**Table of Contents**

** **

 

** **

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

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

**x****  ****Quarterly report under Section 13or 15(d) of the Securities Exchange Act of 1934 for the quarterly periodended September 30, 2008**

** **

**o****   ****Transition report under Section 13or 15(d) of the Securities Exchange Act of 1934 (No fee required) for theperiod from               to               **

 

**Commission File Number 0-27666**

 

**NORTHERN CALIFORNIA BANCORP, INC.**

(Name of Small Business Issuer in its Charter)

 

**Incorporated in the State of California**

**IRS Employer Identification Number 77-0421107**

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

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

 

Check whether the issuer:(1) filed all reports required to be filed by Section 13 or 15(d) ofthe Securities Exchange Act during the past 12 months (or for such shorterperiod that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.

Yes  x   No  o

 

Indicateby check mark whether the registrant is an accelerated filer, a non-acceleratedfiler, or a smaller report5ing company (as defined in Rule 12b-2 of theAct).

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

 

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

 

As of November 4,2008, the Corporation had 1,803,908 shares of common stock outstanding.

 

 

 

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Tableof Contents

 

TABLE OF CONTENTS

 
| **Facing Page**        |                                                                                        | 1      |
|------------------------|---------------------------------------------------------------------------------------------|--------|
| **Table  of Contents** | 2                                                                                           |
| ** **             |                                                                                        |   |
| **PART I**        | Financial Information                                                                       | 3-6    |
| Item 1                 | Financial Statements                                                                        |   |
|                   | Consolidated Balance Sheets                                                                 | 3      |
|                   | Consolidated Statements of  Operations                                                      | 4      |
|                   | Consolidated****Statements****of  Changes in Shareholders’ Equity                      | 5      |
|                   | Consolidated Statements of  Cash Flows                                                      | 6      |
|                   | Summary of  Accounting Policies                                                             | 7-13   |
| Item 2                 | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 14-32  |
| Item 4T                | Controls and  Procedures                                                                    | 32-33  |
|                   |                                                                                        |   |
| **PART II**       | Other Information                                                                           |   |
| Item 1                 | Legal Proceedings                                                                           | 33     |
| Item 2                 | Unregistered  Sales of Equity Securities and Use of Proceeds                                | 33     |
| Item 3                 | Defaults  Upon Senior Securities                                                            | 33     |
| Item 4                 | Submission  of Matters to a Vote of Security Holders                                        | 33     |
| Item 5                 | Other Information                                                                           | 33     |
| Item  6                | Exhibits                                                                                    | 34     |
| Signatures             |                                                                                        | 34     |
| Certifications         | 35-38                                                                                       |
|                        |                                                                                             |        |  |

 

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**PART I-FINANCIAL INFORMATION**

 

### Item 1.              FINANCIALSTATEMENTS

###  

NORTHERN CALIFORNIA BANCORP, INC.

AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

 
| ** **                                                                                              | ** ** | **September 30** | ** ** | **December 31** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|----------------------|------------|
| **(in thousands except share data)**                                                | ** ** | **2008**              | ** ** | **2007**             | ** ** |
| ** **                                                                                              | ** ** | **(Unaudited)**       | ** ** | **(Audited)**        | ** ** |
| ASSETS:                                                                                                 |       |                  |       |                 |       |
| Cash and Due  From Banks                                                                                |       | $                     | 8,262      |                 | $          | 8,063 |   |
| Federal Funds  Sold                                                                                     |       | —                |       | 12,090               |       |
| Total Cash and  Cash Equivalents                                                                        |       | 8,262                 |       | 20,153               |       |
| Trading Assets                                                                                          |       | 591                   |       | 1,224                |       |
| Interest-bearing  deposits with other Financial Institutions                                            |       | 6,500                 |       | —               |       |
| Investment  Securities, available for sale (Note 5)                                                     |       | 76,338                |       | 36,801               |       |
| Investment  Securities, held to maturity at cost (fair value approximates $8,052 in 2007)  (Note 5)     |       | —                |       | 7,869                |       |
| Other  Investments (Note 6)                                                                             |       | 3,647                 |       | 2,824                |       |
| Loans Held for  Sale, at lower of cost or market                                                        |       | 1,248                 |       | 1,887                |       |
| Loans, net of  allowance for loan losses of $2,280 in 2008; $2,028 in 2007 (Note 7)                     |       | 158,508               |       | 166,861              |       |
| Bank Premises  and Equipment, Net                                                                       |       | 5,056                 |       | 4,874                |       |
| Cash Surrender  Value of Life Insurance                                                                 |       | 3,937                 |       | 3,845                |       |
| Other Real  Estate Owned                                                                                |       | 6,349                 |       | —               |       |
| Interest  Receivable and Other Assets                                                                   |       | 6,170                 |       | 7,527                |       |
| Total Assets                                                                                            |       | $                     | 276,606    |                 | $          | 253,875 |   |
|                                                                                                    |       |                  |       |                 |       |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY:                                                             |       |                  |       |                 |       |
|                                                                                                    |       |                  |       |                 |       |
| Non-interest  bearing demand                                                                            |       | $                     | 25,388     |                 | $          | 24,814 |   |
| Interest-bearing  demand                                                                                |       | 16,863                |       | 15,600               |       |
| Savings                                                                                                 |       | 7,099                 |       | 5,487                |       |
| Time less than  $100,000                                                                                |       | 76,376                |       | 58,812               |       |
| Time in  denominations of $100,000 or more                                                              |       | 56,385                |       | 62,620               |       |
| Total Deposits                                                                                          |       | 182,111               |       | 167,333              |       |
|                                                                                                    |       |                  |       |                 |       |
| Federal Home  Loan Bank Borrowed Funds                                                                  |       | 60,500                |       | 52,500               |       |
| Federal Funds  Purchased                                                                                |       | 840                   |       | —               |       |
| Junior Subordinated  Debt Securities                                                                    |       | 8,248                 |       | 8,248                |       |
| Revolving Line  of Credit                                                                               |       | 2,500                 |       | —               |       |
| Payable for  investment securities purchased                                                            |       | 2,705                 |       | 5,225                |       |
| Interest Payable  and Other Liabilities                                                                 |       | 7,585                 |       | 6,125                |       |
| Total  Liabilities                                                                                      |       | 264,489               |       | 239,431              |       |
|                                                                                                    |       |                  |       |                 |       |
| Shareholders’  Equity:                                                                             |       |                  |       |                 |       |
| Common Stock -  No Par Value, authorized 2,500,000 Outstanding:1,803,908 in 2008 and  1,792,238 in 2007 |       | 5,173                 |       | 5,502                |       |
| Retained  Earnings                                                                                      |       | 9,479                 |       | 8,831                |       |
| Accumulated  Other Comprehensive Income (Loss) (Note 8)                                                 |       | (2,535                | )          | 101                  |       |
| Total  Shareholders’ Equity                                                                        |       | 12,117                |       | 14,434               |       |
| Total  Liabilities & Shareholders’ Equity                                                 |       | $                     | 276,606    |                 | $          | 253,865 |   |

 

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NORTHERN CALIFORNIA BANCORP, INC.

AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

 
| ** **                                                              | ** ** | **THREE-MONTH PERIOD  ENDING** | ** ** | **NINE-MONTH PERIOD  ENDING** | ** ** |
|-------------------------------------------------------------------------|------------|-------------------------------------|------------|------------------------------------|------------|
| ** **                                                              | ** ** | **September  30**         | ** ** | **September  30**        | ** ** |
| **(in thousands except share data)**                | ** ** | **2008**                            | ** ** | **2007**                           | ** ** | **2008** | ** ** | **2007** | ** ** |
| INTEREST INCOME:                                                        |       |                                |       |                               |       |   |   |   |   |
| Loans                                                                   |       | $                                   | 2,863      |                               | $          | 3,640 |   | $ | 9,574 |   | $ | 10,373 |   |
| Time deposits  with other financial institutions                        |       | 4                                   |       | 13                                 |       | 16 |   | 41 |   |
| Investment  securities                                                  |       | 1,018                               |       | 598                                |       | 2,740 |   | 1,433 |   |
| Federal funds  sold                                                     |       | 58                                  |       | 132                                |       | 209 |   | 364 |   |
| Total Interest  Income                                                  |       | 3,943                               |       | 4,383                              |       | 12,539 |   | 12,214 |   |
|                                                                    |       |                                |       |                               |       |   |   |   |   |
| INTEREST  EXPENSE:                                                      |       |                                |       |                               |       |   |   |   |   |
| Interest-bearing  transaction accounts                                  |       | 13                                  |       | 12                                 |       | 37 |   | 38 |   |
| Savings and time  deposit accounts                                      |       | 833                                 |       | 709                                |       | 2,506 |   | 1,894 |   |
| Time deposits in  denominations of $100,000 or more                     |       | 647                                 |       | 673                                |       | 2,129 |   | 1,670 |   |
| Notes payable  and other                                                |       | 906                                 |       | 779                                |       | 2,633 |   | 2,032 |   |
| Total Interest  Expense                                                 |       | 2,399                               |       | 2,173                              |       | 7,305 |   | 5,634 |   |
|                                                                    |       |                                |       |                               |       |   |   |   |   |
| Net Interest  Income                                                    |       | 1,544                               |       | 2,210                              |       | 5,234 |   | 6,580 |   |
| Provision for  loan losses                                              |       | 250                                 |       | 140                                |       | 250 |   | 415 |   |
| Net interest  income, after provision for loan losses                   |       | 1,294                               |       | 2,070                              |       | 4,984 |   | 6,165 |   |
|                                                                    |       |                                |       |                               |       |   |   |   |   |
| NON-INTEREST  INCOME:                                                   |       |                                |       |                               |       |   |   |   |   |
| Service charges  on deposit accounts                                    |       | 168                                 |       | 153                                |       | 572 |   | 460 |   |
| Income from  sales and servicing of Small Business Administration Loans |       | 69                                  |       | 54                                 |       | 285 |   | 409 |   |
| Other income                                                            |       | 896                                 |       | 697                                |       | 2,761 |   | 2,389 |   |
| Total  non-interest income                                              |       | 1,133                               |       | 904                                |       | 3,618 |   | 3,258 |   |
|                                                                    |       |                                |       |                               |       |   |   |   |   |
| NON-INTEREST  EXPENSE:                                                  |       |                                |       |                               |       |   |   |   |   |
| Salaries and  Employee Benefits                                         |       | 881                                 |       | 1,004                              |       | 2,885 |   | 3,064 |   |
| Occupancy and  Equipment Expense                                        |       | 243                                 |       | 195                                |       | 715 |   | 622 |   |
| Professional  Fees                                                      |       | 50                                  |       | 36                                 |       | 167 |   | 124 |   |
| Data Processing                                                         |       | 86                                  |       | 92                                 |       | 277 |   | 270 |   |
| Other general  and administrative                                       |       | 1,056                               |       | 870                                |       | 2,747 |   | 2,580 |   |
| Total  non-interest expenses                                            |       | 2,316                               |       | 2,197                              |       | 6,791 |   | 6,660 |   |
|                                                                    |       |                                |       |                               |       |   |   |   |   |
| Income before  tax provision (benefit)                                  |       | 111                                 |       | 777                                |       | 1,811 |   | 2,763 |   |
| Income tax  provision (benefit)                                         |       | (43                                 | )          | 413                                |       | 801 |   | 1,278 |   |
| Net income                                                              |       | $                                   | 154        |                               | $          | 364 |   | $ | 1,010 |   | $ | 1,485 |   |
|                                                                    |       |                                |       |                               |       |   |   |   |   |
| Earnings per  common share                                              |       |                                |       |                               |       |   |   |   |   |
| Basic                                                                   |       | $                                   | 0.084      |                               | $          | 0.207 |   | $ | 0.552 |   | $ | 0.851 |   |
| Diluted                                                                 |       | $                                   | 0.083      |                               | $          | 0.180 |   | $ | 0.543 |   | $ | 0.802 |   |

 

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NORTHERN CALIFORNIA BANCORP, INC. ANDSUBSIDIARY

CONSOLIDATED STATEMENTS OFCHANGES IN SHAREHOLDERS’ EQUITY

** **
| ** **                                                                                                        | ** ** | ** **         | ** ** | ** ** | ** ** | ** **   | ** ** | **Accumulated**         | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|------------|------------|--------------|------------|-------------------------|------------|------------|------------|
| ** **                                                                                                        | ** ** | ** **         | ** ** | ** ** | ** ** | ** **   | ** ** | **Other Compre-**  | ** ** | ** ** | ** ** |
| ** **                                                                                                        | ** ** | **Number of** | ** ** | **Common** | ** ** | **Retained** | ** ** | **hensive Income** | ** ** | ** ** | ** ** |
| **(in thousands except share data)**                                                          | ** ** | **Shares**         | ** ** | **Stock**  | ** ** | **Earnings** | ** ** | **(Loss)**              | ** ** | **Total**  | ** ** |
| ** **                                                                                                        | ** ** | ** **         | ** ** | ** ** | ** ** | ** **   | ** ** | ** **              | ** ** | ** ** | ** ** |
| Balance at  December 31, 2006                                                                                |       | 1,721,715          |       | $          | 5,060      |         | $          | 7,363                   |       | $          | (21        | ) | $ | 12,402 |   |
|                                                                                                              |       |               |       |       |       |         |       |                    |       |       |       |
| Comprehensive  income:                                                                                            |       |               |       |       |       |         |       |                    |       |       |       |
| Net income                                                                                                        |       | —             |       | —     |       | 1,929        |       | —                  |       | 1,929      |       |
| Change in net  unrealized gain on securities and other assets net of reclassification  adjustment and tax effects |       | —             |       | —     |       | —       |       | 122                     |       | 122        |       |
| Total  comprehensive income                                                                                       |       |               |       |       |       |         |       |                    |       | 2,051      |       |
|                                                                                                              |       |               |       |       |       |         |       |                    |       |       |       |
| $0.25 per share  dividend                                                                                         |       | —             |       | —     |       | (461         | )          | —                  |       | (461       | )          |
| Exercise of  stock options, net of tax benefit                                                                    |       | 124,203            |       | 442        |       | —       |       | —                  |       | 442        |       |
|                                                                                                              |       |               |       |       |       |         |       |                    |       |       |       |
| Balance at  December 31, 2007 (audited)                                                                      |       | 1,845,918          |       | 5,502      |       | 8,831        |       | 101                     |       | 14,434     |       |
| Cumulative  effect – application of new accounting standard EITF 06-4 and EITF 06-10                         |       | —             |       | —     |       | (362         | )          | —                  |       | (362       | )          |
|                                                                                                              |       | 1,845,918          |       | 5,502      |       | 8,469        |       | 101                     |       | 14,072     |       |
| Comprehensive  income:                                                                                            |       |               |       |       |       |         |       |                    |       |       |       |
| Net income                                                                                                        |       | —             |       | —     |       | 1,010        |       | —                  |       | 1,010      |       |
| Change in net  unrealized loss on securities and other assets net of reclassification  adjustment and tax effects |       | —             |       | —     |       | —       |       | (2,636                  | )          | (2,636     | )          |
| Total  comprehensive income                                                                                       |       |               |       |       |       |         |       |                    |       | (1,626     | )          |
| Repurchase of  common stock                                                                                       |       | (46,010            | )          | (341       | )          |         |       |                    |       | (341       | )          |
| Exercise of  stock options, net of tax benefit                                                                    |       | 4,000              |       | 12         |       | —       |       | —                  |       | 12         |       |
|                                                                                                              |       |               |       |       |       |         |       |                    |       |       |       |
| Balance at  September 30, 2008 (unaudited)                                                                   |       | 1,803,908          |       | $          | 5,173      |         | $          | 9,479                   |       | $          | (2,535     | ) | $ | 12,117 |   |

 

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NO0RTHERN CALIFORNIA BANCORP, INC.

AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

NINE MONTHS ENDED SEPTMENBER 30, 2008 AND 2007

 
| ** **                                                                         | ** ** | **2008** | ** ** | **2007** | ** ** |
|------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| **CASH  FLOWS FROM OPERATING ACTIVITIES**                                          |       |     |       |     |       |
| Net income                                                                         |       | $        | 1,010      |     | $          | 1,485 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |     |       |     |       |
| Depreciation and  amortization expense                                             |       | 228      |       | 214      |       |
| Realized gain on  sales of available-for-sale securities, net                      |       | (449     | )          | —   |       |
| Amortization of  deferred loan (fees) costs, net                                   |       | 243      |       | 243      |       |
| Accretion of  discounts and amortization of premiums on investment securities, net |       | (161     | )          | (6       | )          |
| Provision for  loan losses                                                         |       | 250      |       | 415      |       |
| Unrealized loss  on foreclosed real estate                                         |       | 532      |       | —   |       |
| Increase in cash  surrender value of life insurance                                |       | (92      | )          | (93      | )          |
| (Increase)  decrease in assets:                                                    |       |     |       |     |       |
| Trading assets                                                                     |       | 633      |       | 431      |       |
| Loans held for  sale                                                               |       | 639      |       | (395     | )          |
| Interest  receivable                                                               |       | 10       |       | (434     | )          |
| Other assets                                                                       |       | 1,347    |       | (754     | )          |
| Increase  (decrease) in liabilities:                                               |       |     |       |     |       |
| Interest payable                                                                   |       | (476     | )          | 532      |       |
| Other liabilities                                                                  |       | 1,571    |       | 1,473    |       |
| Net cash  provided by operating activities                                         |       | 5,285    |       | 3,111    |       |
|                                                                               |       |     |       |     |       |
| **CASH  FLOWS FROM INVESTING ACTIVITIES**                                          |       |     |       |     |       |
| Increase in  interest-bearing deposits with other financial institutions           |       | (6,500   | )          | —   |       |
| Proceeds from  maturity/sale of investment securities                              |       | 36,763   |       | 11,964   |       |
| Purchase of  investments                                                           |       | (73,801  | )          | (34,024  | )          |
| Net increase in  loans                                                             |       | (11,802  | )          | (46,647  | )          |
| Loan purchases                                                                     |       | —   |       | (1,462   | )          |
| Loan sales                                                                         |       | 12,781   |       | 21,474   |       |
| Additions to  bank premises and equipment                                          |       | (407     | )          | (496     | )          |
| Net cash used by  investing activities                                             |       | (42,966  | )          | (49,191  | )          |
|                                                                               |       |     |       |     |       |
| **CASH  FLOWS FROM FINANCING ACTIVITIES**                                          |       |     |       |     |       |
| Net increase in  deposits                                                          |       | 14,779   |       | 19,941   |       |
| Proceeds from  borrowings                                                          |       | 11,340   |       | 17,500   |       |
| Repurchase of  common stock                                                        |       | (341     | )          | (2,750   | )          |
| Proceeds from  exercise of stock options                                           |       | 12       |       | 279      |       |
| Net cash  provided by financing activities                                         |       | 25,790   |       | 34,970   |       |
|                                                                               |       |     |       |     |       |
| Net decrease in  cash and cash equivalents                                         |       | (11,891  | )          | (11,110  | )          |
|                                                                               |       |     |       |     |       |
| **CASH  AND CASH EQUIVALENTS, BEGINNING**                                          |       | 20,153   |       | 22,434   |       |
|                                                                               |       |     |       |     |       |
| **CASH  AND CASH EQUIVALENTS, ENDING**                                             |       | $        | 8,262      |     | $          | 11,324 |   |

 

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**SUMMARY OF ACCOUNTING POLICIES**

 

(NOTE 1) NATURE OFBUSINESS AND ****BASIS OF PRESENTATION****

 

*Nature of Business*

 

Northern CaliforniaBancorp, Inc. (the “Corporation”) was incorporated on August 29,1995, as a for-profit corporation under the California Corporate laws for theprincipal purpose of engaging in banking and non-banking activities as allowedfor a bank holding company. The Corporation’s sources of revenues at this timeare dividends on investments, gains on securities transactions and potentialdividends, management fees and tax equalization payments, if any, from theBank.

 

The Corporation owns 100%of Monterey County Bank (the “Bank”) which operates five full service branchesin Monterey County, California. The Corporation owns 100% of the common stockof two unconsolidated special purpose business trusts, “Northern CaliforniaBancorp, Inc. Trust I” and “Northern California Bancorp, Inc. TrustII”.

 

*Basis of Presentation*

 

Theinterim condensed financial statements of Northern California Bancorp, Inc.and subsidiary (“Corporation”) are unaudited and reflect all adjustments(consisting only of normal recurring adjustments), which are, in the opinion ofmanagement, necessary for a fair presentation, in all material respects, of thefinancial position and operating results of the Corporation for the interimperiods.  The results of operations for the nine months ended September 30,2008 are not necessarily indicative of the results to be expected for theentire fiscal year ending December 31, 2008.  The year-endbalance sheet data at December 31, 2007 was derived from the auditedfinancial statements. All material intercompany balances and transactions havebeen eliminated in consolidation.

 

Thisfinancial information should be read in conjunction with the audited financialstatements and notes thereto included in the Corporation’s Form 10-KSB forthe fiscal year ended December 31, 2007.

 

(NOTE 2) RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

 

InSeptember 2006, the Financial Accounting Standards Board (FASB) issuedStatement of Financial Accounting Standard (SFAS) No. 157, *Fair Value Measurements,* which definesfair value, establishes a framework for measuring fair value, and expandsdisclosures about fair value measurements. SFAS No. 157 does not requireany new fair value measurements, but applies under other existing accountingpronouncements that require or permit fair value measurements. SFAS No. 157emphasizes that fair value is a market-based measurement, not anentity-specific measurement and, therefore, should be determined based on theassumptions that market participants would use in pricing that asset orliability. SFAS No. 157 also establishes a fair value hierarchy thatdistinguishes between market participant assumptions developed based on marketdata obtained from independent sources and the Corporation’s own assumptionsabout market participant assumptions based on the best information available.SFAS No. 157 is effective for financial statements issued for fiscal yearsbeginning after November 15, 2007 and interim periods within those fiscalyears with earlier adoption permitted.  The adoption of SFAS 

 

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No. 157did not have an impact on the Corporation’s consolidated financial statementsand results of operations.

 

InFebruary 2007, the FASB issued SFAS No. 159, *The Fair Value Option for Financial Assets andFinancial Liabilities – including an amendment of FASB Statement No. 115*which is effective for financial statements issued for fiscal years beginningafter November 15, 2007.

 

The Corporation adoptedSFAS 159 on January 1, 2008.  The Corporation did not elect thefair value option, under SFAS 159, for any of our existing financial assets orfinancial liabilities as of January 1, 2008, nor have we elected the fairvalue option for any new financial assets or financial liabilities originatedor entered into during the nine months ended 2008.

 

OnSeptember 7, 2006, the Task Force reached a consensus on EITF Issue No. 06-4,Accounting for Deferred Compensation and Postretirement Benefit Aspects ofEndorsement Split-Dollar Life Insurance Arrangements (“EITF 06-4”) and on March 15,2007, the Task Force reached a consensus on EITF Issue No. 06-10,Accounting for Collateral Assignment Split-Dollar Life Insurance Arrangements(“EITF06-10”). The scope of these two issues relates to the recognition of aliability and related compensation costs for endorsement split-dollar lifeinsurance arrangements and for collateral assignment split-dollar lifeinsurance arrangements, respectively. EITF 06-4 and EITF 06-10 are botheffective for fiscal years beginning after December 15, 2007, althoughearly adoption is permitted. The Corporation adopted EITF 06-4 and EITF 06-10effective as of January 1, 2008 as a change in accounting principlethrough a $362,000 cumulative-effect adjustment to retained earnings. BeginningJanuary 1, 2008, a monthly charge to expense of approximately $9,143 ismade to recognize the liability for future benefits.

 

(NOTE3) STOCK BASED COMPENSATION

 

TheCorporation records compensation expense associated with stock-based awards inaccordance with (SFAS) No. 123 (revised 2004), *Share-Based Payment* (SFAS No. 123R) as interpreted bySEC Staff Accounting Bulletin No. 107. SFAS No. 123R supersedes APB No. 25,and amends SFAS No. 95 *Statement ofCash Flows*. Generally, the approach in SFAS No. 123R is similarto the approach described in SFAS No. 123, *Accounting for Stock Based Compensation*(SFAS No. 123). However, SFAS No. 123R requires all stock-based payments toemployees, including grants of employee stock options, to be recognized in theincome statement based on their fair values at the date of grant. Nostock-based compensation expense was recorded for the nine months ended September 30,2008 and 2007, respectively.  The Corporation selected to use the modifiedprospective method of adopting SFAS 123R.  Thus, stock option expense isrecognized only for options that vested after January 1, 2006. Future compensation expense may be greater if additional stock options aregranted by the Corporation.

 

Underthe Corporation’s 1998 Stock Option Plan, the Corporation may grant incentivestock options and non-qualified stock options to directors, officers, andemployees of the Corporation and its subsidiary, so long as the Corporationowns a majority of the equity interest of such subsidiary. Incentive stockoptions are granted at fair value of the common stock on the date of grant. However,an incentive stock option granted to an individual owning 10% or more of theCorporation’s stock after such grant must have an exercise price of at least110%****of such fair market value and anexercise period of not more than five years. Non-qualified stock options may begranted at prices not lower than 85% of the fair market value of the commonstock on the date of grant. The Board of Directors is authorized to determinewhen options become exercisable within a period not exceeding 10 years from thedate of grant. Under the Plan,

 

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64,661shares of common stock have been reserved for the granting of these options. AtSeptember 30, 2008, 64,661 options were outstanding. During 2008, nooptions were granted, and 4,000 options were exercised by officers, employees,and board members. As of September 30, 2008, all options have been vestedand all related compensation expense has been formerly expensed.

 

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

 

Underthe Corporation’s 2007 Stock Option Plan, the Corporation may grant incentivestock options and non-qualified stock options to directors, officers, andemployees of the Corporation and its subsidiary, so long as the Corporationowns a majority of the equity interest of such subsidiary. Incentive stockoptions are granted at fair value of the common stock on the date of grant. However,an incentive stock option granted to an individual owning 10% or more of theCorporation’s stock after such grant must have an exercise price of at least110%****of such fair market value and anexercise period of not more than five years. The Board of Directors isauthorized to determine when options become exercisable within a period notexceeding 10 years from the date of grant. Under the Plan, 300,000 shares ofcommon stock have been reserved for the granting of these options. At September 30,2008, no options were granted or outstanding.

 

**No pre-tax stock-based compensation expense was requiredfor the nine months ended September 30, 2008 and 2007. There were nooptions granted during the nine months ended September 30, 2008 or 2007.**

** **

(NOTE 4) EARNINGS PER SHARE

 

**Basic earnings per share represents income available tocommon stockholders divided by the weighted-average number of common sharesoutstanding during the period. Diluted earnings per share reflects additionalcommon shares that would have been outstanding, if potential dilutive commonshares had been issued, as well as any adjustment to income that would resultfrom the assumed issuance. Potential common shares that may be issued by theBank relate to outstanding stock options and warrants and are determined usingthe treasury stock method.**

** **

**The weighted-average number of shares used in computingbasic and diluted earnings per share is as follows:**

 
| ** **                                                         | ** ** | **Earnings per share Calculation**                        | ** ** |
|--------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| ** **                                                         | ** ** | **For the nine months ended September 30** | ** ** |
| ** **                                                         | ** ** | **2008**                                                                 | ** ** | **2007** | ** ** |
| ** **                                                         | ** ** | ** **                                                               | ** ** | **Weighted** | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** |
| ** **                                                         | ** ** | **Net**                                                                  | ** ** | **Average** | ** ** | **Per Share** | ** ** | **Net** | ** ** | **Average** | ** ** | **Per Share** | ** ** |
| ** **                                                         | ** ** | **Income**                                                               | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Income** | ** ** | **Shares** | ** ** | **Amount** | ** ** |
| Basic earnings  per share                                          |       | $                                                                        | 1,010      |   | 1,830,699 |   | $ | 0.552 |   | $ | 1,485 |   | 1,744,444 |   | $ | 0.851 |   |
|                                                               |       |                                                                     |       |   |   |   |   |   |   |   |   |   |   |
| Effect of  dilutive shares assumed exercise of outstanding options |       | —                                                                   |       | 30,411 |   | (0.009 | ) | — |   | 106,927 |   | (0.049 | ) |
|                                                               |       |                                                                     |       |   |   |   |   |   |   |   |   |   |   |
| Diluted earnings  per share                                        |       | $                                                                        | 1,010      |   | 1,861,110 |   | $ | 0.543 |   | $ | 1,485 |   | 1,851,371 |   | $ | 0.802 |   |

** **

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** **
| ** **                                              | ** ** | **September 30** | ** ** | **December 31** | ** ** |
|---------------------------------------------------------|------------|-----------------------|------------|----------------------|------------|
| **(in thousands)**                                 | ** ** | **2008**              | ** ** | **2007**             | ** ** |
|                                                    |       |                  |       |                 |       |
| (NOTE 5)  INVESTMENT SECURITIES:                        |       |                  |       |                 |       |
|                                                    |       |                  |       |                 |       |
| Available for  sale:                                    |       |                  |       |                 |       |
| Corporate Debt  Securities                              |       | $                     | 1,500      |                 | $          | — |   |
| Government  National Mortgage Association               |       | —                |       | 385                  |       |
| Mortgage Backed  Securities                             |       | 2,753                 |       | —               |       |
| State/Local  Agency                                     |       | 20,161                |       | 225                  |       |
| U.S. government  Agencies                               |       | 51,924                |       | 36,191               |       |
|                                                    |       | $                     | 76,338     |                 | $          | 36,801 |   |
|                                                    |       |                  |       |                 |       |
| Held to  maturity:                                      |       |                  |       |                 |       |
| State/Local  Agency                                     |       | $                     | —     |                 | $          | 7,869 |   |
|                                                    |       |                  |       |                 |       |
| (NOTE 6) OTHER  INVESTMENTS                             |       |                  |       |                 |       |
|                                                    |       |                  |       |                 |       |
| AT Services LLC                                         |       | $                     | 20         |                 | $          | 20 |   |
| Federal Home  Loan Bank stock, restricted               |       | 2,881                 |       | 2,495                |       |
| Independent  Bankers Financial Corporation              |       | 51                    |       | 51                   |       |
| Metrocities  Mortgage, LLC                              |       | 10                    |       | 10                   |       |
| Northern  California Bancorp, Inc. Trust I         |       | 93                    |       | 93                   |       |
| Northern  California Bancorp, Inc. Trust II        |       | 155                   |       | 155                  |       |
| Visa, Inc.                                         |       | 437                   |       | —               |       |
|                                                    |       | $                     | 3,647      |                 | $          | 2,824 |   |
|                                                    |       |                  |       |                 |       |
| (NOTE 7) LOANS  and ALLOWANCE FOR POSSIBLE LOAN LOSSES: |       |                  |       |                 |       |
|                                                    |       |                  |       |                 |       |
| Commercial and  Industrial                              |       | $                     | 29,726     |                 | $          | 28,310 |   |
| Construction                                            |       | 17,179                |       | 23,396               |       |
| Real Estate -  Mortgage                                 |       | 113,285               |       | 116,625              |       |
| Installment                                             |       | 859                   |       | 876                  |       |
| Government  Guaranteed Loans Purchased                  |       | 26                    |       | 32                   |       |
|                                                    |       | 161,075               |       | 169,239              |       |
| Allowance for  loan losses                              |       | (2,280                | )          | (2,028               | )          |
| Deferred  origination fees, net                         |       | (287                  | )          | (350                 | )          |
| Net Loans                                               |       | $                     | 158,508    |                 | $          | 166,861 |   |
|                                                    |       |                  |       |                 |       |
| Balance at Beginning  of Period                         |       | $                     | 2,028      |                 | $          | 1,409 |   |
| Recoveries                                              |       | 2                     |       | 4                    |       |
| Provision for  Possible Loan Losses                     |       | 250                   |       | 865                  |       |
| Loans Charged  Off                                      |       | —                |       | (250                 | )          |
| Balance at End  of Period                               |       | $                     | 2,280      |                 | $          | 2,028 |   |

** **

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** **

(NOTE 8) COMPREHENSIVE INCOME (LOSS):

 

Thecomponents of other comprehensive income (loss) and related tax effects for thenine month period ended September 30, 2008 and the year ended December 31,2007 are as follows:

 
| ** **                                                                                | ** ** | **September 30** | ** ** | **December 31** | ** ** |
|-------------------------------------------------------------------------------------------|------------|-----------------------|------------|----------------------|------------|
| ** **                                                                                | ** ** | **2008**              | ** ** | **2007**             | ** ** |
| ** **                                                                                | ** ** | **(Unaudited)**       | ** ** | **(Audited)**        | ** ** |
| Unrealized  holding gains (losses) on available for sale securities and other assets, net |       | $                     | (5,242     | )                    | $          | 438 |   |
| Reclassification  for (gains) losses realized in income                                   |       | 449                   |       | (216                 | )          |
| Net unrealized  gains (losses)                                                            |       | (4,793                | )          | 222                  |       |
| Tax effect                                                                                |       | 2,157                 |       | (100                 | )          |
|                                                                                      |       |                  |       |                 |       |
| Net-of-tax  amount                                                                        |       | $                     | (2,636     | )                    | $          | 122 |   |

 

Thecomponents of accumulated othercomprehensive income (loss) and related tax effects are as follows:

 
| ** **                                                             | ** ** | **September 30** | ** ** | **December 31** | ** ** |
|------------------------------------------------------------------------|------------|-----------------------|------------|----------------------|------------|
| ** **                                                             | ** ** | **2008**              | ** ** | **2007**             | ** ** |
| ** **                                                             | ** ** | **(Unaudited)**       | ** ** | **(Audited)**        | ** ** |
| Unrealized  holding gains (losses) on available for sale securities    |       | $                     | (4,634     | )                    | $          | 163 |   |
| Unrealized  holding gains on available for sale asset strip receivable |       | 25                    |       | 21                   |       |
| Tax effect                                                             |       | 2,074                 |       | (83                  | )          |
|                                                                   |       |                  |       |                 |       |
| Net-of-tax  amount                                                     |       | $                     | (2,535     | )                    | $          | 101 |   |

 
| (NOTE 9)  SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: |       |                  |       |     |       |
|--------------------------------------------------------------|------------|-----------------------|------------|----------|------------|
|                                                         |       |                  |       |     |       |
| ** **                                                   | ** ** | **September 30** | ** ** |
| ** **                                                   | ** ** | **2008**              | ** ** | **2007** | ** ** |
| Payments during the period ending:       |       |                  |       |     |       |
| Interest                                                     |       | $                     | 7,400      |     | $          | 5,000 |   |
| Income Taxes                                                 |       | $                     | 1,120      |     | $          | 1,041 |   |
|                                                         |       |                  |       |     |       |
| Noncash  Investing and Financing Activities:                 |       |                  |       |     |       |
| Transfer of  loans to other real estate owned                |       | $                     | 6,349      |     | $          | — |   |

** **

(NOTE 10) FAIR VALUE MEASUREMENTS:

 

Effective January 1, 2008, the Corporationadopted SFAS No. 157, which establishes a hierarchy for measuring fairvalue under GAAP. This standard applies to all financial assets and liabilitiesthat are being measured and reported at fair value on a recurring andnon-recurring basis. Fair value is measured in levels, which are described inmore detail below, and is 

 

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determined based on the observability andreliability of the assumptions used to determine fair value.

 

**Level 1:** Valuation forassets and liabilities traded in active exchange markets. Valuations areobtained from readily available pricing sources for market transactionsinvolving identical assets or liabilities.

 

**Level 2:** Valuation forassets and liabilities traded in less active dealer or broker markets.Valuations are obtained from third party pricing services for identical orcomparable assets or liabilities.

 

**Level 3:** Valuation forassets and liabilities that are derived from other valuation methodologies,including option pricing models, discounted cash flow models, and similartechniques, and not based on market exchange, dealer, or broker tradedtransactions. These valuations incorporate certain assumptions and projectionsin determining the fair value assigned to such assets or liabilities.

 

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

 
| ** **                     | ** ** | **At September 30, 2008** | ** ** |
|--------------------------------|------------|------------------------------------------|------------|
| ** **                     | ** ** | **Total**                                | ** ** | **(Level 1)** | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
| Available-for-sale  securities |       | $                                        | 76,338     |   | $ | — |   | $ | 76,338 |   | $ | — |   |
|                           |       |                                     |       |   |   |   |   |   |   |
| Total                          |       | $                                        | 76,338     |   | $ | — |   | $ | 76,338 |   | $ | — |   |

 

The Corporation may also be required, from time totime, to measure certain other financial assets at fair value on anon-recurring basis in accordance with GAAP. During the nine months ended September 30,2008, we measured collateral dependent impaired loans and other real estateowned (OREO) at fair value. The assets are measured at fair value on anon-recurring basis and the following table provides the assets’ SFAS No. 157designated levels, as well as the fair value losses recognized during the ninemonths ended September 30, 2008.

 
| ** **     | ** ** | **Total** | ** ** | **(Level 1)** | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** | **Losses for the  nine months  ended  September 30,  2008** | ** ** |
|----------------|------------|-----------|------------|--------------------|------------|--------------------|------------|--------------------|------------|---------------------------------------------------------------------------------|------------|
| Impaired loans |       | $         | 5,327      |               | $          | —             |       | $                  | —     |                                                                            | $          | 5,327 |   | $ | 447 |   |
| OREO           |       | 6,349     |       | —             |       | —             |       | 6,349              |       | 532                                                                             |       |
|           |       | $         | 11,676     |               | $          | —             |       | $                  | —     |                                                                            | $          | 11,676 |   | $ | 979 |   |

 

Because the Corporation did not elect the fair valueoption for any financial assets or liabilities under SFAS No. 159, therewere no other assets or liabilities that have been measured at fair valueduring the nine months ended September 30, 2008.

 

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(NOTE 11) OFF-BALANCE SHEET COMMITMENTS:

 

The Bank is a party tofinancial instruments with off-balance-sheet risk in the normal course ofbusiness to meet the financing needs of its customers. These financialinstruments include commitments to extend credit. Such commitments involve, tovarying degrees, elements of credit and interest rate risk in excess of theamount recognized in the consolidated balance sheets.

 

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

 

**At September 30, 2008 and December 31, 2007, suchcommitments to extend credit were $15,939,000 and $20,794,000, respectively, ofundisbursed lines of credit, undisbursed loans in process, and commitmentletters.**

** **

**The Bank has a letter of credit in the amount of$330,000, expiring April 17, 2011, issued by Federal Home Loan Bank of SanFrancisco, which is used to secure local agency deposits. The beneficiary ofthe letter of credit is the Administrator of Local Agency Security, Departmentof Financial Institutions.**

** **

**SubsequentEvent**

 

On October 3, 2008, Congress passed theEmergency Economic Stabilization Act of 2008 (EESA), which provides the U. S.Treasury with broad authority to implement certain actions to help restorestability and liquidity to U.S. markets.  One of the provisions resultingfrom the Act is the Treasury Capital Purchase Program (CPP), which providesdirect equity investment of perpetual preferred stock by the Treasury inqualified financial institutions.  The program is voluntary and requiresan institution to comply with a number of restrictions and provisions,including limits on executive compensation, stock redemptions and declarationof dividends.  Applications must be submitted by November 14, 2008and are subject to approval by the Treasury.  The CPP provides for aminimum investment of 1 percent of Risk-Weighted Assets, with a maximuminvestment equal to the lesser of 3 percent of Total Risk-Weighted Assets or$25 billion.  The perpetual preferred stock investment will have a dividendrate of 5% per year until the fifth anniversary of the Treasury investment, anda dividend of 9% thereafter.  The CPP also requires the Treasury toreceive warrants for common stock equal to 15% of the capital invested by theTreasury.  The Corporation has filed an application to participate in thisprogram.  Participation in the program is not automatic and is subject toapproval by the Treasury.

 

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** **

**ITEM 2:****                              MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

** **

**Statements Regarding Forward-Looking Information**

** **

**Except for historical information contained herein, thematters discussed or incorporated by reference in this report containforward-looking statements within the meaning of Section 27A of theSecurities Act of 1933, as amended (the “Securities Act”), and Section 21Eof the Securities Exchange Act of 1934 (the “Exchange Act”), that involvesubstantial risks and uncertainties.  When used in this report, or in thedocuments incorporated by reference herein, the words “anticipate,” “believe,” “estimate,”“may,” “intend,” “expect,” and similar expressions identify certain of suchforward-looking statements.  Actual results of Monterey County Bank coulddiffer materially from such forward-looking statements contained herein. Factors that could cause future results to vary from current expectationsinclude, but are not limited to, the following: changes in economic conditions(both generally and more specifically in the markets in which the Bankoperates); changes in interest rates, deposit flows, loan demand, real estatevalues and competition; changes in accounting principles, policies orguidelines and in government legislation and regulation (which change from timeto time and over which the Bank has no control); other factors affecting theBank’s operations, markets, products and services; and other risks detailed inthis Form 10-Q and in the Bank’s other reports filed with the FederalDeposit Insurance Corporation and pursuant to the rules and regulations ofthe Securities and Exchange Commission.  Readers are cautioned not toplace undue reliance on these forward-looking statements, which reflectmanagement’s analysis only as of the date hereof.  The Corporationundertakes no obligation to publicly revise these forward-looking statements toreflect events or circumstances that arise after the date thereof.**

** **

**CRITICALACCOUNTING POLICIES**

 

Thepreparation of financial statements in accordance with accounting principlesgenerally accepted in the United States of America requires management to makea number of judgments, estimates and assumptions that affect the reportedamount of assets, liabilities, income and expenses in the Corporation’sfinancial statements and accompanying notes. Management believes that thejudgments, estimates and assumptions used in preparation of the Corporation’sfinancial statements are appropriate given the factual circumstances as of September 30,2008.

 

Various elements of the Corporation’s accountingpolicies, by their nature, are inherently subject to estimation techniques,valuation assumptions and other subjective assessments. Critical accountingpolicies are those that involve the most complex and subjective decisions andassessments and have the greatest potential impact on the Corporation’s resultsof operation. In particular, management has identified one accounting policythat, due to judgments, estimates and assumptions inherent in this policy, andthe sensitivity of the Corporation’s financial statements to those judgments,estimates and assumptions, is critical to an understanding of the Corporation’sfinancial statements. This policy relates to the methodology that determinesthe Corporation’s allowance for loan losses. Management has discussed thedevelopment and selection of this critical accounting policy with theCorporation’s Audit Committee of the Board of Directors. Although Managementbelieves the level of the allowance at September 30, 2008 is adequate toabsorb losses inherent in the loan portfolio, a decline in the regional economymay 

 

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result in increasing losses that cannot reasonably be predicted at thistime. For further information regarding the allowance for loan losses see “Provisionand Allowance for Loan Losses” included elsewhere herein.

 

**OVERVIEW**

 

Thefollowing discussion reviews and analyzes the operating results and financialcondition of the Corporation, focusing on the Bank. It should be read inconjunction with the financial statements and the other financial datapresented elsewhere herein.

 

Forthe nine months ended September 30, 2008 net income was $1,010,000,compared to $1,485,000 for the same period in 2007. For the nine months ended September 30,2008 net interest income decreased $1,346,000, total non-interest incomeincreased $360,000, non-interest expense increased $131,000 and the income taxprovision decreased $477,000.

 

Thefollowing table sets forth certain selected financial ratios of the Corporationfor the three and nine months ended September 30, 2008 and 2007.

 
| ** **                                           | ** ** | **Three Months Ended September 30** | ** ** | **Nine months Ended September 30** | ** ** |
|------------------------------------------------------|------------|---------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                           | ** ** | **2008**                                                | ** ** | **2007**                                               | ** ** | **2008** | ** ** | **2007** | ** ** |
| Summary of  Operating Results:                       |       |                                                    |       |                                                   |       |   |   |   |   |
|                                                 |       |                                                    |       |                                                   |       |   |   |   |   |
| Total interest  income                               |       | $                                                       | 3,943      |                                                   | $          | 4,383 |   | $ | 12,539 |   | $ | 12,214 |   |
| Total interest  expense                              |       | 2,399                                                   |       | 2,173                                                  |       | 7,305 |   | 5,634 |   |
| Net interest  income                                 |       | 1,544                                                   |       | 2,210                                                  |       | 5,234 |   | 6,580 |   |
|                                                 |       |                                                    |       |                                                   |       |   |   |   |   |
| Provision for  possible loan losses                  |       | 250                                                     |       | 140                                                    |       | 250 |   | 415 |   |
| Net interest  income after provision for loan losses |       | 1,294                                                   |       | 2,070                                                  |       | 4,984 |   | 6,165 |   |
|                                                 |       |                                                    |       |                                                   |       |   |   |   |   |
| Total  non-interest income                           |       | 1,133                                                   |       | 904                                                    |       | 3,618 |   | 3,258 |   |
| Total  non-interest expenses                         |       | 2,316                                                   |       | 2,197                                                  |       | 6,791 |   | 6,660 |   |
|                                                 |       |                                                    |       |                                                   |       |   |   |   |   |
| Income before  taxes                                 |       | 111                                                     |       | 777                                                    |       | 1,811 |   | 2,763 |   |
| Provision for  (benefit of) income taxes             |       | (43                                                     | )          | 413                                                    |       | 801 |   | 1,278 |   |
|                                                 |       |                                                    |       |                                                   |       |   |   |   |   |
| Net income                                           |       | $                                                       | 154        |                                                   | $          | 364 |   | $ | 1,010 |   | $ | 1,485 |   |
|                                                 |       |                                                    |       |                                                   |       |   |   |   |   |
| Per Common Share  Data:                              |       |                                                    |       |                                                   |       |   |   |   |   |
|                                                 |       |                                                    |       |                                                   |       |   |   |   |   |
| Net income -  Primary (1)                            |       | $                                                       | 0.084      |                                                   | $          | 0.207 |   | $ | 0.552 |   | $ | 0.851 |   |
| Net income -  Diluted (2)                            |       | 0.083                                                   |       | 0.180                                                  |       | 0.543 |   | 0.802 |   |
| Book value, end  of period                           |       | 6.67                                                    |       | 7.95                                                   |       | 6.67 |   | 7.95 |   |
| Avg shares  outstanding (3)                          |       | 1,810,618                                               |       | 1,793,961                                              |       | 1,830,699 |   | 1,744,444 |   |
|                                                 |       |                                                    |       |                                                   |       |   |   |   |   |
| Balance Sheet  Data:                                 |       |                                                    |       |                                                   |       |   |   |   |   |
|                                                 |       |                                                    |       |                                                   |       |   |   |   |   |
| Total loans, net  of unearned income (4)             |       | $                                                       | 159,756    |                                                   | $          | 156,422 |   | $ | 159,756 |   | $ | 156,422 |   |
| Total assets                                         |       | 276,606                                                 |       | 229,129                                                |       | 276,606 |   | 229,129 |   |
| Total deposits                                       |       | 182,111                                                 |       | 151,569                                                |       | 182,111 |   | 151,569 |   |
| Stockholders’  equity                           |       | 12,117                                                  |       | 14,264                                                 |       | 12,117 |   | 14,264 |   |

 

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| ** **                                                     | ** ** | **Three Months Ended September 30** | ** ** | **Nine months Ended September 30** | ** ** |
|----------------------------------------------------------------|------------|---------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                                     | ** ** | **2008**                                                | ** ** | **2007**                                               | ** ** | **2008** | ** ** | **2007** | ** ** |
| Selected  Financial Ratios:                                    |       |                                                    |       |                                                   |       |   |   |   |   |
|                                                           |       |                                                    |       |                                                   |       |   |   |   |   |
| Return on  average assets (5) (6)                         |       | 0.23                                                    | %          | 0.66                                                   | %          | 0.51 | % | 0.98 | % |
| Return on  average stockholders’ equity (5) (6)      |       | 4.80                                                    | %          | 10.45                                                  | %          | 9.62 | % | 14.73 | % |
| Net interest  spread                                           |       | 2.21                                                    | %          | 3.69                                                   | %          | 2.44 | % | 4.09 | % |
| Net yield on  interest earning assets (5)                      |       | 2.63                                                    | %          | 4.37                                                   | %          | 2.95 | % | 4.78 | % |
| Avg  shareholders’ equity to average assets (5)           |       | 4.70                                                    | %          | 6.27                                                   | %          | 5.25 | % | 6.63 | % |
| Risked-Based  capital ratios                                   |       |                                                    |       |                                                   |       |   |   |   |   |
| Tier 1                                                         |       | 8.84                                                    | %          | 9.70                                                   | %          | 8.84 | % | 9.70 | % |
| Total                                                          |       | 13.89                                                   | %          | 13.03                                                  | %          | 13.89 | % | 13.03 | % |
| Total loans to  total deposits at end of period (4)            |       | 87.72                                                   | %          | 103.20                                                 | %          | 87.72 | % | 103.20 | % |
| Allowance for  loan losses to total loans at end of period (4) |       | 1.40                                                    | %          | 1.00                                                   | %          | 1.40 | % | 1.00 | % |
| Nonperforming  loans to total loans at end of period (4)       |       | 3.23                                                    | %          | 0.12                                                   | %          | 3.23 | % | 0.12 | % |
| Net charge-offs  to average loans (4)                          |       | 0.00                                                    | %          | 0.18                                                   | %          | 0.00 | % | 0.18 | % |

 

----

(1)         Basicearnings per share amounts were computed on the basis of the weighted averagenumber of shares of common stock outstanding during the year. The weightedaverage number of common shares used for this computation was 1,830,699 and1,744,444 for September 30, 2008 and 2007, respectively.

 

(2)         Dilutedearnings per share amounts were computed on the basis of the weighted averagenumber of shares of common stock and common stock equivalents outstandingduring the year. Common stock equivalents include director/employee stockoptions. The weighted average number of shares used for this computation was1,861,110 and 1,851,371 for September 30, 2008 and 2007, respectively.

 

(3)         Weightedaverage common shares.

 

(4)         Includesloans being held for sale.

 

(5)         Averagesare of daily balances.

 

(6)         September 30,2008 calculated on an annualized basis.

 

**NETINTEREST INCOME**

 

Netinterest income, the difference between (a) interest and fees earned oninterest-earning assets and (b) interest paid on interest-bearingliabilities, is the most significant component of the Bank’s earnings. Changesin net interest income from period to period result from increases or decreasesin the average balances of interest-earning assets and interest-

 

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earning liabilities, theavailability of particular sources of funds and changes in prevailing interestrates.

 

Netinterest income for the nine months ended September 30, 2008 was$5,234,000 compared to $6,580,000 for the same period in 2007. The decrease of$1,346,000 resulted primarily from the decline in loan rates as shown on page 20in the rate and volume analysis table and a reduction in interest income of$332,300 on loans on non-accrual status during the period.

 

Thefollowing tables show the components of the Bank’s net interest income, settingforth, for the quarter and the nine months ended September 30, 2008 and2007, (i) average assets, liabilities and investments, (ii) interestincome earned on interest-earning assets and interest expense paid on interest-bearingliabilities, (iii) average yields earned on interest-earning assets andaverage rates paid on interest-bearing liabilities, (iv) the net interestspread (i.e., the average yield earned on interest-earning assets less theaverage rate paid on interest-bearing liabilities) and (v) the netinterest yield on average interest-earning assets (i.e., net interest incomedivided by average interest-earning assets). Yields are computed on atax-equivalent basis, resulting in adjustments to interest earned on municipalbonds of $246,000 and $107,000 for the nine months ended September 30,2008 and 2007, respectively. Non-accrual loans and overdrafts are included inaverage loan balances. Average loans are presented net of unearned income.

 

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**DISTRIBUTION,RATE AND YIELD ANALYSIS OF NET INTEREST INCOME:**

 

Thefollowing tables show the consolidated average balances of earning assets, andinterest-bearing liabilities; the amount of interest income and interestexpense; the average yield or rate for each category of averageinterest-earning assets and average interest-bearing liabilities; and the netinterest income and the net interest spread for the periods indicated:

 
| ** **                                                  | ** ** | **Three Months Ended September 30, 2008** | ** ** | **Three Months Ended September 30, 2007** | ** ** |
|-------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                  | ** ** | **Average**                                                        | ** ** | ** **                                                         | ** ** | **Yield/** | ** ** | **Average** | ** ** | ** ** | ** ** | **Yield/** | ** ** |
| **(dollars in thousands)**                        | ** ** | **Balance**                                                        | ** ** | **Interest**                                                       | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Rate** | ** ** |
| Assets:                                                     |       |                                                               |       |                                                               |       |   |   |   |   |   |   |   |   |
| Loans                                                       |       | $                                                                  | 162,905    |                                                               | $          | 2,863 |   | 7.03 | % | $ | 150,935 |   | $ | 3,640 |   | 9.65 | % |
| Interest-bearing  deposits - in other banks                 |       | 603                                                                |       | 3                                                                  |       | 1.99 | % | 1,000 |   | 13 |   | 5.37 | % |
| Invest  securities - taxable                                |       | 57,201                                                             |       | 770                                                                |       | 5.38 | % | 36,566 |   | 516 |   | 5.64 | % |
| Invest  securities - nontaxable                             |       | 18,939                                                             |       | 359                                                                |       | 7.58 | % | 7,127 |   | 120 |   | 6.71 | % |
| Federal funds  sold                                         |       | 11,640                                                             |       | 58                                                                 |       | 1.99 | % | 10,245 |   | 133 |   | 5.20 | % |
| Total  interest-earning assets                              |       | 251,288                                                            |       | 4,053                                                              |       | 6.45 | % | 205,873 |   | 4,422 |   | 8.59 | % |
|                                                        |       |                                                               |       |                                                               |       |   |   |   |   |   |   |   |   |
| Allowance for  credit losses                                |       | (2,032                                                             | )          |                                                               |       |   |   | (1,443 | ) |   |   |   |   |
| Non-interest  bearing assets:                               |       |                                                               |       |                                                               |       |   |   |   |   |   |   |   |   |
| Cash and due  from banks                                    |       | 6,713                                                              |       |                                                               |       |   |   | 6,024 |   |   |   |   |   |
| Premises and  equipment                                     |       | 5,086                                                              |       |                                                               |       |   |   | 4,929 |   |   |   |   |   |
| Accrued interest  receivable                                |       | 1,666                                                              |       |                                                               |       |   |   | 1,219 |   |   |   |   |   |
| Other assets                                                |       | 10,217                                                             |       |                                                               |       |   |   | 5,486 |   |   |   |   |   |
| Total average  assets                                       |       | $                                                                  | 272,938    |                                                               |       |   |   |   | $ | 222,088 |   |   |   |   |   |
|                                                        |       |                                                               |       |                                                               |       |   |   |   |   |   |   |   |   |
| Liabilities and  Shareholders’ Equity:                 |       |                                                               |       |                                                               |       |   |   |   |   |   |   |   |   |
| Interest-bearing  liabilities:                              |       |                                                               |       |                                                               |       |   |   |   |   |   |   |   |   |
| Interest-bearing  demand                                    |       | $                                                                  | 15,802     |                                                               | $          | 10 |   | 0.25 | % | $ | 14,721 |   | $ | 10 |   | 0.27 | % |
| Money market  savings                                       |       | 1,785                                                              |       | 3                                                                  |       | 0.67 | % | 1,513 |   | 3 |   | 0.73 | % |
| Savings deposits                                            |       | 6,728                                                              |       | 17                                                                 |       | 1.01 | % | 4,588 |   | 12 |   | 1.01 | % |
| Time deposits  >$100M                                    |       | 58,815                                                             |       | 647                                                                |       | 4.40 | % | 50,863 |   | 673 |   | 5.29 | % |
| Time deposits  <$100M                                    |       | 72,329                                                             |       | 816                                                                |       | 4.51 | % | 52,609 |   | 698 |   | 5.30 | % |
| Other Borrowing                                             |       | 70,738                                                             |       | 907                                                                |       | 5.13 | % | 52,987 |   | 779 |   | 5.88 | % |
| Total  interest-bearing liabilities                         |       | 226,197                                                            |       | 2,400                                                              |       | 4.24 | % | 177,281 |   | 2,175 |   | 4.90 | % |
|                                                        |       |                                                               |       |                                                               |       |   |   |   |   |   |   |   |   |
| Non-interest  bearing liabilities:                          |       |                                                               |       |                                                               |       |   |   |   |   |   |   |   |   |
| Noninterest-bearing  checking                               |       | 26,024                                                             |       |                                                               |       |   |   | 25,728 |   |   |   |   |   |
| Accrued interest  payable                                   |       | 1,851                                                              |       |                                                               |       |   |   | 1,619 |   |   |   |   |   |
| Other  liabilities                                          |       | 6,026                                                              |       |                                                               |       |   |   | 3,566 |   |   |   |   |   |
| Total  Liabilities                                          |       | 260,098                                                            |       |                                                               |       |   |   | 208,194 |   |   |   |   |   |
| Total  shareholders equity                                  |       | 12,840                                                             |       |                                                               |       |   |   | 13,894 |   |   |   |   |   |
| Total average  liabilities and shareholders equity          |       | $                                                                  | 272,938    |                                                               |       |   |   |   | $ | 222,088 |   |   |   |   |   |
| Net interest  income                                        |       |                                                               |       | $                                                                  | 1,653      |   |   |   |   |   | $ | 2,247 |   |   |   |
| Interest income  as a percentage of average earning assets  |       |                                                               |       |                                                               |       | 6.45 | % |   |   |   |   | 8.59 | % |
| Interest expense  as a percentage of average earning assets |       |                                                               |       |                                                               |       | 3.82 | % |   |   |   |   | 4.23 | % |
| Net yield on  interest earning assets                       |       |                                                               |       |                                                               |       | 2.63 | % |   |   |   |   | 4.36 | % |
|                                                        |       |                                                               |       |                                                               |       |   |   |   |   |   |   |   |   |
| Net interest  spread                                        |       |                                                               |       |                                                               |       | 2.21 | % |   |   |   |   | 3.68 | % |

 

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| ** **                                                  | ** ** | **Nine months Ended September 30, 2008** | ** ** | **Nine months Ended September 30, 2007** | ** ** |
|-------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                                  | ** ** | **Average**                                                       | ** ** | ** **                                                        | ** ** | **Yield/** | ** ** | **Average** | ** ** | ** ** | ** ** | **Yield/** | ** ** |
| **(dollars in thousands)**                        | ** ** | **Balance**                                                       | ** ** | **Interest**                                                      | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Rate** | ** ** |
| Assets:                                                     |       |                                                              |       |                                                              |       |   |   |   |   |   |   |   |   |
| Loans                                                       |       | $                                                                 | 167,304    |                                                              | $          | 9,574 |   | 7.63 | % | $ | 140,301 |   | $ | 10,373 |   | 9.86 | % |
| Time deposits -  in other banks                             |       | 693                                                               |       | 16                                                                |       | 3.00 | % | 1,048 |   | 41 |   | 5.28 | % |
| Invest  securities - taxable                                |       | 53,962                                                            |       | 2,192                                                             |       | 5.42 | % | 28,912 |   | 1,194 |   | 5.51 | % |
| Invest  securities - nontaxable                             |       | 14,682                                                            |       | 794                                                               |       | 7.21 | % | 7,049 |   | 346 |   | 6.54 | % |
| Federal funds  sold                                         |       | 11,200                                                            |       | 209                                                               |       | 2.49 | % | 9,382 |   | 367 |   | 5.21 | % |
| Total  interest-earning assets                              |       | 247,841                                                           |       | 12,785                                                            |       | 6.88 | % | 186,692 |   | 12,321 |   | 8.80 | % |
|                                                        |       |                                                              |       |                                                              |       |   |   |   |   |   |   |   |   |
| Allowance for  credit losses                                |       | (2,053                                                            | )          |                                                              |       |   |   | (1,386 | ) |   |   |   |   |
| Non-interest  bearing assets:                               |       |                                                              |       |                                                              |       |   |   |   |   |   |   |   |   |
| Cash and due  from banks                                    |       | 6,479                                                             |       |                                                              |       |   |   | 6,358 |   |   |   |   |   |
| Premises and  equipment                                     |       | 4,989                                                             |       |                                                              |       |   |   | 4,848 |   |   |   |   |   |
| Accrued interest  receivable                                |       | 1,494                                                             |       |                                                              |       |   |   | 1,099 |   |   |   |   |   |
| Other assets                                                |       | 6,995                                                             |       |                                                              |       |   |   | 5,124 |   |   |   |   |   |
| Total average  assets                                       |       | $                                                                 | 265,745    |                                                              |       |   |   |   | $ | 202,735 |   |   |   |   |   |
|                                                        |       |                                                              |       |                                                              |       |   |   |   |   |   |   |   |   |
| Liabilities and  Shareholders’ Equity:                 |       |                                                              |       |                                                              |       |   |   |   |   |   |   |   |   |
| Interest Bearing  Liabilities:                              |       |                                                              |       |                                                              |       |   |   |   |   |   |   |   |   |
| Interest-bearing  demand                                    |       | $                                                                 | 14,475     |                                                              | $          | 27 |   | 0.25 | % | $ | 14,633 |   | $ | 28 |   | 0.25 | % |
| Money market  savings                                       |       | 1,768                                                             |       | 10                                                                |       | 0.73 | % | 1,793 |   | 10 |   | 0.73 | % |
| Savings deposits                                            |       | 6,180                                                             |       | 49                                                                |       | 1.05 | % | 4,567 |   | 35 |   | 1.01 | % |
| Time deposits  >$100M                                    |       | 60,175                                                            |       | 2,129                                                             |       | 4.72 | % | 43,183 |   | 1,670 |   | 5.16 | % |
| Time deposits  <$100M                                    |       | 70,180                                                            |       | 2,458                                                             |       | 4.67 | % | 48,843 |   | 1,860 |   | 5.08 | % |
| Other Borrowing                                             |       | 66,474                                                            |       | 2,634                                                             |       | 5.28 | % | 46,401 |   | 2,032 |   | 5.84 | % |
| Total  interest-bearing liabilities                         |       | 219,252                                                           |       | 7,307                                                             |       | 4.44 | % | 159,420 |   | 5,635 |   | 4.71 | % |
|                                                        |       |                                                              |       |                                                              |       |   |   |   |   |   |   |   |   |
| Non-interest  bearing liabilities:                          |       |                                                              |       |                                                              |       |   |   |   |   |   |   |   |   |
| Noninterest-bearing  checking                               |       | 25,787                                                            |       |                                                              |       |   |   | 25,777 |   |   |   |   |   |
| Accrued interest  payable                                   |       | 1,989                                                             |       |                                                              |       |   |   | 1,500 |   |   |   |   |   |
| Other  liabilities                                          |       | 4,727                                                             |       |                                                              |       |   |   | 2,597 |   |   |   |   |   |
| Total  Liabilities                                          |       | 251,755                                                           |       |                                                              |       |   |   | 189,294 |   |   |   |   |   |
| Total  shareholders equity                                  |       | 13,990                                                            |       |                                                              |       |   |   | 13,441 |   |   |   |   |   |
| Total average  liabilities and shareholders equity          |       | $                                                                 | 265,745    |                                                              |       |   |   |   | $ | 202,735 |   |   |   |   |   |
| Net interest  income                                        |       |                                                              |       | $                                                                 | 5,478      |   |   |   |   |   | $ | 6,686 |   |   |   |
| Interest income  as a percentage of average earning assets  |       |                                                              |       |                                                              |       | 6.88 | % |   |   |   |   | 8.80 | % |
| Interest expense  as a percentage of average earning assets |       |                                                              |       |                                                              |       | 3.93 | % |   |   |   |   | 4.02 | % |
| Net yield on  interest earning assets                       |       |                                                              |       |                                                              |       | 2.95 | % |   |   |   |   | 4.78 | % |
|                                                        |       |                                                              |       |                                                              |       |   |   |   |   |   |   |   |   |
| Net interest  spread                                        |       |                                                              |       |                                                              |       | 2.44 | % |   |   |   |   | 4.09 | % |

 

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**Rate andVolume Analysis:**

 

Thefollowing tables show the increase or decrease in interest income, interestexpense and net interest income, resulting from changes in rates and volumes,for the three months and nine months ended September 30, 2008 comparedwith the same period in 2007.

 
| ** **                                   | ** ** | **Increase (decrease) in the three months ended**            | ** ** |
|----------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|
| ** **                                   | ** ** | **September 30, 2008 compared with September 30, 2007** | ** ** |
| ** **                                   | ** ** | **Volume**                                                                                 | ** ** | **Rate** | ** ** | **Total** | ** ** |
| Increase  (decrease) in interest income:     |       |                                                                                       |       |   |   |   |   |
| Loans                                        |       | $                                                                                          | 289        |   | $ | (1,066 | ) | $ | (777 | ) |
| Time deposits -  in other banks              |       | (5                                                                                         | )          | (5 | ) | (10 | ) |
| Invest  securities - taxable                 |       | 291                                                                                        |       | (37 | ) | 254 |   |
| Invest  securities - nontaxable              |       | 199                                                                                        |       | 40 |   | 239 |   |
| Federal funds  sold                          |       | 18                                                                                         |       | (93 | ) | (75 | ) |
|                                         |       | 792                                                                                        |       | (1,161 | ) | (369 | ) |
|                                         |       |                                                                                       |       |   |   |   |   |
| Increase  (decrease) in interest expense:    |       |                                                                                       |       |   |   |   |   |
| Interest-bearing  demand                     |       | 1                                                                                          |       | (1 | ) | — |   |
| Money market  savings                        |       | 1                                                                                          |       | (1 | ) | — |   |
| Savings deposits                             |       | 6                                                                                          |       | (1 | ) | 5 |   |
| Time deposits  >$100M                     |       | 105                                                                                        |       | (131 | ) | (26 | ) |
| Time deposits  <$100M                     |       | 262                                                                                        |       | (144 | ) | 118 |   |
| Other Borrowing                              |       | 261                                                                                        |       | (133 | ) | 128 |   |
|                                         |       | 636                                                                                        |       | (411 | ) | 225 |   |
| Increase  (decrease) in net interest income: |       | $                                                                                          | 156        |   | $ | (750 | ) | $ | (594 | ) |

 
| ** **                                   | ** ** | **Increase (decrease) in the nine months ended**             | ** ** |
|----------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|
| ** **                                   | ** ** | **September 30, 2008 compared with September 30, 2007** | ** ** |
| ** **                                   | ** ** | **Volume**                                                                                 | ** ** | **Rate** | ** ** | **Total** | ** ** |
| Increase  (decrease) in interest income:     |       |                                                                                       |       |   |   |   |   |
| Loans                                        |       | $                                                                                          | 1,996      |   | $ | (2,795 | ) | $ | (799 | ) |
| Time deposits -  in other banks              |       | (14                                                                                        | )          | (11 | ) | (25 | ) |
| Invest  securities - taxable                 |       | 1,035                                                                                      |       | (37 | ) | 998 |   |
| Invest  securities - nontaxable              |       | 375                                                                                        |       | 73 |   | 448 |   |
| Federal funds  sold                          |       | 71                                                                                         |       | (229 | ) | (158 | ) |
|                                         |       | 3,463                                                                                      |       | (2,999 | ) | 464 |   |
|                                         |       |                                                                                       |       |   |   |   |   |
| Increase  (decrease) in interest expense:    |       |                                                                                       |       |   |   |   |   |
| Interest-bearing  demand                     |       | —                                                                                     |       | (1 | ) | (1 | ) |
| Money market  savings                        |       | —                                                                                     |       | — |   | — |   |
| Savings deposits                             |       | 12                                                                                         |       | 2 |   | 14 |   |
| Time deposits  >$100M                     |       | 657                                                                                        |       | (198 | ) | 459 |   |
| Time deposits  <$100M                     |       | 813                                                                                        |       | (215 | ) | 598 |   |
| Other Borrowing                              |       | 879                                                                                        |       | (277 | ) | 602 |   |
|                                         |       | 2,361                                                                                      |       | (689 | ) | 1,672 |   |
| Increase  (decrease) in net interest income: |       | $                                                                                          | 1,102      |   | $ | (2,310 | ) | $ | (1,208 | ) |

 

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**Provisionand Allowance for Loan Losses**

 

The Corporation maintains a detailed, systematicanalysis and procedural discipline to determine the amount of the allowance forloan losses (“ALL”).  The ALL is based on estimates and is intendedto be adequate to provide for probable losses inherent in the loanportfolio.  This process involves deriving probable loss estimatesthat are based on individual loan loss estimation, historical loss rates andmanagement’s judgment.

 

The Corporation employs several methodologies forestimating probable losses.  Methodologies are determined based on anumber of factors, including type of asset, risk rating, concentrations, andcollateral value.

 

The Corporation calculates the required ALL on amonthly basis and makes adjusting entries quarterly. The review of theadequacy of the allowance takes into consideration such factors asconcentrations of credit, changes in the growth, size and composition of theloan portfolio, overall and individual portfolio quality, review of specificproblem loans, collateral, guarantees and economic conditions that may affectthe borrowers’ ability to pay and/or the value of the underlyingcollateral.  Additional factors considered include: geographiclocation of borrowers, changes in the Company’s product-specific credit policyand lending staff experience.  These estimates depend on subjectivefactors and, therefore, contain inherent uncertainties.

 

The Corporation’s ALL is maintained at a levelbelieved adequate by management to absorb known and inherent probable losses onexisting loans.  A provision for loan losses is charged toexpense.  The allowance is charged for losses when managementbelieves that full recovery on the loan is unlikely.  Generally, theCompany charges off any loan classified as a “loss”; portions of loans whichare deemed to be uncollectible; overdrafts which have been outstanding for morethan 90 days; and, all other unsecured loans past due 120 or moredays.  Subsequent recoveries, if any, are credited to the ALL.

 

Althoughno assurance can be given that actual losses will not exceed the amountprovided for in the allowance, Management believes that the allowance isadequate to provide for all estimated credit losses in light of all knownrelevant factors. At September 30,2008 and 2007 the Bank’s allowance stood at 1.40 percent and 1.00percent, respectively.

 

Provisionsmade to the allowance during the nine months ended September 30, 2008 and2007 were $250,000 and $415,000, respectively. No loans were charged off duringthe nine months ended September 30, 2008 compared to $250,000 for the sameperiod in 2007. Recoveries during the nine months ended September 30, 2008 and 2007 were$2,000 and $1,000, respectively.

 

Duringthe nine months ending September 30, 2008, $6,881,000 of loans secured byreal estate were foreclosed and transferred to other real estate owned.

 

TheBank’s non-performing (delinquent 90 days or more and on non-accrual) net loansas a percentage of total loans were 3.23 percent and 0.12 percent as of the endof September 30, 2008 and 2007, respectively. The significant increase innon-accrual loans is primarily attributable to the continued economic slowdownand the softening of the real estate market.

 

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**Non-InterestIncome**

 

Totalnon-interest income for the nine months ended September 30, 2008 was $3,618,000compared with $3,258,000 for the same period in 2007. The increase of $360,000primarily resulted from income of $694,000 related to the Visa, Inc.initial public stock offering and increases in gains on sale of securities of$449,000, an increase in merchant credit card discount fees of $232,000;partially offset by a charge of $532,000 to establish an evaluation allowanceon other real estate owned and decreases in sales and servicing of SmallBusiness Administration Loans of $124,000 and a decrease in credit card/storedvalue card revenue of $321,000.

 

TheBank will reduce its sponsorship of credit card and stored value card programsover the next six months by terminating sponsorship agreements on all programsexcept a drug manufactures’ rebate card program. The heightened monitoringrequired for third party relationships to ensure compliance with various lawsand regulations applicable to these types of programs makes it imprudent for theBank to continue with these programs. The characteristics of the drugmanufactures’ rebate card program significantly reduces the same level ofrequired monitoring.

 

Thesale of Small Business Administration (SBA) guaranteed loans is a significantcontributor to the Bank’s income. SBA guaranteed loans yield up to 3 3/4% overthe New York prime rate, and the guaranteed portions can be sold at premiums,which vary with market conditions. SBA loans are guaranteed by the full faithof the United States Government from 75 to 85 percent of the principal amount.

 

Therecan be no assurance that the gains on sale will continue at, or above, thelevels realized in the past three years. In addition, increasing competitionamong lenders for qualified SBA borrowers makes it difficult for the Bank tocontinually expand its program in this area, and may limit the level of premiumthat can be earned with regard thereto.

 

**Non-InterestExpense**

 

Salaryand benefits expense for the nine months ended September 30, 2008 decreased$179,000 compared with the same periods in 2007. The decrease was due toreduced bonus accruals and staff vacancies partially offset by merit pay increases and the hiring in March 2008 of fouremployees to staff the Salinas branch office, which opened during the secondquarter of 2008.

 

Totaloccupancy and equipment expense for the nine months ended September 30, 2008 was $715,000compared to $622,000 for the same period in 2007. The increase was primarilydue to rental expense for the Salinas branch office.

 

Professionalfees for the nine months ended September 30, 2008 were $167,000 compared to $124,000 forthe same period in 2007. The increase was primarily due to an increase in loancollection expense.

 

Dataprocessing expense for the nine months ended September 30, 2008 was $277,000compared to $270,000 for the same period in 2007. The increase of $7,000 wasdue primarily to growth in deposit accounts.

 

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Othergeneral and administrative expenses for the nine months ended September 30, 2008 totaled$2,747,000 compared with $2,580,000 for the same period in 2007, which is anincrease of $167,000. Significant changes occurred in the following categories;increases occurred in merchantcredit card processing expense of $214,000, other real estate owned expense of$76,000, FDIC insurance premiums of $52,000, stationary/supplies of $32,000, ATM expense of $31,000, postageexpense of $20,000, loan expense of $18,000 and insurance expense of $11,000;while decreases occurred in advertising expense of $55,000, businessdevelopment of $33,000, directorfees of $25,000, donations of $24,000, entertainmentand meals of $18,000, shareholder expense of $18,000 and other losses of$11,000. Included in the Visa, Inc. initial public offering transactionwas the reversal of a litigation reserve, established in 2007, of $110,000representing the Bank’s share of the liability associated with the settlementby VISA of litigation brought by American Express and Discover.

 

**Provisionfor Income Taxes**

 

The tax provision was $801,000 for the nine monthsended September 30, 2008 compared to tax provision of $1,278,000 for thesame period in 2007, representing 44.24% and 46.25% of pre-tax income for thoseperiods. The amount of the tax provision is determined by applying theCorporation’s statutory income tax rates to pre-tax book income, adjusted forpermanent differences between pre-tax book income and actual taxable income.Such permanent differences include but are not limited to tax-exempt interestincome; increases in the cash surrender value of bank-owned life insurance,certain other expenses that are not allowed as tax deductions, and tax credits.

 

Deferred tax assets and liabilities are measuredusing the enacted tax rates expected to apply to taxable income in the periodsin which the deferred tax asset or liability is expected to be realized orsettled. The Bank maintains a valuation allowance with respect to deferred taxassets due to the uncertainty surrounding the realization of certain netdeferred tax assets.

 

**LOANS**

 

Averageloans represented 67.50% of average earning assets, and 62.96% of average totalassets for the nine months ended September 30, 2008 compared with 75.15% and 69.20%,respectively during 2007. For the nine months ended September 30, 2008, average loans increased 19.25% to$167,304,000 from $140,301,000 for the same period in 2007. Average real estateloans increased $21,949,000 (23.80%), average construction loans increased$1,923,000 (9.51%), average commercial loans increased $2,907,000 (10.70%), andaverage installment loans increased $224,000 (33.61%).

 

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

 

TheBank is a recognized leader for Small Business Administration lending inMonterey County, and holds SBA’s coveted Preferred Lender Status. Generally,SBA loans are guaranteed, by the SBA, for 75 to 85 percent of their principalamount, which can be retained in 

 

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portfolio or sold toinvestors. Such loans are made at floating interest rates, generally withlonger terms (up to 25 years) than are available on a conventional loan basisto small businesses.  The unguaranteed portion of the loans, althoughgenerally supported by collateral, is considered to be more risky thanconventional commercial loans because they may be based upon credit standardsthe Bank would not otherwise apply, such as lower cash flow coverage, or longerrepayment terms.

 

TheBank’s real estate loan portfolio consists of both real estate constructionloans and real estate mortgage loans. The Bank has initiated a program togenerate more commercial and industrial real estate loans, which generallyyield higher returns than normal commercial loans. The Bank has also developeda broker program for generating residential real estate loans. Real estateconstruction loans are made for a much shorter term, and often at higherinterest rates, than conventional single-family residential real estate loans. Thecost of administering such loans is often higher than for other real estateloans, as principal is drawn on periodically as construction progresses.

 

TheBank also makes real estate loans secured by a first deed of trust on singlefamily residential properties and commercial and industrial real estate. Californiacommercial banks are permitted, depending on the type and maturity of the loan,to lend up to 90 percent of the fair market value of real property (or more ifthe loan is insured either by private mortgage insurers or governmentalagencies). In certain instances, the appraised value may exceed the actualamount that could be realized on foreclosure, or declines in market valuesubsequent to making the loan can impair the Bank’s security.

 

Consumerloans are made for the purpose of financing the purchase of various types ofconsumer goods, home improvement loans, auto loans and other personal loans. Consumerinstallment loans generally provide for monthly payments of principal andinterest, at a fixed rate. Most of the Bank’s consumer installment loans aregenerally secured by the personal property being purchased. The Bank generallymakes consumer loans to those customers with a prior banking relationship withthe Bank.

 

**Non-performingand Non-accrual Loans**

 

TheBank’s present policy is to cease accruing interest on loans which are past dueas to principal or interest 90 days or more, except for loans which are wellsecured or when collection of interest and principal is deemed likely. When aloan is placed on non-accrual, previously accrued and unpaid interest isgenerally reversed out of income unless adequate collateral from which tocollect the principal of, and interest on, the loan appears to be available.

 

TheBank generally repurchases from the secondary market the guaranteed portion ofSmall Business Administration (SBA) guaranteed loans when those loans areplaced on non-accrual status. After the foreclosure and collection process iscomplete, the SBA reimburses the Bank for this principal balance. Therefore,although these balances do not earn interest during this period, they generallydo not result in a loss of principal to the Bank. The information provided inthe following table is net of the amounts guaranteed by the Small BusinessAdministration.

 

Thefollowing table presents information with respect to loans which, as of thedates indicated, were past due 90 days or more or were placed on non-accrualstatus (referred to collectively as “non-performing loans”):

 

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| ** **                                                     | ** ** | **Nine months as of** | ** ** | **Twelve months as of** | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------|------------|----------------------------------------|------------|
| ** **                                                     | ** ** | **September 30,**               | ** ** | **December 31,**                  | ** ** |
| ** **                                                     | ** ** | **2008**                             | ** ** | **2007**                               | ** ** | **2007** | ** ** |
| ** **                                                     | ** ** | **(Dollars in thousands)** | ** ** |
| Accruing, past  due 90 days or more:                           |       |                                 |       |                                   |       |   |   |
|                                                           |       |                                 |       |                                   |       |   |   |
| Real Estate                                                    |       | $                                    | —     |                                   | $          | — |   | $ | — |   |
| Commercial                                                     |       | —                               |       | —                                 |       | — |   |
| Installment                                                    |       | —                               |       | —                                 |       | — |   |
| Other                                                          |       | —                               |       | —                                 |       | — |   |
| Total accruing                                                 |       | —                               |       | —                                 |       | — |   |
|                                                           |       |                                 |       |                                   |       |   |   |
| Nonaccrual  loans:                                             |       |                                 |       |                                   |       |   |   |
|                                                           |       |                                 |       |                                   |       |   |   |
| Real Estate                                                    |       | 3,929                                |       | —                                 |       | 3,200 |   |
| Commercial                                                     |       | 1,165                                |       | 41                                     |       | 41 |   |
| Installment                                                    |       | 155                                  |       | 155                                    |       | 155 |   |
| Other                                                          |       | —                               |       | —                                 |       | — |   |
| Total nonaccrual                                               |       | 5,249                                |       | 196                                    |       | 3,396 |   |
|                                                           |       |                                 |       |                                   |       |   |   |
| Total  nonperforming                                           |       | $                                    | 5,249      |                                   | $          | 196 |   | $ | 3,396 |   |
|                                                           |       |                                 |       |                                   |       |   |   |
| Total loans end  of period                                     |       | $                                    | 162,323    |                                   | $          | 158,334 |   | $ | 171,126 |   |
|                                                           |       |                                 |       |                                   |       |   |   |
| Ratio of  non-performing loans to total loans at end of period |       | 3.23                                 | %          | 0.12                                   | %          | 1.98 | % |

 

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Summaryof Loan Loss Experience

 
| ** **                                                                     | ** ** | ** **                           | ** ** | ** **            | ** ** | **As of the** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------|------------|-----------------------|------------|-------------------------|------------|
| ** **                                                                     | ** ** | **As of the period**  | ** ** | **Year ended**   | ** ** |
| ** **                                                                     | ** ** | **Ended September 30,**    | ** ** | **December 31,** | ** ** |
| ** **                                                                     | ** ** | **2008**                             | ** ** | **2007**              | ** ** | **2007**                | ** ** |
| ** **                                                                     | ** ** | **(Dollars in thousands)** | ** ** |
| Average loans  outstanding                                                     |       | $                                    | 167,304    |                  | $          | 140,301                 |       | $ | 146,944 |   |
|                                                                           |       |                                 |       |                  |       |                    |       |
| Allowance,  beginning of period                                                |       | $                                    | 2,028      |                  | $          | 1,409                   |       | $ | 1409 |   |
|                                                                           |       |                                 |       |                  |       |                    |       |
| Loans charged  off during period:                                              |       |                                 |       |                  |       |                    |       |
| Commercial                                                                     |       | —                               |       | 249                   |       | 249                     |       |
| Installment                                                                    |       | —                               |       | 1                     |       | 1                       |       |
| Real Estate                                                                    |       | —                               |       | —                |       | —                  |       |
| Other                                                                          |       | —                               |       | —                |       | —                  |       |
| Total charge  offs                                                             |       | —                               |       | 250                   |       | 250                     |       |
|                                                                           |       |                                 |       |                  |       |                    |       |
| Recoveries  during period:                                                     |       |                                 |       |                  |       |                    |       |
| Commercial                                                                     |       | 2                                    |       | 1                     |       | —                  |       |
| Installment                                                                    |       | —                               |       | —                |       | —                  |       |
| Real Estate                                                                    |       | —                               |       | —                |       | —                  |       |
| Other                                                                          |       | —                               |       | —                |       | 4                       |       |
| Total recoveries                                                               |       | 2                                    |       | 1                     |       | 4                       |       |
|                                                                           |       |                                 |       |                  |       |                    |       |
| Net loans  charged off during the period                                       |       | (2                                   | )          | 249                   |       | 246                     |       |
|                                                                           |       |                                 |       |                  |       |                    |       |
| Additions to  allowance for possible loan losses                               |       | 250                                  |       | 415                   |       | 865                     |       |
|                                                                           |       |                                 |       |                  |       |                    |       |
| Allowance, end  of period                                                      |       | $                                    | 2,280      |                  | $          | 1,575                   |       | $ | 2,028 |   |
| Ratio of net  loans charged off to average loans outstanding during the period |       | 0.00                                 | %          | 0.18                  | %          | 0.17                    | %          |
| Ratio of allowance  to total loans at end of period                            |       | 1.40                                 | %          | 1.00                  | %          | 1.19                    | %          |
| Ratio of  allowance for loan losses to non-performing loans at end of period   |       | 43.44                                | %          | 803.68                | %          | 59.72                   | %          |

 

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**Non-performingAssets**

 

The followingtable presents information with respect to nonperforming assets, as of thedates indicated. The non-accrual loans are net of the guaranteed portion ofSmall Business Administration loans and the other real estate owned wasacquired through foreclosure.  The otherreal estate owned was recorded at fair value on the date of acquisition.  Subsequent to the acquisition of one of theproperties a write down of $532,000 was recorded based on a current appraisalless estimated selling costs.

** **
| ** **                                                              | ** ** | ** **                           | ** ** | ** **            | ** ** | **As of the** | ** ** |
|-------------------------------------------------------------------------|------------|--------------------------------------|------------|-----------------------|------------|-------------------------|------------|
| ** **                                                              | ** ** | **As of the period**  | ** ** | **Year ended**   | ** ** |
| ** **                                                              | ** ** | **Ended September 30,**    | ** ** | **December 31,** | ** ** |
| ** **                                                              | ** ** | **2008**                             | ** ** | **2007**              | ** ** | **2007**                | ** ** |
| ** **                                                              | ** ** | **(Dollars in thousands)** | ** ** |
| Nonaccrual  loans                                                       |       | $                                    | 5,249      |                  | $          | 196                     |       | $ | 3,396 |   |
| Other  real estate owned, net                                           |       | 6,349                                |       | —                |       | —                  |       |
| Total  nonperforming assets                                             |       | $                                    | 11,598     |                  | $          | 196                     |       | $ | 3,396 |   |
|                                                                    |       |                                 |       |                  |       |                    |       |
| Nonperforming  loans to total gross loans                               |       | 3.23                                 | %          | 0.12                  | %          | 1.98                    | %          |
| Nonperforming  assets to total gross loans plus other real estate owned |       | 6.88                                 | %          | 0.12                  | %          | 1.98                    | %          |

 

**Deposits**

 

Average interestbearing and non-interest bearing deposits for the nine months ended September 30, 2008 were$178,565,000 an increase of 28.65% compared with the same period in 2007.  Average certificates of deposit represented73.00% of average deposits for the nine months ended September 30, 2008 compared with 66.30% for the same periodin 2007.  Average interest bearingchecking, money market and savings accounts as a group were 12.56% of averagedeposits for the nine months ended September 30,2008 compared with 15.13% for the same period in 2007.  Average demand deposits represented 14.44% ofaverage deposits for the nine months ended September 30, 2008 compared with 18.57% for the same periodin 2007.

 

The following table sets forth the scheduled maturities of the Company’stime deposits in denominations of $100,000 or greater at September 30,2008:

 

**Maturities of Time Deposits of**

**$100,000 or More**

(Dollarsin Thousands)

 
| Three  months or less                   |   | $      | 12,517 |   |
|-----------------------------------------|--------|--------|--------|--------|
| Over  three months through nine months  |   | 7,959  |   |
| Over  nine months through twelve months |   | 17,151 |   |
| Over  twelve months                     |   | 18,758 |   |
| Total                                   |   | $      | 56,385 |   |

 

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**Table of Contents**

** **

**Borrowing**

** **

**The Corporation has a $3,000,000 revolving line of creditfrom Marshall & Ilsley Bank with a variable interest rate based on theone month LIBOR Rate plus 2.25% with a minimum rate of 4.50% and maturity dateof March 31, 2009.  The line ofcredit is collateralized by 100% of the outstanding shares of Monterey CountyBank stock.  At September 30, 2008,$2,500,000 was outstanding on the line and the interest rate was 4.50%.   The Company utilized $2,000,000 of theborrowings for a capital contribution into Monterey County Bank.**

** **

**The Bank has lines of credit from the Federal Home LoanBank (FHLB) of San Francisco, Bank of the West, Marshall & IlsleyBank, Pacific Coast Bankers’ Bank and The Independent Bank with remainingavailable borrowing capacity on**September 30, 2008 of $5,508,000 (based on pledged collateral), $4,500,000,$5,000,000, $6,000,000 and $5,000,000, respectively.  The Federal Home Loan Bank line of credit hasa maximum borrowing capacity of twenty five percent (25%) of the Bank’s totalassets, adjusted quarterly.  The FederalHome Loan Bank line of credit is secured by a portion of the Bank’s real estatesecured loans and securities at September 30, 2008.  The total principal balance of pledged loanswas $37,620,000 and securities of $51,923,000. The following table provides information on twenty FHLB advancestotaling $60,500,000 and outstanding at September 30, 2008.

** **
| ** ** | ** ** | ** ** | ** ** | **Funding** | ** ** | **Maturity** | ** ** |
|------------|------------|------------|------------|-------------|------------|--------------|------------|
| **Amount** | ** ** | **Rate**   | ** ** | **Date**    | ** ** | **Date**     | ** ** |
| $          | 1,000,000  |       | 7.72       | %           | 6/1/00     |         | 6/3/30     |   |
| 4,000,000  |       | 5.96       | %          | 8/2/04      |       | 7/28/34      |       |
| 5,000,000  |       | 5.63       | %          | 12/24/04    |       | 12/22/34     |       |
| 2,000,000  |       | 5.13       | %          | 5/4/05      |       | 5/1/35       |       |
| 3,000,000  |       | 4.30       | %          | 6/17/05     |       | 6/17/10      |       |
| 5,000,000  |       | 4.96       | %          | 11/14/05    |       | 11/15/10     |       |
| 2,250,000  |       | 4.75       | %          | 1/26/06     |       | 1/26/11      |       |
| 1,750,000  |       | 4.72       | %          | 1/26/06     |       | 1/26/11      |       |
| 1,500,000  |       | 5.52       | %          | 7/17/06     |       | 7/18/11      |       |
| 3,500,000  |       | 5.49       | %          | 7/17/06     |       | 7/18/11      |       |
| 1,000,000  |       | 5.22       | %          | 8/25/06     |       | 8/25/11      |       |
| 2,000,000  |       | 5.31       | %          | 11/17/06    |       | 11/17/36     |       |
| 5,000,000  |       | 5.88       | %          | 6/29/07     |       | 6/29/37      |       |
| 5,000,000  |       | 5.20       | %          | 7/30/07     |       | 7/30/12      |       |
| 2,500,000  |       | 4.88       | %          | 8/20/07     |       | 8/20/10      |       |
| 5,000,000  |       | 5.00       | %          | 9/18/07     |       | 9/18/14      |       |
| 3,000,000  |       | 4.84       | %          | 10/1/07     |       | 10/1/12      |       |
| 4,000,000  |       | 2.70       | %          | 1/24/08     |       | 1/24/11      |       |
| 2,000,000  |       | 2.23       | %          | 5/14/08     |       | 11/14/08     |       |
| 2,000,000  |       | 3.32       | %          | 5/14/08     |       | 5/16/11      |       |
| $          | 60,500,000 |       |       |        |       |         |       |   |

** **

**The**Bank of the West, Marshall & Ilsley Bank, PacificCoast Bankers’ Bank and The Independent Bank federal funds lines of credit areunsecured.  The Bank did not utilize anyovernight borrowings in 2008 or 2007.

** **

**The Bank has a letter of credit in the amount of$330,000, expiring April 17, 2011, issued by Federal Home Loan Bank of SanFrancisco, which is used to secure local agency**

 

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**deposits.  The beneficiary of the letter of credit isthe Administrator of Local Agency Security, Department of FinancialInstitutions.**

** **

**CapitalResources**

 

The Corporationmaintains capital to comply with regulatory requirements, to provide a marginof safety for its depositors and stockholders, and to provide for future growthand the ability to pay dividends.  At September 30, 2008,stockholders’ equity was $12,117,000 versus $14,434,000 at December 31,2007.  The Corporation paid cashdividends to shareholders of $0 and $461,000 for the nine months ended September 30, 2008and for the year ended December 31, 2007, respectively.  The Bank paid cash dividends to theCorporation of $0 and $800,000 for the nine months ended September 30, 2008and for the year ended December 31, 2007, respectively.

 

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

 

In general, therisk-based capital guidelines provide detailed definitions of which obligationswill be treated as capital, and assign different weights to various assets andoff-balance sheet items, depending upon the perceived degree of credit riskassociated with each asset.  Each assetis assigned to one of four risk-weighted categories.  For example, 0 percent for cash andunconditionally guaranteed government securities; 20 percent for deposits withother banks and fed funds; 50 percent for state bonds and certain residentialreal estate loans; and 100 percent for commercial loans and other assets.  Capital is categorized as either Tier 1capital, consisting of common stock and retained earnings (or deficit), or Tier2 capital, which includes limited-life preferred stock and allowance for loanlosses (subject to certain limitations). The guidelines also define and set minimum capital requirements (risk-basedcapital ratios), which increased over a transition period, ended December 31,1992.  Under the final 1992 rules, allbanks were required to maintain Tier 1 capital of at least 4 % and totalcapital of 8.0% of risk-adjusted assets. The Bank had a Tier 1 capital to totalrisk-adjusted assets capital ratio of 12.17% and 11.64% at September 30,2008 and 2007, respectively.  The Bank’sTier 1 capital exceeds the minimum regulatory requirement by $15,919,000.  The Bank had a Total Risk-Based capital torisk-adjusted assets ratio of 13.39% and 12.48% at September 30, 2008 and2007, respectively.  The Bank’s TotalRisk-Based capital exceeds the minimum regulatory requirement by $10,494,000.

 

The Tier 1 leveragecapital ratio guidelines require a minimum leverage capital ratio of 4% of Tier1 capital to total assets less goodwill. The Bank had a leverage capital ratio of 8.75% and 8.89% at September 30,2008 and 2007, respectively.  The Bank’sTier 1 leverage capital exceeds the minimum regulatory requirement by$12,869,000.

 

Under regulatoryguidelines, the $8 million in Trust Preferred Securities outstanding qualify asTier 1 capital up to 25% of Tier 1 capital. Any additional Trust Preferred Securities will qualify as Tier 2capital.

 

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The Corporation’s Boardof Directors approved a stock repurchase program pursuant to which theCorporation, from time to time and at management’s discretion, may repurchaseup to $500,000 of the Corporation’s outstanding shares.  The Corporation repurchased 46,010 shares ofcommon stock at an average cost of $7.51 per share in open market transactionsduring the nine months ended September 30, 2008.

 

## **Liquidity**

## ** **

Liquidityrepresents a bank’s ability to provide sufficient cash flows or cash resourcesin a manner that enables it to meet obligations in a timely fashion andadequately provides for anticipated future cash needs.  For the Bank, liquidity considerationsinvolve the capacity to meet expected and potential requirements of depositorsseeking access to balances and to provide for the credit demands of borrowingcustomers.  In the ordinary course of theBank’s business, funds are generated from the repayment of loans, maturitieswithin the investment securities portfolio and the acquisition of depositbalances and short-term borrowings.  Inaddition, the Bank has a secured borrowing arrangement with the Federal HomeLoan Bank of San Francisco of approximately $66,338,000, based on twenty five percent of the Bank’s total assets as reported in the most recent quarterlyConsolidated Reports of Condition and Income for a bank with Domestic OfficesOnly. The line of credit is subject to pledging of acceptable collateral.  Additionally the Bank has unsecured federalfunds lines of credit with Bank of theWest, Marshall & Ilsley Bank,****Pacific Coast Bankers’ Bank and TheIndependent Bank of $4,500,000, $5,000,000, $6,000,000 and $5,000,000, respectively;to meet temporary liquidity requirements. Available borrowing capacities on September 30, 2008 were$4,500,000, $5,000,000, $6,000,000 and $5,000,000, respectively.

 

As a matter of policy,the Bank seeks to maintain a level of liquid assets, including marketableinvestment securities, equal to a least 15 percent of total assets (“totalliquidity”). Additionally the Bank maintains secondary sources of liquidity(borrowing lines from other institutions) equal to at least an additional 10percent of assets.  Within these ratios,the Bank generally has excess funds available to sell as federal funds on adaily basis, and is able to fund its own liquidity needs without the need ofshort-term borrowing.  The Bank’s totalliquidity at September 30,2008 and 2007 was 33.23% and 25.20%,respectively, while its average loan to average deposit ratio for such yearswas 93.69% and 101.08%, respectively.

 

Brokered deposits aredeposit instruments, such as certificates of deposit, deposit notes, bankinvestment contracts and certain municipal investment contracts that are issuedthrough brokers and dealers who then offer and/or sell these depositinstruments to one or more investors. Additionally, deposits on which a financial institution pays an interestrate significantly higher than prevailing rates are considered to be brokereddeposits.  Federal law and regulationrestricts banks from soliciting or accepting brokered deposits, unless the bankis well capitalized under Federal guidelines. The Bank had $2,656,000 in brokered deposits through the Certificate ofDeposit Account Registry Service (CDARS) at September 30, 2008 comparedwith no brokered deposits at September 30, 2007.

 

**InterestRate Risk**

 

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

 

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authorities,liquidity determinations and capital considerations.  The Bank instituted formal asset/liabilitypolicies at the end of 1989.

 

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

 

TheBank monitors its interest rate risk on a quarterly basis through the use of amodel which calculates the effect on earnings of changes in the fed fundsrate.  The model converts a fed fundsrate change into rate changes for each major class of asset and liability, thensimulates the bank’s net interest margin based on the bank’s actual repricingover a one year period, assuming that maturities are reinvested in instrumentsidentical to those maturing during the period. The following table shows the affect on net interest income of an upwardor downward rate shocks at September 30, 2008.

 
| **Rate Shock  Increase(Decrease) in Basis   Points** | ** ** | **Percent  Increase(Decrease) in Net  Interest Income** | ** ** | **Asset/Liability Policy Limits  for Increase(Decrease) in Net  Interest Income** | ** ** |
|--------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------|------------|
| 100                                                                      |       | 3.9                                                                    | %          | 10.0                                                                                                            | %          |
| (100                                                                     | )          | (5.4                                                                   | )%         | (10.0                                                                                                           | )%         |
| 200                                                                      |       | 7.8                                                                    | %          | 20.0                                                                                                            | %          |
| (150                                                                     | )          | (8.1                                                                   | )%         | (20.0                                                                                                           | )%         |

 

**InvestmentSecurities**

 

The Corporation maintains a trading account, at fair value, consisting of marketable securities.  At September 30, 2008 and 2007 the account value was $591,000 and $1,331,000, respectively.  The Corporation has investments of $20,000 in AT Service LLC, which provides title insurance services for commercial, industrial and residential properties, as well as other real estate related financial and informational services, including escrow, real estate information, trustee sale guarantees and real estate tax exchanges, and $10,000 in Metrocities Mortgage, LLC.  In addition, the Corporation has investments in Northern California Bancorp Trust I of $93,000 and Northern California Bancorp Trust II of $155,000. These are special-purpose trust subsidiaries which were formed to facilitate the issuance of trust preferred securities.

 

31

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Thefollowing table sets forth the book and market value of the investmentsecurities at September 30, 2008:

 
| ** **                                 | ** ** | **INVESTMENT PORTFOLIO MIX** | ** ** |
|--------------------------------------------|------------|----------------------------------------|------------|
| ** **                                 | ** ** | **SEPTEMBER 30, 2008**       | ** ** |
| **(in thousands)**                    | ** ** | **Book Value**                    | ** ** | **Market Value** | ** ** |
| Investment  Securities, Available for Sale |       |                                   |       |   |   |
| Corporate  Debt Securities                 |       | $                                      | 1,500      |   | $ | 1,500 |   |
| State/Local  Agency Bonds                  |       | 22,405                                 |       | 20,161 |   |
| Mortgage  Backed Securities                |       | 2,677                                  |       | 2,753 |   |
| U.S.  Government Agency Securities         |       | 54,400                                 |       | 51,924 |   |
| Total                                      |       | $                                      | 80,982     |   | $ | 76,338 |   |

 
| ** **                                       | ** ** | **INVESTMENT PORTFOLIO MIX** | ** ** |
|--------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                       | ** ** | **SEPTEMBER 30, 2008**       | ** ** |
| ** **                                       | ** ** | **Book Value**                    | ** ** | **Market Value** | ** ** |
| Other  Investments, at cost                      |       |                                   |       |   |   |
| AT  Services LLC                                 |       | $                                      | 20         |   | $ | 20 |   |
| Metrocities  Mortgage, LLC                       |       | 10                                     |       | 10 |   |
| Federal  Home Loan Bank stock, restricted        |       | 2,881                                  |       | 2,881 |   |
| Northern  California Bancorp, Inc. Trust I  |       | 93                                     |       | 93 |   |
| Northern  California Bancorp, Inc. Trust II |       | 155                                    |       | 155 |   |
| Independent  Bankers Financial Corporation       |       | 51                                     |       | 51 |   |
| Visa, Inc.  Stock                           |       | 426                                    |       | 437 |   |
|                                             |       | $                                      | 3,636      |   | $ | 3,647 |   |

 

The followingtable summarizes the maturity of the investment securities at September 30, 2008:

 

INVESTMENT PORTFOLIO MATURITIES

(Dollars in thousands)

 
| ** **                         | ** ** | **Amortized Cost** | ** ** | **Fair Value** | ** ** |
|------------------------------------|------------|-------------------------|------------|---------------------|------------|
| Available  for Sale                |       |                    |       |                |       |
| Due  between five and ten years    |       | $                       | 417        |                | $          | 367 |   |
| Due  between ten and fifteen years |       | 51,771                  |       | 49,399              |       |
| Due  over fifteen years            |       | 28,794                  |       | 26,572              |       |
|                               |       | $                       | 80,982     |                | $          | 76,338 |   |

** **

**Item 4T. Controls and Procedures**

** **

(a) The Bank’s Chief Executive Officer and itsChief Financial Officer, after evaluating the effectiveness of the Bank’sdisclosure controls and procedures as defined in Exchange Act Rules 13a-15(e) promulgatedunder the Exchange Act as of the end of the period covered by this report (the “EvaluationDate”) have concluded that as of the Evaluation Date, the Bank’s disclosurecontrols and procedures were adequate and effective to ensure that materialinformation relating to the Bank would be made known to them by others withinthe Bank, particularly during the period in which this report was beingprepared.  Disclosure controls andprocedures are designed 

 

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toensure that information required to be disclosed by us in the reports that wefile or submit under the Exchange Act is recorded, processed, summarized andreported, within the time periods specified in the Securities and ExchangeCommission’s rules and forms. Disclosure controls and procedures include, without limitation, controlsand procedures designed to ensure that information required to be disclosed byus in the reports that we file under the Exchange Act is accumulated andcommunicated to our management, including our Chief Executive Officer and ChiefFinancial Officer, as appropriate to allow timely decisions regarding requireddisclosure.

 

(b) Changesin Internal Controls:  In the quarterended September 30,2008, the Company did not make anysignificant changes in, nor take any corrective actions regarding, its internalcontrols or other factor that could significantly affect these controls.

 

**PART II-OTHERINFORMATION**

 

**Item 1.  Legal Proceedings.**

 

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

 

The defendants have reviewed the lawsuit, categorically deny all of the allegations and will vigorously defend against the untrue allegations.

 

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

 

**Item2.  Unregistered Sales of EquitySecurities and Use of Proceeds**

 

None

 

**Item3.  Defaults of Senior Securities**

 

None

 

**Item 4.  Submission of Matters to a Vote of SecurityHolders.**

** **

None

 

#### **Item5.  Other Information.**

####  

None

 

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#### **Item6.  Exhibits**

####  

| A.     | EXHIBITS |
|--------|----------|
|   |     |   |
|   | 31.1     | Certification of the Chief Executive Officer of  Northern California Bancorp, Inc. pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
|   |     |   |
|   | 31.2     | Certification of the Chief Financial Officer of Northern California  Bancorp, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of  2002. |
|   |     |   |
|   | 32.1     | Certification of the Chief Executive Officer of Northern California  Bancorp, Inc. pursuant to Section 906 of the Sarbanes-Oxley Act of  2002. |
|   |     |   |
|   | 32.2     | Certification of the Chief Financial Officer of Northern California  Bancorp, Inc. pursuant to Section 906 of the Sarbanes-Oxley Act of  2002. |

 

Inaccordance with the requirements of the Exchange Act, the registrant causedthis report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 
|                          | NORTHERN CALIFORNIA  BANCORP, INC. |
|-------------------------------|------------------------------------|
|                          |                               |
| Date: November 12,  2008 | By:                                |   /s/ Charles T. Chrietzberg, Jr. |
|                          |                               | Charles T.  Chrietzberg, Jr. |
|                          |                               | Chairman of the  Board & |
|                          |                               | Chief Executive Officer |
|                          |                               |   |
|                          |                               |   |
| Date: November 12,  2008 | By:                                |   /s/ Bruce N. Warner |
|                          |                               | Bruce N. Warner |
|                          |                               | Chief  Financial Officer and |
|                          |                               | Principal  Accounting Officer |

 

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