UNITED
STATES


SECURITIES
& EXCHANGE COMMISSION


Washington,
D.C. 20549


__________________________





FORM
10-Q





ý
            QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934




For
Quarter Ended September 30, 2008





OR




0
            TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934




For
the transition period from _________to ________




Commission
file number:  0-49892





PACIFIC
STATE BANCORP


(Exact
Name of Registrant as Specified in its Charter)





California
            61-1407606(State
      or other jurisdiction of
              incorporation
      or organization)
            (I.R.S.
      Employer
              Identification
      No.)





1899
W. March Lane, Stockton, CA 95207


(Address
of Principal Executive Offices) (Zip Code)


Registrant’s
Telephone Number, including Area Code (209) 870-3200





Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports,) and (2) has been subject to such filing requirements for
the past 90 days. Yes  ý   No 
0





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer or a non-accelerated filer.  See definition of
“accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange
Act. (Check one):


Large
accelerated filer 0                                                                
Accelerated filer  0                                           Non
–accelerated filer  0  Smaller
reporting company   ý





Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act). Yes  0   No ý





Indicate
the number of shares outstanding of each of the registrant issuer’s classes of
common stock, as of the latest practicable date:





Title
      of Class
            Shares
      outstanding as of November 6, 2008Common
      Stock
              No
      Par Value
            3,718,598


-1-


PART
I. FINANCIAL INFORMATION


ITEM
I. FINANCIAL STATEMENTS





PACIFIC
STATE BANCORP AND SUBSIDIARY


CONDENSED
CONSOLIDATED BALANCE SHEETS


Unaudited
            September
      30,
            
            
            December
      31,(Dollars
      in thousands)
            2008
            
            
            2007ASSETSCash
      and due from banks
            
            $
            13,198
            
            
            $
            13,794Federal
      funds sold
            
            
            10,750
            
            
            
            31,880Total
      cash and cash equivalents
            
            
            23,948
            
            
            
            45,674Interest
      bearing deposits at other banks
            
            
            -
            
            
            
            3,000Investment
      securities
            
            
            41,967
            
            
            
            41,352Loans,
      less allowance for loan losses of $3,892 in 2008 and $3,948 in
      2007
            
            
            322,420
            
            
            
            308,458Premises
      and equipment, net
            
            
            15,977
            
            
            
            14,269Other
      real estate owned
            
            
            190
            
            
            
            -Company
      owned life insurance
            
            
            6,682
            
            
            
            8,025Accrued
      interest receivable and other assets
            
            
            16,638
            
            
            
            10,296Total
      assets
            
            $
            427,822
            
            
            $
            431,074LIABILITIES
      ANDSHAREHOLDERS'
      EQUITYDeposits:Non-interest
      bearing
            
            $
            69,019
            
            
            $
            67,071Interest
      bearing
            
            
            276,147
            
            
            
            274,750Total
      deposits
            
            
            345,166
            
            
            
            341,821Other
      borrowings
            
            
            35,000
            
            
            
            40,000Subordinated
      debentures
            
            
            8,764
            
            
            
            8,764Accrued
      interest payable and other liabilities
            
            
            4,892
            
            
            
            6,453Total
      liabilities
            
            
            393,822
            
            
            
            397,038Commitments
      and contingenciesShareholders'
      equity:Preferred
      stock - 2,000,000 shares authorized; none issued or
      outstanding
            
            
            -
            
            
            
            -Common
      stock - no par value; 24,000,000 shares authorized; issued and outstanding
      –3,718,598 shares in 2008 and 3,707,698 shares in 2007
            
            
            10,753
            
            
            
            10,418Retained
      earnings
            
            
            24,468
            
            
            
            24,004Accumulated
      other comprehensive loss, net of taxes
            
            
            (1,221
            )
            
            
            (386
            )Total
      shareholders' equity
            
            
            34,000
            
            
            
            34,036Total
      liabilities and shareholders' equity
            
            $
            427,822
            
            
            $
            431,074


See notes
to unaudited condensed consolidated financial statements


-2-


PACIFIC
STATE BANCORP


CONDENSED
CONSOLIDATED STATEMENTS OF OPERATIONS


(Unaudited)
              
              Three
      Months Ended September 30,
              
              
              Nine
      Months Ended September 30,(Dollars
      in thousands, except per share data)
              
              2008
              
              
              2007
              
              
              2008
              
              
              2007Interest
      income:Interest
      and fees on loans
              
              $
              6,321
              
              
              $
              7,006
              
              
              $
              18,998
              
              
              $
              21,148Interest
      on Federal funds sold
              
              
              85
              
              
              
              396
              
              
              
              341
              
              
              
              1,065Interest
      on investment securities
              
              
              542
              
              
              
              535
              
              
              
              2,144
              
              
              
              1,362Total
      interest income
              
              
              6,948
              
              
              
              7,937
              
              
              
              21,483
              
              
              
              23,575Interest
      expense:Interest
      on deposits
              
              
              2,587
              
              
              
              3,467
              
              
              
              8,245
              
              
              
              9,623Interest
      on borrowings
              
              
              216
              
              
              
              90
              
              
              
              1,064
              
              
              
              211Interest
      on subordinated debentures
              
              
              97
              
              
              
              139
              
              
              
              359
              
              
              
              516Total
      interest expense
              
              
              2,900
              
              
              
              3,696
              
              
              
              9,668
              
              
              
              10,350Net
      interest income before provision for loan losses
              
              
              4,048
              
              
              
              4,241
              
              
              
              11,815
              
              
              
              13,225Provision
      for loan losses
              
              
              600
              
              
              
              40
              
              
              
              1,410
              
              
              
              260Net
      interest income after provision for loan losses
              
              
              3,448
              
              
              
              4,201
              
              
              
              10,405
              
              
              
              12,965Non-interest
      income:Service
      charges
              
              
              196
              
              
              
              208
              
              
              
              656
              
              
              
              646Gain
      on sale of loans
              
              
              37
              
              
              
              119
              
              
              
              188
              
              
              
              147Gain
      on sale of assets
              
              
              471
              
              
              
              -
              
              
              
              471
              
              
              
              -Gain
      on bank owned life insurance
              
              
              2,574
              
              
              
              -
              
              
              
              2,574
              
              
              
              -Other
      income
              
              
              283
              
              
              
              262
              
              
              
              741
              
              
              
              1,188Total
      non-interest income
              
              
              3,561
              
              
              
              589
              
              
              
              4,630
              
              
              
              1,981Non-interest
      expenses:Salaries
      and employee benefits
              
              
              1,398
              
              
              
              1,264
              
              
              
              3,948
              
              
              
              4,252Occupancy
              
              
              316
              
              
              
              292
              
              
              
              881
              
              
              
              855Furniture
      and equipment
              
              
              259
              
              
              
              157
              
              
              
              633
              
              
              
              524Other
      than temporary impairment charge
              
              
              6,498
              
              
              
              -
              
              
              
              6,498
              
              
              
              -Other
      expenses
              
              
              1,585
              
              
              
              998
              
              
              
              3,416
              
              
              
              2,781Total
      non-interest expenses
              
              
              10,056
              
              
              
              2,711
              
              
              
              15,376
              
              
              
              8,412(Loss)
      income before provision for income taxes
              
              
              (3,047
              )
              
              
              2,079
              
              
              
              (341
              )
              
              
              6,534(Benefit)
      provision for income taxes
              
              
              (1,838
              )
              
              
              778
              
              
              
              (805
              )
              
              
              2,498Net
      (loss) income
              
              $
              (1,209
              )
              
              $
              1,301
              
              
              $
              464
              
              
              $
              4,036Basic
      (loss) earnings per share
              
              $
              (0.33
              )
              
              $
              0.35
              
              
              $
              0.13
              
              
              $
              1.10Diluted
      (loss) earnings per share
              
              $
              (0.33
              )
              
              $
              0.33
              
              
              $
              0.12
              
              
              $
              1.01






See notes
to unaudited condensed consolidated financial statements





-3-





PACIFIC
STATE BANCORP AND SUBSIDIARY


CONSOLIDATED
STATEMENTS OF CASH FLOWS


For
the Nine Month Periods Ended September 30, 2008 and 2007


(In
thousands)





(Unaudited)
            
            2008
            
            
            2007Cash
      flows from operating activities:Net
      income
            
            $
            464
            
            
            $
            4,036Provision
      for loan losses
            
            
            1,410
            
            
            
            260Net
      increase in deferred loan origination costs
            
            
            92
            
            
            
            (174
            )Depreciation,
      amortization and accretion
            
            
            271
            
            
            
            19Gain
      on sale of loans, net
            
            
            (188
            )
            
            
            (147
            )Stock-based
      compensation expense
            
            
            256
            
            
            
            211Company
      owned life insurance earnings
            
            
            (249
            )
            
            
            (179
            )Gain
      on death benefit from company owned life insurance
            
            
            (2,574
            )
            
            
            -Decrease
      (increase) in accrued interest receivable and other assets
            
            
            (6,877
            )
            
            
            (957
            )Other
      than temporary impairment charge
            
            
            6,498
            
            
            
            -(Decrease)
      increase  in accrued interestpayable
      and other liabilities
            
            
            (1,561
            )
            
            
            1,669Net
      cash provided by operating activities
            
            
            (2,458
            )
            
            
            4,738Cash
      flows from investing activities:Decrease
      (increase) in interest bearing deposits at other banks
            
            
            3,000
            
            
            
            (3,000
            )Purchases
      of available-for-sale investment securities
            
            
            (31,082
            )
            
            
            (37,271
            )Proceeds
      from matured and called available-for-sale investment
      securities
            
            
            22,735
            
            
            
            12,767Proceeds
      from principal repayments from available-for-sale government-guaranteed
      mortgage-backed securities
            
            
            899
            
            
            
            2,371Proceeds
      from principal repayments from held-to-maturity government-guarantee
      mortgage-backed securities
            
            
            24
            
            
            
            -Purchase
      of FRB and FHLB stock
            
            
            (14
            )
            
            
            -Net
      increase in loans
            
            
            (15,215
            )
            
            
            (20,713
            )Proceeds
      from company owned life insurance redemption
            
            
            4,166
            
            
            
            -Purchases
      of premises and equipment
            
            
            (2,205
            )
            
            
            (2,259
            )Net
      cash used in investing activities
            
            
            (17,692
            )
            
            
            (48,105
            )Cash
      flows from financing activities:Net
      (decrease) in demand, interest-bearing and savings
deposits
            
            
            (6
            )
            
            
            (22,135
            )Net
      increase  in time deposits
            
            
            3,351
            
            
            
            46,618Proceeds
      from exercise of stock options
            
            
            79
            
            
            
            378Net
      (decrease) increase in other borrowings
            
            
            (5,000
            )
            
            
            3,600Net
      cash (used) provided by financing Activities
            
            
            (1,576
            )
            
            
            28,461Decrease
      in cash and cash equivalents
            
            
            (21,726
            )
            
            
            (14,906
            )Cash
      and cash equivalents at beginning of period
            
            
            45,674
            
            
            
            50,615Cash
      and cash equivalents at end of period
            
            $
            23,948
            
            
            $
            35,709




-4-


Pacific
State Bancorp and Subsidiary


NOTES TO
CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)








1.
GENERAL





Pacific
State Bancorp is a holding company with one bank subsidiary, Pacific State Bank,
(the “Bank”), and two unconsolidated subsidiary grantor trusts, Pacific State
Statutory Trusts II and III.  Pacific State Bancorp commenced
operations on June 24, 2002 after acquiring all of the outstanding shares of
Pacific State Bank.  The Bank is a California state chartered bank
formed on November 2, 1987. The Bank is a member of the Federal Reserve System.
The Bank’s primary source of revenue is interest on loans to customers who are
predominantly small to middle-market businesses and middle-income
individuals.  Pacific State Statutory Trusts II and III are
unconsolidated, wholly owned statutory business trusts formed in March 2004 and
June 2007, respectively for the exclusive purpose of issuing and selling trust
preferred securities.





The Bank
conducts general commercial banking business, primarily in the five county
region that comprises Alameda, Calaveras, San Joaquin, Stanislaus and Tuolumne
counties, and offers commercial banking services to residents and employers of
businesses in the Bank’s service area, including professional firms and small to
medium sized retail and wholesale businesses and manufacturers.  The
Company, as of September 30, 2008, had 86 employees, including 20 officers. The
Bank does not engage in any non-banking related lines of business. The business
of the Bank is not to any significant degree seasonal in nature.  The
Bank has no operations outside California and has no material amount of loans or
deposits concentrated among any one or few persons, groups or
industries.  The Bank operates nine branches with its Administrative
Office located at 1899 W. March Lane, in Stockton, California; additional
branches are located in downtown Stockton and in the communities of Angels Camp,
Arnold, Groveland, Lodi, Modesto, Tracy and Hayward,
California.  Pacific State Bancorp common stock trades on the NASDAQ
Global Market under the symbol of “PSBC”.





2. BASIS
OF PRESENTATION AND CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





In the
opinion of management, the unaudited condensed consolidated financial statements
contain all adjustments (consisting of only normal recurring adjustments)
necessary to present fairly the consolidated financial position of Pacific State
Bancorp (the "Company") at September 30, 2008 and December 31, 2007, and the
results of its operations for the three and nine month periods ended September
30, 2008 and 2007, and its cash flows for the nine month periods ended September
30, 2008 and 2007 in conformity with the instructions to Form 10-Q and Article
10 of Regulation S-X of the Securities and Exchange Commission
(“SEC”).





Certain
disclosures normally presented in the notes to the consolidated financial
statements prepared in accordance with accounting principles generally accepted
in the United States of America for annual financial statements have been
omitted.  The Company believes that the disclosures in the interim
condensed consolidated financial statements are adequate to make the information
not misleading. These interim condensed consolidated financial statements should
be read in conjunction with the consolidated financial statements and notes
thereto included in the Company's 2007 Annual Report to
Shareholders.   The results of operations for the three month and
nine month periods ended September 30, 2008 may not necessarily be indicative of
the operating results for the full year.


-5-


In
preparing such financial statements, management is required to make estimates
and assumptions that affect the reported amounts of assets and liabilities as of
the date of the balance sheet and revenues and expenses for the
period.  Actual results could differ significantly from those
estimates.  Material estimates that are particularly susceptible to
significant changes in the near term relate to the determination of the
allowance for loan losses, the provision for income taxes and the estimated fair
value of investment securities.





Management
has determined that all of the commercial banking products and services offered
by the Company are available in each branch of the Bank, that all branches are
located within the same economic environment and that management does not
allocate resources based on the performance of different lending or transaction
activities. Accordingly, the Company and its subsidiary operate as one business
segment. No customer accounts for more than 10% of the revenue for the Bank or
the Company.





3.
LOANS





Outstanding
loans are summarized below:





September
      30,
            
            
            December
      31,2008
            
            
            2007(In
      thousands)Commercial
            
            $
            86,961
            
            
            $
            83,012Agricultural
            
            
            15,007
            
            
            
            12,646Real
      estate - commercial mortgage
            
            
            135,949
            
            
            
            121,157Real
      estate - construction
            
            
            74,298
            
            
            
            80,168Installment
            
            
            13,981
            
            
            
            15,215Gross
      loans
            
            
            326,196
            
            
            
            312,198Deferred
      loan origination costs, net
            
            
            116
            
            
            
            208Allowance
      for loan losses
            
            
            (3,892
            )
            
            
            (3,948
            )Net
      loans
            
            $
            322,420
            
            
            $
            308,458





4.
COMMITMENTS AND CONTINGENCIES





The
Company is party to claims and legal proceedings arising in the ordinary course
of business.  In the opinion of the Company’s management, the ultimate
liability with respect to such proceedings will not have a materially adverse
effect on the financial condition or results of operations of the Company as a
whole.





In the
normal course of business there are outstanding various commitments to extend
credit which are not reflected in the financial statements, including loan
commitments of approximately $64,107,000 and $121,255,000 and stand-by letters
of credit of $773,000 and $3,491,000 at September 30, 2008 and December 31,
2007, respectively.  However, all such commitments will not
necessarily culminate in actual extensions of credit by the
Company.


-6-


Approximately
$16,838,000 of the loan commitments outstanding at September 30, 2008 are for
real estate loans and are expected to fund within the next twelve
months.  The remaining commitments primarily relate to revolving lines
of credit or other commercial loans, and many of these are expected to expire
without being drawn upon.  Therefore, the total commitments do not
necessarily represent future cash requirements.  Each potential
borrower and the necessary collateral are evaluated on an individual
basis.  Collateral varies, but may include real property, bank
deposits, debt or equity securities or business assets.





Stand-by
letters of credit are commitments written to guarantee the performance of a
customer to a third party.  These guarantees are issued primarily
relating to purchases of inventory by commercial customers and are typically
short term in nature.  Credit risk is similar to that involved in
extending loan commitments to customers and accordingly, evaluation and
collateral requirements similar to those for loan commitments are
used.  Virtually all such commitments are collateralized. The deferred
liability related to the Company’s stand-by letters of credit was not
significant at September 30, 2008 and December 31, 2007.




5.
EARNINGS PER SHARE COMPUTATION





Basic
earnings per share are computed by dividing net income by the weighted average
common shares outstanding for the period.  Diluted earnings per share
reflect the potential dilution that could occur if outstanding stock options
were exercised.   Diluted earnings per share is computed by
dividing net income by the weighted average common shares outstanding for the
period plus the weighted average dilutive effect of outstanding
options.  In the third quarter of 2008, the Company recognized a net
loss.  Due to the loss, the diluted earnings per share are equal to
the basic earnings per share.  At September 30, 2008, the Company had
509,000 anti-dilutive shares outstanding.





6.
COMPREHENSIVE INCOME (LOSS)





Comprehensive
income (loss) is reported in addition to net income (loss) for all periods
presented.  Comprehensive income (loss) is made up of net income
(loss) plus other comprehensive income or loss.  Other comprehensive
income or loss, net of taxes, is comprised of the unrealized gains or losses on
available-for-sale investment securities.  The following table shows
total comprehensive income (loss) and its components for the periods
indicated:





Three
      Months Ended
            
            
            Nine
      Months Ended(in
      thousands)
            
            September 30,
      2008
            
            
            September
      30, 2007
            
            
            September 30,
      2008
            
            
            September 30,
      2007Net
      (loss) income
            
            $
            (1,209
            )
            
            
            1,301
            
            
            $
            464
            
            
            
            4,036Other
      comprehensive loss:Change
      in unrealized loss onavailable
      for sale securities
            
            
            (4,108
            )
            
            
            23
            
            
            
            (5,079
            )
            
            
            (7
            )Reclassification
      adjustment
            
            
            4,255
            
            
            
            -
            
            
            
            4,244
            
            
            
            -Total
      other comprehensive (loss) income
            
            
            147
            
            
            
            23
            
            
            
            (835
            )
            
            
            (7
            )Total
      comprehensive (loss) income
            
            $
            (1,062
            )
            
            
            1,324
            
            
            $
            (371
            )
            
            
            4,029




-7-


7. STOCK
–BASED COMPENSATION





Stock
Option Plan





The
Company’s only stock-based compensation plan, the Pacific State Bancorp 1997
Stock Option Plan (the “Plan”), terminated in 2007. The Plan requires that the
option price may not be less than the fair market value of the stock at the date
the option is granted, and that the stock must be paid in full at the time the
option is exercised. The options expire on a date determined by the Board of
Directors, but not later than ten years from the date of grant. The vesting
period is determined by the Board of Directors and is generally over five years.
New shares are issued upon the exercise of options





Stock
Option Compensation





There
were no stock options granted in the three and nine month periods ended
September 30, 2008.  In July of 2007 the Company issued 30,000
non-qualified stock options, exercisable at $19.70.  Those were the
only stock options issued in 2007.  Stock option compensation expense
is recognized on a straight-line basis over the vesting period of the option.
For the three month periods ended September 30, 2008 and 2007, the compensation
cost recognized for stock option compensation was $85,000 and $83,000,
respectively. For the nine month periods ended September 30, 2008 and 2007, the
compensation cost recognized for stock option compensation was $256,000 and
$211,000, respectively. The excess tax benefits were not significant for the
Company.





At
September 30, 2008, the total compensation cost related to nonvested stock
option awards granted to employees under the Company’s stock option plans but
not yet recognized was $214,000.  This cost is expected to be
recognized over a weighted average remaining period of 3.8 years and will be
adjusted for subsequent changes in estimated forfeitures.




Stock
Option Activity




A summary
of option activity under the stock option plans as of September 30, 2008 and
changes during the period then ended is presented below:





Options
            
            Shares
            
            
            Weighted
      Average Exercise Price
            
            
            Weighted
      Average Remaining Contractual Term
            
            
            Aggregate
      Intrinsic Value ($000)Outstanding
      at January 1, 2008
            
            
            656,769
            
            
            $
            7.69
            
            
            5.5
      years
            
            
            $
            3,205Granted
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Exercised
            
            
            10,900
            
            
            $
            4.98
            
            
            2.4
      Years
            
            
            $
            8Cancelled
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Outstanding
      at September 30, 2008
            
            
            645,869
            
            
            $
            7.73
            
            
            5.1
      years
            
            
            $
            0Options
      vested or expected to vest at September 30, 2008
            
            
            508,612
            
            
            $
            7.08
            
            
            4.1
      Years
            
            
            $
            0Exercisable
      at September 30, 2008
            
            
            508,612
            
            
            $
            7.08
            
            
            4.1
      Years
            
            
            $
            0





The
intrinsic value was derived from the closing market price of the Company’s
common stock of $5.70 as of September 30, 2008 and $12.57 of December 31,
2007.


-8-


8. INCOME
TAXES





The
Company files its income taxes on a consolidated basis with its subsidiaries.
The allocation of income tax expense (benefit) represents each entity’s
proportionate share of the consolidated provision for income taxes.




The
Company accounts for income taxes using the liability or balance sheet method.
Under this method, deferred tax assets and liabilities are recognized for the
tax consequences of temporary differences between the reported amounts of assets
and liabilities and their tax bases. Deferred tax assets and liabilities are
adjusted for the effects of changes in tax laws and rates on the date of
enactment. On the consolidated balance sheet, net deferred tax assets are
included in accrued interest receivable and other assets.




Accounting
for Uncertainty in Income Taxes




The
benefit of a tax position is recognized in the financial statements in the
period during which, based on all available evidence, management believes it is
more likely than not that the position will be sustained upon examination,
including the resolution of appeals or litigation processes, if any.  Tax
positions that meet the more-likely-than-not recognition threshold are measured
as the largest amount of tax benefit that is more than 50 percent likely of
being realized upon settlement with the applicable taxing authority.  The
portion of the benefits associated with tax positions taken that exceeds the
amount measured as described above is reflected as a liability for unrecognized
tax benefits in the accompanying balance sheet along with any associated
interest and penalties that would be payable to the taxing authorities upon
examination.  The Company recognizes accrued interest and penalties related
to unrecognized tax benefits, if applicable, as a component of interest expense
in the consolidated statements of income.  There have been no significant
changes to unrecognized tax benefits or accrued interest and penalties for the
three months ended September 30, 2008.





9.  FAIR
VALUE MEASUREMENT


On
January 1, 2008, the Company adopted Financial Accounting Standards Board (FASB)
Statement No. 157 (SFAS 157), “Fair Value Measurements.”  SFAS 157
defines fair value, establishes a framework for measuring fair value under
accounting principles generally accepted in the United States of America and
expands disclosures about fair value measurements.  There was no
cumulative effect adjustment to beginning retained earnings recorded upon
adoption and no impact on the financial statements in the first nine months of
2008.




-9-


The
following table presents information about the Company’s assets and liabilities
measured at fair value on a recurring and nonrecurring basis as of
September 30, 2008, and indicates the fair value hierarchy of the valuation
techniques utilized by the Company to determine such fair value. In general,
fair values determined by Level 1 inputs utilize quoted prices
(unadjusted) in active markets for identical assets or liabilities that the
Company has the ability to access. Fair values determined by Level 2 inputs
utilize information other than the quoted prices included in Level 1 that are
observable for the asset or liability, either directly or indirectly. Level 2
inputs include quoted prices for similar assets and liabilities in active
markets, and inputs other than quoted prices that are observable for the asset
or liability, such as interest rates and yield curves that are observable at
commonly quoted intervals. Level 3 inputs are unobservable inputs for the asset
or liability, and include situations where there is little, if any, market
activity for the asset or liability. In certain cases, the inputs used to
measure fair value may fall into different levels of the fair value hierarchy.
In such cases, the level in the fair value hierarchy within which the fair value
measurement, in its entirety, falls has been determined based on the lowest
level input that is significant to the fair value measurement. The Company’s
assessment of the significance of a particular input to the fair value
measurement, in its entirety, requires judgment and considers factors specific
to the asset or liability.




(dollars
in thousands)


Description
            
            Fair
      Value
              September
      30, 2008
            
            
            Fair
      Value Measurements
              at
      September 30, 2008 UsingQuoted
      Prices in Active Markets for Identical Assets (Level 1)
            
            
            Other
      Observable Inputs
              (Level
      2)
            
            
            Significant
      Unobservable
              Inputs
              (Level
      3)Assets
      and liabilities measured on a recurring basis:Available-for-sale
      securities
            
            $
            41,919
            
            
            $
            41,919
            
            
            $
            -
            
            
            $
            -Total
            
            $
            49,919
            
            
            $
            41,919
            
            
            $
            -
            
            
            $
            -Assets
      and liabilities measured on a nonrecurring basis:Impaired
      loans
            
            $
            -
            
            
            $
            -
            
            
            $
            -
            
            
            $
            -Other
      real estate owned
            
            
            190
            
            
            
            -
            
            
            
            190
            
            
            
            -Total
            
            $
            190
            
            
            $
            -
            
            
            $
            190
            
            
            $
            -





The
following methods were used to estimate the fair value of each class of
financial instrument above:




Available-for-sale
securities- Fair values for investment securities are based on evaluated
pricing models that vary by asset class and incorporate available trade, bid and
other market information.  Evaluated pricing applications apply
available information, as applicable, through processes such as benchmark
curves, benchmarking to like securities, sector groupings, and matrix
pricing.





Impaired Loans-The fair value of
impaired loans is based on the fair value of the collateral for all collateral
dependent loans and for other impaired loans is estimated using a discounted
cash flow model.


-10-


Other real estate
owned-Other real estate owned
represents real estate which the Company has taken control of in partial or full
satisfaction of loans. At the time of foreclosure, other real estate owned is
recorded at the fair value of the real estate less costs to sell, which becomes
the property’s new basis.





10. NEW
ACCOUNTING PRONOUNCEMENTS





Fair
Value Measurements





In
September 2006, the Financial Accounting Standards Board (FASB) issued Statement
of Financial Accounting Standards No. 157, Fair Value Measurements ("SFAS
No. 157").  SFAS No. 157 defines fair value, establishes a
framework for measuring fair value, and expands disclosures about fair value
measurement.  SFAS No. 157 also emphasizes that fair value is a
market-based measurement, not an entity-specific measurement, and sets out a
fair value hierarchy with the highest priority being quoted prices in active
markets.  Under SFAS No. 157, fair value measurements are
disclosed by level within that hierarchy.  SFAS No. 157 is
effective for fiscal years beginning after November 15, 2007, except for
nonfinancial assets and nonfinancial liabilities that are recognized or
disclosed at fair value in the financial statements on a nonrecurring basis for
which delayed application is permitted until fiscal years beginning after
November 15, 2008.  The adoption of SFAS No. 157 did not have a
material impact on the Company’s financial position, results of operations or
cash flows.





Fair
Value Accounting





In
February 2007, the FASB issued Statement of Financial Accounting Standards
No. 159, The Fair Value Option for Financial Assets and Financial
Liabilities ("SFAS No. 159").  SFAS No. 159 permits
companies to elect to follow fair value accounting for certain financial assets
and liabilities in an effort to mitigate volatility in earnings without having
to apply complex hedge accounting provisions.  The standard also
establishes presentation and disclosure requirements designed to facilitate
comparison between entities that choose different measurement attributes for
similar types of assets and liabilities.  SFAS No. 159 is
effective for fiscal years beginning after November 15, 2007.  The
adoption of SFAS No. 159 did not have a material impact on the Company’s
financial position, results of operations or cash flows.





Business
Combinations





In
December 2007, the FASB issued Statement of Financial Accounting Standards
No. 141 (revised 2007), Business Combinations ("SFAS
No. 141(R)").  SFAS No. 141(R), among other things,
establishes principles and requirements for how the acquirer in a business
combination (i) recognizes and measures in its financial statements the
identifiable assets acquired, the liabilities assumed, and any noncontrolling
interest in the acquired business, (ii) recognizes and measures the
goodwill acquired in the business combination or a gain from a bargain purchase,
and (iii) determines what information to disclose to enable users of the
financial statements to evaluate the nature and financial effects of the
business combination.  The Company is required to adopt SFAS
No. 141(R) for all business combinations for which the acquisition date is
on or after January 1, 2009.  Earlier adoption is
prohibited.  This standard will change the Company’s accounting
treatment for business combinations on a prospective basis.




-11-


Noncontrolling
Interests in Consolidated Financial Statements





In
December 2007, the FASB issued Statement of Financial Accounting Standards
No. 160, Noncontrolling Interests in Consolidated Financial Statements, an
Amendment of ARB No. 51 ("SFAS No. 160").  SFAS No. 160
establishes accounting and reporting standards for noncontrolling interests in a
subsidiary and for the deconsolidation of a subsidiary.  Minority interests
will be recharacterized as noncontrolling interests and classified as a
component of equity.  It also establishes a single method of accounting for
changes in a parent's ownership interest in a subsidiary and requires expanded
disclosures.  This statement is effective for fiscal years beginning
on or after December 15, 2008, with early adoption
prohibited.  The Company does not expect the adoption of this
Statement will have a material impact on its financial position, results of
operations or cash flows.





Accounting
for Deferred Compensation and Postretirement Benefit Aspects of Endorsement
Split-Dollar Life Insurance Arrangements





In
September 2006, the FASB ratified the Emerging Issues Task Force ("EITF")
conclusion under EITF Issue No. 06-4, Accounting for Deferred Compensation
and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance
Arrangements ("EITF 06-4").  EITF 06-4 requires that
endorsement split-dollar life insurance arrangements which provide a
postretirement benefit to an employee be recorded in accordance with FASB
Statement No. 106, Employer's Accounting for Postretirement Benefits Other
Than Pensions or APB Opinion No. 12, Omnibus Opinion—1967, based on the
substance of the agreement with the employee.  Under the provisions of
these Statements, if the employer has effectively agreed to maintain a life
insurance policy during the employee's retirement, the cost of the insurance
policy during postretirement periods should be accrued in accordance with either
Statement 106 or Opinion 12.  Similarly, if the employer has
effectively agreed to provide the employee with a death benefit, the employer
should accrue, over the service period, a liability for the actuarial present
value of the future death benefit as of the employee's expected retirement date,
in accordance with either Statement 106 or
Opinion 12.  EITF 06-4 is effective for fiscal years
beginning after December 15, 2007.  The effects of adopting
EITF 06-4 can be recorded either as (i) a change in accounting principle
through a cumulative-effect adjustment to retained earnings or to other
components of equity as of the beginning of the year of adoption, or (ii) a
change in accounting principle through retrospective application to all prior
periods.  The Company adopted the provisions of EITF 06-4 as of
January 1, 2008 and management determined that adoption did not have an
impact on the financial position, results of operations or cash flows of the
Company.





Accounting
for Collateral Assignment Split-Dollar Life Insurance Arrangements





In March
2007, the FASB ratified the consensus the EITF reached regarding EITF Issue
No. 06-10, Accounting for Collateral Assignment Split-Dollar Life Insurance
Arrangements ("EITF 06-10"), which provides accounting guidance for
postretirement benefits related to collateral assignment split-dollar life
insurance arrangements, whereby the employee owns and controls the insurance
policies.  The consensus concludes that an employer should recognize a
liability for the postretirement benefit in accordance with FASB Statement
No. 106, Employers' Accounting for Postretirement Benefits Other Than
Pensions, or APB Opinion No. 12, Omnibus Opinion – 1967, as well as recognize an
asset based on the substance of the arrangement with the
employee.  EITF 06-10 is effective for fiscal years beginning
after December 15, 2007, with early application permitted.  The
Company adopted the provisions of EITF 06-10 on January 1, 2008 and management
determined that adoption did not have an impact on the financial position,
results of operations or cash flows of the Company.


-12-


In May
2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally
Accepted Accounting Principles”(SFAS No. 162). This standard identifies
the sources of accounting principles and the framework for selecting the
principles to be used in the preparation of financial statements of
nongovernmental entities that are presented in conformity with GAAP. The
provisions of SFAS No. 162 did not have a material impact on the Company’s
condensed consolidated financial statements.





On
October 10, 2008, the FASB issued FSP FAS 157-3, Determining the Fair Value of a
Financial Asset When the Market for That Asset Is Not Active. The FSP clarifies
the application of FASB Statement No. 157, Fair Value Measurements, in a market
that is not active and provides an example to illustrate key considerations in
determining the fair value of a financial asset when the market for that
financial asset is not active. The FSP is effective immediately, and includes
prior period financial statements that have not yet been issued, and therefore
the Company is subject to the provision of the FSP effective September 30, 2008.
The implementation of FSP FAS 157-3 did not affect the Company’s fair value
measurement as of September 30, 2008.





ITEM
2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS





Certain
matters discussed in this Quarterly Report are forward-looking statements that
are subject to risks and uncertainties that could cause actual results to differ
materially from those projected in the forward-looking statements. Such risks
and uncertainties include, among others (1) significant increases in competitive
pressures in the financial services industry; (2) changes in the interest rate
environment resulting in reduced margins; (3) general economic conditions,
either nationally or regionally, may be less favorable than expected, resulting
in among other things, a deterioration in credit quality; (4) changes in the
regulatory environment; (5) loss of key personnel; (6) fluctuations in the real
estate market; (7) changes in business conditions and inflation; (8) operational
risks including data processing systems failures and fraud; and (9) changes in
the securities market.  Therefore the information set forth herein
should be carefully considered when evaluating the business prospects of the
Company.





When the
Company uses in this Quarterly Report the words “anticipate”, “estimate”,
“expect”, “project”, “intend, “commit”, “believe” and similar expressions, the
Company intends to identify forward-looking statements.  Such
statements are not guarantees of performance and are subject to certain risks,
uncertainties and assumptions, including those described in this Quarterly
Report. Should one or more of the uncertainties materialize, or should
underlying assumptions prove incorrect, actual results may vary materially from
those anticipated, estimated, expected, projected, intended, committed or
believed.  The future results and stockholder values of the Company
may differ materially from those expressed in these forward-looking
statements.  Many factors that will determine these results and values
are beyond the Company’s ability to control or predict.  For those
statements, the Company claims the protection of the safe harbor for
forward-looking statements contained in the Private Securities Litigation Reform
Act of 1995.





INTRODUCTION





The
following discussion and analysis sets forth certain statistical information
relating to the Company as of September 30, 2008 and December 31, 2007 and for
the three and nine month periods ended September 30, 2008 and
2007.  The discussion should be read in conjunction with the unaudited
condensed consolidated financial statements and related notes included elsewhere
in this report and the consolidated financial statements and notes thereto
included in Pacific State  Bancorp’s Annual Report filed on Form 10-K
for the year ended December 31, 2007.


-13-


CRITICAL
ACCOUNTING POLICIES





There
have been no changes to the Company’s critical accounting policies from those
discussed in Management’s Discussion and Analysis of Financial Condition and
Results of Operations in the Company’s 2007 Annual Report on Form
10-K.





OVERVIEW





For the
three months ended September 30, 2008:





The
Company’s net income decreased $2,510,000 or 192.9% to a net loss of $1,209,000
for the third quarter of 2008 from $1,301,000 for the same period in
2007.  The primary contributors to the net loss for the third quarter
of 2008 were the (1) other than temporary impairment (“OTTI”) charge on Fannie
Mae and Freddie Mac preferred stock of $6,498,000, (2) $193,000 decrease in net
interest income, a (3) $560,000 increase in provision for loan losses, and (4)
increased non-interest expense of $847,000 related to increased salaries and
legal costs associated with loan collection, compared to the same period in
2007.  The changes above were partially offset by (1) a nontaxable
gain on bank owned life insurance of $2,574,000 and (2) the gain on the sale of
a land lot of $465,000, and (3) the decrease in the provision for income taxes
of $2,616,000 primarily because of a decrease in taxable earnings and a
$2,243,000 tax benefit recorded for the OTTI charge.  The Company
owned approximately $7,000,000 in shares of Fannie Mae and Freddie Mac preferred
stock which declined significantly in value after the Treasury Department
announced the cancelation of preferred stock dividends on September 7,
2008.  The OTTI charge of $6,498,000 was calculated based upon the
market value of the shares on September 30, 2008.  The amount of this
OTTI charge may be subject to significant change in the future as a result of
the significant uncertainties related to Fannie Mae's and Freddie Mac’s business
operations and the Federal conservatorship and the continuing impact of such
factors on the market value of the preferred stock.  Basic loss per
share was $0.33 for the third quarter of 2008 down from earnings per share of
$0.35 for the same period in 2007.  Diluted loss per share was $0.33
for the third quarter of 2008 down from the $0.33 for the same period in
2007.





The
annualized loss on average assets (“ROAA”) was (1.11)% for the three month
period ended September 30, 2008 compared to an annualized return on average
assets of 1.26% for the same period in 2007.  The annualized loss on
average equity (“ROAE”) was (11.56)% for the three month period September 30,
2008 compared to a return on annualized average assets of 15.99% for the same
period in 2007. The decrease in ROAA and ROAE is primarily attributable to the
net loss recorded for the third quarter of 2008 and the decrease in net income
for the nine months ended September 30, 2008 as compared to the same periods in
2007.




-14-


For the
nine months ended September 30, 2008:





The
Company’s net income decreased $3,572,000 or 88.5% to $464,000 for the nine
months ended September 30, 2008 from $4,036,000 for the same period in
2007.  The primary contributors to the decrease in net income for the
nine months ended September 30, 2008 were the (1) $1,410,000 decrease in net
interest income, (2) increase in provision for loan losses of $1,150,000, (3)
$447,000 decrease in other non-interest income, (4) OTTI charge of $6,498,000
and (5) increase in other expenses of $635,000 primarily related to legal costs
of loan collection.  These changes were partially offset by (1) a
nontaxable gain on bank owned life insurance of $2,574,000, (2) a gain on the
sale of real estate owned by the bank of $465,000, (3) decreased salary costs of
$304,000 and (4) decreased provision for income taxes of
$3,303,000.  The decrease in salaries is the result of a lower level
of bonus accrual and increased recognition of deferred loan
costs.  The decrease in the provision for income taxes is a result of
decrease in taxable income primarily from the OTTI charge.  Basic
earnings per share decreased to $0.13 for the nine months ended September 30,
2008 down 88.1% from $1.10 for the same period in 2007.  Diluted
earnings per share decreased to $0.12 for the nine months ended September 30,
2008 down 88.1% from the $1.01 for the same period in 2007.





Total
assets at September 30, 2008 were $428,000,000, a decrease of $3,000,000 or 1%,
from the $431,000,000 at December 31, 2007.  The contraction in assets
was primarily in the Company’s federal funds sold.  Federal funds sold
decreased $21,130,000 or 88.4% annualized to $10,750,000 at September 30, 2008
from $31,880,000 at December 31, 2007.  The decrease in federal funds
sold was used to fund the loan growth of $13,906,000, an increase the level of
investments before the non-cash OTTI charge of $6,498,000 and reduce the a
reduction of FHLB borrowings by $5,000,000.





RESULTS
OF OPERATIONS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2008





Net
interest income before provision for loan losses





Three
      Months Ended September 30,(Dollars
      in thousands, except per share data)
            
            2008
            
            
            2007
            
            
            Dollar Change
            
            
            Percentage ChangeInterest
      income:Interest
      and fees on loans
            
            $
            6,321
            
            
            $
            7,006
            
            
            $
            (685
            )
            
            
            (9.8
            )%Interest
      on Federal funds sold
            
            
            85
            
            
            
            396
            
            
            
            (311
            )
            
            
            (78.5
            )Interest
      on investment securities
            
            
            542
            
            
            
            535
            
            
            
            7
            
            
            
            1.3Total
      interest income
            
            
            6,948
            
            
            
            7,937
            
            
            
            (989
            )
            
            
            (12.5
            )Interest
      expense:Interest
      on deposits
            
            
            2,587
            
            
            
            3,467
            
            
            
            (880
            )
            
            
            (25.4
            )Interest
      on other borrowings
            
            
            216
            
            
            
            90
            
            
            
            126
            
            
            
            140.0Interest
      on subordinated debentures
            
            
            97
            
            
            
            139
            
            
            
            (42
            )
            
            
            (30.2
            )Total
      interest expense
            
            
            2,900
            
            
            
            3,696
            
            
            
            (796
            )
            
            
            (21.5
            )Net
      interest income before provision for loan losses
            
            $
            4,048
            
            
            $
            4,241
            
            
            $
            (193
            )
            
            
            (4.6
            )%





Net
interest income is the interest earned on debt securities, loans (including
yield-related loan fees) and other interest-earning assets minus the interest
paid for deposits and long-term and short-term debt. The net interest margin is
the average yield on earning assets minus the average interest rate paid for
deposits and our other sources of funding.


-15-


The
decreased net interest income performance is primarily the result of the Bank
experiencing a contraction in its net interest margin.  The
contraction of the net interest margin is the result of the more rapid downward
repricing of the Bank’s interest earning assets, after the Federal Reserve rate
cuts of 325 basis points since September 2007, than the Bank’s repricing of
interest bearing liabilities.  Repricing of time deposits led to a
decrease in deposit interest expense during the third quarter while average
balances increased over the same time period.





The
decrease in interest income was primarily attributed to decreases in the yields
earned of 140 basis points on the levels of average loans.  This was
mitigated by increased average loan volume of $20.7 million for the three months
ended September 30, 2008 compared to the same time period in
2007.  Loan volume increased due to the growth of new branches and
increased penetration into existing markets.





The
Company’s average loan balances were $325 million for the three months ended
September 30, 2008 up 6.8% from $304 million for the same period in
2007.  The Company’s average loan yield was 7.75% for the three months
ended September 30, 2008, down from the 9.15% yield experienced for the same
period in 2007.  The Company’s average balances of investment
securities increased $13.3 million to $53 million for the three months ended
September 30, 2008 from the $39.7 million for the same period in 2007. The
Company’s average yield on investments decreased 113 basis points to 4.07% from
5.20% for the same period in 2007.





The
Company’s average balances of Federal funds sold decreased $13.0 million to
$17.7 million for the three months ended September 30, 2008 from the $30.7
million for the same period in 2007. The Company’s average yield on Federal
funds sold decreased 321 basis points to 1.91% from 5.12% for the same period in
2007.





As a
result, the overall yield on average earning assets decreased 140 basis points
to 6.99% for the three months ended September 30, 2008, from 8.39% for the same
period in 2007.





The
decrease in interest expense is primarily attributed to the change in the volume
of interest bearing liabilities.  Deposit balances remained relatively
flat with a decrease in the rate paid on interest bearing deposits.





The
Company’s average balances of time deposits were $215 million for the three
months ended September 30, 2008, down $786,000, or 3.6% from $216 million for
the same period in 2007. The average rate paid on time deposits decreased 83
basis points to 4.53% for the three months ended September 30, 2008 from 5.36%
for the same period in 2007. As a result, interest expense on time deposits
decreased $464 thousand.  The Company’s average balances of interest
bearing demand deposits decreased $3 million to $73 million for the three months
ended September 30, 2008 from $76 million for the same period in
2007.  The average rate paid decreased 212 basis points to 0.68% from
2.80% for the same period in 2007. As a result, interest expense on interest
bearing demand deposits decreased $412 thousand.





The
Company’s average balances of other borrowings increased $9.4 million to $26.7
million for the three months ended September 30, 2008 from $17.3 million for the
same period in 2007 and the rates paid decreased 59 basis points to 4.67% for
the three months ended September 30, 2008 from 5.26% for the same period in
2007. As a result of the increased volume offset by the decreased rates paid,
interest expense on other borrowings increased $84 thousand.  The
overall rates paid on average interest-bearing liabilities decreased 107 basis
points to 3.59% for the three months ended September 30, 2008, from 4.66% for
the same period in 2007.


-16-


As a
result of the changes noted above, the net interest margin for the three months
ended September 30, 2008 decreased 42 basis points to 4.07%, from 4.49% for the
same period in 2007.





The
following table presents for the three month periods indicated the distribution
of consolidated average assets, liabilities and shareholders’
equity.  It also presents the amounts of interest income from the
interest earning assets and the resultant yields expressed in both dollars and
rate percentages.  Average balances are based on daily
averages.  Nonaccrual loans are included in the calculation of average
loans while nonaccrued interest thereon is excluded from the computation of
yields earned:


-17-





PACIFIC
      STATE BANCORPYield
      AnalysisFor
      Year Three Months Ended September 30,(Dollars
      in thousands)
            2008
            
            
            2007Interest
            
            
            Average
            
            
            
            
            
            Interest
            
            
            AverageAverage
            
            Income
      or
            
            
            Yield
      or
            
            
            Average
            
            
            Income
      or
            
            
            Yield
      orAssets:
            Balance
            
            Expense
            
            
            Cost
            
            
            Balance
            
            
            Expense
            
            
            CostInterest-earning
      assets:Loans
            
            $
            324,545
            
            
            $
            6,321
            
            
            
            7.75
            %
            
            $
            303,858
            
            
            $
            7,006
            
            
            
            9.15
            %Investment
      securities
            
            
            53,019
            
            
            
            542
            
            
            
            4.07
            %
            
            
            39,733
            
            
            
            521
            
            
            
            5.20
            %Federal
      funds sold
            
            
            17,739
            
            
            
            85
            
            
            
            1.91
            %
            
            
            30,697
            
            
            
            396
            
            
            
            5.12
            %Interest
      bearing deposits in banks
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            867
            
            
            
            14
            
            
            
            6.41
            %Total
      average earning assets
            
            $
            395,303
            
            
            $
            6,948
            
            
            
            6.99
            %
            
            $
            375,155
            
            
            $
            7,937
            
            
            
            8.39
            %Non-earning
      assets:Cash
      and due from banks
            
            
            13,342
            
            
            
            
            
            
            
            
            
            
            
            14,354Bank
      premises and equipment
            
            
            15,393
            
            
            
            
            
            
            
            
            
            
            
            13,421Other
      assets
            
            
            12,010
            
            
            
            
            
            
            
            
            
            
            
            11,051Allowance
      for loan loss
            
            
            (3,785
            )
            
            
            
            
            
            
            
            
            
            
            (2,704
            )Total
      average assets
            
            $
            432,263
            
            
            
            
            
            
            
            
            
            
            $
            411,277Liabilities
      and Shareholders' Equity:Interest-bearing
      liabilities:DepositsInterest-bearing
      demand
            
            $
            73,397
            
            
            $
            126
            
            
            
            0.68
            %
            
            $
            76,347
            
            
            $
            538
            
            
            
            2.80
            %Savings
            
            
            6,113
            
            
            
            7
            
            
            
            0.46
            %
            
            
            5,288
            
            
            
            11
            
            
            
            0.83
            %Time
      deposits
            
            
            215,307
            
            
            
            2,454
            
            
            
            4.53
            %
            
            
            216,093
            
            
            
            2,918
            
            
            
            5.36
            %Other
      borrowing
            
            
            26,685
            
            
            
            313
            
            
            
            4.67
            %
            
            
            17,264
            
            
            
            229
            
            
            
            5.26
            %Total
      average interest-bearing liabilities
            
            $
            321,502
            
            
            $
            2,900
            
            
            
            3.59
            %
            
            $
            314,992
            
            
            $
            3,696
            
            
            
            4.66
            %Noninterest-bearing
      liabilities:Demand
      deposits
            
            
            65,098
            
            
            
            
            
            
            
            
            
            
            
            61,010Other
      liabilities
            
            
            4,045
            
            
            
            
            
            
            
            
            
            
            
            2,995Total
      average liabilities
            
            
            390,645
            
            
            
            
            
            
            
            
            
            
            
            378,997Shareholders'
      equity:
            
            
            41,618
            
            
            
            
            
            
            
            
            
            
            
            32,280Total
      average liabilities and shareholders' equity
            
            $
            432,263
            
            
            
            
            
            
            
            
            
            
            $
            411,277Net
      interest income
            
            
            
            
            
            $
            4,048
            
            
            
            
            
            
            
            
            
            
            $
            4,241Net
      interest margin
            
            
            
            
            
            
            
            
            
            
            4.07
            %
            
            
            
            
            
            
            
            
            
            
            4.49
            %


(1)
            Loan
      fees included in loan interest income for the three month periods ended
      September 30, 2008 and 2007 amounted to $307 thousand and $615 thousand,
      respectively.


(2)
            Not
      computed on a tax-equivalent basis.


(3)
            For
      the purpose of this table the interest expense related to the Company’s
      junior subordinated debentures is included in other
      borrowings.


(4)
            Net
      interest income divided by the average balance of total earning
      assets.


-18-


The
following table sets forth changes in interest income and interest expense, for
the three month periods indicated and the change attributable to variance in
volume and rates:


Three
      Months ended September 30,2008
      over 2007NetChange
            
            
            Rate
      (2)
            
            
            Volume
      (1)(In
      thousands)Interest
      Income:Loans
      and leases
            
            $
            (685
            )
            
            $
            (1,162
            )
            
            $
            477Investment
      securities
            
            
            21
            
            
            
            (153
            )
            
            
            174Federal
      funds sold
            
            
            (311
            )
            
            
            (144
            )
            
            
            (167
            )Interest
      Bearing Deposits in Banks
            
            
            (14
            )
            
            
            -
            
            
            
            (14
            )Total
      interest income
            
            $
            (989
            )
            
            $
            (1,459
            )
            
            $
            470Interest
      Expense:Interest-bearing
      Demand
            
            $
            (412
            )
            
            $
            (391
            )
            
            $
            (21
            )Savings
            
            
            (4
            )
            
            
            (6
            )
            
            
            2Time
      Deposits
            
            
            (464
            )
            
            
            (453
            )
            
            
            (11
            )Other
      borrowing
            
            
            84
            
            
            
            (41
            )
            
            
            125Total
      interest expense
            
            $
            (796
            )
            
            $
            (891
            )
            
            $
            95Net
      interest income
            
            $
            (193
            )
            
            $
            (568
            )
            
            $
            375





(1)
            The
      volume change in net interest income represents the change in average
      balance multiplied


by the
current year’s rate.


(2)
            The
      rate change in net interest income represents the change in rate
      multiplied by the current year’s average
  balance.





Provision
for loan losses





The
Company recorded $600 thousand in provision for loan losses for the three month
period ended September 30, 2008, an increase of $560 thousand from $40 thousand
for the same period in 2007.  The increase in the provision is based
on management’s assessment of the required level of
reserves.  Management assesses loan quality monthly to maintain an
adequate allowance for loan losses.  Based on the information
currently available, management believes that the allowance for loan losses is
adequate to absorb probable losses in the portfolio.  However, no
assurance can be given that the Company may not sustain charge-offs which are in
excess of the allowance in any given period.  The Company’s loan
portfolio composition and non-performing assets are further discussed under the
“Financial Condition” section below.





Non-Interest
Income





During
the three months ended September 30, 2008, total non-interest income increased
$2,972,000 or 504.6% to $3,561,000, up from $589,000 for the comparable period
in 2007.  The increase in non-interest income was primarily the result
of a nontaxable gain on bank owned life insurance of $2,574,000 and a gain on
the sale of real estate of $465,000.  In other areas overall
non-interest income decreased $67,000 primarily due to decreased loan sales of
$82,000 for the three months ended September 30, 2008 compared to the same time
period in 2007.




-19-


Non-Interest
Expenses





Non-interest
expenses ordinarily consist of salaries and related employee benefits,
occupancy, furniture and equipment expenses, professional fees, appraisal fees,
directors’ fees, postage, stationary and supplies expenses, telephone expenses,
data processing expenses, advertising and promotion expense and other operating
expenses. Non-interest expense for the three months ended September 30, 2008 was
$10.1 million compared to $2.7 million for the same period in 2007, representing
an increase of $7.4 million or 270.9%. The increase is primarily the result of
the OTTI charge taken in the third quarter of 2008 of $6.498
million.  The increase also reflects increases in salaries and
benefits of $134 thousand or 10.6% which is the result of an elevated level of
deferred costs recognized in 2007 compared to 2008.  The increase in
occupancy, furniture and equipment expense of $126 thousand is attributable to
increased costs of maintaining facilities and assets being placed in service
which have begun to depreciate. The increase in other expense of $587 thousand
is primarily the result of increased legal fees associated with loan
collection.





The
following table sets forth a summary of non-interest expense for the three month
periods ended September 30, 2008 and 2007:





Three
      Months Ended(In
      thousands)
            
            September
      30, 2008
            
            
            September
      30, 2007Non-interest
      Expense:Salaries
      and employee benefits
            
            $
            1,398
            
            
            $
            1,264Occupancy
            
            
            316
            
            
            
            292Furniture
      and equipment
            
            
            259
            
            
            
            157Impairment
      charge on investment securities
            
            
            6,498
            
            
            
            -Other
      expenses
            
            
            1,585
            
            
            
            998Total
      Non-Interest Expenses
            
            $
            10,056
            
            
            $
            2,711





Income
Taxes





The
Company’s provision for income taxes includes both federal income and state
franchise taxes and reflects the application of federal and state statutory
rates to the Company’s net income before taxes.  The principal
difference between statutory tax rates and the Company’s effective tax rate is
the benefit derived from investing in tax-exempt securities and Company owned
life insurance.  Increases and decreases in the provision for taxes
reflect changes in the Company’s net income before tax. The Company’s effective
tax rate for the three month period ended September 30, 2008 resulted in a
benefit of 60.3% of pretax loss compared to 37.4% for the same period in
2007.  The change was due primarily to the tax benefit recorded
related to the OTTI charge of $2,243,000 and the receipt of nontaxable life
insurance proceeds of $2,574,000.





The
following table reflects the Company’s tax provision and the related effective
tax rate for the three months periods ended September 30, 2008 and
2007:





Three
      Months Ended(In
      thousands)
            
            September
      30, 2008
            
            
            September
      30, 2007Tax
      (Benefit) Provision
            
            $
            (1,838
            )
            
            $
            778Effective
      Tax Rate
            
            
            (60.3
            )%
            
            
            37.4
            %




-20-





RESULTS
OF OPERATIONS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2008





Net
interest income before provision for loan losses





Nine
      Months Ended September 30,(Dollars
      in thousands, except per share data)
            
            2008
            
            
            2007
            
            
            Dollar Change
            
            
            Percentage ChangeInterest
      income:Interest
      and fees on loans
            
            $
            18,998
            
            
            $
            21,148
            
            
            $
            (2,150
            )
            
            
            (10.2
            )%Interest
      on Federal funds sold
            
            
            341
            
            
            
            1,065
            
            
            
            (724
            )
            
            
            (67.9
            )Interest
      on investment securities
            
            
            2,144
            
            
            
            1,362
            
            
            
            782
            
            
            
            57.4Total
      interest income
            
            
            21,483
            
            
            
            23,575
            
            
            
            (2,092
            )
            
            
            (8.9
            )Interest
      expense:Interest
      on deposits
            
            
            8,245
            
            
            
            9,623
            
            
            
            (1,378
            )
            
            
            (14.3
            )Interest
      on other borrowings
            
            
            1,064
            
            
            
            211
            
            
            
            853
            
            
            
            404.3Interest
      on subordinated debentures
            
            
            359
            
            
            
            516
            
            
            
            (157
            )
            
            
            (30.4
            )Total
      interest expense
            
            
            9,668
            
            
            
            10,350
            
            
            
            (682
            )
            
            
            (6.6
            )Net
      interest income before provision for loan losses
            
            $
            11,815
            
            
            $
            13,225
            
            
            $
            (1,410
            )
            
            
            (10.7
            )%





The
decrease in interest income was primarily attributed to decreases in the yields
earned on the levels of average loans.  Average loan volume for the
nine months ended September 30, 2008 compared to the same time period in 2007
increased $27.6 million, which was offset by a decrease of 170 basis points in
the average rate the Bank was able to charge.  Loan volume increased
due to the growth of new branches and increased penetration into existing
markets.





The
Company’s average loan balances were $325 million for the nine months ended
September 30, 2008 up 9.3% from $297 million for the same period in
2007.  The Company’s average loan yield was 7.81% for the nine months
ended September 30, 2008, down 170 basis points from the 9.51% yield experienced
for the same period in 2007.  As a result of the increase in volume
offset by the decrease in yield, interest income on loans decreased $2.15
million.  The Company’s average balances of investment securities
increased $15 million to $50.0 million for the nine months ended September 30,
2008 from the $34.6 million for the same period in 2007. The Company’s average
yield on investments increased 41 basis points to 5.62% from 5.21% for the same
period in 2007.  As a result of the increase in volume and yield,
interest income on investments increased $752 thousand.





The
Company’s average balances of Federal funds sold decreased $7.9 million to $19.9
million for the nine months ended September 30, 2008 from the $27.8 million for
the same period in 2007. The Company’s average yield on Federal funds sold
decreased 281 basis points to 2.29% from 5.11% for the same period in
2007.





As a
result, the overall yield on average earning assets decreased 151 basis points
to 7.24% for the nine months ended September 30, 2008, from 8.75% for the same
period in 2007.





The
increase in interest expense is primarily attributed to the change in the volume
and mix of interest bearing liabilities, (the level of average borrowings and
time deposits increased significantly while the levels of other interest bearing
deposits declined).  Time deposits increased as the Company
experienced disintermediation from lower yielding transaction accounts into
higher yielding time deposits.


-21-


Rates
paid on deposits were decreased during the period as market rates for deposits
decreased.





The
Company’s average balances of time deposits were $214.6 million for the nine
months ended September 30, 2008, up $17.4 million, or 8.8% from $197 million for
the same period in 2007. The average rate paid on time deposits decreased 94
basis points to 4.36% for the nine months ended September 30, 2008 from 5.30%
for the same period in 2007. As a result, interest expense on time deposits
decreased $809 thousand.  The Company’s average balances of interest
bearing demand deposits decreased $12.5 million to $70.4 million for the nine
months ended September 30, 2008 from $82.9 million for the same period in
2007.  The average rate paid decreased 55 basis points to 2.30% from
2.85% for the same period in 2007. As a result, interest expense on interest
bearing demand deposits decreased $553 thousand.





The
Company’s average balances of other borrowings increased $29.2 million to $44.1
million for the nine months ended September 30, 2008 from $14.9 million for the
same period in 2007 and the rates paid decreased 222 basis points to 4.31% for
the nine months ended September 30, 2008 from 6.53% for the same period in 2007.
As a result of the increased volume offset by the decreased rates paid, interest
expense on other borrowings increased $696 thousand.  The overall
rates paid on average interest-bearing liabilities decreased 75 basis points to
3.86% for the nine months ended September 30, 2008, from 4.61% for the same
period in 2007.





As a
result of the changes noted above, the net interest margin for the nine months
ended September 30, 2008 decreased 93 basis points to 3.98%, from 4.91% for the
same period in 2007.





The
following table presents for the nine month periods indicated the distribution
of consolidated average assets, liabilities and shareholders’
equity.  It also presents the amounts of interest income from the
interest earning assets and the resultant yields expressed in both dollars and
rate percentages.  Average balances are based on daily
averages.  Nonaccrual loans are included in the calculation of average
loans while nonaccrued interest thereon is excluded from the computation of
yields earned:




-22-





PACIFIC
      STATE BANCORPYield
      AnalysisFor
      Nine Months Ended September 30,(Dollars
      in thousands)
            2008
            
            
            2007Interest
            
            
            Average
            
            
            
            
            
            Interest
            
            
            AverageAverage
            
            Income
      or
            
            
            Yield
      or
            
            
            Average
            
            
            Income
      or
            
            
            Yield
      orAssets:
            Balance
            
            Expense
            
            
            Cost
            
            
            Balance
            
            
            Expense
            
            
            CostInterest-earning
      assets:Loans
            
            $
            325,004
            
            
            $
            18,998
            
            
            
            7.81
            %
            
            $
            297,362
            
            
            $
            21,148
            
            
            
            9.51
            %Investment
      securities
            
            
            49,956
            
            
            
            2,100
            
            
            
            5.62
            %
            
            
            34,621
            
            
            
            1,348
            
            
            
            5.21
            %Federal
      funds sold
            
            
            19,930
            
            
            
            341
            
            
            
            2.29
            %
            
            
            27,846
            
            
            
            1,065
            
            
            
            5.11
            %Interest
      bearing deposits in banks
            
            
            1,391
            
            
            
            44
            
            
            
            4.23
            %
            
            
            429
            
            
            
            14
            
            
            
            4.36
            %Total
      average earning assets
            
            $
            396,281
            
            
            $
            21,483
            
            
            
            7.24
            %
            
            $
            360,258
            
            
            $
            23,575
            
            
            
            8.75
            %Non-earning
      assets:Cash
      and due from banks
            
            
            13,435
            
            
            
            
            
            
            
            
            
            
            
            15,649Bank
      premises and equipment
            
            
            14,956
            
            
            
            
            
            
            
            
            
            
            
            12,595Other
      assets
            
            
            16,194
            
            
            
            
            
            
            
            
            
            
            
            11,033Allowance
      for loan loss
            
            
            (3,609
            )
            
            
            
            
            
            
            
            
            
            
            (2,651
            )Total
      average assets
            
            $
            437,257
            
            
            
            
            
            
            
            
            
            
            $
            396,884Liabilities
      and Shareholders' Equity:Interest-bearing
      liabilities:DepositsInterest-bearing
      demand
            
            $
            70,421
            
            
            $
            1,215
            
            
            
            2.30
            %
            
            $
            82,863
            
            
            $
            1,768
            
            
            
            2.85
            %Savings
            
            
            5,623
            
            
            
            22
            
            
            
            0.52
            %
            
            
            5,407
            
            
            
            38
            
            
            
            0.94
            %Time
      deposits
            
            
            214,583
            
            
            
            7,008
            
            
            
            4.36
            %
            
            
            197,246
            
            
            
            7,817
            
            
            
            5.30
            %Other
      borrowing
            
            
            44,109
            
            
            
            1,423
            
            
            
            4.31
            %
            
            
            14,886
            
            
            
            727
            
            
            
            6.53
            %Total
      average interest-bearing liabilities
            
            $
            334,736
            
            
            $
            9,668
            
            
            
            3.86
            %
            
            $
            300,402
            
            
            $
            10,350
            
            
            
            4.61
            %Noninterest-bearing
      liabilities:Demand
      deposits
            
            
            63,101
            
            
            
            
            
            
            
            
            
            
            
            64,609Other
      liabilities
            
            
            4,245
            
            
            
            
            
            
            
            
            
            
            
            1,003Total
      average liabilities
            
            
            402,082
            
            
            
            
            
            
            
            
            
            
            
            366,014Shareholders'
      equity:
            
            
            35,175
            
            
            
            
            
            
            
            
            
            
            
            30,870Total
      average liabilities and shareholders' equity
            
            $
            437,257
            
            
            
            
            
            
            
            
            
            
            $
            396,884Net
      interest income
            
            
            
            
            
            $
            11,815
            
            
            
            
            
            
            
            
            
            
            $
            13,225Net
      interest margin
            
            
            
            
            
            
            
            
            
            
            3.98
            %
            
            
            
            
            
            
            
            
            
            
            4.91
            %





(1)
            Loan
      fees included in loan interest income for the nine month periods ended
      September 30, 2008 and 2007 amounted to $677 thousand and $1,424 thousand,
      respectively.


(2)
            Not
      computed on a tax-equivalent basis.


(3)
            For
      the purpose of this table the interest expense related to the Company’s
      junior subordinated debentures is included in other
      borrowings.


(4)
            Net
      interest income divided by the average balance of total earning
      assets.


-23-


The
following table sets forth changes in interest income and interest expense, for
the nine month periods indicated and the change attributable to variance in
volume and rates.





Nine
      Months ended September 30,2008
      over 2007NetChange
            
            
            Rate
            
            
            Volume(In
      thousands)Interest
      Income:Loans
      and leases
            
            $
            (2,150
            )
            
            $
            (4,116
            )
            
            $
            1,966Investment
      securities
            
            
            752
            
            
            
            155
            
            
            
            597Federal
      funds sold
            
            
            (724
            )
            
            
            (421
            )
            
            
            (303
            )Interest
      Bearing Deposits in Banks
            
            
            30
            
            
            
            (1
            )
            
            
            31Total
      interest income
            
            $
            (2,092
            )
            
            $
            (4,383
            )
            
            $
            2,292Interest
      Expense:Interest-bearing
      Demand
            
            $
            (553
            )
            
            $
            (288
            )
            
            $
            (265
            )Savings
            
            
            (16
            )
            
            
            (18
            )
            
            
            2Time
      Deposits
            
            
            (809
            )
            
            
            (1,496
            )
            
            
            687Other
      borrowing
            
            
            696
            
            
            
            (731
            )
            
            
            1,427Total
      interest expense
            
            $
            (682
            )
            
            $
            (2,532
            )
            
            $
            1,850Net
      interest income
            
            $
            (1,410
            )
            
            $
            (1,851
            )
            
            $
            441





(1)
            The
      volume change in net interest income represents the change in average
      balance multiplied


by the
current year’s rate.


(2)
            The
      rate change in net interest income represents the change in rate
      multiplied by the current year’s average
  balance.





Provision
for loan losses





The
Company recorded $1,410,000 in provision for loan losses for the nine month
period ended September 30, 2008, an increase of $1,150,000 or 442.3% from $260
thousand for the same period in 2007.  The increase in the provision
is based on management’s assessment of the required level of
reserves.  Management assesses loan quality monthly to maintain an
adequate allowance for loan losses.  Based on the information
currently available, management believes that the allowance for loan losses is
adequate to absorb probable losses in the portfolio.  However, no
assurance can be given that the Company may not sustain charge-offs which are in
excess of the allowance in any given period.  The Company’s loan
portfolio composition and non-performing assets are further discussed under the
“Financial Condition” section below.





Non-Interest
Income





During
the nine months ended September 30, 2008, total non-interest income increased
$2,649,000 or 133.7% to $4,630,000, up from $1,981,000 for the comparable period
in 2007.  The increase in non-interest income was primarily the result
of a nontaxable gain on bank owned life insurance of $2,574,000 and a gain on
the sale of real estate of $465,000.  These gains were offset by a
decrease in other income of $447,000 for the nine months ended September 30,
2008 compared to the same time period in 2007.  The decrease in other
income was primarily the result of decrease mortgage broker fees, prepayment
penalties, and appraisal fees.


-24-


Non-Interest
Expenses





Non-interest
expenses ordinarily consist of salaries and related employee benefits,
occupancy, furniture and equipment expenses, professional fees, appraisal fees,
directors’ fees, postage, stationary and supplies expenses, telephone expenses,
data processing expenses, advertising and promotion expense and other operating
expenses. Non-interest expense for the nine months ended September 30, 2008 was
$15.4 million compared to $8.4 million for the same period in 2007, representing
an increase of $6.964 million or 82.8%. The increase is primarily the result of
the OTTI charge taken in 2008 of $6.498 million.  This increase was
offset by decreases in salaries and benefits of $304 thousand or 7.1% which is
the result of a bonus accrual in 2007 that was not recorded in 2008 and
increased deferred loan costs. The increase in occupancy, furniture and
equipment expense of $135 thousand is attributable to increased costs of
maintaining facilities and additional equipment being placed into service. The
increase in other expense of $635 thousand is the result of increased legal fees
associated with loan collection.





The
following table sets forth a summary of non-interest expense for the nine months
periods ended September 30, 2008 and 2007:





Nine
      Months EndedSeptember
      30, 2008
            
            
            September
      30, 2007(In
      thousands)Non-interest
      Expense:Salaries
      and employee benefits
            
            $
            3,948
            
            
            $
            4,252Occupancy
            
            
            881
            
            
            
            855Furniture
      and equipment
            
            
            633
            
            
            
            524Impairment
      charge on investment securities
            
            
            6,498
            
            
            
            -Other
      expenses
            
            
            3,416
            
            
            
            2,781Total
      non-interest expenses
            
            $
            15,376
            
            
            $
            8,412





Income
Taxes





The
Company's effective tax rate for the nine month period ended September 30, 2008
is a benefit of (236%).  For the comparable period for the prior year,
the nine months ended September 30, 2007 the tax rate was 38.3%.  The
tax provision in 2008 differs from 2007 as a result of the imposition of a
$430,000 valuation allowance against tax limitations on capital losses on an
OTTI charge of $6,498,000, the receipt of nontaxable life insurance proceeds of
$2,574,000 and the impact of differences between book and taxable income on the
rate being amplified by the 2008 level of pretax income.





The
following table reflects the Company’s tax provision and the related effective
tax rate for the nine months periods ended September 30, 2008 and
2007:





Nine
      Months Ended(In
      thousands)
            
            September
      30, 2008
            
            
            September
      30, 2007Tax
      (Benefit) Provision
            
            $
            (805
            )
            
            $
            2,498Effective
      Tax Rate
            
            
            (236
            )%
            
            
            38.3
            %


-25-


FINANCIAL
CONDITION





Total
assets at September 30, 2008 were $427,822,000, a decrease of $3,252,000 or 0.8%
(1.0% annualized), from the $431,074,000 at December 31, 2007.  The
decline in assets was primarily in the Company’s level of federal funds sold
which declined $21,130,000 or 66.3% (88.5% annualized).  This decrease
was utilized to fund the growth in loans of $13,962,000 or 4.5% (6.1%
annualized) to $322,420,000 at September 30, 2008 from $308,458,000 at December
31, 2007. Investments also increased by $615,000 or 1.5% (2.0% annualized) to
$41,967,000 at September 30, 2008 from $41,352,000 at December 31,
2007.





Deposits
increased $3,345,000 or 1.0% (1.3% annualized) to $345,166,000 at September 30,
2008 compared to $341,821,000 at December 31, 2007.  The increase in
deposits was comprised of an increase in non-interest bearing deposits of
$1,948,000 or 2.9% (3.9% annualized) to $69,019,000 at September 30, 2008 from
$67,071,000 at December 31, 2007.  In addition to the non-interest
bearing deposit increase, interest bearing deposits increased $1,397,000 or 0.5%
(0.7% annualized) to $276,147,000 at September 30, 2008 from $274,750,000 at
December 31, 2007.  The increase in interest bearing deposits is the
result of several certificate of deposit promotions.





Loan
portfolio composition





The
Company concentrates its lending activities primarily within Calaveras, San
Joaquin, Stanislaus, Tuolumne and Alameda Counties.





The
Company manages its credit risk through diversification of its loan portfolio
and the application of underwriting policies and procedures and credit
monitoring practices. Although the Company has a diversified loan portfolio, a
significant portion of its borrowers' ability to repay the loans is dependent
upon the professional services and residential real estate development industry
sectors. Generally, the loans are secured by real estate or other assets and are
expected to be repaid from cash flows of the borrower or proceeds from the sale
of collateral.





The
following table illustrates loan balance (in thousands)and
percentage change from December 31, 2007 to September 30, 2008 by loan
category:





September
      30, 2008
            
            
            December
      31, 2007
            
            
            Dollar
      Change
            
            
            Percentage
      Change
            
            
            Annualized
      Percentage ChangeCommercial
            
            $
            86,961
            
            
            $
            83,012
            
            
            $
            3,949
            
            
            
            4.76
            %
            
            
            6.35
            %Agricultural
            
            
            15,007
            
            
            
            12,646
            
            
            
            2,361
            
            
            
            18.67
            
            
            
            24.94Real
      estate - commercial mortgage
            
            
            135,949
            
            
            
            121,157
            
            
            
            14,792
            
            
            
            12.21
            
            
            
            16.31Real
      estate - construction
            
            
            74,298
            
            
            
            80,168
            
            
            
            (5,870
            )
            
            
            (7.32
            )
            
            
            (9.78
            )Installment
            
            
            13,981
            
            
            
            15,215
            
            
            
            (1,234
            )
            
            
            (8.11
            )
            
            
            (10.83
            )Gross
      loans
            
            $
            326,196
            
            
            $
            312,198
            
            
            $
            13,998
            
            
            
            4.76
            %
            
            
            6.35
            %





The
Company continues to manage the mix in its loan portfolio consistently with its
identity as a community bank serving Northern California and the Central
Valley.  The Bank has experienced strong growth in its agricultural
and commercial real estate segments of the loan portfolio.  The strong
growth in these segments is consistent with the growth in the region where the
Bank operates.  The Bank has experienced a decline in its real estate
construction and installment segments of the loan portfolio.  These
segments have been negatively affected by the residential real estate market
decline.


-26-


Nonperforming
loans





The Bank
has experienced an increase in nonperforming loans from $432,000 or 0.14% of
gross loans at December 31, 2007 to $8,478,000 or 2.6% of gross loans at
September 30, 2008.  The increase in nonperforming loans is reflective
of the decline in real estate values in the region where the Bank operates;
resulting in the Bank placing certain loans into foreclosure.  Bank’s
management has immediately placed any loan secured by real estate, which has had
a notice of default filed, on non-accrual status.  The increase in
nonperforming loans has also resulted in management increasing the level of the
provision for loan losses over 2007 levels by $560,000 for the quarter ended
September 30, 2008 and $1,150,000 for the nine months ended September 30,
2008.  At present, management believes that the
level of allowance of 1.19% of total loans at September 30, 2008 compared to
1.26% at December 31, 2007 for loan losses currently recorded is sufficient to
provide for both specifically identified and probable
losses.  Management believes the current level of allowance for loan
losses is sufficient despite the increase in nonperforming assets because of a
large recovery received in the amount of $899,000 subsequent to the end of the
quarter.





Management
has been proactive in working with problem customers to repay loans that have
become delinquent or have the potential to become delinquent.  In most
cases, personal guarantees and collateral value are sufficient to repay
outstanding principal and interest.  In the cases where collateral
value and personal guarantees have fallen short of the principle and interest
owed on the loans, management has reserved for the estimated potential
loss.  Management has also ordered real estate appraisals on all new
or renewed loans and on loans which are in foreclosure that are secured by real
estate and on loans where we have identified potential
problems.  Appraisals received thus far indicate generally that
overall collateral levels remain sufficient to repay the loans secured by the
real estate in case of default.  Management has also reviewed all home
equity lines of credit for current loan to values, credit quality and
performance issues.  If issues are identified, the debt availability
is frozen and reductions or new terms are obtained.  The Bank believes
that real estate values remain sufficient in a declining market to repay loans
if the collateral is the source of repayment due to the conservative lending
policies of the Bank.





Analysis
of allowance for loan losses





In
determining the amount of the Company’s Allowance for Loan Losses (“ALL”),
management assesses the diversification of the portfolio. Each credit is
assigned a credit risk rating factor, and this factor, multiplied by the dollars
associated with the credit risk rating, is used to calculate one component of
the ALL. In addition, management estimates the probable loss on individual
credits that are receiving increased management attention due to actual or
perceived increases in credit risk.


-27-


The
Company makes provisions to the ALL on a regular basis through charges to
operations that are reflected in the Company’s statements of operations as a
provision for loan losses. When a loan is deemed uncollectible, it is charged
against the allowance. Any recoveries of previously charged-off loans are
credited back to the allowance. There is no precise method of predicting
specific losses or amounts that ultimately may be charged-off on particular
categories of the loan portfolio. Similarly, the adequacy of the ALL and the
level of the related provision for possible loan losses is determined on a
judgment basis by management based on consideration of a number of factors
including (i) economic conditions, (ii) borrowers' financial condition, (iii)
loan impairment, (iv) evaluation of industry trends, (v) industry and other
concentrations, (vi) loans which are contractually current as to payment terms
but demonstrate a higher degree of risk as identified by management, (vii)
continuing evaluation of the performing loan portfolio, (viii) monthly review
and evaluation of problem loans identified as having a loss potential, (ix)
monthly review by the Board of Directors, (x) off balance sheet risks and (xi)
assessments by regulators and other third parties. Management and the Board of
Directors evaluate the allowance and determine its desired level considering
objective and subjective measures, such as knowledge of the borrowers'
businesses, valuation of collateral, the determination of impaired loans and
exposure to potential losses.





While
management uses available information to recognize losses on loans, future
additions to the allowance may be necessary based on changes in economic
conditions and other qualitative factors. In addition, various regulatory
agencies, as an integral part of their examination process, periodically review
the Company’s ALL. Such agencies may require the Company to provide additions to
the allowance based on their judgment of information available to them at the
time of their examination. There is uncertainty concerning future economic
trends. Accordingly it is not possible to predict the effect future economic
trends may have on the level of the provision for loan losses in future
periods.





The
adequacy of the ALL is calculated upon three components. First is the credit
risk rating of the loan portfolio, including all outstanding loans and
leases.  Every extension of credit has been assigned a risk rating
based upon a comprehensive definition intended to measure the inherent risk of
lending money. Each rating has an assigned risk factor expressed as a reserve
percentage. Central to this assigned risk factor is the historical loss record
of the Company. Secondly, established specific reserves are available for
individual loans currently on management's watch and high-grade loan lists.
These are the estimated potential losses associated with specific borrowers
based upon the collateral and event(s) causing the risk ratings. The third
component is unallocated. This reserve is for qualitative factors that may
effect the portfolio as a whole, such as those factors described
above.





Management
believes the assigned risk grades and our methods for managing risk are
satisfactory.




-28-


The
following table summarizes the activity in the ALL for the periods
indicated:


Three
      Months Ended
            
            
            Nine
      Months Ended(In
      thousands)
            
            September
      30,
            
            
            September
      30,2008
            
            
            2007
            
            
            2008
            
            
            2007Beginning
      Balance:
            
            $
            3,427
            
            
            $
            2,699
            
            
            $
            3,948
            
            
            $
            2,478Provision
      for loan losses
            
            
            600
            
            
            
            40
            
            
            
            1,410
            
            
            
            260Charge-offs:Commercial
            
            
            -
            
            
            
            142
            
            
            
            1,290
            
            
            
            142Real
      Estate
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Other
            
            
            135
            
            
            
            1
            
            
            
            190
            
            
            
            1Total
      Charge-offs
            
            
            135
            
            
            
            143
            
            
            
            1,480
            
            
            
            143Recoveries:Commercial
            
            
            -
            
            
            
            -
            
            
            
            13
            
            
            
            -Other
            
            
            -
            
            
            
            2
            
            
            
            1
            
            
            
            3Total
      Recoveries
            
            
            -
            
            
            
            2
            
            
            
            14
            
            
            
            3Net
      Charge-offs:
            
            
            135
            
            
            
            141
            
            
            
            1,466
            
            
            
            140Ending
      Balance
            
            $
            3,892
            
            
            $
            2,598
            
            
            $
            3,892
            
            
            $
            2,598ALL
      to total loans
            
            
            1.19
            %
            
            
            0.84
            %
            
            
            1.19
            %
            
            
            0.84
            %Net
      Charge-offs to average loans-annualized0.05
            %
            
            
            0.05
            %
            
            
            0.49
            %
            
            
            0.05
            %





Investment
securities





Investment
securities increased $615,000 to $41,967,000 at September 30, 2008, from
$41,352,000 at December 31, 2007.  The Company recorded an OTTI charge
of $6,498,000 against Agency Preferred Stock during the third quarter against
Fannie Mae and Freddie Mac preferred stock.  The OTTI charge was a
non-cash valuation reduction in the investment portfolio.  Federal
funds sold decreased $21,130,000 to $10,750,000 at September 30, 2008, from
$31,880,000 at December 31, 2007.





The
Company’s investment in U.S. Treasury securities decreased to 23.6% of the
investment portfolio at September 30, 2008 compared to 42.3% at December 31,
2007.  Obligations of U.S. Agencies increased to 26.2% of the
investment portfolio at September 30, 2008 compared to 7.2% at December 31,
2007.  The Company’s investment in corporate bonds decreased to 42.7%
of the investment portfolio at September 30, 2008 compared to 42.8% at December
31, 2007. Tax-exempt municipal obligation bonds decreased to 7.5% of the
investment portfolio at September 30, 2008 compared to 7.7% at December 31,
2007.





Deposits





Total
deposits were $345.2 million as of September 30, 2008 an increase of $3.3
million or 1.0% from the December 31, 2007 balance of $341.8
million.  The Company continues to manage the mix of its deposits
consistent with its identity as a community bank serving the financial needs of
its customers.  Non-interest bearing demand deposits and interest
bearing checking deposits increased to 25.6% of total deposits up from 24.9% at
December 31, 2007.  Money market and savings accounts decreased to
16.3% of total deposits from 17.4% at December 31, 2007.  Time
deposits increased to 58.1% of total deposits from 57.7% at December 31,
2007.




-29-


The
Emergency Economic Stabilization Act of 2008 included a provision for an
increase in the amount of deposits insured by the FDIC to $250,000. If not
renewed, the additional FDIC insurance provision expires December 31,
2009.  On October 14, 2008, the FDIC announced a new program -- the
Temporary Liquidity Guarantee Program that provides unlimited deposit insurance
on funds in noninterest-bearing transaction deposit accounts not otherwise
covered by the existing deposit insurance limit of $250,000.  All
eligible institutions will be covered under the program for the first 30 days
without incurring any costs.  After the initial period, participating
institutions will be assessed a 10 basis point surcharge on the additional
insured deposits.





CAPITAL
RESOURCES





Capital
adequacy is a measure of the amount of capital needed to sustain asset growth
and act as a cushion for losses. Capital protects depositors and the deposit
insurance fund from potential losses and is a source of funds for the
investments the Company needs to remain competitive.  Historically,
capital has been generated principally from the retention of
earnings.





At
September 30, 2008 shareholder’s equity was $34,000,000 consistent with the
$34,036,000 at December 31, 2007. Changes within shareholders’ equity relate to
the increases from the net income, stock based compensation expense and proceeds
from the exercise of stock options offset by the increase in unrealized losses
on available for sale securities.





Although
the Bank’s capital ratios remain above the minimum levels required for well
capitalized status, it is currently evaluating the TARP Capital Purchase Program
and the Company’s Board of Directors has authorized management to submit an
application to participate in the program.





Overall
capital adequacy is monitored on a day-to-day basis by the Company’s management
and reported to the Company’s Board of Directors on a quarterly
basis.  The Bank’s regulators measure capital adequacy by using a
risk-based capital framework and by monitoring compliance with minimum leverage
ratio guidelines. Under the risk-based capital standard, assets reported on the
Company’s balance sheet and certain off-balance sheet items are assigned to risk
categories, each of which is assigned a risk weight.





This
standard characterizes an institution's capital as being "Tier 1" capital
(defined as principally comprising shareholders' equity and the qualifying
portion of subordinated debentures) and "Tier 2" capital (defined as principally
comprising Tier 1 capital and the remaining qualifying portion of subordinated
debentures and the qualifying portion of the ALL).





The
minimum ratio of total risk-based capital to risk-adjusted assets, including
certain off-balance sheet items, is 8%. At least one-half (4%) of the total
risk-based capital is to be comprised of Tier 1 capital; the balance may consist
of debt securities and a limited portion of the ALL.





As of
September 30, 2008 the most recent notification by the Federal Deposit Insurance
Corporation (“FDIC”) categorized the Bank as well capitalized under the
regulatory framework for prompt corrective action.  To be categorized
as well capitalized the Bank must meet the minimum ratios as set forth below.
There are no conditions or events since that notification that management
believes have changed the Bank’s category. Management believes that the Company
met all of its capital adequacy requirements.


-30-


The
leverage ratio consists of Tier I capital divided by quarterly average
assets.  The minimum leverage ratio is 3 percent for banking
organizations that do not anticipate significant growth and that have
well-diversified risk, excellent asset quality and in general, are considered
top-rated banks. For all other institutions the minimum rate is 4%.


The
Company’s and the Bank’s risk-based capital ratios are presented
below.




Actual
            
            
            For Capital Adequacy
    Purposes
            
            
            To Be Well Capitalized Under Prompt Corrective
      Action ProvisionsSeptember
      30, 2008
            
            Amount
            
            
            Ratio
            
            
            Minimum Amount
            
            
            Minimum Ratio
            
            
            Minimum Amount
            
            
            Minimum RatioCompany:Total
      capital (to risk-weighted assets)
            
            $
            46,577
            
            
            
            12.0
            %
            
            $
            30,992
            
            
            
            8.0
            %
            
            
            N/A
            
            
            
            N/ATier
      1 capital (to risk weighted assets)
            
            $
            43,224
            
            
            
            11.2
            %
            
            $
            15,496
            
            
            
            4.0
            %
            
            
            N/A
            
            
            
            N/ATier
      1 capital (to average assets)
            
            $
            43,224
            
            
            
            10.0
            %
            
            $
            17,366
            
            
            
            4.0
            %
            
            
            N/A
            
            
            
            N/ABank:Total
      capital (to risk-weighted assets)
            
            $
            44,773
            
            
            
            11.6
            %
            
            $
            30,820
            
            
            
            8.0
            %
            
            $
            38,525
            
            
            
            10.0
            %Tier
      1 capital (to risk-weighted assets)
            
            $
            40,659
            
            
            
            10.6
            %
            
            $
            15,410
            
            
            
            4.0
            %
            
            $
            23,115
            
            
            
            6.0
            %Tier
      1 capital (to average assets)
            
            $
            40,659
            
            
            
            9.4
            %
            
            $
            17,260
            
            
            
            4.0
            %
            
            $
            21,575
            
            
            
            5.0
            %December
      31, 2007:Company:Total
      capital (to risk-weighted assets)
            
            $
            46,285
            
            
            
            12.6
            %
            
            $
            29,433
            
            
            
            8.0
            %
            
            
            N/A
            
            
            
            N/ATier
      1 capital (to risk weighted assets)
            
            $
            42,018
            
            
            
            11.4
            %
            
            $
            14,717
            
            
            
            4.0
            %
            
            
            N/A
            
            
            
            N/ATier
      1 capital (to average assets)
            
            $
            42,018
            
            
            
            10.2
            %
            
            $
            16,524
            
            
            
            4.0
            %
            
            
            N/A
            
            
            
            N/ABank:Total
      capital (to risk-weighted assets)
            
            $
            44,368
            
            
            
            12.1
            %
            
            $
            29,256
            
            
            
            8.0
            %
            
            $
            36,570
            
            
            
            10.0
            %Tier
      1 capital (to risk-weighted assets)
            
            $
            40,198
            
            
            
            11.0
            %
            
            $
            14,628
            
            
            
            4.0
            %
            
            $
            21,942
            
            
            
            6.0
            %Tier
      1 capital (to average assets)
            
            $
            40,198
            
            
            
            9.8
            %
            
            $
            16,428
            
            
            
            4.0
            %
            
            $
            20,535
            
            
            
            5.0
            %




-31-


LIQUIDITY





The
purpose of liquidity management is to ensure efficient and economical funding of
the Company’s assets consistent with the needs of the Company’s depositors,
borrowers and, to a lesser extent, shareholders. This process is managed not by
formally monitoring the cash flows from operations, investing and financing
activities as described in the Company’s statement of cash flows, but through an
understanding principally of depositor and borrower needs. As loan demand
increases, the Company can use asset liquidity from maturing investments along
with deposit growth to fund the new loans.





With
respect to assets, liquidity is provided by cash and money market investments
such as interest-bearing time deposits, federal-funds sold, available-for-sale
investment securities, and principal and interest payments on loans. With
respect to liabilities, liquidity is provided by core deposits, shareholders'
equity and the ability of the Company to borrow funds and to generate
deposits.





Because
estimates of the liquidity needs of the Company may vary from actual needs, the
Company maintains a substantial amount of liquid assets to absorb short-term
increases in loans or reductions in deposits. As loan demand decreases or loans
are paid off, investment assets can absorb these excess funds or deposit rates
can be decreased to run off excess liquidity. Therefore, there is some
correlation between financing activities associated with deposits and investing
activities associated with lending. The Company’s liquid assets (cash and due
from banks, federal funds sold and available-for-sale investment securities)
totaled $65.9 million or 15.4% of total assets at September 30, 2008 compared to
$87.0 million or 20.2% of total assets at December 31, 2007. The Company expects
that its primary source of liquidity will be earnings of the Company,
acquisition of core deposits, and wholesale borrowing arrangements.





ITEM
3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT


MARKET
RISK





Market
risk is the risk of loss in a financial instrument arising from adverse changes
in market rates such as interest rates, commodity prices and equity
prices.  The Company’s market risk s a financial institution arises
primarily from interest rate risk exposure.  Fluctuation in interest
rates will ultimately impact both the level of income and expense recorded on a
large portion of the Company’s assets and liabilities, and the market value of
all interest earning assets and interest bearing liabilities, other than those
that possess a short term to maturity.  Based upon the nature of its
operations, the Company is not subject to fluctuations in foreign currency
exchange or commodity pricing.  However, the Company’s commercial real
estate loan portfolio, concentrated primarily in Northern California, is subject
to risks associated with the local economies.




-32-


The
fundamental objective of the Company’s management of its assets and liabilities
is to maximize the economic value of the Company while maintaining adequate
liquidity and managing exposure to interest rate risk deemed by management to be
acceptable.  Management believes an acceptable degree of exposure to
interest rate risk results from management of assets and liabilities through
using floating rate loans and deposits, maturities, pricing and mix to attempt
to neutralize the potential impact of changes in market interest
rates.  The Company’s profitability is dependent to a large extent
upon its net interest income which is the difference between its interest income
on interest earning assets, such as loans and securities, and interest expense
on interest bearing liabilities, such as deposits, trust preferred securities
and other borrowings.  The Company, like other financial institutions,
is subject to interest rate risk to the degree that its interest earning assets
reprice differently from its interest bearing liabilities.  The
Company manages its mix of assets and liabilities with the goal of limiting
exposure to interest rate risk, ensuring adequate liquidity, and coordinating
its sources and uses of funds.





The
Company seeks to control its interest rate risk exposure in a manner that will
allow for adequate levels of earnings and capital over a range of possible
interest rate environments.  The Company has adopted formal policies
and practices to monitor and manage interest rate risk exposure.  As
part of this effort, the Company measures interest rate risk utilizing both an
internal asset liability measurement system as well as independent third party
reviews to confirm the reasonableness of the assumptions used to measure and
report the Company’s interest rate risk, enabling management to make any
adjustments necessary.





Interest
rate risk is managed by the Company’s Asset Liability Committee (“ALCO”), which
includes members of senior management and several members of the Board of
Directors.  The ALCO monitors interest rate risk by analyzing the
potential impact on interest income from potential changes in interest rates and
considers the impact of alternative strategies or changes in balance sheet
structure.  The ALCO manages the Company’s balance sheet in part to
maintain the potential impact on net interest income within acceptable ranges
despite changes in interest rates.  The Company’s exposure to interest
rate risk is reviewed on at least a quarterly basis by the ALCO.





In
management’s opinion there has not been a material change in the Company’s
market risk or interest rate risk profile for the three or nine months ended
September 30, 2008 compared to December 31, 2007 as discussed under the caption
"Liquidity and Market Risk" and "Net Interest Income Simulation" in the
Company's 2007 Annual Report to Shareholders filed as an exhibit with the
Company’s 2007 Annual Report on Form 10-K, which is incorporated here by
reference.





The
following table reflects the company’s projected net interest income sensitivity
analysis based on period-end data:





(In
      thousands)
            
            September
      30, 2008Change
      in Rates
            
            Adjusted
      Net Interest Income
            
            
            Percent
      Change From BaseUp
      200 basis points
            
            $
            17,719
            
            
            
            2.58
            %Up
      150 basis points
            
            
            17,617
            
            
            
            1.99
            %Up
      100 basis points
            
            
            17,509
            
            
            
            1.36
            %Base
      Scenario
            
            
            17,274
            
            
            
            0.00
            %Down
      100 basis points
            
            
            16,939
            
            
            
            -1.94
            %Down
      150 basis points
            
            
            16,759
            
            
            
            -2.98
            %Down
      200 basis points
            
            $
            16,571
            
            
            
            -4.07
            %




-33-




ITEM
4.    CONTROLS AND PROCEDURES







The
Company's Chief Executive Officer and Chief Financial Officer, based on their
evaluation as of the end of the period covered by this report of the Company's
disclosure controls and procedures (as defined in Exchange Act
Rule 13a—15(e)), have concluded that the Company's disclosure controls and
procedures are designed to ensure that information required to be disclosed by
the Company in its periodic SEC filings is recorded, processed and reported
within the time periods specified in the SEC's rules and forms. Based upon that
evaluation, the Chief Executive Officer and Chief Financial Officer concluded
that the Company's disclosure controls and procedures are effective in timely
alerting them to material information relating to the Company (including its
consolidated and unconsolidated subsidiaries) required to be included in the
Company's periodic SEC filings. There are inherent limitations to the
effectiveness of any system of disclosure controls and procedures, including
cost limitations, judgments used in decision making, assumptions regarding the
likelihood of future events, soundness of internal controls, fraud, the
possibility of human error and the circumvention or overriding of the controls
and procedures.  Accordingly, even effective disclosure controls and
procedures can provide only reasonable, and not absolute, assurance of achieving
their control objectives.




There
were no significant changes in the Company's internal controls or in other
factors during the period covered by this report that have materially affected
or could significantly affect internal control over financial
reporting.





ITEM
4T.                                CONTROLS
AND PROCEDURES





Not
applicable.


Part
II – Other Information








ITEM
1A RISK FACTORS





The
Emergency Economic Stabilization Act of 2008 included a provision for an
increase in the amount of deposits insured by the Federal Deposit Insurance
Corporation (FDIC) to $250,000. On October 14, 2008, the FDIC announced a new
program -- the Temporary Liquidity Guarantee Program that provides unlimited
deposit insurance on funds in noninterest-bearing transaction deposit accounts
not otherwise covered by the existing deposit insurance limit of $250,000. All
eligible institutions will be covered under the program for the first 30 days
without incurring any costs. After the initial period, participating
institutions will be assessed a 10 basis point surcharge on the additional
insured deposits.




The
behavior of depositors in regard to the level of FDIC insurance could cause our
existing customers to reduce the amount of deposits held at the Bank, and could
cause new customers to open deposit accounts at the Bank. The level and
composition of the Bank's deposit portfolio directly impacts the Bank's funding
cost and net interest margin.




The
Federal Reserve Bank has been providing vast amounts of liquidity into the
banking system to compensate for weaknesses in short-term borrowing markets and
other capital markets. A reduction in the Federal Reserve's activities or
capacity could reduce liquidity in the markets, thereby increasing funding costs
to the Bank or reducing the availability of funds to the Bank to finance its
existing operations.




On
October 3, 2008, the Troubled Asset Relief Program ("TARP") was signed into law.
TARP gave the United States Treasury Department ("Treasury") authority to deploy
up to $750 billion into the financial system with an objective of improving
liquidity in capital markets. On October 24, 2008, Treasury announced plans to
direct $250 billion of this authority into preferred stock investments in banks.
Principal terms of this preferred stock program include payment of preferred
cumulative dividends on the Treasury's stock, restrictions on the payment of
common stock dividends, redemption provisions which (during the first three
years) permit redemption only with the proceeds of high-quality private capital,
restrictions on stock repurchase programs, and restrictions on executive
compensation.




The
Company is currently evaluating the potential benefits and costs associated with
applying for issuance of $6 million of preferred stock to the Treasury in the
TARP program.  The Company expects that this transaction, if applied
for and approved, will be completed during the fourth quarter of
2008.




In
addition to the information set forth above, you should carefully consider the
factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on
Form 10-K for the year ended December 31, 2007, which could materially affect
our business, financial condition or future results. Except as described above,
the Company is not aware of any material changes to the risks described in our
Annual Report.





ITEM
6. EXHIBITS





31.1
            Certification of Chief Executive Officer (section
      302 of the Sarbanes Oxley Act)31.2
            Certification of Chief Financial Officer (section
      302 of the Sarbanes-Oxley Act)32.1
            Certification of Chief Executive Officer pursuant to
      section 906 of the Sarbanes-Oxley Act32.2
            Certification of Chief Financial Officer pursuant to
      section 906 of the Sarbanes-Oxley
Act








SIGNATURES





Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.








Pacific
      State BancorpDate:
      November 6, 2008
            By:  /s/
      Steven A. RossoSteven
      A. RossoPresident
      and Chief Executive Officer





Pacific
      State BancorpDate:
      November 6, 2008
            By:  /s/
      Justin R. GarnerJustin
      R. GarnerVice
      President and Interim Chief Financial
Officer


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