------------|-----------------------------|------------|
| ** **                                          | ** ** | **2004**                    | ** ** |
| ** **                                          | ** ** | **(Dollars in  thousands)** | ** ** |
| ** **                                          | ** ** | ** **                  | ** ** |
| Cash with Banks                                     |       | $                           | 174        |   |
| Due from banks - time                               |       | 1,651                       |       |
| Securities available-for-sale                       |       | 983                         |       |
| Investment in the Banks                             |       | 45,387                      |       |
| Other assets                                        |       | 2,442                       |       |
| Total assets                                        |       | $                           | 50,637     |   |
|                                                |       |                        |       |
| Junior subordinated deferrable interest  debentures |       | $                           | 15,464     |   |
| Other liabilities                                   |       | 691                         |       |
| Total liabilities                                   |       | 16,155                      |       |
|                                                |       |                        |       |
| Shareholders’ equity:                          |       |                        |       |
| Preferred stock                                     |       | 6,442                       |       |
| Common stock                                        |       | 39,491                      |       |
| Accumulated deficit                                 |       | (11,725                     | )          |
| Accumulated other comprehensive income              |       | 274                         |       |
| Total shareholders’ equity                     |       | 34,482                      |       |
| Total liabilities and shareholders’ equity     |       | $                           | 50,637     |   |

 

64

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**Statements of Operations**

 
| ** **                                                  | ** ** | **Year ended December 31,** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                  | ** ** | **2004**                         | ** ** | **2003** | ** ** |
| ** **                                                  | ** ** | **(Dollars in thousands)**       | ** ** |
| ** **                                                  | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Interest income                                             |       | $                                | 33         |   | $ | 42 |   |
| Interest expense                                            |       | 966                              |       | 934 |   |
| Net interest expense                                        |       | (933                             | )          | (892 | ) |
|                                                        |       |                             |       |   |   |
| Other operating income                                      |       | 144                              |       | 14 |   |
| Other operating expense                                     |       | 238                              |       | 290 |   |
| Loss before equity in undistributed net  income of the Bank |       | (1,027                           | )          | (1,168 | ) |
| Equity in undistributed net income of  subsidiaries         |       | 2,790                            |       | 944 |   |
| Income before income tax provision  (benefit)               |       | 1,763                            |       | (224 | ) |
| Income tax benefit                                          |       | 423                              |       | 479 |   |
| Net income                                                  |       | $                                | 2,186      |   | $ | 255 |   |

 
| **Statements of Cash Flow**                                                        |       |                             |       |     |       |
|------------------------------------------------------------------------------------|------------|----------------------------------|------------|----------|------------|
| ** **                                                                         |       |                             |       |     |       |
| ** **                                                                         | ** ** | **Year ended December 31,** | ** ** |
| ** **                                                                         | ** ** | **2004**                         | ** ** | **2003** | ** ** |
| ** **                                                                         | ** ** | **(Dollars in thousands)**       | ** ** |
|                                                                               |       |                             |       |     |       |
| Cash flows from operating activities:                                              |       |                             |       |     |       |
| Net income                                                                         |       | $                                | 2,186      |     | $          | 255 |   |
| Adjustment to reconcile net income to net  cash provided by operating activities.: |       |                             |       |     |       |
| Equity in undistributed net income of  subsidiaries, net                           |       | (2,790                           | )          | (944     | )          |
| Net increase in other assets and other  liabilities.                               |       | (615                             | )          | (687     | )          |
| Net cash used in operations                                                        |       | (1,219                           | )          | (1,376   | )          |
|                                                                               |       |                             |       |     |       |
| Cash flows from investing activities:                                              |       |                             |       |     |       |
| Purchase of available-for-sale securities                                          |       | (1,290                           | )          | (1,586   | )          |
| Sales and maturities of available-for-sale  securities                             |       | 1,800                            |       | —   |       |
| Net cash provided by (used in) investing  activities                               |       | 510                              |       | (1,586   | )          |
|                                                                               |       |                             |       |     |       |
| Cash flows from financing activities:                                              |       |                             |       |     |       |
| Proceeds from stock options exercised.                                             |       | 372                              |       | 504      |       |
| Net cash provided by financing activities                                          |       | 372                              |       | 504      |       |
| Net decrease in cash and cash equivalents                                          |       | (337                             | )          | (2,458   | )          |
| Cash and cash equivalents, beginning of the  year                                  |       | 2,162                            |       | 4,620    |       |
| Cash and cash equivalents, end of the year                                         |       | $                                | 1,825      |     | $          | 2,162 |   |
|                                                                               |       |                             |       |     |       |
| Supplemental disclosures of cash flow  information:                                |       |                             |       |     |       |
| Cash paid for Interest                                                             |       | $                                | 1,020      |     | $          | 1,328 |   |
| Cash paid for Income taxes, net                                                    |       | $                                | 51         |     | $          | — |   |

 

65

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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.         |       | Consent of  Ernst & Young LLP                                                                                                                                                                                                                                                                                                |
|        |       |                                                                                                                                                                                                                                                                                                                                  |
| 31.1        |       | Certification  of Scott A. Montgomery under Section 302 of Sarbanes-Oxley Act                                                                                                                                                                                                                                                    |
|        |       |                                                                                                                                                                                                                                                                                                                                  |
| 31.2        |       | Certification  of David R. Brown under Section 302 of Sarbanes-Oxley Act                                                                                                                                                                                                                                                         |

 

66

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| 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 to the Company’s Annual Report on Form 10-K for the year  ended December 31, 1997.                                                         |
|------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2)  | Filed as an  exhibit to the Company’s Annual Report on Form 10-K for the year  ended December 31, 1992 and incorporated herein by reference.                    |
| (3)  | Filed as an  exhibit to the Company’s Report on Form 10-Q for the quarter ended  March 31, 1999 and incorporated herein by reference.                           |
| (4)  | Filed as an  exhibit to Company’s Annual Report on Form 10-K for the year ended  December 31, 1990 and incorporated herein by reference.                        |
| (5)  | Filed as an  exhibit to the Company’s Registration Statement on Form S-2 dated  February 10, 1997 and amendments thereto and incorporated herein by  reference. |
| (6)  | Filed as an  exhibit to the Company’s Annual Report on Form 10-K for the year  ended December 21, 2000 and incorporated herein by reference.                    |
| (7)  | Filed as an  exhibit to the Company’s Report on Form 10-Q for the quarter ended  September 30, 2001 and incorporated herein by reference.                       |
| (8)  | Filed as an  exhibit to the Company’s Annual Report on Form 10-K for the year  ended December 21, 2001 and incorporated herein by reference.                    |
| (9)  | Filed as an  exhibit to the Company’s Annual Report on Form 10-K for the year  ended December 21, 2002 and incorporated herein by reference.                    |
| (10) | Filed as an  exhibit to the Company’s Registration Statement on Form S-8 dated  June 20, 2003 and incorporated herein by reference.                             |
| (11) | Filed as an  exhibit to the Company’s Annual Report on Form 10-K for the year  ended December 21, 2003 and incorporated herein by reference.                    |

 

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