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**U.S. SECURITIES AND EXCHANGE COMMISSION**

**WashingtonD.C.  20549**

 

**FORM 10-K**

 

**x****     ****Annual report under Section 13 or 15(d) of the SecuritiesExchange Act of 1934**

** **

**(Fee required) for fiscal year ended December 31,2009**

 

**o****        ****Transition report under Section 13 or 15(d) of the SecuritiesExchange Act of 1934**

** **

**(No fee required) for the period from             to             **

 

**Commission File Number 0-27666**

 

**NORTHERN CALIFORNIA BANCORP, INC.**

(Exact name of registrant asspecified in its Charter)

 

**Incorporated in the State ofCalifornia**

**IRS Employer IdentificationNumber 77-0421107**

Address:**  601 Munras Avenue, Monterey, CA  93940**

Telephone:**(831) 649-4600**

 

Securities registered under Section 12(g) of the ExchangeAct: **Common stock**

 

Securities registered under Section 12(b) of the ExchangeAct: **None**

 

Indicate by check mark if the registrant is a well-known seasonedissuer, as defined in Rule 405 of the Securities Act. Yes o  No x

 

Indicate by check mark if the registrant is not required to filereports pursuant to Section 13 or Section 15(d) of the ExchangeAct. Yes o  No x

 

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

 

Indicate by checkmark whether the registrant has submitted electronically and posted on itscorporate Web site, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of thischapter) during the preceding 12 months (or for such shorter period that theregistrant was required to submit and post such files). Yes o  No o

 

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-K is not contained herein, and will not be contained,to the best of the registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-K orany amendment to this Form 10-K.  x

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, a non-accelerated filer, or a smaller reportingcompany. See definitions of “large accelerated filer,” “accelerated filer” and “smallerreporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

| Large accelerated filer o |   | Accelerated filer o         |
|---------------------------|--------|-----------------------------|
|                      |   |                        |
| Non-accelerated filer o   |   | Smaller reporting company x |

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act. Yes o  No x

 

Aggregatemarket value of Common Stock held by non-affiliates as of the last business dayof the registrant’s most recently completed second fiscal quarter ended June 30,2009 was $3,445,000.

 

Sharesof stock outstanding as of March 1, 2010: 1,783,230.

 

**DOCUMENTSINCORPORATED BY REFERENCE**

 

Portions of the registrant’s proxy statement to be filed with theSecurities and Exchange Commission in connection with the registrant’s 2010annual meeting of shareholders are incorporated by reference into Part IIIof this Form 10-K.

 

 

 

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FORM 10-KCROSS REFERENCE INDEX

 
| ** **        | ** **                                                                                                   | **PAGE** |
|-------------------|--------------------------------------------------------------------------------------------------------------|----------|
| **PART I**   |                                                                                                         | **3**    |
| **ITEM  1.**      | **BUSINESS**                                                                                                 | **3**    |
| **ITEM 1A.**      | **RISK FACTORS**                                                                                             | **23**   |
| **ITEM 1B**       | **UNRESOLVED STAFF COMMENTS**                                                                                | **28**   |
| **ITEM 2.**       | **PROPERTIES**                                                                                               | **28**   |
| **ITEM 3.**       | **LEGAL PROCEEDINGS**                                                                                        | **29**   |
| **ITEM 4.**       | **REMOVED AND RESERVED**                                                                                     | **29**   |
| **PART II**  |                                                                                                         | **29**   |
| **ITEM 5.**       | **MARKET FOR THE COMMON EQUITY, RELATED  STOCKHOLDER MATTERS, AND ISSUER OF PURCHASES OF EQUITY SECURITIES** | **29**   |
| **ITEM 6.**       | **SELECTED FINANCIAL DATA**                                                                                  | **32**   |
| **ITEM 7.**       | **MANAGEMENT’S DISCUSSION AND ANALYSIS OF  FINANCIAL CONDITION AND RESULTS OF OPERATION**               | **33**   |
| **ITEM 7A.**      | **QUANTITATIVE  AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK**                                               | **56**   |
| **ITEM 8.**       | **FINANCIAL  STATEMENTS AND SUPPLEMENTARY DATA**                                                             | **56**   |
| **ITEM 9.**       | **CHANGES IN  AND DISAGREEMENTS WITH ACCOUNTANTS AND FINANCIAL DISCLOSURE**                                  | **56**   |
| **ITEM 9A(T)**    | **CONTROLS AND  PROCEDURES**                                                                                 | **56**   |
| **ITEM 9B.**      | **OTHER  INFORMATION**                                                                                       | **58**   |
| **PART III** |                                                                                                         | **59**   |
| **ITEM 10.**      | **DIRECTORS,  EXECUTIVE OFFICERS, AND CORPORATE GOVERNANCE**                                                 | **59**   |
| **ITEM 11.**      | **EXECUTIVE COMPENSATION**                                                                                   | **59**   |
| **ITEM 12.**      | **SECURITY OWNERSHIP OF CERTAIN  BENEFICIAL OWNERS AND MANAGEMENT, AND RELATED STOCKHOLDER MATTERS**         | **59**   |
| **ITEM 13.**      | **CERTAIN  RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE**                               | **59**   |
| **ITEM 14.**      | **PRINCIPAL  ACCOUNTANT FEES AND SERVICES**                                                                  | **59**   |
| **ITEM 15.**      | **EXHIBITS AND  FINANCIAL STATEMENT SCHEDULES**                                                              | **60**   |

 

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**Statements RegardingForward-Looking Information**

 

Except forhistorical information contained herein, the matters discussed or incorporatedby reference in this report on Form 10-K contain forward-lookingstatements within the meaning of Section 27A of the Securities Act of1933, as amended (the “Securities Act”), and Section 21E of the SecuritiesExchange Act of 1934 (the “Exchange Act”), that involve substantial risks anduncertainties.  When used in this report, or in the documents incorporatedby reference herein, the words “anticipate,” “believe,” “estimate,” “may,” “intend,”“expect,” and similar expressions identify certain of such forward-lookingstatements.  Actual results of Northern California Bancorp, Inc. (the“Corporation”) could differ materially from such forward-looking statementscontained herein.  Factors that could cause future results to vary fromcurrent expectations include, but are not limited to, the following: changes ineconomic conditions (both generally and more specifically in the markets inwhich the Corporation operates):  changesin interest rates, deposit flows, loan demand, real estate values andcompetition; changes in accounting principles, policies or guidelines and ingovernment legislation and regulation (which change from time to time and overwhich the Corporation has no control); other factors affecting the Corporation’soperations, markets, products and services; and other risks detailed in this Form 10-K(see “Item 1A. Risk Factors”) and in the Corporation’s other reports filed withthe Securities and Exchange Commission.  Readers are cautioned not toplace undue reliance on these forward-looking statements, which reflectmanagement’s analysis only as of the date hereof.  The Corporationundertakes no obligation to publicly revise these forward-looking statements toreflect events or circumstances that arise after the date thereof.

 

**PART I**

 

**ITEM 1.****                                                    ****BUSINESS**

 

**GENERAL**

 

Northern California Bancorp, Inc. wasincorporated on August 29, 1995, as a for-profit corporation underCalifornia corporate laws for the principal purpose of engaging in banking andnon-banking activities as allowed for a bank holding company.  At December 31, 2009, on a consolidatedbasis the Corporation had total assets of $273,295,000, total loans of$166,742,000 and total deposits of $202,422,000.  The Corporation owns 100% of the stock ofMonterey County Bank (the “Bank”).   TheCorporation’s sources of revenues at this time are dividends on investments,gains on securities transactions and potential dividends, management fees andtax equalization payments, if any, from the Bank.

 

The Corporation, as a bank holding company,engages in commercial banking through the Bank. The Corporation may also engage in certain non-banking activitiesclosely related to banking and own certain other business companies that arenot banks, subject to applicable laws and regulations, although it has nocurrent plans to do so.

 

**BANK SUBSIDIARY**

 

Monterey County Bank, anindependent, California chartered commercial banking corporation, was charteredby the State of California on July 30, 1976.  The Bank’s customer base includesindividuals, small and medium-sized businesses and a variety of governmentagencies with residences, offices or other relationships located in or aboutthe city and county of Monterey, California, including the cities of Carmel bythe Sea, Pacific Grove and Salinas.  TheBank offers its

 

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customers a wide varietyof the normal personal, consumer and commercial services expected of a locallyowned, independently operated bank.  TheBank’s deposits are insured by the Federal Deposit Insurance Corporation (the “FDIC”),and, as such, the Bank is subject to regulations by that federal agency and toperiodic audits of its operations and documentary compliance by FDICpersonnel.  As a state chartered bank,which is not a member of the Federal Reserve System, it is also regulated andperiodically examined by the California Department of Financial Institutions(DFI).

 

The Bank’s activities areconducted at its principal branch offices, 601 Munras Ave., Monterey,California and at its four branch offices in Carmel-By-The-Sea, Carmel Valley,Pacific Grove and Salinas, California and a loan production office in Monterey,California.  At December 31, 2009,the Bank had total assets, loans and deposits of approximately $272,154,000, $166,742,000and $202,671,000,respectively.

 

TheBank provides a range of competitive retail and commercial bankingservices.  The deposit services offeredinclude various types of personal and business checking accounts, savingsaccounts, money market investment accounts, certificates of deposit, andretirement accounts.  Lending servicesinclude consumer loans, various types of mortgage loans for residential andcommercial real estate, personal lines of credit, home equity loans, realestate construction, accounts receivable financing and commercial loans tosmall and medium-sized businesses and professionals.  The Bank also provides drive-through facilities,at its Monterey and Carmel offices, and night depository facilities forcustomer convenience.  The Bank offerssafe deposit box facilities, cashiers’ checks, travelers’ checks, U.S. SavingsBonds, and wire transfers.  The Bank doesnot provide trust services.

 

Whilethe Bank has the authority to engage in a wide range of banking activities, andoffers most of the types of banking services of a commercial bank, over thepast three years it has derived much of its profitability and differentiateditself from its competitors through (i) commercial and real estate loansguaranteed by the Small Business Administration (“SBA”), (ii) sponsorshipof credit card and debit card programs and (iii) credit card depositoryservices for merchants.

 

The primary issue that affected the Corporationin 2009 was the depressed economic conditions and related stress in real estatemarkets. The Corporation focused much of its efforts on managing thedeterioration of asset quality resulting from the effect that deterioratingeconomic conditions had on loans made primarily to residential real estatedevelopment projects. The increase in the Corporation’s provision for loanlosses ($3,368,000 in 2009 compared to $1,132,000 in 2008) was largely due toasset quality issues related to this market segment.

 

Management’s efforts focused on identifyingpotentially weak credits as early as possible, which enabled a proactive andaggressive approach to managing these credits and the development of workoutstrategies as appropriate.  Nonetheless,loans 30 days past due increased from $6,925,000 (4.1% of total loans) at December 31,2008 to $8,190,000 (4.9% of total loans) at December 31, 2009.  Past due loans increased during this periodby $1,265,000 or 18.3%.  During the sameperiod, non-performing loans (non-accrual loans and troubled debtrestructurings) increased from $7,091,000 (4.8% of total loans) to $8,884,000(5.3% of total loans) at December 31, 2009. Of the non-performing loansoutstanding at December 31, 2009, $5,137,000 or 57.8% were secured by realestate (net of any charge-offs previously taken).  Total past due loans and non-performing loansare net of the guaranteed portion of SBA loans totaling $1,636,000 and$1,421,000, respectively.  Managementbelieves the presence of real estate collateral mitigates the level of expectedloss though the level of mitigation is uncertain due to the difficultyascertaining 

 

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real estate values at this time.

 

Management utilized a pricing discipline andother strategies to offset pressure on the Corporation’s net yield on earningassets created by declining interest rates and an increase in non-performingloans.  To combat this and other adversefactors, Management’s efforts to improve its net yield on earning assetsincluded the development of a loan pricing model, establishing floors onvariable rate loan products, increased investment in tax free municipalsecurities, increased efforts to attract lower cost checking accounts andincreased use of competitively priced out-of-area deposits and Federal ReserveBank borrowings.  The Corporation’stax-equivalent net yield on earning assets increased to 3.1% for 2009 comparedto 2.9% for 2008.  The tax-equivalent netyield on earning assets was affected in 2008 by the increase in loans beingplaced on non-accrual during the year. Non-accrual loans totaled $8,884,000 atyear-end 2009 compared to $7,091,000 at year-end 2008, an increase of $1,793,000or 25.3%.  The increase in non-accrualloans resulted from slowing economic activity and a depressed real estatemarket.

 

The Bank has providedsponsorship of third party credit card and debit card programs since August 2002.  The Bank gave notice in June 2008 to thethird-party card vendors that it will reduce its sponsorship of credit card andstored value card programs, terminating sponsorship agreements on all programsexcept a drug manufactures’ rebate card program.  The characteristics of the drug manufactures’rebate card program significantly reduces the level of requiredmonitoring.  The Bank decided to continueits sponsorship of a debit card program which issues payroll cards.  The Bank decided to continue its sponsorshipof one credit card program in order to preserve the third party’sindemnification of the Bank against potential expenses and/or liabilities.  The Bank also decided to grant extensions ofits sponsorship of one credit card program to allow time for the finalresolution of issues raised by the FDIC as further discussed under “RegulatoryEnforcement Powers”.  Extension of theprogram sponsorship is considered quarterly with the third party paying anextension fee each time an extension is granted.  The Bank’s sponsorship of the terminatedprograms ended in 2009.    The Bank hasbeen named as a defendant in a lawsuit brought by one of the third-party creditcard companies, seeking to compel the Bank to continue its sponsorship for aperiod of time.  (See “Item 3. LegalProceedings” for further discussion.)

 

The Bank’s revenues,consisting of a monthly fee per card or a minimum monthly fee, from the creditcard programs were $1,075,000, $514,000 and $684,000 in 2009, 2008 and 2007,respectively.  The 2007 revenues included$204,000 in transfer fees received as a result of a card portfolio beingtransferred to another financial institution. The Bank’s revenues from the credit card programs in 2009 increased dueto the collection of quarterly extension fees paid by one of the programs.   The Bank’s revenues, consisting of a monthlyfee per card or a minimum monthly fee, from the debit card programs were$81,000, $155,000 and $293,000 in 2009, 2008 and 2007, respectively.

 

**Northern California Bancorp, Inc.Trust I**

 

On March 27, 2003, Northern California Bancorp, Inc.Trust I, a Delaware statutory business trust and a wholly owned subsidiary ofthe Corporation (“Trust I”), issued an aggregate of $3.0 million of principalamount of Floating Rate TRUPSâ (Capital Trust Pass-through Securitiesof the Trust) (the “Trust Preferred Securities”).  The securities issued by Trust I are fullyguaranteed by the Corporation with respect to distributions and amounts payableupon liquidation, redemption or repayment. The entire proceeds to Trust I from the sale of the Trust PreferredSecurities were used by Trust I in order to purchase $3.0 million in principalamount of the Floating Rate Junior Subordinated Deferrable Interest Debenturesdue 2033 issued by the Corporation (the 

 

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“Subordinated Debt Securities”).

 

Pursuantto Financial Accounting Standards Board (FASB) issued ASC 810-10 (formerlyinterpretation FIN 46(R)) entitled “Consolidation of Variable InterestEntities,” Trust I is not reflected on a consolidated basis in our consolidatedfinancial statements.

 

The Subordinated Debt Securities bear a variableinterest rate equal to the three-month ****London************Interbank************Offered************Rate**** (“LIBOR”) plus 3.25%.  The effective rate at December 31, 2009was 3.53%.  Total broker and legal costsassociated with the issuance of $115,000 are being amortized over a 30 yearperiod.

 

The Corporation exercisedits rights in accordance with Section 2.11 Extension of Interest PaymentPeriod of the Indentures dated March 27, 2003 for Northern CaliforniaBancorp, Inc. Trust I to defer interest payments for an undeterminedperiod of time, not to exceed twenty (20) consecutive quarterly payments.  The deferral of interest payments on NorthernCalifornia Bancorp, Inc. Trust I was effective with the October 7,2009 interest payment.  At December 31,2009 accrued and unpaid interest totaled $60,000.

 

**Northern California Bancorp, Inc. Trust II**

 

On November 13,2003, Northern California Bancorp, Inc. Trust II, a Delawarestatutory business trust and a wholly owned subsidiary of the Corporation (“TrustII”), issued an aggregate of $5.0 million of principal amount of Floating RateTRUPSâ (the “Trust Preferred Securities-II”).   The securities issued by Trust II are fullyguaranteed by the Corporation with respect to distributions and amounts payableupon liquidation, redemption or repayment. The entire proceeds to Trust II from the sale of the Trust PreferredSecurities were used by Trust II in order to purchase $5.0 million in principalamount of the Floating Rate Junior Subordinated Deferrable Interest Debenturesdue 2033 issued by the Corporation (the “Subordinated Debt Securities-II”).

 

Pursuant to FinancialAccounting Standards Board (FASB) issued ASC 810-10 (formerly interpretationFIN 46(R)) entitled “Consolidation of Variable Interest Entities,” Trust II isnot reflected on a consolidated basis in our consolidated financial statements.

 

The Subordinated Debt Securities-II bear a variableinterest rate equal to the three-month LIBOR plus 2.85%.  The effective rate at December 31, 2009was 3.13%. Total broker and legal costs associated with the issuance of $54,000are being amortized over a 30 year period.

 

The Corporation hasexercised its rights in accordance with Section 2.11 Extension of InterestPayment Period of the Indentures dated November 13, 2003 for NorthernCalifornia Bancorp, Inc. Trust II to defer interest payments for anundetermined period of time, not to exceed twenty (20) consecutive quarterlypayments.  The deferral of interestpayments on Northern California Bancorp, Inc. Trust II was effective withthe November 8, 2009 interest payment. At December 31, 2009 accrued and unpaid interest totaled $65,000.

 

**EMPLOYEES**

 

At December 31,2009, the Corporation and the Bank employed a total of 56 full-time equivalentpersons.  Our employees are notrepresented by any union or other collective bargaining agreement and weconsider our relations with our employees to be excellent.

 

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**COMPETITION**

 

Allphases of the Bank’s business have been, since inception, and will continue tobe subject to significant competitive forces. Although the Bank has increasing recognition in its primary service areaof Monterey County as a whole, it nevertheless has to compete with otherindependent local banking institutions, including commercial banks and savingsand loan associations, as well as branch offices of regional and nationalcommercial banks, which have assets, capital and lending limits substantiallylarger than the Bank, as well as wider geographic markets, more supportservices and larger media advertising capabilities.  The Bank competes with respect to its lendingactivities, as well as in attracting demand deposits, with savings banks,savings and loan associations, insurance companies, regulated small loan companiesand credit unions, as well as securities brokerage offices which can issuecommercial paper and other securities (such as shares in money market funds).

 

Amongthe advantages such institutions have over the Bank are their ability tofinance wide ranging advertising campaigns and to allocate their investmentassets to regions of highest yields and demand. Many institutions offer certain services, such as trust services andinternational banking, which the Bank does not currently offer or plan to offer.  By virtue of their greater total capital,such institutions have substantially higher lending limits than the Bank (legallending limits to an individual customer being limited to a percentage of abank’s total capital accounts).  Thesecompetitors may intensify their advertising and marketing activities to counterany efforts by the Bank to further attract new business as a commercialbank.  In addition, as a result oflegislation enacted earlier in the decade, there is increased competitionbetween banks, savings and loan associations and credit unions for the depositand loan business of individuals.  Theseactivities may hinder the Bank’s ability to capture a significant market share.

 

Tocompete with the financial institutions in its primary service area, the Bankintends to use the flexibility which its independent status permits.  Its activities in this regard include anability and intention to respond quickly to changes in the interest rates paidon time and savings deposits and charged on loans, and to charges imposed ondepository accounts, so as to remain competitive in the market place.  It also will continue to emphasizespecialized services for the small business person and professional andpersonal contacts by the Bank’s officers, directors and employees.  If there are customers whose loan demandsexceed the Bank’s lending limits, the Bank has the ability to arrange for suchloans on a participation basis with other financial institutions.  No assurance can be given, however, that theBank’s efforts to compete with other financial institutions in its primaryservice area will be successful.

 

TheBank’s earnings depend largely on rate differentials.  In general, the difference between theinterest rate paid by the Bank on its deposits and its other borrowings, andthe interest rate received by the Bank on loans extended to its customers andsecurities held in the Bank’s portfolio, comprise the major portion of the Bank’searnings.  These rates are highlysensitive to many factors that are beyond the control of the Bank.  Accordingly, the earnings and growth of theBank are subject to the influence of domestic and foreign economic conditions,including inflation, recession and unemployment.

 

Monetaryand fiscal policies of the federal government and the policies of regulatoryagencies, particularly the Federal Reserve Board, also impact on the Bank’sbusiness.  The Federal Reserve Boardimplements national monetary policies (with objectives such as curbinginflation and combating recession) by its open-market operations in U.S.Government securities, by adjusting the required level of reserves forfinancial intermediaries subject to its reserve requirements and by varying thediscount rates applicable to borrowings by depository institutions.  The actions of the

 

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FederalReserve Board in these areas influence the growth of bank loans, investmentsand deposits and also affect interest rates charged on loans and paid ondeposits.  The nature and impact of anyfuture changes in monetary policies cannot be predicted.

 

**SUPERVISIONAND REGULATION**

 

**TheCorporation**

 

On December 29,1995, after receipt of appropriate approvals, the Corporation acquired the Bankthrough a reverse triangular merger (the “Merger”).  As a result, byoperation of law, each outstanding share of common stock of the Bank prior tothe Merger was converted into a share of common stock of the Corporation, whilethe Corporation became the sole owner of the newly issued shares of commonstock of the Bank.

 

The Bank HoldingCompany Act of 1956, as amended, places the Corporation under the supervisionof the Board of Governors of the Federal Reserve System (the “FRB”). TheCorporation must generally obtain the approval of the FRB before acquiring allor substantially all of the assets of any bank, or ownership or control of anyvoting securities of any bank if, after giving effect to such acquisition, theCorporation would own or control more than 5% of the voting shares of suchbank.

 

A bank holdingcompany is generally prohibited from engaging in, or acquiring direct orindirect control of more than 5% of the voting shares of any company engaged innon-banking activities unless the FRB, by order or regulation, has found suchactivities to be so closely related to banking, managing or controlling banksas to be a proper incident thereto. In making such determinations, the FRBconsiders whether the performance of such activities by a bank holding companywould offer advantages to the public, which outweigh possible adverse effects.

 

The FRB’sRegulation “Y” sets out the non-banking activities that are permissible forbank holding companies under the law, subject to the FRB’s approval inindividual cases.  Most of these activities are now permitted forCalifornia banks that are well-capitalized.   The Corporation and itssubsidiaries are also subject to certain restrictions with respect to engagingin the underwriting, public sale and distribution of securities.  TheGramm-Leach-Bliley Act did three fundamental things: 1) it repealed keyprovisions of the Glass Steagal Act to permit commercial banks to affiliatewith investment banks, 2) it substantially modified the Bank Holding CompanyAct of 1956 to permit companies that own commercial banks to engage in any typeof financial activity, and 3) it allowed subsidiaries of banks to engage in abroad range of financial activities that are not permitted by banks. Management believes the Act has resulted in increased competition for financialservices.

 

The Corporation isrequired to file reports with the FRB and provide such additional informationas the FRB may require. The FRB also has the authority to examine theCorporation and each of its subsidiaries with the cost thereof borne by theCorporation.  Under California banking law, the Corporation and itssubsidiaries are also subject to examination by, and may be required to filereports with, the Commissioner of the Department of Financial Institutions.

 

The Corporationand any subsidiaries which it may acquire or organize will be deemed affiliatesof the Bank within the meaning of the Federal Reserve Act.  Pursuantthereto, loans by the Bank to affiliates, investments by the Bank in affiliates’stock, and taking affiliates’ stock by the Bank as collateral for loans to anyborrower is limited to 10% of the Bank’s capital, in the case of

 

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any one affiliate, and islimited to 20% of the Bank’s capital, in the case of all affiliates. Federal and State law place other limitations on transactions between the Bankand its affiliates designed to ensure that the Bank receives treatment in suchtransactions comparable to that available from unaffiliated third parties.

 

The Corporationand its subsidiaries are prohibited from engaging in certain tie-in arrangementsin connection with any extension of credit, sale or lease of property orfurnishing of services.  For example, with certain exceptions, the Bankmay not condition an extension of credit on a customer’s obtaining otherservices provided by it, the Corporation or any other subsidiary, or on apromise from its customer not to obtain other services from a competitor.

 

Future offers orsales of the stock of the Corporation will be subject to the registrationrequirements of the Securities Act of 1933, and qualification under theCalifornia Corporate Securities Act of 1968, and possibly other state Blue Skylaws (unless an exemption is available).

 

**RecentRegulatory Developments**

 

In light of current conditions in the global financial markets and theglobal economy, legislators and banking regulators have increased their focuson the financial services industry. Proposals for legislation that couldsubstantially intensify the regulation of the financial services industry areexpected to be introduced in the U.S. Congress and in state legislatures. Theagencies regulating the financial services industry also adopt changes to theirregulations. Substantial regulatory and legislative initiatives, including acomprehensive overhaul of the regulatory system in the U.S., are possible inthe months or years ahead. Any such action could have a materially adverseeffect on our business, financial condition and results of operations.

 

Recent months have already seen an unprecedented number of governmentinitiatives designed to respond to the stresses experienced in financialmarkets.  In response to the financialcrises affecting the banking system and financial markets and going concernthreats to investment banks and other financial institutions, the EmergencyEconomic Stabilization Act of 2008 (“EESA”) was signed into law on October 3,2008.  Pursuant to EESA, the U.S.Treasury was given the authority to, among other things, purchase up to $700billion of mortgages, mortgage-backed securities and certain other financialinstruments from financial institutions for the purpose of stabilizing andproviding liquidity to the U.S. financial markets. Pursuant to EESA, the U.S.Treasury established the Troubled Asset Relief Program (“TARP”) and has sinceinjected capital into many financial institutions under the TARP CapitalPurchase Program (“TARP CPP”).  Neitherthe Corporation nor the Bank has participated in TARP CPP.

 

On February 10, 2009, the U.S. Treasury announced the FinancialStability Plan (“FSP”) which, among other things, established a new CapitalAssistance Program (“CAP”) through which eligible banking institutions willhave access to U.S. Treasury capital as a bridge to private capital untilmarket conditions normalize, and extended the Debt Guarantee Program  of the FDIC’s Temporary Liquidity GuaranteeProgram (“TLGP”) to October 31, 2009 pursuant to which the FDIC fullyguaranteed certain newly issued senior unsecured debt and provided full FDICdeposit insurance coverage for certain accounts, including noninterest-bearingtransaction deposit accounts. The FSP also extended the Transaction AccountGuarantee Program of the TLGP to June 30, 2010.   As a complement to CAP, a new Public-PrivateInvestment Fund on an initial scale of up to $500 billion, with the potentialto expand up to $1 trillion, was announced to catalyze the removal of legacyassets from the balance sheets of financial institutions. This proposed fundwill combine public and private capital with government financing to help freeup capital to support new lending. In addition, the existing Term Asset-BackedSecurities Lending Facility (“TALF”) would be

 

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expanded(up to $1 trillion) in order to reduce credit spreads and restart thesecuritized credit markets that in recent years supported a substantial portionof lending to households, students, small businesses, and others. Furthermore,the FSP proposed a new framework of governance and oversight to help ensurethat banks receiving funds are held responsible for appropriate use of thosefunds through stronger conditions on lending, dividends and executivecompensation along with enhanced reporting to the public. The Bank participatesin the Transaction Account Guarantee Program under the TLGP.

 

On February 17, 2009, the American Recovery and Reinvestment Act of2009 (“ARRA”) was signed into law.  ARRAis intended to provide tax breaks for individuals and businesses, direct aid todistressed states and individuals, and provide infrastructure spending.  In addition, ARRA imposes new executivecompensation and expenditure limits on all previous and future TARP CPP recipientsand expands the class of employees to whom the limits and restrictionsapply.  ARRA also provides theopportunity for additional repayment flexibility for existing TARP CPPrecipients.  Among other things, ARRA prohibitsthe payment of bonuses, other incentive compensation and severance to certainhighly paid employees (except in the form of restricted stock subject tospecified limitations and conditions), and requires each TARP CPP recipient tocomply with certain other executive compensation related requirements.  These provisions modify the executivecompensation provisions that were included in EESA, and in most instances applyretroactively for so long as any obligation arising from financial assistanceprovided to the recipient under TARP remains outstanding.  On June 10, 2009, the U.S. Treasuryissued final regulations that implement and clarify the provisions of ARRArelating to corporate governance and executive compensation limitations.

 

In addition, ARRA directs the Secretary of the U.S. Treasury to reviewpreviously-paid bonuses, retention awards and other compensation paid to thesenior executive officers and certain other highly-compensated employees ofeach TARP CPP recipient to determine whether any such payments were excessive,inconsistent with the purposes of ARRA or the TARP, or otherwise contrary tothe public interest. If the Secretary determines that any such payments havebeen made by a TARP CPP recipient, the Secretary will seek to negotiate withthe TARP CPP recipient and the subject employee for appropriate reimbursementsto the U.S. government (not the TARP CPP recipient) with respect to any suchcompensation or bonuses. ARRA also permits the Secretary, subject toconsultation with the appropriate federal banking agency, to allow a TARP CPPrecipient to repay any assistance previously provided to such TARP CPPrecipient under the TARP, without regard to whether the TARP CPP recipient hasreplaced such funds from any source, and without regard to any waiting period.Any TARP CPP recipient that repays its TARP assistance pursuant to thisprovision would no longer be subject to the executive compensation provisionsunder ARRA.

 

On February 18, 2009, the U.S. Treasury announced the HomeownerAffordability and Stability Plan (“HASP”), which proposes to providerefinancing for certain homeowners, to support low mortgage rates bystrengthening confidence in Fannie Mae and Freddie Mac, and to establish aHomeowner Stability Initiative to reach at-risk homeowners. Among other things,the Homeowner Stability Initiative would offer monetary incentive to mortgageservicers and mortgage holders for certain modifications of at-risk loans, andwould establish an insurance fund designed to reduce foreclosures.

 

It is not clear at this time what impact EESA, the CPP, the TLGP, theFSP, ARRA, HASP, or other liquidity and funding initiatives will have on thefinancial markets and the other difficulties described above, including thehigh levels of volatility and limited credit availability currently beingexperienced, or on the U.S. banking and financial industries and the broaderU.S. and global economies. Failure of these programs to address the issuesnoted above could have an adverse effect 

 

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onthe Bank and its business.

 

Moreover, in light of current conditions in the global financial marketsand the global economy, legislators and banking regulators have increased theirfocus on the financial services industry. Proposals for legislation that couldsubstantially intensify the regulation of the financial services industry areexpected to be introduced in the U.S. Congress and in state legislatures. Theagencies regulating the financial services industry also adopt changes to theirregulations. Substantial regulatory and legislative initiatives, including acomprehensive overhaul of the regulatory system in the U.S., are possible inthe months or years ahead. Any such action could have a materially adverseeffect on the business, financial condition and results of operations of theBank.

 

Sarbanes-Oxley Actof 2002

 

TheSarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”) was enacted to increase corporateresponsibility, provide for enhanced penalties for accounting and auditingimproprieties at publicly traded companies, and protect investors by improvingthe accuracy and reliability of disclosures pursuant to the securities laws.Sarbanes-Oxley includes important new requirements for public companies in theareas of financial disclosure, corporate governance, and the independence,composition and responsibilities of audit committees. Among other things*,* Sarbanes-Oxley mandates chief executiveand chief financial officer certifications of periodic financial reports,additional financial disclosures concerning off-balance sheet items, andspeedier transaction reporting requirements for executive officers, directorsand 10% shareholders. In addition, penalties for non-compliance with theExchange Act were heightened. SEC rules promulgated pursuant toSarbanes-Oxley impose obligations and restrictions on auditors and auditcommittees intended to enhance their independence from management, and includeextensive additional disclosure, corporate governance and other related rules.Sarbanes-Oxley represents significant federal involvement in matterstraditionally left to state regulatory systems, such as the regulation of theaccounting profession, and to state corporate law, such as the relationshipbetween a Board of Directors and management and between a Board of Directorsand its committees.

 

TheCorporation has not experienced any significant difficulties in complying withSarbanes-Oxley. However, the Corporation has incurred and expects to continueto incur significant costs in the future in connection with compliance with Section 404of Sarbanes-Oxley, which starting with the year ended December 31, 2007,requires management to undertake an assessment of the adequacy andeffectiveness of our internal controls over financial reporting and willrequire our auditors to attest to, and report on, management’s assessment andthe operating effectiveness of these controls. The SEC has extended thecompliance date for the auditor attestation requirements so that the Corporationwill not be required to comply until its fiscal year ending December 31,2010.

 

**MontereyCounty Bank**

 

Both federal andstate laws provide extensive regulation of the banking business.  Stateand federal statutes and regulations apply to many aspects of the Bank’soperations, including minimum capital requirements, reserves against deposits,interest rates payable on deposits, loans, investments, mergers andacquisitions, borrowings, dividends and locations of branch offices. The DFIand the FDIC provide primary supervision, periodic examination and regulationof the Bank.

 

The FDIC, through itsDeposit Insurance Fund (the “DIF”), insures the Bank’s deposits.  Previously, the maximum deposit insurancecoverage was $100,000 per depositor, except that individual retirement accountswere insured up to a maximum of $250,000 per depositor.  Effective 

 

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November 21, 2008and until December 31, 2013, the FDIC expanded deposit insurance limitsunder the FDIC’s TLGP to $250,000 per depositor for certain accounts andunlimited coverage for noninterest-bearing transaction accounts held atfinancial institutions which have not opted out of the Program. On January 1,2014, these increased limits on deposit insurance coverage will return to$100,000 for all deposit categories except individual retirement accounts andcertain other retirement accounts, which will continue to be insured up to$250,000 per depositor.  For thisprotection, the Bank, like all insured banks, pays a quarterly statutoryassessment and is subject to the rules and regulations of the FDIC. Although the Bank is not a member of the Federal Reserve System, certainregulations of the Federal Reserve Board also apply to its operations.

 

California lawrestricts the amount available for cash dividends by state-chartered banks tothe lesser of retained earnings or the bank’s net income for its last threefiscal years (less any distributions to shareholders made during suchperiod).  Cash dividends may also be paid in an amount not exceeding thenet income for such bank’s last preceding fiscal year after obtaining the priorapproval of the Commissioner.  The FDICalso has authority to prohibit the Bank from engaging in unsafe or unsoundpractices.  The FDIC can use this power, under certain circumstances, torestrict or prohibit a bank from paying dividends.

 

Federal lawimposes restrictions on banks with regard to transactions with affiliates,including any extensions of credit to, or the issuance of a guarantee or letterof credit on behalf of, its affiliates, as well as the purchase of orinvestments in stock or other securities thereof, or the taking of such securitiesas collateral for loans, and the purchase of assets from affiliates. These restrictions have the effect of preventing affiliates (such as theCorporation) from borrowing from the Bank unless the loans are secured bymarketable obligations of designated amounts.  Secured loans andinvestments by the Bank are limited to 10% of the Bank’s capital and surplus(as defined by federal regulations) in the case of any one affiliate, and 20%thereof in the case of all affiliates.  California law also imposes certainrestrictions with respect to transactions involving other controlling personsof the Bank.

 

From time to time,legislation is enacted which has the effect of increasing the cost of doingbusiness, limiting or expanding permissible activities or affecting thecompetitive balance between banks and other financial intermediaries. Proposals to change the laws and regulations governing the operations andtaxation of banks, bank holding companies and other financial intermediariesare frequently made in Congress, in the California legislature and beforevarious bank regulatory and other professional agencies. The Bank cannotpredict what, if any legislation or regulations will be enacted, or the impactthereof on its business and profitability.

 

**CapitalAdequacy Standards**

 

Governmentagencies have traditionally regulated bank capital through explicit andimplicit guidelines and rules.  State law requires “adequate” capital,without objective definition.  Federal law and regulations require minimumlevels of risk-based and so-called “Leverage” capital.

 

FDIC guidelinesimplement the risk-based capital requirements. The guidelines establish asystematic analytical framework that makes regulatory capital requirements moresensitive to differences in risk profiles (using the rough measures set forththerein) among banking organizations, take certain off-balance sheet items intoaccount in assessing capital adequacy and minimize disincentives to holdingliquid, low-risk assets. Under these guidelines, assets and credit equivalentamounts of off-balance sheet items, such as letters of credit and outstandingloan 

 

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commitments, are assignedto one of several risk categories, which range from 0% for risk-free assets,such as cash and certain U.S. government securities, to 100% for relativelyhigh-risk assets, such as loans and investments in fixed assets, premises andother real estate owned. The aggregate dollar amount of each category is thenmultiplied by the risk-weight associated with that category. The resultingweighted values from each of the risk categories are then added together todetermine the total risk-weighted assets.

 

A bankingorganization’s risk-based capital ratios are obtained by dividing itsqualifying capital by its total risk adjusted assets, including dollarequivalents for certain off-balance sheet assets.

 

The guidelinesrequire a minimum ratio of qualifying total capital to risk-weighted assets of8%, of which at least 4% must consist of Tier I capital.  Higherrisk-based ratios are required to be considered “well capitalized” under promptcorrective action provisions.

 

A bankingorganization’s qualifying total capital consists of two components: Tier 1capital (core capital) and Tier 2 capital (supplementary capital).  Tier 1capital consists primarily of common stock, related surplus and retainedearnings, qualifying noncumulative perpetual preferred stock and minorityinterests in the equity accounts of consolidated subsidiaries. Trust preferredsecurities qualify as Tier 1 capital up to a maximum of 25% of capital forholding companies only.  Any additional portion will qualify as Tier 2capital for holding companies only.  Intangibles, such as goodwill, aregenerally deducted from Tier 1 capital; however, purchased mortgage servicingrights and purchased credit card relationships may be included, subject tocertain limitations. At least 50% of the banking organization’s totalregulatory capital must consist of Tier 1 capital.

 

Tier 2 capital mayconsist of (i) the allowance for loan and lease losses in an amount up to1.25% of risk-weighted assets; (ii) cumulative perpetual preferred stockand long-term preferred stock and related surplus; (iii) hybrid capitalinstruments (instruments with characteristics of both debt and equity),perpetual debt and mandatory convertible debt securities; and (iv) eligibleterm subordinated debt and intermediate-term preferred stock with an originalmaturity of five years or more, including related surplus, in an amount up to50% of Tier 1 capital. The inclusion of the foregoing elements of Tier 2capital is subject to certain requirements and limitations of the federal bankingagencies.

 

The FDIC imposes aminimum leverage ratio of Tier I capital to average total assets of 3% for thehighest rated banks, and 4% for all other banks.  Institutionsexperiencing or anticipating significant growth or those with other than minimumrisk profiles are expected to maintain capital at least 100-200 basis pointsabove the minimum level.

 

In addition, theFRB and the FDIC have issued or proposed rules to take account of interestrate risk, concentration of credit risk and the risks of nontraditionalactivities in calculating risk-based capital.

 

For capitaladequacy purposes, deferred tax assets that can be realized from taxes paid inprior carry-back years, and from the future reversal of temporary differences,are generally unlimited.  However, deferred tax assets that can only berealized through future taxable earnings, including the implementation of a taxplanning strategy, count toward regulatory capital purposes only up to thelesser of (i) the amount that can be realized within one year of thequarter-end report date or (ii) 10% of Tier I capital.  The amount ofdeferred taxes in excess of this limit, if any, would be deducted from Tier Icapital and total assets in regulatory capital calculations.

 

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Effective January 17,1995, the federal banking agencies issued a final rule relating to capitalstandards and the risks arising from the concentration of credit andnontraditional activities.  Institutions which have significant amounts oftheir assets concentrated in high risk loans or nontraditional bankingactivities and who fail to adequately manage these risks, will be required toset aside capital in excess of the regulatory minimums.  The federalbanking agencies have not imposed any quantitative assessment for determiningwhen these risks are significant, but have identified these issues as importantfactors they will review in assessing an individual bank’s capitaladequacy.  Management of the Corporation does not believe that the Bank’sassets and activities, as currently structured, would lead the FDIC to requireadditional capital under this rule.

 

Future changes inregulations or practices could further reduce the amount of capital recognizedfor purposes of capital adequacy.  Such a change could affect the abilityof the Bank to grow and could restrict the amount of profits, if any, availablefor the payment of dividends.

 

**Prompt CorrectiveAction and Other Enforcement Mechanisms**

 

Under Section 38of the Federal Deposit Insurance Act (“FDIA”), as added by the Federal DepositInsurance Corporation Improvement Act of 1991 (“FDICIA”), each federal bankingagency is required to implement a system of prompt corrective action forinstitutions which it regulates.  The federal banking agencies havepromulgated substantially similar regulations to implement this system ofprompt corrective action.  Under the regulations, an institution shall generallybe deemed to be: (i) “well capitalized” if it has a total risk-basedcapital ratio of 10.0% or more, has a Tier I risk-based capital ratio of6.0% or more, has a Tier I leverage capital ratio of 5.0% or more and isnot subject to specified requirements to meet and maintain a specific capitallevel for any capital measure; (ii) “adequately capitalized” if it has atotal risk-based capital ratio of 8.0% or more, a Tier I risk-basedcapital ratio of 4.0% or more and a Tier I leverage capital ratio of 4.0%or more (3.0% under certain circumstances) and does not meet the definition of “wellcapitalized;” (iii) “undercapitalized” if it has a total risk-basedcapital ratio that is less than 8.0%, a Tier I risk-based capital ratio that isless than 4.0% or a Tier I leverage capital ratio that is less than 4.0%(3.0% under certain circumstances); (iv) “significantly undercapitalized”if it has a total risk-based capital ratio that is less than 6.0%, aTier I risk-based capital ratio that is less than 3.0% or a Tier Ileverage capital ratio that is less than 3.0%; and (v) “criticallyundercapitalized” if it has a ratio of tangible equity to total assets that isequal to or less than 2.0%.

 

Section 38 ofthe FDIA and the implementing regulations also provide that a federal bankingagency may, after notice and an opportunity for a hearing, reclassify a wellcapitalized institution as adequately capitalized and may require an adequatelycapitalized institution or an undercapitalized institution to comply with supervisoryactions as if it were in the next lower category if the institution is in anunsafe or unsound condition or engaging in an unsafe or unsound practice. (The FDIC may not, however, reclassify a significantly undercapitalizedinstitution as critically undercapitalized.)

 

An institutiongenerally must file a written capital restoration plan which meets specifiedrequirements, as well as a performance guaranty by each company that controlsthe institution, with the appropriate federal banking agency within 45 days ofthe date that the institution receives notice or is deemed to have notice thatit is undercapitalized, significantly undercapitalized or criticallyundercapitalized.  Immediately upon becoming undercapitalized, aninstitution shall become subject to the provisions of Section 38 of theFDIA, which sets forth various mandatory and discretionary restrictions on itsoperations.

 

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At December 31,2009, the Bank met the tests to be categorized as “well capitalized” under theprompt corrective action regulations of the FDIC.

 

**Safetyand Soundness Standards**

 

Federal lawrequires the federal banking regulatory agencies to prescribe, by regulation,standards for all insured depository institutions relating to: (i) internalcontrols, information systems and internal audit systems; (ii) loandocumentation; (iii) credit underwriting; (iv) interest rate riskexposure; (v) asset growth; and (vi) compensation, fees andbenefits.  The federal banking agencies recently adopted final regulationsand Interagency Guidelines Prescribing Standards for Safety and Soundness (the “Guidelines”)to implement safety and soundness standards required by the FDIA.  TheGuidelines set forth the safety and soundness standards that the federalbanking agencies use to identify and address problems at insured depositoryinstitutions before capital becomes impaired.  The agencies also proposedasset quality and earnings standards which, if adopted in final, would be addedto the Guidelines.  Under the final regulations, if the FDIC determinesthat the Bank fails to meet any standard prescribed by the Guidelines, theagency may require the Bank to submit to the agency an acceptable plan toachieve compliance with the standard, as required by the FDIA.  The finalregulations establish deadlines for the submission and review of such safetyand soundness compliance plans.

 

**FDICInsurance and Insurance Assessments**

 

Banks and thrifts havehistorically paid varying amounts of premiums on deposits for federal depositinsurance depending upon a risk-based system which evaluated the institution’sregulatory and capital adequacy ratings. The FDIC operated two separate insurance funds, the Bank Insurance Fund(“BIF”) and the Savings Association Insurance Fund (“SAIF”).

 

As a result of theFederal Deposit Insurance Reform Act of 2006 and regulations adopted by theFDIC effective as of November 2, 2007: (i) the BIF and the SAIF havebeen merged into the Deposit Insurance Fund (the “DIF”); (ii) the $100,000insurance level has been indexed to reflect inflation (the first adjustment forinflation will be effective January 1, 2011 and thereafter adjustmentswill occur every 5 years); (iii) deposit insurance coverage for retirementaccounts has been increased to $250,000, and will also be subject to adjustmentevery five years; (iv) banks that historically have capitalized the BIFare entitled to a one-time credit which can be used to off-set premiumsotherwise due (this addresses the fact that institutions that have grownrapidly have not had to pay deposit premiums); (v) a cap on the level ofthe DIF has been imposed and dividends will be paid when the DIF grows beyond aspecified threshold; and (vi) the previous risk-based system for assessingpremiums has been revised.

 

Effective January 1,2007, the FDIC utilized a risk-based assessment system to set semi-annualinsurance premium assessments which categorizes banks into four risk categoriesbased on capital levels and supervisory “CAMELS” ratings and named them RiskCategories I, II, III and IV. The “CAMELS” rating system is based upon an evaluation of the fivecritical elements of an institution’s operations: Capital adequacy, Assetquality, Management, Earnings, Liquidity, and Sensitivity to risk.  This rating system is designed to take intoaccount and reflect all significant financial and operational factors financialinstitution examiners assess in their evaluation of an institution’sperformance.  The following table setsforth these four Risk Categories:

 

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| ** **                    | ** ** | **Supervisory Subgroup** | ** ** |
|-------------------------------|------------|--------------------------|------------|
| **Capital  Group**            | ** ** | **A**                    | ** ** | **B** | ** ** | **C** | ** ** |
| **1. Well Capitalized**       | ** ** | **I**                    | ** ** | ** ** | ** ** | **III** | ** ** |
| **2. Adequately Capitalized** | ** ** | ** **               | ** ** | **II** | ** ** | ** ** | ** ** |
| **3. Undercapitalized**       | ** ** | **III**                  | ** ** | **IV** | ** ** |

** **

Within Risk Category I,the assessment system combines supervisory ratings with other risk measures todifferentiate risk.  For mostinstitutions, the assessment system combines CAMELS component ratings withfinancial ratios to determine an institution’s assessment rate.  For large institutions that have long-termdebt issuer ratings, the new assessment system differentiates risk by combiningCAMELS component ratings with those ratings. For large institutions within Risk Category I, initial assessment ratedeterminations may be modified within limits upon review of additional relevantinformation.  The new assessment systemassess those within Risk Category I that pose the least risk a minimumassessment rate and those that pose the greatest risk a maximum assessment ratethat is two basis points higher.  Aninstitution that poses an intermediate risk within Risk Category I will becharged a rate between the minimum and maximum that will vary incrementally byinstitution.

 

On February 27,2009, the FDIC adopted final rules modifying the risk-based assessmentsystem and setting initial base assessment rates that began on April 1,2009.  Under these new rules, riskassessments for small Risk Category I institutions and large Risk Category Iinstitutions with no long-term debt rating will include a consideration of suchinstitution’s adjusted brokered deposit ratio. The adjusted brokered depositratio affects institutions whose brokered deposits are more than 10% ofdomestic deposits and whose total assets are more than 40% greater than theywere four years previously. The adjusted brokered deposit ratio excludescertain reciprocal deposits for institutions in Risk Category I. Brokereddeposits that consist of balances swept into an insured institution areincluded in the adjusted brokered deposit ratio for all institutions.

 

Further, the new rules revisedthe method for calculating the assessment rate for a large Risk Category Iinstitution with a long-term debt issuer rating so that it equally weights theinstitution’s weighted average CAMELS component ratings, its long-term debtissuer ratings and the financial ratios method assessment rate. The final rule updatesthe uniform amount and the pricing multipliers for the weighted average CAMELScomponent ratings and financial ratios method. It also increases the maximumpossible large bank adjustment from 0.5 basis point to 1.0 basis point.

 

These new rules setforth three possible adjustments to an institution’s initial base assessmentrate: (i) a decrease of up to five basis points for long-term unsecureddebt, including senior unsecured debt (other than debt guaranteed under theTemporary Liquidity Guarantee Program) and subordinated debt and, for smallinstitutions, a portion of Tier 1 capital; (ii) an increase not to exceed50% of an institution’s assessment rate before the increase for securedliabilities in excess of 25% of domestic deposits; and (ii) for non-RiskCategory I institutions, an increase not to exceed 10 basis points for brokereddeposits in excess of 10% of domestic deposits.

 

Under these new rules,the FDIC adopted new initial base assessment rates as of April 1, 2009, asfollows, expressed in terms of cents per $100 in insured deposits:

 

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Initial Base AssessmentRates

 
| ** **                      | ** ** | **Risk Category** | ** ** |
|---------------------------------|------------|-------------------|------------|
| ** **                      | ** ** | **I ***      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                      | ** ** | **Minimum**       | ** ** | **Maximum** | ** ** | **II** | ** ** | **III** | ** ** | **IV** | ** ** |
| Annual  Rates (in basis points) |       | 12                |       | 16 |   | 22 |   | 32 |   | 45 |   |

 

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*Initial base rates thatwere not the minimum or maximum rate will vary between these rates.

 

After applying allpossible adjustments, minimum and maximum total base assessment rates for eachRisk Category are as follows:

 

Total BaseAssessment Rates

 
| ** **                    | ** ** | **Risk  Category  I** | ** ** | **Risk  Category  II** | ** ** | **Risk  Category  III** | ** ** | **Risk  Category  IV** | ** ** |
|-------------------------------|------------|-----------------------|------------|------------------------|------------|-------------------------|------------|------------------------|------------|
| Initial base assessment  rate |       | 12 – 16          |       | 22                     |       | 32                      |       | 45                     |       |
| Unsecured debt  adjustment    |       | -5 – 0           |       | -5 – 0            |       | -5 – 0             |       | -5 – 0            |       |
| Secured liability  adjustment |       | 0 – 8            |       | 0 – 11            |       | 0 – 16             |       | 0 – 22.5          |       |
| Brokered deposit  adjustment  |       |                  |       | 0 – 10            |       | 0 – 10             |       | 0 – 10            |       |
| Total base assessment  rate   |       | 7 – 24           |       | 17 – 43           |       | 27 – 58            |       | 40 – 77.5         |       |

 

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* All amounts for allrisk categories are in basis points annually. Total base rates that are not theminimum or maximum rate will vary between these rates.

 

In addition, on February 27,2009, the FDIC adopted an interim rule that imposed a 20 basis pointemergency special assessment on all insured depository institutions on June 30,2009. The special assessment was collected on September 30, 2009, at thesame time that the risk-based assessments for the second quarter of 2009 werecollected. The interim rule also permits the FDIC to impose an emergencyspecial assessment of up to 10 basis points on all insured depositoryinstitutions whenever, after June 30, 2009, the FDIC estimates that theDIF reserve ratio will fall to a level that the FDIC believes would adverselyaffect public confidence or to a level close to zero or negative at the end ofa calendar quarter.

 

Effective November 21,2008 and until December 31, 2009, the FDIC expanded deposit insurancelimits for certain accounts under the FDIC’s TLGP.  Provided an institution has not opted out ofthe Temporary Liquidity Guarantee Program, the FDIC may (i) guarantee,through the earlier of maturity or June 30, 2012, certain newly issuedsenior unsecured debt issued by participating institutions on or after October 14,2008 and before June 30, 2009 and (ii) provide full FDIC depositinsurance coverage for noninterest-bearing transaction deposit accounts,Negotiable Order of Withdrawal (“NOW”) accounts paying less than 0.5% interestper annum and Interest on Lawyers Trust Accounts (IOLTAs) held at participatingFDIC-insured institutions through December 31, 2009. On May 20,2009, the Helping Families Save Their Homes Act extended the temporary increasein the standard maximum deposit insurance amount to $250,000 per depositorthrough December 31, 2013. The standard maximum deposit insurance amountwill return to $100,000 on January 1, 2014.The fee assessment for coverage of senior unsecureddebt ranges from 50 basis points to 100 basis points per annum, depending onthe initial maturity of the debt. The fee assessment for deposit insurancecoverage is 10 basis points per quarter on amounts in covered accountsexceeding $250,000.  On February 10,2009, the U.S. Treasury extended the TLGP to October 31, 2009 pursuant tothe Financial Stability Plan - Capital Assistance Program.  On August 26, 2009, theFDIC extended the TAGP portion of the TLGP for an additional six months,through June 30, 2010.  The Bank has not opted out ofthe TLGP.

 

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Effective November 17,2009 the FDIC amended its regulations requiring insured institutions to prepaytheir estimated quarterly risk-based assessments for the fourth quarter of2009, and for all of 2010, 2011, and 2012. The prepaid assessment for these periods were collected on December 30,2009, along with each institution’s regular quarterly risk-based depositinsurance assessment for the third quarter of 2009.  For purposes of estimating an institution’sassessments for the fourth quarter of 2009, and for all of 2010, 2011, and2012, and calculating the amount that an institution will prepay on December 30,2009, the institution’s assessment rate was its total base assessment rate ineffect on September 30, 2009.  On September 29,2009, the FDIC increased annual assessment rates uniformly by 3 basis pointsbeginning in 2011.  As a result, aninstitution’s total base assessment rate for purposes of estimating an institution’sassessment for 2011 and 2012 will be increased by an annualized 3 basis pointsbeginning in 2011.  Again for purposes ofcalculating the amount that an institution prepaid on December 30, 2009,an institution’s third quarter 2009 assessment base was increased quarterly ata 5% annual growth rate through the end of 2012.  The FDIC will begin to draw down aninstitution’s prepaid assessments on March 30, 2010, representing paymentfor the regular quarterly risk-based assessment for the fourth quarter of2009.  The Bank’s prepaid assessmenttotaled $1,816,000 and was paid on December 31, 2009.

 

The FDIC may terminateits insurance of deposits if it finds that the Bank has engaged in unsafe andunsound practices, is in an unsafe or unsound condition to continue operations,or has violated any applicable law, regulation, rule, order or conditionimposed by the FDIC.

 

The FinancingCorporation (“FICO”), established by the Competitive Equality Banking Act of1987, is a mixed-ownership government corporation whose sole purpose was tofunction as the financing vehicle for the Federal Savings and Loan InsuranceCorporation.  Effective December 12, 1991, as provided by theResolution Trust Corporation Refinancing, Restructuring and Improvement Act of1991, FICO’s ability to issue new debt was terminated.  Outstanding FICObonds, which are 30-year non-callable bonds with a principal amount ofapproximately $8.1 billion, mature in 2017 through 2019.

 

FICO hasassessment authority, separate from the FDIC’s authority to assess risk-basedpremiums for deposit insurance, to collect funds from FDIC-insured institutionssufficient to pay interest on FICO bonds.  The FDIC acts as collectionagent for FICO.  The FICO assessment rate is adjusted quarterly to reflectchanges in the assessment basis of the respective funds based on the quarterlyCall Report and the Thrift Financial Report submissions.  The FICO ratesare expressed as basis points per $100 of deposits.  The FICO quarterly rates for 2009 were 0.285,0.26, 0.26 and 0.255.  The FICO quarterly rate for the first and secondquarters of 2010 is 0.265 and 0.26, respectively.

 

**InterstateBanking and Branching**

 

On September 29,1994, the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994(the “Interstate Act”) was signed into law.  Under the Interstate Act,beginning one year after the date of enactment, a bank holding company that isadequately capitalized and managed may obtain regulatory approval to acquire anexisting bank located in another state without regard to state law.  Abank holding company would not be permitted to make such an acquisition if,upon consummation, it would control (a) more than 10% of the total amountof deposits of insured depository institutions in the United States or (b) 30%or more of the deposits in the state in which the bank is located.  Astate may limit the percentage of total deposits that may be held in that stateby any one bank or bank holding company if application of such limitation doesnot discriminate against out-of-state banks.  An out-of-state bank holdingcompany may not acquire a state bank in

 

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existence for less than aminimum length of time that may be prescribed by state law except that a statemay not impose more than a five year existence requirement.

 

The Interstate Actalso permitted, effective June 1, 1997, mergers of insured banks locatedin different states and conversion of the branches of the acquired bank intobranches of the resulting bank.  Each state may adopt legislation toprohibit interstate mergers after June 1, 1997 in that state or in otherstates by that state’s banks.  The same concentration limits discussed inthe preceding paragraph apply.  The Interstate Act also permits a nationalor state bank to establish branches in a state other than its home state ifpermitted by the laws of that state, subject to the same requirement and conditionsas for a merger transaction.

 

The Interstate Acthas increased competition in the Bank’s market areas, especially from largerfinancial institutions and their holding companies.

 

On October 2,1995, the “California Interstate Banking and Branching Act of 1995” (the “1995Act”) became effective.  The 1995 Act generally allows out-of-state banksto enter California by merging with, or purchasing, a California bank orindustrial loan company which is at least five years old.

 

**CommunityReinvestment Act and Fair Lending Developments**

 

The Bank issubject to certain fair lending requirements, reporting obligations involvinghome mortgage lending operations and Community Reinvestment Act (the “CRA”). The CRA generally requires the federal banking agencies to evaluate the recordof financial institutions in meeting the credit needs of their local community,including low and moderate income neighborhoods.  In addition tosubstantial penalties and corrective measures that may be required for aviolation of certain fair lending laws, the federal banking agencies may takecompliance with such laws and CRA into account when regulating and supervisingother activities.

 

In May, 1995, thefederal banking agencies issued final regulations which change the manner inwhich they measure a bank’s compliance with its CRA obligations.  Thefinal regulations adopt a performance-based evaluation system which bases CRAratings on an institution’s actual lending service and investment performancerather than the extent to which the institution conducts needs assessments,documents community outreach or complies with other proceduralrequirements.  In March 1994, the Federal Interagency Task Force onFair Lending issued a policy statement on discrimination in lending.  Thepolicy statement describes the three methods that federal agencies will use toprove discrimination: overt evidence of discrimination, evidence of disparatetreatment and evidence of disparate impact. Following the Bank’s most recent CRA examination, the Bank’s rating was “needsto improve.”  The rating is due primarilyto issues related to the Bank’s third party vendor programs.

 

**OtherRegulations and Policies**

 

The federalregulatory agencies have adopted regulations that implement Section 304 ofFDICIA which requires federal banking agencies to adopt uniform regulationsprescribing standards for real estate lending.  Each insured depositoryinstitution must adopt and maintain a comprehensive written real estate lendingpolicy, developed in conformance with prescribed guidelines, and each agencyhas specified loan-to-value limits in guidelines concerning various categoriesof real estate loans.

 

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Section 24 ofthe FDIA, as amended by the FDICIA, generally limits the activities and equityinvestments of FDIC-insured, state-chartered banks to those that arepermissible for national banks.  Under regulations dealing with equityinvestments, an insured state bank generally may not directly or indirectlyacquire or retain any equity investment of a type, or in an amount, that is notpermissible for a national bank.  An insured state bank is not prohibitedfrom, among other things, (i) acquiring or retaining a majority interestin a subsidiary, (ii) investing as a limited partner in a partnership thesole purpose of which is direct or indirect investment in the acquisition,rehabilitation or new construction of a qualified housing project, providedthat such limited partnership investments may not exceed 2% of the bank’s totalassets, (iii) acquiring up to 10% of the voting stock of a company thatsolely provides or reinsures directors’, trustees’ and officers’ liabilityinsurance coverage or bankers’ blanket bond group insurance coverage forinsured depository institutions, and (iv) acquiring or retaining thevoting shares of a depository institution if certain requirements are met.

 

FDIC regulationsimplementing Section 24 of the FDIA provide that an insuredstate-chartered bank may not, directly, or indirectly through a subsidiary,engage as “principal” in any activity that is not permissible for a nationalbank unless the FDIC has determined that such activities would pose no risk tothe insurance fund of which it is a member and the bank is in compliance withapplicable regulatory capital requirements.  Any insured state-charteredbank directly or indirectly engaged in any activity that is not permitted for anational bank must cease the impermissible activity.

 

**Effect ofGovernmental Monetary Policies**

 

The Corporation’s earnings are affected by domesticeconomic conditions and the monetary and fiscal policies of the United Statesgovernment and its agencies.  The FederalReserve’s monetary policies have had, and are likely to continue to have, animportant impact on the operating results of commercial banks through theFederal Reserve’s statutory power to implement national monetary policy inorder, among other things, to curb inflation or combat a recession.  The Federal Reserve, through its monetary andfiscal policies, affects the levels of the Bank’s loans, investments anddeposits through its control over the issuance of United States governmentsecurities, its regulation of the discount rate applicable to member banks andits influence over reserve requirements to which member banks are subject.  We cannot predict the nature or impact offuture changes in monetary and fiscal policies.

 

The actions of the FRB inthese areas influence the growth of bank loans, investments, and deposits andalso affect market interest rates.  From January 2001to June 2003, the FRB decreased interest rates numerous times, reducingthe overnight “Federal Funds” rate from 6.50% to 1.00%, the lowest level infour decades.  From June 2004 to June 2006,the FRB reversed direction and increased rates 17 times to 5.25%.  From September 2007 through December 2008,the FRB reduced rates ten times to their current level of 0.00%.  The nature and timing of any future changesin such policies and their impact on the Corporation cannot be predicted.  However, depending on the degree to which theBank’s interest-earning assets and interest-bearing liabilities are ratesensitive, increases in rates would have a temporary effect of increasing theBank’s net interest margin, while decreases in interest rates would have theopposite effect.  In addition, adverseeconomic conditions, including a downturn in the local or regional economy andrising energy prices, have made a higher provision for loan losses a prudentcourse and have caused higher loan charge-offs, thus adversely affecting theCorporation’s net income or other operating costs.

 

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**Financial Modernization Act**

 

Effective March 11,2000, the Gramm-Leach-Bliley Act eliminated most barriers to affiliations amongbanks and securities firms, insurance companies, and other financial serviceproviders, and enabled full affiliations to occur between such entities. This legislation permits bank holding companies to become “financial holdingcompanies” and thereby acquire securities firms and insurance companies andengage in other activities that are financial in nature.  A bank holdingcompany may become a financial holding company if each of its subsidiary banksis well capitalized under the prompt corrective action provisions discussedabove, is well managed, and has at least a satisfactory rating under the CRA byfiling a declaration that the bank holding company wishes to become a financialholding company.  No regulatory approval will be required for a financialholding company to acquire a company, other than a bank or savings association,engaged in activities that are financial in nature or incidental to activitiesthat are financial in nature, as determined by the FRB.  The Corporationhas no current intention of becoming a financial holding company, does notcurrently qualify to do so, but may do so at some point in the future if deemedappropriate in view of opportunities or circumstances at the time.

 

TheGramm-Leach-Bliley Act defines “financial in nature” to include securitiesunderwriting, dealing and market making; sponsoring mutual funds and investmentcompanies; insurance underwriting and agencies; merchant banking activities;and activities that the FRB has determined to be closely related tobanking.  A national bank (and therefore, a state bank as well) may also engage,subject to limitations on investment, in activities that are financial innature, other than insurance underwriting, insurance company portfolioinvestment, real estate development and real estate investment, through afinancial subsidiary of the bank, if the bank is well capitalized, well managedand has at least a satisfactory CRA rating.  Subsidiary banks of afinancial holding company or national banks with financial subsidiaries mustcontinue to be well capitalized and well managed in order to continue to engagein activities that are financial in nature without regulatory actions orrestrictions, which could include divestiture of the financial in naturesubsidiary or subsidiaries.  In addition, a financial holding company or abank may not acquire a company that is engaged in activities that are financialin nature unless each of the subsidiary banks of the financial holding companyor the bank has a CRA rating of satisfactory or better.

 

TheGramm-Leach-Bliley Act also imposed significant new requirements on financialinstitutions with respect to the privacy of customer information, and modifiedother laws, including those related to community reinvestment.

 

**USA Patriot Act of 2001**

 

The USA PatriotAct of 2001, enacted in response to the terrorist attacks in New York,Pennsylvania and Washington, D.C. on September 11, 2001, is intended tostrengthen U.S. law enforcement’s and the intelligence communities’ ability towork cohesively to combat terrorism on a variety of fronts.  The impact ofthe USA Patriot Act on financial institutions of all kinds has been significantand wide ranging.  The USA Patriot Act contains sweeping anti-moneylaundering and financial transparency laws and requires various regulationsapplicable to financial institutions, including:

 

·                                          due diligence requirements for financialinstitutions that administer, maintain, or manage private bank accounts orcorrespondent accounts for non-U.S. persons;

 

·                                          standards for verifying customeridentification at account opening; and

 

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·                                          rules to promote cooperation amongfinancial institutions, regulators, and law enforcement entities in identifyingparties that may be involved in terrorism or money laundering.

 

The Bankimplemented the requirements under the USA Patriot Act during 2001 and2002.  Compliance with such requirements has all been accomplished withexisting staff, so the financial impact on the Bank has been negligible.

 

**RegulatoryEnforcement Powers**

 

Commercial bankingorganizations, such as the Bank, may be subject to enforcement actions by theFDIC and the DFI for engaging in unsafe or unsound practices in the conduct oftheir businesses or for violations of any law, rule, regulation or anycondition imposed in writing by the agency or any written agreement with theagency.  Enforcement actions may include the imposition of a conservatoror receiver, the issuance of a cease-and-desist order that can be judiciallyenforced, the termination of insurance of deposits, the imposition of civilmoney penalties, the issuance of directives to increase capital, the issuanceof formal and informal agreements, the issuance of removal and prohibitionorders against institution-affiliated parties and the imposition ofrestrictions and sanctions under the prompt corrective action provisions of theFDICIA.

 

TheFDIC requested the Bank consent to a regulatory order resulting from its 2008Consumer Compliance Examination, which was completed in 2009.  The Bank disputes various provisions in theproposed order and is consulting with legal counsel regarding the issues atdispute.  As a result of the Bank’srefusal to sign the order in accord with the FDIC’s time frame, the FDIC hasindicated to the Bank that it will proceed with the Administrative Hearingprocess to issue the order. The FDIC is asserting that three credit and debitcard programs operated by third-party vendors violated certain provisions ofFederal law, which the Bank disputes, and the FDIC is demanding that the Bankmake restitution to affected customers and be subjected to a civil moneypenalty as a result of the alleged violations. The Bank also believes that restitution and civil money penalty are inappropriateunder the circumstances.  The FDIC ispresently investigating the Bank’s involvement in the subject card programsutilizing its subpoena powers pursuant to statutory authority.  The financial and non-financial impact ofthis matter is not known as of the balance sheet date and as of the issuancedate of this report.

 

**Californiaand Federal Change in Bank Control Laws**

 

The Federal Changein Bank Control Act of 1978 prohibits a person or group of persons “acting inconcert” from acquiring “control” of a bank or holding company unless theappropriate federal regulatory agency has been given 60 days’ prior writtennotice of such proposed acquisition and, within that time period, has notissued a notice disapproving the proposed acquisition or extending for up toanother 30 days the period during which such a disapproval may be issued. Anacquisition may be made prior to the expiration of the disapproval period ifthe agency issues written notice of its intent not to disapprove theaction.  The acquisition of more than 10% of a class of voting stock of abank (or holding company) with a class of securities registered under Section 12of the Securities Exchange Act of 1934, as amended (such as the Common stock),is generally presumed, subject to rebuttal, to constitute the acquisition ofcontrol.

 

Under theCalifornia Financial Code, no person shall, directly or indirectly, acquirecontrol of a California licensed bank or a bank holding company unless the DFIhas approved such acquisition of control.  A person would be deemed tohave acquired control of the Corporation 

 

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under this state law ifsuch person, directly or indirectly, has the power (i) to vote 25% or moreof the voting power of the Corporation or (ii) to direct or cause thedirection of the management and policies of the Corporation.  For purposesof this law, a person who directly or indirectly owns or controls 10% or moreof the Common stock would be presumed to control the Corporation, subject torebuttal.

 

Inaddition, any “company” would be required to obtain the approval of the FederalReserve under the Bank Holding Company Act of 1956, as amended (the “BHC Act”),before acquiring 25% (5% in the case of an acquirer that is, or is deemed tobe, a bank holding company) or more of the outstanding Common stock of, or suchlesser number of shares as constitute control over, the Bank or theCorporation.

 

**RESEARCH**

 

Neither theCorporation nor the Bank makes any material expenditures for research anddevelopment.

 

**DEPENDENCEUPON A SINGLE CUSTOMER**

 

Neither theCorporation nor the Bank is dependent upon a single customer or very fewcustomers.  The Bank’s business isconcentrated in, and largely dependent upon the strength of the local economyin, the Monterey Peninsula area of Northern California.  The local economy is affected by bothnational trends and by local factors. Tourism and the activities at the former Fort Ord military base areamong the major contributors to the local economy.

 

**ITEM 1A.  RISK FACTORS**

 

**DIFFICULT CONDITIONS IN THE CAPITAL MARKETS ANDTHE ECONOMY GENERALLY MAY MATERIALLY ADVERSELY AFFECT OUR BUSINESS ANDRESULTS OF OPERATIONS.**

 

Our results of operations are materiallyaffected by conditions in the capital markets and the economy generally. Thecapital and credit markets have been experiencing extreme volatility anddisruption for more than twelve months at unprecedented levels. In many cases,these markets have produced downward pressure on stock prices of, and creditavailability to, certain companies without regard to those companies’underlying financial strength.

 

Recently, concerns over inflation, energy costs,geopolitical issues, the availability and cost of credit, the U.S. mortgagemarket and a declining U.S. real estate market have contributed to increasedvolatility and diminished expectations for the economy and the capital andcredit markets going forward.  Thesefactors, combined with volatile oil prices, declining business and consumerconfidence and increased unemployment, have precipitated an economic slowdownand national recession.  In addition, thefixed-income markets are experiencing a period of extreme volatility which hasnegatively impacted market liquidity conditions.  Initially, the concerns on the part of marketparticipants were focused on the subprime segment of the mortgage-backedsecurities market.  However, theseconcerns have since expanded to include a broad range of mortgage-andasset-backed and other fixed income securities, including those ratedinvestment grade, the U.S. and international credit and interbank money marketsgenerally, and a wide range of financial institutions and markets, asset classesand sectors.

 

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Factors such as consumer spending, businessinvestment, government spending, the volatility and strength of the capitalmarkets, and inflation all affect the business and economic environment and,ultimately, the amount and profitability of our business. In an economicdownturn characterized by higher unemployment, lower family income, lower corporateearnings, lower business investment and lower consumer spending, the demand forour financial products could be adversely affected. Adverse changes in theeconomy could affect earnings negatively and could have a material adverseeffect on our business, results of operations and financial condition.  The current mortgage crisis and economicslowdown has also raised the possibility of future legislative and regulatoryactions in addition to the enactment of EESA that could further impact ourbusiness. We cannot predict whether or when such actions may occur, or whatimpact, if any; such actions could have on our business, results of operationsand financial condition.

 

**THERE CAN BE NO ASSURANCE THAT ACTIONS OF THE U.S.GOVERNMENT, FEDERAL RESERVE AND OTHER GOVERNMENTAL AND REGULATORY BODIES FORTHE PURPOSE OF STABILIZING THE FINANCIAL MARKETS WILL ACHIEVE THE INTENDEDEFFECT.**

 

In response to the financial crises affectingthe banking system and financial markets and going concern threats toinvestment banks and other financial institutions, on October 3, 2008,President Bush signed EESA into law. Pursuant to EESA, the U.S. Treasury has the authority to utilize up to$700 billion to purchase distressed assets from financial institutions orinfuse capital into financial institutions for the purpose of stabilizing thefinancial markets.  The U.S. Treasuryannounced the Capital Purchase Program under EESA pursuant to which it haspurchased and will continue to purchase senior preferred stock in participatingfinancial institutions such as the Corporation. There can be no assurance, however, as to the actual impact that EESA,including the Capital Purchase Program and the Treasury’s Troubled AssetRepurchase Program, will have on the financial markets or on us.  The failure of these programs to helpstabilize the financial markets and a continuation or worsening of currentfinancial market conditions could materially and adversely affect our business,financial condition, results of operations, access to credit or the tradingprice of our common stock.

 

The federal government, Federal Reserve andother governmental and regulatory bodies have taken or are considering takingother actions to address the financial crisis. There can be no assurance as to what impact such actions will have onthe financial markets, including the extreme levels of volatility currentlybeing experienced.  Such continuedvolatility could materially and adversely affect our business, financial conditionand results of operations, or the trading price of our common stock.

 

**WE WILL BE REQUIRED TO PAY SIGNIFICANTLY HIGHERFEDERAL DEPOSIT INSURANCE CORPORATION PREMIUMS IN THE FUTURE.**

 

Recent insured institution failures, as well asdeterioration in banking and economic conditions, have significantly increasedFDIC loss provisions, resulting in a decline in the designated reserve ratio tohistorical lows.  The FDIC expects ahigher rate of insured institution failures in the next few years compared torecent years; thus, the reserve ratio may continue to decline.  In addition, EESA temporarily increased thelimit on FDIC coverage to $250,000 through December 31, 2013.  These developments have caused the premiumsassessed to us by the FDIC to increase.

 

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On December 16, 2008, the FDIC Board ofDirectors determined deposit insurance assessment rates for the first quarterof 2009 at 12 to 14 basis points per $100 of deposits.  Beginning April 1, 2009, the ratesincreased to 12 to 16 basis points per $100 of deposits. Additionally, on February 27,2009, the FDIC announced an interim rule imposing a 20 basis point specialemergency assessment on June 30, 2009, payable September 30,2009.  The special assessment for theBank was $134,000. The interim rule also allows the FDIC to impose aspecial emergency assessment after June 30, 2009, of up to 10 basis pointsif necessary to maintain public confidence in FDIC insurance. These higher FDICassessment rates and special assessments could have an adverse impact on ourresults of operations.

 

**RECENT NEGATIVE DEVELOPMENTS IN THE FINANCIALINDUSTRY AND THE CREDIT MARKETS MAY SUBJECT US TO ADDITIONAL REGULATION.**

 

As a result of the recent global financialcrisis, the potential exists for new federal or state laws and regulationsregarding lending and funding practices and liquidity standards to bepromulgated, and bank regulatory agencies are expected to be active in respondingto concerns and trends identified in examinations, including the expectedissuance of many formal enforcement orders. Negative developments in the financial industry and the domestic andinternational credit markets, and the impact of new legislation in response tothose developments, may negatively impact our operations by restricting ourbusiness operations, including our ability to originate or sell loans, and mayadversely impact our financial performance.

 

**THE GEOGRAPHIC CONCENTRATION OF OUR MARKETS MAKESOUR BUSINESS HIGHLY SUSCEPTIBLE TO LOCAL ECONOMIC CONDITIONS.**

 

Unlike larger banking organizations that aremore geographically diversified, our operations are currently concentrated inthe Monterey Peninsula and Salinas, California markets. As a result of thisgeographic concentration, our financial results depend largely upon economicconditions in these market areas. Deterioration in economic conditions in one or all of these marketscould result in an increase in loan delinquencies, an increase in problemassets and foreclosures, a decrease in the demand for our products and servicesor a decrease in the value of collateral for loans, especially real estate, inturn reducing customers’ borrowing power, the value of assets associated withproblem loans and collateral coverage.

 

**FUTURE GROWTH OR OPERATING RESULTS MAY REQUIRETHE CORPORATION TO RAISE ADDITIONAL CAPITAL BUT THAT CAPITAL MAY NOT BEAVAILABLE OR IT MAY BE DILUTIVE.**

 

The Corporation is required by federal and stateregulatory authorities to maintain adequate levels of capital to support itsoperations.  To the extent theCorporation’s future operating results erode capital or the Corporation electsto expand through loan growth or acquisition it may be required to raisecapital.  The Corporation’s ability toraise capital will depend on conditions in the capital markets, which areoutside of its control, and on the Corporation’s financial performance.Accordingly, the Corporation cannot be assured of its ability to raise capitalwhen needed or on favorable terms. If the Corporation cannot raise additionalcapital when needed, it will be subject to increased regulatory supervision andthe imposition of restrictions on its growth and business.  These could negatively impact the Corporation’sability to operate or further expand its operations through acquisitions or theestablishment of additional branches and may result in increases in operatingexpenses and reductions in revenues that could have a material adverse effecton its financial condition and results of operations.

 

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**THE CORPORATION’S ALLOWANCE FOR POSSIBLE LOANLOSSES MAY BE INSUFFICIENT.**

 

The Corporation maintains an allowance forpossible loan losses, which is a reserve established through a provision forpossible loan losses charged to expense that represents management’s bestestimate of probable losses within the existing portfolio of loans.  The allowance, in the judgment of management,is necessary to reserve for estimated loan losses and risks inherent in theloan portfolio.   The level of theallowance reflects management’s continuing evaluation of industryconcentrations; specific credit risks; loan loss experience; current loanportfolio quality; present economic, political and regulatory conditions andunidentified losses inherent in the current loan portfolio.  The determination of the appropriate level ofthe allowance for possible loan losses inherently involves a high degree ofsubjectivity and requires management to make significant estimates of currentcredit risks and future trends, all of which may undergo material changes.  In addition, bank regulatory agenciesperiodically review the Corporation’s allowance for loan losses and may requirean increase in the provision for possible loan losses or the recognition offurther loan charge-offs, based on judgments different than those ofmanagement.  If charge-offs in future periodsexceed the allowance for possible loan losses, the Corporation will needadditional provisions to increase the allowance for possible loan losses.  Any increases in the allowance for possibleloan losses will result in a decrease in net income and, possibly, capital, andmay have a material adverse effect on the Corporation’s financial condition andresults of operations.

 

**THE CORPORATION IS SUBJECT TO INTEREST RATE RISK.**

 

The Corporation’s earnings and cash flows arelargely dependent upon its net interest income. Net interest income is the difference between interest income earned oninterest-earning assets such as loans and securities and interest expense paidon interest-bearing liabilities such as deposits and borrowed funds.  Interest rates are highly sensitive to manyfactors that are beyond the Corporation’s control, including general economicconditions and policies of various governmental and regulatory agencies.  Changes in monetary policy, including changesin interest rates, could influence not only the interest the Corporationreceives on loans and securities and the amount of interest it pays on depositsand borrowings, but such changes could also affect the Corporation’s ability tooriginate loans and obtain deposits and the fair value of the Corporation’sfinancial assets and liabilities.  If theinterest rates paid on deposits and other borrowings increase at a faster ratethan the interest rates received on loans and other investments, theCorporation’s net interest income, and earnings, could be adverselyaffected.  Earnings could also beadversely affected if the interest rates received on loans and otherinvestments fall more quickly than the interest rates paid on deposits andother borrowings.

 

**THE CORPORATION IS SUBJECT TO ENVIRONMENTALLIABILITY RISK ASSOCIATED WITH LENDING ACTIVITIES.**

 

A significant portion of the Corporation’s loanportfolio is secured by real property. During the ordinary course of business, the Corporation may foreclose onand take title to properties securing certain loans.  In doing so, there is a risk that hazardousor toxic substances could be found on these properties.  If hazardous or toxic substances are found,the Corporation may be liable for remediation costs, as well as for personalinjury and property damage. Environmental laws may require the Corporation to incur substantialexpenses and may materially reduce the affected property’s value or limit theCorporation’s ability to use or sell the affected property.  In addition, 

 

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future laws or more stringent interpretations orenforcement policies with respect to existing laws may increase the Corporation’sexposure to environmental liability.  Theremediation costs and any other financial liabilities associated with anenvironmental hazard could have a material adverse effect on the Corporation’sfinancial condition and results of operations.

 

**THE CORPORATION IS SUBJECT TO EXTENSIVE GOVERNMENTREGULATION AND SUPERVISION.**

 

The Corporation, primarily through the Bank, issubject to extensive federal and state regulation and supervision. Bankingregulations are primarily intended to protect depositors’ funds, federaldeposit insurance funds and the banking system as a whole, not shareholders.These regulations affect the Corporation’s lending practices, capitalstructure, investment practices, dividend policy and growth, among otherthings. Congress and federal regulatory agencies continually review bankinglaws, regulations and policies for possible changes.  Changes to statutes, regulations orregulatory policies, including changes in interpretation or implementation ofstatutes, regulations or policies, could affect the Corporation in substantialand unpredictable ways.  Such changescould subject the Corporation to additional costs, limit the types of financialservices and products the Corporation may offer and/or increase the ability ofnon-banks to offer competing financial services and products, among otherthings.  Failure to comply with laws,regulations or policies could result in sanctions by regulatory agencies, civilmoney penalties and/or reputation damage, which could have a material adverseeffect on the Corporation’s business, financial condition and results ofoperations.

 

**THE CORPORATION’S CONTROLS AND PROCEDURES MAY FAILOR BE CIRCUMVENTED.**

 

Management regularly reviews and updates theCorporation’s internal controls, disclosure controls and procedures, andcorporate governance policies and procedures. Any system of controls, howeverwell designed and operated, is based in part on certain assumptions and canprovide only reasonable, not absolute, assurances that the objectives of thesystem are met.  Any failure orcircumvention of the Corporation’s controls and procedures or failure to complywith regulations related to controls and procedures could have a materialadverse effect on the Corporation’s business, results of operations andfinancial condition.

 

**THE CORPORATION’S INFORMATION SYSTEMS MAY EXPERIENCEAN INTERRUPTION OR BREACH IN SECURITY.**

 

The Corporation relies heavily on communicationsand information systems to conduct its business. Any failure, interruption orbreach in security of these systems could result in failures or disruptions inthe Corporation’s customer relationship management, general ledger, deposit,loan and other systems.  While theCorporation has policies and procedures designed to prevent or limit the effectof the failure, interruption or security breach of its information systems,there can be no assurance that any such failures, interruptions or securitybreaches will not occur or, if they do occur, that they will be adequatelyaddressed.  The occurrence of anyfailures, interruptions or security breaches of the Corporation’s informationsystems could damage the Corporation’s reputation, result in a loss of customerbusiness, subject the Corporation to additional regulatory scrutiny, or exposethe Corporation to civil litigation and possible financial liability, any ofwhich could have a material adverse effect on the Corporation’s financialcondition and results of operations.

 

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**CHANGES IN TECHNOLOGY COULD BE COSTLY.**

 

The banking industry is undergoing technologicalinnovation.  In order to maintain itscompetitive position, the Corporation must react to these innovations andevaluate the technologies to enable it to compete on a cost-effectivebasis.  The cost of such technology,including personnel, may be high in both absolute and relative terms.  There can be no assurance, given the fastpace of change and innovation, that the Corporation’s technology will meet orcontinue to meet its needs.

 

**THE TRADING VOLUME IN THE CORPORATION’S COMMONSTOCK IS LESS THAN THAT OF OTHER LARGER FINANCIAL SERVICES COMPANIES.**

 

Although the Corporation’s common stock islisted for trading on the Over The Counter Bulletin Board (OTCBB), the tradingvolume in its common stock is less than that of other larger financial servicescompanies.  A public trading markethaving the desired characteristics of depth, liquidity and orderliness dependson the presence in the marketplace of willing buyers and sellers of theCorporation’s common stock at any given time. This presence depends on the individual decisions of investors andgeneral economic and market conditions over which the Corporation has nocontrol.  Given the lower trading volumeof the Corporation’s common stock, significant sales of the Corporation’scommon stock, or the expectation of these sales, could cause the Corporation’sstock price to fall.

 

**WE MAY NOT BE ABLE TO PAY DIVIDENDS IN THEFUTURE IN ACCORDANCE WITH PAST PRACTICES.**

 

The Corporation may not be able to pay dividendsin accordance with past practice.  TheCorporation traditionally pays an annual dividend to shareholders.  The payment of dividends is subject to legaland regulatory restrictions and, therefore, any payment of dividends in thefuture will depend in large part on the Corporation’s earnings, capitalrequirements, financial conditions, liquid resources (including the ability toreceive dividends from the Bank), and other factors considered relevant by theCorporation’s Board of Directors.

 

The Corporation has deferred interest paymentson its subordinated debt securities, therefore it may not pay any dividends ordistribution on its capital stock until the total deferred interest ispaid.  Additionally the Corporation,prior to paying any dividend or distribution, must request the prior approvalof the Federal Reserve Bank.

 

The Bank must request the prior approval of theFDIC and the DFI before paying any dividends to the Corporation.

 

**ITEM 1B.****                                      ****UNRESOLVED STAFF COMMENTS.**

 

None.

 

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

 

The main branchoffice of the Bank, which also serves as the principal office of theCorporation, is located at 601 Munras Ave., Monterey, California 93940.  This facility contains a lobby, executive andcustomer service offices, teller stations, safe deposit boxes and relatednon-vault area, vault, operations area, lounge and miscellaneous areas.  A drive-through facility and adequate pavedparking are also on the premises.  Boththe land and all improvements thereto are 

 

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owned by the Bank**.**

 

The Bank also ownsa building located at 556 Abrego St., Monterey, California 93940, which housesa loan production office and additional office space.  The Bank currently operates four branchoffices in Carmel-By-The-Sea, Carmel Valley, Pacific Grove and Salinas,California, all within approximately 20 miles from the Bank’s main office.  The land and improvements dedicated to theCarmel-By-The-Sea, Carmel Valley, Pacific Grove and Salinas branch offices areleased.  See Footnote 13 to the Corporation’sfinancial statements included herewith.

 

Generally, neitherthe Bank nor the Corporation may invest in equity interests in real estate,except for the direct use of the Bank or the Corporation in theirbusiness.  The Bank makes and/orpurchases loans secured by real estate, subject to normal banking practices,its own policies and the restrictions described above under Item 1.

 
| **ITEM 3.** | **LEGAL PROCEEDINGS** |
|-------------|-----------------------|

 

For a discussionof legal proceedings see Note 13, “Commitments andContingencies” in the Consolidated Financial Statements.

 

Although the amount of any ultimate liability with respect to such proceedings cannot be determined, in the opinion of management, any such liability will not have a material effect on the consolidated financial position of the Corporation or the Bank.

 
| **ITEM 4.** | **REMOVED AND RESERVED.** |
|-------------|---------------------------|

 

**PART II**

 
| **ITEM 5.** | **MARKET  FOR THE COMMON EQUITY, RELATED SHAREHOLDER MATTERS, AND ISSUER OF PURCHASES  OF EQUITY SECURITIES** |
|-------------|---------------------------------------------------------------------------------------------------------------|

 

The Corporation’s stock is traded on the OTCBB) a quotation service for securities notlisted or traded on NASDAQ or a national securities exchange, under thestock symbol “NRLB.”  The Corporationalso has knowledge of a limited number of transactions conducted betweenindividual shareholders.

 

The Corporation currently has one company which makes a market for itscommon stock, HoweBarnes Hoeffer & Arnett.

 

At December 31, 2009, there were 530 record holders of common stock of the Corporation.This does not reflect the number of persons or entities who hold their stock innominee or street name through various brokerage firms.

 

The Corporation repurchased 20,678 and 46,010 shares of common stock in2009 and 2008, respectively, at an average price of $4.10 and $7.41 per sharein 2009 and 2008, respectively; no shares were repurchased in 2007.

 

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The information in the following table indicates the high and low bidinformation and volume of trading for our Common Stock for each quarterlyperiod since January 1, 2007, and is based upon information provided bythe OTCBB.  The information does notinclude transactions for which no public records are available.  The OTCBB market quotations reflect inter-dealerprices, without retail mark-up, mark-down or commissions and may notnecessarily represent actual transactions.

 
| **Quarter/Year**     | ** ** | **Price ($)** | ** ** | **Volume** | ** ** |
|----------------------|------------|---------------|------------|------------|------------|
|                 |       |          |       |       |       |
| 1st quarter of  2007 |       | $12.00-17.00  |       | 42,225     |       |
| 2nd quarter of  2007 |       | $17.00-18.50  |       | 25,738     |       |
| 3rd quarter of  2007 |       | $16.00-18.35  |       | 8,793      |       |
| 4th quarter of  2007 |       | $11.00-16.05  |       | 92,520     |       |
|                 |       |          |       |       |       |
| 1st quarter of  2008 |       | $9.10-11.05   |       | 17,484     |       |
| 2nd quarter of  2008 |       | $7.35-9.00    |       | 82,830     |       |
| 3rd quarter of  2008 |       | $3.50-7.80    |       | 41,596     |       |
| 4th quarter of  2008 |       | $2.25-4.72    |       | 33,085     |       |
|                 |       |          |       |       |       |
| 1st quarter of  2009 |       | $2.00-4.25    |       | 7,858      |       |
| 2nd quarter of  2009 |       | $1.70-6.50    |       | 28,526     |       |
| 3rd quarter of  2009 |       | $2.75-5.00    |       | 3,927      |       |
| 4th quarter of  2009 |       | $3.50-6.00    |       | 6,007      |       |

 

The principal source of cash flow of the Corporation, including cashflow to pay dividends on its stock or principal and interest on debt, is frominterest and dividends on investments and tax benefit payments and dividendsfrom the Bank.  There are statutory andregulatory limitations on the payment of dividends by the Bank to the Corporation,as well as by the Corporation to its shareholders.

 

If in the opinion of the applicable federal and/or state regulatoryauthority, a depository institution or holding company is engaged in or isabout to engage in an unsafe or unsound practice (which, depending on thefinancial condition of the depository institution or holding company, couldinclude the payment of dividends), such authority may require, after notice andhearing (except in the case of an emergency proceeding where there is in no noticeor hearing), that such institution or holding company cease and desist fromsuch practice.  Moreover, the FederalReserve and the FDIC have issued policy statements which provide that bankholding companies and insured depository institutions generally should only paydividends out of current operating earnings.

 

Under the FDICIA, an FDIC insured depository institution may not payany dividend if payment would cause it to become undercapitalized or once it isundercapitalized.

 

The Bank’s payment of dividends, as a California chartered commercialbanking corporation, is also regulated by the California Financial Code.  Under the California Financial Code, fundsavailable for cash dividend payments by the Bank are restricted to the lessorof: (i) retained earnings; or (ii) the Bank’s net income for its lastthree fiscal years (less any distributions

 

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to the shareholders made during such period).  As of December 31, 2009 the Bank had$16,347,000 in retained earnings.  TheBank’s net income for the last three fiscal years less distributions toshareholders was $6,577,000.

 

The Corporation did not pay a cashdividend in 2009.  In December 2008and 2007 the Corporation paid cash dividends of $0.25 per share.  The Bank paid cash dividends totaling$500,000 and $800,000 to the Corporation during 2009 and 2007, respectively; nodividends were paid by the Bank in 2008.

 

The Corporation has deferred interest paymentson its subordinated debt securities, therefore it may not pay any dividends ordistribution on its capital stock until the total deferred interest ispaid.  Additionally the Corporation,prior to paying any dividend or distribution, must request the prior approvalof the Federal Reserve Bank.

 

The Bank must request the prior approval of theFederal Deposit Insurance Corporation and the California Department ofFinancial Institutions before paying any dividends to the Corporation.

 

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**ITEM 6.                SELECTED FINANCIAL DATA**

 
| ** **                                                     | ** ** | **As of and for the Years Ended December 31,** | ** ** |
|----------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| **(dollars  in thousands, except per share data)**             | ** ** | **2009**                                            | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
| Five-Year Selected Financial Data                              |       |                                                |       |   |   |   |   |   |   |   |   |
| Summary of Operating Results:                                  |       |                                                |       |   |   |   |   |   |   |   |   |
| Total interest income                                          |       | $                                                   | 15,262     |   | $ | 16,500 |   | $ | 16,941 |   | $ | 13,760 |   | $ | 10,691 |   |
| Total interest expense                                         |       | 8,079                                               |       | 9,749 |   | 8,002 |   | 5,197 |   | 3,672 |   |
| Net interest income                                            |       | 7,183                                               |       | 6,751 |   | 8,939 |   | 8,563 |   | 7,019 |   |
| Provision for loan losses                                      |       | 3,368                                               |       | 1,132 |   | 865 |   | 410 |   | 150 |   |
| Net interest income afterprovision for loan losses             |       | 3,815                                               |       | 5,619 |   | 8,074 |   | 8,153 |   | 6,869 |   |
| Total noninterest income                                       |       | 10,120                                              |       | 5,031 |   | 4,336 |   | 7,177 |   | 4,362 |   |
| Total noninterest expenses                                     |       | 12,983                                              |       | 8,907 |   | 9,005 |   | 8,627 |   | 7,813 |   |
| Income before taxes                                            |       | 952                                                 |       | 1,743 |   | 3,405 |   | 6,703 |   | 3,419 |   |
| Provision for income taxes (benefit)                           |       | (659                                                | )          | 281 |   | 1,476 |   | 2,866 |   | 1,489 |   |
| Net income                                                     |       | $                                                   | 1,611      |   | $ | 1,462 |   | $ | 1,929 |   | $ | 3,837 |   | $ | 1,929 |   |
| Per Common Share Data:                                         |       |                                                |       |   |   |   |   |   |   |   |   |
| Net income - Basic (1)                                         |       | $                                                   | 0.90       |   | $ | 0.80 |   | $ | 1.08 |   | $ | 2.31 |   | $ | 1.20 |   |
| Net income - Diluted (2)                                       |       | 0.90                                                |       | 0.79 |   | 1.03 |   | 2.09 |   | 1.00 |   |
| Book value, end of period                                      |       | 9.06                                                |       | 7.96 |   | 7.82 |   | 7.20 |   | 5.55 |   |
| Avg shares outstanding (3)                                     |       | 1,791,218                                           |       | 1,890,591 |   | 1,785,812 |   | 1,658,675 |   | 1,614,196 |   |
| Balance Sheet Data:                                            |       |                                                |       |   |   |   |   |   |   |   |   |
| Total loans, net of unearned income (4)                        |       | $                                                   | 163,213    |   | $ | 167,180 |   | $ | 168,748 |   | $ | 130,050 |   | $ | 107,300 |   |
| Total assets                                                   |       | 273,295                                             |       | 306,201 |   | 253,865 |   | 190,570 |   | 162,701 |   |
| Total deposits                                                 |       | 202,422                                             |       | 189,730 |   | 167,333 |   | 131,628 |   | 118,120 |   |
| Shareholders’ equity                                      |       | 16,150                                              |       | 14,352 |   | 14,434 |   | 12,402 |   | 8,931 |   |
| Return on average assets (5)                                   |       | 0.55                                                | %          | 0.54 | % | 0.91 | % | 2.24 | % | 1.24 | % |
| Return on average                                              |       |                                                |       |   |   |   |   |   |   |   |   |
| shareholders’ equity (5)                                  |       | 9.98                                                | %          | 10.67 | % | 14.09 | % | 34.94 | % | 24.15 | % |
| Dividend payout ratio                                          |       | —                                              |       | 30.78 | % | 23.90 | % | 15.72 | % | 16.90 | % |
| Net interest spread                                            |       | 2.77                                                | %          | 2.45 | % | 4.07 | % | 4.82 | % | 4.63 | % |
| Net yield on interest-earning assets (5)                       |       | 3.09                                                | %          | 2.87 | % | 4.69 | % | 5.58 | % | 5.09 | % |
| Avg shareholders’ equity to average assets (5)            |       | 5.47                                                | %          | 5.04 | % | 6.44 | % | 6.40 | % | 5.15 | % |
| Risked-Based capital ratios                                    |       |                                                |       |   |   |   |   |   |   |   |   |
| Tier 1                                                         |       | 10.24                                               | %          | 8.80 | % | 9.23 | % | 9.50 | % | 9.50 | % |
| Total                                                          |       | 13.51                                               | %          | 12.31 | % | 12.63 | % | 14.90 | % | 14.90 | % |
| Total loans to total deposits at end of period (4)             |       | 82.37                                               | %          | 88.11 | % | 100.85 | % | 98.80 | % | 90.84 | % |
| Allowance for loan losses to total loans at end of  period (4) |       | 2.12                                                | %          | 1.42 | % | 1.19 | % | 1.07 | % | 1.02 | % |
| Nonperforming loans to total loans at end of period (4)   |       | 5.33                                                | %          | 4.18 | % | 1.98 | % | 0.12 | % | 0.00 | % |
| Net charge-offs to average loans (4)                           |       | 1.33                                                | %          | 0.45 | % | 0.17 | % | 0.09 | % | 0.01 | % |

 

----

(1)         Basicearnings per share amounts were computed on the basis of the weighted averagenumber of shares of common stock during the year.  The weighted average number of shares usedfor this computation was 1,791,218 

 

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for2009, 1,823,965 for 2008, 1,785,812 for 2007, 1,658,675 for 2006 and 1,614,196for 2005.

 

(2)         Fullydiluted earnings per share amounts were computed on the basis of the weightedaverage number of shares of common stock and common stock equivalentsoutstanding during the year.  Commonstock equivalents include employee stock options.  The weighted average number of shares usedfor this computation was 1,795,764, 1,848,173, 1,881,004, 1,831,892 and1,923,532 in 2009, 2008, 2007, 2006 and 2005, respectively.

 

(3)   Weighted average common shares.

 

(4)   Includes loans being held for sale.

 

(5)         Averages are of daily balances.

 
| **ITEM 7.** | **MANAGEMENT’S DISCUSSION AND ANALYSIS OF  FINANCIAL CONDITION AND RESULTS OF OPERATION** |
|-------------|------------------------------------------------------------------------------------------------|

** **

**OVERVIEW**

 

**General**

 

The following discussion reviews and analyzes the operating results andfinancial condition of the Corporation, focusing on the Bank.  It should be read in conjunction with theconsolidated financial statements and the other financial data presentedelsewhere herein.

 

Net income for each of the last three years was $1,611,000 in 2009,$1,462,000 in 2008, and $1,929,000 in 2007. The net income per share for each of the last three years was $0.90,$0.80, and $1.08 respectively.  Thediluted net income per share for the same time periods was $.90, $0.79 and$1.03, respectively.  Return on averageshareholders’ equity was 9.98%, 10.67%, and 14.09% in 2009, 2008 and 2007,respectively.  Return on average assetswas 0.55%, 0.54%, and 0.91% in 2009, 2008 and 2007, respectively.

 

The increase in earnings in 2009 compared to 2008 was due to anincrease in noninterest income of $5,089,000 and a decrease of $940,000 inincome tax expense, partially offset by a decrease of $1,804,000 in netinterest income after provision for loan losses and an increase of $4,077,000in noninterest expense.

 

The decrease in earnings in 2008 compared to 2007 was due to a decreaseof $2,455,000 in net interest income after provision for loan losses, partiallyoffset by an increase in noninterest income of $695,000, and decreases of$98,000 in noninterest expense and $1,195,000 in income tax expense.

 

**CriticalAccounting Policies**

 

Thepreparation of financial statements in accordance with accounting principlesgenerally accepted in the United States of America requires management to makea number of judgments, estimates and assumptions that affect the reported amountof assets, liabilities, income and expenses in the Corporation’s financialstatements and accompanying notes.  Management believes that thejudgments, estimates and assumptions used in preparation of the Corporation’sfinancial statements are appropriate given the factual circumstances as of December 31,2009.

 

Variouselements of the Corporation’s accounting policies, by their nature, areinherently subject to estimation techniques, valuation assumptions and othersubjective assessments.  Critical accounting policies are those thatinvolve the most complex and subjective decisions and

 

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assessments and have thegreatest potential impact of the Corporation’s results of operations.  Inparticular, management has identified one accounting policy that, due tojudgments, estimates and assumptions inherent in this policy, and thesensitivity of the Corporation’s consolidated financial statements to thosejudgments, estimates and assumptions, are critical to an understanding of theCorporation’s consolidated financial statements.  This policy relates tothe methodology that determines the allowance for loan and lease losses. Management has discussed the development and selection of this criticalaccounting policy with the Audit Committee of the Board of Directors. Although Management believes the level of the allowance at December 31,2009 is adequate to absorb losses inherent in the loan portfolio, a decline inthe regional economy may result in increasing losses that cannot reasonably bepredicted at this time.  For further information regarding the allowancefor loan losses see “Provision and Allowance for Loan and Lease Losses,” andNote 6 to the Corporation’s audited consolidated financial statements includedelsewhere herein.

 

**RecentlyIssued Accounting Standards**

 

Referto Note 1 to the Financial Statements — “Summary of Significant AccountingPolicies” for discussion of the recently issued accounting standards.

 

**NETINTEREST INCOME**

 

Net interestincome, the difference between (a) interest and fees earned oninterest-earning assets and (b) interest paid on interest-bearingliabilities, is the most significant component of the Bank’s earnings.  Changes in net interest income from period toperiod result from increases or decreases in the average balances ofinterest-earning assets portfolio, the availability of particular sources offunds and changes in prevailing interest rates.

 

The following tablesummarizes the Corporation’s net interest income.

 
| ** **          | ** ** | **Years Ended**                 | ** ** | **Increase (Decrease)**  | ** ** |
|---------------------|------------|--------------------------------------|------------|-------------------------------|------------|
| ** **          | ** ** | **December 31,**                | ** ** | **From Prior Year** | ** ** |
| ** **          | ** ** | **2009**                             | ** ** | **2008**                      | ** ** | **2007** | ** ** | **2009/2008** | ** ** | **2008/2007** | ** ** |
| ** **          | ** ** | ** **                           | ** ** | ** **                    | ** ** | ** ** | ** ** | **Amt** | ** ** | **%** | ** ** | **Amt** | ** ** | **%** | ** ** |
| ** **          | ** ** | **(Dollars in thousands)** | ** ** |
| Interest Income     |       | $                                    | 15,262     |                          | $          | 16,500 |   | $ | 16,941 |   | $ | (1,238 | ) | (7.50 | ) | $ | (441 | ) | (2.60 | ) |
| Interest Expense    |       | 8,079                                |       | 9,749                         |       | 8,002 |   | (1,670 | ) | (17.14 | ) | 1,747 |   | 21.8 |   |
| Net Interest Income |       | $                                    | 7,183      |                          | $          | 6,751 |   | $ | 8,939 |   | $ | 432 |   | 6.41 |   | $ | (2,188 | ) | (24.5 | ) |

 

Net interest income increased$433,000 or 6.40% from 2008 to 2009. Average interest-earning assets increased 6.75%, while the average rateearned decreased 66 basis points, resulting in a decrease of $1,238,000 intotal interest income.  Interest expensedecreased $1,670,000, the result of a 7.04% increase in averageinterest-bearing liabilities, while the average rate paid decreased 98 basispoints.

 

Net interest incomedecreased $2,188,000 or 24.5% from 2007 to 2008.  Average interest-earning assets increased28.19%, while the average rate earned decreased 202 basis points, resulting ina decrease of $441,000 in total interest income.  Interest expense increased $1,747,000, theresult of a 33.04% increase in average interest-bearing liabilities, while theaverage rate paid decreased 40 basis points.

 

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**AverageBalances, Interest Income and Expense, Rates and Yields**

 

The followingtable shows the components of net interest income, setting forth, for each ofthe three years ended December 31, 2009, 2008 and 2007 (i) averageassets, liabilities and investments, (ii) interest income earned oninterest-earning assets and interest expense paid on interest-bearingliabilities, (iii) average yields earned on interest-earning assets andaverage rates paid on interest-bearing liabilities, (iv) the net interestspread (i.e., the average yield earned on interest-earning assets less theaverage rate paid on interest-bearing liabilities) and (v) the netinterest yield on average interest-earning assets (i.e., net interest incomedivided by average interest-earning assets). Yields are computed on a tax-equivalent basis, resulting in adjustmentsto interest earned on non-taxable securities of $1,026,000, $378,000 and$148,000 in 2009, 2008 and 2007, respectively. Non-accrual loans and overdrafts are included in average loanbalances.  Average loans are presentednet of unearned income.

 

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| ** **                                                         | ** ** | **As of  and for the Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                         | ** ** | **2009**                                             | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                                         | ** ** | ** **                                           | ** ** | **Int** | ** ** | **Avg** | ** ** | ** ** | ** ** | **Int** | ** ** | **Avg** | ** ** | ** ** | ** ** | **Int** | ** ** | **Avg** | ** ** |
| ** **                                                         | ** ** | **Avg**                                              | ** ** | **Earn** | ** ** | **%** | ** ** | **Avg** | ** ** | **Earn** | ** ** | **%** | ** ** | **Avg** | ** ** | **Earn** | ** ** | **%** | ** ** |
| **(dollars in thousands)**                                         | ** ** | **Bal**                                              | ** ** | **Paid** | ** ** | **Rate** | ** ** | **Bal** | ** ** | **Paid** | ** ** | **Rate** | ** ** | **Bal** | ** ** | **Paid** | ** ** | **Rate** | ** ** |
| Assets:                                                            |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans                                                              |       | $                                                    | 169,853    |   | $ | 10,779 |   | 6.35 | % | $ | 166,960 |   | $ | 12,297 |   | 7.37 | % | $ | 146,944 |   | $ | 14,442 |   | 9.83 | % |
| Time  deposits - in other banks                                    |       | 12,536                                               |       | 27 |   | 0.22 | % | 1,306 |   | 29 |   | 2.22 | % | 1,359 |   | 66 |   | 4.86 | % |
| Investment  securities — taxable                              |       | 37,936                                               |       | 2,171 |   | 5.72 | % | 55,039 |   | 3,123 |   | 5.67 | % | 28,777 |   | 1,628 |   | 5.66 | % |
| Investment  securities — nontaxable                           |       | 44,795                                               |       | 3,311 |   | 7.39 | % | 16,667 |   | 1,218 |   | 7.31 | % | 7,260 |   | 477 |   | 6.57 | % |
| Federal  funds sold                                                |       | —                                               |       | — |   |   |   | 8,384 |   | 211 |   | 2.52 | % | 9,401 |   | 476 |   | 5.06 | % |
| Total  interest-earning assets                                     |       | 265,120                                              |       | 16,288 |   | 6.14 | % | 248,356 |   | 16,878 |   | 6.80 | % | 193,741 |   | 17,089 |   | 8.82 | % |
|                                                               |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Allowance  for credit losses                                       |       | (2,723                                               | )          |   |   |   |   | (2,090 | ) |   |   |   |   | (1,471 | ) |   |   |   |   |
| Noninterest-earning  assets:                                       |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash  and due from banks                                           |       | 6,714                                                |       |   |   |   |   | 7,973 |   |   |   |   |   | 6,663 |   |   |   |   |   |
| Premises  and equipment                                            |       | 4,889                                                |       |   |   |   |   | 5,000 |   |   |   |   |   | 4,867 |   |   |   |   |   |
| Accrued  interest receivable                                       |       | 1,590                                                |       |   |   |   |   | 1,555 |   |   |   |   |   | 1,139 |   |   |   |   |   |
| Other  assets                                                      |       | 19,506                                               |       |   |   |   |   | 10,754 |   |   |   |   |   | 7,689 |   |   |   |   |   |
| Total  average assets                                              |       | $                                                    | 295,096    |   |   |   |   |   | $ | 271,548 |   |   |   |   |   | $ | 212,618 |   |   |   |   |   |
|                                                               |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Liabilities  and Shareholders’ Equity:                        |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  Liabilities:                                     |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  demand                                           |       | $                                                    | 14,707     |   | $ | 18 |   | 0.12 | % | $ | 14,239 |   | $ | 36 |   | 0.25 | % | $ | 14,564 |   | $ | 37 |   | 0.25 | % |
| Money  market savings                                              |       | 1,425                                                |       | 3 |   | 0.25 | % | 1,735 |   | 12 |   | 0.69 | % | 1,732 |   | 12 |   | 0.69 | % |
| Savings  deposits                                                  |       | 5,856                                                |       | 29 |   | 0.50 | % | 6,477 |   | 66 |   | 1.02 | % | 4,759 |   | 49 |   | 1.03 | % |
| Time  deposits >$100M                                           |       | 57,959                                               |       | 2,060 |   | 3.55 | % | 58,787 |   | 2,717 |   | 4.62 | % | 46,609 |   | 2,405 |   | 5.16 | % |
| Time  deposits <$100M                                           |       | 95,712                                               |       | 3,388 |   | 3.54 | % | 74,469 |   | 3,379 |   | 4.54 | % | 50,814 |   | 2,589 |   | 5.10 | % |
| Other  Borrowing                                                   |       | 64,295                                               |       | 2,580 |   | 4.01 | % | 68,463 |   | 3,539 |   | 5.17 | % | 50,017 |   | 2,910 |   | 5.82 | % |
| Total  interest-bearing liabilities                                |       | 239,954                                              |       | 8,078 |   | 3.37 | % | 224,170 |   | 9,749 |   | 4.35 | % | 168,495 |   | 8,002 |   | 4.75 | % |
|                                                               |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  liabilities:                                  |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  checking                                      |       | 31,414                                               |       |   |   |   |   | 28,310 |   |   |   |   |   | 27,087 |   |   |   |   |   |
| Accrued  interest payable                                          |       | 1,485                                                |       |   |   |   |   | 1,934 |   |   |   |   |   | 1,628 |   |   |   |   |   |
| Other  liabilities                                                 |       | 6,089                                                |       |   |   |   |   | 3,435 |   |   |   |   |   | 1,731 |   |   |   |   |   |
| Total  Liabilities                                                 |       | 278,942                                              |       |   |   |   |   | 257,849 |   |   |   |   |   | 198,941 |   |   |   |   |   |
| Total  shareholders’ equity                                   |       | 16,154                                               |       |   |   |   |   | 13,699 |   |   |   |   |   | 13,687 |   |   |   |   |   |
| Total  average liabilities and Shareholders’ equity           |       | $                                                    | 295,096    |   |   |   |   |   | $ | 271,548 |   |   |   |   |   | $ | 212,618 |   |   |   |   |   |
| Net  interest income                                               |       |                                                 |       | $ | 8,210 |   |   |   |   |   | $ | 7,129 |   |   |   |   |   | $ | 9,087 |   |   |   |
| Interest  expense as a percentage of Total interest-earning assets |       |                                                 |       |   |   | 3.05 | % |   |   |   |   | 3.93 | % |   |   |   |   | 4.13 | % |
| Net  yield on interest-earning assets                              |       |                                                 |       |   |   | 3.09 | % |   |   |   |   | 2.87 | % |   |   |   |   | 4.69 | % |
| Net  interest spread                                               |       |                                                 |       |   |   | 2.77 | % |   |   |   |   | 2.45 | % |   |   |   |   | 4.07 | % |

 

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**Rate and Volume Analysis**

 

The following tables show the increase or decrease in interest income,interest expense and net interest income, resulting from changes in rates andvolumes, for the year ended December 31, 2009 compared with the sameperiod in 2008 and for the year ended December 31, 2008 compared with thesame period in 2007:

 
| ** **                                   | ** ** | **Increase (decrease) in the year ended**                       | ** ** |
|----------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                   | ** ** | **December 31, 2009 compared with December 31, 2008** | ** ** |
| **(dollars  in thousands)**                  | ** ** | **Volume**                                                      | ** ** | **Rate** | ** ** | **Total** | ** ** |
| Increase  (decrease) in interest income:     |       |                                                            |       |   |   |   |   |
| Loans                                        |       | $                                                               | 213        |   | $ | (1,731 | ) | $ | (1,518 | ) |
| Time  deposits - in other banks              |       | 249                                                             |       | (251 | ) | (2 | ) |
| Invest  securities — taxable            |       | (970                                                            | )          | 18 |   | (952 | ) |
| Invest  securities — nontaxable         |       | 2,056                                                           |       | 37 |   | 2,093 |   |
| Federal  funds sold                          |       | (211                                                            | )          | — |   | (211 | ) |
| Total  interest-earning assets               |       | 1,337                                                           |       | (1,927 | ) | (590 | ) |
|                                         |       |                                                            |       |   |   |   |   |
| Increase  (decrease) in interest expense:    |       |                                                            |       |   |   |   |   |
| Interest-bearing  demand                     |       | 1                                                               |       | (19 | ) | (18 | ) |
| Money  market savings                        |       | (2                                                              | )          | (7 | ) | (9 | ) |
| Savings  deposits                            |       | (6                                                              | )          | (31 | ) | (37 | ) |
| Time  deposits >$100M                     |       | (38                                                             | )          | (619 | ) | (657 | ) |
| Time  deposits <$100M                     |       | 964                                                             |       | (955 | ) | 9 |   |
| Other  Borrowing                             |       | (216                                                            | )          | (743 | ) | (959 | ) |
| Total  interest-bearing liabilities          |       | 703                                                             |       | (2,375 | ) | (1,671 | ) |
| Increase  (decrease) in net interest income: |       | $                                                               | 634        |   | $ | 448 |   | $ | 1,081 |   |

 
| ** **                                   | ** ** | **Increase (decrease) in the year ended**                       | ** ** |
|----------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                   | ** ** | **December 31, 2008 compared with December 31, 2007** | ** ** |
| **(dollars  in thousands)**                  | ** ** | **Volume**                                                      | ** ** | **Rate** | ** ** | **Total** | ** ** |
| Increase  (decrease) in interest income:     |       |                                                            |       |   |   |   |   |
| Loans                                        |       | $                                                               | 1,967      |   | $ | (4,112 | ) | $ | (2,145 | ) |
| Time  deposits - in other banks              |       | (3                                                              | )          | (34 | ) | (37 | ) |
| Invest  securities — taxable            |       | 1,486                                                           |       | 9 |   | 1,495 |   |
| Invest  securities — nontaxable         |       | 618                                                             |       | 123 |   | 741 |   |
| Federal  funds sold                          |       | (51                                                             | )          | (214 | ) | (265 | ) |
| Total  interest-earning assets               |       | 4,017                                                           |       | (4,228 | ) | (211 | ) |
|                                         |       |                                                            |       |   |   |   |   |
| Increase  (decrease) in interest expense:    |       |                                                            |       |   |   |   |   |
| Interest-bearing  demand                     |       | (1                                                              | )          | — |   | (1 | ) |
| Money  market savings                        |       | —                                                          |       | — |   | — |   |
| Savings  deposits                            |       | 18                                                              |       | (1 | ) | 17 |   |
| Time  deposits >$100M                     |       | 628                                                             |       | (316 | ) | 312 |   |
| Time  deposits <$100M                     |       | 1, 205                                                          |       | (415 | ) | 790 |   |
| Other  Borrowing                             |       | 1,073                                                           |       | (444 | ) | 629 |   |
| Total  interest-bearing liabilities          |       | 2,923                                                           |       | (1,176 | ) | 1,747 |   |
| Increase  (decrease) in net interest income: |       | $                                                               | 1,094      |   | $ | (3,052 | ) | $ | (1,958 | ) |

 

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**PROVISIONAND ALLOWANCE FOR LOAN AND LEASE LOSSES**

 

TheCorporation maintains a detailed, systematic analysis and procedural disciplineto determine the amount of the allowance for loan losses (“ALLL”).  TheALLL is based on estimates and is intended to be adequate to provide forprobable losses inherent in the loan portfolio.  This processinvolves deriving probable loss estimates that are based on individual loanloss estimation, historical loss rates and management’s judgment.

 

TheCorporation employs several methodologies for estimating probablelosses.  Methodologies are determined based on a number of factors,including type of asset, risk rating, concentrations, and collateral value.

 

TheCorporation calculates the required ALLL on a quarterly basis and makesadjusting entries as needed. The review of the adequacy of the allowancetakes into consideration such factors as concentrations of credit, changes inthe growth, size and composition of the loan portfolio, overall and individualportfolio quality, review of specific problem loans, collateral, guarantees andeconomic conditions that may affect the borrowers’ ability to pay and/or thevalue of the underlying collateral.  Additional factors consideredinclude: geographic location of borrowers, changes in the Corporation’sproduct-specific credit policy and lending staff experience.  Theseestimates depend on subjective factors and, therefore, contain inherentuncertainties.

 

TheCorporation’s ALLL is maintained at a level believed adequate by management toabsorb known and inherent probable losses on existing loans.  Aprovision for loan losses is charged to expense.  The allowance ischarged for losses when management believes that full recovery on the loan isunlikely.  Generally, the Corporation charges off any loan classifiedas a “loss”; portions of loans which are deemed to be uncollectible; overdraftswhich have been outstanding for more than 90 days; and, all other unsecuredloans past due 120 or more days.  Subsequent recoveries, if any, arecredited to the ALLL.

 

Although noassurance can be given that actual losses will not exceed the amount providedfor in the allowance, Management believes that the allowance is adequate toprovide for all estimated credit losses in light of all known relevantfactors.  At the end of 2009, 2008 and2007, the Bank’s allowance stood at 2.12%, 1.42%, and 1.19% of gross loans, respectively.  Provisions were made to the allowance forloan and lease losses in 2009, 2008 and 2007 of $3,368,000, $1,132,000, and$865,000, respectively.  Loans chargedoff in 2009, 2008 and 2007 totaled $2,329,000, $750,000 and $250,000,respectively.  Recoveries for these sameperiods were $77,000, $3,000, and $4,000, respectively.

 

The Bank’snon-performing (delinquent 90 days or more and on non-accrual) loans as apercentage of total loans were 5.33% 4.18% and 1.98% as of the end of 2009,2008 and 2007, respectively.  The significantincrease in non-accrual loans is primarily attributable to the continuedeconomic slowdown and the softening of the real estate market.

 

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**NON-INTERESTINCOME**

 

The followingtable presents a summary of the noninterest income:

 
| ** **                                    | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                    | ** ** | **2009**                                    | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                    | ** ** | **(Dollars in thousands)**        | ** ** |
| Service  charges on depositAccounts           |       | $                                           | 627        |   | $ | 760 |   | $ | 634 |   |
| Gain on sale of investment securities         |       | 3,189                                       |       | 449 |   | 216 |   |
| Merchant  discount fees                       |       | 4,495                                       |       | 2,731 |   | 2,423 |   |
| Credit  card programs fees                    |       | 1,075                                       |       | 514 |   | 684 |   |
| Income  from sales and servicing of SBA loans |       | 400                                         |       | 329 |   | 480 |   |
| Other  income                                 |       | 334                                         |       | 248 |   | (101 | ) |
|                                          |       |                                        |       |   |   |   |   |
| Total  noninterest income                     |       | $                                           | 10,120     |   | $ | 5,031 |   | $ | 4,336 |   |

 

Total noninterestincome increased $5,089,000 or 101.15% in 2009 when compared with 2008.  The increase resulted from increases in gainon sales of investment securities of $2,740,000, other income of $2,410,000,and income from sales and servicing of Small Business Administration loans of$71,000, while service charges on deposit accounts decreased $133,000.  The increase in other income was due toincreases in merchant discount fees of $1,764,000, fee income from credit cardprograms of $561,000 and a reduction of $829,000 in losses on trading assets($138,000 of losses in 2009 compared with a loss of $967,000 in 2008);partially offset by fee income from stored value card programs decreasing$74,000 and the gain of $694,000 on the mandatory repurchase of Visa, Inc.in conjunction with Visa, Inc.’s initial public offering reported in 2008.

 

Total noninterestincome increased $695,000 or 16.03% in 2008 when compared with 2007.  The increase resulted from increases inservice charges on deposit accounts of $126,000 and other income of $720,000;while income from sales and servicing of Small Business Administration loansdecreased $151,000.  The increase inother income was due primarily to a gain of $694,000 on the mandatoryrepurchase of Visa, Inc. in conjunction with Visa, Inc.’s initialpublic offering, increases in gains on security sales of $233,000 and merchantdiscount fees of $308,000; partially offset by $944,000 in losses on tradingassets compared with a loss of $686,000 in 2007, and decreases of $170,000 infee income from credit card programs and $138,000 in stored value cardprograms.

 

The sale of SmallBusiness Administration (SBA) guaranteed loans is a contributor to the Bank’sincome.  SBA guaranteed loans yield up to3.75% over the New York prime rate, and the guaranteed portions can be sold atpremiums which vary with market conditions. SBA loans are guaranteed by the full faith of the United StatesGovernment up to 85% of the principal amount. The guaranteed portion has risks comparable for an investor in a U.S.Government security and can usually be sold in the secondary financial market,either at a premium or at a yield which allows the Bank to maintain a significantspread for itself.

 

There can be noassurance that the gains on sale of SBA loans will continue at, or above, thelevels realized in the past three years. The Small Business Administration has recently increased the guaranteefees borrowers must pay.  Increasingcompetition among lenders for qualified SBA borrowers makes it difficult forthe Bank to continually expand its program in this area, and may limit thelevel of premium that can be earned with regard thereto.

 

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The followingtable presents a summary of activity in SBA loans for the years ended December 31:

 
| **(Dollars in thousands)** | ** ** | **2009** | ** ** | **2008** | ** ** | **2007** | ** ** |
|--------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| SBA  loans authorized                |       | $        | 8,393      |     | $          | 3,235    |       | $ | 3,065 |   |
| SBA  loans sold                      |       | $        | 2,740      |     | $          | 2,194    |       | $ | 1,933 |   |

 

The followingtable presents a summary of income from sales and servicing of SBA loans forthe years ended December 31:

 
| **(Dollars  in thousands)**                        | ** ** | **2009** | ** ** | **2008** | ** ** | **2007** | ** ** |
|----------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Income  from premium                               |       | $        | 255        |     | $          | 142      |       | $ | 147 |   |
| Income  from servicing                             |       | 145      |       | 187      |       | 333      |       |
| Total  income from sales andservicing of SBA loans |       | $        | 400        |     | $          | 329      |       | $ | 480 |   |

 

**NON-INTERESTEXPENSES**

 

The followingtable presents a summary of other noninterest expenses:

 
| ** **                      | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------|------------|-----------------------------------|------------|
| ** **                      | ** ** | **2009**                          | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                      | ** ** | **(Dollars in thousands)**        | ** ** |
| Salaries and benefits           |       | $                                 | 3,091      |   | $ | 3,664 |   | $ | 4,049 |   |
| Occupancy and equipment expense |       | 1,030                             |       | 967 |   | 866 |   |
| Foreclosed assets, net          |       | 1,401                             |       | 112 |   | — |   |
| Professional fees               |       | 1,034                             |       | 164 |   | 165 |   |
| Prepayment fees on borrowings   |       | 888                               |       | — |   | — |   |
| Data processing                 |       | 292                               |       | 360 |   | 361 |   |
| Other expenses                  |       | 5,247                             |       | 3,640 |   | 3,564 |   |
| Total other expenses            |       | $                                 | 12,983     |   | $ | 8,907 |   | $ | 9,005 |   |

 

Salary and benefits expense decreased $573,000 in 2009 due primarily tothe Bank limiting merit increases, not paying incentive bonuses and suspendingthe 401K contribution match and a $184,000 adjustment which reduced thedeferred compensation accrual.  Salaryand benefits expense decreased $385,000 in 2008 due primarily to the Bank notpaying incentive bonuses, partially offset by an accrual of $110,000 for postretirement benefits associated with a split-dollar insurance program and anincrease of $47,000 in health care insurance premiums.

 

Occupancy and equipment expenses increased $63,000 in 2009, primarilydue to increases of $26,000 in premises rent, $26,000 in depreciation expenseand $22,000 in maintenance expense. Occupancy and equipment expenses increased $101,000 in 2008, primarilydue to increases of $66,000 in premises rent, $18,000 in depreciation expense,$15,000 in utilities expense, and a

 

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reduction of $24,000 in sublease rental income; while merchant terminalexpense decreased $24,000.

 

Professionalfees for 2009 increased $870,000 due primarily to an increase of $677,000 inlegal fees and an increase of $170,000 in audit fees.  The increase in legal fees was a result ofincreased collection expense on loans and cost associated with legalproceedings.  The increase in acudit feesrelated to third party reviews deferred in 2008 to 2009 and additional reviewsof compliance related matter. Professional fees for 2008 were primarily unchanged when compared to2007.

 

Data processing expense for 2009 decreased $68,000 due primarily tonegotiation of a new data processing contract. Data processing expense for 2008 was primarily unchanged when comparedto 2007.

 

Other general and administrative expense for 2009 totaled $5,247,000compared with $3,640,000 for 2008, an increase of $1,607,000.  Significant changes occurred in the followingcategories with increases in merchant processing expense of $1,370,000, FDICand state assessments of $398,000, loan expenses of $105,000 and stored valuecard program expense of $65,000; while decreases occurred in ATM expense of$79,000, business development of $55,000, operational losses of $164,000 andstationary/supplies expense of $46,000.

 

Other general and administrative expense for 2008 totaled $3,640,000compared with $3,564,000 for 2007, an increase of $76,000.  Significant changes occurred in the followingcategories with increases in merchant processing expense of $246,000, FDIC andstate assessments of $88,000, ATM expense of $39,000, loan expenses of $29,000and miscellaneous expense of $22,000; while decreases occurred in advertisingof $61,000, business development of $56,000, operational losses of $25,000,director fees of $24,000 and entertainment and meals of $23,000.

 

**INCOMETAXES**

 

In 2009, the provision forfederal and state income taxes was a benefit of $(659,000), while the provisionwas $281,000 and $1,476,000 for 2008 and 2007, respectively.  This represents (69.17%) of income beforetaxes (benefit) in 2009, 16.12% in 2008 and 43.35% in 2007.  The decrease in the effective tax rate for2009 is a direct result of the Bank’s investing in tax-exempt securities,increased taxable deductions for provisions to the allowance for loan and leaselosses and recognition of a tax benefit for losses on trading assets.

 

The amount of the tax provision is determined by applying the statutoryincome tax rates to pre-tax book income, adjusted for permanent differencesbetween pre-tax book income and actual taxable income.  Such permanent differences include but arenot limited to tax-exempt interest income, increases in the cash surrendervalue of life insurance, and certain other expenses that are not allowed as taxdeductions.

 

**LOANS**

 

Loans, the largest component of earning assets, represented 64.07% ofaverage earning assets, and 57.56% of average total assets during 2009,compared with 67.23% and 61.48%, respectively during 2008.  In 2009, average loans increased 1.74% from$166,960,000 in 2008 to $169,853,000.  Averagereal estate loans increased $6,837,000 or 5.09%, average commercial loansincreased $3,617,000 or 11.62% and average installment loans increased$1,071,000 or 120.60%; 

 

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whileaverage construction loans decreased $8,632,000 or 41.41%.

 

Loans represented 67.23% of average earning assets, and 61.80% ofaverage total assets during 2008, compared with 75.85% and 69.11%, respectivelyduring 2007.  In 2008, average loansincreased 13.62% from $146,944,000 in 2007 to $166,960,000.  Average real estate loans increased$17,314,000 or 17.89%, average commercial loans increased $2,799,000 or 9.88%and average installment loans increased $193,000 or 27.82%; while averageconstruction loans decreased $290,000 or 1.37%.

 

Loansrepresented 75.85% of average earning assets, and 69.11% of average totalassets during 2007, compared with 75.79% and 69.17%, respectively during 2006.  In 2007, average loans increased 23.80% from$118,699,000 in 2006 to $146,944,000. Average real estate loans increased $16,590,000 or 20.69%, averageconstruction loans increased $9,117,000 or 75.89%, average commercial loansincreased $2,687,000 or 10.48%; while average installment loans decreased$149,000 or 17.68%.

 

The Bank’s commercial and industrial loans are generally made for thepurpose of providing working capital, financing the purchase of equipment orinventory, and other business purposes. Such loans generally have maturitiesranging from one year to several years. Short-term business loans are generally intended to finance currenttransactions and typically provide for monthly interest payments with principalbeing payable at maturity or at 90-day intervals. Term loans (usually for aterm of two to five years) normally provide for monthly installments ofprincipal and interest.  The Bank fromtime to time utilizes accounts receivable and inventory as security for loans.

 

The Bank is the recognizedleader for SBA lending in Monterey County, and holds SBA’s coveted PreferredLender Status.  Generally, SBA loans areguaranteed by the SBA for up to 85% of their principal amount, which can beretained in portfolio or sold to investors. Such loans are made at floating interest rates, but generally for longerterms (up to 25 years) than are available on a conventional basis to smallbusinesses.  The unguaranteed portion of the loans, although generallysupported by collateral, is considered to be more risky than conventionalcommercial loans because they may be based upon credit standards the Bank wouldnot otherwise apply, such as lower cash flow coverage, or longer repaymentterms.

 

The Bank’s realestate loan portfolio consists both of real estate construction loans and realestate mortgage loans.  The Bank hasinitiated a program to generate more commercial and industrial real estateloans, which generally yield higher returns than normal commercial loans.  The Bank has also developed a broker programfor generating residential real estate loans. The Bank does not make real estate development loans.  Real estateconstruction loans are made for a much shorter term, and often at higherinterest rates, than conventional single-family residential real estateloans.  The cost of administering suchloans is often higher than for other real estate loans, as principal is drawnon periodically as construction progresses.

 

The Bank alsomakes real estate loans secured by a first deed of trust on single familyresidential properties and commercial and industrial real estate.  California commercial banks are permitted,depending on the type and maturity of the loan, to lend up to 90% of the fairmarket value of real property (or more if the loan is insured either by privatemortgage insurers or governmental agencies). In certain instances, the appraised value may exceed the actual amountwhich could be realized on foreclosure, or declines in market value subsequentto making the loan can impair the Bank’s security.

 

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Consumer loans aremade for the purpose of financing the purchase of various types of consumergoods, home improvement loans, auto loans and other personal loans.  Consumer installment loans generally providefor monthly payments of principal and interest, at a fixed rate.  Most of the Bank’s consumer installment loansare generally secured by the personal property being purchased.  The Bank generally makes consumer loans tothose customers with a prior banking relationship with the Bank.

 

The followingtable presents the composition of the loan portfolio, including loans held forsale, at December 31 for the last five years:

 
| ** **                            | ** ** | **December 31,**      | ** ** |
|---------------------------------------|------------|----------------------------|------------|
| ** **                            | ** ** | **2009**                   | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                            | ** ** | **(Dollars in thousands)** | ** ** |
| Commercial and industrial             |       | $                          | 33,605     |   | $ | 29,887 |   | $ | 30,197 |   | $ | 27,543 |   | $ | 26,236 |   |
| Construction                          |       | 8,705                      |       | 16,040 |   | 23,396 |   | 17,326 |   | 10,456 |   |
| Real estate, mortgage                 |       | 121,887                    |       | 122,951 |   | 116,625 |   | 86,207 |   | 71,006 |   |
| Installment                           |       | 2,746                      |       | 966 |   | 876 |   | 694 |   | 942 |   |
| Government guaranteed loans purchased |       | 16                         |       | 24 |   | 32 |   | 39 |   | 45 |   |
|                                  |       | 166,959                    |       | 169,868 |   | 171,126 |   | 131,809 |   | 108,685 |   |
| Allowance for loan and lease losses   |       | (3,529                     | )          | (2,413 | ) | (2,028 | ) | (1,409 | ) | 1,101 | ) |
| Deferred origination fees, net        |       | (217                       | )          | (275 | ) | (350 | ) | (350 | ) | (284 | ) |
|                                  |       |                       |       |   |   |   |   |   |   |   |   |
| Loans, net                            |       | $                          | 163,213    |   | $ | 167,180 |   | $ | 168,748 |   | $ | 130,050 |   | $ | 107,300 |   |

 

The followingtable shows the maturity distribution and repricing intervals of the Bank’soutstanding loans, excluding non-accrual loans, at December 31, 2009.  Balances of fixed rate loans are displayed inthe column representative of the loan’s stated maturity date.  Balances for variable rate loans aredisplayed in the column representative of the loan’s next interest rate change.

 
| ** **                                             | ** ** | **Loan Maturities and Repricing Schedule** |
|--------------------------------------------------------|------------|----------------------------------------------------------------|
| ** **                                             | ** ** | **(Dollars in thousands)**                           | ** ** |
| ** **                                             | ** ** | **Within One  Year**                                           | ** ** | **After One But  Within Five  Years** | ** ** | **After Five  Years** | ** ** | **Total** | ** ** |
| Construction                                           |       | $                                                              | 5,209 |   | $ | 496 |   | $ | — |   | $ | 5,705 |   |
| Commercial, industrial and guaranteed loans  purchased |       | 21,941                                                         |   | 3,296 |   | 3, 291 |   | 28,528 |   |
| Real estate                                            |       | 49,804                                                         |   | 47,128 |   | 24,953 |   | 121,885 |   |
| Installment                                            |       | 2,584                                                          |   | 67 |   | 109 |   | 2,760 |   |
| Total gross loans                                      |       | $                                                              | 79,538 |   | $ | 50,987 |   | $ | 28,353 |   | $ | 158,878 |   |
| Loans with variable (floating) interest rates          |       | $                                                              | 72,492 |   | $ | 1,977 |   | $ | — |   | $ | 74,469 |   |
| Loans with predetermined (fixed) interest rates        |       | $                                                              | 6,860 |   | $ | 47,974 |   | $ | 28,353 |   | $ | 83,186 |   |

 

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**LoanConcentrations**

 

The Corporationhas concentration in real estate secured loans. At December 31, 2009, loans secured by real estate totaled$121,887,000, or 73.00% of the total loan portfolio, compared to $122,951,000,or 72.38%, at December 31, 2008. While there is a concentration in real estate secured loans, the riskassociated with that concentration is mitigated by the diversity of types ofreal estate held as collateral and the variety of businesses that areborrowers.  The Corporation’s lending isconcentrated in its primary lending area of Monterey County, California with$139,334,000, or 83.56%, located in this area at December 31, 2009compared to $125,650,000, or 73.97%, at December 31, 2008.

 

Concentration ofloans for specific industries and their percentage of total loans at December 31,2009 and 2008 are as follows:

 
| ** **                                        | ** ** | **2009** | ** ** | **2008** | ** ** |
|---------------------------------------------------|------------|----------|------------|----------|------------|
| Real  estate                                      |       | 18.75    | %          | 20.42    | %          |
| Accommodation  and food                           |       | 21.17    | %          | 22.00    | %          |
| Finance  and insurance                            |       | 11.89    | %          | 12.20    | %          |
| Professional,  scientific, and technical services |       | 10.44    | %          | 10.97    | %          |

 

**Non-performingand Non-accrual Loans**

 

The Bank’s presentpolicy is to cease accruing interest on loans which are past due as toprincipal or interest 90 days or more, except for loans which are well securedor when collection of interest and principal is deemed likely.  When a loan is placed on non-accrual,previously accrued and unpaid interest is generally reversed out of incomeunless adequate collateral from which to collect the principal of and intereston the loan appears to be available.

 

The followingtable presents information with respect to loans which, as of the datesindicated, were past due 90 days or more or were placed on non-accrual status(referred to collectively as “non-performing loans”) and other real estateowned (“OREO”), which are foreclosed properties:

 
| ** **                                                              | ** ** | **As of December 31,** | ** ** |
|-------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                              | ** ** | **2008**                    | ** ** | **2007** | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                              | ** ** | **(Dollars in thousands)**  | ** ** |
| Accruing, past due 90 days or more:                                     |       |                        |       |   |   |   |   |   |   |   |   |
| Real Estate                                                             |       | $                           | —     |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Commercial                                                              |       | —                      |       | — |   | — |   | — |   | — |   |
| Installment                                                             |       | —                      |       | — |   | — |   | — |   | — |   |
| Other                                                                   |       | —                      |       | — |   | — |   | — |   | — |   |
| Total accruing                                                          |       | —                      |       | — |   | — |   | — |   | — |   |
| Nonaccrual Loans:                                                       |       |                        |       |   |   |   |   |   |   |   |   |
|                                                                    |       |                        |       |   |   |   |   |   |   |   |   |
| Real Estate                                                             |       | 5,137                       |       | 6,876 |   | 3,200 |   | — |   | — |   |
| Commercial                                                              |       | 2,943                       |       | 215 |   | 41 |   | — |   | — |   |
| Installment                                                             |       | —                      |       | — |   | 155 |   | 155 |   | — |   |
| Other                                                                   |       | —                      |       | — |   | — |   | — |   | — |   |
| Total nonaccrual                                                        |       | 8,080                       |       | 7,091 |   | 3,396 |   | 155 |   | — |   |
|                                                                    |       |                        |       |   |   |   |   |   |   |   |   |
| Total nonperforming loans                                               |       | 8,080                       |       | 7,091 |   | 3,396 |   | 155 |   | — |   |
| OREO                                                                    |       | 14,333                      |       | 7,364 |   | — |   | — |   | — |   |
|                                                                    |       |                        |       |   |   |   |   |   |   |   |   |
| Total nonperforming assets                                              |       | $                           | 23,217     |   | $ | 14,455 |   | $ | 3,396 |   | $ | 155 |   | $ | — |   |
|                                                                    |       |                        |       |   |   |   |   |   |   |   |   |
| Total loans end of period                                               |       | $                           | 166,742    |   | $ | 169,868 |   | $ | 171,126 |   | $ | 131,809 |   | $ | 108,685 |   |
|                                                                    |       |                        |       |   |   |   |   |   |   |   |   |
| Ratio of nonperforming loans to total loans at end  of period           |       | 4.54                        | %          | 4.18 | % | 1.98 | % | 0.12 | % | 0.00 | % |
|                                                                    |       |                        |       |   |   |   |   |   |   |   |   |
| Ratio of nonperforming assets to total loans and  OREO at end of period |       | 12.36                       | %          | 8.17 | % | 1.98 | % | 0.12 | % | 0.00 | % |

 

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Interest income of $103,000 and $218,000 for theyears ended December 31, 2009 and 2008, was recognized on the non-accruingand restructured loans listed in the table above; whereas, interest income of$578,000 and $602,000 would have been recognized under their original terms.

 

**Potential Problem Loans**

 

In addition to loans classified for regulatorypurposes, management also designates certain loans for internal monitoringpurposes in a “watch” category.  Loansmay be placed on management’s watch list as a result of delinquent status,concern about the borrower’s financial condition or the value of the collateralsecuring the loan, substandard classification during regulatory examinations,or simply as a result of management’s desire to monitor more closely a borrower’sfinancial condition and performance. “Watch” category loans may include loanswith loss potential that are still performing and accruing interest and may becurrent under the terms of the loan agreements; however, management may have asignificant degree of concern about the borrowers’ ability to continue toperform according to the terms of the loans. Loss exposure on these loans istypically evaluated based primarily upon adequacy of the cash flow repaying theloan or the estimated liquidation value of the collateral securing theseloans.  Also, “watch” category loans mayinclude credits which, although adequately secured and performing, have pastdelinquency problems or where unfavorable financial trends are exhibited byborrowers.

 

All watch list loans are subject to additionalscrutiny and monitoring on a monthly or quarterly basis. The Company’s philosophyencourages loan officers to identify borrowers that should be monitored in thisfashion and believes this process ultimately results in the identification ofproblem loans in a more timely fashion.

 

Management has identified $4,893,000 and$7,901,000 of loans on its watch list, which were not included in impaired ornon-performing loans at December 31, 2009 and 2008, respectively.

 

The Bank does not haveany foreign loans or loans for highly leveraged transactions.

 

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**Summaryof Loan Loss Experience**

 

The following table reflectsthe activity in the Corporation’s allowance for loan and lease losses for theyears ended December 31, 2009, 2008, 2007, 2006 and 2005:

 
| ** **                                                                     | ** ** | **For the Years ended December 31,** | ** ** |
|--------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                     | ** ** | **2009**                                  | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                     | ** ** | **(Dollars in thousands)**                | ** ** |
| Average  loans outstanding                                                     |       | $                                         | 169,853    |   | $ | 166,960 |   | $ | 146,944 |   | $ | 18,699 |   | $ | 108,963 |   |
|                                                                           |       |                                      |       |   |   |   |   |   |   |   |   |
| Total  loans outstanding at end of the period                                  |       | $                                         | 166,959    |   | $ | 169,868 |   | $ | 171,126 |   | $ | 131,809 |   | $ | 108,685 |   |
|                                                                           |       |                                      |       |   |   |   |   |   |   |   |   |
| Allowance,  beginning of period                                                |       | $                                         | 2,413      |   | $ | 2,028 |   | $ | 1,409 |   | $ | 1,101 |   | $ | 963 |   |
|                                                                           |       |                                      |       |   |   |   |   |   |   |   |   |
| Loans  charged off during period:                                              |       |                                      |       |   |   |   |   |   |   |   |   |
| Commercial                                                                     |       | 358                                       |       | 187 |   | 249 |   | — |   | — |   |
| Installment                                                                    |       | 37                                        |       | — |   | 1 |   | 109 |   | 14 |   |
| Real  Estate                                                                   |       | 1,908                                     |       | 563 |   | — |   | — |   | — |   |
| Other                                                                          |       | 26                                        |       | — |   | — |   | — |   | — |   |
| Total  charge offs                                                             |       | 2,329                                     |       | 750 |   | 250 |   | 109 |   | 14 |   |
|                                                                           |       |                                      |       |   |   |   |   |   |   |   |   |
| Recoveries  during period:                                                     |       |                                      |       |   |   |   |   |   |   |   |   |
| Commercial                                                                     |       | 2                                         |       | 3 |   | — |   | — |   | — |   |
| Installment                                                                    |       | —                                    |       | — |   | — |   | 7 |   | 2 |   |
| Real  Estate                                                                   |       | 75                                        |       | — |   | — |   | — |   | — |   |
| Other                                                                          |       | —                                    |       | — |   | 4 |   | — |   | — |   |
| Total  recoveries                                                              |       | 77                                        |       | 3 |   | 4 |   | 7 |   | 2 |   |
|                                                                           |       |                                      |       |   |   |   |   |   |   |   |   |
| Net  loans charged off during the period                                       |       | 2,252                                     |       | 747 |   | 246 |   | 102 |   | 12 |   |
|                                                                           |       |                                      |       |   |   |   |   |   |   |   |   |
| Additions  to allowance for loan and lease losses                              |       | 3,368                                     |       | 1,132 |   | 865 |   | 410 |   | 150 |   |
|                                                                           |       |                                      |       |   |   |   |   |   |   |   |   |
| Allowance,  end of period                                                      |       | $                                         | 3,529      |   | $ | 2,413 |   | $ | 2,028 |   | $ | 1,409 |   | $ | 1,101 |   |
|                                                                           |       |                                      |       |   |   |   |   |   |   |   |   |
| Ratio  of net loans charged off to average loans outstanding during the period |       | 1.33                                      | %          | 0.45 | % | 0.17 | % | 0.09 | % | 0.01 | % |
|                                                                           |       |                                      |       |   |   |   |   |   |   |   |   |
| Ratio  of allowance to total loans at end of period                            |       | 2.12                                      | %          | 1.42 | % | 1.19 | % | 1.07 | % | 1.02 | % |
|                                                                           |       |                                      |       |   |   |   |   |   |   |   |   |
| Ratio  of nonperforming loans to allowance for loan losses at end of period    |       | 251.75                                    | %          | 293.82 | % | 167.46 | % | 11.00 | % | N/A |   |

 

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The following tablesummarizes the allocation of the allowance for loan and lease losses by loantype based on the Bank’s methodology for evaluating its allowance, and thepercent of loans and leases in each category to total loans at the datesindicated.  The allocation of individual categories of loans includes amountsapplicable to specifically identified as well as unidentified losses inherentin that segment of the loan portfolio and will necessarily change whenevermanagement determines that the risk characteristics of the loan portfolio havechanged.  Management believes that anybreakdown or allocation of the allowance for loan losses into loan categorieslends an appearance of exactness which does not exist, in that the allowance isutilized as a single allowance available for all loans. The allocation belowshould not be interpreted as an indication of the specific amounts of or loancategories in which future charge-offs may occur:

 
| ** **   | ** ** | **December 31, 2009** | ** ** | **December 31, 2008**                          | ** ** |
|--------------|------------|----------------------------|------------|-----------------------------------------------------|------------|
| ** **   | ** ** | **Amount**                 | ** ** | **Percent of  Loans in  Category to   Total Loans** | ** ** | **Amount** | ** ** | **Percent of  Loans in  Category to  Total Loans** | ** ** |
| Commercial   |       | $                          | 995        |                                                | 20.14      | % | $ | 695 |   | 17.53 | % |
| Construction |       | 338                        |       | 5.21                                                | %          | 207 |   | 9.75 | % |
| Real  Estate |       | 2,174                      |       | 73.00                                               | %          | 1,370 |   | 72.15 | % |
| Installment  |       | 9                          |       | 1.65                                                | %          | 31 |   | 0.57 | % |
| Unallocated  |       | 13                         |       | N/A                                                 |       | 110 |   | N/A |   |
| Total        |       | $                          | 3,529      |                                                | 100.00     | % | $ | 2,413 |   | 100.00 | % |

 

**FUNDING SOURCES**

 

Average depositsincreased 13.85% to $207,073,000 in 2009 from $184,017,000 in 2008.  In 2009 average certificates of depositincreased 15.32% and average demand deposits increased 10.96% while averageinterest checking, money market savings accounts as a group decreased 2.06%.  Average certificates of deposit represented74.21% of average deposits in 2009 compared with 72.42% in 2008.  Average interest checking, money market andsavings accounts as a group were 10.62% of average deposits in 2009 comparedwith 12.20% in 2008.  Average demanddeposits represented 15.17% of average deposits in 2009 compared with 15.38% in2008.

 

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The followingtable summarizes the distribution of average daily deposits and the averagedaily rates paid for the years ended December 31, 2009, 2008, 2007,respectively.

 
| ** **                    | ** ** | **Average Deposits**       | ** ** |
|-------------------------------|------------|----------------------------|------------|
| ** **                    | ** ** | **For the year ended**     | ** ** | **For the year ended** | ** ** | **For the year ended** | ** ** |
| ** **                    | ** ** | **December 31, 2009** | ** ** | **December 31, 2008** | ** ** | **December 31, 2007** | ** ** |
| ** **                    | ** ** | ** **                 | ** ** | **($ in thousands)** | ** ** | ** ** | ** ** |
| ** **                    | ** ** | **Average   Balance**      | ** ** | **Average  Rate** | ** ** | **Average   Balance** | ** ** | **Average  Rate** | ** ** | **Average   Balance** | ** ** | **Average  Rate** | ** ** |
| Noninterest-bearing  checking |       | $                          | 31,414     |   |   |   | $ | 28,310 |   |   |   | $ | 27,087 |   |   |   |
|                          |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  demand      |       | 14,707                     |       | 0.12 | % | 14,239 |   | 0.25 | % | 14,564 |   | 0.25 | % |
| Money  market savings         |       | 1,425                      |       | 0.25 | % | 1,735 |   | 0.69 | % | 1,732 |   | 0.75 | % |
| Savings  deposits             |       | 5,856                      |       | 0.50 | % | 6,477 |   | 1.02 | % | 4,759 |   | 1.03 | % |
| Time  deposits >$100M      |       | 57,959                     |       | 3.55 | % | 58,787 |   | 4.62 | % | 46,609 |   | 5.16 | % |
| Time  deposits <$100M      |       | 95,712                     |       | 3.54 | % | 74,469 |   | 4.54 | % | 50,814 |   | 5.10 | % |
|                          |       | 175,659                    |       | 3.13 | % | 155,707 |   | 3.99 | % | 118,478 |   | 4.30 | % |
|                          |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Total  deposits               |       | $                          | 207,073    |   | 2.66 | % | $ | 184,017 |   | 3.50 | % | $ | 145,565 |   | 2.50 | % |

 

The following table setsforth the scheduled maturities of time deposits in denominations of $100,000 orgreater, which amounted to $58,701,000 at December 31, 2009:

 

Maturities of Time Deposits of $100,000 ormore

At December 31, 2009

($ in thousands)

 
| Three months or less                  |   | $      | 9,186  |   |
|---------------------------------------|--------|--------|--------|--------|
| Over three months through six months  |   | 11,599 |   |
| Over six months through twelve months |   | 23,664 |   |
| Over twelve months                    |   | 14,252 |   |
|                                  |   | $      | 58,701 |   |

 

The Corporation has aline of credit with M & I Marshall & Ilsley Bank in theamount of $3,000,000, at a fixed interest rate of 6.50% and a maturity date of April 30,2010.  At December 31, 2009,$2,850,000 was advanced on the line.

 

The Bank has lines ofcredit from the FHLB of San Francisco, and the Federal Reserve Bank withremaining available borrowing capacity on December 31, 2009 of $1,337,000and $2,707,000, respectively.  TheFederal Home Loan Bank line of credit has a maximum borrowing capacity of 20%of the Bank’s total assets, adjusted quarterly. The FHLB line of credit is secured by a portion of the Bank’s realestate secured loans and securities at December 31, 2009.  At December 31, 2009, the totalprincipal balance of pledged loans and securities was $43,869,000 and$8,470,000, respectively.  At December 31,2008, the total principal balance of pledged loans and securities was$38,597,000 and $43,044,000, respectively.

 

The Federal Reserve Bankdiscount window line is secured by a portion the Bank’s securities. At December 31,2009 and 2008 the total market value of securities pledged was $24,245,000 and$21,448,000, respectively. At December 31, 2009 and 2008 the remainingavailable credit on the line was $2,707,000 and $7,165,000, respectively.

 

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Thefollowing table provides information on FHLB advances outstanding at December 31,2009.

 
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Funding** | ** ** | **Maturity** | ** ** |
|------------|------------|------------|------------|------------|------------|-------------|------------|--------------|------------|
| ** ** | ** ** | **Amount** | ** ** | **Rate**   | ** ** | **Date**    | ** ** | **Date**     | ** ** |
|       |       | $          | 5,000,000  |       | 4.96       | %           | 11/14/05   |         | 11/15/10   |   |
|       |       | 1,750,000  |       | 4.74       | %          | 1/26/06     |       | 1/26/11      |       |
|       |       | 2,250,000  |       | 4.75       | %          | 1/26/06     |       | 1/26/11      |       |
|       |       | 3,500,000  |       | 5.51       | %          | 7/17/06     |       | 7/18/11      |       |
|       |       | 1,500,000  |       | 5.52       | %          | 7/17/06     |       | 7/18/11      |       |
|       |       | 1,000,000  |       | 5.22       | %          | 8/25/06     |       | 8/25/11      |       |
|       |       | 5,000,000  |       | 5.21       | %          | 7/30/07     |       | 7/30/12      |       |
|       |       | 3,000,000  |       | 4.85       | %          | 10/1/07     |       | 10/1/12      |       |
|       |       | 5,000,000  |       | 5.01       | %          | 9/18/07     |       | 9/18/14      |       |
|       |       | 1,000,000  |       | 7.72       | %          | 6/1/00      |       | 6/3/30       |       |
|       |       | $          | 29,000,000 |       |       |        |       |         |       |   |

 

The Bank had a loan from the FRB in the amount of$10,000,000 with an interest rate of 0.50% and a maturity date of January 11,2010.  At maturity, the loan was paid off with cash fundsand funding from a new loan in the amount of $5,000,000 with the same terms anda maturity date of February 8, 2010. The loan was paid off at maturity on February 8, 2010.

 

TheBank has two letters of credit issued by FHLB of San Francisco. One letter ofcredit in the amount of $330,000, expiring April 20, 2011, is used tosecure local agency deposits.  Thebeneficiary of the letter of credit is the Administrator of Local Agency Security,DFI.  The other letter of credit, in theamount of $1,300,000, expiring February 17, 2019, has MasterCardInternational Inc. as the beneficiary.

 

**CAPITALRESOURCES**

 

The Corporationand the Bank maintain capital to comply with legal requirements, to provide amargin of safety for depositors and shareholders, and to provide for futuregrowth and the ability to pay dividends. At December 31, 2009, the Corporation’s shareholders’ equity was$16,150,000 versus $14,352,000 at December 31, 2008.  The Corporation paid no cash dividends in2009, whereas cash dividends of $0.25 per share were paid in 2008 and2007.  The Bank paid cash dividendstotaling $500,000, $0 and $800,000 to the Corporation in 2009, 2008 and 2007,respectively.

 

The FDIC and FRBhave adopted capital adequacy guidelines for use in their examination andregulation of banks and bank holding companies. If the capital of a bank or bank holding company falls below the minimumlevels established by these guidelines, it may be denied approval to acquire orestablish additional banks or non-bank businesses, or the FDIC or FederalReserve Board may take other administrative actions.  The guidelines employ two measures ofcapital:  (1) risk-based capital and(2) leverage capital.

 

In general, the risk-basedcapital guidelines provide detailed definitions of which obligations will betreated as capital, and assign different weights to various assets andoff-balance sheet items, depending upon the perceived degree of credit riskassociated with each asset.  Each assetis assigned to one of four risk-weighted categories.  For example, 0% for cash and unconditionallyguaranteed government securities; 20% for deposits with other banks and fedfunds; 50% for state

 

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bonds and certainresidential real estate loans; and 100% for commercial loans and otherassets.  Capital is categorized as eitherTier 1 capital, consisting of common shareholders equity,qualifying perpetual preferred stock to certain limits, minority interests inequity accounts of consolidated subsidiary and trust preferred securities tocertain limits, less goodwill and other intangibles, or Tier 2 capital, which consists of supplementarycapital including allowance for possible credit losses to certain limits,certain preferred stock, eligible subordinated debt, and other qualifyinginstruments).  The guidelines also define and set minimumcapital requirements (risk-based capital ratios).  All banks are required to maintain Tier 1capital of at least 4% and total capital of 8.0% of risk-adjusted assets. TheBank had a Tier 1 capital to total risk-adjusted assets capital ratio of 13.27%and 11.93% at December 31, 2009 and 2008, respectively.  The Bank’s Tier 1 capital exceeds the minimumregulatory requirement by $18,141,000. The Bank had a Total Risk-Based capital to risk-adjusted assets ratio of14.53% and 13.13% at December 31, 2009 and 2008, respectively.  The Bank’s Total Risk-Based capital exceedsthe minimum regulatory requirement by $12,754,000.

 

The Tier 1 leveragecapital ratio guidelines require a minimum leverage capital ratio of 4% of Tier1 capital to total assets less goodwill. The Bank had a leverage capital ratio of 9.63% and 8.48% at December 31,2009 and 2008, respectively.  The Bank’sTier 1 leverage capital exceeds the minimum regulatory requirement by$15,182,000.

 

Asof the end of 2009, the Bank was considered to be “well capitalized” byregulatory standards.  We do not foreseeany circumstances that would cause either the Corporation or the Bank to beless than “well capitalized”, although no assurance can be given that this willnot occur.

 

OnMarch 27, 2003, the Corporation’s wholly owned special-purpose trustsubsidiary, Northern California Bancorp, Inc. Trust I (“Trust I”) issued$3 million in cumulative Trust Preferred Securities.  The securities bear a floating rate ofinterest of 3.25% over the three month LIBOR rate, payable quarterly.  The effective rate at December 31, 2009and 2008 was 3.53% and 8.07%, respectively. Concurrent with the issuance of theTrust Preferred Securities, Trust I used the proceeds from the Trust PreferredSecurities offering to purchase a like amount of Junior Subordinated Debenturesof the Corporation.  The SubordinatedDebentures are the sole assets of Trust I and are eliminated, along with the related income statementeffects, in the consolidated financial statements.  The Corporation pays interest on the JuniorSubordinated Debentures to Trust I, which represents the sole revenue and solesource of dividend distributions to the holders of the Trust PreferredSecurities.  The Corporation has theright, assuming no default has occurred, to defer payments of interest on theJunior Subordinated Debentures at any time for a period not to exceed 20consecutive quarters.  The TrustPreferred Securities will mature on April 7, 2033, but can be redeemed, inwhole or in part, on any January 7, April 7, July 7 or October 7on or after April 7, 2008 at par. The Corporation fully and unconditionally guarantees the obligations ofTrust I, on a subordinated basis.

 

The Corporation received $2.91 million from Trust I upon issuance of theJunior Subordinated Debentures, of which $1 million was contributed by theCorporation to the Bank to increase its capital, $1.14 million was used toretire existing Corporation debt and the remainder held as working capital.

 

On November 13, 2003, the Corporation’s wholly owned special-purposetrust subsidiary, Northern California Bancorp, Inc. Trust II (“Trust II”)issued $5 million in cumulative Trust Preferred Securities.  The securities bear a floating rate ofinterest of 2.85% over the three month LIBOR rate, payable quarterly.  Theeffective rate at December 31, 2009 and 2008 was 3.13% and 6.04%,respectively.  Concurrent with the issuance of the TrustPreferred Securities, Trust II used

 

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the proceeds from the Trust Preferred Securities offering to purchase alike amount of Junior Subordinated Debentures of the Corporation.  The Subordinated Debentures are the soleassets of Trust II and are eliminated, along with the related income statementeffects, in the consolidated financial statements.  The Corporation pays interest on the JuniorSubordinated Debentures to Trust II, which represents the sole revenue and solesource of dividend distributions to the holders of the Trust PreferredSecurities.  The Corporation has theright, assuming no default has occurred, to defer payments of interest on theJunior Subordinated Debentures at any time for a period not to exceed 20consecutive quarters.  The TrustPreferred Securities will mature on August 8, 2033, but can be redeemed,in whole or in part, on any February 8, May 8, August 8 or November 8on or after August 8, 2008 at par. The Corporation fully and unconditionally guarantees the obligations ofTrust II, on a subordinated basis.

 

The Corporation received $4.96 million from Trust II upon issuance of theJunior Subordinated Debentures, of which $2.5 million was contributed by theCorporation to the Bank to increase its capital and the remainder held asworking capital.

 

Under current applicable regulatory guidelines for bank holdingcompanies, a portion of the Trust Preferred Securities qualifies as Tier ICapital, and the remainder as Tier II Capital. No assurance can be given that the Trust Preferred Securities willcontinue to be treated as Tier I Capital in the future.

 

The Corporation has exercised its rights in accordance with Section 2.11Extension of interest Payment Period of the Indentures for both NorthernCalifornia Bancorp, Inc. Trust I and Trust II to defer interest paymentsfor period not to exceed twenty (20) consecutive quarters.

 

**LIQUIDITY**

 

Liquidityrepresents the ability to provide sufficient cash flows or cash resources in amanner that enables an entity to meet its obligations in a timely fashion andadequately provide for anticipated future cash needs.

 

For the Bank, liquidityconsiderations involve the capacity to meet expected and potential requirementsof depositors seeking access to balances and to provide for the credit demandsof borrowing customers.  In the ordinarycourse of the Bank’s business, funds are generated from the repayment of loans,maturities within the investment securities portfolio and the acquisition ofdeposit balances and short-term borrowings. The Bank has lines of credit from the FHLB of San Francisco, and theFederal Reserve Bank with remaining available borrowing capacity on December 31,2009 of $1,337,000 and $2,707,000, respectively.  The FHLB line of credit has a maximumborrowing capacity of 20% of the Bank’s total assets, adjusted quarterly.  The Federal Home Loan Bank line of credit issecured by a portion of the Bank’s real estate secured loans andsecurities.  At December 31, 2009,the total principal balance of pledged loans and securities was $43,869,000 and$8,470,000, respectively.  At December 31,2008, the total principal balance of pledged loans and securities was$38,597,000 and $43,044,000, respectively.

 

The FRB discount windowline is secured by a portion the Bank’s securities, at December 31, 2009and 2008 the total market value of securities pledged was $24,245,000 and$21,448,000. At December 31, 2009 and 2008 the remaining available crediton the line was $2,707,000 and $7,165,000, respectively.

 

As a matter of policy,the Bank seeks to maintain a level of liquid assets, including marketableinvestment securities, equal to a least 15% of total assets (“primary liquidity”),while maintaining sources of secondary liquidity (borrowing lines from otherinstitutions) equal to at least 

 

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an additional 10%of assets.  In addition, it seeks togenerally limit loans to not more than 110% of deposits.  Within theseratios, the Bank generally has excess funds available to sell as federal fundson a daily basis, and is able to fund its own liquidity needs without the needof short-term borrowing.  The Bank’stotal liquidity at December 31, 2009, 2008 and 2007 was 27.94%, 35.49%,and 24.31%, respectively, while its average loan to deposit ratio for suchyears was 82.37%, 89.48% and 100.85%, respectively.

 

Brokered deposits aredeposit instruments, such as certificates of deposit, deposit notes, bankinvestment contracts and certain municipal investment contracts that are issuedthrough brokers and dealers who then offer and/or sell these depositinstruments to one or more investors. Additionally, deposits on which a financial institution pays an interestrate significantly higher than prevailing rates are considered to be brokereddeposits.  Federal law and regulationrestricts banks from soliciting or accepting brokered deposits, unless the bankis well capitalized under Federal guidelines. The Bank had brokered deposits totaling $11,026,000 and $1,996,000 at December 31,2009 and 2008, this represented 5.44% and 1.05% of total deposits,respectively, and no brokered deposits at December 31, 2007. None of theBank’s brokered deposits paid an interest rate significantly higher thanprevailing rates.

 

The Corporation’s sourcesof revenues and liquidity are the dividends, tax equalization payments ormanagement fees from the Bank and gains on securities held in a trading accountand other investments.  The ability ofthe Bank to pay such items to the Corporation is subject to limitations understate and Federal law.

 

**INTERESTRATE RISK**

 

Management of interest rate sensitivity(asset/liability management) involves matching and repricing rates ofinterest-earning assets with interest-bearing liabilities in a manner designedto optimize net interest income within the constraints imposed by regulatoryauthorities, liquidity determinations and capital considerations.

 

The purpose forasset/liability management is to provide stable net interest income growth byprotecting the Bank’s earnings from undue interest rate risk.  The Bank expects to generate earnings fromincreasing loan volume, appropriate loan pricing and expense control and notfrom trying to accurately forecast interest rates.  Another important function of asset/liabilitymanagement is managing the risk/return relationships between interest raterisk, liquidity, market risk and capital adequacy.  The Bank gives priority to liquidity concernsfollowed by capital adequacy, then interest rate risk and market risk in theinvestment portfolio.  The policy of theBank will be to control the exposure of the Bank’s earnings to changinginterest rates by generally maintaining a position within a narrow range aroundan “earnings neutral position.” An earnings neutral position is defined as themix of assets and liabilities that generate a net interest margin that is notaffected by interest rate changes. However, Management does not believe that the Bank can maintain atotally earnings neutral position. Further, the actual timing of repricing of assets and liabilities doesnot always correspond to the timing assumed by the Bank for analyticalpurposes.  Therefore, changes in marketrates of interest will generally impact the Bank’s net interest income and netinterest margin for long or short periods of time.

 

The Bank monitors itsinterest rate risk on a quarterly basis through the use of a model whichcalculates the effect on earnings of changes in the fed funds rate.  The model converts a fed funds rate changeinto rate changes for each major class of asset and liability, then simulatesthe bank’s net interest margin based on the bank’s actual repricing over a oneyear period, assuming 

 

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that maturities arereinvested in instruments identical to those maturing during the period.  The following table shows the affect on netinterest income of 100, 200 and a 300 basis point rate shocks and a negative 25basis point rate shock at December 31, 2009.  The table only includes projections fordecrease 25 basis points since the Federal Funds target rate is currentlybetween 0% and 0.25%.

 

| **Rate Shock Increase (Decrease)  in Basis Points** | ** ** | **Percent Increase (Decrease) in  Net Interest Income** |
|-----------------------------------------------------|------------|---------------------------------------------------------|
| (25)                                                |       | (0.6%)                                                  |
| 100                                                 |       | 4.5%                                                    |
| 200                                                 |       | 10.1%                                                   |
| 300                                                 |       | 15.7%                                                   |

 

**INVESTMENTSECURITIES**

 

TheCorporation maintains a trading account, at fair value, consisting ofmarketable securities.  At December 31,2009 and 2008 the account value was $153,000 and $361,000, respectively.  In addition the Corporation has investmentsin Northern California Bancorp Trust I of $93,000 and Northern CaliforniaBancorp Trust II of $155,000.  These arespecial-purpose trust subsidiaries which were formed to facilitate the issuanceof trust preferred securities.

 

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The following table setsforth the book and market value of investment securities as of December 31,2009, 2008 and 2007:

 

INVESTMENTPORTFOLIO MIX

(Dollars in thousands)

 
| ** **                                       | ** ** | **2009**  | ** ** | **2008**   | ** ** | **2007**  | ** ** |
|--------------------------------------------------|------------|-----------|------------|------------|------------|-----------|------------|
| ** **                                       | ** ** | **Book**  | ** ** | **Market** | ** ** | **Book**  | ** ** | **Market** | ** ** | **Book** | ** ** | **Market** | ** ** |
| ** **                                       | ** ** | **value** | ** ** | **value**  | ** ** | **value** | ** ** | **value** | ** ** | **value** | ** ** | **value** | ** ** |
| Available  for sale:                             |       |      |       |       |       |      |       |   |   |   |   |   |   |
| Government  National Mortgage Association        |       | $         | —     |       | $          | —    |       | $ | — |   | $ | — |   | $ | 386 |   | $ | 385 |   |
| Corporate  Debt Securities                       |       | —    |       | —     |       | 5,846     |       | 5,866 |   | — |   | — |   |
| Mortgage  Backed Securities                      |       | 1,534     |       | 1,490      |       | 4,048     |       | 3,892 |   | — |   | — |   |
| State/Local  Agency Securities                   |       | 53,000    |       | 53,074     |       | 41,839    |       | 40,551 |   | 225 |   | 225 |   |
| U.S.  Government Agencies                        |       | 7,988     |       | 7,849      |       | 42,197    |       | 43,044 |   | 36,027 |   | 36,191 |   |
| Total                                            |       | $         | 62,522     |       | $          | 62,413    |       | $ | 93,930 |   | $ | 93,353 |   | $ | 36,638 |   | $ | 36,801 |   |
|                                             |       |      |       |       |       |      |       |   |   |   |   |   |   |
| Held  to maturity:                               |       |      |       |       |       |      |       |   |   |   |   |   |   |
| State/Local  Agency Securities                   |       | $         | —     |       | $          | —    |       | $ | — |   | $ | — |   | $ | 7,869 |   | $ | 8,105 |   |
|                                             |       |      |       |       |       |      |       |   |   |   |   |   |   |
| Other  Securities:                               |       |      |       |       |       |      |       |   |   |   |   |   |   |
| Federal  Home Loan Bank Stock                    |       | $         | 3,360      |       | $          | 3,360     |       | $ | 3,097 |   | $ | 3,097 |   | $ | 2,495 |   | $ | 2,495 |   |
| AT  Services, LLC                                |       | —    |       | —     |       | 20        |       | 20 |   | 20 |   | 20 |   |
| Metrocities  Mortgage, LLC                       |       | —    |       | —     |       | 10        |       | 10 |   | 10 |   | 10 |   |
| The  Independent Bankers’ Financial Corp.   |       | 51        |       | 51         |       | 51        |       | 51 |   | 51 |   | 51 |   |
| Northern  California Bancorp, Inc. Trust I  |       | 93        |       | 93         |       | 93        |       | 93 |   | 93 |   | 93 |   |
| Northern  California Bancorp, Inc. Trust II |       | 155       |       | 155        |       | 155       |       | 155 |   | 155 |   | 155 |   |
| Visa,  Inc Class B Stock                    |       | 426       |       | 426        |       | 426       |       | 426 |   | — |   | — |   |
| Total                                            |       | $         | 4,085      |       | $          | 4,085     |       | $ | 3,852 |   | $ | 3,852 |   | $ | 2,824 |   | $ | 2,824 |   |

 

The contractualmaturities of investment securities as well as yields based on amortized costof those securities at December 31, 2009 are shown below.  Actual maturities may differ from contractualmaturities because issuers have the right to call or prepay obligations with orwithout call or prepayment penalties.

 
| ** **                    | ** ** | **After  five years to** | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-------------------------------|------------|--------------------------|------------|----------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                    | ** ** | **ten  years**           | ** ** | **After  ten years** | ** ** | **Total**  | ** ** |
| **(Dollars in thousands)**    | ** ** | **Amount**               | ** ** | **Yield**            | ** ** | **Amount** | ** ** | **Yield**  | ** ** | **Amount** | ** ** | **Yield** | ** ** |
| Available-for-sale            |       |                     |       |                 |       |       |       |       |       |       |       |   |   |
| Mortgage Backed Securities    |       | $                        | —     |                 | 0.00       | %          | $          | 1,490      |       | 5.18       | %          | $ | 1,490 |   | 5.18 | % |
| State/Local Agency Securities |       | —                   |       | 0.00                 | %          | 53,074     |       | 4.97       | %          | 53,074     |       | 4.97 | % |
| U.S. Government Agencies      |       | 987                      |       | 4.00                 | %          | 6,862      |       | 5.25       | %          | 7,849      |       | 5.09 | % |
|                          |       | $                        | 987        |                 | 4.00       | %          | $          | 61,426     |       | 5.01       | %          | $ | 62,413 |   | 4.99 | % |

 

**INFLATION**

 

The impact of inflation on afinancial institution can differ significantly from that exerted on othercompanies. Banks, as financial intermediaries, have many assets and liabilitieswhich may move in concert with inflation, both as to interest rates and value.However, financial institutions are affected by inflation’s impact onnoninterest expenses, such as salaries and occupancy expenses.

 

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From 2004 through mid-2006,the Bank experienced an increasing rate environment due to the actions of theFederal Reserve, which began increasing rates in mid-2004.  Beginning in September 2007 the FederalReserve began reducing rates and through the date of this Annual Report on Form 10-K,the Federal Reserve has reduced rates 10 times for an overall rate reduction of525 basis points.  Because of the Bank’sratio of rate sensitive assets to rate sensitive liabilities, the Bank benefitsin the short term from an increasing interest rate market and suffers in adecreasing interest rate market. As such, the management of the money supply bythe Federal Reserve to control the rate of inflation has an impact on theearnings of the Bank. The changes in interest rates may have a correspondingimpact on the ability of borrowers to repay loans with the Bank.

 

#### **OFF-BALANCE SHEET ARRANGEMENTS**

####  

The Bank has various “off-balance sheet” arrangements that might havean impact on its financial condition, liquidity, or results of operations. TheBank’s primary source of funds for its lending is its deposits.

 

As of December 31, 2009the Bank had commitments to extend credit in the amount of $14,839,000.  Commitments to extend credit are agreementsto lend to a customer as long as there is no violation of any conditionestablished in the contract.  Since manyof the commitments are expected to expire without being drawn upon, the totalamount does not necessarily represent future cash requirements.

 

**CONTRACTUAL OBLIGATIONS**

 

The following tablepresents, as of December 31, 2009, the Corporation’s significant fixed anddeterminable contractual obligations by payment date.  The payment amounts represent those amountscontractually due to the recipient and do not include any unamortized premiumsor discounts, or other similar carrying value adjustments

 
| ** **                           | ** ** | **One Year** | ** ** | **After One to** | ** ** | **After Three to** | ** ** | **Over Five** | ** ** | ** ** | ** ** |
|--------------------------------------|------------|-------------------|------------|----------------------------|------------|------------------------------|------------|--------------------|------------|------------|------------|
| **(Dollars in thousands)** | ** ** | **or Less**  | ** ** | **Three Years**       | ** ** | **Five Years**          | ** ** | **Years**          | ** ** | **Total**  | ** ** |
| Deposits  without a stated maturity  |       | $                 | 49,035     |                       | $          | —                       |       | $                  | —     |       | $          | — |   | $ | 49,035 |   |
| Time  deposits                       |       | 110,580           |       | 36, 772                    |       | 4,126                        |       | 2,404              |       | 153,387    |       |
| FHLB  borrowing                      |       | 5,000             |       | 18,000                     |       | 5,000                        |       | 1,000              |       | 29,000     |       |
| Federal  Reserve Bank borrowing      |       | 10,000            |       | —                     |       | —                       |       | —             |       | 10,000     |       |
| Junior  Subordinated Debt            |       | —            |       | —                     |       | —                       |       | 8,241              |       | 8,241      |       |
| Operating  Leases                    |       | 364               |       | 435                        |       | —                       |       | —             |       | 799        |       |
| Standby  Letter of Credit            |       | —            |       | 330                        |       | —                       |       | 1,300              |       | 1,630      |       |
|                                      |            |                   |            |                            |            |                              |            |                    |            |            |            |  |  |  |  |  |

 
| **(Dollars  in thousands)**                  |   |   |   |
|----------------------------------------------|--------|--------|--------|
| **Commitments to extend credit:**            |   |   |   |
| Commercial  and Industrial                   |   | $      | 8,143  |   |
| Construction                                 |   | 162    |   |
| Individuals                                  |   | 983    |   |
| Real  Estate                                 |   | 4,758  |   |
| Revolving  Home Equity and Credit Card Lines |   | 793    |   |
|                                              |        |        |        |  |

 

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**ITEM 7A.****                                      ****QUANTITATIVE AND QUALITATIVEDISCLOSURE ABOUT MARKET RISK.**

 

Not Applicable.

 

**ITEM 8.****                                               ****FINANCIAL STATEMENTS ANDSUPPLEMENTARY DATA**

 

The followingconsolidated financial statements included in the Consolidated Financial Reportissued by Hutchinson and Bloodgood LLP, Certified Public Accountants at the pages indicated

 
| Report of  Independent Registered Public Accounting Firm         |   | 1      |
|------------------------------------------------------------------|--------|--------|
|                                                             |   |   |
| Consolidated Balance Sheets                                      |   | 2      |
|                                                             |   |   |
| Consolidated Statements of Income                                |   | 3      |
|                                                             |   |   |
| Consolidated Statements of Changes in Shareholders’  Equity |   | 4      |
|                                                             |   |   |
| Consolidated Statements of Cash Flows                            |   | 5-6    |
|                                                             |   |   |
| Notes to  Consolidated Financial Statements                      |   | 7-55   |

 

**ITEM 9.****                                               ****CHANGES IN AND DISAGREEMENTS WITHACCOUNTANTS AND FINANCIAL DISCLOSURE**

 

Not Applicable.

 

**ITEM 9A(T).  CONTROLSAND PROCEDURES**

 

**Evaluation of Disclosure Controls and Procedures**

 

We maintain “disclosure controls and procedures,” assuch phrase is defined in Rule 13a-15(e) under the SecuritiesExchange Act of 1934 (the “Exchange Act”), that are designed to ensure thatinformation required to be disclosed in our Exchange Act reports are recorded,processed, summarized and reported within the time periods specified in theSecurities and Exchange Commission rules and forms, and that suchinformation is accumulated and communicated to our management, including ourChief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), asappropriate, to allow timely decisions regarding required disclosure. Weconducted an evaluation under the supervision and with the participation of ourCEO and CFO, of the effectiveness of the design and operation of our disclosurecontrols and procedures (“Disclosure Controls”) as of the end of the periodcovered by this report pursuant to Rule 13a-15(e) of the ExchangeAct. Based on this evaluation, our CEO and CFO concluded that our disclosurecontrols were effective as of the end of the period covered by this report.

 

**Changes in Internal Controls**

 

Our management has evaluated, with the participationof our CEO and our CFO, any changes in our internal control over financialreporting that has occurred during the fourth quarter of our fiscal year ended December 31,2009, as required by Rule 13a-15(d) of the Exchange Act.  Based on this evaluation, we have determinedthat there has been no change in our internal controls over

 

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financialreporting that has occurred in the fourth quarter of our fiscal year ended December 31,2009 that has materially affected, or is reasonably likely to materially affectour internal control over financial reporting.

 

**Limitationson the Effectiveness of Controls**

 

Our management, including our CEO and CFO, does notexpect that our disclosure controls and internal controls will prevent allerrors and all fraud. A control system, no matter how well conceived andoperated, can provide only reasonable, not absolute, assurance that the objectivesof the control system are met. Further, the design of a control system mustreflect the fact that there are resource constraints, and the benefits ofcontrols must be considered relative to their costs. Because of the inherentlimitations in all control systems, no evaluation of controls can provideabsolute assurance that all control issues and instances of fraud, if any,within the Corporation have been detected. These inherent limitations includethe realities that judgments in decision-making can be faulty, and thatbreakdowns can occur because of a simple error or mistake. Additionally,controls can be circumvented by the individual acts of some persons, bycollusion of two or more people, or by management or board override of thecontrol.

 

The design of any system of controls also is basedin part upon certain assumptions about the likelihood of future events, andthere can be no assurance that any design will succeed in achieving its statedgoals under all potential future conditions; over time, controls may becomeinadequate because of changes in conditions, or the degree of compliance withthe policies or procedures may deteriorate. Because of the inherent limitationsin a cost-effective control system, misstatements due to error or fraud may occurand not be detected.

 

**CEO and CFO Certifications**

 

Appearing immediately following the Signaturessection of this report there are Certifications of the CEO and the CFO. TheCertifications are required in accordance with Section 302 of theSarbanes-Oxley Act of 2002 (the “Section 302 Certifications”). This Item9A(T) of this report is the information concerning the evaluation referredto in the Section 302 Certifications and this information should be readin conjunction with the Section 302 Certifications for a more completeunderstanding of the topics presented.

 

**Management’s Annual Report on Internal Control over FinancialReporting**

 

Our management is responsible for establishing andmaintaining adequate internal control over financial reporting. The Corporation’sinternal control over financial reporting is a process designed by or under thesupervision of our CEO and CFO and effected by our board of directors,management and other personnel, to provide reasonable assurance regarding thereliability of financial reporting and the preparation of financial statementsfor external purposes in accordance with generally accepted accountingprinciples.

 

The Corporation’s internal control over financialreporting includes those policies and procedures that (i) pertain to themaintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the Corporation; (ii) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with accounting principlesgenerally accepted in the United States of America, and that receipts andexpenditures of the Corporation are being made only in accordance withauthorizations of management and directors of the Corporation; and (iii) providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use, or disposition of the Corporation’s assets that could have amaterial effect on the financial statements.

 

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Because of its inherent limitations, internalcontrols over financial reporting may not prevent or detect misstatements. Allinternal control systems, no matter how well designed, have inherentlimitations, including the possibility of human error and the circumvention ofoverriding controls. Accordingly, even effective internal control overfinancial reporting can provide only reasonable assurance with respect tofinancial statement preparation. Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

 

Our management assessed the effectiveness of theCorporation’s internal control over financial reporting as of December 31,2009. In making this assessment, it used the criteria set forth by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO) in *Internal Control-Integrated Framework*.Based on this assessment, our management believes that, as of December 31,2009, the Corporation’s internal control over financial reporting waseffective.

 

This annual report does not include an attestationreport of our registered public accounting firm regarding internal control overfinancial reporting. Management’s report was not subject to attestation by ourregistered public accounting firm pursuant to temporary rules of theSecurities and Exchange Commission that permit us to provide only management’sreport in this annual report.

 

**ITEM 9B.  OTHERINFORMATION**

 

Not Applicable

 

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**PART III**

 

**ITEM 10.****                                        ****DIRECTORS, EXECUTIVE OFFICERS,AND CORPORATE GOVERNANCE**

 

The information required by this Item isincorporated from the Proxy Statement for the Corporation’s 2010 Annual Meetingof Shareholders to be filed by no later than April 30, 2010, or will beprovided by amendment to this Annual Report on Form 10-K.

 

**ITEM 11.****                                        ****EXECUTIVE COMPENSATION**

 

The information required by this Item isincorporated from the Proxy Statement for the Corporation’s 2010 Annual Meetingof Shareholders to be filed by no later than April 30, 2010, or will beprovided by amendment to this Annual Report on Form 10-K.

 

**ITEM 12.****                                      ****SECURITY OWNERSHIP OF CERTAINBENEFICIAL OWNERS AND MANAGEMENT, AND RELATED STOCKHOLDER MATTERS**

 

The information required by this Item relating tosecurities authorized for issuance under equity compensation plans isincorporated by reference to the information set forth above under “ITEM 5 -MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUERPURCHASES OF EQUITY SECURITIES - Securities Authorized for Issuance UnderEquity Compensation Plans.”

 

Except for information incorporated by reference toinformation provided under other items of this Annual Report on Form 10-K,the information required by this Item is incorporated from the Proxy Statementfor the Corporation’s 2010 Annual Meeting of Shareholders to be filed by nolater than April 30, 2010, or will be provided by amendment to this AnnualReport on Form 10-K.

 

**ITEM 13.****                                        ****CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS, AND DIRECTOR INDEPENDENCE**

 

The information required by this Item isincorporated from the Proxy Statement for the Corporation’s 2010 Annual Meetingof Shareholders to be filed by no later than April 30, 2010, or will beprovided by amendment to this Annual Report on Form 10-K.

 

**ITEM 14.****                                        ****PRINCIPAL ACCOUNTANTFEES AND SERVICES**

 

The information required by this Item isincorporated from the Proxy Statement for the Corporation’s 2010 Annual Meetingof Shareholders to be filed by no later than April 30, 2010, or will beprovided by amendment to this Annual Report on Form 10-K.

 

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**ITEM 15.****                                        ****EXHIBITS AND FINANCIAL STATEMENTSCHEDULES**

 

A.            EXHIBITS

 
| **Item**       | ** ** | **Description** | ** **                                                                                                                                                                                                                                                           | **Page or  Footnote  Reference** |
|----------------|------------|-----------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------|
|           |       |            |                                                                                                                                                                                                                                                                 |                                  |   |
| 2              |       |            | Plan of Merger and  Merger Agreement, Monterey County Bank with Monterey County Merger Corporation  under the Charter of Monterey County Bank under the Title of Monterey County  Bank, joined in by Northern California Bancorp, Inc. dated November 1,  1995. |                                  | (1) |
|           |       |            |                                                                                                                                                                                                                                                                 |                                  |   |
| 3 (i)          |       |            | Articles of  Incorporation, as amended through January 2009                                                                                                                                                                                                     |                                  | (9) |
|           |       |            |                                                                                                                                                                                                                                                                 |                                  |   |
| 3 (ii)         |       |            | Bylaws                                                                                                                                                                                                                                                               |                                  | (1) |
|           |       |            |                                                                                                                                                                                                                                                                 |                                  |   |
| 10 (i) D  | (1)        |            | Lease agreement Carmel  Branch Office                                                                                                                                                                                                                                |                                  | (1) |
|           |       |            |                                                                                                                                                                                                                                                                 |                                  |   |
|           | (2)        |            | Lease agreement Carmel  By The Sea Office                                                                                                                                                                                                                            |                                  | (4) |
|           |       |            |                                                                                                                                                                                                                                                                 |                                  |   |
|           | (3)        |            | Lease agreement 301  Webster Street, Monterey, CA 93924                                                                                                                                                                                                              |                                  | (5) |
|           |       |            |                                                                                                                                                                                                                                                                 |                                  |   |
| 10 (ii) A | (1)        |            | Employment Contract of  Charles T. Chrietzberg, Jr., dated January 1, 2008                                                                                                                                                                                 |                                  | (8) |
|           |       |            |                                                                                                                                                                                                                                                                 |                                  |   |
|           | (2)        |            | Deferred Compensation  Agreement, dated December 31, 1993                                                                                                                                                                                                       |                                  | (1) |
|           |       |            |                                                                                                                                                                                                                                                                 |                                  |   |
|           | (3)        |            | Northern California  Bancorp, Inc. 2007 Stock Option Plan and Stock Option Agreements                                                                                                                                                                           |                                  | (7) |
|           |       |            |                                                                                                                                                                                                                                                                 |                                  |   |
|           | (4)        |            | Amendment to the Salary  Continuation Agreement Dated December 31, 1993                                                                                                                                                                                         |                                  | (2) |
|           |       |            |                                                                                                                                                                                                                                                                 |                                  |   |
|           | (5)        |            | Life Insurance  Endorsement Method Split Dollar Plan Agreement                                                                                                                                                                                                       |                                  | (2) |
|           |       |            | .                                                                                                                                                                                                                                                                    |                                  |   |
|           | (6)        |            | Amendment to the Life  Insurance Endorsement Method Split Dollar Plan Agreement dated  January 5, 2000                                                                                                                                                          |                                  | (3) |
|           |       |            |                                                                                                                                                                                                                                                                 |                                  |   |
|           | (7)        |            | Amendment to the Life  Insurance Endorsement Method Split Dollar Plan                                                                                                                                                                                                |                                  | (3) |
|           |       |            |                                                                                                                                                                                                                                                                 |                                  |   |
|           | (8)        |            | Amendment to the Salary  Continuation Agreement Dated December 31, 1993                                                                                                                                                                                         |                                  | (3) |
|           |       |            |                                                                                                                                                                                                                                                                 |                                  |   |
|           | (9)        |            | Monterey County Bank  Supplemental Life Insurance Agreement Dated October 26, 2006                                                                                                                                                                              |                                  | (6) |
|           |       |            |                                                                                                                                                                                                                                                                 |                                  |   |
|           | (10)       |            | First Amendment to the  Monterey County Bank Supplemental Life Insurance Agreement dated  October 31, 2006                                                                                                                                                      |                                  | (6) |
|           |       |            |                                                                                                                                                                                                                                                                 |                                  |   |
| 21             |       |            | Subsidiaries                                                                                                                                                                                                                                                         |                                  | (6) |

 

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| 23.1 |   |   | Consent  of Hutchinson and Bloodgood, LLP                                                                                                                     |   | 63 |
|------|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----|
| 31.1 |   |   | Certification  of the Chief Executive Officer of Northern California Bancorp, Inc.  pursuant toSection 302  of the Sarbanes-Oxley Act of 2002.      |   | 64 |
| 31.2 |   |   | Certification of the  Chief Financial Officer of Northern California Bancorp, Inc. pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.      |   | 65 |
| 32.1 |   |   | Certification of the  Chief Executive Officer of Northern California Bancorp, Inc. pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. |   | 66 |
| 32.2 |   |   | Certification of the  Chief Financial Officer of Northern California Bancorp, Inc. pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.      |   | 67 |

 

1)  Filed as an exhibit to Form 10-KSB datedDecember 31, 1995.

2)** **Filed as an exhibit to Form 10-KSBdated December 31, 1999.

3)  Filed as an exhibit to Form 10-KSB datedDecember 31, 2001.

4)  Filed as an exhibit to Form 10-KSB datedDecember 31, 2002.

5)  Filed as an exhibit to Form 10-KSB datedDecember 31, 2004.

6)  Filed as an exhibit to Form 10-KSB datedDecember 31, 2006.

7)  Filed as an Exhibit to DEF 14A filed April 26,2007.

8)  Filed as an exhibit to Form 10-QSB datedMarch 31, 2008.

9 )  Filed as an exhibit to Form 10-KSB datedDecember 31, 2008.

 

B.            REPORTS

 

None

 

**SIGNATURES**

 

In accordance with Section 13or 15(d) of the Exchange Act, the registrant caused this report to besigned on its behalf by the undersigned, thereunto duly authorized.

 
|                            | NORTHERN CALIFORNIA  BANCORP, INC. |
|---------------------------------|------------------------------------|
|                            |                               |
| Date:  March 29, 2010 | By:                                | /s/  Charles T. Chrietzberg, Jr. |
|                            |                               | Charles  T. Chrietzberg, Jr. |
|                            |                               | Chief  Executive Officer and President |
|                            |                               |   |
| Date:  March 29, 2010 | By:                                | /s/  Bruce N. Warner |
|                            |                               | Bruce  N. Warner |
|                            |                               | Chief  Financial Officer and Principal Accounting Officer |

 

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In accordance with theExchange Act, this report has been signed by the following persons on behalf ofthe registrant and in the capacities and on the dates indicated.

 
| **Name**                              | ** ** | **Position** | ** ** | **Date**             |
|---------------------------------------|------------|--------------|------------|----------------------|
|                                  |       |         |       |                 |
| /s/  Charles T. Chrietzberg, Jr. |       |         |       | March 29,  2010 |
| Charles T.  Chrietzberg, Jr.     |       | Director     |       |                 |
|                                  |       |         |       |                 |
| /s/ Sandra G.  Chrietzberg            |       |         |       | March 29,  2010 |
| Sandra G. Chrietzberg                 |       | Director     |       |                 |
|                                  |       |         |       |                 |
|                                  |       |         |       |                 |
| Peter J. Coniglio                     |       | Director     |       |                 |
|                                  |       |         |       |                 |
| /s/ Carla S. Hudson                   |       |         |       | March 29,  2010 |
| Carla S. Hudson                       |       | Director     |       |                 |
|                                  |       |         |       |                 |
| /s/ John M. Lotz                      |       |         |       | March 29,  2010 |
| John M. Lotz                          |       | Director     |       |                 |
|                                  |       |         |       |                 |
| /s/ Mark A. Briant                    |       |         |       | March 29,  2010 |
| Mark A. Briant                        |       | Director     |       |                 |
|                                  |       |         |       |                 |
| /s/ Stephanie G.  Chrietzberg         |       |         |       | March 29,  2010 |
| Stephanie G.  Chrietzberg             |       | Director     |       |                 |

 

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**NORTHERNCALIFORNIA BANCORP, INC.**

**ANDSUBSIDIARY**

 

**CONSOLIDATEDFINANCIAL REPORT**

 

**December 31,2009**

 

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**TABLE OFCONTENTS**

 
| ** **                                                       | **Page** |
|------------------------------------------------------------------|----------|
|                                                             |     |
| **Report of Independent  Registered Public Accounting Firm**     | 1        |
|                                                             |     |
| **FINANCIAL STATEMENTS**                                         |     |
|                                                             |     |
| Consolidated Balance  Sheets                                     | 2        |
| Consolidated  Statements of Income                               | 3        |
| Consolidated  Statements of Changes in Shareholders’ Equity | 4        |
| Consolidated  Statements of Cash Flows                           | 5-6      |
| Notes to  Consolidated Financial Statements                      | 7-55     |

 

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**Report ofIndependent Registered Public Accounting Firm**

 

To the Board ofDirectors

NorthernCalifornia Bancorp, Inc. and Subsidiary

Monterey,California

 

We have auditedthe accompanying consolidated balance sheets of Northern California Bancorp, Inc.and its wholly owned subsidiary, Monterey County Bank (collectively theCorporation),  as of December 31, 2009and 2008 and the related consolidated statements of income, changes inshareholders’ equity, and cash flows for each of the years in the three-yearperiod ended December 31, 2009. These consolidated financial statements are the responsibility of the Corporation’smanagement.  Our responsibility is toexpress an opinion on these consolidated financial statements based on ouraudits.

 

We conducted ouraudits in accordance with standards of the Public Company Accounting OversightBoard (United States).  Those standardsrequire that we plan and perform the audits to obtain reasonable assuranceabout whether the financial statements are free of material misstatement.  An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonablebasis for our opinion.

 

In our opinion,the consolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of Northern California Bancorp, Inc.and its wholly owned subsidiary, Monterey County Bank, as of December 31,2009 and 2008, and the results of their operations and their cash flows foreach of the years in the three-year period ended December 31, 2009 inconformity with accounting principles generally accepted in the United Statesof America.

 

 

*/s/ Hutchinson and Bloodgood LLP*

 

Glendale,California

# March 29, 2010

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

** **

**CONSOLIDATED BALANCE SHEETS**

**December 31, 2009 and 2008**

**(Dollars in Thousands, Except Share Data)**

 
| ** **                                                                                                                                                                                                | ** ** | **2009** | ** ** | **2008** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| **ASSETS**                                                                                                                                                                                                |       |     |       |     |       |
| Cash and due from banks                                                                                                                                                                                   |       | $        | 12,251     |     | $          | 16,348 |   |
| Total cash and cash  equivalents                                                                                                                                                                          |       | 12,251   |       | 16,348   |       |
| Time deposits with  other financial institutions                                                                                                                                                          |       | —   |       | 3,500    |       |
| Trading assets                                                                                                                                                                                            |       | 153      |       | 361      |       |
| Investment securities  available for sale (AFS)                                                                                                                                                           |       | 62,413   |       | 93,353   |       |
| Other investments                                                                                                                                                                                         |       | 4,085    |       | 3,852    |       |
| Loans held for sale                                                                                                                                                                                       |       | 2,216    |       | 1,650    |       |
| Loans, net of allowance  for loan losses of $3,529,000 in 2009 and $2,413,000 in 2008                                                                                                                     |       | 160,997  |       | 165,530  |       |
| Premises and equipment,  net                                                                                                                                                                              |       | 4,909    |       | 4,988    |       |
| Cash surrender value of  life insurance                                                                                                                                                                   |       | 4,097    |       | 3,969    |       |
| Other real estate owned                                                                                                                                                                                   |       | 14,333   |       | 7,364    |       |
| Interest receivable and  other assets                                                                                                                                                                     |       | 7,841    |       | 5,286    |       |
|                                                                                                                                                                                                      |       | $        | 273,295    |     | $          | 306,201 |   |
|                                                                                                                                                                                                      |       |     |       |     |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                                                                                            |       |     |       |     |       |
|                                                                                                                                                                                                      |       |     |       |     |       |
| Deposits:                                                                                                                                                                                                 |       |     |       |     |       |
| Non interest-bearing  demand                                                                                                                                                                              |       | $        | 25,781     |     | $          | 25,812 |   |
| Interest-bearing demand                                                                                                                                                                                   |       | 16,984   |       | 14,240   |       |
| Savings                                                                                                                                                                                                   |       | 6,270    |       | 6,159    |       |
| Time less than $100,000                                                                                                                                                                                   |       | 94,686   |       | 88,188   |       |
| Time of $100,000 or  more                                                                                                                                                                                 |       | 58,701   |       | 55,331   |       |
| Total deposits                                                                                                                                                                                            |       | 202,422  |       | 189,730  |       |
| Federal Home Loan Bank  (FHLB) borrowed funds                                                                                                                                                             |       | 29,000   |       | 66,500   |       |
| Federal funds purchased                                                                                                                                                                                   |       | 10,000   |       | 15,000   |       |
| Revolving line of  credit                                                                                                                                                                                 |       | 2,850    |       | 3,000    |       |
| Payable for investment  securities purchased                                                                                                                                                              |       | —   |       | 3,050    |       |
| Interest payable and  other liabilities                                                                                                                                                                   |       | 4,625    |       | 6,321    |       |
| Junior subordinated  debt securities                                                                                                                                                                      |       | 8,248    |       | 8,248    |       |
| Total liabilities                                                                                                                                                                                         |       | 257,145  |       | 291,849  |       |
| Commitments and  Contingencies (Notes 13, 14, and 17)                                                                                                                                                     |       |     |       |     |       |
| Shareholders’ equity                                                                                                                                                                                 |       |     |       |     |       |
| Common stock, no stated  par value, authorized 10,000,000 in 2009 and 2,500,000 shares in 2008, issued  and outstanding: 1,783,230 and 1,803,908 shares at December 31, 2009 and  2008, respectively |       | 5,088    |       | 5,173    |       |
| Retained earnings                                                                                                                                                                                         |       | 11,092   |       | 9,481    |       |
| Accumulated other  comprehensive loss                                                                                                                                                                     |       | (30      | )          | (302     | )          |
| Total shareholders’  equity                                                                                                                                                                          |       | 16,150   |       | 14,352   |       |
|                                                                                                                                                                                                      |       | $        | 273,295    |     | $          | 306,201 |   |

 

The notes to consolidated financial statements are an integral part ofthese statements.

 

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**NORTHERNCALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**CONSOLIDATEDSTATEMENTS OF INCOME**

**YearsEnded December 31, 2009, 2008, and 2007**

**(Dollarsin Thousands, Except Per Share Data)**

 
| ** **                                                              | ** ** | **2009** | ** ** | **2008** | ** ** | **2007** | ** ** |
|-------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                                    |       |     |       |     |       |     |       |
| Interest income                                                         |       |     |       |     |       |     |       |
| Loans and fee income on  loans                                          |       | $        | 10,779     |     | $          | 12,297   |       | $ | 14,442 |   |
| Time deposits with  other financial institutions                        |       | —   |       | 29       |       | 66       |       |
| Investment securities                                                   |       | 4,456    |       | 3,963    |       | 1,957    |       |
| Federal funds sold                                                      |       | 27       |       | 211      |       | 476      |       |
| Total interest income                                                   |       | 15,262   |       | 16,500   |       | 16,941   |       |
|                                                                    |       |     |       |     |       |     |       |
| Interest expense                                                        |       |     |       |     |       |     |       |
| Interest-bearing  transaction accounts                                  |       | 22       |       | 48       |       | 49       |       |
| Savings and time  deposit accounts                                      |       | 3,417    |       | 3,445    |       | 2,638    |       |
| Time deposits in  denominations of $100,000 or more                     |       | 2,060    |       | 2,717    |       | 2,405    |       |
| Notes payable and other  borrowings                                     |       | 2,580    |       | 3,539    |       | 2,910    |       |
| Total interest expense                                                  |       | 8,079    |       | 9,749    |       | 8,002    |       |
|                                                                    |       |     |       |     |       |     |       |
| Net interest income                                                     |       | 7,183    |       | 6,751    |       | 8,939    |       |
| Provision for loan  losses                                              |       | 3,368    |       | 1,132    |       | 865      |       |
| Net interest income,  after provision for loan losses                   |       | 3,815    |       | 5,619    |       | 8,074    |       |
|                                                                    |       |     |       |     |       |     |       |
| Non-interest income                                                     |       |     |       |     |       |     |       |
| Service charges on  deposit accounts                                    |       | 627      |       | 760      |       | 634      |       |
| Income from sales and  servicing of Small Business Administration loans |       | 400      |       | 329      |       | 480      |       |
| Gain on sale of  investment securities                                  |       | 3,189    |       | 449      |       | 216      |       |
| Other income                                                            |       | 5,904    |       | 3,493    |       | 3,006    |       |
| Total non-interest  income                                              |       | 10,120   |       | 5,031    |       | 4,336    |       |
|                                                                    |       |     |       |     |       |     |       |
| Non-interest expenses                                                   |       |     |       |     |       |     |       |
| Salaries and employee  benefits                                         |       | 3,091    |       | 3,664    |       | 4,049    |       |
| Occupancy and equipment                                                 |       | 1,030    |       | 967      |       | 866      |       |
| Foreclosed assets, net                                                  |       | 1,401    |       | 112      |       | —   |       |
| Professional fees                                                       |       | 1,034    |       | 164      |       | 165      |       |
| Data processing                                                         |       | 292      |       | 360      |       | 361      |       |
| FHLB prepayment fees                                                    |       | 888      |       | —   |       | —   |       |
| Other general and  administrative                                       |       | 5,247    |       | 3,640    |       | 3,564    |       |
| Total non-interest  expenses                                            |       | 12,983   |       | 8,907    |       | 9,005    |       |
|                                                                    |       |     |       |     |       |     |       |
| Income before income  tax provision (benefit)                           |       | 952      |       | 1,743    |       | 3,405    |       |
| Income tax provision  (benefit)                                         |       | (659     | )          | 281      |       | 1,476    |       |
|                                                                    |       |     |       |     |       |     |       |
| Net income                                                              |       | $        | 1,611      |     | $          | 1,462    |       | $ | 1,929 |   |
|                                                                    |       |     |       |     |       |     |       |
| Earnings per common  share                                              |       |     |       |     |       |     |       |
|                                                                    |       |     |       |     |       |     |       |
| Basic                                                                   |       | $        | 0.90       |     | $          | 0.80     |       | $ | 1.08 |   |
|                                                                    |       |     |       |     |       |     |       |
| Diluted                                                                 |       | $        | 0.90       |     | $          | 0.79     |       | $ | 1.03 |   |

 

The notes to consolidated financial statements are an integral part ofthese statements.

 

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**NORTHERNCALIFORNIA BANCORP, INC. AND SUBSIDIARY**

** **

**CONSOLIDATEDSTATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY**

**YearsEnded December 31, 2009, 2008, and 2007**

**(Dollarsin Thousands, Except Share Data)**

 
| ** **                                                                                                            | ** ** | ** **    | ** ** | ** ** | ** ** | ** **   | ** ** | **Accumulated**   | ** ** | ** ** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|---------------|------------|------------|------------|--------------|------------|-------------------|------------|------------|------------|
| ** **                                                                                                            | ** ** | ** **    | ** ** | ** ** | ** ** | ** **   | ** ** | **Other**         | ** ** | ** ** | ** ** |
| ** **                                                                                                            | ** ** | **Number of** | ** ** | **Common** | ** ** | **Retained** | ** ** | **Comprehensive** | ** ** | ** ** | ** ** |
| ** **                                                                                                            | ** ** | **Shares**    | ** ** | **Stock**  | ** ** | **Earnings** | ** ** | **Income (loss)** | ** ** | **Total**  | ** ** |
|                                                                                                                  | ** ** | ** **    | ** ** | ** ** | ** ** | ** **   | ** ** | ** **        | ** ** | ** ** | ** ** |
| Balance at December 31,  2006                                                                                    |       | 1,721,715     |       | $          | 5,060      |         | $          | 7,363             |       | $          | (21        | ) | $ | 12,402 |   |
|                                                                                                                  |       |          |       |       |       |         |       |              |       |       |       |
| Comprehensive income:                                                                                                 |       |          |       |       |       |         |       |              |       |       |       |
| Net income for the year                                                                                               |       | —        |       | —     |       | 1,929        |       | —            |       | 1,929      |       |
| Change in net  unrealized gain on AFS securities and other assets, net of reclassification  adjustment and tax effect |       | —        |       | —     |       | —       |       | 122               |       | 122        |       |
| Total comprehensive  income                                                                                           |       |          |       |       |       |         |       |              |       | 2,051      |       |
|                                                                                                                  |       |          |       |       |       |         |       |              |       |       |       |
| $.25 per share cash  dividend                                                                                         |       | —        |       | —     |       | (461         | )          | —            |       | (461       | )          |
| Exercise of stock  options, including tax benefit                                                                     |       | 124,203       |       | 442        |       | —       |       | —            |       | 442        |       |
| Balance at December 31,  2007                                                                                    |       | 1,845,918     |       | 5,502      |       | 8,831        |       | 101               |       | 14,434     |       |
|                                                                                                                  |       |          |       |       |       |         |       |              |       |       |       |
| Cumulative effect -  application of new accounting standard EITF 06-04 and EITF 06-10                            |       | —        |       | —     |       | (362         | )          | —            |       | (362       | )          |
|                                                                                                                  |       |          |       |       |       |         |       |              |       |       |       |
| Comprehensive income:                                                                                                 |       |          |       |       |       |         |       |              |       |       |       |
| Net income for the year                                                                                               |       | —        |       | —     |       | 1,462        |       | —            |       | 1,462      |       |
| Change in net  unrealized loss on AFS securities and other assets, net of reclassification  adjustment and tax effect |       | —        |       | —     |       | —       |       | (403              | )          | (403       | )          |
| Total comprehensive  income                                                                                           |       |          |       |       |       |         |       |              |       | 1,059      |       |
|                                                                                                                  |       |          |       |       |       |         |       |              |       |       |       |
| Stock repurchase                                                                                                      |       | (46,010       | )          | (341       | )          | —       |       | —            |       | (341       | )          |
| $.25 per share cash  dividend                                                                                         |       | —        |       | —     |       | (450         | )          | —            |       | (450       | )          |
| Exercise of stock  options, including tax benefit                                                                     |       | 4,000         |       | 12         |       | —       |       | —            |       | 12         |       |
| Balance at  December 31, 2008                                                                                    |       | 1,803,908     |       | 5,173      |       | 9,481        |       | (302              | )          | 14,352     |       |
|                                                                                                                  |       |          |       |       |       |         |       |              |       |       |       |
| Comprehensive income:                                                                                                 |       |          |       |       |       |         |       |              |       |       |       |
| Net income for the year                                                                                               |       | —        |       | —     |       | 1,611        |       | —            |       | 1,611      |       |
| Change in net  unrealized loss on AFS securities and other assets, net of reclassification  adjustment and tax effect |       | —        |       | —     |       | —       |       | 272               |       | 272        |       |
| Total comprehensive  income                                                                                           |       |          |       |       |       |         |       |              |       | 1,883      |       |
| Stock repurchase                                                                                                      |       | (20,678       | )          | (85        | )          | —       |       | —            |       | (85        | )          |
| Balance at  December 31, 2009                                                                                    |       | 1,783,230     |       | $          | 5,088      |         | $          | 11,092            |       | $          | (30        | ) | $ | 16,150 |   |

 

The notes to consolidated financial statements are an integral part ofthese statements.

 

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**NORTHERNCALIFORNIA BANCORP, INC. AND SUBSIDIARY**

** **

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**YearsEnded December 31, 2009, 2008, and 2007**

**(Dollarsin Thousands)**

 
| ** **                                                                                | ** ** | **2009** | ** ** | **2008** | ** ** | **2007** | ** ** |
|-------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **CASH  FLOWS FROM OPERATING ACTIVITIES**                                                 |       |     |       |     |       |     |       |
| Net income                                                                                |       | $        | 1,611      |     | $          | 1,462    |       | $ | 1,929 |   |
| Adjustments to  reconcile net income to net cash provided (used) by operating activities: |       |     |       |     |       |     |       |
| Depreciation and  amortization expense                                                    |       | 332      |       | 312      |       | 293      |       |
| Provision for loan  losses                                                                |       | 3,368    |       | 1,132    |       | 865      |       |
| Provision for  foreclosed asset losses                                                    |       | 1,010    |       | —   |       | —   |       |
| Realized gain on sales  of available for sale securities and other investments, net       |       | (3,189   | )          | (449     | )          | (216     | )          |
| Amortization of deferred  loan fees, net                                                  |       | (75      | )          | (291     | )          | (372     | )          |
| Net amortization  (accretion) of securities                                               |       | (595     | )          | (234     | )          | (4       | )          |
| Deferred income tax  benefit                                                              |       | (1,660   | )          | (583     | )          | (91      | )          |
| Loss on sale of  foreclosed asset                                                         |       | 65       |       | —   |       | —   |       |
| Increase in cash  surrender value of life insurance                                       |       | (128     | )          | (124     | )          | (124     | )          |
| (Increase) decrease in  assets:                                                           |       |     |       |     |       |     |       |
| Trading assets                                                                            |       | 208      |       | 863      |       | 538      |       |
| Loans held for sale                                                                       |       | (566     | )          | 237      |       | (705     | )          |
| Interest receivable                                                                       |       | 759      |       | (774     | )          | (392     | )          |
| Other assets                                                                              |       | (1,848   | )          | 3,598    |       | (4,361   | )          |
| Increase (decrease) in  liabilities:                                                      |       |     |       |     |       |     |       |
| Interest payable                                                                          |       | (559     | )          | (417     | )          | 904      |       |
| Other liabilities                                                                         |       | (1,416   | )          | 1,675    |       | 324      |       |
| Net cash provided  (used) by operating activities                                         |       | (2,683   | )          | 6,407    |       | (1,412   | )          |
|                                                                                      |       |     |       |     |       |     |       |
| **CASH  FLOWS FROM INVESTING ACTIVITIES**                                                 |       |     |       |     |       |     |       |
| Net change in time  deposits with other financial institutions                            |       | 3,500    |       | (3,500   | )          | 1,000    |       |
| Activity in  available-for-sale securities                                                |       |     |       |     |       |     |       |
| Sales                                                                                     |       | 130,689  |       | 51,322   |       | 10,221   |       |
| Maturities,  prepayments, and calls                                                       |       | 7,250    |       | 3,700    |       | 13,996   |       |
| Purchases                                                                                 |       | (105,768 | )          | (106,639 | )          | (40,993  | )          |
| Activity in held to  maturities Purchases                                                 |       | —   |       | —   |       | (870     | )          |
| Purchase of stock  investments, restricted                                                |       | (263     | )          | —   |       | —   |       |
| Net increase in loans                                                                     |       | (12,458  | )          | (11,874  | )          | (69,275  | )          |
| Loan purchases                                                                            |       | —   |       | —   |       | (11,001  | )          |
| Proceeds from loan  sales                                                                 |       | 2,740    |       | 6,016    |       | 41,790   |       |
| Proceeds from sale of  other real estate owned                                            |       | 4,303    |       |     |       |     |       |
| Investment in real  estate                                                                |       | (1,111   | )          | (1,015   | )          | —   |       |
| Purchase of life  insurance policies                                                      |       | —   |       | —   |       | (50      | )          |
| Additions to bank  premises and equipment                                                 |       | (253     | )          | (417     | )          | (547     | )          |
| Net cash used by  investing activities                                                    |       | 28,629   |       | (62,407  | )          | (55,729  | )          |
|                                                                                           |            |          |            |          |            |          |            |  |  |  |

 

The notes to consolidated financial statements are an integral part ofthese statements.

 

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**NORTHERN CALIFORNIA BANCORP, INC. ANDSUBSIDIARY**

 

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**Years Ended December 31, 2009,2008, and 2007**

**(Dollars in Thousands)**

 
| ** **                                 | ** ** | **2009**   | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|--------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **CASH  FLOWS FROM FINANCING ACTIVITIES**  |       |       |       |       |       |       |       |
| Net increase in  deposits                  |       | $          | 12,692     |       | $          | 20,974     |       | $ | 37,129 |   |
| Proceeds from  borrowings                  |       | 50,000     |       | 50,000     |       | 20,500     |       |
| Repayments on  borrowings                  |       | (92,650    | )          | (18,000    | )          | (2,750     | )          |
| Proceeds from exercise  of stock options   |       | —     |       | 12         |       | 442        |       |
| Repurchase of common  stock                |       | (85        | )          | (341       | )          | —     |       |
| Cash dividends paid on  common stock       |       | —     |       | (450       | )          | (461       | )          |
| Net cash provided by  financing activities |       | (30,043    | )          | 52,195     |       | 54,860     |       |
|                                       |       |       |       |       |       |       |       |
| Net decrease in cash  and cash equivalents |       | (4,097     | )          | (3,805     | )          | (2,281     | )          |
|                                       |       |       |       |       |       |       |       |
| **CASH  AND CASH EQUIVALENTS, BEGINNING**  |       | 16,348     |       | 20,153     |       | 22,434     |       |
|                                       |       |       |       |       |       |       |       |
| **CASH  AND CASH EQUIVALENTS, ENDING**     |       | $          | 12,251     |       | $          | 16,348     |       | $ | 20,153 |   |
| ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **SUPPLEMENTARY  INFORMATION**             |       |       |       |       |       |       |       |
|                                       |       |       |       |       |       |       |       |
| Interest paid                              |       | $          | 8,638      |       | $          | 9,200      |       | $ | 7,100 |   |
|                                       |       |       |       |       |       |       |       |
| Income taxes paid                          |       | $          | 768        |       | $          | 1,120      |       | $ | 1,262 |   |

 

The notes to consolidated financial statements are an integral part ofthese statements.

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 1.**          SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES

 

***Natureof Business***

 

Northern CaliforniaBancorp, Inc., (the Corporation) provides a variety of financial servicesthrough Monterey County Bank, (the Bank) to individuals and small businessesthrough its five offices in Monterey County. Its primary deposit products are demand and term certificateaccounts.  Its primary lending productsare real estate, commercial, construction, and Small Business Administration(SBA) loans.

 

***Basisof Presentation and Consolidation***

 

The consolidatedfinancial statements include the accounts of Northern California Bancorp, Inc.and its wholly owned subsidiary, Monterey County Bank.  All****significantinter-company balances and transactions have been eliminated in consolidation.

 

Inconsolidating, the Corporation determines whether it has a controllingfinancial interest in an entity by first evaluating whether the entity is avoting interest entity or a variable interest entity under accountingprinciples generally accepted in the United States of America. Voting interestentities are entities in which the total equity investment at risk issufficient to enable the entity to finance itself independently and providesthe equity holders with the obligation to absorb losses, the right to receiveresidual returns and the right to make decisions about the entity’s activities.The Corporation consolidates voting interest entities in which it has all, orat least a majority of, the voting interest.  As defined in applicableaccounting standards, variable interest entities (VIEs) are entities that lackone or more of the characteristics of a voting interest entity.  Acontrolling financial interest in an entity is present when an enterprise has avariable interest, or a combination of variable interests, that will absorb amajority of the entity’s expected losses, receive a majority of the entity’sexpected residual returns, or both.  The enterprise with a controllingfinancial interest, known as the primary beneficiary, consolidates theVIE.  The Corporation’s wholly owned subsidiaries, Northern CaliforniaBancorp, Inc. Trust I and Northern California Bancorp, Inc. Trust II,are VIEs for which the Corporation is not the primary beneficiary. Accordingly, the accounts of these entities are not included in the Corporation’sconsolidated financial statements.

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 1.**          SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES (Continued)

 

***Useof Estimates***

 

In preparing consolidatedfinancial statements in conformity with accounting principles generallyaccepted in the United States of America, management is required to makeestimates and assumptions that affect the reported amounts of assets andliabilities as of the date of the balance sheet and reported amounts ofrevenues and expenses during the reporting period.  Actual results could differ from thoseestimates.  Material estimates that areparticularly susceptible to significant change in the near term relate to thedetermination of the allowance for loan losses and the valuation of deferredtax assets.

 

***Cashand Cash Equivalents***

 

For purposes of reportingcash flows, cash and cash equivalents include cash, amounts due from banks andFederal funds sold on a daily basis, all of which mature within ninety days.

 

***TimeDeposits with Other Financial Institutions***

 

Interest-bearing depositsin banks mature within one year and are carried at cost.

 

***TradingActivities***

 

The Corporation engagesin trading activities consisting of securities that are held principally forresale in the near term.  The securitiesare recorded in the trading assets account at fair value with changes in fairvalue recorded in earnings.  Interest anddividends are included in net interest income.

 

Quoted market prices,when available, are used to determine the fair value of tradinginstruments.  If quoted market prices arenot available, then the fair values are estimated using pricing models, quotedprices of instruments with similar characteristics, or discounted cash flows.

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 1.**          SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES (Continued)

 

***InvestmentSecurities***

 

Investments indebt securities that management has the positive intent and ability to hold tomaturity are classified as “held to maturity” and reflected at cost, adjustedfor amortization of premiums and accretion of discounts, which are recognizedas adjustments to interest income.  Othermarketable securities are classified as “available for sale” and are reflectedat fair value, with unrealized gains and losses excluded from earnings andreported in other comprehensive income.

 

Purchase premiums and discounts are recognized in interest income usingthe interest method over the terms of the securities. Declines in the fairvalue of held to maturity and available for sale securities below their costthat are deemed to be other than temporary are reflected in earnings asrealized losses.  In estimating other-than-temporary impairmentlosses, management considers (1) the length of time and the extent towhich the fair value has been less than cost, (2) the financial conditionand near-term prospects of the issuer, and (3) the Bank does not have theintent to sell the security; and it is more likely than not it will not have tosell the security before recovery of its cost basis.

 

Gains and losseson disposition are generally recognized on the trade date, based on the netproceeds and the adjusted carrying amount of the securities sold using thespecific identification method.

 

***Restricted StockInvestments***

 

FederalHome Loan Bank (FHLB) stock is carried at cost, and is evaluated for impairmentbased on an estimate of the ultimate recoverability of par value.

 

***Salesand Servicing of SBA Loans***

 

The Bank originates loansto customers under the SBA program that generally provides for SBA guaranteesof 70% to 90% of each loan.  The Bankgenerally sells the guaranteed portion of each loan to a third party andretains only the non-guaranteed portion in its own portfolio.  A gain is recognized on these loans throughcollection on sale of a premium over the adjusted carrying value, or throughretention of an ongoing rate differential, less a normal service fee betweenthe rate paid by the borrower to the Bank and the rate paid by the Bank to thepurchaser (excess servicing fee).  Incalculating the gain, the Bank assumes that the loans sold will be outstandingfor one-half of their contractual lives.

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 1.**          SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES (Continued)

 

***Salesand Servicing of SBA Loans (Continued)***

 

The Bank’s investment inan SBA loan is allocated among the retained portion of the loan, excessservicing retained, and the sold portion of the loan, based on the relativefair market value of each portion at the time of loan origination, adjusted forpayments and other activities.  Since theportion retained does not carry an SBA guarantee, part of the gain recognizedon the sold portion of the loan is deferred and amortized as a yieldenhancement on the retained portion of the loan.  Excess servicing fees are reflected as anasset which is amortized over an expected half life; in the event futureprepayments are significant and future expected cash flows are inadequate tocover the unamortized excess servicing asset, additional amortization isrecognized.

 

***LoansHeld for Sale***

 

Loans held for saleconsist of the portion of loans that are guaranteed by the SBA and are carriedat the lower of cost or market.  Marketvalue for loans guaranteed by the SBA is generally determined based on theprice at which the loans were committed to be sold on the trade date.  Direct loan origination costs are recorded atsettlement as an adjustment to gain or loss on sale.

 

***Loansand Loan Fees***

 

The Bank grantsresidential mortgage, commercial, construction, and consumer loans tocustomers.  A substantial portion of theloan portfolio is represented by****mortgage loanson the Monterey Peninsula.  The abilityof the Bank’s debtors to honor their contracts is dependent upon the realestate and general economic conditions in the area.

 

Loans, as reported, havebeen reduced by****undisbursed loan funds, netdeferred loan fees, and the allowance for loan losses.

 

Loans that management hasthe intent and ability to hold for the foreseeable future or until maturity orpay-off generally are reported at their outstanding unpaid principal balancesadjusted for charge-offs, the allowance for loan losses, and any deferred feesor cost on originated loans.  Interestincome is accrued on the unpaid principal balance.  Loan origination fees, net of certain directorigination costs, are deferred and recognized as an adjustment of the relatedloan yield using the interest method.

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 1.**          SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES (Continued)

 

***Loansand Loan Fees (Continued)***

 

The accrual of intereston mortgage and commercial loans is discontinued at the time the loan is 90days past due unless the credit is well-secured and in process ofcollection.  Credit card loans and otherpersonal loans are typically charged off no later than 180 days past due.  Past due status is based on contractual termsof the loan.  In all cases, loans areplaced on nonaccrual or charged-off at an earlier date if collection ofprincipal or interest is considered doubtful.

 

All interest accrued butnot collected for loans that are placed on nonaccrual or charged off isreversed against interest income.  Theinterest on these loans is accounted for on the cash-basis or cost-recoverymethod, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interestamounts contractually due are brought current and future payments are reasonablyassured.

 

Loanorigination fees and costs are deferred and amortized as an adjustment of theloan’s yield over the life of the loan using the interest method, which resultsin a constant rate of return or the straight-line method for lines of credit.

 

***Allowancefor Loan Losses***

 

The allowance for loanlosses is established through a provision for loan losses charged to earningsand is maintained at a level considered adequate to provide for reasonablyforeseeable loan losses.

 

The provision and the levelof the allowance are evaluated on a regular basis by management and are basedupon management’s periodic review of the collectibility of the loans in lightof historical experience, known and inherent risks in the nature and volume ofthe loan portfolio, adverse situations that may affect the borrower’s abilityto repay, estimated value of any underlying collateral, and prevailing economicconditions.  This evaluation isinherently subjective as it requires estimates that are susceptible tosignificant change.  In addition, variousregulatory agencies, as an integral part of their examination process,periodically review the Bank’s allowance for losses on loans and other realestate owned. Such agencies may require the Bank to recognize additions to the allowancebased on their judgment of information available to them at the time of theirexamination.  Ultimately, losses may varyfrom current estimates and future additions to the allowance may be necessary.

 

Loan losses are chargedagainst the allowance when management believes the collectibility of the loanbalance is unlikely.  Subsequentrecoveries, if any, are credited to the allowance.

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 1.**          SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES (Continued)

 

***Allowancefor Loan Losses (Continued)***

 

The allowance consists ofspecific, general and unallocated components. The specific component relates to loans that are classified as eitherdoubtful, substandard or special mention. For such loans that are also classified as impaired, an allowance is establishedwhen the discounted cash flows (or collateral value or observable market price)of the impaired loan is lower than that of the carrying value of thatloan.  The general component coversnon-classified loans and is based on historical loss experience adjusted forqualitative factors.  An unallocatedcomponent is maintained to cover uncertainties that could affect management’sestimate of probable losses.  Theunallocated component of the allowance reflects the margin of imprecisioninherent in the underlying assumptions used in the methodologies for estimatingspecific and general losses in the portfolio.

 

A loan is consideredimpaired when, based on current information and events, it is probable that acreditor will be unable to collect the scheduled payments of principal orinterest when due according to the contractual terms of the loanagreement.  Factors considered bymanagement in determining impairment include payment status, collateral value,and the probability of collecting scheduled principal and interest paymentswhen due.  Loans that experienceinsignificant payment delays and payment shortfalls generally are notclassified as impaired.  Managementdetermines the significance of payment delays and payment shortfalls on acase-by-case basis, taking into consideration all of the circumstancessurrounding the loan and the borrower, including the length of the delay, thereasons for the delay, the borrower’s prior payment record, and the amount ofthe shortfall in relation to the principal and interest owed.  Impairment is measured on a loan-by-loanbasis by either the present value of expected future cash flows discounted atthe loan’s effective interest rate, the loan’s obtainable market price, or thefair value of the collateral if the loan is collateral dependent.  Substantially, all of the Bank’s loans thathave been identified as impaired have been measured by the fair value ofexisting collateral.

 

Large groups of smallerbalance homogeneous loans are collectively evaluated for impairment.  Accordingly, the Bank does not separatelyidentify individual consumer loans for impairment disclosures.

 

***LoanServicing***

 

Rights to service loansfor others are capitalized as separate assets, whether acquired throughpurchase or origination, if such loans are sold or securitized with servicingrights retained.  Accordingly, the totalcost of the loan is allocated to the related servicing right and to the loanbased on the relative fair values if it is practicable to estimate those fairvalues.

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 1.**          SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES (Continued)

 

***LoanServicing (Continued)***

 

The Bank estimates fairvalue based on the present value of estimated expected future cash flows usingprepayment speeds and discount rates commensurate with the risks involved, andservicing costs determined on an incremental cost basis.

 

Capitalized mortgageservicing rights are reported in other assets and amortized to servicingrevenue in proportion to, and over the period of, estimated future netservicing revenues of the underlying assets. Impairment of mortgage servicing rights is assessed based on the fairvalue of those rights.  For purposes ofmeasuring impairment, the rights are stratified based on the followingpredominant risk characteristics of the underlying loans: loan type, size, noterate, date of origination, term, and geographic location.  Impairment is recognized through a valuationallowance for an individual stratum, to the extent that fair value is less thanthe capitalized amount for the stratum.

 

***ForeclosedAssets***

 

Assets acquired through, orin lieu of, loan foreclosure are held for sale and are initially recorded atfair value less cost to sell at the date of foreclosure, establishing a newcost basis. Subsequent to foreclosure, valuations are periodically performed bymanagement and the assets are carried at the lower of carrying amount or fairvalue less estimated cost to sell. Any write-down to fair value at the time oftransfer to foreclosed assets is charged to the allowance for loan losses.Property is evaluated regularly to ensure that the recorded amount is supportedby its current fair value and that valuation allowances to reduce the carryingamount to fair value less estimated costs to dispose are recorded as necessary.Revenue and expenses from operations of foreclosed assets and changes in thevaluation allowance are included in net expenses from foreclosed assets.

 

***Premisesand Equipment***

 

The Banks premises andequipment are stated at cost less accumulated depreciation and amortization.  Depreciation is provided for in amountssufficient to relate the cost of depreciable assets to operations over theirestimated service lives.  Leaseholdimprovements are amortized over the term of the lease or the service lives ofthe improvements, whichever is shorter. The straight-line method of depreciation is followed for financialreporting purposes, while both accelerated and straight-line methods arefollowed for income tax purposes.

 

It is general practice tocharge the cost of****maintenanceand repairs to earnings when incurred; major expenditures for betterments arecapitalized and depreciated.

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 1.**          SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES (Continued)

 

***Company Owned LifeInsurance***

 

The Company has purchasedlife insurance policies on certain key executives. Company owned life insuranceis recorded at the amount that can be realized under the insurance contract atthe balance sheet date, which is the cash surrender value adjusted for othercharges or other amounts due that are probable at settlement.

 

OnSeptember 7, 2006, the Emerging Issues Task Force reached a consensus onthe issue, *Accounting for Deferred Compensation andPostretirement Benefit Aspects of Endorsement Split-Dollar Life InsuranceArrangements,* and on March 15, 2007, on the issue, *Accounting for Collateral Assignment Split-Dollar Life InsuranceArrangements*. The scope of these two issues relates to therecognition of a liability and related compensation costs for endorsementsplit-dollar life insurance arrangements and for collateral assignmentsplit-dollar life insurance arrangements, respectively.  Both issues became effective for fiscal years beginning after December 15,2007, although early adoption was permitted. The Corporation adopted the standards for both issues effective as of January 1,2008 as a change in accounting principle through a $362,000 cumulative-effectadjustment to retained earnings. The amount expensed to recognize the liabilityfor future benefits for the year ended December 31, 2008 was $110,000.

 

***Off-Balance Sheet Financial Instruments***

 

Inthe ordinary course of business, the Bank has entered into off-balance sheetfinancial instruments consisting of commitments to extend credit, commitmentsunder credit card advancements, and standby letters of credit. Such financialinstruments are recorded in the financial statements when they become payable.The credit risk associated with these commitments is considered by managementand is reserved for at a level deemed adequate to provide for known andinherent losses.

 

***IncomeTaxes***

 

Deferredincome taxes are recognized for estimated future tax effects attributable toincome tax carry forwards as well as temporary differences between income taxand financial reporting purposes. A valuation allowance is established whennecessary to reduce the deferred tax asset to the amount expected to berealized.  Deferred tax assets and liabilities are reflected at currentlyenacted income tax rates applicable to the period in which the deferred taxassets or liabilities are expected to be realized or settled. As changes in taxlaws or rates are enacted, deferred tax assets and liabilities are adjustedaccordingly through the provision for income taxes.

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 1.**          SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES (Continued)

 

***IncomeTaxes (continued)***

 

TheCorporation uses a recognition threshold and a measurement attribute for thefinancial statement recognition and measurement of a tax position taken orexpected to be taken in a tax return. Benefits from tax positions arerecognized in the consolidated financial statements only when it is more likelythan not that the tax position will be sustained upon examination by theappropriate taxing authority that would have full knowledge of all relevantinformation. A tax position that meets the more-likely-than-not recognitionthreshold is measured at the largest amount of benefit that is greater than 50%likely of being realized upon ultimate settlement. Tax positions thatpreviously failed to meet the more-likely-than-not recognition threshold arerecognized in the first subsequent financial reporting period in which thatthreshold is met. Previously recognized tax positions that no longer meet themore-likely-than-not recognition threshold are derecognized in the firstsubsequent financial reporting period in which that threshold is no longer met.

 

***Transfers ofFinancial Assets***

 

Transfers of financialassets are accounted for as sales when control over the assets has beensurrendered. Control over transferred assets is deemed to be surrendered when1) the assets have been isolated from the Bank, 2) the transferee (buyer)obtains the right to pledge or exchange the transferred assets, free ofconditions that would constrain it from taking advantage of that right, and 3)the Bank does not maintain effective control over the transferred assetsthrough an agreement to repurchase them before their maturity.

 

***Stock-Based CompensationPlans***

 

The cost relating tostock-based compensation is measured at the grant-date fair value of the equityinstruments issued. Cost is recognized over the required service period,generally defined as the vesting period. The Bank uses the Black-Scholes optionpricing model to estimate the fair value of stock options.

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 1.**          SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES (Continued)

 

***Earningsper share***

 

Basic earnings per sharerepresent income available to common shareholders divided by theweighted-average number of common shares outstanding during the period.  Diluted earnings per share reflect additionalcommon shares that would have been outstanding if dilutive potential commonshares had been issued, as well as any adjustment to income that would resultfrom the assumed issuance.  Potentialcommon shares that may be issued by the Corporation relate solely tooutstanding stock options, and are determined using the treasury stockmethod.  The weighted average number ofshares outstanding for basic earnings per share amounted to 1,791,218 for 2009, 1,823,965 for 2008, and1,785,812 for 2007.  The weighted averagenumber of shares outstanding for dilutive earnings per share amounted to1,795,764 for 2009,1,848,173 for 2008, and 1,881,004 for 2007. The Corporation paid no cash dividends in 2009, and cash dividends of$.25, per share in 2008 and 2007.

 

# ***Recent AccountingPronouncements***

 

InAugust 2009, the Financial Accounting Standards Board (FASB) issuedAccounting Standards Update (ASU) No. 2009-05, *Fair Value Measurements and Disclosures (Topic 820) — MeasuringLiabilities at Fair Value*.  This ASU provides amendmentsfor fair value measurements of liabilities.  It providesclarification that in circumstances in which a quoted price in an active marketfor the identical liability is not available, a reporting entity is required tomeasure fair value using one or more techniques.  ASU 2009-05 alsoclarifies that when estimating a fair value of a liability, a reporting entityis not required to include a separate input or adjustment to other inputsrelating to the existence of a restriction that prevents the transfer of theliability.  ASU 2009-05 is effective for the periods beginning after October 1,2009. Management is assessing the impact of ASU 2009-05 on the consolidated financialcondition, results of operations, and disclosures.

 

InJune 2009, the FASB issued ASU No. 2009-01 (formerly Statement No. 168),*Topic 105 - Generally Accepted AccountingPrinciples - FASB Accounting Standards Codification and the Hierarchy ofGenerally Accepted Accounting Principles*.* *The Codification is the single source of authoritativenongovernmental U.S. generally accepted accounting principles(GAAP).  The Codification does not change current GAAP, but isintended to simplify user access to all authoritative GAAP by providing all theauthoritative literature related to a particular topic in oneplace.  All existing accounting standard documents are superseded andall other accounting literature not included in the Codification is considerednon-authoritative.  The Codification is effective for interim orannual reporting periods ending after September 15,2009.  Management has made the appropriate changes to GAAP referencesin the consolidated financial statements.

 

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**NORTHERN CALIFORNIA BANCORP, INC.AND SUBSIDIARY**

** **

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 1.**          SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES (Continued)

 

# ***Recent AccountingPronouncements (continued)***

 

InJune 2009, the FASB issued Statement No. 166, *Accounting for Transfers of Financial Assets, anamendment of FASB Statement No. 140*(SFAS No. 166).  SFASNo. 166 amends the de-recognition accounting and disclosure guidancerelating to SFAS 140.  SFAS No. 166 eliminates the exemptionfrom consolidation for qualifying special purpose entities (QSPEs). It alsoamends the accounting rules relating to the sale of loans, including thesale of SBA-guaranteed loans.  SFAS No. 166 is effective as ofthe beginning of the first annual reporting period that begins after November 15,2009.  Management is assessing the impact of SFAS No. 166 on theCorporation’s consolidated financial condition, resultsof operations, and disclosures.

 

InJune 2009, the FASB issued SFAS No. 167, *Amendments to Interpretation No. 46(R),* which amendsguidance for consolidation of variable interest entities by replacing thequantitative-based risks and rewards calculation for determining whichenterprise, if any, has a controlling financial interest in a variable interestentity with an approach focused on identifying which enterprise has (1) thepower to direct the activities of a variable interest entity that most significantlyimpact the entity’s economic performance and (2) the obligation to absorblosses of the entity or the right to receive benefits from the entity.Additional disclosures about an enterprise’s involvement in variable interestentities are also required. This guidance is effective as of the beginning ofeach reporting entity’s first annual reporting period that begins after November 15,2009, for interim periods within that first annual reporting period, and forinterim and annual reporting periods thereafter. Early adoption is prohibited.Management is assessing the impact of SFAS 167 on the Corporation’s consolidated financialcondition, results of operations, and disclosures.

 

InApril 2009, the FASB issued ASC 320 (formerly Staff Position FAS 115-2, FAS124-2 and EITF 99-20-2), *Recognition andPresentation of Other-Than-Temporary-Impairment.  *ASC 320 (i) changesexisting guidance for determining whether an impairment of debt securities isother than temporary and (ii) replaces the existing requirement that theentity’s management assert it has both the intent and ability to hold animpaired security until recovery with a requirement that management assert: (a) itdoes not have the intent to sell the security; and (b) it is more likelythan not it will not have to sell the security before recovery of its costbasis.  Under ASC 320, declines in the fair value of held-to-maturityand available-for-sale securities below their cost that are deemed to be otherthan temporary are reflected in earnings as realized losses to the extent theimpairment is related to credit losses.  The amount of impairmentrelated to other factors is recognized in other comprehensiveincome.  ASC 320 is effective for interim and annual periods endingafter June 15, 2009.  The adoption of ASC 320 in the secondquarter of 2009 did not have an impact on Corporation’s consolidated financialstatements. However, the disclosures have been modified to conform to ASC 320,as presented in Note 4.

 

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**NORTHERN CALIFORNIA BANCORP, INC.AND SUBSIDIARY**

** **

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 1.**          SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES (Continued)

 

# ***Recent AccountingPronouncements (continued)***

 

InApril 2009, the FASB issued ASC 820 (formerly FSP FAS 157-4), *Determining Fair Value When the Volume and Level ofActivity for the Asset or Liability Have Significantly Decreased andIdentifying Transactions That Are Not Orderly.  *ASC 820 affirmsthe objective of fair value when a market is not active, clarifies and includesadditional factors for determining whether there has been a significantdecrease in market activity, eliminates the presumption that all transactionsare distressed unless proven otherwise, and requires an entity to disclose achange in valuation technique.  ASC 820 is effective for interim andannual periods ending after June 15, 2009.  The Corporation adoptedthe provisions of ASC 820 on April 1, 2009.  The provisions ofASC 820 did not have a material impact on Corporation’s consolidated financialcondition and results of operations.

# *** ***

# ***Comprehensive Income(Loss)***

 

Accounting principlesgenerally accepted in the United States require that recognized revenue,expenses, gains, and losses be included in net income.  Although certain changes in assets andliabilities, such as unrealized gains and losses on available-for-salesecurities, are reported as a separate component of the equity section of thebalance sheet, such items, along with net income, are components ofcomprehensive income.

 

The components of othercomprehensive income (loss) and related tax effects for the years ended December 31,are as follows:

 
| ** **                                                                                 | ** ** | **2009**                   | ** ** | **2008** | ** ** | **2007** | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------------------------|------------|----------|------------|----------|------------|
| ** **                                                                                 | ** ** | **(Dollars in thousands)** | ** ** |
| Unrealized  holding gains (losses) on available for sale securities and other  assets, net |       | $                          | 3,685      |     | $          | (284     | )          | $ | 438 |   |
| Reclassification adjustment for gains realized in  income                                  |       | (3,189                     | )          | (449     | )          | (216     | )          |
| Net unrealized gains (losses)                                                              |       | 496                        |       | (733     | )          | 222      |       |
| Tax effect                                                                                 |       | (224                       | )          | 330      |       | (100     | )          |
|                                                                                       |       |                       |       |     |       |     |       |
| Other comprehensive gain (loss) net of tax                                                 |       | $                          | 272        |     | $          | (403     | )          | $ | 122 |   |

 

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**NORTHERN CALIFORNIA BANCORP, INC.AND SUBSIDIARY**

** **

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 1.**          SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES (Continued)

 

# ***Comprehensive Income(Loss) (continued)***

 

The components ofaccumulated other comprehensive income (loss) and related tax effects as of December 31are as follows:

 
| ** **                                                             | ** ** | **2009**                   | ** ** | **2008** | ** ** |
|------------------------------------------------------------------------|------------|----------------------------|------------|----------|------------|
| ** **                                                             | ** ** | **(Dollars in thousands)** | ** ** |
| Unrealized  holding gains (losses) on available for sale securities    |       | $                          | (109       | )        | $          | (577 | ) |
| Unrealized  holding gains on available for sale asset strip receivable |       | 55                         |       | 27       |       |
| Tax  effect                                                            |       | 24                         |       | 248      |       |
|                                                                   |       |                       |       |     |       |
| Net-of-tax  amount                                                     |       | $                          | (30        | )        | $          | (302 | ) |

 

***AdvertisingCosts***

 

Advertising costsare charged to operations when incurred. The amount expensed for advertising for the years ended December 31,2009, 2008, and 2007 was $80,000, $103,000, and $164,000, respectively.

 

***Reclassification***

 

Certain amounts have been reclassified in the 2008 and2007 financial statements to conform to the 2009 presentation with no changesto previously reported income.

 

**Note 2.****         ****CASH AND DUE FROM BANKS**

 

The Corporation isrequired to maintain aggregate reserves (in the form of cash and deposits withthe Federal Reserve Bank) to satisfy federal regulatory requirements.  At December 2009 and 2008, the Bank metthese requirements by maintaining reserve balances of $1,890,000 and $942,000,respectively.

 

**Note 3.****         ****TRADING ASSETS**

 

At December 31, 2009and 2008, the Corporation’s trading assets consisted of marketable equitysecurities in the amount of $153,000 and $361,000, respectively.

 

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**NORTHERN CALIFORNIA BANCORP, INC.AND SUBSIDIARY**

** **

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**December 31, 2009 and 2008**

 

**Note 4.****         ****INVESTMENT SECURITIES AND OTHER INVESTMENTS**

 

The following is acomparison of amortized cost and approximate fair value of investmentsecurities at December 31:

 
| ** **                           | ** ** | **2009**                             | ** ** |
|--------------------------------------|------------|--------------------------------------|------------|
| ** **                           | ** ** | ** **                           | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                           | ** ** | **Amortized**                        | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                           | ** ** | **Cost**                             | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
| ** **                           |       | **(Dollars in thousands)** |       |
| **Securities Available for Sale**    |       |                                 |       |   |   |   |   |   |   |
| Mortgage  Backed Securities          |       | $                                    | 1,534      |   | $ | — |   | $ | (44 | ) | $ | 1,490 |   |
| State/Local  Agency Securities       |       | 53,000                               |       | 1,501 |   | (1,427 | ) | 53,074 |   |
| Government  Agency Securities        |       | 7,988                                |       | — |   | (139 | ) | 7,849 |   |
|                                 |       |                                 |       |   |   |   |   |   |   |
| Total  securities available for sale |       | $                                    | 62,522     |   | $ | 1,501 |   | $ | (1,610 | ) | $ | 62,413 |   |

 
| ** **                                           | ** ** | **2009**                   | ** ** |
|------------------------------------------------------|------------|----------------------------|------------|
| ** **                                           | ** ** | ** **                 | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                                           | ** ** | **Amortized**              | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                                           | ** ** | **Cost**                   | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
| ** **                                           | ** ** | **(Dollars in thousands)** | ** ** |
| **Other Investments, at cost**                       |       |                       |       |   |   |   |   |   |   |
| Federal  Home Loan Bank stock, restricted            |       | $                          | 3,360      |   | $ | — |   | $ | — |   | $ | 3,360 |   |
| Northern  California Bancorp, Inc. Trust I           |       | 93                         |       | — |   | — |   | 93 |   |
| Northern  California Bancorp, Inc. Trust II          |       | 155                        |       | — |   | — |   | 155 |   |
| The  Independent Bankers’ Financial Corporation |       | 51                         |       | — |   | — |   | 51 |   |
| Visa,  Inc Class B Stock                        |       | 426                        |       | — |   | — |   | 426 |   |
|                                                 |       |                       |       |   |   |   |   |   |   |
| Total  other investments                             |       | $                          | 4,085      |   | $ | — |   | $ | — |   | $ | 4,085 |   |

 

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**NORTHERN CALIFORNIA BANCORP, INC.AND SUBSIDIARY**

** **

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**December 31,2009 and 2008**

 

**Note 4.****         ****INVESTMENT SECURITIES AND OTHER INVESTMENTS (Continued)**

 
| ** **                           | ** ** | **2008**                   | ** ** |
|--------------------------------------|------------|----------------------------|------------|
| ** **                           | ** ** | ** **                 | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                           | ** ** | **Amortized**              | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                           | ** ** | **Cost**                   | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
| ** **                           | ** ** | **(Dollars in thousands)** | ** ** |
| **Securities  Available for Sale**   |       |                       |       |   |   |   |   |   |   |
| Mortgage  Backed Securities          |       | $                          | 4,048      |   | $ | 19 |   | $ | (175 | ) | $ | 3,892 |   |
| Corporate  Debt Securities           |       | 5,846                      |       | 34 |   | (14 | ) | 5,866 |   |
| State/Local  Agency Securities       |       | 41,839                     |       | 710 |   | (1,998 | ) | 40,551 |   |
| Government  Agency Securities        |       | 42,197                     |       | 847 |   | — |   | 43,044 |   |
|                                 |       |                       |       |   |   |   |   |   |   |
| Total  securities available for sale |       | $                          | 93,930     |   | $ | 1,610 |   | $ | (2,187 | ) | $ | 93,353 |   |

 
| ** **                                           | ** ** | **2008**                   | ** ** |
|------------------------------------------------------|------------|----------------------------|------------|
| ** **                                           | ** ** | ** **                 | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                                           | ** ** | **Amortized**              | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                                           | ** ** | **Cost**                   | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
| ** **                                           | ** ** | **(Dollars in thousands)** | ** ** |
| **Other Investments, at cost**                       |       |                       |       |   |   |   |   |   |   |
| AT  Services LLC                                     |       | $                          | 20         |   | $ | — |   | $ | — |   | $ | 20 |   |
| Federal  Home Loan Bank stock, restricted            |       | 3,097                      |       | — |   | — |   | 3,097 |   |
| Metrocities  Mortgage, LLC                           |       | 10                         |       | — |   | — |   | 10 |   |
| Northern  California Bancorp, Inc. Trust I           |       | 93                         |       | — |   | — |   | 93 |   |
| Northern  California Bancorp, Inc. Trust II          |       | 155                        |       | — |   | — |   | 155 |   |
| The  Independent Bankers’ Financial Corporation |       | 51                         |       | — |   | — |   | 51 |   |
| Visa,  Inc Class B Stock                        |       | 426                        |       | — |   | — |   | 426 |   |
|                                                 |       |                       |       |   |   |   |   |   |   |
| Total  other investments                             |       | $                          | 3,852      |   | $ | — |   | $ | — |   | $ | 3,852 |   |

 

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**NORTHERN CALIFORNIA BANCORP, INC.AND SUBSIDIARY**

** **

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**December 31, 2009 and 2008**

 

**Note 4.****         ****INVESTMENT SECURITIES AND OTHER INVESTMENTS (Continued)**

 

On April 1, 2008State/Local Agency Securities with total amortized cost of $7,869,000 and totalfair value of $8,112,000 were transferred from a held to maturityclassification to an available for sale classification.  Subsequent to the transfer to available forsale, securities with total amortized cost of $4,290,000 and market value of$4,510,000 were sold with a realized gain of $220,000.  The change in classification was made inorder to provide greater flexibility in managing the security portfolio andincrease liquidity.

 

The amortized cost andfair value of debt securities by contractual maturity date at December 31,2009 follows:

 
| ** **                              | ** ** | **Available for Sale**     | ** ** |
|-----------------------------------------|------------|----------------------------|------------|
| ** **                              | ** ** | **Amortized**              | ** ** | **Fair** | ** ** |
| ** **                              | ** ** | **Cost**                   | ** ** | **Value** | ** ** |
| ** **                              | ** ** | **(Dollars in thousands)** | ** ** |
|                                    |       |                       |       |   |   |
| Due after five years  through ten years |       | $                          | 1,417      |   | $ | 1,387 |   |
| Due after ten years                     |       | 61,105                     |       | 61,026 |   |
|                                    |       |                       |       |   |   |
|                                    |       | $                          | 62,522     |   | $ | 62,413 |   |

 

Proceeds from maturityand sales of investment securities for the years ended December 31, 2009,2008, and 2007 were $130,659,000, $55,022,000, and $24,217,000,respectively.  Realized gains for theyears ended December 31, 2009, 2008, and 2007 were $3,189,000, $449,000,and $216,000, respectively.

 

Asa member of the Federal Home Loan Bank (FHLB) system, the Bank is required tomaintain an investment in FHLB stock in an amount equal to the greater of 1% ofits outstanding mortgage loans or 5% of advances from the FHLB. As of December 31,2009 and 2008, the Bank had advances from the FHLB totaling $29,000,000 and$66,500,000, respectively. No ready market exists for FHLB stock, and it has noquoted market value. FHLB stock is evaluated for impairment based on anestimate of the ultimate recoverability of par value.

 

At December 31, 2009and 2008, U.S. Government and Mortgage Backed obligations with a carrying valueof $8,761,000 and $43,044,000, respectively, were pledged to secure advancesfrom the FHLB.

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

**Note 4.****         ****INVESTMENT SECURITIES AND OTHER INVESTMENTS (Continued)**

 

At December 31, 2009and 2008 State/Local Agency obligations with a carrying value of $20,462,000and $23,144,000, respectively, were pledged to secure loans from the FederalReserve Bank.

 

In December 2008,the Bank purchased three debt securities totaling $3,050,000 that hadsettlement dates in January 2009. The Bank had recorded the investment securities purchased as of thetrade date and had recorded the corresponding payable for investment securitiespurchased of $3,050,000 at December 31, 2008.

 

Information pertaining tosecurities with gross unrealized losses at December 31, 2009, aggregatedby investment category and length of time that individual securities have beenin a continuous loss position follows:

 
| ** **                      | ** ** | **Less than 12 Months**    | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
|---------------------------------|------------|----------------------------|------------|-----------------------|------------|-----------|------------|
| ** **                      | ** ** | **Fair**                   | ** ** | **Unrealized**        | ** ** | **Fair**  | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                      | ** ** | **Value**                  | ** ** | **Loss**              | ** ** | **Value** | ** ** | **Loss** | ** ** | **Value** | ** ** | **Loss** | ** ** |
| ** **                      | ** ** | **(Dollars in thousands)** | ** ** |
| Securities  Available for Sale: |       |                       |       |                  |       |      |       |   |   |   |   |   |   |
| Government  Agency Securities   |       | $                          | 7,849      |                  | $          | (139      | )          | $ | — |   | $ | — |   | $ | 7,849 |   | $ | (139 | ) |
| Mortgage  Backed Securities     |       | 1,491                      |       | (44                   | )          | —    |       | — |   | 1,491 |   | (44 | ) |
| State/Local  Agency Securities  |       | 8,827                      |       | (245                  | )          | 8,889     |       | (1,182 | ) | 17,716 |   | (1,427 | ) |
|                            |       |                       |       |                  |       |      |       |   |   |   |   |   |   |
| Total                           |       | $                          | 18,167     |                  | $          | (428      | )          | $ | 8,889 |   | $ | (1,182 | ) | $ | 27,056 |   | $ | (1,610 | ) |

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

**Note 4.****         ****INVESTMENT SECURITIES AND OTHER INVESTMENTS (Continued)**

 

Information pertaining tosecurities with gross unrealized losses at December 31, 2008, aggregatedby investment category and length of time that individual securities have beenin a continuous loss position follows:

 
| ** **                      | ** ** | **Less than 12 Months**    | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
|---------------------------------|------------|----------------------------|------------|-----------------------|------------|-----------|------------|
| ** **                      | ** ** | **Fair**                   | ** ** | **Unrealized**        | ** ** | **Fair**  | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                      | ** ** | **Value**                  | ** ** | **Loss**              | ** ** | **Value** | ** ** | **Loss** | ** ** | **Value** | ** ** | **Loss** | ** ** |
| ** **                      | ** ** | **(Dollars in thousands)** | ** ** |
| Securities  Available for Sale: |       |                       |       |                  |       |      |       |   |   |   |   |   |   |
| Corporate  Debt Securities      |       | $                          | 2,880      |                  | $          | (14       | )          | $ | — |   | $ | — |   | $ | 2,880 |   | $ | (14 | ) |
| Mortgage  Backed Securities     |       | 2,650                      |       | (175                  | )          | —    |       | — |   | 2,650 |   | (175 | ) |
| State/Local  Agency Securities  |       | 24,806                     |       | (1,998                | )          | —    |       | — |   | 24,806 |   | (1,998 | ) |
|                            |       |                       |       |                  |       |      |       |   |   |   |   |   |   |
| Total                           |       | $                          | 30,336     |                  | $          | (2,187    | )          | $ | — |   | $ | — |   | $ | 30,336 |   | $ | (2,187 | ) |

 

Management evaluatessecurities for other-than-temporary impairment at least on a quarterly basis,and more frequently when economic or market concerns warrant such evaluation.Consideration is given to (1) the length of time and the extent to whichthe fair value has been less than cost, (2) the financial condition andnear-term prospects of the issuer, and (3) the Bank does not have theintent to sell the security; and it is more likely than not it will not have tosell the security before recovery of its cost basis.

 

OnDecember 31, 2009, forty securities had an unrealized loss with aggregatedepreciation of 5.62% from the Bank’s amortized cost basis. On December 31,2008, fifty five securities had an unrealized loss with aggregate depreciationof 1.20% from the Bank’s amortized cost basis. The unrealized losses relate toa mortgage backed security issued by federally sponsored agencies, which arefully secured by conforming residential loans, securities issued by agencies ofthe United States and securities issued by local government agencies.  Since the Bank has the ability to hold thesesecurities until estimated maturity, no decline is deemed to be other thantemporary.

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

**Note 5.****         ****SALES AND SERVICING OF SBA LOANS**

 

A summary of the activityof SBA loans for the years ended December 31 follows:

 
| ** **            | ** ** | **2009**                   | ** ** | **2008** | ** ** | **2007** | ** ** |
|-----------------------|------------|----------------------------|------------|----------|------------|----------|------------|
| ** **            | ** ** | **(Dollars in thousands)** | ** ** |
|                  |       |                       |       |     |       |     |       |
| SBA  loans originated |       | $                          | 8,393      |     | $          | 3,235    |       | $ | 3,065 |   |
|                  |       |                       |       |     |       |     |       |
| SBA  loans sold       |       | $                          | 2,740      |     | $          | 2,194    |       | $ | 1,933 |   |

 

A summary ofincome from SBA loans sold for the years ended December 31 is as follows:

 
| ** **                            | ** ** | **2009**                   | ** ** | **2008** | ** ** | **2007** | ** ** |
|---------------------------------------|------------|----------------------------|------------|----------|------------|----------|------------|
| ** **                            | ** ** | **(Dollars in thousands)** | ** ** |
|                                  |       |                       |       |     |       |     |       |
| Income  from premiums                 |       | $                          | 255        |     | $          | 142      |       | $ | 147 |   |
| Income  from servicing                |       | 145                        |       | 187      |       | 333      |       |
|                                  |       |                       |       |     |       |     |       |
| Total  SBA sales and servicing income |       | $                          | 400        |     | $          | 329      |       | $ | 480 |   |

 

**Note 6.****         ****LOANS AND ALLOWANCE FOR LOAN LOSSES**

 

A summary of loanbalances at December 31 follows:

 
| ** **                             | ** ** | **2009**                   | ** ** | **2008**   | ** ** |
|----------------------------------------|------------|----------------------------|------------|------------|------------|
| ** **                             | ** ** | **(Dollars in thousands)** | ** ** |
| ** **                             | ** ** | ** **                 | ** ** | ** ** | ** ** |
| Commercial  and industrial             |       | $                          | 31,389     |       | $          | 28,237 |   |
| Construction                           |       | 8,705                      |       | 16,040     |       |
| Real  estate, mortgage                 |       | 121,887                    |       | 122,951    |       |
| Installment                            |       | 2,746                      |       | 966        |       |
| Government  guaranteed loans purchased |       | 16                         |       | 24         |       |
|                                   |       | 164,743                    |       | 168,218    |       |
| Allowance  for loan losses             |       | (3,529                     | )          | (2,413     | )          |
| Deferred  origination fees, net        |       | (217                       | )          | (275       | )          |
|                                   |       |                       |       |       |       |
| Loans,  net                            |       | $                          | 160,997    |       | $          | 165,530 |   |

 

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**NORTHERN CALIFORNIA BANCORP, INC.AND SUBSIDIARY**

** **

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**December 31, 2009 and 2008**

** **

**Note 6.****         ****LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)**

 

An analysis of theallowance for loan losses for the years ended December 31 follows:

 
| ** **                 | ** ** | **2009**                   | ** ** | **2008** | ** ** | **2007** | ** ** |
|----------------------------|------------|----------------------------|------------|----------|------------|----------|------------|
| ** **                 | ** ** | **(Dollars in thousands)** | ** ** |
|                       |       |                       |       |     |       |     |       |
| Beginning  balance         |       | $                          | 2,413      |     | $          | 2,028    |       | $ | 1,409 |   |
| Recoveries                 |       | 77                         |       | 3        |       | 4        |       |
| Loans  charged off         |       | (2,329                     | )          | (750     | )          | (250     | )          |
| Provision  for loan losses |       | 3,368                      |       | 1,132    |       | 865      |       |
|                       |       |                       |       |     |       |     |       |
| Ending  balance            |       | $                          | 3,529      |     | $          | 2,413    |       | $ | 2,028 |   |

 

The following tablesummarizes the Bank’s investment in loans for which impairment has beenrecognized as of and for the years ended December 31.  Impaired loans consist of the loans onnon-accrual status.

 
| ** **                                                                                                                    | ** ** | **2009**                   | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|------------|------------|------------|------------|
| ** **                                                                                                                    | ** ** | **(Dollars in thousands)** | ** ** |
|                                                                                                                          |       |                       |       |       |       |       |       |
| Total  impaired loans which as a result of write-down or the fair value of the collateral,  did not have a specific allowance |       | $                          | 4,399      |       | $          | 5,728      |       | $ | — |   |
| Impaired  loans which have a specific allowance                                                                               |       | 3,681                      |       | 1,363      |       | 3,396      |       |
| ** **                                                                                                                    | ** ** | ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total  impaired loans                                                                                                         |       | $                          | 8,080      |       | $          | 7,091      |       | $ | 3,396 |   |
|                                                                                                                          |       |                       |       |       |       |       |       |
| Total  specific allowance on impaired loans                                                                                   |       | $                          | 357        |       | $          | 123        |       | $ | 212 |   |

 
| ** **                                                       | ** ** | **2009**                   | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|------------------------------------------------------------------|------------|----------------------------|------------|------------|------------|------------|------------|
| ** **                                                       | ** ** | **(Dollars in thousands)** | ** ** |
| ** **                                                       | ** ** | ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Average  recorded investment in impaired loans during the period |       | $                          | 6,490      |       | $          | 5,073      |       | $ | 702 |   |
| Income  recognized on impaired loans during the period           |       | $                          | —     |       | $          | —     |       | $ | — |   |

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

**Note 6.****        ****LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)**

 

No funds are committed tobe advanced in connection with impaired loans.

 

As of December 31,2009 and 2008, there were no loans past due ninety days or more and stillaccruing interest.

 

Loans serviced for othersare not included in the accompanying consolidated balance sheets.  The unpaid principal balance of loansserviced for others was $30,746,000 and $112,849,000 at December 31, 2009and 2008, respectively.

 

## **Note 7.**         FORECLOSEDASSETS

 

As of December 31,2009 and 2008, foreclosed assets totaled $15,343,000 and $7,364,000,respectively. Based on property values, a valuation allowance of $1,010,000 wasdeemed necessary at December 31, 2009. No valuation allowance was deemednecessary at December 31, 2008.

 

Subsequent to December 31,2009, properties valued $8,582,000 were transferred to foreclosed assets.  Based on property values, a valuationallowance of $212,000 was deemed necessary for these properties.  One property was sold for $225,000, with again on sale of $23,000.

 

Operating expenses forforeclosed assets totaled $326,000 and $112,000 for the years ended December 31,2009 and 2008, respectively. A net loss of $65,000 was recognized on the saleof foreclosed assets for the year ended December 31, 2009. There were nosales of foreclosed assets during the year ended December 31, 2008.

 

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**NORTHERN CALIFORNIA BANCORP, INC.AND SUBSIDIARY**

** **

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**December 31, 2009 and 2008**

 

## **Note 8.**         PREMISESAND EQUIPMENT

 

A summary of the cost andaccumulated depreciation of banking premises and equipment and their estimateduseful lives at December 31 follows:

 
| ** **                | ** ** | ** **                           | ** ** | ** ** | ** ** | **Estimated**    | ** ** |
|---------------------------|------------|--------------------------------------|------------|------------|------------|------------------|------------|
| ** **                | ** ** | **2009**                             | ** ** | **2008**   | ** ** | **Useful Lives** | ** ** |
| ** **                | ** ** | **(Dollars in thousands)** | ** ** | ** ** | ** ** |
|                      |       |                                 |       |       |       |             |       |
| Land                      |       | $                                    | 1,174      |       | $          | 1,174            |       |   |   |
| Building                  |       | 1,816                                |       | 1,816      |       | 40  years        |       |
| Building  improvements    |       | 1,094                                |       | 1,094      |       | 40  years        |       |
| Leasehold  improvements   |       | 1,080                                |       | 1,080      |       | Lease  term      |       |
| Furniture  and equipment  |       | 2,679                                |       | 2,427      |       | 3-8  years       |       |
|                      |       | 7,843                                |       | 7,591      |       |             |       |
| Accumulated  depreciation |       | (2,934                               | )          | (2,603     | )          |             |       |
|                      |       |                                 |       |       |       |             |       |
|                      |       | $                                    | 4,909      |       | $          | 4,988            |       |   |   |

 

Depreciation andamortization expense for the years ended December 31, 2009, 2008, and 2007amounted to $332,000, $312,000, and $293,000, respectively.

 

## **Note 9.**         DEPOSITS

 

At December 31, 2009, the scheduled maturities of time depositsare as follows:

 

**(Dollars in thousands)**

 
| **Years Ending December 31:** |   |   |    |
|------------------------------------|--------|--------|---------|
| 2010                               |   | $      | 110,586 |   |
| 2011                               |   | 29,999 |    |
| 2012                               |   | 6,278  |    |
| 2013                               |   | 2,016  |    |
| 2014                               |   | 2,110  |    |
| Thereafter                         |   | 2,398  |    |
|                               |   |   |    |
|                               |   | $      | 153,387 |   |

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 10.**       JUNIORSUBORDINATED DEBT SECURITIES

 

On March 27, 2003, the Corporation’s wholly owned special-purposetrust subsidiary, Northern California Bancorp, Inc. Trust I (“Trust I”)issued $3 million in cumulative Trust Preferred Securities.  The securities bear a floating rate ofinterest of 3.25% over the three month LIBOR rate, payable quarterly.  The effective rate at December 31, 2009and 2008 was 3.53% and 8.07%, respectively. Concurrent with the issuance of the Trust Preferred Securities, Trust Iused the proceeds from the Trust Preferred Securities offering to purchase alike amount of Junior Subordinated Debentures of the Corporation. TheCorporation will pay interest on the Junior Subordinated Debentures to Trust I,which represents the sole revenue and sole source of dividend distributions tothe holders of the Trust Preferred Securities. The Corporation has the right, assuming no default has occurred, todefer payments of interest on the Junior Subordinated Debentures at any timefor a period not to exceed 20 consecutive quarters.  TheTrust Preferred Securities will mature on April 7, 2033, but can beredeemed, in whole or in part, on any January 7, April 7, July 7or October 7 occurring after April 7, 2008 at par.  The Corporation fully and unconditionallyguarantees the obligations of Trust I, on a subordinated basis.

 

The Corporation received $2.91 million from Trust I upon issuance ofthe Junior Subordinated Debentures, of which $1 million was contributed by theCorporation to the Bank to increase its capital, $1.14 million was used toretire existing Corporation debt and the remainder was held as workingcapital.  Under applicable regulatoryguidelines, a portion of the Trust Preferred Securities will qualify as Tier ICapital and the remainder as Tier II Capital.

 

On November 13, 2003, the Corporation’s wholly ownedspecial-purpose trust subsidiary, Northern California Bancorp, Inc. TrustII (“Trust II”) issued $5 million in cumulative Trust PreferredSecurities.  The securities bear afloating rate of interest of 2.85% over the three month LIBOR rate, payablequarterly.  The effective rate at December 31,2009 and 2008 was 3.13% and 6.04%, respectively. Concurrent with the issuanceof the Trust Preferred Securities, Trust II used the proceeds from the TrustPreferred Securities offering to purchase a like amount of Junior SubordinatedDebentures of the Corporation. The Corporation will pay interest on the JuniorSubordinated Debentures to Trust II, which represents the sole revenue and solesource of dividend distributions to the holders of the Trust PreferredSecurities. The Corporation has the right, assuming no default has occurred, todefer payments of interest on the Junior Subordinated Debentures at any timefor a period not to exceed 20 consecutive quarters.  The Trust Preferred Securities will mature onNovember 8, 2033, but can be redeemed, in whole or in part, on any February 8,May 8, August 8 or November 8 occurring after November 8,2008 at par.  The Corporation fully andunconditionally guarantees the obligations of Trust II on a subordinated basis.

 

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**NORTHERN CALIFORNIA BANCORP, INC.AND SUBSIDIARY**

** **

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 10.**       JUNIORSUBORDINATED DEBT SECURITIES (Continued)

 

The Corporation received $4.96 million fromTrust II upon issuance of the Junior Subordinated Debentures, of which $2.5million was contributed by the Corporation to the Bank to increase its capitaland the remainder was held as working capital.

 

Issuance costs of $116,000 and $54,000related to Trust I and Trust II, respectively have been capitalized and arebeing amortized over the 30-year life of the securities.

 

During the years ended December 31,2009, 2008 and 2007 interest expense on Junior Subordinated Debentures totaled$328,000, $534,000,and $696,000, respectively.  Theamortization of the issuance cost totaled $6,000 for each year ended December 31,2009, 2008 and 2007, respectively.

 

The Corporation exercised its rights inaccordance with Section 2.11 Extension of Interest Payment Period of theIndentures dated March 27, 2003 and November 13, 2003, for NorthernCalifornia Bancorp, Inc. Trust I and Trust II, respectively, to deferinterest payments for an undetermined period of time, not to exceed twenty (20)consecutive quarterly payments.  Thedeferral of interest payments on Northern California Bancorp, Inc. Trust Iwas effective with the October 7, 2009 interest payment.  At December 31, 2009 accrued and unpaidinterest totaled $60,000. The deferral of interest payments on NorthernCalifornia Bancorp, Inc. Trust II was effective with the November 8,2009 interest payment.  At December 31,2009 accrued and unpaid interest totaled $65,000.

 

#### **Note 11.**       FUNDINGSOURCES

 

The Corporation has a line of credit with M & I Marshall &Ilsley Bank in the amount of $3,000,000, a fixed interest rate of 6.50% and amaturity date of April 30, 2010.  AtDecember 31, 2009, $2,850,000 was advanced on the line.

 

The Bank has lines of credit from the Federal Home Loan Bank (FHLB) ofSan Francisco, and the Federal Reserve Bank with remaining available borrowingcapacity on December 31, 2009 of $1,337,000, $2,707,000,respectively.  The Federal Home Loan Bankline of credit has a maximum borrowing capacity of 20% of the Bank’s totalassets, adjusted quarterly.  The FHLBline of credit is secured by a portion of the Bank’s real estate secured loansand securities at December 31, 2009. At December 31, 2009, the total principal balance of pledged loansand securities was $43,869,000 and $8,470,000, respectively.  At December 31, 2008, the totalprincipal balance of pledged loans and securities was $38,597,000 and$43,044,000, respectively.

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 11.**       FUNDINGSOURCES (Continued)

 

The Federal Reserve Bank discount window line is secured by a portionthe Bank’s securities, at December 31, 2009 and 2008 the total marketvalue of securities pledged was $24,245,000 and $21,448,000. At December 31,2009 and 2008 the remaining available credit on the line was $2,707,000 and$7,165,000, respectively. No advances were outstanding on line at December 31,2009 and 2008.

 

The following table provides information on ten FHLB advancesoutstanding at December 31, 2009.

 
| **Advance  Amount**                  | ** **       | **Fixed  Interest  Rate** | ** ** | **Funding  Date** | ** ** | **Maturity  Date** | ** ** |
|--------------------------------------|------------------|---------------------------|------------|-------------------|------------|--------------------|------------|
| **(Dollars in thousands)** |             |
|                                 |             |                      |       |              |       |               |       |
| $                                    |  5,000,000  |                      | 4.96       | %                 | 11/14/05   |               | 11/15/10   |   |
| 1,750,000                            |             | 4.74                      | %          | 01/26/06          |       | 01/26/11           |       |
| 2,250,000                            |             | 4.75                      | %          | 01/26/06          |       | 01/26/11           |       |
| 3,500,000                            |             | 5.51                      | %          | 07/17/06          |       | 07/18/11           |       |
| 1,500,000                            |             | 5.52                      | %          | 07/17/06          |       | 07/18/11           |       |
| 1,000,000                            |             | 5.22                      | %          | 08/25/06          |       | 08/25/11           |       |
| 5,000,000                            |             | 5.21                      | %          | 07/30/07          |       | 07/30/12           |       |
| 3,000,000                            |             | 4.85                      | %          | 10/01/07          |       | 10/01/12           |       |
| 5,000,000                            |             | 5.01                      | %          | 09/18/07          |       | 09/18/14           |       |
| 1,000,000                            |             | 7.72                      | %          | 06/01/00          |       | 06/03/30           |       |
| $                                    |  29,000,000 |                      |       |              |       |               |       |   |

 

The Bank has a loan from the Federal ReserveBank in the amount of $10,000,000 with an interest rate of 0.50% and a maturitydate of January 11, 2010.  Atmaturity, the loan was paid off with cash funds and funding from a new loan inthe amount of $5,000,000 with the same terms and a maturity date of February 8,2010.  The loan was paid off at maturityon February 8, 2010.

 

TheBank has two letters of credit issued by FHLB of San Francisco. One letter ofcredit in the amount of $330,000, expiring April 20, 2011, is used tosecure local agency deposits.  Thebeneficiary of the letter of credit is the Administrator of Local Agency Security,Department of Financial Institutions. The other letter of credit in the amount of $1,300,000, expiring February 17,2019 has MasterCard International Inc. as the beneficiary.

 

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**NORTHERN CALIFORNIA BANCORP, INC.AND SUBSIDIARY**

** **

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 12.**       INCOMETAXES

 

Allocation of federal andCalifornia income taxes between current and deferred portions for the yearended December 31 is as follows:

 
| ** **                                 | ** ** | **2009**                   | ** ** | **2008** | ** ** | **2007** | ** ** |
|--------------------------------------------|------------|----------------------------|------------|----------|------------|----------|------------|
| ** **                                 | ** ** | **(Dollars in thousands)** | ** ** |
| Current  tax provision:                    |       |                       |       |     |       |     |       |
| Federal                                    |       | $                          | 585        |     | $          | 551      |       | $ | 1,099 |   |
| California                                 |       | 416                        |       | 313      |       | 468      |       |
|                                       |       |                       |       |     |       |     |       |
|                                       |       | 1,001                      |       | 864      |       | 1,567    |       |
|                                       |       |                       |       |     |       |     |       |
| Deferred  tax provision (benefit):         |       |                       |       |     |       |     |       |
| Federal                                    |       | (988                       | )          | (279     | )          | (259     | )          |
| California                                 |       | (316                       | )          | (155     | )          | (110     | )          |
| Increase  (decrease) in valuationallowance |       | (356                       | )          | (149     | )          | 278      |       |
|                                       |       |                       |       |     |       |     |       |
|                                       |       | (1,660                     | )          | (583     | )          | (91      | )          |
|                                       |       |                       |       |     |       |     |       |
|                                       |       | $                          | (659       | )        | $          | 281      |       | $ | 1,476 |   |

 

The differences betweenthe statutory federal income tax rates and the effective tax rates for theyears ended December 31 are summarized as follows:

 
| ** **                                    | ** ** | **2009** | ** ** | **2008** | ** ** | **2007** | ** ** |
|-----------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                          |       |     |       |     |       |     |       |
| Statutory  federal tax rate                   |       | 34.00    | %          | 34.00    | %          | 34.00    | %          |
| California  taxes, net of federal tax benefit |       | 7.20     |       | 7.20     |       | 7.20     |       |
| Tax-exempt  interest on municipal bonds       |       | (72.66   | )          | (16.40   | )          | (3.30    | )          |
| Change  in valuation allowance                |       | (37.43   | )          | (8.55    | )          | (2.67    | )          |
| Other,  net                                   |       | (0.29    | )          | (0.13    | )          | 8.12     |       |
|                                          |       |     |       |     |       |     |       |
| Effective  tax rates                          |       | 69.18    | %          | 16.12    | %          | 43.35    | %          |

 

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**NORTHERN CALIFORNIA BANCORP, INC.AND SUBSIDIARY**

** **

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 12.**       INCOMETAXES (Continued)

 

The components of the netdeferred tax asset, included in other assets at December 31, are asfollows:

 
| ** **                | ** ** | **2009**                   | ** ** | **2008** | ** ** |
|---------------------------|------------|----------------------------|------------|----------|------------|
| ** **                | ** ** | **(Dollars in thousands)** | ** ** |
| Deferred  tax asset       |       |                       |       |     |       |
| Federal                   |       | $                          | 2,644      |     | $          | 1,792 |   |
| California                |       | 844                        |       | 616      |       |
|                      |       |                       |       |     |       |
| Total  deferred tax asset |       | 3,488                      |       | 2,408    |       |
| Valuation  allowance      |       | (626                       | )          | (982     | )          |
|                      |       |                       |       |     |       |
| Net  deferred tax asset   |       | $                          | 2,862      |     | $          | 1,426 |   |

 

The tax effects of each typeof income and expense item that give rise to deferred taxes at December 31are as follows:

 
| ** **                             | ** ** | **2009** | ** ** | **2008** | ** ** |
|----------------------------------------|------------|----------|------------|----------|------------|
| Deferred  tax assets (liabilities)     |       |     |       |     |       |
| Net  unrealized gain on securities     |       | $        | 138        |     | $          | 950 |   |
| Allowance  for loan losses             |       | 1,167    |       | 976      |       |
| Accrued  salary continuation liability |       | 276      |       | 383      |       |
| AMT  credit                            |       | 219      |       | —   |       |
| Non-accrual  interest income           |       | 257      |       | 262      |       |
| Other  real estate owned transactions  |       | 674      |       | 46       |       |
| Capital  loss carryover                |       | 693      |       | 62       |       |
| Other                                  |       | 207      |       | (136     | )          |
| Depreciation                           |       | (143     | )          | (135     | )          |
|                                   |       |     |       |     |       |
| Total  deferred tax asset              |       | 3,488    |       | 2,408    |       |
| Valuation  allowance                   |       | (626     | )          | (982     | )          |
|                                   |       |     |       |     |       |
| Net  deferred tax asset                |       | $        | 2,862      |     | $          | 1,426 |   |

 

TheBank establishes a valuation allowance if, based on the weight of evidence, itis more likely than not that some portion or all of the deferred tax assetswill not be realized.

 

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**NORTHERN CALIFORNIA BANCORP, INC.AND SUBSIDIARY**

** **

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 12.**       INCOMETAXES (Continued)

 

TheCorporation adopted the provisions of ASC 740, formerly FIN 48, *Accounting for Uncertainty in Income Taxes*, on January 1,2007. The Corporation had no unrecognized tax benefits which would haverequired an adjustment to the January 1, 2007 beginning balance ofretained earnings. The Corporation has no unrecognized tax benefits at December 31,2009 and 2008. The Corporation recognizes, when applicable interest accrued andpenalties related to unrecognized tax benefits in tax expense. During the yearsended December 31, 2009 and 2008 the Corporation recognized no interestand penalties.

 

#### **Note 13.**       COMMITMENTSAND CONTINGENCIES

 

In the normal course ofbusiness, there are outstanding commitments that are not reflected in theconsolidated financial statements.

 

***Operatinglease commitments***

 

The Bank leases itsbranch offices in Carmel By-The-Sea, Carmel Valley, Pacific Grove and a Salinasbranch office which opened during the second quarter of 2008.  The Carmel By-The-Sea office has a five andone half year lease with four, five year options and commenced in April 2002.  The Carmel Valley building had a twenty-fiveyear lease which commenced in March 1981 and an addendum to the leaseexecuted in 2005 provides for two options to renew the lease for an additional10 years each, and may be adjusted annually for changes in the Consumer PriceIndex.  The Pacific Grove building has afive-year lease with five, five-year options and commenced in April 1997.  The Salinas building has a five-year leasewith four, five-year options and commenced in November 2007.  The Bank leases approximately 1,000 squarefeet of office space at 321 Webster Street, Monterey, CA, which had a term ofthree years commencing September 2000, with a three-year option.  An addendum to the lease was executed in 2004and provided for two, five year options to extend the lease, which commenced inSeptember 2006.  The Bank alsoleases certain equipment used in the normal course of business.

 

Rent expense foroperating leases is included in occupancy and equipment expense and amounted toapproximately $378,000, $352,000, and $286,000 for the years ended December 31,2009, 2008, and 2007, respectively.

 

Effective November 1,2009, the Bank entered into a one year sublease agreement to rent one of theunits in the Carmel-By-The-Sea branch for a monthly rent of $2,000.

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

** **

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 13.**                     COMMITMENTS AND CONTINGENCIES (Continued)

 

***Operating lease commitments (Continued)***

 

Future minimum leasecommitments for all non-cancelable operating leases are as follows:

 
| **Years Ending**      | ** ** | **Minimum  Lease**                   | ** ** |
|-----------------------|------------|--------------------------------------|------------|
| **December 31,** | ** ** | **Commitments**                      | ** ** |
| ** **            | ** ** | **(Dollars in thousands)** | ** ** |
| 2010                  |       | $                                    | 364        |   |
| 2011                  |       | 267                                  |       |
| 2012                  |       | 168                                  |       |
|                  |       |                                 |       |
|                  |       | $                                    | 799        |   |

 

***Loan commitments***

 

The Bank is a party to financial instruments with off-balance-sheetrisk in the normal course of business to meet the financing needs of itscustomers.  These financial instrumentsinclude commitments to extend credit. Such commitments involve, to varying degrees, elements of credit andinterest rate risk in excess of the amount recognized in the consolidatedbalance sheets.

 

The Bank’s exposure to credit loss is represented by the contractualamount of these commitments.  The Bankuses the same credit policies in making commitments as it does foron-balance-sheet instruments.

 

At December 31, 2009and 2008, such commitments to extend credit were $14,839,000 and $13,941,000,respectively, of undisbursed lines of credit, undisbursed loans in process, andcommitment letters.

 

***Contingencies***

 

The Corporation, its principal subsidiary Monterey County Bank and its Chief Executive Officer were named as defendants in a lawsuit filed by Golden State Bank on November 3, 2008 in the Monterey County Court-Civil Division.  The lawsuit involved claims related to loan participations  and seeks to compel arbitration of the issues, rescission of the participation agreements, payment of all principal and interest, damages, attorney fees and costs.

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

** **

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 13.**                     COMMITMENTS AND CONTINGENCIES (Continued)

 

***Contingencies (Continued)***

 

This action was settled in December 2009. Under the terms of the settlement Golden State Bank dismissed its claims without receiving any payment or other consideration from the Corporation, Monterey County Bank or its officers.

 

The Bank, Chief Executive Officer and Chief Credit Officer were named as defendants in a lawsuit filed July 27, 2009 in the Monterey County Superior Court’s Civil Division, by Bank of the Orient.  The lawsuit involves claims related to loan participations purchased by Bank of the Orient from Monterey County Bank.  The lawsuit seeks rescission of the participation agreements, payment of all principal and interest, damages, attorneys’ fees and costs.

 

While the action was originally filed in the Superior Court under the terms of the participation agreements the matter has been submitted to arbitration through the American Arbitration Association.

 

Monterey County Bank was named as defendant in a lawsuit filed February 26, 2009 in Monterey County Superior Court-Civil Division by Tighorn Financial Services, LLC (“Tighorn”).  The lawsuit seeks to compel Monterey County Bank to continue its credit card sponsorship and the servicing of a credit card portfolio under a card sponsorship agreement with the third party.  Pursuant to termination provisions contained in the parties’ Agreement Monterey County Bank gave the third party written notice of termination of the agreement in June 2008.

 

Settlement discussions are pending between the Bank and Tighorn that could result in third Tighorn’s agreement to dismiss the action and to turn over its interest in the receivables realized from the accounts.

 

The Bank, Chief Executive Officer and Chief Credit Officer were named as defendants in a lawsuit filed April 29, 2009 in the Monterey County Superior Court’s Civil Division, by First Foundation Bank.  The lawsuit involves claims related to two loan participations purchased by First Foundation Bank from Monterey County Bank.  The lawsuit seeks to rescind the participation agreements, payment of all principal and interest, damages, attorneys’ fees and costs.

 

Monterey County Bank was named as defendant in two separate actionsfiled  June 17, 2008 and June 26,2008  to foreclose mechanic’s liens onsite improvements performed in the amounts of $1.5 million and $6.0 million,respectively. The actions assert that the mechanic’s liens have priority overthe Bank’s Deeds of Trust against various lots in the subdivision that werebenefited by the site improvements. In the legal counsel’s opinion the Bankdoes not have any exposure in these matters because the priority of its trustdeeds are insured by policies of title insurance.

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

** **

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 13.**                     COMMITMENTS AND CONTINGENCIES (Continued)

 

***Contingencies (Continued)***

 

While the action was originally filed in the Superior Court under the terms of the participation agreements the matter has been submitted to arbitration through the American Arbitration Association.

 

Although the amount of any ultimate liability with respect to the above proceedings cannot be determined, in the opinion of management, any such liability will not have a material effect on the consolidated financial position of the Corporation and its subsidiary.

 

#### **Note 14.**                     CONCENTRATION OF RISK

 

The Bank grants commercial,construction, real estate and installment loans to businesses and individualsprimarily in the MontereyPeninsula area of Northern California.  Most loans are secured by business assets,and commercial and residential real estate. Real estate and construction loansheld for investment represented 79% and 83% of total loans held for investmentat December 31, 2009 and 2008, respectively.  The Bank has no concentration of loans withany one customer.

 

Concentration of loans for specific industries andtheir percentage of total loans at December 31, 2009 and 2008 are asfollows:

 
| ** **                                        | ** ** | **2009** | ** ** | **2008** | ** ** |
|---------------------------------------------------|------------|----------|------------|----------|------------|
|                                              |       |     |       |     |       |
| Real estate                                       |       | 18.75    | %          | 20.42    | %          |
| Accommodation and food                            |       | 21.17    | %          | 22.00    | %          |
| Finance and insurance                             |       | 11.89    | %          | 12.20    | %          |
| Professional, scientific,  and technical services |       | 10.44    | %          | 10.97    | %          |

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

 

#### **Note 15.**                     OTHER INCOME AND OTHER GENERAL ANDADMINISTRATIVE EXPENSES

 

Other income for the years ended December 31,2009, 2008, and 2007 totaled $5,904,000, $3,493,000, and $3,006,000,respectively.  Significant categoriescomprising other income were as follows:

 
| ** **                                   | ** ** | **2009**                             | ** ** | **2008** | ** ** | **2007** | ** ** |
|----------------------------------------------|------------|--------------------------------------|------------|----------|------------|----------|------------|
| ** **                                   | ** ** | **(Dollars in thousands)** | ** ** |
| ** **                                   | ** ** | ** **                           | ** ** |
| Merchant discount fees                       |       | $                                    | 4,495      |     | $          | 2,731    |       | $ | 2,423 |   |
| Commercial banking broker fees               |       | —                               |       | —   |       | 21       |       |
| Life insurance cash surrender value earnings |       | 130                                  |       | 128      |       | 126      |       |
| Credit card marketing program income         |       | 1,075                                |       | 514      |       | 684      |       |
| Stored value card marketing program income   |       | 81                                   |       | 155      |       | 293      |       |
| Trading asset activities                     |       | (138                                 | )          | (944     | )          | (686     | )          |
| Visa, Inc. public stock offering             |       | —                               |       | 694      |       | —   |       |
| Other                                        |       | 261                                  |       | 215      |       | 145      |       |
|                                         |       |                                 |       |     |       |     |       |
|                                         |       | $                                    | 5,904      |     | $          | 3,493    |       | $ | 3,006 |   |

 

Other general and administrative expenses for theyears ended December 31, 2009, 2008, and 2007 totaled $5,247,000,$3,640,000, and $3,564,000, respectively. Significant categories comprising other general and administrativeexpenses were as follows:

 
| ** **                         | ** ** | **2009**                    | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|------------------------------------|------------|-----------------------------|------------|------------|------------|------------|------------|
| ** **                         | ** ** | **(Dollars  in thousands)** | ** ** |
| ** **                         | ** ** | ** **                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Merchant credit processing expense |       | $                           | 3,644      |       | $          | 2,274      |       | $ | 2,028 |   |
| Advertising                        |       | 80                          |       | 103        |       | 164        |       |
| Business development               |       | 59                          |       | 114        |       | 171        |       |
| Insurance                          |       | 113                         |       | 124        |       | 118        |       |
| Stationery and supplies            |       | 121                         |       | 167        |       | 148        |       |
| FDIC and State Assessments         |       | 535                         |       | 137        |       | 49         |       |
| Other                              |       | 695                         |       | 721        |       | 886        |       |
|                               |       |                        |       |       |       |       |       |
|                               |       | $                           | 5,247      |       | $          | 3,640      |       | $ | 3,564 |   |

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 16.**                     MINIMUM REGULATORY CAPITAL REQUIREMENTS

 

The Corporation (on a consolidated basis) and the Bank are subject tovarious regulatory capital requirements administered by the federal bankingagencies.  Failure to meet minimumcapital requirements can initiate certain mandatory and possibly additionaldiscretionary actions by regulators that, if undertaken, could have a directmaterial effect on the Corporation’s and Bank’s financial statements.

 

Under capital adequacy guidelines and the regulatory framework forprompt corrective action, the Corporation and the Bank must meet specificcapital guidelines that involve quantitative measures of their assets,liabilities, and certain off-balance-sheet items as calculated under regulatoryaccounting practices. The capital amounts and classifications are also subjectto qualitative judgments by the regulators about components, risk weightings,and other factors. Under applicableregulatory guidelines, a portion of the Trust Preferred Securities qualify asTier I Capital, and the remainder as Tier II Capital. Prompt correctiveaction provisions are not applicable to bank holding companies.

 

Quantitative measures established by regulation to ensure capitaladequacy require the Corporation and the Bank to maintain minimum amounts andratios (set forth in the following table) of total and Tier 1 capital (asdefined in the regulations) to risk-weighted assets (as defined) and of Tier 1capital (as defined) to average assets (as defined).  Management believes, as of December 31,2009 and 2008, that the Corporation and the Bank met all capital adequacyrequirements to which they are subject.

 

As of December 31, 2009, the most recent notification from theFederal Deposit Insurance Corporation (FDIC) categorized the Bank as wellcapitalized under the regulatory framework for prompt corrective action.  To be categorized as well capitalized, aninstitution must maintain minimum total risk-based, Tier 1 risk-based, and Tier1 leverage ratios as set forth in the following tables.  There are no conditions or events since thenotification that management believes have changed the Bank’s category.  The Corporation’s and the Bank’s actualcapital amounts and ratios as of December 31, 2009 and 2008 are alsopresented in the tables.

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

#### ** **

#### **Note 16.**                     MINIMUM REGULATORY CAPITAL REQUIREMENTS(Continued)

 

**December31, 2009**

 
| ** **                               | ** ** | **Actual**                           | ** ** | **Minimum  Capital  Requirement** | ** ** | **Minimum To Be  Well Capitalized********Under Prompt  Corrective Action********Provisions** | ** ** |
|------------------------------------------|------------|--------------------------------------|------------|-----------------------------------|------------|----------------------------------------------------------------------------------------------|------------|
| ** **                               | ** ** | **Amount**                           | ** ** | **Ratio**                         | ** ** | **Amount**                                                                                   | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| ** **                               | ** ** | **(Dollars in thousands)** | ** ** |
| Total Capital to  Risk Weighted Assets:  |       |                                 |       |                              |       |                                                                                         |       |   |   |   |   |   |   |
| Consolidated                             |       | $                                    | 26,153     |                              | 13.27      | %                                                                                            | $          | 15,765 |   | 8.0 | % | N/A |   | N/A |   |
| Monterey County  Bank                    |       | $                                    | 27,958     |                              | 14.53      | %                                                                                            | $          | 15,417 |   | 8.0 | % | $ | 19,271 |   | 10.0 | % |
|                                     |       |                                 |       |                              |       |                                                                                         |       |   |   |   |   |   |   |
| Tier 1 Capital  to Risk Weighted Assets: |       |                                 |       |                              |       |                                                                                         |       |   |   |   |   |   |   |
| Consolidated                             |       | $                                    | 19,684     |                              | 9.99       | %                                                                                            | $          | 7,882 |   | 4.0 | % | N/A |   | N/A |   |
| Monterey County  Bank                    |       | $                                    | 25,549     |                              | 13.27      | %                                                                                            | $          | 7,709 |   | 4.0 | % | $ | 11,563 |   | 6.0 | % |
|                                     |       |                                 |       |                              |       |                                                                                         |       |   |   |   |   |   |   |
| Tier 1 Capital  to Average Assets:       |       |                                 |       |                              |       |                                                                                         |       |   |   |   |   |   |   |
| Consolidated                             |       | $                                    | 19,684     |                              | 7.29       | %                                                                                            | $          | 10,843 |   | 4.0 | % | N/A |   | N/A |   |
| Monterey County  Bank                    |       | $                                    | 25,549     |                              | 9.63       | %                                                                                            | $          | 10,795 |   | 4.0 | % | $ | 13,493 |   | 5.0 | % |

 

**December 31,2008**

 
| ** **                               | ** ** | **Actual**                  | ** ** | **Minimum  Capital  Requirement** | ** ** | **Minimum To  Be  Well Capitalized  Under Prompt  Corrective  Action Provisions** | ** ** |
|------------------------------------------|------------|-----------------------------|------------|-----------------------------------|------------|-----------------------------------------------------------------------------------|------------|
| ** **                               | ** ** | **Amount**                  | ** ** | **Ratio**                         | ** ** | **Amount**                                                                        | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| ** **                               | ** ** | **(Dollars  in thousands)** | ** ** |
| Total Capital to Risk Weighted  Assets:  |       |                        |       |                              |       |                                                                              |       |   |   |   |   |   |   |
| Consolidated                             |       | $                           | 24,733     |                              | 12.2       | %                                                                                 | $          | 16,244 |   | 8.0 | % | N/A |   | N/A |   |
| Monterey County Bank                     |       | $                           | 26,515     |                              | 13.1       | %                                                                                 | $          | 16,155 |   | 8.0 | % | $ | 20,193 |   | 10.0 | % |
|                                     |       |                        |       |                              |       |                                                                              |       |   |   |   |   |   |   |
| Tier 1 Capital to Risk  Weighted Assets: |       |                        |       |                              |       |                                                                              |       |   |   |   |   |   |   |
| Consolidated                             |       | $                           | 17,892     |                              | 8.8        | %                                                                                 | $          | 8,122 |   | 4.0 | % | N/A |   | N/A |   |
| Monterey County Bank                     |       | $                           | 24,086     |                              | 11.9       | %                                                                                 | $          | 8,077 |   | 4.0 | % | $ | 12,116 |   | 6.0 | % |
|                                     |       |                        |       |                              |       |                                                                              |       |   |   |   |   |   |   |
| Tier 1 Capital to Average  Assets:       |       |                        |       |                              |       |                                                                              |       |   |   |   |   |   |   |
| Consolidated                             |       | $                           | 17,892     |                              | 6.3        | %                                                                                 | $          | 11,417 |   | 4.0 | % | N/A |   | N/A |   |
| Monterey County Bank                     |       | $                           | 24,086     |                              | 8.5        | %                                                                                 | $          | 11,363 |   | 4.0 | % | $ | 14,185 |   | 5.0 | % |

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 17.**                     OTHER REGULATORY MATTERS

 

The Corporation is subject to regulation by the Board of Governors ofthe Federal Reserve System under the Bank Holding Corporation Act.  The Bank is subject to regulation, supervision,and regular examination by the California Department of Financial Institutions(DFI) and the FDIC.  The regulations ofthese agencies affect most aspects of the Corporation’s business and prescribepermissible types of loans and investments, the amount of required reserves,requirements for branch offices, the permissible scope of the Corporation’sactivities, and various other requirements. The Corporation is also subject to certain regulations of the FederalReserve Bank dealing primarily with check clearing activities, establishment ofbanking reserves, Truth-in-Lending (Regulation Z), and Equal Credit Opportunity(Regulation B).

 

The Bank is currently in discussions with the FDIC regarding a draftregulatory order, resulting from its 2008 Consumer Compliance Examination,which was completed in 2009.  The FDICalleged certain violations existed per their examination which the Bank deniescommitting such alleged violations.  TheBank anticipates entering negotiations with the FDIC in the near future todetermine if a mutually agreeable resolution can be reached.  The financial and non-financial impact ofthis matter is not known as of the balance sheet date and as of the issuancedate of this report.

 

#### **Note 18.**                     STOCK-BASED COMPENSATION

 

Under the Corporation’s 1998 Stock Option Plan, the Corporation maygrant incentive stock options and non-qualified stock options to directors,officers, and employees of the Corporation and its subsidiary, so long as theCorporation owns a majority of the equity interest of such subsidiary.  Incentive stock options are granted at fairvalue of the common stock on the date of grant. However, an incentive stock option granted to an individual owning 10%or more of the Corporation’s stock after such grant must have an exercise priceof at least 110%****of such fair market value and anexercise period of not more than five years. Non-qualified stock options may be granted at prices not lower than 85%of the fair market value of the common stock on the date of grant.  The Board of Directors (Board) is authorizedto determine when options become exercisable within a period not exceeding 10years from the date of grant.  Under thePlan, 26,161 shares of common stock have been reserved for the granting ofthese options.  At December 31,2009, all 26,161 options were outstanding. During 2009, no options were granted or exercised by officers,employees, and Board members.  As of December 31,2009, all options have been vested.

 

No further Options may be granted under the 1998 Stock Option Plan.  The plan provided that options could begranted for a period of ten years from the date the Plan was adopted by theBoard.  The Board adopted the Plan on April 16,1998.  The Plan remains in effect untilall Options granted under the Plan have been satisfied or expired.

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 18.**                     STOCK-BASED COMPENSATION  (Continued)

 

Under the Corporation’s 2007 Stock Option Plan, the Corporation maygrant incentive stock options and non-qualified stock options to directors,officers, and employees of the Corporation and its subsidiary, so long as theCorporation owns a majority of the equity interest of such subsidiary.  Incentive stock options are granted at fairvalue of the common stock on the date of grant. However, an incentive stock option granted to an individual owning 10%or more of the Corporation’s stock after such grant must have an exercise priceof at least 110%****of such fair market value and anexercise period of not more than five years. The Board is authorized to determine when options become exercisablewithin a period not exceeding 10 years from the date of grant.  Under the Plan, 300,000 shares of commonstock have been reserved for the granting of these options.  Through December 31, 2009, no optionshave been granted under the 2007 stock option plan.

 

At December 31, 2009, options for the purchase of 26,161 shares ofthe Corporation’s common stock were outstanding and exercisable at pricesranging from $2.25 - $ 4.00.  The statusof all stock options is as follows:

 
| ** **                             | ** ** | **Shares** | ** ** | **Exercise  Price  Range**                                                | ** ** | **Weighted  Average  Remaining  Contractual Life** | ** ** |
|----------------------------------------|------------|------------|------------|---------------------------------------------------------------------------|------------|----------------------------------------------------|------------|
|                                   |       |       |       |                                                                      |       |                                               |       |
| Outstanding at  December 31, 2007 |       | 76,534     |       | $2.25 - $4.00                                                             |       | 2.2 Years                                          |       |
|                                   |       |       |       |                                                                      |       |                                               |       |
| Exercised                              |       | (4,000     | )          |              $3.00 |       |                                               |       |
| Expired unexercised                    |       | (10,373    | )          | $3.00 - $4.00                                                             |       |                                               |       |
|                                   |       |       |       |                                                                      |       |                                               |       |
| Outstanding at  December 31, 2008 |       | 62,161     |       | $3.00 - $4.40                                                             |       | 1.6 Years                                          |       |
|                                   |       |       |       |                                                                      |       |                                               |       |
| Expired unexercised                    |       | (36,000    | )          | $3.00 - $4.40                                                             |       |                                               |       |
|                                   |       |       |       |                                                                      |       |                                               |       |
| Outstanding at  December 31, 2009 |       | 26,161     |       | $2.25 - $4.00                                                             |       | 2.7 Years                                          |       |

 

The weighted average exercise price was $3.10, $3.00, and $3.56 for theyears ending December 31, 2009, 2008, and 2007, respectively.  No options were granted in 2009, 2008 and2007.  All options are vested andexercisable as of December 31, 2009 and 2008.

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 18.**                      STOCK-BASED COMPENSATION  (Continued)

 

There was $10,000 ofintrinsic value attributable to options outstanding and exercisable at December 31,2009.  The aggregate intrinsic valuerepresents the total pretax intrinsic value based on stock options with anexercise price less than the Corporation’s closing stock price of $3.55 as of December 31,2009, which would have been received by the option holders had those optionholders exercised those options as of that date.

#### ** **

#### **Note 19.**                      RELATED PARTY TRANSACTIONS

 

The Corporation has andexpects to have in the future, banking transactions in the ordinary course ofits business with directors, officers, principal shareholders, and theirassociates.  These transactions,including loans and deposits, are granted on substantially the same terms,including interest rates and collateral on loans, as those prevailing at thesame time for comparable transactions with others and do not involve more thanthe normal risk of collectibility or present other unfavorable features.

 

Aggregate loantransactions with related parties are approximately as follows:

 
| **(Dollars  in thousands)**           |
|---------------------------------------|
|                                  |
| Balance as of  December 31, 2007 |   | $ | 4,132 |   |
| New loans                             |   | 1,256 |   |
| Advances on lines of  credit          |   | 54 |   |
| Repayments                            |   | (699 | ) |
|                                  |   |   |   |
| Balance as of  December 31, 2008 |   | 4,743 |   |
| New loans                             |   | — |   |
| Advances on lines of  credit          |   | 259 |   |
| Repayments                            |   | (84 | ) |
|                                  |   |   |   |
| Balance as of  December 31, 2009 |   | $ | 4,918 |   |

 

Related party deposits totaled $836,000 and $611,000 at December 31,2009 and 2008, respectively.

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 20.**                      EMPLOYEE BENEFIT PLANS

 

During 1995, the Corporation established an employee stock ownershipplan (ESOP) to invest in the Corporation’s common stock for the benefit ofeligible employees.  The Board determinesthe Corporation’s contribution to the plan. Shares in the plan generally vest after seven years.  The Corporation did not contribute to theESOP trust in 2009, 2008, or 2007.  Therewere no shares in the plan as of December 31, 2009.

 

The Bank has a salary reduction plan under Section 401(k) ofthe Internal Revenue Code.  The plancovers substantially all full-time employees who have completed one year ofservice with the Bank.  Employees areallowed to defer up to 15% of their compensation subject to certain limitsbased on federal tax laws.  Under theprovisions of the plan, the Bank’s contribution policy is discretionary.  The Bank initiated a matching contribution in2001 of 100% of each employee’s contribution up to 6% of the employee’scompensation. There were no matching contributions made for the year ended December 31,2009. The Bank’s matching contributions in 2008, and 2007 totaled $139,000, and$114,000, respectively.

 

#### **Note 21.**                      RESTRICTION ON DIVIDENDS, LOANS AND ADVANCES

#### ** **

Federal and state banking regulations place certainrestrictions on dividends paid and loans or advances made by the Bank to theCorporation.  The total amount ofdividends which may be paid by the Bank to the Corporation at any date isgenerally limited to the lesser of: (i) retained earnings; or (ii) theBank’s net income for its last three fiscal years (less any distributions tothe stockholders made during such period). Loans or advances are limited to 25%of the Bank’s primary capital plus the allowance for loan losses on a securedbasis and 15% on an unsecured basis.

 

The Corporation deferred payment of interest (see Note10), for an undetermined period of time which cannot exceed twenty consecutivequarters, on its subordinated debt securities effective with the October 7,2009 payment on Northern California Bancorp, Inc. Trust I and with the November 8,2009 payment on Northern California Bancorp, Inc. Trust I.  Additionally the Bank currently is prohibitedfrom paying dividends to the Corporation without the prior consent of the FDICand the DFI.

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 22.**                      SALARY CONTINUATION PLANS

 

The Corporation has established salary continuationplans, which provide for payments to a certain officer at retirement.  Included in other liabilities is $671,000 and$855,000 of deferred compensation related to the continuation plans at both December 31,2009 and 2008, respectively.  Alsoincluded in other liabilities is $471,000 in accrued post retirement benefitsunder split-dollar insurance policies. The plans are funded through lifeinsurance policies that generate value to fund the future benefits.

 

**Note 23.****                     ****NON-CASH TRANSACTION**

 

During the year ended December 31, 2009, the Bank had non-cashtransactions relating to the transfer of $10,958,000 in loans to other realestate owned.

 

During the year ended December 31, 2008, the Bank had non-cashtransactions relating to the purchase of three debt securities totaling$3,050,000, transfers of $7,869,000 in securities from held to maturity toavailable for sale, a transfer of $6,348,000 in loans to other real estateowned, and a $362,000 increase in other payables due to the cumulative effectof applying a new accounting standard.

 

The Bank had non-cash transactions relating to the purchase of threedebt securities totaling $5,225,000 for the year ended December 31, 2007.

 

**Note 24.****                     ****STOCK REPURCHASE PROGRAM ANDSTOCK AUTHORIZATION**

 

In 2008, the Board approved a stock repurchase program pursuant towhich the Corporation, from time to time and at management’s discretion, mayrepurchase up to $500,000 in value of the Corporation’s outstandingshares.  The Corporation repurchased20,678 and 46,010 shares of common stock at an average cost of $4.10 and $7.41per share in open market transactions during the years ended December 31,2009 and 2008, respectively.

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

**Note 24.****                     ****STOCK REPURCHASE PROGRAM ANDSTOCK AUTHORIZATION  (Continued)**

 

In October 2008, theBoard and the holders of more than a majority of our issued and outstandingcommon stock approved by written consent, an amendment to the Corporation’sarticles of incorporation (the “Amendment”). The Amendment authorizes the Corporation to issue up to 10,000,000shares of preferred stock, which may be issued from time to time in one or moreseries as determined by the Board.  TheBoard is authorized to designate all rights, preferences, privileges andrestrictions attendant to each series as well as the number of sharesauthorized for issuance in each series of the preferred stock, which mattersshall be expressed in resolutions adopted by the Board and filed with theSecretary of State of the state of California. Additionally, the Amendment authorizes the Corporation to issue anadditional 7,500,000 shares of common stock for a total of 10,000,000 shares ofcommon stock authorized for issuance after the Amendment.  The Amendment became effective January 23,2009.

 

 

#### **Note 25.**                      FAIR VALUE OF FINANCIAL INSTRUMENTS

 

Effective January 1, 2008, theCorporation adopted ASC 820, formerly FAS 157, *FairValue Measurements*.  This standard defines fair value,establishes a framework for measuring fair value in generally accepted accountingprinciples and expands disclosures about fair valuemeasurements.  ASC 820 applies whenever other standards require (orpermit) assets or liabilities to be measured at fair value but does not expandthe use of fair value in any new circumstances.  In this standard,the FASB clarifies the principle that fair value should be based on theassumptions market participants would use when pricing the asset orliability.  In support of this principle, ASC 820 establishes a fairvalue hierarchy that prioritizes the information used to develop thoseassumptions.  The fair value hierarchy is as follows:

 

**Level 1:** Valuation for assets andliabilities traded in active exchange markets. Valuations are obtained fromreadily available pricing sources for market transactions involving identicalassets or liabilities.

** **

**Level 2:** Valuation for assets andliabilities traded in less active dealer or broker markets. Valuations areobtained from third party pricing services for identical or comparable assetsor liabilities.

** **

**Level 3:** Valuation for assets andliabilities that are derived from other valuation methodologies, includingoption pricing models, discounted cash flow models, and similar techniques, andnot based on market exchange, dealer, or broker traded transactions. Thesevaluations incorporate certain assumptions and projections in determining thefair value assigned to such assets or liabilities.

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 25.**                      FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued)

 

The application of ASC 820 in situationswhere the market for a financial asset is not active was clarified in October 2008by the issuance of ASC 820-10-35, formerly FSP FAS 157-3, *Determining the Fair Value of a Financial Asset Whenthe Market for That Asset Is Not Active*.  Thisclarification was effective for financial statements issued as of September 30,2008 and thereafter and did not have a material impact on the methods by whichthe Corporation determines the fair values of its financialassets.  ASC 820 was also clarified in April 2009 effective forthe second quarter 2009 by ASC-10-65, formerly FSP No. FAS 157-4, *Determining Fair Value When the Volume and Level ofActivity for the Asset or Liability Have Significantly Decreased andIdentifying Transactions That Are Not Orderly*.  Thissection clarifies factors that determine whether transactions are orderly ornot in evaluating the reliability of market transactions for fair valueestimates.  ASC 820-10-15, formerly FSP FAS 157-2, deferred theapplication of ASC 820 for nonfinancial assets and nonfinancial liabilitiesthat are measured at fair value on a nonrecurring basis to fiscal yearsbeginning after November 15, 2008.  The Corporation adopted theprovisions of this standard with respect to nonfinancial assets andnonfinancial liabilities beginning on January 1, 2009.

 

*Fair Value Measured on aRecurring Basis*

 

The following tables present the balance ofassets whose fair values are measured on a recurring basis:

 
| ** **                             | ** ** | **At  December 31, 2009** | ** ** |
|----------------------------------------|------------|--------------------------------|------------|
| ** **                             | ** ** | **Total**                      | ** ** | **(Level 1)** | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
| ** **                             | ** ** | **(Dollars  in Thousands)**    | ** ** |
|                                   |       |                           |       |   |   |   |   |   |   |
| Investment securities -  AFS and other |       | $                              | 66,498     |   | $ | — |   | $ | 66,498 |   | $ | — |   |
|                                        |            |                                |            |  |  |  |  |  |  |  |  |  |  |

 
| ** **                             | ** ** | **At  December 31, 2008** | ** ** |
|----------------------------------------|------------|--------------------------------|------------|
| ** **                             | ** ** | **Total**                      | ** ** | **(Level 1)** | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
| ** **                             | ** ** | **(Dollars  in Thousands)**    | ** ** |
|                                   |       |                           |       |   |   |   |   |   |   |
| Investment securities -  AFS and other |       | $                              | 97,205     |   | $ | — |   | $ | 97,205 |   | $ | — |   |
|                                        |            |                                |            |  |  |  |  |  |  |  |  |  |  |

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 25.**                      FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued)

 

The fair values of the Corporation’ssecurities available for sale are determined using Level 2 inputs, which arederived from readily available pricing sources and third-party pricing servicesfor identical or comparable instruments, respectively.

 

*Fair Value Measured on a Nonrecurring Basis*

 

Certain assets are measured at fair value ona nonrecurring basis; that is, the assets are not measured at fair value on anongoing basis but are subject to fair value adjustments in certaincircumstances (for example, when there is evidence of impairment). Thefollowing tables present such assets carried on the balance sheet by captionand by level within the valuation hierarchy:

 
| ** **          | ** ** | ** **                  | ** ** | ** **    | ** ** | ** **    | ** ** | ** **    | ** ** | **Year Ended**        | ** ** |
|---------------------|------------|-----------------------------|------------|---------------|------------|---------------|------------|---------------|------------|-----------------------|------------|
| ** **          | ** ** | ** **                  | ** ** | ** **    | ** ** | ** **    | ** ** | ** **    | ** ** | **December 31,** | ** ** |
| ** **          | ** ** | **Total**                   | ** ** | **(Level 1)** | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** | **2009**              | ** ** |
| ** **          | ** ** | **(Dollars  in Thousands)** | ** ** |
|                |       |                        |       |          |       |          |       |          |       |                  |       |
| Imparied loans      |       | $                           | 6,662      |          | $          | —        |       | $             | —     |                  | $          | 6,662 |   | $ | 357 |   |
| Loans held for sale |       | 2,216                       |       | —        |       | 2,216         |       | —        |       | —                |       |
| OREO                |       | 14,333                      |       | —        |       | —        |       | 14,333        |       | —                |       |
|                |       |                        |       |          |       |          |       |          |       |                  |       |
|                |       | $                           | 23,211     |          | $          | —        |       | $             | 2,216      |                  | $          | 20,995 |   | $ | 357 |   |

 
| ** **           | ** ** | ** **                 | ** ** | ** **    | ** ** | ** **    | ** ** | ** **    | ** ** | **Year Ended**        | ** ** |
|----------------------|------------|----------------------------|------------|---------------|------------|---------------|------------|---------------|------------|-----------------------|------------|
| ** **           | ** ** | ** **                 | ** ** | ** **    | ** ** | ** **    | ** ** | ** **    | ** ** | **December 31,** | ** ** |
| ** **           | ** ** | **Total**                  | ** ** | **(Level 1)** | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** | **2008**              | ** ** |
| ** **           | ** ** | **(Dollars in Thousands)** | ** ** |
|                 |       |                       |       |          |       |          |       |          |       |                  |       |
| Impaired loans       |       | $                          | 7,091      |          | $          | —        |       | $             | —     |                  | $          | 7,091 |   | $ | 123 |   |
| Loans held for  sale |       | 1,650                      |       | —        |       | 1,650         |       | —        |       | —                |       |
| OREO                 |       | 7,364                      |       | —        |       | —        |       | 7,364         |       | —                |       |
|                 |       |                       |       |          |       |          |       |          |       |                  |       |
|                 |       | $                          | 16,105     |          | $          | —        |       | $             | 1,650      |                  | $          | 14,455 |   | $ | 123 |   |

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 25.**                      FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued)

 

*Impaired Loans*

 

Collateral-dependentimpaired loans are carried at the fair value of the collateral less estimatedcosts to sell. The fair value of collateral is determined based on appraisals.In some cases, adjustments were made to the appraised values for variousfactors including age of the appraisal, age of comparables included in theappraisal, and known changes in the market and in the collateral. Whensignificant adjustments were based on unobservable inputs, the resulting fairvalue measurement has been categorized as a Level 3 measurement. Otherwise,collateral-dependent impaired loans are categorized under Level 2.

 

Impairedloans that are not collateral dependent are carried at the present value ofexpected future cash flows discounted at the loan’s effective interest rate.Troubled debt restructurings are also carried at the present value of expectedfuture cash flows. However, expected cash flows for troubled debtrestructurings are discounted using the loan’s original effective interest raterather than the modified interest rate. Since fair value of these loans isbased on management’s own projection of future cash flows, the fair valuemeasurements are categorized as Level 3 measurements.

 

*LoansHeld for Sale*

 

Loansheld for sale are required to be measured at the lower of cost or fair value.Management obtains quotes or bids on all or part of these loans directly fromthe purchasing financial institutions, which are a level 2 inputs. Premiumsreceived or to be received on the quotes or bids are indicative of the factthat cost is lower than fair value. At December 31, 2008, the fair valueof loans held for sale was greater than cost; therefore, the entire balance ofloans held for sale was recorded at cost. There were no loans held for sale at December 31,2009.

 

*ForeclosedAssets*

 

Assets acquiredthrough foreclosure or other proceedings are initially recorded at fair valueat the date of foreclosure less estimated costs of disposal, which establishesa new cost. After foreclosure, valuations are periodically performed, andforeclosed assets held for sale are carried at the lower of cost or fair value,less estimated costs of disposal. All foreclosed assets are real properties.The fair values of real properties initially are determined based onappraisals. In some cases, adjustments were made to the appraised values forvarious factors including age of the appraisal, age of comparables included inthe appraisal, and known changes in the market or in the collateral. Subsequentvaluations of the real properties are based on management estimates or onupdated appraisals. Foreclosed assets are categorized under Level 3 whensignificant adjustments are made by management to appraised values based onunobservable inputs. Otherwise, foreclosed assets are categorized under Level 2if their values are based solely on appraisals.

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 25.**                      FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued)

 

The Corporation in estimating fair value disclosures for financialinstruments used the following methods and assumptions:

 

***Cashand cash equivalents:*** The carrying amounts of cash and short-terminstruments approximate fair values.

 

***Investmentsecurities:***Fair values for investment securities, excluding Federal Home Loan Bank stockand Pacific Coast Banker’s Bank stock, are based on quoted market prices.  The carrying value of Federal Home Loan Bankstock approximates fair value based on the redemption provisions of the FederalHome Loan Bank.

 

***Loans:*******For variable-rate loans that reprice frequently andwith no significant change in credit risk, fair values are based on carryingvalues.  The fair value of performingfixed-rate loans is estimated by discounting future cash flows using theCorporation’s current offering rate for loans with similarcharacteristics.  The fair value ofperforming adjustable-rate loans is considered the same as book value.  The fair value of non-performing loans isestimated at the fair value of the related collateral or, when in management’sopinion foreclosure upon the collateral is unlikely, by discounting future cashflows using rates which take into account management’s estimate of credit risk.

 

***Commitmentsto Extend Credit and Standby Letters of Credit:*****The Corporation does not generally enter intolong-term fixed rate commitments or letters of credit.  These commitments are generally priced atcurrent prevailing rates.  These ratesare generally variable and, therefore, there is no interest rate exposure.  Accordingly, the fair market value of theseinstruments is equal to the carrying value amount of their net deferredfees.  The net deferred fees associatedwith these instruments are not material. The Corporation has no unusual credit risk associated with theseinstruments.

 

***Depositliabilities:***The fair values disclosed for demand deposits (e.g., interest and non-interestchecking, savings, and certain types of money market accounts) are, bydefinition, equal to the amount payable on demand at the reporting date (i.e.,their carrying amounts).  Fair values forfixed-rate certificates of deposit are estimated using a discounted cash flowcalculation that applies interest rates currently being offered on certificatesto a schedule of aggregated expected monthly maturities on time deposits.

 

***Accruedinterest:***The carrying amounts of accrued interest approximate fair value.

 

***CashSurrender Value of Life Insurance:*******The carrying amount of life insurance approximate fairvalue.

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

** **

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 25.**                     FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued)

 

***Short-termborrowing:***The carrying amounts of federal funds purchased, borrowings under repurchaseagreements, and other short-term borrowings maturing within ninety daysapproximate their fair values.  Fairvalues of other borrowings are estimated using discounted cash flow analysesbased on the Corporation’s current incremental borrowing rates for similartypes of borrowing arrangements.

 

***Long-termborrowing:***  The fair values of the Corporation’slong-term borrowings are estimated using discounted cash flow analyses based onthe Corporation’s current incremental borrowing rates for similar types ofborrowing arrangements.

 

The estimated fair values, and related carrying amounts, of theCorporation’s financial instruments as of December 31 are as follows:

 
| ** **                                                  | ** ** | **2009**                   | ** ** | **2008** | ** ** |
|-------------------------------------------------------------|------------|----------------------------|------------|----------|------------|
| ** **                                                  | ** ** | **(Dollars in thousands)** | ** ** |
| ** **                                                  | ** ** | ** **                 | ** ** |
| Cash and cash equivalents                                   |       | $                          | 12,251     |     | $          | 12,251 |   | $ | 16,348 |   | $ | 16,348 |   |
| Interest bearing deposits with other financial institutions |       | 5,256                      |       | 5,256    |       | 3,500 |   | 3,500 |   |
| Trading assets                                              |       | 153                        |       | 153      |       | 361 |   | 361 |   |
| Investment securities AFS                                   |       | 62,413                     |       | 62,413   |       | 93,353 |   | 93,353 |   |
| Other investments                                           |       | 4,085                      |       | 4,085    |       | 3,852 |   | 3,852 |   |
| Loans, held for sale                                        |       | 2,216                      |       | 2,216    |       | 1,650 |   | 1,650 |   |
| Loans, net                                                  |       | 160,997                    |       | 163,839  |       | 165,530 |   | 167,550 |   |
| Accrued interest receivable                                 |       | 1,371                      |       | 1,371    |       | 2,130 |   | 2,130 |   |
|                                                        |       |                       |       |     |       |   |   |   |   |
| Financial Liabilities:                                      |       |                       |       |     |       |   |   |   |   |
| Deposits                                                    |       | 202,422                    |       | 205,699  |       | 189,730 |   | 192,565 |   |
| Long-term debt                                              |       | 50,098                     |       | 46,779   |       | 92,748 |   | 94,349 |   |
| Accrued interest payable                                    |       | 1,274                      |       | 1,274    |       | 1,833 |   | 1,833 |   |
|                                                             |            |                            |            |          |            |  |  |  |  |  |  |  |  |

 

Management uses judgment in estimating thefair value of the Corporation’s financial instruments; however, there areinherent weaknesses in any estimation technique. Therefore, for substantiallyall financial instruments, the fair value estimates presented herein are notnecessarily indicative of the amounts the Corporation’s could have realized ina sales transaction at December 31, 2009 and 2008.

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

** **

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 26.**                     NORTHERN CALIFORNIA BANCORP, INC. (PARENT CORPORATIONONLY)

 

The following are the financial statements of Northern CaliforniaBancorp, Inc. (Parent Corporation only):

 
| **Balance  Sheets  December 31,**             | ** ** | **2009**                   | ** ** | **2008** | ** ** |
|----------------------------------------------------|------------|----------------------------|------------|----------|------------|
| ** **                                         | ** ** | **(Dollars in thousands)** | ** ** |
| Assets                                             |       |                       |       |     |       |
| Cash and due  from banks                           |       | $                          | 257        |     | $          | 244 |   |
| Investment in  common stock ofMonterey County Bank |       | 25,946                     |       | 24,150   |       |
| Investment  securities - trading account           |       | 153                        |       | 361      |       |
| Investment in  Metrocities Mortgage,LLC Stock      |       | —                     |       | 10       |       |
| Investment in AT  Services LLCAcquisition Corp.    |       | —                     |       | 20       |       |
| Northern  California Bancorp, Inc. Trust I    |       | 93                         |       | 93       |       |
| Northern  California Bancorp, Inc. Trust II   |       | 155                        |       | 155      |       |
| Debt issue  costs, net                             |       | 133                        |       | 139      |       |
| Deferred tax  asset                                |       | 594                        |       | 572      |       |
| Accounts  receivable                               |       | 71                         |       | 23       |       |
|                                               |       |                       |       |     |       |
|                                               |       | $                          | 27,402     |     | $          | 25,767 |   |
|                                               |       |                       |       |     |       |
| Liabilities and  Shareholders’ Equity         |       |                       |       |     |       |
| Accounts payable  and accrued expenses             |       | $                          | 151        |     | $          | 148 |   |
| Dividend payable                                   |       | 3                          |       | 19       |       |
| Note payble                                        |       | 2,850                      |       | 3,000    |       |
| Junior  subordinated debt securities               |       | 8,248                      |       | 8,248    |       |
| Total  liabilities                                 |       | 11,252                     |       | 11,415   |       |
| Shareholders’  equity                         |       | 16,150                     |       | 14,352   |       |
|                                               |       |                       |       |     |       |
|                                               |       | $                          | 27,402     |     | $          | 25,767 |   |

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

** **

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 26.**                     NORTHERN CALIFORNIA BANCORP, INC. (PARENT CORPORATIONONLY) (Continued)

** **
| **Statements  of Income  Years Ended December 31,**                            | ** ** | **2009**                   | ** ** | **2008** | ** ** | **2007** | ** ** |
|-------------------------------------------------------------------------------------|------------|----------------------------|------------|----------|------------|----------|------------|
| ** **                                                                          | ** ** | **(Dollars in thousands)** | ** ** |
| Income:                                                                             |       |                       |       |     |       |     |       |
| Gain on sale of  securities                                                         |       | $                          | 22         |     | $          | 23       |       | $ | 108 |   |
| Loss on trading  asset                                                              |       | (138                       | )          | (967     | )          | (794     | )          |
| Other                                                                               |       | 12                         |       | 17       |       | 64       |       |
|                                                                                |       |                       |       |     |       |     |       |
|                                                                                |       | (104                       | )          | (927     | )          | (622     | )          |
| Expense:                                                                            |       |                       |       |     |       |     |       |
| Interest                                                                            |       | 504                        |       | 597      |       | 713      |       |
| Other                                                                               |       | 83                         |       | 86       |       | 72       |       |
|                                                                                |       |                       |       |     |       |     |       |
|                                                                                |       | 587                        |       | 683      |       | 785      |       |
|                                                                                |       |                       |       |     |       |     |       |
| Loss before  income tax benefits and equityin undistributed net income ofsubsidiary |       | (691                       | )          | (1,610   | )          | (1,407   | )          |
| Income tax benefit                                                                  |       | (277                       | )          | (940     | )          | (399     | )          |
|                                                                                |       |                       |       |     |       |     |       |
|                                                                                |       | (414                       | )          | (670     | )          | (1,008   | )          |
| Equity in  undistributed net incomeof subsidiary                                    |       | 2,025                      |       | 2,132    |       | 2,937    |       |
|                                                                                |       |                       |       |     |       |     |       |
|                                                                                |       | $                          | 1,611      |     | $          | 1,462    |       | $ | 1,929 |   |

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

** **

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 26.**                     NORTHERN CALIFORNIA BANCORP, INC. (PARENT CORPORATIONONLY) (Continued)

** **
| **Statements  of Cash Flows  Years Ended December 31,**                  | ** ** | **2009**                   | ** ** | **2008** | ** ** | **2007** | ** ** |
|-------------------------------------------------------------------------------|------------|----------------------------|------------|----------|------------|----------|------------|
| ** **                                                                    | ** ** | **(Dollars in thousands)** | ** ** |
|                                                                          |       |                       |       |     |       |     |       |
| Cash flows from  operating activities:                                        |       |                       |       |     |       |     |       |
| Net income                                                                    |       | $                          | 1,611      |     | $          | 1,462    |       | $ | 1,929 |   |
| Adjustments to  reconcile net income tonet cash used by operating activities: |       |                       |       |     |       |     |       |
| Amortization                                                                  |       | —                     |       | 5        |       | 6        |       |
| Equity in  undistributed income ofMonterey County Bank                        |       | (2,025                     | )          | (2,132   | )          | (2,937   | )          |
| Decrease in  trading securities                                               |       | 208                        |       | 863      |       | 538      |       |
| Increase in  other assets                                                     |       | (64                        | )          | (591     | )          | —   |       |
| Increase in  accrued expenses                                                 |       | 3                          |       | 24       |       | —   |       |
| Increase  (decrease) in other liabilities                                     |       | (15                        | )          | (93      | )          | 25       |       |
|                                                                          |       |                       |       |     |       |     |       |
| Net cash used by  operating activities                                        |       | (282                       | )          | (462     | )          | (439     | )          |
|                                                                          |       |                       |       |     |       |     |       |
| Cash flows from  investing activities:                                        |       |                       |       |     |       |     |       |
| Cash dividends  received from subsidiary                                      |       | 500                        |       | —   |       | 800      |       |
| Paid in capital  to subsidiary                                                |       | —                     |       | (2,000   | )          | —   |       |
| Decrease in  investments                                                      |       | 30                         |       | —   |       | —   |       |
|                                                                          |       |                       |       |     |       |     |       |
| Net cash  provided (used) by investing activities                             |       | 530                        |       | (2,000   | )          | 800      |       |
|                                                                          |       |                       |       |     |       |     |       |
| Cash flows from  financing activities:                                        |       |                       |       |     |       |     |       |
| Cash dividends  paid on common stock                                          |       | —                     |       | (450     | )          | (461     | )          |
| Net advances  (repayments) on borrowings                                      |       | (150                       | )          | 3,000    |       | —   |       |
| Exercise of  stock options                                                    |       | —                     |       | 12       |       | 442      |       |
| Stock repurchase                                                              |       | (85                        | )          | (341     | )          | —   |       |
|                                                                          |       |                       |       |     |       |     |       |
| Net cash  provided (used) by financing activities                             |       | (235                       | )          | 2,221    |       | (19      | )          |
|                                                                               |            |                            |            |          |            |          |            |  |  |  |

 

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**NORTHERN CALIFORNIA BANCORP, INC. AND SUBSIDIARY**

** **

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2009 and 2008**

 

#### **Note 26.**                     NORTHERN CALIFORNIA BANCORP, INC. (PARENT CORPORATIONONLY) (Continued)

** **
| **Statements  of Cash Flows Continued**              | ** ** | **2009**                   | ** ** | **2008** | ** ** | **2007** | ** ** |
|------------------------------------------------------|------------|----------------------------|------------|----------|------------|----------|------------|
| ** **                                           | ** ** | **(Dollars in thousands)** | ** ** |
|                                                 |       |                       |       |     |       |     |       |
| Net increase  (decrease) in cash and cashequivalents |       | $                          | 13         |     | $          | (241     | )          | $ | 342 |   |
|                                                 |       |                       |       |     |       |     |       |
| Cash and cash  equivalents, beginning of year        |       | 244                        |       | 485      |       | 143      |       |
|                                                 |       |                       |       |     |       |     |       |
| Cash and cash  equivalents, end of year              |       | $                          | 257        |     | $          | 244      |       | $ | 485 |   |

 

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