Tableof Contents

 

 

 

**SECURITIESAND 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, 2008** |
|                                                        |                                                                                                     |
| **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 andformer fiscal year, if changed since last report)

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or such shorter period that the registrant was required to file suchreports), and (2) has been subject to such filing requirements for thepast 90 days.

 

Yes  x  No  o

 

Indicate by check mark whetherthe registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer, or a smaller company filer. See definition of“accelerated filer 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 |
|---------------------------|--------------------------|-------------------------|-----------------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Exchange Act Rule 12b-2).Yes  o  No  x

 

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock, as of thelatest practicable date:

 

No par value Common Stock — 6,678,661 shares outstanding at July 31, 2008.

 

 

 

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Tableof Contents

 

**Table of Contents**

 
| PART I  |   |                                                                                                                            | 3      |
|--------------|--------|---------------------------------------------------------------------------------------------------------------------------------|--------|
|         |   |                                                                                                                            |   |
|         |   | Item 1. Financial Statements                                                                                                    | 3      |
|         |   |                                                                                                                            |   |
|         |   | Item 2. Management’s  Discussion and Analysis f Financial Condition and Results of Operations of  Community Valley Bancorp | 11     |
|         |   |                                                                                                                            |   |
|         |   | Item 3.  Quantitative and Qualitative Disclosures about Market Risk                                                             | 27     |
|         |   |                                                                                                                            |   |
|         |   | Item 4. Controls  and Procedures                                                                                                | 28     |
|         |   |                                                                                                                            |   |
| PART II |   |                                                                                                                            | 29     |
|         |   |                                                                                                                            |   |
|         |   | Item 1. Legal  Proceedings                                                                                                      | 29     |
|         |   |                                                                                                                            |   |
|         |   | Item  1A. Risk Factors                                                                                                          | 29     |
|         |   |                                                                                                                            |   |
|         |   | Item 2.  Changes in Securities and Use of Proceeds                                                                              | 29     |
|         |   |                                                                                                                            |   |
|         |   | Item 4.  Submission of Matters to a Vote of Security Holders.                                                                   | 29     |
|         |   |                                                                                                                            |   |
|         |   | Item 5. Other  Information                                                                                                      | 29     |
|         |   |                                                                                                                            |   |
|         |   | Item  6. Exhibits                                                                                                               | 30     |
|         |   |                                                                                                                            |   |
|         |   | Signatures                                                                                                                      | 30     |
|         |   |                                                                                                                            |   |
|         |   | Ex. 31.1. Certification of CEO Pursuant to  Section 302 of the Sarbanes Oxley Act of 2002                                  |   |
|         |   |                                                                                                                            |   |
|         |   | Ex. 31.2 Certification of CFO Pursuant to  Section 302 of the Sarbanes Oxley Act of 2002                                   |   |
|         |   |                                                                                                                            |   |
|         |   | Ex. 32.1 Certification of CEO Pursuant to  Section 906 of the Sarbanes Oxley Act of 2002                                   |   |
|         |   |                                                                                                                            |   |
|         |   | Ex. 32.2 Certification of CFO Pursuant to  Section 906 of the Sarbanes Oxley Act of 2002                                   |   |

 

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**PART I- FINANCIAL INFORMATION**

**Item 1**

**COMMUNITY VALLEY BANCORP**

**CONSOLIDATED BALANCE SHEET (Unaudited)**

(dollars in thousands)

 
| ** **                                                                                                                                                                   | ** ** | **June 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| ASSETS                                                                                                                                                                       |       |                        |       |                            |       |
| Cash and due  from banks                                                                                                                                                     |       | $                           | 23,452     |                            | $          | 31,714 |   |
| Federal funds  sold & other                                                                                                                                         |       | 4,490                       |       | 54,290                          |       |
| Total  cash & cash equivalents                                                                                                                                      |       | 27,942                      |       | 86,004                          |       |
|                                                                                                                                                                         |       |                        |       |                            |       |
| Interest-bearing  deposits in banks                                                                                                                                          |       | 4,844                       |       | 4,250                           |       |
| Investment  securities (fair value of $8,321 at June 30, 2008 and $6,270 at  December 31, 2007)                                                                    |       | 8,711                       |       | 6,264                           |       |
| Loans held for  sale at lower of cost or market                                                                                                                              |       | 566                         |       | —                          |       |
| Loans, less  allowance for loan losses of $6,241 at June 30, 2008 and $5,232 at  December 31, 2007                                                                 |       | 488,938                     |       | 441,350                         |       |
| Premises and  equipment, net                                                                                                                                                 |       | 8,497                       |       | 17,905                          |       |
| Bank owned life  insurance                                                                                                                                                   |       | 10,406                      |       | 10,201                          |       |
| Accrued interest  receivable and other assets                                                                                                                                |       | 14,536                      |       | 14,646                          |       |
| Total assets                                                                                                                                                                 |       | $                           | 564,440    |                            | $          | 580,620 |   |
|                                                                                                                                                                         |       |                        |       |                            |       |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY                                                                                                                                   |       |                        |       |                            |       |
|                                                                                                                                                                         |       |                        |       |                            |       |
| Deposits:                                                                                                                                                                    |       |                        |       |                            |       |
| Non-interest  bearing                                                                                                                                                        |       | $                           | 78,279     |                            | $          | 77,574 |   |
| Interest bearing                                                                                                                                                             |       | 418,913                     |       | 423,417                         |       |
| Total deposits                                                                                                                                                               |       | 497,192                     |       | 500,991                         |       |
|                                                                                                                                                                         |       |                        |       |                            |       |
| Notes payable                                                                                                                                                                |       | 5,017                       |       | 1,093                           |       |
| Junior  subordinated debentures                                                                                                                                              |       | 8,248                       |       | 16,496                          |       |
| Accrued interest  payable and other liabilities                                                                                                                              |       | 14,474                      |       | 11,066                          |       |
| Total  liabilities                                                                                                                                                           |       | 524,931                     |       | 529,646                         |       |
|                                                                                                                                                                         |       |                        |       |                            |       |
| Commitments and  contingencies                                                                                                                                               |       |                        |       |                            |       |
|                                                                                                                                                                         |       |                        |       |                            |       |
| Shareholders’  equity                                                                                                                                                   |       |                        |       |                            |       |
| Common stock -  no par value; 20,000,000 shares authorized; issued and outstanding -  6,678,661 shares at June 30, 2008 and 7,607,908 shares at  December 31, 2007 |       | 10,075                      |       | 10,910                          |       |
|                                                                                                                                                                         |       |                        |       |                            |       |
| Unallocated ESOP  shares 119,062 shares at June 30, 2008 and 126,590 shares at  December 31, 2007 (at cost)                                                        |       | (1,373                      | )          | (1,407                          | )          |
| Retained  Earnings                                                                                                                                                           |       | 30,812                      |       | 41,454                          |       |
| Accumulated  other comprehensive (loss) income, net                                                                                                                          |       | (5                          | )          | 17                              |       |
|                                                                                                                                                                         |       |                        |       |                            |       |
| Total  shareholders’ equity                                                                                                                                             |       | 39,509                      |       | 50,974                          |       |
| Total  liabilities and shareholders’ equity                                                                                                                             |       | $                           | 564,440    |                            | $          | 580,620 |   |

 

See Notes toUnaudited Condensed Consolidated Financial Statements

 

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**COMMUNITY VALLEY BANCORPCONSOLIDATED STATEMENTS OF INCOME (Unaudited)**(dollars in thousands,except per share data)

 
| ** **                                            | ** ** | **For the periods ended June 30,** | ** ** |
|-------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                            | ** ** | **Three Months**                                       | ** ** | **Six Months** | ** ** |
| ** **                                            | ** ** | **2008**                                                    | ** ** | **2007** | ** ** | **2008** | ** ** | **2007** | ** ** |
| Interest income:                                      |       |                                                        |       |   |   |   |   |   |   |
| Interest and  fees on loans                           |       | $                                                           | 8,956      |   | $ | 10,157 |   | $ | 17,901 |   | $ | 20,089 |   |
| Interest on  federal funds sold                       |       | 138                                                         |       | 702 |   | 452 |   | 1,296 |   |
| Interest on  deposits in banks                        |       | 71                                                          |       | 25 |   | 306 |   | 49 |   |
| Interest on  investment securities:                   |       |                                                        |       |   |   |   |   |   |   |
| Taxable                                               |       | 117                                                         |       | 60 |   | 218 |   | 109 |   |
| Exempt from  federal income tax                       |       | 16                                                          |       | 16 |   | 32 |   | 32 |   |
| Total interest  income                                |       | 9,298                                                       |       | 10,960 |   | 18,909 |   | 21,575 |   |
|                                                  |       |                                                        |       |   |   |   |   |   |   |
| Interest  expense:                                    |       |                                                        |       |   |   |   |   |   |   |
| Interest expense  on deposits                         |       | 2,424                                                       |       | 3,248 |   | 5,208 |   | 6,421 |   |
| Interest expense  on junior subordinated debentures   |       | 143                                                         |       | 187 |   | 280 |   | 372 |   |
| Interest expense  on notes payble                     |       | 15                                                          |       | 28 |   | 34 |   | 51 |   |
| Total interest  expense                               |       | 2,582                                                       |       | 3,463 |   | 5,522 |   | 6,844 |   |
| Net interest  income before provision for loan losses |       | 6,716                                                       |       | 7,497 |   | 13,387 |   | 14,731 |   |
| Provision for  loan losses                            |       | 450                                                         |       | — |   | 675 |   | 75 |   |
| Net interest  income after provision for loan losses  |       | 6,266                                                       |       | 7,497 |   | 12,712 |   | 14,656 |   |
|                                                  |       |                                                        |       |   |   |   |   |   |   |
| Non-interest  income                                  |       | 2,210                                                       |       | 1,973 |   | 4,170 |   | 3,687 |   |
|                                                  |       |                                                        |       |   |   |   |   |   |   |
| Non-interest expenses:                                |       |                                                        |       |   |   |   |   |   |   |
| Salaries and  employee benefits                       |       | 3,654                                                       |       | 3,934 |   | 7,351 |   | 7,952 |   |
| Occupancy                                             |       | 714                                                         |       | 454 |   | 1,389 |   | 942 |   |
| Furniture and  equipment                              |       | 651                                                         |       | 534 |   | 1,292 |   | 1,078 |   |
| Other expense                                         |       | 1,703                                                       |       | 1,735 |   | 3,682 |   | 3,390 |   |
| Total  non-interest expense                           |       | 6,722                                                       |       | 6,657 |   | 13,714 |   | 13,362 |   |
|                                                  |       |                                                        |       |   |   |   |   |   |   |
| Income before  provision for income taxes             |       | 1,754                                                       |       | 2,813 |   | 3,168 |   | 4,982 |   |
|                                                  |       |                                                        |       |   |   |   |   |   |   |
| Provision for  income taxes                           |       | 711                                                         |       | 1,171 |   | 1,300 |   | 2,089 |   |
|                                                  |       |                                                        |       |   |   |   |   |   |   |
| Net income                                            |       | $                                                           | 1,043      |   | $ | 1,642 |   | $ | 1,868 |   | $ | 2,892 |   |
|                                                  |       |                                                        |       |   |   |   |   |   |   |
| Basic earnings  per share                             |       | $                                                           | 0.15       |   | $ | 0.22 |   | $ | 0.26 |   | $ | 0.39 |   |
| Diluted earnings  per share                           |       | $                                                           | 0.15       |   | $ | 0.22 |   | $ | 0.25 |   | $ | 0.38 |   |
|                                                  |       |                                                        |       |   |   |   |   |   |   |
| Cash dividends  per share                             |       | $                                                           | 0.04       |   | $ | 0.08 |   | $ | 0.12 |   | $ | 0.16 |   |

 

SeeNotes to Unaudited Condensed Consolidated Financial Statements

 

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COMMUNITY VALLEYBANCORPCONDENSED CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY(Unaudited)(In thousands except share data)

 
| ** **                                                                            | ** ** | **Common Stock** | ** ** | **Unallocated** | ** ** | **Retained**               | ** ** | **Accumulated Other  Comprehensive  (Loss) Income,** | ** ** | **Total  Shareholders’** | ** ** | **Comprehensive** | ** ** |
|---------------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------|------------|----------------------------|------------|----------------------------------------------------------------|------------|-------------------------------|------------|-------------------|------------|
| ** **                                                                            | ** ** | **Shares**            | ** ** | **Amount**      | ** ** | ** ESOP shares** | ** ** | **Earnings**                                                   | ** ** | **net of taxes**    | ** ** | **Equity**        | ** ** | **Income** | ** ** |
| Balance,  January 1, 2007                                                        |       | 7,394,664             |       | $               | 9,727      |                       | $          | (1,514                                                         | )          | $                             | 37,505     |              | $          | 9 |   | $ | 45,727 |   |   |   |
| Comprehensive  income                                                                 |       |                  |       |            |       |                       |       |                                                           |       |                          |       |              |       |   |   |
| Net income                                                                            |       |                  |       |            |       |                       |       | 6,459                                                          |       |                          |       | 6,459             |       | 6,459 |   |
| Other  comprehensive income                                                           |       |                  |       |            |       |                       |       |                                                           |       |                          |       |              |       |   |   |
| Net change in  unrealized gains on available-for-sale investment securities           |       |                  |       |            |       |                       |       |                                                           |       | 8                             |       | 8                 |       | 8 |   |
| Total  comprehensive income                                                           |       |                  |       |            |       |                       |       |                                                           |       |                          |       |              |       | 6,467 |   |
|                                                                                  |       |                  |       |            |       |                       |       |                                                           |       |                          |       |              |       |   |   |
| Exercise of stock  options and related tax benefit                                    |       | 232,108               |       | 1,104           |       |                       |       |                                                           |       |                          |       | 1,104             |       |   |   |
| Amortization of  stock compensation – ESOP shares                                |       |                  |       | 65              |       | 107                        |       |                                                           |       |                          |       | 172               |       |   |   |
| Cash dividends-  $.32 per share                                                       |       |                  |       |            |       |                       |       | (2,425                                                         | )          |                          |       | (2,425            | )          |   |   |
| Stock based  compensation expense                                                     |       |                  |       | 139             |       |                       |       |                                                           |       |                          |       | 139               |       |   |   |
| Retirement of  common stock                                                           |       | (18,864               | )          | (125            | )          |                       |       | (85                                                            | )          |                          |       | (210              | )          |   |   |
|                                                                                  |       |                  |       |            |       |                       |       |                                                           |       |                          |       |              |       |   |   |
| Balance,  December 31, 2007                                                      |       | 7,607,908             |       | 10,910          |       | (1,407                     | )          | 41,454                                                         |       | 17                            |       | 50,974            |       |   |   |
|                                                                                  |       |                  |       |            |       |                       |       |                                                           |       |                          |       |              |       |   |   |
| Comprehensive  income                                                                 |       |                  |       |            |       |                       |       |                                                           |       |                          |       |              |       |   |   |
| Net income                                                                            |       |                  |       |            |       |                       |       | 1,868                                                          |       |                          |       | 1,868             |       | 1,868 |   |
| Other  comprehensive income                                                           |       |                  |       |            |       |                       |       |                                                           |       |                          |       |              |       |   |   |
|                                                                                  |       |                  |       |            |       |                       |       |                                                           |       |                          |       |              |       |   |   |
| Net change in  unrealized (losses) gains on available-for- sale investment securities |       |                  |       |            |       |                       |       |                                                           |       | (22                           | )          | (22               | )          | (22 | ) |
| Total  comprehensive income                                                           |       |                  |       |            |       |                       |       |                                                           |       |                          |       |              |       | 1,846 |   |
|                                                                                  |       |                  |       |            |       |                       |       |                                                           |       |                          |       |              |       |   |   |
| Exercise of stock  options and related tax benefit                                    |       | 82,759                |       | 564             |       |                       |       |                                                           |       |                          |       | 564               |       |   |   |
| Amortization of  stock compensation – ESOP shares                                |       |                  |       | 47              |       | 34                         |       |                                                           |       |                          |       | 81                |       |   |   |
| Cash dividends-  $.12 per share                                                       |       |                  |       |            |       |                       |       | (881                                                           | )          |                          |       | (881              | )          |   |   |
| Stock based  compensation expense                                                     |       |                  |       | 43              |       |                       |       |                                                           |       |                          |       | 43                |       |   |   |
| Retirement of  common stock                                                           |       | (1,012,006            | )          | (1,489          | )          |                       |       | (11,629                                                        | )          |                          |       | (13,118           | )          |   |   |
| Balance,  June 30, 2008                                                          |       | 6,678,661             |       | $               | 10,075     |                       | $          | (1,373                                                         | )          | $                             | 30,812     |              | $          | (5 | ) | $ | 39,509 |   |   |   |
|                                                                                       |            |                       |            |                 |            |                            |            |                                                                |            |                               |            |                   |            |  |  |  |  |  |  |  |  |

 

SeeNotes to Unaudited Condensed Consolidated Financial Statements

 

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COMMUNITYVALLEY BANCORPCONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS(Unaudited)(In thousands)

 
| ** **                                                                         | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| **(dollars in thousands)**                                               | ** ** | **2008**                                      | ** ** | **2007** | ** ** |
| Cash flows from  operating activities:                                             |       |                                          |       |   |   |
| Net income                                                                         |       | $                                             | 1,868      |   | $ | 2,892 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                          |       |   |   |
| Provision for  loan losses                                                         |       | 675                                           |       | 75 |   |
| Decrease in  deferred loan origination fees                                        |       | (138                                          | )          | (282 | ) |
| Depreciation and  amortization, net                                                |       | 1,099                                         |       | 978 |   |
| (Gain) loss on  disposition of Bank premises and equipment                         |       | (4                                            | )          | 27 |   |
| Net increase in  loans held for sale                                               |       | (566                                          | )          | (325 | ) |
| Increase in cash  surrender value of bank-owned life xinsurance, net               |       | (205                                          | )          | (191 | ) |
| Excess tax  benefit from exercise of stock options                                 |       | (162                                          | )          | (345 | ) |
| Non-cash  compensation expense associated with the ESOP                            |       | 81                                            |       | 109 |   |
| Stock based  compensation                                                          |       | 43                                            |       | 85 |   |
| Increase in  accrued interest receivable and other assets                          |       | 593                                           |       | (854 | ) |
| Increase in  accrued interest payable and other liabilities                        |       | 4,305                                         |       | 1,375 |   |
| Provision for  deferred income taxes                                               |       | (252                                          | )          | (1,032 | ) |
| Net cash  provided by operating activities                                         |       | 7,337                                         |       | 2,512 |   |
| Cash flows from  investing activities:                                             |       |                                          |       |   |   |
| Increase in  interest-bearing deposits in banks                                    |       | (594                                          | )          | (4,703 | ) |
| Proceeds from  matured or called available-for-sale investment securities          |       | 1,000                                         |       | 1,000 |   |
| Proceeds from  principal payments on available-for-sale investment securities      |       | 107                                           |       | 45 |   |
| Proceeds from  matured or called held-to-maturity investment securities            |       | 1,000                                         |       | — |   |
| Proceeds from  principal payments of held-to-maturity investment securities        |       | 170                                           |       | 112 |   |
| Purchase of  available-for-sale investment securities                              |       | (3,010                                        | )          | (1,000 | ) |
| Purchase of  held-to-maturity investment securities                                |       | (1,750                                        | )          | — |   |
| Purchases of  premises and equipment                                               |       | (506                                          | )          | (2,864 | ) |
| Proceeds from  sale of premises and equipment                                      |       | 9,700                                         |       | 16 |   |
| Net increase in  loans                                                             |       | (49,616                                       | )          | (10,878 | ) |
| Net cash used in  investing activities                                             |       | (43,499                                       | )          | (18,272 | ) |
| Cash flows from  financing activities:                                             |       |                                          |       |   |   |
| Net increase in  demand, interest-bearing and savings deposits                     |       | 6,079                                         |       | 38,860 |   |
| Net decrease in  time deposits                                                     |       | (9,878                                        | )          | (12,188 | ) |
| Proceeds from  note payable                                                        |       | 4,000                                         |       | — |   |
| Repayment of  ESOP note payable                                                    |       | (76                                           | )          | (58 | ) |
| Payment of cash  dividends                                                         |       | (1,223                                        | )          | (1,192 | ) |
| Excess tax  benefit from the exercise of stock options                             |       | 162                                           |       | 345 |   |
| Proceeds from  exercise of stock options                                           |       | 402                                           |       | 505 |   |
| Retirement of  common stock                                                        |       | (13,118                                       | )          | — |   |
| Repayment of  junior subordinated debentures                                       |       | (8,248                                        | )          | — |   |
| Net cash (used  in) provided by financing activities                               |       | (21,900                                       | )          | 26,272 |   |
|                                                                               |       |                                          |       |   |   |
| (Decrease)  increase in cash and cash equivalents                                  |       | (58,062                                       | )          | 10,512 |   |
|                                                                               |       |                                          |       |   |   |
| Cash and cash  equivalents at beginning of year                                    |       | 86,004                                        |       | 62,628 |   |
|                                                                               |       |                                          |       |   |   |
| Cash and cash  equivalents at end of period                                        |       | $                                             | 27,942     |   | $ | 73,140 |   |

 

SeeNotes to Unaudited Condensed Consolidated Financial Statements

 

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Community Valley Bancorp

 

NOTES TO UNAUDITEDCONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

**1. BASISOF PRESENTATION**

 

The accompanyingunaudited condensed consolidated financial statements of Community ValleyBancorp and subsidiaries (the “Company”) have been prepared pursuant to the rules andregulations of the Securities Exchange Commission (the “SEC”) and theinstructions to Form 10-Q and Article 10 of Regulation S-X.Accordingly, certain information and footnote disclosures required byaccounting principles generally accepted in the United States of America forannual 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 2006Annual Report to Shareholders on Form 10-K.

 

The condensedconsolidated financial statements include the accounts of the Company and itswholly owned subsidiaries, Butte Community Bank (the “Bank”) and BCB InsuranceAgency, LLC. All significant inter-company balances and transactions have beeneliminated in consolidation. The Company has also established 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 andsix-month periods ended June 30, 2008 may not necessarily be indicative ofthe operating results for the full year 2008.

 

Management has determinedthat because all of the commercial banking products and services offered by theCompany are available in each branch of the bank, all branches are locatedwithin the same economic environment and management does not allocate resourcesbased on the performance of different lending or transaction activities, it isappropriate to aggregate the Bank branches and report them as a singleoperating segment. No single customer accounts for more than 10% of therevenues of the Company or the Bank.

 

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

 

**2.EARNINGS PER SHARE COMPUTATION**

 

Basic earnings per shareare computed by dividing net income by the weighted average common sharesoutstanding for the period (7,028,451 and 7,223,965 shares for the three andsix month periods ended June 30, 2008 and 7,397,582 and 7,350,838 sharesfor the three month and six month periods ended June 30, 2007). Dilutedearnings per share reflect the potential dilution that could occur if outstandingstock options were exercised using the treasury stock method. Diluted earningsper share is computed by dividing net income by the weighted average commonshares outstanding for the period plus the dilutive effect of options (93,979and 109,191 shares for the three and six month periods ended June 30, 2008and 206,037 and 242,758 shares for the three and six month periods ended June 30,2007).  As of June 30, 2008, 153,330outstanding options were  “out of themoney”, that is the option price was higher than the market price so theseshares were not used in the calculation of earning per share as they areconsidered antidilutive.

 

**3.COMPREHENSIVE INCOME**

 

Comprehensive income isreported in addition to net income for all periods presented. Comprehensiveincome is made up of net income plus other comprehensive income or loss. TheCompany’s only source of comprehensive income or loss, is comprised of changesin unrealized 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.

 

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**4. STOCK–BASEDCOMPENSATION**

 

The Company issues stockoptions under two stock-based compensation plans, the Community Valley Bancorp1997 and 2000 Stock Option Plans. The plans require that the option price maynot be less than the fair market value of the stock at the date the option isgranted, and that the stock must be paid in full at the time the option isexercised. The options expire on a date determined by the Board of Directors,but not later than ten years from the date of grant. The vesting period isdetermined by the Board of Directors and is generally over five years; however,nonstatutory options granted during 1997 vested immediately. Under the 1997plan 22,474 shares of common stock remain reserved for issuance to employeesand directors, and the related options are exercisable until their expiration.However, no new options will be granted under these plans. Under the Company’s2000 stock option plan, 359,688 shares of common stock remain reserved forissuance to employees and directors, of which 85,877 shares are available forfuture grants.  No options were grantedduring the three and six month period ending June 30, 2008.

 

Stock option activity forthe interim 2008 period is summarized as follows (dollars in thousands):

 
| **2008**                                            | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Contractual  Term** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|-----------------------------------------------------|------------|------------|------------|--------------------------------------------|------------|------------------------------------------|------------|---------------------------------|------------|
| Outstanding  at January 1                      |       | 476,921    |       | $                                          | 7.76       |                                     | 4.1 years  |                            | $          | 1,617 |   |
| Exercised                                           |       | (82,759    | )          | $                                          | 4.86       |                                     |       |                            |       |   |
| Granted                                             |       | —     |       | $                                          | 0.00       |                                     |       |                            |       |   |
| Cancelled/Expired                                   |       | (12,000    | )          | $                                          | 12.38      |                                     |       |                            |       |   |
| Outstanding  at June 30                        |       | 382,162    |       | $                                          | 8.24       |                                     | 3.9 years  |                            | $          | 371 |   |
| Options  vested or expected to vest at June 30 |       | 374,519    |       | $                                          | 8.07       |                                     | 4.3 years  |                            | $          | 364 |   |
| Exercisable  at June 30                        |       | 176,426    |       | $                                          | 4.65       |                                     | 1.7 years  |                            | $          | 371 |   |

 

**5.COMMITMENTS AND CONTINGENCIES**

 

The Company is party toclaims and legal proceedings arising in the ordinary course of business. In theopinion of the Company’s management, the amount of ultimate liability withrespect to such proceedings will not have a material adverse effect on thefinancial condition or result of operations of the Company taken as a whole.

 

In the normal course ofbusiness, there are various outstanding commitments to extend credit which arenot reflected in the financial statements, including loan commitments of$167,000,000 and $184,000,000 and stand-by letters of credit of $6,300,000 and$6,700,000 at June 30, 2008 and December 31, 2007, respectively.

 

Of the loan commitmentsoutstanding at June 30, 2008, $78,300,000 are real estate constructionloan commitments that are expected to fund within the next twelve months. 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 or businessassets.

 

Stand-by letters ofcredit are conditional commitments written to guarantee the performance of acustomer to a third party. These guarantees are primarily related to thepurchases of inventory by commercial customers and are typically short-term innature. Credit risk is similar to that involved in extending loan commitmentsto customers and accordingly, evaluation and collateral requirements similar tothose for loan commitments are used. The fair value of the liability related tothese stand-by letters of credit, which represents the fees received forissuing the guarantees, was not significant at June 30, 2008 and December 31,2007. The Company recognizes these fees as revenues over the term of thecommitment or when the commitment is used.

 

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## **6. INCOME TAXES**

##  

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

 

                The Company accounts for incometaxes using the liability or balance sheet method. Under this method, deferredtax assets and liabilities are recognized for the tax consequences of temporarydifferences between the reported amounts of assets and liabilities and theirtax bases. Deferred tax assets and liabilities are adjusted for the effects ofchanges in tax laws and rates on the date of enactment. On the consolidatedbalance sheet, net deferred tax assets are included in accrued interestreceivable and other assets.

 

Accounting forUncertainty in Income Taxes

 

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 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 the benefits associated withtax positions taken that exceeds the amount measured as described above isreflected as a liability for unrecognized tax benefits in the accompanyingbalance sheet along with any associated interest and penalties that would bepayable to the taxing authorities upon examination.  The Company recognizes accrued interest andpenalties related to unrecognized tax benefits, if applicable, as a componentof interest expense in the consolidated statements of income.  There have been no significant changes to unrecognized tax benefits oraccrued interest and penalties for the three months ended June 30, 2008.

 

**7.  OTHER BORROWINGS**

 

On June 30, 2008 theCompany borrowed $4 million from one of its correspondent banks which was downstreamed to Butte Community Bank into the capital accounts.  This note is for a two year period with amaturity date of June 30, 2010 and an interest rate equal to the threemonth LIBOR rate plus 3.25% adjusted quarterly.   At the time the note was written the rate ofinterest was 5.97%.

 

## **8. FAIR VALUE MEASUREMENTS**

##  

On January 1, 2008,the Company adopted Financial Accounting Standards Board (FASB) Statement No. 157(SFAS 157),* Fair Value Measurements.* SFAS No. 157 defines fair value, establishes a framework formeasuring fair value under GAAP, and expands disclosures about fair valuemeasurement. Upon adoption of SFAS No. 157, there was no cumulative effectadjustment to beginning retained earnings and no impact on the financialstatements in the second quarter of 2008.

 

The following tablespresent information about the Company’s assets and liabilities measured at fairvalue on a recurring and non recurring basis as of June 30, 2008. They indicate the fair value hierarchy of the valuation techniques utilized bythe Company to determine such fair value. In general, fair values determined byLevel 1 inputs utilize quoted prices (unadjusted) in active markets foridentical assets or liabilities that the Company has the ability to access.

 

Fair values determined byLevel 2 inputs utilize inputs other than quoted prices included in Level 1 thatare observable for the asset or liability, either directly or indirectly. Level2 inputs include quoted prices for similar assets and liabilities in activemarkets, and inputs other than quoted prices that are observable for the assetor liability, such as interest rates and yield curves that are observable atcommonly quoted intervals. Level 3 inputs are unobservable inputs for the assetor liability, and include situations where there is little, if any, marketactivity for the asset or liability. In certain cases, the inputs used tomeasure fair value may fall into different levels of the fair value hierarchy.In such cases, the level in the fair value hierarchy within which the fairvalue measurement in its entirety falls has been determined based on the lowestlevel input that is significant to the fair value measurement in its entirety.The Company’s assessment of the significance of a particular input to the fairvalue measurement in its entirety requires judgment, and considers factorsspecific to the asset or liability.

 

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Assets and liabilitiesmeasured at fair value on a recurring basis are summarized below:

 
| ** **                                                     | ** ** | ** **                                   | ** ** | **Fair Value Measurements  at June 30, 2008, Using**                  | ** ** |
|----------------------------------------------------------------|------------|----------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|
| **Description**                                                | ** ** | **Fair Value  June 30, 2008** | ** ** | **Quoted Prices in  Active Markets for  Identical Assets  (Level 1)** | ** ** | **Other  Observable  Inputs  (Level 2)** | ** ** | **Significant  Unobservable  Inputs  (Level 3)** | ** ** |
|                                                           |       |                                         |       |                                                                                                |       |   |   |   |   |
| Available-for-sale  securities                                 |       | $                                            | 6,535      |                                                                                                | 6,535      |   |   |   |   |   |
| Mortgage  Servicing Rights                                     |       | 37                                           |       |                                                                                                |       | 37 |   |   |   |
|                                                           |       |                                         |       |                                                                                                |       |   |   |   |   |
| Total assets  measured at fair value on a recurring basis      |       | $                                            | 6,572      |                                                                                                | $          | 6,535 |   | $ | 37 |   | $ | — |   |
|                                                           |       |                                         |       |                                                                                                |       |   |   |   |   |
|                                                           |       |                                         |       |                                                                                                |       |   |   |   |   |
| Junior  subordinated debentures, at fair value                 |       | $                                            | 8,248      |                                                                                                |       |   | $ | 8,248 |   |   |   |
|                                                           |       |                                         |       |                                                                                                |       |   |   |   |   |
| Total  liabilities measured at fair value on a recurring basis |       | $                                            | 8,248      |                                                                                                | $          | — |   | $ | 8,248 |   | $ | — |   |

 

Thefollowing methods were used to estimate the fair value of each class offinancial instrument above:

***Securities***- Fair values for investment securities arebased on quoted market prices.

***Mortgage Servicing Rights —***The fair value of mortgage servicing rightsis estimated using a discounted cash flow model.

***Junior Subordinated Debentures***—The fair value of junior subordinateddebentures is estimated using a discounted cash flow model.

 

Assets measured at fairvalue on a non recurring basis are summarized below:

 
| ** **                                                    | ** ** | **Fair Value Measurements  at June 30, 2008, Using** | ** ** |
|---------------------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|
| **Description**                                               | ** ** | **Fair Value  June 30, 2008**                                       | ** ** | **Quoted Prices in  Active Markets for  Identical Assets  (Level 1)** | ** ** | **Other  Observable  Inputs  (Level 2)** | ** ** | **Significant  Unobservable  Inputs  (Level 3)** | ** ** |
|                                                          |       |                                                                               |       |   |   |   |   |   |   |
| Impaired loans                                                |       | $                                                                                  | 986        |   |   |   | $ | 986 |   |   |   |
|                                                          |       |                                                                               |       |   |   |   |   |   |   |
| Total assets  measured at fair value on a non recurring basis |       | $                                                                                  | 986        |   |   |   | $ | 986 |   |   |   |

 

The following methodswere used to estimate the fair value of each class of financial instrumentabove:

 

***Impaired Loans***—The fair value of impaired loans is based onthe fair value of the collateral for all collateral dependent loans and forother impaired loans is estimated using a discounted cash flow model.

 

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

 

The following isCommunity Valley Bancorp’s (the “Company”) management’s discussion and analysisof the significant changes in balance sheet accounts for June 30, 2008 andDecember 31, 2007 and income and expense accounts for the three and sixmonth periods ended June 30, 2008 and 2007. The discussion is designed toprovide a better understanding of significant trends related to the Company’sfinancial condition, results of operations, liquidity, capital resources andinterest rate sensitivity.

 

In addition to thehistorical information contained herein, this report on Form 10-Q containscertain forward-looking statements. The reader of this report should understandthat all such forward-looking statements are subject to various uncertaintiesand risks that could affect their outcome. The Company’s actual results coulddiffer materially from those suggested by such forward-looking statements.Factors that could cause or contribute to such differences include, but are notlimited to, variances in the actual versus projected growth in assets, returnon assets, loan losses, expenses, rates charged on loans and earned onsecurities investments, rates paid on deposits, competition effects, fee andother noninterest income earned, general economic conditions, nationally,regionally and in the operating market areas of the Company and itssubsidiaries, changes in the regulatory environment, changes in businessconditions and inflation, changes in securities markets, data processingproblems, a decline in real estate values in the Company’s market area, the effects of terrorism, including the events of September 11, 2001 andthereafter, and the conduct of the war on terrorism by the United States andits allies, as well as other factors. This entire report should be read puttingsuch forward-looking statements in context.

 

**GeneralDevelopment of Business**

 

The Company is afinancial holding company (“FHC”) registered and authorized to engage in theactivities permitted under the Bank Holding Company Act of 1956, as amended.The Company was incorporated under the laws of the State of California in 2002and elected to change to a FHC in 2004. As a financial holding company, theCompany is subject to the Federal Holding Company Act and to supervision by theboard of Governors of the Federal Reserve System (“FRB”). Its principal officeis located at 1360 E. Lassen Avenue, Chico, California 95973 and its telephonenumber is (530) 899-2344.

 

The Company owns 100% ofthe issued and outstanding common shares of Butte Community Bank (the “Bank”).The Bank was incorporated and commenced business in Paradise and Oroville,California in 1990. The Bank operates thirteen full service offices within itsservice areas of Butte, Sutter, Yuba, Tehama, Shasta, and Colusa Counties. TheBank also maintains Loan Production Offices in Citrus Heights and Gridley.Butte Community Bank’s primary business is serving the commercial banking needsof small to mid-sized businesses and consumers within those counties. ButteCommunity Bank accepts checking and savings deposits, offers money marketdeposit accounts and certificates of deposit, makes secured and unsecuredcommercial, secured real estate, and other installment and term loans andoffers other customary banking services.

 

On December 1, 2004,the Company formed a wholly-owned subsidiary, CVB Insurance Agency LLC for thepurpose of providing insurance related services.  The name was subsequently changed to ButteCommunity Insurance Agency LLC in April 2006.

 

In July 2007, the Company formed a wholly-ownedunconsolidated subsidiary, Community Valley Bancorp Trust II (the “Trust”), aDelaware statutory business trust, for the purpose of issuing trust preferredsecurities.  Community Valley BancorpTrust I was dissolved in January 2008 when the Trust I securities wereredeemed.

 

**CriticalAccounting Policies**

 

*General*

 

The Company’s significant accounting principles aredescribed in Note 1 of the consolidated financial statements in the Company’s2007 Annual Report to Shareholders on Form 10-K and are essential tounderstanding Management’s Discussion and Analysis of Results of Operations andFinancial Condition. Community Valley Bancorp’s annual consolidated financialstatements are prepared in accordance with accounting principles generallyaccepted in the United States of America (GAAP). The financial informationcontained within our statements is, to a significant extent, financialinformation that is based on measures of the financial effects of transactionsand events that have already occurred. Some of the Company’s accountingprinciples require significant judgment to estimate values of assets orliabilities. In addition, certain accounting principles require significantjudgment in applying the complex accounting principles to transactions todetermine the most appropriate treatment. The following is a summary of themore judgmental and complex accounting estimates and principles.

 

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*Allowance for Loan Losses (ALL)*

 

The allowance for loan losses is management’s bestestimate of the probable losses that may be sustained in our loan portfolio.The allowance is based on two basic principles of accounting:  (1) SFASNo.5 which requires that losses be accrued when they are probable of occurringand estimable and (2) SFAS No. 114, which requires that losses beaccrued on impaired loans based on the differences between the value ofcollateral, present value of future cash flows or values that are observable inthe secondary market and the loan balance.

 

The Company performs periodic and systematic detailedevaluations of its lending portfolio to identify and estimate the inherentrisks and assess the overall collectability. These evaluations include generalconditions such as the portfolio composition, size and maturities of varioussegmented portions of the portfolio such as secured, unsecured, construction,and Small Business Administration (“SBA”).

 

Additional factors include concentrations ofborrowers, industries, geographical sectors, loan product, loan classes andcollateral types, volume and trends of loan delinquencies and non-accrual,criticized and classified assets and trends in the aggregate in significantcredits identified as watch list items. There are several components to thedetermination of the adequacy of the ALL. Each of these components isdetermined based upon estimates that can and do change when the actual eventsoccur. The Company estimates the SFAS No. 5 portion of the ALL based onthe segmentation of its portfolio. For those segments that require an ALL, theCompany estimates loan losses on a monthly basis based upon its ongoing loanreview process and analysis of loan performance. The Company follows asystematic and consistently applied approach to select the most appropriate lossmeasurement methods and support its conclusions and rationale with writtendocumentation. One method of estimating loan losses for groups of loans isthrough the application of loss rates to the groups’ aggregate loan balances.Such rates typically reflect historical loss experience for each group ofloans, adjusted for relevant economic factors over a defined period of time.The Company evaluates and modifies its loss estimation model as needed toensure that the resulting loss estimate is consistent with GAAP.

 

For individually impaired loans, SFAS No. 114provides guidance on the acceptable methods to measure impairment.Specifically, SFAS No. 114 states that when a loan is impaired, theCompany should measure 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, a creditor 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*

 

The Company originates government guaranteed loans andmortgage loans that may be sold in the secondary market.  The amounts ofgains recorded on sales of loans and the initial recording of servicing assetsand interest only (I/O) strips is based on the estimated fair values of therespective components.  In recording the initial value of the servicingassets and the fair value of the I/O strips receivable, the Company usesestimates which are based on management’s expectations of future prepaymentsand discount rates.  Servicing assets are amortized over the estimatedlife of the related loan.  I/O strips are not significant at June 30,2008.  These prepayment and discount rates were based on current marketconditions and historical performance of the various pools of servicedloans.  If actual prepayments with respect to sold loans occur morequickly than projected the carrying value of the servicing assets may have tobe adjusted through a charge to earnings.

 

*Stock-Based Compensation*

 

TheCompany recognizes compensation expense in an amount equal to the fair value ofthe share-based payments such as stock options granted to employees.  The Company records compensation expense (asprevious awards continue to vest) for the unvested portion of previouslygranted awards that were outstanding on January 1, 2006 and for all awardsgranted after that date as they vest. The estimates of the grant date fair values are based on an optionpricing model that uses assumptions based on the expected option life, thelevel of estimated forfeitures, expected stock volatility and the risk-freeinterest rate. The calculation of the fair value of share based payments is bynature inexact, and represents management’s best estimate of the grant datefair value of the share based payments. See Note 4 to the Unaudited CondensedConsolidated Financial Statements for additional information related tostock-based compensation.

 

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*Revenue recognition*

 

The Company’s primary source of revenue is interestincome, which is the difference between the interest income it receives oninterest-earning assets and the interest expense it pays on interest-bearingliabilities, and (ii) fee income, which includes fees earned on depositservices, income from SBA lending, electronic-based cash management services,mortgage brokerage fee income and merchant credit card processingservices.  Interest income is recorded onan accrual basis. Note 1 to the Consolidated Financial Statements in theCompany’s 2007 Annual Report to Shareholders on Form 10-K offers anexplanation of the process for determining when the accrual of interest incomeis discontinued on an impaired loan.

 

*Income Taxes*

 

The Company accounts for income taxes under theasset and liability method. Under the asset and liability method, deferred taxassets and liabilities are recognized for the future tax consequencesattributable to differences between the financial statement carrying amounts ofexisting assets and liabilities and their respective tax bases. Deferred taxassets and liabilities are measured using currently enacted tax rates appliedto such taxable income in the years in which those temporary differences areexpected to be recovered or settled. The effect on deferred tax assets andliabilities of a change in tax rates is recognized in income in the period thatincludes the enactment date. If future income should prove non-existent or lessthan the amount of deferred tax assets within the tax years to which they maybe applied, the asset may not be realized and our net income will be reduced.

 

                The provisions of FinancialAccounting Standards Board (FASB) Interpretation No. 48, *Accounting for Uncertainty in Income Taxes*(FIN 48) have been applied to all tax positions of the Company as of January 1,2007.  FIN 48 prescribes a recognitionthreshold and measurement standard for the financial statement recognition andmeasurement of an income tax position taken or expected to be taken in a taxreturn.    Only tax positions that metthe more-likely-than-not recognition threshold on January 1, 2007 wererecognized or continue to be recognized upon adoption.

 

                The benefit of a tax position isrecognized in the financial statements in the period during which, based on allavailable evidence, management believes it is more likely than not that theposition will be sustained upon examination, including the resolution ofappeals or litigation processes, if any.  Tax positions taken are notoffset or aggregated with other positions. Tax positions that meet the more-likely-than-not recognition thresholdare measured as the largest amount of tax benefit that is more than 50 percentlikely of being realized upon settlement with the applicable taxingauthority.  The portion of the benefitsassociated with tax positions taken that exceeds the amount measured asdescribed 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.  Interest expense and penalties associatedwith unrecognized tax benefits are classified as income tax expense in theconsolidated statement of income.

 

*FairValue*

 

Effective January 1,2008, the Company adopted SFAS No. 157,*Fair Value Measurements,* which among other things, requires enhanceddisclosures about financial instruments carried at fair value. SFAS No. 157establishes a hierarchical disclosure framework associated with the level ofobservable pricing scenarios utilized in measuring financial instruments atfair value. The degree of judgment utilized in measuring the fair value offinancial instruments generally correlates to the level of the observablepricing scenario. Financial instruments with readily available active quotedprices or for which fair value can be measured from actively quoted pricesgenerally will have a higher degree of observable pricing and a lesser degreeof judgment utilized in measuring fair value. Conversely, financial instrumentsrarely traded or not quoted will generally have little or no observable pricingand a higher degree of judgment utilized in measuring fair value. Observablepricing scenarios are impacted by a number of factors, including the type offinancial instrument, whether the financial instrument is new to the market andnot yet established and the characteristics specific to the transaction.

 

**Overview**

 

The Company recorded net incomeof $1,043,000 for the quarter ended June 30, 2008, which was a 36.4%decrease from the $1,642,000 reported for the same period of 2007. Dilutedearnings per share for the second quarter of 2008 were $0.15, compared to the$0.22 recorded in the second quarter of 2007. The annualized return on averageequity (ROAE) and annualized return on average assets (ROAA) for the secondquarter of 2008 were 9.44% and .74%, respectively, as compared to 13.70% and1.15%, respectively, for the same period in 2007. The primary reasons for thedecrease in net income for the quarter ended June 30, 2008 were acompression of the net interest margin of 63 basis points as yields on earningassets decreased 133 basis points while rates paid on interest bearingliabilities decreased 79 basis points. This was partially 

 

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mitigated by the change in the mix of earning assets as average loansincreased and average federal funds sold decreased. Also contributing to thedecrease in net income was the slowdown in the real estate constructionmarket.  For the quarter ended June 30,2008 the provision for loan losses was $450,000 compared with no provision inthe second quarter of 2007.  Thesedecreases were partially offset by increases in services charges on depositaccounts and other non-interest income.

 

Net income for the sixmonths ended June 30, 2008 was $1,868,000 which was a decrease of 35.4%from the $2,892,000 reported for the same period of 2007. Diluted earnings pershare for the six months ended June 30, 2008 were $0.25, compared to the$0.38 recorded for the same period 2007. The ROAE and ROAA for the six monthsended 2008 were 7.71% and .66%, respectively, as compared to 12.41% and 1.03%,respectively, for the same period in 2007. The primary reasons for the decreasein net income for the six month period is generally consistent with thediscussion above for the second quarter as the net interest margin decreased 63basis points from June 30, 2007. The loan loss provision for the six month period ending June 30,2008 was $675,000 compared to $75,000 for the six month period ending June 30,2007.

 

Total assets of theCompany decreased by $16,180,000, 2.8% from $580,620,000 at December 31,2007 to $564,440,000 at June 30, 2008. Net loans were $489,504,000, anincrease of $48,154,000, 10.9% from the December 31, 2007 balance of$441,350,000. Deposit balances at June 30, 2008 decreased to $497,192,000down $3,799,000, .76% from the December 31, 2007 balance of $500,991,000.

 

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

 

**Table One:  Components of Net Income**

** **
| ** **                                                       | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|------------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| **(In thousands, except percentages)**            | ** ** | **2008**                                        | ** ** | **2007**                                      | ** ** | **2008** | ** ** | **2007** | ** ** |
| Net interest  income                                             |       | $                                               | 6,716      |                                          | $          | 7,497 |   | $ | 13,387 |   | $ | 14,731 |   |
| Provision for  loan losses                                       |       | (450                                            | )          | —                                        |       | (675 | ) | (75 | ) |
| Non-interest  income                                             |       | 2,210                                           |       | 1,973                                         |       | 4,170 |   | 3,687 |   |
| Non-interest  expense                                            |       | (6,722                                          | )          | (6,657                                        | )          | (13,714 | ) | (13,362 | ) |
| Provision for  income taxes                                      |       | (711                                            | )          | (1,171                                        | )          | (1,300 | ) | (2,089 | ) |
| Net income                                                       |       | $                                               | 1,043      |                                          | $          | 1,642 |   | $ | 1,868 |   | $ | 2,892 |   |
|                                                             |       |                                            |       |                                          |       |   |   |   |   |
| Average total  assets (In millions)                              |       | $                                               | 565.4      |                                          | $          | 570.6 |   | $ | 569.8 |   | $ | 566.8 |   |
| Net income  (annualized) as a percentage of average total assets |       | 0.74                                            | %          | 1.15                                          | %          | 0.66 | % | 1.02 | % |

 

**Resultsof Operations**

 

**NetInterest Income and Net Interest Margin**

 

Net interest incomerepresents the excess of interest and fees earned on interest earning assets(loans, securities, federal funds sold and investments in time deposits) overthe interest paid on deposits and borrowed funds.  Net interest margin isnet interest income expressed as a percentage of average earning assets.

 

The Company’s net interest margin was 5.22% for thethree months ended June 30, 2008 and 5.19% for the six month period endingJune 30, 2008 compared to 5.85% and 5.82% for the same periods in theprior year.  Net interest incomedecreased $781,000 (10.4%) for the second quarter of 2008 compared to the sameperiod in 2007.  Net interest income decreased $1,344,000 (9.1%) for thesix months ended June 30, 2008 over the same period in 2007. The primaryreason for this decrease was the compression of the net interest margin as aresult of 325 basis point decreases by the Federal Reserve Board since September 2007and because the repricing of our interest bearing liabilities tends to lag  behind our interest bearing assets.

 

Table Two, Analysis ofNet Interest Margin, sets forth the average daily balances for the major assetand liability categories, the related income or expense where applicable, andthe resultant yield or cost attributable to the average earning assets andinterest-bearing liabilities.  Changes inthe average balances and the rates received or paid depend on marketopportunities, how well the Company has managed interest rate risks, productpricing policy, product mix, and external trends and developments.

 

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Table Three, Analysis ofVolume and Rate changes on Net Interest Income, analyzes the changes in netinterest income for the three and six month periods ended June 30, 2008compared to June 30, 2007 that are reported in Table Two.  The analysis shows the impact of volume andrate changes on the major categories of assets and liabilities between theseperiods.  The table explains what portionof the difference or variance in interest income or expense between theseperiods for each major category of assets or liabilities is due to changes inthe balances (volume) or to changes in rates.

 

For example, Table Twoshows that interest income from loans for the three months ended June 30,2008 decreased by $1,201,000 from $10,157,000 at June 30, 2007 to$8,956,000.  The average balance of loansincreased from $452,899,000 to $477,500,000 and the interest rate earneddecreased from 9.00% to 7.54%.  TableThree shows the $1,201,000 decrease in interest income from loans was actuallythe result of a $550,000 increase in interest income from the higher balance ofloans and a $1,751,000 decrease in interest income from the decrease in yieldsearned in the second quarter of 2008 compared to the same period in 2007.

 

A shift in the relativesize of the major balance sheet categories has an impact on net interest incomeand net interest margin.  For example, tothe extent that funds received from maturing or sold securities can berepositioned into loans instead of re-invested in securities, earnings increasebecause of the higher yields received on loans. However, changing the asset mix in this way comes at the price ofadditional risks that must 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.

 

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**TableTwo:  Analysis of Net Interest Margin**

 
| **Three Months Ended June 30,**                              | ** ** | **2008**             | ** ** | **2007**     | ** ** |
|----------------------------------------------------------------------------------|------------|----------------------|------------|--------------|------------|
| **(In thousands, except percentages)**                            | ** ** | **Avg Balance** | ** ** | **Interest** | ** ** | **Avg Yield (4)** | ** ** | **Avg Balance** | ** ** | **Interest** | ** ** | **Avg Yield (4)** | ** ** |
| Assets:                                                                          |       |                 |       |         |       |   |   |   |   |   |   |   |   |
| Earning assets                                                                   |       |                 |       |         |       |   |   |   |   |   |   |   |   |
| Loans (1)                                                                        |       | $                    | 477,500    |         | $          | 8,956 |   | 7.54 | % | $ | 452,899 |   | $ | 10,157 |   | 9.00 | % |
| Taxable  investment securities                                                   |       | 7,494                |       | 117          |       | 6.30 | % | 3,636 |   | 60 |   | 6.62 | % |
| Tax-exempt investment  securities (2)                                            |       | 1,412                |       | 16           |       | 4.66 | % | 1,390 |   | 16 |   | 4.62 | % |
| Federal funds  sold & other                                             |       | 26,027               |       | 138          |       | 2.13 | % | 54,505 |   | 702 |   | 5.17 | % |
| Interest bearing  deposits in banks                                              |       | 5,515                |       | 71           |       | 5.18 | % | 1,844 |   | 25 |   | 5.44 | % |
| Total earning  assets                                                            |       | 517,948              |       | 9,298        |       | 7.22 | % | 514,274 |   | 10,960 |   | 8.55 | % |
| Cash &  due from banks                                                  |       | 18,367               |       |         |       |   |   | 17,146 |   |   |   |   |   |
| Other assets                                                                     |       | 29,087               |       |         |       |   |   | 39,216 |   |   |   |   |   |
| Average total  assets                                                            |       | $                    | 565,402    |         |       |   |   |   | $ | 570,636 |   |   |   |   |   |
|                                                                             |       |                 |       |         |       |   |   |   |   |   |   |   |   |
| Liabilities &  Shareholders’ Equity  Interest bearing liabilities: |       |                 |       |         |       |   |   |   |   |   |   |   |   |
| NOW &  MMDA                                                             |       | $                    | 151,726    |         | $          | 289 |   | 0.77 | % | $ | 148,344 |   | $ | 385 |   | 1.04 | % |
| Savings                                                                          |       | 118,338              |       | 522          |       | 1.77 | % | 118,516 |   | 968 |   | 3.28 | % |
| Time deposits                                                                    |       | 152,529              |       | 1,613        |       | 4.25 | % | 159,048 |   | 1,895 |   | 4.78 | % |
| Other borrowings                                                                 |       | 9,328                |       | 158          |       | 6.80 | % | 9,407 |   | 215 |   | 9.17 | % |
| Total interest  bearing liabilities                                              |       | 431,921              |       | 2,582        |       | 2.40 | % | 435,315 |   | 3,463 |   | 3.19 | % |
| Demand deposits                                                                  |       | 73,683               |       |         |       |   |   | 77,241 |   |   |   |   |   |
| Other  liabilities                                                               |       | 15,334               |       |         |       |   |   | 10,006 |   |   |   |   |   |
| Total  liabilities                                                               |       | 520,938              |       |         |       |   |   | 522,562 |   |   |   |   |   |
| Shareholders’  equity                                                       |       | 44,464               |       |         |       |   |   | 48,074 |   |   |   |   |   |
| Average  liabilities and equity                                                  |       | $                    | 565,402    |         |       |   |   |   | $ | 570,636 |   |   |   |   |   |
| Net interest  income & margin (3)                                       |       |                 |       | $            | 6,716      |   | 5.22 | % |   |   | $ | 7,497 |   | 5.85 | % |

 

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(1)        Loan interest includesloan fees of $440,000 and $494,000 during the quarters ended June 30, 2008and June 30, 2007, respectively.

 

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

 

(3)   Net interest margin iscomputed by dividing net interest income by total average earning assets.

 

(4)   Average yield is calculatedbased on actual days in quarter (91 for June 30, 2008 and June 30,2007) and annualized to actual days in year (366 for 2008 and 365 for 2007).

 

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| **Six months ended June 30,**                               | ** ** | **2008**             | ** ** | **2007**     | ** ** |
|---------------------------------------------------------------------------------|------------|----------------------|------------|--------------|------------|
| **(In thousands, except percentages)**                           | ** ** | **Avg Balance** | ** ** | **Interest** | ** ** | **Avg Yield**** (4)** | ** ** | **Avg Balance** | ** ** | **Interest** | ** ** | **Avg Yield**** (4)** | ** ** |
| Assets:                                                                         |       |                 |       |         |       |   |   |   |   |   |   |   |   |
| Earning assets                                                             |       |                 |       |         |       |   |   |   |   |   |   |   |   |
| Loans (1)                                                                       |       | $                    | 463,743    |         | $          | 17,901 |   | 7.76 | % | $ | 453,057 |   | $ | 20,089 |   | 8.94 | % |
| Taxable  investment securities                                                  |       | 6,884                |       | 218          |       | 6.38 | % | 3,714 |   | 109 |   | 5.93 | % |
| Tax-exempt  investment securities                                               |       | 1,397                |       | 32           |       | 4.66 | % | 1,389 |   | 32 |   | 4.70 | % |
| Federal funds  sold & other                                            |       | 34,519               |       | 452          |       | 2.63 | % | 50,180 |   | 1,296 |   | 5.21 | % |
| Interest bearing  deposits in banks                                             |       | 12,454               |       | 306          |       | 4.94 | % | 1,927 |   | 49 |   | 5.13 | % |
| Total earning  assets                                                           |       | 518,997              |       | 18,909       |       | 7.33 | % | 510,267 |   | 21,575 |   | 8.53 | % |
| Cash &  due from banks                                                 |       | 16,311               |       |         |       |   |   | 17,408 |   |   |   |   |   |
| Other assets                                                                    |       | 34,508               |       |         |       |   |   | 39,094 |   |   |   |   |   |
| Average total  assets                                                           |       | $                    | 569,816    |         |       |   |   |   | $ | 566,770 |   |   |   |   |   |
| Liabilities &  Shareholders’ Equity Interest bearing liabilities: |       |                 |       |         |       |   |   |   |   |   |   |   |   |
| NOW &  MMDA                                                            |       | $                    | 150,861    |         | $          | 624 |   | 0.83 | % | $ | 150,661 |   | $ | 794 |   | 1.06 | % |
| Savings                                                                         |       | 116,563              |       | 1,125        |       | 1.94 | % | 111,141 |   | 1,815 |   | 3.29 | % |
| Time deposits                                                                   |       | 155,354              |       | 3,459        |       | 4.48 | % | 161,459 |   | 3,812 |   | 4.76 | % |
| Other borrowings                                                                |       | 9,597                |       | 314          |       | 6.58 | % | 9,435 |   | 423 |   | 9.05 | % |
| Total interest  bearing liabilities                                             |       | 432,375              |       | 5,522        |       | 2.57 | % | 432,696 |   | 6,844 |   | 3.19 | % |
| Demand deposits                                                                 |       | 74,818               |       |         |       |   |   | 76,956 |   |   |   |   |   |
| Other  liabilities                                                              |       | 13,909               |       |         |       |   |   | 9,500 |   |   |   |   |   |
| Total  liabilities                                                              |       | 521,102              |       |         |       |   |   | 519,152 |   |   |   |   |   |
| Shareholders’  equity                                                      |       | 48,714               |       |         |       |   |   | 47,617 |   |   |   |   |   |
| Average  liabilities and equity                                                 |       | $                    | 569,816    |         |       |   |   |   | $ | 566,770 |   |   |   |   |   |
| Net interest  income & margin  (3)                                     |       |                 |       | $            | 13,387     |   | 5.19 | % |   |   | $ | 14,731 |   | 5.82 | % |

 

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(1)   Loan interest includes loan feesof $968,000 and $1,037,000 during the six months ended June 30, 2008 and June 30,2007, respectively.

 

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

 

(3)   Net interest margin iscomputed by dividing net intereest income by total average earning assets.

 

(4)   Average yield is calculatedbased on actual days in period (182 for June 30, 2008 and 181 for June 30,2007) and annualized to actual days in year (366 for 2008 and 365 for 2007).

 

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Table Three sets forth asummary of the changes in interest income and interest expense from changes inaverage asset and liability balances (volume) and changes in average interestrates.  On a quarter over quarter basis for the period ending June 30,2008 net interest income has decreased $781,000 from the total at June 30,2007.  Interest income from earning assets has decreased by $1,662,000.Changes in the volume of earning assets, primarily loans, have resulted in anincrease in interest income of $297,000 while interest income from changes inrates has decreased by $1,959,000.  Interest expense for the secondquarter of 2008 was $881,000 less than the same period in 2007.  Changes in the volume of interest bearingliabilities, primarily the decrease in balances of certificates of deposit, hasresulted in a net decrease of interest expense of $72,000.  Decreases in average rates paid, on alldeposit products have resulted in an interest expense decrease of $809,000.

 

On a year-to-date basisthrough June 30, 2008, net interest income has decreased $1,344,000 fromthe total at June 30, 2007. Interest income from earning assets has decreased by $2,666,000.  Changes in the volume of earning assets,primarily loans, federal funds sold and certificates of deposits in banks haveresulted in an increase in interest income of $482,000 while interest incomefrom changes in rates has decreased by $3,099,000. Interest expense for the sixmonth period ending June 30, 2008 was $1,323,000 less than the total at June 30,2007.  Changes in the volume of interestbearing liabilities, primarily the increase in balances of savings and thedecrease in time deposits, have resulted in a net decrease of interest expenseof $48,000.  Decreases in average ratespaid on all deposit products have resulted in an interest expense decrease of$1,275,000.

 

**TableThree:  Analysis of Volume and Rate Changes on Net Interest Income andExpenses**

 
| **Three Months Ended June 30, 2008 over 2007  (In thousands)** | ** ** | **Volume** | ** ** | **Rate ****(3)** | ** ** | **Net Change** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|------------|------------|-----------------------|------------|---------------------|------------|
| Increase (decrease) due to change in:                                                                  |       |       |       |                  |       |                |       |
| Interest-earning assets:                                                                          |       |       |       |                  |       |                |       |
| Net loans (1)                                                                                          |       | 550        |       | (1,751                | )          | (1,201              | )          |
| Taxable  investment securities                                                                         |       | 63         |       | (6                    | )          | 57                  |       |
| Tax exempt  investment securities (2)                                                                  |       | 0          |       | 0                     |       | 0                   |       |
| Federal funds  sold                                                                                    |       | (366       | )          | (198                  | )          | (564                | )          |
| Interest bearing  deposits in banks                                                                    |       | 50         |       | (4                    | )          | 46                  |       |
| Total                                                                                                  |       | 297        |       | (1,959                | )          | (1,662              | )          |
| Interest-bearing  liabilities:                                                                         |       |       |       |                  |       |                |       |
| NOW and MMDA  deposits                                                                                 |       | 8          |       | (104                  | )          | (96                 | )          |
| Savings deposits                                                                                       |       | (1         | )          | (445                  | )          | (446                | )          |
| Time deposits                                                                                          |       | (77        | )          | (205                  | )          | (282                | )          |
| Other borrowings                                                                                       |       | (2         | )          | (55                   | )          | (57                 | )          |
| Total                                                                                                  |       | (72        | )          | (809                  | )          | (881                | )          |
| Interest  differential                                                                                 |       | 369        |       | (1,150                | )          | (781                | )          |

 
| **Six Months Ended June 30, 2008 over 2007  (In thousands)** | ** ** | **Volume** | ** ** | **Rate (3)** | ** ** | **Net Change** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|------------|------------|-------------------|------------|---------------------|------------|
| Increase  (decrease) due to change in:                                                               |       |       |       |              |       |                |       |
| Interest-earning  assets:                                                                            |       |       |       |              |       |                |       |
| Net loans (1)                                                                                        |       | $          | 475        |              | $          | (2,663              | )          | $ | (2,188 | ) |
| Taxable  investment securities                                                                       |       | 94         |       | 16                |       | 109                 |       |
| Tax exempt  investment securities (2)                                                                |       | 0          |       | —            |       | —              |       |
| Federal funds  sold                                                                                  |       | (406       | )          | (439              | )          | (844                | )          |
| Interest bearing  deposits in banks                                                                  |       | 269        |       | (12               | )          | 257                 |       |
| Total                                                                                                |       | 432        |       | (3,098            | )          | (2,666              | )          |
| Interest-bearing  liabilities:                                                                       |       |       |       |              |       |                |       |
| NOW and MMDA deposits                                                                                |       | 1          |       | (171              | )          | (170                | )          |
| Savings deposits                                                                                     |       | 88         |       | (778              | )          | (690                | )          |
| Time deposits                                                                                        |       | (145       | )          | (208              | )          | (353                | )          |
| Other borrowings                                                                                     |       | 7          |       | (116              | )          | (109                | )          |
| Total                                                                                                |       | (49        | )          | (1,273            | )          | (1,322              | )          |
| Interest  differential                                                                               |       | $          | 481        |              | $          | (1,825              | )          | $ | (1,344 | ) |

 

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(1) The average balance of non-accruing loans isnot significant as a percentage of total loans and, as such, has been includedin net loans.

 

(2) Does not include taxable-equivalentadjustments that primarily relate to income on certain securities that isexempt from federal income taxes.

 

(3) The rate/volume variance has been includedin the rate variance.

 

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On a quarter over quarterbasis for the period ending June 30, 2008 net interest income hasdecreased $781,000 from the total at June 30, 2007.  Interest incomefrom earning assets has decreased by $1,662,000. Increases in the level ofaverage loans, have resulted in an increase in interest income of $550,000offset by a decrease in the level of federal funds sold of $366,000. Interestincome from volume changes increased $297,000. Decreases in the yields on loansof 146 basis points resulted in a decrease in interest income of $1,751,000 whiledecreases in yields on federal funds sold of 304 basis points decreasedinterest income by $198,000. Interest income from the decline in rates hasdecreased by $1,959,000.

 

On a quarter over quarterbasis, changes in the volume of interest bearing liabilities, primarily thedecrease in balances of certificates of deposit, has resulted in a net decreaseof interest expense of $72,000. Decreases in average rates paid, on all deposit products have resultedin an interest expense decrease of $809,000. The average balances of interest bearing liabilities of $431,921,000were $3,394,000 (.78%) lower in the second quarter of 2008 versus the samequarter in 2007.  As interest bearing liability balances decreased, ratespaid on these liabilities also decreased by 79 basis points on a quarter overquarter basis.  As a result of both the decrease in interest rates and thevolume and mix of interest bearing liabilities, interest expense was $881,000(25.4%) lower in the second quarter versus the same period in 2007.

 

On a year-to-date basis through June 30, 2008,net interest income has decreased $1,344,000 from the total at June 30,2007.  Interest income from earningassets has decreased by $2,666,000. Changes in the volume of earning assets, primarily loans, federal fundssold and certificates of deposits in banks have resulted in an increase ininterest income of $482,000 while interest income from changes in rates hasdecreased by $3,099,000.   Interestexpense for the six month period ending June 30, 2008 was $1,322,000 lessthan the total at June 30, 2007. Changes in the volume of interest bearing liabilities, primarily theincrease in balances of savings and the decrease in time deposits, haveresulted in a net decrease of interest expense of $49,000.  Decreases in average rates paid on alldeposit products have resulted in an interest expense decrease of $1,273,000.

 

The average balances of interest bearing liabilitieswere consistent decreasing only $321,000 (.07%) in the six-month period ended June 30, 2008 compared to the sameperiod in 2007.  Rates paid on interestbearing liabilities decreased 62 basis points compared to the six month periodended June 30, 2007.

 

As a result of the above, the Company’s net interestmargin declined 63 basis points to 5.22% for the three months ended June 30,2008 from 5.85% for he same period in the prior year.  For the six months ended June30, 2008 the netinterest margin also declined 63 basis points to 5.19% compared to 5.82% forthe same periods in the prior year.

 

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**Non-interestIncome**

 

Table Four below providesa summary of the components of non-interest income for the periods indicated(dollars in thousands):

 

**TableFour:  Components of Non-interest Income**

 
| **Three months ended June 30,** | ** ** | **2008** | ** ** | **% of Avg.****Assets** | ** ** | **2007** | ** ** | **% of Avg.****Assets** | ** ** |
|-----------------------------------------------------|------------|----------|------------|-----------------------------------|------------|----------|------------|-----------------------------------|------------|
| Service charges  on deposit accounts                |       | $        | 995        |                              | 0.63       | %        | $          | 873                               |       | 0.61 | % |
| Loan servicing  fees                                |       | 112      |       | 0.08                              | %          | 105      |       | 0.07                              | %          |
| Fees -  alternative investment sales                |       | 154      |       | 0.11                              | %          | 68       |       | 0.05                              | %          |
| Merchant fee  income                                |       | 108      |       | 0.08                              | %          | 107      |       | 0.08                              | %          |
| Gain on the sale  of loans                          |       | 273      |       | 0.19                              | %          | 401      |       | 0.28                              | %          |
| Other                                               |       | 568      |       | 0.80                              | %          | 419      |       | 0.29                              | %          |
| Total  non-interest income                          |       | $        | 2,210      |                              | 1.89       | %        | $          | 1,973                             |       | 1.39 | % |

 
| **Six months ended June 30,** | ** ** | **2008** | ** ** | **% of Avg.  Assets** | ** ** | **2007** | ** ** | **% of Avg.  Assets** | ** ** |
|---------------------------------------------------|------------|----------|------------|---------------------------------|------------|----------|------------|---------------------------------|------------|
| Service charges  on deposit accounts              |       | $        | 1,851      |                            | 0.65       | %        | $          | 1,598                           |       | 0.57 | % |
| Loan servicing  fees                              |       | 223      |       | 0.08                            | %          | 209      |       | 0.07                            | %          |
| Fees -  alternative investment sales              |       | 299      |       | 0.11                            | %          | 155      |       | 0.05                            | %          |
| Merchant fee  income                              |       | 209      |       | 0.07                            | %          | 200      |       | 0.07                            | %          |
| Gain on the sale  of loans                        |       | 501      |       | 0.18                            | %          | 730      |       | 0.26                            | %          |
| Other                                             |       | 1,087    |       | 0.38                            | %          | 797      |       | 0.28                            | %          |
| Total  non-interest income                        |       | $        | 4,170      |                            | 1.47       | %        | $          | 3,687                           |       | 1.31 | % |

 

Non-interest income increasedby $237,000 (12%) to $2,210,000 for the three months ended June 30, 2008as compared to $1,973,000 for the three months ended June 30, 2007. Increases in non-interest income were realized in fees from service charges (up13.9%), loan servicing fees (up 6.7%), fees from alternative investment sales(up 126%) merchant fee income (up 1.0%) and other income (up 35.6%).  Decreases were in gains on the sale of loans(down 31.9%).  The increase in service charge income was the result ofadditional deposit accounts opened during the second quarter throughout oursystem of branches.  Loan servicing fees were up slightly due to thehigher number of loans being serviced. Fees from the sales of alternative investments, such as third-partymutual funds and annuities, were up due to the higher volume of sales duringthe quarter with the addition of another commission based sales person.  Merchant fee income was higher in the secondquarter due to an increase in the volume of credit card sales. Increases in the“Other” category were a result of increased fees from ATM transactions,commissions earned on sales of insurance policies and fees paid for payrollprocessing through our Business Services Division.   Gains on sales of loans into the secondarymarket decreased compared to the prior year as the loans sold by our Governmentand Mortgage Lending Divisions decreased as refinancing and new housingconstruction activity slowed.

 

Non-interest incomeincreased by $483,000 (13.1%) to $4,170,000 for the six months ended June 30,2008 as compared to $3,687,000 for the six months ended June 30,2007.  Increases in non-interest income were realized in fees from servicecharges (up 15.8%), loan servicing fees (up 6.7%), fees from alternativeinvestment sales (up 92.9%), merchant fee income (up 4.5%) and other income (up36.2%).    There was a decrease inthe gain on the sale of loans (down 31.4%).  The increase in service charge income was the result of additionaldeposit accounts opened during the first half of the year throughout our systemof branches.   Loan servicing fees wereup due to the higher number of loans being serviced.  Fees from the sales of alternativeinvestments, such as third-party mutual funds and annuities, were up due to thehigher volume of sales.  Merchant feeincome was higher in the first six months of 2008 due to an increase in thevolume of credit card sales of the same time frame in 2007. Increases in the “Other”category were a result of increased fees from ATM transaction, commissionsearned on sales of insurance policies and fees paid for payroll processingthrough our Business Services Division. Gains on sales of loans into the secondary market decreased during thefirst half of 2008 as compared to the same period in 2007 for the same reasonsstated above for the three month period.

 

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**Non-interestExpense**

 

Non-interest expenseincreased slightly by $65,000 (1.00%) from $6,657,000 in the second quarter of2007 to $6,722,000 in the second quarter of 2008.  Salary and employeebenefits declined by $280,000 (7.1%) as a result of staff attrition and lowerexpenses related to bonus accruals and retirement programs. On a quarter overquarter basis, occupancy expenses were higher by $260,000 (57.3%).  This increase is related to rent expense onthe seven buildings which were sold in January and leased back by theCompany as well as increases in utilities, landscape maintenance, janitorialservices and property taxes.  Furniture and equipment expense was $651,000in the second quarter of 2008 compared to $534,000 in the same period of 2007,representing a 21.9% increase.  This increase relates to the depreciation recordedon the purchase of new technology software and hardware as well as additionalfurniture and fixtures at the new Redding and Anderson branches opened in thethird quarter of 2007.  Other expensesdecreased $32,000 from $1,735,000 to $1,703,000 in the second quarter of 2008versus the second quarter of 2007.

 

Non-interest expenseincreased $352,000 (2.6%) from $13,362,000 in the first six months of 2007 to$13,714,000 in the first six months of 2008. Salary and employee benefitsdeclined by $601,000 (8.2%) as a result of staff attrition and lower expensesrelated to bonus accruals and retirement programs.  On a year over year basis, full timeequivalent employees decreased by 16 to 242. Occupancy expense was up $447,000 (47.4%) from the first six months of2007 to the first six months of 2008. This increase is related to rent expense on the seven buildings whichwere sold in January and leased back by the Company as well as increasesin utilities, landscape maintenance, janitorial services and property taxes.Furniture and equipment expense was up $213,000 (19.7%) from the first sixmonths of 2007 to the first six months of 2008 due to the new branchesdiscussed above and increases in depreciation from purchases of equipment andassociated maintenance contracts.  Otherexpenses increased by $292,000 (8.6%). This increase was attributable to higher telephone and postage costs aswell as increased advertising and promotion costs.

 

**Provisionfor Loan Losses**

 

The Company provided$450,000 for loan losses for the second quarter of 2008 compared to noprovision in the second quarter of 2007. Net loan charge-offs for the second quarter of 2008 and 2007 were$208,000 and $8,000 respectively.  Forthe first six months of 2008, the Company recorded provisions for loan lossesof $675,000 which compared to $75,000 for the first six months of 2007.  Net loan charge-offs for the six months endedJune 30, 2008 and June 30, 2007 were $220,000 and $8,000respectively.   Management assesses itsloan 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.

 

**Provisionfor Income Taxes**

 

The effective tax ratefor the second quarter and first six months of 2008 remained consistent at41.1% and 41.3%, versus 41.6% and 41.9% for the same periods in 2007.

 

**BalanceSheet Analysis**

 

The Company’s totalassets were $564,440,000 at June 30, 2008 down $16,180,000 (2.9%) from$580,620,000 at December 31, 2007.  On a year over year basis, theaverage balance of total assets for the six months ended June 30, 2008 was$569,816,000, which represents a slight increase of $3,046,000 (.54%) over the$566,770,000 during the six-month period ended June 30, 2007.

 

**Loans**

 

The Company concentratesits lending activities in the following principal areas: 1) commercial; 2) realestate mortgage; 3) residential real estate and real estate construction (bothcommercial and residential); 4) agriculture; and 5) consumer loans. Commercial and residential real estate loans are generally secured by improvedproperty, with original maturities of 3-10 years.  At June 30, 2008,these principal areas accounted for approximately 17%, 47%, 16%, 8% and 12%,respectively, of the Company’s loan portfolio.  The mix at December 31,2007 was 17%, 47%, 18%, 6% and 12%.

 

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Growth in the real estateloan category has slowed during the current economic downturn as we areexperiencing more requests by borrowers to extend the terms of their loansthereby reducing the amount of loan payoffs we would normally expect.   New loan growth has occurred in thecommercial, agriculture and consumer loan types.  Increases in loan balances from December 31,2007 for commercial loans of $5,483,000 or (7.1%), commercial and residentialmortgage real estate loans of $25,693,000 or (5.1%), agricultural loans of$12,660,000 or (49.9%), consumer loans of $5,881,000 or (10.9%).  Real estate construction loans decreased$1,258,000 or (1.5%) over the same period.  Table Five below summarizesthe composition of the loan portfolio as of June 30, 2008 and December 31,2007.

 

**TableFive: Loan Portfolio Composition**

 
| **(In thousands)**    | ** ** | **June 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|----------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| Commercial                 |       | $                           | 83,163     |                            | $          | 77,680 |   |
| Real estate:               |       |                        |       |                            |       |
| Mortgage                   |       | 234,224                     |       | 208,531                         |       |
| Construction               |       | 80,633                      |       | 81,891                          |       |
| Agriculture                |       | 38,027                      |       | 25,367                          |       |
| Consumer                   |       | 59,682                      |       | 53,801                          |       |
| Total loans                |       | 495,729                     |       | 447,270                         |       |
| Allowance for  loan losses |       | (6,241                      | )          | (5,232                          | )          |
| Deferred loan  fees, net   |       | (550                        | )          | (688                            | )          |
| Total net loans            |       | $                           | 488,938    |                            | $          | 441,350 |   |

 

The majority of theCompany’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.

 

Commercial loans consistof credit lines for operating needs, loans for equipment purchases, workingcapital, and various other business loan products.  Consumer loans includea range of traditional consumer loan products such as personal lines of creditand loans to finance purchases of autos, boats, recreational vehicles, mobilehomes and various other consumer items.

 

Real estate constructionloans are generally composed of commitments to customers within the Company’sservice area for construction of both commercial properties and custom andsemi-custom single-family residences.  Other real estate loans consistprimarily of loans secured by first trust deeds on commercial and residentialproperties typically with maturities from 3 to 10 years and original loan tovalue ratios generally from 65% to 80%.  Agriculture loans consistprimarily of crop loans to farmers of peaches, prunes, walnuts, andalmonds.  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.

 

**RiskElements**

 

The Company assesses andmanages credit risk on an ongoing basis through a total credit culture thatemphasizes excellent credit quality, extensive internal monitoring andestablished formal lending policies.  Additionally, the Company contractswith an outside loan review consultant to periodically review the existing loanportfolio.  Management believes its ability to identify and assess riskand return characteristics of the Company’s loan portfolio is critical forprofitability and growth.  Management strives to continue its emphasis oncredit quality in the loan approval process, active credit administration andregular monitoring.  With this in mind, management has designed andimplemented a comprehensive loan review and grading system that functions tocontinually assess the credit risk inherent in the loan portfolio.

 

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

 

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

 

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The Company hassignificant extensions of credit and commitments to extend credit that aresecured by real estate.  The ultimate repayment of these loans is generallydependent on personal or business cash flows or the sale or refinancing of thereal estate.  The Company monitors the effects of current and expectedmarket conditions and other factors on the collectability of real estateloans.  The more significant factors management considers involve thefollowing:  lease, absorption and sale rates; real estate values and ratesof return; operating expenses; inflation; and sufficiency of collateralindependent of the real estate including, in limited instances, personalguarantees.

 

In extending credit andcommitments to borrowers, the Company generally requires collateral and/orguarantees as security.  The repayment of such loans is expected to comefrom cash flow or from proceeds from the sale of selected assets of theborrowers.  The Company’s requirement for collateral and/or guarantees isdetermined on a case-by-case basis in connection with management’s evaluationof the creditworthiness of the borrower.  Collateral held varies but mayinclude accounts receivable, inventory, property, plant and equipment,income-producing properties, residences and other real property.  TheCompany secures its collateral by perfecting its security interest in businessassets, obtaining deeds of trust, or outright possession among other means.

 

In management’s judgment,a concentration exists in real estate loans, which represented approximately63.5% of the Company’s loan portfolio at June 30, 2008, which is slightlyless, on a percentage basis, than the 64.9% concentration level at December 31,2007.  Management believes the concentration to have no more than thenormal risk of collectability; however, a substantial decline in the economy ingeneral, or a decline in real estate values in the Company’s primary marketareas in particular, could have an adverse impact on the collectability ofthese loans and require an increase in the provision for loan losses whichcould adversely affect the Company’s future prospects, results of operations,profitability and stock price.  Management believes that its lendingpolicies and underwriting standards will tend to minimize losses in an economicdownturn; however, there is no assurance that losses will not occur under suchcircumstances.  The Company’s loan policies and underwriting standardsinclude, but are not limited to, the following: (1) maintaining a thoroughunderstanding of the Company’s service area and originating a significantmajority of its loans within that area, (2) maintaining a thoroughunderstanding of borrowers’ knowledge, capacity, and market position in theirfield of expertise, (3) basing real estate loan approvals not only onmarket demand for the project, but also on the borrowers’ capacity to supportthe project financially in the event it does not perform to expectations(whether sale or income performance), and (4) maintaining conforming andprudent loan to value and loan to cost ratios based on independent outsideappraisals and ongoing inspection and analysis by the Company’s lendingofficers.  The Company does notparticipate in any sub-prime lending activities.

 

**Nonaccrual,Past Due and Restructured Loans**

 

Management generallyplaces loans on nonaccrual status when they become 90 days past due, unless theloan is well secured and in the process of collection.  Loans are chargedoff when, in the opinion of management, collection appears unlikely.

 

Table Six below setsforth nonaccrual loans as of June 30, 2008 and December 31,2007.  There were no loans past due 90 days or more and still accruinginterest at June 30, 2008 or December 31, 2007.

 

**TableSix:  Non-Performing Loans**

 
| **(In thousands)**     | ** ** | **June 30,2008** | ** ** | **December 31, 2007** | ** ** |
|-----------------------------|------------|-----------------------|------------|---------------------------------|------------|
| Nonaccrual:                 |       |                  |       |                            |       |
| Commercial                  |       | $                     | 197        |                            | $          | — |   |
| Real estate                 |       | 932                   |       | 253                             |       |
| Consumer and  other         |       | —                |       | —                          |       |
| Total  non-performing loans |       | $                     | 1,129      |                            | $          | 253 |   |

 

At June 30, 2008,there were eight non-performing loans which were considered to beimpaired.  Of these two were non-performing commercial loans.   One of the commercial loans was for $178,998and has an 80% SBA guarantee, resulting in an exposure to the Company$35,800.  The other commercial loan wasfor $18,178 and is secured with a truck which the Company is attempting tosell.  There were six non-performing realestate loans.  Of these three were equitylines of credit, one of which has paid off subsequent to the end of thereporting period for $11,810.  The secondloan was for $35,031 with an original loan amount of $75,000.  A new appraisal was completed during the secondquarter resulting in a lower appraised value. As a result of this appraisal, $40,000 of this loan was charged off inthe second quarter of this year.   Thethird loan had a balance of $26,905 and a new appraisal is forthcoming and theCompany has a potential buyer for this property.  The fourth loan was for the construction of asingle family residence that has a current balance of $612,500.  The construction of the home is complete butthe borrowers are granting the Company a deed-in-lieu of foreclosure.   The home was recently in escrow with a salesprice of $732,000 but the purchase was not completed.  A new appraisal has been ordered and ourestimated loan to value is 84%.  Thefifth loan is a construction loan for a duplex located in Sacramento with abalance of

 

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 $119,560. The borrower stopped construction with the structure 40% complete.  The Company is soliciting bids from qualifiedcontractors to complete the project.  Thefinal loan is a lot loan in Amador County with a balance of $126,694.  The lot declined in value and the borrowerhas stated he no longer plans to make the loan payments.   There were no loan concentrations in excessof 10% of total loans not otherwise disclosed as a category of loans as of June 30,2008 or December 31, 2007.  Management is not aware of any potentialproblem loans, which were accruing and current at June 30, 2008, whereserious doubt exists as to the ability of the borrower to comply with thepresent repayment terms.

 

**Allowancefor Loan Losses Activity**

 

We employ a systematicmethodology for determining the allowance for loan losses that includes amonthly review process and monthly adjustment of the allowance.  Ourprocess includes a periodic 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.

 

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

 

Qualitative factorsinclude the general economic environment in our markets and, in particular, thestate of the agriculture industry and other key industries in the NorthernSacramento Valley.  The way a particular loan might be structured, theextent and nature of waivers of existing loan policies, loan concentrations andthe rate of portfolio growth are other qualitative factors that are considered.

 

Our methodology is, andhas been, consistently followed.  However, as we add new products,increase in complexity, and expand our geographic coverage, we expect toenhance our methodology to keep pace with the size and complexity of the loanportfolio.  On an ongoing basis we engage outside firms to independentlyassess our methodology, and to perform independent credit reviews of our loanportfolio.  The FDIC and the California Department of FinancialInstitutions review the allowance for loan losses as an integral part of theexamination processes.  Management believes that our current methodologyis appropriate given our size and level of complexity.  Further,management believes that the allowance for loan losses is adequate as of June 30,2008 to cover known and inherent risks in the loan portfolio.  However,fluctuations in credit quality, or changes in economic conditions or otherfactors could cause management to increase or decrease the allowance for loanlosses as necessary.

 

The Board of Directors of the Bank reviews theadequacy of the allowance for loan losses at least quarterly to includeconsideration of the relative risks in the portfolio and current economicconditions.  The allowance is adjusted based on that review if, in thejudgment of the loan committee and management, changes are warranted.  Theallowance for loan losses totaled $6,241,000 or 1.26% of total loans at June 30,2008 and $5,232,000 or 1.17% at December 31, 2007.  The Company has established a separate reservefor unfunded loan commitments of $306,000 as of June 30, 2008 compared to$860,000 as of December 31, 2007 and included in accrued interest payableand other liabilities on the Company’s balance sheet.

 

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

 

**TableSeven: Allowance for Loan Losses**

 
| ** **                                                                | ** ** | **Three Months  Ended  June 30,** | ** ** | **Six Months  Ended  June 30,** | ** ** |
|---------------------------------------------------------------------------|------------|---------------------------------------------|------------|-------------------------------------------|------------|
| **(In thousands, except for percentages)**            | ** ** | **2008**                                    | ** ** | **2007**                                  | ** ** | **2008** | ** ** | **2007** | ** ** |
| Average loans  outstanding                                                |       | $                                           | 477,500    |                                      | $          | 452,899 |   | $ | 463,743 |   | $ | 453,057 |   |
| Allowance for  possible loan losses at beginning of period                |       | $                                           | 6,025      |                                      | $          | 5,349 |   | $ | 6,092 |   | $ | 5,274 |   |
| Loans charged  off:                                                       |       |                                        |       |                                      |       |   |   |   |   |
| Commercial                                                                |       | (36                                         | )          |                                      |       | (43 | ) |   |   |
| Real estate                                                               |       | (173                                        | )          | (8                                        | )          | (173 | ) | (8 | ) |
| Consumer                                                                  |       | —                                      |       |                                      |       | (5 | ) |   |   |
| Total                                                                     |       | (209                                        | )          | (8                                        | )          | (221 | ) | (8 | ) |
| Recoveries of  loans previously charged off:                              |       |                                        |       |                                      |       |   |   |   |   |
| Commercial                                                                |       | —                                      |       | —                                    |       | — |   |   |   |
| Real estate                                                               |       | —                                      |       | —                                    |       | — |   |   |   |
| Consumer                                                                  |       | 1                                           |       | —                                    |       | 1 |   | — |   |
| Total                                                                     |       | 1                                           |       | —                                    |       | 1 |   | — |   |
| Net loan charge  offs                                                     |       | (208                                        | )          | (8                                        | )          | (220 | ) | (8 | ) |
| Additions to  allowance charged to operating expenses                     |       | 450                                         |       | —                                    |       | 675 |   | 75 |   |
| Allowance for  unfunded loan commitments                                  |       | (26                                         | )          | (36                                       | )          | (306 | ) | (36 | ) |
| Allowance for  loan losses at end of period                               |       | $                                           | 6,241      |                                      | $          | 5,305 |   | $ | 6,241 |   | $ | 5,305 |   |
| Ratio of net  charge-offs to average loans outstanding                    |       | 0.04                                        | %          | 0.00                                      | %          | 0.05 | % | 0.00 | % |
| Provision for  possible loan losses to average loans outstanding          |       | 0.09                                        | %          | 0.00                                      | %          | 0.15 | % | 0.02 | % |
| Allowance for  loan losses to loans net of deferred fees at end of period |       | 1.26                                        | %          | 1.17                                      | %          | 1.26 | % | 1.17 | % |

 

It is the policy ofmanagement to maintain the allowance for loan losses at a level adequate forknown and inherent risks in the portfolio.  Based on information currentlyavailable to analyze inherent credit risk, including economic factors, overallcredit quality, historical delinquencies and a history of actual charge-offs,management believes that the provision for loan losses and the allowance areadequate.  The Company generally makes monthly allocations to theallowance for loan losses.  The budgeted allocation is based on estimatesof loss risk and loan growth.  Adjustments may be made based ondifferences from estimated loan growth, the types of loans constituting thisgrowth, changes in risk ratings within the portfolio, and general economicconditions.  However, no prediction of the ultimate level of loans chargedoff in future years can be made with any certainty.

 

**OtherReal Estate**

 

The Company is still marketing the six single familyresidential lots acquired through foreclosure as discussed in the March 31,2008 10-Q.  These lots with a carryingvalue of $837,250 at June 30, 2008 are classified as other real estate (“ORE”)and included in accrued interest receivable and other assets on the Company’sbalance sheet.  One of the lots islocated in Paradise where a recent wildfire burned the property.  Subsequent to the fire, the Companycharged-off $44,500 of the outstanding balance.   The second lot is located in El Dorado Hillsand is listed with a local realtor.  Thisproperty was written down by $25,000 in the second quarter due to the lack ofbuyer activity.  The final four lots arelocated in Mt. Shasta City and are listed with a local realtor.  The listing price has been recently reducedby $60,000 as the realtor has stated there have been very few sales in thearea.  At December 31, 2007, theCompany did not have any ORE properties.

 

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**Deposits**

 

At June 30, 2008,total deposits were $497,192,000 representing a decrease of $3,799,000 (.76%)from the December 31, 2007 balance of $500,991,000.  Non-interestbearing deposits increased slightly by $705,000 (1.0%) from $77.6 million at December 31,2007.  Interest bearing demand depositsdecreased slightly by $479,000 (.31%) to $152 million while savings depositsincreased $6.3 million (5.7%). Certificate of deposit balances decreased by $10.3 million (6.5%) to$149.2 million.

 

As discussed in the March 31,2008 Form 10-Q, during the months of May, June, and July approximately$96 million in certificate of deposit balances were to mature and reprice.  We saw this as an opportunity to dramaticallydecrease our interest expense as these deposits had an average weighted yieldof 4.95%.   We were able to reduce theweighted average yield of the certificates that matured during May and June by145 basis points and retained 91% of the deposits.  We anticipate similar results with the $24million maturing in July.

 

**CapitalResources**

 

The current and projectedcapital position of the Company and the impact of capital plans and long-termstrategies are reviewed regularly by management. The Company’s capital positionrepresents the level of capital available to support continued operations andexpansion.

 

The Board of Directors ofthe Company authorized the payment of quarterly cash dividends totaling $0.32per share for 2007 and $0.08 and $0.04 per share for the first and secondquarters of 2008 respectively.  The payment of dividends in the future issubject to the discretion of the Board of Directors of the Company and will dependon earnings, the financial condition of the Company and other relevant factors.

 

The Company and itssubsidiary Bank are subject to certain regulations issued by the Board ofGovernors of the Federal Reserve System and the FDIC which require maintenanceof certain levels of capital.  On June 30, 2008 the Company borrowed$4 million from one of its correspondent banks which was downstreamed to ButteCommunity Bank into the capital accounts. This note is for a two year period with a maturity date of June 30,2010 and an interest rate equal to the three month LIBOR rate plus 3.25%adjusted quarterly.   At the time thenote was written the rate of interest was 5.97%. At June 30, 2008,shareholders’ equity was $39,509,000, representing a decrease of $11,465,000 (22.5%)from $50,974,000 at December 31, 2007.  The decrease is primarily theresult of the Tender Offer of 1 million shares at $13.00 per share done in April ofthis year resulting in the retirement of 1 million shares of the Company’scommon stock for a total purchase price of $13 million.  This offer was over subscribed andparticipating shareholders were paid a pro-rata share on May 5, 2008representing 63.38% of the shares tendered. Net income from the period offset by the stock based compensation expenserecorded and cash dividends discussed above also had an affect on thetotal.  The Bank’s ratio of total risk-based capital to risk adjustedassets was 10.2% at June 30, 2008 and 11.4% at December 31, 2007. Tier 1 risk-based capital to risk-adjusted assets was 9.0% at June 30,2008 and 10.4 at December 31, 2007.

 

Table Eight below liststhe Company’s and the Bank’s capital ratios at June 30, 2008 and December 31,2007, as well as the minimum ratios required under regulatory definitions ofcapital adequacy.

 

**TableEight: Capital Ratios**

** **
| **Capital to Risk-Adjusted Assets** | ** ** | **At June 30,  2008** | ** ** | **At December 31,  2007** | ** ** | **Minimum Regulatory  Requirement** | ** ** |
|----------------------------------------------------|------------|---------------------------------|------------|-------------------------------------|------------|------------------------------------------|------------|
| Company                                            |       |                            |       |                                |       |                                     |       |
| Leverage ratio                                     |       | 8.4                             | %          | 11.6                                | %          | 4.0                                      | %          |
| Tier 1  Risk-Based Capital                         |       | 8.9                             | %          | 13.1                                | %          | 4.0                                      | %          |
| Total Risk-Based  Capital                          |       | 10.1                            | %          | 14.1                                | %          | 8.0                                      | %          |
|                                               |       |                            |       |                                |       |                                     |       |
| Bank                                               |       |                            |       |                                |       |                                     |       |
| Leverage ratio                                     |       | 8.6                             | %          | 9.3                                 | %          | 4.0                                      | %          |
| Tier 1  Risk-Based Capital                         |       | 9.0                             | %          | 10.4                                | %          | 4.0                                      | %          |
| Total Risk-Based  Capital                          |       | 10.2                            | %          | 11.4                                | %          | 8.0                                      | %          |

 

Capital ratios arereviewed on a regular basis to ensure that capital exceeds the prescribedregulatory minimums and is adequate to meet future needs.  All ratios arein excess of the regulatory definition of “Minimum” at June 30, 2008 and December 31,2007.  The Bank was considered “well-capitalized” by regulatory standards,at June 30, 2008 and December 31, 2007.

 

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**Item 3.  Quantitative and Qualitative Disclosures aboutMarket Risk**

 

**MarketRisk Management**

 

*Overview*. Market risk is the risk of loss from adverse changes in market prices andrates.  The Company’s market risk arises primarily from interest rate riskinherent in its loan, investment and deposit portfolios.  The goal formanaging the assets and liabilities of the Company is to maximize shareholdervalue and earnings while maintaining a high quality balance sheet withoutexposing the Company to undue interest rate risk.

 

The Board of Directorshas overall responsibility for the interest rate risk managementpolicies.  The Bank has an Asset and Liability Management Committee (ALCO)that establishes and monitors guidelines to control the sensitivity of earningsto changes in interest rates.

 

*Asset/LiabilityManagement*.  Activities involved in asset/liabilitymanagement include, but are not limited to, lending, accepting and placingdeposits, investing in securities, using trust preferred securities andborrowings.  Interest rate risk is the primary market risk associated withasset/liability management.  Sensitivity of earnings to interest ratechanges arises when yields on assets change in a different time period or in adifferent amount from that of interest costs on liabilities.  To mitigateinterest rate risk, the structure of the balance sheet is managed with the goalthat movements of interest rates on assets and liabilities are correlated andcontributes to earnings even in periods of volatile interest rates.  Theasset/liability management policy sets limits on the acceptable amount ofvariance in net interest margin and market value of equity under changinginterest environments.  The Company uses simulation models to forecastearnings, net interest margin and market value of equity.

 

Simulation of earnings isthe primary tool used to measure the sensitivity of earnings to interest ratechanges.  Using computer-modeling techniques, the Company is able toestimate the potential impact of changing interest rates on earnings.  Abalance sheet forecast is prepared monthly using inputs of actual loans,securities and interest bearing liability (i.e. deposits/borrowings) positionsas the beginning base.  The forecast balance sheet is processed againstseven interest rate scenarios.  These scenarios include a 100, 200 and 300basis point rising rate forecast, a flat rate forecast and a 100, 200 and 300basis point falling rate forecast which take place within a one year timeframe.

 

 The net interest income is measured during theyear assuming a gradual change in rates over the twelve-month horizon. The Company’s net interest income, as forecast below, was modeled utilizing aforecast balance sheet projected from balances as of the date indicated.

 

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

 

**TableNine:  Interest Rate Risk Simulation of Net Interest as of June 30,2008 and December 31, 2007**

 
| **(In thousands)**                  | ** ** | **$ Change in NIL  from Current  12 Month Horizon  June 30, 2008** | ** ** | **$ Change in NIL  from Current  12 Month Horizon  December 31, 2007** | ** ** |
|------------------------------------------|------------|------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------|------------|
| Variation from a  constant rate scenario |       |                                                                                                       |       |                                                                                                           |       |
| +200bp                                   |       | $                                                                                                          | 3,299      |                                                                                                           | $          | 3,510 |   |
| -200bp                                   |       | $                                                                                                          | (3,400     | )                                                                                                              | $          | (3,847 | ) |

 

Assumptions areinherently uncertain, and, consequently, the model cannot precisely measure netinterest income or precisely predict the impact of changes in interest rates onnet interest income. Actual results will differ from simulated results due totiming, magnitude and frequency of interest rate changes, as well as changes inmarket conditions and management strategies which might moderate the negativeconsequences of interest rate deviations. In the model above, the simulationshows that the Company is asset sensitive over the one-year horizon asincreasing rates have a positive impact on net interest income and decliningrates have a negative impact.

 

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**Inflation**

 

The impact of inflationon a financial institution differs significantly from that exerted onmanufacturing, or other commercial concerns, primarily because its assets andliabilities are largely monetary.  In general, inflation primarily affectsthe Company and it subsidiaries through its effect on market rates of interest,which affects the Company’s ability to attract loan customers.  Inflationaffects the growth of total assets by increasing the level of loan demand, andpotentially adversely affects capital adequacy because loan growth ininflationary periods can increase at rates higher than the rate capital growsthrough retention of earnings, which may be generated in the future.  Inaddition to its effects on interest rates, inflation increases overalloperating expenses.

 

The economy is not likelyto grow fast enough to absorb the growth of the labor force over the nexttwelve months consequently upward pressure will be placed on the unemploymentrate which is currently around 5.2%. Food prices are rising at an annual rate of nearly 5% and energy pricesare at all time highs.  Slower economicgrowth could moderate the rate of inflation through the remainder of 2008.

 

**Liquidity**

 

Liquidity managementrefers to the Company’s ability to provide funds on an ongoing basis to meetfluctuations in deposit levels as well as the credit needs and requirements ofits clients.  Both assets and liabilities contribute to the Company’sliquidity position.  Federal funds lines, short-term investments andsecurities, and loan repayments contribute to liquidity, along with depositincreases, while loan funding and deposit withdrawals decrease liquidity. The Company assesses the likelihood of projected funding requirements byreviewing historical funding patterns, current and forecasted economicconditions and individual client funding needs.

 

The Company’s sources ofliquidity consist of cash and due from correspondent banks, overnight fundssold to correspondent banks, unpledged marketable investments and loans heldfor sale.  On June 30, 2008, consolidated liquid assets totaled $35.5million or 6.3% of total assets compared to $86 million or 14.8% of totalassets on December 31, 2007.  In addition to liquid assets, theCompany maintains short-term lines of credit in the amount of $15,000,000 withcorrespondent banks.  There were no borrowings outstanding under thesearrangements at June 30, 2008.

 

The Bank also hasinformal agreements with various other banks to sell participations in loans,if necessary.  The Company serves primarily a business and professionalcustomer base and, as such, its deposit base is susceptible to economicfluctuations.  Accordingly, management strives to maintain a balancedposition of liquid assets to volatile and cyclical deposits.

 

Liquidity is alsoaffected by portfolio maturities and the effect of interest rate fluctuationson the marketability of both assets and liabilities.  The Company can sellany of its unpledged securities held in the available-for-sale category to meetliquidity needs.

 

**Off-BalanceSheet Items**

 

The Company has certainongoing commitments under operating leases.  These commitments do notsignificantly impact operating results. As of June 30, 2008 and December 31,2007, commitments to extend credit and letters of credit were the onlyfinancial instruments with off-balance sheet risk.  The Company has notentered into any contracts for financial derivative instruments such asfutures, swaps, options or similar instruments.   Commitments to fund loans and stand-byletters of credit at June 30, 2008 and December 31, 2007 wereapproximately $173.3 million and $190.4 million 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 35.4% and43.1%, respectively.

 

**OtherMatters**

 

**Item 4.  Controls and Procedures**

 

(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, 2008. 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’s management(including the Chief Executive Officer and Chief Financial Officer) to allowtimely decisions regarding required disclosure, and (ii) recorded,processed, summarized and reported within the time periods specified in theCommission’s rules and forms.

 

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(b) Internal ControlOver Financial Reporting: An evaluation of any changes in the Company’sinternal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and15d-15(f)), that occurred during the Company’s fiscal quarter ended June 30,2008, was carried out under the supervision and with the participation of theCompany’s Chief Executive Officer, Chief Financial Officer and other members ofthe Company’s senior management. The Company’s Chief Executive Officer andChief Financial Officer concluded that no change identified in connection withsuch evaluation has materially affected, or is reasonably likely to materiallyaffect, the Company’s internal control over financial reporting.

 

**PART II – OTHER INFORMATION**

 

Item1.  Legal Proceedings.

 

None.

 

Item1A. Risk Factors

 

In addition to the otherinformation set forth in this report, you should carefully consider the factorsdiscussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-Kfor the year ended December 31, 2007, which could materially affect ourbusiness, financial condition or future results. The risks described in ourAnnual Report on Form 10-K are not the only risks facing our Company.Additional risks and uncertainties not currently known to us or that wecurrently deem to be immaterial also may materially adversely affect ourbusiness, financial condition and/or operating results.”  The overall decline in residential realestate values in California, and more specifically in our primary market, hascontinued into 2008.  While the Companyhas not been materially impacted by this trend to the level of some other financialinstitutions, continuing declines in residential real estate will have acontinuing negative impact on the overall economic conditions in the Company’smarkets and may result in increased credit losses and/or reduced opportunitiesfor future growth and profitability.

 

Item2.  Changes in Securities and Use of Proceeds.

 

On March 13, 2008the Company announced a Tender Offer for 1 million shares of the Company’sCommon Stock at $13.00 per share.  Thisoffer was over subscribed and participating shareholders were paid a pro-ratashare on May 5, 2008 representing 63.38% of the shares tendered.

 

Item3.  Defaults Upon Senior Securities.

 

None.

 

Item4.  Submission of Matters to a Vote of Security Holders.

 

TheAnnual Shareholder meeting of the Registrant was held on June 19, 2008.

 

4,741,343shares or 71.2% of the outstanding voting stock was available for quorum.

 

Proposal#1   4,704,859 shares or 70.6% voted forthe election of thirteen directors named in the proxy statement for termsexpiring on the date of the annual meeting in 2009.

 

Item5.  Other Information.

 

None

 

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Table of Contents

 

Item6.  Exhibits

 

(a)  Exhibits

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

 

 

**SIGNATURES**

 

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

 
|                     | COMMUNITY VALLEY BANCORP            |
|---------------------|-------------------------------------|
|                |                                |
| August 8, 2008 |                                | *By: /s/ Keith C. Robbins* |
|                |                                |
|                | Keith C. Robbins                    |
|                |                                |
|                | President, Chief  Executive Officer |
|                |                                |
| August 8, 2008 |                                | *By: /s/ John F. Coger* |
|                |                                |
|                | John F. Coger                       |
|                |                                |
|                | Executive Vice  President, CFO, COO |

 

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