** **

**SECURITIES ANDEXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**Form 10-KSB**

 

| **x** | ** ** | **ANNUAL REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|------------|-----------------------------------------------------------------------------------------------------|

 

**For the Fiscal Year ended December 31, 2007**

 

**OR**

 

| **o** | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|------------|---------------------------------------------------------------------------------------------------------|

 

**Commission file number 333-12892**

 

**MISSION COMMUNITY BANCORP**

(Exact name of registrant as specified in its charter)

 

| **California**                                          | ** ** | **77-0559736**                  |
|---------------------------------------------------------|------------|---------------------------------|
| State or other  jurisdiction of                         |       | I.R.S. Employer                 |
| incorporation or organization                           |       | Identification No.              |
|                                                    |       |                            |
| **581 Higuera St., San Luis  Obispo, California 93401** | ** ** | **(805) 782-5000**              |
| (Address of principal  executive offices)               |       | Issuer’s telephone  number |

 

Securitiesregistered pursuant to Section 12(b) of the Exchange Act: **None**

Securitiesregistered pursuant to Section 12(g) of the Exchange Act: **None**

 

Check whether theissuer is not required to file reports pursuant to Section 13 or 15(d) ofthe Exchange Act.   x

 

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

 

Check if disclosureof delinquent filers pursuant to Item 405 of Regulation S-B is not contained inthis form, and no disclosure will be contained, to the best of the registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-KSB or any amendment to this Form 10-KSBx**.**

 

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).

Yes o****No x

 

Registrant’s revenue forthis year ended **December 31, 2007** was **$13,015,912.**

 

State the aggregatemarket value of the voting stock and non-voting common equity held bynon-affiliates computed by reference to the price at which the common equitywas sold, or the average bid and asked prices of such common equity; as of **March 1, 2008**such aggregate market value was **$15,915,757.**

 

As of **March 1, 2008**, the Registrant had 1,120,576 shares ofCommon Stock outstanding.

 

Transitional SmallBusiness Disclosure Format (check one) Yes oNox

 

**DocumentsIncorporated by Reference:**  Portions ofthe definitive proxy statement for the 2008 Annual Meeting of Shareholders tobe filed with the Securities and Exchange Commission pursuant to SEC regulation14A are incorporated by reference in Part III, Items 9-12 and 14.

 

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**Forward Looking Statements**

 

This Annual Report on Form 10-KSBincludes forward-looking information, which is subject to the “safe harbor”created by Section 27A of the Securities Act of 1933, as amended, and Section 21Eof the Securities Exchange Act and the Private Securities Litigation Reform Actof 1995.  When the Company uses orincorporates by reference in this Annual Report on Form 10-KSB the words “anticipate,”“estimate,” “expect,” “project,” “intend,” “commit,” “believe” and similarexpressions, the Company intends to identify forward-looking statements.  Such statements are subject to certain risks,uncertainties and assumptions, including those described in this Annual Reporton Form 10-KSB.  Should one or moreof these risks or uncertainties materialize, or should underlying assumptionsprove incorrect, actual results may vary materially from those anticipated,estimated, expected, projected, intended, committed or believed.  Such risks and uncertainties include, but arenot limited to, the following factors: (i) general economic conditions,whether national or regional, that could affect the demand for loans and otherbanking services or lead to increased loan losses; (ii) competitivefactors, including increased competition with community, regional and nationalfinancial institutions that may lead to pricing pressures on rates the Bankcharges on loans and pays on deposits or reduce the value of real estatecollateral securing the Bank’s loans; (iii) loss of customers of greatestvalue to the Bank or other losses; (iv) increasing or decreasing interestrate environments that could lead to decreased net interest margin andincreased volatility of rate sensitive loans and deposits; (v) changingbusiness conditions in the banking industry; (vi) changes in the regulatoryenvironment or new legislation; (vii) changes in technology or requiredinvestments in technology; (viii) credit quality deterioration which couldcause an increase in the provision for loan losses; (ix) dividendrestrictions; (x) the effects of the September 11, 2001 terroristattacks and their aftermath; (xi) continued tensions in Iraq and elsewhere inthe Middle East; and (xii) increased regulation of the securities markets,whether pursuant to the Sarbanes-Oxley Act of 2002 or otherwise.

 

Investors and otherreaders are cautioned not to place undue reliance on forward-lookingstatements, which reflect management’s analysis only as of the date of thestatement.

 

The Company undertakes noobligation to revise any forward-looking statement to reflect later events orcircumstances.

 

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# **PART I**

# ** **

## **Item 1.  Description of Business**

## ** **

**BUSINESSDEVELOPMENT**

 

**TheCompany**

 

Mission Community Bancorp (“Bancorp”) is a Californiacorporation that was formed in September 2000 and acquired all of theoutstanding shares of Mission Community Bank (the “Bank”) in a one-bank holdingcompany reorganization effective December 15, 2000.  It is a registered as a bank holding companyunder the Bank Holding Company Act of 1956, as amended, and is headquartered inSan Luis Obispo, California.  Bancorp’sprincipal business is to serve as a bank holding company for the Bank.  Bancorp and the Bank are collectivelyreferred to herein as “the Company.”

 

As of December 31, 2007, the Company hadapproximately $158 million in total assets and $13 million in shareholders’equity.

 

On October 14, 2003, Bancorp formed MissionCommunity Capital Trust I in order to complete a trust preferred securitytransaction and raised approximately $3,000,000 in long-term borrowings thatqualifies as regulatory capital.  See *Market for Common Equity and Related Shareholder Matters*under Item 5 of Part II of this report.

 

The U.S. Department of the Treasury, CommunityDevelopment Financial Institutions Fund, has certified Bancorp and the Bank asCommunity Development Financial Institutions (“CDFI”).  This status also conveys possible CommunityReinvestment Act (“CRA”) credit to institutional depositors and investors inthe Bank and Bancorp.  It also opens tothe Bank and Bancorp various government sponsored programs, grants, and awardsin which they may participate.  The Bankand Bancorp are also certified by the CDFI Fund as Community DevelopmentEntities (“CDE’s”).  As CDE’s, qualifyinginvestments made in the Bank or Bancorp provide the investor with a New MarketsTax Credit equal to 39% of the investment, to be realized over a seven-yearperiod.

 

With its status as a CDFI, Bancorp completed theprivate placement of $500,000 in preferred stock during December 2000 withthe CDFI Fund.  Bancorp also was awardeda second $500,000 Core Award in 2001 from the CDFI Fund, which was funded in December 2002in the form of preferred stock.  This wasmatched with a combination of preferred and common shares through an investmentof $500,000 from the National Community Investment Fund (“NCIF”).  In 2007 the Bank received a $337,500 BankEnterprise Award (“BEA”) from the CDFI Fund.  The award was made under theFiscal Year 2007 BEA Program, which provides an incentive for any FDIC insuredbank to annually increase the levels of financial services provided toeconomically distressed communities.  The Bank also received similarawards in 2004 and 2001 of $1,240,929 and $990,000, respectively.

 

In 2005 Bancorp received a $135,000 CDFI technicalassistance grant to help offset any costs associated with providing additionalservices to the un- and under-banked in its target market area.  Through December 31, 2006, the Companyhad incurred qualifying expenses totaling $100 thousand.  That portion of the grant was recognized innon-interest income in 2006.  Anadditional $33 thousand of qualifying expenditures was incurred in 2007.  Therefore, the Bank recognized $33 thousandof non-interest income related to this grant in 2007.

 

**MissionCommunity Bank**

 

The Bank is a California state-chartered bankheadquartered in San Luis Obispo, California. It is also a member of the Federal Reserve System.  Its deposits are insured by the FDIC up tothe applicable limits of the law.  TheBank commenced operations at its main office in San Luis Obispo on December 18,1997 and opened its first branch office in the city of Paso Robles in San LuisObispo County in 1998 and a second branch office in Arroyo Grande in San LuisObispo County in 2002.  The Bank alsoopened a loan production office, the Business Banking Center, in San LuisObispo in January 2005.  TheBusiness Banking Center is primarily engaged in originating and servicingSBA-guaranteed loans.  In 2008 the Bankintends to open a new branch office in Santa Maria, in Northern Santa Barbaracounty.

 

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The Bank is a community bank engaged in the generalcommercial banking business in the Central Coast of California.  Itoffers a variety of deposit and loan products to individuals and smallbusinesses and a specialization in community development financial services andSBA loans.  Through its communitydevelopment activities, the Bank seeks to provide financial support andservices by promoting community development and economic vitality.

 

At December 31, 2007, the Bank had approximately$157.8 million in assets, $126.4 million in loans, $112.4 million in deposits,and $15.3 million in stockholders’ equity. The Bank does not offer trustservices or international banking services and does not plan to do so in thenear future.

 

The Bank is also certified by the State of CaliforniaDepartment of Insurance to accept deposits or investments under the CaliforniaOrganized Investment Network (the “COIN”). The COIN program provides California tax credits and/or CRA credit toindividuals, corporations, or partnerships that invest at below market ratesfor specified terms.  In addition, theBank has obtained preferred lender status with the Small Business Administrationwhich generally allows it to approve and fund SBA loans without the necessityof having the loan approved in advance by the SBA.

 

**MissionCommunity Development Corporation (“MCDC”)**

 

Mission Community Development Corporation, a communitydevelopment corporation which was incorporated in August 1997, is awholly-owned subsidiary of the Bank. MCDC is a “for-profit” Community Development Corporation (“CDC”), whichprovides financing for small businesses and low- to moderate-income areadevelopment and/or affordable housing projects. Its purpose is to benefit small business and low- to moderate-incomeareas/residents.  The board of directorsof MCDC consists of four members of the Board of Directors of the Bank andthree outside members who are actively involved in representing and supportingthe low income community.

 

At December 31, 2007, MCDC had approximately$204,000 in net loans and $316,000 in shareholder’s equity, and provided loanaccounting services for a very small pool of community development micro loanswhich were funded by a group of banks through the Economic VitalityCorporation, as well as management of an emergency assistance loan pool createdafter the San Simeon earthquake of December 2003.  MCDC also manages a loan pool for the San LuisObispo County Housing Trust Fund to assist in providing affordable housingwithin the county.

 

**MissionCommunity Services Corporation (“MCSC”)**

 

Bancorp and the Bank have an affiliate relationshipwith, but no ownership of, MCSC, which was incorporated in August 1997 andwhich was established in September 2003 as a “not-for-profit” publiccharitable corporation under Internal Revenue Code Section 501(c)(3).  The accounts of MCSC are not included in theCompany’s consolidated financial statements or elsewhere in this Form 10-KSB.  MCSC’s primary focus is to provide technicalassistance and training services to the community, including small business,minority and low-income entrepreneurs. The Board of Directors of MCSC includes representatives from the Company,together with members representing the low-income and business community.  Over the four-year period ended December 31,2007, Bancorp has provided approximately $450 thousand in cash contributions toMCSC.

 

In 2006, MCSC was awarded a five-year, $750,000 grantfrom the U.S. Small Business Administration to fund one of 99 Women’s BusinessCenters nationwide.  While MCSC has notengaged in any direct lending, it intends to provide some lending in the nearfuture.  See also Note L to theConsolidated Financial Statements for additional information regarding MCSC.

 

**The “Mission”Group**

 

Bancorp, the Bank and its subsidiary MCDC, and MCSCform an organizational structure intended to provide traditional community bankfinancial services and to foster economic revitalization and communitydevelopment to its target market areas.

 

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**Recent Developments**

 

On February 14,2008 the Bancorp closed its secondary public offering of its common stock whichwas sold on a best efforts basis. Bancorp sold an aggregate of 410,644 shares of its common stock in theoffering at a purchase price of $18.00 per share, raising gross proceeds ofapproximately $7.4 million.

 

**BUSINESSOF ISSUER**

 

**Principal Products, Services, and Markets**

 

Other than holding the shares of the Bank, Bancorpconducts no significant activities. Bancorp is authorized with the priorapproval of the Board of Governors of the Federal Reserve System (the “FederalReserve Board”), its principal regulator, to engage in a variety of activitieswhich are deemed closely related to the business of banking.

 

The Bank offers checking and savings accounts, moneymarket accounts and time certificates of deposits; offers commercial,agribusiness, government guaranteed, real estate, automobile and otherinstallment and term loans and leases; issues drafts, sells travelers’ checksand provides other customary banking services. Although the Bank does notoperate a trust department or provide international services, it makes trustservices or international services available through correspondentinstitutions.

 

The areas in which the Bank has directed virtually allof its lending activities are commercial loans (including government-guaranteedloans), agricultural loans, construction loans, real estate loans, and consumerloans.  As of December 31, 2007,these five categories accounted for approximately 23.1%, 0.1%, 17.8%, 57.0%,and 2.0% respectively, of the Bank’s gross loan portfolio.  As of that date, $94.5 million, or 74.8%, ofthe Bank’s loans consisted of interim construction and real estate loans, forsingle family residences or for commercial development.  This represents a decrease in constructionand real estate loans from the prior year’s combined 80.0%.  Under the regulatory definition of commercialreal estate—which excludes owner-occupied properties—the Bank’s commercial realestate concentration is reduced to $54.8 million, or 43.4% of total loans.  See *Loan Concentrations*in Management’s Discussion and Analysis under Item 6 of Part II of thisreport.

 

As of December 31, 2007, the Bank had 4,207deposit accounts, including 2,393 demand accounts totaling $34.4 million; 1,180savings accounts with balances totaling $21.4 million; and 634 timecertificates of deposit totaling $56.6 million.

 

The principal sources of the Bank’s revenues areinterest and fees on loans, interest on investments including federal fundssold, gain on sale of loans, grants and awards, and service charges on depositaccounts.  For the year ended December 31,2007, these sources comprised 82.7%, 7.7%, 2.4%, 2.7%,and 2.2%, respectively,of the Bank’s total operating income.

 

**DistributionMethods of the Products and Services**

 

The Bank’s primary service area consists of San LuisObispo County and northern Santa Barbara County, which lie centrally within theState of California along the Pacific Ocean. Secondary market areas include cities and unincorporated areas in theneighboring counties, including Monterey, Kern, Kings, and Fresno.

 

The Bank operates out of three full service offices(in the cities of San Luis Obispo, Paso Robles and Arroyo Grande) plus a loanproduction office and an administrative facility, which are both located in thecity of San Luis Obispo.  The Bankprovides some financial services through direct contact by calling officers whotravel into the neighboring counties. Physical expansion into the neighboring counties would most likely comefrom acquisitions or in the form of loan production offices although there areno immediate plans for acquisitions or loan production offices other than ourproposed Santa Maria branch office.

 

The Bank’s operating policy since its inception hasemphasized community development through small business, commercial and retailbanking.  Most of the Bank’s customersare retail customers, farmers and small to medium-sized businesses.  As a CDFI, the Bank also emphasizes loans andfinancial services to low- to moderate-income communities 

 

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within its target market area.  Most of the Bank’s deposits are attracted byrelationship banking, local activities, and advertising.

 

The business plan of the Bank emphasizes providinghighly specialized financial services in a professional and personalized mannerto individuals and businesses in its service area.  Its key strengths are customer service and anexperienced management team familiar with the community through the Bank’sinvolvement in various community lending and development projects.

 

In 2006 and 2007, the Bank extended its use ofInternet technology as a distribution tool to improve its customer service bymaking available an enhanced Internet Banking and bill-pay product, as well asACH origination.

 

During 2006 the Bank began to capitalize on its statusas one of only two banks in San Luis Obispo County participating in theCertificate of Deposit Account Registry Service (“CDARS”) program.  This program permits the Bank’s customers toplace all of their deposits at the Bank and have those deposits fully-insuredby the FDIC, up to $50 million.  TheCDARS program acts as a clearinghouse, matching deposits from one institutionin the CDARS network of over 1,800 banks with other network banks (inincrements of less than the $100 thousand FDIC insurance limit), so funds thata customer places with the Bank essentially remain on the Bank’s balancesheet.  While the Bank continues to focuson its local market areas, its participation in the CDARS program permits it tobid on additional certificates of deposit through banks across the country tomeet additional funding needs.  These “One-WayBuy” CDARS deposits are considered to be brokered deposits.  When the Bank has excess funds, the CDARSprogram enables the Bank to place those funds in CD’s with CDARS network banks(known as the “One-Way Sell” program), which generally results in a higheryield than if those funds were invested in Federal Funds.  Management expects that brokered depositswill be used from time to time in the future as an alternative source offunding loan growth.  The Bank alsoexpects to continue to use its CDFI and COIN designations to attract lower costdeposits.

 

**Status ofand Publicly Announced New Products or Services**

 

The Bank participated in a 3-year project (2002-2005)sponsored by NCIF to explore and develop a profitable range of retail financialproducts and services to low income and unbanked customers (“low incomecustomers”).  NCIF underwrote a majorityof the costs associated with this project. The project involved developing replicable and profitable businessmodels for both particular products and services targeted at low incomecustomers, and coordinated suites of products that can meet a range ofneeds.  Product and service specifications,target market, cross selling and profitability data were tracked over a two- tothree-year time horizon and suites of products were developed that meethousehold financial and asset building needs while being profitable forfinancial institutions.

 

A Financial Education team of bank employees has beenformed, in an effort to reach out to the community to share sound moneymanagement practices and habits to the target market of low-income andunder-banked individuals.  A series of training workshops covering thefundamentals of banking and financial services have been developed in Englishand Spanish.  In conjunction with thesefinancial education programs, the Bank expects to offer Individual DevelopmentAccounts and access to debit cards and other electronic services.  The Bank expects to increase its focus onprofitable financial services for the un- and under-banked customers in itsmarket area, but does not expect these services will be a material percentageof its deposit activities.

 

The Bank has created a new division at MissionCommunity Bank: the “Hispanic Banking Division,” staffed with employeeswho are bilingual in English and Spanish.  The new division is dedicatedto working closely in the Hispanic communities we serve, and in the communitieswe intend to serve in the future, including Santa Maria.  The divisionwill offer specifically designed deposit and loan products and servicesbenefiting the Hispanic community.

 

In 2007 the Bank received notification from the BankEnterprise Award program of the Department of the Treasury that it would bereceiving a $337,500 grant under that program, based on lending activity thebank commenced in 2006.  Most of theaward—$326 thousand—was recognized in non-interest income in 2007.  The remaining $11,500 of the award iscontingent upon lending activity which had not occurred as of December 31,2007.

 

The Company applied to the CDFI in 2004 for atechnical assistance grant to help offset any costs associated with providingadditional services to the un- and under-banked in its market area, and receiveda grant of $134,935 in 2005.  During 2006the Bank incurred approximately $100,000 in qualifying expenses under thisgrant.  Accordingly, the Bank 

 

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recognized $100,000 of the grant as non-interestincome in 2006.  An additional $33thousand of qualifying expenditures was incurred in 2007.  Therefore, the Bank recognized $33 thousandof non-interest income related to this grant in 2007.

 

**Competition**

 

The banking and financial services business in theBank’s market area is highly competitive. The increasingly competitive environment is a result primarily ofchanges in regulation, and changes in technology and product deliverysystems.  In order to compete with otherfinancial institutions in its service area, the Bank relies upon localadvertising programs; direct personal contact by officers, directors,employees, and shareholders; and specialized services such as courier pick-upand remote deposit capture.  The Bankemphasizes to its customers the advantages of dealing with a locally owned andcommunity development oriented institution. Larger banks may have a competitiveadvantage because of higher lending limits and major advertising and marketingcampaigns in addition to expanded products like trust services, internationalbanking, discount brokerage and insurance services that the Bank does notoffer.  As a service to its customers,the Bank has made arrangements with other financial service providers to extendsuch services to its customers where possible. For borrowers requiring loans in excess of the Bank’s legal lendinglimits, the Bank makes use of loan participations with its correspondent banksand with other independent banks, retaining the portion of such loans which iswithin its legal lending limits. Commercial banks compete with savings and loan associations, creditunions, other financial institutions, securities brokerage firms, and otherentities for funds.  For instance, yieldson corporate and government debt securities and other commercial paper affectthe ability of commercial banks to attract and hold deposits.

 

The Bank utilizes technology to improve itscompetitive advantages by use of ATMs, Internet Banking, ACH origination,electronic bill pay, email, remote deposit capture and credit card and merchantcard relationships.

 

In addition, in order to compete effectively, the Bankhas created a sales and service culture that combines the experience of itssenior officers with the commitment to service and a focus on the individualneeds of its customers that is found at the best community banks.  The Bank also relies on local advertisingprograms, direct personal contact by its officers, directors, employees andshareholders and specialized services such as courier pick-up.  The Bank believes it provides a level ofservice and decision-making responsiveness not generally offered by largerinstitutions.

 

The Bank’s primary service area consists of the Countyof San Luis Obispo and northern Santa Barbara County.    As in most major U.S. cities, large bankscompete in our service area.  However,rather than these large financial institutions, we believe our primarycompetitors for individuals and small and medium-sized business customers arethe community banks that can provide the service and responsiveness attractiveto this customer base.

 

Within San Luis Obispo County, based on data from theFDIC as of June 30, 2007, there were 15 banks with 76 branches withaggregate deposits of $4.6 billion.  Ofthe 15 banks, 7 were community banks (banks with less than $1 billion inassets), with 6 of these banks headquartered in San Luis Obispo County and oneheadquartered in northern Santa Barbara County. In northern Santa Barbara County there were 17 banks with 49 branchoffices having an aggregate of $2.6 billion in deposits.  Six of those banks are community banks withtwo headquartered in northern Santa Barbara County and two headquartered in SanLuis Obispo County.  There were also fivecredit unions operating in San Luis Obispo and northern Santa BarbaraCounties.  Four of those credit unionsare headquartered in the Bank’s target market area.

 

**NoDependence on One or a Few Major Customers**

 

The Bank is limited, due to legal lending limits, inthe size of loans it can make to any one individual borrower (in theaggregate).  It has in its portfolioapproximately 700 loans to nearly 500 loan customers.  As of December 31, 2007, the Bank’slegal lending limit to a single borrower, and such borrower’s related parties,was approximately $4.1 million on a secured basis (first trust deed), and was$2.5 million for unsecured loans, based on regulatory capital plus reserves ofapproximately $16.4 million.

 

A material portion of the Bank’s deposits have notbeen obtained from a single person or a few persons, the loss of any one ormore of which would have a materially adverse effect on the business of theBank.  The Bank has a higher than averagedependence (as measured by peer group analysis) on larger deposit balances(deposits of $100,000 or more) with a total of 253 deposit accounts holding$64.5 million in deposits as of December 31, 2007.  Included in those totals are ten customerswith deposits of $1 million or more totaling $23.0 million.  These deposit balances have been reasonablystable during the past several years and are consistent with the Bank’sdeposit/funding strategy.

 

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The Bank’s business does not appear to be seasonal.

 

**Effect of Government Policies andRegulations**

 

Banking is a business that depends on ratedifferentials.  In general, the differencebetween the interest rate paid by the Bank on its deposits and its other borrowingsand the interest rate received by the Bank on loans extended to its customersand securities held in the Bank’s portfolio comprise the major portion of theBank’s earnings.  These rates are highlysensitive to many factors that are beyond the control of the Bank. Accordingly,the earnings and growth of the Bank are subject to the influence of domesticand foreign economic conditions, including inflation, recession and unemployment.

 

The commercial banking business is not only affectedby general economic conditions but is also influenced by the monetary andfiscal policies of the federal government and the policies of regulatory agencies,particularly the Federal Reserve Board. The Federal Reserve Board implements national monetary policies (withobjectives such as curbing inflation and combating recession) by itsopen-market operations in U.S. Government securities, by adjusting the requiredlevel of reserves for financial institutions subject to its reserverequirements and by varying the discount rates applicable to borrowings by depositoryinstitutions. The actions of the Federal Reserve Board in these areas influencethe growth of bank loans, investments and deposits and also affect interestrates charged on loans and paid on deposits. The nature and impact of any future changes in monetary policies cannotbe predicted.

 

From time to time, legislation is enacted which hasthe effect of increasing the cost of doing business, limiting or expandingpermissible activities or affecting the competitive balance between banks andother financial institutions.  Proposalsto change the laws and regulations governing the operations and taxation ofbanks, bank holding companies and other financial institutions are frequentlymade in Congress, in the California legislature and before various bankregulatory and other professional agencies. For example, the Bank’s ability to originate and sell SBA loans would beseverely impacted if federal appropriations for the SBA lending program werecurtailed or eliminated.

 

**Supervision andRegulation**

** **

Both federal and state law extensively regulates banksand bank holding companies.  Thisregulation is intended primarily for the protection of depositors and thedeposit insurance fund and not for the benefit of shareholders of theCompany.  The following is a summary ofparticular statutes and regulations affecting the Company and the Bank.  This summary is qualified in its entirety bythe statutes and regulations.  Noassurance can be given that such statutes or regulations will not change in thefuture.

 

**Regulation of Mission Community Bancorp**

** **

Mission Community Bancorp is a registered bank holding company underthe Bank Holding Company Act of 1956, as amended, and is regulated by theFederal Reserve Board.  The Company isrequired to file periodic reports with the Federal Reserve Board and suchadditional information as the Federal Reserve Board may require pursuant to theBank Holding Company Act.  The FederalReserve Board may conduct examinations of the Company and its subsidiaries,which includes the Bank.

 

The Bank Holding Company Act requires every bank holding company toobtain the prior approval of the Federal Reserve Board before acquiringsubstantially all the assets of any bank or bank holding company or ownershipor control of any voting shares of any bank or bank holding company, if, afterthe acquisition, it would own or control, directly or indirectly, more than 5%of the voting shares of the bank or bank holding company.

 

The Company is prohibited by the Bank Holding Company Act, except instatutorily prescribed instances, from acquiring direct or indirect ownershipor control of more than 5% of the outstanding voting shares of any company thatis not a bank or bank holding company and from engaging directly or indirectlyin activities other than those of banking, managing or controlling banks orfurnishing services to its subsidiaries. However, the Company, subject to notification or the prior approval ofthe Federal Reserve Board, as applicable in each specific case, may engage inany, or acquire shares of companies engaged in, activities that are deemed bythe Federal Reserve Board to be “so closely related to banking” or managing orcontrolling banks as to be a “proper incident thereto.”

 

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In approving acquisitions by bank holding companies of companiesengaged in banking-related activities, the Federal Reserve Board considerswhether the performance of any activity by a subsidiary of the holding companyreasonably can be expected to produce benefits to the public, including greaterconvenience, increased competition, or gains in efficiency, which outweighpossible adverse effects, including over-concentration of resources, decreaseof competition, conflicts of interest, or unsound banking practices.

 

Regulations and policies of the Federal Reserve Board require a bank holdingcompany to serve as a source of financial and managerial strength to itssubsidiary banks.  It is the FederalReserve Board’s policy that a bank holding company should stand ready to useavailable resources to provide adequate capital funds to a subsidiary bankduring periods of financial stress or adversity and should maintain thefinancial flexibility and capital-raising capacity to obtain additionalresources for assisting a subsidiary bank. Under certain conditions, the Federal Reserve Board may conclude thatcertain actions of a bank holding company, such as a payment of a cashdividend, would constitute an unsafe and unsound banking practice.

 

The Company is required to give the Federal Reserve Board prior writtennotice of any repurchase of its outstanding equity securities which (for aperiod of 12 months) is equal to 10% or more of the Company’s consolidated networth, unless certain conditions are met.

 

Bank holding company transactions with subsidiaries and otheraffiliates are restricted, including qualitative and quantitative restrictionson extensions of credit and similar transactions.

 

The Company and the Bank are deemed to be affiliatesof one another within the meaning set forth in the Federal Reserve Act and aresubject to Sections 23A and 23B of the Federal Reserve Act.  This means, for example, that there arelimitations on loans by the Bank to affiliates, and that all affiliatetransactions must satisfy certain limitations and otherwise be on terms andconditions at least as favorable to the Bank as would be available fornon-affiliates.

 

The securities of the Company are also subject to the requirements ofthe Securities Act, and matters related thereto are regulated by the Securitiesand Exchange Commission.  Certainissuances may also be subject to the California’s corporate securities law asadministered by the California Commissioner of Corporations.  The Company is subject to the publicreporting requirements of the Securities and Exchange Act of 1934, as amended,generally applicable to publicly held companies, under Section 15(d) ofthe Exchange Act.  Companies which file aregistration statement under the Securities Act are required under Section 15(d) ofthe Exchange Act for at least a 12-month period after the effectiveness of suchregistration statement to file periodic quarterly and annual reports under theSecurities Act.  If and when the Companyhas more than 500 shareholders of record, it will be required to register itssecurities with the Securities and Exchange Commission under Section 12(g) ofthe Exchange Act at which time its filing of periodic reports, as well ascertain other reporting obligations, will become mandatory.

 

**Regulation of Mission Community Bank**

** **

As a California state-chartered bank, the Bank is subject toregulation, supervision and examination by the California Department ofFinancial Institutions.  It is also amember of the Federal Reserve System and, as such, is subject to applicableprovisions of the Federal Reserve Act and the regulations promulgatedthereunder by the Board of Governors of the Federal Reserve System.  In addition, the deposits of the Bank areinsured by the Federal Deposit Insurance Corporation to a maximum of $100,000per depositor, and up to a maximum of $250,000 with respect to certainretirement accounts.  For thisprotection, the Bank pays a quarterly assessment to the FDIC and is subject tothe rules and regulations of the FDIC pertaining to deposit insurance andother matters.  The regulations of thoseagencies will govern most aspects of the Bank’s business, including the makingof periodic reports by the Bank, and the Bank’s activities relating todividends, investments, loans, borrowings, capital requirements, certaincheck-clearing activities, branching, mergers and acquisitions, reservesagainst deposits, the issuance of securities and numerous other areas.

 

The earnings and growth of the Bank is largely dependent on its abilityto maintain a favorable differential or “spread” between the yield on itsinterest-earning assets and the rate paid on its deposits and otherinterest-bearing liabilities.  As aresult, the Bank’s performance is influenced by general economic conditions,both domestic and foreign, the monetary and fiscal policies of the federalgovernment, and the policies of the regulatory agencies, particularly theFederal Reserve Board.  The FederalReserve Board implements national monetary policies (such as seeking to curbinflation and combat recession) by its open-market operations in United StatesGovernment securities, by adjusting the 

 

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required level of reserves for financial institutionssubject to its reserve requirements and by varying the discount rate applicableto borrowings by banks which are members of the Federal Reserve System.  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 deposits.  The nature and impact of any future changesin monetary policies cannot be predicted.

 

**Capital Adequacy Requirements**

** **

The Company and the Bank are subject to the regulations of the FederalReserve Board governing capital adequacy. Those regulations incorporate both risk-based and leverage capitalrequirements.  Under existingregulations, the capital requirements for a bank holding company whoseconsolidated assets are less than $500 million, like the Company, are deemed tobe the same as that of its subsidiary bank. The Federal Reserve Board has established risk-based and leveragecapital guidelines for the banks it regulates, which set total capitalrequirements and define capital in terms of “core capital elements,” or Tier 1capital and “supplemental capital elements,” or Tier 2 capital.  Tier 1 capital is generally defined as thesum of the core capital elements less goodwill and certain intangibles.  The following items are defined as corecapital elements:  (i) commonstockholders’ equity; (ii) qualifying non-cumulative perpetual preferred stockand related surplus; and (iii) minority interests in the equity accountsof consolidated subsidiaries. Supplementary capital elements include: (i) allowance for loan and lease losses (but not more than 1.25% ofan institution’s risk-weighted assets); (ii) perpetual preferred stock andrelated surplus not qualifying as core capital; (iii) hybrid capitalinstruments, perpetual debt and mandatory convertible debt instruments; and (iv) termsubordinated debt and intermediate-term preferred stock and relatedsurplus.  The maximum amount ofsupplemental capital elements which qualifies as Tier 2 capital is limited to100% of Tier 1 capital, net of goodwill.

 

The Bank is required to maintain a minimum ratio of qualifying totalcapital to total risk-weighted assets of 8.0% (“Total Risk-Based Capital Ratio”),at least one-half of which must be in the form of Tier 1 capital (“Tier 1Risk-Based Capital Ratio”).  Risk-basedcapital ratios are calculated to provide a measure of capital that reflects thedegree of risk associated with a banking organization’s operations for bothtransactions reported on the balance sheet as assets, and transactions, such asletters of credit and recourse arrangements, which are recorded as off-balancesheet items.  Under the risk-basedcapital guidelines, the nominal dollar amounts of assets and credit-equivalentamounts of off-balance sheet items are multiplied by one of several riskadjustment percentages, which range from 0% for assets with low credit risk,such as certain U. S. Treasury securities, to 100% for assets withrelatively high credit risk, such as business loans.  As of December 31, 2007 and December 31,2006, the Bank’s Total Risk-Based Capital Ratio was 11.7% and 11.3%,respectively, and its Tier 1 Risk-Based Capital Ratio was 10.9% and 10.5%,respectively.

 

The risk-based capital standards also take into account concentrationsof credit and the risks of “non-traditional” activities (those that have notcustomarily been part of the banking business). The regulations requireinstitutions with high or inordinate levels of risk to operate with higherminimum capital standards, and authorize the regulators to review aninstitution’s management of such risks in assessing an institution’s capitaladequacy.

 

Additionally, the regulatory statements of policy on risk-based capitalinclude exposure to interest rate risk as a factor that the regulators willconsider in evaluating a bank’s capital adequacy, although interest rate riskdoes not impact the calculation of a bank’s risk-based capital ratios.  Interest rate risk is the exposure of a bank’scurrent and future earnings and equity capital arising from adverse movementsin interest rates.  While interest riskis inherent in a bank’s role as financial intermediary, it introducesvolatility to bank earnings and to the economic value of the bank or bankholding company.

 

Banks are also required to maintain a leverage capital ratio designedto supplement the risk-based capital guidelines.  Banks that have received the highest ratingof the five categories used by regulators to rate banks and are notanticipating or experiencing any significant growth must maintain a ratio ofTier 1 capital (net of all intangibles) to adjusted total assets (“LeverageCapital Ratio”) of at least 3%.  Allother institutions are required to maintain a leverage ratio of at least 100 to200 basis points above the 3% minimum, for a minimum of 4% to 5%.  Pursuant to federal regulations, banks mustmaintain capital levels commensurate with the level of risk to which they areexposed, including the volume and severity of problem loans, and federalregulators may set higher capital requirements when a bank’s particularcircumstances warrant.  As of December 31,2007 and December 31, 2006, the Bank’s Leverage Capital Ratio was 9.5% and9.3%, respectively.

 

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On March 1, 2005, the Federal Reserve Boardadopted a final rule that allows the continued inclusion oftrust-preferred securities in the Tier I capital of bank holdingcompanies.  However, under the finalrule, after a five-year transition period, the aggregate amount of trustpreferred securities and certain other capital elements that could qualify asTier I capital would be limited to 25 percent of Tier I capital elements, netof goodwill

 

**Prompt Corrective Action Provisions**

** **

Federal law requires each federal banking agency to take promptcorrective action to resolve the problems of insured financial institutions,including but not limited to those that fall below one or more prescribedminimum capital ratios.  The federalbanking agencies have by regulation defined the following five capitalcategories: “well capitalized” (Total Risk-Based Capital Ratio of 10%; Tier 1Risk-Based Capital Ratio of 6%; and Leverage Capital Ratio of 5%); “adequatelycapitalized” (Total Risk-Based Capital Ratio of 8%; Tier 1 Risk-Based CapitalRatio of 4%; and Leverage Capital Ratio of 4%) (or 3% if the institutionreceives the highest rating from its primary regulator); “undercapitalized”(Total Risk-Based Capital Ratio of less than 8%; Tier 1 Risk-Based CapitalRatio of less than 4%; or Leverage Capital Ratio of less than 4%) (or 3% if theinstitution receives the highest rating from its primary regulator); “significantlyundercapitalized” (Total Risk-Based Capital Ratio of less than 6%; Tier 1Risk-Based Capital Ratio of less than 3%; or Leverage Capital Ratio less than3%); and “critically undercapitalized” (tangible equity to total assets lessthan 2%).  A bank may be treated asthough it were in the next lower capital category if after notice and theopportunity for a hearing, the appropriate federal agency finds an unsafe orunsound condition or practice so warrants, but no bank may be treated as “criticallyundercapitalized” unless its actual capital ratio warrants such treatment.

 

At each successively lower capital category, an insured bank is subjectto increased restrictions on its operations. For example, a bank is generally prohibited from paying management feesto any controlling persons or from making capital distributions if to do sowould make the bank “undercapitalized.” Asset growth and branching restrictions apply to undercapitalized banks,which are required to submit written capital restoration plans meeting specifiedrequirements (including a guarantee by the parent holding company, ifany).  “Significantly undercapitalized”banks are subject to broad regulatory authority, including among other things,capital directives, forced mergers, restrictions on the rates of interest theymay pay on deposits, restrictions on asset growth and activities, andprohibitions on paying bonuses or increasing compensation to senior executiveofficers without regulatory approval. Even more severe restrictions apply to critically undercapitalizedbanks.  Most importantly, except underlimited circumstances, not later than 90 days after an insured bank becomescritically undercapitalized, the appropriate federal banking agency is requiredto appoint a conservator or receiver for the bank.

 

In addition to measures taken under the prompt corrective actionprovisions, insured banks may be subject to potential actions by the federalregulators for unsafe or unsound practices in conducting their businesses orfor violations of any law, rule, regulation or any condition imposed in writingby the agency or any written agreement with the agency.  Enforcement actions may include the issuanceof cease and desist orders, termination of insurance of deposits (in the caseof a bank), the imposition of civil money penalties, the issuance of directivesto increase capital, formal and informal agreements, or removal and prohibitionorders against “institution-affiliated” parties.

 

**Safety and Soundness Standards**

** **

The federal banking agencies have also adopted guidelines establishingsafety and soundness standards for all insured depository institutions.  Those guidelines relate to internal controls,information systems, internal audit systems, loan underwriting anddocumentation, compensation and interest rate exposure.  In general, the standards are designed toassist the federal banking agencies in identifying and addressing problems atinsured depository institutions before capital becomes impaired.  If an institution fails to meet thesestandards, the appropriate federal banking agency may require the institutionto submit a compliance plan and institute enforcement proceedings if anacceptable compliance plan is not submitted.

 

**Premiums for Deposit Insurance**

** **

The Bank is a member of the Deposit Insurance Fund, maintained by theFDIC, and pays deposit insurance assessments to the Deposit InsuranceFund.  The Deposit Insurance Fund wasformed on March 31, 2006 following the merger of the Bank Insurance Fundand the Savings Association Insurance Fund in accordance with the FederalDeposit Insurance Reform Act of 2005.

 

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We were not assessed any Deposit Insurance Fund orBank Insurance Fund premiums in 2005 or 2006. In November 2006 the FDIC adopted a new risk-based insuranceassessment system effective January 1, 2007 designed to tie what banks payfor deposit insurance more closely to the risks they pose.  The FDIC also adopted a new base schedule ofrates that the FDIC can adjust up or down, depending on the needs of theDeposit Insurance Fund and set initial premiums beginning January 1, 2007,that range from 5 cents per $100 of domestic deposits in the lowest riskcategory to 43 cents per $100 of domestic deposits for banks in the highestrisk category.  As of December 31,2007, the Bank’s most recent assessment rate (based on deposits as of September 30,2007) was 6.19 cents per $100 of domestic deposits.

 

In addition, all Federal Deposit Insurance Corporation-insuredinstitutions are required to pay assessments to the Federal Deposit InsuranceCorporation at an annual rate of approximately 0.0114% of insured deposits tofund interest payments on bonds issued by the Financing Corporation to fund theclosing and disposal of failed thrift institutions by the Resolution TrustCorporation.  These assessments willcontinue until the Financing Corporation bonds mature in 2017.

 

**Community Reinvestment Act**

** **

The Bank is subject to certain requirements and reporting obligationsinvolving Community Reinvestment Act activities.  The Community Reinvestment Act generallyrequires the federal banking agencies to evaluate the record of a financialinstitution in meeting the credit needs of its local communities, including lowand moderate income neighborhoods. The Community Reinvestment Act furtherrequires the agencies to take a financial institution’s record of meeting itscommunity credit needs into account when evaluating applications for, amongother things, domestic branches, consummating mergers or acquisitions, orholding company formations.  In measuringa bank’s compliance with its Community Reinvestment Act obligations, the regulatorsutilize a performance-based evaluation system which bases CommunityReinvestment Act ratings on the bank’s actual lending service and investmentperformance, rather than on the extent to which the institution conducts needsassessments, documents community outreach activities or complies with otherprocedural requirements.  In connectionwith its assessment of Community Reinvestment Act performance, the agenciesassign a rating of “outstanding,” “satisfactory,” “needs to improve” or “substantialnoncompliance.”  The Bank received an “outstanding”rating in its most recent Community Reinvestment Act examination.

 

**Privacy and Data Security**

** **

The Gramm-Leach-BlileyAct which became effective in 2000 imposed new requirements on financialinstitutions with respect to consumer privacy. The statute generally prohibits disclosure of consumer information tonon-affiliated third parties unless the consumer has been given the opportunityto object and has not objected to such disclosure.  Financial institutions are further requiredto disclose their privacy policies to consumers annually.  Financial institutions, however, will berequired to comply with state law if it is more protective of consumer privacythan the Gramm-Leach-Bliley Act.  Thestatute also directed federal regulators, including the Federal Reserve and theFDIC, to prescribe standards for the security of consumer information.  Bancorp and Bank are subject to suchstandards, as well as standards for notifying consumers in the event of asecurity breach.

 

**Other Consumer Protection Laws and Regulations**

** **

Activities of all insuredbanks are subject to a variety of statutes and regulations designed to protectconsumers, such as the Fair Credit Reporting Act, Equal Credit Opportunity Act,and Truth-in-Lending Act.  Interest andother charges collected or contracted for by the Bank are also subject to stateusury laws and certain other federal laws concerning interest rates.  The Bank’s loan operations are also subjectto federal laws and regulations applicable to credit transactions.  Together, these laws and regulations includeprovisions that:

 

·                                          govern disclosures of credit terms toconsumer borrowers;

·                                          require financial institutions to provideinformation to enable the public and public officials to determine whether afinancial institution is fulfilling its obligation to help meet the housingneeds of the community it serves;

·                                          prohibit discrimination on the basis ofrace, creed, or other prohibited factors in extending credit;

·                                          govern the use and provision ofinformation to credit reporting agencies; and

·                                          govern the manner in which consumer debtsmay be collected by collection agencies.

 

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Mission Community Bank’sdeposit operations are also subject to laws and regulations that:

 

·                                          impose a duty to maintain theconfidentiality of consumer financial records and prescribe procedures forcomplying with administrative subpoenas of financial records; and

·                                          govern automatic deposits to andwithdrawals from deposit accounts and customers’ rights and liabilities arisingfrom the use of automated teller machines and other electronic bankingservices.

** **

**Interstate Banking and Branching**

** **

The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994regulates the interstate activities of banks and bank holding companies andestablishes a framework for nationwide interstate banking and branching.  Since June 1, 1997, a bank in one statehas generally been permitted to merge with a bank in another state without theneed for explicit state law authorization. However, states were given the ability to prohibit interstate mergerswith banks in their own state by “opting-out” (enacting state legislationapplying equally to all out-of-state banks prohibiting such mergers) prior to June 1,1997.

 

Since 1995, adequately capitalized and managed bank holding companieshave been permitted to acquire banks located in any state, subject to twoexceptions: first, any state may still prohibit bank holding companies fromacquiring a bank which is less than five years old; and second, no interstateacquisition can be consummated by a bank holding company if the acquirer wouldcontrol more then 10% of the deposits held by insured depository institutionsnationwide or 30% percent or more of the deposits held by insured depositoryinstitutions in any state in which the target bank has branches.

 

In 1995 California enacted legislation to implement importantprovisions of the Riegle-Neal Act discussed above and to repeal California’sprevious interstate banking laws, which were largely preempted by theRiegle-Neal Act.

 

A bank may establish and operate de novo branches in any state in whichthe bank does not maintain a branch if that state has enacted legislation toexpressly permit all out-of-state banks to establish branches in thatstate.  However, California law expresslyprohibits an out-of-state bank which does not already have a California branchoffice from (i) purchasing a branch office of a California bank (asopposed to purchasing the entire bank) and thereby establishing a Californiabranch office or (ii) establishing a de novo branch in California.

 

The changes effected by the Riegle-Neal Act and California laws haveincreased competition in the environment in which the Bank operates to theextent that out-of-state financial institutions may directly or indirectlyenter the Bank’s market areas.  Itappears that the Riegle-Neal Act has contributed to the acceleratedconsolidation of the banking industry. While many large out-of-state banks have already entered the Californiamarket as a result of this legislation, it is not possible to predict theprecise impact of this legislation on the Bank and the competitive environmentin which it operates.

 

**Financial Modernization Act**

** **

Effective March 11, 2000, the Gramm-Leach-Bliley Act, also knownas the “Financial Modernization Act”, enabled full affiliations to occurbetween banks and securities firms, insurance companies and other financialservice providers.  This legislationpermits bank holding companies to become “financial holding companies” andthereby acquire securities firms and insurance companies and engage in otheractivities that are financial in nature. A bank holding company may become a financial holding company if each ofits subsidiary banks is “well capitalized” and “well managed” under applicabledefinitions, and has at least a satisfactory rating under the CRA by filing adeclaration that the bank holding company wishes to become a financial holdingcompany.

 

The Financial Modernization Act defines “financial in nature” toinclude securities underwriting, dealing and market making; sponsoring mutualfunds and investment companies; insurance underwriting and agency; merchantbanking activities; and activities that the Federal Reserve Board hasdetermined to be closely related to banking. A national bank also may engage, subject to limitations on investment,in activities that are financial in nature, other than insurance underwriting,insurance company portfolio investment, real estate development and real estateinvestment, through a financial subsidiary of the bank, if the bank is wellcapitalized, well managed and has at least a satisfactory CRA rating.  Subsidiary banks of a financial holdingcompany or national banks with financial subsidiaries must continue to be wellcapitalized and well managed in order to continue to engage in activities thatare financial in nature without regulatory 

 

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actions or restrictions, which could includedivestiture of financial subsidiaries. In addition, a financial holding company or a bank may not acquire acompany that is engaged in activities that are financial in nature unless eachof the subsidiary banks of the financial holding company or the bank has a CRArating of satisfactory or better.

 

**USA Patriot Act of 2001**

** **

The USA Patriot Act of2001 was enacted in October 2001 in response to the terrorist attacks on September 11,2001.  The Patriot Act is intended tostrengthen United States law enforcement’s and the intelligence communities’ability to work cohesively to combat terrorism on a variety of fronts.  The impact of the Patriot Act on financialinstitutions of all kinds has been significant and wide ranging.  The Patriot Act substantially enhancedexisting anti-money laundering and financial transparency laws, and requiredappropriate regulatory authorities to adopt rules to promote cooperationamong financial institutions, regulators, and law enforcement entities inidentifying parties that may be involved in terrorism or money laundering.  Under the Patriot Act, financial institutionsare subject to prohibitions regarding specified financial transactions andaccount relationships, as well as enhanced due diligence and “know yourcustomer” standards in their dealings with foreign financial institutions andforeign customers.  For example, theenhanced due diligence policies, procedures, and controls generally requirefinancial institutions to take reasonable steps:

 

·                                          to conduct enhanced scrutiny of accountrelationships to guard against money laundering and report any suspicioustransactions;

·                                          to ascertain the identity of the nominaland beneficial owners of, and the source of funds deposited into, each accountas needed to guard against money laundering and report any suspicioustransactions;

·                                          to ascertain for any foreign bank, theshares of which are not publicly traded, the identity of the owners of theforeign bank, and the nature and extent of the ownership interest of each suchowner; and

·                                          to ascertain whether any foreign bankprovides correspondent accounts to other foreign banks and, if so, the identityof those foreign banks and related due diligence information.

 

The Patriot Act also requires all financial institutions to establishanti-money laundering programs, which must include, at minimum:

 

·                                          the development of internal policies, procedures, andcontrols;

·                                          the designation of a compliance officer;

·                                          an ongoing employee training program; and

·                                          an independent audit function to test theprograms.

 

The Bank has adoptedcomprehensive policies and procedures, and has taken all necessary actions, toensure compliance with all financial transparency and anti-money launderinglaws, including the Patriot Act.

 

**Sarbanes-Oxley Act of 2002**

** **

As a public company, theCompany is subject to the Sarbanes-Oxley Act of 2002, which implements a broadrange of corporate governance and accounting measures for public companiesdesigned to promote honesty and transparency in corporate America and betterprotect investors from corporate wrongdoing. The Sarbanes-Oxley Act’s principal legislation and the derivativeregulation and rule making promulgated by the Securities and ExchangeCommission includes:

 

·                                          the creation of an independent accountingoversight board;

·                                          auditor independence provisions thatrestrict non-audit services that accountants may provide to their auditclients;

·                                          additional corporate governance andresponsibility measures, including the requirement that the chief executiveofficer and chief financial officer certify financial statements;

·                                          a requirement that companies establishand maintain a system of internal control over financial reporting and that acompany’s management provide an annual report regarding its assessment of theeffectiveness of such internal control over financial reporting to the company’sindependent accountants;

·                                          a requirement that the company’sindependent accountants provide an attestation report with respect tomanagement’s assessment of the effectiveness of the company’s internal controlover financial reporting 

 

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(this requirement iscurrently proposed to become effective for companies like the Company, which isnot an accelerated SEC filer, for our first fiscal year ending on or after December 15,2009);

·                                          the forfeiture of bonuses or otherincentive-based compensation and profits from the sale of an issuer’ssecurities by directors and senior officers in the twelve month periodfollowing initial publication of any financial statements that later require restatement;

·                                          an increase in the oversight of, andenhancement of certain requirements relating to audit committees of publiccompanies and how they interact with the company’s independent auditors;

·                                          the requirement that audit committeemembers must be independent and are absolutely barred from acceptingconsulting, advisory or other compensatory fees from the issuer;

·                                          the requirement that companies disclosewhether at least one member of the committee is a “financial expert” (as suchterm is defined by the SEC) and if not, why not;

·                                          expanded disclosure requirements forcorporate insiders, including accelerated reporting of stock transactions byinsiders and a prohibition on insider trading during pension blackout periods;

·                                          a prohibition on personal loans todirectors and officers, except certain loans made by insured financialinstitutions;

·                                          disclosure of a code of ethics and therequirement of filing of a Form 8-K for a change or waiver of such code;

·                                          mandatory disclosure by analysts ofpotential conflicts of interest; and

·                                          a range of enhanced penalties for fraudand other violations.

 

**Commercial Real Estate Lending and Concentrations**

** **

On December 2, 2006, the federal bank regulatory agencies releasedGuidance on Concentrations in Commercial Real Estate Lending, Sound RiskManagement Practices (the Guidance).  TheGuidance, which was issued in response to the agencies’ concern that rising CREconcentrations might expose institutions to unanticipated earnings and capitalvolatility in the event of adverse changes in the commercial real estatemarket, reinforces existing regulations and guidelines for real estate lendingand loan portfolio management.

 

Highlights of theGuidance include the following:

 

·                                          The agencies have observed that CREconcentrations have been rising over the past several years with small tomid-size institutions showing the most significant increase in CREconcentrations over the last decade.  However,some institutions’ risk management practices are not evolving with theirincreasing CRE concentrations, and therefore, the Guidance reminds institutionsthat strong risk management practices and appropriate levels of capital areimportant elements of a sound CRE lending program.

·                                          The Guidance applies to national banksand state chartered banks and is also broadly applicable to bank holdingcompanies.  For purposes of the Guidance,CRE loans include loans for land development and construction, other land loansand loans secured by multifamily and nonfarm residential properties.  The definition also extends to loans to realestate investment trusts and unsecured loans to developers if their performanceis closely linked to the performance of the general CRE market.

·                                          The agencies recognize that banks serve avital role in their communities by supplying credit for business and realestate development.  Therefore, theGuidance is not intended to limit banks’ CRE lending.  Instead, the Guidance encourages institutionsto identify and monitor credit concentrations, establish internal concentrationlimits, and report all concentrations to management and the board of directorson a periodic basis.

·                                          The agencies recognized that differenttypes of CRE lending present different levels of risk, and therefore,institutions are encouraged to segment their CRE portfolios to acknowledgethese distinctions.  However, the CREportfolio should not be divided into multiple sections simply to avoid theappearance of risk concentration.

·                                          Institutions should address the followingkey elements in establishing a risk management framework for identifying,monitoring, and controlling CRE risk: (1) board of directors andmanagement oversight; (2) portfolio management; (3) managementinformation systems; (4) market analysis; (5) credit underwritingstandards; (6) portfolio stress testing and sensitivity analysis; and (7) creditreview function.

·                                          As part of the ongoing supervisorymonitoring processes, the agencies will use certain criteria to identifyinstitutions that are potentially exposed to significant CRE concentrationrisk.  An institution that has 

 

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experienced rapid growthin CRE lending, has notable exposure to a specific type of CRE, or isapproaching or exceeds specified supervisory criteria may be identified forfurther supervisory analysis.

 

The Company believes that the Guidance is applicable to it, as it has aconcentration in CRE loans.  The Companyand its board of directors have discussed the Guidance and believe that MissionCommunity Bank’s  underwriting policy,management information systems, independent credit administration process andmonthly monitoring of real estate loan concentrations will be sufficient toaddress the Guidance. See *Loan Concentrations*in Management’s Discussion and Analysis of Financial Condition and Results ofOperations under Item 6 of Part II of this report.

 

**Allowancefor Loan and Lease Losses**

 

On December 13, 2006, the federal bank regulatory agenciesreleased Interagency Policy Statement on the Allowance for Loan and LeaseLosses (“ALLL”), which revises and replaces the banking agencies’ 1993 policystatement on the ALLL.  The revisedstatement was issued to ensure consistency with generally accepted accountingprinciples (GAAP) and more recent supervisory guidance.  The revised statement extends theapplicability of the policy to credit unions. Additionally, the agencies issued 16 FAQs to assist institutions incomplying with both GAAP and ALLL supervisory guidance.

 

Highlights of the revisedstatement include the following:

 

·                                          The revised statement emphasizes that theALLL represents one of the most significant estimates in an institution’sfinancial statements and regulatory reports and that an assessment of theappropriateness of the ALLL is critical to an institution’s safety andsoundness.

·                                          Each institution has a responsibility todevelop, maintain, and document a comprehensive, systematic, and consistentlyapplied process for determining the amounts of the ALLL.  An institution must maintain an ALLL that issufficient to cover estimated credit losses on individual impaired loans aswell as estimated credit losses inherent in the remainder of the portfolio.

·                                          The revised statement updates the previousguidance on the following issues regarding ALLL: (1) responsibilities ofthe board of directors, management, and bank examiners; (2) factors to beconsidered in the estimation of ALLL; and (3) objectives and elements ofan effective loan review system.

 

The Company believes that its ALLL methodology is comprehensive,systematic, and that it is consistently applied across the Company.  The Company also believes its managementinformation systems, independent credit administration process, policies andprocedures are sufficient to address the guidance.

 

**TransactionsBetween Affiliates**

 

Transactions between a bank and its “affiliates” are quantitatively andqualitatively restricted under the Federal Reserve Act.  The FRB has also issued Regulation W, whichcodifies prior regulations under Sections 23A and 23B of the Federal ReserveAct and interpretative guidance with respect to affiliate transactions.  Regulation W incorporates the exemption fromthe affiliate transaction rules but expands the exemption to cover thepurchase of any type of loan or extension of credit from an affiliate.  Affiliates of a bank include, among otherentities, companies that are under common control with the bank.  In general, subject to certain specifiedexemptions, a bank or its subsidiaries are limited in their ability to engagein “covered transactions” with affiliates:

 

·                                          to an amount equal to 10% of the bank’scapital and surplus, in the case of covered transactions with any oneaffiliate; and

·                                          to an amount equal to 20% of the bank’scapital and surplus, in the case of covered transactions with all affiliates.

 

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Inaddition, a bank and its subsidiaries may engage in covered transactions andother specified transactions only on terms and under circumstances that aresubstantially the same, or at least as favorable to the bank or its subsidiary,as those prevailing at the time for comparable transactions with nonaffiliatedcompanies. A “covered transaction” includes:

 

·                  a loan or extension of credit to an affiliate;

·                  a purchase of, or an investment in, securities issuedby an affiliate;

·                  a purchase of assets from an affiliate, with someexceptions;

·                  the acceptance of securities issued by an affiliate ascollateral for a loan or extension of credit to any party; and

·                  the issuance of a guarantee, acceptance or letter ofcredit on behalf of an affiliate.

 

In addition, underRegulation W:

 

·                  a bank and its subsidiaries may notpurchase a low-quality asset from an affiliate;

·                  covered transactions and other specifiedtransactions between a bank or its subsidiaries and an affiliate must be onterms and conditions that are consistent with safe and sound banking practices;and

·                  with some exceptions, each loan orextension of credit by a bank to an affiliate must be secured by collateralwith a market value ranging from 100% to 130%, depending on the type ofcollateral, of the amount of the loan or extension of credit.

 

Regulation W generally excludes all non-bank and non-savingsassociation subsidiaries of banks from treatment as affiliates, except to theextent that the FRB decides to treat these subsidiaries as affiliates.

 

**Employees**

 

As of March 1, 2008 the Bank had a total of 57 employees.  Neither Bancorp nor MCDC have salariedemployees; Bancorp’s officers all hold similar positions at the Bank.  The Bank, under inter-company arrangements,may charge Bancorp and/or MCDC for management, staff, and services.  For 2007, the Bank charged Bancorp a total of$132,000 for services performed on its behalf by Bank employees.

 

**Certain Business Risks**

** **

In addition to other information contained in thisReport, the following risks may affect the Company.  If any of these risks occur, the Company’sbusiness, financial condition and operations results could be adverselyaffected

 

**Significantreliance on loans secured by real estate may increase the Bank’s vulnerabilityto downturns in the California real estate market and other variables impactingthe value of real estate**

 

A substantial portion of the Bank’s assets consist ofconstruction and real estate loans which are generally secured by real estatein the Central Coast of California.  At December 31,2007, approximately $95 million or 75% of the Bank’s loans were constructionand real estate loans, and at December 31, 2006, approximately $98 millionor 80% of its loans were construction and real estate loans. A real estaterecession in the Central Coast of California could increase the level of non-performingassets and adversely affect results of operations. In recent years, real estateprices in the Central Coast of California rose precipitously; however, thisreal estate market ended in 2006 with declining prices and a slower salespace.  If real estate prices were to fallsignificantly in the Central Coast of California, the security for many realestate secured loans could be reduced and the Bank could incur losses ifborrowers of real estate secured loans default, and the value of the collateralis insufficient to cover losses.   Inaddition, California has experienced, on occasion, significant naturaldisasters, including earthquakes, brush fires and, during early 1998, floodingattributed to the weather phenomenon known as “El Nino.”  The availability of insurance for losses fromsuch catastrophes is limited.  Theoccurrence of one or more of such catastrophes could impair the value of thecollateral for our real estate secured loans and adversely affect us.

 

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**If a significant number ofcustomers fail to perform under their loans, the Company’s business,profitability, and financial condition would be adversely affected**

 

As a lender, the largest risk is the possibility thata significant number of our client borrowers will fail to pay their loans whendue.  If borrower defaults cause lossesin excess of the allowance for loan losses, it could have an adverse effect on theBank’s business, profitability, and financial condition.  An evaluation process designed to determinethe adequacy of the allowance for loan losses has been developed.  Although this evaluation process useshistorical and other objective information, the classification of loans and theestablishment of loan losses are dependent to a great extent upon experienceand judgment.  Although managementbelieves that the allowance for loan losses is at a level adequate to absorbany inherent losses in the loan portfolio, there is no assurance that therewill be no further increase to the allowance for loan losses or that the regulatorswill not require an increase to this allowance.

 

**The Bank’searnings are subject to interest rate risks, especially if rates fall**

 

A major portion of the Bank’s net income comes from theinterest rate spread, which is the difference between the interest rates paidon interest-bearing liabilities, such as deposits and other borrowings, and theinterest rates received on interest-earning assets, such as loans extended toclients and securities held in the investment portfolio.  Interest rates are highly sensitive to manyfactors beyond our control, such as inflation, recession, global economicdisruptions, and unemployment. Fluctuations in interest rates affect the demand of customers forproducts and services.  The Bank issubject to interest rate risk to the degree that interest-bearing liabilitiesreprice or mature more slowly or more rapidly or on a different basis frominterest-earning assets.  Given thecurrent volume and mix of interest-bearing liabilities and interest earningassets, the interest rate spread can be expected to increase when marketinterest rates are rising, and to decline when market interest rates aredeclining, *i.e.*, the Bank is “asset sensitive.”  Although management believes our currentlevel of interest rate sensitivity is reasonable, significant fluctuations ininterest rates may have an adverse impact on the interest rate spread.  Any material decline in the interest ratespread would have a material adverse effect on the Bank’s business andprofitability.

 

**The Bankhas specific risks association with Small Business Administration Loans**

 

The Bank originated $7.1 million and $3.5 million inSBA loans in 2007 and 2006, respectively, and intends to increase its SBA loanorigination in the future.  The Bankrecognized $307,000 and $264,000, respectively, in 2007 and 2006 in gainsrecognized on secondary market sales of SBA loans.  The Bank has regularly sold the guaranteedportions of these loans in the secondary market in previous years.  We can provide no assurance that MissionCommunity Bank will be able to continue originating these loans, or that asecondary market will exist for, or that it will continue to realize premiumsupon the sale of the SBA loans.  Thefederal government presently guarantees 75% to 85% of the principal amount ofeach qualifying SBA loan.  We can provideno assurance that the federal government will maintain the SBA program, or ifit does, that such guaranteed portion will remain at its current funding level.  Furthermore, it is possible that the Bankcould lose its preferred lender status which, subject to certain limitations,allows it to approve and fund SBA loans without the necessity of having theloan approved in advance by the SBA.  Itis also possible that the federal government could reduce the amount of loansthat it guarantees.  We believe that theSBA loan portfolio does not involve more than a normal risk ofcollectibility.  However, since the Bankhas sold some of the guaranteed portions of the SBA loan portfolio, it incurs apro rata credit risk on the non-guaranteed portion of the SBA loans since theBank shares pro rata with the SBA in any recoveries.

 

In addition, we are dependent on the expertise of thepersonnel in our SBA loan department in order to originate and service SBAloans.  If we are unable to retainqualified employees in our SBA Department in the future, our income from theorigination, sale and servicing of SBA loans could be substantially reduced. Further,in 2006, as rates on SBA loans continued to climb, a significant portion of SBAborrowers prepaid their loans, substantially reducing the servicing income wereceive on these loans.  If similarclimbs in interest rates were to occur again, our income from servicing SBAloans could be substantially reduced.

 

**If we are not successful in carrying out the new aspectsof our business plan our profitability will be adversely affected.**

 

We have recently implemented a strategy to grow ourgeneral commercial banking activities and have implemented new initiatives inthis regard, including increased emphasis on our business banking and business

18

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development activities, the creation of a new Hispanic Banking Divisionand the expansion of our physical presence into northern Santa Barbara Countythrough a planned new branch office to be located in the city of SantaMaria.  If we are not successful inimplementing any or all of these new aspects of our business plan, this wouldhave a negative impact on our earnings.

** **

**If the Company or the Bank were to lose its statusas a Community Development Financial Institution, its ability to carry out asignificant portion of its business plan would be adversely affected**

 

A portion of our business is augmented by our statusas a Community Development Financial Institution. That status increases thepotential for receiving grants and awards that, in turn, enable us to increasethe level of community development financial services that we provide in thecommunities we serve and to provide CRA credit for deposits andinvestments.  In order to maintain ourstatus as a certified Community Development Financial Institution 60% of ourbusiness must meet Community Development Financial Institutions Fundrequirements.  As our business hascontinued to expand, the proportion of our business which meets CommunityDevelopment Financial Institutions Fund requirements has decreased, causing usto affirmatively expand our business into areas which will afford us anopportunity to provide more community development activities, such as ourproposed expansion to the city of Santa Maria in northern Santa Barbara county,and our new Hispanic Banking Division. In 2007, 62% of the number of loans we made, and 61% of the dollar amountof the loans we made, were in compliance with the Community DevelopmentFinancial Institution Fund requirements. If we are unsuccessful in expanding our community developmentactivities, and if we are ultimately unable to maintain a sufficient portion ofour business in Community Development Financial Institutions Fund qualifyingbusiness, we could lose our status as a Community Development FinancialInstitution as well as the benefits that go with that status.  Mission Community Bank is a community developmentbank which seeks to provide financial support and services by promotingcommunity development and economic vitality. Most community development banks are located in urban areas, with veryfew exclusively community-development banks in rural areas.  A significant portion of San Luis ObispoCounty is rural.  Because of our marketarea, we may have difficulty locating the types of community developmentprojects that would likely attract awards and grants that might be conferred toother financial institutions in urban areas. In addition, grants and awards that we have received in the past withrespect to our community development activities have strengthened our capitalposition and increased our profitability. The Community Development Financial Institutions Fund and other similarprograms are an important source of capital for community development bankssuch as us.    Although we intend tocontinue to apply for community development related grants awards in thefuture, there can be no assurance that we will receive any future grants or awards.  Further, funding for these grant and awardprograms has diminished in the last several years making it less likely that wewill be the beneficiary of any grants and awards.

** **

**The availability of government grants and awardsto community development financial institutions has declined in recent years,and there can be no assurance that the Company and the Bank will receive anygrants or awards in the future**

 

Grants and awards that we have received in the pastwith respect to our community development activities have strengthened ourcapital position and increased our profitability.  The Community Development FinancialInstitutions Fund and other similar programs are an important source of capitalfor community development banks such as us. In 2007 the Bank received a $337,500 Bank Enterprise Award (“BEA”) fromthe CDFI Fund.  The award was made underthe Fiscal Year 2007 BEA Program, which provides an incentive for any FDICinsured bank to annually increase the levels of financial services provided toeconomically distressed communities.  In2004 and 2001 the Bank received similar BEA awards totaling $1,240,929 and$990,000, respectively.  The Companyreceived a technical assistance grant of $134,935 in 2005 to help offset anycosts associated with providing services to the un- and under-banked in ourmarket areas.  Although we intend tocontinue to apply for community development related grants awards in thefuture, there can be no assurance that we will receive any future grants orawards.  Further, funding for these grantand award programs has trended down over the last several years, making it lesslikely that we will be the beneficiary of any grants and awards.  For example, the CDFI Fund of the U.S.Department of the Treasury has seen a significant fluctuation inappropriations, from $118 million in the 2001 fiscal year to $55 million in2007 and $94 million in 2008.  Theportion of those budgets designated for BEA awards has likewise fluctuated from$48 million in 2001 to $13 million in 2007 and $21 million in 2008.  The President’s initial budget request forfiscal 2009 contains only $29 million in total appropriations for the CDFIFund, and no provision for BEA awards.

 

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**Adverse changes in domestic or global economicconditions, especially in California, could have a material adverse effect onthe Company’s business, growth, and profitability**

 

If conditions worsen in the domestic or globaleconomy, especially in California, our business, growth and profitability arelikely to be materially adversely affected. Almost all of our customers are geographically concentrated inCalifornia, and adverse economic conditions in California, or natural disastersin California, particularly in the Central Coast of California, could harm thebusinesses of a disproportionate number of our customers.  To the extent that our customers’ underlyingbusinesses are harmed, they are more likely to default on their loans.  We can provide no assurance that conditionsin the California economy will not deteriorate in the future and that suchdeterioration will not adversely affect us.

 

**Increasedconstruction costs or construction delays on two new proposed facilities couldhurt our profitability**

 

We are currently engaged in the design stage of aproject for a new headquarters in San Luis Obispo.  We are also in theplanning stage for tenant improvements to a new branch office in Santa Maria innorthern Santa Barbara County.  Further, we are planning to replace ourexisting branch office in Paso Robles on a piece of property we own in PasoRobles.  Although we will budget for the costs of these two projects, andintend to obtain responsible contractors to construct these two new premisesshould any of these projects proceed to fruition, there can be no assurancethat these construction projects will be completed for their budgeted amountsor in any anticipated time frame. Construction projects often substantially exceed initial estimates ofcosts, and extend well past estimated completion dates.  Any significant increase in constructioncosts or any extensive delay in the estimated completion dates of theseprojects would cause us to incur additional expenses for which we have notbudgeted, and would decrease our profitability.  Construction projects often substantiallyexceed initial estimates of costs, and extend well past estimated completiondates.

 

**Maintainingor increasing the Bank’s market share depends on the introduction and marketacceptance of new products and services**

 

Our success depends, in part, upon our ability toadapt our products and services to evolving industry standards and consumerdemand.  There is increasing pressure onfinancial services companies to provide products and services at lowerprices.  In addition, the widespreadadoption of new technologies, including Internet-based services, could requireus to make substantial expenditures to modify or adapt our existing products orservices.  A failure to achieve marketacceptance of any new products we introduce, or a failure to introduce productsthat the market may demand, could have an adverse effect on our business,profitability, or growth prospects.

 

**The Bank faces substantial competition in itsprimary market area**

 

We conduct our banking operations primarily in SanLuis Obispo County and northern Santa Barbara County in the Central Coast ofCalifornia.  Increased competition in ourmarket may result in reduced loans and deposits.  Ultimately, we may not be able to competesuccessfully against current and future competitors.  Many competitors offer the same bankingservices that we offer in our service area. These competitors include national banks, regional banks and other communitybanks.  We also face competition frommany other types of financial institutions, including without limitation,savings and loan institutions, finance companies, brokerage firms, insurancecompanies, credit unions, mortgage banks and other financialintermediaries.  Additionally, banks andother financial institutions with larger capitalization and financialintermediaries not subject to bank regulatory restrictions have larger lendinglimits and are thereby able to serve the credit needs of larger customers.  Areas of competition include interest ratesfor loans and deposits, efforts to obtain deposits, and range and quality ofproducts and services provided, including new technology-driven products andservices.   If we are unable to attractand retain banking customers, we may be unable to continue our loan growth andlevel of deposits and our results of operations and financial condition may beadversely affected.

 

**If theBank fails to retain its key employees, its growth and profitability could beadversely affected**

 

Our future success depends in large part upon thecontinuing contributions of our key management personnel.  If we lose the services of one or more keyemployees within a short period of time, we could be adversely affected.  Our future success is also dependent upon ourcontinuing ability to attract and retain highly qualified personnel.  Competition for such employees amongfinancial institutions in California is intense.  Due to the lack of an experienced candidatepool in the San Luis Obispo area for the types of personnel we need to operatethe Bank, we may be unable to quickly recruit new candidates to fill thepositions of key personnel which we are unable to retain.  Qualified employees demand competitivesalaries which we may not be able to offer. Prior to the retention of our current Chief Financial Officer in 

 

20

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January 2005, it took us approximately six monthsto fill the position of Chief Financial Officer when our previous ChiefFinancial Officer left to pursue other employment.  In addition, in 2006 we had to go severalmonths before filling the key position of Senior Vice President in ourGovernment Lending Department, which significantly impacted the originations ofour SBA loans.  Any inability to attract andretain additional key personnel in the future could adversely affect us.  We can provide no assurance that we will beable to retain any of our key officers and employees or attract and retainqualified personnel in the future. However, we have entered into an employment agreement with AnitaRobinson, the Company’s President and Chief Executive Officer, which continuesuntil December 31, 2012, and an employment agreement with Brooks W. Wise,the Bank’s President, which continues until December 31, 2009.

 

**TheCompany may be unable to manage future growth**

 

We may encounter problems in managing our futureplanned growth.  We currently intend toopen an additional “de novo” branch in Santa Maria, California, and haveidentified a location for this new facility. We may open other branches and loan production offices in thefuture.  In addition, we intend toinvestigate opportunities to invest in other financial institutions that wouldcomplement our existing business, as such opportunities may arise.  No assurance can be provided, however, thatwe will be able to identify additional locations to open additional branches orto identify a suitable acquisition target or consummate any suchacquisition.  Further, our ability tomanage growth will depend primarily on our ability to attract and retainqualified personnel, monitor operations, maintain earnings and controlcosts.  Any failure by us to accomplishthese goals could result in interruptions in our business plans and could alsoadversely affect current operations.

 

**Increasesin the Bank’s allowance for loan losses could materially affect its earningsadversely**

 

Like all financial institutions, we maintain anallowance for loan losses to provide for loan defaults andnon-performance.  Our allowance for loanlosses is based on prior experience, as well as an evaluation of the risks inthe current portfolio.  However, actualloan losses could increase significantly as the result of changes in economic,operating and other conditions, including changes in interest rates, which aregenerally beyond our control.  Thus, suchlosses could exceed our current allowance estimates.  Although we believe that our allowance forloan losses is at a level adequate to absorb any inherent losses in our loanportfolio, we cannot assure you that we will not further increase the allowancefor loan losses.  Any increase in ourallowance for loans losses could materially affect our earnings adversely.

 

In addition, the Federal Reserve Board and theCalifornia Department of Financial Institutions, as an integral part of theirrespective supervisory functions, periodically review our allowance for loanlosses.  Such regulatory agencies mayrequire us to increase our provision for loan losses or to recognize furtherloan charge-offs, based upon judgments different from those of management.  Any increase in our allowance required by theFederal Reserve Board or the Department of Financial Institutions couldadversely affect us.

 

**The Company’s business may be adversely affectedby the highly regulated environment in which it operates**

 

Our operations are subject to extensive governmentalsupervision, regulation and control and recent legislation has substantiallyaffected the banking business.  It cannotpresently be predicted whether or in what form any pending or futurelegislation may be adopted or the extent to which the banking industry and ouroperations would be affected. Some of the legislative and regulatory changesmay benefit us.  However, other changescould increase our costs of doing business or reduce our ability to compete incertain markets.

 

**REPORTSTO SECURITY HOLDERS.**

 

**AnnualReport**

 

An annual report to security holders including auditedfinancial statements is sent each year by the Company.

 

Certain reports are filed by the Company with theSecurities Exchange Commission pursuant to Section 13 or 15(d) of theSecurities Exchange Act of 1934.   TheSEC maintains an Internet site that contains reports and other informationstatements.  The Company files itsreports electronically and they may be viewed from the SEC’s Internet site 

 

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http://www.sec.gov. The public may also read and copy any materials filed with the SEC atthe SEC’s Public Reference Room at 100 F Street, NE, Washington, D.C.  20549. Information regarding the operation of the Public Reference Room isavailable by calling the SEC at 1-800-SEC-0300.

 

The Company’s Internet site ishttp://www.missioncommunitybank.com.

 

## **Item 2.  Description of Property**

## ** **

The Company occupies a property owned by the Bank at581 Higuera Street, San Luis Obispo, California, where the Bank’s main officeis located.  For its administrationoffices, the Bank has been leasing approximately 2,950 square feet at 569Higuera St. in San Luis Obispo at a cost of approximately $6,000 permonth.  The lease expires on June 30,2011.  The administration office islocated next to the Bank’s main office.

 

The Bank also leases a branch office at 1226 ParkStreet, Paso Robles, California, at a cost of $5,125 per month.  The lease expires on July 31, 2008 andprovides for one five-year option.

 

The Bank’s branch office at 154 West Branch Street,Arroyo Grande, California, is leased at a cost of $3,425 per month, plus commonarea operating expenses.  The lease expiresin December 2010 and provides for one five-year option period.

 

The Bank’s Business Banking Center at 3440 and 3480 S.Higuera Street, San Luis Obispo, is leased for a five-year period expiring in2009 at a cost of $6,490 per month.  Onefive-year option period is provided in the lease.

 

During 2005, the Bank purchased a parcel located nearthe intersection of 6th and Spring Streets in Paso Robles, where the Bank iscurrently planning to build a new branch office to replace our existing branchoffice in Paso Robles.  An adjacentparcel was purchased in 2006.  Noagreement to build has been entered into to date.

 

In September 2006, the Bank entered into a50-year ground lease for property at South Higuera Street and Prado Road in SanLuis Obispo, California, where the Bank intended to build a full-service branchand administrative office. The lease provided for rentals of $7,000 per month.  The terms of the lease gave the Bank earlytermination rights through September 30, 2007, which the Bank chose toexercise in July 2007.  In October 2007,the Bank executed a 15-year build-to-suit lease for the South Higuera Streetand Prado Road property.  Currently thelease provides for tentative lease payments of $36,708 per month, subject tothe final size of the yet-to-be-constructed building, and beginning on or aboutOctober 1, 2009.

 

In March 2008, the Bank entered into a 5-yearlease for an office building at 1670 South Broadway in Santa Maria, California,where the Bank intends to open a full-service branch office.  The initial rental cost is $8,679 permonth.  The lease provides for two 5-yearrenewal options and an option to purchase the property for a specified amountduring the last two months of 2010.

 

For the years ended December 31, 2007 and 2006,the Bank’s total occupancy costs were approximately $546,000 and $467,000,respectively.  In the opinion ofmanagement, the premises are adequate for the Bank’s purposes and the Bank hassufficient insurance to cover its interest in the premises.  Note D to the Consolidated FinancialStatements contains additional information about properties.

 

Bancorp is restricted by the bank holding companyregulations in its power to hold real estate property for investment.  TheCompany does not currently invest in real estate, other than for purposes ofoperations and mortgage interests in real estate securing loans made by theBank in the ordinary course of business, and has no plans to do so in thefuture.

 

## **Item3.  Legal Proceedings**

## ** **

The Company is, from time to time, subject to variouspending and threatened legal actions which arise out of the normal course ofits business.  After taking intoconsideration information furnished by counsel to the Company as to the currentstatus of these claims or proceedings to which the Bank is a party, Managementis of the opinion that the ultimate 

 

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aggregate liability represented thereby, if any, willnot have a material adverse affect on the financial condition of the Company.

 

There are no material proceedings adverse to theCompany to which any director, officer, affiliate of the Company or 5%shareholder of the Company, or any associate of any such director, officer,affiliate or 5% shareholder is a party, and none of the above persons has amaterial interest adverse to the Company.

 

## **Item4.  Submission of Matters to a Vote ofSecurity Holders**

## ** **

No matters were submitted to a vote of securityholders during the fourth quarter of 2007.

 

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# ** **

# **PART II**

# ** **

## **Item5. Market  for Common Equity, RelatedShareholder Matters and Issuer Purchases of Equity Securities**

## ** **

**Market Information**

 

The Company’s common stock has traded infrequently inthe over-the-counter market under the symbol “MISS.”  The Company’s Common Stock is not listed onany exchange or market. However, the Seidler Companies, Monroe Securities,Wedbush Morgan Securities, Hill Thompson Magid & Co, and Howe BarnesHoefer & Arnett make a market in the Company’s Common Stock. Certaininformation concerning the Common Stock is reported on the Nasdaq OTC BulletinBoard (www.otcbb.com).

 

The information in the following table indicates thedaily high and low bid prices of the Company’s Common Stock for each quarterlyperiod during the last two years based upon information provided by the OTCBulletin Board. These prices do not include retail mark-ups, mark-downs orcommission.

 
| ** ** | ** **  | **Bid Prices** | ** ** |
|------------|-------------|---------------------|------------|
| ** ** | ** **  | **Low**             | ** ** | **High** | ** ** |
| 2006       | 1st Quarter |                | 23.50      |   | 28.25 |   |
|       | 2nd Quarter |                | 25.00      |   | 27.05 |   |
|       | 3rd Quarter |                | 24.50      |   | 26.75 |   |
|       | 4th Quarter |                | 22.50      |   | 26.75 |   |
| 2007       | 1st Quarter |                | 22.20      |   | 23.00 |   |
|       | 2nd Quarter |                | 18.50      |   | 22.20 |   |
|       | 3rd Quarter |                | 16.05      |   | 18.50 |   |
|       | 4th Quarter |                | 15.75      |   | 18.00 |   |

 

**Holders**

 

As of March 1, 2008, there were 366 holders ofrecord of Bancorp’s Common Stock.

 

**Dividends**

 

The Company’s shareholders are entitled to receivedividends, when and as declared by its Board of Directors, out of funds legallyavailable therefore, subject to the restrictions set forth in the CaliforniaGeneral Corporation Law (the “Corporation Law”). The Corporation Law providesthat a corporation may make a distribution to its shareholders if thecorporation’s retained earnings equal at least the amount of the proposeddistribution. The Corporation Law also provides that, in the event that sufficientretained earnings are not available for the proposed distribution, acorporation may nevertheless make a distribution to its shareholders if itmeets two conditions, which generally stated are as follows: (i) thecorporation’s assets equal at least 1.25 times its liabilities, and (ii) thecorporation’s current assets equal at least its current liabilities or, if theaverage of the corporation’s earnings before taxes on income and beforeinterest expenses for the two preceding fiscal years was less than the averageof the corporation’s interest expenses for such fiscal years, then thecorporation’s current assets  must equalat least 1.25 times its current liabilities. The Company was eligible to paydividends at the end of 2006 and 2007.

 

The availability of operating funds for the Companyand the ability of the Company to pay a cash dividend depends largely on theBank’s ability to pay a cash dividend to Bancorp. The payment of cash dividendsby the Bank is subject to restrictions. In general, dividends may not bepaid from any of the Bank’s capital. Dividends must be paid out of availablenet profits, after deduction of all current operating expenses, actual losses,accrued dividends on preferred stock, if any, and all federal and state taxes.Additionally, a bank is prohibited from declaring a dividend on its shares ofcommon stock until its surplus fund equals its common capital, or, if itssurplus fund does not equal its common capital, until at least one-tenth of thebank’s net profits, for the preceding half year in the case of quarterly orsemi-annual dividends, or the

 

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preceding full year inthe case of an annual dividend, are transferred to its surplus fund each timedividends are declared. Regulatory approval is required if the total of alldividends declared by a bank in any calendar year exceeds the total of its netprofits for that year combined with its retained net profits of the twopreceding years, less any required transfers to surplus or a fund for theretirement of any preferred stock. Furthermore, bank regulators also haveauthority to prohibit the payment of dividends by a bank when it determinessuch payment to be an unsafe and unsound banking practice.

 

Additionally, bank regulatory agencies have authorityto prohibit banks from engaging in activities that, in their respectiveopinions, constitute unsafe and unsound practices in conducting its business.It is possible, depending upon the financial condition of the bank in questionand other factors, that the bank regulatory agencies could assert that thepayment of dividends or other payments might, under some circumstances, be anunsafe or unsound practice. Further, the bank regulatory agencies haveestablished guidelines with respect to the maintenance of appropriate levels ofcapital by banks or bank holding companies under their jurisdiction. Compliancewith the standards set forth in such guidelines and the restrictions that areor may be imposed under the prompt corrective action provisions of federallaw could limit the amount of dividends which the Bank may pay.

 

Under these provisions and considering minimumregulatory capital requirements, the Bank was eligible to pay dividends in 2006and 2007.

 

On November 28, 2006, the Company declared a$0.12 per share cash dividend for holders of the Common Stock of record on December 8,2006. The dividend was paid on December 18, 2006. Series A PreferredStock received a $0.06 per share dividend and Series B and C PreferredStock received a $0.12 per share dividend. The total amount paid was $94,908.

 

On November 26, 2007, the Company declared a$0.12 per share cash dividend for holders of the Common Stock of record on December 7,2007. The dividend was paid on December 17, 2007. Series A PreferredStock received a $0.06 per share dividend and Series B and C PreferredStock received a $0.12 per share dividend. The total amount paid was $96,688.

 

In December 2006 the Bank paid a $300,283dividend to Bancorp, in August 2007 the Bank paid a $198,187 dividend, andin December 2007 the Bank paid a $102,096 dividend to Bancorp.

 

Whether or not stock or cash dividends will be paid inthe future by the Company and/or the Bank will be determined by the Board ofDirectors after consideration of various factors including, but not limited to,profitability, regulatory capital ratios, and financial condition.Additionally, certain provisions of the preferred stock issuances restrict theability of the Company to pay cash dividends unless the required dividends onthe preferred stock are also paid.

 

The Company has issued and outstanding $3,093,000 ofjunior subordinated debt securities due October 2033. The indenturepursuant to which these debt securities were issued provides that the Companymust make interest payments on the debentures before any dividends can be paidon its capital stock and in the event of the Company’s bankruptcy, dissolutionor liquidation, the holder of the debt securities must be paid in full beforeany distributions may be made to the holders of our capital stock. Inaddition, the Company has the right to defer interest payments on the juniorsubordinated debt securities for up to five years, during which time nodividends may be paid to holders of the Company’s capital stock.

 

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**Equity Compensation Plans**

 

The following table shows, as of December 31,2007, each category of equity compensation along with i) the number ofsecurities to be issued upon the exercise of outstanding options, warrants andrights, ii) the weighted-average exercise price of the outstanding options,warrants and rights, and iii) the remaining number of securities available forfuture issuance under the plan, excluding stock options currently outstanding.

 

**Equity Compensation Plan Information**

 
|                                                        |   | **Number of  securities to be  issued upon  exercise of  outstanding  options, warrants  and rights** | ** ** | **Weighted average  exercise price of  outstanding  options, warrants  and rights** | ** ** | **Number of  additional  securities available  for future grant  under the plan** |   |
|-------------------------------------------------------------|--------|-------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------|--------|
| Equity compensation plans approved by  security holders     |   | 80,900                                                                                                |       | $                                                                                   | 13.42      |                                                                              | 10,534 |   |
|                                                        |   |                                                                                                  |       |                                                                                |       |                                                                              |   |
| Equity compensation plans not approved by  security holders |   | —                                                                                                |       | —                                                                              |       | —                                                                            |   |
|                                                        |   |                                                                                                  |       |                                                                                |       |                                                                              |   |
| Total                                                       |   | 80,900                                                                                                |       | $                                                                                   | 13.42      |                                                                              | 10,534 |   |

 

See Note I to the consolidated financial statementsfor a discussion of the Company’s Stock Option Plan.

 

**Purchases of equity securities by Bancorp and affiliated purchasers**

 

On August 10, 2007, in a privately negotiatedtransaction, Mission Community Bancorp (“Mission”) purchased 29,400 shares ofits common stock held by Fannie Mae, at a per share price of $15.62 for a totalpurchase price of $459,228. Other than this one transaction, neither Bancorpnor any affiliate of Bancorp has repurchased any of its common or preferredstock during the period covered by this report, and no stock repurchase planhas been adopted.

 

**Report of Offering of Securities and Use ofProceeds Therefrom**

 

A registration statement with respect to a secondarypublic offering of securities by Bancorp became effective on August 13,2007. The offering was a best efforts offering to sell an aggregate of between166,667 and 597,000 shares of the Bancorp’s authorized but unissued commonstock at a price of $18.00 per share. Seapower Carpenter Capital, Inc.,dba Carpenter & Company acted as Bancorp’s placement agent in theoffering. The offering closed on February 14, 2008 with the sale of410,644 shares for total gross proceeds to the Company of approximately $7.4million. As of the end of the period covered by this report, the Company hadnot received any proceeds from the offering.

 

**Item 6. Management’s Discussion and Analysis**

 

**Executive Summary**

** **

During 2007 and 2006, the Company experienced relatively level years inboth growth and earnings. At December 31, 2007, the Company had totalconsolidated assets of $158.3 million, a 0.1% increase from December 31,2006. Total net loans increased 2.9%, to $125.3 million, over that same period.Deposits decreased 9.5%, to $112.4 million, while shareholders’ equityincreased 8.1%, to $13.1 million, over the past year.

 

The Company’s net income was $765 thousand, or $0.91 per diluted share,for the year ended December 31, 2007. This compares with $870 thousand, or$1.02 per diluted share, in 2006.

 

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The following are the major factors impacting the Company’s results ofoperations and financial condition in the past year.

 

·                  A decrease in thenet interest margin. The net interest margin for 2007 was 4.51%, down 42 basispoints from 2006. The Bank is asset sensitive (see the *Asset andLiability Management* section of this discussion) and benefitedfrom the steady increase in short-term interest rates in 2004 and 2005.Short-term rates leveled off in 2006 and began to decline in 2007. At the sametime, the Bank experienced increasing pressure on the margin due to competitionfor deposits in the local market. Overall, the Bank expects that pressure tocontinue in 2008, as short-term rates are expected to continue to decline.

·                  An increase inthe volume of SBA loans originated, sold, serviced and brokered. SBA loansoriginated for sale doubled in 2007 as compared to 2006, and loans sold in 2007increased 36%. Non-interest income related to SBA loans sold, serviced and brokeredincreased $340 thousand, or 189%, from 2006 to 2007.

·                  More awards forour community development activities. In 2007 the Bank recognized $326 thousandof a $337,500 award from the Bank Enterprise Award program of the Department ofthe Treasury. The award was based on lending activity the bank commenced in2006. The remaining $11,500 of the award is contingent upon lending activitywhich had not occurred as of December 31, 2007.

·                  Credit qualityremained excellent in 2007, although non-performing loans remained above $2million. Net charge-offs totaled only $26 thousand (0.02% of average loans) forthe year.

 

**Critical Accounting Policies**

** **

The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States of America requires theCompany’s management to make estimates and assumptions that affect the reportedamounts of assets and liabilities, disclosure of contingent assets andliabilities at the date of the financial statements, and the reported amountsof revenues and expenses during the reporting period. Actual results coulddiffer from those estimates.

 

A critical accounting policy is defined as one that is both material tothe presentation of the Company’s financial statements and requires managementto make difficult, subjective or complex judgments that could have a materialeffect on the Company’s financial condition and results of operations and may changein future periods. Note A to the Consolidated Financial Statements describesthe significant accounting policies used in the preparation of the ConsolidatedFinancial Statements. Not all of these accounting policies require managementto make difficult, subjective or complex judgments or estimates. However,management believes that the following policies could be considered criticalwithin the SEC’s definition.

 

*Reserves and Contingencies*

 

In the normal course of business, the Company must manage and controlcertain risks inherent to the business of banking. These include credit risk,interest rate risk, fraud risk, and operations and settlement risk. The Companyhas established reserves for risk of losses, including loan losses. Theallowance for loan losses represents management’s estimate of the probablelosses that have occurred as of the date of the financial statements, asfurther described in Note A in the Notes to the Consolidated FinancialStatements. See also *Allowance for Loan Losses*below. These reserves or accruals are reviewed by management at leastquarterly. If the latest estimate of loss (or the actual loss) differs from theaccrual or reserve recorded to date, the financial impact is reflected in theperiod in which the estimate is revised (or the actual loss is determined).

 

*Revenue recognition*

 

The Company’s primary source of revenue is interest income from loansand investment securities. Interest income is recorded on an accrual basis.Note A in the Notes to the Consolidated Financial Statements contains anexplanation of the process for determining when the accrual of interest incomeis discontinued on impaired loans and under what circumstances loans arereturned to an accruing status.

 

The Company also records gains in connection with the sale of theguaranteed portion of certain SBA-guaranteed loans for which the Bank retainsthe right to service the loans. Recording of such gains involves the use ofestimates and assumptions related to the expected life of the loans and futurecash flows. Notes A and C in the Notes to the Consolidated Financial Statementscontain additional information regarding the Company’s accounting policy forrevenue recorded in

 

27

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connection with the sale of loans. SBA loan servicing rights are basedupon estimates and are subject to the risk of prepayments and market valuefluctuation.

 

28

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**Selected Financial Data**

 

The following is selected consolidated financial data with respect tothe Company’s consolidated financial statements for the two years ended December 31,2007 and 2006. The information presented has been derived from the auditedconsolidated financial statements included in Item 7 of Part II of this Form 10-KSB.This information should be read in conjunction with such consolidated financialstatements and the notes thereto.

 
| ** **                                                                           | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| **In thousands, except share and per share data** | ** ** | **2007**                                   | ** ** | **2006** | ** ** |
| Interest income                                                                      |       | $                                          | 11,759     |   | $ | 11,354 |   |
| Interest expense                                                                     |       | 5,129                                      |       | 4,441 |   |
| Net interest income                                                                  |       | 6,630                                      |       | 6,913 |   |
| Provision for loan losses                                                            |       | 150                                        |       | — |   |
| Non-interest income                                                                  |       | 1,257                                      |       | 635 |   |
| Non-interest expense                                                                 |       | 6,594                                      |       | 6,139 |   |
| Income before income taxes                                                           |       | 1,143                                      |       | 1,409 |   |
| Income taxes                                                                         |       | 378                                        |       | 539 |   |
| Net income                                                                           |       | $                                          | 765        |   | $ | 870 |   |
| Net income allocable to preferred stock                                              |       | $                                          | 115        |   | $ | 133 |   |
|                                                                                 |       |                                       |       |   |   |
| **Balance  Sheet Data at End of Year**                                               |       |                                       |       |   |   |
| Assets                                                                               |       | $                                          | 158,329    |   | $ | 158,169 |   |
| Earning assets                                                                       |       | 149,439                                    |       | 148,146 |   |
| Total loans                                                                          |       | 126,429                                    |       | 122,799 |   |
| Deposits                                                                             |       | 112,433                                    |       | 124,281 |   |
| Total shareholders’ equity                                                      |       | 13,138                                     |       | 12,153 |   |
| Preferred equity                                                                     |       | 1,955                                      |       | 1,845 |   |
| Common equity                                                                        |       | 11,183                                     |       | 10,308 |   |
| Number of common shares outstanding                                                  |       | 689,232                                    |       | 673,399 |   |
| **Average  Balance Sheet Data**                                                      |       |                                       |       |   |   |
| Assets                                                                               |       | $                                          | 157,869    |   | $ | 150,899 |   |
| Earning assets                                                                       |       | 148,197                                    |       | 140,894 |   |
| Loans                                                                                |       | 125,691                                    |       | 118,303 |   |
| Deposits                                                                             |       | 121,480                                    |       | 121,038 |   |
| Shareholders’ equity                                                            |       | 12,610                                     |       | 11,555 |   |
| **Per  Share Data**                                                                  |       |                                       |       |   |   |
| Basic earnings per share                                                             |       | $                                          | 0.96       |   | $ | 1.10 |   |
| Diluted earnings per share                                                           |       | 0.91                                       |       | 1.02 |   |
| Average number of common shares outstanding  - basic                                 |       | 679,144                                    |       | 667,810 |   |
| Average number of common shares outstanding  - diluted                               |       | 713,152                                    |       | 720,701 |   |
| Book value per common share                                                          |       | $                                          | 16.23      |   | $ | 15.31 |   |
| Cash dividends declared                                                              |       | 0.12                                       |       | 0.12 |   |
| **Performance  Ratios**                                                              |       |                                       |       |   |   |
| Return on average assets                                                             |       | 0.48                                       | %          | 0.58 | % |
| Return on average shareholders’ equity                                          |       | 6.07                                       | %          | 7.53 | % |
| Average equity to average assets                                                     |       | 7.99                                       | %          | 7.66 | % |
| Efficiency ratio                                                                     |       | 83.61                                      | %          | 81.33 | % |
| Leverage ratio                                                                       |       | 10.03                                      | %          | 9.98 | % |
| Net interest margin                                                                  |       | 4.51                                       | %          | 4.93 | % |
| Non-interest revenue to total revenue                                                |       | 15.94                                      | %          | 8.41 | % |
| **Asset  Quality**                                                                   |       |                                       |       |   |   |
| Non-performing assets                                                                |       | $                                          | 2,056      |   | $ | 2,169 |   |
| Allowance for loan losses                                                            |       | 1,150                                      |       | 1,026 |   |
| Net charge-offs (recoveries)                                                         |       | 26                                         |       | 115 |   |
| Non-performing assets to total assets                                                |       | 1.30                                       | %          | 1.37 | % |
| Allowance for loan losses to loans                                                   |       | 0.91                                       | %          | 0.84 | % |
| Net charge-offs to average loans                                                     |       | 0.02                                       | %          | 0.10 | % |

 

29

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#### **Basis of Presentation**

 

The following discussion and analysis is intended to assist in anunderstanding of the significant factors that affected our consolidatedfinancial condition and results of operations for the years ended December 31,2007 and 2006. This discussion, which refers to the Company on a consolidatedbasis, should be read in conjunction with the Company’s consolidated financialstatements and corresponding notes.

 

Bancorp is inactive except for interest expense associated with thejunior subordinated debentures (related to the trust preferred securities) andminimal other expenses. Therefore, the financial information is primarilyreflective of the Bank.

 

The Bank operates as a traditional community bank, but has also usedmanagement’s expertise as a CDFI to provide a selection of financial servicesidentified as “community development” activities, with a focus on financialservices to under-served markets, small businesses and business professionals.Bancorp and the Bank have received and used both grants and deposits underprograms authorized by CDFI and continuously review various options for bothgrants and deposit programs from various government and public/privateentities. The CDFI status is dependent on management’s specialized knowledge ofworking with various governmental programs and requires a significant increasein reporting and documentation as compared with traditional bank activities.

 

MCDC provides financing for small businesses and low- tomoderate-income areas based on direct loans or funding pools established inconjunction with others. MCDC currently has one small community developmentloan outstanding and provides loan servicing for the San Luis Obispo CountyEconomic Vitality Corporation. MCDC also services the San Simeon EarthquakeRecovery Loan Fund (the “Earthquake Fund”), a loan pool funded by the Bank andother local banks. The Earthquake Fund is structured to provide low costfinancing to individuals and businesses in San Luis Obispo and northern SantaBarbara counties which experienced severe damage in the December 22, 2003,San Simeon Earthquake. As of December 31, 2007, the Earthquake Fund had$27,000 in loans outstanding and $404,000 available to lend. Unless the statedpurpose of the Earthquake Fund is changed in the future, it is unlikely thatthe remainder of the Earthquake Fund will be used; no loans have been fundedsince October 2004. The consortium is looking at alternative communitydevelopment uses for the loan pool. MCDC also manages a loan pool for the SanLuis Obispo County Housing Trust Fund to assist in providing affordablehousing. As of December 31, 2007, the Housing Trust Fund had $1,505,000 inloans outstanding.

 

MCSC provides technical assistanceservices and training to the underserved segments of the community includingsmall businesses, minorities and low-income entrepreneurs, and providestechnical assistance to applicants for the Earthquake Fund. During 2006, MCSCwas awarded a five-year, $750,000 grant from the U.S. Small BusinessAdministration to fund one of 99 Women’s Business Centers nationwide. WhileMCSC has not engaged in any direct lending, it intends to provide some lendingin the near future. As of December 31, 2007, the Bank has had limiteddirect benefit from its association with MCSC. See also Note L to theConsolidated Financial Statements for additional information regarding MCSC.

 

**Resultsof Operations**

** **

 **AverageBalance Sheets and Analysis of Net Interest Income**

 

The principal component of earnings for most banks is net interestincome. Net interest income is the difference between the interest earned onloans and investments and the interest paid on deposits and otherinterest-bearing liabilities.

 

The banking industry uses two key ratios to measure relativeprofitability of net interest income. The net interest rate spread measures thedifference between the average yield on earning assets and the average ratepaid on interest bearing liabilities. The interest rate spread ignores thebeneficial impact of non-interest bearing deposits and capital, and provides adirect perspective on the effect of market interest rate movements. The netinterest margin is defined as net interest income as a percentage of averageinterest-earning assets, which includes the positive impact of obtaining aportion of the funding for earning assets with non-interest bearing depositsand capital.

 

30

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The following table presents, for the periods indicated, the totaldollar amounts of interest income from average interest-earning assets and theresultant yields. Also presented are the dollar amounts of interest expense andaverage interest-bearing liabilities, expressed both in dollars and in rates.

 

***Net Interest Analysis***

*(Dollars in thousands)*

 
|                                                                                   |   | **For the Years Ended** |    |
|----------------------------------------------------------------------------------------|--------|----------------------------------------|---------|
|                                                                                   |   | **December 31, 2007**        |    | **December 31, 2006** |   |
|                                                                                   |   | **Average**                            |    | ** ** |   | **Average** |   | **Average** |   | ** ** |   | **Average** |   |
|                                                                                   |   | **Balance**                            |    | **Interest** |   | **Rate** |   | **Balance** |   | **Interest** |   | **Rate** |   |
| **ASSETS**                                                                             |   |                                   |    |   |   |   |   |   |   |   |   |   |   |
| **Interest-earning  assets:**                                                          |   |                                   |    |   |   |   |   |   |   |   |   |   |   |
| Loans, net of unearned income                                                          |   | $                                      | 125,691 |   | $ | 10,764 |   | 8.56 | % | $ | 118,303 |   | $ | 10,386 |   | 8.78 | % |
| Investment securities                                                                  |   | 16,071                                 |    | 699 |   | 4.64 | % | 16,470 |   | 685 |   | 4.32 | % |
| Federal funds sold                                                                     |   | 2,814                                  |    | 140 |   | 4.98 | % | 4,283 |   | 211 |   | 4.93 | % |
| Other interest income                                                                  |   | 3,621                                  |    | 156 |   | 4.32 | % | 1,838 |   | 72 |   | 3.91 | % |
| **Total  interest-earning assets / interest income**                                   |   | 148,197                                |    | 11,759 |   | 7.97 | % | 140,894 |   | 11,354 |   | 8.08 | % |
| **Non-interest-earning  assets:**                                                      |   |                                   |    |   |   |   |   |   |   |   |   |   |   |
| Allowance for loan losses                                                              |   | (1,051                                 | )       |   |   |   |   | (1,181 | ) |   |   |   |   |
| Cash and due from banks                                                                |   | 2,511                                  |    |   |   |   |   | 2,930 |   |   |   |   |   |
| Premises and equipment                                                                 |   | 3,648                                  |    |   |   |   |   | 3,639 |   |   |   |   |   |
| Other assets                                                                           |   | 4,564                                  |    |   |   |   |   | 4,607 |   |   |   |   |   |
| **Total  assets**                                                                      |   | $                                      | 157,869 |   |   |   |   |   | $ | 150,889 |   |   |   |   |   |
|                                                                                   |   |                                   |    |   |   |   |   |   |   |   |   |   |   |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                         |   |                                   |    |   |   |   |   |   |   |   |   |   |   |
| **Interest-bearing  liabilities:**                                                     |   |                                   |    |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing deposits:                                                             |   |                                   |    |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing demand accounts                                                       |   | $                                      | 13,611  |   | 421 |   | 3.09 | % | $ | 6,747 |   | 121 |   | 1.80 | % |
| Savings deposits                                                                       |   | 22,988                                 |    | 575 |   | 2.50 | % | 30,559 |   | 899 |   | 2.94 | % |
| Certificates of deposit                                                                |   | 60,893                                 |    | 2,931 |   | 4.81 | % | 57,701 |   | 2,541 |   | 4.40 | % |
| Total interest-bearing deposits                                                        |   | 97,492                                 |    | 3,927 |   | 4.03 | % | 95,007 |   | 3,561 |   | 3.75 | % |
| Federal funds purchased                                                                |   | 4                                      |    | — |   | 6.34 | % | — |   | — |   | — |   |
| Federal Home Loan Bank advances                                                        |   | 19,383                                 |    | 925 |   | 4.77 | % | 13,904 |   | 609 |   | 4.38 | % |
| Subordinated debt                                                                      |   | 3,093                                  |    | 277 |   | 8.95 | % | 3,093 |   | 271 |   | 8.76 | % |
| Total borrowed funds                                                                   |   | 22,480                                 |    | 1,202 |   | 5.35 | % | 16,997 |   | 880 |   | 5.17 | % |
| **Total  interest-bearing liabilities / interest expense**                             |   | 119,972                                |    | 5,129 |   | 4.28 | % | 112,004 |   | 4,441 |   | 3.97 | % |
| **Non-interest-bearing  liabilities:**                                                 |   |                                   |    |   |   |   |   |   |   |   |   |   |   |
| Non-interest-bearing deposits                                                          |   | 23,988                                 |    |   |   |   |   | 26,031 |   |   |   |   |   |
| Other liabilities                                                                      |   | 1,299                                  |    |   |   |   |   | 1,299 |   |   |   |   |   |
| Total liabilities                                                                      |   | 145,259                                |    |   |   |   |   | 139,334 |   |   |   |   |   |
| Shareholders’ equity                                                              |   | 12,610                                 |    |   |   |   |   | 11,555 |   |   |   |   |   |
| **Total  liabilities and shareholders’ equity**                                   |   | $                                      | 157,869 |   |   |   |   |   | $ | 150,889 |   |   |   |   |   |
| **Net  interest-rate spread**                                                          |   |                                   |    |   |   | 3.69 | % |   |   |   |   | 4.11 | % |
| Impact of non-interest-bearing sources and  other changes in balance sheet composition |   |                                   |    |   |   | 0.82 | % |   |   |   |   | 0.82 | % |
| **Net  interest income / margin on earning assets**                                    |   |                                   |    | $ | 6,630 |   | 4.51 | % |   |   | $ | 6,913 |   | 4.93 | % |

 

Non-accrualloans are included in the calculation of the average balances of loans;interest not accrued is excluded. Yields on tax-exempt municipal securities(included with investment securities) have been adjusted to their fully-taxableequivalents.

 

Net interest income is affected by changes in the amount and mix of ourinterest-earning assets and interest-bearing liabilities, referred to as thechange due to *volume*. Average interest-earningassets grew by $7.3 million in 2007 over 2006, primarily driven by loanvolume—the most profitable component of interest-earning assets.Interest-bearing liabilities increased $8.0 million over the past year. Netinterest income is also affected by changes in the yields we earn oninterest-earning assets and the rates we pay on interest-bearing deposits andborrowed funds, referred to as the change due to *rate.*Theaverage yield on interest-earning assets decreased by 11 basis points (0.11%)in 2007, while the average rate paid on interest-bearing liabilities *in*creased by 31 basis points, causing pressure on the netinterest margin. As a result, the net interest margin decreased 42 basis pointsin 2007, from 4.93% to 4.51%.

 

31

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The Bank is asset sensitive (see the *Asset andLiability Management* section of this discussion) and benefitedfrom the steady increase in short-term interest rates in 2004 and 2005.Short-term rates leveled off in 2006 and began to decline in 2007. At the sametime, the Bank experienced increasing pressure on the margin due to competitionfor deposits in the local market. Overall, the Bank expects that pressure tocontinue in 2008, as rates short-term rates are expected to continue todecline.

 

The following table sets forth changes in interest income and interestexpense for each major category of interest-earning assets and interest-bearingliabilities, and the amount of those variances attributable to volume and ratechanges for the years indicated.

 

***Rate / Volume Variance Analysis***

*(In thousands)*

 
|                               |   | **Year Ended December 31, 2007**   |   | **Year Ended December 31, 2006**   |   |
|------------------------------------|--------|--------------------------------------------------------|--------|--------------------------------------------------------|--------|
|                               |   | **Compared to 2006**                         |   | **Compared to 2005**                         |   |
|                               |   | **Increase (Decrease)**                           |   | **Increase (Decrease)**                           |   |
|                               |   | **in interest income and expense** |   | **in interest income and expense** |   |
|                               |   | **due to changes in:**                  |   | **due to changes in:**                  |   |
|                               |   | **Volume**                                             |   | **Rate**                                               |   | **Total** |   | **Volume** |   | **Rate** |   | **Total** |   |
| Interest-earning assets:           |   |                                                   |   |                                                   |   |   |   |   |   |   |   |   |   |
| Loans, net of unearned income      |   | $                                                      | 637    |                                                   | $      | (259 | ) | $ | 378 |   | $ | 836 |   | $ | 925 |   | $ | 1,761 |   |
| Investment securities              |   | (16                                                    | )      | 30                                                     |   | 14 |   | 7 |   | 53 |   | 60 |   |
| Federal funds sold                 |   | (73                                                    | )      | 2                                                      |   | (71 | ) | (5 | ) | 79 |   | 74 |   |
| Other interest income              |   | 76                                                     |   | 8                                                      |   | 84 |   | 4 |   | 20 |   | 24 |   |
| Total increase in interest income  |   | 624                                                    |   | (219                                                   | )      | 405 |   | 842 |   | 1,077 |   | 1,919 |   |
|                               |   |                                                   |   |                                                   |   |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities:      |   |                                                   |   |                                                   |   |   |   |   |   |   |   |   |   |
| Transaction accounts               |   | 176                                                    |   | 124                                                    |   | 300 |   | 27 |   | 37 |   | 64 |   |
| Savings deposits                   |   | (202                                                   | )      | (122                                                   | )      | (324 | ) | (218 | ) | 301 |   | 83 |   |
| Certificates of deposit            |   | 145                                                    |   | 245                                                    |   | 390 |   | 360 |   | 816 |   | 1,176 |   |
| Total interest-bearing deposits    |   | 119                                                    |   | 247                                                    |   | 366 |   | 169 |   | 1,154 |   | 1,323 |   |
| Federal funds purchased            |   | —                                                 |   | —                                                 |   | — |   | (3 | ) | — |   | (3 | ) |
| FHLB advances                      |   | 257                                                    |   | 59                                                     |   | 316 |   | 141 |   | 46 |   | 187 |   |
| Subordinated debt                  |   | —                                                 |   | 6                                                      |   | 6 |   | — |   | 55 |   | 55 |   |
| Total borrowed funds               |   | 257                                                    |   | 65                                                     |   | 322 |   | 138 |   | 101 |   | 239 |   |
| Total increase in interest expense |   | 376                                                    |   | 312                                                    |   | 688 |   | 307 |   | 1,255 |   | 1,562 |   |
| Increase in net interest income    |   | $                                                      | 248    |                                                   | $      | (531 | ) | $ | (283 | ) | $ | 535 |   | $ | (178 | ) | $ | 357 |   |

 

Changesnot solely attributable to rate or volume have been allocated to volume andrate changes in proportion to the relationship of the absolute dollar amountsof the changes in each.

 

**Provision for Loan Losses**

 

Credit risk is inherent in the business of making loans. The Bank makesprovisions for loan losses when required to bring the total allowance for loanlosses to a level deemed appropriate. The determination of the appropriatelevel for the allowance is based on such factors as historical experience, thevolume and type of lending conducted, the amount of nonperforming loans,regulatory policies, general economic conditions, and other factors related tothe collectibility of loans in the portfolio. The provision for loan losses ischarged to earnings and totaled $150,000 for 2007. Based on management’sanalysis of the allowance for loan losses as of December 31, 2006, noadditional provision was required in 2006, as management judged the allowanceto be adequate to absorb currently identified potential losses as well as anylikely future losses.

 

See *Allowance for Loan Losses* below foradditional information on the procedures for monitoring the adequacy of theallowance, as well as detailed information concerning the allowance for loanlosses.

 

32

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#### **Non-interest Income**

#### ** **

Non-interest income increased $622 thousand in 2007 as compared to2006, due to increased SBA loan origination, sale, broker and servicingactivity, as well as increased grants and awards related to the Bank’scommunity development activity.

 

The Bank derives a material portion of its non-interest income from thesale of SBA guaranteed loans. Gain on sale of SBA loans increased $44,000 in2007 as compared to 2006, after declining $81 thousand in 2006. In addition,the Bank has been able to broker certain SBA loans to other banks, resulting infee income even though the Bank does not originate the loan. Brokered loan feesincreased $112 thousand in 2007 as compared to 2006.

 

Loan servicing fees increased $184 thousand in 2007, as the early loanpayoffs experienced in 2006 subsided. A number of SBA loans in the Bank’sservicing portfolio paid off early in 2006, primarily because of risinginterest rates in 2005 and 2006. When these loans were paid off the Bank had toaccelerate the amortization of the portion of the loan servicing asset relatedto those loans, reducing servicing fee income in 2006. Loan servicing fees (netof amortization) decreased $134 thousand in 2006 as compared to 2005.

 

In 2007 the Bank received notification from the Bank Enterprise Awardprogram of the Department of the Treasury that it would be receiving a $337,500grant under that program, based on lending activity the bank commenced in 2006.Most of the award—$326 thousand—was recognized in non-interest income in 2007.The remaining $11,500 of the award is contingent upon lending activity whichhad not occurred as of December 31, 2007.

 

In 2005 the Company received a $135,000 CDFI technical assistance grantto help offset any costs associated with providing additional services to theun- and under-banked in its target market area. In 2006, the Company incurredqualifying expenses totaling $100 thousand. That portion of the grant wasrecognized in non-interest income in 2006. Another $34 thousand was recognizedin income in 2007, as additional qualifying expenses or purchases wereincurred. The Bank and the Company expect to continue to apply for grants andawards, but no assurance can be given that any future BEA grants or awards willbe received.

 

#### **Non-interest Expense**

#### ** **

Non-interest expense increased in 2007 by $454 thousand, or 7%.

 

Non-interest expenses that had material changes from 2006 to 2007 were:

 

·                  Salary andbenefits increased by $186 thousand, or 5%. Salaries increased $356 thousand,due to normal salary increases as well as new officers hired during the year.Employee benefit costs for incentive plans and company contributions to the401(k) plan decreased $27 thousand from 2006 to 2007. Group health andworkers’ compensation insurance premiums also decreased ($35 thousand decrease)in 2007. Loan origination costs deferred under SFAS No. 91 increased $176thousand in 2007, due to increased loan production and overall increases in thecosts of originating loans. These deferred costs further reduced our salariesand benefit expense in 2007, but will be amortized against interest income onloans over the life of the related loans.

·                  Occupancyexpense increased by $80 thousand, or 17%, due primarily to the cost of theland lease for the South Higuera property in San Luis Obispo. That lease wasterminated in July 2007.

·                  Data processingexpenses increased by $31 thousand, or 7%, due to the Bank’s expanded use offunctions available in its core processing system, as well the implementationof new internet-based technologies, such as remote deposit capture, which theBank markets under the name, Mission Remote DepositSM.

·                  Professionalfees were up $86 thousand, or 49%, in 2007, as a result of an accelerated schedule ofinternal audits and consulting fees related to the Mission Remote DepositSMimplementation.

·                  Insurance andregulatory assessments increased $53 thousand, or 35%, primarily due to FDICinsurance premiums, which were reinstated throughout the U.S. banking industryin 2007 after several years of minimal premiums.

 

#### **Income Taxes**

#### ** **

The Company’s combined federal and state effective income tax rate was33.1% in 2007 and 38.3% in 2006. The decrease in the effective rate from 2006to 2007 was primarily due to increased tax-free income from municipalsecurities and loans.

 

33

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See Note H to the consolidated financial statements for moreinformation on income taxes.

 

**FinancialCondition**

 

**Investment Activities**

 

Banks purchase and own investment securities for yield, to provideliquidity and to balance the overall interest-rate sensitivity of its assetsand liabilities. The Bank does not maintain a trading account.

 

Investment goals are to obtain the highest yield consistent withmaintaining a stable overall asset and liability position while limitingeconomic risks. In accordance with this policy, management actively manages itsinvestment portfolio between available for sale and held to maturityinvestments, the composition of which has shifted over time. Due to a change ininvestment strategy in 2005, all securities in the held-to-maturity categorywere reclassified to available-for-sale. This change in investment strategy wasintended to improve the Bank’s financial flexibility.

 

Investment policies and limits have been established by the board of directors.Investments can include federally-insured certificates of deposit, obligationsof the U.S. Treasury and U.S. agencies, mortgage-related instruments issues orbacked by U.S. agencies, municipal bonds rated Baa or better (Moody’s),Aaa-rated private label mortgage-backed and asset-backed securities, andcorporate securities rated A or A-1. Guidelines have been established fordiversification of the portfolio among these investment categories andper-transaction limits have been established as well. The Bank’s chieffinancial officer reports investment purchase and sale activity to the Board ona monthly basis and more detailed quarterly reports are presented to theInvestment Committee.

 

The following table presents the distribution of investments by sector,the maturity dates of the investments, and the weighted average yields of theinvestments:

 

34

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**Investment securities composition**

 
| ** **                                         | ** ** | **December 31, 2007**      | ** ** | **December 31, 2006** | ** ** |
|----------------------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **                                         | ** ** | ** **                           | ** ** | **Approx.**                     | ** ** | ** ** | ** ** | ** ** | ** ** | **Approx.** | ** ** | ** ** | ** ** |
| ** **                                         | ** ** | **Amortized**                        | ** ** | **Market**                      | ** ** | **%** | ** ** | **Amortized** | ** ** | **Market** | ** ** | **%** | ** ** |
| ** **                                         | ** ** | **Cost**                             | ** ** | **Value**                       | ** ** | **Yield** | ** ** | **Cost** | ** ** | **Value** | ** ** | **Yield** | ** ** |
| ** **                                         | ** ** | **(Dollars in thousands)** | ** ** |
| U.S. Government agencies:                          |       |                                 |       |                            |       |   |   |   |   |   |   |   |   |
| Within one year                                    |       | $                                    | 1,998      |                            | $          | 2,000 |   | 4.43 | % | $ | 1,999 |   | $ | 1,982 |   | 3.51 | % |
| One to five years                                  |       | 1,995                                |       | 2,010                           |       | 4.24 | % | 3,494 |   | 3,432 |   | 4.16 | % |
| Five to ten years                                  |       | 1,000                                |       | 1,001                           |       | 4.97 | % | 1,000 |   | 990 |   | 4.73 | % |
| After 10 years                                     |       | 1,000                                |       | 999                             |       | 4.31 | % | 999 |   | 966 |   | 4.31 | % |
| Total U.S. Government agencies                     |       | 5,993                                |       | 6,010                           |       | 4.44 | % | 7,492 |   | 7,370 |   | 4.08 | % |
| Mortgage-backed and asset-backed  securities:      |       |                                 |       |                            |       |   |   |   |   |   |   |   |   |
| Within one year                                    |       | 130                                  |       | 128                             |       | 3.88 | % | 3 |   | 3 |   |   |   |
| One to five years                                  |       | 1,003                                |       | 997                             |       | 4.61 | % | 855 |   | 842 |   | 4.10 | % |
| Five to ten years                                  |       | 1,105                                |       | 1,108                           |       | 4.87 | % | 236 |   | 230 |   | 4.09 | % |
| After 10 years                                     |       | 5,738                                |       | 5,917                           |       | 4.82 | % | 5,989 |   | 6,028 |   | 4.30 | % |
| Total mortgage-backed and asset-backed  securities |       | 7,976                                |       | 8,150                           |       | 4.79 | % | 7,083 |   | 7,103 |   | 4.27 | % |
| Municipal securities:                              |       |                                 |       |                            |       |   |   |   |   |   |   |   |   |
| After 10 years                                     |       | 2,972                                |       | 2,964                           |       | 6.00 | % | 1,941 |   | 1,943 |   | 6.01 | % |
| Total municipal securities                         |       | 2,972                                |       | 2,964                           |       | 6.00 | % | 1,941 |   | 1,943 |   | 6.01 | % |
| Total investment securities                        |       | $                                    | 16,941     |                            | $          | 17,124 |   | 4.88 | % | $ | 16,516 |   | $ | 16,416 |   | 4.39 | % |

 

Thenon-accrual security is included in the amortized cost and market value ofsecurities. Yields reflect no interest income on the non-accrual security.Yields on tax-exempt municipal securities have been adjusted to theirfully-taxable equivalents.

 

During 2007 and 2006, the Bank purchased $1.0 million and $1.9 million,respectively, of municipal securities in order to take advantage of theirhigher yields on a fully taxable equivalent basis. All of the municipalsecurities purchased to date are within California, bank qualified, and arerated at least Aaa.

 

In 2004, management established a loss reserve for one of the Bank’sasset-backed securities after concluding it was “other than temporarilyimpaired.”  The security is innon-accrual status, with any interest payments received being credited to the

 

reserve. As of December 31, 2007, the gross book value of the securitywas $328,000 and the reserve was $270,000, for a net book value of $58,000.

 

See Note B in the notes to the consolidated financial statements foradditional information on investment securities.

 

35

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#### **Lending Activities**

#### ** **

The Bank originatesloans, participates in loans from other banks and structures loans for possiblesale in the secondary market.

 

The following table setsforth the composition of our loan portfolio by type of loan at the periods indicated:

 

**LoanPortfolio Composition**

*(Dollarsin thousands)*

 
| ** **                      | ** ** | **As of December 31,** | ** ** |
|---------------------------------|------------|---------------------------------------|------------|
| ** **                      | ** ** | **2007**                              | ** ** | **2006** | ** ** |
| **Type of Loan**      | ** ** | **Amount**                            | ** ** | **Percentage** | ** ** | **Amount** | ** ** | **Percentage** | ** ** |
| Commercial                      |       | $                                     | 26,492     |   | 20.95 | % | $ | 19,041 |   | 15.51 | % |
| Agricultural                    |       | 122                                   |       | 0.10 | % | 123 |   | 0.10 | % |
| Municipal loans                 |       | 2,789                                 |       | 2.21 | % | 2,903 |   | 2.36 | % |
| Real estate                     |       | 72,009                                |       | 56.95 | % | 66,591 |   | 54.23 | % |
| Construction                    |       | 22,513                                |       | 17.81 | % | 31,639 |   | 25.76 | % |
| Consumer                        |       | 2,504                                 |       | 1.98 | % | 2,502 |   | 2.04 | % |
| Total loans                     |       | $                                     | 126,429    |   | 100.00 | % | $ | 122,799 |   | 100.00 | % |
|                            |       |                                  |       |   |   |   |   |   |   |
| Off-balance-sheet  commitments: |       |                                  |       |   |   |   |   |   |   |
| Undisbursed loan  commitments   |       | $                                     | 28,608     |   |   |   | $ | 35,375 |   |   |   |
| Standby letters  of credit      |       | 693                                   |       |   |   | 213 |   |   |   |

 

The following table setsforth as of December 31, 2007, the maturities and sensitivities of loansto interest rate changes:

 

**Maturityand Rate Sensitivity of Loans**

*(Dollarsin thousands)*

 
| ** **       | ** ** | ** **        | ** ** | ** **                                  | ** ** | ** **         | ** ** | ** ** | ** ** | **Rate Structure for Loans** | ** ** |
|------------------|------------|-------------------|------------|---------------------------------------------|------------|--------------------|------------|------------|------------|---------------------------------------------|------------|
| ** **       | ** ** | **Maturity**      | ** ** | **Maturing Beyond One Year** | ** ** |
| ** **       | ** ** | **One year** | ** ** | **One through**                        | ** ** | **Over five** | ** ** | ** ** | ** ** | **Fixed**                                   | ** ** | **Floating** | ** ** |
| ** **       | ** ** | **or less**  | ** ** | **five years**                         | ** ** | **years**          | ** ** | **Total**  | ** ** | **Rate**                                    | ** ** | **Rate** | ** ** |
| Commercial       |       | $                 | 17,928     |                                        | $          | 6,405              |       | $          | 2,159      |                                        | $          | 26,492 |   | $ | 6,618 |   | $ | 1,946 |   |
| Agricultural     |       | 122               |       | —                                      |       | —             |       | 122        |       | —                                      |       | — |   |
| Municipal  loans |       | —            |       | 233                                         |       | 2,556              |       | 2,789      |       | 818                                         |       | 1,971 |   |
| Real  estate     |       | 23,807            |       | 10,905                                      |       | 37,297             |       | 72,009     |       | 41,390                                      |       | 6,812 |   |
| Construction     |       | 19,921            |       | 2,328                                       |       | 264                |       | 22,513     |       | 648                                         |       | 1,944 |   |
| Consumer  Loans  |       | 683               |       | 1,345                                       |       | 476                |       | 2,504      |       | 1,821                                       |       | — |   |
| Total  Loans     |       | $                 | 62,461     |                                        | $          | 21,216             |       | $          | 42,752     |                                        | $          | 126,429 |   | $ | 51,295 |   | $ | 12,673 |   |

 

The Bank funds commercialloans to provide working capital, to finance the purchase of equipment and forother business purposes. These loans can be *short-term,*with maturities ranging from thirty days to one year, or *term loans,*with maturities normally ranging from one to twenty-five years. Short-termloans are generally intended to finance current transactions and typicallyprovide for periodic principal payments, with interest payable monthly. Inyears prior to 2006, term loans have normally provided for floating interestrates, with monthly payments of both principal and interest. However, in 2006,with the increased interest rate environment, the Bank saw a marked increase indemand for fixed rate loans. To retain valued borrower relationships the Bankconverted approximately $5.8 million of floating rate loans to fixed rates in2006. Most of these loans are secured by real estate. The Bank’s Asset andLiability Committee (“ALCO”) approved this fixed rate loan program to mitigatethe Bank’s exposure to falling rates, in light of its asset-sensitivestructure.

 

Included in commercialloans are SBA loans. The Bank originates and services SBA loans and is activein specific SBA programs. Further, the Bank is designated as an SBA preferredlender which allows greater flexibility to meet small business loan requestswith a more timely credit approval process.

 

The Bank makes adjustablerate SBA-guaranteed loans and generally sells the guaranteed portion of the SBAloans in the secondary market while retaining the servicing rights for thoseloans. At December 31, 2007 and 2006, the Bank serviced

 

36

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approximately $24.7million and $23.3 million, respectively, in SBA loans. During 2006, due to theabove-mentioned demand for fixed rate loans, approximately $4.4 million ofpreviously sold adjustable rate SBA loans were repurchased and converted tofixed rate SBA-guaranteed loans. (These repurchased SBA loans are included inthe $5.8 million total loans converted from floating to fixed rates mentionedabove.)  The secondary market for fixedrate SBA loans is very limited, so none of these fixed rate loans had been soldas of December 31, 2007, and the Bank intends to retain these loans forits own portfolio.

 

Consumer loans are usedto finance automobiles, various types of consumer goods, and other personalpurposes. Consumer loans generally provide for the monthly payment of principaland interest. Most consumer loans are secured by the personal property beingpurchased.

 

The Bank is active inconstruction lending for interim loans to finance the construction ofcommercial and single family residential property. Construction loans totaled$22.5 million as of December 31, 2007, a $9.1 million decrease from a yearearlier. These loans are typically extended for terms of no more than 12 to 18months. Generally, the Bank does not provide loans for speculative purposesexcept to known builders who have a track record of successful projects and theexpertise and financial strength for the particular type of building.

 

Residential real estate loansare generally limited to home equity loans and home equity lines of credit. TheBank has not been active in residential real estate lending.

 

Other real estate loansconsist primarily of commercial and industrial real estate loans. These loansare made based on the income generating capacity of the property or the cashflow of the borrower and are secured by the property. The Bank offers bothfixed and variable rate loans with maturities which generally do not exceed 25years. Exceptions are made for SBA-guaranteed loans secured by real estate, orfor other commercial real estate loans which can be readily sold in thesecondary market.

 

#### **Asset Quality**

#### ** **

The risk of nonpayment ofloans is inherent in the banking business. That risk varies with the type andpurpose of the loan, the collateral which is utilized to secure payment and,ultimately, the creditworthiness of the borrower. In order to minimize thiscredit risk, all loans exceeding lending officers’ individual lending limitsare reviewed and approved by a Management Loan Committee. Loans exceeding theManagement Loan Committee’s authorization are reviewed and approved by the LoanCommittee of the board of directors. The Board Loan Committee is comprised ofoutside directors and the Bank’s chief executive officer.

 

Loan grades are assignedbased on a risk assessment of each loan. Loans with minimum risk are graded as “pass,”with other classifications of “special mention,” “substandard,” “doubtful” and “loss,”depending on credit quality. Loans graded “substandard” or “doubtful” areconsidered “classified” loans, and loans graded “loss” are charged off. Asthese loans are identified in our review process, they are added to theinternal watch list and a loss allowance is established for them of at least thefollowing amounts:  special mention – 5%,substandard – 15%, doubtful – 50%, and loss – 100%. These amounts are reducedonly if circumstances for a particular loan are such that the Bank is clearlyinsulated from loss. The Bank engages an outside firm to perform, at leastquarterly, a review of the loan portfolio, and to test the adequacy of theallowance for loan losses. In addition, loans are examined periodically by theBank’s federal and state regulators.

 

37

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The following tableprovides year-end information with respect to the components of our impaired ornonperforming assets at the dates indicated:

 

**Non-PerformingAssets**

*(Dollarsin thousands)*

 
| ** **                                               | ** ** | **As of December 31,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                               | ** ** | **2007**                              | ** ** | **2006** | ** ** |
| Loans  on nonaccrual status                              |       | $                                     | 1,988      |   | $ | 240 |   |
| Loans  past due 90 days or more and accruing             |       | 68                                    |       | 1,929 |   |
| Restructured  loans                                      |       | —                                |       | — |   |
| Total  nonperforming loans                               |       | 2,056                                 |       | 2,169 |   |
| Other  real estate owned                                 |       | —                                |       | — |   |
| Total  nonperforming assets                              |       | $                                     | 2,056      |   | $ | 2,169 |   |
|                                                     |       |                                  |       |   |   |
| Allowance  for loan losses                               |       | $                                     | 1,150      |   | $ | 1,026 |   |
|                                                     |       |                                  |       |   |   |
| Asset  quality ratios:                                   |       |                                  |       |   |   |
| Non-performing  assets to total assets                   |       | 1.30                                  | %          | 1.37 | % |
| Non-performing  loans to total loans                     |       | 1.63                                  | %          | 1.77 | % |
| Allowance  for loan losses to total loans                |       | 0.91                                  | %          | 0.84 | % |
| Allowance  for loan losses to total non-performing loans |       | 56                                    | %          | 47 | % |

 

Non-accrual loans areloans which management believes may not be fully collectible as toprincipal and interest. Generally, loans are placed in non-accrual status whenthey are 90 days or more past due unless they are well-secured and in theprocess of collection. Once placed in non-accrual status, a loan is notreturned to accrual status until it is brought current with respect to bothprincipal and interest payments, the loan is performing to current terms andconditions, the interest rate is commensurate with market interest rates andfuture principal and interest payments are no longer in doubt, at which time afurther review of the loan is conducted.

 

The $1.9 million of loanspast due 90 or more days and accruing as of December 31, 2006, representsone construction loan that was past due on that date, but which was broughtcurrent in mid-January 2007. The loan was expected to be paid off inmid-2007, but those prospects deteriorated and the loan was placed innon-accrual status in August 2007. In December 2007, the Bankreceived a $400 thousand principal payment and all unpaid interest. The loanremains in non-accrual status, but the $106 thousand of interest was recognizedon a cash basis in the fourth quarter of 2007 because the loan is well-securedby real estate collateral and in the process of collection. Management’sanalysis as of December 31, 2007, indicates that the Bank has no lossexposure on this $1.5 million loan.

 

As of December 31,2007, $254 thousand of the non-accrual loans were SBA loans, with $241 thousandof the total guaranteed by the SBA. At December 31, 2006, 100% of the Bank’snon-accrual loans were SBA loans, and $216 thousand of the total was guaranteedby the SBA.

 

Restructured loans arethose loans with concessions in interest rates or repayment terms due to adecline in the financial condition of the borrower. Other real estate owned isacquired in satisfaction of loans through foreclosure or other means and iscarried on an individual asset basis at the lower of the recorded investment inthe related loan or the estimated fair value of the property, less sellingexpenses. The Bank had no restructured loans or other real estate at any timeduring 2006 or 2007.

 

The Bank has no foreignloans.

 

**Potential Problem Loans**

 

At December 31, 2007, theCompany had approximately $2.7 million of loans that were not categorized asnon-performing, but for which known information about the borrower’s financialcondition caused management to have concern about the ability of the borrowersto comply with the repayment terms of the loans. These loans were identifiedthrough the loan review

 

38

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process described above. The $2.8million of potential problem loans are supported by $449 thousand of SBA loanguarantees. Based on the evaluation of current market conditions, loancollateral, other secondary sources of repayment and cash flow generation,management does not anticipate any significant losses related to these loans. Theseloans are subject to continuing management attention and are considered in thedetermination of the allowance for loan losses.

 

While credit quality, asmeasured by loan delinquencies and by the Bank’s internal risk grading system,appears to be satisfactory as of December 31, 2007, there can be noassurances that new problem loans will not develop in future periods. A declinein economic conditions in the Bank’s market area or other factors couldadversely impact individual borrowers or the loan portfolio in general. TheBank has well defined underwriting standards and expects to continue withprompt collection efforts, but economic uncertainties or changes may causeone or more borrowers to experience problems in the coming months.

 

**Loan Concentrations**

 

The Board of Directorshas approved concentration levels (as a percentage of capital) for various loantypes based on the Bank’s business plan and historical loss experience. On aquarterly basis, management provides a loan concentration report to the boardwith information relating to concentrations. Management’s review of possibleconcentrations includes an assessment of loans to multiple borrowers engaged insimilar activities which would cause them to be similarly impacted by economicor other conditions. Management is not aware of any such concentrations insimilar activities.

 

The following tablereflects the major concentrations in the loan portfolio, by type of loan, as ofDecember 31, 2007:

 

**LoanConcentrations**

December 31,2007

*(Dollarsin thousands)*

 
| **Type of Loan**                        | ** ** | **Amount** | ** ** | **Percent of  Total Loans** | ** ** |
|---------------------------------------------------|------------|------------|------------|---------------------------------------|------------|
|                                              |       |       |       |                                  |       |
| Construction  and land development                |       | $          | 22,513     |                                  | 17.8       | % |
| Other  real estate loans (by type of collateral): |       |       |       |                                  |       |
| Non-farm,  non-residential property               |       | 54,798     |       | 43.3                                  | %          |
| 1 to  4 family residential - 1st liens            |       | 4,091      |       | 3.2                                   | %          |
| 1 to  4 family residential - Jr. liens            |       | 6,282      |       | 5.0                                   | %          |
| Multi-family  residential                         |       | 3,102      |       | 2.5                                   | %          |
| Farmland                                          |       | 3,737      |       | 3.0                                   | %          |
| Total  real estate-secured loans                  |       | 94,523     |       | 74.8                                  | %          |
| Commercial  loans and leases                      |       | 29,262     |       | 23.1                                  | %          |
| Agricultural  loans                               |       | 121        |       | 0.1                                   | %          |
| Consumer  loans                                   |       | 2,523      |       | 2.0                                   | %          |
| Total  loans, including loans held for sale       |       | $          | 126,429    |                                  | 100.0      | % |

 

The table indicates aconcentration in commercial real estate loans (construction loans and loanssecured by non-farm, non-residential and multi-family residential properties)totaling $80.4 million. However, under the regulatory definition of commercialreal estate—which excludes owner-occupied properties—the Bank’s commercial realestate concentration is reduced to $54.8 million, or 43.4% of total loans. TheBank has had no loss experience with these types of loans, all are well securedand, except for the one construction loan reported above, none are non-performing.

 

The Bank’s analysis ofloan concentrations compared to a California peer group of 50 banks suggeststhat the Bank does not have an unusually high real estate concentrationcompared to other similar sized banks in California. Banks in Californiatypically are more prone than banks in other states to use real estatecollateral for many commercial loans for business purposes where collateral istaken as an abundance of caution. In its analysis of real estateconcentrations, the Bank carefully considers economic trends and real estatevalues. The commercial real estate market in San Luis Obispo County remainsstrong, with good demand, limited vacancies and rising rents.

 

39

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#### **Allowance for LoanLosses**

#### ** **

The following tablesummarizes, for each reported period, changes in the allowance for loan lossesarising from loans charged off, recoveries on loans previously charged off,additions to the allowance which have been charged to operating expenses, andcertain ratios relating to the allowance for loan losses:

 

**Summaryof Loan Loss Experience**

*(Dollarsin thousands)*

 
| ** **                                 | ** ** | **2007** | ** ** | **2006** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|
|                                       |       |     |       |     |       |
| Balance  at beginning of year              |       | $        | 1,026      |     | $          | 1,141 |   |
| Loans  charged off:                        |       |     |       |     |       |
| Real  Estate                               |       | —   |       | —   |       |
| Commercial                                 |       | (13      | )          | (102     | )          |
| Consumer                                   |       | (4       | )          | (19      | )          |
| Other                                      |       | (14      | )          | —   |       |
| Total  loans charged off                   |       | (31      | )          | (121     | )          |
| Recoveries:                                |       |     |       |     |       |
| Real  Estate                               |       | —   |       | —   |       |
| Commercial                                 |       | 4        |       | 6        |       |
| Consumer                                   |       | —   |       | —   |       |
| Other                                      |       | 1        |       | —   |       |
| Total  recoveries                          |       | 5        |       | 6        |       |
| Net  recoveries (charge-offs)              |       | (26      | )          | (115     | )          |
| Provision  charged to operations           |       | 150      |       | —   |       |
| Balance  at end of year                    |       | $        | 1,150      |     | $          | 1,026 |   |
|                                       |       |     |       |     |       |
| Ratio  of net charge-offs to average loans |       | 0.02     | %          | 0.10     | %          |
| Ratio  of provision to average loans       |       | 0.12     | %          | 0.00     | %          |

 

The Bank performs aquarterly detailed review to identify the risks inherent in the loan portfolio,to assess the overall quality of the loan portfolio and to determine theadequacy of the allowance for loan losses and the related provision for loanlosses to be charged to expense. Systematic reviews follow the methodology setforth by various regulatory policy statements on the allowance for loan losses.

 

A key element of the Bank’smethodology is the previously discussed credit classification process. Theinherent risk present in the “acceptable” portion of the loan portfolio istaken into consideration and adjustments made for trends, changes in economicconditions and other relevant factors that may affect repayment of theloans.

 

Management and the boardconsider the allowance for loan losses to be adequate to provide for lossesinherent in the loan portfolio. Although management uses available informationto recognize losses on loans and leases, future additions to the allowance may benecessary based on changes in economic conditions. In addition, federalregulators periodically review our allowance for loan losses and may recommendadditions based upon their evaluation of the portfolio at the time of theirexamination. Accordingly, there can be no assurance that our allowance for loanlosses will be adequate to cover future loan losses or that significantadditions to the allowance for loan losses will not be required in the future. Materialadditions to the allowance for loan losses would decrease earnings and capitaland would thereby reduce the Bank’s ability to pay dividends, among otheradverse consequences.

 

The ratio of allowancefor loan losses to total loans as of December 31, 2007 was 0.91%. Managementand the board consider this to be adequate based on their analysis and reviewsof the portfolio.

 

40

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As part of theanalysis of the allowance, the Bank assigns certain risk factors to the entireloan portfolio in addition to the specific percentages used for classifiedloans. The following table summarizes the allocation of the allowance for loanlosses by general loan types based on collateral or security type as usedinternally by the Bank as of December 31, 2007 and 2006.

 
| ** **                           | ** ** | **December 31, 2007** | ** ** | **December 31, 2006**   | ** ** |
|--------------------------------------|------------|---------------------------------|------------|-----------------------------------|------------|
| **(dollars in thousands)** | ** ** | **Loans**                       | ** ** | **Percent  of Total  Loans** | ** ** | **Allowance  Allocation** | ** ** | **% of Total  Allowance** | ** ** | **Loans** | ** ** | **Percent  of Total  Loans** | ** ** | **Allowance  Allocation** | ** ** | **% of Total  Allowance** | ** ** |
| Unclassified  loans:                 |       |                            |       |                              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Real  estate and construction        |       | $                               | 86,861     |                              | 68.7       | % | $ | 454 |   | 39.5 | % | $ | 94,772 |   | 77.2 | % | $ | 447 |   | 43.6 | % |
| Other  secured loans                 |       | 30,307                          |       | 24.0                              | %          | 376 |   | 32.7 | % | 23,220 |   | 18.9 | % | 244 |   | 23.8 | % |
| Unsecured  loans                     |       | 4,555                           |       | 3.6                               | %          | 57 |   | 4.9 | % | 2,733 |   | 2.2 | % | 32 |   | 3.1 | % |
| Total  unclassified loans            |       | 121,723                         |       | 96.3                              | %          | 887 |   | 77.1 | % | 120,725 |   | 98.3 | % | 723 |   | 70.5 | % |
| Classified  loans                    |       | 4,706                           |       | 3.7                               | %          | 109 |   | 9.5 | % | 2,074 |   | 1.7 | % | 30 |   | 2.9 | % |
| Other  economic factors              |       |                            |       |                              |       | 154 |   | 13.4 | % |   |   |   |   | 273 |   | 26.6 | % |
| Totals                               |       | $                               | 126,429    |                              | 100.0      | % | $ | 1,150 |   | 100.0 | % | $ | 122,799 |   | 100.0 | % | $ | 1,026 |   | 100.0 | % |

 

**Deposits**

 

Deposits are the primarysource of funding for lending and investing needs. Total deposits were $112.4million as of December 31, 2007, and $124.3 million at December 31,2006. Deposits decreased by $11.9 million, or 10%, following a $3.3 million, or3%, increase in 2006. Increasing competition for deposits in the local marketand from other non-local financial institutions made deposit growth aformidable challenge in 2006 and 2007.

 

The Bank generally pricesdeposits at or above the median rate by classification based on periodicinterest rate surveys in the local market. Deposit rates are then adjusted tobalance the cost of funds versus funding needs and asset and liabilityconsiderations. The Bank has used and expects to continue to use an InvestorSavings product that pays higher rates than normal savings, similar to money marketaccounts, as a special product unique in the Bank’s market, but management alsoexpects to see the relative percentage of Investor Savings to total deposits tocontinue to decline. The *Net Interest Analysis*and *Rate/Volume Analysis* earlier in this Discussioncontain information regarding the average rates paid on deposits for 2007 and2006.

 

In August 2005 theBank launched a new suite of deposit products: the Mission Community Clubprogram. The Community Club provides new bank customers with free checking,higher-than-normal yields on savings accounts and certificates of deposit, andattractive interest rates on credit cards. In exchange for the generation ofnew core deposit account balances, the Bank supported five local non-profitorganizations with grants of $5,000 each in the second quarter of 2006, andanother five non-profit organizations in 2007.

 

During 2006 the Bankbegan to capitalize on its status as one of only two banks in San Luis Obispocounty participating in the Certificate of Deposit Account Registry Service (“CDARS”)program. This program permits the Bank’s customers to place their certificatesof deposit at one institution—Mission Community Bank—and have those CD depositsfully-insured by the FDIC, up to $50 million. The CDARS program acts as aclearinghouse, matching deposits from one institution in the CDARS network ofover 1,800 banks with other network banks (in increments of less than the $100thousand FDIC insurance limit), so funds that a customer places with the Bankessentially remain on the Bank’s balance sheet. As of December 31, 2007,the Bank had issued $3.9 million of certificates of deposit to local customersthrough the CDARS program.

 

41

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The following tablereflects the maturity distribution of certificates of deposit in the amounts of$100,000 or more as of December 31, 2007:

 

**Maturitiesof Time Deposits of $100,000 or More**

 
| ** **                               | ** ** | **(Dollars in thousands)** | ** ** |
|------------------------------------------|------------|--------------------------------------|------------|
| Three  months or less                    |       | $                                    | 20,902     |   |
| Three  months to six months              |       | 6,670                                |       |
| Six  months to one year                  |       | 9,246                                |       |
| Over  one year                           |       | 1,018                                |       |
| Total  time deposits of $100,000 or more |       | $                                    | 37,836     |   |

 

#### **Short Term and OtherBorrowings**

#### ** **

As of December 31,2007, the Bank had $28.2 million in outstanding borrowings from the FederalHome Loan Bank of San Francisco, $3.4 million of which matures during 2008, andthe balance matures on various dates from March 2009 through December 2013.Note F to the consolidated financial statements contains additional informationregarding these borrowings.

 

#### **Off-Balance-SheetFinancial Instruments**

#### ** **

In the normal course ofbusiness, the Bank enters into financial commitments to customers, primarily toextend credit. Those instruments involve, to varying degrees, elements ofcredit and interest rate risk not recognized in the statement of financialposition. As of December 31, 2007, the Bank had outstanding commitments toextend credit totaling $28.6 million and standby letters of credit totalingapproximately $700 thousand. See Note M to the consolidated financial statementsfor additional information on off-balance-sheet commitments and contingencies.

 

The Bank has not enteredinto any off-balance-sheet derivative financial instruments as of December 31,2007.

 

#### **Liquidity Management**

#### ** **

The objective of ourasset/liability strategy is to manage liquidity and interest rate risks toensure the safety and soundness of the Bank and its capital base, whilemaintaining an adequate net interest margin in order to provide an appropriatereturn to shareholders.

 

The Bank’s liquidity,which primarily represents the ability to meet fluctuations in deposit levelsand provide for customers’ credit needs, is managed through various fundingstrategies that reflect the maturity structures of the sources of funds and theassets being funded. The Bank’s liquidity is further augmented by payments ofprincipal and interest on loans and increases in short-term liabilities such asdemand deposits and short-term certificates of deposit. Short-term investments,primarily federal funds sold, is the primary means for providing immediateliquidity. The Bank had $3.3 million in federal funds sold on December 31,2007, and $7.1 million on December 31, 2006.

 

In order to meet the Bank’sliquidity requirements, the Bank endeavors to maintain an appropriate liquidityratio. The liquidity ratio is the sum of cash and deposits at other banks,federal funds sold, and unpledged available-for-sale securities, divided bytotal deposits. As of December 31, 2007 and 2006, the Bank’s liquidityratios were 11.2% and 13.3%, respectively.

 

While the Bank primarilyuses federal funds sold as the primary immediate source of cash liquidity, italso has established short-term borrowing lines (federal funds purchased) for atotal of $11.5 million from its correspondent banks. These lines are forshort-term needs and are rarely used.

 

The Bank also has asecured borrowing facility through the Federal Home Loan Bank of San Francisco(“FHLB”). FHLB borrowings can be structured over various terms ranging fromovernight to ten years. As of December 31, 2007, the Bank had outstandingborrowings from the FHLB totaling $28.2 million. Of the $28.2 million, $3million was borrowed for 10

 

42

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years to offset aspecific pool of the Bank’s fixed rate loans maturing in 2013. Another $2.5million was borrowed for five years to “match-fund” a pool of fixed rate loansmaturing in 2009. Interest rates and terms for FHLB borrowings are generallymore favorable than the rates for similar term brokered certificates of depositor for federal funds purchased. The Bank has the potential (on a secured basis)to borrow up to 25 percent of its total assets or an additional $6.1 millionfrom the FHLB. The Bank anticipates utilizing FHLB borrowings in 2008 whenneeded as part of its normal liquidity management to fund asset growth ona cost-effective basis, and has more than adequate loans to pledge ascollateral should it need additional liquidity that cannot be funded bydeposits.

 

Following is a summary ofthe Company’s contractual obligations extending beyond one year from December 31,2007:

 

**Long-TermContractual Obligations**

 
| ** **                      | ** ** | **Less than**                   | ** ** | **1 thru 3** | ** ** | **3 thru 5** | ** ** | **More than** | ** ** | ** ** | ** ** |
|---------------------------------|------------|--------------------------------------|------------|------------------------|------------|------------------------|------------|--------------------|------------|------------|------------|
| ** **                      | ** ** | **1 year**                      | ** ** | **years**              | ** ** | **years**              | ** ** | **5 years**   | ** ** | **Total**  | ** ** |
| ** **                      | ** ** | **(Dollars in thousands)** | ** ** |
| Borrowed  funds                 |       | $                                    | 3,400      |                   | $          | 21,800                 |       | $                  | —     |       | $          | 3,000 |   | $ | 28,200 |   |
| Junior  subordinated debentures |       | —                               |       | —                 |       | —                 |       | 3,093              |       | 3,093      |       |
| Operating  leases               |       | 322                                  |       | 1,044                  |       | 1,192                  |       | 6,734              |       | 9,292      |       |
| Capital  leases                 |       | —                               |       | —                 |       | —                 |       | —             |       | —     |       |
| Purchase  obligations           |       | —                               |       | —                 |       | —                 |       | —             |       | —     |       |
| Other  long-term liabilities    |       | —                               |       | —                 |       | —                 |       | —             |       | —     |       |
| Total  contractual obligations  |       | $                                    | 3,722      |                   | $          | 22,844                 |       | $                  | 1,192      |       | $          | 12,827 |   | $ | 40,585 |   |

 

While core, localdeposits remain the primary source of deposits, the Bank continues to seekalternate sources for competitive rate deposits. Through the CDARS program (see*Deposits* earlier in this analysis), theBank is able to bid on additional certificates of deposit through banks acrossthe country to meet additional funding needs. These “One-Way Buy” CDARSdeposits are typically priced comparable to FHLB secured borrowing rates, butwith no collateral required. As of December 31, 2007, the Bank hadapproximately $4.5 million of “One-Way Buy” CDARS deposits, which areconsidered to be brokered deposits. The Bank also expects to continue to useits CDFI and COIN designations to attract lower cost deposits.

 

Bancorp is a companyseparate and apart from the Bank and must provide for its own liquidity. Asof December 31, 2007, Bancorp had no borrowings other than the juniorsubordinated debentures reflected in the above table, and had approximately$59,000 in unrestricted cash. See Note Q to the consolidated financialstatements for additional financial information regarding Bancorp.

 

Substantially all ofBancorp’s revenues are obtained from dividends declared and paid by the Bank. Thereare statutory and regulatory provisions that could limit the ability of theBank to pay dividends to Bancorp. See Note O to the consolidated financialstatements for additional information regarding regulatory dividend and capitalrestrictions. Management believes that such restrictions will not have animpact on the ability of Bancorp to meet its ongoing cash obligations.

 

**Asset and Liability Management**

 

The objectives ofinterest rate risk management are to control exposure of net interest income torisks associated with interest rate movements in the market, to achieveconsistent growth in net interest income and to profit from favorable marketopportunities. Even with perfectly matched repricing of assets and liabilities,risks remain in the form of prepayment of assets, and timing lags inadjusting certain assets and liabilities that have varying sensitivities tomarket interest rates.

 

43

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Interest rate sensitivitygap analysis attempts to capture interest rate risk, which is attributable tothe mismatching of interest rate sensitive assets and liabilities. A positivecumulative gap would mean that over the indicated period our assets would beexpected to reprice faster than our liabilities (an asset-sensitive structure),and a negative gap would mean that our liabilities would likely reprice fasterthan our assets (liability-sensitive).

 

The Interest RateSensitivity table below sets forth a “static” gap analysis of the interest ratesensitivity of interest-earning assets and interest-bearing liabilities as of December 31,2007. For purposes of the table, an asset or liability is consideredrate-sensitive in the first period when it can be repriced, matures within itscontractual terms, or is expected to be prepaid. For example, all savings, NOWand money market accounts can be repriced immediately, so they are included inthe left-most column. Based on their contractual terms, loans may repriceor mature beyond one year, but our prepayment assumptions would indicate that acertain percentage of them would likely be paid off earlier. That portionestimated to be paid off early would be shown in one of the columns to the leftof its actual maturity.

 

One should use caution ifattempting to predict future levels of net interest income through the use thistype of static gap analysis, however. The actual impact of interest ratemovements on net interest income may differ significantly from thatimplied by any gap measurement, depending on the direction and magnitude of theinterest rate movements, the repricing characteristics of various on- andoff-balance sheet instruments, as well as competitive pressures. Many of theBank’s loans are tied to the prime rate, which declined in the second half of2007 and is expected to continue to decline in 2008. However, competitivepressures often keep deposit rates from dropping to the same degree and asquickly as loan rates, causing a reduction in the net interest margin eventhough the gap analysis may show the Bank in a more balanced posture.

 

Also, changes in the mixof earning assets or supporting liabilities can either increase or decrease thenet interest margin without affecting this particular measure of interest ratesensitivity. In addition, varying interest rate environments can createunexpected changes in prepayment activity as compared to prepayments assumed inthe interest rate sensitivity analysis. Prepayments may have significantimpact on our net interest margin. These factors are not fully reflected in thefollowing gap analysis and, as a result, the gap report may not provide acomplete assessment of our interest rate risk.

 

**InterestSensitivity - Static Gap Analysis**

*December 31,2007*

 
| ** **                                   | ** ** | **Sensitive to Rate Changes Within** | ** ** | ** **            | ** ** | ** **           | ** ** |
|----------------------------------------------|------------|----------------------------------------------------------|------------|-----------------------|------------|----------------------|------------|
| ** **                                   | ** ** | **3**                                                    | ** ** | **4 to 12** | ** ** | **1 to 5** | ** ** | **Over 5** | ** ** | **Non-Rate-** | ** ** | ** ** | ** ** |
| ** **                                   | ** ** | **Months**                                               | ** ** | **Months**            | ** ** | **Years**            | ** ** | **Years** | ** ** | **Sensitive** | ** ** | **Total** | ** ** |
| ** **                                   | ** ** | **(Dollars in thousands)**                     | ** ** |
| Earning  Assets:                             | ** ** | ** **                                               | ** ** | ** **            | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Loans,  net of unearned income               |       | $                                                        | 57,422     |                  | $          | 20,630               |       | $ | 31,498 |   | $ | 16,879 |   | $ | — |   | $ | 126,429 |   |
| Investment  securities                       |       | 622                                                      |       | 6,530                 |       | 6,171                |       | 3,618 |   | 183 |   | 17,124 |   |
| Other  earning assets                        |       | 7,626                                                    |       | 550                   |       | —               |       | — |   | — |   | 8,176 |   |
| Non-interest-earning  assets                 |       | —                                                   |       | —                |       | —               |       | — |   | 6,601 |   | 6,601 |   |
| Total  assets                                |       | 65,670                                                   |       | 27,710                |       | 37,669               |       | 20,497 |   | 6,784 |   | 158,330 |   |
|                                         |       |                                                     |       |                  |       |                 |       |   |   |   |   |   |   |
| Interest-Bearing  Liabilities:               |       |                                                     |       |                  |       |                 |       |   |   |   |   |   |   |
| Interest-bearing  deposits                   |       | 61,192                                                   |       | 25,675                |       | 2,402                |       | — |   | — |   | 89,269 |   |
| Borrowed  funds                              |       | 1,400                                                    |       | 2,000                 |       | 21,800               |       | 3,000 |   | — |   | 28,200 |   |
| Junior  subordinated debentures              |       | 3,093                                                    |       | —                |       | —               |       | — |   | — |   | 3,093 |   |
| Non-interest-bearing  liabilities and equity |       | —                                                   |       | —                |       | —               |       | — |   | 37,768 |   | 37,768 |   |
| Total  liabilities and equity                |       | 65,685                                                   |       | 27,675                |       | 24,202               |       | 3,000 |   | 37,768 |   | 158,330 |   |
|                                         |       |                                                     |       |                  |       |                 |       |   |   |   |   |   |   |
| Interest  rate sensitivity gap               |       | $                                                        | (15        | )                     | $          | 35                   |       | $ | 13,467 |   | $ | 17,497 |   | $ | (30,984 | ) | $ | — |   |
|                                         |       |                                                     |       |                  |       |                 |       |   |   |   |   |   |   |
| Cumulative  interest rate sensitivity gap    |       | $                                                        | (15        | )                     | $          | 20                   |       | $ | 13,487 |   | $ | 30,984 |   | $ | — |   |   |   |
|                                         |       |                                                     |       |                  |       |                 |       |   |   |   |   |   |   |
| Cumulative  gap to total earning assets      |       | 0                                                        | %          | 0                     | %          | 9                    | %          | 20 | % |   |   |   |   |

 

The table shows thatduring the first year $93 million of the interest earning assets are expectedto reprice, as well as $93 million of interest bearing liabilities—a balancedrate-sensitivity structure over that time period. In general, this means thatin a rising interest rate environment, with all other conditions remainingconstant, net interest income would be expected to increase, and in a declininginterest rate environment net interest income would be expected to decrease. However,as

 

44

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mentioned above,competitive pressures in the local market tend to constrict the Bank’s abilityto reprice deposits downward in a falling rate environment. Thus, although theBank is in a balanced rate sensitive posture on a contractual basis, in apractical sense management views the Bank as asset-sensitive.

 

Based on current economicforecasts, the Bank anticipates that interest rates will continue to decline in2008, and with the Bank’s asset sensitive position, the net interest margin isexpected to experience further downward pressure, even though the gap analysisindicates that the Bank is balanced.

 

#### **Effects of Inflation andEconomic Issues**

#### ** **

A financial institution’sasset and liability structure is substantially different from that of anindustrial firm in that primarily all assets and liabilities of a bank aremonetary in nature, with relatively little investments in fixed assets orinventories. Inflation has an important impact on the growth of total assetsand the resulting need to increase equity capital at higher than normal ratesin order to maintain an appropriate equity to assets ratio. Management believesthat the impact of inflation on financial results depends on the Company’sability to react to changes in interest rates and, by such reaction, reduce theinflationary impact on performance. Management has attempted to structure themix of financial instruments and manage interest rate sensitivity in order tominimize the potential adverse effects of inflation or other market forces onnet interest income and, therefore, earnings and capital.

 

San Luis Obispo Countycontinues to have one of the lowest unemployment rates in California, yet realestate values declined slightly in 2006 and 2007. After several years of strongappreciation, residential and commercial sale activity—and especiallyconstruction activity—has slowed. There can be no assurance that the economywill continue to be strong or that real estate values will return to pre-2006levels in the short term. As such, the Bank closely monitors credit quality,interest rate risk and operational expenses.

 

**Return on Equity and Assets**

 

The following table showsthe Company’s return on average assets and return on average equity for pasttwo years:

 
| ** **                | ** ** | **2007** | ** ** | **2006** | ** ** |
|---------------------------|------------|----------|------------|----------|------------|
| Return  on Average Assets |       | 0.48     | %          | 0.58     | %          |
| Return  on Average Equity |       | 6.07     | %          | 7.53     | %          |

 

45

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## ** **

## **Item7. Financial Statements**

 

**MISSIONCOMMUNITY BANCORP AND SUBSIDIARY**

 

**CONSOLIDATEDFINANCIAL STATEMENTS**

**WITH**

**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

 

**December 31,2007 and 2006**

 

**CONTENTS**

 

**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON THE CONSOLIDATED FINANCIALSTATEMENTS**

 

**CONSOLIDATED FINANCIAL STATEMENTS**

 
| **Consolidated  Balance Sheets**                                    |
|---------------------------------------------------------------------|
| **Consolidated  Statements of Income**                              |
| **Consolidated Statement of  Changes in Shareholders’ Equity** |
| **Consolidated Statements of  Cash Flows**                          |
| **Notes to  Consolidated Financial Statements**                     |

 

46

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| **** | Vavrinek,  Trine, Day & Co., LLP****Certified  Public Accountants & Consultants | ** ** |
|------|-----------------------------------------------------------------------------------------|------------|

 

#### **REPORT OF INDEPENDENT REGISTERED PUBLICACCOUNTING FIRM**

#### ** **

Board of Directors andShareholders of

Mission Community Bancorpand Subsidiary

 

We have audited theaccompanying consolidated balance sheets of Mission Community Bancorp andSubsidiary as of December 31, 2007 and 2006 and the related consolidatedstatements of income, changes in shareholders’ equity, and cash flows of theyears then ended. These consolidated financial statements are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these consolidated financial statements based on our audits.

 

We conducted our auditsin accordance with the standards of the public company accounting oversightboard (United States). Those standards require that we plan and perform theaudit to obtain reasonable assurance about whether the consolidated financialstatements are free of material misstatement. An audit includes examining, on atest basis, evidence supporting the amounts and disclosures in the consolidatedfinancial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation. We believe that ouraudits provide a reasonable basis for our opinion.

 

In our opinion, the consolidatedfinancial statements referred to above present fairly, in all materialrespects, the financial position of Mission Community Bancorp and Subsidiary asof December 31, 2007 and December 31, 2006, and the results of itsoperations and its cash flows for the years then ended, in conformity withaccounting principles generally accepted in the United States of America.

 

 

Laguna Hills, California

March 27, 2008

 

 

25231 Paseo De Alicia,Suite 100    Laguna Hills, CA  92653   Tel: 949.768.0833    Fax:949.768.8408    www.vtdcpa.com

 

FRESNO  ·  LAGUNA HILLS ·  PALOALTO  ·PLEASANTON  ·  RANCHO CUCAMONGA

 

47

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**MISSIONCOMMUNITY BANCORP AND SUBSIDIARY**

**CONSOLIDATED BALANCE SHEETS**

**December 31,2007 and 2006**

 
| ** **                                             | ** ** | **2007**   | ** **  | **2006**   | ** **  |
|--------------------------------------------------------|------------|------------|-------------|------------|-------------|
| **ASSETS**                                             | ** ** | ** ** | ** **  | ** ** | ** **  |
|                                                   |       |       |        |       |        |
| Cash and Due from Banks                                |       | $          | 2,211,704   |       | $           | 3,044,952 |   |
| Federal Funds Sold                                     |       | 3,315,000  |        | 7,070,000  |        |
| **TOTAL  CASH AND CASH EQUIVALENTS**                   | ** ** |       | 5,526,704   |       | 10,114,952  |   |
|                                                   |       |       |        |       |        |
| Certificates of Deposit in  Other Banks                |       | 550,000    |        | 550,000    |        |
|                                                   |       |       |        |       |        |
| Investment Securities  Available for Sale              |       | 17,124,144 |        | 16,415,903 |        |
| ** **                                             | ** ** | ** ** | ** **  | ** ** | ** **  |
| Loans held for sale                                    |       | 3,012,226  |        | 274,015    |        |
|                                                   |       |       |        |       |        |
| Loans:                                                 |       |       |        |       |        |
| Commercial                                             |       | 26,268,836 |        | 21,669,968 |        |
| Agricultural                                           |       | 121,450    |        | 123,000    |        |
| Construction                                           |       | 22,512,642 |        | 31,639,178 |        |
| Real Estate                                            |       | 72,009,406 |        | 66,590,505 |        |
| Consumer                                               |       | 2,504,099  |        | 2,502,159  |        |
| **TOTAL  LOANS**                                       | ** ** |       | 123,416,433 |       | 122,524,810 |   |
| ** **                                             | ** ** | ** ** | ** **  | ** ** | ** **  |
| Allowance for Loan Losses                              |       | (1,149,874 | )           | (1,025,939 | )           |
| **NET LOANS**                                          | ** ** |       | 122,266,559 |       | 121,498,871 |   |
|                                                   |       |       |        |       |        |
| Federal Home Loan Bank Stock  and Other Stock, at Cost |       | 2,021,175  |        | 1,311,225  |        |
| Premises and Equipment                                 |       | 3,537,201  |        | 3,723,808  |        |
| Company Owned Life Insurance                           |       | 2,289,407  |        | 2,207,634  |        |
| Accrued Interest and Other  Assets                     |       | 2,001,960  |        | 2,072,116  |        |
|                                                   |       | $          | 158,329,376 |       | $           | 158,168,524 |   |
|                                                        |            |            |             |            |             |  |  |  |  |  |  |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

48

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| ** **                                                                                | ** ** | **2007**   | ** **  | **2006**   |        |
|-------------------------------------------------------------------------------------------|------------|------------|-------------|------------|-------------|
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                              | ** ** | ** ** | ** **  | ** ** |        |
|                                                                                      |       |       |        |       |        |
| Deposits:                                                                                 |       |       |        |       |        |
| Noninterest-Bearing Demand                                                                |       | $          | 23,164,629  |       | $           | 25,988,437 |   |
| Money Market, NOW and Savings                                                             |       | 32,630,126 |        | 36,935,546 |        |
| Time Deposits Under $100,000                                                              |       | 18,803,034 |        | 23,702,313 |        |
| Time Deposits $100,000 and Over                                                           |       | 37,835,667 |        | 37,654,383 |        |
| **TOTAL DEPOSITS**                                                                        | ** ** |       | 112,433,456 |       | 124,280,679 |   |
|                                                                                      |       |       |        |       |        |
| Other Borrowings                                                                          |       | 28,200,000 |        | 17,400,000 |        |
| Junior Subordinated Debt Securities                                                       |       | 3,093,000  |        | 3,093,000  |        |
| Accrued Interest and Other Liabilities                                                    |       | 1,464,616  |        | 1,241,744  |        |
| **TOTAL LIABILITIES**                                                                     | ** ** |       | 145,191,072 |       | 146,015,423 |   |
|                                                                                      |       |       |        |       |        |
| Commitments and Contingencies - Notes D and M                                             |       | —     |        | —     |        |
|                                                                                      |       |       |        |       |        |
| Shareholders’ Equity:                                                                |       |       |        |       |        |
| Preferred Stock - Authorized 1,000,000 Shares:                                            |       |       |        |       |        |
| Series A - $5 Stated Value; 100,000 Issued and Outstanding  Liquidation Value of $500,000 |       | 392,194    |        | 392,194    |        |
| Series B - $10 Stated Value; 20,500 Issued and Outstanding  Liquidation Value of $205,000 |       | 191,606    |        | 191,606    |        |
| Series C - $10 Stated Value; 50,000 Issued and Outstanding  Liquidation Value of $500,000 |       | 500,000    |        | 500,000    |        |
| Common Stock - Authorized 1,000,000 Shares;                                               |       |       |        |       |        |
| Issued and Outstanding: 689,232 in 2007 and 673,399 in 2006                               |       | 7,125,819  |        | 6,858,648  |        |
| Additional Paid-In Capital                                                                |       | 108,340    |        | 60,798     |        |
| Retained Earnings                                                                         |       | 4,712,120  |        | 4,208,742  |        |
| Accumulated Other Comprehensive Income - Unrealized                                       |       |       |        |       |        |
| Appreciation(Depreciation) on Available-for-Sale Securities, net of tax                   |       | 108,225    |        | (58,887    | )           |
| **TOTAL SHAREHOLDERS’ EQUITY**                                                       | ** ** |       | 13,138,304  |       | 12,153,101  |   |
|                                                                                      |       | $          | 158,329,376 |       | $           | 158,168,524 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

49

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**MISSIONCOMMUNITY BANCORP AND SUBSIDIARY**

**CONSOLIDATED STATEMENTS OF INCOME**

**YearsEnded December 31, 2007 and 2006**

 
| ** **                                         | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|----------------------------------------------------|------------|------------|------------|------------|------------|
| **INTEREST INCOME**                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest and Fees on Loans                         |       | $          | 10,763,845 |       | $          | 10,385,886 |   |
| Interest on Investment Securities                  |       | 698,751    |       | 685,466    |       |
| Other Interest Income                              |       | 296,413    |       | 283,109    |       |
| **TOTAL INTEREST INCOME**                          | ** ** |       | 11,759,009 |       | 11,354,461 |   |
| **INTEREST EXPENSE**                               |       |       |       |       |       |
| Interest on Money Market, NOW and Savings Deposits |       | 995,785    |       | 1,020,225  |       |
| Interest on Time Deposits                          |       | 2,931,209  |       | 2,541,282  |       |
| Other Interest Expense                             |       | 1,202,013  |       | 879,596    |       |
| **TOTAL INTEREST EXPENSE**                         | ** ** |       | 5,129,007  |       | 4,441,103  |   |
| **NET INTEREST INCOME**                            | ** ** |       | 6,630,002  |       | 6,913,358  |   |
| Provision for Loan Losses                          |       | 150,000    |       | —     |       |
| **NET INTEREST INCOME AFTER**                      | ** ** |       |       |       |       |   |
| **PROVISION FOR LOAN LOSSES**                      | ** ** |       | 6,480,002  |       | 6,913,358  |   |
| **NON-INTEREST INCOME**                            |       |       |       |       |       |
| Service charges on deposit accounts                |       | 291,500    |       | 258,043    |       |
| Gain on sale of loans                              |       | 307,914    |       | 263,617    |       |
| Brokered loan fees                                 |       | 147,183    |       | 34,925     |       |
| Loan servicing fees, net of amortization           |       | 65,561     |       | (118,074   | )          |
| Grants and awards                                  |       | 359,480    |       | 100,188    |       |
| Other income and fees                              |       | 85,265     |       | 95,826     |       |
| **TOTAL NON-INTEREST INCOME**                      | ** ** |       | 1,256,903  |       | 634,525    |   |
| **NON-INTEREST EXPENSE**                           |       |       |       |       |       |
| Salaries and employee benefits                     |       | 3,597,155  |       | 3,410,679  |       |
| Occupancy expenses                                 |       | 546,329    |       | 466,793    |       |
| Furniture and equipment                            |       | 442,020    |       | 420,616    |       |
| Data processing                                    |       | 490,629    |       | 460,225    |       |
| Professional fees                                  |       | 263,192    |       | 176,660    |       |
| Marketing and business development                 |       | 293,992    |       | 313,599    |       |
| Office supplies and expenses                       |       | 219,291    |       | 210,805    |       |
| Insurance and regulatory assessments               |       | 206,210    |       | 153,000    |       |
| Loan and lease expenses                            |       | 90,077     |       | 80,002     |       |
| Other expenses                                     |       | 444,873    |       | 447,108    |       |
| **TOTAL NON-INTEREST EXPENSE**                     | ** ** |       | 6,593,768  |       | 6,139,487  |   |
| **INCOME BEFORE INCOME TAXES**                     | ** ** |       | 1,143,137  |       | 1,408,396  |   |
| Income Tax Expense                                 |       | 377,843    |       | 538,827    |       |
| **NET INCOME**                                     | ** ** |       | $          | 765,294    |       | $ | 869,569 |   |
|                                               |       |       |       |       |       |
| Per Share Data (Notes A and N):                    |       |       |       |       |       |
| Net Income - Basic                                 |       | $          | 0.96       |       | $          | 1.10 |   |
| Net Income - Diluted                               |       | $          | 0.91       |       | $          | 1.02 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

50

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**MISSION COMMUNITY BANCORP AND SUBSIDIARY**

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

Years Ended December 31,2007 and 2006

 
| ** **                                                                      | ** ** | ** **    | ** ** | ** **            | ** ** | ** **  | ** ** | ** **        | ** ** | ** **   | ** ** | ** **        | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------------|------------|---------------|------------|-----------------------|------------|-------------|------------|-------------------|------------|--------------|------------|-------------------|------------|-----------------|------------|------------|------------|
| ** **                                                                      | ** ** | ** **    | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional**    | ** ** | ** **   | ** ** | ** **        | ** ** | **Other**       | ** ** | ** ** | ** ** |
| ** **                                                                      | ** ** | **Preferred** | ** ** | **Common Stock** | ** ** | **Paid-In** | ** ** | **Comprehensive** | ** ** | **Retained** | ** ** | **Comprehensive** | ** ** | ** **      | ** ** |
| ** **                                                                      | ** ** | **Stock**     | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**       | ** ** | **Income**   | ** ** | **Earnings**      | ** ** | **Income**      | ** ** | **Total**  | ** ** |
|                                                                            |       |          |       |                  |       |        |       |              |       |         |       |              |       |            |       |       |       |
| **Balance  at January 1, 2006**                                                 |       | $             | 1,083,800  |                  | 659,799    |        | $          | 6,655,784         |       | $            | —     |              |       |            | $          | 3,434,081  |       | $ | (192,441 | ) | $ | 10,981,224 |   |
|                                                                            |       |          |       |                  |       |        |       |              |       |         |       |              |       |            |       |       |       |
| Dividends paid                                                                  |       |          |       |                  |       |        |       |              |       |         |       | (94,908           | )          |            |       | (94,908    | )          |
| Exercise of stock  options, and related tax benefit of $68,062                  |       |          |       | 13,600                |       | 202,864     |       | (302              | )          |         |       |              |       |            |       | 202,562    |       |
| Stock-based  compensation                                                       |       |          |       |                  |       |        |       | 61,100            |       |         |       |              |       |            |       | 61,100     |       |
|                                                                            |       |          |       |                  |       |        |       |              |       |         |       |              |       |            |       |       |       |
| **Comprehensive  Income:**                                                      |       |          |       |                  |       |        |       |              |       |         |       |              |       |            |       |       |       |
| Net income                                                                      |       |          |       |                  |       |        |       |              |       | $            | 869,569    |              | 869,569    |            |       |       | 869,569    |   |
| Net unrealized  gain on available-for-sale securities, net of taxes of $92,809  |       |          |       |                  |       |        |       |              |       | 133,554      |       |              |       | 133,554         |       | 133,554    |       |
|                                                                            |       |          |       |                  |       |        |       |              |       |         |       |              |       |            |       |       |       |
| **Total  Comprehensive Income**                                                 |       |          |       |                  |       |        |       |              |       | $            | 1,003,123  |              |       |            |       |       |       |   |
|                                                                            |       |          |       |                  |       |        |       |              |       |         |       |              |       |            |       |       |       |
| **Balance  at December 31, 2006**                                               |       | $             | 1,083,800  |                  | 673,399    |        | $          | 6,858,648         |       | $            | 60,798     |              |       |            | $          | 4,208,742  |       | $ | (58,887 | ) | $ | 12,153,101 |   |
|                                                                            |       |          |       |                  |       |        |       |              |       |         |       |              |       |            |       |       |       |
| Dividends paid                                                                  |       |          |       |                  |       |        |       |              |       |         |       | (96,688           | )          |            |       | (96,688    | )          |
| Exercise of stock  options, and related tax benefit of $108,841                 |       |          |       | 45,233                |       | 561,171     |       |              |       |         |       |              |       |            |       | 561,171    |       |
| Repurchase of  common stock                                                     |       |          |       | (29,400               | )          | (294,000    | )          |              |       |         |       | (165,228          | )          |            |       | (459,228   | )          |
| Stock-based  compensation                                                       |       |          |       |                  |       |        |       | 47,542            |       |         |       |              |       |            |       | 47,542     |       |
|                                                                            |       |          |       |                  |       |        |       |              |       |         |       |              |       |            |       |       |       |
| **Comprehensive  Income:**                                                      |       |          |       |                  |       |        |       |              |       |         |       |              |       |            |       |       |       |
| Net income                                                                      |       |          |       |                  |       |        |       |              |       | $            | 765,294    |              | 765,294    |            |       |       | 765,294    |   |
| Net unrealized  gain on available-for-sale securities, net of taxes of $116,128 |       |          |       |                  |       |        |       |              |       | 167,112      |       |              |       | 167,112         |       | 167,112    |       |
|                                                                            |       |          |       |                  |       |        |       |              |       |         |       |              |       |            |       |       |       |
| **Total  Comprehensive Income**                                                 |       |          |       |                  |       |        |       |              |       | $            | 932,406    |              |       |            |       |       |       |   |
|                                                                            |       |          |       |                  |       |        |       |              |       |         |       |              |       |            |       |       |       |
| **Balance  at December 31, 2007**                                               |       | $             | 1,083,800  |                  | 689,232    |        | $          | 7,125,819         |       | $            | 108,340    |              |       |            | $          | 4,712,120  |       | $ | 108,225 |   | $ | 13,138,304 |   |

 

51

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**MISSIONCOMMUNITY BANCORP AND SUBSIDIARY**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**YearsEnded December 31, 2007 and 2006**

 
| ** **                                                                         | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **OPERATING ACTIVITIES**                                                      | ** ** | ** ** | ** ** | ** ** |       |
| Net income                                                                         |       | $          | 765,294    |       | $          | 869,569 |   |
| Adjustments to reconcile net income to net cash provided by operating  activities: |       |       |       |       |       |
| Provision for deferred income taxes                                                |       | (54,774    | )          | 102,418    |       |
| Depreciation                                                                       |       | 358,959    |       | 325,146    |       |
| Accretion of discount on securities and loans, net                                 |       | (123,748   | )          | (306,378   | )          |
| Provision for credit losses                                                        |       | 150,000    |       | —     |       |
| Stock-based compensation                                                           |       | 47,542     |       | 61,100     |       |
| Loss on disposal of fixed assets                                                   |       | —     |       | 6,161      |       |
| Gain on loan sales                                                                 |       | (307,914   | )          | (263,617   | )          |
| Proceeds from loan sales                                                           |       | 5,061,817  |       | 3,733,059  |       |
| Loans originated for sale                                                          |       | (7,127,310 | )          | (3,484,238 | )          |
| Increase in company owned life insurance                                           |       | (81,773    | )          | (73,108    | )          |
| Other, net                                                                         |       | 84,497     |       | (201,395   | )          |
| **NET CASH PROVIDED BY (USED IN)  OPERATING ACTIVITIES**                           | ** ** |       | (1,227,410 | )          | 768,717    |   |
| ** **                                                                         |       |       |       |       |       |
| **INVESTING ACTIVITIES**                                                           |       |       |       |       |       |
| Net change in Federal Home Loan Bank and other stock                               |       | (660,850   | )          | 228,600    |       |
| Purchase of available-for-sale securities                                          |       | (3,988,477 | )          | (2,932,428 | )          |
| Proceeds from maturities of available-for-sale securities                          |       | 3,548,050  |       | 2,544,707  |       |
| Net increase in loans                                                              |       | (1,045,241 | )          | (2,954,174 | )          |
| Proceeds from sale of fixed assets                                                 |       | —     |       | 14,400     |       |
| Purchases of premises and equipment                                                |       | (172,352   | )          | (738,040   | )          |
| **NET CASH USED IN INVESTING  ACTIVITIES**                                         | ** ** |       | (2,318,870 | )          | (3,836,935 | ) |
| ** **                                                                         |       |       |       |       |       |
| **FINANCING ACTIVITIES**                                                           |       |       |       |       |       |
| Net decrease in demand deposits and savings accounts                               |       | (7,129,228 | )          | (4,325,793 | )          |
| Net increase (decrease) in time deposits                                           |       | (4,717,995 | )          | 1,018,576  |       |
| Net increase in other borrowings                                                   |       | 10,800,000 |       | 4,000,000  |       |
| Common stock repurchased                                                           |       | (459,228   | )          | —     |       |
| Payment of dividends                                                               |       | (96,688    | )          | (94,908    | )          |
| Proceeds from exercise of stock options                                            |       | 561,171    |       | 202,562    |       |
| **NET CASH PROVIDED BY (USED IN)  FINANCING ACTIVITIES**                           | ** ** |       | (1,041,968 | )          | 800,437    |   |
|                                                                               |       |       |       |       |       |
| **NET DECREASE IN CASH AND CASH  EQUIVALENTS**                                     | ** ** |       | (4,588,248 | )          | (2,267,781 | ) |
| Cash and cash equivalents at beginning of year                                     |       | 10,114,952 |       | 12,382,733 |       |
| **CASH AND CASH EQUIVALENTS AT  END OF YEAR**                                      | ** ** |       | $          | 5,526,704  |       | $ | 10,114,952 |   |
| ** **                                                                         |       |       |       |       |       |
| **Supplemental Disclosures of Cash Flow Information:**                             |       |       |       |       |       |
| Interest paid                                                                      |       | $          | 5,179,256  |       | $          | 4,226,061 |   |
| Taxes paid                                                                         |       | 210,000    |       | 415,000    |       |
| Portfolio loans reclassified to loans held for sale                                |       | 1,172,869  |       | —     |       |
|                                                                                    |            |            |            |            |            |  |  |  |  |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

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**NOTE A -SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

Principles ofConsolidation

 

The financialstatements include the accounts of Mission Community Bancorp (“Bancorp”) andits subsidiary, Mission Community Bank (“the Bank”), and the Bank’s subsidiary,Mission Community Development Corporation, collectively referred to herein as “theCompany.”

 

Nature ofOperations

 

The Bank has been organized as a single reporting segment and operatesthree branches in the Central Coast area of California (in the cities of SanLuis Obispo, Paso Robles and Arroyo Grande).

 

The Bank’s primary source of revenue is providing real estate,commercial (including Small Business Administration (“SBA”) guaranteed loans)and consumer loans to customers, who are predominately small and middle-marketbusinesses and individuals.  The Companyand the Bank are certified by the Department of Treasury as CommunityDevelopment Financial Institution(s) (“CDFI”) with a commitment to focuson providing financial services to low- and moderate-income communities.

 

Mission CommunityDevelopment Corporation

 

Mission CommunityDevelopment Corporation (“MCDC”) is a community development corporation whichprovides financing for small businesses and projects in low- to moderate-incomeareas.  The Board of Directors of MissionCommunity Development Corporation consists of four members of the Board ofDirectors of the Company and three outside members who are actively involved insupporting community affairs and activities. Community development investment islimited to 5% of the Bank’s capital and up to 10% with prior approval by theFederal Reserve Board.  Operations ofMCDC were not material for the years ended December 31, 2007 or 2006.

 

###### *MissionCommunity Services Corporation*

###### * *

Mission CommunityServices Corporation (“MCSC”), an affiliate organization, was organized in 1998and the corporation was established as a not-for-profit company with Section 501(c)(3) status.  This company’s primary focus is to providetechnical support and training services to the underserved segments of thecommunity including small businesses, minorities and low-incomeentrepreneurs.  The Board of Directors ofMission Community Services Corporation includes representatives from theCompany, together with members representing the communities represented.  The accounts of MCSC are not included in theCompany’s consolidated financial statements. See Note L for additional information regarding MCSC.

 

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Use of Estimatesin the Preparation of Financial Statements

 

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements, and the reported amounts of revenues and expenses during thereporting period.  Actual results could differfrom those estimates.

 

Cash and CashEquivalents

 

For purposes ofreporting cash flows, cash and cash equivalents include cash, amounts due fromother banks and federal funds sold. Generally, federal funds are sold for one-day periods.

 

Cash and Due FromBanks

 

Bankingregulations require that all banks maintain a percentage of their deposits asreserves in cash or on deposit with the Federal Reserve Bank (“FRB”).  The Bank was in compliance with thisrequirement, which was $439,000 as of December 31, 2007.

 

The Companymaintains amounts due from other banks which exceed federally insuredlimits.  The Company has not experiencedany losses in such accounts.

 

InvestmentSecurities

 

Bonds, notes, anddebentures for which the Company has the positive intent and ability to hold tomaturity are reported at cost, adjusted for premiums and discounts that arerecognized in interest income using the interest method over the period tomaturity.

 

Investments notclassified as trading securities nor as held-to-maturity securities areclassified as available-for-sale securities and recorded at fair value.  Unrealized gains or losses onavailable-for-sale securities are excluded from net income and reported as aseparate component of comprehensive income, net of taxes, which is included inshareholders’ equity.  Premiums ordiscounts are amortized or accreted into income using the interest method.  Realized gains or losses on sales ofsecurities are recorded using the specific identification method.

 

Other-than-temporarydeclines in the fair value of individual held-to-maturity andavailable-for-sale securities below their cost result in write-downs of theindividual securities to their fair value. The related write-downs are included in earnings as realized losses.  In estimating other-than-temporary impairmentlosses, management considers the length of time and the extent to which thefair value has been less than cost, the financial condition and near-termprospects of the issuer, and the intent and ability of the Bank to retain itsinvestment in the issuer for a period of time sufficient to allow for anyanticipated recovery in fair value.

 

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Loans

 

Loans are reportedat the principal amount outstanding, net of any deferred loan origination feeincome and deferred direct loan origination costs, and net of any unearnedinterest on discounted loans.  Deferredloan origination fee income and direct loan origination costs are amortized tointerest income over the life of the loan using the interest method.  Interest on loans is accrued to income dailybased upon the outstanding principal balances.

 

Loans for whichthe accrual of interest has been discontinued are designated as non-accrualloans.  Loans are classified asnon-accrual when principal or interest is past due 90 days or more based on thecontractual terms of the loan or when, in the opinion of management, thereexists a reasonable doubt as to the full and timely collection of eitherprincipal or interest, unless the loan is well secured and in the process ofcollection.  Income on such loans is thenonly recognized to the extent that cash is received and where the futurecollection of principal is probable. Accrual of interest is resumed only when principal and interest arebrought fully current and when such loans are considered to be collectible asto both principal and interest.

 

For impairmentrecognized in accordance with Financial Accounting Standards Board (“FASB”)Statement of Financial Accounting Standards (“SFAS”) No. 114, *“Accounting by Creditors for Impairment of a Loan,”* asamended by SFAS No. 118, the entire change in the present value ofexpected cash flows is reported as either provision for credit losses in thesame manner in which impairment initially was recognized, or as a reduction inthe amount of provision for credit losses that otherwise would be reported.

 

### **Loans Held for Sale**

### ** **

Mortgage loans andSBA loans originated and intended for sale in the secondary market are carriedat the lower of cost or estimated market value in the aggregate.  Net unrealized losses are recognized througha valuation allowance by charges to income. Gains or losses realized on the sales of loans are recognized at thetime of sale and are determined by the difference between the net salesproceeds and the carrying value of the loans sold, adjusted for any servicingasset or liability.  Gains and losses onsales of loans are included in non-interest income.

 

The Bank hasadopted SFAS No. 140, *“Accounting for Transfersand Servicing of Financial Assets and Extinguishments of Liabilities,”*and, effective January 1, 2007, SFAS No. 156, “*Accountingfor Servicing of Financial Assets—an amendment of FASB Statement No. 140.”* SFAS No. 140 providesaccounting and reporting standards for transfers and servicing of financialassets and extinguishments of liabilities. Under this Statement, after a transfer of financial assets, an entityrecognizes the financial and servicing assets it controls and liabilities ithas incurred, derecognizes financial assets when control has been surrendered,and derecognizes liabilities when extinguished.  SFAS No. 156permits the Bank to choose between two different methods of measuring ongoingchanges in the value of its SBA loan servicing asset: the amortization methodor the fair value measurement method. Before adoption of SFAS No. 156 the Bank amortized the SBA loanservicing asset over the period that servicing fees are expected to bereceived, and recognized an impairment loss if the value of the servicing assetwas determined to be impaired.  The Bankadopted the amortization method in 2007, so adopting SFAS No. 156 did nothave a material effect on our 2007 financial statements.

 

55

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Allowance for LoanLosses

 

The allowance for loan losses is increased by charges to income anddecreased by charge-offs (net of recoveries). Charge-offs are loans and leases deemed uncollectible, which are chargedto the allowance.  Management performs,at least quarterly, an analysis of the allowance for loan losses to determineits adequacy.  In this analysis, allnon-classified loans are segmented into components by loan type and internalrisk rating.  Estimated loss factors areapplied to each loan pool based on historical losses as well as management’sassessment of current factors that may impact these historical factors, such aschanges in the local economy, changes in underwriting standards, changes inloans concentrations and trends in past due and non-performing loans.  Significant loans classified as less thanacceptable by management, the Bank’s regulators or external credit reviewconsultants are evaluated separately in the process.  In this evaluation, management reviews theborrower’s ability to repay as well as the estimated value of any underlyingcollateral.

 

Premises andEquipment

 

###### *Land iscarried at cost.  Premises and equipmentare carried at cost less accumulated depreciation and amortization.  Depreciation is computed using thestraight-line method over the estimated useful lives, which range from three toten years for furniture and fixtures and forty years for buildings.  Leasehold improvements are amortized usingthe straight-line method over the estimated useful lives of the improvements orthe remaining lease term, whichever is shorter. Expenditures for betterments or major repairs are capitalized and thosefor ordinary repairs and maintenance are charged to operations as incurred.*

###### * *

###### *AdvertisingCosts*

###### * *

The Bank expenses thecosts of advertising in the period incurred.

 

Income Taxes

 

Deferred taxassets and liabilities are reflected at currently enacted income tax ratesapplicable to the period in which the deferred tax assets or liabilities areexpected to be realized or settled.  Aschanges in tax laws or rates are enacted, deferred tax assets and liabilitiesare adjusted through the provision for income taxes.  The Company classifies any interest orpenalties related to income taxes as a part of income tax expense whenincurred.  No such interest or penaltieswere incurred for in 2006 or 2007.

 

ComprehensiveIncome

 

SFAS No. 130,*“Reporting Comprehensive Income*,*”* requires the disclosure of comprehensive income and itscomponents.  Changes in unrealized gainor loss on available-for-sale securities net of income taxes is the only componentof accumulated other comprehensive income for the Company.

 

FinancialInstruments

 

In the ordinarycourse of business, the Company has entered into off-balance sheet financialinstruments consisting of commitments to extend credit, commercial letters ofcredit and standby letters of credit. Such financial instruments are recorded in the financial statements whenthey are funded or related fees are incurred or received.

 

56

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Earnings Per Share (“EPS”)

 

EPS is computedunder the provisions of Statement of Accounting Standards No. 128, *Earnings per Share,* (“SFAS No. 128”) and the EmergingIssues Task Force (“EITF”) Consensus on Issue No. 03-6, *Participating Securities and the Two-Class Method under FASB StatementNo. 128.*  EITF 03-6requires that income per share for the Company’s common stock be calculatedassuming 100% of the Company’s earnings are distributed as dividends to itscommon and preferred shareholders based on their respective dividend rights,even though the Company does not anticipate distributing 100% of its earningsas dividends.   Basic EPS is computed bydividing income available to common shareholders, using the method prescribedabove under EITF 03-6, by the weighted-average number of common sharesoutstanding for the period.  Diluted EPSreflects the potential dilution that could occur if options or other contractsto issue common stock were exercised or converted into common stock or resultedin the issuance of common stock that then shared in the earnings of theCompany.

 

Stock-Based Compensation

 

During2006 and 2007 the Company had one stock option plan (see Note I to theconsolidated financial statements).  On January 1,2006, the Company implemented Statement of Financial Accounting Standards No. 123(Revised 2004), *Share-Based Payment* (“SFAS No. 123R”),which addresses accounting for equity-based compensation arrangements,including employee stock options.  SFAS No. 123Rreplaced SFAS No. 123 and superseded Accounting Principles Board (APB)Opinion No. 25, *Accounting for StockIssued to Employees,*and the related guidance.  SFAS No. 123R generally requiresentities to recognize the cost of employee services received in exchange forawards of stock options or other equity instruments based on the grant-datefair value of those awards.  This cost isrecognized over the period which an employee is required to provide services inexchange for the award, generally the vesting period.  The Company adopted SFAS No. 123R usingthe “modified prospective method.”  Underthis method, compensation expense is recognized using the fair-value method forall new stock option awards as well as any existing awards that are modified,repurchased or cancelled.  Compensationexpense for unvested options that were outstanding at December 31, 2005,is recognized over the requisite service period based on the fair value ofthose options as previously calculated under the pro forma disclosures of SFAS No. 123.  The fair value of each grant is estimatedusing the Black-Scholes option pricing model.

 

57

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Recent****Accounting Pronouncements

 

InMarch 2006 the Financial Accounting Standards Board (“FASB”) issuedStatement of Financial Accounting Standards No. 156 (“SFAS No. 156”),*Accounting for Servicing of Financial Assets—anAmendment of FASB Statement No. 140,* which permitted the Bank,beginning in 2007, to choose between two different methods of measuring ongoingchanges in the value of its SBA loan servicing asset: the amortization methodor the fair value measurement method.  Under SFAS No. 140, prior to SFAS No. 156, the Bank amortizedthe SBA loan servicing asset over the period that servicing fees were expectedto be received, and recognized an impairment loss if the value of the servicingasset was determined to be impaired.   The Bank elected in 2007 to continue to use the amortization method,with testing for impairment, to measure ongoing changes in the value of its SBAloan servicing asset.  Accordingly, thisresults in no change in our accounting for this asset.

 

InJuly 2006 the FASB issued FASB Interpretation No. 48 (“FIN 48”), *Accounting for Uncertainty in Income Taxes,* which clarifiesthe accounting for uncertainty in tax positions taken or expected to be takenon a tax return.  FIN 48 provides thatthe tax effects from an uncertain tax position can be recognized in ourfinancial statements only if, based on its technical merits, the position ismore likely than not to be sustained on audit. The provisions of FIN 48 wereeffective beginning with the 2007 calendar year, with the cumulative effect ofthe change in accounting principle recorded as an adjustment to openingretained earnings.  Management believesthat all tax positions taken to date meet the “more likely than not” standardand, therefore, no accounting adjustment has been made to our financialstatements as a result of adopting FIN 48 in 2007.

 

InSeptember 2006 the FASB issued Statement of Financial Accounting StandardsNo. 157 (“SFAS No. 157”), *Fair Value Measurements,*which defines fair value, establishes a framework for measuring fair value, andexpands disclosures about fair value measurements.  SFAS No. 157 will be effective for the2008 calendar year.  The Bank expects in2008 to review the reported fair values of its securities portfolio, as well asthose of other financial instruments, and may make some adjustments to thosefair values in light of the guidance provided by SFAS No. 157.  Those potential adjustments are not expectedto have any impact on net income or earnings per share, but may affectcomprehensive income and accumulated other comprehensive income, to the extentthat revisions are made to the fair values of available-for-sale securities.

 

InFebruary 2007 the FASB issued Statement of Financial Accounting Standards No. 159(“SFAS No. 159”), *The Fair Value Option forFinancial Assets and Financial Liabilities—Including an amendment of FASBStatement No. 115,* which will permit the Bank, beginning in2008, to make an irrevocable choice to measure many financial instruments andcertain other items at fair value, on an instrument-by-instrument basis.  SFAS No. 159 will be effective for the2008 calendar year.  Upon adoption ofSFAS No. 159 in 2008, the Bank does not expect to change the valuation ofany of its existing cost-based financial instruments to fair value.  Accordingly, this statement is not expectedto result in any change in the Company’s accounting for financial assets andfinancial liabilities.

 

Reclassifications

 

Certainreclassifications were made to prior years’ presentations to conform to thecurrent year.  These reclassificationshad no effect on net income or earnings per share.

 

58

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**NOTE B -INVESTMENT SECURITIES**

 

Investmentsecurities have been classified in the consolidated balance sheets according tomanagement’s intent.  The amortized costof securities and their approximate fair values at December 31 were asfollows:

 
| ** **                                              | ** ** | ** **    | ** ** | **Gross**      | ** ** | **Gross**      | ** ** | **Estimated** | ** ** |
|---------------------------------------------------------|------------|---------------|------------|----------------|------------|----------------|------------|---------------|------------|
| ** **                                              | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Market**    | ** ** |
| ** **                                              | ** ** | **Cost**      | ** ** | **Gains**      | ** ** | **Losses**     | ** ** | **Value**     | ** ** |
| **Securities  Available for Sale:  December 31, 2007:** |       |          |       |           |       |           |       |          |       |
| U.S. Government  agencies                               |       | $             | 5,992,575  |           | $          | 26,962         |       | $             | (9,377     | ) | $ | 6,010,160 |   |
| Mortgage-backed  securities                             |       | 7,327,838     |       | 36,520         |       | (35,465        | )          | 7,328,893     |       |
| Municipal  securities                                   |       | 2,971,893     |       | 15,549         |       | (23,272        | )          | 2,964,170     |       |
| Asset-backed  securities                                |       | 648,406       |       | 173,014        |       | (499           | )          | 820,921       |       |
|                                                    |       | $             | 16,940,712 |           | $          | 252,045        |       | $             | (68,613    | ) | $ | 17,124,144 |   |
|                                                    |       |          |       |           |       |           |       |          |       |
| **December  31, 2006:**                                 |       |          |       |           |       |           |       |          |       |
| U.S. Government  agencies                               |       | $             | 7,492,390  |           | $          | 5,297          |       | $             | (127,932   | ) | $ | 7,369,755 |   |
| Mortgage-backed  securities                             |       | 6,850,095     |       | 3,674          |       | (111,923       | )          | 6,741,846     |       |
| Municipal  securities                                   |       | 1,940,944     |       | 9,328          |       | (7,640         | )          | 1,942,632     |       |
| Asset-backed  securities                                |       | 232,282       |       | 130,310        |       | (922           | )          | 361,670       |       |
|                                                    |       | $             | 16,515,711 |           | $          | 148,609        |       | $             | (248,417   | ) | $ | 16,415,903 |   |

 

During2004, one of the Bank’s asset-backed securities was identified as “other thantemporarily impaired,” and a loss reserve was established for thissecurity.  The security is in non-accrualstatus, with any interest payments received being credited to the reserve.  As of December 31, 2007, the gross bookvalue of the security was $328,000 and the reserve was $270,000, for a net bookvalue of $58,000.  The fair value on December 31,2007, was $227,000, resulting in an unrealized gain of $169,000.

 

Thescheduled maturities of investment securities at December 31, 2007, wereas follows.  Actual maturities may differfrom contractual maturities because some investment securities may allow theright to call or prepay the obligation with or without call or prepaymentpenalties.

 
| ** **                      | ** ** | **Available-for-Sale Securities** | ** ** |
|---------------------------------|------------|----------------------------------------|------------|
| ** **                      | ** ** | **Amortized**                          | ** ** | **Fair** | ** ** |
| ** **                      | ** ** | **Cost**                               | ** ** | **Value** | ** ** |
|                            |       |                                   |       |   |   |
| Within one year                 |       | $                                      | 2,127,521  |   | $ | 2,128,471 |   |
| Due in one year  to five years  |       | 2,998,119                              |       | 3,006,819 |   |
| Due in five  years to ten years |       | 2,105,380                              |       | 2,108,511 |   |
| Due in greater  than ten years  |       | 9,709,692                              |       | 9,880,343 |   |
|                            |       | $                                      | 16,940,712 |   | $ | 17,124,144 |   |

 

59

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### **Includedin accumulated other comprehensive income at December 31, 2007 were netunrealized gains on investment securities available for sale of $183,432 lessapplicable income taxes of $75,207.  At December 31,2006, accumulated other comprehensive income included net unrealized losses onavailable-for-sale securities of $99,808 less applicable income taxes of$40,921.  No securities were sold in 2007or 2006.**

### ** **

Investmentsecurities in a temporary unrealized loss position as of December 31, 2007and 2006 are shown in the following table, based on the length of time theyhave been continuously in an unrealized loss position:

 
| ** **                  | ** ** | **Less than 12 Months** | ** ** | **12 Months or Longer** | ** ** | **Total** | ** ** |
|-----------------------------|------------|----------------------------------------|------------|----------------------------------------|------------|-----------|------------|
| ** **                  | ** ** | **Fair**                               | ** ** | **Unrealized**                         | ** ** | **Fair**  | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                  | ** ** | **Value**                              | ** ** | **Losses**                             | ** ** | **Value** | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** |
| **December  31, 2007:**     |       |                                   |       |                                   |       |      |       |   |   |   |   |   |   |
| U.S. Government  agencies   |       | $                                      | —     |                                   | $          | —    |       | $ | 2,490,320 |   | $ | 9,377 |   | $ | 2,490,320 |   | $ | 9,377 |   |
| Mortgage-backed  securities |       | 611,527                                |       | 2,965                                  |       | 3,507,599 |       | 32,500 |   | 4,119,126 |   | 35,465 |   |
| Municipal  securities       |       | 360,412                                |       | 2,725                                  |       | 1,211,867 |       | 20,547 |   | 1,572,279 |   | 23,272 |   |
| Asset-backed  securities    |       | —                                 |       | —                                 |       | 107,314   |       | 499 |   | 107,314 |   | 499 |   |
|                        |       | $                                      | 971,939    |                                   | $          | 5,690     |       | $ | 7,317,100 |   | $ | 62,923 |   | $ | 8,289,039 |   | $ | 68,613 |   |
|                        |       |                                   |       |                                   |       |      |       |   |   |   |   |   |   |
| **December  31, 2006:**     |       |                                   |       |                                   |       |      |       |   |   |   |   |   |   |
| U.S. Government  agencies   |       | $                                      | —     |                                   | $          | —    |       | $ | 6,370,690 |   | $ | 127,932 |   | $ | 6,370,690 |   | $ | 127,932 |   |
| Mortgage-backed  securities |       | 154,675                                |       | 50                                     |       | 6,156,761 |       | 111,873 |   | 6,311,436 |   | 111,923 |   |
| Municipal  securities       |       | 1,224,764                              |       | 7,640                                  |       | —    |       | — |   | 1,224,764 |   | 7,640 |   |
| Asset-backed  securities    |       | —                                 |       | —                                 |       | 144,257   |       | 922 |   | 144,257 |   | 922 |   |
|                        |       | $                                      | 1,379,439  |                                   | $          | 7,690     |       | $ | 12,671,708 |   | $ | 240,727 |   | $ | 14,051,147 |   | $ | 248,417 |   |

 

The unrealizedlosses on investments in U.S. Government agency and mortgage-backed securitieswhich have been in an unrealized loss position for one year or longer as of December 31,2007 (a total of 20 securities), were caused by market interest rate increasessubsequent to the purchase of the securities. The unrealized losses on all but four of these 20 securities havedecreased from December 31, 2006 to December 31, 2007.  Because the Bank has the ability to hold allthese investments until a recovery in fair value, which may be maturity, theunrealized losses on these investments are not considered to beother-than-temporarily impaired as of December 31, 2007.  Other than the one impaired asset-backedsecurity footnoted above, none of the Bank’s securities has exhibited a declinein value as a result of changes in credit risk.

 

Investmentssecurities carried at $10,631,000 and $10,598,000 as of December 31, 2007and 2006, respectively, were pledged to secure public deposits as required bylaw.

 

60

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### **NOTE C - LOANS**

### ** **

The Bank’s loanportfolio consists primarily of loans to borrowers within the Central Coastarea of California.  Although the Bankseeks to avoid concentrations of loans to a single industry or based upon asingle class of collateral, real estate and real estate associated businessesare among the principal industries in the Bank’s market area and, as a result,the Bank’s loan and collateral portfolios are concentrated in those industriesand in that geographic area.  As of December 31,2007, 64% of the loan portfolio was secured by commercial real estate(including construction and land development loans as well as loans secured bynon-farm, non-residential and multi-family residential properties).  Under guidelines for commercial real estate (“CRE”)lending issued by the bank regulatory agencies in 2006, which generallyexcludes owner-occupied properties from the definition of commercial realestate, CRE loans represented 43% of the loan portfolio as of December 31,2007.

 

Included in totalloans are net deferred loan fees of $22,000 and $181,000 at December 31,2007 and 2006, respectively.

 

The following is asummary of the investment in impaired loans as of December 31, includingthe related allowance for loan losses and cash-basis income recognized.  Also shown are loans on non-accrual and thosethat are past due and still accruing interest:

 
| ** **                                                   | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|--------------------------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Impaired Loans:                                              |       |       |       |       |       |
| Impaired loans  with a related allowance for loan losses     |       | $          | 273,000    |       | $          | 136,000 |   |
| Impaired loans  with no related allowance for loan losses    |       | 1,715,000  |       | 104,000    |       |
| Total impaired  loans                                        |       | 1,988,000  |       | 240,000    |       |
| Related  Allowance for Loan Losses                           |       | 20,000     |       | 12,000     |       |
| Average Recorded  Investment in Impaired Loans               |       | 980,400    |       | 271,600    |       |
| Interest Income  Recognized for Cash Payments While Impaired |       | 106,000    |       | —     |       |
| Total Loans on  Non-accrual                                  |       | 1,988,000  |       | 240,000    |       |
| Total Loans Past  Due 90 Days or More and Still Accruing     |       | 68,000     |       | 1,929,000  |       |
|                                                              |            |            |            |            |            |  |  |

 

Following is asummary of the changes in the allowance for possible loan losses for the yearsended December 31:

 
| ** **                                       | ** ** | **2007** | ** ** | **2006** | ** ** |
|--------------------------------------------------|------------|----------|------------|----------|------------|
|                                             |       |     |       |     |       |
| Balance at  Beginning of Year                    |       | $        | 1,025,939  |     | $          | 1,141,096 |   |
| Additions to the  Allowance Charged to Expense   |       | 150,000  |       | —   |       |
| Less Loans  Charged Off                          |       | (31,425  | )          | (121,374 | )          |
| Plus Recoveries  on Loans Previously Charged Off |       | 5,360    |       | 6,217    |       |
| Balance at End  of Year                          |       | $        | 1,149,874  |     | $          | 1,025,939 |   |

 

61

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**NOTE C -LOANS - Continued**

 

The Bank alsooriginates SBA-guaranteed loans for sale to institutional investors.  At December 31, 2007 and 2006 the Bankwas servicing $24,722,000 and $23,306,000, respectively, in loans previouslysold or participated.  The Bank hasrecorded servicing assets related to these sold loans of approximately $253,000and $283,000 at December 31, 2007 and 2006, respectively.  In calculating the gain on sale of SBA loansand the related servicing asset, the Bank used the following assumptions forsales recorded in 2007:

 
| ** **     | ** ** | **Range**       | ** ** | **Weighted Average** |
|----------------|------------|-----------------|------------|----------------------|
| Discount rate  |       | 9.00% to 12.25% |       | 10.40%               |
| Estimated life |       | 48 months       |       | 48 months            |

 

Managementperforms an analysis each quarter to reassess these assumptions, which aresignificant determinants on the value ascribed to the servicing asset.  Following is a summary of the changes in thebalances of the SBA loan servicing asset for 2007 and 2006:

 
| ** **                    | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
|                          |       |     |       |     |       |
| Balance at  Beginning of Year |       | $        | 282,696    |     | $          | 574,302 |   |
| Additions to the  Asset       |       | 96,127   |       | 78,046   |       |
| Less  amortization            |       | (126,251 | )          | (369,652 | )          |
| Balance at End  of Year       |       | $        | 252,572    |     | $          | 282,696 |   |

 

The estimated fairvalue of the servicing assets approximated the carrying amount at December 31,2007 and 2006.  These assets are includedin accrued interest and other assets in the consolidated balance sheets.  Amortization of these assets is netted againstloan servicing fees in the consolidated statements of income.

 

62

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**NOTE D -PREMISES AND EQUIPMENT**

 

A summary ofpremises and equipment as of December 31 follows:

 
| ** **                                 | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|--------------------------------------------|------------|------------|------------|------------|------------|
|                                       |       |       |       |       |       |
| Land                                       |       | $          | 2,171,007  |       | $          | 2,171,007 |   |
| Buildings                                  |       | 823,227    |       | 763,418    |       |
| Leasehold  improvements                    |       | 339,319    |       | 338,359    |       |
| Furniture,  fixtures, and equipment        |       | 2,309,514  |       | 2,197,931  |       |
|                                       |       | 5,643,067  |       | 5,470,715  |       |
| Accumulated  depreciation and amortization |       | (2,105,866 | )          | (1,746,907 | )          |
| Net premises and  equipment                |       | $          | 3,537,201  |       | $          | 3,723,808 |   |

 

The Bank hasentered into operating leases for its branches and operating facilities, whichexpire at various dates through 2024. These leases include provisions for periodic rent increases as well aspayment by the lessee of certain operating expenses.  Rental expense relating to these leases was$324,000 in 2007 and $278,000 in 2006.

 

At December 31,2007, the approximate future minimum annual payments under these leases for thenext five years are as follows:

 
| 2008        |   | $         | 234,856   |   |
|-------------|--------|-----------|-----------|--------|
| 2009        |   | 267,586   |      |
| 2010        |   | 563,439   |      |
| 2011        |   | 496,220   |      |
| 2012        |   | 470,827   |      |
| Later years |   | 6,714,629 |      |
|        |   | $         | 8,747,557 |   |

 

The minimum rentalpayments shown above are given for the existing lease obligations and do notreflect any increases in rent unless the increases are scheduled and currentlydeterminable.  It does not represent aforecast of future rental expenses. Included in the above table are obligations under a 15-yearbuild-to-suit lease for property in San Luis Obispo, California, upon which theBank intends to lease a full-service branch and administrative office.  Currently the lease provides for tentativerentals of $36,708 per month, subject to the final size of the yet-to-be-constructedbuilding, and beginning on or about October 1, 2009.  As of December 31, 2006, the Bank wasobligated under a 50-year land lease for property on this site.  The terms of that lease gave the Bank earlytermination rights through September 30, 2007, which the Bank chose toexercise in July 2007.

 

63

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**NOTE E -DEPOSITS**

 

At December 31,2007, the scheduled maturities of time deposits are as follows:

 
| Due in one year           |   | $         | 54,168,153 |   |
|---------------------------|--------|-----------|------------|--------|
| Due in one to  five years |   | 2,470,548 |       |
|                      |   | $         | 56,638,701 |   |

 

Ten depositcustomers comprised $23.0 million, or 20.5%, of the Bank’s total deposits as ofDecember 31, 2007.

 

**NOTE F -OTHER BORROWINGS**

 

Other borrowings at December 31,2007 are comprised of the following advances from the Federal Home Loan Bank ofSan Francisco:

 
| **Maturity  Date** | ** ** | **Interest   Rate** | ** ** | **Amount** | ** ** |
|--------------------|------------|---------------------|------------|------------|------------|
| 3/31/2008          |       | 4.34                | %          | $          | 1,400,000  |   |
| 12/4/2008          |       | 5.33                | %          | 2,000,000  |       |
| 3/30/2009          |       | 3.19                | %          | 2,000,000  |       |
| 5/13/2009          |       | 4.48                | %          | 500,000    |       |
| 5/24/2009          |       | 5.16                | %          | 3,000,000  |       |
| 11/30/2009         |       | 3.87                | %          | 2,300,000  |       |
| 12/7/2009          |       | 3.82                | %          | 2,000,000  |       |
| 12/14/2009         |       | 4.01                | %          | 3,000,000  |       |
| 12/28/2009         |       | 3.96                | %          | 3,000,000  |       |
| 12/28/2009         |       | 3.83                | %          | 3,000,000  |       |
| 5/24/2010          |       | 5.13                | %          | 3,000,000  |       |
| 11/19/2013         |       | 4.82                | %          | 1,000,000  |       |
| 12/11/2013         |       | 4.98                | %          | 1,000,000  |       |
| 12/16/2013         |       | 4.88                | %          | 1,000,000  |       |
|               |       |                |       | $          | 28,200,000 |   |

 

These advances aresecured by loans of approximately $76 million. As of December 31, 2007, the Bank had a borrowing capacity ofapproximately $6.1 million with the Federal Home Loan Bank of San Francisco inaddition to the borrowings listed above.

 

The Bank also hasunsecured borrowing lines with correspondent banks totaling $11.5 million.  As of December 31, 2007, there were nobalances outstanding on these lines.

 

64

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**NOTE G -JUNIOR SUBORDINATED DEBT SECURITIES**

 

On October 14,2003, the Company issued $3,093,000 of junior subordinated debt securities (the“debt securities”) to Mission Community Capital Trust, a statutory trustcreated under the laws of the State of Delaware.  These debt securities are subordinated toeffectively all borrowings of the Company and are due and payable on October 7,2033.  Interest is payable quarterly onthese debt securities at LIBOR plus 2.95% for an effective rate of 8.19% as of December 31,2007.  The debt securities can be redeemedfor 105% of the principal balance through October 7, 2008 and at parthereafter.  They can also be redeemed atpar if certain events occur that impact the tax treatment or the capitaltreatment of the issuance.

 

The Company alsopurchased a 3% minority interest in Mission Community Capital Trust. Thebalance of the equity of Mission Community Capital Trust is comprised ofmandatorily redeemable preferred securities. Under FASB Interpretation No. 46 (FIN 46), “*Consolidation of Variable Interest Entities, aninterpretation of ARB No. 51,”*Mission Community Capital Trustis not consolidated into the Company’s financial statements.  The Federal Reserve Board has ruled thatsubordinated notes payable to unconsolidated special purpose entities (“SPE’s”)such as Mission Community Capital Trust, net of the bank holding company’sinvestment in the SPE, qualify as Tier 1 Capital, subject to certain limits.

 

**NOTE H -INCOME TAXES**

 

The income tax expensefor the years ended December 31, 2007 and 2006 is comprised of thefollowing:

 
| ** **     | ** ** | **2007** | ** ** | **2006** | ** ** |
|----------------|------------|----------|------------|----------|------------|
| Current Taxes: |       |     |       |     |       |
| Federal        |       | $        | 309,294    |     | $          | 311,061 |   |
| State          |       | 123,323  |       | 125,348  |       |
|           |       | 432,617  |       | 436,409  |       |
| Deferred       |       | (54,774  | )          | 102,418  |       |
|           |       | $        | 377,843    |     | $          | 538,827 |   |

 

65

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**NOTE H -INCOME TAXES - Continued**

 

A comparison ofthe federal statutory income tax rates to the Company’s effective income taxfollows:

 
| ** **                                                     | ** ** | **2007**   | ** ** | **2006** | ** ** |
|----------------------------------------------------------------|------------|------------|------------|----------|------------|
| ** **                                                     | ** ** | **Amount** | ** ** | **Rate** | ** ** | **Amount** | ** ** | **Rate** | ** ** |
|                                                           |       |       |       |     |       |   |   |   |   |
| Federal tax rate                                               |       | $          | 388,667    |     | 34.0       | % | $ | 478,855 |   | 34.0 | % |
| California  franchise taxes, net of federal tax benefit        |       | 79,987     |       | 7.0      | %          | 96,190 |   | 6.8 | % |
| Interest on  municipal securities and loans                    |       | (79,623    | )          | (7.0     | )%         | (32,669 | ) | (2.3 | )% |
| Increase in cash  surrender value of bank-owned life insurance |       | (27,803    | )          | (2.4     | )%         | (24,857 | ) | (1.7 | )% |
| Other items -  net                                             |       | 16,615     |       | 1.5      | %          | 21,308 |   | 1.5 | % |
|                                                           |       | $          | 377,843    |     | 33.1       | % | $ | 538,827 |   | 38.3 | % |

 

Deferred taxes area result of differences between income tax accounting and generally acceptedaccounting principles with respect to income and expense recognition.  The Company’s principal timing differencesare from the cash basis of tax reporting and the allowance for loan and leaselosses.

 

The following is asummary of the components of the net deferred tax asset accounts recognized inthe accompanying consolidated balance sheets:

 
| ** **                                        | ** ** | **2007** | ** ** | **2006** | ** ** |
|---------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred Tax  Assets:                             |       |     |       |     |       |
| Allowance for  Loan Losses Due to Tax Limitations |       | $        | 474,813    |     | $          | 410,505 |   |
| Unrealized Loss  on Available-for-Sale Securities |       | —   |       | 40,921   |       |
| Reserve for  impaired security                    |       | 110,994  |       | 101,406  |       |
| Other                                             |       | 203,531  |       | 118,153  |       |
|                                              |       | 789,338  |       | 670,985  |       |
| Deferred Tax  Liabilities:                        |       |     |       |     |       |
| Deferred loan  costs                              |       | (188,336 | )          | (145,150 | )          |
| Depreciation  Differences                         |       | (81,221  | )          | (106,896 | )          |
| Unrealized Gain  on Available-for-Sale Securities |       | (75,207  | )          | —   |       |
| BEA award  deferred for tax purposes              |       | (134,157 | )          | —   |       |
| Other                                             |       | (48,466  | )          | (95,634  | )          |
|                                              |       | (527,387 | )          | (347,680 | )          |
| Net Deferred Tax  Assets                          |       | $        | 261,951    |     | $          | 323,305 |   |

 

As of December 31,2007, tax years for 2004 through 2007 remain open to audit by the InternalRevenue Service and by the California Franchise Tax Board.  In the opinion of management, all significanttax positions taken, or expected to be taken, by the Company in any open taxyear would more likely than not be sustained upon examination by the taxauthorities.

 

66

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**NOTE I -STOCK OPTION PLAN**

 

During 1998, the Board ofDirectors adopted a stock option plan, which was approved by the shareholders,under which 180,000 shares of the Company’s common stock may be issued.  Options are granted at a price not less than100% of the fair value of the stock on the date of grant, generally for a termof ten years, with vesting occurring ratably over five years.  The stock option plan provides foracceleration of vesting of all options upon change in control of the Bank.  The Bank recognized in 2007 and 2006stock-based compensation of $48 thousand and $61 thousand, respectively.  Income tax benefits related to thatstock-based compensation was $1 thousand and $2 thousand for 2007 and 2006,respectively.

 

Nooptions were granted in 2007 or 2006.

 

A summary of the statusof the Company’s fixed stock option plan as of December 31, 2007 andchanges during the year is presented below:

 
| ** **                        | ** ** | ** ** | ** ** | ** **    | ** ** | **Weighted-**   | ** ** | **Aggregate**     | ** ** |
|-----------------------------------|------------|------------|------------|---------------|------------|-----------------|------------|-------------------|------------|
| ** **                        | ** ** | ** ** | ** ** | **Weighted-** | ** ** | **Average**     | ** ** | **Intrinsic**     | ** ** |
| ** **                        | ** ** | ** ** | ** ** | **Average**   | ** ** | **Remaining**   | ** ** | **Value of** | ** ** |
| ** **                        | ** ** | ** ** | ** ** | **Exercise**  | ** ** | **Contractual** | ** ** | **In-the-Money**  | ** ** |
| ** **                        | ** ** | **Shares** | ** ** | **Price**     | ** ** | **Term**        | ** ** | **Options**       | ** ** |
| Outstanding at  Beginning of Year |       | 126,133    |       | $             | 12.20      |            |       |              |       |   |
| Granted                           |       | —     |       | —        |       |            |       |              |       |
| Exercised                         |       | (45,233    | )          | 10.00         |       |            |       |              |       |
| Forfeited                         |       | —     |       | —        |       |            |       |              |       |
| Outstanding at  End of Year       |       | 80,900     |       | $             | 13.42      |            | 3.3 Years  |              | $          | 424,630 |   |
|                              |       |       |       |          |       |            |       |              |       |
| Options  Exercisable at Year-End  |       | 69,200     |       | $             | 11.38      |            | 2.6 Years  |              | $          | 424,630 |   |

 

Thetotal intrinsic value of options exercised during the years ended December 31,2007 and 2006 were $362,000 and $212,000, respectively.

 

Asof December 31, 2007, the Company has unvested options outstanding withunrecognized compensation expense totaling $84 thousand, which is scheduled tobe recognized as follows (in thousands):

 
| 2008                                  |   | $  | 42     |   |
|---------------------------------------|--------|----|--------|--------|
| 2009                                  |   | 42 |   |
| Total  unrecognized compensation cost |   | $  | 84     |   |

 

 

67

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**NOTE J –DEFINED CONTRIBUTION PLAN**

 

The Company hasadopted a defined contribution plan, the Mission Community Bank 401k ProfitSharing Plan (“the 401k Plan”), covering substantially all employees fulfillingminimum age and service requirements. Matching and discretionary employer contributions to the 401k Plan aredetermined annually by the Board of Directors. The expense for the 401k Plan was approximately $165,000 in 2007 and$116,000 in 2006.

 

**NOTE K -PREFERRED STOCK**

 

Series A –the Series A Preferred Stock has a $5.00 stated value and is non-voting,convertible and redeemable.  Each shareis convertible into one-half share of voting common stock of the Company.  Series A shares are not entitled to anyfixed rate of return, but do participate on the same basis (as if converted ona two-for-one exchange) in any dividends declared on the Company’s commonstock.  Series A shares may beredeemed upon request of the holder at their stated value if the Bank is foundto be in default under any Community Development Financial Institutions ProgramAssistance Agreement for Equity Investments in Regulated Institutions, or anysuccessor agreement.  In the event ofliquidation, the holders of Series A shares will be entitled to aliquidation preference of $5.00 per share before the holders of common stockreceive any distributions and after the holders of common stock receivedistributions of $10.00 per share, all distributions will be on the same basis(as if converted on a one-for-two exchange). These shares were issued for $392,194 (net of issuance costs of$107,806) pursuant to an award from the Community Development Financial InstitutionsFund of the Department of the Treasury.

 

Series B –the Series B Preferred Stock has a $10.00 stated value and is non-voting,non-convertible and non-redeemable.  Series Bshares are not entitled to any fixed rate of return but do participate on thesame basis in any dividends declared on the Company’s common stock. In theevent of liquidation, the holders of Series B shares will be entitled to aliquidation preference of $10.00 per share before the holders of common stockreceive any distributions.  Additionally,in the event of a specified “change in control event” (including certainmergers or sales of assets), holders of the Series B Preferred Stock shallbe entitled to receive payment on the same basis as the holders of the commonstock of the Company.  These shares wereissued for $191,606 (net of issuance costs of $13,394) pursuant to aninvestment from the National Community Investment Fund (“NCIF”).  In connection with this investment, NCIF alsopurchased 29,500 shares of the Company’s common stock for $10.00 pershare.  As part of the investmentagreement, the Company by covenant agreed that so long as NCIF or any successorowns and holds any of the Shares to remain a CDFI and to meet certain reportingrequirements.

 

Series C –the Series C Preferred Stock has $10.00 stated value and is non-voting,convertible and redeemable.  Each shareis convertible into one share of voting common stock of the Company.  Series C shares are not entitled to anyfixed rate of return, but do participate on the same basis (as if converted ona one-to-one exchange) in any dividends declared on the Company’s commonstock.  Series C shares may beredeemed upon request of the holder at their stated value if the Bank is foundto be in default under any Community Development Financial Institutions ProgramAssistance Agreement for Equity Investments in Regulated Institutions, or anysuccessor agreement.  In the event ofliquidation, the holders of Series C shares will be entitled to aliquidation preference of $10.00 per share (as adjusted for any stockdividends, combinations or splits with respect to such shares) before theholders of common stock receive any distributions.  These shares were issued for $500,000pursuant to an award from the Community Development Financial Institutions Fundof the Department of the Treasury.

 

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### **NOTE L - RELATED PARTY TRANSACTIONS**

### ** **

In the ordinarycourse of business, the Bank has granted loans to certain directors and thecompanies with which they are associated. In the Bank’s opinion, all loans and loan commitments to such partiesare made on substantially the same terms, including interest rate andcollateral, as those prevailing at the time for comparable transactions withother persons.

 

Thefollowing is a summary of the activity in these loans:

 
| ** **                            | ** ** | **2007**   | ** ** | **2006** | ** ** |
|---------------------------------------|------------|------------|------------|----------|------------|
|                                  |       |       |       |     |       |
| Balance at the  beginning of the year |       | $          | 2,730,982  |     | $          | 3,348,855 |   |
| New loans and  advances               |       | 1,227,114  |       | 169,142  |       |
| Repayments                            |       | (1,459,196 | )          | (787,015 | )          |
| Balance at the  end of the year       |       | $          | 2,498,900  |     | $          | 2,730,982 |   |

 

Deposits from relatedparties held by the Bank totaled approximately $4,609,000 at December 31,2007, and $3,790,000 at December 31, 2006.

 

During 2003,Bancorp pledged a $250,000 certificate of deposit in an unaffiliated bank ascollateral for borrowings of MCSC.  As ofJanuary 1, 2006, MCSC had drawn $75,000 on its line of credit with theunaffiliated bank, and Bancorp recognized a $75,000 contribution to MCSCrelated to its potential liability for this borrowing.  The line of credit was not in use as of December 31,2006 and, accordingly, no potential liability for the line of credit wasrecognized by Bancorp as of December 31, 2006.  During 2006 Bancorp made cash contributionsto MCSC totaling $163,987.  Of thatamount, $88,987 was recognized as expense and the remaining $75,000 was appliedagainst the $75,000 accrued liability. As of December 31, 2007, MCSC had borrowed $28,000 on the line ofcredit.  No potential liability wasrecognized by Bancorp as of December 31, 2007, because the outstandingbalance on the line is expected to be repaid with funds receivable from theU.S. Small Business Administration under a grant program.  During 2007 Bancorp made cash contributionsto MCSC totaling $36,013.

 

69

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**NOTE M -COMMITMENTS AND CONTINGENCIES**

 

In the normalcourse of business, the Bank enters into financial commitments to meet thefinancing needs of its customers.  Thesefinancial commitments include commitments to extend credit and standby lettersof credit.  Those instruments involve tovarying degrees, elements of credit and interest rate risk not recognized inthe statement of financial position.

 

The Bank’sexposure to credit loss in the event of nonperformance on commitments to extendcredit and standby letters of credit is represented by the contractual amountof those instruments.  The Bank uses thesame credit policies in making commitments as it does for loans reflected inthe financial statements.

 

As of December 31,the Bank had the following outstanding financial commitments whose contractualamount represents credit risk:

 
| ** **                    | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
|                          |       |     |       |     |       |
| Commitments to  Extend Credit |       | $        | 28,608,000 |     | $          | 35,375,000 |   |
| Standby Letters  of Credit    |       | 693,000  |       | 213,000  |       |
|                          |       | $        | 29,301,000 |     | $          | 35,588,000 |   |

 

Commitments toextend credit are agreements to lend to a customer as long as there is noviolation of any condition established in the contract.  Standby letters of credit are conditionalcommitments to guarantee the performance of a Bank customer to a thirdparty.  Since many of the commitments andstandby letters of credit are expected to expire without being drawn upon, thetotal amounts do not necessarily represent future cash requirements.  The Bank evaluates each customer’screditworthiness on a case-by-case basis. The amount of collateral obtained if deemed necessary by the Bank isbased on management’s credit evaluation of the customer.

 

The Bank hasestablished an allowance for possible losses on unfunded loan commitments inthe amount of $55,000, which is included in other liabilities in theconsolidated statements of condition.  Todate, no losses have been charged against this allowance.

 

In the ordinarycourse of business, various claims and lawsuits are brought by and against theCompany and the Bank.  In the opinion ofmanagement, there is no pending or threatened proceeding in which an adversedecision could result in a material adverse change in the consolidatedfinancial condition or results of operations of the Company.

 

70

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**NOTE N -EARNINGS PER SHARE**

 

The following is areconciliation of net income and shares outstanding to the income and number ofshares used in the computation of earnings per share:

 
| ** **                                                              | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                    |       |     |       |     |       |
| Average common  shares outstanding during the year (used for basic EPS) |       | 679,144  |       | 667,810  |       |
| Dilutive effect  of outstanding stock options                           |       | 34,008   |       | 52,891   |       |
| Average common  shares used for diluted EPS                             |       | 713,152  |       | 720,701  |       |
|                                                                    |       |     |       |     |       |
| Net income                                                              |       | $        | 765,294    |     | $          | 869,569 |   |
| Less income  allocated to preferred stock                               |       | (115,214 | )          | (132,874 | )          |
| Income allocated  to common stock                                       |       | $        | 650,080    |     | $          | 736,695 |   |
|                                                                    |       |     |       |     |       |
| Basic earnings  per common share                                        |       | $        | 0.96       |     | $          | 1.10 |   |
| Diluted earnings  per common share                                      |       | 0.91     |       | 1.02     |       |

 

Excluded from thediluted EPS computation for 2007 were options for 19,500 shares (19,563 in2006) because the effect would be antidilutive for those periods.  Those options have an exercise price of$25.50 per share and will expire on March 28, 2015.

 

**NOTE O -REGULATORY MATTERS**

 

The Bank issubject to various regulatory capital requirements administered by the federalbank regulatory agencies.  Failure tomeet minimum capital requirements can initiate certain mandatory, and possiblydiscretionary, actions by regulators that, if undertaken, could have a directmaterial effect on the Bank’s financial statements.  Under capital adequacy guidelines and theregulatory framework for prompt corrective action, the Bank must meet specificcapital guidelines that involve quantitative measures of the Bank’s assets,liabilities, and certain off-balance-sheet items as calculated under regulatoryaccounting practices.  The Bank’s capitalamounts and classification are also subject to qualitative judgments by the regulatorsabout components, risk weightings, and other factors.

 

Quantitativemeasures established by regulation to ensure capital adequacy require the Bankto maintain minimum amounts and ratios (set forth in the table below) of Totaland Tier 1 capital (as defined in the regulations) to risk-weighted assets (asdefined), and of Tier 1 capital (as defined) to average assets (asdefined).  Management believes, as of December 31,2007, that the Bank meets all capital adequacy requirements to which it issubject.

 

71

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As of December 31,2007, the most recent notification from the Federal Reserve Board categorizedthe Bank as well-capitalized under the regulatory framework for promptcorrective action.  There are noconditions or events since that notification that management believes havechanged the Bank’s category.  To becategorized as well-capitalized, the Bank must maintain minimum ratios as setforth in the table below.  The followingtable also sets forth the Bank’s actual capital amounts and ratios (dollaramounts in thousands):

 
| ** **                                | ** ** | ** ** | ** ** | ** **           | ** ** | **Amount of Capital Required** | ** ** |
|-------------------------------------------|------------|------------|------------|----------------------|------------|-----------------------------------------------|------------|
| ** **                                | ** ** | ** ** | ** ** | ** **           | ** ** | **To Be**                                | ** ** | **To Be Adequately** | ** ** |
| ** **                                | ** ** | **Actual** | ** ** | **Well-Capitalized** | ** ** | **Capitalized**                               | ** ** |
| ** **                                | ** ** | **Amount** | ** ** | **Ratio**            | ** ** | **Amount**                                    | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| **As of  December 31, 2007:**             |       |       |       |                 |       |                                          |       |   |   |   |   |   |   |
| Total Capital  (to Risk-Weighted Assets)  |       | $          | 16,324     |                 | 11.74      | %                                             | $          | 13,899 |   | 10.0 | % | $ | 11,119 |   | 8.0 | % |
| Tier 1 Capital  (to Risk-Weighted Assets) |       | $          | 15,119     |                 | 10.88      | %                                             | $          | 8,340 |   | 6.0 | % | $ | 5,560 |   | 4.0 | % |
| Tier 1 Capital  (to Average Assets)       |       | $          | 15,119     |                 | 9.47       | %                                             | $          | 7,979 |   | 5.0 | % | $ | 6,383 |   | 4.0 | % |
|                                      |       |       |       |                 |       |                                          |       |   |   |   |   |   |   |
| **As of  December 31, 2006:**             |       |       |       |                 |       |                                          |       |   |   |   |   |   |   |
| Total Capital  (to Risk-Weighted Assets)  |       | $          | 15,390     |                 | 11.35      | %                                             | $          | 13,564 |   | 10.0 | % | $ | 10,851 |   | 8.0 | % |
| Tier 1 Capital  (to Risk-Weighted Assets) |       | $          | 14,309     |                 | 10.55      | %                                             | $          | 8,139 |   | 6.0 | % | $ | 5,426 |   | 4.0 | % |
| Tier 1 Capital  (to Average Assets)       |       | $          | 14,309     |                 | 9.34       | %                                             | $          | 7,657 |   | 5.0 | % | $ | 6,126 |   | 4.0 | % |

 

The Company is notsubject to similar regulatory capital requirements because its consolidatedassets do not exceed $500 million, the minimum asset size criteria for bankholding companies subject to those requirements.

 

Bankingregulations limit the amount of cash dividends that may be paid without priorapproval of the Bank’s primary regulatory agency.  Cash dividends are limited by the CaliforniaFinancial Code to the lesser of the Bank’s retained earnings or its net incomefor the last three fiscal years, net of the amount of any dividends or othercapital distributions made during those periods.  As of December 31, 2007, $2,654,000 wasavailable for cash dividend distributions from the Bank to Bancorp withoutprior regulatory approval.  However,dividend distributions from the Bank in excess of $2,425,000 would change theBank’s prompt corrective action status from well-capitalized toadequately-capitalized.

 

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### ** **

**NOTE P - GRANTS AND AWARDS**

### ** **

During 2005 theCompany received a $135,000 technical assistance grant from the CommunityDevelopment Financial Institutions Fund. During 2006 the Bank incurred approximately $100,000 of qualifyingexpenses under the grant.  Accordingly,the Bank recognized $100,000 of this grant as non-interest income in 2006.  An additional $13 thousand of qualifyingexpenditures was incurred in the first quarter of 2007, and another $20thousand in the fourth quarter of 2007. Therefore, the Bank recognized $33 thousand of non-interest incomerelated to this grant in 2007.

 

In 2007 the Bankreceived notification from the Bank Enterprise Award program of the Departmentof the Treasury that it was awarded a grant of up to $337,500 under that program,based on lending activity the bank commenced in 2006.  The first installment of that grant, $240thousand, was recognized in non-interest income in the third quarter of2007.  Most of the remaining portion ofthe award—$86 thousand—was recognized in the fourth quarter of 2007.  The remaining $12 thousand of the award iscontingent upon future disbursements, which may or may not occur, under thelending facility that was the basis for the award.

 

Although the Bankis a certified CDFI bank and expects to continue to apply for various grantsand awards, there can be no assurance that it will receive similar futuregrants or awards.

 

**NOTE Q -MISSION COMMUNITY BANCORP (Parent Company Only)**

 

On December 15,2000, Mission Community Bancorp acquired Mission Community Bank by issuing600,566 shares of common stock in exchange for all outstanding shares of theBank’s common stock.  There was no cashinvolved in this transaction.

 

Following are theseparate financial statements for Mission Community Bancorp (parent companyonly):

 

**Mission Community Bancorp (Parent Company Only)**

** **

**CONDENSED BALANCE SHEETS**

 
| ** **                                    | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|-----------------------------------------------|------------|------------|------------|------------|------------|
| **ASSETS**                                    |       |       |       |       |       |
| Cash                                          |       | $          | 59,065     |       | $          | 383,135 |   |
| Deposits in other banks                       |       | 250,000    |       | 250,000    |       |
| Investment in subsidiary bank                 |       | 15,252,121 |       | 14,270,445 |       |
| Other assets                                  |       | 866,559    |       | 545,262    |       |
| **TOTAL ASSETS**                              |       | $          | 16,427,745 |       | $          | 15,448,842 |   |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY** |       |       |       |       |       |
| Junior subordinated debentures                |       | $          | 3,093,000  |       | $          | 3,093,000 |   |
| Due to Mission Community Bank                 |       | 131,685    |       | 113,685    |       |
| Other liabilities                             |       | 64,756     |       | 89,056     |       |
| **TOTAL LIABILITIES**                         |       | 3,289,441  |       | 3,295,741  |       |
| **TOTAL SHAREHOLDERS’ EQUITY**           |       | 13,138,304 |       | 12,153,101 |       |
|                                          |       | $          | 16,427,745 |       | $          | 15,448,842 |   |

 

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**CONDENSED STATEMENTS OF INCOME**

 
| ** **                                                        | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Interest income                                                   |       | $        | 11,750     |     | $          | 10,019 |   |
| Interest expense                                                  |       | 276,864  |       | 270,942  |       |
| Net interest (expense)                                            |       | (265,114 | )          | (260,923 | )          |
| Dividends received from subsidiary                                |       | 300,283  |       | 300,283  |       |
| Less contributions to Mission Community Services Corp.            |       | 36,013   |       | 88,987   |       |
| Less other expenses                                               |       | 210,756  |       | 73,480   |       |
| Loss before taxes                                                 |       | (211,600 | )          | (123,107 | )          |
| Income taxes expense (benefit)                                    |       | (209,872 | )          | (173,590 | )          |
| Income (loss) before equity in undistributed income of subsidiary |       | (1,728   | )          | 50,483   |       |
| Equity in undistributed income of subsidiary                      |       | 767,022  |       | 819,086  |       |
| Net income                                                        |       | $        | 765,294    |     | $          | 869,569 |   |

 

**CONDENSED STATEMENTS CASH FLOWS**

 
| ** **                                                                     | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|--------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **Operating activities:**                                                      |       |       |       |       |       |
| Net income                                                                     |       | $          | 765,294    |       | $          | 869,569 |   |
| Adjustments to reconcile net income to net cash used by operating  activities: |       |       |       |       |       |
| Income of subsidiary                                                           |       | (1,067,305 | )          | (1,119,369 | )          |
| Amortization expense                                                           |       | 17,232     |       | 17,232     |       |
| Other, net                                                                     |       | (344,829   | )          | (188,451   | )          |
| Net cash used by operating activities                                          |       | (629,608   | )          | (421,019   | )          |
| **Investing activities:**                                                      |       |       |       |       |       |
| Dividends received from subsidiary                                             |       | 300,283    |       | 300,283    |       |
| Net cash provided by investing activities                                      |       | 300,283    |       | 300,283    |       |
| **Financing activities:**                                                      |       |       |       |       |       |
| Proceeds from issuance of common stock                                         |       | 561,171    |       | 202,562    |       |
| Common stock repurchased                                                       |       | (459,228   | )          | —     |       |
| Cash dividends paid                                                            |       | (96,688    | )          | (94,908    | )          |
| Net cash provided by financing activities                                      |       | 5,255      |       | 107,654    |       |
| Net decrease in cash                                                           |       | (324,070   | )          | (13,082    | )          |
| Cash at beginning of year                                                      |       | 383,135    |       | 396,217    |       |
| Cash at end of year                                                            |       | $          | 59,065     |       | $          | 383,135 |   |

 

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**NOTE R -FAIR VALUE OF FINANCIAL INSTRUMENTS**

 

The fair value ofa financial instrument is the amount at which the asset or obligation could beexchanged in a current transaction between willing parties, other than in aforced or liquidation sale.  Fair valueestimates are made at a specific point in time based on relevant marketinformation and information about the financial instrument.  These estimates do not reflect any premium ordiscount that could result from offering for sale at one time the entireholdings of a particular financial instrument. Because no market value exists for a significant portion of thefinancial instruments, fair value estimates are based on judgments regardingfuture expected loss experience, current economic conditions, riskcharacteristics of various financial instruments, and other factors.  These estimates are subjective in nature,involve uncertainties and matters of judgment and, therefore, cannot bedetermined with precision.  Changes inassumptions could significantly affect the estimates.

 

Fair valueestimates are based on financial instruments both on and off the balance sheetwithout attempting to estimate the value of anticipated future business and thevalue of assets and liabilities that are not considered financialinstruments.  Additionally, taxconsequences related to the realization of the unrealized gains and losses canhave a potential effect on fair value estimates and have not been considered inmany of the estimates.

 

The followingmethods and assumptions were used to estimate the fair value of significantfinancial instruments:

 

## **FinancialAssets**

## ** **

The carrying amounts of cash and short-term investments are consideredto approximate fair value.  Short-terminvestments include federal funds sold and interest bearing deposits withBanks.  The fair values of investmentsecurities, including available-for-sale, are generally based on quoted marketprices.  The fair value of loans areestimated using a combination of techniques, including discounting estimatedfuture cash flows and quoted market prices of similar instruments, whereavailable.

 

## **FinancialLiabilities**

## ** **

The carryingamounts of deposit liabilities payable on demand and short-term borrowed fundsare considered to approximate fair value. For fixed maturity deposits, fair value is estimated by discountingestimated future cash flows using currently offered rates for deposits ofsimilar remaining maturities.  The fairvalue of long-term debt is based on rates currently available to the Bank fordebt with similar terms and remaining maturities.

 

## **Off-BalanceSheet Financial Instruments**

## ** **

The fair value ofcommitments to extend credit and standby letters of credit is estimated usingthe fees currently charged to enter into similar agreements.  The fair value of these financial instrumentsis not material.

 

75

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** **

The estimated fair value of financial instruments issummarized as follows:

 
| ** **                               | ** ** | **December 31,** | ** ** |
|------------------------------------------|------------|-----------------------|------------|
| ** **                               | ** ** | **2007**              | ** ** | **2006** | ** ** |
| ** **                               | ** ** | **Carrying  Value**   | ** ** | **Fair  Value** | ** ** | **Carrying  Value** | ** ** | **Fair  Value** | ** ** |
| **Financial Assets:**                    |       |                  |       |   |   |   |   |   |   |
| Cash and due from banks                  |       | $                     | 2,212,000  |   | $ | 2,212,000 |   | $ | 3,045,000 |   | $ | 3,045,000 |   |
| Federal funds sold                       |       | 3,315,000             |       | 3,315,000 |   | 7,070,000 |   | 7,070,000 |   |
| Interest-bearing deposits in other banks |       | 550,000               |       | 550,000 |   | 550,000 |   | 550,000 |   |
| Investment securities                    |       | 17,124,000            |       | 17,124,000 |   | 16,416,000 |   | 16,416,000 |   |
| Loans, net                               |       | 125,279,000           |       | 128,412,000 |   | 121,773,000 |   | 121,837,000 |   |
| Federal Home Loan Bank and other stocks  |       | 2,021,000             |       | 2,021,000 |   | 1,311,000 |   | 1,311,000 |   |
| Accrued interest receivable              |       | 747,000               |       | 747,000 |   | 841,000 |   | 841,000 |   |
|                                     |       |                  |       |   |   |   |   |   |   |
| **Financial Liabilities:**               |       |                  |       |   |   |   |   |   |   |
| Deposits                                 |       | 112,433,000           |       | 112,448,000 |   | 124,281,000 |   | 124,224,000 |   |
| Other borrowings                         |       | 28,200,000            |       | 28,514,000 |   | 17,400,000 |   | 17,175,000 |   |
| Junior subordinated debt securities      |       | 3,093,000             |       | 3,212,000 |   | 3,093,000 |   | 3,537,000 |   |
| Accrued interest and other liabilities   |       | 1,465,000             |       | 1,465,000 |   | 1,242,000 |   | 1,242,000 |   |
|                                          |            |                       |            |  |  |  |  |  |  |  |  |  |  |

 

**NOTE S -SUBSEQUENT EVENT**

** **

On February 15, 2008, Bancorp closed a secondary stock offering with atotal of 410,644 new common shares being issued for gross cash proceeds of$7,391,592. The company incurred approximately $600,000 in offering expenses,which will be deducted from the gross proceeds.

 

76

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**Item 8.  Changes In and Disagreements With Accountantson Accounting and Financial Disclosure**

 

There have been nochanges in or disagreements with the Company’s accountants.

 

**Item8A.  Controls and Procedures**

 

Our Chief Executive Officerand our Chief Financial Officer carried out an evaluation as of December 31,2007, of the effectiveness of the design and operation of our disclosurecontrols and procedures as defined in Exchange Act Rule 15a-15.  Based upon that evaluation, the ChiefExecutive Officer and the Chief Financial Officer concluded that currentdisclosure controls and procedures are effective in timely alerting them tomaterial information relating to the Company and/or Bank that is required to beincluded in our periodic filings with the Securities and Exchange Commissionand also with bank or bank holding company regulatory agencies.

 

There were no significantchanges in the Company’s internal controls or in other factors that couldsignificantly affect the Company’s internal controls over financial reportingin the fourth quarter of 2007.

 

However, the Bank did engagea firm to perform a specific internal assessment of the Bank’s informationtechnology and information security systems for a three-year period beginningin 2006.  It has made minor staffingchanges to improve internal controls based on recommendations made during theinternal auditing process.

 

**Management’sAnnual Report on Internal Control Over Financial Reporting**

 

*Thefollowing section of this Annual Report on Form 10-KSB will not be deemedincorporated by reference by any general statement incorporating by referencethis Annual Report on Form 10-KSB into any filing under the Securities Actof 1933 or under the Securities Exchange Act of 1934, except to the extent thatwe specifically incorporate this information by reference, and will nototherwise be deemed filed under these Acts.*

 

Management is responsiblefor establishing and maintaining adequate internal control over financialreporting for the Company and the Bank, including periodic filings with theSecurities Exchange Commission, the Federal Deposit Insurance Corporation (“FDIC”),the Federal Reserve Bank of San Francisco (“FRBSF”) and the CaliforniaDepartment of Financial Institutions (“DFI”). Such periodic financial reports are prepared internally and reviewed bymanagement prior to filing.  Thesefinancial reports are also reviewed for timely filing, completeness andaccuracy with possible civil monetary penalties for late filing and intentionalinaccurate reporting by the various agencies where the reports are filed.

 

The Company’s internalcontrol over financial reporting is a process designed under the supervision ofthe Company’s management, including its Chief Executive Officer and its ChiefFinancial Officer, to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of the Company’s financial statementsfor external reporting purposes in accordance with accounting principles thatare generally accepted in the United States of America.

 

The Company’s internal control over financial reporting includespolicies and procedures that pertain to the maintenance of records which, inreasonable detail, accurately and fairly reflect transactions and dispositionsof assets; provide reasonable assurance that transactions are recorded asnecessary to permit preparation of financial statements in accordance withgenerally accepted accounting principles, and that receipts and expendituresare being made only in accordance with authorizations of management and thedirectors of the Company; and provide reasonable assurance regarding preventionor timely detection of unauthorized acquisition, use or disposition of theCompany’s assets that could have a material effect on the Company’s financialstatements.

 

Management recognizes thatthere are inherent limitations in the effectiveness of any system of internalcontrol and, accordingly, even effective internal control can provide onlyreasonable assurance with respect to financial statement preparation and fairpresentation. Further, because of changes in conditions, the effectiveness ofinternal control may vary over time.

 

Under the supervision andwith the participation of the Company’s management, including the Company’sChief Executive Officer and Chief Financial Officer, the Company conducted anassessment of the effectiveness of the Company’s internal control overfinancial reporting based on the framework established in InternalControl-Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission and interpretive guidance provided bythe Securities and Exchange Commission. Based on this assessment, management has determined that the Company’sinternal control 

 

77

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over financial reporting asof December 31, 2007 is effective.

 

Internal controls overthe Bank’s operational, lending procedures and underwriting, financial systemsand other systems are reviewed by internal auditors, holding company and/orbank examiners, and by registered public accountants.  At present, Bancorp, based on its asset sizeand lack of activity other than banking, is not independently examined by theFRB.

 

Bancorp and the Bank haveelected to outsource the internal audit function to firms who specialize inperforming such auditing functions for community banks.  Internal audit engagements are in writing,including the anticipated scope, and are generally for 18 to 24 months withinterim auditing during the term of the engagement.  Engagements are presented to and approved bythe Board’s Audit Committee.  Each of theinternal audits, along with management’s response to any observations, iscompleted in writing and presented to the Audit Committee.  Management is then responsible to take anycorrective action required to modify procedures or policies to improve internalcontrols and procedures. Based on internal audits performed in 2006 and 2007,neither management nor the Audit Committee has been informed of any materialweaknesses in internal controls over financial reporting.

 

Internal controls, lending,and financial reporting are also periodically reviewed by bank and bank holdingcompany examiners.  As a state chartedbank, the Bank is examined by the FRBSF and the DFI.  Written reports of examination by state orfederal regulators are provided to the Bank, reviewed by management and by theBoard’s Audit Committee.  If anexamination revealed material issues, the Bank could be subject to regulatory actionincluding formal or informal agreements to take corrective action.  Bank examination reports are confidential,and the results are not disclosed unless there are material exceptions noted.  In the event of material exceptions, a bankcould be required to enter into a formal agreement (such as a Memorandum ofUnderstanding or Cease and Desist Order) which would document the specificweaknesses and corrective action that must be taken.  These formal agreements are generallyrequired to be disclosed to the public. As of December 2007, the Bank is not operating under any formal orinformal agreement with the FRB or DFI nor is any such agreement pending oranticipated.

 

Finally, internal controlsand financial reporting is reviewed by independent registered publicaccountants on an annual basis.  Theseaudited reports, including any recommendations for improvements in accountingor internal controls, are presented to management and the Board’s AuditCommittee.  As of December 31, 2007,the Company’s independent registered public accountants have certified theaudited financial statements of the Company, with no material weaknessesidentified in internal controls or financial reporting.  This Annual Report on Form 10-K does notinclude an attestation report of our registered public accounting firmregarding internal control over financial reporting.  Management’s report was not subject toattestation by our registered pubic accounting firm pursuant to temporary rules ofthe Securities and Exchange Commission that permit us to provide onlymanagement’s report in this Annual Report on Form 10-K.

 

**Item8B.  Other Information**

 

None.

 

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# ** **

# **PART III**

# ** **

**Item9.  Directors, Executive Officers,Promoters, Control Persons and Corporate Governance; Compliance With Section 16(a) ofthe Exchange Act.**

 

Information for this itemis incorporated by reference to the Company’s proxy statement for the annualmeeting of shareholders to be held May 28, 2008.

 

**Section 16(a) BeneficialOwnership Reporting Compliance**

 

The Company does not have a class of equitysecurities registered pursuant to Section 12 of the Securities ExchangeAct of 1934 (the “Exchange Act”). Therefore, the Company’s officers and directors, and persons who ownmore than 10% of the Company’s Common Stock, are not subject to the reportingrequirements under Section 16(a) of the Exchange Act.

 

**Item 10.  Executive Compensation**

 

The information for thisitem is incorporated by reference to the Company’s proxy statement for theannual meeting of shareholders to be held May 28, 2008.

 

**Item 11.****    SecurityOwnership of Certain Beneficial Owners and Management and Related ShareholderMatters**

 

The information required by Item 11 with respect tosecurities authorized for issuance under equity compensation plans is set forthunder “Item 5—Market for Common Equity, Related Shareholder Matters and IssuerPurchases of Equity Securities,” above. The other information for this item is incorporated by reference to theCompany’s proxy statement for the annual meeting of shareholders to be held May 28,2008.

 

**Item12.  Certain Relationships and RelatedTransactions, and Director Independence**

 

The information for thisitem is incorporated by reference to the Company’s proxy statement for the annualmeeting of shareholders to be held May 28, 2008.

 

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## ** **

## **Item 13.  Exhibits**

## ** **

**Exhibit Index:**

 
| **Exhibit #** |   |                                                                                                                                                                                                                                                           | **Page** |
|--------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|----------|
| 2.1                |   | Plan  of Reorganization and Agreement of Merger dated as of October 4, 2000  (A)                                                                                                                                                                          |     |
| 3.1                |   | Restated  Articles of Incorporation (I)                                                                                                                                                                                                                        |     |
| 3.2                |   | Certificate  of Amendment to Articles of Incorporation (L)                                                                                                                                                                                                     |     |
| 3.3                |   | Bylaws  (B)                                                                                                                                                                                                                                                    |     |
| 4.1                |   | Certificate  of Determination for Series A Non-Voting Preferred Stock (B)                                                                                                                                                                                 |     |
| 4.2                |   | Certificate  of Determination for Series B Non-Voting Preferred Stock (B)                                                                                                                                                                                 |     |
| 4.3                |   | Certificate  of Determination for Series C Non-Voting Preferred Stock (D)                                                                                                                                                                                 |     |
| 4.4                |   | Purchase  Agreement dated October 10, 2003, by and among Registrant, Mission  Community Capital Trust I, and Bear Stearns & Co., Inc. (E)                                                                                                   |     |
| 4.5                |   | Indenture  dated as of October 14, 2003 by and between Registrant and Wells Fargo  Bank, National Association, as trustee (E)                                                                                                                             |     |
| 4.6                |   | Declaration  of Trust Mission Community Capital Trust I dated October 10, 2003 (E)                                                                                                                                                                        |     |
| 4.7                |   | Amended  and Restated Declaration of Trust of Mission Community Capital Trust I dated  October 14, 2003 by and among the Registrant, Wells Fargo Delaware Trust  Company, as Trustee, and Anita M. Robinson and William C. Demmin, as  Administrators (E) |     |
| 4.8                |   | Guarantee  Agreement dated October 14, 2003 between Registrant, as Guarantor, and  Wells Fargo Bank, National Association, as Guarantee Trustee (E)                                                                                                       |     |
| 4.9                |   | Fee  Agreement dated October 14, 2003 by and among the Registrant, Wells  Fargo Delaware Trust Co., Bear Stearns & Co., Inc. and Mission  Community Capital Trust I (E)                                                                     |     |
| 10.1               |   | Purchase  and Sale Agreement and Lease dated January, 1997, as amended (B)                                                                                                                                                                                     |     |
| 10.2               |   | Intentionally  omitted                                                                                                                                                                                                                                         |     |
| 10.3               |   | Lease  Agreement – Paso Robles (B)                                                                                                                                                                                                                        |     |
| 10.4               |   | Lease  Agreement – San Luis Obispo (B)                                                                                                                                                                                                                    |     |
| 10.5               |   | Lease  Agreement – Arroyo Grande (B)                                                                                                                                                                                                                      |     |
| 10.6               |   | 1998  Stock Option Plan, as amended (B)                                                                                                                                                                                                                        |     |
| 10.7               |   | Lease  Agreement – 569 Higuera, San Luis Obispo (D)                                                                                                                                                                                                       |     |
| 10.8               |   | Lease  Agreement – 671 Tefft Street, Nipomo (C)                                                                                                                                                                                                           |     |
| 10.9               |   | Intentionally  omitted                                                                                                                                                                                                                                         |     |
| 10.10              |   | Lease  Agreement – 3480 S. Higuera, San Luis Obispo (F)                                                                                                                                                                                                   |     |
| 10.11              |   | Salary  Protection Agreement — Mr. Pigeon (G)                                                                                                                                                                                                        |     |
| 10.12              |   | Salary  Protection Agreement — Mr. Judge (H)                                                                                                                                                                                                         |     |
| 10.13              |   | Second  Amended and Restated Employment Agreement dated August 28, 2006 between  Anita M. Robinson and Mission Community Bank (J)                                                                                                                         |     |
| 10.14              |   | Employment  Agreement dated June 3, 2007 between Brooks Wise and Mission Community  Bank(J)                                                                                                                                                               |     |
| 10.15              |   | Financial  Advisory Services Agreement dated January 4, 2007 between the Company  and Seapower Carpenter Capital, Inc. (K)                                                                                                                           |     |
| 10.16              |   | Common  Stock Repurchase Agreement dated August 10, 2007 between Fannie Mae and  the Company (M)                                                                                                                                                          |     |
| 10.17              |   | Build-to-Suit  Lease Agreement between Walter Bros. Construction Co., Inc. and Mission  Community Bank for property at South Higuera Street and Prado Road in San  Luis Obispo, California (N)                                                            |     |
| 10.18              |   | Lease  Agreement – 1670 South Broadway, Santa Maria                                                                                                                                                                                                       |     |

 

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| **Exhibit #** |   |                                                                                                                                       | **Page** |
|--------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------|----------|
| 14                 |   | Code of Ethics                                                                                                                             |     |
| 21                 |   | Subsidiaries of the  registrant                                                                                                            |     |
| 23.1               |   | Consent of Independent  Registered Public Accounting Firm                                                                                  |     |
| 31.1               |   | Certification of CEO  pursuant to Section 302 of Sarbanes Oxley Act                                                                   |     |
| 31.2               |   | Certification of CFO  pursuant to Section 302 of Sarbanes Oxley Act                                                                   |     |
| 32.1               |   | Certification of CEO  pursuant to Section 906 of Sarbanes Oxley Act                                                                   |     |
| 32.2               |   | Certification of CFO  pursuant to Section 906 of Sarbanes Oxley Act                                                                   |     |
|               | (A)    | Included in the Company’s Form 8-K filed on December 18, 2000                                                               |     |
|               | (B)    | Included in the Company’s Form 10-KSB filed on April 2, 2001                                                                |     |
|               | (C)    | Included in the Company’s Form 10-QSB filed August 12, 2002                                                                 |     |
|               | (D)    | Included in the Company’s Form 10-QSB filed on November 12, 2002                                                            |     |
|               | (E)    | Included in the Company’s Form 8-K filed on October 21, 2003                                                                |     |
|               | (F)    | Included in the Company’s Form 10-QSB filed on August 10, 2004                                                              |     |
|               | (G)    | Included in the Company’s Form 8-K filed on January 19, 2005                                                                |     |
|               | (H)    | Included in the Company’s Form 8-K filed on February 17, 2005                                                               |     |
|               | (I)    | Included in the Company’s Form 10-QSB filed on August 14, 2006                                                              |     |
|               | (J)    | Included in the Company’s Form 8-K filed on June 13, 2007                                                                   |     |
|               | (K)    | Included in the Company’s Form SB-2 Registration Statement filed on June 13, 2007                                           |     |
|               | (L)    | Included in the Company’s Pre-Effective Amendment No. 1 to the Form SB-2 Registration Statement filed on July 24, 2007 |     |
|               | (M)    | Included in the Company’s Form 8-K filed on August 14, 2007                                                                 |     |
|               | (N)    | Included  in the Company’s Form 8-K filed on October 23, 2007                                                               |     |
|                    |        |                                                                                                                                            |          |  |  |

 

**Item 14. Principal Accountant Fees and Services**

 

The information for thisitem is incorporated by reference to the Company’s proxy statement for theannual meeting of shareholders to be held May 28, 2008.

 

**SUPPLEMENTALINFORMATION TO BE FURNISHED WITH REPORTS FILED PURSUANT TO SECTION 15(d) OFTHE ACT BY REGISTRANTS WHICH HAVE NOT REGISTERED SECURITIES PURSUANT TO SECTION 12OF THE ACT**

 

As of the date of thefiling of this report, neither the Company’s proxy materials nor annual reportto shareholders has been sent to the Company’s shareholders.  The Company will furnish copies of theCompany’s proxy materials and annual report to shareholders to the Commissionon or prior to the time it is sent to the Company’s shareholders.

 

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**Signatures**

 

Pursuant to the requirements of Section 13 of the SecuritiesExchange Act of 1934, the Company has duly caused this report to be signed onits behalf by the undersigned thereunto duly authorized.

 

**MISSION COMMUNITY BANCORP**

 

 
| By: /s/                               | Anita M. Robinson |   |
|---------------------------------------|-------------------|--------|
| ANITA M. ROBINSON                     |
| President and Chief Executive Officer |
| Dated:  March 27, 2008 |

 
| By: /s/                                              | Ronald B. Pigeon |   |
|------------------------------------------------------|------------------|--------|
| RONALD B. PIGEON                                     |
| Executive Vice President and Chief Financial Officer |
| Dated:  March 27, 2008                |

 

[Signatures continue onnext page]

 

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

 

 
| /s/ Bruce M. Breault  |   | Director                                 | March 27, 2008 |
|-----------------------|--------|------------------------------------------|---------------------|
| BRUCE M. BREAULT      |   |                                     |                |
|                  |   |                                     |                |
|                  |   |                                     |                |
|                  |   | Vice Chairman of the Board               |                |
| ROXANNE M. CARR       |   |                                     |                |
|                  |   |                                     |                |
| /s/ William B. Coy    |   | Chairman of the Board                    | March 27, 2008 |
| WILLIAM B. COY        |   |                                     |                |
|                  |   |                                     |                |
| /s/ Richard Korsgaard |   | Director                                 | March 27, 2008 |
| RICHARD KORSGAARD     |   |                                     |                |
|                  |   |                                     |                |
|                  |   | Executive Vice President and Chief       | March 27, 2008 |
| /s/ Ronald B. Pigeon  |   | Financial Officer                        |                |
| RONALD B. PIGEON      |   | (Principal Accounting Officer)           |                |
|                  |   |                                     |                |
| /s/ Anita M. Robinson |   | Director,  President and Chief Executive | March 27, 2008 |
| ANITA M. ROBINSON     |   | Officer (Principal  Executive Officer)   |                |
|                  |   |                                     |                |
|                  |   | Director                                 |                |
| ROBIN L. ROSSI        |   |                                     |                |
|                  |   |                                     |                |
| /s/ Gary E. Stemper   |   | Director                                 | March 27, 2008 |
| GARY E. STEMPER       |   |                                     |                |
|                  |   |                                     |                |
| /s/ Brooks W. Wise    |   | Director                                 | March 27, 2008 |
| BROOKS W. WISE        |   |                                     |                |
|                  |   |                                     |                |
| /s/ Karl F. Wittstrom |   | Director                                 | March 27, 2008 |
| KARL F. WITTSTROM     |   |                                     |                |

 

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