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

**WashingtonD.C.  20549**

 

**FORM 10-K**

 

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

**(Feerequired) for fiscal year ended December 31, 2008**

 

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

**(No fee required) for theperiod 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 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-associates as of the last business dayof the registrant’s most recently completed second fiscal quarter – June 30,2008 was $4,488,000.

 

Sharesof stock outstanding as of March 1, 2009: 1,845,918.

 

**DOCUMENTSINCORPORATED BY REFERENCE**

 

Portions of the registrant’s proxy statement to be filed with theSecurities and Exchange Commission in connection with the registrant’s 2009annual meeting of stockholders are incorporated by reference into Part IIIof this Form 10-K.

 

Portionsof the Independent Auditor’s Report for the fiscal year ended December 31,2008 are incorporated by reference in Part II Item 7.

 

 

 

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FORM 10-KCROSS REFERENCE INDEX

 
| ** **           | ** ** | ** **                                                                                                    | ** ** | **PAGE** |
|----------------------|------------|---------------------------------------------------------------------------------------------------------------|------------|----------|
| **PART I**      | ** ** |                                                                                                          |       | 3        |
| **ITEM  1.**         | ** ** | **BUSINESS**                                                                                                  | ** ** | 3        |
| **ITEM 1A.**         | ** ** | **RISK  FACTORS**                                                                                             | ** ** | 22       |
| **ITEM 1B.**         | ** ** | **UNRESOLVED  STAFF COMMENTS**                                                                                | ** ** | 27       |
| **ITEM 2.**          | ** ** | **PROPERTIES**                                                                                                | ** ** | 28       |
| **ITEM 3.**          | ** ** | **LEGAL  PROCEEDINGS**                                                                                        | ** ** | 28       |
| **ITEM 4.**          | ** ** | **SUBMISSION  OF MATTERS TO A VOTE OF SECURITY HOLDERS**                                                      | ** ** | 28       |
| **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**                                                                                  | ** ** | 31       |
| **ITEM 7.**          | ** ** | **MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION**                | ** ** | 32       |
| **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 for historicalinformation contained herein, the matters discussed or incorporated byreference in this report on Form 10-K contain forward-looking statementswithin the meaning of Section 27A of the Securities Act of 1933, asamended (the “Securities Act”), and Section 21E of the Securities ExchangeAct 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 could differmaterially from such forward-looking statements contained herein.  Factorsthat could cause future results to vary from current expectations include, butare not limited to, the following: changes in economic conditions (bothgenerally and more specifically in the markets in which the Corporationoperates):  changes in interest rates,deposit flows, loan demand, real estate values and competition; changes inaccounting principles, policies or guidelines and in government legislation andregulation (which change from time to time and over which the Corporation hasno control); other factors affecting the Corporation’s operations, markets,products and services; and other risks detailed in this Form 10-K (see “Item1A. Risk Factors”) and in the Corporation’s other reports filed with theSecurities and Exchange Commission.  Readers are cautioned not to placeundue reliance on these forward-looking statements, which reflect management’sanalysis only as of the date hereof.  The Corporation undertakes noobligation to publicly revise these forward-looking statements to reflectevents or circumstances that arise after the date thereof.

 

**PART I**

 

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

 

**GENERAL**

 

Northern California Bancorp, Inc. (the “Corporation”)was incorporated 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, 2008, on a consolidatedbasis the Corporation had total assets of $306,201,000, total loans of$169,593,000 and total deposits of $189,730,000.  The Corporation owns 100% of Monterey CountyBank (the “Bank”).   The Corporation’ssources of revenues at this time are dividends on investments, gains onsecurities transactions and potential dividends, management fees and taxequalization 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,Pacific Grove and Salinas.  The Bankoffers its customers a wide variety of the normal personal, consumer andcommercial services expected of a locally 

 

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owned, independentlyoperated bank.  The Bank’s deposits areinsured by the Federal Deposit Insurance Corporation (the “FDIC”), and, assuch, the Bank is subject to regulations by that federal agency and to periodicaudits of its operations and documentary compliance by FDIC personnel.  As a state chartered bank, which is not amember of the Federal Reserve System, it is also regulated and periodically examinedby the California Department of Financial Institutions.

 

The Bank’s activities areconducted at its principal offices, 601 Munras Ave., Monterey, California andat its four branch offices in Carmel-By-The-Sea, Carmel Valley, Pacific Groveand Salinas, California and a loan production office in Monterey,California.  At December 31, 2008,the Bank had total assets, loans and deposits of approximately $304,847,000, $169,593,000and $189,974,000,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, and retirementaccounts.  Lending services includeconsumer loans, various types of mortgage loans for residential and commercialreal estate, personal lines of credit, home equity loans, real estateconstruction, accounts receivable financing, commercial loans to small andmedium-sized businesses and professionals. The Bank also provides drive-through facilities, at its Monterey andCarmel offices, and night depository facilities for customer convenience.  The Bank offers safe deposit box facilities,cashiers’ checks, travelers’ checks, U.S. Savings Bonds, and wiretransfers.  The Bank does not providetrust 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 2008 was the downturn in the economy 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 ($1,132,000 in 2008 compared to $865,000 in 2007) was largely due toasset quality issues related to this market segment.

 

Management’s efforts focused on developingmethodologies to identify potentially weak credits as early as possible, whichenabled a proactive and aggressive approach to managing these credits and thedevelopment of workout strategies as appropriate.  Nonetheless, loans 30 days past due increasedfrom $3,800,000 (2.23 percent of total loans) at December 31, 2007 to$6,925,000 (4.08 percent of total loans) at December 31, 2008.  Past due loans increased during this periodby $3,125,000 or 82.2 percent.  Duringthe same period, non-performing loans (non-accrual loans and troubled debtrestructurings) increased from $3,396,000 (2.0 percent of total loans) to$7,091,000 (4.8 percent of total loans) at December 31, 2008. Of thenon-performing loans outstanding at December 31, 2008, $6,876,000 or 90.6percent were secured by real estate (net of any charge-offs previouslytaken).  Total past due loans andnon-performing loans are net of the guaranteed portion of Small BusinessAdministration (“SBA”) loans totaling $1,421,000 and $1,348,000,respectively.  Management believes thepresence of real estate collateral mitigates the level of expected loss thoughthe level of mitigation is uncertain due to the difficulty ascertaining realestate values at this time.

 

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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, Federal ReserveBank borrowings and Federal Home Loan Bank borrowings.  Despite these and other actions, theCorporation’s tax-equivalent net yield on earning assets decreased to 2.87percent for 2008 compared to 4.69 percent for 2007.  The tax-equivalent net yield on earningassets was affected in 2008 by the increase in loans being placed onnon-accrual during the year. Non-accrual loans totaled $7,091,000 at year-end2008 compared to $3,396,000 at year-end 2007, an increase of $3,695,000 or108.8 percent.  The increase innon-accrual loans resulted from slowing economic activity and a depressed realestate market.

 

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 heightened monitoring required forthird-party relationships to ensure compliance with various laws andregulations applicable to these types of programs makes it imprudent for theBank to continue with these programs. The characteristics of the drug manufactures’ rebate card programsignificantly reduces the level of required monitoring.  Management anticipates its sponsorship of theaffected programs will end by June 2009. The Bank has been named as a defendant in a lawsuit brought by one ofthe third-party credit card companies, seeking to compel the Bank to continueits sponsorship for a period of time. (See “Item 3. Legal Proceedings” for further discussion.)

 

The Bank’s revenues,consisting of a monthly fee per card or a minimum monthly fee, from the creditcard programs were $514,000, $648,000 and $1,308,000 in 2008, 2007 and 2006,respectively.  The 2006 revenues reflectthe purchase by one of the sponsored programs of an existing credit cardportfolio containing approximately 250,000 accounts.  The portfolio was subsequently transferred toanother sponsor resulting in transfer fees in the amount of $382,000 and$204,000 in 2006 and 2007, respectively. The Bank’s revenues, consisting of a monthly fee per card or a minimummonthly fee, from the debit card programs were $155,000, $293,000 and $75,000in 2008, 2007 and 2006, respectively. The Bank’s revenues from the credit card and debit card programs in 2008were not significantly impacted by its decision to terminate the sponsorshipagreements.  Revenues for 2009 will beimpacted, although the amount of the impact will depend on the actual dates thesponsorships end.

 

**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 “Subordinated 

 

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Debt Securities”).

 

Pursuant to FinancialAccounting Standards Board Interpretation No. 46R, “Consolidation ofVariable Interest Entities (VIE’s) (FIN 46R),” Trust I is not reflected on a consolidatedbasis in our consolidated financial 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, 2008 was 8.07%.  Total broker and legal costs associated withthe issuance of $115,000 are being amortized over a 30 year period.

 

**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 FIN46R, “Consolidationof Variable Interest Entities (VIE’s) (FIN 46),” Trust II is not reflected on aconsolidated 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, 2008was 6.04%. Total broker and legal costs associated with the issuance of $54,000are being amortized over a 30 year period.

 

**EMPLOYEES**

 

At December 31,2008, the Corporation and the Bank employed a total of 54 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.

 

**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 loancompanies and credit unions, as well as securities brokerage offices which canissue commercial paper and other securities (such as shares in money marketfunds).

 

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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 tooffer.  By virtue of their greater totalcapital, such institutions have substantially higher lending limits than theBank (legal lending limits to an individual customer being limited to apercentage of a bank’s total capital accounts). These competitors may intensify their advertising and marketingactivities to counter any efforts by the Bank to further attract new businessas a commercial bank.  In addition, as aresult of legislation enacted earlier in the decade, there is increasedcompetition between banks, savings and loan associations and credit unions forthe deposit and loan business of individuals. These activities may hinder the Bank’s ability to capture a significantmarket 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 Federal Reserve Board inthese areas influence the growth of bank loans, investments and deposits andalso affect interest rates charged on loans and paid on deposits.  The nature and impact of any future changesin monetary policies cannot be predicted.

 

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**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 (the “Act”) does three fundamental things: 1) it repealskey provisions of the Glass Steagal Act to permit commercial banks to affiliatewith investment banks, 2) it substantially modifies the Bank Holding CompanyAct of 1956 to permit companies that own commercial banks to engage in any typeof financial activity, and 3) it allows 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 any oneaffiliate, and is limited to 20% of the Bank’s capital, in the case of allaffiliates.  Federal and State law place other limitations on transactionsbetween the Bank and its affiliates designed to ensure that the Bank receivestreatment in such transactions comparable to that available from unaffiliatedthird parties.

 

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The Corporationand its subsidiaries are prohibited from engaging in certain tie-inarrangements in connection with any extension of credit, sale or lease of propertyor furnishing 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 currentconditions in the global financial markets and the global economy, legislatorsand banking regulators have increased their focus on the financial servicesindustry.  Proposals for legislation thatcould substantially intensify the regulation of the financial services industryare expected to be introduced in the U.S. Congress and in state legislatures.The agencies regulating the financial services industry also adopt changes totheir regulations. Substantial regulatory and legislative initiatives,including a comprehensive overhaul of the regulatory system in the U.S., arepossible in the months or years ahead. Any such action could have a materiallyadverse effect on our business, financial condition and results of operations.

 

Recent months havealready seen an unprecedented number of government initiatives designed torespond to the stresses experienced in financial markets.  In response to the financial crises affectingthe banking system and financial markets and going concern threats toinvestment banks and other financial institutions, the Emergency EconomicStabilization Act of 2008 (“EESA”) was signed into law on October 3, 2008.  Pursuant to EESA, the Secretary of 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 issued on or before March 14, 2008 from financial institutionsfor the purpose of stabilizing and providing liquidity to the U.S. financialmarkets. Pursuant to EESA, the U.S. Treasury established the Troubled AssetRelief Program (“TARP”) and has since injected capital into many financialinstitutions under the TARP Capital Purchase Program (“TARP-CPP”).  Neither the Corporation nor the Bank hasparticipated in the TARP-CPP.

 

On February 10,2009, the Treasury announced the Financial Stability Plan (the “FSP”), which,among other things, proposes to establish a new Capital Assistance Program (“CAP”)through which eligible banking institutions will have access to U.S. Treasurycapital as a bridge to private capital until market conditions normalize, andextends to October 31, 2009, the FDIC’s Temporary Liquidity GuaranteeProgram (the “TLGP”) pursuant to which the FDIC will fully guarantee certainnewly issued senior unsecured debt and provide full FDIC deposit insurancecoverage for certain accounts, including noninterest bearing deposit transactionaccounts. As a complement to CAP, a new Public-Private Investment Fund on aninitial scale of up to $500 billion, with the potential to expand up to $1trillion, was announced to catalyze the removal of legacy assets from thebalance sheets of financial institutions. This proposed fund will combinepublic and private capital with government financing to help free up capital tosupport new lending. In addition, the existing Term Asset-Backed SecuritiesLending Facility (“TALF”) would be expanded (up to $1 trillion) in order toreduce credit spreads and restart the securitized credit markets that in recentyears supported a substantial portion of lending to households, students, smallbusinesses, and others. Furthermore, the FSP proposes a new framework of governanceand oversight to help ensure 

 

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that banks receivingfunds are held responsible for appropriate use of those funds through strongerconditions on lending, dividends and executive compensation along with enhancedreporting to the public.

 

On February 17,2009, the American Recovery and Reinvestment Act of 2009 (“ARRA”) was signedinto law.  ARRA is intended to providetax breaks for individuals and businesses, direct aid to distressed states andindividuals, 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, ARRAprohibits the payment of bonuses, other incentive compensation and severance tocertain highly paid employees (except in the form of restricted stock subjectto specified limitations and conditions), and requires each TARP-CPP recipientto comply 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.  To the extent that the executive compensationprovisions in ARRA are more restrictive than the restrictions described in theTreasury’s executive compensation guidelines already issued under EESA, the newARRA guidelines appear to supersede those restrictions.  However, both ARRA and the existing Treasuryguidelines contemplate that the Secretary of the Treasury will adopt standardsto provide additional guidance regarding how the executive compensationrestrictions under ARRA and EESA will be applied.

 

In addition, ARRA directsthe Secretary of the Treasury to review previously-paid bonuses, retentionawards and other compensation paid to the senior executive officers and certainother highly-compensated employees of each TARP-CPP recipient to determinewhether any such payments were excessive, inconsistent with the purposes ofARRA or TARP, or otherwise contrary to the public interest. If the Secretarydetermines that any such payments have been made by a TARP-CPP recipient, theSecretary will seek to negotiate with the TARP-CPP recipient and the subjectemployee for appropriate reimbursements to the U.S. government (not theTARP-CPP recipient) with respect to any such compensation 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 Treasury announced the Homeowner Affordability and Stability Plan (“HASP”),which proposes to provide refinancing for certain homeowners, to support lowmortgage rates by strengthening confidence in Fannie Mae and Freddie Mac, andto establish a Homeowner Stability Initiative to reach at-risk homeowners.Among other things, the Homeowner Stability Initiative would offer monetaryincentive to mortgage servicers and mortgage holders for certain modificationsof at-risk loans, and would establish an insurance fund designed to reduceforeclosures.

 

It is not clear atthis time what impact EESA, the CPP, the TLGP, the FSP, ARRA, HASP, or otherliquidity and funding initiatives will have on the financial markets and theother difficulties described above, including the high levels of volatility andlimited credit availability currently being experienced, or on the U.S. bankingand financial industries and the broader U.S. and global economies. Failure ofthese programs to address the issues noted above could have an adverse effect 

 

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on the Corporation andits business.

 

**Sarbanes-OxleyAct**

 

The Sarbanes-OxleyAct of 2002 (the “SOX Act”) was enacted in response to issues in corporategovernance and accountability.  Key provisions of the SOX Act provide for:

 

·                  Expanded oversight of the accountingprofession by creating a new independent public company oversight board to bemonitored by the SEC.

·                  Revised rules on auditorindependence to restrict the nature of non-audit services provided to auditclients and to require such services to be pre-approved by the audit committee.

·                  Improved corporate responsibility throughmandatory listing standards relating to audit committees, certifications ofperiodic reports by the Chief Executive Officer and Chief Financial Officer,and making issuer interference with an audit a crime.

·                  Enhanced financial disclosures, includingperiodic reviews for the largest issuers and real time disclosure of materialcompany information.

·                  Enhanced criminal penalties for a broadarray of white-collar crimes and increases in the statute of limitations forsecurities fraud lawsuits.

·                  Provides for mandated internal control reportand assessment with the annual report and an attestation and a report on suchreport by the company’s auditor.

 

The effect of theSOX Act has been higher compliance and accounting/auditing costs ascorporations have modified procedures.

 

**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. TheCalifornia Department of Financial Institutions (the “DFI”) and the FDICprovide primary supervision, periodic examination and regulation of 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 November 21, 2008 and until December 31,2009, the FDIC expanded deposit insurance limits under the FDIC’s TLGP to$250,000 per depositor for certain accounts and unlimited coverage fornon-interest bearing transaction accounts held at financial institutions whohave not opted out of the Program. On January 1, 2010, these increasedlimits on deposit insurance coverage will return to $100,000 for all depositcategories except individual retirement accounts and certain other retirementaccounts, which will continue to be insured up to $250,000 per depositor.  For this protection, the Bank, like allinsured banks, pays a semi-annual statutory assessment and is subject to the rules andregulations of the FDIC.  Although the Bank is not a member of the FederalReserve System, certain regulations of the Federal Reserve Board also apply toits 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 stockholders made during suchperiod).  Cash dividends may also be paid in an 

 

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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 suchsecurities as collateral for loans, and the purchase of assets fromaffiliates.  These restrictions have the effect of preventing affiliates(such as the Corporation) from borrowing from the Bank unless the loans aresecured by marketable obligations of designated amounts.  Secured loansand investments by the Bank are limited to 10% of the Bank’s capital andsurplus (as defined by federal regulations) in the case of any one affiliate,and 20% thereof in the case of all affiliates.  California law alsoimposes certain restrictions with respect to transactions involving othercontrolling persons of 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 forth therein)among banking organizations, take certain off-balance sheet items into accountin assessing capital adequacy and minimize disincentives to holding liquid,low-risk assets. Under these guidelines, assets and credit equivalent amountsof off-balance sheet items, such as letters of credit and outstanding loancommitments, are assigned to one of several risk categories, which range from0% for risk-free assets, such as cash and certain U.S. government securities,to 100% for relatively high-risk assets, such as loans and investments in fixedassets, premises and other real estate owned. The aggregate dollar amount ofeach category is then multiplied by the risk-weight associated with thatcategory. The resulting weighted values from each of the risk categories arethen added together to determine 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.

 

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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. Any additional portion will qualify as Tier 2 capital.  Intangibles, suchas goodwill, are generally deducted from Tier 1 capital; however, purchasedmortgage servicing rights and purchased credit card relationships may beincluded, subject to certain limitations. At least 50% of the bankingorganization’s total regulatory 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 federalbanking agencies.

 

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 thanminimum risk profiles are expected to maintain capital at least 100-200 basispoints above the minimum level.

 

In addition, theFederal Reserve Board and the FDIC have issued or proposed rules to takeaccount of interest rate risk, concentration of credit risk and the risks ofnontraditional activities in calculating risk-based capital.

 

For capital adequacypurposes, deferred tax assets that can be realized from taxes paid in priorcarry-back years, and from the future reversal of temporary differences, aregenerally 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.

 

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.

 

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**PromptCorrective Action 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 shallgenerally be deemed to be: (i) “well capitalized” if it has a totalrisk-based capital ratio of 10.0% or more, has a Tier I risk-based capitalratio of 6.0% or more, has a Tier I leverage capital ratio of 5.0% or moreand is not subject to specified requirements to meet and maintain a specificcapital level for any capital measure; (ii) “adequately capitalized” if ithas a total 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) “critically undercapitalized”if it has a ratio of tangible equity to total assets that is equal to or lessthan 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 withsupervisory actions as if it were in the next lower category if the institutionis in an unsafe or unsound condition or engaging in an unsafe or unsoundpractice.  (The FDIC may not, however, reclassify a significantlyundercapitalized institution 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.

 

At December 31,2008, 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.  

 

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The agencies alsoproposed asset quality and earnings standards which, if adopted in final, wouldbe added to the Guidelines.  Under the final regulations, if the FDICdetermines that the Bank fails to meet any standard prescribed by theGuidelines, the agency may require the Bank to submit to the agency anacceptable plan to achieve compliance with the standard, as required by theFDIA.  The final regulations establish deadlines for the submission andreview of such safety and 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 utilizes 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 names 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:

 
| ** **                          | ** ** | **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 

 

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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 beginning 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 percent ofdomestic deposits and whose total assets are more than 40 percent greater thanthey were 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 I institutionwith a long-term debt issuer rating so that it equally weights the institution’sweighted average CAMELS component ratings, its long-term debt issuer ratingsand 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 percent of an institution’s assessment rate before the increase for securedliabilities in excess of 25 percent of domestic deposits; and (ii) fornon-Risk Category I institutions, an increase not to exceed 10 basis points forbrokered deposits in excess of 10 percent 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:

 

Initial Base Assessment Rates

 
|                                               | ** ** | **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:

 

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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 imposes a 20 basis pointemergency special assessment on all insured depository institutions on June 30,2009. The special assessment will be collected September 30, 2009, at thesame time that the risk-based assessments for the second quarter of 2009 arecollected. The interim rule also permits the FDIC to impose an emergency specialassessment of up to 10 basis points on all insured depository institutionswhenever, after June 30, 2009, the FDIC estimates that the DIF reserveratio will fall to a level that the FDIC believes would adversely affect publicconfidence or to a level close to zero or negative at the end of a calendarquarter.

 

Effective November 21,2008 and until December 31, 2009, the FDIC expanded deposit insurancelimits for certain accounts under the FDIC’s Temporary Liquidity GuaranteeProgram.  Provided an institution has notopted out of the 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. Coverage under theTLGP was available for the first 30 days without charge. The fee assessment forcoverage of senior unsecured debt ranges from 50 basis points to 100 basispoints per annum, depending on the initial maturity of the debt. The feeassessment for deposit insurance coverage is 10 basis points per quarter onamounts in covered accounts exceeding $250,000. On February 10, 2009, the Treasury extended the Temporary LiquidityGuarantee Program to October 31, 2009 pursuant to the Financial StabilityPlan - Capital Assistance Program.  TheBank has not opted out of the TLGP.

 

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 condition imposedby 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.

 

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FICOhas assessment authority, separate from the FDIC’s authority to assessrisk-based premiums for deposit insurance, to collect funds from FDIC-insuredinstitutions sufficient to pay interest on FICO bonds.  The FDIC acts ascollection agent for FICO.  The FICO assessment rate is adjusted quarterlyto reflect changes in the assessment basis of the respective funds based on thequarterly Call Report and the Thrift Financial Report submissions.  TheFICO quarterly rates for 2008 were 1.14, 1.12, 1.12 and 1.10.  The FICOquarterly rate for the first and second quarters of 2009 is 1.14 and 1.04,respectively.

 

**InterstateBanking and Branching**

 

OnSeptember 29, 1994, the President signed into law the Riegle-NealInterstate Banking and Branching Efficiency Act of 1994 (the “Interstate Act”). Under the Interstate Act, beginning one year after the date of enactment, abank holding company that is adequately capitalized and managed may obtainregulatory approval to acquire an existing bank located in another statewithout regard to state law.  A bank holding company would not bepermitted to make such an acquisition if, upon consummation, it would control (a) morethan 10% of the total amount of deposits of insured depository institutions inthe United States or (b) 30% or more of the deposits in the state in whichthe bank is located.  A state may limit the percentage of total depositsthat may be held in that state by any one bank or bank holding company ifapplication of such limitation does not discriminate against out-of-statebanks.  An out-of-state bank holding company may not acquire a state bankin existence for less than a minimum length of time that may be prescribed bystate law except that a state may not impose more than a five year existencerequirement.

 

TheInterstate Act also permitted, effective June 1, 1997, mergers of insuredbanks located in different states and conversion of the branches of theacquired bank into branches of the resulting bank.  Each state may adoptlegislation to prohibit interstate mergers after June 1, 1997 in thatstate or in other states by that state’s banks.  The same concentrationlimits discussed in the preceding paragraph apply.  The Interstate Actalso permits a national or state bank to establish branches in a state otherthan its home state if permitted by the laws of that state, subject to the samerequirement and conditions as for a merger transaction.

 

TheInterstate Act has increased competition in the Bank’s market areas, especiallyfrom larger financial institutions and their holding companies.

 

OnOctober 2, 1995, the “California Interstate Banking and Branching Act of1995” (the “1995 Act”) became effective.  The 1995 Act generally allowsout-of-state banks to enter California by merging with, or purchasing, aCalifornia bank or industrial loan company which is at least five years old.

 

**CommunityReinvestment Act and Fair Lending Developments**

 

TheBank is subject to certain fair lending requirements, reporting obligationsinvolving home 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.

 

InMay, 1995, the federal banking agencies issued final regulations which changethe manner 

 

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in which they measure a bank’scompliance with its CRA obligations.  The final regulations adopt aperformance-based evaluation system which bases CRA ratings on an institution’sactual lending service and investment performance rather than the extent towhich the institution conducts needs assessments, documents community outreachor complies with other procedural requirements.  In March 1994, theFederal Interagency Task Force on Fair Lending issued a policy statement ondiscrimination in lending.  The policy statement describes the threemethods that federal agencies will use to prove discrimination: overt evidenceof discrimination, evidence of disparate treatment and evidence of disparateimpact. .  Following the Bank’s most recent CRA examination, the Bank’srating was “needs to improve”.  Therating is due primarily to issues related to the Bank’s third party vendorprograms.

 

**OtherRegulations and Policies**

 

Thefederal regulatory agencies have adopted regulations that implement Section 304of FDICIA 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.

 

Section 24of the FDIA, as amended by the FDICIA, generally limits the activities andequity investments 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 interest ina 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.

 

FDICregulations implementing 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 of GovernmentalMonetary 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 

 

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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.

 

**Financial Modernization Act**

 

EffectiveMarch 11, 2000, the Gramm-Leach-Bliley Act eliminated most barriers toaffiliations among banks and securities firms, insurance companies, and otherfinancial service providers, and enabled full affiliations to occur betweensuch entities.  This legislation permits bank holding companies to become “financialholding companies” and thereby acquire securities firms and insurance companiesand engage in other activities that are financial in nature.  A bankholding company may become a financial holding company if each of itssubsidiary banks is well capitalized under the prompt corrective actionprovisions discussed above, is well managed, and has at least a satisfactoryrating under the Community Reinvestment Act by filing a declaration that thebank holding company wishes to become a financial holding company.  Noregulatory approval will be required for a financial holding company to acquirea company, other than a bank or savings association, engaged in activities thatare financial in nature or incidental to activities that are financial innature, as determined by the Federal Reserve Board.  The Corporation hasno 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 Federal Reserve Board has determined to be closelyrelated to banking.  A national bank (and therefore, a state bank as well)may also engage, subject to limitations on investment, in activities that arefinancial in nature, other than insurance underwriting, insurance companyportfolio investment, real estate development and real estate investment,through a financial subsidiary of the bank, if the bank is well capitalized,well managed and has at least a satisfactory CRA rating.  Subsidiary banksof a financial holding company or national banks with financial subsidiariesmust continue to be well capitalized and well managed in order to continue toengage in 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 

 

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of the financial holdingcompany or 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**

 

TheUSA Patriot Act of 2001, enacted in response to the terrorist attacks in NewYork, Pennsylvania and Washington, D.C. on September 11, 2001, is intendedto strengthen U.S. law enforcement’s and the intelligence communities’ abilityto work cohesively to combat terrorism on a variety of fronts.  The impactof the USA Patriot Act on financial institutions of all kinds has beensignificant and wide ranging.  The USA Patriot Act contains sweepinganti-money laundering and financial transparency laws and requires variousregulations applicable 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

 

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

 

TheBank implemented 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**

 

Commercialbanking organizations, such as the Bank, may be subject to enforcement actionsby the FDIC and the DFI for engaging in unsafe or unsound practices in theconduct of their businesses or for violations of any law, rule, regulation orany condition imposed in writing by the agency or any written agreement withthe agency.  Enforcement actions may include the imposition of aconservator or receiver, the issuance of a cease-and-desist order that can bejudicially enforced, the termination of insurance of deposits, the impositionof civil money penalties, the issuance of directives to increase capital, theissuance of formal and informal agreements, the issuance of removal andprohibition orders against institution-affiliated parties and the imposition ofrestrictions and sanctions under the prompt corrective action provisions of theFDICIA.

 

The Bank has been in discussions with the FDIC regarding the issuanceof a cease-and-desist order.  For moreinformation, please see Footnote 17 to the consolidated financial statementsincluded elsewhere herein.

 

**Californiaand Federal Change in Bank Control Laws**

 

TheFederal Change in Bank Control Act of 1978 prohibits a person or group ofpersons “acting in concert” from acquiring “control” of a bank or holdingcompany unless the appropriate federal regulatory agency has been given 60 days’prior written notice of such proposed acquisition 

 

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and, within that timeperiod, has not issued a notice disapproving the proposed acquisition orextending for up to another 30 days the period during which such a disapprovalmay be issued. An acquisition may be made prior to the expiration of thedisapproval period if the agency issues written notice of its intent not to disapprovethe action.  The acquisition of more than 10% of a class of voting stockof a bank (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.

 

Underthe California 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 under this state law if such person,directly or indirectly, has the power (i) to vote 25% or more of thevoting power of the Corporation or (ii) to direct or cause the directionof the management and policies of the Corporation.  For purposes of thislaw, a person who directly or indirectly owns or controls 10% or more of theCommon stock would be presumed to control the Corporation, subject to rebuttal.

 

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 the Corporationnor the Bank makes any material expenditures for research and development.

 

**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.****                                       RISKFACTORS**

 

**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.

 

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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, assetclasses and sectors.

 

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, lowercorporate earnings, lower business investment and lower consumer spending, thedemand for our financial products could be adversely affected. Adverse changesin the economy could affect earnings negatively and could have a materialadverse effect on our business, results of operations and financialcondition.  The current mortgage crisisand economic slowdown has also raised the possibility of future legislative andregulatory actions in addition to the recent enactment of EESA that couldfurther impact our business. We cannot predict whether or when such actions mayoccur, or what impact, if any; such actions could have on our business, resultsof operations and 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 Treasury has the authority to utilize up to $700billion to purchase distressed assets from financial institutions or infusecapital into financial institutions for the purpose of stabilizing thefinancial markets.  The 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, financialcondition and results of operations, or the trading price of our common stock.

 

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**WE MAY BE REQUIRED TO PAY SIGNIFICANTLYHIGHER FEDERAL DEPOSIT INSURANCE CORPORATION (FDIC) 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, 2009.  These developments will cause the premiumsassessed to us by the FDIC to increase.

 

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 rates willincrease 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 interim rule also allows the FDIC to impose a special emergencyassessment after June 30, 2009, of up to 10 basis points if necessary tomaintain public confidence in FDIC insurance. These higher FDIC assessmentrates and special assessments could have an adverse impact on our results ofoperations.

 

**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 inresponding to concerns and trends identified in examinations, including theexpected issuance of many formal enforcement orders.  Negative developments in the financialindustry and the domestic and international credit markets, and the impact ofnew legislation in response to those developments, may negatively impact ouroperations by restricting our business operations, including our ability tooriginate or sell loans, and may adversely 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 

 

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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.

 

**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 futureperiods exceed the allowance for possible loan losses, the Corporation willneed additional provisions to increase the allowance for possible loanlosses.  Any increases in the allowancefor possible loan losses will result in a decrease in net income and, possibly,capital, and may have a material adverse effect on the Corporation’s financialcondition and results 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 

 

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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.  Environmentallaws may require the Corporation to incur substantial expenses and maymaterially reduce the affected property’s value or limit the Corporation’sability to use or sell the affected property. In addition, 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, capital structure,investment practices, dividend policy and growth, among other things. Congressand federal regulatory agencies continually review banking laws, regulationsand policies for possible changes. Changes to statutes, regulations or regulatory policies, includingchanges in interpretation or implementation of statutes, regulations orpolicies, could affect the Corporation in substantial and unpredictableways.  Such changes could subject theCorporation to additional costs, limit the types of financial services andproducts the Corporation may offer and/or increase the ability of non-banks tooffer competing financial services and products, among other things.  Failure to comply with laws, regulations orpolicies could result in sanctions by regulatory agencies, civil moneypenalties and/or reputation damage, which could have a material adverse effecton the Corporation’s business, financial condition and results of operations.

 

**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.**

 

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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.

 

**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, the trading volumein 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 stockholders.  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.

 

**ITEM 1B.****                                       UNRESOLVEDSTAFF COMMENTS.**

 

None.

 

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

 

The main office ofthe Bank, which also serves as the principal office of the Corporation, islocated 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 owned by the Bank**.**  The Bank also owns a building located at 556Abrego St., Monterey, California 93940, which houses a loan production officeand additional office space.  The Bankcurrently operates four branch offices in Carmel-By-The-Sea, Carmel Valley,Pacific Grove and Salinas, California, all within approximately 20 miles fromthe Bank’s main office.  The land andimprovements dedicated to the Carmel-By-The-Sea, Carmel Valley, Pacific Groveand Salinas branch offices are leased. See Footnote 13 to the Corporation’s financial statements includedherewith.

 

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.****                                                LEGALPROCEEDINGS**

 

The Corporation, the Bank and Charles T. Chrietzberg, Jr. were named as defendants in a lawsuit filed November 3, 2008 in the Monterey County Court-Civil Division by Golden State Bank.  The lawsuit involves claims related to loan participations purchased by Golden State Bank from Monterey County Bank.  The lawsuit seeks to compel arbitration of the issues, rescission of the participation agreements, payment of all principal and interest, damages, attorneys’ fees and costs.

 

The defendants have reviewed the lawsuit, categorically deny all of the allegations and will vigorously defend the suit.  The parties have agreed to have this matter decided by binding arbitration.

 

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

 

The Bank has reviewed the lawsuit, categorically denies all of the allegations, believes it gave proper notice, and will vigorously defend the suit.

 

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.****                                                SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS**

 

On October 28, 2008, the Board of Directors unanimously approved,and the holders of more than a majority of our issued and outstanding CommonStock approved by written consent, an amendment to the Corporation’s Articlesof Incorporation (the “Amendment”).  TheAmendment authorizes the Corporation to issue up to 10,000,000 shares ofpreferred stock, which may be issued 

 

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fromtime to time in one or more series as determined by the Board ofDirectors.  The Board of Directors isauthorized to designate all rights, preferences, privileges and restrictionsattendant to each series as well as the number of shares authorized forissuance in each series, which matters shall be expressed in resolutionsadopted by the Board of Directors and filed with the Secretary of State of theState of California.  Additionally, theAmendment authorizes the Corporation to issue an additional 7,500,000 shares ofCommon Stock for a total of 10,000,000 shares of Common Stock authorized forissuance after the Amendment.

 

The Amendment became effective January 23, 2009.

 

**PART II**

 

**ITEM 5.****                                                MARKETFOR THE COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER OF PURCHASES OFEQUITY SECURITIES**

 

The Corporation’s stock is traded on the OTCBB (over-the-counterbulletin board) a quotation service for securities not listed or tradedon NASDAQ or a national securities exchange, stock symbol “NRLB.”  TheCorporation also has knowledge of a limited number of transactions conductedbetween individual shareholders.

 

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

 

At December 31, 2008, there were 530 record holders ofcommon stock of the Corporation. This does not reflect the number of persons orentities who hold their stock in nominee or street name through variousbrokerage firms.

 

The Corporation repurchased 46,010 shares of common stock at an averageof $7.41 per share in 2008; no shares were repurchased in 2007 or 2006.

 

The following table sets forth, according to information known to theCorporation, the price paid per share in, and volume of, transactions in theCorporation’s stock during the quarters ended March 31, 2006 to December 31,2008.

 
| **Quarter/Year**    | ** ** | **Price**   | ** ** | **Volume ****(1)** | ** ** |
|---------------------|------------|-------------|------------|-------------------------|------------|
|                |       |        |       |                    |       |
| 1st quarter of 2006 |       | 7.70-10.70  |       | 13,941                  |       |
| 2nd quarter of 2006 |       | 8.00-12.15  |       | 902                     |       |
| 3rd quarter of 2006 |       | 8.00-13.05  |       | 1,593                   |       |
| 4th quarter of 2006 |       | 8.00-13.25  |       | 5,452                   |       |
|                |       |        |       |                    |       |
| 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                  |       |

 

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(1)        For the period presented, the information indicated might not includeinformation on shares which may have been traded directly by shareholders orthrough dealers.

 

The principal source of cash flow of the Corporation, including cashflow to pay dividends on its stock or principal and interest on debt, isinterest 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 theCorporation, 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 nonotice or hearing), that such institution or holding company cease and desistfrom such 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 Act of 1991 (“FDICIA”), an FDIC insured depositoryinstitution may not pay any dividend if payment would cause it to becomeundercapitalized or once it is undercapitalized.

 

The Bank’s payment of dividends, as a California chartered commercialbanking corporation, is 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 to the stockholders made during suchperiod).  As of December 31, 2008the Bank had $14,822,000 in retained earnings. The Bank’s net income for the last three fiscal years less distributionsto stockholders was $7,704,000.

 

In December 2008, 2007 and 2006 theCorporation paid cash dividends of $0.25, $0.25 and $0.35 per share,respectively.  The Bank paid cashdividends totaling $800,000 and $625,000 to the Corporation during 2007 and2006, respectively; no dividends were paid in 2008.

 

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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)** | ** ** | **2008**                                                                               | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Five-Year Selected  Financial Data                                              |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Summary of  Operating Results:                                                  |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Total interest  income                                                          |       | $                                                                                      | 16,500     |   | $ | 16,941 |   | $ | 13,760 |   | $ | 10,691 |   | $ | 7,355 |   |
| Total interest  expense                                                         |       | 9,749                                                                                  |       | 8,002 |   | 5,197 |   | 3,672 |   | 2,435 |   |
| Net interest  income                                                            |       | 6,751                                                                                  |       | 8,939 |   | 8,563 |   | 7,019 |   | 4,920 |   |
| Provision for  possible loan losses                                             |       | 1,132                                                                                  |       | 865 |   | 410 |   | 150 |   | 185 |   |
| Net interest  income after provision for loan losses                            |       | 5,619                                                                                  |       | 8,074 |   | 8,153 |   | 6,869 |   | 4,735 |   |
| Total  non-interest income                                                      |       | 5,031                                                                                  |       | 4,336 |   | 7,177 |   | 4,362 |   | 4,227 |   |
| Total  non-interest expenses                                                    |       | 8,907                                                                                  |       | 9,005 |   | 8,627 |   | 7,813 |   | 7,116 |   |
| Income before  taxes                                                            |       | 1,743                                                                                  |       | 3,405 |   | 6,703 |   | 3,419 |   | 1,846 |   |
| Provision for  income taxes                                                     |       | 281                                                                                    |       | 1,476 |   | 2,866 |   | 1,489 |   | 781 |   |
| Net income                                                                      |       | $                                                                                      | 1,462      |   | $ | 1,929 |   | $ | 3,837 |   | $ | 1,929 |   | $ | 1,065 |   |
| Per Common Share  Data:                                                         |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Net income -  Primary (1)                                                       |       | $                                                                                      | 0.80       |   | $ | 1.08 |   | $ | 2.31 |   | $ | 1.20 |   | $ | 0.68 |   |
| Net income -  Diluted (2)                                                       |       | 0.79                                                                                   |       | 1.03 |   | 2.09 |   | 1.00 |   | 0.56 |   |
| Book value, end  of period                                                      |       | 7.96                                                                                   |       | 7.82 |   | 7.20 |   | 5.55 |   | 4.55 |   |
| Avg shares  outstanding (3)                                                     |       | 1,890,591                                                                              |       | 1,785,812 |   | 1,658,675 |   | 1,614,196 |   | 1,576,589 |   |
| Balance Sheet  Data:                                                            |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Total loans, net  of unearned income (4)                                        |       | $                                                                                      | 167,180    |   | $ | 168,748 |   | $ | 130,050 |   | $ | 107,300 |   | $ | 95,036 |   |
| Total assets                                                                    |       | 306,201                                                                                |       | 253,865 |   | 190,570 |   | 162,701 |   | 134,039 |   |
| Total deposits                                                                  |       | 189,730                                                                                |       | 167,333 |   | 131,628 |   | 118,120 |   | 97,263 |   |
| Shareholders’  equity                                                      |       | 14,352                                                                                 |       | 14,434 |   | 12,402 |   | 8,931 |   | 7,321 |   |
| Return on  average assets (5) (6)                                          |       | 0.54                                                                                   | %          | 0.91 | % | 2.24 | % | 1.24 | % | 0.88 | % |
| Return on  average shareholders’ equity (5) (6)                       |       | 10.67                                                                                  | %          | 14.09 | % | 34.94 | % | 24.15 | % | 15.35 | % |
| Dividend payout  ratio                                                          |       | 30.78                                                                                  | %          | 23.90 | % | 15.72 | % | 16.90 | % | 24.88 | % |
| Net interest  spread                                                            |       | 2.45                                                                                   | %          | 4.07 | % | 4.82 | % | 4.63 | % | 4.02 | % |
| Net yield on  interest earning assets (5)                                       |       | 2.87                                                                                   | %          | 4.69 | % | 5.58 | % | 5.09 | % | 4.47 | % |
| Avg  shareholders’ equity to average assets (5)                            |       | 5.04                                                                                   | %          | 6.44 | % | 6.40 | % | 5.15 | % | 5.75 | % |
| Risked-Based  capital ratios                                                    |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Tier 1                                                                          |       | 8.80                                                                                   | %          | 9.23 | % | 9.50 | % | 9.50 | % | 8.22 | % |
| Total                                                                           |       | 12.31                                                                                  | %          | 12.63 | % | 14.90 | % | 14.90 | % | 14.83 | % |
| Total loans to  total deposits at end of period (4)                             |       | 88.11                                                                                  | %          | 100.85 | % | 98.80 | % | 90.84 | % | 97.71 | % |
| Allowance for  loan losses to total loans at end of period (4)                  |       | 1.42                                                                                   | %          | 1.19 | % | 1.07 | % | 1.02 | % | 1.00 | % |
| Nonperforming  loans to total loans at end of period (4)                        |       | 4.18                                                                                   | %          | 1.98 | % | 0.12 | % | 0.00 | % | 0.04 | % |
| Net charge-offs  to average loans (4)                                           |       | 0.45                                                                                   | %          | 0.17 | % | 0.09 | % | 0.01 | % | 0.00 | % |

 

----

(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 1,823,965 for 2008, 

 

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1,785,812 for 2007,1,658,675 for 2006, 1,614,196 for 2005 and 1,576,589 for 2004.

 

(2)        Fullydiluted earnings per share amounts were computed on the basis of the weightedaverage number of shares of common stock and common stock equivalents outstandingduring the year.  Common stockequivalents include employee stock options. The weighted average number of shares used for this computation was1,848,173, 1,881,004, 1,831,892, 1,923,532 and 1,919,512 in 2008, 2007, 2006,2005 and 2004, respectively.

 

(3)        Weightedaverage common shares.

 

(4)        Includesloans being held for sale.

 

(5)        Averagesare of daily balances.

 

**ITEM 7.****                                               ****MANAGEMENT’S DISCUSSION ANDANALYSIS 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 $1,462,000 in 2008,$1,929,000 in 2007, and $3,837,000 in 2006. The primary net income per share for each of the last three years was$0.80, $1.08, and $2.31 respectively. The diluted net income per share for the same time periods was $.079,$1.03 and $2.09, respectively.  Return onaverage shareholders’ equity was 10.67%, 14.09% and 34.94% in 2008, 2007 and2006, respectively.  Return on averageassets was 0.54%, 0.91%, and 2.24% in 2008, 2007 and 2006, respectively.

 

The decrease in earnings in 2008 was due to a decrease of $2,455,000 innet interest income after provision for loan losses, partially offset by anincrease in non-interest income of $695,000, and decreases of $98,000 innon-interest expense and $1,195,000 in income tax expense.

 

The decrease in earnings in 2007 was due to decreases of $79,000 in netinterest income after provision for loan losses, $2,841,000 in non-interestincome and $1,390,000 in income tax expense; while non-interest expenseincreased $378,000.

 

The increase in earnings in 2006 was due to increases of $1,284,000 innet interest income after provision for loan losses, $2,815,000 in non-interestincome, $814,000 in non-interest expense and $1,377,000 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 reportedamount of assets, liabilities, income and expenses in the Corporation’sfinancial statements 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 31,2008.

 

Variouselements of the Corporation’s accounting policies, by their nature, areinherently subject to estimation techniques, valuation assumptions and othersubjective assessments.  Critical 

 

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accounting policies arethose that involve the most complex and subjective decisions and assessmentsand have the greatest potential impact of the Corporation’s results ofoperation.  In particular, management has identified one accounting policythat, due to judgments, estimates and assumptions inherent in this policy, andthe sensitivity 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 31,2008 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 theallowance for loan losses see “Provision and Allowance for Loan 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 of interestearning assets portfolio, the availability of particular sources of funds and changesin prevailing interest rates.

 

The following tablesummarizes the Corporation’s net interest income.

 
| ** **           | ** ** | **Years Ended**                 | ** ** | **Increase (Decrease)**  | ** ** |
|----------------------|------------|--------------------------------------|------------|-------------------------------|------------|
| ** **           | ** ** | **December 31,**                | ** ** | **From Prior Year** | ** ** |
| ** **           | ** ** | **2008**                             | ** ** | **2007**                      | ** ** | **2006** | ** ** | **2008/2007** | ** ** | **2007/2006** | ** ** |
| ** **           | ** ** | ** **                           | ** ** | ** **                    | ** ** | ** ** | ** ** | **Amt** | ** ** | **%** | ** ** | **Amt** | ** ** | **%** | ** ** |
| ** **           | ** ** | **(Dollars in thousands)** | ** ** |
| Interest Income      |       | $                                    | 16,500     |                          | $          | 16,941 |   | $ | 13,760 |   | $ | (441 | ) | (2.60 | ) | $ | 3,181 |   | 23.1 |   |
| Interest Expense     |       | 9,749                                |       | 8,002                         |       | 5,197 |   | 1,747 |   | 21.8 |   | 2,805 |   | 54.0 |   |
| Net Interest  Income |       | $                                    | 6,751      |                          | $          | 8,939 |   | $ | 8,563 |   | $ | (2,188 | ) | (24.5 | ) | $ | 376 |   | 4.4 |   |

 

Net interest incomedecreased $2,188,000 or 24.5% from 2007 to 2008.  Average interest-bearing 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, the resultof a 33.04% increase in average interest-bearing liabilities, while the averagerate paid decreased 40 basis points.

 

Net interest incomeincreased $376,000 or 4.4% from 2006 to 2007. Average interest-bearing assets increased 23.71%, while the average rateearned decreased 8 basis points, resulting in an increase of $3,181,000 intotal interest income.  Interest expenseincreased $2,805,000, the result of a 32.02% increase in averageinterest-bearing liabilities, while the average rate paid increased 68 basispoints.

 

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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, 2008, 2007 and 2006 (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 $378,000, $148,000 and $149,000in 2008, 2007 and 2006, 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,** | ** ** |
|--------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                         | ** ** | **2008**                                             | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                                         | ** ** | ** **                                           | ** ** | **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                                                              |       | $                                                    | 166,960    |   | $ | 12,297 |   | 7.37 | % | $ | 146,944 |   | $ | 14,442 |   | 9.83 | % | $ | 118,699 |   | $ | 11,953 |   | 10.07 | % |
| Time deposits -  in other banks                                    |       | 1,306                                                |       | 29 |   | 2.22 | % | 1,359 |   | 66 |   | 4.86 | % | 1,000 |   | 50 |   | 5.00 | % |
| Investment  securities — taxable                              |       | 55,039                                               |       | 3,123 |   | 5.67 | % | 28,777 |   | 1,628 |   | 5.66 | % | 15,145 |   | 705 |   | 4.66 | % |
| Investment  securities — nontaxable                           |       | 16,667                                               |       | 1,218 |   | 7.31 | % | 7,260 |   | 477 |   | 6.57 | % | 7,019 |   | 480 |   | 6.84 | % |
| Federal funds  sold                                                |       | 8,384                                                |       | 211 |   | 2.52 | % | 9,401 |   | 476 |   | 5.06 | % | 14,745 |   | 721 |   | 4.89 | % |
| Total  interest-earning assets                                     |       | 248,356                                              |       | 16,878 |   | 6.80 | % | 193,741 |   | 17,089 |   | 8.82 | % | 156,608 |   | 13,909 |   | 8.88 | % |
|                                                               |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Allowance for  credit losses                                       |       | (2,090                                               | )          |   |   |   |   | (1,471 | ) |   |   |   |   | (1,162 | ) |   |   |   |   |
| Non-interest  bearing assets:                                      |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash and due from  banks                                           |       | 7,973                                                |       |   |   |   |   | 6,663 |   |   |   |   |   | 5,187 |   |   |   |   |   |
| Premises and  equipment                                            |       | 5,000                                                |       |   |   |   |   | 4,867 |   |   |   |   |   | 4,441 |   |   |   |   |   |
| Accrued interest  receivable                                       |       | 1,555                                                |       |   |   |   |   | 1,139 |   |   |   |   |   | 797 |   |   |   |   |   |
| Other assets                                                       |       | 10,754                                               |       |   |   |   |   | 7,689 |   |   |   |   |   | 5,726 |   |   |   |   |   |
| Total average  assets                                              |       | $                                                    | 271,548    |   |   |   |   |   | $ | 212,618 |   |   |   |   |   | $ | 171,597 |   |   |   |   |   |
|                                                               |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Liabilities and  Shareholders’ Equity:                        |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest Bearing  Liabilities:                                     |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  demand                                           |       | $                                                    | 14,239     |   | $ | 36 |   | 0.25 | % | $ | 14,564 |   | $ | 37 |   | 0.25 | % | $ | 13,243 |   | $ | 41 |   | 0.31 | % |
| Money market  savings                                              |       | 1,735                                                |       | 12 |   | 0.69 | % | 1,732 |   | 12 |   | 0.69 | % | 3,589 |   | 27 |   | 0.75 | % |
| Savings deposits                                                   |       | 6,477                                                |       | 66 |   | 1.02 | % | 4,759 |   | 49 |   | 1.03 | % | 7,355 |   | 74 |   | 1.01 | % |
| Time deposits  >$100M                                           |       | 58,787                                               |       | 2,717 |   | 4.62 | % | 46,609 |   | 2,405 |   | 5.16 | % | 32,372 |   | 1,479 |   | 4.57 | % |
| Time deposits  <$100M                                           |       | 74,469                                               |       | 3,379 |   | 4.54 | % | 50,814 |   | 2,589 |   | 5.10 | % | 33,174 |   | 1,369 |   | 4.13 | % |
| Other Borrowing                                                    |       | 68,463                                               |       | 3,539 |   | 5.17 | % | 50,017 |   | 2,910 |   | 5.82 | % | 37,894 |   | 2,207 |   | 5.82 | % |
| Total  interest-bearing liabilities                                |       | 224,170                                              |       | 9,749 |   | 4.35 | % | 168,495 |   | 8,002 |   | 4.75 | % | 127,627 |   | 5,197 |   | 4.07 | % |
|                                                               |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Non-interest  bearing liabilities:                                 |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  checking                                      |       | 28,310                                               |       |   |   |   |   | 27,087 |   |   |   |   |   | 30,155 |   |   |   |   |   |
| Accrued interest  payable                                          |       | 1,934                                                |       |   |   |   |   | 1,628 |   |   |   |   |   | 995 |   |   |   |   |   |
| Other liabilities                                                  |       | 3,435                                                |       |   |   |   |   | 1,731 |   |   |   |   |   | 1,838 |   |   |   |   |   |
| Total Liabilities                                                  |       | 257,849                                              |       |   |   |   |   | 198,941 |   |   |   |   |   | 160,615 |   |   |   |   |   |
| Total  shareholders’ equity                                   |       | 13,699                                               |       |   |   |   |   | 13,687 |   |   |   |   |   | 10,982 |   |   |   |   |   |
| Total average  liabilities and                                     |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Shareholders’  equity                                         |       | $                                                    | 271,548    |   |   |   |   |   | $ | 212,618 |   |   |   |   |   | $ | 171,597 |   |   |   |   |   |
| Net interest  income                                               |       |                                                 |       | $ | 7,129 |   |   |   |   |   | $ | 9,087 |   |   |   |   |   | $ | 8,712 |   |   |   |
| Interest expense  as a percentage of Total interest-earning assets |       |                                                 |       |   |   | 3.93 | % |   |   |   |   | 4.13 | % |   |   |   |   | 3.32 | % |
| Net yield on  interest earning assets                              |       |                                                 |       |   |   | 2.87 | % |   |   |   |   | 4.69 | % |   |   |   |   | 5.56 | % |
| Net interest  spread                                               |       |                                                 |       |   |   | 2.45 | % |   |   |   |   | 4.07 | % |   |   |   |   | 4.81 | % |

 

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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, 2008 compared with the sameperiod in 2007 and for the year ended December 31, 2007 compared with thesame period in 2006.

 
| ** **                                   | ** ** | **Increase (decrease) in the twelve months 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 | ) |

 
| ** **                                   | ** ** | **Increase (decrease) in the twelve months ended**         | ** ** |
|----------------------------------------------|------------|------------------------------------------------------------------------------------------|------------|
| ** **                                   | ** ** | **December 31, 2007 compared with December 31, 2006** | ** ** |
| **(dollars in thousands)**         | ** ** | **Volume**                                                                               | ** ** | **Rate** | ** ** | **Total** | ** ** |
| Increase  (decrease) in interest income:     |       |                                                                                     |       |   |   |   |   |
| Loans                                        |       | $                                                                                        | 2,844      |   | $ | (355 | ) | $ | 2,489 |   |
| Time deposits -  in other banks              |       | 18                                                                                       |       | (2 | ) | 16 |   |
| Invest securities  — taxable            |       | 635                                                                                      |       | 288 |   | 923 |   |
| Invest  securities — nontaxable         |       | 16                                                                                       |       | (19 | ) | (3 | ) |
| Federal funds  sold                          |       | (261                                                                                     | )          | 16 |   | (245 | ) |
| Total  interest-earning assets               |       | 3,252                                                                                    |       | (72 | ) | 3,180 |   |
|                                         |       |                                                                                     |       |   |   |   |   |
| Increase  (decrease) in interest expense:    |       |                                                                                     |       |   |   |   |   |
| Interest-bearing  demand                     |       | 4                                                                                        |       | (8 | ) | (4 | ) |
| Money market  savings                        |       | (14                                                                                      | )          | (1 | ) | (15 | ) |
| Savings deposits                             |       | (26                                                                                      | )          | 1 |   | (25 | ) |
| Time deposits  >$100M                     |       | 650                                                                                      |       | 276 |   | 926 |   |
| Time deposits  <$100M                     |       | 728                                                                                      |       | 492 |   | 1,220 |   |
| Other borrowing                              |       | 706                                                                                      |       | (3 | ) | 703 |   |
| Total  interest-bearing liabilities          |       | 2,048                                                                                    |       | 757 |   | 2,805 |   |
| Increase  (decrease) in net interest expense |       | $                                                                                        | 1,204      |   | $ | (829 | ) | $ | 375 |   |

 

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**PROVISIONAND ALLOWANCE FOR LOAN LOSSES**

 

TheCorporation maintains a detailed, systematic analysis and procedural disciplineto determine the amount of the allowance for loan losses (“ALL”).  TheALL 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 ALL on a monthly basis and makes adjustingentries quarterly. The review of the adequacy of the allowance takes intoconsideration such factors as concentrations of credit, changes in the growth,size and composition of the loan portfolio, overall and individual portfolioquality, review of specific problem loans, collateral, guarantees and economicconditions that may affect the borrowers’ ability to pay and/or the value ofthe underlying collateral.  Additional factors considered include:geographic location of borrowers, changes in the Corporation’s product-specificcredit policy and lending staff experience.  These estimates dependon subjective factors and, therefore, contain inherent uncertainties.

 

TheCorporation’s ALL 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 ALL.

 

Although no assurance canbe given that actual losses will not exceed the amount provided for in theallowance, Management believes that the allowance is adequate to provide forall estimated credit losses in light of all known relevant factors.  At the end of 2008, 2007 and 2006, the Bank’sallowance stood at 1.42%, 1.19%, and 1.07% of gross loans, respectively.  Provisions were made to the allowance forloan losses in 2008, 2007 and 2006 of $1,132,000, $865,000, and $410,000,respectively.  Loans charged off in 2008,2007 and 2006 totaled $750,000, $250,000 and $109,000, respectively.  Recoveries for these same periods were$3,000, $4,000, and $7,000, respectively.

 

The Bank’snon-performing (delinquent 90 days or more and on non-accrual) loans as apercentage of total loans were 4.18 percent 1.98 percent and 0.12 percent as ofthe end of 2008, 2007 and 2006, 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 non-interest income:

 
| ** **                                              | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                              | ** ** | **2008**                                    | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                              | ** ** | **(Dollars in thousands)**        | ** ** |
| Service charges  on deposit Accounts                    |       | $                                           | 760        |   | $ | 634 |   | $ | 547 |   |
| Gain on sale of  Pacific Coast Bankers’ Bank Stock |       | —                                      |       | — |   | 1,313 |   |
| Other service  charges, commissions and  fees           |       | 3,942                                       |       | 3,222 |   | 4,627 |   |
| Income from  sales and servicing of  SBA loans          |       | 329                                         |       | 480 |   | 690 |   |
|                                                    |       |                                        |       |   |   |   |   |
| Total  non-interest income                              |       | $                                           | 5,031      |   | $ | 4,336 |   | $ | 7,177 |   |

 

Total non-interest incomeincreased $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.

 

Total non-interest incomedecreased $2,841,000 or 39.58% in 2007 when compared with 2006.  The decrease resulted from the gain on saleof the Bank’s investment in Pacific Coast Bankers’ Bank of $1,313,000 reportedin 2006, decreases in other income of $1,405,000, and $210,000 in income fromsales and servicing of Small Business Administration Loans; partially offset byan increase in service charges on deposit accounts of $87,000.  The decrease in other income was dueprimarily to a $686,000 in losses on trading assets compared with a gain of$283,000 in 2006, and decreases of $624,000 in fee income from credit cardprograms, $191,000 in merchant discount fees and commercial banking originationfees decreased $104,000, while stored value card programs increased $218,000.

 

Total non-interest incomeincreased $2,815,000 or 64.84% in 2006 when compared with 2005.  The increase resulted from the gain on saleof the Bank’s investment in Pacific Coast Bankers’ Bank of $1,313,000, anincrease in other of $1,820,000, and decreases of $302,000 in income from salesand servicing of Small Business Administration Loans and $16,000 in servicecharges on deposit accounts.  Theincrease in other income was due primarily to a $50,000 mark to market gain ontrading assets compared with a $427,000 mark to market loss in 2005, andincreases of $1,100,000 in fee income from credit card programs, $272,000 inmerchant discount fees and $29,800 from stored value card programs, whilecommercial banking origination fees decreased $287,000.

 

The sale of SmallBusiness Administration (SBA) guaranteed loans is a significant contributor tothe Bank’s income.  SBA guaranteed loansyield up to 3.75% over the New York prime rate, and the guaranteed portions canbe sold at premiums which vary with market conditions.  SBA loans are guaranteed by the full faith ofthe United States Government up to 85 percent of the 

 

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principalamount.  The guaranteed portion has riskscomparable for an investor to a U. S. Government security and can usually besold in the secondary financial market, either at a premium or at a yield whichallows the Bank to maintain a significant spread for itself.

 

There can be noassurance that the gains on sale will continue at, or above, the levels realizedin the past three years.  The SmallBusiness Administration has recently increased the guarantee fees borrowersmust pay.  Increasing competition amonglenders for qualified SBA borrowers makes it difficult for the Bank tocontinually expand its program in this area, and may limit the level of premiumthat can be earned with regard thereto.

 

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

 
| **(Dollars in thousands)** | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|--------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| SBA loans  authorized                |       | $        | 3,235      |     | $          | 3,065    |       | $ | 3,645 |   |
| SBA loans sold                       |       | $        | 2,194      |     | $          | 1,933    |       | $ | 4,428 |   |

 

The following tablepresents a summary of income from sales and servicing of SBA loans for theyears ended December 31:

 
| **(Dollars in thousands)**                 | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Income from  premium                                 |       | $        | 142        |     | $          | 147      |       | $ | 350 |   |
| Income from  servicing                               |       | 187      |       | 333      |       | 340      |       |
| Total income  from sales and servicing  of SBA loans |       | $        | 329        |     | $          | 480      |       | $ | 690 |   |

 

**NON-INTERESTEXPENSES**

 

The following tablepresents a summary of other non-interest expense:

 
| ** **                       | ** ** | **Years  Ended  December 31,** | ** ** |
|----------------------------------|------------|---------------------------------------------------------|------------|
| ** **                       | ** ** | **2008**                                                | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                       | ** ** | **(Dollars in thousands)**                    | ** ** |
| Salaries and  benefits           |       | $                                                       | 3,664      |   | $ | 4,049 |   | $ | 3,854 |   |
| Occupancy and  equipment expense |       | 967                                                     |       | 866 |   | 790 |   |
| Professional  fees               |       | 164                                                     |       | 165 |   | 149 |   |
| Data processing                  |       | 360                                                     |       | 361 |   | 322 |   |
| Other expenses                   |       | 3,752                                                   |       | 3,564 |   | 3,512 |   |
| Total other  expenses            |       | $                                                       | 8,907      |   | $ | 9,005 |   | $ | 8,627 |   |

 

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 

 

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premiums.  Salary and benefitsexpense increased $195,000 in 2007 as a result the addition of a LoanProcessor, a full year’s salary for a Marketing Officer hired in November 2006and merit increases.  Salary and benefitsexpense increased $572,000 in 2006 as a result the addition of a MarketingOfficer, Business Development Officer and a Credit Analyst, increasedcommissions paid due to increased credit card and stored value card programrevenues, and merit increases and bonus payments.

 

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 reduction of $24,000 in sublease rentalincome; while merchant terminal expense decreased $24,000.  Occupancy and equipment expenses increased$76,000 in 2007, primarily due to increases of $17,000 in depreciation expense,$11,000 in premises rent, $12,000 in merchant terminal expense, $11,000 inrepairs and maintenance and $12,000 in storage facilities rent; while subleaserental income decreased $5,000. Occupancy and equipment expenses increased $125,000 in 2006, primarilydue to increases of $40,000 in net merchant terminal expense, $16,000 indepreciation expense, $11,000 in premises rent and $6,000 in property taxes;while sublease rental income decreased $45,000.

 

Data processing expense for 2008 was primarily unchanged when comparedto 2007.  Data processing expenseincreased $39,000 in 2007, the result of offering new services to customers andgrowth in the numbers of customer accounts. Data processing expense decreased $34,000 in 2006, the result ofcontinued efforts to implement more cost effective programs.

 

Professional fees for 2008 were primarily unchanged when compared to2007.  In 2007, professional feesincreased $16,000 due to increased legal fees. In 2006, professional fees increased $8,000 due to increased legal fees.

 

Other general and administrative expense for 2008 totaled $3,752,000compared with $3,564,000 for 2007, an increase of $188,000.  Significant changes occurred in the followingcategories with increases in merchant processing expense of $246,000, otherreal estate owned expense of $112,000, FDIC and state assessments of $88,000,ATM expense of $39,000, loan expenses of $29,000 and miscellaneous expense of$22,000; while decreases occurred in advertising of $61,000, businessdevelopment of $56,000, operational losses of $25,000, director fees of $24,000and entertainment and meals of $23,000.  The Bank reversed a reserve of $110,000 established for its liabilityassociated with the settlement by VISA of litigation brought by AmericanExpress and Discover.

 

Other general and administrative expense for 2007 totaled $3,564,000compared with $3,512,000 for 2006, an increase of $52,000.  The Bank established a reserve of $110,000for its potential liability associated with the settlement by VISA oflitigation brought by American Express and Discover.  Significant changes occurred in the followingcategories with increases in director fees of $72,000, business development of$47,000, stationary/supplies of $25,000 and entertainment and meals of $16,000;while decreases occurred in merchant processing expense of $126,000,advertising of $60,000, donations $52,000, operational losses of $51,000 andtravel $15,000.   Additionally noprovision for debt securities losses was made in 2007 compared with a credit of$110,000 in 2006.

 

Other general and administrative expense in 2006 totaled $3,512,000compared with $3,369,000 for 2005, an increase of $143,000.  Significant changes occurred in the followingcategories with increases in merchant processing expense of $104,000,advertising of $83,000, 

 

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operational expenses of $62,000, business development of $61,000,stationery/supplies of $42,000, loan expense of $36,000, travel expense of$23,000, bank fees of $21,000, dues and memberships of $13,000, and collectionexpense of $10,000; while decreases occurred in provision for debt securitieslosses of $229,000, provision for loss unfunded loan commitments of $71,000,director fees of $13,000, and meals of $10,000.

 

**INCOMETAXES**

 

In 2008, the provision forfederal and state income taxes was $281,000, while the provision was $1,476,000and $2,866,000 for 2007 and 2006, respectively. This represents 16.12% of income before taxes in 2008, 43.35% in 2007and 42.76% in 2006.  The decrease in theeffective tax rate for 2008 is a direct result of the Bank’s investing intax-exempt securities, losses on trading assets deferred for tax purposes, anda decrease in the valuation allowance.

 

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 67.23% of average earningassets, and 61.80% of average total assets during 2008, compared with 75.85%and 69.11%, respectively during 2007.  In2008, average loans increased 13.62% from $146,944,000 in 2007 to$166,960,000.  Average real estate loansincreased $17,314,000 or 17.89%, average commercial loans increased $2,799,000or 9.88% and average installment loans increased $193,000 or 27.82%; whileaverage construction loans decreased $290,000 or 1.37%.

 

Loans,the largest component of earning assets, represented 75.85% of average earningassets, and 69.11% of average total assets during 2007, compared with 75.79%and 69.17%, respectively during 2006.  In2007, average loans increased 23.80% from $118,699,000 in 2006 to$146,944,000.  Average real estate loansincreased $16,590,000 or 20.69%, average construction loans increased $9,117,000or 75.89%, average commercial loans increased $2,687,000 or 10.48%; whileaverage installment loans decreased $149,000 or 17.68%.

 

Loan policies and proceduresprovide the overall direction to the administration of the loan portfolio.  The Bank’s loan underwriting process isintended to encourage sound and consistent credit decisions are made.  Emphasis is placed upon credit quality, theborrower’s ability to repay through cash flow, secondary and (occasionallytertiary) repayment sources, and the value of collateral.

 

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.

 

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The Bank is therecognized leader for SBA lending in Monterey County, and holds SBA’s covetedPreferred Lender Status.  Generally, SBAloans are guaranteed by the SBA for up to 85 percent of their principal amount,which can be retained in portfolio or sold to investors.  Such loans are made at floating interestrates, but generally for longer terms (up to 25 years) than are available on aconventional basis to small businesses.  The unguaranteed portion of theloans, although generally supported by collateral, is considered to be morerisky than conventional commercial loans because they may be based upon creditstandards the Bank would not otherwise apply, such as lower cash flow coverage,or longer repayment terms.

 

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 percent of thefair market value of real property (or more if the loan is insured either byprivate mortgage insurers or governmental agencies).  In certain instances, the appraised value mayexceed the actual amount which could be realized on foreclosure, or declines inmarket value subsequent to making the loan can impair the Bank’s security.

 

Consumer loans are madefor the purpose of financing the purchase of various types of consumer goods,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:

 

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| ** **                             | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------|------------|---------------------------------------------|------------|
| ** **                             | ** ** | **2008**                                    | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                             | ** ** | **(Dollars in thousands)**        | ** ** |
| Commercial and  industrial             |       | $                                           | 29,887     |   | $ | 30,197 |   | $ | 27,543 |   | $ | 26,236 |   | $ | 23,854 |   |
| Construction                           |       | 16,040                                      |       | 23,396 |   | 17,326 |   | 10,456 |   | 7,373 |   |
| Real estate,  mortgage                 |       | 122,951                                     |       | 116,625 |   | 86,207 |   | 71,006 |   | 64,339 |   |
| Installment                            |       | 966                                         |       | 876 |   | 694 |   | 942 |   | 622 |   |
| Government  guaranteed loans purchased |       | 24                                          |       | 32 |   | 39 |   | 45 |   | 51 |   |
|                                   |       | 169,868                                     |       | 171,126 |   | 131,809 |   | 108,685 |   | 96,239 |   |
| Allowance for  loan losses             |       | (2,413                                      | )          | (2,028 | ) | (1,409 | ) | 1,101 | ) | (963 | ) |
| Deferred  origination fees, net        |       | (275                                        | )          | (350 | ) | (350 | ) | (284 | ) | (240 | ) |
|                                   |       |                                        |       |   |   |   |   |   |   |   |   |
| Loans, net                             |       | $                                           | 167,180    |   | $ | 168,748 |   | $ | 130,050 |   | $ | 107,300 |   | $ | 95,036 |   |

 

The followingtable shows the maturity distribution and repricing intervals of the Bank’soutstanding loans at December 31, 2008. Balances of fixed rate loans are displayed in the column representativeof the loan’s stated maturity date.  Balancesfor variable rate loans are displayed in the column representative of the loan’snext interest rate change.

 

Loan Maturitiesand Repricing Schedule

(Dollars inthousands)

 
| ** **                                             | ** ** | **Within One  Year** | ** ** | **After One But  Within Five  Years** | ** ** | **After Five  Years** | ** ** | **Total** | ** ** |
|--------------------------------------------------------|------------|---------------------------|------------|------------------------------------------------------|------------|----------------------------|------------|-----------|------------|
| Construction                                           |       | $                         | 16,040     |                                                 | $          | —                     |       | $         | —     |   | $ | 16,040 |   |
| Commercial,  industrial and guaranteed loans purchased |       | 21,757                    |       | 4,922                                                |       | 3, 232                     |       | 29,911    |       |
| Real estate                                            |       | 39,989                    |       | 52,262                                               |       | 30,700                     |       | 122,951   |       |
| Installment                                            |       | 718                       |       | 132                                                  |       | 116                        |       | 966       |       |
| Total gross  loans                                     |       | $                         | 78,504     |                                                 | $          | 57,315                     |       | $         | 34,048     |   | $ | 169,868 |   |
| Loans with  variable (floating) interest rates         |       | $                         | 63,619     |                                                 | $          | 4,186                      |       | $         | —     |   | $ | 67,805 |   |
| Loans with  predetermined (fixed) interest rates       |       | $                         | 14,886     |                                                 | $          | 53,129                     |       | $         | 34,048     |   | $ | 102,063 |   |

 

**LoanConcentrations**

 

The Corporationhas concentration in real estate secured loans. At December 31, 2008 loans secured by real estate totaled$122,951,000, or 72.38% of the total loan portfolio, compared to $116,625,000,or 68.15%, at December 31, 2007. 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$125,650,000, or 73.97%, located in this area at December 31, 2008compared to $136,326,000, or 79.64%, at December 31, 2007.

 

Concentration of loansfor specific industries and their percentage of total loans at December 31,2008 and 2007 are as follows:

 

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| ** **                                        | ** ** | **2008** | ** ** | **2007** | ** ** |
|---------------------------------------------------|------------|----------|------------|----------|------------|
| Real estate                                       |       | 20.42    | %          | 28.19    | %          |
| Accommodation  and food                           |       | 22.00    | %          | 17.85    | %          |
| Finance and  insurance                            |       | 12.20    | %          | 10.30    | %          |
| Professional,  scientific, and technical services |       | 10.97    | %          | 8.98     | %          |

 

**Non-performingand Non-accrual Loans**

 

The Bank’s present policyis to cease accruing interest on loans which are past due as to principal orinterest 90 days or more, except for loans which are well secured or whencollection 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 income unlessadequate collateral from which to collect the principal of and interest on, theloan 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”):

 
| ** **                                                              | ** ** | **As of December 31,** | ** ** |
|-------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                              | ** ** | **2008**                              | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                              | ** ** | **(Dollars in thousands)**  | ** ** |
| Accruing, past  due 90 days or more:                                    |       |                                  |       |   |   |   |   |   |   |   |   |
| Real Estate                                                             |       | $                                     | —     |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Commercial                                                              |       | —                                |       | — |   | — |   | — |   | — |   |
| Installment                                                             |       | —                                |       | — |   | — |   | — |   | — |   |
| Other                                                                   |       | —                                |       | — |   | — |   | — |   | — |   |
| Total accruing                                                          |       | —                                |       | — |   | — |   | — |   | — |   |
| Nonaccrual  Loans:                                                      |       |                                  |       |   |   |   |   |   |   |   |   |
| Real Estate                                                             |       | 6,876                                 |       | 3,200 |   | — |   | — |   | — |   |
| Commercial                                                              |       | 215                                   |       | 41 |   | — |   | — |   | 43 |   |
| Installment                                                             |       | —                                |       | 155 |   | 155 |   | — |   | — |   |
| Other                                                                   |       | —                                |       | — |   | — |   | — |   | — |   |
| Total nonaccrual                                                        |       | 7,091                                 |       | 3,396 |   | 155 |   | — |   | 43 |   |
| Total  nonperforming loans                                              |       | 7,091                                 |       | 3,396 |   | 155 |   | — |   | 43 |   |
| OREO                                                                    |       | 7,364                                 |       | — |   | — |   | — |   | — |   |
| Total  nonperforming assets                                             |       | $                                     | 14,455     |   | $ | 3,396 |   | $ | 155 |   | $ | —- |   | $ | 43 |   |
| Total loans end  of period                                              |       | 169,868                               |       | 171,126 |   | 131,809 |   | 108,685 |   | 96,239 |   |
|                                                                    |       |                                  |       |   |   |   |   |   |   |   |   |
| Ratio of  nonperforming loans to total loans at end of period           |       | 4.18                                  | %          | 1.98 | % | 0.12 | % | 0.00 | % | 0.04 | % |
|                                                                    |       |                                  |       |   |   |   |   |   |   |   |   |
| Ratio of  nonperforming assets to total loans and OREO at end of period |       | 8.17                                  | %          | 1.98 | % | 0.12 | % | 0.00 | % | 0.04 | % |

 

Interest income of $218,000 for the year ended December 31,2008, was recognized on the non-accruing and restructured loans listed in thetable above; whereas, interest income of $602,000 would have been recognizedunder their original terms.

 

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**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 these loans.  Also, “watch” category loans may includecredits 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’sphilosophy encourages loan officers to identify borrowers that should bemonitored in this fashion and believes this process ultimately results in theidentification of problem loans in a more timely fashion.

 

Management has identified $7,901,000 and $59,000of loans on its watch list, which were not included in impaired ornon-performing loans at December 31, 2008 and 2007, 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 losses for the years endedDecember 31, 2008, 2007, 2006, 2005 and 2004:

 
| ** **                                                                     | ** ** | **For the Years ended December 31,** | ** ** |
|--------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                     | ** ** | **2008**                                                      | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                     | ** ** | **(Dollars in thousands)**                          | ** ** |
| Average loans  outstanding                                                     |       | $                                                             | 166,960    |   | $ | 146,944 |   | $ | 18,699 |   | $ | 108,963 |   | $ | 86,870 |   |
|                                                                           |       |                                                          |       |   |   |   |   |   |   |   |   |
| Total loans  outstanding at end of the period                                  |       | $                                                             | 169,868    |   | $ | 171,126 |   | $ | 131,809 |   | $ | 108,685 |   | $ | 96,239 |   |
|                                                                           |       |                                                          |       |   |   |   |   |   |   |   |   |
| Allowance,  beginning of period                                                |       | $                                                             | 2,028      |   | $ | 1,409 |   | $ | 1,101 |   | $ | 963 |   | $ | 775 |   |
|                                                                           |       |                                                          |       |   |   |   |   |   |   |   |   |
| Loans charged off  during period:                                              |       |                                                          |       |   |   |   |   |   |   |   |   |
| Commercial                                                                     |       | 187                                                           |       | 249 |   | — |   | — |   | — |   |
| Installment                                                                    |       | —                                                        |       | 1 |   | 109 |   | 14 |   | — |   |
| Real Estate                                                                    |       | 563                                                           |       | — |   | — |   | — |   | — |   |
| Other                                                                          |       | —                                                        |       | — |   | — |   | — |   | — |   |
| Total charge  offs                                                             |       | 750                                                           |       | 250 |   | 109 |   | 14 |   | — |   |
|                                                                           |       |                                                          |       |   |   |   |   |   |   |   |   |
| Recoveries  during period:                                                     |       |                                                          |       |   |   |   |   |   |   |   |   |
| Commercial                                                                     |       | 3                                                             |       | — |   | — |   | — |   | — |   |
| Installment                                                                    |       | —                                                        |       | — |   | 7 |   | 2 |   | 3 |   |
| Real Estate                                                                    |       | —                                                        |       | — |   | — |   | — |   | — |   |
| Other                                                                          |       | —                                                        |       | 4 |   | — |   | — |   | — |   |
| Total recoveries                                                               |       | 3                                                             |       | 4 |   | 7 |   | 2 |   | 3 |   |
|                                                                           |       |                                                          |       |   |   |   |   |   |   |   |   |
| Net loans  charged off during the period                                       |       | 747                                                           |       | 246 |   | 102 |   | 12 |   | (3 | ) |
|                                                                           |       |                                                          |       |   |   |   |   |   |   |   |   |
| Additions to  allowance for possible loan losses                               |       | 1,132                                                         |       | 865 |   | 410 |   | 150 |   | 185 |   |
|                                                                           |       |                                                          |       |   |   |   |   |   |   |   |   |
| Allowance, end  of period                                                      |       | $                                                             | 2,413      |   | $ | 2,028 |   | $ | 1,409 |   | $ | 1,101 |   | $ | 963 |   |
|                                                                           |       |                                                          |       |   |   |   |   |   |   |   |   |
| Ratio of net  loans charged off to average loans outstanding during the period |       | 0.45                                                          | %          | 0.17 | % | 0.09 | % | 0.01 | % | 0.00 | % |
|                                                                           |       |                                                          |       |   |   |   |   |   |   |   |   |
| Ratio of  allowance to total loans at end of period                            |       | 1.42                                                          | %          | 1.19 | % | 1.07 | % | 1.02 | % | 1.00 | % |
|                                                                           |       |                                                          |       |   |   |   |   |   |   |   |   |
| Ratio of  nonperforming loans to allowance for loan losses at end of period    |       | 293.82                                                        | %          | 167.46 | % | 11.00 | % | N/A |   | 4.47 | % |

 

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The following tablesummarizes the allocation of the allowance for loan losses by loan type basedon the Bank’s methodology for evaluating its allowance, and the percent ofloans and leases in each category to total loans at the dates indicated.  Theallocation of individual categories of loans includes amounts applicable tospecifically identified as well as unidentified losses inherent in that segmentof the loan portfolio and will necessarily change whenever managementdetermines 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, 2008** | ** ** | **December 31, 2007**                                        | ** ** |
|--------------|------------|---------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **   | ** ** | **Amount**                      | ** ** | **Percent of  Loans in  Category to  Total Loans** | ** ** | **Amount** | ** ** | **Percent of  Loans in  Category to  Total Loans** | ** ** |
| Commercial   |       | $                               | 695        |                                                                   | 17.53      | % | $ | 607 |   | 17.69 | % |
| Construction |       | 207                             |       | 9.75                                                                   | %          | 243 |   | 14.22 | % |
| Real Estate  |       | 1,370                           |       | 72.15                                                                  | %          | 1,134 |   | 67.58 | % |
| Installment  |       | 31                              |       | 0.57                                                                   | %          | 28 |   | 0.51 | % |
| Unallocated  |       | 110                             |       | N/A                                                                    |       | 16 |   | N/A |   |
| Total        |       | $                               | 2,413      |                                                                   | 100.00     | % | $ | 2,028 |   | 100.00 | % |

 

**FUNDING SOURCES**

 

Average depositsincreased 26.42% to $184,017,000 in 2008 from $145,652,000 in 2007.  In 2008 average certificates of depositincreased 36.78%, average interest checking, money market and savings accountsas a group increased 6.63% and average demand deposits increased 4.52%.  Average certificates of deposit represented72.42% of average deposits in 2008 compared with 66.93% in 2007.  Average interest checking, money market andsavings accounts as a group were 12.20% of average deposits in 2008 comparedwith 14.46% in 2007.  Average demanddeposits represented 15.38% of average deposits in 2008 compared with 18.61% in2007.

 

The followingtable summarizes the distribution of average daily deposits and the averagedaily rates paid for the years ended December 31, 2008, 2007, 2006,respectively.

 
| ** **                     | ** ** | **Average Deposits**             | ** ** |
|--------------------------------|------------|---------------------------------------|------------|
| ** **                     | ** ** | ** **                            | ** ** | ** ** | ** ** | **For the year ended** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                     | ** ** | **For the year ended** | ** ** | **December 31, 2007** | ** ** | **For the year ended** | ** ** |
| ** **                     | ** ** | **December 31, 2008**       | ** ** | **($ in thousands)** | ** ** | **December 31, 2006** | ** ** |
| ** **                     | ** ** | **Average  Balance**                  | ** ** | **Average  Rate** | ** ** | **Average  Balance** | ** ** | **Average  Rate** | ** ** | **Average  Balance** | ** ** | **Average  Rate** | ** ** |
|                           |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| Non-interest-bearing  checking |       | $                                     | 28,310     |   |   |   | $ | 27,087 |   |   |   | $ | 30,155 |   |   |   |
|                           |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  demand       |       | 14,239                                |       | 0.25 | % | 14,564 |   | 0.25 | % | 13,243 |   | 0.31 | % |
| Money market  savings          |       | 1,735                                 |       | 0.69 | % | 1,732 |   | 0.75 | % | 3,589 |   | 0.75 | % |
| Savings deposits               |       | 6,477                                 |       | 1.02 | % | 4,759 |   | 1.03 | % | 7,355 |   | 1.00 | % |
| Time deposits  >$100M       |       | 58,787                                |       | 4.62 | % | 46,609 |   | 5.16 | % | 32,372 |   | 4.57 | % |
| Time deposits <$100M        |       | 74,469                                |       | 4.54 | % | 50,814 |   | 5.10 | % | 33,174 |   | 4.13 | % |
|                           |       | 155,707                               |       | 3.99 | % | 118,478 |   | 4.30 | % | 89,733 |   | 3.33 | % |
|                           |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| Total deposits                 |       | $                                     | 184,017    |   | 3.37 | % | $ | 145,565 |   | 3.50 | % | $ | 119,888 |   | 2.50 | % |

 

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The following table setsforth the scheduled maturities of time deposits in denominations of $100,000 orgreater, which amounted to $55,331,000 at December 31, 2008:

 

Maturities of Time Deposits of $100,000 ormore

At December 31, 2008

($ in thousands)

 

| Three months or  less                  |   | $      | 11,173 |   |
|----------------------------------------|--------|--------|--------|--------|
| Over three  months through six months  |   | 9,152  |   |
| Over six months  through twelve months |   | 22,651 |   |
| Over twelve  months                    |   | 12,355 |   |
|                                   |   | $      | 55,331 |   |

 

The Corporation has aline of credit with M & I Marshall & Ilsley Bank in theamount of $3,000,000, at a floating interest rate based on the one month LIBORRate plus 2.75% with a floor rate of 4.50% and a maturity date of March 31,2009.  Subsequent to year end, the lineof credit was extended until May 31, 2009. At December 31, 2008, the line of credit was fully advanced.

 

The Bank has lines ofcredit from the Federal Home Loan Bank (FHLB) of San Francisco, the FederalReserve Bank of San Francisco, Bank of the West, M & I Marshall &Ilsley Bank, Pacific Coast Bankers’ Bank and The Independent Bank withremaining available borrowing capacity on December 31, 2008 of $1,337,000,$7,165,00, $4,500,000, $5,000,000, $6,000,000 and $5,000,000, respectively.  The Federal Home Loan Bank line of credit hasa maximum borrowing capacity of 25% of the Bank’s total assets, adjustedquarterly.  The Federal Home Loan Bankline of credit is secured by a portion of the Bank’s real estate secured loansand securities 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 Bank discount window line is secured by a portion ofthe Bank’s securities at December 31, 2008.  At December 31, 2008 the total marketvalue of securities pledged was $21,448,000.

 

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Thefollowing table provides information on twenty-one FHLB advances outstanding atDecember 31, 2008.

 
| ** ** | ** ** | ** ** | ** ** | **Funding** | ** ** | **Maturity** | ** ** |
|------------|------------|------------|------------|-------------|------------|--------------|------------|
| **Amount** | ** ** | **Rate**   | ** ** | **Date**    | ** ** | **Date**     | ** ** |
| $          | 1,000,000  |       | 7.72       | %           | 6/1/00     |         | 6/3/30     |   |
| 3,000,000  |       | 4.30       | %          | 6/17/05     |       | 6/17/10      |       |
| 5,000,000  |       | 4.96       | %          | 11/14/05    |       | 11/15/10     |       |
| 2,250,000  |       | 4.75       | %          | 1/26/06     |       | 1/26/11      |       |
| 1,750,000  |       | 4.72       | %          | 1/26/06     |       | 1/26/11      |       |
| 1,500,000  |       | 5.52       | %          | 7/17/06     |       | 7/18/11      |       |
| 3,500,000  |       | 5.49       | %          | 7/17/06     |       | 7/18/11      |       |
| 1,000,000  |       | 5.22       | %          | 8/25/06     |       | 8/25/11      |       |
| 5,000,000  |       | 5.20       | %          | 7/30/07     |       | 7/30/12      |       |
| 2,500,000  |       | 4.88       | %          | 8/20/07     |       | 8/20/10      |       |
| 5,000,000  |       | 5.00       | %          | 9/18/07     |       | 9/18/14      |       |
| 3,000,000  |       | 4.84       | %          | 10/1/07     |       | 10/1/12      |       |
| 4,000,000  |       | 2.70       | %          | 1/24/08     |       | 1/24/11      |       |
| 2,000,000  |       | 3.32       | %          | 5/14/08     |       | 5/16/11      |       |
| 5,000,000  |       | 3.57       | %          | 10/2/08     |       | 10/4/10      |       |
| 2,000,000  |       | 2.34       | %          | 11/21/08    |       | 11/23/09     |       |
| 3,000,000  |       | 3.00       | %          | 11/21/08    |       | 11/22/10     |       |
| 3,000,000  |       | 3.26       | %          | 11/21/08    |       | 11/2/11      |       |
| 3,000,000  |       | 3.92       | %          | 11/21/08    |       | 11/21/13     |       |
| 2,500,000  |       | 1.31       | %          | 12/16/08    |       | 12/16/09     |       |
| 7,500,000  |       | 1.30       | %          | 12/16/08    |       | 12/16/09     |       |
|       |       |       |       |        |       |         |       |
| $          | 66,500,000 |       |       |        |       |         |       |   |

 

Subsequent to year end the Bank prepaid five advance totaling$17,000,000.

 

The Bank had a loan from the Federal Reserve Bank inthe amount of $15,000,000 with an interest rate of 0.50% and a maturity date ofFebruary 9, 2009.  At maturity, the loan was paid off with funding froma new loan for the same amount and terms with a maturity date of May 8,2009.

 

The Bank of the West, M &I Marshall & Ilsley Bank, Pacific Coast Bankers’ Bank and TheIndependent Bank lines of credit areunsecured.  The Bank’s use of overnightborrowing during 2008 was limited to testing the line availability and noovernight borrowings were utilized in 2007 or 2006.

 

The Bank has a $330,000letter of credit issued by the Federal Home Loan Bank of San Francisco tosecure the uninsured portion of local agency deposits maintained with theBank.  The letter of credit matures April 17,2011.

 

**CAPITALRESOURCES**

 

The Corporation maintainscapital to comply with legal requirements, to provide a margin of safety forits depositors and shareholders, and to provide for future growth and theability to pay dividends.  At December 31,2008, stockholders’ equity was $14,352,000 versus $14,434,000 at December 31,2007.  The Corporation paid cashdividends of $0.25, $0.25 and $0.35 per share in 2008, 2007 and 2006,respectively.  The Bank paid cashdividends totaling $0, $800,000 and 

 

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$625,000 to theCorporation in 2008, 2007 and 2006, respectively.

 

The FDIC andFederal Reserve Board have adopted capital adequacy guidelines for use in theirexamination and regulation of banks and bank holding companies.  If the capital of a bank or bank holdingcompany falls below the minimum levels established by these guidelines, it maybe denied approval to acquire or establish additional banks or non-bankbusinesses, or the FDIC or Federal Reserve Board may take other administrativeactions.  The guidelines employ twomeasures of capital:  (1) risk-basedcapital and (2) leverage capital.

 

In general, the risk-based capital guidelines providedetailed definitions of which obligations will be treated as capital, andassign different weights to various assets and off-balance sheet items,depending upon the perceived degree of credit risk associated with eachasset.  Each asset is assigned to one offour risk-weighted categories.  Forexample, 0 percent for cash and unconditionally guaranteed governmentsecurities; 20 percent for deposits with other banks and fed funds; 50 percentfor state bonds and certain residential real estate loans; and 100 percent forcommercial loans and other assets. Capital is categorized as either Tier 1 capital, consisting of commonstock and retained earnings (or deficit), or Tier 2 capital, which includeslimited-life preferred stock and allowance for loan losses (subject to certainlimitations).  The guidelines also defineand set minimum capital requirements (risk-based capital ratios).  All banks are required to maintain Tier 1capital of at least 4 percent and total capital of 8.0% of risk-adjustedassets. The Bank had a Tier 1 capital to total risk-adjusted assets capitalratio of 11.93% and 10.77% at December 31, 2008 and 2007,respectively.  The Bank’s Tier 1 capitalexceeds the minimum regulatory requirement by $16,008,000.  The Bank had a Total Risk-Based capital torisk-adjusted assets ratio of 13.13% and 11.86% at December 31, 2008 and2007, respectively.  The Bank’s TotalRisk-Based capital exceeds the minimum regulatory requirement by $10,360,000.

 

The Tier 1 leverage capital ratio guidelines require aminimum leverage capital ratio of 4% of Tier 1 capital to total assets lessgoodwill.  The Bank had a leveragecapital ratio of 8.48% and 8.59% at December 31, 2008 and 2007,respectively.  The Bank’s Tier 1 leveragecapital exceeds the minimum regulatory requirement by $12,723,000.

 

As of the end of 2008, theBank was considered to be “well capitalized” by regulatory standards.  We do not foresee any circumstances thatwould cause either the Corporation or the Bank to be less than “wellcapitalized”, although no assurance can be given that this will not occur.

 

On March 27, 2003, theCorporation’s wholly owned special-purpose trust subsidiary, NorthernCalifornia Bancorp, Inc. Trust I (“Trust I”) issued $3 million incumulative Trust Preferred Securities.  The securities bear a floating rate of interestof 3.25% over the three month LIBOR rate, payable quarterly.  The effective rate at December 31, 2008and 2007 was 8.07% and 8.49%, 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 withthe related income statement effects, in the consolidated financialstatements.  The Corporation paysinterest on the Junior Subordinated Debentures to Trust I, which represents thesole revenue and sole source of dividend distributions to the holders of theTrust Preferred Securities.  TheCorporation has the right, assuming no default has occurred, to defer paymentsof interest on the Junior Subordinated Debentures at any time for a period notto exceed 20 consecutive quarters.  TheTrust Preferred Securities will mature on April 7, 2033, but can be redeemed,in whole 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 

 

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subordinated basis.

 

The Corporation received $2.91 million from Trust I upon issuance of theJunior Subordinated Debentures, of which $1 million was contributed by the Corporationto the Bank to increase its capital, $1.14 million was used to retire existingCorporation 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, 2008 and 2007 was 6.04% and 7.76%,respectively.  Concurrent with the issuance of the TrustPreferred Securities, Trust II 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 II and are eliminated, along with therelated income statement effects, in the consolidated financialstatements.  The Corporation paysinterest on the Junior Subordinated Debentures to Trust II, which representsthe sole revenue and sole source of dividend distributions to the holders ofthe Trust Preferred Securities.  TheCorporation has the right, assuming no default has occurred, to defer paymentsof interest on the Junior Subordinated Debentures at any time for a period notto exceed 20 consecutive quarters.  TheTrust Preferred Securities will mature on August 8, 2033, but can beredeemed, in whole or in part, on any February 8, May 8, August 8or November 8 on or after August 8, 2008 at par.  The Corporation fully and unconditionallyguarantees the obligations of Trust 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 the Corporationto the Bank to increase its capital and the remainder held as working capital.

 

Under current applicable regulatory guidelines, a portion of the TrustPreferred Securities qualifies as Tier I Capital, and the remainder as Tier IICapital.  No assurance can be given thatthe Trust Preferred Securities will continue to be treated as Tier I Capital inthe future.

 

**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,liquidity considerations involve the capacity to meet expected and potentialrequirements of depositors seeking access to balances and to provide for thecredit demands of borrowing customers. In the ordinary course of the Bank’s business, funds are generated fromthe repayment of loans, maturities within the investment securities portfolioand the acquisition of deposit balances and short-term borrowings.  In addition, the Bank has a line of creditfrom the Federal Home Loan Bank of San Francisco of approximately $68,222,000,based on 25 percent of the Bank’s total assets as reported in the most recentquarterly Consolidated Reports of Condition and Income for A bank with DomesticOffices Only.  The line of credit issubject to pledging of acceptable collateral. Additionally the Bank has unsecured federal funds lines of credit with Bank of the West $4,500,000, M & IMarshall & Ilsley Bank $5,000,000, Pacific Coast Bankers’ Bank $6,000,000 and The Independent Bank$5,000,000 to meet temporary liquidity requirements.  Availableborrowing capacities on December 31, 2008 were $4,500,000, $5,000,000,$6,000,000 

 

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and $5,000,000, respectively.

 

As a matter of policy,the Bank seeks to maintain a level of liquid assets, including marketableinvestment securities, equal to a least 15 percent of total assets (“primaryliquidity”), while maintaining sources of secondary liquidity (borrowing linesfrom other institutions) equal to at least an additional 10 percent ofassets.  In addition, it seeks togenerally limit loans to not more than 110 percent of deposits.  Withinthese ratios, the Bank generally has excess funds available to sell as federalfunds on a daily basis, and is able to fund its own liquidity needs without theneed of short-term borrowing.  The Bank’stotal liquidity at December 31, 2008, 2007 and 2006 was 35.49%, 27.09%,and 24.31%, respectively, while its average loan to deposit ratio for suchyears was 89.48%, 100.85% and 98.80%, respectively.

 

Brokered deposits are deposit instruments, such ascertificates of deposit, deposit notes, bank investment contracts and certainmunicipal investment contracts that are issued through brokers and dealers whothen offer and/or sell these deposit instruments to one or more investors.  Additionally, deposits on which a financialinstitution pays an interest rate significantly higher than prevailing ratesare considered to be brokered deposits. Federal law and regulation restricts banks from soliciting or acceptingbrokered deposits, unless the bank is well capitalized under Federalguidelines.  The Bank had brokereddeposits totaling $1,996,000 or 1.05% of total deposits at December 31,2008, no brokered deposits at December 31, 2007 and brokered depositstotaling $5,046,000 or 3.83% of total deposits at December 31, 2006. Noneof the Bank’s brokered deposits paid an interest rate significantly higher thanprevailing rates.

 

The Corporation’s sources of revenues and liquidityare the dividends, tax equalization payments or management fees from the Bankand gains on securities held in a trading account and other investments.  The ability of the Bank to pay such items tothe Corporation is subject to limitations under state and Federal law.

 

**INTERESTRATE RISK**

 

Managementof interest rate sensitivity (asset/liability management) involves matching andrepricing rates of interest-earning assets with interest-bearing liabilities ina manner designed to optimize net interest income within the constraintsimposed by regulatory authorities, liquidity determinations and capitalconsiderations.

 

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 rate risk,liquidity, market risk and capital adequacy. The Bank gives priority to liquidity concerns followed by capitaladequacy, then interest rate risk and market risk in the investmentportfolio.  The policy of the Bank willbe to control the exposure of the Bank’s earnings to changing interest rates bygenerally maintaining a position within a narrow range around an “earningsneutral position.” An earnings neutral position is defined as the mix of assetsand liabilities that generate a net interest margin that is not affected byinterest rate changes.  However,Management does not believe that the Bank can maintain a totally earningsneutral position.  Further, the actualtiming of repricing of assets and liabilities does not always correspond to thetiming assumed by the Bank for analytical purposes.  Therefore, changes in market rates ofinterest will generally impact the Bank’s net interest income and net interestmargin for long or short periods of time.

 

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The Bank monitors its interest rate risk on aquarterly basis through the use of a model which calculates the effect onearnings of changes in the fed funds rate. The model converts a fed funds rate change into rate changes for eachmajor class of asset and liability, then simulates the bank’s net interestmargin based on the bank’s actual repricing over a one year period, assumingthat maturities are reinvested in instruments identical to those maturingduring the period.  The following tableshows the affect on net interest income of a 100 and a 200 basis point rateshock at December 31, 2008.  Thetable does not include projections for decrease in rates, the Federal Fundstarget rate is currently between 0% and 0.25%.

 

| **Rate Shock Increase in  Basis Points** | ** ** | **Percent Increase in  Net Interest Income** | ** ** |
|--------------------------------------------------------------|------------|------------------------------------------------------------------|------------|
| 100                                                          |       | 3.0                                                              | %          |
| 200                                                          |       | 6.7                                                              | %          |

 

**INVESTMENTSECURITIES**

 

The Corporation maintains atrading account, at fair value, consisting of marketable securities.  At December 31, 2008 and 2007 theaccount value was $361,000 and $1,224,000, respectively.  The Corporation has investments of $20,000 inAT Service LLC, which provides title insurance services for commercial,industrial and residential properties, as well as other real estate relatedfinancial and informational services, including escrow, real estateinformation, trustee sale guarantees and real estate tax exchanges, and $10,000in Metrocities Mortgage, LLC.  Inaddition the Corporation has investments in Northern California Bancorp Trust Iof $93,000 and Northern California Bancorp Trust II of $155,000.  These are special-purpose trust subsidiarieswhich were formed to facilitate the issuance of trust preferred securities.

 

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The following table setsforth the book and market value of investment securities as of December 31,2008, 2007 and 2006:

 

INVESTMENT PORTFOLIO MIX

(Dollars in thousands)

 
| ** **                                       | ** ** | **2008**  | ** ** | **2007**   | ** ** | **2006**  | ** ** |
|--------------------------------------------------|------------|-----------|------------|------------|------------|-----------|------------|
| ** **                                       | ** ** | **Book**  | ** ** | **Market** | ** ** | **Book**  | ** ** | **Market** | ** ** | **Book** | ** ** | **Market** | ** ** |
| ** **                                       | ** ** | **value** | ** ** | **value**  | ** ** | **value** | ** ** | **value** | ** ** | **value** | ** ** | **value** | ** ** |
| Available for  sale:                             |       |      |       |       |       |      |       |   |   |   |   |   |   |
| Government  National Mortgage Association        |       | $         | —     |       | $          | —    |       | $ | 386 |   | $ | 385 |   | $ | 641 |   | $ | 626 |   |
| Corporate Debt  Securities                       |       | 5,846     |       | 5,866      |       | —    |       | — |   | — |   | — |   |
| Mortgage Backed  Securities                      |       | 4,048     |       | 3,892      |       | —    |       | — |   | — |   | — |   |
| State/Local  Agency Securities                   |       | 41,839    |       | 40,551     |       | 225       |       | 225 |   | — |   | — |   |
| U.S. Government  Agencies                        |       | 42,197    |       | 43,044     |       | 36,027    |       | 36,191 |   | 14,724 |   | 14,660 |   |
| Total                                            |       | $         | 93,930     |       | $          | 93,353    |       | $ | 36,638 |   | $ | 36,801 |   | $ | 15,365 |   | $ | 15,286 |   |
|                                             |       |      |       |       |       |      |       |   |   |   |   |   |   |
| Held to  maturity:                               |       |      |       |       |       |      |       |   |   |   |   |   |   |
| State/Local  Agency Securities                   |       | $         | —     |       | $          | —    |       | $ | 7,869 |   | $ | 8,105 |   | $ | 7,012 |   | $ | 7,280 |   |
|                                             |       |      |       |       |       |      |       |   |   |   |   |   |   |
| Other Securities:                                |       |      |       |       |       |      |       |   |   |   |   |   |   |
| Federal Home  Loan Bank Stock                    |       | $         | 3,097      |       | $          | 3,097     |       | $ | 2,495 |   | $ | 2,495 |   | $ | 1,633 |   | $ | 1,633 |   |
| AT Services, LLC                                 |       | 20        |       | 20         |       | 20        |       | 20 |   | 20 |   | 20 |   |
| Metrocities  Mortgage, LLC                       |       | 10        |       | 10         |       | 10        |       | 10 |   | 10 |   | 10 |   |
| The Independent  Bankers’ Financial Corp.   |       | 51        |       | 51         |       | 51        |       | 51 |   | 50 |   | 50 |   |
| MasterCard Inc  Class “B” Stock   |       | —    |       | —     |       | —    |       | — |   | 6 |   | 6 |   |
| 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        |       | —    |       | — |   | — |   | — |   |
| Total                                            |       | $         | 3,852      |       | $          | 3,852     |       | $ | 2,824 |   | $ | 2,824 |   | $ | 1,967 |   | $ | 1,967 |   |

 

The contractualmaturities of investment securities as well as yields based on amortized costof those securities at December 31, 2008 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 one year to** | ** ** | **After five years to** | ** ** | ** ** | ** ** | ** **         | ** ** | ** ** | ** ** | ** **         | ** ** |
|-----------------------------------------------|------------|-------------------------------------|------------|---------------------|------------|--------------------------------------|------------|----------------------------------------|------------|------------|------------|--------------------|------------|------------|------------|--------------------|------------|
| ** **                                    | ** ** | **One year or less** | ** ** | **five years** | ** ** | **ten years**                   | ** ** | **After ten years**          | ** ** | **Total**  | ** ** |
| **(Dollars in thousands)**          | ** ** | **Amount**                          | ** ** | **Yield (1)**  | ** ** | **Amount**                           | ** ** | **Yield (1)**                     | ** ** | **Amount** | ** ** | **Yield (1)** | ** ** | **Amount** | ** ** | **Yield (1)** | ** ** | **Amount** | ** ** | **Yield (1)** | ** ** |
| Available-for-sale  Corporate Debt Securities |       | $                                   | 4,929      |                | 9.15       | %                                    | $          | 917                                    |       | 9.84       | %          | $                  | —     |       | 0.00       | %                  | $          | — |   | 0.00 | % | $ | 5,846 |   | 9.26 | % |
| Mortgage Backed  Securities                   |       | —                              |       | 0.00                | %          | —                               |       | 0.00                                   | %          | —     |       | 0.00               | %          | 4,048      |       | 5.59               | %          | 4,048 |   | 5.59 | % |
| State/Local  Agency Securities                |       | —                              |       | 0.00                | %          | —                               |       | 0.00                                   | %          | 417        |       | 4.91               | %          | 41,422     |       | 5.28               | %          | 41,839 |   | 5.27 | % |
| U.S. Government  Agencies                     |       | —                              |       | 0.00                | %          | —                               |       | 0.00                                   | %          | —     |       | 0.00               | %          | 42,197     |       | 5.12               | %          | 42,197 |   | 5.12 | % |
|                                          |       | $                                   | 4,929      |                | 9.15       | %                                    | $          | 917                                    |       | 9.84       | %          | $                  | 417        |       | 4.91       | %                  | $          | 87,667 |   | 5.21 | % | $ | 93,930 |   | 5.37 | % |

 

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**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 onnon-interest expenses, such as salaries and occupancy expenses.

 

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**

####  

TheBank has various “off-balance sheet” arrangements that might have an impact onits financial condition, liquidity, or results of operations. The Bank’sprimary source of funds for its lending is its deposits.  If necessary to meet the demand of depositswithdrawals or loan funding, the Bank could obtain funding through the purchaseof Federal Funds.  The Bank hascontinuous lines of credit with four banks providing for Federal Fundsfacilities up to a maximum of $20,500,000. Any borrowings on the lines are due on demand and the interest rate isnegotiated at the time of the borrowing. There were no borrowings outstandingagainst the lines as of December 31, 2008.

 

Asof December 31, 2008 the Bank had commitments to extend credit in theamount of $13,941,000.  Commitments toextend credit are agreements to lend to a customer as long as there is noviolation of any condition established in the contract.  Since many of the commitments are expected toexpire without being drawn upon, the total amount does not necessarilyrepresent future cash requirements.

 

**CONTRACTUAL OBLIGATIONS**

 

Thefollowing table presents, as of December 31, 2008, the Corporation’ssignificant fixed and determinable contractual obligations by paymentdate.  The payment amounts representthose amounts contractually due to the recipient and do not include anyunamortized premiums or 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  |       | $                 | 46,211     |                       | $          | —                       |       | $                  | —     |       | $          | — |   | $ | 46,211 |   |
| Time deposits                        |       | 110,246           |       | 29,152                     |       | 3,937                        |       | 184                |       | 143,519    |       |
| FHLB borrowing                       |       | 12,000            |       | 37,500                     |       | 11,000                       |       | 6,000              |       | 66,500     |       |
| Federal Reserve  Bank borrowing      |       | 15,000            |       | —                     |       | —                       |       | —             |       | 15,000     |       |
| Junior  Subordinated Debt            |       | —            |       | —                     |       | —                       |       | 8,241              |       | 8,241      |       |
| Operating Leases                     |       | 364               |       | 631                        |       | 168                          |       | —             |       | 1,163      |       |
| Standby Letter  of Credit            |       | —            |       | 330                        |       | —                       |       | —             |       | 330        |       |
|                                      |            |                   |            |                            |            |                              |            |                    |            |            |            |  |  |  |  |  |

 

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| **(Dollars in thousands)**         | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|
| **Commitments  to extend credit:**           |       |       |       |
| Commercial and  Industrial                   |       | $          | 5,960      |   |
| Construction                                 |       | 1,456      |       |
| Individuals                                  |       | 2,736      |       |
| Real Estate                                  |       | 3,003      |       |
| Revolving Home  Equity and Credit Card Lines |       | 786        |       |
|                                              |            |            |            |  |

 

**ITEM 7A.****                                            QUANTITATIVEAND QUALITATIVE DISCLOSURE ABOUT MARKET RISK.**

 

Not Applicable.

 

**ITEM 8.****                                                     FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA**

 

The followingconsolidated financial statements included in the Consolidated Financial Reportissued by Hutchinson and Bloodgood LLP, Certified Public Accountants at the pages indicatedare incorporated herein by reference:

 
| Report of Independent Registered Public Accounting  Firm         |   | 1      |
|------------------------------------------------------------------|--------|--------|
|                                                             |   |   |
| Consolidated Balance Sheets                                      |   | 2      |
|                                                             |   |   |
| Consolidated Statements of Income                                |   | 3      |
|                                                             |   |   |
| Consolidated Statements of Changes in Stockholders’  Equity |   | 4      |
|                                                             |   |   |
| Consolidated Statements of Cash Flows                            |   | 5-6    |
|                                                             |   |   |
| Notes to Consolidated Financial Statements                       |   | 7-53   |

 

**ITEM 9.****                                                     CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS AND FINANCIAL DISCLOSURE**

 

Not Applicable.

 

**ITEM 9A(T).****                           ****CONTROLS AND PROCEDURES**

 

**Evaluation of Disclosure Controls and Procedures**

 

We maintain “disclosure controls and procedures,” assuch term is defined in Rule 13a-15(e) under the Securities ExchangeAct of 1934 (the “Exchange Act”), that are designed to ensure that informationrequired to be disclosed in our Exchange Act reports is recorded, processed,summarized and reported within the time periods specified in the Securities andExchange Commission rules and forms, and that such information isaccumulated and communicated to our management, including our Chief ExecutiveOfficer (“CEO”) and Chief Financial Officer (“CFO”), as appropriate, to allowtimely decisions regarding required disclosure. We conducted an evaluationunder the supervision and with the participation of our CEO and CFO, of theeffectiveness of the design and operation of our disclosure controls andprocedures (“Disclosure Controls”) as of the end 

 

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of the period covered bythis report pursuant to Rule 13a-15(e) of the Exchange Act. Based onthis Evaluation, our CEO and CFO concluded that our Disclosure Controls wereeffective 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 31,2008, 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 financial reportingthat has occurred in the fourth quarter of our fiscal year ended December 31,2008 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 theobjectives of the control system are met. Further, the design of a controlsystem must reflect the fact that there are resource constraints, and thebenefits of controls must be considered relative to their costs. Because of theinherent limitations in all control systems, no evaluation of controls canprovide absolute assurance that all control issues and instances of fraud, ifany, within the Corporation have been detected. These inherent limitationsinclude the 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 mayoccur and 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 Item ofthis report, which you are currently reading is the information concerning theEvaluation referred to in the Section 302 Certifications and thisinformation should be read in conjunction with the Section 302Certifications for a more complete understanding 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.

 

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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.

 

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 of compliancewith the policies or procedures may deteriorate.

 

Our management assessed the effectiveness of theCorporation’s internal control over financial reporting as of December 31,2008. In making this assessment, it used the criteria set forth by the Committeeof Sponsoring Organizations of the Treadway Commission (COSO) in *Internal Control-Integrated Framework*.Based on this assessment, our management believe that, as of December 31,2008, the Corporation’s internal control over financial reporting was effective.

 

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 2009 Annual Meetingof Stockholders to be filed by no later than April 30, 2009, or will beprovided by amendment to this Annual Report on Form 10-K.

 

**ITEM 11.****                                        EXECUTIVECOMPENSATION**

 

The information required by this Item isincorporated from the Proxy Statement for the Corporation’s 2009 Annual Meetingof Stockholders to be filed by no later than April 30, 2009, or will beprovided by amendment to this Annual Report on Form 10-K.

 

**ITEM 12.****                                        SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT, AND RELATED STOCKHOLDERMATTERS**

 

The information required by this Item isincorporated from the Proxy Statement for the Corporation’s 2009 Annual Meetingof Stockholders to be filed by no later than April 30, 2009, or will beprovided by amendment to this Annual Report on Form 10-K.

 

**ITEM 13.****                                        CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE**

 

The information required by this Item isincorporated from the Proxy Statement for the Corporation’s 2009 Annual Meetingof Stockholders to be filed by no later than April 30, 2009, 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 2009 Annual Meetingof Stockholders to be filed by no later than April 30, 2009, or will beprovided by amendment to this Annual Report on Form 10-K.

 

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**ITEM 15.****                                              EXHIBITSAND FINANCIAL STATEMENT SCHEDULES**

 

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                                                                                                                                                                                                     |       |                                  |
|           |       |                                                                                                                                                                                                                                                                 |       |                                  |
| 3 (ii)         |       | Bylaws                                                                                                                                                                                                                                                               |       | (1)                                   |
|           |       |                                                                                                                                                                                                                                                                 |       |                                  |
| 10 (i) D  | (1)        | Lease agreement Carmel  Branch Office                                                                                                                                                                                                                                |       | (1)                                   |
|           |       |                                                                                                                                                                                                                                                                 |       |                                  |
|           | (2)        | Lease agreement Carmel  By The Sea Office                                                                                                                                                                                                                            |       | (5)                                   |
|           |       |                                                                                                                                                                                                                                                                 |       |                                  |
|           | (3)        | Lease agreement 301  Webster Street, Monterey, CA 93924                                                                                                                                                                                                              |       | (6)                                   |
|           |       |                                                                                                                                                                                                                                                                 |       |                                  |
| 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. 1998 Stock Option Plan and Stock Option Agreements                                                                                                                                                                           |       | (2)                                   |
|           |       |                                                                                                                                                                                                                                                                 |       |                                  |
|           | (4)        | Amendment to the Salary  Continuation Agreement Dated December 31, 1993                                                                                                                                                                                         |       | (3)                                   |
|           |       |                                                                                                                                                                                                                                                                 |       |                                  |
|           | (5)        | Life Insurance  Endorsement Method Split Dollar Plan Agreement                                                                                                                                                                                                       |       | (3)                                   |
|           |       |                                                                                                                                                                                                                                                                 |       |                                  |
|           | (6)        | Amendment to the Life  Insurance Endorsement Method Split Dollar Plan Agreement dated  January 5, 2000                                                                                                                                                          |       | (4)                                   |
|           |       |                                                                                                                                                                                                                                                                 |       |                                  |
|           | (7)        | Amendment to the Life  Insurance Endorsement Method Split Dollar Plan                                                                                                                                                                                                |       | (4)                                   |
|           |       |                                                                                                                                                                                                                                                                 |       |                                  |
|           | (8)        | Amendment to the Salary  Continuation Agreement Dated December 31, 1993                                                                                                                                                                                         |       | (4)                                   |
|           |       |                                                                                                                                                                                                                                                                 |       |                                  |
|           | (9)        | Monterey County Bank  Supplemental Life Insurance Agreement Dated October 26, 2006                                                                                                                                                                              |       | (7)                                   |
|           |       |                                                                                                                                                                                                                                                                 |       |                                  |
|           | (10)       | First Amendment to the  Monterey County Bank Supplemental Life Insurance Agreement dated  October 31, 2006                                                                                                                                                      |       | (7)                                   |

 

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| 21     |   | Subsidiaries                                                                                                                                                  |   | (7)    |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
|   |   |                                                                                                                                                          |   |   |
| 23.1   |   | Consent of Hutchinson  and Bloodgood, LLP                                                                                                                     |   |   |
|   |   |                                                                                                                                                          |   |   |
| 31.1   |   | Certification of the  Chief Executive Officer of Northern California Bancorp, Inc. pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.      |   |   |
|   |   |                                                                                                                                                          |   |   |
| 31.2   |   | Certification of the  Chief Financial Officer of Northern California Bancorp, Inc. pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.      |   |   |
|   |   |                                                                                                                                                          |   |   |
| 32.1   |   | Certification of the  Chief Executive Officer of Northern California Bancorp, Inc. pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. |   |   |
|   |   |                                                                                                                                                          |   |   |
| 32.2   |   | Certification of the  Chief Financial Officer of Northern California Bancorp, Inc. pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.      |   |   |

 

----

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

(2)  Filed as an exhibit to Form 10-KSB datedDecember 31, 1998.

(3)  Filed as an exhibit to Form 10-KSB datedDecember 31, 1999.

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

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

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

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

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

 

B.                                     REPORTS

 

None

 

**SIGNATURES**

 

In accordance with Section 13 or 15(d) ofthe Exchange Act, the registrant caused this report to be signed on its behalfby the undersigned, thereunto duly authorized.

 

|                                            |   |   | NORTHERN CALIFORNIA  BANCORP, INC.                        |
|-------------------------------------------------|--------|--------|-----------------------------------------------------------|
|                                            |   |   |                                                      |
| Date:    April 7, 2009 |   | By:    | /s/  Charles T. Chrietzberg, Jr.                     |
|                                            |   |   | Charles T.  Chrietzberg, Jr.                         |
|                                            |   |   | Chief Executive Officer  and President                    |
|                                            |   |   |                                                      |
| Date:    April 7, 2009 |   | 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. |       |         |       | April 7, 2009 |
| Charles  T. Chrietzberg, Jr.     |       | Director     |       |               |
|                                  |       |         |       |               |
| /s/ Sandra G.  Chrietzberg            |       |         |       | April 7, 2009 |
| Sandra G. Chrietzberg                 |       | Director     |       |               |
|                                  |       |         |       |               |
| /s/ Peter J. Coniglio                 |       |         |       | April 7, 2009 |
| Peter J. Coniglio                     |       | Director     |       |               |
|                                  |       |         |       |               |
|                                  |       |         |       |               |
| Carla S. Hudson                       |       | Director     |       |               |
|                                  |       |         |       |               |
| /s/ John M. Lotz                      |       |         |       | April 7, 2009 |
| John M. Lotz                          |       | Director     |       |               |
|                                  |       |         |       |               |
| /s/ Mark A. Briant                    |       |         |       | April 7, 2009 |
| Mark A. Briant                        |       | Director     |       |               |
|                                  |       |         |       |               |
| /s/ Stephanie G. Chrietzberg          |       |         |       | April 7, 2009 |
| Stephanie G.  Chrietzberg             |       | Director     |       |               |

 

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**NORTHERNCALIFORNIA BANCORP, INC.**

**ANDSUBSIDIARY**

 

**CONSOLIDATEDFINANCIAL REPORT**

 

**December 31,2008**

 

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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                       |       | 7-53     |

 

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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, as of December 31,2008 and 2007 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, 2008. These consolidated financial statements are the responsibility of theCorporation’s management.  Ourresponsibility is to express an opinion on these consolidated financialstatements based on our audits.

 

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 statementpresentation.  We believe that our auditsprovide a reasonable basis 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, as of December 31, 2008 and 2007, and theresults of their operations and their cash flows for each of the years in thethree-year period ended December 31, 2008 in conformity with accountingprinciples generally accepted in the United States of America.

 

 

/S/Hutchinson andBloodgood LLP

Watsonville,California

# March 27, 2009

 

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

** **

**CONSOLIDATED BALANCE SHEETS**

**December 31, 2008 and 2007**

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

 
| ** **                                                                                                                                                                | ** ** | **2008** | ** ** | **2007** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| **ASSETS**                                                                                                                                                                |       |     |       |     |       |
| Cash and due from banks                                                                                                                                                   |       | $        | 16,348     |     | $          | 8,063 |   |
| Federal funds sold                                                                                                                                                        |       | —   |       | 12,090   |       |
| Total cash and cash equivalents                                                                                                                                           |       | 16,348   |       | 20,153   |       |
| Time deposits with other financial  institutions                                                                                                                          |       | 3,500    |       | —   |       |
| Trading assets                                                                                                                                                            |       | 361      |       | 1,224    |       |
| Investment securities available for sale  (AFS)                                                                                                                           |       | 93,353   |       | 36,801   |       |
| Investment securities held to maturity, at cost  (fair value approximates $8,105,000 in 2007)                                                                             |       | —   |       | 7,869    |       |
| Other investments                                                                                                                                                         |       | 3,852    |       | 2,824    |       |
| Loans held for sale                                                                                                                                                       |       | 1,650    |       | 1,887    |       |
| Loans, net of allowance for loan losses of  $2,413,000 in 2008 and $2,028,000 in 2007                                                                                     |       | 165,530  |       | 166,861  |       |
| Premises and equipment, net                                                                                                                                               |       | 4,988    |       | 4,874    |       |
| Cash surrender value of life insurance                                                                                                                                    |       | 3,969    |       | 3,845    |       |
| Other real estate owned                                                                                                                                                   |       | 7,364    |       | —   |       |
| Interest receivable and other assets                                                                                                                                      |       | 5,286    |       | 7,527    |       |
|                                                                                                                                                                      |       | $        | 306,201    |     | $          | 253,865 |   |
|                                                                                                                                                                      |       |     |       |     |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                                                            |       |     |       |     |       |
|                                                                                                                                                                      |       |     |       |     |       |
| Deposits:                                                                                                                                                                 |       |     |       |     |       |
| Non interest-bearing demand                                                                                                                                               |       | $        | 25,812     |     | $          | 26,237 |   |
| Interest-bearing demand                                                                                                                                                   |       | 14,240   |       | 15,600   |       |
| Savings                                                                                                                                                                   |       | 6,159    |       | 5,487    |       |
| Time less than $100,000                                                                                                                                                   |       | 88,188   |       | 58,812   |       |
| Time in denominations of $100,000 or more                                                                                                                                 |       | 55,331   |       | 62,620   |       |
| Total deposits                                                                                                                                                            |       | 189,730  |       | 168,756  |       |
| Federal Home Loan Bank borrowed funds                                                                                                                                     |       | 66,500   |       | 52,500   |       |
| Federal funds purchased                                                                                                                                                   |       | 15,000   |       | —   |       |
| Revolving line of credit                                                                                                                                                  |       | 3,000    |       | —   |       |
| Payable for investment securities purchased                                                                                                                               |       | 3,050    |       | 5,225    |       |
| Interest payable and other liabilities                                                                                                                                    |       | 6,321    |       | 4,702    |       |
| Junior subordinated debt securities                                                                                                                                       |       | 8,248    |       | 8,248    |       |
| Total liabilities                                                                                                                                                         |       | 291,849  |       | 239,431  |       |
| Commitments and Contingencies (Notes 13,  14, and 17)                                                                                                                     |       |     |       |     |       |
| Shareholders’ equity                                                                                                                                                 |       |     |       |     |       |
| Common stock, no stated par value,  authorized 2,500,000 shares, issued and outstanding: 1,803,908 and 1,845,918  shares at December 31, 2008 and 2007, respectively |       | 5,173    |       | 5,502    |       |
| Retained earnings                                                                                                                                                         |       | 9,481    |       | 8,831    |       |
| Accumulated other comprehensive income  (loss)                                                                                                                            |       | (302     | )          | 101      |       |
| Total shareholders’ equity                                                                                                                                           |       | 14,352   |       | 14,434   |       |
|                                                                                                                                                                      |       | $        | 306,201    |     | $          | 253,865 |   |

 

The notes to consolidated financialstatements are an integral part of these statements.

 

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

** **

**CONSOLIDATED STATEMENTS OF INCOME**

**Years Ended December 31, 2008, 2007, and 2006**

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

 
| ** **                                                              | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Interest income                                                         |       |     |       |     |       |     |       |
| Loans and fee income on loans                                           |       | $        | 12,297     |     | $          | 14,442   |       | $ | 11,953 |   |
| Time deposits with other financial  institutions                        |       | 29       |       | 66       |       | 50       |       |
| Investment securities                                                   |       | 3,963    |       | 1,957    |       | 1,036    |       |
| Federal funds sold                                                      |       | 211      |       | 476      |       | 721      |       |
| Total interest income                                                   |       | 16,500   |       | 16,941   |       | 13,760   |       |
|                                                                    |       |     |       |     |       |     |       |
| Interest expense                                                        |       |     |       |     |       |     |       |
| Interest-bearing transaction accounts                                   |       | 48       |       | 49       |       | 68       |       |
| Savings and time deposit accounts                                       |       | 3,445    |       | 2,638    |       | 1,443    |       |
| Time deposits in denominations of $100,000  or more                     |       | 2,717    |       | 2,405    |       | 1,479    |       |
| Notes payable and other borrowings                                      |       | 3,539    |       | 2,910    |       | 2,207    |       |
| Total interest expense                                                  |       | 9,749    |       | 8,002    |       | 5,197    |       |
|                                                                    |       |     |       |     |       |     |       |
| Net interest income                                                     |       | 6,751    |       | 8,939    |       | 8,563    |       |
| Provision for loan losses                                               |       | 1,132    |       | 865      |       | 410      |       |
| Net interest income, after provision for  loan losses                   |       | 5,619    |       | 8,074    |       | 8,153    |       |
|                                                                    |       |     |       |     |       |     |       |
| Non-interest income                                                     |       |     |       |     |       |     |       |
| Service charges on deposit accounts                                     |       | 760      |       | 634      |       | 547      |       |
| Income from sales and servicing of Small Business  Administration loans |       | 329      |       | 480      |       | 690      |       |
| Gain on sale of Pacific Coast Bankers’ Bank  Stock                 |       | —   |       | —   |       | 1,313    |       |
| Other income                                                            |       | 3,942    |       | 3,222    |       | 4,627    |       |
| Total non-interest income                                               |       | 5,031    |       | 4,336    |       | 7,177    |       |
|                                                                    |       |     |       |     |       |     |       |
| Non-interest expenses                                                   |       |     |       |     |       |     |       |
| Salaries and employee benefits                                          |       | 3,664    |       | 4,049    |       | 3,854    |       |
| Occupancy and equipment                                                 |       | 967      |       | 866      |       | 790      |       |
| Professional fees                                                       |       | 164      |       | 165      |       | 149      |       |
| Data processing                                                         |       | 360      |       | 361      |       | 322      |       |
| Other general and administrative                                        |       | 3,752    |       | 3,564    |       | 3,512    |       |
| Total non-interest expenses                                             |       | 8,907    |       | 9,005    |       | 8,627    |       |
|                                                                    |       |     |       |     |       |     |       |
| Income before income tax provision                                      |       | 1,743    |       | 3,405    |       | 6,703    |       |
| Income tax provision                                                    |       | 281      |       | 1,476    |       | 2,866    |       |
|                                                                    |       |     |       |     |       |     |       |
| Net income                                                              |       | $        | 1,462      |     | $          | 1,929    |       | $ | 3,837 |   |
|                                                                    |       |     |       |     |       |     |       |
| Earnings per common share                                               |       |     |       |     |       |     |       |
|                                                                    |       |     |       |     |       |     |       |
| Basic                                                                   |       | $        | 0.80       |     | $          | 1.08     |       | $ | 2.31 |   |
|                                                                    |       |     |       |     |       |     |       |
| Diluted                                                                 |       | $        | 0.79       |     | $          | 1.03     |       | $ | 2.09 |   |

 

The notes to consolidated financialstatements are an integral part of these statements.

 

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

** **

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

**Years Ended December 31, 2008, 2007, and 2006**

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

 
| ** **                                                                                                           | ** ** | ** **         | ** ** | ** ** | ** ** | ** **   | ** ** | **Accumulated**        | ** ** | ** ** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|------------|------------|--------------|------------|------------------------|------------|------------|------------|
| ** **                                                                                                           | ** ** | ** **         | ** ** | ** ** | ** ** | ** **   | ** ** | **Other**              | ** ** | ** ** | ** ** |
| ** **                                                                                                           | ** ** | **Number of** | ** ** | **Common** | ** ** | **Retained** | ** ** | **Comprehensive**      | ** ** | ** ** | ** ** |
| ** **                                                                                                           | ** ** | **Shares**         | ** ** | **Stock**  | ** ** | **Earnings** | ** ** | **Income (loss)** | ** ** | **Total**  | ** ** |
| ** **                                                                                                           | ** ** | ** **         | ** ** | ** ** | ** ** | ** **   | ** ** | ** **             | ** ** | ** ** | ** ** |
| Balance at December 31, 2005                                                                                    |       | 1,631,439          |       | $          | 4,772      |         | $          | 4,129                  |       | $          | 30         |   | $ | 8,931 |   |
|                                                                                                                 |       |               |       |       |       |         |       |                   |       |       |       |
| Comprehensive income:                                                                                                |       |               |       |       |       |         |       |                   |       |       |       |
| Net income for the year                                                                                              |       | —             |       | —     |       | 3,837        |       | —                 |       | 3,837      |       |
| Change in net unrealized gain on AFS securities  and other assets, net of reclassification adjustment and tax effect |       | —             |       | —     |       | —       |       | (51                    | )          | (51        | )          |
| Total comprehensive income                                                                                           |       |               |       |       |       |         |       |                   |       | 3,786      |       |
|                                                                                                                 |       |               |       |       |       |         |       |                   |       |       |       |
| $.35 per share cash dividend                                                                                         |       | —             |       | —     |       | (603         | )          | —                 |       | (603       | )          |
| Stock compensation expense, net of tax benefit                                                                       |       |               |       | 18         |       | —       |       | —                 |       | 18         |       |
| Exercise of stock options, including tax  benefit                                                                    |       | 90,276             |       | 270        |       | —       |       | —                 |       | 270        |       |
| 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 |   |

 

The notes to consolidated financialstatements are an integral part of these statements.

 

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

 

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**Years Ended December 31, 2008, 2007, and 2006**

**(Dollars in Thousands)**

 
| ** **                                                                                | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **CASH FLOWS FROM OPERATING ACTIVITIES**                                                  |       |     |       |     |       |     |       |
| Net income                                                                                |       | $        | 1,462      |     | $          | 1,929    |       | $ | 3,837 |   |
| Adjustments to reconcile net income to net  cash provided (used) by operating activities: |       |     |       |     |       |     |       |
| Depreciation and amortization expense                                                     |       | 312      |       | 293      |       | 277      |       |
| Provision for loan losses                                                                 |       | 1,132    |       | 865      |       | 410      |       |
| Realized gain on sales of available for  sale securities and other investments, net       |       | (449     | )          | (216     | )          | (1,308   | )          |
| Amortization of deferred loan fees, net                                                   |       | (291     | )          | (372     | )          | (334     | )          |
| Net amortization (accretion) of securities                                                |       | (234     | )          | (4       | )          | (3       | )          |
| Stock based compensation                                                                  |       | —   |       | —   |       | 18       |       |
| Deferred income tax benefit                                                               |       | (583     | )          | (91      | )          | (32      | )          |
| Loss on sale of equipment                                                                 |       | —   |       | —   |       | 12       |       |
| Increase in cash surrender value of life  insurance                                       |       | (124     | )          | (124     | )          | (104     | )          |
| (Increase) decrease in assets:                                                            |       |     |       |     |       |     |       |
| Trading assets                                                                            |       | 863      |       | 538      |       | (735     | )          |
| Loans held for sale                                                                       |       | 237      |       | (705     | )          | 4,133    |       |
| Interest receivable                                                                       |       | (774     | )          | (392     | )          | (187     | )          |
| Other assets                                                                              |       | 3,598    |       | (4,361   | )          | (465     | )          |
| Increase (decrease) in liabilities:                                                       |       |     |       |     |       |     |       |
| Interest payable                                                                          |       | (417     | )          | 904      |       | 589      |       |
| Other liabilities                                                                         |       | 1,675    |       | 324      |       | (148     | )          |
| Net cash provided (used) by operating  activities                                         |       | 6,407    |       | (1,412   | )          | 5,960    |       |
|                                                                                      |       |     |       |     |       |     |       |
| **CASH FLOWS FROM INVESTING ACTIVITIES**                                                  |       |     |       |     |       |     |       |
| Net change in time deposits with other  financial institutions                            |       | (3,500   | )          | 1,000    |       | —   |       |
| Activity in available-for-sale securities                                                 |       |     |       |     |       |     |       |
| Sales                                                                                     |       | 51,322   |       | 10,221   |       | 2,831    |       |
| Maturities, prepayments, and calls                                                        |       | 3,700    |       | 13,996   |       | 3,000    |       |
| Purchases                                                                                 |       | (106,639 | )          | (40,993  | )          | (8,575   | )          |
| Activity in held to maturities                                                            |       |     |       |     |       |     |       |
| Purchases                                                                                 |       | —   |       | (870     | )          | —   |       |
| Net increase in loans                                                                     |       | (11,874  | )          | (69,275  | )          | (42,450  | )          |
| Loan purchases                                                                            |       | —   |       | (11,001  | )          | (19,150  | )          |
| Proceeds from loan sales                                                                  |       | 6,016    |       | 41,790   |       | 34,642   |       |
| Investment in real estate                                                                 |       | (1,015   | )          | —   |       | —   |       |
| Proceeds from sale of equipment                                                           |       | —   |       | —   |       | 49       |       |
| Purchase of life insurance policies                                                       |       | —   |       | (50      | )          | (1,100   | )          |
| Additions to bank premises and equipment                                                  |       | (417     | )          | (547     | )          | (584     | )          |
| Net cash used by investing activities                                                     |       | (62,407  | )          | (55,729  | )          | (31,337  | )          |
|                                                                                           |            |          |            |          |            |          |            |  |  |  |

 

The notes to consolidated financial statementsare an integral part of these statements.

 

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**NORTHERNCALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**Years EndedDecember 31, 2008, 2007, and 2006**

**(Dollars inThousands)**

 
| ** **                                | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **CASH FLOWS FROM FINANCING ACTIVITIES**  |       |     |       |     |       |     |       |
| Net increase in deposits                  |       | $        | 20,974     |     | $          | 37,129   |       | $ | 14,013 |   |
| Proceeds from borrowings                  |       | 50,000   |       | 20,500   |       | 12,000   |       |
| Repayments on borrowings                  |       | (18,000  | )          | (2,750   | )          | (2,000   | )          |
| Proceeds from exercise of stock options   |       | 12       |       | 442      |       | 270      |       |
| Repurchase of common stock                |       | (341     | )          | —   |       | —   |       |
| Cash dividends paid on common stock       |       | (450     | )          | (461     | )          | (603     | )          |
| Net cash provided by financing activities |       | 52,195   |       | 54,860   |       | 23,680   |       |
|                                      |       |     |       |     |       |     |       |
| Net decrease in cash and cash equivalents |       | (3,805   | )          | (2,281   | )          | (1,697   | )          |
|                                      |       |     |       |     |       |     |       |
| **CASH AND CASH EQUIVALENTS, BEGINNING**  |       | 20,153   |       | 22,434   |       | 24,131   |       |
|                                      |       |     |       |     |       |     |       |
| **CASH AND CASH EQUIVALENTS, ENDING**     |       | $        | 16,348     |     | $          | 20,153   |       | $ | 22,434 |   |
|                                      |       |     |       |     |       |     |       |
| **SUPPLEMENTARY INFORMATION**             |       |     |       |     |       |     |       |
|                                      |       |     |       |     |       |     |       |
| Interest paid                             |       | $        | 9,200      |     | $          | 7,100    |       | $ | 3,296 |   |
|                                      |       |     |       |     |       |     |       |
| Income taxes paid                         |       | $        | 1,120      |     | $          | 1,262    |       | $ | 1,520 |   |

 

The notes to consolidated financial statementsare an integral part of these statements.

 

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

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**December 31, 2008 and 2007**

 

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

#### ** **

***Nature of Business***

 

Northern California Bancorp, Inc., (the Corporation) provides avariety of financial services through Monterey County Bank, (the Bank) toindividuals and small businesses through its four offices on the MontereyPeninsula.  Its primary deposit productsare demand and term certificate accounts. Its primary lending products are real estate, commercial, construction,and Small Business Administration (SBA) loans.

 

***Basis of Presentation andConsolidation***

 

The consolidated financial statements include theaccounts of Northern California Bancorp, Inc. and its wholly ownedsubsidiary, Monterey County Bank.  All****significant inter-company balances and transactions havebeen eliminated in consolidation.

 

In consolidating, the Corporation determineswhether it has a controlling financial interest in an entity by firstevaluating whether the entity is a voting interest entity or a variableinterest entity under accounting principles generally accepted in the UnitedStates of America. Voting interest entities are entities in which the totalequity investment at risk is sufficient to enable the entity to finance itselfindependently and provides the equity holders with the obligation to absorblosses, the right to receive residual returns and the right to make decisionsabout the entity’s activities. The Corporation consolidates voting interestentities in which it has all, or at least a majority of, the votinginterest.  As defined in applicable accounting standards, variableinterest entities (VIEs) are entities that lack one or more of thecharacteristics of a voting interest entity.  A controlling financialinterest in an entity is present when an enterprise has a variable interest, ora combination of variable interests, that will absorb a majority of the entity’sexpected losses, receive a majority of the entity’s expected residual returns,or both.  The enterprise with a controlling financial interest, known asthe primary beneficiary, consolidates the VIE.  The Corporation’s whollyowned subsidiaries, Northern California Bancorp, Inc. Trust I and NorthernCalifornia Bancorp, Inc. Trust II, are VIEs for which the Corporation isnot the primary beneficiary.  Accordingly, the accounts of these entitiesare not included in the Corporation’s consolidated financial statements.

#### ** **

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

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2008 and 2007**

 

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

#### ** **

***Use of Estimates***

 

In preparing consolidated financial statements inconformity with accounting principles generally accepted in the United Statesof America, management is required to make estimates and assumptions thataffect the reported amounts of assets and liabilities as of the date of thebalance sheet and reported amounts of revenues and expenses during thereporting period.  Actual results coulddiffer from those estimates.  Materialestimates that are particularly susceptible to significant change in the nearterm relate to the determination of the allowance for loan losses, and thevaluation of deferred tax assets.

 

***Cash and Cash Equivalents***

 

For purposes of reporting cash flows, cash and cashequivalents include cash, amounts due from banks and Federal funds sold on adaily basis, all of which mature within ninety days.

 

***Time Deposits with Other Financial Institutions***

 

Interest-bearing deposits in banks mature within one year and arecarried at cost.

 

***Trading Activities***

 

The Corporation engages in trading activities consisting of securitiesthat are held principally for resale in the near term.  The securities are recorded in the trading assetsaccount at fair value with changes in fair value recorded in earnings.  Interest and dividends are included in netinterest income.

 

Quoted market prices, when available, are used to determine the fairvalue of trading instruments.  If quotedmarket prices are not available, then the fair values are estimated usingpricing models, quoted prices of instruments with similar characteristics, ordiscounted cash flows.

#### ** **

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

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2008 and 2007**

 

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

#### ** **

***Investment Securities***

 

Investments in debtsecurities 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.

 

Purchasepremiums and discounts are recognized in interest income using the interestmethod over the terms of the securities. Declines in the fair value of held tomaturity and available for sale securities below their cost that are deemed tobe other than temporary are reflected in earnings as realized 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 intent and ability ofthe Bank to retain its investment in the issuer for a period of time sufficientto allow for any anticipated recovery in fair value.  Gains and losses on disposition are generallyrecognized on the trade date, based on the net proceeds and the adjustedcarrying amount of the securities sold using the specific identificationmethod.

 

***Sales and Servicing of SBA Loans***

 

The Bank originates loans to customers under the SBAprogram that generally provides for SBA guarantees of 70% to 85% of eachloan.  The Bank generally sells theguaranteed portion of each loan to a third party and retains only thenon-guaranteed portion in its own portfolio. A gain is recognized on these loans through collection on sale of apremium over the adjusted carrying value, or through retention of an ongoingrate differential, less a normal service fee between the rate paid by theborrower to the Bank and the rate paid by the Bank to the purchaser (excessservicing fee).  In calculating the gain,the Bank assumes that the loans sold will be outstanding for one-half of theircontractual lives.

#### ** **

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

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2008 and 2007**

 

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

#### ** **

***Sales and Servicing of SBA Loans(Continued)***

 

The Bank’s investment in an SBA loan is allocated among the retainedportion of the loan, excess servicing retained, and the sold portion of theloan, based on the relative fair market value of each portion at the time ofloan origination, adjusted for payments and other activities.  Since the portion retained does not carry anSBA guarantee, part of the gain recognized on the sold portion of the loan isdeferred and amortized as a yield enhancement on the retained portion of theloan.  Excess servicing fees arereflected as an asset which is amortized over an expected half life; in theevent future prepayments are significant and future expected cash flows areinadequate to cover the unamortized excess servicing asset, additionalamortization is recognized.

 

***Loans Held for Sale***

 

Loans held for sale consist of the portion of loans that are guaranteedby the SBA and are carried at the lower of cost or market.  Market value for loans guaranteed by the SBAis generally determined based on the price at which the loans were committed tobe sold on the trade date.  Direct loanorigination costs are recorded at settlement as an adjustment to gain or losson sale.

 

***Loans and Loan Fees***

 

The Bank grants residential mortgage, commercial,construction, and consumer loans to customers. A substantial portion of the loan portfolio is represented by****mortgage loans on the Monterey Peninsula.  The ability of the Bank’s debtors to honortheir contracts is dependent upon the real estate and general economicconditions in the area.

 

Loans, as reported, have been reduced by****undisbursedloan funds, net deferred loan fees, and the allowance for loan losses.

 

Loans that management has the intent and ability to hold for theforeseeable future or until maturity or pay-off generally are reported at theiroutstanding unpaid principal balances adjusted for charge-offs, the allowancefor loan losses, and any deferred fees or cost on originated loans.  Interest income is accrued on the unpaidprincipal balance.  Loan originationfees, net of certain direct origination costs, are deferred and recognized asan adjustment of the related loan yield using the interest method.

#### ** **

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

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2008 and 2007**

 

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

#### ** **

***Loans and Loan Fees (Continued)***

 

The accrual of interest on mortgage and commercial loans isdiscontinued at the time the loan is 90 days past due unless the credit iswell-secured and in process of collection. Credit card loans and other personal loans are typically charged off nolater than 180 days past due.  Past duestatus is based on contractual terms of the loan.  In all cases, loans are placed on nonaccrualor charged-off at an earlier date if collection of principal or interest isconsidered doubtful.

 

All interest accrued but not collected for loans that are placed onnonaccrual or charged off is reversed against interest income.  The interest on these loans is accounted foron the cash-basis or cost-recovery method, until qualifying for return toaccrual.  Loans are returned to accrualstatus when all the principal and interest amounts contractually due arebrought current and future payments are reasonably assured.

 

***Allowance for Loan Losses***

 

The allowance for loan losses is established through a provision forloan losses charged to earnings and is maintained at a level consideredadequate to provide for reasonably foreseeable loan losses.

 

The provision and the level of the allowance are evaluated on a regularbasis by management and are based upon management’s periodic review of thecollectibility of the loans in light of historical experience, known andinherent risks in the nature and volume of the loan portfolio, adversesituations that may affect the borrower’s ability to repay, estimated value ofany underlying collateral, and prevailing economic conditions.  This evaluation is inherently subjective asit requires estimates that are susceptible to significant change.  In addition, various regulatory agencies, asan integral part of their examination process, periodically review the Bank’sallowance for losses on loans and other real estate owned. Such agencies mayrequire the Bank to recognize additions to the allowance based on theirjudgment 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 charged against the allowance when management believesthe collectibility of the loan balance is unlikely.  Subsequent recoveries, if any, are creditedto the allowance.

#### ** **

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

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2008 and 2007**

 

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

#### ** **

***Allowance for Loan Losses (Continued)***

 

The allowance consists of specific, general andunallocated components.  The specificcomponent relates to loans that are classified as either doubtful, substandardor special mention.  For such loans thatare also classified as impaired, an allowance is established when thediscounted cash flows (or collateral value or observable market price) of theimpaired loan is lower than that of the carrying value of that loan.  The general component covers non-classifiedloans and is based on historical loss experience adjusted for qualitativefactors.  An unallocated component ismaintained to cover uncertainties that could affect management’s estimate ofprobable losses.  The unallocatedcomponent of the allowance reflects the margin of imprecision inherent in theunderlying assumptions used in the methodologies for estimating specific andgeneral losses in the portfolio.

 

A loan is considered impaired when, based on current information andevents, it is probable that a creditor will be unable to collect the scheduledpayments of principal or interest when due according to the contractual termsof the loan agreement.  Factorsconsidered by management in determining impairment include payment status,collateral value, and the probability of collecting scheduled principal andinterest payments when due.  Loans thatexperience insignificant payment delays and payment shortfalls generally are notclassified as impaired.  Management determinesthe significance of payment delays and payment shortfalls on a case-by-casebasis, taking into consideration all of the circumstances surrounding the loanand the borrower, including the length of the delay, the reasons for the delay,the borrower’s prior payment record, and the amount of the shortfall inrelation to the principal and interest owed. Impairment is measured on a loan-by-loan basis by either the presentvalue of expected future cash flows discounted at the loan’s effective interestrate, the loan’s obtainable market price, or the fair value of the collateralif the loan is collateral dependent. Substantially, all of the Bank’s loans that have been identified asimpaired have been measured by the fair value of existing collateral.

 

Large groups of smaller balance homogeneous loans are collectivelyevaluated for impairment.  Accordingly,the Bank does not separately identify individual consumer loans for impairmentdisclosures.

 

***Loan Servicing***

 

Rights to service loans for others are capitalized as separate assets,whether acquired through purchase or origination, if such loans are sold orsecuritized with servicing rights retained. Accordingly, the total cost of the loan is allocated to the relatedservicing right and to the loan based on the relative fair values if it ispracticable to estimate those fair values.

 

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

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2008 and 2007**

 

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

#### ** **

***Loan Servicing (Continued)***

 

The Bank estimates fair value based on the present value of estimated expectedfuture cash flows using prepayment speeds and discount rates commensurate withthe risks involved, and servicing costs determined on an incremental costbasis.

 

Capitalized mortgage servicing rights are reported in other assets andamortized to servicing revenue in proportion to, and over the period of,estimated future net servicing revenues of the underlying assets.  Impairment of mortgage servicing rights isassessed based on the fair value of those rights.  For purposes of measuring impairment, therights are stratified based on the following predominant risk characteristicsof the underlying loans: loan type, size, note rate, date of origination, term,and geographic location.  Impairment isrecognized through a valuation allowance for an individual stratum, to theextent that fair value is less than the capitalized amount for the stratum.

 

***Foreclosed Assets***

 

Assets acquired through, or in lieu of, loan foreclosure are held forsale and are initially recorded at fair value less cost to sell at the date offoreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed bymanagement and the assets are carried at the lower of carrying amount or fairvalue less cost to sell.  Revenue andexpenses from operations and changes in the valuation allowance are included innet expenses from foreclosed assets.

 

***Premises and Equipment***

 

The Banks premises and equipment are stated at cost less accumulateddepreciation and amortization. Depreciation is provided for in amounts sufficient to relate the cost ofdepreciable assets to operations over their estimated service lives.  Leasehold improvements are amortized over theterm of the lease or the service lives of the improvements, whichever isshorter.  The straight-line method ofdepreciation is followed for financial reporting purposes, while bothaccelerated and straight-line methods are followed for income tax purposes.

 

It is general practice to charge 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, 2008 and 2007**

 

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

#### ** **

***Income Taxes***

 

Deferred income taxes are recognized forestimated future tax effects attributable to income tax carry forwards as wellas temporary differences between income tax and financial reporting purposes.Valuation allowances are established when necessary to reduce the deferred taxasset to the amount expected to be realized.  Deferred tax assets and liabilitiesare reflected at currently enacted income tax rates applicable to the period inwhich the deferred tax assets or liabilities are expected to be realized orsettled. As changes in tax laws or rates are enacted, deferred tax assets andliabilities are adjusted accordingly through the provision for income taxes.

 

***Transfers of Financial Assets***

 

Transfers of financial assets are accounted for assales when control over the assets has been surrendered. Control overtransferred assets is deemed to be surrendered when 1) the assets have beenisolated from the Bank, 2) the transferee (buyer) obtains the right to pledgeor exchange the transferred assets, free of conditions that would constrain itfrom taking advantage of that right, and 3) the Bank does not maintaineffective control over the transferred assets through an agreement torepurchase them before their maturity.

 

***Stock Option Plans***

 

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 atprices not lower than 85% of the fair market value of the common stock on thedate of grant.  The Board of Directors(Board) is authorized to determine when options become exercisable within aperiod not exceeding 10 years from the date of grant.  Under the Plan, 62,161 shares of common stockhave been reserved for the granting of these options.  At December 31, 2008, all 62,161 optionswere outstanding.  During 2008, nooptions were granted and 12,000 options were exercised by officers, employees,and Board members.  As of December 31,2008, all options have been vested.

 

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

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2008 and 2007**

 

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

#### ** **

***Stock Option Plans (Continued)***

 

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.

 

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, 2008, no optionshave been granted under the 2007 stock option plan.

 

The Corporation adopted the provisions of Statement of FinancialAccounting Standards (SFAS) No. 123R, effective January 1, 2006,using the modified prospective method and began recording compensation expenseassociated with stock-based awards in accordance with SFAS No. 123R.  SFAS No. 123R requires all share-basedpayments to employees, including grants of employee stock options, to berecognized as compensation expense through the income statement based on theirfair values at issue date. SFAS No. 123R also requires the benefits of taxdeductions in excess of recognized compensation cost to be reported as afinancing cash flow, rather than as an operating cash flow required undercurrent guidelines.  Pre-tax stock-basedcompensation expense was approximately $18,000 for the year ended December 31,2006.  There was no stock basedcompensation for the years ended December 31, 2008 and 2007.  There were no options granted since 2005.

 

Future levels ofcompensation cost recognized related to stock-based compensation awards (includingthe aforementioned expected costs during the period of adoption) may beimpacted by new awards and/or modifications, repurchases and cancellations ofexisting awards before and after the adoption of this standard.

 

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

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2008 and 2007**

 

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

#### ** **

***Earnings per share***

 

Basic earnings per share represent income available to commonshareholders divided by the weighted-average number of common sharesoutstanding during the period.  Dilutedearnings per share reflect additional common shares that would have beenoutstanding if dilutive potential common shares had been issued, as well as anyadjustment to income that would result from the assumed issuance.  Potential common shares that may be issued bythe Corporation relate solely to outstanding stock options, and are determinedusing the treasury stock method.  Theweighted average number of shares outstanding for basic earnings per shareamounted to 1,823,965for 2008, 1,785,812 for 2007, and 1,658,675 for 2006.  The weighted average number of sharesoutstanding for dilutive earnings per share amounted to 1,848,173 for 2008, 1,881,004 for 2007, and1,831,892 for 2006.  The Corporation paidcash dividends of $.25, $.25, and $.35 per share in 2008, 2007, and 2006, respectively.

 

# ***Recent AccountingPronouncements***

# *** ***

In December 2007, the FinancialAccounting Standards Board (FASB) issued SFAS No. 141R, *Business Combinations.* This new statementrevises SFAS No. 141, which was issued June 2001. SFAS No. 141Rchanges multiple aspects of the accounting for business combinations. Under theguidance in SFAS No. 141R, the acquisition method must be used, whichrequires the acquirer to recognize most identifiable assets acquired,liabilities assumed and non-controlling interests in the acquiree at their fullfair value on the acquisition date. Goodwill is to be recognized as the excessof the consideration transferred plus the fair value of the non-controllinginterest over the fair values of the identifiable net assets acquired.Subsequent changes in the fair value of contingent consideration classified asa liability are to be recognized in earnings, while contingent considerationclassified as equity is not to be remeasured. Costs such as transaction costsare to be excluded from acquisition accounting, generally leading torecognizing expense and additionally, restructuring costs that do not meetcertain criteria at the acquisition date are to be subsequently recognized aspost-acquisition costs. SFAS No. 141R is effective for businesscombinations for which the acquisition date is on or after the beginning of thefirst annual reporting period beginning on or after December 15, 2008. TheCorporation does not expect the adoption of SFAS No.141R to have a materialimpact on its consolidated financial statements.

 

In March 2008, the FASB issued SFAS No. 161, *Disclosure about Derivative Instruments and HedgingActivities,* which amends SFAS No. 133, *Accounting for Derivative Instruments and HedgingActivities.* This new statement has the same scope as SFAS No. 133.Accordingly, it applies to all entities. SFAS No. 161 is intended toimprove financial reporting about derivative instruments and hedging activitiesby requiring enhanced disclosures to enable investors a better and clearer understandingof the derivative instruments and hedging activities.

 

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** **

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

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2008 and 2007**

 

#### **Note1.   SUMMARY OF SIGNIFICANT ACCOUNTINGPOLICIES (Continued)**

#### ** **

# ***Recent AccountingPronouncements (Continued)***

# *** ***

Entities are required to provide enhanced disclosures about how and whyan entity uses derivative instruments, how derivative instruments and relatedhedged items are accounted for under SFAS No. 133 and its relatedinterpretations, and how derivative instruments and related hedged items affectan entity’s financial position, financial performance, and cash flows. SFAS No. 161is effective for financial statements issued for fiscal years and interimperiods beginning after November 15, 2008, with early adoption encouraged.The statement encourages, but does not require, comparative disclosures forearlier periods at initial adoption. The Corporation does not expect theadoption of SFAS No.161R to have a material impact on its consolidatedfinancial statements.

 

In December 2008, the FASB issued FSP SFAS No.140-4 andFIN 46R-8, Disclosure by Public Entities (Enterprises) about Transfers ofFinancial Assets and Interests in VIEs. This FSP amends SFAS No. 140, *Accounting for Transfer and Servicing of Financial Assets andExtinguishments of Liabilities*, to require public entities toprovide additional disclosures about transfers of financial assets. It alsoamends FIN 46R, Consolidation of VIEs, to require public enterprises,including sponsors that have a variable interest in a VIE, to provideadditional disclosures about their involvement with VIEs. Additionally, thisFSP requires certain disclosures to be provided by a public enterprise that isa sponsor of a qualifying special purpose entity, or SPE, that holds a variableinterest in the qualifying SPE but was not the transferor (nontransferor) offinancial assets to the qualifying SPE, and a servicer of a qualifying SPE thatholds a significant variable interest in the qualifying SPE but was not thetransferor (nontransferor) of financial assets to the qualifying SPE. FSP SFAS No. 140-4and FIN 46R-8 is effective for the first reporting period, interim orannual, ending after December 31, 2008, with earlier adoption encouraged.An entity (enterprise) is encouraged, but not required, to disclose comparativeinformation in periods earlier than the effective date for disclosures thatwere not previously required for public entities (enterprises) by SFAS No. 140and FIN 46R. However, once this FSP is adopted, comparative disclosuresare required for periods subsequent to the effective date. The Corporation doesnot expect the adoption of FSP SFAS No. 140-4 and FIN 46R-8 to have amaterial impact on its consolidated financial statements.

 

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

# *** ***

Accounting principles generally accepted in the UnitedStates require that recognized revenue, expenses, gains, and losses be includedin net income.  Although certain changesin assets and liabilities, such as unrealized gains and losses onavailable-for-sale securities, are reported as a separate component of theequity section of the balance sheet, such items, along with net income, arecomponents of comprehensive income.

 

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

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2008 and 2007**

 

#### **Note1.   SUMMARY OF SIGNIFICANT ACCOUNTINGPOLICIES (Continued)**

#### ** **

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

# *** ***

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

 
| ** **                                                                                | ** ** | **2008**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|----------|------------|----------|------------|
| ** **                                                                                | ** ** | **(Dollars in thousands)** | ** ** |
| Unrealized  holding gains (losses) on available for sale securities and other assets, net |       | $                                    | (284       | )        | $          | 438      |       | $ | (98 | ) |
| Reclassification  adjustment for losses (gains) realized in income                        |       | (449                                 | )          | (216     | )          | 5        |       |
| Net unrealized  gains (losses)                                                            |       | (733                                 | )          | 222      |       | (93      | )          |
| Tax effect                                                                                |       | 330                                  |       | (100     | )          | 42       |       |
|                                                                                      |       |                                 |       |     |       |     |       |
| Other  comprehensive gain (loss) net of tax                                               |       | $                                    | (403       | )        | $          | 122      |       | $ | (51 | ) |

 

The components of accumulated other comprehensiveincome (loss) and related tax effects for the years ended December 31 areas follows:

 
| ** **                                                             | ** ** | **2008**                             | ** ** | **2007** | ** ** |
|------------------------------------------------------------------------|------------|--------------------------------------|------------|----------|------------|
| ** **                                                             | ** ** | **(Dollars in thousands)** | ** ** |
| Unrealized  holding gains (losses) on available for sale securities    |       | $                                    | (577       | )        | $          | 163 |   |
| Unrealized  holding gains on available for sale asset strip receivable |       | 27                                   |       | 21       |       |
| Tax effect                                                             |       | 248                                  |       | (83      | )          |
|                                                                   |       |                                 |       |     |       |
| Net-of-tax  amount                                                     |       | $                                    | (302       | )        | $          | 101 |   |

 

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

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2008 and 2007**

 

#### **Note1.   SUMMARY OF SIGNIFICANT ACCOUNTINGPOLICIES (Continued)**

#### ** **

***AdvertisingCosts***

 

Advertising costs arecharged to operations when incurred.  Theamount expensed for advertising for the years ended December 31, 2008,2007, and 2006 was $103,000, $164,000, and $224,000, respectively.

 

***BankOwned Life Insurance***

 

On September 7, 2006, the Task Forcereached a consensus on Emerging Issues Tax Force (EITF) Issue No. 06-4, *Accounting for Deferred Compensation and Postretirement Benefit Aspectsof Endorsement Split-Dollar Life Insurance Arrangements* (“EITF 06-4”)and on March 15, 2007, the Task Force reached a consensus on EITF Issue No. 06-10,*Accounting for Collateral Assignment Split-DollarLife Insurance Arrangements*(“EITF 06-10”). The scope of these twoissues relates to the recognition of a liability and related compensation costsfor endorsement split-dollar life insurance arrangements and for collateralassignment split-dollar life insurance arrangements, respectively.  EITF 06-4 and EITF 06-10 are both effectivefor fiscal years beginning after December 15, 2007, although earlyadoption is permitted.  The Corporation adopted EITF 06-4 and EITF06-10 effective as of January 1, 2008 as a change in accounting principlethrough a $362,000 cumulative-effect adjustment to retained earnings. Theamount expensed to recognize the liability for future benefits for the yearended December 31, 2008 was $110,000.

 

***Reclassification***

 

Certain amountshave been reclassified in the 2007 financial statements to conform to the 2008presentation with no changes to previously reported income.

 

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

 

The Corporation is required to maintain aggregatereserves (in the form of cash and deposits with the Federal Reserve Bank) tosatisfy federal regulatory requirements. At December 2008 and 2007, the Bank met these requirements bymaintaining reserve balances of $942,000 and $790,000, respectively.

 

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

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2008 and 2007**

 

**Note 3.   TRADING ASSETS**

 

At December 31, 2008 and 2007, the Corporation’s trading assetsconsisted of marketable equity securities in the amount of $361,000 and$1,224,000, respectively.

 

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

 

The following is a comparison of amortized cost and approximate fairvalue of investment securities at December 31:

 
| ** **                           | ** ** | **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 |   |

 

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

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2008 and 2007**

 

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

 
| ** **                                           | ** ** | **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 |   |

 
| ** **                           | ** ** | **2007**                             | ** ** |
|--------------------------------------|------------|--------------------------------------|------------|
| ** **                           | ** ** | ** **                           | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                           | ** ** | **Amortized**                        | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                           | ** ** | **Cost**                             | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
| ** **                           | ** ** | **(Dollars in thousands)** | ** ** |
| **Securities  Available for Sale**   |       |                                 |       |   |   |   |   |   |   |
| Mortgage Backed  Securities          |       | $                                    | 386        |   | $ | — |   | $ | (1 | ) | $ | 385 |   |
| State/Local  Agency Securities       |       | 225                                  |       | — |   | — |   | 225 |   |
| Government  Agency Securities        |       | 36,027                               |       | 179 |   | (15 | ) | 36,191 |   |
|                                 |       |                                 |       |   |   |   |   |   |   |
| Total securities  available for sale |       | $                                    | 36,638     |   | $ | 179 |   | $ | (16 | ) | $ | 36,801 |   |
|                                 |       |                                 |       |   |   |   |   |   |   |
| **Securities  Held to Maturity**     |       |                                 |       |   |   |   |   |   |   |
| State/Local  Agency Securities       |       | $                                    | 7,869      |   | $ | 239 |   | $ | (3 | ) | $ | 8,105 |   |

 

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

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2008 and 2007**

 

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

 
| ** **                                           | ** ** | **2007**                             | ** ** |
|------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                           | ** ** | ** **                           | ** ** | **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            |       | 2,495                                |       | — |   | — |   | 2,495 |   |
| 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 |   |
|                                                 |       |                                 |       |   |   |   |   |   |   |
| Total other  investments                             |       | $                                    | 2,824      |   | $ | — |   | $ | — |   | $ | 2,824 |   |

 

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.

 

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**NORTHERNCALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31,2008 and 2007**

 

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

 

The amortized cost andfair value of debt securities by contractual maturity date at December 31,2008 follows:

 
| ** **                              | ** ** | **Available for Sale**     | ** ** |
|-----------------------------------------|------------|--------------------------------------|------------|
| ** **                              | ** ** | **Amortized**                        | ** ** | **Fair** | ** ** |
| ** **                              | ** ** | **Cost**                             | ** ** | **Value** | ** ** |
| ** **                              | ** ** | **(Dollars in thousands)** | ** ** |
|                                    |       |                                 |       |   |   |
| Due  within one year                    |       | $                                    | 4,929      |   | $ | 4,962 |   |
| Due  after one year through five years  |       | 917                                  |       | 905 |   |
| Due  after five years through ten years |       | 417                                  |       | 363 |   |
| Due  after ten years                    |       | 87,667                               |       | 87,123 |   |
|                                    |       |                                 |       |   |   |
|                                    |       | $                                    | 93,930     |   | $ | 93,353 |   |

 

Proceeds from maturityand sales of investment securities for the years ended December 31, 2008,2007, and 2006 were $55,022,000, $24,217,000, and $5,831,000,respectively.  Realized gains for theyears ended December 31, 2008, 2007, and 2006 were $449,000, $216,000, and$1,308,000, respectively.

 

OnJanuary 31, 2006, Monterey County Bank, a wholly owned subsidiary ofNorthern California Bancorp, Inc., sold its shares of common stock inPacific Coast Banker’s Bancshares (“PCBB”). The gross sales proceeds were $1,757,000. After subtracting the bookvalue of $440,000, the resulting pretax gain was $1,313,000. The after tax gainwas approximately $790,000. Monterey County Bank owned 3,699 shares of PCBBthat sold for $475 per share less a $4,000 sales charge.

 

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 31,2008 and 2007, the Bank had advances from the FHLB totaling $66,500,000 and$52,500,000, 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, 2008and 2007, U.S. Government obligations with a carrying value of $43,044,000 and$31,576,000, respectively, were pledged to secure advances from the FHLB.

 

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**NORTHERNCALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31,2008 and 2007**

 

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

 

At December 31, 2008State/Local Agency obligations with a carrying value of $23,144,000 werepledged to secure loans from the Federal Reserve Bank.

 

In December 2008,the bank purchased three debt securities totaling $3,050,000 that havesettlement dates in January 2009. The bank records their investment purchases as of the trade date and hasrecorded the corresponding payable for investment securities purchased of$3,050,000 at December 31, 2008.

 

In December 2007,the bank purchased two debt securities totaling $5,225,000 that have settlementdates in January 2008.  The Bank hadrecorded the corresponding payable for investment securities purchased of$5,225,000 at December 31, 2007.

 

Informationpertaining to securities with gross unrealized losses at December 31,2008, aggregated by investment category and length of time that individualsecurities have been in 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 | ) |

 

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**NORTHERNCALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31,2008 and 2007**

 

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

 

Informationpertaining to securities with gross unrealized losses at December 31,2007, aggregated by investment category and length of time that individualsecurities have been in 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:    |       |                                   |       |                                 |       |      |       |   |   |   |   |   |   |
| GNMA  - Mortgage Backed Securities |       | $                                      | 385        |                                 | $          | (1        | )          | $ | — |   | $ | — |   | $ | 385 |   | $ | (1 | ) |
| Government  Agencies               |       | 2,147                                  |       | (14                                  | )          | 1,000     |       | (1 | ) | 3,147 |   | (15 | ) |
|                               |       |                                   |       |                                 |       |      |       |   |   |   |   |   |   |
| Total                              |       | $                                      | 2,532      |                                 | $          | (15       | )          | $ | 1,000 |   | $ | (1 | ) | $ | 3,532 |   | $ | (16 | ) |
|                               |       |                                   |       |                                 |       |      |       |   |   |   |   |   |   |
| Securities  Held to Maturity:      |       |                                   |       |                                 |       |      |       |   |   |   |   |   |   |
| State/Local  Agency Securities     |       | $                                      | 867        |                                 | $          | (3        | )          | $ | — |   | $ | — |   | $ | 867 |   | $ | (3 | ) |

 

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 intent and ability of theBank to retain its investment in the issuer for a period of time sufficient toallow for any anticipated recovery in fair value.

 

OnDecember 31, 2008, fifty five securities had an unrealized loss withaggregate depreciation of 1.20% from the Bank’s amortized cost basis. On December 31,2007, four securities had an unrealized loss with aggregate depreciation of0.05% from the Bank’s amortized cost basis. The unrealized losses relate to amortgage 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 theBank has the ability to hold these securities until estimated maturity, nodecline is deemed to be other than temporary.

 

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**NORTHERNCALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31,2008 and 2007**

 

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

** **

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

 
| ** **            | ** ** | **2008**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
|-----------------------|------------|--------------------------------------|------------|----------|------------|----------|------------|
| ** **            | ** ** | **(Dollars in thousands)** | ** ** |
|                  |       |                                 |       |     |       |     |       |
| SBA  loans originated |       | $                                    | 3,235      |     | $          | 3,065    |       | $ | 3,645 |   |
|                  |       |                                 |       |     |       |     |       |
| SBA  loans sold       |       | $                                    | 2,194      |     | $          | 1,933    |       | $ | 4,428 |   |

 

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

 
| ** **                            | ** ** | **2008**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
|---------------------------------------|------------|--------------------------------------|------------|----------|------------|----------|------------|
| ** **                            | ** ** | **(Dollars in thousands)** | ** ** |
|                                  |       |                                 |       |     |       |     |       |
| Income  from premiums                 |       | $                                    | 142        |     | $          | 147      |       | $ | 350 |   |
| Income  from servicing                |       | 187                                  |       | 333      |       | 340      |       |
|                                  |       |                                 |       |     |       |     |       |
| Total  SBA sales and servicing income |       | $                                    | 329        |     | $          | 480      |       | $ | 690 |   |

 

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

** **

A summary of loanbalances at December 31 follows:

** **
| ** **                             | ** ** | **2008**                             | ** ** | **2007**   | ** ** |
|----------------------------------------|------------|--------------------------------------|------------|------------|------------|
| ** **                             | ** ** | **(Dollars in thousands)** | ** ** |
| ** **                             | ** ** | ** **                           | ** ** | ** ** | ** ** |
| Commercial  and industrial             |       | $                                    | 28,237     |       | $          | 28,310 |   |
| Construction                           |       | 16,040                               |       | 23,396     |       |
| Real  estate, mortgage                 |       | 122,951                              |       | 116,625    |       |
| Installment                            |       | 966                                  |       | 876        |       |
| Government  guaranteed loans purchased |       | 24                                   |       | 32         |       |
|                                   |       | 168,218                              |       | 169,239    |       |
| Allowance  for loan losses             |       | (2,413                               | )          | (2,028     | )          |
| Deferred  origination fees, net        |       | (275                                 | )          | (350       | )          |
|                                   |       |                                 |       |       |       |
| Loans,  net                            |       | $                                    | 165,530    |       | $          | 166,861 |   |

 

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**NORTHERNCALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31,2008 and 2007**

 

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

 

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

 
| ** **                 | ** ** | **2008**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
|----------------------------|------------|--------------------------------------|------------|----------|------------|----------|------------|
| ** **                 | ** ** | **(Dollars in thousands)** | ** ** |
|                       |       |                                 |       |     |       |     |       |
| Beginning  balance         |       | $                                    | 2,028      |     | $          | 1,409    |       | $ | 1,101 |   |
| Recoveries                 |       | 3                                    |       | 4        |       | 7        |       |
| Loans  charged off         |       | (750                                 | )          | (250     | )          | (109     | )          |
| Provision  for loan losses |       | 1,132                                |       | 865      |       | 410      |       |
|                       |       |                                 |       |     |       |     |       |
| Ending  balance            |       | $                                    | 2,413      |     | $          | 2,028    |       | $ | 1,409 |   |

 

The following tablesummarizes the Corporation’s investment in loans for which impairment has beenrecognized as of and for the years ended December 31. Impaired loansconsist of the loans on non-accrual status.

 
| ** **                                                                                                                    | ** ** | **2008**                             | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------|------------|------------|------------|
| ** **                                                                                                                    | ** ** | **(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 |       | $                                    | 5,728      |       | $          | —     |       | $ | — |   |
| Impaired  loans which have a specific allowance                                                                               |       | 1,363                                |       | 3,396      |       | 155        |       |
| ** **                                                                                                                    | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total  impaired loans at period end                                                                                           |       | $                                    | 7,091      |       | $          | 3,396      |       | $ | 155 |   |
|                                                                                                                          |       |                                 |       |       |       |       |       |
| Total  specific allowance on impaired loans                                                                                   |       | $                                    | 123        |       | $          | 212        |       | $ | 31 |   |

 

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**NORTHERNCALIFORNIA BANCORP, INC. AND SUBSIDIARY**

 

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31,2008 and 2007**

 

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

 
| ** **                                                       | ** ** | **2008**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
|------------------------------------------------------------------|------------|--------------------------------------|------------|----------|------------|----------|------------|
| ** **                                                       | ** ** | **(Dollars in thousands)** | ** ** |
|                                                             |       |                                 |       |     |       |     |       |
| Average  recorded investment in impaired loans during the period |       | $                                    | 5,073      |     | $          | 702      |       | $ | 142 |   |
| Income  recognized on impaired loans during the period           |       | $                                    | —     |     | $          | —   |       | $ | — |   |

 

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

 

As of December 31,2008 and 2007, there were no loans past due ninety days or more and stillaccruing interest.

 

Loans serviced for othersare not included in the accompanying balance sheets. The unpaid principalbalance of loans serviced for others was $112,849,000 and $109,294,000 at December 31,2008 and 2007, respectively.

 

## **Note 7.**       FORECLOSEDASSETS

## ** **

As of December 31,2008, foreclosed assets totaled $7,364,000. There were no foreclosed assets at December 31,2007. Based on property values, no valuation allowance is deemed necessary.

 

Operating expenses forforeclosed assets totaled $112,000 for the year ended December 31, 2008.

 

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**NORTHERN CALIFORNIABANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**December 31, 2008and 2007**

 

## **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**         | ** ** |
|---------------------------|------------|--------------------------------------|------------|------------|------------|-----------------------|------------|
| ** **                | ** ** | **2008**                             | ** ** | **2007**   | ** ** | **Useful Lives** | ** ** |
|                      |       | **(Dollars in thousands)** |       |       |       |
|                      |       |                                 |       |       |       |                  |       |
| Land                      |       | $                                    | 1,174      |       | $          | 1,174                 |       |   |   |
| Building                  |       | 1,816                                |       | 1,808      |       | 40 years              |       |
| Building  improvements    |       | 1,094                                |       | 1,114      |       | 40 years              |       |
| Leasehold  improvements   |       | 1,080                                |       | 835        |       | Lease term            |       |
| Furniture  and equipment  |       | 2,427                                |       | 2,243      |       | 3-8 years             |       |
|                      |       | 7,591                                |       | 7,174      |       |                  |       |
| Accumulated  depreciation |       | (2,603                               | )          | (2,300     | )          |                  |       |
|                      |       |                                 |       |       |       |                  |       |
|                      |       | $                                    | 4,988      |       | $          | 4,874                 |       |   |   |

 

Depreciation andamortization expense for the years ended December 31, 2008, 2007, and 2006amounted to $312,000, $293,000, and $277,000, respectively.

 

## **Note 9.       DEPOSITS**

## ** **

At December 31,2008, the scheduled maturities of time deposits are as follows:

 
| **(Dollars in thousands)** |
|--------------------------------------|
| ** **                           |
| Years Ending December 31:       |   |   |   |
| 2009                                 |   | $ | 110,246 |   |
| 2010                                 |   | 26,160 |   |
| 2011                                 |   | 2,992 |   |
| 2012                                 |   | 2,641 |   |
| 2013                                 |   | 1,296 |   |
| Thereafter                           |   | 184 |   |
|                                 |   |   |   |
|                                 |   | $ | 143,519 |   |

 

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**NORTHERN CALIFORNIABANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**December 31, 2008and 2007**

 

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

#### ** **

On March 27, 2003, the Corporation’swholly owned special-purpose trust subsidiary, Northern California Bancorp, Inc.Trust I (“Trust I”) issued $3 million in cumulative Trust PreferredSecurities.  The securities bear afloating rate of interest of 3.25% over the three month LIBOR rate, payablequarterly.  The effective rate at December 31, 2008 and 2007was 8.07% and 8.49%, respectively.  Concurrent with the issuance of the TrustPreferred Securities, Trust I used the proceeds from the Trust PreferredSecurities offering to purchase a like amount of Junior Subordinated Debenturesof the Corporation. The Corporation will pay 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 Trust Preferred Securities will mature onApril 7, 2033, but can be redeemed, in whole or in part, on any January 7,April 7, July 7 or October 7 occurring after April 7, 2008at par.  The Corporation fully andunconditionally guarantees 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 31,2008 and 2007 was 6.04% and 7.76%, 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 CALIFORNIABANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**December 31, 2008and 2007**

 

#### **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 31,2008, 2007 and 2006 interest expense on Junior Subordinated Debentures totaled$534,000, $696,000,and $676,000, respectively.  Theamortization of the issuance cost totaled $6,000 for each year ended December 31,2008, 2007 and 2006, respectively.

 

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

#### ** **

The Corporation has a line of credit with M & I Marshall &Ilsley Bank in the amount of $3,000,000, a floating interest rate based on theone month LIBOR Rate plus 2.75% with a 4.50% floor and a maturity date of March 31,2009.  At December 31, 2008, theline of credit was fully advanced

 

The Bank has lines of credit from the Federal Home Loan Bank (FHLB) ofSan Francisco, Federal Reserve Bank, Bank of the West, M & I Marshall &Ilsley Bank, Pacific Coast Bankers’ Bank and The Independent Bank withremaining available borrowing capacity on December 31, 2008 of $1,337,000,$7,165,00, $4,500,000, $5,000,000, $6,000,000 and $5,000,000,respectively.  The Federal Home Loan Bankline of credit has a maximum borrowing capacity of 25% of the Bank’s totalassets, adjusted quarterly.  The FederalHome Loan Bank line of credit is secured by a portion of the Bank’s real estatesecured loans and securities at December 31, 2008.  At December 31, 2008, the totalprincipal balance of pledged loans and securities was $38,597,000 and$43,044,000, respectively.

 

The Federal Reserve Bank discount window line is secured by a portionthe Bank’s securities at December 31, 2008.  At December 31, 2008 the total marketvalue of securities pledged was $21,448,000.

 

At December 31, 2007, the total principal balance of pledged loansand securities was $41,309,000 and $31,576,000, respectively.

 

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**NORTHERN CALIFORNIABANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**December 31, 2008and 2007**

 

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

#### ** **

The following table provides information on twenty-one FHLB advancesoutstanding at December 31, 2008.

 
| ** **                           | ** ** | **Fixed**    | ** ** | ** **  | ** ** | ** **   | ** ** |
|--------------------------------------|------------|--------------|------------|-------------|------------|--------------|------------|
| **Advance**                          | ** ** | **Interest** | ** ** | **Funding** | ** ** | **Maturity** | ** ** |
| **Amount**                           | ** ** | **Rate**     | ** ** | **Date**    | ** ** | **Date**     | ** ** |
| **(Dollars in thousands)** | ** ** |
|                                 |       |         |       |        |       |         |       |
| $                                    | 3,000,000  |         | 4.30       | %           | 06/17/05   |         | 06/17/10   |   |
| 2,500,000                            |       | 4.88         | %          | 08/20/07    |       | 08/20/10     |       |
| 5,000,000                            |       | 3.57         | %          | 10/02/08    |       | 10/04/10     |       |
| 5,000,000                            |       | 4.96         | %          | 11/14/05    |       | 11/15/10     |       |
| 4,000,000                            |       | 2.70         | %          | 01/24/08    |       | 01/24/11     |       |
| 2,250,000                            |       | 4.75         | %          | 01/26/06    |       | 01/26/11     |       |
| 1,750,000                            |       | 4.72         | %          | 01/26/06    |       | 01/26/11     |       |
| 2,000,000                            |       | 3.32         | %          | 05/14/08    |       | 05/16/11     |       |
| 1,500,000                            |       | 5.52         | %          | 07/17/06    |       | 07/18/11     |       |
| 3,500,000                            |       | 5.49         | %          | 07/17/06    |       | 07/18/11     |       |
| 1,000,000                            |       | 5.22         | %          | 08/25/06    |       | 08/25/11     |       |
| 5,000,000                            |       | 5.20         | %          | 07/30/07    |       | 07/30/12     |       |
| 3,000,000                            |       | 4.84         | %          | 10/01/07    |       | 10/01/12     |       |
| 5,000,000                            |       | 5.00         | %          | 09/18/07    |       | 09/18/14     |       |
| 1,000,000                            |       | 7.72         | %          | 06/01/00    |       | 06/03/30     |       |
| 2,000,000                            |       | 2.34         | %          | 11/21/08    |       | 11/23/09     |       |
| 3,000,000                            |       | 3.00         | %          | 11/21/08    |       | 11/22/10     |       |
| 3,000,000                            |       | 3.26         | %          | 11/21/08    |       | 11/02/11     |       |
| 3,000,000                            |       | 3.92         | %          | 11/21/08    |       | 11/21/13     |       |
| 2,500,000                            |       | 1.31         | %          | 12/16/08    |       | 12/16/09     |       |
| 7,500,000                            |       | 1.30         | %          | 12/16/08    |       | 12/16/09     |       |
| $                                    | 66,500,000 |         |       |        |       |         |       |   |

 

Subsequent to year end the Bank prepaid fiveadvance totaling $17,000,000.

 

The Bank has a loan from the Federal ReserveBank in the amount of $15,000,000 with an interest rate of 0.50% and a maturitydate of February 9, 2009.  Atmaturity, the loan was paid off with funding from a new loan for the sameamount and terms with a maturity date of May 8, 2009.

 

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**NORTHERN CALIFORNIABANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**December 31, 2008and 2007**

 

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

#### ** **

The Bank of the West, M & I Marshall &Ilsley Bank, Pacific Coast Bankers’ Bank and The Independent Bank lines of credit are unsecured.  The Bank’s use of overnight borrowing during2008 was limited to testing the line availability.  No overnight borrowings were utilized in2007.

 

The Bank has a $330,000letter of credit issued by the Federal Home Loan Bank of San Francisco tosecure the uninsured portion of local agency deposits maintained with theBank.  The letter of credit matures April 17,2011.

 

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

#### ** **

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

 
| ** **                                  | ** ** | **2008**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
|---------------------------------------------|------------|--------------------------------------|------------|----------|------------|----------|------------|
| ** **                                  | ** ** | **(Dollars in thousands)** | ** ** |
| Current  tax provision:                     |       |                                 |       |     |       |     |       |
| Federal                                     |       | $                                    | 551        |     | $          | 1,099    |       | $ | 2,130 |   |
| California                                  |       | 313                                  |       | 468      |       | 768      |       |
|                                        |       |                                 |       |     |       |     |       |
|                                        |       | 864                                  |       | 1,567    |       | 2,898    |       |
|                                        |       |                                 |       |     |       |     |       |
| Deferred  tax provision (benefit):          |       |                                 |       |     |       |     |       |
| Federal                                     |       | (279                                 | )          | (259     | )          | (117     | )          |
| California                                  |       | (155                                 | )          | (110     | )          | (50      | )          |
| Increase  (decrease) in valuation allowance |       | (149                                 | )          | 278      |       | 135      |       |
|                                        |       |                                 |       |     |       |     |       |
|                                        |       | (583)                                |       | (91      | )          | (32      | )          |
|                                        |       |                                 |       |     |       |     |       |
|                                        |       | $                                    | 281        |     | $          | 1,476    |       | $ | 2,866 |   |

 

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**NORTHERN CALIFORNIABANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**December 31, 2008and 2007**

 

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

#### ** **

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

 
| ** **                                    | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|-----------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                          |       |     |       |     |       |     |       |
| 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       |       | (16.40   | )          | (3.30    | )          | (1.68    | )          |
| Other,  net                                   |       | (8.68    | )          | 5.45     |       | 3.24     |       |
|                                          |       |     |       |     |       |     |       |
| Effective  tax rates                          |       | 16.12    | %          | 43.35    | %          | 42.76    | %          |

 

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

 
| ** **                | ** ** | ** ** | ** ** | **2008**                             | ** ** | **2007** | ** ** |
|---------------------------|------------|------------|------------|--------------------------------------|------------|----------|------------|
| ** **                | ** ** | ** ** | ** ** | **(Dollars in thousands)** | ** ** |
| Deferred  tax asset       |       |       |       |                                 |       |     |       |
| Federal                   |       |       |       | $                                    | 1,538      |     | $          | 1,194 |   |
| California                |       |       |       | 562                                  |       | 371      |       |
|                      |       |       |       |                                 |       |     |       |
| Total  deferred tax asset |       |       |       | 2,100                                |       | 1,565    |       |
| Valuation  allowance      |       |       |       | (674                                 | )          | (823     | )          |
|                      |       |       |       |                                 |       |     |       |
| Net  deferred tax asset   |       |       |       | $                                    | 1,426      |     | $          | 742 |   |

 

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#### **Table ofContents**

 

**NORTHERN CALIFORNIABANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**December 31, 2008and 2007**

 

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

 

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

 
| ** **                             | ** ** | **2008** | ** ** | **2007** | ** ** |
|----------------------------------------|------------|----------|------------|----------|------------|
| Deferred  tax assets (liabilities)     |       |     |       |     |       |
| Net  unrealized gain on securities     |       | $        | 950        |     | $          | 310 |   |
| Allowance  for loan losses             |       | 976      |       | 860      |       |
| Accrued  salary continuation liability |       | 383      |       | 383      |       |
| Other                                  |       | (74      | )          | 100      |       |
| Depreciation                           |       | (135     | )          | (88      | )          |
|                                   |       |     |       |     |       |
| Total  deferred tax asset              |       | 2,100    |       | 1,565    |       |
| Valuation  allowance                   |       | (674     | )          | (823     | )          |
|                                   |       |     |       |     |       |
| Net  deferred tax asset                |       | $        | 1,426      |     | $          | 742 |   |

 

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.

 

TheCorporation adopted the provisions of FASB Interpretation No. 48,Accounting for Uncertainty in Income Taxes, on January 1, 2007. TheCorporation had no unrecognized tax benefits which would have required anadjustment to the January 1, 2007 beginning balance of retained earnings.The Corporation has no unrecognized tax benefits at January 1, 2008 and atDecember 31, 2008. The Corporation recognizes, when applicable interestaccrued and penalties related to unrecognized tax benefits in tax expense.During the years ended December 31, 2008 and 2007 the Corporationrecognized no interest and penalties.

 

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**NORTHERN CALIFORNIABANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**December 31, 2008and 2007**

 

#### **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 has 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 1,000square feet at 321 Webster Street, Monterey, CA.  The 321 Webster Street lease has 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 $352,000, $286,000, and $275,000 for the years ended December 31,2008, 2007, and 2006, respectively.

 

Effective April 1,2000, the Bank entered into a five year sublease agreement to rent one of theunits in the Carmel Valley branch, upon expiration of the sublease in 2005 theBank elected to retain the space for its own use.

 

Effective July 1,2002, the Bank entered into a five year and three months sublease agreement torent one of the units in the Carmel-By-The-Sea branch.  The sublease was terminated in 2006 due todefault for non-payment of rent. Sublease rental income for the year ending December 31, 2006 wasapproximately $24,000 and in 2007 approximately $18,000 in delinquent 2006 rentwas collected.  The Bank retained thesubleased portion of the facility for its own use during 2007 and 2008.  The Bank has now engaged a real estate brokerto sublease the space.

 

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**NORTHERN CALIFORNIABANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**December 31, 2008and 2007**

 

#### **Note 13.**    COMMITMENTSAND CONTINGENCIES (Continued)

#### ** **

***Operatinglease commitments (Continued)***

 

Future minimum lease commitments for all non-cancelable operatingleases are as follows:

 

| **Years Ending** | ** ** | **Minimum Lease**               | ** ** |
|-----------------------|------------|--------------------------------------|------------|
| **December 31**  | ** ** | **Commitments**                      | ** ** |
| ** **            | ** ** | **(Dollars in thousands)** | ** ** |
| 2009                  |       | $                                    | 364        |   |
| 2010                  |       | 364                                  |       |
| 2011                  |       | 267                                  |       |
| 2012                  |       | 168                                  |       |
|                  |       |                                 |       |
|                  |       | $                                    | 1,163      |   |

 

***Loancommitments***

 

The Bank is a party tofinancial instruments with off-balance-sheet risk in the normal course ofbusiness to meet the financing needs of its customers.  These financial instruments includecommitments to extend credit.  Suchcommitments involve, to varying degrees, elements of credit and interest raterisk in excess of the amount recognized in the consolidated balance sheets.

 

The Bank’s exposure tocredit loss is represented by the contractual amount of these commitments.  The Bank uses the same credit policies inmaking commitments as it does for on-balance-sheet instruments.

 

At December 31, 2008 and 2007, such commitments to extend creditwere $13,941,000 and $20,794,000, respectively, of undisbursed lines of credit,undisbursed loans in process, and commitment letters.

 

***Contingencies***

 

The Corporation, its principal subsidiary Monterey County Bank and its Chief Executive Officer were named as defendants in a lawsuit filed November 3, 2008 in the Monterey County Court-Civil Division.  The lawsuit involves claims related to loan participations purchased by another community bank.  The lawsuit 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 CALIFORNIABANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**December 31, 2008and 2007**

 

#### **Note 13.**    COMMITMENTSAND CONTINGENCIES (Continued)

#### ** **

***Contingencies(Continued)***

 

The defendants have reviewed the lawsuit, categorically deny all of the allegations and will vigorously defend the suit.  The parties have agreed to have this matter decided by binding arbitration.

 

Monterey County Bank was named as defendant in a lawsuit filed February 26, 2009 in Monterey County Court-Civil Division by a third party provider.  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.

 

The defendant has reviewed the lawsuit, categorically denies all of the allegations and will vigorously defend the suit.

 

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 and its subsidiary.

 

#### **Note 14.**    CONCENTRATIONOF RISK

#### ** **

TheBank grants commercial, construction, real estate and installment loans to businessesand individuals primarily in the Monterey Peninsula 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 83% of total loans held for investment at December 31,2008 and 2007.  The Bank has noconcentration of loans with any one customer.

 

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**NORTHERN CALIFORNIABANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**December 31, 2008and 2007**

 

#### **Note 14.**    CONCENTRATIONOF RISK (Continued)

#### ** **

Concentration of loansfor specific industries and their percentage of total loans at December 31,2008 and 2007 are as follows:

#### ** **

| ** **                                        | ** ** | **2008** | ** ** | **2007** | ** ** |
|---------------------------------------------------|------------|----------|------------|----------|------------|
|                                              |       |     |       |     |       |
| Real  estate                                      |       | 20.42    | %          | 28.49    | %          |
| Accommodation  and food                           |       | 22.00    | %          | 17.85    | %          |
| Finance  and insurance                            |       | 12.20    | %          | 10.30    | %          |
| Professional,  scientific, and technical services |       | 10.97    | %          | 8.98     | %          |

#### ** **

#### **Note 15.**    OTHERINCOME AND OTHER GENERAL AND ADMINISTRATIVE EXPENSES

#### ** **

Other income for the years ended December 31,2008, 2007, and 2006 totaled $3,942,000, $3,222,000, and $4,627,000,respectively.  Significant categoriescomprising other income were as follows:

 
| ** **                                                 | ** ** | **2008**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
|------------------------------------------------------------|------------|--------------------------------------|------------|----------|------------|----------|------------|
| ** **                                                 | ** ** | **(Dollars in thousands)** | ** ** |
|                                                       |       |                                 |       |     |       |     |       |
| Merchant  discount fees                                    |       | $                                    | 2,731      |     | $          | 2,423    |       | $ | 2,614 |   |
| Commercial  banking broker fees                            |       | —                               |       | 21       |       | 125      |       |
| Life  insurance cash surrender value earnings              |       | 128                                  |       | 126      |       | 108      |       |
| Credit  card marketing program income                      |       | 514                                  |       | 684      |       | 1,308    |       |
| Stored  value card marketing program income                |       | 155                                  |       | 293      |       | 75       |       |
| Trading  asset activities                                  |       | (944                                 | )          | (686     | )          | 283      |       |
| Net  gain (loss) realized on available for sale securities |       | 449                                  |       | 216      |       | (5       | )          |
| Visa, Inc.  public stock offering                     |       | 694                                  |       | —   |       | —   |       |
| Other                                                      |       | 215                                  |       | 145      |       | 119      |       |
|                                                       |       |                                 |       |     |       |     |       |
|                                                       |       | $                                    | 3,942      |     | $          | 3,222    |       | $ | 4,627 |   |

 

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**NORTHERN CALIFORNIABANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**December 31, 2008and 2007**

 

#### **Note 15.**    OTHERINCOME AND OTHER GENERAL AND ADMINISTRATIVE EXPENSES (Continued)

#### ** **

Other general and administrative expenses for theyears ended December 31, 2008, 2007, and 2006 totaled $3,752,000,$3,564,000, and $3,512,000, respectively. Significant categories comprisingother general and administrative expenses were as follows:

#### ** **

| ** **                          | ** ** | **2008**                             | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|-------------------------------------|------------|--------------------------------------|------------|------------|------------|------------|------------|
| ** **                          | ** ** | **(Dollars in thousands)** | ** ** |
| ** **                          | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Merchant  credit processing expense |       | $                                    | 2,274      |       | $          | 2,028      |       | $ | 2,154 |   |
| Advertising                         |       | 103                                  |       | 164        |       | 224        |       |
| Business  development               |       | 114                                  |       | 171        |       | 124        |       |
| Insurance                           |       | 124                                  |       | 118        |       | 111        |       |
| Stationery  and supplies            |       | 167                                  |       | 148        |       | 123        |       |
| FDIC  and State Assessments         |       | 137                                  |       | 49         |       | 44         |       |
| Other                               |       | 833                                  |       | 886        |       | 732        |       |
|                                |       |                                 |       |       |       |       |       |
|                                |       | $                                    | 3,752      |       | $          | 3,564      |       | $ | 3,512 |   |

#### ** **

#### **Note 16.**    MINIMUMREGULATORY CAPITAL REQUIREMENTS

#### ** **

The Corporation (on aconsolidated basis) and the Bank are subject to various regulatory capitalrequirements administered by the federal banking agencies. Failure to meetminimum capital requirements can initiate certain mandatory and possiblyadditional discretionary actions by regulators that, if undertaken, could havea direct material effect on the Corporation’s and Bank’s financial statements.

 

Under capital adequacyguidelines and the regulatory framework for prompt corrective action, theCorporation and the Bank must meet specific capital guidelines that involvequantitative measures of their assets, liabilities, and certainoff-balance-sheet items as calculated under regulatory accounting practices.The capital amounts and classifications are also subject to qualitativejudgments by the regulators about components, risk weightings, and otherfactors. Under applicable regulatoryguidelines, a portion of the Trust Preferred Securities qualify as Tier ICapital, and the remainder as Tier II Capital. Prompt corrective actionprovisions are not applicable to bank holding companies.

 

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Tableof Contents

 

**NORTHERN CALIFORNIABANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**December 31, 2008and 2007**

 

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

#### ** **

Quantitative measuresestablished by regulation to ensure capital adequacy require the Corporationand the Bank to maintain minimum amounts and ratios (set forth in the followingtable) of total and Tier 1 capital (as defined in the regulations) torisk-weighted assets (as defined) and of Tier 1 capital (as defined) to averageassets (as defined).  Managementbelieves, as of December 31, 2008 and 2007, that the Corporation and theBank met all capital adequacy requirements to which they are subject.

 

As of December 31,2008, the most recent notification from the Federal Deposit InsuranceCorporation categorized the Bank as well capitalized under the regulatoryframework for prompt corrective action. To be categorized as well capitalized, an institution must maintainminimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as setforth in the following tables.  There areno conditions or events since the notification that management believes havechanged the Bank’s category.  TheCorporation’s and the Bank’s actual capital amounts and ratios as of December 31,2008 and 2007 are also presented in the tables.

 

**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 CALIFORNIABANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**December 31, 2008and 2007**

 

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

 

**December 31, 2007**

 
|                                     |   | **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                             |   | $                                    | 23,849     |                              | 12.6       | %                                                                                                     | $          | 15,108 |   | 8.0 | % | N/A |   | N/A |   |
| Monterey County  Bank                    |   | $                                    | 22,197     |                              | 11.9       | %                                                                                                     | $          | 14,977 |   | 8.0 | % | $ | 18,721 |   | 10.0 | % |
|                                     |   |                                 |       |                              |       |                                                                                                  |       |   |   |   |   |   |   |
| Tier 1 Capital  to Risk Weighted Assets: |   |                                 |       |                              |       |                                                                                                  |       |   |   |   |   |   |   |
| Consolidated                             |   | $                                    | 17,429     |                              | 9.2        | %                                                                                                     | $          | 7,554 |   | 4.0 | % | N/A |   | N/A |   |
| Monterey County  Bank                    |   | $                                    | 20,169     |                              | 10.8       | %                                                                                                     | $          | 7,488 |   | 4.0 | % | $ | 11,232 |   | 6.0 | % |
|                                     |   |                                 |       |                              |       |                                                                                                  |       |   |   |   |   |   |   |
| Tier 1 Capital  to Average Assets:       |   |                                 |       |                              |       |                                                                                                  |       |   |   |   |   |   |   |
| Consolidated                             |   | $                                    | 17,429     |                              | 7.4        | %                                                                                                     | $          | 9,410 |   | 4.0 | % | N/A |   | N/A |   |
| Monterey County  Bank                    |   | $                                    | 20,169     |                              | 8.6        | %                                                                                                     | $          | 9,393 |   | 4.0 | % | $ | 11,742 |   | 5.0 | % |
|                                          |        |                                      |            |                                   |            |                                                                                                       |            |  |  |  |  |  |  |  |  |  |  |

 

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

#### ** **

The Corporation issubject to regulation by the Board of Governors of the Federal Reserve Systemunder the Bank Holding Corporation Act. The Bank is subject to regulation, supervision, and regular examinationby the California Department of Financial Institutions and the Federal DepositInsurance Corporation.  The regulationsof these agencies affect most aspects of the Corporation’s business andprescribe permissible types of loans and investments, the amount of requiredreserves, requirements for branch offices, the permissible scope of theCorporation’s activities, and various other requirements.  The Corporation is also subject to certainregulations of the Federal Reserve Bank dealing primarily with check clearingactivities, establishment of banking reserves, Truth-in-Lending (Regulation Z),and Equal Credit Opportunity (Regulation B).

 

The Bank is currently indiscussions with the Federal Deposit Insurance Corporation regarding a draftregulatory order, resulting from its 2008 Consumer Compliance Examination,which was completed in 2009.  The Bankdoes not agree with some of the provisions of the draft order and is seekingexpert opinions regarding the matters at issue. The FDIC has indicated to the Bank that it will proceed with anAdministrative Hearing if the Bank doesn’t sign the proposed order 

 

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

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2008 and 2007**

 

#### **Note 17.  OTHER REGULATORY MATTERS(Continued)**

#### ** **

by the end of March. Thefinancial and non-financial impact of this matter is not known as of thebalance sheet date and as of the issuance date of this report.

 

#### **Note 18.  STOCK OPTIONS AND STOCK DIVIDENDS**

#### ** **

At December 31,2008, options for the purchase of 62,161 shares of the Corporation’s commonstock were outstanding and exercisable at prices ranging from $3.00 - $4.40.  The status of all stock options isas follows:

 
| ** **                             | ** ** | **Shares** | ** ** | **Exercise Price  Range**                                                | ** ** | **Weighted  Average  Remaining  Contractual Life** | ** ** |
|----------------------------------------|------------|------------|------------|-------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
|                                   |       |       |       |                                                                          |       |                                                    |       |
| Outstanding at  December 31, 2006 |       | 202,864    |       | $1.86 - $4.40                                                                 |       | 2.3 Years                                               |       |
|                                   |       |       |       |                                                                          |       |                                                    |       |
| Exercised                              |       | (124,203   | )          | $1.86 - $3.30                                                                 |       |                                                    |       |
| Expired  unexercised                   |       | (2,127     | )          |             $3.00 |       |                                                    |       |
|                                   |       |       |       |                                                                          |       |                                                    |       |
| Outstanding at  December 31, 2007 |       | 76,534     |       | $2.25 - $4.40                                                                 |       | 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                                               |       |

 

The weighted averageexercise price was $3.00, $3.56, and $3.19 for the years ending December 31,2008, 2007, and 2006, respectively.  Nooptions were granted in 2008, 2007 and 2006. All options are vested and exercisable as of December 31, 2008 and2007.

 

Therewas no intrinsic value attributable to options exercised during the year ended December 31,2008 and options outstanding and exercisable at December 31, 2008.  The aggregate intrinsic value represents thetotal pretax intrinsic value based on stock options with an exercise price lessthan the Corporation’s closing stock price of $3.00 as of December 31,2008, which would have been received by the option holders had those optionholders exercised those options as of that date.

 

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

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2008 and 2007**

 

#### **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, 2006 |   | $      | 1,629  |   |
|---------------------------------------|--------|--------|--------|--------|
| New loans                             |   | 3,761  |   |
| Advances on  lines of credit          |   | 19     |   |
| Repayments                            |   | (1,277 | )      |
|                                  |   |   |   |
| 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  |   |

 

Related party depositstotaled $611,000 and $1,103,000 at December 31, 2008 and 2007,respectively.

 

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

#### ** **

During 1995, theCorporation established an employee stock ownership plan (ESOP) to invest inthe Corporation’s common stock for the benefit of eligible employees.  The Board determines the Corporation’scontribution to the plan.  Shares in theplan generally vest after seven years. The Corporation did not contribute to the ESOP trust in 2008, 2007, or2006.  There were no shares in the planas of December 31, 2008.

 

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**NORTHERN CALIFORNIABANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**December 31, 2008and 2007**

#### ** **

#### **Note 20.  EMPLOYEE BENEFIT PLANS (Continued)**

#### ** **

The Bank has a salaryreduction plan under Section 401(k) of the Internal RevenueCode.  The plan covers substantially allfull-time employees who have completed one year of service with the Bank.  Employees are allowed to defer up to 15% oftheir compensation subject to certain limits based on federal tax laws.  Under the provisions of the plan, the Bank’scontribution policy is discretionary. The Bank initiated a matching contribution in 2001 of 100% of eachemployee’s contribution up to 6% of the employee’s compensation.  The Bank’s matching contributions in 2008,2007, and 2006 totaled $139,000, $114,000, and $129,000, respectively.

 

#### **Note 21.  RESTRICTION ON DIVIDENDS, LOANSAND ADVANCES**

#### ** **

Federal and state bankingregulations place certain restrictions on dividends paid and loans or advancesmade by the Bank to the Corporation.  Thetotal amount of dividends which may be paid by the Bank to the Corporation atany date is generally 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), and loans or advances are limited to25% of the Bank’s primary capital plus the allowance for loan losses on asecured basis and 15% on an unsecured basis.

 

TheCorporation’s ability to pay cash dividends is dependent on dividends paid toit by the Bank, and is also limited by state corporate law.  TheCalifornia General Corporation Law allows a California corporation to paydividends if the Corporation’s retained earnings equal at least the amount ofthe proposed dividend.  If the Corporation does not have sufficientretained earnings available for the proposed dividend, it may still pay adividend to its shareholders if immediately after giving effect to the dividendthe sum of the Corporation’s assets (exclusive of goodwill and deferredcharges) would be at least equal to 125% of its liabilities (not includingdeferred taxes, deferred income and other deferred liabilities) and the currentassets of the Corporation would be at least equal to its current liabilities,or, if the average of its earnings before taxes on income and before interestexpense for the two preceding fiscal years was less than the average of itsinterest expense for the two preceding fiscal years, at least equal to 125% ofits current liabilities.  In addition, during any period in which it hasdeferred payment of interest otherwise due and payable on its subordinated debtsecurities, the Corporation may not make any dividends or distributions withrespect to its capital stock.

 

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

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2008 and 2007**

 

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

#### ** **

The Corporation hasestablished salary continuation plans, which provide for payments to a certainofficer at retirement.  Included in otherliabilities is $855,000 of deferred compensation related to the continuationplans at both December 31, 2008 and 2007. Also included in other liabilities is $471,000 in accrued postretirement benefits under split-dollar insurance policies. The plans are fundedthrough life insurance policies that generate value to fund the futurebenefits.

 

**Note 23.  NON-CASHTRANSACTION**

 

Duringthe year ended December 31, 2008, the Bank had non-cash transactionsrelating to the purchase of three debt securities totaling $3,050,000,transfers of $7,869,000 in securities from held to maturity to available forsale, a transfer of $6,348,000 in loans to other real estate owned, and a$362,000 increase in other payables due to the cumulative effect - applicationof new accounting standard EITF 06-04 and EITF 06-10.

 

TheBank had non-cash transactions relating to the purchase of three debtsecurities totaling $5,225,000 for the year ended December 31, 2007.

 

**Note 24.  STOCKREPURCHASE PROGRAM AND STOCK AUTHORIZATION**

 

In 2008, the Boardapproved a stock repurchase program pursuant to which the Corporation, fromtime to time and at management’s discretion, may repurchase up to $500,000 invalue of the Corporation’s outstanding shares. The Corporation repurchased 46,010 shares of common stock at an averagecost of $7.41 per share in open market transactions during the year ended December 31,2008.

 

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 toissue up to 10,000,000 shares of preferred stock, which may be issued from timeto time in one or more series as determined by the Board.  The Board is authorized to designate all rights,preferences, privileges and restrictions attendant to each series as well asthe number of shares authorized for issuance in each series of the preferredstock, which matters shall be expressed in resolutions adopted by the Board andfiled with the Secretary of State of the state of California.  Additionally, the Amendment authorizes theCorporation to issue an additional 7,500,000 shares of common stock for a totalof 10,000,000 shares of common stock authorized for issuance after theAmendment.  The Amendment becameeffective January 23, 2009.

 

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**NORTHERN CALIFORNIABANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**December 31, 2008and 2007**

 

#### **Note 25.  FAIR VALUE OF FINANCIALINSTRUMENTS**

#### ** **

Effective January 1,2008, the Corporation adopted SFAS No. 157, which establishes a hierarchyfor measuring fair value under GAAP. This standard applies to all financialassets and liabilities that are being measured and reported at fair value on arecurring and non-recurring basis. Fair value is measured in levels, which aredescribed in more detail below, and is determined based on the observabilityand reliability of the assumptions used to determine fair value.

 

InOctober 2008, the FASB issued FSP Financial Accounting Standard No. 157-3,*Determining the Fair Value of a FinancialAsset When the Market for That Asset Is Not Active*.  The FSPwas effective immediately and clarifies the application of FASB Statement No. 157,*Fair Value Measurements* andprovides an example to illustrate key considerations in determining the fairvalue of a financial asset when the market for that financial asset is notactive.

 

**Level 1:**Valuation for assets and liabilities traded in active exchange markets.Valuations are obtained from readily available pricing sources for markettransactions involving identical assets or liabilities.

 

**Level 2:**Valuation for assets and liabilities traded in less active dealer or brokermarkets. Valuations are obtained from third party pricing services foridentical or comparable assets or liabilities.

 

**Level 3:**Valuation for assets and liabilities that are derived from other valuationmethodologies, including option pricing models, discounted cash flow models,and similar techniques, and not based on market exchange, dealer, or brokertraded transactions. These valuations incorporate certain assumptions andprojections in determining the fair value assigned to such assets or liabilities.

 

The Corporation measures and reportsavailable-for-sale securities and mortgage servicing rights at fair value on arecurring basis. The following table shows the balances of these assets basedon the SFAS No. 157 designated levels.

 
| ** **                             | ** ** | **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 CALIFORNIABANCORP, INC. AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**December 31, 2008and 2007**

 

#### **Note 25.  FAIR VALUE OF FINANCIALINSTRUMENTS (Continued)**

#### ** **

The Corporation may also be required, fromtime to time, to measure certain other financial assets at fair value on anon-recurring basis in accordance with GAAP. During the year ended December 31,2008, the Corporation measured collateral dependent impaired loans and otherreal estate owned (OREO) at fair value. The assets are measured at fair valueon a non-recurring basis and the following table provides the assets’ SFAS No. 157designated levels, as well as the fair value losses recognized during the yearended December 31, 2008.

 
| ** **     | ** ** | ** **                           | ** ** | ** **         | ** ** | ** **         | ** ** | ** **         | ** ** | **Losses for the** | ** ** |
|----------------|------------|--------------------------------------|------------|--------------------|------------|--------------------|------------|--------------------|------------|------------------------------|------------|
| ** **     | ** ** | ** **                           | ** ** | ** **         | ** ** | ** **         | ** ** | ** **         | ** ** | **Twelve**                   | ** ** |
| ** **     | ** ** | ** **                           | ** ** | ** **         | ** ** | ** **         | ** ** | ** **         | ** ** | **Months Ended**        | ** ** |
| ** **     | ** ** | ** **                           | ** ** | ** **         | ** ** | ** **         | ** ** | ** **         | ** ** | **December 31,**        | ** ** |
| ** **     | ** ** | **Total**                            | ** ** | **(Level 1)** | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** | **2008**                     | ** ** |
| ** **     | ** ** | **(Dollars in Thousands)** | ** ** |
|           |       |                                 |       |               |       |               |       |               |       |                         |       |
| Imparied loans |       | $                                    | 7,091      |               | $          | —             |       | $                  | —     |                         | $          | 7,091 |   | $ | 123 |   |
| OREO           |       | 7,364                                |       | —             |       | —             |       | 7,364              |       | —                       |       |
|           |       |                                 |       |               |       |               |       |               |       |                         |       |
|           |       | $                                    | 14,455     |               | $          | —             |       | $                  | —     |                         | $          | 14,455 |   | $ | 123 |   |

 

SFAS No. 107, “Disclosures about Fair Value ofFinancial Instruments” requires disclosure of estimated fair values of allfinancial instruments where it is practicable to estimate such values. In caseswhere quoted market prices are not available, fair values are based onestimates using present value or other valuation techniques. Those techniquesare significantly affected by the assumptions used, including the discount rateand estimates of future cash flows. Accordingly, the derived fair valueestimates cannot be substantiated by comparison to independent markets and, inmany cases, could not be realized in immediate settlement of the instrument. StatementNo. 107 excludes certain financial instruments and all non-financialinstruments from its disclosure requirements. Accordingly, the aggregate fairvalue amounts presented do not represent the underlying value of theCorporation.

 

The Corporation in estimatingfair value disclosures for financial instruments used the following methods andassumptions:

 

***Cashand cash equivalents:*** The carrying amounts of cashand short-term instruments approximate fair values.

 

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

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2008 and 2007**

 

#### **Note25.  FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued)**

#### ** **

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

 

***Loans:***For variable-rate loans that reprice frequently and with no significantchange in credit risk, fair values are based on carrying values.  The fair value of performing fixed-rate loansis estimated by discounting future cash flows using the Corporation’s currentoffering rate for loans with similar characteristics.  The fair value of performing adjustable-rateloans is considered the same as book value. The fair value of non-performing loans is estimated at the fair value ofthe related collateral or, when in management’s opinion foreclosure upon thecollateral is unlikely, by discounting future cash flows using rates which takeinto account management’s estimate of credit risk.

 

***Commitmentsto Extend Credit and Standby Letters of Credit:*****The Corporation does not generally enter into long-termfixed rate commitments or letters of credit. These commitments are generally priced at current prevailing rates.  These rates are generally variable and,therefore, there is no interest rate exposure. Accordingly, the fair market value of these instruments is equal to thecarrying value amount of their net deferred fees.  The net deferred fees associated with theseinstruments are not material.  TheCorporation has no unusual credit risk associated with these instruments.

 

***Depositliabilities:*** The fair values disclosed for demanddeposits (e.g., interest and non-interest checking, savings, and certain typesof money market accounts) are, by definition, equal to the amount payable ondemand at the reporting date (i.e., their carrying amounts).  Fair values for fixed-rate certificates ofdeposit are estimated using a discounted cash flow calculation that appliesinterest rates currently being offered on certificates to a schedule ofaggregated expected monthly maturities on time deposits.

 

***Accruedinterest:*** The carrying amounts of accrued interestapproximate fair value.

 

***CashSurrender Value of Life Insurance:***The carryingamount of life insurance approximate fair value.

 

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

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2008 and 2007**

 

#### **Note25.  FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued)**

#### ** **

***Short-termborrowing:*** The carrying amounts of federal fundspurchased, borrowings under repurchase agreements, and other short-termborrowings maturing within ninety days approximate their fair values.  Fair values of other borrowings are estimatedusing discounted cash flow analyses based on the Corporation’s currentincremental borrowing rates for similar types of borrowing arrangements.

 

***Long-termborrowing:***  Thefair values of the Corporation’s long-term borrowings are estimated usingdiscounted cash flow analyses based on the Corporation’s current incrementalborrowing rates for similar types of borrowing arrangements.

 

The estimated fairvalues, and related carrying amounts, of the Corporation’s financialinstruments as of December 31 are as follows:

 
| ** **                                       | ** ** | **2008**                             | ** ** | **2007**  | ** ** |
|--------------------------------------------------|------------|--------------------------------------|------------|-----------|------------|
| ** **                                       | ** ** | **Carrying**                         | ** ** | **Fair**  | ** ** | **Carrying** | ** ** | **Fair** | ** ** |
| ** **                                       | ** ** | **Amount**                           | ** ** | **Value** | ** ** | **Amount** | ** ** | **Value** | ** ** |
| ** **                                       | ** ** | **(Dollars in thousands)** | ** ** |
| Financial  Assets:                               |       |                                 |       |      |       |   |   |   |   |
| Cash and cash  equivalents                       |       | $                                    | 16,348     |      | $          | 16,348 |   | $ | 20,153 |   | $ | 20,153 |   |
| Time deposits  with other financial institutions |       | 3,500                                |       | 3,500     |       | — |   | — |   |
| Trading assets                                   |       | 361                                  |       | 361       |       | 1,224 |   | 1,224 |   |
| Investment  securities AFS                       |       | 93,353                               |       | 93,353    |       | 36,801 |   | 36,801 |   |
| Investment  securities held to maturity          |       | —                               |       | —    |       | 7,869 |   | 8,105 |   |
| Other  investments                               |       | 3,852                                |       | 3,852     |       | 2,824 |   | 2,824 |   |
| Loans, held for  sale                            |       | 1,650                                |       | 1,650     |       | 1,887 |   | 1,887 |   |
| Loans, net                                       |       | 165,530                              |       | 167,550   |       | 166,861 |   | 177,199 |   |
| Accrued interest  receivable                     |       | 2,130                                |       | 2,130     |       | 1,352 |   | 1,352 |   |
|                                             |       |                                 |       |      |       |   |   |   |   |
| Financial  Liabilities:                          |       |                                 |       |      |       |   |   |   |   |
| Deposits                                         |       | 189,730                              |       | 192,565   |       | 167,333 |   | 167,017 |   |
| Long-term debt                                   |       | 92,748                               |       | 94,349    |       | 60,748 |   | 63,640 |   |
| Accrued interest  payable                        |       | 1,833                                |       | 1,833     |       | 2,250 |   | 2,250 |   |
|                                                  |            |                                      |            |           |            |  |  |  |  |  |  |  |  |

 

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

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2008 and 2007**

 

#### **Note26.  NORTHERN CALIFORNIA BANCORP, INC. (PARENT CORPORATION ONLY)**

#### ** **

The following are thefinancial statements of Northern California Bancorp, Inc. (ParentCorporation only):

 
| **Balance Sheets**                             | ** ** | ** **                           | ** ** | ** ** | ** ** |
|-----------------------------------------------------|------------|--------------------------------------|------------|------------|------------|
| **December 31,**                               | ** ** | **2008**                             | ** ** | **2007**   | ** ** |
| ** **                                          | ** ** | **(Dollars in thousands)** | ** ** |
| Assets                                              |       |                                 |       |       |       |
| Cash and due  from banks                            |       | $                                    | 244        |       | $          | 485 |   |
| Investment in  common stock of Monterey County Bank |       | 24,150                               |       | 20,781     |       |
| Investment  securities - trading account            |       | 361                                  |       | 1,224      |       |
| Investment in  Metrocities Mortgage, LLC Stock      |       | 10                                   |       | 10         |       |
| Investment in AT  Services LLC Acquisition Corp.    |       | 20                                   |       | 20         |       |
| Northern  California Bancorp, Inc. Trust I     |       | 93                                   |       | 93         |       |
| Northern  California Bancorp, Inc. Trust II    |       | 155                                  |       | 155        |       |
| Debt issue  costs, net                              |       | 139                                  |       | 144        |       |
| Deferred tax  asset                                 |       | 572                                  |       | —     |       |
| Accounts  receivable                                |       | 23                                   |       | 4          |       |
|                                                |       |                                 |       |       |       |
|                                                |       | $                                    | 25,767     |       | $          | 22,916 |   |
|                                                |       |                                 |       |       |       |
| Liabilities and  Shareholders’ Equity          |       |                                 |       |       |       |
| Accounts payable  and accrued expenses              |       | $                                    | 148        |       | $          | 124 |   |
| Dividend payable                                    |       | 19                                   |       | 41         |       |
| Deferred tax  liability                             |       | —                               |       | 69         |       |
| Note payble                                         |       | 3,000                                |       | —     |       |
| Junior  subordinated debt securities                |       | 8,248                                |       | 8,248      |       |
| Total  liabilities                                  |       | 11,415                               |       | 8,482      |       |
| Shareholders’  equity                          |       | 14,352                               |       | 14,434     |       |
|                                                |       |                                 |       |       |       |
|                                                |       | $                                    | 25,767     |       | $          | 22,916 |   |

 

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

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2008 and 2007**

 

#### **Note26.  NORTHERN CALIFORNIA BANCORP, INC. (PARENT CORPORATION ONLY) (Continued)**

** **
| **Statements of Income**                                                    | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------|------------|------------|------------|
| **Years Ended December 31,**                                           | ** ** | **2008**                             | ** ** | **2007**   | ** ** | **2006**   | ** ** |
| ** **                                                                            | ** ** | **(Dollars in thousands)** | ** ** |
| Income:                                                                               |       |                                 |       |       |       |       |       |
| Gain on sale of  securities                                                           |       | $                                    | 23         |       | $          | 108        |       | $ | 233 |   |
| Gain (loss) on  trading asset                                                         |       | (967                                 | )          | (794       | )          | 50         |       |
| Other                                                                                 |       | 17                                   |       | 64         |       | 58         |       |
|                                                                                  |       |                                 |       |       |       |       |       |
|                                                                                  |       | (927                                 | )          | (622       | )          | 341        |       |
| Expense:                                                                              |       |                                 |       |       |       |       |       |
| Interest                                                                              |       | 597                                  |       | 713        |       | 685        |       |
| Other                                                                                 |       | 86                                   |       | 72         |       | 54         |       |
|                                                                                  |       |                                 |       |       |       |       |       |
|                                                                                  |       | 683                                  |       | 785        |       | 739        |       |
|                                                                                  |       |                                 |       |       |       |       |       |
| Loss before  income tax benefits and equity in undistributed net income of subsidiary |       | (1,610                               | )          | (1,407     | )          | (398       | )          |
| Income tax  benefit                                                                   |       | (940                                 | )          | (399       | )          | (175       | )          |
|                                                                                  |       |                                 |       |       |       |       |       |
|                                                                                  |       | (670                                 | )          | (1,008     | )          | (223       | )          |
| Equity in  undistributed net income of subsidiary                                     |       | 2,132                                |       | 2,937      |       | 4,060      |       |
|                                                                                  |       |                                 |       |       |       |       |       |
|                                                                                  |       | $                                    | 1,462      |       | $          | 1,929      |       | $ | 3,837 |   |

 

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

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2008 and 2007**

 

#### **Note26.  NORTHERN CALIFORNIA BANCORP, INC. (PARENT CORPORATION ONLY) (Continued)**

 
| **Statements of Cash Flows**                                                 | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------|------------|------------|------------|
| **Years Ended December 31,**                                                 | ** ** | **2008**                             | ** ** | **2007**   | ** ** | **2006**   | ** ** |
| ** **                                                                                  | ** ** | **(Dollars in thousands)** | ** ** |
|                                                                                        |       |                                 |       |       |       |       |       |
| Cash flows from  operating activities:                                                      |       |                                 |       |       |       |       |       |
| Net income                                                                                  |       | $                                    | 1,462      |       | $          | 1,929      |       | $ | 3,837 |   |
| Adjustments to reconcile  net income to net cash used by operating activities: Amortization |       | 5                                    |       | 6          |       | 6          |       |
| Equity in  undistributed income of Monterey County Bank                                     |       | (2,132                               | )          | (2,937     | )          | (4,060     | )          |
| Stock based  compensation                                                                   |       | —                               |       | —     |       | 18         |       |
| (Increase)  decrease in trading securities                                                  |       | 863                                  |       | 538        |       | (735       | )          |
| (Increase)  decrease in other assets                                                        |       | (591                                 | )          | —     |       | 2          |       |
| Increase in  accrued expenses                                                               |       | 24                                   |       | —     |       | 18         |       |
| Increase  (decrease) in other liabilities                                                   |       | (93                                  | )          | 25         |       | 65         |       |
|                                                                                        |       |                                 |       |       |       |       |       |
| Net cash used by  operating activities                                                      |       | (462                                 | )          | (439       | )          | (849       | )          |
|                                                                                        |       |                                 |       |       |       |       |       |
| Cash flows from  investing activities:                                                      |       |                                 |       |       |       |       |       |
| Cash dividends  received from subsidiary                                                    |       | —                               |       | 800        |       | 625        |       |
| Paid in capital  to subsidiary                                                              |       | (2,000                               | )          | —     |       | —     |       |
| Decrease in  investments                                                                    |       | —                               |       | —     |       | 120        |       |
|                                                                                        |       |                                 |       |       |       |       |       |
| Net cash  provided (used) by investing activities                                           |       | (2,000                               | )          | 800        |       | 745        |       |
|                                                                                        |       |                                 |       |       |       |       |       |
| Cash flows from  financing activities:                                                      |       |                                 |       |       |       |       |       |
| Cash dividends  paid on common stock                                                        |       | (450                                 | )          | (461       | )          | (603       | )          |
| Proceeds from  borrowings                                                                   |       | 3,000                                |       | —     |       | —     |       |
| Exercise of  stock options                                                                  |       | 12                                   |       | 442        |       | 270        |       |
| Stock repurchase                                                                            |       | (341                                 | )          | —     |       | —     |       |
|                                                                                        |       |                                 |       |       |       |       |       |
| Net cash  provided (used) by financing activities                                           |       | 2,221                                |       | (19        | )          | (333       | )          |
|                                                                                        |       |                                 |       |       |       |       |       |
| Net increase  (decrease) in cash and cash equivalents                                       |       | $                                    | (241       | )          | $          | 342        |       | $ | (437 | ) |
|                                                                                        |       |                                 |       |       |       |       |       |
| Cash and cash  equivalents, beginning of year                                               |       | 485                                  |       | 143        |       | 580        |       |
|                                                                                        |       |                                 |       |       |       |       |       |
| Cash and cash  equivalents, end of year                                                     |       | $                                    | 244        |       | $          | 485        |       | $ | 143 |   |

 

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