Table ofContents

 

 

 

**SECURITIES AND 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 the Quarterly Period Ended June 30, 2010**

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

 

**COMMUNITY VALLEY BANCORP**

(Exact name of registrant as specified in its charter)

 

| **California**                  | ** ** | **000-51678**            | ** ** | **68-0479553**           |
|---------------------------------|------------|--------------------------|------------|--------------------------|
| (State or other jurisdiction of |       | (Commission File Number) |       | (IRS Employer ID Number) |
| incorporation or organization)  |       |                     |       |                     |

 

| **1360 E. Lassen Avenue, Chico, California** | ** ** | **95973**  |
|----------------------------------------------|------------|------------|
| (Address of principal executive offices)     |       | (Zip code) |

 

**(530) 899-2344**

(Registrant’s telephone number, including area code)

 

 

(Former name, former address and former fiscal year, if changed sincelast report.)

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or such shorter period that the registrantwas required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes x  No o

 

Indicateby check mark whether the registrant has submitted electronically and posted onits corporate Web site, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 ofthis chapter) during the preceding 12 months (or for such shorter period thatthe registrant was required to submit and post such files). Yes o  No o

 

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

 

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

 

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

 

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

 

No par value Common Stock — 6,699,603 shares outstanding at July 30,2010.

 

 

 

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Tableof Contents

 

**Table of Contents**

 
| PART I  |   |                                                                                                                                  |   | 3      |
|--------------|--------|---------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
|         |   |                                                                                                                                  |   |   |
|         |   | Item 1. Financial Statements  (unaudited)                                                                                             |   | 3      |
|         |   |                                                                                                                                  |   |   |
|         |   | Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of  Operations of Community Valley Bancorp |   | 18     |
|         |   |                                                                                                                                  |   |   |
|         |   | Item 3. Quantitative and Qualitative Disclosures about  Market Risk                                                                   |   | 39     |
|         |   |                                                                                                                                  |   |   |
|         |   | Item 4. Controls and Procedures                                                                                                       |   | 41     |
|         |   |                                                                                                                                  |   |   |
| PART II |   |                                                                                                                                  |   | 42     |
|         |   |                                                                                                                                  |   |   |
|         |   | Item  1. Legal Proceedings                                                                                                            |   | 42     |
|         |   |                                                                                                                                  |   |   |
|         |   | Item  1A. Risk Factors                                                                                                                |   | 42     |
|         |   |                                                                                                                                  |   |   |
|         |   | Item 2. Changes in Securities and Use of Proceeds                                                                                     |   | 42     |
|         |   |                                                                                                                                  |   |   |
|         |   | Item 4. (Removed and Reserved)                                                                                                        |   | 42     |
|         |   |                                                                                                                                  |   |   |
|         |   | Item  5. Other Information                                                                                                            |   | 42     |
|         |   |                                                                                                                                  |   |   |
|         |   | Item 6.  Exhibits                                                                                                                     |   | 42     |
|         |   |                                                                                                                                  |   |   |
|         |   | Signatures                                                                                                                            |   | 43     |
|         |   |                                                                                                                                  |   |   |
|         |   | Ex.  31.1. Certification of CEO Pursuant to Section 302 of the Sarbanes Oxley  Act of 2002                                       |   | 44     |
|         |   |                                                                                                                                  |   |   |
|         |   | Ex.  31.2 Certification of CFO Pursuant to Section 302 of the Sarbanes Oxley  Act of 2002                                        |   | 45     |
|         |   |                                                                                                                                  |   |   |
|         |   | Ex.  32.1 Certification of CEO Pursuant to Section 906 of the Sarbanes Oxley  Act of 2002                                        |   | 46     |
|         |   |                                                                                                                                  |   |   |
|         |   | Ex.  32.2 Certification of CFO Pursuant to Section 906 of the Sarbanes Oxley  Act of 2002                                        |   | 47     |

 

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**PART I -FINANCIAL INFORMATION**

**Item 1**

**COMMUNITY VALLEY BANCORP**

**CONDENSED CONSOLIDATED BALANCE SHEET (Unaudited)**

(dollars in thousands, except share data)

 
| ** **                                                                                                                                    | ** ** | **June 30, 2010** | ** ** | **December 31, 2009** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| ASSETS                                                                                                                                        |       |                        |       |                            |       |
| Cash and due from banks                                                                                                                       |       | $                           | 12,034     |                            | $          | 12,119 |   |
| Excess Balance Agreement/Federal Reserve Bank                                                                                                 |       | 32,748                      |       | —                          |       |
| Federal funds sold                                                                                                                            |       | 215                         |       | 46,535                          |       |
| Total cash & cash equivalents                                                                                                             |       | 44,997                      |       | 58,654                          |       |
|                                                                                                                                          |       |                        |       |                            |       |
| Interest-bearing deposits in banks                                                                                                            |       | 1,895                       |       | 2,740                           |       |
| Investment securities (fair value of $4,334 at  June 30, 2010, and $5,620 at December 31, 2009)                                               |       | 4,324                       |       | 5,606                           |       |
| Loans held for sale at lower of cost or market  value                                                                                         |       | —                      |       | 1,137                           |       |
| Loans, less allowance for loan losses of $15,745  at June 30, 2010 and $12,975 at December 31, 2009                                           |       | 404,538                     |       | 420,036                         |       |
| Premises and equipment, net                                                                                                                   |       | 4,546                       |       | 5,271                           |       |
| Other real estate                                                                                                                             |       | 11,211                      |       | 13,493                          |       |
| Bank owned life insurance                                                                                                                     |       | 11,713                      |       | 11,680                          |       |
| Accrued interest receivable and other assets                                                                                                  |       | 16,319                      |       | 19,845                          |       |
| Total assets                                                                                                                                  |       | $                           | 499,543    |                            | $          | 538,462 |   |
| ** **                                                                                                                                    |       |                        |       |                            |       |
| LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                                                     |       |                        |       |                            |       |
|                                                                                                                                          |       |                        |       |                            |       |
| Deposits:                                                                                                                                     |       |                        |       |                            |       |
| Non-interest bearing                                                                                                                          |       | $                           | 67,284     |                            | $          | 77,340 |   |
| Interest bearing                                                                                                                              |       | 403,031                     |       | 420,823                         |       |
| Total deposits                                                                                                                                |       | 470,315                     |       | 498,163                         |       |
|                                                                                                                                          |       |                        |       |                            |       |
| ESOP note payable                                                                                                                             |       | 1,046                       |       | 1,122                           |       |
| Junior subordinated debentures                                                                                                                |       | 8,248                       |       | 8,248                           |       |
| Accrued interest payable and other liabilities                                                                                                |       | 9,153                       |       | 14,977                          |       |
| Total liabilities                                                                                                                             |       | 488,762                     |       | 522,510                         |       |
| ** **                                                                                                                                    |       |                        |       |                            |       |
| Commitments and contingencies (Note 8)                                                                                                        |       |                        |       |                            |       |
|                                                                                                                                          |       |                        |       |                            |       |
| Shareholders’ equity                                                                                                                     |       |                        |       |                            |       |
| Preferred stock - no par value; 10,000,000 shares  authorized; issued and outstanding -345,647 shares at June 30, 2010 and December  31,2009  |       | 3,313                       |       | 3,313                           |       |
| Common stock - no par value; 20,000,000 shares  authorized; issued and outstanding - 6,699,603 shares at June 30, 2010 and December  31, 2009 |       | 10,160                      |       | 10,186                          |       |
| Unallocated ESOP shares - 147,215 shares at June  30, 2010 and 160,826 shares at December 31, 2009 (at cost)                                  |       | (1,527                      | )          | (1,582                          | )          |
| (Accumulated deficit) retained earnings                                                                                                       |       | (1,292                      | )          | 3,908                           |       |
| Accumulated other comprehensive income, net                                                                                                   |       | 127                         |       | 127                             |       |
| Total shareholders’ equity                                                                                                               |       | 10,781                      |       | 15,952                          |       |
| Total liabilities and shareholders’ equity                                                                                               |       | $                           | 499,543    |                            | $          | 538,462 |   |

 

See Notes to Unaudited Condensed Consolidated Financial Statements

 

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**COMMUNITY VALLEY BANCORP**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(Unaudited)**

(dollars in thousands, except per share data)

 
| ** **                                                     | ** ** | **For the three months  ended June 30,** | ** ** | **For the six months ended  June 30,** | ** ** |
|----------------------------------------------------------------|------------|------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                     | ** ** | **2010**                                 | ** ** | **2009**                               | ** ** | **2010** | ** ** | **2009** | ** ** |
| Interest income:                                               |       |                                     |       |                                   |       |   |   |   |   |
| Interest and fees on loans                                     |       | $                                        | 5,621      |                                   | $          | 7,363 |   | $ | 11,102 |   | $ | 14,410 |   |
| Interest on Federal funds sold/Excess balance  agreement (FRB) |       | 23                                       |       | 23                                     |       | 50 |   | 51 |   |
| Interest on deposits in banks                                  |       | 10                                       |       | 19                                     |       | 22 |   | 43 |   |
| Interest on investment securities:                             |       |                                     |       |                                   |       |   |   |   |   |
| Taxable                                                        |       | 27                                       |       | 64                                     |       | 57 |   | 119 |   |
| Exempt from Federal income tax                                 |       | 16                                       |       | 16                                     |       | 32 |   | 32 |   |
| Total interest income                                          |       | 5,697                                    |       | 7,485                                  |       | 11,263 |   | 14,655 |   |
|                                                           |       |                                     |       |                                   |       |   |   |   |   |
| Interest expense:                                              |       |                                     |       |                                   |       |   |   |   |   |
| Interest expense on deposits                                   |       | 820                                      |       | 1,653                                  |       | 1,738 |   | 3,523 |   |
| Interest expense on junior subordinated debentures             |       | 147                                      |       | 143                                    |       | 437 |   | 286 |   |
| Interest expense on notes payable                              |       | 26                                       |       | 81                                     |       | 52 |   | 159 |   |
| Total interest expense                                         |       | 993                                      |       | 1,877                                  |       | 2,227 |   | 3,968 |   |
| Net interest income before provision for loan  losses          |       | 4,704                                    |       | 5,608                                  |       | 9,036 |   | 10,687 |   |
| Provision for loan losses                                      |       | 4,943                                    |       | 4,000                                  |       | 10,232 |   | 7,100 |   |
| Net interest (loss) income after provision for  loan losses    |       | (239                                     | )          | 1,608                                  |       | (1,196 | ) | 3,587 |   |
|                                                           |       |                                     |       |                                   |       |   |   |   |   |
| Non-interest income:                                           |       |                                     |       |                                   |       |   |   |   |   |
| Sale of merchant processing portfolio                          |       | —                                   |       | —                                 |       | — |   | 2,640 |   |
| Loss on sale of investment security                            |       | —                                   |       | —                                 |       | — |   | (172 | ) |
| Retirement benefit derecognition                               |       | 6,333                                    |       | —                                 |       | 6,333 |   | — |   |
| Other income                                                   |       | 1,224                                    |       | 2,670                                  |       | 3,132 |   | 5,029 |   |
| Total non-interest income                                      |       | 7,557                                    |       | 2,670                                  |       | 9,465 |   | 7,497 |   |
|                                                           |       |                                     |       |                                   |       |   |   |   |   |
| Non-interest expenses:                                         |       |                                     |       |                                   |       |   |   |   |   |
| Salaries and employee benefits                                 |       | 2,805                                    |       | 3,165                                  |       | 5,798 |   | 6,564 |   |
| Occupancy                                                      |       | 634                                      |       | 681                                    |       | 1,331 |   | 1,386 |   |
| Furniture and equipment                                        |       | 428                                      |       | 639                                    |       | 914 |   | 1,288 |   |
| Other real estate                                              |       | 1,019                                    |       | 733                                    |       | 2,409 |   | 1,357 |   |
| Federal Deposit Insurance Corporation (FDIC)  assessments      |       | 761                                      |       | 955                                    |       | 1,105 |   | 1,048 |   |
| Other expense                                                  |       | 1,388                                    |       | 1,885                                  |       | 3,215 |   | 3,189 |   |
| Total non-interest expense                                     |       | 7,035                                    |       | 8,058                                  |       | 14,772 |   | 14,832 |   |
|                                                           |       |                                     |       |                                   |       |   |   |   |   |
| Income (loss) before provision (benefit) for  income taxes     |       | 283                                      |       | (3,780                                 | )          | (6,503 | ) | (3,748 | ) |
|                                                           |       |                                     |       |                                   |       |   |   |   |   |
| Provision (benefit) for income taxes                           |       | 883                                      |       | (1,280                                 | )          | (1,424 | ) | (1,348 | ) |
|                                                           |       |                                     |       |                                   |       |   |   |   |   |
| Net loss                                                       |       | (600                                     | )          | (2,500                                 | )          | (5,079 | ) | (2,400 | ) |
| Dividends on preferred stock                                   |       | (60                                      | )          | —                                 |       | (121 | ) | — |   |
| Net loss available to common shareholders                      |       | $                                        | (660       | )                                      | $          | (2,500 | ) | $ | (5,200 | ) | $ | (2,400 | ) |
|                                                           |       |                                     |       |                                   |       |   |   |   |   |
| Basic and diluted loss per share                               |       | $                                        | (0.09      | )                                      | $          | (0.38 | ) | $ | (0.78 | ) | $ | (0.37 | ) |

 

SeeNotes to Unaudited Condensed Consolidated Financial Statements

 

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**COMMUNITY VALLEY BANCORP**

**CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY  (Unaudited)**

(In thousands, except number of shares)

 
| ** **                                                                  | ** ** | **Preferred  Stock** | ** ** | **Common  Stock** | ** ** | **Unallocated** | ** ** | **Retained  Earnings  (Accumulated** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Total  Shareholders’** | ** ** | **Comprehensive** | ** ** |
|-----------------------------------------------------------------------------|------------|----------------------|------------|-------------------|------------|-----------------|------------|--------------------------------------|------------|---------------------------------------|------------|-------------------------------|------------|-------------------|------------|
| ** **                                                                  | ** ** | **Shares**           | ** ** | **Amount**        | ** ** | **Shares**      | ** ** | **Amount**                           | ** ** | **ESOP shares**                  | ** ** | **Deficit)**                  | ** ** | **Income**        | ** ** | **Equity** | ** ** | **Loss** | ** ** |
| Balance,  January 1, 2009                                                   |       | —               |       | $                 | —     |            | 6,699,553  |                                 | $          | 10,147                                |       | $                             | (1,438     | )                 | $          | 31,416 |   | $ | 14 |   | $ | 40,139 |   |   |   |
|                                                                        |       |                 |       |              |       |            |       |                                 |       |                                  |       |                          |       |              |       |   |   |   |   |
| Comprehensive  loss                                                         |       |                 |       |              |       |            |       |                                 |       |                                  |       |                          |       |              |       |   |   |   |   |
| Net  loss                                                                   |       |                 |       |              |       |            |       |                                 |       |                                  |       | (27,508                       | )          |              |       | (27,508 | ) | $ | (27,508 | ) |
| Other  comprehensive income                                                 |       |                 |       |              |       |            |       |                                 |       |                                  |       |                          |       |              |       |   |   |   |   |
| Net  change in unrealized gains on available-for-sale investment securities |       |                 |       |              |       |            |       |                                 |       |                                  |       |                          |       | 113               |       | 113 |   | 113 |   |
| Total  comprehensive loss                                                   |       |                 |       |              |       |            |       |                                 |       |                                  |       |                          |       |              |       |   |   | $ | (27,395 | ) |
|                                                                        |       |                 |       |              |       |            |       |                                 |       |                                  |       |                          |       |              |       |   |   |   |   |
| Exercise  of stock options and related tax benefit                          |       |                 |       |              |       | 50              |       | —                               |       |                                  |       |                          |       |              |       | — |   |   |   |
| Amortization  of stock compensation-ESOP shares                             |       |                 |       |              |       |            |       | (16                                  | )          | 72                                    |       |                          |       |              |       | 56 |   |   |   |
| Shares  acquired or redeemed by ESOP                                        |       |                 |       |              |       |            |       |                                 |       | (216                                  | )          |                          |       |              |       | (216 | ) |   |   |
| Sale  of Stock - Preferred A                                                |       | 240,000              |       | 1,200             |       |            |       |                                 |       |                                  |       |                          |       |              |       | 1,200 |   |   |   |
| Sale  of Stock - Preferred B                                                |       | 105,647              |       | 2,113             |       |            |       |                                 |       |                                  |       |                          |       |              |       | 2,113 |   |   |   |
| Stock-based  compensation expense                                           |       |                 |       |              |       |            |       | 55                                   |       |                                  |       |                          |       |              |       | 55 |   |   |   |
| Balance,  December 31, 2009                                                 |       | 345,647              |       | 3,313             |       | 6,699,603       |       | 10,186                               |       | (1,582                                | )          | 3,908                         |       | 127               |       | 15,952 |   |   |   |
|                                                                        |       |                 |       |              |       |            |       |                                 |       |                                  |       |                          |       |              |       |   |   |   |   |
| Comprehensive  loss                                                         |       |                 |       |              |       |            |       |                                 |       |                                  |       |                          |       |              |       |   |   |   |   |
| Net  loss                                                                   |       |                 |       |              |       |            |       |                                 |       |                                  |       | (5,079                        | )          |              |       | (5,079 | ) | $ | (5,079 | ) |
| Other  comprehensive income                                                 |       |                 |       |              |       |            |       |                                 |       |                                  |       |                          |       |              |       |   |   |   |   |
| Net  change in unrealized gains on available-for-sale investment securities |       |                 |       |              |       |            |       |                                 |       |                                  |       |                          |       | —            |       | — |   | — |   |
| Total  comprehensive loss                                                   |       |                 |       |              |       |            |       |                                 |       |                                  |       |                          |       |              |       |   |   | $ | (5,079 | ) |
|                                                                        |       |                 |       |              |       |            |       |                                 |       |                                  |       |                          |       |              |       |   |   |   |   |
| Amortization  of stock compensation-ESOP shares                             |       |                 |       |              |       |            |       | (40                                  | )          | 55                                    |       |                          |       |              |       | 15 |   |   |   |
| Preferred  stock cumulative dividends- $.08 per share                       |       |                 |       |              |       |            |       |                                 |       |                                  |       | (121                          | )          |              |       | (121 | ) |   |   |
| Stock-based  compensation expense                                           |       |                 |       |              |       |            |       | 14                                   |       |                                  |       |                          |       |              |       | 14 |   |   |   |
| Balance,  June 30, 2010                                                     |       | 345,647              |       | $                 | 3,313      |            | 6,699,603  |                                 | $          | 10,160                                |       | $                             | (1,527     | )                 | $          | (1,292 | ) | $ | 127 |   | $ | 10,781 |   |   |   |

 

See Notes to Unaudited Condensed Consolidated Financial Statements

 

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**COMMUNITY VALLEY BANCORP**

**CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS(Unaudited)**

(In thousands)

 
| ** **                                                                       | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                       | ** ** | **June 30,**    | ** ** |
| ** **                                                                       | ** ** | **2010**             | ** ** | **2009** | ** ** |
| Cash flows from operating activities:                                            |       |                 |       |   |   |
| Net loss                                                                         |       | $                    | (5,079     | ) | $ | (2,400 | ) |
| Adjustments to reconcile net loss to net cash  provided by operating activities: |       |                 |       |   |   |
| Provision for loan losses                                                        |       | 10,232               |       | 7,100 |   |
| Decrease in deferred loan origination fees                                       |       | (82                  | )          | (255 | ) |
| Depreciation and amortization, net                                               |       | 637                  |       | 994 |   |
| Loss (gain) on disposition of Bank premises and  equipment                       |       | 305                  |       | (14 | ) |
| Loss on write-down of other real estate                                          |       | 1,603                |       | 1,798 |   |
| Loss on sale of other real estate                                                |       | 156                  |       | — |   |
| Net decrease (increase) in loans held for sale                                   |       | 1,137                |       | (901 | ) |
| Increase in cash surrender value of bank-owned  life insurance, net              |       | (122                 | )          | (217 | ) |
| Non-cash compensation expense associated with the  ESOP                          |       | 15                   |       | 33 |   |
| Stock based compensation                                                         |       | 14                   |       | 31 |   |
| Loss on sale of investment security                                              |       | —               |       | 172 |   |
| Decrease (increase) in accrued interest receivable  and other assets             |       | 3,526                |       | (2,454 | ) |
| (Decrease) increase in accrued interest payable  and other liabilities           |       | (5,945               | )          | 1,322 |   |
| Provision for deferred income taxes                                              |       | —               |       | (992 | ) |
| Net cash provided by operating activities                                        |       | 6,397                |       | 4,217 |   |
|                                                                             |       |                 |       |   |   |
| Cash flows from investing activities:                                            |       |                 |       |   |   |
| Decrease (increase) in interest-bearing deposits  in banks                       |       | 845                  |       | (857 | ) |
| Proceeds from matured or called available-for-sale  investment securities        |       | 1,000                |       | 3,000 |   |
| Proceeds from principal payments on  available-for-sale investment securities    |       | 226                  |       | 154 |   |
| Proceeds from matured or called held-to-maturity  investment securities          |       | 1,000                |       | 88 |   |
| Proceeds from principal payments on  held-to-maturity investment securities      |       | 55                   |       | 92 |   |
| Purchase of available-for-sale investment  securities                            |       | (1,000               | )          | (1,000 | ) |
| Purchase of held-to-maturity investment securities                               |       | —               |       | (996 | ) |
| Purchases of premises and equipment                                              |       | (221                 | )          | (142 | ) |
| Proceeds from sale of premises and equipment                                     |       | 4                    |       | 20 |   |
| Proceeds from sale of other real estate                                          |       | 6,427                |       | 1,265 |   |
| Premiums paid for life insurance policies                                        |       | 89                   |       | (39 | ) |
| Net (increase) decrease in loans                                                 |       | (555                 | )          | 3,820 |   |
| Net cash provided by investing activities                                        |       | 7,870                |       | 5,405 |   |
|                                                                             |       |                 |       |   |   |
| Cash flows from financing activities:                                            |       |                 |       |   |   |
| Net decrease in demand, interest-bearing and  savings deposits                   |       | (16,017              | )          | (7,191 | ) |
| Net decrease in time deposits                                                    |       | (11,831              | )          | (4,749 | ) |
| Repayment of note payable                                                        |       | —               |       | (500 | ) |
| Repayment of ESOP note payable                                                   |       | (76                  | )          | (75 | ) |
| Proceeds from ESOP note payable                                                  |       | —               |       | 216 |   |
| Purchase of ESOP shares                                                          |       | —               |       | (216 | ) |
| Proceeds from exercise of stock options                                          |       | —               |       | 1 |   |
| Net cash used in financing activities                                            |       | (27,924              | )          | (12,514 | ) |
|                                                                             |       |                 |       |   |   |
| Decrease in cash and cash equivalents                                            |       | (13,657              | )          | (2,892 | ) |
|                                                                             |       |                 |       |   |   |
| Cash and cash equivalents at beginning of year                                   |       | 58,654               |       | 58,348 |   |
|                                                                             |       |                 |       |   |   |
| Cash and cash equivalents at end of period                                       |       | $                    | 44,997     |   | $ | 55,456 |   |

 

SeeNotes to Unaudited Condensed Consolidated Financial Statements

 

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Community Valley Bancorp

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

**1. BASIS OF PRESENTATION**

 

Theaccompanying unaudited condensed consolidated financial statements of CommunityValley Bancorp and subsidiaries (the “Company”) have been prepared pursuant tothe rules and regulations of the Securities and Exchange Commission (the “SEC”)and the instructions to Form 10-Q and Article 10 of Regulation S-X.Accordingly, certain information and footnote disclosures required byaccounting principles generally accepted in the United States of America (GAAP)for annual financial statements are not included herein, however the Companybelieves that the disclosures made are adequate to make the information notmisleading. In the opinion of management, all adjustments (which consist solelyof normal recurring adjustments) considered necessary for a fair presentationof the results for the interim periods presented have been included. Theseinterim consolidated financial statements should be read in conjunction withthe financial statements and related notes contained in the Company’s 2009Annual Report to Shareholders on Form 10-K.

 

Thecondensed consolidated financial statements include the accounts of the Companyand its wholly owned subsidiaries, Butte Community Bank (the “Bank”) and BCBInsurance Agency, LLC. All significant inter-company balances and transactionshave been eliminated in consolidation. The Company also has a wholly-ownedunconsolidated subsidiary, Community Valley Bancorp Trust II (the “Trust”), aDelaware statutory business trust, formed for the sole purpose of issuing trustpreferred securities. The results of operations for the three month and sixmonth periods ended June 30, 2010 may not necessarily be indicative of theoperating results for the full year 2010.

 

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

 

Thepreparation of the condensed consolidated financial statements in conformitywith accounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions.  These estimatesand assumptions affect the reported amounts of assets and liabilities at thedate of the financial statements and the reported amounts of revenues andexpenses during the reporting period.  Actual results could differ fromthese estimates.

 

**2. REGULATORY MATTERS**

 

EffectiveMay 11, 2010, in connection with the Bank’s regularly scheduled 2010 JointFDIC and California Department of Financial Institutions (“DFI”) examination,the Bank entered into a Consent Order (“Order”) with the FDIC and the DFI.  The FDIC and DFI in the Consent Order, whichsupersedes the Memorandum of Understanding (MOU) that was entered into betweenthe Bank and the FDIC and DFI in April 2009, order certain actions to betaken by the Bank including among others:

 

·                  Having and retaining qualified management;

·                  Obtaining an independent study of themanagement and personnel structure of the Bank within 180 days of the date ofthe Order to determine whether the Bank is staffed by qualified individualscommensurate with its size and risk profile to ensure the safe and profitableoperation of the Bank;

·                  Within 90 days of the date of the Order,increasing and maintaining the Bank’s Tier 1 capital to a level such that itsleverage ratio is at least 10% and its total risk-based capital is at least13%;

·                  Not paying cash dividends or making any otherpayments to its shareholder without the prior written consent of the FDIC andDFI;

·                  Reducing or eliminating certain classifiedassets within 180 days of the date of the Order;

·                  Within 30 days of the date of the Order,revising or developing, adopting and implementing a comprehensive policy fordetermining the adequacy of the allowance for loan losses, and increasing andmaintaining its allowance for loan losses to be compliant with suchcomprehensive policy;

·                  With certain exceptions, not extending anyadditional credit to or for the benefit of any borrower who has a loan that hasbeen charged off or classified;

·                  Within 90 days of the date of the Order,revising or developing, adopting and implementing written lending andcollection policies to provide effective guidance and control over the Bank’slending function as satisfactory to the FDIC and DFI;

 

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·                  Within 90 days of the date of the Order,revising or developing, adopting and implementing a written plan forsystematically reducing its concentration of construction and land loans to becompliant with banking laws and bank regulatory agency guidance;

·                  Within 90 days of the date of the Order,revising or developing, adopting and implementing a written liquidity and fundsmanagement policy that adequately addresses liquidity needs and appropriatelyreduces its reliance on non-core funding sources as satisfactory to the FDICand DFI;

·                  Within 30 days of the date of the Order,revising or developing, adopting and implementing a written plan addressingretention of profits, reducing overhead expenses, and setting forth acomprehensive budget for 2010 as satisfactory to the FDIC and DFI;

·                  Within 180 days of the date of the Order,revising or developing, adopting and implementing a written three yearstrategic plan as satisfactory to the FDIC and DFI;

·                  Not establishing any new branches or otheroffices of the Bank without the prior consent of the FDIC and DFI;

·                  Complying with the banking laws andregulations on brokered deposits, and within 60 days of the date of the Order,submiting to the FDIC and DFI a written plan for eliminating its reliance onbrokered deposits; and

·                  Within 30 days of the end of each quarterfollowing the date of the Order, furnish written progress reports to the FDICand DFI.

 

Asof June 30, 2010, the Bank’s Tier 1 capital to average assets ratio was3.6% and total risk-based capital ratio was 5.4%.

 

EffectiveJuly 23, 2010 the Company entered into a Formal Agreement (“Agreement”)with the Federal Reserve Bank of San Francisco (FRB) which supersedes theMemorandum of Understanding (MOU) that was entered into between the Company andthe FRB in July 2009. The Agreement stipulates that the Company notdeclare or pay any dividends, make any payments of principal or interest ontrust preferred securities, or make any other capital distributions without theprior written approval of the FRB; to not incur, increase or renew any exitingdebt or guarantee any debt without the prior written approval of the FRB; tocomply with certain notice provisions in the case of any new director or seniorexecutive officer; and to comply with any legal restrictions regardingindemnification and severance payments to institution-affiliated partieswithout written approval from the FRB and concurrence from the FDIC.

 

Whilemanagement believes that progress has been made in addressing certain of therequirements set forth in the Consent Order and Formal Agreement, the Board ofDirectors and management are committed to putting the necessary resources andplans in place to become fully compliant within the timelines as set forthabove. As stated by the Order, the Bank has complied with those items requiringimmediate action including:

 

·                  Not paying cash dividends or making any otherpayment to its shareholders;

 

·                  With certain exceptions, not extending anyadditional credit to or for the benefit of any borrower who has a loan that hasbeen charged off or classified;

 

·                  Not establishing any new branches or otheroffices of the Bank;

 

Tofurther comply with the Order, the Bank has:

 

·                  Revised, adopted and implemented acomprehensive policy for determining the adequacy of the allowance for loanlosses, and increasing and maintaining its allowance for loan losses to becompliant with such comprehensive policy;

 

·                  Developed and implemented a written planaddressing profits, expenses, and setting forth a comprehensive budget for2010; and

 

·                  Submitted quarterly progress reports to theFDIC, DFI and FRB.

 

Inaddition, management is specifically focusing its efforts in the followingareas:

 

·                  Increasing andstrengthening our capital position. The Company has engaged Cappello CapitalCorp. of Santa Monica, California to be its financial advisor in connectionwith its recapitalization. We intend to raise additional capital through aplanned capital raise in the third and fourth quarter of 2010.

 

·                  Managing andimproving asset quality. The economic recession and the deterioration of thehousing and real estate markets have had an adverse impact on the creditquality of our loan portfolio. Management continues to work with borrowers onrepayment strategies and loan collections. In addition, the Company is workingwith Cappello Capital Corp. to identify investors interested in purchasing ournon performing assets.

 

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·                  Decreasing concentrations in our loanportfolio. We have effectively limited any new commercial real estate lendingand we are decreasing the existing level of these loans through the normal saleof the related real estate collateral by borrowers.

 

*RegulatoryCapital Guidelines*

 

Federal bank regulatoryagencies use capital adequacy guidelines in the examination and regulation ofbank holding companies and banks. The guidelines are “risk-based,” meaning thatthey are designed to make capital requirements more sensitive to differences inrisk profiles among banks and bank holding companies.  Regulations also include additional capitalcategories for all depository institutions under the regulatory framework forprompt corrective action which establishes a framework of supervisory actionsfor insured depository institutions that are not adequately capitalized.  For depository institutions that fail to meetthese minimum capital requirements, certain mandatory, and possibly additionaldiscretionary, actions by regulators are initiated that can have a directmaterial effect on the Bank.  Thesequantitative measures are established by regulation and require that minimumamounts and ratios of total and Tier 1 capital to risk-weighted assets and ofTier 1 capital to average assets be maintained. Capital amounts and classification are also subject to qualitativejudgments by the regulators about components, risk weightings and otherfactors.

 

*PromptCorrective Action*

 

Underthe Supervisory Prompt Correction Action Directive received from the FDIC onMay 3, 2010, the Bank filed a capital restoration plan on May 28,2010, and is subject to among other things, recapitalization of the Bank,refraining from accepting, renewing or rolling over any brokered deposits;restricting the interest rates that the Bank pays on deposits to comply withrate restrictions in certain FDIC Rules and Regulations; ensuring thataverage total assets during any calendar quarter do not exceed average totalassets during the preceding calendar quarter; refraining from making anycapital distributions or dividend payments to its parent or paying any bonusesor increased compensation to any director or officer of the Bank without priorwritten approval from the FDIC; retaining qualified senior executive officers;restrictions on access to the Federal Reserve’s discount window; and beingprohibited from opening new branches and from relocating, selling or disposingof any existing branches without the approval of the FDIC.

 

Under the prompt correctiveaction guidelines, a depository institution is assigned to one of five capitalcategories depending on its total risk-based capital ratio, Tier 1 risk-basedcapital ratio, and leverage ratio, together with certain subjective factors.The categories are “well capitalized,” “adequately capitalized,” “undercapitalized,”“significantly undercapitalized,” and “critically undercapitalized.”Institutions that are deemed to be undercapitalized, depending on the categoryto which they are assigned, are subject to certain mandatory supervisorycorrective actions.  The Bank’s totalcapital to risk-weighted assets ratio of 5.4% dropped below 6.0% as ofJune 30, 2010, therefore, the Bank is considered “significantlyundercapitalized” for purposes of the prompt correction action regulations.

 

Certain minimum ratios underthe provisions of the prompt corrective action guidelines and the actualcapital ratios of the Company and the Bank at June 30, 2010, are set forthin the table below:

 
| ** **                      | ** ** | **Requirements for the Bank Under the Prompt  Corrective Action Provisions to be:** | ** ** | ** **                  | ** ** | ** **             | ** ** |
|---------------------------------|------------|-------------------------------------------------------------------------------------|------------|-----------------------------|------------|------------------------|------------|
| ** **                      | ** ** | **Well  Capitalized**                                                               | ** ** | **Adequately  Capitalized** | ** ** | **Under  Capitalized** | ** ** | **Significantly  Under  Capitalized** | ** ** | **Bank** | ** ** | **Company** | ** ** |
| Tier 1 leverage capital ratio   |       | >   5.0                                                           | %          | >  4.0              | %          | <  4.0         | %          | <  3.0 | % | 3.6 | % | 1.9 | % |
| Tier 1 risk-based capital ratio |       | >   6.0                                                           | %          | >  4.0              | %          | <  4.0         | %          | <  3.0 | % | 4.1 | % | 2.1 | % |
| Total risk-based capital ratio  |       | > 10.0                                                                           | %          | >  8.0              | %          | <  8.0         | %          | <  6.0 | % | 5.4 | % | 5.4 | % |

 

Under the Consent Orderdiscussed above, the Bank is required to raise its Tier 1 leverage capital ratioto 10% and its total risk-based capital ratio to 13% which are significantlyhigher than the level for being categorized as “Well Capitalized.”

 

**3. GOING CONCERN CONSIDERATIONS**

 

Theaccompanying consolidated financial statements have been prepared assuming theCompany will continue as a going concern which contemplates the realization ofassets and the discharge of liabilities in the normal course of business forthe foreseeable future. We have determined that significant additional sourcesof liquidity and capital will be required for us to continue operations through2010 and beyond.  As of June 30, 2010, we estimate that to increasethe Bank’s leverage ratio to 10%, we will need at least $32,850,000 of new Tier1 capital. Additional losses in subsequent quarters will increase the capitalneeds necessary to meet the requirement. We have engaged financial advisors toassist the Company in its efforts to raise additional capital, sell assets, andexplore other strategic alternatives to address our current and expectedliquidity and capital deficiencies. However, there can be no assurance that theCompany will be able to maintain sufficient liquidity or to raise additionalcapital to satisfy regulatory requirements and meet obligations as they occur.As described above under “Regulatory Matters” in Note 2, the Company and theBank did not meet either the minimum regulatory capital requirements or theleverage ratio requirement of 10% outlined in the Consent Order 

 

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signedMay 11, 2010 which superseded the Memorandum of Understanding. As such,the Company is considered undercapitalized and the Bank has been categorized assignificantly undercapitalized under the Prompt Corrective Action Directivereceived on May 3, 2010.  Theaccompanying financial statements do not reflect the impact of the conditionsincluded in the Consent Order and Prompt Corrective Action Directive discussedabove. Further, the regulators are continually monitoring liquidity and capitaladequacy and evaluating the Company’s ability to continue to operate in a safeand sound manner. The Bank’s regulators could, if deemed warranted, takefurther actions, including the assumption of control of the Bank, to protectthe interests of depositors insured by the FDIC. The uncertainty regarding theCompany’s ability to obtain additional capital, improve asset quality and meetfuture liquidity requirements raises substantial doubt about the Company’sability to continue as a going concern.

 

While considerable risks tothe Company’s future financial performance exist, management believes theCompany is capable of responding to these risks and carrying on operationswhile it implements its strategic plan and pursues opportunities with respectto augmenting capital. If successfully implemented, the Company’s capital planwill address its near-term capital resources and liquidity needs. However,there can be no guarantee that any restructuring or recapitalization plan willbe successfully implemented.

 

**4. ALLOWANCE FOR LOAN LOSSES**

 

The allowance for loanlosses is established through a provision for loan losses which is charged toexpense. Additions to the allowance for loan losses are expected to maintainthe adequacy of the total allowance after loan losses and loan growth. Theallowance for loan losses is maintained to provide for losses related toimpaired loans and other losses that can be reasonably expected to occur in thenormal course of business. The determination of the allowance for loan lossesis based on estimates made by management to include consideration of thecharacter of the loan portfolio, specifically identified problem loans,potential losses inherent in the portfolio taken as a whole and economicconditions in the Company’s service area.

 

A loan is consideredimpaired when, based on current information and events, it is probable that theCompany will be unable to collect all amounts due (including both principal andinterest) in accordance with the contractual terms of the loan agreement. Animpaired loan is measured based on the present value of expected future cashflows discounted at the loan’s effective interest rate or, as a practicalmatter, at the loan’s observable market price or the fair value of collateralif the loan is collateral dependent. Interest income on impaired loans, ifappropriate, is recognized on a cash basis.

 

Classified loans and loansdetermined to be impaired are evaluated by management for specific risk ofloss. In addition, a reserve factor is assigned to currently performing loansbased on management’s assessment of the following for each identified loantype: (1) inherent credit risk, (2) historical losses and, (3) wherethe Company has not experienced losses, the loss experience of peer banks.These estimates are particularly susceptible to changes in the economicenvironment and market conditions.

 

The Company’s Board ofDirectors reviews the adequacy of the allowance for loan losses at leastquarterly, to include consideration of the relative risks in the portfolio andcurrent economic conditions. The allowance for loan losses is adjusted based onthat review if, in the judgment of the Board of Directors and management,changes are warranted. The allowance for loan losses at June 30, 2010 and2009 reflects management’s estimate of possible losses in the portfolio.

 

Changes in the allowance for loan losses were as follows (inthousands):

 
| ** **                      | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                      | ** ** | **2010**                              | ** ** | **2009**                            | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                      | ** ** | ** **                            | ** ** | ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Balance, beginning of year      |       | $                                     | 14,979     |                                | $          | 8,729 |   | $ | 12,975 |   | $ | 7,910 |   |
| Provision charged to operations |       | 4,943                                 |       | 4,000                               |       | 10,232 |   | 7,100 |   |
| Losses charged to allowance     |       | (4,192                                | )          | (3,512                              | )          | (7,722 | ) | (5,794 | ) |
| Recoveries                      |       | 15                                    |       | 1                                   |       | 260 |   | 2 |   |
|                            |       |                                  |       |                                |       |   |   |   |   |
| Balance, end of period          |       | $                                     | 15,745     |                                | $          | 9,218 |   | $ | 15,745 |   | $ | 9,218 |   |

 

At June 30, 2010 and December 31, 2009, impaired loanstotaled $71,094,000 and $54,123,000, respectively. Specific reserves recordedtotaled $2,377,000 on impaired loans totaling $9,873,000 at June 30, 2010and specific reserves recorded totaled $4,045,000 on impaired loans totaling$20,146,000 at December 31, 2009. The remaining impaired loans did notrequire a specific reserve at June 30, 2010 or December 31, 2009.Interest recognized for cash payments received on impaired loans was $113,000and $203,000 for the three and six months ended June 30, 2010,respectively. The amount of interest recognized for cash payments received wasnot significant for the same periods ended June 30, 2009. At June 30,2010 and December 31, 2009, the Company had $424,000 committed to lendadditional funds to borrowers whose loans were restructured.

 

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At June 30, 2010 and December 31, 2009, nonaccrual loanstotaled $66,839,000 and $51,075,000, respectively. Interest foregone onnonaccrual loans totaled $888,000 and $405,000 for the three months ended June 30,2010 and 2009, respectively, and $1,805,000 and $745,000 for the six monthsended June 30, 2010 and 2009, respectively. There were no loans greaterthan ninety days past due still accruing interest at June 30, 2010 andDecember 31, 2009. Interest recognized for cash payments received onnonaccrual loans was not significant for the three and six months endedJune 30, 2010 and 2009.

 

**5. (LOSS) EARNINGS PER SHARE COMPUTATION**

 

Basicloss per share is computed by dividing net loss available to commonshareholders by the weighted average common shares outstanding for the period(6,545,610 and 6,542,212 shares for the three and six month periods ended June 30,2010 and 6,527,737 and 6,542,539 shares for the three and six month periods endedJune 30, 2009). Diluted earnings per share reflects the potential dilutionthat could occur if outstanding stock options were exercised using the treasurystock method. Diluted earnings per share is computed by dividing net incomeavailable to common shareholders by the weighted average common sharesoutstanding for the period plus the dilutive effect of options.  As of June 30, 2010, 156,521 outstandingstock options were “out of the money” compared to 314,186 at June 30,2009; that is, the option price was higher than the market price so theseshares would not be used in the calculation of diluted earnings per share asthey are considered antidilutive.  Inaddition, diluted earnings per share are not presented when a loss occursbecause the conversion of potential common stock is anti-dilutive. Therefore,there was no dilutive effect of options and basic and dilutive earnings pershare were the same for all periods presented.

 

**6. COMPREHENSIVE LOSS**

 

Comprehensiveloss is reported in addition to net loss for all periods presented.Comprehensive loss is made up of net loss plus other comprehensive income orloss. The Company’s only source of comprehensive income or loss is changes inunrealized gains or losses, net of taxes, on available-for-sale securities,adjusted for the effect of realized gains or losses on available-for-salesecurities, net of taxes. Comprehensive loss was $(605,000) and $(5,079,000)for the three and six month periods ended June 30, 2010 compared tocomprehensive loss of $(2,514,000) and $(2,336,000) for the same periods in2009, respectively.

 

**7. STOCK - BASED COMPENSATION**

 

TheCompany issues stock options under one stock-based compensation plan, theCommunity Valley Bancorp 2000 Stock Option Plan. The plan requires that theoption price may not be less than the fair market value of the stock at thedate the option is granted, and that the stock must be paid in full at the timethe option is exercised. The options expire on a date determined by the Boardof Directors, but not later than ten years from the date of grant. The vestingperiod is determined by the Board of Directors and is generally over fiveyears. Under the Company’s 2000 stock option plan, 164,521 shares of commonstock remain reserved for issuance to employees and directors. There are274,322 additional shares available for future grants.

 

Stockoption activity for the interim 2010 period is summarized below:

 
| **2010**                                           | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Contractual  Term** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|----------------------------------------------------|------------|------------|------------|--------------------------------------------|------------|------------------------------------------|------------|---------------------------------|------------|
| Outstanding at January 1                      |       | 311,751    |       | $                                          | 8.02       |                                     | 2.3 years  |                            | $          | — |   |
| Cancelled/Expired                                  |       | (147,230   | )          | $                                          | 4.72       |                                     |       |                            |       |   |
| Outstanding at June 30                        |       | 164,521    |       | $                                          | 10.59      |                                     | 3.7 years  |                            | $          | — |   |
| Options vested or expected to vest at June 30 |       | 161,231    |       | $                                          | 10.59      |                                     | 3.6 years  |                            | $          | — |   |
| Exercisable at June 30                        |       | 156,521    |       | $                                          | 10.59      |                                     | 3.5 years  |                            | $          | — |   |

 

**8. COMMITMENTS AND CONTINGENCIES**

 

TheCompany is party to claims and legal proceedings arising in the ordinary courseof business. In the opinion of the Company’s management, the amount of ultimateliability with respect to such proceedings will not have a material adverseeffect on the financial condition or results of operations of the Company takenas a whole.

 

Inthe normal course of business, there are various outstanding commitments toextend credit which are not reflected in the financial statements, includingloan commitments of $78,067,000 and $110,890,000 and stand-by letters of creditof $4,545,000 and $4,387,000 at June 30, 2010 and December 31, 2009,respectively.

 

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Ofthe loan commitments outstanding at June 30, 2010, $11,142,000 are realestate construction loan commitments that are not expected to fund within thenext twelve months due to the current downturn in the real estate market. Theremaining commitments primarily relate to revolving lines of credit or othercommercial loans, and many of these are expected to expire without being drawnupon. Therefore, the total commitments do not necessarily represent future cashrequirements. Each loan commitment and the amount and type of collateralobtained, if any, are evaluated on an individual basis. Collateral held varies,but may include real property, bank deposits, debt or equity securities orbusiness assets.

 

AtJune 30, 2010, the Company had $424,000, which is included in theoutstanding commitments, committed to lend additional funds to borrowers whoseloans were restructured.

 

Stand-byletters of credit are conditional commitments written to guarantee theperformance of a customer to a third party. These guarantees are primarilyrelated to the purchases of inventory by commercial customers and are typicallyshort-term in nature. Credit risk is similar to that involved in extending loancommitments to customers and accordingly, evaluation and collateralrequirements similar to those for loan commitments are used. The fair value ofthe liability related to these stand-by letters of credit, which represents thefees received for issuing the guarantees, was not significant at June 30,2010 and December 31, 2009. The Company recognizes these fees as revenuesover the term of the commitment or when the commitment is used.

 

**9.  INCOME TAXES**

 

TheCompany files its income tax returns on a consolidated basis with itssubsidiaries. The allocation of income tax expense (benefit) represents eachentity’s proportionate share of the consolidated provision (benefit) for incometaxes.

 

TheCompany accounts for income taxes under the asset and liability method. Underthe asset and liability method, deferred tax assets and liabilities arerecognized for the future tax consequences attributable to differences betweenthe financial statement carrying amounts of existing assets and liabilities andtheir respective tax bases. Deferred tax assets and liabilities are measuredusing currently enacted tax rates applied to such taxable income in the yearsin which those temporary differences are expected to be recovered or settled.The effect on deferred tax assets and liabilities of a change in tax rates isrecognized in income in the period that includes the enactment date.

 

Acomprehensive model is used for recognizing, measuring, presenting anddisclosing in the financial statements tax positions taken or expected to betaken on a tax return.  A tax position isrecognized as a benefit only if it is “more likely than not” that the taxposition would be sustained in a tax examination, with a tax examination beingpresumed to occur.  The amount recognizedis the largest amount of tax benefit that is greater than 50% likely of beingrealized on examination.  For taxpositions not meeting the “more likely than not” test, no tax benefit isrecorded.

 

If management determines,based on available evidence at the time, that it is more likely than not thatsome portion or all of the Company’s deferred tax assets will not be realized,then a valuation allowance against the deferred tax asset is established. Inevaluating the likelihood of realizing the benefit of the deferred tax asset,management estimates future taxable income based on management’s business plansand ongoing tax planning strategies against which the deferred tax asset may beapplied. This process involves significant judgment about assumptions that aresubject to revision from period to period based on changes in tax laws orvariances between the Company’s projected operating performance and the Company’sactual results and other factors. A valuation allowance for deferred tax assetsis established through an expense recorded in the statement of operations.

 

For the three years endedDecember 31, 2009, 2008 and 2007, the Company is in a cumulative pretaxloss position. For purposes of establishing a deferred tax valuation allowance,this cumulative pretax loss position is considered significant, objectiveevidence that the Company’s deferred tax assets may not be realizable in thefuture. The cumulative pretax loss position was caused primarily by the significantamount of loan loss provision and other real estate expense taken in 2009. As aresult of these losses and the losses recognized in the current quarter, avaluation allowance was recorded on substantially all of the Company’s netdeferred tax assets at June 30, 2010 and December 31, 2009. Due tocontinued deteriorating market conditions, the Company has determined thatthere is not sufficient additional positive evidence to support the realizationof its net deferred tax assets. However, a current tax receivable can berealized from the carryback of the 2010 projected net operating loss. Netoperating loss carrybacks for the year ending December 31, 2010 arelimited to the $3.9 million in taxes paid for the 2008 tax year net of $258,000alternative minimum tax.

 

Theamount of deferred tax assets considered realizable is subject to adjustment infuture periods. Management will continue to monitor all available evidencerelated to the Company’s ability to utilize its net deferred tax assets. TheCompany’s income tax expense in future periods will be increased or reduced tothe extent of offsetting increases or decreases to the Company’s net deferredtax asset valuation allowance.

 

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**10.  NOTE PAYABLE AND OTHERBORROWING ARRANGEMENTS**

 

The ESOP obtained financingthrough a $1,300,000 unsecured line of credit from another financialinstitution with the Company acting as the guarantor. The note has a variableinterest rate, based on an independent index, and a maturity date ofOctober 16, 2016. The interest rate was 5.75% at June 30, 2010. Thebalance on the line of credit totaled $1,046,000 and $1,122,000 atJune 30, 2010 and December 31, 2009, respectively.

 

Tomeet unanticipated funding requirements, the Bank obtained a line of creditwith the Federal Reserve Bank of San Francisco (FRB) in 2010, with a borrowingcapacity of $9,971,000 at June 30, 2010. This line is collateralized byagriculture loans and commercial real estate loans with a carrying value of$22,360,000. There were no outstanding borrowings at June 30, 2010.

 

**11. INVESTMENT SECURITIES**

 

Theamortized cost and estimated fair value of available-for-sale investmentsecurities at June 30, 2010 and December 31, 2009 consisted of thefollowing (dollars in thousands):

 

Available for Sale

 
| ** **                                       | ** ** | **June 30, 2010**   | ** ** |
|--------------------------------------------------|------------|---------------------|------------|
| ** **                                       | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** |
| Debt securities:                                 |       |                |       |   |   |   |   |   |   |
| U.S. Government agencies                         |       | $                   | 2,581      |   | $ | 112 |   | $ | — |   | $ | 2,693 |   |
| Obligations of states and political subdivisions |       | 1,358               |       | 99 |   | — |   | 1,457 |   |
|                                             |       | $                   | 3,939      |   | $ | 211 |   | $ | — |   | $ | 4,150 |   |

 
| ** **                                       | ** ** | **December 31, 2009** | ** ** |
|--------------------------------------------------|------------|-----------------------|------------|
| ** **                                       | ** ** | **Amortized  Cost**   | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** |
| Debt securities:                                 |       |                  |       |   |   |   |   |   |   |
| U.S. Government agencies                         |       | $                     | 2,807      |   | $ | 131 |   | $ | — |   | $ | 2,938 |   |
| Obligations of states and political subdivisions |       | 1,358                 |       | 81 |   | — |   | 1,439 |   |
|                                             |       | $                     | 4,165      |   | $ | 212 |   | $ | — |   | $ | 4,377 |   |

 

Net unrealized gains on available-for-sale investment securitiestotaling $211,000 and $212,000 were recorded, net of $84,000 and $85,000 in taxexpenses, as accumulated other comprehensive income within shareholders’ equityfor 2010 and 2009, respectively. There were no sales or transfers ofavailable-for-sale investment securities for the periods ended June 30,2010 and 2009.

 

Theamortized cost and estimated fair value of held-to-maturity investmentsecurities at June 30, 2010 and December 31, 2009 consisted of the following(dollars in thousands):

 

Held to Maturity

 
| ** **               | ** ** | **June 30, 2010**   | ** ** |
|--------------------------|------------|---------------------|------------|
| ** **               | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** |
| Debt securities:         |       |                |       |   |   |   |   |   |   |
| U.S. Government agencies |       | $                   | 174        |   | $ | 10 |   | $ | — |   | $ | 184 |   |
|                          |            |                     |            |  |  |  |  |  |  |  |  |  |  |

 
| ** **               | ** ** | **December 31, 2009** | ** ** |
|--------------------------|------------|-----------------------|------------|
| ** **               | ** ** | **Amortized  Cost**   | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** |
| Debt securities:         |       |                  |       |   |   |   |   |   |   |
| U.S. Government agencies |       | $                     | 1,229      |   | $ | 14 |   | $ | — |   | $ | 1,243 |   |
|                          |            |                       |            |  |  |  |  |  |  |  |  |  |  |

 

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There were no sales or transfers of held-to-maturity investmentsecurities for the periods ended June 30, 2010 and 2009.

 

There were no investment securities with unrealized losses at June 30,2010 and December 31, 2009.

 

Investment securities with amortized costs totaling $2,358,000 and$3,445,000 and fair values totaling $2,459,000 and $3,446,000 were pledged tosecure public deposits and treasury, tax and loan accounts at June 30, 2010and December 31, 2009, respectively.

 

**12. FAIR VALUE MEASUREMENTS**

 

The carrying amounts and estimated fair values of the Company’sfinancial instruments are as follows (dollars in thousands):

 
| ** **                                                  | ** ** | **June 30, 2010**    | ** ** | **December 31, 2009** | ** ** |
|-------------------------------------------------------------|------------|----------------------|------------|-----------------------|------------|
| ** **                                                  | ** ** | **Carrying  Amount** | ** ** | **Fair Value**        | ** ** | **Carrying  Amount** | ** ** | **Fair Value** | ** ** |
|                                                        |       |                 |       |                  |       |   |   |   |   |
| Financial assets:                                           |       |                 |       |                  |       |   |   |   |   |
| Cash and due from banks                                     |       | $                    | 12,034     |                  | $          | 12,034 |   | $ | 12,119 |   | $ | 12,119 |   |
| Excess balance agreement/Federal Reserve Bank               |       | 32,748               |       | 32,748                |       | — |   | — |   |
| Federal funds sold                                          |       | 215                  |       | 215                   |       | 46,535 |   | 46,535 |   |
| Interest-bearing deposits in banks                          |       | 1,895                |       | 1,893                 |       | 2,740 |   | 2,742 |   |
| Loans held for sale                                         |       | —               |       | —                |       | 1,137 |   | 1,137 |   |
| Investment securities                                       |       | 4,324                |       | 4,334                 |       | 5,606 |   | 5,620 |   |
| Loans                                                       |       | 404,538              |       | 413,832               |       | 420,036 |   | 426,724 |   |
| Other investments                                           |       | 947                  |       | 947                   |       | 985 |   | 985 |   |
| Accrued interest receivable                                 |       | 1,689                |       | 1,689                 |       | 2,380 |   | 2,380 |   |
| Cash surrender value of Bank owned life insurance  policies |       | 11,713               |       | 11,713                |       | 11,680 |   | 11,680 |   |
| Loan servicing assets                                       |       | 2,548                |       | 2,548                 |       | 3,463 |   | 3,463 |   |
|                                                        |       |                 |       |                  |       |   |   |   |   |
| Financial liabilities:                                      |       |                 |       |                  |       |   |   |   |   |
| Deposits                                                    |       | $                    | 470,315    |                  | $          | 471,426 |   | $ | 498,163 |   | $ | 500,337 |   |
| Note payable                                                |       | 1,046                |       | 1,046                 |       | 1,122 |   | 1,122 |   |
| Junior subordinated debentures                              |       | 8,248                |       | 6,971                 |       | 8,248 |   | 6,787 |   |
| Accrued interest payable                                    |       | 560                  |       | 560                   |       | 346 |   | 346 |   |

 

Estimated fair values are disclosed for financial instruments for whichit is practicable to estimate fair value. These estimates are made at aspecific point in time based on relevant market data and information about thefinancial instruments. These estimates do not reflect any premium or discountthat could result from offering the Company’s entire holdings of a particularfinancial instrument for sale at one time, nor do they attempt to estimate thevalue of anticipated future business related to the instruments. In addition,the tax ramifications related to the realization of unrealized gains and lossescan have a significant effect on fair value estimates and have not beenconsidered in any of these estimates.

 

Because no market exists for a significant portion of the Company’sfinancial instruments, fair value estimates are based on judgments regardingcurrent economic conditions, risk characteristics of various financialinstruments and other factors. These estimates are subjective in nature andinvolve uncertainties and matters of significant judgment and therefore cannotbe determined with precision. Changes in assumptions could significantly affectthe fair values presented.

 

The following methods and assumptions were used by the Company toestimate the fair value of its financial instruments at June 30, 2010 and December 31,2009:

 

Cash and cash equivalents: Cash and cash equivalentsinclude cash and due from banks, Excess balance agreement with the FederalReserve Bank and Federal funds sold where the carrying amount is estimated tobe fair value.

 

Interest-bearing deposits in banks: The fair values ofinterest-bearing deposits in banks are estimated by discounting their futurecash flows using rates at each reporting date for instruments with similarremaining maturities offered by comparable financial institutions.

 

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Investment securities: For investment securities,fair values are based on quoted market prices, where available. If quotedmarket prices are not available, fair values are estimated using quoted marketprices for similar securities and indications of value provided by brokers.

 

Loans: Fair values of loans held for sale are estimatedusing quoted market prices for similar loans or the amount that purchasers havecommitted to purchase the loans. For variable-rate loans that repricefrequently with no significant change in credit risk, fair values are based oncarrying values.  The fair values forother loans are estimated using discounted cash flow analyses, using interestrates offered at each reporting date for loans with similar terms to borrowersof comparable creditworthiness adjusted for the allowance for loan losses. Thecarrying amount of accrued interest receivable approximates its fair value.

 

Other investments: Other investments include non-marketableequity securities. The carrying value of these investments approximates theirfair value.

 

Bank owned life insurance policies: The fair values of lifeinsurance policies are based on cash surrender values at each reporting dateprovided by the insurers.

 

Loan servicing assets: The fair value of loanservicing assets is determined by an independent third party. The valuationmodel takes into consideration discounted cash flows using current interestrates and prepayment speeds for each type of underlying asset being serviced.

 

Deposits: The fair values of time deposits are based on thediscounted value of contractual cash flows using discount rates equal to theinterest rates offered at each reporting date by the Bank for time depositswith similar maturities. The fair values of deposits that have no statedmaturities are based on the carrying amounts reported in the balance sheet.

 

Note payable: The ESOP note payable reprice is based upon anindependent index. The carrying amount of the note payable approximates itsfair value.

 

Junior subordinated debentures: The fair value of thejunior subordinated debentures was determined based on the current market forlike-kind instruments of a similar maturity and structure.

 

Accrued interest payable:  The carrying value of accrued interestpayable approximates fair value.

 

Commitments to extend credit and standby letters of credit: Commitmentsto extend credit are primarily for variable rate loans and standby letters ofcredit. The fair value of commitments are estimated using the fees currentlycharged to enter into similar agreements and are not significant and,therefore, not included in the above table.

 

Thefollowing tables present information about the Company’s assets and liabilitiesmeasured at fair value on a recurring and non recurring basis as ofJune 30, 2010 and December 31, 2009.

 

*Recurring Basis*

 

Assets and liabilities measured at fair value on a recurring basis areas follows (dollars in thousands):

 
| ** **                               | ** ** | **June 30, 2010**   | ** ** |
|------------------------------------------|------------|---------------------|------------|
| **Description**                          | ** ** | **Fair Value** | ** ** | **Quoted Prices in  Active Markets for  Identical Assets  (Level 1)** | ** ** | **Other  Observable  Inputs  (Level 2)** | ** ** | **Significant  Unobservable  Inputs  (Level 3)** | ** ** |
| Investment securities available-for-sale |       | $                   | 4,150      |   | $ | — |   | $ | 4,150 |   | $ | — |   |
|                                          |            |                     |            |  |  |  |  |  |  |  |  |  |  |

 
| ** **                               | ** ** | **December 31, 2009** | ** ** |
|------------------------------------------|------------|-----------------------|------------|
| **Description**                          | ** ** | **Fair Value**        | ** ** | **Quoted Prices in  Active Markets for  Identical Assets  (Level 1)** | ** ** | **Other  Observable  Inputs  (Level 2)** | ** ** | **Significant  Unobservable  Inputs  (Level 3)** | ** ** |
| Investment securities available-for-sale |       | $                     | 4,377      |   | $ | — |   | $ | 4,377 |   | $ | — |   |
|                                          |            |                       |            |  |  |  |  |  |  |  |  |  |  |

 

Fairvalues for investment securities are based on quoted market prices for similarinstruments in active markets.

 

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*Non-recurring Basis*

 

Assets measured at fair value on a non-recurring basis are summarizedbelow (dollars in thousands):

 
| ** **                                                    | ** ** | **June 30, 2010**   | ** ** | **Total Losses**                                                                                    | ** ** |
|---------------------------------------------------------------|------------|---------------------|------------|-----------------------------------------------------------------------------------------------------|------------|
| **Description**                                               | ** ** | **Fair Value** | ** ** | **Quoted Prices in  Active Markets for  Identical Assets  (Level 1)** | ** ** | **Other  Observable  Inputs  (Level 2)** | ** ** | **Significant  Unobservable  Inputs  (Level 3)** | ** ** | **For the Six  Months Ended  June 30,  2010** | ** ** |
| Impaired loans                                                |       | $                   | 38,594     |                                                                                                | $          | — |   | $ | 38,060 |   | $ | 534 |   | $ | 5,676 |   |
| Other real estate                                             |       | 11,211              |       | —                                                                                              |       | 11,211 |   | — |   | 1,661 |   |
| Total assets measured at fair value on a  non-recurring basis |       | $                   | 49,805     |                                                                                                | $          | — |   | $ | 49,271 |   | $ | 534 |   | $ | 7,337 |   |

 
| ** **                                                    | ** ** | **December 31, 2009** | ** ** | **Total Losses**                                                                                    | ** ** |
|---------------------------------------------------------------|------------|-----------------------|------------|-----------------------------------------------------------------------------------------------------|------------|
| **Description**                                               | ** ** | **Fair Value**   | ** ** | **Quoted Prices in  Active Markets for  Identical Assets  (Level 1)** | ** ** | **Other  Observable  Inputs  (Level 2)** | ** ** | **Significant  Unobservable  Inputs  (Level 3)** | ** ** | **For the Twelve  Months Ended  December 31,  2009** | ** ** |
| Impaired loans                                                |       | $                     | 37,962     |                                                                                                | $          | — |   | $ | 34,548 |   | $ | 3,414 |   | $ | 13,473 |   |
| Other real estate                                             |       | 13,493                |       | —                                                                                              |       | 13,493 |   | — |   | 5,528 |   |
| Total assets measured at fair value on a  non-recurring basis |       | $                     | 51,455     |                                                                                                | $          | — |   | $ | 48,041 |   | $ | 3,414 |   | $ | 19,001 |   |

 

***Impaired Loans*****— Impaired loans, carried at fair value, which are measured forimpairment using the fair value of the collateral for collateral dependentloans, had a carrying amount of $38,594,000 which included a specific reserveof $2,377,000.  At December 31, 2009,impaired loans carried at fair value had a carrying amount of $37,962,000,which included a specific reserve of $4,045,000. Impaired loans are measured atan observable market price, if available, or at the fair value of the loan’scollateral, if the loan is collateral dependent. The fair value of the loan’scollateral is determined by appraisals or independent valuation which is thenadjusted for the cost related to liquidation of the collateral. When the fairvalue of the loan’s collateral is based on an observable market price orcurrent appraised value, the Company classifies the fair value of the impairedloans as a nonrecurring valuation within level 2 of the valuationhierarchy.  When the Company measuresimpairment using anything but an observable market price or a current appraisedvalue, such loans would be classified within level 3 of the valuationhierarchy.  The impact on income fromimpaired loans for the six months ending June 30, 2010 was$5,676,000.  These losses representlosses only for the loans identified as impaired and carried at fair value atJune 30, 2010.

 

***Other Real Estate***— The fairvalue of other real estate is based primarily on the values obtained throughcurrent property appraisals which use observable data.

 

**13.  RETIREMENT BENEFIT PLAN**

 

Salarycontinuation plans had been previously established for sixteen current andformer key executives of the Company. In addition, retirement plans had beenestablished for members of the Board of Directors. Under these plans, thedirectors and executives, or designated beneficiaries, would receive monthlypayments for five to twenty years after retirement or death. The estimatedpresent value of these future benefits was being accrued over the period fromthe effective date of each plan until the participant’s expected retirementdate. The expense recognized under these plans totaled $195,000 and $391,000for the six month periods ended June 30, 2010 and 2009, respectively.

 

EffectiveJune 29, 2010, thirteen of the executives and the entire Board of Directorssigned agreements relinquishing rights to these salary continuation, deferredcompensation and director retirement benefits.  Non-interest income of $6,333,000was recognized as a result of the derecognition of the retirement benefitliability.

 

Inconnection with these plans, the Company purchased single premium lifeinsurance policies with cash surrender values totaling $11,713,000 and$11,680,000 at June 30, 2010 and December 31, 2009, respectively. These policies remain in effect with the Bank continuing as the beneficiary ofthe policies.

 

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**14.  NEW ACCOUNTINGPRONOUNCEMENTS**

 

*Accounting for Transfers of Financial Assets*

 

In June 2009, the FASBissued ASC Topic 860 (previously SFAS No. 166), *Accounting for Transfers of Financial Assets, an amendment of SFAS No. 140.*This standard, adopted by the Company on January 1, 2010, amends thederecognition accounting and disclosure guidance included in previously issuedstandards. This standard eliminates the exemption from consolidation forqualifying special-purpose entities (SPEs) and also requires a transferor toevaluate all existing qualifying SPEs to determine whether they must beconsolidated in accordance with ASC Topic 810. This standard also provides morestringent requirements for derecognition of a portion of a financial asset andestablishes new conditions for reporting the transfer of a portion of afinancial asset as a sale. This new accounting standard has specificallyimpacted how we account for the sale and transfer of the guaranteed portion ofthe Company’s Small Business Administration (“SBA”) loans. The terms of thesale of the government guaranteed portion of SBA loans require the Company torefund the premium to the purchaser if the SBA loan is repaid within 90 days ofthe transfer. Under the new accounting guidance, the obligation to refund thepremium means that the transferred guaranteed portion of the loan does not meetthe definition of a “participating interest” for the 90-day period that thepremium refund obligation exists. As a result, the transfer must be accountedfor as a secured borrowing during the 90 period after the date of transfer.After the 90-day period, assuming the transferred guaranteed portion and theretained unguaranteed portion of the SBA loan now meet the definition of a “participatinginterest,” the transfer of the guaranteed portion can be accounted for as asale if all of the other conditions for sale accounting have been met.

 

*Transfers and Servicing*

 

In December 2009, theFASB issued Accounting Standards Update (ASU) No. 2009-16, *Transfers and Servicing (ASC Topic 860): Accountingfor Transfers of Financial Assets,*which updates the derecognitionguidance in ASC Topic 860 for previously issued SFAS No. 166. This update,adopted by the Company on January 1, 2010, reflects the Board’s response toissues entities have encountered when applying ASC 860, including:(1) requires that all arrangements made in connection with a transfer offinancial assets be considered in the derecognition analysis,(2) clarifies when a transferred asset is considered legally isolated fromthe transferor, (3) modifies the requirements related to a transferee’s abilityto freely pledge or exchange transferred financial assets, and (4) providesguidance on when a portion of a financial asset can be derecognized. This newaccounting standard has specifically impacted how we account for transfers ofthe guaranteed portion of the Company’s Small Business Administration (“SBA”)loans. The terms of the sale of the government guaranteed portion of SBA loansrequire the Company to refund the premium to the purchaser if the SBA loan isrepaid within 90 days of the transfer. Under the new accounting guidance, theobligation to refund the premium means that the transferred guaranteed portionof the loan does not meet the definition of a “participating interest” for the90-day period that the premium refund obligation exists. As a result, thetransfer must be accounted for as a secured borrowing during the 90 periodafter the date of transfer. After the 90-day period, assuming the transferredguaranteed portion and the retained unguaranteed portion of the SBA loan nowmeet the definition of a “participating interest,” the transfer of theguaranteed portion can be accounted for as a sale if all of the other conditionsfor sale accounting have been met.

 

*Fair Value Measurements*

 

InJanuary 2010, the FASB issued ASU 2010-06, *Fair Value Measurements and Disclosures*(“Topic 820”)*: Improving Disclosures about Fair Value Measurements*(“ASU 10-06”). ASU 10-06 revises two disclosure requirementsconcerning fair value measurements and clarifies two others. It requiresseparate presentation of significant transfers into and out of Levels 1 and 2of the fair value hierarchy and disclosure of the reasons for such transfers. Italso requires the presentation of purchases, sales, issuances and settlementswithin Level 3 on a gross basis rather than a net basis. The amendments alsoclarify that disclosures should be disaggregated by class of asset or liabilityand that disclosures about inputs and valuation techniques should be providedfor both recurring and non-recurring fair value measurements. The Company’sdisclosures about fair value measurements are presented in Note 12: Fair ValueMeasurements. These new disclosure requirements were adopted by the Companyduring the current period, with the exception of the requirement concerninggross presentation of Level 3 activity, which is effective for fiscal yearsbeginning after December 15, 2010.  With respect to the portions ofthis ASU that were adopted during the current period, the adoption of thisstandard did not have a material impact on the Company’s financial position,results of operations, cash flows, or disclosures.  Management does notbelieve that the adoption of the remaining portion of this ASU will have amaterial impact on the Company’s financial position, results of operation, cashflows, or disclosures.

 

*LoanModifications*

 

InApril 2010, the FASB issued ASU 2010-18, which states that modificationsof loans that are accounted for within a pool under ASC 310-30 do not result inthe removal of those loans from the pool even if the modification of thoseloans would otherwise be considered a troubled debt restructuring. An entitywill continue to be required to consider whether the pool of assets in whichthe loan is included is impaired if expected cash flows for the pool change.The amendments do not affect the accounting for loans under the scope of ASC310-30 that are not accounted for within pools. Loans accounted forindividually under ASC 310-30 continue to be subject to the troubled debtrestructuring accounting provisions within ASC 310-40, “Receivables—TroubledDebt Restructurings by Creditors”. The amendments are effective formodifications of loans accounted for within pools under Subtopic 310-30occurring in the first interim or annual period ending on or afterJuly 15, 2010. The Company does not expect that the adoption of thispronouncement will have a material impact on the Company’s financial condition,results of operations or cash flows.

 

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

 

Thefollowing is Community Valley Bancorp’s (the “Company’s”) management’sdiscussion and analysis of the significant changes in balance sheet accountsbetween June 30, 2010 and December 31, 2009 and income and expenseaccounts for the three and six month periods ended June 30, 2010 and 2009.The discussion is designed to provide a better understanding of significanttrends related to the Company’s financial condition, results of operations,liquidity, capital resources and interest rate sensitivity.

 

Inaddition to the historical information contained herein, this report onForm 10-Q contains certain forward-looking statements. The reader of thisreport should understand that all such forward-looking statements are subjectto various uncertainties and risks that could affect their outcome. The Company’sactual results could differ materially from those suggested by suchforward-looking statements. Factors that could cause or contribute to suchdifferences include, but are not limited to, variances in the actual versusprojected growth in assets, return on assets, loan losses, expenses, ratescharged on loans and earned on securities investments, rates paid on deposits,competition effects, fee and other noninterest income earned, general economicconditions, nationally, regionally and in the operating market areas of theCompany and its subsidiaries, changes in the regulatory environment, changes inbusiness conditions and inflation, changes in securities markets, dataprocessing problems, a decline in real estate values in the Company’s marketarea,  the effects of terrorism, including the events ofSeptember 11, 2001 and thereafter, and the conduct of the war on terrorismby the United States and its allies, as well as other factors. This entirereport should be read putting such forward-looking statements in context.

 

**General Development of Business**

 

TheCompany is a financial holding company (“FHC”) registered and authorized toengage in the activities permitted under the Bank Holding Company Act of 1956,as amended. The Company was incorporated under the laws of the State ofCalifornia in 2002 and elected to change to a FHC in 2004. As a financialholding company, the Company is subject to the Federal Holding Company Act andto supervision by the board of Governors of the Federal Reserve System (“FRB”).Its principal office is located at 1360 E. Lassen Avenue, Chico, California95973 and its telephone number is (530) 899-2344.

 

TheCompany owns 100% of the issued and outstanding common shares of ButteCommunity Bank (the “Bank”). The Bank was incorporated and commenced businessin Paradise and Oroville, California in 1990. The Bank operates fourteen fullservice offices within its service areas of Butte, Sutter, Yuba, Tehama,Shasta, and Colusa Counties. Butte Community Bank’s primary business is servingthe commercial banking needs of small to mid-sized businesses and consumerswithin those counties. Butte Community Bank accepts checking and savingsdeposits, offers money market deposit accounts and certificates of deposit,makes secured and unsecured commercial, secured real estate, and otherinstallment and term loans and offers other customary banking services.

 

OnDecember 1, 2004, the Company formed a wholly-owned subsidiary, CVBInsurance Agency LLC for the purpose of providing insurance relatedservices.  The name was subsequentlychanged to Butte Community Insurance Agency LLC in April 2006.

 

OnJuly 10, 2007 the Company formed a wholly-owned unconsolidated subsidiary,Community Valley Bancorp Trust II (the “Trust”), a Delaware statutory businesstrust, for the purpose of issuing trust preferred securities.

 

**Consent Order**

 

EffectiveMay 11, 2010, in connection with the Bank’s regularly scheduled 2010 JointFDIC and California Department of Financial Institutions (“DFI”) examination,the Bank entered into a Consent Order (“Order”) with the FDIC and the DFI.  The FDIC and DFI in the Consent Order, whichsupersedes the Memorandum of Understanding (MOU) that was entered into betweenthe Bank and the FDIC and DFI in April 2009, order certain actions to betaken by the Bank including among others:

 

·                  Having and retaining qualified management;

·                  Obtaining an independent study of themanagement and personnel structure of the Bank within 180 days of the date ofthe Order to determine whether the Bank is staffed by qualified individualscommensurate with its size and risk profile to ensure the safe and profitableoperation of the Bank;

·                  Within 90 days of the date of the Order,increasing and maintaining the Bank’s Tier 1 capital to a level such that itsleverage ratio is at least 10% and its total risk-based capital is at least13%;

·                  Not paying cash dividends or making any otherpayments to its shareholder without the prior written consent of the FDIC andDFI;

·                  Reducing or eliminating certain classifiedassets within 180 days of the date of the Order;

·                  Within 30 days of the date of the Order,revising or developing, adopting and implementing a comprehensive policy fordetermining the adequacy of the allowance for loan losses, and increasing andmaintaining its allowance for loan losses to be compliant with suchcomprehensive policy;

 

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·                  With certain exceptions, not extending anyadditional credit to or for the benefit of any borrower who has a loan that hasbeen charged off or classified;

·                  Within 90 days of the date of the Order,revising or developing, adopting and implementing written lending andcollection policies to provide effective guidance and control over the Bank’slending function as satisfactory to the FDIC and DFI;

·                  Within 90 days of the date of the Order,revising or developing, adopting and implementing a written plan forsystematically reducing its concentration of construction and land loans to becompliant with banking laws and bank regulatory agency guidance;

·                  Within 90 days of the date of the Order,revising or developing, adopting and implementing a written liquidity and fundsmanagement policy that adequately addresses liquidity needs and appropriatelyreduces its reliance on non-core funding sources as satisfactory to the FDICand DFI;

·                  Within 30 days of the date of the Order,revising or developing, adopting and implementing a written plan addressingretention of profits, reducing overhead expenses, and setting forth acomprehensive budget for 2010 as satisfactory to the FDIC and DFI;

·                  Within 180 days of the date of the Order,revising or developing, adopting and implementing a written three yearstrategic plan as satisfactory to the FDIC and DFI;

·                  Not establishing any new branches or otheroffices of the Bank without the prior consent of the FDIC and DFI;

·                  Complying with the banking laws andregulations on brokered deposits, and within 60 days of the date of the Order,submitting to the FDIC and DFI a written plan for eliminating its reliance onbrokered deposits; and

·                  Within 30 days of the end of each quarterfollowing the date of the Order, furnish written progress reports to the FDICand DFI.

 

Asof June 30, 2010, the Bank’s Tier 1 capital to average assets ratio was 3.6%and total risk-based capital ratio was 5.4%.

 

EffectiveJuly 23, 2010 the Company entered into a Formal Agreement (“Agreement”)with the Federal Reserve Bank of San Francisco (FRB) which supersedes theMemorandum of Understanding (MOU) that was entered into between the Company andthe FRB in July 2009. The Agreement stipulates that the Company notdeclare or pay any dividends, make any payments of principal or interest ontrust preferred securities, or make any other capital distributions without theprior written approval of the FRB; to not incur, increase or renew any existingdebt or guarantee any debt without the prior written approval of the FRB; tocomply with certain notice provisions in the case of any new director or seniorexecutive officer; and to comply with any legal restrictions regardingindemnification and severance payments to institution-affiliated partieswithout written approval from the FRB and concurrence from the FDIC.

 

Whilemanagement believes that progress has been made in addressing certain of therequirements set forth in the Consent Order and Formal Agreement, the Board ofDirectors and management are committed to putting the necessary resources andplans in place to become fully compliant within the timelines as set forthabove. As stated by the Order, the Bank has complied with those items requiringimmediate action including:

 

·                  Not paying cash dividends or making any otherpayment to its shareholders;

 

·                  With certain exceptions, not extending anyadditional credit to or for the benefit of any borrower who has a loan that hasbeen charged off or classified;

 

·                  Not establishing any new branches or otheroffices of the Bank;

 

Tofurther comply with the Order, the Bank has:

 

·                  Revised, adopted and implemented acomprehensive policy for determining the adequacy of the allowance for loanlosses, and increasing and maintaining its allowance for loan losses to becompliant with such comprehensive policy;

 

·                  Developed and implemented a written planaddressing profits, expenses, and setting forth a comprehensive budget for2010; and

 

·                  Submitted quarterly progress reports to theFDIC, DFI and FRB.

 

Inaddition, management is specifically focusing its efforts in the followingareas:

 

·                  Increasing andstrengthening our capital position. The Company has engaged Cappello CapitalCorp. of Santa Monica, California to be its financial advisor in connectionwith its recapitalization. We intend to raise additional capital through aplanned capital raise in the third and fourth quarter of 2010.

 

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·                  Managing andimproving asset quality. The economic recession and the deterioration of thehousing and real estate markets have had an adverse impact on the creditquality of our loan portfolio. Management continues to work with borrowers onrepayment strategies and loan collections. In addition, the Company is workingwith Cappello Capital Corp. to identify investors interested in purchasing ournon performing assets.

 

·                  Decreasing concentrations in our loanportfolio. We have effectively limited any new commercial real estate lendingand we are decreasing the existing level of these loans through the normal saleof the related real estate collateral by borrowers.

 

**RegulatoryCapital Guidelines**

 

Federal bank regulatoryagencies use capital adequacy guidelines in the examination and regulation ofbank holding companies and banks.  Theguidelines are “risk-based,” meaning that they are designed to make capitalrequirements more sensitive to differences in risk profiles among banks andbank holding companies. Regulations also include additional capital categoriesfor all depository institutions under the regulatory framework for promptcorrective action which establishes a framework of supervisory actions forinsured depository institutions that are not adequately capitalized.  For depository institutions that fail to meetthese minimum capital requirements, certain mandatory, and possibly additionaldiscretionary, actions by regulators are initiated that can have a directmaterial effect on the Bank. These quantitative measures are established byregulation and require that minimum amounts and ratios of total and Tier 1capital to risk-weighted assets and of Tier 1 capital to average assets bemaintained.  Capital amounts andclassification are also subject to qualitative judgments by the regulatorsabout components, risk weightings and other factors.

 

**PromptCorrective Action**

 

Under the Supervisory PromptCorrection Action Directive received from the FDIC on May 3, 2010, theBank filed a capital restoration plan on May 28, 2010, and is subject to amongother things, recapitalization of the Bank, refraining from accepting, renewingor rolling over any brokered deposit; restricting the interest rates that theBank pays on deposits to comply with rate restrictions in certain FDICRules and Regulations; ensuring that average total assets during anycalendar quarter do not exceed average total assets during the precedingcalendar quarter; refraining from making any capital distributions or dividendpayments to its parent or paying any bonuses or increased compensation to anydirector or officer of the Bank without prior written approval from the FDIC;retaining qualified senior executive officers; restrictions on access to theFederal Reserve’s discount window; and being prohibited from opening newbranches and from relocating, selling or disposing of any existing brancheswithout the approval of the FDIC.

 

Under the prompt correctiveaction guidelines, a depository institution is assigned to one of five capitalcategories depending on its total risk-based capital ratio, Tier 1 risk-basedcapital ratio, and leverage ratio, together with certain subjective factors.The categories are “well capitalized,” “adequately capitalized,” “undercapitalized,”“significantly undercapitalized,” and “critically undercapitalized.”Institutions that are deemed to be undercapitalized, depending on the categoryto which they are assigned, are subject to certain mandatory supervisorycorrective actions.  The Bank’s totalcapital to risk-weighted assets ratio dropped below 6.0% as of June 30,2010, therefore, the Bank is considered “significantly undercapitalized” forpurposes of the prompt correction action regulations.

 

Certain minimum ratios underthe provisions of the prompt corrective action guidelines and the actualcapital ratios of the Company and the Bank at June 30, 2010, are set forthin the table below:

 
| ** **                      | ** ** | **Requirements for the Bank Under the Prompt  Corrective Action Provisions to be:** | ** ** | ** **                  | ** ** | ** **             | ** ** |
|---------------------------------|------------|-------------------------------------------------------------------------------------|------------|-----------------------------|------------|------------------------|------------|
| ** **                      | ** ** | **Well  Capitalized**                                                               | ** ** | **Adequately  Capitalized** | ** ** | **Under  Capitalized** | ** ** | **Significantly  Under  Capitalized** | ** ** | **Bank** | ** ** | **Company** | ** ** |
| Tier 1 leverage capital ratio   |       | >   5.0                                                           | %          | >  4.0              | %          | <  4.0         | %          | <  3.0 | % | 3.6 | % | 1.9 | % |
| Tier 1 risk-based capital ratio |       | >   6.0                                                           | %          | >  4.0              | %          | <  4.0         | %          | <  3.0 | % | 4.1 | % | 2.1 | % |
| Total risk-based capital ratio  |       | > 10.0                                                                           | %          | >  8.0              | %          | <  8.0         | %          | <  6.0 | % | 5.4 | % | 5.4 | % |

 

Under the Consent Orderdiscussed above, the Bank is required to raise its Tier 1 leverage capitalratio to 10% and its total risk-based capital ratio to 13% which aresignificantly higher than the level for being categorized as “Well Capitalized.”

 

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**Going Concern Considerations**

 

Theaccompanying consolidated financial statements have been prepared assuming theCompany will continue as a going concern which contemplates the realization ofassets and the discharge of liabilities in the normal course of business forthe foreseeable future.  We have determinedthat significant additional sources of liquidity and capital will be requiredfor us to continue operations through 2010 and beyond.  As of June 30,2010, we estimate that to increase the Bank’s leverage ratio to 10%, we willneed at least $32,850,000 of new Tier 1 capital. Additional losses insubsequent quarters will increase the capital needs necessary to meet therequirement. We have engaged financial advisors to assist the Company in itsefforts to raise additional capital, sell assets, and explore other strategicalternatives to address our current and expected liquidity and capitaldeficiencies. However, there can be no assurance that the Company will be ableto maintain sufficient liquidity or to raise additional capital to satisfyregulatory requirements and meet obligations as they occur. As described aboveunder “Consent Order,” “Regulatory Capital Guidelines” and “Prompt CorrectiveAction”, the Company and the Bank did not meet either the minimum regulatorycapital requirements or the leverage ratio requirement of 10% outlined in theConsent Order signed May 11, 2010 which superseded the Memorandum ofUnderstanding. As such, the Company is considered undercapitalized and the Bankhas been categorized as significantly undercapitalized under the PromptCorrective Action Directive received on May 3, 2010. The accompanyingfinancial statements do not reflect the impact of the conditions included inthe Consent Order and Prompt Corrective Action Directive discussed above.Further, the regulators are continually monitoring liquidity and capitaladequacy and evaluating the Company’s ability to continue to operate in a safeand sound manner. The Bank’s regulators could, if deemed warranted, takefurther actions, including the assumption of control of the Bank, to protectthe interests of depositors insured by the FDIC. The uncertainty regarding theCompany’s ability to obtain additional capital, improve asset quality and meetfuture liquidity requirements raises substantial doubt about the Company’sability to continue as a going concern.

 

While considerable risks tothe Company’s future financial performance exist, management believes theCompany is capable of responding to these risks and carrying on operationswhile it implements its strategic plan and pursues opportunities with respectto augmenting capital. If successfully implemented, the Company’s capital planwill address its near-term capital resources and liquidity needs. However,there can be no guarantee that any restructuring or recapitalization plan willbe successfully implemented.

 

**Critical Accounting Policies**

 

*General*

 

TheCompany’s significant accounting principles are described in Note 1 of theconsolidated financial statements in the Company’s 2009 Annual Report toShareholders on Form 10-K and are essential to understanding Management’sDiscussion and Analysis of Results of Operations and Financial Condition.Community Valley Bancorp’s annual consolidated financial statements areprepared in accordance with accounting principles generally accepted in theUnited States of America (GAAP). The financial information contained within ourstatements is, to a significant extent, financial information that is based onmeasures of the financial effects of transactions and events that have alreadyoccurred. Some of the Company’s accounting principles require significantjudgment to estimate values of assets or liabilities. In addition, certainaccounting principles require significant judgment in applying the complexaccounting principles to transactions to determine the most appropriatetreatment. The following is a summary of the more judgmental and complexaccounting estimates and principles.

 

*Allowance for Loan Losses (ALL)*

 

Theallowance for loan losses is management’s best estimate of the probable lossesthat may be sustained in our loan portfolio. The allowance is based on twobasic principles of accounting:  (1) ASC 450 which requires thatlosses be accrued when they are probable of occurring and estimable and(2) ASC 310 which requires that losses be accrued on impaired loans basedon the differences between the value of collateral, present value of futurecash flows or values that are observable in the market and the loan balance.

 

TheCompany performs periodic and systematic detailed evaluations of its lendingportfolio to identify and estimate the inherent risks and assess the overallcollectibility. These evaluations include general conditions such as theportfolio composition, size and maturities of various segmented portions of theportfolio such as secured, unsecured, construction, and Small BusinessAdministration (“SBA”).

 

Additionalfactors that are evaluated include concentrations of borrowers, industries,geographical sectors, loan product, loan classes and collateral types, volumeand trends of loan delinquencies and non-accrual loans, criticized andclassified assets and trends in the aggregate in significant credits identifiedas watch list items. There are several components to the determination of theadequacy of the ALL. Each of these components is determined based uponestimates that can and do change when the actual events occur. The Companyestimates the ASC 450 portion of the ALL based on the segmentation of itsportfolio. The Company estimates loan losses on a monthly basis based upon itsongoing loan review process and analysis of loan performance. The Companyfollows a systematic and consistently applied approach to select the mostappropriate loss measurement methods and supports its conclusions and rationalewith written documentation. The primary method used in estimating loan lossesfor groups of loans is through the application of loss rates to the groups’aggregate loan balances. Such rates typically reflect historical lossexperience for each group of loans, adjusted for relevant economic factors,over a rolling twelve month period. The Company evaluates and modifies its lossestimation model as needed to ensure that the resulting loss estimate isconsistent with GAAP.

 

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Forindividually impaired loans, the Company follows the guidance in ASC 310 on theacceptable methods to measure impairment. Specifically, when a loan is impaired,the Company measures impairment based on the present value of expected futureprincipal and interest cash flows discounted at the loan’s effective interestrate, except that as a practical expedient, the Company may measure impairmentbased on a loan’s observable market price or the fair value of collateral, ifthe loan is collateral dependent. When developing the estimate of future cashflows for a loan, the Company considers all available information reflectingpast events and current conditions, including the effect of existingenvironmental factors.

 

*Loan Sales and Servicing*

 

TheCompany originates government guaranteed loans that may be sold in thesecondary market.  The amount of gains recorded on sales of loans and theinitial recording of servicing assets and interest only (I/O) strips is basedon the estimated fair values of the respective components.  In recordingthe initial fair value of the servicing assets and the fair value of the I/Ostrips receivable, the Company uses estimates which are based on management’sexpectations of future prepayments and discount rates.  Servicing assetsare amortized over the estimated life of the related loan.  I/O strips arenot significant at June 30, 2010.  These prepayment and discountrates are based on current market conditions and historical performance of thevarious pools of serviced loans.  If actual prepayments with respect tosold loans occur more quickly than projected, the carrying value of theservicing assets may have to be adjusted through a charge to earnings.

 

*Stock-Based Compensation*

 

Compensationcost is recognized for all share-based payments over the requisite serviceperiods of the awards based on the grant-date fair value of the optionsdetermined using the Black-Scholes-Merton based option valuation model.  Critical assumptions that are assessed incomputing the fair value of share-based payments include stock pricevolatility, expected dividend rates, the risk free interest rate and theexpected lives of such options. Compensation cost recorded is net of estimatedforfeitures expected to occur prior to vesting. See Note 7 to the UnauditedCondensed Consolidated Financial Statements for additional information relatedto stock-based compensation.

 

*Impairment of Investment Securities*

 

Investmentsecurities are evaluated for other-than-temporary impairment on at least aquarterly basis and more frequently when economic or market conditions warrantsuch an evaluation to determine whether a decline in their value belowamortized cost is other than temporary. Management utilizes criteria such asthe magnitude and duration of the decline, the financial condition of theissuer, rating agency changes related to the issuer’s securities and the intentand ability of the Bank to retain its investment in the issues for a period oftime sufficient to allow for an anticipated recovery in fair value, in additionto the reasons underlying the decline, to determine whether the loss in valueis other than temporary. The term “other than temporary” is not intended toindicate that the decline is permanent, but indicates that the prospects for anear-term recovery of value is not necessarily favorable, or that there is alack of evidence to support a realizable value equal to or greater than thecarrying value of the investment. Once a decline in value is determined to beother-than-temporary and management has the ability and intent to hold thesecurity to a forecasted recovery of cost, only the portion of the impairmentloss representing credit exposure would be recognized as a charge to earnings,with the balance recognized as a charge to other comprehensive loss.  Ifmanagement intends to sell the security or it is more likely than not that itwill be required to sell the security before recovering its forecasted cost,the entire impairment loss would be recognized as a charge to earnings.

 

*Revenue Recognition*

 

TheCompany’s primary sources of revenue are net interest income, which is thedifference between the interest income it receives on interest-earning assetsand the interest expense it pays on interest-bearing liabilities, and feeincome, which includes fees earned on deposit services, income from sales andservicing of SBA loans, electronic-based cash management services, and mortgagebrokerage fee income. Interest income is recorded on an accrual basis. However,when, in the opinion of management, loans are considered to be impaired and thefuture collectibility of interest and principal is in serious doubt, loans areplaced on nonaccrual status and the accrual of interest income is suspended.Any interest accrued but unpaid is charged against income. Payments receivedare applied to reduce principal to the extent necessary to ensure collection.Subsequent payments on these loans, or payments received on nonaccrual loansfor which the ultimate collectibility of principal is not in doubt, are appliedfirst to earned but unpaid interest and then to principal.

 

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* *

*Income Taxes*

 

The Company accounts forincome taxes under the asset and liability method. Under the asset andliability method, deferred tax assets and liabilities are recognized for thefuture tax consequences attributable to differences between the financialstatement carrying amounts of existing assets and liabilities and theirrespective tax bases. Deferred tax assets and liabilities are measured usingcurrently enacted tax rates applied to such taxable income in the years inwhich those temporary differences are expected to be recovered or settled. Theeffect on deferred tax assets and liabilities of a change in tax rates isrecognized in income in the period that includes the enactment date.

 

IfManagement determines, based on available evidence at the time, that it is morelikely than not that some portion or all of the Company’s deferred tax assetswill not be realized, then a valuation allowance against the deferred tax assetis established. In evaluating the likelihood of realizing the benefit of thedeferred tax asset, Management estimates future taxable income based onManagement’s business plans and ongoing tax planning strategies against whichthe deferred tax asset may be applied. This process involves significantjudgment about assumptions that are subject to revision from period to periodbased on changes in tax laws or variances between the Company’s projectedoperating performance and the Company’s actual results and other factors. Avaluation allowance for deferred tax assets is established through an expenserecorded in the statement of operations.

 

TheCompany recognizes only tax positions that meet the more likely than notrecognition threshold that the tax position would be sustained in a tax examinationwere recognized or continue to be recognized.

 

Whentax returns are filed, it is highly certain that some positions taken would besustained upon examination by the taxing authorities, while others are subjectto uncertainty about the merits of the position taken or the amount of theposition that would be ultimately sustained.  The benefit of a taxposition is recognized in the financial statements in the period during which,based on all available evidence, management believes it is more likely than notthat the position will be sustained upon examination, including the resolutionof appeals or litigation processes, if any.  Tax positions taken are notoffset or aggregated with other positions.  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.  Interestexpense and penalties associated with unrecognized tax benefits are classifiedas income tax expense in the consolidated statement of income.

 

*Fair Value*

 

Managementutilizes a hierarchical disclosure framework associated with the level ofobservable pricing scenarios for measuring assets and liabilities at fairvalue. The degree of judgment utilized in measuring the fair value of assetsand liabilities generally correlates to the level of the observable pricingscenario. Assets and liabilities with readily available active quoted prices orfor which fair value can be measured from actively quoted prices generally willhave a higher degree of observable pricing and a lesser degree of judgmentutilized in measuring fair value. Conversely, assets and liabilities rarelytraded or not quoted will generally have little or no observable pricing and ahigher degree of judgment utilized in measuring fair value. Observable pricingscenarios are impacted by a number of factors, including the type of asset orliability, whether the asset or liability is new to the market and not yetestablished and the characteristics specific to the transaction.

 

**Overview**

 

TheCompany recorded a net loss of $(600,000) for the quarter ended June 30,2010, which was a 76.0% decrease from the net loss of $(2,500,000) reported forthe same period of 2009. Basic loss per share available to common shareholdersfor the second quarter of 2010 was $(0.09), compared to the $(0.38) recorded inthe second quarter of 2009. The annualized return on average equity (ROAE) andannualized return on average assets (ROAA) for the second quarter of 2010 were(22.24)% and (0.47)%, respectively, as compared to (24.76)% and (1.68)%,respectively, for the same period in 2009. The primary reason for the decreasein net loss for the second quarter ended June 30, 2010 is the non-interestincome recognized in connection with the derecognition of the liability forsalary continuation, deferred compensation and director retirement benefits of$6,333,000 which was partially offset by a decrease in net interest income of$904,000 due to a lower net interest margin, increases in other real estateexpenses and write-downs of $286,000, an increase to the provision for loanlosses of $943,000, and a tax expense of $883,000. We experienced a compressionof the net interest margin of 16 basis points as yields on earning assetsdecreased 72 basis points while rates paid on interest bearing liabilitiesdecreased 67 basis points. The compression is a direct result of increased nonaccrualloans at June 30, 2010 compared to the same period in 2009.

 

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Thenet loss for the six months ended June 30, 2010 was $(5,079,000) which was anincrease of 111.63% from the net loss of $(2,400,000) reported for the sameperiod of 2009. Basic loss per share available to common shareholders for thesix months ended June 30, 2010 was $(0.78), compared to the $(0.37) recordedfor the same period in 2009. The annualized return on average equity (ROAE) andannualized return on average assets (ROAA) for the six months ended June 30,2010 were (40.55)% and (1.98)%, respectively, as compared to (11.94)% and(0.81)%, respectively, for the same period in 2009. The primary reasons for theincrease in net loss for the six month period is due to the one time gain onthe sale of the merchant processing portfolio of $2,640,000 in March of 2009, adecrease in net interest income of $1,651,000 from a compression of the netinterest margin of 15 basis points from June 30, 2009, the provision for loanlosses increased by $3,132,000 to $10,232,000 from $7,100,000 for the sameperiod in 2009 and other real estate expenses and write-downs increased by$1,052,000 to $2,409,000 from $1,357,000. This was partially mitigated by the derecognition of salarycontinuation, deferred compensation and director retirement benefit liabilityof $6,333,000 and a decrease in salaries and employee benefits of $766,000.

 

Totalassets of the Company decreased by $38,919,000 or 7.2% from $538,462,000 atDecember 31, 2009 to $499,543,000 at June 30, 2010. Net loans decreased to$404,538,000, down $15,498,000 or 3.7% from December 31, 2009. Depositbalances at June 30, 2010 decreased to $470,315,000, down $27,848,000 or5.6% from December 31, 2009. Premises and equipment decreased to $4,546,000, down $725,000 or 13.8%.Other real estate decreased to $11,211,000, down $2,282,000 or 16.9% as aresult of the Company’s diligent efforts to sell these properties.  Shareholders’ equity decreased to$10,781,000, down $5,171,000 from year end 2009.

 

TableOne below provides a summary of the components of net loss for the periodsindicated:

 

**Table One:  Components of NetLoss**

 
| ** **                               | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| **(In  thousands, except percentages)**  | ** ** | **2010**                         | ** ** | **2009**                       | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                     |       |                             |       |                           |       |   |   |   |   |
| Net interest income                      |       | $                                | 4,704      |                           | $          | 5,608 |   | $ | 9,036 |   | $ | 10,687 |   |
| Provision for loan losses                |       | (4,943                           | )          | (4,000                         | )          | (10,232 | ) | (7,100 | ) |
| Non-interest income                      |       | 7,557                            |       | 2,670                          |       | 9,465 |   | 7,497 |   |
| Non-interest expense                     |       | (7,035                           | )          | (8,058                         | )          | (14,772 | ) | (14,832 | ) |
| Provision (benefit) for income taxes     |       | 883                              |       | (1,280                         | )          | (1,424 | ) | (1,348 | ) |
|                                     |       |                             |       |                           |       |   |   |   |   |
| Net loss                                 |       | $                                | (600       | )                              | $          | (2,500 | ) | $ | (5,079 | ) | $ | (2,400 | ) |
|                                     |       |                             |       |                           |       |   |   |   |   |
| Average total assets (in millions)       |       | $                                | 513.9      |                           | $          | 597.2 |   | $ | 517.3 |   | $ | 595.7 |   |
| Net loss (annualized) as a percentage of |       |                             |       |                           |       |   |   |   |   |
| average total assets                     |       | (0.47                            | )%         | (1.68                          | )%         | (1.98 | )% | (0.81 | )% |

 

Duringthese difficult economic times, management has been working diligently toimprove asset quality, reduce the concentration in real estate construction anddevelopment loans, increase and preserve capital and liquidity, and reduceexpenses. The Company has been adversely impacted by the continuingdeterioration in the Northern California real estate markets. This hasparticularly impacted our construction lending, a substantial portion of whichhas included loans for the construction of tract projects and single familyspeculative residences, and loans to improve land. Our homebuilder borrowersare continuing to experience declining prices and longer sale periods for theircompleted homes and lots, resulting in slower repayments than originallyprojected. This situation has resulted in a significant amount of loan defaultswithin the construction and land development loan portfolio. Further realestate market declines have had additional adverse affects on the values of theproperties collateralizing these loans and higher losses on sales of theseproperties could incur.

 

TheCompany successfully reduced real estate construction and development loans by$22,352,000 from June 30, 2009. In addition, the Company continues toreduce expenses with recommendations from employees, management, and the Boardof Directors. In 2010, the Company will continue to freeze salaries for thesecond year, reduce employee benefits effective April 1, 2010, suspenddirectors fees effective March 1, 2010, along with additional reductionsin operating expenses such as office supply costs, travel, advertising andpromotion. Further, the Company has eliminated Saturday banking for severalOffices. These Offices either had nominal customer transactions on Saturday orhave another branch within a close proximity. This will allow for reducedbranch costs while increasing productivity.

 

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Managementcontinues to proactively manage credit quality and continues to work with itsborrowers in addressing work out strategies and loan collections.

 

We continue to closelymonitor and manage our liquidity position, understanding that this is ofcritical importance in the current economic environment. Attracting andretaining customer deposits remains our primary source of liquidity. The Bankwill continue to participate in the FDIC voluntary Transaction AccountGuarantee (“TAG”) program which is available through December 31, 2012.Under this program, noninterest bearing transaction accounts and qualified NOWchecking accounts are fully guaranteed by the FDIC for an unlimited amount ofcoverage. The coverage under the TAG program is in addition to, and separatefrom, the coverage available under the FDIC’s general deposit insuranceprotection.

 

Since December 31,2008, the Company has been successful in its strategic plan to deleverage thebalance sheet. Loans have decreased by $61,632,000 or 12.5% fromDecember 31, 2008 to December 31, 2009 and continued to decrease by$12,810,000 or 3.0% from December 31, 2009 to June 30, 2010. Depositshave decreased by $28,322,000 or 5.37% from December 31, 2008 toDecember 31, 2009 and continued to decrease by $27,848,000 or 5.6% fromDecember 31, 2009 to June 30, 2010.

 

As of June 30, 2010,the Company’s and the Bank’s total risk-based capital ratios were less than6.0%, and therefore, the Bank was categorized as “significantlyundercapitalized” under the federal prompt corrective action regulatoryguidelines. In addition, the Bank’s Tier 1 leverage capital ratio of 3.6%remains less than the minimum of 10% required by the terms of the Consent Orderdescribed previously. The primary focus of the Company is to strengthen itscapital position by dedicating substantial efforts to raising additionalcapital. The Company’s Capital Augmentation Committee is working vigorouslywith an investment banking firm to assist in raising capital. Whileconsiderable risks to the Company’s future financial performance exist,management believes the Company can effectively respond to these risks andcarry on operations while it implements its strategic plan and pursuesopportunities with respect to augmenting capital. If successfully implemented,the Company’s capital plan will address its near-term capital resources andliquidity

 

**Results of Operations**

 

**Net Interest Income and Net Interest Margin**

 

Netinterest income represents the excess of interest and fees earned on interestearning assets (loans, securities, federal funds sold and investments in timedeposits) over the interest paid on deposits and borrowed funds.  Netinterest margin is net interest income expressed as a percentage of averageearning assets.

 

TheCompany’s net interest margin was 4.01% for the three month period endedJune 30, 2010 and 3.83% for the six month period ending June 30, 2010which decreased 16 basis points and 15 basis points, respectively, compared to4.17% and 3.98% for the same periods in the prior year. Net interest incomedecreased $904,000 (16.12%) for the second quarter of 2010 compared to the sameperiod in 2009.  Net interest income decreased $1,651,000 (15.44%) for thesix months ended June 30, 2010 over the same period in 2009.The primaryreason for this decrease was the compression of the net interest margin due tothe increase in nonaccrual loans which was partially mitigated by decreasedinterest expense.

 

TableTwo, Analysis of Net Interest Margin, sets forth the average daily balances forthe major asset and liability categories, the related income or expense whereapplicable, and the resultant yield or cost attributable to the average earningassets and interest-bearing liabilities. Changes in the average balances and the rates received or paid depend onmarket opportunities, how well the Company has managed interest rate risks,product pricing policy, product mix, and external trends and developments. Thenet interest margin is also adversely impacted by the significant level ofnonaccrual loans during the quarter ended June 30, 2010.

 

TableThree, Analysis of Volume and Rate changes on Net Interest Income, analyzes thechanges in net interest income for the three and six month periods endedJune 30, 2010 compared to the same periods ended June 30, 2009 thatare reported in Table Two.  The analysisshows the impact of volume and rate changes on the major categories of assetsand liabilities between these periods. The table explains what portion of the difference or variance ininterest income or expense between these periods for each major category ofassets or liabilities is due to changes in the balances (volume) or to changesin rates.

 

Forexample, Table Two shows that interest income from loans for the three monthsended June 30, 2010 decreased by $1,742,000 from $7,363,000 atJune 30, 2009 to $5,621,000.  Theaverage balance of loans decreased from $480,272,000 to $424,306,000 and theinterest rate earned decreased from 6.15% to 5.31%.  Table Three shows the $1,742,000 decrease ininterest income from loans was actually the result of an $858,000 decrease ininterest income from the lower balance of loans and a $884,000 decrease fromthe decrease in yields earned in the second quarter of 2010 compared to thesame period in 2009. This decrease in yields was primarily due to both anincrease in nonaccrual loan balances and interest rate adjustments related torestructured loans.

 

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Ashift in the relative size of the major balance sheet categories has an impacton net interest income and net interest margin. For example, to the extent that funds received from maturing or soldsecurities can be repositioned into loans instead of re-invested in securities,earnings increase because of the higher yields received on loans. However,changing the asset mix in this way comes at the price of additional risks thatmust be successfully managed. Additional credit risk is incurred with loanscompared to the very low risk of default loss on securities, and the Companymust carefully monitor the underwriting process to ensure that the benefit ofthe additional interest earned is not offset by additional credit losses.

 

**Table Two:  Analysis of Net Interest Margin**

 
| ** **                                        | ** ** | **2010**        | ** ** | **2009**     | ** ** |
|---------------------------------------------------|------------|-----------------|------------|--------------|------------|
| **Three  Months Ended June 30,**             | ** ** | ** **      | ** ** | ** **   | ** ** | **Avg Yield** | ** ** | ** ** | ** ** | ** ** | ** ** | **Avg Yield** | ** ** |
| **(In  thousands, except percentages)**           | ** ** | **Avg Balance** | ** ** | **Interest** | ** ** | **(5)** | ** ** | **Avg Balance** | ** ** | **Interest** | ** ** | **(5)** | ** ** |
| Assets:                                           |       |            |       |         |       |   |   |   |   |   |   |   |   |
| Earning assets                                    |       |            |       |         |       |   |   |   |   |   |   |   |   |
| Loans (1)(2)                                      |       | $               | 424,306    |         | $          | 5,621 |   | 5.31 | % | $ | 480,272 |   | $ | 7,363 |   | 6.15 | % |
| Taxable investment securities                     |       | 2,912           |       | 27           |       | 3.72 | % | 5,306 |   | 64 |   | 4.84 | % |
| Tax-exempt investment securities (3)              |       | 1,462           |       | 16           |       | 4.39 | % | 1,397 |   | 16 |   | 4.59 | % |
| Federal funds sold/Excess balance agreement (FRB) |       | 39,833          |       | 23           |       | 0.23 | % | 50,069 |   | 23 |   | 0.18 | % |
| Interest bearing deposits in banks                |       | 2,318           |       | 10           |       | 1.73 | % | 2,349 |   | 19 |   | 3.24 | % |
| Total earning assets                              |       | 470,831         |       | 5,697        |       | 4.85 | % | 539,393 |   | 7,485 |   | 5.57 | % |
| Cash and due from banks                           |       | 17,120          |       |         |       |   |   | 14,071 |   |   |   |   |   |
| Other assets                                      |       | 25,980          |       |         |       |   |   | 43,693 |   |   |   |   |   |
| Average total assets                              |       | $               | 513,931    |         |       |   |   |   | $ | 597,157 |   |   |   |   |   |
|                                              |       |            |       |         |       |   |   |   |   |   |   |   |   |
| Liabilities & Shareholders’ Equity  |       |            |       |         |       |   |   |   |   |   |   |   |   |
| Interest bearing liabilities:                     |       |            |       |         |       |   |   |   |   |   |   |   |   |
| NOW & MMDA                               |       | $               | 152,880    |         | $          | 128 |   | 0.34 | % | $ | 151,949 |   | $ | 169 |   | 0.45 | % |
| Savings                                           |       | 112,176         |       | 147          |       | 0.53 | % | 107,874 |   | 239 |   | 0.89 | % |
| Time deposits                                     |       | 148,412         |       | 545          |       | 1.47 | % | 195,283 |   | 1,245 |   | 2.56 | % |
| Other borrowings                                  |       | 9,327           |       | 173          |       | 7.44 | % | 13,380 |   | 224 |   | 6.71 | % |
| Total interest bearing liabilities                |       | 422,796         |       | 993          |       | 0.94 | % | 468,486 |   | 1,877 |   | 1.61 | % |
| Demand deposits                                   |       | 68,673          |       |         |       |   |   | 74,011 |   |   |   |   |   |
| Other liabilities                                 |       | 11,022          |       |         |       |   |   | 14,157 |   |   |   |   |   |
| Total liabilities                                 |       | 502,491         |       |         |       |   |   | 556,654 |   |   |   |   |   |
| Shareholders’ equity                         |       | 11,440          |       |         |       |   |   | 40,503 |   |   |   |   |   |
| Average liabilities and equity                    |       | $               | 513,931    |         |       |   |   |   | $ | 597,157 |   |   |   |   |   |
|                                              |       |            |       |         |       |   |   |   |   |   |   |   |   |
| Net interest income & margin (4)         |       |            |       | $            | 4,704      |   | 4.01 | % |   |   | $ | 5,608 |   | 4.17 | % |

 

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| (1)   Loan interest includes loan fees of $290,000 and $347,000 during the quarters  ended June 30, 2010 and June 30, 2009, respectively.                                                                                                                                                                                                                                                                        |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                                                                                                                                                                            |
| (2)   Average non-accrual loan balances of $58.75 million and $22.09 million for  the three months ended June 30, 2010 and June 30, 2009,  respectively, are included in total average loans for purposes of calculating  average earning assets. Average interest foregone on non-accrual loans  totaled $815,000 and $320,000, respectively. Refer to Revenue Recognition  under Critical Accounting Policies. |
|                                                                                                                                                                                                                                                                                                                                                                                                                            |
| (3)   Does not include taxable-equivalent adjustments that primarily relate to  income on certain securities that are exempt from federal income taxes.                                                                                                                                                                                                                                                                    |
|                                                                                                                                                                                                                                                                                                                                                                                                                            |
| (4)   Net interest margin is computed by dividing net interest income by total  average earning assets.                                                                                                                                                                                                                                                                                                                    |
|                                                                                                                                                                                                                                                                                                                                                                                                                            |
| (5)   Average yield is calculated based on actual days in quarter (91 for  June 30, 2010 and June 30, 2009) and annualized to actual days in  year (365 for 2010 and 2009).                                                                                                                                                                                                                                      |

 

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| ** **                                        | ** ** | **2010**        | ** ** | **2009**     | ** ** |
|---------------------------------------------------|------------|-----------------|------------|--------------|------------|
| **Six  months ended June 30,**               | ** ** | ** **      | ** ** | ** **   | ** ** | **Avg Yield** | ** ** | ** ** | ** ** | ** ** | ** ** | **Avg Yield** | ** ** |
| **(In  thousands, except percentages)**           | ** ** | **Avg Balance** | ** ** | **Interest** | ** ** | **(5)** | ** ** | **Avg Balance** | ** ** | **Interest** | ** ** | **(5)** | ** ** |
| Assets                                            |       |            |       |         |       |   |   |   |   |   |   |   |   |
| Earning assets:                                   |       |            |       |         |       |   |   |   |   |   |   |   |   |
| Loans (1)(2)                                      |       | $               | 425,916    |         | $          | 11,102 |   | 5.26 | % | $ | 484,880 |   | $ | 14,410 |   | 5.99 | % |
| Taxable investment securities                     |       | 2,980           |       | 57           |       | 3.86 | % | 5,417 |   | 119 |   | 4.43 | % |
| Tax-exempt investment securities (3)              |       | 1,451           |       | 32           |       | 4.45 | % | 1,383 |   | 32 |   | 4.67 | % |
| Federal funds sold/Excess balance agreement (FRB) |       | 42,506          |       | 50           |       | 0.24 | % | 47,830 |   | 51 |   | 0.22 | % |
| Interest bearing deposits in banks                |       | 2,479           |       | 22           |       | 1.79 | % | 2,369 |   | 43 |   | 3.66 | % |
| Total earning assets                              |       | 475,333         |       | 11,263       |       | 4.78 | % | 541,879 |   | 14,655 |   | 5.45 | % |
| Cash and due from banks                           |       | 15,001          |       |         |       |   |   | 15,294 |   |   |   |   |   |
| Other assets                                      |       | 26,927          |       |         |       |   |   | 38,545 |   |   |   |   |   |
| Average total assets                              |       | $               | 517,260    |         |       |   |   |   | $ | 595,718 |   |   |   |   |   |
|                                              |       |            |       |         |       |   |   |   |   |   |   |   |   |
| Liabilities & Shareholders’ Equity  |       |            |       |         |       |   |   |   |   |   |   |   |   |
| Interest bearing liabilities:                     |       |            |       |         |       |   |   |   |   |   |   |   |   |
| NOW & MMDA                               |       | $               | 152,972    |         | $          | 251 |   | 0.33 | % | $ | 152,007 |   | $ | 374 |   | 0.50 | % |
| Savings                                           |       | 113,453         |       | 310          |       | 0.55 | % | 108,019 |   | 535 |   | 1.00 | % |
| Time deposits                                     |       | 150,042         |       | 1,177        |       | 1.58 | % | 195,642 |   | 2,614 |   | 2.69 | % |
| Other borrowings                                  |       | 9,327           |       | 489          |       | 10.57 | % | 13,373 |   | 445 |   | 6.71 | % |
| Total interest bearing liabilities                |       | 425,794         |       | 2,227        |       | 1.05 | % | 469,041 |   | 3,968 |   | 1.71 | % |
| Demand deposits                                   |       | 70,411          |       |         |       |   |   | 73,867 |   |   |   |   |   |
| Other liabilities                                 |       | 7,919           |       |         |       |   |   | 12,291 |   |   |   |   |   |
| Total liabilities                                 |       | 504,124         |       |         |       |   |   | 555,199 |   |   |   |   |   |
| Shareholders’ equity                         |       | 13,137          |       |         |       |   |   | 40,519 |   |   |   |   |   |
| Average liabilities and equity                    |       | $               | 517,260    |         |       |   |   |   | $ | 595,718 |   |   |   |   |   |
|                                              |       |            |       |         |       |   |   |   |   |   |   |   |   |
| Net interest income & margin (4)         |       |            |       | $            | 9,036      |   | 3.83 | % |   |   | $ | 10,687 |   | 3.98 | % |

 

----

| (1)   Loan interest includes loan fees of $510,000 and $618,000 during the six  months ended June 30, 2010 and June 30, 2009, respectively.                                                                                                                                                                                                                                                                      |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                                                                                                                                                                            |
| (2)   Average non-accrual loan balances of $59.77 million and $20.83 million for  the six months ended June 30, 2010 and June 30, 2009, respectively,  are included in total average loans for purposes of calculating average  earning assets. Average interest foregone on non-accrual loans totaled  $1,623,000 and $586,000, respectively. Refer to Revenue Recognition under  Critical Accounting Policies. |
|                                                                                                                                                                                                                                                                                                                                                                                                                            |
| (3)   Does not include taxable-equivalent adjustments that primarily relate to  income on certain securities that are exempt from federal income taxes.                                                                                                                                                                                                                                                                    |
|                                                                                                                                                                                                                                                                                                                                                                                                                            |
| (4)   Net interest margin is computed by dividing net interest income by total  average earning assets.                                                                                                                                                                                                                                                                                                                    |
|                                                                                                                                                                                                                                                                                                                                                                                                                            |
| (5)   Average yield is calculated based on actual days in period (181 for  June 30, 2010 and June 30, 2009) and annualized to actual days in  year (365 for 2010 and 2009).                                                                                                                                                                                                                                      |

 

TableThree sets forth a summary of the changes in interest income and interestexpense from changes in average asset and liability balances (volume) andchanges in average interest rates and increased levels of nonaccrualloans.  On a quarter over quarter basis for the period ended June 30,2010, net interest income has decreased $904,000 from the same time period in2009.  Interest income from earning assets has decreased by $1,788,000.Changes in the volume of earning assets, primarily loans, have resulted in adecrease in interest income of $891,000 while interest income has decreased by$897,000 from changes in rates and increased levels of nonaccrual loans. Interest expense for the second quarter of 2010 was $884,000 less than the sameperiod in 2009.  Decreases in the volumeof interest bearing liabilities have resulted in a decrease of interest expenseof $356,000.  Decreases in average ratespaid on all deposit products have resulted in an interest expense decrease of$528,000.

 

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Ona year to date basis through June 30, 2010, net interest income hasdecreased $1,651,000 from the total through June 30, 2009.  Interestincome from earning assets has decreased by $3,392,000. Changes in the volumeof earning assets, primarily loans, have resulted in a decrease in interestincome of $1,807,000 while interest income has decreased by $1,585,000 fromchanges in rates and increased levels of nonaccrual loans.  Interestexpense for the second quarter of 2010 was $1,741,000 less than the same periodin 2009.  Decreases in the volume ofinterest bearing liabilities have resulted in a decrease of interest expense of$715,000.  Decreases in average ratespaid on all deposit products have resulted in an interest expense decrease of$1,026,000

 

Theaverage balances of interest bearing liabilities of $422,796,000 were $45,690(9.75%) less in the second quarter of 2010 versus the same quarter in2009.  As interest bearing liability balances decreased, rates paid onthese liabilities also decreased by 67 basis points on a quarter over quarterbasis.  As a result of both the decrease in interest rates and the volumeand mix of interest bearing liabilities, interest expense was $884,000 (47.10%)lower in the second quarter of 2010 versus the same period in 2009. The averagebalances of interest bearing liabilities were $43,247,000 less in the six monthperiod ended June 30, 2010 versus the same period in 2009. Rates paid oninterest bearing liabilities decreased 66 basis points compared to the sixmonth period ended June 30, 2009.

 

Asa result of the above, the Company’s net interest margin declined 16 basispoints to 4.01% for the three months ended June 30, 2010 from 4.17% forthe same period in the prior year. For the six month period ended June 30,2010, the net interest margin declined 15 basis points to 3.83% compared to3.98% for the same period in the prior year. The impact of nonaccrual loans on the net interest margin was 57 and 56basis points for the quarter and six months ended June 30, 2010 and 18 and16 basis points for the quarter and six months ended June 30, 2009).

 

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

 
| **Three Months Ended June 30, 2010 over 2009** | ** ** | ** ** | ** ** | ** **        | ** ** | ** **          | ** ** |
|-----------------------------------------------------------------------------------|------------|------------|------------|-------------------|------------|---------------------|------------|
| **(In thousands)**                                                           | ** ** | **Volume** | ** ** | **Rate (2)** | ** ** | **Net Change** | ** ** |
| Increase (decrease) due to change in:                                             |       |       |       |              |       |                |       |
| Interest-earning assets:                                                          |       |       |       |              |       |                |       |
| Net loans                                                                         |       | $          | (858       | )                 | $          | (884                | )          | $ | (1,742 | ) |
| Taxable investment securities                                                     |       | (29        | )          | (8                | )          | (37                 | )          |
| Tax exempt investment securities (1)                                              |       | 1          |       | (1                | )          | —              |       |
| Federal funds sold                                                                |       | (5         | )          | 5                 |       | —              |       |
| Interest bearing deposits in banks                                                |       | —     |       | (9                | )          | (9                  | )          |
| Total                                                                             |       | (891       | )          | (897              | )          | (1,788              | )          |
|                                                                              |       |       |       |              |       |                |       |
| Interest-bearing liabilities:                                                     |       |       |       |              |       |                |       |
| NOW and MMDA deposits                                                             |       | 1          |       | (42               | )          | (41                 | )          |
| Savings deposits                                                                  |       | 10         |       | (102              | )          | (92                 | )          |
| Time deposits                                                                     |       | (299       | )          | (401              | )          | (700                | )          |
| Other borrowings                                                                  |       | (68        | )          | 17                |       | (51                 | )          |
| Total                                                                             |       | (356       | )          | (528              | )          | (884                | )          |
| Interest differential                                                             |       | $          | (535       | )                 | $          | (369                | )          | $ | (904 | ) |

 

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| **Six  Months Ended June 30, 2010 over 2009** | ** ** | ** ** | ** ** | ** **   | ** ** | ** **     | ** ** |
|----------------------------------------------------|------------|------------|------------|--------------|------------|----------------|------------|
| **(In  thousands)**                                | ** ** | **Volume** | ** ** | **Rate (2)** | ** ** | **Net Change** | ** ** |
| Increase (decrease) due to change in:              |       |       |       |         |       |           |       |
| Interest-earning assets:                           |       |       |       |         |       |           |       |
| Net loans                                          |       | $          | (1,751     | )            | $          | (1,557         | )          | $ | (3,308 | ) |
| Taxable investment securities                      |       | (54        | )          | (8           | )          | (62            | )          |
| Tax exempt investment securities (1)               |       | 2          |       | (2           | )          | —         |       |
| Federal funds sold                                 |       | (6         | )          | 5            |       | (1             | )          |
| Interest bearing deposits in banks                 |       | 2          |       | (23          | )          | (21            | )          |
| Total                                              |       | (1,807     | )          | (1,585       | )          | (3,392         | )          |
|                                               |       |       |       |         |       |           |       |
| Interest-bearing liabilities:                      |       |       |       |         |       |           |       |
| NOW and MMDA deposits                              |       | 2          |       | (125         | )          | (123           | )          |
| Savings deposits                                   |       | 27         |       | (252         | )          | (225           | )          |
| Time deposits                                      |       | (609       | )          | (828         | )          | (1,437         | )          |
| Other borrowings                                   |       | (135       | )          | 179          |       | 44             |       |
| Total                                              |       | (715       | )          | (1,026       | )          | (1,741         | )          |
| Interest differential                              |       | $          | (1,092     | )            | $          | (559           | )          | $ | (1,651 | ) |

 

----

| (1)   Does not include taxable-equivalent adjustments that primarily relate to  income on certain securities that is exempt from federal income taxes. |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                        |
| (2)   The rate/volume variance has been included in the rate variance.                                                                                 |

 

**Non-interest Income**

 

TableFour below provides a summary of the components of non-interest income for theperiods indicated:

 

**Table Four:  Components of Non-interest Income**

 
| ** **                            | ** ** | **Three months ended  June 30,** | ** ** | **Change** | ** ** |
|---------------------------------------|------------|---------------------------------------|------------|------------|------------|
| ** **                            | ** ** | **2010**                              | ** ** | **2009**   | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                            | ** ** | **(In thousands)**                    | ** ** |
| Service charges on deposit accounts   |       | $                                     | 879        |       | $          | 982 |   | $ | (103 | ) | (10.49 | )% |
| Loan servicing fees                   |       | 142                                   |       | 122        |       | 20 |   | 16.39 | % |
| Fees - alternative investment sales   |       | 100                                   |       | 145        |       | (45 | ) | (31.03 | )% |
| Merchant fee income                   |       | 24                                    |       | —     |       | 24 |   | 100.00 | % |
| Transfer of mortgage servicing rights |       | (604                                  | )          | —     |       | (604 | ) | 100.00 | % |
| Gain on the sale of loans             |       | 17                                    |       | 769        |       | (752 | ) | (97.79 | )% |
| Retirement benefit derecognition      |       | 6,333                                 |       | —     |       | 6,333 |   | 100.00 | % |
| Other                                 |       | 666                                   |       | 652        |       | 14 |   | 2.15 | % |
| Total non-interest income             |       | $                                     | 7,557      |       | $          | 2,670 |   | $ | 4,887 |   | 179.23 | % |

 

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| ** **                            | ** ** | **Six months ended  June 30,** | ** ** | **Change** | ** ** |
|---------------------------------------|------------|-------------------------------------|------------|------------|------------|
| ** **                            | ** ** | **2010**                            | ** ** | **2009**   | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                            | ** ** | **(In thousands)**                  | ** ** |
| Sale of merchant processing portfolio |       | $                                   | —     |       | $          | 2,640 |   | $ | (2,640 | ) | (100.00 | )% |
| Loss on sale of investment security   |       | —                              |       | (172       | )          | 172 |   | (100.00 | )% |
| Service charges on deposit accounts   |       | 1,650                               |       | 1,898      |       | (248 | ) | (13.07 | )% |
| Loan servicing fees                   |       | 250                                 |       | 262        |       | (12 | ) | (4.58 | )% |
| Fees - alternative investment sales   |       | 240                                 |       | 254        |       | (14 | ) | (5.51 | )% |
| Merchant fee income                   |       | 24                                  |       | 86         |       | (62 | ) | (72.09 | )% |
| Transfer of mortgage servicing rights |       | (604                                | )          | —     |       | (604 | ) | 100.00 | % |
| Gain on the sale of loans             |       | 163                                 |       | 1,272      |       | (1,109 | ) | (87.19 | )% |
| Retirement benefit derecognition      |       | 6,333                               |       | —     |       | 6,333 |   | 100.00 | % |
| Other                                 |       | 1,409                               |       | 1,257      |       | 152 |   | 12.09 | % |
| Total non-interest income             |       | $                                   | 9,465      |       | $          | 7,497 |   | $ | 1,968 |   | (170.34 | )% |

 

Theprimary reason for the increase in non-interest income for the three monthsended June 30, 2010 is the one time derecognition of the liability forsalary continuation, deferred compensation and director retirement benefits of$6,333,000. Non- interest income decreased $1,446,000 from the three monthsended June 30, 2009 excluding the one time derecognition of the liabilityfor these retirement benefits. The decrease is derived from a reduction of gainon the sale of loans due to fewer loans being originated to sell during thisperiod by our government lending division, the loss on the transfer of mortgageservicing rights, and the decrease in service charges on deposit accounts asconsumers are managing their accounts more efficiently in order to avoidservice charges and fees.

 

Theprimary reason for the increase in non-interest income for the six months endedJune 30, 2010 is consistent with the discussion above for the secondquarter which was partially offset by the sale of the merchant processingportfolio of $2,640,000 in March 2009.

 

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**Non-interest Expense**

 

TableFive below provides a summary of the components of non-interest expense for theperiods indicated:

 

**Table Five:  Components of Non-interest Expense**

 
| ** **                                      | ** ** | **Three months ended  June 30,** | ** ** | **Change** | ** ** |
|-------------------------------------------------|------------|---------------------------------------|------------|------------|------------|
| ** **                                      | ** ** | **2010**                              | ** ** | **2009**   | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                                      | ** ** | **(In thousands)**                    | ** ** |
| Salaries and employee benefits                  |       | $                                     | 2,805      |       | $          | 3,165 |   | $ | (360 | ) | (11.37 | )% |
| Occupancy                                       |       | 634                                   |       | 681        |       | (47 | ) | (6.90 | )% |
| Furniture and equipment                         |       | 428                                   |       | 639        |       | (211 | ) | (33.02 | )% |
| Loss on disposal of Bank premises and equipment |       | (1                                    | )          | —     |       | (1 | ) | 100.00 | % |
| Professional fees                               |       | 579                                   |       | 355        |       | 224 |   | 63.10 | % |
| Telephone and postage                           |       | 152                                   |       | 179        |       | (27 | ) | (15.08 | )% |
| Stationery and supply costs                     |       | 114                                   |       | 134        |       | (20 | ) | (14.93 | )% |
| Director fees and retirement                    |       | 6                                     |       | 64         |       | (58 | ) | (90.63 | )% |
| Advertising and promotion                       |       | 250                                   |       | 289        |       | (39 | ) | (13.49 | )% |
| FDIC assessments                                |       | 761                                   |       | 955        |       | (194 | ) | (20.31 | )% |
| Other real estate expense                       |       | 1,019                                 |       | 733        |       | 286 |   | 39.02 | % |
| Other                                           |       | 288                                   |       | 864        |       | (576 | ) | (66.67 | )% |
| Total non-interest expense                      |       | $                                     | 7,035      |       | $          | 8,058 |   | $ | (1,023 | ) | (70.29 | )% |

 
| ** **                                      | ** ** | **Six months ended  June 30,** | ** ** | **Change** | ** ** |
|-------------------------------------------------|------------|-------------------------------------|------------|------------|------------|
| ** **                                      | ** ** | **2010**                            | ** ** | **2009**   | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                                      | ** ** | **(In thousands)**                  | ** ** |
| Salaries and employee benefits                  |       | $                                   | 5,798      |       | $          | 6,564 |   | $ | (766 | ) | (11.67 | )% |
| Occupancy                                       |       | 1,331                               |       | 1,386      |       | (55 | ) | (3.97 | )% |
| Furniture and equipment                         |       | 914                                 |       | 1,288      |       | (374 | ) | (29.04 | )% |
| Loss on disposal of Bank premises and equipment |       | 305                                 |       | —     |       | 305 |   | 100.00 | % |
| Professional fees                               |       | 946                                 |       | 672        |       | 274 |   | 40.77 | % |
| Telephone and postage                           |       | 325                                 |       | 356        |       | (31 | ) | (8.71 | )% |
| Stationery and supply costs                     |       | 236                                 |       | 273        |       | (37 | ) | (13.55 | )% |
| Director fees and retirement                    |       | 87                                  |       | 169        |       | (82 | ) | (48.52 | )% |
| Advertising and promotion                       |       | 514                                 |       | 623        |       | (109 | ) | (17.50 | )% |
| FDIC assessments                                |       | 1,105                               |       | 1,048      |       | 57 |   | 5.44 | % |
| Other real estate expense                       |       | 2,409                               |       | 1,357      |       | 1,052 |   | 77.52 | % |
| Other                                           |       | 802                                 |       | 1,096      |       | (294 | ) | (26.82 | )% |
| Total non-interest expense                      |       | $                                   | 14,772     |       | $          | 14,832 |   | $ | (60 | ) | 63.96 | % |

 

Theprimary reasons for the decrease in non-interest expense for the three and sixmonth periods ending June 30, 2010 and 2009 are the reduction in salariesand employee benefits largely due to lower full time equivalent employees,salary freezes, and reduced employee benefits. In addition, decreased expensesfor furniture and equipment, the suspension of director fees, and telephone andstationery expenses are a direct result of the efforts of directors, managementand employees to reduce costs. This was partially offset by the increase inother real estate expenses and write-downs, the loss on the disposal of Bankpremises and equipment which was due to the closing of the Churn Creek, ReddingOffice when it was consolidated with the Hilltop, Redding Office, and theincrease in professional fees due to problem loan workouts, propertyforeclosures, and fees paid relating to the recapitalization of the Company.

 

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**Provision for Loan Losses**

 

TheCompany provided $4,943,000 for loan losses in the second quarter of 2010compared to $4,000,000 in the second quarter of 2009.  Net loan charge-offsfor the second quarter of 2010 and 2009 were $4,177,000 and $3,511,000,respectively. For the first six months of 2010 the Company recorded provisionsfor loan losses of $10,232,000 which compared to $7,100,000 for the first sixmonths of 2009. Net loan charge-offs for the six months ended June 30,2010 and 2009 were $7,462,000 and $5,792,000, respectively. Management assessesits loan quality on a monthly basis to maintain an adequate allowance for loanlosses.  The Company’s loan portfolio composition, non-performing assetsand allowance for loan losses are further discussed under the Balance SheetAnalysis section below.

 

**Income Taxes**

 

Incometax for the second quarter and first six months of 2010 was a tax provision of$883,000 and a tax benefit of $1,424,000 as compared to benefits for incometaxes of $1,280,000 and 1,348,000 for the same periods in 2009.  The effective tax rate for federal incometaxes was 312.0% for the three months ended June 30, 2010 and an effectivebenefit rate of 21.9% for the six month period ended June 30, 2010compared to effective benefit rates of 33.9% and 36.0% for the same periods in2009. The difference in the 2010 effective tax rate compared to the statutorytax rate (approximately 41.0%) is primarily the result of the Company’s netloss position and the full valuation allowance on deferred tax assets. The taxbenefit is limited to the $3.9 million net operating loss carryback related totaxes paid for the 2008 tax year net of $258,000 alternative minimum tax.  In 2009, the difference in the effective tax rate compared to thestatutory rate was primarily the result of the Company’s investment inmunicipal securities and Company-owned life insurance policies whose income isexempt from Federal taxes. In addition, the Company received special taxbenefits from the State of California Franchise Tax board for operating andproviding loans in designated ‘Enterprise Zones’.

 

For the three years endedDecember 31, 2009, 2008 and 2007, the Company is in a cumulative pretaxloss position. For purposes of establishing a deferred tax valuation allowance,this cumulative pretax loss position is considered significant, objectiveevidence that the Company may not be able to realize the Company’s deferred taxassets in the future. The cumulative pretax loss position was caused primarilyby the significant amount of loan loss provision and other real estate expensetaken in 2009. As a result of these losses and the losses year to date, avaluation allowance was recorded at June 30, 2010 and December 31,2009. Due to continued deteriorating market conditions, the Company hasdetermined that there is not sufficient additional positive evidence to supportthe realization of its net deferred tax assets. However, a current taxreceivable can be realized from the carryback of a portion of the 2010projected net operating loss. Net operating loss carrybacks for the year endingDecember 31, 2010 are limited to the $3.9 million in taxes paid for the2008 tax year net of $258,000 alternative minimum tax.

 

Theamount of deferred tax assets considered realizable is subject to adjustment infuture periods. Management will need to continue to monitor all availableevidence related to the Company’s ability to utilize its net deferred taxassets. The Company’s income tax expense in future periods will be increased orreduced to the extent of offsetting increases or decreases to the Company’s netdeferred tax asset valuation allowance.

 

**Balance Sheet Analysis**

 

TheCompany’s total assets were $499,543,000 at June 30, 2010, down$38,919,000 (7.23%) from $538,462,000 at December 31, 2009.  On ayear over year basis, the average balance of total assets for the six monthsended June 30, 2010 was $517,260,000, which represents a decrease of $78,458,000(13.17%) from $595,718,000 during the six months ended June 30, 2009.

 

**Loans**

 

TheCompany concentrates its lending activities in the following areas: 1)commercial; 2) real estate mortgage; 3) residential real estate and real estateconstruction (both commercial and residential); 4) agriculture; and 5) consumerloans.  Commercial and residential real estate loans are generally securedby improved property, with original maturities of 3-10 years.

 

Loanbalances have declined in the current quarter mainly in real estate construction.Reductions in real estate construction loans have been the result ofrepayments, foreclosures and reclassification to other real estate (ORE).  Decreases in loan balances fromDecember 31, 2009 consist of real estate construction loans of $7,486,000or 32.56%, real estate mortgage of $3,279,000 or 1.43%, commercial loans of$1,639,000 or 2.03%, and consumer loans of $1,385,000 or 2.22%. The reductionof real estate construction loans is consistent with the plan to reduce ourdependency on real estate related lending and further diversify the loanportfolio to mitigate risk. Table Six below summarizes the composition of theloan portfolio as of June 30, 2010 and December 31, 2009.

 

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**Table Six: Loan Portfolio Composition**

 
| **(In  thousands)**       | ** ** | **June 30, 2010** | ** ** | **% of Total Loans** | ** ** | **December 31, 2009** | ** ** | **% of Total Loans** | ** ** |
|---------------------------|------------|------------------------|------------|----------------------|------------|----------------------------|------------|----------------------|------------|
| Commercial                |       | $                      | 79,119     |                 | 18.82      | %                          | $          | 80,758               |       | 18.64 | % |
| Real estate:              |       |                   |       |                 |       |                       |       |                 |       |
| Mortgage                  |       | 225,399                |       | 53.62                | %          | 228,678                    |       | 52.79                | %          |
| Construction              |       | 15,504                 |       | 3.69                 | %          | 22,990                     |       | 5.31                 | %          |
| Agriculture               |       | 39,422                 |       | 9.38                 | %          | 38,444                     |       | 8.87                 | %          |
| Consumer                  |       | 60,939                 |       | 14.50                | %          | 62,324                     |       | 14.39                | %          |
| Total loans               |       | 420,384                |       |                 |       | 433,194                    |       |                 |       |
| Allowance for loan losses |       | (15,745                | )          |                 |       | (12,975                    | )          |                 |       |
| Deferred loan fees, net   |       | (101                   | )          |                 |       | (183                       | )          |                 |       |
| Total net loans           |       | $                      | 404,538    |                 |       |                       | $          | 420,036              |       |   |   |

 

Themajority of the Company’s loans are direct loans made to individuals and localbusinesses.  The Company relies substantially on local promotionalactivity and personal contacts by bank officers, directors and employees tocompete with other financial institutions.  The Company makes loans toborrowers whose applications include a sound purpose and a viable primaryrepayment source, generally supported by a secondary source of repayment.

 

Commercialloans consist of credit lines for operating needs, loans for equipmentpurchases, working capital, and various other business loan products. Consumer loans include a range of traditional consumer loan products such aspersonal lines of credit and loans to finance purchases of autos, boats,recreational vehicles, mobile homes and various other consumer items.

 

Realestate construction loans are generally comprised of commitments to customers withinthe Company’s service area for construction of both commercial properties andcustom and semi-custom single-family residences.  Other real estate loansconsist primarily of loans secured by first trust deeds on commercial andresidential properties typically with maturities from 3 to 10 years andoriginal loan to value ratios generally from 65% to 90%.  Agricultureloans consist primarily of crop loans to farmers of peaches, prunes, walnuts,and almonds.  In general, except in the case of loans with SBA or FMHAguarantees, the Company does not make long-term mortgage loans; however, ButteCommunity Bank has a residential lending division to assist customers insecuring most forms of longer term single-family mortgage financing.

 

AtJune 30, 2010, agriculture loans and commercial real estate loans withprincipal balances totaling $22,360,000 were pledged as collateral to theFederal Reserve Bank of San Francisco (FRB). The amount of loans pledged doesnot represent the amount of outstanding borrowings at the FRB. The Bank pledgesloans as collateral for the Bank’s borrowings in accordance with the Bank’sagreement with the FRB.

 

**Risk Elements**

 

TheCompany assesses and manages credit risk on an ongoing basis through a creditculture that emphasizes excellent credit quality, extensive internal monitoringand established formal lending policies.  Additionally, the Companycontracts with an outside loan review consultant to semiannually review theexisting loan portfolio.  Management believes its ability to identify andassess risk and return characteristics of the Company’s loan portfolio iscritical.  Management strives to continue its emphasis on credit qualityin the loan approval process, active credit administration and regularmonitoring.  With this in mind, management has designed and implemented acomprehensive loan review and grading system that functions to continuallyassess the credit risk inherent in the loan portfolio.

 

Ultimately,underlying trends in economic and business cycles influence creditquality.  The Company’s business is concentrated in the Butte, Sutter andShasta County areas. The economy of these three counties is diversified withprofessional services, manufacturing, agriculture and real estate investmentand construction.  The real estateelement has been impacted by the continuing economic downturn with constructionactivity slowing dramatically beginning in the later part of 2008. Othersectors of the local economy are reasonably stable with agriculture beingaffected the least.

 

Specialemphasis on community development and lending is placed within the communitiesin which the Company has offices (Chico, Paradise, Magalia, Oroville, YubaCity, Red Bluff, Marysville, Colusa, Corning, Redding and Anderson).

 

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TheCompany has significant extensions of credit and commitments to extend creditthat are secured by real estate.  The ultimate repayment of these loans isgenerally dependent on personal or business cash flows or the sale orrefinancing of the real estate.  The Company monitors the effects ofcurrent and expected market conditions and other factors on the collectabilityof real estate loans.  The more significant factors management considersinvolve the following:  lease, absorption and sale rates; real estatevalues and rates of return; operating expenses; inflation; and sufficiency ofcollateral independent of the real estate including, in limited instances,personal guarantees.  The mostsignificant condition management is dealing with concerning real estate loansis the declining values assigned to properties as new appraisals are completed.

 

Inextending credit and commitments to borrowers, the Company generally requirescollateral and/or guarantees as security.  The repayment of such loans isexpected to come from cash flow or from proceeds from the sale of selectedassets of the borrowers.  The Company’s requirement for collateral and/orguarantees is determined on a case-by-case basis in connection with management’sevaluation of the creditworthiness of the borrower.  Collateral heldvaries but may include accounts receivable, inventory, property, plant andequipment, income-producing properties, residences and other realproperty.  The Company secures its collateral by perfecting its securityinterest in business assets, obtaining deeds of trust, or outright possessionamong other means.

 

Inmanagement’s judgment, a concentration exists in loans secured by real estate,which represented approximately 57.3% of the Company’s loan portfolio atJune 30, 2010, which has decreased slightly from the 58.1% concentrationlevel at December 31, 2009.  Management believes the concentrationhas more than the normal risk of collectability due to the substantial declinein the economy in general and the continuing decline in real estate values inthe Company’s primary market areas. As the Company has been impacted by theslowdown in the economy, we have increased the provision for loan losses whichhas adversely affected the Company’s future prospects, results of operations,profitability and stock price.  Management believes that its lendingpolicies and underwriting standards follow strict regulatory guidelines;however, there is no assurance that losses will not continue to occur under thecurrent economic circumstances.  The Company’s loan policies andunderwriting standards include, but are not limited to, the following:(1) maintaining a thorough understanding of the Company’s service area andoriginating a significant majority of its loans within that area,(2) maintaining a thorough understanding of borrowers’ knowledge,capacity, and market position in their field of expertise, (3) basing realestate loan approvals not only on market demand for the project, but also onthe borrowers’ capacity to support the project financially in the event it doesnot perform to expectations (whether sale or income performance), and (4) maintainingconforming and prudent loan to value and loan to cost ratios based onindependent outside appraisals and ongoing inspection and analysis by theCompany’s lending officers.  Although thelending officers followed these strict conservative underwriting standards atloan origination, the downturn in the current economy, with the risingunemployment rate and the decline in real estate values, has had an impact onthe ability of some of our borrowers to service their debt.   The Company does not participate in anysub-prime lending activities nor is it exposed to sub-prime lending in itsinvestment portfolio.

 

**Impaired, Nonaccrual, Past Due and Restructured Loans and Leases andOther Nonperforming Assets**

 

Managementgenerally places loans on nonaccrual status when they become 90 days past due,unless the loan is well secured and in the process of collection.  Loansare charged off when, in the opinion of management, collection appearsunlikely.

 

TableSeven below sets forth nonaccrual loans as of June 30, 2010 andDecember 31, 2009.   There wereno loans past due 90 days or more and still accruing interest at June 30,2010 or December 31, 2009.

 

**TableSeven:  Impaired, Nonaccrual, Past Due and Restructured Loans and Leasesand Other Nonperforming Assets:**

 

**Non-performing Assets**

(in thousands)

 
| ** **                  | ** ** | **June 30, 2010** | ** ** | **December 31, 2009** | ** ** |
|-----------------------------|------------|------------------------|------------|----------------------------|------------|
| **Nonaccrual Loans:**       |       |                   |       |                       |       |
| Commercial                  |       | $                      | 11,195     |                       | $          | 2,218 |   |
| Real estate                 |       | 53,034                 |       | 48,778                     |       |
| Consumer and other          |       | 2,610                  |       | 79                         |       |
| **SUBTOTAL**                |       | 66,839                 |       | 51,075                     |       |
|                        |       |                   |       |                       |       |
| Other Real Estate (ORE)     |       | 11,211                 |       | 13,493                     |       |
| Total non-performing Assets |       | $                      | 78,050     |                       | $          | 64,568 |   |
| Restructured Loans (1)      |       | $                      | 29,798     |                       | $          | 22,593 |   |

 

----

(1) $24,022and $15,870 of the restructured loans are on nonaccrual and are included in thenonaccrual loans above at June 30, 2010 and December 31, 2009,respectively.

 

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Non-performingloans (defined as non-accrual loans and loans 90 days or more past due andstill accruing interest) totaled $66,839,000 at June 30, 2010, an increaseof $15,764,000 from $51,075,000 at December 31, 2009 primarily as a resultof increasing problem loans in the Company’s real estate/development portfolioand commercial loan portfolios.  Thelarge increase in problem loans is due to declining property values, the slowdown in the sale of lots held as collateral, and the borrowers’ inability topay as agreed. Specific reserves on the non-performing loans of $1,830,000 havebeen recorded at June 30, 2010 compared to $4,045,000 at December 31,2009.  Nonperforming loans as apercentage of total loans were 16.52% at June 30, 2010 compared to 12.16%at December 31, 2009.

 

Non-performingassets, (non-performing loans and ORE) totaled $78,050,000 at June 30,2010, an increase of $13,482,000 from $64,568,000 at December 31,2009.  Non-performing assets as apercentage of total assets were 15.62% at June 30, 2010 compared to 12.0%at December 31, 2009.

 

Totalnon-performing assets consist of 121 loans for a total of $66,839,000classified as impaired and on non-accrual and thirty-nine properties for atotal of $11,211,000 classified as other real estate (ORE) at June 30,2010 compared to total ORE of $13,493,000 at December 31, 2009.  Other than the loans included asnon-performing assets at June 30, 2010, the Company has not identified anypotential problem loans that would result in any loan being included as anon-performing asset at the current date.

 

Setforth below is a table of our significant non-performing assets:

 

Significant Non-Performing Loans:

(in thousands)

 
| ** **       | ** ** | ** **    | ** ** | **Loan  Balance** | ** ** | **Apprasial** | ** ** | **Nonaccrual** | ** ** | **Appraised** | ** ** | **Specific  Reserve** | ** ** | ** **     | ** ** | ** **    | ** ** |
|------------------|------------|---------------|------------|-------------------|------------|---------------|------------|----------------|------------|---------------|------------|-----------------------|------------|----------------|------------|---------------|------------|
| **Loan**         | ** ** | **Type**      | ** ** | **12/31/2009**    | ** ** | **6/30/2010** | ** ** | **Date**       | ** ** | **Date**      | ** ** | **Value**             | ** ** | **12/31/2009** | ** ** | **6/30/2010** | ** ** | **Chargeoffs** | ** ** | **Current  Collateral** | ** ** |
| 1                |       | Commerical RE |       | $                 | 4,326      |          | $          | 4,266          |       | Apr-10        |       | Jan-09                |       | $              | 3,900      |          | $          | 43 |   | $ | — |   | $ | 212 |   | 28 Cottages |   |
| 2                |       | Development   |       | 3,839             |       | 3,642         |       | May-10         |       | Dec-09        |       | 2,592                 |       | 1,400          |       | —        |       | — |   | 21 finished  lots & 29 paper lots |   |
| 3                |       | Development   |       | 1,977             |       | 1,662         |       | Jun-10         |       | Dec-09        |       | 1,820                 |       | —         |       | —        |       | 794 |   | 14.88 acres of land |   |
| 4 & 5   |       | Development   |       | 6,601             |       | 6,249         |       | Apr-10         |       | Jun-09        |       | 10,380                |       | —         |       | —        |       | 1,234 |   | 148 finished lots, a  24.95 acre parcel and a 5 acre parcel |   |
| 6                |       | Development   |       | 2,239             |       | 2,229         |       | Sep-09         |       | Dec-09        |       | 4,000                 |       | —         |       | —        |       | — |   | Golf course |   |
| 7 & 8   |       | Commerical RE |       | 1,902             |       | 1,787         |       | Apr-10         |       | Dec-09        |       | 8,142                 |       | —         |       | —        |       | — |   | Hotel/inn |   |
| 9                |       | Development   |       | 2,471             |       | 2,413         |       | Apr-10         |       | Dec-09        |       | 2,545                 |       | —         |       | —        |       | 929 |   | 250 acres of land |   |
| 10               |       | Commerical RE |       | 1,598             |       | 1,577         |       | Mar-10         |       | Dec-09        |       | 2,980                 |       | —         |       | —        |       | — |   | 67,600 sq.ft. industrial  office/warehouse building |   |
| 11 & 12 |       | Development   |       | 2,250             |       | 2,092         |       | Jun-10         |       | Dec-09        |       | 2,250                 |       | 151            |       | —        |       | 1,514 |   | 31 finished  lots & 2 completed homes |   |
| 13               |       | Development   |       | 2,451             |       | 1,593         |       | Apr-10         |       | Dec-09        |       | 1,540                 |       | 637            |       | —        |       | — |   | 12 lot subdivision |   |
| 14               |       | Development   |       | 4,429             |       | 4,226         |       | Jul-10         |       | Jun-10        |       | 5,180                 |       | —         |       | —        |       | — |   | Office/Condo |   |
| 15               |       | Development   |       | 2,280             |       | 2,280         |       | Sep-09         |       | Jun-10        |       | 1,560                 |       | 450            |       | 989           |       | — |   | 32 lot subdivision |   |
| 16               |       | Commerical RE |       | 3,593             |       | 2,583         |       | Mar-10         |       | Jun-10        |       | 2,700                 |       | —         |       | —        |       | 991 |   | Gas Station |   |
|             |       |          |       | $                 | 39,956     |          | $          | 36,599         |       |          |       |                  |       |           |       | $             | 2,681      |   | $ | 989 |   | $ | 5,674 |   |   |   |
|                  |            |               |            |                   |            |               |            |                |            |               |            |                       |            |                |            |               |            |  |  |  |  |  |  |  |  |  |  |

 

Loan1 is a government guaranteed loan under the United States Department ofAgriculture (USDA) Business and Industry program with an 80% guarantee andmaximum exposure to the Company of $743,000. In October of 2008, the Bank received notice that our borrower hadfiled bankruptcy under Chapter 11.  Itwas at this time that the Bank stopped receiving payments. The Company isprevented from pursuing any additional legal action due to the pendingbankruptcy.

 

Theremainder of the non-performing loans consists primarily of forty-two impairedlot loans that total $13,490,000, fourteen impaired single family home loansthat total $4,981,000, fifteen commercial real estate loans that total$7,115,000, fifteen commercial/industrial loans that total $2,837,000,seventeen single family home loans secured with 2nd deeds of trust for $1,788,000, and twoconsumer loans that total $29,000. These loans are to borrowers who are locatedthroughout Northern California from the Sacramento area to Redding.  After appropriate write downs, the currentappraised values provide the Company with adequate margins in most cases;however, the Bank has allocated a specific reserve that totals an additional$841,000 on these loans.

 

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OtherReal Estate

 

Thelargest of our ORE at June 30, 2010 is a commercial real estate propertyfor the construction of 50,396 sq. feet of industrial condos in ShingleSprings, California carried at $2,608,000. The property was transferred to ORE on December 24, 2009. Toidentify the Company’s potential loss exposure and properly value thecollateral support provided by the property, an updated appraisal was receivedon December 1, 2009 and showed a value of $3,005,000.  The Company charged off an additional $96,000to ORE expense on March 30, 2010. The property is currently in escrow for $2,700,000 and is scheduled toclose in August 2010.

 

Anothersignificant ORE at June 30, 2010 is a 23,646 sq. ft. multi-tenant retailbuilding located in Northern California carried at $945,000. The building istwo years old with no infill and cold shell completed.  This loan was transferred to ORE inApril 2010.  In January 2010, anew appraisal valued the property at $1,070,000.

 

Theremainder of other real estate includes twenty-three land lots that have acurrent value of $4,254,000, nine single family residences at a combinedbalance of $1,963,000, and five commercial real estate properties that total$1,441,000.  These amounts included inORE are supported by current appraisals received by the Company, all within thepast 12 months. When loans are placed into ORE, the Company determines the fairmarket value less the estimated selling costs. The shortfalls are charged to the allowance for loan losses at the timeof transfer.  Properties placed in OREare reviewed continuously and the Company will reappraise the property if it isdeemed necessary.  At a minimum,properties are appraised at least annually. If values have dropped, the Company will establish a valuation allowancefor the ORE through a separate provision for losses on ORE.

 

**Restructured Loans**

(in thousands)

 
| ** **                                        | ** ** | **June 30, 2010** | ** ** | **December 31, 2009** | ** ** |
|---------------------------------------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                                        | ** ** | **Accrual**            | ** ** | **Non  Accrual**           | ** ** | **Unfunded** | ** ** | **Accrual** | ** ** | **Non  Accrual** | ** ** | **Unfunded** | ** ** |
| Agricultural                                      |       | $                      | —     |                       | $          | — |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Commercial and Industrial                         |       | —                 |       | —                     |       | — |   | — |   | — |   | — |   |
| **Real Estate**                                   |       |                   |       |                       |       |   |   |   |   |   |   |   |   |
| Secured by Commercial/Professional Office         |       | —                 |       | 5,250                      |       | — |   | — |   | 4,386 |   | — |   |
| Properties Including Construction and Development |       | 5,776                  |       | 17,393                     |       | 424 |   | 6,723 |   | 10,147 |   | 424 |   |
| Secured by Residential Properties                 |       | —                 |       | 936                        |       | — |   | — |   | 835 |   | — |   |
| Secured by Farmland                               |       | —                 |       | —                     |       | — |   | — |   | — |   | — |   |
| Consumer Loans                                    |       | —                 |       | 443                        |       | — |   | — |   | 502 |   | — |   |
|                                              |       |                   |       |                       |       |   |   |   |   |   |   |   |   |
| Total Restructured Loans                          |       | $                      | 5,776      |                       | $          | 24,022 |   | $ | 424 |   | $ | 6,723 |   | $ | 15,870 |   | $ | 424 |   |
|                                              |       |                   |       |                       |       |   |   |   |   |   |   |   |   |
| Restructured loans as % of total gross loans      |       | 7.09                   | %          |                       |       |   |   | 5.20 | % |   |   |   |   |

 

Restructured loans totaled$29,798,000 at June 30, 2010, an increase of $7,205,000 from the total atDecember 31, 2009.  The significantincrease at June 30, 2010 was due to rate reductions granted for twoadditional borrowers with construction and development loans. A loan may berestructured when the Bank determines that a borrower’s financial condition hasdeteriorated, but still has the ability to repay the loan. A loan is consideredto be a troubled debt restructure when the original terms have been modified infavor of the borrower such that either principal or interest has been forgiven,contractual payments are deferred, or the interest rate is reduced. If therestructured terms are reasonable based on the current market and the borrowerhas made their payments as contractually required for six months, the loan isreviewed and interest may again be accrued. No additional funds were lent tothe borrowers of the restructured loans.

 

**Allowance for Loan Losses Activity**

 

Weemploy a systematic methodology for determining the allowance for loan lossesthat includes a monthly review process and monthly adjustment of the allowance. Our process includes a monthly review of individual loans that have beenspecifically identified as problem loans or have characteristics which couldlead to impairment, as well as detailed reviews of other loans (eitherindividually or in pools).  While this methodology utilizes historical andother objective information, the establishment of the allowance for loan lossesand the classification of loans are, to some extent, based on management’sjudgment and experience.

 

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Ourmethodology incorporates a variety of risk considerations, both quantitativeand qualitative, in establishing an allowance for loan losses that managementbelieves is appropriate at each reporting date.  Quantitative factorsinclude our historical loss experience, delinquency and charge-off trends,collateral values, changes in non-performing loans, and other factors. Quantitative factors also incorporate known information about individual loans,including borrowers’ sensitivity to interest rate movements.

 

Qualitativefactors include the impact of the general economic environment in our marketsand, in particular, the state of the agriculture industry and other keyindustries in the Northern Sacramento Valley.  The way a particular loanmight be structured, the extent and nature of waivers of existing loanpolicies, loan concentrations, trends in delinquencies and charge-offs, and therate of portfolio growth are other qualitative factors that are considered.

 

Ourmethodology is, and has been, consistently followed.  However, as we addnew products, increase in complexity, and expand our geographic coverage, weexpect to enhance our methodology to keep pace with the size and complexity ofthe loan portfolio.  On an ongoing basis we engage outside firms toindependently assess our methodology, and to perform independent credit reviewsof our loan portfolio.  The FDIC and the DFI review the allowance for loanlosses as an integral part of the examination process.  Managementbelieves that our current methodology is appropriate given our size and levelof complexity.  Further, management believes that the allowance for loanlosses is adequate as of June 30, 2010 to cover known and inherent risksin the loan portfolio.  However, fluctuations in credit quality, orchanges in economic conditions or other factors could cause management toincrease or decrease the allowance for loan losses as necessary.

 

TheBoard of Directors of the Bank reviews the adequacy of the allowance for loanlosses at least quarterly to include consideration of the relative risks in theportfolio and current economic conditions.  The allowance is adjustedbased on that review if, in the judgment of the Board of Directors andmanagement, changes are warranted.  The allowance for loan losses totaled$15,745,000 or 3.75% of total loans at June 30, 2010 and $12,975,000 or 3.00%at December 31, 2009.  Net charge-offs for the quarter endedJune 30, 2010 were $4,177,000. The Company has a separate reserve forunfunded loan commitments of $104,000 as of June 30, 2010 and $244,000 asof December 31, 2009 that is included in other liabilities on the balancesheet.

 

TableEight below summarizes, for the periods indicated, the activity in theallowance for loan losses.

 

**Table Eight: Allowance for Loan Losses**

 
| ** **                                                                | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| **(In  thousands, except for percentages)**                               | ** ** | **2010**                              | ** ** | **2009**                            | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                                                      |       |                                  |       |                                |       |   |   |   |   |
| Average loans outstanding                                                 |       | $                                     | 424,306    |                                | $          | 480,272 |   | $ | 424,306 |   | $ | 484,880 |   |
|                                                                      |       |                                  |       |                                |       |   |   |   |   |
| Allowance for possible loan losses at beginning of  period                |       | $                                     | 14,979     |                                | $          | 8,729 |   | $ | 12,975 |   | $ | 7,910 |   |
|                                                                      |       |                                  |       |                                |       |   |   |   |   |
| Loans charged off:                                                        |       |                                  |       |                                |       |   |   |   |   |
| Commercial                                                                |       | (384                                  | )          | (317                                | )          | (730 | ) | (402 | ) |
| Real estate                                                               |       | (2,798                                | )          | (3,014                              | )          | (5,533 | ) | (4,864 | ) |
| Consumer                                                                  |       | (1,010                                | )          | (181                                | )          | (1,459 | ) | (528 | ) |
| Total                                                                     |       | (4,192                                | )          | (3,512                              | )          | (7,722 | ) | (5,794 | ) |
| Recoveries of loans previously charged off:                               |       |                                  |       |                                |       |   |   |   |   |
| Commercial                                                                |       | 7                                     |       | 1                                   |       | 120 |   | 1 |   |
| Real estate                                                               |       | —                                |       | —                              |       | 67 |   | — |   |
| Consumer                                                                  |       | 8                                     |       | —                              |       | 73 |   | 1 |   |
| Total                                                                     |       | 15                                    |       | 1                                   |       | 260 |   | 2 |   |
| Net loan charge offs                                                      |       | (4,177                                | )          | (3,511                              | )          | (7,462 | ) | (5,792 | ) |
|                                                                      |       |                                  |       |                                |       |   |   |   |   |
| Additions to allowance charged to operating  expenses                     |       | 4,943                                 |       | 4,000                               |       | 10,232 |   | 7,100 |   |
|                                                                      |       |                                  |       |                                |       |   |   |   |   |
| Allowance for loan losses at end of period                                |       | $                                     | 15,745     |                                | $          | 9,218 |   | $ | 15,745 |   | $ | 9,218 |   |
|                                                                      |       |                                  |       |                                |       |   |   |   |   |
| Ratio of net charge-offs to average loans  outstanding                    |       | 0.99                                  | %          | 0.73                                | %          | 1.82 | % | 1.19 | % |
| Provision for possible loan losses to average  loans outstanding          |       | 1.16                                  | %          | 0.83                                | %          | 2.41 | % | 1.46 | % |
| Allowance for loan losses to loans net of deferred  fees at end of period |       | 3.75                                  | %          | 1.95                                | %          | 3.75 | % | 1.95 | % |

 

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Itis the policy of management to maintain the allowance for loan losses at alevel adequate for known and inherent risks in the portfolio.  Based oninformation currently available to analyze inherent credit risk, includingeconomic factors, overall credit quality, historical delinquencies and ahistory of actual charge-offs, management believes that the provision for loanlosses and the allowance are adequate.  The Company generally makesmonthly allocations to the allowance for loan losses.  The budgetedallocation is based on estimates of loss risk and loan growth. Adjustments may be made based on differences from estimated loan growth, thetypes of loans constituting this growth, changes in risk ratings within theportfolio, recognition of loan impairment and general economic conditions. However, no prediction of the ultimate level of loans charged off in futureperiods can be made with any certainty.

 

**Deposits**

 

AtJune 30, 2010, total deposits were $470,315,000 representing a decrease of$27,848,000 (5.6%) over the December 31, 2009 balance of$498,163,000. We have experienced a decrease in the level of ournon-interest bearing demand deposits in the first six months of 2010, down$10,056,000. Interest bearing checking and money market accounts decreased$5,697,000 to $147,511,000 and certificate of deposit balances decreased by$12,617,000 to $145,434,000 during the first six months of 2010. Savingsaccounts increased $729,000 to $110,010,000 from December 31, 2009.Brokered deposits totaled $1,105,000 and $17,633,000 at June 30, 2010 and December 31,2009, respectively. The decrease in deposits is consistent with the Company’sstrategic plan to shrink the balance sheet and continue to decrease the cost offunds by reducing certificate of deposits.

 

OnJuly 21, 2010, President Obama signed the Dodd-Frank Wall Street Reformand Consumer Protection Act, which, in part, permanently raised the currentstandard maximum deposit insurance amount to $250,000.  In addition, the Bank is participating in theFDIC Transaction Account Guarantee Program. Under that program, throughDecember 31, 2012, all noninterest-bearing transaction accounts andqualifying NOW accounts are fully guaranteed by the FDIC for the entire amountin the account. Coverage under the Transaction Account Guarantee Program is inaddition to and separate from the coverage available under the FDIC’s generaldeposit insurance rules. Participating institutions are currently assessed a 10basis point surcharge on the additional insured deposits.

 

**Capital Resources**

 

TheCompany and the Bank are subject to certain regulatory capital requirementsadministered by the Board of Governors of the Federal Reserve System and theFDIC. Failure to meet these minimum capital requirements can initiate certainmandatory, and possibly additional discretionary, actions by regulators that,if undertaken, could have a direct material effect on the Company’sconsolidated financial statements. Under capital adequacy guidelines, theCompany and the Bank must meet specific capital guidelines that involve quantitativemeasures of their assets, liabilities and certain off-balance sheet items ascalculated under regulatory accounting practices.  These quantitative measures are establishedby regulation and require that minimum amounts and ratios of total and Tier 1 capitalto risk-weighted assets and of Tier 1 capital to average assets bemaintained.  Capital amounts andclassifications are also subject to qualitative judgments by the regulatorsabout components, risk weightings and other factors. Accordingly, the regulatorshave required the Bank to increase its Tier 1 to average assets capital ratioto equal or exceed 10% and its risk based capital ratio to 13% under theConsent Order.   The Company and the Bankare considered to be significantly undercapitalized at June 30, 2010 underthese regulatory guidelines.

 

TheBank is also subject to additional capital guidelines under the regulatoryframework for prompt corrective action. To be categorized as adequately capitalized, the Bank must maintainminimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as setforth in the table below.  AtJune 30, 2010, the Bank is considered significantly undercapitalized underthe prompt corrective capital regulations and, as required, filed a capitalrestoration plan on May 28, 2010 and is automatically subject to amongother things, restrictions on dividends, restrictions on access to the FederalReserve’s discount window, restrictions on asset growth, and being prohibitedfrom opening new branches, or engaging in new lines of business without theapproval of the FDIC.

 

Inan effort to strengthen the Company’s operations and capital position andenable it to better withstand these continued adverse market conditions, theCapital Augmentation Committee has been working diligently to raise additionalcapital and identify additional capital sources and alternatives inclusive of astrategic combination.

 

AtJune 30, 2010, shareholders’ equity was $10,781,000 representing adecrease of $5,171,000 over the December 31, 2009 balance of $15,952,000.

 

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TableNine below lists the Company’s and the Bank’s capital ratios at June 30,2010 and December 31, 2009, as well as the minimum ratios required underregulatory definitions of capital adequacy and requirements for the Bankincluded in the Consent Order.

 

**TableNine: Capital Ratios**

 
| **Capital  to Risk-Adjusted Assets** | ** ** | **At June 30,  2010** | ** ** | **At December 31,  2009** | ** ** | **Minimum  Regulatory  Requirement** | ** ** | **Required Under  the Consent  Order** | ** ** |
|--------------------------------------|------------|----------------------------|------------|--------------------------------|------------|--------------------------------------|------------|----------------------------------------|------------|
|                                 |       |                       |       |                           |       |                                 |       |                                   |       |
| Company                              |       |                       |       |                           |       |                                 |       |                                   |       |
| Leverage ratio                       |       | 1.9                        | %          | 3.0                            | %          | 4.0                                  | %          |                                   |       |
|                                 |       |                       |       |                           |       |                                 |       |                                   |       |
| Tier 1 Risk-Based Capital ratio      |       | 2.1                        | %          | 3.5                            | %          | 4.0                                  | %          |                                   |       |
|                                 |       |                       |       |                           |       |                                 |       |                                   |       |
| Total Risk-Based Capital ratio       |       | 5.4                        | %          | 6.2                            | %          | 8.0                                  | %          |                                   |       |
|                                 |       |                       |       |                           |       |                                 |       |                                   |       |
| Bank                                 |       |                       |       |                           |       |                                 |       |                                   |       |
| Leverage ratio                       |       | 3.6                        | %          | 4.0                            | %          | 4.0                                  | %          | 10.0                                   | %          |
|                                 |       |                       |       |                           |       |                                 |       |                                   |       |
| Tier 1 Risk-Based Capital ratio      |       | 4.1                        | %          | 4.4                            | %          | 4.0                                  | %          | 0.0                                    | %          |
|                                 |       |                       |       |                           |       |                                 |       |                                   |       |
| Total Risk-Based Capital ratio       |       | 5.4                        | %          | 5.7                            | %          | 8.0                                  | %          | 13.0                                   | %          |

 

Managementis currently adjusting its capital plan in order to conform to theserequirements through restructuring of the balance sheet and the addition of newcapital in the form of common stock.  TheCompany has engaged Cappello Capital Corp. of Santa Monica, California to be itsfinancial advisor in connection with its recapitalization and the sale of nonperforming assets. In addition, an amendment to the Company bylaws to allowissuance of preferred stock was approved by the shareholders at the annualmeeting that was held June 4, 2009. If the Company is not successful inraising additional capital, it will not be able to become fully compliant withthe provisions of the Order or the FRB Agreement. As a result the FederalReserve, the FDIC and/or the DFI may take further enforcement or other actions.This might include a revocation of our bank’s charter and the placement of theBank into receivership. The Company is considering various transactions thatmight enhance its capital position and believes the capital plan will addressits near-term capital resources and liquidity needs.

 

**Item 3.  Quantitative andQualitative Disclosures about Market Risk**

 

**Market Risk Management**

 

*Overview*.  Market risk is therisk of loss from adverse changes in market prices and rates.  The Company’smarket risk arises primarily from interest rate risk inherent in its loan,investment, deposit and borrowing portfolios.  The goal for managing theassets and liabilities of the Company is to maximize shareholder value andearnings while maintaining a high quality balance sheet without exposing theCompany to undue interest rate risk.

 

TheBoard of Directors has overall responsibility for the interest rate riskmanagement policies.  The Bank has an Asset and Liability ManagementCommittee (ALCO) that establishes and monitors guidelines to control thesensitivity of earnings to changes in interest rates.

 

*Asset/Liability Management*.  Activities involvedin asset/liability management include, but are not limited to, lending,accepting and placing deposits, investing in securities, issuing trustpreferred securities and borrowings.  Interest rate risk is the primarymarket risk associated with asset/liability management.  Sensitivity ofearnings to interest rate changes arises when yields on assets change in a differenttime period or in a different amount from that of interest costs onliabilities.  To mitigate interest rate risk, the structure of the balancesheet is managed with the goal that movements of interest rates on assets andliabilities are correlated and contributes to earnings even in periods ofvolatile interest rates.  The asset/liability management policy setslimits on the acceptable amount of variance in net interest margin and marketvalue of equity under changing interest environments.  The Company usessimulation models to forecast earnings, net interest margin and market value ofequity.

 

Simulationof earnings is the primary tool used to measure the sensitivity of earnings tointerest rate changes.  Using computer-modeling techniques, the Company isable to estimate the potential impact of changing interest rates onearnings.  A balance sheet forecast is prepared monthly using inputs ofactual loans, securities and interest bearing liabilities (i.e.deposits/borrowings) positions as the beginning base.  The forecastbalance sheet is processed against eitht interest rate scenarios.  Thesescenarios include a 100, 200, 300 and 400 basis point rising rate forecast, aflat rate forecast and a 100, 200 and 300 basis point falling rate forecastwhich take place within a one year time frame.

 

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

 

TableTen below summarizes the effect on net interest income (NII) of a ±200 basispoint change in interest rates as measured against a constant rate (no change)scenario.  The results shown in Table Ten for the two periods fall withinthe parameters of the Bank’s policy for interest rate risk.

 

**TableTen:  Interest Rate Risk Simulation of Net Interest as of June 30,2010 and December 31, 2009**

** **
| **(In  thousands)**                     | ** ** | **$ Change in  NII  from Current  12 Month  Horizon  June 30, 2010** | ** ** | **$ Change in NII  from Current  12 Month  Horizon  December 31, 2009** | ** ** |
|-----------------------------------------|------------|--------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------|------------|
| Variation from a constant rate scenario | ** ** | ** **                                                                     |       |                                                                              |       |
| +200bp                                  |       | $                                                                              | 203        |                                                                              | $          | 965 |   |
| - 200bp                                 |       | $                                                                              | (458       | )                                                                                 | $          | (36 | ) |

 

Assumptionsare inherently uncertain, and, consequently, the model cannot precisely measurenet interest income or precisely predict the impact of changes in interestrates on net interest income. Actual results will differ from simulated resultsdue to timing, magnitude and frequency of interest rate changes, as well aschanges in market conditions and management strategies which might moderate thenegative consequences of interest rate deviations. In the model above, thesimulation shows that the Company is asset sensitive over the one-year horizonas increasing rates have a greater positive impact on net interest income thandeclining rates.

 

**Inflation**

 

Theimpact of inflation on a financial institution differs significantly from thatexerted on manufacturing, or other commercial concerns, primarily because itsassets and liabilities are largely monetary.  In general, inflationprimarily affects the Company and it subsidiaries through its effect on marketrates of interest, which affects the Company’s ability to attract loancustomers.  Inflation affects the growth of total assets by increasing thelevel of loan demand, and potentially adversely affects capital adequacybecause loan growth in inflationary periods can increase at rates higher thanthe rate capital grows through retention of earnings, which may be generated inthe future.  In addition to its effects on interest rates, inflationincreases overall operating expenses.

 

Inan inflationary environment, people tend to reduce overall spending and begin tosave more. But as individuals and businesses curtail expenditures in an effortto trim costs; this causes the gross domestic product (GDP) to decline.Unemployment rates rise because companies lay off workers to cut costs.  It is these combined factors that cause theeconomy to fall into a recession.  Thecurrent economic slow down is evidenced by continued negative growth in GDP forthe second quarter.

 

**Liquidity**

 

Liquiditymanagement refers to the Company’s ability to provide funds on an ongoing basisto meet fluctuations in deposit levels as well as the credit needs andrequirements of its clients.  Both assets and liabilities contribute tothe Company’s liquidity position.  The line of credit with the FederalReserve Bank, short-term investments and securities, and loan repaymentscontribute to liquidity, along with deposit increases, while loan funding anddeposit withdrawals decrease liquidity.  The Company assesses the likelihoodof projected funding requirements by reviewing historical funding patterns,current and forecasted economic conditions and individual client funding needs.

 

Atthe request of our regulators, daily liquidity reports are prepared bymanagement and submitted to the regulators for their review. These reports arein addition to our regular monthly reports reviewed by the Asset/LiabilityCommittee. These reports measure liquidity by 1) historical point in timeratios; 2) current position as of that day; and 3) projected cash flowanalysis.

 

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TheCompany’s sources of liquidity consist of cash and due from correspondentbanks, excess balance agreement with the FRB, unpledged marketable investmentsand loans held for sale.  On June 30, 2010, consolidated liquidassets totaled $46,577,000 or 9.2% of total assets compared to $58,654,000 or10.9% of total assets on December 31, 2009.  In addition to liquidassets, the Bank has a line of credit with the Discount Window at the FederalReserve Bank of San Francisco, on which the borrowing capacity at June 30,2010 was $9,971,000.

 

TheBank also has informal agreements with various other banks to sellparticipations in loans, if necessary.  The Company serves primarily abusiness and professional customer base and, as such, its deposit base issusceptible to economic fluctuations.  Accordingly, management strives to maintaina balanced position of liquid assets to volatile and cyclical deposits.

 

Liquidityis also affected by portfolio maturities and the effect of interest ratefluctuations on the marketability of both assets and liabilities.  TheCompany can sell any of its unpledged securities held in the available-for-salecategory to meet liquidity needs.

 

**Off-Balance Sheet Items**

 

TheCompany has certain ongoing commitments under operating leases.  Thesecommitments do not significantly impact operating results. As of June 30,2010 and December 31, 2009, commitments to extend credit and letters ofcredit were the only financial instruments with off-balance sheet risk. The Company has not entered into any contracts for financial derivativeinstruments such as futures, swaps, options or similar instruments.   Commitments to fund loans and stand-byletters of credit at June 30, 2010 and December 31, 2009 wereapproximately $82,612,000 and $115,277,000, respectively.  Such loansrelate primarily to revolving lines of credit and other commercial loans, andto real estate construction loans.  As apercentage of net loans, these off-balance sheet items represent 20.3% and27.4%, respectively. Of the loan commitments outstanding at June 30, 2010,$11,142,000 are real estate construction loan commitments that are not expectedto fund within the next twelve months due to the current downturn in the realestate market. The remaining commitments primarily relate to revolving lines ofcredit or other commercial loans, and many of these are expected to expirewithout being drawn upon. Therefore, the total commitments do not necessarilyrepresent future cash requirements.

 

**Other Matters**

 

**Item 4.  Controls andProcedures**

 

(a) DisclosureControls and Procedures: An evaluation of the Company’s disclosure controls andprocedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e))was carried out under the supervision and with the participation of the Company’sChief Executive Officer, Chief Financial Officer and other members of theCompany’s senior management as of the end of the Company’s fiscal quarter endedJune 30, 2010. The Company’s Chief Executive Officer and Chief FinancialOfficer concluded that the Company’s disclosure controls and procedures ascurrently in effect are effective in ensuring that the information required tobe disclosed by the Company in the reports it files or submits under theExchange Act is (i) accumulated and communicated to the Company’smanagement (including the Chief Executive Officer and Chief Financial Officer)to allow timely decisions regarding required disclosure, and(ii) recorded, processed, summarized and reported within the time periodsspecified in the Commission’s rules and forms.

 

(b) InternalControl Over Financial Reporting: An evaluation of any changes in the Company’sinternal control over financial reporting (as defined in Exchange ActRules 13a-15(f) and 15d-15(f)), that occurred during the Company’sfiscal quarter ended June 30, 2010, was carried out under the supervisionand with the participation of the Company’s Chief Executive Officer, ChiefFinancial Officer and other members of the Company’s senior management. TheCompany’s Chief Executive Officer and Chief Financial Officer concluded that nochange identified in connection with such evaluation has materially affected,or is reasonably likely to materially affect, the Company’s internal controlover financial reporting.

 

**Item 5.  Not Applicable**

 

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**PART II— OTHER INFORMATION**

 

Item 1.  Legal Proceedings.

 

None.

 

Item 1A. Risk Factors

 

Inaddition to the other information set forth in this report, you shouldcarefully consider the factors discussed in Part I, “Item 1A. Risk Factors”in our Annual Report on Form 10-K for the year ended December 31,2009, which could materially affect our business, financial condition or futureresults. The risks described in our Annual Report on Form 10-K are not theonly risks facing our Company. Additional risks and uncertainties not currentlyknown to us or that we currently deem to be immaterial also may materiallyadversely affect our business, financial condition and/or operating results.

 

Item 2.  Changes in Securities and Use ofProceeds.

 

TheBoard of Directors approved a plan at their March 2007 meeting torepurchase up to $6,000,000 of the outstanding common stock of theCompany.  The plan states that stockrepurchases may be made from time to time on the open market or throughprivately negotiated transactions.   Thetiming of purchases and the exact number of shares to be purchased depends onmarket conditions.  The share repurchaseplan does not include specific price targets or timetables and may be suspendedat any time.

 

Duringthe six months ended June 30, 2010, no shares of common stock wererepurchased under the share repurchase program. There is approximately$5,671,796 remaining that may yet be purchased under the plan.

 

Item3.  Defaults Upon Senior Securities.

 

None.

 

Item 4.  (Removed and Reserved)

 

None.

 

Item 5.  Other Information.

 

None.

 

Item 6.  Exhibits

 

(a) Exhibits

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

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities and Exchange Act of 1934, the registranthas duly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

 

 
|                |     | COMMUNITY  VALLEY BANCORP          |
|---------------------|----------|------------------------------------|
|                |     |                               |
| July 30,  2010 | * * | *By:*                              | */s/  John F. Coger* |
|                |     |                               |
|                |     | John F. Coger                      |
|                |     |                               |
|                |     | President, Chief Executive Officer |
|                |     |                               |
| July 30,  2010 | * * | *By:*                              | */s/  Barbara A. Crouse* |
|                |     |                               |
|                |     | Barbara A. Crouse                  |
|                |     |                               |
|                |     | Senior Vice President, CFO         |

 

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