**FORM 10-Q**

 

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 
| **ý** | **Quarterly Report Under Section 13 or 15(d) of  the Securities Exchange Act of 1934**                                                                                                                                         |
|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** **                                                                                                                                                                                                                     |
| ** ** | **for the Quarterly Period Ended September 30,  2004**                                                                                                                                                                         |
| ** ** | ** **                                                                                                                                                                                                                     |
| **or**     |
| ** ** | ** **                                                                                                                                                                                                                     |
| **o**      | **Transition Report pursuant to Section 13 or  15(d) of the Securities Exchange Act of 1934**                                                                                                                                  |
| ** ** | ** **                                                                                                                                                                                                                     |
| ** ** | **for the Transition Period from                   to                 ** |
| ** ** | ** **                                                                                                                                                                                                                     |
| ** ** | **Commission File Number: 0-27384**                                                                                                                                                                                            |

 

**CAPITALCORP OF THE WEST**

(Exact name ofregistrant as specified in its charter)

 
| **California**                                                   | ** ** | **77-0405791**          |
|------------------------------------------------------------------|------------|-------------------------|
| (State or other  jurisdiction of  incorporation or organization) |       | IRS Employer ID  Number |

 

**550 WestMain, Merced, CA 95340**

(Address ofprincipal executive offices)

 

Registrant’s telephone number, including areacode:   **(209)725-2200**

 

Former name, former address and former fiscal year, ifchanged since last report:  **Not applicable**

 

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d)of the Securities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past 90 days.

Yes  ý  No  o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Exchange Act).  Yes  ý  No  o

 

The number of shares outstanding of the registrant’scommon stock, no par value, as of September 30, 2004 was 5,772,325.  No shares of preferred stock, no par value,were outstanding at September 30, 2004.

 

 

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**CapitalCorp of the West**

Table of Contents

 
| PART I. — FINANCIAL INFORMATION | ** **                                                                                   |
|--------------------------------------|----------------------------------------------------------------------------------------------|
|                                 |                                                                                         | ** ** |
|                                 |                                                                                         | ** ** |
| Item  1.                             |  Financial Statements                                                                   | ** ** |
|                                 | Consolidated  Balance Sheets (unaudited)                                                     |   |
|                                 | Consolidated Statements of  Income and Comprehensive Income (unaudited)                      |   |
|                                 | Consolidated  Statement of Changes in Stockholders’ Equity (unaudited)                  |   |
|                                 | Consolidated Statements  of Cash Flows (unaudited)                                           |   |
|                                 | Notes  to the Consolidated Financial Statements (unaudited)                                  |   |
|                                 |                                                                                         |   |
| Item  2.                             | Management’s Discussion and  Analysis of Financial Condition and  Results of Operations |   |
|                                 |                                                                                         |   |
| Item 3.                              | Quantitative and  Qualitative Disclosures about Market Risk                                  |   |
| Item 4.                              | Controls and  Procedures                                                                     |   |
|                                 |                                                                                         |
| PART  II. — OTHER INFORMATION   |                                                                                         |
|                                 |                                                                                         |   |
| Item 1.                              | Legal Proceedings                                                                            |   |
| Item 2.                              | Changes in Securities and Use of Proceeds                                                    |   |
| Item 3.                              | Defaults Upon Senior Securities                                                              |   |
| Item 4.                              | Submission of Matters to a Vote  of Security Holders                                         |   |
| Item 5.                              | Other Information                                                                            |   |
| Item 6.                              | Exhibits                                                                                     |   |
|                                 |                                                                                         |   |
| SIGNATURES                           | ** **                                                                                   |
|                                 |                                                                                         |   |
| Exhibit Index                        |                                                                                         |
|                                      |                                                                                              |  |  |  |

 

2

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Capital Corp ofthe West

Consolidated Balance Sheets

 
| ** **                                                                                                                                               | ** ** | **(Unaudited)  September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------|------------|
| ** **                                                                                                                                               | ** ** | **(Dollars in thousands)**           | ** ** |
| **Assets**                                                                                                                                               | ** ** | ** **                           | ** ** | ** **             | ** ** |
| Cash and noninterest-bearing deposits in  other banks                                                                                                    |       | $                                    | 43,894     |                   | $          | 44,292 |   |
| Federal funds sold                                                                                                                                       |       | 3,910                                |       | 1,190                  |       |
| Time deposits at other financial  institutions                                                                                                           |       | 350                                  |       | 350                    |       |
| Investment securities available for sale,  at fair value                                                                                                 |       | 267,031                              |       | 275,403                |       |
| Investment securities held to maturity at  cost, fair value of $120,893 and $97,295 at September 30, 2004 and December  31, 2003                         |       | 120,191                              |       | 96,612                 |       |
| Loans, net of allowance for loan losses of  $14,361 and $13,263 at September 30, 2004 and December 31, 2003                                              |       | 843,619                              |       | 750,989                |       |
| Interest receivable                                                                                                                                      |       | 5,530                                |       | 6,045                  |       |
| Premises and equipment, net                                                                                                                              |       | 20,040                               |       | 16,557                 |       |
| Goodwill                                                                                                                                                 |       | 1,925                                |       | 1,925                  |       |
| Other intangibles                                                                                                                                        |       | 224                                  |       | 724                    |       |
| Cash value of life insurance                                                                                                                             |       | 28,063                               |       | 24,138                 |       |
| Investment in housing tax credit limited  partnerships                                                                                                   |       | 8,763                                |       | 8,717                  |       |
| Other assets                                                                                                                                             |       | 7,856                                |       | 7,600                  |       |
|                                                                                                                                                     |       |                                 |       |                   |       |
| Total assets                                                                                                                                             |       | $                                    | 1,351,396  |                   | $          | 1,234,542 |   |
|                                                                                                                                                     |       |                                 |       |                   |       |
| **Liabilities  and Shareholders’ Equity**                                                                                                           |       |                                 |       |                   |       |
| Deposits                                                                                                                                                 |       |                                 |       |                   |       |
| Noninterest-bearing demand                                                                                                                               |       | $                                    | 234,578    |                   | $          | 206,709 |   |
| Negotiable orders of withdrawal                                                                                                                          |       | 148,409                              |       | 136,975                |       |
| Savings                                                                                                                                                  |       | 345,937                              |       | 330,023                |       |
| Time, under $100,000                                                                                                                                     |       | 196,887                              |       | 182,363                |       |
| Time, $100,000 and over                                                                                                                                  |       | 161,840                              |       | 172,738                |       |
| Total deposits                                                                                                                                           |       | 1,087,651                            |       | 1,028,808              |       |
|                                                                                                                                                     |       |                                 |       |                   |       |
| Borrowed funds                                                                                                                                           |       | 140,159                              |       | 92,817                 |       |
| Junior subordinated debentures                                                                                                                           |       | 16,496                               |       | 16,496                 |       |
| Accrued interest, taxes and other  liabilities                                                                                                           |       | 5,315                                |       | 6,936                  |       |
| Total liabilities                                                                                                                                        |       | 1,249,621                            |       | 1,145,057              |       |
|                                                                                                                                                     |       |                                 |       |                   |       |
| Preferred stock, no par value; 10,000,000  shares authorized;  None outstanding                                                                          |       | —                               |       | —                 |       |
| Common stock, no par value; 20,000,000 shares  authorized; 5,772,325 and 5,660,739 issued & outstanding at September 30,  2004 and December 31, 2003 |       | 56,572                               |       | 54,228                 |       |
| Retained earnings                                                                                                                                        |       | 45,459                               |       | 34,816                 |       |
| Accumulated other comprehensive (loss)  income                                                                                                           |       | (256                                 | )          | 441                    |       |
|                                                                                                                                                     |       |                                 |       |                   |       |
| Total shareholders’ equity                                                                                                                          |       | 101,775                              |       | 89,485                 |       |
|                                                                                                                                                     |       |                                 |       |                   |       |
| Total liabilities and shareholders’ equity                                                                                                          |       | $                                    | 1,351,396  |                   | $          | 1,234,542 |   |

 

See accompanyingnotes to consolidated financial statements

 

3

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Capital Corp ofthe West

Consolidated Statementsof Income andComprehensive Income

(Unaudited)

 
| ** **                                                           | ** ** | **For the  Three Months  Ended September 30,** | ** ** | **For the  Nine Months  Ended September 30**, | ** ** |
|----------------------------------------------------------------------|------------|------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                           | ** ** | **2004**                                       | ** ** | **2003**                                      | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                           | ** ** | **(In thousands, except per share data)**      | ** ** |
| Interest income:                                                     |       |                                           |       |                                          |       |   |   |   |   |
| Interest and fees on loans                                           |       | $                                              | 13,918     |                                          | $          | 12,735 |   | $ | 40,657 |   | $ | 36,154 |   |
| Interest on deposits with other financial  institutions              |       | 1                                              |       | 2                                             |       | 5 |   | 7 |   |
| Interest on investments held to maturity:                            |       |                                           |       |                                          |       |   |   |   |   |
| Taxable                                                              |       | 563                                            |       | 621                                           |       | 1,728 |   | 2,101 |   |
| Non-taxable                                                          |       | 554                                            |       | 328                                           |       | 1,546 |   | 438 |   |
| Interest on investments available for sale:                          |       |                                           |       |                                          |       |   |   |   |   |
| Taxable                                                              |       | 2,496                                          |       | 2,271                                         |       | 7,734 |   | 6,766 |   |
| Non-taxable                                                          |       | 11                                             |       | —                                        |       | 32 |   | 545 |   |
| Interest on federal funds sold                                       |       | 44                                             |       | 95                                            |       | 85 |   | 185 |   |
| Total interest income                                                |       | 17,587                                         |       | 16,052                                        |       | 51,787 |   | 46,196 |   |
|                                                                 |       |                                           |       |                                          |       |   |   |   |   |
| Interest expense:                                                    |       |                                           |       |                                          |       |   |   |   |   |
| Interest on negotiable orders of withdrawal                          |       | 18                                             |       | 14                                            |       | 50 |   | 42 |   |
| Interest on savings deposits                                         |       | 772                                            |       | 728                                           |       | 2,290 |   | 1,951 |   |
| Interest on time deposits, under $100,000                            |       | 1,129                                          |       | 1,127                                         |       | 3,264 |   | 3,351 |   |
| Interest on time, $100,000 and over                                  |       | 869                                            |       | 1,103                                         |       | 2,678 |   | 3,153 |   |
| Interest on subordinated debentures                                  |       | 272                                            |       | 158                                           |       | 801 |   | 473 |   |
| Interest on other borrowings                                         |       | 1,196                                          |       | 1,012                                         |       | 3,428 |   | 3,356 |   |
| Total interest expense                                               |       | 4,256                                          |       | 4,142                                         |       | 12,511 |   | 12,326 |   |
|                                                                 |       |                                           |       |                                          |       |   |   |   |   |
| Net interest income before provision for  loan losses                |       | 13,331                                         |       | 11,910                                        |       | 39,276 |   | 33,870 |   |
| Provision for loan losses                                            |       | 760                                            |       | 751                                           |       | 2,001 |   | 1,904 |   |
| Net interest income after provision for  loan losses                 |       | 12,571                                         |       | 11,159                                        |       | 37,275 |   | 31,966 |   |
|                                                                 |       |                                           |       |                                          |       |   |   |   |   |
| Noninterest income:                                                  |       |                                           |       |                                          |       |   |   |   |   |
| Service charges on deposit accounts                                  |       | 1,641                                          |       | 1,430                                         |       | 4,655 |   | 4,064 |   |
| Increase in cash surrender value of life  insurance policies         |       | 271                                            |       | 256                                           |       | 767 |   | 773 |   |
| Other                                                                |       | 707                                            |       | 864                                           |       | 2,228 |   | 2,444 |   |
| Total noninterest income                                             |       | 2,619                                          |       | 2,550                                         |       | 7,650 |   | 7,281 |   |
|                                                                 |       |                                           |       |                                          |       |   |   |   |   |
| Noninterest Expense:                                                 |       |                                           |       |                                          |       |   |   |   |   |
| Salaries and related benefits                                        |       | 4,976                                          |       | 4,742                                         |       | 15,470 |   | 14,179 |   |
| Equipment                                                            |       | 789                                            |       | 875                                           |       | 2,361 |   | 2,336 |   |
| Premises and occupancy                                               |       | 990                                            |       | 727                                           |       | 2,533 |   | 2,109 |   |
| Professional fees                                                    |       | 335                                            |       | 310                                           |       | 1,103 |   | 1,068 |   |
| Marketing                                                            |       | 281                                            |       | 208                                           |       | 781 |   | 716 |   |
| Intangible amortization                                              |       | 167                                            |       | 170                                           |       | 500 |   | 510 |   |
| Supplies                                                             |       | 222                                            |       | 183                                           |       | 622 |   | 615 |   |
| Other                                                                |       | 1,405                                          |       | 1,782                                         |       | 4,509 |   | 4,662 |   |
| Total noninterest expense                                            |       | 9,165                                          |       | 8,997                                         |       | 27,879 |   | 26,195 |   |
|                                                                 |       |                                           |       |                                          |       |   |   |   |   |
| Income before income taxes                                           |       | 6,025                                          |       | 4,712                                         |       | 17,046 |   | 13,052 |   |
| Provision for income taxes                                           |       | 2,042                                          |       | 1,084                                         |       | 5,539 |   | 3,002 |   |
| Net income                                                           |       | $                                              | 3,983      |                                          | $          | 3,628 |   | $ | 11,507 |   | $ | 10,050 |   |
| Comprehensive Income:                                                |       |                                           |       |                                          |       |   |   |   |   |
| Unrealized gain (loss) on securities  arising during the period, net |       | 2,087                                          |       | (1,368                                        | )          | (697 | ) | (1,960 | ) |
| Comprehensive income                                                 |       | $                                              | 6,070      |                                          | $          | 2,260 |   | $ | 10,810 |   | $ | 8,090 |   |
|                                                                 |       |                                           |       |                                          |       |   |   |   |   |
| Basic earnings per share                                             |       | $                                              | 0.69       |                                          | $          | 0.65 |   | $ | 2.01 |   | $ | 1.79 |   |
| Diluted earnings per share                                           |       | $                                              | 0.67       |                                          | $          | 0.62 |   | $ | 1.94 |   | $ | 1.73 |   |

 

See accompanyingnotes to consolidated financial statements

 

4

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Capital Corp ofthe West

Consolidated Statement ofChanges in Shareholders’Equity

(Unaudited)

 
|                                                                                            |   | **Common  Stock**      |   |        |   | **Accumulated  other** |   |                             |   |
|-------------------------------------------------------------------------------------------------|--------|------------------------|--------|-------------|--------|------------------------|--------|----------------------------------|--------|
| **(Amounts  in thousands)**                                                                     |   | **Number  of  shares** |   | **Amounts** |   | **Retained  earnings** |   | **comprehensive  income (loss)** |   | **Total** |   |
|                                                                                            |   |                   |   |        |   |                   |   |                             |   |   |   |
| Balance, December 31, 2003                                                                      |   | 5,661                  |   | $           | 54,228 |                   | $      | 34,816                           |   | $ | 441 |   | $ | 89,485 |   |
|                                                                                            |   |                   |   |        |   |                   |   |                             |   |   |   |
| Exercise of stock options                                                                       |   | 94                     |   | 1,720       |   | —                 |   | —                           |   | 1,720 |   |
|                                                                                            |   |                   |   |        |   |                   |   |                             |   |   |   |
| Issuance of shares pursuant to 401k and  ESOP plans                                             |   | 17                     |   | 624         |   | —                 |   | —                           |   | 624 |   |
|                                                                                            |   |                   |   |        |   |                   |   |                             |   |   |   |
| Net Change in fair market value of  investment securities and swaps, net of tax benefit of $484 |   | —                 |   | —      |   | —                 |   | (697                             | )      | (697 | ) |
|                                                                                            |   |                   |   |        |   |                   |   |                             |   |   |   |
| Cash dividend                                                                                   |   | —                 |   | —      |   | (864                   | )      |                             |   | (864 | )  |
|                                                                                            |   |                   |   |        |   |                   |   |                             |   |   |   |
| Net income                                                                                      |   | —                 |   | —      |   | 11,507                 |   | —                           |   | 11,507 |   |
|                                                                                            |   |                   |   |        |   |                   |   |                             |   |   |   |
| Balance, September 30, 2004                                                                     |   | 5,772                  |   | $           | 56,572 |                   | $      | 45,459                           |   | $ | (256 | ) | $ | 101,775 |   |

 

See accompanyingnotes to consolidated financial statements

 

5

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Capital Corp ofthe West

Consolidated Statementsof Cash Flows

(Unaudited)

 
| ** **                                                                         | ** ** | **Nine months  ended  September 30,  2004** | ** ** | **Nine months  ended  September 30,  2003** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|
| **(Dollars in thousands)**                                                         | ** ** | ** **                                  | ** ** |
| **Operating activities:**                                                          | ** ** | ** **                                  | ** ** | ** **                                  | ** ** |
| Net income                                                                         |       | $                                           | 11,507     |                                        | $          | 10,050 | ** ** |
| Adjustments to reconcile net income to net  cash provided by Operating activities: |       |                                        |       |                                        |       |
| Provision for loan losses                                                          |       | 2,001                                       |       | 1,904                                       |       |
| Depreciation, amortization and accretion,  net                                     |       | 4,846                                       |       | 4,069                                       |       |
| Gain on sale of real estate owned                                                  |       | —                                      |       | (81                                         | )          |
| Net increase in interest receivable &  other assets                            |       | (3,837                                      | )          | (4,970                                      | )          |
| Net increase in deferred loan fees                                                 |       | 1,012                                       |       | 560                                         |       |
| Net decrease in accrued interest, taxes  & other liabilities                   |       | (1,621                                      | )          | (747                                        | )          |
| Net cash provided by operating activities                                          |       | 13,908                                      |       | 10,785                                      |       |
|                                                                               |       |                                        |       |                                        |       |
| **Investing activities:**                                                          |       |                                        |       |                                        |       |
| Investment securities purchases – available  for sale securities              |       | (57,719                                     | )          | (106,848                                    | )          |
| Investment securities purchases – held to  maturity securities                |       | (31,807                                     | )          | (60,308                                     | )          |
| Proceeds from maturities of available for  sale investment securities              |       | 47,951                                      |       | 92,740                                      |       |
| Proceeds from maturities of held to  maturity investment securities                |       | 8,228                                       |       | 26,456                                      |       |
| Proceeds from sales of available for sale  securities                              |       | 15,975                                      |       | 4,034                                       |       |
| Net increase in time deposits in other  financial institutions                     |       | —                                      |       | 150                                         |       |
| Proceeds from sales of loans                                                       |       | 2,480                                       |       | 3,210                                       |       |
| Net increase in loans                                                              |       | (99,638                                     | )          | (93,775                                     | )          |
| Purchase of premises and equipment                                                 |       | (4,721                                      | )          | (1,716                                      | )          |
| Proceeds from sales of real estate owned                                           |       | —                                      |       | 81                                          |       |
| Net cash used in investing activities                                              |       | (119,251                                    | )          | (135,976                                    | )          |
|                                                                               |       |                                        |       |                                        |       |
| **Financing activities:**                                                          |       |                                        |       |                                        |       |
| Net increase in demand, NOW and savings  deposits                                  |       | 55,217                                      |       | 97,570                                      |       |
| Net increase in certificates of deposit                                            |       | 3,626                                       |       | 42,883                                      |       |
| Net proceeds (repayments) from other  borrowings                                   |       | 47,342                                      |       | (19,969                                     | )          |
| Payment of cash dividends                                                          |       | (864                                        | )          | —                                      |       |
| Issuance of shares pursuant to 401K and  ESOP plans                                |       | 624                                         |       | 43                                          |       |
| Exercise of stock options                                                          |       | 1,720                                       |       | 325                                         |       |
| Cash in lieu of fractional shares from  stock dividend                             |       | —                                      |       | (14                                         | )          |
| Net cash provided by financing activities                                          |       | 107,665                                     |       | 120,838                                     |       |
|                                                                               |       |                                        |       |                                        |       |
| Net increase (decrease) in cash and cash  equivalents                              |       | 2,322                                       |       | (4,353                                      | )          |
|                                                                               |       |                                        |       |                                        |       |
| Cash and cash equivalents at beginning of  period                                  |       | 45,482                                      |       | 73,183                                      |       |
| Cash and cash equivalents at end of period                                         |       | $                                           | 47,804     |                                        | $          | 68,830 |   |
|                                                                               |       |                                        |       |                                        |       |
| **Cash paid during the quarter:**                                                  |       |                                        |       |                                        |       |
| Interest paid                                                                      |       | $                                           | 11,501     |                                        | $          | 11,757 |   |
| Income tax payments                                                                |       | 7,561                                       |       | 3,775                                       |       |
| **Supplemental disclosure of noncash  investing and financing activities:**        |       |                                        |       |                                        |       |
| Change in fair market value of investment  securities and swaps, net of tax        |       | (697                                        | )          | (1,960                                      | )          |
| Transfer of securities from available for  sale to held to maturity                |       | —                                      |       | 24,557                                      |       |

 

See accompanyingnotes to consolidated financial statements

 

6

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Capital Corp ofthe West

Notes to Consolidated Financial Statements

September 30, 2004and December 31, 2003

(Unaudited)

 

GENERAL - COMPANY

 

Capital Corp of the West (the “Company” or “Capital Corp”) is a bankholding company incorporated under the laws of the State of California on April26, 1995.  On November 1, 1995, theCompany became registered as a bank holding company, and is a holder of all ofthe capital stock of County Bank (the “Bank”). During 1998, the Company formed Capital West Group, a subsidiary thatengages in the financial institution advisory business but is currentlyinactive.  The Company’s primary asset isthe Bank****and the Bank is the Company’s primarysource of income.  The Company’s securitiesconsist of 20,000,000 shares of Common Stock, no par value, 10,000,000 sharesof Authorized Preferred Stock, and $16,000,000 of Trust Preferred CapitalSecurities which have a liquidation amount of $1,000 per capital security.  As of September 30, 2004 there were 5,772,325common shares outstanding, held of record by approximately 1,700shareholders.  There were no preferredshares outstanding at September 30, 2004. The Bank has three wholly owned subsidiaries, Merced Area Investment& Development, Inc. (“MAID”), County Asset Advisors (“CAA”), and CountyInvestment Trust (“REIT”).  CAA iscurrently inactive.  On April 26, 2002,the Company entered into an agreement to purchase Regency Investment Advisors,Inc (“RIA”).  The purchase of RIA wascompleted during the second quarter, 2002. On October 15, 2004, the Company sold RIA to the president of RIA in anRIA management buyout for an all cash price of $615,000 and a special one-timecash dividend to the Company.  The saleof the RIA stock and the receipt of the dividend resulted in a gain of $63,000that will be recorded in the fourth quarter of 2004.  The Company has two other wholly ownedsubsidiaries, County Statutory Trust (“Trust”), and Capital West Group,Inc.  The Trust is used in connectionwith the Capital Securities that have been issued by the Company.  Capital West Group, Inc. is currentlyinactive.  All references herein to the“Company” include the Company, the Company’s subsidiaries, the Bank and theBank’s subsidiaries, unless the context otherwise requires.

 

GENERAL - BANK

 

The Bank was organized on August 1, 1977, as CountyBank of Merced, a California state banking corporation.  The Bank commenced operations on December 22,1977.  In November 1992, the Bank changedits legal name to County Bank.  TheBank’s securities consist of one class of Common Stock, no par value and iswholly owned by the Company.  The Bank’sdeposits are insured under the Federal Deposit Insurance Act by the FederalDeposit Insurance Corporation (“FDIC”) up to applicable limits statedtherein.  The Bank is a member of theFederal Reserve System.

 

INDUSTRY ANDMARKET AREA

 

The Bank engages in general commercial bankingbusiness primarily in Fresno, Madera, Mariposa, Merced, San Francisco, SanJoaquin, Stanislaus and Tuolomne counties. The Bank has twenty full service branch offices; two of which arelocated in Merced with the branch located in downtown Merced currently servingas both a branch and as administrative headquarters. There are offices inAtwater, Dos Palos, Hilmar, Livingston, Los Banos, Madera, Mariposa, SanFrancisco, Sonora, Stockton, two offices in Modesto, four in Fresno and twooffices in Turlock.  The Bank’sadministrative headquarters also provides accommodations for the activities ofMAID, the Bank’s wholly owned real estate subsidiary.

 

7

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OTHER FINANCIALNOTES

 

All adjustments which in the opinion of Management arenecessary for a fair presentation of the Company’s financial position at September30, 2004 and December 31, 2003 and the results of operations for the three andnine month periods ended September 30, 2004 and 2003, and the statements ofcash flows for the nine months ended September 30, 2004 and 2003 have beenincluded.  The interim results for thethree and nine months ended September 30, 2004 are not necessarily indicativeof results to be expected for the full year. These financial statements should be read in conjunction with thefinancial statements and the notes included in the Company’s Annual Report onForm 10-K for the year ended December 31, 2003.

 

The accompanying unaudited financial statements havebeen prepared on a basis consistent with generally accepted accountingprinciples and with the instructions to Form 10-Q and Rule 10-01 of RegulationS-X.

 

EARNINGS PER SHARE

 

Basic earnings per share (EPS) is computed by dividingnet income available to shareholders by the weighted average number of commonshares outstanding during the period. Diluted earnings per share is computed by dividing net income availableto common shareholders by the weighted average number of common sharesoutstanding during the period plus potential common shares outstanding.  Diluted earnings per share reflects thepotential dilution that could occur if securities or other contracts to issuecommon stock were exercised or converted into common stock or resulted in theissuance of common stock that then shared in the earnings of the Company.

 

The following tables provide a reconciliation of thenumerator and denominator of the basic and diluted earnings per sharecomputation for the three and nine month periods ended September 30, 2004 and2003:

 
| ** **                                         | ** ** | **For The Three Months  Ended September 30,** | ** ** | **For The Nine Months  Ended September 30,** | ** ** |
|----------------------------------------------------|------------|-----------------------------------------------|------------|----------------------------------------------|------------|
| **(Dollars in thousands, except  per share data)** | ** ** | **2004**                                      | ** ** | **2003**                                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                               |       |                                          |       |                                         |       |   |   |   |   |
| Basic EPS computation:                             |       |                                          |       |                                         |       |   |   |   |   |
| Net income                                         |       | $                                             | 3,983      |                                         | $          | 3,628 |   | $ | 11,507 |   | $ | 10,050 |   |
| Average common shares outstanding                  |       | 5,765                                         |       | 5,610                                        |       | 5,718 |   | 5,602 |   |
| Basic EPS                                          |       | $                                             | 0.69       |                                         | $          | 0.65 |   | $ | 2.01 |   | $ | 1.79 |   |
|                                               |       |                                          |       |                                         |       |   |   |   |   |
| Diluted EPS Computations:                          |       |                                          |       |                                         |       |   |   |   |   |
| Net income                                         |       | $                                             | 3,983      |                                         | $          | 3,628 |   | $ | 11,507 |   | $ | 10,050 |   |
| Average common shares outstanding                  |       | 5,765                                         |       | 5,610                                        |       | 5,718 |   | 5,602 |   |
| Effect of stock options                            |       | 187                                           |       | 238                                          |       | 207 |   | 211 |   |
|                                               |       | 5,952                                         |       | 5,848                                        |       | 5,925 |   | 5,813 |   |
| Diluted EPS                                        |       | $                                             | 0.67       |                                         | $          | 0.62 |   | $ | 1.94 |   | $ | 1.73 |   |

 

8

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INTANGIBLE ASSETS

 

The Company has intangible assets consisting of core deposit premiumsand goodwill.  Core deposit premiums areamortized using an accelerated method over a period of ten years.  Intangible assets related to goodwill are nolonger amortized after December 31, 2001 but are reviewed periodically forpotential impairment.  During 2004,management has determined there was no impairment of goodwill.  As of September 30, 2004 and December 31,2003, the Company had unamortized core deposit premiums of $224,000 and$724,000, respectively.  Amortization ofcore deposit premiums and other intangibles was $167,000 and $170,000 duringthe third quarter of 2004 and 2003 and $500,000 and $510,000 for the ninemonths ended September 30, 2004 and 2003. Core deposit premiums and other intangibles are scheduled to amortize ata rate of approximately $167,000 per quarter through the quarter endingDecember 31, 2004 and at a rate of $57,000 during the first quarter of2005.  Core deposit premiums of $460,000and $4,340,000 were initially recorded as a result of purchasing deposits fromTown and Country Finance and Thrift in July, 1996 and from the purchase ofthree branches from Bank of America in December, 1997, respectively.

 

BORROWEDFUNDS

 

During the fourth quarter of 2004, the Bank increased its borrowingsfor the Federal Home Loan Bank (“FHLB”) of San Francisco.  In September, 2004, the Bank borrowed anadditional $17,900,000 from the FHLB. The proceeds from this borrowing were used to increase the liquidity ofthe Company, purchase additional investment securities, and provide liquidityto fund new loan requests.  The FHLBborrowings are secured by pledged investment securities.

 

STOCKCOMPENSATION

 

The Company provides stock-based compensation to certain officers anddirectors.  The Company uses theintrinsic value method to account for its stock option plans (in accordancewith the provisions of Accounting Principles Board Opinion No. 25).  Under this method, compensation expense isrecognized for awards of options to purchase shares of common stock toemployees under compensatory plans only if the fair market value of the stock atthe option grant date (or other measurement date, if later) is greater than theamount the employee must pay to acquire the stock.  Statement of Financial Accounting StandardsNo. 123, Accounting for Stock-Based Compensation (SFAS 123) permits companies tocontinue using the intrinsic value method or to adopt a fair value based modelto account for stock option plans.  Thefair value based method results in recognizing as expense over the vestingperiod the fair value of all stock-based awards on the date of grant.  The Company has elected to continue to usethe intrinsic value method.

 

9

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Hadcompensation cost for the Company’s option plans been determined in accordancewith SFAS 123, the Company’s net income and earnings per share would have beenreduced to the pro forma amounts indicated as follows:

 
| ** **                                                                                  | ** ** | **For the three months  ended September 30,** | ** ** | **For the nine months  ended September 30,** | ** ** |
|---------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|----------------------------------------------|------------|
| **(dollars in thousands except  per share amounts)**                                        | ** ** | **2004**                                      | ** ** | **2003**                                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                        |       |                                          |       |                                         |       |   |   |   |   |
| Net income:                                                                                 |       |                                          |       |                                         |       |   |   |   |   |
| As reported                                                                                 |       | $                                             | 3,983      |                                         | $          | 3,628 |   | $ | 11,507 |   | $ | 10,050 |   |
| Pro forma                                                                                   |       | $                                             | 3,792      |                                         | $          | 3,446 |   | $ | 10,809 |   | $ | 9,580 |   |
|                                                                                        |       |                                          |       |                                         |       |   |   |   |   |
| Basic earnings per share:                                                                   |       |                                          |       |                                         |       |   |   |   |   |
| As reported                                                                                 |       | $                                             | 0.69       |                                         | $          | 0.65 |   | $ | 2.01 |   | $ | 1.79 |   |
| Pro forma                                                                                   |       | $                                             | 0.66       |                                         | $          | 0.61 |   | $ | 1.89 |   | $ | 1.71 |   |
|                                                                                        |       |                                          |       |                                         |       |   |   |   |   |
| Diluted earnings per share:                                                                 |       |                                          |       |                                         |       |   |   |   |   |
| As reported                                                                                 |       | $                                             | 0.67       |                                         | $          | 0.62 |   | $ | 1.94 |   | $ | 1.73 |   |
| Pro forma                                                                                   |       | $                                             | 0.64       |                                         | $          | 0.59 |   | $ | 1.82 |   | $ | 1.65 |   |
|                                                                                        |       |                                          |       |                                         |       |   |   |   |   |
| Stock-based employee compensation cost  included in salaries and related benefits:          |       |                                          |       |                                         |       |   |   |   |   |
| As reported                                                                                 |       | $                                             | —     |                                         | $          | — |   | $ | — |   | $ | — |   |
| Pro forma                                                                                   |       | $                                             | 204        |                                         | $          | 189 |   | $ | 782 |   | $ | 486 |   |
|                                                                                        |       |                                          |       |                                         |       |   |   |   |   |
| Stock-based employee compensation cost, net  of related tax effects included in net income: |       |                                          |       |                                         |       |   |   |   |   |
| As reported                                                                                 |       | $                                             | —     |                                         | $          | — |   | $ | — |   | $ | — |   |
| Pro forma                                                                                   |       | $                                             | 191        |                                         | $          | 182 |   | $ | 698 |   | $ | 470 |   |

 

10

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RECENT ACCOUNTING PRONOUNCEMENTS

 

InDecember 2003, the FASB issued FASB Interpretation No. 46 (revised December2003), *Consolidation of Variable Interest Entities*,which addresses how a business enterprise should evaluate whether it has acontrolling financial interest in a “Variable Interest Entity” (“VIE”) throughmeans other than voting rights and accordingly should consolidate theentity.  FIN 46R replaces FASBInterpretation No. 46, *Consolidation of VariableInterest Entities*, which was issued in January 2003.  The Company will be required to apply FIN 46Rto variable interests in VIEs created after December 31, 2003.  For variable interests in VIEs created beforeJanuary 1, 2004, the Interpretation will be applied beginning on January 1,2005.  For any VIEs that must beconsolidated under FIN 46R that were created before January 1, 2004, theassets, liabilities and noncontrolling interests of the VIE initially would bemeasured at their carrying amounts with any difference between the net amountadded to the balance sheet and any previously recognized interest beingrecognized as the cumulative effect of an accounting change.  If determining the carrying amounts is notpracticable, fair value at the date FIN 46R first applies may be used tomeasure the assets, liabilities and noncontrolling interest of the VIE.

 

The Company has adopted FIN 46R and applied it toexisting VIEs in which the Company has variable interests.  As a result of adopting FIN 46R, the balancesheet line items related to Capital Securities and the related income statementeffect of dividends on Capital Securities in the September 30, 2003consolidated financial statements have been reclassified to conform with the2004 presentation.  The juniorsubordinated debentures issued to the Trusts as VIEs were reflected aslong-term debt in the consolidated balance sheets at September 30, 2004 andDecember 31, 2003.  Prior toDecember 31, 2003, the Trusts were consolidated subsidiaries and wereincluded in liabilities in the consolidated balance sheet, as “CapitalSecurities”. The common securities and debentures, along with the relatedincome effects were eliminated in the consolidated financial statements.

 

In December 2003, FASB issued Statement No. 132 (revised 2003), *Employers’ Disclosures about Pensions and Other PostretirementBenefits. *This Statementprescribes employers’ disclosures about pension plans and other postretirementbenefit plans; it does not change the measurement or recognition of thoseplans.  The Statement retains and revisesthe disclosure requirements contained in the original Statement 132.  It also requires additional disclosures aboutthe assets, obligations, cash flows, and net periodic benefit cost of definedbenefit plans and other postretiment benefit plans.  The Statement generally is effective forfiscal years ending after December 15, 2003. The Company currently does not have any postretirement benefit plansthat are within the scope of this Statement.

 

InMarch, 2004, the Emerging Issues Task Force (“EITF”) Issue No. 03-1 “TheMeaning of Other-Than-Temporary Impairment and its Application to CertainInvestments” consensus was published. Issue No. 03-1 contained new guidance effectively codifying theprovisions of SEC Staff Accounting Bulletin No. 59 and creates a new model thatcalls for new judgments and additional evidence gathering.  In September 2004, the FASB delayed therequirement to record impairment losses under EITF 03-1.  The disclosure requirements of EITF 03-1remain in effect.  Management has done ananalysis of the impact of this accounting pronouncement, which is discussed inthe section of this report entitled, Financial Condition.  The Company does not expect the adoption ofthe final EITF****will have a material impact ofthe Company’s Consolidated Financial Statements.

 

11

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**Item 2.             Management’s Discussion And Analysis Of FinancialCondition And Results Of Operations**

 

The following Management’s Discussion and Analysis of FinancialCondition and Results of Operations contains forward-looking statementsthat are subject to risks and uncertainties and include information about possibleor assumed future results of operations. Many possible events or factors could affect the future financialresults and performance of the company. This could cause results or performance to differ materially from thoseexpressed in our forward-looking statements. Words such as “expects”, “anticipates”, “believes”, “estimates”,variations of such words and other similar expressions are intended to identifysuch forward-looking statements.  Thesestatements are not guarantees of future performance and involve certain risks,uncertainties and assumptions which are difficult to predict.  Therefore, actual outcomes and results maydiffer materially from what is expressed or forecasted in, or implied by, suchforward-looking statements.

 

Readers of the Company’s Form 10-Q should not relysolely on forward looking statements and should consider all uncertainties andrisks discussed throughout this report, as well as those discussed in theCompany’s 2003 Annual Report on Form 10 - K filed on March 15, 2004**.**  These statements are representative only onthe date as of which they are made, and the Company undertakes no obligation toupdate any forward-looking statements made. Some possible events or factors that could occur that may causedifferences from expected results include the following: the Company’s loangrowth is dependent on economic conditions, as well as various discretionaryfactors, such as decisions to sell, or purchase certain loans or loanportfolios; participations of loans and the quality of the management of theborrower, industry, product and geographic concentrations, the expensesassociated with the Company’s efforts to comply with the internal controlprovisions of Sarbanes-Oxley and the Company’s degree of success in complyingwith those provisions, and the mix of the loan portfolio.  The rate of charge-offs and provision expensecan be affected by local, regional and international economic and marketconditions, concentrations of borrowers, industries, products and geographicalconditions, the mix of the loan portfolio and management’s judgements regardingthe collectibility of loans.  Liquidityrequirements may change as a result of fluctuations in assets and liabilitiesand off-balance sheet exposures, which will impact the capital and debtfinancing needs of the Company and the mix of funding sources.  Decisions to purchase, hold, or sellsecurities are also dependent on liquidity requirements and market volatility,as well as on and off-balance sheet positions. Factors that may impact interest rate risk include local, regional andinternational economic conditions, levels, mix, maturities, yields or rates ofassets and liabilities and the wholesale and retail funding sources of theCompany.

 

The Company is also exposed to the potential of lossesarising from adverse changes in market rates and prices which can adverselyimpact the value of financial products, including securities, loans, anddeposits.  In addition, the bankingindustry in general is subject to various monetary and fiscal policies andregulations, which include those determined by the Federal Reserve Board, theFederal Deposit Insurance Corporation and state regulators, whose policies andregulations could affect the Company’s results.

 

Otherfactors that may cause actual results to differ from the forward-lookingstatements include the following: competition with other local and regionalbanks, savings and loan associations, credit unions and other nonbank financialinstitutions, such as investment banking firms, investment advisory firms,brokerage firms, mutual funds and insurance companies, as well as otherentities which offer financial services; interest rate, market and monetaryfluctuations; inflation; market volatility; general economic conditions;introduction and acceptance of new banking-related products, services andenhancements; fee

 

12

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pricingstrategies, mergers and acquisitions and their integration into the Company,civil disturbances or terrorist threats or acts, or apprehension about thepossible future occurrences or acts of this type, outbreak or escalation ofhostilities in which the United States is involved, any declaration of war bythe U.S. Congress or any other national or international calamity, crisis oremergency, and management’s ability to manage these and other risks.

 

**Critical accounting policies and estimates**

 

The Company’s discussion and analysis of its financialcondition and results of operations are based upon the Company’s consolidatedfinancial statements, which have been prepared in accordance with accountingprinciples generally accepted in the United States of America.  The preparation of these financial statementsrequires Management to make estimates and judgments that affect the reportedamounts of assets, liabilities, revenues and expenses, and related disclosureof contingent assets and liabilities.  Onan on-going basis, Management evaluates its estimates, including those relatedto the adequacy of the allowance for loan losses, goodwill and intangibleassets, and market valuation of securities. Management bases its estimates on historical experience and on variousother assumptions that are believed to be reasonable under the circumstances,the results of which form the basis for making judgments about the carryingvalues of assets and liabilities that are not readily apparent from othersources.  Actual results may differ fromthese estimates under different assumptions or conditions (see caption“Allowance for Loan Losses” for a more detailed discussion).

 

Management believes the accounting policies discussedbelow are the most critical to the Company’s financial statements because theirapplication places the most significant demands on management’s judgments.  Each of these estimates is discussed below.

 

The allowance for loan losses has been determined tobe critical as estimation of this allowance involves material estimates bymanagement and is susceptible to significant changes in the near term.  Estimation of the adequacy of the allowancefor loan losses requires that management assess the credit risk inherent in theloan portfolio.  Assessing credit riskinvolves determining the probability of sustaining a loss because other partiesto contractual financial instruments fail to perform in accordance with theterms of the contract.  Managementactively seeks to reduce the credit risks of the Company, in order to keeppotential exposure to credit losses at acceptable levels.  In the event of nonperformance by the otherparties to our financial instruments, the Company would be exposed to creditlosses that could significantly affect the Company’s financial position andearnings.

 

Goodwill and intangible assets are recorded to reflectthe value attributable to intangible elements acquired in the purchase of awhole company, or the purchase of specified assets or liabilities of acompany.  On an annual basis or ascircumstances dictate, management reviews goodwill and evaluates events or developmentsthat may indicate impairment in the carrying value of goodwill and intangibleassets.  If management determines thatthe carrying value of goodwill and intangible assets exceeds the implied fairvalue of these assets, then writing down goodwill and intangible assets totheir implied value requires an impairment charge be taken.  Events that may indicate goodwill impairmentinclude significant or adverse changes in results of operations of thebusiness, economic or political climate; an adverse action or assessment by aregulator; unanticipated competition; and a more likely-than-not expectationthat a reporting unit will be sold or disposed of (see caption “IntangibleAssets” for a more detailed discussion of the Company’s goodwill and intangibleassets).

 

Securities classified as available for sale arerecorded at fair value, which initially is the purchase cost of thesecurity.  However, any subsequentchanges in the value of these securities are excluded from

 

13

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net income and recorded as an unrealized gain (loss)on securities, a separate component of comprehensive income in the ConsolidatedStatements of Income and Comprehensive Income. Upon the sale of these securities to a third party, gains and losses,which are measured from the acquisition price, are recorded in consolidated netincome.  Management believes the marketvaluations to be critical, as the timing and amount of income, if any, from theavailable for sale securities typically depends upon factors beyondmanagement’s control.  These factorsinclude the condition of the securities markets, and the volume of markettrading that occurs in the specific securities held by the Company.

 

During 2003, California enacted tax legislation thatadded new penalties for institutions that engaged in strategies andtransactions that the Franchise Tax Board (“FTB”) defined as abusive taxshelters.  The FTB gave taxpayers untilApril 15, 2004 to take advantage of a voluntary compliance initiative (“VCI”)that would allow taxpayers to amend prior year filings without being subject tothe new tax shelter penalties.  On April15, 2004, the Company took advantage of the VCI, amended tax returns for thetax years ended December 31, 2001 and 2002, and paid the FTB $2,411,000.  As part of this process, the Companymaintained the legal rights to pursue a claim of refund from the FTB for aportion of the amounts paid, and has every intention of doing so.  As of September 30, 2004, the Company has arecorded income tax receivable of $1,563,000 based on a claim of refundpertaining to REIT benefits.  Companymanagement believes the strategy used is lawful and defensible, and intends todefend the tax position taken.  If the Companyis ultimately unsuccessful in its claims against California, it would adverselyaffect the Company’s financial condition and results of operations and theCompany could be held liable for additional accuracy related penalties.

 

14

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The following discussion and analysis is designed toprovide a better understanding of the significant changes and trends related tothe Company and its subsidiaries’ financial condition, operating results, assetand liability management, liquidity and capital resources and should be read inconjunction with the Consolidated Financial Statements of the Company and theNotes thereto.

# ** **

# **Results OfOperations**

** **

**Three and Nine Months EndedSeptember 30, 2004 Compared With Three and Nine Months Ended September 30, 2003**

* *

*Overview.*  For the threeand nine months ended September 30, 2004 the Company reported record net incomeof $3,983,000 and $11,507,000.  Thiscompares to $3,628,000 and $10,050,000 for the same periods in 2003 andrepresents an increase of $355,000 and $1,457,000 or 10% and 15% over the prioryear periods.  Basic earnings per sharewere $0.69 and $2.01 for the three and nine months ended September 30,2004.  This compares to $0.65 and $1.79for the prior year period.  Fully dilutedearnings per share were $0.67 and $1.94 for the three and nine months endedSeptember 30, 2004.  This compares to$0.62 and $1.73 for the prior year periods. The changes represent an increase of $0.04 and $0.05 per share for basicand fully diluted earnings per share for the three months and $0.22 and $0.21per share for basic and fully diluted earnings per share for the nine monthsended September 30, 2004, over the same periods of 2003.  The annualized return on average assets was1.21% and 1.20% for the first three and nine months of 2004 which compares with1.26% and 1.23% for the three and nine months ended September 30, 2003respectively.  The Company’s annualizedreturn on average equity was 16.26% and 16.14% for the three and nine monthsended September 30, 2004 which compares with 17.27% and 16.43% for the same periodsin 2003.  The decreased return on assetsand decreased return on equity were primarily the result of a small increase ininterest earning assets that was more than offset by an increase in theCompany’s effective tax rate.

 

*Net Interest Income.*  The Company’sprimary source of income is net interest income and is determined by thedifference between interest income and fees derived from earning assets andinterest paid on interest bearing liabilities. Net interest income for the three month period ended September 30, 2004rose 12% and for the nine month period ended September 30, 2004 rose 16% to atotal of $13,331,000 and $39,276,000 and represented an increase of $1,421,000and $5,406,000 when compared to the $11,910,000 and $33,870,000 achieved duringthe three and nine months ended September 30, 2003.

 

Total interest and fees on earning assets were$17,587,000 and $51,787,000 for the three and nine months ended September 30,2004, rising 10% or $1,535,000 for the three month period ended September 30,2004 and rising 12% or $5,591,000 for the nine month period ended September 30,2004 when compared to the $16,052,000 and $46,196,000 achieved during the threeand nine months ended September 30, 2003. Total interest income is affected by changes in volume of and ratesearned on interest-earning assets. Interest-earning assets consist primarily of loans, investmentsecurities and federal funds sold.  Theincrease in total interest income for the three and nine months ended September30, 2004 was primarily the result of an increase in volume of interest earningassets.  Average interest-earningassets for the three and nine months ended September 30, 2004 were$1,211,253,000 and $1,186,843,000 compared with $1,074,219,000 and$1,009,309,000 for the three and nine months ended September 30, 2003, anincrease of $137,034,000 or 13% and $177,534,000 or 18% during both timeperiods.

 

15

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Interest expense is a function of the volume of andthe rates paid on interest-bearing liabilities.  Interest-bearing liabilities consistprimarily of certain deposits and borrowed funds.  Total interest expense was $4,256,000 and$12,511,000 for the three and nine months ended September 30, 2004, comparedwith $4,142,000 and $12,326,000 for the three and nine months ended September30, 2003, an increase of $114,000 or 3% and an increase of $185,000 or 2%.These modest changes were primarily the result of a decrease in the interestrate paid on interest-bearing liabilities that was more than offset by anincrease in average outstanding interest-bearing liabilities. Average interest-bearingliabilities were $989,592,000 and $976,482,000 for the three and nine monthsended September 30, 2004 compared with $896,098,000 and $843,231,000 for thesame three and nine months in 2003, an increase of $93,494,000 and $133,251,000or 10% and 16%.  Average interest ratespaid on interest-bearing liabilities were 1.71% for the three and nine monthsended September 30, 2004 compared with 1.83% and 1.95% for the same three andnine months of 2003, a decrease in interest rates paid of 12 and 24 basispoints.

 

The increase in interest-earning assets andinterest-bearing liabilities was primarily the result of increased marketpenetration within our target markets, accomplished by increasing the loan anddeposit production of existing facilities and the addition of one new retailbanking facility in Fresno, California in June, 2003.

 

The Company’s taxable equivalent net interest margin,the ratio of net interest income to average interest-earning assets, was4.45% and 4.49% for the three and nine months ended September 30, 2004 comparedwith 4.45% and 4.54% for the same periods in 2003.  Net interest margin provides a measurement ofthe Company’s ability to employ funds profitably during the period beingmeasured.  The Company’s modest decreasein net interest margin for the nine month period ended September 30, 2004 whencompared to the same period in 2003 was primarily attributable to a larger dropin overall interest – earning asset yields than the corresponding drop ininterest-bearing liabilities.

 

16

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*Average Balances And Rates Earned And Paid.* The following table presents condensed average balance sheet informationfor the Company, together with interest rates earned and paid on the varioussources and uses of its funds for each of the periods indicated.  Nonaccruing loans are included in thecalculation of the average balances of loans, but the nonaccrued interest onsuch loans is excluded.

 

AVERAGE BALANCE SHEET& ANALYSIS OF NET INTEREST EARNINGS

 
| ** **                                      | ** ** | **Three months ended  September 30, 2004** | ** ** | **Three months ended  September 30, 2003** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                      | ** ** | **Average  Balance**                       | ** ** | **Taxable  Equivalent  Interest**          | ** ** | **Taxable  Equivalent  Yield/rate** | ** ** | **Average  Balance** | ** ** | **Taxable  Equivalent  Interest** | ** ** | **Taxable  Equivalent  Yield/rate** | ** ** |
| ** **                                      | ** ** | **(Dollars  in thousands)**                | ** ** |
| **Assets**                                      |       |                                       |       |                                       |       |   |   |   |   |   |   |   |   |
| Federal funds sold                              |       | $                                          | 12,284     |                                       | $          | 44 |   | 1.42 | % | $ | 39,055 |   | $ | 95 |   | 0.97 | % |
| Time deposits at other financial  institutions  |       | 350                                        |       | 1                                          |       | 1.13 |   | 510 |   | 2 |   | 1.56 |   |
| Taxable investment securities (1)               |       | 311,199                                    |       | 3,083                                      |       | 3.93 |   | 298,688 |   | 2,926 |   | 3.89 |   |
| Nontaxable investment securities (1)            |       | 57,373                                     |       | 750                                        |       | 5.19 |   | 30,763 |   | 438 |   | 5.65 |   |
| Loans, gross: (2)                               |       | 830,047                                    |       | 13,918                                     |       | 6.65 |   | 705,203 |   | 12,735 |   | 7.16 |   |
| Total interest-earning assets:                  |       | 1,211,253                                  |       | 17,796                                     |       | 5.83 |   | 1,074,219 |   | 16,196 |   | 5.98 |   |
| Allowance for loan losses                       |       | (14,106                                    | )          |                                       |       |   |   | (12,962 | )  |   |   |   |   |
| Cash and due from banks                         |       | 41,569                                     |       |                                       |       |   |   | 35,422 |   |   |   |   |   |
| Premises and equipment, net                     |       | 19,367                                     |       |                                       |       |   |   | 15,238 |   |   |   |   |   |
| Interest receivable and other assets            |       | 54,224                                     |       |                                       |       |   |   | 43,056 |   |   |   |   |   |
| Total assets                                    |       | $                                          | 1,312,307  |                                       |       |   |   |   | $ | 1,154,973 |   |   |   |   |   |
|                                            |       |                                       |       |                                       |       |   |   |   |   |   |   |   |   |
| **Liabilities And Shareholders’ Equity**   |       |                                       |       |                                       |       |   |   |   |   |   |   |   |   |
| Negotiable order of withdrawal                  |       | $                                          | 149,659    |                                       | $          | 18 |   | 0.05 | % | $ | 123,275 |   | $ | 14 |   | 0.05 | % |
| Savings deposits                                |       | 348,290                                    |       | 772                                        |       | 0.88 |   | 305,228 |   | 728 |   | 0.95 |   |
| Time deposits                                   |       | 351,454                                    |       | 1,998                                      |       | 2.26 |   | 373,908 |   | 2,230 |   | 2.37 |   |
| Other borrowings                                |       | 123,693                                    |       | 1,196                                      |       | 3.84 |   | 87,501 |   | 1,012 |   | 4.59 |   |
| Subordinated Debentures                         |       | 16,496                                     |       | 272                                        |       | 6.54 |   | 6,186 |   | 158 |   | 10.13 |   |
| Total interest-bearing liabilities              |       | 989,592                                    |       | 4,256                                      |       | 1.71 |   | 896,098 |   | 4,142 |   | 1.83 |   |
|                                            |       |                                       |       |                                       |       |   |   |   |   |   |   |   |   |
| Noninterest-bearing deposits                    |       | 219,849                                    |       |                                       |       |   |   | 168,849 |   |   |   |   |   |
| Accrued interest, taxes and other  liabilities  |       | 4,886                                      |       |                                       |       |   |   | 5,999 |   |   |   |   |   |
| Total liabilities                               |       | 1,214,327                                  |       |                                       |       |   |   | 1,070,946 |   |   |   |   |   |
|                                            |       |                                       |       |                                       |       |   |   |   |   |   |   |   |   |
| Total shareholders’ equity                 |       | 97,980                                     |       |                                       |       |   |   | 84,027 |   |   |   |   |   |
| Total liabilities and shareholders’ equity |       | $                                          | 1,312,307  |                                       |       |   |   |   | $ | 1,154,973 |   |   |   |   |   |
|                                            |       |                                       |       |                                       |       |   |   |   |   |   |   |   |   |
| Net interest income and margin (3)              |       |                                       |       | $                                          | 13,540     |   | 4.45 | % |   |   | $ | 12,054 |   | 4.45 | % |
|                                                 |            |                                            |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

| (1) | Tax-equivalent  adjustments included in the nontaxable investment securities portfolio are $185,000 and $110,000 for the three  months ended September 30, 2004 and 2003, respectively. Tax equivalent  adjustments included in the taxable investment securities created by a  dividends received deduction were **$**24,000** **and $34,000** **for  the three months ended September 30, 2004 and 2003, respectively, using an  expected 35% effective tax rate. |
|-----|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | Amounts  of interest earned includes loan fees of $670,000 and $308,000 for the three  months ended September 30, 2004 and 2003, respectively.                                                                                                                                                                                                                                                                                                                                |
| (3) | Net  interest margin is computed by dividing net interest income by total average  interest-earning assets.                                                                                                                                                                                                                                                                                                                                                                   |

 

17

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| ** **                                      | ** ** | **Nine months ended  September 30, 2004** | ** ** | **Nine months ended  September 30, 2003** | ** ** |
|-------------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                      | ** ** | **Average  Balance**                      | ** ** | **Taxable  Equivalent  Interest**         | ** ** | **Taxable  Equivalent  Yield/rate** | ** ** | **Average  Balance** | ** ** | **Taxable  Equivalent  Interest** | ** ** | **Taxable  Equivalent  Yield/rate** | ** ** |
| ** **                                      | ** ** | **(Dollars in thousands)**                | ** ** |
| **Assets**                                      |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| Federal funds sold                              |       | $                                         | 9,605      |                                      | $          | 85 |   | 1.18 | % | $ | 23,215 |   | $ | 185 |   | 1.07 | % |
| Time deposits at other financial institutions   |       | 350                                       |       | 5                                         |       | 1.90 |   | 556 |   | 7 |   | 1.68 |   |
| Taxable investment securities (1)               |       | 323,864                                   |       | 9,543                                     |       | 3.93 |   | 283,558 |   | 8,968 |   | 4.23 |   |
| Nontaxable investment securities (1)            |       | 53,027                                    |       | 2,096                                     |       | 5.27 |   | 29,610 |   | 1,305 |   | 5.89 |   |
| Loans, gross: (2)                               |       | 799,997                                   |       | 40,657                                    |       | 6.77 |   | 672,370 |   | 36,154 |   | 7.19 |   |
| Total interest-earning assets:                  |       | 1,186,843                                 |       | 52,386                                    |       | 5.88 |   | 1,009,309 |   | 46,619 |   | 6.18 |   |
| Allowance for loan losses                       |       | (13,809                                   | )          |                                      |       |   |   | (12,735 | ) |   |   |   |   |
| Cash and due from banks                         |       | 40,135                                    |       |                                      |       |   |   | 34,198 |   |   |   |   |   |
| Premises and equipment, net                     |       | 18,100                                    |       |                                      |       |   |   | 14,951 |   |   |   |   |   |
| Interest receivable and other assets            |       | 50,959                                    |       |                                      |       |   |   | 41,527 |   |   |   |   |   |
| Total assets                                    |       | $                                         | 1,282,228  |                                      |       |   |   |   | $ | 1,087,250 |   |   |   |   |   |
|                                            |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| **Liabilities And Shareholders’ Equity**   |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| Negotiable order of withdrawal                  |       | $                                         | 142,725    |                                      | $          | 50 |   | 0.05 |   | $ | 119,517 |   | $ | 42 |   | 0.05 |   |
| Savings deposits                                |       | 347,091                                   |       | 2,290                                     |       | 0.88 |   | 259,356 |   | 1,951 |   | 1.01 |   |
| Time deposits                                   |       | 354,831                                   |       | 5,942                                     |       | 2.23 |   | 346,955 |   | 6,504 |   | 2.51 |   |
| Other borrowings                                |       | 115,339                                   |       | 3,428                                     |       | 3.96 |   | 111,217 |   | 3,356 |   | 4.03 |   |
| Subordinated Debentures                         |       | 16,496                                    |       | 801                                       |       | 6.47 |   | 6,186 |   | 473 |   | 10.22 |   |
| Total interest-bearing liabilities              |       | 976,482                                   |       | 12,511                                    |       | 1.71 |   | 843,231 |   | 12,326 |   | 1.95 |   |
|                                            |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| Noninterest-bearing deposits                    |       | 205,897                                   |       |                                      |       |   |   | 156,638 |   |   |   |   |   |
| Accrued interest, taxes and other  liabilities  |       | 4,808                                     |       |                                      |       |   |   | 5,843 |   |   |   |   |   |
| Total liabilities                               |       | 1,187,187                                 |       |                                      |       |   |   | 1,005,712 |   |   |   |   |   |
|                                            |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| Total shareholders’ equity                 |       | 95,041                                    |       |                                      |       |   |   | 81,538 |   |   |   |   |   |
| Total liabilities and shareholders’ equity |       | $                                         | 1,282,228  |                                      |       |   |   |   | $ | 1,087,250 |   |   |   |   |   |
|                                            |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| Net interest income and margin (3)              |       |                                      |       | $                                         | 39,875     |   | 4.49 | % |   |   | $ | 34,293 |   | 4.54 | % |

 

----

| (1) | Tax-equivalent  adjustments included in the nontaxable investment securities portfolio are  $518,000 and $322,000 for the nine months ended September 30, 2004 and 2003,  respectively. Tax equivalent adjustments included in the taxable investment  securities created by a dividends received deduction were $81,000 and $101,000 for the nine  months ended September 30, 2004 and 2003, respectively, using an expected 35%  effective tax rate. |
|-----|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | Amounts  of interest earned includes loan fees of $1,810,000 and $1,408,000 for the  nine months ended September 30, 2004 and 2003, respectively.                                                                                                                                                                                                                                                                                                      |
| (3) | Net  interest margin is computed by dividing net interest income by total average  interest-earning assets.                                                                                                                                                                                                                                                                                                                                            |

 

18

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*Net Interest Income Changes Due To Volume And Rate.* The following table sets forth, for the periods indicated, a summary ofthe changes in average asset and liability balances and interest earned andinterest paid resulting from changes in average asset and liability balances(volume) and changes in average interest rates and the total net change ininterest income and expenses.  Thechanges in interest due to both rate and volume have been allocated to volumeand rate changes in proportion to the relationship of the absolute dollaramount of the change in each.

 

Net Interest Income Variance Analysis:

 

| ** **                                     | ** ** | **Three months ended  September 30, 2004 compared to September 30, 2003** | ** ** |
|------------------------------------------------|------------|---------------------------------------------------------------------------|------------|
| **(Dollar in thousands)**                      | ** ** | **Volume**                                                                | ** ** | **Rate** | ** ** | **Total** | ** ** |
|                                           |       |                                                                      |       |   |   |   |   |
| Increase (decrease) in interest income:        |       |                                                                      |       |   |   |   |   |
| Federal funds sold                             |       | $                                                                         | (83        | ) | $ | 32 |   | $ | (51 | ) |
| Time deposits at other financial  institutions |       | (1                                                                        | )          | — |   | (1 | ) |
| Taxable investment securities                  |       | 124                                                                       |       | 33 |   | 157 |   |
| Tax-exempt investment securities               |       | 350                                                                       |       | (38 | ) | 312 |   |
| Loans                                          |       | 2,129                                                                     |       | (946 | ) | 1,183 |   |
| Total:                                         |       | $                                                                         | 2,519      |   | $ | (919 | ) | $ | 1,600 |   |
|                                           |       |                                                                      |       |   |   |   |   |
| Increase (decrease) in interest expense:       |       |                                                                      |       |   |   |   |   |
| Interest bearing demand                        |       | $                                                                         | 3          |   | $ | 1 |   | $ | 4 |   |
| Savings deposits                               |       | 97                                                                        |       | (53 | ) | 44 |   |
| Time deposits                                  |       | (130                                                                      | )          | (102 | ) | (232 | ) |
| Other borrowings                               |       | 367                                                                       |       | (183 | ) | 184 |   |
| Subordinated Debentures                        |       | 186                                                                       |       | (72 | ) | 114 |   |
| Total:                                         |       | $                                                                         | 523        |   | $ | (409 | ) | $ | 114 |   |
|                                           |       |                                                                      |       |   |   |   |   |
| Increase (decrease) in net interest income     |       | $                                                                         | 1,996      |   | $ | (510 | ) | $ | 1,486 |   |

 

| ** **                                     | ** ** | **Nine months ended  September 30, 2004 compared to September 30, 2003** | ** ** |
|------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| **(Dollar in thousands)**                      | ** ** | **Volume**                                                               | ** ** | **Rate** | ** ** | **Total** | ** ** |
|                                           |       |                                                                     |       |   |   |   |   |
| Increase (decrease) in interest income:        |       |                                                                     |       |   |   |   |   |
| Federal funds sold                             |       | $                                                                        | (96        | ) | $ | (4 | ) | $ | (100 | ) |
| Time deposits at other financial  institutions |       | (2                                                                       | )          | — |   | (2 | ) |
| Taxable investment securities                  |       | 668                                                                      |       | (93 | ) | 575 |   |
| Tax-exempt investment securities               |       | 804                                                                      |       | (13 | ) | 791 |   |
| Loans                                          |       | 4,523                                                                    |       | (20 | ) | 4,503 |   |
| Total:                                         |       | $                                                                        | 5,897      |   | $ | (130 | ) | $ | 5,767 |   |
|                                           |       |                                                                     |       |   |   |   |   |
| Increase (decrease) in interest expense:       |       |                                                                     |       |   |   |   |   |
| Interest bearing demand                        |       | $                                                                        | 8          |   | $ | — |   | $ | 8 |   |
| Savings deposits                               |       | 367                                                                      |       | (28 | ) | 339 |   |
| Time deposits                                  |       | (14                                                                      | )          | (548 | ) | (562 | ) |
| Other borrowings                               |       | 76                                                                       |       | (4 | ) | 72 |   |
| Subordinated debentures                        |       | 364                                                                      |       | (36 | ) | 328 |   |
| Total:                                         |       | $                                                                        | 801        |   | $ | (616 | ) | $ | 185 |   |
|                                           |       |                                                                     |       |   |   |   |   |
| Increase (decrease) in net interest income     |       | $                                                                        | 5,096      |   | $ | 486 |   | $ | 5,582 |   |

 

19

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*Provision For Loan Losses.*** **Theprovision for loan losses for the three and nine months ended September 30,2004 was $760,000 and $2,001,000 compared with $751,000 and $1,904,000 for thethree and nine months ended September 30, 2003, an increase of $9,000 and$97,000 or 1% and 5%.  See “Allowance forLoan Losses” contained herein.  As ofSeptember 30, 2004 the allowance for loan losses was $14,361,000 or 1.67% oftotal loans which compares to the allowance for loan losses of $13,263,000 or1.74% of total loans as of December 31, 2003. At September 30, 2004, nonperforming assets totaled $4,306,000 or 0.32%of total assets, nonperforming loans totaled $4,246,000 or 0.49% of total loansand the allowance for loan losses totaled 338% of nonperforming loans.  At December 31, 2003, nonperforming assetstotaled $4,047,000 or 0.33% of total assets, nonperforming loans totaled$3,987,000 or 0.52% of total loans and the allowance for loan losses totaled333% of nonperforming loans.  Noassurance can be given that nonperforming loans will not increase or that theallowance for loan losses will be adequate to cover losses inherent in the loanportfolio.  The increase in nonperformingloans between December 31, 2003 and September 30, 2004 was due to thedowngrading of a $1,000,000 real estate loan during the second quarter of2004.  This loan is adequately secured bya first deed of trust.  Nonperformingloans decreased $695,000 during the three months ended September 30, 2004.  The improvement in nonperforming loans forthe quarter was primarily the result of the return to performing status of onelarge commercial credit during the quarter. The level of net charge-offs decreased slightly to $156,000 for thethree months ended September 30, 2004 when compared to the $200,000 recordedfor the same period in 2003.  For thenine months ended September 30, 2004, the level of net charge-offs were$903,000, an increase of $42,000 over the $861,000 recorded for the same periodin 2003.  Net charge-off activity levelsare expected to continue in the range of 0.15% to 0.20% of average loans forthe remainder of the 2004.

* *

*Noninterest Income.*** **Noninterestincome increased by $69,000 and $369,000 or 3% and 5% to $2,619,000 and$7,650,000 for the three and nine months ended September 30, 2004 compared with$2,550,000 and $7,281,000 for the same periods during 2003.  Service charges on deposit accounts increasedby $211,000 and $591,000 or 15% to $1,641,000 and $4,655,000 for the three andnine months ended September 30, 2004 compared with $1,430,000 and $4,064,000achieved during for the same period in 2003. The increase in fees is the result of increased customer use of existingfee based products.  Other incomedecreased by $157,000 and $216,000 or 18% and 9% for the three and nine monthperiods ended September 30, 2004 when compared to the same periods in2003.  The primary source of the decreasein other income is the sale of the consumer credit card portfolio in March,2003 for a gain of $82,000, the gain on sale of foreclosure property for an$81,000 gain in February 2003, and reduced mortgage packaging fees for the ninemonths ended September 30, 2004 of $281,000, a decrease of $155,000 from the$436,000 achieved during the same nine month period in 2003.

 

*Noninterest Expense.*** **Noninterest expenses increased by $168,000and $1,684,000 or 2% and 6% to $9,165,000 and $27,879,000 for the three andnine months ended September 30, 2004 compared with the $8,997,000 and$26,195,000 recorded during for the same periods in 2003.  The primary components of noninterestexpenses were salaries and employee benefits, equipment expense, premises andoccupancy expense, professional fees, marketing expense, supplies expense andother operating expenses.

 

Forthe three and nine months ended September 30, 2004, salaries and relatedbenefits increased by $234,000 and $1,291,000 or 5% and 9% to $4,976,000 and$15,470,000 from the $4,742,000 and $14,179,000 recorded for the same period in2003. The salary expense increase was primarily the result of normal salaryprogression, increased back office staffing, and incentive bonus payments.  

Equipment expense decreased by $86,000 and increasedby $25,000 or as reduction of 10% and an increase of 1% to

 

20

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$789,000 and $2,361,000 for the three and nine monthsended September 30, 2004 from the $875,000 and $2,336,000 recorded during thesame periods in 2003.  The levels ofequipment costs were related to timing of branch equipment upgrades andtechnology spending.  No new branchlocations were opened during the third quarter of 2004 which helped hold downequipment costs.  Premises and occupancyexpenses increased by $263,000 or 36% and $424,000 or 20% to $990,000 and$2,533,000 for the three and nine months ended September 30, 2004 from $727,000and $2,109,000 during the same periods in 2003. The primary reason for the increase in occupancy costs in 2004 isrelated to branch site improvements and the addition of a new retail bankingfacility in Fresno in June 2003.  When comparing the results of the three andnine months ended September 30, 2004 to three and nine months ended September30, 2003, professional fees increased by $25,000 or 8% for the three monthperiod and increased $35,000 or 3% for the nine month period, marketingexpenses increased by $73,000 and $65,000 or 35% and 9%, goodwill and intangibleamortization expense decreased by $3,000 and $10,000 or 2%, supplies expenseincreased by $39,000 and $7,000 or 21% and 1%, and other expenses decreased$377,000 and $153,000 or 21% and 3% from 2003 levels.  These general and administrative expense changeswere the result of general growth of the Company during the period, and thetiming between quarters as to when these expenses were incurred.  The rate of increase in general andadministrative expenses year over year has been less than the growth rate ofthe Company as a whole.  As the Companycontinues to grow, management intends to continue to take steps to keep thegrowth rate of general and administrative expenses at a rate that is lower thanthe growth rate of the Company.

 

*Provision For Income Taxes.*** **TheCompany recorded an increase in the income tax provision of $958,000 and$2,537,000 or 88% and 85% to $2,042,000 and $5,539,000 for the three and ninemonths ended September 30, 2004 compared to $1,084,000 and $3,002,000 recordedfor the same period in 2003.  During thethree and nine months ended September 30, 2004 the Company achieved aneffective tax rate of 34% and 32% which compares to 23% for the three and ninemonths ended September 30, 2003.  During2004, the effective tax rate has increased by 11% for the third quarter and 9%for the year to date over comparable 2003 levels.  The effective tax rate for the third quarterof 2003 includes a REIT benefit that was reversed in the fourth quarter of 2003when the Franchise Tax Board listed certain REIT transactions as abusive taxshelters.  For the full year 2003, theCompany’s effective tax rate was 26%. The increase in the effective tax rate to 34% in the third quarter of2004 when compared to the 32% for the nine months ended September 30, 2004, wasprimarily the result of the filing of the 2003 income tax return during thethird quarter of 2004, which resulted in the realization of decreased benefitsfor federal housing tax credits and decreased benefits related to EnterpriseZone credits than previously estimated by management.  For the three and nine months ended September30, 2004, the effective tax rate was negatively affected by the elimination ofa recorded tax benefit related to the Bank’s REIT as well as increased levelsof fully taxable earnings.  The Company’seffective tax rate of 32% for the nine months ended September 30, 2004 and 23%for the same period in 2003 is also influenced by the Bank’s investment in suchassets as limited partnerships which own low income housing projects thatgenerate federal and state income tax credits and other investments withearnings that provide the Company with tax exempt income such as municipalsecurities and single premium universal life policies.

 

**Financial Condition**

 

Totalassets at September 30, 2004 were $1,351,396,000, an increase of $116,854,000or 9% compared with total assets of $1,234,542,000 at December 31, 2003.  Net loans were $843,619,000 at September 30,2004, an increase of $92,630,000 or 12% compared with net loans of $750,989,000at December 31, 2003.  Deposits were$1,087,651,000 at September 30, 2004, an increase of $58,843,000 or 6% comparedwith deposits of $1,028,808,000 at December 31, 2003.  The increase in total assets of

 

21

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the Company between December 31, 2003 and September30, 2004 was primarily the result of an increase in deposits and other borrowedfunds that were obtained to fund additional purchases or originations ofinterest earning assets.

 

Total shareholders’ equity was $101,775,000 atSeptember 30, 2004, an increase of $12,290,000 or 14% from $89,485,000 atDecember 31, 2003. The growth in shareholders’ equity between December 31, 2003and September 30, 2004 was achieved through the retention of accumulated earningswhich was partially offset by a decline in other comprehensive income.  Other comprehensive income consists ofchanges in the fair market value compared to book value of available for saleinvestment securities and valuation changes in the Bank’s interest rate swap,net of estimated federal and state income taxes.

* *

*Off-Balance Sheet Commitments. *The following table shows the distribution of theCompany’s undisbursed loan commitments at the dates indicated.

 

| **(Dollars in thousands)**   | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|------------------------------|------------|-------------------------|------------|------------------------|------------|
|                         |       |                    |       |                   |       |
| Letters of credit            |       | $                       | 13,337     |                   | $          | 7,380 |   |
| Commitments to extend credit |       | 394,141                 |       | 348,282                |       |
| Total                        |       | $                       | 407,478    |                   | $          | 355,662 |   |

 

22

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*Cash Value of Life Insurance. *The Bank maintains certain cash surrender value lifeinsurance policies to help offset some of the cost of employee benefitprograms.  They are associated with asalary continuation plan for the Company’s executive management and deferredretirement benefits for participating board members.  These plans are informally linked withuniversal life insurance policies maintained by the Bank.  Income from these policies is reflected innoninterest income.  At September 30,2004, the Bank held $28,063,000 in cash surrender value life insurance, anincrease of $3,925,000 from the $24,138,000 maintained at December 31, 2003.

 

*Investment in Housing Tax Credit LimitedPartnerships. *The Bank invests in housing tax creditlimited partnerships to help meet the Bank’s Community Reinvestment Act (“CRA”)low income housing investment requirements as well as to obtain federal andstate income tax credits.  Thesepartnerships provide the funding for low-income housing projects that might nototherwise be created.

 

*Investment Securities. *At September 30, 2004 equity securitiesincluded $14.7 million of preferred stock issued by the Federal NationalMortgage Association and the Federal Home Loan Mortgage Corporation.  These issues of preferred stock are tied tovarious short term indexes ranging from the one year LIBOR interest rate to thefive year U.S. Treasury rate.  Thesesecurities have AA- credit ratings from the securities rating agencies and arecallable by the issuer at par.  AtSeptember 30, 2004, the unrealized loss on these securities totaled $2.4million compared to $1.8 million at December 31, 2003.  It is expected that these investments willincrease in value as short term interest rates rise.

 

In March 2004, the FASBissued Emerging Issues Task Force Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and ItsApplication to Certain Investments”. This EITF describes a model involving three steps:  (1) determine whether an investment isimpaired, (2) determine whether the impairment is other-than-temporary, and (3)recognize the impairment loss in earnings. The EITF also requires several additional disclosures for cost-methodinvestments.  The EITF’s impairmentaccounting guidance was effective for reporting periods beginning after June15, 2004. In September 2004, the FASB delayed the requirement to recordimpairment losses under EITF 03-1.  Thedisclosure requirements of EITF 03-1 remain in effect.  The Company does not expect the adoption ofthe final EITF****will have a material impact ofthe Company’s Consolidated Financial Statements.

 

At September 30,2004, management believes the impairments described above are temporary and,accordingly, no impairment loss has been recognized in the Company’sconsolidated statement of income.

 

*Nonperforming Assets. *Nonperforming assets include nonaccrualloans, loans 90 days or more past due, restructured loans and other real estateowned.

 

Nonperformingloans are those which the borrower fails to perform in accordance with theoriginal terms of the obligation and include loans on nonaccrual status, loanspast due 90 days or more and restructured loans.  The Company generally places loans onnonaccrual status and accrued but unpaid interest is reversed against thecurrent year’s income when interest or principal payments become 90 days ormore past due unless the outstanding principal and interest is adequatelysecured and, in the opinion of management, is deemed in the process ofcollection.  Interest income onnonaccrual loans is recorded on a cash basis. Payments may be treated as interest income or return of principaldepending upon management’s opinion of the ultimate risk of loss on theindividual loan.  Cash payments aretreated as interest income where management believes the remaining principalbalance is fully collectible.  Additionalloans not 90 days past due may also be placed on nonaccrual status ifmanagement reasonably

 

23

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believes the borrower will not be able to comply withthe contractual loan repayment terms and collection of principal or interest isin question.

 

A“restructured loan” is a loan on which interest accrues at a below market rateor upon which certain principal has been forgiven so as to aid the borrower inthe final repayment of the loan, with any interest previously accrued, but notyet collected, being reversed against current income.  Interest is reported on a cash basis untilthe borrower’s ability to service the restructured loan in accordance with itsterms is established.  The Company had norestructured loans as of the dates indicated in the table below.

 

24

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The following table summarizes nonperforming assets ofthe Company at September 30, 2004 and December 31, 2003:

 

| **(Dollars in thousands)**              | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                              | ** ** | ** **              | ** ** | ** **             | ** ** |
| Nonaccrual loans                        |       | $                       | 3,836      |                   | $          | 3,987 |   |
| Accruing loans past due 90 days or more |       | 410                     |       | —                 |       |
| Total nonperforming loans               |       | 4,246                   |       | 3,987                  |       |
| Other real estate owned                 |       | 60                      |       | 60                     |       |
| Total nonperforming assets              |       | $                       | 4,306      |                   | $          | 4,047 |   |
|                                    |       |                    |       |                   |       |
| Nonperforming loans to total loans      |       | 0.49                    | %          | 0.52                   | %          |
| Nonperforming assets to total assets    |       | 0.32                    | %          | 0.33                   | %          |

 

Contractual accrued interest income on loans onnonaccrual status as of September 30, 2004 and 2003, that would have beenrecognized if the loans had been current in accordance with their originalterms was approximately $93,000 and$45,000, respectively.

 

At September 30, 2004, nonperforming assetsrepresented 0.32% of total assets, a decrease of 1 basis points when comparedto the 0.33% at December 31, 2003. Nonperforming loans represented 0.49% of total loans at September 30,2004, a decrease of 3 basis points compared to the 0.52% at December 31,2003.  Nonperforming loans that weresecured by first deeds of trust on real property were $4,139,000 at September30, 2004 and $3,716,000 at December 31, 2003.  Other forms of collateral such as inventory and equipment secured thenonperforming loans as of each date.  Noassurance can be given that the collateral securing nonperforming loans will besufficient to prevent losses on such loans.

 

The increase in nonperforming loans and nonperformingassets as of September 30, 2004 compared with their levels as of December 31,2003, was due to the addition of anonperforming $1,000,000 commercial loan in the second quarter of 2004.  This commercial loan is well secured by afirst deed of trust.  During the thirdquarter of 2004, the level of nonperforming loans decreased by $695,000, dueprimarily to the return to performing status of one large commercial credit.

 

At September 30, 2004 and December 31, 2003, theCompany had $60,000 invested in one property, respectively, that had beenacquired through foreclosure.  Theproperty was carried at the lower of its estimated market value, as evidencedby an independent appraisal, or the recorded investment in the related loan,less estimated selling expenses.  Atforeclosure, if the fair value of the real estate is less than the Company’srecorded investment in the related loan, a charge is made to the allowance forloan losses.  The Company expects to sellmost of these properties within a twelve month period.    No assurance can be given that the Companywill sell the remaining property during 2004 or at any time or the amount forwhich the property might be sold.

 

Management defines impaired loans, regardless of pastdue status on loans, as those on which principal and interest are not expectedto be collected under the original contractual loan repayment terms.  An impaired loan is charged off at the timemanagement believes the collection process has been exhausted.  At September 30, 2004 and December 31, 2003,impaired loans were measured based on the present value of future cash flowsdiscounted at the loan’s effective rate, the loan’s observable market

 

25

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price or the fair value of collateral if the loan iscollateral-dependent.  Impaired loans atSeptember 30, 2004 were **$**4,246,000 for which the Company madeprovisions to the allowance for loan losses of approximately $484,000.

 

Except for loans that are disclosed above, there wereno assets as of September 30, 2004, where known information about possiblecredit problems of borrower causes management to have serious doubts as to theability of the borrower to comply with the present loan repayment terms andwhich may become nonperforming assets. Given the magnitude of the Company’s loan portfolio, however, it isalways possible that current credit problems may exist that may not have beendiscovered by management.

 

**Allowancefor Loan Losses**

 

The following table summarizes the loan loss experience of the Companyfor the nine months ended September 30, 2004 and 2003, and for the year endedDecember 31, 2003.

** **

| ** **                                  | ** ** | **September 30**           | ** ** | **December 31** | ** ** |
|---------------------------------------------|------------|----------------------------|------------|-----------------|------------|
| ** **                                  | ** ** | **2004**                   | ** ** | **2003**        | ** ** | **2003** | ** ** |
| ** **                                  | ** ** | **(Dollars in thousands)** | ** ** |
| Allowance for Loan Losses:                  |       |                       |       |            |       |   |   |
| Balance at beginning of period              |       | $                          | 13,263     |            | $          | 12,134 |   | $ | 12,134 |   |
| Provision for loan losses                   |       | 2,001                      |       | 1,904           |       | 2,455 |   |
| Charge-offs:                                |       |                       |       |            |       |   |   |
| Commercial and agricultural                 |       | 1,104                      |       | 750             |       | 1,010 |   |
| Real estate mortgage                        |       | —                     |       | —          |       | 29 |   |
| Consumer                                    |       | 316                        |       | 646             |       | 956 |   |
| Total charge-offs                           |       | 1,420                      |       | 1,396           |       | 1,995 |   |
| Recoveries                                  |       |                       |       |            |       |   |   |
| Commercial and agricultural                 |       | 305                        |       | 229             |       | 302 |   |
| Consumer                                    |       | 212                        |       | 306             |       | 367 |   |
| Total recoveries                            |       | 517                        |       | 535             |       | 669 |   |
| Net charge-offs                             |       | 903                        |       | 861             |       | 1,326 |   |
| Balance at end of period                    |       | $                          | 14,361     |            | $          | 13,177 |   | $ | 13,263 |   |
|                                        |       |                       |       |            |       |   |   |
| Loans outstanding at period-end             |       | $                          | 857,980    |            | $          | 721,922 |   | $ | 764,252 |   |
| Average loans outstanding                   |       | $                          | 799,997    |            | $          | 672,370 |   | $ | 687,419 |   |
|                                        |       |                       |       |            |       |   |   |
| Annualized net charge-offs to average loans |       | 0.15                       | %          | 0.17            | %          | 0.19 | % |
| Allowance for loan losses                   |       |                       |       |            |       |   |   |
| To total loans                              |       | 1.67                       | %          | 1.83            | %          | 1.74 | % |
| To nonperforming loans                      |       | 338.25                     | %          | 760.36          | %          | 332.70 | % |
| To nonperforming assets                     |       | 333.51                     | %          | 734.86          | %          | 327.74 | % |

 

TheCompany maintains an allowance for loan losses at a level considered bymanagement to be adequate to cover the inherent risks of loss associated withits loan portfolio under prevailing economic conditions.  In determining the adequacy of the allowancefor loan losses, management takes into consideration growth trends in theportfolio, examination of financial institution supervisory authorities, priorloan loss experience for the Company, concentrations of credit risk,delinquency trends, general economic conditions, the interest rate environmentand internal and external credit reviews. In addition, the risks management considers vary depending on the natureof the loan.  The normal risks consideredby management with respect to agricultural loans include the fluctuating valueof the collateral, changes in weather conditions and the availability ofadequate water resources in the Company’s local market

 

26

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area.  Thenormal risks considered by management with respect to real estate constructionloans include fluctuation in real estate values, the demand for improvedcommercial and industrial properties and housing, the availability of permanentfinancing in the Company’s market area and borrowers’ ability to obtain permanentfinancing.  The normal risks consideredby management with respect to real estate mortgage loans include fluctuationsin the value of real estate. Additionally, the Company relies on data obtained through independentappraisals for significant properties to determine loss exposure onnonperforming loans.

 

Thebalance in the allowance is affected by the amounts provided from operations,amounts charged off and recoveries of loans previously charged off.  The Company recorded a provision for loanlosses of $760,000 and $2,001,000 for the three and nine months ended September30, 2004 compared with $751,000 and $1,904,000 during the same periods of 2003.The increase in loan loss provision during the first nine months of 2004 wasrecorded to coincide with the higher level of nonperforming loans and growthwithin the loan portfolio during the first nine months of 2004 when compared tothe same period in 2003.  The Company’scharge-offs, net of recoveries, were $903,000 for the nine months endedSeptember 30, 2004 compared with $861,000 for the same nine months in2003.  The increase in net charge-offsfor the first nine months of 2004 was primarily due to increased charge-offsthat occurred within the commercial and agricultural segment and decreasedrecoveries within the consumer loan segment of the loan portfolio.

 

Asof September 30, 2004, the allowance for loan losses was $14,361,000 or 1.67%of total loans outstanding, compared with $13,263,000 or 1.74% of total loansoutstanding as of December 31, 2003 and $13,177,000 or 1.83% of total loansoutstanding as of September 30, 2003.

 

TheCompany uses a method developed by management for determining the appropriatelevel of its allowance for loan losses. This method applies relevant risk factors to the entire loan portfolio,including nonperforming loans.  Themethodology is based, in part, on the Company’s loan grading and classificationsystem.  The Company grades its loansthrough internal reviews and periodically subjects loans to external reviewswhich then are assessed by the Company’s audit committee and management.  Credit reviews are performed on a monthlybasis and the quality grading process occurs on a quarterly basis. Risk factorsapplied to the performing loan portfolio are based on the Company’s past losshistory considering the current portfolio’s characteristics, current economicconditions and other relevant factors. General reserves are applied to various categories of loans atpercentages ranging up to 1.8% based on the Company’s assessment of creditrisks for each category.  Risk factorsare applied to the carrying value of each classified loan: (i) loansinternally graded “Watch” or “Special Mention” carry a risk factor from 1.0% to2.0%; (ii) ”Substandard” loans carry a risk factor from 15% to 40%depending on collateral securing the loan, if any; (iii) “Doubtful” loans carrya 50% risk factor; and (iv) “Loss” loans are charged off 100%.  In addition, a portion of the allowance isspecially allocated to identified problem credits.  The analysis also includes reference tofactors such as the delinquency status of the loan portfolio, inherent risk bytype of loans, industry statistical data, recommendations made by the Company’sregulatory authorities and outside loan reviewers, and current economicenvironment.  Important components of theoverall credit rating process are the asset quality rating process and theinternal loan review process.

 

Theallowance is based on estimates and ultimate future losses may vary fromcurrent estimates.  It is always possiblethat future economic or other factors may adversely affect the Company’sborrowers, and thereby cause loan losses to exceed the current allowance.  In addition, there can be no assurance thatfuture economic or other factors will not adversely affect the Company’sborrowers, or that the Company’s asset quality may not deteriorate throughrapid growth, failure to enforce underwriting standards, failure to maintainappropriate underwriting standards, failure to maintain an adequate number

 

27

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of qualified loan personnel, failure to identify andmonitor potential problem loans or for other reasons, and thereby cause loanlosses to exceed the current allowance.

* *

*External Factors Affecting Asset Quality. *As a result of the Company’s loan portfolio mix, thefuture quality of its assets could be affected by adverse economic trends inits region or in the agricultural community. These trends are beyond the control of the Company.

 

Californiais an earthquake-prone region. Accordingly, a major earthquake could result in material loss to theCompany.  At times the Company’s servicearea has experienced other natural disasters such as floods and droughts.  The Company’s properties and substantiallyall of the real and personal property securing loans in the Company’s portfolioare located in California.  The Companyfaces the risk that many of its borrowers face uninsured property damage,interruption of their businesses or loss of their jobs from earthquakes, floodsor droughts.  As a result these borrowersmay be unable to repay their loans in accordance with their terms and thecollateral for such loans may decline significantly in value.  The Company’s service area is a largelyagricultural region and therefore is highly dependent on a reliable supply ofwater for irrigation purposes.  The areaobtains nearly all of its water from the run-off of melting snow in themountains of the Sierra Nevada to the east. Although such sources have usually been available in the past, watersupply can be adversely affected by light snowfall over one or more winters orby any diversion of water from its present natural courses.  Any such natural disaster could impair theability of many of the Company’s borrowers to meet their obligations to theCompany.

 

Partsof California have experienced significant floods in the late 1990s. Noassurance can be given that future flooding will not have an adverse impact onthe Company and its borrowers and depositors.

* *

*Liquidity.*In order to maintain adequate liquidity, the Companymust have sufficient resources available at all times to meet its cash flowrequirements.  The need for liquidity ina banking institution arises principally to provide for deposit withdrawals,the credit needs of its customers and to take advantage of investmentopportunities as they arise.  The Companymay achieve desired liquidity from both assets and liabilities.  The Company considers cash and deposits heldin other banks, federal funds sold, other short term investments, maturingloans and investments, payments of principal and interest on loans andinvestments and potential loan sales as sources of asset liquidity.  Deposit growth and access to credit linesestablished with correspondent banks and market sources of funds are consideredby the Company as sources of liability liquidity.  The holding company’s primary source ofliquidity is from dividends received from the Bank.  Dividends from the Bank are subject tocertain regulatory restrictions.

 

TheCompany reviews its liquidity position on a regular basis based upon itscurrent position and expected trends of loans and deposits. These assetsinclude cash and deposits in other banks, available-for-salesecurities and federal funds sold.  TheCompany’s liquid assets totaled $315,185,000 and $321,235,000 on September 30,2004 and December 31, 2003, respectively, and constituted 23% and 26% of totalassets on those dates.  Liquidity is alsoaffected by the collateral requirements of its public deposits and certainborrowings.  Total pledged securitieswere $312,061,000 at September 30, 2004 compared with $295,024,000****at December 31, 2003.

 

Althoughthe Company’s primary sources of liquidity include liquid assets and a stabledeposit base, the Company maintains lines of credit with the Federal ReserveBank of San Francisco (“FRBSF”), Federal Home Loan Bank of San Francisco,Pacific Coast Bankers’ Bank, Union Bank of California, Wells Fargo Bank andFirst Tennessee Bank aggregating $203,962,000 of which $130,828,000 wasoutstanding as of September 30, 2004 and $83,346,000 was outstanding as ofDecember 31, 2003. The

 

28

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increase in borrowings outstanding during 2004produced an inflow of funds that were used to purchase additional investmentsecurities and provided funds to the Bank that allowed $20,000,000 in brokereddeposits to mature.  Management believesthat the Company maintains adequate amounts of liquid assets to meet itsliquidity needs.  The Company’s liquiditymight be insufficient if deposit withdrawals were to exceed anticipatedlevels.  Deposit withdrawals can increaseif a company experiences financial difficulties or receives adverse publicityfor other reasons, or if its pricing, products or services are not competitivewith those offered by other institutions.

* *

*Capital Resources. *Capitalserves as a source of funds and helps protect depositors against potentiallosses.  The primary source of capitalfor the Company has been internally generated capital through retainedearnings.  The Company’s shareholders’equity increased by $12,290,000 or 14% from December 31, 2003 to September 30,2004.

 

TheCompany is subject to various regulatory capital requirements administered bythe federal banking agencies.  Failure tomeet minimum capital requirements can initiate mandatory and possiblyadditional discretionary actions by the regulators that, if undertaken, couldhave a material adverse effect on the Company’s financial statements.  Management believes, as of September 30,2004, that the Company and the Bank met all applicable capitalrequirements.  The Company’s leveragecapital ratio at September 30, 2004 was 8.69% as compared with 8.55% as ofDecember 31, 2003.  The Company’s totalrisk based capital ratio at September 30, 2004 was 11.81% as compared to 11.57%as of December 31, 2003.

 

TheCompany’s and Bank’s actual capital amounts and ratios met all regulatoryrequirements as of September 30, 2004 and were summarized as follows:

 
| ** **                               | ** ** | **Actual** | ** ** | **For Capital  Adequacy Purposes** | ** ** | **To Be Well Capitalized  Under Prompt  Corrective  Action Provisions:** | ** ** |
|------------------------------------------|------------|------------|------------|------------------------------------|------------|--------------------------------------------------------------------------|------------|
| **Dollars in thousands**                 | ** ** | **Amount** | ** ** | **Ratio**                          | ** ** | **Amount**                                                               | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| Consolidated                             |       |       |       |                               |       |                                                                     |       |   |   |   |   |   |   |
|                                     |       |       |       |                               |       |                                                                     |       |   |   |   |   |   |   |
| As of September 30, 2004                 |       |       |       |                               |       |                                                                     |       |   |   |   |   |   |   |
| Total capital (to risk weighted assets)  |       | $          | 127,854    |                               | 11.79      | %                                                                        | $          | 86,724 |   | 8.0 | % | $ | 108,405 |   | 10.0 | % |
| Tier 1 capital (to risk weighted assets) |       | 114,294    |       | 10.54                              |       | 43,362                                                                   |       | 4.0 |   | 65,043 |   | 6.0 |   |
| Leverage ratio*                          |       | 114,294    |       | 8.72                               |       | 52,406                                                                   |       | 4.0 |   | 65,508 |   | 5.0 |   |
|                                     |       |       |       |                               |       |                                                                     |       |   |   |   |   |   |   |
| The Bank:                                |       |       |       |                               |       |                                                                     |       |   |   |   |   |   |   |
|                                     |       |       |       |                               |       |                                                                     |       |   |   |   |   |   |   |
| As of September 30, 2004                 |       |       |       |                               |       |                                                                     |       |   |   |   |   |   |   |
| Total capital (to risk weighted assets)  |       | $          | 116,054    |                               | 10.85      | %                                                                        | $          | 86,416 |   | 8.0 | % | $ | 108,020 |   | 10.0 | % |
| Tier 1 capital (to risk weighted assets) |       | 102,541    |       | 9.49                               |       | 43,208                                                                   |       | 4.0 |   | 64,812 |   | 6.0 |   |
| Leverage ratio*                          |       | 102,541    |       | 7.85                               |       | 52,283                                                                   |       | 4.0 |   | 65,354 |   | 5.0 |   |

 

----

***** The leverage ratio consists of Tier 1capital divided by adjusted quarterly average assets.  The minimum leverage ratio is 3 percent forbanking organizations that do not anticipate significant growth and that havewell-diversified risk, excellent asset quality and in general, are consideredtop-rated banks.

 

TheCompany issues dividends solely at the discretion of the Company’s Board of Directors,subject to compliance with regulatory requirements.  In order to pay any cash dividends, theCompany must receive payments of dividends or management fees from theBank.  There are certain regulatorylimitations on the payment of cash dividends by banks.

 

On October 26, 2004, theBank entered into a written agreement (the Agreement) with the FRBSF relatingto certain deficiencies identified by the FRB with respect to the Bank’scompliance with 

 

29

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the Bank Secrecy Act (“BSA”) and otherapplicable laws and regulations relating to anti-money laundering (“AML”).  CCOW has filed a Form 8-K containing theBank’s Agreement with the FRBSF with the SEC.

 

The banking industry,including the Bank, is subject to significantly increased regulatory scrutinyand enforcement regarding BSA matters. Under the Agreement, the Bank will, among other actions to be taken, (i)develop a written program designed to improve the Bank’s system of internalcontrols to ensure compliance with applicable provisions of the BSA; (ii)develop an enhanced written customer due diligence program designed toreasonably ensure the identification and reporting of all known or suspectedviolations of law and suspicious transactions against or involving the Bank;(iii) establish enhanced written policies and procedures designed to strengthenthe Bank’s internal controls and audit program, and (iv) submit quarterlyprogress reports to the FRBSF detailing actions taken to secure compliance withthe Agreement.

 

The Bank has already madesignificant progress in addressing the deficiencies identified by theFRBSF.  The compliance effort will entailcertain additional expenditures.  In addition,while the Agreement is in place, its effect may be to limit the Bank’s abilityto engage in certain expansionary activity. Neither of these effects are expected to have a material adverse impacton the financial condition nor results of operations of the Bank or the Company.

* *

*Deposits.*  Deposits arethe Company’s primary source of funds. At September 30, 2004, the Company had a deposit mix of 32% in savingsdeposits, 33% in time deposits, 14% in interest-bearing checking accountsand 21% in noninterest-bearing demand accounts.  Noninterest-bearing demand deposits enhancethe Company’s net interest income by lowering its costs of funds.

 

TheCompany obtains deposits primarily from the communities it serves.  No material portion of its deposits has beenobtained from or is dependent on any one person or industry.  The Company’s business is not seasonal innature.  The Company accepts deposits inexcess of $100,000 from customers.  Thesedeposits are priced to remain competitive. At September 30, 2004, the Company had brokered deposits of $299,000.

 

Maturitiesof time certificates of deposits of $100,000 or more outstanding at September30, 2004 and December 31, 2003 are summarized as follows:

 

| ** **                | ** ** | **September 30, 2004**     | ** ** | **December 31, 2003** | ** ** |
|---------------------------|------------|----------------------------|------------|-----------------------|------------|
| ** **                | ** ** | **(Dollars in thousands)** | ** ** |
|                      |       |                       |       |                  |       |
| Three months or less      |       | $                          | 41,222     |                  | $          | 68,249 |   |
| Over three to six months  |       | 37,778                     |       | 37,829                |       |
| Over six to twelve months |       | 43,242                     |       | 31,060                |       |
| Over twelve months        |       | 39,598                     |       | 35,600                |       |
| Total                     |       | $                          | 161,840    |                  | $          | 172,738 |   |

 

**Borrowed Funds**

 

Borrowedfunds increased by $47,342,000 or 51% to $140,159,000 at September 30, 2004compared to the $92,817,000 outstanding at December 31, 2003.  The increase in borrowed funds during 2004was primarily used to purchase new investment securities and to allow$20,000,000 in brokered certificates of deposit to mature.

 

30

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**Return on Equity and Assets**

 
| ** **                          | ** ** | **Three months ended  September 30  2004** | ** ** | **Three months ended  September 30  2003** | ** ** | **Year ended  December 31  2003** | ** ** |
|-------------------------------------|------------|--------------------------------------------|------------|--------------------------------------------|------------|-----------------------------------|------------|
|                                |       |                                       |       |                                       |       |                              |       |
| Annualized return on average assets |       | 1.21                                       | %          | 1.26                                       | %          | 1.23                              | %          |
| Annualized return on average equity |       | 16.26                                      | %          | 17.27                                      | %          | 16.43                             | %          |
| Dividend payout ratio               |       | 7.73                                       | %          | —                                     |       | —                            |       |
| Average equity to average assets    |       | 7.47                                       | %          | 7.28                                       | %          | 7.46                              | %          |

 

**Impact of Inflation**

 

Theprimary impact of inflation on the Company is its effect on interestrates.  The Company’s primary source ofincome is net interest income which is affected by changes in interestrates.  The Company attempts to limitinflation’s impact on its net interest margin through management of rate sensitiveassets and liabilities and the analysis of interest rate sensitivity.  The effect of inflation on premises andequipment, as well as on interest expenses, has not been significant for theperiods covered in this report.

 

31

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**Item 3.             Quantitative and Qualitative Disclosuresabout Market Risk**

 

In the normalcourse of business, the Company is exposed to market risk which includes bothprice and liquidity risk.  Price risk iscreated from fluctuations in interest rates and the mismatch in repricingcharacteristics of assets, liabilities, and off balance sheet instruments at aspecified point in time.  Mismatches ininterest rate repricing among assets and liabilities arise primarily throughthe interaction of the various types of loans versus the types of deposits thatare maintained as well as from management’s discretionary investment and fundsgathering activities.  Liquidity riskarises from the possibility that the Company may not be able to satisfy currentand future financial commitments or that the Company may not be able toliquidate financial instruments at market prices.  Risk management policies and procedures havebeen established and are utilized to manage the Company’s exposure to marketrisk.  Quarterly testing of the Company’sassets and liabilities under both increasing and decreasing interest rateenvironments are performed to insure the Company does not assume a magnitude ofrisk that is outside approved policy limits.

 

The Company’ssuccess is largely dependent upon its ability to manage interest raterisk.  Interest rate risk can be definedas the exposure of the Company’s net interest income to adverse movements ininterest rates.  Although the Companymanages other risks, such as credit and liquidity risk in the normal course ofits business, management considers interest rate risk to be its mostsignificant market risk and could potentially have the largest material effecton the Company’s financial condition and results of operations.  Correspondingly, the overall strategy of theCompany is to manage interest rate risk, through balance sheet structure, to beinterest rate neutral.

 

The Company’sinterest rate risk management is the responsibility of the Asset/LiabilityManagement Committee (ALCO), which reports to the Board of Directors.  ALCO establishes policies that monitors andcoordinates the Company’s sources, uses and pricing of funds.  ALCO is also involved in formulating theeconomic projections for the Company’s budget and strategic plan.  ALCO sets specific rate sensitivity limitsfor the Company.  ALCO monitors andadjusts the Company’s exposure to changes in interest rates to achievepredetermined risk targets that it believes are consistent with current andexpected market conditions.  Balancesheet management personnel monitor the asset and liability changes on anongoing basis and provide report information and recommendations to the ALCOcommittee in regards to those changes.

 

It is the opinionof management there has been no material change in the Company’s market riskduring the nine months ended September 30, 2004 when compared to the level ofmarket risk at December 31, 2003.  Ifinterest rates were to suddenly and materially fall from levels anticipated inthe fourth quarter of 2004, the Company could become susceptible to anincreased level of market risk.

 

32

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**Item 4.             Controls and Procedures**

 

EvaluationOf Disclosure Controls And Procedures

 

Under the supervision andwith the participation of the Company’s management, including its chiefexecutive office and chief financial officer, the Company conducted anevaluation of the effectiveness of the design and operation of its disclosurecontrols and procedures as defined by Rules 13a – 15 under the Securities ExchangeAct of 1934.

 

Based on the evaluation, thechief executive officer and chief financial officer concluded that as of theend of the period covered by this report the disclosure controls and procedureswere adequate and effective, and that the material information required to beincluded in this report, including information from the Company’s consolidatedsubsidiaries, was properly recorded, processed, summarized and reported, andwas made known to the chief executive officer and chief financial officer byothers within the Company in a timely manner, particularly during the periodwhen this quarterly report on Form 10-Q was being prepared.

 

ChangesIn Internal Controls

 

There were no changes in ourinternal control over financial reporting that occurred during our last fiscalquarter that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.

 

33

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**PART II****- Other Information**

 

**Item 1****.             Legal Proceedings**

 

The Company is a party to routine litigation in theordinary course of its business.  In theopinion of management, pending and threatened litigation is not likely to havea material adverse effect on the financial condition or results of operationsof the Company.

** **

**Item 2****.             Changesin Securities and Use of Proceeds.**

 

None.

** **

**Item 3.****            DefaultsUpon Senior Securities.**

 

None.

** **

**Item 4.****            Submissionof Matters to a Vote of Securities Holders.**

 

None

 

**Item 5.****            OtherInformation.**

 

None

 

34

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**Item 6.**** Exhibits**

 

See Exhibit Index

 

35

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**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.

 
|                   | CAPITAL CORP OF THE WEST |
|------------------------|--------------------------|
|                   | (Registrant)             |   |
|                   |                     |   |   |
|                   |                     |   |   |
| Date: November 5, 2004 | By                       | /s/    Thomas  T. Hawker |   |
|                   |                     |   | Thomas T. Hawker |   |
|                   |                     |   | President and |   |
|                   |                     |   | Chief Executive Officer |   |
|                   |                     |   |   |
|                   |                     |   |   |
| Date: November 5, 2004 | By                       | /s/    R. Dale  McKinney |   |
|                   |                     |   | R. Dale McKinney |   |
|                   |                     |   | Chief Financial Officer |   |
|                        |                          |  |  |  |  |

 

36

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Exhibit Index

 
| **Exhibit** | ** ** | **Description**                                                                                                                                                                                 |
|-------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |       |                                                                                                                                                                                            |
| 10          |       | Employment  Agreement between Thomas T. Hawker and Capital Corp. of the West  (incorporated by reference to Exhibit 10 to Current Report on Form 8-K of the  registrant dated November 4, 2004) |
|        |       |                                                                                                                                                                                            |
| 31.1        |       | Certification  of Registrant’s Chief Executive Officer Pursuant to Section 302 of the  Sarbanes-Oxley Act of 2003                                                                          |
|        |       |                                                                                                                                                                                            |
| 31.2        |       | Certification  of Registrant’s Chief Financial Officer Pursuant to Section 302 of the  Sarbanes-Oxley Act of 2003                                                                          |
|        |       |                                                                                                                                                                                            |
| 32.1        |       | Certification  of Registrant’s Chief Executive Officer Pursuant to 18 U.S.C. Section 1350                                                                                                  |
|        |       |                                                                                                                                                                                            |
| 32.2        |       | Certification  of Registrant’s Chief Financial Officer Pursuant to 18 U.S.C. Section 1350                                                                                                  |

 

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