**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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**Form 10-KSB**

 

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

**forthe fiscal year ended December 31, 2003**

 

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

**forthe transition period from        to      .**

 

**CommissionFile Number 0-15982**

 

**NATIONALMERCANTILE BANCORP**

(Exact name of small businessissuer in its charter)

 

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

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

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

 

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

 

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

 

The issuer’s revenues for its most recent fiscal year:  $18.5 million.

 

The aggregate market value of the voting common equity held bynonaffiliates of the registrant, based upon the closing sale price of itsCommon Stock as reported by the National Association of Securities DealersAutomated Quotation System on March 19, 2004, was approximately $28.3million.

 

The number of shares of Common Stock, no par value, of the issueroutstanding as of March 19, 2004 was 2,900,003.

 

**DOCUMENTSINCORPORATED BY REFERENCE**:

 

Certain portions of the Company’s Proxy Statement to be filed with theSecurities and Exchange Commission pursuant to Rule 14a-6 under the SecuritiesExchange Act of 1934 in connection with the Company’s 2004 Annual Meeting ofShareholders are incorporated by reference in Part III, Items 9-12 and 14 andis of this Annual Report on Form 10-KSB.

 

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

 

 

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**NATIONALMERCANTILE BANCORP**

 

**Tableof Contents**

 

**Form10-KSB**

**Forthe Fiscal Year Ended December 31, 2003**

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

 

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**ANNUALREPORT ON FORM 10-K**

 

Certain matters discussed in this Form 10-KSB may constituteforward-looking statements within the meaning of the Securities Exchange Act of1934 (the “Exchange Act”) and as such may involve risks and uncertainties.  These forward-looking statements relate to,among other things, expectations of the business environment in which NationalMercantile Bancorp (referred to as “we” or “our” when such reference includesNational Mercantile Bancorp and its subsidiaries, collectively, “NationalMercantile” when referring only to the parent company and “the Banks” whenreferring only to National Mercantile’s banking subsidiaries, MercantileNational Bank and South Bay Bank, N.A.) operates, projections of futureperformance, perceived opportunities in the market and statements regarding ourmission and vision.  Our actual results,performance, or achievements may differ significantly from the results,performance, or achievements expressed or implied in such forward-lookingstatements.  Statements regardingpolicies 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

 

**CRITICAL ACCOUNTING POLICIES**

 

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

 

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

 

We operate throughout the west side of Los Angeles County including theSouth Bay, Century City and San Fernando Valley with banking offices in CenturyCity, Torrance, Encino and El Segundo and a loan production office in BeverlyHills.  Additionally, we target OrangeCounty businesses through our loan production office in Costa Mesa,California.  Our targeted market nichesfor businesses include the entertainment industry, the healthcare industry,professional services providers, the real estate escrow industry, propertymanagers and community-based nonprofit organizations.    Entertainment industry customers include television, music andfilm production companies, talent agencies, individual performers, directorsand producers (whom we attract by establishing relationships with businessmanagement firms) and others affiliated with the entertainment industry.  Healthcare organizations include 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.  Additionally, we targetdevelopers of small commercial real estate properties and residentialproperties – including small home tracks and luxury homes for resale.  Furthermore, we provide loans for thepurchase or refinance of commercial properties including owner-occupiedbusiness facilities and retail properties.

 

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

 

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

 

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To implement this philosophy, we operate each of our Bank subsidiariesby retaining their independent names. Our banking subsidiaries have established strong client followings intheir market areas through attention to client service and an understanding ofclient needs.

 

In an effort to capitalize on the identities and reputations of theBanks, we intend to continue to market our services under each Bank’s name,primarily through each Bank’s relationship managers.  The primary focus for the Banks’ relationship managers is tocultivate and nurture their client relationships.  Relationship managers are assigned to each borrowing client toprovide continuity in the relationship. This emphasis on personalized relationships requires that all of therelationship managers maintain close ties to the communities or industry niche inwhich they serve, so they are able to capitalize on their efforts throughexpanded business opportunities for the Banks.

 

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

 

At December 31, 2003, we had total assets of $355.2 million, totalloans, net, of $256.6 million and total deposits of $298.7 million.

 

**Corporate History**

 

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

 

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

 

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

 

**Competition**

 

The banking and financial services industry in California generally,and in the Banks’ market areas specifically, is highly competitive.  The increasingly competitive environment isprimarily a result of changes in regulation, changes in technology and productdelivery systems, and the accelerating pace of consolidation among financialservices providers.  Our primary servicearea is dominated by a relatively small number of major banks that have manyoffices operating over a wide geographical area.  We compete for loans, deposits, and customers with othercommercial banks, savings and loan associations, securities and brokeragecompanies, mortgage companies, insurance companies, finance companies, moneymarket funds, credit unions, and other nonbank financial serviceproviders.  Many of these competitorsare much larger in total assets and capitalization, have greater access tocapital markets and offer a broader range of financial services than us.  Nondepository institutions can be expectedto increase the extent to which they act as financial intermediaries.  Large institutional users and sources ofcredit may also increase the extent to which they interact directly, meetingbusiness credit needs outside the banking system.  Furthermore, the geographic constraints on portions of thefinancial services industry can be expected to erode.  In addition, many of the major commercial banks operating in ourprimary service area offer services, such as trust services, which are notoffered directly by us and, by virtue of their greater total capitalization,such banks have substantially higher lending limits.

 

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

 

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**Economic Conditions and Government Policies**

 

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

 

The monetary and fiscal policies of the federal government and the policies of regulatory agencies, particularly the Board of Governors of the Federal Reserve System (the “Federal Reserve”), influence our business.  The Federal Reserve implements national monetary policies (with objectives such as curbing inflation and combating recession) through its open-market operations in U.S.  Government securities by adjusting the required level of reserves for depository institutions subject to its reserve requirements, and by varying the target federal funds and discount rates applicable to borrowings by depository institutions.  The actions of the Federal Reserve in these areas influence the growth of bank loans, investments, and deposits and also affect interest rates earned on interest-earning assets and paid on interest-bearing liabilities.  We cannot fully predict the nature and impact on us of any future changes in monetary and fiscal policies.

 

**Supervision and Regulation**

 

*General*

 

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

 

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

 

Set forth below is a summary description of certain of the material laws and regulations that relate to the operations of National Mercantile and the Banks.  The description does not purport to be a complete description of these laws and regulations and is qualified in its entirety by reference to the applicable laws and regulations.

 

*National Mercantile*

 

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

 

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

 

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

 

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*The Banks*

 

Both Banks are national banks and members of the Federal Reserve System.  The Banks are subject to primary supervision, examination, and regulation by the Office of the Comptroller of the Currency (the “OCC”) and are also subject to regulations of the Federal Deposit Insurance Corporation (“FDIC”) and the Federal Reserve.  The Banks are subject to requirements and restrictions under federal and state law, including requirements to maintain reserves against deposits, restrictions on the types and amounts of loans that may be granted and limitations on the types of investments that may be made and services that may be offered.  Various consumer laws and regulations also affect the Banks’ operations.  These laws primarily protect depositors and other customers of the Banks, rather than National Mercantile and its shareholders.

 

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

 

*Memorandumof Understanding*

 

In October 2002, Mercantile executed an informal non-binding memorandum of understanding with the OCC relating to its interest rate risk management.  The memorandum provided for Mercantile to take certain actions that the OCC believed would strengthen Mercantile’s interest rate risk management process, including the review of its interest rate risk limits and interest rate risk modeling assumptions and the retention of an independent consultant to conduct a review of Mercantile’s interest rate risk management processes.  Mercantile substantially completed the actions provided in the MOU and was notified by the OCC that the MOU was terminated.

 

*USAPatriot Act of 2001*

 

The USA Patriot Act of2001 (“Patriot Act”) is intended to strengthen the U.S law enforcement and theintelligence communities’ abilities to work cohesively to combat terrorism on avariety of fronts. The potential impact of the Patriot Act on financialinstitutions of all kinds is significant and wide ranging. The Patriot Actcontains sweeping anti-money laundering and financial transparency laws andrequires various regulations, including: (i) due diligence requirements forfinancial institutions that administer, maintain, or manage private bankaccounts or correspondent accounts for non-US persons; (ii) standards forverifying customer identification at account opening; (iii) rules to promote cooperationamong financial institutions, regulators, and law enforcement entities inidentifying parties that may be involved in terrorism or money laundering; and(iv) reports by non-financial trades and businesses filed with the TreasuryDepartment’s Financial Crimes Enforcement Network for transactions exceeding$10,000, and filing of suspicious activities reports by securities brokers anddealers if they believe a customer may be violating U.S. laws and regulations.

 

On April 30, 2003,the U.S. Treasury issued final regulations to implement section 326 of thePatriot Act requiring institutions to incorporate into their written moneylaundering 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.  We haveestablished policies and procedures implementing the requirements of thePatriot Act.

 

*Privacy*

 

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

 

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

 

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

 

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*InteragencyGuidance on Response Programs to Protect Against Identity Theft*

 

On August 12, 2003,the Federal bank and thrift regulatory agencies requested public comment onproposed guidance that would require financial institutions to develop programsto respond to incidents of unauthorized access to customer information,including procedures for notifying customers under certain circumstances. Theproposed guidance: (i) interprets previously issued interagency customerinformation security guidelines that require financial institutions toimplement information security programs designed to protect their customers’information; and (ii) describes the components of a response program and sets astandard for providing notice to customers affected by unauthorized access toor use of customer information that could result in substantial harm orinconvenience to those customers, thereby reducing the risk of losses due tofraud or identity theft.

 

*FDIC*

 

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

 

Under FDIC regulations, each insured depository institution is assignedto one of three capital groups for insurance premium purposes — “wellcapitalized,” “adequately capitalized” and “undercapitalized” — which aredefined in the same manner as under prompt corrective action rules, asdiscussed 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 schedule semiannually.

 

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

 

All FDIC-insured depository institutions must pay an annual assessment to provide funds for the payment of interest on bonds issued by the Financing Corporation ( “FICO”), a federal corporation chartered under the authority of the Federal Housing Finance Board.  The bonds, commonly referred to as FICO bonds, were issued to capitalize the Federal Savings and Loan Insurance Corporation.  The FICO has established assessment rates effective for the first quarter of 2004 at approximately $.0154 per $100 annually for assessable deposits. The FICO assessments are adjusted quarterly to reflect changes in the assessment bases of the FDIC’s insurance funds and do not vary depending on a depository institution’s capitalization or supervisory evaluations.

 

*Dividends and Capital Distributions*

 

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

 

OCC approval is required for a national bank to pay a dividend if thetotal of all dividends declared in any calendar year exceeds the total of thebank’s net profits (as defined) for that year combined with its retained netprofits for the preceding two calendar years, less any required transfer to surplusor a fund for the retirement of any preferred stock.  A national bank may not pay any dividend that exceeds itsretained net earnings, as defined by the OCC.  The OCC and the Federal Reserve have also issued banking circularsemphasizing that the level of cash dividends should bear a direct correlationto the level of a national bank’s current and expected earnings stream, thebank’s need to maintain an adequate capital base and other factors.

 

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

 

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

 

Mercantile has a substantial accumulated deficit and does notanticipate having positive retained earnings for the foreseeable future.  South Bay has an accumulated surplus of$130,000 as of December 31, 2003. Mercantile and South Bay may from time to time be permitted to makecapital distributions to National Mercantile with the consent of the OCC.  It is not anticipated that such consentcould be obtained unless the distributing bank were to remain “wellcapitalized” following such distribution.

 

The payment of dividends by National Mercantile is limited by the termsof the Trust Preferred Securities indenture. National Mercantile may not declare or pay any dividends or otherdistributions on its common stock or preferred stock if it is in default underthe terms of the indenture or if it has elected to defer payments of intereston the Trust Preferred Securities.

 

*Transactions with Affiliates*

 

The Banks are subject to certain restrictions imposed by federal law onany extensions of credit to, or the issuance of a guarantee or letter of crediton behalf of, National Mercantile or other affiliates, the purchase of, orinvestments in, stock or other securities thereof, the taking of suchsecurities as collateral for loans, and the purchase of assets of NationalMercantile or other affiliates.  Suchrestrictions prevent National Mercantile and such other affiliates fromborrowing from the Banks unless the loans are secured by marketable obligationsof designated amounts.  Further, suchsecured loans and investments by the Banks to or in National Mercantile or toor in any other affiliate are limited, individually, to 10% of the respectiveBank’s capital and surplus (as defined by federal regulations), and suchsecured loans and investments are limited, in the aggregate, to 20% of therespective Bank’s capital and surplus (as defined by federal regulations).

 

*Capital Adequacy Requirements*

 

Both the Federal Reserve and the OCC have adopted similar, but notidentical, “risk-based” and “leverage” capital adequacy guidelines for bankholding companies and national banks, respectively.  Under the risk-based capital guidelines, different categories ofassets are assigned different risk weights, ranging from zero percent forassets considered risk-free (e.g., cash) to 100% for assets consideredrelatively high-risk (e.g., commercial loans). These risk weights are multiplied by corresponding asset balances todetermine a risk-adjusted asset base. Certain off-balance sheet items (e.g., standby letters of credit) areadded to the risk-adjusted asset base. The minimum required ratio of total capital to risk-weighted assets forboth bank holding companies and national banks is presently 8%.  At least half of the total capital isrequired to be “Tier 1 capital,” consisting principally of common shareholders’equity, a limited amount of perpetual preferred stock and minority interests inthe equity, less goodwill, intangible assets and certain other items.  The remainder (Tier 2 capital) may consistof a limited amount of subordinated debt, certain hybrid capital instrumentsand other debt securities, preferred stock and a limited amount of the generalloan-loss allowance.

 

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

 

*Prompt Corrective Action Rules*

 

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

 

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

 

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undercapitalized, or (ii) the amount which is necessary (or would havebeen necessary) to bring the bank into compliance with all applicable capitalstandards as of the time the bank fails to comply with the capital restorationplan.  A holding company guarantee of acapital restoration plan results in a priority claim to the holding company’sassets ahead of its other unsecured creditors and shareholders that isenforceable even in the event of the holding company’s bankruptcy or thesubsidiary bank’s insolvency.

 

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

 

As a condition to the approval of National Mercantile’s acquisition of South Bay, National Mercantile agreed with the Federal Reserve that it would maintain its and each of the Bank’s regulatory capital ratios in the well capitalized category for the three years following the closing date of the acquisition, December 14, 2001.  At December 31, 2003, each of the Banks and National Mercantile exceeded the required ratios for classification as well capitalized.

 

*Safety and Soundness Standards*

 

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

 

In addition, the federal banking agencies have also adopted safety and soundness guidelines with respect to asset quality and earnings standards.  These guidelines provide six standards for establishing and maintaining a system to identify problem assets and prevent those assets from deteriorating.  Under these standards, an insured depository institution should (i) conduct periodic asset quality reviews to identify problem assets; (ii) estimate the inherent losses in problem assets and establish reserves that are sufficient to absorb estimated losses; (iii) compare problem asset totals to capital; (iv) take appropriate corrective action to resolve problem assets; (v) consider the size and potential risks of material asset concentrations; and (vi) provide periodic asset quality reports with adequate information for management and the board of directors to assess the level of asset risk.

 

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

 

*CrossGuarantees*

 

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

 

*Community Reinvestment Act and Fair Lending*

 

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

 

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

 

Further, the federal banking agencies may take compliance with such laws and CRA obligations into account when regulating and supervising other activities.  An assessment of CRA compliance is required in connection with applications for OCC approval of

 

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

 

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

 

**Employees**

 

At December 31, 2003, we had 95 full-time equivalent employees.  None of the employees is covered by a collective bargaining agreement.  We consider our employee relations to be satisfactory.

 

**ITEM 2****.  PROPERTIES.**

 

National Mercantile leases approximately 14,000 square feet in an office building at 1880 Century Park East, Los Angeles, California, which serves as its administrative headquarters.  The rent for the period January 2004 to April 2014 is $2.23 per square foot or $30,952 per month, subject to an annual CPI adjustment and for changes in property taxes and operating costs.  The lease for the former administrative offices at 1840 Century Park East was scheduled to expire in October 2004, however, the lease was terminated in January 2004 by agreement with the landlord.

 

Mercantile’s principal banking office is located in 7,715 square feet in an office building at 1840 Century Park East, Los Angeles, California.  The effective rent is $3.00 per square foot or $23,145 per month.  The lease expires in October 2004.  We have entered into a lease for approximately 1,800 square feet at 1880 Century Park East, Los Angeles, California in which we will relocate Mercantile’s principal banking office anticipated in June 2004.

 

Mercantile also leases an approximately 1,650 square foot facility in Encino, California for the primary purpose of providing branch banking operations in the San Fernando Valley.  The lease expires in May 2004 and we are currently negotiating a renewal of the lease.

 

South Bay owns a two-story stand alone office building at 2200 Sepulveda Boulevard, Torrance, California, which serves as its principal banking office.  South Bay also leases an approximately 1,500 square foot facility in El Segundo, California for the primary purpose of providing branch banking operations in the Los Angeles airport area.  The El Segundo lease expires in June 2004 and we are currently negotiating for another office space in the area.

 

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

 

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

 

From time to time, we are involved in certain legal proceedings arising in the normal course of our business.  We believe that the outcome of these matters existing as of December 31, 2003 will not have a material adverse effect on us.

 

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

 

There was no submission of matters to a vote of shareholders during the quarter ended December 31, 2003.

 

###### **PARTII**

###### ** **

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

 

The Common Stock and Series A Noncumulative Convertible PerpetualPreferred Stock (the “Series A Preferred”) of National Mercantile are traded onthe Nasdaq SmallCap Market, under the symbols MBLA and MBLAP,respectively.  The following table

 

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shows the high and low trade prices of the Common Stock and Series APreferred for each quarter of 2002 and 2003 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, 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 |   |
| March 31, 2003     |   | 7.45              |   | 6.52                    |   | 15.75 |   | 12.00 |   |
| June 30, 2003      |   | 7.35              |   | 6.57                    |   | 14.60 |   | 13.00 |   |
| September 30, 2003 |   | 8.39              |   | 7.09                    |   | 16.50 |   | 14.25 |   |
| December 31, 2003  |   | 12.32             |   | 7.45                    |   | 25.50 |   | 16.00 |   |
|                         |        |                   |        |                         |        |  |  |  |  |  |  |  |  |

 

At March 19, 2004, National Mercantile had 150 shareholders ofrecord for its Common Stock and 16 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 19, 2004, approximately 41% and 20% of the Common Stock and Series APreferred, respectively, were held in street name.

 

National Mercantile has not paid a cash dividend on the Common Stocksince July 1990, and has never paid a cash dividend on the Series APreferred.  The Series A Preferred isentitled to a noncumulative cash dividend at a rate of 6.5% of its liquidationpreference quarterly on the first day of January, April, July andOctober of each year, before any dividend may be declared upon or paidupon the Common Stock.  As a Californiacorporation, under the California General Corporation Law, generally NationalMercantile may not pay dividends in cash or property except (ii) out ofpositive retained earnings or (ii) if, after giving effect to the distribution,National Mercantile’s assets would be at least 1.25 times its liabilities andits current assets would exceed its current liabilities (determined on aconsolidated basis under generally accepted accounting principles).  At December 31, 2003, NationalMercantile had an accumulated deficit of $13.9 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$13.9 million before it can pay a dividend in cash or property.

 

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

 

*Outstanding Awards Under All EquityCompensation Plans*. The following table sets forth as of December 31, 2003 informationregarding outstanding options under all of our equity compensation plans andthe number of shares available for future option grants under equitycompensation plans currently in effect.

 
|                                                       |   | **(a)**                                                                                      |   | **(b)**                                                                      |   | **(c)**                                                                                                                               |
|------------------------------------------------------------|--------|----------------------------------------------------------------------------------------------|--------|------------------------------------------------------------------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------|
| Plan category                                              |   | Number of securities to be issued upon exercise of outstanding  options, warrants and rights |   | Weighted-average exercise price of outstanding options, warrants and  rights |   | Number of securities remaining available for issuance under equity  compensation plans (excluding securities reflected in column (a)) |
|                                                       |   |                                                                                         |   |                                                                         |   |                                                                                                                                  |
| Equity compensation plans approved by security holders (1) |   | 495,883                                                                                      |   | $                                                                            | 6.84   |                                                                                                                                  | 105,584 |
|                                                            |        |                                                                                              |        |                                                                              |        |                                                                                                                                       |  |

 

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

 

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***ITEM 6***.              MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

**EXECUTIVE LEVELOVERVIEW**

 

We recorded  net income of$207,000 for 2003 compared to a net loss of $253,000 for 2002.  On a per share basis, in 2003 we recorded abasic earnings per share of $0.08 and fully-diluted earnings per share of $0.05compared to basic and fully-diluted loss of $0.15 per share for 2002.  Theincrease in net earnings was primarily due to a  $660,000 decrease in provision for loan losses as well as a$627,000 decrease in interest expense on the Junior Subordinated Debenturespartially offset by a $510,000 decrease in net interest income (excludinginterest relating to the Junior Subordinated Debentures) and a $435,000increase in operating expenses.   (Thecomparison of interest expense and net interest income considers thereclassification of the trust preferred securities discussed below in whichinterest on the trust preferred securities after June 30, 2003 isreflected in interest expense rather than as previously reported as minorityinterest in the Company’s income of the Junior Subordinated Debentures.)

 

Total assets at December 31, 2003 were $355.2 million compared to$355.4 million at year end 2002.  Whiletotal assets were nearly unchanged, the composition of assets at the year endsreflects a $12.1 million decrease in loans receivable and a $8.7 milliondecrease in federal funds sold offset by a $5.7 million increase in cash anddue from banks – demand, a $4.4 million increase in due from banks – time.   Securities available-for-sale andsecurities held-to-maturity increased $4.7 million and $4.6 million,respectively at December 31, 2003 compared to the prior year end.  During the 2003 year, particularly in thethird quarter,  we experienced a morerapid repayment of construction loans than funding of newly originatedloans.  Due to the nature ofconstruction loans, the outstanding balance of newly originated loans increasesgradually during the life of the loan and repays in a lump sum.  The proceeds from loan repayments wereredeployed into investment securities and interest-bearing balances at otherbanks.

 

The allowance for credit losses at December 31, 2003 was $3.6million compared to $4.8 million at December 31, 2002.  The decrease is due to net charge-offs of$2.5 million partially offset by provisions to the allowance during the year of$1.3 million.

 

Total deposits at December 31, 2003 were $298.7 million unchangedfrom year-end 2002.  The composition ofdeposits at December 31, 2003, however, reflects a $12.4 million increase in noninterest-bearing demand depositsand a $12.3 million increase in money market accounts offset by a $15.7 milliondecrease and a $4.6 million decrease in time certificates of deposit $100,000and over, and under $100,000, respectively. The change in the composition of deposits reflects management’s emphasison business banking at South Bay generating lower cost transaction depositaccounts combined with more aggressive pricing of the higher cost timecertificates of deposit.

 

In July 2001, National Mercantile formed National MercantileCapital Trust (the “Trust”) as a Delaware statutory business trust for theexclusive purpose of issuing and selling trust preferred securities (the “TrustPreferred Securities”).  The trustutilized the proceeds from the issuance of the Trust Preferred Securities topurchase National Mercantile’s junior subordinated interest debentures (the“Junior Subordinated Debentures”). Through June 30, 2003, the Company’s financial statements reflectedthe Trust as a consolidated subsidiary, with its Trust Preferred Securitiesreflected on the consolidated balance sheet as mezzanine equity, shown asguaranteed preferred beneficial interests in the Company’s Junior SubordinatedDebentures, net, and payments on the Trust Preferred Securities set forth asexpenses and classified as minority interest in the Company’s income of theguaranteed preferred beneficial interest in the Junior Subordinated Debentures.

 

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

 

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**Table 1**

**Operations Summary**

 
|                                                                                                                   |   | **Year Ended  December 31,  2003** |   |   |   |   |   | **Year Ended  December 31,  2002** |   |
|------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------|--------|--------|--------|--------|--------|-----------------------------------------|--------|
| **Increase  (Decrease)**                                                                                               |
| **Amount**                                                                                                             |   | **%**                                   |
|                                                                                                                   |   | **(Dollars  in thousands)**             |   |
| Interest income                                                                                                        |   | $                                       | 17,124 |   | $      | (2,448 | )      | (12.5                                   | )%     | $ | 19,572 |   |
| Interest expense                                                                                                       |   | 3,180                                   |   | (1,484 | )      | (31.8  | )%     | 4,664                                   |   |
| Net interest income                                                                                                    |   | 13,944                                  |   | (964   | )      | (6.5   | )%     | 14,908                                  |   |
| Provision for credit losses                                                                                            |   | 1,265                                   |   | (660   | )      | (34.3  | )%     | 1,925                                   |   |
| Other operating income                                                                                                 |   | 1,376                                   |   | (126   | )      | (8.4   | )%     | 1,502                                   |   |
| Other operating expense                                                                                                |   | 13,296                                  |   | 435    |   | 3.4    | %      | 12,861                                  |   |
| Minority interest in the Company’s income  of the:                                                                |   |                                    |   |   |   |   |   |                                    |   |
| Guaranteed preferred beneficial interests  in the Company’s junior subordinated deferrable interest debenture-net |   | 456                                     |   | (1,081 | )      | (70.3  | )%     | 1,537                                   |   |
| Series A Preferred Stock of South Bay Bank,  N.A.                                                                      |   | —                                  |   | (213   | )      | N/A    |   | 213                                     |   |
| Income before income taxes                                                                                             |   | 303                                     |   | 429    |   | (340.5 | )%     | (126                                    | )      |
| Income taxes                                                                                                           |   | 96                                      |   | (31    | )      | (24.4  | )%     | 127                                     |   |
| Net income (loss)                                                                                                      |   | $                                       | 207    |   | $      | 460    |   | (181.8                                  | )%     | $ | (253 | ) |

 

**CRITICAL ACCOUNTINGPOLICIES**

 

Our accounting policiesare integral to understanding the results reported. Accounting policies aredescribed in detail in Note 1 of the Notes to Consolidated FinancialStatements.  Our most complex accountingpolicies require management’s judgment to ascertain the valuation of assets,liabilities, commitments and contingencies. We have established detailed policies and control procedures that areintended to ensure valuation methods are well controlled and appliedconsistently from period to period.  Inaddition, the policies and procedures are intended to ensure that the processfor changing methodologies occurs in an appropriate manner.  The following is a brief description of ourcurrent accounting policies involving significant management valuationjudgments.

 

*Allowance for Credit Losses*

 

The allowance for credit losses represents management’s best estimateof losses inherent in the existing loan portfolio. The allowance for creditlosses is increased by the provision for credit losses charged to expense andreduced by loans charged off, net of recoveries. The allowance for creditlosses is determined based on management’s assessment of several factors: (i)reviews and evaluation of individual loans including underlying cash flow andcollateral values, (ii) the level of and changes in classified andnonperforming loans, (iii) historical loan loss experiences, (iv) changes inthe nature and volume of the loan portfolio, and (v) current economicconditions and the related impact on specific borrowers and industry groups.

 

We review and manage the credit quality of the loan portfolio through aprocess that includes a risk grading system, uniform underwriting criteria,early identification of problem credits, regular monitoring of any classifiedassets graded as ‘‘criticized’’ by our internal grading system, and anindependent loan review process.  Thecalculation of the adequacy of the allowance for credit losses is based on thisinternal risk grading system as well as other factors including loan grademigration trends and collateral values.

 

The internal risk grading utilizes an 10-level grading system – sixpass grades for unclassified loans based upon our assessment of the borrower’sability to service the loan and the quality of the collateral and fourclassification grades for “criticized” loans depending on the severity of theunderwriting weakness and liklihood of loss. We use a statistical grading migration analysis as part of our allowancefor credit losses evaluation for unclassified loans which is a method by whichthe types and gradings of historical loans charged-off are related to thecurrent loan portfolio.  This analysis attemptsto use historical trends in loan risk grading, nonperforming assets andconcentrations 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 is established forvarious loan types and unclassified grades ranging from zero for loans securedby cash or marketable securities to 1.0% for unsecured commercial loans.  This methodology assumes, among other things,(i) consistency in underwriting standards and internal risk grading between thecurrent loan portfolio and the historical sample, (ii) that the factors thatresulted in historical loans charged-off, such as industry economic condition,will be the same factors that cause future loans to be charged-off, and (iii)the economic environment experienced during the period of historical loanscharged-off is similar to the future economic environment.

 

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Generally, the allowance for credit losses established for classifiedloans that are collateral-dependent is based on the net realizable value of thecollateral.  In measuring the netrealizable value of the collateral, management uses current appraisals that,among other techniques, observe market transactions of similar property andadjust for differences.  Changes in thefinancial condition of individual borrowers, in economic conditions, inhistorical loss experience and in the condition of the various markets in whichcollateral may be sold may all affect the required level of the allowance forcredit losses and the associated provision for credit losses.

 

On a periodic basis -twice in 2003- we engage an outside loan reviewfirm to review our loan portfolio, risk grade accuracy and the reasonablenessof loan evaluations.  Annually, thisoutside loan review team analyzes our methodology for calculating the allowancefor credit losses based on our loss histories and policies.

 

Each Bank’s board of directors reviews the adequacy of that Bank’sallowance for credit losses on a quarterly basis.  We utilize our judgment to determine the provision for creditlosses and establish the allowance for credit losses.  We believe, based on information known to management, that theallowance for credit losses at December 31, 2003 was adequate to absorbinherent losses in the existing loan portfolio.  However, credit quality is affected by many factors beyond ourcontrol, including local and national economies, and facts may exist which arenot known to us that adversely affect the likelihood of repayment of variousloans in the loan portfolio and realization of collateral upon a default.  Accordingly, no assurance can be given thatwe will not sustain loan losses materially in excess of the allowance forcredit losses.  In addition, the OCC, asan integral part of its examination process, periodically reviews the allowancefor credit losses and could require additional provisions for credit losses.

 

*Goodwill and Other Intangible Assets*

 

As discussed in Note 2 of the Notes to Consolidated FinancialStatements, we must assess goodwill and other intangible assets each year, ormore frequently upon the occurrence of certain events, for impairment.  Impairment is the condition that exists whenthe carrying amount of the asset exceeds its implied fair value.

 

Thegoodwill impairment test involves comparing the fair value of South Bay withits carrying amount, including goodwill. We retained an independent valuation consultant to evaluate the goodwillas of October 1, 2003.  Thevaluation consultant conducted the analysis utilizing two valuation methods –the income approach and the market approach.

 

Theincome approach measures the present worth of anticipated future net cash flowsgenerated by South Bay.  Net cash flowforecasts require analysis of the significant variables influencing revenues,expenses, working capital and capital investment as well as residual value andcost of capital.  Our forecasts were fora three-year period reflecting average annual asset growth of 12.8%, an averageloan to deposit ratio of 97.5%, an average net interest margin of 5.1%, andaverage annual return on assets of 1.0%. A 10.8% cost of capital and a $29.1 million residual value was utilizedin the analysis to discount the projected cash flows.

 

Themarket approach derives a valuation by analyzing the prices at which shares ofcapital stock of reasonably similar companies are trading in the public market,or the transaction price at which similar companies have been acquired.  The analysis identified ten transactionsduring the period from January 2001 through September 2003 involvingseller companies with similarities to South Bay in size and operating characteristics.  Transaction multiples were considered forpurchase price to (i) earnings, and (ii) total assets.  The purchase price to earnings multiple forthe South Bay acquisition was 11.38 compared to a range from 8.03 to 33.37 withan average of 17.62% for the transactions studied.  The South Bay transaction purchase price to total assets multiplewas 0.15 compared to a range of 0.08 to 0.33 with an average of 0.20 for thecomparable transactions.

 

Theconsultant also analyzed our stock price as part of their market approachanalysis.  This analysis involvedapplying price multiples based on our stock price at or near the valuation dateto the performance measures of South Bay. Additionally, the consultants considered guideline companies operatingin the same market segment as South Bay. The stock trading values of similar companies was not consideredreliable due to the small volume of trading activity, however, the results werenot inconsistent with those of the transaction method.

 

Thefair value indications derived from the income approach was $28.2 million andfrom the two market approaches, transaction and stock price analysis, $26.8million and $22.1 million, respectively. The fair value of South Bay under both approaches exceeds the carryingvalue at October 1, 2003 of $20.3 million, therefore, goodwill is notconsidered impaired.  The testing ofgoodwill and other intangible assets for impairment requires re-measurement offair values.  If the future fair valueswere materially less than the recorded value, we would be required to take acharge against earnings to write down the goodwill and other intangible assetsto the lower value.

 

*Deferred Tax Assets*

 

At December 31, 2003 we had total deferred tax assets of $7.0million of which $6.9 million is represented by (i) federal NOLs of $18.9 million,which begin to expire in 2009; (ii) California NOLs of $766,000 which willexpire in 2004.  In order to utilize thebenefit of the deferred tax assets related to the NOLs, we must generateaggregate taxable income equal to the amount of the NOLs during the periodprior to their expiration.

 

If future taxable income should prove non-existent or less than theamount of the deferred tax assets within the tax years to which they may beapplied, the asset may not be realized. A valuation allowance may be established to reduce the deferred taxasset to its realizable value.  Any adjustment required to the valuationallowance is coupled with a related entry to income tax expense.  A chargeto earnings will be made in the event that we determine that a valuationallowance to the deferred tax asset is necessary.  Our deferred tax assets are described further in Note 6 of theNotes to Consolidated Financial Statements.

 

We use estimates of future taxable income to evaluate if it is morelikely than not that the benefit of our deferred tax assets will berealized.  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.

 

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**OPERATIONS SUMMARY ANALYSIS**

 

**Net Interest Income**

 

Our earnings depend largely upon the difference between the incomeearned on our loans and other investments and the interest paid on our depositsand borrowed funds.  This difference isnet interest income.  Our ability togenerate net interest income is largely dependent on our ability to maintainsound asset quality and appropriate levels of capital and liquidity.  Our inability to maintain strong assetquality, capital or liquidity may adversely affect (i) the ability toaccommodate desirable borrowing customers, thereby inhibiting growth in qualityhigher-yielding earning assets; (ii) the ability to attract comparativelystable, lower-cost deposits; and (iii) the costs of wholesale funding sources.

 

Net interest income decreased $1.0 million to $13.9 million during 2003compared to $14.9 million during 2002. The decrease was attributable to thereclassification of Trust Preferred Securities, discussed above, and loweryields on earning assets, partially offset by a greater volume of averageearning assets, a greater volume of noninterest-bearing liabilities, a lowervolume of average interest-bearing liabilities and a lower cost ofinterest-bearing liabilities.  Thereclassification of Trust Preferred Securities resulted in the $454,000 ofpayments on the Junior Subordinated Debentures being classified as interest in2003, while no interest expense was recorded in 2003 on the Trust PreferredSecurities.  The net yield on earningassets in 2003 declined to 4.29% for 2003 from 4.73% for 2002 (the net yield onearning assets in 2003 would have been 4.43% without the reclassification  of the Trust Preferred Securities).

 

Average earning assets increased $9.5 million to $324.8 million during2003 compared to 2002 while the average yield on earning assets declined 0.94 %from 6.21% to 5.27%.  Total interestincome decreased $2.4 million signficantly due to the lower yields on earningassets offset only slightly by the greater average earning assets.  Thelower yields are due to the sustained decline in interest rates over the pastthree years impacting the yields on adjustable rate earning assets as well asnewly originated fixed rate loans and existing fixed rate loans upon renewal atmaturity.

 

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Interest income from loans decreased $1.7 million during 2003 due to a81 basis point (one basis point is equal to .01%) decline in yield, partiallyoffset by a $6.3 million increase in average loans receivable.  The average amount of securitiesavailable-for-sale decreased $7.4 million while the average yield declined 144basis points resulting in a $741,000 decrease in interest income.  Interest income from federal funds solddecreased approximately $73,000 despite $7.3 million greater average volume dueto a 57% decrease in average yield.

 

Average interest-bearing liabilities decreased $7.1 million to $205.3million during 2003 compared to $212.4 million during 2002.  Interest expense decreased  $1.5 million  for 2003 compared to 2002 due to the lower average volume ofinterest bearing liabilities and a 65 basis point decline in the average costof funds for 2003.  Averageinterest-bearing liabilities decreased $14.8 million and interest expensedeclined $1.9 million without the reclass of the Trust Preferred Securitiesinto liabilities.  The decrease in thecost of funds was due to the overall lower interest rate environment during2003 and a change in the composition of interest-bearing liabilities to lowercost funds.  Relatively high-cost otherborrowings, consisting primarily of advances from the Federal Home Loan Bank,averaged $7.5 million in 2003 compared to $11.3 million in 2002.  The average amount of moderate-cost timecertificates of deposit decreased $21.9 million while lower-cost money marketand savings deposits and interest-bearing demand deposits increased $12.3 millionand $0.2 million, respectively.

 

Noninterest-bearing demand deposits averaged $119.8 million during 2003compared to $102.2 million in 2002. Shareholders’ equity averaged $31.6 million during 2003 compared to$25.9 million during the prior year primarily due to the sale and issuance of$7.7 million common shares in December 2002.

 

While Mercantile andSouth Bay had similar volumes of interest earning assets, a significantdifference existed in the composition of South Bay’s interest earning assetsand the related yields.  Accordingly, the acquisition of South Bay inDecember 2001 has affected the net interest spread during the 2002 and2003 periods as compared to 2001.  During 2003 average loans receivable ofSouth Bay were $22.4 million, or 19%, greater than Mercantile’s average loansreceivable while lower-yielding Federal funds sold and investment securities atSouth Bay were $25.8 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 0.42% in 2003.

 

Significant differencesin the composition and related costs of funding liabilities between Mercantileand South Bay also affected our net interest spread and net yield on earningassets for the 2003 periods.  Average noninterest bearing deposits atMercantile for the year ended December 31, 2003 were $56.8 million greaterthan South Bay while average interest bearing liabilities at Mercantile were$41.8 million less than South Bay.  During 2003, time certificates ofdeposit averaged $19.5 million and $44.8 million at Mercantile and South Bay,respectively, with rates of 1.49% and 2.34%, respectively.  The greaterrelative volume of higher costing funding liabilities at South Bay thanMercantile has increased the rate on our total interest bearing liabilitiesapproximately 0.58% in 2003.

 

In 2003 we replacedhigher costing liabilities at South Bay with Federal funds purchased fromMercantile in order to lower our overall cost of funds.  Additionally, weallocated greater resources to South Bay, primarily in salaries, to increaseits emphasis on business banking.  Management expects this emphasis toresult in further diversification of the loan portfolio through growth of commercialloans, in additional to growth of lower cost funds, particularly noninterestbearing.

 

**Table 2**

**Ratios to Average Assets**

 
|                                                                                           |   | **2003** |   | **2002** |   |
|------------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|
| Net interest income                                                                            |   | 3.82     | %      | 4.15     | %      |
| Other operating income                                                                         |   | 0.38     | %      | 0.42     | %      |
| Provision for credit losses                                                                    |   | (0.35    | )%     | (0.54    | )%     |
| Other operating expense                                                                        |   | (3.64    | )%     | (3.58    | )%     |
| Minority interest in the Company’s junior  subordinated deferrable interest debenture-net |   | (0.12    | )%     | (0.43    | )%     |
| Income before income taxes                                                                     |   | 0.09     | %      | 0.02     | %      |
|                                                                                           |   |     |   |     |   |
| Net income                                                                                     |   | 0.06     | %      | (0.07    | )%     |

 

16

----

 

**Interest Rate Spreadand Net Interest Margin**

 

We analyze earnings performance using, among other measures, theinterest rate spread and net interest margin. The interest rate spread represents the difference between the weightedaverage yield received on interest earning assets and the weighted average ratepaid on interest bearing liabilities. Net interest margin (also called the net yield on interest earningassets) is net interest income expressed as a percentage of average totalinterest earning assets.  Our netinterest margin is affected by changes in the yields earned on assets and ratespaid on liabilities, referred to as rate changes, and changes to the relativeamount of interest earning assets and interest bearing liabilities.  Interest rates charged on our loans areaffected principally by the demand for such loans, the supply of moneyavailable for lending purposes, and other competitive factors.  These factors are in turn affected 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 weighted average yieldon each category of interest earning assets, the weighted average rate paid oneach category of interest bearing liabilities, and the resulting interest ratespread and net yield on interest earning assets for 2003, 2002 and 2001.  We had no tax exempt interest income for2003, 2002 or 2001.

 

Our net interest margin remains high in comparison with the interestrate spread due to the continued significance of noninterest-bearing demanddeposits relative to total funding sources. Average noninterest bearing demand deposits totaled $119.8 million,representing 38.7% of average deposits, during 2003, compared to $102.2million, representing 34.0% of average deposits, during 2002.  Of these noninterest bearing demand depositsduring 2003, $27.0 million or 22.5% of average noninterest bearing depositswere represented by real estate title and escrow company deposits, compared to$23.9 million or 23.4% of average noninterest bearing deposits during2002.  While these deposits arenoninterest bearing, they are not cost free funds.  Customer service expenses, primarily costs related to externalaccounting and data processing services provided to title and escrow companydepositors are incurred by us to the extent that such depositors maintaincertain average noninterest bearing deposits. Customer service expense is classified as other operating expense.  If customer service expenses related toescrow customers had been classified as interest expense, our reported netinterest income for 2003 and 2002, would have been reduced by $132,000 and$206,000, respectively, and the net interest margin for 2003 and 2002 wouldhave decreased 6 basis points and 7 basis points, respectively.  Similarly, this would create identicalreductions in other operating expense.    The expense associated with these deposits declined in 2003 from 2002despite the increase in volume because we reduced the amount of third-partycustomer services provided for these depositors.

 

17

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**Table 3**

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

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

 
|                                                                        |                             | **2003 vs  2002**           |       | **2002 vs  2001** |     |
|-----------------------------------------------------------------------------|----------------------------------|-----------------------------|------------|-------------------|----------|
|                                                                        |                             |                        |       |              |     | **Net  Increase  (Decrease)** |   |   |   |   |   | **Net  Increase  (Decrease)** |   |
| **Increase  (decrease) due to:**                                            | **Increase  (decrease) due to:** |
| **Volume**                                                                  |                             | **Rate**                    | **Volume** |              | **Rate** |
|                                                                        |                             | **(Dollars  in thousands)** | ** ** |
| Interest Income:                                                            |                             |                        |       |              |     |   |   |   |   |   |   |   |   |
| Federal funds sold and securities purchased  under agreement to resell      |                             | $                           | 119        |              | $        | (192 | ) | $ | (73 | ) | $ | 192 |   | $ | (572 | ) | $ | (380 | ) |
| Due from banks - interest bearing                                           |                             | 5                           |       | —            |     | 5 |   | — |   | — |   | — |   |
| Securities available-for-sale                                               |                             | (370                        | )          | (371              | )        | (741 | ) | (1,164 | ) | (420 | ) | (1,584 | ) |
| Securities held-to-maturity                                                 |                             | 38                          |       | —            |     | 38 |   | — |   | — |   | — |   |
| Loans receivable (2)                                                        |                             | 435                         |       | (2,112            | )        | (1,677 | ) | 12,075 |   | (4,342 | ) | 7,733 |   |
| Total interest-earning assets                                               |                             | 227                         |       | (2,675            | )        | (2,448 | ) | 11,103 |   | (5,334 | ) | 5,769 |   |
|                                                                        |                             |                        |       |              |     |   |   |   |   |   |   |   |   |
| Interest Expense:                                                           |                             |                        |       |              |     |   |   |   |   |   |   |   |   |
| Interest-bearing deposits:                                                  |                             |                        |       |              |     |   |   |   |   |   |   |   |   |
| Demand                                                                      |                             | $                           | 3          |              | $        | (199 | ) | $ | (196 | ) | $ | 178 |   | $ | 52 |   | $ | 230 |   |
| Money market and savings                                                    |                             | 203                         |       | (724              | )        | (521 | ) | 1,162 |   | (755 | ) | 407 |   |
| Time certificates of deposit:                                               |                             |                        |       |              |     |   |   |   |   |   |   |   |   |
| $100,000 or more                                                            |                             | (307                        | )          | (3                | )        | (310 | ) | 619 |   | (1,183 | ) | (564 | ) |
| Under $100,000                                                              |                             | (200                        | )          | (476              | )        | (676 | ) | 1,397 |   | (246 | ) | 1,151 |   |
| Total time certificates of deposit                                          |                             | (507                        | )          | (479              | )        | (986 | ) | 2,016 |   | (1,429 | ) | 587 |   |
| Total interest-bearing deposits                                             |                             | (301                        | )          | (1,402            | )        | (1,703 | ) | 3,356 |   | (2,132 | ) | 1,224 |   |
| Other borrowings                                                            |                             | (161                        | )          | 44                |     | (117 | ) | (463 | ) | (70 | ) | (533 | ) |
| Junior subordinated debentures (3)                                          |                             | 454                         |       | —            |     | 454 |   | — |   | — |   | — |   |
| Federal funds purchased and securities sold  under agreements to repurchase |                             | (98                         | )          | (20               | )        | (118 | ) | 79 |   | 18 |   | 97 |   |
| Total interest-bearing liabilities                                          |                             | (106                        | )          | (1,378            | )        | (1,484 | ) | 2,972 |   | (2,184 | ) | 788 |   |
|                                                                        |                             |                        |       |              |     |   |   |   |   |   |   |   |   |
| Net interest income                                                         |                             | $                           | 333        |              | $        | (1,297 | ) | $ | (964 | ) | $ | 8,131 |   | $ | (3,150 | ) | $ | 4,981 |   |
|                                                                             |                                  |                             |            |                   |          |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)   The change in interest income or interestexpense that is attributable to both changes in average balance and averagerate has been allocated to the changes due to ‘(i) average balance and (ii)average rate in proportion to the relationship of the absolute amounts ofchanges in each.

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

(3)   The implementation of FASB Interpretation No.46, effective July 1, 2003 resulted in the reclassification of theCompany’s Junior Subordinated Debentures from mezzanine equity to liabilitiesand the related interest to interest expense after June 30, 2003.

 

18

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**Table 4**

**AverageBalance Sheet and**

**Analysis ofNet Interest Income**

 
|                                                                                                                         |   | **2003**                    |    | **2002**                       |   | **2001**                            |   |
|------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|---------|--------------------------------|--------|-------------------------------------|--------|
|                                                                                                                         |   | **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                                                      |   | $                           | 33,829  |                           | $      | 359                                 |   | 1.06 | % | $ | 26,514 |   | $ | 432 |   | 1.63 | % | $ | 21,446 |   | $ | 812 |   | 3.79 | % |
| Due from banks - interest bearing                                                                                            |   | 1,304                       |    | 17                             |   | 1.30                                | %      | 1,348 |   | 12 |   | 0.89 | % | — |   | — |   | — |   |
| Securities available-for-sale                                                                                                |   | 25,672                      |    | 911                            |   | 3.55                                | %      | 33,077 |   | 1,652 |   | 4.99 | % | 51,665 |   | 3,236 |   | 6.26 | % |
| Securities held-to-maturity                                                                                                  |   | 3,254                       |    | 38                             |   | 1.17                                | %      | — |   | — |   | — |   | — |   | — |   | — |   |
| Loans receivable (1) (2)                                                                                                     |   | 260,756                     |    | 15,799                         |   | 6.06                                | %      | 254,424 |   | 17,476 |   | 6.87 | % | 113,615 |   | 9,743 |   | 8.58 | % |
| Total interest earning assets                                                                                                |   | 324,815                     |    | $                              | 17,124 |                                | 5.27   | % | 315,363 |   | $ | 19,572 |   | 6.21 | % | 186,726 |   | $ | 13,791 |   | 7.39 | % |
|                                                                                                                         |   |                        |    |                           |   |                                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest earning assets:                                                                                                  |   |                        |    |                           |   |                                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash and due from banks - demand                                                                                             |   | 22,171                      |    |                           |   |                                |   | 20,775 |   |   |   |   |   | 11,698 |   |   |   |   |   |
| Other assets                                                                                                                 |   | 21,859                      |    |                           |   |                                |   | 28,348 |   |   |   |   |   | 4,900 |   |   |   |   |   |
| Allowance for credit losses and net unrealized  (loss) gain on sales of securities available-for-sale                        |   | (4,025                      | )       |                           |   |                                |   | (5,652 | ) |   |   |   |   | (2,794 | ) |   |   |   |   |
| Total assets                                                                                                                 |   | $                           | 364,820 |                           |   |                                |   |   | $ | 358,834 |   |   |   |   |   | $ | 200,530 |   |   |   |   |   |
|                                                                                                                         |   |                        |    |                           |   |                                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Liabilities and shareholders’ equity:                                                                                   |   |                        |    |                           |   |                                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing deposits:                                                                                                   |   |                        |    |                           |   |                                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Demand                                                                                                                       |   | $                           | 28,269  |                           | $      | 126                                 |   | 0.45 | % | $ | 28,024 |   | $ | 322 |   | 1.15 | % | $ | 9,562 |   | $ | 92 |   | 0.96 | % |
| Money market and savings                                                                                                     |   | 98,763                      |    | 905                            |   | 0.92                                | %      | 86,444 |   | 1,426 |   | 1.65 | % | 40,396 |   | 1,019 |   | 2.52 | % |
| Time certificates of deposit:                                                                                                |   |                        |    |                           |   |                                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| $100,000 or more                                                                                                             |   | 29,150                      |    | 535                            |   | 1.84                                | %      | 45,770 |   | 845 |   | 1.85 | % | 31,807 |   | 1,409 |   | 4.43 | % |
| Under $100,000                                                                                                               |   | 33,316                      |    | 783                            |   | 2.35                                | %      | 38,606 |   | 1,459 |   | 3.78 | % | 6,975 |   | 308 |   | 4.42 | % |
| Total time certificates of deposit                                                                                           |   | 62,466                      |    | 1,318                          |   | 2.11                                | %      | 84,376 |   | 2,304 |   | 2.73 | % | 38,782 |   | 1,717 |   | 4.43 | % |
| Total interest-bearing deposits                                                                                              |   | 189,498                     |    | 2,349                          |   | 1.24                                | %      | 198,844 |   | 4,052 |   | 2.04 | % | 88,740 |   | 2,828 |   | 3.19 | % |
| Other borrowings                                                                                                             |   | 7,500                       |    | 361                            |   | 4.81                                | %      | 11,308 |   | 478 |   | 4.23 | % | 20,865 |   | 1,011 |   | 4.85 | % |
| Junior subordinated debentures (3)                                                                                           |   | 7,733                       |    | 454                            |   | 5.87                                | %      | — |   | — |   | — |   | — |   | — |   | — |   |
| Federal funds purchased and securities sold under  agreements to repurchase                                                  |   | 609                         |    | 16                             |   | 2.63                                | %      | 2,294 |   | 134 |   | 5.84 | % | 733 |   | 37 |   | 5.05 | % |
| Total interest-bearing liabilities                                                                                           |   | 205,340                     |    | 3,180                          |   | 1.55                                | %      | 212,446 |   | 4,664 |   | 2.20 | % | 110,338 |   | 3,876 |   | 3.51 | % |
|                                                                                                                         |   |                        |    |                           |   |                                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing liabilities:                                                                                             |   |                        |    |                           |   |                                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest bearing demand deposits                                                                                          |   | 119,789                     |    |                           |   |                                |   | 102,213 |   |   |   |   |   | 58,883 |   |   |   |   |   |
| Other liabilities                                                                                                            |   | 845                         |    |                           |   |                                |   | 3,716 |   |   |   |   |   | 1,197 |   |   |   |   |   |
| Guaranteed preferred beneficial interests in the  Company’s junior subordinated deferrable interest debentures, net (3) |   | 7,267                       |    |                           |   |                                |   | 14,525 |   |   |   |   |   | 7,592 |   |   |   |   |   |
| Shareholders’ equity                                                                                                    |   | 31,579                      |    |                           |   |                                |   | 25,934 |   |   |   |   |   | 22,520 |   |   |   |   |   |
| Total liabilities and shareholders’ equity                                                                              |   | $                           | 364,820 |                           |   |                                |   |   | $ | 358,834 |   |   |   |   |   | $ | 200,530 |   |   |   |   |   |
|                                                                                                                         |   |                        |    |                           |   |                                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest income (interest rate spread)                                                                                   |   |                        |    | $                              | 13,944 |                                | 3.72   | % |   |   | $ | 14,908 |   | 4.01 | % |   |   | $ | 9,915 |   | 3.88 | % |
|                                                                                                                         |   |                        |    |                           |   |                                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net yield on earning assets (2)                                                                                              |   |                        |    |                           |   | 4.29                                | %      |   |   |   |   | 4.73 | % |   |   |   |   | 5.31 | % |

 

----

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

(2)          Yields and amounts earned on loans receivableinclude loan fees of $882,000, $645,000 and $403,000 for the years endedDecember 31, 2003, 2002 and 2001, respectively.

(3)          The implementation of FASB Interpretation No.46, effective July 1, 2003 resulted in the reclassification of theCompany’s Junior Subordinated Debentures from mezzanine equity to liabilitiesand the related interest to interest expense after June 30, 2003.

 

19

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**Provision for Credit Losses**

** **

Provisions for credit losses charged to operations reflect management’sjudgment of the adequacy of the allowance for credit losses and are determinedthrough periodic analysis of the loan portfolio.  This analysis includes a detailed review of the classification andcategorization of problem loans and loans to be charged off; an assessment ofthe overall quality and collectibility of the loan portfolio; and considerationof the loan loss experience, trends in problem loan concentrations of creditrisk, as well as current and expected future economic conditions (particularlySouthern California).  Management, incombination with an outside firm, performs a periodic risk and credit analysis,the results of which are reported to the Board of Directors.

 

During 2003, we provided $1.3 million to the allowance for creditlosses to maintain an adequate allowance after the charge-off of variousloans.  In 2003 net charge-offs were$2.5 million compared to $3.6 million in 2002. Management determined that a decrease in the allowance for credit losseswas warranted due to the reduction in nonperforming loans.

 

Based on continued loan growth, the relative uncertainty regarding thestate of the economy, the level of nonperforming loans and a relativelyconstant level of charge offs, it is anticipated that regular provisions forcredit losses will be made during 2004. Credit quality will be influenced by underlying trends in the economiccycle, particularly in Southern California, and other factors which are beyondmanagement’s control.  Accordingly, noassurance can be given that we will not sustain loan losses that in anyparticular period are sizable in relation to the allowance for creditlosses.  Subsequent evaluation of theloan portfolio, in light of factors then prevailing, by us and our regulatorsmay indicate a requirement for increases in the allowance for credit lossesthrough  additions to the provision forcredit losses.

 

**Other OperatingIncome**

 

Other operating income was $1.4 million and $1.5 million in 2003 and2002, respectively.  During 2003 werecorded a net gain of $51,000 on the sales of securitiesavailable-for-sale.  In 2002, there wereno sales of securities and therefore, no gains nor losses on sales ofsecurities.  Fee income related tointernational services was $44,000 in 2003 compared to $37,000 in 2002.  Investment services fees remained stable at$84,000 in 2003 compared to $82,000 in 2002. Deposit related services were $1.3 million in 2003 as compared to $1.4million in 2002.  In 2003 we recorded aloss of $136,000 on the sale or write-down of OREO.

 

**Other OperatingExpenses**

 

Other operating expense increased $435,000 to $13.3 million in 2003,compared to $12.9 million during 2002. Salaries and related benefits increased $381,000 or 5.6 % to $7.2million, primarily due to the addition of business development staff.  Other professional services expenseincreased 57.2 % to $833,000 due to costs associated with problem loanresolution, goodwill and intangible valuation and expanded internal auditreviews.  Legal expenses decreased 12.6% to $473,000 during 2003 from $541,000 during 2002 largely due to decreasedactivity required for loan collections at both Banks.  During 2003, $223,000 was recorded for the amortization of coredeposit intangibles associated with the South Bay acquisition.  Customer services expense declined $93,000during 2003 due to the decline in interest rates resulting in the bank payingfor fewer third-party services, such as accounting and bookkeeping services,for its escrow and title insurance depositors.

 

**Income Taxes**

 

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

 

At December 31, 2003, our deferred tax asset totaled $7.0 million,respectively, with no recorded valuation allowance.

 

For tax purposes at December 31, 2003, we had (i) federal netoperation loss carryforwards (“NOLs”) of $18.9 million, which begin to expirein 2009; (ii) California NOLs of $766,000 which will expire in 2004; (iii) afederal 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 expire in 2002, however, thestate legislature suspended NOL utilization and extended the relatedcarryforward expiration.  The AMTcredits carryforward indefinitely.

 

An income tax provision of $96,000 was recorded for 2003.  During 2002, a $127,000 income tax provisionwas recorded despite the net loss as taxable income was greater than thereported results of operations due to non-deductible expenses for tax purposes.

 

20

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Federal and state income tax laws provide that following an ownershipchange of a corporation with NOLs, a net unrealized built-in loss or tax creditcarryovers, the amount of annual post-ownership change taxable income that canbe offset by pre-ownership change NOLs, built-in losses or tax creditcarryovers generally cannot exceed a prescribed annual limitation.  The annual limitation generally equals theproduct of the fair market value of the corporation immediately before theownership change (subject to certain adjustments) and the federal long-termtax-exempt rate prescribed monthly by the Internal Revenue Service.  If such limitations were to apply to us, ourability to reduce future taxable income by the NOLs could be severely limited.

 

## **Accumulated OtherComprehensive Income**

 

Changes in the unrealized gain on available-for-sale securities, net oftaxes is the only component of our other comprehensive income.  At December 31, 2003 the net unrealizedgain on available-for-sale securities, net of taxes was $71,000 compared to$202,000 at December 31, 2002. During 2003 there was a $131,000 net unrealized holding loss.

 

**FINANCIAL CONDITION**

 

## **Regulatory Capital**

## ** **

The following table sets forth the regulatory standards forwell-capitalized banks and our regulatory capital ratios as ofDecember 31, 2003 and 2002.

 

**Table 5**

**Regulatory Capital Information**

**of the National Mercantile and Banks**

 
|                              |   | **Minimum  For Capital  Adequacy  Purposes** |   | **Well  Capitalized  Standards** |   | **December 31,** |   |
|-----------------------------------|--------|----------------------------------------------|--------|----------------------------------|--------|-----------------------|--------|
|                              |   |                                         |   | **2003**                         |   | **2002**              |   |
| **National Mercantile  Bancorp:** |   |                                         |   |                             |   |                  |   |   |   |
| Tier 1 leverage                   |   | 4.00                                         | %      | N/A                              |   | 8.69                  | %      | 8.60 | % |
| Tier 1 risk-based capital         |   | 4.00                                         | %      | N/A                              |   | 11.02                 | %      | 10.57 | % |
| Total risk-based capital          |   | 8.00                                         | %      | N/A                              |   | 13.84                 | %      | 13.31 | % |
|                              |   |                                         |   |                             |   |                  |   |   |   |
| **Mercantile National  Bank:**    |   |                                         |   |                             |   |                  |   |   |   |
| Tier 1 leverage                   |   | 4.00                                         | %      | 5.00                             | %      | 8.13                  | %      | 7.20 | % |
| Tier 1 risk-based capital         |   | 4.00                                         | %      | 6.00                             | %      | 10.88                 | %      | 9.89 | % |
| Total risk-based capital          |   | 8.00                                         | %      | 10.00                            | %      | 12.13                 | %      | 11.15 | % |
|                              |   |                                         |   |                             |   |                  |   |   |   |
| **South Bay Bank, NA:**           |   |                                         |   |                             |   |                  |   |   |   |
| Tier 1 leverage                   |   | 4.00                                         | %      | 5.00                             | %      | 9.44                  | %      | 9.38 | % |
| Tier 1 risk-based capital         |   | 4.00                                         | %      | 6.00                             | %      | 11.18                 | %      | 10.90 | % |
| Total risk-based capital          |   | 8.00                                         | %      | 10.00                            | %      | 12.37                 | %      | 12.15 | % |

 

Our Tier 1 capital, which is comprised ofshareholders’ equity as modified by certain regulatory adjustments, was $31.2million and $29.9 million at December 31, 2003 and 2002,respectively.  National Mercantile’sTier 1 capital increased in 2003 as a result of retained earnings, exercisedstock options and a reduction of disallowed deferred tax asset.  Federal Reserve capital rules allow trustpreferred securities to represent 25% of Tier 1 capital with the balancetreated as Tier 2 capital for the Total Risk-based Capital Ratio.  At December 31, 2003 and 2002, TrustPreferred Securities represented $10.6 million and $10.3 million, respectively,of National Mercantile’s Tier 1 capital, and $4.4 million and $4.7 million,respectively, of its Tier 2 capital. Disallowed against National Mercantile’s Tier 1 capital is $3.2 millionof goodwill recorded in the acquisition of South Bay, $1.9 million of otherintangible assets and $5.9 million of deferred tax asset based upon estimatedearnings.  A reduction in estimatedearnings will increase the amount of the disallowed deferred tax asset and willhave the effect of reducing our regulatory capital.

 

Mercantile’s Tier 1 capital was $15.7 million and $12.6 million atDecember 31, 2003 and 2002, respectively. The increase in Tier 1 capital during 2003 was due to the decrease ofthe disallowed portion of the deferred tax asset related to the NOL.  Because the allowable portion of thedeferred tax asset is based upon our estimated twelve-month’s earnings of theconsolidated entity, as discussed above, an increase in estimated earnings willlikewise increase Mercantile’s regulatory capital.

 

21

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South Bay’s Tier 1 capital at December 31, 2003 was $15.4 millioncompared to $17.0 million at December 31, 2002.  The decrease is due to an increase in the goodwill disallowed forregulatory purposes.

 

## **LiquidityManagement**

 

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

 

Our deposit base provides the majority of funding requirements.  Average deposits, a relatively stable andlow-cost source of funds has, along with shareholders’ equity, provided 84.8 %and 83.9 % of funding for average total assets during 2003 and 2002,respectively.  The other borrowings,specifically Federal Home Loan Bank (“FHLB”) advances, which averaged $7.5million during 2003 compared to $11.3 million during 2002, and federal fundspurchased and securities sold under agreements to repurchase, which averaged$609,000 in 2003 compared to $2.3 million in 2002, comprise the balance of theliability funding.  The decline inrelatively high-cost other borrowings during 2002 was offset by deposits andcapital sources of funding.

 

Liquidity is also provided by assets such as federal funds sold andsecurities purchased under resale agreements that may be immediately convertedto cash at minimal cost. The aggregate of these assets averaged $33.8 millionduring 2003, as compared to $26.5 million during 2002.

 

The portfolio of available-for-sale securities is an additional sourceof liquidity, which averaged $25.7 million during 2003 compared to $33.1million in 2002.  The securitiesavailable-for-sale increased in 2003 due to the deployment of funds intosecurities pending redeployment into loans. The unpledged portion of investment securities at December 31, 2003totaled $15.6 million and was available as collateral for borrowings.  At December 31, 2003 an additional $2.3million borrowing capacity remained on pledged securities.  Maturing loans also provide liquidity, ofwhich $79.9 million of the Banks’ loans are scheduled to mature in 2004.

 

Net cash provided by operating activities totaled $2.4 million in 2003compared to $2.5 million in 2002.  Theprimary source of funds is net income from operations adjusted for provisionfor credit losses and depreciation and amortization.  Net cash used in investing activities totaled $426,000 in 2003compared to $407,000 net cash provided by investing activities in 2002.  The decrease in cash provided by investingactivities resulted from an increase in purchase of securitiesavailable-for-sale and securities held-to-maturity partially offset by anincrease in the proceeds from sales and repayments of securitiesavailable-for-sale and a decrease in net loan originations.  Net cash used in financing activities was$581,000 in 2003 compared to $17.1 million provided by financing activities in2002.  The decrease in 2003 resultedprimarily from a decrease in other borrowed funds offset by an increase indemand, money market and savings deposits.

 

**Interest Rate Risk Management**

 

Interest rate risk management seeks to maintain a stable growth ofincome and manage the risk associated with changes in interest rates.  Net interest income, the primary source ofearnings, is affected by interest rate movements.  Changes in interest rates have a lesser impact the more thatassets and liabilities reprice in approximately equivalent amounts at basicallythe same time intervals.  Imbalances inthese repricing opportunities at any point in time constitute interest sensitivitygaps, which is the difference between interest sensitive assets and interestsensitive liabilities.

 

Interest rate risk, including interest rate sensitivity and therepricing characteristics of assets and liabilities, is managed by the InterestRate Risk Management Committee (“IRRMC”). The principal objective of IRRMC is to maximize net interest incomewithin acceptable levels of risk established by policy.

 

We manage interest rate sensitivity by matching the repricingopportunities on our earning assets to those on our funding liabilities.  We use various strategies to manage therepricing characteristics of our assets and liabilities to ensure that exposureto interest rate fluctuations is limited within guidelines of acceptable levelsof risk-taking.  Hedging strategies,including the terms and pricing of loans and deposits, and managing thedeployment of our securities are used to reduce mismatches in interest raterepricing opportunities of portfolio assets and their funding sources.  Interest rate risk is measured usingfinancial modeling techniques, including stress tests, to measure the impact ofchanges in interest rates on future earnings. These static measurements do not reflect the results of any projectedactivity and are best used as early indicators of potential interest rateexposures.

 

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

 

22

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

 

Table 6 compares our interest rate gap position as of December 31,2003 and 2002.  The gap report shows acumulative one year interest rate asset sensitivity gap of $85.9 million atDecember 31, 2003, a change from an asset sensitivity gap of $36.7 millionat December 31, 2002.  The increasein asset sensitivity was due to a $21.0 million increase in loans receivablematuring or repricing in less than one year , an increase of $13.7 insecurities-available-for-sale maturing or repricing in less than one year and areduction in time certificates of deposit of $25.6 million maturing in lessthan one year partially offset by an increase in immediately repricableinterest-bearing demand, money market and savings deposits of $7.9 million..  The greater volume of loans repricingwithin one year is due to the greater emphasis on growth in commercial loanswhich are typically adjustable rate loans. The increase in interest-bearing demand, money market and savingsdeposits is due similarly to the emphasis on commercial borrowers as well as achange in mix from time certificates of deposit to savings deposits.  In the low interest rate environment,depositors have moved maturing time certificates of deposits to savingsdeposits.

 

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

 

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

 

Our asset sensitive position during a period of slowly declininginterest rates is not expected to have a significant negative impact on netinterest income since we have a large base of immediately adjustable interestbearing demand, savings and money market deposits.  However, since we are asset sensitive, in a period of rapidlydeclining interest rates, 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 2003, 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.

 

23

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**Table 6**

**Rate-Sensitive Assets and Liabilities**

 
|                                                                     |   | **December 31,  2003**   |   |
|--------------------------------------------------------------------------|--------|-------------------------------|--------|
|                                                                     |   | **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  |   | $                             | 10,000 |   | $ | — |   | $ | — |   | $ | — |   | $ | 10,000 |   |
| Securities available-for-sale, at amortized  cost                        |   | 10,507                        |   | 4,186 |   | 4,875 |   | 11,309 |   | 30,877 |   |
| Securities held to maturity                                              |   | —                        |   | — |   | — |   | 4,597 |   | 4,597 |   |
| Due from banks - time                                                    |   | —                        |   | 4,728 |   | — |   | — |   | 4,728 |   |
| FRB and other stock, at cost                                             |   | —                        |   | — |   | — |   | 1,872 |   | 1,872 |   |
| Loans receivable (1)                                                     |   | 221,578                       |   | 6,647 |   | 27,973 |   | 4,341 |   | 260,539 |   |
| Total rate-sensitive assets                                              |   | 242,085                       |   | 15,561 |   | 32,848 |   | 22,119 |   | 312,613 |   |
|                                                                     |   |                          |   |   |   |   |   |   |   |   |   |
| Rate-Sensitive Liabilities:  (2)                                    |   |                          |   |   |   |   |   |   |   |   |   |
| Interest bearing deposits:                                               |   |                          |   |   |   |   |   |   |   |   |   |
| Demand, money market and savings                                         |   | 123,696                       |   | — |   | — |   | — |   | 123,696 |   |
| Time certificates of deposit                                             |   | 28,427                        |   | 19,263 |   | 7,333 |   | — |   | 55,023 |   |
| Other borrowings                                                         |   | —                        |   | 399 |   | — |   | — |   | 399 |   |
| Total rate-sensitive liabilities                                         |   | 152,123                       |   | 19,662 |   | 7,333 |   | 0 |   | 179,118 |   |
| Interest rate-sensitivity gap                                            |   | 89,962                        |   | (4,101 | ) | 25,515 |   | 22,119 |   | 133,495 |   |
| Cumulative interest rate-sensitivity gap                                 |   | $                             | 89,962 |   | $ | 85,861 |   | $ | 111,376 |   | $ | 133,495 |   |   |   |
| Cumulative ratio of rate sensitive assets  to rate-sensitive liabilities |   | 159                           | %      | 150 | % | 162 | % | 175 | % |   |   |
|                                                                          |        |                               |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)          Loans receivable excludes nonaccrual loans.

(2)          Deposits which are subject to immediatewithdrawal are presented as repricing within three months or less.

The distribution of other time deposits is based onscheduled maturities.

 

24

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**Table 6**

**Rate-Sensitive Assets 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 immediatewithdrawal are presented as repricing within three months or less.

The distribution of other time deposits is based onscheduled maturities.

 

**Investment Securities**

 

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

 

We generally classify our investment securities as available-for-saleexcept for investment securities we have the ability and the positive intent tohold to maturity which are classified as held-to-maturity securities.   There were no held-to-maturity securitiesat December 31, 2002.

 

Table 7 provides certain information regarding our investmentsecurities.

 

25

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**Table 7**

 

**Estimated Fair Values of and Unrealized**

**Gains and Losses on Investment Securities**

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

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

 
|                                                                            |   | **December 31,  2002** | ** **   |
|---------------------------------------------------------------------------------|--------|-----------------------------|--------------|
|                                                                            |   | **Total  amortized  cost**  | ** **   | **Gross  unrealized  gains** | ** ** | **Gross  unrealized  loss** | ** ** | **Estimated  fair  value** | ** ** |
|                                                                            |   | **(Dollars  in thousands)** | ** **   |
| **Available-For-Sale:**                                                         |   |                        |         |   |   |   |   |   |   |
| 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 |   |

 

26

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At December 31, 2003, we held no securities from any issuer otherthan by U.S. government agencies and corporations in which the aggregate bookvalue exceeded 10% of our shareholders’ equity.

 

Our present strategy is to stagger the maturities of investmentsecurities to meet our overall liquidity requirements.  Table 10 sets forth information concerningthe contractual maturity of and weighted average yield of our investmentsecurities at December 31, 2003.

 

**Table 8**

**Maturities of and Weighted Average Yields on**

**Investment Securities**

 
|                                                                      |   | **Within one  year**        |       | **After one  but  within five years** |       | **After five  but  within ten years** |       | **After ten  years** |       |       |       | **Weighted  Average** |       |
|---------------------------------------------------------------------------|--------|-----------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|----------------------|------------|------------|------------|-----------------------|------------|
|                                                                      |   | **Amount**                  |       | **Yield**                             |       | **Amount**                            |       | **Yield**            |       | **Amount** |       | **Yield**             |       | **Amount** |   | **Yield** |   | **Total** |   | **Yield** |   |
|                                                                      |   | **(Dollars  in thousands)** |       |
| **Securities available-for-sale:**                                        |   |                        |       |                                  |       |                                  |       |                 |       |       |       |                  |       |   |   |   |   |   |   |   |   |
| U.S  Treasury securities                                                  | $      | 599                         |       | 1.13                                  | %          | $                                     | —     |                 | —     |       | $          | —                |       | — |   | $ | — |   | — |   | $ | 599 |   | 1.13 | % |
| GNMA-issued/guaranteed  mortgage pass-through certificates           |   | —                      |       | —                                |       | —                                |       | —               |       | —     |       | —                |       | 363 |   | 3.86 | % | 363 |   | 3.86 | % |
| Other U.S. government and federal agencies                                |   | 1,018                       |       | 1.12                                  | %          | 4,542                                 |       | 1.98                 | %          | 7,239      |       | 4.63                  | %          | — |   | — |   | 12,799 |   | 3.41 | % |
| FHLMC/FNMA-issued mortgage pass-through  certificates                     |   | 6                           |       | 7.10                                  | %          | 276                                   |       | 5.81                 | %          | 1,019      |       | 3.33                  | %          | 2,688 |   | 5.09 | % | 3,989 |   | 4.69 | % |
| CMO’s and REMIC’s issued by U.S.  government-sponsored agencies |   | —                      |       | —                                |       | 57                                    |       | 7.27                 | %          | —     |       | —                |       | — |   | — |   | 57 |   | 7.27 | % |
| Mortgage mutual funds                                                     |   | 9,902                       |       | 3.10                                  | %          | —                                |       | —               |       | —     |       | —                |       | — |   | — |   | 9,902 |   | 3.10 | % |
| Privately issued corporate bonds, CMO’s and  REMIC’s securities |   | 3,168                       |       | 2.02                                  | %          | —                                |       | —               |       | —     |       | —                |       | — |   | — |   | 3,168 |   | 2.02 | % |
|                                                                      |   | $                           | 14,693     |                                  | 2.65       | %                                     | $          | 4,875                |       | 2.26       | %          | $                     | 8,258      |   | 4.47 | % | $ | 3,051 |   | 4.94 | % | $ | 30,877 |   | 3.30 | % |
|                                                                      |   |                        |       |                                  |       |                                  |       |                 |       |       |       |                  |       |   |   |   |   |   |   |   |   |
| **Amortized Cost**                                                        |   | $                           | 14,299     |                                  |       |                                  | $          | 5,344                |       |       |       | $                     | 8,204      |   |   |   | $ | 2,909 |   |   |   | $ | 30,756 |   |   |   |
|                                                                      |   |                        |       |                                  |       |                                  |       |                 |       |       |       |                  |       |   |   |   |   |   |   |   |   |
| FRB and other equity stocks                                               |   | $                           | 1,872      |                                  | 0.00       | %                                     | $          | —               |       | —     |       | $                     | —     |   | — |   | $ | — |   | — |   | $ | 1,872 |   | 0.00 | % |
|                                                                      |   |                        |       |                                  |       |                                  |       |                 |       |       |       |                  |       |   |   |   |   |   |   |   |   |
|                                                                      |   | **Within one  year**        | ** ** | **After one  but  within five years** | ** ** | **After five  but  within ten years** | ** ** | **After ten  years** | ** ** |       | ** ** | **Weighted  Average** | ** ** |
|                                                                      |   | **Amount**                  | ** ** | **Yield**                             | ** ** | **Amount**                            | ** ** | **Yield**            | ** ** | **Amount** | ** ** | **Yield**             | ** ** | **Amount** | ** ** | **Yield** | ** ** | **Total** | ** ** | **Yield** | ** ** |
|                                                                      |   | **(Dollars  in thousands)** | ** ** |
| **Securities held-to-maturity:**                                          |   |                        |       |                                  |       |                                  |       |                 |       |       |       |                  |       |   |   |   |   |   |   |   |   |
| FHLMC/FNMA-issued mortgage pass-through  certificates                     |   | $                           | —     |                                  | —     |                                  | $          | —               |       | —     |       | $                     | 4,597      |   | 4.58 | % | $ | — |   | — |   | $ | 4,597 |   | 4.58 | % |
|                                                                      |   | $                           | —     |                                  | —     |                                  | $          | —               |       | —     |       | $                     | 4,597      |   | 4.58 | % | $ | — |   | — |   | $ | 4,597 |   | 4.58 | % |

 

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

 

**Lending Activities**

 

Through Mercantile and South Bay we engage in commercial banking,serving small to medium-sized businesses in the niche markets of entertainment,healthcare, business banking, and community-based nonprofit organizations,business executives, professionals and other individuals, providing commercialand residential real estate financing, real estate construction financing andcommercial lending, consumer and home equity loans.  Our primary geographic focus is the Los Angeles basin of LosAngeles County, with four branch banking offices consisting of MercantileBank’s offices located in Century City and Encino, and South Bay Bank’s officeslocated in Torrance and El Segundo.  Weoffer a full range of loan, deposit and investment products which are designedto meet specific customer needs and are offered with highly personalizedservice.

 

27

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Loan products include commercial real estate loans, constructionfinancing, revolving lines of credit, term loans and consumer and home equityloans, along with an array of deposits and investment accounts that oftencontain terms and conditions tailored to meet the specific demands of themarket niche in which the borrower operates, including the ability to evaluatethe revenue streams and other sources of repayment supporting the loan.  In order to provide the personalized servicerequired by these customers, we use a team approach to customer servicecombining an experienced relationship management officer with operationssupport personnel.

 

Our targeted market niches have included the entertainment industry,professional services providers, healthcare and community-based nonprofitorganizations.  Entertainment industrycustomers include television, music and film production companies, talentagencies, individual performers, directors and producers (whom we attract byestablishing relationships with business management firms), and othersaffiliated with the entertainment industry.  Professional service customers include legal, accounting, insurance,advertising firms and their individual directors, officers, partners and shareholders.  Healthcare organizations include primarilyoutpatient healthcare providers such as physician medical groups, independentpractice associations and surgery centers.

 

# ***Loan Portfolio***

 

The following table sets forth the composition of our loan portfolio atthe dates indicated**:**

 

 

**Table 9**

**Loan Portfolio Composition**

 
|                                                                  |   | **December 31,**       |    |
|-----------------------------------------------------------------------|--------|-----------------------------|---------|
|                                                                  |   | **2003**                    |    | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|                                                                  |   | **Amount**                  |    | **Percent** |   | **Amount** |   | **Percent** |   | **Amount (1)** |   | **Percent** |   | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   |
|                                                                  |   | **(Dollars  in thousands)** |    |
| Real Estate loans:                                                    |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Secured by one to four family residential  properties                 |   | $                           | 8,167   |   | 3 | % | $ | 10,797 |   | 4 | % | $ | 27,069 |   | 10 | % | $ | 6,578 |   | 6 | % | $ | 4,405 |   | 6 | % |
| Secured by multifamily residential properties                         |   | 13,071                      |    | 5 |   | 12,596 |   | 5 |   | 8,492 |   | 3 |   | 3,765 |   | 3 |   | 5,355 |   | 7 |   |
| Secured by commercial real properties                                 |   | 132,320                     |    | 52 |   | 119,872 |   | 44 |   | 95,142 |   | 36 |   | 40,540 |   | 37 |   | 28,233 |   | 38 |   |
| Real estate construction and land development                         |   | 27,210                      |    | 10 |   | 37,934 |   | 14 |   | 30,811 |   | 12 |   | 1,890 |   | 2 |   | 6 |   | — |   |
| Commercial loans:                                                     |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Other - secured and unsecured                                         |   | 76,699                      |    | 29 |   | 86,015 |   | 32 |   | 85,292 |   | 33 |   | 53,433 |   | 48 |   | 33,221 |   | 45 |   |
| Consumer installment, home equity and unsecured  loans to individuals |   | 3,510                       |    | 1 |   | 5,566 |   | 1 |   | 15,306 |   | 6 |   | 4,373 |   | 4 |   | 2,863 |   | 4 |   |
| Total loans outstanding                                               |   | 260,977                     |    | 100 | % | 272,780 |   | 100 | % | 262,112 |   | 100 | % | 110,579 |   | 100 | % | 74,083 |   | 100 | % |
|                                                                  |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Deferred net loan origination fees and purchased  loan discount       |   | (728                        | )       |   |   | (458 | ) |   |   | (144 | ) |   |   | (331 | ) |   |   | (240 | ) |   |   |
| Loans receivable, net                                                 |   | $                           | 260,249 |   |   |   | $ | 272,322 |   |   |   | $ | 261,968 |   |   |   | $ | 110,248 |   |   |   | $ | 73,843 |   |   |   |

 

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

 

Most of the our commercial loans are generally within $100,000 to $3.0million and our consumer and home equity loans generally are less than$100,000.  The Banks may not make anyloan, with certain limited exceptions, in excess of their loan to one borrowerlimit under applicable regulations ($2.7 million for Mercantile and $2.6million for South Bay at December 31, 2003).  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.  At December 31, 2003 wehad $10.5 million in loans originated and service by other banks in which wepurchased a non-recourse participation.

 

*Commercial Loans Secured by Real Estate. *We offer adjustable and fixed ratesecured loans to finance the purchase or holding of commercial real estate, oneto four family residences and multi-family residences.  These loans generally have maturitiesranging from three to fifteen years and payments based on a 15 to 25 yearsschedule.  The original principal amountof a real estate loan generally does not exceed 65% to 75% of the appraisedvalue of the property (or the lesser of the appraised value or the purchaseprice for the property if the loan is made to finance the purchase of theproperty).

 

*Other Secured and Unsecured Commercial Loans*.  We offer adjustable and fixed rate securedand unsecured commercial loans for working capital, the purchase of assets andother business purposes.  We underwritethese loans primarily on the basis of the 

 

28

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borrower’s ability to service the debt from cash flow without relianceon the liquidation of the underlying collateral, where applicable.  These loans generally have maturity terms of12 months and are typically renewed.

 

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

 

*Real Estate 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.

 

*Consumer Installment 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 entertainment industry in SouthernCalifornia.  Table 10 below presentsinformation about the loans outstanding to entertainment related customers atDecember 31, 2003 and 2002.

 

**Table 10**

**Industry Concentrations of Loans**

 
|                                                                                                   |   | **December 31,**       |   |
|--------------------------------------------------------------------------------------------------------|--------|-----------------------------|--------|
|                                                                                                   |   | **2003**                    |   | **2002** |   |
|                                                                                                   |   | **(Dollars  in thousands)** |   |
| Entertainment industry-related loans:                                                                  |   |                        |   |   |   |
| Loans for single productions of motion  picture and television feature films                           |   | $                           | 9,218  |   | $ | 6,652 |   |
| Other loans to entertainment-related  enterprises, such as television, music, film and talent agencies |   | 15,508                      |   | 19,620 |   |
| Loans to individuals involved primarily in  the entertainment industry                                 |   | 1,796                       |   | 4,868 |   |
| Total entertainment industry-related loans                                                             |   | $                           | 26,522 |   | $ | 31,140 |   |
| Percent of total loans outstanding                                                                     |   | 10.2                        | %      | 11.4 | % |

 

*Loan Rate Composition and Maturities*

 

Of our total loans outstanding, excluding loans on nonaccrual, 81.7%and 68.7% had adjustable rates at December 31, 2003 and 2002,respectively.  Adjustable rate loansgenerally have interest rates tied to the prime rate and adjust with changes inthe rate on a daily, monthly or quarterly basis.

 

Of our total loans outstanding, excluding nonaccrual loans, atDecember 31, 2003, 30.7% were due in one year or less, 46.8% were due in1-5 years and 22.5% were due after 5 years.  As is customary in the banking industry, loans can be renewed by mutualagreement between the borrower and us. Because we are unable to estimate the extent to which its borrowers willrenew their loans, Table 11 is based on contractual maturities.

 

29

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**Table 11**

**Loan Maturities**

 
|                                                                                  |   | **December 31,  2003**                      |       |
|---------------------------------------------------------------------------------------|--------|--------------------------------------------------|------------|
|                                                                                  |   | **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                                                                   |   | $                                                | 31,776     |   | $ | 8,546 |   | $ | 40,322 |   |
| After one year but within five years                                                  |   | 30,869                                           |       | 2,964 |   | 33,833 |   |
| After five years                                                                      |   | 2,251                                            |       | 3,083 |   | 5,334 |   |
| Commercial other secured and unsecured                                                |   |                                             |       |   |   |   |   |
| In one year or less                                                                   |   | 12,706                                           |       | 2,299 |   | 15,005 |   |
| After one year but within five years                                                  |   | 43,659                                           |       | 22,571 |   | 66,230 |   |
| After five years                                                                      |   | 46,702                                           |       | 403 |   | 47,105 |   |
| Real estate construction and land  development                                        |   |                                             |       |   |   |   |   |
| In one year or less                                                                   |   | 7,229                                            |       | 1,893 |   | 9,122 |   |
| After one year but within five years                                                  |   | 10,320                                           |       | 2,164 |   | 12,484 |   |
| After five years                                                                      |   | 5,005                                            |       | 309 |   | 5,314 |   |
| Consumer installment, home equity lines of  credit and unsecured loans to individuals |   |                                             |       |   |   |   |   |
| In one year or less                                                                   |   | 12,398                                           |       | 3,043 |   | 15,441 |   |
| After one year but within five years                                                  |   | 9,086                                            |       | 274 |   | 9,360 |   |
| After five years                                                                      |   | 989                                              |       | — |   | 989 |   |
| Total loans outstanding (1)                                                           |   | $                                                | 212,990    |   | $ | 47,549 |   | $ | 260,539 |   |

 

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(1)          Excluding nonaccrual loans

 

*Loan Commitments*

 

*Off-Balance Sheet Credit Commitments and Contingent Obligations*

 

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

 

Loan commitments are agreements to lend to a customer a specifiedamount subject to certain conditions. Loan commitments generally have fixed expiration dates or othertermination clauses and may require payment of a fee.  We had outstanding loan commitments aggregating $64.5 million atDecember 31, 2003, substantially all of which were for real estatecontruction and commercial lines of credit.

 

Standby letters of credit are conditional commitments issued by us tosecure the financial performance of a customer to a third party and areprimarily issued to support private borrowing arrangements. The credit riskinvolved in issuing a letter of credit for a customer is essentially the sameas that involved in extending a loan to that customer. We use the same creditunderwriting policies in accepting such contingent obligations as it does forloans. When deemed necessary, we hold appropriate collateral supporting thosecommitments. The nature of collateral obtained varies and may include depositsheld in financial institutions and real properties.  At December 31, 2003 letters of credit amounted to $1.3million.

 

Many of these commitments are expected to expire without being drawnupon and, as such, the total commitment amounts do not necessarily represent futurecash requirements.

 

**Asset Quality andCredit Risk Management**

 

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

 

30

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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 loans and other realestate owned.  Nonperforming loans are(i) loans which have been placed on nonaccrual status, (ii) troubled debtrestructurings (“TDR’s”), or (iii) loans which are contractually past dueninety days or more with respect to principal or interest, and have not beenrestructured or placed on nonaccrual status, and are accruing interest asdescribed below.  Other real estateowned consists of real properties securing loans of which we have taken titlein partial or complete satisfaction of the loan.  Other than loans included in nonperforming assets atDecember 31, 2003, we had no loans that cause management to have seriousdoubts about the ability of the borrower to comply with the present loanrepayment terms and we had no other interest earning assets that wereconsidered impaired at December 31, 2003. Information about nonperforming assets is presented in Table 12.

 

**Table 12**

**Nonperforming Assets**

 
|                                                                                                                       |   | **December 31,**       |   |
|----------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|--------|
|                                                                                                                       |   | **2003**                    |   | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|                                                                                                                       |   | **(Dollars  in thousands)** |   |
|                                                                                                                       |   |                        |   |   |   |   |   |   |   |   |   |
| Nonaccrual loans                                                                                                           |   | $                           | 438    |   | $ | 5,787 |   | $ | 7,807 |   | $ | 683 |   | $ | 932 |   |
| 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                                                                                                        |   | 438                         |   | 5,996 |   | 9,402 |   | 683 |   | 932 |   |
| Other real estate owned                                                                                                    |   | 925                         |   | 1,000 |   | — |   | — |   | 382 |   |
| Other assets-SBA guaranteed loan                                                                                           |   | —                      |   | — |   | — |   | — |   | 150 |   |
| Total nonperforming assets                                                                                                 |   | $                           | 1,363  |   | $ | 6,996 |   | $ | 9,402 |   | $ | 683 |   | $ | 1,464 |   |
|                                                                                                                       |   |                        |   |   |   |   |   |   |   |   |   |
| Allowance for credit losses as a percent of  nonaccrual loans                                                              |   | 829.9                       | %      | 83.7 | % | 83.8 | % | 380.2 | % | 203.4 | % |
| Allowance for credit losses as a percent of  nonperforming loans                                                           |   | 829.9                       | %      | 80.8 | % | 69.6 | % | 380.2 | % | 203.4 | % |
| Total nonperforming assets as a percent of  loans receivable                                                               |   | 0.5                         | %      | 2.6 | % | 3.6 | % | 0.6 | % | 2.0 | % |
| Total nonperforming assets as a percent of  total shareholders’ equity                                                |   | 4.3                         | %      | 22.4 | % | 36.9 | % | 3.3 | % | 12.6 | % |

 

*Nonaccrual Loans.* Nonaccrual loans are thoseloans for which management has discontinued accrual of interest because thereexists reasonable doubt as to the full and timely collection of eitherprincipal or interest.  Our policy is toplace a loan on nonaccrual status if either principal or interest payments arepast due in excess of ninety days unless the loan is both well secured and in processof collection, or if full collection of interest or principal becomesuncertain, regardless of the time period involved.

 

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

 

Nonaccrual loans decreased to $438,000 at December 31, 2003, from$5.8 million at December 31, 2002. The decrease was primarily due to the charge off and collection ofnonaccrual loans partially offset by the newly classified loans.  Nonaccrual loans at December 31, 2003were comprised primarily of secured commercial loans.  The value of the collateral securing these loans may not be adequateto avoid a charge off of a portion of the credit.  The additional interest income that would have been recorded fromnonaccrual loans, if the loans had not been on nonaccrual status, was $48,000and $388,000 for 2003 and 2002, respectively. Interest payments received on nonaccrual loans are applied to principalunless there is no doubt as to ultimate full repayment of principal, in 

 

31

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which case, the interest payment is recognized as interest income.  Interest income not recognized on nonaccrualloans reduced the net yield on earning assets by 1 basis point and 12 basispoints for 2003 and 2002, respectively.

 

*Troubled Debt Restructurings.* A TDR is a loanfor which we have, for economic or legal reasons related to a borrower’sfinancial difficulties, granted a concession to the borrower we would nototherwise consider, including modifications of loan terms to alleviate theburden of the borrower’s near-term cash flow requirements in order to help the borrowerto improve its financial condition and eventual ability to repay the loan.  At December 31, 2003 and 2002 and forthe years then ended we had no TDRs, accordingly, no interest income wasrecorded in 2003 and 2002 on TDRs.

 

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

 

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

 

There were no loans contractually past due and still accruing interestat December 31, 2003.  Loanscontractually past due and still accruing interest totalled $209,000 atDecember 31, 2002.

 

*Other Real Estate Owned.*** **Wecarry OREO at the lesser of our recorded investment or the fair value lessestimated costs to sell. We periodically revalue OREO properties and chargeother expenses for any further write-downs. At December 31, 2003 we had $925,000 recorded as OREO and atDecember 31, 2002 we had $1.0 million recorded as OREO.

 

*Impaired Loans. *Due to the size and nature of the ourloan portfolio, impaired loans are determined by a periodic evaluation on anindividual loan basis.  AtDecember 31, 2003 we had classified $408,000 of our loans as impaired forwhich $408,000 of specific reserves were allocated.  At December 31, 2002 we had classified $4.2 million of ourloans as impaired for which $1.7 million of specific reserves wereallocated.  The impaired loans areincluded in nonaccrual loans.  Theaverage recorded investment in impaired loans during the year endedDecember 31, 2003, was $1.7 million and no interest income was recognizedon these loans.

 

Foregone interest income attributable to nonperforming loans amountedto $48,000 in 2003 and $388,000 in 2002. This resulted in a reduction in yield on average loans receivable of 2basis points and 12 basis points for the years ended December 31, 2003 and2002, respectively.

 

*Allowance for Credit Losses*

 

The calculation of the adequacy of the allowance for credit losses isbased on a variety of factors (see Allowance for Credit Losses under CriticalAccounting Policies).  Table 13presents, at December 31, 2003 and the prior four years, the compositionof our allocation of the allowance for credit losses to specific loancategories.  Our current practice is tomake specific allocations of the allowance for credit losses to criticized andclassified loans, and unspecified allocations to each loan category based onour risk assessment.  This allocationshould not be interpreted as an indication that loan charge-offs will occur inthe future in these amounts or proportions, or as an indication of futurecharge-off trends.  In addition, theportion of the allowance for credit losses allocated to each loan category doesnot represent the total amount available for future losses that may occurwithin such categories, since the total allowance for credit losses isapplicable to the entire portfolio.

 

32

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**Table 13**

**Allocation of Allowance For Credit Losses**

 
|                                                                                      |   | **December 31,**       |   |
|-------------------------------------------------------------------------------------------|--------|-----------------------------|--------|
|                                                                                      |   | **2003**                    |   | **%(1)** |   | **2002** |   | **%(1)** |   | **2001** |   | **%(1)** |   | **2000** |   | **%(1)** |   | **1999** |   | **%(1)** |   |
|                                                                                      |   | **(Dollars  in thousands)** |   |
|                                                                                      |   |                        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial loans:                                                                         |   |                        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Secured by one to four family residential  properties                                     |   | $                           | 114    |   | 3 | % | $ | 192 |   | 4 | % | $ | 675 |   | 10 | % | $ | 155 |   | 6 | % | $ | 102 |   | 6 | % |
| Secured by multifamily residential properties                                             |   | 182                         |   | 5 |   | 224 |   | 5 |   | 212 |   | 3 |   | 73 |   | 3 |   | 103 |   | 7 |   |
| Secured by commercial real properties                                                     |   | 1,843                       |   | 51 |   | 2,129 |   | 44 |   | 2,376 |   | 36 |   | 842 |   | 37 |   | 659 |   | 38 |   |
| Other - secured and unsecured                                                             |   | 1,068                       |   | 29 |   | 1,528 |   | 31 |   | 2,128 |   | 33 |   | 1,355 |   | 48 |   | 938 |   | 45 |   |
| Real estate construction and land development                                             |   | 379                         |   | 11 |   | 674 |   | 14 |   | 769 |   | 12 |   | 47 |   | 2 |   | — |   | — |   |
| Consumer installment, home equity lines of credit  and unsecured loans to individuals (1) |   | 49                          |   | 1 |   | 99 |   | 2 |   | 381 |   | 6 |   | 125 |   | 4 |   | 94 |   | 4 |   |
| Allowance allocable to loans receivable                                                   |   | $                           | 3,635  |   | 100 | % | $ | 4,846 |   | 100 | % | $ | 6,541 |   | 100 | % | $ | 2,597 |   | 100 | % | $ | 1,896 |   | 100 | % |
|                                                                                           |        |                             |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

 

The allowance for credit losses at December 31, 2003 was $3.6million compared to $4.8 million at December 31, 2002.  The decrease is due to net charge-offs of$2.5 million partially offset by  $1.3million provision for credit losses. Total loans charged-off in 2003 was $2.9 million.

 

The additional provisions to the allowance were recorded based upon ouranalysis of the adequacy of allowance for credit losses.  The allowance for credit losses forclassified loans graded as “criticized” by our internal grading system that arecollateral-dependent is based upon the net realizable value of the collateralthat we periodically evaluate.  Theallowance for unsecured classified loans is based upon the severity of thecredit weakness ranging from 3.0% for “special mention”, 15.0% for“substandard” to 50% for “doubtful”. The volume of more severely classified loans – “substandard” and“doubtful” - declined to $690,000 at December 31, 2003 million from $8.7million at year end 2002.

 

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

 

33

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**Table 14**

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

 
|                                                                                                     |   | **December 31,**       |   |
|----------------------------------------------------------------------------------------------------------|--------|-----------------------------|--------|
|                                                                                                     |   | **2003**                    |   | **2002** |   |
|                                                                                                     |   | **(Dollars  in thousands)** |   |
|                                                                                                     |   |                        |   |   |   |
| Balance, beginning of period                                                                             |   | $                           | 4,846  |   | $ | 6,542 |   |
| Loans charged off:                                                                                       |   |                        |   |   |   |
| Real Estate loans:                                                                                       |   |                        |   |   |   |
| Secured by one to four family residential  properties                                                    |   | 38                          |   | — |   |
| Secured by multifamily residential  properties                                                           |   | —                      |   | — |   |
| Secured by commercial real properties                                                                    |   | 75                          |   | 44 |   |
| Real estate construction and land development                                                            |   | —                      |   | 31 |   |
| Commercial loans:                                                                                        |   |                        |   |   |   |
| Other - secured and unsecured                                                                            |   | 2,697                       |   | 3,849 |   |
| Consumer installment, home equity lines of  credit and unsecured loans to individuals                    |   | 41                          |   | 138 |   |
| Total loans charged-off                                                                                  |   | 2,851                       |   | 4,062 |   |
|                                                                                                     |   |                        |   |   |   |
| Recoveries of loans previously charged off:                                                              |   |                        |   |   |   |
| Real Estate loans:                                                                                       |   |                        |   |   |   |
| Secured by one to four family residential  properties                                                    |   | 1                           |   | — |   |
| Secured by multifamily residential  properties                                                           |   | —                      |   | — |   |
| Secured by commercial real properties                                                                    |   | 13                          |   | — |   |
| Real estate construction and land  development                                                           |   | —                      |   | 191 |   |
| Commercial Loans                                                                                         |   |                        |   |   |   |
| Other - secured and unsecured                                                                            |   | 291                         |   | 189 |   |
| Consumer installment, home equity lines of  credit and unsecured loans to individuals                    |   | 70                          |   | 61 |   |
| Total recoveries of loans previously  charged off                                                        |   | 375                         |   | 441 |   |
| Net (recoveries) charge-offs                                                                             |   | 2,476                       |   | 3,621 |   |
| Provision for credit losses                                                                              |   | 1,265                       |   | 1,925 |   |
| Allowance acquired in acquisition of South  Bay Bank, N.A                                                |   | —                      |   | — |   |
| Balance, end of period                                                                                   |   | $                           | 3,635  |   | $ | 4,846 |   |
|                                                                                                     |   |                        |   |   |   |
| Net loans (recoveries) charged-off as a  percentage of allowance for credit losses                       |   | 68.12                       | %      | 74.72 | % |
| Net loans (recoveries) charged-off as a  percentage of average gross loans outstanding during the period |   | 0.95                        | %      | 1.42 | % |
| Recoveries of loans previously charged off  as a percentage of loans charged off in the previous year    |   | 9.23                        | %      | 89.82 | % |

 

**Deposits**

 

While South Bay historically has had a greater portion of its depositsfrom retail banking customers, we emphasize developing business clientrelationships at both Banks in order to increase our core deposit base.  We offer internet-based cash managementservices, and for many business customers, provide regular courier servicebetween 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.  In 2002 we suspended the money deskoperation for the generation of new deposits in order to reduce these highercost deposits.

 

We experienced a 2.7% increase in average total deposits during 2003compared to 2002. This increase in deposits occurred primarily as a result ofgrowth of $17.6 million in non interest-bearing demand and $12.3 million increasein money market and savings accounts partially offset by a $21.9 milliondecrease in time certificates of deposit.

 

34

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**Table 15**

**AverageDeposit Composition**

 
|                                            |   | **December 31,**       |    |
|-------------------------------------------------|--------|-----------------------------|---------|
|                                            |   | **2003**                    |    | **2002** |   | **2001** |   |
|                                            |   | **Amount**                  |    | **Percent** |   | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   |
|                                            |   | **(Dollars  in thousands)** |    |
|                                            |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing demand deposits:            |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Real estate title and escrow company  customers |   | $                           | 26,989  |   | 9 | % | $ | 26,104 |   | 9 | % | $ | 19,746 |   | 13 | % |
| Other noninterest-bearing demand                |   | 92,799                      |    | 30 | % | 76,109 |   | 25 | % | 39,137 |   | 28 | % |
| Interest-bearing demand                         |   | 28,269                      |    | 9 | % | 28,024 |   | 9 | % | 9,562 |   | 6 | % |
| Money market and savings                        |   | 98,764                      |    | 32 | % | 86,444 |   | 29 | % | 40,396 |   | 27 | % |
| Time certificates of deposit:                   |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Money desk                                      |   | —                      |    | 0 | % | 2,558 |   | 1 | % | 3,461 |   | 2 | % |
| Other:                                          |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| $100,000 or more                                |   | 29,150                      |    | 9 | % | 43,212 |   | 14 | % | 26,021 |   | 18 | % |
| Under $100,000                                  |   | 33,316                      |    | 11 | % | 38,606 |   | 13 | % | 9,300 |   | 6 | % |
| Total time certificates of deposit              |   | 62,466                      |    | 20 | % | 84,376 |   | 28 | % | 38,782 |   | 26 | % |
| Total deposits                                  |   | $                           | 309,287 |   | 100 | % | $ | 301,057 |   | 100 | % | $ | 147,623 |   | 100 | % |

 

**Table 16**

**Maturities of Time Certificates of Deposit**

**$100,000 or more**

 
|                                                 |   | **December 31,  2003** |       |
|------------------------------------------------------|--------|-----------------------------|------------|
|                                                 |   | **Money  Desk**             |       | **All  Other** |   | **Total** |   |
|                                                 |   | **(Dollars  in thousands)** |       |
|                                                 |   |                        |       |   |   |   |   |
| Time certificates of deposit maturing:               |   |                        |       |   |   |   |   |
| In three months or less                              |   | $                           | —     |   | $ | 15,494 |   | $ | 15,494 |   |
| After three months but within six months             |   | —                      |       | 4,176 |   | 4,176 |   |
| After six months but within twelve months            |   | —                      |       | 5,570 |   | 5,570 |   |
| After twelve months                                  |   | —                      |       | 2,068 |   | 2,068 |   |
| Total time certificates of deposit $100,000  or more |   | $                           | —     |   | $ | 27,308 |   | $ | 27,308 |   |
|                                                 |   |                        |       |   |   |   |   |
|                                                 |   | **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 |   |

 

35

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## **Borrowed Funds**

 

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

 

**Table 17**

**BorrowedFunds**

 
|                                                                     |   | **2003**                    |   | **2002**    |   | **2001**     |   |
|--------------------------------------------------------------------------|--------|-----------------------------|--------|-------------|--------|--------------|--------|
|                                                                     |   | **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 |   | $                           | 399    |        | 2.20   | %            | $      | 609 |   | 2.63 | % | $ | 1,476 |   | 4.65 | % | $ | 2,294 |   | 5.84 | % | $ | 3,096 |   | 4.77 | % | $ | 733 |   | 5.05 | % |
|                                                                     |   |                        |   |        |   |         |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Other borrowings                                                         |   | 7,500                       |   | 4.70        | %      | 7,500        |   | 4.81 | % | 7,500 |   | 4.70 | % | 11,308 |   | 4.23 | % | 17,500 |   | 4.25 | % | 20,865 |   | 4.85 | % |
|                                                                          |        |                             |        |             |        |              |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The maximum amount of securities sold with agreements to repurchase atany month end was $800,000, $11.7 million and $5.0 million during 2003, 2002and 2001, respectively.

 

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

 

At December 31, 2003,  $5.5million of borrowed funds were scheduled to mature during 2004, and $2.0million were scheduled to mature during 2005.

 

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

 

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

 

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

 

The Company adopted FASB Interpretation No. 46, Consolidation ofVariable Interest Entities (FIN 46) as of July 1, 2003 resulting in thedeconsolidation of the Trust. Accordingly, the Junior Subordinated Debentures have been classified inliabilities at December 31, 2003 and the related interest was classifiedas interest expense for the six months then ended.  For dates and periods prior to the adoption of FIN 46, the TrustPreferred Securities, net of the cost of issuance, were recorded as a minorityinterest – guaranteed preferred beneficial interests in the Company’s JuniorSubordinated Debentures, net - and the related interest was recorded as a minorityinterest in the Company’s income.  Therecorded balance of Junior Subordinated Debentures was $15.5 million atDecember 31, 2003.  For the yearended December 31, 2003, interest expense associated with the JuniorSubordinated Debentures was $454,000 for the six month period followingadoption of FIN 46 and the minority interest in the Company’s income of thetrust subsidiary was $456,000 for the six months ended June 30, 2003 priorto adoption of FIN 46.  Minorityinterest in the Company’s income of the trust subsidiary was $1.6 million forthe year ended December 31, 2002.

 

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

 

36

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December 31, 2003, we were paying an interest rate of 5.75% underthe terms of the swap.  The counterparty to the swap has the option to call the swap under a declining premiumschedule beginning July 2006.

 

The interest rate swap reduces the adverse impact of our 10.25% fixedrate Trust Preferred Securities in a low interest rate environment.  The Company does not utilize derivatives forspeculative purposes.  Under Statement of Financial AccountingStandards No. 133 this swap transaction is designated as a fair valuehedge.  Accordingly, the effectiveportion of the change in the fair value of the swap transaction is recordedeach period in current income. The terms of the swap are symmetrical with the terms of the TrustPreferred Securities, including the payment deferral terms, and consideredhighly effective in offsetting changes in fair value of the Trust PreferredSecurities.  Accordingly, no ineffectiveness will be recorded tocurrent earnings related to the interest rate swap.

 

**Contractual Obligations**

 

The following table provides the amounts due under specifiedcontractual obligations for the periods indicated as of December 31, 2003.

 

**Table 18**

**Contractual Obligations**

 
|                                |   | **Payments  Due**            |    |
|-------------------------------------|--------|------------------------------|---------|
|                                |   | **Twelve  months  and less** |    | **After one  year  but within  three years** |   | **After  three  years but  within five  years** |   | **After five  years** |   | **Total** |   |
|                                |   | **(Dollars  in thousands)**  |    |
| Commitment to fund loans            |   | $                            | 64,540  |   | $ | — |   | $ | — |   | $ | — |   | $ | 64,540 |   |
| Commitments under letters of credit |   | 1,310                        |    | — |   | — |   | — |   | 1,310 |   |
| Deposits                            |   | 291,384                      |    | 6,954 |   | 379 |   | — |   | 298,717 |   |
| Borrowings                          |   | 5,899                        |    | 2,000 |   | — |   | 15,464 |   | 23,363 |   |
| Interest expense                    |   | 1,777                        |    | 3,192 |   | 3,170 |   | 43,721 |   | 51,861 |   |
| Operating lease obligations         |   | 313                          |    | 539 |   | 779 |   | 2,448 |   | 4,079 |   |
| Purchase obligations                |   | 119                          |    | — |   | — |   | — |   | 119 |   |
| Other liabilities                   |   | 1,405                        |    | — |   | — |   | — |   | 1,405 |   |
| Total                               |   | $                            | 366,747 |   | $ | 12,685 |   | $ | 4,328 |   | $ | 45,595 |   | $ | 429,355 |   |

 

The obligations are categorized by their contractual due dates.  Approximately $21.8 million of thecommitments to fund loans relate to real estate contruction and are expected tofund within the next 12 months.  Thebalance of the commitments to fund loans is primarily revolving lines of creditor other commercial loans, and many of these commitments are expected to expirewithout being drawn upon.  Additionally,payments due for deposits reflect the contractual terms with our depositors towithdraw deposits, however, we do not anticipate the withdrawl of thesedeposits.  Total contractualobligations, therefore, do not necessarily represent future cashrequirements.  We may, at our option,prepay certain borrowings prior to their maturity date.  Furthermore, the actual payment of certaincurrent liabilities may be deferred into future periods.

 

## **Selected FinancialRatios**

 

The following Table 19 sets forth selected financial ratios:

 

**Table 19**

**Selected Performance Ratios**

 
|                                                 |   | **For the  Year Ended  December 31,** |   |
|------------------------------------------------------|--------|--------------------------------------------|--------|
|                                                 |   | **2003**                                   |   | **2002** |   | **2001** |   |
|                                                 |   |                                       |   |   |   |   |   |
| Return on average assets                             |   | 0.06                                       | %      | -0.07 | % | 0.59 | % |
| Return on average shareholders’ equity          |   | 0.66                                       | %      | -0.98 | % | 5.13 | % |
| Average shareholders’ equity to average  assets |   | 8.66                                       | %      | 7.23 | % | 11.23 | % |

 

37

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**Recent Accounting Pronouncements**

 

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

 

**FACTORS, WHICH MAYAFFECT FUTURE OPERATING RESULTS**

 

***We face riskfrom changes in interest rates***.

** **

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

 

38

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•                  Our ability to originate loans;

•                  The ability of our borrowers to make payments on theirloans;

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

•                  The average life of our interest-earning assets;

•                  Our ability to generate deposits instead of otheravailable funding alternatives; and

•                  Our ability to access the wholesale funding market.

 

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

 

***We face riskfrom possible declines in the quality of our assets***.

 

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

 

***Our allowancesfor credit losses may be inadequate.***

 

We establish allowances for credit losses against each segment of ourloan portfolio.  At December 31,2003, our allowance for credit losses equaled 1.40% of loans receivable and829.9% of nonperforming loans.  Althoughwe believed that we had established adequate allowances for credit losses as ofDecember 31, 2003, the credit quality or our assets is affected by manyfactors beyond our control, including local and national economic conditions, andthe possible existence of facts which are not known to us which adverselyaffect the likelihood of repayment of various loans in our loan portfolio andrealization of the collateral upon a default. Accordingly, we can give no assurance that we will not sustain loanlosses materially in excess of the allowance for credit losses.  In addition, the Office of the Comptrollerof the Currency, as an integral part of its examination process, periodicallyreviews our allowance for credit losses and could require additional provisionsfor credit losses.  Material futureadditions to the allowance for credit losses may also be necessary due toincreases in the size and changes in the composition of our loan portfolio.  Increases in our provisions for credit losseswould adversely affect our results of operations.

 

***Economicconditions may worsen.***

 

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

 

***Because asignificant amount of the loans we make are to borrowers in California, ouroperations could suffer as a result of local recession or natural disasters inCalifornia.***

** **

At December 31, 2003, almost all of our loans outstanding werecollateralized by real properties located in California.  Because of this concentration in California,our financial position and results of operations have been and are expected tocontinue to be influenced by general trends in the California economy and itsreal estate market.  Real estate marketdeclines may adversely affect the values of the properties collateralizingloans.  If the principal balances of ourloans, together with any primary financing on the mortgaged properties, equalor exceed the value of the mortgaged properties, we could incur higher losseson sales of properties collateralizing foreclosed loans.  In addition, California historically 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.

 

***Our business isvery competitive.***

** **

There is intense competition in Southern California and elsewhere inthe United States for banking customers. We experience competition for deposits from many sources, includingcredit unions, insurance companies and money market and other mutual funds, aswell as other commercial banks and savings institutions.  We compete for loans and deposits primarilywith other commercial banks, 

 

39

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mortgage companies, commercial finance companies and savingsinstitutions.  In recent yearsout-of-state financial institutions have entered the California market, whichhas also increased competition.  Many ofour competitors have greater financial strength, marketing capability and namerecognition than we do, and operate on a statewide or nationwide basis.  In addition, recent developments intechnology and mass marketing have permitted larger companies to market loansmore aggressively to our small business customers.  Such advantages may give our competitors opportunities to realizegreater efficiencies and economies of scale than we can.  We can provide no assurance that we will beable to compete effectively against our competition.

 

***Our business isheavily regulated.***

 

Both National Mercantile, as a bank holding company, and the Banks, aresubject to significant governmental supervision and regulation, which isintended primarily for the protection of depositors.  Statutes and regulations affecting us may be changed at any time,and the interpretation of these statutes and regulations by examiningauthorities also may change.  We cannotassure you that future changes in applicable statutes and regulations or intheir interpretation will not adversely affect our business.

 

*Recent accounting changes may giverise to a future regulatory capital event that would reduce our consolidatedcapital ratios.*

 

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

 

Underapplicable regulatory guidelines, a portion of the Trust Preferred Securitiesqualifies as Tier I capital, and the remaining portion will qualifies as TierII capital.  On July 2, 2003, theFederal Reserve Board issued Supervisory Letter (SR 03-13) affirming thehistorical capital treatment of trust preferred securities as Tier I capitaldespite the deconsolidation of the trusts holding the securities. SR 03-13remained in effect at December 31, 2003, and we continue to include thesesecurities in our Tier I capital. There remains the potential that thisdetermination by the Federal Reserve Board may change at a later date.

 

IfTier I capital treatment for our Trust Preferred Securities were disallowed,there would be a reduction in our consolidated capital ratios. The followingtable shows as of December 31, 2003 (i) National Mercantile’s currentcapital position, (ii) our pro forma capital position if the Federal ReserveBoard granted Tier II status to our Trust Preferred Securities, (iii) our proforma capital position if the Federal Reserve Board excludes entirely our TrustPreferred Securities from capital, and (iv) the minimum regulatory capitalrequirements for well-capitalized status.

 
|                                                                               |   | **Leverage  ratio** |   | **Tier I  risk-based  capital ratio ** |   | **Total  risk-based  capital ratio** |   |
|------------------------------------------------------------------------------------|--------|---------------------|--------|--------------------------------------------------|--------|-------------------------------------------|--------|
|                                                                               |   |                |   |                                             |   |                                      |   |
| (i) National Mercantile Bancorp                                                    |   | 8.69                | %      | 11.02                                            | %      | 13.84                                     | %      |
| (ii) Assuming Trust Preferred Securities  only qualified as Tier II capital   |   | 5.75                | %      | 7.26                                             | %      | 13.91                                     | %      |
| (iii) Assuming Trust  Preferred Securities are excluded entirely from capital |   | 5.75                | %      | 7.26                                             | %      | 8.52                                      | %      |
| (iv) Minimum regulatory  requirements for Capital Adequacy Purposes                |   | 4.00                | %      | 4.00                                             | %      | 8.00                                      | %      |

 

Asthe table shows, in the event that the Federal Reserve elected to change itsposition with regards to the capital treatment of Trust Preferred Securities wewould remain above minimums for Federal Reserve capital adequacy guidelines.

 

***Our ability touse our net operating losses may be limited.***

** **

**As of December 31, 2003, we had netoperating loss carryforwards of $18.5 million and $766,000 for federal andstate tax purposes, respectively.  Ourfederal net operating loss carryforward begins to expire in 2009.  Our state net operating loss carryforwardscontinue to expire but remain available in reducing amounts through 2004.  Our ability to use these carryforwards inthe future would be significantly limited if we experience an “ownershipchange” within the meaning of Section 382 of the Internal**

 

40

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Revenue Code.  If our use ofthese carryforwards is limited, we would be required to pay taxes on ourtaxable income to the extent our taxable income exceeded the limited amountswhich could be offset, and our net income would be lower.

 

***A significantportion of our loan portfolio consists of construction loans which have greaterrisks than loans secured by completed real properties***

** **

At December 31, 2003, we had outstanding construction loans in theamount of $27.2 million, representing 10.4% of our loan portfolio.  These types of loans generally have greaterrisks than loans on completed homes, multifamily and commercialproperties.  A construction loangenerally does not cover the full amount of the construction costs, so the borrowermust 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 in December 2001,we recorded goodwill in the amount of $2.2 million.  We must evaluate the goodwill regularly for impairment. We had anunaffiliated consultant conduct goodwill impairment testing in the fourthquarter of 2003, and we determined that this goodwill was not impaired.  If in the future we determine that thegoodwill is impaired, we would be required to write-off some or all of thegoodwill, which could have a material adverse effect on our financial conditionand results of operations.

 

***We have asignificant deferred tax asset and our ability to realize that asset depends inpart on the certainty of future earnings***

** **

At December 31, 2003, we had a deferred tax asset of $7.0 millionrelating primarily to our NOLs.  Iffuture taxable income should be less than the amount of the NOLs within the taxyears to which it may be applied, the deferred tax asset may not be realized.  To support our position that the benefits ofthis asset will be realized, we must estimate future earnings.  These estimates are based on many factors,including prior periods results.  If weare unable to generate future earnings in an amount sufficient to support theasset, we would have to establish a valuation allowance and correspondingcharge to earnings to reduce the deferred tax asset to its realizablevalue.  A material valuation allowanceon this asset would have a material adverse effect on our results of operationsand financial condition.

 

***ITEM 7***.     FINANCIAL STATEMENTS

*** ***

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

 

1.               *FinancialStatements*

 
| Report of Independent Auditors – Ernst & Young LLP                                                          |   |
|----------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                 |   |
| Consolidated  Balance Sheet at December 31, 2003                                                                |   |
|                                                                                                                 |   |
| Consolidated Statements of Operations for  the years ended December 31, 2003 and 2002                           |   |
|                                                                                                                 |   |
| Consolidated Statements of Changes in  Shareholders’ Equity for the years ended December 31, 2003 and 2002 |   |
|                                                                                                                 |   |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2003 and 2002                           |   |
|                                                                                                                 |   |
| Notes to  Consolidated Financial Statements for the two years ended December 31,  2003                          |   |

 

**ITEM 8**.           **CHANGES IN AND DISAGREEMENTS WITHACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

Not applicable.

 

41

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**ITEM8A**.  **CONTROLSAND PROCEDURES**

 

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

 

During the quarter ended December 31, 2003, there were nosignificant changes in our internal controls or in other factors that couldsignificantly affect those controls.

 

**PART III**

 

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

*** ***

The information required by this item will appear under the captions“Election of Directors,’’ ‘‘ Executive Officers,’’ and ‘‘Compliance withSection 16(a) Beneficial Ownership Reporting’’ in the Company’s proxystatement for the 2004 Annual Meeting of Shareholders (the ‘‘2004 ProxyStatement’’), and such information shall be deemed to be incorporated herein byreference to that portion of the 2004 Proxy Statement, if filed with theSecurities and Exchange Commission not later than 120 days after the endof  our most recently completed fiscalyear.

 

***ITEM 10***.          EXECUTIVE COMPENSATION

*** ***

The information required by this item will appear under the captions“Compensation of Executive Officers,” “Compensation of Directors,’’ ‘‘SummaryCompensation Table,’’ ‘‘Report on Executive Compensation for 2003,’’ ‘‘2003Option Exercises and Year-End Option Values” and “Compensation CommitteeInterlocks and Insider Participation’’ in the 2004 Proxy Statement, and suchinformation shall be deemed to be incorporated herein by reference to thoseportions of the 2004 Proxy Statement, if filed with the Securities and ExchangeCommission not later than 120 days after the end of our most recently completedfiscal year.

 

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

 

The information required by this item will appear under the caption‘‘Security Ownership of Principal Shareholders and Management’’ in the 2004Proxy Statement, and such information either shall be deemed to be incorporatedherein by reference to that portion of the 2004 Proxy Statement, if filed withthe Securities and Exchange Commission not later than 120 days after the end ofour most recently completed fiscal year.

 

***ITEM 12***.          CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS

*** ***

The information required by this item will appear under the caption‘‘Certain Relationships and Related Transactions’’ in the 2004 Proxy Statement,and such information shall be deemed to be incorporated herein by reference tothat portion of the 2004 Proxy Statement, if filed with the Securities andExchange Commission not later than 120 days after the end of our most recentlycompleted fiscal year.

 

 

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

*** ***

(c) Exhibits

 

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

 

(b) Reports on Form 8-K

 

On October 31, 2003,the Company filed a report on Form 8-K reporting under Item 5 the Company’spress release regarding third quarter 2003 operating results.

 

42

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***ITEM 14***.          PRINCIPALACCOUNTANT FEES AND SERVICES

*** ***

The information required by this item will appear under the caption“Independent Public Accountants” in the 2004 Proxy Statement, and suchinformation shall be deemed to be incorporated herein by reference to thatportion of the 2004 Proxy Statement, if filed with the Securities and ExchangeCommission not later than 120 days after the end of our most recently completedfiscal year.

 

 

*SIGNATURES*

 

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

 

 
|                      | NATIONAL MERCANTILE BANCORP |
|---------------------------|-----------------------------|
|                      | (Registrant)                |
|                      |                        |   |
|                      | By                          | /s/  SCOTT A. MONTGOMERY |
|                      |                        | Scott A. Montgomery |
| Date: March 29, 2004 |                        | Chief Executive Officer |

 

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

 
| **Signature** |                       | **Title** |                                                 | **Date** |
|---------------|----------------------------|-----------|------------------------------------------------------|----------|
|          |                       |      |                                                 |     |   |
| /s/           | ROBERT E. GIPSON           |      |                                                 |     |   |
|          | Robert E. Gipson           |      | Chairman of the Board                                |     | March 29, 2004 |
|          |                       |      |                                                 |     |   |
| /s/           | ROBERT E. THOMSON          |      |                                                 |     |   |
|          | Robert E. Thomson          |      | Vice Chair                                           |     | March 29, 2004 |
|          |                       |      |                                                 |     |   |
| /s/           | DONALD E. BENSON           |      |                                                 |     |   |
|          | Donald E. Benson           |      | Director                                             |     | March 29, 2004 |
|          |                       |      |                                                 |     |   |
| /s/           | JOSEPH N. COHEN            |      |                                                 |     |   |
|          | Joseph N. Cohen            |      | Director                                             |     | March 29, 2004 |
|          |                       |      |                                                 |     |   |
| /s/           | W. DOUGLAS HILE            |      |                                                 |     |   |
|          | W. Douglas Hile            |      | Director                                             |     | March 29, 2004 |
|          |                       |      |                                                 |     |   |
| /s/           | ANTOINETTE HUBENETTE, M.D. |      |                                                 |     |   |
|          | Antoinette Hubenette, M.D. |      | Director                                             |     | March 29, 2004 |
|          |                       |      |                                                 |     |   |
| /s/           | SCOTT A. MONTGOMERY        |      |                                                 |     |   |
|          | Scott A. Montgomery        |      | Director, Chief Executive Officer                    |     | March 29, 2004 |
|          |                       |      |                                                 |     |   |
| /s/           | DION G. MORROW             |      |                                                 |     |   |
|          | Dion G. Morrow             |      | Director                                             |     | March 29, 2004 |
|          |                       |      |                                                 |     |   |
| /s/           | CARL R. TERZIAN            |      |                                                 |     |   |
|          | Carl R. Terzian            |      | Director                                             |     | March 29, 2004 |
|          |                       |      |                                                 |     |   |
| /s/           | DAVID R. BROWN             |      |                                                 |     |   |
|          | David R. Brown             |      | Principal Financial and Principal Accounting Officer |     | March 29, 2004 |

 

43

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**REPORT OF INDEPENDENT AUDITORS**

 

 

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

 

We have audited the consolidated balance sheet ofNational Mercantile Bancorp (a California corporation) and Subsidiaries(collectively the “Company”) as of December 31, 2003, and the relatedconsolidated statements of operations, shareholders’ equity, and cash flows foreach of the two years in the period ended December 31, 2003. Thesefinancial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements basedon our audits.

 

We conducted our audits in accordance with auditingstandards generally accepted in the United States.  Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement.  Anaudit includes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements.  An audit also includes assessingthe accounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation.  Webelieve that our audits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements referred toabove present fairly, in all material respects, the consolidated financial**position of National Mercantile Bancorpand Subsidiaries at December 31, 2003, and the consolidated results oftheir operations and their cash flows for each of the two years in the periodended December 31, 2003, in conformity with accounting principlesgenerally accepted in the United States.

 

As are further described in Note 1 to the consolidated financialstatements, at July 1, 2003 the Company adopted FASB Interpretation No.(FIN) 46, Consolidation of Variable Interest Entities, as revised, whichrequired the deconsolidation of its trust subsidiaries that had issued itsmandatorily redeemable preferred securities and to which the Company had issuedits junior subordinated debentures.

 

 
|                    | Ernst & Young LLP |   |
|-------------------------|-----------------------|--------|
|                    |                  |
| Los Angeles, California |                  |
| February 13, 2004  |                  |

 

44

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**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEET**

 
|                                                                                                                   |   | **December 31,  2003**  |    |
|------------------------------------------------------------------------------------------------------------------------|--------|------------------------------|---------|
|                                                                                                                   |   | **(Dollars  in  thousands)** |    |
| ASSETS                                                                                                                 |   |                         |    |
| Cash and due from banks-demand                                                                                         |   | $                            | 24,556  |   |
| Due from banks-interest bearing                                                                                        |   | 4,728                        |    |
| Federal funds sold and securities purchased  under agreements to resell                                                |   | 10,000                       |    |
| Cash and cash equivalents                                                                                              |   | 39,284                       |    |
| Securities available-for-sale, at fair  value; aggregate amortized cost of $30,756                                     |   | 30,877                       |    |
| Securities held-to-maturity, at amortized  cost                                                                        |   | 4,597                        |    |
| FRB and other stock, at cost                                                                                           |   | 1,872                        |    |
| Loans receivable                                                                                                       |   | 260,249                      |    |
| Allowance for credit losses                                                                                            |   | (3,635                       | )       |
| Net loans receivable                                                                                                   |   | 256,614                      |    |
|                                                                                                                   |   |                         |    |
| Premises and equipment, net                                                                                            |   | 5,444                        |    |
| Other real estate owned                                                                                                |   | 925                          |    |
| Deferred tax asset                                                                                                     |   | 6,950                        |    |
| Goodwill                                                                                                               |   | 3,225                        |    |
| Intangible assets, net                                                                                                 |   | 1,854                        |    |
| Accrued interest receivable and other  assets                                                                          |   | 3,564                        |    |
| Total assets                                                                                                           |   | $                            | 355,206 |   |
|                                                                                                                   |   |                         |    |
| LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                              |   |                         |    |
| Deposits:                                                                                                              |   |                         |    |
| Noninterest-bearing demand                                                                                             |   | $                            | 119,998 |   |
| Interest-bearing demand                                                                                                |   | 29,349                       |    |
| Money market                                                                                                           |   | 55,422                       |    |
| Savings                                                                                                                |   | 38,925                       |    |
| Time certificates of deposit:                                                                                          |   |                         |    |
| $100,000 or more                                                                                                       |   | 27,308                       |    |
| Under $100,000                                                                                                         |   | 27,715                       |    |
| Total deposits                                                                                                         |   | 298,717                      |    |
|                                                                                                                   |   |                         |    |
| Federal funds purchased and securities sold  under agreements to repurchase                                            |   | 399                          |    |
| Other borrowings                                                                                                       |   | 7,500                        |    |
| Junior subordinated deferrable interest  debentures                                                                    |   | 15,464                       |    |
| Accrued interest payable and other  liabilities                                                                        |   | 1,405                        |    |
| Total liabilities                                                                                                      |   | 323,485                      |    |
|                                                                                                                   |   |                         |    |
| 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 729,585  shares |   | 5,959                        |    |
| 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 2,772,279 shares                                |   | 38,602                       |    |
| Accumulated deficit                                                                                                    |   | (13,911                      | )       |
| Accumulated other comprehensive income                                                                                 |   | 71                           |    |
| Total shareholders’ equity                                                                                        |   | 31,721                       |    |
| Total liabilities and shareholders’ equity                                                                        |   | $                            | 355,206 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

45

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**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

 
|                                                                                                                     |   | **For The  Year Ended  December 31,**          |   |
|--------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------|--------|
|                                                                                                                     |   | **2003**                                            |   | **2002** |   |
|                                                                                                                     |   | **(Dollars  in thousands,  except per share data)** |   |
| Interest income:                                                                                                         |   |                                                |   |   |   |
| Loans, including fees                                                                                                    |   | $                                                   | 15,799 |   | $ | 17,488 |   |
| Securities                                                                                                               |   | 949                                                 |   | 1,652 |   |
| Due from banks - interest bearing                                                                                        |   | 17                                                  |   | — |   |
| Federal funds sold and securities purchased  under agreements to resell                                                  |   | 359                                                 |   | 432 |   |
| Total interest income                                                                                                    |   | 17,124                                              |   | 19,572 |   |
| Interest expense:                                                                                                        |   |                                                |   |   |   |
| Interest-bearing demand                                                                                                  |   | 126                                                 |   | 322 |   |
| Money market and savings                                                                                                 |   | 905                                                 |   | 1,426 |   |
| Time certificates of deposit:                                                                                            |   |                                                |   |   |   |
| $100,000 or more                                                                                                         |   | 535                                                 |   | 845 |   |
| Under $100,000                                                                                                           |   | 783                                                 |   | 1,459 |   |
| Total interest expense on deposits                                                                                       |   | 2,349                                               |   | 4,052 |   |
| Federal funds purchased and securities sold  under agreements to repurchase                                              |   | 16                                                  |   | 134 |   |
| Junior subordinated deferrable interest  debentures                                                                      |   | 454                                                 |   | — |   |
| Other borrowings                                                                                                         |   | 361                                                 |   | 478 |   |
| Total interest expense                                                                                                   |   | 3,180                                               |   | 4,664 |   |
| Net interest income before provision for  credit losses                                                                  |   | 13,944                                              |   | 14,908 |   |
| Provision for credit losses                                                                                              |   | 1,265                                               |   | 1,925 |   |
| Net interest income after provision for  credit losses                                                                   |   | 12,679                                              |   | 12,983 |   |
| Other operating income:                                                                                                  |   |                                                |   |   |   |
| Net gain on sale of securities  available-for-sale                                                                       |   | 51                                                  |   | — |   |
| International services                                                                                                   |   | 44                                                  |   | 37 |   |
| Investment division                                                                                                      |   | 84                                                  |   | 82 |   |
| Deposit-related and other customer services                                                                              |   | 1,333                                               |   | 1,383 |   |
| Loss on sale of other real estate owned                                                                                  |   | (136                                                | )      | — |   |
| Total other operating income                                                                                             |   | 1,376                                               |   | 1,502 |   |
| Other operating expenses:                                                                                                |   |                                                |   |   |   |
| Salaries and related benefits                                                                                            |   | 7,157                                               |   | 6,776 |   |
| Net occupancy                                                                                                            |   | 1,329                                               |   | 1,368 |   |
| Furniture and equipment                                                                                                  |   | 464                                                 |   | 418 |   |
| Printing and communications                                                                                              |   | 504                                                 |   | 562 |   |
| Insurance and regulatory assessments                                                                                     |   | 381                                                 |   | 358 |   |
| Client services                                                                                                          |   | 563                                                 |   | 656 |   |
| Computer data processing                                                                                                 |   | 994                                                 |   | 953 |   |
| Legal services                                                                                                           |   | 473                                                 |   | 541 |   |
| Other professional services                                                                                              |   | 833                                                 |   | 530 |   |
| Amortization of core deposit intangible                                                                                  |   | 223                                                 |   | 223 |   |
| Promotion and other expenses                                                                                             |   | 375                                                 |   | 476 |   |
| Total other operating expenses                                                                                           |   | 13,296                                              |   | 12,861 |   |
| Income before income tax provision and  minority interests                                                               |   | 759                                                 |   | 1,624 |   |
|                                                                                                                     |   |                                                |   |   |   |
| Minority interest in the Company’s income  of the:                                                                  |   |                                                |   |   |   |
| Guaranteed preferred beneficial interests  in the Company’s junior subordinated deferrable interest debentures, net |   | 456                                                 |   | 1,537 |   |
| Series A Preferred Stock of South Bay Bank,  N.A                                                                         |   | —                                              |   | 213 |   |
| Income (loss) before income tax provision                                                                                |   | 303                                                 |   | (126 | ) |
| Income tax provision                                                                                                     |   | 96                                                  |   | 127 |   |
| Net income (loss)                                                                                                        |   | $                                                   | 207    |   | $ | (253 | ) |
| Earnings (loss) per share:                                                                                               |   |                                                |   |   |   |
| Basic                                                                                                                    |   | $                                                   | 0.08   |   | $ | (0.15 | ) |
| Diluted                                                                                                                  |   | $                                                   | 0.05   |   | $ | (0.15 | ) |

 

See accompanying notes to consolidated financial statements.

 

46

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**NATIONALMERCANTILE BANCORP AND SUBSIDIARIES**

 

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

 
|                                                                      |   | **Preferred  Stock Series A**                 |   | **Preferred  Stock Series B** |   | **Common  Stock** |   | **Additional  Paid-in** |   | **Accumulated** |   | **Accumulated  Other  Comprehensive** |   |        |   |
|---------------------------------------------------------------------------|--------|-----------------------------------------------|--------|-------------------------------|--------|-------------------|--------|-------------------------|--------|-----------------|--------|---------------------------------------|--------|-------------|--------|
|                                                                      |   | **Shares**                                    |   | **Amount**                    |   | **Shares**        |   | **Amount**              |   | **Shares**      |   | **Amount**                            |   | **Capital** |   | **Deficit** |   | **Income** |   | **Total** |   |
|                                                                      |   | **(Dollars  in thousands except share data)** |   |
| 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 |   |
| Preferred stock converted into common stock on a  2:1 basis               |   | (5,400                                        | )      | (44                           | )      |              |   |                    |   | 10,800          |   | 44                                    |   |        |   |   |   |   |   | — |   |
| Stock options exercised                                                   |   |                                          |   |                          |   |              |   |                    |   | 81,935          |   | 504                                   |   |        |   |   |   |   |   | 504 |   |
| Cumulative effect of change in accounting  principal (Note 1)             |   |                                          |   |                          |   |              |   |                    |   |            |   |                                  |   |        |   | (63 | ) |   |   | (63 | ) |
| Comprehensive income (loss):                                              |   |                                          |   |                          |   |              |   |                    |   |            |   |                                  |   |        |   |   |   |   |   |   |   |
| Unrealized holding loss during the period, net                            |   |                                          |   |                          |   |              |   |                    |   |            |   |                                  |   |        |   |   |   | (131 | ) | (131 | ) |
| Net income                                                                |   |                                          |   |                          |   |              |   |                    |   |            |   |                                  |   |        |   | 207 |   |   |   | 207 |   |
| Comprehensive income                                                      |   |                                          |   |                          |   |              |   |                    |   |            |   |                                  |   |        |   |   |   |   |   | 76 |   |
| Balance at December 31, 2003                                         |   | 729,585                                       |   | $                             | 5,959  |              | 1,000  |                    | $      | 1,000           |   | 2,772,279                             |   | $           | 38,602 |   | $ | — |   | $ | (13,911 | ) | $ | 71 |   | $ | 31,721 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

47

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**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

 
|                                                                                        |   | **For the  Year Ended December 31,** |   |
|---------------------------------------------------------------------------------------------|--------|-------------------------------------------|--------|
|                                                                                        |   | **2003**                                  |   | **2002** |   |
|                                                                                        |   | **(Dollars  in thousands)**               |   |
| Cash flows from operating activities:                                                       |   |                                      |   |   |   |
| Net income (loss)                                                                           |   | $                                         | 207    |   | $ | (253 | ) |
| Adjustments to reconcile net income to net  cash used in operating activities:              |   |                                      |   |   |   |
| Depreciation and amortization                                                               |   | 479                                       |   | 693 |   |
| Provision for credit losses                                                                 |   | 1,265                                     |   | 1,925 |   |
| Valuation allowance for OREO                                                                |   | 75                                        |   | — |   |
| Gain on sale of securities available for  sale                                              |   | (51                                       | )      | — |   |
| Loss on sales of OREO                                                                       |   | 61                                        |   | — |   |
| Net amortization of premium on securities  available-for-sale                               |   | 239                                       |   | 238 |   |
| Net amortization of premium on securities  held-to-maturity                                 |   | 24                                        |   | — |   |
| Net amortization of core deposit intangible                                                 |   | 223                                       |   | — |   |
| Net amortization of premium on loans  purchased                                             |   | 281                                       |   | 348 |   |
| Decrease in accrued interest receivable and  other assets                                   |   | 132                                       |   | 1,340 |   |
| Decrease in accrued interest payable and  other liabilities                                 |   | (545                                      | )      | (1,800 | ) |
| Net cash provided by operating activities                                                   |   | 2,390                                     |   | 2,491 |   |
| Cash flows from investing activities:                                                       |   |                                      |   |   |   |
| Purchase of securities available-for-sale                                                   |   | (33,339                                   | )      | (8,002 | ) |
| Proceeds from sales of securities  available-for-sale                                       |   | 2,545                                     |   | — |   |
| Proceeds from repayments and maturities of  securities available-for-sale                   |   | 25,674                                    |   | 23,367 |   |
| Purchase of securities held-to-maturity                                                     |   | (5,021                                    | )      | — |   |
| Proceeds from repayments and maturities of  securities held-to-maturity                     |   | 400                                       |   | — |   |
| Proceeds from sales of OREO                                                                 |   | 474                                       |   | — |   |
| Loan originations and principal  collections, net                                           |   | 8,782                                     |   | (15,324 | ) |
| Redemption of Federal Reserve stock and  other stocks                                       |   | 146                                       |   | 534 |   |
| Purchases of premises and equipment                                                         |   | (87                                       | )      | (168 | ) |
| Net cash provided by (used in) investing  activities                                        |   | (426                                      | )      | 407 |   |
| Cash flows from financing activities:                                                       |   |                                      |   |   |   |
| Net increase in demand deposits, money  market and savings accounts                         |   | 20,333                                    |   | 14,074 |   |
| Net decrease in time certificates of  deposit                                               |   | (20,341                                   | )      | (24,489 | ) |
| Net decrease in securities sold under  agreements to repurchase and federal funds purchased |   | (1,077                                    | )      | (1,620 | ) |
| Net decrease in other borrowings                                                            |   | —                                    |   | (10,000 | ) |
| Redemption of South Bay Bank preferred  stock.                                              |   | —                                    |   | (2,500 | ) |
| Net proceeds from issuance of common stock                                                  |   | —                                    |   | 7,572 |   |
| Dividends paid on subsidiary preferred  stock                                               |   | —                                    |   | (213 | ) |
| Net proceeds from exercise of stock options                                                 |   | 504                                       |   | 86 |   |
| Net cash used in financing activities                                                       |   | (581                                      | )      | (17,090 | ) |
| Net increase (decrease) in cash and cash  equivalents                                       |   | 1,383                                     |   | (14,192 | ) |
| Cash and cash equivalents, January 1                                                   |   | 37,901                                    |   | 52,093 |   |
| Cash and cash equivalents, December 31                                                 |   | $                                         | 39,284 |   | $ | 37,901 |   |
|                                                                                        |   |                                      |   |   |   |
| Supplemental disclosures of cash flow  information:                                         |   |                                      |   |   |   |
| Cash paid for Interest                                                                      |   | $                                         | 3,885  |   | $ | 5,852 |   |
| Cash paid for Income taxes, net                                                             |   | —                                    |   | — |   |
| Unrealized gain on securitites  available-for-sale, net of tax effect                       |   | 71                                        |   | 146 |   |
| Transfers to OREO from loans receivable,  net                                               |   | $                                         | 535    |   | $ | 1,000 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

48

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**NATIONALMERCANTILE BANCORP AND SUBSIDIARIES**

 

**NOTES****TOCONSOLIDATED FINANCIAL STATEMENTS**

 

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

## ** **

*Basis of Presentation*

 

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

 

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

 

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

 

*Cash and Cash Equivalents*

 

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

 

*Securities*

 

Securities available-for-sale are carried at fair value.  Unrealized gains or losses onavailable-for-sale securities are excluded from earnings and reported asaccumulated other comprehensive income, net of deferred income taxes, in aseparate component of shareholders’ equity until realized.  Realized gains or losses on salesavailable-for-sale securities are recorded using the specific identificationmethod.

 

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

 

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

 

*Loans*

 

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

 

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

 

Loans are placed on nonaccrual status when a loan becomes 90 days pastdue as to interest or principal unless the loan is both well secured and inprocess of collection.  Loans are alsoplaced on nonaccrual status when the full collection of interest or principalbecomes uncertain.  When a loan isplaced on nonaccrual status, the accrued and unpaid interest receivable isreversed and the accretion of deferred loan fees is ceased.  Thereafter, interest collected on the loanis accounted for on the cash collection or cost recovery method untilqualifying for return to accrual status. Generally, a loan may be returned to accrual status when all delinquentprincipal and interest are brought current in accordance with the terms of theloan agreement and certain performance criteria have been met.

 

The Company considers a loan to be impaired when it is probable that itwill be unable to collect all amounts due according to the contractual terms ofthe loan agreement.  Once a loan isdetermined to be impaired, the impairment is measured based on the present 

 

49

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value of the expected future cash flows discounted at the loan’s effectiveinterest rate, except that as a practical expedient, the impairment is measuredby using the loan’s observable market price or the fair value of the collateralif the loan is collateral dependent.

 

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

 

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

 

*Allowance for Credit Losses*

 

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

 

The calculation of the adequacy of the allowance for credit losses isbased on a variety of factors, including loan classifications, migration trendsand underlying cash flow and collateral values.  On a periodic basis, management engages an outside loan reviewfirm to review the Company’s loan portfolio, risk grade accuracy and thereasonableness of loan evaluations. Annually, this outside loan review team analyzes the Company’smethodology for calculating the allowance for credit losses based on theCompany’s loss histories and policies. The Company uses a migration analysis as part of its allowance forcredit losses evaluation which is a method by which specific charge-offs arerelated to the prior life of the same loan compared to the total loan pools inwhich the loan was graded.  This methodallows for management to use historical trends that are relative to theCompany’s portfolio rather than use outside factors that may not take intoconsideration trends relative to the specific loan portfolio.  In addition, this analysis takes intoconsideration other trends that are qualitative relative to the Company’smarketplace, demographic trends, amount and trends in nonperforming assets andconcentration factors.

 

*Premises and Equipment, Net*

 

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

 

*Other Real Estate Owned*

 

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

 

*Income Taxes*

 

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

 

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

 

50

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*Comprehensive Income*

 

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

 

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

 

*Earnings per Share*

 

Basic earnings per share is computed using the weighted average numberof common shares outstanding during the period.  The weighted average number of common shares outstanding used incomputing basic earnings per share for the years ended December 31, 2003and 2002 was 2,707,931 and 1,650,997, respectively.  Diluted earnings per share for the year ended December 31,2003 was $0.05.  The weighted averagenumber of common shares and common share equivalents outstanding used incomputing diluted earnings per share for the year ended December 31, 2003was 4,410,394.  The following table is areconciliation of net income and shares used in the computation of basic anddiluted earnings per share:

 
|                                          |   | **Earnings  available to  shareholders** |   | **Weighted  Average  Shares** |      | **Per share  amount** |   |
|-----------------------------------------------|--------|------------------------------------------|--------|-------------------------------|-----------|-----------------------|--------|
|                                          |   | **(in thousands)**                       |   |                          |      |                  |   |
|                                          |   |                                     |   |                          |      |                  |   |
| *For the year ended  December 31, 2003:* |   |                                     |   |                          |      |                  |   |
| Basic EPS                                     |   | $                                        | 207    |                          | 2,707,931 |                  | $      | 0.08 |   |
|                                          |   |                                     |   |                          |      |                  |   |
| Effect of dilutive securities:                |   |                                     |   |                          |      |                  |   |
| Options                                       |   |                                     |   | 76,294                        |      |                  |   |
| Convertible preferred stock                   |   |                                     |   | 1,626,169                     |      |                  |   |
| Diluted earnings per share                    |   | 207                                      |   | 4,410,394                     |      | $                     | 0.05   |   |
|                                          |   |                                     |   |                          |      |                  |   |
|                                          |   |                                     |   |                          |      |                  |   |
| *For the year ended  December 31, 2002:* |   |                                     |   |                          |      |                  |   |
| Basic and diluted loss per share              |   | $                                        | (253   | )                             | 1,650,997 |                  | $      | (0.15 | ) |

 

*Fair Value of Financial Instruments*

 

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

 

*Stock Options*

 

The Company applies Accounting Principles Board Opinion No. 25 andrelated Interpretations in accounting for the stock incentive plans.  SFAS No. 123, ‘‘Accounting for Stock-BasedCompensation,’’ encourages, but does not require, companies to recordcompensation cost for stock-based employee compensation plans at fair value.Compensation expense is recorded on the date of grant only if the currentmarket price of the underlying stock exceeded the exercise price.  All options were granted at current marketprices, accordingly, no compensation cost has been recognized for theplans.  Pro forma net income and proforma earnings per share 

 

51

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disclosures for employee stock option grants are based on recognitionas expense, over the vesting period, the fair value on the date of grant of allstock-based awards made during 2003 and 2002.

 

*Recent Accounting**Pronouncements*

 

InJanuary 2003, the FASB issued Statement of Financial Accounting StandardsNo. 148 “Accounting for Stock-Based Compensation” (“SFAS No. 148”). SFAS No.148 amends Statement of Financial Accounting Standards No. 123 “Accounting forStock-Based Compensation” (“SFAS No. 123”), to provide alternative methodsof transition for a voluntary change to the fair value based method ofaccounting for stock-based employee compensation. In addition, SFAS No. 148amends the disclosure requirements of SFAS No. 123 to require prominentdisclosures in both annual and interim financial statements about the method ofaccounting for stock-based employee compensation and the effect of the methodused on reported results. If awards of stock-based employee compensation wereoutstanding and accounted for under the intrinsic value method of AccountingPrinciples Board Opinion No. 25 “Accounting for Stock” (“APB No. 25”) issued toemployees, certain disclosures have to be made for any period for which anincome statement is presented.

 

SFASNo. 148 is effective for financial statements for fiscal years ending afterDecember 15, 2002.  We continue toapply APB No. 25 in accounting for stock based compensation and have adoptedthe disclosure requirements of SFAS No. 123 and SFAS No. 148.

 

InApril 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 onDerivative Instruments and Hedging Activities” (“SFAS No. 149”). The changes inSFAS No. 149 improve financial reporting by requiring that contracts withcomparable characteristics be accounted for similarly. In particular, SFAS No.149 (1) clarifies under what circumstances a contract with an initial netinvestment meets the characteristic of a derivative discussed in paragraph 6(b)of SFAS No. 133 and No. 138, (2) clarifies when a derivative contains afinancing component, (3) amends the definition of an underlying to conform itto language used in FIN 45, and (4) amends certain other existingpronouncements. One point of clarification in SFAS No. 149 was that loancommitments that relate to the origination of mortgage loans that will be heldfor sale shall be accounted for as derivative instruments by the issuer of theloan commitment. We have no such commitments at December 31, 2003. Thosechanges will result in more consistent reporting of contracts as either derivativesor hybrid instruments.

 

SFASNo. 149 is generally effective for contracts entered into or modified afterJune 30, 2003, and for hedging relationships designated afterJune 30, 2003. The adoption of SFAS No. 149 did not have a material impacton our financial condition or operating results.

 

InMay 2003, the FASB issued Statement of Financial Accounting Standards No. 150,Accounting for Certain Financial Instruments with Characteristics of bothLiabilities and Equity (SFAS 150).  SFAS150 establishes standards for how an issuer classifies and measures certainfinancial instruments with characteristics of both liabilities and equity.  It requires than an issuer classify afinancial instrument that is within its scope as a liability (or an asset insome circumstances).  Many of thoseinstruments were previously classified as equity.

 

TheCompany adopted SFAS 150 effective July 1, 2003, which had no effect onthe Company’s financial statements.

 

InJanuary 2003, the FASB issued Financial Accounting Standards BoardInterpretation No. 46 “Consolidation of Variable Interest Entities” (“FIN46”).  FIN 46 changes the consolidationrequirements by requiring a variable interest entity to be consolidated by acompany if that company is subject to the majority of the risk of loss from thevariable interest entity’s activities or entitled to receive a majority of theentity’s residual returns or both.  Inaddition, FIN No. 46 requires disclosures about variable interest entities thatthe company is not required to consolidate but in which it has a significantvariable interest.  The consolidationrequirements of FIN No. 46 apply to variable interest entities created afterJanuary 31, 2003 and apply to existing variable interest entities no laterthan the end of the first interim or annual reporting period ending afterMarch 15, 2004.

 

FIN46 may be applied prospectively with a cumulative-effect adjustment as of thedate on which it is first applied or by restating previously issued financialstatements for one or more years with a cumulative-effect adjustment as of thebeginning of the first year restated. The Company adopted FIN 46 effective July 1, 2003 and accordinglyrecorded a cumulative-effect adjustment as of that date and reclassified theJunior Subordinated Debentures as other liabilities and the related interest asother interest expense.

 

FIN46 may have an impact on the treatment of the Trust Preferred Securities wehave issued and ability for those instruments to provide us with Tier Icapital. FIN 46 required us to deconsolidate the trust entities that issuedthese Trust Preferred Securities. The Federal Reserve has issued regulationsthat allow for the inclusion of these instruments in Tier I capital regardlessof the impact of FIN 46 on the consolidation of the trusts. There remains thepotential that this determination by the Federal Reserve may be changed at alater date. We do not expect FIN 46 to have any other material impact on ourfinancial condition or operating results.

 

52

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

 

As of December 31, 2003, the Company had goodwill of $3.2 millionand core deposit intangibles of $1.9 million from the South Bayacquisition.  In accordance with SFASNo. 142 goodwill is not amortized.  SFASNo. 142 also requires an analysis of impairment of goodwill annually or morefrequently upon the occurrence of certain events.  During 2003, the required impairment tests of goodwill wereconducted, and based upon these evaluations, the Company’s goodwill was notimpaired at December 31, 2003.  TheCompany has no other indefinite-lived intangible assets.  The core deposit intangibles were estimatedto have an original life of 10 years and 4 months. Amortization for intangiblesfor 2003 and each of the next five years is estimated to be $223,000 per year.

 

**Note 3—Investment Securities**

 

The following is a summary of amortized cost, gross unrealized gains,gross unrealized losses, and estimated fair values of the Company’s investmentsecurities available-for-sale and held-to-maturity at December 31, 2003:

 
|                                                                            |   | **December 31,  2003** |       |
|---------------------------------------------------------------------------------|--------|-----------------------------|------------|
|                                                                            |   | **Total  amortized  cost**  |       | **Gross  unrealized  gains** |   | **Gross  unrealized  loss** |   | **Estimated  fair  value** |   |
|                                                                            |   | **(Dollars  in thousands)** |       |
| **Available-For-Sale**                                                          |   |                        |       |   |   |   |   |   |   |
|                                                                            |   |                        |       |   |   |   |   |   |   |
| U.S. Treasury securities                                                        |   | $                           | 600        |   | $ | — |   | $ | 1 |   | $ | 599 |   |
| GNMA-issued/guaranteed  mortgage pass through certificates                 |   | 351                         |       | 12 |   | — |   | 363 |   |
| Other U.S. government and federal agency  securities                            |   | 12,758                      |       | 45 |   | 4 |   | 12,799 |   |
| FHLMC/FNMA-issued mortgage pass through  certificates                           |   | 3,828                       |       | 161 |   | — |   | 3,989 |   |
| CMO’s and REMIC’s issued by U.S.  government-sponsored  agencies |   | 56                          |       | 1 |   | — |   | 57 |   |
| Mortgage mutual funds                                                           |   | 10,000                      |       | — |   | 98 |   | 9,902 |   |
| Privately issued corporate bonds, CMO’s and  REMIC’s securities       |   | 3,163                       |       | 5 |   | — |   | 3,168 |   |
|                                                                            |   | $                           | 30,756     |   | $ | 224 |   | $ | 103 |   | $ | 30,877 |   |
|                                                                            |   |                        |       |   |   |   |   |   |   |
| FRB and other equity stocks                                                     |   | $                           | 1,872      |   | $ | — |   | $ | — |   | $ | 1,872 |   |
|                                                                            |   |                        |       |   |   |   |   |   |   |
|                                                                            |   |                        |       |   |   |   |   |   |   |
|                                                                            |   | **December 31,  2003** | ** ** |
|                                                                            |   | **Total  amortized  cost**  |       | **Gross  unrealized  gains** | ** ** | **Gross  unrealized  loss** | ** ** | **Estimated  fair  value** | ** ** |
|                                                                            |   | **(Dollars  in thousands)** | ** ** |
| **Held-to-Maturity**                                                            |   |                        |       |   |   |   |   |   |   |
|                                                                            |   |                        |       |   |   |   |   |   |   |
| FHLMC/FNMA-issued mortgage pass through  certificates                           |   | $                           | 4,597      |   | $ | 43 |   | $ | — |   | $ | 4,640 |   |
|                                                                            |   | $                           | 4,597      |   | $ | 43 |   | $ | — |   | $ | 4,640 |   |

 

 

The Company had gross proceeds and gross realized gains related to thesale of investment securities of $2.5 million and $100,000, respectively, andgross realized losses related to a valuation reserve of $49,000 established onother-than-temporarily impaired securities, for the year ended December 31,2003.  The Company had no sales ofinvestment securities for the year ended December 31, 2002.

 

The estimated fair value and amortized cost of securitiesavailable-for-sale and held-to-maturity at December 31, 2003 bycontractual maturity, are shown below:

 

53

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**Maturities of and Weighted Average Yields on**

**Investment Securities**

 
|                                                                      |   | **Within one  year**        |       | **After one  but  within five years** |       | **After five  but  within ten years** |       | **After ten  years** |       |       |       | **Weighted  Average** |       |
|---------------------------------------------------------------------------|--------|-----------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|----------------------|------------|------------|------------|-----------------------|------------|
|                                                                      |   | **Amount**                  |       | **Yield**                             |       | **Amount**                            |       | **Yield**            |       | **Amount** |       | **Yield**             |       | **Amount** |   | **Yield** |   | **Total** |   | **Yield** |   |
|                                                                      |   | **(Dollars  in thousands)** |       |
| **Securities available-for-sale:**                                        |   |                        |       |                                  |       |                                  |       |                 |       |       |       |                  |       |   |   |   |   |   |   |   |   |
| U.S Treasury securities                                                   |   | $                           | 599        |                                  | 1.13       | %                                     | $          | —               |       | —     |       | $                     | —     |   | — |   | $ | — |   | — |   | $ | 599 |   | 1.13 | % |
| GNMA-issued/guaranteed  mortgage pass-through certificates           |   | —                      |       | —                                |       | —                                |       | —               |       | —     |       | —                |       | 363 |   | 3.86 | % | 363 |   | 3.86 | % |
| Other U.S. government and federal agencies                                |   | 1,018                       |       | 1.12                                  | %          | 4,542                                 |       | 1.98                 | %          | 7,239      |       | 4.63                  | %          | — |   | — |   | 12,799 |   | 3.41 | % |
| FHLMC/FNMA-issued mortgage pass-through  certificates                     |   | 6                           |       | 7.10                                  | %          | 276                                   |       | 5.81                 | %          | 1,019      |       | 3.33                  | %          | 2,688 |   | 5.09 | % | 3,989 |   | 4.69 | % |
| CMO’s and REMIC’s issued by U.S.  government-sponsored agencies |   | —                      |       | —                                |       | 57                                    |       | 7.27                 | %          | —     |       | —                |       | — |   | — |   | 57 |   | 7.27 | % |
| Mortgage mutual funds                                                     |   | 9,902                       |       | 3.10                                  | %          | —                                |       | —               |       | —     |       | —                |       | — |   | — |   | 9,902 |   | 3.10 | % |
| Privately issued Corporate bonds, CMO’s and  REMIC’s securities |   | 3,168                       |       | 2.02                                  | %          | —                                |       | —               |       | —     |       | —                |       | — |   | — |   | 3,168 |   | 2.02 | % |
|                                                                      |   | $                           | 14,693     |                                  | 2.65       | %                                     | $          | 4,875                |       | 2.26       | %          | $                     | 8,258      |   | 4.47 | % | $ | 3,051 |   | 4.94 | % | $ | 30,877 |   | 3.30 | % |
|                                                                      |   |                        |       |                                  |       |                                  |       |                 |       |       |       |                  |       |   |   |   |   |   |   |   |   |
| **Amortized Cost**                                                        |   | $                           | 14,299     |                                  |       |                                  | $          | 5,344                |       |       |       | $                     | 8,204      |   |   |   | $ | 2,909 |   |   |   | $ | 30,756 |   |   |   |
|                                                                      |   |                        |       |                                  |       |                                  |       |                 |       |       |       |                  |       |   |   |   |   |   |   |   |   |
|                                                                      |   |                        |       |                                  |       |                                  |       |                 |       |       |       |                  |       |   |   |   |   |   |   |   |   |
| FRB and other equity stocks.                                              |   | $                           | 1,872      |                                  | 0.00       | %                                     | $          | —               |       | —     |       | $                     | —     |   | — |   | $ | — |   | — |   | $ | 1,872 |   | 0.00 | % |
|                                                                      |   |                        |       |                                  |       |                                  |       |                 |       |       |       |                  |       |   |   |   |   |   |   |   |   |
|                                                                      |   | **Within one  year**        | ** ** | **After one  but  within five years** | ** ** | **After five  but  within ten years** | ** ** | **After ten  years** | ** ** |       | ** ** | **Weighted  Average** | ** ** |
|                                                                      |   | **Amount**                  | ** ** | **Yield**                             | ** ** | **Amount**                            | ** ** | **Yield**            | ** ** | **Amount** | ** ** | **Yield**             | ** ** | **Amount** | ** ** | **Yield** | ** ** | **Total** | ** ** | **Yield** | ** ** |
|                                                                      |   | **(Dollars  in thousands)** | ** ** |
| **Securities held-to-maturity:**                                          |   |                        |       |                                  |       |                                  |       |                 |       |       |       |                  |       |   |   |   |   |   |   |   |   |
| FHLMC/FNMA-issued mortgage pass-through  certificates                     |   | $                           | —     |                                  | —     |                                  | $          | —               |       | —     |       | $                     | 4,597      |   | 4.58 | % | $ | — |   | — |   | $ | 4,597 |   | 4.58 | % |
|                                                                      |   | $                           | —     |                                  | —     |                                  | $          | —               |       | —     |       | $                     | 4,597      |   | 4.58 | % | $ | — |   | — |   | $ | 4,597 |   | 4.58 | % |

 

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

 

Investment securities totaling $8.5 million were pledged to secure governmenttax deposits, bankruptcy deposits, or for other purposes required or permittedby law at December 31, 2003.

 

*Impaired Securities*

 

InNovember 2003, the FASB’s Emerging Issues Task Force (“EITF”) reached aconsensus requiring certain disclosures for impaired securities as described inEITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and ItsApplication to Certain Investments”. Any security for which the current fairvalue is less than the carrying value is considered impaired. On a quarterlybasis, impaired securities are evaluated to determine if the impairments areother-than-temporary. For those securities that are identified as having another-than-temporary impairment, the loss is reported as a reduction in currentperiod income. For all other temporary impairments, the current periodunrealized losses are recorded to other comprehensive income.

 

Asof December 31, 2003, temporarily impaired securities had a fair value of$14.5 million and unrealized losses of $103,000.  Securities that were not impaired had a fair value of $22.8million and unrealized gains of $267,000 at December 31, 2003.  The following table shows fair value andunrealized loss positions of temporarily impaired securities, categorized bywhether the securities have been impaired for less than twelve months or ifthey have been impaired for twelve months or more as of December 31, 2003.

 

54

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|                                                 |   | **Less than  12 months**    |   | **12 months  or longer** |   | **Total**      |   |
|------------------------------------------------------|--------|-----------------------------|--------|--------------------------|--------|----------------|--------|
|                                                 |   | **Fair value**              |   | **Unrealized  losses**   |   | **Fair value** |   | **Unrealized  losses** |   | **Fair value** |   | **Unrealized  losses** |   |
|                                                 |   | **(Dollars  in thousands)** |   |
| U.S. Treasury obligations                            |   | $                           | 599    |                     | $      | 1              |   | $ | — |   | $ | — |   | $ | 599 |   | $ | 1 |   |
| Other U.S. government and federal agency  securities |   | 4,038                       |   | 4                        |   | —         |   | — |   | 4,038 |   | 4 |   |
| Mortgage mutual funds                                |   | 9,902                       |   | 98                       |   | —         |   | — |   | 9,902 |   | 98 |   |
| Total temporarily impaired securities                |   | $                           | 14,539 |                     | $      | 103            |   | $ | — |   | $ | — |   | $ | 14,539 |   | $ | 103 |   |

 

TheU.S. Treasury obligations and other U.S. government and federal agencysecurities are impaired due to declines in fair values resulting from increasesin market interest rates from the time of purchase.  In total, there are three impaired securities.  None of the securities has exhibited adecline in value as a result of changes in credit risk.  As such, management does not consider theimpairments on these securities to be other-than-temporary.

 

Theimpaired mortgage mutual fund is a fund holding primarily short duration fixedrate and adjustable rate mortgage securities that is valued at its closing netasset value.  The Company believes thatthe primary reason for the impairment of these securities is due to thevolatility of interest rates.  TheCompany does not believe that the decline in the net asset value of thesesecurities has given rise to an other than-temporary-impairment andfurthermore, and it has the intent and ability to hold these securities for theforeseeable future, and therefore does not expect to realize a loss on themutual fund investment.  As such, theCompany does not consider the impairment on this security to beother-than-temporary.

 

**Note 4—LoansReceivable and Allowance for Credit Losses**

 

The following is a summary of the major categories of loans receivableoutstanding at December 31, 2003:

 
|                                                     |   | **2003**                     |    |
|----------------------------------------------------------|--------|------------------------------|---------|
|                                                     |   | **(Dollars  in  thousands)** |    |
| Real Estate loans:                                       |   |                         |    |
| Secured by one-to-four family residential  properties    |   | $                            | 8,167   |   |
| Secured by multifamily residential  properties           |   | 13,071                       |    |
| Secured by commercial real properties                    |   | 132,320                      |    |
| Real estate construction and land  development           |   | 27,210                       |    |
| Commercial loans                                         |   |                         |    |
| Other, secured and unsecured                             |   | 76,699                       |    |
| Home equity lines of credit                              |   | —                       |    |
| Consumer installment and unsecured loans to  individuals |   | 3,510                        |    |
|                                                     |   | 260,977                      |    |
| Unearned income                                          |   | (728                         | )       |
|                                                     |   | $                            | 260,249 |   |
|                                                     |   |                         |    |
| Weighted average yield for loans at December 31     |   | 6.99                         | %       |

 

At December 31, 2003, the Company had identified impaired loanswith recorded investments of $408,000.  At December 31,2003, specific allowances for credit losses totaling $408,000 were establishedfor these loans.  The average recordedinvestment of impaired loans was $1.7 million and $4.3 million during 2003 and2002, respectively.  No interest incomewas recognized on impaired loans during the years ended December 31, 2003and 2002.

 

In the normal course of business, the Banks may make loans to officersand directors as well as loans to companies and individuals affiliated with orguaranteed by officers and directors of the Company and the Banks.  Such loans are made in the ordinary courseof 

 

55

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business at rates and terms no more favorable than those offered toother customers with a similar credit standing.  The outstanding principal balance of these loans was $5.9 millionat December 31, 2003 and $4.5 million at December 31, 2002.  During 2003 there were $1.7 million ofadvances and $1.2 million  ofrepayments.  Interest income recognizedon these loans amounted to $322,000 and $374,000 during 2003 and 2002,respectively.  At December 31,2003, none of these loans were on nonaccrual status. Based on analysis ofinformation presently known to management about the loans to officers anddirectors and their affiliates, management believes all have the ability tocomply with the present loan repayment terms.

 

The following is a summary of activity in the allowance for creditlosses for the year ended December 31, 2003:

 
|                                       |   | **2003**                     |   |
|--------------------------------------------|--------|------------------------------|--------|
|                                       |   | **(Dollars  in  thousands)** |   |
|                                       |   |                         |   |
| Balance, beginning of year                 |   | $                            | 4,846  |   |
| Provision for credit losses                |   | 1,265                        |   |
| Loans charged off                          |   | (2,851                       | )      |
| Recoveries of loans previously charged off |   | 375                          |   |
| Balance, end of year                       |   | $                            | 3,635  |   |

 

Total loans charged-off in 2003 was $2.9 million.  The additional provision for credit losseswas recorded based upon the analysis of the adequacy of allowance for creditlosses.  The allowance for credit lossesfor classified loans graded as “criticized” by the Company’s internal gradingsystem that are collateral-dependent is based upon the net realizable value ofthe collateral that is periodically evaluate. The allowance for unsecured classified loans is based upon the severityof the credit weakness.

 

The following is a summary of nonperforming loans at December 31,2003:

 
|                                                                                                                       |   | **2003**                     |   |
|----------------------------------------------------------------------------------------------------------------------------|--------|------------------------------|--------|
|                                                                                                                       |   | **(Dollars  in  thousands)** |   |
|                                                                                                                       |   |                         |   |
| Nonaccrual loans                                                                                                           |   | $                            | 438    |   |
| Troubled debt restructurings                                                                                               |   | —                       |   |
| Loans contractually past due ninety or more  days with respect to either principal or interest and still accruing interest |   | —                       |   |
|                                                                                                                       |   | $                            | 438    |   |

 

Interest foregone on nonperforming loans outstanding atDecember 31, 2003 and 2002 was $47,000 and $388,000, respectively.  Foregone interest on nonperforming loansdoes not include interest forgone on loans on nonperforming status that wererestored to performing status prior to year end, or subsequent to either beingcharged off prior to year end or transferred to OREO prior to year end.

 

The ability of the Company’s borrowers to honor their loan agreementsis substantially dependent upon economic conditions and real estate marketvalues throughout the Company’s market area. At December 31, 2003, loansaggregating $180.8 million were collateralized by liens on residential andcommercial real properties.  While theCompany’s loan portfolio is generally diversified with regard to the industriesrepresented, at December 31, 2003, the Company’s loans to businesses andindividuals engaged in entertainment industry related activities amounted to$26.5 million.

 

*Troubled Debt Restructurings.* A TDR is a loanfor which the Company has, for economic or legal reasons related to aborrower’s financial difficulties, granted a concession to the borrower itwould not otherwise consider, including modifications of loan terms toalleviate the burden of the borrower’s near-term cash flow requirements inorder to help the borrower to improve its financial condition and eventualability to repay the loan.  AtDecember 31, 2003 and 2002, the Company had no TDRs.

 

**Note 5—Premises andEquipment and Lease Commitments**

 

The following is a summary of the major components of premises andequipment at December 31, 2003:

 

56

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|                                            |   | **2003**                     |   |
|-------------------------------------------------|--------|------------------------------|--------|
|                                            |   | **(Dollars  in  thousands)** |   |
|                                            |   |                         |   |
| Land                                            |   | $                            | 1,392  |   |
| Buildings                                       |   | 3,870                        |   |
| Leasehold improvements                          |   | 1,464                        |   |
| Furniture, fixtures and equipment               |   | 5,499                        |   |
|                                            |   | 12,225                       |   |
| Less accumulated amortization and  depreciation |   | (6,781                       | )      |
|                                            |   | $                            | 5,444  |   |

 

Depreciation and amortization expense was $479,000 in 2003 and $456,000in 2002.  Rental expense on operatingleases included in occupancy expense in the Consolidated Statements ofOperations was $808,000 in 2003 and $915,000 in 2002.

 

The future minimum annual rental commitments at December 31, 2003are summarized below.

 
|                                    |   | **(Dollars  in  thousands)** |   |
|-----------------------------------------|--------|------------------------------|--------|
| *For the year ended  December 31,* |   |                         |   |
| 2004                                    |   | $                            | 313    |   |
| 2005                                    |   | 280                          |   |
| 2006                                    |   | 259                          |   |
| 2007                                    |   | 260                          |   |
| 2008                                    |   | 519                          |   |
| Thereafter                              |   | 2,448                        |   |
|                                    |   | $                            | 4,079  |   |

 

**Note 6—Income Taxes**

 

A deferred federal and state income tax provision of $96,000 and$127,000 was recognized during 2003 and 2002, respectively.

 

A reconciliation of the amounts computed by applying the federalstatutory rate of 34% for 2003 and 2002 to the income and the effective tax rateare as follows:

 
|                                           |   | **2003**                     |   | **2002**                     |   |
|------------------------------------------------|--------|------------------------------|--------|------------------------------|--------|
|                                           |   | **(Dollars  in  thousands)** |   | **(Dollars  in  thousands)** |   |
|                                           |   |                         |   |                         |   |
| Tax provision (benefit) at statuory rate       |   | $                            | 103    |                         | $      | (43 | ) |
| Increase (reduction) in taxes resulting  from: |   |                         |   |                         |   |
| Book deductions without tax benefit            |   | (22                          | )      | 151                          |   |
| Permanent differences                          |   | 15                           |   | 19                           |   |
|                                           |   | $                            | 96     |                         | $      | 127 |   |

 

57

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The major components of the net deferred tax asset at December 31,2003 are as follows:

 
| **(Dollars in thousands)**      |   | **2003** |   |
|---------------------------------|--------|----------|--------|
| Deferred tax assets:            |   |     |   |
| Net operating losses            |   | $        | 6,879  |   |
| Accrued expenses                |   | 146      |   |
| Alternative minimum tax credits |   | 314      |   |
| Nonaccrual interest             |   | 138      |   |
| Loan fees                       |   | 170      |   |
| Bad debt expense                |   | 334      |   |
| Core deposits                   |   | 58       |   |
| Other.                          |   | 2        |   |
|                            |   |     |   |
| Total deferred tax assets.      |   | 8,041    |   |
|                            |   |     |   |
| Deferred tax liabilities:       |   |     |   |
| Depreciation                    |   | (777     | )      |
| Securities available for sale   |   | (50      | )      |
| FHLB stock dividend             |   | (39      | )      |
| Loan premium amortization       |   | (225     | )      |
| Total deferred tax liabilities  |   | (1,091   | )      |
| Net deferred tax asset          |   | $        | 6,950  |   |

 

For tax purposes at December 31, 2003, the Company had (i) federalNOLs of $18.9 million, which begin to expire in 2009; (ii) California NOLs of$766,000 which begin to expire in 2004; (iii) a federal AMT credit carryforwardof $298,000; and (iv) a California AMT credit carryforward of $16,000.  The AMT credits carryforward indefinitely.

 

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

 

**Note 7—Benefit Plans**

 

*Stock Incentive Plans*.  At December 31, 2003, the Company hadin effect one stock incentive plan pursuant to which up to a total of 668,510shares of common stock may be issued. Under this plan, the Company may grant to directors, officers, employeesand consultants stock-based incentive compensation in a variety of forms,including without limitation nonqualified options, incentive options, sales andbonuses of common stock and stock appreciation rights, on such terms andconditions as the Board 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, 2003, the only outstanding awards under thisplan were stock options, and at that date 105,584 shares were available forfuture awards.

 

At December 31, 2003, there were also outstanding options andtandem stock appreciation rights granted under two prior stock incentive plans.

 

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

 

58

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|                                |   |    |   | **Option  Price Range  Per Share** |   |
|-------------------------------------|--------|---------|--------|------------------------------------|--------|
|                                |   |    |   |                               |   |   |   |   |   |
| Outstanding, December 31, 2001 |   | 457,289 |   | $                                  | 4.31   |   | - |   | $ | 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 |   | $                                  | 4.31   |   | - |   | $ | 8.52 |   |
| Granted                             |   | 165,200 |   | 6.75                               |   | - |   | 11.50 |   |
| Cancelled                           |   | (10,800 | )      | 5.75                               |   | - |   | 8.52 |   |
| Exercised                           |   | (81,935 | )      | 4.47                               |   | - |   | 8.52 |   |
| Outstanding, December 31, 2003 |   | 493,308 |   | $                                  | 4.31   |   | - |   | $ | 11.50 |   |

 

Of the outstanding options at December 31, 2003:  (i) options to purchase 330,483 shares werevested and exercisable; and (ii) the remaining options become exercisable asfollows: 2004  — 96,750 and 2005 —68,650.

 

The estimated per share weighted average fair value of options grantedwas $7.81 and $4.08 during 2003 and 2002. The Company applies Accounting Principles Board Opinion No. 25 andrelated Interpretations in accounting for the stock incentive plans.  SFAS No. 123, ‘‘Accounting for Stock-BasedCompensation,’’ encourages, but does not require, companies to recordcompensation cost for stock-based employee compensation plans at fair value.  Accordingly, no compensation cost has beenrecognized for the plans.  Hadcompensation cost for the options granted been determined based on the fairvalue at the grant dates for awards under the plans consistent with the methodof SFAS No. 123, the Company’s net earnings for 2003 would have been decreasedby $121,000 and the net loss for 2002 would have increased by $92,000.  Basic and diluted earnings per share wouldhave decreased by $0.04 and  $0.03 for2003, respectively.  Basic and dilutedloss per share would have increased by $0.06 for 2002.

 

The fair values of options granted during 2003 and 2002 were estimatedon the date of grant using the Black-Scholes option-pricing model with thefollowing weighted-average assumptions used: 2003— no dividend yield, expectedvolatility of 62%, risk-free interest rate of 4.28%, and an expected life of 10years; 2002— no dividend yield, expected volatility of 59%, risk-free interestrate of 4.06%, and an expected life of 10 years.

 

*Defined Contribution Retirement Plan*. TheCompany maintains a defined contribution retirement plan undersection 401(k) of the Internal Revenue Code. Employees are eligible toparticipate following****six months of continuous employment. Underthe plan, the Company has partially matched employee contributions since May 1,2001.  Such matching contributionsbecome fully vested when the employee reaches three years of service.  The Company’s matching contributions for2003 and 2002 were $89,000 and $90,000, respectively.

 

**Note 8—Borrowed Funds**

 

The following summarizes borrowed funds and weighted average rates.

 
|                                                                     |   | **2003**                    |   |
|--------------------------------------------------------------------------|--------|-----------------------------|--------|
|                                                                     |   | **Year-end**                |   | **Average** |   |
|                                                                     |   | **Balance**                 |   | **Weighted  Average  Rate** |   | **Balance** |   | **Weighted  Average  Rate** |   |
|                                                                     |   | **(Dollars  in thousands)** |   |
|                                                                     |   |                        |   |   |   |   |   |   |   |
| Federal funds purchased and securities sold  under repurchase agreements |   | $                           | 399    |   | 2.20 | % | $ | 609 |   | 2.63 | % |
|                                                                     |   |                        |   |   |   |   |   |   |   |
| Other borrowings                                                         |   | 7,500                       |   | 4.70 | % | 7,500 |   | 4.81 | % |
|                                                                          |        |                             |        |  |  |  |  |  |  |  |  |

 

The maximum amount of federal funds purchased and securities sold underagreements to repurchase at any month-end was $792,000 during 2003.

 

59

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Other borrowings are primarily comprised of Federal Home Loan Bank(“FHLB”) advances.  At December 31,2003 FHLB advances included: (i) a $2.5 million putable borrowing with a fixedrate of 5.93%, with puts commencing July 2002 and continuing every threemonths thereafter, through July 2004; (ii) fixed rate borrowings of $3.0million maturing April 2004 with a rate of 3.85%; (iii) fixed rateborrowings of $2.0 million maturing April 2005 with a rate of 4.45%.  The maximum amount of other borrowingsoutstanding at any month-end was $7.5 million during 2003.

 

The Banks had $2.3 million of unused borrowing capacity from the FHLBat December 31, 2003 based upon pledged securities.

 

**Note 9—Junior SubordinatedDeferrable Interest Debentures**

 

The Company formed National Mercantile Capital Trust I (the “Trust”), astatutory business trust under the Delaware Business Trust Act, pursuant to aDeclaration of Trust dated as of June 27, 2001, for the sole purpose ofissuing and selling certain securities representing undivided beneficialinterests in the assets of the Trust and investing the proceeds thereof incertain debentures of the Company.

 

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

 

Also, on July 16, 2001 the Trust issued 15,000 of 10.25% fixedrate securities (the “Trust Preferred Securities”), with a liquidation amountof $1,000 per Trust Preferred Security and an aggregate liquidation amount of$15.0 million due July 25, 2031.  The Trust Preferred Securities areunconditionally guaranteed by the Company with respect to distributions andpayments upon liquidation, redemption and otherwise to the extent provided inand pursuant to the terms of a Guarantee Agreement.

 

The Trust used the proceeds from the issuance and the sale of the TrustPreferred Securities and the Common Securities to purchase $15.5 millionaggregate principal amount of the Company’s 10.25% fixed rate juniorsubordinated deferrable interest debentures due July 25, 2031 (“JuniorSubordinated Debentures’) that pay interest each January 26 and July 26.  The interest is deferrable, at the Company’soption, for a period up to ten consecutive semi-annual payments, but in anyevent 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 tomaturity.  The debentures are theprimary assets of the Trust.

 

The recorded balance of Junior Subordinated Debentures was $15.5million at December 31, 2003.

 

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

 

National Mercantile is a legal entity separate and distinct from theBanks, and as such has separate and distinct financial obligations includingdeferrable debt service of $1.5 million on the Junior Subordinated Debentureand other modest operating expenses. While National Mercantile from time to time holds short-terminvestments,  its assets primarilyconsist of the common shares of the Banks and it has historically not engagedin any other business activity. Accordingly, dividends and capital distributions from the Banksconstitute the principal 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 required for a national bank to pay a dividend if thetotal of all dividends declared in any calendar year exceeds the total of thebank’s net profits (as defined) for that year combined with its retained netprofits for the preceding two calendar years, less any required transfer tosurplus or a fund for the retirement of any preferred stock.  A national bank may not pay any dividendthat exceeds its retained net earnings, as defined by the OCC.  The OCC and the Federal Reserve Board havealso issued banking circulars emphasizing that the level of cash dividendsshould bear a direct correlation to the level of a national bank’s current andexpected earnings stream, the bank’s need to maintain an adequate capital baseand other factors.

 

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

 

Mercantile has no retained earnings, and therefore is presently unableto pay dividends.  Mercantile has asubstantial accumulated deficit and does not anticipate having positiveretained earnings for the foreseeable future. South Bay has retained earnings of $130,000 as of December 31,2003.  Mercantile and South Bay may fromtime to time be permitted to make capital distributions to 

 

60

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National Mercantile with the consent of the OCC.  It is not anticipated that such consentcould be obtained unless the distributing bank were to remain “well capitalized”following such distribution.

 

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

 

Federal Reserve Board regulations require the Banks to maintain certainminimum reserve balances.  Cash balancesmaintained to meet reserve requirements are not available for use by the Banksor National Mercantile.  During 2003 and2002, the average reserve balances for the Banks were approximately $6.2million and $4.6 million, respectively. Neither National Mercantile nor the Banks is required to maintaincompensating balances to assure credit availability under existing borrowingarrangements.

 

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

 

Quantitative measures established by regulation to ensure capitaladequacy require National Mercantile and the Banks to maintain minimum amountsand ratios (set forth in the table below) of total and Tier 1 capital (asdefined in the regulations) to risk-weighted assets (as defined).  Management believes, as of December 31,2003, National Mercantile and Banks meet all capital adequacy requirements towhich they are subject.

 

At December 31, 2003, each Bank was categorized as wellcapitalized under the regulatory framework for prompt corrective action.  To be categorized as well capitalized underthe prompt corrective action rules, each Bank must maintain minimum totalrisk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in thefollowing table.  There are noconditions or events since the most recent notification which managementbelieves have changed the Banks’ category.

 

The following table presents, at the dates indicated, certain informationregarding the regulatory capital of National Mercantile and the Banks and therequired amounts of regulatory capital for National Mercantile and the Banks tomeet applicable regulatory capital requirements and, in the case of the Banks,to be well capitalized 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, 2003           |   |                        |   |                                |   |                                                                                |   |   |   |   |   |   |   |
| Total Capital to Risk Weighted Assets  |   |                        |   |                                |   |                                                                                |   |   |   |   |   |   |   |
| National Mercantile Bancorp            |   | $                           | 39,163 |                                | 13.84  | %                                                                                   | $      | 22,653 |   | >=8.0 | % | N/A |   | >=10.0 | % |
| Mercantile National Bank               |   | 17,484                      |   | 12.13                               | %      | 11,528                                                                              |   | >=8.0 | % | $ | 14,410 |   | >=10.0 | % |
| South Bay Bank, N.A.                   |   | 17,031                      |   | 12.37                               | %      | 11,015                                                                              |   | >=8.0 | % | $ | 13,769 |   | >=10.0 | % |
| Tier 1 Capital to Risk Weighted Assets |   |                        |   |                                |   |                                                                                |   |   |   |   |   |   |   |
| National Mercantile Bancorp            |   | 31,195                      |   | 11.02                               | %      | 11,326                                                                              |   | >=4.0 | % | N/A |   | >=6.0 | % |
| Mercantile National Bank               |   | 15,680                      |   | 10.88                               | %      | 5,764                                                                               |   | >=4.0 | % | 8,646 |   | >=6.0 | % |
| South Bay Bank, N.A.                   |   | 15,400                      |   | 11.18                               | %      | 5,508                                                                               |   | >=4.0 | % | 8,262 |   | >=6.0 | % |
| Tier 1 Capital to Average Assets       |   |                        |   |                                |   |                                                                                |   |   |   |   |   |   |   |
| National Mercantile Bancorp            |   | 31,195                      |   | 8.69                                | %      | 14,365                                                                              |   | >=4.0 | % | N/A |   | >=5.0 | % |
| Mercantile National Bank               |   | 15,680                      |   | 8.13                                | %      | 7,711                                                                               |   | >=4.0 | % | 9,639 |   | >=5.0 | % |
| South Bay Bank, N.A.                   |   | 15,400                      |   | 9.44                                | %      | 6,526                                                                               |   | >=4.0 | % | 8,158 |   | >=5.0 | % |
|                                        |        |                             |        |                                     |        |                                                                                     |        |  |  |  |  |  |  |  |  |  |

 

61

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**Note 11—Commitmentsand Contingencies**

 

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

 

Exposure to credit loss in the event of nonperformance by the otherparty to the financial instrument for commitments to extend credit, letters ofcredit and financial guarantees written, is represented by the contractualnotional amount of those instruments. The Company uses the same credit policies in making commitments andconditional obligations as it does for on-balance sheet instruments.

 

The Company had outstanding loan commitments aggregating $64.5 millionat December 31, 2003, substantially all of which were for adjustable ratecommercial loans.  In addition, theCompany had $1.3 million outstanding letters of credit at December 31,2003.

 

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

 

The Company from time to time is party to lawsuits, which arise in thenormal course of business. The Company does not believe that any pendinglawsuit at December 31, 2003 will have a material adverse effect on thefinancial position or results of operations of the Company.

 

**Note 12—Disclosuresabout the Fair Value of Financial Instruments**

 

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

 

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

 

*Securities available-for-sale and securities held-to-maturity*:  For securities classified asavailable-for-sale, fair value equals quoted market prices, if available. If aquoted market price is not available, fair value is estimated using quotedmarket prices for similar securities.

 

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

 

*Loans*: Variable rate loans have carrying amounts that approximate fair value.The fair value of fixed rate loans is estimated by discounting the future cashflows using the current rates at which similar loans would be made to borrowerswith similar credit ratings and for the same remaining maturities. Inestablishing the credit risk component of the fair value calculations forloans, the Company concluded the allowance for credit losses represented areasonable estimate of credit risk component of the fair value atDecember 31, 2003.

 

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

 

*Deposits*: The fair value of demand and interest checking deposits, money marketaccounts and savings deposits is the amount payable on demand at the reportingdate.  The fair value of fixed-maturitycertificates of deposit is estimated by discounting the future cash flows usingthe rates currently offered for deposits of similar maturities.

 

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

 

*Junior subordinated debentures:* The fair value of the junior subordinated debentures is based upon thereciprocal change in value of the interest rate swap as the terms of the swapare symmetrical with the terms of the debentures.

 

*Other borrowings*:  The fair value of fixed-rate borrowings is estimated bydiscounting the future cash flows using the rates currently offered forborrowings of similar maturities. Borrowings with maturities greater than one year bear interest atvariable rates and approximate fair value.

 

The estimated fair values of financial instruments are presented below.

 

62

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|                                                                        |   | **December 31,  2003** |   |
|-----------------------------------------------------------------------------|--------|-----------------------------|--------|
|                                                                        |   | **Carrying  Amount**        |   | **Fair  Value** |   |
|                                                                        |   | **(Dollars  in thousands)** |   |
| Financial Assets:                                                           |   |                        |   |   |   |
| Cash, cash equivalents and deposit with  other financial institutions       |   | $                           | 39,284 |   | $ | 39,284 |   |
| Securities available-for-sale                                               |   | 30,877                      |   | 30,877 |   |
| Securities held-to-maturity                                                 |   | 4,597                       |   | 4,640 |   |
| FRB and other stock                                                         |   | 1,872                       |   | 1,872 |   |
| Loans, net of allowance for credit losses                                   |   | 256,614                     |   | 393,253 |   |
| Interest rate swap                                                          |   | —                      |   | 409 |   |
| Financial Liabilities:                                                      |   |                        |   |   |   |
| Demand deposits, money market and savings                                   |   | 243,694                     |   | 243,694 |   |
| Time certificates of deposit                                                |   | 55,023                      |   | 43,176 |   |
| Federal funds purchased and securities sold  under agreements to repurchase |   | 399                         |   | 399 |   |
| Junior subordinated debentures                                              |   | 15,464                      |   | 15,585 |   |
| Other borrowings                                                            |   | 7,500                       |   | 7,649 |   |
|                                                                             |        |                             |        |  |  |  |  |

 

**Note 13—Derivatives**

 

In January 2003, National Mercantile entered into a interest rate swapagreement pursuant to which it exchanged a fixed rate payment obligation of10.25% on a notional principal amount of $15.0 million for a floating rateinterest based on the six-month London InterBank Offerred Rate plus 458 basispoints for a 29-year period ending July 25, 2031.  The interest rate swap agreement results in the company paying orreceiving the difference between the fixed and floating rates at specifiedintervals calculated based on the notional amounts.  The differential paid or received on the interest rate swap isrecognized as an adjustment to interest expense.  At December 31, 2003, the Company was paying an interest rate of5.75% under the terms of the swap.  Thecounter party to the swap has the option to call the swap under a decliningpremium schedule beginning July 2006.

 

The interest rate swap reduces the adverse impact of the Company’s10.25% Junior Subordinated Debentures in a declining interest rateenvironment.  The Company does notutilize derivatives for speculative purposes. UnderStatement of Financial Accounting Standards No. 133 this swap transaction isdesignated as a fair value hedge. Accordingly, the effective portion of the change in the fair value ofthe swap transaction is recorded each period in current income.  The terms of the swap are symmetrical withthe terms of the Trust Preferred Securities, including the payment deferralterms, and considered highly effective in offsetting changes in fair value ofthe Trust Preferred Securities. Accordingly, no ineffectivenesswill be recorded to current earnings related to the interest rate swap.

 

**Note 14—ParentCompany Information**

 

The following financial information presents the condensed balancesheet of the Company on a parent-only basis as of December 31, 2003, andthe related condensed statements of operations and cash flows for each of theyears in the two-year period ended December 31, 2003.

 

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**Balance Sheet**

 
|                                                |   | **December 31,  2003**  |   |
|-----------------------------------------------------|--------|------------------------------|--------|
|                                                |   | **(Dollars  in  thousands)** |   |
|                                                |   |                         |   |
| Cash with Banks                                     |   | $                            | 1,158  |   |
| Due from banks - time                               |   | 1,004                        |   |
| Securities available-for-sale                       |   | 1,550                        |   |
| Investment in the Banks                             |   | 42,393                       |   |
| Other assets                                        |   | 2,068                        |   |
| Total assets                                        |   | $                            | 48,173 |   |
|                                                |   |                         |   |
| Junior subordinated deferrable interest  debentures |   | $                            | 15,464 |   |
| Other liabilities                                   |   | 988                          |   |
| Total liabilities                                   |   | 16,452                       |   |
|                                                |   |                         |   |
| Shareholders’ equity:                          |   |                         |   |
| Preferred stock                                     |   | 6,986                        |   |
| Common stock                                        |   | 38,576                       |   |
| Accumulated deficit                                 |   | (13,912                      | )      |
| Accumulated other comprehensive income              |   | 71                           |   |
| Total shareholders’ equity                     |   | 31,721                       |   |
| Total liabilities and shareholders’ equity     |   | $                            | 48,173 |   |

 

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**Statements of Operations**

 
|                                                          |   | **Year ended  December 31,** |   |
|---------------------------------------------------------------|--------|-----------------------------------|--------|
|                                                          |   | **2003**                          |   | **2002** |   |
|                                                          |   | **(Dollars  in thousands)**       |   |
|                                                          |   |                              |   |   |   |
| Interest income                                               |   | $                                 | 42     |   | $ | 6 |   |
| Interest expense                                              |   | 934                               |   | 1,585 |   |
| Net interest income                                           |   | (892                              | )      | (1,579 | ) |
|                                                          |   |                              |   |   |   |
| Other operating income                                        |   | 14                                |   | 38 |   |
| Other operating expense                                       |   | 290                               |   | 228 |   |
| Income before equity in undistributed net  income of the Bank |   | (1,168                            | )      | (1,769 | ) |
| Equity in undistributed net income of  subsidiaries           |   | 944                               |   | 791 |   |
| Income before income tax benefit                              |   | (224                              | )      | (978 | ) |
| Income tax benefit                                            |   | 479                               |   | 725 |   |
| Net income (loss)                                             |   | $                                 | 255    |   | $ | (253 | ) |

 

**Statements of Cash Flow**

 
|                                                                               |   | **Year ended  December 31,** | ** ** |
|------------------------------------------------------------------------------------|--------|-----------------------------------|------------|
|                                                                               |   | **2003**                          | ** ** | **2002** | ** ** |
|                                                                               |   | **(Dollars  in thousands)**       | ** ** |
|                                                                               |   |                              |       |   |   |
| Cash flows from operating activities:                                              |   |                              |       |   |   |
| Net income (loss)                                                                  |   | $                                 | 255        |   | $ | (253 | ) |
| Adjustment to reconcile net income to net  cash provided by operating activities.: |   |                              |       |   |   |
| Equity in undistributed net income of  subsidiaries, net                           |   | (944                              | )          | (791 | ) |
| Net increase in other assets and other  liabilities                                |   | (687                              | )          | (780 | ) |
| Net cash provided by (used in) operations                                          |   | (1,376                            | )          | (1,824 | ) |
|                                                                               |   |                              |       |   |   |
| 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.                                 |   | —                            |       | — |   |
| Purchase of available-for-sale securities                                          |   | (1,586                            | )          | — |   |
| Purchase of time deposits at banks                                                 |   | —                            |       | — |   |
| Loans purchased and principal collections,  net                                    |   | —                            |       | 879 |   |
| Net cash used in investing activities                                              |   | (1,586                            | )          | (1,321 | ) |
|                                                                               |   |                              |       |   |   |
| Cash flows from financing activities:                                              |   |                              |       |   |   |
| Net proceeds from issuance of debentures                                           |   | —                            |       | — |   |
| Net proceeds from issuance of preferred  stock                                     |   | —                            |       | — |   |
| Net proceeds from common stock offering                                            |   | —                            |       | 7,572 |   |
| Proceeds from stock options exercised                                              |   | 504                               |       | 86 |   |
| Net cash provided by financing activities                                          |   | 504                               |       | 7,658 |   |
| Net (decrease) increase in cash and cash  equivalents                              |   | (2,458                            | )          | 4,513 |   |
| Cash and cash equivalents, beginning of the  year                                  |   | 4,620                             |       | 107 |   |
|                                                                               |   |                              |       |   |   |
| Cash and cash equivalents, end of the year                                         |   | $                                 | 2,162      |   | $ | 4,620 |   |
|                                                                               |   |                              |       |   |   |
| Supplemental disclosures of cash flow  information:                                |   |                              |       |   |   |
| Cash paid for Interest                                                             |   | $                                 | 1,328      |   | $ | 1,528 |   |
| Cash paid for Income taxes, net                                                    |   | $                                 | —     |   | $ | — |   |

 

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**INDEX TO EXHIBITS**

** **
| **Exhibit**                  |   |                                                                                                                                                                                                                                                                                                                                   |
|------------------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                         |   |                                                                                                                                                                                                                                                                                                                                   |
|      3.1 |   | Amended and  Restated Articles of Incorporation, dated June 20, 1997 (1); Certificate of  Amendment of the Articles of Incorporation, filed May 4, 2000 (6);  Certificate of Determination of Rights, Preferences and Privileges of Series  B Convertible Perpetual Preferred Stock filed December 14, 2001(8)                         |
|                         |   |                                                                                                                                                                                                                                                                                                                                   |
|      3.2 |   | Bylaws of the Company, as amended, restated as of December 18, 1992  (2)                                                                                                                                                                                                                                                               |
|                         |   |                                                                                                                                                                                                                                                                                                                                   |
|      4.1 |   | Indenture for Junior Subordinated Debt Securities dated as of July  16, 2001  (7)                                                                                                                                                                                                                                                 |
|                         |   |                                                                                                                                                                                                                                                                                                                                   |
|    10.1            |   | Employment Agreement dated January 1, 1999 between Mercantile  National Bank and Scott A. Montgomery (3); Assignment, Assumption — Amendment  of Employment Agreement among National Mercantile Bancorp, Mercantile  National Bank and Scott A. Montgomery                                                                        |
|                         |   |                                                                                                                                                                                                                                                                                                                                   |
|    10.2            |   | Form of Indemnity Agreement between the Company and its directors (4)                                                                                                                                                                                                                                                                  |
|                         |   |                                                                                                                                                                                                                                                                                                                                   |
|    10.3            |   | 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            |   | National Mercantile Bancorp Amended 1996 Stock Incentive Plan (10)                                                                                                                                                                                                                                                                     |
|                         |   |                                                                                                                                                                                                                                                                                                                                   |
|    10.5            |   | Registration Rights Agreement between the Company and Conrad Company  (5)                                                                                                                                                                                                                                                              |
|                         |   |                                                                                                                                                                                                                                                                                                                                   |
|    10.6            |   | Amended and Restated Declaration of Trust of National Mercantile  Capital Trust I, dated as of June 27, 2001 (7)                                                                                                                                                                                                                       |
|                         |   |                                                                                                                                                                                                                                                                                                                                   |
|    10.7            |   | Guarantee Agreement of National Mercantile Bancorp for trust  preferred securities dated July 16, 2001 (7)                                                                                                                                                                                                                             |
|                         |   |                                                                                                                                                                                                                                                                                                                                   |
|    10.8            |   | Severence Agreement dated November 14, 2002 between National  Mercantile Bancorp and David Brown (9)                                                                                                                                                                                                                                   |
|                         |   |                                                                                                                                                                                                                                                                                                                                   |
|    10.9            |   | Severence Agreement dated September 26, 2003 between National  Mercantile Bancorp and Robert Bartlett                                                                                                                                                                                                                                  |
|                         |   |                                                                                                                                                                                                                                                                                                                                   |
|    10.10           |   | Eighth floor lease at 1880 Century Park East, Los Angeles,  California, dated as of November 12, 2003 between Century Park and Mercantile  National Bank                                                                                                                                                                               |
|                         |   |                                                                                                                                                                                                                                                                                                                                   |
|    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 7. Financial  Statements” in this Annual Report on Form 10-KSB) |
|                         |   |                                                                                                                                                                                                                                                                                                                                   |
|    21.             |   | Subsidiaries of the Registrant                                                                                                                                                                                                                                                                                                         |
|                         |   |                                                                                                                                                                                                                                                                                                                                   |
|    23.             |   | Consent of Ernst & Young LLP                                                                                                                                                                                                                                                                                                       |
|                         |   |                                                                                                                                                                                                                                                                                                                                   |
|    31.1            |   | Certification of Scott A. Montgomery under Section 302 of  Sarbanes-Oxley Act                                                                                                                                                                                                                                                          |
|                         |   |                                                                                                                                                                                                                                                                                                                                   |
|    31.2            |   | Certification of David R. Brown under Section 302 of Sarbanes-Oxley  Act                                                                                                                                                                                                                                                               |
|                         |   |                                                                                                                                                                                                                                                                                                                                   |
|    32.1            |   | Certification of Scott A. Montgomery under Section 906 of  Sarbanes-Oxley Act                                                                                                                                                                                                                                                          |
|                         |   |                                                                                                                                                                                                                                                                                                                                   |
|    32.2            |   | Certification of David R. Brown under Section 906 of Sarbanes-Oxley  Act                                                                                                                                                                                                                                                               |

----

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

 

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(2)    Filed as an exhibit to the Company’s Annual Reporton Form 10-K for the year ended December 31, 1992 and incorporated herein byreference.

(3)    Filed as an exhibit to the Company’s Report on Form10-Q for the quarter ended March 31, 1999 and incorporated herein by reference.

(4)    Filed as an exhibit to Company’s Annual Report onForm 10-K for the year ended December 31, 1990 and incorporated herein byreference.

(5)    Filed as an exhibit to the Company’s RegistrationStatement on Form S-2 dated February 10, 1997 and amendments thereto andincorporated herein by reference.

(6)    Filed as an exhibit to the Company’s Annual Reporton Form 10-K for the year ended December 21, 2000 and incorporated herein byreference.

(7)    Filed as an exhibit to the Company’s Report on Form10-Q for the quarter ended September 30, 2001 and incorporated herein byreference.

(8)    Filed as an exhibit to the Company’s Annual Reporton Form 10-K for the year ended December 21, 2001 and incorporated herein byreference.

(9)    Filed as an exhibit to the Company’s Annual Reporton Form 10-K for the year ended December 21, 2002 and incorporated herein byreference.

(10)  Filedas an exhibit to the Company's Registration Statement on Form S-8 dated June20, 2003 and incorporated herein by reference.

 

 

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