Table of Contents

 

 

 

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

**Washington, D.C.  20549**

 

**FORM 10-Q**

 

**x****      Quarterlyreport under Section 13 or 15(d) of the Securities Exchange Act of1934**

 

**for the quarterly periodended September 30, 2010**

 

**o****         Transitionreport under Section 13 or 15(d) of the Securities Exchange Act of1934**

 

**(No fee required) for theperiod from                to                **

 

**Commission File Number 0-27666**

 

**NORTHERN CALIFORNIA BANCORP, INC.**

(Name of Small BusinessIssuer in its Charter)

 

**Incorporated in the State ofCalifornia**

**IRS Employer IdentificationNumber 77-0421107**

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

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

 

Check whether the issuer: (1) filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act duringthe past 12 months (or for such shorter period that the registrant was requiredto file such reports), and (2) has been subject to such filing requirementsfor the past 90 days.  Yes  x  No  o

 

Indicate by check markwhether the registrant has submitted electronically and posted on its corporateWeb site, if any, every Interactive Data File required to be submitted andposted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter)during the preceding 12 months (or for such shorter period that the registrantwas required to submit and post such files).  Yes  o  No  o

 

Indicateby check mark whether the registrant is an accelerated filer, a non-acceleratedfiler, or a smaller reporting 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 mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act. Yes  o  No  x

 

As of November 10, 2010, the Corporation had 1,785,891 shares ofcommon stock outstanding.

 

 

 

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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 |
|                  | Notes to Consolidated Financial Statements                                                  | 7-18 |
| Item 2                | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 19-41 |
| Item  3               | (Not  Applicable)                                                                           |   |
| Item 4T               | Controls and  Procedures                                                                    | 41 |
|                  |                                                                                        |   |
| **PART II**      | Other Information                                                                           |   |
| Item 1                | Legal Proceedings                                                                           | 42-43 |
| Item 2                | Unregistered  Sales of Equity Securities and Use of Proceeds                                | 42 |
| Item 3                | Defaults  Upon Senior Securities                                                            | 43 |
| Item 4                | Submission  of Matters to a Vote of Security Holders                                        | 43 |
| Item 5                | Other Information                                                                           | 43 |
| Item 6                | Exhibits                                                                                    | 43 |
| Signatures            | 44                                                                                          |
| Certifications        | 45-48                                                                                       |

 

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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)**                   | ** ** | **2010**               | ** ** | **2009**              | ** ** |
| ** **                                                                 | ** ** | **(Unaudited)**        | ** ** | **(Audited)**         | ** ** |
| ASSETS:                                                                    |       |                   |       |                  |       |
| Cash and Due From Banks                                                    |       | $                      | 34,769     |                  | $          | 12,251 |   |
| Trading Assets                                                             |       | 106                    |       | 153                   |       |
| Time Deposits with other Financial Institutions                            |       | 5,000                  |       | —                |       |
| Investment Securities, available for sale                                  |       | 42,934                 |       | 62,413                |       |
| Other Investments                                                          |       | 3,835                  |       | 4,085                 |       |
| Loans Held for Sale, at lower of cost or market                            |       | 1,598                  |       | 2,216                 |       |
| Loans, net of allowance for loan losses of $3,253  in 2010; $3,529 in 2009 |       | 153,931                |       | 160,997               |       |
| Bank Premises and Equipment, Net                                           |       | 4,891                  |       | 4,909                 |       |
| Cash Surrender Value of Life Insurance                                     |       | 4,192                  |       | 4,097                 |       |
| Other Real Estate Owned                                                    |       | 27,575                 |       | 14,333                |       |
| Interest Receivable and Other Assets                                       |       | 8,814                  |       | 7,841                 |       |
| Total Assets                                                               |       | $                      | 287,645    |                  | $          | 273,295 |   |
|                                                                       |       |                   |       |                  |       |
| LIABILITIES AND SHAREHOLDERS’ EQUITY:                                 |       |                   |       |                  |       |
|                                                                       |       |                   |       |                  |       |
| Non interest-bearing demand                                                |       | $                      | 33,363     |                  | $          | 25,781 |   |
| Interest-bearing demand                                                    |       | 17,152                 |       | 16,984                |       |
| Savings                                                                    |       | 8,399                  |       | 6,270                 |       |
| Time less than $100,000                                                    |       | 89,185                 |       | 94,686                |       |
| Time in denominations of $100,000 or more                                  |       | 70,716                 |       | 58,701                |       |
| Total Deposits                                                             |       | 218,815                |       | 202,422               |       |
|                                                                       |       |                   |       |                  |       |
| Revolving line of credit                                                   |       | 2,850                  |       | 2,850                 |       |
| Federal Home Loan Bank Borrowed Funds                                      |       | 34,000                 |       | 29,000                |       |
| Federal Reserve Bank Borrowed Funds                                        |       | —                 |       | 10,000                |       |
| Junior Subordinated Debt Securities                                        |       | 8,248                  |       | 8,248                 |       |
| Secured Borrowings — SBA Loans                                        |       | 3,047                  |       | —                |       |
| Interest Payable and Other Liabilities                                     |       | 5,325                  |       | 4,625                 |       |
| Total Liabilities                                                          |       | 272,285                |       | 257,145               |       |
|                                                                       |       |                   |       |                  |       |
| Shareholders’ Equity:                                                 |       |                   |       |                  |       |
| Common Stock - No Par Value                                                |       |                   |       |                  |       |
| Authorized: 10,000,000 in 2010 and 2009                                    |       |                   |       |                  |       |
| Outstanding:1,785,891 in 2010 and 1,783,230 in 2009                        |       | 5,094                  |       | 5,088                 |       |
| Retained Earnings                                                          |       | 9,740                  |       | 11,092                |       |
| Accumulated Other Comprehensive Income (Loss)                              |       | 526                    |       | (30                   | )          |
| Total Shareholders’ Equity                                            |       | 15,360                 |       | 16,150                |       |
| Total Liabilities & Shareholders’ Equity                          |       | $                      | 287,645    |                  | $          | 273,295 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

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NORTHERN CALIFORNIA BANCORP, INC.

AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

 
| ** **                                                              | ** ** | **THREE-MONTH**        | ** ** | **NINE-MONTH**         | ** ** |
|-------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                              | ** ** | **PERIOD ENDING** | ** ** | **PERIOD ENDING** | ** ** |
| ** **                                                              | ** ** | **September 30**  | ** ** | **September 30**  | ** ** |
| **(in thousands except share data)**                | ** ** | **2010**               | ** ** | **2009**               | ** ** | **2010** | ** ** | **2009** | ** ** |
| INTEREST INCOME:                                                        |       |                   |       |                   |       |   |   |   |   |
| Loans                                                                   |       | $                      | 2,347      |                   | $          | 2,550 |   | $ | 7,412 |   | $ | 8,239 |   |
| Time deposits with other financial institutions                         |       | 21                     |       | 4                      |       | 41 |   | 14 |   |
| Investment securities                                                   |       | 630                    |       | 1,037                  |       | 2,179 |   | 3,795 |   |
| Federal funds sold                                                      |       | —                 |       | —                 |       | — |   | 1 |   |
| Total Interest Income                                                   |       | 2,998                  |       | 3,591                  |       | 9,632 |   | 12,049 |   |
|                                                                    |       |                   |       |                   |       |   |   |   |   |
| INTEREST EXPENSE:                                                       |       |                   |       |                   |       |   |   |   |   |
| Interest-bearing transaction accounts                                   |       | 5                      |       | 5                      |       | 15 |   | 17 |   |
| Savings and time deposit accounts                                       |       | 525                    |       | 862                    |       | 1,673 |   | 2,698 |   |
| Time deposits in denominations of $100,000 or more                      |       | 430                    |       | 532                    |       | 1,243 |   | 1,600 |   |
| Notes payable and other                                                 |       | 526                    |       | 531                    |       | 1,538 |   | 2,080 |   |
| Total Interest Expense                                                  |       | 1,486                  |       | 1,930                  |       | 4,469 |   | 6,395 |   |
|                                                                    |       |                   |       |                   |       |   |   |   |   |
| Net Interest Income                                                     |       | 1,512                  |       | 1,661                  |       | 5,163 |   | 5,654 |   |
| Provision for loan losses                                               |       | —                 |       | 1,272                  |       | — |   | 1,918 |   |
| Net interest income, after provision for loan  losses                   |       | 1,512                  |       | 389                    |       | 5,163 |   | 3,736 |   |
|                                                                    |       |                   |       |                   |       |   |   |   |   |
| NON-INTEREST INCOME:                                                    |       |                   |       |                   |       |   |   |   |   |
| Service charges on deposit accounts                                     |       | 99                     |       | 148                    |       | 337 |   | 493 |   |
| Income from sales and servicing of Small Business  Administration Loans |       | 136                    |       | 219                    |       | 257 |   | 316 |   |
| Gain on sales of investment securities                                  |       | 518                    |       | 2,018                  |       | 936 |   | 3,153 |   |
| Other income                                                            |       | 1,473                  |       | 1,687                  |       | 3,747 |   | 4,413 |   |
| Total non-interest income                                               |       | 2,226                  |       | 4,072                  |       | 5,277 |   | 8,375 |   |
|                                                                    |       |                   |       |                   |       |   |   |   |   |
| NON-INTEREST EXPENSE:                                                   |       |                   |       |                   |       |   |   |   |   |
| Salaries and Employee Benefits                                          |       | 882                    |       | 828                    |       | 2,678 |   | 2,398 |   |
| Occupancy and Equipment Expense                                         |       | 259                    |       | 254                    |       | 777 |   | 769 |   |
| Foreclosed assets, net                                                  |       | 916                    |       | 163                    |       | 1,997 |   | 792 |   |
| Professional Fees                                                       |       | 403                    |       | 172                    |       | 1,239 |   | 699 |   |
| Prepayment fees on borrowings                                           |       | —                 |       | 457                    |       | — |   | 888 |   |
| Data Processing                                                         |       | 56                     |       | 67                     |       | 192 |   | 247 |   |
| FDIC Settlement - Card Programs                                         |       | 1,800                  |       | —                 |       | 1,800 |   | — |   |
| Litigation Settlement                                                   |       | 158                    |       | —                 |       | 1,038 |   | — |   |
| Other general and administrative                                        |       | 1,310                  |       | 1,479                  |       | 3,523 |   | 4,025 |   |
| Total non-interest expenses                                             |       | 5,784                  |       | 3,420                  |       | 13,244 |   | 9,818 |   |
| Income (loss) before income tax provision  (benefit)                    |       | (2,046                 | )          | 1,041                  |       | (2,804 | ) | 2,293 |   |
| Income tax provision (benefit)                                          |       | (1,031                 | )          | 297                    |       | (1,452 | ) | 470 |   |
| Net income (loss)                                                       |       | $                      | (1,015     | )                      | $          | 744 |   | $ | (1,352 | ) | $ | 1,823 |   |
|                                                                    |       |                   |       |                   |       |   |   |   |   |
| Earnings (loss) per common share                                        |       |                   |       |                   |       |   |   |   |   |
| Basic                                                                   |       | $                      | (0.57      | )                      | $          | 0.42 |   | $ | (0.76 | ) | $ | 1.02 |   |
| Diluted                                                                 |       | $                      | (0.57      | )                      | $          | 0.42 |   | $ | (0.76 | ) | $ | 1.01 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

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NORTHERN CALIFORNIA BANCORP, INC.

AND SUBSIDIARY

CONSOLIDATEDSTATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

** **
| ** **                                                                                                               | ** ** | ** **         | ** ** | ** ** | ** ** | ** **   | ** ** | **Accumulated**         | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|------------|------------|--------------|------------|-------------------------|------------|------------|------------|
| ** **                                                                                                               | ** ** | ** **         | ** ** | ** ** | ** ** | ** **   | ** ** | **Other Comprehensive** | ** ** | ** ** | ** ** |
| ** **                                                                                                               | ** ** | **Number of** | ** ** | **Common** | ** ** | **Retained** | ** ** | **Income**              | ** ** | ** ** | ** ** |
| **(in thousands except share data)**                                                                 | ** ** | **Shares**         | ** ** | **Stock**  | ** ** | **Earnings** | ** ** | **(Loss)**              | ** ** | **Total**  | ** ** |
| Balance at December 31, 2008                                                                                             |       | 1,803,908          |       | $          | 5,173      |         | $          | 9,481                   |       | $          | (302       | ) | $ | 14,352 |   |
|                                                                                                                     |       |               |       |       |       |         |       |                    |       |       |       |
| Comprehensive income:                                                                                                    |       |               |       |       |       |         |       |                    |       |       |       |
| Net income for the year                                                                                                  |       | —             |       | —     |       | 1,611        |       | —                  |       | 1,611      |       |
| Change in net unrealized loss on AFS securities  and other assets, net of tax reclassification adjustment and tax effect |       | —             |       | —     |       | —       |       | 272                     |       | 272        |       |
| Total comprehensive income                                                                                               |       |               |       |       |       |         |       |                    |       | 1,883      |       |
|                                                                                                                     |       |               |       |       |       |         |       |                    |       |       |       |
| Stock repurchase                                                                                                         |       | (20,678            | )          | (85        | )          | —       |       | —                  |       | (85        | )          |
|                                                                                                                     |       |               |       |       |       |         |       |                    |       |       |       |
| Balance at December 31, 2009 (Audited)                                                                                   |       | 1,783,230          |       | 5,088      |       | 11,092       |       | (30                     | )          | 16,150     |       |
|                                                                                                                     |       |               |       |       |       |         |       |                    |       |       |       |
| Comprehensive loss:                                                                                                      |       |               |       |       |       |         |       |                    |       |       |       |
| Net loss for the year                                                                                                    |       | —             |       | —     |       | (1,352       | )          | —                  |       | (1,352     | )          |
| Change in net unrealized loss on AFS securities  and other assets, net of tax reclassification adjustment and tax effect |       | —             |       | —     |       | —       |       | 556                     |       | 556        |       |
| Total comprehensive loss                                                                                                 |       |               |       |       |       |         |       |                    |       | (796       | )          |
|                                                                                                                     |       |               |       |       |       |         |       |                    |       |       |       |
| Exercise of stock options, Including tax benefit                                                                         |       | 2,661              |       | 6          |       | —       |       | —                  |       | 6          |       |
|                                                                                                                     |       |               |       |       |       |         |       |                    |       |       |       |
| Balance at September 30, 2010 (Unaudited)                                                                                |       | 1,785,891          |       | $          | 5,094      |         | $          | 9,740                   |       | $          | 526        |   | $ | 15,360 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

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NORTHERN CALIFORNIA BANCORP, INC.

AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

 
| ** **                                                                                | ** ** | **NINE MONTH PERIOD ENDED**

**SEPTEMBER 30,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|------------------------------------------------|------------|
| **(in thousands)**                                                                   | ** ** | **2010**                                       | ** ** | **2009** | ** ** |
| **CASH FLOWS FROM OPERATING  ACTIVITIES**                                                 |       |                                           |       |   |   |
| Net income (loss)                                                                         |       | $                                              | (1,352     | ) | $ | 1,823 |   |
| Adjustments to reconcile net income (loss) to net  cash provided by operating activities: |       |                                           |       |   |   |
| Depreciation and amortization expense                                                     |       | 278                                            |       | 255 |   |
| Realized gain on sales of available-for-sale  securities, net                             |       | (936                                           | )          | (3,153 | ) |
| Amortization of deferred loan fees, net                                                   |       | 28                                             |       | 75 |   |
| Amortization (accretion) of discounts and premiums  on investment securities, net         |       | (58                                            | )          | (272 | ) |
| Provision for loan losses                                                                 |       | —                                         |       | 1,918 |   |
| Provision for foreclosed asset losses                                                     |       | 1,050                                          |       | 522 |   |
| Loss on sale of foreclosed assets                                                         |       | 136                                            |       | 67 |   |
| Increase in cash surrender value of life insurance                                        |       | (95                                            | )          | (95 | ) |
| Deferred income tax expense (benefit)                                                     |       | (1,453                                         | )          | (322 | ) |
| (Increase) decrease in assets:                                                            |       |                                           |       |   |   |
| Trading assets                                                                            |       | 47                                             |       | 85 |   |
| Loans held for sale                                                                       |       | 618                                            |       | 1,174 |   |
| Interest receivable                                                                       |       | 339                                            |       | 326 |   |
| Other assets                                                                              |       | 132                                            |       | (1,546 | ) |
| Increase (decrease) in liabilities:                                                       |       |                                           |       |   |   |
| Interest payable                                                                          |       | 334                                            |       | (541 | ) |
| Other liabilities                                                                         |       | 3,488                                          |       | 463 |   |
| Net cash provided by operating activities                                                 |       | 2,556                                          |       | 859 |   |
|                                                                                      |       |                                           |       |   |   |
| **CASH FLOWS FROM INVESTING  ACTIVITIES**                                                 |       |                                           |       |   |   |
| Net change in time deposits with other financial  institutions                            |       | (5,000                                         | )          | (27,416 | ) |
| Activity in available-for sale securities                                                 |       |                                           |       |   |   |
| Sales                                                                                     |       | 24,235                                         |       | 129,868 |   |
| Maturities, prepayments, and calls                                                        |       | 1,604                                          |       | 4,324 |   |
| Purchases                                                                                 |       | (4,554                                         | )          | (83,824 | ) |
| Net increase in loans                                                                     |       | (4,919                                         | )          | (11,313 | ) |
| Proceeds from loan sales                                                                  |       | 1,830                                          |       | — |   |
| Proceeds from sale of other real estate owned                                             |       | 2,566                                          |       | 2,491 |   |
| Investment in other real estate owned                                                     |       | (6,942                                         | )          | (1,111 | ) |
| Proceeds from sale of equipment                                                           |       | 34                                             |       | — |   |
| Additions to bank premises and equipment                                                  |       | (291                                           | )          | (73 | ) |
| Net cash provided by investing activities                                                 |       | 8,563                                          |       | 12,946 |   |
|                                                                                      |       |                                           |       |   |   |
| **CASH FLOWS FROM FINANCING  ACTIVITIES**                                                 |       |                                           |       |   |   |
| Net increase in deposits                                                                  |       | 16,393                                         |       | 28,162 |   |
| Proceeds from borrowings                                                                  |       | 5,000                                          |       | 5,000 |   |
| Repayments on borrowing, net                                                              |       | (10,000                                        | )          | (57,500 | ) |
| Proceeds from exercise of stock options                                                   |       | 6                                              |       | — |   |
| Repurchase of common stock                                                                |       | —                                         |       | (85 | ) |
| Net cash provided (used) by financing activities                                          |       | 11,399                                         |       | (24,423 | ) |
|                                                                                      |       |                                           |       |   |   |
| Net increase (decrease) in cash and cash  equivalents                                     |       | 22,518                                         |       | (10,618 | ) |
|                                                                                      |       |                                           |       |   |   |
| **CASH AND CASH EQUIVALENTS,  BEGINNING**                                                 |       | 12,251                                         |       | 16,348 |   |
| ** **                                                                                |       |                                           |       |   |   |
| **CASH AND CASH EQUIVALENTS, ENDING**                                                     |       | $                                              | 34,769     |   | $ | 5,730 |   |

 

Non-cash transaction during the nine months ended September 30, 2010and 2009 included the transfer of $10,375,000 and $8,851,000, respectively ofloans to other real estate owned.

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

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**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

(NOTE 1) NATURE OFBUSINESS AND BASIS OF PRESENTATION

 

*Nature of Business*

 

NorthernCalifornia Bancorp, 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.  TheCorporation’s sources of revenues at this time are dividends on investments,gains on securities transactions and potential dividends, management fees andtax equalization payments, if any, from Monterey County Bank (the “Bank”).

 

TheCorporation owns 100% of the Bank which operates five full service branches inMonterey County, California. The Corporation owns 100% of the common stock oftwo unconsolidated special purpose business trusts, “Northern CaliforniaBancorp, Inc. Trust I” and “Northern California Bancorp, Inc. TrustII”.

 

*Basisof Presentation*

 

Theinterim condensed consolidated financial statements of Northern CaliforniaBancorp, Inc. and Monterey County Bank are unaudited and reflect alladjustments (consisting only of normal recurring adjustments), which are, inthe opinion of management, necessary for a fair presentation, in all materialrespects, of the consolidated financial position and operating results of theCorporation for the interim periods.  The results of operations for thenine months ended September 30, 2010 are not necessarily indicative of theresults to be expected for the entire fiscal year ending December 31,2010.  The year-end consolidated balance sheet dataat December 31, 2009 was derived from the audited consolidatedfinancial statements.  All materialintercompany balances and transactions have been eliminated in consolidation.

 

Thisfinancial information should be read in conjunction with the audited financialstatements and notes thereto included in the Corporation’s Form 10-K forthe fiscal year ended December 31, 2009.

 

(NOTE2)  CRITICAL ACCOUNTING 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 the judgments, estimates and assumptions usedin preparation of the Corporation’s financial statements are appropriate giventhe factual circumstances as of September 30, 2010.

 

Variouselements of the Corporation’s accounting policies, by their nature, areinherently subject to estimation techniques, valuation assumptions and othersubjective assessments.  Criticalaccounting policies are those that involve the most complex and subjectivedecisions and assessments and have the greatest potential impact on theCorporation’s results of operation.  Inparticular, management has identified the following accounting policy that, dueto judgments, estimates and assumptions inherent in this policy, and thesensitivity of the Corporation’s financial statements to those judgments,estimates and assumptions, is critical to an understanding of the Corporation’sfinancial statements.  This policyrelates to the methodology that determines the Corporation’s allowance for loanand lease losses.  Management has 

 

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discussedthe development and selection of this critical accounting policy with theCorporation’s Audit Committee of the Board of Directors.  Although Management believes the level of theallowance at September 30, 2010 is adequate to absorb losses inherent inthe loan portfolio, a decline in the regional economy may result in increasinglosses that cannot reasonably be predicted at this time.  For further information regarding the allowancefor loan losses see “Provision and Allowance for Loan and Lease Losses”included elsewhere herein.

 

Another critical accountingpolicy relates to the valuation of other real estate owned (OREO). Assetsacquired through, or in lieu of, loan foreclosure are held for sale and areinitially recorded at fair value less cost to sell at the date of foreclosure,establishing a new cost basis. Subsequent to foreclosure, valuations areperiodically performed by management and the assets are carried at the lower ofcarrying amount or fair value less estimated cost to sell. Any write-down tofair value at the time of transfer to OREO is charged to the allowance for loanand lease losses. Property is evaluated regularly to ensure that the recordedamount is supported by its current fair value and that valuation allowances toreduce the carrying amount to fair value less estimated costs to dispose arerecorded as necessary. Revenue and expenses from operations of OREO and changesin the valuation allowance are included in net expenses from OREO.

 

(NOTE 3) RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

 

InAugust 2009, the Financial Accounting Standards Board (FASB) issuedAccounting Standards Update (ASU) No. 2009-05, *Fair Value Measurements and Disclosures (Topic 820) : MeasuringLiabilities at Fair Value.*  This ASU provides amendmentsfor fair value measurements of liabilities.  It providesclarification that in circumstances in which a quoted price in an active marketfor the identical liability is not available, a reporting entity is required tomeasure fair value using one or more techniques.  ASU 2009-05 alsoclarifies that when estimating a fair value of a liability, a reporting entityis not required to include a separate input or adjustment to other inputsrelating to the existence of a restriction that prevents the transfer of theliability.  ASU 2009-05 is effective for the periods beginning after October 1,2009.  The adoption of ASU 2009-05 did not have a material impact on theCorporation’s consolidated financial statements.

 

InJanuary 2010, the FASB issued ASU No. 2010-06, *Fair ValueMeasurements and Disclosures (Topic 820):  Improving Disclosuresabout Fair Value Measurements*.  ASU 2010-06 revises twodisclosure requirements concerning fair value measurements and clarifies twoothers.  It requires separate presentation of significant transfersinto and out of Levels 1 and 2 of the fair value hierarchy and disclosure ofthe reasons for such transfers.  It will also require thepresentation of purchases, sales, issuances, and settlements within Level 3 ona gross basis rather than a net basis.  The amendments also clarifythat disclosures should be disaggregated by class of asset or liability andthat disclosures about inputs and valuation techniques should be provided forboth recurring and non-recurring fair valuemeasurements.   These new disclosure requirements becameeffective on January 1, 2010, except for the requirement concerning grosspresentation of Level 3 activity, which is effective for fiscal years beginningafter December 15, 2010.  There was no significant effect to theCorporation’s financial statement disclosures upon adoption of this ASU.

 

InJune 2009, the FASB issued ASU 2009-16 (formerly**Statementof Financial Accounting Standards (SFAS) No. 166), *Accounting for Transfers of Financial Assets, anamendment of FASB Statement No. 140*.  ASU 2009-16amends the de-recognition accounting and disclosure guidance relating to SFAS No. 140.  ASU2009-16 eliminates the exemption from consolidation for qualifying specialpurpose entities (QSPEs), and requires a transferor to evaluate all existingQSPEs to determine whether they must be consolidated in accordance with ASU2009-16.  It also

 

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amendsthe sale recognition rules for sales of participating interests in loans.ASU 2009-16 is effective as of the beginning of the first annual reportingperiod that begins after November 15, 2009.  As a result of theadoption of ASU 2009-16, the Corporation delays the accounting recognition ofsales of the guaranteed portion of SBA loans for 90 days.  The Corporation also ensures the proportionatesharing of cash flows prior to recognizing the sale of participation interestsin loans.

 

InJune 2009, the FASB issued ASU 2009-17 (formerly SFAS No. 167), *Improvements to Financial Reporting by EnterprisesInvolved with Variable Interest Entities.*This Statement amends ASCTopic 810, *Consolidation* to require an enterpriseto perform an analysis and ongoing reassessments to determine whether theenterprise’s variable interest or interests give it a controlling financialinterest in a variable interest entity, and amends certain guidance fordetermining whether an entity is a variable interest entity. It also requiresenhanced disclosures that will provide users of financial statements with moretransparent information about an enterprise’s involvement in a variableinterest entity. This Statement, which became effective for the Corporation on January 1,2010, did not have an impact on its consolidated financial statements as theCorporation has no interests in any variable interest entities.

 

InFebruary 2010, the FASBissued ASU 2010-09, *Subsequent Events (Topic 855):  Amendmentsto Certain Recognition and Disclosure Requirements*.  Theamendments remove the requirement for an SEC registrant to disclose the datethrough which subsequent events were evaluated, as this requirement would havepotentially conflicted with SEC reporting requirements.  Removal ofthe disclosure requirement did not have an affect on the nature or timing ofsubsequent events evaluations performed by the Corporation.  ASU2010-09 became effective upon issuance.

 

(NOTE4) STOCK BASED COMPENSATION

 

TheCorporation’s compensation cost relating to share-based payment transactions isrecognized in the financial statements based upon the fair value of the equityor liability instruments issued. Based on the stock-based compensation awardsoutstanding for the nine months ended September 30, 2010 and 2009, therewas no stock-based compensation expense.

 

Underthe Corporation’s 1998 Stock Option Plan, the Corporation granted 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 subsidiaryUnder the Plan, 64,661options had been reserved for the granting, all of which had been granted inprior periods.  At September 30,2010, 23,500 options were outstanding. During 2010, 2,661 options were exercised by officers, employees, andboard members.  No further options may begranted under the 1998 Stock Option Plan. The plan provided that options could be granted for a period of tenyears from the date the plan was adopted by the Board.  The Board adopted the plan on April 16,1998.  The plan remains in effect untilall options granted under the Plan have been satisfied or expired.

 

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 stock options are granted at fairvalue of the common stock on the date of grant. However, an incentive stock option granted to an individual owning 10%or more of the Corporation’s stock after such grant must have an exercise priceof at least 110% of such fair market value and an exercise period of not morethan five years.  The Board of Directorsis authorized to determine when options become exercisable within a period notexceeding 10 years 

 

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fromthe date of grant.  Under the Plan,300,000 shares of common stock have been reserved for the granting of theseoptions.  At September 30, 2010, nooptions have been granted under the 2007 stock option plan.  Thus, no pre-tax stock-based compensationexpense was required for the nine months ended September 30, 2010 and2009.

 

(NOTE 5) EARNINGS (LOSS) PER SHARE

 

Basicearnings (loss) per share represents income (loss) available to commonshareholders divided by the weighted-average number of common sharesoutstanding during the period.  Dilutedearnings (loss) per share reflect additional common shares that would have beenoutstanding, if potential dilutive common shares had been issued, as well asany adjustment to income that would result from the assumed issuance.  Potential common shares that may be issued bythe Corporation relate to outstanding stock options and warrants and aredetermined using the treasury stock method.

 

Theweighted-average number of shares used in computing basic and diluted earnings(loss) per share is as follows:

 
| ** **                                                          | ** ** | **Earnings (Loss) per Share  Calculation**                 | ** ** |
|---------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|
| ** **                                                          | ** ** | **For the three months ended September 30** | ** ** |
| ** **                                                          | ** ** | **2010**                                                                  | ** ** | **2009** | ** ** |
| ** **                                                          | ** ** | ** **                                                                | ** ** | **Weighted** | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** |
| **(in thousands except per**                         | ** ** | **Net**                                                                   | ** ** | **Average** | ** ** | **Per Share** | ** ** | **Net** | ** ** | **Average** | ** ** | **Per Share** | ** ** |
| **share data)**                                                | ** ** | **(Loss)**                                                                | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Income** | ** ** | **Shares** | ** ** | **Amount** | ** ** |
| Basic (loss) earnings per share                                     |       | $                                                                         | (1,015     | ) | 1,785,891 |   | $ | (0.57 | ) | $ | 744 |   | 1,783,230 |   | $ | 0.42 |   |
|                                                                |       |                                                                      |       |   |   |   |   |   |   |   |   |   |   |
| Effect of dilutive shares: assumed exercise of outstanding  options |       | —                                                                    |       | — |   | — |   | — |   | 5,504 |   | — |   |
|                                                                |       |                                                                      |       |   |   |   |   |   |   |   |   |   |   |
| Diluted (loss) earnings per share                                   |       | $                                                                         | (1,015     | ) | 1,785,891 |   | $ | (0.57 | ) | $ | 744 |   | 1,788,734 |   | $ | 0.42 |   |

 
| ** **                                                          | ** ** | **Earnings (Loss) per Share  Calculation**                | ** ** |
|---------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| ** **                                                          | ** ** | **For the nine months ended September 30** | ** ** |
| ** **                                                          | ** ** | **2010**                                                                 | ** ** | **2009** | ** ** |
| ** **                                                          | ** ** | ** **                                                               | ** ** | **Weighted** | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** |
| **(in thousands except per**                         | ** ** | **Net**                                                                  | ** ** | **Average** | ** ** | **Per Share** | ** ** | **Net** | ** ** | **Average** | ** ** | **Per Share** | ** ** |
| **share data)**                                                | ** ** | **(Loss)**                                                               | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Income** | ** ** | **Shares** | ** ** | **Amount** | ** ** |
| Basic (loss) earnings per share                                     |       | $                                                                        | (1,352     | ) | 1,785,179 |   | $ | (0.76 | ) | $ | 1,823 |   | 1,793,910 |   | $ | 1.02 |   |
|                                                                |       |                                                                     |       |   |   |   |   |   |   |   |   |   |   |
| Effect of dilutive shares: assumed exercise of outstanding  options |       | —                                                                   |       | — |   | — |   | — |   | 3,244 |   | 0.01 |   |
|                                                                |       |                                                                     |       |   |   |   |   |   |   |   |   |   |   |
| Diluted (loss) earnings per share                                   |       | $                                                                        | (1,352     | ) | 1,785,179 |   | $ | (0.76 | ) | $ | 1,823 |   | 1,797,154 |   | $ | 1.01 |   |

 

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(NOTE 6) INVESTMENT SECURITIES

 

Thefollowing table presents investment securities, available for sale at September 30,2010 and December 31, 2009:

 
| ** **                          | ** ** | **September 30, 2010**     | ** ** |
|-------------------------------------|------------|--------------------------------------|------------|
| ** **                          | ** ** | ** **                           | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                          | ** ** | **Amortized**                        | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                          | ** ** | **Cost**                             | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
| ** **                          | ** ** | **(Dollars in thousands)** | ** ** |
| Securities Available for  Sale      |       |                                 |       |   |   |   |   |   |   |
| Mortgage Backed Securities          |       | $                                    | 675        |   | $ | 33 |   | $ | — |   | $ | 708 |   |
| State/Local Agency Securities       |       | 39,369                               |       | 1,288 |   | (451 | ) | 40,206 |   |
| Government Agency Securities        |       | 1,997                                |       | 23 |   | — |   | 2,020 |   |
|                                |       |                                 |       |   |   |   |   |   |   |
| Total securities available for sale |       | $                                    | 42,041     |   | $ | 1,344 |   | $ | (451 | ) | $ | 42,934 |   |

 
| ** **                          | ** ** | **December 31, 2009**      | ** ** |
|-------------------------------------|------------|--------------------------------------|------------|
| ** **                          | ** ** | ** **                           | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                          | ** ** | **Amortized**                        | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                          | ** ** | **Cost**                             | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
| ** **                          | ** ** | **(Dollars in thousands)** | ** ** |
| Securities Available for  Sale      |       |                                 |       |   |   |   |   |   |   |
| Mortgage Backed Securities          |       | $                                    | 1,534      |   | $ | — |   | $ | (44 | ) | $ | 1,490 |   |
| State/Local Agency Securities       |       | 53,000                               |       | 1,501 |   | (1,427 | ) | 53,074 |   |
| Government Agency Securities        |       | 7,988                                |       | — |   | (139 | ) | 7,849 |   |
|                                |       |                                 |       |   |   |   |   |   |   |
| Total securities available for sale |       | $                                    | 62,522     |   | $ | 1,501 |   | $ | (1,610 | ) | $ | 62,413 |   |

 

Inaddition, the Corporation maintains a trading account, at fair value,consisting of marketable securities.  At September 30,2010 and December 31, 2009 the account value was $106,000 and $153,000,respectively.

 

Theamortized cost and fair value of debt securities by contractual maturity date atSeptember 30, 2010 follows:

 
| ** **                           | ** ** | **Available for Sale** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|
| ** **                           | ** ** | **Amortized**                    | ** ** | **Fair** | ** ** |
| **(Dollars in thousands)** | ** ** | **Cost**                         | ** ** | **Value** | ** ** |
|                                 |       |                             |       |   |   |
| Due after ten years                  |       | $                                | 42,041     |   | $ | 42,934 |   |
|                                      |            |                                  |            |  |  |  |  |

 

Proceedsfrom calls, maturities and sales of investment securities for the nine monthsended September 30, 2010, and 2009 were $25,395,000, and $129,848,000,respectively.  Realized gains for ninemonths ended September 30, 2010, and 2009 were $936,000, and $3,153,000,respectively.

 

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AtSeptember 30, 2010 and December 31, 2009, U.S. Government andMortgage Backed obligations with a carrying value of $2,726,000 and $8,761,000,respectively, were pledged to secure advances from the Federal Home Loan Bankof San Francisco.

 

AtSeptember 30, 2010 and December 31, 2009 State/Local Agencyobligations with a carrying value of $17,856,000 and $20,462,000, respectively,were pledged to secure loans from the Federal Reserve Bank of San Francisco.

 

InSeptember 2010, the Bank sold debt securities with proceeds totaling$769,000 that had settlement dates in October 2010.  The Bank had recorded the investmentsecurities sold as of the trade date and had recorded the correspondingreceivable of $769,000 at September 30, 2010.

 

Information pertaining to securities with gross unrealized losses at September 30,2010, aggregated by investment category and length of time that individualsecurities have been in a continuous loss position follows:

 
| ** **                      | ** ** | **Less than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
|---------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|-----------|------------|
| ** **                      | ** ** | **Fair**                               | ** ** | **Unrealized**                       | ** ** | **Fair**  | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                      | ** ** | **Value**                              | ** ** | **Loss**                             | ** ** | **Value** | ** ** | **Loss** | ** ** | **Value** | ** ** | **Loss** | ** ** |
| ** **                      | ** ** | **(Dollars in thousands)**   | ** ** |
| Securities  Available for Sale: |       |                                   |       |                                 |       |      |       |   |   |   |   |   |   |
|                            |       |                                   |       |                                 |       |      |       |   |   |   |   |   |   |
| State/Local  Agency Securities  |       | $                                      | 2,699      |                                 | $          | (136      | )          | $ | 5,316 |   | $ | (315 | ) | $ | 8,015 |   | $ | (451 | ) |
|                                 |            |                                        |            |                                      |            |           |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

Information pertaining to securities with gross unrealized losses at December 31,2009, aggregated by investment category and length of time that individualsecurities have been in a continuous loss position follows:

 
| ** **                      | ** ** | **Less than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
|---------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|-----------|------------|
| ** **                      | ** ** | **Fair**                               | ** ** | **Unrealized**                       | ** ** | **Fair**  | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                      | ** ** | **Value**                              | ** ** | **Loss**                             | ** ** | **Value** | ** ** | **Loss** | ** ** | **Value** | ** ** | **Loss** | ** ** |
| ** **                      | ** ** | **(Dollars in thousands)**   | ** ** |
| Securities  Available for Sale: |       |                                   |       |                                 |       |      |       |   |   |   |   |   |   |
|                            |       |                                   |       |                                 |       |      |       |   |   |   |   |   |   |
| Government  Agency Securities   |       | $                                      | 7,849      |                                 | $          | (139      | )          | $ | — |   | $ | — |   | $ | 7,849 |   | $ | (139 | ) |
|                            |       |                                   |       |                                 |       |      |       |   |   |   |   |   |   |
| Mortgage  Backed Securities     |       | 1,491                                  |       | (44                                  | )          | —    |       | — |   | 1,491 |   | (44 | ) |
|                            |       |                                   |       |                                 |       |      |       |   |   |   |   |   |   |
| State/Local  Agency Securities  |       | 8,827                                  |       | (245                                 | )          | 8,889     |       | (1,182 | ) | 17,716 |   | (1,427 | ) |
|                            |       |                                   |       |                                 |       |      |       |   |   |   |   |   |   |
| Total                           |       | $                                      | 18,167     |                                 | $          | (428      | )          | $ | 8,889 |   | $ | (1,182 | ) | $ | 27,056 |   | $ | (1,610 | ) |

 

Management evaluates securities for other-than-temporary impairment atleast on a quarterly basis, and more frequently when economic or marketconcerns warrant such evaluation. Consideration is given to (1) the lengthof time and the extent to which the fair value has been less than cost, (2) thefinancial condition and near-term prospects of the issuer, and (3) if Bankdoes not have the intent to sell the security; whether it is more likely thannot it will not have to sell the security before recovery of its cost basis.

 

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OnSeptember 30, 2010, twelve securities had an unrealized loss withaggregate depreciation of 5.32% from the Bank’s amortized cost basis. On December 31,2009, forty securities had an unrealized loss with aggregate depreciation of5.62% from the Bank’s amortized cost basis. The unrealized losses relateprimarily to securities issued by agencies of the United States and securitiesissued by local government agencies. Since the Bank has the ability to hold these securities until estimatedmaturity, no decline is deemed to be other than temporary.

 

(NOTE 7) LOANS AND ALLOWANCE FOR LOAN LOSSES

 

Thefollowing table presents information on loans and the allowance for loan andlosses at September 30, 2010 and December 31, 2009:

 
| ** **                            | ** ** | **SEPTEMBER 30** | ** ** | **DECEMBER 31** | ** ** |
|---------------------------------------|------------|-----------------------|------------|----------------------|------------|
| **(dollars in thousands)**  | ** ** | **2010**              | ** ** | **2009**             | ** ** |
| Commercial and Industrial             |       | $                     | 36,028     |                 | $          | 31,389 |   |
| Construction                          |       | 1,265                 |       | 8,705                |       |
| Real Estate - Mortgage                |       | 119,495               |       | 121,887              |       |
| Installment                           |       | 566                   |       | 2,746                |       |
| Government Guaranteed Loans Purchased |       | 9                     |       | 16                   |       |
|                                  |       | 157,363               |       | 164,743              |       |
| Allowance for loan losses             |       | (3,253                | )          | (3,529               | )          |
| Deferred origination fees, net        |       | (179                  | )          | (217                 | )          |
| Net Loans                             |       | $                     | 153,931    |                 | $          | 160,997 |   |
|                                  |       |                  |       |                 |       |
| Balance at Beginning of Period        |       | $                     | 3,529      |                 | $          | 2,413 |   |
| Recoveries                            |       | 2                     |       | 77                   |       |
| Provision for Loan Losses             |       | —                |       | 3,368                |       |
| Charge Offs                           |       | (278                  | )          | (2,329               | )          |
| Balance at End of Period              |       | $                     | 3,253      |                 | $          | 3,529 |   |

 

The following table summarizes the Bank’s investment in loans for whichimpairment has been recognized as of and for the periods ended September 30,2010 and December 31, 2009. Impaired loans consist of the loans on non-accrual status.  There were two loans past due 90 days or moreand still accruing as of September 30, 2010 that were not consideredimpaired since they are well secured and process of collection, and no loans werepast due 90 days or more and still accruing as of December 31, 2009.

 
| ** **                                                                                                                    | ** ** | **September 30, 2010**     | ** ** | **December 31, 2009** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                    | ** ** | **(Dollars in thousands)** | ** ** |
| Total impaired loans which as a result of  write-down or the fair value of the collateral, did not have a specific  allowance |       | $                                    | 2,195      |                            | $          | 4,399 |   |
| Impaired loans which have a specific allowance                                                                                |       | 2,185                                |       | 3,681                           |       |
| ** **                                                                                                                    | ** ** | ** **                           | ** ** | ** **                      | ** ** |
| Total impaired loans                                                                                                          |       | $                                    | 4,380      |                            | $          | 8,080 |   |
|                                                                                                                          |       |                                 |       |                            |       |
| Total specific allowance on impaired loans                                                                                    |       | $                                    | 117        |                            | $          | 357 |   |
|                                                                                                                          |       |                                 |       |                            |       |
| Average recorded investment in impaired loans  during the period                                                              |       | $                                    | 7,087      |                            | $          | 6,490 |   |
|                                                                                                                          |       |                                 |       |                            |       |
| Income recognized on impaired loans during the  period                                                                        |       | $                                    | —     |                            | $          | — |   |

 

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(NOTE8) FORECLOSED ASSETS

 

Asof September 30, 2010 and December 31, 2009, foreclosed assetstotaled $27,575,000 and $14,333,000, respectively, net of valuation allowance.Based on property values, a valuation allowance of $2,060,000 and $1,010,000 wasdeemed necessary at September 30, 2010 and December 31, 2009,respectively.

 

Duringthe nine months ended September 30, 2010 four properties were purchasedfor $6,942,000 in a negotiated settlement of a lawsuit.

 

Duringthe nine months ended September 30, 2010 four properties were sold for$3,419,000, with a loss on sale of $136,000. One property valued at $520,000 was acquired through trade.  During the nine months ended September 30,2009 four properties were sold for $7,700,000, with a loss on sale of$67,000.  Two properties valued at$4,185,000 were acquired through trade, resulting in a deferred gain on sale of$279,000.

 

Operatingexpenses for foreclosed assets totaled $1,997,000 and $792,000 for the ninemonths ended September 30, 2010 and 2009, respectively.

 

(NOTE 9) FAIR VALUE MEASUREMENTS:

 

Authoritativeguidance establishes a hierarchy for measuring fair value under generallyaccepted accounting principles (GAAP) in the United States of America andapplies to all financial assets and liabilities that are being measured andreported at fair value on a recurring and non-recurring basis. Fair value ismeasured in levels, which are described in more detail below, and is determinedbased on the observability and reliability of the assumptions used to determinefair value.

 

**Level 1:** Valuation for assets andliabilities traded in active exchange markets. Valuations are obtained fromreadily available pricing sources for market transactions involving identicalassets or liabilities.

 

**Level 2:** Valuation for assets andliabilities traded in less active dealer or broker markets. Valuations areobtained from third party pricing services for identical or comparable assetsor liabilities.

 

**Level 3:** Valuation for assets andliabilities that are derived from other valuation methodologies, includingoption pricing models, discounted cash flow models, and similar techniques, andnot based on market exchange, dealer, or broker traded transactions. Thesevaluations incorporate certain assumptions and projections by management indetermining the fair value assigned to such assets or liabilities.

 

TheCorporation measures and reports available-for-sale securities at fair value ona recurring basis. The following tables show the balances of these assets basedon the designated levels at September 30, 2010 and December 31, 2009.

 
| ** **                           | ** ** | **At September 30, 2010** | ** ** |
|--------------------------------------|------------|------------------------------------------|------------|
| **(dollars in thousands)** | ** ** | **Total**                                | ** ** | **(Level 1)** | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
| Investment securities — AFS     |       | $                                        | 42,934     |   | $ | — |   | $ | 42,934 |   | $ | — |   |
|                                      |            |                                          |            |  |  |  |  |  |  |  |  |  |  |

 

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| ** **                           | ** ** | **At December 31, 2009** | ** ** |
|--------------------------------------|------------|-----------------------------------------|------------|
| **(dollars in thousands)** | ** ** | **Total**                               | ** ** | **(Level 1)** | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
| Investment securities — AFS     |       | $                                       | 62,413     |   | $ | — |   | $ | 62,413 |   | $ | — |   |
|                                      |            |                                         |            |  |  |  |  |  |  |  |  |  |  |

 

Fairvalues of investment securities available for sale are based on brokerquotes.  Such third party information wasnot adjusted by management; thus, the fair values of investment securitiesavailable for sale are classified as level 2.

 

TheCorporation is also required, from time to time, to measure certain otherassets at fair value on a non-recurring basis in accordance with GAAP. Duringthe nine months ended September 30, 2010, the Corporation measuredcollateral dependent impaired loans, loans held for sale, 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’ designatedlevels, as well as the fair value losses recognized during the nine monthsended September 30, 2010 and the year ended December 31, 2009.

 
| ** **                           | ** ** | **At September 30,** | ** ** |
|--------------------------------------|------------|--------------------------------|------------|
| **(dollars in thousands)** | ** ** | **Total**                      | ** ** | **(Level 1)** | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** | **Losses for the****nine months****ended September  30, 2010** | ** ** |
| Impaired loans                       |       | $                              | 4,380      |   | $ | — |   | $ | — |   | $ | 4,380 |   | $ | 117 |   |
| Loans held for sale                  |       | 1,598                          |       | — |   | 1,598 |   | — |   | — |   |
| OREO                                 |       | 27,575                         |       | — |   | — |   | 27,575 |   | — |   |
|                                 |       | $                              | 33,553     |   | $ | — |   | $ | 1,598 |   | $ | 31,955 |   | $ | 117 |   |

 
| ** **                           | ** ** | **At December 31, 2009** | ** ** |
|--------------------------------------|------------|-----------------------------------------|------------|
| **(dollars in thousands)** | ** ** | **Total**                               | ** ** | **(Level 1)** | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** | **Losses for the  year ended  December 31,  2009** | ** ** |
| Impaired loans                       |       | $                                       | 8,080      |   | $ | — |   | $ | — |   | $ | 8,080 |   | $ | 357 |   |
| Loans held for sale                  |       | 2,216                                   |       | — |   | 2,216 |   | — |   | — |   |
| OREO                                 |       | 14,333                                  |       | — |   | — |   | 14,333 |   | — |   |
|                                 |       | $                                       | 24,629     |   | $ | — |   | $ | 2,216 |   | $ | 22,413 |   | $ | 357 |   |

 

*Impaired Loans*

 

Collateral-dependent impaired loans are carried at the fair value of thecollateral, less estimated costs to sell. The fair value of collateral isdetermined based on appraisals. In some cases, adjustments were made to theappraised values for various factors including age of the appraisal, age ofcomparables included in the appraisal, and known changes in the market and inthe collateral. When significant adjustments were based on unobservable inputs,the resulting fair value measurement has been categorized as a Level 3measurement. Otherwise, collateral-dependent impaired loans are categorizedunder Level 2.

 

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Impaired loans that are not collateral dependent are carried at thepresent value of expected future cash flows discounted at the loan’s effectiveinterest rate. Troubled debt restructurings are also carried at the presentvalue of expected future cash flows. However, expected cash flows for troubleddebt restructurings are discounted using the loan’s original effective interestrate rather than the modified interest rate. Since fair value of these loans isbased on management’s own projection of future cash flows, the fair valuemeasurements are categorized as Level 3 measurements.

 

*Loans Held for Sale*

 

Loans held for sale are required to be measured at the lower of cost orfair value. Management obtains quotes or bids on all or part of these loansdirectly from the purchasing financial institutions, which are a level 2inputs. Premiums received or to be received on the quotes or bids areindicative of the fact that cost is lower than fair value. At September 30,2010, the fair value of loans held for sale was greater than cost; therefore,the entire balance of loans held for sale was recorded at cost.

 

*Foreclosed Assets*

 

Assets acquired through foreclosure or other proceedings are initiallyrecorded at fair value at the date of foreclosure less estimated costs ofdisposal, which establishes a new cost. After foreclosure, valuations areperiodically performed, and foreclosed assets held for sale are carried at thelower of cost or fair value, less estimated costs of disposal. All foreclosedassets are real properties. The fair values of real properties initially aredetermined based on appraisals. In some cases, adjustments were made to theappraised values for various factors including age of the appraisal, age ofcomparables included in the appraisal, and known changes in the market or inthe collateral. Subsequent valuations of the real properties are based onmanagement estimates or on updated appraisals. Foreclosed assets arecategorized under Level 3 when significant adjustments are made by managementto appraised values based on unobservable inputs. Otherwise, foreclosed assetsare categorized under Level 2 if their values are based solely on appraisals.

 

Currentauthoritative guidance requires interim reporting period disclosure about thefair value of financial instruments, including assets, liabilities andoff-balance sheet items for which it is practicable to estimate fair value. Thefair value estimates are made based upon relevant market information, ifavailable, and upon the characteristics of the financial instrumentsthemselves. Because no market exists for a significant portion of theCorporation’s financial instruments, fair value estimates are based uponjudgments regarding future expected loss experience, current economicconditions, risk characteristics of various financial instruments and otherfactors. The estimated fair value of the Corporation’s financial instruments asof September 30, 2010 and December 31, 2009 is shown below.

 

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| ** **                                | ** ** | **September 30, 2010** | ** ** | **December 31, 2009** | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                | ** ** | **Carrying**                     | ** ** | **Fair**                        | ** ** | **Carrying** | ** ** | **Fair** | ** ** |
| **(dollars in thousands)**      | ** ** | **Amount**                       | ** ** | **Value**                       | ** ** | **Amount** | ** ** | **Value** | ** ** |
| Financial Assets                          |       |                             |       |                            |       |   |   |   |   |
| Cash and cash equivalents                 |       | 34,769                           |       | 34,769                          |       | 12,251 |   | 12,251 |   |
| Interest Bearing Deposits                 |       | 5,000                            |       | 5,000                           |       | — |   | — |   |
| Investment Securities, available for sale |       | 42,934                           |       | 42,934                          |       | 62,413 |   | 62,413 |   |
| Other Investments                         |       | 3,835                            |       | 3,835                           |       | 4,085 |   | 4,085 |   |
| Trading Assets                            |       | 106                              |       | 106                             |       | 153 |   | 153 |   |
| Loans, held for sale                      |       | 1,598                            |       | 1,598                           |       | 2,216 |   | 2,216 |   |
| Loans, net                                |       | 153,931                          |       | 187,002                         |       | 160,997 |   | 163,839 |   |
| Accrued interest receivable               |       | 1,032                            |       | 1,032                           |       | 1,371 |   | 1,371 |   |
|                                      |       |                             |       |                            |       |   |   |   |   |
| Financial Liabilities                     |       |                             |       |                            |       |   |   |   |   |
| Deposits                                  |       | 218,815                          |       | 219,659                         |       | 202,422 |   | 205,699 |   |
| Long-term debt                            |       | 42,248                           |       | 43,913                          |       | 37,248 |   | 33,929 |   |
| Short-term debt                           |       | 2,850                            |       | 2,850                           |       | 12,850 |   | 12,850 |   |
| Accrued Interest Payable                  |       | 1,608                            |       | 1,608                           |       | 1,274 |   | 1,274 |   |

 

(NOTE 10) OFF-BALANCESHEET COMMITMENTS:

 

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

 

TheBank’s exposure to credit loss is represented by the contractual amount ofthese commitments.  The Bank uses thesame credit policies in making commitments as it does for on-balance-sheetinstruments.

 

At September 30, 2010 and December 31, 2009, such commitmentsto extend credit were $15,231,000 and $14,839,000, respectively, comprised ofundisbursed lines of credit, undisbursed loans in process, and commitmentletters.

 

The Bank has two letters of credit issued byFederal Home Loan Bank of San Francisco. One letter of credit in the amount of$330,000, expiring April 17, 2011, is used to secure local agencydeposits.  The beneficiary of the letterof credit is the Administrator of Local Agency Security, California Departmentof Financial Institutions.  The otherletter of credit in the amount of $1,300,000, expiring February 17, 2019,has MasterCard International Inc. as the beneficiary and is used to securesettlement of credit card transactions.

 

(NOTE11) CONSENT ORDER

 

TheCorporation’s wholly-owned subsidiary bank, Monterey County Bank (the “Bank,”)has entered into a Consent Order (the “Order”) with the Federal DepositInsurance Corporation (the “FDIC”) and the California Department of FinancialInstitutions (the “CDFI”).   The Order became effective on September 1,2010. Among other requirements, the Order requires the Bank to maintain Tier 1capital in such an amount to ensure that the Bank’s leverage ratio equals orexceeds 9% and the Bank’s total risk-based capital ratio equals or exceeds 12%within 120 days of the effective date of the Order (i.e., by December 29,2010). The Bank’s leverage ratio and

 

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totalrisk-based capital ratio are 8.48% and 13.91%, respectively, as of September 30,2010. The Bank is taking certain steps, including the sale of certain of itsmerchant card processing accounts (see Note 12 below), to achieve compliancewith the minimum required leverage capital ratio by the due date. For moreinformation on the Order, see the “Other Regulatory Matters” section of Item 2of this Form 10-Q.

 

(NOTE12) SUBSEQUENT EVENT

 

Subsequentto September 30, 2010 the Bank entered into and closed an agreement tosell certain of its merchant credit card processing accounts to Elavon, Inc,for $1,850,000, effective as of November 1, 2010.   TheAgreement calls for the Bank to receive an initial payment of $1,000,000 atclosing, with $800,000 due within thirty (30) days of the Bank attaining aLeverage Capital Ratio of 9%, a payment of $50,000 due upon the completion ofthe transition of the merchant accounts purchased to Elavon’s processingsystem, additionally,  the Bank willshare in the monthly net income of the accounts sold.  Since the Bank’s basis in the sold accountsis zero under U.S. generally accounting principles, the entire purchase pricewill be recognized as income.

 

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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, the mattersdiscussed or incorporated by reference in this report contain forward-lookingstatements within the meaning of Section 27A of the Securities Act of1933, as amended (the “Securities Act”), and Section 21E of the SecuritiesExchange Act of 1934 (the “Exchange Act”), that involve substantial risks anduncertainties.  When used in this report, or in the documents incorporatedby reference herein, the words “anticipate,” “believe,” “estimate,” “may,” “intend,”“expect,” and similar expressions identify certain of such forward-lookingstatements.  Actual results of the Corporation and the Bank could differmaterially from such forward-looking statements contained herein.  Factorsthat could cause future results to vary from current expectations include, butare not limited to, the following: changes in economic conditions (bothgenerally and more specifically in the markets in which the Bank operates);changes in interest rates, deposit flows, loan demand, real estate values andcompetition; changes in accounting principles, policies or guidelines and ingovernment legislation and regulation (which change from time to time and overwhich the Bank has no control); other factors affecting the Bank’s operations,markets, products and services; and other risks detailed in this Form 10-Qand in the Bank’s other reports filed with the Federal Deposit InsuranceCorporation (FDIC) and pursuant to the rules and regulations of the Securitiesand Exchange Commission.  Readers are cautioned not to place unduereliance on these forward-looking statements, which reflect management’sanalysis only as of the date hereof.  The Corporation undertakes noobligation to publicly revise these forward-looking statements to reflectevents or circumstances that arise after the date thereof.

 

**OVERVIEW OF THE RESULTS OF OPERATION AND FINANCIAL CONDITION**

 

**Results of Operations Summary**

 

**Third quarter 2010 compared to third quarter 2009**

 

Netloss for the quarter ended September 30, 2010 was $1,015,000 compared withnet income of $744,000 for the quarter ended September 30, 2009. Basicloss per share for the third quarter of 2010 was ($0.57), compared to basicearnings of $0.42 for the third quarter of 2009. The Corporation’s annualizedreturn on average equity was (24.97%) and annualized return on average assetswas (1.39%) for the quarter ended September 30, 2010, compared to a returnon average equity of 13.14% and a return on assets of 0.78% for same quarter in2009. The primary reasons for the change in net income during the quarter of2010 are as follows:

 

The net interest income decreased from $1,661,000 to $1,512,000, dueprimarily to a decline of $8,018,000 in average interest-earning assets whileaverage interest bearing liabilities increased $8,688,000.  As a result, net interest income decreased$149,000 or 8.97% during the three months ended September 30, 2010.

 

No provision for loan losses was recorded during the third quarter of2010 compared to a provision of $1,272,000 during the third quarter of 2009.

 

Total non-interest income was $2,226,000 during the third quarter of2010 compared to $4,072,000 during the third quarter of 2009.  The decrease of $1,846,000 was due primarilyto decreases of $1,500,000 in gains on sales of investment securities and$214,000 in other income.

 

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Total non-interest expense was $5,784,000 during the third quarter of2010 compared to $3,420,000 during the third quarter of 2009, an increase of$2,364,000.  The resolution of an FDICinvestigation of a third-party credit card program and a third-party debit cardprogram resulted in charges to earnings, net of receivables from thethird-party debit card program, of $1,250,000 for potential restitution tocardholders, $250,000 in civil money penalty and a charitable donation of$300,000, for a total of $1,800,000. See the Other Regulator Matters section ofthis report for additional information. Additionally, changes occurred as the result of an accrual of estimatedlitigation settlement expense of $158,000 and increases of $753,000 in expensesrelated to foreclosed assets and $231,000 in professional fees.  These increases in expense were partiallyoffset by a decrease of $457,000 in prepayment fees on borrowings and a declineof $169,000 in other general and administrative expense.

 

Subsequent to September 30, 2010 the Bank entered into and closedan agreement to sell certain of its merchant credit card processing accounts toElavon, Inc. for $1,850,000, effective as of November 1, 2010.    The Agreement calls for the Bank to receivean initial payment of $1,000,000 at closing, with $800,000 due within thirty(30) days of the Bank attaining a Leverage Capital Ratio of 9%, a payment of$50,000 due upon the completion of the transition of the merchant accountspurchased to Elavon’s processing system, additionally, the Bank will share inthe monthly net income of the accounts sold. Since the Bank’s basis in the sold accounts is zero under U.S. generallyaccounting principles, the entire purchase price will be recognized as income.

 

**Nine months ended September 30, 2010 compared to the same periodin 2009**

 

Netloss for the nine months ended September 30, 2010 was $1,352,000 comparedwith net income of $1,823,000 for the nine months ended September 30,2009. Basic loss per share for the third quarter of 2010 was $(0.76), comparedto basic earnings per share of $1.02 for the nine months ended September 30,2009. The Corporation’s annualized return on average equity was (11.09%) andannualized return on average assets was (0.62%) for the nine months ended September 30,2010, compared to an annualized return on average equity of 15.15% and anannualized return on average assets of .80% for the nine months ended September 30,2009. The primary reasons for the change in net income during the nine monthsended September 30, 2010 are as follows:

 

Net interest income decreased from $5,654,000 to $5,163,000, a declineof $491,000 or (8.68%).  Averageinterest-earning assets declined $16,727,000 while interest-bearing liabilitiesdecreased $16,786,000.  The interest rateon the interest-earning assets was approximately 300 basis points higher thanthe interest rate paid on the interest-bearing liabilities.

 

No provision for loan losses was during the third quarter of 2010compared to a provision of $1,918,000 during the nine months ended September 30,2009.

 

Total non-interest income was $5,277,000 during the nine months ended September 30,2010 compared to $8,375,000 during the nine months ended September 30,2009.  The decrease of $3,098,000 was dueprimarily to decreases of $2,217,000 in gains on sales of investment securitiesand $666,000 in other income.

 

Total non-interest expense was $13,244,000 during the nine months endedSeptember 30, 2010 compared to $9,818,000 during the nine months ended September 30,2009, an increase of $3,426,000.  Theresolution of an FDIC investigation of a third-party credit card program and a

 

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third-party debit card program resulted in charges to earnings, net ofreceivables from the third-party debit card program, of $1,250,000 forpotential restitution to cardholders, $250,000 in civil money penalty and acharitable donation of $300,000, for a total of $1,800,000. See the Other RegulatorMatters section of this report for additional information.  Additionally changes occurred as the resultof litigation settlement expense of $1,038,000 and increases of $1,205,000 inexpenses related to foreclosed assets, $540,000 professional fees and $280,000in salaries and employee benefits, partially offset by a decrease of $888,000in prepayment fees on borrowings and a decrease of $502,000 in other generaland administrative expense.

 

Subsequent to September 30, 2010 the Bank entered into and closedan agreement to sell certain of its merchant credit card processing accounts toElavon, Inc. for $1,850,000, effective as of November 1, 2010.    The Agreement calls for the Bank to receivean initial payment of $1,000,000 at closing, with $800,000 due within thirty(30) days of the Bank attaining a Leverage Capital Ratio of 9%, a payment of$50,000 due upon the completion of the transition of the merchant accountspurchased to Elavon’s processing system, additionally, the Bank will share inthe monthly net income of the accounts sold. Since the Bank’s basis in the sold accounts is zero under U.S. generallyaccounting principles, the entire purchase price will be recognized as income.

 

The following table sets forth certain selected financial data andratios of the Corporation for the three months and nine months ended September 30,2010 and 2009.

 
| ** **                                               | ** ** | **Three Months Ended September 30** | ** ** | **Nine Months Ended September 30** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------------------|------------|--------------------------------------------------------|------------|
| **(in thousands except share data)** | ** ** | **2010**                                                | ** ** | **2009**                                               | ** ** | **2010** | ** ** | **2009** | ** ** |
| Summary of Operating Results:                            |       |                                                    |       |                                                   |       |   |   |   |   |
| Total interest income                                    |       | $                                                       | 2,998      |                                                   | $          | 3,591 |   | $ | 9,632 |   | $ | 12,049 |   |
| Total interest expense                                   |       | 1,486                                                   |       | 1,930                                                  |       | 4,469 |   | 6,395 |   |
| Net interest income                                      |       | 1,512                                                   |       | 1,661                                                  |       | 5,163 |   | 5,654 |   |
|                                                     |       |                                                    |       |                                                   |       |   |   |   |   |
| Provision for loan losses                                |       | —                                                  |       | 1,272                                                  |       | — |   | 1,918 |   |
| Net interest income after provision for loan  losses     |       | 1,512                                                   |       | 389                                                    |       | 5,163 |   | 3,736 |   |
|                                                     |       |                                                    |       |                                                   |       |   |   |   |   |
| Total non-interest income                                |       | 2,226                                                   |       | 4,072                                                  |       | 5,277 |   | 8,375 |   |
| Total non-interest expenses                              |       | 5,784                                                   |       | 3,420                                                  |       | 13,244 |   | 9,818 |   |
|                                                     |       |                                                    |       |                                                   |       |   |   |   |   |
| Income (loss) before tax provision (benefit)             |       | (2,046                                                  | )          | 1,041                                                  |       | (2,804 | ) | 2,293 |   |
| Income tax provision (benefit)                           |       | (1,031                                                  | )          | 297                                                    |       | (1,452 | ) | 470 |   |
|                                                     |       |                                                    |       |                                                   |       |   |   |   |   |
| Net income (loss)                                        |       | $                                                       | (1,015     | )                                                      | $          | 744 |   | $ | (1,352 | ) | $ | 1,823 |   |
|                                                     |       |                                                    |       |                                                   |       |   |   |   |   |
| Per Common Share Data:                                   |       |                                                    |       |                                                   |       |   |   |   |   |
|                                                     |       |                                                    |       |                                                   |       |   |   |   |   |
| Net income (loss) - Basic (1)                            |       | $                                                       | (0.57      | )                                                      | 0.42       |   | $ | (0.76 | ) | $ | 1.02 |   |
| Net income (loss) - Diluted (2)                          |       | (0.57                                                   | )          | 0.42                                                   |       | (0.76 | ) | 1.01 |   |
| Book value, end of period                                |       | 8.60                                                    |       | 9.44                                                   |       | 8.60 |   | 9.44 |   |
| Shares outstanding end of period                         |       | 1,785,891                                               |       | 1,783,230                                              |       | 1,785,891 |   | 1,783,230 |   |
|                                                     |       |                                                    |       |                                                   |       |   |   |   |   |
| Balance Sheet Data:                                      |       |                                                    |       |                                                   |       |   |   |   |   |
|                                                     |       |                                                    |       |                                                   |       |   |   |   |   |
| Total loans, net of unearned income (3)                  |       | $                                                       | 155,529    |                                                   | 167,287    |   | $ | 155,529 |   | $ | 167,287 |   |
| Total assets                                             |       | 287,645                                                 |       | 280,929                                                |       | 287,645 |   | 280,929 |   |
| Total deposits                                           |       | 218,815                                                 |       | 217,892                                                |       | 218,815 |   | 217,892 |   |
| Stockholders’ equity                                |       | 15,360                                                  |       | 16,824                                                 |       | 15,360 |   | 16,824 |   |

 

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| ** **                                                               | ** ** | **Three Months Ended September 30** | ** ** | **Nine Months Ended September 30** | ** ** |
|--------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                                               | ** ** | **2010**                                                | ** ** | **2009**                                               | ** ** | **2010** | ** ** | **2009** | ** ** |
| Selected Financial Ratios:                                               |       |                                                    |       |                                                   |       |   |   |   |   |
| Return on average assets (4) (4)                                    |       | (1.39                                                   | )%         | 1.03                                                   | %          | (0.47 | )% | 0.80 | % |
| Return on average stockholders’ equity  (4) (5)                |       | (24.97                                                  | )%         | 17.34                                                  | %          | (8.32 | )% | 15.15 | % |
| Net interest spread                                                      |       | 2.63                                                    | %          | 1.73                                                   | %          | 3.05 | % | 3.03 | % |
| Net yield on interest earning assets (4)                                 |       | 2.80                                                    | %          | 2.28                                                   | %          | 3.22 | % | 3.24 | % |
| Avg shareholders’ equity to average assets (4)                      |       | 5.57                                                    | %          | 5.93                                                   | %          | 5.68 | % | 5.29 | % |
| Risked-Based capital ratios                                              |       |                                                    |       |                                                   |       |   |   |   |   |
| Tier 1                                                                   |       | 9.44                                                    | %          | 10.47                                                  | %          | 9.44 | % | 10.47 | % |
| Total                                                                    |       | 12.92                                                   | %          | 13.39                                                  | %          | 12.92 | % | 13.39 | % |
| Total loans to total deposits at end of period (3)                       |       | 72.65                                                   | %          | 76.78                                                  | %          | 72.65 | % | 76.78 | % |
| Allowance for loan and lease losses to total loans  at end of period (3) |       | 2.05                                                    | %          | 1.75                                                   | %          | 2.05 | % | 1.75 | % |
| Nonperforming loans to total loans at end of  period (3)                 |       | 2.76                                                    | %          | 4.42                                                   | %          | 4.50 | % | 5.66 | % |
| Net charge-offs to average loans (3)                                     |       | 0.17                                                    | %          | 0.79                                                   | %          | 0.17 | % | 0.79 | % |

 

----

(1)          Basic earnings per shareamounts were computed on the basis of the weighted average number of shares ofcommon stock outstanding during the year. The weighted average number of common shares used for this computationwas 1,785,891 and 1,783,230 for the three months ended September 30, 2010and 2009, respectively.  The weightedaverage number of common shares used for this computation was 1,785,179 and1,793,910 for the nine months ended September 30, 2010 and 2009,respectively.

 

(2)          Diluted earnings per shareamounts were computed on the basis of the weighted average number of shares ofcommon stock and common stock equivalents outstanding during the year.  Common stock equivalents include director/employeestock options. The weighted average number of common shares used for thiscomputation was 1,785,891 and 1,788,734 for the three months ended September 30,2010 and 2009, respectively.  Theweighted average number of shares used for this computation was 1,785,179 and1,797,154 for the nine months ended September 30, 2010 and 2009,respectively.

 

(3)          Includes loansheld for sale.

 

(4)          Averages are of dailybalances.

 

(5)          Calculated onan annualized basis.

 

**NET INTEREST INCOME**

 

Net interest income, the difference between (a) interest and fees earnedon interest-earning assets and (b) interest paid on interest-bearingliabilities, is the most significant component of the Bank’s earnings.  Changes in net interest income from period toperiod result from increases or decreases in the average balances ofinterest-earning assets and interest-earning liabilities, the availability ofparticular sources of funds and changes in prevailing interest rates.

 

Net interest income for the quarter ended September 30, 2010 was$1,512,000 compared to $1,661,000 for the quarter ended September 30,2009, which was a decrease of $149,000 primarily resulting from decreases of$203,000 in interest on loans and $407,000 in interest on investmentsecurities, partially offset by decreases interest expense of $337,000 on savingsand time deposit accounts and $102,000 on time deposits in denominations of$100,000 or more.

 

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Net interest income for the nine months ended September 30, 2010was $5,163,000 compared to $5,654,000 for the nine months ended September 30,of 2009, which was a decrease of $491,000 primarily resulting from decreases of$827,000 in interest on loans and $1,616,000 in interest on investmentsecurities, partially offset by decreases interest expense of $1,025,000 onsavings and time deposit accounts, $542,000 on notes payable and otherborrowings and $357,000 on time deposits of $100,000 or more.

 

**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.  Yields are computed on a tax-equivalentbasis, resulting in adjustments to interest earned on municipal bonds of$255,000 and $279,000 for the three months ended and $844,000 and $787,000 forthe nine months September 30, 2010 and 2009, respectively.  Non-accrual loans and overdrafts are includedin average loan balances.  Average loansare presented net of unearned income.

 

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| ** **                                                  | ** ** | **Three Months Ended September 30,  2010** | ** ** | **Three Months Ended September 30,  2009** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                                                  | ** ** | **Average**                                                    | ** ** | ** **                                                     | ** ** | **Yield/** | ** ** | **Average** | ** ** | ** ** | ** ** | **Yield/** | ** ** |
| **(dollars in thousands)**                        | ** ** | **Balance**                                                    | ** ** | **Interest**                                                   | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Rate** | ** ** |
| Assets:                                                     |       |                                                           |       |                                                           | ** ** | ** ** |   |   |   |   |   |   |   |
| Loans                                                       |       | $                                                              | 159,029    |                                                           | $          | 2,347 |   | 5.90 | % | $ | 172,696 |   | $ | 2,550 |   | 5.91 | % |
| Time deposits - in other banks                              |       | 39,966                                                         |       | 21                                                             |       | 0.21 | % | 12,929 |   | 4 |   | 0.12 | % |
| Investment securities - taxable                             |       | 7,061                                                          |       | 56                                                             |       | 3.17 | % | 26,617 |   | 417 |   | 6.27 | % |
| Investment securities - nontaxable                          |       | 46,267                                                         |       | 829                                                            |       | 7.17 | % | 48,099 |   | 899 |   | 7.48 | % |
| Total interest-earning assets                               |       | 252,323                                                        |       | 3,253                                                          |       | 5.16 | % | 260,341 |   | 3,870 |   | 5.95 | % |
|                                                        |       |                                                           |       |                                                           |       |   |   |   |   |   |   |   |   |
| Allowance for loan and lease losses                         |       | (3,253                                                         | )          |                                                           | ** ** | ** ** |   | (2,977 | ) |   |   |   |   |
| Non-interest bearing assets:                                |       |                                                           |       |                                                           | ** ** | ** ** |   |   |   |   |   |   |   |
| Cash and due from banks                                     |       | 4,957                                                          |       |                                                           | ** ** | ** ** |   | 6,166 |   |   |   |   |   |
| Bank premises and equipment                                 |       | 4,945                                                          |       |                                                           | ** ** | ** ** |   | 4,843 |   |   |   |   |   |
| Accrued interest receivable                                 |       | 1,334                                                          |       |                                                           | ** ** | ** ** |   | 1,648 |   |   |   |   |   |
| Other assets                                                |       | 31,477                                                         |       |                                                           | ** ** | ** ** |   | 19,559 |   |   |   |   |   |
| Total average assets                                        |       | $                                                              | 291,783    |                                                           |       | ** ** | ** ** |   | $ | 289,580 |   |   |   |   |   |
|                                                        |       |                                                           |       |                                                           |       |   |   |   |   |   |   |   |   |
| Liabilities and Shareholders’ Equity:                  |       |                                                           |       |                                                           | ** ** | ** ** |   |   |   |   |   |   |   |
| Interest-bearing liabilities:                               |       |                                                           |       |                                                           | ** ** | ** ** |   |   |   |   |   |   |   |
| Interest-bearing demand                                     |       | $                                                              | 15,818     |                                                           | $          | 4 |   | 0.10 | % | $ | 14,575 |   | $ | 4 |   | 0.11 | % |
| Money market savings                                        |       | 1,835                                                          |       | 1                                                              |       | 0.22 | % | 1,292 |   | 1 |   | 0.31 | % |
| Savings deposits                                            |       | 7,701                                                          |       | 10                                                             |       | 0.52 | % | 5,844 |   | 7 |   | 0.48 | % |
| Time deposits >$100M                                     |       | 71,156                                                         |       | 430                                                            |       | 2.42 | % | 60,403 |   | 532 |   | 3.52 | % |
| Time deposits <$100M                                     |       | 93,364                                                         |       | 515                                                            |       | 2.21 | % | 96,629 |   | 855 |   | 3.54 | % |
| Other Borrowings                                            |       | 45,098                                                         |       | 526                                                            |       | 4.67 | % | 47,541 |   | 531 |   | 4.47 | % |
| Total interest-bearing liabilities                          |       | 234,972                                                        |       | 1,486                                                          |       | 2.53 | % | 226,284 |   | 1,930 |   | 3.41 | % |
|                                                        |       |                                                           |       |                                                           |       |   |   |   |   |   |   |   |   |
| Non-interest bearing liabilities:                           |       |                                                           |       |                                                           | ** ** | ** ** |   |   |   |   |   |   |   |
| Noninterest-bearing checking                                |       | 34,466                                                         |       |                                                           | ** ** | ** ** |   | 36,976 |   |   |   |   |   |
| Accrued interest payable                                    |       | 1,568                                                          |       |                                                           | ** ** | ** ** |   | 1,376 |   |   |   |   |   |
| Other liabilities                                           |       | 4,515                                                          |       |                                                           | ** ** | ** ** |   | 7,781 |   |   |   |   |   |
| Total Liabilities                                           |       | 275,521                                                        |       |                                                           | ** ** | ** ** |   | 272,417 |   |   |   |   |   |
| Total shareholders’ equity                             |       | 16,262                                                         |       |                                                           | ** ** | ** ** |   | 17,163 |   |   |   |   |   |
| Total average liabilities and Shareholders’ equity     |       | $                                                              | 291,783    |                                                           |       | ** ** | ** ** |   | $ | 289,580 |   |   |   |   |   |
|                                                        |       |                                                           |       |                                                           |       |   |   |   |   |   |   |   |   |
| Net interest income                                         |       |                                                           |       | $                                                              | 1,767      | ** ** | ** ** |   |   |   | $ | 1,940 |   |   |   |
| Interest income as a percentage of average earning  assets  |       |                                                           |       |                                                           | ** ** | 5.16 | % |   |   |   |   | 5.95 | % |
| Interest expense as a percentage of average  earning assets |       |                                                           |       |                                                           | ** ** | 2.36 | % |   |   |   |   | 2.97 | % |
| Net yield on interest earning assets                        |       |                                                           |       |                                                           | ** ** | 2.80 | % |   |   |   |   | 2.98 | % |
| Net interest spread                                         |       |                                                           |       |                                                           |       | 2.63 | % |   |   |   |   | 2.53 | % |

 

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| ** **                                                  | ** ** | **Nine Months Ended September 30, 2010** | ** ** | **Nine Months Ended September 30, 2009** | ** ** |
|-------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                                  | ** ** | **Average**                                                       | ** ** | ** **                                                        | ** ** | **Yield/** | ** ** | **Average** | ** ** | ** ** | ** ** | **Yield/** | ** ** |
| **(dollars in thousands)**                        | ** ** | **Balance**                                                       | ** ** | **Interest**                                                      | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Rate** | ** ** |
| Assets:                                                     |       |                                                              |       |                                                              |       |   |   |   |   |   |   |   |   |
| Loans                                                       |       | $                                                                 | 160,395    |                                                              | $          | 7,412 |   | 6.16 | % | $ | 171,349 |   | $ | 8,239 |   | 6.41 | % |
| Time deposits - in other banks                              |       | 26,185                                                            |       | 41                                                                |       | 0.21 | % | 2,802 |   | 14 |   | 0.67 | % |
| Investment securities - taxable                             |       | 11,043                                                            |       | 300                                                               |       | 3.62 | % | 46,748 |   | 2,039 |   | 5.82 | % |
| Investment securities - nontaxable                          |       | 50,791                                                            |       | 2,723                                                             |       | 7.15 | % | 44,242 |   | 2,544 |   | 7.67 | % |
|                                                        |       |                                                              |       |                                                              |       |   |   |   |   |   |   |   |   |
| Total interest-earning assets                               |       | 248,414                                                           |       | 10,476                                                            |       | 5.62 | % | 265,141 |   | 12,836 |   | 6.45 | % |
|                                                        |       |                                                              |       |                                                              |       |   |   |   |   |   |   |   |   |
| Allowance for loan and lease losses                         |       | (3,385                                                            | )          |                                                              |       |   |   | (2,653 | ) |   |   |   |   |
| Non-interest bearing assets:                                |       |                                                              |       |                                                              |       |   |   |   |   |   |   |   |   |
| Cash and due from banks                                     |       | 4,963                                                             |       |                                                              |       |   |   | 15,449 |   |   |   |   |   |
| Bank premises and equipment                                 |       | 4,967                                                             |       |                                                              |       |   |   | 4,898 |   |   |   |   |   |
| Accrued interest receivable                                 |       | 1,392                                                             |       |                                                              |       |   |   | 1,722 |   |   |   |   |   |
| Other assets                                                |       | 29,957                                                            |       |                                                              |       |   |   | 18,450 |   |   |   |   |   |
| Total average assets                                        |       | $                                                                 | 286,308    |                                                              |       |   |   |   | $ | 303,007 |   |   |   |   |   |
|                                                        |       |                                                              |       |                                                              |       |   |   |   |   |   |   |   |   |
| Liabilities and Shareholders’ Equity:                  |       |                                                              |       |                                                              |       |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities:                               |       |                                                              |       |                                                              |       |   |   |   |   |   |   |   |   |
| Interest-bearing demand                                     |       | $                                                                 | 15,443     |                                                              | $          | 12 |   | 0.10 | % | $ | 14,821 |   | $ | 14 |   | 0.13 | % |
| Money market savings                                        |       | 1,862                                                             |       | 3                                                                 |       | 0.21 | % | 1,407 |   | 3 |   | 0.28 | % |
| Savings deposits                                            |       | 7,356                                                             |       | 28                                                                |       | 0.51 | % | 5,697 |   | 21 |   | 0.49 | % |
| Time deposits >$100M                                     |       | 66,114                                                            |       | 1,243                                                             |       | 2.51 | % | 57,207 |   | 1,600 |   | 3.73 | % |
| Time deposits <$100M                                     |       | 95,979                                                            |       | 1,645                                                             |       | 2.29 | % | 96,908 |   | 2,677 |   | 3.68 | % |
| Other Borrowings                                            |       | 44,640                                                            |       | 1,538                                                             |       | 4.59 | % | 72,140 |   | 2,080 |   | 3.84 | % |
| Total interest-bearing liabilities                          |       | 231,394                                                           |       | 4,469                                                             |       | 2.57 | % | 248,180 |   | 6,395 |   | 3.44 | % |
|                                                        |       |                                                              |       |                                                              |       |   |   |   |   |   |   |   |   |
| Non-interest bearing liabilities:                           |       |                                                              |       |                                                              |       |   |   |   |   |   |   |   |   |
| Noninterest-bearing checking                                |       | 33,749                                                            |       |                                                              |       |   |   | 34,188 |   |   |   |   |   |
| Accrued interest payable                                    |       | 1,393                                                             |       |                                                              |       |   |   | 1,542 |   |   |   |   |   |
| Other liabilities                                           |       | 3,510                                                             |       |                                                              |       |   |   | 3,058 |   |   |   |   |   |
| Total Liabilities                                           |       | 270,046                                                           |       |                                                              |       |   |   | 286,968 |   |   |   |   |   |
| Total shareholders’ equity                             |       | 16,262                                                            |       |                                                              |       |   |   | 16,039 |   |   |   |   |   |
| Total average liabilities and Shareholders’ equity     |       | $                                                                 | 286,308    |                                                              |       |   |   |   | $ | 303,007 |   |   |   |   |   |
|                                                        |       |                                                              |       |                                                              |       |   |   |   |   |   |   |   |   |
| Net interest income                                         |       |                                                              |       | $                                                                 | 6,007      |   |   |   |   |   | $ | 6,441 |   |   |   |
| Interest income as a percentage of average earning  assets  |       |                                                              |       |                                                              |       | 5.62 | % |   |   |   |   | 6.45 | % |
| Interest expense as a percentage of average  earning assets |       |                                                              |       |                                                              |       | 2.40 | % |   |   |   |   | 3.22 | % |
| Net yield on interest earning assets                        |       |                                                              |       |                                                              |       | 3.22 | % |   |   |   |   | 3.24 | % |
| Net interest spread                                         |       |                                                              |       |                                                              |       | 3.05 | % |   |   |   |   | 3.03 | % |

 

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**Rate and Volume Analysis:**

 

The following tables show the increase or decrease in interest income,interest expense and net interest income, resulting from changes in rates andvolumes, for the three months and nine months ended September 30, 2010compared with the same periods in 2009.

 
| ** **                                  | ** ** | **Increase (decrease) in the three months ended**            | ** ** |
|---------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|
| ** **                                  | ** ** | **September 30, 2010 compared with September 30, 2009** | ** ** |
| **(dollars in thousands)**        | ** ** | **Volume**                                                                                 | ** ** | **Rate** | ** ** | **Total** | ** ** |
| Increase (decrease) in interest income:     |       |                                                                                       |       |   |   |   |   |
| Loans                                       |       | $                                                                                          | (202       | ) | $ | (1 | ) | $ | (203 | ) |
| Time deposits - in other banks              |       | 8                                                                                          |       | 9 |   | 17 |   |
| Investment securities - taxable             |       | (306                                                                                       | )          | (55 | ) | (361 | ) |
| Investment securities - nontaxable          |       | (34                                                                                        | )          | (36 | ) | (70 | ) |
|                                        |       | (534                                                                                       | )          | (83 | ) | (617 | ) |
|                                        |       |                                                                                       |       |   |   |   |   |
| Increase (decrease) in interest expense:    |       |                                                                                       |       |   |   |   |   |
| Interest-bearing demand                     |       | —                                                                                     |       | — |   | — |   |
| Savings deposits                            |       | 2                                                                                          |       | 1 |   | 3 |   |
| Time deposits >$100M                     |       | 95                                                                                         |       | (197 | ) | (102 | ) |
| Time deposits <$100M                     |       | (29                                                                                        | )          | (311 | ) | (340 | ) |
| Other borrowing                             |       | (27                                                                                        | )          | 22 |   | (5 | ) |
|                                        |       | 41                                                                                         |       | (485 | ) | (444 | ) |
| Increase (decrease) in net interest income: |       | $                                                                                          | (575       | ) | $ | 402 |   | $ | (173 | ) |

 
| ** **                                  | ** ** | **Increase (decrease) in the nine months ended**             | ** ** |
|---------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|
| ** **                                  | ** ** | **September 30, 2010 compared with September 30, 2009** | ** ** |
| **(dollars in thousands)**        | ** ** | **Volume**                                                                                 | ** ** | **Rate** | ** ** | **Total** | ** ** |
| Increase (decrease) in interest income:     |       |                                                                                       |       |   |   |   |   |
| Loans                                       |       | $                                                                                          | (527       | ) | $ | (300 | ) | $ | (827 | ) |
| Time deposits - in other banks              |       | 125                                                                                        |       | (99 | ) | 26 |   |
| Investment securities - taxable             |       | (1,557                                                                                     | )          | (182 | ) | (1,739 | ) |
| Investment securities - nontaxable          |       | 376                                                                                        |       | (196 | ) | 180 |   |
|                                        |       | (1,583                                                                                     | )          | (777 | ) | (2,360 | ) |
|                                        |       |                                                                                       |       |   |   |   |   |
| Increase (decrease) in interest expense:    |       |                                                                                       |       |   |   |   |   |
| Interest-bearing demand                     |       | 1                                                                                          |       | (2 | ) | (1 | ) |
| Money market savings                        |       | 1                                                                                          |       | (1 | ) | — |   |
| Savings deposits                            |       | 6                                                                                          |       | 1 |   | 7 |   |
| Time deposits >$100M                     |       | 249                                                                                        |       | (606 | ) | (357 | ) |
| Time deposits <$100M                     |       | (26                                                                                        | )          | (1,007 | ) | (1,033 | ) |
| Other borrowing                             |       | (793                                                                                       | )          | 251 |   | (542 | ) |
|                                        |       | (562                                                                                       | )          | (1,364 | ) | (1,926 | ) |
| Increase (decrease) in net interest income: |       | $                                                                                          | (1,021     | ) | $ | 587 |   | $ | (434 | ) |

 

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**Provision and Allowance for Loan and Lease Losses**

 

TheCorporation maintains a detailed, systematic analysis and procedural disciplineto determine the amount of the allowance for loan and lease losses (“ALLL”).  TheALLL is based on estimates and is intended to be adequate to provide forprobable losses inherent in the loan portfolio.  This processinvolves deriving probable loss estimates that are based on individual loanloss estimation, historical loss rates and management’s judgment.

 

TheCorporation employs several methodologies for estimating probablelosses.  Methodologies are determined based on a number of factors,including loan type of collateral, risk rating, concentrations, and collateralvalue.

 

TheCorporation calculates the required ALLL on a quarterly basis and makesadjusting entries as needed. The review of the adequacy of the allowancetakes into consideration such factors as concentrations of credit, changes inthe growth, size and composition of the loan portfolio, overall and individualportfolio quality, review of specific problem loans, collateral, guarantees andeconomic conditions that may affect the borrowers’ ability to pay and/or thevalue of the underlying collateral.  Additional factors consideredinclude: geographic location of borrowers, changes in the Corporation’sproduct-specific credit policy and lending staff experience.  Theseestimates depend on subjective factors and, therefore, contain inherentuncertainties.

 

TheCorporation’s ALLL is maintained at a level believed adequate by management toabsorb known and inherent probable losses on existing loans.  Aprovision for loan losses is charged to expense.  The allowance ischarged for losses when management believes that full recovery on the loan isunlikely.  Generally, the Corporation charges off any loan classifiedas a “loss”; portions of loans which are deemed to be uncollectible; overdraftswhich have been outstanding for more than 90 days; and all other unsecuredloans past due 120 or more days.  Subsequent recoveries, if any, arecredited to the ALLL.

 

Although no assurance can be given that actual losses will not exceedthe amount provided for in the allowance, management believes that theallowance is adequate to provide for all estimated credit losses in light ofall known relevant factors. At September 30, 2010 and 2009 the Bank’sallowance stood at 2.05 percent and 1.75 percent of total loans, respectively.

 

No provision was made to the ALLL during the nine months ended September 30,2010 compared to $1,918,000 for the same period in 2009.  Loans charged off during the nine monthsended September 30, 2010 totaled $278,000 compared to $1,351,000 for thesame period in 2009.  Recoveries totaled$2,000 during the nine months ended September 30, 2010 and 2009.

 

The Bank’s non-performing (delinquent 90 days or more and onnon-accrual) net loans as a percentage of total loans were 4.50 percent and5.66 percent as of the end of September 30, 2010 and 2009, respectively.

 

**Non-Interest Income**

 

Total non-interest income for the three months ended September 30,2010 was $2,226,000 compared with $4,072,000 for the same period in 2009.  The decrease of $1,846,000 was due primarilyto decreases of $1,500,000 in gains on sales of investment securities, $115,000in merchant discount fees, $83,000 in income from the sale and servicing of SBALoans and $49,000 in services on deposit accounts.

 

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Total non-interest income for the nine months ended September 30,2010 was $5,277,000 compared with $8,375,000 for the same period in 2009.  The decrease of $3,098,000 was due primarilyto decreases of $878,000 in merchant discount fees, $2,217,000 in gains onsales of investment securities, $156,000 in service charges on deposit accountsand $59,000 in income from sales and servicing of Small Business Administrationloans, partially offset by an increase of $391,000 in credit card/stored valuecard program fees.

 

**Non-Interest Expense**

 

Salary and benefits expense for the three months and nine months ended September 30,2010 increased $54,000 and $280,000 compared with the same periods in2009.  The increase was due to theaddition of a Credit Administration Officer, a loan processor and a senioraccounting staff position.

 

Total occupancy and equipment expense for the three months and ninemonths ended September 30, 2010 was $259,000 and $777,000 resulting in anominal change when compared to the same period in 2009.

 

Professional fees for the three months ended September 30, 2010were $403,000 compared to $172,000 for the same period in 2009.  Professional fees for the nine months ended September 30,2010 were $1,239,000 compared to $699,000 for the same period in 2009. Theincreases were primarily due to increases in accounting/audit expense and legalfees associated with regulatory matters discussed elsewhere herein as well aslawsuits related to various loans and loan collection expense.

 

Data processing expense for the three months and nine months ended September 30,2010 was $56,000 and $192,000, respectively; representing decreases of $11,000and $55,000 when compared the same period in 2009.

 

During the three and nine months ended September 30, 2010 noprepayment fees on borrowings from the FHLB fo San Francisco were paid onborrowing compared with $457,000 and $888,000, respectively for the sameperiods in 2009.

 

Duringthe three and nine months ended September 30, 2010 litigation settlementexpenses totaled $158,000 and $1,038,000, respectively.  No litigation settlement expenses wereincurred during the same periods in 2009. See Part II — Other Information Item 1 Legal Proceedings Section foraddition information.

 

Othergeneral and administrative expenses for the three months ended September 30,2010 totaled $1,310,000 compared with $1,479,000 for the same period in 2009,which is an decrease of $169,000. Significant changes occurred in the following categories: increases inATM expense of $76,000, director fees of $26,000, business development expensesof $20,000 and Bank business credit card expense of $16,000; partially offsetby decreases in FDIC insurance premiums of $122,000, merchant card processingexpense of $84,000, prepaid debit card expense of $58,000, loan expense of$47,000 and credit card program expense of $19,000.

 

Othergeneral and administrative expenses for the for the nine months ended  September 30, 2010 totaled $3,523,000compared with $4,025,000 for the same period in 2009, which is a decrease of$502,000.  Significant changes occurredin the following categories: increases in ATM expense of $43,000, otheroperating losses of $82,000, Bank Business credit card expense of $54,000, FDICinsurance premiums of $35,000 and director fees of $28,000, partially offset bydecreases of $568,000 in merchant card processing expense, $58,000 in prepaiddebit card 

 

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expense,$37,000 in loan expense, $36,000 in credit card program expense, $22,000 ininsurance expense, $18,000 in miscellaneous expense, $18,000 in bank securityexpense and $15,000 in advertising expense.

 

OREOexpenses and provision for losses on foreclosed assets for the three months andnine months ended September 30, 2010 totaled $916,000 and $1,997,000,respectively compared to $163,000 and $792,000 during the same period in2009.  These increases are due to thecontinued decline in real estate values as a result of local and nationaleconomic conditions.

 

FDICsettlement expense included funding a restitution reserve for $1,250,000, civilmoney penalty of $250,000, net of a receivable from the third-party debit cardprogram, and $300,000 charitable donation. These non-recurring expenses affected both the three months and ninemonths ended September 30, 2010.

 

**Provision for Income Taxes**

 

Theincome tax provision (benefit) was ($1,031,000) for the three months ended September 30,2010 compared to $297,000 for the same period in 2009, representing (50.39%)and 28.53% of pre-tax income for those periods. The decrease in the effective tax rate for 2010 is a direct result ofthe Bank’s investing in tax-exempt securities and decreasing income.

 

Theincome tax provision (benefit) was ($1,452,000) for the nine months ended September 30,2010 compared to $470,000 for the same period in 2009, representing (51.78%)and 20.50% of pre-tax income for those periods. The decrease in the effective tax rate for 2010 is a direct result ofthe Bank’s investing in tax-exempt securities and decreasing income.

 

Theamount of the tax provision is determined by applying the Corporation’sstatutory income tax rates to pre-tax book income, adjusted for permanentdifferences between pre-tax book income and actual taxable income. Suchpermanent 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.

 

Deferredtax assets and liabilities are measured using the enacted tax rates expected toapply to taxable income in the periods in which the deferred tax asset orliability is expected to be realized or settled.  The Bank maintains a valuation allowance withrespect to deferred tax assets due to the uncertainty surrounding therealization of certain net deferred tax assets.

 

**LOANS**

 

Average loans represented 64.57% of average earning assets and 56.02%of average total assets for the nine months ended September 30, 2010compared with 64.63% and 56.55%, respectively during 2009. For the nine monthsended September 30, 2010, average loans decreased 6.39% to $160,395,000from $171,349,000 for the same period in 2009. Average real estate loans increased $148,000 (0.12%), average commercialloans increased $482,000 (1.37%); while average construction loans decreased$11,056,000 (82.5%) and average installment loans decreased $528,000 (31.13%).

 

The Bank’s commercial and industrial loans are generally made for thepurpose of providing working capital, financing the purchase of equipment orinventory, and other business purposes. Such loans generally have maturities ofone year or longer.  Short-term businessloans are generally intended to finance current transactions and typicallyprovide for monthly interest payments with principal being payable at maturityor at 90-day intervals. Term loans (usually for 

 

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a term of two to five years) normally provide for monthly installmentsof principal and interest.  The Bank fromtime to time utilizes accounts receivable and inventory as security for loans.

 

The Bank is a recognized leader for Small Business Administration (SBA)lending in Monterey County, and holds SBA’s coveted Preferred LenderStatus.  Generally, SBA loans areguaranteed, by the SBA, for 75 to 90 percent of their principal amount, whichcan be retained in the loan portfolio or sold to investors.  Such loans are made at floating interestrates, generally with longer terms (up to 25 years) than are available on aconventional loan basis to small businesses.  The unguaranteed portion ofthe loans, although generally supported by collateral, is considered to be morerisky than conventional commercial loans because they may be based upon creditstandards the Bank would not otherwise apply, such as lower cash flow coverage,or longer repayment terms.

 

The Bank also makes real estate loans secured by a first deed of truston single family residential properties and commercial and industrial realestate.  California commercial banks arepermitted, depending on the type and maturity of the loan, to lend up to 90percent of the fair market value of real property (or more if the loan isinsured either by private mortgage insurers or governmental agencies).  In certain instances, the appraised value mayexceed the actual amount that could be realized on foreclosure, or declines inmarket value subsequent 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 personalloans.  Consumer installment loansgenerally provide for monthly payments of principal and interest, at a fixedrate.  Most of the Bank’s consumerinstallment loans are generally secured by the personal property beingpurchased.  The Bank generally makesconsumer loans to those customers with a prior banking relationship with theBank.

 

**Non-performing and Non-accrual Loans**

 

The Bank’s present policy is to cease accruing interest on loans whichare past due as to principal or interest 90 days or more, except for loanswhich are well secured or when collection of interest and principal is deemedlikely.  When a loan is placed onnon-accrual, previously accrued and unpaid interest is generally reversed outof income unless adequate collateral from which to collect the principal andinterest on the loan is available and in the process of collection.

 

In relation to SBA loans sold, the Bank generally repurchases from thesecondary market the guaranteed portion of SBA guaranteed loans when thoseloans are placed on non-accrual status. After the foreclosure and collection process is complete, the SBAreimburses the Bank for this principal balance. Therefore, although these balances do not earn interest during thisperiod, they generally do not result in a loss of principal to the Bank.

 

The following table presents information with respect to loans which,as of the dates indicated, were past due 90 days or more or were placed onnon-accrual status and foreclosed assets (referred to collectively as “non-performingassets”):

 

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| ** **                                                           | ** ** | **As of**                       | ** ** | **As of**        | ** ** |
|----------------------------------------------------------------------|------------|--------------------------------------|------------|-----------------------|------------|
| ** **                                                           | ** ** | **September 30,**               | ** ** | **December 31,** | ** ** |
| ** **                                                           | ** ** | **2010**                             | ** ** | **2009**              | ** ** | **2009** | ** ** |
| ** **                                                           | ** ** | **(Dollars in thousands)** | ** ** | ** **            | ** ** |
| Accruing, past due 90 days or more:                                  |       |                                 |       |                  |       |   |   |
|                                                                 |       |                                 |       |                  |       |   |   |
| Real Estate                                                          |       | $                                    | 2,777      | (1)                   | $          | 2,112 |   | $ | — |   |
| Commercial                                                           |       | —                               |       | —                |       | — |   |
| Installment                                                          |       | —                               |       | —                |       | — |   |
| Other                                                                |       | —                               |       | —                |       | — |   |
|                                                                 |       |                                 |       |                  |       |   |   |
| Total accruing                                                       |       | 2,777                                |       | 2,112                 |       | — |   |
|                                                                 |       |                                 |       |                  |       |   |   |
| Nonaccrual Loans:                                                    |       |                                 |       |                  |       |   |   |
| Real Estate                                                          |       | 2,322                                |       | 5,961                 |       | 5,137 |   |
| Commercial                                                           |       | 2,058                                |       | 1,582                 |       | 2,943 |   |
| Installment                                                          |       | —                               |       | —                |       | — |   |
| Other                                                                |       | —                               |       | —                |       | — |   |
| Total nonaccrual                                                     |       | 4,380                                |       | 7,543                 |       | 8,080 |   |
|                                                                 |       |                                 |       |                  |       |   |   |
| Total nonperforming loans                                            |       | 4,380                                |       | 7,543                 |       | 8,080 |   |
| Other Real Estate Owned                                              |       | 27,575                               |       | 13,923                |       | 14,333 |   |
| Total nonperforming assets                                           |       | $                                    | 31,955     |                  | $          | 21,466 |   | $ | 22,413 |   |
|                                                                 |       |                                 |       |                  |       |   |   |
| Total loans end of period                                            |       | $                                    | 158,961    |                  | $          | 170,505 |   | $ | 166,959 |   |
|                                                                 |       |                                 |       |                  |       |   |   |
| Ratio of nonperforming loans to total loans at end  of period        |       | 2.76                                 | %          | 4.42                  | %          | 4.84 | % |
| Ratio nonperforming assets to total loans and OREO  at end of period |       | 17.13                                | %          | 11.63                 | %          | 12.36 | % |

 

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(1)           Two loans which are well secured andin process of collection.

 

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Summaryof Loan Loss Experience

 
| ** **                                                                     | ** ** | **Nine Months**                 | ** ** | **Year ended**   | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------|------------|-----------------------|------------|
| ** **                                                                     | ** ** | **Ended September 30,**    | ** ** | **December 31,** | ** ** |
| ** **                                                                     | ** ** | **2010**                             | ** ** | **2009**              | ** ** | **2009** | ** ** |
| ** **                                                                     | ** ** | **(Dollars in thousands)** | ** ** |
| Average loans outstanding                                                      |       | $                                    | 160,395    |                  | $          | 171,349 |   | $ | 169,853 |   |
|                                                                           |       |                                 |       |                  |       |   |   |
| Total loans outstanding at end of the period                                   |       | $                                    | 158,961    |                  | $          | 170,505 |   | $ | 166,959 |   |
|                                                                           |       |                                 |       |                  |       |   |   |
| Allowance, beginning of period                                                 |       | 3,529                                |       | 2,413                 |       | 2,413 |   |
|                                                                           |       |                                 |       |                  |       |   |   |
| Loans charged off during period:                                               |       |                                 |       |                  |       |   |   |
| Commercial                                                                     |       | (250                                 | )          | (13                   | )          | (358 | ) |
| Installment                                                                    |       | —                               |       | (30                   | )          | (37 | ) |
| Real Estate                                                                    |       | (28                                  | )          | (1,308                | )          | (1,908 | ) |
| Other                                                                          |       | —                               |       | —                |       | (26 | ) |
| Total charge offs                                                              |       | (278                                 | )          | (1,351                | )          | (2,329 | ) |
|                                                                           |       |                                 |       |                  |       |   |   |
| Recoveries during period:                                                      |       |                                 |       |                  |       |   |   |
| Commercial                                                                     |       | 2                                    |       | 2                     |       | 2 |   |
| Installment                                                                    |       | —                               |       | —                |       | — |   |
| Real Estate                                                                    |       | —                               |       | —                |       | 75 |   |
| Other                                                                          |       | —                               |       | —                |       | — |   |
| Total recoveries                                                               |       | 2                                    |       | 2                     |       | 77 |   |
|                                                                           |       |                                 |       |                  |       |   |   |
| Net loans charged off during the period                                        |       | (276                                 | )          | (1,349                | )          | (2,252 | ) |
|                                                                           |       |                                 |       |                  |       |   |   |
| Additions to allowance for possible loan losses                                |       | —                               |       | 1,918                 |       | 3,368 |   |
| Allowance, end of period                                                       |       | $                                    | 3,253      |                  | $          | 2,982 |   | $ | 3,529 |   |
|                                                                           |       |                                 |       |                  |       |   |   |
| Ratio of net loans charged off to average loans  outstanding during the period |       | 0.17                                 | %          | 0.79                  | %          | 1.33 | % |
|                                                                           |       |                                 |       |                  |       |   |   |
| Ratio of allowance to total loans at end of period                             |       | 2.05                                 | %          | 1.75                  | %          | 2.12 | % |
|                                                                           |       |                                 |       |                  |       |   |   |
| Ratio of nonperforming loans to allowance for loan  losses at end of period    |       | 134.63                               | %          | 252.95                | %          | 228.96 | % |

 

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Thefollowing table provides a breakdown of the allowance for loan losses bycategories as of the dates indicated:

 
|                                      |       | **As of September 30,** |       | **As of**                                               |       |
|-------------------------------------------|------------|----------------------------------------|------------|--------------------------------------------------------------|------------|
|                                      |       | **2010**                               |       | **2009**                                                     |       | **December 31, 2009** |   |
|                                      |       | **Amount**                             | ** ** | **% of  Loans in  Category  to Total  Loans** | ** ** | **Amount** | ** ** | **% of  Loans in  Category  to Total  Loans** | ** ** | **Amount** | ** ** | **% of  Loans in  Category  to Total  Loans** |   |
| ** **                                | ** ** | **(Dollars in thousands)**   | ** ** |
| Balance at End of Period Applicable to:   |       |                                   |       |                                                         |       |   |   |   |   |   |   |   |   |
|                                      |       |                                   |       |                                                         |       |   |   |   |   |   |   |   |   |
| Construction                              |       | $                                      | 25         |                                                         | 0.8        | % | $ | 112 |   | 6.6 | % | $ | 338 |   | 5.2 | % |
| Commercial                                |       | 810                                    |       | 23.7                                                         | %          | 645 |   | 21.4 | % | 995 |   | 20.1 | % |
| Installment                               |       | 4                                      |       | 0.3                                                          | %          | 218 |   | 0.4 | % | 9 |   | 1.7 | % |
| Real Estate                               |       | 2,289                                  |       | 75.2                                                         | %          | 1,996 |   | 71.6 | % | 2 174 |   | 73.0 | % |
| Unallocated                               |       | 125                                    |       | —                                                       |       | 11 |   | — |   | 13 |   | — |   |
| Total allowance for loan and lease losses |       | $                                      | 3,253      |                                                         | 100.0      | % | $ | 2,982 |   | 100.0 | % | $ | 3,529 |   | 100.0 | % |
|                                      |       |                                   |       |                                                         |       |   |   |   |   |   |   |   |   |
| Total loans end of period                 |       | $                                      | 158,961    |                                                         |       |   | $ | 170,505 |   |   |   | $ | 166,959 |   |   |   |

 

**Non-performing Assets**

 

The following table presents information with respect to nonperformingassets, as of the dates indicated. The non-accrual loans are net of theguaranteed portion of SBA loans and the OREO was acquired through deed-in-lieuor foreclosure.  The OREO was recorded atfair value less selling costs on the date of acquisition.

 
| ** **                                                     | ** ** | **As of**                       | ** ** | **As of**        | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------|------------|-----------------------|------------|
| ** **                                                     | ** ** | **September 30,**               | ** ** | **December 31,** | ** ** |
| ** **                                                     | ** ** | **2010**                             | ** ** | **2009**              | ** ** | **2009** | ** ** |
| ** **                                                     | ** ** | **(Dollars in thousands)** | ** ** |
| Nonperforming loans                                            |       | $                                    | 4,380      |                  | $          | 9,655 |   | $ | 8,080 |   |
| Other real estate owned, net (1)                               |       | 27,575                               |       | 13,923                |       | 14,333 |   |
| Total nonperforming assets                                     |       | $                                    | 31,955     |                  | $          | 23,578 |   | $ | 22,413 |   |
|                                                           |       |                                 |       |                  |       |   |   |
| Nonperforming loans to total gross loans                       |       | 2.76                                 | %          | 4.42                  | %          | 4.84 | % |
| Nonperforming assets to total loans and OREO at  end of period |       | 17.13                                | %          | 11.63                 | %          | 12.36 | % |

 

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(1) net of reserve for foreclosed assets losses of $2,060,000 asof September 30, 2010, $522,000 as of September 30, 2009 and$1,010,000 as of December 31, 2009.

 

**Deposits**

 

Average interest bearing and non-interest-bearing deposits for the ninemonths ended September 30, 2010 were $220,503,000 an increase of 4.89%compared with the same period in 2009. Average certificates of deposit represented 73.51% of average depositsfor the nine months ended September 30, 2010 compared with 73.31% for thesame period in 2009.  Average interestbearing checking, money market and savings accounts as a group were 11.18% ofaverage deposits for the nine months ended September 30, 2010 comparedwith 10.43% for the same period in 2009. Average non-interest bearing deposits represented 15.31% of averagedeposits for the nine months ended September 30, 2010 compared with 16.26%for the same period in 2009.

 

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Thefollowing table sets forth the scheduled maturities of the Corporation’s timedeposits in denominations of $100,000 or greater at September 30, 2010:

 

Maturities of Time Deposits of

$100,000 or More

(Dollars in Thousands)

 
| Three months or less              |   | $      | 19,301 |   |
|-----------------------------------|--------|--------|--------|--------|
| Three months through six months   |   | 8,305  |   |
| Nine months through twelve months |   | 18,084 |   |
| Over twelve months                |   | 25,026 |   |
| Total                             |   | $      | 70,716 |   |

 

**Borrowings**

 

The Corporation has a line of credit with Marshall & IlsleyBank in the amount of $3,000,000, at a floating interest rate based on theone-month LIBOR Rate plus 3.75% with a floor rate of 6.50% and a maturity dateof October 30, 2010.  At September 30,2010, $2,850,000 was outstanding on the line of credit.  Marshall & Ilsley Bank has proposeda one year renewal term, a principal reduction of $150,000 and funding of aninterest reserve account in the amount of $200,000.  .Based on indications from Marshall &Ilsley Bank, management believes the line of credit will be renewed by the endof November.

 

The Bank has lines of credit from the Federal Reserve Bank of SanFrancisco (FRB) and the Federal Home Loan Bank of San Francisco (FHLB) withremaining available borrowing capacity on September 30, 2010 of $9,152,000and $98,000, respectively.  The FRBdiscount window line is secured by a portion of the Bank’s investmentsecurities at September 30, 2010. At September 30, 2010, the total book value of securities pledgedto the FRB was $10,681,000 with no outstanding loan balance.  The FHLB line of credit has a maximumborrowing capacity of 20% of the Bank’s total assets, adjusted quarterly.  The FHLB line of credit is secured by ablanket lien on the Bank’s loan and securities at September 30, 2010.  The total principal balance at September 30,2010 of pledged loans and securities at the FHLB was $158,961,000 and$2,726,000, respectively.

 

The following table provides information on eleven FHLB advancesoutstanding at September 30, 2010.

 
| ** ** | ** **       | ** ** | ** ** | **Funding** | ** ** | **Maturity** | ** ** |
|------------|------------------|------------|------------|-------------|------------|--------------|------------|
| **Amount** | ** **       | **Rate**   | ** ** | **Date**    | ** ** | **Date**     | ** ** |
| $          |  5,000,000  |       | 4.96       | %           | 11/14/05   |         | 11/15/10   |   |
| 1,750,000  |             | 4.74       | %          | 1/26/06     |       | 1/26/11      |       |
| 2,250,000  |             | 4.75       | %          | 1/26/06     |       | 1/26/11      |       |
| 3,500,000  |             | 5.51       | %          | 7/17/06     |       | 7/18/11      |       |
| 1,500,000  |             | 5.52       | %          | 7/17/06     |       | 7/18/11      |       |
| 1,000,000  |             | 5.22       | %          | 8/25/06     |       | 8/25/11      |       |
| 5,000,000  |             | 5.21       | %          | 7/30/07     |       | 7/30/12      |       |
| 3,000,000  |             | 4.85       | %          | 10/1/07     |       | 10/1/12      |       |
| 5,000,000  |             | 1.75       | %          | 3/15/10     |       | 3/15/13      |       |
| 5,000,000  |             | 5.01       | %          | 9/18/07     |       | 9/18/14      |       |
| 1,000,000  |             | 7.72       | %          | 6/1/00      |       | 6/3/30       |       |
| $          |  34,000,000 |       |       |        |       |         |       |   |

 

The Bank has two letters of credit issued bythe FHLB. One letter of credit in the amount of $330,000, expiring April 17,2011, is used to secure local agency deposits. The beneficiary of 

 

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the letter of credit is the Administrator ofLocal Agency Security, Department of Financial Institutions.  The other letter of credit in the amount of$1,300,000, expiring February 17, 2019 has MasterCard International Inc.as the beneficiary and is used to secure settlement of credit cardtransactions.

 

**Capital Resources**

 

The Corporation maintains capital to comply with regulatoryrequirements, to provide a margin of safety for its depositors andstockholders, and to provide for future growth and the ability to paydividends.  At September 30, 2010,shareholders’ equity was $15,360,000 versus $16,150,000 at December 31,2009.  The Corporation paid no cashdividends to shareholders for the nine months ended September 30, 2010 andfor the year ended December 31, 2009. The Bank paid no cash dividends to the Corporation for the nine monthsended September 30, 2010 and $500,000 in dividends for the year ended December 31,2009.

 

The FDIC and Federal Reserve Board have adopted capital adequacyguidelines for use in their examination and regulation of banks and bankholding companies.  If the capital of abank or bank holding company falls below the minimum levels established bythese guidelines, it may be denied approval to acquire or establish additionalbanks or non-bank businesses, or the FDIC or Federal Reserve Board may takeother administrative actions.  Theguidelines employ two measures of capital: (1) risk-based capital and (2) leverage capital.

 

In general, the risk-based capital guidelines provide detaileddefinitions of which obligations will be treated as capital, and assigndifferent weights to various assets and off-balance sheet items, depending uponthe perceived degree of credit risk associated with each asset.  Each asset is assigned to one of fourrisk-weighted categories.  For example, 0percent for cash and unconditionally guaranteed government securities; 20percent for deposits with other banks and fed funds; 50 percent for state bondsand certain residential real estate loans; and 100 percent for commercial loansand other assets.  Capital is categorizedas either Tier 1 capital, consisting of common stock and retained earnings (ordeficit), or Tier 2 capital, which includes limited-life preferred stock andallowance for loan losses (subject to certain limitations).  The guidelines also define and set minimumcapital requirements to maintain Tier 1 capital of at least 5.0% and totalcapital of 8.0% of risk-adjusted assets. The Bank had a Tier 1 capital to totalrisk-adjusted assets capital ratio of 12.55% and 13.39% at September 30,2010 and 2009, respectively.  The Bank’sTier 1 capital exceeds the minimum regulatory requirement by $16,780,000.  The Bank had a Total Risk-Based capital torisk-adjusted assets ratio of 13.91% and 14.64% at September 30, 2010 and2009, respectively.  The Bank’s TotalRisk-Based capital exceeds the minimum regulatory requirement by $11,595,000.

 

TheTier 1 leverage capital ratio guidelines require a minimum leverage capitalratio of 5.0% of Tier 1 capital to total assets less goodwill.  The Bank had a leverage capital ratio of8.48% and 9.04% at September 30, 2010 and 2009, respectively.  The Bank’s Tier 1 leverage capital exceedsthe minimum regulatory requirement by $13,008,000 under the Prompt CorrectiveAction framework.  However , under therecently issued Consent Order (see Other Regulatory Matters section), the Bankmust achieve a 9% leverage capital ratio by December 29, 2010.

 

Underregulatory guidelines, the $8 million in Trust Preferred Securities outstandingqualify as Tier 1 capital up to 25% of Tier 1 capital.  Any additional Trust Preferred Securitieswill qualify as Tier 2 capital.

 

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TheCorporation’s Board of Directors approved a stock repurchase program pursuantto which the Corporation, from time to time and at management’s discretion, mayrepurchase up to $500,000 of the Corporation’s outstanding shares.  The Corporation did not repurchase any sharesof stock during the nine months ended September 30, 2010.  The Corporation repurchased 20,678 shares ofcommon stock at an average cost of $4.20 per share in open market transactionsduring 2009.  The Corporation repurchased46,010 shares of common stock at an average cost of $7.51 per share in openmarket transactions during 2008.

 

InOctober 2008, the Board and the holders of more than a majority of ourissued and outstanding common stock approved by written consent, an amendmentto the Corporation’s articles of incorporation (the “Amendment”).  The Amendment authorizes the Corporation toissue up to 10,000,000 shares of preferred stock, which may be issued from timeto time in one or more series as determined by the Board.  The Board is authorized to designate allrights, preferences, privileges and restrictions attendant to each series aswell as the number of shares authorized for issuance in each series of thepreferred stock, which matters shall be expressed in resolutions adopted by theBoard and filed with the Secretary of State of the state of California.  Additionally, the Amendment authorizes theCorporation to issue an additional 7,500,000 shares of common stock for a totalof 10,000,000 shares of common stock authorized for issuance after theAmendment.  The Amendment becameeffective January 23, 2009. There were no shares issued as of September 30,2010.

 

**Other Regulatory Matters**

 

TheCorporation’s wholly-owned subsidiary bank, Monterey County Bank (the “Bank”)has entered into a Consent Order (the “Order”) with the Federal DepositInsurance Corporation (the “FDIC”) and the California Department of FinancialInstitutions (the “CDFI”).   The Orderbecame effective on September 1, 2010.

 

TheOrder requires the Bank to take corrective actions to address certainviolations of law and/or regulation. These corrective actions require the Bank to:

 

1.                     have and retainqualified management having such qualifications and experience commensuratewith his or her duties and responsibilities at the Bank and notify the FDIC andthe CDFI prior to adding any individual to the Bank’s Board of Directors oremploying any individual as a senior executive officer of the Bank;

 

2.                     develop andadopt a capital plan that complies with the FDIC’s Statement of Policy onRisk-Based Capital contained in Appendix A to Part 325 of the FDIC’s rules andregulations in order to maintain Tier 1 capital in such an amount to ensurethat the Bank’s  leverage ratio equals orexceeds 9% and the Bank’s total risk-based capital ratio equals or exceeds 12%;

 

3.                     not pay cashdividends or make any other payments to the Bank’s shareholders absent theprior written consent of the FDIC and the CDFI;

 

4.                     eliminate,either by charge-off or collection, assets classified as “Loss” in theexamination report of the FDIC and the CDFI relating to their examination ofthe Bank on February 16, 2010 (the “ROE”);

 

5.                     formulate awritten plan to reduce the Bank’s risk exposure in adversely classified “Substandard”or “Doubtful” assets listed in the ROE;

 

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6.                     not extend anyadditional credit to or for the benefit of any borrower who has a loan or otherextension of credit that either: (a) has been charged off or classified(in whole or in part) as “Loss” and is uncollected, or (b) absent theprior approval of the Bank’s board or loan committee,  has been classified (in whole or in part) as “Doubtful”or “Substandard;”

 

7.                     review theappropriateness of the Bank’s allowance for loan and lease losses (“ALLL”) andestablish a comprehensive policy for determining the appropriate level of theALLL, including documenting the analysis according to the standards set forthin the  applicable policy guidelines ofthe FDIC;

 

8.                     develop orrevise, adopt, and implement a written lending and collection policy to provideeffective guidance and control over the Bank’s lending functions in accordancewith the requirements of the Order;

 

9.                     develop orrevise, adopt, and implement a written liquidity and funds management policythat adequately addresses liquidity needs and contingency funding,appropriately reduces the Bank’s reliance on non-core funding sources andcomplies with FDIC’s Guidance on Liquidity Risk Management, dated August 26,2008;

 

10.                     comply with the FDIC’s rules andregulations relating to brokered deposits and formulate and submit forapproval, a written plan to eliminate the Bank’s reliance on brokered deposits;

 

11.                     develop or revise, adopt,and implement a written plan addressing retention of profits, reducing overheadexpenses, and setting forth a comprehensive budget to cover the three-yearperiod from January 1, 2011 to December 31, 2013, which shall includeformal goals, strategies and benchmarks which are consistent with sound bankingpractices to improve the Bank’s net interest margin, increase interest income,reduce discretionary expenses, and improve and sustain earnings;

 

12.                     develop and submit forregulatory review and approval, a written three-year strategic plan, includinga written profit plan, which includes, among other things, specific goals forthe dollar volume of total loans, total investment securities and totaldeposits as of December 31, 2011 through December 31, 2013;

 

13.                     refrain from engaging in anyexpansionary activities, including opening any branches absent prior regulatoryapproval;

 

14.                     inform the FDIC and the CDFIprior to making any planned public announcement or notification regardingchanges to the Bank’s financial condition, executive management or board ofdirectors;

 

15.                     furnish written progressreports to the FDIC and the CDFI detailing the form and manner of any actionstaken to secure compliance with the Order; and provide a description of theOrder to the Bank’s shareholders in conjunction with the Bank’s nextshareholder communication and also in conjunction with the Bank’s notice orproxy statement preceding the next shareholder meeting.

 

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TheCorporation’s wholly-owned subsidiary bank, Monterey County Bank, hasstipulated to the issuance of a Consent Order, Order for Restitution and Orderto Pay Civil Money Penalties (collectively, the “Order”) by the Federal DepositInsurance Corporation (the “FDIC”).  TheOrder became effective on September 29, 2010.

 

Withoutadmitting or denying any of the alleged charges of unsafe or unsound bankingpractices and any violations of law, the Bank has agreed to take the followingcorrective actions to address certain alleged violations of law and/orregulation, as more fully discussed in the Order:

 

1.                     provide fullaccurate disclosure and refrain from making misleading statements to consumersregarding the Bank’s balance transfer credit card programs, the interest ratesand fees associated with these programs, the Bank’s debt collection practices,and the Bank’s stored value card programs;

 

2.                     develop andmaintain effective monitoring, training and audit procedures to review eachaspect of the Bank’s agreement with third parties in order to ensure that thirdparty vendors comply with consumer protection laws, regulatory guidance,regulations, and policies (“consumer laws”);

 

3.                     develop andmaintain an adequate compliance management system that implements a writtencompliance program to ensure the Bank’s compliance with consumer laws;

 

4.                     retain aqualified compliance officer with the requisite knowledge and experience toadminister an effective compliance management system, including experience withthird-party debit and credit card agreements;

 

5.                     have anindependent audit to ensure compliance with consumer laws;

 

6.                     correct, to theextent possible, all violations of consumer laws and refrain from making,either directly or indirectly, any false, deceptive or misleadingrepresentations with respect to any extension of credit or other Bank product;and

 

7.                     contribute$300,000 to an established local or national non-profit organization for thespecific purpose of consumer financial education and counseling.

 

In addition, the Order requires the Bank’s Board of Directors toparticipate fully in the oversight of the Bank’s compliance management systemand to assume full responsibility for the approval of sound compliance policiesand objectives. The Order requires the Board to establish a compliancecommittee comprised of at least three directors who are not Bank officers thatwill meet at least monthly to review among other things, compliance withconsumer laws and compliance with the Order.

 

The Order further requires that the Bank make restitution payments tocertain consumers who had or currently have a credit card and/or a prepaiddebit card issued by the Bank through agreements with certain third partyvendors.  In this regard, the Bank mustprepare a restitution plan for regulatory approval with respect to makingrestitution payments to such consumers not to exceed $2.5 million in theaggregate and reserve or deposit into a segregated account for the payment ofrestitution an amount not less than $1.5 million. The Bank is also required toretain an independent accounting firm to determine compliance with therestitution plan.

 

As a result of the alleged violations of laws and/or regulation, theFDIC has assessed a civil money penalty in the amount of $500,000 against theBank.

 

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The Order also requires that the Bank furnish written progress reportsto the FDIC detailing the form and manner of any actions taken to securecompliance with the Order and provide a description of the Order to the Bank’sshareholders in conjunction with the Bank’s next shareholder communication andalso in conjunction with the Bank’s notice or proxy statement preceding thenext shareholder meeting.

 

TheCorporation has entered into a written agreement (the “Agreement”) with theFederal Reserve Bank of San Francisco, effective as of October 29, 2010,pursuant to which the Company has agreed to take the following actions:

 

1.                     takeappropriate steps to fully utilize the Company’s financial and managerialresources to serve as a source of strength to Monterey County Bank, the Company’swholly-owned bank subsidiary (the “Bank”), including taking steps to ensure theBank’s compliance with the Consent Order, dated September 1, 2010, between theBank and the Federal Deposit Insurance Corporation (the “FDIC”) and any othersupervisory action taken by the Bank’s federal and state regulators;

 

2.                     refrain fromdeclaring or paying dividends, taking dividends or any form of payment from theBank representing a reduction in the Bank’s capital, or making anydistributions of interest, principal or other sums on the Company’ssubordinated debentures or trusted preferred securities absent prior regulatoryapproval;

 

3.                     refrain fromincurring, increasing or guaranteeing any debt or repurchasing or redeeming anyshares of its stock absent prior regulatory approval;

 

4.                     develop andsubmit for regulatory approval a cash flow projection of the Company’s plannedsources and uses of cash for debt service, operating expenses and otherpurposes;

 

5.                     comply withappropriate regulatory notice and approval requirements when appointing any newdirectors or senior executive officers or changing the responsibilities of anysenior executive officer and comply with the limitations on indemnification andseverance payments set forth in Section 18(k) of the Federal Deposit InsuranceAct (12 USC 1828(i)) and Part 359 of the FDIC’s implementing regulations; and

 

6.                     furnish writtenprogress reports to the Federal Reserve Bank of San Francisco detailing theform and manner of any actions taken to secure compliance with the Agreement.

 

TheBoard of Directors and management are diligently working to ensure compliancewith the requirements of these regulatory actions.

 

**Liquidity**

 

Liquidity represents the ability to provide sufficient cash flows orcash resources in a manner that enables an entity to meet its obligations in atimely fashion and adequately provide for anticipated future cash needs.

 

For the Bank, liquidity considerations involve the capacity to meetexpected and potential requirements of depositors seeking access to balancesand to provide for the credit demands of borrowing customers.  In the ordinary course of the Bank’sbusiness, funds are generated from the repayment of loans, maturities withinthe investment securities portfolio and the acquisition

 

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of deposit balances and short-term borrowings.  In addition, the Bank has a line of creditfrom the Federal Home Loan Bank of San Francisco of approximately $58,589,000,based on 20 percent of the Bank’s total assets as reported in the most recentquarterly Consolidated Reports of Condition and Income for a bank with DomesticOffices Only.  The line of credit issubject to pledging of acceptable collateral. At September 30, 2010, $98,000 inexcess collateral was pledged.  The Bankhas a borrowing line with the Federal Reserve Bank of San Francisco secured****a portion of the Bank’s securities, with availableovernight borrowing of $9,152,000 at September 30, 2010.

 

As a matter of policy, the Bank seeks to maintain a level of liquidassets, including marketable investment securities, equal to a least 15 percentof total assets (“total liquidity”). Additionally the Bank maintains secondarysources of liquidity (borrowing lines from other institutions) equal to atleast an additional 10 percent of assets. Within these ratios, the Bank generally has excess funds available tosell as federal funds on a daily basis, and is able to fund its own liquidityneeds without the need of short-term borrowing. The Bank’s total liquidity at September 30, 2010 and 2009 was 29.49% and35.26%, respectively, while its average loan to average deposit ratio for suchyears was 72.74% and 81.51%, respectively.

 

Brokereddeposits are deposit instruments, such as certificates of deposit, depositnotes, bank investment contracts and certain municipal investment contractsthat are issued through brokers and dealers who then offer and/or sell thesedeposit instruments 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 has received notice from the FDIC that its capitalclassification has been designated as adequately capitalized; therefore the Bankis prohibited from accepting new or renewing any brokered deposits. The Bankhad $48,623,000 in brokered deposits at September 30, 2010 compared with$6,300,000 in brokered deposits at September 30, 2009.

 

**Deferralof Interest Payments on Trust Preferred Securities**

 

The Corporation has exercised its rights in accordance with Section2.11 Extension of Interest Payment Period of the Indentures dated March 27,2003 for Northern California Bancorp, Inc. Trust I and November 3, 2003 forNorthern California Bancorp, Inc. Trust II to defer interest payments for anundetermined period of time, not to exceed twenty (20) consecutive quarterlypayments.  The deferral of interestpayments on Northern California Bancorp, Inc. Trust I was effective with theOctober 7, 2009 interest payment.  Thedeferral of interest payments on Northern California Bancorp, Inc. Trust II waseffective with the November 8, 2009 interest payment.

 

**InterestRate Risk**

 

Managementof interest rate sensitivity (asset/liability management) involves matching andrepricing rates of interest-earning assets with interest-bearing liabilities ina manner designed to optimize net interest income within the constraintsimposed by regulatory authorities, liquidity determinations and capitalconsiderations.  The Bank institutedformal asset/liability policies at the end of 1989.

 

The purpose of asset/liability management is to provide stable netinterest income growth by protecting the Bank’s earnings from undue interestrate risk.  The Bank expects to generateearnings from increasing loan volume, appropriate loan pricing and expensecontrol and not from trying to accurately forecast interest rates.  Another important function of asset/liability

 

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management is managing the risk/return relationships between interestrate risk, 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 is to control the exposure of the Bank’s earnings to changing interestrates by generally maintaining a position within a narrow range around an “earningsneutral position.” An earnings neutral position is defined as the mix of assetsand liabilities that generate a net interest margin that is not affected byinterest rate changes.  However,Management does not believe that the Bank can maintain a totally earningsneutral position.  Further, the actualtiming of repricing of assets and liabilities does not always correspond to thetiming assumed by the Bank for analytical purposes.  Therefore, changes in market rates ofinterest will generally impact the Bank’s net interest income and net interestmargin for long or short periods of time.

 

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 variousrate shocks, expressed in basis points, at September 30, 2010.  The table includes one projection for a decreasein rates, as the Federal Funds target rate is currently between 0% and 0.25%.

 
| **Rate Shock Increase(Decrease)  in Basis Points** | ** ** | **Percent Increase(Decrease)  in Net Interest Income** | ** ** |
|------------------------------------------------------------------------|------------|----------------------------------------------------------------------------|------------|
| (25)                                                                   |       | (1.8                                                                       | )%         |
| 100                                                                    |       | 8.1                                                                        | %          |
| 200                                                                    |       | 16.6                                                                       | %          |
| 300                                                                    |       | 25.2                                                                       | %          |
| 400                                                                    |       | 33.9                                                                       | %          |

 

**Item 4T. Controls and Procedures**

 

(a)The Corporation’s Chief Executive Officer and its Chief Financial Officer,after evaluating the effectiveness of the Bank’s disclosure controls andprocedures as defined in Exchange Act Rules 13a-15(e) promulgated under the ExchangeAct as of the end of the period covered by this report (the “Evaluation Date”)have concluded that as of the Evaluation Date, the Corporation’s disclosurecontrols and procedures were adequate and effective to ensure that materialinformation relating to the Corporation would be made known to them by otherswithin the Bank, particularly during the period in which this report was beingprepared.  Disclosure controls andprocedures are designed to ensure that information required to be disclosed byus in the reports that we file or submit under the Exchange Act is recorded,processed, summarized and reported, within the time periods specified in theSecurities and Exchange Commission’s rules and forms.  Disclosure controls and procedures include,without limitation, controls and procedures designed to ensure that informationrequired to be disclosed by us in the reports that we file under the ExchangeAct is accumulated and communicated to our management, including our ChiefExecutive Officer and Chief Financial Officer, as appropriate to allow timelydecisions regarding required disclosure.

 

(b) Changes in Internal Controls: In the quarter ended September 30, 2010, the Corporation did not makeany significant changes in, nor take any corrective actions regarding, itsinternal controls or other factor that could significantly affect thesecontrols.

 

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** **

**PART II-OTHER INFORMATION**

 

**Item 1.  Legal Proceedings**

 

The Bank, its Chief Executive Officer and Chief Credit Officer werenamed as defendants in a lawsuit filed July 27, 2009 in the Monterey CountySuperior Court by Bank of the Orient. The lawsuit involved claims related to loan participations purchasedfrom the Bank and sought rescission of the participation agreements or damagesand attorneys’ fees and costs.  While theaction was originally filed in the Superior Court under the terms of theparticipation agreements the matter was submitted to arbitration through theAmerican Arbitration Association.

 

The parties reached a settlement of the claims raised in the litigationwhich has been consummated.    Thesettlement resulted in a one-time after tax charge to the Bank’s earnings of$390,000 in the second quarter of 2010.

 

The Bank, its Chief Financial Officer and a former Senior VicePresident were named as defendants in a lawsuit filed February 26, 2009 inMonterey County Superior Court, Civil Division, by Tighorn Financial Services,LLC (“Tighorn”).  The lawsuit seeks tocompel the Bank to continue its credit card sponsorship program with Tighornand the servicing of a credit card portfolio under a card sponsorship agreementwith a third party.  The suit also allegesthat Tighorn was misled into entering the credit card sponsorship agreement.For its part, the Bank has responded by contending that it properly terminatedthe sponsorship agreement pursuant to termination provisions contained in theparties’ Agreement, and that the Bank properly gave Tighorn written notice oftermination of the Agreement in June 2008. The Bank has filed a counter claim for damages and equitable reliefagainst Tighorn, and the Bank’s Chief financial Officer has filedcross-complaints against two Tighorn representatives and a third party claimingindemnity and equitable apportionment under California law.

 

The Bank, Chief Executive Officer and Chief Credit Officer were namedas defendants in a lawsuit filed April 29, 2009 in the Monterey County SuperiorCourt, by First Foundation Bank.  Thelawsuit involves claims related to two loan participations purchased by FirstFoundation Bank from Monterey County Bank. The lawsuit seeks to rescind the participation agreements, payment ofall principal and interest, damages, attorneys’ fees and costs.  While the action was originally filed in theSuperior Court, under the terms of the participation agreements, the matter hasbeen submitted to arbitration through the American Arbitration Association.

 

TheBank was named as defendant in two separate actions filed June 17, 2008 andJune 26, 2008 to foreclose mechanic’s liens on site improvements performed inthe amounts of $1.5 million and $6.0 million, respectively. The actions assertthat the mechanic’s liens have priority over the Bank’s Deeds of Trust againstvarious lots in the subdivision that were benefited by the site improvements.The Bank is being defended by its title insurer and in legal counsel’s opinionthe Bank does not have any exposure in these matters because the priority ofits trust deeds is insured by policies of title insurance.

 

The Bank and its Chief Lending Officer were named as defendants in alawsuit filed by Travis Construction Company in the Superior Court of MontereyCounty to foreclose a mechanic’s lien in connection with a single familyresidence financed by the Bank.  Underthe terms of a settlement reached in the lawsuit the title company will pay$137,000 and the Bank will pay the contractor $113,000 in exchange for a releaseof the mechanic’s lien and dismissal of the suit.

 

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Northern California Bancorp, Inc, Monterey County Bank and the ChiefExecutive Officer among other unrelated parties were named as defendants in alawsuit filed July 22, 2010 in the Monterey County Superior Court by SouthValley Developers, Inc. and Paseo Vista LLC. The lawsuit seeks a declaration of the parties’ respective obligationsunder a profit participation agreement in which the bank is a successor ininterest as well as for breach of contract and fraud related to a loan extendedto one of the plaintiffs and for injunctive relief pending the declaratoryjudgment.

 

Although the amount of any ultimate liability with respect to the aboveproceedings cannot be determined, in the opinion of management, any suchliability will not have a material effect on the consolidated financialposition of the Corporation and its subsidiary, except as previously addressedabove.

 

**Item 2.  Unregistered Sales ofEquity Securities and Useof Proceeds**

 

None

 

**Item 3.  Defaults upon SeniorSecurities**

 

None

 

**Item 4.  Submission of Matters toa Vote of Security Holders**

 

None

 

**Item 5.  Other Information**

 

None

 

**Item 6.  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. |

 

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

 
| NORTHERN CALIFORNIA  BANCORP, INC. |
|------------------------------------|
|                               |   |   |   |
| Date:  November 12, 2010           | By: | /s/  Charles T. Chrietzberg, Jr. |
|                               | Charles  T. Chrietzberg, Jr. |
|                               | Chairman  of the Board & |
|                               | Chief  Executive Officer |
|                               |   |   |
|                               |   |   |
| Date:  November 12, 2010           | By: | /s/  Bruce N. Warner |
|                               | Bruce  N. Warner |
|                               | Chief  Financial Officer and |
|                               | Principal  Accounting Officer |
|                                    |  |  |  |  |

 

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