**SECURITIES AND EXCHANGE COMMISSION****WASHINGTON, D.C. 20549**

**FORM 10-Q**

**ý****        ****QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934**

**For the Quarterly Period Ended September 30,2006**

**o****        ****TRANSITION REPORT PURSUANT TOSECTION 13 OR 15 (d) OF THE SECURITIESEXCHANGE ACT OF 1934**

**COMMUNITYVALLEY BANCORP**

(Exact name of registrant as specified in its charter)
| California                                 | ** ** | **000-51678**            | ** ** | **68-0479553**           |
|--------------------------------------------|------------|--------------------------|------------|--------------------------|
| (State or other jurisdiction of            |       | (Commission File Number) |       | (IRS Employer ID Number) |
| incorporation or organization)             |       |                     |       |                     |
|                                       |       |                     |       |                     |
| **2041 Forest Avenue,  Chico, California** | ** ** | **95928**                |
| (Address of principal executive offices)   |       | (Zip code)               |

 

**(530) 899-2344**

(Registrant’s telephone number,including area code)

**not applicable**(Former name, former address and former fiscal year, ifchangedsince last report.)

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

Yes  x  No  o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Exchange Act Rule 12-b-2.
| Large accelerated filer |   | o |   | Accelerated filer |   | x |   | Non-accelerated filer |   | o |
|-------------------------|--------|---|--------|-------------------|--------|---|--------|-----------------------|--------|---|

 

Indicateby check mark whether the registrant is a shell company (as defined in ExchangeAct Rule 12b-2. Yes  o  No  x

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date:

No parvalue Common Stock — 7,471,362 shares outstanding at November 9, 2006.

 

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PART 1-FINANCIAL INFORMATION

Item 1. FINANCIAL STATEMENTS

COMMUNITY VALLEYBANCORPCONDENSED CONSOLIDATED BALANCE SHEET (Unaudited)
| (In thousands except per share data)                                                                                                                     | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ASSETS                                                                                                                                                                            |       |                         |       |                        |       |
|                                                                                                                                                                              |       |                         |       |                        |       |
| Cash and due from banks                                                                                                                                                           |       | $                            | 16,455     |                        | $          | 18,988 |   |
| Federal funds sold                                                                                                                                                                |       | 8,410                        |       | 29,015                      |       |
| Total cash and  cash equivalents                                                                                                                                                  |       | 24,865                       |       | 48,003                      |       |
|                                                                                                                                                                              |       |                         |       |                        |       |
| Interest-bearing  deposits in banks                                                                                                                                               |       | 3,664                        |       | 6,636                       |       |
| Investment securities  (fair value of $5,201 at September 30, 2006 and $6,640 at December 31, 2005)                                                                               |       | 5,231                        |       | 6,676                       |       |
| Loans held for sale at  lower of cost or market                                                                                                                                   |       | 1,899                        |       | 2,197                       |       |
| Loans, less allowance  for loan losses of $5,368 at September 30, 2006 and $4,716 at December 31,  2005                                                                           |       | 461,498                      |       | 401,221                     |       |
|                                                                                                                                                                              |       |                         |       |                        |       |
| Premises and equipment,  net                                                                                                                                                      |       | 14,366                       |       | 11,221                      |       |
| Accrued interest  receivable and other assets                                                                                                                                     |       | 19,898                       |       | 18,823                      |       |
| Total assets                                                                                                                                                                      |       | $                            | 531,421    |                        | $          | 494,777 |   |
|                                                                                                                                                                              |       |                         |       |                        |       |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY                                                                                                                                        |       |                         |       |                        |       |
|                                                                                                                                                                              |       |                         |       |                        |       |
| Deposits:                                                                                                                                                                         |       |                         |       |                        |       |
| Non-interest  bearing                                                                                                                                                             |       | $                            | 84,625     |                        | $          | 83,336 |   |
| Interest bearing                                                                                                                                                                  |       | 381,806                      |       | 350,682                     |       |
| Total deposits                                                                                                                                                                    |       | 466,431                      |       | 434,018                     |       |
|                                                                                                                                                                              |       |                         |       |                        |       |
| Notes payable                                                                                                                                                                     |       | 1,244                        |       | 1,782                       |       |
| Junior subordinated  debentures                                                                                                                                                   |       | 8,248                        |       | 8,248                       |       |
|                                                                                                                                                                              |       |                         |       |                        |       |
| Accrued interest  payable and other liabilities                                                                                                                                   |       | 9,686                        |       | 9,174                       |       |
|                                                                                                                                                                              |       |                         |       |                        |       |
| Total  liabilities                                                                                                                                                                |       | 485,609                      |       | 453,222                     |       |
|                                                                                                                                                                              |       |                         |       |                        |       |
| Commitments and  contingencies                                                                                                                                                    |       |                         |       |                        |       |
|                                                                                                                                                                              |       |                         |       |                        |       |
| Shareholders’ equity:                                                                                                                                                        |       |                         |       |                        |       |
| Common stock –  no par value; 20,000,000 shares authorized; issued and outstanding –  7,469,163 shares at September 30, 2006 and 7,408,047 shares at December 31,  2005 |       | 9,844                        |       | 9,051                       |       |
|                                                                                                                                                                              |       |                         |       |                        |       |
| Unallocated ESOP  shares (169,868 shares at September 30, 2006 and 185,051 shares at December  31, 2005, at cost)                                                                 |       | (1,575                       | )          | (1,391                      | )          |
|                                                                                                                                                                              |       |                         |       |                        |       |
| Retained  earnings                                                                                                                                                                |       | 37,554                       |       | 33,908                      |       |
|                                                                                                                                                                              |       |                         |       |                        |       |
| Accumulated  other comprehensive loss net of taxes                                                                                                                                |       | (11                          | )          | (13                         | )          |
|                                                                                                                                                                              |       |                         |       |                        |       |
| Total  shareholders’ equity                                                                                                                                                  |       | 45,812                       |       | 41,555                      |       |
| Total liabilities and  shareholders equity                                                                                                                                        |       | $                            | 531,421    |                        | $          | 494,777 |   |

 

See Notes to UnauditedCondensed Consolidated Financial Statements

 

2

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COMMUNITY VALLEYBANCORPCONDENSED CONSOLIDATED STATEMENT OF INCOME(Unaudited)
|                                                                    | ** ** | **For the periods ended September 30,** | ** ** |
|--------------------------------------------------------------------|------------|------------------------------------------------------------------|------------|
| ** **                                                         | ** ** | **Three months**                                            | ** ** | **Nine Months** | ** ** |
| **(In thousands, except per share data)** | ** ** | **2006**                                                         | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                               |       |                                                             |       |   |   |   |   |   |   |
| Interest income:                                                   |       |                                                             |       |   |   |   |   |   |   |
| Interest and fees on loans                                         |       | $                                                                | 10,414     |   | $ | 8,273 |   | $ | 29,203 |   | $ | 22,252 |   |
| Interest on Federal funds sold                                     |       | 166                                                              |       | 177 |   | 521 |   | 642 |   |
| Interest on deposits in banks                                      |       | 36                                                               |       | 60 |   | 143 |   | 188 |   |
| Interest and dividends on investment securities:                   |       |                                                             |       |   |   |   |   |   |   |
| Taxable                                                            |       | 37                                                               |       | 43 |   | 131 |   | 137 |   |
| Exempt from Federal income taxes                                   |       | 17                                                               |       | 27 |   | 49 |   | 83 |   |
| Dividends                                                          |       |                                                             |       | 3 |   | 8 |   | 10 |   |
|                                                               |       |                                                             |       |   |   |   |   |   |   |
| Total interest income                                              |       | 10,670                                                           |       | 8,583 |   | 30,055 |   | 23,312 |   |
| Interest  expense:                                                 |       |                                                             |       |   |   |   |   |   |   |
| Interest on deposits                                               |       | 2,346                                                            |       | 1,231 |   | 5,900 |   | 3,248 |   |
| Interest on junior subordinated debentures                         |       | 192                                                              |       | 153 |   | 544 |   | 428 |   |
| Interest on note payable                                           |       | 23                                                               |       | 21 |   | 60 |   | 46 |   |
| Total interest expense                                             |       | 2,561                                                            |       | 1,405 |   | 6,504 |   | 3,722 |   |
|                                                               |       |                                                             |       |   |   |   |   |   |   |
| Net interest income before provision for loan losses               |       | 8,109                                                            |       | 7,178 |   | 23,551 |   | 19,590 |   |
| Provision for  loan losses                                         |       | 225                                                              |       | 225 |   | 675 |   | 675 |   |
| Net interest income after provision for loan losses                |       | 7,884                                                            |       | 6,953 |   | 22,876 |   | 18,915 |   |
|                                                               |       |                                                             |       |   |   |   |   |   |   |
| Non-interest  income                                               |       | 1,523                                                            |       | 1,966 |   | 4,884 |   | 5,231 |   |
|                                                               |       |                                                             |       |   |   |   |   |   |   |
| Non-interest  expenses:                                            |       |                                                             |       |   |   |   |   |   |   |
| Salaries and employee benefits                                     |       | 3,804                                                            |       | 3,096 |   | 11,292 |   | 8,920 |   |
| Occupancy                                                          |       | 393                                                              |       | 326 |   | 1,032 |   | 884 |   |
| Furniture and equipment                                            |       | 483                                                              |       | 465 |   | 1,422 |   | 1,295 |   |
| Other expense                                                      |       | 1,590                                                            |       | 1,468 |   | 4,319 |   | 4,061 |   |
| Total non-interest expense                                         |       | 6,270                                                            |       | 5,355 |   | 18,065 |   | 15,160 |   |
|                                                               |       |                                                             |       |   |   |   |   |   |   |
| Income before provision for income taxes                           |       | 3,137                                                            |       | 3,564 |   | 9,695 |   | 8,986 |   |
|                                                               |       |                                                             |       |   |   |   |   |   |   |
| Provision for  income taxes                                        |       | 1,404                                                            |       | 1,405 |   | 4,103 |   | 3,643 |   |
|                                                               |       |                                                             |       |   |   |   |   |   |   |
| Net income                                                         |       | $                                                                | 1,733      |   | $ | 2,159 |   | $ | 5,592 |   | $ | 5,343 |   |
|                                                               |       |                                                             |       |   |   |   |   |   |   |
| Basic earnings  per share                                          |       | $                                                                | .24        |   | $ | .30 |   | $ | .77 |   | $ | .75 |   |
| Diluted earnings  per share                                        |       | $                                                                | .23        |   | $ | .28 |   | $ | .73 |   | $ | .70 |   |
|                                                               |       |                                                             |       |   |   |   |   |   |   |
| Cash dividends per  share                                          |       | $                                                                | .07        |   | $ | .04 |   | $ | .18 |   | $ | .1175 |   |

 

See Notes toUnaudited Condensed Consolidated Financial Statements

3

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COMMUNITY VALLEYBANCORP

CONDENSEDCONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY

(Unaudited)

(In thousandsexcept share data)

 
|                                                                                   | ** ** | ** **            | ** ** | ** ** | ** ** | ** **      | ** ** | ** **        | ** ** | **Accumulated**        | ** ** | ** **        | ** ** | ** ** | ** ** |
|-----------------------------------------------------------------------------------|------------|-----------------------|------------|------------|------------|-----------------|------------|-------------------|------------|------------------------|------------|-------------------|------------|------------|------------|
| ** **                                                                        | ** ** | ** **            | ** ** | ** ** | ** ** | **Unallocated** | ** ** | ** **        | ** ** | **Other**              | ** ** | **Total**         | ** ** | ** ** | ** ** |
| ** **                                                                        | ** ** | **Common Stock** | ** ** | **ESOP**   | ** ** | **Retained**    | ** ** | **Comprehensive** | ** ** | **Shareholders’** | ** ** | **Comprehensive** | ** ** |
| ** **                                                                        | ** ** | **Shares**            | ** ** | **Amount** | ** ** | **Shares**      | ** ** | **Earnings**      | ** ** | **Income**             | ** ** | **Equity**        | ** ** | **Income** | ** ** |
|                                                                              |       |                  |       |       |       |            |       |              |       |                   |       |              |       |       |       |
| Balance, January 1, 2005                                                          |       | 7,273,582             |       | $          | 7,862      |            | $          | (1,144            | )          | $                      | 27,802     |              | $          | 11         |       | $ | 34,531 |   |   |   |
|                                                                              |       |                  |       |       |       |            |       |              |       |                   |       |              |       |       |       |
| Comprehensive income:                                                             |       |                  |       |       |       |            |       |              |       |                   |       |              |       |       |       |
| Net  income                                                                       |       |                  |       |       |       |            |       | 7,198             |       |                   |       | 7,198             |       | $          | 7,198      |   |
| Other comprehensive income, net of tax                                            |       |                  |       |       |       |            |       |              |       |                   |       |              |       |       |       |
| Net change in unrealized gains on available-for-sale  investment securities       |       |                  |       |       |       |            |       |              |       | (24                    | )          | (24               | )          | (24        | )          |
| Total comprehensive income                                                        |       |                  |       |       |       |            |       |              |       |                   |       |              |       | $          | 7,174      |   |
| Exercise of stock  options and related tax benefit                                |       | 134,465               |       | 1,039      |       |            |       |              |       |                   |       | 1,039             |       |       |       |
| Amortization of stock  compensation - ESOP shares                                 |       |                  |       | 150        |       | 101             |       |              |       |                   |       | 251               |       |       |       |
| Shares acquired or  redeemed by ESOP                                              |       |                  |       |       |       | (348            | )          |              |       |                   |       | (348              | )          |       |       |
| Cash dividends- $.15 per  share                                                   |       |                  |       |       |       |            |       | (1,092            | )          |                   |       | (1,092            | )          |       |       |
|                                                                              | ** ** | ** **            |       |       |       |            |       |              |       |                   |       |              |       |       |       |
| Balance, December 31,  2005                                                       |       | 7,408,047             |       | 9,051      |       | (1,391          | )          | 33,908            |       | (13                    | )          | 41,555            |       |       |       |
|                                                                              |       |                  |       |       |       |            |       |              |       |                   |       |              |       |       |       |
| Comprehensive income                                                              |       |                  |       |       |       |            |       |              |       |                   |       |              |       |       |       |
| Net  income                                                                       |       |                  |       |       |       |            |       | 5,592             |       |                   |       | 5,592             |       | $          | 5,592      |   |
| Other  comprehensive income, net of taxes:                                        |       |                  |       |       |       |            |       |              |       |                   |       |              |       |       |       |
| Net  change in unrealized gain (loss) on available-for-sale investment securities |       |                  |       |       |       |            |       |              |       | 2                      |       | 2                 |       | 2          |       |
| Total comprehensive income                                                        |       |                  |       |       |       |            |       |              |       |                   |       |              |       | $          | 5,590      |   |
| Exercise of stock  options and related tax benefit                                |       | 104,716               |       | 763        |       |            |       |              |       |                   |       | 763               |       |       |       |
| Repurchase of common  stock                                                       |       | (43,600               | )          | (332       | )          |            |       | (605              | )          |                   |       | (937              | )          |       |       |
| Amortization of stock  compensation - ESOP shares                                 |       |                  |       | 233        |       | (184            | )          |              |       |                   |       | 49                |       |       |       |
| Stock-based compensation  expense                                                 |       |                  |       | 129        |       |            |       |              |       |                   |       | 129               |       |       |       |
| Cash dividends $.18 per  share                                                    |       |                  |       |       |       |            |       | (1,341            | )          |                   |       | (1,341            | )          |       |       |
|                                                                              |       |                  |       |       |       |            |       |              |       |                   |       |              |       |       |       |
| Balance, September 30, 2006                                                       |       | 7,469,163             |       | $          | 9,844      |            | $          | (1,575            | )          | $                      | 37,554     |              | $          | (11        | )          | $ | 45,812 |   |   |   |

 

SeeNotes to Unaudited Condensed Consolidated Financial Statements

4

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COMMUNITY VALLEYBANCORPCONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS (Unaudited)****(In thousands)
| **For the nine months ended September 30,**          | ** ** | **2006** | ** ** | **2005** | ** ** |
|------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                               |       |     |       |     |       |
| Cash flows from  operating activities:                                             |       |     |       |     |       |
| Net income                                                                         |       | $        | 5,592      |     | $          | 5,343 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |     |       |     |       |
| Provision for  loan losses                                                         |       | 675      |       | 675      |       |
| (Decrease)  increase in deferred loan origination costs, net                       |       | (176     | )          | 47       |       |
| Depreciation and  amortization, net                                                |       | 1,218    |       | 1,140    |       |
| Loss (gain) on  disposition of Bank premises and equipment                         |       | 11       |       | (20      | )          |
| Net decrease  (increase) decrease in loans held for sale                           |       | 298      |       | (1,453   | )          |
| Increase in cash  surrender value of bank-owned life insurance                     |       | (258     | )          | (217     | )          |
| Non-cash compensation  expense associated with the ESOP                            |       | 404      |       | 205      |       |
| Share based  compensation expense associated with stock options                    |       | 129      |       |     |       |
| Provision for  deferred tax benefit                                                |       | (10      | )          |     |       |
| Increase in accrued  interest receivable and other assets                          |       | (428     | )          | (1,188   | )          |
| Increase in accrued  interest payable and other liabilities                        |       | 308      |       | 3,406    |       |
|                                                                               |       |     |       |     |       |
| Net cash provided by  operating activities                                         |       | 7,763    |       | 7,938    |       |
|                                                                               |       |     |       |     |       |
| Cash flows from  investing activities:                                             |       |     |       |     |       |
| Decrease in  interest-bearing deposits in banks                                    |       | 2,972    |       | 2,079    |       |
| Proceeds from  called available-for-sale investment securities                     |       |     |       | 1,000    |       |
| Proceeds from  matured available-for-sale investment securities                    |       | 1,000    |       |     |       |
| Proceeds from  principal payments on available-for-sale investment securities      |       | 20       |       |     |       |
| Proceeds from  called held-to-maturity investment securities                       |       | 246      |       |     |       |
| Proceeds from  matured held-to-maturity investment securities                      |       |     |       | 106      |       |
| Proceeds from principal  payments of held-to-maturity investment securities        |       | 176      |       | 280      |       |
| Purchases of  held-to-maturity investment securities                               |       |     |       | (1,234   | )          |
| Purchase of  available-for-sale investment securities                              |       |     |       | (2,008   | )          |
| Purchases of  premises and equipment                                               |       | (4,365   | )          | (3,149   | )          |
| Proceeds from  sale of premises and equipment                                      |       | (2       | )          | 54       |       |
| Premiums paid  for bank-owned life insurance                                       |       |     |       | (1,450   | )          |
| Investment in  ATM program                                                         |       |     |       | (9,989   | )          |
|                                                                               |       |     |       |     |       |
| Net increase in  loans                                                             |       | (60,797  | )          | (64,682  | )          |
| Net cash used in  investing activities                                             |       | (60,750  | )          | (69,004  | )          |
|                                                                               |       |     |       |     |       |
| Cash flows from  financing activities:                                             |       |     |       |     |       |
| Net (decrease) increase  in demand, interest-bearing and savings deposits          |       | $        | (22,034    | )        | $          | 27,750 |   |
| Net increase in  time deposits                                                     |       | 54,446   |       | 13,791   |       |
| Repayment of  note payable                                                         |       | (800     | )          |     |       |
| Proceeds from  note payable                                                        |       |     |       | 800      |       |
| Repayment of  ESOP loan, net                                                       |       | (92      | )          | (170     | )          |
| Proceeds from  ESOP loan                                                           |       | 354      |       | 348      |       |
| Purchase of  unallocated ESOP shares                                               |       | (354     | )          | (348     | )          |
| Payment of cash  dividends                                                         |       | (1,116   | )          | (841     | )          |
| Proceeds from the  exercise of stock options                                       |       | 383      |       | 453      |       |
| Repurchase of common  stock                                                        |       | (937     | )          |     |       |
|                                                                               |       |     |       |     |       |
| Net cash  provided by financing activities                                         |       | 29,850   |       | 41,783   |       |
|                                                                               |       |     |       |     |       |
| Decrease in cash  and cash equivalents                                             |       | (23,137  | )          | (19,283  | )          |
|                                                                               |       |     |       |     |       |
| Cash and cash  equivalents at beginning of year                                    |       | 48,003   |       | 68,218   |       |
|                                                                               |       |     |       |     |       |
| Cash and cash equivalents at end of period                                         |       | $        | 24,866     |     | $          | 48,935 |   |

 

See Notes toUnaudited Condensed Consolidated Financial Statements

5

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**CommunityValley Bancorp and Subsidiaries**

NOTES TO UNAUDITEDCONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1.  BASIS OF PRESENTATION

The accompanyingunaudited condensed consolidated financial statements of Community ValleyBancorp and subsidiaries (the “Company”) have been prepared pursuant to therules and regulations of the Securities Exchange Commission (the “SEC”) and theinstructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly,certain information and footnote disclosures required by accounting principles generallyaccepted in the United States of America for annual financial statements arenot included herein, however the Company believes that the disclosures made areadequate to make the information not misleading. In the opinion of management,all adjustments (which consist solely of normal recurring adjustments)considered necessary for a fair presentation of the results for the interimperiods presented have been included. These interim consolidated financialstatements should be read in conjunction with the financial statements andrelated notes contained in the Company’s 2005 Annual Report to Shareholders onForm 10-K.

The condensedconsolidated financial statements include the accounts of the Company and itswholly owned subsidiaries, Butte Community Bank (the “Bank”) and ButteCommunity Insurance Agency, LLC formerly CVB Insurance Agency, LLC. Allsignificant inter-company balances and transactions have been eliminated inconsolidation. The Company has also established a wholly-owned unconsolidatedsubsidiary, Community Valley Bancorp Trust I (the “Trust”), a Delawarestatutory business trust, formed for the sole purpose of issuing trustpreferred securities. The results of operations for the three-month andnine-month periods ended September 30, 2006 may not necessarily be indicativeof the operating results for the full year 2006.

Management hasdetermined that because all of the commercial banking products and servicesoffered by the Company are available in each branch of the bank, all branchesare located within the same economic environment and management does notallocate resources based on the performance of different lending or transactionactivities, it is appropriate to aggregate the Bank branches and report them asa single operating segment. No single customer accounts for more than 10% ofthe revenues of the Company or the Bank.

The preparation ofconsolidated financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions.  These estimates and assumptions affect thereported amounts of assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting period.  Actual results could differ from these estimates.

2.  EARNINGS PER SHARE COMPUTATION

Basic earnings per share are computed by dividing net income by the weighted average common shares outstanding for the period (7,302,769 and 7,276,991 shares for the three and nine month periods ended September 30, 2006 and 7,183,171 and  7,147,502 shares for the three and nine month periods ended September 30, 2005).  Diluted earnings per share reflect the potential dilution that could occur if outstanding stock options were exercised using the treasury stock method.   Diluted earnings per share is computed by dividing net income by the weighted average common shares outstanding for the period plus the dilutive effect of options (399,415 and 406,098 shares for the three and nine month periods ended September 30, 2006 and 441,510 and 456,626 shares for the three and  nine month periods ended September 30, 2005).    During the periods covered the Company had no stock options that were considered anti-dilutive.

6

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3.  COMPREHENSIVE INCOME

Comprehensive income is reported in addition to net income for all periods presented.  Comprehensive income is made up of net income plus other comprehensive income or loss.  The Company’s only source of other  comprehensive income or loss, is comprised of changes in unrealized gains or losses, net of taxes, on available-for-sale securities, adjusted for the effect of realized gains or losses on available-for-sale securities, net of taxes.

## **4.**  **STOCK –BASED COMPENSATION**

The Company issuesstock options under two stock-based compensation plans, the Community ValleyBancorp 1997 and 2000 Stock Option Plans. The plans require that the optionprice may not be less than the fair market value of the stock at the date theoption is granted, and that the stock must be paid in full at the time theoption is exercised. The options expire on a date determined by the Board ofDirectors, but not later than ten years from the date of grant. The vestingperiod is determined by the Board of Directors and is generally over five years;however, nonstatutory options granted during 1997 vested immediately. Under the1997 plan, 227,540 shares of common stock remain reserved for issuance toemployees and directors, and the related options are exercisable until theirexpiration. However, no new options will be granted under this plan. Under theCompany’s 2000 stock option plan, 584,371 shares of common stock remainreserved for issuance to employees and directors, of which 75,877 shares areavailable for future grants.

On January 1,2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”)No. 123(R), “Share-Based Payment,” which addresses the accounting forstock-based payment transactions. SFAS No. 123(R) eliminates the abilityto account for stock-based compensation transactions using the intrinsic valuemethod under Accounting Principles Board Opinion (“APB”) No. 25,“Accounting for Stock Issued to Employees,” and instead generally requires thatsuch transactions be accounted for using a fair-value based method. The Companyhas elected the modified prospective transition method as permitted under SFASNo. 123(R), and accordingly prior periods have not been restated toreflect the impact of SFAS No. 123(R). The modified prospective transitionmethod requires that stock-based compensation expense be recorded for all newand unvested stock options that are ultimately expected to vest as therequisite service is rendered beginning on January 1, 2006. Stock-basedcompensation for awards granted prior to January 1, 2006 is based upon thegrant-date fair value of such compensation as determined under the pro formaprovisions of SFAS No. 123, “Accounting for Stock-Based Compensation.” TheCompany issues new shares of common stock upon the exercise of stock options.

The Company uses aBlack-Scholes option valuation model to determine the fair value of stock-basedcompensation under SFAS No. 123(R), consistent with that used for proforma disclosures under SFAS No. 123. The Black-Scholes model incorporatesvarious assumptions including the expected term of awards, volatility of stockprice, risk-free rates of return and dividend yield. The expected term of anaward is generally no less than the option vesting period and is based on theCompany’s historical experience. Expected volatility is based upon thehistorical volatility of the Company’s stock price. The risk-free interest rateis approximated using rates available on U.S. Treasury securities with aremaining term equal to the option’s expected life.

SFAS 123(R)requires the cash flows resulting from the tax benefits resulting from taxdeductions in excess of the compensation cost recognized for those options(excess tax benefits) to be classified as a cash flow from financing in thestatement of cash flows. These excess tax benefits for the three and ninemonths ending September 30, 2006 were $54,000 and $380,844 for the Company.

The Companyrecorded an incremental $43 thousand ($40 thousand after tax) of stock-basedcompensation expense during the three months ended September 30, 2006 and$129 thousand ($119 thousand after tax) for the nine month period endedSeptember 30, 2006 as a result of the adoption of SFAS No. 123(R). As aresult, there was not a significant impact on the net income before or afterthe provision for income taxes or on the basic or diluted earnings pershare.  SFAS No. 123(R),*  Share-BasedPayment* , requires the fair value method of accounting for stockoptions whereby compensation expense will be recognized based on the computedfair value of the options on the grant date for stock options granted on orafter January 1, 2006.

7

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Certain pro formadisclosures of the expense recognition provisions of Statement No. 123 arerequired for periods prior to implementation of the standard for companies,such as Community Valley Bancorp, which used the intrinsic-value method foraccounting for stock options, and are as follows:
|                                                                                                                                          | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                                               | ** ** | **September 30, 2005** | ** ** | **September 30, 2005** | ** ** |
| Net earnings as  reported                                                                                                                |       | $                                | 2,159      |                             | $          | 5,343 |   |
| Deduct: Total stock-based compensation expense  determined under the fair value based method for all awards, net of related  tax effects |       | $                                | (90        | )                                | $          | (267 | ) |
|                                                                                                                                     |       |                             |       |                             |       |
| Pro forma net  income                                                                                                                    |       | $                                | 2,069      |                             | $          | 5,076 |   |
|                                                                                                                                     |       |                             |       |                             |       |
| Basic earnings  per share - as reported                                                                                                  |       | $                                | 0.30       |                             | $          | 0.75 |   |
| Basic earnings  per share - pro forma                                                                                                    |       | $                                | 0.29       |                             | $          | 0.71 |   |
|                                                                                                                                     |       |                             |       |                             |       |
| Diluted earnings  per share - as reported                                                                                                |       | $                                | 0.28       |                             | $          | 0.70 |   |
| Diluted earnings per  share - pro forma                                                                                                  |       | $                                | 0.27       |                             | $          | 0.67 |   |

 

The fair value ofthe options granted during the nine month period ended September 30, 2006 and2005 are noted below and are based on the following assumptions:
|                                                                 | ** ** | **Nine Months Ended**  | ** ** |
|-----------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                      | ** ** | **September 30, 2006** | ** ** | **September 30, 2005** | ** ** |
| Dividend Yield                                                  |       | 1.11                             | %          | 1.12 | % |
| Expected  Volatility                                            |       | 32.35                            | %          | 58.0 | % |
| Risk-free  interest rate                                        |       | 4.50                             | %          | 4.00 | % |
| Expected Option  Life                                           |       | 7.5 years                        |       | 6.5 years |   |
| Weighted average fair  value of options granted during the year |       | $                                | 3.58       |   | $ | 5.81 |   |
|                                                                 |            |                                  |            |  |  |  |  |

 

Stock optionactivity for the nine month period ended September 30, 2006 and 2005 issummarized as follows:
| ** **                                         | ** ** | **Number of Stock** | ** ** | ** **                         | ** **     | **Weighted Average** | ** ** | **Weighted Average** | ** ** |
|----------------------------------------------------|------------|-------------------------------|------------|------------------------------------|----------------|---------------------------|------------|---------------------------|------------|
| **2006**                                           | ** ** | **Options Outstanding**  | ** ** | **Exercise Price Range** | ** **     | **Exercise Price**   | ** ** | **Contractual Life** | ** ** |
| ** **                                         | ** ** | ** **                    | ** ** | ** **                         | ** **     | ** **                | ** ** | ** **                | ** ** |
| Outstanding at  January 1                          |       | 841,950                       |       | $                                  | 2.30 to $14.75 |                      | $          | 5.74                      |       |   |   |
| Exercised                                          |       | (104,716                      | )          | $                                  | 2.23 to $13.25 |                      | $          | 3.64                      |       |   |   |
| Granted                                            |       | 6,000                         |       | $                                  | 15.40          |                      | $          | 15.40                     |       |   |   |
| Cancelled or  expired                              |       | (7,200                        | )          | $                                  | 7.13 to $14.75 |                      | $          | 11.36                     |       |   |   |
|                                               |       |                          |       |                               |           |                      |       |                      |       |
| Outstanding at  September 30                       |       | 736,034                       |       | $                                  | 2.30 to $15.40 |                      | $          | 5.84                      |       | 5.18 years |   |
| Options vested  or expected to vestat September 30 |       | 724,363                       |       | $                                  | 2.30 to $15.40 |                      | $          | 5.76                      |       | 2.9 years |   |
| Exercisable at  September 30                       |       | 629,983                       |       | $                                  | 2.30 to $15.40 |                      | $          | 4.79                      |       | 5.0 years |   |

 
|                              | ** ** | ** **             | ** ** | ** **              | ** **      | **Weighted** | ** ** |
|------------------------------|------------|------------------------|------------|-------------------------|-----------------|--------------|------------|
| ** **                   | ** ** | **Number of**     | ** ** | ** **              | ** **      | **Average**  | ** ** |
| ** **                   | ** ** | **Stock Options** | ** ** | **Exercise Price** | ** **      | **Exercise** | ** ** |
| **2005**                     | ** ** | **Outstanding**        | ** ** | **Range**               | ** **      | **Price**    | ** ** |
|                         |       |                   |       |                    |            |         |       |
| Outstanding at  January 1    |       | 966,028                |       | $                       | 1.02 to $13.88  |         | $          | 5.22 |   |
| Exercised                    |       | (109,198               | )          | $                       | 1.02 to $7.50   |         | $          | 3.92 |   |
| Granted                      |       | 34,000                 |       | $                       | 13.25 to $13.75 |         | $          | 14.05 |   |
| Cancelled or  expired        |       | (10,000                | )          | $                       | 13.75           |         | $          | 13.75 |   |
|                         |       |                   |       |                    |            |         |       |
| Outstanding at  September 30 |       | 880,830                |       | $                       | 2.30 to $13.75  |         | $          | 5.46 |   |
| Exercisable at  September 30 |       | 759,832                |       | $                       | 2.30 to $13.75  |         | $          | 4.70 |   |

 

8

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The total fairvalue of the shares that vested during the quarter and nine months endedSeptember 30, 2006 was $140,000 and $374,000. The aggregate intrinsic value is calculated as the difference betweenthe exercise price of the underlying awards and the quoted price of theCompany’s common stock for options that were in-the-money at September 30,2006. The intrinsic value of options outstanding, options vested or expected tovest, and exercisable relating to the above stock option plan was $7.84million, $7.79 million and $7.35 million, respectively, as of September 30,2006. During the nine months ended September 30, 2006 and 2005, the aggregateintrinsic value of options exercised relating to the above stock option planwas $1,396,000and $1,083,000, respectively.

As required bySFAS 123 (R), management made an estimate of expected forfeitures and isrecognizing compensation costs only for those equity awards expected to vest.Management has estimated the forfeiture rate to be approximately 2% for theremaining non-vested options.

At September 30,2006, the total compensation cost related to non-vested stock option awardsgranted to employees under the Company’s stock option plans but not yetrecognized was $352,000. Stock option compensation expense is recognized on astraight-line basis over the vesting period of the option. This cost isexpected to be recognized over a weighted average remaining period of 2.3 yearsand will be adjusted for subsequent changes in estimated forfeitures.

## 5.  COMMITMENTS AND CONTINGENCIES

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

In the normal course of business, there are various outstandingcommitments to extend credit which are not reflected in the financialstatements, including loan commitments of $188,837,000 and $200,693,000 and stand-by letters of credit of $6,003,000and $4,895,000 at September 30, 2006 and December 31, 2005, respectively.

Of the loan commitments outstanding at September 30, 2006, $115,261,000are real estate construction loan commitments that are expected to fund withinthe next twelve months. The remaining commitments primarily relate to revolvinglines of credit or other commercial loans, and many of these are expected toexpire without being drawn upon. Therefore, the total commitments do notnecessarily represent future cash requirements. Each loan commitment and theamount and type of collateral obtained, if any, are evaluated on an individualbasis. Collateral held varies, but may include real property, bank deposits,debt or equity securities or business assets.

9

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Stand-by lettersof credit are conditional commitments written to guarantee the performance of acustomer to a third party. These guarantees are primarily related to thepurchases of inventory by commercial customers and are typically short-term innature. Credit risk is similar to that involved in extending loan commitmentsto customers and accordingly, evaluation and collateral requirements similar tothose for loan commitments are used.  Thefair value of the liability related to these stand-by letters of credit, whichrepresents the fees received for issuing the guarantees, was not significant atSeptember 30, 2006 and December 31, 2005. The Company recognizes these fees as revenues over the term of thecommitment or when the commitment is used.

## 6.  NEWACCOUNTING PRONOUNCEMENTS

*Accountingfor Servicing of Financial Assets*

In March 2006, theFinancial Accounting Standards Board (FASB) issued Statement No. 156 (SFAS156),*Accounting for Servicing of FinancialAssets — An Amendment of FASB Statement No. 140.*  SFAS 156 requires that a servicing asset orliability be recognized each time a contract to service a financial asset isentered into, requires that all separately recognized servicing assets andservicing liabilities be initially measured at fair value, if practicable, andpermits the subsequent measurement of servicing assets and servicingliabilities based on the amortization method or the fair value measurementmethod. SFAS 156 also permits a one-time reclassification of available-for-salesecurities to trading securities provided that the available-for-salesecurities are identified in some manner as offsetting the entity’s exposure tochanges in the fair value of servicing assets or servicing liabilities that aservicer elects to are subsequently measured at fair value.

The Company shouldapply the requirements for recognition and initial measurement of servicingassets and servicing liabilities prospectively to all transactions after theeffective date entered into on or after January 1, 2007  SFAS 156 permitsa one-time reclassification of available-for-sale securities to tradingsecurities provided that they are identified in some manner as offsetting theentity’s exposure to changes in fair value of servicing assets or servicingliabilities that a servicer elects to subsequently measure at fair value. Theprovisions of SFAS 156 are effective as of the beginning of the first fiscalyear that begins after September 15, 2006.

*Accountingfor Uncertainty in Income Taxes*

In July 2006, theFASB issued Financial Accounting Standards Interpretation No. 48 (FIN), *Accounting for Uncertainty in Income Taxes. *FIN 48 clarifies the accountingfor uncertainty in income taxes recognized in an enterprise’s financialstatements in accordance with FASB Statement No. 109, *Accountingfor Income Taxes,*Fin 48 prescribes a recognition threshold andmeasurement attributable for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a taxreturn.  FIN 48 also provides guidance onderecognition, classification, interest and penalties, accounting in interimperiods, disclosures and transitions. FIN 48 is effective for fiscal years beginning after December 15, 2006.

*StaffAccounting Bulletin 108: Considering the Effects of Prior Year Misstatements*

On September 13,2006, the Securities and Exchange Commission published Staff AccountingBulleting No. 108 *Considering the Effects ofPrior Year Misstatements when Quantifying Misstatements in Current YearFinancial Statements*.  The interpretations in this StaffAccounting Bulleting are being issued to address diversity in practice inquantifying financial statement misstatements and the potential under currentpractice to build up improper amounts on the balance sheet.  This guidancewill apply to the first fiscal year ending after November 15, 2006 and early applicationin interim periods is encouraged.  We do not believe the adoption of SAB108 will have a material impact on our financial position, results ofoperations or cash flows.

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In September 2006, the FASB ratified the consensus reached by theEmerging Issues Task Force (“EITF”) on Issue No. 06-5, *“Accounting for Purchases of Life Insurance —Determining the Amount That Could Be Realized in Accordance with FASB TechnicalBulletin No. 85-4, Accounting for Purchases of Life Insurance.”* FASB Technical Bulletin No. 85-4 requires that the amount that could berealized under the insurance contract as of the date of the statement offinancial position should be reported as an asset.  Since theissuance of FASB Technical Bulletin No. 85-4, there has been diversity inpractice in the calculation of the amount that could be realized underinsurance contracts.  EITF Issue No. 06-5, which is effectiveJanuary 1, 2008, concludes that the Company should consider any additionalamounts (e.g., cash stabilization reserves and deferred acquisition cost taxes)included in the contractual terms of the insurance policy other than the cashsurrender value in determining the amount that could be realized in accordancewith FASB Technical Bulletin No. 85-4.  The adoption of EITF Issue No.06-5 is not expected to have a material impact on the Company’s results ofoperations and financial condition.

**Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OF COMMUNITY VALLEY BANCORP**

The following isCommunity Valley Bancorp’s (the “Company”) management’s discussion and analysisof the significant changes in balance sheet accounts for September 30, 2006 andDecember 31, 2005 and income and expense accounts for the three and nine monthperiods ended September 30, 2006 and 2005.

The discussion isdesigned to provide a better understanding of significant trends related to theCompany’s financial condition, results of operations, liquidity, capitalresources and interest rate sensitivity.  In addition to the historical information contained herein, this reporton Form 10-Q contains certain forward-looking statements.  The reader of this report should understandthat all such forward-looking statements are subject to various uncertaintiesand risks that could affect their outcome.  The Company’s actual results could differ materially from thosesuggested by such forward-looking statements. Factorsthat could cause or contribute to such differences include, but are not limitedto, variances in the actual versus projected growth in assets, return onassets, loan losses, expenses, rates charged on loans and earned on securitiesinvestments, rates paid on deposits, competition effects, fee and othernoninterest income earned, general economic conditions, nationally, regionallyand in the operating market areas of the Company and its subsidiaries, changesin the regulatory environment, changes in business conditions and inflation,changes in securities markets, data processing problems, a decline inreal estate values in the Company’s market area,  the effects of terrorism,including the events of September 11, 2001 and thereafter, and the conduct ofthe war on terrorism by the United States and its allies, as well as other factors. Thisentire report should be read putting such forward-looking statements incontext.

## **General Development of Business**

The Company is afinancial holding company (“FHC”) registered and authorized to engage in theactivities permitted under the Bank Holding Company Act of 1956, as amended.The Company was incorporated under the laws of the State of California in 2002and elected to change to a FHC in 2004.   As a financial holding company, the Company is subject to the FederalHolding Company Act and to supervision by the board of Governors of the FederalReserve System (“FRB”).** **Its principal office is located at2041 Forest Avenue, Chico, California 95928 and its telephone number is (530)899-2344.

The Company owns100% of the issued and outstanding common shares of Butte Community Bank.  Butte Community Bank was incorporated andcommenced business in Paradise and Oroville, California in 1990.  Butte Community Bank operates thirteen fullservice offices within its primary service areas of Butte, Sutter, Yuba,Tehama, and Shasta Counties.  The Bankalso maintains Loan Production Offices in Citrus Heights and Gridley. ButteCommunity Bank’s primary business is serving the commercial banking needs ofsmall to mid-sized businesses and consumers within those counties.  Butte Community Bank accepts checking andsavings deposits, offers money market deposit accounts and certificates ofdeposit, makes secured and unsecured commercial, secured real estate, and otherinstallment and term loans and offers other customary banking services.

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On December 19,2002, the Company formed a wholly-owned unconsolidated subsidiary, CommunityValley Bancorp Trust I (the “Trust”), a Delaware statutory business trust, forthe purpose of issuing trust preferred securities.

On December 1,2004, the Company formed a wholly-owned subsidiary, CVB Insurance Agency LLCfor the purpose of providing insurance related services. The name was changedto Butte Community Insurance Agency LLC in April, 2006.

**CriticalAccounting Policies**

*General*

The Company’ssignificant accounting principles are described in Note 1 of the consolidatedfinancial statements in the Company’s 2005 Annual Report to Shareholders onForm 10-K and are essential to understanding Management’s Discussion andAnalysis of Results of Operations and Financial Condition. Community ValleyBancorp’s annual consolidated financial statements are prepared in accordancewith accounting principles generally accepted in the United States of America(GAAP). The financial information contained within our statements is, to asignificant extent, financial information that is based on measures of thefinancial effects of transactions and events that have already occurred. Someof the Company’s accounting principles require significant judgment to estimatevalues of assets or liabilities. In addition, certain accounting principlesrequire significant judgment in applying the complex accounting principles totransactions to determine the most appropriate treatment. The following is asummary of the more judgmental and complex accounting estimates and principles.

*Allowancefor Loan Losses (ALL)*

The allowance forloan losses is management’s best estimate of the probable losses that may besustained in our loan portfolio. The allowance is based on two basic principlesof accounting:  (1) SFAS No.5 which requires that losses be accruedwhen they are probable of occurring and estimable and (2) SFAS No. 114,which requires that losses be accrued on impaired loans based on thedifferences between the value of collateral, present value of future cash flowsor values that are observable in the secondary market and the loan balance.

The Companyperforms periodic and systematic detailed evaluations of its lending portfolioto identify and estimate the inherent risks and assess the overall collectibility.These evaluations include general conditions such as the portfolio composition,size and maturities of various segmented portions of the portfolio such assecured, unsecured, construction, and Small Business Administration (“SBA”).

Additional factorsinclude concentrations of borrowers, industries, geographical sectors, loanproduct, loan classes and collateral types, volume and trends of loandelinquencies and non-accrual, criticized and classified assets and trends inthe aggregate in significant credits identified as watch list items. There areseveral components to the determination of the adequacy of the ALL. Each ofthese components is determined based upon estimates that can and do change whenthe actual events occur. The Company estimates the SFAS No. 5 portion ofthe ALL based on the segmentation of its portfolio. For those segments thatrequire an ALL, the Company estimates loan losses on a monthly basis based uponits ongoing loan review process and analysis of loan performance. The Companyfollows a systematic and consistently applied approach to select the mostappropriate loss measurement methods and support its conclusions and rationalewith written documentation. One method of estimating loan losses for groups ofloans is through the application of loss rates to the groups’ aggregate loanbalances. Such rates typically reflect historical loss experience for eachgroup of loans, adjusted for relevant economic factors over a defined period oftime. The Company evaluates and modifies its loss estimation model as needed toensure that the resulting loss estimate is consistent with GAAP.

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For individuallyimpaired loans, SFAS No. 114 provides guidance on the acceptable methodsto measure impairment. Specifically, SFAS No. 114 states that when a loanis impaired, the Company should measure impairment based on the present valueof expected future principal and interest cash flows discounted at the loan’seffective interest rate, except that as a practical expedient, a creditor maymeasure impairment based on a loan’s observable market price or the fair valueof collateral, if the loan is collateral dependent. When developing theestimate of future cash flows for a loan, the Company considers all availableinformation reflecting past events and current conditions, including the effectof existing environmental factors.

*LoanSales and Servicing*

The Companyoriginates government guaranteed loans and mortgage loans that may be sold inthe secondary market.  The amounts of gains recorded on sales of loans andthe initial recording of servicing assets and interest only (I/O) strips isbased on the estimated fair values of the respective components.  Inrecording the initial value of the servicing assets and the fair value of theI/O strips receivable, the Company uses estimates which are based onmanagement’s expectations of future prepayments and discount rates. Servicing assets are amortized over the estimated life of the relatedloan.  I/O strips are not significant at September 30, 2006.  Theseprepayment and discount rates were based on current market conditions andhistorical performance of the various pools of serviced loans.  If actualprepayments with respect to sold loans occur more quickly than projected thecarrying value of the servicing assets may have to be adjusted through a chargeto earnings.

*Stock-BasedCompensation*

On January 1,2006, the Company adopted Statement of Financial Accounting Standards No.123(R),*Share Based Payment*(“SFAS 123(R)”) using the modified prospective transition method.

Prior periods havenot been restated to reflect the impact of SFAS No. 123(R). Prior to adoptionof this statement, the Company accounted for its share-based employeecompensation plans under the recognition and measurement provisions of APB OpinionNo. 25, Accounting *for Stock-BasedCompensation*  and nostock-based compensation expense was recorded*..*  As a result of adoptingthis statement the Company will recognize stock-based compensation expense forall preexisting non-vested stock options and all new stock option grants thatare expected to vest as the requisite service is rendered. See Note 4 to theCondensed Consolidated Financial Statements for additional information relatedto implementation of SFAS 123(R).

*Revenuerecognition*

The Company’sprimary source of revenue is interest income, which is the difference betweenthe interest income it receives on interest-earning assets and the interestexpense it pays on interest-bearing liabilities, and (ii) fee income,which includes fees earned on deposit services, income from SBA lending,electronic-based cash management services, mortgage brokerage fee income andmerchant credit card processing services. Interest income is recorded on anaccrual basis. Note 1 to the Consolidated Financial Statements in the Company’s2005 Annual Report to Shareholders on Form 10-K offers an explanation of theprocess for determining when the accrual of interest income is discontinued onan impaired loan.

*IncomeTaxes*

The Companyaccounts for income taxes under the asset and liability method. Under the assetand liability method, deferred tax assets and liabilities are recognized forthe future tax consequences attributable to differences between the financialstatement carrying amounts of existing assets and liabilities and theirrespective tax bases. Deferred tax assets and liabilities are measured usingcurrently enacted tax rates applied to such taxable income in the years inwhich those temporary differences are expected to be recovered or settled. Theeffect on deferred tax assets and liabilities of a change in tax rates isrecognized in income in the period that includes the enactment date. If futureincome should prove non-existent or less than the amount of deferred tax assetswithin the tax years to which they may be applied, the asset may not berealized and our net income will be reduced.

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**Overview**

The Company recorded net income of $1,733,000 for the quarter ended September 30, 2006, which was a decrease of 19.7% from the $2,159,000 reported for the same period of 2005.  Diluted earnings per share for the third quarter of 2006 were $0.23, compared to the $0.28 recorded in the third quarter of 2005.  The annualized return on average equity (ROAE) and return on average assets (ROA) for the third quarter of 2006 were 14.98% and 1.31%, respectively, as compared to 21.82% and 1.73%, respectively, for the same period in 2005.  During the third quarter of 2005 the Company recognized substantial gains from the sale of loans into the secondary market through our Government Lending and Real Estate divisions.   These gains were $590,000 less during the current quarter but were partially offset by an increase of $120,000 in service charge income.

Net income for the nine months ended September 30, 2006 was $5,592,000 (up 4.7%) compared to the $5,343,000 recorded in the first nine months of 2005.   Diluted earnings per share for the first nine months of 2006 were $0.73, compared to the $0.70 recorded in the same period of 2005.  The annualized ROAE and ROA for the first nine months of 2006 were 16.86% and 1.46%, respectively, as compared to 19.14% and 1.52%, respectively, for the same period in 2005. The primary reasons for the increase in net income for the first nine months of 2006 was the growth in the net interest margin, as a result of the overall positive effect of the rising interest rate environment, and in the growth in earning assets the Company experienced. As a result the increase in net interest income of $3,961,000 was partially offset by decreases in non-interest income of $347,000 and increases in non-interest expenses of $2,905,000.

Total assets of the Company increased by $36,644,000 or (7.4%) from December 31, 2005 to $531,421,000 at September 30, 2006.  Net loans totaled $463,397,000, up $59,979,000 (14.9%) from the ending balances on December 31, 2005.  Deposit balances at September 30, 2006 totaled $466,431,000, up $32,413,000 (7.5%) from December 31, 2005.

Table One below provides a summary of the components of net income for the periods indicated:

**Table One:  Components of Net Income**
| ** **                                                       | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** |
|------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                       | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| **(In thousands, except percentages)**            | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                             |       |                             |       |                            |       |   |   |   |   |
| Net interest  income                                             |       | $                                | 8,109      |                            | $          | 7,178 |   | $ | 23,551 |   | $ | 19,590 |   |
| Provision for  loan losses                                       |       | (225                             | )          | (225                            | )          | (675 | ) | (675 | ) |
| Non-interest  income                                             |       | 1,523                            |       | 1,966                           |       | 4,884 |   | 5,231 |   |
| Non-interest  expense                                            |       | (6,270                           | )          | (5,355                          | )          | (18,065 | ) | (15,160 | ) |
| Provision for  income taxes                                      |       | (1,404                           | )          | (1,405                          | )          | (4,103 | ) | (3,643 | ) |
|                                                             |       |                             |       |                            |       |   |   |   |   |
| Net income                                                       |       | $                                | 1,733      |                            | $          | 2,159 |   | $ | 5,592 |   | $ | 5,343 |   |
|                                                             |       |                             |       |                            |       |   |   |   |   |
| Average total  assets (In millions)                              |       | $                                | 523.4      |                            | $          | 495.1 |   | $ | 512.6 |   | $ | 470.3 |   |
|                                                             |       |                             |       |                            |       |   |   |   |   |
| Net income (annualized)  as a percentage of average total assets |       | 1.31                             | %          | 1.73                            | %          | 1.46 | % | 1.52 | % |

 

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**Resultsof Operations**

## **Net Interest Income and Net Interest Margin**

Net interestincome represents the excess of interest and fees earned on interest earningassets (loans, securities, federal funds sold and investments in time deposits)over the interest paid on deposits and borrowed funds.  Net interest margin is net interest incomeexpressed as a percentage of average earning assets.

The Company’s netinterest margin was 6.74% for the three months ended September 30, 2006 and6.75% for the nine month period ending September 30, 2006 up from 6.45% and 6.22%for the same periods in the prior year. Net interest income increased $931,000 (13.0%) for the third quarter of2006 compared to the same period in 2005. Net interest income increased $3,961,000 (20.2%) for the nine monthsended September 30, 2006 over the same period in 2005.  The primary reason for this increase was thegrowth in average loans of $53,794,000 and 65,820,000 for the third quarter andfirst nine months of 2006 over the same periods in 2005 along with the overallpositive impact of the rising interest rate environment.

The averagebalances of interest bearing liabilities were $39,506,000 (11.4%) higher in thethird quarter of 2006 versus the same quarter in 2005. Rates paid on theseliabilities also increased 106 basis points on a quarter over quarterbasis.  As a result, interest expense was$1,115,000 (90.6%) higher in the third quarter of 2006 versus the prior yearperiod.  The average balances of interestbearing liabilities were $40,475,000 (12.1%) higher in the nine-month periodended September 30, 2006 versus the same period in 2005.  Rates paid on interest bearing liabilitiesincreased 83 basis points compared to the nine month period ended September 30,2005.  As a result, interest expense was$2,782,000 (74.7%) higher in the first nine months of 2006 versus the sameperiod in the prior year. Management expects to see an increase in interestexpense for the remainder of this year due in part to a rising interest rateenvironment and increasing levels of deposits at higher rates as a fundingsource for loan growth.

Table Two,Analysis of Net Interest Margin, and Table Three, Analysis of Volume and RateChanges on Net Interest Income and Expenses, are provided to enable the readerto understand the components and past trends of the Company’s interest incomeand expense.  Table Two provides ananalysis of net interest margin setting forth average assets, liabilities andshareholders’ equity; interest income earned and interest expense paid and averagerates earned and paid; and the net interest margin.

15

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**TableTwo:  Analysis of Net Interest Margin**
| ** **                                                                                                  | ** ** | **2006**         | ** ** | **2005**     | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|------------------|------------|--------------|------------|
| **Three Months Ended September 30,  (In thousands, except percentages)** | ** ** | **Avg  Balance** | ** ** | **Interest** | ** ** | **Avg  Yield (4)** | ** ** | **Avg  Balance** | ** ** | **Interest** | ** ** | **Avg  Yield (4)** | ** ** |
| **Assets:**                                                                                                 |       |             |       |         |       |   |   |   |   |   |   |   |   |
| Earning assets                                                                                              |       |             |       |         |       |   |   |   |   |   |   |   |   |
| Loans (1)                                                                                                   |       | $                | 455,586    |         | $          | 10,414 |   | 9.17 | % | $ | 405,419 |   | $ | 8,273 |   | 8.10 | % |
| Taxable investment securities                                                                               |       | 3,860            |       | 37           |       | 3.84 | % | 5,640 |   | 46 |   | 3.24 | % |
| Tax-exempt investment securities (2)                                                                        |       | 1,349            |       | 17           |       | 5.05 | % | 2,372 |   | 27 |   | 4.52 | % |
| Federal funds sold                                                                                          |       | 12,510           |       | 166          |       | 5.32 | % | 20,287 |   | 177 |   | 3.46 | % |
| Interest bearing deposits in banks                                                                          |       | 3,783            |       | 36           |       | 3.82 | % | 7,751 |   | 60 |   | 3.07 | % |
| Total earning  assets                                                                                       |       | 477,088          |       | $            | 10,670     |   | 8.97 | % | 441,470 |   | $ | 8,583 |   | 7.71 | % |
| Cash & due  from banks                                                                                  |       | 18,109           |       |         |       |   |   | 18,829 |   |   |   |   |   |
| Other assets                                                                                                |       | 28,213           |       |         |       |   |   | 34,759 |   |   |   |   |   |
| Average total  assets                                                                                       |       | $                | 523,410    |         |       |   |   |   | $ | 495,058 |   |   |   |   |   |
|                                                                                                        |       |             |       |         |       |   |   |   |   |   |   |   |   |
| **Liabilities  & Shareholders’ Equity**                                                            | ** ** | ** **       | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest bearing  liabilities:                                                                              |       |             |       |         |       |   |   |   |   |   |   |   |   |
| NOW & MMDA                                                                                              |       | $                | 170,598    |         | $          | 446 |   | 1.05 | % | $ | 183,817 |   | $ | 322 |   | 0.69 | % |
| Savings                                                                                                     |       | 33,934           |       | 42           |       | 0.50 | % | 38,587 |   | 49 |   | 0.50 | % |
| Time deposits                                                                                               |       | 171,120          |       | 1,858        |       | 4.36 | % | 113,202 |   | 860 |   | 3.01 | % |
| Other borrowings                                                                                            |       | 9,367            |       | 215          |       | 9.21 | % | 9,907 |   | 174 |   | 6.97 | % |
| Total interest  bearing liabilities                                                                         |       | 385,019          |       | $            | 2,561      |   | 2.67 | % | 345,513 |   | $ | 1,405 |   |   |   |
| Demand deposits                                                                                             |       | 87,974           |       |         |       |   |   | 97,123 |   |   |   |   |   |
| Other  liabilities                                                                                          |       | 4,521            |       |         |       |   |   | 13,169 |   |   |   |   |   |
| Total  liabilities                                                                                          |       | 477,514          |       |         |       |   |   | 455,805 |   |   |   |   |   |
| Shareholders’  equity                                                                                  |       | 45,896           |       |         |       |   |   | 39,253 |   |   |   |   |   |
| Average  liabilities and equity                                                                             |       | $                | 523,410    |         |       |   |   |   | $ | 495,058 |   |   |   |   |   |
|                                                                                                        |       |             |       |         |       |   |   |   |   |   |   |   |   |
| Net interest income  & margin (3)                                                                       |       | 477,088          |       | 8,109        |       | 6.74 | % | 441,470 |   | $ | 7,178 |   | 6.45 | % |

 

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(1)                   Loan interestincludes loan fees of $664,000 and $636,000 during the three months endedSeptember 30, 2006 and September 30, 2005 respectively.

(2)                   Does notinclude taxable-equivalent adjustments that primarily relate to income oncertain securities that are exempt from federal income taxes.

(3)                   Net interestmargin is computed by dividing net interest income by total average earningassets.

(4)                   Average yieldis calculated based on actual days in quarter (92 for September 30, 2006 andSeptember 30, 2005) and annualized to actual days in year (365 for 2006 and2005).

16

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| ** **                                                                                                 | ** ** | **2006**         | ** ** | **2005**     | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|------------------|------------|--------------|------------|
| **Nine Months Ended September 30,  (In thousands, except percentages)** | ** ** | **Avg  Balance** | ** ** | **Interest** | ** ** | **Avg  Yield (4)** | ** ** | **Avg  Balance** | ** ** | **Interest** | ** ** | **Avg  Yield (4)** | ** ** |
| **Assets:**                                                                                                |       |             |       |         |       |   |   |   |   |   |   |   |   |
| Earning assets                                                                                             |       |             |       |         |       |   |   |   |   |   |   |   |   |
| Loans (1)                                                                                                  |       | $                | 440,858    |         | $          | 29,203 |   | 8.86 | % | $ | 374,231 |   | $ | 22,252 |   | 7.94 | % |
| Taxable investment securities                                                                              |       | 4,607            |       | 139          |       | 4.03 | % | 5,771 |   | 147 |   | 3.40 | % |
| Tax-exempt investment securities (2)                                                                       |       | 1,369            |       | 49           |       | 4.79 | % | 2,281 |   | 83 |   | 4.85 | % |
| Federal funds sold                                                                                         |       | 14,697           |       | 521          |       | 4.74 | % | 30,066 |   | 642 |   | 2.85 | % |
| Interest bearing deposits in banks                                                                         |       | 4,788            |       | 143          |       | 3.99 | % | 8,410 |   | 188 |   | 2.99 | % |
| Total earning  assets                                                                                      |       | 466,319          |       | $            | 30,055     |   | 8.62 | % | 420,759 |   | 23,312 |   | 7.38 | % |
| Cash & due from  banks                                                                                 |       | 17,134           |       |         |       |   |   | 21,692 |   |   |   |   |   |
| Other assets                                                                                               |       | 29,167           |       |         |       |   |   | 27,821 |   |   |   |   |   |
| Average total  assets                                                                                      |       | $                | 512,620    |         |       |   |   |   | $ | 470,272 |   |   |   |   |   |
|                                                                                                       |       |             |       |         |       |   |   |   |   |   |   |   |   |
| **Liabilities  & Shareholders’ Equity**                                                           | ** ** | ** **       | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest bearing  liabilities:                                                                             |       |             |       |         |       |   |   |   |   |   |   |   |   |
| NOW & MMDA                                                                                             |       | $                | 178,563    |         | 1,308      |   | 0.98 | % | $ | 181,894 |   | 858 |   | 0.63 | % |
| Savings                                                                                                    |       | 35,470           |       | 130          |       | 0.49 | % | 36,624 |   | 135 |   | 0.49 | % |
| Time deposits                                                                                              |       | 150,388          |       | 4,462        |       | 3.97 | % | 105,296 |   | 2,255 |   | 2.87 | % |
| Other borrowings                                                                                           |       | 9,287            |       | 604          |       | 8.70 | % | 9,419 |   | 474 |   | 6.75 | % |
| Total interest  bearing liabilities                                                                        |       | 373,708          |       | 6,504        |       | 2.33 | % | 333,233 |   | 3,722 |   | 1.50 | % |
| Demand deposits                                                                                            |       | 88,489           |       |         |       |   |   | 90,493 |   |   |   |   |   |
| Other  liabilities                                                                                         |       | 6,067            |       |         |       |   |   | 9,214 |   |   |   |   |   |
| Total  liabilities                                                                                         |       | 468,264          |       |         |       |   |   | 432,940 |   |   |   |   |   |
| Shareholders’  equity                                                                                 |       | 44,356           |       |         |       |   |   | 37,332 |   |   |   |   |   |
| Average  liabilities and equity                                                                            |       | $                | 512,620    |         |       |   |   |   | $ | 470,272 |   |   |   |   |   |
|                                                                                                       |       |             |       |         |       |   |   |   |   |   |   |   |   |
| Net interest income  & margin (3)                                                                      |       | 466,319          |       | 23,551       |       | 6.75 | % | 420,759 |   | 19,590 |   | 6.22 | % |
|                                                                                                            |            |                  |            |              |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1)                   Loan interestincludes loan fees of $1,909,000 and $1,826,000 during the nine months endedSeptember 30, 2006 and September 30, 2004, respectively.

(2)                   Does notinclude taxable-equivalent adjustments that primarily relate to income oncertain securities that is exempt from federal income taxes.

(3)                   Net interestmargin is computed by dividing net interest income by total average earningassets.

(4)                   Average yieldis calculated based on actual days in period (273 for September 30, 2006 andSeptember 30, 2005) and annualized to actual days in year (365 for 2006 and2005).

 

17

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TableThree sets forth a summary of the changes in interest income and interestexpense from changes in average asset and liability balances (volume) andchanges in average interest rates.  On aquarter over quarter basis for the period ending September 30, 2006 netinterest income has increased $931,000 over the same time period in 2005.  Interest income from earning assets hasincreased by $2,087,000. Changes in the volume of earning assets, primarilyloans, have resulted in an increase in interest income of $899,000 whileinterest income from changes in rates has increased by $1,188,000.  Interest expense for the third quarter of2006 was $1,156,000 more than the same time period in 2005.  Changes in the volume of interest bearingliabilities, primarily the increase in balances of time deposits, has resultedin a net increase of interest expense of $401,000.  Increases in average rates paid, primarily onNOW and Money Market accounts, time deposits and junior subordinated debentureshave resulted in an interest expense increase of $755,000.  On a year-to-date basis through September 30,2006, net interest income has increased $3,961,000 over the same time period in2005.  Interest income from earningassets has increased by $6,743,000. Changes in the volume of earning assets, primarily loans, have resultedin an increase in interest income of $3,476,000 while interest income fromchanges in rates has increased by $3,267,000. Interest expense for the nine month period was $2,782,000 more than thesame time period in 2005.  Changes in thevolume of interest bearing liabilities, primarily the increase in balances oftime deposits, have resulted in a net increase in interest expense of $942,000.  Increases in average rates paid, primarily onNOW and Money Market accounts, time deposits and junior subordinated debentureshave resulted in an interest expense increase of $1,840,000.

**Table Three:  Analysis of Volume and Rate Changes on NetInterest Income and Expenses**

(In thousands) Three Months Ended September 30, 2006over 2005

Increase(decrease) due to change in:
|                                      | ** ** | **Volume** | ** ** | **Rate (3)** | ** ** | **Net Change** | ** ** |
|--------------------------------------|------------|------------|------------|-------------------|------------|---------------------|------------|
| Interest-earning  assets:            |       |       |       |              |       |                |       |
| Net loans (1)                        |       | $          | 1,024      |              | $          | 1,117               |       | $ | 2,141 |   |
| Taxable investment securities        |       | (15        | )          | 6                 |       | (9                  | )          |
| Tax exempt investment securities (2) |       | (12        | )          | 2                 |       | (10                 | )          |
| Federal funds sold                   |       | (68        | )          | 57                |       | (11                 | )          |
| Interest bearing deposits in banks   |       | (31        | )          | 7                 |       | (24                 | )          |
| Total                                |       | 899        |       | 1,188             |       | 2,087               |       |
|                                 |       |       |       |              |       |                |       |
| Interest-bearing  liabilities:       |       |       |       |              |       |                |       |
| NOW & MMDA                       |       | (23        | )          | 147               |       | 124                 |       |
| Savings deposits                     |       | (6         | )          | (1                | )          | (7                  | )          |
| Time deposits                        |       | 440        |       | 558               |       | 998                 |       |
| Other borrowings                     |       | (9         | )          | 50                |       | 41                  |       |
| Total                                |       | 401        |       | 755               |       | 1,156               |       |
| Interest differential                |       | $          | 498        |              | $          | 433                 |       | $ | 931 |   |

 

----

(1)   Theaverage balance of non-accruing loans is immaterial as a percentage of totalloans and, as such, has been included in net loans.

(2)   Doesnot include taxable-equivalent adjustments that primarily relate to income oncertain securities that is exempt from federal income taxes.

(3)   Therate/volume variance has been included in the rate variance.

18

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**Table Three:  Analysis of Volume and Rate Changes on NetInterest Income and Expenses**

(In thousands) Nine Months Ended September 30, 2006over 2005

Increase(decrease) due to change in:
|                                      | ** ** | **Volume** | ** ** | **Rate (3)** | ** ** | **Net Change** | ** ** |
|--------------------------------------|------------|------------|------------|-------------------|------------|---------------------|------------|
| Interest-earning  assets:            |       |       |       |              |       |                |       |
| Net loans (1)                        |       | $          | 3,947      |              | $          | 3,004               |       | $ | 6,951 |   |
| Taxable investment securities        |       | (30        | )          | 22                |       | (8                  | )          |
| Tax exempt investment securities (2) |       | (33        | )          | (1                | )          | (34                 | )          |
| Federal funds sold                   |       | (327       | )          | 206               |       | (121                | )          |
| Investment in time deposits          |       | (81        | )          | 36                |       | (45                 | )          |
| Total                                |       | 3,476      |       | 3,267             |       | 6,743               |       |
|                                 |       |       |       |              |       |                |       |
| Interest-bearing  liabilities:       |       |       |       |              |       |                |       |
| Demand deposits                      |       | (16        | )          | 466               |       | 450                 |       |
| Savings deposits                     |       | (4         | )          | (1                | )          | (5                  | )          |
| Time deposits                        |       | 968        |       | 1,239             |       | 2,207               |       |
| Other borrowings                     |       | (7         | )          | 137               |       | 130                 |       |
| Total                                |       | 941        |       | 1,841             |       | 2,782               |       |
| Interest differential                |       | $          | 2,535      |              | $          | 1,426               |       | $ | 3,961 |   |

 

----

(1)          The average balance ofnon-accruing loans is immaterial as a percentage of total loans and, as such,has been included in net loans.

(2)          Does not includetaxable-equivalent adjustments that primarily relate to income on certainsecurities that is exempt from federal income taxes.

(3)          The rate/volume variancehas been included in the rate variance.

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## **Non-interestIncome**

Table Four belowprovides a summary of the components of noninterest income for the periodsindicated (dollars in thousands) (percent of assets annualized):

**Table Four: Components of Noninterest Income**

Three Months Ended September30,     
|                                      | ** ** | ** ** | ** ** | **% of Avg** | ** ** | ** ** | ** ** | **% of Avg.** | ** ** |
|--------------------------------------|------------|------------|------------|------------------------|------------|------------|------------|-------------------------|------------|
| ** **                           | ** ** | **2006**   | ** ** | **Assets**             | ** ** | **2005**   | ** ** | **Assets**              | ** ** |
|                                 |       |       |       |                   |       |       |       |                    |       |
| Service charges  on deposit accounts |       | $          | 726        |                   | 0.55       | %          | $          | 606                     |       | 0.49 | % |
| Loan servicing  fees                 |       | 104        |       | 0.08                   | %          | 110        |       | 0.09                    | %          |
| Fees -  alternative investment sales |       | 80         |       | 0.06                   | %          | 91         |       | 0.07                    | %          |
| Merchant fee  income                 |       | 101        |       | 0.08                   | %          | 101        |       | 0.08                    | %          |
| Gain on the sale  of loans           |       | 180        |       | 0.14                   | %          | 770        |       | 0.62                    | %          |
| Other                                |       | 332        |       | 0.25                   | %          | 288        |       | 0.23                    | %          |
|                                 |       |       |       |                   |       |       |       |                    |       |
| Total  non-interest income           |       | $          | 1,523      |                   | 1.16       | %          | $          | 1,966                   |       | 1.58 | % |

 

NineMonths Ended September 30, 
|                                      | ** ** | ** ** | ** ** | **% of Avg** | ** ** | ** ** | ** ** | **% of Avg.** | ** ** |
|--------------------------------------|------------|------------|------------|------------------------|------------|------------|------------|-------------------------|------------|
| ** **                           | ** ** | **2006**   | ** ** | **Assets**             | ** ** | **2005**   | ** ** | **Assets**              | ** ** |
|                                 |       |       |       |                   |       |       |       |                    |       |
| Service charges  on deposit accounts |       | $          | 1,983      |                   | 0.39       | %          | $          | 1,749                   |       | 0.42 | % |
| Loan servicing  fees                 |       | 315        |       | 0.06                   | %          | 310        |       | 0.07                    | %          |
| Fees -  alternative investment sales |       | 235        |       | 0.05                   | %          | 426        |       | 0.10                    | %          |
| Merchant fee  income                 |       | 288        |       | 0.06                   | %          | 287        |       | 0.07                    | %          |
| Gain on the sale  of loans           |       | 1,112      |       | 0.22                   | %          | 1,584      |       | 0.38                    | %          |
| Other                                |       | 951        |       | 0.19                   | %          | 875        |       | 0.21                    | %          |
|                                 |       |       |       |                   |       |       |       |                    |       |
| Total  non-interest income           |       | $          | 4,884      |                   | 0.95       | %          | $          | 5,231                   |       | 1.25 | % |

 

Non-interest incomedeclined $443,000 (29.1%) to $1,523,000 for the three months ended September30, 2006 as compared to $1,523,000 for the three months ended September 30,2005.    Increases in non-interest incomewere realized in fees from service charges (up 19.8%) and other (up15.3%).  Decreases in non-interest incomewere in loan servicing fees (down 5.5%), fees from alternative investment sales(down 13.8%), gain on sale of loans (down 328%).  There was no change in merchant processingfees. The increase in service charge income was the result of additionaldeposit accounts opened during the third quarter and fees resulting from theoverdraft privilege deposit product. Increases in the Other category were a result of increased fees from ATMtransactions, commissions earned on the sales of insurance policies and feespaid for payroll processing through our Business Services Division.  Loan servicing fees were down slightly as theportfolio of serviced loans in our Government Lending and Real Estate LoanDepartments decreased.

20

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The InvestmentDepartment, which sells third-party mutual funds and annuities, experienced adecrease in fees due to fewer sales during the third quarter.  The gain on sale of loans had the largestdecrease of the non-interest income items as the level of government guaranteedloans sold into the secondary market slowed and real estate loans sold into thesecondary market decreased as refinancing activity slowed.  Merchant fee income was unchanged from thethird quarter of 2005.

Forthe nine months ended September 30, 2006, non-interest income was down $347,000(7.1%) to $4,884,000 as compared to the $5,231,000 total for the nine monthsended September 30, 2005.   All of thecomponents of non-interest income showed gains except fees from alternativeinvestment sales and gains received on the sale of loans.  Increases were realized in service charges ondeposit accounts (up 13.4%) as more demand deposit accounts were opened, loanservicing (up 1.6%), merchant fee income (up .35%) and other (up 8.7%) fromincreases in wire transfer fees, safe deposit rent, commissions on insurancepolicy sales and ATM access fees. Decreases in non-interest income wererealized from alternative investment sales (down 81.3%) as fewer non-depositinvestment products were sold and gains on sale of loans (down 42.4%) as fewerloans were sold into the secondary market.

**Non-interest Expense**

Non-interest expense increased $915,000 (17.1%) to$6,270,000 in the third quarter of 2006 versus $5,355,000 in the third quarterof 2005.    Salary and employee benefitsincreased $708,000 (22.9%) resulting from normal cost of living raises,commissions paid and staffing additions made during the year as the Companycontinues to grow. Benefit costs and employer taxes increased commensurate withthe salaries.    On a quarter overquarter basis, occupancy expenses were higher by $67,000 (20.6%) which isrelated to building depreciation, utilities, janitorial services and propertytaxes.   Furniture and equipment expensewas $483,000 in the third quarter of 2006 compared to $465,000 in the sameperiod of 2005, representing a 3.9% increase.  This increase relates to the depreciation recorded on the purchase ofnew technology software and hardware as well as additional furniture andfixtures as the Red Bluff and Redding branches have been relocated to largerfacilities. Other expenses increased $122,000 (8.3%) in the third quarter of2006 versus the third quarter of 2005.  This increase was attributed to higher telephone, postage and insurancecosts as well as increased advertising and promotion costs associated with thenew offices.

Non-interest expense for the nine month period endedSeptember 30, 2006 increased $2,905,000 (19.2%) to $18,065,000 versus$15,160,000 for the same period in 2005. Salaries and benefits increased by $2,372,000 (26.6%) due to cost ofliving raises added benefit costs and employer taxes along with the staffingadditions made during the year as the Company continues to grow. On a year overyear basis, full time equivalent employees increased by 20 to 250.   Occupancy expense was up $148,000 (16.7%)from the first nine months of 2005 to the first nine months of 2006 which isrelated to building depreciation, utilities, janitorial services and propertytaxes as the Red Bluff and Redding branches have been relocated to larger moreexpensive quarters.  Furniture andequipment expense was up 129,000 (10.0%) which is also related to the relocationof the two branches mentioned above.   Other expenses increased by $256,000 (6.3%).   This increase was attributed to highertelephone, postage and insurance costs as well as increased advertising andpromotion costs associated with the new offices.

## **Provision for Loan Losses**

The Company provided $225,000 for loan losses for thethird quarter of 2006 which was the same amount as the third quarter of2005.  Net loan charge-offs for the threemonths ended September 30, 2006 were $36,000 as compared to $2,000 in netcharge-offs for the three months ended September 30, 2005.   For the first nine months of 2006, theCompany made provisions for loan losses of $675,000 which was the same as theprovision for the first nine months of 2005. Net loan charge-offs for the nine months ended September 30, 2006 were$45,000 as compared to net charge-offs of $9,000 for the nine months endedSeptember 30, 2005.  Management assessesits loan quality on a monthly basis to maintain an adequate allowance for loanlosses.  The Company’s loan portfoliocomposition, non-performing assets and allowance for loan losses are furtherdiscussed under the Balance Sheet Analysis section below.

21

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**Provision for Income Taxes**

The effective tax rate for the third quarter and firstnine months of 2006 was 44.8% and 42.3%, versus 39.4% and 40.5%, for the sameperiod in 2005.

**Balance Sheet Analysis**

The Company’s total assets were $531,421,000 atSeptember 30, 2006 as compared to $494,777,000 at December 31, 2005,representing an increase of 7.4%.  Theaverage balance of total assets for the nine months ended September 30, 2006was $512,620,000, which represents an increase of $42,348,000 (9.0%) over the$470,272,000 for the nine-month period ended September 30, 2005.

## **Loans**

The Company concentrates its lending activities in thefollowing principal areas: 1) commercial; 2) real estate; 3) residential realestate and real estate construction (both commercial and residential); 4)agriculture; and 5) consumer loans. Commercial and residential real estate loans are generally secured byimproved property, with original maturities of 3-10 years.  At September 30, 2006, these principal areasaccounted for approximately 15%, 43%, 25%, 8% and 9%, respectively, of theCompany’s loan portfolio.    The mix atDecember 31, 2005 was 15%, 43%, 27%, 6% and 9%.    Continuing strong economic activity in theCompany’s market area, new borrowers developed through the Company’s marketingefforts and credit extensions expanded to existing borrowers, offset by normalloan pay-downs and payoffs, resulted in net increases in loan balances forcommercial loans ($6,869,000 or 11.0%), residential real estate ($29,427,000 or17.0%), real estate construction ($6,995,000 or 6.3%), agricultural loans($10,145,000 or 40.9%) and consumer ($7,317,000 or 20.0%).  These changes in real estate lending areconsistent with the Company’s history of increased real estate activity duringthe summer months.  Table Five belowsummarizes the composition of the loan portfolio as of September 30, 2006 andDecember 31, 2005.

**Table Five: Loan PortfolioComposition**
|                            | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------------|------------|------------------------|------------|-----------------------|------------|
| **(In thousands)**    | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| Commercial                 |       | $                      | 68,031     |                  | $          | 61,162 |   |
| Real estate:               |       |                   |       |                  |       |
| Mortgage                   |       | 202,876                |       | 173,449               |       |
| Construction               |       | 118,125                |       | 111,130               |       |
|                       |       |                   |       |                  |       |
| Agriculture                |       | 34,948                 |       | 24,803                |       |
| Consumer                   |       | 43,818                 |       | 36,501                |       |
| Total loans                |       | 467,798                |       | 407,045               |       |
| Allowance for  loan losses |       | (5,368                 | )          | (4,716                | )          |
| Deferred loan  fees, net   |       | (932                   | )          | (1,108                | )          |
| Total net loans            |       | $                      | 461,498    |                  | $          | 401,221 |   |

 

Themajority of the Company’s loans are direct loans made to individuals and localbusinesses.  The Company reliessubstantially on local promotional activity and personal contacts by bankofficers, directors and employees to compete with other financialinstitutions.  The Company makes loans toborrowers whose applications include a sound purpose and a viable primaryrepayment source, generally supported by a secondary source of repayment.

22

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Commercialloans consist of credit lines for operating needs, loans for equipment purchases,working capital, and various other business loan products.  Consumer loans include a range of traditionalconsumer loan products such as personal lines of credit and loans to financepurchases of autos, boats, recreational vehicles, mobile homes and variousother consumer items.

Realestate construction loans are generally composed of commitments to customerswithin the Company’s service area for construction of both commercialproperties and custom and semi-custom single-family residences.  Real estate mortgage loans consist primarilyof loans secured by first trust deeds on commercial and residential propertiestypically with maturities from 3 to 10 years and original loan to value ratiosgenerally from 65% to 80%.  Agricultureloans consist primarily of crop loans to farmers of peaches, prunes, walnuts,and almonds.  In general, except in thecase of loans with SBA or FMHA guarantees, the Company does not make long-termmortgage loans; however, Butte Community Bank has a residential lendingdivision to assist customers in securing most forms of longer termsingle-family mortgage financing.

## **RiskElements**

The Company assesses and manages credit risk on anongoing basis through a credit culture that emphasizes excellent creditquality, extensive internal monitoring and established formal lendingpolicies.  Additionally, the Companycontracts with an outside loan review consultant to periodically review theexisting loan portfolio.  Managementbelieves its ability to identify and assess risk and return characteristics ofthe Company’s loan portfolio is critical for profitability and growth.  Management strives to continue its emphasison credit quality in the loan approval process, active credit administrationand regular monitoring.  With this inmind, management has designed and implemented a comprehensive loan review andgrading system that functions to continually assess the credit risk inherent inthe loan portfolio.

Ultimately, underlying trends in economic and businesscycles may influence credit quality.  TheCompany’s business is concentrated in the Butte, Sutter and Shasta CountyAreas. The economy of these three counties is diversified with professionalservices, manufacturing, agriculture and real estate investment andconstruction.

Special emphasis is placed within the communities inwhich the Company has branches (Chico, Paradise, Magalia, Oroville, Yuba City,Red Bluff, Marysville, Colusa, Corning and Redding).  The Company also maintains loan production officesin the cities of Citrus Heights and Gridley. Single-family residentialconstruction is the primary lending product from the Citrus Heights locationserving the greater Sacramento area.  Theprimary focus of the loan production office in Gridley is commercial andagricultural loans.

The Company has significant extensions of credit andcommitments to extend credit that are secured by real estate.  The ultimate repayment of these loans isgenerally dependent on personal or business cash flows or the sale orrefinancing of the real estate.  TheCompany monitors the effects of current and expected market conditions andother factors on the collectability of real estate loans.  The more significant factors managementconsiders involve the following:  lease,absorption and sale rates; real estate values and rates of return; operatingexpenses; inflation; and sufficiency of collateral independent of the realestate including, in limited instances, personal guarantees.

In extending credit and commitments to borrowers, theCompany generally requires collateral and/or guarantees as security.  The repayment of such loans is expected tocome from cash flow or from proceeds from the sale of selected assets of theborrowers.  The Company’s requirement forcollateral and/or guarantees is determined on a case-by-case basis inconnection with management’s evaluation of the creditworthiness of theborrower.  Collateral held varies but mayinclude accounts receivable, inventory, property, plant and equipment,income-producing properties, residences and other real property.  The Company secures its collateral byperfecting its security interest in business assets, obtaining deeds of trust,or outright possession among other means.

23

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In management’sjudgment, a concentration exists in real estate loans, which representedapproximately 68.6% of the Company’s loan portfolio at September 30, 2006,which is a slight decrease from the 69.9% concentration level at December 31,2005.  Management believes theconcentration to have no more than the normal risk of collectability; however,a substantial decline in the economy in general, or a decline in real estatevalues in the Company’s primary market areas in particular, could have anadverse impact on the collectability of these loans and require an increase inthe provision for loan losses which could adversely affect the Company’s futureprospects, results of operations, profitability and stock price.  Management believes that its lending policiesand underwriting standards will tend to minimize losses in an economic downturn;however, there is no assurance that losses will not occur under suchcircumstances.  The Company’s loanpolicies and underwriting standards include, but are not limited to, thefollowing: (1) maintaining a thorough understanding of the Company’s servicearea and originating a significant majority of its loans within that area, (2)maintaining a thorough understanding of borrowers’ knowledge, capacity, andmarket position in their field of expertise, (3) basing real estate loanapprovals not only on market demand for the project, but also on the borrowers’capacity to support the project financially in the event it does not perform toexpectations (whether sale or income performance), and (4) maintainingconforming and prudent loan to value and loan to cost ratios based onindependent outside appraisals and ongoing inspection and analysis by theCompany’s lending officers.

## **Nonaccrual,Past Due and Restructured Loans**

Managementgenerally places loans on nonaccrual status when they become 90 days past due,unless the loan is well secured and in the process of collection.  Loans are charged off when, in the opinion ofmanagement, collection appears unlikely.

Table Six belowsets forth nonaccrual loans as of September 30, 2006 and December 31,2005.  There were no loans past due 90days or more and still accruing interest at September 30, 2006 or December 31,2005.

**Table Six:  Non-Performing Loans**
|                             | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------|------------|------------------------|------------|-----------------------|------------|
| **(In thousands)**     | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| Nonaccrual:                 |       |                   |       |                  |       |
| Commercial                  |       |                   |       |                  |       |
| Real estate                 |       | 1,858                  |       |                  |       |
| Consumer and other          |       | 2                      |       | 9                     |       |
| Total non-performing  loans |       | $                      | 1,860      |                  | $          | 9 |   |
|                             |            |                        |            |                       |            |  |  |

 

At September 30, 2006, there were three non-performingloans which were considered to be impaired.  One is a real estate securedgovernment guaranteed loan for $1,502,000 of which the unguaranteed portionrepresenting the Company’s potential loss exposure is $300,000.  Theproperty is in foreclosure and management does not foresee a loss from thisloan.  The second non-performing loan wasto finance the construction of two homes that the borrower has been unable tosell.  The foreclosure process has begunon these properties.  The finalnon-performing loan was for an automobile that has been repossessed and isbeing prepared for resale.  There is noexpected loss from this loan.  There wereno loan concentrations in excess of 10% of total loans not otherwise disclosedas a category of loans as of September 30, 2006 or December 31, 2005.  Management is not aware of any potentialproblem loans, which were accruing and current at September 30, 2006, whereserious doubt exists as to the ability of the borrower to comply with thepresent repayment terms.

24

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## **Allowancefor Loan Losses Activity**

Weemploy a systematic methodology for determining the allowance for loan lossesthat includes a monthly review process and monthly adjustment of theallowance.  Our process includes a periodic review of individual loansthat have been specifically identified as problem loans or have characteristicswhich could lead to impairment, as well as detailed reviews of other loans(either individually or in pools).  While this methodology utilizeshistorical and other objective information, the establishment of the allowancefor loan losses and the classification of loans are, to some extent, based onmanagement’s judgment and experience.

Ourmethodology incorporates a variety of risk considerations, both quantitativeand qualitative, in establishing an allowance for loan losses that managementbelieves is appropriate at each reporting date.  Quantitative factorsinclude our historical loss experience, delinquency and charge-off trends,collateral values, changes in non-performing loans, and other factors. Quantitative factors also incorporate known information about individual loans,including borrowers’ sensitivity to interest rate movements and borrowers’sensitivity to quantifiable external factors including commodity prices as wellas acts of nature (freezes, earthquakes, fires, etc.) that occur in aparticular period.

Qualitativefactors include the general economic environment in our markets and, inparticular, the state of the agriculture industry and other key industries inthe Northern Sacramento Valley.  The way a particular loan might bestructured, the extent and nature of waivers of existing loan policies, loanconcentrations and the rate of portfolio growth are other qualitative factorsthat are considered.

Ourmethodology is, and has been, consistently followed.  However, as we addnew products, increase in complexity, and expand our geographic coverage, weexpect to enhance our methodology to keep pace with the size and complexity ofthe loan portfolio.  On an ongoing basis we engage outside firms toindependently assess our methodology, and to perform independent credit reviewsof our loan portfolio.  The FDIC and the California Department ofFinancial Institutions review the allowance for loan losses as an integral partof the examination processes.  Management believes that our currentmethodology is appropriate given our size and level of complexity. Further, management believes that the allowance for loan losses is adequate asof September 30, 2006 to cover known and inherent risks in the loanportfolio.  However, fluctuations in credit quality, or changes in economicconditions or other factors could cause management to increase or decrease theallowance for loan losses as necessary.

TheBoard of Directors of the Bank reviews the adequacy of the allowance for loanlosses at least quarterly to include consideration of the relative risks in theportfolio and current economic conditions. The allowance is adjusted based on that review if, in the judgment ofthe loan committee and management, changes are warranted.  The allowance for loan losses totaled$5,368,000 or 1.15% of total loans at September 30, 2006 and $4,717,000 or1.16% at December 31, 2005.  The Companyhas established a separate reserve for unfunded loan commitments of $460,000and $481,000 as of September 30, 2006 and December 31, 2005 respectively.  Net charge-offs were $36,000 for the thirdquarter of 2006 and $45,000 for the nine months ended September 30, 2006.

25

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Table Seven belowsummarizes, for the periods indicated, the activity in the allowance for loanlosses.

**Table Seven: Allowance for LoanLosses**
|                                                                           | ** ** | **Three Months  Ended  September 30,** | ** ** | **Nine Months  Ended  September 30,** | ** ** |
|---------------------------------------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| **(In thousands, except for percentages)**            | ** ** | **2006**                                         | ** ** | **2005**                                        | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                      |       |                                             |       |                                            |       |   |   |   |   |
| Average loans  outstanding                                                |       | $                                                | 458,887    |                                            | $          | 405,419 |   | $ | 441,325 |   | $ | 374,231 |   |
|                                                                      |       |                                             |       |                                            |       |   |   |   |   |
| Allowance for possible  loan losses at beginning of period                |       | $                                                | 5,184      |                                            | $          | 4,825 |   | $ | 4,716 |   | $ | 4,381 |   |
|                                                                      |       |                                             |       |                                            |       |   |   |   |   |
| Loans charged  off:                                                       |       |                                             |       |                                            |       |   |   |   |   |
| Commercial                                                                |       | (35                                              | )          |                                            |       | (35 | ) | (5 | ) |
| Real estate                                                               |       |                                             |       |                                            |       |   |   |   |   |
| Consumer                                                                  |       | (1                                               | )          | (3                                              | )          | (11 | ) | (4 | ) |
| Total                                                                     |       | (36                                              | )          | (3                                              | )          | (46 | ) | (9 | ) |
| Recoveries of  loans previously charged off:                              |       |                                             |       |                                            |       |   |   |   |   |
| Commercial                                                                |       |                                             |       |                                            |       |   |   |   |   |
| Real estate                                                               |       |                                             |       |                                            |       |   |   |   |   |
| Consumer                                                                  |       |                                             |       |                                            |       | 1 |   |   |   |
| Total                                                                     |       |                                             |       |                                            |       |   |   |   |   |
| Net loan  charge-offs                                                     |       | (36                                              | )          | (3                                              | )          | (45 | ) | (9 | ) |
|                                                                      |       |                                             |       |                                            |       |   |   |   |   |
| Additions to  allowance charged to operating expenses                     |       | 225                                              |       | 225                                             |       | 675 |   | 675 |   |
| Allowance for  unfunded commitments                                       |       | (5                                               | )          | (403                                            | )          | 22 |   | (403 | ) |
| Allowance for  loan losses at end of period                               |       | $                                                | 5,368      |                                            | $          | 4,644 |   | 5,368 |   | 4,644 |   |
| Ratio of net  charge-offs to average loans outstanding                    |       | .00                                              | %          | .00                                             | %          | .00 | % | .00 | % |
| Provision for  probable loan losses to average loans outstanding          |       | .05                                              | %          | .06                                             | %          | .15 | % | .18 | % |
| Allowance for loan  losses to loans net of deferred fees at end of period |       | 1.16                                             | %          | 1.13                                            | %          | 1.16 | % | 1.13 | % |

 

It is the policyof management to maintain the allowance for loan losses at a level adequate forknown and inherent risks in the portfolio. Based on information currently available to analyze inherent creditrisk, including economic factors, overall credit quality, historicaldelinquencies and a history of actual charge-offs, management believes that theprovision for loan losses and the allowance are prudent and adequate.  The Company generally makes monthlyallocations to the allowance for loan losses. The budgeted allocation is based on estimates of loss risk and loangrowth.  Adjustments may be made based ondifferences from estimated loan growth, the types of loans constituting thisgrowth, changes in risk ratings within the portfolio, and general economicconditions.  However, no prediction ofthe ultimate level of loans charged off in future years can be made with anycertainty.

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**Other Real Estate**

At September 30, 2006 and December 31, 2005, theCompany did not have any other real estate (“ORE”) properties.

## **Deposits**

At September 30, 2006, total deposits were$466,431,000 representing an increase of $32,413,000 (7.5%) over the December31, 2005 balance of $434,018,000.  Achange in the mix of deposits has occurred throughout the first nine months of2006 due to a shift from interest bearing demand deposits to certificates ofdeposit as rates have continued to increase. Non-interest bearing demand deposits have increased by $1.3 millionwhile interest bearing demand deposits have decreased by $20.9 million in thefirst nine months of 2006.  Certificatesof deposit have increased $55 million or 46% since December 31, 2005. Brokered certificates of deposit represent $19 million. In order to keep upwith the rapid growth in loans during the first nine months of 2006, rates oncertificates of deposit were raised to encourage depositors to move theirmaturing funds from other institutions to the Bank.

## **CapitalResources**

The current and projected capital position of theCompany and the impact of capital plans and long-term strategies are reviewedregularly by management. The Company’s capital position represents the level ofcapital available to support continued operations and expansion.

The Board of Directors of the Company authorized thepayment of quarterly cash dividends totaling $0.16 per share for 2005 and $0.18per share for the first three quarters of 2006.  The payment of dividendsin the future is subject to the discretion of the Board of Directors of theCompany and will depend on earnings, the financial condition of the Company andother relevant factors.

The Company and its subsidiary Bank are subject to certainregulations issued by the Board of Governors of the Federal Reserve System andthe FDIC which require maintenance of certain levels of capital.  AtSeptember 30, 2006, shareholders’ equity was $45,992,000, representing anincrease of $4,437,000 (10.7%) from $41,555,000 at December 31, 2005.  Theincrease is primarily the result of the exercise of stock options and netincome from the period offset by the stock based compensation expense recordedand cash dividends discussed above.  The Bank’s ratio of total risk-basedcapital to risk adjusted assets was 10.8% at September 30, 2006 compared to11.3% at December 31, 2005.  Tier 1 risk-based capital to risk-adjustedassets was 9.7% at September 30, 2006 and 10.1% at December 31, 2005.

Table Eight below lists the Company and the Bankcapital ratios at September 30, 2006 and December 31, 2005, as well as theminimum ratios required under regulatory definitions of capital adequacy. 

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**TableEight:  Capital Ratios**
| Capital to Risk-Adjusted Assets | ** ** | **At September 30,  2006** | ** ** | **At December 31,  2005** | ** ** | **Minimum  Regulatory Requirement** | ** ** |
|------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|------------------------------------------|------------|
| ** **                                     |       |                                 |       |                                |       |                                     |       |
| **Company**                                    |       |                                 |       |                                |       |                                     |       |
| ** **                                     |       |                                 |       |                                |       |                                     |       |
| Leverage ratio                                 |       | 10.5                                 | %          | 9.8                                 | %          | 4.0                                      | %          |
|                                           |       |                                 |       |                                |       |                                     |       |
| Tier 1 Risk-Based Capital                      |       | 10.8                                 | %          | 11.4                                | %          | 4.0                                      | %          |
|                                           |       |                                 |       |                                |       |                                     |       |
| Total Risk-Based Capital                       |       | 11.7                                 | %          | 12.5                                | %          | 8.0                                      | %          |
|                                           |       |                                 |       |                                |       |                                     |       |
| **Bank**                                       |       |                                 |       |                                |       |                                     |       |
| ** **                                     |       |                                 |       |                                |       |                                     |       |
| Leverage ratio                                 |       | 9.9                                  | %          | 8.8                                 | %          | 4.0                                      | %          |
| ** **                                     |       |                                 |       |                                |       |                                     |       |
| Tier 1 Risk-Based Capital                      |       | 9.7                                  | %          | 10.1                                | %          | 4.0                                      | %          |
|                                           |       |                                 |       |                                |       |                                     |       |
| Total Risk-Based  Capital                      |       | 10.6                                 | %          | 11.3                                | %          | 8.0                                      | %          |

 

Capital ratios are reviewed on a regular basis toensure that capital exceeds the prescribed regulatory minimums and is adequateto meet future needs.  All ratios are inexcess of the regulatory definition of “Minimum” at September 30, 2006 andDecember 31, 2005.  The Bank wasconsidered “well-capitalized” by regulatory standards, at September 30, 2006and December 31, 2005.

**Item 3.  Quantitativeand Qualitative Disclosures about Market Risk**

**Market Risk Management**

*Overview*.  Market risk is the risk of loss from adversechanges in market prices and rates.  TheCompany’s market risk arises primarily from interest rate risk inherent in itsloan, investment and deposit portfolios. The goal for managing the assets and liabilities of the Company is tomaximize shareholder value and earnings while maintaining a high quality balancesheet without exposing the Company to undue interest rate risk.

TheBoard of Directors has overall responsibility for the interest rate riskmanagement policies.  The Bank has anAsset and Liability Management Committee (ALCO) that establishes and monitorsguidelines to control the sensitivity of earnings to changes in interest rates.

*Asset/LiabilityManagement*.  Activitiesinvolved in asset/liability management include, but are not limited to,lending, accepting and placing deposits, investing in securities, using trustpreferred securities and borrowings. Interest rate risk is the primary market risk associated withasset/liability management.  Sensitivityof earnings to interest rate changes arises when yields on assets change in adifferent time period or in a different amount from that of interest costs onliabilities.  To mitigate interest raterisk, the structure of the balance sheet is managed with the goal thatmovements of interest rates on assets and liabilities are correlated andcontributes to earnings even in periods of volatile interest rates.  The asset/liability management policy setslimits on the acceptable amount of variance in net interest margin and marketvalue of equity under changing interest environments.  The Company uses simulation models toforecast earnings, net interest margin and market value of equity.

Simulationof earnings is the primary tool used to measure the sensitivity of earnings tointerest rate changes.  Usingcomputer-modeling techniques, the Company is able to estimate the potentialimpact of changing interest rates on earnings. A balance sheet forecast is prepared monthly using inputs of actualloans, securities and interest bearing liability (i.e. deposits/borrowings)positions as the beginning base.  The forecastbalance sheet is processed against seven interest rate scenarios.  These scenarios include a 100, 200 and 300basis point rising rate forecast, a flat rate forecast and a 100, 200 and 300basis point falling rate forecast which take place within a one year timeframe.

28

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Thenet interest income is measured during the year assuming a gradual change inrates over the twelve-month horizon.  TheCompany’s net interest income, as forecast below, was modeled utilizing aforecast balance sheet projected from balances as of the date indicated.

Table Nine belowsummarizes the effect on net interest income (NII) of a ±200 basis point changein interest rates as measured against a constant rate (no change)scenario.  The results shown in Tablenine for the two periods, fall within the parameters of the Bank’s policy forinterest rate risk.

**Table Nine: Interest Rate Risk Simulation of Net Interest as of September 30, 2006and December 31, 2005**
| (In thousands)                     | ** ** | **$ Change in NII  from Current  12 Month Horizon  September 30, 2006** | ** ** | **$ Change in NII  from Current  12 Month Horizon  December 31, 2005** | ** ** |
|-----------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------|------------|
| Variation from a constant rate scenario |       |                                                                                                            |       |                                                                                                           |       |
| +200bp                                  |       | $                                                                                                               | 3,519      |                                                                                                           | $          | 1,732 |   |
| - 200bp                                 |       | $                                                                                                               | (4,130     | )                                                                                                              | $          | (2,380 | ) |

 

Assumptions are inherently uncertain, and, consequently,the model cannot precisely measure net interest income or precisely predict theimpact of changes in interest rates on net interest income. Actual results willdiffer from simulated results due to timing, magnitude and frequency ofinterest rate changes, as well as changes in market conditions and managementstrategies which might moderate the negative consequences of interest ratedeviations. In the model above, the simulation shows that the Company is assetsensitive over the one-year horizon as increasing rates have a positive impacton net interest income and declining rates have a negative impact.

## **Inflation**

The impact of inflation on a financial institutiondiffers significantly from that exerted on manufacturing, or other commercialconcerns, primarily because its assets and liabilities are largelymonetary.  In general, inflationprimarily affects the Company and it subsidiaries through its effect on marketrates of interest, which affects the Company’s ability to attract loancustomers.  Inflation affects the growthof total assets by increasing the level of loan demand, and potentiallyadversely affects capital adequacy because loan growth in inflationary periodscan increase at rates higher than the rate that capital grows through retentionof earnings, which may be generated in the future.  In addition to its effects on interest rates,inflation increases overall operating expenses. Inflation has not had a material effect upon the results of operationsof the Company and its subsidiaries during the three and nine month periodsended September 30, 2006, and 2005.

**Liquidity**

Liquidity management refers to the Company’s abilityto provide funds on an ongoing basis to meet fluctuations in deposit levels aswell as the credit needs and requirements of its clients.  Both assets and liabilities contribute to theCompany’s liquidity position.  Federalfunds lines, short-term investments and securities, and loan repayments contributeto liquidity, along with deposit increases, while loan funding and depositwithdrawals decrease liquidity.  TheCompany assesses the likelihood of projected funding requirements by reviewinghistorical funding patterns, current and forecasted economic conditions andindividual client funding needs. Commitments to fund loans and stand-by letters of credit at September30, 2006 and December 31, 2005 were approximately $194,840,000 and$205,588,000, respectively.  Such loansrelate primarily to revolving lines of credit and other commercial loans, andto real estate construction loans.

29

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TheCompany’s sources of liquidity consist of cash and due from correspondentbanks, overnight funds sold to correspondent banks, unpledged marketableinvestments and loans held for sale.  OnSeptember 30, 2006, consolidated liquid assets totaled $27.7 million or 5.2% oftotal assets compared to $52.2 million or 10.5% of total assets on December 31,2005.  In addition to liquid assets, theCompany maintains short-term lines of credit in the amount of $15,000,000 withcorrespondent banks.  There were noborrowings outstanding under these arrangements at September 30, 2006.

TheBank also has informal agreements with various other banks to sellparticipations in loans, if necessary. The Company serves primarily a business and professional customer baseand, as such, its deposit base is susceptible to economic fluctuations.  Accordingly, management strives to maintain abalanced position of liquid assets to volatile and cyclical deposits.

Liquidity is also affected by portfolio maturities andthe effect of interest rate fluctuations on the marketability of both assetsand liabilities.  The Company can sellany of its unpledged securities held in the available-for-sale category to meetliquidity needs.

## **Off-BalanceSheet Items**

The Company has certain ongoing commitments underoperating leases.  These commitments donot significantly impact operating results. As of September 30, 2006 andDecember 31, 2005, commitments to extend credit and letters of credit were theonly financial instruments with off-balance sheet risk.  The Company has not entered into anycontracts for financial derivative instruments such as futures, swaps, optionsor similar instruments.  Loan commitmentsand stand-by letters of credit were $194,840,000 and $205,588,000 at September30, 2006 and December 31, 2005, respectively. As a percentage of net loans, these off-balance sheet items represent44.5% and 51.2%, respectively.

**Item 4.Controls and Procedures**

(a) Disclosure Controls and Procedures: An evaluationof the Company’s disclosure controls and procedures (as defined in Exchange ActRules 13a-15(e) and 15d-15(e)) was carried out under the supervision and withthe participation of the Company’s Chief Executive Officer, Chief FinancialOfficer and other members of the Company’s senior management as of the end ofthe Company’s fiscal quarter ended September 30, 2006. The Company’s ChiefExecutive Officer and Chief Financial Officer concluded that the Company’sdisclosure controls and procedures as currently in effect are effective inensuring that the information required to be disclosed by the Company in thereports it files or submits under the Exchange Act is (i) accumulated andcommunicated to the Company’s management (including the Chief Executive Officerand Chief Financial Officer) to allow timely decisions regarding requireddisclosure, and (ii) recorded, processed, summarized and reported within thetime periods specified in the Commission’s rules and forms.

(b) Internal Control Over Financial Reporting: An evaluation of any changes in the Company’s internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)), that occurred during the Company’s fiscal quarter ended September 30, 2006, was carried out under the supervision and with the participation of the Company’s Chief Executive Officer, Chief Financial Officer and other members of the Company’s senior management. The Company’s Chief Executive Officer and Chief Financial Officer concluded that no change identified in connection with such evaluation has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

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## **PART II – OTHER INFORMATION**

Item 1.  Legal Proceedings.

None

Item 1A.  Risk Factors

In addition to theother information set forth in this report, you should carefully consider thefactors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report onForm 10-K for the year ended December 31, 2005, which could materially affectour business, financial condition or future results. The risks described in ourAnnual Report on Form 10-K are not the only risks facing our Company.Additional risks and uncertainties not currently known to us or that wecurrently deem to be immaterial also may materially adversely affect ourbusiness, financial condition and/or operating results.”

Item 2.  Changes in Securities and Use of Proceeds.

The Board ofDirectors approved a plan at their June 2003 meeting to repurchase up to$3,000,000 of the outstanding common stock of the Company.  The plan states that stock repurchases may bemade from time to time on the open market or through privately negotiatedtransactions.  The timing of purchasesand the exact number of shares to be purchased depends on marketconditions.  The share repurchase plandoes not include specific price targets or timetables and may be suspended atany time.

During the ninemonths ended September 30, 2006, 55,400 shares of common stock (of which 11,800shares were in the process of cancellation and not deducted from total sharesoutstanding) were repurchased under the share repurchase program at an averagecost of $16.91 per share, totaling $936,872. From the beginning of the share repurchase program in June 2003 throughSeptember 30, 2006, the Company repurchased a total of 74,415 shares andreturned in excess of $1.4 million to its shareholders at an average cost of$15.40 per share.  From October 1, 2006through November 2, 2006, the Company repurchased an additional 74,900 sharesof common stock at an average cost of $17.61 per share for a total of$1,318,965, resulting in remaining buyback authority under the share repurchaseprogram of $241,925.

Shares repurchasedduring the third quarter ending September 30, 2006
| **Period**                  | ** ** | **(a) Total number of  Shares (or Units)  Purchased** | ** ** | **(b) Average Price  Paid per Share  (or Unit)** | ** ** | **(c)Total Number of Shares  (or Units) Purchased as Part  of Publicly Announced Plans  or Programs** | ** ** | **(d) Maximum Number (or  approximate dollar value)  of shares (or Units) that may  yet be purchased under the  Plans or Programs** | ** **   |
|-----------------------------|------------|--------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------------|
| Month #1 7-1-06 to  7-31-06 |       | 0                                                                              |       | 0.0000                                                                    |       | 0                                                                                                                                                            |       | $                                                                                                                                                                                                                   | 2,017,915.50 |   |
| Month #2 8-1-06 to  8-31-06 |       | 15,000                                                                         |       | 17.00                                                                     |       | 15,000                                                                                                                                                       |       | $                                                                                                                                                                                                                   | 1,762,915.50 |   |
| Month #3 9-1-06 to 9-30-06  |       | 11,800                                                                         |       | 17.1208                                                                   |       | 11,800                                                                                                                                                       |       | $                                                                                                                                                                                                                   | 1,560,890.50 |   |

 

31

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Item 3.  Defaults Upon Senior Securities.

None

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

None

Item 5.  Subsequent Event

On October 30,2006 the Company moved its full service branch office in Marysville to 904 BStreet.  This location is a larger sitewith better visibility and a drive-up window capability.

Item 6.  Exhibits

(a)  Exhibits
| Exhibit    | ** ** | ** **                                                                       |
|------------|------------|----------------------------------------------------------------------------------|
| **Number** | ** ** | **Document Description**                                                         |
|       |       |                                                                             |
| (31.1)     |       | Certification of CEO pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
|       |       |                                                                             |
| (31.2)     |       | Certification of CFO pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
|       |       |                                                                             |
| (32.1)     |       | Certification of CEO pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |
|       |       |                                                                             |
| (32.2)     |       | Certification of CFO pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |

 

**SIGNATURES**

Pursuant to therequirements of the Securities and Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.
|                    | COMMUNITY VALLEY  BANCORP                         |
|--------------------|---------------------------------------------------|
|               |                                              |
| November 10,  2006 |                                              | *By: /s/ Keith C. Robbins* |   |
|               | * *                                          |
|               | Keith C. Robbins                                  |
|               |                                              |
|               | President, Chief  Executive Officer               |
|               |                                              |
|               |                                              |
| November 10,  2006 |                                              | *By: /s/ John F. Coger* | * * |
|               | * *                                          |
|               | John F. Coger                                     |
|               | Executive Vice President, Chief Financial Officer |
|               | and Chief Operating Officer                       |
|                    |                                                   |  |  |  |

 

32

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