UNITED STATES

SECURITIES &EXCHANGE COMMISSION

Washington, D.C. 20549

__________________________

**FORM 10-Q**

 

| [X] | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|-----|----------------------------------------------------------------------------------------------|

 

**For Quarter EndedMarch 31, 2010**

**OR**

 

| [  ] | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934** |
|-----------|-----------------------------------------------------------------------------------------------|

 

**Forthe transition period from _________to ________**

 

**Commission filenumber:  000-49892**

**PACIFIC STATEBANCORP**

(Exact Name ofRegistrant as Specified in its Charter)

| **California**                                                   | **61-1407606**                        |
|------------------------------------------------------------------|---------------------------------------|
| (State or other  jurisdiction of

incorporation or organization) | (I.R.S. Employer

Identification No.) |

**1899 W. MarchLane, Stockton, CA 95207**

(Address of PrincipalExecutive Offices) (Zip Code)

Registrant'sTelephone Number, including Area Code (209) 870-3214

 

Indicate by check mark whether the registrant (1) has filedall reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports,) and (2) has beensubject to such filing requirements for the past 90 days. Yes [X]   No [  ]

Indicate by check mark whether the registrant has submittedelectronically and posted on its corporate Web site, if any, every InteractiveData File required to be submitted and posted pursuant to Rule 405 ofRegulation S-T (Section 232.405 of this chapter) during the preceding 12 months(or for such shorter period that the registrant was required to submit and postsuch files).   Yes  [X]   No [ ]

Indicate by check mark whether the registrant is a largeaccelerated filer, an accelerated filer, a non-accelerated filer or asmaller reporting company.  See definition of  "acceleratedfiler," "large accelerated filer" and "smaller reportingcompany"  in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer [ ]  Acceleratedfiler [ ]  Non -accelerated filer  []  Smaller reporting company   [X]

Indicate by check mark whether the registrant is a shellcompany (as defined in Rule 12b-2 of the Exchange Act). Yes  []   No [X]

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

| **Title of Class**                 | **Shares  outstanding as of May 10, 2010** |
|------------------------------------|--------------------------------------------|
|  

Common Stock

No Par Value |  

3,722,198                          |

**PARTI.  FINANCIAL INFORMATION**

**ITEM I.  FINANCIALSTATEMENTS** 

 

| **PACIFIC STATE BANCORP AND  SUBSIDIARY**                                                                           |              |
|---------------------------------------------------------------------------------------------------------------------|--------------|
| **CONDENSED CONSOLIDATED BALANCE  SHEETS**                                                                          | ** **   |
| Unaudited                                                                                                           | ** **   | **March 31,** | ** ** | ** ** | **December 31,** |   |
| (Dollars in thousands)                                                                                              | ** **   | **2010** | ** ** | ** ** | **2009** |   |
| **ASSETS**                                                                                                          |    |   |   |   |   |   |
| Cash and due from banks                                                                                             |         | $ | 9,816 |   |   | $ | 10,517 |   |
| Federal funds sold                                                                                                  |         |   | 13,994 |   |   |   | 45,568 |   |
| Total cash and cash equivalents                                                                                     |         |   | 23,810 |   |   |   | 56,085 |   |
| Investment securities                                                                                               |         |   | 21,039 |   |   |   | 23,941 |   |
| Loans, less  allowance for loan losses of $10,815 in 2010 and $10,508 in 2009                                       |         |   | 233,202 |   |   |   | 245,846 |   |
| Premises and equipment, net                                                                                         |         |   | 15,995 |   |   |   | 16,234 |   |
| Other real estate owned                                                                                             |         |   | 12,678 |   |   |   | 10,934 |   |
| Company owned life insurance                                                                                        |         |   | 7,099 |   |   |   | 7,030 |   |
| Accrued interest receivable and other assets                                                                        |         |   | 8,695 |   |   |   | 9,775 |   |
| Total assets                                                                                                        |         | $ | 322,518 |   |   | $ | 369,845 |   |
| **LIABILITIES AND**                                                                                                 |         |   |   |   |   |   |   |   |
| **SHAREHOLDERS' EQUITY**                                                                                            |         |   |   |   |   |   |   |   |
| Deposits:                                                                                                           |         |   |   |   |   |   |   |   |
| Non-interest bearing                                                                                                |         | $ | 49,846 |   |   | $ | 59,871 |   |
| Interest bearing                                                                                                    |         |   | 237,904 |   |   |   | 262,554 |   |
| Total deposits                                                                                                      |         |   | 287,750 |   |   |   | 322,425 |   |
| Other borrowings                                                                                                    |         |   | 19,000 |   |   |   | 29,000 |   |
| Subordinated debentures                                                                                             |         |   | 8,764 |   |   |   | 8,764 |   |
| Accrued interest payable and other liabilities                                                                      |         |   | 3,728 |   |   |   | 3,977 |   |
| Total liabilities                                                                                                   |         |   | 319,242 |   |   |   | 364,166 |   |
|                                                                                                                |         |   |   |   |   |   |   |   |
| Shareholders' equity:                                                                                               |         |   |   |   |   |   |   |   |
| Preferred stock -  2,000,000 shares authorized; none issued or outstanding                                          |         |   | - |   |   |   | - |   |
| Common stock no par  value; 24,000,000 shares authorized; issued and outstanding 3,722,198 shares  in 2010 and 2009 |         |   | 10,823 |   |   |   | 10,823 |   |
| Accumulated deficit                                                                                                 |         |   | (6,557) |   |   |   | (4,224) |   |
| Accumulated other comprehensive loss, net of taxes                                                                  |         |   | (990) |   |   |   | (920) |   |
| Total shareholders' equity                                                                                          |         |   | 3,276 |   |   |   | 5,679 |   |
| Total liabilities and shareholders'  equity                                                                         |         | $ | 322,518 |   |   | $ | 369,845 |   |

See notes to unaudited condensedconsolidated financial statements

 

 

| **PACIFIC STATE BANCORP**                             | ** ** |
|-------------------------------------------------------|------------|
| **CONDENSED CONSOLIDATED  STATEMENTS OF OPERATIONS**  | ** ** |
| Unaudited                                             | ** ** | **Three Months Ended March 31,** |   |
| (Dollars  in thousands)                               | ** ** | **2010** | ** ** | ** ** | **2009** |   |
| **Interest  income:**                                 |       |   |   |   |   |   |
| Interest  and fees on loans                           |       | $ | 3,759 |   |   | $ | 5,024 |   |
| Interest  on Federal funds sold                       |       |   | 22 |   |   |   | 16 |   |
| Interest  on investment securities                    |       |   | 166 |   |   |   | 512 |   |
| Total  interest income                                |       |   | 3,947 |   |   |   | 5,552 |   |
|                                                  |       |   |   |   |   |   |   |   |
| **Interest  expense:**                                |       |   |   |   |   |   |   |   |
| Interest  on deposits                                 |       |   | 1,106 |   |   |   | 1,837 |   |
| Interest  on borrowings                               |       |   | 153 |   |   |   | 306 |   |
| Interest  on subordinated debentures                  |       |   | 50 |   |   |   | 84 |   |
| Total  interest expense                               |       |   | 1,309 |   |   |   | 2,227 |   |
|                                                  |       |   |   |   |   |   |   |   |
| Net  interest income before provision for loan losses |       |   | 2,638 |   |   |   | 3,325 |   |
| Provision  for loan losses                            |       |   | 395 |   |   |   | 972 |   |
| Net  interest income after provision for loan losses  |       |   | 2,243 |   |   |   | 2,353 |   |
|                                                  |       |   |   |   |   |   |   |   |
| **Non-interest  income:**                             |       |   |   |   |   |   |   |   |
| Service  charges                                      |       |   | 131 |   |   |   | 164 |   |
| Gain  on sale of loans                                |       |   | - |   |   |   | 12 |   |
| Other  income                                         |       |   | 231 |   |   |   | 203 |   |
| Total  non-interest income                            |       |   | 362 |   |   |   | 379 |   |
|                                                  |       |   |   |   |   |   |   |   |
| **Non-interest  expenses:**                           |       |   |   |   |   |   |   |   |
| Salaries  and employee benefits                       |       |   | 1,483 |   |   |   | 1,154 |   |
| Occupancy                                             |       |   | 293 |   |   |   | 279 |   |
| Furniture  and equipment                              |       |   | 248 |   |   |   | 268 |   |
| Other  real estate                                    |       |   | 895 |   |   |   | 431 |   |
| Other  expenses                                       |       |   | 1,236 |   |   |   | 1,165 |   |
| Total  non-interest expenses                          |       |   | 4,155 |   |   |   | 3,297 |   |
|                                                  |       |   |   |   |   |   |   |   |
| Loss  before benefit for income taxes                 |       |   | (1,550) |   |   |   | (565) |   |
| Provision  (benefit) for income taxes                 |       |   | 783 |   |   |   | (271) |   |
| Net  loss                                             |       | $ | (2,333) |   |   | $ | (294) |   |
|                                                  |       |   |   |   |   |   |   |   |
| Basic  loss per share                                 |       | $ | (0.63) |   |   | $ | (0.08) |   |
|                                                  |       |   |   |   |   |   |   |   |
| Diluted  loss per share                               |       | $ | (0.63) |   |   | $ | (0.08) |   |

See notes to unaudited condensedconsolidated financial statements

 

 

**PACIFIC STATE BANCORP ANDSUBSIDIARY**

**CONSOLIDATED STATEMENTS OF CASHFLOWS**

**For the Three Month Periods EndedMarch 31, 2010 and 2009**

(In thousands) 

| (Unaudited)                                                                                                   | ** ** | **2010** | ** ** | ** ** | **2009** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|----------|------------|------------|----------|------------|
| **Cash flows from operating  activities:**                                                                    |       |     |       |       |     |       |
| Net (loss)                                                                                                    |       | $        | (2,333)    |       |     | $          | (294) |   |
| Provision for loan  losses                                                                                    |       |     | 395        |       |     |       | 972 |   |
| Net decrease  (increase) in deferred loan origination costs                                                   |       |     | 32         |       |     |       | (183) |   |
| Depreciation,  amortization and accretion                                                                     |       |     | 311        |       |     |       | 235 |   |
| Stock-based  compensation expense                                                                             |       |     | -          |       |     |       | 14 |   |
| Company owned life  insurance earnings                                                                        |       |     | (69)       |       |     |       | (69) |   |
| Other real estate  impairment                                                                                 |       |     | 835        |       |     |       | 357 |   |
| Decrease (increase)  in accrued interest receivable and other assets                                          |       |     | 1,129      |       |     |       | (414 | ) |
| Decrease in accrued  interest payable and other liabilities                                                   |       |     | (249)      |       |     |       | (212) |   |
| Net cash provided  by operating activities

                                                             |       |     | 51         |       |     |       | 406 |   |
| **Cash flows from investing  activities:**                                                                    |       |     |       |       |     |       |   |   |
| Purchases of  available-for-sale investment securities                                                        |       |     | -          |       |     |       | (6,626) |   |
| Proceeds from  matured and called available-for-sale investment securities                                    |       |     | 500        |       |     |       | 4,994 |   |
| Proceeds from principal  repayments from available-for-sale government-guaranteed mortgage-backed  securities |       |     | 2,209      |       |     |       | 1,935 |   |
| Proceeds from  principal repayments from held-to-maturity government-guarantee  mortgage-backed securities    |       |     | 2          |       |     |       | 3 |   |
| Proceeds from the  sale of other real estate                                                                  |       |     | 211        |       |     |       | 874 |   |
| Net decrease in  loans                                                                                        |       |     | 9,426      |       |     |       | 1,301 |   |
| Purchases of  premises and equipment                                                                          |       |     | -          |       |     |       | (438) |   |
| Net cash provided  by investing activities

                                                             |       |     | 12,349     |       |     |       | 2,043 |   |
| **Cash flows from financing  activities:**                                                                    |       |     |       |       |     |       |   |   |
| Net  decrease in demand, interest-bearing and savings deposits                                                |       |     | (8,601)    |       |     |       | (14,441) |   |
| Net  decrease in time deposits                                                                           |       |     | (26,074)   |       |     |       | (5,756) |   |
| Net  decrease in other borrowings                                                                             |       |     | (10,000)   |       |     |       | - |   |
| Net  cash used in financing Activities                                                                        |       |     | (44,675)   |       |     |       | (20,197) |   |
| Decrease  in cash and cash equivalents                                                                        |       |     | (32,275)   |       |     |       | (17,748) |   |
| Cash  and cash equivalents at beginning of period                                                             |       |     | 56,085     |       |     |       | 38,511 |   |
| Cash  and cash equivalents at end of period                                                                   |       | $        | 23,810     |       |     | $          | 20,763 |   |

 

 

 

PACIFIC STATE BANCORP ANDSUBSIDIARY

NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS

(Unaudited)

1. GENERAL

 

Pacific State Bancorp is a holdingcompany with one bank subsidiary, Pacific State Bank, (the "Bank"),and two unconsolidated subsidiary grantor trusts, Pacific State StatutoryTrusts II and III.  Pacific State Bancorp commenced operations onJune 24, 2002 after acquiring all of the outstanding shares of Pacific StateBank.  The Bank is a California state chartered bank formed onNovember 2, 1987. The Bank is a member of the Federal Reserve System. TheBank's primary source of revenue is interest on loans to customers who arepredominantly small to middle-market businesses and middle-income individuals.  PacificState Statutory Trusts II and III are unconsolidated, wholly owned statutorybusiness trusts formed in March 2004 and June 2007, respectively for theexclusive purpose of issuing and selling trust preferred securities.

 

The Bank conducts general commercialbanking business, primarily in the five county region that comprises Alameda,Calaveras, San Joaquin, Stanislaus and Tuolumne counties, and offers commercialbanking services to residents and employers of businesses in the Bank's servicearea, including professional firms and small to medium sized retail andwholesale businesses and manufacturers.  The Company, as of April 22,2010, had 91 employees. The Bank does not engage in any non-banking relatedlines of business. The business of the Bank is not to any significant degreeseasonal in nature.  The Bank has no operations outsideCalifornia and has nomaterial amount of loans or deposits concentrated among any one or few persons,groups or industries.  The Bank operates nine branches with its AdministrativeOffice located at 1899 W. March Lane, in Stockton, California; additionalbranches are located in the communities of Angels Camp, Arnold, Groveland,Lodi, Modesto, Stockton, Tracy, and Hayward, California.  PacificState Bancorp common stock trades on the NASDAQ Global Market under the symbolof "PSBC".

 

On November 10, 2009, the Company received a notice fromthe Nasdaq Global Market stating that the Company no longer met the $1.00 pershare requirement for continued listing on the Nasdaq Global Select Marketunder Listing Rule 5450 (a)(1). This notice did not result in an immediatedelisting of the Company's common stock from the Nasdaq Global Select Market,as a grace period of 180 calendar days or until May 10, 2010, is provided underthe listing rules. However, we elected to apply to transfer listing to theNASDAQ Capital Market as set forth in Listing Rule 5505.  As a resultof such transfer, the Company became eligible for an additional 180 calendarday grace period. The requirements for initial listing on the Nasdaq CapitalMarket include a minimum market value of publicly held shares of $15 million,which the Company does not currently meet. If at any time during this graceperiod the bid price of the Company's common stock closes at $1.00 per share ormore for a minimum of ten consecutive business days, Nasdaq will provide uswritten confirmation of compliance. As a result of not complying by May 10,2010 with the requirements for listing our common stock on the Nasdaq CapitalMarket, it is likely that we will be delisted and the shares will likelythereafter trade on the "over-the-counter" bulletin board market.

 

GOING CONCERN CONSIDERATION

The consolidated financial statementsfor the period ended March 31, 2010 have been prepared on a going concernbasis, which contemplates the realization of assets and the discharge ofliabilities in the normal course of business. As a result, the consolidatedfinancial statements do not include any adjustments that may result from theoutcome of any regulatory action or the Company's or the Bank's inability tomeet its existing debt obligations. The Bank has recently incurred significantoperating losses, experienced a significant deterioration in the quality of itsassets and become subject to enhanced regulatory scrutiny. These factors, amongothers, were deemed to cast substantial doubt on the Company's and the Bank'sability to continue as a going concern. If the Company cannot continue tooperate as a going concern, it is likely that shareholders will lose all orsubstantially all of their investment in the Company.

 

On February 18, 2010, the Company andthe Bank consented to enter into a written agreement with the Federal ReserveBank of San Francisco (the "FRBSF") and the State of California Departmentof Financial Institutions (the "CDFI") as follow-up to an examinationof the Bank the "Written Agreement"). Among other things, the WrittenAgreement provides that the Company and the Bank shall submit to the FRBSF andthe CDFI their continuing plans to enhance lending and credit administrationfunctions, to maintain policies and procedures for the maintenance of anadequate allocation for loan and lease losses, to improve the Bank's earningsand overall condition, improve management of the Bank's liquidity position andfunds management practices and update its capital plan in order to maintainsufficient capital at the Company and the Bank. The Written Agreement alsorestricts the Company and the Bank from making the payment of dividends, anypayments on trust preferred securities, any reduction in capital or thepurchase or redemption of stock without the prior approval of the FRBSF, aswell as other restrictions. Progress reports detailing the form and manner ofall actions taken to secure compliance with the Written Agreement must besubmitted to the FRBSF at least quarterly. 

 

In addition to the Written Agreement'srequirements, as a result of being undercapitalized under the prompt correctiveaction rules, the Bank is subject to certain regulatory restrictions. Theseinclude, among others, that the Bank may not make any capital distributions,must submit an acceptable capital restoration plan to the FRBSF, may notincrease its average total assets during a calendar quarter to exceed itsaverage total assets during the preceding calendar quarter and may not acquirea business, establish or acquire a branch office or engage in a new line ofbusiness.

 

Management of the Company has takencertain steps in an effort to continue with safe and sound banking practicesexercising the contractual right to defer the interest on the juniorsubordinated debentures, taking a number of actions to contain costs,continuing to reduce its lending exposure, and increasing the borrowing line atthe Federal Reserve Bank's discount window in an amount up to approximately $38million. However, in March, 2010, the CDFI presented the Bank with a proposedcease and desist order requiring the Bank to raise capital and, on April 15,2010, the Bank executed a Waiver and Consent to the Order of the CDFI (the"Consent"). The Consent requires the Bank, within 90 days of theeffective date of the Order, either to increase and to maintain tangiblecapital at a level equal to 10% of total tangible assets or merge with a depositoryinstitution to sell to an acquirer acceptable to the CDFI.  The effectivedate was the date that the CDFI executed the Order which was May 3, 2010. As ofMarch 31, 2010, the Bank had a ratio of tangible capital to assets of 3.7%,which was not sufficient to meet the higher level that the Bank would beobligated to maintain under the Consent. As a result, if by August 1, 2010 theBank cannot comply with the Consent provisions, the Bank may be subject tofurther supervisory action, which could have a material adverse effect on itsresults of operations, financial condition and business.

 

As a result of the Written Agreementand the Consent, we are actively seeking additional capital either directlythrough the sale of securities or indirectly through the merger with anotherbank or financial institution (which could be accompanied by a financing) orsale to an acquirer. We expect that any sale of securities would most likely bethrough a private placement to institutional investors. While we have haddiscussions with various financing sources and potential merger partners, atthe date of this Report we have no agreements for any such transaction. Anymerger or financing likely would involve a change of control of the Company.

 

If the Bank is not successful in raisingadditional capital, it will not be able to become fully compliant with theprovisions of the Written Agreement or the Consent discussed above. As aresult, the FRBSF, CDFI or the FDIC may take further enforcement action,including placing the Bank into receivership. If the Bank is placed into FDICreceivership, it is likely that the Bank would be required to cease operationsand liquidate. If the Bank were to liquidate it is unlikely that there would beany assets available to the holders of the common shareholders of the Company.

 

2. BASIS OF PRESENTATION AND CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS

 

In the opinion of management, theunaudited condensed consolidated financial statements contain all adjustments(consisting of only normal recurring adjustments) necessary to present fairlythe consolidated financial position of Pacific State Bancorp (the"Company") at March 31, 2010 and December 31, 2009, and the resultsof its operations for the three month periods ended March 31, 2010 and 2009,and its cash flows for the three month periods ended March 31, 2010 and 2009 inconformity with the instructions to Form 10-Q and Article 10 of Regulation S-Xof the Securities and Exchange Commission ("SEC").

 

Certain disclosures normally presentedin the notes to the consolidated financial statements prepared in accordancewith accounting principles generally accepted in the United States of Americafor annual financial statements have been omitted.  The Companybelieves that the disclosures in the interim condensed consolidated financialstatements are adequate to make the information not misleading. These interimcondensed consolidated financial statements should be read in conjunction withthe consolidated financial statements and notes thereto included in theCompany's 2009 Annual Report to Shareholders.   The results ofoperations for the three month period ended March 31, 2010 may not necessarilybe indicative of the operating results for the full year.

 

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

 

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

 

 NOTE 3. INVESTMENT SECURITIES

The amortized cost, gross unrealized gains and losses, andfair value of available-for-sale ("AFS") debt securities at March 31,2010 and December 31, 2009 were: 

 

|                                                      |         |                |         |                         |         |                          |         |   |            |   |   |   |   |
|-----------------------------------------------------------|--------------|---------------------|--------------|------------------------------|--------------|-------------------------------|--------------|--------|-----------------|--------|--------|--------|--------|
| **  **(Dollars  in thousands)                   |    | **Amortized  Cost** |    | **Gross  Unrealized  Gains** |    | **Gross  Unrealized  Losses** |         |   | **Fair  Value** |
| **Available-for-sale  debt securities, March 31, 2010**   |    |                |         |                    |         |                          |    |   |            |   |   |   |   |
| U.S. Treasury securities                                  |    | $                   | 5,001        |                    | $            | 44                            |    | $      | -               |   |   | $      | 5,045  |
| Obligations of states and political Subdivisions          |    |                | 2,183        |                    |         | 1                             |    |   | (261)           |   |   |   | 1,923  |
| Mortgage-backed securities                                |    |                | 5,524        |                    |         | 322                           |    |   | -               |   |   |   | 5,846  |
| Other MBS & CMO                                       |    |                | 5,023        |                    |         | 121                           |    |   | -               |   |   |   | 5,144  |
| Corporate bonds                                           |    |                | 4,953        |                    |         | 43                            |    |   | (1,948)         |   |   |   | 3,048  |
| **  Total available-for-sale  debt securities** |    | $                   | 22,684       |                    | $            | 531                           |    | $      | (2,209)         |   |   | $      | 21,006 |
|                                                      |
|                                                      |

** **

| **  **(Dollars  in thousands)                               |    | **Amortized  Cost** |    | **Gross  Unrealized  Gains** |    | **Gross  Unrealized  Losses** |         |   | **Fair  Value** |
|-----------------------------------------------------------------------|--------------|---------------------|--------------|------------------------------|--------------|-------------------------------|--------------|--------|-----------------|
|  **Available-for-sale  debt securities, December 31, 2009** |    |                |         |                    |         |                          |    |   |            |   |   |   |   |
| U.S. Treasury  securities                                             |    | $                   | 5,002        |                    | $            | 66                            |    | $      | -               |   |   | $ | 5,068 |
| Obligations of states and political Subdivisions                      |    |                | 2,730        |                    |         | 3                             |    |   | (74)            |   |   |   | 2,662 |
| Mortgage-backed securities                                            |    |                | 7,036        |                         |         | 307                           |         |   | -               |   |   |   | 7,343 |
| Other MBS & CMO                                                   |    |                | 5,742        |                         |         | 106                           |         |   | -               |   |   |   | 5,848 |
| Corporate bonds                                                       |    |                | 4,955        |                    |         | 28                            |    |   | (1,998)         |   |   |   | 2,985 |
| **  Total available-for-sale  debt securities**             |    | $                   | 25,465       |                    | $            | 513                           |    | $      | (2,072)         |   |   | $ | 23,906 |

At March 31, 2010, the amortized costand fair value of held to maturity debt securities were $33,000. At December31, 2009, both the amortized cost and fair value of held-to-maturity debtsecurities was $35,000. The accumulated net unrealized losses on AFS debtsecurities included in accumulated OCI was $990,000 at March 31, 2010. 

 

The following table presents thecurrent fair value and the associated gross unrealized losses on investments insecurities with gross unrealized losses at March 31, 2010 and December 31,2009, including debt securities for which a portion of other-than-temporaryimpairment has been recognized in OCI. The table also discloses whether thesesecurities have had gross unrealized losses for less than twelve months, or fortwelve months or longer. 

 

**March 31, 2009 Unrealized Security Losses on AFS**
|                                               | Less than 12 Months |        | 12 Months or More |      | Total              |
|----------------------------------------------------|---------------------|-------------|-------------------|-----------|--------------------|
|                                               |                | Fair

Value |              |      | Unrealized

Losses |   |   | Fair

Value |   |   | Unrealized

Losses |   |   | Fair

Value |   |   | Unrealized

Losses |
| (In  Thousands)                                    |
| Obligations  of states and political sub-divisions | $                   | 1,064       |              | $

  | (261)              |   | $ | 608 |   | $ | - | $ |   | 1,672 |   | $ | (261) |
| Corporate bonds                                    |                | 1,164       |              |      | (615)              |   |   | 836 |   |   | (1,333) |   |   | 2,000 |   |   | (1,948) |
|                                               | $                   | 2,228       |              | $         | (876)              |   | $ | 1,444 |   | $ | (1,333) |   | $ | 3,672 |   | $ | (2,209) |
|                                               |                |        |              |      |               |   |   |   |   |   |   |   |   |   |   |   |   |   |

** **

**December 31, 2009 Unrealized Security Losses on AFS**
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              | Less than 12 Months |        | 12 Months or More |      | Total              |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|---------------------|-------------|-------------------|-----------|--------------------|
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |                | Fair

Value |              |      | Unrealized

Losses |   |   | Fair

Value |   |   | Unrealized

Losses |   |   | Fair

Value |   |   | Unrealized

Losses |
|                                                                                   (In  Thousands) |
| Obligations  of states and political sub-divisions                                                                                                                                                                                                                                                                                                                                                                                                                                                                | $                   | 1,311       |              | $

  | (60)               |   | $ | 594 |   | $ | (14) | $ |   | 1,905 |   | $ | (74) |
| Corporate bonds                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |                | 1,171       |              |      | (611)              |   |   | 782 |   |   | (1,387) |   |   | 1,953 |   |   | (1,998) |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              | $                   | 2,482       |              | $         | (671)              |   | $ | 1,376 |   | $ | (1,401) |   | $ | 3,858 |   | $ | (2,072) |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |                |        |              |      |               |   |   |   |   |   |   |   |   |   |   |   |   |   |

 

 

Securities are pledged or assigned tosecure borrowed funds, government and for other purposes. The market value ofpledged securities was $17.272 million and $19.716 million at March 31, 2010and December 31, 2009. 

The following table summarizes thecontractual maturities of the Company's investment securities at theiramortized cost and their weighted-average yields at March 31, 2010. The yieldon tax-exempt securities has not been adjusted to a tax-equivalent yield basis.The expected maturity distribution of the Company's mortgage-backed securitiesand the contractual maturity distribution of the Company's other debtsecurities, and the yields of the Company's AFS debt securities portfolio atMarch 31, 2010 are summarized in the following table. Actual maturities maydiffer from the contractual or expected maturities since borrowers may have theright to prepay obligations with or without prepayment penalties. 

 

 

**March31, 2010 Investment Yields**
|  (Dollars  in thousands)                                          | **Within One Year**                                              | **One to Five Years** | **Five to Ten Years**                                | **Over Ten Years** | **Total**                                                             |
|------------------------------------------------------------------------|------------------------------------------------------------------|-----------------------|------------------------------------------------------|--------------------|-----------------------------------------------------------------------|
|                                                                   | Amount                                                           | Yield                 | Amount                                               | Yield              | Amount                                                                | Yield | Amount | Yield | Amount | Yield |
| **Available-for-sale  securities:**                                    |                                                             |                  |                                                 |               |                                                                  |   |   |   |   |   |
| US  Government Agencies and Treasuries..............................   | $ 5,001                                                          | 2.35%                 | $  -                                            | -%                 | $           -            | -% | $         - | -% | $5,001 | 2.35% |
| Municipal  Obligations ..........                                      | -                                                                | -%                    | -                                                    | -%                 | 361                                                                   | 2.87% | 1,821 | 4.78% | 2,182 | 4.46% |
| Corporate  and Other Bonds..                                           | -                                                                | -%                    | -                                                    | -%                 | -                                                                     | -% | 4,953 | 4.54% | 4,953 | 4.54% |
| Mortgage-  backed securities .                                         |        226                         | 3.46%                 |        -               | -%                 |              - | -% |   10,322 | 4.74% |   10,548 | 4.14% |
| **Total  available-for-sale securities..............................** |    5,227                                               | 2.40%                 |    -                                       | -%                 |        361                              | 2.87% |   17,0965 | 4.69% |    22,684 | 4.13% |
|                                                                   |                                                             |                  |                                                 |               |                                                                  |   |   |   |   |   |
| **Held-to-maturity Securities**                                        |                                                             |                  |                                                 |               |                                                                  |   |   |   |   |   |
| Mortgage-backed securities...                                          | $            - | -%                    | $          7 | 5.44%              | $        10                             | 6.35% | $        16 | 4.68% | $         33 | 5.33% |

 
|   |   |
|--------|--------|

 

NOTE 4. LOANS

 

Outstanding loans are summarized below:

 
|                                 |   | March 31,      |     |   | December 31, |   |
|--------------------------------------|--------|----------------|----------|--------|--------------|--------|
|                                 |   | 2010           |     |   | 2009         |   |
|                                 |   | (In thousands) |     |
|                                 |   |           |     |   |         |   |
| Commercial                           |   | $              | 62,832   |   |         | $      | 66,091 |   |
| Agricultural                         |   |           | 7,531    |   |         |   | 7,770 |   |
| Real estate - commercial mortgage    |   |           | 151,292  |   |         |   | 150,120 |   |
| Real estate-construction             |   |           | 9,065    |   |         |   | 17,531 |   |
| Installment                          |   |           | 13,128   |   |         |   | 14,641 |   |
| Gross loans                          |   |           | 243,848  |   |         |   | 256,153 |   |
| Deferred loan origination costs, net |   |           | 169      |   |         |   | 201 |   |
| Allowance for loan losses            |   |           | (10,815) |   |         |   | (10,508) |   |
| Net loans                            |   | $              | 233,202  |   |         | $      | 245,846 |   |

 

The Company's level of nonperforming loans increased inthe first three months of 2010.  There were loans in the amount of$22,864,000 on nonaccrual at December 31, 2009.  At March 31, 2010the Company had loans in the amount of $23,989,000 on nonaccrual.  Theforgone interest related to the loans on nonaccrual totaled $759,000 for thefirst three months of 2010.  The Company held an average of$23,427,000 on nonaccrual for the three month period ended March 31,2010.  

 

NOTE 5. OTHER REAL ESTATE OWNED, NET

 

The following table summarizes the Other Real Estate Owned("OREO") for the periods shown:

 
|                                |   | Three Months Ended |        |   |
|-------------------------------------|--------|--------------------|-------------|--------|
| (Dollars in thousands)              |   | March 31,          |        |   |
|                                |   | 2010               |        |   | 2009 |   |   |
| Balance, beginning period           |   | $                  | 10,934      |   |   | $ | 2,029 |   |   |
| Additions to OREO                   |   |               | 2,790       |   |   |   | 2,080 |   |   |
| Disposition of OREO                 |   |               | (248)  |   |   |   |  (874) |   |   |
| Valuation adjustments in the period |   |               | (798)       |   |   |   | (357) |   |   |
| Total OREO                          |   | $                  | 12,678      |   |   | $ | 2,878 |   |   |

 

 

NOTE 6. COMMITMENTS AND CONTINGENCIES

 

The Company is party to claims andlegal proceedings arising in the ordinary course of business.  In theopinion of the Company's management, the ultimate liability with respect tosuch proceedings will not have a materially adverse effect on the financialcondition or results of operations of the Company as a whole.

 

In the normal course of business thereare outstanding various commitments to extend credit which are not reflected inthe consolidated financial statements, including loan commitments ofapproximately $23,760,000 and $28,740,000 and stand-by letters of credit of$1,112,000 and $1,394,000 at March 31, 2010 and December 31, 2009,respectively.  However, all such commitments will not necessarilyculminate in actual extensions of credit by the Company.

 

Approximately $329,000 of the loancommitments outstanding at March 31, 2010 are for real estate loans and areexpected to fund within the next twelve months.  The remainingcommitments primarily relate to revolving lines of credit or other commercialloans, may expire without being drawn upon.  Therefore, the totalcommitments do not necessarily represent future cashrequirements.  Each potential borrower and the necessary collateralare evaluated on an individual basis.  Collateral varies, but mayinclude real property, bank deposits, debt or equity securities or businessassets.

 

Stand-by letters of credit arecommitments written to guarantee the performance of a customer to a thirdparty.  These letters of credit are issued primarily relating to realestate transactions and performance under specific contracts.  Creditrisk is similar to that involved in extending loan commitments to customers andaccordingly, evaluation and collateral requirements similar to those for loancommitments are used.  Virtually all such commitments arecollateralized. The deferred liability related to the Company's stand-byletters of credit was not significant at March 31, 2010 and December 31, 2009.

 

NOTE 7. LOSS PER SHARE COMPUTATION

 

Basic loss per share are computed by dividing net loss bythe weighted average common shares outstanding for theperiod.  Diluted earnings per share reflect the potential dilutionthat could occur if outstanding stock options wereexercised.  Diluted earnings per share is computed by dividing netincome by the weighted average common shares outstanding for the period plus theweighted average dilutive effect of outstanding options.  In thethree months ended March 31, 2010 and March 31, 2009, the Company recognized anet loss.  Due to the net loss, the diluted loss per share is equalto the basic loss per share.  At March 31, 2010, the Company had412,169 anti-dilutive shares outstanding.

 

NOTE 8. COMPREHENSIVE LOSS

 

Comprehensive loss is reported inaddition to net loss for all periods presented.  Comprehensive lossis made up of net loss plus other comprehensive loss.  Other comprehensiveloss, net of taxes, is comprised of the unrealized gains or losses onavailable-for-sale investment securities.  The following table showstotal comprehensive loss and its components for the periods indicated:

 
|                                                                                                  |   | Three Months Ended March 31, |    |   |
|-------------------------------------------------------------------------------------------------------|--------|------------------------------|---------|--------|
| *(in thousands)*                                                                                      |   | 2010                         |    |   | 2009 |   |
| Net (loss)                                                                                            |   | $                            | (2,333) |   |   | $ | (294) |   |
| Other comprehensive loss:                                                                             |   |                         |    |   |   |   |   |   |
|      Change  in unrealized loss on available for sale securities, net of tax |   |                         | (70)    |   |   |   | (54) |   |
|      Reclassification  adjustment, net of tax                                |   |                         | -       |   |   |   | 22 |   |
| Total other comprehensive (loss)                                                                      |   |                         | (70)    |   |   |   | (32) |   |
| Total comprehensive (loss)                                                                            |   | $                            | (2,403) |   |   | $ | (326) |   |
|                                                                                                  |   |                         |    |   |   |   |   |   |   |   |

 

NOTE 9. STOCK BASED COMPENSATION

 

*Stock Option Plan*

 

The Company's only stock-basedcompensation plan, the Pacific State Bancorp 1997 Stock Option Plan (the"Plan"), terminated in 2007. The Plan requires that the option pricemay not be less than the fair market value of the stock at the date the optionis granted, and that the stock must be paid in full at the time the option isexercised. The options expire on a date determined by the Board of Directors,but not later than ten years from the date of grant. The vesting period isdetermined by the Board of Directors and is generally over five years.  Newshares are issued upon the exercise of options

 

*Stock Option Compensation*

 

There were no stock options granted in2009 or 2010.  For the three month periods ended March 31, 2010 and 2009,the compensation cost recognized for stock option compensation was $0 and$14,000, respectively. The excess tax benefits were not significant for theCompany.

 

At March 31, 2010, all outstandingoptions are fully vested and therefore the Company will no longer recordexpense related to stock options without additional stock optionissuance.  In order for the Company to issue stock options an additionalstock option plan would have to be authorized by shareholders by vote.

 

 

*Stock Option Activity*

 

A summary of option activity under thestock option plans as of March 31, 2010 and changes during the period thenended is presented below:

 
| Options                                              |   | Shares |     |   | Weighted Average Exercise Price |   |   | Weighted Average Remaining  Contractual Term |   |      | Aggregate Intrinsic Value ($000) |   |
|------------------------------------------------------|--------|--------|----------|--------|---------------------------------|--------|--------|----------------------------------------------|--------|-----------|----------------------------------|--------|
| Outstanding at January 1, 2010                       |   |   | 501,069  |   |                            | $      | 7.40   |                                         |   | 3.5 Years |                             |   | $ | - |   |
| Granted                                              |   |   | -        |   |                            |   | -      |                                         |   |      | -                                |   |   |   | - |   |
| Exercised                                            |   |   | -        |   |                            |   | -      |                                         |   |      | -                                |   |   |   | - |   |
| Cancelled                                            |   |   | (88,900) |   |                            |   | 8.41   |                                         |   |      | 2.6 Years                        |   |   |   | - |   |
| Outstanding at March 31, 2010                        |   |   | 412,169  |   |                            | $      | 7.18   |                                         |   | 3.4 Years |                             |   | $ | - |   |
| Options vested or expected to vest at March 31, 2010 |   |   | 412,169  |   |                            | $      | 7.18   |                                         |   | 3.4 Years |                             |   | $ | - |   |
| Exercisable at March 31, 2010                        |   |   | 412,169  |   |                            | $      | 7.18   |                                         |   | 3.4 Years |                             |   | $ | - |   |

 

The intrinsic value was derived fromthe closing market price of the Company's common stock of $0.37 as of March 31,2010.

 

NOTE 10. INCOME TAXES

 

The Company files its income taxes on aconsolidated basis with its subsidiaries. The allocation of income tax expense(benefit) represents each entity's proportionate share of the consolidatedprovision for income taxes.

 

The Company accounts for income taxesusing the asset and liability or balance sheet method. Under this method,deferred tax assets and liabilities are recognized for the tax consequences oftemporary differences between the reported amounts of assets and liabilitiesand their tax bases. Deferred tax assets and liabilities are adjusted for theeffects of changes in tax laws and rates on the date of enactment. On theconsolidated balance sheet, net deferred tax assets are included in accruedinterest receivable and other assets.  During the first quarter of 2010the Company recorded a change in valuation allowance against its tax deferredassets of $754 thousand.  The Company will maintain the deferred taxvaluation allowance until it is reasonable to reverse the allowance.  

* *

Deferred Tax Assets

 

The Company recorded a net provisionfor income taxes of $783,000 for the three months ended March 31, 2010,compared to a tax credit of $271,000 in the first quarter of 2009.  TheCompany recorded a tax credit of $705,000 for the quarter ended March 31, 2010related to the periods pretax losses, the tax credit was then offset by theCompany's recorded increase in its tax valuation allowance of $1,448,000 in theperiod. The Company had a net deferred tax asset of $0 as of March 31, 2010 and$734,000 as of December 31, 2009.  Balance sheet changes and assumptionssince the previous reporting period have led management to believe that theCompany can no longer project with greater than 50% certainty that futureearnings will be adequate to realize the tax benefit recorded. Prospective earnings, tax law changes or capital changes could prompt theCompany to reevaluate the assumptions used to establish the valuation allowancewhich could result in the reversal of all or part of the valuation allowance. 

 

Accounting for Uncertainty in Income Taxes

 

The benefit of a tax position isrecognized in the financial statements in the period during which, based on allavailable evidence, management believes it is more likely than not that theposition will be sustained upon examination, including the resolution ofappeals or litigation processes, if any.  Tax positions that meet themore-likely-than-not recognition threshold are measured as the largest amountof tax benefit that is more than 50 percent likely of being realized uponsettlement with the applicable taxing authority.  The portion of thebenefits associated with tax positions taken that exceeds the amount measuredas described above is reflected as a liability for unrecognized tax benefits inthe accompanying balance sheet along with any associated interest and penaltiesthat would be payable to the taxing authorities upon examination.  TheCompany recognizes accrued interest and penalties related to unrecognized taxbenefits, if applicable, as a component of interest expense in the consolidatedstatements of operations.  There have been no significant changes tounrecognized tax benefits or accrued interest and penalties for the threemonths ended March 31, 2010.

NOTE 11.  FAIR VALUE MEASUREMENT

 

The measurement of fair value under USGAAP uses a hierarchy intended to maximize the use of observable inputs andminimize the use of unobservable inputs.  This hierarchy uses threelevels of inputs to measure the fair value of assets and liabilities as follows:

 

***Level 1:*** Quoted prices inactive exchange markets for identical assets or liabilities; also includescertain U.S. Treasury and other U.S. government and agency securities activelytraded in over-the-counter markets.

 

***Level 2:***Observableinputs other than Level 1 including quoted prices for similar assets orliabilities, quoted prices in less active markets, or other observable inputsthat can be corroborated by observable market data; also includes derivativecontracts whose value is determined using a pricing model with observablemarket inputs or can be derived principally from or corroborated by observablemarket data.  This category generally includes certain U.S.government and agency securities, corporate debt securities, derivative instruments,and residential mortgage loans held for sale.

 

***Level 3:***Unobservableinputs supported by little or no market activity for financial instrumentswhose value is determined using pricing models, discounted cash flowmethodologies, or similar techniques, as well as instruments for which thedetermination of fair value requires significant management judgment orestimation; also includes observable inputs for single dealer nonbinding quotesnot corroborated by observable market data. This category generally includescertain private equity investments, retained interests from securitizations,and certain collateralized debt obligations.

 

Assets measured at fair value on a recurring basiscomprised the following at March 31, 2010:

 

(Dollars in thousands)
| **Description**                                       | ** ** | **Fair Value**

**March 31, 2010** | ** ** | ** ** | **Fair Value Measurements**

**at March 31, 2010 using**            | ** ** |
|-------------------------------------------------------|------------|------------------------------------|------------|------------|---------------------------------------------------------------------|------------|
|                                                  |       |                               |       | ** ** | **Quoted Prices in Active  Markets for Identical Assets (Level 1)** | ** ** | ** ** | **Other Observable Inputs**

**(Level 2)** | ** ** | ** ** | **Significant Unobservable**

** Inputs**

**(Level 3)** | ** ** |
| Assets and liabilities measured on a recurring basis: |       |                               |       |       |                                                                |       |   |   |   |   |   |   |
| Available-for-sale securities                         |       | $                                  | 21,006     |       |                                                                | $          | 8,241 |   |   | $ | 12,765 |   |   | $ | - |   |
| Total                                                 |       | $                                  | 21,006     |       |                                                                | $          | 8,241 |   |   | $ | 12,765 |   |   | $ | - |   |

 
| **Description**                                       | ** ** | **Fair Value**

**December 31, 2010** | ** ** | ** ** | **Fair Value Measurements**

**at December 31, 2010 using**         | ** ** |
|-------------------------------------------------------|------------|---------------------------------------|------------|------------|---------------------------------------------------------------------|------------|
|                                                  |       |                                  |       | ** ** | **Quoted Prices in Active  Markets for Identical Assets (Level 1)** | ** ** | ** ** | **Other Observable Inputs**

**(Level 2)** | ** ** | ** ** | **Significant Unobservable**

** Inputs**

**(Level 3)** | ** ** |
| Assets and liabilities measured on a recurring basis: |       |                                  |       |       |                                                                |       |   |   |   |   |   |   |
| Available-for-sale securities                         |       | $                                     | 23,906     |       |                                                                | $          | 8,517 |   |   | $ | 15,100 |   |   | $ | 289 |   |
| Total                                                 |       | $                                     | 23,906     |       |                                                                | $          | 8,517 |   |   | $ | 15,100 |   |   | $ | 289 |   |

 

The investment securities measured atfair value utilizing Level 1 and Level 2 inputs are obligations of theU.S. Treasury, agencies and corporations of the U.S. government, includingmortgage-backed securities, bank eligible obligations of any state or politicalsubdivision in the U.S., bank eligible corporate obligations, includingprivate-label mortgage-backed securities and common stocks issued by variousunrelated banking holding companies.  The fair values used by theCompany are obtained from an independent pricing service and represent eitherquoted market prices for the identical securities (Level 1 inputs) or fairvalues determined by pricing models that consider observable market data, suchas interest rate volatilities, LIBOR yield curve, credit spreads and pricesfrom market makers and live trading systems (Level 2 inputs).

 

Certain financial assets and financialliabilities are measured at fair value on a nonrecurring basis; that is, theinstruments are not measured at fair value on an ongoing basis but are subjectto fair value adjustments in certain circumstances (for example, when there isevidence of impairment).  Financial assets measured at fair value ona non-recurring basis included the following:

 

***Impaired Loans:***Impairedloans are measured and reported at fair value in accordance with the provisionsof generally accepted accounting principles*.*  Management'sdetermination of the fair value for these loans represents the estimated netproceeds to be received from the sale of the collateral based on observablemarket prices and market value provided by independent, licensed or certifiedappraisers (Level 2 Inputs).  At March 31, 2010, impaired loans withan aggregate outstanding principal balance of $61.1 million were measured andreported at a fair value of $57.4 million.  The Company hasrecognized losses on impaired loans of $4.7 million through the allowance forloan losses.

 

***Other real estate owned****-*** **Otherreal estate owned represents real estate which the Company has taken control ofin partial or full satisfaction of loans. At the time of foreclosure, otherreal estate owned is recorded at the fair value of the real estate less coststo sell, which becomes the property's new basis.

 

(Dollars in thousands)
| **Description**                                          | ** ** | **Fair Value**

**March 31, 2010** | ** ** | ** ** | **                Fair Value Measurements**

**                 at March 31, 2010 using** | ** ** | ** ** | ** **          | ** ** | ** ** | ** **  | ** ** |
|----------------------------------------------------------|------------|------------------------------------|------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|---------------------|------------|------------|-------------|------------|
|                                                     | ** ** | **Fair Value **               | ** ** | ** ** | **Level 1**                                                                                                                                                                                                                                | ** ** | ** ** |  

**Level 2** | ** ** | ** ** | **Level 3** | ** ** | **Total Losses** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Assets and liabilities measured on a nonrecurring basis: |       |                               |       |       |                                                                                                                                                                                                                                       |       |       |                |       |       |        |       | ** ** | ** ** | ** ** | ** ** |   |   |
| Impaired loans                                           |       | $                                  | 57,403     |       |                                                                                                                                                                                                                                       | $          | -          |                |       | $          | 57,403      |       |   | $ | - |    $ | 4,716 |   |   |   |   |   |
| Other real estate owned                                  |       |                               | 12,678     |       |                                                                                                                                                                                                                                       |       | -          |                |       |       | 12,678      |       |   |   | - |   | 5,280 |   |   |   |   |   |
| Total                                                    |       | $                                  | 70,081     |       |                                                                                                                                                                                                                                       | $          | -          |                |       | $          | 70,081      |       |   | $ | - |    $ | 9,996 |   |   |   |   |   |

 

(Dollars in thousands)
| **Description**                                          | ** ** | **Fair Value**

**December 31, 2010** | ** ** | ** ** | **                Fair Value Measurements**

**                 at December 31, 2010 using** | ** ** | ** ** | ** **          | ** ** | ** ** | ** **          | ** ** |
|----------------------------------------------------------|------------|---------------------------------------|------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|---------------------|------------|------------|---------------------|------------|
|                                                     | ** ** | **Fair Value **                  | ** ** | ** ** | **Level 1**                                                                                                                                                                                                                                   | ** ** | ** ** |  

**Level 2** | ** ** | ** ** |  

**Level 3** | ** ** | **Total Losses** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Assets and liabilities measured on a nonrecurring basis: |       |                                  |       |       |                                                                                                                                                                                                                                          |       |       |                |       |       |                |       | ** ** | ** ** | ** ** | ** ** |   |   |
| Impaired loans                                           |       | $                                     | 60,551     |       |                                                                                                                                                                                                                                          | $          | -          |                |       | $          | 60,551              |       |   | $ | - |    $ | 2,876 |   |   |   |   |   |
| Other real estate owned                                  |       |                                  | 10,934     |       |                                                                                                                                                                                                                                          |       | -          |                |       |       | 10,934              |       |   |   | - |   | 4,504 |   |   |   |   |   |
| Total                                                    |       | $                                     | 71,485     |       |                                                                                                                                                                                                                                          | $          | -          |                |       | $          | 71,485              |       |   | $ | - |    $ | 7,380 |   |   |   |   |   |

 

 

The following table presents the fair values of financialassets and liabilities carried on the Company's consolidated balance sheet,including those financial assets and financial liabilities that are notmeasured and reported at fair value on a recurring basis or non-recurringbasis:

 
|                         |   | March 31, 2010 |    |   | December 31, 2009 |   |
|------------------------------|--------|----------------|---------|--------|-------------------|--------|
|                         |   | Carrying       |    |   | Fair              |   |   | Carrying |   |   | Fair |   |
| (In thousands)               |   | Amount         |    |   | Value             |   |   | Amount |   |   | Value |   |
| Financial assets:            |   |           |    |   |              |   |   |   |   |   |   |   |
| Cash and due from banks      |   | $              | 9,816   |   |              | $      | 9,816 |   |   | $ | 10,517 |   |   | $ | 10,517 |   |
| Federal funds sold           |   |           | 13,994  |   |              |   | 13,994 |   |   |   | 45,568 |   |   |   | 45,568 |   |
| Investment securities        |   |           | 21,039  |   |              |   | 21,039 |   |   |   | 23,941 |   |   |   | 23,941 |   |
| Loans, net                   |   |           | 233,202 |   |              |   | 232,113 |   |   |   | 245,846 |   |   |   | 244,698 |   |
| Company owned life insurance |   |           | 7,099   |   |              |   | 7,099 |   |   |   | 7,030 |   |   |   | 7,030 |   |
| Accrued interest receivable  |   |           | 1,105   |   |              |   | 1,105 |   |   |   | 1,022 |   |   |   | 1,022 |   |
| Other investments            |   |           | 2,495   |   |              |   | 2,495 |   |   |   | 2,495 |   |   |   | 2,495 |   |
|                         |   |           |    |   |              |   |   |   |   |   |   |   |   |   |   |   |
| Financial liabilities:       |   |           |    |   |              |   |   |   |   |   |   |   |   |   |   |   |
| Deposits                     |   | $              | 287,750 |   |              | $      | 290,251 |   |   | $ | 322,425 |   |   | $ | 324,731 |   |
| Other borrowings             |   |           | 19,000  |   |              |   | 19,346 |   |   |   | 29,000 |   |   |   | 29,495 |   |
| Subordinated debentures      |   |           | 8,764   |   |              |   | 1,753 |   |   |   | 8,764 |   |   |   | 1,753 |   |
| Accrued interest payable     |   |           | 1,107   |   |              |   | 1,107 |   |   |   | 1,393 |   |   |   | 1,393 |   |

 

The methodologies for estimating thefair value of financial assets and liabilities that are measured at fair valueon a recurring or non-recurring basis are discussed above.  Forcertain financial assets and liabilities, carrying value approximates fairvalue due to the nature of the financial instrument.  Theseinstruments include cash and cash equivalents, demand and other non-maturitydeposits and overnight borrowings.  The Company used the followingmethods and assumptions in estimating the fair value of the following financialinstruments:

 

***Loans:***The fair value ofperforming variable rate loans that reprice frequently and performing demandloans, with no significant change in credit risk, is based on carryingvalue.  The fair value of fixed rate performing loans is estimatedusing discounted cash flow analyses and interest rates currently being offeredfor loans with similar terms to borrowers of similar credit quality.

 

The fair value of significantnonperforming loans is based on either the estimated fair value of underlyingcollateral or estimated cash flows, discounted at a rate commensurate with therisk.  Assumptions regarding credit risk, cash flows, and discountrates are determined using available market information and specific borrowerinformation.

 

***Deposits:***The fair valueof fixed maturity certificates of deposit is estimated using a discounted cashflow calculation based on current rates offered for deposits of similarremaining maturities.

  

***Borrowings:***The fairvalue of long-term borrowings is estimated using discounted cash flow analysisbased on rates currently available to the Company for borrowings with similarterms.

 

***Junior Subordinated Notes Held bySubsidiary Trust:***The fair value of the junior subordinated notes heldby subsidiary trust is estimated using current market rates of securitieswith similar risk and remaining maturity.

 

Bank premises and equipment, customerrelationships, deposit base, banking center networks, and other informationrequired to compute the Company's aggregate fair value are not included in theabove information.  Accordingly, the above fair values are not intendedto represent the aggregate fair value of the Company.

 

NOTE 12. NEW ACCOUNTING PRONOUNCEMENTS

 

On June 12, 2009, the FASB issued two new accountingstandards: SFAS No. 166, "Accounting for Transfers of Financial Assetsan amendment of FASB Statement No. 140" (SFAS 166) and SFAS No. 167,"Amendments to FASB Interpretation No. 46(R)" (SFAS 167), which willamend FASB ASC 860-10, "Transfers and Servicing," and FASB ASC810-10, "Consolidation of Variable Interest Entities("VIE")."  Among other things, SFAS 166 eliminates theconcept of a qualified special purpose entity ("QSPE"). As a result,existing QSPEs generally will be subject to consolidation in accordance withthe guidance provided in SFAS 167. 

SFAS 167 significantly changes thecriteria by which an enterprise determines whether it must consolidate a VIE. AVIE is an entity, typically an SPE, which has insufficient equity at risk orwhich is not controlled through voting rights held by equity investors.Currently, a VIE is consolidated by the enterprise that will absorb a majorityof the expected losses or expected residual returns created by the assets ofthe VIE. SFAS 167 requires that a VIE be consolidated by the enterprise thathas both the power to direct the activities that most significantly impact theVIE's economic performance and the obligation to absorb losses or the right toreceive benefits that could potentially be significant to the VIE. SFAS 167also requires that an enterprise continually reassess, based on current factsand circumstances, whether it should consolidate the VIEs with which it isinvolved. 

 

Both SFAS 166 and SFAS 167 will beeffective as of the beginning of each reporting entity's first annual reportingperiod that began after November 15, 2009, for interim periods within thatfirst annual reporting period and for interim and annual reporting periodsthereafter.    The recognition and measurement provisionsof SFAS 166 shall be applied to transfers that occur on or after the effectivedate.  Pacific State Bancorp adopted both SFAS 166 and SFAS 167 onJanuary 1, 2010, as required.  The adoption of these new ASCs did nothave a material impact on the consolidated financial statements of the Company.

 

In January 2010, the FASB issued ASUNo. 2010-06, Fair Value Measurements and Disclosures (Topic 820) ImprovingDisclosures about Fair Value Measurements. FASB ASU No. 2009-06 requires (i)fair value disclosures by each class of assets and liabilities (generally asubset within a line item as presented in the statement of financial position)rather than major category, (ii) for items measured at fair value on arecurring basis, the amounts of significant transfers between Levels 1 and 2,and transfers into and out of Level 3, and the reasons for those transfers,including separate discussion related to the transfers into each level apartfrom transfers out of each level, and (iii) gross presentation of the amountsof purchases, sales, issuances, and settlements in the Level 3 recurringmeasurement reconciliation. Additionally, the ASU clarifies that a descriptionof the valuation techniques(s) and inputs used to measure fair values isrequired for both recurring and nonrecurring fair value measurements. Also, ifa valuation technique has changed, entities should disclose that change and thereason for the change. Disclosures other than the gross presentation changes inthe Level 3 reconciliation are effective for the first reporting periodbeginning after December 15, 2009. The requirement to present the Level 3activity of purchases, sales, issuances, and settlements on a gross basis willbe effective for fiscal years beginning after December 15, 2010. The adoptionof this ASU did not have a material impact on the Company's consolidatedfinancial statements. 

 

In February 2010, the FASB issued ASUNo. 2010-09, Subsequent Events (Topic 855) Amendments to Certain Recognitionand disclosure Requirements. This ASU eliminates the requirement for todisclose the date through which a Company has evaluated subsequent events and refinesthe scope of the disclosure requirements for reissued financial statements.This ASU is effective for the first quarter of 2010. This ASU did not have amaterial impact on the Company's consolidated financial statements. 

 

In March, the FASB issued ASU No.2010-11, Derivatives and Hedging (Topic 815)-Scope Exception Related toEmbedded Credit Derivatives. The ASU eliminates the scope exception forbifurcation of embedded credit derivatives in interests in securitizedfinancial assets, unless they are created solely by subordination of onefinancial instrument to another. The ASU is effective the first quarterbeginning after June 15, 2010. The Company has evaluated the impact of adoptionand does not expect the ASU will have a material impact on the Company'sconsolidated financial statements. 

 

In April, the FASB issued ASU No.2010-18, Receivables (Topic 310)-Effect of a Loan Modification When the Loan IsPart of a Pool That is Accounted for as a Single Asset. This ASU clarifies thatmodifications of loans that are accounted for within a pool under Topic 310-30do not result in the removal of those loans from the pool even if themodification of those loans would otherwise be considered a troubled debtrestructuring. An entity will continue to be required to consider whether thepool of assets in which the loan is included is impaired if expected cash flowsfor the pool change. No additional disclosures are required with this ASU. Theamendments in this ASU are effective for modifications of loans accounted forwithin pools under Topic 310-30 occurring in the first interim or annual periodending on or after July 15, 2010. The amendments are to be appliedprospectively and early application is permitted. Upon initial adoption of theguidance in this ASU, an entity may make a onetime election to terminateaccounting for loans as a pool under Topic 310-30. This election may be appliedon a pool-by-pool basis and does not preclude an entity from applying poolaccounting to subsequent acquisitions of loans with credit deterioration. TheCompany has evaluated the impact of adoption and does not expect the ASU willhave a material impact on the Company's consolidated financial statements. 

 

 

 

**ITEM 2. MANAGEMENT'S DISCUSSIONAND ANALYSIS OF**

**FINANCIAL CONDITION AND RESULTSOF OPERATIONS**

 

Certain matters discussed in thisQuarterly Report are forward-looking statements that are subject to risks anduncertainties that could cause actual results to differ materially from thoseprojected in the forward-looking statements. Such risks and uncertaintiesinclude, among others (1) significant increases in competitive pressures in thefinancial services industry; (2) changes in the interest rate environmentresulting in reduced margins; (3) general economic conditions, eithernationally or regionally, may be less favorable than expected, resulting inamong other things, a deterioration in credit quality; (4) changes in theregulatory environment; (5) loss of key personnel; (6) fluctuations in the realestate market; (7) changes in business conditions and inflation; (8)operational risks including data processing systems failures and fraud; (9)changes in the securities market: and (10) changes in capital and globalmarkets and availability of capital.  Therefore the information setforth herein should be carefully considered when evaluating the businessprospects of the Company.

 

When the Company uses in this QuarterlyReport the words "anticipate", "estimate","expect", "project", "intend","commit", "believe" and similar expressions, the Companyintends to identify forward-looking statements.  Such statements arenot guarantees of performance and are subject to certain risks, uncertaintiesand assumptions, including those described in this Quarterly Report. Should oneor more of the uncertainties materialize, or should underlying assumptionsprove incorrect, actual results may vary materially from those anticipated,estimated, expected, projected, intended, committed or believed.  Thefuture results and stockholder values of the Company may differ materially fromthose expressed in these forward-looking statements.  Many factorsthat will determine these results and values are beyond the Company's abilityto control or predict.  For those statements, the Company claims theprotection of the safe harbor for forward-looking statements contained in thePrivate Securities Litigation Reform Act of 1995.

 

**INTRODUCTION**

 

The following discussion and analysissets forth certain statistical information relating to the Company as of March31, 2010 and December 31, 2009.  The discussion should be read inconjunction with the unaudited condensed consolidated financial statements andrelated notes included elsewhere in this report and the consolidated financialstatements and notes thereto included in Pacific State Bancorp's AnnualReport filed on Form 10-K for the year ended December 31, 2009.

 

**CRITICAL ACCOUNTING POLICIES**

 

There have been no changes to theCompany's critical accounting policies from those discussed in Management'sDiscussion and Analysis of Financial Condition and Results of Operations in theCompany's 2009 Annual Report on Form 10-K.

 

**OVERVIEW**

 

The 2010 first quarter net loss of$2.333 million compares to a net loss of $294 thousand for the first quarter of2009.  During the first quarter of 2010, the Company experiencedincreased costs associated with deteriorating real estate values and anelevated level of nonperforming assets.  Decreased real estate values ledthe Company to record $895 thousand in other real estate expense the firstquarter of 2010 compared to $431 thousand recorded for the same time period in2009.  In addition, elevated levels of nonperforming assets coupled withlower levels of average earning assets led to a reduction of interest income of$1.607 million.  The Company also wrote down the final $734,000 ofremaining net deferred tax asset in the period, impacting the March 31, 2010tax provision.

 

The annualized loss on average assetswas 2.68% for the three month period ended March 31, 2010 compared to anannualized loss on average assets of 0.29% for the same period in2009.  The annualized loss on average equity was 167.69% forthe three month period March 31, 2010 compared to a loss on annualized averageequity of 4.24% for the same period in 2009. The loss on average assetsand loss on average equity in the first quarter 2010 compared to thesame time period in 2009 is primarily attributable to the larger net lossrecorded in 2010 offset somewhat by a reduced asset and equity base in theperiod in which the losses resulted.

 

On November 10, 2009, the Company received a notice fromthe Nasdaq Global Market stating that the Company no longer met the $1.00 pershare requirement for continued listing on the Nasdaq Global Select Marketunder Listing Rule 5450 (a)(1). This notice did not result in an immediatedelisting of the Company's common stock from the Nasdaq Global Select Market,as a grace period of 180 calendar days or until May 10, 2010, is provided underthe listing rules. However, we elected to apply to transfer listing to theNASDAQ Capital Market as set forth in Listing Rule 5505.  As a resultof such transfer, the Company became eligible for an additional 180 calendarday grace period. The requirements for initial listing on the Nasdaq CapitalMarket include a minimum market value of publicly held shares of $15 million,which the Company does not currently meet. If at any time during this graceperiod the bid price of the Company's common stock closes at $1.00 per share ormore for a minimum of ten consecutive business days, Nasdaq will provide uswritten confirmation of compliance. As a result of not complying by May 10,2010 with the requirements for listing our common stock on the Nasdaq CapitalMarket, it is likely that we will be delisted and the shares will likelythereafter trade on the "over-the-counter" bulletin boardmarket.  

 

On February 18, 2010, the Company and the Bank consented toenter into a written agreement with the Federal Reserve Bank of San Francisco(the "FRBSF") and the State of California Department of FinancialInstitutions (the "CDFI") as follow-up to an examination of the Bank(the "Written Agreement").  Among other things, the WrittenAgreement provides that the Company and the Bank shall submit to the FRBSF andthe CDFI their continuing plans to enhance lending and credit administrationfunctions, to maintain policies and procedures for the maintenance of anadequate allocation for loan and lease losses, to improve the Bank's earningsand overall condition, improve management of the Bank's liquidity position andfunds management practices and update its capital plan in order to maintainsufficient capital at the Company and the Bank.  The WrittenAgreement also restricts the Company and the Bank from making the payment ofdividends, any payments on trust preferred securities, any reduction in capitalor the purchase or redemption of stock without the prior approval of the FRBSF,as well as other restrictions. Progress reports detailing the form and mannerof all actions taken to secure compliance with the Written Agreement must besubmitted to the FRBSF at least quarterly. 

 

In addition to the Written Agreement's requirements, as aresult of being undercapitalized under the prompt corrective action rules, theBank is subject to certain regulatory restrictions. These include, amongothers, that the Bank may not make any capital distributions, must submit anacceptable capital restoration plan to the FRBSF, may not increase its averagetotal assets during a calendar quarter to exceed its average total assetsduring the preceding calendar quarter and may not acquire a business, establishor acquire a branch office or engage in a new line of business.

 

Management of the Company has taken certain steps in aneffort to continue with safe and sound banking practices exercising thecontractual right to defer the interest on the junior subordinated debentures,taking a number of actions to contain costs, continuing to reduce its lendingexposure, and increasing the borrowing line at the Federal Reserve Bank'sdiscount window in an amount up to approximately $38 million.  However, inMarch, 2010, the CDFI presented the Bank with a proposed cease and desist orderrequiring the Bank to raise capital and, on April 15, 2010, theBank executed a Waiver and Consent to the Order of the CDFI (the"Consent").  The Consent requires the Bank, within 90days of the effective date of the Order, either to increase and tomaintain tangible capital at a level equal to 10% of total tangible assets ormerge with a depository institution or sell to an acquirer acceptable to theCDFI.  The effective date was the date that the CDFI executedthe Order which was May 3, 2010.   As of March 31, 2010, the Bank hada ratio of tangible capital to assets of 3.7%, which wasnot sufficient to meet the higher level that the Bank would be obligated tomaintain under the Consent.  As a result, if by August 1, 2010 theBank cannot comply with the Consent provisions, the Bank may be subject tofurther supervisory action, which could have a material adverse effect on itsresults of operations, financial condition and business.

 

As a result of the Written Agreement and the Consent, weare actively seeking additional capital either directly through the sale ofsecurities or indirectly through the merger with another bank or financialinstitution (which could be accompanied by a financing) or sale to an acquirer.We expect that any sale of securities would most likely be through a privateplacement to institutional investors.  While we have had discussionswith various financing sources and potential merger partners, at the date ofthis Report we have no agreements for any such transaction. Any merger, sale orfinancing likely would involve a change of control of the Company.

 

If the Bank is not successful in raising additionalcapital, it will not be able to become fully compliant with the provisions ofthe Written Agreement or the Consent discussed above.  As a result,the FRBSF, CDFI or the FDIC may take further enforcement action, includingplacing the Bank into receivership. If the Bank is placed into FDICreceivership, it is likely that the Bank would be required to cease operationsand liquidate. If the Bank were to liquidate it is unlikely that there would beany assets available to the holders of the common shareholders of the Company.

 

The consolidated financial statementscontained in the Company's Annual Report to Shareholders for 2009 and thisQuarterly Report as of March 31, 2010 have been prepared on a going concernbasis, which contemplates the realization of assets and the discharge ofliabilities in the normal course of business. As a result, the consolidatedfinancial statements do not include any adjustments that may result from theoutcome of any regulatory action or the Company's or the Bank's inability tomeet its existing debt obligations. The Bank has recently incurred significantoperating losses, experienced a significant deterioration in the quality of itsassets and become subject to enhanced regulatory scrutiny. These factors, amongothers, were deemed to cast significant doubt on the Company's and the Bank'sability to continue as a going concern. If the Company cannot continue tooperate as a going concern, it is likely that shareholders will lose all orsubstantially all of their investment in the Company.

 

**RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED MARCH31, 2010**

 

The 2010 first quarter net loss of$2.333 million compares to a net loss of $294 thousand for the first quarter of2009.  The increased net loss for the first quarter 2010compared to the first quarter of 2009 was primarily related to reduced netinterest income and increased non-interest expense on OREO properties,professional fees and FDIC insurance assessment charges.  High levels ofnonperforming assets and an overall decrease in average earning assets resultedin decreased interest income in 2010 compared to 2009.  In addition, realestate values have continued to deteriorate for certain properties the Companycurrently holds as other real estate owned.  The continued valuedeterioration has led management to record impairment charges against propertypreviously valued at higher amounts based on third party appraisals.  Inaddition to impairment charges, the Company has incurred operating costsassociated with other real owned.  Total expense related to OREO for thethree months ended March 31, 2010 was $895 thousand compared to $431 thousandin the same time period in 2009. In addition the Company wrote down theremaining net deferred tax asset by $734,000 in the first quarter of 2010,ending the period with a $0 remaining net deferred tax asset.

 

These losses have resulted in a decrease in ourshareholders' equity and regulatory capital. Our shareholders' equity was $3.3million at March 31, 2010, and $5.7 million at December 31, 2009.  Asof March 31, 2010, the Company and the Bank's regulatory capital levels wereconsidered "under capitalized" under the prompt corrective actionrules of the Federal Deposit Insurance Corporation ("FDIC"). Theseconditions create an uncertainty about the Company's ability to continue as agoing concern. The consolidated financial statements set forth in thisQuarterly Report have been prepared on a going concern basis, whichcontemplates the realization of assets and the discharge of liabilities in thenormal course of business for the foreseeable future, and do not include anyadjustments to reflect the possible future effects on the recoverability andclassification of assets, or the amounts and classification of liabilities thatmay result from the outcome of the Company's inability to repay the outstandingprincipal balance of its debt or from any extraordinary regulatory action,either of which would affect its ability to continue as a going concern. 

 

 

**Net interest income before provision for loan losses**

 
|                                                  | ** ** | **Three Months Ended March 31,** | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|
| (Dollars  in thousands, except per share data)        | ** ** | **2010**                         | ** ** | ** ** | **2009** | ** ** | ** ** | **Dollar Change** | ** ** | ** ** | **Percentage Change** | ** ** |
| **Interest  income:**                                 |       |                             |       |   |   |   |   |   |   |   |   |   |
| Interest and fees on loans                            |       | $                                | 3,759      |   |   | $ | 5,024 |   |   | $ | (1,265) |   |   |   | (25) | % |
| Interest  on Federal funds sold                       |       |                             | 22         |   |   |   | 16 |   |   |   |                6 |   |   |   | 38 |   |
| Interest  on investment securities                    |       |                             | 166        |   |   |   | 512 |   |   |   | (346) |   |   |   | (68) |   |
| Total  interest income                                |       |                             | 3,947      |   |   |   | 5,552 |   |   |   | (1,605) |   |   |   | (29) |   |
|                                                  |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Interest  expense:**                                |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest  on deposits                                 |       |                             | 1,106      |   |   |   | 1,837 |   |   |   | (731) |   |   |   | (40) |   |
| Interest  on other borrowings                         |       |                             | 153        |   |   |   | 306 |   |   |   |  (153) |   |   |   | (50) |   |
| Interest  on subordinated debentures                  |       |                             | 50         |   |   |   | 84 |   |   |   | (34) |   |   |   | (41) |   |
| Total  interest expense                               |       |                             | 1,309      |   |   |   | 2,227 |   |   |   | (918) |   |   |   | (41) |   |
| Net  interest income before provision for loan losses |       | $                                | 2,638      |   |   | $ | 3,325 |   |   | $ | (687) |   |   |   | (21) | % |

 

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

 

The decreased net interest incomeperformance is primarily the result of the Bank experiencing a contraction inits net interest margin.  The contraction of the net interest marginis the result of an increased level of nonaccrual loans and nonperformingassets as well as a smaller earning asset base and smaller interest bearingliability totals.  Increased levels of nonaccrual loans have theeffect of reducing loan yields over the time period.  Increasedlevels of nonaccrual loans coupled with decreasing market rates charged on loanbalances have caused the yields earned on the loan portfolio to decrease from6.65% for the first quarter of 2009 to 6.10% for the first quarter of2010.  The yield earned on all interest earning assets in the firstquarter of 2010 totaled 5.24% compared to 6.18% for the same time period in2009.  In addition to the decrease in yields earned on assets, totalaverage earning assets decreased $58.865 million to $305.292 million for thefirst quarter of 2010 from $364.157 million for the same time period in 2009.  Thedecrease in average earning assets occurred primarily in the loan portfoliowhere average balances decreased $56.109 million or 18.3% to $250.086 millionin the first quarter of 2010 from $306.195 million for the same time period in2009.

 

The net interest margin for the threemonths ended March 31, 2010 decreased 27 basis points to 3.43%, from 3.70% forthe same period in 2009.  The decrease in interest income described abovewas offset by a decrease in the level of funding and rate paid for the fundingof assets during the first quarter of 2010 compared to the same time period in2009.  The cost of funding in the first quarter of 2010 totaled 1.86%compared to 2.84% in the first quarter of 2009.  The cost of fundingdecreased primarily because of decreased market rates paid for deposits andborrowings during the first quarter of 2010 compared to the same timeperiod in 2009.  In addition to decreased rates paid on deposits, theaverage balance on which interest was paid decreased by $32.441 million to$285.202 million for the first quarter of 2010 from $317.643 million for thesame period in 2009.  The decrease was primarily attributable to adecrease of $20.653 million in other borrowings to $28.122 million for thefirst quarter of 2010 from $48.775 million for the same time period in 2009.

 

 

The following table presents for thethree month period indicated the distribution of consolidated average assets,liabilities and shareholders' equity.  It also presents the amountsof interest income from the interest earning assets and the resultant yieldsexpressed in both dollars and rate percentages.  Average balances arebased on daily averages.  Nonaccrual loans are included in thecalculation of average loans while nonaccrued interest thereon is excluded fromthe computation of yields earned:

 

 
| **PACIFIC STATE BANCORP**                          | ** **                            |
|----------------------------------------------------|---------------------------------------|
| **Yield Analysis**                                 | ** **                            |
|                                               | **For Three Months Ended March  31,** | ** ** |
| **(Dollars in thousands)**                         | **2010**                              | ** ** | ** ** | **2009** | ** ** |
|                                               |                                  |   |   | Interest |   |   | Average |   |   |   |   |   | Interest |   |   | Average |   |
|                                               | Average                               |   |   | Income or |   |   | Yield or |   |   | Average |   |   | Income or |   |   | Yield or |   |
| **Assets:**                                        | Balance                               |   |   | Expense |   |   | Cost |   |   | Balance |   |   | Expense |   |   | Cost |   |
| Interest-earning assets:                           |                                  |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans(1)(2)                                        |                                  | $ | 250,086 |   |   | $ | 3,759 |   |   |   | 6.10 | % |   | $ | 306,195 |   |   | $ | 5,024 |   |   |   | 6.65 | % |
| Investment securities(2)                           |                                  |   | 24,930 |   |   |   | 166 |   |   |   | 2.70 | % |   |   | 41,444 |   |   |   | 512 |   |   |   | 5.01 | % |
| Federal funds sold                                 |                                  |   | 30,276 |   |   |   | 22 |   |   |   | 0.29 | % |   |   | 16,518 |   |   |   | 16 |   |   |   | 0.39 | % |
| Interest bearing deposits in banks                 |                                  |   | - |   |   |   | - |   |   |   | - |   |   |   | - |   |   |   | - |   |   |   | - |   |
| Total average earning assets                       |                                  | $ | 305,292 |   |   | $ | 3,947 |   |   |   | 5.24 | % |   | $ | 364,157 |   |   | $ | 5,552 |   |   |   | 6.18 | % |
|                                               |                                  |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Non-earning assets:                                |                                  |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash and due from banks                            |                                  |   | 10,800 |   |   |   |   |   |   |   |   |   |   |   | 12,136 |   |   |   |   |   |   |   |   |   |
| Bank premises and equipment                        |                                  |   | 27,856 |   |   |   |   |   |   |   |   |   |   |   | 19,257 |   |   |   |   |   |   |   |   |   |
| Other assets                                       |                                  |   | 14,070 |   |   |   |   |   |   |   |   |   |   |   | 20,017 |   |   |   |   |   |   |   |   |   |
| Allowance for loan loss                            |                                  |   | (10,458 | ) |   |   |   |   |   |   |   |   |   |   | (6,243 | ) |   |   |   |   |   |   |   |   |
| Total average assets                               |                                  | $ | 347,560 |   |   |   |   |   |   |   |   |   |   | $ | 409,324 |   |   |   |   |   |   |   |   |   |
|                                               |                                  |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                               |                                  |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Liabilities and Shareholders' Equity:**          | ** **                            |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities:                      |                                  |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Deposits                                           |                                  |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing demand                            |                                  | $ | 55,660 |   |   | $ | 97 |   |   |   | 0.71 | % |   | $ | 70,837 |   |   | $ | 211 |   |   |   | 1.21 | % |
| Savings                                            |                                  |   | 27,560 |   |   |   | 48 |   |   |   | 0.71 | % |   |   | 9,537 |   |   |   | 21 |   |   |   | 0.89 | % |
| Time deposits                                      |                                  |   | 172,183 |   |   |   | 961 |   |   |   | 2.26 | % |   |   | 188,494 |   |   |   | 1,605 |   |   |   | 3.45 | % |
| Other borrowings(3)                                |                                  |   | 28,122 |   |   |   | 203 |   |   |   | 2.93 | % |   |   | 48,775 |   |   |   | 390 |   |   |   | 3.24 | % |
|                                               |                                  |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total average interest-bearing liabilities         |                                  | $ | 283,525 |   |   | $ | 1,309 |   |   |   | 1.87 | % |   | $ | 317,643 |   |   | $ | 2,227 |   |   |   | 2.84 | % |
|                                               |                                  |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing liabilities:                   |                                  |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Demand deposits                                    |                                  |   | 54,500 |   |   |   |   |   |   |   |   |   |   |   | 59,424 |   |   |   |   |   |   |   |   |   |
| Other liabilities                                  |                                  |   | 3,970 |   |   |   |   |   |   |   |   |   |   |   | 4,500 |   |   |   |   |   |   |   |   |   |
| Total average liabilities                          |                                  |   | 341,995 |   |   |   |   |   |   |   |   |   |   |   | 381,567 |   |   |   |   |   |   |   |   |   |
| Shareholders' equity                               |                                  |   | 5,565 |   |   |   |   |   |   |   |   |   |   |   | 27,757 |   |   |   |   |   |   |   |   |   |
| Total average liabilities and shareholders' equity |                                  | $ | 347,560 |   |   |   |   |   |   |   |   |   |   | $ | 409,324 |   |   |   |   |   |   |   |   |   |
|                                               |                                  |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest income                                |                                  |   |   |   |   | $ | 2,638 |   |   |   |   |   |   |   |   |   |   | $ | 3,325 |   |   |   |   |   |
|                                               |                                  |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest margin(4)                             |                                  |   |   |   |   |   |   |   |   |   | 3.43 | % |   |   |   |   |   |   |   |   |   |   | 3.70 | % |

 

(1)          Net loan (costs) fees included in loan interest income for the three monthperiods ended March 31, 2010 and 2009 amounted to $(33,000) and $7,000,respectively.

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

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

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

 

 

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

 
|                               | ** ** | **Three Months ended March 31,** | ** **                                                      |
|------------------------------------|------------|----------------------------------|-----------------------------------------------------------------|
|                               | ** ** | **2010 over 2009**               | ** **                                                      |
|                               | ** ** | **Net**                          | ** **                                                      |   |   |   |   |   |   |
|                               | ** ** | **Change**                       | ** **                                                      | ** ** | **Rate (1)** | ** ** | ** ** | **Volume (2)** | ** ** |
| **(In thousands)**                 |       |                             |                                                            |   |   |   |   |   |   |
|                               |       |                             |                                                            |   |   |   |   |   |   |
| Interest Income:                   |       |                             |                                                            |   |   |   |   |   |   |
| Loans and leases                   |       | $                                |      (1,265)                                |   |   | $ |        (344) |   |   | $ |        (921) |   |
| Investment securities              |       |                             |         (346)                |   |   |   |         (144) |   |   |   |         (204) |   |
| Federal funds sold                 |       |                             |          6              |   |   |   |       (7) |   |   |   | 13   |   |
| Interest bearing deposits in banks |       |                             |             - |   |   |   |              - |   |   |   |   | - |
| Total interest income              |       | $                                |      (1,605)                                |   |   | $ |       (495) |   |   | $ |      (1,111) |   |
|                               |       |                             |                                                            |   |   |   |   |   |   |   |   |   |
|                               |       |                             |                                                            |   |   |   |   |   |   |   |   |   |
| Interest Expense:                  |       |                             |                                                            |   |   |   |   |   |   |   |   |   |
| Interest-bearing demand            |       | $                                |         (114)                |   |   | $ |       (69) |   |   | $ |          (45) |   |
| Savings                            |       |                             |            28      |   |   |   |            (13) |   |   |   |            40 |   |
| Time deposits                      |       |                             |         (645)                |   |   |   |       (506) |   |   |   |        (139) |   |
| Other borrowings                   |       |                             |          (187)          |   |   |   |         (22) |   |   |   |            (165) |   |
| Total interest expense             |       | $                                |      (918)                                  |   |   | $ |       (610) |   |   | $ |        (309) |   |
| Net interest income                |       | $                                |         (687)                |   |   | $ |       115 |   |   | $ |        (802) |   |

 

(1)          The rate change in net interest income represents the change in rate multipliedby the current year's average balance.

(2)          The volume change in net interest income represents the change in averagebalance multiplied by the current year's rate.

 

**Provision for loan losses**

 

The Company recorded $395 thousand inprovision for loan losses for the three month period ended March 31, 2010, adecrease of $577,000 from $972,000 for the same period in 2009.  Thedecrease in the provision is based on management's assessment of the requiredlevel of reserves.  Management assesses loan quality monthly tomaintain an adequate allowance for loan losses.  Based on theinformation currently available, management believes that the allowance forloan losses is adequate to absorb probable losses in theportfolio.  However, no assurance can be given that the Company maynot sustain charge-offs which are in excess of the allowance in any givenperiod.  The Company's loan portfolio composition and non-performingassets are further discussed under the "Financial Condition" sectionbelow.

 

**Non-Interest income**

 

During the three months ended March 31,2010, the total non-interest income was $362 thousand.  Thisnon-interest income compares to non-interest income of $379 thousand for thecomparable period in 2009.  The primary reason for the decrease innon-interest income in the first quarter of 2010 was the decline in servicecharges of $33 thousand.  The decrease is primarily related to decreaseddeposit activity.  The increase in other income of $28 thousand wasrelated to the receipt of rental income of $98 thousand related to a propertycurrently classified as other real estate owned.  

** **

**Non-Interest Expenses**

 

Non-interest expenses ordinarilyconsist of salaries and related employee benefits, occupancy, furniture andequipment expenses, other real estate, professional fees, appraisal fees,directors' fees, postage, stationary and supplies expenses, telephone expenses,data processing expenses, advertising and promotion expense and other operatingexpenses. Non-interest expense for the three months ended March 31, 2010 was$4.155 million compared to $3.297 million for the same period in 2009,representing an increase of $858 thousand or 26%. The increase is primarily theresult of salaries and employee benefits and other real estate costs, addedprofessional fees and FDIC assessment costs.  For further information onother real estate please see the section titled "Other real estateowned" included in this report. 

 

The following table sets forth asummary of non-interest expense for the three month periods ended March 31,2010 and 2009:

 
|                           |   | Three Months Ended March 31, |   |   |   |   |   |          |   |
|--------------------------------|--------|------------------------------|--------|--------|--------|--------|--------|---------------|--------|
| (In thousands)                 |   | 2010                         |   |   | 2009   |   |   | Dollar Change |   |   | Percentage Change |   |
| Non-interest expenses:         |   |                         |   |   |   |   |   |          |   |   |   |   |
| Salaries and employee benefits |   | $                            | 1,483  |   |   | $      | 1,154  |          |   | $ | 329 |   |   |   | 29 | % |
| Occupancy                      |   |                         | 293    |   |   |   | 279    |          |   |   | 14 |   |   |   | 5 |   |
| Furniture and equipment        |   |                         | 248    |   |   |   | 268    |          |   |   | (20) |   |   |   | (7) |   |
| Other real estate              |   |                         | 895    |   |   |   | 431    |          |   |   | 464 |   |   |   | 108 |   |
| Other expenses                 |   |                         | 1,236  |   |   |   | 1,165  |          |   |   | 71 |   |   |   | 6 |   |
| Total non-interest expenses    |   | $                            | 4,155  |   |   | $      | 3,297  |          |   | $ | 858 |   |   |   | 26 | % |

 

**Income Taxes**

 

The Company recorded a net provisionfor income taxes of $783,000 for the three months ended March 31, 2010,compared to a tax credit of $271,000 in the first quarter of 2009.  TheCompany recorded a tax credit of $705,000 for the quarter ended March 31, 2010related to the periods pretax losses, the tax credit was then offset by theCompany's recorded increase in its tax valuation allowance of $1,448,000 in theperiod. The Company had a net deferred tax asset of $0 as of March 31,2010.  Balance sheet changes and assumptions since the previous reportingperiod have led management to believe that the Company can no longer projectwith greater than 50% certainty that future earnings will be adequate torealize the tax benefit recorded.  Prospective earnings, tax law changesor capital changes could prompt the Company to reevaluate the assumptions usedto establish the valuation allowance which could result in the reversal of allor part of the valuation allowance. The effective tax rate difference from theactual tax rate is primarily due to the write off of the Company's previouslyrecorded net deferred tax asset of $734,000 during the period ended March 31,2010.

** **

**FINANCIAL CONDITION**

 

Total assets at March 31, 2010 were$322.518 million, a decrease of $47.327 million or 12.8%, from the $369.845 millionat December 31, 2009.  The contraction in assets was primarily in theCompany's fed funds sold, loan portfolio and securitiesportfolio.  The decrease in fed funds sold is result of one FHLBadvance that matured in January 2010 for $10 million without renewal andcustomer deposit contractions.  The reduction in the size of the loanportfolio is primarily the result of assets being reclassified to other realestate, charge-offs and pay downs.  The investment portfoliodecreased as a result of large principal pay downs in the mortgage backedsection of the portfolio.  Pay downs have occurred as interest ratesfor mortgages have declined and borrowers prepay their mortgages at a fasterrate.  The remainder of the balance sheet continued on a flat trend.

 

The Company experienced a decrease indeposits primarily in non-interest bearing deposits.  Non-interestbearing deposits decreased $10.025 million or 16.7% to $49.846 million at March31, 2010 from $59.871 million at December 31, 2009.  The Company also experienceda decrease in interest-bearing deposits of $24.650 million or 9.4% from$262.554 million at December 31, 2009 to $237.904 million at March 31,2010.  The decrease in interest-bearing deposits was primarily related toa reduction in rates paid for interest-bearing deposits and customerdiversification of their deposit balances to other institutions in order totake advantage of FDIC insurance coverage.  The reduction in ratesresulted in rate sensitive customers placing deposits elsewhere.  In addition,heightened media coverage of bank failures has led some customers to diversifytheir deposits to multiple institutions, leading to withdrawals of uninsuredbalances. The decrease in deposits has been funded by a reduction in the loanand investment portfolios.  Whether we will continue to be successful inretaining our low cost deposit base will depend on various factors, includingdeposit pricing strategies, the effects of competition, client behavior, andregulatory limitations. In addition, the continued availability of governmentTransaction Account Guarantee Program (the "TAG Program") providingexpanded deposit insurance may affect our ability to retain deposit balances.The Bank is currently an active participant in the TAG program. The Company hasalso reduced its borrowings by $10 million due to a maturity which was notrenewed.  On March 31, 2010 the Bank utilized $21,319,000 in brokereddeposits compared to $26,303,000 at December 31, 2009.The Bank is currentlyunder regulatory restrictions and prohibited from acquiring and using any"new" or renewing any existing brokered deposit funds.  Thecurrent brokered deposit balances are planned to mature as originallycontracted and will not be renewed by the Bank.

*** ***

***Going Concern, Capital and Regulatory Considerations***

The consolidated financialstatements for the three months ended March 31, 2010 have been prepared on agoing concern basis, which contemplates the realization of assets and thedischarge of liabilities in the normal course of business. As a result, theconsolidated financial statements do not include any adjustments that mayresult from the outcome of any regulatory action or the Company's or the Bank'sinability to meet its existing debt obligations. The Bank has recently incurredsignificant operating losses, experienced a significant deterioration in thequality of its assets and become subject to enhanced regulatoryscrutiny. These factors, among others, were deemed to cast substantialdoubt on the Company's and the Bank's ability to continue as a going concern.If the Company cannot continue to operate as a going concern, it is likely thatshareholders will lose all or substantially all of their investment in theCompany. 

As discussed above in the"Overview", on February 18, 2010, the Company and the Bank enteredinto the Written Agreement with the FRB and the CDFI. Additionally, on April15, 2010, the Bank  executed a Waiver and Consent to anOrder of the CDFI (the "Consent")  requiring the Bank,within 90 days of the effective date of the Order, either to increase andto maintain tangible capital at a level equal to 10% of total tangible assetsor merge with a depository institution or sell to an acquirer acceptable to theCDFI.  The effective date was May 3, 2010, when the CDFI executedthe Order.   As of March 31, 2010, the Bank had a ratioof tangible capital to assets of 3.7%, which was not sufficientto meet the higher level that the Bank would be obligated to maintain under theConsent.  As a result, if by August 1, 2010, the Bank cannotcomply with the Consent provisions, the Bank may be subject to furthersupervisory action, which could have a material adverse effect on its resultsof operations, financial condition and business.

The Company is actively pursuing abroad range of strategic alternatives, including a capital infusion or amerger, in order to address any doubt related to the Company's ability tocontinue as a going concern. There can be no assurance that the pursuit ofstrategic alternatives will result in any transaction, or that any suchtransaction will allow the Company's shareholders to avoid a loss of all orsubstantially all of their investment in the Company. The pursuit ofstrategic alternatives may also involve significant expenses and management timeand attention. 

 

If the Bank is not successful in raising additionalcapital, it will not be able to become fully compliant with the provisions ofthe Written Agreement or the Consent discussed above.  As a result,the FRBSF, CDFI or the FDIC may take further enforcement action, includingplacing the Bank into receivership. If the Bank is placed into FDICreceivership, it is likely that the Bank would be required to cease operationsand liquidate. If the Bank were to liquidate it is unlikely that there would beany assets available to the holders of the common shareholders of the Company.

 

**Loan portfolio composition**

 

The Company concentrates its lendingactivities primarily within Alameda, Calaveras, San Joaquin, Stanislaus, andTuolumne Counties.

 

The Company manages its credit riskthrough diversification of its loan portfolio and the application ofunderwriting policies and procedures and credit monitoring practices. Althoughthe Company has a diversified loan portfolio, a significant portion of itsborrowers' ability to repay the loans is dependent upon the professionalservices and real estate values. Generally, the loans are secured by realestate or other assets and are expected to be repaid from cash flows of theborrower or proceeds from the sale of collateral.

 

The following table illustrates loanbalances and percentage changes from December 31, 2009 to March 31, 2010 byloan category:

 
| (Dollars in thousands)             |   | March 31, 2010 |    |   | December 31, 2009 |   |    | Dollar Change |   |   | Percentage Change |   |
|------------------------------------|--------|----------------|---------|--------|-------------------|--------|---------|---------------|--------|--------|-------------------|--------|
| Commercial                         |   | $              | 62,832  |   |              | $      | 66,091  |          |   | $      | (3,259)           |   |   |   | (4.93) | % |
| Agricultural                       |   |           | 7,531   |   |              |   | 7,770   |          |   |   | (239)             |   |   |   | (3.08) |   |
| Real estate -  commercial mortgage |   |           | 151,292 |   |              |   | 150,120 |          |   |   | 1,172             |   |   |   | 0.78 |   |
| Real estate -  construction        |   |           | 9,065   |   |              |   | 17,531  |          |   |   | (8,466)           |   |   |   | (48.29) |   |
| Installment                        |   |           | 13,128  |   |              |   | 14,641  |          |   |   | (1,513)           |   |   |   | (10.33) |   |
| Gross loans                        |   | $              | 243,848 |   |              | $      | 256,153 |          |   | $      | (12,305)          |   |   |   | (4.80) | % |

 

The Company continues to manage the mixin its loan portfolio consistently with its identity as a community bankserving Northern California and the Central Valley.  The Bank hasexperienced contraction in its commercial, agricultural, construction andinstallment segments of the loan portfolio.  The contraction in thesesegments reflects the weak economic environment and customer deleveraging whichcontinued from 2008 through the first three months of 2010.  Thereal estate construction segment has been reduced significantly due to thecompletion of construction projects and a permanent loan being extended, paydowns on completed projects and foreclosure of certain projects which have beenreclassified to other real estate owned.  The real estate commercialmortgage segment has increased primarily through permanent financing loansextended to completed construction projects already financed through the Bank.

 

**Nonperforming loans**

 

The Company's level of nonperformingloans increased in the first three months of 2010.  There were loansin the amount of $22,864,000 on nonaccrual at December 31, 2009.  AtMarch 31, 2010 the Company had loans in the amount of $23,989,000 onnonaccrual.  The forgone interest related to the loans on nonaccrualtotaled $759,000 for the first three months of 2010.  The Companyheld an average of $23,427,000 on nonaccrual for the three month period endedMarch 31, 2010.  At present, management believes that the level ofallowance of 4.43% of total loans at March 31, 2010 compared to 4.10% atDecember 31, 2009 is sufficient to provide for both specifically identified andprobable losses.

 

Management has been proactive inworking with problem customers to repay loans that have become delinquent orhave the potential to become delinquent.  In most cases, personalguarantees and collateral value are sufficient to repay outstanding principaland interest.  In the cases where collateral value and personalguarantees have fallen short of the principal and interest owed on the loans,management has reserved for the estimated potentialloss.  Management  also regularly orders real estate appraisalson all loans which are in foreclosure that are secured by real estate and onloans where we have identified potential problems.

 

 

In determining the amount of theCompany's Allowance for Loan Losses ("ALL"), management assesses thediversification of the portfolio. Each credit is assigned a credit risk ratingfactor, and this factor, multiplied by the dollars associated with the creditrisk rating, is used to calculate one component of the ALL. In addition,management estimates the probable loss on individual credits that are receivingincreased management attention due to actual or perceived increases in creditrisk.

 

The Company makes provisions to the ALLon a regular basis through charges to operations that are reflected in theCompany's statements of operations as a provision for loan losses. When a loanis deemed uncollectible, it is charged against the allowance. Any recoveries ofpreviously charged-off loans are credited back to the allowance. There is noprecise method of predicting specific losses or amounts that ultimately may becharged-off on particular categories of the loan portfolio. Similarly, theadequacy of the ALL and the level of the related provision for possible loanlosses is determined on a judgment basis by management based on considerationof a number of factors including (i) economic conditions, (ii) borrowers'financial condition, (iii) loan impairment, (iv) evaluation of industry trends,(v) industry and other concentrations, (vi) loans which are contractuallycurrent as to payment terms but demonstrate a higher degree of risk asidentified by management, (vii) continuing evaluation of the performing loanportfolio, (viii) monthly review and evaluation of problem loans identified ashaving a loss potential, (ix) monthly review by the Board of Directors, (x) offbalance sheet risks and (xi) assessments by regulators and other third parties.Management and the Board of Directors evaluate the allowance and determine itsdesired level considering objective and subjective measures, such as knowledgeof the borrowers' businesses, valuation of collateral, the determination ofimpaired loans and exposure to potential losses.

 

While Management uses availableinformation to recognize losses on loans, future additions to the allowance maybe necessary based on changes in economic conditions and other qualitativefactors. In addition, various regulatory agencies, as an integral part of theirexamination process, periodically review the Company's ALL. Such agencies mayrequire the Company to provide additions to the allowance based on theirjudgment of information available to them at the time of their examination.There is uncertainty concerning future economic trends. Accordingly, it is notpossible to predict the effect future economic trends may have on the level ofthe provision for loan losses in future periods.

 

The adequacy of the ALL is calculatedupon two components. First, is the credit risk rating of the loan portfolio,including all outstanding loans and leases.  Every extension ofcredit has been assigned a risk rating based upon a comprehensive definitionintended to measure the inherent risk of lending money.  Each ratinghas an assigned risk factor expressed as a reserve percentage. Central to thisassigned risk factor is the historical loss record of the Company. Secondly,established specific reserves are available for individual loans currentlydeemed to be impaired. These are the estimated potential losses associated withspecific borrowers based upon the collateral and event(s) causing the riskratings. Any loan that has been assigned a specific reserve is removed from thecalculation related to the first component of the ALL.

 

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

 

The following table summarizes the activity in the ALL forthe periods indicated:
|                                        |   | Three Months Ended |   |   |
|---------------------------------------------|--------|--------------------|--------|--------|
| (Dollars in thousands)                      |   | March 31,          |   |   |
|                                        |   | 2010               |   |   | 2009 |   |   |
| Beginning Balance:                          |   | $                  | 10,508 |   |   | $ | 6,019 |   |   |
| Provision for loan losses                   |   |               | 395    |   |   |   | 972 |   |   |
| Charge-offs:                                |   |               |   |   |   |   |   |   |   |
| Commercial                                  |   |               | 103    |   |   |   | 102 |   |   |
| Real Estate                                 |   |               | -      |   |   |   | 486 |   |   |
| Other                                       |   |               |   |   |   |   | 47 |   |   |
| Total Charge-offs                           |   |               | 103    |   |   |   | 635 |   |   |
| Recoveries:                                 |   |               |   |   |   |   |   |   |   |
| Commercial                                  |   |               | -      |   |   |   | - |   |   |
| Real Estate                                 |   |               | (15)   |   |   |   | (50) |   |   |
| Other                                       |   |               | -      |   |   |   | - |   |   |
| Total Recoveries                            |   |               | (15)   |   |   |   | (50) |   |   |
| Net Charge-offs                             |   |               | 88     |   |   |   | 583 |   |   |
| Ending Balance                              |   | $                  | 10,815 |   |   | $ | 6,406 |   |   |
| ALL to total loans                          |   |               | 4.43   | %      |   |   | 2.11 | % |   |
| Net Charge-offs to average loans-annualized |   |               | 0.04   | %      |   |   | 0.64 | % |   |

 

**Other real estate owned**

 

At December 31, 2009, the Company had$10,934,000 invested in properties acquired through foreclosure.  Inthe first three months of 2010, the Company foreclosed on one property totaling$2,790,000. The Company received proceeds of $211,000 on properties soldduring the first three months of 2010, recorded impairment charges andselling and administration expense on properties previously recorded into otherreal estate of $858,000 and recorded a loss on the sale of other realestate of $37,000.  At March 31, 2010, the carrying value of allproperties was $12,678,000. These properties were carried at the lower of costor their estimated market value, as evidenced by an independent appraisal lessestimated selling expenses. At foreclosure, if the fair value of the realestate is less than the Company's recorded investment in the related loan, acharge is made to the allowance for loan losses. If the value of the propertyis subsequently determined to be less than the recorded investment in theproperty, an impairment charge on the property is recorded.  No assurancecan be given that the Company will sell the properties during 2010 or at anytime or for an amount that will be sufficient to recover the Company'sinvestment in these properties.

 

**Investment securities**

 

Investment securities decreased$2,902,000 to $21,039,000 at March 31, 2010, from $23,941,000 at December 31,2009.  The decrease was primarily the result of activity related tomortgage backed security principle payments.  Since the purchase ofcertain mortgage backed securities, market rates on similar mortgages havedecreased substantially.  The decrease in market rates has driven upprepayment speeds on these securities, resulting in decreased securitybalances.   Federal funds sold decreased $31,574,000 to $13,994,000at March 31, 2010, from $45,568,000 at December 31, 2009.  Thedecrease in federal funds sold was primarily the result of decreasing deposit balancesoffset by decreases in the investment and loan portfolios.

 

**Deposits**

 

Total deposits were $287.750 million asof March 31, 2010, a decrease of $34.675 million or 10.8% from the December 31,2009 balance of $322.425 million.  The Company continues to manage the mixof its deposits consistent with its identity as a community bank serving thefinancial needs of its customers.  Non-interest bearing demanddeposits and interest bearing checking deposits decreased to 23.2% of totaldeposits from 24.0% at December 31, 2009.  Money market and savingsaccounts increased to 22.8% of total deposits from 19.8% at December 31,2009.  Time deposits decreased to 53.9% of total deposits from 56.2%at December 31, 2009.  During the three months ended March 31, 2010, theCompany decreased its reliance on brokered deposits as a source of funding by$4,984,000 from $26,303,000 at December 31, 2009 to $21,319,000 at March 31,2010.  The Company will only be able to utilize the brokered depositmarket in the future to replace maturing deposits if, at the time, the Companyis considered well capitalized by regulatory standards.  All remainingbrokered deposits have maturities beyond two years from the end of the period.

 

TheEmergency Economic Stabilization Act of 2008 included a provision for anincrease in the amount of deposits insured by the FDIC. The $250,000 standardinsurance limit is permanent for certain retirement accounts, which includesIRAs. The $250,000 limit is temporary for all other deposit accounts throughDecember 31, 2013. On January 1, 2014, the standard insurance amount willreturn to $100,000 per depositor for all account categories except certainretirement accounts, which will remain at $250,000 per depositor.

 

The Bank is a participating institution in the TransactionAccount Guarantee Program ("TAG Program"), which the FDIC extended inApril of 2010 from June 30, 2010 to December 31, 2010. The TAG Programprovides the Bank's deposit customers in non-interest bearing andinterest-bearing NOW accounts paying fifty basis points or less full FDICinsurance for an unlimited amount. The current expiration of the TAG Program isanticipated to be the Bank's most significant liquidity risk in the near termand mitigating the liquidity impact of such an event remains a priority. As ofMarch 31, 2010, the Company had approximately 31 deposit accounts with balancesgreater than $250,000 participating in the TAG Program providing unlimitedinsurance coverage for a total of $15 million in deposits. Based on currentliquidity sources, management anticipates that the Bank will have adequatecollateral and other sources of liquidity to meet these potential needs.However, it could require the Bank to utilize the majority of its availableliquidity and potentially utilize a portion of our borrowing capacity at thediscount window. 

** **

**CAPITAL RESOURCES**

 

Capital adequacy is a measure of theamount of capital needed to sustain asset growth and act as a cushion forlosses. Capital protects depositors and the deposit insurance fund frompotential losses and is a source of funds for the investments the Company needsto remain competitive.  Historically, capital has been generatedprincipally from the retention of earnings, stock offerings, issuance of juniorsubordinated debentures and grants of stock options.

 

The recent losses incurred have reducedthe Company's Risk-Based Capital levels to under capitalized. The Companyhas developed and filed with the FRBSF for review a Capital Plan to returnthe Company to a well capitalized status. The Risk-Based Capital computationsfor the Company are complex and are impacted by operating losses and variouslimitations including loan loss reserves which are limited to 1.25% ofrisk-based assets as well as deferred income taxes which generally cannotexceed 10% of Tier 1 risk-based capital.

 

At March 31, 2010 shareholders' equitywas $3,276,000 compared with $5,679,000 at December 31, 2009. Changes withinshareholders' equity reflect decreases from the net loss during the first threemonths of 2010 and an increase in unrealized losses on available for salesecurities.

 

Overall capital adequacy is monitoredon a day-to-day basis by the Company's management and reported to the Company'sBoard of Directors on a monthly basis.  The Bank's regulators measurecapital adequacy by using a risk-based capital framework and by monitoringcompliance with minimum leverage ratio guidelines. Under the risk-based capitalstandard, assets reported on the Company's balance sheet and certainoff-balance sheet items are assigned to risk categories, each of which isassigned a risk weight.

 

This standard characterizes aninstitution's capital as being "Tier 1" capital (defined asprincipally comprising shareholders' equity and the qualifying portion ofsubordinated debentures) and "Tier 2" capital (defined as principallycomprising Tier 1 capital and the remaining qualifying portion of subordinateddebentures and the qualifying portion of the ALL).

 

The standard regulatory minimum ratioof total risk-based capital to risk-adjusted assets, including certainoff-balance sheet items, is 8%. At least one-half (4%) of the total risk-basedcapital is to be comprised of Tier 1 capital; the balance may consist of debtsecurities and a limited portion of the ALL.

 

As of March 31, 2010 the most recent notification by theFederal Deposit Insurance Corporation ("FDIC") categorized the Bankas "under capitalized" under the regulatory framework for promptcorrective action.  There are no conditions or events since thatnotification that management believes have changed the Bank'scategory.  The Company is subject to various regulatory capitalrequirements administered by the federal banking agencies. Failure to meetminimum capital requirements can initiate mandatory and possibly additionaldiscretionary actions by the regulators that, if undertaken, could have amaterial adverse effect on the Company's consolidated financialstatements.  The Company is actively seeking additional capital throughthe sale of debt or equity securities or merger with another financialinstitution. We may also improve our capital ratios through reducing totalassets, principally through securities or loan sales or loan participations.See "Going Concern, Capital and Regulatory Considerations" discussedabove.

 

The leverage ratio consists of Tier Icapital divided by quarterly average assets.  The standard regulatoryminimum leverage ratio is 3 percent for banking organizations that do notanticipate significant growth and that have well-diversified risk, excellentasset quality and in general, are considered top-rated banks. For all otherinstitutions the minimum rate is 4%.

 

In March, 2010, the CDFI presented theBank with a proposed cease and desist order requiring the Bank to raise capitaland, on April 15, 2010, the Bank executed a Waiver and Consent to the Order ofthe CDFI (the "Consent").  The Consent requires the Bank, within90 days of the effective date of the Order, either to increase and to maintaintangible capital at a level equal to 10% of total tangible assets or merge witha depository institution to sell to an acquirer acceptable to the CDFI. The effective date was the date that the CDFI executed the Order which was May3, 2010.   As of March 31, 2010, the Bank had a ratio of tangiblecapital to assets of 3.7%, which was not sufficient to meet the higher levelthat the Bank would be obligated to maintain under the Consent.  As aresult, if by August 1, 2010 the Bank cannot comply with the Consentprovisions, the Bank may be subject to further supervisory action, which couldhave a material adverse effect on its results of operations, financialcondition and business.

 

The Company's and the Bank's risk-based capital ratios arepresented below:

 
|                                     |   | Actual |   |   | For Capital Adequacy Purposes |   |   | To Be Well Capitalized Under  Prompt Corrective Action Provisions |   |
|------------------------------------------|--------|--------|--------|--------|-------------------------------|--------|--------|-------------------------------------------------------------------|--------|
| March 31, 2010                           |   | Amount |   |   | Ratio                         |   |   | Minimum Amount                                                    |   |   | Minimum Ratio |   |   | Minimum Amount |   |   | Minimum Ratio |   |
| **Company:**                             |   |   |   |   |                          |   |   |                                                              |   |   |   |   |   |   |   |   |   |   |
| Total capital (to risk-weighted assets)  |   | $      | 16,357 |   |                          |   | 5.8    | %                                                                 |   | $ | 22,398 |   |   |   | 8.0 | % |   |   | N/A |   |   |   | N/A |   |
| Tier 1 capital (to risk weighted assets) |   | $      | 5,688  |   |                          |   | 2.0    | %                                                                 |   | $ | 11,199 |   |   |   | 4.0 | % |   |   | N/A |   |   |   | N/A |   |
| Tier 1 capital (to average assets)       |   | $      | 5,588  |   |                          |   | 1.4    | %                                                                 |   | $ | 15,845 |   |   |   | 4.0 | % |   |   | N/A |   |   |   | N/A |   |
| **Bank:**                                |   |   |   |   |                          |   |   |                                                              |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total capital (to risk-weighted assets)  |   | $      | 16,581 |   |                          |   | 5.9    | %                                                                 |   | $ | 22,376 |   |   |   | 8.0 | % |   | $ | 27,970 |   |   |   | 10.0 | % |
| Tier 1 capital (to risk-weighted assets) |   | $      | 12,993 |   |                          |   | 4.7    | %                                                                 |   | $ | 11,188 |   |   |   | 4.0 | % |   | $ | 16,782 |   |   |   | 6.0 | % |
| Tier 1 capital (to average assets)       |   | $      | 12,993 |   |                          |   | 3.7    | %                                                                 |   | $ | 13,892 |   |   |   | 4.0 | % |   | $ | 17,365 |   |   |   | 5.0 | % |
|                                     |   |   |   |   |                          |   |   |                                                              |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| December 31, 2009:                       |   |   |   |   |                          |   |   |                                                              |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Company:**                             |   |   |   |   |                          |   |   |                                                              |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total capital (to risk-weighted assets)  |   | $      | 19,103 |   |                          |   | 6.5    | %                                                                 |   | $ | 23,388 |   |   |   | 8.0 | % |   |   | N/A |   |   |   | N/A |   |
| Tier 1 capital (to risk weighted assets) |   | $      | 8,796  |   |                          |   | 3.0    | %                                                                 |   | $ | 11,694 |   |   |   | 4.0 | % |   |   | N/A |   |   |   | N/A |   |
| Tier 1 capital (to average assets)       |   | $      | 8,796  |   |                          |   | 2.3    | %                                                                 |   | $ | 15,462 |   |   |   | 4.0 | % |   |   | N/A |   |   |   | N/A |   |
| **Bank:**                                |   |   |   |   |                          |   |   |                                                              |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total capital (to risk-weighted assets)  |   | $      | 19,004 |   |                          |   | 6.5    | %                                                                 |   | $ | 23,367 |   |   |   | 8.0 | % |   | $ | 29,209 |   |   |   | 10.0 | % |
| Tier 1 capital (to risk-weighted assets) |   | $      | 15,273 |   |                          |   | 5.2    | %                                                                 |   | $ | 11,683 |   |   |   | 4.0 | % |   | $ | 17,525 |   |   |   | 6.0 | % |
| Tier 1 capital (to average assets)       |   | $      | 15,273 |   |                          |   | 4.0    | %                                                                 |   | $ | 15,452 |   |   |   | 4.0 | % |   | $ | 19,315 |   |   |   | 5.0 | % |

 

 

**LIQUIDITY**

 

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

 

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

 

Because estimates of the liquidityneeds of the Company may vary from actual needs, the Company maintains asubstantial amount of liquid assets to absorb short-term increases in loans orreductions in deposits. As loan demand decreases or loans are paid off,investment assets can absorb these excess funds or deposit rates can bedecreased to run off excess liquidity. Therefore, there is some correlation betweenfinancing activities associated with deposits and investing activitiesassociated with lending. The Company's liquid assets (cash and due from banks,federal funds sold and available-for-sale investment securities) totaled $44.8million or 13.9% of total assets at March 31, 2010 compared to $80 million or21.6% of total assets at December 31, 2009. The Company expects that itsprimary source of liquidity will be acquisition of deposits and wholesaleborrowing arrangements.

 

**ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUTMARKET RISK**

 

Market risk is the risk of loss in afinancial instrument arising from adverse changes in market rates such asinterest rates, commodity prices and equity prices.  The Company'smarket risk as a financial institution arises primarily from interest rate riskexposure.  Fluctuation in interest rates will ultimately impact boththe level of income and expense recorded on a large portion of the Company'sassets and liabilities, and the market value of all interest earning assets andinterest bearing liabilities, other than those that possess a short term tomaturity.  Based upon the nature of its operations, the Company isnot subject to fluctuations in foreign currency exchange or commoditypricing.  However, the Company's commercial real estate loanportfolio, concentrated primarily in Northern California, is subject to risksassociated with the local economies.

 

The fundamental objective of theCompany's management of its assets and liabilities is to maximize the economicvalue of the Company while maintaining adequate liquidity and managing exposureto interest rate risk deemed by management to beacceptable.  Management believes an acceptable degree of exposure tointerest rate risk results from management of assets and liabilities throughusing floating rate loans and deposits, maturities, pricing and mix to attemptto neutralize the potential impact of changes in market interestrates.  The Company's profitability is dependent to a large extentupon its net interest income which is the difference between its interestincome on interest earning assets, such as loans and securities, and interestexpense on interest bearing liabilities, such as deposits, trust preferredsecurities and other borrowings.  The Company, like other financialinstitutions, is subject to interest rate risk to the degree that its interestearning assets reprice differently from its interest bearingliabilities.  The Company manages its mix of assets and liabilitieswith the goal of limiting exposure to interest rate risk, ensuring adequateliquidity, and coordinating its sources and uses of funds.

 

The Company seeks to control itsinterest rate risk exposure in a manner that will allow for adequate levels ofearnings and capital over a range of possible interest rateenvironments.  The Company has adopted formal policies and practicesto monitor and manage interest rate risk exposure.  As part of thiseffort, the Company measures interest rate risk utilizing both an internalasset liability measurement system as well as independent third party reviewsto confirm the reasonableness of the assumptions used to measure and report theCompany's interest rate risk, enabling management to make any adjustmentsnecessary.

 

Interest rate risk is managed by theCompany's Asset Liability Committee ("ALCO"), which includes membersof senior management and several members of the Board ofDirectors.  The ALCO monitors interest rate risk by analyzing thepotential impact on interest income from potential changes in interest ratesand considers the impact of alternative strategies or changes in balance sheetstructure.  The ALCO manages the Company's balance sheet in part tomaintain the potential impact on net interest income within acceptable ranges despitechanges in interest rates.  The Company's exposure to interest raterisk is reviewed on at least a quarterly basis by the ALCO.

 

In management's opinion there has notbeen a material change in the Company's market risk or interest rate riskprofile for the three months ended March 31, 2010 compared to December 31, 2009as discussed under the caption "Liquidity and Market Risk" and"Net Interest Income Simulation" in the Company's 2009 Annual Reportto Shareholders filed as an exhibit with the Company's 2009 Annual Report onForm 10-K, which is incorporated here by reference.

 

The following table reflects thecompany's projected net interest income sensitivity analysis based onperiod-end data:

 
| (Dollars in thousands) |   | March 31, 2010               |   |
|------------------------|--------|------------------------------|--------|
| Change in Rates        |   | Adjusted Net Interest Income |   |   | Percent Change From Base |   |
|                   |   |                         |   |   |   |   |
| Up 300 basis points    |   |  $                      | 12,223 |   |   |   | 10.26  | % |
| Up 200 basis points    |   |                         | 11,850 |   |   |   | 6.90 | % |
| Up 100 basis points    |   |                         | 11,473 |   |   |   | 3.49 | % |
| Base Scenario          |   |                         | 11,085 |   |   |   | 0.00 | % |
| Down 100 basis points  |   |                         | 10,786 |   |   |   | (2.70) | % |
| Down 200 basis points  |   |                         | 10,510 |   |   |   | (5.19) | % |
| Down 300 basis points  |   | $                            | 10,254 |   |   |   | (7.50) | % |

 

**ITEM 4.  CONTROLS ANDPROCEDURES**

 

 

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

 

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

 

**ITEM 4T. CONTROLS AND PROCEDURES**

** **

**The information required by this item is included inItem 4 above.**

** **

**PART II.  OTHERINFORMATION**

 

 

**ITEM 1. LEGAL PROCEEDINGS.**

 

There are no material pending legal proceedings, otherthan ordinary routine litigation incidental to its business, to which theCompany is a party or of which any of its property is the subject.

 

**ITEM 1A.  RISK FACTORS**

In addition to the information set forth above, youshould carefully consider the factors discussed in Part I, "Item 1A. RiskFactors" in our Annual Report on Form 10-K for the year ended December 31,2009, which could materially affect our business, financial condition or futureresults. Except as described above, the Company is not aware of any materialchanges to the risks described in our Annual Report.

 

**ITEM 6. EXHIBITS**

 
| 31.1 | Certification of Chief Executive Officer (section  302 of the Sarbanes Oxley Act)            |
|------|----------------------------------------------------------------------------------------------|
| 31.2 | Certification of Principal Financial and Accounting  Officer                                 |
| 32.1 | Certification of Chief Executive Officer pursuant to  section 906 of the Sarbanes-Oxley Act  |
| 32.2 | Certification of Chief  Financial Officer pursuant to  section 906 of the Sarbanes-Oxley Act |

 

**SIGNATURES**

 

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

 

 
|               | **Pacific State Bancorp**                           |
|--------------------|-----------------------------------------------------|
| Date: May 15, 2010 | By:    /s/   Rick D. Simas |
|               | Rick D. Simas                                       |
|               | President and Chief Executive Officer               |

 
|               | **Pacific State Bancorp**                          |
|--------------------|----------------------------------------------------|
| Date: May 15, 2010 | By:   /s/   Donald A. Kalkofen |
|               | Donald A. Kalkofen                                 |
|               | Vice President and Director of Finance             |