**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**Form 10-KSB**

 

**ANNUAL REPORT PURSUANT TO SECTION13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934**

 

| **For the year ended December 31,  2002** |   | **Commission File Number 0-15982** |
|-------------------------------------------|--------|------------------------------------|

 

**NATIONAL MERCANTILE BANCORP**

(Exactname of registrant as specified in its charter)

 

**California**

(State or otherjurisdiction ofincorporation or organization)

 

**1840 Century Park EastLos Angeles, California**

(Address to principalexecutive offices)

 

**95-3819685**

(I.R.S. EmployerIdentification No.)

 

**90067**

(Zip Code)

 

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

Nosecurities registered pursuant to Section 12(b) of the Act

Securitiesregistered pursuant to Section 12(g) of the Act:

 

**Common Stock, No Par Value**

**Series A Noncumulative Convertible Perpetual Preferred Stock**

(Titleof Class)

 

Indicate by check mark whether the registrant:  (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.     ýYes      o   No

 

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, and willnot be contained, to the registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form10-KSB. o

 

The aggregate market value of the voting common equityheld by nonaffiliates of the registrant, based upon the closing sale price ofits Common Stock as reported by the National Association of Securities DealersAutomated Quotation System on March 18, 2003, was approximately $17.6 million.

 

The number of shares of Common Stock, no par value, ofthe registrant outstanding as of March 18, 2003 was 2,689,329.

 

**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 2003 Annual Meeting ofShareholders are incorporated by reference in Part III, Items 10-13 of thisAnnual Report on Form 10-KSB.

 

**Index to Exhibits on Page 65**

 

 

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**NATIONAL MERCANTILE BANCORP**

 

**Table of Contents**

 

**Form 10-KSB**

**For the Fiscal Year Ended December 31, 2002**

 
|                 |                                                                                        | **Page** |
|----------------------|---------------------------------------------------------------------------------------------|----------|
| **PART I**           |                                                                                        |     |
| Item 1.              | Business                                                                                    | 3        |
| Item 2.              | Properties                                                                                  | 9        |
| Item 3.              | Legal Proceedings                                                                           | 10       |
| Item  4.             | Submission  Of Matters To A Vote Of Security Holders                                        | 10       |
|                 |                                                                                        |     |
| **PART II**          |                                                                                        |     |
| Item  5.             | Market  For Registrant’s Common Equity And Related Shareholder  Matters           | 10       |
| Item  6.             | Management’s  Discussion And Analysis Of Financial Condition And Results Of Operations | 11       |
| Item 7.              | Financial Statements                                                                        | 40       |
| Item  8.             | Changes  In And Disagreements With Accountants On Accounting And Financial Disclosure       | 41       |
|                 |                                                                                        |     |
| **PART III**         |                                                                                        |     |
| Item  9.             | Directors  And Executive Officers Of The Registrant                                         | 41       |
| Item 10.             | Executive Compensation                                                                      | 41       |
| Item  11.            | Security  Ownership Of Certain Beneficial Owners And Management                             | 41       |
| Item  12.            | Certain  Relationships And Related Transactions                                             | 41       |
|                 |                                                                                        |     |
| **PART IV**          |                                                                                        |     |
| Item 13.             | Exhibits,  Financial Statement Schedules, And Reports On Form 8-K                           | 41       |
| Signatures           |                                                                                        | 42       |
| Financial Statements | 47                                                                                          |
| Exhibit Index        | 65                                                                                          |

 

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**ANNUALREPORT ON FORM 10-K**

 

Certain matters discussed in this Form 10-KSB mayconstitute forward-looking statements within the meaning of the SecuritiesExchange Act of 1934 (the “Exchange Act”) and as such may involve risks anduncertainties.  These forward-lookingstatements relate to, among other things, expectations of the businessenvironment in which National Mercantile Bancorp (referred to as “we” or “our”when such reference includes National Mercantile Bancorp and its subsidiaries,collectively, “National Mercantile” when referring only to the parent companyand “the Banks” when referring only to National Mercantile’s bankingsubsidiaries, Mercantile National Bank and South Bay Bank, N.A.) operates, projectionsof future performance, perceived opportunities in the market and statementsregarding our mission and vision.  Ouractual results, performance, or achievements may differ significantly from theresults, performance, or achievements expressed or implied in suchforward-looking statements.  Statementsregarding policies and procedures are not intended to imply, and should not beinterpreted to mean, that we will conduct our business in accordance with suchpolicies for any particular period of time, as we may at any time and from timeto time amend or repeal such policies and adopt new policies.  For discussion of the factors that mightcause such a difference, see “Item 6. Management’s Discussion and Analysis of Financial Condition and Resultsof Operations— Factors Which May Affect Future Operating Results”.

 

**PART I**

 

***ITEM 1.     BUSINESS***

 

**National Mercantile Bancorp**

 

National Mercantile is a bank holding company whoseprincipal assets are the capital stock of two bank subsidiaries: MercantileNational Bank (“Mercantile”) and South Bay Bank, N.A.  (“South Bay”).  NationalMercantile has been authorized by the Federal Reserve Bank of San Francisco toengage in lending activities separate from the Banks but to date has not doneso.  National Mercantile Capital TrustI, which is a Delaware statutory business trust formed for the exclusivepurpose of issuing and selling trust preferred securities, is also a subsidiaryof National Mercantile.

 

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

 

We operate throughout the west side of Los AngelesCounty including the South Bay, Century City and San Fernando Valley withbanking offices in Century City, Torrance, Encino and El Segundo.  Our targeted market niches for businessesinclude 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 residential properties. Entertainment industry customers include television, music and filmproduction companies, talent agencies, individual performers, directors andproducers (whom we attract by establishing relationships with businessmanagement firms) and others affiliated with the entertainment industry.  Healthcare organizations include primarilyoutpatient healthcare providers such as physician medical groups, independentpractice associations and surgery centers. Professional service customers include legal, accounting, insurance,advertising firms and their individual directors, officers, partners andshareholders.

 

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

 

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

 

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To implement this philosophy, we operate each of ourBank subsidiaries by retaining their independent names.  Our banking subsidiaries have establishedstrong client followings in their market areas through attention to clientservice and an understanding of client needs.

 

In an effort to capitalize on the identities andreputations of the Banks, we intend to continue to market our services undereach Bank’s name, primarily through each Bank’s relationship managers.  The primary focus for the Banks’relationship managers is to cultivate and nurture their clientrelationships.  Relationship managersare assigned to each borrowing client to provide continuity in therelationship.  This emphasis onpersonalized relationships requires that all of the relationship managersmaintain close ties to the communities or industry niche in which they serve,so they are able to capitalize on their efforts through expanded businessopportunities for the Banks.

 

Client service decisions and day-to-day operations aremaintained at the Banks.  NationalMercantile offers the advantages of affiliation with a multi-bank holdingcompany by providing expanded client support services, such as increased clientlending capacity, business cash management, and following the full integrationof operations, centralized administrative functions, including support incredit policy formulation and review, investment management, data processing,accounting, loan servicing and other specialized support functions.  All of these centralized services aredesigned to enhance the ability of the relationship manager to expand theirclient relationship base.

 

At December 31, 2002, we had total assets of $355.4million, total loans, net, of $267.5 million and total deposits of $298.7million.

 

**History**

 

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

 

In March 2001, Mercantile opened a regional office inEncino, California which expanded our client-focused niche banking services tothe San Fernando Valley area of Los Angeles. The Encino regional office focuses on providing banking services tothose affiliated with the healthcare industry as well as expanding the clientbase in the entertainment industry, professional service providers andcommunity-based nonprofit organizations.

 

In December 2001, National Mercantile acquired SouthBay, which had offices in Torrance and El Segundo.  The acquisition of South Bay was accounted for under the purchaseaccounting method.  Accordingly, theassets acquired and liabilities assumed were recorded at their fair values andthe results of operations reflect only the period since acquisition.

 

**Competition**

 

The banking and financial services industry inCalifornia generally, and in the Banks’ market areas specifically, is highlycompetitive.  The increasinglycompetitive environment is a result primarily of changes in regulation, changesin technology and product delivery systems, and the accelerating pace ofconsolidation among financial services providers.  Our primary service area is dominated by a relatively smallnumber of major banks that have many offices operating over a wide geographicalarea.  We compete for loans, deposits,and customers with other commercial banks, savings and loan associations,securities and brokerage companies, mortgage companies, insurance companies,finance companies, money market funds, credit unions, and other nonbankfinancial service providers.  Many ofthese competitors are much larger in total assets and capitalization, havegreater access to capital markets and offer a broader range of financialservices than us.  Nondepositoryinstitutions can be expected to increase the extent to which they act asfinancial intermediaries.  Large institutionalusers and sources of credit may also increase the extent to which they interactdirectly, meeting business credit needs outside the banking system.  Furthermore, the geographic constraints onportions of the financial services industry can be expected to erode.  In addition, many of the major commercialbanks operating in our primary service area offer services, such as trustservices, which are not offered directly by us and, by virtue of their greatertotal capitalization, such banks have substantially higher lending limits.

 

To compete with other financial institutions in ourprimary service area, we rely principally upon personal contact by ourofficers, directors and employees and providing, through third parties,specialized services such as messenger, accounting and other relatedservices.  For clients whose loandemands exceed our legal lending limit, we arrange for such loans on aparticipation basis with other banks. We also assist clients requiring other services not offered by us in obtainingsuch services from other providers.

 

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**Economic Conditions and GovernmentPolicies**

 

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

 

The monetary and fiscal policies of the federalgovernment and the policies of regulatory agencies, particularly the Board ofGovernors of the Federal Reserve System (the “Federal Reserve”), influence ourbusiness.  The Federal Reserveimplements national monetary policies (with objectives such as curbinginflation and combating recession) through its open-market operations inU.S.  Government securities by adjustingthe required level of reserves for depository institutions subject to itsreserve requirements, and by varying the target federal funds and discountrates applicable to borrowings by depository institutions.  The actions of the Federal Reserve in theseareas influence the growth of bank loans, investments, and deposits and alsoaffect interest rates earned on interest-earning assets and paid oninterest-bearing liabilities.  We cannotfully predict the nature and impact on us of any future changes in monetary andfiscal policies.

 

**Supervision and Regulation**

 

* General*

 

Bank holding companies and banks are extensivelyregulated under both federal and state law. This regulation is intended primarily for the protection of depositorsand the deposit insurance fund and not for the benefit of shareholders ofNational Mercantile.  Set forth below isa summary description of certain of the material laws and regulations thatrelate to the operations of National Mercantile and the Banks.  The description does not purport to be acomplete description of these laws and regulations and is qualified in itsentirety by reference to the applicable laws and regulations.

 

It can be expected that new legislation andregulations will be adopted which will have the effect of increasing the costof doing business, limiting or expanding permissible activities, or affectingthe competitive balance between banks and other financial services providers.

 

* National Mercantile*

 

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

 

As a bank holding company, National Mercantile isrequired to obtain the Federal Reserve’s prior approval before acquiringownership or control of more than 5% of the outstanding shares of any class ofvoting securities, or substantially all the assets, of any company, including abank 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 soclosely related to banking or managing or controlling banks as to be a properincident thereto.

 

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

 

* The Banks*

 

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

 

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The OCC and the Federal Reserve have various remediesif they should determine that the financial condition, capital resources, assetquality, earnings prospects, management, liquidity, or other aspects of abank’s operations are unsatisfactory or that a bank or its management isviolating 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 resultingfrom any violation or practice, to issue an administrative order that can bejudicially enforced, to direct an increase in capital, to restrict the growthof the bank, to assess civil monetary penalties, to remove officers anddirectors, and ultimately to terminate the bank’s deposit insurance.

 

*Memorandumof Understanding*

 

In October 2002, Mercantile executed an informalnon-binding memorandum of understanding with the OCC relating to its interestrate risk management.  The memorandumprovides for Mercantile to take certain actions that the OCC believes wouldstrengthen Mercantile’s interest rate risk management process, including thereview of its interest rate risk limits and interest rate risk modelingassumptions and the retention of an independent consultant to conduct a reviewof Mercantile’s interest rate risk management processes by February 28, 2003.  Mercantile has taken the substantive actionsprovided in the memorandum and intends to continually evaluate and enhance itsinterest rate risk management processes as appropriate.

 

*USAPatriot Act of 2001*

 

On October 26, 2001, President Bush signed the USAPatriot Act of 2001 (“Patriot Act”). The Patriot Act is intended to strengthenthe U.S law enforcement and the intelligence communities’ abilities to workcohesively to combat terrorism on a variety of fronts. The potential impact ofthe Patriot Act on financial institutions of all kinds is significant and wideranging. The Patriot Act contains sweeping anti-money laundering and financialtransparency laws and requires various regulations, including: (i) duediligence requirements for financial institutions that administer, maintain, ormanage private bank accounts or correspondent accounts for non-US persons; (ii)standards for verifying customer identification at account opening; (iii) rulesto promote cooperation among financial institutions, regulators, and lawenforcement entities in identifying parties that may be involved in terrorismor money laundering; and (iv) reports by non-financial trades and businessesfiled with the Treasury Department’s Financial Crimes Enforcement Network fortransactions exceeding $10,000, and filing of suspicious activities reports bysecurities brokers and dealers if they believe a customer may be violating U.S.laws and regulations.

 

On July 23, 2002, the U.S. Treasury proposedregulations requiring institutions to incorporate into their written moneylaundering plans a customer identification program implementing reasonableprocedures for: (i) verifying the identity of any person seeking to open anaccount, to the extent reasonable and practicable; (ii) maintaining records ofthe information used to verify the person’s identity; and (iii) determiningwhether the person appears on any list of known or suspected terrorists orterrorist organizations.

 

Account is defined as a formal banking or businessrelationship established to provide ongoing services, dealings, or otherfinancial transactions. We do not expect the proposed regulations will have amaterial impact on our operations.

 

*  FDIC*

 

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

 

Under FDIC regulations, each insured depositoryinstitution is assigned to one of three capital groups for insurance premiumpurposes — “well capitalized,” “adequately capitalized” and “undercapitalized”— which are defined in the same manner as under prompt corrective action rules,as discussed under “Capital Adequacy Requirements” below.  These three groups are then divided intosubgroups which are based on supervisory evaluations by the institution’sprimary federal regulator, resulting in nine assessment classifications.  Currently, assessment rates for BIF-insuredbanks range from 0% of insured deposits for well-capitalized banks with minorsupervisory concerns to 0.027% of insured deposits for undercapitalized bankswith substantial supervisory concerns. The FDIC may increase or decrease the assessment rate schedulesemiannually.

 

The FDIC may terminate the deposit insurance of anyinsured depository institution if the FDIC determines, after a hearing, thatthe institution has engaged or is engaging in unsafe or unsound practiceswhich, as with the OCC’s enforcement authority, are not limited to cases ofcapital inadequacy, is in an unsafe or unsound condition to continue operationsor has violated any applicable law, regulation or order or any conditionimposed in writing by the FDIC.  Inaddition, FDIC regulations provide that any insured institution that fallsbelow a 2% minimum leverage ratio (see below) will be subject to FDIC depositinsurance termination proceedings unless it has submitted, and is in compliancewith, a capital plan with its primary federal regulator and the FDIC.  The FDIC may also suspend deposit insurancetemporarily during the hearing process if the institution has no tangiblecapital.  The FDIC is additionallyauthorized by statute to appoint itself as conservator or receiver of aninsured depository institution (in addition to the powers of the institution’s 

 

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primary federal regulatory authority) in cases, among others and uponcompliance with certain procedures, of unsafe or unsound conditions orpractices or willful violations of cease and desist orders.

 

All FDIC-insured depository institutions must pay anannual assessment to provide funds for the payment of interest on bonds issuedby the Financing Corporation, a federal corporation chartered under theauthority of the Federal Housing Finance Board. The bonds, commonly referred toas FICO bonds, were issued to capitalize the Federal Savings and Loan InsuranceCorporation.  The FDIC established theFICO assessment rates effective for the fourth quarter of 2002 at approximately$.0184 per $100 annually for assessable deposits. The FICO assessments areadjusted quarterly to reflect changes in the assessment bases of the FDIC’sinsurance funds and do not vary depending on a depository institution’scapitalization or supervisory evaluations.

 

* Dividends and Capital Distributions*

 

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

 

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

 

National banks that are not in compliance withregulatory capital requirements generally are not permitted to paydividends.  The OCC also can prohibit anational bank from engaging in an unsafe or unsound practice in itsbusiness.  Depending on the bank’sfinancial condition, payment of dividends could be deemed to constitute anunsafe or unsound practice.  Exceptunder certain circumstances, and with prior regulatory approval, a bank may notpay a dividend if, after so doing, it would be undercapitalized.  The Banks’ ability to pay dividends in thefuture is, and could be, further influenced by regulatory policies oragreements and by capital guidelines.

 

Neither Mercantile nor South Bay has retainedearnings, and therefore neither is presently able to pay dividends.  Mercantile has a substantial accumulateddeficit and does not anticipate having positive retained earnings for theforeseeable future.  South Bay has anaccumulated deficit of $482,000 as of December 31, 2002.  Mercantile and South Bay may from time totime be permitted to make capital distributions to National Mercantile with theconsent of the OCC.  It is notanticipated that such consent could be obtained unless the distributing bankwere to remain “well capitalized” following such distribution.

 

The payment of dividends by National Mercantile islimited by the terms of the Trust Preferred Securities indenture.  National Mercantile may not declare or payany dividends or other distributions on its common stock or preferred stock ifit is in default under the terms of the indenture or if it has elected to deferpayments of interest on the Trust Preferred Securities.

 

* Transactions with Affiliates*

 

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

 

  *Capital Adequacy Requirements*

 

Both the Federal Reserve and the OCC have adoptedsimilar, but not identical, “risk-based” and “leverage” capital adequacyguidelines for bank holding companies and national banks, respectively.  Under the risk-based capital guidelines,different categories of assets are assigned different risk weights, rangingfrom zero percent for assets considered risk-free (e.g., cash) to 100% forassets considered relatively high-risk (e.g., commercial loans).  These risk weights are multiplied bycorresponding asset balances to determine a risk-adjusted asset base.  Certain off-balance sheet items (e.g., standbyletters 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 is 

 

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presently 8%.  At least half ofthe total capital is required to be “Tier 1 capital,” consisting principally ofcommon shareholders’ equity, a limited amount of perpetual preferred stock andminority interests in the equity, less goodwill, intangible assets and certainother items.  The remainder (Tier 2 capital)may consist of a limited amount of subordinated debt, certain hybrid capitalinstruments and other debt securities, preferred stock and a limited amount ofthe general loan-loss allowance.

 

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

 

* Prompt Corrective Action Rules*

 

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

** **

The OCC may subject national banks which are not atleast “adequately capitalized” to a broad range of restrictions and regulatoryrequirements.  An undercapitalized bankmay not pay management fees to any person having control of the institution,nor, except under certain circumstances and with prior regulatory approval,make any capital distribution. Undercapitalized banks are subject to increased monitoring by the OCC,are restricted in their asset growth, must obtain regulatory approval forcertain corporate activities, such as acquisitions, new branches and new linesof business, and, in most cases, must submit to the OCC a plan to bring theircapital levels to the minimum required in order to be classified as adequatelycapitalized.  The OCC may not approve acapital restoration plan unless each company that controls the bank guaranteesthat the bank will comply with it.  UnderFederal Reserve policy, a bank holding company is expected to act as a sourceof financial strength to its subsidiary banks and to commit resources tosupport each such bank.  In addition, abank holding company is required to guarantee that its subsidiary bank willcomply with any capital restoration plan. The amount of such a guarantee is limited to the lesser of (i) 5% of thebank’s total assets at the time it became undercapitalized, or (ii) the amountwhich is necessary (or would have been necessary) to bring the bank intocompliance with all applicable capital standards as of the time the bank failsto comply with the capital restoration plan. A holding company guarantee of a capital restoration plan results in apriority claim 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.

 

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

 

As a condition to the approval of National Mercantile’sacquisition of South Bay, National Mercantile agreed with the Federal Reservethat it would maintain its and each of the Bank’s regulatory capital ratios inthe well capitalized category for the three years following the closing.  At December 31, 2002, each of the Banks andNational Mercantile exceeded the required ratios for classification as wellcapitalized.

 

* Safety and Soundness Standards*

 

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

 

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

 

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

 

*CrossGuarantees*

 

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

 

* Community Reinvestment Act and Fair Lending*

 

The Banks are subject to certain fair lendingrequirements and reporting obligations involving home mortgage lendingoperations and Community Reinvestment Act (“CRA”) activities.  A bank may be subject to substantialpenalties and corrective measures for a violation of certain fair lendinglaws.  The CRA requires the Banks toascertain and meet the credit needs of the communities it serves, includinglow- and moderate-income neighborhoods. The Banks’ compliance with the CRA is reviewed and evaluated by the OCC,which assigns the Banks a publicly available CRA rating at the conclusion ofthe examination.

 

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

 

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

 

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

 

**Employees**

 

At December 31, 2002, we had 85 total employees and 83full-time employees.  None of theemployees is covered by a collective bargaining agreement.  We consider our employee relations to besatisfactory.

 

**ITEM2.  PROPERTIES.**

 

We lease approximately 24,000 square feet in an officebuilding at 1840 Century Park East, Century City, California, the location ofNational Mercantile’s administrative headquarters and Mercantile’s principalbanking office.  The effective rent forthe period November 1, 2001 to October 31, 2004 is $2.83 per square foot or$67,607 per month. The rent is subject to annual adjustments for changes inproperty taxes and operating costs.  Thelease expires in October 2004.

 

Mercantile also leases an approximately 1,650 squarefoot facility in Encino, California for the primary purpose of providing branchbanking operations in the San Fernando Valley.

 

South Bay owns a two-story stand alone office buildingat 2200 Sepulveda Boulevard, Torrance, California which serves as its principalbanking office.  South Bay also leasesan approximately 1,500 square foot facility in El Segundo, California for theprimary purpose of providing branch banking operations in the Los Angelesairport area.

 

9

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

 

**ITEM3.  LEGAL PROCEEDINGS.**

 

From time to time, we are involved in certain legalproceedings arising in the normal course of our business.  We believe that the outcome of these mattersexisting as of December 31, 2002 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 ofshareholders during the quarter ended December 31, 2002.

 

 

###### **PARTII**

*** ***

***ITEM 5.  MARKET FORREGISTRANT’S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS***

 

The Common Stock and Series A NoncumulativeConvertible Perpetual Preferred Stock (the “Series A Preferred”) of NationalMercantile are traded on the Nasdaq SmallCap Market, under the symbols MBLA andMBLAP, respectively.  The followingtable shows the high and low trade prices of the Common Stock and Series APreferred for each quarter of 2001 and 2002 as reported by the Nasdaq.Additionally, there may have been transactions at prices other than those shownduring that time.

 
|               |   | **Common Stock** |   | **Series A  Preferred** |   |
|--------------------|--------|------------------|--------|-------------------------|--------|
| **Quarter Ended:** |   | **High**         |   | **Low**                 |   | **High** |   | **Low** |   |
|               |   |             |   |                    |   |   |   |   |   |
| 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 |   |
| March 31, 2002     |   | 6.90             |   | 5.45                    |   | 13.03 |   | 11.90 |   |
| June 30, 2002      |   | 6.75             |   | 5.16                    |   | 13.05 |   | 12.50 |   |
| September 30, 2002 |   | 6.20             |   | 5.01                    |   | 11.90 |   | 10.00 |   |
| December 31, 2002  |   | 7.00             |   | 5.81                    |   | 14.40 |   | 12.00 |   |

 

At March 18, 2002, National Mercantile had 169 shareholdersof record for its Common Stock and 19 shareholders of record for its Series APreferred.  The number of beneficialowners for the Common Stock and Series A Preferred is higher as many peoplehold their shares in “street” name.  AtMarch 18, 2003, approximately 36% and 18% of the Common Stock and Series APreferred, respectively, were held in street name.

 

National Mercantile has not paid a cash dividend onthe Common Stock since July 1990, and has never paid a cash dividend on theSeries A Preferred.  The Series APreferred is entitled to a noncumulative cash dividend at a rate of 6.5% of itsliquidation preference quarterly on the first day of January, April, July, andOctober of each year, commencing October 1, 2001, before any dividend may be declaredupon or paid upon the Common Stock.  Asa California corporation, under the California General Corporation Law,generally National Mercantile may not pay dividends in cash or property except(ii) out of positive retained earnings or (ii) if, after giving effect to thedistribution, National Mercantile’s assets would be at least 1.25 times itsliabilities and its current assets would exceed its current liabilities(determined on a consolidated basis under generally accepted accountingprinciples).  At December 31, 2002,National Mercantile had an accumulated deficit of $14.1 million.  Further, it is unlikely that its assets willever be at least 1.25 times its liabilities. Accordingly, National Mercantile must generate net income in excess of$14.1 million before it can pay a dividend in cash or property.

 

In December 2002 National Mercantile issued and sold1,006,287 shares of Common Stock for $7.65 per share, or an aggregate of $7.7million.  The issuance and sale of theseshares was exempt from registration under the Securities Act of 1933, pursuantto Section 4(2) of the Securities Act and Regulation D thereunder astransactions not involving a public offering. National Mercantile did not employ any general solicitation or generaladvertising in connection with the offering, and each investor represented thathe or she was an “accredited investor” as defined in Regulation D under theSecurities Act.  Wedbush MorganSecurities served as National Mercantile’s financial advisor and was paid feesand expenses totaling $97,000.

 

10

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*OutstandingAwards Under All Equity Compensation Plans*.  The following table sets forth as ofDecember 31, 2002 information regarding outstanding options under all of ourequity compensation plans and the number of shares available for future optiongrants under equity compensation plans currently in effect.

 
|                                                       |   | **(a)**                                                                                            |   | **(b)**                                                                            |   | **(c)**                                                                                                                                       |   |
|------------------------------------------------------------|--------|----------------------------------------------------------------------------------------------------|--------|------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------|--------|
| **Plan category**                                          |   | **Number of securities to  be issued upon exercise  of outstanding options,  warrants and rights** |   | **Weighted-average  exercise price of  outstanding options,  warrants and rights** |   | **Number of securities  remaining available for  issuance under equity  compensation plans  (excluding securities  reflected in column (a))** |   |
| Equity  compensation plans approved by security holders(1) |   | 420,843                                                                                            |   | $                                                                                  | 6.36   |                                                                                                                                          | 46,834 |   |
|                                                            |        |                                                                                                    |        |                                                                                    |        |                                                                                                                                               |        |  |

 

----

(1) Includes the 1996 Stock Incentive Plan and two stock option planswhich have been terminated but under which there remain outstanding options topurchase an aggregate of 58,424 shares of our Common Stock.

 

 

***ITEM 6.      MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS***

 

**OVERVIEW**

 

We recorded  anet loss of $253,000 for 2002 compared to net income of $1.2 million for2001.  On a per share basis, in 2002 werecorded a basic and fully-diluted loss of $0.15 compared to basic earnings of$0.72 and fully-diluted earnings of $0.28 for 2001.  The decrease in net earnings was due to a $4.2 million increasein operating expenses, a $1.4 million increase in the provision for credit losses,an $815,000 increase in the minority interest of the holders of the guaranteedpreferred beneficial interests in National Mercantiles’s junior subordinateddeferrable interest debentures (the “Trust Preferred Securities) in our incomeand a $213,000 minority interest of the South Bay Bank Series A Preferred Stockin our income.  Partially offsettingthese factors, net interest income increased $5.0 million in 2002, despite alower net yield on earning assets, and other operating income increased $269,000over 2001.  In comparing the results ofoperations, most income and expense items are greater in 2002 than 2001 as aresult of the acquisition of South Bay in December 2001.  Accordingly, the 2002 year includes theoperations of South Bay.

 

Total assets at December 31, 2002 were $355.4 millioncompared to $374.4 million at year end 2001. Federal funds sold and securities purchased under agreements to reselldecreased $20.7 million to $18.7 million at December 31, 2002 from $39.4million at December 31, 2001.  TheFederal funds sold at December 31, 2002 included $27.6 million that wasmaintained to accommodate the anticipated withdrawal of a short-term demanddeposit.  Securities available-for-saledecreased $15.5 million at December 31, 2002 compared to the prior year endprimarily due to the repayments of principal of our mortgage-backedsecurities.  These decreases werepartially offset by an increase in loans receivable of $10.4 million.  The net decrease in total assets funded a$10.4 million decrease in total deposits, a $10.0 million decrease in otherborrowed funds and a $1.6 million decrease in federal funds purchased andsecurities sold under agreements to repurchase.

 

The Trust Preferred Securities are accounted for onthe balance sheet as guaranteed preferred beneficial interests in the Company’sjunior subordinated deferrable interest debentures, net of issuance costs.  The amount earned by the holders of theTrust Preferred Securities is treated as an allocation of income to minorityinterests.

 

The allowance for credit losses at December 31, 2002was $4.8 million compared to $6.5 million at December 31, 2001.  The decrease is due to net charge-offs of$3.6 million partially offset by provisions to the allowance during the year of$1.9 million.

 

11

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**Table 1**

**OperationsSummary**

 
|                                                                                                                   |   | **Year  Ended  December 31,********2002** |       | **Increase  (Decrease)** |   | **Year  Ended  December 31,  2001** |   |
|------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------|------------|--------------------------|--------|-------------------------------------|--------|
|                                                                                                                   |   |                                      | **Amount** |                     | **%**  |                                |   |
|                                                                                                                   |   | **(Dollars  in thousands)**               |       |
| Interest income                                                                                                        |   | $                                         | 19,572     |                     | $      | 5,781                               |   | 41.9 | % | $ | 13,791 |   |
| Interest expense                                                                                                       |   | 4,664                                     |       | 788                      |   | 20.3                                | %      | 3,876 |   |
| Net interest income                                                                                                    |   | 14,908                                    |       | 4,993                    |   | 50.4                                | %      | 9,915 |   |
| Provision for credit losses                                                                                            |   | 1,925                                     |       | 1,408                    |   | 272.3                               | %      | 517 |   |
| Other operating income                                                                                                 |   | 1,502                                     |       | 269                      |   | 21.8                                | %      | 1,233 |   |
| Other operating expense                                                                                                |   | 12,861                                    |       | 4,200                    |   | 48.5                                | %      | 8,661 |   |
| Minority interest in the Company’s income of the:                                                                 |   |                                      |       |                     |   |                                |   |   |   |
| Guaranteed preferred beneficial interests in the Company’s junior  subordinated deferrable interest debenture-net |   | 1,537                                     |       | 815                      |   | 112.9                               | %      | 722 |   |
| Series A Preferred Stock of South Bay Bank, N.A.                                                                       |   | 213                                       |       | 213                      |   | N/A                                 |   | — |   |
| Income before income taxes                                                                                             |   | (126                                      | )          | (1,374                   | )      | (110.1                              | )%     | 1,248 |   |
| Income taxes                                                                                                           |   | 127                                       |       | 35                       |   | 38.0                                | %      | 92 |   |
| Net income (loss)                                                                                                      |   | $                                         | (253       | )                        | $      | (1,409                              | )      | (121.9 | )% | $ | 1,156 |   |

 

## **OPERATIONS SUMMARYANALYSIS**

 

**Net InterestIncome**

 

Our earnings depend largely upon the differencebetween the income earned on our loans and other investments and the interestpaid on our deposits and borrowed funds. This difference is net interestincome. Our ability to generate net interest income is largely dependent on ourability to maintain sound asset quality and appropriate levels of capital andliquidity. Our inability to maintain strong asset quality, capital or liquiditymay adversely affect (i) the ability to accommodate desirable borrowingcustomers, thereby inhibiting growth in quality higher-yielding earning assets;(ii) the ability to attract comparatively stable, lower-cost deposits; and(iii) the costs of wholesale funding sources.

 

Net interest income increased $5.0 million to $14.9million during 2002 compared to $9.9 million during 2001.  The increase was attributable to the SouthBay acquisition in December 2001 that contributed a significantly greatervolume of earning assets.  The net yieldon earning assets declined to 4.73 percent for 2002 from 5.31 percent for2001.  Despite a greater decline in thecost of interest bearing liabilities than yields on interest earning assets,the decline in net yield on earning assets was due to lower yields on a greatervolume of earning assets than interest bearing liabilities.

 

Average earning assets increased $128.6 million to$315.4 million during 2002 compared to 2001 while the average yield on earningassets declined 1.18 percent from 7.39 percent to 6.21 percent.  Total interest income increased $5.8 milliondue to the greater volume of earning assets as a result of the South Bayacquisition offset by overall lower yields on earning assets.  The lower yields are due to the sustaineddecline in interest rates over the past two years affecting the yields onadjustable rate loans tied to rate indices as well as newly originated fixedrate loans and existing fixed rate loans upon renewal at maturity.

 

Interest income from loans increased $7.7 millionduring 2002 due to $140.8 million greater average volume offset by a 171 basispoint (one basis point is equal to .01 percent) decline in yield.  The average amount of securitiesavailable-for-sale decreased $18.6 million while the average yield declined 127basis points resulting in a $1.6 million decrease in interest income fromsecurities available-for-sale.  Interestincome from federal funds sold decreased approximately $400,000 despite $5.1million greater average volume due to a 2.16 percent decrease in average yield.

 

Average interest-bearing liabilities increased $102.1million to $212.4 million during 2002 compared to $110.3 million during2001.  Interest expense increased  $800,000 for 2002 compared to 2001 due tothe greater average volume of interest bearing liabilities partially offset bya 131 basis point decline in the average cost of funds for 2002.  The decrease in the cost of funds was due tothe overall lower interest rate environment during 2002 and a change in thecomposition of interest-bearing liabilities to lower cost funds.  Relatively high-cost other borrowings,consisting primarily of advances from the Federal Home Loan Bank, averaged$11.3 million in 2002 compared to $20.9 million in 2001.  The average amount of moderate-cost timecertificates of deposit increased $45.6 million while lower-cost money marketand savings deposits and interest-bearing demand deposits increased $46.0million and $18.5 million, respectively.

 

12

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The net interest spread increased to 4.01 percent from3.88 percent due to a greater volume of earning assets funded bynoninterest-bearing sources of funds. Noninterest-bearing demand deposits averaged $102.2 million during 2002compared to $58.9 million in 2001. Guaranteed preferred beneficial interests in National Mercantile’sjunior subordinated deferrable interest debentures that were issued in June2001 averaged $14.5 million for 2002 compared to $7.6 million in 2001.  Shareholders’ equity averaged $25.9 millionduring 2002 compared to $22.5 million during the prior year primarily due tothe $1.0 million Series B preferred stock issued in December 2001 and $1.8million additional paid in capital representing the discount on the South BaySeries A Preferred Stock related to the beneficial conversion rights providedin the South Bay acquisition.  The SouthBay Series A Preferred Stock was redeemed on December 31, 2002.

 

While Mercantile and South Bay had similar volumes ofinterest earning assets, a significant difference existed in the composition ofSouth Bay’s interest earning assets, and the related yields.  Accordingly,the acquisition of South Bay in December 2001 has affected the net interestspread during the 2002 periods.  During 2002 average loans receivable ofSouth Bay were $33.0 million, or 30%, greater than Mercantile’s average loansreceivable while lower-yielding Federal funds sold and investment securities atSouth Bay were $26.1 million less than Mercantile.  The greater relativevolume of higher yielding earning assets at South Bay than Mercantile increasedthe yield of our total interest earning assets approximately 0.53% in 2002.

 

Significant differences in the composition and relatedcosts of funding liabilities between Mercantile and South Bay also affected ournet interest spread and net yield on earning assets for the 2002 periods. Average noninterest bearing deposits at Mercantile for the year ended December31, 2002 were $45.5 million greater than South Bay while average interestbearing liabilities at Mercantile were $40.6 million less than South Bay. During 2002, time certificates of deposit averaged $24.7 million and $59.6million at Mercantile and South Bay, respectively, with rates of 2.22% and2.94%, respectively.  The greater relative volume of higher costingfunding liabilities at South Bay than Mercantile has increased the rate on ourtotal interest bearing liabilities approximately 0.63% in 2002.

 

In 2002 we replaced higher costing liabilities atSouth Bay with Federal funds purchased from Mercantile in order to lower ouroverall cost of funds.  Additionally, we allocated greater resources toSouth Bay, primarily in salaries, to increase its emphasis on businessbanking.  Management expects this emphasis to result in furtherdiversification of the loan portfolio through growth of commercial loans, inadditional to growth of lower cost funds, particularly noninterest bearing.

 

**Table 2**

**Ratiosto Average Assets**

 
|                                                                                           |   | **2002** |   | **2001** |   |
|------------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|
| Net interest income                                                                            |   | 4.15     | %      | 4.94     | %      |
| Other operating income                                                                         |   | 0.42     | %      | 0.61     | %      |
| Provision for credit losses                                                                    |   | (0.54    | )%     | (0.26    | )%     |
| Other operating expense                                                                        |   | (3.58    | )%     | (4.32    | )%     |
| Minority interest in the Company’s junior subordinated deferrable  interest debenture-net |   | (0.43    | )%     | (0.36    | )%     |
| Income before income taxes                                                                     |   | 0.02     | %      | 0.61     | %      |
|                                                                                           |   |     |   |     |   |
| Net income (loss)                                                                              |   | (0.07    | )%     | 0.58     | %      |

 

**InterestRate 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 onour loans are affected principally by the demand for such loans, the supply ofmoney available for lending purposes, and other competitive factors.  These factors are in turn affected bygeneral economic conditions and other factors beyond our control, such asfederal economic policies, the general supply of money in the economy,legislative tax policies, governmental budgetary matters, and actions of theFederal Reserve Board.  Table 3 presentsinformation concerning the change in interest income and interest expenseattributable to changes in average volume and average rate.  Table 4 presents the 

 

13

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weighted average yield on each category of interest earning assets, theweighted average rate paid on each category of interest bearing liabilities,and the resulting interest rate spread and net yield on interest earning assetsfor 2002, 2001 and 2000.  We had no taxexempt interest income for 2002, 2001 or 2000.

 

Our net interest margin remains high in comparisonwith the interest rate spread due to the continued significance of noninterestbearing demand deposits relative to total funding sources.  Average noninterest bearing demand depositstotaled $102.2 million, representing 34.0 percent of average deposits, during2002, compared to $58.9 million, representing 39.9 percent of average deposits,during 2001.  Of these noninterestbearing demand deposits during 2002, $23.9 million or 23.4 percent of averagenoninterest bearing deposits were represented by real estate title and escrowcompany deposits, compared to $19.7 million or 33.5 percent of averagenoninterest bearing deposits during 2001. 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 2002 and2001, would have been reduced by $206,000 and $510,000, respectively, and thenet interest margin for 2002 and 2001 would have decreased 7 basis points and46 basis points, respectively. Similarly, this would create identical reductions in other operatingexpense.     The expense associated withthese deposits declined in 2002 from 2001 despite the increase in volumebecause we reduced the amount of third-party customer services provided forthese depositors.

 

14

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**Table 3**

**Increase (Decrease) in InterestIncome/Expense Due to Change inAverage Volume and Average Rate(1)**

 
|                                                                        |   | **2002 vs  2001**                |   | **2001 vs  2000**            |   |
|-----------------------------------------------------------------------------|--------|----------------------------------|--------|------------------------------|--------|
|                                                                        |   | **Increase  (decrease) due to:** |   | **Net  Increase (Decrease)** |   | **Increase  (decrease) due to:** |   | **Net  Increase** |   |
|                                                                        |   | **Volume**                       |   | **Rate**                     |   |   | **Volume** |   | **Rate** |   | **(Decrease)** |   |
|                                                                        |   | **(Dollars in thousands)**       |   |
| Interest Income:                                                            |   |                             |   |                         |   |   |   |   |   |   |   |   |   |
| Federal funds sold and securities purchased under agreement to resell       |   | $                                | 192    |                         | $      | (572 | ) | $ | (380 | ) | $ | 760 |   | $ | (560 | ) | $ | 200 |   |
| Securities available-for-sale                                               |   | (1,164                           | )      | (420                         | )      | (1,584 | ) | (1,339 | ) | (225 | ) | (1,564 | ) |
| Loans receivable(2)                                                         |   | 12,075                           |   | (4,342                       | )      | 7,733 |   | 2,260 |   | (1,566 | ) | 694 |   |
| Total interest-earning assets                                               |   | 11,103                           |   | (5,334                       | )      | 5,769 |   | 1,681 |   | (2,351 | ) | (670 | ) |
|                                                                        |   |                             |   |                         |   |   |   |   |   |   |   |   |   |
| Interest Expense:                                                           |   |                             |   |                         |   |   |   |   |   |   |   |   |   |
| Interest-bearing deposits:                                                  |   |                             |   |                         |   |   |   |   |   |   |   |   |   |
| Demand                                                                      |   | $                                | 178    |                         | $      | 52 |   | $ | 230 |   | $ | 21 |   | $ | (42 | ) | $ | (21 | ) |
| Money market and savings                                                    |   | 1,162                            |   | (755                         | )      | 407 |   | 91 |   | (330 | ) | (239 | ) |
| Time certificates of deposit:                                               |   |                             |   |                         |   |   |   |   |   |   |   |   |   |
| $ 100,000 or more                                                           |   | 619                              |   | (1,183                       | )      | (564 | ) | 583 |   | (277 | ) | 306 |   |
| Under $100,000                                                              |   | 1,397                            |   | (246                         | )      | 1,151 |   | 20 |   | (111 | ) | (91 | ) |
| Total time certificates of deposit                                          |   | 2,016                            |   | (1,429                       | )      | 587 |   | 603 |   | (388 | ) | 215 |   |
| Total interest-bearing deposits                                             |   | 3,356                            |   | (2,132                       | )      | 1,224 |   | 715 |   | (760 | ) | (45 | ) |
| Other borrowings                                                            |   | (463                             | )      | (70                          | )      | (533 | ) | (742 | ) | (329 | ) | (1,071 | ) |
| Federal funds purchased and securities sold under agreements to  repurchase |   | 79                               |   | 18                           |   | 97 |   | (18 | ) | (13 | ) | (31 | ) |
| Total interest-bearing liabilities                                          |   | 2,972                            |   | (2,184                       | )      | 788 |   | (45 | ) | (1,102 | ) | (1,147 | ) |
|                                                                        |   |                             |   |                         |   |   |   |   |   |   |   |   |   |
| Net interest income                                                         |   | $                                | 8,131  |                         | $      | (3,150 | ) | $ | 4,981 |   | $ | 1,726 |   | $ | (1,249 | ) | $ | 477 |   |

 

----

(1)   The change in interest incomeor interest expense that is attributable to both changes in average balance andaverage rate has been allocated to the changes due to (i) average balance and(ii) average rate in proportion to the relationship of the  absolute amounts of changes in each.

 

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

 

15

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**Table 4**

**Average Balance Sheet and**

**Analysis of Net Interest Income**

 
|                                                                                                                     |   | **2002**                   |    | **2001**                       |   | **2000**                            |   |
|--------------------------------------------------------------------------------------------------------------------------|--------|----------------------------|---------|--------------------------------|--------|-------------------------------------|--------|
|                                                                                                                     |   | **Average  Amount**        |    | **Interest  Income/  Expense** |   | **Weighted  Average  Yield/  Rate** |   | **Average  Amount** |   | **Interest  Income/  Expense** |   | **Weighted  Average  Yield/  Rate** |   | **Average  Amount** |   | **Interest  Income/  Expense** |   | **Weighted  Average  Yield/  Rate** |   |
|                                                                                                                     |   | **(Dollars in thousands)** |    |
| Assets:                                                                                                                  |   |                       |    |                           |   |                                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Federal funds sold and securities purchased under agreements to resell                                                   |   | $                          | 26,514  |                           | 432    |                                | 1.63   | % | $ | 21,446 |   | $ | 812 |   | 3.79 | % | $ | 9,566 |   | $ | 612 |   | 6.40 | % |
| Due from banks - time                                                                                                    |   | 1,348                      |    | 12                             |   | 0.89                                | %      | — |   | — |   | — |   | — |   | — |   | — |   |
| Securities available-for-sale                                                                                            |   | 33,077                     |    | 1,652                          |   | 4.99                                | %      | 51,665 |   | 3,236 |   | 6.26 | % | 71,662 |   | 4,799 |   | 6.70 | % |
| Loans receivable (1) (2)                                                                                                 |   | 254,424                    |    | 17,476                         |   | 6.87                                | %      | 113,615 |   | 9,743 |   | 8.58 | % | 90,909 |   | 9,049 |   | 9.95 | % |
| Total interest earning assets                                                                                            |   | 315,363                    |    | 19,572                         |   | 6.21                                | %      | 186,726 |   | 13,791 |   | 7.39 | % | 172,137 |   | 14,460 |   | 8.40 | % |
|                                                                                                                     |   |                       |    |                           |   |                                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest earning assets:                                                                                              |   |                       |    |                           |   |                                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash and due from banks - demand                                                                                         |   | 20,775                     |    |                           |   |                                |   | 11,698 |   |   |   |   |   | 9,462 |   |   |   |   |   |
| Other assets                                                                                                             |   | 28,348                     |    |                           |   |                                |   | 4,900 |   |   |   |   |   | 2,571 |   |   |   |   |   |
| Allowance for credit losses and net unrealized (loss) gain on sales of  securities available-for-sale                    |   | (5,652                     | )       |                           |   |                                |   | (2,794 | ) |   |   |   |   | (4,778 | ) |   |   |   |   |
| Total assets                                                                                                             |   | $                          | 358,834 |                           |   |                                |   |   | $ | 200,530 |   |   |   |   |   | $ | 179,392 |   |   |   |   |   |
|                                                                                                                     |   |                       |    |                           |   |                                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Liabilities and shareholders’ equity:                                                                               |   |                       |    |                           |   |                                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing deposits:                                                                                               |   |                       |    |                           |   |                                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Demand                                                                                                                   |   | $                          | 28,024  |                           | 322    |                                | 1.15   | % | $ | 9,562 |   | $ | 92 |   | 0.96 | % | $ | 8,066 |   | $ | 113 |   | 1.40 | % |
| Money market and savings                                                                                                 |   | 86,444                     |    | 1,426                          |   | 1.65                                | %      | 40,396 |   | 1,019 |   | 2.52 | % | 37,660 |   | 1,258 |   | 3.34 | % |
| Time certificates of deposit:                                                                                            |   | —                     |    |                           |   |                                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| $ 100,000 or more                                                                                                        |   | 45,770                     |    | 845                            |   | 1.85                                | %      | 31,807 |   | 1,409 |   | 4.43 | % | 20,809 |   | 1,103 |   | 5.30 | % |
| Under $100,000                                                                                                           |   | 38,606                     |    | 1,459                          |   | 3.78                                | %      | 6,975 |   | 308 |   | 4.42 | % | 6,647 |   | 399 |   | 6.00 | % |
| Total time certificates of deposit                                                                                       |   | 84,376                     |    | 2,304                          |   | 2.73                                | %      | 38,782 |   | 1,717 |   | 4.43 | % | 27,456 |   | 1,502 |   | 5.47 | % |
| Total interest-bearing deposits                                                                                          |   | 198,844                    |    | 4,052                          |   | 2.04                                | %      | 88,740 |   | 2,828 |   | 3.19 | % | 73,182 |   | 2,873 |   | 3.93 | % |
| Other borrowings                                                                                                         |   | 11,308                     |    | 478                            |   | 4.23                                | %      | 20,865 |   | 1,011 |   | 4.85 | % | 32,424 |   | 2,082 |   | 6.42 | % |
| Federal funds purchased and securities sold under agreements to  repurchase                                              |   | 2,294                      |    | 134                            |   | 5.84                                | %      | 733 |   | 37 |   | 5.05 | % | 998 |   | 68 |   | 6.81 | % |
| Total interest-bearing liabilities                                                                                       |   | 212,446                    |    | 4,664                          |   | 2.20                                | %      | 110,338 |   | 3,876 |   | 3.51 | % | 106,604 |   | 5,023 |   | 4.71 | % |
|                                                                                                                     |   |                       |    |                           |   |                                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing liabilities:                                                                                         |   |                       |    |                           |   |                                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest bearing demand deposits                                                                                      |   | 102,213                    |    |                           |   |                                |   | 58,883 |   |   |   |   |   | 56,787 |   |   |   |   |   |
| Other liabilities                                                                                                        |   | 3,716                      |    |                           |   |                                |   | 1,197 |   |   |   |   |   | 1,630 |   |   |   |   |   |
| Guaranteed preferred beneficial interests in the Company’s junior  subordinated deferrable interest debentures, net |   | 14,525                     |    |                           |   |                                |   | 7,592 |   |   |   |   |   | — |   |   |   |   |   |
| Shareholders’ equity                                                                                                |   | 25,934                     |    |                           |   |                                |   | 22,520 |   |   |   |   |   | 14,371 |   |   |   |   |   |
| Total liabilities and shareholders’ equity                                                                          |   | $                          | 358,834 |                           |   |                                |   |   | $ | 200,530 |   |   |   |   |   | $ | 179,392 |   |   |   |   |   |
|                                                                                                                     |   |                       |    |                           |   |                                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest income (spread)                                                                                             |   |                       |    | $                              | 14,908 |                                | 4.01   | % |   |   | $ | 9,915 |   | 3.88 | % |   |   | $ | 9,437 |   | 3.69 | % |
|                                                                                                                          |        |                            |         |                                |        |                                     |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

16

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**Provision for Credit Losses**

 

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

 

During 2002, we provided $1.9 million to the allowancefor credit losses to maintain an adequate allowance after the charge-off ofseveral credits.  In 2002 netcharge-offs were $3.6 compared to $218,000 in 2001.  Management determined that a decrease in the allowance for creditlosses was warranted due to the charge off of nonperforming loans.

 

Based on continued loan growth, the relativeuncertainty regarding the state of the economy, the level of nonperformingloans and a relatively constant level of charge offs, it is anticipated thatregular provisions for credit losses will be made during 2003.  Credit quality will be influenced byunderlying trends in the economic cycle, particularly in Southern California,and other factors which are beyond management’s control.  Accordingly, no assurance can be given thatwe will not sustain loan losses that in any particular period are sizable inrelation to the allowance for credit losses. Subsequent evaluation of the loan portfolio, in light of factors thenprevailing, by us and our regulators may indicate a requirement for increasesin the allowance for credit losses through additions to the provision for credit losses.

 

**OtherOperating Income**

 

Other operating income was $1.5 million and $1.2million in 2002 and 2001, respectively. During 2002, there were no sales of securities, accordingly we recordedno net gain on the sale of securities available-for-sale.  In 2001, we sold $33.0 million in securitiesand reported a net gain of $374,000. Fee income related to international services decreased $14,000 as wehave reduced our focus over the past two years on providing theseservices.  Investment services fees declined$22,000 in 2002 compared to prior year due to reduced investor interest in theequities market.  Deposit relatedservices increased 102 percent to $1.4 million during 2002, compared to similarfee income of $684,000 in 2001.  Theincrease in deposit related services was primarily due to deposits acquired inthe South Bay acquisition.

 

**OtherOperating Expenses**

 

Other operating expense increased $4.2 million to$12.9 million in 2002, compared to $8.7 million during 2001.  Salaries and related benefits increased $2.3million or 51.5 percent  to $6.8million, computer data processing expense increased 112.7 percent to $953,000and net occupancy expense increased 32.3 percent to $1.4 million.  During 2002, increases were recorded in mostother noninterest expenses including furniture and equipment expenses up 52.0percent to $418,000, printing and communication expenses 73.5 percent higher,other professional services 29.0 percent higher, promotion and othermiscellaneous expenses up 44.7 percent and insurance and regulatory expense up14.7 percent.  The increased noninterestexpenses are primarily due to the acquisition of South Bay in December 2001 andthe results of its operations in the year 2002.  South Bay is being operated as a separate banking subsidiary,however, certain administrative functions, such as accounting, finance, humanresources, operations administration and loan services, have beencentralized.  Legal expenses increased138.3 percent to $541,000 during 2002 from $227,000 during 2001 largely due toincreased activity required for loan collections at both Banks.  During 2002, $223,000 was recorded for theamortization of core deposit intangibles associated with the South Bayacquisition.  Customer services expensesdeclined $170,000 during 2002 due to the decline in interest rates resulting inthe bank paying for fewer third-party services, such as accounting andbookkeeping services, for its escrow and title insurance depositors.

 

**IncomeTaxes**

 

Deferred tax assets and liabilities are recognized forthe expected future tax consequences of existing differences between financialreporting and tax reporting bases of assets and liabilities, as well as foroperating losses and tax credit carryforwards, using enacted tax laws andrates.  Deferred tax assets will bereduced through a valuation allowance whenever it becomes more likely than notthat all or some portion will not be realized. Deferred income tax expense (benefit) represents the net change in thedeferred tax asset or liability balance during the year. This amount, togetherwith income taxes currently payable or refundable in the current year,represents the total tax expense for the year.

 

At December 31, 2002, our deferred tax asset totaled$8.0 million, respectively, with no recorded valuation allowance.

 

17

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For tax purposes at December 31, 2002, we had (i)federal net operation loss carryforwards (“NOLs”) of $18.2 million, which beginto expire in 2009; (ii) California NOLs of $559,000 which will expire in 2005;(iii) a federal alternative minimum tax (“AMT”) credit carryforward of$298,000, and (iv) a California AMT credit carryforward of $16,000.  The California NOL was scheduled to expirein 2002, however, the state legislature suspended NOL utilization and extendedthe related carryforward expiration. The AMT credits carryforward indefinitely.

 

An income tax provision of $127,000 was recorded for2002.  Taxable income was greater thanthe reported results of operations due to the amortization of the core depositintangible and the minority interest of the South Bay Series A preferred sharesin our income, which are not deductible charges for tax purposes.  During 2001, a $92,000 provision for incometax was recorded representing AMT due to the utilization of previouslyunrecognized tax benefits to offset current period tax liability.

 

Federal and state income tax laws provide thatfollowing an ownership change of a corporation with NOLs, a net unrealizedbuilt-in loss or tax credit carryovers, the amount of annual post-ownershipchange taxable income that can be offset by pre-ownership change NOLs, built-inlosses or tax credit carryovers generally cannot exceed a prescribed annuallimitation.  The annual limitationgenerally equals the product of the fair market value of the corporationimmediately before the ownership change (subject to certain adjustments) andthe federal long-term tax-exempt rate prescribed monthly by the InternalRevenue Service.  If such limitationswere to apply to us, our ability to reduce future taxable income by the NOLscould be severely limited.

 

## **Accumulated OtherComprehensive Income**

 

Changes in the unrealized gain on available-for-salesecurities, net of taxes is the only component of our other comprehensiveincome.  At December 31, 2002 the netunrealized gain on available-for-sale securities was $202,000 compared to anunrealized gain of $56,000 at December 31, 2001.

 

Continuing the trend from 2001, the U.S. economyexperienced significant declines in interest rates during 2002 across allmaturity durations following the Federal Reserve Open Market Committeereduction in the federal funds target rate and the discount rate.  The reduction in interest rates increased theestimated fair value of our portfolio of largely fixed rate available-for-salesecurities resulting in $146,000 and $966,000 net unrealized holding gainsduring 2002 and 2001, respectively.

 

**FINANCIALCONDITION**

 

## **Regulatory Capital**

 

The following table sets forth the regulatorystandards for well-capitalized institutions and our regulatory capital ratiosas of December 31, 2002 and 2001.

 

**Table 5**

**RegulatoryCapital Information**

**ofNational Mercantile and the Banks**

 
|                             |   | **For  Capital  Adequacy  Purposes** |   | **Well  Capitalized  Standards** |   | **December 31,** |   |
|----------------------------------|--------|--------------------------------------|--------|----------------------------------|--------|------------------|--------|
| **2002**                         |   | **2001**                             |
| **National Mercantile Bancorp:** |   |                                 |   |                             |   |             |   |   |   |
| Tier 1 leverage                  |   | 4.00                                 | %      | N/A                              |   | 8.60             | %      | 5.55 | % |
| Tier 1 risk-based capital        |   | 4.00                                 | %      | N/A                              |   | 10.57            | %      | 6.85 | % |
| Total risk-based capital         |   | 8.00                                 | %      | N/A                              |   | 13.31            | %      | 11.53 | % |
|                             |   |                                 |   |                             |   |             |   |   |   |
| **Mercantile National Bank:**    |   |                                 |   |                             |   |             |   |   |   |
| Tier 1 leverage                  |   | 4.00                                 | %      | 5.00                             | %      | 7.20             | %      | 6.85 | % |
| Tier 1 risk-based capital        |   | 4.00                                 | %      | 6.00                             | %      | 9.89             | %      | 10.50 | % |
| Total risk-based capital         |   | 8.00                                 | %      | 10.00                            | %      | 11.15            | %      | 11.76 | % |
|                             |   |                                 |   |                             |   |             |   |   |   |
| **South Bay Bank, NA:**          |   |                                 |   |                             |   |             |   |   |   |
| Tier 1 leverage                  |   | 4.00                                 | %      | 5.00                             | %      | 9.38             | %      | 8.72 | % |
| Tier 1 risk-based capital        |   | 4.00                                 | %      | 6.00                             | %      | 10.90            | %      | 9.63 | % |
| Total risk-based capital         |   | 8.00                                 | %      | 10.00                            | %      | 12.15            | %      | 10.90 | % |

 

## **National Mercantile’s Tier 1capital, which is comprised of shareholders’ equity as modified by certainregulatory adjustments, was $29.9 million and $19.6 million at December 31,2002 and 2001, respectively.  NationalMercantile’s Tier 1 capital increased in 2002 as a result of the issuance of$7.7 million in common shares and the inclusion of a greater amount of ourTrust Preferred**

 

18

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Securities in Tier 1 capital. Federal Reserve capital rules allow trust preferred securities torepresent 25% of Tier 1 capital with the excess treated as Tier 2 capital.  At December 31, 2002 and 2001, TrustPreferred Securities represented $10.3 million and $4.7 million, respectively,of National Mercantile’s Tier 1 capital, and $4.2 and $9.8 million,respectively, of its Tier 2 capital. Offsetting these additions to Tier 1 capital was the redemption of theSouth Bay Series A Preferred which eliminated a $676,000 minority interest inSouth Bay’s preferred stock as well as a $1.8 million discount for beneficialconversion rights recorded as additional paid in capital.  Disallowed against National Mercantile’sTier 1 capital is $2.2 million of goodwill recorded in the acquisition of SouthBay, $2.1 million of other intangible assets and $7.2 million of deferred taxasset based upon estimated earnings.  Areduction in estimated earnings will increase the amount of the disalloweddeferred tax asset and will have the effect of reducing our regulatory capital.

 

The increase in National Mercantile’s regulatorycapital ratios at December 31, 2002 compared to the prior year is due to thenet increases in regulatory capital discussed above as well as a decrease intotal assets.

 

Mercantile’s Tier 1 capital was $12.6 million and$13.1 million at December 31, 2002 and 2001, respectively.  The decrease in Tier 1 capital during 2002was due to an increase in the amount of the purchase price of South Bay to thedeferred tax asset offset by retained earnings from operations.  The deferred tax asset related to the NOL isrecorded on Mercantile’s books.  Becausethe allowable portion of the deferred tax asset is based upon our estimatedtwelve-month’s earnings of the consolidated entity, as discussed above, areduction in estimated earnings will likewise reduce Mercantile’s regulatorycapital.

 

South Bay’s Tier 1 capital at December 31, 2002 was$17.0 million compared to $16.1 million at December 31, 2001.  The increase is due to a reduction in thegoodwill disallowed for regulatory purposes, the sale of $3.0 million of commonshares to National Mercantile and earnings from operations offset by theredemption of $2.5 million outstanding South Bay Series A Preferred, thepayment of $800,000 of dividends to National Mercantile and the payment ofdividends of $213,000 to South Bay Series A Preferred shareholders.

 

**Liquidity Management**

 

The objective of liquidity management is to maintaincash flow adequate to fund our operations and meet obligations and othercommitments on a timely and cost effective basis.  We manage to this objective primarily through the selection ofasset and liability maturity mixes.  Ourliquidity position is enhanced by the ability to raise additional funds asneeded through available borrowings or accessing the wholesale deposit market.

 

Our deposit base provides the majority of fundingrequirements.  This relatively stableand low-cost source of funds has, along with shareholders’ equity, provided83.9 percent and 73.6 percent of funding for average total assets during 2002and 2001, respectively.  The increase of10.3 percent was attributable to the deposits provided by the South Bayacquisition with reduced funding from other borrowings.  The other borrowings, specifically FederalHome Loan Bank (“FHLB”) advances, which averaged $11.3 million during 2002compared to $20.9 million during 2001, and federal funds purchased andsecurities sold under agreements to repurchase, which averaged $2.3 million in2002 compared to $733,000 in 2001, comprise the balance of the liabilityfunding.  The decline in relativelyhigh-cost other borrowings during 2002 was offset by deposits and capitalsources of funding.

 

Liquidity is also provided by assets such as federalfunds sold and securities purchased under resale agreements that may beimmediately converted to cash at minimal cost. The aggregate of these assetsaveraged $26.5 million during 2002, as compared to $21.4 million during 2001.

 

The portfolio of available-for-sale securities is anadditional source of liquidity, which averaged $33.1 million during 2002compared to $51.7 million in 2001.  Thesecurities available-for-sale were reduced in 2002 in order to payoff otherborrowings and reduce the exposure to value deterioration in the event of arebound in interest rates.  Theunpledged portion of investment securities at December 31, 2002 totaled $7.9million and was available as collateral for borrowings.  Maturing loans also provide liquidity, ofwhich $207.2 million of the Banks’ loans are scheduled to mature in 2003.

 

Net cash provided by operating activities totaled $2.6million in 2002 compared to $2.0 million in 2001.  The primary source of funds is net income from operationsadjusted for provision for credit losses and depreciation andamortization.  Net cash provided byinvesting activities totaled $20,000 in 2002 compared to $19.3 million in 2001.  The decrease in cash provided by investingactivities resulted from a reduction in the proceeds from sales, repayments andmaturities of securities available-for-sale partially offset by anincrease  in net loan originations.  Net cash used in financing activities was$17.1 million in 2002 compared to $4.1 million provided by financing activitiesin 2001.  The decrease in 2002 resultedprimarily from a decrease in time certificates of deposits, other borrowedfunds and securities sold under agreements to repurchase in addition to theredemption of the South Bay Series A Preferred offset by an increase in demand,money market and savings deposits and the issuance of common stock.

 

19

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**Interest Rate Risk Management**

 

Interest rate risk management seeks to maintain astable growth of income and manage the risk associated with changes in interestrates.  Net interest income, the primarysource of earnings, is affected by interest rate movements.  Changes in interest rates have a lesserimpact the more that assets and liabilities reprice in approximately equivalentamounts at basically the same time intervals. Imbalances in these repricing opportunities at any point in timeconstitute interest sensitivity gaps, which is the difference between interestsensitive assets and interest sensitive liabilities.

 

Interest rate risk, including interest ratesensitivity and the repricing characteristics of assets and liabilities, ismanaged by the Interest Rate Risk Management Committee (“IRRMC”).  The principal objective of IRRMC is tomaximize net interest income within acceptable levels of risk established bypolicy.

 

We manage interest rate sensitivity by matching therepricing opportunities on our earning assets to those on our fundingliabilities.  We use various strategiesto manage the repricing characteristics of our assets and liabilities to ensurethat exposure to interest rate fluctuations is limited within guidelines ofacceptable levels of risk-taking. Hedging strategies, including the terms and pricing of loans and deposits,and managing the deployment of our securities are used to reduce mismatches ininterest rate repricing opportunities of portfolio assets and their fundingsources.  Interest rate risk is measuredusing financial modeling techniques, including stress tests, to measure theimpact of changes in interest rates on future earnings.  These static measurements do not reflect theresults of any projected activity and are best used as early indicators ofpotential interest rate exposures.

 

An asset sensitive gap means an excess of interestsensitive assets over interest sensitive liabilities, whereas a liabilitysensitive gap means an excess of interest sensitive liabilities over interestsensitive assets.  In a changing rateenvironment, a mismatched gap position generally indicates that changes in theincome from interest earning assets will not be proportionate to changes in thecost of interest bearing liabilities, resulting in net interest incomevolatility.

 

Table 6 compares our interest rate gap position as ofDecember 31, 2002 and 2001.  The gapreport shows a cumulative one year interest rate asset sensitivity gap of $36.7million at December 31, 2002, a change from an asset sensitivity gap of $19.2million at December 31, 2001.  Theincrease in asset sensitivity was due to a $30.5 million increase in loansreceivable maturing or repricing in less than one year and a reduction in otherborrowings maturing in less than one year partially offset by an increase inimmediately repricable demand, money market and savings deposits.  The greater volume of loans repricing withinone year is due to the greater emphasis on growth in commercial loans which aretypically adjustable rate loans.  Theincrease in demand, money market and savings deposits is due similarly to theemphasis on commercial borrowers as well as a change in mix from timecertificates of deposit to savings deposits. In the low interest rate environment, depositors have moved maturingtime certificates of deposits to savings deposits.

 

Since interest rate changes do not affect allcategories of assets and liabilities equally or simultaneously, a cumulativegap analysis alone cannot be used to evaluate the interest rate sensitivityposition.  To supplement traditional gapanalysis, interest rate sensitivities are also monitored through the use ofsimulation modeling techniques that apply alternative interest rate scenariosto periodic forecasts of future business activity and estimate the relatedimpact on net interest income.  The useof simulation modeling assists management in its continuing efforts to achieveearnings growth in varying interest environments.

 

Key assumptions in the model include anticipatedprepayments on mortgage-related instruments, contractual cash flow andmaturities of all financial instruments, anticipated future business activity,deposit rate sensitivity and changes in market conditions.  These assumptions are inherently uncertainand, as a result, these models cannot precisely estimate the impact that higher or lower rate environmentswill have on net interest income. Actual results will differ from simulated results due to the timing,magnitude and frequency of interest rate changes, changes in cash flow patternsand market conditions, as well as changes in management’s strategies.  The model results are consistent with thegap analysis reflecting our asset sensitivity position.

 

Our asset sensitive position during a period of slowlydeclining interest rates is not expected to have a significant negative impacton net interest income since we have a large base of immediately adjustableinterest bearing demand, savings and money market deposits.  However, since we are asset sensitive, in aperiod of rapidly declining interest rates, such as the environment that wasexperienced during 2001, the rapid decline will have a negative effect on ournet interest income as changes in the rates of interest bearing depositshistorically have not changed proportionately with changes in market interestrates.  Additionally, in low and declinginginterest rate environments, such as the environment experienced in 2002, theinterest rates paid on funding liabilities may begin to reach floors preventingfurther downward adjustments while rates on earning assets continue to adjustdownward.  This condition will likewisehave a negative impact on our net interest income.

 

20

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**Table6**

**Rate-SensitiveAssets and Liabilities**

 
|                                                                     |   | **December  31, 2002**        |   |
|--------------------------------------------------------------------------|--------|-------------------------------|--------|
|                                                                     |   | **Maturing  or repricing in** |   |
|                                                                     |   | **Less  than  three  months** |   | **After  three  months  but within  one year** |   | **After  one  year  but within  5 years** |   | **After  5 years** |   | **Total** |   |
|                                                                     |   | **(Dollars  in thousands)**   |   |
| Rate-Sensitive Assets:                                                   |   |                          |   |   |   |   |   |   |   |   |   |
| Federal funds sold and securities purchased under agreements to resell   |   | $                             | 18,700 |   | $ | — |   | $ | — |   | $ | — |   | $ | 18,700 |   |
| Securities available-for-sale, at amortized cost                         |   | —                        |   | 998 |   | 1,857 |   | 22,969 |   | 25,824 |   |
| Due from banks - time                                                    |   | —                        |   | 325 |   | — |   | — |   | 325 |   |
| FRB and other stock, at cost                                             |   | —                        |   | — |   | — |   | 2,018 |   | 2,018 |   |
| Loans receivable(1)                                                      |   | 196,286                       |   | 10,907 |   | 40,375 |   | 19,425 |   | 266,993 |   |
| Total rate-sensitive assets                                              |   | 214,986                       |   | 12,230 |   | 42,232 |   | 44,412 |   | 313,860 |   |
|                                                                     |   |                          |   |   |   |   |   |   |   |   |   |
| Rate-Sensitive Liabilities:(2)                                           |   |                          |   |   |   |   |   |   |   |   |   |
| Interest bearing deposits:                                               |   |                          |   |   |   |   |   |   |   |   |   |
| Demand, money market and savings                                         |   | 115,781                       |   | — |   | — |   | — |   | 115,781 |   |
| Time certificates of deposit                                             |   | 41,381                        |   | 31,865 |   | 6,617 |   | — |   | 79,863 |   |
| Other borrowings                                                         |   | —                        |   | 1,476 |   | — |   | — |   | 1,476 |   |
| Total rate-sensitive liabilities                                         |   | 157,162                       |   | 33,341 |   | 6,617 |   | 0 |   | 197,120 |   |
| Interest rate-sensitivity gap                                            |   | 57,824                        |   | (21,111 | ) | 35,615 |   | 44,412 |   | 116,740 |   |
| Cumulative interest rate-sensitivity gap                                 |   | $                             | 57,824 |   | $ | 36,713 |   | $ | 72,328 |   | $ | 116,740 |   |   |   |
| Cumulative ratio of rate sensitive assets to rate-sensitive  liabilities |   | 137                           | %      | 119 | % | 137 | % | 159 | % |   |   |
|                                                                          |        |                               |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

(1)          Loans receivable excludes nonaccrual loans.

(2)          Deposits which are subject to immediate withdrawal are presented asrepricing within three months or less.

The distribution of other time deposits is based on scheduledmaturities.

 

21

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|                                                                     |   | **December  31, 2001**        |   |
|--------------------------------------------------------------------------|--------|-------------------------------|--------|
|                                                                     |   | **Maturing  or repricing in** |   |
|                                                                     |   | **Less  than  three  months** |   | **After  three  months  but within  one year** |   | **After  one  year  but within  5 years** |   | **After  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(1)                                                      |   | 156,825                       |   | 19,838 |   | 58,051 |   | 19,447 |   | 254,161 |   |
| Total rate-sensitive assets                                              |   | 198,244                       |   | 19,838 |   | 58,147 |   | 61,516 |   | 337,745 |   |
|                                                                     |   |                          |   |   |   |   |   |   |   |   |   |
| Rate-Sensitive Liabilities:(2)                                           |   |                          |   |   |   |   |   |   |   |   |   |
| 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 |   | 16,247 |   | 0 |   | 215,091 |   |
| Interest rate-sensitivity gap                                            |   | 42,692                        |   | (23,454 | ) | 41,900 |   | 61,516 |   | 122,654 |   |
| Cumulative interest rate-sensitivity gap                                 |   | $                             | 42,692 |   | $ | 19,238 |   | $ | 61,138 |   | $ | 122,654 |   |   |   |
| Cumulative ratio of rate sensitive assets to rate-sensitive  liabilities |   | 127                           | %      | 110 | % | 128 | % | 157 | % |   |   |
|                                                                          |        |                               |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)          Loans receivable excludes nonaccrual loans.

(2)          Deposits which are subject to immediate withdrawal are presented asrepricing within three months or less.

The distribution of other time deposits is based on scheduled maturities.

 

**InvestmentSecurities**

 

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

 

We generally classify our investment securities asavailable-for-sale except for investment securities we have the ability and thepositive intent to hold to maturity which are classified as held-to-maturitysecurities.   There were noheld-to-maturity securities at December 31, 2002 and 2001.

 

Table 7 provides certain information regarding ourinvestment securities.

 

22

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**Table 7**

** **

**EstimatedFair Values of and Unrealized**

**Gainsand Losses on Investment Securities**

 
|                                                                            |   | **December 31, 2002**      |       |
|---------------------------------------------------------------------------------|--------|----------------------------|------------|
|                                                                            |   | **Total  amortized  cost** |       | **Gross  unrealized  gains** |   | **Gross  unrealized  loss** |   | **Estimated  fair  value** |   |
|                                                                            |   | **(Dollars in thousands)** |       |
|                                                                            |   |                       | ** ** |   | ** ** |   | ** ** |   | ** ** |
| U.S. Treasury securities                                                        |   | $                          | 998        |   | $ | — |   | $ | 1 |   | $ | 997 |   |
| GNMA-issued/guaranteed  mortgage pass through certificates                      |   | 2,409                      |       | 73 |   | — |   | 2,482 |   |
| FHLMC/FNMA-issued mortgage  pass through certificates                           |   | 12,370                     |       | 506 |   | — |   | 12,876 |   |
| CMO’s and REMIC’s issued by  U.S. government-sponsored  agencies |   | 4,544                      |       | 44 |   | — |   | 4,588 |   |
| Privately issued corporate  bonds, CMO and REMIC securities                     |   | 5,503                      |       | 12 |   | 288 |   | 5,227 |   |
|                                                                            |   | $                          | 25,824     |   | $ | 635 |   | $ | 289 |   | $ | 26,170 |   |
|                                                                            |   |                       |       |   |   |   |   |   |   |
| FRB and other equity stocks                                                     |   | $                          | 2,018      |   | — |   | — |   | $ | 2,018 |   |

 
|                                                                            |   | **December 31, 2001**      |       |
|---------------------------------------------------------------------------------|--------|----------------------------|------------|
|                                                                            |   | **Total  amortized  cost** |       | **Gross  unrealized  gains** |   | **Gross  unrealized  loss** |   | **Estimated  fair  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 |   | 32 |   | 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 and REMIC securities                     |   | 2,510                      |       | 4 |   | 175 |   | 2,339 |   |
|                                                                            |   | $                          | 41,532     |   | $ | 358 |   | $ | 263 |   | $ | 41,627 |   |
|                                                                            |   |                       |       |   |   |   |   |   |   |
| FRB and other equity stocks                                                     |   | $                          | 2,552      |   | — |   | ` |   | $ | 2,552 |   |

 
|                                                                            |   | **December 31, 2000**      |       |
|---------------------------------------------------------------------------------|--------|----------------------------|------------|
|                                                                            |   | **Total  amortized  cost** |       | **Gross  unrealized  gains** |   | **Gross  unrealized  loss** |   | **Estimated  fair  value** |   |
|                                                                            |   | **(Dollars in thousands)** |       |
|                                                                            |   |                       | ** ** |   | ** ** |   | ** ** |   | ** ** |
| U.S. Treasury securities                                                        |   | $                          | 2,008      |   | $ | 9 |   | $ | — |   | $ | 2,017 |   |
| GNMA-issued/guaranteed  mortgage pass through certificates                      |   | 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                           |   | 15,172                     |       | 86 |   | 36 |   | 15,222 |   |
| CMO’s and REMIC’s issued by  U.S. government-sponsored  agencies |   | 36,532                     |       | 1 |   | 669 |   | 35,864 |   |
| Privately issued corporate  bonds, CMO and REMIC securities                     |   | 4,001                      |       | — |   | 87 |   | 3,914 |   |
|                                                                            |   | $                          | 64,953     |   | $ | 256 |   | $ | 792 |   | $ | 64,417 |   |
|                                                                            |   |                       |       |   |   |   |   |   |   |
| FRB and other equity stocks                                                     |   | $                          | 2,733      |   | — |   | — |   | $ | 2,773 |   |

 

23

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At December 31, 2002, we held no securities from anyissuer other than by U.S. government agencies and corporations in which theaggregate book value exceeded 10% of our shareholders’ equity.

 

Our present strategy is to stagger the maturities ofinvestment securities to meet our overall liquidity requirements.  Table 10 sets forth information concerningthe contractual maturity of and weighted average yield of our investmentsecurities at December 31, 2002.

 

**Table 8**

**Maturitiesof and Weighted Average Yields on**

**InvestmentSecurities**

 
|                                                                      |   | **Within one  year**        |       | **After one but  within five years** |      | **After five  but  within ten years** |   | **After ten  years** |       | **Total** |      | **Weighted  Average  Yield** |   |
|---------------------------------------------------------------------------|--------|-----------------------------|------------|--------------------------------------|-----------|---------------------------------------|--------|----------------------|------------|-----------|-----------|------------------------------|--------|
| **Amount**                                                                |   | **Yield**                   | **Amount** |                                 | **Yield** | **Amount**                            |   | **Yield**            | **Amount** |      | **Yield** |
|                                                                      |   | **(Dollars in  thousands)** |       |
|                                                                      |   |                        |       |                                 |      |                                  |   |                 |       |      |      |                         |   |   |   |   |   |   |   |   |   |
| Securities available-for-sale:                                            |   |                        |       |                                 |      |                                  |   |                 |       |      |      |                         |   |   |   |   |   |   |   |   |   |
| U.S Treasury securities                                                   |   | $                           | 997        |                                 | 1.19      | %                                     | $      | —               |       | —    |      | $                            | — |   | — |   | $ | — |   | — |   | $ | 997 |   | 1.19 | % |
| GNMA-issued/guaranteed  mortgage pass-through certificates           |   | —                      |       | —                               |      | —                                |   | —               |       | —    |      | —                       |   | 2,482 |   | 7.20 | % | 2,482 |   | 7.20 | % |
| Other U.S. government and  federal agencies                               |   | —                      |       | —                               |      | —                                |   | —               |       | —    |      | —                       |   | — |   | — |   | — |   | — |   |
| FHLMC/FNMA-issued mortgage  pass-through certificates                     |   | —                      |       | —                               |      | 1,898                                 |   | 5.53                 | %          | 1,043     |      | 6.17                         | %      | 9,935 |   | 6.76 | % | 12,876 |   | 6.53 | % |
| CMO’s and REMIC’s issued by  U.S. government-sponsored agencies |   | —                      |       | —                               |      | —                                |   | —               |       | 1,721     |      | 5.51                         | %      | 2,867 |   | 6.57 | % | 4,588 |   | 6.17 | % |
| Privately issued corporate  bonds, CMO’s and REMIC’s securities |   | —                      |       | —                               |      | —                                |   | —               |       | 1,917     |      | 0                            |   | 3,310 |   | 4.45 | % | 5,227 |   | 3.65 | % |
|                                                                      |   | $                           | 997        |                                 | 4.29      | %                                     | $      | 1,898                |       | 5.53      | %         | $                            | 4,681  |   | 0 |   | $ | 18,594 |   | 6.38 | % | $ | 26,170 |   | 5.76 | % |
|                                                                      |   |                        |       |                                 |      |                                  |   |                 |       |      |      |                         |   |   |   |   |   |   |   |   |   |
| Amortized Cost                                                            |   | $                           | 998        |                                 |      |                                  | $      | 1,857                |       |      |      | $                            | 4,619  |   |   |   | $ | 18,350 |   |   |   | $ | 25,824 |   |   |   |
|                                                                      |   |                        |       |                                 |      |                                  |   |                 |       |      |      |                         |   |   |   |   |   |   |   |   |   |
| FRB and other equity stocks                                               |   | 2,018                       |       | —                               |      | —                                |   | —               |       | —    |      | —                       |   | — |   | 0.00 | % | 2,018 |   | — |   |

 

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

 

**LendingActivities**

 

Through Mercantile and South Bay we engage incommercial banking, serving small to medium-sized businesses in the nichemarkets of entertainment, healthcare, business banking, and community-basednonprofit organizations, business executives, professionals and otherindividuals, providing commercial and residential real estate financing, realestate construction financing and commercial lending, consumer and home equityloans.  Our primary geographic focus isthe Los Angeles basin of Los Angeles County, with four branch banking offices consistingof Mercantile Bank’s offices located in Century City and Encino, and South BayBank’s offices located in Torrance and El Segundo.  We offer a full range of loan, deposit and investment productswhich are designed to meet specific customer needs and are offered with highlypersonalized service.

 

Loan products include commercial real estate loans,construction financing, revolving lines of credit, term loans and consumer andhome equity loans, along with an array of deposits and investment accounts thatoften contain 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 market niches have included theentertainment industry, professional services providers, healthcare andcommunity-based nonprofit organizations. Entertainment industry customers include television, music and filmproduction companies, talent agencies, individual performers, directors andproducers (whom we attract by establishing relationships with businessmanagement firms), and others affiliated with the entertainment industry.   Professional service customers includelegal, accounting, insurance, advertising firms and their individual directors,officers, partners and shareholders. Healthcare organizations include primarily outpatient healthcareproviders such as physician medical groups, independent practice associationsand surgery centers.

 

24

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# ***Loan Portfolio***

 

The following table sets forth the composition of ourloan portfolio at the dates indicated**:**

** **

**Table 9**

**Loan Portfolio Composition**

 
|                                                                  |   | **December  31,**          |    |
|-----------------------------------------------------------------------|--------|----------------------------|---------|
|                                                                  |   | **2002**                   |    | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
|                                                                  |   | **Amount**                 |    | **Percent** |   | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   |
|                                                                  |   | **(Dollars in thousands)** |    |
| Commercial loans:                                                     |   |                       |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Secured by one to four  family residential properties                 |   | $                          | 10,797  |   | 4 | % | $ | 27,069 |   | 10 | % | $ | 6,578 |   | 6 | % | $ | 4,405 |   | 6 | % | $ | 5,005 |   | 9 | % |
| Secured by multifamily  residential properties                        |   | 12,596                     |    | 5 |   | 8,492 |   | 3 |   | 3,765 |   | 3 |   | 5,355 |   | 7 |   | 3,111 |   | 5 |   |
| Secured by commercial real  properties.                               |   | 119,872                    |    | 44 |   | 95,142 |   | 36 |   | 40,540 |   | 37 |   | 28,233 |   | 38 |   | 20,839 |   | 36 |   |
| Other - secured and  unsecured                                        |   | 86,015                     |    | 32 |   | 85,292 |   | 33 |   | 53,433 |   | 48 |   | 33,221 |   | 45 |   | 24,337 |   | 43 |   |
| Real estate construction and  land development                        |   | 37,934                     |    | 14 |   | 30,811 |   | 12 |   | 1,890 |   | 2 |   | 6 |   | — |   | — |   | — |   |
| Consumer installment, home  equity and unsecured loans to individuals |   | 5,566                      |    | 1 |   | 15,306 |   | 6 |   | 4,373 |   | 4 |   | 2,863 |   | 4 |   | 3,978 |   | 7 |   |
| Total loans outstanding                                               |   | 272,780                    |    | 100 | % | 262,112 |   | 100 | % | 110,579 |   | 100 | % | 74,083 |   | 100 | % | 57,270 |   | 100 | % |
|                                                                  |   |                       |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Deferred net loan  origination fees and purchased loan discount       |   | (458                       | )       |   |   | (144 | ) |   |   | (331 | ) |   |   | (240 | ) |   |   | (298 | ) |   |   |
| Loans receivable, net                                                 |   | $                          | 272,322 |   |   |   | $ | 261,968 |   |   |   | $ | 110,248 |   |   |   | $ | 73,843 |   |   |   | $ | 56,972 |   |   |   |

** **

Most of the our commercial loans are generally within$100,000 to $3.0 million and our consumer and home equity loans generally areless than $100,000.  The Banks may notmake any loan, with certain limited exceptions, in excess of their loan to oneborrower limit under applicable regulations ($2.3 million for Mercantile and$2.8 million for South Bay at December 31, 2002).  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.

 

*CommercialLoans Secured by Real Estate. *Weoffer adjustable and fixed rate secured loans to finance the purchase orholding of commercial real estate, one to four family residences andmulti-family residences.  These loansgenerally have maturities ranging from three to fifteen years and paymentsbased on a 15 to 25 years schedule.  Theoriginal principal amount of a real estate loan generally does not exceed 65%to 75% of the appraised value of the property (or the lesser of the appraisedvalue or the purchase price for the property if the loan is made to finance thepurchase of the property).

* *

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

 

Collateral for commercial loans may include commercialor residential real property, accounts receivable, inventory, equipment, marketablesecurities or other assets.  Unsecuredcommercial loans include short-term term loans and lines of credit. Ourunderwriting guidelines for these loans generally require that the borrowerhave low levels of existing debt, working capital sufficient to cover the loanand a history of earnings and cash flow. Typically, unsecured lines of creditmust be unused for a continuous 30-day period within each year to demonstratethe borrower’s ability to have sufficient funds to operate without the credit line.

 

*RealEstate Construction and Land Development Loans*.  Real estate construction and landdevelopment loans are short-term secured loans made to finance the constructionof commercial, one to four-family and multifamily residential properties or forimprovements to raw land.  These loansinclude financing for developers for the construction of residential tracthomes and custom homes.  Our real estateconstruction and loan development loans are primarily for properties located inSouthern California.  These loanstypically have adjustable rates with terms of twelve to fifteen months.  We monitor the progress of the constructionand disburse the loan proceeds directly to the various contractors duringstages of improvement.  Generally, theamount of a construction loan generally does not exceed 65% of the appraisedcompletion value and the borrower’s funds are disbursed prior to disbursementof the construction loan.

 

25

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*ConsumerInstallment Loans and Home Equity Lines of 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 Concentrations*

 

We provide banking services to the entertainmentindustry in Southern California.  Table10 below presents information about the loans outstanding to entertainmentrelated customers at December 31, 2002 and 2001.

 

**Table 10**

**Industry Concentrations of Loans**

 
|                                                                                                                                               |   | **December 31,**           |   |
|----------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------|--------|
|                                                                                                                                               |   | **2002**                   |   | **2001** |   |
|                                                                                                                                               |   | **(Dollars in thousands)** |   |
| Entertainment industry-related  loans:                                                                                                             |   |                       |   |   |   |
| Loans for single  productions of motion picture and television feature films                                                                       |   | $                          | 6,652  |   | $ | 5,054 |   |
| Other loans to  entertainment-related enterprises, such as television, music, film and talent  agencies                                            |   | 19,620                     |   | 12,069 |   |
| Loans to individuals  involved primarily in the entertainment industry                                                                             |   | 4,868                      |   | 7,144 |   |
| Loans to business  management, legal and accounting firms, including their principals and  employees, serving primarily the entertainmemt industry |   | —                     |   | 2,183 |   |
| Total entertainment  industry-related loans                                                                                                        |   | $                          | 31,140 |   | $ | 26,450 |   |
| Percent of total loans  outstanding                                                                                                                |   | 11.4                       | %      | 10.1 | % |

 

*Loan Rate Composition and Maturities*

 

Of our total loans outstanding, excluding loans onnonaccrual, 68.7% and 55.6% had adjustable rates at December 31, 2002 and 2001,respectively.  Adjustable rate loansgenerally have interest rates tied to the prime rate and adjust with changes inthe rate on a daily, monthly or quarterly basis.

 

Of our total loans outstanding, excluding nonaccrualloans, at December 31, 2002, 36.7% were due in one year or less, 45.3% were duein 1-5 years and 17.9% were due after 5 years.   As is customary in the banking industry, loans can be renewed bymutual agreement between the borrower and us. Because we are unable to estimate the extent to which its borrowers willrenew their loans, Table 11 is based on contractual maturities.

 

*Loan Commitments*

 

Loan commitments are agreements to lend to a customera specified amount subject to certain conditions.  Loan commitments generally have fixed expiration dates or othertermination clauses and may require payment of a fee.  Since portions of the commitments are expected to expire withoutbeing drawn upon, the total amount of commitments does not necessarilyrepresent future cash requirements.

 

We had outstanding loan commitments aggregating $55.7million at December 31, 2002, substantially all of which were for commercialloans with variable rates.  In addition,we had $629,000 outstanding letters of credit at December 31, 2002.

 

 

26

----

 

 

**Table 11**

**Loan Maturities**

 
|                                                                                  |   | **December 31, 2002**                           |    |
|---------------------------------------------------------------------------------------|--------|-------------------------------------------------|---------|
|                                                                                  |   | **Interest rates  are floating  or adjustable** |    | **Interest rates  are fixed or  predetermined** |   | **Total** |   |
|                                                                                  |   | **(Dollars in thousands)**                      |    |
|                                                                                  |   |                                            |    |   |   |   |   |
| Aggregate maturities of  total loans outstanding:                                     |   |                                            |    |   |   |   |   |
| Commercial secured by real  estate                                                    |   |                                            |    |   |   |   |   |
| In one year or less                                                                   |   | $                                               | 41,726  |   | $ | 6,344 |   | $ | 48,070 |   |
| After one year but within  five years                                                 |   | 40,089                                          |    | 21,622 |   | 61,711 |   |
| After five years                                                                      |   | 14,333                                          |    | 15,201 |   | 29,534 |   |
| Commecial other secured and  unsecured                                                |   |                                            |    |   |   |   |   |
| In one year or less                                                                   |   | 29,174                                          |    | 16,187 |   | 45,361 |   |
| After one year but within  five years                                                 |   | 18,970                                          |    | 10,944 |   | 29,914 |   |
| After five years                                                                      |   | 5,301                                           |    | 3,602 |   | 8,903 |   |
| Real estate construction  and land development                                        |   |                                            |    |   |   |   |   |
| In one year or less                                                                   |   | 3,323                                           |    | 746 |   | 4,069 |   |
| After one year but within  five years                                                 |   | 21,254                                          |    | 3,204 |   | 24,458 |   |
| After five years                                                                      |   | 8,785                                           |    | 622 |   | 9,407 |   |
| Consumer installment, home  equity lines of credit and unsecured loans to individuals |   |                                            |    |   |   |   |   |
| In one year or less                                                                   |   | 152                                             |    | 451 |   | 603 |   |
| After one year but within  five years                                                 |   | 358                                             |    | 4,605 |   | 4,963 |   |
| After five years                                                                      |   | —                                          |    | — |   | — |   |
| Total loans outstanding(1)                                                            |   | $                                               | 183,465 |   | $ | 83,528 |   | $ | 266,993 |   |

 

----

(1) Excluding nonaccrualloans

** **

**AssetQuality and 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*

 

Nonperforming assets consist of nonperforming loansand other real estate owned. Nonperforming loans are (i) loans which have been placed on nonaccrualstatus, (ii) troubled debt restructurings (“TDR’s”), or (iii) loans which arecontractually past due ninety days or more with respect to principal orinterest, and have not been restructured or placed on nonaccrual status, andare accruing interest as described below. Other real estate owned consists of real properties securing loans ofwhich we have taken title in partial or complete satisfaction of the loan.  Other than the nonperforming assets atDecember 31, 2002, we had no loans that cause management to have serious doubtsabout the ability of the borrower to comply with the present loan repaymentterms and we had no other interest earning assets that were considered impairedat December 31, 2002.  Information aboutnonperforming assets is presented in Table 12.

 

27

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**Table 12**

**Nonperforming Assets**

 
|                                                                                                                        |   | **December 31,**           |   |
|-----------------------------------------------------------------------------------------------------------------------------|--------|----------------------------|--------|
|                                                                                                                        |   | **2002**                   |   | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
|                                                                                                                        |   | **(Dollars in thousands)** |   |
|                                                                                                                        |   |                       |   |   |   |   |   |   |   |   |   |
| Nonaccrual loans                                                                                                            |   | $                          | 5,787  |   | $ | 7,807 |   | $ | 683 |   | $ | 932 |   | $ | 1,505 |   |
| Troubled debt  restructurings                                                                                               |   | —                     |   | 953 |   | — |   | — |   | — |   |
| Loans contractually past  due ninety or more days with respect to either principal or interest and  still accruing interest |   | 209                        |   | 642 |   | — |   | — |   | — |   |
| Nonperforming loans                                                                                                         |   | 5,996                      |   | 9,402 |   | 683 |   | 932 |   | 1,505 |   |
| Other real estate owned                                                                                                     |   | 1,000                      |   | — |   | — |   | 382 |   | 593 |   |
| Other assets-SBA guaranteed  loan                                                                                           |   | —                     |   | — |   | — |   | 150 |   | — |   |
| Total nonperforming assets                                                                                                  |   | $                          | 6,996  |   | $ | 9,402 |   | $ | 683 |   | $ | 1,464 |   | $ | 2,098 |   |
|                                                                                                                        |   |                       |   |   |   |   |   |   |   |   |   |
| Allowance for credit losses  as a percent of nonaccrual loans                                                               |   | 83.7                       | %      | 83.8 | % | 380.2 | % | 203.4 | % | 142.5 | % |
| Allowance for credit losses  as a percent of nonperforming loans                                                            |   | 80.8                       | %      | 69.6 | % | 380.2 | % | 203.4 | % | 142.5 | % |
| Total nonperforming assets  as a percent of loans receivable                                                                |   | 2.6                        | %      | 3.6 | % | 0.6 | % | 2.0 | % | 3.7 | % |
| Total nonperforming assets  as a percent of total shareholders’ equity                                                 |   | 22.4                       | %      | 36.9 | % | 3.3 | % | 12.6 | % | 15.8 | % |

 

*NonaccrualLoans.* Nonaccrual loans are those loans for which managementhas discontinued accrual of interest because there exists reasonable doubt asto the full and timely collection of either principal or interest.  It is our policy that a loan will be placedon nonaccrual status if either principal or interest payments are past due inexcess of ninety days unless the loan is both well secured and in process ofcollection, or if full collection of interest or principal becomes uncertain,regardless of the time period involved.

 

When a loan is placed on nonaccrual status, allinterest previously accrued but uncollected is reversed against current periodoperating results. Income on such loans is then recognized only to the extentthat cash is received, and, where the ultimate collection of the carryingamount of the loan is probable, after giving consideration to the borrower’scurrent financial condition, historical repayment performance and otherfactors. Accrual of interest is resumed only when (i) principal and interestare brought fully current, and (ii) such loans are either considered, inmanagement’s judgment, to be fully collectible or otherwise become well securedand in the process of collection. (See “Net Interest Income’’ for a discussionof the effects on operating results of nonperforming loans.)

 

Nonaccrual loans at December 31, 2002, decreased to$5.8 million from $7.8 million at December 31, 2001.  The decrease was primarily due to the charge off of a portion ofnonaccrual loans partially offset by the classification of additionalloans.  Nonaccrual loans at December 31,2002 were comprised primarily of secured commercial loans.  The value of the collateral securing these loansmay not be adequate to avoid a charge off of a portion of the credit.  The additional interest income that wouldhave been recorded from nonaccrual loans, if the loans had not been onnonaccrual status, was $388,000 and $110,000 for 2002 and 2001,respectively.  Interest paymentsreceived on nonaccrual loans are applied to principal unless there is no doubtas to ultimate full repayment of principal, in which case, the interest paymentis recognized as interest income. Interest income not recognized on nonaccrual loans reduced the net yieldon earning assets by 12 basis points and 5 basis points for 2002 and 2001.

 

*TroubledDebt Restructurings.* A TDR is a loan for which we have, foreconomic or legal reasons related to a borrower’s financial difficulties,granted a concession to the borrower it would not otherwise consider, includingmodifications of loan terms to alleviate the burden of the borrower’s near-termcash flow requirements in order to help the borrower to improve its financialcondition and eventual ability to repay the loan.  At December 31, 2002 we had no TDRs.  At December 31, 2001 TDRs were $953,000 representing a loan toone borrower.  The real estatecollateral on this loan has been foreclosed in satisfaction of payment and isrecorded as other real estate owned (“OREO”) at December 31, 2002.  No interest income was recorded in 2002 onTDRs.

 

*LoansContractually Past Due 90 or More Days.* Loans contractuallypast due 90 or more days are those loans which have become contractually pastdue at least ninety days with respect to principal or interest. Interestaccruals may be continued on these loans when such loans are well secured andin the process of collection and, accordingly, management has determined suchloans to be fully collectible as to both principal and interest.

 

For this purpose, a loan is considered well secured ifthe collateral has a realizable value in excess of the amount of principal andaccrued interest outstanding and/or is guaranteed by a financially capableparty. A loan is considered to be in the process of collection if collection ofthe loan is proceeding in due course either through legal action or throughother collection efforts which management reasonably expects to result inrepayment of the loan or its restoration to a current status in the nearfuture.

 

28

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Loans contractually past due and still accruinginterest totalled $209,000 and $642,000 at December 31, 2002 and 2001,respectively.

 

*OtherReal Estate Owned.*** **Wecarry OREO at the lesser of our recorded investment or the fair value lessselling costs. We periodically revalue OREO properties and charge otherexpenses for any further write-downs. At December 31, 2002 we had $1.0 million recorded as OREO.

 

*Impaired Loans. *Due to the size and nature of the our loan portfolio,impaired loans are determined by a periodic evaluation on an individual loanbasis.  At December 31, 2002 we hadclassified $4.2 million of our loans as impaired for which $1.7 million ofspecific reserves were allocated.  AtDecember 31, 2001, $7.1 million of our loans were classified as impaired forwhich $3.1 million of specific reserves were allocated.  The impaired loans are included innonaccrual loans.  The average recordedinvestment in impaired loans during the year ended December 31, 2002, was $2.2million and no interest income was recognized on these loans.

 

Foregone interest income attributable to nonperformingloans amounted to $388,000 in 2002 and $110,000 in 2001.  This resulted in a reduction in yield onaverage loans receivable of 12 basis points and 5 basis points for the yearsended December 31, 2002 and 2001, respectively.

 

*Allowance for Credit Losses*

 

The calculation of the adequacy of the allowance forcredit losses is based on a variety of factors, including loan classifications,migration trends and underlying cash flow and collateral values.  On a periodic basis -twice in 2002- weengage an outside loan review firm to review our loan portfolio, risk gradeaccuracy and the reasonableness of loan evaluations.  Annually, this outside loan review team analyzes our methodologyfor calculating the allowance for credit losses based on our loss histories andpolicies.

 

Each Bank’s board of directors reviews the adequacy ofthat Bank’s allowance for credit losses on a quarterly basis.  We utilize our judgment to determine theprovision for credit losses and establish the allowance for credit losses.  We believe, based on information known tomanagement, that the allowance for credit losses at December 31, 2002 was adequateto absorb inherent losses in the existing loan portfolio.  However, credit quality is affected by manyfactors beyond our control, including local and national economies, and factsmay exist which are not known to us 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 13 presents, at December 31, 2002 and the priorfour years, the composition of our allocation of the allowance for credit lossesto specific loan categories.  Ourcurrent practice is to make specific allocations of the allowance for creditlosses to criticized and classified loans, and unspecified allocations to eachloan category based on our risk assessment. This allocation should not be interpreted as an indication that loancharge-offs will occur in the future in these amounts or proportions, or as anindication of future charge-off trends. In addition, the portion of the allowance for credit losses allocated toeach loan category does not represent the total amount available for futurelosses that may occur within such categories, since the total allowance forcredit losses is applicable to the entire portfolio.

 

29

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**Table13**

**Allocationof Allowance For Credit Losses**

 
|                                                                                     |   | **December 31,**           |   |
|------------------------------------------------------------------------------------------|--------|----------------------------|--------|
|                                                                                     |   | **2002**                   |   | **%(1)** |   | **2001** |   | **%(1)** |   | **2000** |   | **%(1)** |   | **1999** |   | **%(1)** |   | **1998** |   | **%(1)** |   |
|                                                                                     |   | **(Dollars in thousands)** |   |
|                                                                                     |   |                       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial loans:                                                                        |   |                       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Secured by one to four family  residential properties                                    |   | $                          | 192    |   | 4 | % | $ | 675 |   | 10 | % | $ | 155 |   | 6 | % | $ | 102 |   | 6 | % | $ | 132 |   | 9 | % |   |
| Secured by multifamily  residential properties                                           |   | 224                        |   | 5 | % | 212 |   | 3 |   | 73 |   | 3 |   | 103 |   | 7 |   | 73 |   | 5 |   |
| Secured by commercial real  properties                                                   |   | 2,129                      |   | 45 | % | 2,376 |   | 36 |   | 842 |   | 37 |   | 659 |   | 38 |   | 590 |   | 36 |   |
| Other - secured and  unsecured                                                           |   | 1,528                      |   | 32 | % | 2,128 |   | 33 |   | 1,355 |   | 48 |   | 938 |   | 45 |   | 1,061 |   | 43 |   |
| Real estate construction  and land development                                           |   | 674                        |   | 14 | % | 769 |   | 12 |   | 47 |   | 2 |   | — |   | — |   | — |   | — |   |
| Consumer installment, home  equity lines of credit and unsecured loans to individuals(1) |   | 99                         |   | 2 | % | 381 |   | 6 |   | 125 |   | 4 |   | 94 |   | 4 |   | 288 |   | 7 |   |
| Allowance allocable to  loans receivable                                                 |   | $                          | 4,846  |   | 100 | % | $ | 6,541 |   | 100 | % | $ | 2,597 |   | 100 | % | $ | 1,896 |   | 100 | % | $ | 2,144 |   | 100 | % |
|                                                                                          |        |                            |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1) Percentage of loans in eachcategory to total loans.

 

The allowance for credit losses at December 31, 2002was $4.8 million compared to $6.5 million at December 31, 2001.  The decrease is due to net charge-offs of$3.6 million partially offset by provisions to the allowance during the year of$1.9 million.  Total loans charged-offin 2002 was $4.1 million primarily the result of the write-down of commercialloans secured by manufacturing equipment. The write-downs were required to reduce the recorded value of the loansto the adjusted value of the collateral based upon our periodic evaluation.

 

The additional provisions to the allowance wererecorded based upon our analysis of the adequacy of allowance for creditlosses.  The allowance for credit lossesfor classified loans graded as “criticized” by our internal grading system thatare collateral-dependent is based upon the net realizable value of thecollateral that we periodically evaluate. The allowance for unsecured classified loans is based upon the severityof the credit weakness ranging from 3.0% for “special mention”, 15.0% for“substandard” to 50% for “doubtful”. The volume of more severely classified loans – “substandard” and“doubtful” - declined 30.4% during 2002 to $8.7 at December 31, 2002 millionfrom $12.5 million at year end 2001.

 

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

 

30

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**Table 14**

**Analysis of Changes in Allowance forCredit Losses**

 
|                                                                                                      |   | **December 31,**           |       |
|-----------------------------------------------------------------------------------------------------------|--------|----------------------------|------------|
|                                                                                                      |   | **2002**                   |       | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
|                                                                                                      |   | **(Dollars in thousands)** |       |
|                                                                                                      |   |                       | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| Balance, beginning of  period                                                                             |   | $                          | 6,542      |   | $ | 2,597 |   | $ | 1,896 |   | $ | 2,144 |   | $ | 2,023 |   |
| Loans charged off:                                                                                        |   |                       |       |   |   |   |   |   |   |   |   |
| Real estate construction  and land development                                                            |   | 31                         |       | — |   | — |   | — |   | — |   |
| Commercial loans:                                                                                         |   |                       |       |   |   |   |   |   |   |   |   |
| Secured by one to four  family residential properties                                                     |   | —                     |       | — |   | — |   | — |   | 4 |   |
| Secured by multifamily  residential properties                                                            |   | —                     |       | — |   | — |   | — |   | — |   |
| Secured by commercial real  properties                                                                    |   | 44                         |       | — |   | — |   | 128 |   | 31 |   |
| Other - secured and  unsecured                                                                            |   | 3,849                      |       | 387 |   | 7 |   | 344 |   | 176 |   |
| Home equity lines of credit                                                                               |   | —                     |       | — |   | — |   | — |   | — |   |
| Consumer installment and  unsecured loans to individuals                                                  |   | 138                        |       | 104 |   | 111 |   | 105 |   | 196 |   |
| Total loans charged-off                                                                                   |   | 4,062                      |       | 491 |   | 118 |   | 577 |   | 407 |   |
|                                                                                                      |   |                       |       |   |   |   |   |   |   |   |   |
| Recoveries of loans  previously charged off:                                                              |   |                       |       |   |   |   |   |   |   |   |   |
| Real estate construction  and land development                                                            |   | 191                        |       | — |   | — |   | — |   | — |   |
| Commercial loans:                                                                                         |   |                       |       |   |   |   |   |   |   |   |   |
| Secured by one to four  family residential properties                                                     |   | —                     |       | 6 |   | — |   | 30 |   | 1 |   |
| Secured by multifamily  residential properties                                                            |   | —                     |       | — |   | — |   | — |   | 10 |   |
| Secured by commercial real  properties                                                                    |   | —                     |       | — |   | — |   | 144 |   | — |   |
| Other - secured and  unsecured                                                                            |   | 189                        |       | 227 |   | 1,350 |   | 100 |   | 216 |   |
| Home equity lines of credit                                                                               |   | —                     |       | — |   | — |   | — |   | — |   |
| Consumer installment and  unsecured loans to individuals                                                  |   | 61                         |       | 40 |   | 45 |   | 55 |   | 301 |   |
| Total recoveries of loans  previously charged off                                                         |   | 441                        |       | 273 |   | 1,395 |   | 329 |   | 528 |   |
| Net loans (recoveries)  charged-off                                                                       |   | 3,621                      |       | 218 |   | (1,277 | ) | 248 |   | (121 | ) |
| Provision for credit losses                                                                               |   | 1,925                      |       | 517 |   | (576 | ) | — |   | — |   |
| Allowance acquired in  acquisition of South Bay Bank, N.A.                                                |   | —                     |       | 3,646 |   | — |   | — |   | — |   |
| Balance, end of period                                                                                    |   | $                          | 4,846      |   | $ | 6,542 |   | $ | 2,597 |   | $ | 1,896 |   | $ | 2,144 |   |
|                                                                                                      |   |                       |       |   |   |   |   |   |   |   |   |
| Net loans (recoveries)  charged-off as a percentage of allowance for credit losses                        |   | 74.72                      | %          | 3.33 | % | -49.17 | % | 13.08 | % | -5.66 | % |
| Net loans (recoveries)  charged-off as a percentage of average gross loans outstanding during the  period |   | 1.42                       | %          | 0.19 | % | -1.40 | % | 0.40 | % | -0.20 | % |
| Recoveries of loans  previously charged off as a percentage of loans charged off in the previous  year    |   | 89.82                      | %          | 231.36 | % | 241.77 | % | 80.84 | % | 40.16 | % |

 

*Off-BalanceSheet Credit Commitments and Contingent Obligations*

 

We are a party to financial instruments withoff-balance sheet credit risk in the normal course of business to meet thefinancing needs of its customers.  Inaddition to undisbursed commitments to extend credit under loan facilities,these instruments include conditional obligations under standby and commercialletters of credit.  Our  exposure to credit loss in the event ofnonperformance by customers is represented by the contractual amount of theinstruments.

 

Standby letters of credit are conditional commitmentsissued by us to secure the financial performance of a customer to a third partyand are primarily issued to support private borrowing arrangements. The creditrisk involved in issuing a letter of credit for a customer is essentially thesame as that involved in extending a loan to that customer. We use the samecredit underwriting policies in accepting such contingent obligations as itdoes for loans. When deemed necessary, we hold appropriate collateralsupporting those commitments. The nature of collateral obtained varies and mayinclude deposits held in financial institutions and real properties.

 

At December 31, 2002 and 2001, standby letters ofcredit amounted to $629,000 and $157,000, respectively, and there were nocommercial letters of credit outstanding.

 

31

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Undisbursed commitments under revocable andirrevocable loan facilities amounted to $55.7 million and $83.4 million atDecember 31, 2002 and 2001, respectively. Many of these commitments are expected to expire without being drawnupon and, as such, the total commitment amounts do not necessarily representfuture cash requirements.

 

**Deposits**

 

While South Bay historically has had a greater portionof its deposits from retail banking customers, we emphasize developing businessclient relationships at both Banks in order to increase our core depositbase.  We offer internet-based cashmanagement services, and for many business customers, provide regular courierservice between their business locations and our banking offices.  Additionally, we attract deposits in servingthe specific market niches of escrow and title companies and nonprofitcommunity organizations.  Each Bankoffers its own rates in order to compete in its specific markets.  We have suspended the money desk operationfor the generation of new deposits in order to reduce these higher costdeposits.

 

We experienced a 13.6% increase in average totaldeposits during 2002 compared to 2001. This increase in deposits occurredprimarily as a result of growth in time certificates of deposit 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 15**

**Average Deposit Composition**

 
|                                            |   | **December 31,**            |       |
|-------------------------------------------------|--------|-----------------------------|------------|
|                                            |   | **2002**                    |       | **2001** |   | **2000** |   |
|                                            |   | **Amount**                  |       | **Percent** |   | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   |
|                                            |   | **(Dollars  in thousands)** | ** ** |
|                                            |   |                        |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing demand  deposits:           |   |                        |       |   |   |   |   |   |   |   |   |   |   |
| Real estate title and  escrow company customers |   | $                           | 26,104     |   | 9 | % | $ | 19,746 |   | 13 | % | $ | 14,806 |   | 11 | % |
| Other noninterest-bearing  demand               |   | 76,109                      |       | 25 | % | 39,137 |   | 28 | % | 41,981 |   | 32 | % |
| Interest-bearing demand                         |   | 28,024                      |       | 9 | % | 9,562 |   | 6 | % | 8,066 |   | 6 | % |
| Money market and savings                        |   | 86,444                      |       | 29 | % | 40,396 |   | 27 | % | 37,660 |   | 29 | % |
| Time certificates of  deposit:                  |   |                        |       |   |   |   |   |   |   |   |   |   |   |
| Money desk                                      |   | 2,558                       |       | 1 | % | 3,461 |   | 2 | % | 5,867 |   | 5 | % |
| Other:                                          |   |                        |       |   |   |   |   |   |   |   |   |   |   |
| $100,000 or more                                |   | 43,212                      |       | 14 | % | 26,021 |   | 18 | % | 17,023 |   | 13 | % |
| Under $100,000                                  |   | 38,606                      |       | 13 | % | 9,300 |   | 6 | % | 4,566 |   | 4 | % |
| Total time certificates of  deposit             |   | 84,376                      |       | 28 | % | 38,782 |   | 26 | % | 27,456 |   | 21 | % |
| Total deposits                                  |   | $                           | 301,057    |   | 100 | % | $ | 147,623 |   | 100 | % | $ | 129,969 |   | 100 | % |
|                                                 |        |                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

32

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**Table 16**

**Maturities of Time Certificates ofDeposit**

**$100,000 or more**

 
|                                                 |   | **December 31, 2002**      |   |
|------------------------------------------------------|--------|----------------------------|--------|
|                                                 |   | **Money  Desk**            |   | **All  Other** |   | **Total** |   |
|                                                 |   | **(Dollars in thousands)** |   |
|                                                 |   |                       |   |   |   |   |   |
| Time certificates of  deposit maturing:              |   |                       |   |   |   |   |   |
| In three months or less                              |   | $                          | 400    |   | $ | 26,656 |   | $ | 27,056 |   |
| After three months but  within six months            |   | 100                        |   | 4,722 |   | 4,822 |   |
| After six months but within  twelve months           |   | —                     |   | 9,396 |   | 9,396 |   |
| After twelve months                                  |   | 100                        |   | 1,632 |   | 1,732 |   |
| Total time certificates of  deposit $100,000 or more |   | $                          | 600    |   | $ | 42,406 |   | $ | 43,006 |   |

 
|                                                 |   | **December 31, 2002**      |   |
|------------------------------------------------------|--------|----------------------------|--------|
|                                                 |   | **Money  Desk**            |   | **All  Other** |   | **Total** |   |
|                                                 |   | **(Dollars in thousands)** |   |
|                                                 |   |                       |   |   |   |   |   |
| Time certificates of  deposit maturing:              |   |                       |   |   |   |   |   |
| 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 |   |

 

## **Borrowed Funds**

 

Borrowed funds and related weighted average rates aresummarized below in Table 17.

** **

**Table17**

**BorrowedFunds**

 
|                                                                      |   | **2002**                   |   | **2001**    |   | **2000**     |   |
|---------------------------------------------------------------------------|--------|----------------------------|--------|-------------|--------|--------------|--------|
|                                                                      |   | **Year-end**               |   | **Average** |   | **Year-end** |   | **Average** |   | **Year-end** |   | **Average** |   |
|                                                                      |   | **Balance**                |   | **Rate**    |   | **Balance**  |   | **Rate** |   | **Balance** |   | **Rate** |   | **Balance** |   | **Rate** |   | **Balance** |   | **Rate** |   | **Balance** |   | **Rate** |   |
|                                                                      |   | **(Dollars in thousands)** |   |
|                                                                      |   |                       |   |        |   |         |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Federal funds purchased and securities sold under  repurchase agreements. |   | $                          | 1,476  |        | 4.65   | %            | $      | 2,294 |   | 5.84 | % | $ | 3,096 |   | 4.77 | % | $ | 733 |   | 5.05 | % | $ | 7,500 |   | 6.71 | % | $ | 998 |   | 6.81 | % |
| Other borrowings                                                          |   | 7,500                      |   | 4.70        | %      | 11,308       |   | 4.23 | % | 17,500 |   | 4.25 | % | 20,865 |   | 4.85 | % | 40,000 |   | 6.59 | % | 32,424 |   | 6.42 | % |
|                                                                           |        |                            |        |             |        |              |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The maximum amount of securities sold with agreementsto repurchase at any month end was $11.7 million ,$5.0 million and $7.5 millionduring 2002, 2001 and 2000, respectively.

 

The maximum amount of other borrowings at any monthend was $17.5 million during 2002 and $38.0 million during 2001.

 

At December 31, 2002, $5.5 million of borrowed funds were scheduled to mature during 2004, and$2.0 million were scheduled to mature during 2005.

 

## **GuaranteedPreferred Beneficial Interests in National Mercantile’s Junior SubordinatedDeferrable Interest Debentures**

 

In 2001, National Mercantile, through NationalMercantile Capital Trust I (the “Trust”), issued 15,000 of 10.25% fixed ratesecurities (the “Trust Preferred Securities”), with an aggregate liquidationamount of $15.0 million due July 25, 2031.  The Trust Preferred Securitiesrepresent undivided beneficial interests in the assets of the Trust and areunconditionally guaranteed by National

 

33

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**Table 16**

**Maturities of Time Certificates ofDeposit**

**$100,000 or more**

 
|                                                 |   | **December 31, 2002**      |   |
|------------------------------------------------------|--------|----------------------------|--------|
|                                                 |   | **Money  Desk**            |   | **All  Other** |   | **Total** |   |
|                                                 |   | **(Dollars in thousands)** |   |
|                                                 |   |                       |   |   |   |   |   |
| Time certificates of  deposit maturing:              |   |                       |   |   |   |   |   |
| In three months or less                              |   | $                          | 400    |   | $ | 26,656 |   | $ | 27,056 |   |
| After three months but  within six months            |   | 100                        |   | 4,722 |   | 4,822 |   |
| After six months but within  twelve months           |   | —                     |   | 9,396 |   | 9,396 |   |
| After twelve months                                  |   | 100                        |   | 1,632 |   | 1,732 |   |
| Total time certificates of  deposit $100,000 or more |   | $                          | 600    |   | $ | 42,406 |   | $ | 43,006 |   |
|                                                 |   |                       |   |   |   |   |   |
|                                                 |   | **December 31, 2001**      |   |
|                                                 |   | **Money  Desk**            |   | **All  Other** |   | **Total** |   |
|                                                 |   | **(Dollars in thousands)** |   |
|                                                 |   |                       |   |   |   |   |   |
| Time certificates of  deposit maturing:              |   |                       |   |   |   |   |   |
| 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 |   |

 

**Borrowed Funds**

 

Borrowed funds and related weighted average rates aresummarized below in Table 17.

 

**Table 17**

**Borrowed Funds**

 
|                                                                     |   | **2002**                    |   | **2001**    |   | **2000**     |   |
|--------------------------------------------------------------------------|--------|-----------------------------|--------|-------------|--------|--------------|--------|
|                                                                     |   | **Year-end**                |   | **Average** |   | **Year-end** |   | **Average** |   | **Year-end** |   | **Average** |   |
|                                                                     |   | **Balance**                 |   | **Rate**    |   | **Balance**  |   | **Rate** |   | **Balance** |   | **Rate** |   | **Balance** |   | **Rate** |   | **Balance** |   | **Rate** |   | **Balance** |   | **Rate** |   |
|                                                                     |   | **(Dollars in  thousands)** |   |
|                                                                     |   |                        |   |        |   |         |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Federal funds purchased and  securities sold under repurchase agreements |   | $                           | 1,476  |        | 4.65   | %            | $      | 2,294 |   | 5.84 | % | $ | 3,096 |   | 4.77 | % | $ | 733 |   | 5.05 | % | $ | 7,500 |   | 6.71 | % | $ | 998 |   | 6.81 | % |
|                                                                     |   |                        |   |        |   |         |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Other borrowings                                                         |   | 7,500                       |   | 4.70        | %      | 11,308       |   | 4.23 | % | 17,500 |   | 4.25 | % | 20,865 |   | 4.85 | % | 40,000 |   | 6.59 | % | 32,424 |   | 6.42 | % |
|                                                                          |        |                             |        |             |        |              |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The maximum amount ofsecurities sold with agreements to repurchase at any month end was $11.7 million,$5.0 million and $7.5 million during 2002, 2001 and 2000, respectively.

 

The maximum amount ofother borrowings at any month end was $17.5 million during 2002 and $38.0million during 2001.

 

At December 31,2002,  $5.5 million of borrowed fundswere scheduled to mature during 2004, and $2.0 million were scheduled to matureduring 2005.

 

**Guaranteed Preferred BeneficialInterests in National Mercantile’s Junior Subordinated Deferrable InterestDebentures**

 

In 2001, NationalMercantile, through National Mercantile Capital Trust I (the “Trust”), issued15,000 of 10.25% fixed rate securities (the “Trust Preferred Securities”), withan aggregate liquidation amount of $15.0 million due July 25, 2031.  TheTrust Preferred Securities represent undivided beneficial interests in theassets of the Trust and are unconditionally guaranteed by National 

 

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Mercantile with respect to distributions and payments upon liquidation,redemption and otherwise pursuant to the terms of a Guarantee Agreement.

 

The primary assets of theTrust are $15.5 million aggregate principal amount of National Mercantile10.25% fixed rate junior subordinated deferrable interest debentures due July25, 2031 that pay interest each January 26 and July 26.  The interest is deferrable, at NationalMercantile’s option, for a period up to ten consecutive semi-annual payments,but in any event not beyond June 25, 2031. The debentures are redeemable, in whole or in part, at NationalMercantile’s option on or after five years from issuance at declining premiumsto maturity.

 

The costs associated withthe Trust Preferred Securities issuance have been capitalized and are beingamortized using a method that approximates the interest method over a period ofthirty years.  The recorded balance ofTrust Preferred Securities was $14.5 million at December 31, 2002.  Minority interest in income of trustsubsidiary was $1.6 million and $722,000 for the years ended December 31, 2002and 2001, respectively.

 

InJanuary 2003, National Mercantile entered into a interest rate swap agreementpursuant to which it exchanged a fixed rate payment obligation of 10.25% on anotional principal amount of $15.0 million for a floating rate interest basedon the six-month London InterBank Offerred Rate plus 458 basis points for a29-year period ending July 25, 2031.  The interest rate swap agreement results inthe company paying or receiving the difference between the fixed and floatingrates at specified intervals calculated based on the notional amounts.  The differential paid or received onthe interest rate swap is recognized as an adjustment to interest expense.  At January 25, 2003, we are paying aninterest rate of 5.93% under the terms of the swap which will reduce its interestexpense for the year-to-date period ended July 25, 2003, the next reset date,by $329,000.  The counter party to theswap has the option to call the swap under a declining premium schedulebeginning July 2006.

 

The interest rate swapreduces the adverse impact of our 10.25% fixed rate Trust Preferred Securitiesin a declining interest rate environment. The Company does not utilize derivatives for speculative purposes.  Under Statement of Financial Accounting Standards No. 133 this swaptransaction is designated as a fair value hedge.  Accordingly, the effective portion of the change in the fairvalue of the swap transaction is recorded each period in current income.  The terms of the swap are symmetrical withthe terms of the Trust Preferred Securities, including the payment deferralterms, and considered highly effective in offsetting changes in fair value ofthe Trust Preferred Securities. Accordingly, no ineffectivenesswill be recorded to current earnings related to the interest rate swap.

 

**Selected Financial Ratios**

 

The following Table 18 sets forth selected financialratios:

 

**Table 18**

**SelectedPerformance Ratios**

 
|                                                 |   | **For the Year Ended  December 31,** |   |
|------------------------------------------------------|--------|--------------------------------------|--------|
|                                                 |   | **2002**                             |   | **2001** |   | **2000** |   |
|                                                 |   |                                 |   |   |   |   |   |
| Return on average assets                             |   | -0.07                                | %      | 0.59 | % | 1.64 | % |
| Return on average  shareholders’ equity         |   | -0.98                                | %      | 5.13 | % | 20.49 | % |
| Average shareholders’  equity to average assets |   | 7.23                                 | %      | 11.23 | % | 8.01 | % |

** **

**Critical Accounting Policies**

 

Our accounting policies are integral to understandingthe results reported. Accounting policies are described in detail in Note 1 ofthe Notes to Consolidated Financial Statements.  Our most complex accounting policies require management’sjudgment to ascertain the valuation of assets, liabilities, commitments andcontingencies.  We have establisheddetailed policies and control procedures that are intended to ensure valuationmethods are well controlled and applied consistently from period toperiod.  In addition, the policies andprocedures are intended to ensure that the process for changing methodologiesoccurs in an appropriate manner.  Thefollowing is a brief description of our current accounting policies involvingsignificant management valuation judgments.

 

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*Allowance for Credit Losses*

 

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

 

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

 

The internal risk grading utilizes an 10-level gradingsystem – six pass grades for unclassified loans based upon our assessment ofthe borrower’s ability to service the loan and the quality of the collateraland four classification grades for “criticized” loans depending on the severityof the underwriting weakness and liklihood of loss.  We use a statistical grading migration analysis as part of ourallowance for credit losses evaluation for unclassified loans which is a methodby which the types and gradings of historical loans charged-off are related tothe current loan portfolio.  This analysisattempts to use historical trends in loan risk grading, nonperforming assetsand concentrations that are characteristic to our portfolio and consider otherfactors affecting loan losses that are specific to our marketplace and customerdemographic.

 

An allowance based upon the migration analysis isestablished for various loan types and unclassified grades ranging from zerofor loans secured by cash or marketable securities to 1.0% for unsecuredcommercial loans.  This methodologyassumes, among other things, (i) consistency in underwriting standards andinternal risk grading between the current loan portfolio and the historicalsample, (ii) that the factors that resulted in historical loans charged-off,such as industry economic condition, will be the same factors that cause futureloans to be charged-off, and (iii) the economic environment experienced duringthe period of historical loans charged-off is similar to the future economicenvironment.

 

Generally, the allowance for credit losses establishedfor classified loans that are collateral-dependent is based on the netrealizable value of the collateral.  Inmeasuring the net realizable value of the collateral, management uses currentappraisals that, among other techniques, observe market transactions of similarproperty and adjust for differences. Changes in the financial condition of individual borrowers, in economicconditions, in historical loss experience and in the condition of the variousmarkets in which collateral may be sold may all affect the required level ofthe allowance for credit losses and the associated provision for credit losses.

 

*Goodwill and Other Intangible Assets*

 

As discussed in Note 2 of the Notes to ConsolidatedFinancial Statements, we must assess goodwill and other intangible assets eachyear, or more frequently upon the occurrence of certain events, forimpairment.  Impairment is the conditionthat exists when the carrying amount of the asset exceeds its implied fairvalue.

 

The goodwill impairment test involves comparing thefair value of South Bay with its carrying amount, including goodwill.  During 2002, we retained an independentvaluation consultant to conduct the analysis that utilized two valuationmethods – the income approach and the market approach.

 

The income approach measures the present worth ofanticipated future net cash flows generated by South Bay.  Net cash flow forecasts require analysis ofthe significant variables influencing revenues, expenses, working capital andcapital investment as well as residual value and cost of capital.  Our forecasts were for a three-year periodreflecting average annual asset growth of 14.3%, an average loan to depositratio of 97.9%, an average net interest margin of 5.0%, and average annualreturn on assets of 1.37%.  A 15.0% costof capital and a $34.6 million residual value was utilized in the analysis todiscount the projected cash flows.

 

The market approach derives a valuation by analyzingthe prices at which shares of capital stock of reasonably similar companies aretrading in the public market, or the transaction price at which similarcompanies have been acquired.  Theanalysis identified seventeen transactions during the period from January 1998thru September 2002 involving seller companies with similarities to South Bayin size and operating characteristics. Transaction multiples were considered for purchase price to (i)earnings, (ii) book value, and (iii) total assets.  The purchase price to earnings multiple for the South Bayacquisition was 11.38 compared to a range from 11.38 to 57.14 with an averageof 22.8 for the transactions studied. Purchase price to book value multiples ranged from 0.65 to 2.83 with anaverage of 1.62, whereas South Bay’s book value transaction multiple was1.44.  The South Bay transactionpurchase price to total assets multiple was 0.15 compared to a range of 0.07 to0.23with an average of 0.16 for the comparable transactions.  Little consideration was given to the stocktrading values of similar companies due to the small volume of tradingactivity.

 

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The fair value indications derived from the income andmarket approaches are $32 million and $28 million, respectively. The fair valueof South Bay under both approaches exceeds the carrying value at October 1,2002 of $20.8 million, therefore, goodwill is not considered impaired.  The testing of goodwill and other intangibleassets for impairment requires re-measurement of fair values.  If the future fair values were materiallyless than the recorded value, we would be required to take a charge againstearnings to write down the goodwill and other intangible assets to the lowervalue.

 

*Deferred Tax Assets*

 

At December 31, 2002 we had total deferred tax assetsof $8.0 million of which $6.5 million is represented by (i) federal NOLs of$18.2 million, which begin to expire in 2009; (ii) California NOLs of $559,000which will expire in 2005.  In order toutilize the benefit of the deferred tax assets related to the NOLs, we mustgenerate aggregate taxable income equal to the amount of the NOLs during theperiod prior to their expiration.

 

If future taxable income should prove non-existent orless than the amount of the deferred tax assets within the tax years to whichthey may be applied, the asset may not be realized.  An evaluation allowance may be established to reduce the deferredtax asset to its realizable value.  Any adjustment required to thevaluation allowance is coupled with a related entry to income taxexpense.  A charge to earnings will be made in the event that we determinethat a valuation allowance to the deferred tax asset is necessary.  Our deferred tax assets are describedfurther in Note 6 of the Notes to Consolidated Financial Statements.

 

We use estimates of future taxable income to evaluateif it is more likely than not that the benefit of our deferred tax assets willbe realized.  Our analysis utilizesalternative scenarios reflecting a range of assumptions for asset growth rates,loan to deposit ratios, interest rates and inflation rates.  The results of the analysis support ourposition that it is more likely than not that our deferred tax assets will berealized.

** **

**Recent Accounting Pronouncements**

 

*Accounting for Asset RetirementObligations*

 

In June 2001, the Financial Accounting Standards Board(“FASB”) issued Statement of Financial Accounting Standards No. 143 “Accountingfor Asset Retirement Obligations” (“SFAS No. 143”). SFAS No. 143 addressesfinancial accounting and reporting for obligations associated with the retirementof tangible long-lived assets and the associated asset retirement costs.  SFAS No. 143 requires that the fair value ofa liability for an asset retirement obligation be recognized in the period inwhich it is incurred if a reasonable estimate of fair value can be made. Theassociated asset retirement costs are capitalized as part of the carryingamount of the long-lived asset.

 

SFAS No. 143 is effective for financial statementsissued for fiscal years beginning after June 15, 2002.  The adoption of SFAS No. 143 did not have amaterial impact on our financial condition or operating results.

 

*Accounting for Impairment orDisposal of Long-Lived Assets*

 

In August 2001, the FASB issued Statement of FinancialAccounting Standards No. 144 “Accounting for the Impairment or Disposal ofLong-Lived Assets” (“SFAS No. 144”). SFAS No. 144 establishes a single accounting model for the impairment ordisposal of long-lived assets, including discontinued operations.  SFAS No. 144 superseded SFAS No. 121,“Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assetsto Be Disposed Of”, and APB Opinion No. 30 (“APB No. 30”), “Reporting theResults of Operations—Reporting the Effects of Disposal of a Segment of aBusiness, and Extraordinary, Unusual and Infrequently Occurring Events andTransactions.”

 

We adopted SFAS No. 144 on January 1, 2002.  The implementation of this standard had nomaterial impact on our financial condition or operating results.

 

*Gains and Losses from Extinguishmentof Debt*

 

In April 2002, the FASB issued Statement of FinancialAccounting Standards No. 145 “Rescission of FASB Statements No. 4, 44, and 64,Amendment of FASB Statement No. 13, and Technical Corrections” (“SFAS No.145”).  Among other provisions, SFAS No.145 rescinds SFAS 4, “Reporting Gains and Losses from Extinguishment of Debt.”Accordingly, gains or losses from extinguishment of debt shall not be reportedas extraordinary items unless the extinguishment qualifies as an extraordinaryitem under 

 

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the criteria of APB No. 30. Gains or losses from extinguishment of debt that do not meet thecriteria of APB No. 30 should be reclassified to income from continuingoperations in all prior periods presented.

 

SFAS No. 145 is effective for fiscal years beginningafter May 15, 2002.  We do not expectadoption of SFAS No. 145 to have a material impact on our financial conditionor operating results.

 

*Accounting for Costs Associated withExit or Disposal Activities*

 

In June 2002, the FASB issued Statement of FinancialAccounting Standards No. 146 “Accounting for Costs Associated with Exit orDisposal Activities” (“SFAS 146”). SFAS No. 146 requires that a liability for acost associated with an exit or disposal activity be recognized when theliability is incurred and nullifies the guidance of EITF No. 94-3, “LiabilityRecognition for Certain Employee Termination Benefits and Other Costs to Exitan Activity (including Certain Costs Incurred in Restructuring)”, whichrecognized a liability for an exit cost at the date of an entity’s commitmentto an exit plan. SFAS No. 146 requires that the initial measurement of aliability be at fair value.

 

SFAS No. 146 will be effective for exit or disposalactivities that are initiated after December 31, 2002.  We do not expect adoption of SFAS No. 146 tohave a material impact on our financial condition or operating results.

 

*Acquisitions of Certain FinancialInstitutions*

 

In July 2002, the FASB issued Statement of FinancialAccounting Standards No. 147 “Acquisitions of Certain Financial Institutions”(“SFAS No. 147”). SFAS No. 147 provides interpretive guidance on theapplication of the purchase method to acquisitions of financialinstitutions.  Except for transactionsbetween two or more mutual enterprises, SFAS No. 146 requires thattransactions involving the acquisition of financial institutions be accountedfor in accordance with Statement of Financial Accounting StandardsNo. 141.  In addition, SFAS No. 147amends SFAS No. 144 to include in its scope long-term customer-relationshipintangible assets of financial institutions such as depositor- andborrower-relationship intangible assets and credit cardholder intangibleassets.  Consequently, those intangibleassets are subject to the same undiscounted cash flow recoverability test andimpairment loss recognition and measurement provisions that SFAS No. 144requires for other long-lived assets that are held and used.

 

Provisions of SFAS No. 147, which relate to theapplication of the purchase method of accounting, are effective foracquisitions for which the date of acquisition is on or after October 1,2002.  We do not expect adoption of SFASNo. 147 to have a material impact on our financial condition or operatingresults.

 

*Accounting for Stock-BasedCompensation—Transition and Disclosure*

 

In January 2003, the FASB issued Statement ofFinancial Accounting Standards No. 148 “Accounting for Stock-BasedCompensation” (“SFAS No. 148”). SFAS No. 148 amends Statement of FinancialAccounting Standards No. 123 “Accounting for Stock-Based Compensation” (“SFASNo. 123”), to provide alternative methods of transition for a voluntarychange to the fair value based method of accounting for stock-based employeecompensation. In addition, SFAS No. 148 amends the disclosure requirements ofSFAS No. 123 to require prominent disclosures in both annual and interimfinancial statements about the method of accounting for stock-based employeecompensation and the effect of the method used on reported results. If awardsof stock-based employee compensation were outstanding and accounted for underthe intrinsic value method of Accounting Principles Board Opinion No. 25“Accounting for Stock” (“APB No. 25”) issued to employees, certain disclosureshave to be made for any period for which an income statement is presented.

 

SFAS No. 148 is effective for financial statements forfiscal years ending after December 15, 2002. We continue to apply APB No. 25 in accounting for stock basedcompensation and have adopted the disclosure requirements of SFAS No. 123 andSFAS No. 148.

 

*Guarantor’s Accounting andDisclosure Requirements for Guarantees, Including Indirect Guarantees ofIndebtedness of Others—an interpretation of FASB Statements No. 5, 57, and 107and rescission of FASB Interpretation No. 34*

 

In November 2002, the FASB issued Financial AccountingStandards Board Interpretation No. 45 “Guarantor’s Accounting and DisclosureRequirements for Guarantees, Including Indirect Guarantees of Indebtedness ofOthers—an interpretation of FASB Statements No. 5, 57, and 107 and rescissionof FASB Interpretation No. 34” (“FIN 45”). FIN 45 addresses the disclosures to be made by a guarantor in itsinterim and annual financial statements about its obligations under guarantees.FIN 45 also clarifies the 

 

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requirements related to the recognition of a liability by a guarantorat the inception of a guarantee for the obligations the guarantor hasundertaken in issuing that guarantee.

 

The initial recognition and initial measurement of aliability of a guarantor will be applied only on a prospective basis toguarantees issued or modified after December 31, 2002, irrespective of theguarantor’s fiscal year-end. The guarantor’s previous accounting for guaranteesissued prior to the date of this Interpretation’s initial application shall notbe revised or restated to reflect the effect of the recognition and measurementprovisions of the Interpretation.

 

The disclosure requirements in FIN 45 are effectivefor financial statements of interim or annual periods ending after December 15,2002.  The implementation of the initialrecognition provisions of FIN 45 did not have a significant impact on ourfinancial condition or operating results. We do not expect the full adoption of FIN 45 to have a material impacton our financial condition or operating results.

 

*Consolidation of Variable InterestEntities*

 

In January 2003, the FASB issued Financial AccountingStandards Board Interpretation No. 46 “Consolidation of Variable InterestEntities” (“FIN 46”). FIN 46 explains how to identify variable interestentities and how an enterprise assesses its interests in a variable interestentity to decide whether to consolidate that entity.  FIN 46 requires existing unconsolidated variable interestentities to be consolidated by their primary beneficiaries if the entities donot effectively disperse risks among parties involved.  Variable interest entities that effectivelydisperse risks will not be consolidated unless a single party holds an interestor combination of interests that effectively recombines risks that werepreviously dispersed.

 

FIN 46 applies immediately to variable interestentities created after January 31, 2003, and to variable interest entities in whichan enterprise obtains an interest after that date. It applies in the firstfiscal year or interim period beginning after June 15, 2003, to variableinterest entities in which an enterprise holds a variable interest that itacquired before February 1, 2003.

 

FIN 46 may be applied prospectively with acumulative-effect adjustment as of the date on which it is first applied or byrestating previously issued financial statements for one or more years with acumulative-effect adjustment as of the beginning of the first year restated.

 

We do not expect the adoption of FIN 46 to have amaterial impact on our financial condition or operating results.

 

 

**FACTORS WHICH MAY AFFECT FUTURE OPERATING RESULTS**

 

*We face risk from changes ininterest rates.*

 

The success of our business depends, to a largeextent, on our net interest income. Changes in market interest rates can affect our net interest income byaffecting the spread between our interest-earning assets and interest-bearingliabilities.  This may be due to thedifferent maturities of our interest-earning assets and interest-bearingliabilities, as well as an increase in the general level of interestrates.  Changes in market interest ratesalso affect, among other things:

 

•  Our ability tooriginate loans;

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

•  The value ofour interest-earning assets and our ability to realize gains from the sale ofthese assets;

•  The averagelife of our interest-earning assets;

•  Our ability togenerate deposits instead of other available funding alternatives; and

•  Our ability toaccess the wholesale funding market.

 

Interest rates are highly sensitive to 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 condition depends significantly on thequality of our assets.  While we havedeveloped and implemented underwriting policies and procedures to guide us inthe making of loans, compliance with these policies and procedures in makingloans does not guarantee repayment of the loans.  If the level of our non-performing assets rises, our results ofoperations and financial

 

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condition will be affected.  Aborrower’s ability to pay its loan in accordance with its terms can beadversely affected by a number of factors, such as a decrease in the borrower’srevenues and cash flows due to adverse changes in economic conditions or adecline in the demand for the borrower’s products and/or services.

 

*Ourallowances for credit losses may be inadequate.*

 

We establish allowances for credit losses against eachsegment of our loan portfolio.  AtDecember 31, 2002, our allowance for credit losses equaled 2.5% of loansreceivable and 69.6% of nonperforming loans. Although we believed that we had established adequate allowances forcredit losses as of December 31, 2002, the credit quality or our assets isaffected by many factors beyond our control, including local and nationaleconomic conditions, and the possible existence of facts which are not known tous which adversely affect the likelihood of repayment of various loans in ourloan portfolio and realization of the collateral upon a default.  Accordingly, we can give no assurance thatwe will not sustain loan losses materially in excess of the allowance forcredit losses.  In addition, the Officeof the Comptroller of the Currency, as an integral part of its examinationprocess, periodically reviews our allowance for credit losses and could requireadditional provisions for credit losses. Material future additions to the allowance for credit losses may also benecessary due to increases in the size and changes in the composition of ourloan portfolio.  Increases in ourprovisions for credit losses would adversely affect our results of operations.

 

*Economicconditions may worsen.*

 

Our business is strongly influenced by economicconditions 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, anunfavorable economy could reduce the demand for our loans and other productsand services.

** **

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

*sufferas a result of local recession or natural disasters in California.*

 

At December 31, 2002, approximately 64% of our loansoutstanding were collateralized by properties located in California.  Because of this concentration in California,our financial position and results of operations have been and are expected tocontinue to be influenced by general trends in the California economy and itsreal estate market.  Real estate marketdeclines may adversely affect the values of the properties collateralizingloans.  If the principal balances of ourloans, together with any primary financing on the mortgaged properties, equalor exceed the value of the mortgaged properties, we could incur higher losseson sales of properties collateralizing foreclosed loans.  In addition, California historically hasbeen vulnerable to certain natural disaster risks, such as earthquakes anderosion-caused mudslides, which are not typically covered by the standardhazard insurance policies maintained by borrowers.  Uninsured disasters may adversely impact our ability to recoverlosses on properties affected by such disasters and adversely impact ourresults of operations.

 

*Ourbusiness is very competitive.*

 

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

 

*Ourbusiness is heavily regulated.*

 

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

 

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

 

As of December 31, 2002, we had net operating losscarryforwards of $18.0 million and $559,000 for federal and state tax purposes,respectively.  Our federal net operatingloss carryforward begins to expire in 2009. Our state net operating loss carryforwards continue to expire but remainavailable in reducing amounts through 2005. Our ability to use these carryforwards in the future would besignificantly limited if we experience an “ownership change” within the meaningof Section 382 of the Internal Revenue Code. If our use of these carryforwards is limited, we would be required topay taxes on our taxable income to the extent our taxable income exceeded thelimited amounts which could be offset, and our net income would be lower.

 

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

 

At December 31, 2002, we had outstanding constructionloans in the amount of $37.9 million, representing 13.9% of our loanportfolio.  These types of loansgenerally have greater risks than loans on completed homes, multifamily andcommercial properties.  A constructionloan generally does not cover the full amount of the construction costs, so theborrower must have adequate funds to pay for the balance of the project.  Price increases, delays and unanticipateddifficulties can materially increase these costs.  Further, even if completed, there is no assurance that theborrower will be able to sell the project on a timely or profitable basis, asthese are closely related to real estate market conditions, which can fluctuatesubstantially between the start and completion of the project.  If the borrower defaults prior to completionof the project, the value of the project will likely be less than theoutstanding loan, and we could be required to complete construction with ourown funds to minimize losses on the project.

 

*We havegoodwill from the acquisition of South Bay which must be evaluated regularlyfor impairment*

 

In connection with the acquisition of South Bay inDecember 2001, we recorded goodwill in the amount of $2..2 million.  We must evaluate the goodwill regularly forimpairment. We had an unaffiliated consultant conduct goodwill impairmenttesting in the fourth quarter of 2002, and we determined that this goodwill wasnot impaired.  If in the future wedetermine that the goodwill is impaired, we would be required to write-off someor all of the goodwill, which could have a material adverse effect on ourfinancial condition and results of operations.

 

*We havea significant deferred tax asset and our ability to realize that asset dependsin part on the certainty of future earnings*

 

At December 31, 2002, we had a deferred tax asset of$8.0 million relating primarily to our NOLs. If future taxable income should be less than the amount of the NOLswithin the tax years to which it may be applied, the deferred tax asset may notbe realized.  To support our positionthat the benefits of this asset will be realized, we must estimate futureearnings.  These estimates are based onmany factors, including prior periods results. If we are unable to generate future earnings in an amount sufficient tosupport the asset, we would have to establish a valuation allowance andcorresponding charge to earnings to reduce the deferred tax asset to itsrealizable value.  A material valuationallowance on this asset would have a material adverse effect on our results ofoperations and financial condition.

 

**ITEM 7.  FINANCIAL STATEMENTS**

 

The consolidated financial statements required by thisItem are included herewith as a separate section of this Report as follows:

 

1.             *Financial Statements*

 
|                                                                                                             | **Page** |
|------------------------------------------------------------------------------------------------------------------|----------|
| Report of Independent  Auditors – Ernst & Young LLP                                                     | 45       |
|                                                                                                             |     |
| Report of  Independent Public Accountants – Arthur Andersen LLP.                                            | 46       |
|                                                                                                             |     |
| Consolidated Balance Sheet  at December 31, 2002                                                                 | 47       |
|                                                                                                             |     |
| Consolidated  Statements of Operations for the years ended December 31, 2002 and 2001                            | 48       |
|                                                                                                             |     |
| Consolidated  Statements of Changes in Shareholders’ Equity for the years ended December  31, 2002 and 2001 | 49       |
|                                                                                                             |     |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2002 and 2001                            | 50       |
|                                                                                                             |     |
| Notes to  Consolidated Financial Statements for the two years ended December 31, 2002                            | 51       |

 

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

 

See 2003 proxy statement.

 

**PART III**

 

**ITEM 9.  DIRECTORS AND EXECUTIVE OFFICERS OF THEREGISTRANT**

 

The information required by this item will appearunder the captions “Election of Directors,’’ “ Executive Officers,’’ and“Compliance with Section 16(a) Beneficial Ownership Reporting ’’ in theCompany’s proxy statement for the 2003 Annual Meeting of Shareholders (the“2003 Proxy Statement’’), and such information shall be deemed to beincorporated herein by reference to that portion of the 2003 Proxy Statement,if filed with the Securities and Exchange Commission pursuant to Regulation 14Anot later than 120 days after the end of the Company’s most recently completedfiscal year.

 

**ITEM 10.               EXECUTIVE COMPENSATION**

 

The information required by this item will appearunder the captions “Compensation of Executive Officers,” “Compensation ofDirectors,’’ “Summary Compensation Table,’’ “Report on Executive Compensationfor 2002,’’ “2002 Option Exercises and Year-End Option Values” and“Compensation Committee Interlocks and Insider Participation’’ in the 2003Proxy Statement, and such information shall be deemed to be incorporated hereinby reference to those portions of the 2003 Proxy Statement, if filed with theSecurities and Exchange Commission pursuant to Regulation 14A not later than120 days after the end of our most recently completed fiscal year.

 

**ITEM 11.               SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS ANDMANAGEMENT**

 

The information required by this item will appearunder the caption “Security Ownership of Principal Shareholders andManagement’’ in the 2003 Proxy Statement, and such information either shall bedeemed to be incorporated herein by reference to that portion of the 2003 ProxyStatement, if filed with the Securities and Exchange Commission pursuant toRegulation 14A not later than 120 days after the end of our most recentlycompleted fiscal year.

 

**ITEM 12.               CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS**

 

The information required by this item will appearunder the caption “Certain Relationships and Related Transactions’’ in the 2003Proxy Statement, and such information shall be deemed to be incorporated hereinby reference to that portion of the 2003 Proxy Statement, if filed with theSecurities and Exchange Commission pursuant to Regulation 14A not later than120 days after the end of our most recently completed fiscal year.

 

**PART IV**

 

 

**ITEM 13.               EXHIBITS AND REPORTS ON FORM 8-K**

 

(c) Exhibits

 

See Index to Exhibits on page 65 of this Report onForm 10-KSB

 

(b) Reports on Form 8-K

 

On November 7, 2002, theCompany filed a report on Form 8-K reporting under Item 5 the Company’s pressrelease regarding third quarter 2002 operating results.

 

On November 12, 2002, theCompany filed a report on Form 8-K reporting under Item 5 the Company’s pressrelease regarding the commencement of private financing.

 

**ITEM 14.               CONTROLS AND PROCEDURES**

 

Our management, includingthe Chief Executive Officer and Chief Financial Officer, has conducted anevaluation of the effectiveness of our disclosure controls and procedurespursuant to Rule 13a-14 under the Securities Exchange Act of 1934, as 

 

41

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amended, within 90 days of the filing of this annual report.  Based on that evaluation, the Chief ExecutiveOfficer and the Chief Financial Officer believe that our disclosure controlsand procedures were effective in ensuring that information required to bedisclosed by the Company in this quarterly report has been made known to themin a timely manner.

 

During the quarter endedDecember 31, 2002, there were no significant changes in our internal controlsor in other factors that could significantly affect those controls.

 

*SIGNATURES*

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, theregistrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 
|                 | NATIONAL MERCANTILE  BANCORP |
|----------------------|------------------------------|
|                 | (Registrant)                 |
|                 |                         |   |
|                 | By                           | /s/  SCOTT A.  MONTGOMERY |
|                 |                         | Scott A. Montgomery |
| Date: April 14, 2003 |                         | Chief Executive Officer |

 

Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.

 
| **Signature** |                        | **Title** |                                                 | **Date** |
|---------------|-----------------------------|-----------|------------------------------------------------------|----------|
|          |                        |      |                                                 |     |   |
| /s/           | ROBERT E. GIPSON            |      |                                                 |     |   |
|          | Robert E. Gipson            |      | Chairman of the Board                                |     | April 14, 2003 |
|          |                        |      |                                                 |     |   |
| /s/           | ROBERT E. THOMSON           |      |                                                 |     |   |
|          | Robert E. Thomson           |      | Vice Chair                                           |     | April 14, 2003 |
|          |                        |      |                                                 |     |   |
| /s/           | DONALD E. BENSON            |      |                                                 |     |   |
|          | Donald E. Benson            |      | Director                                             |     | April 14, 2003 |
|          |                        |      |                                                 |     |   |
| /s/           | JOSEPH N. COHEN             |      |                                                 |     |   |
|          | Joseph N. Cohen             |      | Director                                             |     | April 14, 2003 |
|          |                        |      |                                                 |     |   |
| /s/           | ANTOINETTE HUBENETTE,  M.D. |      |                                                 |     |   |
|          | Antoinette Hubenette,  M.D. |      | Director                                             |     | April 14, 2003 |
|          |                        |      |                                                 |     |   |
| /s/           | SCOTT A. MONTGOMERY         |      |                                                 |     |   |
|          | Scott A. Montgomery         |      | Director, Chief Executive Officer                    |     | April 14, 2003 |
|          |                        |      |                                                 |     |   |
| /s/           | DION G. MORROW              |      |                                                 |     |   |
|          | Dion G. Morrow              |      | Director                                             |     | April 14, 2003 |
|          |                        |      |                                                 |     |   |
| /s/           | CARL R. TERZIAN             |      |                                                 |     |   |
|          | Carl R. Terzian             |      | Director                                             |     | April 14, 2003 |
|          |                        |      |                                                 |     |   |
| /s/           | DAVID R. BROWN              |      |                                                 |     |   |
|          | David R. Brown              |      | Principal Financial and Principal Accounting Officer |     | April 14, 2003 |

 

42

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Certification

 

I, Scott Montgomery, certify that:

 

1.     I have reviewed this annualreport on Form 10-KSB of National Mercantile Bancorp;

 

2.     Based on my knowledge, thisannual report does not contain any untrue statement of a material fact or omitto state a material fact necessary to make the statements made, in light of thecircumstances under which such statements were made, not misleading with respectto the period covered by this annual report;

 

3.     Based on my knowledge, thefinancial statements, and other financial information included in this annualreport, fairly present in all material respects the financial condition,results of operations and cash flows of the registrant as of, and for, theperiods presented in this annual report;

 

4.     The registrant’s othercertifying officers and I are responsible for establishing and maintainingdisclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and15d-14) for the registrant and we have:

 

(a)   designed such disclosure controls andprocedures to ensure that material information relating to the registrant,including its consolidated subsidiaries, is made known to us by others withinthose entities, particularly during the period in which this annual report isbeing prepared;

 

(b)   evaluated the effectiveness of theregistrant’s disclosure controls and procedures as of a date within 90 daysprior to the filing date of this annual report (the “Evaluation Date”); and

 

(c)   presented in this annual report ourconclusions about the effectiveness of the disclosure controls and proceduresbased on our evaluation as of the Evaluation Date;

 

5.     The registrant’s othercertifying officers and I have disclosed, based on our most recent evaluation,to the registrant’s auditors and the audit committee of registrant’s board ofdirectors (or persons performing the equivalent function):

 

(a)   all significant deficiencies in thedesign or operation of internal controls which could adversely affect theregistrant’s ability to record, process, summarize and report financial dataand have identified for the registrant’s auditors any material weaknesses ininternal controls; and

 

(b)   any fraud, whether or not material,that involves management or other employees who have a significant role in theregistrant’s internal controls; and

 

6.     The registrant’s othercertifying officers and I have indicated in this annual report whether or notthere were significant changes in internal controls or in other factors thatcould significantly affect internal controls subsequent to the date of our mostrecent evaluation, including any corrective actions with regard to significantdeficiencies and material weaknesses.

 
| Date:  April 14, 2003 | /s/  SCOTT A. MONTGOMERY |   |
|----------------------------|-------------------------------|--------|
|                       | Scott A. Montgomery           |
|                       | Chief Executive Officer       |

 

43

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Certification

 

I, David Brown, certify that:

 

1.     I have reviewed this annualreport on Form 10-KSB of National Mercantile Bancorp;

 

2.     Based on my knowledge, thisannual report does not contain any untrue statement of a material fact or omitto state a material fact necessary to make the statements made, in light of thecircumstances under which such statements were made, not misleading withrespect to the period covered by this annual report;

 

3.     Based on my knowledge, thefinancial statements, and other financial information included in this annualreport, fairly present in all material respects the financial condition,results of operations and cash flows of the registrant as of, and for, theperiods presented in this annual report;

 

4.     The registrant’s othercertifying officers and I are responsible for establishing and maintainingdisclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and15d-14) for the registrant and we have:

 

(a)   designed such disclosure controls andprocedures to ensure that material information relating to the registrant,including its consolidated subsidiaries, is made known to us by others withinthose entities, particularly during the period in which this annual report isbeing prepared;

 

(b)   evaluated the effectiveness of theregistrant’s disclosure controls and procedures as of a date within 90 daysprior to the filing date of this annual report (the “Evaluation Date”); and

 

(c)   presented in this annual report ourconclusions about the effectiveness of the disclosure controls and proceduresbased on our evaluation as of the Evaluation Date;

 

5.     The registrant’s othercertifying officers and I have disclosed, based on our most recent evaluation,to the registrant’s auditors and the audit committee of registrant’s board ofdirectors (or persons performing the equivalent function):

 

(a)   all significant deficiencies in thedesign or operation of internal controls which could adversely affect theregistrant’s ability to record, process, summarize and report financial dataand have identified for the registrant’s auditors any material weaknesses ininternal controls; and

 

(b)   any fraud, whether or not material,that involves management or other employees who have a significant role in theregistrant’s internal controls; and

 

6.     The registrant’s othercertifying officers and I have indicated in this annual report whether or notthere were significant changes in internal controls or in other factors thatcould significantly affect internal controls subsequent to the date of our mostrecent evaluation, including any corrective actions with regard to significantdeficiencies and material weaknesses.

 
| Date:  April 14, 2003 | /s/  DAVID R. BROWN |   |
|----------------------------|--------------------------|--------|
|                       | David R. Brown           |
|                       | Chief Financial Officer  |

 

44

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**REPORT OF INDEPENDENT AUDITORS**

 

 

To the Shareholders and the Board of Directors of National Mercantile Bancorp and Subsidiaries:

 

We have audited the consolidated balance sheet of National MercantileBancorp (a California corporation) and Subsidiaries (collectively the“Company”) as of December 31, 2002, and the related consolidated statements ofoperations, shareholders’ equity, and cash flows for the year then ended. These financial statements are the responsibility of the Company’smanagement.  Our responsibility is to express an opinion on thesefinancial statements based on our audit.

 

We conducted our audit in accordance with auditing standards generallyaccepted in the United States.  Those standards require that we plan andperform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement.  An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements.  An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation.  We believe thatour audit provides a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above presentfairly, in all material respects, the consolidated financial**position of National Mercantile Bancorpand Subsidiaries at December 31, 2002, and the consolidated results of theiroperations and their cash flows for the year then ended, in conformity withaccounting principles generally accepted in the United States.

 

Ernst & Young LLP

 

Los Angeles, California

February 14, 2003

 

45

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**REPORTOF INDEPENDENT PUBLIC ACCOUNTANTS**

 

 

To the Shareholders and the Board of Directors of National Mercantile Bancorp and Subsidiaries:

 

We have audited the accompanying consolidated balance sheet of NationalMercantile Bancorp (a California corporation) and Subsidiaries (collectivelythe “Company”) as of December 31, 2001, and the related consolidated statementsof operations, changes in shareholders’ equity and cash flows for the yearsended December 31, 2001 and 2000.  Thesefinancial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these financial statements based on our audits.

 

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

 

In our opinion, the financial statements referred toabove present fairly, in all material respects, the financial**positionof National Mercantile Bancorp and Subsidiaries as of December 31, 2001, andthe results of their operations and their cash flows for the years endedDecember 31, 2001 and 2000 in conformity with accounting principles generallyaccepted in the United States.

 

 

Arthur Andersen LLP

 

Los Angeles, California

March 14, 2002

 

 

*This isa copy of the audit report previously issued by Arthur Andersen LLP inconnection with National Mercantile Bancorp’s filing on Form 10-KSB for theyear ended December 31, 2001.  Arthur Andersen LLP has not reissued thisreport in connection with this filing on Form 10-KSB.*

 

46

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**NATIONALMERCANTILE BANCORP AND SUBSIDIARIES**

** **

**CONSOLIDATED BALANCE SHEET**

** **
|                                                                                                                      |   | **December  31,  2002**     |    |
|---------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|---------|
|                                                                                                                      |   | **(Dollars in  thousands)** |    |
| ASSETS                                                                                                                    |   |                        |    |
| Cash and due from  banks-demand                                                                                           |   | $                           | 18,876  |   |
| Federal funds sold and  securities purchased under agreements to resell                                                   |   | 18,700                      |    |
| Cash and cash equivalents                                                                                                 |   | 37,576                      |    |
| Securities available-for-sale,  at fair value; aggregate amortized cost of $25,824                                        |   | 26,170                      |    |
| Due from banks-time                                                                                                       |   | 325                         |    |
| FRB and other stock, at  cost                                                                                             |   | 2,018                       |    |
|                                                                                                                      |   |                        |    |
| Loans receivable                                                                                                          |   | 272,323                     |    |
| Allowance for credit losses                                                                                               |   | (4,846                      | )       |
| Net loans receivable                                                                                                      |   | 267,477                     |    |
|                                                                                                                      |   |                        |    |
| Premises and equipment, net                                                                                               |   | 5,836                       |    |
| Other real estate owned                                                                                                   |   | 1,000                       |    |
| Deferred tax asset                                                                                                        |   | 7,984                       |    |
| Goodwill                                                                                                                  |   | 2,174                       |    |
| Intangible assets, net                                                                                                    |   | 2,077                       |    |
| Accrued interest receivable  and other assets                                                                             |   | 2,748                       |    |
| Total assets                                                                                                              |   | $                           | 355,385 |   |
|                                                                                                                      |   |                        |    |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY                                                                                |   |                        |    |
| Deposits:                                                                                                                 |   |                        |    |
| Noninterest-bearing demand                                                                                                |   | $                           | 107,580 |   |
| Interest-bearing demand                                                                                                   |   | 30,465                      |    |
| Money market                                                                                                              |   | 43,134                      |    |
| Savings                                                                                                                   |   | 42,182                      |    |
| Time certificates of  deposit:                                                                                            |   |                        |    |
| $ 100,000 or more                                                                                                         |   | 43,006                      |    |
| Under $100,000                                                                                                            |   | 32,358                      |    |
| Total deposits                                                                                                            |   | 298,725                     |    |
|                                                                                                                      |   |                        |    |
| Federal funds purchased and  securities sold under agreements to repurchase                                               |   | 1,476                       |    |
| Other borrowings                                                                                                          |   | 7,500                       |    |
| Accrued interest payable  and other liabilities                                                                           |   | 1,950                       |    |
| Total liabilities                                                                                                         |   | 309,651                     |    |
|                                                                                                                      |   |                        |    |
| Guaranteed preferred  beneficial interests in the Company’s junior subordinated deferrable interest  debentures, net |   | 14,530                      |    |
|                                                                                                                      |   |                        |    |
| Shareholders’ equity:                                                                                                |   |                        |    |
| Preferred stock, no par  value - authorized 1,000,000 shares:                                                             |   |                        |    |
| Series A non-cumulative  convertible perpetual preferred stock; authorized 990,000 shares; outstanding  734,985 shares    |   | 6,003                       |    |
| Series B non-cumulative  convertible perpetual preferred stock; authorized 1,000 shares; outstanding  1,000 shares        |   | 1,000                       |    |
| Common stock, no par value;  authorized 10,000,000 shares; outstanding 2,679,544 shares                                   |   | 38,054                      |    |
| Additional paid-in capital                                                                                                |   | -                           |    |
| Accumulated deficit                                                                                                       |   | (14,055                     | )       |
| Accumulated other  comprehensive income                                                                                   |   | 202                         |    |
| Total shareholders’ equity                                                                                           |   | 31,204                      |    |
| Total liabilities and  shareholders’ equity                                                                          |   | $                           | 355,385 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

47

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**NATIONALMERCANTILE BANCORP AND SUBSIDIARIES**

** **

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

 
|                                                                                                                      |   | **For The Year Ended  December 31,**               |       |
|---------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------------------------|------------|
|                                                                                                                      |   | **2002**                                           |       | **2001** |   |
|                                                                                                                      |   | **(Dollars in thousands,  except per share data)** |       |
| Interest income:                                                                                                          |   |                                               | ** ** |   | ** ** |
| Loans, including fees                                                                                                     |   | $                                                  | 17,488     |   | $ | 9,743 |   |
| Securities  available-for-sale                                                                                            |   | 1,652                                              |       | 3,236 |   |
| Federal funds sold and  securities purchased under agreements to resell                                                   |   | 432                                                |       | 812 |   |
| Total interest income                                                                                                     |   | 19,572                                             |       | 13,791 |   |
| Interest expense:                                                                                                         |   |                                               |       |   |   |
| Interest-bearing demand                                                                                                   |   | 322                                                |       | 92 |   |
| Money market and savings                                                                                                  |   | 1,426                                              |       | 1,019 |   |
| Time certificates of  deposit:                                                                                            |   |                                               |       |   |   |
| $ 100,000 or more                                                                                                         |   | 845                                                |       | 1,409 |   |
| Under $100,000                                                                                                            |   | 1,459                                              |       | 308 |   |
| Total interest expense on  deposits                                                                                       |   | 4,052                                              |       | 2,828 |   |
| Federal funds purchased and  securities sold under agreements to repurchase                                               |   | 134                                                |       | 37 |   |
| Other borrowings                                                                                                          |   | 478                                                |       | 1,011 |   |
| Total interest expense                                                                                                    |   | 4,664                                              |       | 3,876 |   |
| Net interest income before  provision for credit losses                                                                   |   | 14,908                                             |       | 9,915 |   |
| Provision for credit losses                                                                                               |   | 1,925                                              |       | 517 |   |
| Net interest income after  provision for credit losses                                                                    |   | 12,983                                             |       | 9,398 |   |
| Other operating income:                                                                                                   |   |                                               |       |   |   |
| Net gain on sale of  securities available-for-sale                                                                        |   | —                                             |       | 374 |   |
| International services                                                                                                    |   | 37                                                 |       | 51 |   |
| Investment division                                                                                                       |   | 82                                                 |       | 104 |   |
| Deposit-related and other  customer services                                                                              |   | 1,383                                              |       | 684 |   |
| Gain on sale of other real  estate owned                                                                                  |   | —                                             |       | 20 |   |
| Total other operating  income                                                                                             |   | 1,502                                              |       | 1,233 |   |
| Other operating expenses:                                                                                                 |   |                                               |       |   |   |
| Salaries and related benefits                                                                                             |   | 6,776                                              |       | 4,474 |   |
| Net occupancy                                                                                                             |   | 1,368                                              |       | 1,034 |   |
| Furniture and equipment                                                                                                   |   | 418                                                |       | 275 |   |
| Printing and communications                                                                                               |   | 562                                                |       | 324 |   |
| Insurance and regulatory  assessments                                                                                     |   | 358                                                |       | 312 |   |
| Client services                                                                                                           |   | 656                                                |       | 826 |   |
| Computer data processing                                                                                                  |   | 953                                                |       | 448 |   |
| Legal services                                                                                                            |   | 541                                                |       | 227 |   |
| Other professional services                                                                                               |   | 530                                                |       | 411 |   |
| Amortization of core  deposit intangible                                                                                  |   | 223                                                |       | — |   |
| Promotion and other  expenses                                                                                             |   | 476                                                |       | 330 |   |
| Total other operating  expenses                                                                                           |   | 12,861                                             |       | 8,661 |   |
| Income before income tax  provision and minority interests                                                                |   | 1,624                                              |       | 1,970 |   |
|                                                                                                                      |   |                                               |       |   |   |
| Minority interest in the  Company’s income of the:                                                                   |   |                                               |       |   |   |
| Guaranteed preferred  beneficial interests in the Company’s junior subordinated deferrable interest  debentures, net |   | 1,537                                              |       | 722 |   |
| Series A Preferred Stock of  South Bay Bank, N.A                                                                          |   | 213                                                |       | — |   |
| Income (loss) before income  tax provision                                                                                |   | (126                                               | )          | 1,248 |   |
| Income tax provision                                                                                                      |   | 127                                                |       | 92 |   |
| Net income (loss)                                                                                                         |   | $                                                  | (253       | ) | $ | 1,156 |   |
| Earnings (loss) per share:                                                                                                |   |                                               |       |   |   |
| Basic                                                                                                                     |   | $                                                  | (0.15      | ) | $ | 0.72 |   |
| Diluted                                                                                                                   |   | $                                                  | (0.15      | ) | $ | 0.28 |   |

 

See accompanying notes toconsolidated financial statements.

 

48

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**NATIONALMERCANTILE BANCORP AND SUBSIDIARIES**

 

**CONSOLIDATEDSTATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY**

 
|                                                                      |                         |                                         |       |   |       |       |   | **Additional  Paid-in  Capital** |   | **Accumulated  Deficit** |   | **Accumulated  Other  Comprehensive  Income** |   | **Total** |   |
|---------------------------------------------------------------------------|------------------------------|----------------------------------------------|------------|--------|------------|------------|--------|----------------------------------|--------|--------------------------|--------|-----------------------------------------------|--------|-----------|--------|
|                                                                      |                         |
|                                                                      |                         |                                         |
|                                                                      |                         |                                         |
| **Preferred Stock Series A**                                              | **Preferred Stock Series B** | **Common Stock**                             |
| **Shares**                                                                |                         | **Amount**                                   | **Shares** |   | **Amount** | **Shares** |   | **Amount**                       |
|                                                                      |                         | **(Dollars in thousands except share data)** |       |
|                                                                      |                         |                                         |       |   |       |       |   |                             |   |                     |   |                                          |   |      |   |   |   |   |   |   |   |
| 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:                                                     |                         |                                         |       |   |       |       |   |                             |   |                     |   |                                          |   |      |   |   |   |   |   |   |   |
| Unrealized holding gain during the period                                 |                         |                                         |       |   |       |       |   |                             |   |                     |   |                                          |   |      |   |   |   | 966 |   | 966 |   |
| Less: Reclassification adjustment for gain included in net 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 |   |
| Preferred stock converted into common stock on a 2:1 basis                |                         | (15,595                                      | )          | (128   | )          |       |   |                             |   | 31,190                   |   | 128                                           |   |      |   |   |   |   |   | — |   |
| Common stock issued                                                       |                         |                                         |       |   |       |       |   |                             |   | 1,006,287                |   | 7,572                                         |   |      |   |   |   |   |   | 7,572 |   |
| Stock options exercised                                                   |                         |                                         |       |   |       |       |   |                             |   | 18,600                   |   | 86                                            |   |      |   |   |   |   |   | 86 |   |
| Redemption of beneficial conversion rights of subsidiary preferred  stock |                         |                                         |       |   |       |       |   |                             |   |                     |   |                                          |   | (1,824    | )      |   |   |   |   | (1,824 | ) |
| Comprehensive income (loss):                                              |                         |                                         |       |   |       |       |   |                             |   |                     |   |                                          |   |      |   |   |   |   |   |   |   |
| Unrealized holding gain during the period, net                            |                         |                                         |       |   |       |       |   |                             |   |                     |   |                                          |   |      |   |   |   | 146 |   | 146 |   |
|                                                                      |                         |                                         |       |   |       |       |   |                             |   |                     |   |                                          |   |      |   |   |   |   |   |   |   |
| Net loss                                                                  |                         |                                         |       |   |       |       |   |                             |   |                     |   |                                          |   |      |   | (253 | ) |   |   | (253 | ) |
| Comprehensive loss                                                        |                         |                                         |       |   |       |       |   |                             |   |                     |   |                                          |   |      |   |   |   |   |   | (107 | ) |
| Balance at December 31, 2002                                              |                         | 734,985                                      |       | $      | 6,003      |       | 1,000  |                             | $      | 1,000                    |   | 2,679,544                                     |   | $         | 38,054 |   | $ | — |   | $ | (14,055 | ) | $ | 202 |   | $ | 31,204 |   |

 

See accompanying notes to consolidated financial statements.

 

49

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**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

 

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

 
|                                                                                                                                                                                                                           |   | **For The Year Ended December 31,** |   |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------------|--------|
|                                                                                                                                                                                                                           |   | **2002**                            |   | **2001** |   |
|                                                                                                                                                                                                                           |   | **(Dollars in thousands)**          |   |
| Cash flow from operating  activities:                                                                                                                                                                                          |   |                                |   |   |   |
| Net income (loss)                                                                                                                                                                                                              |   | $                                   | (253   | ) | $ | 1,156 |   |
| Adjustments to reconcile  net income (loss) to net cash provided by operating activities:                                                                                                                                      |   |                                |   |   |   |
| Depreciation and  amortization                                                                                                                                                                                                 |   | 693                                 |   | 233 |   |
| Provision for credit losses                                                                                                                                                                                                    |   | 1,925                               |   | 517 |   |
| Net gain on sale of  securities available-for-sale                                                                                                                                                                             |   | —                              |   | (374 | ) |
| Net amortization of premium  on securities                                                                                                                                                                                     |   | 238                                 |   | 60 |   |
| Net amortization of  discount (premium) on loans purchased                                                                                                                                                                     |   | 348                                 |   | (29 | ) |
| Increase in accrued  interest receivable and other assets                                                                                                                                                                      |   | 1,340                               |   | 195 |   |
| Increase (decrease) in  accrued interest payable and other liabilities                                                                                                                                                         |   | (1,800                              | )      | 192 |   |
| Net cash provided by  operating activities                                                                                                                                                                                     |   | 2,491                               |   | 1,950 |   |
| Cash flows from investing  activities:                                                                                                                                                                                         |   |                                |   |   |   |
| Purchase of time deposits  of other banks                                                                                                                                                                                      |   | (325                                | )      | — |   |
| Purchase of securities  available-for-sale                                                                                                                                                                                     |   | (8,002                              | )      | (7,049 | ) |
| Proceeds from sales of  securities available-for-sale                                                                                                                                                                          |   | —                              |   | 33,001 |   |
| Proceeds from repayments  and maturities of securities available-for-sale                                                                                                                                                      |   | 23,367                              |   | 27,108 |   |
| Proceeds from sales of FRB  and other stock                                                                                                                                                                                    |   | 534                                 |   | 1,027 |   |
| Loan originations and  principal collections, net                                                                                                                                                                              |   | (15,324                             | )      | (10,622 | ) |
| Purchases of premises and  equipment                                                                                                                                                                                           |   | (168                                | )      | (236 | ) |
| Net cash used for purchase  of South Bay Bank, N.A.                                                                                                                                                                            |   | —                              |   | (24,786 | ) |
| Net cash provided by  investing activities                                                                                                                                                                                     |   | 82                                  |   | 18,443 |   |
| Cash flows from financing  activities:                                                                                                                                                                                         |   |                                |   |   |   |
| Net increase in demand  deposits, money market and savings accounts                                                                                                                                                            |   | 14,074                              |   | 29,314 |   |
| Net decrease in time  certificates of deposit                                                                                                                                                                                  |   | (24,489                             | )      | (3,815 | ) |
| Net decrease in securities  sold under agreements to repurchase and federal funds purchased                                                                                                                                    |   | (1,620                              | )      | (7,524 | ) |
| Net decrease in other  borrowings                                                                                                                                                                                              |   | (10,000                             | )      | (29,580 | ) |
| Net proceeds from issuance  of common stock                                                                                                                                                                                    |   | 7,572                               |   | — |   |
| Net proceeds from issuance  of preferred stock                                                                                                                                                                                 |   | —                              |   | 1,000 |   |
| Redemption of South Bay  Bank preferred stock                                                                                                                                                                                  |   | (2,500                              | )      | — |   |
| Dividends paid on South Bay  Bank preferred stock                                                                                                                                                                              |   | (213                                | )      | — |   |
| Net proceeds from issuance  of noncumulative deferrable interest debentures                                                                                                                                                    |   | —                              |   | 14,506 |   |
| Net proceeds from exercise  of stock options                                                                                                                                                                                   |   | 86                                  |   | 202 |   |
| Net cash provided by (used  in) financing activities                                                                                                                                                                           |   | (17,090                             | )      | 4,103 |   |
| Net increase (decrease) in  cash and cash equivalents                                                                                                                                                                          |   | (14,517                             | )      | 24,496 |   |
| Cash and cash equivalents,  January 1                                                                                                                                                                                          |   | 52,093                              |   | 27,597 |   |
| Cash and cash equivalents,  December 31                                                                                                                                                                                        |   | $                                   | 37,576 |   | $ | 52,093 |   |
|                                                                                                                                                                                                                           |   |                                |   |   |   |
| Supplemental disclosures of  cash flow information:                                                                                                                                                                            |   |                                |   |   |   |
| Cash paid for -                                                                                                                                                                                                                |   |                                |   |   |   |
| Interest                                                                                                                                                                                                                       |   | $                                   | 5,852  |   | $ | 3,205 |   |
| Income taxes, net                                                                                                                                                                                                              |   | —                              |   | 64 |   |
| Unrealized gain on  securities available-for-sale, net of tax effect                                                                                                                                                           |   | 146                                 |   | 592 |   |
| Transfers to OREO from  loans receivable, net                                                                                                                                                                                  |   | 1,000                               |   | — |   |
| 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.

 

 

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**NATIONAL MERCANTILE BANCORP ANDSUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

## **Note1—Summary of Significant Accounting Policies**

 

*Basis of Presentation*

 

The consolidatedfinancial statements include the accounts of National Mercantile Bancorp(“National Mercantile” when referring only to the parent company or the“Company” when such reference includes National Mercantile Bancorp and itssubsidiaries, collectively) and of its wholly owned subsidiaries, MercantileNational Bank (“Mercantile”) and South Bay Bank, N.A. (“South Bay”) (andcollectively, the “Banks”).  NationalMercantile Capital Trust I, which is a Delaware statutory business trust formedfor the exclusive purpose of issuing and selling trust preferred securities, isalso a subsidiary of National Mercantile. All intercompany transactions and balances have been eliminated.   Certain prior year amounts have beenreclassified to conform to the current year presentation.

 

The accounting andreporting policies of the Company conform to accounting principles generallyaccepted in the United States and to prevailing practices within the bankingindustry.  The preparation of theseconsolidated financial statements requires management to make estimates andassumptions that affect the reported amount of assets and liabilities, anddisclosure of contingent assets and liabilities at the date of consolidatedfinancial statements and the reported amounts of revenues and expenses duringreported periods.  Actual results coulddiffer from those estimates.

 

The Company, through theBanks, engages in commercial banking in the Los Angeles area providingcommercial and residential real estate financing, real estate constructionfinancing and commercial lending serving niche markets represented byprofessional service providers, entertainment, healthcare and community-basednonprofit borrowers, and associated individuals with commercial banking andpersonal banking needs.

 

*Cash and Cash Equivalents*

 

For purposes of reportingcash flows, cash and cash equivalents include cash and due from banks-demand,federal funds sold and securities purchased under agreements to resell.

 

*Securities*

 

Securities available-for-saleare carried at fair value.  Unrealizedgains or losses on available-for-sale securities are excluded from earnings andreported as accumulated other comprehensive income, net of deferred incometaxes, in a separate 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 on salesavailable-for-sale securities are recorded using the specific identificationmethod.

 

*Loans*

 

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

 

Interest income isaccrued as earned.  Net deferred feesare accreted into interest income using the effective interest method.

 

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 accrualstatus.  Generally, a loan may bereturned to accrual status when all delinquent principal and interest are broughtcurrent in accordance with the terms of the loan agreement and certainperformance criteria have been met.

 

The Company considers aloan to be impaired when it is probable that it will be unable to collect allamounts due according to the contractual terms of the loan agreement.  Once a loan is determined to be impaired,the impairment is measured based on the present value of the expected futurecash flows discounted at the loan’s effective interest rate, except that as apractical expedient, the 

 

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impairment is measured by using the loan’s observable market price orthe fair value of the collateral if the loan is collateral dependent.

 

When the measurement ofthe impaired loan is less than the recorded amount of the loan, impairment isrecognized by creating a valuation allowance with a corresponding charge to theprovision for credit losses or by adjusting an existing valuation allowance forthe impaired loan with a corresponding charge or credit to the provision forcredit losses.

 

The Company’s policy isto record cash receipts received on impaired and nonaccrual loans first asreductions to principal and then to interest income.

 

*Allowance for Credit Losses*

 

The provisions for creditlosses charged to operations reflect management’s judgment of the adequacy ofthe allowance for credit losses and are determined through periodic analysis ofthe loan portfolio, problem loans and consideration of such other factors asthe Company’s loan loss experience, trends in problem loans, concentrations ofcredit risk, and economic conditions (particularly Southern California), aswell as the results of the Company’s ongoing examination process and itsregulatory examinations.

 

The calculation of theadequacy of the allowance for credit losses is based on a variety of factors,including loan classifications, migration trends and underlying cash flow andcollateral values.  On a periodic basis,management engages an outside loan review firm to review the Company’s loanportfolio, risk grade accuracy and the reasonableness of loan evaluations.  Annually, this outside loan review teamanalyzes the Company’s methodology for calculating the allowance for creditlosses based on the Company’s loss histories and policies.  The Company uses a migration analysis aspart of its allowance for credit losses evaluation which 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 the Company’s portfolio rather than use outside factors thatmay not take into consideration trends relative to the specific loanportfolio.  In addition, this analysistakes into consideration other trends that are qualitative relative to theCompany’s marketplace, demographic trends, amount and trends in nonperformingassets and concentration factors.

 

*Premises and Equipment, Net*

 

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

 

*OtherReal Estate Owned*

 

Other Real Estate Owned(“OREO”) is comprised of real estate acquired in satisfaction of loans.  Properties acquired by foreclosure or deedin lieu of foreclosure are transferred to OREO and are initially recorded atthe lower of the loan balance or fair value at the date of transfer of theproperty, establishing a new cost basis. Subsequently, OREO is carried at the lower of cost or fair value lesscosts to sell.  The fair value of theOREO property is based upon a current appraisal.  Losses that result from the ongoing periodic valuation of theseproperties are charged to other operating expenses in the period in which theyare identified.  Expenses for holdingcosts are charged to other operating expenses as incurred.

 

*Income Taxes*

 

The Company and the Banksfile consolidated federal income tax returns and combined state income taxreturns.

 

Deferred tax assets andliabilities are recognized for the expected future tax consequences of existingdifferences between financial reporting and tax reporting bases of assets andliabilities, as well as for operating losses and tax credit carryforwards,using enacted tax laws and rates. Deferred tax assets will be reduced through a valuation allowancewhenever it becomes more likely than not that all or some portion will not berealized.  Deferred income taxes(benefit) represents the net change in deferred tax asset or liability balanceduring the year.  This amount, togetherwith income taxes currently payable or refundable in the current year,represents the total tax expense (benefit) for the year.

 

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*Comprehensive Income*

 

Comprehensive income isdefined as the change in equity during a period from transactions and otherevents 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 of othercomprehensive income together with total comprehensive income are reported inthe consolidated statements of changes in shareholders’ equity.  The accumulated balance of othercomprehensive income is reported as a net amount after taxes.

 

*Earnings per Share*

 

Basic earnings per shareis computed using the weighted average number of common shares outstandingduring the period.  The weighted averagenumber of common shares outstanding used in computing basic earnings per sharefor the years ended December 31, 2002 and 2001 was 1,650,997 and 1,608,307,respectively.  Diluted loss per sharefor the year ended December 31, 2002 was $0.15 and does not include commonshare equivalents as they are anti-dilutive. The weighted average number of common shares and common shareequivalents outstanding used in computing diluted earnings per share for theyear ended December 31, 2001 was 4,099,898. The following table is a reconciliation of net income and shares used inthe computation of basic and diluted earnings per share:

 

|                              |   | **Net  Income  (Loss)** |       | **Weighted  Average  Shares** |       | **Per  Share  Amount** |       |
|-----------------------------------|--------|-------------------------|------------|-------------------------------|------------|------------------------|------------|
|                              |   | **(in  thousands)**     |       |                          |       |                   |       |
|                              |   |                    | ** ** |                          | ** ** |                   | ** ** |
| *For the year ended 2002:*        |   |                    |       |                          |       |                   |       |
| Basic  and diluted loss per share |   | $                       | (253       | )                             | 1,650,997  |                   | $          | (0.15 | ) |
|                              |   |                    |       |                          |       |                   |       |
| *For the year ended 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 |   |

 

*Fair Value of Financial Instruments*

 

Estimated fair valueamounts have been determined using available market information and appropriatevaluation methodologies.  Considerablejudgment is required to interpret market data and to develop the estimates offair value.  Accordingly, the estimatesof fair value in the financial statements are not necessarily indicative of theamounts the Company could realize in a current market exchange.  The use of different market assumptions andestimation methodologies may have a material effect on the estimated fair valueamounts.

 

*Stock Options*

 

The Company appliesAccounting Principles Board Opinion No. 25 and related Interpretations inaccounting for the stock incentive plans. SFAS No. 123, “Accounting for Stock-Based Compensation,” encourages, butdoes not require, companies to record compensation cost for stock-basedemployee compensation plans at fair value. Compensation expense is recorded onthe date of grant only if the current market price of the underlying stockexceeded the exercise price.  Alloptions were granted at current market prices, accordingly, no compensationcost has been recognized for the plans. Pro forma net income and pro forma earnings per share disclosures foremployee stock option grants are based on recognition as expense, over thevesting period, the fair value on the date of grant of all stock-based awardsmade during 2002 and 2001.

 

*RecentAccounting**Pronouncements*

 

On July 20, 2001, theFinancial Accounting Standards Board issued Statement of Financial AccountingStandard No. 141-Business Combinations (“SFAS No. 141”). The standard concludesthat all business combinations within the scope of the statement will beaccounted for using the purchase method. Previously, the pooling-of-interests method was required whenevercertain criteria 

 

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were met.  Because thosecriteria did not distinguish economically dissimilar transactions, similarbusiness combinations were accounted for using different methods that produceddramatically different financial statement results.  SFAS No. 141 requires separate recognition of intangible assetsapart from goodwill if they meet one of two criteria, the contractual-legalcriterion or the separability criterion. SFAS No. 141 also requires the disclosure of the primary reasons for abusiness combination and the allocation of the purchase price paid to theassets acquired and liabilities assumed by major balance sheet caption.

 

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

 

On July 20, 2001 theFinancial Accounting Standards Board also issued Statement of FinancialAccounting Standard No. 142-Goodwill and Other Intangible Assets (“SFAS No.142”).  It addresses how intangibleassets that are acquired individually or within a group of assets (but notthose acquired in a business combination) should be accounted for in thefinancial statements upon their acquisition. SFAS No.142 adopts a more aggregate view of goodwill and bases theaccounting on the units of the combined entity into which an acquired entity isaggregated.

 

SFAS No. 142 alsoprescribes that goodwill and intangible assets that have indefinite usefullives will not be amortized but rather tested at least annually forimpairment.  Intangible assets that havedefinite lives will continue to be amortized over their useful lives, but nolonger with the constraint of the 40-year ceiling.  SFAS No. 142 provides specific guidance for the testing ofgoodwill for impairment, which may require re-measurement of the fair value ofthe reporting unit.  Impairment lossesare to be reported as resulting from a change in accounting principle.  Additional ongoing financial statementdisclosures are also required.

 

We adopted SFAS No. 142as of January 1, 2002 as disussed in Note 2 of the Notes to ConsolidatedFinancial Statements.  The Companyconducted a goodwill impairment test during 2002 in accordance with SFAS No.142 and determined that its goodwill is not considered impaired.

 

**Note 2—Goodwill and Other IntangibleAssets**

 

As of December 31, 2002,the Company had goodwill of $2.2 million and core deposit intangibles of $2.1million from the South Bay Bank acquisition. In accordance with SFAS No. 142 goodwill is not amortized.  SFAS No. 142 also requires an analysis ofimpairment of goodwill annually or more frequently upon the occurrence ofcertain events.  During 2002, therequired impairment tests of goodwill were conducted, and based upon theseevaluations, the Company’s goodwill was not impaired at December 31, 2002.  The Company has no other indefinite-livedintangible assets.  The core depositintangibles are estimated to have a life of 10 years and 4 months. Amortizationfor intangibles for 2002 and each of the next five years is estimated to be$223,000 per year.

 

**Note 3—Investment Securities**

 

The following is asummary of amortized cost, gross unrealized gains, gross unrealized losses, andestimated fair values of the Company’s investment securities available-for-saleat December 31, 2002:

 

|                                                                      |   | **December  31, 2002**      |       |
|---------------------------------------------------------------------------|--------|-----------------------------|------------|
|                                                                      |   | **Total  amortized  cost**  |       | **Gross  unrealized  gains** |   | **Gross  unrealized  loss** |   | **Estimated  fair  value** |   |
|                                                                      |   | **(Dollars  in thousands)** |       |
|                                                                      |   |                        | ** ** |   | ** ** |   | ** ** |   | ** ** |
| U.S.  Treasury securities                                                 |   | $                           | 998        |   | $ | — |   | $ | 1 |   | $ | 997 |   |
| GNMA-issued/guaranteed  mortgage pass through certificates                |   | 2,409                       |       | 73 |   | — |   | 2,482 |   |
| Other  U.S. government and federal agency securities                      |   | —                      |       | — |   | — |   | — |   |
| FHLMC/FNMA-issued  mortgage pass through certificates                     |   | 12,370                      |       | 506 |   | — |   | 12,876 |   |
| CMO’s  and REMIC’s issued by U.S. government-sponsored agencies |   | 4,544                       |       | 44 |   | — |   | 4,588 |   |
| Privately  issued corporate bonds, CMO’s and REMIC’s securities |   | 5,503                       |       | 12 |   | 288 |   | 5,227 |   |
|                                                                      |   | $                           | 25,824     |   | $ | 635 |   | $ | 289 |   | $ | 26,170 |   |

 

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The Company had no salesof investment securities for the year ended December 31, 2002.  The Company had gross proceeds and netrealized gains related to the sale of investment securities of $33.0 millionand $374,000, respectively, for the year ended December 31, 2001.

 

The estimated fair valueand amortized cost of securities available-for-sale at December 31, 2002 bycontractual maturity, are shown below:

 

|                                                                      |   | **Within  one year**        |   | **After  one but  within five years** |   | **After  five but  within ten years** |   | **After  ten years** |   |       |   | **Weighted  Average** |   |
|---------------------------------------------------------------------------|--------|-----------------------------|--------|---------------------------------------|--------|---------------------------------------|--------|----------------------|--------|------------|--------|-----------------------|--------|
|                                                                      |   | **Amount**                  |   | **Yield**                             |   | **Amount**                            |   | **Yield**            |   | **Amount** |   | **Yield**             |   | **Amount** |   | **Yield** |   | **Total** |   | **Yield** |   |
|                                                                      |   | **(Dollars  in thousands)** |   |
|                                                                      |   |                        |   |                                  |   |                                  |   |                 |   |       |   |                  |   |   |   |   |   |   |   |   |   |
| Securities  available-for-sale:                                           |   |                        |   |                                  |   |                                  |   |                 |   |       |   |                  |   |   |   |   |   |   |   |   |   |
| U.S  Treasury securities                                                  |   | $                           | 997    |                                  | 1.19   | %                                     | $      | —               |   | —     |   | $                     | — |   | — |   | $ | — |   | — |   | $ | 997 |   | 1.19 | % |
| GNMA-issued/guaranteed  mortgage pass-through certificates                |   | —                      |   | —                                |   | —                                |   | —               |   | —     |   | —                |   | 2,482 |   | 7.20 | % | 2,482 |   | 7.20 | % |
| Other  U.S. government and federal agencies                               |   | —                      |   | —                                |   | —                                |   | —               |   | —     |   | —                |   | — |   | — |   | — |   | — |   |
| FHLMC/FNMA-issued  mortgage pass-through certificates                     |   | —                      |   | —                                |   | 1,898                                 |   | 5.53                 | %      | 1,043      |   | 6.17                  | %      | 9,935 |   | 6.76 | % | 12,876 |   | 6.53 | % |
| CMO’s  and REMIC’s issued by U.S. government-sponsored agencies |   | —                      |   | —                                |   | —                                |   | —               |   | 1,721      |   | 5.51                  | %      | 2,867 |   | 6.57 | % | 4,588 |   | 6.17 | % |
| Privately  issued Corporate bonds, CMO’s and REMIC’s securities |   | —                      |   | —                                |   | —                                |   | —               |   | 1,917      |   | 2.26                  | %      | 3,310 |   | 4.45 | % | 5,227 |   | 3.65 | % |
|                                                                      |   | $                           | 997    |                                  | 1.19   | %                                     | $      | 1,898                |   | 5.53       | %      | $                     | 4,681  |   | 4.33 | % | $ | 18,594 |   | 6.38 | % | $ | 26,170 |   | 5.76 | % |
|                                                                      |   |                        |   |                                  |   |                                  |   |                 |   |       |   |                  |   |   |   |   |   |   |   |   |   |
| **Amortized Cost**                                                        |   | $                           | 998    |                                  |   |                                  | $      | 1,857                |   |       |   | $                     | 4,619  |   |   |   | $ | 18,350 |   |   |   | $ | 25,824 |   |   |   |

 

Actual maturities maydiffer from contractual maturities to the extent that borrowers have the rightto call or prepay obligations with or without call or repayment penalties.

 

Investment securitiestotaling $18.3 million were pledged to secure government tax deposits,bankruptcy deposits, or for other purposes required or permitted by law at December31, 2002.

 

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

 

The following is asummary of the major categories of loans receivable outstanding at December 31,2002:

** **

| **(Dollars  in thousands)**                              |   |    |    |
|----------------------------------------------------------|--------|---------|---------|
|                                                     |   |    |    |
| Commercial loans:                                        |   |    |    |
| Secured by one-to-four  family residential properties    |   | $       | 10,797  |   |
| Secured by multifamily  residential properties           |   | 12,596  |    |
| Secured by commercial  real properties                   |   | 119,872 |    |
| Other, secured and  unsecured                            |   | 86,015  |    |
| Real estate  construction and land development           |   | 37,934  |    |
| Home equity lines of  credit                             |   | 846     |    |
| Consumer installment  and unsecured loans to individuals |   | 4,720   |    |
|                                                     |   | 272,780 |    |
| Unearned income                                          |   | (457    | )       |
|                                                     |   | $       | 272,323 |   |
|                                                     |   |    |    |
| Weighted average yield  for loans at December 31, 2002   |   | 6.99    | %       |

** **

At December 31, 2002, theCompany had identified impaired loans with recorded investments of  $4.2 million.  At December 31, 2002, specific allowances for credit lossestotaling $1.7 million were established for these loans.  The average recorded investment of impairedloans was $4.3 million and $831,000 during 2002 and 2001, respectively.  No interest income recognized on impairedloans during the year ended December 31, 2002. During 2001 interest income recognized on impaired loans was $4,000.

 

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In the normal course ofbusiness, the Banks may make loans to officers and directors as well as loansto companies and individuals affiliated with or guaranteed by officers anddirectors of the Company and the Banks. Such loans are made in the ordinary course of business at rates andterms no more favorable than those offered to other customers with a similarcredit standing.  The outstandingprincipal balance of these loans was $4.5 million at December 31, 2002 and $3.3million at December 31, 2001.  During2002 there were $3.6 million of advances and $2.4 million  of repayments.  Interest income recognized on these loans amounted to $374,000and $1,000 during 2002 and 2001, respectively. At December 31, 2002, none ofthese loans were on nonaccrual status. Based on analysis of informationpresently known to management about the loans to officers and directors andtheir affiliates, management believes all have the ability to comply with thepresent loan repayment terms.

 

The following is asummary of activity in the allowance for credit losses for the year endedDecember 31, 2002:

 

| Balance, beginning of  year                 |   | $      | 6,542  |   |
|---------------------------------------------|--------|--------|--------|--------|
| Provision for credit  losses                |   | 1,925  |   |
| Loans charged off                           |   | (4,062 | )      |
| Recoveries of loans  previously charged off |   | 441    |   |
| Balance, end of year                        |   | $      | 4,846  |   |

 

Total loans charged-offin 2002 was $4.1 million primarily the result of the write-down of commercialloans secured by manufacturing equipment. The write-downs were required to reduce the recorded value of the loansto the adjusted value of the collateral based upon the Company’s periodicevaluation.

 

The additional provisionfor credit losses was recorded based upon the analysis of the adequacy ofallowance for credit losses.  Theallowance for credit losses for classified loans graded as “criticized” by theCompany’s internal grading system that are collateral-dependent is based uponthe net realizable value of the collateral that is periodically evaluate.  The allowance for unsecured classified loansis based upon the severity of the credit weakness.

 

The following is asummary of nonperforming loans at December 31, 2002:

 

| Nonaccrual loans                                                                                                            |   | $      | 5,787  |   |
|-----------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|--------|
| Troubled debt  restructurings                                                                                               |   | — |   |
| Loans contractually  past due ninety or more days with respect to either principal or interest and  still accruing interest |   | 209    |   |
|                                                                                                                        |   | $      | 5,996  |   |

 

Interest foregone onnonperforming loans outstanding at December 31, 2002 and 2001 was $388,000 and$110,000, respectively.  Foregoneinterest on nonperforming loans does not include interest forgone on loans onnonperforming status that were restored to performing status prior to year end,or subsequent to either being charged off prior to year end or transferred toOREO prior to year end.

 

*Troubled Debt Restructurings.*A TDR is a loan for which the Company has, for economic or legal reasonsrelated to a borrower’s financial difficulties, granted a concession to theborrower it would not otherwise consider, including modifications of loan termsto alleviate the burden of the borrower’s near-term cash flow requirements inorder to help the borrower to improve its financial condition and eventualability to repay the loan.  At December31, 2002 we had no TDRs.  At December31, 2001 TDRs were $953,000 of which the real estate collateral wassubsequently foreclosed in satisfaction of payment.

 

The ability of theCompany’s borrowers to honor their contracts is substantially dependent uponeconomic conditions and real estate market values throughout the Company’smarket area. At December 31, 2002, loans aggregating $182.0 million werecollateralized by liens on residential and commercial real properties.  While the Company’s loan portfolio isgenerally diversified with regard to the industries represented, at December31, 2002, the Company’s loans to businesses and individuals engaged inentertainment industry related activities amounted to $31.1 million.

 

56

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

 

The following is asummary of the major components of premises and equipment at December 31, 2002:

 

| **(Dollars in thousands)**                      |   |   |   |
|-------------------------------------------------|--------|--------|--------|
| Land                                            |   | $      | 1,392  |   |
| Buildings                                       |   | 3,870  |   |
| Leasehold  improvements                         |   | 1,461  |   |
| Furniture,  fixtures and equipment              |   | 4,409  |   |
|                                            |   | 11,132 |   |
| Less  accumulated amortization and depreciation |   | (5,296 | )      |
|                                            |   | $      | 5,836  |   |

 

Depreciation andamortization expense was $456,000 in 2002 and $233,000 in 2001.  Rental expense on operating leases includedin occupancy expense in the Consolidated Statements of Operations was $915,000in 2002 and $828,000 in 2001.

 

The future minimum annualrental commitments at December 31, 2002 are summarized below.

 

| **(Dollars in thousands)**        |   |   |   |
|-----------------------------------|--------|--------|--------|
| *For the year ended December 31,* |   |   |   |
| 2003                              |   | $      | 945    |   |
| 2004                              |   | 732    |   |
| 2005                              |   | 6      |   |
| 2006                              |   | 1      |   |
| 2007                              |   | 1      |   |
|                              |   | $      | 1,685  |   |

 

**Note 6—Income Taxes**

 

A deferred federal andstate income tax provision of $127,000 and $92,000 was recognized during 2002and 2001, respectively.

 

A reconciliation of theamounts computed by applying the federal statutory rate of 34% for 2002 and2001 to the income and the effective tax rate are as follows:

 

|                                          |   | **2002**                    |   | **2001** |   |
|-----------------------------------------------|--------|-----------------------------|--------|----------|--------|
|                                          |   | **(Dollars  in thousands)** |   |
| Tax provision (benefit) at statuory rate      |   | $                           | (43    | )        | $      | 424 |   |
| Increase (reduction) in taxes resulting from: |   |                        |   |     |   |
| Book deductions without tax benefit           |   | 151                         |   | —   |   |
| Permanent differences                         |   | 19                          |   | (332     | )      |
|                                          |   | $                           | 127    |     | $      | 92 |   |

 

57

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The major components ofthe net deferred tax asset at December 31, 2002 are as follows:

 

| **(Dollars in thousands)**            |   |   |       |
|---------------------------------------|--------|--------|------------|
| Deferred tax assets:                  |   |   | ** ** |
| Net operating losses                  |   | $      | 6,539      |   |
| Accrued expenses                      |   | 287    |       |
| Alternative minimum tax credits       |   | 314    |       |
| Nonaccrual interest                   |   | 135    |       |
| Loan Fees                             |   | 115    |       |
| Securities available for sale         |   | 209    |       |
| Bad debt expense                      |   | 343    |       |
| Depreciation                          |   | 25     |       |
| Other                                 |   | 32     |       |
| Total deferred tax assets             |   | 7,999  |       |
|                                  |   |   |       |
| Deferred tax liabilities:             |   |   |       |
| Federal Home Loan Bank stock dividend |   | 15     |       |
| Total deferred tax liabilities        |   | 15     |       |
| Net deferred tax asset                |   | $      | 7,984      |   |

 

For tax purposes atDecember 31, 2002, the Company had (i) federal NOLs of $18.2 million, whichbegin to expire in 2009; (ii) California NOLs of $559,000 which begin to expirein 2005; (iii) a federal AMT credit carryforward of $298,000; and (iv) aCalifornia AMT credit carryforward of $16,000. The AMT credits carryforward indefinitely.

 

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

 

**Note7—Benefit Plans**

 

*Stock Incentive Plans*.  At December 31, 2002, the Company had ineffect one stock incentive plan pursuant to which up to a total of 548,510shares of common stock may be issued. Under this plan, the Company may grant to directors, officers, employeesand consultants stock-based incentive compensation in a variety of forms,including without limitation nonqualified options, incentive options, sales andbonuses of common stock and stock appreciation rights, on such terms andconditions as the Board committee determines. However, the exercise price ofoptions granted to nonemployee directors may not be less than the fair marketvalue of the common stock on the date of grant.  At December 31, 2002, the only outstanding awards under this planwere stock options, and at that date 140,534 shares were available for futureawards.

 

At December 31, 2002,there were also outstanding options and tandem stock appreciation rightsgranted under two prior stock incentive plans.

 

The following summarizesoption grants, cancellations and exercises under the stock incentive plans forthe periods indicated .

 

|                            |   |    |   | **Option  Price Range  Per Share** |   |
|---------------------------------|--------|---------|--------|------------------------------------|--------|
|                            |   |    |   |                               |   |   |   |   |   |
| 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 |   |
| Granted                         |   | 12,500  |   | 5.26                               |   | - |   | 6.70 |   |
| Cancelled                       |   | (30,346 | )      | 4.59                               |   | - |   | 8.52 |   |
| Exercised                       |   | (18,600 | )      | 4.50                               |   | - |   | 6.60 |   |
| Outstanding,  December 31, 2002 |   | 420,843 |   | $                                  | 3.94   |   | - |   | $ | 8.52 |   |

 

58

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Of the outstandingoptions at December 31, 2002:  (i)options to purchase 358,243 shares were vested and exercisable; and (ii) theremaining options become exercisable as follows: 2003 — 57,100 and 2004 —5,500.

 

The estimated per shareweighted average fair value of options granted was $4.08 and $3.82 during 2002and 2001.  The Company appliesAccounting Principles Board Opinion No. 25 and related Interpretations inaccounting for the stock incentive plans. SFAS No. 123, “Accounting for Stock-Based Compensation,” encourages, butdoes not require, companies to record compensation cost for stock-basedemployee compensation plans at fair value. Accordingly, no compensation cost has been recognized for the plans.  Had compensation cost or the options grantedbeen determined based on the fair value at the grant dates for awards under theplans consistent with the method of SFAS No. 123, the Company’s net loss for2002 would have been increased by $92,000 and net income for 2001 would havedecreased by $90,000.  Basic and dilutedloss per share would have increased by $0.06 for 2002.  Basic and diluted earnings per share wouldhave decreased by $0.08 and  $0.03 for2001, respectively.

 

The fair values ofoptions granted during 2002 and 2001 were estimated on the date of grant usingthe Black-Scholes option-pricing model with the following weighted-averageassumptions used: 2002— no dividend yield, expected volatility of 59%,risk-free interest rate of 4.06%, and an expected life of 10 years; 2001— no dividendyield, expected volatility of 68%, risk-free interest rate of 5.11%, and anexpected life of 10 years.

 

*Defined Contribution Retirement Plan*.The Company maintains a defined contribution retirement plan under section401(k) of the Internal Revenue Code. Employees are eligible to participatefollowingsix months of continuous employment. Under the plan, the Company haspartially matched employee contributions since May 1, 2001.  Such matching contributions become fullyvested when the employee reaches three years of service.  The Company’s matching contributions for2002 and 2001 were $90,000 and $69,000, respectively.

 

**Note 8—Borrowed Funds**

 

The following summarizesborrowed funds and weighted average rates.

 

|                                                                     |   | **2002**                    |   |
|--------------------------------------------------------------------------|--------|-----------------------------|--------|
|                                                                     |   | **Year-end**                |   | **Average** |   |
|                                                                     |   | **Balance**                 |   | **Weighted  Average  Rate** |   | **Balance** |   | **Weighted  Average  Rate** |   |
|                                                                     |   | **(Dollars  in thousands)** |   |
|                                                                     |   |                        |   |   |   |   |   |   |   |
| Federal  funds purchased and securities sold under repurchase agreements |   | $                           | 1,475  |   | 4.65 | % | $ | 2,294 |   | 5.84 | % |
|                                                                     |   |                        |   |   |   |   |   |   |   |
| Other  borrowings                                                        |   | 7,500                       |   | 4.70 | % | 11,308 |   | 4.23 | % |
|                                                                          |        |                             |        |  |  |  |  |  |  |  |  |

 

The maximum amount offederal funds purchased and securities sold under agreements to repurchase atany month-end was $11.7 million during 2002.

 

Other borrowings areprimarily comprised of Federal Home Loan Bank (“FHLB”) advances.  At December 31, 2002 FHLB advances included:(i) a $2.5 million putable borrowing with a fixed rate of 5.93%, with putscommencing July 2002 and continuing every three months thereafter, through July2004; (ii) fixed rate borrowings of $3.0 million maturing April 2004 with arate of 3.85%; (iii) fixed rate borrowings of $2.0 million maturing April 2005with a rate of 4.45%.  The maximumamount of other borrowings outstanding at any month-end was $17.5 millionduring 2002.

 

The Banks had $7.7million of unused borrowing capacity from the FHLB at December 31, 2002 basedupon pledged securities.

 

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

 

The Company formedNational Mercantile Capital Trust I (the “Trust”), a statutory business trustunder the Delaware Business Trust Act, pursuant to a Declaration of Trust datedas of June 27, 2001, for the sole purpose of issuing and selling certainsecurities representing undivided beneficial interests in the assets of theTrust and investing the proceeds thereof in certain debentures of the Company.

 

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On July 16, 2001 theTrust issued and sold to the Company 464 common securities (liquidation amountof $1,000 per common security) of the Trust (the “Common Securities”),representing common beneficial interests in the assets of the Trust.

 

Also, on July 16, 2001the Trust issued 15,000 of 10.25% fixed rate securities (the “Trust PreferredSecurities”), with a liquidation amount of $1,000 per Trust Preferred Securityand an aggregate liquidation amount of $15.0 million due July 25, 2031. The Trust Preferred Securities are unconditionally guaranteed by the Companywith respect to distributions and payments upon liquidation, redemption andotherwise to the extent provided in and pursuant to the terms of a GuaranteeAgreement.

 

The Trust used theproceeds from the issuance and the sale of the Trust Preferred Securities andthe Common Securities to purchase $15.5 million aggregate principal amount ofthe Company’s 10.25% fixed rate junior subordinated deferrable interestdebentures due July 25, 2031 that pay interest each January 26 and July26.  The interest is deferrable, at theCompany’s option, for a period up to ten consecutive semi-annual payments, butin any event not beyond June 25, 2031. The debentures are redeemable, in whole or in part, at the Company’soption on or after five years from issuance at declining premiums to maturity.  The debentures are the primary assets of theTrust.

 

The Trust PreferredSecurities are reflected on the Consolidated Balance Sheet as “Guaranteedpreferred beneficial interests in the Company’s junior subordinated deferrableinterest debentures.”  The accrueddistributions payable on the Trust Preferred Securities are reflected as“Minority interest in income of the trust subsidiary” in the ConsolidatedStatements of Operations. The costs associated with the Trust PreferredSecurities issuance have been netted against the proceeds and are beingaccreted using a method that approximates the interest method over a period ofthirty years.  The recorded balance ofTrust Preferred Securities was $14.5 million at December 31, 2002.  Minority interest in income of trustsubsidiary was $1.6 million for the year ended December 31, 2002.

 

The regulatory capitalgenerated from the Trust Preferred Securities supported the acquisition ofSouth Bay.

** **

**Note10—Availability to National Mercantile of Funds from Banks; Restrictions onCash Balances; Regulatory Capital**

 

National Mercantile is alegal entity separate and distinct from the Banks, and as such has separate anddistinct financial obligations including deferrable debt service of $1.5million (related to the Trust Preferred Securities) and other modest operatingexpenses.  While National Mercantileholds short-term investments of $4.6 million, its assets primarily consist ofthe common shares of the Banks. Accordingly, dividends and capital distributions from the Banksconstitute the principal ongoing source of cash to the Company.  The Banks are subject to various statutoryand regulatory restrictions on their ability to pay dividends to the Company.

 

OCC approval is requiredfor a national bank to pay a dividend if the total of all dividends declared inany calendar year exceeds the total of the bank’s net profits (as defined) forthat year combined with its retained net profits for the preceding two calendaryears, less any required transfer to surplus or a fund for the retirement ofany preferred stock.  A national bankmay not pay any dividend that exceeds its retained net earnings, as defined bythe OCC.   The OCC and the FederalReserve Board have also issued banking circulars emphasizing that the level ofcash dividends should bear a direct correlation to the level of a nationalbank’s current and expected earnings stream, the bank’s need to maintain anadequate capital base and other factors.

 

National banks that arenot in compliance with regulatory capital requirements generally are notpermitted to pay dividends.  The OCCalso can prohibit a national bank from engaging in an unsafe or unsoundpractice in its business.  Depending onthe bank’s financial condition, payment of dividends could be deemed toconstitute an unsafe or unsound practice. Except under certain circumstances, and with prior regulatory approval,a bank may not pay a dividend if, after so doing, it would beundercapitalized.  The Banks’ ability topay dividends in the future is, and could be, further influenced by regulatorypolicies or agreements and by capital guidelines.

 

Neither Mercantile norSouth Bay has retained earnings, and therefore neither is presently able to paydividends.  Mercantile has a substantialaccumulated deficit and does not anticipate having positive retained earningsfor the foreseeable future.  South Bayhas an accumulated deficit of $482,000 as of December 31, 2002.  Mercantile and South Bay may from time totime be permitted to make capital distributions to National Mercantile with theconsent of the OCC.  It is notanticipated that such consent could be obtained unless the distributing bankwere to remain “well capitalized” following such distribution.

 

Federal law restricts theBanks’ extension of credit to, the issuance of a guarantee or letter of crediton behalf of, investments in or taking as collateral stock or other securitiesof National Mercantile.  Restrictionsprevent National Mercantile from borrowing from the Banks unless the loans aresecured by designated amounts of marketable obligations.  Further, secured loans to and investments inNational Mercantile or its affiliates by a bank are limited to 10% of  the bank’s capital stock and surplus (asdefined by federal regulations) and are limited, in the aggregate, to 20% ofthe bank’s contributed capital (as defined by federal regulations).

 

Federal Reserve Boardregulations require the Banks to maintain certain minimum reservebalances.  Cash balances maintained tomeet reserve requirements are not available for use by the Banks or National Mercantile.  During 2002 and 2001, the average reserve 

 

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balances for the Banks were approximately $4.6 million and $1.8million, respectively.  Neither NationalMercantile nor the Banks is required to maintain compensating balances toassure credit availability under existing borrowing arrangements.

 

National Mercantile andthe Banks are subject to various capital requirements administered by thefederal 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 National Mercantile’s financial statements. Under capitaladequacy guidelines and the regulatory framework for prompt corrective action,National Mercantile and Banks must meet specific capital guidelines thatinvolve quantitative measures of National Mercantile’s and the Banks’ assets,liabilities and certain off-balance-sheet items as calculated under regulatoryaccounting practices. National Mercantile’s and the Banks’ capital amounts andclassification are also subject to qualitative judgment by the regulators aboutcomponents, risk weightings and other factors.

 

Quantitative measuresestablished by regulation to ensure capital adequacy require NationalMercantile and the Banks to maintain minimum amounts and ratios (set forth inthe table below) of total and Tier 1 capital (as defined in the regulations) torisk-weighted assets (as defined). Management believes, as of December 31, 2002, National Mercantile andBanks meet all capital adequacy requirements to which they are subject.

 

At December 31, 2002,each Bank was categorized as well capitalized under the regulatory frameworkfor prompt corrective action.  To becategorized as well capitalized under the prompt corrective action rules, eachBank must maintain minimum total risk-based, Tier 1 risk-based and Tier 1leverage ratios as set forth in the following table.  There are no conditions or events since the most recentnotification which management believes have changed the Banks’ category.

 

The following tablepresents, at the dates indicated, certain information regarding the regulatorycapital of National Mercantile and the Banks and the required amounts ofregulatory capital for National Mercantile and the Banks to meet applicableregulatory capital requirements and, in the case of the Banks, to be wellcapitalized under the prompt corrective action rules.

 

|                                    |   | **Actual**                  |   | **For  Capital  Adequacy Purposes** |   | **To be  Categorized  as Well  Capitalized under  Prompt Corrective  Action Rules** |   |
|-----------------------------------------|--------|-----------------------------|--------|-------------------------------------|--------|-------------------------------------------------------------------------------------|--------|
|                                    |   | **Amount**                  |   | **Ratio**                           |   | **Amount**                                                                          |   | **Ratio** |   | **Amount** |   | **Ratio** |   |
|                                    |   | **(Dollars  in thousands)** |   |
| As  of December 31, 2002                |   |                        |   |                                |   |                                                                                |   |   |   |   |   |   |   |
| Total  Capital to Risk Weighted Assets  |   |                        |   |                                |   |                                                                                |   |   |   |   |   |   |   |
| National  Mercantile Bancorp            |   | $                           | 37,685 |                                | 13.31  | %                                                                                   | $      | 22,646 |   | >=8.0 | % | N/A |   | >=10.0 | % |
| Mercantile  National Bank               |   | 14,151                      |   | 11.15                               | %      | 10,149                                                                              |   | >=8.0 | % | $ | 12,686 |   | >=10.0 | % |
| South  Bay Bank, N.A                    |   | 18,979                      |   | 12.15                               | %      | 12,498                                                                              |   | >=8.0 | % | $ | 15,622 |   | >=10.0 | % |
| Tier  1 Capital to Risk Weighted Assets |   |                        |   |                                |   |                                                                                |   |   |   |   |   |   |   |
| National  Mercantile Bancorp            |   | 29,933                      |   | 10.57                               | %      | 11,323                                                                              |   | >=4.0 | % | N/A |   | >=6.0 | % |
| Mercantile  National Bank               |   | 12,552                      |   | 9.89                                | %      | 5,074                                                                               |   | >=4.0 | % | 7,612 |   | >=6.0 | % |
| South  Bay Bank, N.A                    |   | 17,023                      |   | 10.90                               | %      | 6,249                                                                               |   | >=4.0 | % | 9,373 |   | >=6.0 | % |
| Tier  1 Capital to Average Assets       |   |                        |   |                                |   |                                                                                |   |   |   |   |   |   |   |
| National  Mercantile Bancorp            |   | 29,933                      |   | 8.60                                | %      | 13,836                                                                              |   | >=4.0 | % | N/A |   | >=5.0 | % |
| Mercantile  National Bank               |   | 12,552                      |   | 7.20                                | %      | 7,015                                                                               |   | >=4.0 | % | 8,768 |   | >=5.0 | % |
| South  Bay Bank, N.A                    |   | 17,023                      |   | 9.38                                | %      | 7,209                                                                               |   | >=4.0 | % | 9,011 |   | >=5.0 | % |
|                                         |        |                             |        |                                     |        |                                                                                     |        |  |  |  |  |  |  |  |  |  |

 

**Note11—Commitments and Contingencies**

 

In the normal course ofbusiness, the Company is a party to financial instruments with off-balancesheet risk.  These financial instrumentsinclude commitments to extend credit, letters of credit and financialguarantees.  These instruments involve,to varying degrees, elements of credit and interest rate risk in excess of theamount reflected in the consolidated balance sheet.

 

Exposure to credit lossin the event of nonperformance by the other party to the financial instrumentfor commitments to extend credit, letters of credit and financial guaranteeswritten, is represented by the contractual notional amount of thoseinstruments.  The Company uses the samecredit policies in making commitments and conditional obligations as it doesfor on-balance sheet instruments.

 

The Company hadoutstanding loan commitments aggregating $55.7 million at December 31, 2002,substantially all of which were for commercial loans with variable rates.  In addition, the Company had $629,000outstanding letters of credit at December 31, 2002.

 

Loan commitments areagreements to lend to a customer a specified amount subject to certainconditions.  Loan commitments generallyhave fixed expiration dates or other termination clauses and may requirepayment of a fee.  Since portions of the

 

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commitments are expected to expire without being drawn upon, the totalamount of commitments does not necessarily represent future cash requirements.

 

The Company from time totime is party to lawsuits, which arise in the normal course of business. TheCompany does not believe that any pending lawsuit at December 31, 2002 willhave a material adverse effect on the financial position or results ofoperations of the Company.

 

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

 

The following methods andassumptions were used to estimate the fair value of each class of financialinstruments for which it is practical to estimate that value.

 

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

 

*Securities available-for-sale*:  For securities classified as available-for-sale,fair value equals quoted market prices, if available. If a quoted market priceis not available, fair value is estimated using quoted market prices forsimilar securities.

 

*FederalReserve Bank (FRB) and other stock*:  FRB and other stock may be redeemed at the carrying amount,therefore, the carrying amount is a reasonable estimation of fair value.

* *

*Loans*:  Variable rate loans have carrying amountsthat approximate fair value. The fair value of fixed rate loans is estimated bydiscounting the future cash flows using the current rates at which similarloans would be made to borrowers with similar credit ratings and for the sameremaining maturities. In establishing the credit risk component of the fairvalue calculations for loans, the Company concluded the allowance for creditlosses represented a reasonable estimate of credit risk component of the fairvalue at December 31, 2002.

 

*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.

 

*Federalfunds purchased and securities sold under agreements to repurchase*:  The fair value of fixed-rate securities soldunder agreements to repurchase is estimated by discounting the future cashflows using the rates currently offered for instruments of similar maturities.

 

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

 

The estimated fair valuesof financial instruments are presented below.

 

|                                                                        |   | **December  31, 2002**      |   |
|-----------------------------------------------------------------------------|--------|-----------------------------|--------|
|                                                                        |   | **Carrying  Amount**        |   | **Fair  Value** |   |
|                                                                        |   | **(Dollars  in thousands)** |   |
| Financial  Assets:                                                          |   |                        |   |   |   |
| Cash,  cash equivalents and deposit with other financial institutions       |   | $                           | 37,901 |   | $ | 37,901 |   |
| Securities  available-for-sale                                              |   | 26,170                      |   | 26,170 |   |
| FRB  and other stock                                                        |   | 2,018                       |   | 2,018 |   |
| Loans,  net of allowance for credit losses                                  |   | 267,477                     |   | 270,596 |   |
| Financial  Liabilities:                                                     |   |                        |   |   |   |
| Demand  deposits, money market and savings                                  |   | 223,361                     |   | 223,361 |   |
| Time  certificates of deposit                                               |   | 75,364                      |   | 80,320 |   |
| Federal  funds purchased and securities sold under agreements to repurchase |   | 1,476                       |   | 1,493 |   |
| Other  borrowings                                                           |   | 7,500                       |   | 7,816 |   |
|                                                                             |        |                             |        |  |  |  |  |

 

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**Note13—Subsequent Event - unaudited**

 

InJanuary 2003, National Mercantile entered into a interest rate swap agreementpursuant to which it exchanged a fixed rate payment obligation of 10.25% on anotional principal amount of $15.0 million for a floating rate interest basedon the six-month London InterBank Offerred Rate plus 458 basis points for a29-year period ending July 25, 2031.  The interest rate swap agreement results inthe company paying or receiving the difference between the fixed and floatingrates at specified intervals calculated based on the notional amounts.  The differential paid or received onthe interest rate swap is recognized as an adjustment to interest expense.  At January 25, 2003, the Company was payingan interest rate of 5.93% under the terms of the swap which will reduce itsinterest expense for the year-to-date period ended July 25, 2003, the nextreset date, by $329,000.  The counterparty to the swap has the option to call the swap under a declining premium schedulebeginning July 2006.

 

The interest rate swapreduces the adverse impact of the Company’s 10.25% fixed rate Trust PreferredSecurities in a declining interest rate environment.  The Company does not utilize derivatives for speculative purposes.  Under Statement of Financial Accounting Standards No. 133 this swaptransaction is designated as a fair value hedge.  Accordingly, the effective portion of the change in the fairvalue of the swap transaction is recorded each period in current income.  The terms of the swap are symmetrical withthe terms of the Trust Preferred Securities, including the payment deferralterms, and considered highly effective in offsetting changes in fair value ofthe Trust Preferred Securities. Accordingly, no ineffectivenesswill be recorded to current earnings related to the interest rate swap.

** **

**Note14—Parent Company Information**

 

The following financialinformation presents the condensed balance sheet of the Company on aparent-only basis as of December 31, 2002, and the related condensed statementsof operations and cash flows for each of the years in the two-year period endedDecember 31, 2002.

 

| **Balance Sheet**                                   |   |                        |       |
|-----------------------------------------------------|--------|-----------------------------|------------|
|                                                |   |                        |       |
|                                                |   | **December  31,  2002**     |       |
|                                                |   | **(Dollars  in thousands)** |       |
|                                                |   |                        | ** ** |
| Cash  with Banks                                    |   | $                           | 120        |   |
| Due  from banks - time                              |   | 4,500                       |       |
| Investment  in the Banks                            |   | 41,693                      |       |
| Other  assets                                       |   | 1,262                       |       |
| Total  assets                                       |   | $                           | 47,575     |   |
|                                                |   |                        |       |
| Junior  subordinated deferrable interest debentures |   | $                           | 15,464     |   |
| Other  liabilities                                  |   | 907                         |       |
| Total  liabilities                                  |   | 16,371                      |       |
|                                                |   |                        |       |
| Shareholders’  equity:                         |   |                        |       |
| Preferred  stock                                    |   | 7,003                       |       |
| Common  stock                                       |   | 38,054                      |       |
| Accumulated  deficit                                |   | (14,055                     | )          |
| Accumulated  other comprehensive income             |   | 202                         |       |
| Total  shareholders’ equity                    |   | 31,204                      |       |
| Total  liabilities and shareholders’ equity    |   | $                           | 47,575     |   |

 

63

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| **Statements of Operations**                                  |   |                         |       |     |       |
|---------------------------------------------------------------|--------|------------------------------|------------|----------|------------|
|                                                          |   | **Year  ended December 31,** |       |
|                                                          |   | **2002**                     |       | **2001** |       |
|                                                          |   | **(Dollars  in thousands)**  |       |
|                                                          |   |                         | ** ** |     | ** ** |
| Interest  income                                              |   | $                            | 6          |     | $          | 364 |   |
| Interest  expense                                             |   | 1,585                        |       | 746      |       |
| Net  interest income                                          |   | (1,579                       | )          | (382     | )          |
|                                                          |   |                         |       |     |       |
| Other  operating income                                       |   | 38                           |       |     |       |
| Other  operating expense                                      |   | 228                          |       | 8        |       |
| Income  before equity in undistributed net income of the Bank |   | (1,769                       | )          | (390     | )          |
| Equity  in undistributed net income of subsidiaries           |   | 791                          |       | 1,546    |       |
| Income  (loss) before income tax benefit                      |   | (978                         | )          | 1,156    |       |
| Income  tax benefit                                           |   | 725                          |       | —   |       |
| Net  income (loss                                             |   | $                            | (253       | )        | $          | 1,156 |   |

 

| **Statements of Cash Flows**                                                       |   |                         |   |     |   |
|------------------------------------------------------------------------------------|--------|------------------------------|--------|----------|--------|
|                                                                               |   | **Year  ended December 31,** |   |
|                                                                               |   | **2002**                     |   | **2001** |   |
|                                                                               |   | **(Dollars  in thousands)**  |   |
|                                                                               |   |                         |   |     |   |
| Cash  flows from operating activities:                                             |   |                         |   |     |   |
| Net  income (loss)                                                                 |   | $                            | (253   | )        | $      | 1,156 |   |
| Adjustment  to reconcile net income to net cash provided by operating activities.: |   |                         |   |     |   |
| Equity  in undistributed net income of subsidiaries, net                           |   | (791                         | )      | (1,546   | )      |
| Net  increase in other assets and other liabilities                                |   | (780                         | )      | 1,378    |   |
| Net  cash provided by (used in) operations                                         |   | (1,824                       | )      | 988      |   |
|                                                                               |   |                         |   |     |   |
| Cash  flows from investing activities:                                             |   |                         |   |     |   |
| Investment  in South Bay Bank, N.A                                                 |   | (3,000                       | )      | —   |   |
| Dividends  from South Bay Bank, N.A                                                |   | 800                          |   | —   |   |
| Net  cash used in purchase of South Bay Bank, N.A                                  |   | —                       |   | (24,786  | )      |
| Capital  surplus reduction from Mercantile National Bank                           |   | —                       |   | 6,000    |   |
| Purchase  of time deposits at banks                                                |   | (4,500                       | )      | —   |   |
| Loans  purchased and principal collections, net                                    |   | 879                          |   | 421      |   |
| Net  cash used in investing activities                                             |   | (5,821                       | )      | (18,365  | )      |
|                                                                               |   |                         |   |     |   |
| Cash  flows from financing activities:                                             |   |                         |   |     |   |
| Net  proceeds from issuance of debentures                                          |   | —                       |   | 14,506   |   |
| Net  proceeds from issuance of preferred stock                                     |   | —                       |   | 1,000    |   |
| Net  proceeds from common stock offering                                           |   | 7,572                        |   | —   |   |
| Proceeds  from stock options exercised                                             |   | 86                           |   | 202      |   |
| Net  cash provided by financing activities                                         |   | 7,658                        |   | 15,708   |   |
| Net  (decrease) increase in cash and cash equivalents                              |   | 13                           |   | (1,669   | )      |
| Cash  and cash equivalents, beginning of the year                                  |   | 107                          |   | 1,776    |   |
| Cash  and cash equivalents, end of the year                                        |   | $                            | 120    |     | $      | 107 |   |

 

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**INDEX TO EXHIBITS**

** **
| **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); Certificate of  Determination of Rights, Preferences and Privileges of Series B Convertible  Perpetual Preferred Stock filed December 14, 2001                                                                                                                                                                                  |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 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, 1999 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        |   | National Mercantile  Bancorp Amended 1996 Stock Incentive Plan *                                                                                                                                                                                                                                                                                                                                                                                                                             |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.7        |   | Registration Rights  Agreement between the Company and Conrad Company (7)                                                                                                                                                                                                                                                                                                                                                                                                                    |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.8        |   | Guarantee Agreement of  National Mercantile Bancorp for trust preferred securities dated July 16,  2001 (10)                                                                                                                                                                                                                                                                                                                                                                                 |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.9        |   | Severence Agreement  dated November 13, 2002 between National Mercantile Bancorp and Hank  McCaffrey *                                                                                                                                                                                                                                                                                                                                                                                       |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.10       |   | Severence Agreement  dated November 14, 2002 between National Mercantile Bancorp and David Brown *                                                                                                                                                                                                                                                                                                                                                                                           |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 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*                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 23.         |   | Consent of Ernst &  Young LLP *                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 99.1        |   | Confirmation of Receipt  of Assurances from Arthur Andersen, LLP *                                                                                                                                                                                                                                                                                                                                                                                                                           |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 99.2        |   | Certification of Scott  A. Montgomery *                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
|        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 99.3        |   | Certification of David  R. Brown *                                                                                                                                                                                                                                                                                                                                                                                                                                                           |

 

65

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*       Includedin this Report

(1)    Filed asan exhibit to the Company’s Annual Report on Form 10-K for the year endedDecember 31, 1997.

(2)    Filed asan exhibit to the Company’s Annual Report on Form 10-K for the year endedDecember 31, 1992 and incorporated herein by reference.

(3)    Filed asan exhibit to the Company’s Report on Form 10-Q for the quarter ended March 31,1999 and incorporated herein by reference.

(4)    Filed asan exhibit to Company’s Annual Report on Form 10-K for the year ended December31, 1990 and incorporated herein by reference.

(5)    Filed asan exhibit to the Company’s Annual Report on Form 10-K for the year endedDecember 31, 1995 and incorporated herein by reference.

(6)    Filed asan exhibit to the Company’s Report on Form 10-Q for the quarter ended March 31,1998 and incorporated herein by reference.

(7)    Filed asan exhibit to the Company’s Registration Statement on Form S-2 dated February10, 1997 and amendments thereto and incorporated herein by reference.

(8)    Filed asan exhibit to the Company’s Annual Report on Form 10-K for the year endedDecember 21, 2000 and incorporated herein by reference.

(9)    Filed asan exhibit to the Company’s Report on Form 8-K dated July 24, 2001 andincorporated herein by reference.

(10)  Filed as anexhibit to the Company’s Report on Form 10-Q for the quarter ended September30, 2001 and incorporated herein by reference.

 

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