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**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-K**

 

**(Mark One)**

 

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

 

**For the fiscal year ended December 31,2008**

 

**OR**

 

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

 

**For the transition period from             to             **

 

**Commission file number 001-33890**

 

**1**ST PACIFIC BANCORP

(Exact name of registrant as specified in its charter)

 

| **California**(State or Other Jurisdiction of  Incorporation or Organization)                  | ** ** | **20-5738252**(IRS Employer  Identification No) |
|------------------------------------------------------------------------------------------------|------------|-------------------------------------------------|
|                                                                                           |       |                                            |
| **9333  Genesee Avenue #300****San Diego, California**(Address of Principal Executive Offices) | ** ** | **92121**  (Zip Code)                           |

 

**(858) 875-2000**

(Issuer’s telephone number)

 

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OFTHE ACT:

 
| **Title of each class** | ** ** | **Name of each exchange on which registered** | ** ** |
|----------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| Common  Stock, No Par Value            |       | The NASDAQ Stock Market LLC                                                 |       |

 

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OFTHE ACT:**(None)**

 

Indicate by checkmark if the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act. Yes oNo x

 

Indicate by checkmark if the registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Act. Yes oNo x

 

Note-Checkingabove box will not relieve any registrant required to file reports pursuant to Section 13or 15(d) of the Exchange Act from their obligations under those Sections.

 

**Persons who respond to thecollection of information contained in this form are not required to respondunless the form displays a currently valid OMB control number.**

 

Indicate by checkmark whether the registrant (1) has filed all reports required to be filedby Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the Registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes xNo o

 

Indicate by checkmark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K(229.405 of this chapter) is not contained herein, and will not be contained,to the best of registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-K orany amendment to this Form 10-K. o

 

Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer,a non-accelerated filer or a smaller reporting company. See the definitions of “largeaccelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2of the Exchange Act.

 
| Large  accelerated filer o                                                          | Accelerated  filer o         |
|------------------------------------------------------------------------------------------|------------------------------|
|                                                                                     |                         |
| Non-accelerated  filer   o  (Do not check if a smaller reporting company) | Smaller  reporting company x |

 

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2of the Act).Yes o  No x

 

The aggregatemarket value of the common stock held by non-affiliates of the Registrant as ofJune 30, 2008 was approximately $36.1 million. The number of Registrant’sshares of common stock outstanding at March 24, 2009 was 4,980,481.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Certaininformation required by Part III of this Annual Report is incorporated byreference from (i) the Registrant’s definitive proxy statement to be filedwith the Securities and Exchange Commission pursuant to Regulation 14A if filednot later than 120 days after the end of the fiscal year covered by this AnnualReport, or (ii) if the Registrant’s definitive proxy statement is notfiled within the 120 day period, then from an amendment to this Annual Report,which will be filed not later than the end of the 120 day period.

 

 

 

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**1**st Pacific Bancorp

 

**TABLE OF CONTENTS**

 
| ** **                        | ** **                                                                                                             | **PAGE**   |
|-----------------------------------|------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                        | ** **                                                                                                             | ** ** |
| **PART I**                   | ** **                                                                                                             | **1**      |
| ITEM 1.                           | BUSINESS                                                                                                               | 1          |
| ITEM 1A.                          | RISK FACTORS                                                                                                           | 16         |
| ITEM 1B.                          | UNRESOLVED  STAFF COMMENTS                                                                                             | 24         |
| ITEM 2.                           | PROPERTIES                                                                                                             | 24         |
| ITEM 3.                           | LEGAL PROCEEDINGS                                                                                                      | 25         |
| ITEM 4.                           | SUBMISSION  OF MATTERS TO A VOTE OF SECURITY HOLDERS                                                                   | 25         |
|                              |                                                                                                                   |       |
| **PART II**                  | ** **                                                                                                             | **25**     |
| ITEM 5.                           | MARKET FOR  REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS AND ISSUER  PURCHASES OF EQUITY SECURITIES | 25         |
| ITEM 6.                           | SELECTED FINANCIAL  DATA                                                                                               | 27         |
| ITEM 7.                           | MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS                            | 28         |
| ITEM 7A.                          | QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                                            | 51         |
| ITEM 8.                           | FINANCIAL  STATEMENTS AND SUPPLEMENTARY DATA                                                                           | 52         |
| ITEM 9.                           | CHANGES IN  AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE                                  | 52         |
| ITEM 9A(T).                       | CONTROLS AND  PROCEDURES                                                                                               | 52         |
| ITEM 9B.                          | OTHER INFORMATION                                                                                                      | 53         |
|                              |                                                                                                                   |       |
| **PART III**                 | ** **                                                                                                             | **54**     |
| ITEM 10.                          | DIRECTORS,  EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE                                                                | 54         |
| ITEM 11.                          | EXECUTIVE  COMPENSATION                                                                                                | 54         |
| ITEM 12.                          | SECURITY  OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER  MATTERS                       | 54         |
| ITEM 13.                          | CERTAIN  RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE                                             | 55         |
| ITEM 14.                          | PRINCIPAL  ACCOUNTING FEES AND SERVICES                                                                                | 55         |
|                              |                                                                                                                   |       |
| **PART IV**                  | ** **                                                                                                             | **55**     |
| ITEM 15.                          | EXHIBITS,  FINANCIAL STATEMENT SCHEDULES                                                                               | 55         |
|                              |                                                                                                                   |       |
| **SIGNATURES**                    | **59**                                                                                                                 |
| ** **                        | ** **                                                                                                             |
| **INDEX TO FINANCIAL STATEMENTS** | **61**                                                                                                                 |

 

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**PART I**

 

**ITEM1.**                                                     BUSINESS

** **

**General**

** **

1st PacificBancorp (the “Company”, “we”, “our”, or “us”) is a California corporationincorporated on August 4, 2006 and is registered with the Board ofGovernors of the Federal Reserve System as a bank holding company under theBank Holding Company Act of 1956, as amended. 1st Pacific Bank of California (the “Bank”) is a wholly-owned banksubsidiary of the Company and was incorporated in California on April 17,2000.  The Bank is a Californiacorporation licensed to operate as a commercial bank under the CaliforniaBanking Law by the California Department of Financial Institutions (the “DFI”).  In accordance with the Federal DepositInsurance Act, the Federal Deposit Insurance Corporation (the “FDIC”) insuresthe deposits of the Bank.  The Bank is amember of the Federal Reserve System.

 

A reorganizationto form a holding company was completed on January 16, 2007, whereby alloutstanding shares of the Bank were converted into an equal number of shares ofthe Company. Prior to the reorganization, the Company had minimal activity,which was primarily related to preparing for the reorganization.  At present, the Company does not engage inany material business activities other than ownership of the Bank. Referencesto the Company are references to 1st Pacific Bancorp (including the Bank),except for periods prior to January 16, 2007, in which case, references tothe Company are to the Bank.

 

After completingits initial public offering, the Company commenced operations on November 17,2000, from a branch office in the Golden Triangle area of San Diego and abranch office in the Tri-Cities area of North San Diego County (“NorthCounty”).  In the following years, theCompany opened additional branch offices, one in the Mission Valley area of SanDiego, one in the Inland North County area of San Diego and one in El Cajon.

 

On July 1,2007, the Company completed the acquisition of Landmark National Bank (“Landmark”),with assets of approximately $109.0 million. Landmark’s two established officesbecame part of the Bank’s branch network; one in Solana Beach and one indowntown La Jolla. As a result of the acquisition, the financial results foundherein reflect the combined entity beginning July 2, 2007.

 

During the thirdquarter of 2007, the Company moved its corporate headquarters location withinthe University Towne Centre area of San Diego and relocated the Golden Trianglebranch office to the same facility. In February 2008, the Company opened alimited service branch office in downtown San Diego.

 

The Company isorganized as a single operating unit with eight branch offices. The Company’sprimary source of revenue is interest earned on loans it provides to customers.  The Company funds its lending activitiesprimarily through providing deposit products and services to customers, butalso through advances from the Federal Home Loan Bank of which we are a member,correspondent banks, the Federal Reserve Bank and brokered deposits.  The Company’s customers are predominatelysmall and medium-sized businesses and professionals in San Diego County.  As of December 31, 2008, the Company hasgrown to approximately $421 million in total assets.

 

**Strategy**

** **

The Company’smission statement is: “To build relationships that create significant resultsfor our customers, employees, shareholders and community.”  The Company believes that to be successful inits competitive environment, it needs to attract and retain great people (e.g.directors and employees) to foster and grow loyal client relationships, whichbuild enduring franchise value.  Thisstrategy is synopsized by the Company’s corporate motto:  *People.Relationships.Results.*

 

**Services Offered**

** **

The primaryoperational focus of the Company is to meet the financial service needs of itstarget market — small and medium-sized businesses and professionals — withinits service area.  Therefore, the Companyoffers a full line of loan and deposit products and certain related financialservices designed to cater to this target market.  As a community bank, the Company’s personnelare actively involved in the community and an emphasis is placed onpersonalized “relationship banking,” where the banking relationship ispredicated on the banker’s familiarity with the customer and its business.

 

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***Lending Services.***Asdiscussed in further detail below, the Company’s lending activities focus oncommercial and residential real estate loans, construction loans, commercialbusiness loans and loans made or guaranteed through the Small BusinessAdministration (the “SBA”) loan program responsive to the target market’sneeds.  The Company believes these loanproducts take advantage of the local economy and the consolidation of bankinginstitutions in San Diego County and contiguous areas, which have createdopportunities for an independent, service-oriented bank.

 

*RealEstate Loans*.  TheCompany offers real estate loans for construction and term financing.  Construction loans include loans forsingle-family homes (both owner occupied and speculative), small residentialtract developments, commercial projects (such as multi-family housing,industrial, office and retail centers) and early stage acquisition anddevelopment loans for land and lots. Permanent financing is offered for commercial properties andsingle-family residential properties.

 

*CommercialLoans*.  The Companyoffers the following types of commercial loans:

 

·                                          Short-termworking capital loans, both secured and unsecured.

 

·                                          Revolvingcredit accounts, secured and unsecured, such as credit extensions supported byformal business assets (e.g. accounts receivable and inventory).

 

·                                          Singlepurpose loans, such as term loans for facilities, plant and equipment.

 

·                                          Stand-byletters of credit.

 

*SBALoan Programs*.  TheSBA, headquartered in Washington, D.C., and operating in 10 regions throughoutthe United States, offers financial assistance to eligible small businesses inthe form of partial government guarantees on loans made to such businesses byqualified participating lenders under the SBA’s guaranteed loan program (the “7(a) program”).  In order to be eligible for the 7(a) program,a business generally must be operated for profit and, depending on the industryof the potential borrower, must fall within specified limitations on numbers ofemployees or annual revenues.  TheCompany is an SBA qualified participating lender and, in 2002, was awarded SBA’s“Preferred Lender” status.  ThisPreferred Lender status allows the Company to make loans under SBA programswithout prior SBA approval.

 

SBA 7(a) programloans are SBA-guaranteed loans made by approved financial institutions.  For term loans, the loan guarantees vary from75% to 85% of the loan balance, depending on the size of the loan, and termsvary from five to twenty-five years depending on the purpose of the loan.  Revolving loans are limited to a maximum termof seven years and the loan guarantee may not exceed 50% of the loanamount.  The aggregate balance of the SBAguaranteed portions of all outstanding SBA loans to one borrower and itsaffiliates may not exceed $2.0 million.

 

SBA 7(a) programloans are typically written at variable rates of interest, which rates aregenerally limited by SBA guidelines. These guidelines limit the maximum rate for loans with maturities lessthan seven years to 225 basis points over the lowest prime-lending rate publishedin The Wall Street Journal (“WSJ Prime”). The maximum rate for loans with maturities in excess of seven years is275 basis points over the WSJ Prime. Typically rates are adjusted on the first day of each calendar quarter.

 

In addition toparticipation in the SBA’s 7(a) programs, the Company also offers loansprimarily for real estate-related projects under Section 504 of the SmallBusiness Administration Act of 1953 (“504 loans”), such as for purchasing landand improvements, construction, modernizing or converting existing facilitiesand purchasing certain machinery and equipment. Under the 504 loan program, the borrower must provide at least 10% ofthe equity for the financing.  Under atypical 504 loan, the Company will make a loan for 50% of the principal amount,which is secured by, among other assets, a first priority mortgage on theunderlying property.  The Company willprovide the remaining amount of the funds as a short-term loan with a maturityfrom 90 days up to one year (the “Bridge Loan”).  The borrower repays the Bridge Loan with theproceeds received from a bond issuance by a certified development company — anot-for-profit corporation established to create and issue debt securities thatare fully guaranteed by the SBA.  Thedebt securities are sold to institutional investors.  Under the 504 loan program, SBA debenturesmay be issued for up to $4.0 million and, if a public policy is met, up to $8.0million for manufacturers.

 

Like many othergovernment programs, the lending programs of the SBA are federal governmentprograms authorized by legislation and uncertainties surround the SBA programsdue to reliance on the United States 

 

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Congressand the federal budgeting process for each fiscal year.  There can be no assurance that the SBAlending program will continue in its present manner.

 

*ConsumerLoans*.  The Companyloans for personal, family or household purposes.  These loans represent a small portion of theCompany’s overall loan portfolio. However, these loans are important in terms of servicing customer needsin the market area of the Company’s offices and ancillary lending needs of theCompany’s primary target market.

 

***Deposit Products and Services.***TheCompany’s expertise is developing custom-tailored financial solutions forindividuals, businesses and professionals desiring personalized bankingservices.  The diverse needs of itscommercial and consumer customers are considered and, as such, the Companyoffers a wide range of accounts and services, designed around the preferencesof our customers.  Account officersconsult with the various specialists in the Company to satisfy the customer’simmediate and long-range deposit and borrowing needs. As a community bank, thefollowing services offered are designed to make banking easy and convenient.

 

*BankDeposits. *The Companyoffers personal and business checking, money market, savings and certificatesof deposit accounts which can all be tied into a one-statement package.  The types and terms of such accounts areoffered on a competitive basis.  Theinterest rates payable by the Company on the various types of interest-bearingdeposit accounts are a function of a number of factors, including rates paid bythe Company’s competitors, the need for liquidity for lending operations andthe changes in monetary policy as announced by the Federal Open MarketCommittee.

 

*CashManagement Services*. The Company specializes in meeting the unique banking needs of businessowners.  The Company accomplishes this byhaving developed a comprehensive set of cash management tools andservices.  Some of the cash managementproducts the Company offers are online banking, automated clearing house (“ACH”)origination, wire transfers, daily sweep products, lockbox processing andaccount transfers / management.  TheCompany also has a wire transfer system with advanced features for businesscustomers that, among other things, provide immediate confirmation of wirereceipts.  In addition to these products,the Company offers courier service to collect deposits from San Diego-areacustomers and has a correspondent relationship with another bank allowing theCompany to accept deposits at thousands of third party locations for non-localdepository needs.

 

The Company alsooffers a service called Remote Deposit Capture which allows the customer tocreate and submit a deposit from their place of business. In March 2007,an additional feature called BusinessPro Deposit Link was introduced. Thisfeature was added to the Company’s online banking program for businesses.Deposit Link allows customers to make deposits into their checking accountsfrom their offices. Checks can be scanned, transmitted and deposited to theirbusiness checking accounts using office computers. This service is valuable tobusinesses that frequently make deposits because it reduces the number of bankvisits and/ or courier costs. The Company has thirty (30) Deposit Link Servicecustomers as of February 2009.

 

*InternetBanking*.  Throughinternet banking customers may conduct their banking business remotely from anylocation and business customers are able to access cash management products,originate wire transfers and complete ACH transactions. Business customers mayhave multiple user access with separately defined user capabilities.

 

**Marketing Focus**

 

The Companymarkets and advertises its services primarily to targeted customers in itsprimary service area. The Company focuses on meeting the needs of its targetedcustomers, as well as being well informed about its market andcompetition.  Among other things, the Company’s key focus is to establishand build strong financial relationships with its customers using a trustedadvisor and relationship approach.  The Company communicates to customersand prospects directly through its business development sales force and throughmedia advertising and direct mail communications.

 

The Companyestablished an Advisory Board in November 2002, which consists of manylocal community and business leaders.  In addition to their roles asadvisors to the Company, the Advisory Board members represent the Company atevents with the objective of increasing the Company’s visibility. Furthermore, members of the Company’s Board of Directors are visible and activein the San Diego community.  Over time, the Company expects tocontinue to benefit from involvement in these civic and community activitiesand the goodwill and recognition it provides to the Company.  The Company’son-going public relations efforts emphasize its local ownership, relationship—basedphilosophy, customer service and commitment to its community.

 

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**Service Area**

** **

The Companyconsiders its primary market to be the greater San Diego County region and thisis where it has chosen to locate all of its branch offices. San Diego and thesurrounding county has grown from a small military town to a population ofapproximately three million people in part because of its desirable climate,diversified economy and employment base.

 

The Company’sexecutive office and its original head office are both located in the GoldenTriangle area of San Diego, which is a hub of the “North City” businesscenter.  The Company’s second originalbranch office is located in the Tri-Cities area of North County (Oceanside,Carlsbad and Vista).  The Company’s thirdbranch office was opened in 2003 in the Mission Valley area ofSan Diego.  In 2005, the Companyopened its fourth branch office in the Inland North County Area ofSan Diego along the Interstate 15 corridor. A fifth branch office wasopened in April 2006 in the city of El Cajon in San Diego’s East CountyArea.  Effective July 1, 2007, theCompany completed its acquisition of Landmark and added two branch offices inSolana Beach and La Jolla to the Company’s branch network. In February 2008,the Company opened a limited service branch office in downtown San Diego.

 

**Risk Management**

** **

As a fundamentalpart of its business, the Company has developed risk management practices toidentify, measure, monitor and control the risks involved in its variousproducts and lines of business.  Whilethe Company’s business is dependent on taking risks, appropriate management ofthese business risks is critical to its success.  The Company has a risk management program toevaluate a broad spectrum of risks, including, but not limited to, credit risk,market risk, liquidity risk, operational risk, legal risk and reputationalrisk.  In assessing its risk managementpractices across the Company’s functional areas (e.g. lending, branchoperations, informational technology, asset and liability management, andadministration), management considers the following elements of a sound riskmanagement system in each critical area: the level of board and senior management oversight; the adequacy ofpolicies, procedures and limits; the adequacy of internal controls; the resultsof internal monitoring and / or independent reviews and audits; and theexperience of its personnel.

 

While the Companybelieves it has a sound risk management program that will address its futuregrowth plans, the Company’s ability to manage future growth will depend on,among other things, its ability to manage associated risks, including:monitoring operations, controlling funding costs and operating expenses,maintaining positive customer relations, and hiring and retaining qualifiedpersonnel.

 

**Competition**

** **

The bankingbusiness in California, generally, and specifically in the greaterSan Diego and adjacent areas, is highly competitive with respect to bothloans and deposits.  The business isdominated by a relatively small number of major banks, most of which have manyoffices operating over wide geographic areas. Many of the major commercial banks and their affiliates, including thoseheadquartered outside California, offer certain services (such as trust andsecurities brokerage services) that are not offered directly by theCompany.  By virtue of their greatertotal capitalization, such banks have substantially higher lending limits andsubstantially larger advertising and promotional budgets.  In addition, the Company faces strongcompetition from other community banks headquartered in the greaterSan Diego area that are also serving individuals and businesses.

 

In recent years, alarge number of mergers and consolidations of both banks and savings entitieshave occurred in California and throughout the nation.  A substantial number of the larger banks havebeen involved in major mergers.  Theresult is that these institutions generally have centralized and standardizedservices and some lending functions and decisions are sent outside thearea.  Acquisitions by major interstatebank holding companies and other large acquirers in the greater San Diegovicinity have resulted in numerous branch consolidations in the area.  Many long-standing relationships have beendisrupted or severed, while many other customers are now subjected to lesspersonalized and more “standardized” services.

 

As a result ofthis merger and consolidation activity, since 2000, community banking in San Diego has undergone a growth periodand a significant number of new or *de novo*institutions have opened.  Despite the increased competition from newercommunity banks, larger institutions continue to control the majority of thedeposit market share in the region.  Thiscontinues to present the Company with the opportunity to attract customers whoare dissatisfied with the level of service provided by larger banks.  Additionally, it is expected that mergeractivity will continue to provide opportunities in its market area.

 

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In order tocompete with the major financial institutions in the Company’s primary serviceareas, the contacts of the Company’s organizers, founders, advisors, directorsand officers are used to the fullest extent possible with residents andbusinesses in the Company’s primary service areas.  Specialized services, local promotionalactivity and personal contacts by the Company’s officers, directors and otheremployees are emphasized. Programs have been developed to specifically addressthe needs of small to medium-sized businesses, professional businesses, as wellas business owners and their employees. Legal lending limits sometimes prevent the Company from making a loan onits own. In these circumstances, the Company can arrange for loans to be madeon a participation basis with other financial institutions and intermediaries.

 

**Subsidiaries**

 

The Bank is asubsidiary of our Company.

 

On June 28,2007, the Company formed a Delaware trust affiliate, FPBN Trust I (the “Trust”)for the purpose of issuing trust preferred securities. The Company accounts forits investment in the Trust using the equity method under which thesubsidiaries net earnings are recognized in the Company’s statement of income,pursuant to Financial Accounting Standards Board Interpretation No. 46 (“FIN46”), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.”Pursuant to FIN 46, the Trust is not consolidated into the Company’s financialstatements. The Federal Reserve Board has ruled that subordinated notes payableto unconsolidated special purpose entities (“SPE’s”) such as the Trust, net ofthe bank holding company’s investment in the SPE, qualify as Tier 1 Capital, subjectto certain limits.

 

**Employees**

** **

Currently, theCompany employs Messrs. James H. Burgess, Larry A. Prosi, and Richard H.Revier, under written employment agreements. See “Item 10, Directors, Executive Officers and Corporate Governance,”below.  On December 31, 2008, theCompany employed 100 persons full-time and 5 persons part-time.  None of the Company’s employees arerepresented by any collective bargaining agreements.  The Company considers its relations withemployees to be excellent.

 

**SUPERVISION ANDREGULATION**

** **

**The following summarizes the materialelements of the regulatory framework that apply to banks and bank holdingcompanies and is only a summary and does not purport to be complete.  It does not describe all of the statutes,regulations and regulatory policies that are applicable.  Also, it does not restate all of therequirements of the statutes, regulations and regulatory policies that aredescribed.  Consequently, the followingsummary is qualified in its entirety by reference to the applicable statutes,regulations and regulatory policies.  Noassurance can be given that such statutes and regulations will not change inthe future.  Moreover, any changes mayhave a material effect on the business of the Company.  As a listed company on NASDAQ, the Company issubject to NASDAQ rules for listed companies.**

 

**General**

** **

***Bank Holding Company Regulation.***  TheCompany is a bank holding company within the meaning of the Bank HoldingCompany Act, and is registered as such with and subject to the supervision ofthe Federal Reserve Board (“FRB”). Generally, a bank holding company is required to obtain the approval ofthe FRB before it may acquire all or substantially all of the assets of anybank, or ownership or control of the voting shares of any bank if, after givingeffect to such acquisition of shares, the bank holding company would own orcontrol more than 5% of the voting shares of such bank.  The FRB’s approval is also required for themerger or consolidation of bank holding companies.  The Company is required to file reports withthe FRB and provide such additional information as the FRB may require.  The FRB also has the authority to examine theCompany and each of its subsidiaries, as well as any arrangements between itand any of its subsidiaries, with the cost of any such examination to be borneby the Company.

 

Banking subsidiaries of bank holding companies are also subject tocertain restrictions imposed by federal law in dealings with their holdingcompanies and other affiliates.  Subjectto certain restrictions set forth in the Federal Reserve Act, a bank can loanor extend credit to an affiliate, purchase or invest in the securities of anaffiliate, purchase assets from an affiliate, or issue a guarantee, acceptance,or letter of credit on behalf of an affiliate; provided that the aggregateamount of the above transactions of a bank and its subsidiaries does not exceed10% of the capital stock and surplus of the bank on a per affiliate basis or20% of the capital stock and surplus of the 

 

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bank on an aggregate affiliate basis.  In addition, such transactions must be onterms and conditions that are consistent with safe and sound banking practicesand, in particular, a bank and its subsidiaries generally may not purchase froman affiliate a low-quality asset, as that term is defined in the FederalReserve Act.  Such restrictions alsoprevent a bank holding company and its other affiliates from borrowing from abanking subsidiary of the bank holding company unless the loans are secured bymarketable collateral of designated amounts. Further, the Company and the Bank are prohibited from engaging in certaintie-in arrangements in connection with any extension of credit, sale or leaseof property or furnishing of services.

 

Under the FRB’s regulations, a bank holding company is required to serveas a source of financial and managerial strength to its subsidiary banks andmay not conduct its operations in an unsafe and unsound manner.  In addition, it is the FRB’s policy that inserving as a source of strength to its subsidiary banks, a bank holding companyshould stand ready to use available resources to provide adequate capital fundsto its subsidiary banks during periods of financial stress or adversity andshould maintain the financial flexibility and capital-raising capacity toobtain additional resources for assisting its subsidiary banks.  A bank holding company’s failure to meet itsobligations to serve as a source of strength to its subsidiary banks willgenerally be considered by the FRB to be an unsafe and unsound banking practiceor a violation of the FRB’s regulations or both.  Under certain conditions, the FRB mayconclude that certain actions of a bank holding company, such as payment ofcash dividends, would constitute unsafe and unsound banking practices becausethey violate the FRB’s “source of strength” doctrine.

 

A bank holdingcompany is prohibited from engaging in or acquiring direct or indirectownership or control of more than 5% of the voting shares of any companyengaged in nonbanking activities.  One ofthe principal exceptions to this prohibition is for activities found by the FRBto be so closely related to banking or managing or controlling banks as to be aproper incident thereto. In making these determinations, the FRB considerswhether the performance of such activities by a bank holding company wouldoffer advantages to the public which outweigh possible adverse effects.

 

As a publiccompany, the Company is subject to the Sarbanes-Oxley Act of 2002.  The Sarbanes-Oxley Act amends certain partsof the Securities and Exchange Act of 1934, as amended (the “Exchange Act”) andis intended to protect investors by, among other things, improving thereliability of financial reporting, increasing management accountability, andincreasing the independence of directors and our external accountants.

 

The Company issubject to the periodic reporting requirements of the Exchange Act, whichinclude but are not limited to the filing of annual, quarterly and othercurrent reports with the Securities and Exchange Commission (“SEC”).

 

***BankingRegulation.*** Various requirements and restrictions under federal and state lawsaffect the operation of the Company.  Asa California state-chartered bank, the Company is regulated, supervised andregularly examined by the DFI.  In addition,the FRB is the Company’s primary federal regulator.  Federal regulations address several areasincluding loans, deposits, check and item processing, investments, mergers andacquisitions, borrowings, dividends, and the number and locations of branchoffices. Deposits of the Company are insured up to the maximum limits allowed bythe FDIC.  As a result of this depositinsurance function, the FDIC has certain supervisory authority and powers overFDIC-insured institutions.

 

**Proposed Legislative andRegulatory Changes**

** **

Proposals pendingin Congress would, among other things, change lending practices related toloans secured by single-family residences, restrict “predatory” and “subprime”mortgage activities, forestall foreclosures on single family homes, protectrenters of foreclosed properties, license mortgage loan originators, restrictownership of industrial banks, enhance the privacy of personal information.Certain of these proposals, if adopted, could significantly change theregulation or operations of banks and the financial services industry.  The Company cannot predict whether any ofthese proposals will be adopted, and, if adopted, how these proposals willaffect us or the Bank.

 

**Federal Reserve BankRegulation**

** **

Eachstate-chartered bank that is a member of the FRB is referred to as a “statemember bank.”  The Bank, like all otherstate member banks, subscribes to capital stock in the FRB of its district (theFederal Reserve Bank of San Francisco in the case of the Bank) in anamount equal to 6% of its combined capital and surplus (but excluding retainedearnings); 3% must be paid-in and the remaining 3% is on call.  The FDIC insures the deposits of the Bank andmonitors the Bank in such capacity.  TheFRB discount window and other services are available to all 

 

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depositoryinstitutions on an equivalent basis. However, being a state member bank reduces the number of federalsupervisors from two to one where a bank is owned by a bank holding company.

 

**Impact of MonetaryPolicies**

 

Banking is abusiness that depends on rate differentials. In general, the difference between the interest rate paid by the Companyon its deposits and other borrowings and the interest rate earned by the Companyon loans, securities and other interest-earning assets comprises the majorsource of the Company’s earnings.  Theserates are highly sensitive to many factors which are beyond the control of theCompany and, accordingly, the earnings and growth of the Company are subject tothe influence of economic conditions generally, both domestic and foreign,including inflation, recession, and unemployment; and also to the influence ofmonetary and fiscal policies of the United States and its agencies, particularlythe FRB.  The FRB implements nationalmonetary policy, such as seeking to curb inflation and combat recession, by itsopen-market dealings in United States government securities, by adjusting therequired level of reserves for financial institutions subject to reserverequirements, by placing limitations upon savings and time deposit interestrates, and through adjustments to the discount rate applicable to borrowings bybanks which are members of the Federal Reserve System.  The actions of the FRB in these areasinfluence the growth of bank loans, investments, and deposits and also affectinterest rates.  The nature and timing ofany future changes in such policies and their impact on the Company cannot bepredicted; however, the impact on the Company’s net interest margin, whetherpositive or negative, depends on the degree to which the Company’sinterest-earning assets and interest-bearing liabilities are ratesensitive.  In addition, adverse economicconditions could make a higher provision for loan losses a prudent course andcould cause higher loan charge-offs, thus adversely affecting the Company’s netincome.

 

**Federal Banking LoanRegulation**

** **

On December 6,2006, the federal bank regulatory agencies released final guidance on “Concentrationsin Commercial Real Estate Lending” (the “Final Guidance”), largely consistentwith the proposed guidance they released on January 10, 2006.  This guidance defines commercial real estate(“CRE”) loans as exposures secured by raw land, land development and construction(including 1-4 family residential construction), multi-family property, andnon-farm nonresidential property where the primary or a significant source ofrepayment is derived from rental income associated with the property or theproceeds of the sale, refinancing, or permanent financing of the property.  Loans on owner occupied CRE are generallyexcluded.

 

The Final Guidancerequires that appropriate processes be in place to identify, monitor andcontrol risks associated with real estate lending concentrations.  This could include enhanced strategicplanning, CRE underwriting policies, risk management, internal controls,portfolio stress testing and risk exposure limits as well as appropriatelydesigned compensation and incentive programs. Higher allowances for loan losses and higher capital levels may also berequired.  The Final Guidance istriggered when CRE loan concentrations exceed either:

 

·                                          Totalreported loans for construction, land development, and other land of 100% ormore of a bank’s total capital; or

 

·                                          Totalreported loans secured by multifamily and nonfarm nonresidential properties andloans for construction, land development, and other land of 300% or more of abank’s total capital.

 

Management of theCompany believes that the Final Guidance may apply to the Company’s CRE lendingactivities due to its concentration in construction and land development loans.The Company has always had meaningful exposures to loans secured by commercialreal estate due to the nature of its growing markets and the loan needs of bothits retail and commercial customers.  TheCompany believes its long-term experience in CRE lending, underwriting policies,internal controls, and other policies currently in place are generallyappropriate in managing its concentrations as required under the FinalGuidance.  Furthermore, the Company hasadopted additional enhancements to its analysis and review of CRE concentrationsconsistent with many of the requirements found in the Final Guidance.

 

**Banking Legislation**

 

From time to timelegislation is proposed or enacted which has the effect of increasing the costof doing business and changing the competitive balance between banks and otherfinancial and non-financial institutions. These laws have generally had the effect of altering competitiverelationships existing among financial institutions, reducing the historicaldistinctions between the services offered by banks, savings and loanassociations and other 

 

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financialinstitutions, and increasing the cost of funds to banks and other depositoryinstitutions.  Certain of the potentiallysignificant changes, which have been enacted in the past several years, arediscussed below.

 

***TheSarbanes-Oxley Act of 2002. ***OnJuly 30, 2002, in the wake of numerous corporate scandals and in anattempt to protect investors and help restore investor confidence by improvingthe accuracy and reliability of corporate disclosures made pursuant to thesecurities laws, President George W. Bush signed into law the Sarbanes-OxleyAct of 2002 (the “Act”).  The Act appliesto any issuer, such as the Company, that has securities registered under, or isotherwise required to file reports under, the Exchange Act.  The Act imposes new and unprecedentedcorporate disclosure and governance mandates on public companies, including theCompany.

 

While certainprovisions of the Act, such as accelerated filing deadlines for periodicreports, do not currently apply to the Company, most of the Act’s provisionsare (or upon implementation will be) applicable.  These provisions include (i) therequirement for certifications of each annual and quarterly report by theissuer’s principal executive and financial officers, with criminal penaltiesimposed for knowing or willful violations, (ii) the forfeiture of bonusesor profits received by such officers if accounting restatements are required asa result of misconduct, (iii) disclosure of all material off-balance sheettransactions and relationships that may have a material effect upon thefinancial status of an issuer and of any “material correcting adjustments” inthe issuer’s financials, (iv) disclosure of management’s assessment ofinternal controls and procedures, (v) disclosure as to whether the issuerhas adopted a “code of ethics” for its senior financial officers and, if not,an explanation as to why not, and (vi) prohibitions or limits on loans toofficers, directors and other insiders except to the extent such loans complywith FRB Regulation O.  The Act alsoimposes certain additional regulations, such as accelerated filing periods forreports on Form 4 of changes in the beneficial ownership of officers,directors and principal security holders.

 

The Act alsoimposes increased requirements on auditors and the auditing procedures of theirpublic clients, including prohibitions on the performing of specified non-auditservices contemporaneously with an audit. The Act heightens the requirements for, and the authority of, auditcommittees.  Among other provisions, theAct vests an issuer’s audit committee with direct responsibility for theappointment, compensation and oversight of any registered public accountingfirm engaged to perform audit services and with the ability to hire independentoutside legal counsel and other advisors.

 

The Act alsorequires that each audit committee member be entirely “independent” (meaningthat no member may be affiliated with the issuer or may accept (or haverecently received) any consulting, advisory or other compensatory fees from theissuer) and be a member of the issuer’s board of directors and that thecommittee include a designated “audit committee financial expert.”

 

Finally, the Actrequires that legal counsel for subject companies report any evidence ofmaterial violations of securities laws or breaches of fiduciary duty to or bytheir client and imposes federal criminal penalties, including fines andimprisonment of up to 25 years, upon those convicted of defrauding shareholdersof public companies.

 

In 2009, theCompany will be required to comply with Section 404 of the Sarbanes OxleyAct of 2002, which requires the Company’s independent public accounting firm,which audits the Company’s financial statements to include in the annual reportan attestation report on the effectiveness of management’s assessment of theCompany’s internal controls over financial reporting. The Company hasexperienced increased costs associated with the increased level of disclosureand compliance required under the Act, and expects a certain amount of unknownadditional costs associated with this additional requirement.

 

***Gramm-Leach-BlileyAct. ***The FinancialServices Act of 1999, known as the Gramm-Leach-Bliley Act (“GLBA”), was signedinto law on November 12, 1999 and became effective on March 11,2000.  The GLBA repeals provisions of theGlass-Steagall Act, which had prohibited commercial banks and securities firmsfrom affiliating with each other and engaging in each other’s businesses.  Thus, many of the barriers prohibitingaffiliations between commercial banks and securities firms have been eliminated.

 

The Bank HoldingCompany Act (“BHCA”) was amended by GLBA to allow a new “financial holdingcompany” (“FHC”) to offer banking, insurance, securities and other financialproducts to consumers.  Specifically, theGLBA amended Section 4 of the BHCA in order to provide for a framework forthe engagement in new financial activities. A bank holding company (“BHC”) may elect to become an FHC if all itssubsidiary depository institutions are well capitalized and well managed.

 

Under the GLBA,national banks (as well as FDIC-insured state banks, subject to variousrequirements) are permitted to engage through “financial subsidiaries” incertain financial activities permissible for affiliates of FHCs.  

 

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However,to be able to engage in such activities the bank must also be well capitalizedand well managed and receive at least a “satisfactory” rating in its mostrecent Community Reinvestment Act examination. In addition, if the bank ranks as one of the top 50 largest insuredbanks in the United States, it must have an issue of outstanding long-term debtrated in one of the three highest rating categories by an independent ratingagency.  If the bank falls within thenext group of 50, it must either meet the debt-rating test described above orsatisfy a comparable test jointly agreed to by the FRB and the TreasuryDepartment.  No debt rating is requiredfor any bank, such as the Bank, not within the top 100 largest insured banks inthe United States.

 

The Company cannotbe certain of the effect of the foregoing legislation on its business, althoughthere is likely to be consolidation among financial services institutions andincreased competition for the Company.

 

***TheRiegle-Neal Act.*** The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994(the “Riegle-Neal Act”), enacted on September 29, 1994, repealed theMcFadden Act of 1927, which required states to decide whether national or statebanks could enter their state, and allowed banks to open branches across statelines beginning on June 1, 1997. The Riegle-Neal Act also repealed the 1956 Douglas Amendment to theBHCA, which placed the same requirements on BHCs.  The repeal of the Douglas Amendment now makesit possible for banks to buy out of-state banks in any state and convert theminto interstate branches.

 

The Riegle-NealAct provides that interstate branching and merging of existing banks ispermitted, provided that the banks are at least “adequately capitalized” anddemonstrate good management.  The statesare also authorized to enact a law to permit interstate banks to branch denovo.

 

On September 28,1995, the California Interstate Banking and Branching Act of 1995 (“CIBBA”) wasenacted and signed into law allowing early interstate branching inCalifornia.  CIBBA authorizesout-of-state banks to enter California by the acquisition of or merger with aCalifornia bank that has been in existence for at least five years, unless theCalifornia bank is in danger of failing or in certain other emergencysituations.

 

***FederalDeposit Insurance Corporation Improvement Act of 1991.***  The Federal Deposit Insurance CorporationImprovement Act of 1991 (“FDICIA”) was signed into law on December 19,1991. FDICIA recapitalized the FDIC’s Bank Insurance Fund, granted broadauthorization to the FDIC to increase deposit insurance premium assessments andto borrow from other sources, and continued the expansion of regulatoryenforcement powers, along with many other significant changes.

 

FDICIA establishesfive categories of capitalization: “well capitalized,” “adequately capitalized,”“undercapitalized,” “significantly undercapitalized,” and “criticallyundercapitalized.”  If a bank falls inthe “undercapitalized,” “significantly undercapitalized” or “criticallyundercapitalized” categories, it will be subject to significant enforcementactions by its primary federal regulator). See “Enforcement Powers-Corrective Measures for Capital Deficiencies,”below.

 

FDICIA also grantsthe regulatory agencies authority to prescribe standards relating to internalcontrols, credit underwriting, asset growth and compensation, among others, andrequires the regulatory agencies to promulgate regulations prohibitingexcessive compensation or fees.  Manyregulations have been adopted by the regulatory agencies to begin to implementthese provisions and subsequent legislation (the Riegle-Neal Act, discussedabove) gives the regulatory agencies the option of prescribing the safety andsoundness standards as guidelines rather than regulations.

 

As previouslynoted, FDICIA places restrictions on certain bank activities authorized understate law.  FDICIA generally restrictsactivities through subsidiaries to those permissible for national banks,thereby effectively eliminating real estate investment powers. Insuranceactivities are also limited, except to the extent permissible for nationalbanks.

 

***USA Patriot Act***.  The United and Strengthening America byProviding Appropriate Tools Required to Intercept and Obstruct Terrorism Act of2001 (the “USA Patriot Act”) was signed into law on October 26, 2001.  The USA Patriot Act requires financialinstitutions, such as the Company, to implement and follow procedures designedto help prevent, detect and prosecute international money laundering and thefinancing of terrorism.  Title III of theUSA Patriot Act is the International Money Laundering Abatement and FinancialAnti-Terrorism Act of 2001 (“IMLAFATA”). In general, the IMLAFATA amends current law, primarily the Bank SecrecyAct (see “—Bank Secrecy Act,” below), to authorize the Secretary of theTreasury, in consultation with the heads of other government agencies, to adoptspecial measures applicable to banks, bank holding companies and otherfinancial institutions including enhanced record-keeping and reportingrequirements for certain financial transactions that are 

 

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ofprimary money laundering concern, due diligence requirements concerning thebeneficial ownership of certain types of accounts, and restrictions orprohibitions on certain types of accounts with foreign financialinstitutions.  Among its otherprovisions, the IMLAFATA requires financial institutions to: (i) establishan anti-money laundering program; (ii) establish due diligence policies,procedures and controls with respect to private banking accounts andcorrespondent banking accounts involving foreign individuals and certainforeign banks; and (iii) avoid establishing, maintaining, administering ormanaging correspondent accounts in the United States for, or on behalf of, aforeign bank that does not have a physical presence in any country.  In addition, the IMLAFATA contains aprovision encouraging cooperation among financial institutions, regulatoryauthorities and law enforcement authorities with respect to individuals,entities and organizations engaged in, or reasonably suspected of engaging in,terrorist acts or money laundering activities. The IMLAFATA expands the circumstances under which deposited funds maybe forfeited and requires covered financial institutions to respond undercertain circumstances to requests for information from federal banking agencieswithin 120 hours.  The IMLAFATA alsoamends the BHCA and the Bank Merger Act to require the federal banking agenciesto consider the effectiveness of a financial institution’s anti-moneylaundering activities when reviewing an application under these Acts.  Among other programs implemented to complywith the USA Patriot Act, the Company implemented a customer identificationprogram.

 

***Bank Secrecy Act***.  The Financial Recordkeeping and Reporting ofCurrency and Foreign Transactions Act of 1970 (the “Bank Secrecy Act”) is adisclosure law that forms the basis of the United States federal government’sframework to prevent and detect money laundering and to deter other criminalenterprises.  Following the September 11,2001 terrorist attacks, an additional purpose was added to the Bank SecrecyAct:  “To assist in the conduct ofintelligence or counter-intelligence activities, including analysis, to protectagainst international terrorism.”  Underthe Bank Secrecy Act, financial institutions such as the Bank are required tomaintain certain records and file certain reports regarding domestic currencytransactions and cross-border transportations of currency.  This, in turn, allows law enforcementofficials to create a paper trail for tracing illicit funds that resulted fromdrug trafficking or other criminal activities. Among other requirements, the Bank Secrecy Act requires financialinstitutions to report imports and exports of currency in excess of $10,000and, in general, all cash transactions in excess of $10,000.  The Bank has established a Bank Secrecy Actcompliance policy under which, among other precautions, the Bank keeps currencytransaction reports to document cash transactions in excess of $10,000 or inmultiples totaling more than $10,000 during one business day, monitors certainpotentially suspicious transactions such as the exchange of a large number ofsmall denomination bills for large denomination bills, and scrutinizes electronicfunds transfers for Bank Secrecy Act compliance.

 

**Administrative Actions**

** **

Following the September 11,2001 terrorist attacks on the United States, President George W. Bush signed anexecutive order on September 24, 2001 that has a number of consequencesfor the operations of commercial banks. First, it ordered the freezing of assets of persons on a list includedin the order and requires each financial institution to monitor its deposits todetermine whether they should be frozen. Second, it makes it illegal to do business with any of the persons orentities named on the list.  This meansthat the Bank is obligated to carefully screen its customers on an ongoingbasis to assure that the Bank is permitted to do business with them.  These types of administrative orders andsimilar regulations of bank regulators may increase the cost of operating theCompany and it is possible that further such orders will be made although theCompany is not aware of any at this time.

 

**The Financial StabilityPlan**

** **

In February 2009,the U.S. Department of the Treasury outlined the “Financial Stability Plan:Deploying our Full Arsenal to Attack the Credit Crisis on All Fronts.” TheFinancial Stability Plan includes a wide variety of measures intended toaddress the domestic and global financial crisis and deterioration of creditmarkets. Many aspects of the Financial Stability Plan are conceptual in natureand contemplate future specific regulations and further regulatory andlegislative enactment. Key aspects of the Financial Stability Plan aredescribed below.

 

The FinancialStability Plan includes a variety of measures aimed at addressing issues in theU.S. banking sector. These measures include requiring banking institutions withassets in excess of $100 billion to undergo a forward-looking comprehensive “stresstest” and providing such institutions with access to a U.S. Treasury-provided “capitalbuffer” to help absorb losses if the results of the test indicate thatadditional capital is needed and it cannot be obtained in the private sector; apublic-private investment fund which will be designed to involve both publicand private capital and public financing for the acquisition of troubled andilliquid assets in the banking sector; substantial expenditures to support government-sponsoredenterprises in the housing sector and a commitment of funds to help preventavoidable foreclosures of owner-occupied residential real estate; a consumerand business lending initiative intended to support the purchase of loans byproviding financing to private investors to help 

 

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unfreezeand lower interest rates for auto, small business, credit card and otherconsumer and business credit; increased transparency and disclosure of exposureon bank balance sheets; requirements relating to accountability and monitoringof funds received by banking institutions under the Financial Stability Plan; restrictionson dividends, stock repurchases and acquisitions on banks receiving assistanceunder the Financial Stability Plan; and limitations on executive compensationfor senior executives at institutions receiving funds under the FinancialStability Plan, including a cap of $500,000 in total annual compensation (notincluding restricted stock payable only when the government is receivingpayments on its investment), “say on pay” shareholder votes and new disclosureand accountability requirements applicable to luxury purchases. As the Companyhas less than $100 billion in assets, we do not believe that the stress testwill apply to the Company and it is too early to tell whether and to whatextent the other provisions may affect us.

 

**Restrictions on TransactionsWith Insiders**

** **

Sections 23Aand 23B of the Federal Reserve Act regulate transactions between insuredinstitutions and their “affiliates” and transactions by the Bank that benefitaffiliates.  For these purposes, an “affiliate”is a company under common control with the institution.  In general, Section 23A imposes limitson the dollar amount of such transactions, and also requires certain levels ofcollateral for loans to affiliates.  Section 23Bgenerally requires that certain transactions between a bank and its respectiveaffiliates be on terms substantially the same, or at least as favorable to suchbank, as those prevailing at the time for comparable transactions with orinvolving other nonaffiliated persons. At this time the Bank does not have any “affiliates” other than theCompany.

 

The restrictionson loans to directors, executive officers, principal stockholders and theirrelated interests (collectively referred to herein as “insiders”) contained inthe Federal Reserve Act and Regulation O promulgated thereunder apply to allfederally insured institutions and their subsidiaries and holdingcompanies.  These restrictions includelimits on loans to one borrower and conditions that must be met before such a loancan be made.  There is also an aggregatelimitation on all loans to insiders and their related interests.  These loans cannot exceed the institution’stotal unimpaired capital and surplus, and the FDIC may determine that a lesseramount is appropriate.  Insiders aresubject to enforcement actions for knowingly accepting loans in violation ofapplicable restrictions.

 

**Deposit InsuranceAssessments**

** **

On October 3,2008, President Bush signed into law the Emergency Economic Stabilization Actof 2008 after the Senate and House passed legislation which temporarilyincreases deposit insurance coverage from $100,000 to $250,000 per depositorper insured bank through December 31, 2009. The legislation provides thatthe basic deposit insurance limit will return to $100,000 after December 31,2009. Certain retirement accounts, such as Individual Retirement Accounts,remain insured up to $250,000 per depositor per insured bank.

 

The Bank chose toparticipate in the increased deposit insurance program outlined above which wasimplemented by the FDIC. The program provides full deposit insurance coveragefor all funds in noninterest bearing transaction deposit accounts through December 31,2009. The cost of participating was a 10 basis points surcharge in addition tothe current deposit insurance assessment. There were no charges for the first30 days.  The new insurance coverage isover and above the $250,000 in coverage already provided. The FDIC providesseparate insurance coverage for deposit accounts held in different categoriesof ownership. Customers may qualify for more than $250,000 in coverage at oneinsured bank if they own deposit accounts in different categories.

 

Each bank isrequired to pay deposit insurance premiums. The premium amount is based upon arisk classification system established by the FDIC. For the first quarter of2009 only, the FDIC’s Board adopted new rates that will raise the current ratesuniformly by seven basis points. The FDIC proposed to establish new initialbase assessment rates that will be subject to adjustment as described beloweffective April 1, 2009.

 

To determine aBank’s initial base assessment rate, the FDIC proposes to: (1) introduce anew financial ratio into the financial ratios method applicable to most RiskCategory 1 institutions to include brokered deposits above a threshold that areused to fund rapid asset growth; (2) for a large Risk Category 1institution with long-term debt issuer ratings, combine weighted average CAMELScomponent ratings, the debt issuer ratings, and the financial ratios methodassessment rate; and (3) use a new uniform amount and pricing multipliersfor each method.

 

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The FDIC alsoproposes to introduce three adjustments that could be made to an institution’sinitial base assessment rate: (1) a potential decrease for long-termunsecured debt, including senior and subordinated debt and, for smallinstitutions, a portion of Tier 1 capital; (2) a potential increase forsecured liabilities above a threshold amount; and (3) for non-RiskCategory 1 institutions, a potential increase for brokered deposits above athreshold amount.

 

Banks with higherlevels of capital and a low degree of supervisory concern are assessed lowerpremiums than banks with lower levels of capital or a higher degree ofsupervisory concern. Insured institutions are not allowed to disclose theirrisk assessment classification and no assurance can be given as to what thefuture level of premiums will be.

 

·                  As of January 1,2009, the FDIC implemented a new interim rate schedule which will apply to the June 30,2009 payment, based on March 31, 2009 data.  Under this interim rule the base chargefor annual insurance deposit assessments ranges from a minimum of 12 basispoints to a maximum of 50 basis points per $100 of insured deposits dependingupon the risk assessment category into which the institution falls.

 

·                  A new proposedrate schedule will take effect beginning April 1, 2009. These new rateswill apply to the September 30, 2009 payment based on June 30, 2009data and beyond. Depending on the institution’s initial risk category andadjustments described above, the charge for annual insurance depositassessments ranges from a minimum of 7 to 77.5 basis points per $100 of insureddeposits.

 

On March 2,2009, the Company received notification from the FDIC announcing that aninterim rule for a special assessment of 20 basis points for June 30,2009, to be collected September 30, 2009, would be charged. Thisassessment was adopted to assist in bringing the FDIC reserve ratio back up tothe statutorily mandated minimum of 1.15 within a reasonable period of time.

 

These significantincreases in insurance premiums and the cost of special assessments could havean adverse effect on the operation expenses and result of operations of theCompany. Management cannot predict what insurance assessment rates will be inthe future. The FDIC is authorized to terminate a depository institution’sdeposit insurance upon a finding by the FDIC that the institution’s financialcondition is unsafe or unsound or that the institution has engaged in unsafe orunsound practices or has violated any applicable rule, regulation, order orcondition enacted or imposed by the institution’s regulatory agency. TheCompany’s premium amount for the year ended December 31, 2008, was$282,616 compared to $222,912 for the year ended December 31, 2007.

 

**Risk-Based CapitalGuidelines**

** **

The federalbanking agencies have issued risk-based capital guidelines that include adefinition of capital and a framework for calculating risk weighted assets byassigning assets and off-balance sheet items to broad credit risk categories. Abank’s or bank holding company’s risk-based capital ratio is calculated by dividingits qualifying total capital (the numerator of the ratio) by its risk-weightedassets (the denominator of the ratio).

 

On December 16,2008, the federal banking agencies approved a final rule on the deductionof goodwill from Tier 1 capital. This rule will permit a bankingorganization to reduce the amount of goodwill it must deduct from Tier 1capital by any associated deferred tax liability. The regulatory capitaldeduction for goodwill will be equal to the maximum capital reduction thatcould occur as a result of a complete write-off of the goodwill under generallyaccepted accounting principles (GAAP). The final rule is effective in January 2009and banking organizations may adopt its provisions for purposes of regulatorycapital reporting for the period ending December 31, 2008.

 

Qualifying totalcapital consists of two types of capital components: “core capital elements”(comprising Tier 1 capital) and “supplementary capital elements” (comprisingTier 2 capital).  The Tier 1 componentmust represent at least 50% of qualifying total capital and may consist of thefollowing items that are defined as core capital elements: (i) commonstockholders’ equity; (ii) qualifying noncumulative perpetual preferredstock (including related surplus); and (iii) minority interest in theequity accounts of consolidated subsidiaries. The Tier 2 component may consist of the following items: (i) allowancefor loan and lease losses (subject to limitations); (ii) perpetualpreferred stock and related surplus (subject to conditions); (iii) hybridcapital instruments (as defined) and mandatory convertible debt securities; and(iv) term subordinated debt and intermediate-term preferred stock,including related surplus (subject to limitations).

 

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Assets and creditequivalent amounts of off-balance sheet items are assigned to one of severalbroad risk categories, according to the obligor, or, if relevant, the guarantoror the nature of collateral.  Theaggregate dollar value of the amount in each category is then multiplied by therisk weight associated with that category. The resulting weighted values from each of the risk categories are addedtogether, and this sum is the institution’s total risk weighted assets thatcomprise the denominator of the risk-based capital ratio.

 

A two-step processdetermines risk weights for all off-balance sheet items.  First, the “credit equivalent amount” ofoff-balance sheet items is determined, in most cases by multiplying theoff-balance sheet item by a credit conversion factor.  Second, the credit equivalent amount istreated like any balance sheet asset and generally is assigned to theappropriate risk category according to the obligor, or, if relevant, theguarantor or the nature of the collateral.

 

All banks and bankholding companies are required to meet a minimum ratio of qualifying totalcapital to risk weighted assets of 8%, of which at least 4% should be in theform of Tier 1 capital.  The Bank’s andCompany’s total capital and Tier 1 capital to risk weighted assets as of December 31,2008, exceeded these requirements.

 

The regulatoryagencies have adopted leverage requirements that apply in addition to therisk-based capital requirements.  Underthese requirements, banks and bank holding companies are required to maintaincore capital of at least 3% of their quarterly average assets (the “LeverageRatio”).  However, an institution may berequired to maintain core capital of at least 4% or 5% or possibly higher,depending upon its activities, risks, rate of growth, and other factors deemedmaterial by regulatory authorities.  At December 31,2008, the Bank’s and Company’s leverage ratio was in excess of thisrequirement.

 

**Enforcement Powers**

** **

Federal regulatoryagencies have broad and strong enforcement authority reaching a wide range ofpersons and entities. Some of these provisions include those which: (i) establisha broad category of persons subject to enforcement under the Federal DepositInsurance Act; (ii) establish broad authority for the issuance of ceaseand desist orders and provide for the issuance of temporary cease and desistorders;  (iii) provide for thesuspension and removal of wrongdoers on an industry-wide basis; (iv) prohibitthe participation of persons suspended or removed or convicted of a crimeinvolving dishonesty or breach of trust from serving in another insuredinstitution; (v) require regulatory approval of new directors and seniorexecutive officers in certain cases; (vi) provide protection fromretaliation against “whistleblowers” and establish rewards for “whistleblowers”in certain enforcement actions resulting in the recovery of money; (vii) requirethe regulators to publicize all final enforcement orders;  (viii) require each insured financialinstitution to provide its independent auditor with its most recent Report ofCondition (“Call Report”); (ix) permit the imposition of significantpenalties for failure to file accurate and timely Call Reports; and (x) providefor the assessment of significant civil money penalties and the imposition ofcivil and criminal forfeiture and other civil and criminal fines and penalties.

 

***Crime Control Act of 1990.***  The Crime Control Act of 1990 furtherstrengthened the authority of federal regulators to enforce capitalrequirements, increased civil and criminal penalties for financial fraud, andenacted provisions allowing the FDIC to regulate or prohibit certain forms ofgolden parachute benefits and indemnification payments to officers anddirectors of financial institutions.

 

***Corrective Measures for Capital Deficiencies.***  The prompt corrective action regulations,which were promulgated to implement certain provisions of FDICIA, alsoeffectively impose capital requirements on national banks, by subjecting bankswith less capital to increasingly stringent supervisory actions.  For purposes of the prompt corrective actionregulations, a bank is “undercapitalized” if it has a total risk-based capitalratio of less than 8%; a Tier 1 risk-based capital ratio of less than 4%; or aleverage ratio of less than 4% (or less than 3% if the bank has received acomposite rating of 1 in its most recent examination report and is notexperiencing significant growth).  A bankis “adequately capitalized” if it has a total risk-based capital ratio of 8% orhigher; a Tier 1 risk-based capital ratio of 4% or higher; a leverage ratio of4% or higher (3% or higher if the bank was rated a composite 1 in its mostrecent examination report and is not experiencing significant growth); and doesnot meet the criteria for a “well capitalized” bank.  A bank is “well capitalized” if it has atotal risk-based capital ratio of 10% or higher; a Tier 1 risk-based capital ratioof 6% or higher; a leverage ratio of 5% or higher; and is not subject to anywritten requirement to meet and maintain any higher capital level(s).  There is no assurance as to what capitalratios the Bank will be able to maintain. As of December 31, 2008, theBank was “adequately capitalized”.

 

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As a result of1st Pacific Bank of California being considered“adequately capitalized”, we are no longer able to accept, renew or rolloverbrokered deposits unless and until such time as we receive a waiver from theFDIC.  There can be no assurance thatsuch a waiver will be granted, on terms requested, or in time for 1st Pacific Bank of California to effectivelyutilize brokered deposits as a source of required liquidity.  If 1st Pacific Bank of California does not receivesuch a waiver, we will not be able to use new brokered deposits or renewexisting brokered deposits as a source of liquidity.  Even with a waiver, the interest ratelimitations on brokered deposits could have the effect of reducing demand forsome deposit products.

 

Under theprovisions of FDICIA and the prompt corrective action regulations, for example,an “undercapitalized” bank is subject to a limit on the interest it may pay ondeposits.  Also, an undercapitalized bankcannot make any capital distribution, including paying a dividend (with someexceptions), or pay any management fee (other than compensation to anindividual in his or her capacity as an officer or employee of the bank).  Such a bank also must submit a capitalrestoration plan to its primary federal regulator for approval, restrict totalasset growth and obtain regulatory approval prior to making any acquisition,opening any new branch office or engaging in any new line of business.  Additional broad regulatory authority isgranted with respect to “significantly undercapitalized” banks, includingforced mergers, ordering new elections for directors, forcing divestiture byits holding company, if any, requiring management changes, and prohibiting thepayment of bonuses to senior management. Additional mandatory and discretionary regulatory actions apply to “significantlyundercapitalized” and “critically undercapitalized” banks, the latter being abank with capital at or less than 2%. The primary federal regulator may appoint a receiver or conservator fora “critically undercapitalized” bank after 90 days, even if the bank is stillsolvent.  Failure of a bank to maintainthe required capital could result in such bank being declared insolvent andclosed.

 

**Community ReinvestmentAct and Fair Lending Developments**

** **

The Company issubject to certain fair lending requirements and reporting obligationsinvolving home mortgage lending operations and Community Reinvestment Act (“CRA”)activities.  The CRA generally requiresthe federal banking agencies to evaluate the record of financial institutionsin meeting the credit needs of their local communities, including low andmoderate income neighborhoods. In addition to substantial penalties andcorrective measures that may be required for a violation of certain fairlending laws, the federal banking agencies may take compliance with such lawsand CRA into account when regulating and supervising other activities.

 

The federalbanking agencies have adopted regulations to measure a bank’s compliance withits CRA obligations on a performance-based evaluation system. This system basesCRA ratings on an institution’s actual lending service and investmentperformance rather than the extent to which the institution conducts needsassessments, documents community outreach or complies with other proceduralrequirements. In March 1994, the Federal Interagency Task Force on FairLending issued a policy statement on discrimination in lending. The policystatement describes the three methods that federal agencies will use to provediscrimination: overt evidence of discrimination, evidence of disparatetreatment and evidence of disparate impact.

 

**Allowance For Loan andLease Losses**

** **

On December 13,2006, the FRB and the other federal financial institution regulatory agenciesissued an interagency policy statement on the allowance for loan and leaselosses (the “Policy Statement”). The Policy Statement replaces a 1993 policystatement, which described the responsibilities of the boards of directors andmanagement of banks and savings associations and of examiners regardingallowance for loan and lease losses. In addition to the Policy Statement, theaccounting profession groups periodically provide guidance to the bankingindustry on allowance for loan and lease losses (“ALLL”) methodology.

 

 The Policy Statement outlines theresponsibility of the institution’s management and board of directors regardingtheir roles in maintaining ALLL at an appropriate level and for documenting itsanalysis. Management should evaluate the ALLL reported on the balance sheet asof the end of each quarter, or more frequently if warranted, and charge orcredit the provision for loan and lease losses (“PLLL”) to bring the ALLL to anappropriate level as of each evaluation date. The determinations of the amountsof the ALLL and PLLL should be based on management’s current judgments aboutthe credit quality of the loan portfolio, and should consider all knownrelevant internal and external factors that affect loan collectability as ofthe evaluation date.

 

In carrying outits responsibility for maintaining an appropriate ALLL, management is expectedto adopt and adhere to written policies and procedures that, at a minimum,ensure that: (1) the institution’s process for determining an appropriatelevel for ALLL is based on a comprehensive, well-documented, and consistentlyapplied analysis of its loan portfolio; (2) the institution has aneffective loan review system and controls (including an effective loanclassification or credit grading system) that identify, monitor, and addressasset quality problems in an accurate and timely manner; (3) the institutionhas adequate data capture and reporting systems to supply the informationnecessary to support and document its estimate of an appropriate ALLL; (4) theinstitution evaluates any loss estimation models before they are employed andmodifies the models’ assumptions, as needed, to ensue that the resulting lossestimates are consistent with GAAP; (5) the institution promptly chargesoff loans, or portions of loans, that available information confirms to beuncollectible, and; (6) the institution periodically validates the ALLLmethodology.

 

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The PolicyStatement also provides guidance to examiners in evaluating the credit qualityof an institution’s loan portfolio, the appropriateness of its ALLL methodologyand documentation, and the appropriateness of the reported ALLL in theinstitution’s regulatory reports. In their review and classification or gradingof the loan portfolio, examiners should consider all significant factors thataffect the collectability of the portfolio, including the value of anycollateral.

 

**Other Aspects of Federaland State Law**

 

The Company isalso subject to federal and state statutory and regulatory provisions covering,among other things, security procedures, technology and information securityand risk assessment, currency and foreign transactions reporting, insider andaffiliated party transactions, management interlocks, truth-in-lending,electronic funds transfers, funds availability, electronic banking, check imageprocessing, financial privacy, truth-in-savings, home mortgage disclosure, andequal credit opportunity.  There are alsoa variety of federal statutes that restrict the acquisition of control of theCompany and/or the Bank.

 

**ProposedLegislation**

 

From time to time,various types of federal and state legislation have been proposed that couldresult in additional regulation of, and restrictions on, the business of theCompany.  It cannot be predicted whetherany legislation currently being considered will be adopted or how suchlegislation or any other legislation that might be enacted in the future wouldaffect the business of the Company.

 

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**ITEM1A.**                                            RISK FACTORS

 

***The following risk factors and all otherinformation contained in this Annual Report on Form 10-K and the documentsincorporated by reference in this Form 10-K should be carefully consideredbefore investing.  Investing in our common stock involves a high degree ofrisk.  The risks and uncertainties described below are not the only oneswe face.  Additional risks and uncertainties not presently known to us orthat we currently believe are immaterial also may impair our business.  Ifany of the events described in the following risks occur, our business, resultsof operations and financial condition could be materially adversely affected. In addition, the trading price of our common stock could decline due to any ofthe events described in these risks, and you may lose all or part of yourinvestment.***

 

**We havereported a substantial net loss for the year ended December 2008.  Although we were profitable in each of theprevious five years, no assurance can be given as to when or if we will returnto profitability.**

 

Our business hashistorically been that of a portfolio lender, which means that ourprofitability depends primarily on our ability to originate quality loans andcollect loan fees, interest and principal as they come due.  Whenloans become non-performing or their ultimate collection is in doubt, ourincome is adversely affected.  Our provision for loan losses was $15.9million for 2008 and was a significant contributing factor to our reported netloss for the year of $21.9 million. Our ability to return to profitability willsignificantly depend on the stabilization and subsequent successful resolutionof our non-performing assets and other real estate owned in our loan portfolioand the successful execution of our revised business strategies, the timing andcertainty of which cannot be predicted, and no assurance can be given that wewill be successful in such efforts.

 

**Our loanportfolio suffered substantial deterioration during 2008 and we continue towork through significant non-performing loans or loans otherwise adverselyclassified. No assurance can be given that the portfolio will not experiencefurther weakness or loss.**

 

Like most insured financialinstitutions, 1st Pacific Bank of California employs an asset quality ratingsystem where assets are assigned a pass, special mention or classified rating. “Pass”assets represent those assets where there is a reasonable likelihood the assetwill be repaid in accordance with its terms.  Assets designated as “specialmention” have potential weaknesses that deserve management’s closeattention.  If left uncorrected, these potential weaknesses mayresult in deterioration of the repayment prospects for the asset or in the bank’scredit position at some future date.  While a higher level of lossreserves may be established, special mention assets are not adverselyclassified and do not expose an institution to sufficient risk to warrantadverse classification.  All other assets not rated as “pass” or “specialmention” are designated as “classified assets,” which consist of all loansclassified as substandard, doubtful and loss.  As a result of thesignificant weakening in economic conditions in our market area, our loanportfolio has suffered significant deterioration during 2008.  Noassurance can be given that additional loans will not be designated as “classified”or that existing classified loans will not migrate into lower classificationswithin that designation, resulting in additional provisions for loanlosses.  Our management team will need to continue to implement itsstrategy for reducing our classified assets, which includes, among otheroptions, selling loans and other real estate owned, which may result inadditional losses and expenses, or restructuring loans, which may result inreduced income from the current stated contractual rate.

 

**We face lending risks, especially with respect to our small-and medium-sized business clients.**

 

Therisk of loan defaults or borrowers’ inabilities to make scheduled payments ontheir loans is inherent in the banking business. Moreover, we focus primarilyon lending to small- and medium-sized businesses. These businesses may not havethe capital or other resources required to weather significant businessdownturns or downturns in the markets in which they compete. Consequently, wemay assume greater lending risks than other financial institutions which have asmaller concentration of those types of loans and which tend to make loans tolarger businesses. Borrower defaults or borrowers’ inabilities to makescheduled payments may result in losses which may exceed our allowances forloan losses. These risks, if they occur, may require higher than expected loanloss provisions which, in turn, can materially impair profitability, capitaladequacy and overall financial condition.

 

**We could suffer losses if we do not properly assess lendingrisks.**

 

Eachloan involves inherent risk that the borrower will not be able to repay theloan.  Although we attempt to evaluatethe risks related to each loan we make, if we do not adequately assess andprotect ourselves against these 

 

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risks, we may not be fullyrepaid.  We could suffer significant loanlosses if there is a systemic fault in our loan underwriting or if we have notidentified all of the important risks of different types of lending.

 

**Our ability to raise deposits will be impaired because the Bank willmost likely be deemed to be “adequately capitalized” for regulatory purposes.**

** **

Asa result of recent changes to 1st Pacific Bank of California’s loan lossreserves, it will most likely be deemed to be “adequately capitalized” afterits next call report is filed. Institutions that are “adequately capitalized” must obtain a waiver fromthe Federal Deposit Insurance Corporation in order to accept, renew or rollover brokered deposits. In addition, certain interest-rate limits apply to an “adequatelycapitalized” institution’s brokered and solicited deposits.  There can be no assurance that such a waiverwill be granted, or granted on the terms requested.  Even with a waiver, the interest ratelimitations on brokered and solicited deposits could have the effect ofreducing demand for some of the deposit products. If 1st Pacific Bank ofCalifornia’s level of deposits were to be reduced, either by the lack of a fullbrokered deposit waiver or by the interest rate limits on brokered or soliciteddeposits, 1st Pacific Bank of California would likely be forced to furtherreduce its assets, and seek alternative funding sources that may not beavailable.  Other possible consequencesof 1st Pacific Bank of California now being “adequately capitalized” includethe potential for increases in 1st Pacific Bank of California’s borrowing costsand terms from the Federal Home Loan Bank and other financial institutions, aswell as increases in its premiums to the Deposit Insurance Fund administered bythe Federal Deposit Insurance Corporation to insure deposits.  Such changes could have a materially adverseeffect on our operations.

 

**We are limited in the amount we can lend to any individual borrower.**

 

Weare limited in the amount that we can lend to a single borrower. Therefore, thesize of the loans which we can offer to potential customers is less than thesize of loans that our competitors with larger lending limits can offer. Legallending limits also affect our ability to seek relationships with larger andmore established businesses. We may not be able to attract and retain customersseeking loans in excess of their lending limits because we cannot make suchloans and we may not be able to find other lenders willing to participate insuch loans with us on favorable terms.

 

**The current changing economic environment poses significantchallenges for us.**

 

We are operating in achallenging and uncertain economic environment, including generally uncertainnational and local conditions. Financial institutions continue to be affectedby the softening of the real estate market and constrained financial markets.While we have no sub-prime residential loans or securities backed by such loanson our books, we have some direct exposure to the residential real estatemarket and we are affected by these events. Continued declines in real estatevalues, home sales volumes and financial stress on borrowers as a result of theuncertain economic environment, including job losses, interest rate resets onadjustable rate mortgage loans and other factors could have adverse effects onour borrowers which would adversely affect our financial condition and resultsof operations. This deterioration in economic conditions coupled with thenational economic recession could drive losses beyond that which is providedfor in our allowance for loan losses and result in the following otherconsequences:

 

·             loan delinquencies, problem assets and foreclosures may increase;

 

·             demand for our products and services may decline;

 

·             low cost or non-interest bearing deposits may decrease;

 

·             collateral for our loans, especially real estate, may decline in value, in turnreducing customers’ borrowing power, and reducing the value of assets andcollateral associated with our existing loans and;

 

·             increased regulatory scrutiny.

 

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**Declines in Southern California real estate values couldmaterially impair profitability and financial condition.**

 

Approximately74% of our loans are secured by real estate collateral. Nearly all of the realestate securing these loans is located in Southern California, primarily in SanDiego County. Real estate values are generally affected by factors such as:

 

·             the socioeconomic conditions of the area where real estate collateral islocated;

 

·             fluctuations in interest rates;

 

·             the availability of real estate financing;

 

·             property and income tax laws;

 

·             local zoning ordinances governing the manner in which real estate may be used;and

 

·             federal, state and local environmental regulations.

 

However,declines in real estate values could significantly reduce the value of the realestate collateral securing our loans, increasing the likelihood of defaults.Moreover, if the value of real estate collateral declines to a level that isnot enough to provide adequate security for the underlying loans, we will needto make additional loan loss provisions which, in turn, will reduce ourprofits. Also, if a borrower defaults on a real estate secured loan, we may beforced to foreclose on the property and carry it as a nonearning asset which,in turn, may reduce net interest income.

 

**Ourvaluation and write-downs of other real estate owned may not accurately reflectcurrent market values or be adequate to address current and future losses,which could affect our financial condition and profitability.**

 

Although we typically obtainappraisals on our other real estate owned prior to taking title to theproperties and at other intervals thereafter, due to the rapid and severedeterioration in our markets, there can be no assurance that such valuationsaccurately reflect the current market value which may be paid by a willingpurchaser in an arms-length transaction.  Moreover, we cannot provideassurance that the losses associated with the other real estate owned will notexceed the estimated amounts and adversely affect future results of our operations.  Thecalculation for the adequacy of write-downs of our other real estate owned isbased on several factors, including the appraised value of the real property,economic conditions in the property’s sub-market, comparable sales, currentbuyer demand, availability of financing, entitlement and developmentobligations and costs, and historic loss experience.  All of thesefactors have caused significant write-downs in recent periods and can changewithout notice based on market and economic conditions.  Therefore,our valuation of write-downs of other real estate owned may not accuratelyreflect current values or be adequate to address current and future losses,which could affect our financial condition and profitability.

 

**Changing interest rates may adversely affect our financialperformance.**

 

Ourprofitability largely depends on the difference between the rates of interestwe earn on our loans and investments, and the interest rates we pay on depositsand other borrowings. This relationship, known as the net interest margin, issubject to fluctuation and is affected by economic and competitive factorswhich influence interest rates, the volume and mix of interest-earning assetsand interest-bearing liabilities, and the level of nonperforming assets.Fluctuations in interest rates will affect the demand of customers for ourproducts and services. We are subject to interest rate risk to the degree thatour interest-bearing liabilities reprice or mature more slowly or more rapidlyor on a different basis than our interest-earning assets. Given our currentvolume and mix of interest-bearing liabilities and interest-earning assets, ourinterest margin could be expected to increase during times of rising interestrates and decline during times of falling interest rates. Therefore,significant fluctuations in interest rates may have an adverse effect on ourresults of operations.

 

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**We are limited in our ability to pay cash dividends.**

 

1stPacific Bancorp depends on dividends from 1st Pacific Bank of California inorder to pay cash dividends to its security holders. In addition, the amountand timing of any dividends is at the discretion of 1st Pacific Bancorp’s boardof directors.

 

**Our ability to service our debt, pay dividends, and otherwisesatisfy our obligations as they come due is substantially dependent on capitaldistributions from 1st Pacific Bank of California which we have agreed with theCalifornia Department of Financial Institutions and the Federal Reserve Bank ofSan Francisco not to take.**

 

Theprimary source of our funds from which we service our debt and pay ourobligations and dividends is the receipt of dividends from 1st Pacific Bank ofCalifornia.  This source of funds is nolonger available.  The availability ofdividends from 1st Pacific Bank of California is limited by various statutesand regulations.  Based on the financialcondition of 1st Pacific Bank of California and other factors, 1st Pacific Bank of California hasagreed with the applicable regulatory authorities to restrict payment ofdividends or other payments, including payments to us.  In this regard, 1st Pacific Bank of California has agreed with theCalifornia Department of Financial Institutions and the Federal Reserve Bank ofSan Francisco to seek their approval before paying dividends to us.  We do not believe that the CaliforniaDepartment of Financial Institutions or the Federal Reserve Bank of SanFrancisco will permit payment of any dividends by 1st Pacific Bank ofCalifornia to us.  As a result of 1stPacific Bank of California’s continued inability to pay dividends to us, we maynot be able to service our debt, pay our obligations or pay dividends on ouroutstanding equity securities.  Thecontinued inability to receive dividends from 1st Pacific Bank of Californiahas and will continue to adversely affect our business, financial condition,results of operations and prospects.

 

TheFederal Reserve Bank of San Francisco has also requested certain limits on ourpaying of dividends, making payments on trust preferred securities or any othercapital distributions based upon 1st Pacific Bank of California’s financialcondition.  In this regard, the FederalReserve Bank of San Francisco has advised us that it expects we will not payany dividends, make payments on trust preferred securities or make any othercapital distributions, without at least 30 days prior written approval of theFederal Reserve Bank of San Francisco. As a result, our business, financialcondition, results of operations and prospects have been and will continue tobe materially adversely affected. We deferred payment on the trust preferredsecurities for the first time recently and do not anticipate resuming thosepayments in the near term. Our inability to receive dividends from 1st PacificBank of California could adversely affect our business, financial condition,results of operations and prospects in the event there is a default in thepayment of the trust preferred securities, and that can occur after 20consecutive quarterly deferral periods and in other circumstances because uponthe event of default, an immediate payment demand could be made on us of allamounts due under the trust preferred instruments. Currently, the outstandingprincipal amount of the trust preferred securities is $5 million.

 

**We are reliant upon brokered deposits and other fundingalternatives that may increase our cost of funds, adversely affect ouroperating results and may result in a shortage of financing sources.**

 

We derive liquidity throughcore deposit growth and payoff, maturity and sale of investment securities andloans. We have found it necessary to also solicit deposits frombrokers.  These brokered deposits represent funds that brokers gatherfrom third parties and package in batches in order to find higher interestrates that are typically available for certificates of deposits with largebalances, as compared to individually deposited smaller denominationdeposits.  Deposit holders then earn a higher rate on the money thatthey have invested, and the broker charges a fee for its service.  Aspart of its funding strategy, 1st Pacific Bank of California generally obtainsbrokered deposits of various maturities to ensure that any run-off of brokereddeposits is staggered and manageable.  While brokered deposits aretypically more expensive than core deposits, such funds can be obtainedrelatively quickly, without expensive marketing costs, and do not typicallyallow for early withdrawal provisions.  However,as a result of 1st Pacific Bank of California no longer being considered to be “well-capitalized”,we are no longer able to accept, renew or rollover brokered deposits unless anduntil such time as we receive a waiver from the Federal Deposit InsuranceCorporation. There can be no assurance that such a waiver will be granted, onthe terms requested, or in time for 1st Pacific Bank of California toeffectively utilize brokered deposits as a source of requiredliquidity.  If 1st Pacific Bank of California does not receive such awaiver, we will not be able to use new brokered deposits or renew existingbrokered deposits as a source of liquidity. Even with a waiver, the interestrate limitations on brokered and solicited deposits could have the effect ofreducing demand for some of the deposit products.

 

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**We rely onFederal Home Loan Bank system borrowings for secondary and contingent liquiditysources.**

 

We utilize borrowings fromthe Federal Home Loan Bank system for secondary and contingent sources ofliquidity.  Also, from time to time, we utilize this borrowing sourceto capitalize on market opportunities to fund investment and loaninitiatives.  Our Federal Home Loan Bank system borrowings totaled$50 million at December 31, 2008.  Based on recent adjustmentsby the FHLB to the Bank’s borrowing capacity on pledged loan collateral, theBank has only limited ability for additional borrowing under the existingarrangements.  Although the Bank isworking to provide the FHLB with “detailed collateral reporting” to increaseits borrowing capacity, there is no guarantee the FHLB will increase the Bank’sborrowing capacity beyond its current level. Further, as the advances come due and are repaid by 1st Pacific Bank ofCalifornia to the Federal Home Loan Bank, the Federal Home Loan Bank is notobligated to re-lend the funds to 1st Pacific Bank of California.  Ifwe are unable to find alternative sources of liquidity which, if available,will probably be at a higher cost and on terms that do not match the structureof our liabilities as well as Federal Home Loan Bank system borrowings do, thenour liquidity position may be further weakened.

 

**Our future growth may be limited if we are not able to raiseadditional capital.**

 

Banksand bank holding companies are required to conform to regulatory capitaladequacy guidelines and maintain their capital at specified percentages oftheir assets. These guidelines may limit our ability to grow and could resultin banking regulators requiring increased capital levels or reduced loan andother earning asset levels. Therefore, in order to continue to increase ourearning assets and net income, we may, from time to time, need to raiseadditional capital. Additional capital may not be available or, if it is, thatadditional capital may not be available on economically reasonable terms.

 

**Our ability to grow may be impacted by our capital levels.**

 

Weintend to continue to expand our businesses and operations to increase depositsand loans. Continued growth may present operating and other problems that couldadversely affect our business, financial condition and results of operations. Amongother things growth without additional capital could cause us to becomeinadequately capitalized and subject us to regulatory enforcement action, see“SUPERVISION AND REGULATION – Enforcement Powers.” Our growth may place astrain on our administrative, operational, personnel and financial resourcesand increase demands on our systems and controls. Our ability to manage growthsuccessfully will depend on our ability to attract qualified personnel andmaintain cost controls and asset quality while attracting additional loans anddeposits on favorable terms, as well as on factors beyond our control, such aseconomic conditions and interest rate trends. If we grow too quickly and arenot able to attract qualified personnel, control costs and maintain assetquality, this continued rapid growth could materially adversely affect ourfinancial performance.

 

**We compete against larger banks and other institutions.**

 

Wecompete for loans and deposits with other banks, savings and thriftassociations and credit unions located in our service areas, as well as withother financial services organizations such as brokerage firms, insurancecompanies and money market mutual funds. These competitors aggressively solicitcustomers within their market area by advertising through direct mail, theelectronic media and other means. Many competitors have been in businesslonger, have established customer bases and are substantially larger. Thesecompeting financial institutions offer services, including internationalbanking services that we can only offer through correspondents, if at all.Additionally, these competitors have greater capital resources and,consequently, higher lending limits. At December 31, 2008, our lending limitper borrower was approximately $5.4 million for unsecured loans and $9.0 

 

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million for secured loans.These limitations were calculated using the California Financial Code, Article 1for lending limits and are primarily based on the capital level of the Bank.Finally, some competitors are not subject to the same degree of regulation.

 

**We compete against banks and other institutions that havereceived Federal capital.**

 

Wehave applied for, but at this time have not received, funding from the U.S.Treasury under the Capital Purchase Program of the Troubled Asset ReliefProgram, known as TARP.  Many of ourcompetitors have already received TARP money and therefore have increased theircapital resources and lending limits. These competitors may be better able to compete against us due to thisnew source of capital from which we have not received any capital.

 

**Current banking laws and regulations affect activities.**

 

Weare subject to extensive regulation. Supervision, regulation and examination ofbanks and bank holding companies by regulatory agencies are intended primarilyto protect depositors rather than security holders. These regulatory agenciesexamine bank holding companies and commercial banks, establish capital andother financial requirements and approve acquisitions or other changes ofcontrol of financial institutions. Our ability to establish new facilities ormake acquisitions requires approvals from applicable regulatory bodies. Changesin legislation and regulations will continue to have a significant impact onthe banking industry. Although some of the legislative and regulatory changesmay benefit us, others may increase our costs of doing business and indirectlyassist our non-bank competitors who are not subject to similar regulation.

 

**The requirements of being a public company may strain ourresources and distract management.**

 

Asa public company, we are subject to the reporting requirements of theSecurities Exchange Act of 1934, as amended (the “Exchange Act”) and theSarbanes-Oxley Act of 2002 (the “Sarbanes-Oxley Act”). These requirements areextensive. The Exchange Act requires that we file annual, quarterly and currentreports with respect to our business and financial condition. TheSarbanes-Oxley Act requires that we maintain effective disclosure controls andprocedures and internal controls for financial reporting. In order to maintainand improve the effectiveness of our disclosure controls and procedures andinternal control over financial reporting, significant resources and managementoversight are required. This may divert management’s attention from otherbusiness concerns, which could have a material adverse effect on our business,financial condition and results of operations.

 

**Economic conditions either nationally or locally in areas inwhich our operations are concentrated may adversely affect our business.**

 

Deteriorationin local, regional, national or global economic conditions could cause us toexperience a reduction in deposits and new loans, an increase in the number ofborrowers who default on their loans and a reduction in the value of thecollateral securing their loans, all of which could adversely affect ourperformance and financial condition. Unlike larger banks that are moregeographically diversified, we provide banking and financial services locally,specifically, within San Diego County. Therefore, we are particularly vulnerableto adverse local economic conditions.

 

**The efforts of the federal government to stabilize thefinancial institution sector could result in more rigorous competition for 1stPacific Bank of California.**

 

Sincethe beginning of 2008, the financial sector has consolidated as largeinstitutions have combined, often with federal government assistance.  In some cases, the federal rescue effortsalso have resulted in substantial government funds being put into theseinstitutions as new capital or commitments to guarantee new or existingdebt.  These institutions are now in astronger position to compete with our bank, especially for on-line bankingproducts such as certificates of deposit and home mortgage loans, by offeringhigher rates on deposits and lower rates on loans.

 

**The efforts of the federal government to stabilize thefinancial institution sector could result in more costs than benefits to 1stPacific Bank of California.**

 

Mostof the extraordinary rescue efforts of the federal government in 2008 and 2009have been designed to assist large, money-center financial institutions andbroker-dealers in order to avoid further risk to the functioning of thenational and international financial systems. 1st Pacific Bank of California is expected to receive little direct 

 

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benefit from those efforts,although the federal insurance on 1st Pacific Bank of California’s depositsrose from $100,000 to $250,000 per account holder, temporarily.  1st Pacific Bank of California is likely tohelp pay for these rescue efforts, however, through higher premiums paid to theFederal Deposit Insurance Corporation. For example, the Federal Deposit Insurance Corporation has established aTemporary Liquidity Guarantee Program to guarantee temporarily all newly-issuedsenior unsecured debt of certain financial institutions.  1st Pacific Bank of California will notparticipate in this program but any losses from the program will be assessedagainst all FDIC-insured institutions, regardless of whether they participate.Further, these rescue efforts may lead to higher corporate income taxrates.  Any such losses and higher taxesor assessments would adversely affect 1st Pacific Bank of California’s netincome.

 

**Legislative or other government action to provide mortgagerelief may negatively impact our business.**

 

Asdelinquencies, defaults and foreclosures in and of residential mortgages haveincreased dramatically, there are several federal, state and local initiativesthat would, if made final, restrict our ability to foreclose and resell theproperty of a customer in default. Any restriction on our ability to forecloseon a loan, any requirement that we forego a portion of the amount otherwise dueon a loan or any requirement that we modify any original loan terms is likelyto negatively impact our business, financial condition, liquidity and resultsof operations. These initiatives have come in the form of proposed legislationand regulations, including those pertaining to federal bankruptcy laws,government investigations and calls for voluntary standard setting.

 

Regardlessof whether a specific law is proposed or enacted, there are several federal andstate government initiatives that seek to obtain the voluntary agreement ofservicers to subscribe to a code of conduct or statement of principles ormethodologies when working with borrowers facing foreclosure on their homes.Generally speaking, the principles call for servicers to reach out to borrowerswith adjustable rate mortgages before their loans “reset” with higher monthlypayments that might result in a default by a borrower and seek to modify loansprior to the reset. Applicable servicing agreements, federal tax law andaccounting standards generally limit the ability of a servicer to modify a loanbefore the borrower has defaulted on the loan or the servicer has determinedthat a default by the borrower is reasonably likely to occur. Servicingagreements generally require the servicer to act in the best interests of theinvestors or at least not to take actions that are materially adverse to theinterests of the investors. Compliance with the code or principles contemplatedby various federal and state initiatives must conform to these othercontractual, tax and accounting standards. As a result, servicers have toconfront competing demands from consumers and those advocating on their behalfto make home retention the overarching priority when dealing with borrowers indefault, on the one hand, and the requirements of investors to maximize returnson the loans, on the other. If we are unable to strike the right balancebetween these demands and requirements, the results of our operations could beadversely affected.

 

**Our financial condition and results of operations would beadversely affected if our allowance for loan losses is not sufficient to absorbactual losses or if we are required to increase our allowance.**

 

Despiteour underwriting criteria, we may experience loan delinquencies and losses. Inorder to absorb losses associated with nonperforming loans, we both maintain anallowance for loan losses based on, among other things, historical experience,an evaluation of economic conditions, and regular reviews of delinquencies andloan portfolio quality. Determination of the allowance inherently involves ahigh degree of subjectivity and requires us to make significant estimates ofcurrent credit risks and future trends, all of which may undergo materialchanges. We may be required to increase our allowance for loan losses for anyof several reasons. Changes in economic conditions affecting borrowers, newinformation regarding existing loans, identification of additional problem loansand other factors, both within and outside of our control, may require anincrease in our allowances. In addition, actual charge-offs in future periods,if not adequately reserved for, will require additional increases in ourallowances for loan losses. Any increases in our allowances for loan losseswill result in a decrease in our net income and, possibly, our capital, and maymaterially affect our results of operations in the period in which theallowance is increased.

 

**We rely on our management and other key personnel, and theloss of any of them may adversely affect our operations.**

 

Weare and will continue to be dependent upon the services of our executivemanagement team. In addition, we will continue to depend on our ability toretain and recruit key banking officers. The unexpected loss of services of anykey management personnel or banking officers could have an adverse effect onour business and financial condition because of their skills, knowledge of ourmarket, years of industry experience and the difficulty of promptly findingqualified replacement personnel.  In the event that the employment of ourexecutive officers is 

 

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terminated in the futurewithout cause, under the terms of their respective employment agreements, mostof our executive officers would be entitled to receive continued salary at therate then in effect for varying periods of time following termination. Suchobligations to make severance payments could be triggered in the event we areacquired and the executive officer is terminated in connection with suchacquisition.

 

**Failure to implement new technologies in our operations mayadversely affect our growth or profits.**

 

Advancesin technology increasingly affect the market for financial services, includingbanking services and consumer finance services. Our ability to competesuccessfully in these markets may depend on the extent to which we are able toexploit such technological changes. However, we may not be able to properly ortimely anticipate or implement such technologies or properly train our staff touse such technologies. Further, the added cost of technology for small banks suchas us adversely affects our profitability. Any failure to adapt to newtechnologies could adversely affect our business, financial condition oroperating results.

 

**We may be subject to an increased likelihood of class actionlitigation and additional regulatory enforcement.**

 

Themarket price of our common stock has declined substantially over the past year,reflective of such factors as our reported losses, investors’ perceptions aboutour business prospects and the financial services industry in general.  The occurrence of these events could resultin shareholder class action lawsuits, even if the activities subject tocomplaint are not unlawful.  These eventsand negative publicity may result in more regulation and legislative scrutinyof our industry practices and may expose us to increased shareholder litigationand additional regulatory enforcement actions, which could adversely affect ourbusiness.

 

**We can issue common stock and preferred stock without yourapproval, diluting your proportional ownership interest.**

 

Ourarticles of incorporation authorize us to issue 10,000,000 shares of commonstock and 10,000,000 shares of preferred stock. As of February 28, 2009,we had no shares of preferred stock outstanding and had 4,980,481 shares ofcommon stock issued and outstanding. We also have 1,545,976 shares reservedunder our stock option plans covering our directors, officers, employees andconsultants. As of February 28, 2009, there were options and warrantsoutstanding to purchase a total of 980,148 shares at a weighted average priceof $8.38 per share.  Consequently, any shares of common stock or preferredstock that we issue subsequent to your purchase of our stock will dilute yourproportional ownership interest in us.

 

**The price of our common stock may decrease, preventing youfrom selling your shares at a profit.**

 

Themarket price of our common stock could decrease and prevent you from sellingyour shares at a profit. The market price of our common stock has fluctuated inrecent years. Fluctuations may occur, among other reasons, due to:

 

·             operating results;

 

·             market demand;

 

·             announcements by competitors;

 

·             economic changes;

 

·             general market conditions; and

 

·             legislative and regulatory changes.

 

Thetrading price of our common stock may continue to fluctuate in response tothese factors and others, many of which are beyond our control.

 

**“Penny Stock” rules may make buying or selling ourcommon stock difficult.**

 

Whileour market price is below $5.00 per share, trading in our common stock may besubject to the “penny stock” rules. The SEC has adopted regulations thatgenerally define a penny stock to be any equity security that has a marketprice of less than $5.00 per share, subject to certain exceptions. These rules wouldrequire that any broker-dealer that would recommend our common stock to personsother than prior customers and accredited investors, 

 

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must, prior to the sale,make a special written suitability determination for the purchaser and receivethe purchaser’s written agreement to execute the transaction. Unless anexception is available, the regulations would require the delivery, prior toany transaction involving a penny stock, of a disclosure schedule explainingthe penny stock market and the risks associated with trading in the penny stockmarket. In addition, broker-dealers must disclose commissions payable to boththe broker-dealer and the registered representative and current quotations forthe securities they offer. The additional burdens imposed upon broker-dealersby such requirements may discourage broker-dealers from effecting transactionsin our common stock, which could severely limit the market price and liquidityof our common stock.

 

**An investment in our common stock is not an insured deposit.**

 

Ourcommon stock is not a bank deposit and, therefore, is not insured against lossby the Federal Deposit Insurance Corporation, commonly referred to as the FDIC,any other deposit insurance fund or by any other public or private entity.Investment in our common stock is subject to the same market forces that affectthe price of common stock in any company.

 

**ITEM1B.**                                            UNRESOLVEDSTAFF COMMENTS

** **

The Company is notaware of any unresolved comments from the staff of the SEC.

 

**ITEM2.**                                                     PROPERTIES

** **

The Company’scorporate headquarters is located at 9333 Genesee Avenue #300, San Diego,California. In addition, the Company currently operates eight branch offices inSan Diego County. Each office is leased pursuant to an operating lease, theprincipal terms of which are outlined in the table below.  For additional information regarding theCompany’s premises and equipment see Note D to the Financial Statementsincluded in “Item 8, Financial Statements,” below.

 
| ** ** | ** ** | ** **                                                                                      | ** ** | **Approx.**    | ** ** | **Monthly**    | ** ** | ** **     | ** ** |
|------------|------------|-------------------------------------------------------------------------------------------------|------------|----------------|------------|----------------|------------|----------------|------------|
| **Date**   | ** ** | ** **                                                                                      | ** ** | **Usable Sq.** | ** ** | **Monthly**    | ** ** | **Lease**      | ** ** |
| **Opened** | ** ** | **Address**                                                                                     | ** ** | **Footage**    | ** ** | **Obligation** | ** ** | **Expiration** | ** ** |
| 9/2007     |       | Corporate  Headquarters  9333 Genesee Avenue, Ste. 300, San Diego, CA                           |       | 11,327         |       | $              | 42,030     |           | 8/2017     |   |
|       |       |                                                                                            |       |           |       |           |       |           |       |
| 9/2007     |       | University  Towne Centre Branch Office  9333 Genesee Avenue, Ste. 100, San Diego, CA            |       | 4,461          |       | $              | 16,736     |           | 8/2017     |   |
|       |       |                                                                                            |       |           |       |           |       |           |       |
| 11/2000    |       | Tri-Cities  Branch Office  3500 College Blvd., Oceanside, CA                                    |       | 2,838          |       | $              | 11,056     |           | 12/2009    |   |
|       |       |                                                                                            |       |           |       |           |       |           |       |
| 8/2003     |       | Mission  Valley Branch Office  8889 Rio San Diego Dr., San Diego, CA                            |       | 3,904          |       | $              | 11,671     |           | 8/2013     |   |
|       |       |                                                                                            |       |           |       |           |       |           |       |
| 2/2005     |       | Inland North  County Branch Office  13500 Evening Creek Dr. North, Ste. 100, San Diego, CA |       | 4,664          |       | $              | 17,669     |           | 2/2012     |   |
|       |       |                                                                                            |       |           |       |           |       |           |       |
| 8/2007     |       | East County  Branch Office  343 E. Main St., El Cajon, CA                                       |       | 4,000          |       | $              | 10,460     |           | 7/2017     |   |
|       |       |                                                                                            |       |           |       |           |       |           |       |
| 7/2007     |       | Solana Beach  Branch Office  937 Lomas Santa Fe Drive, Solana Beach, CA                         |       | 7,513          |       | $              | 24,244     |           | 8/2011     |   |
|       |       |                                                                                            |       |           |       |           |       |           |       |
| 7/2007     |       | La Jolla  Branch Office  7817 Ivanhoe Avenue, Ste. 100, La Jolla, CA                            |       | 7,008          |       | $              | 29,807     |           | 1/2018     |   |
|       |       |                                                                                            |       |           |       |           |       |           |       |
| 2/2008     |       | Downtown San  Diego Office  525 B Street, Suite 1500, San Diego, CA                        |       | 550            |       | $              | 1,500      |           | 10/2009    |   |

 

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Managementbelieves that the Company’s present facilities are in good physical conditionand are adequately covered by insurance. Certain of the leases noted abovecontain options to extend the term of the lease.  The Company is confident that, if necessary,it would be able to secure suitable alternative space on similar terms withouthaving a substantial effect on operations.

 

**ITEM3.**                                                     LEGALPROCEEDINGS

 

The Company andits subsidiaries are involved only in routine litigation incidental to thebusiness of banking, none of which the Company’s management expects to have amaterial adverse effect on the Company.

 

**ITEM4.**                                                     SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

 

No matters weresubmitted for a vote of security holders during the fourth quarter of 2008.

 

**PART II**

 
| **ITEM  5.** | **MARKET FOR REGISTRANT’S COMMON EQUITY AND  RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES** |
|--------------|---------------------------------------------------------------------------------------------------------------------------|

 

**Market Information**

 

Our common stockbegan trading on the NASDAQ Global Market (“NASDAQ”) under the symbol “FPBN” asof January 3, 2008, and continues to be listed there as of the datehereof. Before such listing, from January 30, 2007 until January 3,2008, our common stock was quoted on the OTC Bulletin Board (“OTCBB”) under thesymbol “FPBN.” Prior to our bank holding company reorganization and the Company’sstock being quoted on the OTCBB, the Bank’s common stock was quoted on theOTCBB under the symbol “FPBS”.  The OTCBBis a regulated quotation service that displays real-time quotes, last-saleprices and volume information in over-the-counter equity securities.  Unlike the NASDAQ, the OTCBB does not imposelisting standards and does not provide automated trade executions.  Historical trading in the Company’s and theBank’s stock has not been extensive and such trades cannot be characterized asconstituting an active trading market.

 

The followingtable sets forth, for the fiscal periods indicated, the high and low salesprices or closing bid prices for our common stock for the two most recentfiscal years (the Bank’s common stock for periods prior to our bank holdingcompany reorganization). The quotations for the periods in which our commonstock traded on the OTC Bulletin Board reflect inter-dealer prices, withoutretail mark-up, markdown or commission and may not represent actualtransactions. Trading prices are based on published financial sources.

 
| ** **     | ** ** | **High** | ** ** | **Low** | ** ** | **Share Volume** | ** ** |
|----------------|------------|----------|------------|---------|------------|-----------------------|------------|
| 2007           |       |     |       |    |       |                  |       |
| First Quarter  |       | $        | 16.35      |    | $          | 15.25                 |       | 88,516 |   |
| Second Quarter |       | $        | 16.45      |    | $          | 14.75                 |       | 74,264 |   |
| Third Quarter  |       | $        | 15.30      |    | $          | 12.75                 |       | 89,458 |   |
| Fourth Quarter |       | $        | 13.20      |    | $          | 9.01                  |       | 174,204 |   |
|           |       |     |       |    |       |                  |       |
| 2008           |       |     |       |    |       |                  |       |
| First Quarter  |       | $        | 10.75      |    | $          | 7.27                  |       | 136,067 |   |
| Second Quarter |       | $        | 9.00       |    | $          | 7.50                  |       | 86,206 |   |
| Third Quarter  |       | $        | 8.20       |    | $          | 3.75                  |       | 266,253 |   |
| Fourth Quarter |       | $        | 8.00       |    | $          | 1.60                  |       | 270,174 |   |

 

**Stockholders**

 

As of December 31,2008, the Company had approximately 500 common stock holders of record.

 

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**Dividends**

 

To date, 1stPacific Bancorp has not paid any cash dividends.  Payment of stock or cash dividends in thefuture will depend upon 1st Pacific Bancorp’s earnings and financial conditionand other factors deemed relevant by the Board of Directors, as well as 1stPacific Bancorp’s legal ability to pay dividends.

 

Further, underCalifornia law, 1st Pacific Bancorp would be prohibited from paying dividendsunless: (1) its retained earnings immediately prior to the dividendpayment equals or exceeds the amount of the dividend; or (2) immediatelyafter giving effect to the dividend the sum of 1st Pacific Bancorp’s assetswould be at least equal to 125% of its liabilities, and 1st Pacific Bancorp’s current assets would be atleast equal to its current liabilities, or, if the average of its earningsbefore taxes on income and before interest expense for the two preceding fiscalyears was less than the average of its interest expense for those fiscal years,the current assets of 1st Pacific Bancorp would be at least equal to 125% ofits current liabilities.  The primarysource of funds with which dividends could be paid to shareholders would comefrom cash dividends received by 1st Pacific Bancorp from the Bank. During 2007,the Bank paid $4,400,000 in cash dividends to 1st Pacific Bancorp. Nodividends were paid in 2008. 1st Pacific Bancorp also must service the debt onits Trust Preferred Securities (which are further discussed in the sectionbelow entitled “Liquidity Management, Interest Rate Risk, Financing andCapital Resources”) before declaring or paying any dividends. Pursuant to itsrights under the indenture agreement, in January 2009, the Company elected todefer interest payments on the Trust Preferred Securities and may continue thiselection for up to twenty consecutive quarterly periods.

 

The Bank, as astate-chartered bank, is subject to dividend restrictions set forth in theCalifornia Financial Code, and administered by the DFI. Under suchrestrictions, the Bank may not pay cash dividends in an amount which exceedsthe lesser of the retained earnings of the Bank or the Bank’s net income forthe last three fiscal years (less the amount of distributions to shareholdersduring that period of time).  If theabove test is not met, cash dividends may only be paid with the prior approvalof the DFI, in an amount not exceeding the Bank’s net income for its lastfiscal year or the amount of its net income for the current fiscal year. Suchrestrictions do not apply to stock dividends, which generally require neitherthe satisfaction of any tests nor the approval of the DFI. Notwithstanding theforegoing, if the DFI finds that the shareholders’ equity is not adequate orthat the declarations of a dividend would be unsafe or unsound, the DFI mayorder the state bank not to pay any dividend. The FRB may also limit dividends paid by the Company. Based on theseregulations and the Company’s current financial results, 1st Pacific Bancorp has resolved not to declare orpay any dividends without prior approval of the FRB and the Bank has agreed notto declare or pay any dividends without prior approval of the FRB and the DFI.

 

**Equity Compensation PlanInformation**

** **

See “Item 12,Security Ownership of Certain Beneficial Owners and Management and RelatedStockholder Matters — Securities Authorized for Issuance Under EquityCompensation Plan,” below.

 

**Purchases of EquitySecurities by Company and Affiliated Purchases**

** **

Neither theCompany nor any affiliate of the Company has repurchased any of its common orpreferred stock during the fourth quarter of the fiscal year covered by thisreport, and no stock repurchase plan has been adopted.

 

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**ITEM6.**                                                     SELECTEDFINANCIAL DATA

 

The followingselected financial data of the Company has been derived from and should be readin conjunction with the Company’s audited Financial Statements and notesincluded in “Item 8, Financial Statements and Supplementary Data.” Theinformation contained in this summary may not be indicative of future financialcondition or results of operations.

 

**Selected Financial Data**

 
| ** **                                              | ** ** | **As of or For the Periods Ending December 31,** | ** ** |
|---------------------------------------------------------|------------|------------------------------------------------------------------------------------------|------------|
| ** **                                              | ** ** | **2008**                                                                                 | ** ** | **2007****(1)** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                              | ** ** | **(dollars in thousands, except per share data)**          | ** ** |
| **Summary of Operations**                               |       |                                                                                     |       |   |   |   |   |   |   |   |   |
| Interest Income                                         |       | $                                                                                        | 27,228     |   | $ | 29,201 |   | $ | 23,460 |   | $ | 16,695 |   | $ | 10,363 |   |
| Interest Expense                                        |       | 10,370                                                                                   |       | 11,960 |   | 8,217 |   | 4,125 |   | 1,923 |   |
| Net Interest Income                                     |       | 16,858                                                                                   |       | 17,241 |   | 15,243 |   | 12,570 |   | 8,440 |   |
| Provision for Loan Losses                               |       | 15,900                                                                                   |       | 338 |   | 444 |   | 553 |   | 850 |   |
| Noninterest Income                                      |       | 1,222                                                                                    |       | 710 |   | 539 |   | 491 |   | 466 |   |
| Goodwill Impairment                                     |       | 10,364                                                                                   |       | — |   | — |   | — |   | — |   |
| Other Noninterest Expense                               |       | 16,830                                                                                   |       | 13,402 |   | 9,973 |   | 8,532 |   | 5,993 |   |
| Income (Loss) before Income Taxes                       |       | (25,014                                                                                  | )          | 4,211 |   | 5,364 |   | 3,976 |   | 2,063 |   |
| Income Taxes (Benefit)                                  |       | (3,154                                                                                   | )          | 1,746 |   | 2,189 |   | 1,626 |   | 837 |   |
| Net Income (Loss)                                       |       | $                                                                                        | (21,860    | ) | $ | 2,465 |   | $ | 3,176 |   | $ | 2,350 |   | $ | 1,226 |   |
|                                                    |       |                                                                                     |       |   |   |   |   |   |   |   |   |
| **Per Share Data**                                      |       |                                                                                     |       |   |   |   |   |   |   |   |   |
| Net Income (Loss) — Basic                          |       | $                                                                                        | (4.41      | ) | $ | .56 |   | $ | .82 |   | $ | .61 |   | $ | .34 |   |
| Net Income (Loss) — Diluted                        |       | (4.41                                                                                    | )          | .52 |   | .76 |   | .56 |   | .32 |   |
| Tangible Book Value                                     |       | 4.26                                                                                     |       | 6.68 |   | 6.67 |   | 5.77 |   | 5.16 |   |
| Ending Number of Shares Outstanding                     |       | 4,980,481                                                                                |       | 4,944,443 |   | 3,889,692 |   | 3,849,540 |   | 3,819,920 |   |
| Weighted Average Number of Shares  Outstanding          |       | 4,961,074                                                                                |       | 4,405,191 |   | 3,865,330 |   | 3,840,596 |   | 3,560,036 |   |
|                                                    |       |                                                                                     |       |   |   |   |   |   |   |   |   |
| **Balance Sheet Data — At Period End**             |       |                                                                                     |       |   |   |   |   |   |   |   |   |
| Total Assets                                            |       | $                                                                                        | 420,910    |   | $ | 414,647 |   | $ | 318,464 |   | $ | 265,582 |   | $ | 209,709 |   |
| Total Loans                                             |       | 351,899                                                                                  |       | 349,819 |   | 275,266 |   | 230,382 |   | 188,552 |   |
| Allowance for Loan Losses                               |       | 5,059                                                                                    |       | 4,517 |   | 3,251 |   | 2,809 |   | 2,265 |   |
| Investment Securities                                   |       | 25,053                                                                                   |       | 23,746 |   | 8,998 |   | 3,146 |   | 5,940 |   |
| Other Real Estate Owned                                 |       | 1,390                                                                                    |       | — |   | — |   | — |   | — |   |
| Total Deposits                                          |       | 333,836                                                                                  |       | 345,362 |   | 261,838 |   | 237,208 |   | 180,291 |   |
| Total Shareholders’ Equity                         |       | 22,581                                                                                   |       | 44,974 |   | 25,936 |   | 22,230 |   | 19,697 |   |
|                                                    |       |                                                                                     |       |   |   |   |   |   |   |   |   |
| **Operating Ratios and Other Selected Data**            |       |                                                                                     |       |   |   |   |   |   |   |   |   |
| Return on Average Assets                                |       | -4.98                                                                                    | %          | .67 | % | 1.13 | % | 1.01 | % | .71 | % |
| Return on Average Equity                                |       | -48.82                                                                                   | %          | 6.96 | % | 13.25 | % | 11.28 | % | 7.00 | % |
| Efficiency Ratio                                        |       | 150.41                                                                                   | %          | 74.66 | % | 63.19 | % | 65.32 | % | 67.29 | % |
| Net Interest Margin                                     |       | 4.09                                                                                     | %          | 4.87 | % | 5.61 | % | 5.56 | % | 5.06 | % |
| Dividend Payout Ratio                                   |       | 0.00                                                                                     | %          | 0.00 | % | 0.00 | % | 0.00 | % | 0.00 | % |
| Tangible Equity to Assets                               |       | 5.07                                                                                     | %          | 8.20 | % | 8.14 | % | 8.37 | % | 9.39 | % |
|                                                    |       |                                                                                     |       |   |   |   |   |   |   |   |   |
| **Selected Asset Quality Ratios — At Period  End** |       |                                                                                     |       |   |   |   |   |   |   |   |   |
| Nonperforming Loans to Total Loans                      |       | 3.49                                                                                     | %          | 1.59 | % | 0.00 | % | 0.46 | % | 0.00 | % |
| Nonperforming Assets to Total Assets                    |       | 3.54                                                                                     | %          | 1.34 | % | 0.00 | % | 0.40 | % | 0.00 | % |
| ALLL as a Percentage of Total Loans                     |       | 1.44                                                                                     | %          | 1.29 | % | 1.18 | % | 1.22 | % | 1.20 | % |

 

----

(1) FYE 2007 includes theacquisition of Landmark National Bank, effective July 1, 2007.

 

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

 

**BASIS OF PRESENTATION**

 

The followingManagement’s Discussion and Analysis of Financial Condition and Results ofOperations (“MD&A”), is intended to assist the reader in understanding theoperations and present business condition of the Company. This discussion,which refers to the Company on a consolidated basis, should be read inconjunction with the Company’s audited consolidated financial statements andcorresponding notes thereto, included in “Item 8 — Financial Statements andSupplementary Data” of this report, as well as the information in the “Forward-LookingInformation” and “Item 1A — Risk Factors.”

 

On January 16,2007, 1st Pacific Bancorp acquired 100% of the outstanding shares of commonstock of 1st Pacific Bank of California which wereconverted into an equal number of shares of common stock of 1st PacificBancorp.  There was no cash involved inthe transaction. The reorganization was accounted for as a pooling of interestsand the consolidated financial statements contained herein have been restatedto give full effect to this transaction. The presentation of the 2006 financialstatements has been changed to show the effect of the bank holding companyreorganization and reflects consolidation of holding company assets ofapproximately $19,000 and a net loss of approximately $26,000 for the periodended December 31, 2006.

 

1st Pacific Bancorp is inactive except forinterest expense associated with the junior subordinated debentures (related tothe trust preferred securities; discussed further in the section below entitled“Liquidity Management, Interest Rate Risk, Financing and Capital Resources”)and minimal other expenses. Therefore, financial information is primarilyreflective of the Bank.

 

The MD&A belowincludes the following sections:

 

·                  *Financial Overview*— a general description of our businessand a summary of the financial results for the current year.

 

·                  *Distribution of Assets, Liabilities and Stockholders’ Equity: InterestRates and Interest Differential* — average balances and average ratesearned and paid in the past three years, analysis of changes in interest due tovolume and rate.

 

·                  *Liquidity Management, Interest Rate Risk, Financing and CapitalResources*— a discussion of liquidity, interest rate risk,short-term and other borrowings, capital resources and the effects of inflationon interest rates.

 

·                  *Loan Portfolio* — a discussion of types of loans, maturitiesand sensitivities of loans to changes in interest rates analysis, loan qualitydiscussion, loan concentrations and allowance for loan losses.

 

·                  *Deposits*— a discussion of sources of deposits, distributionof average deposits and average rates paid and scheduled maturity distributionof time deposits of $100,000 or more.

 

·                  *Noninterest Income and Noninterest Expense* — a discussion ofmaterial changes in noninterest income and noninterest expense.

 

·                  *Income Taxes* — a discussion of changes in income taxexpense.

 

·                  *Contractual Obligations* —a discussion of contractual obligationsby cross-reference to “Item 8 - Financial Statements and Supplementary Data.”

 

·                  *Off-Balance Sheet Arrangements* — a discussion of the Company’soff-balance sheet financial instruments.

 

·                  *Critical Accounting Policies and Estimates* — a discussion ofaccounting policies considered material to the presentation of the Company’sfinancial statements.

 

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**FINANCIAL OVERVIEW**

** **

We are a SanDiego-based bank holding company for 1st Pacific Bank of California.  We provide traditional commercial financialservices to small and medium-sized businesses and individuals in several SanDiego County communities.  Thecomparability of our 2008 financial results with our 2007 financial results isaffected by the Company’s acquisition of Landmark National Bank (“Landmark”),which was completed July 1, 2007, and operating results include theoperations of Landmark since the date of the acquisition. For furtherdiscussion on this acquisition, see Note O, “Merger-Related Activity” of ourConsolidated Financial Statements included in “Item 8-Financial Statements andSupplementary Data” of this report.

 

During 2008, totalassets increased 1.5% to $420.9 million from $414.6 million at year end 2007.Compared to the prior year-end, FHLB borrowings, increased from $10.0 millionto $50.0 million. Total deposits decreased approximately $11.5 million to$333.8 million and total loans outstanding increased approximately $2.1 millionto $351.9 million.

 

Net loss for theyear ended December 31, 2008, was $21.9 million versus net income of $2.5million in 2007. The net loss was primarily the result of a one-time,non-recurring 100% write-down of goodwill in the amount of $10.4 million andthe addition of $15.9 million to the allowance for loan losses to cover loancharge-offs and provide reserves for increased problem loans.

 

The Bank’s netinterest margin was under pressure beginning mid-2007 when the pricing of loansand deposits became very competitive. This pressure on net interest margin intensified as the Federal OpenMarket Committee (“FOMC”) implemented an easing policy beginning in September 2007.During 2008, the FOMC began an extensive rate reduction campaign, which reducedthe Bank’s prime rate 400 basis points by year-end. The Bank met the prime ratereductions with aggressive repricing of deposits, which helped to shield thenet interest margin from the severe prime rate reduction.

 

While the Bankplans for modest growth in 2009, the year is likely to be one where we continueto feel pressure on our capital and net interest margin and strong competitionfor deposits, especially in light of our not being able to accept brokereddeposits without regulatory approval, see “SUPERVISION AND REGULATION –Enforcement Powers.” Pressure on net interest margin is expected to continue in2009 as a result of the low rate environment and as the Bank works through itsnonperforming assets. Along with continued loan growth, the Bank expectssignificant workouts in its special assets portfolio. Management alsoanticipates continued volatility in its net interest margin due to changes inearning asset mix, changes in cost of funds, and changes in the level ofinterest rates or the direction of interest rates.

 

Noninterestexpenses increased from $13.4 million in 2007 to $27.2 million in 2008, a $13.8million increase.  The bulk of thisvariance can be explained by two events experienced by the Company in 2008: (1) agoodwill write-off of $10.4 million, and; (2) an other-than-temporaryimpairment (“OTTI”) charge of $800,000 on a corporate bond investment. Both ofthese events were due to the volatile economic and market conditions in late2008.

 

The Company also,for the first time in history, posted significant loan charge-offs of $15.4million. Non-performing loans increased 121% between December 2007 and December 2008,from 1.34% of total assets to 2.91%, respectively. The percentage ofnon-performing assets, which includes $1.4 million in OREO and $1.3 million innon-accrual debt securities, to total assets increased from 1.34% at December 31,2007 to 3.54% at December 31, 2008. The level of loan loss reserve at December 31,2008 was 1.44%; up from 1.29% at December 2007. The loan loss provisioncharged against earnings during 2008 was $15.9 million up from $338,000 in2007.

 

As a result of thelosses experienced in 2008, the Bank is considered “adequately” capitalized at December 31,2008. The Bank has implemented a number of initiatives to improve its operatingresults and is evaluating a number of alternatives to improve its capitalratios back to the “well-capitalized” level. The Company will continue to focuson the financial services needs within our target market — small andmedium-sized businesses and professionals in the greater San Diego County area.There are a number of factors that could prevent the Company from achieving itsplans, see “Risk Factors.”

 

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**DISTRIBUTION OF ASSETS,LIABILITIES AND STOCKHOLDERS’ EQUITY; INTEREST RATES AND INTEREST DIFFERENTIAL**

** **

The followingtable sets forth a summary of average balances with corresponding interestincome and interest expense as well as average yield and cost information forthe periods indicated. Nonaccrual loans are included in the calculation of theaverage balances of loans, and interest not accrued is excluded.

 

**Average Balances withRates Earned and Paid**

 
| ** **                                                                | ** ** | **For the Periods Ended December 31,** | ** ** |
|---------------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                                                | ** ** | **2008**                                                        | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                                                | ** ** | **(dollars in thousands)**                            | ** ** |
| ** **                                                                | ** ** | **Average  Balance**                                            | ** ** | **Interest  Earned  or Paid** | ** ** | **Average  Yield or  Rate  Paid** | ** ** | **Average  Balance** | ** ** | **Interest  Earned  or Paid** | ** ** | **Average  Yield or  Rate  Paid** | ** ** | **Average  Balance** | ** ** | **Interest  Earned  or Paid** | ** ** | **Average  Yield or  Rate  Paid** | ** ** |
| **Assets**                                                                |       |                                                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-Earning  Assets:                                                 |       |                                                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Investment  Securities                                                    |       | $                                                               | 30,116     |   | $ | 1,585 |   | 5.26 | % | $ | 15,564 |   | $ | 812 |   | 5.22 | % | $ | 6,448 |   | $ | 285 |   | 4.42 | % |
| Federal Funds  Sold and Other                                             |       | 15,718                                                          |       | 340 |   | 2.16 | % | 20,127 |   | 1,009 |   | 5.01 | % | 13,208 |   | 650 |   | 4.92 | % |
| Federal Reserve,  FHLB and Bankers’ Bank Stock                       |       | 4,551                                                           |       | 200 |   | 4.40 | % | 2,820 |   | 139 |   | 4.92 | % | 1,794 |   | 90 |   | 5.00 | % |
| Loans (1)                                                                 |       | 362,067                                                         |       | 25,103 |   | 6.93 | % | 315,255 |   | 27,241 |   | 8.64 | % | 250,369 |   | 22,435 |   | 8.96 | % |
| Total  Interest-Earning Assets                                            |       | 412,452                                                         |       | 27,228 |   | 6.60 | % | 353,766 |   | 29,201 |   | 8.25 | % | 271,819 |   | 23,460 |   | 8.63 | % |
| Noninterest-Earning  Assets, net                                          |       | 26,274                                                          |       |   |   |   |   | 14,522 |   |   |   |   |   | 8,442 |   |   |   |   |   |
| Total Assets                                                              |       | $                                                               | 438,726    |   |   |   |   |   | $ | 368,288 |   |   |   |   |   | $ | 280,261 |   |   |   |   |   |
|                                                                      |       |                                                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Liabilities  and Shareholders’ Equity**                            |       |                                                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-Bearing  Liabilities:                                            |       |                                                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  Checking                                                |       | $                                                               | 15,851     |   | $ | 76 |   | 0.48 | % | $ | 15,219 |   | $ | 154 |   | 1.01 | % | $ | 14,200 |   | $ | 174 |   | 1.22 | % |
| Savings &  Money Market                                          |       | 99,023                                                          |       | 2,190 |   | 2.21 | % | 95,754 |   | 3,824 |   | 3.99 | % | 67,989 |   | 2,541 |   | 3.74 | % |
| Time Deposits  under $100k                                                |       | 39,636                                                          |       | 1,540 |   | 3.88 | % | 25,864 |   | 1,260 |   | 4.87 | % | 26,109 |   | 1,092 |   | 4.18 | % |
| Time Deposits,  $100k or More                                             |       | 118,110                                                         |       | 4,870 |   | 4.12 | % | 108,056 |   | 5,509 |   | 5.10 | % | 82,840 |   | 3,756 |   | 4.53 | % |
| Other Borrowings                                                          |       | 46,414                                                          |       | 1,694 |   | 3.65 | % | 20,584 |   | 1,213 |   | 5.89 | % | 10,819 |   | 654 |   | 6.04 | % |
| Total  Interest-Bearing Liabilities                                       |       | 319,034                                                         |       | 10,370 |   | 3.25 | % | 265,477 |   | 11,960 |   | 4.51 | % | 201,957 |   | 8,217 |   | 4.07 | % |
| Demand Deposits                                                           |       | 70,628                                                          |       |   |   |   |   | 64,319 |   |   |   |   |   | 52,550 |   |   |   |   |   |
| Other Liabilities                                                         |       | 4,290                                                           |       |   |   |   |   | 2,831 |   |   |   |   |   | 1,573 |   |   |   |   |   |
| Shareholders’  Equity                                                |       | 44,774                                                          |       |   |   |   |   | 35,661 |   |   |   |   |   | 24,181 |   |   |   |   |   |
| Total Liabilities  and Shareholders’ Equity                          |       | $                                                               | 438,726    |   |   |   |   |   | $ | 368,288 |   |   |   |   |   | $ | 280,261 |   |   |   |   |   |
| Net Interest  Income                                                      |       |                                                            |       | $ | 16,858 |   |   |   |   |   | $ | 17,241 |   |   |   |   |   | $ | 15,243 |   |   |   |
| **Net  Interest Margin**  (Net Interest Income / Interest-Earning Assets) | ** ** | ** **                                                      | ** ** | ** ** | ** ** | **4.09** | **%** | ** ** | ** ** | ** ** | ** ** | **4.87** | **%** | ** ** | ** ** | ** ** | ** ** | **5.61** | **%** |

 

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(1) Interest income includes amortized loan fees, net of costs, ofapproximately $396,000, $540,000 and $706,000 in 2008, 2007 and 2006,respectively.

 

The principalcomponent of the Company’s revenues is net interest income.  Net interest income is the difference (the “interestrate spread”) between the interest earned on the Company’s loans andinvestments and the interest paid on deposits and other interest-bearingliabilities.  As the Company is assetsensitive, net interest margin typically improves during a rising rateenvironment and declines during a declining rate environment.

 

For 2008, netinterest income was $16.9 million compared to $17.2 million for the year endingDecember 31, 2007, a 2% decrease. Even though the Bank’s volume of average earning assets increased $58.3million in 2008 to $412.5 million, a 16% increase, net interest income declinedas a result of the sharp decrease in net interest margin from 4.87% to 4.09%, areduction of 78 basis points. This decrease in net interest margin compared tothe prior year reflects the cumulative effects of changes in monetary policy,including a 400 basis point reduction in the Bank’s prime rate by year-end2008. The severe drop in the federal funds target rate from 4.25% at December 31,2007 to 0.25% by the end of 2008 has had a detrimental effect on the Bank’s net interest margin.

 

To counter thecontraction of its net interest margin, the Company regularly and aggressivelyrepriced deposit rates downward as the prime lending rate made a rapid descent.Because of the prime lending rate drop the percentage of loan assets which werepriced at their floor increased to 42% as of December 31, 2008. Despitethese factors, net interest margin has been negatively affected by interestrate cuts, the resulting decrease in total loan yields and the activecompetition in the local market for deposits. The Company closely monitors and manages its 

 

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interestrate sensitivity; however, management anticipates instability of its netinterest margin to continue due to changes in the earning asset mix, changes incost of funds, and changes in the level of interest rates or the direction ofinterest rates.  For further informationregarding the Company’s interest rate risk, see the “Liquidity Management,Interest Rate Risk, Financing and Capital Resources” section below.

 

For 2007, netinterest income was $17.2 million compared to $15.2 million for the year endingDecember 31, 2006, a 13% increase. This growth in net interest income for the year ending December 31,2007 primarily relates to the increase in average earning assets, whichincreased from $271.8 million in 2006 to $353.8 million in 2007, a 30% increase,mostly due to the acquisition of Landmark which was effective July 1,2007. However, this volume increase was offset by the decrease in the netinterest margin from 5.61% to 4.87%, a decline of 74 basis points, or 13%.  This decrease in net interest margin comparedto the prior year reflects the cumulative effects of changes in monetarypolicy, including 100 basis points in increases to the target Federal Fundsrate between January and June of 2006 and then a cumulative 100 basispoint cut in the target Federal Funds rate in a three-month period beginning inSeptember of 2007.  The federalfunds target rate was 4.25% at December 31, 2007.

 

The followingtables show the changes in interest income and expense as a result of changesin volume and rate for each of the last two fiscal years.  Changes due to both rate and volume areallocated to volume.

 

**Analysis of Volume andInterest Rate Changes**

 
| ** **                          | ** ** | **(dollars in thousands)**                                                                                    | ** ** |
|-------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                          | ** ** | **Year Ended December 31, 2008  Versus the Year Ended  December 31, 2007** | ** ** |
| ** **                          | ** ** | **Amount of Change Attributed to**                                                                  | ** ** |
| ** **                          | ** ** | **Volume**                                                                                                              | ** ** | **Rate** | ** ** | **Total  Change** | ** ** |
| Investment securities (1)           |       | $                                                                                                                       | 766        |   | $ | 7 |   | $ | 773 |   |
| Federal funds sold                  |       | (95                                                                                                                     | )          | (574 | ) | (669 | ) |
| Other earning assets                |       | 76                                                                                                                      |       | (15 | ) | 61 |   |
| Loans                               |       | 3,246                                                                                                                   |       | (5,384 | ) | (2,138 | ) |
| Changes in interest income          |       | 3,993                                                                                                                   |       | (5,966 | ) | (1,973 | ) |
|                                |       |                                                                                                                    |       |   |   |   |   |
| NOW, savings and money market       |       | 75                                                                                                                      |       | (1,787 | ) | (1,712 | ) |
| Time deposits under $100,000        |       | 535                                                                                                                     |       | (255 | ) | 280 |   |
| Time deposits of $100,000 or more   |       | 415                                                                                                                     |       | (1,054 | ) | (639 | ) |
| Other borrowings                    |       | 943                                                                                                                     |       | (462 | ) | 481 |   |
| Changes in interest expense         |       | 1,968                                                                                                                   |       | (3,558 | ) | (1,590 | ) |
| Total change in net interest income |       | $                                                                                                                       | 2,025      |   | $ | (2,408 | ) | $ | (383 | ) |

 
| ** **                          | ** ** | **Year Ended December 31, 2007  Versus the Year Ended  December 31, 2006** | ** ** |
|-------------------------------------|------------|--------------------------------------------------------------------------------------|------------|
| ** **                          | ** ** | **Amount of Change Attributed to**                                                   | ** ** |
| ** **                          | ** ** | **Volume**                                                                           | ** ** | **Rate** | ** ** | **Total   Change** | ** ** |
| Investment securities               |       | $                                                                                    | 474        |   | $ | 53 |   | $ | 527 |   |
| Federal funds sold                  |       | 347                                                                                  |       | 12 |   | 359 |   |
| Other earning assets                |       | 50                                                                                   |       | (1 | ) | 49 |   |
| Loans                               |       | 5,607                                                                                |       | (801 | ) | 4,806 |   |
| Changes in interest income          |       | 6,478                                                                                |       | (737 | ) | 5,741 |   |
|                                |       |                                                                                 |       |   |   |   |   |
| NOW, savings and money market       |       | 1,119                                                                                |       | 144 |   | 1,263 |   |
| Time deposits under $100,000        |       | (11                                                                                  | )          | 179 |   | 168 |   |
| Time deposits of $100,000 or more   |       | 1,285                                                                                |       | 468 |   | 1,753 |   |
| Other borrowings                    |       | 575                                                                                  |       | (16 | ) | 559 |   |
| Changes in interest expense         |       | 2,968                                                                                |       | 775 |   | 3,743 |   |
| Total change in net interest income |       | $                                                                                    | 3,510      |   | $ | (1,512 | ) | $ | 1,998 |   |

 

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**(1)**          Bank-qualified municipals receive preferentialtreatment for federal income tax purposes. Changes shown are before any suchFederal tax benefit.

 

The Companyexpects its risk exposure to changes in interest rates during 2009 to remainmanageable and within acceptable policy ranges. Management will continue tostrive for an optimal balance between risk and earnings.

 

**LIQUIDITY MANAGEMENT,INTEREST RATE RISK, FINANCING AND CAPITAL RESOURCES**

 

***Liquidity Management***

 

Balance sheetliquidity, which is a measure of an entity’s ability to meet fluctuations indeposit levels and provide for customers’ credit needs, is managed throughvarious funding strategies that reflect the maturity structures of the sourcesof funds being gathered and the assets being funded.

 

The Bank’sliquidity results primarily from funds provided by short-term liabilities suchas demand deposits, certificates of deposit, and short-term borrowings and isaugmented by payments of principal and interest on loans.  The Bank has access to short-terminvestments, primarily Federal funds sold, which is the primary means forproviding immediate liquidity. As an additional aid to managing short-termliquidity needs, the Bank also maintains credit facilities at correspondentbanks which may be reduced or withdrawn at any time, and borrowing facilitiesthrough its Federal Home Loan Bank membership and the FRB Discount Window whichmay include provisions for pledging of collateral. Below is a summary of thetotal borrowing capacity available under these facilities and amountsoutstanding at December 31, 2008:

 

**Capacity and OutstandingBorrowings**

 
| **Source of Borrowing Facility**    | ** ** | **Capacity** | ** ** | **Outstanding at 12/31/2008** | ** ** |
|----------------------------------------------------|------------|--------------|------------|-----------------------------------------|------------|
| Secured line based on pledged loan  collateral at: |       |         |       |                                    |       |
| Federal Home Loan Bank                             |       | $            | 59,330,025 |                                    | $          | 50,000,000 |   |
| Federal Reserve Bank                               |       | $            | 36,471,740 |                                    | $          | 0 |   |
| Unsecured lines at correspondent banks             |       | $            | 10,000,000 |                                    | $          | 0 |   |

 

The objective ofthe Bank’s asset/liability strategy is to manage and monitor liquidityproactively to ensure the safety and soundness of the Bank’s capital base,while maintaining adequate net interest margins and spreads to provide anappropriate return to shareholders.  TheBank has procedures in place to manage its liquidity on a daily basis andmaintains “contingency” sources of liquidity, whereby a certain level ofliquidity sources are reserved to be used for unforeseen contingency purposes.To allow for more efficient balance sheet management, the Company manages its “on”balance sheet liquidity ratios and “off” balance sheet liquidity sources.Additionally, the Bank has established thresholds for non-core deposits. Non-coredeposits are defined as time deposits greater than $100,000 and all brokereddeposits.  Brokered deposits are depositsobtained through any person engaged in the business of placing deposits orfacilitating the placement of deposits, of third parties with insureddepository institutions, with some limited exceptions.  Brokered deposits also include depositsobtained through any insured depository institution that is not wellcapitalized, or any employee of such institution, which engages in the solicitationof deposits by offering rates of interest which are significantly higher thanthe prevailing rates of interest on deposits offered by other insureddepository institutions in such depository institution’s normal market area.During 2008, total brokered deposits increased from $48.2 million at December 31,2007, to $84.9 million at December 31, 2008. This increase of $36.7million in total brokered deposits is primarily the result of increasedbalances in the Certificate of Deposit Account Registry Service (“CDARs”)reciprocal program, which are considered brokered deposits and increased by$28.8 million during 2008 and totaled $36.2 million at December 31, 2008. 

 

As a result ofthe Bank no longer being considered “well-capitalized,” the Bank is no longerable to accept, renew or rollover brokered deposits unless and until such timeas it receives a waiver from the FDIC. See also “SUPERVISION AND REGULATION - EnforcementPowers.”  The Bank intends to apply for awaiver, from the FDIC to continue to accept, renew or rollover CDARS reciprocalbrokered deposits; however, there can be no guarantee this waiver will begranted and, if not, the Bank will need to seek other alternatives, which maybe more costly for funding purposes, as these deposits mature.

 

In August 2008,the Company modified its policy as a result of an increased interest in CDARsand the desire of the Bank to continue to offer this program as an option toits customers seeking additional deposit insurance. CDARs deposits continue tobe considered brokered, however, they are not viewed as having the same degreeof volatility as other traditional brokered deposits. As of December 31,2008, total CDARs deposits were $36.2 million compared to $7.3 million at December 31,2007.

 

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In order to managethe Bank’s liquidity, management monitors a number of liquidity ratios,including the level of liquid assets to funding sources (both on and off thebalance sheet), the level of dependence on non-core funding sources, the levelof loans to funding sources, the level of short-term investments to totalassets, contingent sources to total deposits, available liquidity to totalfunding and the level of unfunded loan commitments.  As of December 31, 2008, managementconsiders the Bank’s liquidity sufficient to meet the Bank’s liquidity needs.

 

Despite thesignificant net loss in 2008, the Company had positive cash flow fromoperations because the goodwill impairment charge and the provision for loanlosses are non-cash expenses. Net financing activities of $28.7 million;primarily from increased borrowings, were used to fund net investing activitiesof $22.7 million, primarily net increase in loans funded.

 

1st Pacific Bancorp is a company separate andapart from the Bank and must provide for its own liquidity. As of December 31,2008, 1st Pacific Bancorp had no borrowings other thanjunior subordinated debentures and had approximately $39,000 in unrestrictedcash. See Note P, Condensed Financial Information of Parent Company only, tothe consolidated financial statements for additional financial informationregarding 1st Pacific Bancorp.

 

Substantially allof 1st Pacific Bancorp’s revenues are obtained fromdividends declared and paid by the Bank. Banking regulations limit the amountof cash dividends that may be paid without prior approval of the Bank’s primaryregulatory agency. The California Financial Code provides that a bank may notmake a cash distribution to its shareholder in excess of the lesser or the Bank’sundivided profits or the Bank’s net income for its last three fiscal years lessthe amount of any distribution made by the Bank to shareholders during the sameperiod. As a result of the net loss experienced in 2008 and agreement with theBank’s regulators, it is unlikely the Bank will be able to make dividendpayments to 1st Pacific Bancorp in the foreseeable future.Pursuant to its rights under the indenture agreement, the Company has electedto defer interest payments on the subordinated debentures and may continue suchdeferment for up to twenty calendar quarters. Management is evaluatingalternate means to provide 1st Pacific Bancorp with cash to meet its otherminimal operating expenses.

 

***Interest Rate Risk***

** **

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

 

The table belowsets forth the interest rate sensitivity of the Company’s interest-earningassets and interest-bearing liabilities as of December 31, 2008, using theinterest rate sensitivity gap ratio.  Forpurposes of the following table, an asset or liability is consideredrate-sensitive within a specified period when it can be repriced or matureswithin its contractual terms.  When therate on a loan with a floating rate has reached a contractual floor or ceilinglevel, the loan is treated as a fixed rate loan for purposes of determining itsrate-sensitivity until the rate is again free to float.

 

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**Interest Rate Sensitivityof Interest-Earning Assets and Liabilities**

 
| ** **                                                            | ** ** | **Estimated Maturity or Repricing** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                            | ** ** | **Up to  Three  Months**                      | ** ** | **Over Three  Months  To Less  Than One  Year** | ** ** | **Over  One to  Five  Years** | ** ** | **Over  Five  Years** | ** ** | **Total** | ** ** |
| ** **                                                            | ** ** | **(dollars in thousands)**                         | ** ** |
| **Interest-Earning Assets:**                                          |       |                                               |       |   |   |   |   |   |   |   |   |
| Investment Securities                                                 |       | $                                                  | 3,674      |   | $ | 1,925 |   | $ | 3,313 |   | $ | 16,141 |   | $ | 25,053 |   |
| Federal Funds Sold                                                    |       | 18,010                                             |       | — |   | — |   | — |   | 18,010 |   |
| Loans                                                                 |       | 111,831                                            |       | 75,528 |   | 92,713 |   | 71,827 |   | 351,899 |   |
| Totals                                                                |       | $                                                  | 133,515    |   | $ | 77,453 |   | $ | 96,026 |   | $ | 87,968 |   | $ | 394,962 |   |
|                                                                  |       |                                               |       |   |   |   |   |   |   |   |   |
| **Interest-Bearing Liabilities:**                                     |       |                                               |       |   |   |   |   |   |   |   |   |
| Interest-Bearing Checking                                             |       | $                                                  | 16,731     |   | $ | — |   | $ | — |   | $ | — |   | $ | 16,731 |   |
| Savings & Money Market                                       |       | 77,037                                             |       | — |   | — |   | — |   | 77,037 |   |
| Time Deposits                                                         |       | 33,129                                             |       | 131,930 |   | 12,474 |   | — |   | 177,533 |   |
| Other Borrowings                                                      |       | 10,155                                             |       | 15,000 |   | 35,000 |   | — |   | 60,155 |   |
| Totals                                                                |       | $                                                  | 137,052    |   | $ | 146,930 |   | $ | 47,474 |   | $ | — |   | $ | 331,456 |   |
|                                                                  |       |                                               |       |   |   |   |   |   |   |   |   |
| Interest Rate Sensitivity Gap                                         |       | $                                                  | (3,537     | ) | $ | (69,477 | ) | $ | 48,552 |   | $ | 87,968 |   | $ | 63,506 |   |
| Cumulative Interest Rate  Sensitivity Gap                             |       | $                                                  | (3,537     | ) | $ | (73,014 | ) | $ | (24,462 | ) | $ | 63,506 |   | $ | 63,506 |   |
| Cumulative Interest Rate  Sensitivity Gap Ratio Based on Total Assets |       | -0.84                                              | %          | -17.35 | % | -5.81 | % | 15.09 | % | 15.09 | % |

 

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Gap analysis is amethod of analyzing exposure to interest rate risk, by measuring the ability ofthe Company to reprice its interest rate-sensitive assets and liabilities.  The actual impact of interest rate movementson the Company’s net interest income may differ from that implied by any gapmeasurement, depending on the direction and magnitude of the interest ratemovements and the repricing characteristics of various on and off-balance sheetinstruments, as well as competitive pressures. These factors are not fully reflected in the foregoing gap analysis and,as a result, the gap report may not provide a complete assessment of theCompany’s interest rate risk.  Inaddition to gap analysis, such as the table above, the Company estimates theeffect of changing interest rates on its net interest income using therepricing and maturity characteristics of its assets and liabilities and theestimated effects on yields and costs of those assets and liabilities.

 

Based on the gapanalysis and the Company’s assessment of its exposure to interest rate risk,the Company is considered to be “asset sensitive.”  In general, “asset sensitive” means that,over time, the Company’s assets will reprice faster than its liabilities.  In a rising interest rate environment, netinterest income can be expected to increase and, in a declining interest rateenvironment, net interest income can be expected to decrease.  In addition, a rising interest rateenvironment will affect the Company’s ability to reprice loans that bearvariable interest rates but are currently at their floor rates and will notfluctuate immediately.  At December 31,2008, approximately $152 million, or 42% of loans were priced at their floorinterest rate.  If interest ratesincrease, the rates earned on these loans will begin to adjust above theirfloor rates and the Company’s asset sensitivity will increase. Conversely, inthe current declining interest rate environment, the Company will benefit fromfloor rates built into existing variable rate loans as the indexed ratesdecline to the floor rates and stop adjusting downwards. The benefit derived,if any, by the Company when loan rates drop to their floor rates may bemitigated by the increased likelihood that those loans may be refinanced by theborrowers with other financial institutions.

 

The impact ofinflation on a financial institution can differ significantly from that exertedon other companies.  Banks, as financialintermediaries, have many assets and liabilities, which may move in concertwith inflation both as to interest rates and value.  This is especially true for banks with a highpercentage of interest rate-sensitive assets and liabilities.  The Company manages its sensitivity tochanges in interest rates by performing a gap analysis of its rate sensitivebalance sheet and modeling the effects of changes in interest rates on its netinterest income.  The Company attempts tostructure its mix of financial instruments and manage its interest ratesensitivity gap in order to minimize the potential adverse effects of inflationor other market forces on its net interest income and, therefore, its earningsand capital.

 

***Short-Term and Other Borrowings***

** **

The Bank mayborrow up to $10.0 million overnight on an unsecured basis from itscorrespondent banks; each of these facilities may be withdrawn at any time bythe correspondent bank. In addition, the Bank has arranged a borrowing linewith the Federal Home Loan Bank of San Francisco (“the FHLB”), under which theBank may borrow up to 15% of its assets subject to providing adequatecollateral and fulfilling other conditions of the line. The Bank also has asecured borrowing facility with the Federal Reserve Bank. See Note H to theFinancial Statements included in “Item 8, Financial Statements andSupplementary Data,” below for additional details.

 

As of December 31,2008, the Bank had $50.0 million in outstanding fixed rate FHLB advances whichare outlined below:

 
| **Year of  Maturity** | ** ** | **Principal  Balance** | ** ** | **Weighted Average  Interest Rate** | ** ** |
|----------------------------|------------|------------------------|------------|-----------------------------------------------|------------|
| 2009                       |       | $                      | 15,000,000 |                                          | 2.01       | % |
| 2010                       |       | 25,000,000             |       | 2.88                                          | %          |
| 2011                       |       | 5,000,000              |       | 2.01                                          | %          |
| 2012                       |       | 5,000,000              |       | 4.31                                          | %          |
|                       |       | $                      | 50,000,000 |                                          | 2.68       | % |

 

At December 31,2007, the Bank had $10.0 million outstanding in two term FHLB advances whichare still outstanding as of December 31, 2008 in the table above: (1) a$5.0 million advance with an interest rate of 4.5% and a final maturity of September 14,2009 and callable by the FHLB beginning September 14, 2008 and quarterlythereafter; (2) a $5.0 million advance with an interest rate of 4.31%, anda final maturity of September 13, 2012 and callable by the FHLB on September 13,2009. As of December 31, 2006, the Bank had $24.0 million outstanding in 

 

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FHLBadvances under these borrowing lines, which matured in January 2007 andhad a weighted average interest rate of 5.34%.

 

Below is a tableof maximum amounts of FHLB borrowings outstanding at any month-end during thereporting periods, and the approximate average amounts outstanding and weightedaverage interest rate as of December 31 of the reporting periods.

 
| **Year Ended**                  | ** ** | **Maximum Amt  Outstanding at  any Month-End** | ** ** | **Average Balance** | ** ** | **Weighted  Average  Interest Rate** | ** ** |
|--------------------------------------|------------|---------------------------------------------------------------|------------|--------------------------|------------|-------------------------------------------|------------|
| **(dollars in thousands)** | ** ** |
| 2008                                 |       | $                                                             | 65,000     |                     | $          | 36,247                                    |       | 3.31 | % |
| 2007                                 |       | $                                                             | 29,000     |                     | $          | 13,006                                    |       | 5.11 | % |
| 2006                                 |       | $                                                             | 24,000     |                     | $          | 5,786                                     |       | 5.29 | % |

 

On March 31,2005, the Bank issued $5.0 million in Floating Rate Junior SubordinatedDebentures in a private placement offering. This offering was undertaken in order to raise the Bank’s capitalratios.  Under risk-based capitalguidelines, subordinated debentures qualify for Tier 2 capital treatment up to50% of Tier 1 capital and, therefore, increased the Bank’s total risk-basedcapital ratio.  The terms of thesubordinated debt are: a final maturity of June 15, 2020, a right onbehalf of the Bank for early redemptions beginning in June, 2010, and aninterest rate which floats quarterly based on 3 Month LIBOR plus a spread of178 basis points.  The interest rate onthe subordinated debt as of December 31, 2008 is 3.78%.

 

On June 28,2007, the Company completed a private placement of $5.0 million in aggregateprincipal amount of floating rate preferred securities (the “Trust PreferredSecurities”) through a newly-formed Delaware trust affiliate, FPBN Trust I (the“Trust”).  The Trust used the proceedsfrom the sale of the Trust Preferred Securities together with the proceeds fromthe sale of Common Securities to purchase $5,155,000 in aggregate principalamount of the Company’s unsecured floating rate junior subordinated debtsecurities due September 1, 2037, issued by the Company (the “JuniorSubordinated Debt Securities”).  As of December 31,2008, the coupon interest rate was 3.58% (3 month LIBOR plus 1.40%) and floatsquarterly.  The Company shall have theright, subject to regulatory approval, to redeem the debt securities, in wholeor from time to time in part, on any interest payment date on or after September 1,2012.  The net proceeds to the Companyfrom the sale of the Junior Subordinated Debt Securities were used by theCompany to fund a portion of the cash consideration in the acquisition ofLandmark.

 

***Capital Resources***

** **

The Bank opened inNovember 2000 after completing its initial public offering and raising$11.5 million in capital.  In 2002, theBank completed a secondary offering of securities, raising $4.2 million in newcapital.  During 2003 and 2004, the Bankraised approximately $4.3 million from the conversion of 95% of common stockpurchase warrants that were issued in connection with its 2000 initial publicoffering and the 2002 secondary offering. On May 16, 2005, the Bank’s board of directors declared atwo-for-one stock split of the Bank’s common stock payable to shareholders ofrecord on June 15, 2005.  Theshareholders received one additional share for each share they owned.  All share and per share data has beenrestated for prior periods to reflect this stock split.  In 2007, the Company issued approximately 1.0million shares valued at $15.9 million in connection with the acquisition ofLandmark.

 

The Company’sshareholders’ equity at December 31, 2008 was $22.6 million, a decrease of$22.4 million compared to the $45.0 million at December 31, 2007.  The decrease was primarily the result of netlosses for the year which included a one-time goodwill write down of $10.4million. Tangible book value per share totaled $4.27 at December 31, 2008,compared to $6.68 as of December 31, 2007.

 

In 1990, thebanking industry began to phase in new regulatory capital adequacy requirementsbased on risk-adjusted assets.  Theserequirements take into consideration the risk inherent in investments, loans,and other assets for both on-balance sheet and off-balance sheet items.  Under these requirements, the regulatoryagencies have set minimum thresholds for Tier 1 capital, total capital andleverage ratios.  The Bank’s risk-adjustedcapital ratios, shown below as of December 31, 2008, 2007 and 2006 havebeen computed in accordance with regulatory accounting policies.  See also Note N-”Regulatory Matters” of theFinancial Statements and “Item 1, Description of Business - Supervision andRegulation - Risk-Based Capital Guidelines” above for more information onregulatory capital requirements.

 

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**Capital Ratios**

 
| ** **                                                     | ** ** | **December 31,** | ** ** | ** ** | ** ** |
|----------------------------------------------------------------|------------|-----------------------|------------|------------|------------|
| ** **                                                     | ** ** | **2008**              | ** ** | **2007**   | ** ** | **2006** | ** ** | **Minimum Requirements** | ** ** |
| Tier 1 Capital to Average Assets (“Leverage  Ratio”) |       | 5.4                   | %          | 9.0        | %          | 8.7 | % | 4.0 | % |
| Tier 1 Capital to Risk-Weighted Assets                         |       | 6.2                   | %          | 9.5        | %          | 8.7 | % | 4.0 | % |
| Total Capital to Risk-Weighted Assets                          |       | 8.7                   | %          | 12.0       | %          | 11.5 | % | 8.0 | % |

** **

**On October 3, 2008, theEmergency Economic Stabilization Act of 2008, or EESA, was enacted, whichincreased FDIC insurance coverage (See “Deposit Insurance Assessments” above),as well as provided up to $700 billion in funding for the financial servicesindustry. Pursuant to the EESA, the U.S. Treasury was initially authorized bycongress to use $350 billion for the Troubled Asset Relief Program, or TARP. Ofthis amount, the U.S. Treasury allocated $250 million to the Capital PurchaseProgram, or CPP. This program allows a qualifying institution to apply for upto three percent of its total risk-weighted assets in capital, which will be inthe form of non-cumulative perpetual preferred stock of the institution with a dividendrate of 5% until the fifth anniversary of the investment and 9% thereafter. TheU.S. Treasury will also receive warrants for common stock of the institutionequal to 15% of the capital invested. On January 15, 2009, the second $350billion of TARP funding was released to the U.S. Treasury. The Bank applied in October 2008for TARP funding of 3% of risk-weighted assets (approximately $12 million) andis currently waiting to hear about the status of the application as of thefiling date of this report.**

** **

Under California law, 1stPacific Bancorp would be prohibited from paying dividends unless: (1) itsretained earnings immediately prior to the dividend payment equals or exceedsthe amount of the dividend; or (2) immediately after giving effect to the dividend,the sum of 1st Pacific Bancorp’s assets would be at least equal to 125% of itsliabilities, and 1st Pacific Bancorp’s current assets would be at least equalto its current liabilities, or, if the average of its earnings before taxes onincome and before interest expense for the two preceding fiscal years was lessthan the average of its interest expense for the two preceding those fiscalyears, the current assets of 1st Pacific Bancorp would be at least equal to 125%of its current liabilities.  The primarysource of funds with which dividends could be paid to shareholders would comefrom cash dividends received by, the Company from the Bank.  The Bank, as a state-chartered bank, issubject to dividend restrictions set forth in the California Financial Code,and administered by the DFI. Under such restrictions, the Bank may not pay cashdividends in an amount which exceeds the lesser of the retained earnings of theBank or the Bank’s net income for the last three fiscal years (less the amountof distributions to shareholders during that period of time).  If the above test is not met, cash dividendsmay only be paid with the prior approval of the DFI, in an amount not exceedingthe Bank’s net income for its last fiscal year or the amount of its net incomefor the current fiscal year. The FRB may also limit dividends paid by theCompany. Based on these regulations and the Company’s current financialresults, the Company has resolved not to declare or pay any dividends withoutprior approval of the FRB and the Bank has agreed not to declare or pay anydividends without prior approval of the FRB and the DFI.

 

**INVESTMENT PORTFOLIO**

** **

The primaryobjective of the Company’s investment portfolio is to contribute to maximizingshareholder value by providing adequate liquidity sources to meet fluctuationsin the Company’s loan demand and deposit structure.  To meet this objective, the Company investsin securities that generate reasonable rates of return to the Company given itsliquidity objectives.  Secondary objectivesof the investment portfolio which may be considered include: meeting pledgingrequirements of public or other depositors; minimizing the Company’s taxliability; accomplishing strategic goals; and assisting various local publicentities with their financing needs (which may assist the Company in meetingits CRA objectives).

 

The Board ofDirectors has established policies regarding the investment activities of theCompany, including establishment of risk limits and ensuring that managementhas the requisite skills to manage the risks associated with the Company’sinvestment activities.  The Board ofDirectors reviews portfolio activity and risk levels and requires management todemonstrate compliance with approved risk limits.  Senior management is responsible forestablishing and enforcing policies and procedures for conducting investmentactivities.  Management must have anunderstanding of the nature and level of various risks involved in the Company’sinvestments and how such risks fit within the overall risk characteristics ofthe Company’s balance sheet.

 

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The ChiefFinancial Officer acts as the Company’s Investment Officer and ensures that theday-to-day guidelines of the Company’s investment policies are properlyimplemented and that all investments meet regulatory and accountingguidelines.  The Chief Executive Officeror the Chief Financial Officer must approve each investment transaction.  The Company monitors its investment portfolioclosely, and accordingly, its composition may change substantially over time.

 

At December 31,2008, the Company held securities guaranteed or issued by the Federal NationalMortgage Association (“FNMA”) totaling $3.9 million which was in excess of 10%of the Company’s shareholder equity.  Thecontractual maturity distribution based on amortized cost and fair value as of December 31,2008, is shown below. Mortgage-backed securities (“MBS”) have contractual termsto maturity, but require periodic payments to reduce principal. In addition,expected maturities may differ from contractual maturities because obligorsand/or issuers may have the right to call or prepay obligations with or withoutcall or prepayment penalties. See Note B — Investment Securities in the notesto consolidated financial statements for additional information on investmentsecurities.

 

**Amounts and Distributionof Investment Portfolio**

 
| ** **                              | ** ** | **December 31,**                | ** ** |
|-----------------------------------------|------------|--------------------------------------|------------|
| ** **                              | ** ** | **2008**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                              | ** ** | **(dollars in thousands)** | ** ** |
| ** **                              | ** ** | **Amortized  Cost**                  | ** ** | **Market  Value** | ** ** | **Wghtd  Avg  Yield** | ** ** | **Amortized  Cost** | ** ** | **Market  Value** | ** ** | **Wghtd  Avg  Yield** | ** ** | **Amortized  Cost** | ** ** | **Market  Value** | ** ** | **Wghtd  Avg  Yield** | ** ** |
| **Available-for-Sale Securities:**      |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Corporate Debt Securities:              |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| One Year or Less                        |       | $                                    | 2,988      |   | $ | 2,910 |   | 4.52 | % | $ | 994 |   | $ | 965 |   | 5.83 | % | $ | — |   | $ | — |   |   |   |
| One Year to Five Years (1)              |       | 2,749                                |       | 2,668 |   | 3.06 | % | 8,902 |   | 8,692 |   | 6.22 | % | 3,958 |   | 3,985 |   | 5.86 | % |
| Total                                   |       | 5,737                                |       | 5,578 |   | 3.82 | % | 9,896 |   | 9,657 |   | 6.18 | % | 3,958 |   | 3,985 |   | 5.86 | % |
|                                    |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Bank-Qualified Municipals:              |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Due after Ten Years (2)                 |       | 4,827                                |       | 4,361 |   | 4.79 | % | — |   | — |   |   |   | — |   | — |   |   |   |
|                                    |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Collateralized Mortgage Obligations:    |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Due after Ten Years                     |       | 9,451                                |       | 8,349 |   | 6.77 | % | — |   | — |   |   |   | — |   | — |   |   |   |
|                                    |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Government-Sponsored Agency Securities: |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| One Year or Less                        |       | —                               |       | — |   |   |   | 1,996 |   | 1,998 |   | 5.48 | % | — |   | — |   |   |   |
|                                    |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Government-Sponsored Agency - MBS:      |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| (Unallocated)                           |       | 5,729                                |       | 5,816 |   | 5.43 | % | 10,531 |   | 10,668 |   | 5.64 | % | — |   | — |   |   |   |
|                                    |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. Agency - MBS (Unallocated)         |       | 996                                  |       | 949 |   | 4.00 | % | 1,415 |   | 1,423 |   | 5.05 | % | 5,023 |   | 5,013 |   | 6.84 | % |
|                                    |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total Investment Securities             |       | $                                    | 26,740     |   | $ | 25,053 |   | 4.91 | % | $ | 23,838 |   | $ | 23,746 |   | 5.64 | % | $ | 8,981 |   | $ | 8,998 |   | 4.98 | % |

 

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**(1)**          Includes amortized cost of $1.2 million for a corporatebond which was on non-accrual as of December 31, 2008.

** **

**(2)**          Bank-qualified municipals receive preferentialtreatment for federal income tax purposes. Weighted average yields shown arebefore any such Federal tax benefit.

 

During 2008, the Company placeda corporate bond with a par value of $2.0 million on non-accrual status andultimately recognized $800,000 in OTTI charges during the year. This corporatebond was an investment in debt of Washington Mutual Inc., the bankrupt formerparent of Washington Mutual Bank. The OTTI charge reflected a write-down to 60%of par. Trading activity in the bond was limited and volatile; however, in January 2009,the bond was sold and the Bank recognized a gain upon sale.

 

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**LOAN PORTFOLIO**

** **

**Types of Loans**

** **

The Bankoriginates, purchases, or acquires participating interests in loans for itsportfolio and for possible sale in the secondary market.  Total loans were $349.8 million at December 31,2007 and increased to $351.9 million at December 31, 2008, an increase of$2.1 million, or approximately 1.0%. Types of loans include construction and land development loans,residential and commercial real estate loans, commercial business loans, SBAloans, and consumer loans. At year end 2008, real estate loans made up 42% ofthe portfolio and have grown 23% since the prior year. Consumer loans grew by60% while construction and land loans, commercial loans and SBA loans eachdeclined by 13%, 11% and 44%, respectively. The yield on loans dropped from8.64% in 2007 to 6.93% in 2008, mostly due to a 400 basis point drop in theprime rate during 2008.

 

**Loan PortfolioComposition by Type of Loan**

 
| ** **                                        | ** ** | **December 31,**                | ** ** |
|---------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                        | ** ** | **2008**                             | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                        | ** ** | **(dollars in thousands)** | ** ** |
| **Loans:**                                        |       |                                 |       |   |   |   |   |   |   |   |   |
| Construction & Land Development          |       | $                                    | 109,593    |   | $ | 125,661 |   | $ | 116,389 |   | $ | 94,912 |   | $ | 59,579 |   |
| Real Estate — Residential &Commercial    |       | 147,965                              |       | 120,531 |   | 81,131 |   | 65,123 |   | 57,058 |   |
| SBA Loans — 7a & 504                |       | 8,820                                |       | 15,880 |   | 19,883 |   | 21,965 |   | 24,640 |   |
| Commercial Business                               |       | 69,225                               |       | 77,582 |   | 52,797 |   | 43,970 |   | 41,555 |   |
| Consumer                                          |       | 16,296                               |       | 10,165 |   | 5,066 |   | 4,412 |   | 5,720 |   |
| Total Loans                                       |       | 351,899                              |       | 349,819 |   | 275,266 |   | 230,382 |   | 188,552 |   |
| Allowance for Loan Losses                         |       | (5,059                               | )          | (4,517 | ) | (3,251 | ) | (2,809 | ) | (2,265 | ) |
| Net Loans                                         |       | $                                    | 346,840    |   | $ | 345,302 |   | $ | 272,015 |   | $ | 227,573 |   | $ | 186,287 |   |
|                                              |       |                                 |       |   |   |   |   |   |   |   |   |
| **Commitments:**                                  |       |                                 |       |   |   |   |   |   |   |   |   |
| Standby Letters of Credit                         |       | $                                    | 3,819      |   | $ | 5,994 |   | $ | 3,224 |   | $ | 1,649 |   | $ | 153 |   |
| Undisbursed Loans and Commitments to Grant  Loans |       | 108,235                              |       | 98,385 |   | 87,527 |   | 85,661 |   | 69,034 |   |
| Total  Commitments                                |       | $                                    | 112,054    |   | $ | 104,379 |   | $ | 90,751 |   | $ | 87,310 |   | $ | 69,187 |   |

 

Construction loansare primarily made as interim loans to finance the construction of commercialand single family residential property. These loans are typically for a term of approximately 12 months.  Other real estate loans consist primarily ofcommercial and industrial real estate loans. This type of loan is made based on the income generating capacity of theproperty or the cash flow of the borrower. These loans are secured by the property. In general, our policy is to restrict these loans to no more than 75% ofthe lower of the appraised value or the purchase price of the property.  We offer both fixed and variable rate loanswith maturities that generally do not exceed 15 years, unless the loans are SBAloans secured by real estate or other commercial real estate loans easily soldin the secondary market.

 

A portion of totalreal estate loans and commercial business loans are made under certain SBA loanprograms.  These loans generally arestructured such that they may be sold, either as a whole with servicingreleased, as is the case for SBA 504 loans, or in the case of SBA 7(a) loans,the guaranteed portion may be sold in the secondary market and the servicing isretained.  To date, SBA 7(a) loanshave only been sold in a limited number of cases; however, certain SBA 504loans have been packaged for sale when the rates and terms of the loans do notmeet our asset and liability management objectives.

 

Commercial loansare made to provide working capital, finance the purchase of equipment and forother business purposes.  These loans canbe “short-term,” with maturities ranging from 30 days to one year, or “termloans” with maturities normally ranging from one to 25 years.  Short-term loans are generally intended tofinance current transactions and typically provide for periodic principal payments,with interest payable monthly.  Termloans normally provide for floating interest rates, with monthly payments ofboth principal and interest.

 

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**Maturities andSensitivities of Loans to Changes in Interest Rates**

** **

Many of the Bank’sloans have floating interest rates, typically tied to the prime-lending rate aspublished in The Wall Street Journal. The majority of these floating rate loans are adjusted at leastquarterly.

 

**Loan Maturity by Category**

 
| ** **                                       | ** ** | **December 31, 2008**              | ** ** |
|--------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                       | ** ** | **(dollars in thousands)**         | ** ** |
| ** **                                       | ** ** | **Due in  One Year  Or Less** | ** ** | **Due After  One Year to  Five Years** | ** ** | **Due After  Five Years** | ** ** | **Total** | ** ** |
| Construction & Land Development         |       | $                                            | 92,797     |   | $ | 16,608 |   | $ | 188 |   | $ | 109,593 |   |
| Real Estate - Residential &  Commercial |       | 39,755                                       |       | 32,531 |   | 75,679 |   | 147,965 |   |
| SBA Loans - 7a & 504                    |       | 958                                          |       | 1,225 |   | 6,637 |   | 8,820 |   |
| Commercial Business                              |       | 8,648                                        |       | 21,495 |   | 39,082 |   | 69,225 |   |
| Consumer                                         |       | 15,975                                       |       | 256 |   | 65 |   | 16,296 |   |
| Total                                            |       | $                                            | 158,133    |   | $ | 72,115 |   | $ | 121,651 |   | $ | 351,899 |   |
|                                             |       |                                         |       |   |   |   |   |   |   |
| Floating Rate                                    |       |                                         |       |   |   |   |   | $ | 114,358 |   |
| Fixed Rate                                       |       |                                         |       |   |   |   |   | 237,541 |   |
|                                             |       |                                         |       |   |   | Total |   | $ | 351,899 |   |

 

As stated in the “Liquidityand Interest Rate Risk” section above, when the rate on a loan with a floatingrate has reached a contractual floor or ceiling level, the loan is treated as afixed rate loan for purposes of determining its rate-sensitivity until the rateis again free to float.  At December 31,2008, approximately $152 million of the fixed rate loans, noted above, werefloating rate loans priced at their floor interest rate.  We monitor the level of sensitivity of theCompany’s loan portfolio to changes in interest rates on a regular basis underour interest rate risk management program.

 

**Allowance for Loan Losses**

** **

Many banksexperienced a significant decline in loan asset quality including increaseddelinquency and problem credit issues in 2008 causing management, regulatoryagencies and auditors to review allowance for loan and lease lossesmethodologies with a tremendous amount of scrutiny. Arriving at an appropriateallowance involves a high degree of management judgment.

 

The followingtable summarizes, for the periods indicated, changes in the allowance for loanlosses arising from loans charged off, recoveries on loans previously chargedoff, additions to the allowance which have been charged to operating expensesand certain ratios relating to the allowance for loan losses:

 

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**Changes in Allowance forLoan Losses**

 
| ** **                                        | ** ** | **For the Year Ended  December 31,** | ** ** |
|---------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                        | ** ** | **2008**                                                 | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                        | ** ** | **(dollars in thousands)**                     | ** ** |
| **Allowance for Loan Losses:**                    |       |                                                     |       |   |   |   |   |   |   |   |   |
| Balance at Beginning of Period                    |       | $                                                        | 4,517      |   | $ | 3,251 |   | $ | 2,809 |   | $ | 2,265 |   | $ | 1,454 |   |
| Landmark Bank Acquisition Allowance               |       | —                                                   |       | 1,026 |   | — |   | — |   | — |   |
| **Net Loans Charged off:**                        |       |                                                     |       |   |   |   |   |   |   |   |   |
| Total Charge Offs                                 |       | (15,371                                                  | )          | (105 | ) | (2 | ) | (11 | ) | (41 | ) |
| Total Recoveries on Loans Previously  Charged Off |       | 13                                                       |       | 7 |   | — |   | 2 |   | 2 |   |
| Net Loans (Charged Off) Recoveries                |       | (15,358                                                  | )          | (98 | ) | (2 | ) | (9 | ) | (39 | ) |
|                                              |       |                                                     |       |   |   |   |   |   |   |   |   |
| Provision for Loan Losses                         |       | 15,900                                                   |       | 338 |   | 444 |   | 553 |   | 850 |   |
| Balance at End of Period                          |       | $                                                        | 5,059      |   | $ | 4,517 |   | $ | 3,251 |   | $ | 2,809 |   | $ | 2,265 |   |
|                                              |       |                                                     |       |   |   |   |   |   |   |   |   |
| **Ratios:**                                       |       |                                                     |       |   |   |   |   |   |   |   |   |
| Net Loans Charged Off to Average Loans            |       | 4.24                                                     | %          | 0.03 | % | 0.00 | % | 0.00 | % | 0.03 | % |
| Allowance for Loan Losses to Total Loans          |       | 1.44                                                     | %          | 1.29 | % | 1.18 | % | 1.22 | % | 1.20 | % |

 

Provisions forloan losses are based on an analysis of the loan portfolio and include suchfactors as historical experience, the volume and type of loans in theportfolio, the amount of nonperforming loans, regulatory policies, generaleconomic conditions, and other factors related to the ability to collect onloans in the portfolio.  The amountprovided for loan losses is charged to earnings.  The provision for loan losses was $15.9million for 2008 compared to $338,000 for the year ending December 31,2007. The Bank ended 2008 with a 1.44% level of allowance for loan losses tototal loans compared to 1.29% for the year ended December 31, 2007.

 

Since itsinception in 2000 through December 31, 2007, the Bank has charged off atotal of $164,508 with recoveries of $14,052, leaving a net charge off totalfor the Bank of $150,456; which represented 0.043% of the Bank’s December 31,2007 net loans. During 2008, the Bank posted significant loan charge-offstotaling $15.4 million (see “Loan Quality” below for further discussion ofcharge-offs).

 

As of December 31,2008, our loan loss reserve was $5.1 million, or 1.44% of total loansoutstanding. The year-end provision for loan losses followed an extensivereview of the entire loan portfolio including a stress test to assist inprojecting future losses. Nonperforming loans as of December 31, 2008totaled $12.3 million, with an additional $1.4 million in OREO. However, thedetermination of the adequacy of the loan loss reserve took into considerationthe reasonable potential for loans returning to a performing status and theadequacy of the collateral securing those loans.

 

On a quarterlybasis, the Bank performs a detailed internal review to identify the risksinherent in the loan portfolio, to assess the overall quality of the loanportfolio and to determine the adequacy of the allowance for loan losses andthe related provision for loan losses, which is charged to expense.

 

In addition to itsinternal review process, the credit quality of the Bank’s loan portfolio isevaluated by contracted, independent credit reviewers, by examiners as part ofthe regulatory review process, and by CPA’s as part of the annual financialaudit.

 

During 2008, theBank decided to transition to a different independent credit review servicethan had been used in previous years. The Bank felt the transition to a newthird party reviewer was warranted to increase the level of background andexperience of the contractor in construction and real estate lending, andespecially in regards to nonperforming assets. The new credit review contractorperformed special reviews of commercial real estate loans in September 2008and December 2008 and a routine credit review covering fourth quarteractivity. Management utilized the results of these independent reviews inassessing the adequacy of the allowance for loan losses.

 

In January 2008,a joint examination from the Federal Reserve Bank of San Francisco and the DFIwas completed, with no changes recommended either to the loan loss allowancecalculation methodology or to the level of the allowance for loan losses.Furthermore, a targeted asset quality examination was completed by theregulators 

 

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in October 2008.  As a result of this targeted asset qualityexam, the Bank agreed to improve asset quality, reduce the level of problemloans, develop a plan to reduce the concentration of commercial real estate (“CRE”)loans, enhance its CRE stress testing assessments, and enhance its loanpolicies and procedures.

 

A key element ofthe methodology for assessing the risks inherent in the loan portfolio is thecredit classification process.  Loansidentified as less than “pass” are reviewed individually to estimate the amountof probable losses that need to be included in the allowance.  These reviews include analysis of financialinformation as well as evaluation of collateral securing the credit.  Three allocation components are used: Generalbased on qualitative factors, Specific and Specific Impaired. The Generalcomponent estimates probable future loan loss based on qualitative designationand considers factors such as national and local economic changes, changes tomanagement or staff and unemployment rates as well as historical experience;the Specific component is designed to calculate a reserve for criticized andclassified loans; and the Specific Impaired component allocates a probable lossamount on impaired loans. Additionally, the inherent risk present in the “pass”portion of the loan portfolio is assessed by taking into considerationhistorical losses on pools of similar loans, adjusted for trends, conditionsand other relevant factors that may affect repayment of the loans in thesepools.  Upon completion, the writtenanalysis is presented to the Board of Directors for discussion, review andapproval.

 

We consider thecurrent allowance for loan losses to be adequate to provide for risks inherentin the loan portfolio.  All availableinformation is used to recognize losses on loans and leases; however, futureadditions to the allowance may be necessary based on changes in economicconditions.  In addition, regulatoryagencies, as an integral part of their examination process, periodically reviewthe allowance for loan losses and may recommend additions based upon theirevaluation of the portfolio at the time of their examination.  Accordingly, there can be no assurance thatthe allowance for loan losses will be adequate to cover future loan losses orthat significant additions to the allowance for loan losses will not berequired in the future.  Materialadditions to the allowance for loan losses would decrease earnings and capital,among other adverse consequences.

 

**Allocation of the Allowance for Loan Loss by Loan Type**

 
|                                             |   | **December 31,**                |       |
|--------------------------------------------------|--------|--------------------------------------|------------|
|                                             |   | **2008**                             | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** |   |
|                                             |   | **(dollars in thousands)** |       |
|                                             |   | **Allowance  Amount**                | ** ** | **Type as  a  % of Loans** | ** ** | **Allowance  Amount** | ** ** | **Type as  a  % of Loans** | ** ** | **Allowance  Amount** | ** ** | **Type as  a  % of Loans** | ** ** | **Allowance  Amount** | ** ** | **Type as  a  % of Loans** | ** ** | **Allowance  Amount** | ** ** | **Type as  a  % of Loans** |   |
| Construction &  Land Development        |   | $                                    | 2,363      |   | 31.1 | % | $ | 1,984 |   | 35.9 | % | $ | 1,119 |   | 42.3 | % | $ | 863 |   | 41.2 | % | $ | 261 |   | 31.6 | % |
| Real Estate -  Residential & Commercial |   | 945                                  |       | 42.1 | % | 690 |   | 34.5 | % | 626 |   | 29.5 | % | 518 |   | 28.3 | % | 405 |   | 30.3 | % |
| SBA  Loans-7a & 504                     |   | 199                                  |       | 2.5 | % | 141 |   | 4.5 | % | 500 |   | 7.2 | % | 456 |   | 9.5 | % | 636 |   | 13.1 | % |
| Commercial  Business                             |   | 1,392                                |       | 19.7 | % | 1,589 |   | 22.2 | % | 814 |   | 19.2 | % | 817 |   | 19.1 | % | 614 |   | 22.0 | % |
| Consumer                                         |   | 160                                  |       | 4.6 | % | 66 |   | 2.9 | % | 31 |   | 1.8 | % | 25 |   | 1.9 | % | 31 |   | 3.0 | % |
| Unallocated                                      |   | —                               |       | 0.0 | % | 47 |   | 0.0 | % | 161 |   | 0.0 | % | 130 |   | 0.0 | % | 318 |   | 0.0 | % |
| Totals                                           |   | $                                    | 5,059      |   | 100.0 | % | $ | 4,517 |   | 100.0 | % | $ | 3,251 |   | 100.0 | % | $ | 2,809 |   | 100.0 | % | $ | 2,265 |   | 100.0 | % |

 

**Loan Quality**

 

The risk ofnonpayment of loans is an inherent feature of the banking business.  That risk varies with the type and purpose ofthe loan, the collateral that is utilized to secure payment, the market for thecollateral and ultimately, the credit worthiness of the borrower.  In order to minimize this credit risk, theChief Executive Officer, the Chief Operating Officer, the Chief Credit Officer,or the Loan Committee of the Board of Directors of the Bank approve virtuallyall loans made by the Company.  The LoanCommittee is comprised of directors and members of its senior management.

 

The Company gradesits loans from “pass” to “loss,” depending on credit quality, with “pass”representing loans with an acceptable degree of risk given the favorableaspects of the credit and with both primary and secondary sources ofrepayment.  Classified loans orsubstandard loans are ranked below “pass” loans.  As these loans are identified in the reviewprocess, they are added to the internal watch list and loss allowances areestablished.  Additionally, loans areexamined regularly by the Company’s regulatory agencies.

 

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Non-accrual loansare loans which management believes may not be fully collectible as toprincipal and interest. Generally loans which are past due 90 days or loanswhich management believes the interest may not be collectible are placed onnon-accrual status.  A loan which hasbeen placed on non-accrual status is not returned to accrual basis until it hasbeen brought current with respect to both principal and interest payments, isperforming to current terms and conditions, its interest rate is commensuratewith market interest rates and future principal and interest payments are nolonger in doubt.

 

Loan charge-offsand partial loan impairment write downs are accounted for at the time wereasonably believe a loan is not likely to be fully collected as to principaland interest.  Our charge-off activityduring 2008 reflects the underlying trends in the economy and their impact onour loan portfolio.  Loan charge-offs,net of recoveries, amounted to $25,000, $233,000, $4.0 million, and $11.1million in the 1st through 4th quarters of 2008,respectively.  The following summarizesthe total charge-offs in 2008 of $15.4 million by type of loan (dollars inthousands):

 
| Construction and Land Development Loans       |   | $     | 6,920  |   |
|-----------------------------------------------|--------|-------|--------|--------|
| Real Estate — Residential and Commercial |   | 886   |   |
| Commercial Business                           |   | 7,565 |   |
| Total Charge-offs                             |   | $     | 15,371 |   |

 

Included incommercial business loan charge-offs is one loan for $6.98 million which wasnot secured by real estate but was used for a purchase option contract on aland acquisition and development project. We have no other loans of this type secured by a purchase optioncontract on a land acquisition and development project. Furthermore, includedin charge-offs on construction and land development is $6.4 million related tofive land development loans to four different borrowing relationships.  In summary, $13.4 million or 87% of loancharge-offs in 2008 related to land acquisition and development activities andwere comprised of only five borrowing relationships.

 

As reflected inthe above charge-off activity, the impact of the economic slowdown on the SanDiego and Southern California economies was significant during 2008:  land values dropped by 30%-60%, the values ofsingle family homes dropped by 20%-50%, new home construction was reduced toalmost zero, the declining trends affected office, retail and industrialproperties in the second half of the year, the unemployment rate substantiallyincreased over 2007 and the credit crisis affected all phases of theeconomy.  While the economic problemsbegan in 2007, the affects were not noticeable in our loan portfolio until2008, especially the second half of the year. Our borrowers have been adversely affected by these developments, withreal estate developers, contractors and investors feeling the effect of a cashflow squeeze, commercial enterprises in related lines of business also notingreduced revenues and cash flows, and, finally, many businesses not related tothe real estate industry noting reduced revenues.

 

These economictrends developed and intensified over the course of 2008.  The following information is provided to showrelevant trends related to various components of our loan portfolio during2008.

 

*NonaccrualLoans —*Nonaccrual loans remained relatively stable from $5.5million at December 31, 2007, through April 30, 2008 at $4.1 million;however, stress in the loan portfolio began to materialize as evidenced by thefollowing significant conditions in the nonaccrual loan portfolio:

 
| · | During May 2008,  one real estate relationship with 4 loans, 2 of them land loans, was placed  on nonaccrual, increasing nonaccrual balances to $8.9 million.                                                                                                                                 |
|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                               |
| · | During June, two real  estate loans, one a land loan and one a multifamily project, and two SBA 7a  loans increased nonaccrual balances to $11.6 million.                                                                                                                                          |
|   |                                                                                                                                                                                                                                                                                               |
| · | In July, three  additional land loans to one relationship brought nonaccrual totals to $17.2  million.                                                                                                                                                                                             |
|   |                                                                                                                                                                                                                                                                                               |
| · | In October 2008 we  placed three loans on nonaccrual, two land loans and an office building loan,  bringing nonaccrual balances to $21.1 million.                                                                                                                                             |
|   |                                                                                                                                                                                                                                                                                               |
| · | Nonaccrual loans peaked  in November 2008, after adding another land loan and a construction  loan, to an aggregate $22.4 million.                                                                                                                                                            |
|   |                                                                                                                                                                                                                                                                                               |
| · | In December, we  received payoff and a partial charge-off on one substantial nonaccrual loan  of $2.0 million, foreclosed on 4 properties, liquidated one SBA borrowers’  assets and charged off $4.1 million related to nonaccrual loans, reducing  total nonaccrual loans to $12.3 million. |

 

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*SpecialMention Loans -*Loans internally graded and categorized asspecial mention also demonstrate the deteriorating effect of the economy on ourloan portfolio, with large increases in the second half of the year.  Total loans in this category were $13.0million, $8.7 million, $19.4 million, and $32.9 million at the end of the 1st through 4th quarters of 2008,respectively.  Growth in this categorywas concentrated in the following areas:

 
| · | In the 2nd quarter, the reduction resulted from a real  estate loan being downgraded.                                                                                         |
|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                               |
| · | In the 3rd quarter,  increased balances related to three land and construction loans, three real  estate secured term loans and two commercial loans — one guaranteed by SBA. |
|   |                                                                                                                                                                               |
| · | In the 4th quarter, increased balances related to two  construction loans, a boat loan and two commercial loans.                                                              |

 

*SubstandardLoans -*Loans internally classified substandard or worse alsoexhibited a similar trend.  Total loansin this category were $16.9 million, $29.8 million, $34.3 million, and $22.7million at the end of the 1st through 4th quarters of 2008,respectively.  The changes in thiscategory were concentrated as follows:

 
| · | In the 2nd quarter, increases relate to one real estate  related commercial loan, two commercial real estate term loans and an SBA  loan; however, one construction loan was paid off.                                                            |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                   |
| · | In the 3rd quarter,  increases related to two land loans, two real estate term loans and an SBA  loan, somewhat offset by $3.1 million in charge-offs recorded during the  quarter.                                                                    |
|   |                                                                                                                                                                                                                                                   |
| · | In the 4th quarter, reductions primarily related to  $11.1 million in charge-offs and partial impairment write downs recorded plus  one real estate term loan payoff, partially offset by increases related to  two commercial real estate loans. |

 

**Components ofNonperforming Assets**

 
| ** **                                                        | ** ** | **For the Year Ended  December 31,** | ** ** |
|-------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                        | ** ** | **2008**                                                 | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                        | ** ** | **(dollars in thousands)**                     | ** ** |
|                                                              |       |                                                     |       |   |   |   |   |   |   |   |   |
| Non-Accrual Loans                                                 |       | $                                                        | 12,264     |   | $ | 5,492 |   | $ | — |   | $ | 1,052 |   | $ | — |   |
| Loans 90 Days Past Due and Still Accruing                         |       | —                                                   |       | 62 |   | — |   | — |   | — |   |
| Restructured Loans                                                |       | —                                                   |       | — |   | — |   | — |   | — |   |
| Total Nonperforming Loans                                         |       | 12,264                                                   |       | 5,554 |   | — |   | 1,052 |   | — |   |
|                                                              |       |                                                     |       |   |   |   |   |   |   |   |   |
| Non-Accrual Debt Securities                                       |       | 1,260                                                    |       | — |   | — |   | — |   | — |   |
| Other Real Estate Owned                                           |       | 1,390                                                    |       | — |   | — |   | — |   | — |   |
| Total Nonperforming Assets                                        |       | $                                                        | 14,914     |   | $ | 5,554 |   | $ | — |   | $ | 1,052 |   | $ | — |   |
|                                                              |       |                                                     |       |   |   |   |   |   |   |   |   |
| Non-Accrual Loans as a Percentage of Total  Loans                 |       | 3.49                                                     | %          | 1.57 | % | 0.00 | % | 0.46 | % | 0.00 | % |
| Loans 90 Days Past Due as a Percentage of  Total Loans            |       | 0.00                                                     | %          | 0.02 | % | 0.00 | % | 0.00 | % | 0.00 | % |
| Restructured Loans as a Percentage of Total  Loans                |       | 0.00                                                     | %          | 0.00 | % | 0.00 | % | 0.00 | % | 0.00 | % |
| Nonperforming Loans as a Percentage of  Total Loans               |       | 3.49                                                     | %          | 1.59 | % | 0.00 | % | 0.46 | % | 0.00 | % |
|                                                              |       |                                                     |       |   |   |   |   |   |   |   |   |
| Allowance for Loan Losses as a Percentage  of Nonperforming Loans |       | 33.92                                                    | %          | 81.32 | % | N/A |   | 267.00 | % | N/A |   |
| Nonperforming Assets as a Percentage of  Total Assets             |       | 3.54                                                     | %          | 1.34 | % | 0.00 | % | 0.40 | % | 0.00 | % |

 

During 2008, theCompany had an average recorded investment in loans in a non-accrual status of$13.3 million.  Restructured loans arethose loans where the Company has made concessions in interest rates orrepayment terms due to a decline in the financial condition of the borrower.Other real estate owned may be acquired in satisfaction of loan receivablesthrough foreclosure or other means.  Ifacquired, these properties are recorded on an individual asset basis at theestimated fair value less selling expenses. The Company had no restructuredloans or other real estate at any time during 2006 or 2007.

 

Further decline in economicconditions in the Company’s market area or other factors could adversely impactindividual borrowers or the loan portfolio in general. The Company has welldefined underwriting standards and expects to continue with prompt collectionefforts, but economic uncertainties or changes may cause one or more borrowersto experience problems in the coming year.

 

As of December31, 2008, the Bank had $1.0 million of potential problem loans which are notdisclosed as nonperforming loans, but where known information about possiblecredit problems of borrowers causes management to have serious doubts as to theability of such borrowers to comply with their present loan repayment terms andwhich may result in disclosure of such loans as nonperforming loans in thefuture.

 

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**Loan Concentrations**

 

The Company’s loanportfolio consists primarily of loans to borrowers within San DiegoCounty.  Although the Company seeks toavoid concentrations of loans to a single industry or based upon a single classof collateral, real estate and real estate associated businesses are among theprincipal industries in its market area and, as a result, the Company’s loanand collateral portfolios are, to some degree, concentrated in thoseindustries.

 

As of December 31,2008, the Company held approximately 74% of its loan portfolio in real estaterelated market segments: 31% in construction and land development loans, 42% inreal estate term loans and 1% in SBA 504 loans. Approximately 21% of theCompany’s loan portfolio consists of Commercial & Industrial Loans, ofwhich a 2% concentration is SBA 7a loans. The Commercial & Industrialloans were highly concentrated in secured loans, representing 14% of the totalportfolio. Given the trends in the real estate markets, the bank is making aconcerted effort to be very selective in its real estate and constructionlending activity.

 

The followingtable reflects the major concentrations of the loan portfolio, by type of loan,as of December 31, 2008:

 

**LoanConcentrations**

 

(Dollars in thousands)

 
| **Type of Loan**                        | ** ** | **Amount** | ** ** | **Percent of Total Loans** | ** ** |
|---------------------------------------------------|------------|------------|------------|-------------------------------------------|------------|
| Construction and Land Development                 |       |       |       |                                      |       |
| Land and Land Development                         |       | $          | 37,778     |                                      | 10.7       | % |
| Construction - Commercial                         |       | 42,164     |       | 12.0                                      | %          |
| Construction - Residential 1-4                    |       | 29,651     |       | 8.4                                       | %          |
| Total Construction and Land Development  Loans    |       | 109,593    |       | 31.1                                      | %          |
|                                              |       |       |       |                                      |       |
| Other Real Estate Loans (by type of  collateral): |       |       |       |                                      |       |
| 1-4 Family Residential — 1st Trust Deed |       | 16,794     |       | 4.8                                       | %          |
| 1-4 Family Residential — Junior Liens        |       | 8,186      |       | 2.3                                       | %          |
| Multifamily                                       |       | 12,787     |       | 3.7                                       | %          |
| Non-Farm/Non Residential — Owner Occupied    |       | 30,719     |       | 8.7                                       | %          |
| Non-Farm/Non Residential — Real Estate       |       | 79,479     |       | 22.6                                      | %          |
| Total Real Estate Secured Loans                   |       | 147,965    |       | 42.1                                      | %          |
|                                              |       |       |       |                                      |       |
| Commercial Loans:                                 |       |       |       |                                      |       |
| Unsecured                                         |       | 5,452      |       | 1.6                                       | %          |
| Secured                                           |       | 63,443     |       | 18.0                                      | %          |
| Other Commercial                                  |       | 330        |       | 0.1                                       | %          |
| Total Commercial Loans                            |       | 69,225     |       | 19.7                                      | %          |
|                                              |       |       |       |                                      |       |
| SBA 504 Loans                                     |       | 2,534      |       | 0.7                                       | %          |
| SBA 7a Loans                                      |       | 6,286      |       | 1.8                                       | %          |
| Consumer Loans                                    |       | 16,296     |       | 4.6                                       | %          |
| Total Loans                                       |       | $          | 351,899    |                                      | 100.0      | % |

 

**DEPOSITS**

 

Total depositswere $345.4 million at December 31, 2007, and decreased to $333.8 millionat December 31, 2008, a decrease of $11.6 million, or approximately 3%.Increasing competition for deposits and a slowing economy, as the prime rateplummeted 400 basis points by year end, forced aggressive deposit pricing. Thecost of interest-bearing deposits in 2007 was 4.39% and dropped 121 basispoints to 3.18% during 2008. The Bank offers a variety of deposit accounts,having a wide range of interest rates and terms, consisting of demand, savings,money market, time accounts, CDARS and brokered deposits. To attract and retaindeposits, the Bank primarily relies on competitive pricing policies, customerservice and referrals. The target market of the Bank is small-to-medium sizedbusinesses and professionals. The following table summarizes average depositsand average rates paid for the periods indicated:

 

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**Distribution of AverageDeposits and Average Rates Paid**

 
| ** **                           | ** ** | **For the Period Ended December 31,** | ** ** |
|--------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                           | ** ** | **2008**                                                       | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                           | ** ** | **(dollars in thousands)**                           | ** ** |
| ** **                           | ** ** | **Average  Balance**                                           | ** ** | **Average  Rate** | ** ** | **Average  Balance** | ** ** | **Average  Rate** | ** ** | **Average  Balance** | ** ** | **Average  Rate** | ** ** |
| Interest Bearing Checking            |       | $                                                              | 15,851     |   | .48 | % | $ | 15,219 |   | 1.01 | % | $ | 14,200 |   | 1.22 | % |
| Savings & Money Market      |       | 99,023                                                         |       | 2.21 | % | 95,754 |   | 3.99 | % | 67,989 |   | 3.74 | % |
| TCD Less than $100,000               |       | 39,636                                                         |       | 3.88 | % | 25,864 |   | 4.87 | % | 26,109 |   | 4.18 | % |
| TCD $100,000 or More                 |       | 118,110                                                        |       | 4.12 | % | 108,056 |   | 5.10 | % | 82,840 |   | 4.53 | % |
| Total Interest-Bearing Deposits      |       | 272,620                                                        |       | 3.18 | % | 244,893 |   | 4.39 | % | 191,138 |   | 3.96 | % |
|                                 |       |                                                           |       |   |   |   |   |   |   |   |   |   |   |
| Non Interest-Bearing Demand Deposits |       | 70,628                                                         |       | 0.00 | % | 64,319 |   | 0.00 | % | 52,550 |   | 0.00 | % |
|                                 |       |                                                           |       |   |   |   |   |   |   |   |   |   |   |
| Total  Deposits                      |       | $                                                              | 343,248    |   | 2.53 | % | $ | 309,212 |   | 3.48 | % | $ | 243,688 |   | 3.10 | % |

 

A fifth branchoffice was opened in El Cajon in April 2006 and contributed to depositgrowth in 2007 with total deposits of $12 million at December 31,2007.  The increase in 2007 is primarilydue to acquiring two established branch offices with the acquisition ofLandmark.  The limited service branchoffice opened in Downtown San Diego in February 2008, contributedapproximately $4 million in deposits. The changes in interest rates paid ondeposit accounts from 2007 to 2008 reflect a very competitive interest rateenvironment during 2008. Interest rates paid on deposit accounts are managedproactively to remain competitive and to react to changes in Federal monetarypolicy.

 

The coming year islikely to be as challenging as the past one and, while the Company plans forgrowth in deposits, the Bank will continue to feel pressure on its net interestmargin and strong competition for deposits. As of December 31, 2008, the Company had approximately 5,228deposit accounts comprised of savings and money market accounts (23%),certificates of deposit (53%), and transaction accounts (24%).

 

To augment marketing effortsand as a means to build new relationships in the community, the Bankperiodically attracts new deposits through the development of new depositproducts and by offering a variety of deposit promotions, which areoccasionally advertised, typically in print media.  During 2008, two newdeposit products were introduced, a Personal Banking Program and a PremierBanking Program.  These two programsbundle a variety of bank products and services in a package designed to createa multi-product core relationship with the customer from the start.  In addition, the Bank conducted two depositcampaigns in 2008 that resulted in approximately $25.0 million in new depositsto the Bank.  Typically, when offering a promotional deposit campaign, theCompany will offer higher than average competitive interest rates.  Theserates are typically higher than standard interest rates offered by the Company,but are generally not the highest interest rates available in the marketplace.  The Bank expects to continue to periodically run promotionaldeposit campaigns and market directly to its strategic niche in order to growits deposit base and to attract new deposit relationships with an emphasis onattracting low cost demand deposits.

 

Deposits are alsoacquired from non-traditional sources through relationships with correspondentbanks and related deposit programs as well as through deposit brokers. The Bankparticipates in a “portfolio deposit program” offered by a correspondent bankin which it receives variable rate money market deposits as pass through fundsfrom the correspondent bank. The Bank’s participation in this program totaled$6 million at December 31, 2008.

 

During 2007, as aresult of the acquisition of Landmark, the Bank began participating in theCDARS program. This program permits the Bank’s customers to place depositsthrough their relationship bank with other participating institutions and havethose deposits fully-insured by the FDIC, up to $50 million. The CDARS programacts as a clearinghouse, placing customer deposits from one institution in theCDARS network with over 1,500 other network banks (in increments of less thanthe $250,000 FDIC insurance limit). Funds that a customer places into the CDARSprogram are reciprocated by other participating banks so the funds essentiallyremain on the Bank’s balance sheet. As of December 31, 2008, the Bank hadissued approximately $36.0 million of certificates of deposit to localcustomers through the CDARS program.

 

Deposits are alsoreceived in the form of time certificates through the use of deposit brokerswho place the funds with the Company on behalf of their clients.  The total level of deposits from thesenon-traditional sources was approximately $48.7 million at December 31,2008, compared to approximately $48.2 million at December 31, 

 

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2007.  The level of deposits the Bank accepts fromthese non-traditional sources is carefully managed as these types of depositsexpose the Company to different characteristics in managing its liquidity.  The Company has adopted procedures to monitorthese deposits and has made arrangements for borrowing funds from other sources(see “Short-Term and Other Borrowings” below) should these programs become lessavailable.  However, should deposits fromthese programs suddenly decline, the Company’s other sources of funds couldbecome more costly. As an adequately capitalized institution, the Bank may notaccept, renew or roll over brokered deposits unless it has obtained a waiverfrom the FDIC. Although the Bank plans to apply for such a waiver related to aportion of its brokered deposits, there is no guarantee that such applicationwill be approved. See the Enforcement Powers section of “Supervision andRegulation” above.

 

**Scheduled MaturityDistribution of Time Deposits of $100,000 or More**

 

As of December 31, 2008,(in thousands)

 
| Three Months or Less                  |   | $      | 16,946  |   |
|---------------------------------------|--------|--------|---------|--------|
| Over Three Months Through Six Months  |   | 30,157 |    |
| Over Six Months Through Twelve Months |   | 53,435 |    |
| Over Twelve Months                    |   | 11,927 |    |
| Total                                 |   | $      | 112,465 |   |

 

**NONINTEREST INCOME ANDNONINTEREST EXPENSE**

 

Noninterest income for2008 was $1,222,000, compared to $710,000 for 2007, an increase of $512,000, or72%.  This increase includes $374,000 inincome for service charges and miscellaneous income, a non-recurring gain of$152,000 on the early prepayment of $20.0 million in FHLB advances and gain onsale of securities of $16,000 partially offset by a decline in brokered feeincome of $35,000. The significant increase in service charges on deposits canmostly be attributed to: 1) a change in systems and procedures to more effectivelycollect non-sufficient funds and overdraft charges; and 2) the additionalincome received for servicing the deposits of two additional Landmark branchlocations beginning July 1, 2007. As a percentage of total average assets,noninterest income was 0.28% for 2008 compared to 0.19% for 2007.

 

Noninterestexpense for 2008 was $27.2 million compared to $13.4 million for 2007, anincrease of $13.8 million or 103%.  On arelative basis, total noninterest expenses as a percentage of total averageassets increased from 3.6% in 2007 to 6.2% in 2008, an increase of 4.1%. Belowis more analysis and further breakdown of the $13.8 million increase innoninterest expenses:

 

Salary andbenefits expense increased from $7.5 million in 2007 to $9.1 million in 2008,or $1.6 million, a 21% increase.  Whilethe number of full-time equivalent employees decreased from 107 at December 31,2007 to 105 at December 31, 2008, the expense for salaries and benefitsincreased. The additional expense is primarily due to the full-year affect ofsalaries and benefits for an additional 20 permanent staff positions as aresult of the acquisition of Landmark and severance expenses of approximately$279,000 paid in 2008 related to the former chief executive officer. Theremaining increases in total salary and benefits are explained by additionalstaff positions added during 2007; 30 full-time equivalent positions were addedduring 2007, of which 20 were from Landmark.

 

Occupancy andequipment expense increased approximately $718,000 or 31%, from $2.3 million in2007 to $3.1 million in 2008, which includes a full-year of occupancy expensesrelated to two additional branch office locations acquired from Landmarkbeginning in July 2007.  Theoccupancy expense for these two offices increased $478,000 when comparing thefull year of 2008 to approximately six months of 2007. The remainder of theincrease in occupancy expenses is primarily the result of the relocation of theCompany’s headquarters office in late 2007 to a larger facility to accommodatethe Company’s growth.

 

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Other operatingexpenses increased from $3.6 million in 2007 to $15.1 million in 2008, anincrease of $11.5 million. Of this increase approximately $11.2 million resultsfrom the following nonrecurring expenses: 1) a complete write down of thegoodwill asset recorded in the Landmark acquisition totaling $10.4 million; and2) the recognition of an $800,000 OTTI charge on a corporate bond investment(see the Investment Portfolio section above). After excluding these one-timenonrecurring expenses, the remaining net increase of approximately $320,000 inother operating expenses is the result of the following:

 

Increases in otheroperating expenses:

 

·                  $347,000 inprofessional fees which included significant increases in legal expense andrelated loan collection expenses, operational and compliance costs andinsurance expenses;

 

·                  $135,000 in dataprocessing expense mostly due to a full year of expenses related to theintegration of Landmark including software, item processing, third partyprocessing and account opening charges for CDARs deposits;

 

·                  $66,000 inregulatory fees mostly due to an increase of $60,000 in FDIC assessmentcharges;

 

·                  $134,000 inamortization expense for core deposit intangible.

 

Decreases incertain other operating expense due to concerted efforts to reduce controllablecosts:

 

·                  $143,000 inmarketing expenses, including media advertising, investor relations andmarketing consultants;

 

·                  $128,000 insupplies and miscellaneous expenses, including stationery, telephone and boardcosts;

 

·                  $88,000 in humanresources and training costs.

 

**INCOME TAXES**

** **

During 2008, theCompany recognized income tax benefits of $3.2 million compared to income taxexpenses of $1.7 million for 2007.  Totalincome tax expense (benefit) as a percentage of income (loss) before taxes was12.6% in 2008 compared to 41.4% in 2007. The change in the effective tax ratefor book purposes primarily results from the goodwill impairment charge beingnontaxable and the increase in the deferred tax valuation allowance by $2.8million. See also Note F, Income Taxes, to the Financial Statements for moreinformation.

 

**CONTRACTUAL OBLIGATIONS**

** **

See Note D,Premises and Equipment included in “Item 8 — Financial Statements andSupplementary Data.”

 

**OFF-BALANCE SHEETARRANGEMENTS**

** **

The Company is aparty to financial instruments with off-balance sheet risk in the normal courseof business to meet the financing needs of its customers.  These financial instruments includecommitments to extend credit and standby letters of credit totaling $112.1million at December 31, 2008 and $104.4 million as of December 31,2007.

 

The Company leasesits facilities under non-cancellable operating leases and routinely enterscontracts for services to be provided over extended future periods, which maycontain penalty clauses for the early termination of the contracts.

 

In addition, theCompany is a member of the FHLB and is offered wholesale credit products andservices which provide the Company with access to funds that help meet theborrowing needs of its customers. Our liquidity sources are described in the “LiquidityManagement” section above. For additional information regarding the Company’s off-balancesheet arrangements, see Notes D, G and H to the Financial Statements includedin “Item 8, Financial Statements and Supplementary Data.”

 

**CRITICAL ACCOUNTINGPOLICIES AND ESTIMATES**

** **

This form 10-K isbased on the Company’s financial statements, which have been prepared inaccordance with accounting principles generally accepted in the United Statesof America. The process of preparing these financial statements requiresmanagement to make difficult, subjective or complex judgments that could have amaterial effect on the Company’s financial condition and results of operationsand may change in future periods. A critical accounting policy is defined asone that is material to the presentation of the Company’s financial 

 

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statements.A summary of significant accounting policies is presented in Note A of theFinancial Statements found in “Item 8- Financial Statements and SupplementaryData,” below. Management believes that the following are critical accountingpolicies.

 

*Useof Estimates in the Preparation of Financial Statements*.  The preparation of financial statements inconformity with accounting principles generally accepted in the United Statesrequires the Company’s management to make estimates and assumptions that affectthe reported amounts of assets and liabilities, disclosure of contingent assetsand liabilities at the date of the financial statements, and the reportedamounts of revenues and expenses during the reporting period.  Actual results could differ from thoseestimates.

 

*Loans*.  Loans receivable that management has theintent and ability to hold for the foreseeable future or until maturity orpayoff are reported at their outstanding unpaid principal balances reduced byany charge-offs or specific valuation accounts and net of any deferred fees orcosts on originated loans, or unamortized premiums or discounts on purchasedloans.  Loan origination fees and certaindirect origination costs are capitalized and recognized as an adjustment of theyield of the related loan.  The accrualof interest on impaired loans is discontinued when, in management’s opinion,the borrower may be unable to meet payments as they become due.  Interest income is subsequently recognizedonly to the extent cash payments are received.

 

*Allowancefor Loan Losses*.  Theallowance for loan losses is adjusted by charges to income and decreased bycharge-offs (net of recoveries). Management’s periodic evaluation of the adequacy of the allowance isbased on the Company’s past loan loss experience, known and inherent risks inthe portfolio, adverse situations that may affect the borrower’s ability torepay, the estimated value of any underlying collateral, and current economicconditions. This evaluation is inherently subjective, as it requires estimatesthat are susceptible to significant revision as more information becomesavailable.

* *

*Stock-BasedCompensation*.  In December 2004,Financial Accounting Standards Board revised Statement of Financial AccountingStandard 123 and issued it under its new name, “Share-Based Payment” (the “Statement”).  The Statement eliminates the alternative touse APB Opinion 25’s intrinsic value method of accounting.  Instead, the Statement generally requiresentities to recognize the cost of employee services received in exchange forawards of stock options, or other equity instruments, based on the grant-date fairvalue of those awards.

 

The Bank adoptedSFAS No. 123 (R) on January 1, 2006 using the “modifiedprospective method.”  Under this methodcompensation expense is recognized using the fair-value method for all newstock option awards as well as any existing awards that are modified,repurchased or cancelled after January 1, 2006 and prior periods are notrestated.  In addition, the unvestedportion of previously awarded options outstanding as of January 1, 2006will also be recognized as expense over the requisite service period based onthe fair value of those options as previously calculated at the grant dateunder the pro-forma disclosures of SFAS No. 123 (R). See Note A, Summaryof Significant Accounting Policies included in “Item 8 - Financial Statementsand Supplementary Data.”

 

*Goodwilland Other Intangibles.*Net assets of companies acquired inpurchase transactions are recorded at fair value at the date of acquisition.The historical cost basis of individual assets and liabilities are adjusted toreflect their fair value. Identified intangibles are amortized on anaccelerated or straight-line basis over the period benefited. Goodwill is notamortized but is reviewed for potential impairment on an annual basis, or ifevents or circumstances indicate a potential impairment. Other intangible assetssubject to amortization are evaluated for impairment in accordance with SFAS No. 144,Accounting for the Impairment or Disposal of Long-Lived Assets. An impairmentloss will be recognized if the carrying amount of the intangible asset is notrecoverable and exceeds fair value. The carrying amount of the intangible isconsidered not recoverable if it exceeds the sum of the undiscounted cash flowsexpected to result from the use of the asset.

 

*Income Taxes.* Deferred income taxes are computed using theasset and liability method, which recognizes a liability or asset representingthe tax effects, based on current tax law, of future deductible or taxableamounts attributable to events that have been recognized in the financialstatements.  A valuation allowance isestablished to reduce the deferred tax asset to the level at which it is “morelikely than not” that the tax asset or benefits will be realized.  Realization of tax benefits of deductibletemporary differences and operating loss carry-forwards depends on havingsufficient taxable income of an appropriate character within the carry-forwardperiods.

 

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**FORWARD-LOOKINGSTATEMENTS**

 

This Annual Reporton Form 10-K and other documents that we incorporate by reference intothis report contain forward-looking statements concerning the Company’sbeliefs, plans, objectives, goals, expectations, anticipations, estimates,intentions, operations, future results and prospects, including statements thatinclude the words “may,” “could,” “should,” “would,” “believe,” “expect,” “will,”“shall,” “anticipate,” “estimate,” “propose,” “continue,” “predict,” “intend,” “plan”and similar expressions. These forward-looking statements are based uponcurrent expectations and are subject to risk, uncertainties and assumptions,including those described in this annual report and the other documents thatare incorporated by reference herein. Should one or more of these risks or uncertainties materialize, orshould underlying assumptions prove incorrect, actual results may varymaterially from those anticipated, estimated, expected, projected, intended,committed or believed.

 

In connection withthe safe harbors created by Section 21E of the Exchange Act and theprovisions of the Private Securities Litigation Reform Act of 1995, the Companyprovides the following cautionary statement identifying important factors (someof which are beyond the Company’s control) which could cause the actual resultsor events to differ materially from those set forth in or implied by theforward-looking statements and related assumptions.  Such factors include, but are not limited to,the following:

 

·                  The factors described in Item 1A-Risk Factorsof this Annual Report on Form 10-K.

 

·                  Potential losses of businesses and populationin the County of San Diego, and rising housing and insurance costs that may beresponsible for such losses.

 

·                  The effects of trade, monetary and fiscalpolicies and laws.

 

·                  Stock, bond market and monetary fluctuations.

 

·                  Risks of loss of funding of Small BusinessAdministration (“SBA”) loan programs, or changes in those programs.

 

·                  Credit risks of commercial, SBA, real estate,consumer and other lending activities, including risks related to changes inthe values of real estate and other security for loans.

 

·                  Risks associated with concentrations,including commercial real estate loans, in the loan portfolio.

 

·                  The questionable availability of take-outfinancing or problems with sales or lease-ups with respect to commercial andresidential projects, due to the current economic environment.

 

·                  Changes in federal and state banking andfinancial services laws and regulations.

 

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·                  Competitors in our market area of similarsize, with similar business plans and/or offering similar services.

 

·                  Our ability to develop competitive newproducts and services and the acceptance of those products and services bytargeted customers and, when required, regulators.

 

·                  Our ability to securely and effectivelyimplement new technology (including Internet services) for both the delivery ofservices and internal operations.

 

·                  The willingness of customers to substitutecompetitors’ products and services for our products and services and viceversa.

 

·                  Changes in consumer and business spending andsavings habits.

 

·                  Unanticipated regulatory or judicial proceedings.

 

·                  The loss of significant customers.

 

·                  Increased regulation of the securitiesmarkets, including the securities of 1st Pacific Bancorp, whether pursuant tothe Sarbanes-Oxley Act of 2002 or otherwise.

 

·                  Changes in critical accounting policies andjudgments.

 

·                  Other internal and external developments thatcould materially impact our operational and financial performance.

 

Investors andother readers are cautioned not to place undue reliance on forward-lookingstatements, which reflect management’s analysis only as of the date of thestatement.  Actual results may differmaterially from what is expected. The Company undertakes no obligation, unlessrequired by law, to update publicly any forward-looking statements, whether asa result of new information, future events or otherwise.

 

**ITEM7A.**                                            QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Market risk for the Company is primarily derived from the exposure tointerest rate risk.  Other types ofmarket risk, such as foreign currency exchange risk, commodity price risk andequity price risk, are not significant in the normal course of the Company’soperations.  Furthermore, the Company hasnot entered into any significant market risk sensitive instruments for tradingpurposes.

 

One of the objectivesof the Company’s asset/liability strategy is to manage interest rate risks toensure the safety and soundness of the Company’s capital base, whilemaintaining adequate net interest margins and spreads to provide an appropriatereturn to shareholders. The objectives of interest rate risk management are tocontrol 

 

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exposureof net interest income to risks associated with interest rate movements in themarket, to achieve consistent growth in net interest income and to profit fromfavorable market opportunities.

 

To manage interestrate risk, the Company performs a gap analysis, which is a method of analyzingexposure to interest rate risk, by measuring the ability of the Company toreprice its interest rate sensitive assets and liabilities.  In addition to gap analysis, the Companyestimates the effect of changing interest rates on its net interest income usingthe repricing and maturity characteristics of its assets and liabilities andthe estimated effects on yields and costs of those assets and liabilities.  Based on the gap analysis and the Company’sassessment of its exposure to interest rate risk, the Company is “assetsensitive.”  In general, “asset sensitive”means that, over time, the Company’s assets will reprice faster than itsliabilities.  In a rising interest rateenvironment, net interest income can be expected to increase and, in adeclining interest rate environment, net interest income can be expected todecrease.  During a declining rateenvironment, the Company’s interest rate risk exposure is somewhat mitigated byfloor rates built into loan contracts.

 

Using the Company’scurrent interest rate risk model, the Company estimates the following changesin its net interest income assuming different interest rate shocks to theFederal Funds rate, which was 0.25%, as of December 31, 2008:

 
| **Projected  Shock to Federal  Funds Rate** | ** ** | **Estimated Change in  Net Interest Income** | ** ** | **Percentage  Change in Net  Interest Income** | ** ** |
|------------------------------------------------------------|------------|------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| + 300 bp                                                   |       | $                                                                | 1,638,000  |                                                          | 10.9       | % |
| + 200 bp                                                   |       | $                                                                | 451,000    |                                                          | 3.0        | % |
| + 100 bp                                                   |       | $                                                                | 88,000     |                                                          | 0.6        | % |

 

These hypotheticalestimates are based upon various assumptions. Actual results will differ fromsimulated results due to timing, magnitude, and frequency of interest ratechanges, as well as changes in market conditions and management strategy. Whilethe assumptions are developed upon current economic and market conditions, wecannot make any assurances as to the predictive nature of these assumptions.Furthermore, the sensitivity analysis does not reflect actions our Board mighttake in responding to or anticipating changes in interest rates. Informationconcerning market risk is also contained in “Item 7, Management’s Discussionand Analysis of Financial Condition and Results of Operations” included in thisreport.

 

**ITEM8.**                                                     FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA

** **

The financialstatements and supplementary data required by this Item 8 are set forth at the pages indicatedon the Index to Financial Statements included in this Annual Report on Form 10-K.

 
| **ITEM 9.** | **CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS  ON ACCOUNTING AND FINANCIAL DISCLOSURE** |
|-------------|-------------------------------------------------------------------------------------------|

** **

None.

 

**ITEM9A(T).**                            CONTROLS ANDPROCEDURES

** **

Under the supervisionand with the participation of management, including the Company’s principalexecutive officer and principal financial officer, the Company has evaluatedthe effectiveness of its disclosure controls and procedures as defined in Rule 13a-15(e) and15d-15(e) under the Exchange Act for the end of the period covered by thisAnnual Report on Form 10-K.  Basedon that evaluation, the Company’s principal executive officer and principalfinancial officer have concluded that these controls and procedures areeffective in all material respects, including those to ensure that informationrequired to be disclosed in reports filed or submitted under the Exchange Actis recorded, processed, summarized and reported, within the time periodsspecified in the rules and forms of the SEC, and is accumulated andcommunicated to management, including the principal executive officer and theprincipal financial officer, as appropriate, to allow for timely decisionsregarding required disclosure.

 

**Report of Management on InternalControl Over Financial Reporting**

 

Themanagement of 1st Pacific Bancorp is responsible forestablishing and maintaining adequate internal control over financialreporting.  The Company’s internalcontrol over financial reporting is a process designed to 

 

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provide reasonableassurance regarding the reliability of financial reporting and the preparationof financial statements for external purposes in accordance with accountingprinciples generally accepted in the United States of America.

 

TheCompany’s internal control over financial reporting includes those policies andprocedures that (i) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (ii) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with accounting principles generallyaccepted in the United States of America, (iii) provide reasonableassurance that receipts and expenditures of the company are being made only inaccordance with authorization of management and directors of the company, and (iv) providereasonable assurance regarding prevention or timely detection of theunauthorized acquisition, use, or disposition of the company’s assets thatcould have a material effect on the financial statements.

 

Managementhas assessed the Company’s internal control over financial reporting as of December 31,2008. The assessment was based on criteria for effective internal control overfinancial reporting described in the *Internal Control —Integrated Framework* issued by the Sponsoring Organizations of theTreadway Commission. Based on the assessment, Management believes that theCompany maintained effective internal control over financial reporting as of December 31,2008.

 

Thisannual report does not include an attestation report of the Company’sregistered public accounting firm regarding internal control over financialreporting. Management’s report was not subject to attestation by the Company’sregistered public accounting firm pursuant to temporary rules of theSecurities and Exchange Commission that permit the Company to provide onlymanagement’s report in this annual report.

 

**Changes in Internal Control OverFinancial Reporting**

** **

There have been nosignificant changes in the Company’s internal control over financial reportingduring the Company’s most recent fiscal quarter that have materially affected,or are reasonably likely to affect, the Company’s internal control overfinancial reporting. Inherent limitations exist in any system of internalcontrol including the possibility of human error and the potential ofoverriding controls. Even effective internal controls can provide onlyreasonable assurance with respect to financial statement preparation. Theeffectiveness of an internal control system may also be affected by changes inconditions.

 

**ITEM9B.**                                            OTHERINFORMATION

 

None.

 

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**PART III**

** **

**ITEM10.**                                              DIRECTORS,EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

 

The informationrequired by this Item is incorporated by reference to the sections entitled “Proposal1 — Election of Directors” and “Board of Directors and Committees” in theCompany’s definitive proxy statement for its 2009 annual meeting ofshareholders. The proxy statement is to be filed with the SEC pursuant toRegulation 14A within 120 days after the fiscal year covered by this annualreport.

 

**Code of Ethics**

** **

The Company hasadopted a code of ethics that applies to the Company’s Chief Executive Officer,Chief Financial Officer, Chief Credit Officer, Chief Operating Officer andsenior managers, a copy of which is available on the Company’s website atwww.1stpacbank.com.

 

**Changesin Nomination Procedures**

** **

The Company hasnot adopted any material changes to the procedures by which security holdersmay recommend nominees to the Company’s Board of Directors since the Company’slast annual report.

 

**ITEM11.**                                              EXECUTIVECOMPENSATION

 

The informationrequired by this Item is incorporated by reference to the section entitled “ExecutiveCompensation” in the Company’s definitive proxy statement for its 2009 annualmeeting of shareholders.

 
| **ITEM 12.** | **SECURITY OWNERSHIP OF CERTAIN BENEFICIAL  OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS** |
|--------------|-----------------------------------------------------------------------------------------------------|

 

The informationrequired by this Item is incorporated by reference to the section entitled “SecurityOwnership of Certain Beneficial Owners and Management” in the Company’sdefinitive proxy statement for its 2009 annual meeting of shareholders.

 

**Securities Authorized forIssuance Under Equity Compensation Plan**

 

Our shareholdershave approved each of the Second Amended and Restated 2000 Stock Option Plan of1st Pacific Bank of California (the “2000 Plan”), under which eligibleparticipants could receive stock options as designated by our board ofdirectors, and the 1st Pacific Bancorp 2007 Omnibus Stock Incentive Plan (the “OmnibusPlan”), under which we have the ability to grant other types of equity awardsto eligible participants besides stock options. The aggregate number of sharesof our common stock that may be issued pursuant to awards granted under theOmnibus Plan is 400,000.

 

The followingtable sets forth certain information as of December 31, 2008, with respectto compensation plans under which our shares of common stock were issuable asof that date. We have no equity compensation plans that have not been approvedby our shareholders.

 

**EQUITY COMPENSATION PLAN INFORMATION**

**AT DECEMBER 31, 2008**

 
| **Number of Securities to be Issued  Upon Exercise of Outstanding  Options, Warrants and Rights** | ** ** | **Weighted-Average Exercise  Price of Outstanding Options,  Warrants and Rights** | ** ** | **Number of Securities Remaining Available for  Future Issuance Under Equity Compensation  Plans (excluding securities reflected in Column 1)** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| 980,148                                                                                                                                                  |       | $8.38                                                                                                           |       | 370,988                                                                                                                                                                                                                    |       |

 

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**ITEM13.**                                              CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

 

The informationrequired by this Item is incorporated by reference to the sections entitled “TransactionsWith Related Persons” and “Other Material Transactions” in the Company’sdefinitive proxy statement for its 2009 annual meeting of shareholders.

 

**ITEM14.**                                              PRINCIPALACCOUNTING FEES AND SERVICES

 

The informationrequired by this Item is incorporated by reference to the section entitled “IndependentPublic Accountants” in the Company’s definitive proxy statement for its 2009annual meeting of shareholders.

 

**PART IV**

** **

**ITEM15.**                                              EXHIBITS,FINANCIAL STATEMENT SCHEDULES

 

(a) (1)      Financial Statements. The consolidatedfinancial statements listed on the index to Item 8 of this Annual Report on Form 10-Kare filed as a part of this Annual Report.

 

     (2)      Financial Statement Schedules. Allfinancial statement schedules have been omitted since the information is eithernot applicable or required or is included in the financial statements or notesthereof.

 

     (3)      Exhibits.Those exhibits marked with a (*) refer to exhibits filed herewith. The otherexhibits are incorporated herein by reference, as indicated in the followinglist. Those exhibits marked with a (†) refer to management contracts orcompensatory plans or arrangements.

 

**EXHIBIT INDEX**

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                      |
|----------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1                  |       | Agreement and Plan of Reorganization and Merger by  and between 1st Pacific Bancorp, PBC Merger Company and 1st Pacific Bank of  California dated as of November 7, 2006, incorporated by reference to  Exhibit 2 to 1st Pacific Bancorp’s Registration Statement on  Form S-4EF filed on November 9, 2006. |
|                 |       |                                                                                                                                                                                                                                                                                                                                 |
| 2.2                  |       | Agreement and Plan of Reorganization and Merger  dated February 22, 2007, by and among 1st Pacific Bancorp, 1st Pacific  Bank of California and Landmark National Bank incorporated by reference to  Exhibit 10.2 to 1st Pacific Bancorp’s report on Form 8-K filed  February 23, 2007.                     |
|                 |       |                                                                                                                                                                                                                                                                                                                                 |
| 3.1                  |       | Articles of Incorporation of 1st Pacific Bancorp  incorporated by reference to Exhibit 3.1 to 1st Pacific Bancorp’s  Registration Statement on Form S-4EF filed on November 9, 2006.                                                                                                                             |
|                 |       |                                                                                                                                                                                                                                                                                                                                 |
| 3.2                  |       | Bylaws of 1st Pacific Bancorp incorporated by  reference to Exhibit 3.2 to 1st Pacific Bancorp’s Registration Statement  on Form S-4EF filed on November 9, 2006.                                                                                                                                                |
|                 |       |                                                                                                                                                                                                                                                                                                                                 |
| 4.1                  |       | Specimen form of Certificate for 1st Pacific Bancorp  Common Stock incorporated by reference to Exhibit 4 to 1st Pacific  Bancorp’s Registration Statement on Form S-4EF filed on November 9,  2006.                                                                                                             |
|                 |       |                                                                                                                                                                                                                                                                                                                                 |
| 4.2†            |       | Second Amended and Restated 2000 Stock Option Plan  of 1st Pacific Bank of California, as amended by Amendment No. 1, incorporated  by reference to Exhibit 4.1 to 1st Pacific Bancorp’s Registration  Statement on Form S-8 filed February 21, 2007.                                                       |
|                 |       |                                                                                                                                                                                                                                                                                                                                 |
| 4.3†            |       | 1st Pacific Bancorp  2007 Omnibus Stock and Incentive Plan, incorporated by reference to  Exhibit 4.3 to 1st Pacific Bancorp’s report on Form 8-K  filed April 10, 2007.                                                                                                                               |
|                 |       |                                                                                                                                                                                                                                                                                                                                 |
| 4.4†            |       | 1st Pacific Bancorp  2007 Omnibus Stock Incentive Plan, incorporated by reference                                                                                                                                                                                                                                               |

 

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|       |   | to Exhibit 4.3 to 1st Pacific Bancorp’s Registration Statement on  Form S-8 filed March 17, 2008.                                                                                                                                                                                                                                                                                                                                    |
|------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.1       |   | Shopping Center Lease, dated November 1, 1999,  among 95 College Plaza, Ltd., 1st Pacific Bank of California and La Jolla  Association (3500 College Boulevard, Oceanside, California), incorporated by  reference to Exhibit 10.4 to 1st Pacific Bancorp’s report on Form 10-K  filed March 23, 2007.                                                                                                                     |
|       |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.2       |   | First Amendment to Shopping Center Lease, dated  November 17, 2004, among 95 College Plaza, Ltd., 1st Pacific Bank of California and La Jolla  Association (3500 College Boulevard, Oceanside, California), incorporated by  reference to Exhibit 10.5 to 1st Pacific Bancorp’s report on Form 10-K  filed March 23, 2007.                                                                                                 |
|       |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.3       |   | Lease dated April 15, 2003, between Griffin  Properties, LLC and 1st Pacific Bank of California (8889 Rio  San Diego Drive, San Diego, California), incorporated by reference  to Exhibit 10.6 to 1st Pacific Bancorp’s report on Form 10-K  filed March 23, 2007.                                                                                                                                               |
|       |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.4       |   | First Amendment to Lease Agreement dated  July 25, 2003, between Griffin Properties, LLC and 1st Pacific Bank of California (8889 Rio  San Diego Drive, San Diego, California), incorporated by reference  to Exhibit 10.7 to 1st Pacific Bancorp’s report on Form 10-K  filed March 23, 2007.                                                                                                                   |
|       |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.5       |   | Lease dated September 30, 2004, between Legacy  Sabre Springs, LLC and 1st Pacific Bank of  California (13500 Evening Creek Drive North, Suite 100, San Diego,  California), incorporated by reference to Exhibit 10.9 to 1st Pacific Bancorp’s report on Form 10-K  filed March 23, 2007.                                                                                                                       |
|       |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.6       |   | Amendment No. 1 to Lease dated January 27,  2005, between Kilroy Realty, L.P., a Delaware Limited Partnership, Kilroy  Realty Corporation, a Maryland Corporation, General Partner and 1st Pacific Bank of California (13500 Evening  Creek Drive North, Suite 100, San Diego, California), incorporated  by reference to Exhibit 10.10 to 1st Pacific  Bancorp’s report on Form 10-K filed March 23, 2007. |
|       |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.7       |   | Indenture Agreement between 1st Pacific Bank of California and Wilmington  Trust Company, as Trustee, dated March 31, 2005, for Floating Rate  Junior Subordinated Debentures Due 2020, incorporated by reference to  Exhibit 10.11 to 1st Pacific Bancorp’s report on Form 10-K  filed March 23, 2007.                                                                                                                    |
|       |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.8† |   | Form of Indemnification Agreement entered into  by and between 1st Pacific Bank of California and each of its  directors and officers, incorporated by reference to Exhibit 10.13 to 1st Pacific Bancorp’s report on Form 10-K  filed March 23, 2007.                                                                                                                                                                      |
|       |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.9† |   | 1st Pacific Bank of  California Incentive Compensation Plan - Senior Management, incorporated by  reference to Exhibit 10.14 to 1st Pacific Bancorp’s report on Form 10-K  filed March 23, 2007.                                                                                                                                                                                                                                |
|       |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.10      |   | Lease dated August 11 2006, among AMJ  Properties, LLC, and 1st Pacific Bank of California (343 East Main  Street, El Cajon, California), incorporated by reference to  Exhibit 10.14 to 1st Pacific Bancorp’s report on Form 10-K  filed March 23, 2007.                                                                                                                                                                  |
|       |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.11      |   | Standard Office Lease by and between Arden Realty  Limited Partnership and 1st Pacific Bank of California dated February 5,  2007, incorporated by reference to Exhibit 10.1 to 1st Pacific Bancorp’s  report on Form 8-K filed February 13, 2007.                                                                                                                                                                                   |
|       |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.12      |   | Form of Landmark Director-Shareholder’s  Agreement, each dated February 22, 2007, incorporated by reference to  Exhibit 10.3 to 1st Pacific Bancorp’s report on Form 8-K filed  February 23, 2007.                                                                                                                                                                                                                         |
|       |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.13      |   | Landmark Director-Shareholder’s Agreement dated  February 22, 2007, between 1st Pacific Bancorp and 1st Pacific Bank of  California on one hand and F.J. “Rick” Mandelbaum, incorporated by reference  to Exhibit 10.4 to 1st Pacific Bancorp’s report on Form 8-K filed  February 23, 2007.                                                                                                                          |

 

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| 10.14       |   | Form of Affiliates Agreement, each dated  February 22, 2007, incorporated by reference to Exhibit 10.6 to 1st  Pacific Bancorp’s report on Form 8-K filed February 23, 2007.                                                                                                                                               |
|-------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |   |                                                                                                                                                                                                                                                                                                                                                     |
| 10.15       |   | Standard Office Lease dated January 9, 2003  among Kavenish Ivanhoe, Ltd. LP and Landmark National Bank (7817 Ivanhoe,  Suite 100, La Jolla, California), incorporated by reference to  Exhibit 10.1 to 1st Pacific Bancorp’s report on form 10-Q filed  November 14, 2007.                                                |
|        |   |                                                                                                                                                                                                                                                                                                                                                     |
| 10.16       |   | Standard Office Lease dated August 15, 2001  among Solana Beach Holdings, LP and Landmark National Bank (937 Lomas Santa  Fe Drive, Solana Beach, California), incorporated by reference to  Exhibit 10.2 to 1st Pacific Bancorp’s report on form 10-Q filed  November 14, 2007.                                                |
|        |   |                                                                                                                                                                                                                                                                                                                                                     |
| 10.17† |   | Employment Agreement, effective as of  November 8, 2007, by and among 1st Pacific Bancorp, 1st Pacific Bank of California and A. Vincent  Siciliano, incorporated by reference to Exhibit 10.1 to 1st Pacific Bancorp’s report on Form 8-K  filed November 15, 2007.                                             |
|        |   |                                                                                                                                                                                                                                                                                                                                                     |
| 10.18† |   | Employment Agreement, effective as of  December 21, 2007, by and among 1st Pacific Bancorp, 1st Pacific Bank of California and Richard H.  Revier, incorporated by reference to Exhibit 10.1 to 1st Pacific Bancorp’s report on Form 8-K  filed December 28, 2007.                                               |
|        |   |                                                                                                                                                                                                                                                                                                                                                     |
| 10.19† |   | Employment Agreement, effective as of  December 21, 2007, by and among 1st Pacific Bancorp, 1st Pacific Bank of California and Larry Prosi,  incorporated by reference to Exhibit 10.2 to 1st Pacific Bancorp’s report on Form 8-K  filed December 28, 2007.                                                     |
|        |   |                                                                                                                                                                                                                                                                                                                                                     |
| 10.20† |   | Employment Agreement, effective as of  January 8, 2009, by and among 1st Pacific Bancorp, 1st Pacific Bank of California and James H.  Burgess, incorporated by reference to Exhibit 10.1 to 1st Pacific Bancorp’s report on Form 8-K  filed January 12, 2009.                                                   |
|        |   |                                                                                                                                                                                                                                                                                                                                                     |
| 10.21† |   | Senior Executive Bonus Plan dated November 15,  2007, incorporated by reference to Exhibit 10.1 to 1st Pacific Bancorp’s report on Form 8-K  filed November 15, 2007.                                                                                                                                                      |
|        |   |                                                                                                                                                                                                                                                                                                                                                     |
| 10.22       |   | Declaration of Trust of FPBN Trust I, dated as of  June 28, 2007, among 1st Pacific  Bancorp, as sponsor, the California and institutional trustee named therein,  and the administrators names therein, incorporated by reference to  Exhibit 10.1 to 1st Pacific Bancorp’s report on Form 10-K  filed July 5, 2007. |
|        |   |                                                                                                                                                                                                                                                                                                                                                     |
| 10.23       |   | Indenture, dated as of June 28, 2007, between 1st Pacific Bancorp, as issuer, and the trustee  named therein, relating to the Junior Subordinated Debt Securities due 2037,  incorporated by reference to Exhibit 10.2 to 1st Pacific Bancorp’s report on Form 10-K  filed July 5, 2007.                              |
|        |   |                                                                                                                                                                                                                                                                                                                                                     |
| 10.24       |   | Guarantee Agreement, dated as of June 28, 2007,  between 1st Pacific Bancorp and the guarantee trustee  named therein, incorporated by reference to Exhibit 10.3 to 1st Pacific Bancorp’s report on Form 10-K  filed July 5, 2007.                                                                                    |
|        |   |                                                                                                                                                                                                                                                                                                                                                     |
| 10.25       |   | Separation and Consulting Agreement and General  Release of Claims dated July 3, 2008, between 1st Pacific Bancorp, 1st  Pacific Bank of California and A. Vincent Siciliano, incorporated by  reference to 1st Pacific Bancorp’s report on Form 8-K filed July 7,  2008.                                                            |
|        |   |                                                                                                                                                                                                                                                                                                                                                     |
| 21.1        |   | List of subsidiaries of 1st Pacific Bancorp,  incorporated by reference to 1st Pacific Bancorp’s report on Form 10-K  filed March 23, 2007.                                                                                                                                                                                          |
|        |   |                                                                                                                                                                                                                                                                                                                                                     |
| 23.1*       |   | Consent of Vavrinek, Trine, Day & Co. LLP                                                                                                                                                                                                                                                                                                       |
|        |   |                                                                                                                                                                                                                                                                                                                                                     |
| 24          |   | Power of Attorney (incorporated by reference to the  signature page to this Form 10-K)                                                                                                                                                                                                                                                         |

 

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| 31.1*  |   | Certification of the Chief Executive Officer  pursuant to Rule 13a-14(a)/15d-14(a).                                                                                                   |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                       |
| 31.2*  |   | Certification of the Chief Financial Officer  pursuant to Rule 13a-14(a)/15d-14(a).                                                                                                   |
|   |   |                                                                                                                                                                                       |
| 32.1*  |   | Certification of the Chief Executive Officer and  Chief Financial Officer pursuant to 18 USC Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |

 
| (b)    | See (a)3 above. |
|--------|-----------------|
|   |            |
| (c)    | See (a)1 above. |

 

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**SIGNATURES**

** **

Pursuant to therequirements of Section 13 or 15(d) of the Securities and ExchangeAct of 1934, the registrant has duly caused this report to be signed in itsbehalf by the undersigned, thereunto duly authorized.

 
| Date: March 27, 2009 | **1****st PACIFIC BANCORP** |
|---------------------------|----------------------------------|
|                      | ** **                       |
|                      | ** **                       |
|                      | By:                              | /s/ Ronald J. Carlson |
|                      | ** **                       | Ronald J. Carlson |
|                      | ** **                       | President & Chief Executive Officer |
|                      | ** **                       |
|                      | By:                              | /s/ James H. Burgess |
|                      | ** **                       | James H. Burgess |
|                      | ** **                       | Executive Vice President & Chief Financial  Officer |

** **

**POWER OF ATTORNEY**

** **

KNOW ALL MEN BYTHESE PRESENTS that each person whose signature appears below constitutes andappoints Ronald J. Carlson and James H. Burgess, and each of them, as suchperson’s true and lawful attorneys-in-fact and agents, with full power ofsubstitution and resubstitution, for such person and in such person’s name,place and stead, in any and all capacities, to sign any and all amendments(including post-effective amendments) to this Annual Report on Form 10-K,and to file the same with all exhibits thereto, and other documents inconnection therewith, with the Securities and Exchange Commission, grantingunto said attorneys-in-fact and agents full power and authority to do and performeach and every act and thing requisite and necessary to be done in and aboutthe premises, as fully to all intents and purposes as he or she might do inperson, hereby ratifying and confirming all that said attorneys-in-fact andagents, or their substitute or substitutes, may lawfully do or cause to be doneby virtue hereof.

 

In accordance withthe Exchange Act, this report has been signed by the following persons onbehalf of the registrant and in the capacities on the dates indicated:

 
| **Signature**         | ** ** | **Title**                                                    | ** ** | **Date**            |
|-----------------------|------------|--------------------------------------------------------------|------------|---------------------|
|                  |       |                                                         |       |                |
| /s/ Ronald J. Carlson |       | President, Chief Executive Officer, Director (principal      |       | March 27, 2009 |
| Ronald J. Carlson     |       | executive officer)                                           |       |                |
|                  |       |                                                         |       |                |
| /s/ James H. Burgess  |       | Executive Vice President, Chief Financial Officer (principal |       | March 27, 2009 |
| James H. Burgess      |       | financial officer and principal accounting officer)          |       |                |
|                  |       |                                                         |       |                |
|                  |       |                                                         |       |                |
| /s/ Robert P. Cange   |       | Director                                                     |       | March 27, 2009 |
| Robert P. Cange       |       |                                                         |       |                |
|                  |       |                                                         |       |                |
|                  |       |                                                         |       |                |
| /s/ Albert Colucci    |       | Director                                                     |       | March 27, 2009 |
| Albert Colucci        |       |                                                         |       |                |

 

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| **Signature**                    | ** ** | **Title** | ** ** | **Date**            |
|----------------------------------|------------|-----------|------------|---------------------|
|                             |       |      |       |                |
| /s/ James G. Knight              |       | Director  |       | March 27, 2009 |
| James G. Knight                  |       |      |       |                |
|                             |       |      |       |                |
|                             |       |      |       |                |
| /s/ Susan Lew                    |       | Director  |       | March 27, 2009 |
| Susan Lew                        |       |      |       |                |
|                             |       |      |       |                |
|                             |       |      |       |                |
| /s/ Albert Logan                 |       | Director  |       | March 27, 2009 |
| Albert Logan                     |       |      |       |                |
|                             |       |      |       |                |
| /s/ Christopher Scripps McKellar |       | Director  |       | March 27, 2009 |
| Christopher Scripps McKellar     |       |      |       |                |

 

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**1****ST PACIFIC BANCORP**

** **

**INDEXTO CONSOLIDATED FINANCIAL STATEMENTS**

 
| ** **                                                      | **Page** |
|-----------------------------------------------------------------|----------|
|                                                            |     |
| REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING  FIRM        | F-1      |
|                                                            |     |
| CONSOLIDATED FINANCIAL STATEMENTS                               |     |
|                                                            |     |
| Consolidated Statements of Financial Condition                  | F-2      |
| Consolidated Statements of Operations                           | F-3      |
| Consolidated Statement of Changes in Shareholders’  Equity | F-4      |
| Consolidated Statements of Cash Flows                           | F-5      |
| Consolidated Notes to Financial Statements                      | F-6      |

 

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

 

**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

 

Board of Directors andShareholders of

1st Pacific Bancorp andSubsidiary

 

We have audited theaccompanying consolidated statements of financial condition of 1st PacificBancorp and Subsidiary as of December 31, 2008 and 2007, and the related consolidatedstatements of operations, changes in shareholders' equity, and cash flows forthe three years ended December 31, 2008. These consolidated financial statements are the responsibility of theCompany's management.  Our responsibilityis to express an opinion on these consolidated financial statements based onour audits.

 

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

 

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of 1st Pacific Bancorp and Subsidiaryas of December 31, 2008 and 2007, and the results of its operations and cashflows for the three years ended December 31, 2008 in conformity with accountingprinciples generally accepted in the United States of America.

 

 

 

Laguna Hills, California

March 27, 2009

 

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

 

**FRESNO ****· LAGUNA HILLS ****·  PALO ALTO****· PLEASANTON ****·  RANCHO CUCAMONGA**

 

F-1

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Table of Contents

 

**1stPACIFIC BANCORP AND SUBSIDIARY**

 

**CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION**

**December 31,2008 and 2007**

** **
| ** **                                                                                                                          | ** ** | **2008**    | ** **  | **2007**    | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|-------------|-------------|-------------|------------|
| **ASSETS**                                                                                                                          |       |        |        |        |       |
| Cash  and Due from Banks                                                                                                            |       | $           | 6,482,152   |        | $          | 6,397,189 |   |
| Federal  Funds Sold                                                                                                                 |       | 18,010,000  |        | 11,160,000  |       |
| **TOTAL CASH AND CASH EQUIVALENTS**                                                                                                 |       | 24,492,152  |        | 17,557,189  |       |
| Investment  Securities Available for Sale                                                                                           |       | 25,052,874  |        | 23,746,429  |       |
| Loans:                                                                                                                              |       |        |        |        |       |
| Construction  and Land Development                                                                                                  |       | 109,592,264 |        | 125,661,143 |       |
| Real  Estate - Commercial and Residential                                                                                           |       | 147,965,134 |        | 120,530,541 |       |
| Commercial                                                                                                                          |       | 69,224,976  |        | 77,581,769  |       |
| SBA                                                                                                                                 |       | 8,820,177   |        | 15,880,428  |       |
| Consumer                                                                                                                            |       | 16,296,228  |        | 10,164,841  |       |
| **TOTAL LOANS**                                                                                                                     |       | 351,898,779 |        | 349,818,722 |       |
| Allowance  for Loan Losses                                                                                                          |       | (5,058,837  | )           | (4,516,625  | )          |
| **NET LOANS**                                                                                                                       |       | 346,839,942 |        | 345,302,097 |       |
| Federal  Reserve, FHLB and Bankers’ Bank Stock, at Cost                                                                        |       | 4,611,400   |        | 3,184,200   |       |
| Premises  and Equipment                                                                                                             |       | 3,611,224   |        | 4,094,785   |       |
| Other  Real Estate Owned                                                                                                            |       | 1,390,000   |        | —      |       |
| Goodwill  and Other Intangible Assets                                                                                               |       | 1,312,544   |        | 11,906,536  |       |
| Accrued  Interest and Other Assets                                                                                                  |       | 13,599,879  |        | 8,856,089   |       |
|                                                                                                                                |       | $           | 420,910,015 |        | $          | 414,647,325 |   |
|                                                                                                                                |       |        |        |        |       |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                       | ** ** | ** **  | ** **  | ** **  | ** ** |
| Deposits:                                                                                                                           |       |        |        |        |       |
| Noninterest-Bearing  Demand                                                                                                         |       | $           | 62,534,488  |        | $          | 73,366,761 |   |
| NOW  Interest-Bearing Checking                                                                                                      |       | 16,730,751  |        | 16,344,597  |       |
| Savings  and Money Market Accounts                                                                                                  |       | 77,037,436  |        | 98,639,209  |       |
| Time  Deposits Under $100,000                                                                                                       |       | 65,068,342  |        | 32,500,598  |       |
| Time  Deposits $100,000 and Over                                                                                                    |       | 112,465,076 |        | 124,510,442 |       |
| **TOTAL DEPOSITS**                                                                                                                  |       | 333,836,093 |        | 345,361,607 |       |
| Subordinated  Debt and Other Borrowings                                                                                             |       | 60,155,000  |        | 20,155,000  |       |
| Accrued  Interest and Other Liabilities                                                                                             |       | 4,337,719   |        | 4,156,771   |       |
| **TOTAL LIABILITIES**                                                                                                               |       | 398,328,812 |        | 369,673,378 |       |
| Commitments  and Contingencies - Notes D and G                                                                                      |       |        |        |        |       |
| Shareholders’  Equity:                                                                                                         |       |        |        |        |       |
| Common  Stock - 10,000,000 Shares Authorized, No Par Value; Shares Issued and  Outstanding: 4,980,481 in 2008 and 4,944,443 in 2007 |       | 37,232,651  |        | 37,028,186  |       |
| Additional  Paid-in Capital                                                                                                         |       | 555,094     |        | 350,511     |       |
| Retained  Earnings (Deficit)                                                                                                        |       | (14,210,945 | )           | 7,649,040   |       |
| Accumulated  Other Comprehensive Income (Loss), Net of Taxes                                                                        |       | (995,597    | )           | (53,790     | )          |
| **TOTAL SHAREHOLDERS’ EQUITY**                                                                                                 |       | 22,581,203  |        | 44,973,947  |       |
|                                                                                                                                |       | $           | 420,910,015 |        | $          | 414,647,325 |   |

 

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

 

F-2

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##### **1st PACIFIC BANCORP AND SUBSIDIARY**

##### ** **

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**For theYears Ended December 31, 2008, 2007 and 2006**

 
| ** **                                            | ** ** | **2008**    | ** **  | **2007**   | ** ** | **2006**   | ** ** |
|-------------------------------------------------------|------------|-------------|-------------|------------|------------|------------|------------|
| **INTEREST INCOME**                                   |       |        |        |       |       |       |       |
| Interest  and Fees on Loans                           |       | $           | 25,103,570  |       | $          | 27,241,609 |       | $ | 22,435,495 |   |
| Interest  on Investment Securities                    |       | 1,798,850   |        | 951,054    |       | 374,560    |       |
| Interest  on Federal Funds Sold and Other             |       | 326,031     |        | 1,008,764  |       | 649,660    |       |
| **TOTAL INTEREST INCOME**                             |       | 27,228,451  |        | 29,201,427 |       | 23,459,715 |       |
|                                                  |       |        |        |       |       |       |       |
| **INTEREST EXPENSE**                                  |       |        |        |       |       |       |       |
| Interest  on NOW, Savings and Money Market Accounts   |       | 2,266,210   |        | 3,978,053  |       | 2,714,586  |       |
| Interest  on Time Deposits                            |       | 6,409,604   |        | 6,769,382  |       | 4,848,524  |       |
| Interest  on Borrowings                               |       | 1,694,384   |        | 1,212,927  |       | 653,812    |       |
| **TOTAL INTEREST EXPENSE**                            |       | 10,370,198  |        | 11,960,362 |       | 8,216,922  |       |
|                                                  |       |        |        |       |       |       |       |
| **NET INTEREST INCOME**                               |       | 16,858,253  |        | 17,241,065 |       | 15,242,793 |       |
|                                                  |       |        |        |       |       |       |       |
| Provision  for Loan Losses                            |       | 15,900,000  |        | 338,000    |       | 444,000    |       |
| **NET INTEREST INCOME AFTER**                         |       |        |        |       |       |       |       |
| **PROVISION FOR LOAN LOSSES**                         |       | 958,253     |        | 16,903,065 |       | 14,798,793 |       |
|                                                  |       |        |        |       |       |       |       |
| **NONINTEREST INCOME**                                |       |        |        |       |       |       |       |
| Service  Charges, Fees and Other Income               |       | 953,104     |        | 577,844    |       | 395,676    |       |
| Gain  on Prepayment of FHLB Advances                  |       | 151,557     |        | —     |       | —     |       |
| Gain  on Sale of Investment Securities                |       | 19,198      |        | 3,411      |       | —     |       |
| Brokered  Loan Fees and Gain on Loan Sales            |       | 97,824      |        | 128,283    |       | 142,762    |       |
|                                                  |       | 1,221,683   |        | 709,538    |       | 538,438    |       |
| **NONINTEREST EXPENSE**                               |       |        |        |       |       |       |       |
| Salaries  and Employee Benefits                       |       | 9,052,949   |        | 7,459,716  |       | 6,075,991  |       |
| Occupancy  and Equipment Expense                      |       | 3,055,285   |        | 2,337,517  |       | 1,536,809  |       |
| Marketing  and Business Promotion                     |       | 507,026     |        | 649,786    |       | 591,434    |       |
| Data  Processing                                      |       | 1,228,305   |        | 1,092,885  |       | 717,034    |       |
| Professional  and Regulatory Fees                     |       | 1,250,486   |        | 837,431    |       | 428,325    |       |
| Office  and Administrative Expenses                   |       | 678,979     |        | 874,322    |       | 601,350    |       |
| Core  Deposit Intangible Amortization                 |       | 233,153     |        | 98,702     |       | —     |       |
| Goodwill  and Other-Than-Temporary Impairment Charges |       | 11,163,857  |        | —     |       | —     |       |
| Other  Miscellaneous Expenses                         |       | 24,114      |        | 51,262     |       | 21,817     |       |
|                                                  |       | 27,194,154  |        | 13,401,621 |       | 9,972,760  |       |
| **INCOME (LOSS) BEFORE INCOME TAXES**                 |       | (25,014,218 | )           | 4,210,982  |       | 5,364,471  |       |
|                                                  |       |        |        |       |       |       |       |
| Income  Tax Expense (Benefit)                         |       | (3,154,233  | )           | 1,745,801  |       | 2,188,953  |       |
| **NET INCOME (LOSS)**                                 |       | $           | (21,859,985 | )          | $          | 2,465,181  |       | $ | 3,175,518 |   |
|                                                  |       |        |        |       |       |       |       |
| **NET INCOME (LOSS) PER SHARE - BASIC**               |       | $           | (4.41       | )          | $          | 0.56       |       | $ | 0.82 |   |
| **NET INCOME (LOSS) PER SHARE - DILUTED**             |       | $           | (4.41       | )          | $          | 0.52       |       | $ | 0.76 |   |

 

The accompanyingnotes are an integral part of these consolidated financial statements.

 

F-3

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Table of Contents

 

**1stPACIFIC BANCORP AND SUBSIDIARY**

 

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

**For theYears Ended December 31, 2008, 2007 and 2006**

 
| ** **                                                                                | ** ** | ** **            | ** ** | ** **     | ** ** | ** **   | ** ** | ** **    | ** ** | ** **        | ** **  | **Accumulated**   | ** ** |
|-------------------------------------------------------------------------------------------|------------|-----------------------|------------|----------------|------------|--------------|------------|---------------|------------|-------------------|-------------|-------------------|------------|
| ** **                                                                                | ** ** | **Common Stock** | ** ** | **Additional** | ** ** | **Retained** | ** ** | ** **    | ** ** | **Other**         | ** **  |
| ** **                                                                                | ** ** | **Number of**    | ** ** | ** **     | ** ** | **Paid-in**  | ** ** | **Earnings**  | ** ** | **Comprehensive** | ** **  | **Comprehensive** | ** ** |
| ** **                                                                                | ** ** | **Shares**            | ** ** | **Amount**     | ** ** | **Capital**  | ** ** | **(Deficit)** | ** ** | **Income**        | ** **  | **Income**        | ** ** |
| **Balance, January 1, 2006**                                                         |       | 3,849,540             |       | $              | 20,261,472 |         | $          | —        |       | $                 | 2,008,341   |              |       |   | $ | (39,451 | ) |
|                                                                                      |       |                  |       |           |       |         |       |          |       |              |        |              |       |
| Stock-Based  Compensation                                                                 |       |                  |       |           |       | 104,915      |       |          |       |              |        |              |       |
| Exercise  of Stock Options, Including Tax Benefits of $142,600                            |       | 40,152                |       | 375,608        |       |         |       |          |       |              |        |              |       |
|                                                                                      |       |                  |       |           |       |         |       |          |       |              |        |              |       |
| **Comprehensive Income:**                                                                 |       |                  |       |           |       |         |       |          |       |              |        |              |       |
| Net  Income                                                                               |       |                  |       |           |       |         |       | 3,175,518     |       | $                 | 3,175,518   |              |       |   |
| Unrecognized  Gain in Investment Securities Available for Sale, Net of Taxes of $34,643   |       |                  |       |           |       |         |       |          |       | 49,852            |        | 49,852            |       |
| **Total Comprehensive Income**                                                            |       |                  |       |           |       |         |       |          |       | $                 | 3,225,370   |              |       |   |
| **Balance, December 31, 2006**                                                       |       | 3,889,692             |       | 20,637,080     |       | 104,915      |       | 5,183,859     |       |              |        | 10,401            |       |
|                                                                                      |       |                  |       |           |       |         |       |          |       |              |        |              |       |
| Stock-Based  Compensation                                                                 |       |                  |       |           |       | 245,596      |       |          |       |              |        |              |       |
| Exercise  of Stock Options, Including Tax Benefits of $87,300                             |       | 56,971                |       | 503,262        |       |         |       |          |       |              |        |              |       |
|                                                                                      |       |                  |       |           |       |         |       |          |       |              |        |              |       |
| Shares  and Substituted Warrants Issued in Purchase of Landmark National Bank             |       | 1,000,180             |       | 15,926,244     |       |         |       |          |       |              |        |              |       |
|                                                                                      |       |                  |       |           |       |         |       |          |       |              |        |              |       |
| Shares  Repurchased upon Exercise of Dissenters’ Rights                              |       | (2,400                | )          | (38,400        | )          |         |       |          |       |              |        |              |       |
|                                                                                      |       |                  |       |           |       |         |       |          |       |              |        |              |       |
| **Comprehensive Income:**                                                                 |       |                  |       |           |       |         |       |          |       |              |        |              |       |
| Net  Income                                                                               |       |                  |       |           |       |         |       | 2,465,181     |       | $                 | 2,465,181   |              |       |   |
| Unrecognized  Loss in Investment Securities Available for Sale, Net of Taxes of $43,209   |       |                  |       |           |       |         |       |          |       | (62,179           | )           | (62,179           | )          |
|                                                                                      |       |                  |       |           |       |         |       |          |       |              |        |              |       |
| Add  Reclassification of Gain Included in Net Income, Net of Taxes of $1,399              |       |                  |       |           |       |         |       |          |       | (2,012            | )           | (2,012            | )          |
| **Total Comprehensive Income**                                                            |       |                  |       |           |       |         |       |          |       | $                 | 2,400,990   |              |       |   |
| **Balance, December 31, 2007**                                                       |       | 4,944,443             |       | 37,028,186     |       | 350,511      |       | 7,649,040     |       |              |        | (53,790           | )          |
|                                                                                      |       |                  |       |           |       |         |       |          |       |              |        |              |       |
| Stock-Based  Compensation                                                                 |       |                  |       |           |       | 204,583      |       |          |       |              |        |              |       |
| Exercise  of Stock Options, Including Tax Benefits of $23,900                             |       | 36,038                |       | 204,465        |       |         |       |          |       |              |        |              |       |
|                                                                                      |       |                  |       |           |       |         |       |          |       |              |        |              |       |
| **Comprehensive Loss:**                                                                   |       |                  |       |           |       |         |       |          |       |              |        |              |       |
| Net  Loss                                                                                 |       |                  |       |           |       |         |       | (21,859,985   | )          | $                 | (21,859,985 | )                 |       |   |
| Unrecognized  Loss in Investment Securities Available for Sale, Net of Taxes of $974,604  |       |                  |       |           |       |         |       |          |       | (1,402,480        | )           | (1,402,480        | )          |
|                                                                                      |       |                  |       |           |       |         |       |          |       |              |        |              |       |
| Add  Reclassification of Net Losses Included in Net Loss, Net of Tax Benefit of  $320,129 |       |                  |       |           |       |         |       |          |       | 460,673           |        | 460,673           |       |
| **Total Comprehensive Loss**                                                              |       |                  |       |           |       |         |       |          |       | $                 | (22,801,792 | )                 |       |   |
| **Balance, December 31, 2008**                                                       |       | 4,980,481             |       | $              | 37,232,651 |         | $          | 555,094       |       | $                 | (14,210,945 | )                 |       |   | $ | (995,597 | ) |

 

The accompanyingnotes are an integral part of these consolidated financial statements.

 

F-4

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Table of Contents

 

**1stPACIFIC BANCORP AND SUBSIDIARY**

 

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**For theYears Ended December 31, 2008, 2007 and 2006**

 
| ** **                                                  | ** ** | **2008**    | ** **  | **2007**    | ** ** | **2006**    | ** ** |
|-------------------------------------------------------------|------------|-------------|-------------|-------------|------------|-------------|------------|
| **OPERATING ACTIVITIES**                                    | ** ** | ** **  | ** **  | ** **  | ** ** | ** **  | ** ** |
| Net  Income (Loss)                                          |       | $           | (21,859,985 | )           | $          | 2,465,181   |       | $ | 3,175,517 |   |
| Adjustments  to Reconcile Net Income (Loss) to              |       |        |        |        |       |        |       |
| Net  Cash Provided by Operating Activities:                 |       |        |        |        |       |        |       |
| Provision  for Loan Losses                                  |       | 15,900,000  |        | 338,000     |       | 444,000     |       |
| Depreciation  and Amortization                              |       | 825,472     |        | 699,632     |       | 487,027     |       |
| Stock-Based  Compensation                                   |       | 204,583     |        | 245,596     |       | 104,915     |       |
| (Gain)  Loss on Sale of Securities                          |       | (19,198     | )           | (3,411      | )          | —      |       |
| Impairment  Loss on Investment Securities                   |       | 800,000     |        | —      |       | —      |       |
| Loss  on Sale of Fixed Assets                               |       | 6,711       |        | 11,832      |       | —      |       |
| Deferred  Income Tax Expense (Benefit), Net                 |       | (569,430    | )           | 258,000     |       | (245,300    | )          |
| Goodwill  Impairment                                        |       | 10,363,857  |        | —      |       | —      |       |
| Core  Deposit Intangible Amortization                       |       | 233,153     |        | 98,702      |       | —      |       |
| Other  Items                                                |       | (3,641,722  | )           | (1,623,823  | )          | (211,495    | )          |
| ** **                                                  | ** ** | ** **  | ** **  | ** **  | ** ** | ** **  | ** ** |
| **NET CASH PROVIDED BY OPERATING ACTIVITIES**               |       | 2,243,441   |        | 2,489,709   |       | 3,754,664   |       |
|                                                        |       |        |        |        |       |        |       |
| **INVESTING ACTIVITIES**                                    | ** ** | ** **  | ** **  | ** **  | ** ** | ** **  | ** ** |
| Purchases  of Investment Securities                         |       | (19,273,842 | )           | (8,834,243  | )          | (7,261,146  | )          |
| Maturities  and Sales of Investment Securities              |       | 15,785,680  |        | 7,929,748   |       | 1,492,924   |       |
| Change  in Equity Securities                                |       | (1,322,800  | )           | 393,650     |       | (471,350    | )          |
| Net  Change in Loans                                        |       | (18,827,845 | )           | (2,312,418  | )          | (44,885,345 | )          |
| Cash  paid for Acquisition of Landmark                      |       | —      |        | (9,374,764  | )          | —      |       |
| Cash  and Cash Equivalents Acquired from Landmark           |       | —      |        | 5,417,390   |       | —      |       |
| Purchases  of Premises and Equipment                        |       | (348,622    | )           | (1,570,197  | )          | (499,121    | )          |
| ** **                                                  | ** ** | ** **  | ** **  | ** **  | ** ** | ** **  | ** ** |
| **NET CASH USED BY INVESTING ACTIVITIES**                   |       | (23,987,429 | )           | (8,350,834  | )          | (51,624,038 | )          |
|                                                        |       |        |        |        |       |        |       |
| **FINANCING ACTIVITIES**                                    | ** ** | ** **  | ** **  | ** **  | ** ** | ** **  | ** ** |
| Net  Increase (Decrease) in DDA and Savings                 |       | (32,047,892 | )           | (17,044,578 | )          | 1,574,158   |       |
| Net  Increase in Time Deposits                              |       | 20,522,378  |        | 18,768,583  |       | 23,055,908  |       |
| Proceeds  from Debt Issuance                                |       | —      |        | 5,155,000   |       | —      |       |
| Increase  (Decrease) in Short-Term Borrowings               |       | 40,000,000  |        | (14,010,000 | )          | 24,010,000  |       |
| Repurchases  of Stock                                       |       | —      |        | (38,400     | )          | —      |       |
| Stock  Options Exercised                                    |       | 204,465     |        | 503,262     |       | 375,608     |       |
| ** **                                                  | ** ** | ** **  | ** **  | ** **  | ** ** | ** **  | ** ** |
| **NET CASH PROVIDED (USED) BY FINANCING ACTIVITIES**        |       | 28,678,951  |        | (6,666,133  | )          | 49,015,674  |       |
|                                                        |       |        |        |        |       |        |       |
| **INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS**        |       | 6,934,963   |        | (12,527,258 | )          | 1,146,300   |       |
| Cash  and Cash Equivalents at Beginning of Period           |       | 17,557,189  |        | 30,084,447  |       | 28,938,147  |       |
|                                                        |       |        |        |        |       |        |       |
| **CASH AND CASH EQUIVALENTS AT END OF YEAR**                |       | $           | 24,492,152  |        | $          | 17,557,189  |       | $ | 30,084,447 |   |
| ** **                                                  | ** ** | ** **  | ** **  | ** **  | ** ** | ** **  | ** ** |
| **Supplemental disclosures of cash flow  Information:**     | ** ** | ** **  | ** **  | ** **  | ** ** | ** **  | ** ** |
| Interest  Paid                                              |       | $           | 10,104,380  |        | $          | 11,814,960  |       | $ | 7,970,434 |   |
| Taxes  paid                                                 |       | $           | 579,097     |        | $          | 1,345,000   |       | $ | 2,680,000 |   |
| **Supplemental disclosure of noncash investing  activity:** | ** ** | ** **  | ** **  | ** **  | ** ** | ** **  | ** ** |
| Transfer  of loans to other real estate owned               |       | $           | 1,390,000   |        | $          | —      |       | $ | — |   |

 

The accompanyingnotes are an integral part of these consolidated financial statements.

 

F-5

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Tableof Contents

 

**1st PACIFIC BANCORP ANDSUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

Basis ofPresentation

 

On January 16, 2007,1st Pacific Bancorp (the “Company”) acquired 100% of the outstanding shares of commonstock of 1st Pacific Bank of California (the “Bank”) whichwere converted into an equal number of shares of common stock of 1st PacificBancorp.  There was no cash involved inthe transaction. The reorganization was accounted for like a pooling ofinterests and the consolidated financial statements contained herein have beenrestated to give full effect to this transaction.

 

Principles ofConsolidation

 

Theconsolidated financial statements include the accounts of the Company and itswholly owned subsidiary, the Bank. All significant intercompany balances andtransactions have been eliminated in consolidation.

 

Nature ofOperations

 

The Company is a California corporation incorporated on August 4,2006 and is registered with the Board of Governors of the Federal ReserveSystem as a bank holding company under the Bank Holding Company Act of 1956, asamended.  The Bank is a wholly-owned banksubsidiary of the Company and was incorporated in California on April 17,2000.  The Bank is a Californiacorporation licensed to operate as a commercial bank under the CaliforniaBanking Law by the California Department of Financial Institutions (the “DFI”).  In accordance with the Federal DepositInsurance Act, the Federal Deposit Insurance Corporation (the “FDIC”) insuresthe deposits of the Bank.  The Bank is amember of the Federal Reserve System.

 

The Company is organizedas a single operating segment and operates seven full-service branch offices,three in San Diego, California, one in Oceanside, California, one in El Cajon,California, one in Solana Beach, California, and one in La Jolla, California.In February 2008, a limited service branch office was opened in downtownSan Diego. The Company’s primary source of revenue is derived from providingloans and deposits to its customers, who are predominately small andmiddle-market businesses and professionals in San Diego County.

 

Use of Estimatesin the Preparation of Financial Statements

 

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

 

Cash and CashEquivalents

 

For purposes of reportingcash flows, cash and cash equivalents include cash, due from banks and federalfunds sold.  Generally, federal funds aresold for one-day periods.

 

F-6

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Tableof Contents

 

**1st PACIFIC BANCORP AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

Cash and Due fromBanks

 

Banking regulations requirethat banks maintain a percentage of their deposits as reserves in cash or ondeposit with the Federal Reserve Bank. The Bank was in compliance with all reserve requirements as of December 31,2008.  The Bank maintains amounts duefrom banks, which exceed federally insured limits; the Bank has not experiencedany losses in such accounts.

 

InvestmentSecurities

 

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

 

Investments notclassified as trading securities nor as held-to-maturity securities areclassified as available-for-sale securities and recorded at fair value.  Unrealized gains or losses onavailable-for-sale securities are excluded from net income and reported as anamount net of taxes as a separate component of other comprehensive incomeincluded in shareholders’ equity. Premiums or discounts on held-to-maturity and available-for-salesecurities are amortized or accreted into income using the interestmethod.  Realized gains or losses onsales of held-to-maturity or available-for-sale securities are recorded usingthe specific identification method.

 

Declines in the fairvalue of individual held-to-maturity and available-for-sale securities belowtheir cost that are other-than-temporary result in write-downs of theindividual securities to their fair value. The related write-downs are included in earnings as realizedlosses.  In estimatingother-than-temporary impairment losses, management considers: the length oftime and the extent to which the fair value has been less than cost, thefinancial condition and near-term prospects of the issuer, and the intent andability of the Bank to retain its investment in the issuer for a period of timesufficient to allow for any anticipated recovery in fair value.

 

Loans

 

Loans that management hasthe intent and ability to hold for the foreseeable future or until maturity orpayoff are reported at their outstanding unpaid principal balances reduced byany charge-offs or specific valuation accounts and net of any deferred fees orcosts on originated loans, or unamortized premiums or discounts on purchasedloans.  Loan origination fees and certaindirect origination costs are capitalized and recognized as an adjustment of theyield of the related loan.

 

The accrual of intereston impaired loans is discontinued when, in management’s opinion, the borrowermay be unable to meet payments as they become due, generally when past due 90days based on the contractual terms of the loan. Interest income issubsequently recognized only to the extent cash payments are received.  For impairment recognized in accordance withFinancial Accounting Standards Board (FASB) Statement of Financial AccountingStandards (SFAS) No. 114, “*Accounting by Creditorsfor Impairment of a Loan,”* as amended by SFAS No. 118, theentire change in the present value of expected cash flows is reported as eitherprovision for credit losses in the same manner in which impairment initiallywas recognized, or as a reduction in the amount of provision for credit lossesthat otherwise would be reported.

 

F-7

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Tableof Contents

 

**1st PACIFIC BANCORP AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

Allowance for LoanLosses

 

The allowance for loanlosses is adjusted by charges to income and decreased by charge-offs (net ofrecoveries).  Management’s periodicevaluation of the adequacy of the allowance is based on the Company’s past loanloss experience, known and inherent risks in the portfolio, adverse situationsthat may affect the borrower’s ability to repay, the estimated value of anyunderlying collateral, and current economic conditions.  This evaluation is inherently subjective, asit requires estimates that are susceptible to significant revision as moreinformation becomes available.

 

The allowance consists ofspecific, general and unallocated components. The specific component relates to loans that are categorized doubtful,substandard and special mention.  Thegeneral component covers non-classified loans and is based on historical lossexperience adjusted for qualitative factors. An unallocated component is maintained to cover uncertainties that couldaffect management’s estimate of probable losses and reflects the margin ofimprecision inherent in the underlying assumptions used in the methodologiesfor estimating specific and general losses in the portfolio.

 

Premises andEquipment

 

Premises and equipmentare carried at cost less accumulated depreciation and amortization.  Depreciation is computed using thestraight-line method over the estimated useful lives, which ranges from threeto ten years for furniture and fixtures. Leasehold improvements are amortized using the straight-line method overthe estimated useful lives of the improvements or the remaining lease term,whichever is shorter.  Expenditures forbetterments or major repairs are capitalized and those for ordinary repairs andmaintenance are charged to operations as incurred.

 

Federal Home LoanBank (FHLB) Stock

 

The Company is a memberof the FHLB system. Members are required to own a certain amount of stock basedon the level of borrowings and other factors, any may invest in additionalamounts. FHLB stock is carried at cost, classified as a restricted security,and periodically evaluated for impairment based on the ultimate recovery of parvalue. Both cash and stock dividends are reported as income.

 

Other Real EstateOwned

 

Real Estate propertiesacquired through, or in lieu of, loan foreclosure are initially recorded at thelesser of the outstanding loan balance or the fair value at the date offoreclosure minus estimated costs to sell. The excess of the recorded loanbalance over the net fair value of the property at the time of foreclosure, ifany, is charged to the allowance for loans losses. After foreclosure, theproperties are carried at the lower of carrying value or fair value lessestimated costs to sell. Any subsequent valuation adjustments, operationexpenses or income, and gains and losses on disposition of such properties arerecognized in current operations. The valuation allowance is established basedon evaluation of appraisals and current market trends.

 

Advertising Costs

 

The Company expenses thecosts of advertising in the year incurred.

 

F-8

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Tableof Contents

 

**1st PACIFIC BANCORP AND SUBSIDARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

Income Taxes

 

Deferred income taxes arecomputed using the asset and liability method, which recognizes a liability orasset representing the tax effects, based on current tax law, of futuredeductible or taxable amounts attributable to events that have been recognizedin the financial statements.  A valuationallowance is established to reduce the deferred tax asset to the level at whichit is “more likely than not” that the tax asset or benefits will berealized.  Realization of tax benefits ofdeductible temporary differences and operating loss carry-forwards depends onhaving sufficient taxable income of an appropriate character within thecarry-forward periods.

 

Accounting forUncertainty in Income Taxes

 

The Company has adopted Financial Accounting Standards Interpretation No. 48(“FIN 48”), *Accounting for Uncertainty in Income Taxes.*FIN48 clarifies the accounting for uncertainty in tax positions taken or expectedto be taken on a tax return and provides that the tax effects from an uncertaintax position can be recognized in the financial statements only if, based onits merits, the position is more likely than not to be sustained on audit bythe taxing authorities. Management believes that all tax positions taken todate are highly certain and, accordingly, no accounting adjustment has beenmade to the financial statements. Interest and penalties related to uncertaintax positions are recorded as part of income tax expense.

 

FinancialInstruments

 

In the ordinary course ofbusiness, the Company has entered into off-balance sheet financial instrumentsconsisting of commitments to extend credit, commercial letters of credit, andstandby letters of credit as described in Note G.  Such financial instruments are recorded inthe financial statements when they are funded or related fees are incurred orreceived.

 

Earnings Per Share (EPS)

 

Basic EPS excludesdilution and is computed by dividing income available to common stockholders bythe weighted-average number of common shares outstanding for the period.  Diluted EPS reflects the potential dilutionthat could occur if securities or other contracts to issue common stock wereexercised or converted into common stock or resulted in the issuance of commonstock that then shared in the earnings of the entity.

 

The number of weightedaverage shares outstanding used to calculate basic and diluted EPS for theyears ended 2008, 2007 and 2006 were as follows:

 
| **Calculation Type** | ** ** | **2008**  | ** ** | **2007**  | ** ** | **2006**  | ** ** |
|---------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
| Basic EPS                 |       | 4,961,074 |       | 4,405,191 |       | 3,865,330 |       |
| Diluted EPS               |       | 4,961,074 |       | 4,715,218 |       | 4,193,154 |       |

 

At December 31,2008, the potentially dilutive securities that were outstanding have beenexcluded from the calculation of diluted EPS as the effects are anti-dilutive.

 

F-9

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Tableof Contents

 

**1stPACIFIC BANCORP AND SUBSIDARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

Goodwill and OtherIntangibles

 

Net assets of companiesacquired in purchase transactions are recorded at fair value at the date ofacquisition. The historical cost basis of individual assets and liabilities areadjusted to reflect their fair value. Identified intangibles are amortized onan accelerated or straight-line basis over the period benefited. Goodwill isnot amortized but is reviewed for potential impairment on an annual basis, orif events or circumstances indicate a potential impairment. Other intangibleassets subject to amortization are evaluated for impairment in accordance withSFAS No. 144, *Accounting for theImpairment or Disposal of Long-Lived Assets*. An impairment loss willbe recognized if the carrying amount of the intangible asset is not recoverableand exceeds fair value. The carrying amount of the intangible is considered notrecoverable if it exceeds the sum of the undiscounted cash flows expected toresult from the use of the asset.

 

Investment in Trust

 

On June 28, 2007, the Company completed a private placement of$5.0 million in aggregate principal amount of floating rate preferredsecurities (the “Trust Preferred Securities”) through a newly formed Delawaretrust affiliate, FPBN Trust I (the “Trust”). The Company purchased a 3%minority interest in the Trust. The balance of the equity of the Trust iscomprised of mandatorily redeemable preferred securities. The Company accountsfor its investment in the Trust using the equity method under which the subsidiariesnet earnings are recognized in the Bancorp’s statement of income, pursuant toFinancial Accounting Standards Board Interpretation No. 46 (“FIN 46”), “Consolidationof Variable Interest Entities, an Interpretation of ARB No. 51.”

 

Pursuant to FIN 46, the Trust is not consolidated into the Company’sfinancial statements. The Federal Reserve Board has ruled that subordinatednotes payable to unconsolidated special purpose entities (“SPE’s”) such as theTrust, net of the bank holding company’s investment in the SPE, qualify as Tier1 Capital, subject to certain limits.

 

Fair Value Measurement

 

As defined by SFAS No. 107,*Disclosures about Fair Value of FinancialInstruments*, the Company discloses the estimated fair value offinancial instruments.  The Company’sestimated fair value amounts have been determined using available marketinformation and appropriate valuation methodologies. However, considerablejudgment is required to develop the estimates of fair value.  Accordingly, the estimates are not necessarilyindicative of the amounts the Company could have realized in a current marketexchange.  The use of different marketassumptions and/or estimation methodologies may have a material effect on theestimated fair value amounts. Applicable disclosures are presented in Note M ofthese consolidated financial statements.

 

Effective January 1,2008, the Company adopted SFAS No. 157, *Fair ValueMeasurements.* This Statement amends SFAS No. 107 and definesfair value, establishes a framework for measuring fair value and expandsdisclosures about fair value measurements. This Statement establishes a fairvalue hierarchy about the assumptions used to measure fair value and clarifiesassumptions about risk and the effect of a restriction on the sale or use of anasset. The impact of adoption of SFAS No. 157 is not material. Applicabledisclosures are presented in Note L of these consolidated financial statements.

 

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Tableof Contents

 

**1stPACIFIC BANCORP AND SUBSIDARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

In February 2008,the FASB issued Staff Position (“FSP”) 157-2, *EffectiveDate of FASB Statement No. 157.* This FSP delays the effectivedate of SFAS 157 for all non-financial assets and non-financial liabilities,except those that are recognized or disclosed at fair value on a recurringbasis (at least annually) for fiscal year beginning after November 15,2008. Major categories of assets that are recognized or disclosed at fair valuefor which the Company has not applied the provision of SFAS 157 include OtherReal Estate Owned, Goodwill and Intangible Assets.

 

In February 2007,the FASB issued SFAS No. 159, *The Fair Value Option forFinancial Assets and Financial Liabilities — Including an Amendment of FASBStatement No. 115*. SFAS No. 159 permits an entity tochoose to measure many financial instruments and certain other items at fairvalue. Most of the provisions of SFAS No. 159 are elective; however, theamendment to SFAS No. 115, *Accounting for CertainInvestments in Debt and Equity Securities*, applies to all entitieswith available-for-sale or trading securities. For financial instrumentselected to be accounted for at fair value, an entity will report the unrealizedgains and losses in earnings. This new standard was effective, for the Companyon January 1, 2008. The Company did not elect the fair value options for anyfinancial assets or financial liabilities as of January 1, 2008.

 

Statement 157 definesfair value as the exchange price that would be received for an asset or paid totransfer a liability (an exit price) in the principal or most advantageousmarket for the asset or liability in an orderly transaction between marketparticipants on the measurement date. Statement 157 also establishes a fairvalue hierarchy, which requires an entity to maximize the use of observableinputs and minimize the use of unobservable inputs when measuring fair value.The standard describes three levels of inputs that may be used to measure fairvalue:

 

Level 1: Quoted prices(unadjusted) or identical assets or liabilities in active markets that theentity has the ability to access as of the measurement date.

 

Level 2: Significantother observable inputs other than Level 1 prices such as quoted prices forsimilar assets or liabilities; quoted prices in markets that are not active; orother inputs that are observable or can be corroborated by observable marketdata.

 

Level 3: Significantunobservable inputs that reflect a Company’s own assumptions about the factorsthat market participants would use in pricing an asset or liability.

 

Stock-Based CompensationPlans

 

The Bank has adopted SFASNo. 123(R) “*Shared-Based Payment.”*ThisStatement generally requires entities to recognize the cost of employeeservices received in exchange for awards of stock options, or other equityinstruments, based on the grant-date fair value of those awards.  This cost is recognized over the period inwhich an employee is required to provide services in exchange for the award,generally the vesting period.

 

F-11

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Tableof Contents

 

**1stPACIFIC BANCORP AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

ComprehensiveIncome

 

The Company adopted SFAS No. 130,*“Reporting Comprehensive Income,”* whichrequires the disclosure of comprehensive income and its components.  Changes in unrealized gain or loss onavailable-for-sale securities, net of taxes, are the only components of othercomprehensive income for the Company.

 

Reclassifications

 

Certain amounts have been reclassified in the 2007 and 2006 financialstatements to conform to the 2008 financial statement presentation.

 

F-12

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Tableof Contents

 

**1stPACIFIC BANCORP AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE B - INVESTMENT SECURITIES**

 

Debt and equitysecurities have been classified in the statements of condition according to management’sintent.  The approximate amortized cost,gross unrealized holding gains and losses, and fair value of available-for-salesecurities at December 31 were as follows:

 
| ** **                              | ** ** | ** **    | ** ** | **Gross**      | ** ** | **Gross**      | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|---------------|------------|----------------|------------|----------------|------------|------------|------------|
| ** **                              | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair**   | ** ** |
| ** **                              | ** ** | **Cost**      | ** ** | **Gains**      | ** ** | **Losses**     | ** ** | **Value**  | ** ** |
| **Available-for-Sale  Securities:**     | ** ** | ** **    | ** ** | ** **     | ** ** | ** **     | ** ** | ** ** | ** ** |
| **December 31,  2008**             | ** ** | ** **    | ** ** | ** **     | ** ** | ** **     | ** ** | ** ** | ** ** |
| Corporate Debt  Securities              |       | $             | 5,736,787  |           | $          | 60,000         |       | $          | (218,867   | ) | $ | 5,577,920 |   |
| Bank-Qualified  Municipals              |       | 4,826,452     |       | 5              |       | (465,867       | )          | 4,360,590  |       |
| Government-Sponsored  Agency - MBS      |       | 5,729,350     |       | 101,902        |       | (15,406        | )          | 5,815,846  |       |
| Collateralized  Mortgage Obligations    |       | 9,451,374     |       | —         |       | (1,102,430     | )          | 8,348,944  |       |
| U.S. Agency MBS                         |       | 996,363       |       | —         |       | (46,789        | )          | 949,574    |       |
| ** **                              |       | $             | 26,740,326 |           | $          | 161,907        |       | $          | (1,849,359 | ) | $ | 25,052,874 |   |
| ** **                              | ** ** | ** **    | ** ** | ** **     | ** ** | ** **     | ** ** | ** ** | ** ** |
| **December 31,  2007**             | ** ** | ** **    | ** ** | ** **     | ** ** | ** **     | ** ** | ** ** | ** ** |
| Corporate Debt  Securities              |       | $             | 9,895,810  |           | $          | 20,292         |       | $          | (259,040   | ) | $ | 9,657,062 |   |
| Government-Sponsored  Agency Securities |       | 1,995,670     |       | 2,636          |       | (24            | )          | 1,998,282  |       |
| Government-Sponsored  Agency - MBS      |       | 10,530,576    |       | 141,842        |       | (4,416         | )          | 10,668,002 |       |
| U.S. Agency MBS                         |       | 1,415,544     |       | 7,539          |       | —         |       | 1,423,083  |       |
| ** **                              |       | $             | 23,837,600 |           | $          | 172,309        |       | $          | (263,480   | ) | $ | 23,746,429 |   |

 

Investment securities ina temporary unrealized loss position as of December 31, 2008 and 2007 areshown in the following table, based on the length of time they have beencontinuously in an unrealized loss position:

 
| ** **                              | ** ** | **Less than 12 months** | ** ** | **12 months or Longer** | ** ** | **Total**  | ** ** |
|-----------------------------------------|------------|-------------------------|------------|-------------------------|------------|------------|------------|
| ** **                              | ** ** | **Fair**                | ** ** | **Unrealized**          | ** ** | **Fair**   | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                              | ** ** | **Value**               | ** ** | **Losses**              | ** ** | **Value**  | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** |
| **December 31,  2008**             | ** ** | ** **              | ** ** | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Corporate Debt  Securities              |       | $                       | 4,317,920  |                    | $          | 218,867    |       | $ | — |   | $ | — |   | $ | 4,317,920 |   | $ | 218,867 |   |
| Bank-Qualified  Municipals              |       | 3,820,584               |       | 465,867                 |       |       |       |   |   | 3,820,584 |   | 465,867 |   |
| Government-Sponsored  Agency - MBS      |       | 1,739,291               |       | 15,406                  |       | —     |       | — |   | 1,739,291 |   | 15,406 |   |
| Collateralized  Mortgage Obligations    |       | 8,348,943               |       | 1,102,430               |       |       |       |   |   | 8,348,943 |   | 1,102,430 |   |
| U.S. Agency -  MBS                      |       | 949,574                 |       | 46,789                  |       | —     |       | — |   | 949,574 |   | 46,789 |   |
| ** **                              |       | $                       | 19,176,312 |                    | $          | 1,849,359  |       | $ | — |   | $ | — |   | $ | 19,176,312 |   | $ | 1,849,359 |   |
| ** **                              | ** ** | ** **              | ** ** | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **December 31,  2007**             | ** ** | ** **              | ** ** | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Corporate Debt  Securities              |       | $                       | 6,653,645  |                    | $          | 259,040    |       | $ | — |   | $ | — |   | $ | 6,653,645 |   | $ | 259,040 |   |
| Government-Sponsored  Agency Securities |       | 499,531                 |       | 24                      |       | —     |       | — |   | 499,531 |   | 24 |   |
| Government-Sponsored  Agency - MBS      |       | 490,926                 |       | 4,120                   |       | 102,288    |       | 296 |   | 593,214 |   | 4,416 |   |
| ** **                              |       | $                       | 7,644,102  |                    | $          | 263,184    |       | $ | 102,288 |   | $ | 296 |   | $ | 7,746,390 |   | $ | 263,480 |   |

 

F-13

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Tableof Contents

 

**1stPACIFIC BANCORP AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE B - INVESTMENT SECURITIES - Continued**

 

At December 31,2008, certain investment securities included in available-for-sale categorieshad a fair value that was below their amortized cost. The Company conducts aregular assessment of its investment portfolios to determine whether anysecurities are other-than-temporarily impaired. This assessment is based on thenature of the securities, the financial condition of the issuer, the extent andduration of the loss and the intent and ability of the Company, as of thereporting date, to hold these securities either to maturity or through theexpected recovery period. Unrealized losses at December 31, 2008, areconcentrated in ten municipal securities and four private-label collateralizedmortgage obligations all of which were purchased during 2008 and have beenaffected by the dislocation in the securities market; however each of thesebonds continues to be rated investment grade by independent rating agencies. Asof December 31, 2008, based on the nature of these investments and asmanagement has the ability to hold the debt securities for the foreseeablefuture, these unrealized losses were not considered other-than-temporary.

 

During2008, the Company recognized $800,000 in other-than-temporary impairment (“OTTI”)charges related to the Company’s $2.0 million par investment in debtobligations of Washington Mutual Inc., the bankrupt former parent of WashingtonMutual Bank. The OTTI charge reflected a write-down to 60% of par. Althoughtrading in the bond has been limited, subsequent to year-end the Company wasable to sell the bond and recognized a gain; thus, no further impairment willbe necessary.

 

The scheduled maturitiesof securities available for sale at December 31, 2008 are included below.Actual maturities may differ from contractual maturities because someinvestment securities may allow the right to call or prepay the obligation withor without call or prepayment penalties.

 
| ** **                           | ** ** | **Amortized** | ** ** | **Fair**  | ** ** |
|--------------------------------------|------------|---------------|------------|-----------|------------|
| ** **                           | ** ** | **Cost**      | ** ** | **Value** | ** ** |
|                                 |       |          |       |      |       |
| Due within One  Year                 |       | $             | 2,988,012  |      | $          | 2,909,754 |   |
| After One Year  through Five Years   |       | 2,748,775     |       | 2,668,166 |       |
| After Five Years  through Ten Years  |       | —        |       | —    |       |
| After Ten Years                      |       | 4,826,452     |       | 4,360,590 |       |
| Mortgaged-Backed  Securities         |       | 6,725,713     |       | 6,765,420 |       |
| Collateralized  Mortgage Obligations |       | 9,451,374     |       | 8,348,944 |       |
|                                 |       |          |       |      |       |
|                                 |       | $             | 26,740,326 |      | $          | 25,052,874 |   |

 

As of December 31,2008, included in accumulated other comprehensive income is net unrealizedlosses of $1,687,452 less deferred tax benefit of $691,855. As of December 31,2007, included in accumulated other comprehensive income is net unrealizedlosses of $91,170 less deferred tax benefit of $37,380.

 

During2008, the Company received proceeds from sales of investment securities of$9,997,379 and gross gains of $61,481 and gross losses of $42,283 were includedin non-interest income. Total proceeds from sales of available-for-salesecurities in 2007 were $1,757,424 and gross gains of $3,609 and gross lossesof $198 were included in non-interest income. There were no sales in 2006.

 

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Tableof Contents

 

**1stPACIFIC BANCORP AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE C -LOANS**

 

The Company’s loan portfolio consists primarily of loans to borrowerswithin San Diego County, California. Although the Company seeks to avoid concentrations of loans to a singleindustry or based upon a single class of collateral, real estate and realestate associated businesses are among the principal industries in the Company’smarket area and, as a result, loan and collateral portfolios are, to somedegree, concentrated in those industries.

 

A summary of the changesin the allowance for loan losses as of December 31 follows:

 
| ** **                                     | ** ** | **2008**    | ** ** | **2007**  | ** ** | **2006**  | ** ** |
|------------------------------------------------|------------|-------------|------------|-----------|------------|-----------|------------|
| Balance at  Beginning of Year                  |       | $           | 4,516,625  |      | $          | 3,251,002 |       | $ | 2,808,883 |   |
| Allowance from  Landmark Bank Acquisition      |       | —      |       | 1,025,581 |       | —    |       |
| Additions to the  Allowance Charged to Expense |       | 15,900,000  |       | 338,000   |       | 444,000   |       |
| Recoveries on  Loans Charged Off               |       | 12,506      |       | 7,088     |       | 384       |       |
|                                           |       | 20,429,131  |       | 4,621,671 |       | 3,253,267 |       |
|                                           |       |        |       |      |       |      |       |
| Less Loans  Charged Off                        |       | (15,370,294 | )          | (105,046  | )          | (2,265    | )          |
|                                           |       |        |       |      |       |      |       |
|                                           |       | $           | 5,058,837  |      | $          | 4,516,625 |       | $ | 3,251,002 |   |

 

The following is asummary of the investment in impaired loans, the related allowance for loanlosses, and income recognized thereon and information pertaining to loans onnonaccrual and certain past due loans as of December 31:

 
| ** **                                               | ** ** | **2008** | ** ** | **2007** | ** ** | **2006**  | ** ** |
|----------------------------------------------------------|------------|----------|------------|----------|------------|-----------|------------|
|                                                     |       |     |       |     |       |      |       |
| Recorded  Investment in Impaired Loans                   |       | $        | 12,263,545 |     | $          | 5,492,134 |       | $ | — |   |
| Related  Allowance for Loan Losses                       |       | $        | 639,922    |     | $          | 536,397   |       | $ | — |   |
| Average Recorded  Investment in Impaired Loans           |       | $        | 13,320,387 |     | $          | 3,874,991 |       | $ | 1,229,197 |   |
| Interest Income  Recognized for Cash Payments            |       | $        | 265,955    |     | $          | 82,296    |       | $ | 95,176 |   |
| Total Loans on  Nonaccrual                               |       | $        | 12,263,545 |     | $          | 5,492,134 |       | $ | — |   |
| Total Loans Past  Due 90 Days or More and Still Accruing |       | $        | —     |     | $          | 62,092    |       | $ | — |   |

 

The Company has pledged certain loans as collateral for publicdeposits. These loans totaled $1,154,000 as of December 31, 2008 and$1,093,000 as of December 31, 2007. In addition, as of December 31, 2008, loans totaling $183.5 millionand $63.3 million were pledged to secure credit facilities available throughthe Federal Home Loan Bank and the Federal Reserve Bank of San Francisco,respectively, discussed in Note H.

 

Included in total loansare deferred loan fees, net of deferred loan costs, of $511,825 as of December 31,2008 and $261,569 as of December 31, 2007.

 

F-15

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**1st PACIFIC BANCORP ANDSUBSIDIARY**

 

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE D - PREMISES AND EQUIPMENT**

 

A summary of premises and equipment as of December 31 follows:

 
| ** **                                      | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|-------------------------------------------------|------------|------------|------------|------------|------------|
|                                            |       |       |       |       |       |
| Furniture,  Fixtures, and Equipment             |       | $          | 2,948,777  |       | $          | 2,911,270 |   |
| Computer  Equipment                             |       | 853,148    |       | 739,770    |       |
| Leasehold  Improvements                         |       | 2,352,044  |       | 2,272,456  |       |
| Construction in  Progress                       |       | 127,646    |       | 26,343     |       |
|                                            |       | 6,281,615  |       | 5,949,839  |       |
| Less Accumulated  Depreciation and Amortization |       | (2,670,391 | )          | (1,855,054 | )          |
|                                            |       |       |       |       |       |
|                                            |       | $          | 3,611,224  |       | $          | 4,094,785 |   |

 

Below is a summary offuture lease rental payables under non-cancelable operating lease commitments,including estimated common area charges and parking costs. The table belowincludes commitments on existing office leases at December 31, 2008:

 
| 2009       |   | $         | 1,951,492  |   |
|------------|--------|-----------|------------|--------|
| 2010       |   | 1,874,475 |       |
| 2011       |   | 1,880,441 |       |
| 2012       |   | 1,533,852 |       |
| 2013       |   | 1,475,744 |       |
| Thereafter |   | 5,671,122 |       |
|       |   |      |       |
|       |   | $         | 14,387,126 |   |

 

The minimum rentalpayments shown above are given for the existing lease obligations and are not aforecast of future rental expense.  Theoperating leases generally include either annual fixed increases in the minimumrent or an increase based on the increase in the consumer price index.  Additionally, each lease requires paymenttowards common area charges, either as a pro-rata portion of all operatingcosts or for increases in such costs over a base year.  Management expects that in the normal courseof business, leases that expire will be renewed through existing renewaloptions or be replaced by other leases.

 

Total rental expense wasapproximately $1,717,000 for the year ended December 31, 2008; $1,262,000for the year ended December 31, 2007 and $725,000 for the year ended December 31,2006.

 

**NOTE E - DEPOSITS**

 

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

 
| Due in One Year  or Less     |   | $          | 165,059,000 |   |
|------------------------------|--------|------------|-------------|--------|
| Due from One to  Three Years |   | 12,474,000 |        |
|                         |   |       |        |
|                         |   | $          | 177,533,000 |   |

 

Deposits from executiveofficers, directors and their related interests with which they are associatedheld by the Company totaled $4,525,839 at December 31, 2008 and $4,524,331at December 31, 2007.

 

F-16

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**1st PACIFIC BANCORP ANDSUBSIDIARY**

 

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE F - INCOME TAXES**

 

The following is asummary of the components of the net deferred tax asset accounts recognized inthe accompanying statements of financial condition at December 31:

 
| ** **                                        | ** ** | **2008**   | ** ** | **2007**  | ** ** |
|---------------------------------------------------|------------|------------|------------|-----------|------------|
| Deferred Tax  Assets:                             |       |       |       |      |       |
| Allowance for  Loan Losses Due to Tax Limitations |       | $          | 593,900    |      | $          | 1,689,600 |   |
| State Franchise  Taxes                            |       | 300        |       | 119,700   |       |
| Operating Loss  Carry-forwards                    |       | 7,804,300  |       | 2,980,500 |       |
| Purchase  Accounting Adjustments                  |       | —     |       | 376,400   |       |
| Unrecognized  Loss on Investments                 |       | 691,900    |       | 37,400    |       |
| Other Items                                       |       | 547,200    |       | 224,800   |       |
|                                              |       | 9,637,600  |       | 5,428,400 |       |
| Deferred Tax  Liabilities:                        |       |       |       |      |       |
| Deferred Loan  Costs                              |       | (330,600   | )          | (267,200  | )          |
| Other Items                                       |       | (196,500   | )          | (133,200  | )          |
|                                              |       | (527,100   | )          | (400,400  | )          |
| Valuation  Allowance                              |       | (3,310,000 | )          | (451,400  | )          |
|                                              |       |       |       |      |       |
| Net Deferred Tax  Assets                          |       | $          | 5,800,500  |      | $          | 4,576,600 |   |

 

The Company has netoperating loss carry-forwards of approximately $17.7 million for Federal incomeand $25.1 million for California franchise tax purposes, including tax benefitsacquired in the acquisition of Landmark which are limited in use toapproximately $1,060,000 annually. Federal net operating loss carry-forwards,to the extent not used will expire by 2028. California net operating losscarry-forwards, to the extent not used will expire by 2028.

 

The valuation allowancerecorded against deferred tax assets was increased during 2008 by $2,858,570.The total valuation allowance at December 31, 2008, of $3,310,000 wasnecessary to reduce net deferred tax assets to a level considered reasonablebased on analysis of the Company’s historical operating results and discountedfor future expectations.

 

The provision (benefit)for income taxes consists of the following:

 
| ** **                                                  | ** ** | **2008**   | ** ** | **2007**  | ** ** | **2006**  | ** ** |
|-------------------------------------------------------------|------------|------------|------------|-----------|------------|-----------|------------|
| Current  Provision (Benefit)                                |       | $          | (2,584,803 | )         | $          | 1,487,801 |       | $ | 2,434,253 |   |
| Deferred Taxes  (Benefits)                                  |       | (3,428,000 | )          | 258,000   |       | (245,300  | )          |
| Total                                                       |       | (6,012,803 | )          | 1,745,801 |       | 2,188,953 |       |
| Provision for Valuation Allowance On Deferred Income  Taxes |       | 2,858,570  |       | —    |       | —    |       |
| Income Tax Expense (Benefit)                                |       | $          | (3,154,233 | )         | $          | 1,745,801 |       | $ | 2,188,953 |   |

 

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**1stPACIFIC BANCORP AND SUBSIDIARY**

 

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE F – INCOME TAXES - Continued**

 

The principal sources ofdeferred income taxes and the tax effect of each are as follows:

 
| ** **                             | ** ** | **2008**   | ** ** | **2007** | ** ** | **2006** | ** ** |
|----------------------------------------|------------|------------|------------|----------|------------|----------|------------|
| Provision for  Loan Losses             |       | $          | 1,095,700  |     | $          | (139,100 | )          | $ | (182,700 | ) |
| State Taxes                            |       | 119,400    |       | 44,300   |       | (65,200  | )          |
| Stock Option  Expense                  |       | (77,300    | )          | (92,100  | )          | —   |       |
| Deferred  Compensation                 |       | —     |       | 79,600   |       | —   |       |
| Purchase Accounting  Basis Adjustments |       | 419,400    |       | 114,300  |       | 200      |       |
| Net Operating  Loss Carry-forwards     |       | (4,823,800 | )          | 207,800  |       | —   |       |
| Organizational  Costs                  |       | 1,000      |       | 54,400   |       | —   |       |
| Alternative  Miminum Tax               |       | (173,700   | )          | —   |       | —   |       |
| Other                                  |       | 11,300     |       | (11,200  | )          | 2,400    |       |
|                                   |       |       |       |     |       |     |       |
| Net deferred taxes  (benefits)         |       | $          | (3,428,000 | )        | $          | 258,000  |       | $ | (245,300 | ) |

 

As a result of the following items, the total tax provision (benefit),before the valuation allowance was different from the amount computed byapplying the statutory income tax rate to earnings before income taxes:

 
| ** **                        | ** ** | **2008**   | ** ** | **2007** | ** ** | **2006** | ** ** |
|-----------------------------------|------------|------------|------------|----------|------------|----------|------------|
| Federal  “Expected” Tax |       | $          | (8,504,800 | )        | -34.0      | %        | $          | 1,431,700 |   | 34.0 | % | $ | 1,823,900 |   | 34.0 | % |
| State Franchise  Tax, Net         |       | (1,059,000 | )          | -4.2     | %          | 283,000  |       | 6.7 | % | 338,000 |   | 6.3 | % |
| Goodwill  Impairment              |       | 3,523,711  |       | 14.1     | %          | —   |       | n/a |   | — |   | n/a |   |
| Valuation  Allowance              |       | 2,858,570  |       | 11.4     | %          | —   |       | n/a |   | — |   | n/a |   |
| Other                             |       | 27,286     |       | 0.1      | %          | 31,101   |       | 0.7 | % | 27,053 |   | 0.5 | % |
|                              |       | $          | (3,154,233 | )        | -12.6      | %        | $          | 1,745,801 |   | 41.4 | % | $ | 2,188,953 |   | 40.8 | % |

 

The Company is subject tofederal income tax and franchise tax of the state of California. Income taxreturns for the years ended December 31, 2007, 2006 and 2005 are open toaudit by federal authorities and returns for the years ended December 31,2007, 2006, 2005 and 2004 are open to audit by California state authorities.Unrecognized tax benefits are not expected to significantly increase ordecrease within the next twelve months.

 

**NOTE G - COMMITMENTS**

 

In the ordinary course of business, the Company enters into financialcommitments to meet the financing needs of its customers.  These financial commitments includecommitments to extend credit and standby letters of credit.  Those instruments involve to varying degrees,elements of credit and interest rate risk not recognized in the Company’sfinancial statements.

 

The Company’s exposure to loan loss in the event of nonperformance oncommitments to extend credit and standby letters of credit is represented bythe contractual amount of those instruments. The Company uses the same credit policies in making commitments as itdoes for loans reflected in the financial statements.

 

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**1stPACIFIC BANCORP AND SUBSIDIARY**

 

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE G – COMMITMENTS - Continued**

 

As of December 31,2008 and 2007, the Company had the following outstanding financial commitmentswhose contractual amount represents credit risk:

 
| ** **                    | ** ** | **2008**  | ** **  | **2007**  | ** ** |
|-------------------------------|------------|-----------|-------------|-----------|------------|
|                          |       |      |        |      |       |
| Commitments to  Extend Credit |       | $         | 108,235,000 |      | $          | 98,385,000 |   |
| Standby Letters  of Credit    |       | 3,819,000 |        | 5,994,000 |       |
|                          |       |      |        |      |       |
|                          |       | $         | 112,054,000 |      | $          | 104,379,000 |   |

 

Commitments to extendcredit are agreements to lend to a customer as long as there is no violation ofany condition established in the contract. Since many of the commitments areexpected to expire without being drawn upon, the total amounts do notnecessarily represent future cash requirements. The Company evaluates each client’s credit worthiness on a case-by-casebasis.  The amount of collateral obtainedif deemed necessary by the Company is based on management’s credit evaluationof the customer.  The majority of theCompany’s commitments to extend credit and standby letters of credit aresecured by real estate or business assets of the related customers.

 

**NOTE H - BORROWING ARRANGEMENTS**

 

The Company hasestablished secured and unsecured lines of credit and may borrow funds fromtime to time on a term or overnight basis from FHLB, the FRB, or other financialinstitutions.

 

*FederalFunds Arrangements with Commercial Banks.* As of December 2008, we had unsecured lines ofcredit with correspondent banks, subject to availability, in the amount of$10.0 million. These facilities may be withdrawn by the correspondent banks attheir discretion.

 

*FRBSecured Line of Credit.*The Company established a secured line of credit with the FRB during2008. At December 31, 2008, our secured FRB borrowing capacity was $35.2million. Available credit at the FRB Discount Window is based on borrowingcapacity of land and construction loans pledged under the Borrower-in-Custodyprogram. Additional capacity is available based on investment collateral heldin safekeeping at FRB.

 

*FHLBSecured Line of Credit.* The facility with the FHLB is provided under the blanket lien programand collateralized by a large portion of our real estate secured loans. At December 31,2008, approximately $241.2 million of real estate and commercial loans arepledged to secure our FHLB advances and provided a borrowing capacity ofapproximately $59.0 million. The Company had $50.0 million outstanding in FHLBadvances at December 31, 2008, all of which have fixed rates. A summary,by year of maturity, is presented below:

 
| ** ** | ** ** | **Principal**

**Balance** | ** ** | **Weighted Average**

**Interest Rate** | ** ** |
|------------|------------|----------------------------|------------|---------------------------------------------------|------------|
| 2009       |       | $                          | 15,000,000 |                                              | 2.01       | % |
| 2010       |       | 25,000,000                 |       | 2.88                                              | %          |
| 2011       |       | 5,000,000                  |       | 2.01                                              | %          |
| 2012       |       | 5,000,000                  |       | 4.31                                              | %          |
|       |       | $                          | 50,000,000 |                                              | 2.68       | % |

 

F-19

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**1stPACIFIC BANCORP AND SUBSIDIARY**

 

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE H – BORROWING ARRANGEMENTS –Continued**

 

On March 31, 2005, the Company issued $5.0 million in FloatingRate Junior Subordinated Debentures in a private placement offering.  This offering was undertaken in order toraise the Company’s capital ratios. Under current risk-based capital guidelines, subordinated debenturesqualify for Tier 2 capital treatment up to 50% of Tier 1 capital and,therefore, increased the Company’s total risk-based capital ratio.  The terms of the subordinated debt are: afinal maturity of June 15, 2020, a right on behalf of the Company forearly redemptions beginning in June, 2010, and an interest rate which floatsquarterly based on 3-Month LIBOR plus a spread of 178 basis points. Theinterest rate on the subordinated debt as of December 31, 2008 was 3.78%.

 

OnJune 28, 2007, the Company completed a private placement of $5.0 millionin aggregate principal amount of floating rate preferred securities (the “TrustPreferred Securities”) through a newly formed Delaware trust affiliate, FPBNTrust I (the “Trust”). The Trust used the proceeds from the sale of the TrustPreferred Securities together with the proceeds from the sale of CommonSecurities to purchase $5,155,000 in aggregate principal amount of the Company’sunsecured floating rate junior subordinated debt securities due September 1,2037 issued by the Company (the “Junior Subordinated Debt Securities”). As of December 31,2008, the coupon interest rate was 3.58% (3 month LIBOR plus 1.40%) and floatsquarterly. The Company shall have the right, subject to regulatory approval, toredeem the debt securities, in whole or from time to time in part, on anyinterest payment date on or after September 1, 2012. The net proceeds tothe Company from the sale of the Junior Subordinated Debt Securities were usedby the Company to fund a portion of the cash consideration in the acquisitionof Landmark. Pursuant to its rights under the indenture agreement, the Companyhas elected to defer interest payments on the Trust Securities and may continuethis election for up to twenty consecutive quarterly periods.

 

**NOTE I - EMPLOYEE BENEFIT PLAN**

 

The Company has aretirement savings 401(k) plan in which substantially all employees mayparticipate.  The Company makesdiscretionary contributions to the plan. Total contribution expense for the plan was $68,000 in 2008, $95,000 in2007 and $73,000 in 2006.

 

**NOTE J – STOCK-BASED COMPENSATIONPLANS**

 

The 2000 Stock Option Plan (the “2000 Plan”) was approved by thestockholders on April 26, 2001, which makes available options on shares ofthe Company’s common stock for grant to employees, directors and consultants atprices not less than the fair market value of such shares at dates of grant.During 2003 and 2005, the shareholders approved amendments to the 2000 planincreasing the total shares available under the 2000 Plan to 1,145,976.  All options under the 2000 Plan shall expireon such date as the Board of Directors may determine, but not later than tenyears from the date an option is granted, and generally vest over fiveyears.  The 2000 Plan provides foraccelerated vesting if there is a change of control.

 

On April 5, 2007, the board of directors of 1st Pacific Bancorp adopted the 1st Pacific Bancorp 2007 Omnibus Stock IncentivePlan (the “Omnibus Plan”). The Omnibus Plan, which also became effective on April 5,2007, provides that any director, employee or consultant (including any prospectivedirector, employee or consultant) of the Company and any affiliate of theCompany shall be eligible to be designated a participant in the Omnibus Planfor purposes of receiving awards. The Board, as administrator of the OmnibusPlan, has the power to determine the terms of the awards, including theexercise price, the number of shares subject to each award, the vesting andexercisability of the awards and the form of consideration payable uponexercise.

 

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**1st PACIFIC BANCORP ANDSUBSIDIARY**

 

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE J - STOCK-BASED COMPENSATIONPLANS – Continued**

 

Subject to adjustment in certaincircumstances, the aggregate number of shares of the Company’s common stockthat may be issued pursuant to awards granted under the Omnibus Plan is400,000. The Omnibus Plan provides for the grant of (i) stock optionsintended to qualify as ISOs under Section 422 of the Internal Revenue Codeto the Company’s and its affiliates’ employees and (ii) non-statutorystock options (“NSOs”), stock appreciation rights, restricted stock awards,restricted stock units, unrestricted stock awards, performance unit awards,performance share awards and other stock based awards (each, an “Award”) to theCompany’s and its affiliates’ directors, employees and consultants. The Companymay grant performance units and shares which are awards that will result in apayment to a participant only if performance goals established by theadministrator are achieved. The administrator will establish performance goalsat its discretion, which, depending on the extent to which they are met, willdetermine the number and/or value of performance units and performance sharesto be paid to the participant. In the event that 1st Pacific Bancorp experiences a “change incontrol,” all outstanding stock options, stock appreciation rights, restrictedstock, unrestricted stock and performance shares would become immediatelyvested.

 

The Company recognized stock-based compensation expense ofapproximately $105,000 in 2006, $246,000 in 2007 and $205,000 in 2008. Therelated tax benefits were $31,000, $92,000 and $77,000, for 2006, 2007 and2008, respectively. As of December 31, 2008, options to purchase of980,148 shares of common stock were outstanding and the number of shares ofcommon stock remaining available for future issuance under equity compensationplans was 370,988.

 

The fair value of each option grant was estimated on the date of grantusing the Black-Scholes option-pricing model with the assumptions presentedbelow:

 
| ** **                              | ** ** | **2008**  | ** ** | **2007**  | ** ** | **2006**  | ** ** |
|-----------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
|                                    |       |      |       |      |       |      |       |
| Expected  Volatility                    |       | 30.14     | %          | 26.58     | %          | 16.90     | %          |
| Expected Term                           |       | 6.5 Years |       | 6.5 Years |       | 6.5 Years |       |
| Expected  Dividends                     |       | None      |       | None      |       | None      |       |
| Risk Free Rate                          |       | 3.10      | %          | 4.23      | %          | 4.54      | %          |
| Weighted-Average  Grant Date Fair Value |       | $         | 3.06       |      | $          | 4.74      |       | $ | 4.36 |   |
|                                         |            |           |            |           |            |           |            |  |  |  |

 

Although trading in the Company’s stock hasnot been extensive, the stock was quoted on the OTC Bulletin Board andbeginning January 3, 2008, began trading on the NASDAQ ® Global Market.The expected volatility is based on historical activity.  The expected term represents the estimatedaverage period of time that the options remain outstanding.  Since the Company does not have sufficienthistorical data on the exercise of stock options, the expected term is based onthe “simplified” method that measures the expected term as the average of thevesting period and the contractual term. The risk free rate of return reflects the grant date interest rateoffered for U.S. Treasury bonds over the expected term of the options.

 

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**1st PACIFIC BANCORP ANDSUBSIDIARY**

 

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE J - STOCK-BASED COMPENSATIONPLANS – Continued**

 

The following information and tables present total activity, intrinsicvalues and unrecognized compensation costs related to the Company’s Plans fornon-performance based options, performance based options and non-vested stockgrants.

 

*Non-Performance Based Options*

 

A summary of the total non-performance based option activity under theCompany’s 2000 Plan and Omnibus Plan as of December 31, 2008 and changesduring the year then ended is presented below:

 
| ** **                                  | ** ** | ** **      | ** ** | ** **    | ** ** | **Weighted-**   | ** ** | ** **    | ** ** |
|---------------------------------------------|------------|-----------------|------------|---------------|------------|-----------------|------------|---------------|------------|
| ** **                                  | ** ** | ** **      | ** ** | **Weighted-** | ** ** | **Average**     | ** ** | ** **    | ** ** |
| ** **                                  | ** ** | ** **      | ** ** | **Average**   | ** ** | **Remaining**   | ** ** | **Aggregate** | ** ** |
| ** **                                  | ** ** | **Shares**      | ** ** | **Exercise**  | ** ** | **Contractual** | ** ** | **Intrinsic** | ** ** |
| **Non-Performance Based Options** | ** ** | **Outstanding** | ** ** | **Price**     | ** ** | **Term**        | ** ** | **Value**     | ** ** |
|                                        |       |            |       |          |       |            |       |          |       |
| Outstanding at  Beginning of Year           |       | 895,866         |       | $             | 8.44       |            |       |          |       |   |
| Granted                                     |       | 101,000         |       | $             | 8.27       |            |       |          |       |   |
| Exercised                                   |       | (33,538         | )          | $             | 5.38       |            |       |          |       |   |
| Forfeited and  Expired                      |       | (41,180         | )          | $             | 14.45      |            |       |          |       |   |
|                                        |       |            |       |          |       |            |       |          |       |
| Outstanding at  End of Year                 |       | 922,148         |       | $             | 8.26       |            | 5.16 Years |          | $          | — |   |
|                                        |       |            |       |          |       |            |       |          |       |
| Options  Exercisable                        |       | 669,302         |       | $             | 7.06       |            | 5.38 Years |          | $          | — |   |

 

The total intrinsic valueof non-performance based options exercised during the years ended December 31,2008, 2007 and 2006 was $58,000, $269,000 and $347,000, respectively.  As of December 31, 2008, there remained$899,138 of total unrecognized compensation cost related to these outstandingstock options that will be recognized over a weighted average period of approximately2.4 years.

 

*Performance Based Options*

 

During 2008, no share based option awards were granted. When awarded,vesting is contingent upon meeting company-wide performance goals.  Share options under this performance relatedplan are granted at-the-money, contingently vest over a period of 4 to 5 years,if performance goals are met and have contractual lives of 10 years.

 

The fair value of each performance based option granted is estimated onthe date of grant using Black-Scholes option valuation model assumingperformance goals will be achieved. If such goals are not met, no compensationcost is recognized.

 

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**1st PACIFIC BANCORP ANDSUBSIDIARY**

 

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE J - STOCK-BASED COMPENSATIONPLANS – Continued**

 

A summary of the total performance based options issued under theCompany’s Omnibus Plan as of December 31, 2008 and changes during the yearthen ended is presented below:

 
| ** **                              | ** ** | ** **      | ** ** | ** **    | ** ** | **Weighted-**   | ** ** | ** **    | ** ** |
|-----------------------------------------|------------|-----------------|------------|---------------|------------|-----------------|------------|---------------|------------|
| ** **                              | ** ** | ** **      | ** ** | **Weighted-** | ** ** | **Average**     | ** ** | ** **    | ** ** |
| ** **                              | ** ** | ** **      | ** ** | **Average**   | ** ** | **Remaining**   | ** ** | **Aggregate** | ** ** |
| ** **                              | ** ** | **Shares**      | ** ** | **Exercise**  | ** ** | **Contractual** | ** ** | **Intrinsic** | ** ** |
| **Performance Based Options** | ** ** | **Outstanding** | ** ** | **Price**     | ** ** | **Term**        | ** ** | **Value**     | ** ** |
|                                    |       |            |       |          |       |            |       |          |       |
| Outstanding at  January 1, 2008    |       | 98,000          |       | $             | 10.71      |            |       |          |       |   |
| Granted                                 |       | —          |       | —        |       |            |       |          |       |
| Exercised                               |       | —          |       | —        |       |            |       |          |       |
| Forfeited                               |       | (40,000         | )          | $             | 11.50      |            |       |          |       |   |
| Outstanding at  December 31, 2008  |       | 58,000          |       | $             | 10.16      |            | 8.89 Years |          | $          | — |   |
| Exercisable at  December 31, 2008  |       | —          |       | n/a           |       | n/a             |       | n/a           |       |
|                                         |            |                 |            |               |            |                 |            |               |            |  |  |

 

During 2008, no compensation cost was recognized related to theseperformance based options as the performance goals were not met. As of December 31,2008, there remained $196,384 of total unrecognized compensation cost relatedto the outstanding performance based stock options that will be recognized overa weighted average period of approximately 2.4 years assuming performance goalsare met.

 

*Non-Vested Stock Grants*

 

A summary of the total non-vested stock grant activity under the Company’sOmnibus Plan as of December 31, 2008 and changes during the year thenended is presented below:

 
| ** **                            | ** ** | ** **      | ** ** | **Weighted-**       | ** ** |
|---------------------------------------|------------|-----------------|------------|---------------------|------------|
| ** **                            | ** ** | ** **      | ** ** | **Average**         | ** ** |
| ** **                            | ** ** | **Shares**      | ** ** | **Grant-Date**      | ** ** |
| **Non-Vested Stock Grants** | ** ** | **Outstanding** | ** ** | **Fair Value** | ** ** |
|                                  |       |            |       |                |       |
| Nonvested at  Beginning of Year       |       | 10,000          |       | $                   | 11.50      |   |
| Granted                               |       | —          |       | n/a                 |       |
| Vested                                |       | (2,500          | )          | $                   | 11.50      |   |
| Forfeited                             |       | (7,500          | )          | $                   | 11.50      |   |
|                                  |       |            |       |                |       |
| Nonvested at End  of Year             |       | —          |       | n/a                 |       |

 

During 2008, no compensation was recognized related to non-vested stockgrants.

 

**NOTE K - WARRANTS**

 

In connection with the acquisition of Landmark National Bank, 1st Pacific Bancorpissued substitute warrants to Landmark National Bank warrant holders. Eachwarrant allows for the purchase of one share of 1st Pacific Bancorp’s common stock for $12.85 pershare. All warrants expire on December 31, 2009. As of December 31,2008, a total of 25,239 of these warrants remained outstanding and exercisable.

 

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**1st PACIFIC BANCORP ANDSUBSIDIARY**

 

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE L - FAIR VALUE MEASUREMENT**

 

The following is adescription of valuation methodologies used for assets and liabilities recordedat fair value:

 

Securities: The fair values of securities available forsale are determined by obtaining quoted prices on nationally recognizedsecurities exchanges (Level 1) or matrix pricing, which is a mathematicaltechnique used widely in the industry to value debt securities without relyingexclusively on quoted prices for specific securities but rather by relying onthe securities’ relationship to other benchmark quoted securities (Level 2).

 

Incertain cases where there is limited activity or less transparency for inputsto the valuation, securities are classified in Level 3 of the valuationhierarchy. For instance, in the valuation of certain collateralized mortgageand debt obligations and high-yield debt securities, the determination of fairvalue may require benchmarking to similar instruments or analyzing default andrecovery rates.

 

Other Real Estate Owned:  Thefair value of foreclosed real estate is generally based on estimated marketprices from independently prepared appraisals and adjusted for current marketconditions, as necessary, on a nonrecurring basis. When a current appraisedvalue is not available or management determines the fair value of thecollateral is further impaired below the appraised value and there is noobservable market price, management assumptions are used to adjust fair value,if necessary (Level 3).

 

Collateral-DependentImpaired Loans:  The Bank does not record loans at fair valueon a recurring basis. However, from time to time, fair value adjustments arerecorded on these loans to reflect (1) partial write-downs, throughcharge-offs or specific reserve allowances, that are based on the currentappraised or market-quoted value of the underlying collateral or (2) thefull charge-off of the loan carrying value. In some cases, the properties forwhich market quotes or appraised values have been obtained are located in areaswhere comparable sales data is limited, outdated, or unavailable. Fair valueestimates for collateral-dependent impaired loans are obtained from real estatebrokers or other third-party consultants (Level 3).

 

The following table provides the hierarchyand fair value for each major category of assets and liabilities measured atfair value at December 31, 2008 (in thousands):

 

**Assetsand liabilities measured at fair value on a recurring basis**

 
| ** **                     | ** ** | **Total** | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
|--------------------------------|------------|-----------|------------|------------------|------------|------------------|------------|------------------|------------|
| Securities  available for Sale |       | $         | 25,053     |             | $          | —           |       | $                | 25,053     |   | $ | — |   |
| Total                          |       | $         | 25,053     |             | $          | —           |       | $                | 25,053     |   | $ | — |   |

 

**Assetsmeasured at fair value on a non-recurring basis**

 
| ** **                      | ** ** | **Total** | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
|---------------------------------|------------|-----------|------------|------------------|------------|------------------|------------|------------------|------------|
| Foreclosed  assets (OREO) (1)   |       | $         | 1,390      |             | $          | —           |       | $                | —     |   | $ | 1,390 |   |
| Non-Accrual/Impaired  Loans (2) |       | 11,624    |       | —           |       | —           |       | 11,624           |       |
| Total                           |       | $         | 13,014     |             | $          | —           |       | $                | —     |   | $ | 13,014 |   |

 

----

(1)           Represents Other Real Estate Owned net of cost to sell of$139,000.

(2)      Represents the carrying value less related write-downs, rewrites, duefrom SBA and other payoffs/paydowns. The related allowance for loan losses hasalso been subtracted.

 

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**1st PACIFIC BANCORP ANDSUBSIDIARY**

 

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE M - FAIR VALUE OF FINANCIALINSTRUMENTS**

 

Financial AccountingStandards Board (“FASB”) SFAS No. 107 specifies the disclosure of theestimated fair value of financial instruments. The Company’s estimated fair value amounts have been determined by theBank using available market information and appropriate valuationmethodologies. However, considerable judgment is required to develop theestimates of fair value.  Accordingly,the estimates are not necessarily indicative of the amounts the Company couldhave realized in a current market exchange. The use of different market assumptions and/or estimation methodologiesmay have a material effect on the estimated fair value amounts.

 

Fair value estimates aresubjective in nature and involve uncertainties and matters of significantjudgment and therefore cannot be determined with precision.  Changes in assumptions could significantlyaffect the estimates.  The followingmethods and assumptions were used by the Company in estimating fair values offinancial instruments:

 

Financial Assets: Thecarrying amounts of cash, short-term investments, and due from customers onacceptances and bank acceptances outstanding are considered to approximate fairvalue. Short-term investments include federal funds sold, securities purchasedunder agreements to resell, and interest bearing deposits with banks.  The fair values of investment securities,including available for sale, are based on quoted market prices of similarsecurities, if available, or other model-based valuation techniques, also knownas matrix pricing (See Note L - Fair Value Measurement above). The fair valueof loans is estimated using a combination of techniques, including discountingestimated future cash flows.

 

Financial Liabilities: Thecarrying amounts of deposit liabilities payable on demand, commercial paper,and other borrowed funds are considered to approximate fair value.  For fixed maturity deposits, fair value isestimated by discounting estimated future cash flows using currently offeredrates for deposits of similar remaining maturities.  The fair value of long-term debt is based onrates currently available to the Company for debt with similar terms andremaining maturities.

 

Off-BalanceSheet Financial Instruments: The fair value of commitments to extend credit and standby letters ofcredit is estimated using the fees currently charged to enter into similaragreements.  The fair value of thesefinancial instruments is not material.

 

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**1st PACIFIC BANCORP ANDSUBSIDIARY**

 

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE M - FAIR VALUE OF FINANCIALINSTRUMENTS - Continued**

 

Theestimated fair value of financial instruments at December 31 is summarizedbelow (in thousands):

 
| ** **                                                   | ** ** | **2008**     | ** ** | **2007**  | ** ** |
|--------------------------------------------------------------|------------|--------------|------------|-----------|------------|
| ** **                                                   | ** ** | **Carrying** | ** ** | **Fair**  | ** ** | **Carrying** | ** ** | **Fair** | ** ** |
| ** **                                                   | ** ** | **Value**    | ** ** | **Value** | ** ** | **Value** | ** ** | **Value** | ** ** |
| **Financial  Assets:**                                       |       |         |       |      |       |   |   |   |   |
| Cash and Due  from Banks                                     |       | $            | 6,482      |      | $          | 6,482 |   | $ | 6,397 |   | $ | 6,397 |   |
| Federal Funds  Sold                                          |       | 18,010       |       | 18,010    |       | 11,160 |   | 11,160 |   |
| Investment  Securities                                       |       | 25,053       |       | 25,053    |       | 23,746 |   | 23,746 |   |
| Loans                                                        |       | 346,840      |       | 347,135   |       | 345,302 |   | 348,809 |   |
| Federal Reserve,  FHLB and Bankers’ Bank Stock, at Cost |       | 4,611        |       | 4,611     |       | 3,184 |   | 3,184 |   |
| Accrued Interest  Receivable                                 |       | 1,415        |       | 1,415     |       | 1,913 |   | 1,913 |   |
|                                                         |       |         |       |      |       |   |   |   |   |
| **Financial  Liabilities:**                                  |       |         |       |      |       |   |   |   |   |
| Deposits                                                     |       | 333,836      |       | 335,657   |       | 345,362 |   | 346,006 |   |
| Borrowings and  Notes Payable                                |       | 60,155       |       | 60,666    |       | 20,155 |   | 19,910 |   |
| Accrued Interest  and Other Liabilities                      |       | 4,338        |       | 4,338     |       | 4,157 |   | 4,157 |   |
|                                                              |            |              |            |           |            |  |  |  |  |  |  |  |  |

 

**NOTE N - REGULATORY MATTERS**

 

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

 

Quantitative measuresestablished by regulation to ensure capital adequacy require the Bank tomaintain minimum amounts and ratios, set forth in the table below, of total andTier 1 capital (as defined in the regulations) to risk-weighted assets (asdefined), and of Tier 1 capital to average assets (as defined).  Management believes, as of December 31,2008, that the Bank meets all capital adequacy requirements to which it issubject.

 

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**1st PACIFIC BANCORP ANDSUBSIDIARY**

 

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE N - REGULATORY MATTERS -Continued**

 

Under the regulatoryframework for prompt corrective action, the Bank must maintain minimum ratiosas set forth in the table below.  Thefollowing table also sets forth the Bank’s actual capital amounts and ratios(dollar amounts in thousands):

 
| ** **                                | ** ** | ** ** | ** ** | ** **      | ** ** | **Amount of Capital Required**         |       |
|-------------------------------------------|------------|------------|------------|-----------------|------------|-------------------------------------------------------|------------|
| ** **                                | ** ** | ** ** | ** ** | ** **      | ** ** | **Under Prompt Corrective Provisions** |       |
| ** **                                | ** ** | ** ** | ** ** | ** **      | ** ** | **To Be**                                        | ** ** | **To Be** |   |
| ** **                                | ** ** | ** ** | ** ** | ** **      | ** ** | **Adequately**                                        | ** ** | **Well** |   |
| ** **                                | ** ** | **Actual** | ** ** | **Capitalized** |       | **Capitalized**                                       |       |
| ** **                                | ** ** | **Amount** | ** ** | **Ratio**       | ** ** | **Amount**                                            | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| **As of  December 31, 2008**         |       |       |       |            |       |                                                  |       |   |   |   |   |   |   |
| Total Capital  (to Risk-Weighted Assets)  |       | $          | 33,301     |            | 8.7        | %                                                     | $          | 30,503 |   | 8 | % | $ | 38,129 |   | 10 | % |
| Tier 1 Capital  (to Risk-Weighted Assets) |       | $          | 23,531     |            | 6.2        | %                                                     | $          | 15,251 |   | 4 | % | $ | 22,877 |   | 6 | % |
| Tier 1 Capital  (to Average Assets)       |       | $          | 23,531     |            | 5.4        | %                                                     | $          | 17,458 |   | 4 | % | $ | 21,822 |   | 5 | % |
|                                      |       |       |       |            |       |                                                  |       |   |   |   |   |   |   |
| **As of  December 31, 2007:**        |       |       |       |            |       |                                                  |       |   |   |   |   |   |   |
| Total Capital  (to Risk-Weighted Assets)  |       | $          | 46,481     |            | 12.0       | %                                                     | $          | 30,979 |   | 8 | % | $ | 38,724 |   | 10 | % |
| Tier 1 Capital  (to Risk-Weighted Assets) |       | $          | 36,932     |            | 9.5        | %                                                     | $          | 15,490 |   | 4 | % | $ | 23,234 |   | 6 | % |
| Tier 1 Capital  (to Average Assets)       |       | $          | 36,932     |            | 9.0        | %                                                     | $          | 16,928 |   | 4 | % | $ | 21,160 |   | 5 | % |

 

Based on the Bank’sactual capital ratios at December 31, 2008, the Bank is consideredadequately capitalized. There are no conditions or events since that date thatmanagement believes have changed the Bank’s category.

 

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

 

As an adequatelycapitalized institution, the Bank may not accept, renew or roll over brokereddeposits unless it has obtained a waiver from the FDIC. Although the Bank plansto apply for such a waiver related to a portion of its brokered deposits, thereis no guarantee that such application will be approved.

 

Banking regulations limitthe amount of cash dividends that may be paid without prior approval of theBank’s primary regulatory agency. The California Financial Code provides that abank may not make a cash distribution to its shareholders in excess of thelesser of the Bank’s undivided profits or the Bank’s net income for its lastthree fiscal years less the amount of any distribution made by the Bank toshareholders during the same period. Based on these regulations and the Company’sfinancial results, the Company has resolved not to declare or pay any dividendswithout the prior approval of the Federal Reserve.

 

**NOTE O - MERGER-RELATED ACTIVITY**

 

Effective July 1, 2007, the Company acquired 100% of theoutstanding common stock of Landmark National Bank (“Landmark”) and acquired all of its assets andassumed all of its liabilities.  Landmarkoperated two full-service branch offices in Solana Beach and La Jolla, CA,serving predominately small and middle-market businesses and professionals inthe County of San Diego.  Landmark’sresults of operations are included in the Company’s results beginning July 2,2007.  As a result of the acquisition,the Company has expanded its branch network in San Diego County, addedexperienced banking personnel, and added loan and deposit totals complementaryto its existing product offerings.

 

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**1st PACIFIC BANCORP ANDSUBSIDIARY**

 

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE O - MERGER-RELATED ACTIVITY- Continued**

 

The purchase priceconsisted of approximately 35% cash consideration and 65% stock, totaling $25.3million, which was comprised of the following:

 
| Common Stock -  1,000,180 shares issued (1) |   | $         | 15,926,244 |   |
|---------------------------------------------|--------|-----------|------------|--------|
| Cash  Consideration                         |   | 8,619,912 |       |
| Transaction Fees  and Costs                 |   | 754,852   |       |
| Total Purchase  Price                       |   | $         | 25,301,008 |   |

 

----

(1)  Thevalue of the shares of common stock issued was determined based on the weightedaverage market price of all shares traded over the 3 trading days before andafter the terms of the acquisition were agreed to and announced on February 22,2007.  The weighted average price forthese trading days was $15.923378 per share.

 

The merger wasaccounted for using the purchase method of accounting. Accordingly, thepurchase price was allocated to the assets acquired and liabilities assumedbased on their estimated fair values at the merger date as summarized below.

 
| Cash and Cash  Equivalents                                  |   | $           | 5,417,390  |   |
|-------------------------------------------------------------|--------|-------------|------------|--------|
| Investment  Securities & Interest-bearing Deposits |   | 13,843,596  |       |
| Loans, Net                                                  |   | 71,313,143  |       |
| Premises and  Equipment                                     |   | 858,834     |       |
| Equity  Securities                                          |   | 1,491,000   |       |
| Core Deposit  Intangible (CDI)                              |   | 1,644,399   |       |
| Goodwill                                                    |   | 10,360,839  |       |
| Deferred Tax  Benefit and Other Assets                      |   | 4,405,684   |       |
| Total Assets  Acquired                                      |   | 109,334,885 |       |
|                                                        |   |        |       |
| Deposits                                                    |   | 81,799,124  |       |
| Other  Liabilities                                          |   | 2,234,753   |       |
| Total  Liabilities Assumed                                  |   | 84,033,877  |       |
|                                                        |   |        |       |
| Net Assets  Acquired                                        |   | $           | 25,301,008 |   |

 

Goodwillrecorded in this transaction is not deductible for income tax purposes. Thecore deposit intangible will be amortized over the expected account retentionperiod, which was originally estimated at approximately 8 years. The coredeposit intangible is evaluated periodically to determine the reasonableness ofthe projected amortization period by comparing actual deposit retention toprojected retention. At December 31, 2008, the core deposit intangiblebalance of $1,312,544 is net of accumulated amortization of $331,855. The tablebelow summarizes the Company’s estimated core deposit intangible amortizationexpense for the next five fiscal years:

 
| 2009   |   | $       | 340,400   |   |
|--------|--------|---------|-----------|--------|
| 2010   |   | 337,973 |      |
| 2011   |   | 267,297 |      |
| 2012   |   | 164,101 |      |
| 2013   |   | 161,770 |      |
|   |   | $       | 1,271,541 |   |

 

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**1stPACIFIC BANCORP AND SUBSIDIARY**

 

###### **NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

###### ** **

**NOTE O - MERGER-RELATED ACTIVITY - Continued**

 

During 2008, theCompany performed impairment testing during the second, third and fourthquarters on the goodwill recorded in the 2007 acquisition of Landmark becauseof the declining trends in the marketplace. These reviews showed continued andsignificant deterioration of the stock market in the fourth quarter of 2008 andincreasingly low multiples in reported mergers and acquisitions activity.Taking these factors into consideration, along with the Company’s decliningoperating results, a goodwill impairment loss of $10.4 million, representing100% of the recorded goodwill, was recorded in the fourth quarter based on anestimate of the fair value of the Company as one reporting unit.

 

**NOTE P - CONDENSED FINANCIALINFORMATION OF PARENT COMPANY ONLY**

 

On January 16, 2007,the Company was involved in a corporate reorganization whereby the Bank becamea wholly-owned subsidiary of the Company which was accounted for like a poolingof interest. The earnings of the subsidiary are recognized using the equitymethod of accounting. Condensedfinancial statements of the parent company only are presented below as if thepooling was effective January 1, 2006:

 

**1****st**** Pacific Bancorp (Parent Company Only)**

 

**CONDENSEDBALANCE SHEETS**

 
| ** **                                     | ** ** | **December 31,** | ** ** |
|------------------------------------------------|------------|-----------------------|------------|
| ** **                                     | ** ** | **2008**              | ** ** | **2007** | ** ** |
| **ASSETS**                                     |       |                  |       |   |   |
| Cash                                           |       | $                     | 38,635     |   | $ | 167,296 |   |
| Investment in  Subsidary                       |       | 27,253,470            |       | 49,590,817 |   |
| Investment in  FPBN Trust I                    |       | 155,000               |       | 155,000 |   |
| Accrued Interest  and Other Assets             |       | 312,483               |       | 253,995 |   |
|                                           |       | $                     | 27,759,588 |   | $ | 50,167,108 |   |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY** | ** ** | ** **            | ** ** | ** ** | ** ** |
| Subordinated  Debt and Other Borrowings        |       | $                     | 5,155,000  |   | $ | 5,155,000 |   |
| Accrued Interest  and Other Liabilities        |       | 23,385                |       | 38,161 |   |
| **TOTAL LIABILITIES**                          |       | 5,178,385             |       | 5,193,161 |   |
|                                           |       |                  |       |   |   |
| **TOTAL SHAREHOLDERS’ EQUITY**            |       | 22,581,203            |       | 44,973,947 |   |
|                                           |       | $                     | 27,759,588 |   | $ | 50,167,108 |   |

 

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**1stPACIFIC BANCORP AND SUBSIDIARY**

 

###### **NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

###### ** **

**NOTE P - CONDENSED FINANCIALINFORMATION OF PARENT COMPANY ONLY - Continued**

 

**CONDENSEDINCOME STATEMENT**

** **
| ** **                                                                | ** ** | **December 31,** | ** **  |
|---------------------------------------------------------------------------|------------|-----------------------|-------------|
| ** **                                                                | ** ** | **2008**              | ** **  | **2007** | ** ** | **2006** | ** ** |
|                                                                      |       |                  |        |   |   |   |   |
| **INCOME**                                                                |       |                  |        |   |   |   |   |
| Dividends from  Statutory Trusts                                          |       | $                     | 7,221       |   | $ | 5,498 |   | $ | — |   |
| Cash dividends  from 1st Pacific Bank                                     |       | —                |        | 4,400,000 |   | — |   |
| **TOTAL INCOME**                                                          |       | 7,221                 |        | 4,405,498 |   | — |   |
| **EXPENSES**                                                              |       |                  |        |   |   |   |   |
| Interest on  Subordinated Debt Securities and Other Borrowings            |       | 240,167               |        | 183,520 |   | 69 |   |
| Other Expenses                                                            |       | 209,115               |        | 145,009 |   | 44,435 |   |
| Income Tax  Benefit                                                       |       | (182,200              | )           | (132,000 | ) | (18,247 | ) |
| **TOTAL EXPENSE**                                                         |       | 267,082               |        | 196,529 |   | 26,257 |   |
|                                                                      |       |                  |        |   |   |   |   |
| **INCOME  (LOSS) BEFORE EQUITY IN****UNDISTRIBUTED INCOME OF SUBSIDIARY** |       | (259,861              | )           | 4,208,969 |   | (26,257 | ) |
| Dividends in  (Excess) of Equity in Undistributed Income of Subsidiary    |       | (21,600,124           | )           | (1,743,788 | ) | 3,201,775 |   |
| **NET INCOME (LOSS)**                                                     |       | $                     | (21,859,985 | ) | $ | 2,465,181 |   | $ | 3,175,518 |   |

 

F-30

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Table of Contents

 

**1stPACIFIC BANCORP AND SUBSIDIARY**

 

###### **NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

###### ** **

**NOTE P - CONDENSED FINANCIALINFORMATION OF PARENT COMPANY ONLY - Continued**

 

**CONDENSEDSTATEMENTS OF CASH FLOWS**

** **
| ** **                                           | ** ** | **December 31,** | ** **  |
|------------------------------------------------------|------------|-----------------------|-------------|
| ** **                                           | ** ** | **2008**              | ** **  | **2007** | ** ** | **2006** | ** ** |
| **OPERATING  ACTIVITIES**                            |       |                  |        |   |   |   |   |
| Net Income  (Loss)                                   |       | $                     | (21,859,985 | ) | $ | 2,465,181 |   | $ | 3,175,518 |   |
| Adjustments to  Reconcile Net Income to              |       |                  |        |   |   |   |   |
| Net Cash  Provided (Used) by Operating Activities:   |       |                  |        |   |   |   |   |
| Equity in Income  (Loss) of Subsidiary               |       | 21,600,124            |        | (2,656,212 | ) | (3,201,775 | ) |
| Other Items                                          |       | (73,265               | )           | (232,449 | ) | 16,615 |   |
| **NET CASH USED BY****OPERATING ACTIVITIES**         |       | (333,126              | )           | (423,480 | ) | (9,642 | ) |
|                                                 |       |                  |        |   |   |   |   |
| **INVESTING  ACTIVITIES**                            |       |                  |        |   |   |   |   |
| Investment in  Subsidiaries                          |       | —                |        | (243,090 | ) | — |   |
| Dividends  Received from Subsidiary                  |       | —                |        | 4,400,000 |   | — |   |
| Cash paid for  Acquisition of Landmark               |       | —                |        | (9,176,504 | ) | — |   |
| **NET CASH USED BY****INVESTING ACTIVITIES**         |       | —                |        | (5,019,594 | ) | — |   |
|                                                 |       |                  |        |   |   |   |   |
| **FINANCING  ACTIVITIES**                            |       |                  |        |   |   |   |   |
| Proceeds from  Trust Preferred Securities            |       | —                |        | 5,155,000 |   | — |   |
| (Decrease)  Increase in Short-Term Borrowings        |       | —                |        | (10,000 | ) | 10,000 |   |
| Repurchases of  Stock                                |       | —                |        | (38,400 | ) | 150 |   |
| Stock Options  Exercised                             |       | 204,465               |        | 503,262 |   | — |   |
| **NET CASH PROVIDED BY****FINANCING ACTIVITIES**     |       | 204,465               |        | 5,609,862 |   | 10,150 |   |
|                                                 |       |                  |        |   |   |   |   |
| **INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS** |       | (128,661              | )           | 166,788 |   | 508 |   |
| Cash and Cash  Equivalents at Beginning of Period    |       | 167,296               |        | 508 |   | — |   |
| **CASH AND CASH****EQUIVALENTS AT END OF  YEAR**     |       | $                     | 38,635      |   | $ | 167,296 |   | $ | 508 |   |

 

F-31

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