** **

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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**Form 10-KSB**

 

**ANNUAL REPORTPURSUANT TO SECTION 13 OR 15(d)**

**OF THE SECURITIESEXCHANGE ACT OF 1934**

** **

| **For the year ended December 31,  2001** |   | **Commission File Number 0-15982** |
|-------------------------------------------|--------|------------------------------------|

 

**NATIONAL MERCANTILE BANCORP**

**(Exact name of registrant as specified in its charter)**

 

**California**

(State or otherjurisdiction of

incorporation ororganization)

 

**1840 Century Park East**

**Los Angeles, California**

(Address to principalexecutive offices)

**95-3819685**

(I.R.S. Employer

Identification No.)

 

 

**90067**

(Zip Code)

 

**Registrant’s telephone number, including area code:  (310) 277-2265**

**No securities registered pursuant to Section 12(b) of the Act**

**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)**

 

                Indicate by checkmark whether the registrant:  (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.     ýYes      o   No

 

                Indicate by checkmark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-Kis not contained herein, and will not be contained, to the registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-KSB. o

 

                The aggregatemarket value of the voting common equity held by nonaffiliates of theregistrant, based upon the closing sale price of its Common Stock as reportedby the National Association of Securities Dealers Automated Quotation System onApril 11, 2002, was approximately $9.5 million.

 

                The number ofshares of Common Stock, no par value, of the registrant outstanding as of April11, 2002 was 1,630,253.

 

**DOCUMENTS INCORPORATED BY REFERENCE**:

 

Certain portions of the Company’s Proxy Statement tobe filed with the Commission pursuant to Rule 14a-6 under the SecuritiesExchange Act of 1934 in connection with the Company’s 2001 Annual Meeting ofShareholders are incorporated by reference in Part III, Items 10-13 of thisAnnual Report on Form 10-KSB.

 

**This Report Includes a Total of  73 Pages**

**Index to Exhibits on Page 70**

** **

**NATIONAL MERCANTILE BANCORP**

 

**Table of Contents**

 

**Form 10-KSB**

**For the Fiscal Year Ended December 31, 2001**

 

 
|                     |   |                                                                                        | **Page** |
|--------------------------|--------|---------------------------------------------------------------------------------------------|----------|
| **PART I**               |   |                                                                                        |     |
| Item 1.                  |   | Business                                                                                    | 3        |
| Item 2.                  |   | Properties                                                                                  | 11       |
| Item 3.                  |   | Legal Proceedings                                                                           | 12       |
| Item  4.                 |   | Submission  Of Matters To A Vote Of Security Holders                                        | 12       |
|                     |   |                                                                                        |     |
| **PART II**              |   |                                                                                        |     |
| Item  5.                 |   | Market  For Registrant’s Common Equity And Related Shareholder  Matters           | 13       |
| Item  6.                 |   | Management’s  Discussion And Analysis Of Financial Condition And Results Of Operations | 14       |
| Item 7.                  |   | Financial  Statements                                                                       | 43       |
| Item 8.                  |   | Changes  In And Disagreements With Accountants On Accounting And Financial Disclosure       | 43       |
|                     |   |                                                                                        |     |
| **PART III**             |   |                                                                                        |     |
| Item 9.                  |   | Directors  And Executive Officers Of The Registrant                                         | 43       |
| Item 10.                 |   | Executive  Compensation                                                                     | 43       |
| Item 11.                 |   | Security  Ownership Of Certain Beneficial Owners And Management                             | 43       |
| Item 12.                 |   | Certain  Relationships And Related Transactions                                             | 44       |
|                     |   |                                                                                        |     |
| **PART IV**              |   |                                                                                        |     |
| Item 13.                 |   | Exhibits, Financial  Statement Schedules, And Reports On Form 8-K                           | 14       |
| Signatures               | 45     |
| **Financial Statements** | **46** |
| **Exhibit Index**        | **70** |

** **

**2**

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**ANNUAL REPORT ON FORM10-K**

 

                    Certain matters discussed in this Form 10-KSB may constitute forward-looking statements within the meaning of the Securities Exchange Act of 1934 (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 National Mercantile Bancorp (referred to as “we” or “our” when such reference includes 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, Mercantile National Bank and South Bay Bank, N.A.) operates, projections of future performance, perceived opportunities in the market and statements regarding our mission 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.  For discussion of the factors that might cause such a difference, see “Item 6. Management’s Discussion and Analysis of Financial Condition and Results of Operations— Factors Which May Affect Future Operating Results”.

 

**PART I**

 

***ITEM1.      BUSINESS***

**National Mercantile Bancorp**

 

        National Mercantile Bancorp (“National Mercantile”, on a parent-only basis, and “we” or “our”, on a consolidated basis) is a bank holding company with two bank subsidiaries: Mercantile National Bank (“Mercantile National”) and South Bay Bank, N.A. (“South Bay”). National Mercantile’s principal assets are the capital stock of Mercantile National and 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.

 

        National Mercantile Capital Trust I, which is a Delaware statutory business trust formed for the exclusive purpose of issuing and selling trust preferred securities, is also a subsidiary of National Mercantile.

 

        Our present businessstrategy is to attract individual and small- to mid-sized business borrowers inspecific market niches located in our primary service areas by offering avariety of loan products and a full range of banking services coupled withhighly personalized service. Our lending products include revolving lines ofcredit, term loans, commercial real estate loans, construction lending 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.  In order toprovide the personalized service required by these customers, we use a team approachto customer service combining an experienced relationship management officerwith operations support personnel.

 

        We operate throughout thewest side of Los Angeles County including the South Bay, Century City and SanFernando Valley with banking offices in Century City, Torrance, Encino and ElSegundo.  Our targeted market nichesincluding the entertainment industry, the healthcare industry, professionalservices providers, the real estate escrow industry, property managers andcommunity-based nonprofit organizations. Additionally, we target developers of small commercial real estateproperties and customer residential properties.  Entertainment industry customers include television, music andfilm production companies, talent agencies, individual performers, directorsand producers (whom we attract by establishing relationships with businessmanagement firms) and others affiliated with the entertainment industry.  Healthcare organizations include primarily outpatienthealthcare providers such as physician medical groups, independent practiceassociations and surgery centers. Professional service customers include legal, accounting, insurance,advertising firms and their individual directors, officers, partners andshareholders.  In order to grow andexpand our array of products and services, we may from time to time open denovo branch banking offices or acquire other financial service-relatedcompanies including “in-market” acquisitions with banks of similar size andmarket presence.  No assurance can bemade that we will identify a company which 

 

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can be acquired on terms and conditions acceptable to us or that wecould obtain the necessary regulatory approvals for such an acquisition

 

        At December 31, 2001, wehad total assets of $374.4 million, total loans, net, of $262.0 million andtotal deposits of $309.1 million.

 

**History**

 

        Mercantile National wasorganized in 1981 as a national banking association and commenced operationsthrough an office in Century City in 1982. In 1983 National Mercantile was organized under the laws of the State ofCalifornia and registered as a bank holding company under the Bank HoldingCompany Act of 1956, as amended (the ‘‘BHCA’’), to serve as a holding companyfor Mercantile National.

 

        In March 2001, MercantileNational opened a regional office in Encino, California which expanded ourclient-focused niche banking services to the San Fernando Valley area of LosAngeles.  The Encino regional officefocuses on providing banking services to those affiliated with the healthcareindustry as well as expanding the client base in the entertainment industry,professional service providers and community-based nonprofit organizations.

 

        In December 2001, weacquired South Bay, which had offices in Torrance and El Segundo.  The acquisition of South Bay was accountedfor under the purchase accounting method. Accordingly, the assets acquired and liabilities assumed were recordedat their fair values and the results of operations reflect only the periodsince acquisition.

 

**Competition**

 

                The banking andfinancial services industry in California generally, and in the Banks’ marketareas specifically, is highly competitive. The increasingly competitiveenvironment is a result primarily of changes in regulation, changes intechnology and product delivery systems, and the accelerating pace ofconsolidation among financial services providers. Our primary service area isdominated by a relatively small number of major banks that have many officesoperating over a wide geographical area. The Banks compete for loans, deposits, and customers with othercommercial banks, savings and loan associations, securities and brokeragecompanies, mortgage companies, insurance companies, finance companies, moneymarket funds, credit unions, and other nonbank financial serviceproviders.  Many of these competitorsare much larger in total assets and capitalization, have greater access tocapital markets and offer a broader range of financial services than the Banks.  Nondepository institutions can be expectedto increase 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 on portions of thefinancial services industry can be expected to erode.  In addition, many of the major commercial banks operating in ourprimary service area offer services, such as trust services, which are notoffered directly by us and, by virtue of their greater total capitalization,such banks have substantially higher lending limits.

 

        Tocompete with other financial institutions in our primary service area, we relyprincipally upon personal contact by our officers, directors and employees andproviding, through third parties, specialized services such as messenger,accounting and other related services. For clients whose loan demands exceed our legal lending limit, wearrange for such loans on a participation basis with other banks. Our Banksalso assist clients requiring other services not offered by us in obtainingsuch services from other providers.

 

Economic Conditions, Government Policies, Legislation, and Regulation

 

        Our profitability, like most financial institutions, is primarily dependent on interest rate differentials. In general, the difference between the interest rates paid by the Banks on interest-bearing liabilities, such as deposits and other borrowings, and the interest rates received by the Banks on their interest-earning assets, such as loans extended to their clients and securities held in their investment portfolios, comprise the major portion of our earnings.  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 National Mercantile and the Banks cannot be predicted.

 

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        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 National Mercantile and the Banks of any future changes in monetary and fiscal policies.

 

        From time to time, legislative acts, as well as regulations, are enacted which have the effect of increasing the cost of doing business, limiting or expanding permissible activities, or affecting the competitive balance between banks and other financial services providers.  Proposals to change the laws and regulations governing the operations and taxation of banks, bank holding companies, and other financial institutions and financial services providers are frequently made in the U.S. Congress, in the state legislatures, and before various regulatory agencies.

 

Supervision and Regulation

 

*  General*

 

        Bank holding companies and banks are extensively regulated under both federal and state law.  This regulation is intended primarily for the protection of depositors and the deposit insurance fund and not for the benefit of shareholders of National Mercantile.  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 BHCA.

 

        As a bank holding company, National Mercantile is required to seek 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.

 

        National Mercantile is required by the Federal Reserve to maintain certain levels of capital. See “—Capital Standards, below.”

 

        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.

 

        National Mercantile is also a bank holding company within the meaning of Section 3700 of the California Financial Code. As such, National Mercantile and its subsidiaries are subject to examination by, and may be required to file reports with, the California Department of Financial Institutions.

 

5

 

        National Mercantile’s Common Stock and Series A Noncumulative Convertible Perpetual Preferred Stock are registered with the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). As a result, National Mercantile is subject to the information, proxy solicitation, and other requirements and restrictions of the Exchange Act.

 

 

*  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 “Comptroller”) 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 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 or 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.

 

*  USA Patriot Act of 2001*

 

        On October 26, 2001, President Bush signed the USA Patriot Act of 2001.  Enacted in response to the terrorist attacks in New York, Pennsylvania and Washington, D.C. on September 11, 2001, the Patriot Act is intended to strengthen U.S. law enforcement’s and the intelligence community’s ability to work cohesively to combat terrorism on a variety of fronts.  The potential impact of the Patriot Act on financial institution of all kinds is significant and wide ranging. The Patriot Act contains sweeping anti-money laundering and financial transparency laws and requires various regulations, including: (i) due diligence requirements for financial institutions that administer, maintain, or manage private banks accounts or correspondent accounts for non-U.S. persons; (ii) standards for verifying customer identification at account opening; (iii) rules to promote cooperation among financial institutions, regulators, and law enforcement entities in identifying parties that may be involved in terrorism or money laundering; (iv) reports by nonfinancial trades and business filed with the Treasury Department’s Financial Crimes Enforcement Network for transactions exceeding $10,000 and; (v) filing of suspicious activities reports securities by brokers and dealers if they believe a customer may be violating U.S. laws and regulations.

 

        We are not able to predict the impact of the Patriot Act on our financial condition or results of operations at this time.

 

*    FDIC*

The Banks are subject toexamination and regulation by the Federal Deposit Insurance Corporation  (the “FDIC”) under the Federal DepositInsurance Act (“FDIA”) because its deposit accounts are insured by the FDICunder the Bank Insurance Fund (“BIF”).

 

Under FDIC regulations, insured depositoryinstitution’s are assigned to one of three capital groups for insurance premiumpurposes — “well capitalized,” “adequately capitalized” and “undercapitalized”— which are defined in the same manner as the regulations establishing theprompt corrective action system under Section 38 of the FDIA, as discussedunder “Capital Adequacy Requirements” below. These three groups are then divided into subgroups which are based onsupervisory evaluations by the institution’s primary federal regulator,resulting in nine assessment classifications. Assessment rates for BIF-insuredbanks range from 0% of insured deposits for well-capitalized banks 

 

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with minor supervisory concerns to 0.027% of insured deposits forundercapitalized banks with substantial supervisory concerns.

 

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 which, as with the OCC’senforcement authority, are not limited to cases of capital inadequacy, is in anunsafe or unsound condition to continue operations or has violated anyapplicable law, regulation or order or any condition imposed in writing by theFDIC.  In addition, FDIC regulationsprovide that any insured institution that falls below a 2% minimum leverageratio (see below) will be subject to FDIC deposit insurance terminationproceedings unless it has submitted, and is in compliance with, a capital planwith its primary federal regulator and the FDIC.  The FDIC may also suspend deposit insurance temporarily duringthe hearing process if the institution has no tangible capital.  The FDIC is additionally authorized bystatute to appoint itself as conservator or receiver of an insured depositoryinstitution (in addition to the powers of the institution’s primary federalregulatory authority) in cases, among others and upon compliance with certainprocedures, of unsafe or unsound conditions or practices or willful violationsof cease and desist orders.

 

*    Dividends and Other Distributions*

 

        Dividends and capital distributions from the Banks constitute the principal source of income 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.  These include specific restrictions on dividends and capital distributions, as well as requirements to maintain specified levels of regulatory capital and to operate in a safe and sound manner.

 

                In general, anational bank may not, without prior OCC approval, pay a dividend if the totalof all dividends declared in any calendar year exceeds the total of the bank’snet profits (as defined) for that year combined with its retained net profitsfor the preceding two calendar years, less any required transfer to surplus ora fund for the retirement of any preferred stock.  With a vote of two-thirds or more of its shareholders, a nationalbank may make a capital distribution resulting in the reduction of itspermanent capital.  No capitaldistribution or dividend can be made if the national bank were to be “undercapitalized” following such capital distribution or dividend, and it could beexpected that OCC approval would not be likely if such capital distribution ordividend would result in the bank’s being less than “well capitalized”.  A national bank may not declare a dividendin excess of its undivided profits.  TheOCC and the Federal Reserve have also issued banking circulars emphasizing thatthe level of cash dividends should bear a direct correlation to the level of anational bank’s current and expected earnings stream, the bank’s need tomaintain an adequate capital base and other factors.  Further, the OCC would not permit a dividend or capitaldistribution if it believed that such dividend or capital distribution wouldconstitute an unsafe or unsound practice.

 

            Mercantile National is presently unable topay dividends to National Mercantile because it has no undivided profits anddoes not anticipate having undivided profits for the foreseeable future.  It could, from time to time and with theconsent of the OCC, pay a capital distribution to National Mercantile, but itis not anticipated that such would be approved unless Mercantile National wereto remain “well capitalized” following such distribution.

 

        South Bay has undivided profits of $74,000 as of December 31, 2001, which would be available for dividends.  South Bay has two classes of stock outstanding:  Common Stock, all of which is held by National Mercantile, and Series A Perpetual Preferred Stock, all of which is held by two directors of South Bay.  The South Bay Preferred Stock has priority as to dividends each quarter over the Common Stock in the amount of $53,125.

 

                The OCCregulations incorporate guidelines establishing standards for safety andsoundness, including operational and managerial standards relating to internalcontrols and information systems, internal audit systems, loan documentation,credit underwriting, interest rate exposure, asset growth and compensation,fees and benefits, and prohibit compensation deemed excessive.  If the OCC finds that a bank has failed tomeet any applicable standard, it may require the institution to submit anacceptable plan to achieve compliance and, if the bank fails to comply, the OCCmust, by order, require it to correct the deficiency.

 

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                The OCC hasenforcement powers with respect to national banks for violations of federal lawsor regulations that are similar to the powers of the Federal Reserve withrespect to bank holding companies and nonbanking subsidiaries.  See “Bank Holding Companies,” above.

 

*    Transactions with Affiliates*

 

        The Banks are subject to certain restrictions imposed by federal law on any extensions of credit to, or the issuance of a guarantee or letter of credit on behalf of, National Mercantile or other affiliates, the purchase of, or investments in, stock or other securities thereof, the taking of such securities as collateral for loans, and the purchase of assets of National Mercantile or other affiliates. Such restrictions prevent National Mercantile and such other affiliates from borrowing from the Banks unless the loans are secured by marketable obligations of designated amounts.  Further, such secured loans and investments by the Banks to or in National Mercantile or to or in any other affiliate are limited, individually, to 10% of the respective Bank’s capital and surplus (as defined by federal regulations), and such secured loans and investments are limited, in the aggregate, to 20% of the respective Bank’s capital and surplus (as defined by federal regulations). California law also imposes certain restrictions with respect to transactions involving National Mercantile and other controlling persons of the Banks.  Additional restrictions on transactions with affiliates may be imposed on the Banks under the prompt corrective action provisions of federal law.  See “—Prompt Corrective Action and Other Enforcement Mechanisms.”

 

   *CapitalAdequacy Requirements*

 

                Both the FederalReserve Board and the OCC have adopted similar, but not identical, “risk-based”and “leverage” capital adequacy guidelines for bank holding companies andnational banks, respectively.  Under therisk-based capital guidelines, different categories of assets are assigneddifferent risk weights, ranging from zero percent for risk-free assets (e.g.,cash) to 100% for relatively high-risk assets (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 thetotal capital is required to be “Tier 1 capital,” consisting principally ofcommon shareholders’ equity, a limited amount of perpetual preferred stock andminority interests in the equity.  Theremainder (Tier 2 capital) may consist of a limited amount of subordinateddebt, certain hybrid capital instruments and other debt securities, preferredstock and a limited amount of the general loan-loss allowance

 

                The minimum Tier 1leverage ratio, consisting of Tier 1 capital to average adjusted total assets,is 3% for bank holding companies and national banks that have the highestregulatory examination rating and are not contemplating significant growth orexpansion.  All other bank holdingcompanies and national banks are expected to maintain a ratio of at least 1% to2% or more above the stated minimum. Our capital ratios are shown in the table below.

 

                The OCC hasadopted regulations establishing capital categories for national banks andprompt corrective actions for undercapitalized institutions.  The regulations create five capitalcategories: well capitalized, adequately capitalized, undercapitalized,significantly undercapitalized and critically undercapitalized.  The following table shows as of December 31,2001 the minimum total risk-based capital, Tier 1 risk-based capital and Tier 1leverage ratios, all of which must be satisfied for a bank to be classified as wellcapitalized, adequately capitalized or undercapitalized, respectively, togetherwith our ratios which in all cases exceed the well capitalized minimums:

 

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** **
|                         |   | **Total**         |   | **Tier 1**        |   | **Tier 1**   |   |   |   |
|------------------------------|--------|-------------------|--------|-------------------|--------|--------------|--------|--------|--------|
|                         |   | **risk-based**    |   | **risk-based**    |   | **leverage** |   |   |   |
|                         |   | **capital ratio** |   | **capital ratio** |   | **ratio**    |   |   |   |
| Actual:                      |   |              |   |              |   |         |   |   |   |
| National  Mercantile Bancorp |   | 11.53             | %      | 6.85              | %      | 5.55         | %      |   |   |
| Mercantile  National Bank    |   | 11.76             | %      | 10.50             | %      | 6.85         | %      |   |   |
| South  Bay Bank, NA          |   | 10.90             | %      | 9.63              | %      | 8.72         | %      |   |   |
|                         |   |              |   |              |   |         |   |   |   |
| Minimum:                     |   |              |   |              |   |         |   |   |   |
| Well  capitalized (1)        |   | 10.00             | %      | 6.00              | %      | 5.00         | %      |   |   |
| Adequately  capitalized      |   | 8.00              | %      | 4.00              | %      | 4.00         | %      | (2     | )      |
| Undercapitalized             |   | 6.00              | %      | 4.00              | %      | 3.00         | %      |   |   |

 

(1)   A bank may not be classified as wellcapitalized if it is subject to a specific agreement with OCC to meet andmaintain a specific level of capital.

(2)   3% for institutions having a composite rating of “1” in the mostrecent OCC examination.

 

**       **If any one or more of a bank’s ratios are below theminimum ratios required to be classified as undercapitalized, it will beclassified as significantly undercapitalized provided that if its ratio oftangible equity to total assets is 2% or less, it will be classified ascritically undercapitalized.  A bank maybe reclassified by the OCC to the next level below that determined by thecriteria described above 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 a bankcannot be reclassified as critically undercapitalized for such reasons.

 

**       **The OCC may subject national banks to a broad range ofrestrictions and regulatory requirements. A national bank may not pay management fees to any person having controlof the institution, nor, except under certain circumstances and with priorregulatory approval, make any capital distribution if, after doing so, it wouldbe undercapitalized.  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 capitalrestoration plan unless each company that controls the bank guarantees that thebank will comply with it.  Significantlyand critically undercapitalized banks are subject to additional mandatory anddiscretionary restrictions and, in the case of critically undercapitalizedinstitutions, must be placed into conservatorship or receivership unless theOCC and the FDIC agree otherwise.

 

                Under FederalReserve policy, a bank holding company is expected to act as a source offinancial strength to its subsidiary banks and to commit resources to supporteach such bank.  In addition, a bankholding company is required to guarantee that its subsidiary bank will complywith any capital restoration plan.  Theamount of such a guarantee is limited to the lesser of (i) 5% of the bank’stotal assets at the time it became undercapitalized, or (ii) the amount whichis necessary (or would have been necessary) to bring the bank into compliancewith all applicable capital standards as of the time the bank fails to complywith the capital restoration plan.  Aholding company guarantee of a capital restoration plan results in a priorityclaim to the holding company’s assets ahead of its other unsecured creditorsand shareholders that is enforceable even in the event of the holding company’sbankruptcy or the subsidiary bank’s insolvency.

 

        As a condition to the approval of National Mercantile’s acquisition of South Bay, we agreed with the Federal Reserve that we would maintain National Mercantile’s and each of the Bank’s regulatory capital ratios in the well capitalized category for the three years following the closing.  At December 31, 2001, each of the Banks and National Mercantile exceeded the required ratios for classification as well capitalized.

 

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*     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 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.

 

*  Premiums for Deposit Insurance*

 

        Through the Bank Insurance Fund (“BIF”), the FDIC insures the deposits of the Banks up to prescribed limits for each depositor. The amount of FDIC assessments paid by each BIF member institution is based on its relative risk of default as measured by regulatory capital ratios and other factors. Specifically, the assessment rate is based on the institution’s capitalization risk category and supervisory subgroup category.  An institution’s capitalization risk category is based on the FDIC’s determination of whether the institution is well capitalized, adequately capitalized or less than adequately capitalized.  An institution’s supervisory subgroup category is based on the FDIC’s assessment of the financial condition of the institution and the probability that FDIC intervention or other corrective action will be required.

 

        The assessment rate currently ranges from zero to 27 cents per $100 of domestic deposits. The FDIC may increase or decrease the assessment rate schedule on a semi-annual basis.  An increase in the assessment rate could have a material adverse effect on National Mercantile’s earnings, depending on the amount of the increase.  The FDIC is authorized to terminate a depository institution’s deposit insurance upon a finding by the FDIC that the institution’s financial condition is unsafe or unsound or that the institution has engaged in unsafe or unsound practices or has violated any applicable rule, regulation, order or condition enacted or imposed by the institution’s regulatory agency.  The termination of deposit insurance for one or more of National Mercantile’s subsidiary depository institutions would have a material adverse effect on National Mercantile’s earnings.

 

        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, 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 FDIC established the FICO assessment rates effective for the fourth quarter of 2001 at approximately $.0184 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.

 

*  Interstate Banking and Branching*

 

        The BHCA permits bank holding companies from any state to acquire banks and bank holding companies located in any other state, subject to certain conditions, including certain nationwide- and state-imposed concentration limits. The Banks have the ability, subject to certain restrictions, to acquire by acquisition or merger branches outside their home state. The establishment of new interstate branches is also possible in those states with laws that expressly permit it.  Interstate branches are subject to certain laws of the states in which they are located.  Competition may increase further as banks branch across state lines and enter new markets.

 

10

 

*  Community Reinvestment Act and Fair Lending Developments*

 

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

 

        The Community Reinvestment Act 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 Community Reinvestment Act obligations into account when regulating and supervising other activities.  An assessment of Community Reinvestment Act 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 Community Reinvestment Act record.  In the case of a bank holding company applying for approval to acquire a bank or other bank holding company, the Federal Reserve Board 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 Community Reinvestment Act

 

        In connection with its assessment of Community Reinvestment Act performance, the appropriate bank regulatory agency assigns a rating of “outstanding”, “satisfactory”, “needs to improve” or “substantial noncompliance”. The results of the most recent exam for each of the Banks are as follows.

 
| Date of most recent |   |                     |   |         |   |
|---------------------|--------|--------------------------|--------|--------------|--------|
| Bank examination    |   |                     |   | CRA rating   |   |
| 3/02/1998           |   | Mercantile National Bank |   | Satisfactory |   |
| 11/15/1999          |   | South Bay Bank           |   | Satisfactory |   |

 

Employees

 

        At December 31, 2001, we had 105 full-time employees.  None of the employees is covered by a collective bargaining agreement.  We consider our employee relations to be satisfactory.

 

 

ITEM 2.  PROPERTIES.

 

        We lease approximately 24,000 square feet in an office building at 1840 Century Park East, Century City, California, the location of National Mercantile’s administrative headquarters and Mercantile National’s principal banking office.  The effective rent for the period November 1, 2000 to October 31, 2004 is $2.83 per square foot or $67,607 per month. The rent is subject to annual adjustments for changes in property taxes and operating costs.  The lease expires in October 2004.

 

11

 

        In connection with the lease, National Mercantile issued the landlord a warrant to purchase up to 9.9% of the outstanding shares of capital stock of the Company at December 31, 1997. The exercise price of the warrant is currently $5.00 per share of Common Stock and $10.00 per share of Series A Noncumulative Convertible Perpetual Preferred Stock.  The warrant expires on December 31, 2002. The Company also granted the landlord registration rights with respect to capital stock purchased by the landlord (or its assignee) pursuant to the warrant.

 

        Mercantile National also leases an approximately 1,650 square foot facility in Encino, California for the primary purpose of providing branch banking operations in the San Fernando Valley.

 

        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 an approximately 1500 square foot facility in El Segundo, California for the primary purpose of providing branch banking operations in the Los Angeles airport area.

 

        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 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, 2001.

 

12

 

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

*** ***

***ITEM5.      MARKET FOR REGISTRANT’S COMMONEQUITY AND RELATED SHAREHOLDER MATTERS***

                The Common Stockand Series A Noncumulative Convertible Perpetual Preferred Stock (the “Series APreferred”) of National Mercantile are traded on the Nasdaq SmallCap Market,under the symbols MBLA and MBLAP, respectively.  The following table shows the high and low trade prices of theCommon Stock and Series A Preferred for each quarter of 2000 and 2001 asreported by the Nasdaq. Additionally, there may have been transactions atprices other than those shown during that time.

 
|                |   |             |   |          |   | **Series A** |   |
|---------------------|--------|------------------|--------|---------------|--------|--------------|--------|
|                |   | **Common Stock** |   | **Preferred** |   |
| **Quarter  Ended:** |   | **High**         |   | **Low**       |   | **High**     |   | **Low** |   |
|                |   |             |   |          |   |         |   |   |   |
| March  31, 2000     |   | 8.88             |   | 4.38          |   | 16.00        |   | 8.50 |   |
| June  30, 2000      |   | 8.00             |   | 5.50          |   | 16.25        |   | 12.50 |   |
| September  30, 2000 |   | 8.31             |   | 6.00          |   | 15.88        |   | 13.00 |   |
| December  31, 2000  |   | 7.61             |   | 6.25          |   | 14.75        |   | 13.00 |   |
| March  31, 2001     |   | 8.00             |   | 6.38          |   | 14.50        |   | 13.75 |   |
| June  30, 2001      |   | 7.65             |   | 6.60          |   | 14.00        |   | 14.00 |   |
| September  30, 2001 |   | 8.30             |   | 6.60          |   | 17.00        |   | 14.06 |   |
| December  31, 2001  |   | 7.35             |   | 5.65          |   | 13.50        |   | 11.90 |   |

 

         At March29, 2002, Naitonal Mercantile had 179 shareholders of record for its CommonStock and 21 shareholders of record for its Series A Preferred.  The number of beneficial owners for theCommon Stock and Series A Preferred is higher as many people hold their sharesin “street” name.  At March 29, 2002,approximately 82% and 19% of the Common Stock and Series A Preferred, respectively,were held in street name.

 

        NationalMercantile has not paid a cash dividend on the Common Stock since July 1990,and has never paid a cash dividend on the Series A Preferred.  The Series A Preferred is entitled to anoncumulative cash dividend at a rate of 6.5% of its liquidation preferencequarterly on the first day of January, April, July, and October of each year,commencing October 1, 2000, before any dividend may be declared upon or paidupon the Common Stock.  As a Californiacorporation, under the California General Corporation Law, generally we may notpay dividends in cash or property except (ii) out of positive retained earningsor (ii) if, after giving effect to the distribution, National Mercantile’sassets would be at least 1.25 times its liabilities and its current assets wouldexceed its current liabilities (determined on a consolidated basis undergenerally accepted accounting principles). At December 31, 2001, NationalMercantile had an accumulated deficit of $13.8 million.  Further, it is unlikely that our assets willever be at least 1.25 times its liabilities. Accordingly, the National Mercantile must generate net income of inexcess of $13.8 million before it can pay a dividend in cash or property.

 

13

----

 

***ITEM 6.***                 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONAND RESULTS OF OPERATIONS

 

**OVERVIEW**

 

        NationalMercantile Bancorp (“National Mercantile”, on a parent-only basis, and “we” or“our”, on a consolidated basis) recorded net earnings of $1.2 million for 2001 compared to $2.9 millionfor 2000.  On a per share basis, 2001recorded basic earnings of $0.72 and fully-diluted earnings of $0.28 comparedto $2.77 and $1.08, respectively, for 2000. The decrease in net earnings was due to a $791,000 increase in operatingexpenses and $722,000 allocated to the minority interest in our trust preferreddebentures.  Additionally, in 2001provisions for credit losses were $517,000 compared to a $576,000 recapture ofallowances for credit losses, resulting in a reverse provision, in 2000.  Partially offsetting these factors, netinterest income increased $478,000 in 2001, despite a lower net yield onearning assets, and other operating income increased $365,000 over 2000.

 

        Totalassets at December 31, 2001 were $374.4 million compared to $204.8 million atyear end 2000.  The increase is largelyattributable to the acquisition of South Bay in December 2001.  Contributing to asset growth was theissuance of $15 million trust preferred securities in July 2001 and $29.3million growth in demand, money market and savings accounts partially offset bya $29.6 million reduction in other borrowings. This additional net funding was primarily deployed in greater levels offederal funds sold and loans partially offset by a lower volume of investmentsecurities available for sale.

 

        The trustpreferred securities are accounted for on the balance sheet as guaranteedpreferred beneficial interests in the Company’s junior subordinated deferrableinterest debentures, net of issuance costs. The amount earned by the holders of the trust preferred securities istreated as an allocation of income to minority interests.

 

        Theallowance for credit losses at December 31, 2001 was $6.5 million compared to$2.6 million at December 31, 2000.  Theincrease is primarily due to the addition of the South Bay allowance for creditlosses of $3.6 million and secondarily due to provisions to the allowanceduring the year of $517,000 partially offset by net charge-offs of $218,000.

 
| **Table 1**                                     |   |                       |   |           |   |             |   |     |   |
|-------------------------------------------------|--------|----------------------------|--------|----------------|--------|------------------|--------|----------|--------|
| **Operations Summary**                          |   |                       |   |           |   |             |   |     |   |
|                                            |   | **Year Ended**             |   | **Increase**   |   | **Year Ended**   |   |
|                                            |   | **December 31,**           |   | **(Decrease)** |   | **December 31,** |   |
|                                            |   | **2001**                   |   | **Amount**     |   | **%**            |   | **2000** |   |
|                                            |   | **(Dollars in thousands)** |   |
| Interest  income                                |   | $                          | 13,791 |           | $      | (669             | )      | (4.6%    | )      | $ | 14,460 |   |
| Interest  expense                               |   | 3,876                      |   | (1,147         | )      | (22.8%           | )      | 5,023    |   |
| Net  interest income                            |   | 9,915                      |   | 478            |   | 5.1              | %      | 9,437    |   |
| Provision  for credit losses                    |   | 517                        |   | 1,093          |   | (189.8%          | )      | (576     | )      |
| Other  operating income                         |   | 1,233                      |   | 365            |   | 42.1             | %      | 868      |   |
| Other  operating expense                        |   | 8,661                      |   | 791            |   | 10.1             | %      | 7,870    |   |
| Minority  interest in the company’s junior |   |                       |   |           |   |             |   |     |   |
| subordinated  deferrable interest debenture-net |   | 722                        |   | 722            |   | 100.0            | %      | 0        |   |
|                                            |   |                       |   |           |   |             |   |     |   |
| Income  before income taxes                     |   | 1,248                      |   | (1,763         | )      | (58.5%           | )      | 3,011    |   |
| Income  taxes                                   |   | 92                         |   | 25             |   | 37.3             | %      | 67       |   |
| Net  income                                     |   | $                          | 1,156  |           | $      | (1,788           | )      | (60.7%   | )      | $ | 2,944 |   |

 

14

----

## ** **

## **OPERATIONS SUMMARY ANALYSIS**

 

**Net Interest Income**

 

        Ourearnings depend largely upon the difference between the income earned on ourloans and other investments and the interest paid on our deposits and borrowedfunds. This difference is net interest income. Our ability to generate net interestincome is largely dependent on our ability to maintain sound asset quality andappropriate levels of capital and liquidity. Our inability to maintain strongasset quality, capital or liquidity may adversely affect (i) the ability toaccommodate desirable borrowing customers, thereby inhibiting growth in qualityhigher-yielding earning assets; (ii) the ability to attract comparativelystable, lower-cost deposits; and (iii) the costs of wholesale funding sources.

 

        Netinterest income increased $478,000 to $9.9 million during 2001 compared to $9.4million during 2000.  The increase wasachieved despite a narrowing of the net yield on earning assets due to asignificantly greater volume of earning assets funded by a greater volume ofnoninterest-bearing liabilities combined with a greater decrease in the overallcost of funds than the decrease in the yield on earning assets.

 

        Averageearning assets increased $14.6 million to $186.7 million during 2001 comparedto 2000 while the average yield on earning assets declined from 8.40 percent to7.39 percent.  Total interest incomedecreased $669,000 due to an overall decline in interest rates during 2001 anda shift in the mix of earning assets to lower yielding assets.

 

        Interestincome from loans increased $694,000 to $9.7 million during 2001 due to $22.7million greater average volume offset by a 137 basis point (one basis point isequal to .01 percent) decline in yield. The average amount of securities available-for-sale decreased $20.0million while the average yield declined 44 basis points resulting in a $1.6million decrease in interest income. Interest income from federal funds sold increased $200,000 due to $11.9million greater average volume largely offset, however, by a 2.61 percentdecrease in average yield.  The greatervolume of federal funds sold was due to the maintenance of readily liquid fundsduring the period required to consummate the acquisition of South Bay.

 

        Averageinterest-bearing liabilities increased $3.7 million to $110.3 million during2001 compared to $106.6 million during 2000. Interest expense decreased, however, due to a 120 basis point decline inthe average cost of funds for 2001.  Thedecrease in the cost of funds was due to the overall lower interest rateenvironment during 2001 and a change in the composition of interest-bearingliabilities to lower cost funds. Relatively high-cost other borrowings, consisting primarily of advancesfrom the Federal Home Loan Bank, averaged $11.6 million lower in 2001 than2000.  The average amount ofmoderate-cost time certificates of deposit increased $11.3 million whilelower-cost money market and savings deposits and interest-bearing demanddeposits increased $2.7 million and $1.5 million, respectively.

 

        The netinterest margin increased to 3.87 percent from 3.69 percent due to a greatervolume of earning assets funded by noninterest-bearing sources of funds.  Noninterest-bearing demand deposits averaged$58.9 million during 2001 compared to $56.8 million in 2000.  Guaranteed preferred beneficial interests inNational Mercantile’s junior subordinated deferrable interest debentures thatwere issued in June 2001 averaged $7.6 million for the year.  Shareholders’ equity averaged $22.5 millionduring 2001 compared to $14.4 million during the prior year primarily due toour secondary offering of common shares in September 2000.

 

         Netinterest income increased $2.4 million to $9.4 million during 2000 compared to$7.0 million during 1999.  Thecomponents of net interest income continued to reflect increased interestincome from loans, compared to 1999. Average interest earning assets increased during 2000 to $172.1 millioncompared to $139.5 million during 1999. This $32.6 million or 23.4% increase in average interest earning assetsresulted primarily from a $29.1 million increase in average loansreceivable.  This increase was funded byan increase in average deposits of $17.6 million combined with a $13.1 millionincrease in average borrowed funds. 

 

15

----

 
| **Table 2**                                      |   |     |   |     |       |
|--------------------------------------------------|--------|----------|--------|----------|------------|
| **Ratios to  Average Assets**                    |   |     |   |     |       |
|                                             |   | **2001** |   | **2000** | ** ** |
| Net  interest income                             |   | 4.94     | %      | 5.26     | %          |
| Other  Operating income                          |   | 0.61     | %      | 0.48     | %          |
| Provision  for credit losses                     |   | (0.26%   | )      | 0.32     | %          |
| Other  operating expense                         |   | (4.32%   | )      | (4.39%   | )          |
| Minority  interest in the company’s junior  |   |     |   |     |       |
| subordinated  deferrable interest debenture, net |   | (0.36%   | )      | —   |       |
| Income  before income taxes                      |   | 0.61     | %      | 1.68     | %          |
|                                             |   |     |   |     |       |
| Net  income                                      |   | 0.58     | %      | 1.64     | %          |

* *

*    Interest Rate Spread and Net interest Margin*

 

**       **We analyze earnings performance using, among othermeasures, the interest rate spread and net interest margin.  The interest rate spread represents thedifference between the weighted average yield received on interest earningassets and the weighted average rate paid on interest bearing liabilities.  Net interest margin (also called the netyield on interest earning assets) is net interest income expressed as apercentage of average total interest earning assets.  Our net interest margin is affected by changes in the yieldsearned on assets and rates paid on liabilities, referred to as rate changes andchanges relative to the amount of interest earning assets and interest bearingliabilities. Interest rates charged on our loans are affected principally bythe demand for such loans, the supply of money available for lending purposes,and other competitive factors.  Thesefactors are in turn affected by general economic conditions and other factorsbeyond our control, such as federal economic policies, the general supply ofmoney in the economy, legislative tax policies, governmental budgetary matters,and actions of the Federal Reserve Board. Table 3 presents information concerning the change in interest incomeand interest expense attributable to changes in average volume and averagerate.  Table 4 presents the weightedaverage yield on each category of interest earning assets, the weighted averagerate paid on each category of interest bearing liabilities, and the resultinginterest rate spread and net yield on interest earning assets for 2001 and2000.  Yields on tax-exempt investmentsecurities presented in Table 4 have not been adjusted to a fully taxableequivalent because we do not realize a substantial tax benefit due to theutilization of net operating loss carryforwards.

 

        Our netinterest margin remains high in comparison with the interest rate spread due tothe continued significance of noninterest bearing demand deposits relative tototal funding sources.  Averagenoninterest bearing demand deposits totaled $58.9 million, representing 39.9%of average deposits, during 2001, compared to $56.8 million, representing 43.7%of average deposits, during 2000.  Ofthese noninterest bearing demand deposits during 2001, $19.7 million or 33.5%of average noninterest bearing deposits were represented by real estate titleand escrow company deposits, compared to $14.8 million or 26.1% of averagenoninterest bearing deposits during 2000. 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 2001 and2000, would have been reduced by $510,000 and $550,000, respectively.  Similarly, this would create identicalreductions in other operating expense. The net interest margin for 2001 and 2000 would have decreased 46 basispoints and 32 basis points, respectively.  The expense associated with these deposits declined in 2001 from 2000despite the increase in volume because we reduced the amount of customerservices provided.

 

16

----

 
|                                                                        |              |                            |   |         |   | **Net**                         |   |         |   |     |   | **Net**        |   |
|-----------------------------------------------------------------------------|-------------------|---------------------------------|--------|--------------|--------|---------------------------------|--------|--------------|--------|----------|--------|----------------|--------|
|                                                                        |              | **Increase (decrease) due to:** |   | **Increase** |   | **Increase (decrease) due to:** |   | **Increase** |   |
|                                                                        |              | **Volume**                      |   | **Rate**     |   | **(Decrease)**                  |   | **Volume**   |   | **Rate** |   | **(Decrease)** |   |
|                                                                        |              |                            |   |         |   | **(Dollars in thousands)**      |   |         |   |     |   |
| Interest  Income:                                                           |              |                            |   |         |   |                            |   |         |   |     |   |           |   |
| Federal  funds sold and securities purchased                                |              |                            |   |         |   |                            |   |         |   |     |   |           |   |
| under  agreement to resell                                                  |              | $                               | 760    |         | $      | (560                            | )      | $            | 200    |     | $      | 98             |   | $ | 129 |   | $ | 227 |   |
| Securities  available-for-sale                                              |              | (1,339                          | )      | (224         | )      | (1,563                          | )      | 100          |   | 320      |   | 420            |   |
| Loans  receivable (2)                                                       |              | 2,260                           |   | (1,566       | )      | 694                             |   | 2,723        |   | 545      |   | 3,268          |   |
| Total  interest-earning assets                                              |              | 1,681                           |   | (2,350       | )      | (669                            | )      | 2,921        |   | 994      |   | 3,915          |   |
|                                                                        |              |                            |   |         |   |                            |   |         |   |     |   |           |   |
| Interest  Expense:                                                          |              |                            |   |         |   |                            |   |         |   |     |   |           |   |
| Interest-bearing  deposits:                                                 |              |                            |   |         |   |                            |   |         |   |     |   |           |   |
| Demand                                                                      |              | $                               | 21     |         | $      | (42                             | )      | $            | (21    | )        | $      | 15             |   | $ | 7 |   | $ | 22 |   |
| Money  market and savings                                                   |              | 91                              |   | (330         | )      | (239                            | )      | 235          |   | 187      |   | 422            |   |
| Time  certificates of deposit:                                              |              |                            |   |         |   |                            |   |         |   |     |   |           |   |
|                                                                        | $100,000  or more |                            | 583    |         | (277   | )                               | 306    |         | 58     |     | 49     |           | 107    |   |
| Under  $100,000                                                             |              | 20                              |   | (111         | )      | (91                             | )      | (222         | )      | 41       |   | (181           | )      |
| Total  time certificates of deposit.....                                    |              | 603                             |   | (388         | )      | 215                             |   | (164         | )      | 90       |   | (74            | )      |
| Total  interest-bearing deposits                                            |              | 715                             |   | (760         | )      | (45                             | )      | 86           |   | 284      |   | 370            |   |
| Other  borrowings                                                           |              | (742                            | )      | (329         | )      | (1,071                          | )      | 699          |   | 378      |   | 1,077          |   |
| Federal  funds purchased and securities sold under agreements to repurchase |              | (18                             | )      | (13          | )      | (31                             | )      | (8           | )      | 26       |   | 18             |   |
| Total  interest-bearing liabilities                                         |              | (45                             | )      | (1,102       | )      | (1,147                          | )      | 777          |   | 688      |   | 1,465          |   |
|                                                                        |              |                            |   |         |   |                            |   |         |   |     |   |           |   |
| Net  interest income                                                        |              | $                               | 1,726  |         | $      | (1,248                          | )      | $            | 478    |     | $      | 2,144          |   | $ | 306 |   | $ | 2,450 |   |
|                                                                             |                   |                                 |        |              |        |                                 |        |              |        |          |        |                |        |  |  |  |  |  |  |  |

----

(1)  The change in interest income or interest expense that isattributable to both changes in average balance and average rate has beenallocated to the changes due to (i) average balance and (ii) average rate in proportionto the relationship of the absolute amounts of changes in each.

(2)  Table does not include interest income thatwould have been earned on nonaccrual loans.

 

17

 
| **Table 4**                                                                                                               |   |        |    |         |   |                       |   |        |    |         |   |        |   |
|---------------------------------------------------------------------------------------------------------------------------|--------|-------------|---------|--------------|--------|----------------------------|--------|-------------|---------|--------------|--------|-------------|--------|
| **Average  Balance Sheet and**                                                                                            |   |        |    |         |   |                       |   |        |    |         |   |        |   |
| **Analysis  of Net Interest Income**                                                                                      |   |        |    |         |   |                       |   |        |    |         |   |        |   |
|                                                                                                                      |   | **2001**    |    | **2000**     |   |
|                                                                                                                      |   |        |    | **Interest** |   | **Average**                |   |        |    | **Interest** |   | **Average** |
|                                                                                                                      |   | **Average** |    | **Income/**  |   | **Yield/**                 |   | **Average** |    | **Income/**  |   | **Yield/**  |   |
|                                                                                                                      |   | **Amount**  |    | **Expense**  |   | **Rate**                   |   | **Amount**  |    | **Expense**  |   | **Rate**    |   |
|                                                                                                                      |   |        |    |         |   | **(Dollars in thousands)** |   |        |    |         |   |
| Assets:                                                                                                                   |   |        |    |         |   |                       |   |        |    |         |   |        |   |
| Federal  funds sold and securities purchased under agreements to resell                                                   |   | $           | 21,446  |         | $      | 812                        |   | 3.79        | %       | $            | 9,566  |        | $      | 612 |   | 6.40 | % |
| Securities  available-for-sale                                                                                            |   | 51,665      |    | 3,236        |   | 6.26                       | %      | 71,662      |    | 4,799        |   | 6.70        | %      |
| Loans  receivable (1) (2)                                                                                                 |   | 113,615     |    | 9,743        |   | 8.58                       | %      | 90,909      |    | 9,049        |   | 9.95        | %      |
| Total  interest earning assets                                                                                            |   | 186,727     |    | 13,791       |   | 7.39                       | %      | 172,137     |    | 14,460       |   | 8.40        | %      |
|                                                                                                                      |   |        |    |         |   |                       |   |        |    |         |   |        |   |
| Noninterest  earning assets:                                                                                              |   |        |    |         |   |                       |   |        |    |         |   |        |   |
| Cash  and due from banks — demand                                                                                    |   | 11,698      |    |         |   |                       |   | 9,462       |    |         |   |        |   |
| Other  assets                                                                                                             |   | 4,900       |    |         |   |                       |   | 2,571       |    |         |   |        |   |
| Allowance  for credit losses and net unrealized (loss) gain on sale of securities  available-for-sale                     |   | (2,794      | )       |         |   |                       |   | (4,778      | )  |         |   |        |   |
| Total  assets                                                                                                             |   | $           | 200,530 |         |   |                       |   |        | $       | 179,392      |   |        |   |   |   |
|                                                                                                                      |   |        |    |         |   |                       |   |        |    |         |   |        |   |
| Liabilities  and shareholders’ equity:                                                                               |   |        |    |         |   |                       |   |        |    |         |   |        |   |
| Interest-bearing  deposits:                                                                                               |   |        |    |         |   |                       |   |        |    |         |   |        |   |
| Demand                                                                                                                    |   | $           | 9,562   |         | $      | 92                         |   | 0.96        | %       | $            | 8,066  |        | $      | 113 |   | 1.40 | % |
| Money  market and savings                                                                                                 |   | 40,396      |    | 1,019        |   | 2.52                       | %      | 37,660      |    | 1,258        |   | 3.34        | %      |
| Time  certificates of deposit:                                                                                            |   |        |    |         |   |                       |   |        |    |         |   |        |   |
| $  100,000 or more                                                                                                        |   | 31,807      |    | 1,409        |   | 4.43                       | %      | 20,809      |    | 1,103        |   | 5.30        | %      |
| Under  $100,000                                                                                                           |   | 6,975       |    | 308          |   | 4.42                       | %      | 6,647       |    | 399          |   | 6.00        | %      |
| Total  time certificates of deposit                                                                                       |   | 38,782      |    | 1,717        |   | 4.43                       | %      | 27,456      |    | 1,502        |   | 5.47        | %      |
| Total  interest-bearing deposits                                                                                          |   | 88,740      |    | 2,828        |   | 3.19                       | %      | 73,182      |    | 2,873        |   | 3.93        | %      |
| Other  borrowings                                                                                                         |   | 20,865      |    | 1,011        |   | 4.85                       | %      | 32,424      |    | 2,082        |   | 6.42        | %      |
| Federal  funds purchased and securities sold under agreements to repurchase                                               |   | 733         |    | 37           |   | 5.05                       | %      | 998         |    | 68           |   | 6.81        | %      |
| Total  interest-bearing liabilities                                                                                       |   | 110,338     |    | 3,876        |   | 3.51                       | %      | 106,604     |    | 5,023        |   | 4.71        | %      |
|                                                                                                                      |   |        |    |         |   |                       |   |        |    |         |   |        |   |
| Noninterest-bearing  liabilities:                                                                                         |   |        |    |         |   |                       |   |        |    |         |   |        |   |
| Noninterest  bearing demand deposits                                                                                      |   | 58,883      |    |         |   |                       |   | 56,787      |    |         |   |        |   |
| Other  liabilities                                                                                                        |   | 1,197       |    |         |   |                       |   | 1,630       |    |         |   |        |   |
| Guaranteed  preferred beneficial interests in the Company’s junior subordinated  deferrable interest debentures, net |   | 7,592       |    |         |   |                       |   | —      |    |         |   |        |   |
| Shareholders’  equity                                                                                                |   | 22,520      |    |         |   |                       |   | 14,371      |    |         |   |        |   |
| Total  liabilities and shareholders’ equity                                                                          |   | $           | 200,530 |         |   |                       |   |        | $       | 179,392      |   |        |   |   |   |
|                                                                                                                      |   |        |    |         |   |                       |   |        |    |         |   |        |   |
| Net  interest income (spread)                                                                                             |   |        |    | $            | 9,915  |                       | 3.88   | %           |    |         | $      | 9,437       |   | 3.69 | % |
|                                                                                                                      |   |        |    |         |   |                       |   |        |    |         |   |        |   |
| Net  yield on earning assets (2)                                                                                          |   |        |    |         |   | 5.31                       | %      |        |    |         |   | 5.48        | %      |

----

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

(2)  Yields and amounts earned on loansreceivable include loan fees of $403,000 and $222,000 for the years endedDecember 31, 2001 and 2000, respectively.

 

18

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**Provisionfor Credit Losses**

 

        Provisionsfor credit losses charged to operations reflect management’s judgment of theadequacy of the allowance for credit losses and are determined through periodicanalysis of the loan portfolio.  Thisanalysis includes a detailed review of the classification and categorization ofproblem loans and loans to be charged off; an assessment of the overall qualityand collectibility of the loan portfolio; and consideration of the loan lossexperience, trends in problem loan concentrations of credit risk, as well ascurrent and expected future economic conditions (particularly SouthernCalifornia).  Management, in combinationwith an outside firm, performs a periodic risk and credit analysis, the resultsof which are reported to the Board of Directors.

 

        During2001, we provided $517,000 to the allowance for credit losses.  Management determined that an increase inthe allowance for credit losses was warranted due to: (i) a reassessment of thequality of the loan portfolio resulting in the downgrade of several signficantcredits; and (ii) the slowdown in economic activity during 2001.  In 2001 net charge-offs were $218,000compared to net recoveries of $1.3 million in 2000.

 

        During2000 we realized a net recovery of $1.3 million related to a previously chargedoff loan.  The entire recovery wasaccounted for as an increase to the allowance for credit losses.  Based on the resulting level of theallowance for credit losses after giving effect for this recovery, managementrecognized $576,000 as a negative provision for credit losses during 2000.  Management determined that an increase inthe allowance for credit losses was warranted due to: (i) an increasing portionof the loan portfolio being represented by larger loans (loans with balancesgreater than $1.0 million); and (ii) the recent growth in loans receivable.

 

        Based oncontinued loan growth, the relative uncertainty regarding the state of theeconomy, the level of nonperforming loans and a relatively constant level ofcharge offs, it is anticipated that regular provisions for credit losses willbe made during 2002.  Credit qualitywill be influenced by underlying trends in the economic cycle, particularly inSouthern California, and other factors which are beyond management’scontrol.  Accordingly, no assurance canbe given that we will not sustain loan losses that in any particular period aresizable in relation 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 arequirement for increases in the allowance for credit losses through  additions to the provision for creditlosses.

 

**OtherOperating Income**

 

**       **Other operating income was $1,233,000 and $868,000 in2001 and 2000, respectively.  Abreakdown of other operating income by category is reflected below:

 

19

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| **Table 5**                                             |   |                       |       |     |   |
|---------------------------------------------------------|--------|----------------------------|------------|----------|--------|
| **Other  Operating Income**                             |   |                       |       |     |   |
|                                                    |   | **2001**                   |       | **2000** |   |
|                                                    |   | **(Dollars in thousands)** | ** ** |
| **Other operating income:**                             |   |                       |       |     |   |
| *Securities transactions:*                              |   |                       |       |     |   |
| Net  gain on sale of securities available—for-sale |   | $                          | 374        |     | $      | 18 |   |
| *Fee income:*                                           |   |                       |       |     |   |
| International  services                                 |   | 51                         |       | 110      |   |
| Investment  services                                    |   | 104                        |       | 88       |   |
| Deposit  and other customer services                    |   | 684                        |       | 583      |   |
| *Other:*                                                |   |                       |       |     |   |
| Gain  on other real estate owned and fixed assets       |   | 20                         |       | 69       |   |
| Total  other operating income                           |   | $                          | 1,233      |     | $      | 868 |   |

 

        During2001 we recorded a net gain on the sale of securities available-for-sale of$374,000 compared to a net gain of $18,000 during 2000.

 

*          *Feeincome related to international services decreased $59,000 or 53.6% as we havereduced our focus on providing these services. Investment and deposit related services increased 17.4% to $788,000during 2001, compared to similar fee income of $671,000 in 2000.  The increase in investment and depositrelated services was primarily due to deposit growth of “transaction” and moneymarket type accounts during 2001.

 

**OtherOperating Expenses**

 

        Otheroperating expense increased $791,000 to $8.7 million in 2001, compared to $7.9million during 2000.  A breakdown ofother operating expense by category is reflected below:

 
| **Table 6**                           |   |                       |   |     |   |
|---------------------------------------|--------|----------------------------|--------|----------|--------|
| **Other  Operating Expenses**         |   |                       |   |     |   |
|                                  |   | **2001**                   |   | **2000** |   |
|                                  |   | **(Dollars in thousands)** |   |
| **Other operating expenses:**         |   |                       |   |     |   |
| Salaries  and related benefits        |   | $                          | 4,474  |     | $      | 3,906 |   |
| Net  occupancy                        |   | 1,034                      |   | 966      |   |
| Furniture  and equipment              |   | 275                        |   | 323      |   |
| Printing  and communications          |   | 324                        |   | 280      |   |
| Insurance  and regulatory assessments |   | 312                        |   | 296      |   |
| Client  services                      |   | 826                        |   | 835      |   |
| Computer  data processing             |   | 448                        |   | 416      |   |
| Legal  services                       |   | 227                        |   | 170      |   |
| Other  professional services          |   | 411                        |   | 396      |   |
| Other  real estate owned expenses     |   | (25                        | )      | 3        |   |
| Promotion  and other expenses         |   | 355                        |   | 279      |   |
| Total  other operating expenses       |   | $                          | 8,661  |     | $      | 7,870 |   |

 

20

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         Salariesand related benefits increased 14.5% and net occupancy expense increased 7.0%primarily due to our expansion of banking services with a new branch bankingoffice in Encino.  Furniture andequipment expenses decreased 14.9% during 2001 to $275,000, compared to$323,000 during 2000 due to costs associated with a refurbishment project ofexisting facilities in 2000.  Legalexpenses increased 33.5% to $227,000 during 2001 from $170,000 during 2000primarily due to increased activity required for loan collections.

 

21

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**Income Taxes**

 

        Deferredtax assets and liabilities are recognized for the expected future taxconsequences of existing differences between financial reporting and taxreporting bases of assets and liabilities, as well as for operating losses andtax credit carryforwards, using enacted tax laws and rates.  Deferred tax assets will be reduced througha valuation 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 (benefit) for the year.

 

        AtDecember 31, 2001, our deferred tax asset totaled $8.4 million with no recordedvaluation allowance.  At December 31,2000 the deferred tax asset was $7.0 million, however, a valuation allowancerecorded against the asset resulted in a net deferred tax asset of zero.  During 2001 a reduction in the deferred taxvaluation allowance was recorded as part of purchase accounting for theacquisition of South Bay with the benefit shown as a reduction of goodwill.

 

        For taxpurposes at December 31, 2001, the Company had (i) federal NOLs of $16.9million, which begin to expire in 2009; (ii) California NOLs of $273,000 whichwill expire in 2002; (iii) a federal AMT credit carryforward of $279,000, and(iv) a California AMT credit carryforward of $16,000.  The AMT credits carryforward indefinitely.

 

        No incometax provision was recorded during 2001 and 2000 other than alternative minimumtax (“AMT”) of $92,000 and $67,000, respectively, due to the utilization ofpreviously unrecognized tax benefits to offset current period tax liability.

 

        Additionally,federal and state income tax laws provide that following an ownership change ofa 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 adjustments) and the federal long-termtax-exempt rate prescribed monthly by the Internal Revenue Service.  If such limitations were to apply to theCompany, the ability of the Company to reduce future taxable income by the NOLscould be severely limited.

 

## **Accumulated Other Comprehensive Income**

 

         Changesin the unrealized gain on available-for-sale securities, net of taxes is theonly component of other comprehensive income for the Company.  At December 31, 2001 the net unrealized gainon available-for-sale securities was $56,000 compared to an unrealized loss of$536,000 at December 31, 2000.

 

         During2001 the U.S. economy experienced significant delines in interest rates acrossall maturity durations following the Federal Reserve Open Market Committeereduction in the federal funds target rate and the discount rate.  The reduction in interest rates increasedthe estimated fair value of the Company’s portfolio of largely fixed rateavailable-for-sale securities resulting in $966,000 unrealized holding gainduring 2001 .

 

22

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**FINANCIALCONDITION**

 

## **Regulatory Capital**

 

                The followingtable sets forth the regulatory standards for well-capitalized institutions andour regulatory capital ratios as of December 31, 2001 and 2000.

 
| **Table 7**                         |   |                 |   |             |   |     |   |
|-------------------------------------|--------|----------------------|--------|------------------|--------|----------|--------|
| **Regulatory  Capital Information** |   |                 |   |             |   |     |   |
| **of the  Company and Banks**       |   |                 |   |             |   |     |   |
|                                |   | **Well Capitalized** |   | **December 31,** |   |
|                                |   | **Standards**        |   | **2001**         |   | **2000** |   |
| **National  Mercantile Bancorp:**   |   |                 |   |             |   |     |   |
| Tier  1 leverage                    |   | 5.00                 | %      | 5.55             | %      | 10.73    | %      |
| Tier  1 risk-based capital          |   | 6.00                 | %      | 6.85             | %      | 17.00    | %      |
| Total  risk-based capital           |   | 10.00                | %      | 11.53            | %      | 18.26    | %      |
|                                |   |                 |   |             |   |     |   |
| **Mercantile National Bank:**       |   |                 |   |             |   |     |   |
| Tier  1 leverage                    |   | 5.00                 | %      | 6.85             | %      | 9.31     | %      |
| Tier  1 risk-based capital          |   | 6.00                 | %      | 10.50            | %      | 14.74    | %      |
| Total  risk-based capital           |   | 10.00                | %      | 11.76            | %      | 16.00    | %      |
|                                |   |                 |   |             |   |     |   |
| **South Bay Bank, NA:**             |   |                 |   |             |   |     |   |
| Tier  1 leverage                    |   | 5.00                 | %      | 8.72             | %      | n/a      |   |
| Tier  1 risk-based capital          |   | 6.00                 | %      | 9.63             | %      | n/a      |   |
| Total  risk-based capital           |   | 10.00                | %      | 10.90            | %      | n/a      |   |

 

## **        National Mercantile’s  Tier 1 capital, which is comprised ofshareholders’ equity as modified by certain regulatory adjustments, was $19.6million and $21.2 million at December 31, 2001 and 2000, respectively.  Our Tier 1 capital in 2001was affected byseveral factors.   During 2001 we issued$15 million in trust preferred securities. Federal Reserve Bank capital rules allow trust preferred securities torepresent 25% of total Tier 1 capital with the excess treated as Tier 2capital.  At December 31, 2001 trustpreferred securities represented $4.7 million and $9.8 million of Tier 1 andTier 2 capital, respectively.   Weissued $1 million Series B Preferred stock in December 2001.  Additionally, $676,000 minority interest inSouth Bay’s preferred stock, net of the discount for beneficial conversionrights as well as the $1.8 million discount recorded as additional paid incapital is includable in National Mercantile’s Tier 1 capital.  Disallowed against National Mercantile’s Tier1 capital is the $5.6 million goodwill recorded in the acquisition of South Bayand $5.7 million of the deferred tax asset that is not expected to be utilizedduring the next twelve months based upon estimated consolidated earnings of$3.0 million for 2002.  A reduction inestimated earnings will increase the amount of the disallowed tax asset andwill have the effect of reducing our regulatory capital.**

 

        Thereduction of our regulatory capital ratios at December 31, 2001 compared to theprior year is due to the changes in capital discussed above as well as theconsolidation of South Bay’s assets acquired in the business combination.

## ** **

        MercantileNational’s Tier 1 capital was $13.1 million and $18.2 million at December 31,2001 and 2000, respectively.  Thedecrease in Tier 1 capital during 2001 was due to a $6 million reduction incapital surplus paid to National Mercantile in conjunction with the financingof the South Bay acquisition.  SouthBay’s Tier 1 capital at December 31, 2001 was $16.1 million represented byNational Mercantile’s $24.8 million investment and undistributed earnings and$2.5 million preferred stock less $5.6 million goodwill and $5.7 milliondisallowed deferred tax asset.  Becausethe disallowed deferred tax asset is based upon our estimated twelve-month’searnings of the consolidated entity, as discussed above, a reduction inestimated earnings will likewise reduce South Bay’s regulatory capital.

 

23

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## ** **Liquidity Management

 

                The objective ofliquidity management is to maintain cash flow adequate to fund our operations andmeet obligations and other commitments on a timely and cost effectivebasis.  We manage to this objectiveprimarily through the selection of asset and liability maturity mixes.  Our liquidity position is enhanced by theability to raise additional funds as needed through available borrowings oraccessing the wholesale deposit market.

 

                Our deposit baseprovides the majority of funding requirements. This relatively stable and low-cost source of funds has, along withshareholders’ equity, provided 73.6% and 80.5% of funding for average totalassets during 2001 and 2000, respectively. The reduction of 6.9%, despite significant deposit growth, wasattributable to the funds provided by the additional capital raised in thethird quarter of 2000 and the proceeds from the trust preferred issuance inJune 2001.

 

                A significantportion of remaining funding of average total assets is provided by otherborrowings, specifically FHLB advances, which averaged $20.9 million during2001 compared to $32.4 million during 2000. The decline in other borrowings during 2001 was offset by growth indeposits and capital sources of funding as well as the reduction in securitiesavailable-for-sale.

 

                Liquidity is alsoprovided by assets such as federal funds sold and securities purchased underresale agreements that may be immediately converted to cash at minimal cost.The aggregate of these assets averaged $21.4 million during 2001, as comparedto $9.6 million during 2000.  Thisincrease resulted primarily from the growth in our average deposits, increasein capital funds and reduction in securities available-for-sale.  Liquid assets were maintained at relativelyhigh levels in 2001 due to the liquidity required to consummate the South Bay acquisition.

 

        Theportfolio of available-for-sale securities is an additional source ofliquidity, which averaged $51.7 million during 2001 compared to $71.7 millionin 2000.  The securitiesavailable-for-sale were reduced in 2001 in order to payoff other borrowings andreduce the exposure to value deterioration in anticipation of a rebound ininterest rates.  The unpledged portionof investment securities at December 31, 2001 totaled $8.8 million and wasavailable as collateral for borrowings. Maturing loans also provide liquidity, of which $145.8 million of theBank’s loans are scheduled to mature in 2002.

 

        AtDecember 31, 2001, the balance of cash and cash equivalents was $52.1 million,an increase of $24.5 million from the end of the prior year.

 

        Net cashprovided by operating activities totaled $1.1 million in 2001 compared to $2.9million in 2000.  The primary source offunds is net income from operations adjusted for: provision for loan losses anddepreciation and amortization.  Net cashprovided by investing activities totaled $19.3 million in 2001 compared to netcash used in investing activities of $28.7 million in 2000.  The increase in cash provided by investingactivities resulted from proceeds from sales, repayments and maturities ofsecurities available-for-sale and a decrease in net loan originations; thesefactors were partially offset by cash used in acquiring South Bay.  Net cash provided by financing activitiesamounted to $4.1 million in 2001 compared to $43.1 million in 2000.  The decrease in 2001 resulted primarily froma decrease in time certificates of deposits, borrowed funds and securities soldunder agreements to repurchase offset by an increase in demand, money marketand savings deposits and the issuance of trust preferred securities.

 

 

## **Interest Rate RiskManagement**

 

                Interest rate riskmanagement seeks to maintain a stable growth of income and manage the riskassociated with changes in interest rates. Net interest income, the primary source of earnings, is affected byinterest rate movements.  Changes ininterest rates have a lesser impact the more that assets and liabilitiesreprice in approximately equivalent amounts at basically the same timeintervals.  Imbalances in theserepricing opportunities at any point in time 

 

24

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constitute interest sensitivity gaps, which is the difference betweeninterest sensitive assets and interest sensitive liabilities.

 

                Interest raterisk, including interest rate sensitivity and the repricing characteristics ofassets and liabilities, is managed by the Interest Rate Risk ManagementCommittee (“IRRMC”).  The principalobjective of IRRMC is to maximize net interest income within acceptable levelsof risk established by policy.

 

                We manage interestrate sensitivity by matching the repricing opportunities on our earning assetsto those on our funding liabilities.  Weuse various strategies to manage the repricing characteristics of our assetsand liabilities to ensure that exposure to interest rate fluctuations islimited within guidelines of acceptable levels of risk-taking.  Hedging strategies, including the terms andpricing of loans and deposits, and managing the deployment of our securitiesare used to reduce mismatches in interest rate repricing opportunities ofportfolio assets and their funding sources. Interest rate risk is measured using financial modeling techniques,including stress tests, to measure the impact of changes in interest rates onfuture earnings.  These staticmeasurements do not reflect the results of any projected activity and are bestused as early indicators of potential interest rate exposures.

 

                An asset sensitivegap means an excess of interest sensitive assets over interest sensitiveliabilities, whereas a liability sensitive gap means an excess of interestsensitive liabilities over interest sensitive assets.  In a changing rate environment, a mismatched gap positiongenerally indicates that changes in the income from interest earning assetswill not be proportionate to changes in the cost of interest bearing liabilities,resulting in net interest income volatility.

 

                 Table 8 compares our interest rate gapposition as of December 31, 2001 and 2000. The gap report shows a cumulative one year interest rate assetsensitivity gap of $27.0 million at December 31, 2001, a change from an assetsensitivity gap of $12.3 million at December 31, 2000.  Our federal funds sold at December 31, 2001was $39.4 million providing ready liquidity to accommodate the anticipatedwithdrawal of a short-term deposit of approximately $29.7 million.  Adjusted for this temporary position, thecumulative one year interest rate gap would be a liability sensitive gap of$2.7 million and a ratio of rate sensitive assets to rate sensitive liabilitiesof 99%.

 

                Since interestrate changes do not affect all categories of assets and liabilities equally orsimultaneously, a cumulative gap analysis alone cannot be used to evaluate theinterest rate sensitivity position.  Tosupplement traditional gap analysis, interest rate sensitivities are alsomonitored through the use of simulation modeling techniques that applyalternative interest rate scenarios to periodic forecasts of future businessactivity and estimate the related impact on net interest income.  The use of simulation modeling assistsmanagement in its continuing efforts to achieve earnings growth in varyinginterest environments.

 

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

 

                At December 31,2001 and 2000, our distribution of rate sensitive assets and liabilities was asfollows:

 

25

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| **Table 8**                                                                   |   |                         |   |            |   |           |   |        |   |      |   |
|-------------------------------------------------------------------------------|--------|------------------------------|--------|-----------------|--------|----------------|--------|-------------|--------|-----------|--------|
| **Rate-Sensitive  Assets and Liabilities**                                    |   |                         |   |            |   |           |   |        |   |      |   |
|                                                                          |   | **December 31, 2001**        |   |
|                                                                          |   | **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                                         |   | $                            | 39,405 |            | $      | —         |   | $           | — |      | $      | — |   | $ | 39,405 |   |
| Securities  available-for-sale, at amortized cost                             |   | 2,014                        |   | —          |   | 96             |   | 39,517      |   | 41,627    |   |
| FRB  and other stock, at cost                                                 |   | —                       |   | —          |   | —         |   | 2,552       |   | 2,552     |   |
| Loans  receivable                                                             |   | 164,632                      |   | 19,838          |   | 58,051         |   | 19,447      |   | 261,968   |   |
| Total  rate-sensitive assets                                                  |   | 206,051                      |   | 19,838          |   | 58,147         |   | 61,516      |   | 345,552   |   |
|                                                                          |   |                         |   |            |   |           |   |        |   |      |   |
| Rate-Sensitive  Liabilities:  (1)                                        |   |                         |   |            |   |           |   |        |   |      |   |
| Interest  bearing deposits:                                                   |   |                         |   |            |   |           |   |        |   |      |   |
| Demand,  money market and                                                     |   |                         |   |            |   |           |   |        |   |      |   |
| savings                                                                       |   | 94,642                       |   | —          |   | —         |   | 94,642      |   |      |   |
| Time  certificates of deposit                                                 |   | 48,253                       |   | 37,853          |   | 13,747         |   | —      |   | 99,853    |   |
| Other  borrowings                                                             |   | 12,657                       |   | 5,439           |   | 2,500          |   | —      |   | 20,596    |   |
| Total  rate-sensitive liabilities                                             |   | 155,552                      |   | 43,292          |   | 16,248         |   | 0           |   | 215,091   |   |
| Interest  rate-sensitivity gap                                                |   | 50,499                       |   | (23,454         | )      | 41,900         |   | 61,516      |   | 130,460   |   |
| Cumulative  interest rate—sensitivity gap                                |   | $                            | 50,499 |            | $      | 27,045         |   | $           | 68,946 |      | $      | 130,461 |   |   |   |
| Cumulative  ratio of rate sensitive assets to rate—sensitive liabilities |   | 132                          | %      | 114             | %      | 132            | %      | 161         | %      |      |   |
|                                                                               |        |                              |        |                 |        |                |        |             |        |           |        |  |  |  |  |  |

 

(1)  Deposits which are subject to immediatewithdrawal are presented as repricing within three months or less.  The distribution of other time deposits isbased on scheduled maturities.

 

26

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| **Table 8**                                       |   |                         |   |             |   |            |   |        |   |      |   |
|---------------------------------------------------|--------|------------------------------|--------|------------------|--------|-----------------|--------|-------------|--------|-----------|--------|
| **Rate—Sensitive Assets and Liabilities**    |   |                         |   |             |   |            |   |        |   |      |   |
|                                              |   | **December  31, 2000**       |   |
|                                              |   | **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              |   | $                            | 19,700 |             | $      | —          |   | $           | — |      | $      | — |   | $ | 19,700 |   |
| Securities available-for-sale, at amortized  cost |   | 18,014                       |   | 10,227           |   | 24,728          |   | 11,984      |   | 64,953    |   |
| FRB and other stock, at cost                      |   | —                       |   | —           |   | —          |   | 2,733       |   | 2,733     |   |
| Loans receivable                                  |   | 68,667                       |   | 14,149           |   | 23,871          |   | 3,561       |   | 110,248   |   |
| Total rate-sensitive assets                       |   | 106,381                      |   | 24,376           |   | 48,599          |   | 18,278      |   | 197,634   |   |
|                                              |   |                         |   |             |   |            |   |        |   |      |   |
| Rate-Sensitive Liabilities:  (1)             |   |                         |   |             |   |            |   |        |   |      |   |
| Interest bearing deposits:                        |   |                         |   |             |   |            |   |        |   |      |   |
| Demand, money market and savings                  |   | 42,499                       |   | —           |   | —          |   | —      |   | 42,499    |   |
| Time certificates of deposit                      |   | 21,150                       |   | 9,782            |   | 753             |   | 428         |   | 32,113    |   |
| Other borrowings                                  |   | 45,000                       |   | —           |   | 2,500           |   | —      |   | 47,500    |   |
| Total rate-sensitive liabilities                  |   | 108,649                      |   | 9,782            |   | 3,253           |   | 428         |   | 122,112   |   |
| Interest rate-sensitivity gap                     |   | (2,268                       | )      | 14,594           |   | 45,346          |   | 17,850      |   | 75,522    |   |
| Cumulative interest rate-sensitivity gap          |   | $                            | (2,268 | )                | $      | 12,326          |   | $           | 57,671 |      | $      | 75,522 |   |   |   |
| Cumulative ratio of rate sensitive assets to      |   |                         |   |             |   |            |   |        |   |      |   |
| rate-sensitive liabilities                        |   | 98                           | %      | 110              | %      | 147             | %      | 162         | %      |      |   |
|                                                   |        |                              |        |                  |        |                 |        |             |        |           |        |  |  |  |  |  |

 

(1)  Deposits which are subjectto immediate withdrawal are presented as repricing within three months orless.  The distribution of other timedeposits is based on scheduled maturities.

 

27

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**Investment Securities**

 

        We investin investment securities consisting primarily of mortgage-related securitiesto: (i) generate interest income pending the ability to deploy those funds inloans meeting our lending strategies; (ii) increase net interest income wherethe rates earned on such investments exceed the related cost of funds,consistent with the management of interest rate risk; and (iii) providesufficient liquidity in order to maintain cash flow adequate to fund ouroperations and meet obligations and other commitments on a timely and costefficient basis.

 

### *   *We generally classify ourinvestment securities as available-for-sale except for investment securities wehave the ability and the positive intent to hold to maturity which areclassified as held-to-maturity securities.  There were no held-to-maturity securities at December 31, 2001 and 2000.

 

        Table 9provides certain information regarding, our investment securities.

 
| **Table 9**                                    |   |                        |       |                        |       |           |   |          |   |          |   |           |   |           |   |          |   |
|------------------------------------------------|--------|-----------------------------|------------|-----------------------------|------------|----------------|--------|---------------|--------|---------------|--------|----------------|--------|----------------|--------|---------------|--------|
|                                           |   |                        |       |                        |       |           |   |          |   |          |   |           |   |           |   |          |   |
| **Estimated  Fair Values of and Unrealized**   |   |                        |       |                        |       |           |   |          |   |          |   |           |   |           |   |          |   |
| **Gains and  Losses on Investment Securities** |   |                        |       |                        |       |           |   |          |   |          |   |           |   |           |   |          |   |
|                                           |   | **December  31, 2001**      |       | **December  31, 2000**      |       |
|                                           |   | **Total**                   |       | **Gross**                   |       | **Gross**      |   | **Estimated** |   | **Total**     |   | **Gross**      |   | **Gross**      |   | **Estimated** |   |
|                                           |   | **amortized**               |       | **unrealized**              |       | **unrealized** |   | **fair**      |   | **amortized** |   | **unrealized** |   | **unrealized** |   | **fair**      |   |
|                                           |   | **cost**                    |       | **gains**                   |       | **loss**       |   | **value**     |   | **cost**      |   | **gains**      |   | **loss**       |   | **value**     |   |
|                                           |   | **(Dollars in  thousands)** | ** ** | **(Dollars in  thousands)** | ** ** |
| U.S.  Treasury securities                      |   | $                           | 2,001      |                        | $          | 13             |   | $             | — |          | $      | 2,014          |   | $              | 2,008  |          | $      | 9 |   | $ | — |   | $ | 2,017 |   |
| GNMA-issued/guaranteed  mortgage          |   |                        |       |                        |       |           |   |          |   |          |   |           |   |           |   |          |   |
| pass  through certificates                     |   | 4,503                       |       | —                      |       | 27             |   | 4,476         |   | 5,288         |   | 118            |   | —         |   | 5,406         |   |
| Other  U.S. government and federal             |   |                        |       |                        |       |           |   |          |   |          |   |           |   |           |   |          |   |
| agency  securities                             |   | —                      |       | —                      |       | —         |   | —        |   | 1,952         |   | 42             |   | —         |   | 1,994         |   |
| FHLMC/FNMA-issued  mortgage                    |   |                        |       |                        |       |           |   |          |   |          |   |           |   |           |   |          |   |
| pass  through certificates                     |   | 15,928                      |       | 179                         |       | 32             |   | 16,075        |   | 15,172        |   | 86             |   | 36             |   | 15,222        |   |
| CMO’s  and REMIC’s issued by U.S.    |   |                        |       |                        |       |           |   |          |   |          |   |           |   |           |   |          |   |
| government-sponsored  agencies            |   | 16,590                      |       | 162                         |       | 29             |   | 16,723        |   | 36,532        |   | 1              |   | 669            |   | 35,864        |   |
| Privately  issued Corporate bonds,             |   |                        |       |                        |       |           |   |          |   |          |   |           |   |           |   |          |   |
| CMO’s  and REMIC’s securities        |   | 2,510                       |       | 4                           |       | 175            |   | 2,339         |   | 4,001         |   | —         |   | 87             |   | 3,914         |   |
|                                           |   | $                           | 41,532     |                        | $          | 358            |   | $             | 263    |          | $      | 41,627         |   | $              | 64,953 |          | $      | 256 |   | $ | 792 |   | $ | 64,417 |   |
|                                           |   |                        |       |                        |       |           |   |          |   |          |   |           |   |           |   |          |   |
| FRB  and other stocks                          |   | 2,552                       |       | —                      |       | —         |   | 2,552         |   | 2,733         |   | —         |   | —         |   | 2,733         |   |

 

        AtDecember 31, 2001, we held no securities from any issuer other than by the U.S.government and U.S. government agencies and corporations in which the aggregatebook value exceeded 10% of our shareholders’ equity.

 

        Ourpresent strategy is to stagger the maturities of investment securities to meetour overall liquidity requirements.  Table10 sets forth information concerning the contractual maturity of and weightedaverage yield of the Company’s investment securities at December 31, 2001.

 

28

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| **Table 10**                                                            |   |                        |       |                   |   |                  |   |                 |   |       |   |        |   |       |   |         |   |      |   |      |   |
|-------------------------------------------------------------------------|--------|-----------------------------|------------|------------------------|--------|-----------------------|--------|----------------------|--------|------------|--------|-------------|--------|------------|--------|--------------|--------|-----------|--------|-----------|--------|
| **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                                                |   | $                           | 2,014      |                   | 6.10   | %                     | $      | —               |   | —     |   | $           | — |       | — |         | $      | —    |   | —    |   | $ | 2,014 |   | 6.10 | % |
| GNMA-issued/guaranteed  mortgage pass-through certificates         |   | —                      |       | —                 |   | —                |   | —               |   | —     |   | —      |   | 4,476      |   | 6.17         | %      | 4,476     |   | 6.17      | %      |
| Other  U.S. government and federal                                      |   |                        |       |                   |   |                  |   |                 |   |       |   |        |   |       |   |         |   |      |   |      |   |
| agencies                                                                |   | —                      |       | —                 |   | —                |   | —               |   | —     |   | —      |   | —     |   | —       |   | —    |   | —    |   |
| FHLMC/FNMA-issued  mortgage                                             |   |                        |       |                   |   |                  |   |                 |   |       |   |        |   |       |   |         |   |      |   |      |   |
| pass-through  certificates                                              |   | —                      |       | —                 |   | 96                    |   | 6.33                 | %      | 1,645      |   | 5.96        | %      | 14,334     |   | 6.53         | %      | 16,075    |   | 6.47      | %      |
| CMO’s  and REMIC’s issued by                                  |   |                        |       |                   |   |                  |   |                 |   |       |   |        |   |       |   |         |   |      |   |      |   |
| U.S.  government-sponsored                                              |   |                        |       |                   |   |                  |   |                 |   |       |   |        |   |       |   |         |   |      |   |      |   |
| agencies                                                                |   | —                      |       | —                 |   | —                |   | —               |   | 1,993      |   | 5.33        | %      | 14,730     |   | 5.54         | %      | 16,723    |   | 5.51      | %      |
| Privately  issued Corporate bonds,                                      |   |                        |       |                   |   |                  |   |                 |   |       |   |        |   |       |   |         |   |      |   |      |   |
| CMO’s  and REMIC’s securities..                               |   | —                      |       | —                 |   | —                |   | —               |   | —     |   | —      |   | 2,339      |   | 4.80         | %      | 2,339     |   | 4.80      | %      |
|                                                                    |   | $                           | 2,014      |                   | 6.10   | %                     | $      | 96                   |   | 6.33       | %      | $           | 3,638  |       | 5.61   | %            | $      | 35,879    |   | 5.96      | %      | $ | 41,627 |   | 5.94 | % |
|                                                                    |   |                        |       |                   |   |                  |   |                 |   |       |   |        |   |       |   |         |   |      |   |      |   |
| Amortized  Cost                                                         |   | $                           | 2,001      |                   |   |                  | $      | 96                   |   |       |   | $           | 3,643  |       |   |         | $      | 35,792    |   |      |   | $ | 41,532 |   |   |   |

 

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

 

 

**Lending Activities**

 

Our present lendingstrategy is to attract individual and small to mid-sized business borrowers inspecific market niches, as well as real estate developers and investors,located in the coastal area of Los Angeles County, including the South Bay,LAX, and west Los Angeles, and the San Fernando Valley area of Los Angeles, byoffering a variety of loan products and a full range of banking servicescoupled with highly personalized service. Loan products include commercial real estate loans, constructionfinancing, revolving lines of credit, term loans and consumer and home equityloans, along with an array of deposits and investment accounts that oftencontain terms and conditions tailored to meet the specific demands of themarket niche in which the borrower operates, including the ability to evaluatethe revenue streams 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.

 

Our targeted marketniches have included the entertainment industry, professional servicesproviders, healthcare and community-based nonprofit organizations.  Entertainment industry customers includetelevision, music and film production companies, talent agencies, individualperformers, directors and producers (whom the Company attracts 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.

 

29

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# ***Loan Portfolio***

 

The following table setsforth the composition of our loan portfolio at the dates indicated**:**

 
| **Table 11**                                             |   |                        |    |        |   |       |   |        |   |       |   |        |   |       |   |        |   |       |   |        |   |   |
|----------------------------------------------------------|--------|-----------------------------|---------|-------------|--------|------------|--------|-------------|--------|------------|--------|-------------|--------|------------|--------|-------------|--------|------------|--------|-------------|--------|--------|
| **Loan  Portfolio Composition**                          |   |                        |    |        |   |       |   |        |   |       |   |        |   |       |   |        |   |       |   |        |   |   |
|                                                     |   | **December  31,**           |    |
|                                                     |   | **2001**                    |    | **2000**    |   | **1999**   |   | **1998**    |   | **1997**   |   |
|                                                     |   | **Amount**                  |    | **Percent** |   | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   |   |
|                                                     |   | **(Dollars in  thousands)** |    |
| Commercial  loans:                                       |   |                        |    |        |   |       |   |        |   |       |   |        |   |       |   |        |   |       |   |        |   |   |
| Secured  by one to four family                           |   |                        |    |        |   |       |   |        |   |       |   |        |   |       |   |        |   |       |   |        |   |   |
| residential  properties                                  |   | $                           | 27,069  |        | 10     | %          | $      | 6,578       |   | 6          | %      | $           | 4,405  |       | 6      | %           | $      | 5,005      |   | 9           | %      | $      | 6,545 |   | 11 | % |   |
| Secured  by multifamily residential properties           |   | 8,492                       |    | 3           |   | 3,765      |   | 3           |   | 5,355      |   | 7           |   | 3,111      |   | 5           |   | 2,494      |   | 4           |   |   |
|                                                     |   |                        |    |        |   |       |   |        |   |       |   |        |   |       |   |        |   |       |   |        |   |   |
| Secured  by commercial real properties                   |   | 95,142                      |    | 36          |   | 40,540     |   | 37          |   | 28,233     |   | 38          |   | 20,839     |   | 36          |   | 22,324     |   | 36          |   |   |
|                                                     |   |                        |    |        |   |       |   |        |   |       |   |        |   |       |   |        |   |       |   |        |   |   |
| Other  — secured and unsecured                      |   | 85,292                      |    | 33          |   | 53,433     |   | 48          |   | 33,221     |   | 45          |   | 24,337     |   | 43          |   | 21,264     |   | 35          |   |   |
| Real  estate construction and land development           |   | 30,811                      |    | 12          |   | 1,890      |   | 2           |   | 6          |   | —      |   | —     |   | —      |   | 3,148      |   | 5           |   |   |
| Home  equity lines of credit..                           |   | 6,511                       |    | 3           |   | 644        |   | 1           |   | 367        |   | 1           |   | 271        |   | 1           |   | 252        |   | 0           |   |   |
| Consumer  installment and unsecured loans to individuals |   | 8,795                       |    | 3           |   | 3,729      |   | 3           |   | 2,496      |   | 3           |   | 3,707      |   | 7           |   | 5,508      |   | 9           |   |   |
| Total  loans outstanding                                 |   | 262,112                     |    | 100         | %      | 110,579    |   | 100         | %      | 74,083     |   | 100         | %      | 57,270     |   | 100         | %      | 61,535     |   | 100         | %      |   |
|                                                     |   |                        |    |        |   |       |   |        |   |       |   |        |   |       |   |        |   |       |   |        |   |   |
| Deferred  net loan origination                           |   |                        |    |        |   |       |   |        |   |       |   |        |   |       |   |        |   |       |   |        |   |   |
| fees  and purchased loan discount                        |   | (144                        | )       |        |   | (331       | )      |        |   | (240       | )      |        |   | (298       | )      |        |   | (283       | )      |        |   |   |
| Loans  receivable, net                                   |   | $                           | 261,968 |        |   |       | $      | 110,248     |   |       |   | $           | 73,843 |       |   |        | $      | 56,972     |   |        |   | $      | 61,252 |   |   |   |   |
|                                                          |        |                             |         |             |        |            |        |             |        |            |        |             |        |            |        |             |        |            |        |             |        |        |  |  |  |  |  |  |  |  |

 

Most of the ourcommercial loans are generally within $100,000 to $3.0 million and our consumerand home equity loans generally are less than $100,000.  The Banks are restricted and may not make anyloan, with certain limited exceptions, in excess of their loan to one borrowerlimit under applicable regulations ($2.3 million for Mercantile National and$2.9 million for South Bay at December 31, 2001).  If a Bank’s borrower requests a loan in excess of these amountswe may originate the loan with the participation of the other Bank or otherlenders.

 

*Real Estate Financing. *We offer adjustable and fixed rate loans to financethe purchase or holding of commercial real estate.  Real estate secured loans generally have terms ranging from threeto fifteen years and payments based on a 15 to 25 year amortizationschedule.  Real estate secured loansfrequently have a maturity date shorter than the amortization period.  The original principal amount of a realestate secured loan generally does not exceed 65% to 75% of the appraised valueof the property (or the lesser of the appraised value or the purchase price forthe property if the loan is made to finance the purchase of the property).

 

*Commercial Loans*. We offer adjustable and fixed rate secured and unsecured commercialloans for working capital, the purchase of assets and other business purposes.We underwrite these loans primarily on the basis of the borrower’s ability toservice the debt from cash flow without reliance on the liquidation of theunderlying collateral, where applicable.

 

Collateral for commercialloans may include commercial or residential real property, accounts receivable,inventory, equipment, marketable securities or other assets.  Unsecured commercial loans includeshort-term term loans and lines of credit. The Company’s 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 and cash flow. Typically, unsecured lines of credit must be unused fora continuous 30-day period within each year to demonstrate the borrower’sability to have sufficient funds to operate without the credit line.

 

30

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*Real Estate Construction and Land Development Loans*. Real estate construction and land development loans are short-termsecured loans made to finance the construction of commercial and single-familyresidential properties or for improvements to raw land.  These loans typically are adjustable ratewith terms of twelve to fifteen months. We monitor the progress of the construction and disburse the loanproceeds directly to the various contractors during stages of improvement.  Generally, the amount of a construction loangenerally does not exceed 65% of the appraised completion value and theborrower’s funds are disbursed prior to disbursement of the construction loan.

 

*Consumer Loans and Home Equity Linesof Credit*.  We offer consumer loans and home equitylines of credit. Home equity lines of credit provide the borrower with a lineof credit in an amount which generally does not exceed 80% of the appraisedvalue of the borrower’s residence net of senior mortgages.  Consumer loans are primarily adjustable rateopen ended unsecured loans (such as credit card loans) but also include fixedrate term loans (generally under five years) to purchase personal propertywhich are secured by that personal property. These loans (other than purchasemoney loans) generally provide for monthly payments of interest and a portionof the outstanding principal balance.

 

 

***Loan Concentration****s*

 

We provide bankingservices to the entertainment industry in Southern California.  Table 12 below presents information aboutthe loans outstanding to entertainment related customers at December 31, 2001and 2000.

** **
| **Table 12**                                                           |   |                       |   |     |   |
|------------------------------------------------------------------------|--------|----------------------------|--------|----------|--------|
| **Industry  Concentrations of Loans**                                  |   |                       |   |     |   |
|                                                                   |   | **December 31,**           |   |
|                                                                   |   | **2001**                   |   | **2000** |   |
|                                                                   |   | **(Dollars in thousands)** |   |
| Entertainment  industry-related loans:                                 |   |                       |   |     |   |
| Loans  for single productions of motion picture and television         |   |                       |   |     |   |
| feature  films                                                         |   | $                          | 5,054  |     | $      | 6,677 |   |
| Other  loans to entertainment-related enterprises, such as television, |   |                       |   |     |   |
| music,  film and talent agencies                                       |   | 12,069                     |   | 18,970   |   |
| Loans  to individuals involved primarily in the entertainment industry |   | 7,144                      |   | 4,072    |   |
| Loans  to business management, legal and accounting firms,             |   |                       |   |     |   |
| including  their principals and employees, serving primarily the       |   |                       |   |     |   |
| entertainmemt  industry                                                |   | 2,183                      |   | 205      |   |
| Total  entertainment industry-related loans                            |   | $                          | 26,450 |     | $      | 29,924 |   |
| Percent  of total loans outstanding                                    |   | 10.1                       | %      | 27.1     | %      |

 

        The loansto the entertainment related industry at December 31, 2001 decreased to $26.5million compared to $29.9 million at December 31, 2000.  As a percentage of the total loans outstanding,however, loans to the entertainment industry declined more significantly to10.1% at December 31, 2001 from 27.1% at December 31, 2000.  The decrease during 2001 was attributable toacquisition of South Bay, which has no entertainment industry concentration,and growth in loans from other industries resulting in greater diversificationof the loan portfolio.

 

31

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***Loan Rate Composition and Maturities***

 

                Of our total loansoutstanding, 55.6% and 64.1% had adjustable rates at December 31, 2001 and 2000,respectively.  Adjustable rate loansgenerally have interest rates tied to the prime rate and adjust with changes inthe rate on a current, monthly or quarterly basis.

 

                Of our total loansoutstanding at December 31, 2001, 55.6% were due in one year or less, 34.3%were due in 1-5 years and 10.1% were due after 5 years.   As is customary in the banking industry,loans can be renewed by mutual agreement between the borrower and us.  Because we are unable to estimate the extentto which its borrowers will renew their loans, Table 13 is based on contractualmaturities.

 

 
| **Table 13**                                      |   |                       |    |               |   |      |   |
|---------------------------------------------------|--------|----------------------------|---------|--------------------|--------|-----------|--------|
| **Loan  Maturities**                              |   |                       |    |               |   |      |   |
|                                              |   | **December 31, 2001**      |    |
|                                              |   | **Interest rates**         |    | **Interest rates** |   |      |   |
|                                              |   | **are floating**           |    | **are fixed or**   |   |      |   |
|                                              |   | **or adjustable**          |    | **predetermined**  |   | **Total** |   |
|                                              |   | **(Dollars in thousands)** |    |
| Aggregate  maturities of total loans outstanding: |   |                       |    |               |   |      |   |
| Commercial  secured by real estate                |   |                       |    |               |   |      |   |
| In  one year or less                              |   | $                          | 51,822  |               | $      | 26,722    |   | $ | 78,544 |   |
| After  one year but within five years             |   | 13,830                     |    | 52,033             |   | 65,863    |   |
| After  five years                                 |   | 4,171                      |    | 19,447             |   | 23,618    |   |
| Commecial  other secured and unsecured            |   |                       |    |               |   |      |   |
| In  one year or less                              |   | 53,156                     |    | 10,093             |   | 63,249    |   |
| After  one year but within five years             |   | 17,434                     |    | 1,980              |   | 19,414    |   |
| After  five years                                 |   | 2,629                      |    | —             |   | 2,629     |   |
| Other                                             |   |                       |    |               |   |      |   |
| In  one year or less                              |   | 2,087                      |    | 1,953              |   | 4,040     |   |
| After  one year but within five years             |   | 438                        |    | 4,184              |   | 4,622     |   |
| After  five years                                 |   | 133                        |    | —             |   | 133       |   |
| Total  loans outstanding                          |   | $                          | 145,700 |               | $      | 116,412   |   | $ | 262,112 |   |

 

 

### ***Credit Risk Management***

 

**       **We assess and manage credit risk on an ongoing basisthrough diversification guidelines, lending limits, credit review and approvalpolicies and internal monitoring.  Aspart of the control process, an independent credit review firm regularlyexamines 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.

 

***Nonperforming Assets***

 

                Nonperformingassets consist of nonperforming loans and other real estate owned.  Nonperforming loans are (i) loans which havebeen placed on nonaccrual status, (ii) troubled debt restructurings (“TDR’s”),or (iii) loans which are contractually past due ninety days or more withrespect to principal or interest, and have not been restructured or placed onnonaccrual status, and are accruing interest as described below.  Other real estate owned consists of real 

 

32

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properties securing loans of which we have taken title in partial orcomplete satisfaction of the loan. Information about nonperforming assets ispresented in Table 14.

 

 
| **Table 14**                                                                                                                |   |                       |   |     |   |     |   |     |   |     |   |
|-----------------------------------------------------------------------------------------------------------------------------|--------|----------------------------|--------|----------|--------|----------|--------|----------|--------|----------|--------|
| **Nonperforming  Assets**                                                                                                   |   |                       |   |     |   |     |   |     |   |     |   |
|                                                                                                                        |   | **December 31,**           |   |
|                                                                                                                        |   | **2001**                   |   | **2000** |   | **1999** |   | **1998** |   | **1997** |   |
|                                                                                                                        |   | **(Dollars in thousands)** |   |
| Nonaccrual  loans                                                                                                           |   | $                          | 7,807  |     | $      | 683      |   | $        | 932    |     | $      | 1,505 |   | $ | 1,201 |   |
| Troubled  debt restructurings                                                                                               |   | 953                        |   | —   |   | —   |   | —   |   | 5,422    |   |
| Loans  contractually past due ninety or more days with respect to either principal  or interest and still accruing interest |   | 642                        |   | —   |   | —   |   | —   |   | —   |   |
| Nonperforming  loans                                                                                                        |   | 9,402                      |   | 683      |   | 932      |   | 1,505    |   | 6,623    |   |
| Other  real estate owned                                                                                                    |   | —                     |   | —   |   | 382      |   | 593      |   | 777      |   |
| Other  assets—SBA guaranteed loan                                                                                      |   | —                     |   | —   |   | 150      |   | —   |   | —   |   |
| Total  nonperforming assets                                                                                                 |   | $                          | 9,402  |     | $      | 683      |   | $        | 1,464  |     | $      | 2,098 |   | $ | 7,400 |   |
|                                                                                                                        |   |                       |   |     |   |     |   |     |   |     |   |
| Allowance  for credit losses as a percent of nonaccrual loans                                                               |   | 83.8                       | %      | 380.2    | %      | 203.4    | %      | 142.5    | %      | 168.4    | %      |
| Allowance  for credit losses as a percent of                                                                                |   |                       |   |     |   |     |   |     |   |     |   |
| nonperforming  loans                                                                                                        |   | 69.6                       | %      | 380.2    | %      | 203.4    | %      | 142.5    | %      | 30.5     | %      |
| Total  nonperforming assets as a percent of loans receivable                                                                |   | 3.6                        | %      | 0.6      | %      | 2.0      | %      | 3.7      | %      | 12.1     | %      |
| Total  nonperforming assets as a percent of total                                                                           |   |                       |   |     |   |     |   |     |   |     |   |
| shareholders’  equity                                                                                                  |   | 36.9                       | %      | 3.3      | %      | 12.6     | %      | 15.8     | %      | 59.5     | %      |

 

**       ***NonaccrualLoans.* Nonaccrualloans are those loans for which management has discontinued accrual of interestbecause there exists reasonable doubt as to the full and timely collection ofeither principal or interest.  It is theCompany’s policy that a loan will be placed on nonaccrual status if eitherprincipal or interest payments are past due in excess of ninety days unless theloan is both well secured and in process of collection, or if full collectionof interest or principal becomes uncertain, regardless of the time periodinvolved.

 

                When a loan isplaced on nonaccrual status, all interest previously accrued but uncollected isreversed against current period operating results. Income on such loans is thenrecognized only to the extent that cash is received, and, where the ultimatecollection of the carrying amount of the loan is probable, after givingconsideration to the borrower’s current financial condition, historicalrepayment performance and other factors. Accrual of interest is resumed onlywhen (i) principal and interest are brought fully current, and (ii) such loansare either considered, in management’s judgment, to be fully collectible orotherwise become well secured and in the process of collection. (See ‘‘NetInterest Income’’ for a discussion of the effects on operating results ofnonperforming loans.)

 

                Nonaccrual loansat December 31, 2001, increased to $7.8 million from $683,000 at December 31,2000. Nonaccrual loans at December 31, 2001 were comprised primarily of securedcommercial loans, including $449,000 that is partially guaranteed by the SBA.  The value of the collateral securing theseloans may not be adequate to avoid a charge off of a portion of thecredit.  $5.6 million of the nonaccrualloans at December 31, 2001 was acquired in the South Bay business combination and$900,000 has been subsequently collected. The additional interest income that would have been recorded fromnonaccrual loans, if the loans had not been on nonaccrual status, was $110,000and $83,000 for 2001 and 2000, respectively. Interest payments received on nonaccrual loans are applied to principalunless there is no doubt as to ultimate full repayment of principal, in whichcase, the interest payment is recognized as interest income.  Interest income not recognized on nonaccrualloans reduced the net yield on earning assets by 5 basis points for 2001 and2000.

 

33

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**       ***TroubledDebt 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 itwould not otherwise consider, including modifications of loan terms toalleviate the burden of the borrower’s near-term cash flow requirements inorder to help the borrower to improve its financial condition and eventualability to repay the loan. At December 31, 2001 TDRs were $953,000 representinga loan to one borrower acquired in the South Bay acquisition.  This loan was restructured to provide for an8-month extension with accrued interest capitalized and a reduction in the loanrate.  At December 31, 2000 we had noTDRs.

 

**       ***LoansContractually Past Due 90 or More Days.* Loans contractually past due 90 or more days arethose loans which have become contractually past due at least ninety days withrespect to principal or interest. Interest accruals may be continued for loansthat have become contractually past due ninety days when such loans are wellsecured 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 collateral has a realizable value inexcess of the amount of principal and accrued interest outstanding and/or isguaranteed by a financially capable party. A loan is considered to be in theprocess of collection if collection of the loan is proceeding in due courseeither through legal action or through other collection efforts whichmanagement reasonably expects to result in repayment of the loan or itsrestoration to a current status in the near future.

 

                At December 31,2001 there were loans of $642,000 past due 90 days or more and stillaccruing.  There were no loanscontractually past due 90 or more days and still accruing interest at December31, 2000.

 

*         Other Real Estate Owned.*** **We carry OREO at the lesser of ourrecorded investment or the fair value less selling costs. We periodicallyrevalue OREO properties and charge other expenses for any further write-downs.At December 31, 2001 and 2000 we had no OREO.

 

 

***Impaired Loans***

 

                Due to the sizeand nature of the our loan portfolio, impaired loans are determined by aperiodic evaluation on an individual loan basis.  At December 31, 2001 we had classified $7.1 million of our loansas impaired for which $3.1 million of specific reserves were allocated.  At December 31, 2000, $683,000 of our loanswere classified as impaired and no related specific reserves wereprovided.  The average recordedinvestment in, and the amount of interest income recognized on impaired loansduring the year ended December 31, 2001, were $831,000 and $4,000, respectively.

 

                Foregone interestincome attributable to nonperforming loans amounted to $110,000 in 2001 and$83,000 in 2000.  This resulted in areduction in yield on average loans receivable of 9 basis points and 10 basispoints for the years ended December 31, 2001 and 2000, respectively.

 

***Allowance for Credit Losses***

 

**       **We review and manage the credit quality of the loanportfolio through a  process thatincludes a risk rating system, uniform underwriting criteria, earlyidentification of problem credits, regular monitoring of any classified assetsgraded as ‘‘criticized’’ by our internal grading system, and an independentloan review process. The loan approval process is also tied to the risk ratingsystem. The Classified Asset Committee (‘‘CAC’’) meets on a quarterly basis toreview, monitor, take corrective action upon all criticized assets, and reviewthe adequacy of the allowance for credit losses. The CAC is currently chairedby the each Bank’s Chief Credit Officer, with the results of the CAC’s meetingsreviewed by the Officers and Directors’ Loan Committee quarterly.

 

        Thecalculation of the adequacy of the allowance for credit losses is based on avariety of factors, including loan classifications, migration trends andunderlying cash flow and collateral values. On a periodic basis (two times peryear), we engage an outside loan review firm to review our loan portfolio, riskgrade accuracy and the reasonableness 

 

34

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of loan evaluations. Annually, this outside loan review team analyzes our methodology forcalculating the allowance for credit losses based on our loss histories andpolicies.  We use a migration analysisas part of our allowance for credit losses evaluation that is a method by whichspecific charge-offs are related to the prior life of the same loan compared tothe total loan pools in which the loan was graded.  This method allows for management to use historical trends thatare relative to our portfolio rather than use outside factors that may not takeinto consideration trends relative to the specific loan portfolio. In addition,this analysis takes into consideration other trends that are qualitativerelative to our marketplace, demographic trends, amount and trends innonperforming assets and concentration factors.

 

                South Bay prior tothe acquisition applied a different process than that which we use.  We are currently implementing our creditreview and management practices at South Bay. The resulting changes in methodology are not expected to have a materialimpact on the financial statements.

 

        EachBank’s board of directors reviews the adequacy of the allowance for creditlosses on a quarterly basis. We utilize our judgment to determine the provisionfor 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, 2001 wasadequate to absorb estimated 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 which 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.

 

                Table 15 presents,at December 31, 2001 and 2000, the composition of our allocation of theallowance for credit losses to specific loan categories designated bymanagement for this purpose. 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.

 
| **Table 15**                                                 |   |                        |   |     |   |     |   |                        |   |     |   |     |   |      |   |     |   |     |   |     |   |
|--------------------------------------------------------------|--------|-----------------------------|--------|----------|--------|----------|--------|-----------------------------|--------|----------|--------|----------|--------|-----------|--------|----------|--------|----------|--------|----------|--------|
| **Allocation of Allowance For Credit Losses**                |   |                        |   |     |   |     |   |                        |   |     |   |     |   |      |   |     |   |     |   |     |   |
|                                                         |   | **December  31,**           |   |
|                                                         |   | **2001**                    |   | **%(1)** |   | **2000** |   | **%(1)**                    |   | **1999** |   | **%(1)** |   | **1998%** |   | **%(1)** |   | **1997** |   | **%(1)** |   |
|                                                         |   | **(Dollars in  thousands)** |   |     |   |     |   | **(Dollars in  thousands)** |   |     |   |     |   |
|                                                         |   |                        |   |     |   |     |   |                        |   |     |   |     |   |      |   |     |   |     |   |     |   |
| Allocation  of the Allowance for Credit Losses:              |   |                        |   |     |   |     |   |                        |   |     |   |     |   |      |   |     |   |     |   |     |   |
| Commercial  loans:                                           |   |                        |   |     |   |     |   |                        |   |     |   |     |   |      |   |     |   |     |   |     |   |
| Secured  by one to four family residential properties        |   | $                           | 675    |     | 10     | %        | $      | 155                         |   | 6        | %      | $        | 102    |      | 6      | %        | $      | 132      |   | 9        | %      | $ | 154 |   | 11 | % |
| Secured  by multifamily residential properties               |   | 212                         |   | 3        | %      | 73       |   | 3                           |   | 103      |   | 7        |   | 73        |   | 5        |   | 49       |   | 4        |   |
| Secured  by commercial real properties                       |   | 2,376                       |   | 36       | %      | 842      |   | 37                          |   | 659      |   | 38       |   | 590       |   | 36       |   | 512      |   | 36       |   |
| Other  — secured and unsecured                          |   | 2,128                       |   | 33       | %      | 1,355    |   | 48                          |   | 938      |   | 45       |   | 1,061     |   | 43       |   | 1,056    |   | 35       |   |
| Real  estate construction and land development               |   | 769                         |   | 12       | %      | 47       |   | 2                           |   | —   |   | —   |   | —    |   | —   |   | 63       |   | 5        |   |
| Home  equity lines of credit                                 |   | 162                         |   | 3        | %      | 12       |   | 1                           |   | 3        |   | 1        |   | 4         |   | 0        |   | 2        |   | 0        |   |
| Consumer  installment and unsecured loans to individuals (1) |   | 219                         |   | 3        | %      | 113      |   | 3                           |   | 91       |   | 3        |   | 284       |   | 7        |   | 187      |   | 9        |   |
| Allowance  allocable to loans receivable                     |   | $                           | 6,542  |     | 100    | %        | $      | 2,597                       |   | 100      | %      | $        | 1,896  |      | 100    | %        | $      | 2,144    |   | 100      | %      | $ | 2,023 |   | 100 | % |

----

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

 

35

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Table 16 presents an analysis of changes in the allowance for creditlosses during the periods indicated:

 
| **Table 16**                                                |   |                       |   |        |   |     |   |       |   |     |   |
|-------------------------------------------------------------|--------|----------------------------|--------|-------------|--------|----------|--------|------------|--------|----------|--------|
| **Analysis of Changes in Allowance for Credit Losses**      |   |                       |   |        |   |     |   |       |   |     |   |
|                                                        |   | **December 31,**           |   |
|                                                        |   | **2001**                   |   | **2000**    |   | **1999** |   | **1998**   |   | **1997** |   |
|                                                        |   | **(Dollars in thousands)** |   |
| Balance, beginning of  period                               |   | $                          | 2,597  |        | $      | 1,896    |   | $          | 2,144  |     | $      | 2,023 |   | $ | 2,969 |   |
| Loan charged off:                                           |   |                       |   |        |   |     |   |       |   |     |   |
| Real estate construction  and land development              |   | —                     |   | —      |   | —   |   | —     |   | —   |   |
| Commercial loans:                                           |   |                       |   |        |   |     |   |       |   |     |   |
| Secured by one to four  family residential properties       |   | —                     |   | —      |   | —   |   | 4          |   | 310      |   |
| Secured by multifamily  residential properties              |   | —                     |   | —      |   | —   |   | —     |   | 256      |   |
| Secured by commercial  real properties                      |   | —                     |   | —      |   | 128      |   | 31         |   | 56       |   |
| Other - secured and  unsecured                              |   | 387                        |   | 7           |   | 344      |   | 176        |   | 350      |   |
| Home equity lines of  credit                                |   | —                     |   | —      |   | —   |   | —     |   | —   |   |
| Consumer installment and  unsecured loans to individuals    |   | 104                        |   | 111         |   | 105      |   | 196        |   | 343      |   |
| Total loan charge-offs                                      |   | 491                        |   | 118         |   | 577      |   | 407        |   | 1,315    |   |
|                                                        |   |                       |   |        |   |     |   |       |   |     |   |
| Recoveries of loans  previously charged off:                |   |                       |   |        |   |     |   |       |   |     |   |
| Real estate construction  and land development              |   | —                     |   | —      |   | —   |   | —     |   | —   |   |
| Commercial loans:                                           |   |                       |   |        |   |     |   |       |   |     |   |
| Secured by one to four  family residential properties       |   | 6                          |   | —      |   | 30       |   | 1          |   | 71       |   |
| Secured by multifamily  residential properties              |   | —                     |   | —      |   | —   |   | 10         |   | —   |   |
| Secured by commercial  real properties                      |   | —                     |   | —      |   | 144      |   | —     |   | 4        |   |
| Other - secured and  unsecured                              |   | 227                        |   | 1,350       |   | 100      |   | 216        |   | 202      |   |
| Home equity lines of  credit                                |   | —                     |   | —      |   | —   |   | —     |   | —   |   |
| Consumer installment and  unsecured loans to individuals    |   | 40                         |   | 45          |   | 55       |   | 301        |   | 92       |   |
| Total recoveries of  loans previously charged off           |   | 273                        |   | 1,395       |   | 329      |   | 528        |   | 369      |   |
| Net (recoveries)  charge-offs                               |   | 218                        |   | (1,277      | )      | 248      |   | (121       | )      | 946      |   |
| Provision for credit  losses                                |   | 517                        |   | (576        | )      | —   |   | —     |   | —   |   |
| Allowance acquired in  acquisition of South Bay Bank, N.A   |   | 3,646                      |   | —      |   | —   |   | —     |   | —   |   |
| Balance, end of period                                      |   | $                          | 6,542  |        | $      | 2,597    |   | $          | 1,896  |     | $      | 2,144 |   | $ | 2,023 |   |
|                                                        |   |                       |   |        |   |     |   |       |   |     |   |
| Net loan (recoveries)  charge-offs as a percentage of       |   |                       |   |        |   |     |   |       |   |     |   |
| allowance for credit  losses                                |   | 3.33                       | %      | —49.17 | %      | 13.08    | %      | —5.66 | %      | 46.76    | %      |
| Net loan (recoveries)  charge-offs as a percentage of       |   |                       |   |        |   |     |   |       |   |     |   |
| average gross loans  outstanding during the period          |   | 0.19                       | %      | —1.40  | %      | 0.40     | %      | —0.20 | %      | 1.59     | %      |
| Recoveries of loans  previously charged off as a percentage |   |                       |   |        |   |     |   |       |   |     |   |
| of loans charged off in  the previous year                  |   | 231.36                     | %      | 241.77      | %      | 80.84    | %      | 40.16      | %      | 28.38    | %      |

 

 

*    Off-Balance Sheet Credit Commitments andContingent Obligations*

 

                The Company is aparty to financial instruments with off-balance sheet credit risk in the normalcourse of business to meet the financing needs of its customers. In addition toundisbursed commitments to extend credit under loan facilities, theseinstruments include conditional obligations under standby and commercialletters of credit. The Company’s exposure to credit loss in the event ofnonperformance by customers is represented by the contractual amount of theinstruments.

 

                Standby letters ofcredit are conditional commitments issued by the Company to secure thefinancial performance of a customer to a third party and are primarily issuedto support private borrowing arrangements. The credit risk involved in issuinga letter of credit for a customer is essentially the same as that involved inextending a loan to that customer. The Company uses the same creditunderwriting policies in accepting such contingent 

 

36

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obligations as it does for loans. When deemed necessary, the Companyholds appropriate collateral supporting those commitments. The nature ofcollateral obtained varies and may include deposits held in financialinstitutions and real properties.

 

         At December 31, 2001 and 2000, standbyletters of credit amounted to $157,000 and $731,000, respectively, and therewere no commercial letters of credit outstanding.

 

        Undisbursedcommitments under revocable and irrevocable loan facilities amounted to $83.4million and $26.1 million at December 31, 2001 and 2000, respectively.  Many of these commitments are expected toexpire without being drawn upon and, as such, the total commitment amounts donot necessarily represent future cash requirements.

 

 **Deposits**

 

        Asindicated in Table 17, the Bank experienced a 13.6% increase in average totaldeposits during 2001 compared to 2000. This increase in deposits occurredprimarily as a result of growth in time certificates of deposits of $11.3million and growth in demand deposits of real estate and escrow companycustomers of $4.9 million, offset by a decline in other non-interest bearingdemand of $2.8 million and a decline in higher cost money desk deposits of $2.4million.

 

 
| **Table 17**                        |   |                       |    |        |   |       |   |        |   |
|-------------------------------------|--------|----------------------------|---------|-------------|--------|------------|--------|-------------|--------|
| **Deposit  Composition**            |   |                       |    |        |   |       |   |        |   |
| **(Balances  are averages)**        |   |                       |    |        |   |       |   |        |   |
|                                |   | **December 31,**           |    |
|                                |   | **2001**                   |    | **2000**    |   |
|                                |   | **Amount**                 |    | **Percent** |   | **Amount** |   | **Percent** |   |
|                                |   | **(Dollars in thousands)** |    |
| Noninterest-bearing  demand         |   |                       |    |        |   |       |   |        |   |
| deposits:                           |   |                       |    |        |   |       |   |        |   |
| Real  estate title and escrow       |   |                       |    |        |   |       |   |        |   |
| company  customers                  |   | $                          | 19,746  |        | 13     | %          | $      | 14,806      |   | 11 | % |
| Other  noninterest-bearing          |   |                       |    |        |   |       |   |        |   |
| demand                              |   | 39,137                     |    | 27          |   | 41,981     |   | 32          |   |
| Interest-bearing  demand            |   | 9,562                      |    | 6           |   | 8,066      |   | 6           |   |
| Money  market                       |   | 39,127                     |    | 27          |   | 36,312     |   | 28          |   |
| Savings                             |   | 1,269                      |    | 1           |   | 1,348      |   | 1           |   |
| Time  certificates of deposit:      |   |                       |    |        |   |       |   |        |   |
| Money  Desk                         |   | 3,461                      |    | 2           |   | 5,867      |   | 5           |   |
| Other:                              |   |                       |    |        |   |       |   |        |   |
| $100,000  or more                   |   | 26,021                     |    | 18          |   | 17,023     |   | 13          |   |
| Under  $100,000                     |   | 9,300                      |    | 6           |   | 4,566      |   | 4           |   |
| Total  time certificates of deposit |   | 38,782                     |    | 26          |   | 27,456     |   | 22          |   |
| Total  Deposits                     |   | $                          | 147,623 |        | 100    | %          | $      | 129,969     |   | 100 | % |

 

37

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** **
| **Table 18**                                           |                 |                       |       |      |   |      |   |
|--------------------------------------------------------|----------------------|----------------------------|------------|-----------|--------|-----------|--------|
| **Maturities  of Time Certificates of Deposit**        |                 |                       |       |      |   |      |   |
| **$**                                                  | **100,000 or  more** |                       |       |      |   |      |   |   |
|                                                   |                 | **December 31, 2001**      |       |
|                                                   |                 | **Money**                  |       | **All**   |   |      |   |
|                                                   |                 | **Desk**                   |       | **Other** |   | **Total** |   |
|                                                   |                 | **(Dollars in thousands)** | ** ** |
| Aggregate  maturities of time certificates of deposit: |                 |                       |       |      |   |      |   |
| In  three months or less                               |                 | $                          | 2,000      |      | $      | 32,555    |   | $ | 34,555 |   |
| After  three months but within six months              |                 | 100                        |       | 14,485    |   | 14,585    |   |
| After  six months but within twelve months             |                 | —                     |       | 8,852     |   | 8,852     |   |
| After  twelve months                                   |                 | 272                        |       | 3,821     |   | 4,093     |   |
| Total  time certificates of deposit $100,000 or more   |                 | $                          | 2,372      |      | $      | 59,713    |   | $ | 62,085 |   |
|                                                        |                      |                            |            |           |        |           |        |  |  |  |  |

 
|                                                   |   | **December 31, 2000**      |       |
|--------------------------------------------------------|--------|----------------------------|------------|
|                                                   |   | **Money**                  |       | **All** |   |   |   |
|                                                   |   | **Desk**                   |       | **Other** |   | **Total** |   |
|                                                   |   | **(Dollars in thousands)** | ** ** |
| Aggregate  maturities of time certificates of deposit: |   |                       |       |   |   |   |   |
| In  three months or less                               |   | $                          | 2,033      |   | $ | 16,911 |   | $ | 18,944 |   |
| After  three months but within six months              |   | 300                        |       | 3,261 |   | 3,561 |   |
| After  six months but within twelve months             |   | —                     |       | 3,160 |   | 3,160 |   |
| After  twelve months                                   |   | 100                        |       | 100 |   | 200 |   |
| Total  time certificates of deposit $100,000 or more   |   | $                          | 2,433      |   | $ | 23,432 |   | $ | 25,865 |   |

 

## ** **

## **Borrowed Funds**

 

        Borrowedfunds and related weighted average rates are summarized below in Table 19.

** **
| **Table 19**                            |   |                        |   |        |   |         |   |        |   |        |   |     |   |        |   |     |   |
|-----------------------------------------|--------|-----------------------------|--------|-------------|--------|--------------|--------|-------------|--------|-------------|--------|----------|--------|-------------|--------|----------|--------|
| **Borrowed  Funds**                     |   |                        |   |        |   |         |   |        |   |        |   |     |   |        |   |     |   |
|                                    |   | **2001**                    |   | **2000**    |   |
|                                    |   | **Year-end**                |   | **Average** |   | **Year-end** |   | **Average** |   |
|                                    |   | **Balance**                 |   | **Rate**    |   | **Balance**  |   | **Rate**    |   | **Balance** |   | **Rate** |   | **Balance** |   | **Rate** |   |
|                                    |   | **(Dollars in  thousands)** |   |
| Federal  funds purchased and securities |   |                        |   |        |   |         |   |        |   |        |   |     |   |        |   |     |   |
| sold  under repurchase agreements       |   | $                           | 3,096  |        | 4.77   | %            | $      | 733         |   | 5.05        | %      | $        | 7,500  |        | 6.71   | %        | $      | 998 |   | 6.81 | % |
| Other  borrowings                       |   | 17,500                      |   | 4.25        | %      | 20,865       |   | 4.85        | %      | 40,000      |   | 6.59     | %      | 32,424      |   | 6.42     | %      |
|                                         |        |                             |        |             |        |              |        |             |        |             |        |          |        |             |        |          |        |  |  |  |  |

 

                The maximum amountof securities sold with agreements to repurchase at any month end was $5.0million and $7.5 million during 2001 and 2000, respectively.

 

                The maximum amountof other borrowings at any month end was $38.0 million during 2001 and $40.0million during 2000.

 

38

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                At December 31,2001,  $15.0 million of borrowed fundswere scheduled to mature during 2002, and $2.5 million were scheduled to matureduring 2004.

 

 

**Selected Financial Ratios**

 

                The followingTable 20 sets forth selected financial ratios:

 
| **Table 20**                                         |   |                   |   |     |   |
|------------------------------------------------------|--------|------------------------|--------|----------|--------|
| **Selected Performance Ratios**                      |   |                   |   |     |   |
|                                                 |   | **For the Year Ended** |   |
|                                                 |   | **December 31,**       |   |
|                                                 |   | **2001**               |   | **2000** |   |
| Return  on average assets                            |   | 0.59                   | %      | 1.64     | %      |
| Return  on average shareholders’ equity         |   | 5.13                   | %      | 20.49    | %      |
| Average  shareholders’ equity to average assets |   | 11.23                  | %      | 8.01     | %      |

 

 

**Recent Accounting Pronouncements**

 

        On July 20, 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 141-Business Combinations (“SFAS No. 141”). The standard concludes that all business combinations within the scope of the statement will be accounted for using the purchase method.  Previously, the pooling-of-interests method was required whenever certain criteria were met.  Because those criteria did not distinguish economically dissimilar transactions, similar business combinations were accounted for using different methods that produced dramatically different financial statement results.  SFAS No. 141 requires separate recognition of intangible assets apart from goodwill if they meet one of two criteria, the contractual-legal criterion or the separability criterion.  SFAS No. 141 also requires the disclosure of the primary reasons for a business combination and the allocation of the purchase price paid to the assets acquired and liabilities assumed by major balance sheet caption.

 

        The provisions of SFAS No. 141 apply to all business combinations initiated after June 30, 2001.  Accordingly, the Company’s acquisition of South Bay Bank, N.A. has been accounted for under SFAS No. 141.

 

        On July 20, 2001 the Financial Accounting Standards Board also issued Statement of Financial Accounting Standard No. 142-Goodwill and Other Intangible Assets (“SFAS No. 142”).  It addresses how intangible assets that are acquired individually or within a group of assets (but not those acquired in a business combination) should be accounted for in the financial statements upon their acquisition.  SFAS No.142 adopts a more aggregate view of goodwill and bases the accounting on the units of the combined entity into which an acquired entity is aggregated.

 

        SFAS No. 142 also prescribes that goodwill and intangible assets that have indefinite useful lives will not be amortized but rather tested at least annually for impairment.  Intangible assets that have definite lives will continue to be amortized over their useful lives, but no longer with the constraint of the 40-year ceiling.  SFAS No. 142 provides specific guidance for the testing of goodwill for impairment, which may require re-measurement of the fair value of the reporting unit.  Additional ongoing financial statement disclosures are also required.

 

        The provisions of the statement are required to be applied starting with fiscal years beginning after December 15, 2001. The statement is required to be applied at the beginning of the fiscal year and applied to all goodwill and other intangible assets recognized in the financial statements at that date.  Impairment losses are to be reported as resulting from a change in accounting principle.

 

39

 

        We had $5.6 million goodwill recorded as of December 31, 2001.  The adoption of SFAS No. 142 will not have a significant impact on our financial position.

 

40

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# ***FACTORS WHICH MAY AFFECT FUTURE OPERATING RESULTS***

 

***We facerisk from changes in interest rates***.

** **

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

 

•  Our ability to originate loans;

•  The ability of our borrowers to makepayments on their loans;

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

•  The average life of our interest-earningassets;

•  Our ability to generate deposits instead ofother available funding alternatives; and

•  Our ability to access the wholesale fundingmarket.

 

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

 

***We facerisk from possible declines in the quality of our assets***.

** **

       Our financial conditiondepends significantly on the quality of our assets.  While we have developed and implemented underwriting policies andprocedures to guide us in the making of loans, compliance with these policiesand procedures in making loans does not guarantee repayment of the loans.  If the level of our non-performing assets rises,our results of operations and financial condition will be affected.  A borrower’s ability to pay its loan inaccordance with its terms can be adversely affected by a number of factors,such as a decrease in the borrower’s revenues and cash flows due to adversechanges in economic conditions or a decline in the demand for the borrower’sproducts and/or services.

 

***Ourallowances for credit losses may be inadequate***.

** **

       We establish allowances for creditlosses against each segment of our loan portfolio.  At December 31, 2001, our allowance for credit losses equaled2.5% of loans receivable and 69.6% of nonperforming loans.  Although we believed that we had establishedadequate allowances for credit losses as of December 31, 2001, the creditquality or our assets is affected by many factors beyond our control, includinglocal and national economic conditions, and the possible existence of factswhich are not known to us which adversely affect the likelihood of repayment ofvarious loans in our loan portfolio and realization of the collateral upon adefault.  Accordingly, we can give noassurance that we will not sustain loan losses materially in excess of theallowance for credit losses.  Inaddition, the Office of the Comptroller of the Currency, as an integral part ofits examination process, periodically reviews our allowance for credit lossesand could require additional provisions for credit losses.  Material future additions to the allowancefor credit losses may also be necessary due to increases in the size andchanges in the composition of our loan portfolio.  Increases in our provisions for credit losses would adverselyaffect our results of operations.

 

***Economicconditions may worsen***.

** **

       Our business is strongly influenced byeconomic conditions in our market area (principally, the Greater Los Angelesmetropolitan area) as well as regional and national economic conditions and inour niche markets, including the entertainment industry in SouthernCalifornia.  During the past severalyears economic conditions in these areas have been favorable.  Should the economic condition in these areasdeteriorate, the financial condition of our borrowers could weaken, which couldlead to higher levels of loan defaults or a decline in the value of collateralfor our loans.  In addition, an unfavorableeconomy could reduce the demand for our loans and other products and services.

** **

**41**

----

** **

***Becausea significant amount of the loans we make are to borrowers in California, ouroperations could***

***suffer asa result of local recession or natural disasters in California***.

** **

      At December 31, 2001, approximately 64%of our loans outstanding were collateralized by properties located inCalifornia.  Because of thisconcentration in California, our financial position and results of operationshave been and are expected to continue to be influenced by general trends inthe California economy and its real estate market.  Real estate market declines may adversely affect the values ofthe properties collateralizing loans. If the principal balances of our loans, together with any primaryfinancing on the mortgaged properties, equal or exceed the value of themortgaged properties, we could incur higher losses on sales of propertiescollateralizing foreclosed loans.  Inaddition, California historically has been vulnerable to certain naturaldisaster risks, such as earthquakes and erosion-caused mudslides, which are nottypically covered by the standard hazard insurance policies maintained byborrowers.  Uninsured disasters may adverselyimpact our ability to recover losses on properties affected by such disastersand adversely impact our results of operations.

 

***Ourbusiness is very competitive***.

** **

      There is intensecompetition in Southern California and elsewhere in the United States forbanking customers.  We experiencecompetition for deposits from many sources, including credit unions, insurancecompanies and money market and other mutual funds, as well as other commercialbanks and savings institutions.  Wecompete for loans and deposits primarily with 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, marketing capability and name recognition thanwe do, and operate on a statewide or nationwide basis.  In addition, recent developments intechnology and mass marketing have permitted larger companies to market loansmore aggressively to our small business customers.  Such advantages may give our competitors opportunities to realizegreater efficiencies and economies of scale than we can.  We can provide no assurance that we will beable to compete effectively against our competition.

** **

***Our businessis heavily regulated***.

** **

       Both National Mercantile, as a bankholding company, and the Banks, are subject to significant governmentalsupervision and regulation, which is intended primarily for the protection ofdepositors.  Statutes and regulationsaffecting us may be changed at any time, and the interpretation of thesestatutes and regulations by examining authorities also may change.  We cannot assure you that future changes inapplicable statutes and regulations or in their interpretation will notadversely affect our business.

 

***Our ability to use our net operating losses may be limited*****.**

 

       During the past three years, althoughwe have had taxable income, we have not paid any income taxes other thanalternative minimum taxes because of our net operating loss carryforwards.  As of December 31, 2001, we had netoperating loss carryforwards of $16.9 million and $273,000 million for federaland state tax purposes, respectively. Our federal net operating loss carryforward begins to expire in 2009.  Our state net operating loss carryforwardscontinue to expire but remain available in reducing amounts through 2002.  Our ability to use these carryforwards inthe future would be significantly limited if we experience an “ownershipchange” within the meaning of Section 382 of the Internal Revenue Code.  If our use of these carryforwards islimited, we would be required to pay taxes on our taxable income to the extentour taxable income exceeded the limited amounts which could be offset, and ournet income would be lower.

 

42

----

 

 

***ITEM 7***.      FINANCIALSTATEMENTS

                The consolidatedfinancial statements required by this Item are included herewith as a separatesection of this Report as follows:

 

   1.   *Financial Statements*
|                                                                                                             | **Page** |
|------------------------------------------------------------------------------------------------------------------|----------|
| Report of  Independent Public Accountants                                                                        | 46       |
|                                                                                                             |     |
| Consolidated Balance Sheet  at December 31, 2001                                                                 | 47       |
|                                                                                                             |     |
| Consolidated  Statements of Operations for the years ended December 31, 2001 and 2000                            | 48       |
|                                                                                                             |     |
| Consolidated  Statements of Changes in Shareholders’ Equity for the years ended December  31, 2001 and 2000 | 49       |
|                                                                                                             |     |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2001 and 2000                            | 50       |
|                                                                                                             |     |
| Notes to  Consolidated Financial Statements for the two years ended December 31, 2001                            | 51       |

 

 

**ITEM8**.    **CHANGES IN ANDDISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

Not applicable.

 

**PART III**

 

***ITEM9.***      DIRECTORS AND EXECUTIVE OFFICERS OF THEREGISTRANT

                The informationrequired by this item will appear under the captions “Election of Directors,’’‘‘ Executive Officers,’’ and ‘‘Compliance with Section 16(a) BeneficialOwnership Reporting ‘‘ in the Company’s proxy statement for the 2002 AnnualMeeting of Shareholders (the ‘‘2002 Proxy Statement’’), and such informationshall be deemed to be incorporated herein by reference to that portion of the2002 Proxy Statement, if filed with the Securities and Exchange Commissionpursuant to Regulation 14A not later than 120 days after the end of theCompany’s most recently completed fiscal year.

 

***ITEM10.***   EXECUTIVECOMPENSATION

                The informationrequired by this item will appear under the captions “Compensation of ExecutiveOfficers,” “Compensation of Directors,’’ ‘‘Summary Compensation Table,’’‘‘Report on Executive Compensation for 2001,’’ ‘‘2001 Option Exercises andYear-End Option Values” and “Compensation Committee Interlocks and InsiderParticipation’’ in the 2002 Proxy Statement, and such information shall bedeemed to be incorporated herein by reference to those portions of the 2002Proxy Statement, if filed with the Securities and Exchange Commission pursuantto Regulation 14A not later than 120 days after the end of our most recentlycompleted fiscal year.

 

***ITEM11.***   SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

                The informationrequired by this item will appear under the caption ‘‘Security Ownership ofPrincipal Shareholders and Management’’ in the 2002 Proxy Statement, and suchinformation either shall be deemed to be incorporated herein by reference tothat portion of the 2002 Proxy Statement, if filed with the Securities andExchange Commission pursuant to Regulation 14A not later than 120 days afterthe end of our most recently completed fiscal year.

 

 

43

----

 

***ITEM12.***   CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS

                The informationrequired by this item will appear under the caption ‘‘Certain Relationships andRelated Transactions’’ in the 2002 Proxy Statement, and such information shallbe deemed to be incorporated herein by reference to that portion of the 2002Proxy Statement, if filed with the Securities and Exchange Commission pursuantto Regulation 14A not later than 120 days after the end of our most recentlycompleted fiscal year.

 

 

**PART IV**

 

***ITEM13.***   EXHIBITSAND REPORTS ON FORM 8-K

 

(c) Exhibits

 

                SeeIndex to Exhibits on page 70 of this Report on Form 10-KSB

 

(b) Reports on Form 8-K

 

On October 30,2001 the Company filed a report on Form 8-K reporting under Item 5 the pressrelease of the Registrant issued on October 26, 2001 which containsinformation meeting the requirements of this Item 5

 

On December 19, 2001, the Company filed a report on Form 8-K reportingunder Item 2. the acquisition of South Bay Bank, N.A.

 

44

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*SIGNATURES*

 

         Pursuantto the requirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.

 
|   | NATIONAL MERCANTILE BANCORP |
|--------|-----------------------------|
|   | (Registrant)                |
|   |                        |   |
|   | By                          | /s/  SCOTT A.  MONTGOMERY |
|   |                        | Scott A. Montgomery |
|   |                        | Chief Executive Officer |

 

 

 

Date: April 15, 2002

 

         Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated.

 
| **Signature** |                        | **Title** |                                                 | **Date** |
|---------------|-----------------------------|-----------|------------------------------------------------------|----------|
|          |                        |      |                                                 |     |
| /s/           | ROBERT E. GIPSON            |      |                                                 |     |   |
|          | Robert E. Gipson            |      | Chairman of the Board                                |     | April 15, 2002 |
|          |                        |      |                                                 |     |
| /s/           | ROBERT E. THOMSON           |      |                                                 |     |   |
|          | Robert E. Thomson           |      | Vice Chair                                           |     | April 15, 2002 |
|          |                        |      |                                                 |     |
| /s/           | DONALD E. BENSON            |      |                                                 |     |   |
|          | Donald E. Benson            |      | Director                                             |     | April 15, 2002 |
|          |                        |      |                                                 |     |
| /s/           | JOSEPH N. COHEN             |      |                                                 |     |   |
|          | Joseph N. Cohen             |      | Director                                             |     | April 15, 2002 |
|          |                        |      |                                                 |     |
| /s/           | ALAN GRAHM                  |      |                                                 |     |   |
|          | Alan Grahm                  |      | Director                                             |     | April 15, 2002 |
|          |                        |      |                                                 |     |
| /s/           | ANTOINETTE HUBENETTE,  M.D. |      |                                                 |     |   |
|          | Antoinette Hubenette,  M.D. |      | Director                                             |     | April 15, 2002 |
|          |                        |      |                                                 |     |
| /s/           | SCOTT A. MONTGOMERY         |      |                                                 |     |   |
|          | Scott A. Montgomery         |      | Director, Chief Executive Officer                    |     | April 15, 2002 |
|          |                        |      |                                                 |     |
| /s/           | DION G. MORROW              |      |                                                 |     |   |
|          | Dion G. Morrow              |      | Director                                             |     | April 15, 2002 |
|          |                        |      |                                                 |     |
| /s/           | CARL R. TERZIAN             |      |                                                 |     |   |
|          | Carl R. Terzian             |      | Director                                             |     | April 15, 2002 |
|          |                        |      |                                                 |     |
| /s/           | DAVID R. BROWN              |      |                                                 |     |   |
|          | David R. Brown              |      | Principal Financial and Principal Accounting Officer |     | April 15, 2002 |

 

45

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**REPORTOF INDEPENDENT PUBLIC ACCOUNTANTS**

 

To theShareholders and the Board of Directors

 of National Mercantile Bancorp and Subsidiaries:

 

We have auditedthe accompanying consolidated balance sheet of National Mercantile Bancorp (aCalifornia corporation) and Subsidiaries (collectively the “Company”) as ofDecember 31, 2001, and the related consolidated statements of operations, changesin shareholders’ equity and cash flows for the years ended December 31, 2001and 2000.  These financial statementsare the responsibility of the Company’s management.  Our responsibility is to express an opinion on these financialstatements based on our audits.

 

We conducted ouraudits in accordance with auditing standards generally accepted in the UnitedStates.  Those standards require that weplan and perform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting theamounts and disclosures in the financial statements.  An audit also includes assessing the accounting principles usedand significant estimates made by management, as well as evaluating the overallfinancial statement presentation.  Webelieve that our audits provide a reasonable basis for our opinion.

 

In our opinion,the financial statements referred to above present fairly, in all materialrespects, the financial**position of National Mercantile Bancorpand Subsidiaries as of December 31, 2001, and the results of their operationsand their cash flows for the years ended December 31, 2001 and 2000 inconformity with accounting principles generally accepted in the United States.

 

 

Arthur Andersen LLP

 

Los Angeles, California

March 14, 2002

 

 

46

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** **

**NATIONALMERCANTILE BANCORP AND SUBSIDIARIES**

** **

**CONSOLIDATED BALANCE SHEETS**

** **

 
|                                                                                                                                                                                                                     |   | **December  31,**           |    |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|---------|
|                                                                                                                                                                                                                     |   | **2001**                    |    |
|                                                                                                                                                                                                                     |   | **(Dollars in  thousands)** |    |
| ASSETS                                                                                                                                                                                                                   |   |                        |    |
| Cash and due from  banks-demand                                                                                                                                                                                          |   | $                           | 12,688  |   |
| Federal funds sold and  securities purchased under agreements to resell                                                                                                                                                  |   | 39,405                      |    |
| Cash and cash equivalents                                                                                                                                                                                                |   | 52,093                      |    |
| Securities  available-for-sale, at fair value; aggregate amortized cost of $41,532 and  $64,953 at December 31, 2001 and 2000, respectively                                                                              |   | 41,627                      |    |
| FRB and other stock, at  cost                                                                                                                                                                                            |   | 2,552                       |    |
|                                                                                                                                                                                                                     |   |                        |    |
| Loans receivable                                                                                                                                                                                                         |   | 261,968                     |    |
| Allowance for credit losses                                                                                                                                                                                              |   | (6,542                      | )       |
| Net loans receivable                                                                                                                                                                                                     |   | 255,426                     |    |
|                                                                                                                                                                                                                     |   |                        |    |
| Premises and equipment, net                                                                                                                                                                                              |   | 6,121                       |    |
| Deferred tax asset, net                                                                                                                                                                                                  |   | 8,364                       |    |
| Goodwill                                                                                                                                                                                                                 |   | 5,616                       |    |
| Accrued interest receivable  and other assets                                                                                                                                                                            |   | 2,566                       |    |
| Total assets                                                                                                                                                                                                             |   | $                           | 374,365 |   |
|                                                                                                                                                                                                                     |   |                        |    |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY                                                                                                                                                                               |   |                        |    |
| Deposits:                                                                                                                                                                                                                |   |                        |    |
| Noninterest-bearing demand                                                                                                                                                                                               |   | $                           | 114,645 |   |
| Interest-bearing demand                                                                                                                                                                                                  |   | 23,425                      |    |
| Money market                                                                                                                                                                                                             |   | 40,033                      |    |
| Savings                                                                                                                                                                                                                  |   | 31,184                      |    |
| Time certificates of  deposit:                                                                                                                                                                                           |   |                        |    |
| $100,000 or more                                                                                                                                                                                                         |   | 62,085                      |    |
| Under $100,000                                                                                                                                                                                                           |   | 37,768                      |    |
| Total deposits                                                                                                                                                                                                           |   | 309,140                     |    |
|                                                                                                                                                                                                                     |   |                        |    |
| Federal funds purchased and  securities sold under agreements to repurchase                                                                                                                                              |   | 3,096                       |    |
| Other borrowings                                                                                                                                                                                                         |   | 17,500                      |    |
| Accrued interest payable  and other liabilities                                                                                                                                                                          |   | 3,963                       |    |
| Total liabilities                                                                                                                                                                                                        |   | 333,699                     |    |
|                                                                                                                                                                                                                     |   |                        |    |
| Guaranteed preferred  beneficial interests in the Company’s junior subordinated deferrable interest  debentures, net                                                                                                |   | 14,513                      |    |
| Minority interest in the  Series A preferred stock of consolidated subsidiary, South Bay Bank, N.A.                                                                                                                      |   | 676                         |    |
|                                                                                                                                                                                                                     |   |                        |    |
| Shareholders’ equity:                                                                                                                                                                                               |   |                        |    |
| Preferred stock, no par  value:Series A non-cumulative convertible perpetual preferred stock;authorized  990,000 shares; outstanding 750,580 sharesand 770,423  shares at December 31, 2001 and 2000, respectively  |   | 6,131                  |    |
| Preferred stock, no par  value:  Series B non-cumulative convertible perpetual preferred stock; authorized  1,000 shares; outstanding 1,000 shares at December 31, 2001                                             |   | 1,000                  |    |
| Common stock, no par value;  authorized 10,000,000 shares; outstanding 1,623,467 shares and 1,547,429  shares at December 31, 2001 and 2000, respectively                                                                |   | 30,268                      |    |
| Additional paid-in capital                                                                                                                                                                                               |   | 1,824                       |    |
| Accumulated deficit                                                                                                                                                                                                      |   | (13,802                     | )       |
| Accumulated other  comprehensive income                                                                                                                                                                                  |   | 56                          |    |
| Total shareholders’ equity                                                                                                                                                                                          |   | 25,477                      |    |
| Total liabilities and  shareholders’ equity                                                                                                                                                                         |   | $                           | 374,365 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

47

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**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

 

**CONSOLIDATED STATEMENTS OF OPERATIONS**

 
| ** **                                                                  | ** ** | **For The Year Ended  December 31,**               | ** ** |
|-----------------------------------------------------------------------------|------------|----------------------------------------------------|------------|
|                                                                        |       | **2001**                                           |       | **2000** |   |
| ** **                                                                  | ** ** | **(Dollars in thousands,  except per share data)** | ** ** |
| Interest income:                                                            |       |                                               |       |   |   |
| Loans, including fees                                                       |       | $                                                  | 9,743      |   | $ | 9,049 |   |
| Securities  available-for-sale                                              |       | 3,236                                              |       | 4,799 |   |
| Federal funds sold and  securities purchased under agreements to resell     |       | 812                                                |       | 612 |   |
| Total interest income                                                       |       | 13,791                                             |       | 14,460 |   |
| Interest expense:                                                           |       |                                               |       |   |   |
| Interest-bearing demand                                                     |       | 92                                                 |       | 113 |   |
| Money market and savings                                                    |       | 1,019                                              |       | 1,258 |   |
| Time certificates of  deposit:                                              |       |                                               |       |   |   |
| $100,000 or more                                                            |       | 1,409                                              |       | 1,103 |   |
| Under $100,000                                                              |       | 308                                                |       | 399 |   |
| Total interest expense on  deposits                                         |       | 2,828                                              |       | 2,873 |   |
| Federal funds purchased and  securities sold under agreements to repurchase |       | 37                                                 |       | 68 |   |
| Other borrowings                                                            |       | 1,011                                              |       | 2,082 |   |
| Total interest expense                                                      |       | 3,876                                              |       | 5,023 |   |
| Net interest income before  provision for credit losses                     |       | 9,915                                              |       | 9,437 |   |
| Provision for credit losses                                                 |       | 517                                                |       | (576 | ) |
| Net interest income after  provision for credit losses                      |       | 9,398                                              |       | 10,013 |   |
| Other operating income:                                                     |       |                                               |       |   |   |
| Net gain on sale of  securities available-for-sale                          |       | 374                                                |       | 18 |   |
| International services                                                      |       | 51                                                 |       | 110 |   |
| Investment division.                                                        |       | 104                                                |       | 88 |   |
| Deposit-related and other  customer services                                |       | 684                                                |       | 583 |   |
| Gain on sale of other real  estate owned and other foreclosed assets        |       | 20                                                 |       | 69 |   |
| Total other operating  income                                               |       | 1,233                                              |       | 868 |   |
| Other operating expenses:                                                   |       |                                               |       |   |   |
| Salaries and related  benefits                                              |       | 4,474                                              |       | 3,906 |   |
| Net occupancy                                                               |       | 1,034                                              |       | 966 |   |
| Furniture and equipment                                                     |       | 275                                                |       | 323 |   |
| Printing and communications                                                 |       | 324                                                |       | 280 |   |
| Insurance and regulatory  assessments                                       |       | 312                                                |       | 296 |   |
| Client services                                                             |       | 826                                                |       | 835 |   |
| Computer data processing                                                    |       | 448                                                |       | 416 |   |
| Legal services                                                              |       | 227                                                |       | 170 |   |
| Other professional services                                                 |       | 411                                                |       | 396 |   |
| Promotion and other  expenses                                               |       | 330                                                |       | 282 |   |
| Total other operating  expenses                                             |       | 8,661                                              |       | 7,870 |   |
| Net income before minority  interest and income tax provision               |       | 1,970                                              |       | 3,011 |   |
|                                                                        |       |                                               |       |   |   |
| Minority interest in the  income of the trust subsidiary                    |       | 722                                                |       | — |   |
| Net income before income  tax provision                                     |       | 1,248                                              |       | 3,011 |   |
| Income tax provision                                                        |       | 92                                                 |       | 67 |   |
| Net income                                                                  |       | $                                                  | 1,156      |   | $ | 2,944 |   |
| Earnings per share                                                          |       |                                               |       |   |   |
| Basic                                                                       |       | $                                                  | 0.72       |   | $ | 2.77 |   |
| Diluted                                                                     |       | $                                                  | 0.28       |   | $ | 1.08 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

48

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**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

 

**CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY**

 
|                                                             |   |                                          |   |                          |   |              |   |       |   |       |   |       |   | **Additional  Paid-in  Capital** |   | **Accumulated  Deficit** |      | **Accumulated  Other  Comprehensive  Income  (Loss)** |   |   |    |
|------------------------------------------------------------------|--------|-----------------------------------------------|--------|-------------------------------|--------|-------------------|--------|------------|--------|------------|--------|------------|--------|----------------------------------|--------|--------------------------|-----------|-------------------------------------------------------|--------|--------|---------|
|                                                             |   |                                          |   |                          |   |              |   |       |   |       |   |       |   |                             |   |                     |      |                                                  |
|                                                             |   |                                          |   |                          |   |              |   |       |   |       |   |       |   |                             |   |                     |      |                                                  |
|                                                             |   | **Preferred  Stock Series A**                 |   | **Preferred  Stock Series B** |   | **Common  Stock** |   |       |   |       |   |       |
|                                                             |   | **Shares**                                    |   | **Amount**                    |   | **Shares**        |   | **Amount** |   | **Shares** |   | **Amount** |   |                             |   |                     | **Total** |                                                  |
|                                                             |   | **(Dollars in  thousands except share data)** |   |
| Balance at                                                       |   |                                          |   |                          |   |              |   |       |   |       |   |       |   |                             |   |                     |      |                                                  |   |   |    |
| December 31, 1999                                                |   | 900,000                                       |   | $                             | 7,350  |              | — |       | $      | —     |   | 677,195    |   | $                                | 24,614 |                     | $         | —                                                |   | $      | (17,902 | ) | $ | (2,475 | ) | $ | 11,587 |   |
| Preferred stock converted  into common stock on a 2:1 basis      |   | (129,577                                      | )      | (1,058                        | )      |              |   |       |   | 259,154    |   | 1,058      |   |                             |   |                     |      |                                                  |   | — |    |
| Issuance of common stock                                         |   |                                          |   |                          |   |              |   |       |   | 602,081    |   | 4,190      |   |                             |   |                     |      |                                                  |   | 4,190  |    |
| Stock options exercised                                          |   |                                          |   |                          |   |              |   |       |   | 8,999      |   | 43         |   |                             |   |                     |      |                                                  |   | 43     |    |
| Comprehensive income:                                            |   |                                          |   |                          |   |              |   |       |   |       |   |       |   |                             |   |                     |      |                                                  |   |   |    |
| Other comprehensive income:                                      |   |                                          |   |                          |   |              |   |       |   |       |   |       |   |                             |   |                     |      |                                                  |   |   |    |
| Unrealized holding gain  during the period.                      |   |                                          |   |                          |   |              |   |       |   |       |   |       |   |                             |   |                     |      | 1,957                                                 |   | 1,957  |    |
| Less: Reclassificationadjustment forgain included  in net income |   |                                          |   |                          |   |              |   |       |   |       |   |       |   |                             |   |                     |      | (18                                                   | )      | (18    | )       |
| Net income                                                       |   |                                          |   |                          |   |              |   |       |   |       |   |       |   |                             |   | 2,944                    |      |                                                  |   | 2,944  |    |
| Comprehensive income                                             |   |                                          |   |                          |   |              |   |       |   |       |   |       |   |                             |   |                     |      |                                                  |   | 4,883  |    |
| Balance at December 31, 2000                                     |   | 770,423                                       |   | $                             | 6,292  |              | — |       | $      | —     |   | 1,547,429  |   | $                                | 29,905 |                     | $         | —                                                |   | $      | (14,958 | ) | $ | (536 | ) | $ | 20,703 |   |
| Preferred stock converted  into common stock on a 2:1 basis      |   | (19,843                                       | )      | (161                          | )      |              |   |       |   | 39,686     |   | 161        |   |                             |   |                     |      |                                                  |   | — |    |
| Issuance of preferred stock                                      |   |                                          |   |                          |   | 1,000             |   | 1,000      |   |       |   |       |   |                             |   |                     |      |                                                  |   | 1,000  |    |
| Stock options exercised                                          |   |                                          |   |                          |   |              |   |       |   | 36,352     |   | 202        |   |                             |   |                     |      |                                                  |   | 202    |    |
| Beneficial conversion rights  of subsidiary preferred stock      |   |                                          |   |                          |   |              |   |       |   |       |   |       |   | 1,824                            |   |                     |      |                                                  |   | 1,824  |    |
| Comprehensive income                                             |   |                                          |   |                          |   |              |   |       |   |       |   |       |   |                             |   |                     |      |                                                  |   |   |    |
| Other comprehensive income                                       |   |                                          |   |                          |   |              |   |       |   |       |   |       |   |                             |   |                     |      |                                                  |   |   |    |
| Unrealized holding gain  during the period                       |   |                                          |   |                          |   |              |   |       |   |       |   |       |   |                             |   |                     |      | 966                                                   |   | 966    |    |
| Less: Reclassificationadjustment forgain included  innet income  |   |                                          |   |                          |   |              |   |       |   |       |   |       |   |                             |   |                     |      | (374                                                  | )      | (374   | )       |
| Net income                                                       |   |                                          |   |                          |   |              |   |       |   |       |   |       |   |                             |   | 1,156                    |      |                                                  |   | 1,156  |    |
| Comprehensive income                                             |   |                                          |   |                          |   |              |   |       |   |       |   |       |   |                             |   |                     |      |                                                  |   | 1,748  |    |
| Balance at December 31, 2001                                     |   | 750,580                                       |   | $                             | 6,131  |              | 1,000  |       | $      | 1,000      |   | 1,623,467  |   | $                                | 30,268 |                     | $         | 1,824                                                 |   | $      | (13,802 | ) | $ | 56 |   | $ | 25,477 |   |

 

 

See accompanying notes toconsolidated financial statements.

 

 

49

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**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

 

**CONSOLIDATED STATEMENTS OF CASH FLOWS**
|                                                                                                                                                                                                                           |   | **For The Year Ended December 31,** |   |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------------|--------|
|                                                                                                                                                                                                                           |   | **2001**                            |   | **2000** |   |
|                                                                                                                                                                                                                           |   | **(Dollars in thousands)**          |   |
| Cash flow from operating  activities:                                                                                                                                                                                          |   |                                |   |   |   |
| Net income                                                                                                                                                                                                                     |   | $                                   | 1,156  |   | $ | 2,944 |   |
| Adjustments to reconcile  net income to net cash provided by operating activities:                                                                                                                                             |   |                                |   |   |   |
| Depreciation and  amortization                                                                                                                                                                                                 |   | 233                                 |   | 197 |   |
| Provision for credit losses                                                                                                                                                                                                    |   | 517                                 |   | (576 | ) |
| Gain on sale of other real  estate owned                                                                                                                                                                                       |   | —                              |   | (69 | ) |
| Net gain on sale of  securities available-for-sale                                                                                                                                                                             |   | (374                                | )      | (18 | ) |
| Net amortization  (accretion) of premium (discount) on securities available-for-sale                                                                                                                                           |   | 60                                  |   | (28 | ) |
| Net accretion of discounts  on loans purchased                                                                                                                                                                                 |   | (29                                 | )      | (36 | ) |
| Increase (decrease) in  accrued interest receivable and other assets                                                                                                                                                           |   | 195                                 |   | (204 | ) |
| Increase in accrued  interest payable and other liabilities                                                                                                                                                                    |   | 192                                 |   | 711 |   |
| Net cash provided by  operating activities                                                                                                                                                                                     |   | 1,950                               |   | 2,921 |   |
| Cash flows from investing  activities:                                                                                                                                                                                         |   |                                |   |   |   |
| Purchase of securities  available-for-sale                                                                                                                                                                                     |   | (7,049                              | )      | (2,899 | ) |
| Proceeds from sales of  securities available-for-sale                                                                                                                                                                          |   | 33,001                              |   | 1,891 |   |
| Proceeds from repayments  and maturities of securities available-for-sale                                                                                                                                                      |   | 27,108                              |   | 7,078 |   |
| Proceeds from sales of FRB  and other stock                                                                                                                                                                                    |   | 1,027                               |   | — |   |
| Loan originations and  principal collections, net                                                                                                                                                                              |   | (10,622                             | )      | (35,327 | ) |
| Proceeds from sale of other  real estate owned                                                                                                                                                                                 |   | —                              |   | 486 |   |
| Proceeds from sale of other  assets-SBA guaranteed loans                                                                                                                                                                       |   | —                              |   | 209 |   |
| Purchases of premises and  equipment                                                                                                                                                                                           |   | (236                                | )      | (97 | ) |
| Net cash used for purchase  of South Bay Bank, N.A.                                                                                                                                                                            |   | (24,786                             | )      | — |   |
| Net cash provided by (used  in) investing activities                                                                                                                                                                           |   | 18,443                              |   | (28,659 | ) |
| Cash flows from financing  activities:                                                                                                                                                                                         |   |                                |   |   |   |
| Net increase in demand  deposits, money market and savings accounts                                                                                                                                                            |   | 29,314                              |   | 11,483 |   |
| Net increase (decrease) in  time certificates of deposit                                                                                                                                                                       |   | (3,815                              | )      | 6,080 |   |
| Net increase (decrease) in  securities sold under agreements to repurchase and federal funds purchased                                                                                                                         |   | (7,524                              | )      | 7,500 |   |
| Net increase (decrease) in  other borrowings                                                                                                                                                                                   |   | (29,580                             | )      | 13,800 |   |
| Net proceeds from issuance  of common stock                                                                                                                                                                                    |   | —                              |   | 4,190 |   |
| Net proceeds from issuance  of preferred stock                                                                                                                                                                                 |   | 1,000                               |   | — |   |
| Net proceeds from issuance  of noncumulative                                                                                                                                                                                   |   |                                |   |   |   |
| deferrable interest  debentures                                                                                                                                                                                                |   | 14,506                              |   | — |   |
| Net proceeds from exercise  of stock options                                                                                                                                                                                   |   | 202                                 |   | 43 |   |
| Net cash provided by  financing activities                                                                                                                                                                                     |   | 4,103                               |   | 43,096 |   |
| Net increase in cash and  cash equivalents                                                                                                                                                                                     |   | 24,496                              |   | 17,358 |   |
| Cash and cash equivalents,  January 1                                                                                                                                                                                          |   | 27,597                              |   | 10,239 |   |
| Cash and cash equivalents,  December 31                                                                                                                                                                                        |   | $                                   | 52,093 |   | $ | 27,597 |   |
|                                                                                                                                                                                                                           |   |                                |   |   |   |
| Supplemental disclosures of  cash flow information:                                                                                                                                                                            |   |                                |   |   |   |
| Cash paid for —                                                                                                                                                                                                           |   |                                |   |   |   |
| Interest                                                                                                                                                                                                                       |   | 3,205                               |   | 5,004 |   |
| Income taxes                                                                                                                                                                                                                   |   | 64                                  |   | 22 |   |
| Unrealized gain on  securities available-for-sale                                                                                                                                                                              |   | 592                                 |   | 1,939 |   |
| Transfers to OREO from  loans receivable, net                                                                                                                                                                                  |   | —                              |   | 35 |   |
| Supplemental disclosures of  noncash investing and financing activities:                                                                                                                                                       |   |                                |   |   |   |
| The Company purchased all  of the capital stock of South Bay Bank, N.A. for $29,841,000 cash including  $174,000 direct cost.  In connection  with the purchase, assets acquired and liabilities assumed were as follows: |   |                                |   |   |   |
| Fair value of assets  acquired                                                                                                                                                                                                 |   | 182,704                             |   | — |   |
| Fair value of liabilities  assumed                                                                                                                                                                                             |   | 163,479                             |   | — |   |

 

See accompanying notes to consolidatedfinancial statements.

 

50

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**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

 

## **Note 1—Summary of Significant Accounting Policies**

 

*    Basis of Presentation*

 

                The consolidatedfinancial statements include the accounts of the National Mercantile Bancorp(“National Mercantile” or the “Company”) and of its wholly-owned subsidiaries,Mercantile National Bank (“Mercantile National”) and South Bay Bank, N.A.(“South Bay”) (and collectively, the “Banks”). National Mercantile Capital Trust I, which is a Delaware statutorybusiness trust formed for the exclusive purpose of issuing and selling trustpreferred securities, is also a subsidiary of National Mercantile.  All intercompany transactions and balanceshave been eliminated.   Certain prioryear amounts have been reclassified to conform to the current yearpresentation.

 

        Theaccounting and reporting policies of the Company conform to accountingprinciples generally accepted in the United States and to prevailing practiceswithin the banking industry.  Thepreparation of these consolidated financial statements requires management tomake estimates and assumptions that affect the reported amount of assets andliabilities, and disclosure of contingent assets and liabilities at the date ofconsolidated financial statements and the reported amounts of revenues andexpenses during reported periods. Actual results could differ from those estimates.

 

                The Company,through the Banks, engages in commercial banking in the Los Angeles areaproviding commercial and residential real estate financing, real estateconstruction financing and commercial lending serving niche markets representedby professional service providers, entertainment, healthcare and community-basednonprofit borrowers, and associated individuals with commercial banking andpersonal banking needs.

 

 

 

*    Cash and Cash Equivalents*

 

                For purposes ofreporting cash flows, cash and cash equivalents include cash and due frombanks-demand, federal funds sold and securities purchased under agreements toresell.

 

*    Securities*

 

                Securitiesavailable-for-sale are carried at estimated fair value.  Unrealized gains or losses onavailable-for-sale securities are excluded from earnings and reported asaccumulated other comprehensive income, net of deferred income taxes, in aseparate component of shareholders’ equity until realized.  Premiums or discounts on available-for-salesecurities are amortized or accreted into income using the effective interestmethod.  Realized gains or losses onsales available-for-sale securities are recorded using the specificidentification method.

 

*    Loans*

 

        Loans aregenerally carried at principal amounts outstanding less unearned income.  Unearned income includes deferredunamortized fees net of direct incremental loan origination costs.

 

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

 

51

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        TheCompany considers a loan to be impaired when it is probable that it will beunable to collect all amounts due according to the contractual terms of theloan agreement.  Once a loan isdetermined to be impaired, the impairment is measured based on the presentvalue of the expected future cash flows discounted at the loan’s effectiveinterest rate, except that as a practical expedient, the impairment is measuredby using the loan’s observable market price or the fair value of the collateralif the loan is collateral dependent.

 

        When themeasurement of the impaired loan is less than the recorded amount of the loan,impairment is recognized by creating a valuation allowance with a correspondingcharge to the provision for credit losses or by adjusting an existing valuationallowance for the impaired loan with a corresponding charge or credit to theprovision for credit losses.

 

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

 

*    Allowance for Credit Losses*

 

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

 

                The calculation ofthe adequacy of the allowance for credit losses is based on a variety offactors, including loan classifications, migration trends and underlying cashflow and collateral values.  On aperiodic basis, management engages an outside loan review firm to review theCompany’s loan portfolio, risk grade accuracy and the reasonableness of loanevaluations.  Annually, this outsideloan 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 a methodby which specific charge-offs are related to the prior life of the same loancompared 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*

 

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

 

*    Other Real Estate Owned*

 

Other Real Estate Owned (‘‘OREO’’) is comprised ofreal estate acquired in satisfaction of loans. Properties acquired by foreclosure or deed in lieu of foreclosure aretransferred to OREO and are initially recorded at the lower of the loan balanceor fair value at the date of transfer of the property, establishing a new cost basis.  Subsequently, OREO is carried at the lowerof cost or fair value less costs to sell. The fair value of the OREO property is based upon a current appraisal.  Losses that result from the ongoing periodicvaluation of these properties are charged to other operating expenses in theperiod in which they are identified. Expenses for holding costs are charged to other operating expenses asincurred.

 

52

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*    Income Taxes*

 

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

 

        Deferredtax assets and liabilities are recognized for the expected future taxconsequences of existing differences between financial reporting and taxreporting bases of assets and liabilities, as well as for operating losses andtax credit carryforwards, using enacted tax laws and rates.  Deferred tax assets will be reduced througha valuation allowance whenever it becomes more likely than not that all, orsome portion will not be realized. Deferred income taxes (benefit) represents the net change in deferredtax asset or liability balance during the year.  This amount, together with income taxes currently payable orrefundable in the current year, represents the total tax expense (benefit) forthe year.

 

*    Comprehensive Income*

 

                Comprehensiveincome is defined as the change in equity during a period from transactions andother events and circumstances from nonowner sources.  The accumulated balance of other comprehensive income is requiredto be displayed separately from retained earnings and additional paid incapital in the consolidated balance sheet.

 

                The components ofother comprehensive income together with total comprehensive income arereported in the consolidated statements of changes in shareholders’equity.  The accumulated balance ofother comprehensive income is reported as a net amount after taxes.

 

 

53

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*    Earnings per Share*

 

        Basicearnings per share is computed using the weighted average number of commonshares outstanding during the period. The weighted average number of common shares outstanding used incomputing basic earnings per share for the years ended December 31, 2001 and2000 was 1,608,307 and 1,061,133, respectively.  The weighted average number of common shares and common shareequivalents outstanding used in computing diluted earnings per share for theyears ended December 31, 2001 and 2000 was 4,099,898, and 2,719,949,respectively.  The following table is areconciliation of net income and shares used in the computation of basic anddiluted earnings per share: 

|                                              |   |                |   |       |      | **Per  share** |   |
|---------------------------------------------------|--------|---------------------|--------|------------|-----------|----------------|--------|
|                                              |   | **Net  Income**     |   | **Shares** |      | **amount**     |   |
|                                              |   | **(in  thousands)** |   |       |      |           |   |
| *For the  twelve months ended December 31, 2001:* |   |                |   |       |      |           |   |
| Basic EPS                                         |   | $                   | 1,156  |       | 1,608,307 |           | $      | 0.72 |   |
|                                              |   |                |   |       |      |           |   |
| Effect of dilutive  securities:                   |   |                |   |       |      |           |   |
| Options and warrants                              |   |                |   | 114,970    |      |           |   |
| Convertible preferred stock                       |   |                |   | 2,376,621  |      |           |   |
| Diluted EPS                                       |   | $                   | 1,156  |       | 4,099,898 |           | $      | 0.28 |   |
|                                              |   |                |   |       |      |           |   |
| *For the  twelve months ended December 31, 2000:* |   |                |   |       |      |           |   |
| Basic EPS                                         |   | $                   | 2,944  |       | 1,061,133 |           | $      | 2.77 |   |
|                                              |   |                |   |       |      |           |   |
| Effect of dilutive  securities:                   |   |                |   |       |      |           |   |
| Options and warrants                              |   |                |   | 117,970    |      |           |   |
| Convertible preferred stock                       |   |                |   | 1,540,846  |      |           |   |
| Diluted EPS                                       |   | $                   | 2,944  |       | 2,719,949 |           | $      | 1.08 |   |

 

 

*    Fair Value of Financial Instruments*

 

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

 

*    Stock Options*

 

*       *The Company applies Accounting PrinciplesBoard Opinion No. 25 and related Interpretations in accounting for the stockincentive plans.  SFAS No. 123,‘‘Accounting for Stock-Based Compensation,’’ encourages, but does not require,companies to record compensation cost for stock-based employee compensationplans at fair value. Compensation expense is recorded on the date of grant onlyif the current market price of the underlying stock exceeded the exerciseprice.  All options were granted atcurrent 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 2001 and 2000.

 

54

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*    Recent Accounting**Pronouncements*

 

        On July 20, 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 141-Business Combinations (“SFAS No. 141”). The standard concludes that all business combinations within the scope of the statement will be accounted for using the purchase method.  Previously, the pooling-of-interests method was required whenever certain criteria were met.  Because those criteria did not distinguish economically dissimilar transactions, similar business combinations were accounted for using different methods that produced dramatically different financial statement results.  SFAS No. 141 requires separate recognition of intangible assets apart from goodwill if they meet one of two criteria, the contractual-legal criterion or the separability criterion.  SFAS No. 141 also requires the disclosure of the primary reasons for a business combination and the allocation of the purchase price paid to the assets acquired and liabilities assumed by major balance sheet caption.

 

        The provisions of SFAS No. 141 apply to all business combinations initiated after June 30, 2001.  Accordingly, the Company’s acquisition of South Bay Bank, N.A. has been accounted for under SFAS No. 141.

 

        On July 20, 2001 the Financial Accounting Standards Board also issued Statement of Financial Accounting Standard No. 142-Goodwill and Other Intangible Assets (“SFAS No. 142”).  It addresses how intangible assets that are acquired individually or within a group of assets (but not those acquired in a business combination) should be accounted for in the financial statements upon their acquisition.  SFAS No.142 adopts a more aggregate view of goodwill and bases the accounting on the units of the combined entity into which an acquired entity is aggregated.

 

        SFAS No. 142 also prescribes that goodwill and intangible assets that have indefinite useful lives will not be amortized but rather tested at least annually for impairment.  Intangible assets that have definite lives will continue to be amortized over their useful lives, but no longer with the constraint of the 40-year ceiling.  SFAS No. 142 provides specific guidance for the testing of goodwill for impairment, which may require re-measurement of the fair value of the reporting unit.  Additional ongoing financial statement disclosures are also required.

 

        The provisions of the statement are required to be applied starting with fiscal years beginning after December 15, 2001. The statement is required to be applied at the beginning of the fiscal year and applied to all goodwill and other intangible assets recognized in the financial statements at that date.  Impairment losses are to be reported as resulting from a change in accounting principle.

 

        The Company has $5.6 million goodwill recorded as of December 31, 2001.  The adoption of SFAS No. 142 will not have a significant impact on our financial position.

 

55

 

**Note 2—Business Combination**

 

                On December 14,2001, the Company acquired South Bay Bank, N.A. (‘South Bay”) for a purchaseprice of $29.7 million in cash and direct costs of $174,000.  As part of the transaction, South Baydeclared a $5 million dividend prior to the closing of the transaction payableto the shareholder of record immediately following the closing.  The dividend received by the Company wasaccounted for as a reduction in the purchase price.  The source of funds for the acquisition was available cash,primarily from the $15 million trust preferred securities issuance in June2001.

 

        Thepurchase price has been allocated to the assets acquired and liabilitiesassumed based on the estimated fair values at the date of acquisition.  The excess of purchase price over theestimated fair values of the net assets acquired, totaling $5.6 million, wasrecorded as goodwill and other intangible assets.  Goodwill will be evaluated regularly for possible impairmentunder the provision of SFAS No. 142. The following is a summary of the purchase price allocation:

 

| Purchase price of  acquisition:                                              |   |    |   |
|------------------------------------------------------------------------------|--------|---------|--------|
| Cash paid to shareholders                                                    |   | $       | 29,667 |   |
| Direct costs of acquisition                                                  |   | 174     |   |
| Less: Dividend received  from South Bay Bank                                 |   | (5,000  | )      |
| Total purchase price                                                         |   | 24,841  |   |
|                                                                         |   |    |   |
| Assets acquired:                                                             |   |    |   |
| Cash and due from banks                                                      |   | 55      |   |
| Securities available for  sale                                               |   | 30,210  |   |
| Loans, net of allowance                                                      |   | 137,641 |   |
| Premises and fixed assets                                                    |   | 5,592   |   |
| Other assets                                                                 |   | 9,206   |   |
| Total assets acquired                                                        |   | 182,704 |   |
|                                                                         |   |    |   |
| Liabilities assumed:                                                         |   |    |   |
| Deposits                                                                     |   | 149,094 |   |
| Federal funds purchased and  securitiespurchased  under agreements to resell |   |    |   |
| Liabilities for borrowed money                                               |   | 7,080   |   |
| Other liabilities                                                            |   | 1,685   |   |
| Preferred stock                                                              |   | 2,500   |   |
| Total liabilities assumed                                                    |   | 163,479 |   |
|                                                                         |   |    |   |
| Goodwill                                                                     |   | $       | 5,616  |   |

 

        Theacquisition was accounted for using the purchase method of accounting and,accordingly, South Bay’s results of operations have been included in theconsolidated financial statements since the date of acquisition.

 

 

56

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**Note 3—Investment Securities**

 

        Thefollowing is a summary of amortized cost, gross unrealized gains, grossunrealized losses, and estimated fair values of the Company’s investmentsecurities available-for-sale at December 31, 2001:

 

|                                                                      |   | **December 31, 2000**      |   |
|---------------------------------------------------------------------------|--------|----------------------------|--------|
|                                                                      |   |                       |   | **Gross** |   | **Gross** |   | **Estimated** |   |
|                                                                      |   | **Amortized**              |   | **unrealized** |   | **unrealized** |   | **fair** |   |
|                                                                      |   | **cost**                   |   | **gains** |   | **loss** |   | **value** |   |
|                                                                      |   | **(Dollars in thousands)** |   |
| U.S. Treasury securities                                                  |   | $                          | 2,001  |   | $ | 13 |   | $ | — |   | $ | 2,014 |   |
| GNMA-issued/guaranteed  mortgage pass through certificates                |   | 4,503                      |   | — |   | 27 |   | 4,476 |   |
| FHLMC/FNMA-issued mortgage  pass through certificates                     |   | 15,928                     |   | 179 |   | 332 |   | 16,075 |   |
| CMO’s and REMIC’s issued by  U.S. government-sponsored agencies |   | 16,590                     |   | 162 |   | 29 |   | 16,723 |   |
| Privately issued Corporate  bonds, CMO’s and REMIC’s securities |   | 2,510                      |   | 4 |   | 175 |   | 2,339 |   |
|                                                                      |   | $                          | 41,532 |   | $ | 358 |   | $ | 263 |   | $ | 41,627 |   |

 

        TheCompany had gross proceeds and net realized gains related to the sale ofinvestment securities of $33.0 million and $374,000, respectively, for the yearended December 31, 2001.

 

        Theestimated fair value and amortized cost of securities available-for-sale atDecember 31, 2001 by contractual maturity, are shown below:

 
|                                                                      |   |                       |   | **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                                                   |   | $                          | 2,014  |                  |   |                 | $      | —              |   | —       |    | $            | — |   | — |   | $ | — |   | — |   | $ | 2,014 |   | 6.10 | % |
| GNMA-issued/guaranteed  mortgage pass-through certificates           |   |  —               |   |  —          |   |  —         |   |  —        |   |  — |    |  — |   | 4,476 |   |  6.17 | % | 4,476 |   | 6.17 |  % |
| Other U.S. government and federal agencies                                |   | —                     |   | —                |   | —               |   | —              |   | —       |    | —       |   | — |   | — |   | — |   | — |   |
| FHLMC/FNMA-issued mortgage pass-through certificates                      |   | —                     |   | —                |   | 96                   |   | 6.33                | %      | 1,645        |    | 5.96         | %      | 14,334 |   | 6.53 | % | 16,075 |   | 6.47 | % |
| CMO’s and REMIC’s issued by U.S. government-sponsored  agencies |   | —                     |   | —                |   | —               |   | —              |   | 1,993        |    | 5.33         | %      | 14,730 |   | 5.54 | % | 16,723 |   | 5.51 | % |
| Privately issued Corporate bonds,                                         |   |                       |   |                  |   |                 |   |                |   |         |    |         |   |   |   |   |   |   |   |   |   |
| CMO’s and REMIC’s securities                                    |   | —                     |   | —                |   | —               |   | —              |   | —       |    | —       |   | 2,339 |   | 4.80 | % | 2,339 |   | 4.80 | % |
|                                                                      |   | $                          | 2,014  |                  | 6.10   | %               | $      | 96                  |   | 6.33         | %  | $            | 3,638  |   | 5.61 | %  | $ | 35,879 |   | 5.96 | %  | $ | 41,627 |   | 5.94 | % |
|                                                                      |   |                       |   |                  |   |                 |   |                |   |         |    |         |   |   |   |   |   |   |   |   |   |
| Amortized Cost                                                            |   | $                          | 2,001  |                  |   |                 | $      | 96                  |   |         |    | $            | 3,643  |   |   |   | $ | 35,792 |   |   |   | $ | 41,532 |   |   |   |

 

** **

        Actual maturities may differ from contractual maturities tothe extent that borrowers have the right to call or prepay obligations with orwithout call or repayment penalties.

 

        Investmentsecurities totaling $24.9 million were pledged to secure government taxdeposits, bankruptcy deposits, or for other purposes required or permitted bylaw at December 31, 2001.

 

 

57

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**Note4—Loans Receivable and Allowance for Credit Losses**

 

        Thefollowing is a summary of the major categories of loans receivable outstandingat December 31, 2001:

** **

| Commercial loans:                                       |   |    |    |
|---------------------------------------------------------|--------|---------|---------|
| Secured by one-to-four family residential properties    |   | $       | 27,069  |   |
| Secured by multifamily residential properties           |   | 8,492   |    |
| Secured by commercial real properties                   |   | 95,142  |    |
| Other, secured and unsecured                            |   | 85,292  |    |
| Real estate construction and land development           |   | 30,811  |    |
| Home equity lines of credit                             |   | 6,511   |    |
| Consumer installment and unsecured loans to individuals |   | 8,795   |    |
|                                                    |   | 262,112 |    |
| Defered fees, cost and unearned income                  |   | (144    | )       |
|                                                    |   | $       | 261,968 |   |
|                                                    |   |    |    |
| Weighted average yield for loans at December 31         |   | 7.37    | %       |

 

        AtDecember 31, 2001, the Company had identified impaired loans with recordedinvestments of  $7.1 million, of which$5.4 million were acquired in the acquisition of South Bay.  At December 31, 2001, specific allowancesfor credit losses totaling $3.1 million were established for these loans.  The average recorded investment of impairedloans was $831,000 and $665,000 during 2001 and 2000, respectively.  During the years ended December 31, 2001 and2000 interest income recognized on impaired loans was $4,000 and $2,000,respectively.

 

        In thenormal course of business, the Banks may make loans to officers and directorsas well as loans to companies and individuals affiliated with or guaranteed byofficers and directors of the Company and the Banks.  Such loans are made in the ordinary course of business at ratesand terms no more favorable than those offered to other customers with asimilar credit standing.  The outstandingprincipal balance of these loans was $3,348,000 at December 31, 2001 and$29,000 at December 31, 2000.  During2001 there were $55,000 of advances and $15,000 of repayments.  Loans to officers and directors acquired inthe purchase of South Bay totaled $3.3 million at the acquisition date,December 14, 2001, and no additional advances or repayments were recordedthrough December 31, 2001.  Interestincome recognized on these loans amounted to $1,000 during both 2001and 2000.At December 31, 2001, none of these loans were on nonaccrual status. Based onanalysis of information presently known to management about the loans toofficers and directors and their affiliates, management believes all have theability to comply with the present loan repayment terms.

 

58

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        Thefollowing is a summary of activity in the allowance for credit losses for theyear ended December 31, 2001:

 

|                                       |   | **2001**                     |   |
|--------------------------------------------|--------|------------------------------|--------|
|                                       |   | **(Dollars  in  thousands)** |   |
| Balance, beginning of year                 |   | $                            | 2,597  |   |
| Allowance of acquired subsidiary           |   | 3,646                        |   |
| Provision for credit losses                |   | 517                          |   |
| Loans charged off                          |   | (491                         | )      |
| Recoveries of loans previously charged off |   | 273                          |   |
| Balance, end of year                       |   | $                            | 6,542  |   |

 

        Thefollowing is a summary of nonperforming loans at December 31, 2001:

 

| **(Dollars in thousands)**                                                                                                |   |   |   |
|---------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|
| Nonaccrual loans                                                                                                          |   | $      | 7,807  |   |
| Troubled debt restructurings                                                                                              |   | 953    |   |
| Loans contractually past due ninety or more days with respectto either principal or interest and still accruing  interest |   | 642    |   |
|                                                                                                                      |   | $      | 8,449  |   |

 

        Interestforegone on nonperforming loans outstanding at December 31, 2001 and 2000 was$110,000 and $83,000, respectively. Foregone interest on nonperforming loans does not include interestforgone on loans on nonperforming status that were restored to performingstatus prior to year end, or subsequent to either being charged off prior toyear end or transferred to OREO prior to year end.

 

**       ***TroubledDebt 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 itwould not otherwise consider, including modifications of loan terms toalleviate the burden of the borrower’s near-term cash flow requirements inorder to help the borrower to improve its financial condition and eventualability to repay the loan. At December 31, 2001 TDRs were $953,000 representinga loan to one borrower acquired in the South Bay acquisition.  This loan was restructured to provide for an8-month extension with accrued interest capitalized and a reduction in the loanrate.  At December 31, 2000 we had noTDRs.

 

        Theability of the Company’s borrowers to honor their contracts is substantiallydependent upon economic conditions and real estate market values throughout theCompany’s market area. At December 31, 2001, loans aggregating $168 millionwere collateralized by liens on residential and commercial real properties.While the Company’s loan portfolio is generally diversified with regard to theindustries represented, at December 31, 2001, the Company’s loans to businessesand individuals engaged in entertainment industry related activities amountedto $26.5 million.

 

59

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**Note5—Premises and Equipment and Lease Commitments**

 

        Thefollowing is a summary of the major components of premises and equipment atDecember 31, 2001:

 

| **(Dollars in thousands)**                      |   |   |   |
|-------------------------------------------------|--------|--------|--------|
| Land                                            |   | $      | 1,392  |   |
| Buildings                                       |   | 3,865  |   |
| Leasehold improvements                          |   | 1,427  |   |
| Furniture, fixtures and equipment               |   | 4,271  |   |
|                                            |   | 10,955 |   |
| Less: Accumulated amortization and depreciation |   | (4,834 | )      |
|                                            |   | $      | 6,121  |   |

 

        Depreciationand amortization expense was $233,000 in 2001 and $197,000 in 2000.  Rental expense on operating leases includedin occupancy expense in the Consolidated Statements of Operations was $828,000in 2001 and $791,000 in 2000.

 

         In connection with the lease on the CenturyCity facility, the Company issued the landlord a warrant to purchase up to 9.9%of the outstanding shares of capital stock of the Company at December 31, 1997.The exercise price of the warrant is currently $5.00 per share of Common Stockand $10.00 per share of Series A Preferred. The warrant expires on December 31, 2002.  The Company also granted the landlord registration rights withrespect to capital stock purchased by the landlord (or its assignee) pursuantto the Warrant.

 

        Thefuture minimum annual rental commitments at December 31, 2001 are summarizedbelow.

 

| **(Dollars in thousands)**        |   |   |   |
|-----------------------------------|--------|--------|--------|
| *For the year ended December 31,* |   |   |   |
| 2002                              |   | $      | 981    |   |
| 2003                              |   | 963    |   |
| 2004                              |   | 754    |   |
| 2005                              |   | 33     |   |
| 2006                              |   | — |   |
|                              |   | $      | 2,731  |   |

 

60

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**Note6—Income Taxes**

 

        A currentfederal and state income tax provision of $92,000 and $67,000 was recognizedduring 2001 and 2000, respectively, primarily due to alternative minimum tax(“AMT”) that could not be offset by net operating loss carryforwards (“NOLs”).

 

        Areconciliation of the amounts computed by applying the federal statutory rateof 34% for 2001 and 2000 to the income and the effective tax rate are asfollows:

 
|                                          |   | **2001**                    |   | **2000**                    |   |
|-----------------------------------------------|--------|-----------------------------|--------|-----------------------------|--------|
|                                          |   | **(Dollars  in thousands)** |   | **(Dollars  in thousands)** |   |
| Tax provision (benefit) at statuory rate      |   | $                           | 424    |                        | 34.0   | % | $ | 1,024 |   | 34.0 | % |
| Increase (reduction) in taxes resulting from: |   |                        |   |                        |   |   |   |   |   |
| Valuation allowance on deferred tax asset     |   | —                      |   | —                      |   | (977 | ) | (32.4 | ) |
| Other, net                                    |   | (332                        | )      | (26.6                       | )      | 20 |   | 0.6 |   |
|                                          |   | $                           | 92     |                        | 7.4    | % | $ | 67 |   | 2.2 | % |

 

The major components of the net deferred tax asset at December 31, 2001are as follows:

 

| **(Dollars  in thousands)**                    |   |   |   |
|------------------------------------------------|--------|--------|--------|
| Deferred tax assets:                           |   |   |   |
| Net operating losses                           |   | $      | 5,790  |   |
| Accrued expenses                               |   | 373    |   |
| Alternative minimum tax credits                |   | 309    |   |
| Nonaccrual interest                            |   | 115    |   |
| State taxes                                    |   | 276    |   |
| Loan Fees                                      |   | 54     |   |
| Securities available for sale                  |   | 319    |   |
| Bad debt expense                               |   | 1,169  |   |
| Total deferred tax assets                      |   | 8,405  |   |
|                                           |   |   |   |
| Deferred tax liabilities:                      |   |   |   |
| Depreciation                                   |   | 24     |   |
| FHLB stock dividend                            |   | 17     |   |
| Total deferred tax liabilities                 |   | 41     |   |
| Net deferred tax asset                         |   | 8,364  |   |
| Valuation allowance                            |   | — |   |
| Deferred tax asset, net of valuation allowance |   | $      | 8,364  |   |

 

61

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        For taxpurposes at December 31, 2001, the Company had (i) federal NOLs of $16.9million, which begin to expire in 2009; (ii) California NOLs of $273,000 whichwill expire in 2002; (iii) a federal AMT credit carryforward of $279,000; and(iv) a California AMT credit carryforward of $16,000.  The AMT credits carryforward indefinitely.

 

**Note7—Benefit Plans**

 

*StockIncentive Plans*.  At December 31, 2001, the Company had ineffect one stock incentive plan pursuant to which up to a total of 348,510shares of common stock may be issued. At December 31, 2001, there were also outstanding options and tandemstock appreciation rights granted under three prior stock incentive plans.  Under this plan, the Company could grant todirectors, officers, employees and consultants stock-based incentivecompensation in a variety of forms, including without limitation nonqualifiedoptions, incentive options, sales and bonuses of common stock and stockappreciation rights.  Generally, theBoard of Directors or a committee of the Board of Directors may grant awardsunder these plans on such terms and conditions as the Board of Directors orcommittee determines. However, the exercise price of options granted tononemployee directors may not be less than the fair market value of the commonstock on the date of grant.  At December31, 2001, the only outstanding awards under this plan were stock options, andat that date 25,084 shares were available for future awards.

 

        Thefollowing summarizes option grants, cancellations and exercises under the stockincentive plans for the periods indicated .

 

| ** **                     |   |    |   | **Option  price********range per********share** |   |
|--------------------------------|--------|---------|--------|-------------------------------------------------|--------|
| Outstanding, December 31, 1999 |   | 348,751 |   | $                                               | 4.44   |   | — |   | $ | 8.52 |   |
| Granted                        |   | 55,550  |   | 3.94                                            |   | — |   | 7.97 |   |
| Cancelled                      |   | (16,560 | )      | 4.44                                            |   | — |   | 7.66 |   |
| Exercised                      |   | (8,999  | )      | 4.59                                            |   | — |   | 6.06 |   |
| Outstanding, December 31, 2000 |   | 378,742 |   | $                                               | 3.94   |   | — |   | $ | 8.52 |   |
| Granted                        |   | 151,800 |   | 4.50                                            |   | — |   | 7.66 |   |
| Cancelled                      |   | (36,901 | )      | 3.94                                            |   | — |   | 7.66 |   |
| Exercised                      |   | (36,352 | )      | 4.47                                            |   | — |   | 7.66 |   |
| Outstanding, December 31, 2001 |   | 457,289 |   | $                                               | 4.44   |   | — |   | $ | 8.52 |   |

** **

Of the outstandingoptions at December 31, 2001:  (i) optionsto purchase 287,353 shares were vested and exercisable; and (ii) the remainingoptions become exercisable as follows: 2002 — 110,761 and 2003 — 59,175.

 

 The estimated per share weighted average fair value of optionsgranted was $3.82 and $4.36 during 2001 and 2000.  The Company applies Accounting Principles Board Opinion No. 25and related 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.Accordingly, no compensation cost has been recognized for the plans.  Had compensation cost for the optionsgranted been determined based on the fair value at the grant dates for awardsunder the plans consistent with the method of SFAS No. 123, the Company’s netincome for 2001 and 2000 would have been decreased by $132,000 and $119,000,respectively.  Basic and dilutedearnings per share would have decreased by $.08 and  $.03 for 2001, respectively, and $.10 and  $.04 for 2000, respectively.

 

                The fair values ofoptions granted during 2001 and 2000 were estimated on the date of grant usingthe Black-Scholes option-pricing model with the following weighted-averageassumptions used: 2001— no dividend yield, expected volatility of 68%,risk-free interest rate of 5.11%, and an expected life of 10 years; 2000— nodividend yield, expected volatility of 88%, risk-free interest rate of 5.11%,and an expected life of 10 years.

 

62

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        *DefinedContribution Retirement Plan*. The Company maintains a definedcontribution retirement plan under section 401(k) of the Internal Revenue Code.Employees are eligible to participate following****six months of continuousemployment. Under the plan, employee contributions were partially matched bythe Company through August 31, 1995 and subsequently reinstated May 1,2000.  Such matching contributionsbecome fully vested when the employee reaches three years of service.  The Company’s matching contributions for2001 and 2000 was $69,000 and $46,000, respectively.

 

**Note 8—Borrowed Funds**

 

            The following summarizes borrowed funds andweighted average rates.

 

|                                                                   |   | **2001**                    |   |
|------------------------------------------------------------------------|--------|-----------------------------|--------|
|                                                                   |   | **Year-end**                |   | **Average** |   |
|                                                                   |   | **Balance**                 |   | **Rate** |   | **Balance** |   | **Rate** |   |
|                                                                   |   | **(Dollars  in thousands)** |   |
| Federal funds purchased and securitiessold under repurchase agreements |   | $                           | 3,096  |   | 4.77 | % | $ | 733 |   | 5.05 | % |
| Other borrowings                                                       |   | 17,500                      |   | 4.25 | % | 20,865 |   | 4.85 | % |
|                                                                        |        |                             |        |  |  |  |  |  |  |  |  |

 

         Themaximum amount of federal funds purchased and securities sold under agreementsto repurchase at any month-end was $5.0 million during 2001.

 

         Other borrowings are primarily comprised of Federal HomeLoan Bank (“FHLB”) advances.  AtDecember 31, 2001 FHLB advances included: (i) fixed rate borrowings of $7.0 millionmaturing February 2002 with a rate of 4.98%; (ii) fixed rate borrowings of $4.0million maturing July 2002 with a rate of 4.06%; (iii) variable rate borrowingsof $4.0 million maturing July 2002 with a rate of 2.13% based on the LondonInter Bank Offering Rate (“LIBOR”) index; and (iv) a $2.5 million putableborrowing with a fixed rate of 5.93%, with puts commencing July 2002 andcontinuing every three months thereafter, through July 2004.  The maximum amount of other borrowingsoutstanding at any month-end was $38.0 million during 2001.

 

         TheBanks had $2.2 million of unused borrowing capacity from the FHLB at December31, 2001 based upon pledged securities.

 

**Note9—Guaranteed Preferred Beneficial Interests in Company’s Junior SubordinatedDeferrable Interest Debentures**

 

         The Company formed National Mercantile Capital Trust I (the“Trust”), a statutory business trust under the Delaware Business Trust Actpursuant to a Declaration of Trust dated as of June 27, 2001, for the solepurpose of issuing and selling certain securities representing undividedbeneficial interests in the assets of the Trust and investing the proceedsthereof in certain debentures of the Company.

 

         On July 16, 2001 the Trust issued and sold to the Company464 common securities (liquidation amount of $1,000 per common security) of theTrust (the “Common Securities”), representing common beneficial interests inthe assets of the Trust.

 

         Also, on July 16, 2001 the Trust issued 15,000 of 10.25%fixed rate securities (the “Trust Preferred Securities”), with a liquidationamount of $1,000 per Trust Preferred Security and an aggregate liquidationamount of $15,000,000 due July 25, 2031.  The Trust Preferred Securitiesare unconditionally 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.

 

63

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         The Trust used the proceeds from the issuance and the saleof the Trust Preferred Securities and the Common Securities to purchase$15,464,000 aggregate principal amount of the Company’s 10.25 percent fixedrate junior subordinated deferrable interest debentures due July 25, 2031 thatpay dividends each January 26 and July 26 during the term of thissecurity.  The interest is deferrable,at the Company's option for a period up to ten consecutive semi-annual payment,but in any event not beyond June 25, 2031. The debentures are redeemable, in whole or in part, at the Company’soption on or after eight years from issuance at declining premiums tomaturity.  The debentures are the soleassets of the Trust.

 

         The Trust Preferred Securities are reflected on theConsolidated Balance Sheet as “Guaranteed preferred beneficial interests in theCompany’s junior subordinated deferrable interest debentures.”  The accrued distributions payable on theTrust Preferred Securities are reflected as “Minority interest in income of thetrust subsidiary” in the Consolidated Statements of Operations. The costsassociated with the Trust Preferred Securities issuance have been capitalizedand are being amortized using a method that approximates the interest methodover a period of thirty years.  The recordedbalance of Trust Preferred Securities was $14.5 million at December 31,2001.  Minority interest in income oftrust subsidiary was $722,000 for the year ended December 31, 2001.

 

         The Company used the proceeds from the debentures as partialconsideration in the acquisition of South Bay.

 

**Note10—Availability of Funds from Bank; Restrictions on Cash Balances; Capital**

 

                NationalMercantile is a legal entity separate and distinct from the Banks, and as suchhas separate and distinct financial obligations including deferrable debtservice of $1.5 million and other modest operating expenses.  At present, substantially all of theCompany’s assets are the common shares of the Banks.  Accordingly, dividends from the Banks will be the principalsource of cash to the Company.  TheBanks are subject to various statutory and regulatory restrictions on theirability to pay dividends to the Company.

 

         OCC approval is required for a national bank to pay adividend if the total of all dividends declared in any calendar year exceedsthe total of the bank’s net profits (as defined) for that year combined withits retained net profits for the preceding two calendar years, less anyrequired transfer to surplus or a fund for the retirement of any preferredstock.  A national bank may not pay anydividend that exceeds its retained net profits then on hand after deducting itsloan losses and bad debts, as defined by the OCC.   The OCC and the Federal Reserve Board have also issued bankingcirculars emphasizing that the level of cash dividends should bear a directcorrelation to the level of a national bank’s current and expected earningsstream, the bank’s need to maintain an adequate capital base and other factors.

 

         National banks that are not in compliance with regulatorycapital requirements 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 National is presently unable to pay dividends toNational Mercantile because it has no undivided profits and does not anticipatehaving undivided profits for the foreseeable future.  It could, from time to time and with the consent of the OCC, paya capital distribution to National Mercantile, but it is not anticipated thatsuch would be approved unless Mercantile National were to remain “wellcapitalized” following such distribution.

 

         South Bay has undivided profits of $74,000 as of December31, 2001, which would be available for dividends.  South Bay has two classes of stock outstanding:  Common Stock, all of which is held byNational Mercantile, and Series A Perpetual Preferred Stock, all of which isheld by two directors of South Bay.  TheSouth Bay Preferred Stock has priority as to dividends each quarter over theCommon Stock in the amount of $53,125.

 

        Inaddition, 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 the Company.  Restrictions prevent the Company from borrowing from the Banksunless the loans are secured by designated amounts of marketable obligations.  Further, secured loans to and investments inthe Company or its affiliates by the Bank are limited to 10% of the Bank’scapital stock and surplus (as defined by federal regulations) and are limited,in the aggregate, to 20% of the Bank’s contributed capital (as defined byfederal regulations).

 

64

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        FederalReserve Board regulations require the Banks to maintain certain minimum reservebalances.  Cash balances maintained tomeet reserve requirements are not available for use by the Banks or theCompany.  During 2001 and 2000, theaverage reserve balances for the Banks were approximately $1.8 million and $2.4million, respectively.  Neither theCompany nor the Banks is required to maintain compensating balances to assurecredit availability under existing borrowing arrangements.

 

        TheCompany and the Banks are subject to various capital requirements administeredby the federal banking regulatory agencies. Failure to meet minimum capitalrequirements can initiate certain mandatory—and possibly additionaldiscretionary—actions by regulators that, if undertaken, could have a directmaterial effect on the Company’s financial statements. Under capital adequacyguidelines and the regulatory framework for prompt corrective action, theCompany and Banks must meet specific capital guidelines that involvequantitative measures of the Company’s and the Banks’ assets, liabilities andcertain off-balance-sheet items as calculated under regulatory accountingpractices. The Company’s and the Banks’ capital amounts and classification arealso subject to qualitative judgment by the regulators about components, riskweightings and other factors.

 

         Quantitativemeasures established by regulation to ensure capital adequacy require theCompany and the Banks to maintain minimum amounts and ratios (set forth in thetable below) of total and Tier 1 capital (as defined in the

regulations) to risk-weighted assets (asdefined).  Management believes, as ofDecember 31, 2001, the Company and Banks meet all capital adequacy requirementsto which they are subject.

 

                At December 31,2001, the Banks were categorized as well capitalized under the regulatoryframework for prompt corrective action. To be categorized as well capitalized under the prompt corrective actionrules, the Banks must maintain minimum total risk-based, Tier 1 risk-based andTier 1 leverage ratios as set forth in the following table.  There are no conditions or events since the mostrecent notification which management believes have changed the Banks’ category.

 

                The followingtable presents, at the dates indicated, certain information regarding theregulatory capital of the Company and the Banks and the required amounts ofregulatory capital for the Company and the Banks to meet applicable regulatorycapital requirements and, in the case of the Banks, to be well capitalizedunder the prompt corrective action rules.

 
|                                   |   | **Actual**                  |   | **For  Capital********Adequacy Purposes** |   |       |   | **To be  Categorized********as Well********Capitalized under Prompt Corrective Action** |   |
|----------------------------------------|--------|-----------------------------|--------|-------------------------------------------|--------|------------|--------|-----------------------------------------------------------------------------------------|--------|
|                                   |   | **Amount**                  |   | **Ratio**                                 |   | **Amount** |   | **Ratio**                                                                               |   | **Amount** |   | **Ratio** |   |
|                                   |   | **(Dollars  in thousands)** |   |
| As of December 31, 2001                |   |                        |   |                                      |   |       |   |                                                                                    |   |   |   |   |   |
| Total Capital to Risk Weighted Assets  |   |                        |   |                                      |   |       |   |                                                                                    |   |   |   |   |   |
| National Mercantile Bancorp            |   | $                           | 32,908 |                                      | 11.53  | %          | $      | 22,840                                                                                  |   | >=8.0 | % | $ | 28,550 |   | >=10.0 | % |
| Mercantile National Bank               |   | 14,675                      |   | 11.76                                     | %      | 9,982      |   | >=8.0                                                                                | %      | 12,478 |   | >=10.0 | % |
| South Bay Bank, N.A.                   |   | 18,264                      |   | 10.90                                     | %      | 12,590     |   | >=8.0                                                                                | %      | 15,737 |   | >=10.0 | % |
| Tier 1 Capital to Risk Weighted Assets |   |                        |   |                                      |   |       |   |                                                                                    |   |   |   |   |   |
| National Mercantile Bancorp            |   | 19,562                      |   | 6.85                                      | %      | 11,420     |   | >=4.0                                                                                | %      | 17,130 |   | >=6.0 | % |
| Mercantile National Bank               |   | 13,100                      |   | 10.50                                     | %      | 4,991      |   | >=4.0                                                                                | %      | 7,487 |   | >=6.0 | % |
| South Bay Bank, N.A.                   |   | 16,143                      |   | 9.63                                      | %      | 6,295      |   | >=4.0                                                                                | %      | 9,442 |   | >=6.0 | % |
| Tier 1 Capital to Average Assets       |   |                        |   |                                      |   |       |   |                                                                                    |   |   |   |   |   |
| National Mercantile Bancorp            |   | 19,562                      |   | 5.55                                      | %      | 14,560     |   | >=4.0                                                                                | %      | 18,200 |   | >=5.0 | % |
| Mercantile National Bank               |   | 13,100                      |   | 6.85                                      | %      | 7,654      |   | >=4.0                                                                                | %      | 9,567 |   | >=5.0 | % |
| South Bay Bank, N.A.                   |   | 16,143                      |   | 8.72                                      | %      | 6,971      |   | >=4.0                                                                                | %      | 8,713 |   | >=5.0 | % |
|                                        |        |                             |        |                                           |        |            |        |                                                                                         |        |  |  |  |  |  |  |  |

 

65

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**Note11—Commitments and Contingencies**

 

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

 

        Exposureto credit loss in the event of nonperformance by the other party to thefinancial instrument for commitments to extend credit, letters of credit andfinancial guarantees written, is represented by the contractual notional amountof those instruments.  The Company usesthe same credit policies in making commitments and conditional obligations asis does for on-balance sheet instruments.

 

        TheCompany had outstanding loan commitments aggregating $83.4 million at December31, 2001, substantially all of which were commercial loans with variablerates.  In addition, the Company had$157,000 outstanding letters of credit at December 31, 2001.

 

        Loancommitments are agreements to lend to a customer subject to certainconditions.  Loan commitments generallyhave fixed expiration dates or other termination clauses and may requirepayment of a fee.  Since portions of thecommitments are expected to expire without being drawn upon, the total amountof commitments does not necessarily represent future cash requirements.

 

        TheCompany from time to time is party to lawsuits, which arise in the normalcourse of business. The Company does not believe that any pending lawsuit atDecember 31, 2001 will have a material adverse effect on the financial positionor results of operations of the Company.

 

**Note12—Beneficial Conversion Rights on Subsidiary Preferred Stock**

 

        Inconjunction with the Company’s acquisition of South Bay the Company enteredinto modification agreements with the holders of South Bay Series A Preferredstock providing for, among other terms, the right to convert the preferredshares into Company common shares in lieu of South Bay common shares.  The holders of South Bay Series A Preferredstock may exchange their preferred shares for shares of Company common stock atany time after June 30, 2005, at the option of the holders, into thenumber of Company common shares equal to the result obtained by dividing thestated value of $25.00 per share by a determined exchange price.  The exchange price is an amount equal to 50%of the book value per share of the Company common, on a fully diluted basis, asof June 30, 2005.

 

        Theintrinsic value of the beneficial conversion feature is the excess of theaggregate fair value of the Company common shares that the preferredshareholders would receive at conversion over the aggregate stated value of theSouth Bay Series A Preferred shares. The Company has recorded the value of the beneficial conversion rightsof $1.8 million, measured at the modification date, December 13, 2001, asadditional paid in capital and has recorded a discount to the minority interestin the South Bay Series A Preferred shares. The discount is being amortized against retained earnings over theperiod from the modification date through the earlier conversion date, June 30,2005 using the effective yield method.

 

66

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

 

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

 

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

 

*        Securities available-for-sale*: 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 otherstock*:  FRB and other stock may be redeemed at thecarrying amount, therefore, the carrying amount is a reasonable estimation offair value.

* *

*         Loans*:  Variablerate loans have carrying amounts that approximate fair value. The fair value offixed rate loans is estimated by discounting the future cash flows using thecurrent rates at which similar loans would be made to borrowers with similarcredit ratings and for the same remaining maturities. In establishing thecredit risk component of the fair value calculations for loans, the Companyconcluded the allowance for credit losses represented a reasonable estimate ofcredit risk component of the fair value at December 31, 2001.

 

        *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 sold underagreements to repurchase*: The fair value of fixed-rate securities sold under agreements torepurchase is estimated by discounting the future cash flows using the ratescurrently offered for instruments of similar maturities.

 

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

 

        Theestimated fair values of financial instruments are presented below.

 

 

|                                                                         |   | **December 31, 2001**      |       |
|------------------------------------------------------------------------------|--------|----------------------------|------------|
|                                                                         |   | **Carrying**               |       | **Fair** |   |
|                                                                         |   | **Amount**                 |       | **Value** | ** ** |
|                                                                         |   | **(Dollars in thousands)** | ** ** |
|                                                                         |   |                       |       |
| Financial Assets:                                                            |   |                       |       |   |   |
| Cash, cash equivalents and  deposit with  other financial institutions       |   | $                          | 52,093     |   | $ | 52,093 |   |
| Securities  available-for-sale                                               |   | 41,627                     |       | 41,627 |   |
| FRB and other stock                                                          |   | 2,552                      |       | 2,552 |   |
| Loans, net of allowance for  credit losses                                   |   | 255,426                    |       | 256,548 |   |
| Financial Liabilities:                                                       |   |                       |       |   |   |
| Demand deposits, money  market and savings                                   |   | 209,287                    |       | 209,287 |   |
| Time certificates of  deposit                                                |   | 99,853                     |       | 99,974 |   |
| Federal funds purchased and  securities sold  under agreements to repurchase |   | 3,096                      |       | 3,115 |   |
| Other borrowings                                                             |   | 17,500                     |       | 17,684 |   |
|                                                                              |        |                            |            |  |  |  |  |

 

67

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**Note14—Parent Company Information**

 

        Thefollowing financial information presents the condensed balance sheet of theCompany on a parent-only basis as of December 31, 2001, and the relatedcondensed statements of operations and cash flows for each of the years in thetwo-year period ended December 31, 2001.

 

| **Balance Sheet**                                                                           |   |              |   |
|---------------------------------------------------------------------------------------------|--------|-------------------|--------|
|                                                                                        |   | **December  31,** |   |
|                                                                                        |   | **2001**          |   |
|                                                                                        |   | **(Dollars  in**  |   |
|                                                                                        |   | **thousands)**    |   |
| Cash with Banks                                                                             |   | $                 | 107    |   |
| Loan receivable                                                                             |   | 879               |   |
| Investment in subsidiaries                                                                  |   | 41,057            |   |
| Other assets                                                                                |   | 493               |   |
| Total assets                                                                                |   | $                 | 42,536 |   |
|                                                                                        |   |              |   |
| Junior subordinated  deferrable interest debentures                                         |   | $                 | 15,464 |   |
| Other liabilities                                                                           |   | 919               |   |
| Total liabilities                                                                           |   | 16,383            |   |
|                                                                                        |   |              |   |
| Minority interest in the  preferred stock of  consolidated subsidiary, South Bay Bank, N.A. |   | 676               |   |
|                                                                                        |   |              |   |
| Shareholders’ equity:                                                                  |   |              |   |
| Preferred stock                                                                             |   | 7,131             |   |
| Common stock                                                                                |   | 30,268            |   |
| Paid in surplus                                                                             |   | 1,824             |   |
| Accumulated deficit                                                                         |   | (13,802           | )      |
| Accumulated other  comprehensive income                                                     |   | 56                |   |
|                                                                                        |   |              |   |
| Total shareholders’ equity                                                             |   | 25,477            |   |
| Total liabilities and  shareholder’s equity                                            |   | $                 | 42,536 |   |

 

68

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**NATIONAL MERCANTILE BANCORP ANDSUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**

 

 
|                                                                                |   | **Year ended December 31,** |       |
|-------------------------------------------------------------------------------------|--------|-----------------------------|------------|
|                                                                                |   | **2001**                    |       | **2000** |   |
|                                                                                |   | **(Dollars in thousands)**  | ** ** |
| Interest income                                                                     |   | $                           | 364        |   | $ | 142 |   |
| Interest expense                                                                    |   | 746                         |       | — |   |
| Net interest income                                                                 |   | (382                        | )          | 142 |   |
|                                                                                |   |                        |       |   |   |
| Other operating expense                                                             |   | 8                           |       | — |   |
| Income before equity in  undistributed net income of subsidiaries                   |   | (390                        | )          | 142 |   |
| Equity in undistributed net  income of subsidiaries                                 |   | 1,546                       |       | 2,802 |   |
| Net income                                                                          |   | $                           | 1,156      |   | $ | 2,944 |   |
|                                                                                |   |                        |       |   |   |
|                                                                                |   |                        |       |   |   |
|                                                                                |   |                        |       |   |   |
| **Statements  of Cash Flow**                                                        |   |                        |       |   |   |
|                                                                                |   | **Year ended December 31,** | ** ** |
|                                                                                |   | **2001**                    |       | **2000** | ** ** |
|                                                                                |   | **(Dollars in thousands)**  | ** ** |
| Cash flows from operating  activities:                                              |   |                        |       |   |   |
| Net income                                                                          |   | $                           | 1,156      |   | $ | 2,944 |   |
| Adjustment to reconcile net  income to net cash provided by  operating activities.: |   |                        |       |   |   |
| Equity in undistributed net  income of subsidiaries, net                            |   | (1,546                      | )          | (2,802 | ) |
| Net increase in other  assets and other liabilities                                 |   | 1,378                       |       | (10 | ) |
| Net cash provided by  operating activities                                          |   | 988                         |       | 132 |   |
|                                                                                |   |                        |       |   |   |
| Cash flows from investing  activities:                                              |   |                        |       |   |   |
| Net cash used in purchase  of South Bay Bank, N.A.                                  |   | (24,786                     | )          | — |   |
| Investment in Mercantile  National Bank                                             |   | —                      |       | (2,400 | ) |
| Capital surplus reduction  from Mercantile National Bank                            |   | 6,000                       |       | — |   |
| Loans purchased and principal  collections, net                                     |   | 421                         |       | (804 | ) |
| Net cash used in investing  activities                                              |   | (18,365                     | )          | (3,204 | ) |
|                                                                                |   |                        |       |   |   |
| Cash flows from financing  activities:                                              |   |                        |       |   |   |
| Net proceeds from issuance  of debentures                                           |   | 14,506                      |       | — |   |
| Proceeds from issuance of  preferred stock                                          |   | 1,000                       |       | 4,190 |   |
| Proceeds from stock options  exercised                                              |   | 202                         |       | 43 |   |
| Net cash provided by  financing activities                                          |   | 15,708                      |       | 4,233 |   |
| Net (decrease) increase in  cash and cash equivalents                               |   | (1,669                      | )          | 1,161 |   |
| Cash and cash equivalents,  beginning of the year                                   |   | 1,776                       |       | 615 |   |
| Cash and cash equivalents,  end of the year                                         |   | $                           | 107        |   | $ | 1,776 |   |

 

69

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**INDEX TOEXHIBITS**

** **
| **Exhibit**      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|------------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|    2.1 | Agreement and  Plan of Reorganization by and between National Mercantile Bancorp and South  Bay Bank, N.A., entered into as of July 18, 2001 (9)                                                                                                                                                                                                                                                                                                                                             |
|             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|    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.(8)                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|    3.2 | Bylaws of the  Company, as amended, restated as of December 18, 1992 (2)                                                                                                                                                                                                                                                                                                                                                                                                                     |
|             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|    3.3 | Amended and  Restated Declaration of Trust of National Mercantile Capital Trust I,

dated as of June  27, 2001 (10)                                                                                                                                                                                                                                                                                                                                                                          |
|             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|    4.1 | Indenture for  Junior Subordinated Debt Securities dated as of July 16, 2001  (10)                                                                                                                                                                                                                                                                                                                                                                                                      |
|             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.1             | Employment  Agreement dated January 1, 2000 between Mercantile National Bank and Scott

A. Montgomery  (3)                                                                                                                                                                                                                                                                                                                                                                                   |
|             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.2             | Form of  Indemnity Agreement between the Company and its directors (4)                                                                                                                                                                                                                                                                                                                                                                                                                       |
|             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.3             | First Floor  Lease at 1840 Century Park East, Los Angeles, California, dated as of  December 21, 1982 between Northrop Corporation and Mercantile National Bank  (2)                                                                                                                                                                                                                                                                                                                         |
|             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.4             | Second Floor  Lease at 1840 Century Park East, Los Angeles, California, dated as of  December 21, 1982 between Northrop Corporation and Mercantile National Bank  for space at 1840 Century Park East, Los Angeles, California, as amended by  Amendment to Second Floor Lease dated as of June 7, 1986, and as amended by  Second Amendment to Second Floor Lease dated as of December 18, 1992 between  California State Teachers’ Retirement System and Mercantile National Bank (2) |
|             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.5             | Lease  Restructure Agreement dated December 31, 1995 by and between California State  Teachers’ Retirement System and Mercantile National Bank (5)                                                                                                                                                                                                                                                                                                                                      |
|             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.6             | Warrant  Agreement dated December 31, 1995 by and between the Company and California  State Teachers’ Retirement System (5)                                                                                                                                                                                                                                                                                                                                                             |
|             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.7             | Registration  Rights Agreement dated December 31, 1995 by and between the Company and  California State Teachers’ Retirement System (5)                                                                                                                                                                                                                                                                                                                                                 |
|             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10. 8            | National  Mercantile Bancorp Amended 1996 Stock Incentive Plan (6)                                                                                                                                                                                                                                                                                                                                                                                                                           |
|             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.9             | Registration  Rights Agreement between the Company and Conrad Company (7)                                                                                                                                                                                                                                                                                                                                                                                                                    |
|             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.10            | Registration  Rights Agreement between the Company and Wildwood Enterprises Inc. Profit  Sharing Plan and Trust (7)                                                                                                                                                                                                                                                                                                                                                                          |
|             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.11            | Guarantee  Agreement of National Mercantile Bancorp for trust preferred securities dated  July 16, 2001 (10)                                                                                                                                                                                                                                                                                                                                                                                 |
|             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 11.              | Statement  regarding computation of per share earnings (see ‘‘Note 1—Summary of  Significant Accounting

Policies—Earnings  (Loss) Per Share’’—of the ‘‘Notes to the Consolidated Financial Statements’’  in “Item 8. Financial Statements” in this Annual Report on Form 10-KSB)                                                                                                                                           |
|             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 21.              | Subsidiaries of  the Registrant*                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 99.              | Confirmation of  Receipt of Assurances from Arthur Andersen, LLP.                                                                                                                                                                                                                                                                                                                                                                                                                            |

 

70

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----

*     Included in this Report

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

(2)    Filed as an exhibit to the Company’s AnnualReport on Form 10-K for the year ended December 31, 1992 and incorporatedherein by reference.

(3)    Filed as an exhibit to the Company’s Reporton Form 10-Q for the quarter ended March 31, 1999 and incorporated herein byreference.

(4)    Filed as an exhibit to Company’s AnnualReport on Form 10-K for the year ended December 31, 1990 and incorporatedherein by reference.

(5)    Filed as an exhibit to the Company’s AnnualReport on Form 10-K for the year ended December 31, 1995 and incorporatedherein by reference.

(6)    Filed as an exhibit to the Company’s Reporton Form 10-Q for the quarter ended March 31, 1998 and incorporated herein byreference.

(7)    Filed as an exhibit to the Company’sRegistration Statement on Form S-2 dated February 10, 1997 and amendmentsthereto and incorporated herein by reference.

(8)    Filed as an exhibit to the Company's AnnualReport on Form 10-K for the year ended December 21, 2000 and incorporatedherein by reference.

(9)    Filed as an exhibit to the Company’s Reporton Form 8-K dated July 24, 2001 and incorporated herein by reference.

(10)  Filed as an exhibit to the Company’s Report onForm 10-Q for the quarter ended September 30, 2001 and incorporated herein byreference.